## _cr05107 — IMF Staff Report Executive Summary and Selected Sections ## Source details **Canonical URL:** [_cr05107 — IMF Staff Report Executive Summary and Selected Sections](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05107.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05107.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05107.pdf.json) --- ### Background, EU Accession, and Euro Adoption Strategy - Cyprus joined the European Union on May 1, 2004, one week after rejection of the UN-sponsored “Annan Plan” referendum (Turkish Cypriots approved the plan by 2:1; Greek Cypriots opposed it by 3:1). - EU accession accelerated adoption of EU institutions and regulations and prompted important reforms and implementation challenges. - Authorities aim for early euro adoption (ERM2 entry in 2005), making fiscal consolidation a central objective. - Exchange regime and ERM2 prospects: - Historical exchange regime: formal ±15 percent corridor but de facto narrow band around central parity of €1.7086 : £C1. - Cyprus appears well-placed to join ERM2 in 2005, provided fiscal adjustment is maintained and structural reforms advance. - Authorities view current exchange rate parity as appropriate; staff support conditional on readiness to take additional fiscal measures if needed. ### Recent Economic Developments and Outlook - Growth, demand, labor, and prices: - Real GDP growth: 3.5 percent for 2004 (estimated); 3.8 percent for 2005 (projected). - Staff projects average growth of about 4 percent during 2006–08 (contingent on EU recovery and oil price moderation). - Domestic demand (annual percentage change series, 1999–2005): 2.1, 6.1, 3.2, 4.7, 2.3, 6.1, 1.6. - Private consumption (1999–2005): 3.0, 6.5, 3.7, 1.5, 2.6, 7.2, 1.1. - Unemployment: around 3½ percent; table series (1999–2005): 3.6, 3.4, 2.9, 3.2, 3.5, 3.4, 3.2. - Inflation: subdued; CPI (period average) series (1999–2005): 1.6, 4.1, 2.0, 2.8, 4.1, 2.5, 2.5. Staff expects inflation in the neighborhood of 2½ percent assuming restrained monetary policy. - External position and tourism: - Current account deficit: oscillated between 3½ and 4½ percent of GDP for several years; likely on that order in 2004. - Tourism arrivals recovered in 2004 (rising by 3 percent year-on-year to end-October); tourism spending remained sluggish. - Risks: - Sustained higher oil prices could slow growth and raise air travel costs. - Geopolitical uncertainties could divert travelers. - Wage indexation could transmit energy price increases into higher wages. ### Fiscal Developments, Convergence Program (CP), and Recommendations - Historical fiscal deterioration and composition: - General government overall balance (1999–2005): -4.4, -2.4, -2.3, -4.5, -6.3, -4.8, -3.0. - General government deficit rose from 2.3 percent of GDP in 2001 to 6.3 percent of GDP in 2003. - Expenditure-to-GDP ratio increased by more than 7 percentage points since 2000, driven by current expenditure overruns and increased social spending following VAT rise to 15 percent. - Public debt-to-GDP ratio rose to almost 70 percent in 2003; staff reports 72.3 percent for 2004 in tables. - Convergence Program (CP) targets and measures: - May 2004 CP: target deficit of 5.2 percent of GDP in 2004 and 2.9 percent of GDP in 2005. - December 2004 revised CP: reported budgetary impact: 1.2 percent of GDP in 2004 and 2.8 percent of GDP in 2005; expenditure measures dominate 2004, revenue measures more prominent in 2005. - Notable measures: increase in public sector retirement ages; freeze on new government positions; tax amnesty yielding £C60 million (0.8 percent of GDP) by early December 2004. - Fiscal outturns and projections: - Preliminary 2004 central government outturn after 10 months: deficit of about 3 percent of GDP; authorities expected a 2004 deficit of about 4¾ percent of GDP. - Staff projection under full implementation of CP measures: 2005 deficit would fall to about 3 percent of GDP. - Under CP baseline, public debt-to-GDP ratio falls from 72 percent in 2004 to 61 percent in 2009 (Annex I). - Staff recommendations and contingent measures: - Credible fiscal adjustment is essential for ERM2 entry and medium-term sustainability. - Establish an explicit multi-year fiscal framework and consider a fiscal ROSC. - If CP underperforms, proposed measures include: better targeting of social benefits; more aggressive collection of tax arrears; widening the tax base (including sectors with preferential treatment); broadening and revising fees for government services; and, if necessary, a further increase in the VAT rate from the current EU-minimum of 15 percent (relative to an EU-average standard rate of 19.4 percent). - Authorities expressed willingness to consider most of these measures; December CP proposes tighter eligibility criteria for social benefits. ### Monetary Policy, Credit, and Financial Sector Oversight - CBC policy and rates: - Central Bank of Cyprus (CBC) raised policy rates by 100 b.p. on April 30, 2004; policy rates then stood 250 b.p. above corresponding euro area policy rates and were left high thereafter. - CBC described monetary policy as vigilant in face of fiscal laxity and capital account liberalization on May 1, 2004. - Credit growth and inflation pressures: - Credit growth slowed to 5–6 percent per annum in 2002–03 (from an average over 13 percent during 1999–2001); expected to rebound slightly in 2004–05. - Inflationary pressures noted in summer 2004 due to higher oil prices; policy considered inappropriate to relax given ERM2 plans. - Financial sector prudential issues: - Financial sector regulation generally strong; compliance with EU directives induced reforms. - NPL treatment thresholds tightened: 12 months → 9 months (2003) → 6 months (2004) → 3 months (2006, and referenced also a plan to reduce to 3 months earlier). - NPL ratios modestly risen; authorities reported average recovery of a nonperforming asset about 10 years (authorities’ estimate). - Cooperative and credit societies (CCSs) hold about a quarter of deposit base but fall outside CBC supervisory remit; many CCSs undercapitalized and to be aligned with EU directives by end of a 5-year transitional period. - Staff encourages consolidation of supervision, strengthening cooperative sector capital, and undertaking a Financial Sector Assessment (FSAP). ### External Sector, Reserves, and Financing - Balance of payments and reserves: - Current account balance (selected series and projections, percent of GDP): historical series and projections show deficits around -2.17 to -6.44 percent over various years and projections (table entries). - Gross official reserves (millions US$): 1,977; 1,870; 2,397; 3,174; 3,459; 4,253; 4,755; 5,232; 5,755; 6,239 (multi-year series). - Reserves in months of imports (official reserves): 5.3; 4.4; 5.6; 7.0; 6.5; 6.8; 7.1; 7.3; 7.6; 7.7. - External vulnerabilities and financing: - Current account deficits around 3½–4½ percent of GDP in recent years. - Medium-term scenarios indicate plausible shocks would leave Cyprus in a relatively comfortable position, though staff cautioned about growing external liabilities. - Gross external financing need (US$ billions): 2.3 (2004), projected 2.8 (2005), 2.6 (2006), 2.7 (2007), 2.8 (2008), 2.8 (2009); in percent of GDP: 13.4 (2004), projected 15.4 (2005), 13.6 (2006), 13.1 (2007), 12.6 (2008), 12.1 (2009). - Sovereign Eurobond placement of €500 million during the summer priced at 23 b.p. over comparable German bund benchmark; it was significantly oversubscribed. ### Public Debt and Sustainability Stress Tests — Key Scenarios and Outcomes - Public debt baseline and alternatives (selected outcomes from Annex I Table 1): - Baseline: public debt-to-GDP falls from 72 percent in 2004 to 61 percent in 2009. - Scenario A1 (historical averages): debt-to-GDP falls to 66 percent by 2009. - Scenario A2 (primary balance unchanged): debt-to-GDP rises to 71 percent by 2009. - Bound (stress) tests — selected results: - B1 (real interest rate at historical average plus two standard deviations in 2005–06): public debt-to-GDP = 69.2 percent in 2009. - B2 (real GDP growth at historical average minus two standard deviations in 2005–06): public debt-to-GDP = 82.1 percent in 2009 (identified as most significant bound test). - B3 (primary balance at historical average minus two standard deviations in 2005–06): public debt-to-GDP = 68.8 percent in 2009. - B4 (combination of B1–B3 using one standard deviation shocks): public debt-to-GDP = 73.2 percent in 2009. - B5 (one-time 30 percent real depreciation in 2005): public debt-to-GDP = 80.5 percent in 2009. - B6 (10 percent of GDP increase in other debt-creating flows in 2005): public debt-to-GDP = 71.1 percent in 2009. - Staff overall assessment: - Under the baseline scenario both public and external debt ratios decline over 2005–09; sustainability does not appear to be at serious risk under shocks of plausible magnitudes, but significant downside scenarios (notably large growth shocks or depreciations) materially worsen debt ratios. ### External Debt Stress Tests (selected) - External debt baseline and stress outcomes (Annex I Table 2 highlights): - Baseline: external debt-to-GDP falls from 57 percent in 2004 to 51 percent by 2009. - B1 (higher nominal interest rate): external debt-to-GDP = 54.9 percent in 2009. - B2 (lower real GDP growth): external debt-to-GDP = 55.0 percent in 2009. - B3 (change in U.S. dollar GDP deflator adverse shock): external debt-to-GDP = 79.7 percent in 2009 (largest increase). - B6 (one-time 30 percent nominal depreciation in 2005): external debt-to-GDP = 70.3 percent in 2009. ### Structural Policies, Labor Market, and Public Enterprises - Structural reforms and EU acquis compliance: - Liberalization advances: air transport (May 1, 2004), electricity (Transmission System Operator established April 2004), telecommunications, and removal of some price controls (cement and petroleum products abolished May 2004). - Remaining needs: foster competition, promote efficiency in public enterprises (PEs), corporatize Electricity Authority and telecommunications company early, and consider privatization where appropriate. - Labor market rigidities: - Centralized wage bargaining and automatic backward-looking wage indexation (COLA) are structural rigidities; staff recommends redesigning COLA (e.g., exclude changes in VAT and energy prices) and limit seniority-based public sector salary rules. - Authorities acknowledged real wage growth tended to outstrip productivity and agreed to limit increases beyond COLA in the public sector, but rejected broader revision of COLA. - Public enterprises and governance: - PEs produce about 8 percent of GDP; government guaranteed about 3½ percent of GDP in PE debt as of end-2003 (total government guaranteed debt about 10 percent of GDP). - Authorities reluctant to pursue comprehensive PE privatization; staff favors corporate governance modernization. ### Issues Related to Reunification, NGC Areas, and IMF Technical Assistance - Reunification context: - Annan Plan envisaged a “bicommunal, bizonal federation” (United Cyprus Republic); referenda held April 24, 2004 resulted in divergent outcomes. - Authorities estimated cost of rebuilding infrastructure in the north at £C5 billion (69 percent of 2004 GDP in the G/C areas). - Staff view: with firm implementation and goodwill the plan was economically and financially viable (as set out in staff statement to donors’ meeting prior to the referendum); authorities disagreed with staff’s viability assessment in the draft report. - Areas not under government control (NGC) snapshot (Annex II): - NGC areas comprise 1/3 of land area and about 22 percent of the population; produce less than 10 percent of combined Cyprus GDP. - Output concentrated in public sector, tourism, agriculture, and commerce; most external trade and tourism with Turkey. - Turkish lira circulates in NGC areas; public finances heavily dependent on transfers and loans from Turkey. - Selected indicators (NGC, 1999–2003): nominal GNP (US$ million) 964 (1999) to 1,284 (2003); tourism arrivals (thousands) 414 (1999) to 470 (2003); CPI (Dec–Dec percent change) 55.3 (1999) to 12.6 (2003). - IMF technical assistance to T/C community: - IMF staff can provide TA to the T/C community only with consent of the government of the Republic of Cyprus; authorities agreed on need to improve economic management in NGC areas and discussions on a framework for IMF TA continue. - EU aid package under approval: €259 million for 2005–07; United States appropriation: $31 million for energy, banking sector reform, and SME development. ### Statistics, Data Dissemination, and IMF Relations - Data quality and SDDS: - Cypriot statistics generally of good quality except for NGC areas; improvements possible in timeliness, consistency, and definitions. - Authorities intend to subscribe to the SDDS in the near future. - Core statistical indicators and reporting lags: - Quarterly GDP growth rates published with a delay of one quarter; annual national accounts with a delay of up to half a year. - Monthly indicators exist but with lags; balance of payments compiled per BPM5 since 1995. - IMF administrative data (as of December 31, 2004): - Joined IMF: December 21, 1961. - Quota: 139.60; Fund holdings of currency: 92.33; Reserve position in Fund: 47.28. - SDR net cumulative allocation: 19.44; holdings: 2.51. - Outstanding purchases and loans: None. - Article IV process and timelines: - Next Article IV consultation proposed on current 24-month cycle; last Article IV discussions October 23–November 4, 2002; staff visits October 10–13, 2003 and July 22–23, 2004. - IMF Executive Board concluded the 2004 Article IV consultation on February 18, 2005; Public Information Notice (PIN No. 05/39) issued March 22, 2005. *Source: IMF staff report and annexes (content unit _cr05107).* ### Executive Summary ...................................................................................................... ### Executive Summary ### Background to the Discussions - Cyprus joined the European Union on May 1, 2004, one week after rejection of the UN-sponsored “Annan Plan” referendum (Turkish Cypriots approved the plan by 2:1; Greek Cypriots opposed it by 3:1). - EU accession accelerated adoption of EU institutions and regulations, prompting important reforms and posing significant implementation challenges for authorities and the private sector. - Authorities aim for early euro adoption (ERM2 entry in 2005), making fiscal consolidation a central objective. ### Recent Economic Developments - Real GDP growth: 3.5 percent for 2004 (estimated); 3.8 percent for 2005 (projected). - Growth drivers and conditions: - Recovery led by consumption (fiscal easing in late 2003 and possible EU accession confidence effects); drag from net exports. - Tourism picked up (driven by stronger European economy) though per-tourist spending remained sluggish. - Labor market and prices: - Unemployment: around 3½ percent. - Inflation: subdued but has crept up modestly on rising energy prices. - External position: - Current account deficit: oscillated between 3½ and 4½ percent of GDP for several years; likely remained on that order in 2004. - Fiscal deterioration and composition: - General government deficit: 2.3 percent of GDP in 2001 → 6.3 percent of GDP in 2003. - Expenditure-to-GDP ratio increased by more than 7 percentage points since 2000, driven primarily by overruns on current expenditure and increased social spending following VAT rise to the EU minimum of 15 percent. - Public debt: - Debt-to-GDP ratio rose to almost 70 percent in 2003. - Part of the increase reflected stock-flow adjustments related to sinking funds required under domestic law (sinking funds to be extinguished by 2008). - Monetary policy response: - Central Bank of Cyprus (CBC) raised policy rates by 100 b.p. on April 30, 2004, bringing them to 250 b.p. above corresponding euro area policy rates. - CBC left rates high since April given inflation pressures, some appreciation, capital inflows, and increased borrowing abroad. ### Macroeconomic Outlook - Near-term prospects: - Staff projects growth of 3.8 percent for 2005 (authorities forecast 4 percent). - Inflation expected to remain in the neighborhood of 2½ percent, assuming continued restrained monetary policy. - Unemployment expected to hold around 3½ percent; foreign workers are about 13 percent of the labor force. - Risks: - Sustained higher oil prices could slow growth in Europe and raise air travel costs, damping tourism. - Geopolitical uncertainties in the region could divert travelers to other destinations. - Wage indexation could transmit energy price increases into higher wages. - Medium-term: - Staff projects average growth of about 4 percent during 2006–08, contingent on durable EU recovery and some moderation in oil prices. - Uncertainty is high due to the unresolved reunification issue and uncertain effects of EU accession. ### Fiscal Policy and Convergence Program - Convergence Program (CP) objectives and composition: - May 2004 CP aimed to redress fiscal slippage: target deficit of 5.2 percent of GDP in 2004 and 2.9 percent of GDP in 2005, with further tightening thereafter. - December 2004 revised CP: expenditure measures dominate 2004; revenue measures more prominent in 2005. Total reported budgetary impact: 1.2 percent of GDP in 2004 and 2.8 percent of GDP in 2005. - Notable measures welcomed by staff include increase in public sector retirement ages and a freeze on new government positions. - CP design features and risks: - CP includes many relatively small measures (diversification strategy) which spreads risk but raises administrative complexity and risks cumulative optimism about yields. - Specific medium-term measures include tax amnesty (expected widening of tax base), regularization of dividend policy for semi-government organizations, and fees for issuance of title deeds for buildings with minor irregularities. - Historical fiscal record: - Slippage in achieving fiscal adjustment targets occurred in several past years; general government overall balance: -2.4 (2000), -2.3 (2001), -4.5 (2002), -6.3 (2003), -4.8 (2004 est.), -3.0 (2005 proj.) as tabulated in the source. - Staff recommendations for fiscal policy: - Credible fiscal adjustment is essential for ERM2 entry and medium-term sustainability. - Establishing an explicit multi-year fiscal framework would buttress policy credibility. - Authorities’ interest in a fiscal ROSC is welcome. ### Monetary Policy and Financial Sector - CBC action and stance: - April 30, 2004 policy rate hike of 100 b.p.; policy rates then 250 b.p. above corresponding euro area policy rates. - Monetary policy described as vigilant in face of fiscal laxity and capital account liberalization on May 1, 2004. - Financial sector oversight: - Financial sector regulation generally strong; compliance with EU directives induced interest rate liberalization and reforms. - Coordination among supervisory bodies has improved but still requires strengthening. - Supervision of the cooperative sector needs alignment with bank prudential regulations. - Staff advice: - Authorities are encouraged to undertake a Financial Sector Assessment (FSAP). ### External Sector and Euro Adoption Strategy - ERM2 prospects: - Cyprus appears well-placed to join ERM2 in 2005, provided fiscal adjustment is resolutely maintained and structural reforms advance. - Long-standing use of an ERM2-type exchange rate regime offers continuity. - Current parity seems broadly in line with fundamentals, given continued full employment and rebound in tourism. - External vulnerabilities: - Current account deficits around 3½–4½ percent of GDP in recent years. - Continued attention to competitiveness and medium-term external sustainability is required. ### Structural Policies - Progress and outstanding reforms: - Significant strides to meet EU requirements, including liberalization of air travel, electricity, and telecommunications. - Remaining needs include fostering competition and promoting efficiency, particularly in public enterprises. - Labor market: centralized wage bargaining and backward-looking wage indexation remain rigidities that need reform to enhance competitiveness. - Public sector and governance: - Improve utilization of government property and regularize dividend policy for public enterprises. - Staff encouragements: - Strengthen supervision of cooperative sector. - Undertake an FSAP. ### Issues Related to Reunification and IMF Technical Assistance - Reunification context: - Reunification prospects remain uncertain following divergent referendum outcomes (T/C approved “Annan Plan”; G/C rejected). - Lack of clarity on reunification is a major medium-term uncertainty for GDP prospects. - IMF technical assistance (TA): - IMF activities, including TA, could support reunification and improve living standards across Cyprus. - Authorities consent to provide IMF TA to the Turkish Cypriot (T/C) community in northern Cyprus could help establish a baseline for advancing all of Cyprus toward best practices in a number of areas. *Source: Executive Summary (IMF staff report).