## 1. Macroeconomic Performance (cr17375) ## Source details **Canonical URL:** [1. Macroeconomic Performance (cr17375)](https://www.imf.org/-/media/files/publications/cr/2017/cr17375.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2017/cr17375.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2017/cr17375.pdf.json) --- ### Recent developments and macroeconomic background - Recovery since 2012–13 banking crisis: - GDP growth accelerated for three consecutive years; GDP grew by 3.8 percent (year-on-year) in the first nine months of 2017, accelerating from 3 percent in 2016. - Output lifted to 4 percent below its pre-crisis peak; output gap narrowed to about 2 percent. - Unemployment fell to 10.3 percent as of September 2017, from a peak of 16.8 percent; pre-crisis rate was 4 percent. - Core inflation returned to (low) positive territory after protracted deflation. - Fiscal balance swung from a large deficit to a small surplus; headline and primary balances reached 0.5 percent and 3.0 percent of GDP, respectively, in 2016. - Sovereign accessed capital markets on increasingly favorable terms and received a series of credit rating upgrades, now close to investment grade. - Persisting legacies and vulnerabilities: - Gross debt of the nonfinancial private sector was 259 percent of GDP in Q2:2017: - Household gross debt: 119 percent of GDP. - Nonfinancial corporates: 140 percent of GDP. - NPLs: NPLs in the three large domestic banks about 55 percent of loans and more than 100 percent of GDP as of March 2017; economy-wide NPLs were 44 percent of total loans and 124 percent of GDP as of Q2:2017. - Public debt elevated: public debt was 107.1 percent of GDP at end-2016 and declined below 100 percent of GDP in late 2017. ### Sectoral drivers and external rebalancing - Strong foreign demand propelled tourism, construction and professional services; construction of dwellings grew by more than 15 percent in 2016 and gained momentum. - Financial intermediation contraction (shrinking bank loan books) was a drag. - External position and REERs: - Unit labor cost- and CPI-based REERs fell by 20 and 10 percent, respectively, and stabilized for the past two years. - Net exports of tourism and other services rose by more than 3 percentage points of GDP in recent years. - Current account deficit widened to 4.9 percent of GDP in 2016; excluding lumpy SPE-related items and interest on foreign debt of SPEs, it dropped to 0.2 percent of GDP. - Private net financial inflows were more than 30 percent of GDP per year in 2014–16. ### Banking sector and real estate - Bank balance-sheet highlights: - Bank loans net of deposits were 49 percent of GDP as of Q3:2017 due to large deposit holdings. - Households’ deposits on aggregate almost 20 percent larger than their loan obligations. - Capital exceeds regulatory requirements; provisioning nearly 47 percent of NPLs as of Q2:2017. - Banks placing excess liquidity (some 15 percent of assets) at the central bank. - Real estate: - Residential prices declined 30 percent and retail prices 50 percent relative to the 2008–09 peak; stabilized in 2015 and rose moderately since mid-2016. - At least two-thirds of loans collateralized with real estate. - Turnover more active in the luxury market, partly due to the CbI scheme. *Source: IMF staff report chapter "1. Macroeconomic Performance" (cr17375).* ### Outlook and risks - Staff baseline: - Growth expected to average 3¾ percent during 2017–18, then moderate gradually to around 2½ percent by 2022 as investments are completed. - High import intensity of investment will cause some re-widening of the current account deficit despite further expansion of tourism. - NPL reduction expected to remain subdued without more effective measures to strengthen payment discipline. - Potential output and labor market: - Potential growth around 2¼ percent if slow structural reform momentum, excessive debt and weak payment discipline persist. - Natural unemployment rate likely risen due to structural mismatches and erosion of skills from sustained unemployment. - Risks (selected): - Upside: sustained foreign-financed construction activity could keep growth elevated longer. - Downside: resource shortages, price/wage pressures, skewed growth toward construction increasing vulnerability to a new boom-bust cycle, continued slow NPL resolution, erosion of fiscal discipline, adverse international initiatives on corporate taxation or retrenchment by foreign correspondent banks. - Positive surprise: financially viable development of offshore hydrocarbon deposits could significantly boost growth. --- ### Deleveraging Strategy and Financial Sector Policies ### Policy priority and objective - Primary objective: Achieving sustainable deleveraging and NPL reduction to support balanced and sustainable growth. - Quantitative target: Gradually lower nonfinancial private-sector debt net of deposits by 40 percentage points of GDP over a period of five years—bringing it close to its early post-EU accession ratio. ### Rationale and caution - Status quo unsustainable: high private debt and NPLs constrain banks’ ability to lend and raise financial stability risks. - Caution on relying on growth alone: “growing out of debt” unlikely feasible given required rapid growth rates and uncertain improvement in payment discipline. ### Deleveraging strategy — key elements and operational tools - Dual focus: reduce both private debt and NPLs; cleaning up bank portfolios while leaving borrowers over-indebted is not sustainable. - Combination of tools over a five-year period: - Debt-asset (D-A) swaps, use of banks’ provisions, borrowers’ own funds and current income, and burden-sharing. - Banks and supervision: - Banks should remain adequately provisioned and capitalized. - Supervisors should monitor new lending and loan classification closely; banks encouraged to strengthen capital buffers by curtailing operating costs and raising capital as market conditions allow. - NPL targets should be calibrated based on ambitious and credible medium-term strategies embedded in realistic capital plans, prepared by each bank and approved by the supervisor. ### Segment-specific tools and safeguards - Small borrowers (household and SME NPLs): - (i) Outsource NPL management to third parties with specialized skills and an arm’s length relationship with borrowers. - (ii) Segment portfolios and offer standardized restructuring packages to viable borrowers. - Update provisioning assumptions frequently to reflect recent time-to-liquidation and collateral recovery rates. - Real estate portfolio and D-A swaps: - Voluntary D-A swaps useful but risk replacing credit risk with real estate risk. - Recommended safeguards: - (i) Engage in D-A swaps only when upside value-extraction prospects are favorable or as part of larger restructuring. - (ii) Onboard properties at a forced-sale discount so losses incurred upfront. - (iii) Impose a cap on real estate holdings, with a capital surcharge escalating with share of real estate and length of holding period. - D-A swaps typically booked at a conservative 25–30 percent discount on the lowest current market valuation and used in combination with cash repayment and other measures. - Portfolio divestment: - Divest parts of problem-loan portfolios via sale-of-loans law or securitization once enabling legislation approved; large price discounts relative to book value may be needed. ### NPL flows, coverage and operational caveats - NPL evolution: - Total NPLs €22.8 billion as of June 2017, €5.9 billion below their maximum in Q1:2015; relative to GDP, NPLs 124 percent. - NPL composition: Households 56 percent; NFCs 42 percent; small borrowers (SMEs and households) about 90 percent of NPLs. - Flow decomposition (Q4:2015–Q2:2017, stock normalized to 100): Migration from performing 17.0; Interest accrued on NPLs 10.1; Migration into performing 19.1; NPL cash repayment 10.2; Debt-to-asset swaps 3.9; Write-offs 9.8; Remaining NPLs 56.9; Outflow 43.1; Inflow 27.1; Net Outflow 16.0. - Provisioning: - Provisioning coverage ratio rose to just-above the EU-average of 45 percent; provisions nearly 47 percent of NPLs as of Q2:2017; in Q2:2017 provisioning increased almost 4 percentage points. - Caveats: - A shift to NPL targets could encourage excessive use of balance-sheet operations that consume provisions; supervisory calibration and bank-specific realistic capital plans are necessary. ### Strengthening claims enforcement and incentives for payment - Problem drivers of strategic default: - Lengthy and inefficient commercial claims enforcement and foreclosure procedures, perceived blanket protection of primary residences, and competing claims from failing to issue/transfer title deeds. - Legal and procedural reforms recommended: - Strengthen foreclosure framework by: (i) lowering or eliminating minimum reserve prices and introducing virtual auctions; (ii) allowing more flexible borrower notification procedures; (iii) clarifying applicability to legacy cases; (iv) reviewing protections for primary residences and guarantors. - Promote utilization of new debt restructuring tools for individuals and corporates and continue transfer of property titles to trapped buyers. - Expedite court and civil procedure reforms; introduce credit scoring system. - Context: 2015 “trapped buyers” law—of original 14 thousand applications for compulsory transfer of property title, eight thousand cases remain outstanding; constitutionality recently challenged by banks. --- ### Fiscal Policy, Real Estate, and the NHS ### Fiscal stance, outlook and risks of procyclicality - Recent outcomes: - Headline and primary balances reached 0.5 percent and 3.0 percent of GDP, respectively, in 2016; each expected to increase by a further ½ percentage point in 2017. - Gross public debt declined below 100 percent of GDP in late 2017. - Projections and staff vs authorities: - Authorities expect overall surplus to increase to 1.3 percent of GDP next year; staff expects 1.1 percent based on its macro forecasts. - Staff memorandum output gap sequence (2015–2022): -6.0, -4.3, -2.0, -0.3, 0.6, 1.1, 1.4, 1.7. - Staff forecasts public debt to decline to 82 percent of GDP by 2020 (authorities’ DBP2018 shows 86 percent of GDP in staff’s forecasts and 75 percent of GDP by 2022 in authorities’ plan). - Recommendation to avoid procyclicality: - Cap increases in fiscal spending by medium-term GDP growth: set an annual ceiling for nominal spending that increases in line with medium-term growth (with downward adjustment to compensate for any future cuts to tax rates or narrowing of tax bases). - Institute mechanism to keep public-sector wage bill in check. - Closely monitor costs—including arrears—of the National Health Service (NHS) to be rolled out in June 2019. ### Real estate, CbI scheme and macroprudential considerations - Recent effects and risks: - Investment incentives, including the CbI scheme, supported construction; risks now of procyclicality, excessive concentration in real estate and over-supply of luxury properties. - Large luxury projects mainly foreign financed or pre-sold; if domestic credit funds luxury construction or activity spills over to the general housing market, tighten lending standards and raise macroprudential capital requirements. - Policy recommendations: - Decouple CbI eligibility from real estate; ensure full AML/CFT compliance and source-of-wealth/source-of-funds checks for applicants. - Streamline title deed issuance and transfer for new properties. - Reinstating immovable property tax (IPT) and raising transfer duty would provide countercyclical tools; EU compliance: VAT imposed on transactions of buildable land. ### NHS design, financing and fiscal implications - NHS timeline and design: - NHS operational in two stages: June, 2019 for GP and outpatient services, pharmaceuticals and laboratory tests; June, 2020 for in-patient services. - Funding via employee, employer and government contributions (fixed payroll percentages up to a maximum income level) and contributions on non-earned income. - Contribution rates and numeric parameters: - 4.7 percent of economy-wide payroll. - From March 1, 2019: - Employees/government officials: 1.7 percent of payroll - Employers: 1.85 percent of payroll - State contribution: 1.65 percent of economy-wide payroll - From March 1, 2020: - Employees/government officials: 2.65 percent of payroll - Employers: 2.9 percent of payroll - Self-employed: 2.55 percent of income; 4.0 percent of income - Pensioners/those living on other income: 1.7 percent of income; 2.65 percent of income - New employment