## _cr0776

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### Executive Summary — Background and outlook
- Euro adoption in 2008 is within Cyprus’s grasp; the economic outlook is favorable.
- Economic growth has rebounded to "3½ –4 percent" after a lull in 2002–03.
- Inflation has receded but remains the Maastricht criterion requiring vigilance.
- The fiscal deficit was cut sharply to under "2½ percent of GDP" in 2005 and an estimated "1.9 percent of GDP" in 2006.

### Key short-term policy objective: euro adoption (2008)
- Ensure smooth euro adoption in 2008 by keeping policies aligned with the Maastricht criteria and allaying concerns about the rounding up of prices during conversion.
- Keep inflation in check by:
  - Encouraging wage moderation.
  - Securing greater fiscal consolidation than envisaged in the 2007 budget.
- Committees and draft laws for institutional reform of monetary policy expected to be adopted in early 2007.
- Support dual display of prices to assuage public concerns about price rounding.

### Fiscal policy: recent performance and medium-term priorities
- Fiscal consolidation achievements:
  - Fiscal deficit halved to under "2½ percent of GDP" in 2003–05.
  - Cyprus became the first new EU member to have its excessive deficit procedure abrogated in July 2006.
  - Data through September 2006 suggest the deficit was on track to fall under "2 percent of GDP" in 2006, notwithstanding a supplementary budget (about "1 percent of GDP") due to health care overruns.
- Composition of adjustment:
  - Almost three-quarters of the 2003–05 fiscal improvement reflected increased revenues, mostly from one-off measures (tax amnesty yielded "¾ percent of GDP" in 2004 and nearly "1 percent of GDP" in 2005).
  - Tight expenditure control (moderation in public sector wage increases and ceilings on public consumption and investment) aided consolidation.
- Medium-term fiscal policy recommendations:
  - Effect high-quality fiscal adjustment by rationalizing, prioritizing, and controlling public expenditure, including investment.
  - Introduce the planned medium-term budget framework (MTBF); MTBF expected fully operational for the 2008 budget with a rolling three-year horizon.
  - Establish a proper legal framework and institutional setting for PPPs (gateway process, dedicated PPP unit, ex ante cost-benefit and value-for-money assessments, upgraded reporting).

### Pension and health care reform
- Pension reform is urgent and on the government agenda.
  - Raise the retirement age back to "65".
  - Build in periodic automatic adjustments to ensure the system keeps up with demographic trends.
- National Health Insurance System:
  - The planned system will likely require user fees and means testing to limit potential abuse and cost increases.
  - NHIS to be introduced in 2008, funded through higher social security contributions; public hospitals sheltered from competition for two to three years.

### Monetary and financial sector developments
- Inflation and interest rates:
  - Inflation moderated to around "2 percent" in 2004–05; 12-month HICP inflation rose through the first seven months of 2006, then declined rapidly to "1.5 percent" in December 2006.
  - Central Bank of Cyprus increased interest rates by "25 basis points" on September 1 (2006) after three consecutive rate cuts totaling "125 basis points" in 2005.
  - Harmonization of the CBoC operational framework with euro area practices on September 1, 2006 led to a 100 basis point short-end differential between the Cyprus pound and the euro.
- Exchange rate and reserves:
  - Central parity: "1£C = €1.7086".
  - The exchange rate had traded close to the (unofficial) upper band of "plus 2.25 percent" above the central parity.
  - Gross reserves have risen (figures reported in source tables and figures).
- Credit growth and supervisory needs:
  - Private sector credit growth increased to "more than 15 percent" in October from "about 6 percent" in 2004–05.
  - Broad money (M2, end-of-period stocks in millions of £C): 8,165.2, 8,494.1, 8,971.5, 9,885.0, 10,724.8 (2002–06).
  - Claims on private sector (in millions of £C): 7,904.1, 8,302.0, 8,843.7, 9,390.8, 10,252.5 (2002–06).
  - Recommendation: unify the supervision of cooperative credit institutions with that of commercial banks.
- Financial-sector structure and soundness:
  - Cooperative bank sector accounts for roughly 30 percent of private-sector claims; cooperative consolidation ongoing (Number of CCIs: 2002: 362; 2003: 361; 2004: 359; 2005: 347; 2006 1/: 305).
  - Nonperforming loans declined but remain high by international standards (Nonperforming loans to total gross loans: 2001: 7.9; 2002: 9.5; 2003: 11.3; 2004: 11.7; 2005: 7.1).
  - Return on assets: 0.6, -0.7, -0.3, 0.2, 0.8 (2001–05).
  - Mission urged rapid modernization of the foreclosure process and more rapid write-offs where loans are effectively uncollectible.

### External sector developments and competitiveness
- Current account and competitiveness:
  - The current account deficit widened in 2004–06 to "over 6 percent of GDP".
  - Nonenergy imports surged in 2004—prompted by a sharp increase in investment and a reduction in excise duties on cars in 2003—and recorded robust growth in 2005–06.
  - Declines in competitiveness, including appreciation of the real exchange rate, have contributed to a decline in export market share of goods; services exports have been more resilient.
- Impact of oil prices on the current account (Cyprus pounds; impact in percent of GDP):
  - 2004: oil imports "303.0"; price per barrel "17.7"; impact on current account "0.5" percent of GDP.
  - 2005: oil imports "466.9"; price per barrel "24.7"; impact on current account "1.5" percent of GDP.
  - 2006: oil imports "576.3"; price per barrel "29.6"; impact on current account "1.1" percent of GDP.
- External debt and financing:
  - Baseline external debt (percent of GDP): 35.7, 47.4, 51.6, 64.2, 74.4, 81.5, 80.9, 80.4, 79.9, 79.5, 79.2 (2001–11).
  - Gross external financing need (in millions of US dollars): 729.3, 799.0, 755.9, 1,478.0, 1,776.2, 1,777.9, 1,813.6, 1,962.1, 1,961.9, 1,985.0, 2,005.7 (2001–11).

### Labor market, wages, and competitiveness
- Employment and migration:
  - Employment growth has remained strong; unemployment ranks among the lowest in the EU.
  - Foreign labor comprises about "16 percent" of the total labor force.
  - Turkish Cypriots constitute almost "1 percent" of the labor force in areas under the effective control of the Republic of Cyprus.
- Wages and inflation:
  - Real wage growth remained high; wage growth averaged about "4 percent" in 2004–06.
  - Widespread backward-looking COLAs and seniority-based public sector wage pressures create real-wage rigidities.
- Structural reform priorities:
  - Further structural reform is needed to safeguard external competitiveness.
  - Authorities emphasize human capital, R&D, and promoting domestic competition.
  - Staff supports redesigning the wage-setting mechanism to reduce backward-looking wage indexation and real wage rigidities.

### Public investment pipeline and PPPs (selected)
- Total estimated costs of pipeline of projects: 1,695 (20.5 percent of 2006 GDP).
  - Energy (Vasilikos Center) 2005-09: 200 (2.4).
  - Roads: 320 (3.9).
    - Nicosia Orbital Motorway 2006-09: 240 (2.9).
    - Paphos-Polis Highway 2006-10: 80 (1).
  - Airports: 290 (3.5).
    - Larnaka International Airport (phase I) 2005-08: 230 (2.8).
    - Paphos International Airport (phase I) 2005-07: 60 (0.7).
  - Marinas (Ayia Napa, Larnaka, Limassol and Paphos) 2005-09: 175 (2.1).
  - Note: As of December 15, 2006 only the airport terminal projects had begun.
- Recommendation: refrain from new public investment projects until PPP legal and institutional frameworks (including PPP unit and gateway process) and reporting standards are in place.

### Mission policy recommendations and priorities (summarized)
- Short-term priorities for euro adoption:
  - Contain inflationary pressures.
  - Assuage public concern on price rounding (support dual display of prices).
  - Ensure wage moderation.
  - Achieve faster fiscal consolidation than envisaged by authorities.
- Fiscal policy and public expenditure:
  - Avoid supplementary budgets and rigorously apply 2007 budget provision prohibiting them.
  - Strengthen expenditure control mechanisms to observe budget limits.
- Pension and social security reform (two-staged strategy):
  - First wave: tighten pension eligibility (including for a pension at age 63), increase social security contributions, reduce supplementary pension relative to basic pension.
  - Second wave: further increase contribution rates and introduce additional parametric reforms.
  - Mission-specific calls:
    - Raise the effective retirement age back to "65 years" for all employees; address early retirement in an actuarially neutral manner with limited exceptions for strenuous occupations.
    - Switch indexation of all benefits to consumer prices from wages.
    - Introduce explicit mechanism of periodic adjustments in retirement age and/or pension benefits.
    - Improve alignment of pension benefits in the public sector with those in the private sector (staff estimates public sector benefits about "80 percent" higher in net present value terms).
- Health care:
  - Introduce user fees with means-tested exemptions to limit abuse and contain costs.
- Financial-sector vigilance:
  - Monitor credit and house-price developments closely; reconsider prudential measures if credit expansion persists.
  - Accelerate foreclosure process reforms and encourage banks to write off loans that are effectively uncollectible.
  - Ensure supervisors have clear objectives, operational independence, adequate resources, and professional staff; strengthen insurance supervision capacity.