* ### 11. The authorities cited preliminary data for 2004 as evidence that the need for ### _cr05107 - 11. The authorities cited preliminary data for 2004 as evidence that the need for ### Fiscal stance and budgetary performance - Preliminary 2004 central government outturn after 10 months: deficit of about 3 percent of GDP. - Authorities expected to "overperform" relative to the deficit target in the May CP, achieving a deficit for the year of about 4¾ percent of GDP. - December update to the CP approved by authorities was more ambitious than the May program. - Main sources of 2004 budgetary improvement: - Better revenue performance—especially VAT and excises. - Delayed public investment. - Historical pattern: fiscal slippage occurred when initially-approved budgets were repeatedly amended during the year; 2003 budget amended twelve times, 2004 amended three times. - Political/institutional actions in 2004: - Finance minister rejected a large supplemental budget in July and resisted loosening the fiscal stance thereafter. - With presidential support, the finance minister pressed for public sector wage restraint citing euro adoption prospects. - Trade unions complained the CP was approved without consultation and that labor bore a disproportionate share of adjustment. - Specific 2004 measures and outcomes: - Tax amnesty yielded £C60 million (0.8 percent of GDP) by early December—well beyond the original projection. - Only one significant supplementary budget passed in 2004; a C£60 million appropriation for agricultural subsidies (among other things) approved in November. ### Fiscal projections, risks, and staff recommendations - Staff projection under full implementation of CP measures: - 2005 deficit would fall to about 3 percent of GDP, assuming all CP measures are passed and scrupulously implemented. - Authorities acknowledged downside risks: - Fiscal impact of higher oil prices. - Conceivable slowdown in tourism if further geopolitical tensions occur. - Authorities estimate sustained high oil prices could worsen public finances by about 0.2 percentage points of GDP relative to the baseline deficit path. - Mission (staff) proposed measures if CP underperforms: - Better targeting of social benefits. - More aggressive collection of tax arrears. - Widening the tax base to cover sectors with preferential treatment (examples cited: commercial businesses owned by the church or the cooperatives). - Further broadening and revision of fees for government services. - If necessary, a further increase in the VAT rate from the current EU-minimum of 15 percent (relative to an EU-average standard rate of 19.4 percent). - Authorities indicated willingness to consider most of these measures; December CP proposes tighter eligibility criteria for social benefits. - Medium-term: Under the CP, public debt set to decline rapidly toward 60 percent of GDP from 2005 onward; without CP measures, debt might quickly become unsustainable. - Projected health and pension outlays underscore urgency of CP implementation; CP proposes significant parametric reforms to both public and general pension systems. - Authorities likely to request a fiscal ROSC during 2005 and showed willingness to consider a medium-term fiscal framework to modernize budget practices and reduce frequent supplementary budget revisions. ### Monetary policy and financial sector prudential issues - Authorities intends to maintain a cautious monetary policy stance. - Credit growth: - Slowed in 2002–03 to 5–6 percent per annum (from an average of over 13 percent during 1999–2001). - Expected to rebound slightly in 2004–05. - Inflationary pressures noted during the summer due to higher oil prices; authorities deemed it inappropriate to relax policy given uncertainty and ERM2 participation plans in 2005. - Financial sector regulatory alignment with EU norms: - Securities market supervision strengthened after the 2000 stock market crash (stricter disclosure rules and listing requirements). - Insurance sector consolidation following EU-compliant legislation in January 2003. - Minimum reserve requirements on foreign currency deposits increased. - Threshold for declaring an overdue loan nonperforming reduced: from 12 to 9 months in 2003, 6 months in 2004, and to 3 months in 2006. - NPL ratios have risen modestly; recovery of a nonperforming asset reported to take about 10 years on average (authorities), versus 6-9 months in many other EU members. - Ratings of key Cypriot banks remain above investment grade. - Supervision fragmentation and cooperative sector vulnerabilities: - Cooperative and credit societies (CCSs) hold about a quarter of the financial system’s deposit base but fall outside the CBC’s supervisory remit and face lenient tax/regulatory treatment compared with banks. - Many CCSs are undercapitalized; to be aligned with EU directives by end of a 5-year transitional period. - Limited availability of prudential data on CCSs; no reliable data on their NPL or recovery ratios; uniform provisioning policy not possible at present. - Locus of lender-of-last-resort responsibilities remains unclear. - CBC and private banks concurred with staff that supervision should be consolidated in one institution; cooperative sector disagreed. - Other vulnerabilities noted: - Interactions with the offshore sector (tax preferences phased out on January 1, 2003; offshore institutions operating at end-2001 grandfathered until end-2005). - Run-up in real estate prices: real estate prices rose by about 7 percent in 2004. - Credit exposure as of end-August 2004: 17 percent of outstanding credit to construction sector; 44 percent to household sector (most for mortgages). - During first eight months of 2004, 57 percent of new credit to households and the self-employed was used to finance house purchases. - CBC issued a circular in late 2003 tightening collateral requirements for real estate lending and signaled caution in Monetary Policy Committee statement after September meeting. ### External sector and euro adoption strategy - Authorities reiterated intention to adopt the euro as soon as possible and to join ERM2 in the first part of 2005. - Historical exchange regime: formal ±15 percent corridor but de facto narrow band around central parity of €1.7086 : £C1. - Authorities’ rationale: - Moving to a new regime (e.g., inflation targeting) would send confusing market signals. - ERM2 participation would help forge political will for fiscal adjustment; governing coalition in power through 2006 offers favorable political economy for reforms. - Staff support conditional on readiness to take additional fiscal measures if CP underperforms; need for strengthened structural reforms for successful EMU performance. - Competitiveness and exchange rate assessments: - Authorities viewed current exchange rate parity as appropriate despite modest competitiveness losses over past two years and some market share loss to cheaper tourism destinations. - Over longer horizon, real effective exchange rate remains near historic equilibrium. - ULC-based REER index (with tourism weights) appreciated by 13 percent since 2002. - Exports of goods now comprise less than a quarter of total exports; exports of services—particularly non-tourism (e.g., financial and legal) services—have held up well. - Tourism arrivals: 2002–03 decline reversed in 2004, rising by 3 percent year-on-year to end-October; tourism spending remained sluggish, with possible measurement issues noted by authorities. - External sustainability and financing: - Medium-term scenarios indicate plausible shocks would leave Cyprus in a relatively comfortable position, though staff cautioned about growing external liabilities. - Authorities noted Cyprus can finance modest current account deficits given strong growth record and EU membership. - Sovereign Eurobond placement of €500 million during the summer priced at 23 b.p. over comparable German bund benchmark; it was significantly oversubscribed. ### Trade policy and sectoral adjustments - Trade policy gradually aligned with EU requirements; adopting the EU common trade policy had limited revenue impact. - Removal of tariffs on imports resulted in moderate revenue loss; application of EU tariffs on imports from outside EU had marginal revenue impact because average tariffs in Cyprus were close to EU levels. - Agricultural sector will need to adjust under the Common Agricultural Policy; Cyprus granted transitional period to provide supplementary state aid to farmers until 2010. - Elimination of Multi-Fiber Agreement