levy: 6 percentage point levy on employment - Fiscal and labor-market risks: - As currently budgeted, introduction of NHS largely fiscally neutral—but government liable to cover provider shortfalls. - Levy could adversely affect demand for labor, especially low-wage workers; may push low-wage employment into the shadow economy. - Five-yearly functional reviews by Parliament allow adjustment of contribution rates. --- ### External Sector Assessment, Debt Sustainability and Risk Scenarios ### External sector assessment (EBA-lite) — conclusions and metrics - Overall conclusion: external sector assessed as weaker than warranted by fundamentals and desirable policy settings in 2017, reflecting the need to eliminate the remaining net credit gap. - CA approach (2017): - Underlying CA (excluding SPEs and one-off aircraft import): deficit of 2.3 percent of GDP. - Headline CA deficit: 4.9 percent of GDP. - Estimated CA fitted value: CA 0.1 (percent of GDP). - Estimated residual between underlying CA and fitted value: -2.4 percent of GDP for 2017. - CA gap (percent of GDP): CA -2.4 (within range of negative 2 to negative 2½ percentage points of GDP). - REER approach: - Total REER gap: 15 percent (residual component: 12 percent; policy-gap component: 3 percent). - REER gap range reported: 4 to 15 percent. ### Credit gap and adjustment channels - Credit-gap statistics: - Remaining credit gap as of end-2017 projected to be 30 percent of GDP. - Net credit ratio decreased by about 50 percentage points since its peak in 2013. - Adjustment implications: - Narrowing the private credit gap central to external rebalancing; adjustment would likely require lower private consumption and investment and progress in reducing foreign-financed credit. ### External debt and gross financing needs - External debt: - Gross external debt (Table 1): 2014 554.4; 2015 572.7; 2016 592.0; 2017 580.7; 2018 564.7; 2019 552.7; 2020 537.0; 2021 524.5; 2022 510.7 (units as reported). - Net IIP (all residents) at end-2016: -128 percent of GDP; net IIP excluding SPEs at end-2016: -51 percent of GDP. - Excluding SPEs reduces gross external debt to 3.4 times GDP; net external debt excluding SPEs about 1½ percent of GDP. - Baseline projection: - Gross external debt projected to decline from about 600 percent of GDP (€107 billion) in 2017 to 511 percent of GDP (€122 billion) by 2022. - Even excluding SPEs, gross debt forecast to remain above 2.5 times GDP in 2022. - Gross external financing needs (GFN): - Projected to remain very high (about 2.5 times GDP) over the projection period. - About 85 percent and 40 percent of external debt owed by banks and other private sector borrowers, respectively, is short-term, raising rollover risk. ### Debt sustainability and stress tests — selected outcomes - Public debt baseline and projections (Table 1/Table 2 highlights): - Public debt (percent of GDP): 2014 107.5; 2015 107.5; 2016 107.1; 2017 99.7; 2018 95.5; 2019 90.9; 2020 85.8; 2021 81.7; 2022 75.0. - Table 2 primary balance (ESA2010, percent of GDP): 2014 2.6; 2015 2.7; 2016 3.0; 2017 3.4; 2018 3.5; 2019 3.8; 2020 3.8; 2021 3.7; 2022 3.7. - Stress-test scenarios: - Growth shock (one standard deviation 3.4 percentage points decrease in growth during 2018–19, 25 bp rise in interest rates): public debt up 13 percentage points to 104 percent of GDP by 2019, declining to 88 percent by 2022. - Combined shocks: public debt peaks at 107 percent of GDP in 2019 before declining to 94 percent by 2022; GPFN would peak at 13.3 percent of GDP in 2019. - Contingent liability shock (one-off 40 percent of GDP increase in fiscal spending): public debt about 148 percent of GDP by 2022. - GPFN finding: - In short-duration individual macro-fiscal shocks or sustained historical adverse episodes, GPFN would peak around 12 percent of GDP—below the 20 percent benchmark. - Risks to external debt: - Interest rate shock: 2 percentage points increase in average interest rates would raise the debt ratio by about 65 percentage points by 2022 relative to baseline. - Growth shock: one-half standard deviation decrease in growth could increase debt-to-GDP by 64 percentage points by 2022. - Combination of moderate shocks could raise debt ratio by about 60 percentage points by 2022. --- ### Policy Priorities and Staff Appraisal — Key Recommendations ### Use current growth window to resolve legacy problems - Prepare and implement a decisive deleveraging plan to simultaneously and significantly reduce excessive private indebtedness and banks’ NPLs in a non-disruptive manner. - Utilize an array of restructuring tools with burden sharing to limit short-term GDP dampening. - Strengthen the foreclosure framework, clarify protections for primary residences, and streamline court procedures. - Raise awareness of the long-term economic and social toll of weak payment discipline. ### Banking sector actions - Banks need ambitious and credible NPL reduction strategies aligned with realistic capital and provision plans that incorporate NPL recovery-rate assumptions and capital costs. - Enhance use of existing instruments in the law; limit warehousing of swapped properties on balance sheets. - Preserve prudent standards for new lending and loan classification. - Explore options for selling or securitizing loans; put in place legal frameworks and capital safeguards. - External NPL-servicing platforms can be effective if they bring skills, experience and functional changes. ### Fiscal policy and public-sector management - Safeguard expenditure reforms via a ceiling on public spending that increases with medium-term GDP growth to avoid procyclicality and secure downward debt path. - Adopt draft civil service reform law to regulate wage bill growth; closely oversee costs of the planned NHS. - Complete revenue administration and public expenditure reforms to create room for growth-enhancing spending. - Save upside revenue surprises to accelerate public debt decline. ### Structural reforms for balanced growth - Establish a dedicated commercial court with specialized judges to reduce enforcement delays. - Gradually roll back incentives for construction and tighten lending standards to avoid excess luxury supply and concentration of activity. - Restart privatization and governance reforms to enhance competition and productivity. ### Authorities’ positions (selected) - Authorities expect growth near 3¾ percent in the reporting year, easing slightly during 2018–19, stabilizing around 2¾ percent during 2019–20; potential growth projected to increase to just below 2½ percent. - Authorities consider growth shifting to a more durable model; ongoing construction partly funded by FDI and elastic supply of foreign workers seen as reducing broad-based wage/price pressure risk. - Authorities acknowledge delayed NPL resolution would hinder banks’ ability to support growth. *Source: IMF staff report chapter "1. Macroeconomic Performance" and related annexes (cr17375).* ### 1. Macroeconomic Performance _________________________________________________________________ 21 ### 1. Macroeconomic Performance ### Context - Impressive turnaround since the 2012–13 banking crisis: - GDP growth accelerated for three consecutive years. - Unemployment has fallen. - Underlying current account deficit narrowed alongside improved external price competitiveness. - Fiscal balance swung from a large deficit to a small surplus. - Emergency bank liquidity fully repaid; bank deposits rising. - Property prices begun to edge up after a large correction. - Sovereign accessed capital markets on increasingly favorable terms and received a series of credit rating upgrades, now close to investment grade (Annex I). - Remaining legacies from the boom-bust cycle: - Private sector debt remains extremely high. - Banks’ nonperforming loans (NPLs) relative to both total loans and GDP among the highest in the world. - Public debt remains elevated. - High debt and NPLs increase vulnerability to adverse shocks, including tightening global financial conditions. ### Recent Developments — A Strengthening Recovery with External Rebalancing - Growth and output: - GDP grew by 3.8 percent (year-on-year) in the first nine months of 2017, accelerating from 3 percent in 2016. - Output lifted to 4 percent below its pre-crisis peak. - Output gap narrowed to about 2 percent. - Sector drivers: - Strong foreign demand propelled tourism, construction and professional services. - Contracting financial intermediation (reflecting banks’ contracting loan books) was a drag on growth. - Construction of dwellings grew by more than 15 percent in 2016 and has since gained momentum. - Prices and labor market: - Following protracted deflation, core inflation returned to (low) positive territory. - Unemployment fell to 10.3 percent as of September 2017, from a peak of 16.8 percent; pre-crisis rate was 4 percent. - Labor force participation is rising gradually. - Compensation per employee in the public sector rose sharply in Q2:2017. - Disposable incomes benefited in 2017 from the roll back of the temporary solidarity levy on wages introduced during the crisis. - External position: - Unit labor cost- and CPI-based real effective exchange rates (REERs) fell by 20 and 10 percent, respectively, and stabilized for the past two years. - Net exports of tourism and other services rose by more than 3 percentage points of GDP in recent years. - Current account deficit widened to 4.9 percent of GDP in 2016; excluding lumpy SPE-related items and interest on foreign debt of SPEs, it dropped to 0.2 percent of GDP. - Private net financial inflows were more than 30 percent of GDP per year in 2014–16, likely attracted by relatively high interest rates and the citizenship-by-investment (CbI) program. - Private sector debt and bank balance-sheet developments: - Gross debt of Cyprus’s nonfinancial private sector was 259 percent of GDP in Q2:2017. - Household gross debt: 119 percent of GDP. - Nonfinancial corporates: 140 percent of GDP. - Gross debt declined by nearly €1 billion since end-2014; bank loans decreased by more than €3 billion, mainly on write-downs, with limited net repayments (including debt-to-asset (D-A) swaps). - Debt ratio decreased by 18 percentage points of GDP since end-2014, supported by pick-up in nominal GDP. - Bank loans net of deposits were 49 percent of GDP as of Q3:2017 due to large deposit holdings. - Households’ deposits on aggregate almost 20 percent larger than their loan obligations, though distribution mismatch may exist. - Nonperforming loans and banking sector: - NPLs in the three large domestic banks about 55 percent of loans and more than 100 percent of GDP as of March 2017. - Economy-wide NPLs were 44 percent of total loans and 124 percent of GDP as of Q2:2017. - NPL reduction slow and uneven; over 90 percent (by value) of remaining NPLs owed by households and SMEs (Annex III). - Banks placing excess liquidity (some 15 percent of assets) at the central bank. - Capital exceeds regulatory requirements; provisioning nearly 47 percent of NPLs as of Q2:2017. - Profits under pressure from provisioning adjustments, narrowing interest margins and limited operational expense rationalization despite significant overbanking. - Real estate: - Residential prices declined 30 percent and retail prices 50 percent relative to the 2008–09 peak, stabilized in 2015, and rose moderately since mid-2016. - Price-to-rent and price-to-income ratios returned to historical levels. - At least two-thirds of loans collateralized with real estate. - Turnover more active in the luxury market, partly due to the CbI scheme. - Political and reform environment: - Presidential elections widely perceived as delaying essential reforms. - Pace of reform waned since end of the IMF-ESM program in March 2016 and after May 2016 elections. - Two-year reunification negotiations suspended in July 2017; presidential elections scheduled for January–February 2018 diverted attention from macro-financial agenda. ### Outlook and Risks - Staff baseline scenario: - Growth expected to average 3¾ percent during 2017–18, then moderate gradually to around 2½ percent by 2022 as investments are completed. - Forecast underpinned by: - Existing pipeline of large, mainly foreign-financed construction projects that will take several years to complete. - Continued weak payment discipline allowing private consumption to grow broadly in line with income. - High import intensity of investment will cause some re-widening of the current account deficit despite further expansion of tourism. - NPL reduction expected to remain subdued without more