### Financial-sector recovery and cooperative banks (chapter highlights)
- Financial sector recovered from the bursting of the stock market bubble.
- Commercial banks’ profitability improved in 2005–06 due to cost-cutting, remedial actions, and favorable macro conditions.
- Cooperative credit institutions (CCIs) represent roughly 30 percent of private-sector claims; consolidation ongoing (market share of all CCIs: 2002: 24.4; 2003: 26.8; 2004: 26.4; 2005: 24.0; 2006: 24.2).
- Staff advised consideration of unifying supervision of commercial banks and CCIs to realize economies of scale.

### Article IV cycle recommendation, projections, and key tables
- Recommendation: Article IV consultation remain on a 24-month cycle.
- Real economy projections (annual percentage change, 2002–08):
  - Gross domestic product: 2.0, 1.8, 4.2, 3.9, 3.7, 3.9, 4.0.
  - Domestic demand: 4.3, 1.7, 6.5, 3.1, 5.1, 4.5, 3.8.
  - Net exports (contribution to growth): -2.2, 0.1, -2.4, 0.7, -1.5, -0.7, 0.1.
  - Employment growth: 1.9, 3.7, 2.9, 1.9, 1.5, 1.5, 1.5.
  - Unemployment rate (in percent): 3.2, 3.5, 3.6, 5.2, 4.9, 4.8, 4.7.
  - Harmonized index of consumer prices (period average): 2.8, 4.0, 1.9, 2.0, 2.2, 2.5, 2.4.
- Public finance (general government, percent of GDP, 2002–08):
  - Overall balance: -4.4, -6.3, -4.1, -2.4, -1.9, -1.6, -0.7.
  - Primary balance: -1.3, -2.9, -0.8, 1.1, 1.4, 1.5, 2.3.
  - Total revenue: 35.8, 38.8, 38.8, 41.2, 42.1, 42.3, 42.4.
  - Total expenditure and net lending: 40.3, 45.1, 42.9, 43.6, 44.0, 43.9, 43.1.
  - Public debt (net of intragovernmental debt and short-term liabilities of the Central Bank): 64.7, 69.1, 70.4, 69.2, 64.8, 60.6, 52.6.
  - GDP (in millions of £C): 6,416.5, 6,865.9, 7,389.8, 7,861.6, 8,356.8, 8,909.3, 9,496.0 (2002–08).

### Exchange rate regime, technical assistance, and statistics
- The euro replaced the ECU as the basis of the peg on January 1, 1999.
- Effective from May 2, 2005, Cyprus has participated in ERM2; present rate (December 14, 2006) CYP 0.578 :€1.
- Cyprus maintains the peg of the Cyprus pound within a narrow (informal) band since June, 1992.
- Technical assistance (selected): MAE Government debt management — February–March 1989; FAD VAT training program — June–October 1992; FAD Public Investment and PPPs — March–April 2006; FAD Medium-term Budget Framework — May 2006.
- AML/CFT: MONEYVAL Committee found legal provisions and supervisory arrangements satisfactory in February 2006; authorities intend to implement recommendations in the first six months of 2007 and align laws with EU Third Money Laundering Directive by 15 December, 2007.
- Statistical issues:
  - National accounts: consistent series from 1995 onwards; chain-link methodology introduced with 2000 base year.
  - Balance of payments compiled using BPM5 from 2002; concerns remain about coverage and timeliness for some series.
  - Central government fiscal data: good quality and coverage; some publication lags for monthly and consolidated data.

### Staff appraisal: macro priorities and conclusions
- Cyprus has made substantial progress addressing macroeconomic imbalances and reforms and is well placed for EMU accession planned in 2008.
- Macroeconomic policy priority: ensure continued observance of the Maastricht criteria, especially regarding inflation, via fiscal and wage restraint.
- Fiscal strategy: observe 2007 spending limits; save higher-than-expected revenues; focus adjustment on high-quality measures and reining in current expenditures.
- Long-run fiscal sustainability depends critically on pension-system reforms and measures to address aging-related pressures.
- Financial sector: although commercial banks are profitable and well capitalized, credit and house-price developments need close monitoring; supervisory strengthening and foreclosure-process reform are priorities.
- Competitiveness and structural reform: redesign wage-setting to align real wage growth with productivity and enhance domestic competition in key markets.

*Source: _cr0776 (IMF staff report content as supplied).*

### Executive Summary

### Executive Summary

### Background and outlook
- Euro adoption in 2008 is within Cyprus’s grasp; the economic outlook is favorable.
- Economic growth has rebounded to "3½ –4 percent" after a lull in 2002–03.
- Inflation has receded but remains the Maastricht criterion requiring vigilance.
- The fiscal deficit was cut sharply to under "2½ percent of GDP" in 2005 and an estimated "1.9 percent of GDP" in 2006.

### Key short-term policy objective: euro adoption (2008)
- Ensure smooth euro adoption in 2008 by keeping policies aligned with the Maastricht criteria and allaying concerns about the rounding up of prices during conversion.
- Keep inflation in check by:
  - Encouraging wage moderation.
  - Securing greater fiscal consolidation than envisaged in the 2007 budget.

### Fiscal policy: recent performance and medium-term priorities
- Fiscal consolidation achievements:
  - Fiscal deficit halved to under "2½ percent of GDP" in 2003–05.
  - Cyprus became the first new EU member to have its excessive deficit procedure abrogated in July 2006.
  - Data through September 2006 suggest the deficit was on track to fall under "2 percent of GDP" in 2006, notwithstanding a supplementary budget (about "1 percent of GDP") due to health care overruns.
- Composition of adjustment:
  - Almost three-quarters of the 2003–05 fiscal improvement reflected increased revenues, mostly from one-off measures (tax amnesty yielded "¾ percent of GDP" in 2004 and nearly "1 percent of GDP" in 2005).
  - Tight expenditure control (moderation in public sector wage increases and ceilings on public consumption and investment) aided consolidation.
- Medium-term fiscal policy recommendations:
  - Effect high-quality fiscal adjustment by rationalizing, prioritizing, and controlling public expenditure, including investment.
  - Introduce the planned medium-term budget framework.
  - Establish a proper legal framework and institutional setting for PPPs.

### Pension and health care reform
- Pension reform is urgent and on the government agenda.
  - Raise the retirement age back to "65".
  - Build in periodic automatic adjustments to ensure the system keeps up with demographic trends.
- National Health Insurance System:
  - The planned system will likely require user fees and means testing to limit potential abuse and cost increases.

### Monetary and financial sector developments
- Inflation and interest rates:
  - Inflation moderated to around "2 percent" in 2004–05; 12-month HICP inflation rose through the first seven months of 2006, then declined rapidly to "1.5 percent" in December 2006.
  - Factors moderating inflation: waning impact of previous tax rate hikes, decline in car excise tax in late 2003, increased competition in telecommunications and air transportation, euro appreciation, and lower oil prices.
  - The Central Bank of Cyprus increased interest rates by "25 basis points" on September 1 (year not specified in summary) after three consecutive rate cuts totaling "125 basis points" in 2005.
- Exchange rate and reserves:
  - Central parity: "1£C = €1.7086".
  - The exchange rate had traded close to the (unofficial) upper band of "plus 2.25 percent" above the central parity.
  - Gross reserves have risen (figures in source tables and figures).
- Credit growth and supervisory needs:
  - Private sector credit growth increased to "more than 15 percent" in October from "about 6 percent" in 2004–05.
  - Supervisors are closely monitoring credit and house price developments to contain risks to the financial sector.
  - Recommendation: unify the supervision of cooperative credit institutions with that of commercial banks.

### External sector developments
- Current account and competitiveness:
  - The current account deficit widened in 2004–06 to "over 6 percent of GDP".
  - Nonenergy imports surged in 2004—prompted by a sharp increase in investment and a reduction in excise duties on cars in 2003—and recorded robust growth in 2005–06.
  - Declines in competitiveness, including appreciation of the real exchange rate, have contributed to a decline in export market share of goods; services exports have been more resilient.
- Impact of oil prices on the current account (Cyprus pounds; impact in percent of GDP):
  - 2004: oil imports "303.0" (millions Cyprus pounds); price per barrel "17.7"; impact on current account "0.5" percent of GDP.
  - 2005: oil imports "466.9"; price per barrel "24.7"; impact on current account "1.5" percent of GDP.
  - 2006: oil imports "576.3"; price per barrel "29.6"; impact on current account "1.1" percent of GDP.

