## 1cypea2023001

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### Impact of Russia’s invasion of Ukraine and recent developments
- Context and vulnerabilities:
  - High share of contact-intensive services (a quarter of GDP) and pre-war exports to Russia (a tenth of GDP).
  - Output contraction about 4½ percent in 2020.
  - Primary fiscal balance: surplus of 3½ percent of GDP in 2019 → deficit of 3½ percent of GDP in 2020.
  - Public debt ratio rose to 113½ percent of GDP at peak-pandemic.
  - Recovery aided by contact-intensive services and ICT sector; supply constraints and high energy prices contributed to inflation pressures.
- Recent growth and demand:
  - GDP expanded by 5.6 percent in 2022; growth slowing thereafter.
  - Tourism: 3.2 million arrivals in 2022 (0.8 million short of the 2019 record).
  - Export-oriented ICT and business services expanded; foreign company relocations supported activity.
  - GDP growth slowed in Q4 2022; indicators point to stabilization at a lower level in early 2023.
- Labour market:
  - Output gap estimated at 1½ percent of potential GDP in 2022; gradually closing.
  - Unemployment around 6 percent in February 2022.
  - Participation rate at historic high; vacancies elevated in services.
- Inflation and wages:
  - Headline inflation: peaked at 10.6 percent in July; fell to 6.1 percent in March.
  - Core inflation: peaked at 7.2 percent in August; averaged 5.7 percent since then; 5.2 percent in February.
  - Nominal wages increased by 6.8 percent in 2022; real wages declined by 1.3 percent in 2022.
  - Corporate profits above pre-Covid levels and higher than in the rest of the euro area.

### Impact of the war on sectors and external linkages
- Tourism and FDI:
  - Receipts from Russian tourists shrank from about €44 0 million in 2021 (1½ percent of GDP, around than a fifth of the total) to almost zero in 2022.
  - Cyprus’s direct investment positions with Russia—assets and liabilities of around 450 percent of GDP in 2022—reflect past round-tripping.
- Services exports and sanctions:
  - EU bans since June and October 2022 restrict a range of professional and IT/legal/engineering services to Russia; net financial services flows were down by a third (y-o-y) in Q4 2022 but still accounted for €1 billion (3.8 percent of GDP) in 2022.
- Energy and banking exposure:
  - Energy imports from Russia about 1 percent (2020).
  - Russian deposits about 4 percent at end-2021.
  - Lending exposure to Russian businesses described as anecdotally negligible.
  - RCB liquidated end-2022; remaining portfolio managed by Finstella Ltd under CAC and electronic money institution licenses.

### External position and trade
- Current account deficit widened from -6¾ percent in 2021 to exceed -9 percent in 2022.
- Terms-of-trade worsened moderately; real exchange rate depreciated.
- External position in 2022 assessed weaker than level implied by fundamentals and desirable policies.
- NIIP (excluding SPEs) improved but remains elevated.
- Selected external statistics and projections (percent of GDP unless otherwise stated):
  - Current account balance: 2022: -9.1; 2023 Est.: -7.9; 2024: -7.4; medium-term remains high but narrows slowly.
  - Gross external debt: 2022: 620.7; 2023 Est.: 555.3; projected to decline below 500 in 2028.
  - Net IIP: 2022: -105.3; 2023 Est.: -103.7.

### Key policy challenge and high-level recommendations
- Primary challenge: rebuild policy buffers and reduce inflation pressures while advancing structural reforms.
- Authorities committed to fiscal discipline and RRP reforms: strengthen governance; improve education; green the economy.
- Tackle slow resolution of legacy NPLs to reduce private sector indebtedness and vulnerabilities amid financial tightening.
- Recognize political constraint: uncertain parliamentary majority may hinder effectiveness.

### Growth outlook and risks
- Near-term and medium-term projections:
  - Growth projected to slow to around 2½ percent in 2023.
  - Forecast to recover in 2024 and average 3 percent in the medium-term.
- Drivers and supports:
  - Downside drivers in 2023: erosion in household disposable income from inflation; tighter financial conditions; delayed impact of sanctions on professional/financial services.
  - Supporting factors: domestic savings buffers; recovering tourist arrivals; continued influx of foreign companies; RRP investments.
- Inflation outlook:
  - Headline inflation: around 4   percent in 2023; 2½ percent in 2024.
  - Core inflation expected to be stickier due to second-round wage effects.
  - Pass-through: a 1 ppt increase in inflation from an exogenous shock raises private sector wages by 1.4 percent and public sector wages by 2.3 percent.
- Risks:
  - Tilted to the downside for growth and upside for inflation.
  - External shocks: further effects from Russia’s war, a recession in Europe, new commodity price shocks, increased geopolitical risks.
  - Domestic risks: stronger pass-through to wages; uncertainty about CoLA revisions.
  - Offsetting positives: de-escalation of war; fall in oil prices; upward EU growth revisions.

### Fiscal developments, stance, and recommendations
- 2022 fiscal outcome and 2023 stance:
  - Revenues increased by 14½ percent in 2022; expenses declined as pandemic support expired.
  - Headline balance: deficit of 1¾ percent of GDP in 2021 → surplus of 2¼ percent of GDP in 2022.
  - Cost-of-living measures cost below 1 percent of GDP; total listed measures — 0.96 percent of 2022 GDP.
  - Staff projects a primary surplus of 3½ percent of GDP in 2023 under current spending plans; estimated moderately tight fiscal impulse of 0.2 percent of GDP in 2023.
- Wage bill and CoLA:
  - Assuming no change in CoLA, wage bill projected to grow by about 7 percent; unwinding of crisis-era cuts ~1.5 ppts; CoLA ~2.5 ppts.
  - Upward revisions to CoLA would increase the wage bill and reduce fiscal space; stronger automatic wage-inflation link would make fiscal policy more pro-cyclical.
- Social protection:
  - GMI is well-targeted and relatively generous; consider more frequent adjustments to consumption basket and strengthen activation requirements.
- Response to shocks:
  - Allow automatic stabilizers to operate in a slowdown.
  - Additional support for vulnerable may be warranted if higher energy prices persist, but should be temporary, targeted, and not relax the overall fiscal stance unless there is significant slack and absent wage pressures.
- Medium-term objectives and fiscal rules:
  - Aim to reduce public debt toward the 60 percent benchmark and direct fiscal space to productive investments once buffers are rebuilt.
  - Recommend a modernized risk-based fiscal rule with a medium-term overall balance and debt anchors, and an expenditure ceiling as operational rule.
  - Strengthen the national Fiscal Council capacity.

### Public debt, financing, and sovereign risk
- Key figures and structure:
  - Public debt: 2021: 101.1 percent of GDP; end-2022: 86.5 percent of GDP; projected 2023 Est.: 78.3; 2028: 54.9.
  - End-2022 cash buffers about 10 percent of GDP.
  - More than 2/3 of public debt has fixed interest rates; weighted average maturity around 7 years; residual maturity reported as 5.9 years in Annex III.
  - Cyprus issued first 10-year sustainable bond in April: amount €1 billion, yield 4.2 percent.
- Sovereign risk assessment (Annex III):
  - Overall risk: Moderate.
  - Medium-term risk: Moderate (mechanical signals: Fanchart = Low, GFN = Moderate, Stress test = Low).
  - Long-term risk: Low.
  - Main judgment: public debt is sustainable and projected on a downward path conditional on fiscal consolidation.

