IMF Executive Board Concludes 2006 Article IV Consultation with Cyprus

Public Information Notice (PIN) No. 07/21
February 21, 2007

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2006 Article IV Consultation with Cyprus is also available.

On January 26, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cyprus.1


Economic activity has recovered from a relatively weak performance in 2002-03. Declines in interest rates and strong capital inflows associated with Cyprus's accession to the European Union in May 2004 spurred growth in private consumption and investment, while recovering tourist receipts reduced the external drag on the economy. These developments were reflected in tight labor market conditions and continued progress toward real convergence with the euro area.

Inflation has slowed, reflecting changes in tax rates, increased competition in the wake of EU accession-related reforms, and global developments. Most recently, inflation went up somewhat in the first half of 2006, but then declined rapidly to a year-on-year rate of 1.5 percent in December. These developments were largely driven by variation in oil prices and movements of the euro—and the Cypriot pound that is fixed to it—against other currencies.

Before the latest deceleration in inflation, the Central Bank of Cyprus increased interest rates by 25 bps on September 1. This rate hike followed three consecutive cuts (totaling 125 bps) in 2005, which had been made in response to strong capital inflows related to Cyprus's participation in ERM2 in May, 2005. Although interest rate differentials against the euro have fallen significantly, the exchange rate continues to trade close to the (unofficial) upper band.

The fiscal deficit was cut in half to under 2½ percent of GDP in 2003-05. As a result, in July 2006, Cyprus became the first new member of the EU to have its excessive deficit procedure abrogated. Further fiscal adjustment is in store in 2006, with the deficit projected to fall below 2 percent of GDP. Initially, fiscal consolidation relied on one-off measures, but the adjustment has also benefited from tight expenditure control, combining moderation in public sector wage increases and expenditure ceilings on public consumption and investment. In the long run, aging challenges fiscal sustainability.

Rising energy costs and robust domestic demand have led to a widening of the external current account deficit in 2004-06. Non-energy imports surged in 2004—prompted by a sharp increase in investment and a reduction in excise duties—and recorded robust growth in 2005-06. Pressure on export margins continued but less so than earlier in the decade. Recent declines in competitiveness—as the real exchange rate has appreciated—have contributed to the fall in the export share of goods, but services exports have held their ground.

The economy is experiencing rapid credit growth and brisk house price increases. Total credit to the private sector accelerated recently, with mortgage lending leading the expansion.

Executive Board Assessment

Executive Directors welcomed the Cypriot authorities' substantial progress in addressing macroeconomic imbalances and reforming the economy. Inflation has receded, the fiscal deficit was cut sharply, and the economy has continued to recover, raising living standards in Cyprus closer to those in the rest of the EU and placing the economy at the doorstep of the EMU. Directors noted that continued observance of the Maastricht criteria, in particular the inflation criterion, and a smooth adoption of the euro will lay the groundwork for sustained growth going forward. This will require both fiscal and wage restraint, along with policies fostering domestic competition and continued vigilance of monetary policy.

Directors welcomed the favorable fiscal outturn in 2006 and the focus on durable fiscal measures in the 2007 budget. They encouraged the authorities to remain ambitious in their fiscal adjustment efforts to safeguard against inflation risks by observing spending limits, avoiding supplementary budgets and saving any higher-than-envisaged revenues.

Directors supported the authorities' intention to balance the budget by 2010 and stressed that high-quality fiscal adjustment should be ensured by keeping current expenditure in check. They welcomed the planned full implementation of a medium-term budget framework in 2008, as it would provide a strong institutional framework to rationalize, prioritize, and control public expenditure. Directors considered the suspension of the ambitious public investment program to be appropriate to allow the authorities to put in place a proper legal framework and institutional setting for private-public-partnerships. These actions will help bring economic considerations to bear on the selection and procurement of public investment projects.

Directors stressed that long-run fiscal sustainability hinges on mitigating the aging-related pressures on public expenditure. They called on the authorities to implement pension reforms that would allow the social security system to deal with adverse demographic trends, noting that prompt action would allow a more gradual phasing in of reforms and grandfathering of the rights of employees. Directors noted the need to avert rising health care costs when the National Health Insurance System is introduced in 2008 and encouraged the authorities to consider adequate incentives to this end, such as user fees.

