Public Information Notice No. 09/108

Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with Cyprus

August 17, 2009

On August 5, 2009 the Executive Board of the International Monetary Fund (IMF) concluded the 2009 Article IV consultation with Cyprus.¹

Background

The global crisis is beginning to affect Cyprus. The economy has been relatively shielded from the crisis so far, recording positive growth in the first quarter of 2009, well above the euro area. The financial sector has not required public capital injections. The relative resilience is due to the elimination of exchange rate risk following euro adoption, conservative financial sector practices with limited exposure to toxic assets and strict supervision, and a domestic demand-based growth with less reliance on manufacturing exports. However, the economy is beginning to slow in response to the global crisis. Growth is projected to fall sharply to ⅓ percent in 2009 as banks and the private sector restructure balance sheets. On current policies, a tepid but uncertain recovery is expected to begin starting 2010.

Despite its resilience so far, the economy is slowing down and risks are increasing. The overheating of the economy in 2007–08 has left the private sector highly leveraged, and banks and households exposed to the property market. The expected slowdown will increase credit risk in banks, which, in some plausible but unlikely extreme scenarios, could have systemic implications given the size and concentration of the banking sector. The government and the Central Bank of Cyprus (CBC) have taken action to ensure the soundness of the banking system. There has been significant progress in implementing EU Directives and recommendations made by the recent Financial Sector Assessment Program (FSAP). In particular, deposit insurance coverage and funding has increased; a crisis management law is being drafted to empower the government to preemptively address liquidity or insolvency problems; and a legal and regulatory framework for covered bonds has been initiated to facilitate the availability of refinancing under the ECB’s facilities. Nevertheless bank soundness indicators are being adversely affected by the economic environment.

Large current account deficits partly indicate competitiveness problems especially in the manufacturing and tourism sectors. In particular, the backward-looking automatic indexation mechanism (COLA) has recently contributed to wages outstripping productivity increases. The external position would therefore be vulnerable if the current sources of financing—foreign direct investment and non-resident deposit flows into the banking system—were to decline. While there has been progress—albeit slow—in implementing the wide-ranging structural reforms of the government’s National Reform Programme, reforming the COLA is not part of the agenda at this juncture.

The largely revenue-based fiscal consolidation has started unwinding. This is due to softening growth, the lapse of temporary revenue-generating factors, and increases in untargeted social spending starting 2008. Although important pension reforms were recently enacted, they rely mainly on contribution increases and do not yet fully address the large ageing-related increases in pension expenditures. Fiscal policies could potentially become unsustainable if current policies, which significantly increase the inelastic component of budget spending (especially payroll), are implemented.

Executive Board Assessment

The Executive Directors noted that Cyprus has weathered the crisis well. The overheating of the economy in 2007–08 has given rise to certain risks that would need to be managed carefully as the economy slows. Policies would need to mitigate short-term risks while ensuring medium-term sustainability.

Directors endorsed the government’s objective to achieve a balanced budget over the medium term. They noted that, based on strengthened policies, the budget deficit will need to decline by about ½−¾ percent of GDP a year with a significant upfront correction to avoid unfavorable debt-deficit dynamics going forward. Directors emphasized that fiscal adjustment should rely on reducing public consumption, particularly the wage bill, and on broader public administration reforms. They considered that the temporary stimulus measures should be allowed to expire once the recovery sets in, and the social support measures should be carefully targeted to the needy. Directors welcomed the passage of pension reforms. A few Directors considered that additional pension reforms may be necessary in future, including raising the retirement age and better aligning public and private benefits.

Directors recommended the adoption of a medium-term budget framework and more effective management of public sector liabilities. The government’s recent initiative in this area could be further enhanced by monitoring contingent liabilities and minimizing the possibility of moral hazard and adverse selection in public sector aid programs.

Directors were reassured that financial sector risks appear to be manageable. Nonetheless, given the size and concentration of the financial sector, they expressed concern that problems can potentially become systemic, underscoring the importance of early detection of risks and intervention to preserve financial sector stability. They encouraged the Central Bank of Cyprus (CBC) to enhance monitoring of banks’ funding, cross-border exposures, and counterparty risk management. With the potential for a further deterioration in asset quality, the CBC should require higher capital buffers, particularly from systemically-important banks.

Directors recommended that supervision and the safety net be further improved over the medium term. They noted that Cyprus’ reputation as a financial center relies on continued effective supervision by an independent and accountable central bank. In the view of most Directors, a single supervisor for all credit institutions and a more integrated supervisory structure in the CBC should be considered. The stress-testing framework should be enhanced and supervisory and financial stability resources bolstered. Directors welcomed Cyprus’ participation in a Financial Sector Assessment Program (FSAP), and called for implementation of its recommendations.

Directors underlined the importance of improving competitiveness to assist the recovery and support external viability. They encouraged the authorities to reverse the deterioration in productivity and unit labor costs by implementing the broad-ranging National Reform Program, including cutting red tape, streamlining the bureaucracy, and implementing other structural reforms. Directors supported eliminating the automatic wage indexation mechanism (COLA) or mitigating its impact through productivity improvements and better targeting.