### Financial sector resilience, macroprudentials, and NPL resolution
- Banking sector health:
  - End-2022 bank capital adequacy ratio above most euro area peers; liquidity ratio highest.
  - Short duration of bonds in banks’ portfolios cushioned rate increases.
  - Bank profitability boosted by higher rates and voluntary staff exits (reductions up to 20 percent).
  - New mortgage lending contracted; new loans to NFCs have held up.
- Macroprudential policy:
  - CBC increased CCyB from zero to ½ percent (beginning end-November 2023); phased-in higher O-SII buffers.
  - Staff suggests considering gradually increasing CCyB, accounting for capital-generating capacity.
- NPLs and resolution tools:
  - High legacy NPLs impede growth; progress by large banks in disposing legacy NPLs; slower for smaller banks.
  - Foreclosure framework: repeated suspensions hindered effectiveness; March 2023 parliamentary vote turned down a proposal for a new suspension and framework now operational.
  - CACs and Credit Servicers: CACs hold bulk of NPLs; electronic access to land registry provided; public disclosure of aggregate CAC statistics recommended.
  - Mortgage-to-rent scheme (MtR): plan to transfer some primary residences to KEDIPES and implement MtR with rent subsidies for vulnerable borrowers; implementation contingent on final notification and EC approval; recommend transparent price-setting for embedded repurchase option.
  - Insolvency tools: transposition of EU Directive on Preventive Restructuring and Second Chance; establish dedicated commercial court for cases above €2 million.

### Non-bank financial intermediaries, AML/CFT, and reputational risks
- NBFIs:
  - Growing and improving market diversification; supervisory framework needs strengthening.
  - Contagion risks to banking sector limited due to diversification and small domestic exposures.
  - Recommend strengthening supervisory activities and providing more resources to CySEC.
- AML/CFT and sanctions compliance:
  - Continue addressing AML/CFT weaknesses in supervision of banks and gatekeepers; ensure preventive measures and beneficial ownership accuracy.
  - National Sanctions Implementation Unit established (June 2022) with UK OFSI cooperation.
  - Progress: bills passed to include CASPs among obliged entities; expand Beneficial Ownership Register access; CIP-related criminal investigations ongoing.
  - Continue strengthening enforcement of sanctions compliance to mitigate reputational risks.

### Structural reforms, green transition, and energy investments
- Structural priorities:
  - Resolve legacy NPLs; streamline immigration to address labour shortages; address housing affordability via supply-side measures (strategic rezoning; reinstatement of immovable property tax).
  - Education reforms: increase STEM graduates and vocational participation; update ALMP strategy.
  - Digitalization: modernize NHS IT and public services; enhance communications infrastructure.
- Green transition and energy:
  - Targets: reduce emissions by 32 percent (relative to 2005) in non-ETS sectors by 2030; emissions neutral by 2050.
  - RES share in gross final energy consumption: 2021: 18.4 percent (2011: 6.5 percent); on track for 23 percent goal for 2030.
  - Planned investments: Euro-Asia Interconnector and new LNG terminal; funding mainly from PCI grants and multilateral loans; funding for projects about €3 billion.
  - NECP envisages renewables investments of about €3.3 billion and energy efficiency €2.3 billion by 2030; Plan being updated to be ready by June 2024.
  - Authorities plan to finalize carbon tax legislation by end-2023.

### Key projections and selected indicators (selected time series extracted)
- Real GDP growth (percent): 2019: 5.5; 2020: -4.4; 2021: 6.6; 2022: 2.5; 2023 Est.: 2.8; 2024: 3.0; 2025: 3.1; 2026: 2.9; 2027: 2.9; 2028: 2.9.
- HICP (period average): 2019: 0.5; 2020: -1.1; 2021: 2.3; 2022: 8.1; 2023 Est.: 3.9; 2024: 2.5.
- Unemployment rate (percent, period average): 2019: 7.1; 2020: 7.6; 2021: 7.5; 2022: 6.8; 2023 Est.: 6.5.
- General government debt (percent of GDP): 2019: 90.4; 2020: 113.5; 2021: 101.1; 2022: 86.5; 2023 Est.: 78.3; 2024: 70.6; 2028: 54.9.
- General government balance (percent of GDP): 2019: 1.3; 2020: -5.8; 2021: -1.7; 2022: 2.3; 2023 Est.: 2.1.
- Gross external debt (percent of GDP): 2019: 824.3; 2020: 801.7; 2021: 699.5; 2022: 620.7; 2023 Est.: 555.3.

### Risk assessment, stress tests, and policy priorities
- Sovereign risk: Overall Moderate; near-term low, medium-term moderate, long-term low.
- External debt vulnerabilities: gross external debt high (621 percent of GDP in 2022); gross external financing needs averaging 150 percent of GDP through projection period.
- Key risks (selected from Risk-Assessment Matrix):
  - Intensification of regional conflict(s): Likelihood = High; Impact = High. Policy: allow automatic stabilizers; targeted temporary support; advance reforms.
  - Abrupt global slowdown: Likelihood = High; Impact = High. Policy: allow automatic stabilizers; targeted support; advance reforms.
  - Stronger pass-through of inflation to wages (significant CoLA revision): Likelihood = High; Impact = High. Policy: control public sector wages; adjust fiscal stance.
  - Slow NPL resolution: Likelihood = High; Impact = Medium. Policy: enforce foreclosure framework; avoid undermining credit discipline.
- Policy priorities:
  - Maintain moderately contractionary fiscal stance in 2023 to reduce public debt and contain price pressures.
  - Rebuild buffers and direct fiscal space to productive green and digital investments as debt approaches 60 percent of GDP.
  - Strengthen SOE governance, finalize NHS reform, and reinforce AML/CFT and sanctions compliance.
  - Continue structural reforms to transform Cyprus toward a regional business and ICT hub: improve governance, judicial efficiency, immigration procedures, education and digital skills, and housing supply.

*Source: SM/23/116, 05/11/23 (IMF staff report for the 2023 Article IV consultation with Cyprus).*

### 1. Impact of Russia’s Invasion of Ukraine __________________________________________________________ 13

### 1. Impact of Russia’s Invasion of Ukraine

### Context
- Cyprus proved resilient to the twin shocks of the pandemic and spillovers from Russia’s war in Ukraine, helped by fiscal buffers.
- Economy vulnerabilities noted: high share of contact-intensive services (a quarter of GDP) and pre-war exports to Russia (a tenth of GDP).
- Output contraction about 4½ percent in 2020 (peak of the pandemic).
- Primary fiscal balance turned from a surplus of 3½ percent of GDP in 2019 into an equally large deficit in 2020.
- Public debt ratio rose to 113½ percent of GDP at peak-pandemic.
- Recovery supported by contact-intensive services and a fast-growing ICT sector, but supply constraints and high energy prices contributed to inflation pressures.

### Key policy challenge and recommendations
- Continue rebuilding policy buffers and reduce inflation pressures while advancing on long-standing structural reforms.
- New government (took office in February) committed to maintaining fiscal discipline and to structural reforms under the Recovery and Resilience Plan (RRP), including:
  - Strengthen governance.
  - Improve education.
  - Green the economy.
- Tackle slow resolution of legacy NPLs to reduce private sector indebtedness and vulnerabilities amid financial tightening.
- Recognize political constraint: an uncertain parliamentary majority may hinder effectiveness.

### Recent developments — Growth and demand
- GDP expanded by 5.6 percent in 2022, but growth is now slowing.
- Tourism: 3.2 million arrivals in 2022 (0.8 million short of the 2019 record); promotion campaign and pent-up demand supported recovery despite collapse in tourism from Russia and Ukraine.
- Export-oriented ICT and business services expanded, supported by foreign companies relocating to Cyprus.
- GDP growth slowed in the last quarter of 2022 and high-frequency indicators point to stabilization at a lower level in early 2023.

### Labor market
- Labor market remained tight; output gap estimated at 1½ percent of potential GDP in 2022, now gradually closing.
- Unemployment reached around 6 percent in February 2022 (post-financial-crisis low).
- Participation rate reached a historic high.
- Vacancies elevated in services; tourism faces difficulties attracting workers back; restrictions on employment of third country nationals have been relaxed.

### Inflation and wages
- Headline inflation peaked at 10.6 percent in July (driven by energy and tourism-related price rebound); fell to 6.1 percent in March.
- Core inflation peaked at 7.2 percent in August; averaged 5.7 percent since then and reached 5.2 percent in February.
- Inflation expectations from producers and professional forecasters have remained elevated.
- Nominal wages increased by 6.8 percent in 2022; real wages declined by 1.3 percent in 2022 (all losses in Q3 and Q4).
- Corporate profits remained above pre-Covid levels and higher than in the rest of the euro area, sustained by passing on high input costs.

