## _cr09255

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---

### Executive Summary — Context and key vulnerabilities
- Overheating in 2007–08 produced:
  - a highly leveraged private sector;
  - large current account deficits (headline 2008 current account deficit of 18½ percent of GDP, with an estimated one-third attributable to temporary and technical factors);
  - large exposure of banks to property prices.
- Financial sector resilience and supporting factors:
  - financial sector holding up but size and concentration could pose systemic risks;
  - elimination of exchange rate risk following euro adoption (January 1, 2008);
  - conservative financial sector practices, limited exposure to toxic assets, and strict supervision;
  - successful sovereign bond issue in June 2009: €1½ billion five-year bond (¾ of the government’s financing needs for 2009).
- Macro imbalances and amplification:
  - growth in 2007–08 largely credit-financed with strong real wage growth and low unemployment;
  - rapid credit growth driven by excess liquidity; CBC minimum liquidity requirement reduced from 75 to 70 percent for all foreign currency deposits;
  - private sector external debt (including non-resident deposits) at 421 percent of GDP; net external debt small at 4 percent of GDP due to banks accumulating assets abroad;
  - loan-to-value ratios around 70–80 percent.
- Inflation and competitiveness:
  - sharp uptick in inflation in 2008 due to demand-pull and cost-push factors and temporary factors (drought, euro adoption);
  - double-digit and growing current account deficits indicate overheating and competitiveness problems; CGER methodologies point to a significant competitive disadvantage and rising unit labor costs in manufacturing.
- Public finances:
  - general government debt was 49½ percent of GDP; 2008 budget surplus declined to 0.9 percent of GDP;
  - pension reform enacted but relies largely on contribution increases and does not fully address ageing-related increases in pension expenditures.

### Staff views — findings and recommended policies
- Financial sector:
  - Early detection and intervention are key; supervisory capacity should be bolstered.
- Fiscal policy:
  - Recommend a ½−¾ percent a year public consumption-based fiscal adjustment to meet the government’s medium-term budget balance objective and avoid an unsustainable debt-deficit cycle.
  - Measures: wage bill control, public administration reform, targeted social support.
- Structural reforms and competitiveness:
  - Speedy implementation of the government’s structural reform program to shore up competitiveness.
  - COLA (inflation-indexed wage adjustment mechanism) should ideally be eliminated or better targeted.

### Authorities’ views and policy stance
- Government expects to meet fiscal objectives without altering current plans.
- Recommendations to improve financial sector stability were well received.
- Reforming COLA is unlikely to be on the policy agenda.

### Selected quantitative highlights (as reported)
- 2008 headline current account deficit: 18½ percent of GDP (about one-third due to temporary/technical factors).
- Public debt: 49½ percent of GDP.
- Loan-to-value ratios on property lending: 70–80 percent.
- Private sector external debt (including non-resident deposits): 421 percent of GDP.
- Net external debt: 4 percent of GDP.
- CBC minimum liquidity requirement reduced from 75 to 70 percent for all foreign currency deposits.
- Euro adoption date: January 1, 2008.
- Successful sovereign bond issuance in June 2009: €1½ billion five-year bond (¾ of government’s financing needs for 2009).
- Recommended fiscal adjustment: ½−¾ percent a year in public consumption-based consolidation.
- 2008 general government budget surplus: 0.9 percent of GDP.

### Mission, interlocutors, and outreach
- Mission team: A. Banerji (head), P. Sodsriwiboon (both EUR), and Y. Lu (MCM), joined by K. Driessen (MCM); Mr. Galac (OED) also attended.
- Interlocutors: Minister of Finance Stavrakis, Governor Orphanides, senior public sector and parliamentary officials, private banks and businesses, labor unions, and academia.
- Outreach: A press conference was held and the concluding statement published.

---

### Financial sector resilience, risks, and policy recommendations
- Banking sector resilience and status:
  - Resident and non-resident deposits held steady; planned expansion of deposit insurance supported confidence.
  - Banks reportedly do not face liquidity problems; public recapitalization has not been necessary.
- Size, concentration, and cross-border exposure:
  - Domestic assets about 690 percent of GDP.
  - Sector dominated by three domestic banking groups: Bank of Cyprus, Marfin Popular Bank, and Hellenic Bank.
  - Foreign presence significant; Greece’s Alpha Bank predominant foreign player.
- Bank responses and asset quality:
  - Banks restructuring: increasing interest rate spreads, issuing subordinated/convertible loan capital, securing funding, enhancing risk management.
  - Lending decelerated; underwriting tightened.
  - Profitability declined due to low margins, mark-to-market losses, and larger provision write-offs.
  - NPLs low but rising; capital buffers declined.
- Regulatory and supervisory actions:
  - Progress implementing EU Directives and FSAP recommendations.
  - Measures: increased deposit insurance coverage and funding; crisis management law drafted; covered bond framework initiated.
- Key vulnerabilities and uncertainties:
  - Reliance on non-resident funds could deteriorate if originating countries weaken.
  - Households vulnerable to interest rate increases due to adjustable-rate mortgages.
  - House prices expected to decline by some 15–20 percent on average, larger in vacation home market.
  - Medium-term growth may settle at about 3 percent per year absent competitiveness improvements.
- Fiscal context affecting financial stability:
  - Government intends to keep budget deficit below 3 percent of GDP in 2009–10 and balance the budget over the medium term (Stability Program).
  - Fiscal stimulus measures amounting to 1½ percent of GDP announced in late 2008 for 2009–10.
  - Staff estimate general government deficit likely to reach some 4 percent of GDP in 2009 under current policies.

### Staff fiscal policy recommendations (selected)
- Tighten the budget deficit by an estimated ½−¾ percent of GDP a year on average compared to the baseline, with an upfront correction in 2009–10.
- Prioritize reduction of the wage bill (about one third of total spending) via hiring and wage controls, more efficient civil service use, and public administration reform.
- Favor spending-based consolidation; resist discretionary tax cuts and avoid higher tax rates that could hurt competitiveness and foreign capital inflows.
- Reverse temporary stimulus measures when the economy recovers.
- Introduce a medium-term budget framework; improve public sector asset-liability and cash management; transparently account for contingent liabilities.
- Design public sector aid and guarantee schemes to protect competition and minimize moral hazard and adverse selection (offer partial guarantees; limit guarantees to new lending and verifiable sectors).

### Pension and social policy guidance
- Pension reform increases contribution rates, tightens eligibility, and aims to establish an independent asset manager.
- Real reserves accumulating in the Social Investment Fund with periodic viability reviews.
- Staff view: further reforms likely needed over time, including raising retirement age, indexing benefits to prices, and aligning public and private pension benefits.
- Recommend targeting social support to the truly needy and reconsider untargeted schemes.

---

### Stress testing, systemic risk assessment, and supervisory recommendations
- Stress test results and scenarios:
  - Pre-shock CAR about 10½ percent.
  - Under extreme assumptions, losses at the four largest banks could increase by about €3½ billion (20 percent of GDP).
  - CAR could fall to some 4½ percent; capital injections of some 10½ percent of GDP would be needed to satisfy minimum CAR of 8 percent.
- Scenario assumptions used:
  1. NPLs up by 100 percent, LGD at 80 percent;
  2. All interest rates down by 200 bps;
  3. Exchange rate appreciation by 30 percent;
  4. Real estate prices decline by 30 percent;
  5. Equity prices decline by 50 percent.
- Risk exposures and contagion:
  - Contagion from Greek parent banks possible but considered unlikely.
  - March 2009 exposures: Greece 32½ percent; Eastern Europe 4 percent (of total consolidated banking system exposure).
  - December 2008 holdings: placements and bonds issued by other Euro area banks and non-Euro area banks amounted to 8¼ and 10¾ percent of total consolidated assets respectively.
  - Bank equity investments: ¼ percent of total assets at end-April 2009.
  - Banks’ total net foreign currency open position: about 1.2 percent of total capital at end-April 2009 (foreign currency open positions limited to 6 percent of capital).
- Supervisory, regulatory, and macroprudential recommendations:
  - Maintain vigilant supervision and enhanced cross-border cooperation; participate in supervisory colleges for largest EU banks by end-2009.
  - CBC should maintain prudential liquidity requirements and implement CEBS guidance on liquidity management; monitor funding, cross-border exposures, and counterparty risk.
  - Consider requiring banks to hold more capital, potentially suspending dividend payouts.
  - Review loan-to-value ratios on second homes; shorten foreclosure procedures.
  - Avoid moral hazard for institutions “too big to fail.”
  - Expand stress testing to include cooperatives and wider risks; improve statistics on real estate and household leverage (CYSTAT); bolster supervisory resources and financial stability assessment capacities.
  - Over the medium term consider a single supervisor for all credit institutions, integrated into the CBC.

