## cr18337 ## Source details **Canonical URL:** [cr18337](https://www.imf.org/-/media/files/publications/cr/2018/cr18337.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2018/cr18337.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2018/cr18337.pdf.json) --- ### Outlook and Growth - Real GDP growth: - Projected at 4.2 percent in 2018–19. - Over the medium term, projected to slow to around 2½ percent (long-run potential). - Growth drivers and demand: - Buoyed by services and foreign-financed construction, including higher foreign investment in the construction sector and Citizenship by Investment (CbI) related activity. - Continued strength in professional and tourism services. - Higher disposable incomes from the labor market recovery and delays in repayment of bank loans sustained private consumption. - Labor market and inflation indicators: - Unemployment rate: 14.9 (2015), 13.0 (2016), 11.1 (2017), 8.5 (2018), 7.0 (2019 projection). - HICP (period average): -1.5 (2015), -1.2 (2016), 0.7 (2017), 0.9 (2018), 1.8 (2019). - Core inflation dipped to -0.1 percent (yoy) in September (2018). - HICP inflation reached 1.7 percent (yoy) in September (2018). - Employment growth: -1.3 (2015), 1.4 (2016), 4.6 (2017), 3.9 (2018), 2.5 (2019 projection). - Sector contributions: - Professional services: 0.7 p.p. - Manufacturing: 0.3 p.p. - Investment fund industry and education also sizable contributors. - Tourism and professional services highlighted as production-side drivers. ### Fiscal performance and public debt - Fiscal balances: - Primary surplus expected to be around 5 percent in 2018–19. - General government balance: -0.3 (2015), 0.3 (2016), 1.8 (2017), 2.7 (2018), 2.5 (2019). - Primary Fiscal Balance: 2.7 (2015), 3.0 (2016), 4.3 (2017), 5.1 (2018), 5.0 (2019). - Public debt trajectory: - General government debt: 108.0 percent of GDP (2015), 105.5 (2016), 96.1 (2017), 106.1 (2018), 99.7 (2019). - Public debt expected to fall below 70 percent of GDP by 2023 under the baseline. - Fiscal risks and recommended discipline: - Risk that realization of contingent liabilities or erosion of fiscal discipline could undermine sustainability. - Directors cautioned against relying on transitory revenues and one-off measures to finance permanent spending. - Authorities committed to cap expenditure increases, including the public wage bill, in line with the medium-term GDP growth rate. - Fiscal projections and requirements: - Staff projects primary balance improvement to 5.1 percent of GDP in 2018. - Maintain a primary surplus above 4¾ percent of GDP over the medium term to limit debt risks. - Specific measures: keep wage bill growth below nominal GDP growth, strict monitoring of NHS costs, advance PFM reforms, and use NPL recovery proceeds primarily to pay down debt. - Public debt stress implications: - Baseline: rapid downward path after 2018 one-off increase; public debt projected to 68 percent of GDP by 2023. - Probability assessment: with adverse shocks more likely than favorable ones, public debt could remain above 100 percent until 2023 with probability of 8 percent. - Fiscal cost of CCB deal: expected around €3.5 billion (17 percent of GDP) plus contingent liabilities; APS contingent liabilities assessment expects limited calls (~€155 million). ### Banking sector, NPLs, and financial stability - NPL levels and trends: - NPLs declined by €11.5 billion over the period covered (of which €8.0 billion in corporate, mainly large enterprises, and €2.6 billion in households). - NPLs fell from 161 percent of GDP (48 percent of loans) in 2014 to 84 percent of GDP (39 percent of loans) in 2018:Q2. - NPL-to-loans ratio: 44 percent (€22.8 billion) in 2017:Q2 to 39 percent (€16.9 billion) in 2018:Q2. - NPL-to-GDP ratio: 125 percent in 2017:Q2 to 85 percent in 2018:Q2. - NPL flows (Q3:2017–Q2:2018, stock at beginning normalized to 100): - Migration from performing: 9.0 - One-time interest gross-up (due to IFRS9): 3.9 - Interest accrued on NPLs: 4.5 - Migration into performing: 8.7 - NPL cash repayment: 4.8 - Debt-to-asset/equity swaps: 2.7 - Write-offs: 15.6 - Debt instruments held for sale: 13.6 - Remaining NPLs: 54.6 - Aggregate net outflow of NPLs over the period: 27.9 - Key transactions and market activity: - Sale by Bank of Cyprus of NPLs worth nearly 14 percent of GDP in 2018:Q2 accounted for nearly a third of NPL outflows (transaction pending supervisory approval). - Resolution of Cyprus Cooperative Bank (CCB): portfolio sold to Hellenic Bank; residual entity with NPLs evolved into government-owned AMC (CAMC). - Banking sector pressures: - Narrow interest margins, high provisioning needs, excess staffing, large branch networks; profitability remains weak. - Outstanding credit to non-financial private sector declined by almost 60 percentage points of GDP in September (yoy), to 149 percent of GDP. - Pure new loans to households increased from a low base; net credit transactions: NFCs +1.9 percent (yoy), households +0.6 percent (yoy) in September. - Bank liquidity remains ample; customer deposits stabilized after CCB-related outflows. - Provisioning and collateral: - Provisioning level: 49 percent of NPLs as of 2018:Q2. - Collateralization high but foreclosure cumbersome, reducing recovery values. - Policy and supervisory recommendations: - Steadfast implementation of amended legislative framework on foreclosure, insolvency, sale of loans, and securitization. - Strengthen court system and remove uncertainties related to title deeds. - Enhance governance and supervisory framework for AMC (CAMC) and credit-acquiring companies. - Target Estia scheme better; base on assessment of borrowers’ capacity to repay to limit moral hazard. - Banks should strengthen balance sheets, diversify income, consolidate operations, improve cost-income ratios, strengthen provisioning, and follow prudent debt-to-asset swap policies. - Strengthen regulatory guidance on loan restructuring and develop supervisory framework for CACs including reporting, on-site inspections and off-site monitoring. ### Private sector debt overhang and deleveraging (Figure 4) - Debt levels (2018:Q2): - Household gross debt: 100 percent of GDP. - NFC debt: 197 percent of GDP (includes about 76 percent of GDP from SPEs). - Net debt-to-GDP for households and NFCs: 72 percent of GDP (excluding SPEs), a decline of 27 percentage points of GDP (yoy). - Drivers of corporate debt decline: - GDP denominator effects, NPL write-downs, repayments and debt-to-asset swaps. - Household financial position and vulnerability: - Median net wealth decreased by 36 percent (2009–10 to 2014). - Debt-to-income ratio increased from 1.57 to 2.51; euro-area 0.72. - Debt-service-to-income ratio increased from 0.23 to 0.36; euro-area 0.14. - Mortgage-debt-service-to-income ratio 0.25 to 0.34; euro-area 0.16. - Debt burdens particularly heavy for bottom-20-percent income or wealth households. - NPL composition by borrower: - Small borrowers (households and SMEs) account for almost 95 percent of NPLs. - Household NPLs: 55 percent of loans (€11.8 billion) to 51 percent (€10.2 billion) year-on-year. - NFC NPLs: 58 percent of loans (€8.9 billion) to 45 percent (€5.3 billion) year-on-year. - NFC NPLs by sector (2018:Q2): Construction €1.8 billion; Real estate €0.9 billion; Tourism and trade €2.3 billion; Others €1.4 billion. ### External position and external financing - Current account and trade: - Current account balance: -1.5 (2015), -5.1 (2016), -8.4 (2017), -4.1 (2018), -7.8 (2019 projection). - Trade Balance (goods and services): 0.8 (2015), -0.6 (2016), -3.5 (2017), -0.2 (2018), -3.8 (2019). - Adjusted 2017 current account (adjusting for SPEs and one-off airplane purchases): -2.6 percent of GDP. - Nominal GDP (billions of euros): 17.7 (2015), 18.5 (2016), 19.6 (2017), 20.7 (2018), 21.9 (2019). - External assessment: - External position in 2017 weaker than warranted by fundamentals; CA gap in 2017 was -3.5 percent of GDP. - EBA-lite CA and REER models suggest REER overvaluation and external position weaker than fundamentals, reflecting a large positive credit gap and high domestic absorption. - External financing dependence: - Growth heavily dependent on foreign financing; strengthening external resilience important to meet medium-term financing needs. - NIIP and external debt: - NIIP: -122 percent (2017) down from -130 percent (2011). - Excluding SPEs, NIIP improved from -64 percent to -43 percent of GDP. - Gross external debt projected to decline from around 519 (gross) percent of GDP in 2018 to 442 percent by 2023 (baseline). - Gross public financing needs (GPFN) increased after CCB placement and expected to remain below 20 percent of GDP benchmark for advanced economies; placement at CCB was €3.19 billion (15 percent of projected GDP in 2018). ### Debt Sustainability Analysis — scenarios and stress tests - Baseline narrative: - Public debt rises in 2018 after CCB-related transactions, then resumes a rapid decline to 68 percent of GDP by 2023 under baseline assumptions (high primary surpluses and robust growth). - Stress test examples: - Growth shock (one standard deviation, 3.4 p.p. decrease during 2019–20) with interest rate rises: public debt would rise by 13 percentage points to 103 percent of GDP by 2020, then decline to 80 percent by 2023. - Primary balance shock (decrease by 1.6 percent of GDP during 2019–20) with interest rate rises: public debt marginally to 71–72 percent by 2023 in respective scenarios. - Combined macro-fiscal shocks: public debt peaks at 107 percent of GDP in 2020 then declines to 88 percent by 2023; GPFN peaks at 14 percent of GDP in 2020. - Adverse macro-fiscal-contingent liability scenario (additional 10 percent of GDP contingent liabilities realized in 2019): public debt rises to 114 percent of GDP in 2019 and declines to 97 percent by 2023; GFN spikes to 20 percent of GDP in 2019. - Large contingent liability shock (one-off 25 percent of GDP increase in 2019 and sovereign borrowing cost spike of 625 bps): public debt reaches 129 percent of GDP in 2020 and 106 percent by 2023. - External debt stress tests: - A two-percentage-point increase in average interest rates on external debt would increase debt ratio by 56 percentage points by 2023. - A one-half standard deviation decrease in real GDP growth could increase debt-to-GDP by 66 percentage points by 2023. - GFN and rollover risk: - GFN projected to decline but remain elevated (over 150 percent of GDP) through projection period due to short-term private sector debt. - Nearly 90 percent of banks’ external debt is short-term; private sector short-term external debt was 151 percent of GDP in 2017. ### Policy priorities and structural reforms - Repair private and public balance sheets: - (i) Implement amended legal tools to lower NPLs and private debt overhang. - (ii) Safeguard fiscal space and reduce public debt risks by maintaining strict spending discipline. - (iii) Enact structural reforms, especially in judiciary and public administration, to attract investment and enhance productivity. - Financial sector measures: - Accelerate genuine NPL resolution (reduce reliance on repeated restructurings). - Improve payment discipline and increase cash repayments/migration of NPLs into performing. - Develop regulatory and supervisory framework for credit-acquiring companies and CAMC with clear governance, transparency, and operational targets. - Provide regulatory guidance for sustainable loan restructurings to limit re-defaults. - Judicial, institutional and governance reforms: - Increase efficiency of the courts, speed up enforcement of commercial claims, clear backlog of cases, and introduce e-justice. - Expedite legislation to strengthen governance and autonomy of the Central Bank of Cyprus (CBC). - Strengthen public financial management, monitor local government and SOE risks, and improve corporate governance of commercial SOEs. - Mitigate AML/CFT risks and prepare for MONEYVAL assessment. - Labor market and inclusiveness: - Active Labor Market Policies (ALMPs) and investment in higher value-added sectors to reduce youth unemployment (about 19 percent in 2018:Q2) and skills mismatch. - Strengthen education, promote dual-education apprenticeships, and target policies to protect the vulnerable. ### Property market, CbI, and construction risks - Property market: - Overall property prices rising only moderately; luxury segment picking up rapidly with CbI support. - Investment fund flows into non-financial assets increasing. - Risks and recommended actions: - Avoid unsustainable increase in luxury construction; decouple CbI eligibility from real estate to avoid over-concentration. - If luxury construction becomes reliant on domestic credit, tighten macroprudential measures. - Reinstating immovable property tax (IPT) and raising transfer duty would add countercyclical tools. - Ensure AML/CFT compliance in CbI-related sectors and supervision of those sectors. ### Design and governance recommendations for AMC and Estia - AMC (CAMC) governance and operations: - Clear mandate with operational targets and sunset clause; supervisory board with majority independent members; skilled management compensated on performance; transparent reporting and public accountability. - Limit mandate to managing CCB assets to minimize fiscal costs. - Estia subsidy scheme recommendations: - Better target subsidy to borrower repayment capacity; tighten