## 1. Digitization and Technology Adoption in Cyprus ## Source details **Canonical URL:** [1. Digitization and Technology Adoption in Cyprus](https://www.imf.org/-/media/files/publications/cr/2019/1cypea2019002.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2019/1cypea2019002.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2019/1cypea2019002.pdf.json) --- ### Context and recent macro developments - Recovery and legacy challenges: - Real GDP has now surpassed its pre-crisis peak; unemployment has declined but remains above pre-crisis levels. - Large NPL disposals and resolution of a systemic bank strengthened bank balance sheets; public debt rose in the process. - NPLs remain among the highest in Europe; a significant private sector debt overhang persists; productivity growth is weak. - Growth and demand (selected figures): - Real GDP growth: 4.1 percent (2018) → 3.3 percent (2019:H1, yoy). - Drivers: robust domestic demand, strong investment from infrastructure projects, transitory boost ahead of passport scheme changes. - Net exports weakening with declining tourism receipts, partly due to Brexit effects. - Inflation and labor market: - HICP inflation: 0.5 percent (same period last year) → 0.7 percent (year to date, period average) in September 2019. - Average core inflation: 0.6 percent in September 2019. - Nominal compensation per employee rose by 4.1 percent in 2019:Q2. - Unemployment: 7.3 percent (2018:Q2) → 6.5 percent (2019:Q2). ### External sector and external position - Underlying current account and external stocks: - Underlying current account deficit (adjusted for SPEs): 1.9 percent of GDP (2017) → 3.4 percent (2018) → 4.8 percent (2019:Q2, annual basis). - Cyprus’s EBA-lite Current Account model: external position moderately weaker than implied by fundamentals and desirable policy settings. - External debt (excluding SPEs): 273 percent of GDP (2018:Q1) → 260 percent (2019:Q2). - NIIP excluding SPEs: -34 percent of GDP at end-2019:Q2. - External flows: - Net private financial inflows gradually slowing. - FDI inflows robust in 2018; portfolio investment inflows and non-resident bank deposits have declined. ### Banking sector, NPLs, and debt resolution - NPL scale and disposal progress: - NPL ratio: 42½ percent of loans (104 percent of GDP) at end-2017 → 31 percent of loans (48 percent of GDP) at end-May 2019 after transfers to CACs and CAMC. - Total NPLs end-2018: €10.4 bn (30½ percent of total loans). - CAMC/KEDIPES holds €6.9 bn in NPLs. - Largest two banks (BoC and Hellenic Bank) hold ~70 percent of NPLs. - Private sector deleveraging and workout outcomes: - Non-financial private sector debt declined by 10½ percentage points over the year through 2019:Q2. - Outstanding bank credit to the non-financial private sector declined by 57 percent of GDP over the year through 2019:Q2, mainly due to sale/transfer of NPLs. - Cure rate (share of restructured loans with no arrears): 64 percent (2018:Q2) → 60 percent (2019:Q2). - Restructuring reliance on balloon payments (for NFCs), interest reductions, waiver of arrears and maturity extensions instead of principal reductions. - Estia state subsidy scheme (overview): - Under Estia: the government will cover one-third of eligible borrowers’ total monthly installments at the end of each year, subject to continued borrower payments; banks will take a haircut up to the level of market price of underlying collateral. - Authorities estimate NPLs worth up to about €2 billion (10 percent of GDP) could benefit. - Applications for the subsidy program started in September (year not specified in excerpt) with a lower-than-expected take-up so far. - NPL market transactions (2018–2019H1): - Total NPL sales listed: €10,094 mn across seven transactions (largest: KEDIPES €6,900 mn; BoC Helix €2,638 mn). ### Credit, monetary conditions, and interest rates - Net credit growth (end Sep 2019, 12m): - Domestic NFCs: 1.0 percent. - Households: 0.3 percent. - Lending and rates: - Accommodative monetary conditions eased interest rates for new loans; pure new credit growth continued to decelerate due to weak demand from the debt overhang. - Mortgage and other nominal interest rates for new loans eased (exact series presented in source figures). ### Fiscal developments, surpluses, and debt projections - Fiscal performance January–August (Mill. of Euros): - Revenue: 5,246 (2018) → 5,870 (2019) 11.9 percent change. - Current revenue: 5,181 → 5,715 10.3 percent. - Tax revenue: 3,383 → 3,562 5.3 percent. - Social security contributions: 1,212 → 1,572 29.7 percent. - Capital revenue: 661 → 551 -35.0 percent. - Expenditure: 4,513 → 4,946 9.6 percent. - Overall balance (Mill. of Euros): 733 → 924 (In percent of GDP) 3.5 → 4.2. - Sovereign debt issuance and liability management: - Authorities issued €1.75 billion of long-term (15- and 30-year) sovereign bonds in February and April to prefund an early repayment of a Russian loan. - Staff fiscal projections (selected percent of GDP): - Total revenue: 39.2 (2018) 41.4 (2019) 43.7 (2020) ... 44.4 (2024). - Overall balance: -4.4 (2018) 3.6 (2019) 2.4 (2020) ... 3.7 (2024). - Primary balance: -2.0 (2018) 5.9 (2019) 4.8 (2020) ... 5.3 (2024). - Gross public debt: 100.6 (2018) 94.8 (2019) 87.9 (2020) ... 64.2 (2024). - Baseline debt trajectory: - Public debt ratio expected to decline by 31 percentage points of GDP over five years to 64 percent by 2024 (Annex V DSA). - Under baseline, public debt projected to resume rapid decline from 2019 to 64 percent of GDP by 2024. ### Outlook and macroeconomic projections - Short-term: - Real GDP growth expected to reach around 3 percent in 2019–20 in the baseline scenario. - Inflation projected to remain subdued in 2019, gradually rising due to higher energy prices and an emerging positive output gap. - Current account deficit expected to widen reflecting trading partners’ slowing growth and high construction-related imports. - Medium-term: - Growth projected to slow to potential of around 2½ percent. - Contributing factors: dissipation of transitory investment boom, tightening of CIP scheme, faster NPL and debt workouts impacting debt servicing and private consumption. - International investment position expected to improve gradually. - Selected IMF staff projections (Table 1 highlights, percent or units as shown in source): - Real GDP growth (percent change): 6.7 (2016), 4.4 (2017), 4.1 (2018), 3.1 (2019), 2.9 (2020), 2.8 (2021), 2.6 (2022), 2.5 (2023), 2.5 (2024). - Unemployment rate (percent, period average): 13.0 (2016), 11.1 (2017), 8.4 (2018), 7.0 (2019), 6.0 (2020), 5.4 (2021), 5.2 (2022), 5.1 (2023), 5.0 (2024). - HICP (period average): -1.2 (2016), 0.7 (2017), 0.8 (2018), 0.7 (2019), 1.6 (2020), 1.8 (2021), 2.0 (2022–2024). - Nominal GDP (bn euros): 18.9 (2016), 20.0 (2017), 21.1 (2018), 22.0 (2019), 23.1 (2020), 24.2 (2021), 25.4 (2022), 26.7 (2023), 28.0 (2024). ### Risks to the outlook and stress scenarios - Key downside risks: - High remaining NPLs and private sector debt overhang. - Weak productivity growth undermining medium-term potential. - Political pressure to unwind financial and fiscal reforms. - External exposure to slowing EU and UK markets and regulatory changes affecting tourism, transport and financial services exports. - Potential negative assessment on AML/CFT compliance. - Debt and external stress scenarios (selected outcomes preserved from source): - Growth shock (one standard deviation 4.1 pp decrease in growth during 2020–21 plus interest rate increases 51 and 106 bps) would raise public debt by 16 percentage points relative to baseline to 100 percent of GDP by 2021, before declining to 80 percent by 2024. - Adverse macro-fiscal-contingent liability scenario (permanent lower growth and primary balance, higher rates, contingent liabilities 13 percent of GDP realized): public debt would rise to 105 percent of GDP in 2020 and decline slowly to 98 percent by 2024; GFN would spike to 20 percent of GDP in 2020. - Interest rate shock: a two-percentage point increase in average interest rates on external debt throughout the projection period would raise the external debt ratio by 105 percentage points above baseline by 2024. - Growth shock: a one-half standard deviation decrease in projected real GDP growth throughout the projection period could increase the external debt ratio by 90 percentage points by 2024 relative to baseline. - Combination of shocks: one-quarter standard deviation shocks to nominal interest rate, growth, and current account would raise the debt ratio by 109 percentage points by 2024 relative to baseline. ### Financial sector stability, profitability, and policy priorities - Bank performance and capitalization: - Regulatory capital ratio: 17.5 percent (2018) → 18.0 percent (2019Q1). - Tier I capital ratio: 16.6 percent (2018) → 17.1 percent (2019Q1). - Return on assets (annual): -1.1 (2017) → 0.4 (2018) → 0.7 (2019Q1). - NPLs (EBA definition): 42.5 (2017) → 30.5 (2018) → 30.9 (2019Q1). - Provisions to NPLs: 42.3 (2017) → 47.3 (2018) → 52.6 (2019Q1). - Staff recommendations for banks: - Maintain adequate provisioning coverage and capital buffers. - Raise private capital and encourage organic capital generation by diversifying revenue sources, rationalizing operational costs and undertaking digitization solutions. - Strengthen supervisory capacity and monitor risks from negative interest rates for large depositors and cross-selling of financial products. - Reduce property holdings to targeted levels and discourage excessive holding of foreclosed properties via Pillar 2 requirements and explicit bank-specific objectives. - NPL resolution priorities: - Ensure foreclosure framework effectiveness; finalize e-auction and judicial reforms to reduce backlogs. - Strengthen oversight and data monitoring of CACs (about 50 percent of GDP in NPLs housed in CACs). - Finalize CAMC governance, operational structure, business strategy, performance metrics and an appropriate sunset clause while balancing operational independence with public accountability. - Enhance corporate restructuring options and improve insolvency practitioner frameworks. ### Digitization and technology adoption: findings and policy actions - Digital gap and human capital: - Cyprus lags in digital transformation and technology adoption, particularly weak in human capital and digital skills despite good educational attainment and academic research output. - In 2017: 66 percent of adults in Cyprus used electronic payments versus above 95 percent in digital-frontier countries; 8 percent used mobile payment versus above 25 percent in digital-frontier countries. - Government digital strategy initiatives (selected items): - New information system for the Tax Department to strengthen tax administration. - E-justice system to improve efficiency and speed of courts. - New resources planning system to improve core PFM functions including budget management and payroll. - E-health projects to enable digital management of health care information. - Institutional developments: - Newly appointed national Chief Scientist and a soon-to-be-established Deputy Ministry of Innovation and Digital Policy to centralize coordination among