### Key financial-sector quantitative indicators (preserved)
- Four largest banks potential losses under extreme stress: about €3½ billion (20 percent of GDP).
- Pre-shock CAR: about 10½ percent.
- Post-shock CAR: some 4½ percent.
- Capital injections needed to restore 8 percent CAR: some 10½ percent of GDP.
- Banks’ assets: some 690 percent of GDP.
- Bank equity investments: ¼ percent of total assets at end-April 2009.
- Banks’ total net foreign currency open position: about 1.2 percent of total capital at end-April 2009.
- March 2009 exposures: Greece 32½ percent; Eastern Europe 4 percent.
- December 2008 holdings: placements and bonds issued by other Euro area banks and non-Euro area banks amounted to 8¼ and 10¾ percent of total consolidated assets respectively.
- Budget deficit adjustment needed: estimated ½−¾ percent of GDP a year to reach budget balance over the medium term.

---

### Competitiveness, productivity, and COLA
- Assessment:
  - Cyprus attractive to foreign investors but ranking on global competitiveness indicators is low, reflecting high wage growth relative to productivity.
  - National Reform Programme implementation has been slow; red tape and bureaucracy must be tackled.
- Productivity and COLA:
  - Deterioration in productivity and unit labor costs must be reversed.
  - COLA has allowed wage increases to outstrip productivity, especially in the public sector; staff view is that COLA should ideally be eliminated.
  - If COLA preserved, its damaging effect must be minimized by keeping inflation under control through productivity-enhancing structural reforms and considering more effective targeting to better achieve social cohesion.

---

### Fiscal sustainability, projections, and adjustment scenarios
- Public debt sustainability (selected box values from bound tests and tables):
  - Baseline and scenario box values reported (examples): Baseline: -5.1; Scenario: -6.5; Historical: 0.9; Baseline: 2.7; Scenario: 1.8; Historical: 3.8; Baseline: 1.4; Scenario: 2.4; Historical: 2.2.
  - External debt box values: Baseline: 41.5; Scenario: 50.4; Historical: 29.2; Baseline: 2.7; Scenario: 4.2; Historical: 3.8; Baseline: -6.1; Scenario: -7.8; Historical: -3.5.
- Macroeconomic projections and key indicators (selected):
  - Potential output and projections include 4.2, 4.2, 4.2, 3.3, 3.2, 2.1, 2.4.
  - Output gap examples: 0.2, 0.0, 0.1, 1.1, 0.5, -0.3, -1.6.
  - GDP growth projections (selected): 4.4, 3.6, 0.3, 1.1, 2.7, 3.3, 3.3, 3.3.
  - Current account balance (percent of GDP, selected): -5.0, -5.9, -7.1, -11.8, -18.3, -10.3, -10.2.
  - Total external debt (percent of GDP) examples: 124.4, 116.2, 117.3, 118.2, 119.3, 120.4, 121.5, 122.7.
  - Net external debt examples: 39.0, 4.0, 4.0, 8.1, 10.8, 12.6, 13.5, 14.8.
  - Gross public debt (percent of GDP) projection path examples: 59.4, 49.4, 52.7, 55.6, 59.8, 63.7, 67.8, 72.2.
- General government accounts (selected projections):
  - Total revenue: 46.4, 44.9, 42.6, 42.6, 42.7, 42.8, 42.8, 42.8 (percent of GDP).
  - Total expenditure: 42.9, 44.0, 46.5, 48.5, 49.5, 50.1, 50.7, 51.2.
  - Overall balance: 3.4, 0.9, -3.9, -5.9, -6.8, -7.2, -7.8, -8.3.
  - Primary balance: 6.5, 3.8, -1.5, -3.6, -4.5, -5.1, -5.8, -6.4.
  - Medium-term public debt trajectory noted above.

---

### Financial sector measures taken by authorities (selected)
- Crisis management law being prepared (EC consultation) to empower government loans, guarantees, recapitalization in exchange for ownership stake, and asset purchases.
- Deposit Insurance:
  - Expanding coverage to €100,000 per depositor and per bank for deposits in all currencies; payout period to be reduced in line with EU regulations.
  - Since December 2008, capital of the Deposit Protection Fund being gradually raised to €100 million by 2012 with higher bank contributions; maximum required special/supplementary contributions and borrowing ceiling raised.
- Emergency Liquidity Assistance (ELA):
  - Guidance for ELA progressing; eligible collateral identified; applicable haircuts to be determined; policy framework ready for CBC Board submission.
  - Draft law for covered bonds initiated.
- Bank Supervision:
  - CBC implementing EU regulatory framework and Basel Committee core principles; increased frequency of liquidity reporting since October 2008.
  - CBC to implement CEBS guidance on liquidity buffers and survival periods; increased reporting of capital adequacy and large exposure limits; reduced limits on connected lending; increased monetary penalties.
- Cross-border Supervision:
  - CBC collaborating under MoUs and EU arrangements; supervisory colleges planned with CBC as home supervisor for Bank of Cyprus and Marfin Popular Bank.
- Bank Resolution:
  - CBC plans to adopt EC policy on early intervention measures to be issued at end-2009.

---

### Data adequacy, statistics, and IMF relations (selected)
- Data provision adequate for surveillance; transition to ESA 1995 complicated national accounts and fiscal analysis; new accounts do not provide household disposable income.
- Financial sector data: currency-linked and indexed bonds held by nonresidents classified as domestic; authorities now include non-resident deposits in gross external debt.
- Data gaps: property prices and household sector assets data do not exist.
- Cyprus planning to subscribe to IMF’s SDDS shortly.
- Membership: Joined 12/21/1961; Article VIII.
- Quota and holdings: Quota 139.60 (SDR million); Fund holdings of currency 122.17 (87.51 percent); reserve position in Fund 17.47 (12.52 percent).
- Article IV consultation cycle: recommended on a 12-month cycle.
- FSAP mission: September 23–October 6, 2008; FSAP Technical Notes published on June 1, 2009 (CR/09/167, 6/1/2009).

---

### Executive Board assessment and public information highlights
- Economy beginning to slow; projected growth fall to ⅓ percent in 2009 with tepid recovery from 2010 under current policies.
- Risks: highly leveraged private sector; banks and households exposed to property market; large current account deficits; COLA contributing to wages outstripping productivity.
- Directors endorsed balanced budget objective over the medium term and recommended fiscal adjustment of about ½−¾ percent of GDP a year with an upfront correction.
- Financial sector recommendations: enhance monitoring of funding, cross-border exposures and counterparty risk; require higher capital buffers for systemically-important banks; consider single supervisor for credit institutions; enhance stress testing and supervisory resources.
- Competitiveness recommendations: implement National Reform Program, cut red tape, streamline bureaucracy, consider eliminating COLA or mitigating its impact.

---

### Selected economic indicators (2005–09, selected entries)
- GDP growth (annual): 2005: 3.9; 2006: 4.1; 2007: 4.4; 2008: 3.6; 2009: 0.3 (2009 projection).
- Domestic demand contribution to growth: 2005: 3.2; 2006: 5.7; 2007: 7.7; 2008: 9.3; 2009: -2.7.
- HICP period average: 2005: 2.0; 2006: 2.2; 2007: 2.2; 2008: 4.4; 2009: 0.9.
- Unemployment rate: 2005: 5.3; 2006: 4.6; 2007: 3.9; 2008: 3.7; 2009: 5.6.
- General government overall balance (percent of GDP): 2005: -2.4; 2006: -1.2; 2007: 3.4; 2008: 0.9; 2009: -3.9.
- Gross public debt (percent of GDP): 2005: 69.1; 2006: 64.6; 2007: 59.4; 2008: 49.4; 2009: 52.7.
- Trade balance (percent of GDP): 2005: -25.4; 2006: -27.7; 2007: -30.3; 2008: -32.8; 2009: -26.6.
- Current account balance (percent of GDP): 2005: -5.9; 2006: -7.1; 2007: -11.8; 2008: -18.3; 2009: -10.3.
- Exchange rate regime: Euro Area Member; Present rate (July 13, 2009): US$ 1.44 per euro.