eligibility criteria to reduce moral hazard. - Key parameters under discussion include: - Household income not exceeding €50K. - Market value of the primary residence not exceeding €350K. - Remaining net household wealth not exceeding 125 percent of the market value of the primary residence. - No threshold for property size. - Subsidy payment fixed at one-third of the borrower’s installment for all eligible households. - State subsidy paid at the end of each year, contingent on bank confirmation that borrower has been current, with clawback provisions for redefaults. - Estimated cost of the scheme: 0.1-0.2 percent of GDP annually (also noted elsewhere as net total maximum annual fiscal cost of Estia at €20 million in authority text). - Regulatory recommendations for CACs: - CBC to develop supervisory regime, fit-and-proper criteria for shareholders and directors, change-of-control rules, reporting requirements, and on-site/off-site monitoring. ### NHS introduction and fiscal implications - Steady-state fiscal impact: - Public healthcare providers will operate under SHSO; Ministry of Health spending expected to shrink from more than 3 percent of GDP to less than ½ percent of GDP. - Government contributions to NHS expected to amount to 2½ percent of GDP. - In steady state, fiscal impact expected to be neutral if public providers become efficient and SHSO revenue covers expenses. - Short-run transition risks: - Temporary fiscal outlay increase likely; government to fill deficits in the short run. - Law on SHSO requires central government to fill financial shortfalls in first five years after providers become autonomous. - Excess demand for public health care exists; shift to choice among providers may move demand from public to private providers gradually. - Cost containment mechanisms: - Capitation for primary care, gatekeeping referrals, new IT system to flag unusual referrals, global budget for special services, central procurement and pricing for pharmaceuticals. - Long-term vigilance: - Periodic actuarial review every three years. - Population aging pressures could increase health expenditure-to-GDP ratio by 1.5 percentage points from 2015 to 2035 under UN medium-fertility scenario; 0.1-0.2 p.p. faster if fertility or mortality lower. - Ensure SHSO tools to make public providers self-financed and guard against arrears accumulation. ### Risks summary (Annex III) - External risks: - Rising protectionism and retreat from multilateralism — Relative likelihood: High; Time horizon: ST, MT. - Sharp tightening of global financial conditions — Relative likelihood: High; Time horizon: ST. - Weaker-than-expected Euro Area growth — Relative likelihood: Medium; Time horizon: MT. - Domestic risks: - NPL management amid weak payment discipline — Relative likelihood: High; Time horizon: ST, MT. - Renewed boom-bust cycle linked to construction and CbI — Relative likelihood: Medium, High; Time horizon: ST, MT. - Policy responses emphasized: - Intensify NPL reduction, maintain strict fiscal discipline, implement judicial and institutional reforms, decouple CbI from real estate, and build buffers against contingent liabilities. *Source: CYPRUS — STAFF REPORT FOR THE 2018 ARTICLE IV CONSULTATION (Selected excerpts).* ### 4.2 percent in 2018–19, supported by the services sector and largely foreign-financed ### 4.2 percent in 2018–19, supported by the services sector and largely foreign-financed investments ### Outlook and Growth - Real GDP growth: - Projected at 4.2 percent in 2018–19. - Over the medium term, projected to slow to around 2½ percent (long-run potential) as transitory effects of the investment boom dissipate. - Growth drivers: - Buoyed by services and foreign-financed construction, including higher foreign investment in the construction sector and Citizenship by Investment (CbI) related activity. - Continued strength in professional and tourism services. - Higher disposable incomes from the labor market recovery and delays in repayment of bank loans sustained private consumption. - Labor market and inflation: - Unemployment rate: 14.9 (2015), 13.0 (2016), 11.1 (2017), 8.5 (2018), 7.0 (2019 projection). - HICP (period average): -1.5 (2015), -1.2 (2016), 0.7 (2017), 0.9 (2018), 1.8 (2019). - Core inflation dipped to -0.1 percent (yoy) in September (2018). - HICP inflation reached 1.7 percent (yoy) in September (2018) mainly reflecting stronger energy prices. - Employment growth: -1.3 (2015), 1.4 (2016), 4.6 (2017), 3.9 (2018), 2.5 (2019 projection). ### Fiscal performance and public debt - Fiscal balances: - Primary surplus expected to be around 5 percent in 2018–19. - General government balance: -0.3 (2015), 0.3 (2016), 1.8 (2017), 2.7 (2018), 2.5 (2019). - Primary Fiscal Balance: 2.7 (2015), 3.0 (2016), 4.3 (2017), 5.1 (2018), 5.0 (2019). - Public debt: - General government debt: 108.0 percent of GDP (2015), 105.5 (2016), 96.1 (2017), 106.1 (2018), 99.7 (2019). - Public debt expected to be on a firm declining path, falling below 70 percent of GDP by 2023, despite a sharp increase earlier this year following the resolution of the Cyprus Cooperative Bank. - Fiscal risks: - Fiscal performance expected to improve, but public debt sustainability could be undermined by realization of contingent liabilities or erosion of fiscal discipline. - Directors cautioned against relying on transitory revenues from cyclical gains and one-off measures to finance permanent spending initiatives. - Authorities committed to cap expenditure increases, including the public wage bill, in line with the medium-term GDP growth rate. ### Banking sector, NPLs, and financial stability - NPLs and banking vulnerabilities: - Banking sector still faces one of the highest NPL ratios in Europe. - Private and public debt remain large; NPL ratios are still among the highest in Europe. - Despite the offloading of NPLs, the sector continues to be pressured by high NPLs and weak profitability. - Outstanding credit to the non-financial private sector declined by almost 60 percentage points of GDP in September (yoy), to 149 percent of GDP, reflecting GDP denominator effects as well as write-offs, and sale or transfer of loans. - Net credit transactions picked up by 1.9 percent for NFCs and 0.6 percent for households in September (yoy). - Pure new loans to households have increased, albeit from a low base. - Bank liquidity remains ample. Customer deposits declined earlier owing to deposit outflows in Cyprus Cooperative Bank (CCB) but have broadly stabilized following recent government measures. - Recent actions and recommendations: - Resolution of a large systemic state-owned bank (Cyprus Cooperative Bank) undertaken in early 2018, with significant fiscal cost. - Legislative measures strengthening the insolvency and foreclosure regime were approved and are catalyzing cleanup of bank balance sheets. - Directors emphasized steadfast implementation of the amended legislative framework on foreclosure, insolvency, sale of loans, and securitization, supplemented by strengthening the court system and removal of uncertainties related to title deeds. - Enhance governance and supervisory framework for the recently-established asset management company. - The proposed Estia scheme should be better targeted and based on appropriate assessment of borrowers’ capacity to repay to limit moral hazard. - Banks urged to continue efforts to strengthen balance sheets, diversify income sources, consolidate operations to improve cost-income ratios, and be vigilant over lending policies, adequacy of provisioning, and debt-to-asset swap policies. - Strengthen regulatory guidance on loan restructuring. ### External position and external financing - Current account and external deficits: - Current account balance: -1.5 (2015), -5.1 (2016), -8.4 (2017), -4.1 (2018), -7.8 (2019 projection). - Trade Balance (goods and services): 0.8 (2015), -0.6 (2016), -3.5 (2017), -0.2 (2018), -3.8 (2019). - Nominal GDP (billions of euros): 17.7 (2015), 18.5 (2016), 19.6 (2017), 20.7 (2018), 21.9 (2019). - Assessment: - Underlying current account deficit widened; external position remains weaker than warranted by fundamentals and desirable policy settings. - Current account deficit rose to 8.4 percent of GDP in 2017; adjusting for effects of special purpose entities and one-off purchases of airplanes, the deficit was 2.6 percent of GDP. - The Fund’s EBA-lite CA model suggests the external position is weaker than implied by fundamentals and desirable policy settings, mainly reflecting Cyprus’s still large positive credit gap contributing to high domestic absorption. - External financing: - Growth is heavily dependent on foreign financing; meeting medium-term financing needs underscores the importance of strengthening external resilience. ### Policy priorities and structural reforms - Key policy priorities: - Achieve further private and public balance sheet repair by: - (i) steadfastly implementing recently amended legal tools to lower NPLs and the private debt overhang; - (ii) safeguarding fiscal space and reducing risks to public debt sustainability by maintaining strict spending discipline; - (iii) enacting structural reforms, especially in the judiciary and public administration, to attract investment and enhance productivity. - Institutional and structural reform recommendations: - Increase efficiency of the courts, speed up enforcement of commercial claims, and clear the backlog of cases. - Expedite legislation to strengthen the governance and autonomy of the Central Bank of Cyprus. - Mitigate AML/CFT risks. - Strengthen public financial management, monitor risks from local governments and the state-owned sector, and improve corporate governance of commercial state-owned enterprises. - Active labor market policies and investment in higher value-added sectors to reduce high youth unemployment and skills mismatch and promote more inclusive growth. - Risks to the outlook: - Implementation of NPL resolution delayed would weaken the outlook. - Public debt sustainability could be undermined by realization of contingent liabilities or erosion of fiscal discipline. *Source: CYPRUS — STAFF REPORT FOR THE 2018 ARTICLE IV CONSULTATION (Selected excerpts).* ### 6. The private sector debt overhang persists despite some deleveraging (Figure 4). ### 6. The private sector debt overhang persists despite some deleveraging (Figure 4) ### Private sector debt levels and deleveraging - Household gross debt declined by almost 15 percentage points of GDP last year, but remains very high at 100 percent of GDP in 2018:Q2. - Nonfinancial corporate debt has declined from 218 percent of GDP to 197 percent of GDP in 2018:Q2; this measure includes about 76 percent of GDP from SPEs. - The decline in corporate debt reflects GDP denominator effects, and increasingly a combination of NPL write-downs, repayments and debt-to-asset swaps. - Given substantial financial asset holdings (especially by households), net debt-to-GDP for households and NFCs stood at 72 percent of GDP in 2018:Q2 (excluding SPEs), a decline of 27 percentage points of GDP (yoy). ### Non-performing loans (NPLs): stock, flows, and challenges - NPLs declined by €11.5 billion over the period covered (of which €8.0 billion in corporate, mainly large enterprises, and €2.6 billion in households). - NPLs fell from 161 percent of GDP (48 percent of loans) in 2014 to 84 percent of GDP (39 percent of loans) in 2018:Q2. - Components of NPL flows (Q3:2017–Q2:2018, stock at beginning normalized to 100): - Migration from performing: 9.0 - One-time interest gross-up (due to IFRS9): 3.9 - Interest accrued on NPLs: 4.5 - Migration into performing: 8.7 - NPL cash repayment: 4.8 - Debt-to-asset/equity swaps: 2.7 - Write-offs: 15.6 - Debt instruments held for sale: 13.6 - Remaining NPLs: 54.6 - Aggregate net outflow of NPLs over the period: 27.9 - A sale by Bank of Cyprus of NPLs worth nearly 14 percent of GDP in 2018:Q2 accounted for nearly a third of the NPL outflows over the past year; the transaction is pending supervisory approval. - NPL workouts remain challenging due to weaknesses in the legal framework for foreclosure and weak enforcement, resulting in low recovery rates and increasing redefault rates among restructured loans. - Resolution steps (see Box 1) moved NPLs initially left behind in a residual entity to the newly-established Cyprus Asset Management Company (AMC), implying a substantial aggregate reduction in the NPL ratio of nearly 35 percent of GDP in 2018:Q3 (¶13, Box 1). - Additional sales of NPLs to credit-acquiring companies have begun. ### Outlook and risks tied to deleveraging and NPLs - Baseline near-term growth is expected to remain at around 4.2 percent in 2018–19. - Inflation is projected to accelerate to close to 2 percent. - The current account deficit is expected to widen in the near term. - Over the medium term, growth is projected to slow to around 2½ percent (long-run potential). - The baseline assumes gradual structural reforms and stronger enforcement to resolve NPLs. - Risks (tilted to the downside) include: - Implementation delays in NPL resolution could undermine investment prospects and growth and negatively affect banking capital. - Increased moral hazard and realization of contingent liabilities from publicly supported schemes could exacerbate debt sustainability risks via the sovereign-bank nexus. - Political pressure to unwind