IMF Executive Board Concludes 2011 Article IV Consultation with Cyprus

Public Information Notice (PIN) No. 11/145
November 29, 2011

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 2011 Article IV Consultation with Cyprus is also available.

On November 18, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cyprus.1

Background

The Cypriot economy faces strong headwinds and downside risks due to financial turbulence in the euro area, the large exposure of Cypriot banks to Greece, and the need for substantial fiscal consolidation to stabilize public finances. Reflecting these developments, the government has lost access to international capital markets and confronts the challenge of accessing financing to meet its fiscal needs in 2012 and beyond.

Following a weak recovery in 2010, staff expects no economic growth this year and a modest contraction in 2012. Factors that will weigh upon growth include tight credit and a climate of uncertainty, continued downsizing of the construction sector after past excesses, slowing external demand, and planned fiscal consolidation. Downside risks are dominant, in light of the potential for external conditions to worsen and for adverse feedback loops between fiscal imbalances and bank balance sheet vulnerabilities.

Fiscal balances have deteriorated sharply over the past three years, reflecting in large part underlying structural factors. Adjustment measures planned for 2011 fell short of target, and staff expect the deficit to widen to some 7 percent of GDP in 2011. The authorities have renewed their commitment to restore sound public finances. They have passed a first package of adjustment measures and are seeking passage of a second and larger set of measures that would yield fiscal savings of some 4 percent of GDP in 2012, if fully implemented. Additional measures will be required to reduce the deficit further and achieve the government’s target of a balanced budget by 2014. Over the longer-term, the public pension system will generate another source of fiscal pressures, as population aging and rising dependency ratios feed through to large increases in pension outlays.

The large banking sector, with assets totaling over 8 times GDP by the broadest measure, and with significant exposure to Greece, is a significant vulnerability. Banks face significant capital needs to reflect mark to market valuations on their sovereign bond holdings and to achieve a 9 percent core tier one capital ratio, as mandated by the European Banking Authority. Non-performing loans are increasing, and further loan deterioration could add to recapitalization needs. Meanwhile, the system is also vulnerable to an outflow of deposits in the event of adverse circumstances. Cypriot banks receive significant liquidity support from the European Central Bank.

Executive Board Assessment

Executive Directors noted that Cyprus faces daunting economic challenges in the face of faltering external demand, growing exposure to the turmoil in the euro area, particularly in Greece, and worsening domestic financial conditions. Directors thus urged the authorities to act forcefully to restore sound public finances and safeguard the stability of the banking system. Steadfast implementation of fiscal and structural reforms on several fronts would also be critical for a return to durable growth over the medium term.

Directors agreed that an ambitious and credible fiscal adjustment is essential to regain access to the international capital markets and put the public debt ratio on a downward path. They supported the authorities’ plans to achieve fiscal balance over the next three years as an appropriate strategy for undertaking the necessary fiscal correction without unduly damaging growth prospects. Directors considered that front-loading the adjustment with measures to reverse recent increases in public sector wages and poorly targeted transfers would provide a credible signal of the authorities’ commitment to medium-term consolidation and bolster investor confidence. Reforms of the cost-of-living allowance system would also be important for achieving the fiscal targets and improving real wage flexibility and competitiveness.

Directors underscored the importance of other fiscal reforms to underpin the consolidation efforts. Priorities should include the introduction of a medium-term budget framework and the adoption of fiscal rules consistent with EU directives. Directors also highlighted the need for reforming the national pension and healthcare systems, which threaten to put unsustainable pressures on the budget as the population ages.

Directors expressed concern about the vulnerabilities arising from Cyprus’s large banking sector and the possibility of adverse feedback loops with the public finances and the real economy in the context of weakening balance sheets. They stressed the importance of building prudent capital buffers and of ensuring adequate liquidity in the financial system. These actions should be supported by contingency planning and the immediate passage of legislation to provide the authorities with full powers to recapitalize or resolve banks, if necessary. Cooperative credit institutions should also be watched closely and brought under the same regulatory and supervisory frameworks as banks.


Cyprus: Selected Economic Indicators, 2006–11
(Annual percentage change, unless otherwise indicated)
 
 

2006

2007

2008

2009

2010

20111/

 

Real economy

           

Gross domestic product

4.1

5.1

3.6

-1.9

1.1

0.0

Domestic demand (contribution to annual growth)

6.2

9.1

7.5

-6.3

0.3

-0.5

Harmonized index of consumer prices (period average)

2.2

2.2

4.4

0.2

2.6

4.0

Unemployment rate (percent)

4.6

4.0

3.6

5.4

6.4

7.6

             

Public finances (general government, percent of GDP)

           

Overall balance

-1.2

3.4

0.9

-5.9

-5.3

-7.0

Primary balance

2.1

6.4

3.7

-3.4

-3.1

-4.4

Gross public debt

64.1

58.0

48.2

57.8

60.7.

64.0

             

Interest rates (percent)

           

Deposit rates 2/

4.4

4.9

3.7

3.6

Lending rates 3/

6.3

6.7

6.9

5.8

             

Balance of payments (percent of GDP)

           

Trade balance (goods and services)

-4.0

-6.5

-11.0

-5.1

-5.1

-4.4

Current account balance

-6.9

-11.7

-16.8

-7.8

-7.7

-7.2

             

Fund Position (September 30, 2011)

           

Holdings of Currency (percent of quota)

         

63.0

Holdings of SDR's (percent of allocation)

         

105.0

Quota (millions of SDR)

         

158.2

             

Exchange rates

           

Exchange rate regime

Euro Area Member

Present rate (November 2, 2011)

US$ 1.38 per euro

Nominal effective exchange rate (2005=100)

100.6

100.3

102.5

104.3

101.9

Real effective exchange rate (HIPC, 2005=100)

100.4

99.9

102.6

103.5

101.1

             
 

Sources: Eurostat; Central Bank of Cyprus; and IMF staff estimates.

1/ Data for 2011 are projections.

2/ Due to a change in methodology, comparable interest rate data are available since November 2007. For 2007 data refers to the average of MFI interest rates on new deposits for households and non-financial corporations up to 1 year for November and December. Starting from 2008, the same average covers the whole year.

3/ Due to a change in methodology, comparable interest rate data are available since November 2007. For 2007 data refers to the average of MFI interest rates on new loans for households and non-financial corporations up to 1 year for November and December. Starting from 2008, the same average covers the whole year.


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. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm



IMF EXTERNAL RELATIONS DEPARTMENT

Public Affairs    Media Relations
E-mail: publicaffairs@imf.org E-mail: media@imf.org
Fax: 202-623-6220 Phone: 202-623-7100