---

### Authorities’ stated policy intentions (selected)
- Authorities aim to keep the deficit-to-GDP ratio between 2.5 to 3.0 percent of GDP and will constrain the deficit-to-GDP ratio from exceeding the 3 percent level.
- Financial sector legislation and crisis preparedness:
  - Deposit insurance coverage quintupled to €100,000; 10% coinsurance clause removed; coverage for deposits in all currencies.
  - Draft crisis management law to allow decisive temporary government action in low probability liquidity/solvency cases.
  - Draft covered bond law to improve access to ECB liquidity facilities.
  - Implementation of FSAP recommendations ongoing, especially on transparency and corporate governance.
- Structural reforms:
  - Social Security Fund reform adopted in April secures social pension scheme until 2050 via increased contributions and stricter eligibility;
  - Healthcare reform progressing slower than envisaged; national life-long learning strategy implemented; major infrastructure investments under way.
- Authorities expect real growth between 0.4 and 1.0 percent in both 2009 and 2010 under their central scenario; Fund forecast: 0.3 percent in 2009 and 1.0 percent in 2010.
- Authorities expect unemployment to rise to between 5 and 5¾ percent in 2009 and 2010; medium-term average growth about 3 percent per year.
- Authorities intend to pursue anti-cyclical fiscal and financial sector policies, allowing full operation of automatic stabilizers and implementing discretionary measures estimated at 1.5 percent of GDP in 2009.

*Source: IMF staff report (content unit _cr09255).*

### Executive Summary

### Executive Summary

### Context and key vulnerabilities
- The global crisis has started to affect Cyprus following an overheating of the economy in 2007–08, which produced:
  - a highly leveraged private sector;
  - large current account deficits (headline 2008 current account deficit of 18½ percent of GDP, with an estimated one-third attributable to temporary and technical factors);
  - large exposure of banks to property prices.
- The financial sector is holding up, but its size and concentration could pose systemic risks.
- Growth in Q1 2009 remained positive and above the euro area average.
- Factors supporting resilience:
  - elimination of exchange rate risk following euro adoption (January 1, 2008);
  - conservative financial sector practices, limited exposure to toxic assets, and strict supervision;
  - continued investor confidence evidenced by a successful sovereign bond issue in June 2009 (a €1½ billion five-year bond—¾ of the government’s financing needs for 2009).
- Macroeconomic imbalances and sources of amplification:
  - growth during 2007–08 was largely credit-financed, with strong real wage growth and low unemployment;
  - rapid credit growth driven by excess liquidity as the Central Bank of Cyprus (CBC) lowered interest rates and reduced liquidity and prudential requirements (minimum liquidity requirement reduced from 75 to 70 percent for all foreign currency deposits);
  - credit channeled to the property market amid FDI inflows into property and anticipation of a 15 percent VAT on land starting in 2008;
  - households and corporations became highly leveraged; private sector external debt at 421 percent of GDP (including non-resident deposits), while net external debt was small at 4 percent of GDP as banks accumulated assets abroad;
  - loan-to-value ratios around 70–80 percent provide some buffer to banks against property price declines.
- Inflation and competitiveness:
  - sharp uptick in inflation in 2008 driven by demand-pull and cost-push factors (large positive output gap, high oil and food prices), wage increases indexed to past inflation, and temporary factors including a severe drought and euro adoption;
  - double-digit and growing current account deficits indicate overheating and competitiveness problems; CGER methodologies point to a significant competitive disadvantage and rising unit labor costs in the manufacturing sector;
  - Cyprus has been gaining market share in financial services but losing ground in manufacturing and tourism.
- Public finances:
  - fiscal consolidation prior to 2008 was largely revenue-based and partially dependent on temporary factors (asset revaluations and gains);
  - general government debt was a low 49½ percent of GDP but the 2008 budget surplus declined sharply to 0.9 percent of GDP as consolidation started unwinding and untargeted social spending increased;
  - pension reform was enacted but places adjustment largely on contribution increases and does not fully address ageing-related increases in pension expenditures.

### Staff views (findings and recommended policies)
- Financial sector:
  - Early detection and intervention are key to preventing problems from escalating to systemic proportions.
  - Supervisory capacity should be bolstered to preempt and manage crises.
- Fiscal policy:
  - A ½−¾ percent a year public consumption-based fiscal adjustment would be necessary to meet the government’s objective of medium-term budget balance and to avoid an unsustainable public debt-deficit cycle.
  - Recommended measures: wage bill control, public administration reform, and targeted social support.
  - The recent pension reform is commendable but may need to be bolstered in the future.
- Structural reforms and competitiveness:
  - The government’s structural reform program should be implemented speedily to shore up competitiveness.
  - The inflation-indexed wage adjustment mechanism (COLA) should ideally be eliminated or at least better targeted.

### Authorities’ views and policy stance
- The government expects to meet its fiscal objectives without altering current plans.
- Recommendations to improve financial sector stability were well received by the authorities.
- Reforming the COLA is unlikely to be on the policy agenda.

### Mission, interlocutors, and outreach
- Mission team: A. Banerji (head), P. Sodsriwiboon (both EUR), and Y. Lu (MCM), joined by K. Driessen (MCM); Mr. Galac (OED) also attended.
- Interlocutors: Minister of Finance Stavrakis, Governor Orphanides, senior public sector and parliamentary officials, private banks and businesses, labor unions, and academia.
- Outreach: A press conference was held and the concluding statement published.

### Selected quantitative highlights and indicators (as reported)
- 2008 headline current account deficit: 18½ percent of GDP (about one-third due to temporary/technical factors).
- Public debt: 49½ percent of GDP.
- Loan-to-value ratios on property lending: 70–80 percent.
- Private sector external debt (including non-resident deposits): 421 percent of GDP.
- Net external debt: 4 percent of GDP.
- CBC minimum liquidity requirement reduced from 75 to 70 percent for all foreign currency deposits.
- Euro adoption date: January 1, 2008.
- Successful sovereign bond issuance in June 2009: €1½ billion five-year bond (¾ of government’s financing needs for 2009).
- Recommended fiscal adjustment: ½−¾ percent a year in public consumption-based consolidation.
- 2008 general government budget surplus: 0.9 percent of GDP.

*Source: _cr09255 - Executive Summary*

### 6.      The financial sector is withstanding the global crisis; public recapitalization has

### 6.      The financial sector is withstanding the global crisis; public recapitalization has not been necessary

### Banking sector resilience and immediate status
- Resident and non-resident deposits have held steady thanks to confidence in the banking system, the planned expansion of deposit insurance, and the relative strength of the banking sector compared to that of the region.
- Banks reportedly do not face liquidity problems.
- Public recapitalization has not been necessary.

### Size, concentration, and cross-border exposure (risks)
- Domestic assets of some 690 percent of GDP: the financial sector is large relative to the economy.
- The sector is concentrated, dominated by three domestic banking groups: the Bank of Cyprus, Marfin Popular Bank, and Hellenic Bank (spanning banking, insurance, investment banking, and asset management subsidiaries).
- Problems can quickly escalate to systemic proportions because of size and concentration.
- The big three have diversified geographically by tapping emerging European economies.
- Foreign presence is growing and significant, with Greece’s Alpha Bank the predominant foreign player.
- Banks have been competing aggressively with local cooperative banks—the second largest presence in the domestic financial sector—for market share, resulting in lower margins.
- Overseas operations are under close scrutiny and have been frozen in some cases as banks wait for the situation to improve.

### Bank responses to the crisis and asset quality
- Banks are restructuring balance sheets by:
  - increasing interest rate spreads to preserve profitability;
  - strengthening capital by issuing subordinated or convertible loan capital;
  - securing funding; and
  - enhancing risk management.
- Lending has decelerated as underwriting standards have been tightened to protect asset quality.
- Deposit rates have started to decline as liquidity concerns have subsided.
- Bank profitability has declined due to:
  - low interest margins induced by intense competition;
  - mark-to-market losses on assets; and
  - larger provision write-offs.
- Nonperforming loans (NPLs), while low, have risen in all sectors.
- Capital buffers have declined.