crisis-era fiscal measures could slow debt reduction and raise the sovereign risk premium and refinancing costs. - High dependence on construction sector, particularly financed through the CbI scheme, could undermine sustainability of growth. - External risks: financial distress in other markets, sharp tightening of global financial conditions, rising protectionism, slower euro area growth, or a hard Brexit. - Upside possibilities: - Exploitation of offshore gas deposits could boost long-term growth. - Faster progress in dealing with NPLs could attract additional FDI, increase credit flows, and strengthen economic growth. ### Financial sector vulnerabilities and policy priorities - Legacies from the banking crisis continue to weigh on financial stability. - Key pressures on banks: - Narrow interest margins. - Higher NPL provisioning needs. - Inefficient cost structure with excess staffing levels and too large branch networks. - Cyprus’s provisioning level: 49 percent of NPLs as of 2018:Q2 (around the EU average). - Collateralization is high, but foreclosure against collateral is cumbersome, undermining recovery values. - Policy priorities: - Repair bank balance sheets by lowering operational costs and strengthening collateral execution for NPL recovery. - Provide more specific regulatory guidance to achieve sustainable loan restructuring plans that minimize longer-term re-default probability. - Maintain vigilance over bank lending policies, adequacy of provisioning coverage and debt-to-asset swaps policy. - Develop a regulatory and supervisory framework for credit-acquiring companies, focusing on reporting requirements, on-site inspections and off-site monitoring (Annex VI). - Regulatory changes with impact on provisioning and capital: IFRS9, MREL, common minimum coverage levels of the European Commission and the ECB’s supervisory expectation for prudential provisioning; SSM on-site inspections scheduled later this year. ### Recent authorities’ measures to reduce vulnerabilities and catalyze NPL resolution - Two key steps taken: - In September, assets (primarily performing loans) and all customer deposits of the troubled second-largest, government-owned bank (CCB) were sold to Hellenic Bank, leaving the bulk of the NPLs in a residual entity that evolved into a government-owned AMC. - In July, Parliament adopted amendments strengthening the legal framework for NPL resolution: sales of loans law, foreclosure law, bankruptcy law, company law, personal insolvency laws, regulation on insolvency practitioners (IPs), and a securitization law. Tax legislation was amended to extend exemptions for debt-to-asset swaps and certain restructurings. A subsidy scheme, Estia, was approved to support repayments by eligible debtors on loans collateralized by primary residence (¶16). - Assessment of the legislative package: - Marks an important step to improve payment discipline; steadfast implementation is key. - Amendments include extending non-consensual personal repayment plans, clarifying application of new foreclosure procedures to legacy cases, simplifying debtor notification, and allowing electronic foreclosure auctions. - Shortcomings remain: protections for guarantors were rolled over and extended to post-2015 guarantees; little progress on problems in issuance and transfer of title deeds; judicial reforms and outsourcing of NPL restructuring to third-party loan servicers remain critical. ### Design and governance recommendations for the AMC and subsidy scheme - AMC governance and operations should: - Have a clear mandate with operational targets. - Have a supervisory board with a majority of independent members acting in the interest of the company first. - Be run by skilled management compensated based on performance. - Have a mandate limited to managing the CCB’s assets with a clear sunset clause to minimize fiscal costs. - Provide transparent reporting for public accountability. - The subsidy scheme (Estia) should be better targeted: - Ensure subsidy is calibrated to individual borrower repayment capacity and tighten eligibility criteria to reduce moral hazard. - Complement the insolvency framework without undermining it and help ensure comprehensive debt solutions. - Key parameters under discussion include: - Household income not exceeding €50K. - Market value of the primary residence not exceeding €350K. - Remaining net household wealth not exceeding 125 percent of the market value of the primary residence. - No threshold exists for the size of the property. - Subsidy payment fixed at one-third of the borrower’s installment for all eligible households. - State subsidy paid at the end of each year, contingent on bank confirmation that borrower has been current, with clawback provisions for redefaults. - The scheme is estimated to cost 0.1-0.2 percent of GDP annually. ### Box 1 — The Sale of the Cyprus Cooperative Bank (CCB): key facts and fiscal implications - Transaction structure: - Portfolio acquired by Hellenic Bank (HB) — Assets: 10.3 billion; Liabilities (customer deposits and others): 9.8 billion; Equity: 0.5 billion. - Within assets: Government bonds 4.1 billion; Loans, net of provisions 4.6 billion; Cash 0.4 billion; NPLs (net of provisions) 1.6 billion. - Residual entity — Assets: NPLs (gross book value) 7.0 billion; Performing loans 0.5 billion; Immovable property and other assets 0.9 billion. Liabilities: Government deposits 3.5 billion. - The assets involved in the acquisition are worth €10.3 billion and consist of government bonds, loans including a relatively small amount of NPLs, and cash, matched with customer deposits on the liability side. - With HB’s (old) assets worth €6.7 billion, the combined bank has assets of about €17 billion; Bank of Cyprus assets are €23.4 billion. - “Bad assets” of €8.3 billion in gross terms were left in the residual entity, together with the government deposits on the liability side. Servicing of these assets will be outsourced to a private company. - Fiscal cost and contingent items: - The fiscal cost of the CCB deal is expected to be around €3.5 billion (17 percent of GDP) plus contingent liabilities. - Direct and contingent costs include: - Nearly €3.5 billion of bonds and cash placed by the government to support the bank. - APS covering unexpected losses of a portfolio with a net value of €2.6 billion (authorities expect contingent liabilities related to these APSs will be limited to €155 million, based on an assessment by an independent auditor). - Exchange of previously-issued bonds for shorter maturity bonds to be paid out over the next five years, increasing annual gross financing needs by €0.5–0.75 billion. - Redundancy payments to about one-third of the 2,600 staff, estimated at €128 million. - Staff’s baseline DSA assumes neither a guarantee call on the APS schemes, nor any recovery from the NPLs in the AMC. Even if a significant share of APS contingent liabilities are realized with little recovery from assets, the impact would be less than the assumed contingent liability shock in the DSA. *International Monetary Fund — Report on the Discussions (selected excerpts).* ### 17. Risks arising from the property market appear to be limited for now but warrant close ### 17. Risks arising from the property market appear to be limited for now but warrant close monitoring ### Property market assessment and risks - Overall property prices are rising only moderately, although the luxury segment is picking up more rapidly with the support of the CbI scheme. - Investment fund flows into non-financial assets are increasing. - Risks and recommended actions: - Avoid an unsustainable increase in construction activity in the luxury segment. - Further decoupling the CbI scheme’s eligibility requirements from real estate would help avoid excessive concentration of economic activity and reduce the risk of over-supply of luxury properties. - If construction in the luxury market were to become reliant on domestic credit, tightening macroprudential measures would be appropriate. - Reinstating the immovable property tax (IPT) and raising the transfer duty on immovable property would provide additional countercyclical tools. - Ensure compliance with AML/CFT standards by the sectors involved in the CbI scheme and supervision of those sectors for compliance with requirements. ### Authorities’ views on property, NPLs, and related measures - Authorities agreed with staff that NPLs are yet to be resolved in an economic sense, while noting that a more enabling environment is now in place. - Strengthened legal tools will allow banks to: - Incentivize sustainable restructuring of loans by creating a credible threat of foreclosure. - Execute on collateral if no viable restructuring can be achieved. - Developments noted: - Removal of a sizable share of NPLs from the banking system following the CCB transaction and recent sales of NPLs by credit institutions. - Further sales of NPLs by banks are expected, but a gradual approach is needed given the magnitude of the legacy problem. - Supervisory priorities: - Closely supervise banks’ risk management, focusing on restructuring, management of real estate assets, and improving operational efficiency. - On Estia (proposed burden sharing subsidy scheme): - The Ministry of Finance underscored Estia as an important catalyst for resolving a difficult segment of the NPL portfolio. - Estia has helped forge political consensus for strengthening foreclosure and insolvency regimes and would support banks against reputational risk of foreclosing on primary homes. - Following discussions with the IMF and EU Institutions, options to tighten the eligibility criteria will be considered by the authorities. - Central Bank of Cyprus (CBC): - Agreed on the need to complete the regulatory and supervisory framework for newly-licensed credit-acquiring companies and the governance framework for the state-owned AMC. - A new board and management for the AMC are expected to be in place by year-end. - Objective for the AMC is to recover loans at a steady pace to respect financial stability considerations. - National authorities have already placed limits on the CbI scheme that benefits the luxury market segment. ### Fiscal sector: recent performance and projections - Fiscal performance: - The general government primary balance improved from 3.0 percent of GDP in 2016 to 4.3 percent of GDP in 2017. - Public debt has declined by 9 percentage points to 96.1 percent of GDP. - Fiscal performance through August shows strong revenue overperformance driven by VAT collections while spending remains contained. - Staff projections: - Staff projects further improvement of the primary balance to 5.1 percent of GDP in 2018. - The fiscal support for the CCB is expected to lead to a one-off spike in public debt this year. - Baseline and medium-term projections and risks: - Under the baseline scenario, the fiscal structural balance is expected to weaken slightly next year and to stabilize thereafter. - Structural primary balance projected to worsen by ½ percent of potential GDP, reflecting: - Cut in interest levy. - Introduction of the Estia scheme. - Decline in EU transfers. - Likely increases in health expenditures following rollout of the National Health System starting next year. - Over the medium term, the structural primary surplus is expected to remain broadly unchanged and the primary surplus to stabilize at around 5 percent of GDP. - Tables/figures excerpted (staff projections and memorandum items preserved in source). - Policy recommendations to secure debt trajectory: - Maintain strict spending discipline to ensure a firmly declining debt path. - Limit expenditure growth to medium-term economic growth—implies maintaining a primary surplus above 4¾ percent of GDP over the medium term. - Specific measures: - Keep wage bill growth firmly below nominal GDP growth by containing annual increments, staffing, COLA and general wage increases, and enact civil service reform. - With the introduction of the National Health System, implement strict monitoring and regulatory framework, including assessing health treatments and controlling cost of services; design provider payment mechanisms to manage incentives given expected pickup in demand. - Advance public financial management reforms to strengthen spending control. - Proceeds from NPL recovery in the CCB’s residual entity should primarily pay down debt rather than finance new spending. - Build higher cash buffers in view of higher financing needs owing to the CCB transaction. - Authorities’ views on fiscal stance: - Ministry of Finance agreed on need to maintain strict spending discipline and keep expenditure growth below medium-term GDP growth rate. - Noted limited risks to budget from contingent liabilities from NPLs as any calls on the APS guarantees would be met fully through the AMC without drawing on the budget. - Potential dividends from the AMC would be used towards reducing the debt burden, though MOF maintains conservative assumptions of no such revenues. - In health sector, a global budget is expected to help contain risks; an actuarial assessment will be undertaken every 3 years following NHS implementation, as required by law. ### Structural reforms and competitiveness - Key challenges: - Enforcing contracts is hampered by lengthy judicial processes. - Weaknesses in government effectiveness reflecting administrative