effective measures to strengthen payment discipline. - Potential output and labor market: - Ongoing investment will help raise potential growth, but slow structural reform momentum, excessive debt and weak payment discipline would keep potential growth around 2¼ percent. - Negative output gap expected to close in next few years; output may temporarily overshoot potential, exerting upward pressure on prices and productivity-adjusted wages, before reverting to potential over the longer run. - Natural unemployment rate likely risen due to structural mismatches and erosion of skills from sustained unemployment. - Risks (Annex IV): - Upside: sustained foreign-financed construction activity could keep growth elevated longer. - Downside: - Resource shortages, pressures on prices and wages if construction momentum persists. - Skewed growth toward construction increasing vulnerability to a new boom-bust cycle if external financing slows (e.g., risk-off from faster-than-expected policy tightening by major central banks) or if property supply outstrips demand. - Continued slow NPL resolution keeping financial sector vulnerabilities elevated. - Erosion of fiscal discipline raising financing costs and weakening growth. - Adverse international initiatives on corporate taxation or retrenchment by foreign correspondent banks could harm Cyprus’s role as a business and financial hub. - Positive surprise: financially viable development of offshore hydrocarbon deposits could significantly boost growth. ### Authorities’ Views - Authorities expect recent positive macroeconomic trends to continue over the medium term: - Growth near 3¾ percent in the reporting year, easing slightly during 2018–19, stabilizing at around 2¾ percent during 2019–20. - Domestic demand to remain main growth driver, but less vigorous than at present. - Private consumption supported by growing employment and wages, with only modest dampening from NPL reduction. - Investment active, benefiting from projects in tourism, energy and business services. - Current account deficit likely to remain sustainable at around 4 percent of GDP. - Potential growth projected to increase to just below 2½ percent; negative output gap closing with a positive gap opening. - Authorities’ assessment of risks: - Growth now shifts to a more durable model compared with prior cycle; not dependent on fiscal deficit spending or unsustainable credit expansion. - Ongoing construction partly funded by foreign direct investment and thus less volatile. - Elastic supply of foreign workers and segmented property market reduce risk of broad-based wage or price pressures from luxury construction. - Delayed NPL resolution would hinder banks’ ability to support growth through new lending. - Energy sector prospects could yield a positive growth surprise. ### Policy Priority: Achieving Sustainable Deleveraging and NPL Reduction - Rationale: - Eliminating private sector debt overhang and excessive NPLs is essential to support balanced and sustainable growth. - High debt and NPLs have so far not prevented growth due to alternative funding sources (foreign financing, current profits) and strategic nonpayment, but these sources may be finite or unreliable. - Status quo unsustainable: financial stability risks would persist and potential borrowers (especially SMEs) could remain ineligible for new credit. - Limited opportunities for prudent new lending would curtail banks’ profit potential and further concentrate investment in self-funded or foreign-investor sectors. - Policy objective: - Gradually lower nonfinancial private-sector debt net of deposits by 40 percentage points of GDP over a period of five years—bringing it close to its early post-EU accession ratio—is an appropriate target. - Caution on relying on growth alone: - Hopes of achieving the target by “growing out of debt” (either by increasing repayment capacity or mechanically raising the denominator) unlikely feasible given the very rapid growth rates that would be needed and potential for volatility amid high debt and NPLs. - No assurance that higher incomes would automatically improve payment discipline. *Source: IMF staff report chapter "1. Macroeconomic Performance" (cr17375).* ### 16. The current period of strong externally-driven growth provides a window to initiate a ### 16. The current period of strong externally-driven growth provides a window to initiate a ### Deleveraging strategy: objectives and rationale - Window of opportunity: The current period of strong externally-driven growth provides an auspicious opportunity to initiate a comprehensive and ambitious strategy for sizable deleveraging. - Dual focus required: Reducing both private debt and NPLs is needed because cleaning up banks’ portfolios while leaving borrowers saddled with excessive debt would not be sustainable for banks or the economy. - Key elements: Banks should remain adequately provisioned and capitalized, and borrowers should be incentivized to engage with banks by strengthening legal and other restructuring measures. - Timeframe target: A broad set of tools—debt-assets (D-A) swaps, use of banks’ provisions, borrowers’ own funds and current income—in combination with burden-sharing, could deliver a sizable reduction in private debt and NPLs within a five-year period. ### External sector assessment (EBA-lite results and implications) - Current assessment: Given the need for deleveraging, the external sector was assessed as weaker than warranted by fundamentals and desired policy settings in 2017, reflecting, in particular, the need to eliminate the remaining net credit gap. - Macroeconomic effects of deleveraging: - Deleveraging would decrease domestic absorption. - It would raise the current account. - It would lower net IIP liabilities (e.g., by lowering foreign funding used by Cypriot banks to support domestic credit). - Summary of EBA-lite results (as presented): - CA Norm (percent of GDP) (1) — CA 0.1; ES -0.3; REER ... - Underlying CA (percent of GDP) (2) — CA -2.3; ES -2.3; REER ... - CA gap (percent of GDP) (2) – (1) — CA -2.4; ES -2.0; REER ... - REER gap (percent) (elasticity: -0.47) — CA 5.2; ES 4.2; REER 15.0 - Assessment: CA — Weaker; ES — Weaker; REER — Weaker - Note on interpretation: A CA gap within [-4, -2] percent of GDP or [10, 20] percent for the REER gap corresponds to an external position that is weaker than implied by fundamentals and desirable policy settings. ### Financial sector policies and supervisory stance - Banks’ operating environment: - Cypriot banks with large legacy-NPLs face a challenging operating environment. - Progress made on larger corporates’ NPLs, but performance across the three large banks has been uneven. - Shrinking interest margins amid excess liquidity and strong competition, limited opportunities for healthy new lending, and little reduction in operating expenses despite decreasing loan books weigh on profits. - Increased provisioning in Q2:2017 raised provisioning cover to the EU-bank average of 45 percent but further pulled down profits. - Supervisory guidance: - Supervisors should closely monitor new lending and loan classification. - Banks should be encouraged to strengthen capital buffers by curtailing operating costs and raising capital as market conditions allow. - Need for new approaches: - The CBC’s current bank-specific NPL restructuring targets are no longer encouraging performance; planned shift to targets on NPLs could encourage overreliance on balance-sheet operations that consume provisions rather than promote viable workouts. - NPL targets should be calibrated based on ambitious and credible medium-term strategies embedded in realistic capital plans, prepared by each bank and approved by the supervisor. - These plans should utilize a range of tools and incentivize viable borrowers to agree to sustainable loan workouts. - Tools and operational measures (by segment): - Small borrowers (household and SME NPLs): - (i) Effective outsourcing of NPL management to third parties with specialized debt recovery and restructuring skills and an arm’s length relationship with borrowers. - (ii) Segment the portfolio according to characteristics of the loan and offer standardized restructuring packages to viable borrowers within each category to discourage holdouts and re-restructurings. - Update assumptions underpinning provisioning requirements frequently to reflect recent time-to-liquidation and collateral recovery-rate performance. - Real estate portfolio: - Voluntary D-A swaps are useful to avoid forced-sale costs but risk replacing credit risk with real estate risk if properties cannot be sold without depressing prices. - Safeguards recommended: - (i) Engage in D-A swaps only when prospects for upside value-extraction are favorable (using plausible assumptions for maintenance and depreciation costs) or as part of a larger restructuring deal. - (ii) Onboard properties at a forced-sale discount such that any loss is incurred upfront. - (iii) Impose a cap on real estate holdings, together with a capital surcharge that escalates with the share of real estate in a bank’s assets and length of holding period. - Portfolio divestment: - Divesting parts of problem-loan portfolios allows banks to refocus and transfer assets to parties better placed to resolve NPLs. - This could be achieved under the new sale of loans law or through securitization, once enabling legislation has been approved. - Large price discounts relative to book value may be needed, consistent with deficiencies in the frameworks for private debt restructuring. - Operational caveats and risks: - In the near term, a shift to NPL targets could encourage excessive use of balance-sheet operations that consume provisions. - Supervisory calibration and bank-specific realistic capital plans are necessary to prevent undue financial stability risks. ### Authorities’ views on bank behavior and tools - Observations: - Progress with reducing NPLs has been uneven; some banks have made considerably more progress and effective use of available tools, others insufficiently ambitious. - The recent increase in provisioning was necessary; the supervisor will continue frequent reviews of the adequacy of provisions to ensure NPL reduction plans remain feasible. - Continuing inflows from new defaults and re-defaults and IFRS9 expected-loss provisioning could lead to further provisioning calls. - Policy and implementation priorities: - Explore options for selling or securitizing loans; needed legal frameworks and capital safeguards should be put in place. - External NPL-servicing platforms can be effective if they bring appropriate skills, experience and functional changes. - Monitor onboarding and holding periods for D-A swaps and real estate to prevent excessive onboarding when properties cannot be sold. - D-A swaps are typically booked at a conservative 25–30 percent discount on the lowest current market valuation and are typically used in combination with cash repayment and other measures. - Maintain close oversight on loan classification requirements and credit standards for new lending. ### Strengthening claims enforcement and incentives for payment - Problem statement: - Improved payment discipline is essential for sustainable deleveraging and a well-functioning market economy. - Strategic default is enabled by lengthy and inefficient procedures for commercial claims enforcement and foreclosure, perceived blanket protection of primary residences, and competing claims from failing to issue or transfer title deeds. - Strategic default imposes a heavy social and economic cost by limiting banks’ ability to extend healthy credit and perpetuating vulnerabilities. - Recommended legal and procedural reforms to modify borrowers’ incentives: - Strengthen the foreclosure framework by: - (i) lowering or eliminating minimum reserve prices and introducing virtual auctions; - (ii) allowing more flexible procedures for notifying borrowers; - (iii) clarifying the applicability of the new foreclosure procedures to legacy cases; - (iv) reviewing and clarifying existing protections for primary residences and guarantors. - More widely promote utilization of the new debt restructuring tools for individuals and corporates and continue transfer of property titles to eligible trapped buyers. - The planned introduction of a credit scoring system is welcome. - Strengthen enforcement of commercial claims to enhance collection and provide incentives for mutually-agreeable restructurings. - Move court and civil procedure reforms forward on an expedited basis. - Context on trapped buyers law: - The 