### Regulatory and supervisory actions taken
- Significant progress implementing EU Directives and recommendations from the September–October 2008 FSAP (Financial Sector Assessment Program).
- Specific measures under way:
  - deposit insurance coverage and funding is being increased;
  - a crisis management law is being drafted to empower the government to preemptively address liquidity or insolvency problems affecting financial institutions;
  - a legal and regulatory framework for covered bonds has been initiated to increase available collateral for banks and to reap benefits of the ECB’s refinancing facilities.

### Key vulnerabilities and uncertainties
- The financial sector is partly reliant on non-resident funds; these inflows, while steady so far, could deteriorate or strengthen depending on growth in originating countries and the condition of their banking sectors.
- Households are vulnerable to interest rate increases given the large share of adjustable-rate mortgages.
- House prices are expected to decline by some 15–20 percent on average, with larger declines in the vacation home market; prices are expected to adjust gradually due to a lengthy foreclosure process and structural rigidities delaying property-related transactions.
- Medium-term recovery will likely be tepid, with growth settling at about a moderate 3 percent per year absent significant improvements in competitiveness.
- Growth risks include a potential deterioration in non-resident deposit inflows and further weakening of bank soundness as the downturn progresses.

### Growth outlook highlights (selected staff vs. authorities views)
- All agreed that growth is headed for a sharp decline in 2009–10.
- Staff’s central estimates: ⅓ percent growth in 2009 (staff more pessimistic).
- Government’s forecast: 1 percent growth in 2009 (more optimistic than staff).
- Recovery assumptions: staff assume precautionary savings by highly leveraged households and corporations and moderation of credit as banks restructure balance sheets.
- With rising savings and delayed investments, the current account deficit is expected to improve sharply, helped also by lower commodity prices.

### Fiscal context affecting financial stability
- The government intends to keep the budget deficit below 3 percent of GDP in 2009–10 and balance the budget over the medium term (Stability Program).
- Fiscal stimulus measures amounting to 1½ percent of GDP were announced in late 2008 and will be implemented in 2009–10 (temporary tax relief measures for tourism and housing loan subsidies to support construction).
- Staff estimate the general government deficit is likely to reach some 4 percent of GDP in 2009, reversing surpluses of 2007–08, and expand thereafter under current policies.

### Fiscal policy recommendations (staff)
- Tighten the budget deficit by an estimated ½−¾ percent of GDP a year on average compared to the baseline, with a significant upfront course correction in 2009–10.
- Prioritize reduction of the wage bill (about one third of total spending) through:
  - hiring and wage controls;
  - a more efficient use of civil servants within broader public administration reform;
  - potential extension of flexicurity concepts to the public sector.
- Favor a spending-based consolidation as more durable.
- Resist discretionary tax cuts; avoid higher tax rates that could hurt competitiveness and foreign capital inflows.
- Ensure temporary stimulus measures are reversed when the economy recovers.
- Introduce a medium-term budget framework in line with 2006–07 IMF technical assistance.
- Improve public sector asset-liability and cash management and transparently account for contingent liabilities.
- Design public sector aid programs and loan guarantee schemes to:
  - protect competition and minimize moral hazard (offer partial guarantees);
  - limit adverse selection (limit guarantees to new lending and to sectors where creditor quality is easily verifiable).

### Pension and social policy
- Passage of long-delayed pension reforms increases contribution rates, tightens eligibility criteria, and aims to establish an independent body to manage assets.
- Real reserves are being accumulated in the Social Investment Fund with periodic reviews of viability.
- Staff view: additional reforms will likely be needed over time to curb ageing-related spending, including:
  - raising the retirement age in line with other euro area countries;
  - indexing benefits to prices to reduce spending pressures;
  - better aligning public and private pension benefits (including by reducing lump sum payments to the former).
- Staff recommend targeting social support measures to reach the truly needy and reconsider untargeted schemes introduced in the past.

*Source: _cr09255 - 6.      The financial sector is withstanding the global crisis; public recapitalization has not been necessary*

### 22.      Given the systemic importance of the large banking sector, there was agreement

### _cr09255 - 22.      Given the systemic importance of the large banking sector, there was agreement

### Financial stability: overarching assessment
- The large banking sector is systemically important; policies must focus on early detection of risks and nipping problems in the bud.
- The financial sector’s resilience would:
  - serve as a bulwark against a greater deterioration of growth;
  - via reputational effects, enhance the growth potential of Cyprus;
  - prevent outflows in non-resident deposits that could undermine external sustainability.
- Early detection of risks and timely intervention are key to preserving financial sector stability.

### Stress test results and scenarios
- Pre-shock total capital adequacy ratio (CAR), including Tier 1 and Tier 2 capital, remains above the regulatory minimum.
- Stress tests based on end-2008 balance sheets indicate large exposures to real estate and credit risk.
- Under extreme assumptions:
  - Losses at the four largest banks could increase by about €3½ billion (20 percent of GDP).
  - CAR could fall from about 10½ percent to some 4½ percent.
  - Capital injections of some 10½ percent of GDP would be needed to satisfy the minimum CAR of 8 percent.
- Scenario assumptions used in stress tests:
  1. NPLs up by 100 percent, LGD at 80 percent;
  2. All interest rates down by 200 bps;
  3. Exchange rate appreciation by 30 percent;
  4. Real estate prices decline by 30 percent;
  5. Equity prices decline by 50 percent.

### Risk exposures, contagion, and liquidity
- Cross-border and counterparty risks:
  - Contagion from Greek parent banks is possible but considered unlikely due to home country policies targeting financial groups as a whole.
  - Cypriot banks’ operations in Greece and Eastern Europe expose asset quality to slowdowns abroad.
  - In March 2009, Cypriot banks’ total loan exposures relating to operations in Greece and Eastern Europe amounted to 32½ and 4 percent of total consolidated banking system exposure respectively.
  - As net lenders in the European money market, Cypriot banks had sizeable exposures to European financial institutions through bond investments, exposing them to counterparty risk; these exposures eased somewhat after government and central bank interventions.
  - In December 2008, banks held 8¼ and 10¾ percent of total consolidated assets in the form of placements and bonds issued by other Euro area banks and non-Euro area banks respectively.
- Market and balance-sheet risk indicators:
  - Bank equity investments stood at ¼ percent of total assets at end-April 2009.
  - Banks’ total net foreign currency open position amounted to about 1.2 percent of total capital at end-April 2009.
  - Foreign currency open positions are required to be limited to 6 percent of capital.
  - Liquidity buffers are reasonably high due to conservative liquidity requirements; specific liquidity requirement minima and maxima are specified by the Central Bank of Cyprus.

### Supervisory, regulatory, and macroprudential recommendations
- Maintain vigilant supervision and enhanced cross-border cooperation, including participation in supervisory colleges for the largest EU banks by end-2009.
- The Central Bank of Cyprus (CBC) should:
  - maintain prudential regulation on liquidity requirements and implement the CEBS’s guidance on liquidity management;
  - closely monitor banks’ funding, cross-border exposures, and counterparty risk management;
  - consider requiring banks to hold more capital—thereby potentially forcing suspension of dividend payouts and bolstering capital—given expected deterioration in asset quality and liquidity risk;
  - review loan-to-value ratios on second homes in line with property price developments;
  - shorten foreclosure procedures to allow more rapid property price correction and bank balance sheet adjustment.
- Supervisor should consider measures to avoid moral hazard associated with institutions that are “too big to fail.”
- FSAP-related recommendations:
  - Expand the stress testing framework to include wider coverage of institutions (including cooperatives) and risks.
  - Improve monitoring and cross-checking of stress-test results.
  - Improve statistics on real estate and household leverage produced by the Statistical Services of Cyprus (CYSTAT).
  - Bolster supervisory resources and financial stability assessment capacities.
  - Over the medium term, consider a single supervisor for all credit institutions operating in Cyprus—a more integrated supervisory structure based in the CBC would be preferable to the current sectoral approach.