### Labor market, wages, and competitiveness
- Employment and migration:
  - Employment growth has remained strong; unemployment ranks among the lowest in the EU.
  - An open labor market and booming employment opportunities have attracted a growing number of low-skilled foreign workers.
  - Foreign workers have contributed to lower real wage increases despite pervasive backward-looking COLAs and seniority-based public sector wage pressures.
- Wages and inflation:
  - Real wage growth remained high; wage growth averaged about "4 percent" in 2004–06 (source text: "Still, these remain high and averaged about 4 percent in 2004–06").
- Structural reform priorities to sustain growth and competitiveness:
  - Further structural reform is needed to safeguard external competitiveness.
  - Authorities emphasize human capital, R&D, and promoting domestic competition.
  - Staff supports these objectives and argues for redesigning the wage-setting mechanism to reduce backward-looking wage indexation and real wage rigidities.

### Other notable findings
- Investment and tourism:
  - Recovering tourist receipts reduced the external drag on the economy; tourism is slowly recovering.
- Regional disparity:
  - Publicly available data suggest that GDP per capita in the areas of the Republic of Cyprus not under the effective control of the government (NGCAs) was less than half that of the government-controlled areas (GCAs) in 2005.

*Source: _cr0776 - Executive Summary*

### 8.      Despite all parties’ stated interest, a solution to the Cyprus problem remains

### _cr0776 - 8.      Despite all parties’ stated interest, a solution to the Cyprus problem remains

### Background and political context
- Cyprus entered the EU in 2004 after the failure of the “Annan Plan” for reunification.
- Following a two-year hiatus in face-to-face talks, G/C and T/C leaders agreed in July 2006 to hold “technical discussions” intended to improve day-to-day lives, build confidence, and prepare for a comprehensive political settlement; these talks have yet to bear fruit.
- Staff was not in a position to deliver nonfinancial Fund assistance (such as TA) to the T/C community, as suggested by Directors in concluding the 2004 Article IV consultation.

### Comparative indicators (2005, unless otherwise indicated)
- Table header label: GCANGCA
- GDP per capita (in US$): 22,127 10,314
- Labor productivity (in US$), 2004: 46,073 16,464
- Tourist arrivals (thousands), 2004: 2,349 599
- Trade balance (in percent of GDP): -25.0 -52.0
- General govt. expenditure (in percent of GDP): 43.6 48.9
- CPI inflation (y-o-y), Nov. 2006: 1.1 19.5

### A. Economic outlook — near term prospects and risks
- Outlook:
  - Activity is set to strengthen in 2007–08, sustaining employment growth.
  - Gradual slowing of domestic demand is expected to be more than offset by a broad-based recovery in services exports.
  - External current account deficit is envisaged to narrow gradually and continue to be financed by foreign direct investment, portfolio inflows, and bank borrowing.
- Inflation:
  - Staff saw inflation as hovering close to the Maastricht limit; authorities expressed confidence it would remain below this limit.
  - Authorities cited reduction in energy-related cost pressures and reduction in excise duties for cars as factors holding down inflation in 2007; partial offset expected from aligning VAT rates with EU directives.
- Risks:
  - Declining oil prices seen as boosting activity.
  - Opening of Turkish ports to Cypriot vessels (prospects uncertain) could provide further stimulus; transportation services account for almost 15 percent of total exports.
  - Further appreciation of the euro against the dollar could hamper European recovery and hurt Cyprus’s external competitiveness.
  - The island remains exposed to regional geopolitical tensions.

### B. Adopting the euro — timing, assessment, and competitiveness
- Authorities’ plan and timing:
  - Aim to enter the euro area on January 1, 2008.
  - Plan to submit euro-adoption petition in early 2007.
  - Expect assessment against Maastricht criteria in the first half of 2007.
  - Subject to positive assessment, Cypriot pound exchange rate would be locked in as of mid-2007, with the lock-in rate determined in line with Treaty provisions.
- Benefits and cautions:
  - Economy has already benefited from lower interest rates and removal of barriers; euro would further reduce transaction costs and possibly long-run interest rates.
  - Mission agreed exchange rate appeared broadly in line with fundamentals but underscored need to enhance productivity because of limited scope for further loss of external competitiveness once in the euro zone.
- External debt and current account:
  - Staff’s external debt sustainability analysis suggests the current account deficit in the baseline scenario needs to be narrowed substantially to stabilize the external debt position.
- Policy actions for smooth changeover:
  - Committees established; draft laws to reform institutional framework for monetary policy expected to be adopted in early 2007.
  - Mission noted need to contain inflationary pressures and assuage public concerns about price rounding when converted to euros; welcomed planned dual display of prices.
  - Vigorous domestic competition highlighted as most effective discipline on retailers.
  - To ensure inflation remained in check, mission called for continued wage moderation and faster fiscal consolidation than envisaged by the authorities.

### Box 1 — External competitiveness (summary)
- Cyprus coped well with declines in price and cost competitiveness since early 1990s; recent REER appreciation reversed earlier gains but appears to be moderating.
- ULC-based REER suggests more appreciation owing to strong real wage increases.
- Studies cited (Pattichis and others (2005); Kyriacou and Papageorgiou (2005)) conclude Cyprus pound broadly in line with economic fundamentals.
- In business competitiveness, Cyprus compares favorably to most new member countries, but not with the rest of Europe.

### C. Safeguarding fiscal consolidation — 2007 budget and medium-term framework
- 2007 budget:
  - Targets a further reduction in the fiscal deficit to 1.6 percent of GDP in 2007.
  - Budget described as free of one-off measures and focused on current expenditure adjustment.
  - Authorities noted increase in (other) transfers, primarily social in nature.
  - Need to offset termination of EU budgetary transfers amounting to 0.4 percent of GDP from 2007 onward.
  - Mission stressed more consolidation than the budget envisages is essential to safeguard moderation of inflation; recommended avoiding supplementary budgets and strengthening expenditure control mechanisms.
- Convergence Program (CP) targets:
  - CP targets fiscal balance by 2010.
  - CP envisages lowering public debt to 46 percent of GDP by 2010.
  - Staff’s debt sustainability analysis indicates debt projections are sensitive to certain shocks.
  - The mission supported the medium-term fiscal consolidation plan and stressed reining in current expenditures as means to high-quality adjustment.
- Medium-term budget framework (MTBF):
  - Phased in; elements included in 2007 budget: submission of 2007–09 budgets for line ministries and prohibition of supplementary budgets except in national emergency.
  - MTBF expected fully operational for the 2008 budget with a rolling three-year horizon and institutional framework linking medium-term targets to annual budget process.
  - MTBF would establish expenditure ceilings for line ministries; National Lisbon Program (NLP) to govern final allocation, including investment budget.
- Public investment and PPPs:
  - Authorities halted ambitious public investment plan to be carried out as PPPs; with exception of few projects already underway, all new projects in pipeline suspended.
  - Need for proper legal framework for PPPs, gateway process, dedicated PPP unit for ex ante cost-benefit and value-for-money assessments, and upgraded reporting requirements to protect integrity of government financial statements.
- Convergence Program table highlights (selected rows; values in percent of GDP where shown):
  - General government balance: -1.9 -1.6 -0.7 -0.4 -0.1 1.5
  - Revenue: 42.1 42.3 42.4 42.3 42.1 -0.2 (adjustment)
  - Expenditure: 44.0 43.9 43.1 42.7 42.2 -1.7 (adjustment)
  - General government gross debt: 64.8 60.6 52.6 49.0 46.1 -14.5 (adjustment)
  - Primary balance: 1.4 1.5 2.3 2.1 2.2 0.7 (memorandum)
  - Main budgetary measures include termination of compensating grants on EU budget (-0.4), widening VAT base (0.4/0.8), taxation of motor vehicles (-0.4), restrictive policy on public employment growth (-0.1/-0.3/-0.4), decrease in interest expenditure (-0.1/-0.3/-0.5/-0.8), ceiling on growth rate of current expenditure (-0.8/0.3/-0.1/0.1), public sector retirement measures (-0.2/0.2/-0.1/0.2) (as presented).

### D. Aging and long-term fiscal risks
- Demographics and pensions:
  - Gains in life expectancy and declines in fertility will lead to an aging population; increasing dependency ratio projected.
  - Public pension spending is projected to rise nearly 13 percent of GDP by 2050.
  - Without pension reform or complementary fiscal measures, consequence would be an explosive increase in the debt-to-GDP ratio.
- Public debt projections:
  - Staff debt sustainability analysis shows long-run debt will explode under current policies (graphical depiction in source).
- Pipeline of PPP projects (Estimated costs, CYP millions; percent of 2006 GDP = 20.5 total):
  - Total estimated costs of pipeline of projects: 1,695 (20.5 percent of 2006 GDP)
  - Energy (Vasilikos Center) 2005-09: 200 (2.4)
  - Roads: 320 (3.9)
    - Nicosia Orbital Motorway 2006-09: 240 (2.9)
    - Paphos-Polis Highway 2006-10: 80 (1)
  - Airports: 290 (3.5)
    - Larnaka International Airport (phase I) 2005-08: 230 (2.8)
    - Paphos International Airport (phase I) 2005-07: 60 (0.7)
  - Marinas (Ayia Napa, Larnaka, Limassol and Paphos) 2005-09: 175 (2.1)
  - Note: As of December 15, 2006 only the airport terminal projects had begun.