2015 “trapped buyers” law allows transfer of the property title to a buyer who has fulfilled his financial commitments by shifting the mortgage encumbrance to another property of the developer. - The constitutionality of the law was recently challenged by the banks; of the original 14 thousand applications for compulsory transfer of property title, eight thousand cases remain outstanding. ### Authorities’ perspectives on incentives and implementation - Observations: - The economic recovery is expected to deliver some gradual reduction in NPLs, but more proactive use of available tools is needed. - Delay between economic improvement and faster NPL reduction is expected due to time needed to ramp up restructuring capacity and migration of cured NPLs to performing status. - Some borrowers remain affected by job losses and bail-in of deposits; strategic default incidence appears non-insignificant, as evidenced by the rise in household and firm deposits. - Some sectors benefiting from the recovery have not seen faster-than-average NPL reductions. - Introduction of foreclosure and insolvency laws has increased incentives for negotiated solutions, but targeted amendments could enhance functionality. - Inefficient court procedures allowing repeated appeals are a concern. - Significant progress is being achieved on issuance and transfer of legacy title deeds. - Policy stance: - Banks should enhance use of all existing instruments in the law. - Debtors’ demand for new credit and the fact that properties cannot be sold or bequeathed unless the mortgagor agrees provides banks leverage in negotiations. - Political commitment is needed to strengthen the payment culture. ### Policy Priority: Ensuring Fiscal Sustainability without Procyclicality - Recent fiscal outturns: - Headline and primary balances reached 0.5 percent and 3.0 percent of GDP, respectively, in 2016. - Each is expected to increase by a further ½ percentage point in 2017. - These favorable outturns reflect strong revenue collection—especially in construction—and several one-off revenues, despite 1½ percentage points of GDP of loosening measures adopted during 2015–17. - Gross public debt declined below 100 percent of GDP in late 2017. - Draft budget and staff projections (selected figures and points): - Authorities expect the overall surplus to increase to 1.3 percent of GDP next year (authorities’ projection). - Staff expects 1.1 percent based on its macroeconomic forecasts and somewhat less-restrained spending growth. - Output gap: authorities’ scenario projects the output gap to turn positive in 2019 and widen through 2022 in staff’s forecasts; staff’s memorandum output gap sequence: -6.0, -4.3, -2.0, -0.3, 0.6, 1.1, 1.4, 1.7 (for 2015–2022 respectively). - Public debt projection: staff forecasts public debt to decline to 82 percent of GDP by 2020 (authorities’ DBP2018 shows 86 percent of GDP in staff’s forecasts and 75 percent of GDP by 2022 in authorities’ plan). - Risks of procyclicality: - With the output gap already positive and projected to widen, a growing share of revenue would be sourced from above-potential output. - Spending growing faster than cyclically-adjusted revenue is expected to erode the structural balance and contribute to overheating. - Recommendation to avoid procyclicality: - Cap increases in fiscal spending by medium-term GDP growth: set an annual ceiling for nominal spending that increases in line with medium-term growth (with downward adjustment to compensate for any future cuts to tax rates or narrowing of tax bases). - Such a cap would avoid procyclical policies, help prevent a structural loosening, and accelerate the downward path of debt to rebuild fiscal space. - Institute a durable mechanism to keep the public-sector wage bill in check. - Closely monitor costs—including arrears—of the National Health Service (NHS) to be rolled out in June 2019 to ensure public finances are not put at risk. *Source: cr17375 (IMF staff).* ### 29. The authorities remain committed to fiscal prudence while continuing to support the ### 29. The authorities remain committed to fiscal prudence while continuing to support the ### Fiscal stance and outlook - A strategy of lowering tax rates and providing tax breaks has lifted GDP growth and tax revenue and, together with consolidation of government spending, enabled the swift elimination of fiscal deficits. - In recent years, fiscal outturns have significantly exceeded the goal of overall fiscal balance. - The primary surplus is on track to exceed 3 percent of GDP (with an overall surplus of 1 percent of GDP) in 2017. - Fiscal plans through 2020 envisage that expenditure will increase in line with medium-term GDP growth, keeping the overall surplus at around 1 percent of GDP. - The collective agreement with public sector unions, and adoption of the law indefinitely freezing hiring and the law allowing extended staff mobility within the broader public sector will help to support this goal. - Revenue from upside growth surprises will be saved, further accelerating the decline in gross public debt, which is expected to fall below 100 percent of GDP by end-2017, one year ahead of plan. - Regarding fiscal risks: - The forthcoming NHS is intended to be fiscally neutral. This assumption will be reviewed based on the external consultant’s report due in early 2018. - Pending legal claims for compensation for measures taken to address the financial crisis could pose additional fiscal risks. ### Real estate: recent effects and risks - Several investment incentives, including the CbI scheme, provided welcome support to construction and the economy more broadly in the aftermath of the crisis. - This support has now achieved its goal, and could turn procyclical. - Risks identified: - Excessive concentration of economic activity in real estate and risk of over-supply of luxury properties. - Potential reliance of luxury market construction on domestic credit or spillovers to other housing segments. - Indicators and dynamics noted: - Large luxury construction projects are mainly foreign financed or financed through pre-selling, helping to limit financial stability risks. - If signs emerge that construction in the luxury market is becoming reliant on domestic credit or that activity is spilling over to other segments, tightening bank lending standards and raising macroprudential capital requirements would be appropriate. ### Policy recommendations for real estate and CbI scheme integrity - Further decoupling the scheme’s eligibility requirements from real estate to avoid excessive concentration and reduce over-supply risk. - Ensure full compliance with AML/CFT standards by all sectors involved in the CbI scheme and supervision of those sectors for compliance to maintain the integrity of the CbI scheme and mitigate correspondent banking pressures. - AML/CFT requirements should include checking the source of wealth and source of funds of applicants, including by the authorities as part of eligibility criteria and processes. - Streamline procedures for issuing and transferring title deeds for new properties, with timely transfer of titles to buyers. - Tighten bank lending standards and raise macroprudential capital requirements if domestic credit funds luxury construction or activity spills over. - Reinstating the recently rescinded immovable property tax (IPT) and raising the transfer duty on immovable property would provide additional countercyclical tools. - To comply with EU requirements, VAT will be imposed on transactions of buildable land, thereby partly offsetting—from a tax-incidence perspective—the previous elimination of the IPT and reduction in property transfer fees. ### Enforcement of commercial claims and court efficiency - Delays in court processes weaken the attractiveness of the country as a business destination and undermine effective implementation of the foreclosure and insolvency laws. - Recommended actions: - Review and update the civil procedure law. - Modernize rules for appeals and interim injunctions to limit undue delays. - Consider introducing a streamlined procedure for enforcement of small claims. - Establish a commercial court and introduce specialization of judges in the lower courts to allow more expeditious case handling. ### Authorities’ views (selected) - Increased construction activity has supported the recovery, and associated risks appear manageable. - Regulatory improvements to the CbI—with stricter controls on intermediaries (including real estate agents and lawyers)—are being considered, but there are no plans to amend the eligibility criteria. - Some construction projects will generate future revenue streams (e.g., the casino and marinas) that will underpin their value. - Caution is needed to prevent a recurrence of developer reliance on domestic bank financing; tightening of lending standards is warranted for developers and if foreign demand spills over to the general housing market. - Judicial reform is high on the agenda; a study by independent experts of the structure and operations of Cypriot courts is expected to deliver recommendations by Spring 2018. - The recent establishment of the Administrative Court and the anticipated commencement of a Commercial Court in 2018 would help clear the backlog of cases. - Several initiatives to attract investment beyond traditional sectors are in progress, including simplifying licensing procedures for strategic investments and promoting start-ups and the filming industry. - The law to corporatize the Cyprus Telecom Authority (CyTA), maintaining state majority ownership and grandfathering employees’ rights, will be submitted to parliament for approval. - Following the successful sale of the operations of the port of Limassol, assignment of the operations of the port and marina of Larnaca is expected in the coming months. - Several broad-based tax reductions have been adopted, including allowing more accelerated capital depreciation and tax deductibility of equity-financing, and eliminating the temporary solidarity levy on wages, which should help to partly offset the new NHS levy. ### Staff appraisal — key findings and priorities - The Cypriot economy is continuing to bounce back from the severe disruption that followed the 2012–13 banking crisis. - Legacy issues remain: excessive NPLs and private and public debt continue to cloud the economic outlook. - Growth drivers and risks: - Strong foreign demand, large foreign investment, strong tourism revenue and persistent weak payment discipline are currently masking the effect of the debt overhang. - Growth is expected to remain robust for the next few years while large foreign-financed projects are built, but realized growth is projected to moderate with the completion of ongoing construction projects. - Short-run upside growth surprises from construction could raise prospect of a new boom-bust cycle. - Continued slow progress on reducing NPLs would keep banking vulnerabilities elevated. - Risk-off sentiment in global financial markets could weaken capital inflows. - Discovery of economically-viable offshore gas reserves could significantly increase growth prospects. ### Policy priorities and recommended actions - Use current strong, externally-led growth to resolve legacy problems by: - Prompt preparation and implementation of a decisive deleveraging plan, together with improved payment discipline. - Simultaneously and significantly reducing excessive private indebtedness and banks’ NPLs in a non-disruptive manner. - Utilizing an array of restructuring tools, together with burden sharing, to limit short-term dampening on GDP growth. - Strengthening the foreclosure framework, clarifying existing protections for primary residences, and streamlining court procedures. - Raising awareness of the potentially-heavy long-term economic and social toll of weak payment discipline. - Banks actions: - Banks require ambitious and credible strategies for reducing NPLs, while also complying fully with supervisory norms. - New approaches are needed to tackle the large pool of smaller-value NPLs. - Strategies should be consistent with long-term plans for capital and provisions that incorporate realistic assumptions on NPL recovery rates as well as the cost and availability of additional capital. - Use of debt-assets swaps should be limited if banks are warehousing swapped properties on their balance sheets. - Prudent standards for new lending and loan classification should be preserved. - Fiscal policy: - Safeguard improvements brought by previous expenditure reforms through a ceiling on public spending. - A spending cap that increases in step with medium-term GDP growth is advised to contain spending pressures and the risk that cyclical or one-off revenue is spent; this would also secure the downward path for public debt. - Adopt the draft civil service reform law to regulate wage bill growth while closely overseeing the costs of the planned new National Health Scheme. - Complete pending revenue administration and public expenditure reforms to create room for growth-enhancing spending. - Structural reforms to ensure balanced and sustainable growth: - Establish a dedicated commercial court with specialized judges to reduce delays and uncertainty in claims enforcement. - Gradually roll back incentives for construction and tighten lending standards to avoid excess supply of luxury properties, protect financial stability and prevent excessive concentration of economic activity. - Restart the privatization program and undertake governance reform to enhance competition and increase productivity. *IMF staff appraisal drawn from the source content.