research, entrepreneurship, private financing and government resources. - Expected outcomes: more attractive investment climate for FDIs of regional and global technology companies and human capital development. - Banking digitalization (Annex IX highlights): - Digitalization is an opportunity to lower recurrent costs and improve profitability amid low-interest/low-growth environment. - Cross-country evidence: digital advanced banks increased ROE by 0.9 percent (2011–2017) while less digital advanced banks saw ROE decline by 1.1 percent. - Cyprus operational capacity indicators (ratio to Euro area average): Deposits per branch 0.6; Population per branch 0.5; Population per ATM 1.1; Assets per bank employee 0.5. - Digital policy recommendations: - Build a forward-looking regulatory framework flexible to innovation while maintaining integrity, soundness, and consumer protection. - Ensure supply of ICT skilled labor and take preemptive measures (retraining) for employees displaced by digitalization. - Strengthen oversight of larger banks in a more consolidated system. ### Structural reforms, competitiveness, and inclusiveness - Structural impediments and policy priorities: - Key constraints: access to finance, costly judicial processes, inefficient government administration, low R&D investment, skills mismatches. - Priorities: invest in ICT infrastructure, expand STEM training, promote R&D and technological innovation, reduce restrictions in implementing the EU Market Services Directive, and faster implementation of government digital strategy. - Public sector governance: improve judicial efficiency, strengthen insolvency institutional framework, reform civil service, strengthen CBC governance, reform SOE governance, and strengthen PFM at local government level. - Inclusive growth measures: - Job retraining initiatives and improved links between education and jobs to reduce skills mismatches and benefit youth and long-term unemployed. ### Property market and macro-financial considerations - Market dynamics and indicators: - Residential prices: overall residential prices grew by 2.7 percent (yoy) in 2019:Q1. - Developer price quotes: 8 percent (yoy) increase in 2019:Q2 for newly constructed luxury housing. - Rents rose 17 percent in 2018. - Real estate accounted for around 5 percent of consolidated assets of the two largest banks in 2018. - Macro-financial recommendations: - Monitor sectoral/regional developments; consider targeted macroprudential measures if warranted. - Monitor large holdings of repossessed real estate by banks and CACs to mitigate liquidity mismatch risks. ### Staff appraisal: key recommendations (summary) - Maintain strict spending discipline; cap expenditure growth at the rate of nominal medium-term output growth to keep public debt on a downward path. - Finalize and implement Estia to facilitate sustainable debt restructuring and reduce private sector overhang; minimize moral hazard risks. - Advance NPL resolution efforts while supporting sustainable private sector deleveraging (reduce reliance on non-principal-reducing measures). - Strengthen AML/CFT framework ahead of MONEYVAL assessment. - Prioritize reforms to boost productivity: judicial efficiency, insolvency framework, ICT investment, STEM and R&D, and government digital strategy implementation. *Source: IMF staff report, Cyprus — 1. Digitization and Technology Adoption in Cyprus (content unit 1cypea2019002).* ### 1. Digitization and Technology Adoption in Cyprus_______________________________________________19 ### 1. Digitization and Technology Adoption in Cyprus_______________________________________________19 ### Context - Cyprus’s recovery compares favorably to other euro area economies affected by the financial crisis: Real GDP has now surpassed its pre-crisis peak and unemployment has declined significantly. - Large NPL disposals and resolution of a systemic bank have strengthened bank balance sheets, though public debt rose in the process. - Strict fiscal discipline and progress with reforms helped Cyprus regain investment grade status and reduced risk premia to historical lows. - Challenges: NPLs remain among the highest in Europe; a significant private sector debt overhang persists; productivity growth is weak; political pressure to unwind financial and fiscal reforms risks the outlook. ### Recent macroeconomic developments - Growth: - Real GDP growth decelerated to 3.3 percent (yoy) in 2019:H1, from 4.1 percent in 2018. - Deceleration largely reflects construction and services sector activity. - Domestic demand remains robust due to strong investment driven by ongoing infrastructure projects and a transitory boost ahead of changes in the passport scheme. - Continued employment recovery supported steady consumption growth; net exports weakening with declining tourism receipts, partly due to Brexit effects. - Inflation and labor market: - HICP inflation reached 0.7 percent (year to date, period average) in September 2019, compared with 0.5 percent over the same period last year. - Average core inflation reached 0.6 percent in September 2019. - Nominal compensation per employee rose by 4.1 percent in 2019:Q2, mostly reflecting public sector wage increases. - Unemployment declined to 6.5 percent in 2019:Q2 from 7.3 percent a year earlier, but remains above pre-crisis levels. ### External sector and external position - Underlying current account deficit: - Widened from 1.9 percent of GDP in 2017 to 3.4 percent last year and 4.8 percent in 2019:Q2 (annual basis), after adjusting for effects of special purpose entities (SPEs). - Cyprus’s EBA-lite Current Account model suggests the external position is moderately weaker than implied by fundamentals and desirable policy settings. - External flows and stocks: - Net private financial inflows are gradually slowing. - FDI inflows remained robust in 2018; portfolio investment inflows and non-resident bank deposits have declined. - Decline in monetary and financial sector borrowing has partly offset increased public debt. - Direct intercompany borrowing remains high (partly reflecting SPEs) though down from end-2017 peak. - External debt (excluding SPEs) declined from 273 percent of GDP in 2018:Q1 to 260 percent in 2019:Q2. - Net International Investment Position (NIIP), excluding SPEs, reached -34 percent of GDP at end-2019:Q2. ### Banking sector, NPLs, and debt resolution - NPLs and bank balance sheets: - Transfer of two large NPL portfolios to credit acquiring companies (CACs), including a large one-off non-market transaction to the state-owned asset management company (CAMC), reduced the NPL ratio from 42½ percent of loans (104 percent of GDP) at end-2017 to 31 percent of loans (48 percent of GDP) at end-May 2019. - Private sector deleveraging and workout outcomes: - Despite large reductions in NPLs on bank balance sheets, private sector deleveraging has been more limited. - Loan repayments, debt-to-asset swaps and write-offs led to a decline of only 10½ pp in non-financial private sector debt over the year through 2019:Q2. - Sustainable debt restructuring remains challenging; greater reliance on balloon payments (for NFCs), interest reductions, waiver of arrears and maturity extensions instead of principal reductions. - Cure rate (share of restructured loans with no arrears) declined to 60 percent at 2019:Q2 from 64 percent a year earlier. - Policy measures and state subsidy scheme (Estia): - Debt workouts are pending as borrowers await finalization of the state subsidy scheme for restructuring and repayment of NPLs collateralized by primary homes (Estia). - Under Estia: the government will cover one-third of eligible borrowers’ total monthly installments at the end of each year, subject to continued borrower payments; banks will take a haircut up to the level of market price of underlying collateral. - Applications for the subsidy program for restructuring started in September (year not specified in excerpt) with a lower-than-expected take-up rate so far. - Authorities estimate that NPLs worth up to about €2 billion (10 percent of GDP) could benefit. ### Credit, monetary conditions, and private sector borrowing - Net credit growth: - Net credit transactions grew by 1.0 percent for domestic non-financial corporates (NFCs) and 0.3 percent for households over 12 months at end of September 2019. - Outstanding bank credit to the non-financial private sector declined by 57 percent of GDP over the year through 2019:Q2 mainly due to sale/transfer of NPLs. - Accommodative monetary conditions have eased interest rates for new loans, but pure new credit growth continued to decelerate, reflecting weak demand from the debt overhang. - Interest rates: - Nominal interest rates for new loans have been eased by accommodative monetary conditions (exact series and values are presented in figures referenced in source). ### Fiscal developments - Fiscal performance: - The report notes strong fiscal performance and a rise in the general government primary surplus (specific figures appear elsewhere in the source tables and figures). ### Key risks and policy implications highlighted - Risks: - High remaining NPLs and significant private sector debt overhang. - Weak productivity growth undermining medium-term growth potential. - Political pressure to unwind financial and fiscal reforms could weigh on the outlook. - External exposure to slowing EU and UK markets and financial regulatory changes affecting tourism, transport and financial services exports. - Policy implications and actions referenced in the text: - Continue strict fiscal discipline and reforms to preserve investment grade status and low risk premia. - Finalize and implement the state subsidy scheme (Estia) to facilitate sustainable debt restructuring and reduce private sector overhang. - Advance NPL resolution efforts while supporting sustainable private sector deleveraging (reducing reliance on non-principal-reducing measures). - Monitor external vulnerabilities given widening underlying current account deficits and slowing private financial inflows. *Source: IMF staff report, Cyprus — 1. Digitization and Technology Adoption in Cyprus (PDF content unit).