## 1. A Medium-Term Fiscal Anchor for Cyprus

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---

### Context and recent macro developments
- Growth drivers: expanding ICT activity, tourism, and implementation of the Recovery and Resilience Plan (RRP).
- Public and private balance-sheet developments:
  - Public debt fell more than 30 percentage points of GDP since 2014, below 80 percent of GDP in 2023.
  - Combined household and non-financial corporation (NFC) non-equity liabilities: from over 460 percent of GDP in 2014 to below 275 percent in 2023.
  - Legacy NPLs have fallen substantially; most are held outside the banking sector in credit acquiring companies (CACs), though some small banks continue to hold large stocks.
- Growth and activity:
  - Real GDP growth: 2022: 5.1 percent; 2023: 2.5 percent.
  - Output gap: declined but remained positive.
  - New shocks: drop in tourists from Russia partly offset by other visitors; decline in Israeli tourists and expected temporary fall in Israeli FDI following regional conflict.
- Inflation and labor market:
  - Headline inflation: Peak July 2022: 10.6 percent; March 2024: 1.6 percent.
  - Core inflation (March 2024): 2.5 percent (EA core inflation: 2.9 percent).
  - Registered unemployment (2023): 5.9 percent.
  - Wages grew 6.6 percent in 2023.
- Fiscal and external:
  - Primary surplus: 2022: 3.9 percent of GDP; 2023: 4.5 percent of GDP.
  - Revenue growth (yoy, 2023): 12 percent.
  - Cash buffers: 10 percent of GDP.
  - Gross debt (2023): 77 percent of GDP.
  - Current account (CA) deficit (2023): 12.1 percent of GDP; primary income balance (2023): -10.1 percent of GDP.
  - CA deficit financed entirely by non-debt creating flows.
- Financial conditions and real estate:
  - Financial conditions tightened in 2023 to the tightest level since the 2013 crisis.
  - House prices grew 2.9 percent in 2023; foreigners accounted for close to half of property demand.
  - Banking sector: higher net interest margins, increased profits, strengthened capital adequacy, broadly stable NPLs; loan renegotiations increased.

### Outlook and key projections
- Growth and inflation:
  - Staff projection: 2024: 2.6 percent; medium-term potential: around 3 percent.
  - Inflation projection (2024 average): just above 2 percent.
- Selected economic indicator forecasts (Percent, year-over-year or percent of GDP; nominal GDP in billions of euros):
  - Real GDP: 2023: 2.5; 2024: 2.6; 2025: 2.8; 2026: 3.0.
  - HICP (period average, SA): 2023: 3.9; 2024: 2.2; 2025: 2.0; 2026: 2.0.
  - General government balance (% of GDP): 2023: 3.1; 2024: 2.7; 2025: 2.5; 2026: 2.5.
  - General government debt (% of GDP): 2023: 77.3; 2024: 71.1; 2025: 65.7; 2026: 60.7.
  - Current account balance (% of GDP): 2023: -12.1; 2024: -11.1; 2025: -10.2; 2026: -10.0.
  - Nominal GDP (billions of euros): 2023: 29.8; 2024: 31.7; 2025: 33.4; 2026: 35.2.
- Risks:
  - Short-term: mostly external and to the downside (downturn in major tourism markets, escalation of regional conflicts).
  - Medium-term: large adverse risks from climate change (rising temperatures, more intense heatwaves, sea level rise); upside from rebalancing the growth model and attracting talent and foreign investment.

### Authorities’ views
- Authorities expect real GDP growth slightly higher than staff projections in 2024 and 2025 due to higher expected tourist arrivals, other services exports, and payouts from structural reforms.
- Authorities concur with staff’s inflation projections but emphasize upside risks from wage growth and oil prices.
- They expect the CA deficit to remain elevated, partly due to temporary profit outflows driven by high bank profitability that will normalize later.

### Policy guidance: rebuild fiscal buffers and lower public debt
- Assessment of 2024 stance:
  - Authorities’ planned neutral fiscal stance in 2024 judged appropriate.
  - 2024 budget targets: Overall balance: 2.8 percent of GDP; Primary balance: 4.3 percent of GDP.
- Recommended strategy:
  - Continue large primary surpluses until public debt falls comfortably below 60 percent of GDP.
  - Projected timing: 60-percent threshold projected to be met in 2027, but should be viewed as a ceiling with a buffer below it.
  - Once debt target met, a primary deficit of around 0.5 percent would stabilize debt assuming conservative “r-g” dynamics and debt around 50 percent of GDP.
- Long-term pressures and fiscal space:
  - Long-term spending pressures could increase expenditure by around 2.5 percent of GDP by 2030 (pensions, long-term care, climate mitigation/adaptation), implying the need to preserve fiscal space.

*Source: IMF staff report chapter "1. A Medium-Term Fiscal Anchor for Cyprus".*

---

### Box 1 — Key fiscal anchor points and debt dynamics
- Fiscal planning objectives:
  - Preserve space to address demographic and climate-related spending pressures and provide a buffer against shocks.
  - Anchor debt at a level comfortably below 60 percent of GDP to allow a robust fiscal response to shocks without undermining sustainability or market confidence.
- Debt dynamics considerations:
  - Historical “r-g” averaged -2.7 percent a year over the last decade, with significant variability.
  - Assuming a conservative “r-g” of -1 percent and debt around 50 percent of GDP, a primary deficit of around ½ percent of GDP would stabilize debt.
- Long-term spending pressures (by 2030):
  - Pensions (EC Ageing Report 2024): expected increase by 1.1 percent of GDP.
  - Long-term care: expected increase by 0.1 percent of GDP.
  - Climate mitigation and adaptation: estimated range 0.6–2.2 percent of GDP annually until 2050.
  - Combined impact: around 2½ percentage points of GDP increase in expenditure by 2030 (not including other needs such as infrastructure and defense).

---

### Fiscal policy and public expenditure priorities

### Expenditure policy
- Priorities:
  - Capital expenditures should be prioritized in line with the full absorption of RRF funds.
  - Timely completion of RRP milestones—both reforms and investments—is crucial to harness benefits and avoid loss of allocations.
- Wage policy and public wage bill:
  - Public sector wage bill and employment are high relative to EU peers.
  - Upward revision to the CoLA increased public pay indexation (CoLA to two-thirds of CPI inflation, up from half); further increases to CoLA indexation should be avoided.
  - Wage adjustments should be based on macroeconomic and productivity developments.
  - A thorough review of the public sector wage bill should underpin a comprehensive reform.
- Subsidies and exemptions:
  - Phase-out of the temporary fuel excise reductions is welcome.
  - VAT exemptions and electricity subsidies should be allowed to expire, as planned, this year.

### Tax policy
- Green taxation:
  - A key RRP milestone to better align consumer incentives with green objectives.
- Corporate tax regime:
  - EU’s Minimum Tax Directive mandates a minimum 15 percent CIT rate for multinational enterprises, above Cyprus’ rate of 12.5 percent.
- Ongoing reform opportunity:
  - Comprehensive tax review should incorporate these changes and reassess PIT incentives under the headquartering policy.

### Health system and SOEs
- NHS and SOE oversight:
  - More progress needed with implementation of the National Health System (NHS) and financial oversight of state-owned enterprises (SOEs).
  - Public hospitals plan to fully cover operational costs from 2024; a detailed action plan and a one-year extension (subject to one-time renewal) were agreed for hospitals to achieve full sufficiency.
  - Further SOE reforms recommended: updated inventory of public entities, comprehensive ownership policy, strengthened and institutionalized oversight, and formalized transparent structure for SOE board nominations.

---

### Financial sector resilience, macroprudential stance, and NPL resolution

### Banking sector soundness and risks
- Capital and liquidity:
  - Banks are highly capitalized; CET1 ratio: 21.3 percent in 2023.
  - System buffer availability (above Pillar 2 Guidance): 8.1 percent.
  - Liquidity risks remain low; buffers well above regulatory requirements.
- Asset quality and credit:
  - NPL ratio: 7.9 percent in December 2023.
  - Net interest margins increased; bank profits increased and capital adequacy strengthened.
  - Recent decline in credit growth mainly due to lower demand rather than credit rationing.
- Macroprudential measures:
  - Increase in neutral CCyB to 1 percent, effective June 2024, is welcome.
  - Around two-thirds of bank loans are secured by real estate collateral.
  - LTV and DSTI limits help mitigate real estate risks but careful monitoring required.

