Mission Concluding Statement 

Cyprus -- 2010 Article IV Consultation: Preliminary Conclusions

July 6, 2010

This statement presents the preliminary findings and main recommendations of the IMF’s 2010 Article IV surveillance mission. Article IV surveillance is conducted with all IMF member countries on a regular basis. The mission is grateful to the authorities for their warm hospitality and cooperation.

Overview

1. Economic conditions have started to stabilize after the economic downturn, and the Cypriot economy is poised to return to modest growth in 2011. However, global financial risks remain elevated and growth prospects in main trading partners remain muted, which weigh on the outlook for Cyprus. Meanwhile, pressures in Euro area sovereign debt markets have intensified, and countries across the Euro area are responding by undertaking ambitious fiscal consolidation efforts. Cyprus also should act forcefully and with a greater sense of urgency to reverse its high fiscal deficits, in order to safeguard the sustainability of public financing and increase the scope for private sector growth. The banking sector remains sound overall, although the growth in non-performing loans calls for vigilance. Turning to medium-term prospects, containing the growth of public spending and enhancing wage flexibility are needed to boost productivity and improve growth.

Economic outlook

2. The impact of the global crisis hit the Cypriot economy in the second half of 2009. Conservative financial sector practices and strict supervision, and the elimination of exchange rate risk following euro adoption, initially sheltered the economy from the global financial crisis. However, the deteriorating international environment and Cyprus’ close trade and investment links with its key economic partners, including the U.K. and Russia, exposed the economy to a sharp correction in foreign demand for housing and a decrease in tourism and other service revenues. The resulting downturn was led by a decline in private consumption and fixed investment, and a significant destocking process. The slowdown in domestic demand together with lower oil prices helped to cut the current account deficit by more than half in 2009, to 8.5 percent of GDP. The current account deficit will likely stabilize in 2010 and decline gradually toward more sustainable levels over the medium term as the global economy and external demand for Cypriot goods and services recover.

3. The economy is projected to bottom out in 2010 and give way to a mild recovery in 2011 and stronger growth in following years. The sizeable increase in unemployment along with declining consumer borrowing and the negative confidence shock will weigh on private consumption; investment will be subdued due to continued weakness in the property market and construction sector; and public consumption will be restrained due to the need for fiscal consolidation. The mission expects growth to be around zero or slightly below in 2010, followed by a modest recovery in 2011 and a gradual acceleration in later years.

Fiscal policy

4. The foremost policy challenge for Cyprus is to reverse the large structural fiscal deficit that has emerged in recent years. The deficit was driven by rapid growth in public sector wages and employment as well as the expansion of social spending, much of which was not well-targeted to help the poorest portions of the population. Meanwhile, the end of the real estate boom has caused an enduring loss of associated revenues, which will not return to previous levels even as the economy resumes growth. While Cyprus has moderate levels of public debt relative to many other Euro area countries as a result of past policies, it must act forcefully to preserve this favorable legacy and protect debt sustainability. The need for action has become more urgent in the face of growing pressures in Euro area sovereign debt markets and the increasing focus of investors on fiscal imbalances.

5. The government’s targets for reducing the deficit to below 3 percent of GDP by 2012, which would put the public debt ratio on a declining path, are appropriate, but bold measures are required to achieve these goals. The government has taken some important first steps, including the launching of a gradual reduction in public sector employment and foregoing general increases in public sector wages. While these measures will help to stabilize the deficit near last year’s levels of 6 percent of GDP, further actions are needed to put it on the declining path needed to meet the official targets. Such measures should focus foremost on reducing public expenditure, in particular by reducing the wage bill and better targeting of social transfers, in light of the large size of the public sector (close to half of GDP) and the need to keep tax rates low to preserve the attractiveness of the Cypriot economy to investors. Options that should be considered include adjustments to the incremental salary step increases, introduction of contributions of government employees toward their unfunded government pensions, and a reform of the cost of living adjustment to increase wage flexibility while protecting lower paid workers.