* ### 4.2 percent of GDP in 2017 to 5.4 percent of GDP in 2018 (excluding the one-off impact of the sale ### 1cypea2019002 - 4.2 percent of GDP in 2017 to 5.4 percent of GDP in 2018 (excluding the one-off impact of the sale ### Fiscal developments: January–August and 2018–2019 highlights - General government overall balance recorded a surplus of 4.2 percent of GDP (est.) in January–August this year, about ¾ percentage point higher than over the same period last year; temporary fiscal savings were generated by the transition to the single-payer National Health Service (NHS). - Revenues and expenditures, January–Aug (Mill. of Euros): - Revenue: 5,246 (2018) → 5,870 (2019) 11.9 percent change - Current revenue: 5,181 → 5,715 10.3 percent - Tax revenue: 3,383 → 3,562 5.3 percent - Indirect taxes: 2,115 → 2,176 2.9 percent - Direct taxes: 1,269 → 1,386 9.2 percent - Social security contributions: 1,212 → 1,572 29.7 percent - Other current revenue: 586 → 581 -0.7 percent - Capital revenue: 661 → 551 35.0 percent - Expenditure: 4,513 → 4,946 9.6 percent - Current expenditure: 4,283 → 4,805 12.2 percent - Social Transfers: 1,727 → 1,917 11.0 percent - Capital expenditure: 231 → 140 -39.2 percent - Overall balance: 733 → 924 - (In percent of GDP) 3.5 → 4.2 - Authorities undertook a liability management operation and issued €1.75 billion of long-term (15- and 30-year) sovereign bonds in February and April to prefund an early repayment of a Russian loan this year. ### Outlook and macroeconomic projections - Short-term: - Real GDP growth is expected to reach around 3 percent in 2019–20 in the baseline scenario. - Drivers: foreign-financed investments in residential properties, education, health and tourism infrastructure, and higher household disposable incomes. - Inflation projected to remain subdued this year, gradually rising due to higher energy prices and an emerging positive output gap. - Current account deficit expected to widen reflecting trading partners’ slowing growth and the continued high level of construction-related imports. - Medium-term: - Growth projected to slow to potential of around 2½ percent. - Contributing factors to slowdown: dissipation of transitory investment boom effects, tightening of CIP scheme, and faster NPL and debt workouts impacting debt servicing and private consumption (Annex VII). - Current account deficit would narrow on lower investment imports and a pickup in exports with external demand recovery. - International investment position expected to improve gradually with decelerating FDI inflows and MFI deleveraging. - Staff: steady implementation of reforms to reduce debt overhang, lower systemic financial risks and build up skilled human capital would support consumption, investments and TFP growth over the longer term. ### Risks to the outlook - Domestic downside risks: - Delays in NPL resolution and backsliding on reforms could undermine bank capital and credit extension, adversely affecting growth. - Realization of contingent liabilities from publicly supported schemes or difficulties in raising capital could weaken the fiscal position and exacerbate debt sustainability risks arising from the sovereign-bank nexus. - High external debt increases vulnerability to interest rate and growth shocks. - Political pressure or court decisions to unwind crisis-era fiscal measures could reduce the primary surplus, erode confidence, and raise the sovereign risk premium and refinancing costs. - External risks: - Rising protectionist trade policies, sharper-than-expected slowdown in euro area growth or a hard Brexit could affect transport and tourism revenues and FDI flows. - Financial distress in other markets could raise interest rates and stress leveraged firms and households. - A potential negative assessment on AML/CFT compliance risks could deter investments and pressure correspondent banking relationships. - Upside possibility: - Exploitation of offshore gas deposits and energy sector investments for regional connectivity could boost growth over the longer term. ### Financial sector: stability, profitability, and NPL resolution - Banking sector status: - Banking sector more consolidated and asset quality has improved, but profitability remains under pressure. - Lower provisioning needs helped banks turn a net profit last year; operating profits declined due to low efficiency. - Non-resident banking services are declining while domestic competitive pressures are rising. - Potential need for further provisioning as banks seek to lower NPL ratios to below 15 percent by 2021 amid legal uncertainties. - Liquidity buffers sizable and bank capitalization improving; regulatory change allows conversion of deferred tax assets into deferred tax credits. - Staff recommendations to strengthen banks: - Maintain adequate provisioning coverage and capital buffers to insulate against potential further losses from NPL workouts and sales of loans. - Raise private capital and encourage organic capital generation by diversifying revenue sources, rationalizing operational costs and undertaking digitization solutions. - Strengthen supervisory capacity and monitor risks from negative interest rates for large depositors and cross-selling of financial products. - NPL resolution priorities: - Foreclosure framework: 2018 amendments to foreclosure and insolvency legislation, sales of loans law, and law on securitization enhanced NPL toolkit. Recent amendments allowing borrowers to file court injunctions if the Financial Ombudsman deems non-compliance with the CBC restructuring code have created uncertainties and could weaken prospects for collateral recovery; responsibility for ensuring overall compliance of the CBC’s restructuring code should remain with the bank supervisor. Electronic foreclosure auctions and judicial reforms to reduce backlogs are key. - Credit Acquiring Companies (CACs) and Cyprus Asset Management Company (CAMC): With about 50 percent of GDP in NPLs now housed in CACs, strengthening oversight and close data monitoring is important. CAMC performance: just 7 percent of loans underwent some workout solution over the first 9 months of operation; need to finalize governance, operational structure, business strategic plan, performance measurement framework, and an appropriate sunset clause while balancing operational independence with public accountability and transparency. - Viable corporate restructuring solutions: Consider enhancing corporate restructuring options for viable enterprises; examinership procedure usage remains limited and implementation faces issues. - Estia and support for vulnerable primary homeowners: Close monitoring to prevent abuse and reassess borrower eligibility; complementary schemes should ensure further burden sharing and be well-targeted with full cost-benefit analysis prior to implementation. ### Property market and macro-financial considerations - Property price and market dynamics: - Overall residential prices grew by 2.7 percent (yoy) in 2019:Q1; sales transactions rose by nearly 6 percent during 2018. - More recent developer price quotes show an 8 percent (yoy) increase in 2019:Q2 for newly constructed housing concentrated in luxury segment. - Rents rose 17 percent in 2018, driven by foreign students and lagging rental supply; authorities increased rental and housing subsidies and incentives for developers to increase affordable housing and rental supplies. - Market highly segmented with larger price increases in luxury coastal segments (e.g., Limassol), fueled by CIP-linked demand from non-residents; limited spillovers to other segments so far. - Real estate holdings by banks, CACs and investment funds have increased; in 2018 real estate accounted for around 5 percent of consolidated assets of the two largest banks; on average these properties were sold within two years and at higher values than acquisition values during 2018–2019H1. - Macro-financial risk management: - Macro-financial risks from the property market appear limited now but warrant close monitoring. - Sales of repossessed collateral could depress prices but no downward pressures evident yet. - Continue monitoring sectoral and regional developments and consider macroprudential measures tailored to market segments if warranted (e.g., if luxury sales associate with rapid credit growth or high loan-to-value ratios). - Monitor large holdings of repossessed real estate by banks and CACs and increased real estate holdings by investment funds to mitigate liquidity mismatch risks. - Use supervisory tools, in particular Pillar 2 requirements and explicit bank-specific objectives, to discourage excessive holding of foreclosed properties by banks. ### Fiscal sector: surpluses, debt projections, and scenarios - Short- and medium-term fiscal stance: - Cyprus projected to maintain large fiscal surpluses enabling rapid debt reduction, but risks remain. - 2019 general government primary balance projected to reach around 6 percent of GDP; this implies a slight weakening in structural terms to around 4¼ percent of potential GDP next year. - Over the medium term, staff projects an overall surplus of 2¾ – 3½ percent of GDP. - Under baseline, public debt ratio expected to decline by 31 percentage points of GDP over the next five years to 64 percent by 2024 (Annex V DSA). - Risks and adverse scenario: - Key risks: external growth shocks (trade tensions, weaker euro area growth), potential court-mandated increases in the wage bill, higher-than-expected NHS transfers, contingent liabilities from government guarantees and pension deficits of public entities, and weak asset quality in the financial sector. - Under an adverse scenario with lower-than-projected growth, some fiscal slippage and realization of financial contingent liabilities, public debt would exceed 98 percent of GDP through 2024. - Fiscal projections and staff numbers (selected, percent of GDP unless otherwise noted): - Staff projections (selected rows): - Total revenue: 39.2 (2018) 41.4 (2019) 43.7 (2020) 44.2 (2021) 44.0 (2022) 43.9 (2023) 44.4 (2024) - Total expenditure: 43.6 37.8 41.3 41.4 41.1 40.9 40.7 - Overall balance: -4.4 3.6 2.4 2.8 2.8 3.0 3.7 - Primary balance: -2.0 5.9 4.8 4.9 4.8 4.7 5.3 - Gross public debt: 100.6 94.8 87.9 83.7 76.6 71.9 64.2 - Cyclically-adjusted tax revenue and other structural indicators provided in staff tables (see projections table for exact values). - Notable fiscal measures and assumptions: - Key measures include: cut of excise on fuel (0.3 percent of GDP), the subsidy scheme to mortgage borrowers (0.1 pp), reversal of wage cuts (0.2 pp), deficit of public hospitals (0.1 pp) and increase in SSC (-.5 pp). Fiscal data include the impact of NHS from 2019. - A potential unfavorable Supreme Court ruling on crisis-era civil service pay reductions could have fiscal impact; authorities have appealed and plan a constitutional amendment to nullify adverse fiscal impact if needed. *Source: IMF staff report excerpt (Cyprus country section) contained in the supplied content unit.