* ### 44. It is recommended that Cyprus remain on the standard 12-month Article IV ### 44. It is recommended that Cyprus remain on the standard 12-month Article IV ### Macroeconomic performance - Real GDP: 2014 -1.4; 2015 2.0; 2016 3.0; 2017 3.8; 2018 3.6; 2019 2.9; 2020 2.6; 2021 2.5; 2022 2.5 (percent change). - Domestic demand: 2014 -1.5; 2015 3.3; 2016 4.8; 2017 4.4; 2018 3.6; 2019 2.9; 2020 2.7; 2021 2.5; 2022 2.5 (percent change). - Gross capital formation: 2014 -3.2; 2015 12.4; 2016 17.2; 2017 8.8; 2018 6.8; 2019 4.2; 2020 3.8; 2021 3.6; 2022 3.5 (percent change). - Exports of goods and services: 2014 4.2; 2015 6.3; 2016 3.9; 2017 0.0; 2018 2.4; 2019 2.2; 2020 2.0; 2021 2.0; 2022 2.0 (percent change). - Imports of goods and services: 2014 4.6; 2015 8.1; 2016 6.6; 2017 0.8; 2018 2.4; 2019 2.3; 2020 2.2; 2021 2.1; 2022 2.1 (percent change). - Potential GDP growth: 2014 0.4; 2015 0.8; 2016 1.1; 2017 1.5; 2018 1.8; 2019 2.0; 2020 2.1; 2021 2.2; 2022 2.2 (percent). - Output gap (percent of potential GDP): 2014 -7.2; 2015 -6.0; 2016 -4.3; 2017 -2.0; 2018 -0.3; 2019 0.6; 2020 1.1; 2021 1.4; 2022 1.7. ### Inflation and labor market - HICP (period average): 2014 -0.3; 2015 -1.5; 2016 -1.2; 2017 0.8; 2018 0.7; 2019 1.1; 2020 1.8; 2021 1.9; 2022 2.0 (percent). - HICP (end of period): 2014 -0.9; 2015 -0.5; 2016 0.1; 2017 0.8; 2018 0.7; 2019 1.1; 2020 1.8; 2021 1.9; 2022 1.9 (percent). - Unemployment rate (percent): 2014 16.1; 2015 14.9; 2016 13.0; 2017 11.3; 2018 10.0; 2019 9.1; 2020 8.4; 2021 7.7; 2022 6.9. - Employment growth (percent): 2014 -0.6; 2015 -1.3; 2016 2.5; 2017 3.2; 2018 2.7; 2019 1.6; 2020 1.4; 2021 1.3; 2022 1.2. - Labor force (percent change): 2014 -0.4; 2015 -2.6; 2016 0.3; 2017 1.2; 2018 1.2; 2019 0.6; 2020 0.6; 2021 0.5; 2022 0.3. ### External indicators - Current account balance (percent of GDP): 2008–2016 series shown; Table 1 projections: 2014 -4.3; 2015 -1.5; 2016 -4.9; 2017 -4.9; 2018 -4.2; 2019 -4.6; 2020 -4.8; 2021 -5.0; 2022 -5.2. - Real effective exchange rate indices (2009 = 100) shown for REER - GDP, REER - ULC, REER - CPI (2000Q1–2017Q2). - Net IIP by functional categories (percent of GDP) and gross external debt (percent of GDP): gross external debt (2008Q1–2017Q1) series shown graphically; Table 1 external debt: 2014 554.4; 2015 572.7; 2016 592.0; 2017 580.7; 2018 564.7; 2019 552.7; 2020 537.0; 2021 524.5; 2022 510.7 (units as reported). - Financial flows by sector (4-quarter sum, percent of GDP) and Net IIP Position (percent of GDP) shown for 2008–2017 series. ### Credit and balance sheets - Domestic credit growth (annual percentage change, Aug-17): NFC, Households, Non-financial private sector total series shown (Sep-11 to Aug-17). - Domestic financial positions by instrument (Billions of Euros): assets and liabilities series displayed 2012Q4–2017Q1. - Domestic economy financial balances by sector (Billions of Euros) shown 2012Q4–2017Q1. - Domestic financial balances by instrument (Billions of Euros) series shown 2012Q4–2017Q1. - Debt of households (2016, percent of GDP): comparisons across countries plotted; Cyprus positioned among peers. - Debt of nonfinancial corporations (2016, percent of GDP): country comparisons with Cyprus among higher-ranked. ### Banking sector - Emergency Liquidity Assistance (Billions of Euros) series Mar-13 to Sep-17. - Nonperforming Loan (NPL) ratio to total loans and provisioning coverage ratio to NPLs: series Jun-13 to Jun-17 (NPL ratios decline in chart; provisioning coverage increases). - Total customer deposits (Dec 31, 2013 = 100): Locally active and Total series Dec-13 to Sep-17. - Banking sector profits (Billions of Euros): components 2010–2017H1 with Net Interest income, Net fee and commission income, Provisions and impairment, Tax expenses, etc. - Balance sheet of the banking sector (Billions of Euros): assets and liabilities/equity components 2010–2016. - Deposits by residency and total deposit growth (y-o-y): series Jan-10 to Aug-17 showing RoW, Other EA residents, Domestic households, Domestic NFCs. ### Housing market - Residential property price index, Real residential property index, Construction cost index (2010Q1 = 100): 2002Q1–2017Q1 series. - Housing loans (stock, Bn Euro) by residency: 2002Q1–2017Q2. - Mortgage interest rate (percent): 2002Q1–2017Q2. - Building permits (Million Sq. M): 2002Q1–2017Q1. - Property sales (Thousand units) and sales to non-residents vs residents: 2000–2016 series and 2017M1-9. - Real growth in construction activities (year-on-year percent change) 2002Q1–2017Q2. ### Fiscal developments - Overall and primary balance (accrual basis, percent of GDP): 2007–2016 time series; Table 2 projections overall balance: 2014 -0.8; 2015 -0.1; 2016 0.5; 2017 1.0; 2018 1.1; 2019 1.4; 2020 1.4; 2021 1.4; 2022 1.4. - Expenditure by main component (percent of GDP) 2007–2016: wages and salaries, goods and services, social transfers, subsidies, interest payments, capital expenditure. - Revenue by main component (percent of GDP) 2007–2016: direct taxes, indirect taxes, social security contributions, other current revenue. - Public debt (percent of GDP) 2007–2016 and projections: Table 1 public debt: 2014 107.5; 2015 107.5; 2016 107.1; 2017 99.7; 2018 95.5; 2019 90.9; 2020 85.8; 2021 81.7; 2022 75.0. ### Selected economic indicators (Table 1 highlights) - Nominal GDP (billions of euros): 2014 17.6; 2015 17.7; 2016 18.1; 2017 18.8; 2018 19.9; 2019 20.7; 2020 21.7; 2021 22.8; 2022 23.9. - Unemployment rate series repeated: 2014 16.1 → 2022 6.9. - External debt (Table 1 memorandum): 2014 554.4; 2015 572.7; 2016 592.0; 2017 580.7; 2018 564.7; 2019 552.7; 2020 537.0; 2021 524.5; 2022 510.7. ### Fiscal developments and projections (Table 2 highlights) - Revenue (percent of GDP): steady at 39.3–40.0 across 2014–2022; specifically 2014 39.3; 2015 38.8; 2016 38.8; 2017 39.7; 2018 39.7; 2019 40.0; 2020 40.0; 2021 40.0; 2022 40.0. - Expenditure (percent of GDP): 2014 40.1; 2015 38.9; 2016 38.3; 2017 38.7; 2018 38.6; 2019 38.6; 2020 38.6; 2021 38.6; 2022 38.6. - Primary balance (ESA2010, percent of GDP): 2014 2.6; 2015 2.7; 2016 3.0; 2017 3.4; 2018 3.5; 2019 3.8; 2020 3.8; 2021 3.7; 2022 3.7. - Public debt net of cash holding (percent of GDP): 2014 101.7; 2015 103.7; 2016 101.7; 2017 96.1; 2018 90.2; 2019 85.4; 2020 80.0; 2021 75.0; 2022 70.1. ### Balance of payments (Table 3 highlights) - Current Account (Millions of Euros): 2013 -896; 2014 -761; 2015 -259; 2016 -889; 2017 -928; 2018 -832; 2019 -951; 2020 -1,041; 2021 -1,147; 2022 -1,238. - Trade balance and goods/services breakdown (Millions of Euros): Goods balance 2013 -2,939 → 2022 -5,055; Services balance 2013 3,269 → 2022 4,612 (series by year provided). - Financial account (Millions of Euros): 2013 -343; 2014 -1,251; 2015 -283; 2016 -1,352; 2017 -768; 2018 -728; 2019 -836; 2020 -948; 2021 -1,064; 2022 -1,150. - Gross external debt (Millions of Euros): 2013 103,234; 2014 97,609; 2015 101,608; 2016 107,284; 2017 109,426; 2018 114,382; 2019 116,664; 2020 119,345; 2021 121,826; 2022 124,153. ### Monetary indicators (Table 4 highlights) - Aggregated balance sheet of MFIs excluding CBC (Assets, Billions of Euros): 2010 135.0; 2011 131.4; 2012 128.1; 2013 90.3; 2014 91.1; 2015 91.0; 2016 86.6. - Cypriot Resident Broad money (M2, Billions of Euros): 2010 241.2; 2011 228.0; 2012 229.3; 2013 190.2; 2014 194.1; 2015 198.2; 2016 212.7. - Private sector credit excluding SPEs (Billions of Euros): 2010 241.0; 2011 246.6; 2012 253.1; 2013 256.8; 2014 257.7; 2015 252.4; 2016 234.2. - Net foreign assets and net domestic assets series shown 2010–2016 (Billions of Euros). ### Financial soundness indicators (Table 5 highlights) - Regulatory capital ratio (percent): 2010 12.3; 2011 8.6; 2012 7.3; 2013 13.5; 2014 15.3; 2015 16.6; 2016 16.8; H1:2017 16.4. - Tier I capital ratio (percent): 2010 10.9; 2011 7.4; 2012 6.3; 2013 12.3; 2014 14.4; 2015 16.0; 2016 16.4; H1:2017 15.5. - Non-performing loans (NPLs) to total gross loans (EBA definition) (percent): 2010 13.3; 2011 17.3; 2012 27.1; 2013 44.4; 2014 47.5; 2015 45.3; 2016 46.4; H1:2017 44.1. - Provisions to NPLs (percent): 2014 33.9; 2015 38.3; 2016 42.3; H1:2017 47.1. - Return on assets (annual return): 2013 -3.7; 2014 -5.4; 2015 -14.7; 2016 -0.1; H1:2017 0.6 (year-to-date). - Return on equity (annual return): 2013 -54.5; 2014 -83.5; 2015 -100.5; 2016 -4.6; H1:2017 2.4 (year-to-date). - Liquidity: Cash, trading and available-for-sale assets to total assets ratio: 2010 10.7; 2011 9.7; 2012 8.6; 2013 7.0; 2014 14.4; 2015 19.8; 2016 22.9; H1:2017 23.6. *Source: IMF staff report figures and tables as presented in the provided chapter.* ### Annex I. Authorities’ Responses to Past Policy Recommendations ### Annex I. Authorities’ Responses to Past Policy Recommendations ### Strengthen Financial Sector Policies - Reduce high NPLs, including by (i) legislating and implementing insolvency and foreclosure frameworks; (ii) addressing impediments to asset sales; and (iii) ensuring ownership of titles reflects the economic ownership and accelerating the issuance of title deeds. - (i) A package of laws to reform the insolvency framework was adopted (2015) and the frameworks implemented (2015). - (ii) A law to allow the sale of loans approved/implemented (2015). - (iii) Trapped buyer’s law implemented (2015) but legal uncertainties remain and coverage limited. - Further strengthen capital buffers and continue efforts to restructure banks and the coop sector. - SSM’s 2015 Capital Review Exercise identified capital and provisioning shortfalls in the CCB, which were rectified through additional budgetary support (2015). - As a condition for the state aid, the CCB is undergoing an organizational restructuring and is to be privatized in stages. - Manage external payment restrictions prudently to safeguard financial stability. - All external payment restrictions have been lifted without causing detrimental effects on the financial stability (2015). - Enhance prudential supervision within the SSM framework and ensure effective AML/CFT supervision. - Cyprus signed a multilateral agreement for the automatic exchange of financial information (2014) and a peer review assessment found Cyprus was largely compliant (2017). ### Put Public Debt on a Sustained Downward Path - Implement medium-term fiscal consolidation that is carefully paced, relies on permanent measures, and is focused on unwinding the spending increases preceding the crisis. - Fiscal relaxation took place during 2015–17. Public debt has peaked and is projected to decline over the medium term, aided by revenue increases as the economic recovery continues. - Focus on implementing key reforms in public financial management (PFM) and revenue administration (RA); pass the law regulating the creation and functioning of SOEs. - PFM and RA reforms are being implemented, supported with Fund technical assistance. The law on SOEs remains to be adopted. ### Implement Structural Reforms - Implement reforms to the welfare system. - Guaranteed minimum income program has been implemented (2015). - Press ahead with a comprehensive privatization program. - Privatization efforts have largely stalled. - Implement concrete actions to improve the business environment. - A comprehensive action plan has been drawn up, but implementation is slow. *Source: Annex I. Authorities’ Responses to Past Policy Recommendations* ### Annex II. Effects of Special Purpose Entities on Cyprus’s Macroeconomic Statistics ### What is an SPE - Cyprus adopts the OECD convention on classifying SPEs. - An entity is considered