### Mission policy recommendations and priorities
- Short-term priorities for euro adoption:
  - Contain inflationary pressures.
  - Assuage public concern on price rounding (support dual display of prices).
  - Ensure wage moderation.
  - Achieve faster fiscal consolidation than envisaged by authorities.
- Fiscal policy and public expenditure:
  - Avoid supplementary budgets and rigorously apply 2007 budget provision prohibiting them.
  - Strengthen expenditure control mechanisms to observe budget limits.
  - Refrain from new public investment projects until PPP legal and institutional frameworks (including PPP unit and gateway process) and reporting standards are in place.
- Pension and social security reform (two-staged strategy recommended by authorities and pressed by mission):
  - First wave: tighten pension eligibility (including for a pension at age 63), increase social security contributions, reduce supplementary pension relative to basic pension.
  - Second wave: further increase contribution rates and introduce additional parametric reforms.
  - Mission-specific calls:
    - Raise the effective retirement age back to 65 years for all employees; address early retirement in an actuarially neutral manner with limited exceptions for strenuous occupations.
    - Switch indexation of all benefits to consumer prices from wages to contain pension expenditures (authorities expressed concern about poverty among pensioners).
    - Introduce explicit mechanism of periodic adjustments in retirement age and/or pension benefits to automatically ensure system sustainability in light of demographic changes.
    - Improve alignment of pension benefits in the public sector with those in the private sector (staff estimates public sector benefits about 80 percent higher in net present value terms).
- Health care:
  - NHIS to be introduced in 2008, funded through higher social security contributions; public hospitals sheltered from competition for two to three years.
  - Mission recommended introducing user fees with means-tested exemptions to limit abuse and contain costs.

*Source: IMF staff report chapter titled "8.      Despite all parties’ stated interest, a solution to the Cyprus problem remains" (PDF content as supplied).*

### 23.      The financial sector has recovered from the bursting of the stock market bubble

### 23.      The financial sector has recovered from the bursting of the stock market bubble

### Financial-sector recovery and cooperative banks
- The financial sector recovered from the bursting of the stock market bubble at the turn of the century.
- Cost-cutting measures, remedial actions to improve loan-portfolio quality, and favorable macroeconomic developments boosted commercial banks’ profitability in 2005–06.
- Cooperative bank sector accounts for roughly 30 percent of private-sector claims.
- Mergers among cooperative credit institutions (CCIs) intensified in 2006 in anticipation of full harmonization of capital requirements with EU directives by end-2007.
- Authorities anticipated that about half of the current CCIs would merge by joining the cooperative central bank.
- A recently established common platform between the Cypriot and Athens stock exchanges was expected to increase liquidity and lower transaction costs.

- Cyprus: Cooperative Credit Institutions (CCIs), 2002–06 (Source: The Authority for the Supervision and Development of Cooperative Societies)
  - Number of CCIs: 2002: 362; 2003: 361; 2004: 359; 2005: 347; 2006 1/: 305
  - Number of employees: 2002: 1,964; 2003: 2,010; 2004: 2,101; 2005: 2,180; 2006: ...
  - Number of branches (including central branches): 2002: 472; 2003: 477; 2004: 477; 2005: 474; 2006: ...
  - Market share of all CCIs (in percent) 2/: 2002: 24.4; 2003: 26.8; 2004: 26.4; 2005: 24.0; 2006: 24.2
  - Notes: 1/ Data for 2006 as of September. 2/ Defined as deposits of all CCIs to total deposits in local and foreign currency.

- Banking-sector composition and intermediation:
  - Cyprus: Claims on the Private Sector 1/ — cooperative banks play an important role.
  - Share of claims by institution (2001): Commercial banks 75%; Cooperative credit institutions 25%.
  - Share of claims by institution (2005): Commercial banks 69%; Cooperative credit institutions 31%.
  - Financial Intermediation in the EU, 2005 (private credit as a share of GDP): Average of EU-15: 116; Average of New Member States: 60.
  - Intermediation is near the EU-15 average.

### Credit expansion, housing, and prudential measures
- The economy is experiencing rapid credit expansion and brisk house price increases, which could become sources of risk.
- Credit to the private sector accelerated recently from an already high level, driven by mortgage lending.
- Although house price increases have slowed, they remained high.
- Authorities actions:
  - Suspended further cuts in the deposit reserve ratio.
  - Issued a circular on foreign currency borrowing to emphasize the exchange rate risk of unhedged borrowing.
  - Clarified loan-to-value ratio guidelines introduced in 2003 and emphasized close monitoring of developments.
- Staff view: Prudential measures to control banking-sector risks may need to be revisited if the pace of credit expansion does not abate.

### Nonperforming loans and foreclosure process
- The share of nonperforming loans (NPLs) is declining but remains high by international standards.
- Authorities attributed the high stock of bad debt to the drawn-out legal foreclosure process, typically lasting some ten years.
- Authorities noted that, had there been a more rapid write-off of loans already provisioned for, the ratio of NPLs would have dropped substantially.
- Legislation to modernize the foreclosure process has been submitted to parliament; mission urged rapid adoption.
- Mission recommendation: More rapid write-offs by commercial banks; authorities noted that in practice write-offs were effectively uncollectible despite formal legal claims.

### Financial-sector supervision
- Supervision is divided among four distinct entities covering commercial banks, cooperative credit institutions, stock markets, and insurance companies.
- Coordination among supervisors has improved, but further scope exists to exploit economies of scale.
- The Fund’s Assessment of Financial Sector Supervision Report (AFSSR) found:
  - Supervision and regulation in the commercial banking sector were strong and complied with international standards.
  - Supervision of cooperative credit institutions and of the insurance market needed strengthening.
- Authorities indicated shortcomings were being addressed but acknowledged remaining weaknesses in insurance-market supervision, notably severe resource constraints that virtually ruled out on-site inspections.
- Mission stressed that supervisors should have:
  - Clear objectives and responsibilities.
  - Operational independence.
  - Adequate resources and professional staff.
- Authorities intended to address resource deficiency in insurance supervision promptly and to complete an FSAP in time for the next Article IV consultation.
- Staff appraisal recommendation: Consider unifying supervision of commercial banks and cooperative credit institutions to realize economies of scale and combine supervisory experience; ensure Superintendent for Insurance can conduct on-site inspections.

### Structural reforms, competitiveness, and public-sector issues
- National Lisbon Program (NLP) implemented to enhance growth potential.
  - Introduction of flexible forms of employment and strong economic growth enabled Cyprus to exceed the 2005 employment targets.
  - Boosting human capital and enhancing R&D are critical elements; a newly established monitoring unit will strengthen implementation.
- Long-standing rigidities highlighted by the mission:
  - Widespread backward-looking COLAs and seniority-based salary rules in the public sector introduce real-wage rigidities and raise wages beyond productivity gains.
    - Staff view: Eliminating COLAs would be preferable; removing energy costs and changes in VAT from the COLA adjustment would partially remove rigidity.
    - Authorities: Real wage increases had moderated recently; COLAs help smooth labor relations.
  - Large public incumbents dominate key product markets, notably telecommunications and energy, though some opening since 2004 has occurred.
    - Authorities committed to intensify competition and have legislation before parliament to enhance investigative powers of the Commission for the Protection of Competition (CPC); they were not considering privatization of these state-owned firms.
  - Public sector efficiency is low and the cost of regulation is high; these issues need addressing to enhance productivity.
  - Further improvements are needed to upgrade the tourism sector; authorities highlighted this in the sector’s Strategic Development Plan.

- Telecommunications sector private-sector market shares (based on revenues; in percent; source: IMF staff estimates)
  - 2004, 2005, 2006 Q2:
    - Fixed telecommunications — Local calls: 1.1; 6.3; 7.0
    - Fixed telecommunications — International calls: ...; 14.0; 22.0
    - Mobile telecommunications: 1.0; 7.8; 10.2
    - Internet: 16.0; 22.2; 39.0

### Staff appraisal: macroeconomic outlook and policy priorities
- Economic outlook and EMU readiness:
  - Substantial progress addressing macroeconomic imbalances and reforms has placed Cyprus at the doorstep of EMU.
  - Economic growth is picking up and outstrips that of the EU; inflation is receding with lower oil prices and a strong euro; fiscal consolidation is poised to continue; real exchange rate is broadly in line with fundamentals.
  - Cyprus well placed to benefit from euro adoption as planned in 2008; euro adoption can lower transaction costs and stimulate investment through lower long-run interest rates.
  - Macroeconomic policy priority: Ensure continued observance of the Maastricht criteria, especially regarding inflation, via fiscal and wage restraint.
  - Dual display of prices should be complemented by policies fostering vigorous domestic competition to curb potential abuses in price conversion to euros.