* ### 23. Spending should continue to be firmly controlled to ensure a declining debt path, ### 1cypea2019002 - 23. Spending should continue to be firmly controlled to ensure a declining debt path, ### Limiting expenditure and fiscal stance - Limiting expenditure growth to nominal medium-term economic growth implies maintaining a primary surplus above 4 percent of GDP over the medium term. - Objectives of this stance: - Strengthen confidence. - Keep debt firmly on a durable downward path. - Support countercyclical policy. - Public spending priorities should better support structural reform efforts to achieve faster and more inclusive medium-term growth. ### Specific expenditure measures and priorities - Wage bill: - Growth in the wage bill should be maintained below nominal GDP growth. - The wage bill remains high by international standards, reflecting the relatively high average wage rate. - Further undoing crisis-era public wage cuts would reverse hard-won savings and crowd out more productive spending. - Education and R&D: - Population aging with a declining share of school-aged children suggests scope to improve the efficiency of education spending. - Given relatively low public and private R&D spending, greater investment in technological innovation, including human capital buildup, would help support growth potential. - National Health System (NHS): - Containing fiscal risks from the NHS will require a strict monitoring and regulatory framework for assessing health treatments and controlling cost of services. - Ensuring competitiveness of the public health sector and managing adequate incentives for provider payment mechanisms will be crucial, given the expected pickup in demand. ### Fiscal institutions, SOEs, and local government - Fiscal institutional measures to contain risks: - Public financial management (PFM) of state-owned enterprises (SOEs) could be strengthened through better internal controls for financial management and monitoring of risks from public bodies including SOEs. - Governance of SOEs should be strengthened and privatization effort reinvigorated to raise economic efficiency and reduce contingent liabilities. - Local government (LG) reform: - Devolving more responsibilities and revenue autonomy to LG units is gaining renewed momentum. - Ensuring PFM controls such as budget planning and reporting framework as well as expenditure control at the LG level is important to safeguard fiscal sustainability. - Tax administration: - Ongoing efforts to modernize tax administration, including enactment of a new tax procedure code and a new IT system to support tax administration, should continue. ### Authorities' views on fiscal policy and institutions - Commitment to maintain spending discipline to safeguard a durable decline in public debt. - Medium-term budget plan for 2020–22 envisages no new spending measures and will maintain the large fiscal surpluses that have bolstered confidence. - Any windfall revenues such as from the CAMC will be saved toward public debt reduction. - Wage bill will increase gradually in part reflecting the ongoing gradual reversal of wage cuts planned through 2023, but spending growth will remain below medium-term nominal GDP growth. - Authorities recognize the risk of crowding out productive spending in areas such as technology and higher education. - Commitment to monitoring the NHS and performance of public hospitals to ensure fiscal risks do not build up. - Ongoing efforts to reform SOEs, including adoption of a code of good governance and a plan to link SOEs’ strategic plans to a three-year budget. - Pending local government reform is expected to generate fiscal savings and improve the efficiency of service delivery. ### Structural reforms to boost productivity and growth potential - Productivity-enhancing structural reforms are key to bolstering medium-term growth potential. - Identified bottlenecks and constraints: - Weak TFP growth and slow labor productivity growth, particularly in the financial sector. - Access to financing constrained by high borrowing costs and lack of alternative non-bank financing sources. - Difficulties in collateral execution and contract enforcement due to costly judicial processes and inefficiencies in government bureaucracy. - Low investment in innovation and R&D; skills mismatches despite a well-educated labor force. - Policy priorities: - Support investment in ICT infrastructure, STEM training, R&D and technological innovation to strengthen technological diffusion. - Reduce restrictions in implementing the EU Market Services Directive to facilitate more competition, attract FDI and foster innovation. - Faster implementation of the government digital strategy to establish a well-functioning ICT ecosystem. ### Digitization and technology adoption (Box 1 summary) - Cyprus lags in digital transformation and technology adoption; particularly weak in human capital and digital skills despite good educational attainment and academic research output. - Government digital strategy initiatives include: - New information system for the Tax Department to strengthen tax administration. - E-justice system to improve efficiency and speed of courts. - New resources planning system to improve core PFM functions including budget management and payroll. - E-health projects to enable digital management of health care information. - Institutional developments: - Newly appointed national Chief Scientist and a soon-to-be-established Deputy Ministry of Innovation and Digital Policy to centralize coordination among research, entrepreneurship, private financing and government resources. - Expected outcomes: more attractive investment climate for FDIs of regional and global technology companies and human capital development. ### Judicial, insolvency, and property-side reforms - Ongoing judicial reform efforts should continue to better enforce commercial claims, support debt workouts and reduce the cost of doing business. - Specialization of judges in financial litigation and recruitment of additional judges should be complemented by reforms of civil procedure rules, clearance of backlogs and introduction of the e-justice system. - Strengthening institutional framework for insolvency services and insolvency professionals is important for higher rates of capital investment. - Need for a more efficient system of issuing and transferring title deeds and clearing their backlog. - Finalization of the framework for electronic auctions and complementary judiciary reforms are key to improve collateral execution and incentives for debt workouts. ### AML/CFT and financial sector priorities - Efforts to mitigate AML/CFT compliance risks are a key priority ahead of the MONEYVAL AML/CFT assessment. - AML/CFT gaps noted: preventive measures, transparency and beneficial ownership of companies and trusts, international cooperation, financial intelligence and investigations. - NPL resolution and sustainable debt workouts remain central to strengthening the financial sector: - Ensure a well-functioning NPL resolution toolkit through restructuring, foreclosure, and insolvency. - Adequate supervisory oversight of durable restructuring is crucial. - Swift finalization of the state-owned CAMC’s governance and operational structure to maximize recovery. - Minimize moral hazard risks inherent in the Estia subsidy scheme. - Broader bank balance sheet priorities: - Maintain adequate provisions and capital buffers. - Reduce property holdings to targeted levels. - Encourage lower cost-to-income ratios through rationalization of operational costs, diversifying income sources, and digitization. ### Staff appraisal and policy recommendations (summary) - Cyprus has made significant strides in recovery; unemployment has declined but remains above pre-crisis levels. - Near-term outlook: - Growth expected to reach around 3 percent in 2019–20, supported by investments and consumption. - Significant downside risks include protectionist trade policies, a sharper-than-expected slowdown in euro area growth, a hard Brexit, and a negative AML/CFT assessment. - Key recommendations: - Maintain strict spending discipline; cap expenditure growth at the rate of nominal medium-term output growth to keep public debt on a downward path. - Prioritize public spending to support structural reforms for faster and more inclusive medium-term growth. - Contain wage bill growth below nominal GDP to prevent crowding out of productive expenditure. - Reallocate education spending towards investment in innovation and human capital where feasible. - Strictly monitor and fine-tune regulatory framework and provider incentives to contain NHS risks. *International Monetary Fund staff summary of chapter content.* ### 41. Productivity enhancing structural reforms are key for bolstering medium-term growth ### Productivity enhancing structural reforms are key for bolstering medium-term growth ### Productivity constraints and structural impediments - Cyprus has maintained its cost competitiveness but suffers from low labor productivity growth. - Key challenges to investment and economic efficiency: - Difficulties with access to finance. - Costly and lengthy judicial processes. - Inefficient government administration. - Low investment in new innovations. - Skills mismatches. - Policies needed to enhance competitiveness: - Greater market diversification. - Increased competition. - Faster technology adoption. ### Authorities' current strategy and welcomed measures - Authorities’ strategy elements that are welcome: - Improve investment in ICT infrastructure. - Expand STEM training. - Promote research and development innovation. - Ease access to finance. ### Public sector governance and efficiency reforms - Renewed efforts are needed to reform public sector governance and efficiency. - Specific priorities: - Improve efficiency of the judiciary. - Strengthen the institutional framework for the insolvency service. - Expedite approval of pending legislation to reform the civil service. - Expedite measures to strengthen the governance and autonomy of the Central Bank of Cyprus. - Implement fiscal institutional measures to enhance governance of state-owned enterprises. - Strengthen public financial management controls at the local government level. - Reform tax administration. - Expected outcomes: contain risks and improve public sector efficiency. ### Inclusive growth and labor market policies - Ensuring growth is inclusive is key to sustaining growth. - Recommended programs: - Job retraining initiatives. - Improve linkages between educational and job opportunities. - Expected benefits: - Reduce skills mismatches. - Allow growth dividends to benefit youth and the long-term unemployed. *Source: IMF staff analysis from the Cyprus country document.