6. Further reforms of the pension system will need to be undertaken in the coming years. The reforms of last year helped to prolong the system’s solvency, but as the workforce matures and today’s workers retire, pension outlays will steadily rise and outstrip contributions, putting pressure on the general budget. A long-term solution will require bringing pension outlays more in line with contributions, through some combination of lower replacement rates and higher retirement age.

Financial Sector

7. The banking sector remains sound, helped by its focus on traditional banking activities and conservative balance sheet. The banks’ predominant reliance on more stable retail funding, negligible exposure to complex securities, high levels of liquidity, and strong supervision helped to shield it from the global crisis, and recent and ongoing stress tests carried out by the Central Bank of Cyprus indicate that the system has the capacity to absorb further shocks. Deposits have continued to grow thanks to confidence in the banking system and its strength relative to the rest of the region. Banks and supervisors responded appropriately to the recent slowdown in economic activity and elevated spillover risks from countries in the region. Banks are taking steps to strengthen capital and liquidity—securing funding and preserving high levels of liquidity, retaining a greater proportion of earnings, and tightening their risk management procedures. Supervisors have stepped-up their vigilance and taken steps to strengthen the regulatory framework. There has been significant progress in implementing European Union Directives and recommendations from the IMF’s 2008 Financial Sector Assessment Program. The forthcoming introduction of a legal framework for covered bonds should improve banks’ access to liquidity from the markets and the European Central Bank. Meanwhile, the draft law on crisis management should make it easier for the authorities to preemptively address potential insolvency problems.

8. Preserving the stability of the banking sector through continued strong supervision and early detection of risks should remain a top priority in light of the difficult economic and financial environment. The economic downturn in Cyprus and elsewhere in the region has had a negative effect on financial soundness indicators such as bank profitability, non-performing loan ratios, and capital buffers, and these pressures are likely to persist until economic recovery in Cyprus and the region takes full hold. Given the large size of the banking sector relative to the economy and relatively high concentration ratios, if problems emerged in this sector they could quickly escalate to systemic proportions with serious spillover to the economy and to public finances. Policies should therefore focus on addressing areas of potential concern early. Ongoing initiatives for cross border cooperation with Greece and other Southeastern European supervisors should be pursued vigorously in light of Cyprus’ extensive international financial linkages.

9. Measures to bolster supervision and transparency of cooperative credit societies will help reduce risks. Improving transparency and supervision of the cooperative credit sector should be a priority, to prevent problems from building up undetected. Actions should include imposing uniform definitions of non-performing loans across commercial banking and cooperative credit sectors; applying the same stress testing framework used for commercial banks to cooperatives; and full and timely reporting of financial system indicators by the Authority for Supervision and Development of Cooperative Societies in a manner consistent with commercial bank requirements. Over the medium term, a single independent supervisor for all credit institutions operating in Cyprus would enhance efficiency, reduce risks, and create a more level playing field.

Structural reforms

10. Structural reform to preserve competitiveness will support the recovery in the near term and enhance growth potential in the longer term. Growth of wage and labor costs in excess of productivity increases has reduced competitiveness, particularly in the manufacturing and tourism sectors, creating headwinds for investment and growth. Moreover, medium-term potential growth is likely to be permanently lower as a result of the global crisis, the fading of the boom in construction and real estate, and Cyprus’ convergence towards per capita income levels of other Eurozone countries. Measures to improve labor market flexibility, streamline the regulatory framework, reduce red tape and improve the business climate will be important to bolster growth potential over the medium term. In this context, reversing the steady growth of public sector wages and employment would free resources to support economic growth, while also reducing wage pressures in the economy and protecting the low tax environment needed to attract investment.

11. Improving the functioning of the labor market through active labor market policies could also help to address the increase in unemployment and support long-term growth potential. Training programs for low skilled and immigrant workers and measures to reduce the high gender gap would help to ease labor market segmentation and increase productivity. The promotion of flexible form of employment would enhance market flexibility and improve employment conditions. Reducing incentives for early retirement would enhance long-term fiscal sustainability and support labor supply in view of the demographic transition to an older population.