- Fiscal policy and budgetary management:
  - Spending limits in the 2007 budget need strict observance; higher-than-expected revenues should be saved.
  - Stronger adjustment in 2007 is needed to safeguard against a reemergence of inflation and to support medium-term consolidation.
  - Intention to balance the budget in 2010 is appropriate; adjustment should focus on high-quality fiscal measures, particularly keeping current expenditures in check.
  - Ban on supplementary budgets should be strictly observed.
  - Planned Medium Term Budget Framework (MTBF) will help rationalize, prioritize, and control public expenditure; MTBF is key to strengthening financial management, including public investment.
  - Suspension of the ambitious pipeline of public investment is appropriate until a proper legal framework and institutional setting for PPPs are in place.
  - Project selection should be guided by cost-benefit analysis and procurement should be oriented by value-for-money considerations.

- Long-run fiscal sustainability and social policies:
  - Fiscal sustainability hinges on pension-system reforms and relieving aging-related pressures on public expenditure.
  - Deep reforms are needed to catch up with demographic developments.
  - Authorities’ plans to address aging-related pressures are welcome; the challenge is to move from diagnosis to action.
  - Recommended measures:
    - Increase effective retirement age back to 65 years and implement periodic automatic adjustments.
    - Switch pension indexation to prices from wages to contain costs and protect net-of-tax pension benefits.
    - Phase in reforms and grandfather existing employee rights where feasible, but act promptly.
  - National Health Insurance System should be adjusted, including by establishing user fees, to limit abuse and ensure expenditures remain manageable.

- Financial-sector vigilance and supervisory reforms:
  - Although commercial banks are profitable and well capitalized, credit and house-price developments need close monitoring to contain financial-sector risks.
  - Rationalization of the cooperative banking sector is welcome to strengthen its capital base.
  - Proposed changes to accelerate the lengthy foreclosure process should be adopted as soon as possible.
  - Supervisory improvements needed: clear responsibilities and objectives, operational independence, professional staff, and adequate resources for all supervisors, particularly the Superintendent for Insurance.
  - Decision to complete an FSAP in time for the next Article IV consultation is welcome.

- Competitiveness and structural reform priorities:
  - Sustaining growth requires avoiding further competitiveness losses and continuing implementation of the National Lisbon Program.
  - Redesign of the wage-setting system is urgent to align real wage growth with productivity developments.
  - Enhancing domestic competition in key markets—either by privatizing state-owned firms or exposing them to vigorous competition—would boost productivity.
  - Commission for the Protection of Competition should be provided adequate resources and legislation to enhance its investigative capacity should be adopted promptly.

*Source: IMF staff report chapter "_cr0776 - 23.      The financial sector has recovered from the bursting of the stock market bubble_"*

### 37.      It is recommended that the Article IV consultation remain on a 24-month cycle.

### _cr0776 - 37.      It is recommended that the Article IV consultation remain on a 24-month cycle.

### Recommendation
- It is recommended that the Article IV consultation remain on a 24-month cycle.

### Real economy: key projections and indicators (2002–08)
- Gross domestic product: 2.0, 1.8, 4.2, 3.9, 3.7, 3.9, 4.0 (annual percentage change for 2002–08).
- Domestic demand: 4.3, 1.7, 6.5, 3.1, 5.1, 4.5, 3.8.
- Net exports (contribution to growth): -2.2, 0.1, -2.4, 0.7, -1.5, -0.7, 0.1.
- Employment growth: 1.9, 3.7, 2.9, 1.9, 1.5, 1.5, 1.5.
- Unemployment rate (in percent): 3.2, 3.5, 3.6, 5.2, 4.9, 4.8, 4.7.
- Harmonized index of consumer prices (period average): 2.8, 4.0, 1.9, 2.0, 2.2, 2.5, 2.4.
- Gross domestic investment (in percent of GDP): 18.8, 17.4, 20.2, 19.4, 19.5, 19.5, 19.6.
- Gross domestic saving (in percent of GDP): 15.1, 15.2, 15.2, 13.8, 13.2, 13.9, 13.9.

### Public finance (general government) and fiscal projections (2002–08)
- Overall balance (percent of GDP): -4.4, -6.3, -4.1, -2.4, -1.9, -1.6, -0.7.
- Primary balance: -1.3, -2.9, -0.8, 1.1, 1.4, 1.5, 2.3.
- Total revenue (percent of GDP): 35.8, 38.8, 38.8, 41.2, 42.1, 42.3, 42.4.
- Total expenditure and net lending (percent of GDP): 40.3, 45.1, 42.9, 43.6, 44.0, 43.9, 43.1.
- Public debt (net of intragovernmental debt and short-term liabilities of the Central Bank): 64.7, 69.1, 70.4, 69.2, 64.8, 60.6, 52.6 (percent of GDP for 2002–08).
- Central government balance (percent of GDP): -7.1, -8.8, -7.1, -5.2, -2.0, -1.4, -0.8.
- GDP (in millions of £C): 6,416.5, 6,865.9, 7,389.8, 7,861.6, 8,356.8, 8,909.3, 9,496.0 (2002–08).

### Monetary and banking system (selected)
- Broad money (M2, end-of-period stocks in millions of £C): 8,165.2, 8,494.1, 8,971.5, 9,885.0, 10,724.8 (2002–06).
- Money supply (M1): 1,038.8, 1,377.1, 1,523.5, 1,804.9, 1,973.5 (2002–06).
- Claims on private sector (in millions of £C): 7,904.1, 8,302.0, 8,843.7, 9,390.8, 10,252.5 (2002–06).
- Commercial banks: total assets (in millions of £C) 12,776, 14,936, 15,565, 16,621, 17,818, 22,023 (2000–05).
- Total deposits (commercial banks, in millions of £C): 9,995, 11,474, 11,999, 12,193, 13,102, 16,023 (2000–05).
- Non-resident deposits (commercial banks, in millions of £C): 3,759, 4,396, 4,209, 4,133, 4,610, 6,649 (2000–05).
- International banking units: total assets (in millions of £C) 10,545, 10,150, 8,139, 9,036, 12,531, 17,081 (2000–05).

### External sector and balance of payments (2002–11 projections)
- Trade balance (in percent of GDP): -27.3, -23.9, -25.6, -25.0, -27.4, -26.7, -26.4, -25.8, -25.3, -24.7 (2002–11).
- Current account (percent of GDP): -3.7, -2.2, -5.0, -5.6, -6.2, -5.6, -5.6, -5.1, -4.6, -4.2 (2002–11).
- Financial account (percent of GDP): 5.8, 1.4, 5.4, 6.2, 6.1, 5.4, 5.4, 4.8, 4.4, 4.0 (2002–11).
- Direct foreign investment, net (percent of GDP): 5.7, 3.0, 2.9, 4.3, 4.3, 4.3, 4.3 (2002–08).
- Portfolio investment, net (percent of GDP): -4.8, 1.9, 7.5, -0.8, -0.8, -0.8, -0.8 (2002–08).
- Change in official reserves (in months of imports of GS): 7.4, 2.1, 4.2, 1.9, 2.6, 1.5, 1.4 (2002–08).