### Structural reforms, competitiveness, and labor market
- Improving competitiveness is key to recovery and enhancing growth potential.
- Cyprus has advantages: relatively low-tax regime, proximity to middle-eastern markets, regulatory reliability underwritten by the EU, and increasing EU integration.
- Competitiveness challenges noted:
  - Small economy size and high labor costs relative to Eastern Europe;
  - Competitiveness problems in manufacturing and tourism;
  - Wage growth that has outstripped productivity increases;
  - Need to replace jobs lost in construction.
- National Reform Programme implementation has been slow; key reforms such as health care reform likely to be delayed due to stakeholder consensus issues and technical problems.
- Staff recommendations on wages and COLA:
  - The backward-looking automatic indexation mechanism (COLA) has allowed wage increases to outstrip productivity, especially in the public sector.
  - Staff view: COLA should ideally be eliminated; if preserved, its damaging effect must be minimized by keeping inflation under control through productivity-enhancing structural reforms, including public administration reform.
  - COLA currently disproportionately benefits the richest 60 percent of employees mainly in the public sector and banks; alternative targeting options to better achieve social cohesion were suggested.
  - Noted willingness of labor unions, government, and businesses to follow through with wage cuts determined by COLA in the second half of 2009.

### Staff appraisal: macro-fiscal outlook and policy priorities
- The global crisis has started to affect Cyprus; vulnerabilities from 2007–08 overheating must be managed as the economy slows.
- Key concerns:
  - Private sector is highly leveraged; banks and households have large exposures to property market corrections.
  - Balance sheets will need to adjust to new economic realities.
  - The evaporation of growth is likely to worsen credit risk with potential systemic implications given the size and concentration of the banking sector.
  - Fiscal policies are on an unsustainable path due to significant and permanent increases in spending while revenues are declining.
  - The large current account deficit—partly financed by non-resident deposit inflows—may not be sustainable.
- Fiscal policy guidance:
  - Government’s fiscal objectives are appropriate but require stronger policies to achieve them.
  - A fiscal stimulus is less likely to be effective given high import elasticities and could reduce investor confidence in fiscal sustainability.
  - A conservative fiscal stance would support confidence in the public sector’s ability to cope with financial sector distress.
  - Without significant course correction in 2009–10, current policies could imply the beginning of an expansionary debt-deficit cycle.
  - The budget deficit would need to decline by an estimated ½−¾ percent of GDP a year to achieve the government’s own objective of budget balance over the medium term.
  - Fiscal adjustment should rely on reducing public consumption—especially the wage bill which accounts for a third of total spending—through hiring and wage controls and broader public administration reform.
  - Social support measures should be targeted to the truly needy; temporary stimulus measures should expire when recovery sets in.
  - Implement a medium-term budget framework to contain spending below nominal GDP growth and control public sector employment.
  - Further pension reforms may be needed over time: increasing the retirement age, indexing benefits to prices, and better aligning public and private pension benefits.
  - Improve management and transparent accounting of public sector contingent liabilities to prevent rapid deterioration of overall exposures.
  - Design public sector aid programs to protect competition and minimize moral hazard and adverse selection.

### Key quantitative indicators and facts preserved from the source
- Four largest banks potential losses under extreme stress: about €3½ billion (20 percent of GDP).
- Pre-shock CAR: about 10½ percent.
- Post-shock CAR: some 4½ percent.
- Capital injections needed to restore 8 percent CAR: some 10½ percent of GDP.
- Banks’ assets: some 690 percent of GDP.
- Bank equity investments: ¼ percent of total assets at end-April 2009.
- Banks’ total net foreign currency open position: about 1.2 percent of total capital at end-April 2009.
- March 2009 exposures: Greece 32½ percent; Eastern Europe 4 percent (of total consolidated banking system exposure).
- December 2008 holdings: placements and bonds issued by other Euro area banks and non-Euro area banks amounted to 8¼ and 10¾ percent of total consolidated assets respectively.
- Budget deficit adjustment needed: estimated ½−¾ percent of GDP a year to reach budget balance over the medium term.

*Source: IMF staff report (content unit _cr09255).*

### 38.      Improved competitiveness will assist recovery and enhance the growth potential.

### 38.      Improved competitiveness will assist recovery and enhance the growth potential.

### Assessment of competitiveness and underlying factors
- Cyprus remains attractive to foreign investors due to strategic, historical, institutional and economic advantages.
- Cyprus's ranking on global competitiveness indicators is low, reflecting in particular high wage growth compared to productivity increases.
- The National Reform Programme should be implemented.
- Red tape and bureaucracy must be tackled as a matter of priority.

### Productivity, unit labor costs, and COLA
- The deterioration in productivity and unit labor costs must be reversed.
- Ideally the COLA should be eliminated as it has resulted in wage increases larger than productivity, especially in the public sector, thereby hampering competitiveness.
- Alternatively, the damaging effect of COLA should be minimized by keeping inflation under control through productivity-enhancing structural reforms.
- Amendments to the framework—for instance by more effectively targeting COLA—should be considered to better achieve social cohesion.

*Source: _cr09255 - 38.      Improved competitiveness will assist recovery and enhance the growth potential.*

### 40.      It is recommended that the next Article IV consultation take place on a 12-month

### It is recommended that the next Article IV consultation take place on a 12-month cycle.

### Recommendation
- It is recommended that the next Article IV consultation take place on a 12-month cycle.

### Public debt sustainability — bound tests (Figure 8)
- Variables and scenarios shown (percent of GDP): baseline, historical, individual shocks (permanent one-half standard deviation) and combined shocks.
- Notes and scenario assumptions:
  - Shaded areas represent actual data.
  - Figures in boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.
  - Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.
  - One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
- Selected baseline and scenario box values shown in the figure captions/text:
  - Baseline: -5.1 (presumably primary balance or similar; exact variable not restated in text).
  - Scenario: -6.5
  - Historical: 0.9
  - Baseline: 2.7
  - Scenario: 1.8
  - Historical: 3.8
  - Baseline: 1.4
  - Scenario: 2.4
  - Historical: 2.2

### External debt sustainability — bound tests (Figure 9)
- Analysis uses net external debt (gross external debt excluding gross external assets in debt instruments). Net external debt declined sharply in 2008 as banks accumulated assets abroad.
- Shocks and scenario assumptions:
  - Individual shocks are permanent one-half standard deviation shocks.
  - Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
  - One-time real depreciation of 30 percent occurs in 2009.
- Selected box values reported:
  - Baseline: 41.5
  - Scenario: 50.4
  - Historical: 29.2
  - Baseline: 2.7
  - Scenario: 4.2
  - Historical: 3.8
  - Baseline: -6.1
  - Scenario: -7.8
  - Historical: -3.5