### Fiscal developments and measures
- Revenues increased by 14½ percent in 2022 due to recovery and inflation.
- Expenses declined as pandemic-era support expired.
- Headline balance swung from a deficit of 1¾ percent of GDP in 2021 to a surplus of 2¼ percent of GDP in 2022.
- Preliminary data indicate sustained collections in early 2023.
- Cost-of-living measures were generally well targeted, time bound, promoted energy conservation, and cost below 1 percent of GDP.
- Table of main measures addressing cost-of-living crisis (amounts are percent of 2022 GDP):
  - Reduction of VAT rates on electricity consumption — Targeted: households and vulnerable customers — Jan - Aug 2022 — 0.09
  - Reduction of excise duties on fuel products — Untargeted — March 2022 - May 2023 — 0.29
  - Subsidy for electricity consumption — Targeted: full compensation for vulnerable households, otherwise tiered — Sept 2022 - Apr 2023 — 0.34
  - Subsidized installation of a photovoltaic system for self-consumption for households and agricultural consumers — Targeted: incremental benefit for vulnerable consumers — Feb 2022 - Dec 2023 — 0.24
  - Total — 0.96

### Public debt and financing
- Public debt declined from 101 percent of GDP in 2021 to 86.5 percent at end-2022.
- Authorities built cash buffers via opportunistic overfinancing during the pandemic: end-2022 cash buffers about 10 percent of GDP (well above 2023 financing needs).
- More than ⅔ of public debt has fixed interest rates; weighted average maturity around 7 years.
- Sovereign debt risk premia relatively high, reflecting a liquidity premium.
- Cyprus issued its first 10-year sustainable bond in April: amount €1 billion, yield 4.2 percent.

### Financial sector and banking
- End-2022 bank capital adequacy ratio stood above most euro area peers; liquidity ratio highest.
- Short duration of bonds in banks’ investment portfolios cushioned impact of interest rate increases.
- Bank profitability boosted by higher interest rates on liquid assets and voluntary staff exits (reductions up to 20 percent).
- Large banks made progress disposing legacy NPLs; progress slower for smaller banks.
- Stage 2 loans (concentrated in tourism) have remained relatively high.
- New lending for mortgages contracted with tighter financial conditions; new loans to NFCs have held up.

### Private sector debt and NPLs
- Private sector deleveraging underway but private sector remains highly indebted.
- Resolution of NPLs slowed ultimate deleveraging; progress achieved by offloading to CACs and public Asset Management Company (KEDIPES), but repayment by borrowers remains slow.
- Stage 2 loans and NPL stocks continue to pose risks if growth disappoints.

### Real estate market
- Residential property price growth picked up in 2022 and reached new post-financial-crisis highs.
- Property sales remained steady despite slowing bank lending; market supported by relocation of employees of foreign companies, especially in premium segments.
- Staff analysis suggests residential real estate prices are aligned with fundamentals.

### External position
- Current account deficit widened from -6¾ percent in 2021 to exceed -9 percent in 2022, driven by higher imports and less-than-full export recovery.
- Negative net international investment position (excluding SPEs) improved but remains elevated.
- Terms-of-trade worsened only moderately as import price increases were partially offset by rising export prices.
- Real exchange rate has depreciated.
- Cyprus’s external position in 2022 assessed weaker than level implied by fundamentals and desirable policies.

*Source: IMF staff report excerpt — "1. Impact of Russia’s Invasion of Ukraine".*

### 13.      Growth is projected to slow this year, but the medium-term outlook is robust. Growth

### 13. Growth is projected to slow this year, but the medium-term outlook is robust.

### Growth outlook
- Growth is projected to slow to around 2½ percent in 2023, reflecting:
  - expected erosion in household disposable income from inflation;
  - tighter financial conditions; and
  - a delayed impact of sanctions against Russia on financial and professional services (as activity related to winding-down Russia-related business is slowing).
- Supporting factors for demand:
  - domestic savings buffers;
  - recovering tourist arrivals;
  - a continued influx of foreign companies; and
  - RRP investments.
- Confidence—driven by services—is higher than in the euro area.
- The output gap will remain positive but small and closing.
- Growth is forecast to start recovering in 2024 and average 3 percent in the medium-term, supported by:
  - RRP investments and structural reforms;
  - large private projects in tourism; and
  - a further expansion of the ICT sector.
- External balance: current account deficits are projected to decline modestly as import prices fall and tourism inflows increase, but the primary income balance is expected to remain in deficit.

### Impact of Russia’s invasion of Ukraine
- Tourism and FDI:
  - Tourism arrivals from Russia have collapsed.
  - Receipts shrank from about €44  0 million in 2021 (1½ percent of GDP, around than a fifth of the total) to almost zero in 2022.
  - Higher arrivals from other regions aided an overall strong recovery, but segments catering to Russian tourists were impacted disproportionately.
  - The stock of direct investments in Russia remains large but has shrunk and new activity has halted.
  - Cyprus’s direct investment positions with Russia—assets and liabilities of around 450 percent of GDP in 2022—reflect past round-tripping of capital.
  - Gross flows declined sharply post-invasion.
- Exports of professional and financial services:
  - Accounting, auditing, bookkeeping and tax consulting services, as well as business/management consulting and public relations services have been banned by EU sanctions since June 2022; and IT consultancy, legal advice, as well as architecture and engineering services since October.
  - Activity has been supported by winding-down Russia-related business and the provision of basic services but is expected to shrink this year.
  - Net flows of financial services were down by a third (y-o-y) in Q4, but they still accounted for €1 billion (3.8 percent of GDP) in 2022 and will likely shrink given the freezing of investment activities.
- Energy and banking exposure:
  - Cyprus’s energy import from Russia is small: about 1 percent was imported from Russia (2020).
  - Russian deposits in the banking system were low at about 4 percent at end-2021.
  - Lending exposure to Russian businesses is anecdotally negligible.
  - Exposures declined after the RCB was orderly liquidated and its banking license revoked at end-2022 (remaining portfolio managed by Finstella Ltd operating under CAC and electronic money institution licenses).

### Inflation outlook and drivers
- Headline inflation projections:
  - around 4   percent in 2023; and
  - 2½ percent in 2024.
- Core inflation is expected to be stickier due to second-round wage effects and elevated producer price expectations.
- Policy assumption: no major revisions to the partial cost-of-living allowance (CoLA); salaries of public sector employees and those in professions governed by collective agreements raised by half of the previous year increase in the CPI.
- Pass-through and second-round effects:
  - A 1 ppt increase in inflation caused by an exogenous shock raises wages in the private sector by 1.4 percent and in the public sector by 2.3 percent.
- Expectations:
  - Producer expectations have plateaued at an elevated level in retail sales and in services, while longer-horizon expectations (3-, 5-, and 10-year) remain well anchored.

### Risks to the baseline
- Tilt: risks are tilted to the downside for growth and upside for inflation.
- External adverse shocks that could worsen the outlook:
  - further effects from Russia’s war in Ukraine (including possible additional sanctions);
  - a recession in Europe;
  - new commodity price shocks; and
  - increased geopolitical risks.
- Domestic risks:
  - stronger pass-through of inflation to wages, amplified by sectoral labor market tightness;
  - uncertainty about wage dynamics, including possible revisions to CoLA.
- Offsetting positive scenarios: de-escalation of the war, a fall in oil prices, and upward growth revisions in the EU.

### Authorities’ views
- Authorities broadly shared staff’s view on the outlook but expect inflation—including core—to normalize faster.
- They expect real GDP growth to slow in 2023 but to pick up slightly more than staff projections in the medium-term due to a higher payout from structural reforms.
- Authorities viewed risks to the outlook as broadly balanced and emphasized progress in economic diversification.
- They agreed on the need to lower public debt levels further to rebuild buffers and saw tight fiscal policy as helpful to tame inflation.
- Authorities considered Cyprus’s social protection system generally well-targeted and sufficient but saw scope for strengthening activation requirements of the GMI.