### External and public debt sustainability (selected metrics and scenarios)
- Baseline: External debt (percent of GDP): 35.7, 47.4, 51.6, 64.2, 74.4, 81.5, 80.9, 80.4, 79.9, 79.5, 79.2 (2001–11).
- Change in external debt: 5.8, 11.7, 4.3, 12.6, 10.2, 7.1, -0.6, -0.5, -0.4, -0.4, -0.4 (2001–11).
- Identified external debt-creating flows (4+8+9): 5.0, 2.9, -3.9, -1.3, 2.0, 3.7, 2.7, 2.6, 2.0, 1.6, 1.2.
- Gross external financing need (in millions of US dollars): 729.3, 799.0, 755.9, 1,478.0, 1,776.2, 1,777.9, 1,813.6, 1,962.1, 1,961.9, 1,985.0, 2,005.7 (2001–11).
- Gross external financing need (in percent of GDP): 7.5, 7.6, 5.7, 9.4, 10.5, 9.8, 9.0, 9.2, 8.6, 8.2, 7.8.
- Key macroeconomic assumptions underlying the baseline:
  - Real GDP growth (in percent): 4.0, 2.0, 1.8, 4.2, 3.9, 3.7, 3.9, 4.0, 4.0, 4.0, 4.0 (2001–11).
  - Nominal external interest rate (in percent): 6.7, 6.4, 5.3, 3.7, 3.3, 4.2, 4.8, 4.6, 4.6, 4.7, 4.7.
  - Growth of exports (US dollar terms, in percent): 6.0, 0.3, 17.3, 18.3, 8.4, 5.8, 9.8, 6.0, 5.8, 5.7, 5.9.
  - Growth of imports (US dollar terms, in percent): 0.4, 5.7, 15.9, 24.0, 8.1, 10.6, 8.2, 6.2, 5.1, 5.0, 5.2.
- Baseline: Public sector debt (percent of GDP): 60.7, 64.7, 69.1, 70.4, 69.2, 64.8, 60.6, 52.6, 49.1, 46.2, 43.6 (2001–11).
- Change in public sector debt: 1.9, 4.0, 4.4, 1.3, -1.2, -4.4, -4.2, -8.0, -3.5, -2.9, -2.6 (2001–11).
- Identified debt-creating flows (4+7+12): -3.3, 7.4, 5.5, -0.8, -3.5, -2.2, -2.4, -3.0, -2.6, -2.6, -2.5.
- Gross financing need (percent of GDP): 28.9, 31.3, 20.3, 19.2, 19.4, 18.2, 16.9, 15.2, 13.6, 12.5, 11.6.
- Key assumptions for public debt baseline:
  - Real GDP growth (in percent): 4.0, 2.0, 1.8, 4.2, 3.9, 3.7, 3.9, 4.0, 4.0, 4.0, 4.0.
  - Average nominal interest rate on public debt (in percent): 6.1, 5.3, 5.7, 4.9, 5.1, 5.0, 5.2, 5.3, 5.5, 5.4, 5.1.
  - Average real interest rate (in percent): 2.7, 4.2, 0.6, 1.6, 2.7, 2.5, 2.6, 2.8, 3.3, 3.2, 3.1.
  - Inflation rate (GDP deflator, in percent): 3.4, 1.2, 5.1, 3.3, 2.4, 2.5, 2.6, 2.5, 2.3, 2.2, 2.0.
- Scenario outcomes: "Scenario with key variables at their historical averages" public sector debt paths reported (examples): 64.8, 63.3, 58.6, 58.0, 58.0, 58.0.

### PPP Gateway Process (proposed)
- Four-phase process with ministerial approval gates:
  - Phase 1: PLANNING — Gate 1: Finance Minister to approve/reject initial project. PPP unit and Budget Directorate jointly evaluate VfM and affordability; report to Finance Minister.
  - Phase 2: DESIGN AND PREPARATION OF TENDER — Gate 2: Finance Minister to approve/reject issuance of tender documents.
  - Phase 3: BIDDING AND NEGOTIATION — Gate 3: Finance Minister to approve/reject preferred bid; Gate 4: Finance Minister to approve/reject contract.
  - Phase 4: CONSTRUCTION AND OPERATION — Supervision, monitoring, and potential renegotiation; final gateway approval for renegotiated contract.
- Roles: PPP Unit evaluates VfM and global sustainability; Budget Directorate assesses budgetary affordability and consistency with fiscal goals; both report to Finance Minister.

### Cooperative Supervision: recommended measures and authorities' responses (selected)
- CP 1.1 Objectives: coordinate transitional change via global change committee; coordination by committee of heads of relevant institutions.
- CP 1.2 Independence: Staff Restructuring Plan approved July 2005; increase in permanent staff from 36 to 57; promotions and recruitments noted; vacancies for 20 officers published.
- CP 2 Permissible Activities: draft regulative decision prepared; prohibition on use of term “Cooperative Credit Institution” included in amending bill being prepared.
- CP 5 Investment Criteria: draft regulative decision prepared and to be forwarded for approval.
- CP 6 Capital Adequacy: Commissioner’s directive on mandatory semi-annual reporting to be finalized by 31/12/2007 at the latest.
- CP 7–19 (credit policies, loan evaluation, large exposure limits, connected lending, market risks, internal controls, money laundering, on-site and off-site supervision, validation of supervisory information): multiple draft regulatory decisions, computerization projects, training programs, EU Twinning Light Program, and ongoing recruitment described; planned reductions in CCIs from 361 (end-2004) to approximately 275 (end-2006) and approximately 150 (end-2007).

### National Lisbon Program: key challenges and actions (selected)
- Challenge 1: Sustainability of public finances.
  - Actions: achieve close to balanced fiscal position via ceilings on public expenditure; improve tax effectiveness; introduce a medium-term budgetary framework.
  - Long-term sustainability: reduce government debt well below 60 percent of GDP; increase female and old-aged labor participation; promote Social Insurance Scheme reforms; reform health sector; redirect public expenditure toward infrastructure, R&D, ICT, education, and health.
- Challenge 2: Enhance competition and business climate.
  - Actions: increase flexibility of semi-government organizations; introduce performance appraisal system; one-stop shops; extend web-enabled services; reduce regulatory burden; rationalize state aid.
- Challenge 3: Diversification toward higher value-added activities.
  - Actions: strengthen institutional framework to promote Cyprus as entrepreneurial base and attract FDI; maintain low taxation burden; extend tax treaties; upgrade tourism product; support SMEs via guarantee schemes and technological upgrading.
- Challenge 4: Promote R&D and innovation.
  - Target: increase total spending on R&D to 1 percent of GDP by 2010.
  - Actions: upgrade R&D program funding; utilize EU research programs; establish research and training centre on public health and environmental issues in cooperation with Harvard University; create technology park; facilitate ICT and e-services.
- Additional challenges: upgrade infrastructure (transport, energy, communications); human capital development (increase female and older worker participation; improve education; life-long learning); social cohesion (introduce National Health Insurance System; needs-targeted social benefits); environmental sustainability (expand environmental infrastructure; promote energy saving and renewables).

### Vulnerability and financial soundness indicators (selected)
- Financial indicators (2002–08): public debt (net): 64.7, 69.1, 70.4, 69.2, 64.8, 60.6, 52.6 (percent of GDP).
- Broad money (percent change, 12-month basis): 10.3, 4.0, 5.6, 10.2, 8.1, 8.5, 8.5.
- Private sector credit, real (percent change): 5.0, 0.9, 4.0, 3.7, 5.4, 5.7, 5.8.
- Total external debt: 47.4, 51.6, 64.2, 74.4, 81.5, 80.9, 80.4 (2002–08).
- Total external debt to exports G&NFS: 93.5, 109.4, 136.6, 156.8, 174.3, 173.6, 173.9 (2002–08).
- Official foreign exchange reserves (US$ billions): 3.2, 3.5, 4.1, 4.4, 4.9, 5.2, 5.5 (2002–08).

### Financial soundness indicators for banks (2001–05, selected)
- Regulatory capital to risk-weighted assets: 14.0, 12.7, 11.7, 11.4, 12.4 (2001–05).
- Regulatory Tier I capital to risk-weighted assets: 11.6, 10.1, 10.0, 9.8, 10.0 (2001–05).
- Nonperforming loans to total gross loans (2001–05): 7.9, 9.5, 11.3, 11.7, 7.1.
- Return on assets: 0.6, -0.7, -0.3, 0.2, 0.8 (2001–05).
- Return on equity: 8.4, -11.1, -4.7, 4.3, 14.1 (2001–05).

### Fund relations and mission (as of November 30, 2006)
- Mission: Nicosia, October 25-November 6, 2006. Staff team: Mr. Hoffmaister (head), Mr. Jafarov, and Ms. Hassine (all EUR).
- Fund relations: Cyprus is on a 24-month cycle, and the previous Article IV consultation was concluded in October 2004; there was a staff visit in December 2005 to discuss economic developments and euro adoption.
- Membership status: Joined December 21, 1961. Accepted the obligations of Article VIII, Sections 2, 3, and 4 effective January 9, 1991.
- Quota (SDR million): 139.60 (100.0 percent of quota).
- Fund holdings of currency: 125.57 (89.95 percent of quota).
- Reserve position in Fund: 14.07 (10.08 percent of quota).
- SDR Department net cumulative allocation (SDR million): 19.44 (100.0 percent of allocation); holdings: 2.72 (14.01 percent of allocation).
- Projected obligations to Fund (SDR million; forthcoming): Charges/interest: 0.68, 0.68, 0.68, 0.68 (2006–09).
- Exchange rate arrangements: Present rate (December 14, 2006) CYP 0.578 :€1. Exchange Rate Regime: ERM2.
- Publication: The authorities have agreed to publish the staff report.

*Concluding note: data, tables, projections, and policy recommendations are those presented in the staff report annexes and tables for Cyprus as provided in the source.*

### 2.25 percent. On January 1, 1999, the euro

### _cr0776 - 2.25 percent. On January 1, 1999, the euro

### Exchange rate regime and currency arrangements
- The euro replaced the ECU as the basis of the peg on January 1, 1999.
- In August 2001, fluctuation margins increased to +15 percent; the central rate remained unchanged.
- Authorized dealers (banks) are, subject to limitations including a limit on spreads between buying and selling rates, free to determine and quote their own buying and selling rates.
- Effective from May 2, 2005, Cyprus has participated in ERM2.
- Cyprus maintains the peg of the Cyprus pound within a narrow (informal) band since June, 1992.
- Cyprus is an Article VIII member and maintains an exchange system free of restrictions subject to Fund jurisdiction; it maintains measures adopted for security reasons, which the authorities are in the process of notifying the Fund for approval in accordance with Decision 144.