### Non-banking financial institutions (NBFIs)
- Monitoring needs:
  - Investment funds and other NBFIs require careful monitoring for potential liquidity mismatches, leverage, and interconnectedness.
  - CySEC efforts to implement ESMA recommendations and strengthen supervisory capacities are welcomed.
  - Real estate risks in NBFIs are diversified; portfolios mostly invested abroad.

### Foreclosure framework and legacy NPLs
- Foreclosure and MtR:
  - Effective foreclosure framework fundamental to resolve legacy NPLs.
  - Mortgage-to-rent (MtR) scheme started in December with promising uptake.
  - Amendments enhanced debtor protection without significantly increasing resolution times.
  - At end-2023 all suspensions of the foreclosure framework were effectively lifted (earlier suspensions had restricted foreclosures for primary residences up to a value of €350,000).
  - New amendments aim to expedite dispute resolution and align incentives for out-of-court settlements (enhanced transparency of debt claims; debtor right to resort to Financial Ombudsman to verify debt claim prior to foreclosure).
- Expected outcome:
  - Unperturbed implementation of the foreclosure framework should speed up legacy NPL resolution and support new, more productive bank lending.

---

### Structural reforms, labor market, AML/CFT, and green transition

### Structural and labor market reforms
- Diversification and competitiveness:
  - Growth model diversifying toward Israel and MENA; professional services and nascent ICT sector growing quickly.
  - Further development of high-value industries requires streamlined business environment, expanded skilled labor supply, and robust AML/CFT framework.
- Judiciary and skills:
  - Strengthening the judiciary is needed to reduce court backlog; 2023 reforms (restructuring top-tier courts, establishment of Court of Appeal) are welcome but more needed.
  - Address skill-mismatches: focus on digital education and skills, increase share of STEM graduates, strengthen activation requirements for job seekers.
- Migration and labor supply:
  - Attracting third-country nationals to alleviate sector-specific labor shortages and increase high-skilled labor; strategy revisions include facilitating Blue Card movement and addressing housing constraints.

### AML/CFT and sanctions enforcement
- Progress and gaps:
  - Progress acknowledged in MONEYVAL follow-up; further strengthening of implementation is needed.
  - Cyprus creating a national sanctions enforcement unit with UK support, expected operational by end of the year.
  - Recommend a single supervisory framework for administrative services and strengthened AML/CFT efforts in real estate and supervision of gatekeepers (lawyers, accountants, trust and company service providers).

### Green transition and climate adaptation
- Targets and gaps:
  - Cyprus aims to: cut emissions in non-ETS sectors by 32 percent by 2030 (compared to 2005) and reach climate neutrality by 2050.
  - Current projections: 13 percent above the 2030 target.
  - Renewable energy share target: one-third by 2030 (from 18 percent in 2021).
- Green taxation and carbon pricing:
  - Implementation of the green taxation package and phaseout of fuel and electricity subsidies should close about a third of the gap to the 2030 target but leave carbon prices low in several sectors.
  - A wider-scope carbon tax covering all non-ETS sectors—combined with targeted sectoral policies—would go further.
- Distributional mitigation:
  - Expected adverse distributional effects on lower-income deciles manageable if limited fiscal resources are channeled to well-targeted support measures and PIT tax reductions.
- Adaptation priorities:
  - (i) reduce risks from extreme heat (early warning systems and contingency plans), (ii) deal with long-term and acute water shortages, (iii) revise coastal development and protection to address sea-level rise.
  - Public investment needed to support adaptation; reforms can boost private investment in adaptation by removing market inefficiencies.

---

### Inflation drivers, monetary transmission, and disinflation policy implications

### Drivers of core inflation (BVAR and decomposition)
- Core inflation in 2023 driven by both supply and demand; demand factors dominated most of the time.
- Supply factors:
  - Peaked in 2022Q3 and then declined; still accounted for around a third of excess core inflation last year.
- Demand factors:
  - Declined since H2 2022 but stickier than supply factors.
  - Fiscal shocks’ estimated impact on core inflation dropped below one percentage point since 2023Q2 and turned negative quarter-over-quarter at end-2023.

### Contributions to inflation
- 2022 decomposition:
  - Nearly three-quarters of inflation driven by unit profits.
  - Remaining portion from higher unit taxes.
  - Unit labor costs made a negligible contribution.
- Implication:
  - Increasing profit share implies firms have been relatively more shielded from inflation than wage earners; reducing profit share toward historic norms likely necessary for sustained disinflation.

### Monetary policy transmission in Cyprus
- Pass-through to new lending: aligns broadly with other European countries.
- Pass-through to outstanding mortgages:
  - "Significantly exceeds the euro area average."
  - More than twice as strong as peers due to high share of flexible rate mortgages.
  - Only around half of the policy rate change has been passed on to outstanding mortgages, due to adjustment constraints and reference to bank base rates.
- Deposit pass-through:
  - Lower and slower than in other countries.
  - Only a quarter of rate hikes passed to household time deposits; zero passed to household overnight deposits.
  - Deposit pass-through somewhat higher for corporations.
- Policy implications:
  - Remaining demand pressures caution against expansionary policies.
  - Mitigation of transmission to the real estate sector should not be hindered.
  - Low banking competition and interaction with financial literacy warrant further analysis.
  - Public sector wage growth should be controlled and further indexation avoided.

---

### External sector assessment and recommended policy responses

### Overall assessment and CA gap
- External position (2023) assessed substantially weaker than level implied by fundamentals.
- Key drivers of CA deficit:
  - Import of physical assets of special purpose entities (SPEs) in the shipping sector.
  - Higher repatriation of income from foreign-owned financial companies.
- CA and NIIP:
  - CA: 2023: -12.1 percent of GDP.
  - NIIP: -97 percent of GDP in 2023 (headline NIIP: -96.6 in table).
  - Excluding SPEs, underlying NIIP improved from -78 percent of GDP in 2014 to -36 percent by 2023Q4.
- IMF staff CA model:
  - Adjusted CA: -7.8 percent of GDP.
  - CA Norm: -1.3 percent of GDP.
  - CA Gap: -6.4 percent of GDP for 2023.
- REER assessment:
  - Multiple model estimates; CA-gap-derived REER overvaluation: 11.2 percent in 2023; other models show small undervaluations. Staff places higher weight on CA model and assesses a slight overvaluation.

### Capital flows and vulnerabilities
- Net capital inflows: 7.2 percent of GDP in 2022; 9.7 percent of GDP in 2023.
- Gross liabilities: 1,790 percent of GDP in 2023; gross assets: 1,577 percent of GDP.
- Under baseline, NIIP projected to deteriorate by about 20 percent of GDP over the medium term.
- With sizable external debt of public and private sectors, Cyprus remains exposed to financial market risks; tightening financial conditions could increase vulnerability.

### Sectoral drivers and policy implications
- Sectoral facts:
  - Households: second largest S-I deficit in the EU; low savings; highest household investment rate in the EU.
  - NFCs: largest S-I deficit drag on CA; low investment rate; low profitability.
  - FCs: surpluses have declined since the GFC; continued deleveraging and severing ties with Russia could weigh further on FC surpluses and the CA.
  - Government: S-I improved and turned into surplus since 2014; among the highest in Europe.
- Policy recommendations:
  - Maintain tight fiscal stance to support external balance.
  - Support private sector deleveraging, including resolution of legacy NPLs, and higher private savings.
  - Implement structural reforms to raise productivity and enhance competitiveness—supported by the RRP.
  - Effectively implement foreclosure framework and fully utilize RRP to boost government investments in an S-I neutral manner.

---

### Green taxation: impacts and scenarios

### Emissions and policy context
- Cyprus targets: non-ETS sector emissions reduction of 32 percent by 2030 (compared to 2005); climate neutrality by 2050.
- Energy reliance: oil and petroleum products account for 90 percent of energy.
- With current and planned policies, emissions projected to remain 13 percent above the 2030 target.

### Assessment of planned fuel excise top-up (IMF-WB CPAT tool)
- Expected outcomes of proposed fuel excise duty top-up:
  - Reduce emissions by an additional 3.8 percent by 2030.
  - Close about one-third of Cyprus’ emissions gap to the 2030 target.
  - Generate additional net revenues of 0.4 percent of GDP, net of base erosion effects.
  - Produce a transitory aggregate demand impact in the range 0.1–0.2 percentage points.
  - Reduce household consumption by 0.4 percent proportionally across income groups.
  - To fully offset impacts on lowest deciles: channel a quarter (third) of revenues to fully offset impact on the four (five) lowest income deciles via well-targeted social transfers and PIT tax allowances or exemptions.