### Fiscal policy: assessment and recommendations
- 2023 stance:
  - A moderately contractionary fiscal stance in 2023 remains appropriate to lower public debt and contain price pressures.
  - Under current spending plans, staff projects a primary surplus of 3½ percent of GDP—lower than in 2022, but sufficient to deliver a moderately tight fiscal impulse (estimated at 0.2 percent of GDP) to help contain price pressures from aggregate demand.
- Wage bill and CoLA:
  - Assuming no change in the CoLA mechanism, the wage bill is projected to grow by about 7 percent with the unwinding of crisis-era wage cuts accounting for about 1.5 ppts and the CoLA for 2.5 ppts.
  - Upward revisions to CoLA would further increase the wage bill, reduce fiscal space, and put pressure on private sector wages; a stronger automatic link between wages and inflation would make fiscal policy more pro-cyclical.
- Social protection:
  - The social safety net—including the Guaranteed Minimum Income (GMI) scheme introduced in 2014—is well-targeted and relatively generous in replacement ratios.
  - More frequent adjustments to the consumption basket could be considered to safeguard purchasing power of vulnerable households, accompanied by strengthened labor activation requirements (for instance regarding the documentation of job search activity).
- Response to shocks:
  - Fiscal response should be informed by the nature of the shock.
  - Automatic stabilizers should be allowed to operate in a further growth slowdown.
  - Higher energy prices may call for additional support to the vulnerable, but such support should be temporary, targeted, not distorting price signals, and—not relaxing the overall fiscal stance—unless slack is larger and wage pressures are absent.
- Medium-term objectives:
  - Aim at reducing public debt while creating fiscal space for productive investments.
  - Under a no-policy-change scenario, continued fiscal surpluses are projected, which—alongside solid growth prospects and favorable interest rate/inflation differential—will keep public debt sustainable and on a downward trajectory.
  - As buffers are rebuilt—debt ratio falling toward the 60 percent benchmark—available fiscal space should be directed to productive investments, including unfunded green projects in the National Energy and Climate Plan (NECP).
- Fiscal rules:
  - A modernized fiscal rule framework would help achieve medium-term fiscal objectives.
  - A new risk-based fiscal rule with a medium-term overall balance and debt anchors, and an expenditure ceiling as the operational rule, would support macroeconomic stabilization.
  - Capacity of the national Fiscal Council should be strengthened to safeguard fiscal sustainability.

### RRP disbursements and fiscal risks
- RRP status:
  - After receiving €157 million in pre-financing in September 2021, the first tranche (€85 million) was disbursed in December 2022, upon completion of 14 RRP milestones—mostly in the electricity market, energy efficiency, the circular economy, anti-corruption, and transparency.
  - Large investments under the plan (over 3½ percent of GDP) may face capacity constraints; timelines and feasibility studies are under review to minimize risks of losing funds.
- Minimizing fiscal risks:
  - Advance the reform of the National Health System (NHS) with careful assessment of subsidy extensions to public hospitals beyond mid-2024.
  - Strengthen governance and oversight of state-owned enterprises (SOEs):
    - SOEs play a substantial role in energy, telecommunications, and water sectors.
    - Potential fiscal risks include government guarantees of around 5 percent of GDP.
    - Steps taken: enhanced SOE reporting, mandated medium-term budgetary frameworks, application of the Code of Public Governance.
    - Further actions: strengthen government capacity to oversee SOEs, increase independence and autonomy of boards, and centralize oversight for commercial entities in a single unit.

*Source: IMF staff report excerpt (chapter 13).*

### 26.      Significant progress has been achieved in improving bank resilience, but risks remain.

### 26.      Significant progress has been achieved in improving bank resilience, but risks remain.

### Banking sector resilience and risks
- Findings:
  - The passthrough from higher policy rates to lending rates has been slow—mortgage rates are mostly variable, but often indexed to a bank base rate linked to a still low deposit rate. This has, for now, mitigated repayment risks.
  - Credit risks are likely to rise for highly leveraged households and corporates with the tightening of financial conditions and slowing growth.
  - Banks' capital ratios are comfortably above regulatory minima, but authorities should closely monitor rising risks.
- Staff appraisal summary:
  - So far, higher policy rates have boosted bank profitability, but credit risks are likely to rise with financial tightening—especially given the high private sector indebtedness—and should be monitored.
  - The initiation of a positive neutral CCyB rate will improve resilience, which would be enhanced by building larger buffers over time.

### Macroprudential policy and buffers
- Actions taken:
  - The CBC increased the countercyclical buffer (CCyB) rate from zero to ½ percent (beginning end-November 2023) when risks were assessed as broadly neutral.
  - The CBC has phased-in higher O-SII buffers in the context of a regular re-assessment.
- Assessment and recommendations:
  - The initial CCyB rate of ½ percent is somewhat lower than in other jurisdictions with positive neutral CCyBs; consideration could be given to gradually increasing it—taking into account bank capital-generating capacity—to provide a larger cushion during stress.
  - The CBC’s holistic approach—based on a range of quantitative and qualitative indicators, including credit dynamics and real estate developments—provides a good basis for guiding macroprudential policy decisions.

### Resolution of legacy NPLs and restructuring
- Key constraints and progress:
  - High NPLs impede growth by impairing credit markets.
  - The Foreclosure Law's effectiveness has been hindered by repeated suspensions; implementation of the 2019 amendments has not been tested in practice.
  - A parliamentary vote in March 2023 turned down a proposal for a new suspension, and the foreclosure framework is now operational.
- Specific elements and recommendations:
  - Foreclosure framework:
    - An effective foreclosure framework and certainty regarding its implementation are critical for addressing strategic defaulters and supporting restructuring.
    - The framework should be implemented forcefully to address strategic defaulters.
  - CACs and Credit Servicers (CS):
    - Repeated suspensions of the foreclosure framework have undermined CACs and CS activities, inducing non-cooperative borrowers to hold off restructurings.
    - CACs and CS now have electronic access to land registry database; access to the credit registry by CS requires CBC approval.
    - Given that CACs now hold the bulk of NPLs, publicly disclosing aggregate CACs statistics would allow better monitoring of solvency risks and progress in resolving legacy NPLs.
  - Mortgage-to-rent scheme (MtR):
    - Authorities plan to transfer some primary residences used as collateral for NPLs (after a debt-to-asset swap) to KEDIPES (a public CAC) and implement an MtR scheme, with rent subsidies for vulnerable borrowers.
    - Progress has been made with better targeting.
    - To further minimize fiscal impact, additional safeguards should include a transparent price-setting procedure for the embedded repurchase option.
    - Implementation is contingent on final notification by the authorities and approval by the European Commission (DG COMP) of necessary amendments to the 2018 decision on liquidation aid to Cyprus Cooperative Bank to allow KEDIPES to manage the scheme.
  - Insolvency tools:
    - Banks should proactively use all available tools to enable timely restructuring of viable businesses in financial difficulties.
    - Recent transposition of the EU Directive on Preventive Restructuring and Second Chance into national legislation should help.
    - Continued efforts are needed to advance envisaged new hybrid/out-of-court restructuring procedures.
    - The establishment of a dedicated court for commercial cases (including insolvency ones) above €2 million—expected to come into effect this year—should help improve judicial efficiency and strengthen enforcement of commercial claims.

### Non-bank financial intermediaries (NBFIs) and supervision
- Findings:
  - NBFIs have been growing, improving market diversification but requiring a stronger supervisory framework.
  - Risks of contagion from NBFIs to the banking sector and the economy are limited—due to diversification of investments and comparatively small domestic exposures as the sector mainly caters to non-residents.
- Recommendations:
  - The CBC has been expanding its macroprudential oversight appropriately.
  - In line with recommendations by the European Securities and Markets Authority (ESMA), supervisory activities should be strengthened.
  - More resources should be provided for the Cyprus Securities and Exchange Commission (CySEC) to address shortcomings in the oversight of cross-border activities.