* ### 44. It is recommended that Cyprus remains on the standard 12-month Article IV ### It is recommended that Cyprus remains on the standard 12-month Article IV consultation cycle. ### Macroeconomic performance - Economic growth has been strong, supported by domestic demand, although signs of moderation are emerging. - In cumulative terms, private consumption has been the major contributor to growth since the crisis. - Main production-side contributors: professional services and tourism. - Net financial assets of households remain large, allowing households to continue drawing down their savings to mitigate the impact of the banking crisis. - Recent growth indicators shown through charts up to 2019H1. ### Inflation and labor market - Headline and core inflation were mostly subdued in 2019. - Headline inflation broadly in line with trends in other euro area countries (HICP Oct-19 chart referenced). - Employment growth remains strong and unemployment rate is declining (data through 2019Q2 / Sep-19). - Compensation of employees has picked up, contributing to higher unit labor costs (Unit Labor Costs indexed to 2009Q1 = 100; series through 2019Q2). - Household saving rate and real GDP growth series shown through 2019Q2. ### External indicators - Underlying current account deficit has widened (Current Account (Percent of GDP) series through 2018/2019). - Real effective exchange rate stayed at post-crisis low (REER series, Index 2009=100, 2019Q2). - Net capital inflows to the private sector and net outflows from CBC have declined but remain large (Financial Flows by Sector: 4-quarter sum, percent of GDP). - Net IIP remains highly negative, reflecting large negative IIP position of the government and the private sector (SPEs). - Gross external debt near post-crisis low, with SPEs accounting for the major share (Gross External Debt Percent of GDP series through 2019Q2). ### Credit and balance sheets - Domestic credit growth remains modest (Domestic Credit Growth annual percentage change, Sep-19). - Growth of pure new loans to households has decelerated (Pure New Loans: 12-m Rolling Sum, yoy percent change, series through Sep-19). - NFCs and the general government remain in large net debt position; loans remain the largest component of net financial liabilities. - Household debt as a percentage of GDP remains one of the highest among euro area countries (Debt of Households, 2019Q2, Percent of GDP). - NFC debt also high relative to peers (Debt of Nonfinancial Corporations, 2019Q2, Percent of GDP). ### Banking sector - Banks have continued deleveraging, but at a slower pace (Banking sector balance sheet trends). - Total profit of the banking sector remained slightly positive, driven by lower provisioning needs (Banking Sector Profits, 2019Q1). - Total customer deposits of locally active banks went up, particularly residents’ deposits; deposits from households and NFCs are increasing steadily (Deposits by Residency and System-Wide Customer Deposits through Nov-19). - NPL ratio was stable and provisioning coverage ratio has risen (Nonperforming Loan and Provision Coverage Ratios series). - Balance-sheet indicators (assets and liabilities) shown in charts (Billions of Euros). ### Housing market - Transaction-based property prices are rising (Residential property price index, Real residential property index, Construction cost index, 2019Q2). - Property sales are recovering, with an increasing sales to non-residents (Cyprus: Property Sales 2019M1-10; note methodological break: post-2018 vs pre-2018 not directly comparable). - Growth in construction activities continues to be strong (Value Added and Real Growth in Construction Activities, 2019Q2). - Stock of housing loans is declining due to deleveraging (Housing Loans Stock, Bn Euro, 2019Q3). - Mortgage interest rates continue to decline (Mortgage Interest Rate series, 2019Q2). - Building permits issuance on upward trend (Building Permits Million Sq. M, 2019Q2). ### Fiscal developments and public debt - Adjusted for the one-off CCB transaction, underlying primary fiscal balance = 5.7 (2018). - Underlying primary balance (Table 1 and Table 2 memorandum): 2.8–5.9 series; explicitly: Underlying primary fiscal balance 4/ shown as 3.0 (2016), 4.2 (2017), 5.4 (2018), 5.9 (2019), 4.8 (2020), 4.9 (2021), 4.8 (2022), 4.7 (2023), 5.3 (2024). - General government balance (percent of GDP): 0.1 (2016), 1.7 (2017), -4.4 (2018), 3.6 (2019), 2.4 (2020), 2.8 (2021), 2.8 (2022), 3.0 (2023), 3.7 (2024). - Revenue and expenditure (percent of GDP): Revenue 37.7 (2016) to 44.4 (2024 projection); Expenditure 37.6 (2016) to 40.7 (2024 projection). - Public debt (percent of GDP): 103.4 (2016), 93.9 (2017), 100.6 (2018), 94.8 (2019), 87.9 (2020), 83.7 (2021), 76.6 (2022), 71.9 (2023), 64.2 (2024). - 10-Year Government Bond Yields and 3-month T-bill yields shown; market conditions described as favorable with 3-month T-bill yields remaining negative (time series through Nov-19). ### Growth inclusiveness and labor-market indicators - Unemployment rates approaching pre-crisis lows (Total and youth series through 2018/2019). - Long-term unemployment declined but remains higher than pre-crisis levels (Long-term unemployment series). - Share of part-time employment and temporary workers declined since the crisis. - Poverty level in Cyprus at below euro area average (At-Risk-Poverty Rate, 2018). - Income equality comparable to European peers (Gini Coefficient of Equivalized Disposable Income, 2018). - NEET (youth not in employment, education or training) shares relatively large for young population (NEET Youth from 15 to 29 years, 2018). ### Key projections and selected economic indicators (Table 1 highlights, 2016–2024) - Real GDP growth: 6.7 (2016), 4.4 (2017), 4.1 (2018), 3.1 (2019), 2.9 (2020), 2.8 (2021), 2.6 (2022), 2.5 (2023), 2.5 (2024) — (Percent change). - Private consumption growth: 4.4 (2016), 4.5 (2017), 3.3 (2018), 3.6 (2019), 3.2 (2020), 2.5 (2021), 2.5 (2022), 2.6 (2023), 2.6 (2024). - Unemployment rate (percent, period average): 13.0 (2016), 11.1 (2017), 8.4 (2018), 7.0 (2019), 6.0 (2020), 5.4 (2021), 5.2 (2022), 5.1 (2023), 5.0 (2024). - HICP (period average): -1.2 (2016), 0.7 (2017), 0.8 (2018), 0.7 (2019), 1.6 (2020), 1.8 (2021), 2.0 (2022), 2.0 (2023), 2.0 (2024). - Nominal GDP (billions of euros): 18.9 (2016), 20.0 (2017), 21.1 (2018), 22.0 (2019), 23.1 (2020), 24.2 (2021), 25.4 (2022), 26.7 (2023), 28.0 (2024). - Current account balance (percent of GDP): -4.2 (2016), -5.1 (2017), -4.4 (2018), -5.2 (2019), -4.8 (2020), -4.3 (2021), -3.9 (2022), -3.3 (2023), -3.0 (2024). - External debt (memorandum): 1147.8 (2016), 1074.5 (2017), 990.9 (2018), 972.2 (2019), 944.0 (2020), 922.2 (2021), 900.7 (2022), 881.3 (2023), 863.8 (2024). - Net IIP: -134.2 (2016), -126.5 (2017), -121.3 (2018), -121.5 (2019), -120.3 (2020), -118.5 (2021), -116.5 (2022), -114.1 (2023), -111.4 (2024). ### Fiscal financing and debt dynamics (Tables 3 and 5 highlights) - Gross borrowing needs (millions of euros): 2,732 (2019), 1,139 (2020), 701 (2021), 1,732 (2022), 1,032 (2023), 1,227 (2024). - General government debt (eop, percent of GDP): 94.8 (2019), 87.9 (2020), 83.7 (2021), 76.6 (2022), 71.9 (2023), 64.2 (2024). - Cash holding (eop, millions of euros): 831 (2019), 842 (2020), 1,540 (2021), 1,458 (2022), 1,976 (2023), 1,800 (2024). - Gross financing requirements (millions of euros, Table 5): 65,305 (2016), 60,227 (2017), 54,639 (2018), 49,366 (2019), 47,537 (2020), 47,862 (2021), 50,632 (2022), 52,722 (2023), 55,436 (2024). - Rollover rates highlighted by sector and year (various percentages shown for General government, Central bank, Private, Banks, Non-financial corporates). ### Balance of payments and external financing (Tables 4 and 5) - Trade balance (goods and services as % of GDP): 1.7 (2016), -0.4 (2017), 0.8 (2018), -1.4 (2019), -1.3 (2020), -0.7 (2021), -0.1 (2022), 0.5 (2023), 1.1 (2024). - Services balance (% of GDP): 23.8 (2016), 24.6 (2017), 22.9 (2018), 19.6 (2019), 19.2 (2020), 19.7 (2021), 20.0 (2022), 20.3 (2023), 20.6 (2024). - Financial account (‑ financing) (% of GDP): -1.9 (2016), -0.9 (2017), -2.5 (2018), -4.8 (2019), -4.5 (2020), -4.0 (2021), -3.6 (2022), -3.0 (2023), -2.7 (2024). - Direct investment (percent of GDP): -10.7 (2016), -6.9 (2017), -34.5 (2018), -14.1 (2019), -13.2 (2020), -13.0 (2021), -13.0 (2022), -13.1 (2023), -13.4 (2024). ### Financial soundness and banking-sector indicators (Table 6 highlights) - Regulatory capital ratio (percent): 7.3 (2012), 13.5 (2013), 15.3 (2014), 16.6 (2015), 16.8 (2016), 16.3 (2017), 17.5 (2018), 18.0 (2019Q1). - Tier I capital ratio (percent): 6.3 (2012), 12.3 (2013), 14.6 (2014), 16.0 (2015), 16.4 (2016), 15.4 (2017), 16.6 (2018), 17.1 (2019Q1). - Non-performing loans (NPLs) to total gross loans (EBA definition): 27.1 (2012), 44.4 (2013), 47.5 (2014), 45.3 (2015), 46.4 (2016), 42.5 (2017), 30.5 (2018), 30.9 (2019Q1). - Provisions to NPLs: series 33.9 (2015), 38.3 (2016), 42.3 (2017), 47.3 (2018), 51.2 (2018 in table), 52.6 (2019Q1). - Return on assets (annual): -3.4 (2012), -4.3 (2013), -0.6 (2014), -0.6 (2015), -0.3 (2016), -1.1 (2017), 0.4 (2018), 0.7 (2019Q1). - Total deposits (other than from credit institutions) to total assets ratio: 71.7 (2012), 63.8 (2013), 63.0 (2014), 65.1 (2015), 74.9 (2016), 75.7 (2017), 79.2 (2018), 80.2 (2019Q1). ### IMF credit and program finance indicators - Fund disbursements and outstanding: Disbursement series show 222.8 (2013), 148.5 (2014), 321.8 (2015), 99.0 (2016), and then 0.0 from 2017 onward; Outstanding stock (millions of SDRs): 222.8 (2013), 371.3 (2014), 693.0 (2015), 792.0 (2016), 569.6 (2017), 569.6 (2018), 569.6 (2019), declining in subsequent projection years to 0.0 by 2026. - Total debt service (millions of SDRs) and percent of quota series provided through projection years. - Program financing (Table 4 memo and Table 7): Program financing and repurchases included under Financial Account with sign conventions explained. *Sources: Central Bank of Cyprus; ECB; Eurostat; Haver Analytics; Cystat; Ministry of Finance; Bloomberg Finance LP; IFS; and IMF staff calculations and estimates.* ### Annex I. Status of Article IV Recommendations ### Annex I. Status of Article IV Recommendations ### Strengthen Financial Sector Policies - Recommendation: Reduce private sector debt and high NPLs, including 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) strengthening supervisory and governance framework for credit-acquiring companies (CACs), including the government-owned CAMC. - Policy actions and status: - The amendments to the foreclosure and insolvency legislation and the sales of loans law as well as the adoption of a law on securitization have enhanced the toolkit to address NPLs (2018). - Banks have made significant progress in offloading NPLs. - Successful workout outside of the banking system is still needed; Parliament recently made further amendments to foreclosure law to weaken the effectiveness of its framework. - A subsidy scheme aimed at encouraging vulnerable borrowers to start servicing their loans through burden sharing is about to be implemented, but its coverage is rather broad. - CAMC has yet to become fully operational. ### Ensure Fiscal Sustainability and Avoid Procyclicality - Recommendations: - Cap fiscal spending and wage bill by medium term GDP growth and nominal GDP growth, respectively, to avoid procyclical policies, prevent structural loosening and mitigate risks stemming from the high level of public debt. - Mitigate fiscal risks from the introduction of a public health insurance system. - 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 status: - Thea authorities have contained fiscal spending and wage bill within medium term GDP growth and nominal GDP growth, respectively. - Some fiscal loosening took place during 2017–2019. - A more durable mechanism to keep the public-sector wage bill in check has not been adopted by Parliament. - The government has decided to reverse crisis-era public wage cuts gradually starting in 2018. - Reforms are ongoing to make the public health sector more competitive. - PFM and RA reforms are being implemented, supported by Fund technical assistance. - Legislative reform of SOEs, however, has stalled. ### Implement Structural Reforms - Recommendations: - Strengthen judicial efficiency and commercial claims enforcement. - Strengthen central bank governance and undertake Local government and civil service reforms. - Continue to improve the AML/CFT framework, including by ensuring effectively mitigating inherent AML/CFT risks. - Policy actions and status: - 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. - The amending legislation to strengthen the governance and autonomy of the CBC is [undergoing legal vetting]. - A draft law on local government reform is currently