### Wider and uniform carbon tax scenarios
- Uniform carbon tax applied across all non-ETS sectors:
  - Would raise carbon prices in currently uncovered sectors and enhance abatement efficiency.
  - Applying transport-sector rates uniformly would produce 1.5 times the emission reduction impact relative to the current plan, closing half of the gap to the 2030 target.
  - Impact on household consumption would be higher and slightly more regressive.
  - Fiscal revenues comparable to current plan; larger shares of revenues (third (half)) would need to be channeled to the bottom four (five) income distribution deciles for protection.
- Full closure of emissions gap via carbon pricing alone:
  - Would require tax rates 2.5 times those currently planned—more economically and socially challenging.
  - Targeted sectoral policies can complement pricing but are generally less efficient and do not generate revenue for redistribution.

---

### Data adequacy, quality, and surveillance implications

### Assessment and coverage
- Overall conclusion: "The data provided to the Fund is adequate for surveillance."
- Data adequacy heatmap highlights high ratings for Prices and National Accounts; some dual-granularity issues in Government Finance Statistics and Monetary and Financial Statistics.
- No alternative data or estimates different from official statistics were used.
- Climate analysis relied on ECMWF and CRU datasets.

### Key data timeliness and frequency indicators (selected)
- Exchange Rates: Date of Latest Observation: Mar-24; Date Received: Apr-24; Expected Frequency: 1W; Expected Timeliness: 3W.
- Consumer Price Index: Mar-24; Apr-24; Frequency: monthly; Expected Timeliness: 3M.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Feb-24; Apr-24; Expected Timeliness: 3M.
- GDP/GNP: 2023: Q4; Mar-24; Expected Timeliness: 1Q.
- Gross External Debt: 2023: Q4; Mar-24; Expected Timeliness: 1Q.

### Corrective actions and capacity development
- Authorities progressing with transaction-based house price indices.
- Ongoing technical assistance and capacity development across revenue administration, public financial management, NPL management, macro-financial modeling, central bank governance, sectoral accounts, property price statistics, SOE governance, and debt management.
- Staff view: data broadly adequate for surveillance but External Sector Statistics complicated by large presence of SPEs; improvements in accuracy and timeliness of initial data desirable.

*Source: IMF staff report chapter "1. A Medium-Term Fiscal Anchor for Cyprus" and associated annexes (content unit 1cypea2024001).*

### 1. A Medium-Term Fiscal Anchor for Cyprus _____________________________________________________ 12

### 1. A Medium-Term Fiscal Anchor for Cyprus

### Context
- Cyprus recovered swiftly from the pandemic and has proven resilient to multiple adverse shocks, supported by strong policy support and fiscal buffers.
- Growth drivers include expanding ICT activity, tourism, and implementation of the Recovery and Resilience Plan (RRP).
- Public debt has fallen more than 30 percentage points of GDP since 2014, falling below 80 percent of GDP in 2023.
- Combined household and non-financial corporation (NFC) non-equity liabilities declined from over 460 percent of GDP in 2014 to below 275 percent in 2023.
- Legacy NPLs have fallen substantially; most are now held outside the banking sector in credit acquiring companies (CACs), though some small banks continue to hold large stocks.

### Recent Developments — Growth and Activity
- Real GDP growth:
  - 2022: 5.1 percent
  - 2023: 2.5 percent
- Output gap is estimated to have declined but remained in positive territory.
- Post-pandemic growth driven by financial services, ICT, tourism, and RRP implementation.
- New shocks: drop in tourists from Russia offset by other visitors; decline in Israeli tourists and expected temporary fall in Israeli FDI following regional conflict.

### Recent Developments — Inflation and Prices
- Headline inflation:
  - Peak July 2022: 10.6 percent
  - March 2024: 1.6 percent
- Core inflation (March 2024): 2.5 percent (EA core inflation: 2.9 percent)
- Producer prices declining since July 2023; inflation expectations contained.

### Recent Developments — Labor Market
- Registered unemployment (2023): 5.9 percent (lowest since GFC)
- Wages grew 6.6 percent in 2023, supported by:
  - Increase in public wage indexation (CoLA) to two-thirds of CPI inflation (up from half)
  - Higher minimum wage in services
- Employment rate and vacancies hit all-time highs in 2023; labor shortages increased, especially in services.

### Recent Developments — Fiscal
- Primary surplus:
  - 2022: 3.9 percent of GDP
  - 2023: 4.5 percent of GDP
- Revenue growth (yoy, 2023): 12 percent, driven by strong activity and accelerated clearance of tax backlogs; VAT performing well partly due to declining “VAT gap.”
- Budgetary measures (selected, budgetary impact %GDP):
  - Upward revision of COLA (public sector employees, Permanent): 0.20
  - Extension of electricity subsidies (Jan. 2023 - Jun. 2024, Some progressivity): 0.32
  - Hosting refugees (Overlapping programs): 0.12
  - Other individual measures listed with impacts as low as 0.00 up to 0.27
- Cash buffers: 10 percent of GDP
- Gross debt (2023): 77 percent of GDP (declining trajectory)
- Debt sustainability risks assessed as ‘low’ (upgrade since last Article IV).

### Recent Developments — External Sector
- Current account (CA) deficit (2023): 12.1 percent of GDP
- Primary income balance (2023): -10.1 percent of GDP
- CA deficit financed entirely by non-debt creating flows; valuation effects kept NIIP largely unchanged.
- RRP disbursements as of April 2024: 22 percent of allocation; joint 2nd and 3rd payment request plus REPowerEU tranche submitted totaling €173 million (0.6 percent of GDP).

### Recent Developments — Financial Conditions and Real Estate
- Financial conditions tightened in 2023 to the tightest level since the 2013 crisis.
- Credit growth slowed for households and NFCs; NFCs increasingly reliant on equity inflows for investment.
- House prices grew 2.9 percent in 2023; foreigners accounted for close to half of property demand.
- Banking sector:
  - Net interest margins increased due to stronger pass-through to lending than deposits.
  - Bank profits increased and capital adequacy strengthened.
  - NPLs broadly stable; loan renegotiations increased.

### Outlook and Risks
- Growth projections:
  - 2024: 2.6 percent (staff projection)
  - Medium-term potential: around 3 percent
- Inflation projection (2024 average): just above 2 percent
- Fiscal and macro projections (Selected Economic Indicator Forecasts, 2023-2026):
  - Real GDP: 2023: 2.5; 2024: 2.6; 2025: 2.8; 2026: 3.0 (Percent, year-over-year)
  - HICP (period average, SA): 2023: 3.9; 2024: 2.2; 2025: 2.0; 2026: 2.0 (Percent)
  - General government balance (% of GDP): 2023: 3.1; 2024: 2.7; 2025: 2.5; 2026: 2.5
  - General government debt (% of GDP): 2023: 77.3; 2024: 71.1; 2025: 65.7; 2026: 60.7
  - Current account balance (% of GDP): 2023: -12.1; 2024: -11.1; 2025: -10.2; 2026: -10.0
  - Nominal GDP (billions of euros): 2023: 29.8; 2024: 31.7; 2025: 33.4; 2026: 35.2
- Short-term risks: mostly external and to the downside (downturn in major tourism markets, escalation of regional conflicts).
- Medium-term risks: large adverse risks from climate change (rising temperatures, more intense heatwaves, sea level rise); upside potential from rebalancing the growth model and attracting talent and foreign investment.

### Authorities’ Views
- Authorities expect real GDP growth slightly higher than staff projections in 2024 and 2025 due to higher expected tourist arrivals, other services exports, and payouts from structural reforms.
- Authorities concur with staff’s inflation projections but emphasize upside risks from wage growth and oil prices.
- They expect the CA deficit to remain elevated, partly due to temporary profit outflows driven by high bank profitability that will normalize later.

### Policy Priorities — Rebuild Fiscal Buffers and Lower Public Debt
- The authorities’ planned neutral fiscal stance in 2024 is deemed appropriate.
- 2024 budget targets:
  - Overall balance: 2.8 percent of GDP
  - Primary balance: 4.3 percent of GDP
- Recommendation: Continue large primary surpluses until public debt falls comfortably below 60 percent of GDP.
- Projected timing: 60-percent threshold is projected to be met in 2027, but should be viewed as a ceiling with a buffer below it.
- Once debt target met, a primary deficit of around 0.5 percent would stabilize debt, assuming favorable “r-g” dynamics and debt around 50 percent of GDP.
- Long-term spending pressures could increase expenditure by around 2.5 percent of GDP by 2030 (pensions, long-term care, climate mitigation/adaptation), implying the need to preserve fiscal space.