### AML/CFT, sanctions compliance, and reputational risks
- Recommendations and progress:
  - Authorities should continue efforts to address identified AML/CFT framework weaknesses, including supervision of banks and gatekeepers (e.g., lawyers, accountants, and trust and company service providers).
  - Preventive measures should be implemented (e.g., customer due diligence and measures for politically exposed persons).
  - Ensure availability and accuracy of beneficial ownership information framework in line with the revised requirements for Recommendation 24 of the FATF.
  - Cyprus should address remaining technical compliance deficiencies (including requirements for correspondent banking relationships).
  - Authorities should continue monitoring any potential misuse of the terminated Citizenship by Investment Program (CIP).
- Sanctions implementation:
  - In the context of the war in Ukraine, enforcement of regulatory provisions on sanctions compliance should be strengthened to mitigate reputational risks.
  - In cooperation with the UK Office of Financial Sanctions Implementation, in June 2022 authorities started establishing a National Sanctions Implementation Unit to ensure effective implementation of EU and UN restrictive measures and to increase awareness among domestic stakeholders.
- Authorities’ stated actions:
  - Authorities remain committed to further enhancing the legal framework and addressing remaining AML/CFT gaps.
  - Progress cited includes passage of bills related to MONEYVAL recommendations, including Crypto Asset Services Providers (CASPs) in the list of obliged entities for the prevention of ML/TF, and expanding access to the Beneficial Ownership Register of companies and other legal entities and bringing it online.
  - Criminal investigations on several suspicious cases identified by the Commission of Inquiry for CIP are ongoing.
  - Authorities expressed interest in participating in the multi-country technical assistance program by the European Commission (DG REFORM) to support effective and uniform implementation of sanctions under the Technical Support Instrument.

### Authorities’ views (financial sector)
- Agreed points:
  - Current global environment poses financial sector risks but those are mitigated by strong buffers.
  - High inflation and rising interest rates may pose debt repayment challenges for highly indebted private sector and closely monitoring financial risks is necessary.
  - The banking sector has ample liquidity improving profitability and sufficient capital to withstand shocks, further enhanced by the built up of macroprudential buffers.
  - While considering building larger countercyclical buffers, authorities emphasized the importance of gradual implementation.
  - Noted further reduction in legacy NPLs and concurred that a sound foreclosure framework is crucial for further progress.

### Growth, fiscal policy, and structural reforms (Staff appraisal highlights)
- Growth and outlook:
  - Growth will slow in 2023, facing headwinds from inflation and financial tightening.
  - The rebound in tourism and expansion of the ICT sector is expected to continue, against headwinds from the tightening of financial conditions and persistent inflation pressures.
  - Risks remain to the downside, including from a deeper slowdown in Europe.
  - Growth is forecast to gradually pick up from 2024 and average 3 percent in the medium-term, supported by structural reforms under the RRP.
  - The external position has been weaker in 2022 than implied by fundamentals and desirable policies and is set to strengthen only gradually.
- Fiscal policy:
  - A moderately contractionary fiscal stance in 2023 remains appropriate to contain price pressures and further reduce public debt.
  - The 2023 budget—underpinned by prudent revenue projections and contained expenditures—generates a small negative fiscal impulse of 0.2 percent of GDP in 2023.
  - Fiscal policy should stand ready to respond if growth turns out weaker than expected, allowing automatic stabilizers to work, and through targeted and time-bound support measures—relaxing the fiscal stance only if significant slack emerges.
  - Fiscal policy should aim at sustaining primary surpluses to reduce public debt over time, supported by a risk-based fiscal framework.
  - As buffers are rebuilt, available fiscal space should be directed to productive investments for the green and digital transitions.
  - Putting the NHS on a sound fiscal footing and strengthening governance and accountability of SOEs will help maintain the planned fiscal path.
- Labor market, wages, and social policy:
  - Decisions on wage indexation and support measures should be based on a holistic view of their macroeconomic impact.
  - A fuller automatic adjustment of wages to inflation through the CoLA mechanism should be avoided as it would likely make inflation more persistent, adversely affect competitiveness, and reduce fiscal space.
  - The guaranteed minimum income may need to be carefully recalibrated while strengthening its activation requirements.
- Structural reform priorities:
  - Steadfast implementation of policies to address legacy NPLs would facilitate faster resolution and private sector deleveraging.
  - Further structural reforms are key to unlock growth potential: streamline immigration to address labor market shortages; address housing affordability via supply-side measures like strategic rezoning and reinstatement of the immovable property tax.
  - Income tax incentives for taking up employment in Cyprus should aim at balancing sustainable development and fiscal costs (the impact of the recently introduced 50 percent renumeration exemption has been small).
  - RRP reforms and investments should focus on improving governance, future-proofing workers’ skills, and supporting the digital transition.
  - Reforms to improve governance include combating corruption and improving judicial services to reduce court backlog; strengthening SOE governance and accountability is also important.
  - Education reforms to increase STEM graduates and vocational participation, and an updated active labor market policies (ALMP) strategy, are priorities.
  - Digitalization of public services, modernizing NHS IT systems, and enhancing communication infrastructure are included in the digital transition agenda.

### Green transition and energy investments
- Targets and current status:
  - Cyprus aims to reduce emissions by 32 percent (relative to 2005) in non-ETS sectors by 2030 and to become emissions neutral by 2050.
  - The share of renewable energy sources (RES) in gross final energy consumption in 2021 was 18.4 percent (compared with 6.5 percent in 2011), well above the 13 percent target set for 2020 and on track to meet the 23 percent goal set for 2030.
- Planned investments and measures:
  - Construction has started on a new LNG terminal and development of electricity interconnection with Europe, Israel, and Egypt through the Euro-Asia Interconnector—EU Projects of Common Interest (PCI)—to reduce reliance on CO2-heavy oil and facilitate transition to RES.
  - Other investments are directed to upgrade and digitalize the electricity grid.
  - Funding for these projects—amounting to about €3 billion—will be mainly from PCI grants and multilateral loans.
  - NECP envisages investments in renewables of about €3.3 billion and in energy efficiency of €2.3 billion by 2030, from yet-to-be fully identified public and EU funds.
  - The Plan is now being updated to be ready by June 2024.
  - Authorities plan to finalize legislation for the introduction of a carbon tax by end-2023.
  - Preliminary analysis of the effects of the EU carbon border adjustment mechanism—which is expected to enter fully into force in 2026—points to a modest impact given limited trading in carbon-intensive sectors.
- Staff appraisal conclusion:
  - A greener growth model is an important element of reforms; integration into the regional electric grid and expansion of renewables—together with liberalization of the domestic electricity market—are key elements and will also improve energy security, but require large public and private investments.

*Source: 1cypea2023001 - 26.      Significant progress has been achieved in improving bank resilience, but risks remain.*

### 48.      It is proposed that the next Article IV consultation take place on the standard 12-

### 1cypea2023001 - 48.      It is proposed that the next Article IV consultation take place on the standard 12-

### Proposed Decision
- The Executive Board endorses the thrust of the staff appraisal in the report for the 2023 Article IV consultation with the Cyprus (SM/23/116, 05/11/23).
- It is expected that the next Article IV consultation with the Cyprus will take place on the standard 12-month cycle.