### Macroeconomic projections and key indicators (selected items from Tables 1 and 5)
- GDP and growth:
  - Potential output and projections: entries include 4.2, 4.2, 4.2, 3.3, 3.2, 2.1, 2.4 (various years as shown).
  - Output gap examples: 0.2, 0.0, 0.1, 1.1, 0.5, -0.3, -1.6.
  - Projections (2009–14, selected): Gross domestic product growth entries include 4.4, 3.6, 0.3, 1.1, 2.7, 3.3, 3.3, 3.3 (per Table 5 projection row).
- Labor market and inflation:
  - Employment growth examples: 3.0, 1.6, 2.7, 5.8, 1.3, 0.2, 0.4 (historical).
  - Unemployment rate examples: 4.7, 5.3, 4.6, 3.9, 3.7, 5.6, 5.9 (historical).
  - Inflation (CPI end of period): 3.9, 1.4, 1.5, 3.7, 1.8, 0.9, 1.4 (historical).
  - Inflation (HICP period average) examples: 1.9, 2.0, 2.2, 2.2, 4.4, 0.9, 1.5.
- External sector and current account (selected):
  - Current account balance (percent of GDP): historical and projection examples include -5.0, -5.9, -7.1, -11.8, -18.3, -10.3, -10.2.
  - Trade balance examples (percent of GDP): -25.7, -25.4, -27.7, -30.3, -32.8, -26.6, -26.8.
  - Exports of goods and non-factor services (selected): 5.1, 4.7, 3.9, 7.2, -2.2, -17.2, 0.5.
  - Imports of goods and non-factor services (selected): 9.6, 3.1, 6.6, 12.5, 7.6, -18.8, 2.6.
- Public finance (Table 7 highlights and projections):
  - Total revenue examples (percent of GDP): 38.7, 41.2, 42.2, 46.4, 44.9, 42.6, 42.6.
  - Total expenditure examples (percent of GDP): 42.8, 43.6, 43.4, 42.9, 44.0, 46.5, 48.5.
  - Overall balance examples (percent of GDP): -4.1, -2.4, -1.2, 3.4, 0.9, -3.9, -5.9.
  - Primary balance examples: -0.8, 1.1, 2.1, 6.5, 3.8, -1.5, -3.6.
  - Structural overall balance examples: -4.2, -2.4, -1.2, 2.9, 0.3, -3.8, -5.2.
  - Gross public debt 1/ (percent of GDP): 70.2, 69.1, 64.6, 59.4, 49.4, 52.7, 55.6.
  - Medium-term projection examples (public debt percent of GDP): 59.4, 49.4, 52.7, 55.6, 59.8, 63.7, 67.8, 72.2.
  - Memorandum: Nominal GDP (billions of euros) examples: 12.7, 13.5, 14.4, 15.6, 17.1, 17.6.
- Balance of payments (Table 6 highlights and projections 2007–14):
  - Capital and financial account examples: 13.0, 18.4, 10.1, 10.1, 9.9, 9.8, 9.7, 9.8.
  - Foreign direct investment, net examples: 2.5, 3.7, 5.3, 4.6, 2.0, 2.4, 2.4.
  - Total external debt (percent of GDP) examples: 124.4, 116.2, 117.3, 118.2, 119.3, 120.4, 121.5, 122.7.
  - Net external debt examples: 39.0, 4.0, 4.0, 8.1, 10.8, 12.6, 13.5, 14.8.
  - Gross official reserves (billions of U.S. dollars, end-of-period) examples: 6.1, 1.1, 1.1, 1.0, 1.0, 1.0, 1.0.

### Financial sector: measures taken by the authorities (Table 3)
- Crisis Management:
  - A crisis management law is being prepared with EC consultation to empower government action: government loans, government guarantees of loans and issuance of government bonds to credit institutions; recapitalization of financial institutions in exchange for ownership stake; purchase of a financial institution’s assets.
- Deposit Insurance:
  - Expanding deposit guarantee scheme to increase statutory deposit protection coverage per depositor and per bank to €100,000 for deposits in all currencies.
  - Payout period to be reduced in line with EU regulations.
  - Since December 2008, capital of the Deposit Protection Fund is being gradually raised to €100 million by 2012 with higher contributions from banks.
  - Maximum amount of required special and/or supplementary contributions and the ceiling on borrowing by the Fund have been raised.
- Emergency Liquidity Assistance (ELA):
  - Progress in establishing guidance for ELA. The CBC has identified eligible collateral for ELA in bank balance sheets. Applicable haircuts will be determined through a last minute evaluation of collateral.
  - Policy framework for provision of ELA by the CBC is ready to be submitted to CBC Board for approval; operational framework is under preparation.
  - Process for establishing legal and regulatory framework for covered bonds has been initiated; draft law is being prepared.
- Bank Supervision:
  - CBC implementing EU regulatory framework and Basel Committee core principles.
  - Since October 2008, frequency of liquidity returns reporting increased.
  - CBC plans to implement CEBS guidance on liquidity buffer and survival period.
  - CBC increased frequency of reporting capital adequacy and large exposure limits, reduced limits on connected lending, and increased monetary penalties.
  - CBC participated in CEBS activities; emphasis on timely adoption of EU Directives and recommendations of CEBS and Basel Committee.
- Cross-border Supervision:
  - CBC collaborating with other supervisors under Memoranda of Understanding and EU-wide arrangements; frequent exchange of information and consultation with Greek supervisors, including joint onsite examinations.
  - Establishment of supervisory colleges planned: CBC as home supervisor will establish colleges for Bank of Cyprus and Marfin Popular Bank; as host supervisor will collaborate with home supervisors.
  - CBC plans to implement CEBS's Liquidity Identify Card to enable meaningful exchanges of information within colleges of supervisors.
- Bank Resolution:
  - CBC plans to adopt the EC's policy on early intervention measures to be issued at end-2009.
- Source of Table 3: National Authorities.

### Financial soundness indicators for banks and cooperatives (Tables 4 and 4 contd.)
- Banking sector (selected indicators, percent unless otherwise noted):
  - Regulatory capital to risk-weighted assets: examples include 12.4, 12.4, 12.8, 11.0 (years shown).
  - Regulatory Tier I capital to risk-weighted assets: examples include 10.0, 10.8, 10.4, 8.6.
  - Nonperforming loans net of provisions to capital: examples 34.8, 20.4, 9.0, 16.2, 7.6 (various years).
  - Nonperforming loans to total gross loans: examples 7.1, 5.4, 3.4, 3.6, 3.2.
  - Sectoral distribution of loans to total loans — residents: 47.9, 42.2, 39.3, 39.5, 54.0.
  - Loans to non-financial corporations: 19.4, 17.4, 17.6, 21.4, 30.2.
  - Loans to households examples: 12.4, 16.4.
  - Nonresidents share of loans examples: 52.1, 57.4, 60.7, 60.5, 46.0.
  - Return on assets examples: 0.8, 1.4, 2.3, 1.0, 1.6.
  - Return on equity examples: 14.1, 25.5, 37.3, 14.5, 18.8.
  - Interest margin to gross income examples: 66.2, 66.1, 55.9, 67.9, 59.0.
  - Liquid assets to total assets (core measure) examples: 29.5, 31.1, 29.5, 27.6, 30.3.
- Credit cooperatives (selected indicators, percent unless otherwise noted):
  - Regulatory capital to risk-weighted assets examples: 12.1, 13.8.
  - Nonperforming loans to total gross loans examples: 8.3, 1.9 (2008 note: nonperforming loan data available only from 2008).
  - Residents share of loans examples: 99.9, 99.9.
  - Loans to households examples: 67.4, 63.6, 63.8, 70.5.
  - Return on assets examples: 0.6, 0.7, 0.7, 0.4.
  - Customer deposits to total (non-interbank) loans examples: 129.2, 133.9, 131.4, 116.9.
- Source: Central Bank of Cyprus; Authority for the Supervision and Development of Cooperative Societies.

### Banking sector structure (Table 2, selected)
- Number of credit institutions: entries per year include 40, 13, 9, 3, 3, 2 (various year columns).
- Commercial banks examples: 14, 14, 4, 4, 4, 2, 3.
- Foreign-owned subsidiaries examples: 44, 9, 10, 9.
- Cooperative credit institutions examples: 35, 8, 3, 4, 29, 31, 70, 119 (table shows series across years).
- Total assets (billions of euros, credit institutions): 48.0, 61.9, 74.7, 91.1, 116.0.
- Commercial banks total assets examples: 30.7, 38.4, 45.7, 79.7, 104.2.
- Concentration (number of institutions with 75 percent of total assets): commercial banks 4, 3, 8, 9, 8.
- Number of bank branches examples: 47,045, 146, 84, 74, 49, 96 (table formatting reflects series across years).
- International Banking Units total assets example entries: 9.2, 14.4 (as reported).
- Sources: Central Bank of Cyprus; CySEC; Insurance Companies' Control Service.

### General government accounts and adjustment scenarios (Table 7 highlights)
- Baseline and adjustment scenario outputs presented for 2007–14.
- Projections (selected):
  - Total revenue: 46.4, 44.9, 42.6, 42.6, 42.7, 42.8, 42.8, 42.8 (percent of GDP across years).
  - Total expenditure: 42.9, 44.0, 46.5, 48.5, 49.5, 50.1, 50.7, 51.2.
  - Overall balance (projections): 3.4, 0.9, -3.9, -5.9, -6.8, -7.2, -7.8, -8.3.
  - Primary balance (projections): 6.5, 3.8, -1.5, -3.6, -4.5, -5.1, -5.8, -6.4.
  - Structural overall balance (projections): 2.9, 0.3, -3.8, -5.2, -6.0, -6.6, -7.3, -8.0.
  - Gross public debt (percent of GDP) projection path: 59.4, 49.4, 52.7, 55.6, 59.8, 63.7, 67.8, 72.2.
- Memorandum item: Nominal GDP (billions of euros) projections: 15.6, 16.9, 17.1, 17.6, 18.5, 19.6, 20.7, 22.0.
- Note: Excludes intragovernmental debt and short-term liabilities of the Central Bank.