quotas expected to have only modest impact on Cypriot exports; textiles and clothing share in total exports declined from over 20 percent in 1998 to less than 10 percent in 2003. ### Structural policies and labor market issues - EU acquis compliance prompted structural reforms: - Air transport liberalized on May 1, 2004; number of airlines to Greece and the UK increased and airfares fell. - Electricity liberalization advanced with establishment in April 2004 of an independent Transmission System Operator. - A few remaining price controls (cement and petroleum products) abolished in May 2004. - Water management improved through higher prices to encourage conservation and cost recovery. - Public enterprises: - PEs produce about 8 percent of GDP; main PEs: Electricity Authority, Cyprus Telecom, Cyprus Airways (only Cyprus Airways is incorporated). - Government guaranteed about 3½ percent of GDP in PE debt as of end-2003 (out of total government guaranteed debt of about 10 percent of GDP). - Authorities unwilling to pursue comprehensive PE reform or corporatization; staff favored corporate governance modernization but privatization firmly opposed by trade unions. - Wage bargaining and COLA: - Authorities considered the current wage bargaining framework effective and rejected staff proposals to revise automatic backward-looking wage indexation (COLA). - Staff argued ERM2/euro adoption offers a window to eliminate this structural rigidity (suggested partial removal of energy costs and VAT changes from COLA calculations). - Authorities acknowledged real wage growth tended to outstrip productivity and agreed generally with staff advice to limit increases beyond COLA, but social partners (notably PEO) opposed increased labor market flexibility. - Labor market and the "green" line: - Estimates of Turkish Cypriots (T/C) traveling daily to work in the south range from 2,300-10,000 (correct figure probably in the middle). - Expansion of crossing points raises prospect of greater T/C employment competition with Greek Cypriots (G/C); authorities felt further T/C employment could be managed without dislocations given low unemployment and possibility of scaling back guest-worker program. ### Issues related to reunification and aid to NGC areas - IMF Article IV consultations have been conducted with the government of the Republic of Cyprus and not the areas not under government control (NGC). - IMF staff participated in background work for the "Annan Plan" negotiations in early 2004, providing technical advice on a macroeconomic framework for a unified country, fiscal management, and banking system reform. - After rejection of the "Annan Plan" by Greek Cypriot voters in April 2004, international community sought to reduce isolation of Turkish Cypriots through aid and technical assistance. - EU aid package under approval: €259 million for 2005–07 emphasizing infrastructure and technical assistance for acquis compliance. - United States appropriation: $31 million for energy, banking sector reform, and SME development. - Absorption concern: the two aid packages sum to about 1/4 of estimated 2003 GNP in the NGC areas. *Source: IMF staff report content provided in the supplied content unit.* ### 29. During the UN negotiations, it became clear that the paucity of authoritative ### _cr05107 - 29. During the UN negotiations, it became clear that the paucity of authoritative ### UN negotiations and data constraints on NGC areas - During the UN negotiations, the paucity of authoritative macroeconomic data on the NGC areas complicated prospects for reunification. - Mission staff were unable to collect data and hold discussions on the economy of the north because the authorities were concerned such contacts might be seen as a first step toward a separate consultation or construed as recognition of the NGC areas. - The issue of staff conducting analytical macroeconomic work on the economy of the NGC areas was raised in the context of discussions on possible provision of IMF TA to the T/C community. - Summary information on the economy of the NGC areas, based on publicly available sources, is included in Annex II. ### Box 3 — The “Annan Plan” to Reunify Cyprus (key elements and concerns) - Background and structure: - Cyprus divided since 1974; Greek Cypriots (G/C) in the south and Turkish Cypriots (T/C) in the north, separated by a ½ mile-wide buffer zone. - The Annan Plan envisaged a “bicommunal, bizonal federation” entitled the United Cyprus Republic (UCR), comprised of two constituent states with a federal structure. - Timetable aimed at EU accession: motivated to see a united Cyprus join the EU on May 1; parties agreed in February 2004 to complete talks by end-March and put the Foundation Agreement to simultaneous referenda on April 24. - Policy, institutional and population provisions: - Proposed harmonization with the acquis communautaire, restitution of property and population relocation, and security arrangements. - A new central bank to be created and a budget systems law enacted. - Up to 20 percent of the G/C population would have the right—over 18 years—to return to their pre-1974 communities in the north. - Some persons living in the NGC areas would need compensation for loss of homes. - Authorities’ economic concerns (during Article IV mission): - Insufficient fiscal capacity of the federal government, potentially called upon to guarantee the debt of the two constituent states despite absence of an internal “stability pact” to limit budget deficits. - Ambiguity in the monetary policy framework—including political appointees to the monetary policy committee, the role of the T/C branch of the new central bank, and uncertainty whether the Cypriot pound would be replaced by a new currency. - Large uncertainty about fiscal transfers to the north, including possible need to recapitalize T/C banks, and uncertain prospects for international donor financing. - Cost estimate cited by the authorities: - The authorities estimate the cost of rebuilding infrastructure in the north at £C5 billion (69 percent of 2004 GDP in the G/C areas). - Staff view: - Staff’s view, as set out in a statement to a donors’ meeting prior to the referendum, was that with firm implementation and goodwill on both sides, the plan was economically and financially viable. ### Box 4 — Prospects for IMF TA to the T/C Community - After rejection of the Annan Plan in April, T/C representatives inquired about IMF technical assistance (TA). - Staff informed them that—consistent with the Articles of Agreement—staff could only provide TA with the consent of the government of the Republic of Cyprus, the recognized government of the member. - Staff sought the government’s approval, positing IMF TA to the T/C community would be in the best interest of all Cypriots and aimed to reassure the G/C side on sovereignty while protecting T/C confidentiality concerns. - The G/C authorities agreed on the need to improve economic management in the NGC areas; discussions on a framework for IMF TA to address these problems are continuing. ### V. Staff appraisal — macroeconomic assessment and policy priorities - EU accession and reform context: - Joining the EU in May 2004 was a signal event; adaptation to EU institutions and harmonization with the acquis communautaire advanced reforms such as capital account liberalization and strengthened financial sector legislation. - Recent growth and macro conditions: - After weak growth, the economy began to rebound in 2004. - Sluggish European growth and geopolitical concerns in the Middle East contributed to subdued growth in 2002–03, particularly in tourism; tourist arrivals and output growth recovered gradually in 2004. - Unemployment remains low; inflation is subdued despite some recent pressures from oil prices. - Fiscal policy priority: - Fiscal consolidation is first order of business due to slippages in recent years and ERM2 ambitions. - Containing the deficit and reducing public debt is important for euro adoption and for addressing medium-term demographic pressures—projected pension and health care costs—necessitating lower debt ratios. - Authorities’ overperformance on their deficit objective for 2004 demonstrates determination that needs to be maintained. - Convergence Program and measures: - If assiduously implemented, the Consolidation strategy in the authorities’ Convergence Program would restore fiscal sustainability. - Politically difficult but important measures include a significant increase in public sector retirement ages, moderation in public sector wage growth, and a freeze on new government positions. - Follow-up on the authorities’ readiness to take further measures if needed will be essential given disappointing past adjustment efforts. - Fiscal framework recommendation: - Establish an explicit multi-year fiscal framework based on realistic assumptions, clear objectives, and specific measures to choose among spending priorities transparently and efficiently. - Authorities’ interest in a fiscal ROSC is welcome. - ERM2 and exchange rate considerations: - Cyprus appears well-placed to join ERM2 at an early stage, conditional on resolute fiscal adjustment. - Long-standing use of an exchange regime similar to ERM2 offers continuity; current parity seems broadly in line with fundamentals given near-full employment and strong reserve position. - Aggressive structural reforms—particularly in the labor market—are needed to enhance competitiveness. - Financial sector supervision and stability: - Financial sector regulation is generally strong, but supervision of the cooperative sector should be strengthened. - Supervision of cooperative credit and saving institutions should be consolidated with bank supervision; their capital base should be strengthened; consolidation in the sector should be encouraged. - Bringing loan classification definitions in line with European best practices is