### Real Economy: Key Projections and Indicators (Selected)
- Real GDP growth: 2019: 5.5; 2020: -4.4; 2021: 6.6; 2022: 2.5; 2023 Est.: 2.8; 2024: 3.0; 2025: 3.1; 2026: 2.9; 2027: 2.9; 2028: 2.9
- Domestic demand: 2019: 6.2; 2020: -3.6; 2021: 3.0; 2022: 9.8; 2023 Est.: 2.6; 2024: 2.9; 2025: 3.2; 2026: 3.4; 2027: 3.4; 2028: 3.3
- Exports of goods and services: 2019: 8.7; 2020: 2.2; 2021: 13.6; 2022: 14.3; 2023 Est.: 6.6; 2024: 3.3; 2025: 3.0; 2026: 3.0; 2027: 2.7; 2028: 2.6
- Imports of goods and services: 2019: 9.5; 2020: 3.2; 2021: 9.0; 2022: 19.5; 2023 Est.: 6.1; 2024: 3.4; 2025: 3.3; 2026: 3.4; 2027: 3.2; 2028: 3.0
- Potential GDP growth: 2019: 5.1; 2020: -0.8; 2021: 4.6; 2022: 3.6; 2023 Est.: 3.5; 2024: 3.0; 2025: 3.1; 2026: 3.1; 2027: 2.9; 2028: 2.9
- Output gap (percent of potential GDP): 2019: 1.2; 2020: -2.4; 2021: -0.5; 2022: 1.4; 2023 Est.: 0.4; 2024: 0.3; 2025: 0.1; 2026: 0.0; 2027: 0.0; 2028: 0.0
- HICP (period average): 2019: 0.5; 2020: -1.1; 2021: 2.3; 2022: 8.1; 2023 Est.: 3.9; 2024: 2.5; 2025: 2.2; 2026: 2.1; 2027: 2.0; 2028: 2.0
- Unemployment rate (percent, period average): 2019: 7.1; 2020: 7.6; 2021: 7.5; 2022: 6.8; 2023 Est.: 6.5; 2024: 6.2; 2025: 5.9; 2026: 5.8; 2027: 5.6; 2028: 5.4

### Public Finance: Developments and Projections (Percent of GDP)
- General government balance: 2019: 1.3; 2020: -5.8; 2021: -1.7; 2022: 2.3; 2023 Est.: 2.1; 2024: 1.9; 2025: 1.7; 2026: 1.6; 2027: 1.3; 2028: 1.2
- Revenue: 2019: 39.4; 2020: 38.8; 2021: 41.4; 2022: 42.1; 2023 Est.: 40.6; 2024: 40.4; 2025: 40.1; 2026: 39.5; 2027: 39.3; 2028: 39.2
- Expenditure: 2019: 38.1; 2020: 44.6; 2021: 43.1; 2022: 39.9; 2023 Est.: 38.5; 2024: 38.5; 2025: 38.3; 2026: 38.0; 2027: 38.0; 2028: 38.0
- Primary Fiscal Balance: 2019: 3.5; 2020: -3.6; 2021: 0.1; 2022: 3.8; 2023 Est.: 3.5; 2024: 3.3; 2025: 3.1; 2026: 2.8; 2027: 2.6; 2028: 2.5
- General government debt (percent of GDP): 2019: 90.4; 2020: 113.5; 2021: 101.1; 2022: 86.5; 2023 Est.: 78.3; 2024: 70.6; 2025: 66.5; 2026: 61.4; 2027: 58.2; 2028: 54.9
- Structural primary balance: 2019: 3.1; 2020: -3.0; 2021: 0.2; 2022: 3.2; 2023 Est.: 3.4; 2024: 3.2; 2025: 3.0; 2026: 2.8; 2027: 2.6; 2028: 2.5

### General Government Financing: Key Figures (Millions of Euros)
- Gross borrowing needs: 2019: 3,335; 2020: 3,675; 2021: 2,779; 2022: 1,630; 2023 Est.: 1,037; 2024: 1,891; 2025: 1,329; 2026: 1,996; 2027: 2,061; 2028: 2,438
- Gross financing sources: 2019: 2,875; 2020: 3,647; 2021: 2,651; 2022: 1,457; 2023 Est.: 1,037; 2024: 1,891; 2025: 1,329; 2026: 1,996; 2027: 2,061; 2028: 2,438
- Cash holding (eop): 2019: 947; 2020: 3,616; 2021: 2,762; 2022: 2,595; 2023 Est.: 2,990; 2024: 2,536; 2025: 3,040; 2026: 3,034; 2027: 3,460; 2028: 3,759
- General government debt (eop, percent of GDP): 2019: 90.4; 2020: 113.5; 2021: 101.1; 2022: 86.5; 2023 Est.: 78.3; 2024: 70.6; 2025: 66.5; 2026: 61.4; 2027: 58.2; 2028: 54.9

### Balance of Payments and External Sector (Selected)
- Current account balance (percent of GDP): 2019: -5.6; 2020: -10.1; 2021: -6.8; 2022: -9.1; 2023 Est.: -7.9; 2024: -7.4; 2025: -7.3; 2026: -7.2; 2027: -7.2; 2028: -7.1
- Trade balance (goods and services): 2019: 1.0; 2020: -1.4; 2021: 2.9; 2022: -0.4; 2023 Est.: 0.5; 2024: 0.8; 2025: 1.0; 2026: 1.0; 2027: 0.8; 2028: 0.7
- Exports (goods and services, percent of GDP): 2019: 76.5; 2020: 81.4; 2021: 86.6; 2022: 91.5; 2023 Est.: 91.8; 2024: 91.7; 2025: 91.2; 2026: 90.7; 2027: 90.0; 2028: 89.5
- Imports (goods and services, percent of GDP): 2019: 75.5; 2020: 82.8; 2021: 83.7; 2022: 91.9; 2023 Est.: 91.2; 2024: 90.9; 2025: 90.2; 2026: 88.7; 2027: 88.2; 2028: 88.8
- Gross external debt: 2019: 824.3; 2020: 801.7; 2021: 699.5; 2022: 620.7; 2023 Est.: 555.3; 2024: 526.5; 2025: 502.7; 2026: 481.0; 2027: 463.8; 2028: 450.1
- Net IIP (percent of GDP): 2019: -115.4; 2020: -134.5; 2021: -117.8; 2022: -105.3; 2023 Est.: -103.7; 2024: -107.6; 2025: -107.7; 2026: -107.5; 2027: -107.2; 2028: -107.7

### External Sector Assessment: Summary Findings and Projections
- Overall assessment: The external position of Cyprus was weaker in 2022 than the level implied by fundamentals and desirable policies. Due to expected improvements in the terms of trade and a declining current account deficit, the external position is likely to improve in 2023. Over the medium term, the current account deficit is set to continue narrowing, albeit slowly and remaining at a high level. The NIIP is projected to remain broadly stable relative to GDP.
- Foreign assets and liabilities:
  - NIIP history: -163 percent of GDP in 2014; -115 percent in 2019; -135 percent in 2020; strongly to –1  18 percent of GDP and -1 05 percent of GDP in 2021 and 2022 (text as provided).
  - Excluding SPEs: underlying NIIP improved from -78 percent of GDP in 2014 to -41 percent at end-2019; fell to -54 percent during the pandemic; recovered to -36 percent by end-2022.
  - Gross liabilities declined to an estimated 1920 percent of GDP in 2022, with around one third in the form of external debt.
  - Under the IMF staff’s baseline scenario, the NIIP is projected to remain broadly stable relative to GDP in the medium term.
- Current account:
  - Background: CA deficit averaged -4.9 percent during 2017-19; widened substantially in 2020; recovered in 2021; deteriorated substantially in 2022 due to widening of the trade balance.
  - Model estimates: EBA CA norm at -2.8 percent of GDP; adjusted CA estimate of -6.6 percent of GDP (accounting for cyclical contributions -0.2 and temporary factors -0.2). Policy gaps contribute 4.2 percentage points. IMF staff assesses the CA gap to be -3.8 percent of GDP for 2022, implying the external position was weaker than warranted by fundamentals and desirable policy settings.
- Real exchange rate:
  - CPI-based REER depreciated by 1.3 percent in 2022.
  - REER gap estimates: CA-gap-based suggests REER overvaluation of 6.5 percent in 2022; ES model suggests no significant REER gap; REER model suggests a negative REER gap of 3.5 percent. Staff assessment: slight overvaluation, weighting CA model more heavily.
- Capital and financial accounts:
  - Capital inflows declined to 4.4 percent of GDP in 2021; increased to 6.0 percent of GDP in 2022 driven by higher FDI.
  - Assessment: With sizable external debt of the public and private sectors, Cyprus remains exposed to financial market risks; tightening financial conditions could increase vulnerability.
- FX interventions and reserves:
  - Background: the euro has the status of a global reserve currency.
  - Assessment: Reserves held by the euro area are typically low relative to standard metrics, but the currency is free floating.