### Box 1 — Cyprus: A Medium-Term Fiscal Anchor for Cyprus (Key Points)
- Fiscal planning should preserve space to address demographic and climate-related spending pressures and to provide a buffer against shocks.
- Debt should be anchored at a level comfortably below 60 percent of GDP to allow a robust fiscal response to shocks without undermining sustainability or market confidence.
- Debt dynamics considerations:
  - Historical “r-g” (growth-interest rate differential) averaged -2.7 percent a year over the last decade, with significant variability.
  - Assuming a conservative “r-g” of -1 percent and debt around 50 percent of GDP, a primary deficit of around ½ percent of GDP would stabilize debt.
- Long-term spending pressures:
  - Pensions (EC Ageing Report 2024): expected increase by 1.1 percent of GDP by 2030.
  - Long-term care: expected increase by 0.1 percent of GDP by 2030.
  - Climate mitigation and adaptation: estimated range 0.6–2.2 percent of GDP annually until 2050 (authorities’ NECP and IMF staff calculations).
  - Combined impact: around 2½ percentage points of GDP increase in expenditure by 2030 (not including other needs such as infrastructure and defense).

*Source: IMF staff report chapter "1. A Medium-Term Fiscal Anchor for Cyprus".*

### 20.      Expenditures should prioritize investments, while further wage indexation should be

### 20.      Expenditures should prioritize investments, while further wage indexation should be avoided.

### Fiscal policy and public expenditures
- Capital expenditures should be prioritized in line with the full absorption of RRF funds.
- Timely completion of RRP milestones, both reforms and investments, is crucial to fully harness benefits and avoid loss of allocations.
- The public sector wage bill and employment are high relative to EU peers.
- Upward revision to the CoLA increases public pay indexation; further increases to CoLA indexation should be avoided.
- Wage adjustments should be based on macroeconomic and productivity developments.
- A thorough review of the public sector wage bill should form the basis of a comprehensive reform.
- The phase-out of the temporary fuel excise reductions is welcome.
- VAT exemptions and electricity subsidies should be allowed to expire, as planned, this year.

### Tax policy
- Green taxation, a key RRP milestone, aims to better align consumer incentives with green objectives.
- The EU’s Minimum Tax Directive mandates a minimum 15 percent CIT rate for multinational enterprises, above Cyprus’ rate of 12.5 percent.
- The ongoing comprehensive review of the tax system is an opportunity to incorporate these changes and to reassess PIT incentives under the headquartering policy.

### Health system and SOEs
- More progress is needed with implementation of the National Health System (NHS) and financial oversight of state-owned enterprises (SOEs).
- The plan for public hospitals to achieve financial self-sufficiency by 2024 was derailed by the pandemic; a new target date should be promptly set.
- Public hospitals will fully cover their operational cost from 2024; a detailed action plan along with a one-year extension (subject to one-time renewal) were agreed for hospitals to achieve full sufficiency.
- Further SOE reforms recommended: updated inventory of public entities, a comprehensive ownership policy, strengthened and institutionalized oversight, and a formalized and transparent institutional structure for SOE board nominations.

### Authorities’ fiscal views and commitments
- Authorities plan to maintain large primary surpluses and are focused on reducing public debt to below 60 percent of GDP by 2027, thereby achieving full compliance with the EU Economic Governance Framework.
- They are considering the steady-state level of public debt and the long-term debt stabilizing primary balance target.
- The temporary reduction in excise duties on fuel was allowed to expire at end March.
- Zero-VAT rates on some food and sanitary products and limited electricity subsidies were temporarily extended to end-June.
- The authorities are not currently planning further upward revisions of the CoLA.

### Financial sector resilience and risks
- The banking system has sufficient capital buffers to withstand severe macroeconomic shocks; banks are highly capitalized and, according to stress tests conducted by the EBA/ECB, well positioned to manage shocks.
- Both systemic institutions covered by 2023 stress tests saw improved resilience due to better asset quality and higher income.
- Despite tighter financial conditions, banking sector risks appear to have declined: robust growth, increasing real wages, declining unemployment, and rising property prices have reduced credit risk.
- The recent decline in credit growth is attributed mainly to lower demand, rather than credit rationing by banks.
- Liquidity risks remain low, as buffers are well above regulatory requirements, the deposit funding base is well diversified, and there is limited asset repricing exposure.

### Macroprudential and real estate considerations
- The increase in the neutral rate of the CCyB to 1 percent, effective June 2024, is welcome.
- Around two-thirds of bank loans are secured by real estate collateral, exposing institutions to collateral risk.
- Real estate prices are aligned with fundamentals and LTV and DSTI limits mitigate risks further, but careful monitoring is required.

### Non-Banking Financial Institutions (NBFIs)
- NBFIs, especially investment funds, require careful monitoring for potential liquidity mismatches, leverage, and interconnectedness.
- Securities markets supervisor (CySEC) efforts to implement ESMA recommendations, including strengthening supervisory capacities and increasing resources, are welcomed.
- Real estate risks in NBFIs are diversified, as portfolios are mostly invested abroad.

### Foreclosure framework and legacy NPLs
- An effective foreclosure framework is fundamental to resolve legacy NPLs.
- The mortgage-to-rent (MtR) scheme started in December with promising uptake.
- Recent amendments enhanced debtor protection without significantly increasing resolution times.
- At end-2023 all suspensions of the foreclosure framework were effectively lifted; earlier pandemic-era suspensions had restricted foreclosures for primary residences up to a value of €350,000.
- New amendments aim to expedite dispute resolution and align incentives for out-of-court settlements by (i) enhancing transparency of debt claims and (ii) granting the debtor the right to resort to the Financial Ombudsman to verify the amount of the debt claim prior to foreclosure.
- Unperturbed implementation of the current foreclosure framework should speed up resolution of legacy NPLs and support new and more productive bank lending.

### Structural reforms and labor market
- Cyprus is diversifying its growth model, reorienting services exports towards Israel and countries in the Middle East and North Africa.
- Professional services are growing; the nascent ICT sector is growing quickly.
- Further development of high-value industries requires a streamlined and stable business environment, expanded supply of skilled labor, and a robust AML/CFT framework.
- Strengthening the judiciary is needed to reduce backlog of court cases; reforms in 2023, including restructuring of top-tier courts and establishment of the Court of Appeal, are welcome but more is needed.
- Addressing skill-mismatches and increasing labor supply would improve long-term growth prospects: focus on digital education and skills, increase share of STEM graduates, and strengthen activation requirements for job seekers.
- Attracting third-country nationals will help alleviate sector-specific labor shortages and increase high-skilled labor; recent strategy revisions focus on facilitating movement within the EU (Blue Card) and addressing housing constraints.
- A stronger domestic private sector would help strengthen the CA; FDI-led model has widened the CA deficit as profit repatriation has grown.

### AML/CFT and sanctions enforcement
- Despite progress, further effort is needed with AML/CFT implementation and sanctions enforcement.
- Cyprus is creating a national sanctions enforcement unit with UK support, expected to be operational by the end of the year.
- Authorities should create a single supervisory framework for administrative services and strengthen AML/CFT efforts in real estate and supervision of gatekeepers (lawyers, accountants, and trust and company service providers).

### Green transition and climate adaptation
- Greater energy integration and diversification would strengthen security and support the green transition; plans include connecting Cyprus’ electricity network with neighbors, introducing natural gas through an LNG terminal, increasing the share of renewable energy sources to one-third by 2030—from 18 percent in 2021—and creating an enabling environment for competition in the energy market.
- Progress on key infrastructure projects is very slow; LNG imports now expected to begin in late 2025.
- Cyprus aims to cut emissions in sectors not covered by the EU Emission Trading System (ETS) by 32 percent by 2030 (compared to 2005) and to reach climate neutrality by 2050.
- Current projections remain 13 percent above the 2030 target.
- Implementation of the green taxation package, on top of the phaseout of the fuel and electricity subsidies, should close about a third of the gap to target but leaves carbon prices low in several sectors.
- A wider-scope carbon tax covering all non-ETS sectors—combined with targeted sectoral policies—would go further in closing the gap.
- Expected adverse distributional effects on lower-income deciles are manageable with limited fiscal resources channeled to well-targeted support measures and PIT tax reductions.
- Climate risks: average temperatures and extreme conditions are rising; sea levels will continue to increase. Slow-moving warming alone could reduce the long-run level of GDP by up to 3.3 percent according to some estimates.
- Recommended adaptation priorities: (i) reduce risks from extreme heat (early warning systems and contingency plans), (ii) deal with long-term and acute water shortages, and (iii) revise coastal development and protection to address sea-level rise.
- Public investment is needed to support adaptation in key public sectors; economic reforms can boost private investment in adaptation by removing market inefficiencies.