inefficiencies. - Judicial reform and commercial claims enforcement priorities: - Greater judicial efficiency to reduce cost of capital and improve access to financing and investment. - Measures to accelerate judicial reform: - Introduce a dedicated commercial court with specialized judges for large commercial cases. - Reform the civil procedure code. - Rationalize appeals. - Clear backlog of cases. - Introduce an e-justice system. - Strengthen Insolvency Service and Insolvency Professionals. - Put in place a system for timely issuance and transfer of title deeds to immovable property and clear existing backlog expeditiously. - Strengthening public sector governance and government effectiveness: - Strengthen public financial management through better internal controls and monitoring of risks from local government and public bodies including SOEs. - Improve corporate governance of commercial state-owned enterprises: strengthen financial oversight, implement effective planning and reporting framework with greater disclosure and transparency, and introduce a code of conduct consistent with OECD principles. - Pending legislation to reform assessment of candidates for appointments and promotions and review civil service structure to facilitate greater mobility and enhance efficiency. - Local government reform to improve service delivery. - Central bank governance: - Legislative amendments underway to strengthen governance and autonomy of the CBC, including establishment of an Executive Committee, strengthen personal autonomy of members, and enhance financial autonomy by prescribing automatic recapitalization below a certain capital threshold. - AML reforms: - Effectively mitigating existing inherent AML/CFT risks is a key priority, including preparation for the upcoming MONEYVAL AML/CFT assessment. - Inherent AML/CFT risks cover issues related to absence of a common EU-wide AML/CFT supervisory framework, gaps in preventive measures, transparency of beneficial ownership, international cooperation, financial intelligence and investigations. - Policies for more inclusive growth: - Youth unemployment remains high at about 19 percent in 2018:Q2 despite declining since 2013. - Employment rate for recent tertiary graduates remains below EU average mainly due to mismatches. - High unemployment compared to pre-crisis levels may reflect loss of skills due to long-term unemployment. - Several Active Labor Market Policies (ALMPs) targeting youth and vulnerable groups have been launched; proper monitoring and evaluation needed. - Recommendations: - Diversify economy toward higher value-added sectors. - Strengthen education system to provide more intensified individual support, labor-market-oriented curricula, and dual-education apprenticeships better linking work-based and school-based programs. ### Staff appraisal - Near-term outlook: - Cypriot economy continues rapid recovery and near-term outlook remains favorable. - Growth has been strong over the past three years and is expected to exceed 4 percent in 2018–19, driven by domestic demand. - Over the medium term, as transitory effects of the investment boom and solid euro area cyclical growth dissipate, growth is expected to slow to potential. - Structural reforms required: - Sustaining high medium-term growth will require progress in structural reforms to lower systemic financial risks and catalyze productivity-enhancing investments. - Financial sector progress and remaining vulnerabilities: - Important strides were made in addressing key vulnerabilities in the banking sector. - NPL ratios, while declining, are still among the highest in Europe. - Recent sale of assets of the government-owned CCB and passage of legislative package to strengthen insolvency and foreclosure frameworks have reduced near-term risks to financial stability, albeit at a high cost to the public purse. *Source: IMF staff report excerpt (chapter 17 and adjacent sections).* ### 30. Steady declines in NPLs and in high corporate and household debt remain a priority in ### Steady declines in NPLs and in high corporate and household debt remain a priority ### NPLs, foreclosure, insolvency, and securitization - Paragraph 30: Steady declines in NPLs and in high corporate and household debt remain a priority to address the large debt overhang and the weak external position. - Paragraph 30: The amendments to the foreclosure and insolvency legislation, the sales of loans law, and the adoption of a law on securitization all enhance the toolkit available to borrowers and creditors to address NPLs on a durable basis. - Paragraph 30: Steadfast implementation of the enhanced frameworks will be key to facilitate this process and ensure timely enforcement. - Paragraph 30: The new frameworks should be supplemented by structural reforms aimed at strengthening institutions, especially the court system, and removing uncertainties related to title deeds. ### Supervision and governance of credit-acquiring companies and CAMC - Paragraph 31: The supervisory and governance framework for credit-acquiring companies—which includes the recently-established CAMC—needs strengthening. - Paragraph 31: Sales of NPLs to credit-acquiring companies have already begun, making it urgent for the central bank to develop a regulatory and supervisory framework for these institutions. - Paragraph 31: The governance framework for the government-owned CAMC needs to adequately balance operational independence with public accountability and transparency. ### Estia scheme and borrower targeting - Paragraph 32: The proposed Estia scheme to encourage distressed borrowers to begin servicing their loans should be better targeted to limit moral hazard risks from strategic defaults. - Paragraph 32: Tighter eligibility criteria and appropriate assessment of a borrower’s capacity to repay the restructured debt on a sustained basis will be important to be sure that those in need of assistance emerge from the process able to make good on their new obligations. - Paragraph 32: Banks should maintain provision coverage at adequate levels and promptly utilize the foreclosure and insolvency framework to address re-defaults. ### Bank balance sheet strengthening and risk management - Paragraph 33: Efforts to strengthen bank balance sheets should continue. - Paragraph 33: Diversifying income sources and consolidating operations are needed to improve cost-income ratios and better position banks in anticipation of regulatory changes and higher competitive pressures. - Paragraph 33: A focus on bank lending policies, sustainability of restructurings, adequacy of provisioning coverage and debt-to-asset swap policies would encourage sound bank risk management practices. ### Fiscal policy stance and spending discipline - Paragraph 34: With public debt already elevated, strict spending discipline should be maintained. - Paragraph 34: While fiscal performance is expected to remain robust with large primary fiscal surpluses, caution is needed to guard against procyclical fiscal pressures. - Paragraph 34: Transitory revenues arising from cyclical gains and one-off measures should not be relied upon to finance permanent spending initiatives. - Paragraph 34: Expenditure rises should be capped by the rate of medium-term GDP growth. - Paragraph 34: Keeping the rise of the public wage bill envelope within the rate of nominal GDP growth will be especially crucial to cap overall spending growth and create room for growth-enhancing spending. - Paragraph 34: The transition to public insurance in the health sector will need to be carefully managed. ### Fiscal structural reforms and public sector governance - Paragraph 35: Fiscal structural reforms are needed to lower risks to the budget and strengthen service delivery. - Paragraph 35: Public financial management could be strengthened through better internal controls for financial management and monitoring of risks from local government and state-owned sector. - Paragraph 35: Improving corporate governance of commercial state-owned enterprises is also key to improving the efficiency of the state-owned sector. - Paragraph 35: Legislative efforts to strengthen the governance and autonomy of the Central Bank of Cyprus should also be expedited, and AML/CFT risks should be mitigated. ### Institutional reforms to boost investment and growth potential - Paragraph 36: Institutional reforms are needed to further enhance the investment climate, and bolster productivity and medium-term growth potential. - Paragraph 36: Reforms to increase the efficiency of courts, clear the backlog of cases, and speed up enforcement of commercial claims should be pursued to reduce cost of capital and improve access to financing and investment. - Paragraph 36: Persistent delays with issuance and transfer of title deeds should be addressed expeditiously, focusing on clearing the backlog but also on avoiding a recurrence of similar problems in the future. ### Inclusive growth, labor market, and skills - Paragraph 37: Ensuring inclusive growth is crucial not just to equity but also to the sustainability of the recovery. - Paragraph 37: Policies to address the high youth unemployment and skills mismatch such as through ALMPs and investments in higher value-added sectors are needed. *Source: cr18337 - 30. Steady declines in NPLs and in high corporate and household debt remain a priority in* ### 38. It is recommended that Cyprus remains on the standard 12-month Article IV ### 38. It is recommended that Cyprus remains on the standard 12-month Article IV consultation cycle. ### Macroeconomic performance and drivers - Economic recovery described as "strong" and supported by "tourism, professional services and construction and real estate." - Cumulative contributions to recovery: "private consumption has contributed the most to the recovery." - Production-side drivers: "tourism and professional services." - Households’ financial net worth: "positive" and households "have been able to counter the impact of the banking crisis by drawing down their savings." ### Key real economy projections and indicators (Table 1) - Real GDP: 2015 2.0; 2016 4.8; 2017 4.2; 2018 4.2; 2019 4.1; 2020 3.6; 2021 3.0; 2022 2.7; 2023 2.4 - (Row as presented: "Real GDP2.04.84.24.24.1 3.63.02.72.4") - Domestic demand: "3.96.18.2 0.77.54.03.43.02.8" (as presented) - Private consumption: "2.44.54.14.0 3.12.82.62.52.5" (as presented) - Gross capital formation 1/: "18.121.9 30.4 -8.828.89.77.05.54.5" (as presented) - Potential GDP growth: "1.21.72.12.42.7 2.82.92.92.8" (as presented) - Output gap (percent of potential GDP): "-7.1-4.3-2.3 -0.60.71.51.61.41.0" (as presented) - HICP (period average): "-1.5-1.20.70.9 1.81.91.92.02.0" (as presented) - Unemployment rate (percent): "14.913.011.18.57.0 6.0 5.55.25.1" (as presented) - Nominal GDP (billions of euros) (Memorandum): "17.7 18.5 19.6 20.7 21.9 23.4 24.8 26.3 27.8" (as presented) ### Inflation and labor market - Headline and core inflation: "Inflation turned positive, but core CPI inflation is still muted." - Cyprus vs euro area: "CPI inflation remains lower than in other euro area countries." - Employment: "Employment has been rising especially in the tourism sector," contributing to a falling unemployment rate. - Compensation and unit labor cost: "Compensation of employees only recently started picking up.... keeping unit labor cost in check." ### External sector and external indicators - Current account: "The overall current account deficit has been widening in step with trade and primary income balances." - Real effective exchange rates: "are near post crisis lows." - Capital flows: "Both capital inflows to the private sector and capital outflows from the CBC have been large." - Net IIP: "The CBC has a large positive net IIP position while the private sector (including SPEs) has a large negative position." - Net IIP trends: "Net IIP remains highly negative with FDI having an increasing share in recent years." - Gross external debt: "Led by MFIs, gross external debt has fallen to below 600 percent of GDP." (Charts show levels and downward trend.) - From Table 4: Current Account Balance (percent of GDP): 2015 -1.5; 2016 -5.1; 2017 -8.4; 2018 -4.1; 2019 -7.8; 2020 -7.4; 2021 -7.0; 2022 -6.5; 2023 -6.2 ### Credit, financial positions, and balance sheets - Domestic credit: "points to early signs of modest expansion." - Domestic financial balances: "Loans explain most of the current negative financial position. NFCs and the general government are the main borrowers." - Household and NFC debt: "Household debt as a percentage of GDP continues to be the highest among euro area countries ... while NFC debt even accounting for SPEs is also high." - From monetary/financial tables: Cypriot resident broad money (M2) and narrow money (M1) dynamics and credit-to-deposit ratios are presented, with credit-to-deposits Ratio (Cypriot residents) ranging in table from "108.9" to "114.0" across years and broad money and credit series documented in detail in Table 6. ### Banking sector - Scale and profitability: "The banking sector has downsized significantly since the crisis... but narrow interest margins and NPL provisioning needs exert pressures on profitability." - Emergency liquidity assistance: "Emergency bank liquidity assistance has been fully repaid." - Deposits: "Customer deposits have been rising until recently when uncertain prospects for the Cyprus Cooperative Bank