### Policy Recommendations and Status (Selected from Annex I)
- Safeguarding financial stability:
  - Introduce effective foreclosure framework: Implemented (parliament turned down a new suspension after two years of suspension).
  - Improve working environment for CACs (online access to land registry): Partially implemented (online access granted; transparency impeded by no public disclosing of CACs statistics and data).
  - Mortgage-to-rent scheme: Partially implemented (revised scheme better targeted; implementation contingent on final notification by the authorities and approval by the EC).
  - AML/CFT framework: Partially implemented (progress in strengthening AML/CFT regulation and supervision).
- Gradually rebuilding buffers:
  - Cyclical tightening of fiscal position: Implemented (primary balance turned into a surplus in 2022).
  - Targeted, temporary support measures: Partially implemented (new measures generally well targeted).
  - Strengthen financial discipline in the NHS: Partially implemented (cost control measures and reforms ongoing).
  - Control the wage bill: Partially implemented (contained within nominal GDP growth; CoLA adjustments under discussion).
  - Reinstate immovable property tax: Not implemented.
- Structural reforms:
  - Enhance rule of law, reduce backlog, strengthen commercial claims enforcement: Partially implemented (broad reforms passed; commercial court legislation approved and to come into effect in second half of the year).
  - Better control of corruption: Partially implemented (whistleblower protection and new independent anti-corruption agency established; some operational questions remain).
  - Address skills gap and mismatches: Partially implemented (small investments and innovations ongoing; broader overhaul not yet implemented).
  - Improve electricity connectiveness: Partially implemented (EuroAsia Interconnector progressing).
  - Introduce carbon tax on non-ETS fuels: Not implemented (progress expected this year).

*Source: SM/23/116, 05/11/23 (IMF staff report for the 2023 Article IV consultation with Cyprus).*

### Annex III  . Sovereign Risk and Debt Sustainability Framework

### Annex III. Sovereign Risk and Debt Sustainability Framework

### Overall Sovereign Risk Assessment
- Overall: Moderate.  
  - "The overall risk of sovereign stress is moderate, reflecting relatively solid economic fundamentals and sizable buffers."
- Near-term: Not published/applicable in surveillance-only cases; assessments performed but not published for surveillance-only or precautionary arrangements.
- Medium-term: Moderate.  
  - Mechanical signals: Fanchart = Low, GFN = Moderate, Stress test = Low.  
  - Staff final assessment: Moderate, "reflecting small-country volatility picked-up by the fan chart analysis' relatively large band for possible outcomes for the debt path. Despite low GFN-associated risks, still-high NPLs in the private sector pose risks to the government financing needs."
- Long-term: Low.  
  - "Long-term risks are low as aging-related risks remain contained (as captured by the European Commission S2 indicator...)."
- Debt stabilization in the baseline: Yes.

### DSA Summary Assessment and Commentary
- Main judgment: "Cyprus's public debt is sustainable, with public debt expected to remain on a downward path and financing needs at manageable levels, conditional on staying the course with fiscal policy consolidation."
- Near-term sovereign stress risks: Low, given:
  - High cash buffers.
  - Moderate funding costs.
  - Stable financing needs.
  - Resilient fiscal and macroeconomic performance.
- Medium-term risks: Moderate due to:
  - Macroeconomic volatility captured in stochastic simulations.
  - High NPLs in the private sector increasing vulnerability of public debt and financing needs to macro-financial shocks.
- Long-term risks: Low.

### Debt Coverage, Structure, and Maturity
- Debt coverage and disclosure: "Consistent with standard recommendations." Government-guaranteed debt is not included in public debt.
- Ownership and creditors:
  - Majority of public debt is owned by non-residents.
  - About one third reflects financing from official creditors, including the ESM, EIB and CEB.
- Currency: All outstanding government debt is in euro.
- Maturity: Authorities have extended average maturity in recent years; residual maturity reported as 5.9 years.
- Instrument and holder trends: (figures and charts indicate marketable vs nonmarketable debt, holders split including external private/official creditors, domestic banks, central bank, etc.)

### Baseline Scenario and Debt Dynamics
- Projection: Public debt projected to remain on a firm downward path, driven by:
  - Continued growth.
  - Primary surpluses.
  - Contained funding costs.
- Contributions to change in public debt shown via components: primary deficit, real interest rate and relative inflation, real GDP growth, exchange rate depreciation, other flows, residual.
- Realism of baseline assumptions:
  - "Baseline assumptions of most debt drivers do not point to a systematic bias in the forecast track record, which is broadly in line with those observed in peer surveillance countries."
  - Cyprus is a small open economy; cyclical position is hard to estimate and historical analysis shows a mixed track record on output gap revisions.
  - Projected decline in public debt relies on continued growth, fiscal prudence and favorable financing conditions.

### Medium-term Risk Tools
- Debt Fanchart Module: Points to medium level of risk.
- GFN Financeability Module: Suggests a low level of risk.
- Vulnerabilities: Given high debt-to-GDP ratio and contingent liabilities from the banking sector, both debt reduction and financing needs are susceptible to a bank stress test.
- Stress-test triggers shown include: banking crisis, commodity prices, exchange rate, contingent liabilities, natural disaster.

### External Debt Sustainability (Annex IV)
- Context: Cyprus is a regional financial center with large external assets and liabilities; SPEs can cause large and volatile gross positions even if net positions are unchanged.
- Baseline projections and levels:
  - External debt stood at 621 percent of GDP in 2022.
  - Government external debt declined to 69 percent of GDP in 2022, down from a peak of 99 percent of GDP in 2021.
  - Net debt declined to 58 percent of GDP.
  - Gross external debt is projected to decline gradually to below 500 percent of GDP in 2028.
  - Government external debt is projected to gradually decline to around 60 percent of GDP at the end of the projection period.
- Gross external financing needs:
  - Projected to start declining this year but remain elevated, "averaging 150 percent of GDP through the projection period," reflecting a sizable stock of private sector short-term debt.
- Risks and policy implications:
  - Standardized shocks to interest rates and economic growth would significantly impede debt reduction.
  - Standardized current account deficit shocks would have a more limited impact on the debt ratio.
  - Policy priorities: sound financial sector policies, structural reforms for diversification, prudent fiscal policy, and strong maturity management.

### External Debt Stress Tests and Bound Tests
- Scenarios illustrated include baseline, historical scenarios, interest rate shock (200 bps), and combined shocks (permanent ¼ standard deviation shocks to real interest rate, growth rate, and current account).
- Shocks materially increase gross external debt paths and gross financing needs, indicating vulnerability given the large stock of gross external debt.