being prepared [under discussion in Parliament]. - Civil service reform has largely stalled. - A cap on the number of citizenships granted under the CIP has been introduced and the required period for holding investment lengthened; and a Committee for Supervision and Control as well as a Registry of Service Providers for the CIP scheme have been established. --- ### Annex II. Revision of National Accounts Data and External Statistics - Major points: - On October 21, the Statistical Service of Cyprus (CYSTA) released a major revision in National Accounts data series according to the Harmonized European Revision Policy and the National Revision Policy. - Revised data suggest a steeper economic contraction during the 2012–13 crisis and a faster subsequent economic recovery. - The 2018 nominal GDP level revised upward by 2 percent compared to the previous estimate. - The cumulative contribution of private consumption to real GDP growth between 2002 and 2018 is now smaller, and the contribution of the net export is larger. - Revision drivers: regular data verification performed by Eurostat, incorporation of 2015 Household Budget Survey, and data revisions from annual economic surveys, Government Financial Statistics as well as the Balance of Payments statistics (⁋2). - Higher nominal GDP levels imply lower ratios of macroeconomic variables to nominal GDP. - External statistics revisions: - The current account balance has been revised upward by 1.6 percent of GDP on average for 2008–18. - Upward revision reflects mainly a large upward revision to services exports resulting from an expanded coverage of Cypriot entities offering financial services abroad, which outweighed a more modest upward revision to imports. - The financial account balance has been revised upward by 1.7 percent of GDP on average, with larger FDI outflows more than offsetting larger other investment inflows. - While gross external debt was revised upward significantly, gross external debt excluding SPEs remain broadly unchanged. - NIIP was revised downward by -13 percent of GDP on average. --- ### Annex III. External Sector Assessment - Overall assessment: - The external position of Cyprus in 2018 was moderately weaker than implied by medium-term fundamentals and desirable policies, notwithstanding the sharp narrowing of the CA deficit and reduction in the REER since the banking crisis. - The overall CA deficit improved in 2018 and is projected to slightly widen in 2019, while the underlying current account deficit, adjusted for one-off and SPEs, widened mainly due to a decline in services exports. - Over the medium term, the current account deficit is set to narrow while the NIIP is projected to increase slightly in the near term and gradually decline over the medium term. - Potential policy responses: - Maintain financial stability through continued efforts to unwind the credit gap to raise the current account and lower net IIP liabilities. - Structural reforms to invest in human capital and technological infrastructure to boost productivity and competitiveness. - Policies to boost service exports and enhance exports diversification, especially market diversification. - Maintain a prudent fiscal policy that avoids procyclicality to safeguard the downward path of public debt and create space to absorb possible contingent fiscal shocks. - Key metrics (2018, % GDP): - NIIP: -121 (underlying -40) - Gross Assets: 2300 (underlying 344) - Debt Assets:567 (underlying 267) - Gross Liab.: 2421 (underlying 384) - Debt Liab.:990 (underlying 259) - Current Account (Actual CA (underlying)): -3.4 - Cycl. Adj. CA: -3.2 - EBA-lite CA Norm: -0.9-0.9 - CA Gap: -2.3 - Policy Gap: 4.3 - Selected assessments: - Underlying NIIP improved from -78 percent in 2014 to -40 percent of GDP in 2018 excluding SPEs. - The NIIP is dominated by the private sector: -120 percent of GDP in 2018 and -38 percent excluding SPEs. - Gross liabilities declined at 2421 percent of GDP in 2018, with around one third in the form of external debt. - Staff assesses the CA gap in 2018 was -2.3 percent of GDP. - Policy gaps decompose into contributions: private credit gap (-1.3 percentage point), private credit growth gap (1.4 percentage point), fiscal policy (0.8 percentage point), public health expenditure gap (3.1 percentage point), and change in reserves and capital control (total 0.4 percentage point). - Real exchange rate: - EBA-lite REER model estimates a small REER undervaluation of 1.5 percent in 2018. - External sustainability (ES) model suggests a REER undervaluation of 0.2 percent. - EBA-lite CA model points to an overvaluation of around 4.4 percent. - Staff’s assessment estimates the REER gap in 2018 to be in the range of -1.5 to 4.4 percent in 2018. - Capital and financial accounts (2018): - Net capital inflows decelerated to 4.7 percent of GDP for the private sector (including SPEs), from 17 percent in 2017. - Net FDI inflows increased to 34.5 percent of GDP (largely due to SPEs). - Private net portfolio outflows reached 17 percent of GDP. - Net public outflows from the central bank declined to 5 percent in 2018 from 17 percent in 2017. - TARGET2 balance stayed at 37 percent of GDP. - Assessment: With sizable external debt of the public and private sectors, Cyprus remains exposed to financial market risks. --- ### Annex IV. Export Competitiveness - Key findings: - Exports recovered robustly post-crisis but slowed in recent years; imports growth outpaced exports. - The current account deficit (excluding Special Purpose Entities) increased from 0.4 (1) percent of GDP in 2015 to 4.4 (3.4) percent in 2018. - Exports of goods have been stagnant as a share of GDP despite subdued unit labor cost and producer price indices for external markets over the past five years and relatively favorable competitiveness rankings. - Exports of services picked up rapidly from 2013 but slowed significantly in 2018 with declining financial service exports and slower growth of other services sectors. - Product diversification of goods exports remains limited; Cyprus’ Economic Complexity Index (ECI) has been stagnant. - Services exports are heavily concentrated to Europe (notably the UK, Russia and the EU); growth has been fueled by ICT, business services and travel, while financial services exports have lagged significantly since 2015. - Policy implications: - Support greater market diversification (into newer, higher growth economies outside Europe) to reduce volatility. - Enhance competition, efficiency and contestability of markets to attract more FDI and improve the quality and cost of services. - Encourage innovation and investment, important for ICT-enabled sectors. - Stronger efforts to address inefficiencies in financial services are critical. - Greater investment in STEM training and technological investments would support technological upgrading and improve exports growth. --- ### Annex V. Debt Sustainability Analysis - Baseline scenario: - Public debt experienced a sharp decline in 2017 to 93.9 percent of GDP at end-2017 from 103.4 percent of GDP a year earlier, due to early repayments. - As part of conditions to sell assets and liabilities of the CCB to Hellenic Bank, the government placed €3.19 billion domestic bonds (15 percent of GDP) at the CCB in July 2018. - Despite an early repayment of the remaining balance of the debt owed to the CBC (€483 million) at end-2018, public debt increased to 100.6 percent of GDP at end-2018. - Public debt is projected to resume a rapid decline from 2019 to 64 percent of GDP by 2024, supported by projected high primary surpluses and robust economic growth. - GPFN will remain well below the benchmark for advanced economies (20 percent of GDP) over the projection horizon. - 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. - Risk assessment: - High NPLs pose a risk to public debt sustainability; as part of the CCB sale, the government agreed to an Asset Protection Scheme (APS) covering the loan portfolio transferred to the HB (€2.6 billion). - Independent estimates put likely fiscal cost at €120 million (0.6 percent of GDP). - Baseline conservatively assumes zero recovery from the NPLs in the public AMC. - Under baseline, public debt ratio projected to remain above the benchmark for advanced economies (85 percent of GDP) until 2021. - Probability that public debt to GDP could remain above 85 percent until 2024 is 17 percent (fan chart in Annex Figure 1). - Gross public financing needs are susceptible to shocks; under short-duration individual macro-fiscal shocks or sustained adverse episodes, GPFN would jump several percentage points of GDP but remain below 20 percent. - Profile of public debt—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, though estimated to have declined in 2018. - 74 percent of public debt is owed to non-residents; about 55 percent of this reflects official financing from the ESM and the IMF, and loans from the European Investment Bank and the Council of Europe Development Bank. - Cyprus issued 15- and 30-year Eurobonds this year, lengthening the average maturity of the stock of Eurobonds. - Relatively low and/or fixed interest rate on official liabilities, long maturities and back-loaded repayment schedule mitigate interest rate and financing risks. - Sovereign credit recently upgraded to investment grade; 10-year sovereign bond spread relative to German bonds was around 106 basis points on average in the past three months, below the lower risk-assessment benchmark. - Reliance on short-term debt is limited: the authorities estimate as of end-September 2019 the weighted average maturity of total debt is 7.3 years, marketable debt 6.3 years; shares of debt that falls due within 1 year and 5 years are 7.2 percent and 42.7 percent, respectively. - Realism of baseline assumptions: - Recent GDP growth and fiscal balance have surpassed staff’s forecasts in recent years, contrasting with prior excessive optimism. - The relatively high 3-year average level of projected cyclically-adjusted primary balance is underpinned by consistent overperformance of tax revenue and authorities’ commitment to expenditure restraint. - Stress tests and alternative scenarios: - Growth shock: A one standard deviation (4.1 percentage points) decrease in growth during 2020–21, accompanied by (i) a 51 and 106 basis points (bps) rise in interest rates in 2020 and 2021, respectively (corresponding to 25 bps rise per one percentage point reduction in primary balance), and (ii) a decrease in inflation by 0.25 percentage points per percentage point reduction in GDP growth, would raise public debt by 16 percentage points relative the baseline to 100 percent of GDP by 2021, before declining to 80 percent of GDP by 2024. - (Further scenarios such as Primary balance shock and real interest rate shock are described in the source text beyond the provided excerpt.) *International Monetary Fund — Annex I. Status of Article IV Recommendations (and accompanying annexes as provided in source content).