### Article IV consultation and IMF assessments
- Last Article IV consultation mission: October 18–29, 2004.
- Staff report: CR/05/107, 3/22/05; discussed by the Executive Board on February 18, 2005.
- IMF Module 2 assessment undertaken March–April 2005 under the Offshore––Financial Centers assessment program covering:
  - Compliance with the Basel Core Principles for Effective Banking Supervision.
  - Observance of the Insurance Core Principles.
  - Implementation of IOSCO Objectives and Principles of Security Regulations.
- The Cypriot authorities have agreed to publish the assessments.

### Technical assistance (chronological listing by department and purpose)
- 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
- FAD: Public Investment and PPPs — March–April 2006
- FAD: Medium-term Budget Framework — May 2006

### Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT)
- The legal provisions and supervisory arrangements for AML/CFT were found to be satisfactory by the Council of Europe’s MONEYVAL Committee in February 2006.
- The authorities intend to implement the recommendations of this evaluation in the first six months of 2007.
- Authorities plan to change existing laws and regulations in line with the requirements of European Union’s Third Money Laundering Directive, due for implementation by Member States by 15 December, 2007, and of the (new) Council of Europe’s Convention on money laundering and terrorist financing.

### Statistical issues and data dissemination
- Cyprus has an open publication policy; statistical data are generally of high quality and adequate frequency.
- Cyprus has not yet subscribed to the Special Data Dissemination Standard (SDDS), but format and requirements for most data broadly observe the general provisions of the standard.
- Some data series have long time lags; advance-release calendars are not disseminated to users.
- National accounts:
  - Consistent series from 1995 onwards available on the Ministry of Finance internet site.
  - Volume national accounts revised to reflect changes in recording FISIM.
  - Chain-link methodology introduced with 2000 base year.
  - Quarterly real GDP growth rates published with a few months delay; annual national accounts published with up to five months delay.
  - Ministry of Finance disseminates monthly economic indicators (trade flows, tourism arrivals, industrial production) with a lag of a couple of months for most indicators.
  - Since January 1999, CPI compiled according to EU HICP definition.
- Balance of payments statistics:
  - Presented in Eurostat Balance of Payments Vade Mecum format (based on IMF BPM5).
  - From 2002, BOP statistics 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.
  - Concerns remain regarding coverage (including the International Investment Position), timeliness, and transparency of revisions.
- Fiscal data:
  - Central government fiscal data: good quality and coverage.
  - Monthly fiscal data: generally high quality, but not published timely.
  - Consolidated general government accounts exist from 1998; published annually and quarterly on the internet with a lag of several months.
- Monetary and financial statistics:
  - Disseminated on a timely basis.
  - Monetary authority and commercial bank balance sheets, interest rates, and relevant information available with a lag of about one month.

### Table of common indicators required for surveillance (as of January 8, 2007) — selected items and timing
- Exchange Rates: Date of latest observation 01/08/07; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation November 06; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M
- Reserve/Base Money: Date of latest observation November 06; Frequency M/M/M
- Broad Money: Date of latest observation November 06; Frequency M/M/M
- Central Bank Balance Sheet: Date of latest observation November 06; Frequency M/M/M
- Consolidated Balance Sheet of the Banking System: Date of latest observation November 06; Frequency M/M/M
- Interest Rates: Date of latest observation 01/08/07; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D
- Consumer Price Index: Date of latest observation December 06; Frequency M/M/M
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Date of latest observation 2005; Frequency A/A/A
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: Date of latest observation 2006 Q2; Frequency Q/Q/Q
- Stocks of Central Government and Central Government-Guaranteed Debt: Date of latest observation 2006 Q2; Frequency Q/Q/Q
- External Current Account Balance: Date of latest observation 2006 Q2; Frequency Q/Q/Q
- Exports and Imports of Goods and Services: Date of latest observation 2006 Q3; Frequency Q/Q/Q
- GDP/GNP: Date of latest observation 2006 Q3; Frequency Q/Q/Q
- Gross External Debt: Date of latest observation 2006 Q2; Frequency Q/Q/Q

### Statement by Cypriot officials — General remarks and macro outlook (Yuri G. Yakusha and Charalambos Christofides; January 26, 2007)
- Authorities welcome the staff's positive assessment and recommendations and thank staff for significant technical assistance.
- Cyprus intends to join EMU and adopt the euro as its currency on January 1, 2008 as planned.
- Macroeconomic policies aimed at ensuring smooth EMU accession and sustainable out-performance of Maastricht criteria where possible.
- Objective to ensure visible benefits for the average Cypriot citizen from European integration.

### Real economy — performance, outlook, productivity, and structural reforms
- Recent growth:
  - Economy recovered with a near 4 percent GDP growth rate.
  - Inflation ended the year at 1.5 percent.
  - External current account deficit widened to around 6 percent of GDP; medium-term expected to ebb to 4 percent of GDP.
  - Employment growth expected in the 1.5-2 percent range going forward.
  - Capital investment contribution to growth expected between 1-1.5 percent.
  - Total Factor Productivity (TFP) expected at 1.5 percent.
- Labor market:
  - Foreign labor comprises about 16 percent of the total labor force.
  - Unemployment rate between 3.5-5 percent depending on definition.
  - Turkish Cypriots constitute almost 1 percent of the labor force in areas under the effective control of the Republic of Cyprus.
  - Cyprus did not place restrictions on working opportunities of Bulgarian and Romanian citizens after their accession to the EU.
- Wages and COLA:
  - Overall wage growth moderate at a nominal rate of 4-6 percent economy-wide.
  - COLA mechanism criticized by Fund missions but credited with contributing to labor peace.
- External sector and services:
  - FDI inflows increased substantially, easing external financing needs.
  - Tourist sector recovering: revenue expanding moderately despite a small decline in arrivals.
  - Exports of services rising; shipping services sector especially strong.
  - Turkish refusal to allow Cypriot-flagged ships to use Turkish ports negatively impacts the shipping export sector.
- Structural measures and investments:
  - Infrastructure investments reducing commuting time.
  - Government reconsidering investments in two new desalination plants to address water shortage.
  - Plans to increase GDP share devoted to R&D in line with Lisbon strategy.
  - Legislation pending to enhance powers of the Commission for the Protection of Competition.
  - Private sector share rising in mobile telephony.
  - Tourism upgrade plans include building marinas and golf courses and attracting professional conventions.
  - Cyprus Airways has taken actions to reduce staffing and other costs.
  - Rapid increase in households with internet access.

### Monetary policy and the financial sector (excerpt)
- The Central Bank of Cyprus (CBoC) will remain focused on containing inflation and keeping the economy on track for EMU accession and locking the parity between the Cyprus pound and the euro at around mid-2007.
- The CBoC has changed policy interest rates by a full 100 basis in one step (once upwards, and once downwards) since [text truncated in source].

*Source: _cr0776 - 2.25 percent. On January 1, 1999, the euro (IMF PDF content provided).*

### 2004. Most recently, on September 1 the CBoC raised interest rates by 25 basis points to

### _cr0776 - 2004. Most recently, on September 1 the CBoC raised interest rates by 25 basis points to

### Monetary policy and exchange rate
- The Central Bank of Cyprus (CBoC) raised interest rates by 25 basis points on September 1 (year context: 2006).
- Earlier in 2005 the CBoC cut rates three consecutive times totaling 125 basis points.
- Harmonization of the CBoC operational framework with euro area practices occurred on September 1, 2006:
  - The bid rate is now used on main financing operations instead of the Lombard rate.
  - This change increased the bid rate on main refinancing operations by 125 basis points.
  - Net effect: a 100 basis point interest rate differential between the Cyprus pound and the euro at the short end.
- Interest rate differentials against the euro have fallen significantly, but the exchange rate continues to trade close to the (unofficial) upper band.
- Inflation developments:
  - Year-on-year CPI inflation was 1.5 percent in December (2006).
  - CPI inflation (period average): 2001: 2.0; 2002: 2.8; 2003: 4.1; 2004: 2.3; 2005: 2.6; 2006: 2.5.
- Interest rates (in percent):
  - Deposit rates 1-year fixed deposits over £C 5,000: 2001: 6.0; 2002: 4.8; 2003: 3.8; 2004: 3.9; 2005: 4.0; 2006: 3.6 (Data for 2006 as of October).
  - Lending rates (enterprises' secured loans): 2001: 7.5; 2002: 7.2; 2003: 6.9; 2004: 7.6; 2005: 7.1; 2006: 6.8 (Data for 2006 as of October).