welcome, but the legal framework must be revised to ensure more timely recovery of collateral on bad loans. - Authorities are encouraged to undertake an early FSAP to advance reforms. - Structural reform agenda: - More remains to be done to foster competition and promote efficiency, including in the public enterprise sector. - The electricity authority and the telecommunications company should be corporatized at an early stage, with eventual consideration of privatization. - Labor market issues: - With near-full employment, labor markets have performed well, but reform scope exists. - Centralized wage bargaining requires reform; the COLA system and seniority-based public sector salary rules build a structural upward drift in the real wage bill, reducing external competitiveness and limiting performance-related pay. - As a first step, redesign the COLA system to exclude changes in the VAT and energy prices. - Role of IMF activities: - IMF activities, including technical assistance, could support reunification and improve living standards for all Cypriots. - Authorities’ consent to provide TA to the T/C community (and to carry out macroeconomic analytical work) could help establish a baseline for advancing best practices. - Statistics and data quality: - Cypriot statistics are generally of good quality, with the exception of the NGC areas. - Improvements are possible in timeliness, consistency and definitions used by the authorities. - Moving promptly toward subscription to the SDDS could facilitate improvements. *Source: _cr05107 - 29. During the UN negotiations, it became clear that the paucity of authoritative* ### 41. It is proposed that the next Article IV consultation be held on the current 24-month ### _cr05107 - 41. It is proposed that the next Article IV consultation be held on the current 24-month cycle. ### Article IV timing - It is proposed that the next Article IV consultation be held on the current 24-month cycle. ### Output, demand, and prices (selected annual figures and projections) - Real GDP growth (1999–2005, annual percentage change): 4.8, 5.0, 4.1, 2.1, 1.9, 3.5, 3.8 (table shows 1999–2005 row: "4.8 5.0 4.1 2.1 1.9 3.5 3.8"). - Domestic demand (annual percentage change): 2.1, 6.1, 3.2, 4.7, 2.3, 6.1, 1.6. - Private consumption: 3.0, 6.5, 3.7, 1.5, 2.6, 7.2, 1.1. - Public consumption: 8.7, -5.0, 12.6, 7.5, 4.7, 2.6, 3.2. - Gross investment: -6.7, 16.0, -6.0, 14.6, -0.7, 5.7, 2.0. - Net exports contribution to GDP growth: 0.8, -0.3, 0.6, -2.1, -2.5, -5.3, -3.0. - Exports of goods and NFS (annual percent change): 8.5, 10.6, 6.3, -5.2, -1.4, 4.3, 6.6. - Imports of goods and NFS (annual percent change): 2.9, 12.9, 4.7, -0.5, -0.4, 9.4, 2.2. - Industrial production index (annual percent change): 1.7, 4.5, 1.8, 3.9, 2.3, -0.2. - Tourist arrivals (annual percent change): 9.5, 10.3, 0.4, -10.3, -4.8, 2.9. - Unemployment (percent): 3.6, 3.4, 2.9, 3.2, 3.5, 3.4, 3.2. - CPI index (period average, percent): 1.6, 4.1, 2.0, 2.8, 4.1, 2.5, 2.5. - CPI index (end of period, percent): 3.7, 3.5, 2.4, 2.9, 2.5, 2.7, 2.5. - Real wages (annual percent change): 3.0, 2.9, 3.1, 1.8, 1.4 (table shows series and ellipses). ### Public finance (general government and central government, percent of GDP) - Total revenue (1999–2005): 33.0, 35.3, 36.6, 36.1, 39.1, 39.0, 40.2. - Total expenditure and net lending (1999–2005): 37.4, 37.7, 38.9, 40.6, 45.4, 43.8, 43.2. - Overall balance (1999–2005): -4.4, -2.4, -2.3, -4.5, -6.3, -4.8, -3.0. - Primary balance (1999–2005): -1.3, 1.1, 1.1, -1.3, -2.8, 0.4, 2.2. - Central government accounts (1999–2005, percent of GDP): - Tax revenue (1999–2005): 24.6, 25.6, 27.2, 27.4, 28.7, 29.4, 29.7. - Income and property: 9.5, 9.8, 10.8, 10.8, 8.6, 8.4, 8.5. - Social security contributions: 4.4, 4.3, 4.6, 4.8, 4.7, 4.8, 4.9. - Indirect taxes: 10.8, 11.5, 11.8, 12.5, 15.4, 16.2, 16.3. - Interest payments (percent of GDP): 5.5, 5.5, 5.4, 4.8, 4.8, 4.8, 4.7. - Wages and salaries (percent of GDP): 9.3, 9.3, 9.2, 9.4, 10.7, 11.3, 11.2. - Cyclically adjusted balance (1999–2005): -0.7, -0.6, -0.6, -1.2, -1.9, -2.0, -2.1. - Public debt (percent of GDP, general government; 1999–2005): 59.9, 59.9, 61.9, 65.2, 69.8, 72.3, 69.5. - Domestic debt (percent of GDP): 43.6, 45.5, 49.4, 51.9, 54.2, 51.2, 50.2. - Long-term domestic: 19.4, 20.7, 25.9, 42.6, 46.3, 42.7, 42.3. - Short-term domestic: 24.2, 24.8, 23.5, 9.3, 7.9, 8.4, 7.9. - Foreign debt (percent of GDP): 16.3, 14.5, 12.5, 13.3, 15.6, 21.1, 19.3. - Long-term foreign: 14.2, 13.5, 11.4, 13.0, 13.9, 17.4, 16.5. - Short-term foreign: 2.1, 1.0, 1.0, 0.3, 1.6, 3.8, 2.8. ### External sector, reserves, and balance of payments (selected levels and percent of GDP) - Current account balance (1999–2008, percent of GDP / projections table): -2.17, -4.88, -3.15, -4.68, -4.52, -6.42, -6.44, -5.74, -5.58, -5.51 (table shows millions and percent rows; also earlier series: -2.3, -5.3, -3.3, -4.5, -3.4, -4.3). - Trade balance (millions of US$ and percent of GDP trends): trade balance (1999–2008 millions): -2,309; -2,606; -2,579; -2,836; -3,125; -3,716; -3,924; -4,231; -4,491; -4,762. - Exports (millions US$): 1,000; 951; 977; 854; 955; 1,052; 1,087; 1,123; 1,188; 1,255. - Imports (millions US$): 3,310; 3,557; 3,555; 3,690; 4,080; 4,768; 5,011; 5,355; 5,679; 6,017. - Services exported (millions US$): 3,190; 4,068; 4,351; 4,458; 5,184; 6,024; 6,514; 7,140; 7,604; 8,079. - Travel (mainly tourism) receipts (millions US$): 1,882; 1,918; 2,006; 1,894; 2,010; 2,132; 2,255; 2,389; 2,560; 2,736. - Investment income, net (millions US$): -38; -542; -526; -449; -383; -386; -390; -417; -419; -416. - Transfers, net (millions US$): 871; 775; 410; 814; 222; 421; 821; 420; 820; 2. - Capital and Financial account balance (millions US$): 367; 543; 354; 557; 406; 642; 644; 574; 558; 551. - Direct foreign investment, net (millions US$): -0.3; 7.5; 7.3; 5.7; 3.7; 2.8; 2.4; 3.0; 1.2; 0.59 (table shows various figures and footnotes). - Gross official reserves (millions US$): 1,977; 1,870; 2,397; 3,174; 3,459; 4,253; 4,755; 5,232; 5,755; 6,239. - In months of imports GS (official reserves): 5.3; 4.4; 5.6; 7.0; 6.5; 6.8; 7.1; 7.3; 7.6; 7.7. - Change in official reserves (millions US$): 456; -107; 527; 777; 285; 794; 502; 477; 523; 484. ### Monetary and credit aggregates - Broad money (M2) annual percent change (1999–2004): 17.2, 9.0, 13.3, 10.3, 4.0, 8.4. - Reserve money (annual percent change): 15.0, 11.1, 7.5, 2.7, 4.8, 6.6. - Domestic credit (annual percent change): 12.7, 12.0, 14.0, 9.5, 5.9, 7.2. - Private sector credit (12-month growth rate) series shown in figures; table summaries: private sector credit, real (percent change, 12-month) 12.6, 9.7, 10.2, 5.0, 0.9, 5.2. - Broad money velocity (annual percent change): -4.5, -5.5, -1.2, -6.4, -0.5, -1.9, -2.1. ### Competitiveness and prices - CPI-based REER (CPI, 2000=100) series (1999–2004): 103.2, 100.0, 101.8, 104.2, 110.2, 113.2 (table 6 and figure 5 references). - Cost competitiveness and market share indices presented with 1990=100 baselines; 2004 data are projections for some series. ### Financial sector and vulnerability indicators - Public debt, net of intergovernmental debt (percent of GDP, 1999–2004): 59.9, 59.9, 61.9, 65.2, 69.8, 72.3. - Financial indicators (1999–2004): - Domestic credit (percent of GDP): 131.2, 134.9, 144.2, 151.4, 150.1, 151.7. - Share of foreign exchange loans in total bank lending (percent): 10.3, 9.2, 13.3, 13.2, 12.5, 13.7. - Share of foreign exchange deposits in total bank deposits (percent): 3.1, 4.2, 4.7, 4.3, 5.0, 7.7. - Total external debt (percent of GDP): 32.9, 30.4, 35.6, 47.7, 51.9, 57.2. - Total external debt to exports G&NFS (percent): 71.3, 55.8, 62.7, 104.6, 123.7, 136.8. - Total external debt service payments to exports G&NFS (percent): 6.5, 7.3, 8.8, 7.2, 6.8, 12.9. - Official foreign exchange reserves (US$ billions, end-period): 2.0, 1.9, 2.4, 3.2, 3.5, 4.3. - Financial Soundness Indicators for Banks (1999–2004, selected): - Regulatory capital to risk-weighted assets: 12.7, 13.5, 14.0, 12.7, 11.7, 11.4. - Regulatory Tier I capital to risk-weighted assets: 11.6, 13.7, 11.6, 10.1, 10.0, 9.8. - Nonperforming loans to total gross loans: 8.4, 8.5, 7.9, 9.5, 11.3, 11.7. - Return on assets: 2.4, 1.5, 0.6, -0.7, -0.3, 0.2. - Return on equity: 30.3, 17.4, 8.4, -11.1, -4.7, 4.3. - Interest margin to gross income: 32.3, 56.3, 56.3, 57.5, 38.7, 32.6, 46.1 (table shows multiple values). - Banking sector regulatory change noted in source text: in 2004 deposit-takers were required to suspend interest on all loans in arrears for more than 6 months and not 100 percent secured (previous thresholds: 9 months in 2003 and 12 months prior). From 2006 the CBC will reduce the time period to 3 months and amend regulations so adequacy of security will not be taken into account (text in Table 7 footnote). ### Medium-term macro framework (Convergence Program vs. Staff estimates, 2004–08) - Staff and Convergence Program comparisons (selected rows): - Real GDP (percent change): CP and Staff entries for 2004–2008 show staff estimates/projections and CP projections; example staff estimates/projections table: Real GDP 3.6, 3.5, 4.0, 3.8, 4.4, 4.0, 4.5, 4.0, 4.5, 4.0 (presented in matrix form across CP and Staff columns in Table 5). - Consumer price index (period average): CP/Staff entries around 2.1–2.6 and repeated 2.5 in projections. - Public finances (percent of GDP, medium term): Revenue ~39.0–40.6; Expenditure ~42.2–43.8; Overall balance ranging from -4.8 to -0.9 across scenarios and years. - Gross public debt (percent of GDP) medium-term path: staff/CP entries include 74.9, 72.3, 71.9, 69.5, 69.2, 66.4, 65.7, 63.5, 58.1, 62.3 (table shows CP and staff series). - External current account balance (percent of GDP) medium term: -4.1, -4.3, -3.7, -4.0, -3.2, -3.3, -3.0, -3.0, -2.0, -2.8 (Table 5 rows). ### Tourism competitiveness indicators (2003) - Cyprus tourism sector indices and ranks (World Travel and Tourism Council, 2003): - Cyprus Index value (overall): 42; Ranking: 85. - Cyprus subindices (Index value / Ranking): - Price 2/: 100 / 6 - Human Resources 4/: 76 / 7 - Infrastructure 4/: 49 / 86 - Environment 5/: 94 / 41 - Technology 6/: 66 / 56 - Openness 8/: 79 / 13 - Social 9/: 70 / 52 - Comparative country values and rankings are listed for Croatia, Egypt, Greece, Israel, Italy, Malta, Spain, Tunisia, Turkey (table entries only; preserved as presented). ### Key social and structural indicators (as reported) - GDP per capita (in current US dollars, 2003): 16,062. - Life expectancy at birth (2002): 75.8 (male) and 80.5 (female). - Automobile ownership (2000): 574 per thousand. - CO2 emissions (ton per capita, 2000): 8.5. - Population density (2002): 82.8 inhabitants per sq. km. - Population (2003): 796 thousands. *Source: IMF staff report content as provided in the supplied PDF content unit.