### Risk-Assessment Matrix — Key Risks, Likelihoods, Impacts, and Policy Responses (Selected)
- Intensification of regional conflict(s) (e.g., escalation of Russia’s war in Ukraine): Likelihood = High; Expected Impact = High.  
  - Policy responses: Allow automatic stabilizers; targeted and temporary support measures; expand active labor market policies; advance structural reforms; encourage market diversification.
- Abrupt global slowdown or recession: Likelihood = High; Expected Impact = High.  
  - Policy responses: Allow automatic stabilizers; targeted and temporary support measures; expand active labor market policies; advance structural reforms; encourage market diversification.
- Commodity price volatility: Likelihood = Medium; Expected Impact = High.  
  - Policy responses: Targeted and temporary support measures; adjust fiscal policy stance to minimize second-round effects.
- Deepening geo-economic fragmentation: Likelihood = High; Expected Impact = Medium.  
  - Policy responses: Advance structural reforms; encourage market diversification; rebuild fiscal buffers.
- Extreme climate events: Likelihood = Medium; Expected Impact = High.  
  - Policy responses: Invest to enhance resilience; incorporate financing needs for climate adaptation into long-term plans.
- Cyberthreats: Likelihood = Medium; Expected Impact = Medium.  
  - Policy responses: Encourage investment in cybersecurity by banks; review and strengthen national cyber security risk management and mitigation policies.
- Stronger pass-through of inflation to wages (significant upward revision to CoLA mechanism): Likelihood = High; Expected Impact = High.  
  - Policy responses: Control public sector wages; adjust fiscal stance to avoid excessive pass-through and minimize risk of a wage-price spiral.
- Slow NPLs resolution (progress stalls, with legacy NPLs largely offloaded to Credit Acquiring Companies): Likelihood = High; Expected Impact = Medium.  
  - Policy responses: Enforce the foreclosure framework and avoid undermining credit discipline.

### Cyprus’s Business Model After Russia’s War (Annex VI — Key Points)
- Strategic opportunity: "The current juncture may offer an opportunity to move to a new business model leveraging Cyprus’s location and strong professional services to transform the country into a regional business and ICT hub."
- Progress: Recent successes in attracting foreign companies and professionals are positive, but "more needs to be done."
- Historical links with Russia:
  - Cyprus used to benefit from strong financial connections with Russia, generating significant business in professional services and spillovers to other segments of the economy.
  - Nearly half of Russian FDI is registered in Cyprus, reflecting past round-tripping of capital to benefit from Cyprus’s tax system and legal framework and the presence of shell companies managing third-country investment into Russia.

*Source: Fund staff.*

### 2.      Disruptions from Russia’s war in Ukraine strongly impacted cross-country capital and

### 2.      Disruptions from Russia’s war in Ukraine strongly impacted cross-country capital and 

### Impact on cross-country capital and payment flows
- Both primary income credit and debit with Russia declined strongly in 2022.
- Confidential data on payment flows between Cyprus to Russia have collapsed, especially flows from Russia to Cyprus.
- Flows with many other countries declined too, likely driven by FDI from and to Russia registered in Cyprus.
- Example: a large decline in outflows to Belgium is likely related to Belgium’s InBev former presence in the Russian beer market (partly registered in Cyprus).
- There has also been a large drop in inflows from the United Kingdom and in outflows to the United States, indicating substantial economic links between these countries and Russia through Cyprus.

### Services exports to Russia and sanctions impact
- Financial services and other services exports were initially resilient but then started falling as investment activities froze and horizontal sanctions restricted services exports.
- Since June 2022, the European Union prohibits the provision of accounting, auditing, bookkeeping and tax consulting, business/management consulting, and public relations services to Russia.
- These sanctions have already had a small impact on Cypriot services exports to Russia from Q3:2022.
- In October 2022, European sanctions further prohibit providing IT consultancy, legal advice, architecture, and engineering services to Russia.
- Financial services in Q4 were down by a third compared to a year earlier and the impact is expected to intensify with implications for growth and the external balance this year.

### Potential for reorientation and regional financial integration (IMF global gravity model)
- An IMF global gravity model on bilateral capital and payment flows (estimated with data from CEPII, the World Bank, and internal IMF sources) shows countries that are closer to each other tend to have more flows, even after controlling for merchandise trade and many other country and country-pair characteristics.
- This suggests Cyprus could leverage its location as the European Union’s most easterly member and placed uniquely between three continents.
- A simple simulation based on this model indicates substantial potential for closer financial ties (and economic integration) with large economies in the region (especially with Israel and Egypt).

### Governance and financial integration
- Including governance indicators—the control of corruption, rule of law, and regulatory quality—in the model shows clearly that better governance results in higher financial integration.
- Despite progress, Cyprus still lags in many of these areas, suggesting important benefits from further improvements.
- A simulation based on the model suggests that improving governance could generate substantial additional flows.
- The source figures and charts referenced link corporate income tax (percent), average hourly wage in financial services (USD), and Rule of Law (scale: -1 to 1, with 1 = strong rule of law) to competitiveness and governance, using Eurostat and other datasets.

### Competition, cost structure, and the need to compete on quality
- Cyprus has low corporate taxes and would keep an edge over most countries even if corporate taxes increased to 15 percent for all companies (rather than just for very large ones in line with the current EU adoption of the global minimum tax).
- Other EU countries offer cheaper wages in services as well as better governance.
- Example comparison: hourly wages in financial services are nearly twice as high as in Lithuania, which on top has much better governance indicators and attempts to attract similar foreign investment.
- Conclusion: In addition to leveraging its location, Cyprus will need to turn into a high-quality destination, rather than relying on cost competitiveness.

### Policy recommendations and steps to harness new growth opportunities
- Address governance issues to support reorienting services exports to new markets:
  - Enhance the rule of law and reduce the backlog of court cases to improve the business environment.
  - Better control of corruption and stronger SOE governance could improve government efficiency.
- Further progress with the AML/CFT framework to contribute to a cleaner financial sector and improve Cyprus’s reputation; this could help relax monitoring standards of U.S. corresponding banks and potentially increase efficiency in the financial sector.
- Continue policy support like the current headquartering scheme to attract new companies in the near-term.
  - The Cyprus Investment Promotion Agency can play a key role in attracting large FDI projects in strategic sectors (finance, health care, education, renewables).
  - The costs and effectiveness of current tax benefits should be continuously scrutinized and improved.
  - New initiatives could build on recent successes in attracting companies from Israel and Lebanon (reflected in increasing payment flows with these countries).
- Overcome capacity constraints and procedural hurdles in immigration, and ease access to the Schengen area for third country nationals with employment permits to enhance Cyprus’s appeal as a strategic location for foreign companies.
  - Emerging constraints on absorbing foreign employees (schooling, housing) are best resolved by market forces, though supply side measures (like strategic rezoning and reinstatement of the immovable property tax) could help.
- Create a digital workforce by modernizing the education system to provide better quality education with a stronger focus on digital skills; attract more foreign IT specialists, especially in the short run.

### Fund relations, statistical and institutional context (selected points)
- Membership Status: Joined December 21, 1961; Article VIII.
- Quota: 303.80 (SDR million) — 100.00 percent of Quota.
- IMF’s Holdings of Currency: 218.75 — 72.00 percent.
- Reserve Tranche Position: 85.06 — 28.00 percent.
- SDR Department net cumulative allocation: 423.98 — 100.00 percent; Holdings: 427.11 — 100.74 percent.
- Outstanding Purchases and Loans: None.
- Historical financial arrangements: EFF approved May 15, 2013 — Amount Approved 891.0 (SDR million); Amount Drawn 792.00 (SDR million).
- Projected Payments to the Fund (SDR millions; Projected from 2022) — Principal 2023–2027: 0 (each year); Charges/Interest 2023–2027: 0.01 (each year); Total 2023–2027: 0.01 (each year).
- Cyprus is a member of the euro area; currency—the euro—floats freely and independently against other currencies. Cyprus has accepted the obligations of Article VIII, Sections 2, 3, and 4.
- Data provision to the Fund is adequate for surveillance purposes.
- CYSTAT publishes full national accounts based on ESA 2010 including quarterly GDP estimates from Q1 1995.
- CBC compiles balance of payments and international investment position on a quarterly and annual basis according to BPM6; data released with roughly a one-quarter lag.
- Cyprus subscribes to the IMF’s Special Data Dissemination Standard (SDDS) since December 2009.
- Cyprus reports thirteen core financial soundness indicators (FSIs) and seven additional FSIs for the deposit takers as well as two additional FSIs for real estate markets on a quarterly basis.

*Prepared by European Department (In consultation with other departments) — Staff Report for the 2023 Article IV Consultation — Informational Annex*

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_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1cypea2023001.pdf_