Turning to the financial sector, Directors noted that commercial banks are profitable and well capitalized. Nonetheless, non-performing loans, while declining, remain high. Rapid credit growth and brisk house price increases could become sources of risk, and the authorities should stand ready to take appropriate measures if the pace of credit growth does not abate and risks increase. Directors welcomed improvements in financial sector supervision, while encouraging steps to consolidate the supervision of commercial banks and cooperative credit institutions. Irrespective of the institutional framework, supervisors should have clear responsibilities and objectives, operational independence, professional staff, and adequate resources. Directors encouraged the early adoption of legislation and regulations to accelerate the lengthy foreclosure process and welcomed the authorities' intention of completing an Financial Sector Assessment Program in time for the next Article IV consultation.

Directors stressed the importance of safeguarding external competitiveness to sustain economic growth. While recognizing that the current wage-setting process has helped smoothen labor relations, Directors concurred that continued high real wage increases point to the need to move towards a mechanism that would better align real wage increases with productivity developments. Directors welcomed progress in opening the telecommunications and energy sectors, and saw scope for further progress to enhance competition in these markets.

Directors encouraged continued efforts towards reaching an agreement on a framework under which Fund technical assistance could be provided to the Turkish Cypriot community in the non-government-controlled areas of the Republic of Cyprus. In this respect, several Directors welcomed the pragmatic approach adopted by the Cypriot authorities.

Directors welcomed the authorities' intention to subscribe to the Special Data Dissemination Standard by 2008.

Cyprus: Selected Economic Indicators

2001 2002 2003 2004 2005 2006

Real economy

Gross domestic product (change in percent)

4.0 2.0 1.8 4.2 3.9 3.7

Domestic demand (contribution to annual growth)

3.4 4.2 1.7 6.6 3.2 5.2

CPI inflation (period average)

2.0 2.8 4.1 2.3 2.6 2.5

Unemployment rate (in percent)

3.0 3.2 3.5 3.6 5.2 4.8

Gross domestic saving (in percent of GDP)

13.2 15.1 15.2 15.2 13.8 13.2

Gross domestic investment (in percent of GDP)

16.4 18.8 17.4 20.2 19.4 19.5

Public finances (general government, in percent of GDP)

Overall balance

-2.2 -4.4 -6.3 -4.1 -2.4 -1.9

Primary balance

1.1 -1.3 -2.9 -0.8 1.1 1.4

Gross public debt 1/

61.5 64.8 69.4 70.3 69.2 64.8

Money and credit (percent change)

Reserve money

7.5 22.7 4.8 8.0 2.6 6.8

Broad money

13.3 10.3 4.0 5.6 10.2 13.3

Domestic credit

14.9 9.5 5.9 4.2 8.0 7.5

Interest rates (in percent)

Deposit rates 2/

6.0 4.8 3.8 3.9 4.0 3.6

Lending rates 3/

7.5 7.2 6.9 7.6 7.1 6.8

Balance of payments (in percent of GDP)

Trade balance

-26.7 -27.3 -23.9 -25.6 -25.0 -27.4

Current account balance

-3.3 -3.7 -2.2 -5.0 -5.6 -6.2

Fund Position (as of November 30, 2006)

Holdings of Currency (in percent of quota)


Holdings of SDR's (in percent of allocation)


Quota (in millions of SDR)


Exchange rates

Exchange Rate Regime:


Present rate (January 31, 2006)

C£0.579 :€1

Real effective exchange rate 4/

101.0 104.1 111.0 113.0 112.9 112.3

Sources: Ministry of Finance; Central Bank; World Bank, World Development Indicators; and IMF staff estimates.

1/ Excludes intragovernmental debt and short-term liabilities of the Central Bank.

2/ For 1-year fixed deposits over £C 5,000. Data for 2006 as of October.

3/ For enterprises' secured loans. Data for 2006 as of October.

4/ CPI-based, 2000=100. Data for 2006 as of October.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.


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