* ### 1.6 percent of GDP during 2020–21, accompanied by 40 bps rise in interest rates ### 1.6 percent of GDP during 2020–21, accompanied by 40 bps rise in interest rates ### Macro-fiscal shock scenarios and debt outcomes - A combined shock: growth shock, interest rate shock, and primary balance shock - Public debt would peak at 103 percent of GDP in 2021 before declining to 85 percent of GDP by 2024. - Gross financing needs (GFN) would peak at 11 percent of GDP in 2021–22 before falling back. - Scenario: primary fiscal balance permanently lower by ½ standard deviation plus realization of contingent liabilities (government guarantees, pension deficits, and court cases amounting to 7 percent of GDP) - Risk premiums: interest rate higher than baseline by 270 basis points in 2020 and 40–60 basis points thereafter. - Public debt would rise to 99 percent of GDP in 2020 and decline to 83 percent in 2024. - Gross financing needs would spike to 16 percent of GDP in 2020 before declining to 7 percent in 2024. - Adverse macro-fiscal-contingent liability (CL) scenario: real GDP growth and primary fiscal balance permanently lower by ½ standard deviation, accompanied by decreased inflation, higher interest rates, and further realization of contingent liabilities from the banking sector (13 percent of GDP) in 2020 (on top of support already provided to the CCB) - Public debt would rise to 105 percent of GDP in 2020 and decline only slowly to 98 percent of GDP in 2024. - Gross financing needs would spike to 20 percent of GDP in 2020 before declining to 9 percent of GDP over the medium term. - Contingent liabilities from the banking sector comprise: - (i) 50 percent default rate for loans covered by the APS and 50 percent loss-given-default rate; and - (ii) 75 percent loss from gross book value of NPLs minus provisions of the banking system. ### Single-shock illustrative effects (preserving source magnitudes) - A fiscal shock lowering the primary balance by 1.6 percent of GDP during 2020–21, accompanied by a 40 bps rise in interest rates (corresponding to 25 bps rise per one percentage point reduction in primary balance) - An increase in the real interest rate by 490 bps during 2020–24 would raise public debt marginally to 67 percent and 66 percent of GDP, respectively. ### External debt developments and baseline projections - Historical and recent levels - External debt declined from 1,074 percent of GDP in 2017 to 991 percent of GDP in 2018. - After excluding SPEs, gross external debt amounted to 259 percent of GDP in 2018. - Net debt declined from 482 to 424 percent of GDP for the economy and from 0 to -7 percent after excluding SPEs. - External debt of MFIs declined from 98 to 74 percent of GDP; other private sector declined from 380 to 356 percent of GDP; inter-company liabilities associated with direct investment declined from 516 to 483 percent of GDP in 2018. - Baseline medium-term projections (including SPEs) - Gross external debt projected to decline from 972 percent of GDP (€214 billion) in 2019 to 865 percent of GDP (€242 billion) by 2024. - Net external debt projected to decline from around 399 percent of GDP to 246 percent of GDP by 2024. - Government external debt as a share of GDP declines to around 58 percent of GDP over the medium-term on assumption of continued fiscal prudence. - Banks forecast to reduce external debt to around 42 percent of GDP. - External debt of private nonbank sectors forecast to remain high around 336 percent of GDP in 2024. - Gross debt excluding SPEs anticipated to fall to around 133 percent of GDP in 2024 from 241 percent of GDP in 2019. - Drivers of external debt ratio decline - Nominal GDP growth forecast to grow by 4.8 percent annually on average in the projection period, contributing to an annual external debt reduction of 24.6 percentage points of GDP. - Trade deficit expected to be sustained at 0.3 percent of GDP annually, on average. - Net interest payments projected at 8 percent of GDP annually, on average. - Net result: average annual decline in external debt by 10.1 percentage points of GDP. ### Risks to external debt sustainability (stress tests and bounds) - Interest rate shock - A two-percentage point increase in average interest rates on external debt throughout the projection period would raise the external debt ratio by 105 percentage points above the baseline by 2024. - Growth shock - A one-half standard deviation decrease in projected real GDP growth throughout the projection period could increase the external debt ratio by 90 percentage points by 2024 relative to baseline. - Current account deterioration - A one-half standard deviation shock to the current account balance would push the debt-to-GDP ratio 22 percentage points higher by 2024 compared to baseline. - Combination of shocks - One-quarter standard deviation shocks to nominal interest rate, growth, and current account would raise the debt ratio by 109 percentage points by 2024 relative to baseline. - Historical scenario - Reversion of growth, interest rate, inflation, and current account balance to their average levels during the previous five years would drive the debt ratio higher by 38 percent of GDP by 2024, mostly reflecting near-zero inflation. ### Gross financing needs and liquidity risks - Projected GFN remain elevated (over 190 percent of GDP) through the projection period, reflecting a sizable stock of short-term private sector external debt. - Short-term debt: around 86 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. - Banks’ reduced non-resident deposits and declining public sector debt drive the projected reduction in GFN. - Cyprus faces rollover risk if borrowers lack sufficient liquid assets or market funding becomes too costly. ### Conclusions and policy implications - While external debt declines and is sustainable in the baseline, the high level leaves Cyprus vulnerable to various risks due to its role as a regional financial center and the presence of SPEs. - Substantial uncertainty surrounds SPEs given limited information on their activities and possible implications from beneficial owners’ home countries. - Policy recommendations and priorities (as implied by analysis) - Maintain sound financial sector policies and structural reforms to diversify the economy, limit boom-bust risks, and support balanced sustainable growth. - Maintain a prudent fiscal policy that avoids procyclicality to safeguard the downward path of external public debt and create space to absorb contingent fiscal shocks. - Closely align the maturity and currency composition of external assets and liabilities. *IMF staff analysis as presented in the source content.* ### Annex VI. Developments in NPL Resolution in Cyprus ### Annex VI. Developments in NPL Resolution in Cyprus ### Scale and composition of NPLs (end-2018) - Total NPLs in the banking system: €10.4 bn (30½ percent of total loans). - Approximately 70 percent of NPLs held by the largest two banks: Bank of Cyprus (BoC) and Hellenic Bank (HB). - State-owned asset management company (CAMC / KEDIPES) holds additional NPLs: €6.9 bn. - Around half of NPLs held by banks have been provisioned; the remainder mostly backed by collaterals. - NPL breakdown (Cyprus: Non-Performing Loans by Credit Institutions, 2018): - Total10.452 - Bank of Cyprus 1/4.847 - Hellenic Bank2.555 - RCB Bank LTD0.082 - Alpha Bank Cyprus Ltd1.354 - Eurobank Cyprus Ltd0.162 - Other banks1.7. - KEDIPES6.9 - Note: 1/ NPLs for BoC includes the impact of Helix transaction and the impact of the agreement for sale of €33mn (gross book value) of retail unsecured NPLs (Velocity) signed in Decmeber 2018. ### NPL market developments and sales (2018–July 2019) - The NPL market in Cyprus is nascent; first NPL portfolio sale recorded in 2018. - Between 2018 and July 2019, seven NPL sales took place, total NPL sales reaching €10 bn versus over €205 bn in the European NPL market. - Largest transaction: transfer of NPLs to CAMC (€6.9 bn). - Second largest: BoC Helix transaction involving €2.6 bn of NPLs. - BoC and HB plan to offload more NPLs by 2021, aiming to reduce NPL ratios to below 10 percent of their total loans. - NPL Sales in Cyprus (date / seller / buyer / Gross Book Value of NPLs (€ mn)): - June, 2018 — Hellenic Bank — B2Kapital Cyprus Ltd — 144 - Sep. 2018 — Cyprus Cooperative Bank — Cyprus Asset Management Company Limited (KEDIPES) — 6,900 - 2018H1 — Alpha Bank — AGI Cypre Ermis LTD 1/ — 9.5 - 2018H2 — Alpha Bank — AGI Cypre Ermis LTD 1/ — 372 - 2018H2 — National Bank of Greece (Cyprus) — CAC Coral Limited 2/ — 0.4 - 2019H1 — Bank of Cyprus — Gordian Holdings Limited — 2,638 - 2019H1 — Bank of Cyprus — APS Loan Management Ltd — 30 - Total — 10,094 - Notes on transactions: - 1/ A SPV or subsidiary of the parent bank, Alpha Group Investments Ltd. - 2/ A subsidiary of the NBG Group. - Helix-related transaction: NPLs transferred to a licensed Cypriot Credit Acquiring Company (CyCAC), renamed Gordian Holdings Limited in 2019H1; SPV issued senior and junior debt tranches; buyer (Apollo investment fund) invested by way of junior loan made to the SPV. ### Investor appetite and preferences - Investors’ focus in southern Europe expected to remain strong; Cyprus is an emerging target market. - Survey evidence: - Around 16 percent of investors surveyed by Ashurst (2019) have already invested in Cyprus. - 30 percent of investors indicated interest in buying NPLs in Cyprus. - Overall investor preference: outright sales processes over joint ventures and synthetic transactions (securitizations). - Asset preferences: - 44 percent of potential NPL investors cite SME loans and large commercial credits as top two asset classes receptive to acquisition. - Sellers’ most popular asset class (39 percent) is commercial real estate backed loans. - European context (2018 NPL sales by country — reported figures in source): - Italy: €103.6 bn - Spain: €43.2 bn - Greece: €13.9 bn - Portugal: €8 bn - Top five buyers in Europe in 2018 (reported): Cerberus (€29.7 bn), SGA (€18.3 bn), Lone Star (€15.1 bn), Instrum (€13.7 bn), Barclays (€10.0 bn). ### NPL workout by CACs and CAMC - CACs, including the CAMC, employ loan restructuring, foreclosures, full settlements, and frequently Debt-to-Asset swaps. - Debt-to-Asset swaps have led to sizable real estate holdings; for CAMC, real estate accounts for 8 percent of total assets as of end-June 2019. - With around 50 percent of GDP in NPLs transferred to CACs, strengthening the supervisory and regulatory framework of CACs (including data reporting and analysis of NPL resolution progress) is crucial. ### Impediments to an active NPL market and policy recommendations - Lack of a stable regulatory regime: - Hinders timely disposals of NPLs and forces banks to hold higher capital. - Cyprus ranked low versus other NPL markets on efficiency of regulatory regime for obtaining and operating under a license to be a servicer of NPLs. - Lengthy foreclosures, weak debt enforcement, and insolvency frameworks prevent banks from freeing regulatory capital and generating new lending capacity. - 2018 amendments to foreclosure and insolvency legislation and the sales of loans law helped address impediments, but recent changes to the foreclosures law (under review by the Supreme Court and not yet in effect) could create significant delays and adversely impact sale prices. - Low profitability and capital ratios of banks: - May create difficulties in closing the bid-ask spread between banks and NPL investors. - More conservative provisioning policies reduce this gap but require adequate profits or capital. - High capital ratios would allow banks to write down NPLs and facilitate sales at higher haircuts. - Small market size and high transaction costs: - 2018 European NPL market volume reported as around €714 bn versus Cyprus’ NPL volume (around €17 bn). - Small market size implies higher costs for buyers; securitization investments and evaluating less mature NPL markets are costly. - Poor data quality and insufficient sell-side resources further increase transaction costs. - Mechanisms to overcome bid-ask gap (reported in source): securitization, a guarantee on the equity tranche of NPLs, a forward purchase scheme in which the state partially funds the purchase price paid by the investor to the banks. *Sources: Central Bank of Cyprus; and banks' financial reports.