### IMF Fund relations and administrative details (Annex I)
- Membership status: Joined 12/21/1961; Article VIII.
- Quota and holdings:
  - Quota: 139.60 (SDR Million) — 100.00 percent quota.
  - Fund holdings of currency: 122.17 — 87.51 percent.
  - Reserve position in Fund: 17.47 — 12.52 percent.
- SDR Department:
  - Net cumulative allocation: 19.44 — 100.00 percent allocation.
  - Holdings: 1.74 — 8.96 percent.
- Outstanding purchases and loans: None.
- Financial arrangements: None.
- Projected obligations to Fund (SDR million; based on existing use of resources and present holdings of SDRs) — forthcoming:
  - 2009–2013 total charges/interest entries: 0.03, 0.07, 0.07, 0.07, 0.07; total row: 0.03, 0.07, 0.07, 0.07, 0.07.
- Exchange rate arrangement:
  - Cyprus adopted the euro on January 1, 2008.
  - The currency floats freely and independently against other currencies.
  - Cyprus has accepted the obligations of Article VIII, Sections 2, 3, and 4 and maintains an exchange system free of restrictions on the making of payments and transfers for current transactions.
- Article IV Consultation:
  - Cyprus is on a 12-month cycle.
  - Previous Article IV consultation mission: October 25–November, 2006; staff report (CR/07/76, 2/21/2007) discussed by the Executive Board on January 26, 2007.
- FSAP participation and ROSCs:
  - FSAP mission: September 23–October 6, 2008.
  - FSAP Technical Notes published on June 1, 2009 (CR/09/167, 6/1/2009).
- Technical assistance: multiple entries spanning 1989–2009 in MAE, FAD, STA departments (dates and purposes listed in Annex I).
- Resident representative: None.
- Safeguards Assessment: Not Applicable.
- HIPC Initiative and MDRI: Not Applicable.

### Response to previous Fund advice (implementation status table, selected)
- Macroeconomic policies:
  - Staff recommendation (2006): Ensure continued observance of Maastricht criteria and smooth adoption of euro.
  - Implementation: Euro adopted on January 1, 2008.
- Fiscal policy:
  - Staff recommendation (2006): For 2007 respect spending limits, save excess revenue; objective of budget balance by 2010 through checks on current expenditures; ban supplementary budgets; implement pension and health care reform.
  - Implementation: Spending limits respected in 2007 and excess revenues saved; no supplementary budgets. Current spending increased in 2008. Pension reform enacted but measures mostly revenue-based. Health care reform delayed.
- Financial sector policy:
  - Staff recommendation (2006): Monitor credit and house price developments; strengthen financial supervision by unifying supervision, improving resources and independence, completing FSAP.
  - Implementation: FSAP completed. Supervision improved in line with EU directives and FSAP recommendations. Stress-testing framework introduced and monitoring improved.
- Structural policies:
  - Staff recommendation (2006): Implement National Lisbon Program; redesign wage-setting by aligning real wage growth to productivity; improve competition.
  - Implementation: National Reform Programme is being implemented but slowly. Wage increases have continued to outstrip productivity especially in manufacturing and public sector.

*International Monetary Fund — Staff Report for the 2009 Article IV Consultation: Informational Annex (prepared July 21, 2009)*

### ANNEX II. C

### ANNEX II. C — CYPRUS: STATISTICAL INFORMATION

### Assessment of Data Adequacy for Surveillance
- General: Data provision is adequate for surveillance.
- National Accounts:
  - Transition to ESA 1995 has complicated analysis of national accounts and fiscal data.
  - New national accounts do not provide information on the disposable income of households, hindering calculation of the household saving ratio.
- Financial sector data:
  - Currency-linked and indexed bonds held by nonresidents are classified as domestic instead of foreign liabilities.
- External debt:
  - Authorities have recently decided to include non-resident deposits in resident banks in gross external debt.
- Other data gaps:
  - Data on property prices and household sector assets do not exist.

### Data Standards and Quality
- Cyprus is planning to subscribe to the IMF’s Special Data Dissemination Standard (SDDS) shortly.
- No data ROSC is available.

### Timeliness and Coverage (Table of Common Indicators Required for Surveillance — selected entries)
- Exchange Rates: Current (frequency D)
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: May 2009 (received Jun 2009) — M
- Reserve/Base Money: Dec 2007 (received Jan 2008) — M
- Broad Money: Dec 2007 (received Jan 2008) — M
- Central Bank Balance Sheet: Dec 2007 (received Jan 2008) — M
- Consolidated Balance Sheet of the Banking System: Dec 2007 (received Jan 2008) — M
- Interest Rates: May 2009 (received Jun 2009) — M
- Consumer Price Index: May 2009 (received Jun 2009) — M
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Q4 2008 (received Apr 2009) — Q
- GDP/GNP: Q1 2009 (received Jun 2009) — Q
- Gross External Debt: Q4 2008 (received Jun 2009) — Q
- International Investment Position: 2008 (received Jun 2009) — A

### Executive Board Assessment — Key Findings and Recommendations
- Macroeconomic context:
  - Cyprus weathered the global crisis relatively well; first quarter 2009 growth was positive and above the euro area.
  - Financial sector has not required public capital injections to date.
  - Resilience attributed to euro adoption (eliminating exchange rate risk), conservative banking practices, strict supervision, and domestic demand–based growth.
  - Economy beginning to slow; growth projected to fall sharply to ⅓ percent in 2009 as banks and the private sector restructure balance sheets.
  - On current policies, a tepid but uncertain recovery is expected to begin starting 2010.
- Risks:
  - Overheating in 2007–08 left private sector highly leveraged; banks and households exposed to the property market.
  - Expected slowdown increases credit risk; in some plausible but unlikely extreme scenarios, systemic implications could arise due to size and concentration of banking sector.
  - Large current account deficits indicate competitiveness problems, especially in manufacturing and tourism.
  - Backward-looking automatic indexation mechanism (COLA) has contributed to wages outstripping productivity increases.
  - External position vulnerable if foreign direct investment and non-resident deposit flows decline.
- Fiscal stance and public finances:
  - Largely revenue-based fiscal consolidation has started unwinding due to softening growth, lapse of temporary revenue factors, and increases in untargeted social spending starting 2008.
  - Recent pension reforms rely mainly on contribution increases and do not yet fully address ageing-related increases in pension expenditures.
  - Directors endorsed government objective to achieve a balanced budget over the medium term.
  - Fiscal adjustment needs to decline the budget deficit by about ½−¾ percent of GDP a year with a significant upfront correction to avoid unfavorable debt-deficit dynamics.
  - Recommended focus: reduce public consumption (particularly wage bill), broader public administration reforms, allow temporary stimulus measures to expire once recovery sets in, target social support to the needy.
  - Recommended adoption of a medium-term budget framework and more effective management of public sector liabilities; monitor contingent liabilities and minimize moral hazard and adverse selection in public sector aid programs.
- Financial sector policies and supervision:
  - Directors reassured that financial sector risks appear manageable but stressed potential for systemic problems given sector size and concentration.
  - CBC should enhance monitoring of banks’ funding, cross-border exposures, and counterparty risk management.
  - With potential asset quality deterioration, CBC should require higher capital buffers, particularly from systemically-important banks.
  - Recommend further improvements to supervision and safety net over the medium term:
    - Consider a single supervisor for all credit institutions and a more integrated supervisory structure in the CBC.
    - Enhance stress-testing framework and bolster supervisory and financial stability resources.
    - Implement FSAP recommendations.
- Competitiveness and structural reforms:
  - Improve competitiveness to assist recovery and external viability.
  - Reverse deterioration in productivity and unit labor costs by implementing the National Reform Program: cut red tape, streamline bureaucracy, implement other structural reforms.
  - Support eliminating automatic wage indexation mechanism (COLA) or mitigating its impact through productivity improvements and better targeting.