triggered heavy outflows." - NPLs and provisioning: "The NPL ratio remains elevated but provisioning and coverage levels have risen substantially." - Foreign deposits: "have decreased sharply since 2013, now accounting for only 25 percent of total deposits." - Financial soundness indicators (Table 7 excerpts): Regulatory capital ratio and Tier I capital ratio series; NPLs to total gross loans series show high peak values (e.g., NPLs end-2014 through end-2017 presented in table). ### Housing market and construction - Property prices and sales: "Following a sharp fall, property prices are now rising marginally." "Property sales are recovering, with an increasing share accounted for sales to non-residents." - Construction activity: "Growth in construction activity has been very strong, albeit from a low base..." - Housing loans: "the stock of housing loans is declining due to continuing deleveraging." - Mortgage interest rates: "on a downward trend." - Building permits: "issuance ... on an upward trend." ### Fiscal developments and public debt - Primary fiscal balance: "The primary fiscal balance has improved markedly... reflecting contained expenditures... and strong revenue collection on the brisk recovery... leading to a decline in the public debt ratio in 2017." - Public debt (Table 2 and Table 3): Public debt (percent of GDP) series: 2015 108.0; 2016 105.5; 2017 96.1; 2018 106.1; 2019 99.7; 2020 90.3; 2021 83.3; 2022 75.4; 2023 68.1 (rows as presented). - Fiscal projections (Table 2 excerpts): - Revenue (percent of GDP): "39.0 38.0 39.0 39.7 39.0 38.2 38.1 38.1 38.0" (2015–23 row as presented) - Expenditure (percent of GDP): "39.3 37.7 37.3 37.0 36.5 35.5 35.3 35.3 35.2" (2015–23 row as presented) - Primary Fiscal Balance (percent of GDP): "2.73.04.35.15.05.05.04.94.8" (as presented) - Market indicators: "Yields on Cypriot Eurobonds have fallen to low levels and spreads to German government bonds have tightened... while 3-month T-bill yields have been negative for over a year." ### Competitiveness, business climate, and governance - Business climate weaknesses: "Among business climate metrics, contract enforcement stands out as a key weakness. Access to financing and government bureaucracy also are perceived to be constraints." - Contract enforcement: "Enforcing contracts takes nearly double the time of peer groups, largely reflecting trial and judgment period." - Court processes: "Court automation and case management are some areas where Cyprus lags euro area peers." - Perceptions: "Perceptions of government effectiveness compare less favorably to that of most other euro area members." "Rule of law ... is also perceived to be weaker relative to much of the rest of the monetary union." ### Inclusiveness and labor market risks - Unemployment trends: "Unemployment rate is declining. However, youth unemployment remains very high, recording one of the largest increases in the EU since pre-crisis levels." - Long-term unemployment: "The share of long-term unemployed has more than doubled." - Employment quality: "An increasing share of employed are working part-time... increasing the risk of poverty from already relatively high levels." - Inequality: "Wealth and income inequality is relatively high by European standards." - Policy focus recommendation: "Policies should focus on protecting the vulnerable." ### General recommendation - Institutional recommendation: "It is recommended that Cyprus remains on the standard 12-month Article IV consultation cycle." *Sources: Central Bank of Cyprus; Cystat; ECB; Eurostat; Haver Analytics; Bloomberg L.P.; Ministry of Finance; World Bank Doing Business; World Economic Forum Global Competitiveness Index; Worldwide Governance Indicators; and IMF staff calculations (figures and tables as presented in the source).* ### Annex I. Authorities’ Response to Past Policy Recommendations ### Annex I. Authorities’ Response to Past Policy Recommendations ### Strengthen Financial Sector Policies - Recommendation: Reduce private sector debt and high NPLs by: - (i) addressing impediments in the foreclosure and insolvency frameworks and asset sales legislation; - (ii) relying on a broad set of tools that includes burden sharing and keeps banks well provisioned and capitalized; and - (iii) outsourcing NPL management to third parties with specialized restructuring skills and at arm’s length relationship with borrowers. - Policy actions and outcomes: - (i) A package of amendments to strengthen the legal framework for NPL resolution was adopted (2018). - (ii) A securitization law was also adopted (2018), but their implementation largely hinges on a broader reform of the judicial system. - (iii) A subsidy scheme aimed at encouraging vulnerable borrowers to start servicing their loans through burden sharing has been approved, but its coverage is rather broad. - The three large domestic banks have outsourced NPL management to third parties in 2017 and early 2018. ### Ensure Fiscal Sustainability and Avoid Procyclicality - Recommendation: Cap fiscal spending by medium term GDP growth to avoid procyclical policies, prevent structural loosening and mitigate risks stemming from the high level of public debt; closely monitor the costs of the National Health Service (NHS); focus on implementing key reforms in public financial management (PFM) and revenue administration (RA); pass the law on creation and functioning of SOEs. - Policy actions and outcomes: - Some fiscal loosening took place during 2017-2018. - A more durable mechanism to keep the public-sector wage bill in check has not been adopted by Parliament. - A NHS review based on the report of an external consultant is still pending. - PFM and RA reforms are being implemented, supported by Fund technical assistance. - The law on SOEs remains to be adopted. ### Implement Structural Reforms - Recommendations and actions: - Strengthen the enforcement of commercial claims and the efficiency of the courts. - The legislation for the establishment of a commercial court is currently undergoing legal vetting. - An action plan is being drawn based on issues identified in a functional review of the Cyprus’s Court System prepared by the Irish Institute of Public Administration. - Restart the privatization program and undertake a central bank governance reform. - Privatization efforts have largely stalled. - The amending legislation to strengthen the governance and autonomy of the CBC is undergoing legal vetting. - Implement concrete actions to improve the business environment. - A comprehensive action plan has been drawn up, but implementation has been slow. - Decouple the CbI scheme’s eligibility requirements from real estate and ensure full compliance with AML/CFT standards by all sectors involved in scheme. - The Council of Ministers put a cap on the number of citizenships granted under the CbI scheme to 700 a year and decided the establishment of a Committee for Supervision and Control as well as a Registry of Service Providers for the CbI scheme. *Source: Annex I. Authorities’ Response to Past Policy Recommendations (cr18337)* ### Annex II. External Sector Assessment ### Current Account (CA) - Background: - In 2017, the overall current account (CA) deficit was -8.4 percent of GDP overall (with underlying balance of -2.6 percent of GDP, adjusted for SPEs and one-off effects of imports of aircrafts due to the commencement of a new airline). - Since 2015, Cyprus’s underlying trade balance moved to surplus and in 2017, it was 1 percent of GDP. - The income balance (adjusted for SPEs) was -3.6 percent of GDP, reflecting large negative NIIP and outward remittances. - Overall assessment: - The external position of Cyprus in 2017 was weaker than warranted by fundamentals and desirable policy settings. - In 2018, the CA balance is projected to improve somewhat reflecting both stronger trade and primary income balances. - Potential policy responses: - Continued efforts to unwind the credit gap, including through further deleveraging by banks, would decrease domestic absorption, raise the current account, and lower net IIP liabilities. - Structural reforms targeting a more diversified economy would help to ensure balanced and sustainable growth. - Maintaining a prudent fiscal policy that avoids procyclicality would help safeguard the downward path of public debt and create space to absorb possible contingent fiscal shocks. - Staff assessment: - The CA gap in 2017 was -3.5 percent of GDP, corresponding to an external position weaker than warranted. - Policy gaps contribute 0.1 percentage point to the CA gap, decomposed into: - private credit gap: -1.1 percentage point (reflecting Cyprus’s still large credit gap relative to the ROW), - fiscal policy: 1.1 percentage point (due to the ROW as Cyprus’s cyclically-adjusted fiscal balance is considered appropriate). - Key numbers: - Actual CA: -8.4% - One-off factors: -5.8% - Underlying CA: -2.6% - CA norm: 0.9% - CA gap: -3.5% - of which policy gap: 0.1% ### Real Exchange Rate (REER) - Background: - CPI- and ULC-based average REERs appreciated slightly in 2017 (around 0.4 and 0.3 percent, respectively) but remained -7 percent and -15 percent lower than 2011 levels, mainly reflecting post-crisis wage declines. - Compared to their 2017 averages, the CPI- and ULC-based REERs depreciated 0.2 percent and 0.4 percent, respectively, in H1 2018 despite public sector wages starting to reverse their downward trend. - Exporters’ producer price indices remain mostly subdued. - Assessment: - The REER EBA-lite model points to REER overvaluation with the REER gap estimated at just under 15 percent, of which the policy gap mostly reflects the private sector credit gap (2.4 percent), as well as the real interest rate (1 percent). - The EBA-lite CA model points to an overvaluation of around 7.2 percent. - Staff’s assessment: an REER overvaluation of around 7 percent (given greater applicability of the CA model for Cyprus). ### Foreign Asset & Liability Position (NIIP) and Trajectory - Background: - NIIP was -122 percent in 2017, compared to -130 percent in 2011. - Composition of foreign liabilities improved: the share of FDI increased by 15 percentage points over the same period; the share of other investment and derivatives declined. - Excluding SPEs’ foreign financial positions, NIIP declined from -64 percent to -43 percent of GDP over the same period. - Government’s NIIP deteriorated from -24 percent to -77 percent of GDP. - Non-SPE private sector’s NIIP declined to -39 percent of GDP as capital inflows returned. - TARGET2 claims and portfolio holdings associated with the Asset Purchase Program resulted in the central bank’s NIIP improving from -19 percent to around 70 percent of GDP. - Assessment: - A CA balance of -3.9 percent of GDP would stabilize the SPE-adjusted NIIP at its 2017 current level; this is 1.3 percentage points larger than the 2017 estimated underlying CA deficit. - Reaching a NIIP position of -35 percent of GDP by 2023 (the European Commission threshold for macroeconomic imbalances) would require sustaining a CA of -2.3 percent of GDP, a deficit 0.3 percentage points smaller than the 2017 underlying CA. ### Capital & Financial Accounts: Flows & Policy Measures - Background: - Net capital inflows slowed in 2017, amounting to 22 percent of GDP for the private sector (including SPEs), from 32 percent in 2016. - Net FDI inflows accelerated to 23 percent of GDP. - Private net portfolio inflows slowed to 5 percent of GDP as residents increased their acquisition of foreign assets. - Net outflows from the central bank continued, pushing its TARGET2 balance to 38 percent of GDP at end-2017. - These trends persisted in 2018, with net capital inflows to the private sector decelerating to 16 percent of GDP for the four quarters through Q2 2018 despite even higher net FDI inflows as private net portfolio inflows slowed further and MFIs continued to reduce non-resident deposits. - Assessment: - With sizable external debt of the public and private sectors, Cyprus remains exposed to financial market risks. ### FX Intervention & Reserves Level - Background and assessment: - The euro has the status of a global reserve currency. - Reserves held by the euro area are typically low relative to standard metrics, but the currency is free floating. *Source: Annex II. External Sector Assessment (cr18337)* ### Cyprus: Export Competitiveness Developments - Services drove the post-crisis growth in exports; exports of goods and services (sum of last four quarters) shown as percent of GDP indicate services-dominant recovery. - Evolution of export shares (2010=100) shows Cyprus relative to comparator economies. - Main export destinations: - Goods: diversified. - Services: roughly 40 percent destined for the UK and Russia. - Tourism: - Russia represents an increasingly sizable share of tourist arrivals; tourist overnight stays by country of origin show notable shares for UK and Russia. - Unit Labor Cost (ULC) developments: - Post-crisis declines in compensation drove ULC compression. - Charted components: productivity per employee (improvement denoted by "-"), compensation per employee, change in ULC, ULC (2010=100). - External producer price indices by industrial grouping: - Y-o-y percent change series for Intermediate goods, Capital goods, Consumer goods remain mostly subdued. *Source: Cyprus: Export Competitiveness Developments (cr18337)* ### Annex