Public Information Notice No. 03/13

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Cyprus

February 14, 2003

On January 31, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cyprus.¹

Background

Over the last two decades economic performance has been impressive, with GDP per capita rapidly approaching the average level in EU countries. Strong growth has kept the unemployment rate below 4 percent for the past 2 decades, inflation has remained under control, and the fiscal deficit has averaged below 3.5 percent of GDP during the past decade. In recent years, Cyprus has achieved substantial progress on the reform agenda. The interest rate ceiling was abolished; the central bank was granted legal independence; capital account liberalization has proceeded without jeopardizing domestic and external stability; and the tax system has been reformed, reducing direct taxes and increasing indirect taxes. These achievements have been recognized by the European Council, which at the Copenhagen summit in December 2002 invited Cyprus to join the EU. Discussions on a United Nations peace plan are underway.

After four years of strong growth, economic activity has tailed off since late 2001, affected by the global economic slowdown, and the authorities estimate growth for 2002 to have declined to 2.3 percent, with falling tourist arrivals and weakening consumer and business confidence. Inflation has risen to 2.9 percent year-on-year in December on account of indirect tax increases, but core inflation remains low. The current account deficit is expected to have deteriorated in 2002 to 5.5 percent, on account of lower tourism receipts and temporary factors.

After notable progress in 1999 and 2000, fiscal consolidation stalled in 2001 and 2002. Despite a favorable cyclical position, the 2001 general government deficit remained virtually unchanged from the previous year. In 2002 a tax reform further aligned indirect taxation with EU standards, while lowering direct taxation and harmonizing the corporate tax rates of domestic and foreign companies. The economic slowdown, compensatory social spending measures accompanying the tax reform, and slippages on the spending side were partly offset by higher transfers from semi-government organizations, and the general government deficit is estimated to have remained around 3 percent of GDP in 2002.

Monetary policy has successfully kept inflation under control. Restrictions on medium- and long-term capital movements have been lifted and liberalization of short-term flows should be completed by EU accession. The liberalization of foreign-currency borrowing for maturities over 2 years was followed by high capital inflows in early 2001, but lower interest rates and the widening of the exchange rate band to ±15 percent have since slowed net inflows. Banks are well capitalized, but their portfolio has been affected by the bursting of the stock market bubble and the economic slowdown. Initiatives are underway to strengthen financial sector regulation and supervision, and align them to EU standards-including for insurance and the stock market. While structural reform has proceeded, some obstacles to competition remain in sectors such as air travel, electricity, and telecommunications, and the automatic wage indexation mechanism fails to exclude the impact on prices of VAT increases and terms of trade changes.

Executive Board Assessment

Executive Directors commended Cyprus's long-standing record of strong economic growth, low inflation, and moderate unemployment, which had allowed the economy to successfully withstand adverse shocks while maintaining macroeconomic stability. They welcomed the substantial progress achieved on the reform agenda, including the abolition of the interest rate ceiling; the granting of legal independence to the central bank; continuing capital account liberalization; and the reform of the tax system. These achievements have helped pave the way for European Union membership in 2004. Directors also welcomed the prospect of a possible peace settlement, which would open new economic opportunities, while noting that differences in development and in macroeconomic and financial stability between the two parts of Cyprus would also pose significant policy challenges. They emphasized that strengthening domestic policies, increasing the economy's flexibility, and reducing external and financial vulnerabilities would be key to ensuring success in meeting these challenges in an unsettled external environment.

Directors noted that, after notable progress in 1999 and 2000, fiscal consolidation had stalled in 2001-02. The momentum towards fiscal consolidation needed to be regained, and Directors consequently urged the authorities to meet the 2003 budgetary target and reduce external imbalances. They noted that prompt action is needed to offset expenditure overruns, particularly on current transfers, so as to ensure the envisaged reduction in the fiscal deficit in 2003. These actions would serve to put the public debt on a downward path, in line with the authorities' medium-term balanced-budget target. While Directors considered that debt and external sustainability were not critical problems at present, Cyprus's vulnerability to external shocks called for a prudent policy course, and some Directors expressed concern about the large estimated current account deficit in 2002.

For the medium term, Directors underscored the need for a sustained reduction in the ratio of public debt to GDP, which would help contain external imbalances. Together with early pension reform, this would reinforce Cyprus's ability to face expenditure pressures arising from demographic trends. Directors emphasized that fiscal policy credibility could be enhanced by establishing a multiyear fiscal framework, based on prudent macroeconomic objectives. Such a framework would allow the authorities to choose among competing spending priorities in a transparent and efficient manner.

Directors praised the prudent conduct of monetary policy, and called on the Central Bank to stand ready to respond flexibly to external developments. They noted that the authorities' reliance on a nominal exchange rate anchor had served Cyprus well, but cautioned that the framework could be challenged by increased capital mobility following the removal of remaining restrictions. In this context, Directors encouraged the authorities to stand ready to use the available policy tools, including exchange rate movements within the widened exchange rate band, to respond to capital flow volatility and other external shocks. Continued prudent monetary policy management would be key to achieving the authorities' objective of joining the euro area as soon as possible.

Directors noted that Cyprus is well placed to take full advantage of the opportunities for international portfolio diversification that capital account liberalization affords. At the same time, Directors called for further strengthening of the banking system and monitoring of external vulnerabilities as remaining restrictions are dismantled. They welcomed the strengthening of financial sector legislation and supervision, in line with EU directives, and stressed the need to closely monitor foreign exchange exposure and maturity mismatches in the financial system and among corporates, particularly in light of the weakening of financial sector balance sheets after the bursting of the stock market bubble, and to take prudential action if needed. They viewed these steps, together with fiscal consolidation, as crucial to reducing external vulnerabilities.

Directors called for coordination and cooperation among Cyprus's multiple financial sector supervisory authorities. They welcomed the authorities' commitment to strengthening the reputation of the offshore sector, and the progress in addressing the supervisory issues identified in the Offshore Financial Center (OFC) Assessment published in August 2001. Directors noted that Cyprus fulfills international standards on anti-money laundering capabilities. They also welcomed the authorities' intention to participate in the FSAP.

While recognizing that the labor market in Cyprus has functioned well, Directors recommended curtailing the recourse to backward-looking wage indexation (the Cost of Living Allowance-COLA system) which they viewed as an element of rigidity and amplification of inflationary shocks (given also the continued inclusion of the impact on prices of VAT increases). While recognizing that Cyprus is well advanced in meeting the requirements of the acquis communautaire, Directors called for further progress on structural reform. They urged the authorities to speed up the liberalization of the air travel, electricity, and telecommunications sectors. The removal of remaining price controls and privatization of government holdings would also reinforce the market base of Cyprus's business sector.

Macroeconomic statistics in Cyprus are adequate for surveillance, and Directors welcomed recent progress in this area, particularly in the domain of balance of payments statistics. However, they highlighted the continued need to improve data coverage, timeliness, and comprehensiveness, particularly in the area of external debt, the reserve template, and the international investment position. The authorities were encouraged to subscribe to the Special Data Dissemination Standard as soon as possible.