### Authorities’ broader views
- Authorities expect strong economic performance and capital buffers to support financial stability, including the impact of anticipated lower interest rates on profitability.
- They view the increase in the neutral CCyB to 1 percent as enhancing resilience and not designed to slow credit growth.
- The authorities expect the expanded role of the Financial Ombudsman to be instrumental in achieving negotiated solutions between debtors and financial institutions on legacy NPLs.
- They are committed to structural reforms in the RRP (judicial reform, education, activation policies, re- and upskilling) and to enhancing AML/CFT implementation and sanctions enforcement.

*CYPRUS  INTERNATIONAL MONETARY FUND*

### 43.      Growth has moderated and inflation has normalized. Slowing private consumption

### 43.      Growth has moderated and inflation has normalized. Slowing private consumption

### Real sector, labor market, and outlook
- 2023 growth moderated due to slowing private consumption growth, lower services exports to Russia, and fading post-pandemic base effects, but "it remained considerably above European peers."
- Labor market:
  - Unemployment at its lowest since the GFC (Global Financial Crisis).
  - Wage growth described as "robust."
  - Job vacancies reached record levels, most in services (figures and charts referenced in source).
- Inflation:
  - Headline inflation fell below 2 percent (HICP period average and end-of-period figures show HICP values of "2.2 percent" and "2.0 percent" in projections).
  - Core inflation remained more persistent; core inflation was "2.4 percent" in December 2023.
  - Inflation of goods and services with low import content was "4.1 percent" in December 2023.
- External position: "In 2023 was substantially weaker than the level implied by fundamentals."
- Growth projections:
  - "Growth is expected to be stable, at around 2½ percent in 2024, supported by rising real incomes and FDI and EU RRP inflows, before gradually reaching 3 percent over the medium term."
- Short-term risks: downturn in major tourism markets; escalation of regional conflicts; delays in RRP implementation.
- Medium-term risks and upside:
  - Large adverse risks from climate change counterbalanced by upside from attracting more foreign investment and talent.

### Fiscal performance and policy guidance
- 2023 fiscal performance:
  - Robust revenue growth more than offset increased expenditures on CoLA and temporary support measures.
  - Resulted in a rise in the primary surplus.
  - Fiscal surpluses and strong nominal growth lowered public debt to "77 percent of GDP," the lowest level since 2014.
  - Debt sustainability risks assessed as "low" on the back of expected further declines in debt, low gross financing needs, and diminishing risks.
- Policy recommendation summary:
  - "Fiscal policy should aim to further lower debt and preserve space for long-term needs."
  - "Large primary surpluses should continue until public debt falls comfortably below 60 percent of GDP."
  - Preserve fiscal space for long-term spending pressures—including from aging and climate change—estimated to be "around 2.5 percent of GDP by 2030."
- Expenditure reform priorities:
  - Ramp up investment spending, aligned with full absorption of RRF funds.
  - Public sector wages should reflect macroeconomic and productivity developments—"further upward revisions of the CoLA should be avoided."
  - Phase-out of temporary fuel excise reductions is welcomed.
  - Remaining VAT exemptions and electricity subsidies "should be allowed to expire as planned."

### Financial sector, macroprudential stance, and NPL resolution
- Banking sector soundness:
  - "Banks, with sizable capital and liquidity buffers, are resilient under stress tests."
  - Asset quality has not deteriorated significantly due to strong growth, tight labor markets, and rising house prices despite higher interest rates.
  - Loan renegotiations have increased, warranting continued vigilance.
- Macroprudential policy:
  - Current stance described as "appropriate."
  - Increase in the positive neutral CCyB (countercyclical capital buffer) is welcome to build policy space for future shocks.
  - Real estate risks: prices estimated to be "in line with fundamentals," but regulatory vigilance required given widespread use of real estate as collateral.
- NPL resolution:
  - "The foreclosure framework should be left to work."
  - Combined with the new mortgage-to-rent scheme and effective operationalization of the Financial Ombudsman role, the framework could accelerate NPL resolution, support new lending, and strengthen the business environment.

### Structural reforms, AML/CFT, and labor/education
- Structural reform priorities:
  - Judicial sector reforms and labor market reforms are critical for long-term growth and structural transformation of Cyprus’ growth model.
  - Need to further simplify procedures, upgrade infrastructures, and increase staffing in the judicial sector.
  - Address skill shortages and mismatches; education system should promote digital skills needed to meet ICT job opportunities.
- AML/CFT:
  - Progress acknowledged in the recent MONEYVAL follow-up report; further strengthening of implementation is needed.
  - Recommend a single supervisory framework for administrative services and strengthened AML/CFT efforts in the real estate sector.

### Energy, climate targets, and adaptation
- Energy infrastructure:
  - Projects to import LNG, upgrade the electricity grid, and link it to neighbors are delayed.
  - "Decisive implementation of these projects remains crucial" to diversify the energy mix, increase renewables, enhance energy security, and reduce emissions.
- Emissions and green taxation:
  - Current emission projections are "13 percent above the 2030 target."
  - The planned green tax will help but "closes only a third of the gap," and does not address low carbon prices in several sectors.
  - Recommendation: widen the scope of the tax to encompass all non-ETS sectors and couple it with targeted sectoral policies to accelerate emission reductions.
  - Growth and distributional impacts of the tax are "expected to be manageable."
- Climate adaptation:
  - Extreme heat, drought, and sea level rise pose risks.
  - Recommend contingency planning, early warning systems, careful planning of coastal development and protection, public investments in adaptation, and reforms to boost private sector climate adaptation.

### Key numeric indicators and projections (selected from tables and text)
- Growth:
  - Real GDP: 2023 "2.5" (percent); 2024 "2.6" (percent); 2025 "2.8" (percent); medium term trending toward "3.0" (percent).
  - Private consumption: 2023 "4.2" (percent); 2024 "3.8" (percent).
- Inflation and labor:
  - HICP (period average) 2023 "3.9" (percent); 2024 "2.2" (percent); HICP (end of period) 2023 "1.9" (percent); core inflation December 2023 "2.4 percent"; goods/services with low import content December "4.1 percent".
  - Unemployment rate (period average): 2023 "6.1" (percent); projected 2024 "5.9" (percent); 2029 "5.0" (percent).
- Public finance:
  - General government balance: 2023 "2.7" (percent of GDP, surplus); 2024 "3.1" (percent); projected 2029 "0.9" (percent).
  - Primary fiscal balance: 2023 "4.5" (percent of GDP); 2024 "4.1" (percent).
  - Public debt: 2023 "77.3" (percent of GDP); 2024 "71.1" (percent); target guidance to fall "comfortably below 60 percent of GDP."
  - Long-term spending pressures estimated at "around 2.5 percent of GDP by 2030."
- Balance of payments and external:
  - Current account balance 2023 "-12.1" (percent of GDP); 2024 projected "-11.1" (percent); 2029 projected "-9.4" (percent).
  - Services balance 2023 "23.0" (percent of GDP).
  - Direct investment (financial account) 2023 "-12.6" (percent of GDP).
  - Gross external debt 2023 "576.0" (percent of GDP).
- Emissions:
  - Emission projections "13 percent above the 2030 target."
- Projections reiterated: "Growth is expected to be stable, at around 2½ percent in 2024" and "gradually reaching 3 percent over the medium term."

*Source: IMF staff report excerpt for Cyprus (text and tables provided in the supplied content).*

### 2.      Persistently high core inflation in 2023 was driven by both demand and supply. A

### 2.      Persistently high core inflation in 2023 was driven by both demand and supply. A

### Drivers of core inflation (BVAR and bottom-up decomposition)
- A Bayesian Vector-Error-Correction model (BVAR) attributes the post-pandemic inflation surge to both supply and demand factors, "with the latter dominating most of the time."
- Supply factors:
  - Peaked in 2022Q3 and then declined.
  - Still accounted for around a third of excess core inflation last year (i.e., deviation of inflation from target).
- Demand factors:
  - Declined since the second half of 2022 but proved stickier than supply factors.
  - Bottom-up decomposition groups: prices sensitive to supply chain disruptions; prices reflective of pent-up demand during re-opening; rent; and others.
  - Significant impact of demand aligns with lingering effects of monetary and fiscal policy easing in response to the pandemic.

### Fiscal versus non-fiscal demand pressures
- BVAR estimation including fiscal policy suggests remaining demand pressures by end-2023 were likely dominated by non-fiscal factors.
- Identification caveat: "the identification of different factors gets more uncertain when different shocks are present at the same time."
- Estimated impact of fiscal policy shocks on core inflation:
  - Dropped below one percentage point since 2023Q2.
  - Turned negative quarter-over-quarter at the end of last year.
- Monetary tightening likely supported the partial yet substantial reduction in non-fiscal demand pressures.

