Cyprus—2009 Article IV Consultation, Concluding Statement of the Mission
June 29, 2009
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
The global crisis has started to affect Cyprus. After some years of credit-financed overheating, the economy is headed for a sharp slowdown which will put pressure on the private sector, banks and the public sector to adjust balance sheets. Cyprus has been relatively shielded from the crisis until now, largely because of a lesser reliance on exports, prudent fiscal policies in the past, euro adoption, and a resilient financial sector which has not needed public capital injections. However, the evaporation of growth in 2009–10 will worsen credit risk in the banking sector which will bear monitoring and make current fiscal policies unsustainable without a policy correction. Structural reforms will be needed to assist the recovery and boost growth potential.
1. Cyprus appears to be weathering the global crisis so far. It is the only country in the euro area to record positive growth in the first quarter of 2009, and among those that have not required public capital injections into its financial sector. The relatively benign impact of the crisis is due, in part, to conservative financial sector practices and strict supervision, and the elimination of exchange rate risk following euro adoption. Past budget surpluses, low public debt, and the long-awaited enactment of pension reforms have also sustained investor confidence, as evidenced by a successful sovereign bond issue in June 2009.
2. Nevertheless, the economy is headed for a sharp slowdown in 2009-10. This deterioration is inevitable given Cyprus’ close links with its key economic partners—the U.K., Greece, and Russia—who are already facing economic difficulties. Growth is forecast to fall sharply to ⅓ percent in 2009 followed by a mild recovery to some 1 percent in 2010. A recession looks unlikely at this stage, although, given large uncertainties, a worse outcome cannot be ruled out. Medium-term recovery will be tepid unless competitiveness is enhanced.
3. The downturn has begun to expose underlying vulnerabilities that have built up during the credit-financed overheating of the economy in 2007-08. The private sector is highly leveraged, and banks and households have large exposures to the property market which is beginning to correct itself. Balance sheets will therefore need to adjust to the new economic realities. Moreover, the budget deficit has increased sharply due to recent inelastic spending increases in combination with declining revenues. Finally, a large current account deficit may not be sustainable over the medium-term.
4. Policies for 2009-10 will need to mitigate short-term risks without endangering medium-term sustainability. Euro adoption has shrunk the policy tool kit, with the onus on fiscal policy, financial sector supervision and structural reforms to deliver the authorities’ medium-term objectives of promoting growth and fostering social cohesion. The mission’s recommendations therefore focus on identifying the main priorities for policymakers.
Financial Sector: Prevention will be easier than a cure
5. A key priority should be to preserve the strength of the financial sector through continued strong supervision and early detection of risks. Given the large size of the sector relative to the economy and high concentration ratios, problems in this sector can quickly escalate to systemic proportions with serious repercussions for the economy. Policies should therefore focus on nipping problems in the bud.
6. The financial sector is holding up, helped by its focus on traditional banking activities, predominant reliance on domestic retail funding, and limited exposure to toxic assets. Both domestic and foreign deposits are holding steady thanks to confidence in the banking system, the planned expansion of deposit insurance, and the relative strength of the banking sector compared with the region. Lending has decelerated as underwriting standards have been tightened to protect asset quality. Deposit rates have started to decline as liquidity concerns have subsided.
7. Banks, supervisors and policymakers have reacted appropriately to the crisis. Banks are restructuring their balance sheets by increasing interest rate spreads to preserve profitability, strengthening capital, securing funding, and enhancing risk management. Supervisors have increased vigilance and welcome improvements to the regulatory framework are in the works. There has been significant progress in implementing EU Directives and recommendations from the IMF’s 2008 Financial Sector Assessment Program. Increased funding for the deposit insurance scheme is reassuring. A legal framework for covered bonds should ease banks’ access to ECB liquidity facilities and should be implemented rapidly. The draft law on crisis management should strengthen the authorities’ hand in preemptively addressing liquidity or insolvency problems.
8. Although bank soundness indicators are likely to weaken further, risks seem manageable. Bank profitability and capital buffers have declined, while NPLs have risen. These indicators are likely to deteriorate further, but stress tests indicate that risks remain contained. Risks from counterparty exposure and contagion have also eased in line with improving global financial conditions. Going forward, the most important risk to financial stability is the worsening economic environment, given a highly leveraged private sector and a relatively unseasoned and untested bank credit portfolio.
9. There will be continued need for strong supervision and enhanced cross-border cooperation. Cyprus’ reputation as a financial center depends on effective and arms-length supervision by an independent and accountable central bank. Since liquidity risk can rise quickly in response to international developments, the Central Bank of Cyprus (CBC) will benefit from EU initiatives on monitoring developments in bank funding, cross-border exposures, and counterparty risk management. The CBC could consider preemptively requiring higher regulatory capital on account of an expected deterioration in asset quality and liquidity risk—this may delay planned dividend pay-outs. Loan-to-value ratios on second homes may need to be reviewed in line with property price developments. Shortening the foreclosure procedure will facilitate a more rapid property price correction and bank balance sheet adjustment. Participation—as host and home supervisor—in supervisory colleges by end-2009 should strengthen cross-border supervision.