III. Risk Assessment Matrix ### External Risks (selected) - Rising protectionism and retreat from multilateralism - Relative likelihood: High - Time horizon: ST, MT - Expected impact: Cypriot economy heavily dependent on foreign demand (UK, Russia, Europe); weaker external demand would adversely affect long-term growth. - Policy response: Seek to broaden sources of foreign demand. Restart structural reforms to make the economy more dynamic and flexible in response to demand shocks. - Unsustainable macroeconomic policies in systemically important countries - Relative likelihood: Medium - Time horizon: ST, MT - Weaker-than-expected Euro Area growth - Relative likelihood: Medium - Time horizon: MT - Sharp tightening of global financial conditions - Relative likelihood: High - Time horizon: ST - Expected impact: Higher interest rates on Cypriot government borrowing and private sector debt, raising refinancing and debt-service costs and straining loan quality. - Policy response: Undertake additional fiscal consolidation to reduce borrowing needs. Incentivize private-sector borrowers to engage with banks by ensuring robust implementation of the strengthened framework for insolvency and foreclosure. ### Domestic Risks (selected) - NPL management amid continued weak payment discipline - Relative likelihood: High - Time horizon: ST, MT - Expected impact: Perceived loan forbearance leads to increased strategic default and moral hazard; negative implications for banks’ ability to extend new credit and higher direct and contingent liabilities for the state. - Policy response: Intensify efforts to reduce NPLs decisively and durably by encouraging banks to remain adequately provisioned and capitalized, and ensuring robust implementation of the strengthened framework for insolvency and foreclosure. - Renewed boom-bust cycle linked to construction and CbI scheme - Relative likelihood: Medium, High - Time horizon: ST, MT - Expected impact: GDP growth could slow sharply, weighing on employment, tax revenue and banks’ asset quality. - Policy response: Enact comprehensive reform agenda to improve prospects for more diversified growth and gradually decouple CbI scheme from real estate in a timely manner. *Source: Annex III. Risk Assessment Matrix (cr18337)* ### Annex IV. Debt Sustainability Analysis (Public DSA) — Baseline Scenario - Summary assessment: - In the baseline, public debt is on a rapid downward path after a sharp one-off increase in 2018. - Risks to debt sustainability remain high. - Debt reduction could be temporarily halted by an adverse short-term growth shock and significantly delayed by a combination of sustained stagnation, a modest primary deficit and persistent deflation. - A large contingent liability or a combination of macro-fiscal shocks and a contingent liability could raise public debt to and keep it at a very high level, particularly if market dislocation persists. - Gross public financing needs (GPFN) have recently increased and could rise further under macro-fiscal and contingent liability shocks but are expected to remain below high vulnerability thresholds. - Baseline Scenario narrative and key figures: 1. Debt issuance to strengthen the balance sheet of the CCB for its sale has reversed the rapid downward path of public debt. - Public debt declined sharply to 96.1 percent of GDP at end-2017 from 105.5 percent of GDP a year earlier, driven by early repurchase to the Fund (July 2017) and repayment to the CBC (November 2017). - As part of the conditions to sell assets and liabilities of the CCB, the government placed €3.19 billion domestic bonds (15 percent of projected GDP in 2018) at the CCB in July 2018. - This transaction contributes to the projected increase in public debt to about 106 percent of GDP at end-2018. 2. From 2019, public debt is projected to resume a rapid decline. - Projected high primary surpluses and robust economic growth support a durable decline in public debt to 68 percent of GDP by 2023. 3. The placement of domestic bonds at the CCB has increased gross public financing needs (GPFN). - The domestic bond issuance was implemented through a private off-market placement, to be redeemed gradually over a five-year period beginning this year. - GPFN will remain about half the benchmark for advanced economies (20 percent of GDP) over the projection horizon. - In June 2017, authorities issued €850 million in Eurobonds and bought back bonds scheduled to mature in 2019; they also made early repurchase to the Fund and repaid part of the debt owed to the CBC. - Authorities plan to issue medium- or long-term Eurobonds each year to maintain a cash buffer sufficient to cover gross financing needs on a nine-month forward rolling basis. *Source: Annex IV. Debt Sustainability Analysis (cr18337)* *Source document: cr18337 - Annex I. Authorities’ Response to Past Policy Recommendations (IMF Country Report PDF)* ### 4. High NPLs poses a risk to the sustainability of public debt. In addition to the domestic ### 4. High NPLs poses a risk to the sustainability of public debt. In addition to the domestic ### Risks to public debt sustainability from NPLs and contingent liabilities - Government agreed a contingent support for completing the transaction of the CCB in the form of an Asset Protection Scheme (APS) covering €2.6 billion performing loan portfolio. - Independent estimates put likely fiscal cost at €155 million (0.8 percent of GDP). - Baseline conservatively assumes zero recovery from the NPLs in the public AMC. - Broader risk from NPLs at other systemic banks could spill over to the government’s balance sheet. ### Vulnerability of public debt and baseline projections - Under the baseline, public debt ratio is projected to remain above the benchmark for advanced economies (85 percent of GDP) until 2020. - Probability assessment: If adverse shocks are more likely than favorable ones, public debt to GDP could remain above 100 percent until 2023 with a probability of 8 percent (fan chart in Annex Figure 1). - Gross public financing needs (GPFN) are susceptible to shocks; under short-duration individual macro-fiscal shocks or sustained historical-adverse episodes for growth and the primary balance, GPFN would jump several percentage points of GDP but remain below the 20 percent benchmark. ### 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 liabilities are to a considerable extent matched by gross assets of similar duration. - About 73 percent of public debt is owed to non-residents. - About 65 percent of the non-resident debt reflects official financing from the ESM and the IMF, a bilateral loan from Russia, and loans from the European Investment Bank and the Council of Europe Development Bank. - Official liabilities feature relatively low and/or fixed interest rates, long maturities, and a back-loaded repayment schedule on a significant share of debt, mitigating interest rate and financing risks. - Sovereign bond spread relative to German bonds was around 192 basis points on average in the past three months, below the lower risk-assessment benchmark. - Reliance on short-term debt is limited and considered low risk. - As of end-September 2018: - Weighted average maturity of total debt is 6.1 years. - Weighted average maturity of marketable debt is 3.7 years. - Shares of debt that falls due within 1 year and 5 years are 10.0 percent and 48.4 percent, respectively. ### Realism of baseline assumptions - Recent GDP growth and the fiscal balance have been stronger than staff’s forecasts, aided by robust external demand and private financial inflows substituting for new bank lending. - Projection errors during 2012–13 reflected exceptional events (damage to the sole power plant in 2011 and the write-down of banks’ holdings of Greek public debt in 2012). ### Stress tests and alternative macro-fiscal scenarios (findings) - Growth shock: - One standard deviation (3.4 percentage points) decrease in growth during 2019–20. - Accompanied by a 36 and 73 basis points rise in interest rates in 2019 and 2020, respectively (corresponding to 25 bps rise per one percentage point reduction in primary balance). - Decrease in inflation by 0.25 percentage points per percentage point reduction in GDP growth. - Result: public debt would rise by 13 percentage points relative to the baseline to 103 percent of GDP by 2020, before declining to 80 percent of GDP by 2023. - Primary balance shock and real interest rate shock: - Decrease in the primary surplus by 1.6 percent of GDP during 2019–20. - Accompanied by 41 bps rise in interest rates (corresponding to 25 bps rise per one percentage point reduction in primary balance) and an increase in the real interest rate by 575 bps during 2019–23. - Result: public debt marginally to 71 and 72 percent of GDP by 2023, respectively. - 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 2020 before declining to 88 percent of GDP by 2023. - Gross financing needs would peak at 14 percent of GDP in 2020 before falling back. ### Adverse macro-fiscal-contingent liability (CL) scenario - Assumptions: - Real GDP growth and primary fiscal balance permanently lower than the baseline by ½ standard deviation. - Decrease in inflation and a rise in interest rates. - Further realization of contingent liabilities from the banking sector (3 percent of GDP) and outside the banking sector (7 percent of GDP) in 2019 (10 percent of GDP in total), on top of support already provided to the CCB. - Results: - Public debt would rise to 114 percent of GDP in 2019 and decline only slowly to 97 percent of GDP in 2023. - Gross financing needs would spike to 20 percent of GDP in 2019 before declining to 9 percent of GDP over the medium term. ### Large contingent liability shock scenario - Assumptions: - One-off 25 percent of GDP increase in public debt in 2019. - Temporary spike in sovereign borrowing costs by 625 basis points in 2019. - Compression of output and a decline of inflation in 2019–20. - Results: - Public debt would reach 129 percent of GDP in 2020 before declining to 106 percent of GDP by 2023. - Such a spike in borrowing costs would likely preclude market access, with further detrimental implications for debt sustainability. ### External debt sustainability analysis (baseline projections) - Gross (net) external debt projected to decline from around 519 (114) percent of GDP (€107 billion) in 2018 to 442 (52) percent (€123 billion) of GDP by 2023. - Government external debt as a share of GDP declines over the medium-term on the assumption of continued fiscal prudence. - Banks forecast to reduce external debt to around 64 percent of GDP, mostly reflecting further declines in nonresident deposits. - External debt of private nonbank sectors forecast to decline somewhat but remain high at more than 200 percent of GDP. - Gross debt excluding that of SPEs anticipated to fall to around 185 percent of GDP in 2023. - Nominal GDP growth expected to be the primary driver of the decline in the gross external debt ratio: nominal GDP is forecast to grow by 6 percent on average in the projection period. - This growth contributes to an annual external debt reduction of 28 percentage points of GDP. - Trade deficit assumed to be sustained at 2.4 percent of GDP annually, on average. - Net interest payments assumed at 6 percent of GDP annually, on average. - Combined, these factors yield an annual decline in external debt by 19 percentage points of GDP on average. ### Risks to external debt sustainability (standard bounds tests) - Interest rates shock: - A two-percentage-point increase in average interest rates on external debt throughout the projection period would increase the debt ratio by 56 percentage points by 2023, compared to the baseline. - Growth shock: - A one-half standard deviation decrease in projected real GDP growth throughout the projection period could increase the debt-to-GDP ratio by 66 percentage points by 2023 compared to the baseline. - Current account deterioration: - A one-half standard deviation shock to the current account balance would push debt 9 percentage points higher by 2023 compared to the baseline. - Combination of shocks: - One-quarter standard deviation shocks to growth and the current account, along with a one-percentage-point increase in average interest rates, would raise the debt ratio by 66 percentage points by 2023 relative to the baseline. - Historical scenario: - Reversion to average levels during the previous five years of growth, interest rate, inflation, and the current account balance would drive the debt ratio higher by about 150 percent of GDP by 2023 (extreme scenario driven mostly by deflation and nearly stagnant nominal GDP). ### Gross external financing needs (GFN) - GFN projected to decline but remain elevated (over 150 percent of GDP) through the projection period due to short-term private sector debt. - Private sector short-term external debt fell roughly 30 percentage points of GDP in 2017 to 151 percent of GDP. - Nearly 90 percent of external debt owed by banks is short-term. - About one-quarter of external debt owed by other private sector borrowers is short-term. - Cyprus faces rollover risk if borrowers lack sufficient liquid assets or market funding becomes too costly. - Projected reduction in GFN largely reflects banks’ reduced non-resident deposits and declining non-financial private sector liabilities as deleveraging continues. ### Conclusion - External debt appears sustainable in the baseline but remains vulnerable to a variety of risks due to its high level. - Ongoing economic expansion, downsizing of the banking sector, and fiscal consolidation have supported debt reduction efforts. - Cyprus’s role as a regional financial center implies gross external debt will remain high. - Staff assumes expansion in gross external debt due to SPEs slows over the medium term under the baseline, but substantial uncertainty remains given limited information on SPE activities and developments in home countries of beneficial owners. *Source: CYPRUS — INTERNATIONAL MONETARY FUND.