### Contributions to inflation: unit profits, taxes, and labor costs
- In 2022:
  - Nearly three-quarters of the inflation was driven by unit profits.
  - The remaining portion came from higher unit taxes.
  - Unit labor costs made a negligible contribution.
- After the spike in energy prices, firms passed on "more than just the immediate nominal import cost shock."
- The increasing profit share implies firms have so far been relatively more shielded from inflation than wage earners.

### Monetary policy transmission: pass-through to lending, mortgages, and deposits
- Pass-through to new lending rates in Cyprus:
  - "Aligns broadly with other European countries," affecting investment.
- Pass-through to outstanding mortgages in Cyprus:
  - "Significantly exceeds the euro area average."
  - More than twice as strong as peers, driven by a high share of flexible rate mortgages.
  - That high share "has not decreased over the past decade, unlike in most other countries."
  - Despite the high share, only around half of the policy rate change has been passed on to outstanding mortgages, due to constraints on mortgage rate adjustments and reference to a bank base rate (partly tied to deposit rates) in some cases.
- Real estate demand:
  - Robust real estate demand has somewhat offset the impact of higher interest rates on aggregate demand.
  - Because of a high share of mortgages in household debt, pass-through to outstanding mortgages plays an important role in transmitting monetary policy to output and prices.
- Deposit pass-through:
  - Lower and slower than in other countries.
  - Only a quarter of rate hikes has been passed on to household time deposits, and nothing to household overnight deposits.
  - Deposit pass-through somewhat higher for corporations.
  - Structural factors likely contributing: low competition and high banking sector liquidity.

### Key quantitative findings and projections (selected figures from the annex)
- Fiscal impact on core inflation:
  - Fiscal policy shocks impact estimated to have dropped below one percentage point since 2023Q2.
- Mortgage and deposit pass-through:
  - Only around half of the policy rate change passed to outstanding mortgages.
  - Only a quarter of rate hikes passed to household time deposits; zero passed to household overnight deposits.
- Debt and fiscal projections (selected figures from Table 3 and related tables):
  - Public debt: 77.3 (actual 2023), projected 71.1 (2024), 65.7 (2025), 60.7 (2026), 56.7 (2027), 53.4 (2028), 50.4 (2029), 48.1 (2030), 46.7 (2031), 46.0 (2032), 46.2 (2033)
  - Change in public debt: -8.3 (2024), -6.2 (2025), -5.4 (2026), -4.9 (2027), -4.0 (2028), -3.3 (2029), -3.0 (2030), -2.3 (2031), -1.4 (2032), -0.6 (2033), 0.1 (2034)
  - Contribution of identified flows to change in public debt: -8.1 (2024), -6.5 (2025), -5.7 (2026), -5.2 (2027), -4.3 (2028), -3.7 (2029), -3.2 (2030), -2.3 (2031), -1.4 (2032), -0.6 (2033), 0.1 (2034)
  - Primary deficit (percent of GDP): -4.4 (2024), -4.1 (2025), -3.9 (2026), -3.8 (2027), -2.9 (2028), -2.7 (2029), -2.4 (2030), -1.6 (2031), -0.9 (2032), -0.2 (2033), 0.6 (2034)
  - Noninterest revenues (percent of GDP): 43.2 (2023), 43.6 (2024), 43.6 (2025), 43.5 (2026), 42.7 (2027), 42.7 (2028), 42.6 (2029), 42.6 (2030), 42.6 (2031), 42.6 (2032), 42.6 (2033)
  - Noninterest expenditures (percent of GDP): 38.8 (2023), 39.5 (2024), 39.7 (2025), 39.7 (2026), 39.8 (2027), 40.0 (2028), 40.2 (2029), 41.0 (2030), 41.7 (2031), 42.4 (2032), 43.2 (2033)
  - Automatic debt dynamics contribution: -4.4 (2024), -3.5 (2025), -2.4 (2026), -2.2 (2027), -1.9 (2028), -1.5 (2029), -1.3 (2030), -1.1 (2031), -1.0 (2032), -1.0 (2033), -0.9 (2034)
  - Real interest rate contribution: -2.3 (2024), -1.5 (2025), -0.5 (2026), -0.3 (2027), -0.1 (2028), 0.2 (2029), 0.2 (2030), 0.3 (2031), 0.4 (2032), 0.4 (2033), 0.4 (2034)
  - Real growth rate contribution: -2.1 (2024), -2.0 (2025), -1.9 (2026), -1.9 (2027), -1.8 (2028), -1.7 (2029), -1.5 (2030), -1.5 (2031), -1.4 (2032), -1.4 (2033), -1.3 (2034)
  - Other identified flows: 0.7 (2024), 1.0 (2025), 0.6 (2026), 0.7 (2027), 0.5 (2028), 0.5 (2029), 0.5 (2030), 0.5 (2031), 0.5 (2032), 0.5 (2033), 0.5 (2034)
  - Gross financing needs (GFN): 2.7 (2023), 3.6 (2024), 2.8 (2025), 4.2 (2026), 4.8 (2027), 5.9 (2028), 2.5 (2029), 0.7 (2030), 0.8 (2031), 1.7 (2032), 2.3 (2033)
  - Debt service (percent of GDP): 7.2 (2023), 7.7 (2024), 6.8 (2025), 8.1 (2026), 7.8 (2027), 8.7 (2028), 5.0 (2029), 2.4 (2030), 1.8 (2031), 2.0 (2032), 1.8 (2033)
  - Memo: Real GDP growth (percent): 2.5 (2023), 2.6 (2024), 2.8 (2025), 3.0 (2026), 3.1 (2027), 3.1 (2028), 3.0 (2029), 3.0 (2030), 3.0 (2031), 3.0 (2032), 3.0 (2033)
  - Memo: Inflation (GDP deflator; percent): 4.7 (2023), 3.7 (2024), 2.5 (2025), 2.3 (2026), 2.3 (2027), 2.1 (2028), 2.3 (2029), 2.3 (2030), 2.3 (2031), 2.3 (2032), 2.3 (2033)
  - Memo: Nominal GDP growth (percent): 7.3 (2023), 6.4 (2024), 5.4 (2025), 5.3 (2026), 5.5 (2027), 5.2 (2028), 5.3 (2029), 5.3 (2030), 5.3 (2031), 5.3 (2032), 5.3 (2033)
  - Memo: Effective interest rate (percent): 1.8 (2023), 1.6 (2024), 1.8 (2025), 1.8 (2026), 2.2 (2027), 2.5 (2028), 2.7 (2029), 3.0 (2030), 3.1 (2031), 3.2 (2032), 3.3 (2033)

### Policy implications and recommendations
- Remaining demand pressures should serve as a caution against expansionary policies.
- Mitigation of transmission to the real estate sector should not be hindered.
- Low competition in the banking sector and its interaction with financial literacy "warrant further analysis."
- To achieve sustained disinflation, the profit share will likely need to decline to historic norms.
- Wage dynamics will determine the inflation outlook; public sector wage growth should be controlled and further indexation be avoided.

*Source: IMF staff (Annex based on Beyer, R. (2024). “Disinflation and Monetary Transmission in Cyprus”. International Monetary Fund, Selected Issue Paper)*

### Annex III. External Sector Assessment

### Annex III. External Sector Assessment

### Overall assessment
- The external position of Cyprus in 2023 is assessed substantially weaker than the level implied by fundamentals.
- Policies contributed positively to the external position.
- The larger estimated current account (CA) gap relative to last year is partly due to:
  - the import of physical assets of special purpose entities (SPEs) in the shipping sector, and
  - higher repatriation of income from foreign-owned financial companies.
- Supported by expected improvements in the terms of trade, the CA deficit is expected to decline, albeit slowly, and remain at a high level, driven by the primary income balance.
- The net international investment position (NIIP) is projected to worsen by around 20 percent of GDP over the projection period.

### Potential policy responses
- Address that the large CA deficit is largely driven by foreign-owned firms transferring profits abroad, resulting in an increasingly negative primary income balance—a symptom of Cyprus’ growth model and recent strong economic performance.
- Maintain a tight fiscal stance to support the external balance.
- Support private sector deleveraging, including through resolution of legacy NPLs, and higher private savings to provide additional support in the medium run.
- Implement structural reforms to raise productivity and enhance competitiveness—supported by the RRP—to improve the business environment and the external position in the long term.