an SPE if it generally meets the following: (i) is a company with no—or very limited—physical presence in the country in which it is registered; (ii) has few or no employees and little or no production in the economy; (iii) is controlled by a nonresident parent company; (iv) its core business is to provide group financing or holding activities; (v) most of its assets and liabilities represent investments in or from other countries; and (vi) it is subject to tax and other legal obligations of the host country. ### Types of SPEs in Cyprus and their Business Models - Non-financial SPEs (mainly ship-owning companies): owners of movable transport equipment; real assets on their balance sheets are matched by financial liabilities incurred to finance the purchase of the movable equipment. - Financial companies: belong to an international group and channel funds between related nonresident entities on behalf of their nonresident parent company; financial assets are matched in size by financial liabilities. - Factoring/invoicing companies: invoice the sales of the worldwide group on behalf of the parent. ### How SPEs affect Macroeconomic Statistics - National Accounts - SPEs increase domestic value added through demand for professional (e.g., legal and accounting) and banking services. For non-financial SPEs, leasing services also contribute to domestic value added. - In the case of ship-owning SPEs, registration and deregistration of ships can give rise to significant volatility in individual GDP components and in the trade balance of the current account. Since 2015, inward transactions by ship-owning SPEs have increased. - External Sector Statistics - Current Account - Non-financial SPEs affect the current account through: (i) imports and exports of movable equipment; (ii) exports and imports of services; and (iii) repatriation of profit to parent companies and payment of interest on external debt. - Financial SPEs do not affect the net current account although they have considerable gross impact, especially on the primary income account via receipts and payments of interest, dividends and re-invested earnings. - Financial Account and Change in Reserves - Financial SPEs have minimal net effect on financial flows, but gross in- and out-flows related to financial SPEs are very large. These flows are mostly in the form of FDI. - External Assets and Liabilities, External Debt - SPEs materially impact stocks of external assets and liabilities. Gross external debt of SPEs includes debt incurred by nonfinancial SPEs to finance purchases of movable equipment. - Most foreign financial assets and liabilities of SPEs are in the form of FDI and are primarily attributable to financial SPEs. - SPEs maintain a net external liability position that is large relative to Cyprus’s GDP. - Domestic Banking Statistics - Non-financial SPEs are thought to have limited linkages with the domestic banking system; domestic banks’ exposure to non-financial SPEs through deposit-taking or lending is thought to be small. - Financial SPEs’ exposure to Cypriot banks is small relative to the size of these SPEs’ balance sheets. In most cases, cross-border financial flows booked on Cypriot-registered financial SPEs are not intermediated through Cyprus. *Source: Annex II. Effects of Special Purpose Entities on Cyprus’s Macroeconomic Statistics* ### Annex III. Evolution of Nonperforming Loans ### Key statistics and trends - Total NPLs stood at €22.8 billion as of June 2017, €5.9 billion below their maximum value in Q1:2015. - Relative to GDP, NPLs remain the highest in the euro area at 124 percent. - NPLs have declined by one fifth relative to their peak. - On a rolling-annual basis, pace of NPL reduction has increased, but the NPL ratio has declined only slowly because outstanding loans have also declined. - NPL composition (shares): - Households: 56 percent of NPLs. - Nonfinancial corporates (NFCs): 42 percent of NPLs. - Small borrowers (SMEs and households) account for about 90 percent of NPLs. - SMEs account for a larger share of NPLs than large corporates due to their greater presence in Cyprus. ### Sectoral and borrower patterns - Reduction in NPLs has been unbalanced across sectors: NFCs account for most of the decline; household NPLs have seen only a very limited reduction. - In nominal terms, NFC NPLs are mostly concentrated in construction, retail trade and tourism, and real estate sectors. - Despite weak balance sheets, these sectors have seen brisk growth and contributed substantially to overall GDP growth in recent years, supported by liquidity provided outside the domestic banking sector. - There is no evidence of activities shifting toward sectors previously less dependent on bank credit. ### NPL flows and coverage - The evolution of the stock of NPLs reflects outflows and inflows: - Nearly one-half of outflows from NPLs has been due to migration of loans to performing status. - About one-third of outflows reflects loan write-offs and debt-to-asset swaps. - Inflows to the nonperforming category totaled about two-thirds of gross outflows and include newly-defaulted loans, redefaults of previously-restructured loans, and accrued-but-unpaid interest on existing NPLs. - Migration and flow breakdown (Q4:2015–Q2:2017, stock normalized to 100): - Migration from performing: 17.0 - Interest accrued on NPLs: 10.1 - Migration into performing: 19.1 - NPL cash repayment: 10.2 - Debt-to-asset swaps: 3.9 - Write-offs: 9.8 - Remaining NPLs: 56.9 - Outflow: 43.1 - Inflow: 27.1 - Net Outflow: 16.0 - Provisioning coverage: - The provisioning coverage ratio of NPLs has risen to just-above the EU-average of 45 percent. - The ratio has risen from below 35 percent during the past two years. - In Q2:2017 alone, the increase was almost 4 percentage points. - Provisions as Percent of NPLs, 2017Q2: Cyprus appears among peers but specific percentile ordering is shown in charts (EU average indicated). *Source: Annex III. Evolution of Nonperforming Loans* ### Annex IV. Risk Assessment Matrix ### Externally sourced risks (selected) - Policy uncertainty (relative likelihood: Medium) - Two-sided risks to U.S. growth; uncertainty associated with negotiating post-Brexit arrangements; evolving political processes, including elections in several large advanced and emerging market economies. - Expected impact: Weaker external demand would adversely affect long-term growth due to Cyprus’s dependence on foreign demand—especially from the UK and Russia—for tourism and business services. - Policy response: Seek to broaden sources of foreign demand beyond a narrow set of countries. Restart structural reforms to make the economy more flexible and dynamic in response to demand shocks. - Retreat from cross-border integration (relative likelihood: High) - Protectionism and economic isolationism would reduce trade, capital and labor flows. - Expected impact: Weaker external demand would adversely affect long-term growth. - Policy response: Restart structural reforms to make the economy more flexible and dynamic in response to demand shocks. - Tighter global financial conditions (relative likelihood: High) - Fed normalization and tapering by ECB increase global rates and term premia; stronger U.S. dollar and euro; adjustments could be disruptive. - Expected impact: Higher interest rates on Cypriot government borrowing would raise the cost of refinancing maturing official loans with market debt. - Policy response: Undertake additional fiscal consolidation to reduce borrowing needs. - Reduced financial services by correspondent banks ("de-risking") (relative likelihood: Medium) - Curtailment of cross-border financial services. - Expected impact: Reduced Cypriot access to foreign correspondents could weigh on the professional services sector and long-term growth. - Policy response: Ensure full compliance with international transparency and exchange of information agreements and AML/CFT standards. ### Domestically sourced risks (selected) - European bank distress (relative likelihood: High) - Strained bank balance sheets and weak profitability in major banks could have knock-on effects. - Expected impact: Market pressure on other euro area banks with elevated NPLs could spill over to Cypriot banks, reigniting financial sector stress with repercussions for public debt sustainability and long-term growth. - Policy response: Intensify efforts to reduce NPLs; undertake further fiscal consolidation to create precautionary headroom. - Post-crisis policy slippage (relative likelihood: High) - Eroding fiscal discipline and inaction on efficiency-enhancing structural reforms. - Expected impact: Slowdown in debt moderation, weakened potential growth, higher sovereign borrowing costs, weakened public debt sustainability and long-term growth. - Policy response: Resist pressure for structural fiscal easing; decisively implement structural reforms; save overperformance and windfall revenues and avoid expenditure slippages. - Slow progress on reducing NPLs (relative likelihood: High) - Current resolution strategies could yield very slow NPL reduction; weak bank profits amid low interest rates could limit capacity to boost capital and provisions. - Expected impact: Constrained scope for banks to expand lending, retarded GDP growth (Medium), potential bank-sovereign feedback loop raising financing needs and borrowing costs with repercussions for public debt and long-term growth (High). - Policy response: Intensify efforts to reduce NPLs; undertake further fiscal consolidation to create precautionary headroom. *Source: Annex IV. Risk Assessment Matrix* ### Annex V. External Sector Assessment and Debt Sustainability ### Annex V. External Sector Assessment and Debt Sustainability ### Overview of Cyprus’s external position - Cyprus runs a large services-trade surplus and a goods-trade deficit due to tourism and exports of financial, business, ship-management and other services; many products are sourced from abroad leading to a sustained goods deficit. - The income account records a deficit reflecting a large net negative international investment position (IIP) and remittances; the secondary income deficit reflects reliance on foreign workers. - The economy tends to run current account deficits, resulting in a buildup of net external liabilities driven primarily by a persistent private saving–investment imbalance; in recent years the public sector ran a net surplus offsetting part of the private imbalance. - Recent private external financing has mainly been portfolio debt and loans—both drawdown of foreign assets and increases in foreign liabilities. ### Gross flows and international investment position (IIP) - Gross financial flows and stocks are extremely large relative to net positions, reflecting Cyprus’s role as a regional financial center. - Stocks of IIP assets and liabilities in 2016: - Assets: 14 times GDP - Liabilities: 16 times GDP - Sum of positions relative to GDP among the highest in the world. - Banking sector other-investment gross IIP positions in 2016: - Banks’ other-investment gross IIP assets: about 1 times GDP - Banks’ other-investment gross IIP liabilities: about 1.2 times GDP - Banks’ IIP liabilities are mostly short-term deposits. - Net IIP: - Net IIP (all residents) at end-2016: -128 percent of GDP - Net IIP excluding SPEs at end-2016: -51 percent of GDP - Financial-flow episodes: - Net inflows to the private sector resumed strongly in 2014, reaching around 30 percent of GDP per year during 2014–16. - Emergency liquidity assistance (ELA) in 2012 to a major Cypriot bank amounted to 58 percent of GDP, contributing to a shift in Cyprus’s Target-2 balance into deficit during the crisis; subsequently Target-2 accumulated a surplus of more than 20 percent of GDP. - SPEs materially affect the IIP and current account; treating SPEs as nonresidents is appropriate for evaluating the external sector. ### Developments during the past decade - The current account deficit narrowed sharply from 15 percent of GDP in 2008 to 1.5 percent of GDP in 2015 due to collapsing import demand after the financial and banking crises; since 2015 the deficit has edged wider with GDP recovery, but remains low excluding lumpy transport-equipment transactions and helped by lower imported energy prices. - Sectoral saving–investment adjustments: - Private sector investment-to-GDP ratio more than halved by 2014 while private saving moderated; private sector driving the correction. - General government narrowed its saving–investment gap only since 2013 and turned positive in 2016. - Recently, the private sector gap has become