* ### 1. Assuming implementation of the CP, the staff’s baseline scenario predicts a decline in ### _cr05107 - 1. Assuming implementation of the CP, the staff’s baseline scenario predicts a decline in ### Public debt sustainability — baseline and alternative scenarios - Baseline projection (assuming implementation of the CP): - Public debt-to-GDP ratio falls from 72 percent in 2004 to 61 percent in 2009. - Debt-stabilizing primary balance implied: 0.8 (Annex I Table 1). - Scenario A1 (historical average values of real interest rate, real GDP growth, and primary balance throughout 2005–09): - Public debt-to-GDP ratio falls only to 66 percent by 2009. - Debt-stabilizing primary balance: 1.3. - Scenario A2 (primary balance unchanged over projection period): - Public debt-to-GDP ratio rises to 71 percent by 2009. - Debt-stabilizing primary balance: 1.0. - Other alternative and stress scenarios (selected results from Annex I Table 1): - A3 (country-specific shock in 2005: reduction in GDP growth of one standard deviation): debt-to-GDP = 60.9 percent in 2009; debt-stabilizing primary balance: 0.8. - A4 (selected variables consistent with market forecast in 2005–09): debt-to-GDP = 60.7 percent in 2009; debt-stabilizing primary balance: 0.8. - Bound tests (stress scenarios) — selected outcomes: - B1 (real interest rate at historical average plus two standard deviations in 2005 and 2006): public debt-to-GDP = 69.2 percent in 2009. - B2 (real GDP growth at historical average minus two standard deviations in 2005 and 2006): public debt-to-GDP = 82.1 percent in 2009. (Identified as the most significant “bounds test”.) - B3 (primary balance at historical average minus two standard deviations in 2005 and 2006): public debt-to-GDP = 68.8 percent in 2009. - B4 (combination of B1–B3 using one standard deviation shocks): public debt-to-GDP = 73.2 percent in 2009. - B5 (one-time 30 percent real depreciation in 2005): public debt-to-GDP = 80.5 percent in 2009. (Noted as increasing the debt ratio the most among listed shocks.) - B6 (10 percent of GDP increase in other debt-creating flows in 2005): public debt-to-GDP = 71.1 percent in 2009. - Key historical and projection datapoints (Annex I Table 1, selected): - Public sector debt: 59.9 (1999), 72.3 (2004), 60.7 (2009). - o/w foreign-currency denominated: 35.1 (1999), 39.9 (2004), 38.3 (2009). - Primary deficit: -1.6 (1999), 0.0 (2004), -2.3 (2009). - Revenue and grants: 30.5 (1999), 35.6 (2004), 37.0 (2009). - Primary (noninterest) expenditure: 28.9 (1999), 35.7 (2004), 34.6 (2009). - Automatic debt dynamics contribution: 6.4 (1999), 0.8 (2004), 0.9 (2009). - Real GDP growth (projections): 4.0 (2005), 4.0 (2006), 4.0 (2007), 4.0 (2008), 4.0 (2009). - Average nominal interest rate on public debt (in percent, projection path excerpt): 7.2 (2005), 6.9 (2006), 7.2 (2007), 7.5 (2008), 7.9 (2009). - Debt-stabilizing primary balance assumptions and scenario outcomes are reported in Annex I Table 1. ### External debt sustainability — baseline and stress tests - Baseline projection: - External debt-to-GDP ratio falls from 57 percent in 2004 to 51 percent by 2009. - Decline achieved mainly through automatic debt dynamics reflecting robust GDP growth and a residual that includes the slight appreciation of the Cyprus pound against the U.S. dollar over the projection period. - Scenario A1 (key variables at their historical averages in 2005–09): - External debt-to-GDP ratio falls to 50 percent by 2009. - Debt-stabilizing non-interest current account: -4.9 (Annex I Table 2). - Stress tests (selected from Annex I Table 2): - B1 (nominal interest rate at historical average plus two standard deviations in 2005 and 2006): external debt-to-GDP = 54.9 percent in 2009. - B2 (real GDP growth at historical average minus two standard deviations in 2005 and 2006): external debt-to-GDP = 55.0 percent in 2009. - B3 (change in U.S. dollar GDP deflator at historical average minus two standard deviations in 2005 and 2006): external debt-to-GDP = 79.7 percent in 2009. (Shock to the U.S. dollar GDP deflator increases external debt by about 29 percentage points relative to baseline.) - B4 (non-interest current account at historical average minus two standard deviations in 2005 and 2006): external debt-to-GDP = 58.4 percent in 2009. - B5 (combination of B1–B4 using one standard deviation shocks): external debt-to-GDP = 71.7 percent in 2009. - B6 (one-time 30 percent nominal depreciation in 2005): external debt-to-GDP = 70.3 percent in 2009. (A one-time 30 percent depreciation also has a significant impact in 2005 but the ratio gradually declines as the impact fades.) - Gross external financing need (Annex I Table 3, selected): - Gross external financing need (in billions of U.S. dollars): 2.3 (2004), projected 2.8 (2005), 2.6 (2006), 2.7 (2007), 2.8 (2008), 2.8 (2009). - Gross external financing need (in percent of GDP): 13.4 (2004), projected 15.4 (2005), 13.6 (2006), 13.1 (2007), 12.6 (2008), 12.1 (2009). - Key macroeconomic assumptions underpinning external projections (selected): - Real GDP growth (percent): 4.2 (2004), 2.4 (2005), 3.5 (2006), 3.8 (2007), 4.0 (2008), 4.0 (2009). - GDP deflator in U.S. dollars (change in percent, projection excerpt): 12.1 (2005), 11.8 (2006), 2.3 (2007), 3.4 (2008), 2.5 (2009). - Nominal external interest rate (percent, projection excerpt): 1.8 (2005), 3.3 (2006), 3.1 (2007), 4.4 (2008), 4.4 (2009). - Current account balance, excluding interest payments (percent of GDP): -2.2 (2004), -2.8 (2005), -2.4 (2006), -1.1 (2007), -0.8 (2008), -0.6 (2009). ### Stress-test diagnostics and interpretation - Public debt stress-test diagnostics: - The most significant single adverse shock for public debt dynamics is the B2 shock (real GDP growth at historical average minus two standard deviations), producing an increase to 82.1 percent by 2009. - A one-time 30 percent real depreciation (B5) raises public debt to 80.5 percent by 2009. - Shocks to real interest rates and to the primary balance lead to smaller deteriorations compared to the GDP growth shock. - External debt stress-test diagnostics: - The shock to the U.S. dollar GDP deflator (B3) produces the largest increase in external debt, raising the ratio by about 29 percentage points relative to baseline. - A one-time 30 percent nominal depreciation (B6) materially raises external debt in 2005, with gradual decline thereafter. - Overall assessment conveyed in the text: - Under the baseline scenario, both public and external debt ratios decline over 2005–09. - Overall, sustainability does not appear to be at serious risk under shocks of plausible magnitudes (as summarized in Annex I Tables 2 and 3). ### Areas Not under Government Control (NGC) — economic snapshot (Annex II) - Geography and population: - NGC areas comprise 1/3 of the land area of Cyprus and about 22 percent of the population. - NGC areas produce less than 10 percent of combined Cyprus GDP. - Sectoral composition and external linkages: - Output concentrated in the public sector, tourism, agriculture, and commerce. - Most external trade and tourism take place with Turkey; tourism arrivals typically number over 400,000 per year, of which three fourths come from Turkey. - Public finances and monetary environment: - Public finances heavily dependent on transfers and loans from Turkey. - Expenditures of just under half of GDP—1/3 of which go to civil service wages—are covered roughly equally by domestic revenue and foreign grants and loans. - The Turkish lira circulates in the NGC areas; monetary tasks mainly involve supervision of the financial sector, including offshore institutions. - Selected indicators, 1999–2003 (Annex II Table, selected datapoints): - Nominal GNP (US $ million): 964 (1999), 1,284 (2003). - Real GNP (percent change): 7.4 (1999), -0.6 (2000), -5.4 (2001), 6.9 (2002), 5.4 (2003). - CPI (Dec to Dec, percent change): 55.3 (1999), 53.2 (2000), 76.8 (2001), 24.5 (2002), 12.6 (2003). - Tourism arrivals (thousands): 414 (1999), 433 (2000), 365 (2001), 426 (2002), 470 (2003); arrivals from Turkey: 334 (1999), 348 (2000), 278 (2001), 316 (2002), 340 (2003). - Current account balance (US $ million): -90 (1999), -33 (2000), -17 (2001), -8 (2002), 19 (2003); as percent of GNP: -9.4 (1999), -3.2 (2000), -1.9 (2001), -0.8 (2002), 1.5 (2003). - Public finance (percent of GNP): Domestic revenue 27.8 (1999) to 31.5 (2003); Foreign grants 7.6 (1999) to 8.6 (2003); Expenditure 47.2 (1999) to 53.9 (2003); Balance -11.8 (1999) to -13.8 (2003). - Population estimates: T/C estimate (thousand) 207 (1999) to 216 (2003); G/C estimate (thousand) 88 (1999) to 88 (2003). - GNP per capita (US $) of NGC Areas (T/C-based): 466 (1999), 649 (2000), 784 (2001), 303 (2002), 461 (2003). - EU accession note: - Cyprus joined the EU on May 1, 2004, with a derogation allowing non-application of the acquis in the NGC areas. ### IMF relations and key administrative data (Appendix I, selected) - Membership and Article VIII status: - Joined IMF: December 21, 1961. - Accepted the obligations of Article VIII, Sections 2, 3, and 4 effective January 9, 1991. - Quota and holdings (as of December 31, 2004): - Quota: 139.60 (percent of quota shown as 100.0). - Fund holdings of currency: 92.33 (66.14 percent of quota). - Reserve position in Fund: 47.28 (33.87 percent of quota). - SDR Department (as of December 31, 2004): - Net cumulative allocation: 19.44 (100.0 percent of allocation). - Holdings: 2.51 (12.91 percent). - Outstanding purchases and loans: None. - Financial arrangements (historical): - Stand-by: Approved 7/16/80; Expiration 7/15/81; Approved SDR 8.50; Drawn SDR 8.50. - Projected obligations to Fund (SDR Million; based on existing use of resources and present holdings of SDRs) — Charges/interest: - 2005: 0.38; 2006: 0.38; 2007: 0.38; 2008: 0.38; 2009: 0.38. - Exchange rate arrangements (note excerpt): - In June 1992, peg of the Cyprus pound changed from a broad basket of currencies to the ECU; central rate set at ECU 1.7086 per £C with a margin of +... *Source: Annexes and tables from the provided IMF content unit.