### Foreign assets and liabilities: position and trajectory
- NIIP path and levels:
  - NIIP: -163 percent of GDP in 2014
  - NIIP: -115 percent of GDP in 2019
  - NIIP: -133 percent of GDP in 2020
  - NIIP: -97 percent of GDP in 2023
- Excluding SPEs, the underlying NIIP improved from -78 percent of GDP in 2014 to -36 percent by 2023Q4.
- 2023 (% GDP) headline positions:
  - NIIP: -96.6
  - Gross Ass.: 1577
  - Debt Ass.: 519
  - Gross Liab.: 1790
  - Debt Liab.: 587
- Gross liabilities declined to 1,790 percent of GDP in 2023, with around one third in the form of external debt.
- Under the IMF staff’s baseline scenario, the NIIP is projected to deteriorate by about 20 percent of GDP in the medium term.
- Assessment: While the deterioration during the pandemic has been reversed, the NIIP remains weak. The size of the NIIP reflects Cyprus’ role as a financial center and the effects of SPEs and remains broadly sustainable when excluding SPEs.

### Current account (CA): developments and assessment
- Historical CA trajectory:
  - CA averaged -4.9 percent during 2017-19.
  - CA increased from 0.3 percent of GDP in 2015 to 7.9 percent in 2022 and to 12.1 percent in 2023.
  - The overall CA deficit widened substantially in 2020 (lower services exports, larger primary income deficit), recovered in 2021 (higher services balance), and deteriorated substantially in 2022 and 2023 (deterioration in net primary income and trade balance; exceptionally high net ship imports by SPEs in 2023).
- EBA/IMF model estimates and adjustments (in percent of GDP):
  - CA-Actual: -12.1
  - Cyclical contributions (from model): (-)-0.2
  - Additional temporary/statistical factors (spike in vessel imports in 2023Q1): 2/-2.5
  - Natural disasters and conflicts: (-)-1.6
  - Adjusted CA: -7.8
  - CA Norm (from model): 3/-1.3
  - CA Gap: -6.4 1.6 2.1  (table indicates CA Gap-6.41.62.1; IMF staff assesses CA gap to be -6.4 percent of GDP for 2023)
  - o/w Relative policy gap: 2.0
- Assessment:
  - The CA norm is estimated at -1.3 percent of GDP, against an adjusted CA estimate of -7.8 percent of GDP (accounting for cyclical contributions, temporary SPE-related vessel registration, and natural disasters).
  - Policy gaps (deviations between current and desired policy settings relative to the world) contribute 2.0 percentage points, mostly driven by a tighter fiscal stance than the rest of the world.
  - Based on the CA model, IMF staff assesses the CA gap to be -6.4 percent of GDP for 2023, implying the external position was substantially weaker than fundamentals warranted.

### Real exchange rate (REER)
- CPI-based REER movements:
  - REER remained broadly stable in 2020 and 2021.
  - REER depreciated by 1.3 percent in 2022.
  - REER appreciated by 0.7 percent in 2023.
- REER gap estimates (in percent):
  - From CA-gap-derived assessment (elasticity -0.6): REER overvaluation of 11.2 percent in 2023.
  - REER model: -2.8 percent.
  - ES model: -3.3 percent.
- Assessment: Considering all model estimates and their uncertainties, and placing higher weight on the CA model, staff’s assessment is of a slight overvaluation (in line with the CA model).

### Capital and financial accounts: flows and vulnerability
- Net capital inflows:
  - Net capital inflows amounted to 7.2 percent of GDP in 2022.
  - Net capital inflows amounted to 9.7 percent of GDP in 2023.
  - Higher FDI net flows more than made up for lower net portfolio flows; net private inflows increased while public inflows declined.
- 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 intervention 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.

### Sectoral drivers and policy implications (summary from Annex V)
- Main drivers of the CA deficit:
  - Chronic saving-investment (S-I) deficits of households and non-financial corporations (NFCs).
  - Declining surpluses of financial corporations (FCs).
- Sectoral facts and figures:
  - Households:
    - Cyprus households have the second largest S-I deficit in the EU.
    - Households show low savings and the highest household investment rate in the EU; accumulation of financial assets is the lowest in the EU.
    - Households prefer physical assets (e.g., real estate) over financial assets.
  - NFCs:
    - NFCs S-I deficit has been the largest drag on the CA in recent years.
    - NFCs are relatively small (GVA per capita and share of economy-wide GVA); Cypriot firms are among the least profitable in the EU (low GDI-to-GVA ratio).
    - Low profitability is attributed to a bigger share directed to taxes (highest in EU) and property income payments (third highest).
    - NFCs investment rate is the lowest in the EU; the sector’s S-I balance is the lowest in the EU.
  - FCs:
    - FCs historically generated large surpluses that partially offset other sectors’ deficits, but surpluses have declined since the GFC.
    - Decline driven by weaker profitability, deleveraging, declining net property income, and rising taxation burden.
    - Continued deleveraging and severing financial ties with Russia could weigh further on FC surpluses and the CA.
  - Government:
    - The government S-I position has improved and turned into a surplus since 2014, and is among the highest in Europe.
    - The improvement in government S-I coincided with deterioration in private S-I balances, raising questions about the impact of fiscal consolidation on private disposable income and savings.
- Policy recommendations to reduce the CA deficit:
  - Enhance the business environment, competitiveness, innovation, and productivity to raise private sector disposable incomes and saving rates.
  - Targeted interventions to repair balance sheets of vulnerable borrowers and SMEs to support household and NFC savings.
  - Boost confidence in the financial sector to facilitate more efficient utilization of household savings.
  - Effectively implement the foreclosure framework to support FCs income.
  - Fully utilize the RRP to boost government investments in a S-I neutral manner.
  - Maintain fiscal discipline and avoid major expenditure expansions to prevent further exacerbation of the saving-investment gap.

*Source: Annex III. External Sector Assessment (selected sections) from the provided IMF content unit.*

### Annex VI. Green Taxation: Along the Path to Climate Mitigation

### Annex VI. Green Taxation: Along the Path to Climate Mitigation in Cyprus

### Climate targets and recent progress
- Cyprus aims for climate neutrality by 2050 and raised its emission reduction target for non-ETS sectors in the NECP to 32 percent by 2030 compared to 2005.
- The Cyprus RRP includes a significant climate component; the planned green taxation reform is a key policy initiative.
- Emissions growth began to reverse and a decoupling of emissions from growth is underway, but challenges remain.

### Emissions profile and projections
- Cyprus still relies on oil and petroleum products for 90 percent of its energy.
- Emissions have exceeded annual allocations in recent years.
- With current and planned policies (including energy infrastructure projects) emissions are projected to remain 13 percent above target by 2030, with little projected decline in non-ETS sectors other than transport.
- Meeting the 2030 target requires timely implementation of planned measures and additional measures.

### Role and rationale for carbon taxation
- Carbon taxation is presented as the most economically efficient mitigation tool: it incentivizes lower and more efficient energy consumption and promotes innovation and adoption of low-carbon technologies.
- Carbon prices are relatively low in Cyprus’ non-ETS sectors compared to the rest of Europe, reflecting relatively low fuel taxation rates.
- The green tax reform includes the introduction of a carbon tax for fuels used in non-ETS sectors.

### Impact assessment of the current green tax reform (fuel excise duty top-up)
- Current plans: fuel excise duty top-up in the transport and non-ETS industry sectors with differentiated rates and schedules.
- Using the IMF-WB CPAT tool, the proposed tax is expected to:
  - Reduce emissions by an additional 3.8 percent by 2030.
  - Close about one-third of Cyprus’ emissions gap to the 2030 target.
  - Generate additional net revenues of 0.4 percent of GDP, net of base erosion effects.
  - Produce a transitory aggregate demand impact in the range 0.1–0.2 percentage points.
  - Reduce household consumption by 0.4 percent proportionally across income groups.
  - Require channeling a quarter (third) of revenues to fully offset the impact on the four (five) lowest income deciles via well-targeted social transfers and PIT tax allowances or exemptions.

### Uniform carbon tax scenario and wider coverage
- A uniform carbon tax applied more widely across non-ETS sectors would:
  - Raise currently low carbon prices in the rest of the non-ETS sectors.
  - Enhance abatement efficiency while minimizing economic costs and smooth the transition to ETS II.
  - Applying transport-sector rates uniformly to all non-ETS sectors would produce 1.5 times the emission reduction impact relative to the current plan, closing half of the gap to the 2030 target.
  - Impact on household consumption would be higher and slightly more regressive.
  - Fiscal revenues would be comparable to the current plan, implying that a larger share of revenues, third (half), would need to be channeled to the bottom four (five) income distribution deciles for protection purposes.