more negative. - Real effective exchange rates (REERs): - REERs peaked in 2009 at around 15–25 percent higher than at the beginning of the decade. - REERs have gradually adjusted downward and are now 10–20 percent below their peak. ### Credit dynamics and the credit gap - Bank credit to the nonfinancial private sector grew rapidly in the run-up to EU accession in 2004 and accelerated before euro adoption in 2008; after accession the resident loan-to-resident deposit ratio widened sharply reflecting greater reliance on external savings intermediated through banks. - Net bank credit (gross loans minus deposits) grew faster than gross credit through 2012, ahead of the banking and housing price collapse. - The ratio of net credit to GDP that prevailed in 2006 is considered appropriate and sustainable. - Credit-gap statistics: - Net credit ratio decreased by about 50 percentage points since its peak in 2013. - Remaining credit gap as of end-2017 is projected to be 30 percent of GDP. - A credit gap of 30 percent of GDP is the largest among the countries included in the Fund’s EBA. ### External Sector Assessment — EBA-Lite conclusions - Overall conclusion: The three EBA-Lite methodologies indicate Cyprus’s external sector in 2017 is weaker than warranted by fundamentals and appropriate policies, even after adjusting for one-offs and SPE effects. - Key methodological adjustments: - Underlying current account (CA) excludes SPE contributions and a one-off import of aircrafts due to a new airline. - Private credit defined as loans net of deposits; NFA excludes SPEs. Current Account (CA) approach (EBA-Lite) - 2017 balances: - Underlying CA for 2017 (excluding SPEs and one-off aircraft import): deficit of 2.3 percent of GDP - Headline CA deficit: 4.9 percent of GDP - Estimated CA fitted value (based on fundamentals and current policy settings): +0.1 percent of GDP - Estimated residual between underlying CA and fitted value: -2.4 percent of GDP for 2017 - Policy-gap contributions: - Total policy gaps contribute -0.1 percentage points to the CA norm. - Decomposition: private credit gap contributes -1.3 percentage points; fiscal policy contributes +1.1 percentage points (entirely due to the ROW as Cyprus’s cyclically-adjusted fiscal balance is considered appropriate). - CA norm and gap: - CA norm (sum of fitted CA and contribution of policy gaps): about 0.1 percent of GDP - CA gap (sum of estimated residual and policy gaps): -2.4 percent of GDP, indicating the current account is too low. - Interpretation: The CA gap could be reduced by narrowing the private credit gap through lower consumption and investment. REER approach (EBA-Lite) - Fitted and actual REER: - The fitted REER, reflecting fundamentals and current policy settings, is estimated to be 12 percent lower than the actual REER. - Policy gaps: - Policy gaps augment the residual by about 3 percentage points, mostly due to the private sector credit gap (2.8 percentage points). - Total REER gap in 2017: - Total REER gap: 15 percent - Residual component: 12 percent - Policy-gap component: 3 percent - Despite sizable depreciation since the Cypriot crisis, the REER gap remains large. ### Implications and adjustment channels - The external imbalance is closely tied to the large remaining private-credit gap (30 percent of GDP): narrowing that gap is central to external rebalancing. - Adjustment would likely require lower private consumption and investment and continued progress in reducing foreign-financed credit. - SPEs and classification choices materially affect measured external vulnerabilities; excluding SPEs yields a substantially smaller net liability position and alters assessment metrics. *Annex V. External Sector Assessment and Debt Sustainability — IMF staff calculations and analysis* ### 15. The external sustainability (ES) approach indicates that a CA of just below zero is ### cr17375 - 15. The external sustainability (ES) approach indicates that a CA of just below zero is ### External Sustainability Approach - A net foreign liability position for 2016 of -51 percent of GDP is used, instead of the economy-wide position of -128 percent of GDP, to remove the contribution of SPEs’ foreign financial positions. - Stabilizing the net IIP at the current high negative level would only require the CA deficit to be at 3.1 percent of GDP, which is some 0.8 percentage points higher than the estimate for the underlying CA in 2017. - Reaching a net IIP of -35 percent of GDP—the level indicated by the European Commission as a threshold for their assessment of macroeconomic imbalances—by 2022 (i.e., over six years) requires sustaining a current account of close to balance, implying a needed reduction in the deficit by just above 2.0 percent of GDP. Sources: Central Bank of Cyprus and IMF staff estimates. ### EBA-lite Conclusions on External Sector - All three EBA-lite approaches point to the external sector being weaker than warranted by fundamentals and desirable policy settings. - The CA gap is estimated to be within the range of negative 2 to negative 2½ percentage points of GDP. - The associated REER gap is within the range of 4 to 15 percent. - Results are contingent on the assumption of a private credit gap of 30 percent of GDP; unwinding the credit gap would be associated with a stronger external balance and higher saving relative to investment that would gradually reduce (or slow the build-up of) net external liabilities. - Methodological caveats and data issues apply; specifically, the coefficient on the credit gap in EBA-Lite is considerably larger than in the EBA model. ### External Debt: Background - Cyprus’s external debt is large, at nearly six times GDP, but net debt is considerably smaller at 1.6 times GDP. - Excluding SPEs reduces gross external debt to 3.4 times GDP. - Large gross debt assets—which include the CBC’s TARGET-2 balance and assets held through its participation in the ECB’s asset purchase program, and total 59 percent of GDP—reduce net external debt excluding SPEs to only 1½ percent of GDP. - Nondebt-creating flows (portfolio equity investment and repatriation of foreign assets) have played a major role in funding external financing needs; net FDI inflows have been relatively modest and volatile. - Past debt dynamics were significantly affected by valuation changes in tradable debt securities: large mark-to-market price declines were recorded in 2012–13, while large gains were registered in 2014–15. ### Baseline Projection for External Debt - Gross external debt is projected to decline from about 600 percent of GDP (€107 billion) in 2017 to 511 percent of GDP (€122 billion) by 2022. - Government external debt declines over the medium term on the assumption of continued fiscal prudence. - Banks are forecast to maintain their current level of external debt (mainly nonresident deposits). - External debt of private nonbank sectors is forecast to increase in the near term and then stabilize, as projected current account deficits are assumed to be mostly financed by net FDI inflows. - Even excluding external debt of SPEs, gross debt is forecast to remain above 2.5 times GDP in 2022, although the associated net position (excluding SPEs) would become positive. - Nominal GDP is forecast to grow by 4.7 percent on average in the projection period, which by itself would account for an annual external debt reduction of 25 percentage points of GDP. - Debt-creating flows, including the trade deficit (2 percent of GDP annually) and net interest payments (6 percent of GDP annually), are forecast to partially offset this denominator effect, leading to an annual decline in external debt by 14 percentage points of GDP on average. ### Risks to External Debt Sustainability (Bound Tests and Scenarios) - Interest rates: A 2 percentage points increase in average interest rates on external debt throughout the projection period would increase the debt ratio by about 65 percentage points by 2022, compared to the baseline. - Growth: A one-half standard deviation decrease in projected real GDP growth throughout the projection period could increase the debt-to-GDP ratio by 64 percentage points by 2022 compared to the baseline. - Current account deterioration: The impact of a one-half standard deviation shock to the current account balance is limited. - Combination of shocks: A combination of one-quarter standard deviation shocks to the nominal interest rate, growth, and current account would raise the debt ratio by 60 percentage points by 2022 relative to the baseline. - Historical scenario: Reversion of the growth rate, interest rate, inflation, and the current account balance to their average levels during the previous five years would boost the debt ratio by more than 200 percent of GDP by 2022. Most of this increase would be due to the low growth rate (-1.1 percent), and to a lesser extent, deflation. The period includes the Cypriot banking crisis episode, so this could be considered an extreme scenario. ### Gross Financing Needs - Gross external financing needs are projected to remain very high (about 2.5 times GDP) over the projection period. - About 85 percent and 40 percent of external debt owed by banks and other private sector borrowers, respectively, is short-term, raising potential rollover risk. - Very large gross external financing needs—especially in the absence of an investment grade credit rating—could expose the economy to liquidity and other risks that may be difficult for the private and public sectors to absorb, given still very large nonperforming loans, high debt overhang in the household and nonfinancial corporate sectors, and elevated public debt. ### Overall Conclusion on External and Public Debt - The baseline indicates external debt is sustainable, but its high level poses risks under various scenarios. - Continued macroeconomic recovery, downsizing of the banking sector, and medium-term fiscal consolidation reduce the external debt ratio, but gross external debt is expected to remain very large relative to GDP due to Cyprus’s status as a regional financial center. - Closely aligning the maturity and currency of external assets and liabilities is important, together with maintaining fiscal prudence and sound financial sector policies. - Public debt: Public debt was 107.1 percent of GDP at end-2016; projected to decline to just below 100 percent of GDP in 2017 and to 75 percent of GDP by 2022 under the baseline. - Public debt reduction is underpinned by a further widening of the primary surplus to 3.8 percent of GDP by 2019 (from 3.0 percent of GDP in 2016) and stabilizing at that level. - Gross public financing needs (GPFN) will remain less than half the benchmark for advanced economies (20 percent of GDP) over the projection horizon. - Risk assessment: Cyprus’s current high level of public debt leaves it more vulnerable to macro-fiscal shocks; under the baseline, public debt could remain above 100 percent by 2022 with a probability of more than 15 percent. *Source: IMF staff estimates and Central Bank of Cyprus as presented in the provided content.