10. There is room to further improve supervision and the safety net. The stress testing framework should be expanded to include a wider coverage of institutions (including cooperatives) and risks. Better monitoring and cross-checking of results and improved CYSTAT statistics on real estate and household leverage would help risk assessment. Additional resources would be required for financial sector supervisors and financial stability assessments. Over the medium term, a single supervisor for all credit institutions operating in Cyprus could enhance efficiency, and establish a level playing field. Given the integrated nature of the financial sector in Cyprus, a more integrated supervisory structure based in the CBC would be preferable to the current sectoral approach. Ongoing work in the EU to strengthen the crisis management framework (including deposit guarantee schemes) is expected to strengthen the Cypriot authorities’ preparedness further.
Fiscal Policy: The public sector must live within its means to be sustainable
11. The mission supports the government’s desired fiscal objectives—to reduce the budget deficit below 3 percent of GDP in 2009-10 and achieve a balanced budget over the medium-term. For a small open economy like Cyprus, fiscal expansion to support growth is less likely to be effective given high import elasticities. As markets increasingly differentiate between country risks even within the euro area, the fiscal multiplier could turn negative if large deficits reduce investor confidence in fiscal sustainability. A conservative fiscal stance would, on the other hand, help sustain confidence in the financial sector by improving the perceived ability of public finances to absorb financial sector-related contingent liabilities, and keep public sector guarantees credible.
12. Current policies would need to be strengthened significantly to achieve the government’s objectives. On current spending plans, we estimate that the general government deficit will reach 3.9 percent of GDP in 2009, a sharp reversal from the surpluses of 2007-08. Without significant course correction in 2009-10, this could be the beginning of an expansionary debt-deficit cycle which will soon be unsustainable. The mission estimates that the budget deficit would need to decline by some ½−¾ percent of GDP a year to achieve the government’s own objective of structural fiscal balance over the medium-term.
13. The announced spending priorities are appropriate; however policies are moving in the opposite direction. According to the Stability Program, the government intends to curtail public consumption while emphasizing productivity-enhancing investments, structural reforms and social spending. The measures identified so far are all on the revenue side, with relatively small and temporary effects on the budget deficit. Spending measures—for example, the envisaged hiring plans and wage increases and untargeted social support measures introduced in past years—will permanently increase public consumption. On the other hand, productivity-enhancing investments have been slow to get off the ground and plans to expedite private investment approvals have not been effective.
14. Fiscal adjustment should rely on reducing public consumption, especially the wage bill which accounts for a third of total spending. Hiring and wage controls and a more efficient use of civil servants in the context of a broader public administration reform would be desirable. It may be time to extend the concept of flexicurity from the private sector to the public sector. These measures would control the wage bill, reduce crowding out of the private sector in the labor market, improve social cohesion, and increase productivity. To further enhance social cohesion and protect the budget, social support measures should be targeted to reach the truly needy; untargeted schemes implemented in 2008 may need to be revisited. It would also be critical that the temporary stimulus measures be reversed when the economy recovers. A medium-term budget framework aiming to contain spending below nominal GDP growth and control public sector employment should be implemented.
15. Public sector asset-liability and cash management should be improved. It should be bolstered by transparently accounting for contingent liabilities which would need to be monitored carefully so that overall exposures do not deteriorate rapidly as economic conditions worsen. Public sector aid programs should be designed to protect competition and minimize moral hazard and adverse selection.
16. The passage of long-delayed pension reforms is commendable; however, additional reforms may be needed down the road to reduce budget spending. The recent reforms increase contribution rates, tighten eligibility criteria, and aim to establish an independent body to manage assets. Real reserves are being accumulated in the Social Investment Fund with periodic reviews to assess the Fund’s viability and take necessary corrective actions. Additional reforms that will become necessary over time are: increasing the retirement age in line with other euro area countries; indexing benefits to prices to reduce spending pressures, and better aligning public and private pension benefits.
Structural reforms: Translating plans into action will be critical
17. Improving competitiveness will assist recovery and enhance growth potential. Cyprus remains attractive to foreign investors due to strategic, historical, institutional and economic advantages. It is also gaining competitiveness in the broader service sector. However, manufacturing and tourism face competitiveness problems, and wage growth has outstripped productivity increases. Cyprus will also need to replace jobs lost in construction.
18. The priorities and plans in the National Reform Program are appropriate; however, implementation has been slow. A key priority should be to reduce red tape and improve the business climate, helped by improving the productivity of the public sector. Plans to implement the EU Services Directive by end-2009 are welcome.
19. Wage increases must align with productivity. The automatic wage indexation mechanism (COLA) hampers competitiveness. Alternative measures could be considered to limit the damaging impact, for instance, by targeting COLA more effectively. Until such time as the COLA mechanism can be amended, it would be important to keep inflation under control by raising productivity though competitiveness-enhancing structural reforms. In this regard, the willingness of labor unions, government, and businesses to follow through with the wage cuts determined by the COLA mechanism in the second half of 2009 is welcome.
We would like to thank the authorities for the fruitful discussions and their warm hospitality.