### Complementary targeted sectoral policies
- Fully closing the emissions gap through carbon pricing alone would require tax rates that are 2.5 times those currently planned, which would be more economically and socially challenging.
- Targeted sectoral policies (feebates, regulations) are often less efficient than carbon taxation because they lack a clear price signal and do not generate fiscal revenue for redistribution.
- Nevertheless, targeted sectoral policies could complement carbon pricing in a multi-pronged strategy to achieve Cyprus’ mitigation targets.

*Source: Annex VI. Green Taxation: Along the Path to Climate Mitigation (content unit 1cypea2024001).*

### Annex IX. Data Issues

### Annex IX. Data Issues

### Data adequacy and quality assessment
- Overall conclusion: "The data provided to the Fund is adequate for surveillance."
- Heatmap / Data Adequacy Assessment (as presented)
  - National Accounts: AAABAAA
  - Prices: AAAAA
  - Government Finance Statistics: AABA
  - External Sector Statistics: AA
  - Monetary and Financial Statistics: AB
  - Inter-sectoral Consistency: A
  - Median Rating: (displayed in table)
- Data Quality Characteristics
  - Granularity (Government Finance Statistics and Monetary and Financial Statistics have dual-granularity cells as noted in the source).
- Questionnaire-based assessment notes
  - The overall questionnaire assessment and sector assessments are based on a standardized questionnaire and scoring system (see IMF Review of the Framework for Data Adequacy Assessment for Surveillance, January 2024, Appendix I).
  - When the questionnaire does not include a question on a specific dimension, the corresponding cell is blank.

### Use of data, alternate sources, and data gaps
- Use of alternative data: "No data or estimates different from official statistics were used."
- Climate analysis: relied on datasets including the European Centre for Medium-Range Weather Forecasts (ECMWF) and the Climate Research Unit (CRU).
- Other data gaps: "None"
- Changes since last Article IV: "The authorities are progressing with transaction-based house price indices."
- Rationale for staff assessment:
  - Staff assess the data provided to the Fund to be adequate for surveillance with no major data weaknesses affecting staff’s analysis of macroeconomic and financial risks.
  - External Sector Statistics are complicated by the large presence of Special Purpose Entities; accuracy and timeliness of initial data could be improved.
  - "The data provided to the Fund has some shortcomings that somewhat hamper surveillance." and "The data provided to the Fund has serious shortcomings that significantly hamper surveillance." are referenced as part of the assessment scale.

### Data Standards and Dissemination
- Cyprus subscribes to the Special Data Dissemination Standard (SDDS) since December 2009 and publishes data on its National Summary Data Page.
- Latest SDDS Annual Observance Report is available on the Dissemination Standards Bulletin Board.
- Data provision table (selected indicators and timing descriptors reproduced from source):
  - Exchange Rates: Current (Date of Latest Observation: Mar-24; Date Received: Apr-24; Frequency of Data: DDDD; Frequency of Reporting: …; Expected Frequency: 1W; Expected Timeliness: 3W)
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Current (Mar-24; Apr-24; MMMM; 1W; 3W)
  - Reserve/Base Money: Feb-24; Mar-24; QQMM; 2W; 2W
  - Broad Money: Feb-24; Mar-24; QQMM; 1M; 1M
  - Central Bank Balance Sheet: Feb-24; Mar-24; QQMM; 2W; 2W
  - Consolidated Balance Sheet of the Banking System: Feb-24; Mar-24; QQMM; 1M; 1M
  - Interest Rates: Current (…)
  - Consumer Price Index: Mar-24; Apr-24; MMMM; 1M; 3M
  - Revenue, Expenditure, Balance and Composition of Financing ‒ General Government: Feb-24; Apr-24; QQAQ; 2Q; 3M
  - Revenue, Expenditure, Balance and Composition of Financing ‒ Central Government: Feb-24; Apr-24; QQMM; 1M; 1M
  - International Investment Position: Feb-24; Apr-24; QQQQ; 1Q; 1M
  - Stocks of Central Government and Central Government-Guaranteed Debt: 2023: Q4; Mar-24; QQQQ; 1Q; 1Q
  - External Current Account Balance: Feb-24; Apr-24; MMMQ; 8W; 1Q
  - Exports and Imports of Goods and Services: 2023: Q4; Mar-24; QQQQ; 1Q; 70D
  - GDP/GNP: 2023: Q4; Mar-24; QQQQ; 1Q; 1Q
  - Gross External Debt: 2023: Q4; Mar-24; QQQQ; 1Q; 1Q
- Frequency and timeliness legend preserved from source: “D” daily; “W” weekly; “M” monthly; “Q” quarterly; “A” annual; "SA" semiannual; "I" irregular; "NA" not available or not applicable; and "NLT" not later than.

### Corrective actions and capacity development priorities
- Staff note: "The data provided to the Fund has some shortcomings that somewhat hamper surveillance."
- Capacity development activity (selected TA and advisory engagements listed in the source):
  - Multiple technical assistance missions and projects across FAD, MCM, STA, RES, LEG departments between 2014 and 2024 covering revenue administration, public financial management, NPL management, cooperative credit sector restructuring, macro-financial modeling, central bank governance, sectoral accounts and balance sheets, property price statistics, SOE governance, debt management, and public wage bill analysis.
  - Two FAD long-term resident advisors on public financial management (Feb 2014–Oct 2016) and revenue administration (Jul 2015–Dec 2016).
- Specific corrective actions underway by authorities (as described by authorities in their statement):
  - Progress on transaction-based house price indices.
  - Legislative efforts to address central bank governance and financial autonomy recommendations from the 2013 safeguards assessment.
  - Ongoing public financial management reforms and state wage bill study, with an action plan for State-Owned Entities governance to be submitted to the Council of Ministers.

### Key statistics and macro-financial indicators (as reported in the source)
- Real GDP growth projections:
  - Staff projections: 2.6 percent for 2024; 2.8 percent for 2025.
  - Authorities expect real GDP growth to be slightly higher than staff projections for 2024 (2.6 percent) and 2025 (2.8 percent).
- Labor market and inflation:
  - Unemployment: 6.1 percent in 2023; expected 5.8 percent in 2024.
  - HICP inflation: 3.9 percent in 2023; expected to fluctuate around the 2 percent mark during 2024-2025.
- External sector:
  - Current account deficit: 12.1 percent of GDP in 2023.
  - Drivers: increase in the trade deficit of goods (including net transactions of mobile transport equipment, mainly ships), elevated imports for home consumption, and outflows driven by high profits on FDIs.
- Fiscal sector:
  - Fiscal surplus: 3.1 percent of GDP in 2023.
  - Government debt: 77.3 percent of GDP in 2023.
  - Authorities’ target: reduce public debt to 60 percent of GDP in 2026.
  - Fiscal measures: remaining VAT reductions and electricity subsidies to expire in June (year implicit in source).
  - Planned tax reform: comprehensive study due to be completed in July 2025; initial phase in 2024 to introduce a carbon tax on fuels (on top of excise and polluting industries not covered by ETS), with compensatory measures for affected households.
- Financial sector resilience:
  - CET1 ratio: 21.3 percent in 2023.
  - System buffer availability (above Pillar 2 Guidance): 8.1 percent.
  - NPL ratio: 7.9 percent in December 2023.
  - Mortgage-to-rent fiscal cost: estimated at 0.9 percent of GDP over the next two years.
  - Banks’ compliance with MREL targets: achieved through Tier 2 and senior bond issuances in 2022 and 2023.
- Regulatory and structural priorities:
  - Increase in neutral countercyclical capital buffer (CCyB) to 1 percent.
  - Strengthening of securities markets supervisor (CySEC) and regulatory framework for NBFIs.
  - Mortgage-to-rent scheme effective December 2023; foreclosure framework amendments adopted in 2023.
  - Expanded role for Financial Ombudsman (FO) to appoint mediators for loan restructuring.

### Rationale and implications for surveillance
- Staff view: Data are broadly adequate for surveillance but certain areas (notably External Sector Statistics) are complicated by structural features (large presence of Special Purpose Entities) that affect accuracy and timeliness of initial data.
- Continued IMF engagement and technical assistance aim to strengthen statistical capacity and remedial actions where shortcomings "somewhat hamper surveillance" or "significantly hamper surveillance" depending on the dimension assessed.

*Source: Annex IX. Data Issues, Cyprus — Staff Report for the 2024 Article IV Consultation (as provided).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2024/english/1cypea2024001.pdf_