* ### 5. GPFN will remain contained even in the presence of sizable shocks. In the event of ### 5. GPFN will remain contained even in the presence of sizable shocks. In the event of ### Summary finding on Gross Public Financing Needs (GPFN) - In the event of short-duration individual macro-fiscal shocks or a sustained scenario corresponding to historical adverse episodes for growth and the primary balance, the GPFN would peak at around 12 percent of GDP, still comfortably below the 20 percent benchmark. ### Public debt profile — vulnerabilities and mitigating factors - Private sector short-term foreign liabilities are very large, reflecting mainly nonresident deposits in Cypriot banks and foreign debts of nonfinancial corporates; gross private liabilities are to a large extent matched by gross assets of a similar duration. - About 80 percent of public debt is owed to non-residents. - About three-quarters of public debt reflects official financing from the ESM and IMF, a bilateral loan from Russia, and loans from the European Investment Bank and Council of Europe Development Bank. - The relatively low and/or fixed interest rate on official liabilities, combined with long maturities and back-loaded repayment schedule on a significant share, mitigates interest rate and financing risks. - Sovereign spread relative to German bunds is around 125 basis points, below the lower risk-assessment benchmark, but Cyprus’s bonds remain at least one notch below investment grade even after upgrades during 2015–17. - Reliance on short-term debt is limited and considered low risk. - Weighted average maturity of total debt is 7.6 years while that of marketable debt is 4.8 years as of end-June 2017. The shares of debt that falls due within 1 year and 5 years are 2.9 percent and 35.1 percent, respectively. ### Realism of baseline assumptions and forecast track record - Recent GDP growth and the fiscal balance have been stronger than expected, due in part to robust external demand and private financial inflows substituting for new bank lending; this over-performance occurred despite sizable structural fiscal consolidation during the program. - Projection errors during 2012–13 indicate excessive optimism, reflecting events difficult to foresee (damage to the sole power plant in 2011 and the write-down of banks’ holdings of Greek public debt in 2012). - In the asymmetric distribution, upside shocks to growth and the primary surplus are limited to 1 percentage point and 2 percentage points, respectively. ### Stress-test scenarios and key quantitative outcomes - Growth shock: - A one standard deviation (3.4 percentage points) decrease in growth during 2018–19, accompanied by (i) a 25 bp rise in interest rates, and (ii) a decrease in inflation by 0.25 percentage points per percentage point reduction in GDP growth, would raise public debt by 13 percentage points to 104 percent of GDP by 2019, before declining to 88 percent of GDP by 2022. - Primary balance shock and real interest rate shock: - A decrease in the primary surplus by 1.7 percent of GDP during 2018–19 would raise public debt marginally to around 78 percent of GDP by 2022. - An increase in the real interest rate by 411 bp during 2018–22 would raise public debt marginally to around 77 percent of GDP by 2022. - Combined macro-fiscal shocks: - Combining the growth and interest rate and primary balance shocks would cause public debt to peak at 107 percent of GDP in 2019 before declining to 94 percent of GDP by 2022. - Gross financing needs would peak at 13.3 percent of GDP in 2019—still below the 20 percent benchmark—before falling back. - Contingent liability shock: - A one-off 40 percent of GDP increase in fiscal spending (corresponding to about 10 percent of banking sector assets), accompanied by weaker nominal GDP growth, higher interest rates and lower inflation, would push up public debt to about 148 percent of GDP, 73 percentage points of GDP higher than the baseline by 2022. - The attendant high level of GPFN and sharp increase in borrowing costs may preclude market access. - Accompanying macroeconomic assumptions for the contingent liability shock: (i) a 1 standard deviation real GDP growth shock; (ii) a 0.25 percentage point decline in inflation for every 1 percentage point decline in growth; and (iii) an increase in interest rates by 25 bp for every 1 percent of GDP deterioration in primary balance. ### Debt Sustainability Analysis (selected baseline projections and indicators) — As of October 31, 2017 - Nominal gross public debt (in percent of GDP): 2015: 68.8; 2016: 107.5; 2017: 107.1; 2018: 99.8; 2019: 95.5; 2020: 90.9; 2021: 85.8; 2022: 81.8. - Public gross financing needs (in percent of GDP): 2015: 12.7; 2016: 18.1; 2017: 8.9; 2018: 11.1; 2019: 6.3; 2020: 6.7; 2021: 6.3; 2022: 5.4. - Real GDP growth (in percent): 2015: 0.3; 2016: 2.0; 2017: 3.0; 2018: 3.8; 2019: 3.6; 2020: 2.9; 2021: 2.6; 2022: 2.5. - Inflation (GDP deflator, in percent): 2015: 1.7; 2016: -1.2; 2017: -0.9; 2018: 0.1; 2019: 1.7; 2020: 1.3; 2021: 2.3; 2022: 2.2. - Effective interest rate (in percent): 2015: 4.4; 2016: 2.6; 2017: 2.4; 2018: 2.4; 2019: 2.5; 2020: 2.7; 2021: 2.8; 2022: 2.9. - Cumulative change in gross public sector debt (2015–2022): -32.1 percent of GDP (projected cumulative). - Identified debt-creating flows (2015–2022 cumulative): -32.2 percent of GDP. - Primary (noninterest) revenue and grants (2015–2022 cumulative): 239.4 percent of GDP. - Primary (noninterest) expenditure (2015–2022 cumulative): 217.4 percent of GDP. - Interest rate/growth differential (2015–2022 cumulative): -10.7 percent of GDP (automatic debt dynamics contribution). - Real interest rate contribution (2015–2022 cumulative): 5.5 percent of GDP. - Real GDP growth contribution (2015–2022 cumulative): -16.2 percent of GDP. - Assumed sovereign spreads and ratings shown for context: EMBIG (bp) 124; 5Y CDS (bp) 207; Moody's Ba3; S&Ps BB+; Fitch BBBB. ### Alternative scenarios and composition highlights - Alternative scenarios displayed include: Historical Scenario and Constant Primary Balance Scenario with differing assumptions for Real GDP growth, Inflation, Primary Balance, and Effective interest rate. - Composition of public debt by maturity and currency indicates medium and long-term debt dominates; short-term share and foreign-currency denominated share are limited in the baseline projections. ### Annex VII — The Proposed National Health Service (NHS): context, reform features, and financing - Context and challenges: - Life expectancy at birth reached 81.8 years in 2015, above the EU-average of 80.6 years. - Total health expenditure in Cyprus was 6.8 percent of GDP in 2015, below the EU-average of 9.8 percent. - Government’s share of health spending was 42.6 percent in 2015, the lowest in the EU. - Cyprus had 44 percent of total health spending financed out-of-pocket, compared with the EU-average of 15 percent. - Almost-free access for about 80 percent of the population creates excess demand and rationing in public services; small co-payments apply for households with incomes above €15,400 without dependents, and the co-payment income threshold is increased by €4,700 for each dependent child for families with incomes below €30,750. - Public sector undercapacity co-exists with private sector overcapacity; private voluntary health insurance is mostly not available due to very high administrative costs associated with the small population. - Legislative action: - In June 2017, Parliament adopted two key health bills making public hospitals and health centers autonomous and introducing a National Health System (NHS). - Hospitals will have managerial and financial autonomy; employees of state hospitals are currently government employees. - NHS design and implementation timetable: - NHS will become operational in two stages: June, 2019 for general practitioner and outpatient services, pharmaceuticals and laboratory tests; and June, 2020 for in-patient services. - NHS will include public providers and participating private providers; all-but-elective services will be covered with modest copayments for specialist and in-patient treatment. - Funding will rely on a combination of employee, employer and government contributions, calculated as fixed payroll percentages (up to a maximum income level), and contributions on non-earned income (including interest earnings and pensions). - Contribution rates have been calibrated to generate an amount equal to current country-wide health spending; NHS will operate under a global budget, reimbursing service-providers with fee-for-service payments. - Part of existing government spending on state hospitals and health centers will be allocated to the NHS; the government will cover any residual costs associated with state hospitals and health centers. - NHS contribution rates (percent): - From March 1, 2019: - Employees/government officials: 1.7 percent of payroll - Employers: 1.85 percent of payroll - State contribution: 1.65 percent of economy-wide payroll - From March 1, 2020: - Employees/government officials: 2.65 percent of payroll - Employers: 2.9 percent of payroll *Source: IMF staff.* ### 4.7 percent of economy-wide ### cr17375 - 4.7 percent of economy-wide ### NHS design and objectives - The NHS aims to provide universal coverage under a single-payer system, financed by contributions from employers and employees, the government budget, and patients’ own co-payments. - Patients will have access to health providers of their choice―both private and public―at a nominal cost and will be insured against a significant part of health costs. - Expected benefits: - Households should be better able to smooth consumption and have less need to accumulate large precautionary savings. - Patient choice of providers, together with reforming public health facilities, is anticipated to foster competition, reduce costs, reallocate demand (capacity) away from (to) public facilities, and improve quality of care. ### Fiscal implications and risks - Public spending on healthcare could increase substantially under the NHS. International evidence suggests that without sizable user fees, broad health coverage can increase demand and overall spending. - Cyprus context: - Introduction of the NHS comes against the backdrop of low total and public health spending relative to the country’s income level—partly due to rationing of care at public health facilities. - Rapid population ageing will add to future health care needs. - As currently budgeted, the introduction of the NHS will be largely fiscally neutral. - Fiscal risk: the government will be obligated to cover any funding shortfalls at the public health providers, or else those facilities may be forced to run arrears or ration service. ### Labor-market and competitiveness implications - Much of the funding for the NHS is to come from a new 6 percentage point levy on employment. - This levy could adversely affect demand for labor, especially among low-wage workers. - Low-wage workers’ employment tax wedge currently fares well compared to similar workers in other advanced economies; the new levy could worsen competitiveness for low-wage employment. - The levy could push low-wage employment into the shadow economy. - There is a clear risk that the tax wedge may need to increase in the future if contributions are insufficient to cover NHS costs. - Behavioral uncertainty: - It is possible that a larger-than-currently-expected share of users opt to forgo facilities participating in the NHS and pay out-of-pocket for private providers outside the scheme, even though such users have already “paid” for NHS services through their contributions. In that case, there would be less pressure on contribution rates. - Legislative design element: - The NHS law stipulates five-yearly functional reviews by Parliament, including the option to amend contribution rates. ### Key numeric parameters and fiscal/coverage details (as presented) - 4.7 percent of economy-wide payroll - Self-employed: 2.55 percent of income; 4.0 percent of income - Pensioners/those living on other income: 1.7 percent of income; 2.65 percent of income - New employment levy: 6 percentage point levy on employment ### Broader macroeconomic context and policy environment - Progress since the crisis and macro developments (selected points from the document): - Real GDP growth for the first nine months of 2017: 3.8%. - Unemployment: currently (2017Q2) around 10.6%, down from a peak of 17.6% in 2015Q1. - Primary surplus expected to reach 4 percent of GDP in 2017. - Overall surplus expected to average around 1.4percent of GDP in the medium-term. - Gross public debt expected to fall below 100 percent of GDP by the end of the year, following early repayment of domestic held debt. - Private sector investment projects amounting to over €3 billion are expected to be completed by 2020. - Policy priorities noted by the authorities: - Address remaining legacies of the crisis: high private sector debt and elevated non-performing loans. - Reform of the courts and strengthening the efficiency of commercial claims enforcement. - Efficiency-enhancing reforms to ensure balanced and sustainable growth. ### Policy implications and recommendations (inferred from text emphasis) - Monitor and manage fiscal exposure from NHS implementation to avoid automatic transfer of provider shortfalls to the government budget. - Design contribution rates and co-payment structures mindful of labor-market distortions: - Avoid excessive increases in the tax wedge on labor, particularly for low-wage workers. - Use five-year functional reviews to adjust contribution rates based on emerging cost and utilization experience. - Encourage measures to reduce inappropriate use of public facilities and to incentivize efficient provider behavior (competition, facility reform). - Track behavioral responses of users (potential shift to out-of-scheme private providers) and adjust fiscal projections accordingly. *Source: IMF staff report excerpts from cr17375 - 4.7 percent of economy-wide* --- _Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17375.pdf_