### Public Information Notice — Key Macro Developments and Projections
- Background and outlook:
  - Global crisis beginning to affect Cyprus; first quarter 2009 growth positive but economy slowing.
  - Projected growth fall to ⅓ percent in 2009; tepid recovery expected from 2010 under current policies.
- Vulnerabilities and policy response:
  - Banks’ soundness indicators being adversely affected by the economic environment.
  - Government and CBC actions: increased deposit insurance coverage and funding; crisis management law being drafted; legal and regulatory framework for covered bonds initiated.
- Authorities’ medium-term objective:
  - Aim to achieve balanced budget over medium term; use fiscal consolidation emphasizing expenditure control and structural reforms.

### Selected Economic Indicators, 2005–09 (annual percentage change or percent of GDP as indicated)
- Real economy:
  - Gross domestic product: 2005: 3.9; 2006: 4.1; 2007: 4.4; 2008: 3.6; 2009: 0.3 (2009 data are projections)
  - Domestic demand (contribution to annual growth): 2005: 3.2; 2006: 5.7; 2007: 7.7; 2008: 9.3; 2009: -2.7
  - Harmonized index of consumer prices (period average): 2005: 2.0; 2006: 2.2; 2007: 2.2; 2008: 4.4; 2009: 0.9
  - Unemployment rate (percent): 2005: 5.3; 2006: 4.6; 2007: 3.9; 2008: 3.7; 2009: 5.6
- Public finances (general government, percent of GDP):
  - Overall balance: 2005: -2.4; 2006: -1.2; 2007: 3.4; 2008: 0.9; 2009: -3.9
  - Primary balance: 2005: 1.1; 2006: 2.1; 2007: 6.5; 2008: 3.8; 2009: -1.5
  - Gross public debt 2/: 2005: 69.1; 2006: 64.6; 2007: 59.4; 2008: 49.4; 2009: 52.7
    - Note 2/: Excludes intragovernmental debt and short-term liabilities of the Central Bank.
- Interest rates (percent):
  - Deposit rates 3/: 2005: 3.7; 2006: 3.6; 2007: 4.4; 2008: 5.4; 2009: 3.3 (2009 data are as of May)
  - Lending rates 4/: 2005: 6.7; 2006: 6.8; 2007: 6.3; 2008: 7.0; 2009: 6.9 (2009 data are as of May)
- Balance of payments (percent of GDP):
  - Trade balance: 2005: -25.4; 2006: -27.7; 2007: -30.3; 2008: -32.8; 2009: -26.6
  - Current account balance: 2005: -5.9; 2006: -7.1; 2007: -11.8; 2008: -18.3; 2009: -10.3
- Fund Position (June 30, 2009):
  - Holdings of Currency (percent of quota): 87.5
  - Holdings of SDR's (percent of allocation): 9.0
  - Quota (millions of SDR): 139.6
- Exchange rates:
  - Exchange rate regime: Euro Area Member
  - Present rate (July 13, 2009): US$ 1.44 per euro
  - Nominal effective exchange rate (CPI, 2000=100) 5/: 2005: 100.0; 2006: 100.5; 2007: 101.2; 2008: 104.7; 2009: 106.2 (2009 data are as of April)
  - Real effective exchange rate (CPI, 2000=100) 5/: 2005: 100.0; 2006: 100.2; 2007: 100.2; 2008: 103.8; 2009: 104.9 (2009 data are as of April)

### Authorities’ Statement — Key Projections and Policy Intentions (Statement by Age Bakker and Tomislav Galac)
- Economic outlook and risks:
  - Authorities expect real growth between 0.4 and 1.0 percent in both 2009 and 2010 under their central scenario.
  - Fund forecast: growth of 0.3 percent in 2009 and 1.0 percent in 2010.
  - Authorities expect unemployment to rise to between 5 and 5¾ percent in 2009 and 2010.
  - In the medium term, authorities expect average growth of about 3 percent per year.
- Financial sector outlook:
  - Authorities expect an increase in non-performing assets in 2009 and 2010, more pronounced for enterprise lending in affected sectors.
  - Household lending expected to have minimal loan losses due to family-provided safety nets, secure employment, and overcollateralization.
  - Banks’ and credit cooperatives’ profits halved in Q1 2009 relative to Q1 2008.
  - Banks have recently raised fresh capital to prepare for anticipated rise in loan losses.
- Fiscal policy stance:
  - Given low public debt (below 50 percent of GDP at end-2008) and strong financial-sector initial conditions, authorities intend to pursue anti-cyclical fiscal and financial sector policies.
  - Full operation of automatic stabilizers will be allowed; discretionary measures will support tourism, vulnerable groups, and small-scale local infrastructure investment to support employment in construction.
  - Total budgetary impact of the 2009 fiscal stimulus is estimated at a cost of 1.5 percent of GDP.
  - Authorities expect the general government shortfall in 2009 and 2010 to be of the order of... [text ends in source; projected shortfall not fully specified in the supplied content].

*Source: ANNEX II. C — Cyprus: Statistical Information (As of July 14, 2009).*

### 2.5 to 3.0 percent of GDP, and will do everything possible to constrain the deficit-to-GDP

### _cr09255 - 2.5 to 3.0 percent of GDP, and will do everything possible to constrain the deficit-to-GDP

### Fiscal stance and macro policy
- The authorities aim to keep the deficit-to-GDP ratio between 2.5 to 3.0 percent of GDP, and will do everything possible to constrain the deficit-to-GDP ratio from exceeding the 3 percent level.
- The authorities will monitor possible lagged positive effects from the Euro area and UK stimuli, and from catching-up of domestic interest rates with the lower EMU level, and will adjust domestic policies accordingly.

### Financial sector legislation and crisis-preparedness
- Recent and proposed legislation to strengthen liquidity, confidence, and crisis management capacity in the financial sector:
  - New regulations for the two deposit insurance schemes:
    - Coverage quintupled to 100,000 euro.
    - Removed the 10% coinsurance clause.
    - Covered deposits in all currencies, for commercial banks and for credit cooperatives, in line with EU legislation.
  - Draft crisis management law:
    - Would allow the government to take decisive but temporary action in a low probability case of liquidity or solvency problems in individual locally incorporated credit and other financial institutions without prior Parliamentary approval.
  - Draft covered bond law and related legislative changes:
    - Intended to improve access of Cypriot banks to the ECB liquidity facilities.
- Implementation of FSAP recommendations:
  - Authorities are analyzing and implementing recommendations of the recent FSAP mission by the IMF.
  - A number of recommendations have already been implemented, especially those related to transparency and corporate governance in the financial sector.
  - Authorities intend to further improve the financial regulation framework immediately following the conclusion of ongoing EU-wide discussions on the regulation of credit rating agencies, alternative and collective investment schemes, and others.
- Strengthened cooperation among domestic supervisory agencies:
  - Since May, the Central Bank of Cyprus and the Authority for the Supervision and Development of Cooperative Societies have begun carrying out joint on-site supervision of cooperatives.
  - All supervisory agencies cooperated in designing the corporate governance code of conduct for financial intermediaries.

### Structural reforms and long-term policies
- Social Security Fund reform:
  - Reform package adopted by the Parliament in April.
  - Secures the financial sustainability of the social pension scheme until 2050.
  - Reform includes both increased contributions and stricter eligibility criteria for enjoyment of benefits.
  - Government and social partners acknowledge persistent long-run demographic pressures but consider recent reforms have settled the issue for a considerable period.
- Other structural efforts:
  - Authorities must give attention to healthcare reforms; decentralization of the public health system has been progressing slower than envisaged.
  - National life-long learning strategy is being implemented to meet demands of the dynamic labor market.
  - Major infrastructure investments being implemented to support growth and diversification, including a new airport and water desalination plants.

### Outlook and competitiveness
- Authorities are confident Cyprus will maintain its position as a competitive principal international financial center and a well-diversified service-oriented economy.
- Observed internationally recognized advantages cited as supporting competitiveness and diversification:
  - Low tax burden.
  - Strong legal and institutional base.
  - Skilled and multilingual labor.
  - Strategic location.
  - Proactive business-friendly government policies.
- Recent successes in health and education tourism are noted as first steps towards further diversification.

*Source: _cr09255 - 2.5 to 3.0 percent of GDP, and will do everything possible to constrain the deficit-to-GDP*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09255.pdf_