### Euro adoption preparations and effects
- Authorities fully committed to adopting the euro on January 1, 2008 (decision by the Council of Ministers).
- Preparations include adapting a large range of laws and conducting a public relations campaign to address inflationary perceptions (e.g., “round prices up” concerns).
- Staff presented data showing that euro adoption in other countries did not lead to significantly higher inflation, though selected frequently used items saw upward pressures.
- Benefits noted:
  - Interest rates and spreads have benefited; Cyprus able to borrow abroad at favorable rates.
  - Remaining small premium attributed mostly to liquidity rather than credit risk, expected to decline as a primary dealer market for government paper starts.

### Financial sector structure and supervision
- The financial sector is generally healthy and undergoing restructuring amid greater competition and EU accession.
- Higher profitability has allowed improved provisioning against NPLs, which appear higher than they would under international recording practices.
- Banks reluctant to write off loans before exhausting lengthy legal foreclosure measures.
- Examples of consolidation and foreign interest:
  - A controlling interest in the second largest commercial bank was acquired by a foreign (Greek) concern; the two subsequently merged.
  - Interest in the largest commercial bank has been expressed by two foreign (Greek) concerns.
- Cooperative sector facing competitive pressure on housing loans and regulatory pressure to improve capitalization; merger activity increasing within the cooperative sector.
- Staff recommendations (shared by authorities) draw on a Detailed Assessment of Standards and Codes for Banking Supervision, Insurance Supervision, and Securities Regulation.
- Authorities moving to implement specific recommendations, including increasing Insurance Supervisor staff for on-site inspections.
- Directors’ recommendations:
  - Stand ready to take measures if rapid credit growth and brisk house price increases become risky.
  - Consolidate supervision of commercial banks and cooperative credit institutions; ensure supervisors have clear responsibilities, operational independence, professional staff, and adequate resources.
  - Accelerate lengthy foreclosure process via legislation and regulations.
  - Complete a Financial Sector Assessment Program in time for the next Article IV consultation.

### Fiscal policy and outcomes
- Fiscal consolidation pace was very fast: deficit more than halved between 2003 and 2005.
- Cyprus was the first country to have its excessive deficit procedure abrogated by the EU.
- Contributing measures included expenditure restraint, low public sector employment growth, zero real wage growth component for two consecutive years, and tight control on public procurement and investment.
- Some measures had a one-off character (e.g., tax amnesty during 2004-05) but helped broaden the tax base.
- Plans for 2007 supportive measures:
  - Public sector real (basic) wages planned to rise by 1 percent (following 0 percent in 2004-05 and 2 percent in 2006).
  - Public sector employment growth limited to 1 percent per year.
  - Current expenditure growth contained to below nominal GDP growth.
  - Continued efforts to improve tax administration.
  - Most expected adjustment between 2007 and 2010 to come from the expenditure side.
- Cyclically adjusted structural balance in 2007 expected to be fairly restrictive; slower consolidation pace between 2006 and 2007 largely due to abatement of one-off measures and termination of compensating EU grants that accounted for 0.4 percent of GDP in 2006.
- Fiscal outturns and projections:
  - Fiscal year 2006 general government deficit around 1.5 percent of GDP (Convergence Program target: 1.9 percent of GDP).
  - Target for 2007 to remain unchanged pending sustainability of favorable revenue performance.
  - Medium-Term Objective: close to balance by 2009-10 to put debt-to-GDP on a distinct downward path.
- Public finances (general government, in percent of GDP) — selected series:
  - Overall balance: 2001: -2.2; 2002: -4.4; 2003: -6.3; 2004: -4.1; 2005: -2.4; 2006: -1.9.
  - Primary balance: 2001: 1.1; 2002: -1.3; 2003: -2.9; 2004: -0.8; 2005: 1.1; 2006: 1.4.
  - Gross public debt (1/ excludes intragovernmental debt and short-term liabilities of the Central Bank): 2001: 61.5; 2002: 64.8; 2003: 69.4; 2004: 70.3; 2005: 69.2; 2006: 64.8.

### Medium- and longer-term fiscal and demographic challenges
- Authorities’ four-pillar strategy:
  1. Utilize the medium term budget framework (MTBF) to institutionalize expenditure rules while increasing accountability and independence for line ministries vs. quantified targets.
  2. Align social welfare spending better with need.
  3. Strengthen modernization of the public sector.
  4. Further improve tax collection by tackling tax evasion and improving tax administration.
- Fund technical assistance has helped implement MTBF, to be fully operational from 2008; further TA recommended for implementation.
- Public-private partnerships (PPPs) present contingent risks; a draft legal framework and institutional gatekeepers have been developed with Fund TA to quantify and manage risks.
- Demographic challenge:
  - Main driver: drop in fertility rate to 1.5 maintained into the indefinite future implies large long-term adverse population impacts.
  - Authorities prepared measures in two stages; staff raised reservations about political sensitivity of raising retirement age fast and linking pension benefits to inflation only.
  - Public debt expected to continue to decline rapidly, eventually falling below 50 percent of GDP before rising under demographic pressures, providing some fiscal space to address the challenge.

### Issues relating to reunification and IMF role
- Government of Cyprus has directed significant aid toward the Turkish Cypriot community and intends to continue under the right conditions, possibly including EU Funds.
- Activities must promote reunification and not provide international cover or recognition to the occupation regime.
- IMF role: authorities cooperative with Fund staff in contacting Turkish Cypriot technocrats to explore non-financial assistance (e.g., collecting information, training), though no assistance agreed so far.

### Executive Board Assessment and recommendations
- Directors welcomed progress in addressing macroeconomic imbalances and reforming the economy.
- Key observations and recommendations:
  - Continued observance of Maastricht criteria, particularly the inflation criterion, and smooth euro adoption required for sustained growth.
  - Fiscal and wage restraint, policies fostering domestic competition, and vigilance in monetary policy needed.
  - Remain ambitious in fiscal adjustment, observe spending limits, avoid supplementary budgets, and save higher-than-envisaged revenues.
  - Support for balancing the budget by 2010 and implementing a MTBF by 2008.
  - Suspension of an ambitious public investment program deemed appropriate pending legal and institutional frameworks for PPPs.
  - Implement pension reforms to address adverse demographic trends; consider measures to avert rising health care costs with National Health Insurance System introduction in 2008 (e.g., user fees).
  - Safeguard external competitiveness; adjust wage-setting toward alignment with productivity; enhance competition in telecommunications and energy sectors.
  - Encourage agreement on Fund TA framework for the Turkish Cypriot community.
  - Authorities’ intention to subscribe to the Special Data Dissemination Standard by 2008 welcomed.

### Selected economic indicators (highlights)
- Real economy:
  - GDP growth (change in percent): 2001: 4.0; 2002: 2.0; 2003: 1.8; 2004: 4.2; 2005: 3.9; 2006: 3.7.
  - Domestic demand (contribution to annual growth): 2001: 3.4; 2002: 4.2; 2003: 1.7; 2004: 6.6; 2005: 3.2; 2006: 5.2.
  - Unemployment rate (in percent): 2001: 3.0; 2002: 3.2; 2003: 3.5; 2004: 3.6; 2005: 5.2; 2006: 4.8.
  - Gross domestic saving (in percent of GDP): 2001: 13.2; 2002: 15.1; 2003: 15.2; 2004: 15.2; 2005: 13.8; 2006: 13.2.
  - Gross domestic investment (in percent of GDP): 2001: 16.4; 2002: 18.8; 2003: 17.4; 2004: 20.2; 2005: 19.4; 2006: 19.5.
- Money and credit (percent change):
  - Reserve money: 2001: 7.5; 2002: 22.7; 2003: 4.8; 2004: 8.0; 2005: 2.6; 2006: 6.8.
  - Broad money: 2001: 13.3; 2002: 10.3; 2003: 4.0; 2004: 5.6; 2005: 10.2; 2006: 13.3.
  - Domestic credit: 2001: 14.9; 2002: 9.5; 2003: 5.9; 2004: 4.2; 2005: 8.0; 2006: 7.5.
- Balance of payments (in percent of GDP):
  - Trade balance: 2001: -26.7; 2002: -27.3; 2003: -23.9; 2004: -25.6; 2005: -25.0; 2006: -27.4.
  - Current account balance: 2001: -3.3; 2002: -3.7; 2003: -2.2; 2004: -5.0; 2005: -5.6; 2006: -6.2.
- Fund position (as of November 30, 2006):
  - Holdings of Currency (in percent of quota): 90.0.
  - Holdings of SDR's (in percent of allocation): 14.0.
  - Quota (in millions of SDR): 139.6.
- Exchange rate regime: ERM2.
  - Present rate (January 31, 2006): C£0.579 :€1.
  - Real effective exchange rate (CPI-based, 2000=100): 2001: 101.0; 2002: 104.1; 2003: 111.0; 2004: 113.0; 2005: 112.9; 2006: 112.3 (Data for 2006 as of October).

*Public Information Notice No. 07/21, February 21, 2007.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr0776.pdf_