* ### 2.25 percent. On January 1, 1999, the euro ### _cr05107 - 2.25 percent. On January 1, 1999, the euro ### Exchange rate and market practices - On January 1, 1999, the euro replaced the ECU as the basis of the peg. - In August 2001, the fluctuation margins increased to +15 percent, but the central rate remained unchanged. - Subject to certain limitations, including a limit on spreads between buying and selling rates, authorized dealers (banks) are free to determine and quote their own buying and selling rates. ### Article IV consultations and staff engagement - Last Article IV consultation discussions: October 23–November 4, 2002. - Staff report: Country Report No. 03/30, 1/16/03; discussed by the Executive Board on January 31, 2003. - Staff visits: October 10–13, 2003, and July 22–23, 2004. ### Assessment of the offshore financial sector - In July 2001, the IMF undertook a Module 2 assessment (procedures agreed July 2000), including a Basel Core Principles assessment of supervision of the offshore banking sector and an assessment of company services to International Business Companies registered in Cyprus. - The assessments were published by the Cypriot authorities on August 20, 2001. ### Technical assistance (selected entries) - MAE: Government debt management — February–March 1989 - FAD: VAT training program — June–October 1992 - MAE: Financial sector liberalization — November–December 1993 - MAE: Reform of government securities — April–May 1994 - STA: Special Data Dissemination Standard — August 1997 - STA: Balance of Payments — March 1999 - STA: Balance of Payments — May–July 2001 - STA: Balance of Payments — November 2001–March 2002 - STA: Balance of Payments — April–June 2002 ### Exchange restrictions and sanctions - Pursuant to UN Security and EU resolutions, economic sanctions have been imposed against Iraq, the Taliban, Rwanda, Sudan, Burma (Myanmar), Congo, Somalia, Zimbabwe, Liberia, Sierra Leone, the Unita Movement in Angola as well as persons (natural or legal) associated with terrorism. - Some bank balances belonging to the former National Bank of Yugoslavia remain frozen at the request of the Prosecutor of the International Criminal Tribunal for the former Yugoslavia. - The authorities will shortly update the Fund in accordance with Decision 144-(52/51). ### Statistical issues and data dissemination - Cyprus has an open publication policy; statistical data are generally of a high quality and adequate frequency, but weaknesses remain with respect to SDDS requirements (e.g., international investment position) and some series have long time lags. - Authorities intend to subscribe to the SDDS in the near future. - National accounts time series available for 1995–2003 online. - Quarterly GDP growth rates published with a delay of one quarter; annual national accounts with a delay of up to half a year. - Monthly indicators (trade flows, tourism arrivals, industrial production) exist but with a lag of several months for most indicators. - Since January 1999, the CPI is compiled following the EU methodology for the Harmonized CPI. - National accounts revised to comply with the 1995 European System of Accounts. - Balance of payments accounts presented per EuroStat Balance of Payments Vade Mecum (BPM5); from 1995 onwards compiled using BPM5 residency definition. - Trade statistics: monthly with a lag of about three months. - Current account statistics: quarterly with a lag of about four months. - Direct investment statistics: annual. - Some concerns remain regarding coverage and classification (especially sectoral breakdown of portfolio investment), timeliness, and transparency of revisions. - Fiscal data for central government: good quality and coverage; monthly fiscal central government data are generally high quality but not published timely. - General government accounts exist from 1998 and are published annually and quarterly (lag of a few months). - Cyprus last reported data for Government Finance Statistics Yearbook in 1998; no data currently reported for International Financial Statistics. - Financial sector data: timely and disseminated efficiently; electronic tables with monetary authority and commercial bank balance sheets and interest rates available with a lag of about one month. - Publication is generally open; substantial information available via internet from Statistical Service, Ministry of Finance, and Central Bank of Cyprus. ### Core statistical indicators (as of December 31, 2004) — metadata summary - Date of latest observation examples: Exchange Rates 12/31/04; International Reserves 10/29/04; Consumer Price Index 12/31/04; Exports/Imports November 2004; Current Account Balance July 2004; General Government Balance Q2 2004; GDP/GNP Q3 2004; External Debt/Debt Service 2003 revised / 2003. - Frequency and modes of reporting vary (Daily, Monthly, Quarterly, Annual, Semi-annual) and modes include Internet/Electronic and Fax/Electronic. - Main reporting/updating agencies: Central Bank of Cyprus (CBC), Ministry of Finance (MoF), Statistical Service. ### IMF staff update (Statement by IMF Staff Representative, February 18, 2005) - New information does not change the thrust of staff appraisal. - Recent 2004 data: - Real GDP grew by 3.5 percent. - Average CPI inflation was 2.3 percent. - Tourism sector performance slightly weaker than expected; projected 2004 current account imbalance will widen modestly. - 2004 general government deficit estimated by authorities at about 4.3 percent of GDP, below the 4.8 percent target in the revised Convergence Program. - Better-than-expected fiscal performance due to expenditure constraint (lower-than-budgeted defense and capital expenditures) and improved revenue performance, including the tax amnesty. - Looking ahead: - 2005 general government deficit target: no more than 3 percent of GDP. - Authorities estimate the tax amnesty will yield more than 1 percent of GDP (previous estimate 0.6 percent). - Agreement on regularization of dividend policy of public enterprises expected to result in another 0.6 percent of GDP. - Preliminary agreements reached with trade unions on increasing retirement age for public sector employees. - Authorities ready to take additional steps if Convergence Program measures yield less than expected. - Authorities have formally requested a fiscal ROSC assessment; timing under discussion. - Discussions ongoing on a framework for Fund technical assistance to the Turkish community in northern Cyprus. ### Authorities’ view (Statement by Jeroen J.M. Kremers and Lucian Croitoru, February 18, 2005) - Authorities consider staff report an accurate assessment; agree key macro challenges are credible fiscal consolidation and strategy for adopting the euro. - Macroeconomic developments: - Growth rebounded to about 3½ percent in 2004; authorities expect growth of 4 percent in 2005. - Consumption was main engine of growth, aided by fiscal easing in 2003 and possible EU accession confidence effects. - Tourism picked up; unemployment remains very low by European standards. - Current account deficit has not exceeded 4½ percent of GDP for several years. - Moderate increase in current account deficit expected for 2004, partly due to one-off items (e.g., higher-than-expected imports of cars after excise duty reduction in November 2003). - Inflation expected to remain in the vicinity of 2½ percent due to restrained monetary policy. - Central bank left interest rates high since April (raised in response to modest outflows preceding EU accession; outflows now reversed). - Fiscal policy: - Authorities adopted an ambitious Convergence Program (CP) in May 2004 targeting significant adjustment: deficit estimated at 5.2 percent of GDP in 2004 to 2.9 percent of GDP in 2005 and 0.9 percent of GDP in 2008. - Under CP, public debt expected to decline rapidly to 60 percent of GDP by 2009. - 2004 deficit brought to 4.3 percent of GDP, down from 6.3 percent of GDP in 2003. - Authorities overperformed relative to the revised CP by 0.5 percent of GDP. - Ecofin Council concluded on January that Cyprus has taken effective action to correct its fiscal imbalances; no other steps necessary under excessive deficit procedures. - Authorities ready to consider additional measures and most staff-proposed measures if CP may fall short. - Preparatory steps toward a medium-term fiscal framework include limiting supplementary budgets and requesting a fiscal ROSC for 2005. - Monetary policy: - Central Bank of Cyprus (CBC) will maintain a cautious stance. - Credit growth: 8 percent in 2002; 5 percent in 2003; annual average 13 percent during 1999–2001; rebounded to 6.5 percent in 2004 and expected to continue increasing slightly in 2005. - Inflationary pressures from higher oil prices; monetary stance to remain consistent with other