* ### 17. The Cypriot economy remains exposed to liquidity and other risks as a result of ### 17. The Cypriot economy remains exposed to liquidity and other risks as a result of ### Macroeconomic and fiscal vulnerabilities - Continued large gross financing needs increase exposure to liquidity and other risks in the presence of still-high non-performing loans and private debt overhang and elevated public debt. - Maintaining a prudent fiscal policy that avoids procyclicality would: - Help safeguard the downward path of external public debt. - Create space to absorb possible contingent fiscal shocks. - It will remain important to closely align the maturity and currency of external assets and liabilities. - Sound financial sector policies and structural reforms targeting a more diversified economy would help ensure balanced and sustainable growth and limit risks of a new boom-bust cycle. ### Public Debt Sustainability — Baseline projections and indicators (as of November 07, 2018) - Nominal gross public debt: - 2016: 74.3 - 2017: 105.5 - 2018: 96.1 - 2019: 106.1 - 2020: 99.7 - 2021: 90.2 - 2022: 83.3 - 2023: 75.4 - 2023 (final listed cell): 68.1 - Public gross financing needs (in percent of GDP): - 2016: 13.5 - 2017: 8.9 - 2018: 9.8 - 2019: 8.2 - 2020: 8.3 - 2021: 7.4 - 2022: 5.6 - 2023: 6.8 - 2023 (final listed cell): 4.7 - Real GDP growth (in percent): - 2016: 0.0 - 2017: 4.8 - 2018: 4.2 - 2019: 4.2 - 2020: 4.1 - 2021: 3.6 - 2022: 3.0 - 2023: 2.7 - 2023 (final listed cell): 2.4 - Inflation (GDP deflator, in percent): - 2016: 1.2 - 2017: -0.6 - 2018: 1.5 - 2019: 1.4 - 2020: 1.8 - 2021: 3.2 - 2022: 2.9 - 2023: 3.2 - 2023 (final listed cell): 3.1 - Nominal GDP growth (in percent): - 2016: 1.3 - 2017: 4.2 - 2018: 5.8 - 2019: 5.6 - 2020: 6.0 - 2021: 6.9 - 2022: 6.1 - 2023: 6.0 - 2023 (final listed cell): 5.6 - Effective interest rate (in percent): - 2016: 4/ - 2017: 4.2 (note: table labeling indicates definition; values listed by year: 4.2, 2.5, 2.6, 2.6, 2.5, 2.5, 2.6, 2.8, 2.8) - Debt dynamics — contribution to change in gross public sector debt (cumulative 2016–2023): - Change in gross public sector debt (cumulative): -28.1 - Identified debt-creating flows (cumulative): -28.0 - Primary deficit (cumulative): -29.8 - Primary (noninterest) revenue and grants (cumulative): 231.0 - Primary (noninterest) expenditure (cumulative): 201.2 - Automatic debt dynamics (cumulative): -17.8 - Other identified debt-creating flows (cumulative): 19.6 - Residual, including asset changes (cumulative): 0.0 (individual yearly entries include 0.1, -0.1, 0.0, etc.) - Change in gross public sector debt by year (selected): - 2016: 5.4 - 2017: -2.5 - 2018: -9.4 - 2019: 10.0 - 2020: -6.4 - 2021: -9.4 - 2022: -6.9 - 2023: -7.9 - cumulative (through 2023): -28.1 ### Debt composition, scenarios, and alternative assumptions - Underlying assumptions (selected): - Baseline Real GDP growth (2018–2023): 4.2, 4.1, 3.6, 3.0, 2.7, 2.4 - Baseline Inflation (2018–2023): 1.4, 1.8, 3.2, 2.9, 3.2, 3.1 - Baseline Primary Balance (2018–2023): 5.1, 5.0, 5.0, 5.0, 4.9, 4.8 - Constant Primary Balance Scenario primary balance: 5.1 across projection years - Effective interest rate examples by scenario: Baseline around 2.6–2.8; Historical and alternative scenarios show higher effective interest rates (up to 4.3 in historical scenario) - Composition of public debt visualizations indicate splits: - By maturity: medium and long-term vs short-term (projected shares shown across 2016–2023) - By currency: local currency-denominated vs foreign currency-denominated (projected shares across 2016–2023) ### Stress tests and shock scenarios (selected outcomes and assumptions) - Stress tests analyzed include: - Primary Balance Shock - Real GDP Growth Shock - Real Interest Rate Shock - Real Exchange Rate Shock - Combined Shock - Contingent Liability Shock - Example stress-test assumptions and underlying adjustments (selected): - Under Primary Balance Shock scenario, primary balance paths adjust (2018–2023) with specific yearly values shown (e.g., 2019 primary balance 3.3 in one panel, 3.5 in another panel depending on shock). - Real GDP Growth Shock scenario alternative real GDP growth path includes 4.2 (2018), 0.7 (2019), 0.2 (2020), 3.0 (2021), 2.7 (2022), 2.4 (2023). - Real Interest Rate Shock example effective interest rate paths include increases such as 2.6 (2018), 2.5 (2019), 3.1 (2020), 3.6 (2021), 4.2 (2022), 4.7 (2023) under the shock. - Combined macro-fiscal shock and contingent liability shock produce materially higher debt paths and public gross financing needs in projection charts (numerical series shown in charts). - Market perception indicators and heat map benchmarks cited include: - Bond spread metrics and EMBIG (bp) references (EMBIG 166 in one table cell). - Benchmarks for early-warning and risk-assessment: 400 and 600 basis points for bond spreads; 17 and 25 percent of GDP for external financing requirement; 1 and 1.5 percent for change in the share of short-term debt; 30 and 45 percent for public debt held by non-residents. ### External debt and external financing needs - Baseline external debt (in percent of GDP) and gross external financing needs (right scale in charts) show: - External debt: series including 569, 554, 573, 576, 554, 519, 507, 487, 470, 453, 442 for 2013–2023 (as presented in tables and charts). - Gross external financing need (in billions of euros) example annual values shown: 71, 52, 45, 43, 43, 39, 38, 40, 41, 42, 43 across a multi-year series. - Gross external financing need (in percent of GDP) examples include values: 39, 12, 96, 25, 42, 32, 22, 21, 18, 6, 17, 0 (presented as chart scales; exact cell values are embedded in tables/figures). - External-sector flows and contributions to external debt dynamics (selected entries): - Change in external debt 2013–2019: -48.1, -14.8, 18.3, 3.9, -22.0, -35.5, -12.0, -20.2, -16.5, -16.8, -11.4 (series shown in table). - Identified external debt-creating flows (4+9+14) 2013–2019: -30.6, -40.5, -12.8, 21.9, -16.8, -34.9, -11.5, -19.8, -16.2, -16.5, -11.1. - Current account deficit, excluding interest payments 2013–2019: -11.4, -12.7, -17.5, -11.0, -8.9, -12.3, -8.4, -9.4, -10.6, -11.9, -12.8. - Exports (selected years): 58.6, 62.0, 64.5, 64.5, 65.0, 64.8, 61.0, 60.0, 59.5, 59.1, 58.9. - Imports (selected years): 56.8, 60.0, 63.7, 65.1, 68.6, 65.0, 64.7, 63.3, 62.5, 61.5, 60.9. - Automatic debt dynamics contributions (selected): contribution from nominal interest rate 16.3, 17.0, 19.0, 16.1, 17.3, 16.4, 16.2, 16.8, 17.6, 18.4, 19.0 (series shown); contribution from real GDP growth 38.4, 7.7, -10.8, -26.4, -23.1, -21.8, -20.0, -17.0, -14.0, -11.8, -10.3. - Scenario averages and shocks noted: - Growth shock example: baseline average 3.3, scenario 1.1, historical 0.8 (in one panel). - CA (current account) shock example: baseline 10.9, scenario 9.3, historical 12.3 (in one panel). - Interest rate shock example (200 bps): baseline 3.7, scenario 5.7, historical 3.0 (in one panel). ### Non-performing loans (NPLs) and financial sector notes - NPL levels and recent trend (Annex V): - NPLs remain very large at 39 percent of total loans or 85 percent of GDP as of 2018Q2. - The NPL-to-GDP ratio was reduced by almost 35 ppts in a year, reflecting increased write-offs and sales of NPLs, and strong GDP growth. - Despite the recovery, outflow from NPLs by cash repayments or migration into performing category does not seem to have accelerated substantially, implying continued weak payment discipline. - There is a sign that restructuring activities have slowed, and two thirds of the restructuring flow is on loans already restructured at least once. ### Key policy implications and recommendations (drawn from analysis in the chapter) - Maintain a prudent, non-procyclical fiscal policy to: - Preserve the downward trajectory of external public debt. - Build buffers to absorb contingent fiscal shocks. - Strengthen financial sector policies to address high NPLs and private debt overhang, including: - Measures to accelerate genuine NPL resolution (reducing reliance on repeated restructurings). - Policies to improve payment discipline and increase cash repayments or migration of NPLs into performing categories. - Implement structural reforms to diversify the economy to reduce vulnerability to liquidity shocks and to limit the risk of a new boom-bust cycle. - Closely align maturity and currency composition of external assets and liabilities to reduce exchange rate and roll-over risks. *Source: IMF staff (Cyprus chapter).* ### 1. NPLs decreased from 44 percent of total loans (€22.8 billion) in 2017:Q2 to 39 percent ### 1. NPLs decreased from 44 percent of total loans (€22.8 billion) in 2017:Q2 to 39 percent (€16.9 billion) in 2018:Q2 ### NPL levels and composition - NPL ratio to outstanding loans: decreased from 44 percent (€22.8 billion) in 2017:Q2 to 39 percent (€16.9 billion) in 2018:Q2. - NPL ratio to annual GDP: 85 percent in 2018:Q2, down from 125 percent a year earlier; stated as the highest in euro area. - Small borrowers (households and SMEs) owe almost 95 percent of the NPLs. - Households (HHs): - NPLs decreased from 55 percent of loans (€11.8 billion) to 51 percent (€10.2 billion) over the year to 2018:Q2. - Non-Financial Corporations (NFCs): - NFC NPLs decreased from 58 percent of loans (€8.9 billion) to 45 percent (€5.3 billion) over the year to 2018:Q2. - NFC NPLs by sector (as of 2018:Q2): - Construction: €1.8 billion - Real estate: €0.9 billion - Tourism and trade: €2.3 billion - Others: €1.4 billion - NFC subcategories: - Large enterprises: 20 percent of loans (€1.1 billion), after a decrease by €0.6 billion in a year. - SMEs: €5.3 billion (see above). - Other financial corporates and government: €0.3 billion. - Total NPL stock at 2018:Q2: €16.9 billion (table shows changes from 2014Q4 to 2018H1: Total 28.4 -1.1 -3.0 -3.4 -4.0 16.9). ### NPL flows and resolution channels (Q3:2017–Q2:2018) - Gross outflows relative to gross inflows: gross outflows were nearly three times gross inflows over the year up to 2018:Q2. - Flow composition (stock normalized to 100 at beginning of period; values as reported): - Outflow: 45.4 - Inflow: 17.5 - Net Outflow: 27.9 - Outflow breakdown (amounts shown in chart): - Write-offs: 15.6 - Debt instruments held for sale (sale of loans): 13.6 - Migration into performing: 8.7 - NPL cash repayment: 4.8 - Debt-to-asset/equity swaps: 2.7 - One-time interest gross-up (due to IFRS9): 3.9 - Interest accrued on NPLs: 4.5 - Remaining NPLs: 54.6 (stock at end of period) - Outflows composition narrative: write-offs (about one-third), sale of loans (about one-third), migration to performing category (20 percent), NPL cash repayment (10 percent), debt-to-asset/equity swaps (6 percent). - Observed drivers: large contributions from write-offs and sale of loans partly reflect limited use of foreclosure and insolvency tools. - Data coverage note: data cover fixed-term loans owned by locally active banks; two banks, RCB and Astro, are excluded. ### Restructuring, viability, and foreclosure framework - Restructuring outcomes: - Almost two-thirds of the restructuring flow is on loans already restructured at least once. - Default rate on restructured loans has increased. - More than a half of NPLs are terminated accounts (outstanding balance has been called in); the euro amount of terminated accounts decreased moderately up to 2018:Q2 compared to the rest of NPLs. - Interpretation: relative non-viability of restructuring likely reflects still-low repayment capacity for a group of debtors whose loans are being evergreened and weak repayment discipline, underscoring the lack of a credible foreclosure framework. - IFRS9 impact: from 2018, a shift to IFRS9 accounting standards required recognition of accrued interest on NPLs as part of NPLs; some write-offs were in response to one-time interest gross-up due to the adoption of IFRS9. ### Household financial position and contributors to NPLs - Household net wealth and income trends: - Median net wealth in a Cypriot household decreased by 36 percent in euro terms between “Wave 1” (2009–10) and “Wave 2” (2014). - Euro-area median net wealth change over same period: -4 percent. - Real assets decreased by 30 percent; financial assets decreased by 29 percent; liabilities increased by 26 percent. - Gross income decreased by 30 percent. - Debt burden indicators (medians, Cyprus versus euro area): - Debt-to-income ratio: Cyprus increased from 1.57 to 2.51; euro-area level 0.72. - Debt-service-to-income ratio: Cyprus 0.23 to 0.36; euro area 0.14. - Mortgage-debt-service-to-income ratio: Cyprus 0.25 to 0.34; euro area 0.16. - Debt-to-asset ratio: Cyprus 0.17 to 0.23; euro area 0.22 to 0.26 (table formatting preserved). - Loan-to-value ratio of