* ### Annex IX. Banks in Cyprus: Staying Competitive in the Digital Age ### Annex IX. Banks in Cyprus: Staying Competitive in the Digital Age ### Banking sector performance and challenges - Cypriot banks have undertaken significant efforts to recover from the financial crisis; nonetheless, operational efficiency and profitability remain low. - The banking sector has become more consolidated and increasingly oriented towards the domestic market, following the decline of non-resident businesses, withdrawal of foreign banks and resolution of non-viable banks. - The economy remains overbanked. - Overall profitability of Cypriot banks has been persistently below the EU regional average, largely due to NPL provisioning costs. - Operational profits were low relative to EU peers due to the high share of personnel costs. - Cost-to-income ratios have been rising over the past few years. - The current low-interest and low-growth environment are further undermining profitability. ### Digitalization: opportunity and imperative - Digitalization of financial services is both an opportunity and an imperative to lower recurrent costs and stay competitive despite large initial costs. - New entrants (fintech and bigtech) and digitally enabled customers are motivating banks to accelerate digital transformation. - Cross-country evidence cited: digital maturity is associated with increased profitability (Accenture, 2019): - Digital advanced banks have on average experienced an overall increase of return on equity (ROE) of 0.9 percent between 2011 and 2017. - Less digital advanced banks have seen a ROE decline of 1.1 percent between 2011 and 2017. - The divergence of profitability is expected to widen in the following years. ### Cyprus digital adoption benchmarks - In 2017, 66 percent of adults in Cyprus used electronic payments versus above 95 percent of digital-frontier countries. - In 2017, 8 percent of adults in Cyprus have used mobile payment, versus above 25 percent in the digital frontier countries. - Competition from domestic fintech companies appears largely absent thus far; existing companies mainly provide online trading platforms to global investors. - In digital payments, both fintech start-ups and incumbent banks have adopted innovative technologies to provide a range of payment solutions. ### Comparative operational capacity indicators (ratio to Euro area average) - Headings (left to right): Deposits per branch (mn euro), Population per branch, Population per ATM, Assets per bank employee (000' euros) - Cyprus: 0.6 ; 0.5 ; 1.1 ; 0.5 - Digital advanced countries 1/: 1.2 ; 1.4 ; 2.2 ; 1.7 - Digital lagging countries 2/: 0.5 ; 0.8 ; 0.9 ; 0.8 - Notes: - 1/ Digital advanced countries include Finland and Sweden, which were top two EU countries in terms of the use of mobile phone payments in 2017. - 2/ Digital laggard countries include Bulgaria, Greece, and Italy, which ranked among bottom five EU countries in terms of use of mobile phone payments in 2017. The selection of countries are based on data availability. - Sources: ECB, Central Bank of Cyprus and IMF staff calculations. ### Policy recommendations and implementation priorities - Build a forward-looking regulatory framework that is flexible to accommodate innovation while maintaining high standards for integrity, soundness, and consumer protection. - Strengthen oversight of larger banks in a likely more consolidated banking system. - Ensure sufficient supply of ICT skilled labor to support digital transformation. - Take preemptive measures to help employees made redundant as banks digitalize (labor market and retraining policies). *Source: Annex IX. Banks in Cyprus: Staying Competitive in the Digital Age (IMF staff report excerpt).* ### 2020. The growth slowdown is due to the deterioration in the external environment, ### 1cypea2019002 - 2020. The growth slowdown is due to the deterioration in the external environment, ### Growth outlook and drivers (2020) - Growth slowdown in 2020 is due to the deterioration in the external environment, mainly reflecting the barriers imposed in international trade and uncertainty related to Brexit, which adversely affect external demand. - Private consumption expected to register a deceleration, reflecting, inter alia, the projected acceleration in loan repayments and the impact of changes in various social contributions, including the recent introduction of contributions towards the new General Healthcare System. - Foreseen deceleration in investment emanates from the gradual completion of construction projects, including foreign-financed tourism-related projects (marinas and casino), residential construction, renewable energy sources and education. ### Risks and inflation - Risks to the outlook are tilted to the downside, due to slowing global growth and the expected decline in contribution of construction to GDP growth. - Headline HICP inflation in 2018 was 0.8percent, and is expected to remain sluggish, despite the projected high growth rate. - Explanations for weak inflationary pressures: - Significant slack in the labor market despite strong employment growth, restricting wage and unit labor cost growth. - Technological change may lower production costs and increase competition, constraining profit margins and weighing on price growth. ### Public finances - Public finances expected to return to nominal surpluses in 2019, after recording a temporary deficit of 4.4 percent of GDP in 2018 (reflecting one-off support measures related to the sale of the Cyprus Cooperative Bank). - Cyprus is expected to record a primary surplus of about 6.2 percent of GDP in 2019 and will continue to record solid primary surpluses on the forecast horizon. - As a result, Cyprus’ public debt is on a firm downward trajectory. - Authorities have capped expenditure growth to nominal medium-term economic growth, as reflected in the medium-term budget plan for 2020–22. - Broad political consensus for spending restraint continues to hold despite spending pressures. ### Financial sector: NPLs, profitability, and reforms - Continued significant progress in reducing NPLs since last year’s Article IV report, among others as a result of the €2.6 billion sale of NPLs by Bank of Cyprus. - Level of NPLs is still very high compared to euro area average; efforts to reduce them need to continue. - Cyprus’ two largest banks, holding around 70 percent of NPLs, plan to further offload NPLs, bringing their levels to below 10 percent of total loans, by the end of 2021. - Strong investor appetite for NPLs has been fostered by the 2018 legislative changes strengthening Cyprus’ foreclosure, insolvency and sales of loan laws. - Recent parliamentary efforts to increase the role of the Ombudsman in debt work outs, which could potentially lengthen judicial processes, have been deferred to the Supreme Court; these efforts have arguably not affected investor appetite. - Restructuring of loans bought by credit acquirers remains a significant challenge: such loans are no longer recorded in the banking system but remain part of private debt and continue to constitute a burden for the economy. - Factors contributing to a speedier debt work-out: - Estia burden sharing mechanism for distressed primary residence mortgage loans is currently being rolled out, after receipt of the first applications last September. - Electronic foreclosure mechanism (e-auction) will be launched soon. - Additional judges to deal with the NPL backlog are being recruited. - Recovering real estate prices are helping banks to offload real estate acquired via debt to asset swaps. - Banking profitability has been considerably affected by the need to hold provisions against NPLs; profitability issues also stem from other sources. - Staff analysis highlights how increased digitization could improve bank profitability; digitalization transformation strategies by Cyprus’ banks are an important development. - Authorities remain committed to further strengthening AML/CFT compliance; since the last Article IV report, regulation of shell companies and oversight of the Citizenship Investment Program (‘CIP’) have been strengthened. - NPL workout by credit acquiring companies, including the public asset management company, is progressing. ### External sector - Revision of National Accounts Data and External Statistics as part of a five-year benchmark revision led to an upward revision of the current account balance by, on average, 1.6 percent of GDP for the period 2008–2018. - Staff requalified Cyprus’ external position from ‘weaker than’ to ‘moderately weaker than implied by medium-term fundamentals and desirable policies’. - Authorities consider external sector developments to be in line with the fundamentals of the Cyprus economy. - Projected current account deficit expected to narrow and is considered to be at a sustainable level, in line with overall domestic economic growth momentum. - Authorities appreciated the technical exchange with staff on the application of the EBA Lite model. ### Competitiveness and structural reforms - Selected Issues Paper provides insight into Cyprus’ export competitiveness and determinants of service exports, informing policy choices such as diversifying export markets and enhancing productivity. - Authorities remain fully committed to structural reform efforts to unlock Cyprus’ growth potential despite implementation challenges in a small island economy reliant on services. - 2019 Cyprus Competitiveness Report (Cyprus Economy and Competitiveness Council) highlights policy areas for improvement: - Addressing low labor productivity. - Promoting entrepreneurship. - Improving business linkages and connectivity. - Improving access to finance. - Continued improvement of public sector efficiency is key to enhancing competitiveness. - Two ongoing far-reaching reforms highlighted: - Local governance reform to increase professionalism and fiscal responsibility. - Reform of the judiciary to increase specialization and capacity, strengthening the business climate and legal certainty. *Source: 1cypea2019002 - 2020. The growth slowdown is due to the deterioration in the external environment,* --- _Source: https://www.imf.org/-/media/files/publications/cr/2019/1cypea2019002.pdf_