policies; some easing possible as fiscal consolidation progresses and oil prices tame. - Financial sector and prudential measures: - Banks rated beyond investing grade. - Enhanced disclosure rules and listing requirements introduced after 2000 stock market crash. - Insurance sector strengthened with legislation in 2003; capital adequacy and minimum reserve requirements on foreign currency raised in 2003. - CBC tightened collateral requirements for real estate lending in late 2003. - Time threshold for declaring an overdue loan nonperforming reduced from 12 percent in 2003 to 3 percent in 2005 to obtain a more realistic view of nonperforming loans (NPL). - NPL ratios remain high due to weak recovery rules, but prudential oversight remains strong. - Agreement between CBC and private banks to consolidate supervision in one institution contested by cooperative and credit societies (which hold a quarter of deposit base). - Offshore sector reputation improved; authorities plan to request a FSAP after MFD updates its 2001 OFC assessment in early 2005. - ERM2 and euro adoption: - Cyprus’s exchange rate regime mirroring ERM2 provides a good basis for joining ERM2 in the first part of 2005 and adopting the euro as soon as possible; de facto narrow band around central parity effectively already in place. - Authorities view current exchange rate parity as appropriate and do not intend to change it for competitiveness; noted that real appreciation partly due to higher inflation from VAT increase by 5 percent since 2002 and other excise tax harmonization. - Competitiveness protection to rely on fiscal adjustments and structural reforms rather than parity changes. - Structural reforms and public enterprises: - Progress in structural reforms and compliance with EU acquis communautair; services and utilities markets opened up. - Considering options to restructure the airline, including disposing one subsidiary. - Authorities prioritize fostering competition and promoting efficiency in public enterprise reform. - COLA (automatic backward-looking wage indexation) acknowledged to work well; authorities will limit increases beyond COLA in the public sector despite staff assessing COLA as a structural rigidity. ### Reunification and the Annan Plan - Authorities do not share the staff’s assessment in the draft report that the Annan Plan was economically and financially viable; note the plan’s viability was not a task of the 2004 Article IV Consultation and was not discussed with Cypriot authorities. - Authorities have provided detailed papers to staff on areas of concern and remain committed to cooperation toward an acceptable reunification plan. ### IMF Executive Board and Public Information Notice (PIN No. 05/39, March 22, 2005) - IMF Executive Board concluded the 2004 Article IV consultation with Cyprus on February 18, 2005. - Background and summary findings: - Real GDP recovered to about 3½ percent in 2004, driven by domestic demand. - Real per capita income reached above 80 percent of the average EU 25 income level when adjusted for purchasing power. - Unemployment remains low by European standards. - Inflation contained despite rising energy prices in 2004. - Growth estimated at close to 4 percent in 2005, subject to uncertainty from oil price volatility, lack of clarity on reunification, and ultimate impact of EU accession. - Note on Article IV process: staff visits, preparation of a report, Executive Board discussion, and summary transmitted to country authorities. *IMF staff report and related statements contained in the provided content unit.* ### 6.3 percent of GDP amid expenditure overruns, the authorities have recently adopted an ### _cr05107 - 6.3 percent of GDP amid expenditure overruns, the authorities have recently adopted an ### Fiscal consolidation, targets, and debt projections - General government deficit targets: - 2004: 4.8 percent of GDP - 2005: 2.9 percent of GDP - Public debt path: - Expected to peak at 72 percent of GDP in 2004 - Projected to reach close to 60 percent of GDP by 2009 - Convergence Program objectives: - Consolidate fiscal accounts and bring deficit and debt to levels compatible with the Maastricht criteria - Authorities ready to take additional measures if the program does not yield the expected impact - Aim to join ERMII in the first half of 2005 and adopt the euro as soon as possible - Policy instruments and commitments: - Target primary fiscal surpluses beginning in 2005, in part through caps on current and capital spending - Containment measures highlighted: raise retirement age in the public sector; limit public sector wage increases; freeze on new government positions - Authorities requested a fiscal Reports on the Observance of Standards and Codes assessment ### Structural reforms and competitiveness - Progress achieved in response to acquis communautaire: - Indirect taxation aligned more closely with EU standards - Direct taxes lowered - Capital account liberalized - Financial sector legislation strengthened in line with EU directives - Recommended further reforms: - Deeper structural reforms, in particular labor market reforms, to prevent further erosion of competitiveness - Reform of the wage-setting mechanism: reduce automatic, backward-looking wage indexation to limit inflation pass-through, enhance merit pay, and restore external competitiveness - Modernize corporate governance in public enterprises and consider privatization where appropriate - Reforms welcomed in electricity distribution, air transport, and water management ### Executive Board assessment and Directors’ views - Overall appraisal: - Directors welcomed Cyprus’s long record of good policy performance, low inflation, near full employment, and a rebound in growth in 2004 - Accession to the EU has prompted important structural reforms that lay the foundation for sustained growth - Fiscal priorities and assessments: - Noted significant fiscal slippage in 2002-03; fiscal adjustment is now the key economic priority - Welcomed appreciable progress in 2004 - Considered the 2005 overall deficit target of 3 percent of GDP to be achievable with continued scrupulous implementation of the Convergence Program measures - Welcomed better-than-expected revenue yield of some measures, but stressed necessity of key expenditure containment measures and readiness to take further measures if needed - Monetary and exchange rate stance: - Supported the central bank’s cautious monetary policy stance - Urged vigilance for possible inflationary pressures in the run-up to euro adoption - Agreed that the current exchange rate parity remains appropriate - Financial sector and supervision: - Welcomed strengthening of financial sector regulations to align with EU norms - Called for vigilance over growing exposure to the real estate market and its interaction with the offshore sector - Stressed importance of effective supervision of the cooperative sector and encouraged consolidation of their supervision under one institution - Looked forward to the Offshore Financial Center assessment update and encouraged participation in the IMF’s Financial Sector Assessment Program - Cross-community technical assistance: - Directors hoped an agreement could be reached to allow Fund staff to provide technical assistance to the Turkish Cypriot community in northern Cyprus ### Policy recommendations and institutional frameworks - Fiscal framework: - Urged adoption of an explicit medium-term fiscal framework to bolster policy formulation and credibility and to eliminate the need for supplementary budgets during the year - Social and long-term fiscal pressures: - Noted mounting demographic pressures reinforce the need for fiscal restraint and a reduction of public debt over the medium term - Emphasized importance of reforms to the health care and pensions systems - Labor market and wages: - Urged reform of automatic wage indexation to reduce inflation pass-through and improve competitiveness and merit-based pay ### Macroeconomic and financial indicators (selected) - Real economy (change in percent): - GDP: 2001: 4.1; 2002: 2.1; 2003: 1.9; 2004: 3.5 - Domestic Demand: 2001: 3.2; 2002: 4.7; 2003: 2.3; 2004: 6.1 - CPI (period average): 2001: 2.0; 2002: 2.8; 2003: 4.1; 2004: 2.5 - Unemployment rate (in percent): 2001: 2.9; 2002: 3.2; 2003: 3.5; 2004: 3.4 - Gross domestic saving (in percent of GDP): 2001: 19.3; 2002: 19.6; 2003: 17.1; 2004: 17.2 - Gross domestic investment (in percent of GDP): 2001: 16.5; 2002: 18.7; 2003: 17.9; 2004: 18.3 - Public finances (general government, in percent of GDP): - Overall balance: 2001: -2.3; 2002: -4.5; 2003: -6.3; 2004: -4.8 - Primary balance: 2001: 1.1; 2002: -1.3; 2003: -2.8; 2004: -0.1 - Gross debt (Maastricht definition): 2001: 61.9; 2002: 65.2; 2003: 69.8; 2004: 72.3 - Money and credit (end of year, percentage change): - Reserve money: 2001: 7.5; 2002: 22.7; 2003: 4.8; 2004: 6.6 - Broad money: 2001: 13.3; 2002: 10.3; 2003: 4.0; 2004: 8.4 - Domestic credit: 2001: 14.9; 2002: 9.5; 2003: 5.9; 2004: 7.2 - Interest rates (year average): - Deposit rates: 2001: 6.0; 2002: 4.8; 2003: 3.8; 2004: 4.2 - Lending rates: 2001: 7.5; 2002: 7.2; 2003: 6.9; 2004: 7.9 - Balance of payments (in percent of GDP): - Trade balance: 2001: -27.2; 2002: -27.2; 2003: -23.8; 2004: -24.6 - Current account: 2001: -3.3; 2002: -4.5; 2003: -3.4; 2004: -4.3 - Fund position (as of end-November, 2004): - Fund holding of currency (in percent of quota): 65.72 - Holdings of SDRs (in percent of allocation): 12.91 - Quota (in millions of SDRs): 139.60 - Exchange rate: - Exchange rate regime: Cyprus pound - Present rate (January 18 , 2005): US$2.24 per Cyprus pound - Real effective exchange rate (based on CPI, 2000=100): 2001: 101.8; 2002: 104.2; 2003: 110.2; 2004: 113.2 *IMF staff and Executive Board assessment material as presented in the source document.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05107.pdf_