main residence: Cyprus 0.32 to 0.42; euro area 0.38 to 0.44. - Distributional notes: - Debt burdens are especially heavy for households in the bottom-20-percent income or wealth level. - Fraction of households with negative net wealth: Cyprus 6.9 percent; euro-area level 5.2 percent. - Implication: financial hardship is likely a main contributor to large NPL stock and difficulties in improving household repayments; weak lending standards focused on collateral values rather than repayment capacity aggravated debt-service vulnerabilities. - Strategic behavior note: median household net wealth about €170,000 in Cyprus as of 2014, higher than euro-area level of €104,000; outstanding loans by a median Cypriot household are 23 percent of total assets (euro-area 26 percent). A sizable share of NPLs, particularly among wealthier debtors, could likely be serviced through disposal of assets. ### Sales of NPLs and regulatory framework for Credit Acquiring Companies (CACs) - Importance: sales of NPLs to qualified third parties are an important element of NPL resolution strategy; third parties may bring operational expertise and manage large portfolios more effectively. - Recent transactions and market developments (dates are dates of agreement where specified): - August 2018 (date of agreement): Bank of Cyprus → Apollo Global Management: €2.7bn, predominantly corporate and SMEs secured by real estate; financed through securitization structure—senior and junior tranches. - June 2018: Hellenic Bank → B2Kapital Cyprus Ltd: €144m, mainly non-retail secured and unsecured exposures. - September 2018: Cyprus Cooperative Bank → Cyprus Asset Management Company (CAMC): €7bn, mainly secured household loans. - Note: Transaction pending supervisory approval (where indicated). - Legal framework: - 2015 Law on the Sales of Loans establishes rules for sales of non-performing loans. - For loans exceeding €1 million where the borrower is an individual or an SME, banks must comply with certain notification requirements. - CACs must be corporate entities registered in Cyprus meeting criteria in the law (e.g., minimum share capital) and are subject to licensing and supervision by the Central Bank of Cyprus (CBC). - CACs are subject to other CBC Directives, including Directive on Arrears Management and Code of Conduct for banks in handling arrears. - The law empowers the CBC to establish regulatory and supervision regimes for CACs and to interfere in the pace of foreclosure in case of financial stability concerns. - Supervision and governance recommendations (as discussed in text): - Better guidance is needed on implementation of law provisions, including “fit-and-proper” criteria for CAC shareholders and directors, and change-of-control rules. - CBC should develop the supervisory regime for CACs to create a level playing field and facilitate market-based resolution of NPLs. - CBC’s powers to block certain actions and appointments by CACs raise potential conflicts; CBC should develop a framework for using such powers. - A solid governance framework is important for government-owned CAMC including clear and transparent governance arrangements and accountability mechanisms to facilitate effective operation, limit moral hazard, and maximize recovery for the government while safeguarding financial stability. *Source: Central Bank of Cyprus; and IMF staff calculations (as presented in the supplied content).* ### 5. The overall fiscal impact of the NHS introduction is expected to be neutral in the long ### 5. The overall fiscal impact of the NHS introduction is expected to be neutral in the long ### Fiscal impact in steady state - Once the NHS is introduced, public healthcare providers will operate under SHSO and the spending by the Ministry of Health is expected to shrink substantially (from more than 3 percent of GDP this year to less than ½ percent of GDP). - The government will make contributions to the NHS, both as an employer on the remuneration of government employees as well as a third party, which are expected to amount to 2½ percent of GDP. - Therefore, once public healthcare providers become efficient over the long run and collect enough revenue from NHS to cover their own expenses, the fiscal impact of the NHS introduction would be neutral. ### Short-run transition risks and required government support - The introduction of the NHS might lead to a temporary increase in the fiscal outlay. - It is expected that it will take time for the SHSO to successfully raise productivity of public healthcare providers, as adjusting the labor structure will need to take place gradually. - The government will likely need to fill the deficit of public healthcare providers in the short run. - The law on SHSO provides that the central government fill any financial shortfalls in the first five years following public healthcare providers becoming autonomous. - The SHSO also needs to ensure that public healthcare providers maintain a certain degree of market share to preserve financial sustainability. - There is currently excess demand for public health care because it is provided free and more than 80 percent of the population is entitled to it while capacity is limited. - With the NHS introduction, patients will be able to choose any healthcare providers participating in the NHS at the same price, which is expected to lead to a shift in demand from public to private healthcare providers. - While the shift is not predicted to lead to a sudden shortfall of demand for public healthcare service given the capacity constraints in the private sector, financial sustainability of public healthcare providers depends in part on maintaining a certain amount of demand. ### NHS mechanisms to contain costs - Payment to primary care doctors and pediatricians is based on capitation and therefore creates right incentives for service providers to not over-supply. - Primary care doctors and pediatricians function as gate keepers as patients are required to obtain referrals first to see specialists. - The new IT system will provide a safeguard against unnecessary referrals as it is designed to flag any unusual referral activities based on the system-wide data. - The total cost of system-wide special service is pre-determined by the global budget, with frequent and periodic changes in unit prices slated to absorb the potential cost impact emanating from volatility of demand. - Economy-wide savings could be envisaged from pharmaceuticals: - Once the NHS is introduced, pharmaceuticals used in the system will be centrally procured and priced, whereas the current practice is markups are added for the part prescribed in the private sector. - Over-subscription is also suspected under the current system, but the new IT system will provide additional checks and balances. ### Long-term sustainability, demographic pressures, and oversight - While NHS’s global budget might mitigate budgetary pressure, vigilance is needed to ensure the sustainability of the NHS and government health expenditure at the same time. - Increased spending pressures could lead to an accumulation of arrears. - The NHS law provides that a periodic actuarial review be undertaken every three years. - In the event an increase in the global budget is warranted, contributions, including those by the government, might need to increase. - Demand pressures on public health spending will likely increase as the rationing is eliminated through the rollout of universal service provision and as an increasing share of elderly population leads to a rapid rise in old age dependency ratio. - Staff calculation based on population projections under the UN’s medium-fertility scenario indicates that, with no policy changes, health expenditure-to-GDP ratio increases 1.5 percentage points (ppts) of GDP from 2015 to 2035. - The pace of increase is faster by additional 0.1-0.2 ppts if fertility rate or mortality rate is lower. - Any increase in the fiscal outlay on health service needs to be carefully reviewed to safeguard fiscal sustainability. - It is critical to ensure that SHSO has adequate tools to make public health providers self-financed. *cr18337 - 5. The overall fiscal impact of the NHS introduction is expected to be neutral in the long* ### 1.0 p.p., professional services at 0.7 p.p., and manufacturing at 0.3 p.p. In addition, other ### cr18337 - 1.0 p.p., professional services at 0.7 p.p., and manufacturing at 0.3 p.p. In addition, other ### Growth and sector contributions - Sectors contributing to growth include professional services, manufacturing, the investment fund industry, and education. - Education growth reflects "the various international educational institutions taking roots and expanding in Cyprus." - The tourism industry is "becoming more diverse, with an increasingly wider offering and a broader spread of tourists throughout the year." - Most investment in Cyprus is foreign-financed, "reflecting strong investor appetite among international investors." - The pick-up in construction has not led to a sizeable increase in real estate prices, with a notable exception for prime residential real estate for a foreign clientele, "mostly concentrated along the Limassol coastline." - The authorities state that foreign residential real estate investments related to the Citizenship by Investment (CbI) scheme are subjected to "a recently strengthened 4-layer due diligence procedure, to continue to ensure compatibility with AML/CFT standards." - "Risks to the investment outlook are on the upside, despite any possible slowdown in CbI financed projects." ### External sector - The authorities view external sector developments in Cyprus as "in line with the fundamentals of the Cyprus economy." - The projected current account deficit is considered "to be at a sustainable level, in line with the overall domestic economic growth momentum." ### Financial sector — NPLs and resolution efforts - Authorities and staff agree that high NPL levels "pose a risk to debt sustainability," although high NPLs have not weighed on strong investor sentiment. - NPL stock evolution: - "From a total of €28.4 billion at the end of 2014, NPLs have come down to €16.9 billion in the first half of 2018." - The decrease in the first half of 2018 is "mostly related to the sale of NPLs by Bank of Cyprus to Apollo Fund (Helix) in the order of €2,7 billion," although the sale "is still subject to supervisory approval." - Further NPL reductions expected in second half of 2018 following the sale of CCB’s good assets to Hellenic Bank. - "The CCB’s NPLs amounting to €5.7 billion have remained outside the banking system, in a residual entity named the Cyprus Asset Management Company (‘CAMC’)." - CCB operation "has come at a major public cost but was necessary to stem the sudden deposit outflows that CCB witnessed mainly in the first half of 2018." - International investors are "taking a keen interest in buying blocks of Cypriot NPLs." - Legislative progress: "The approval by the Cypriot parliament in July 2018 of a major legislative package to strengthen the NPL resolution, has strongly underpinned investor interest." - The legislative package includes amendments to the sale of loans law, foreclosure law, bankruptcy law, company law, personal insolvency laws, and the regulation on insolvency practitioners. - "The sale of NPLs to professional investors also allays concerns that NPLs will be simply warehoused." - Remaining tasks and risks: - "The supervisory and regulatory framework for credit-acquiring firms needs to be finalized (including for CAMC)." - "A major reform of Cyprus’ judicial system should speed up effective contract enforcement." - Estia scheme: - Authorities note concerns about eligibility criteria of Estia ("‘house’"), a burden-sharing scheme to strengthen resolution of a sensitive NPL segment; "At the time of writing, the eligibility criteria of the Estia scheme are being finalized." - Fiscal impact: "At €20 million, the net total maximum annual fiscal cost of Estia is manageable." - Expected benefits: "Estia is expected to facilitate NPL resolution, and has helped fostering political and societal buy-in for the NPL resolution legislative package approved in July 2018." ### Structural reforms and policy priorities - Cyprus is pursuing an "impressive array of structural reforms" while maintaining prudent fiscal policy and reducing financial sector contingent liabilities. - Key reforms and actions: - "In 2019, the long awaited National Health Service will be rolled out." - Judicial strengthening: expected creation of a Commercial Court and hiring additional judges to address a backlog in legacy cases, including NPL cases. - A local government reform is "on the drawing board." - "A legislative proposal to enhance the governance of the Central Bank of Cyprus has been submitted." - Other challenges: - Cyprus is "dealing with the fallout of regional conflicts, with Cyprus facing one of highest levels of asylum applications in the EU." - Some reforms "take more time than expected to move from the drawing board to the implementation stage"; a long-term perspective is important. - Authorities agree that problems of issuance and transfer of title deeds "needs to be addressed" and that judicial reform and measures to ease doing business "need to be further pursued." *IMF staff report excerpt.* --- _Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18337.pdf_