## _cr10291

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### Executive summary
- Economic conditions stabilized; economy projected to bottom out in 2010, with a mild recovery in 2011 followed by stronger growth.
- Global financial risks remain elevated; muted growth prospects in trading partners weigh on the outlook.
- Government steps taken to stabilize the fiscal deficit, but further measures needed to reach official deficit target for 2012 of 3 percent of GDP.
- Staff projects slightly negative growth for 2010 to turn only moderately positive in 2011.
- Current account deficit moderated but remained high, at above 8 percent of GDP.

### Key macroeconomic developments and vulnerabilities
- After average growth of 4¼ percent over 2004-08, the economy contracted by 1.7 percent in 2009.
- Private consumption growth evaporated amid leveraged balance sheets, rising unemployment, and slowing household credit growth.
- Fixed investment contracted sharply; inventory cycle pronounced.
- Inflation moderated to ¼ percent in 2009 from 4½ percent in 2008.
- Wage growth slowed to 4.1 percent from 5.8 in 2008.
- Unemployment rate rose by 1.7 percentages point to 5.3 percent.
- Output gap estimated to have turned negative in Q2 2009; a positive inflation differential with the euro area reopened since early 2010 owing to price developments in the non tradable sectors.
- Real wage growth remained above euro area levels in 2009 due in part to backward-looking inflation-indexed wage adjustment mechanism (COLA).

### Pre-crisis imbalances and balance-sheet indicators
- Prior rapid credit growth raised private sector indebtedness.
- Households hold debt of about 130 percent of GDP at end-2009.
- Corporate debt among the highest in Western Europe; increased during boom years, with reversal initiated in recession.
- Nonperforming loans began to rise in 2009, including in real estate sector.
- Private saving rates rose from 2008 lows.

### Fiscal developments (2004–09) and 2009 fiscal shock
- Cyprus moved from an overall deficit of 6.3 percent of GDP in 2003 to surpluses of 3.4 and 0.9 percent in 2007 and 2008 respectively.
- General government debt declined from 68.9 to 48.4 percent of GDP in 2008.
- Most consolidation reversed in 2009: overall balance deteriorated by 7 percent relative to 2008, pushing gross debt to 56.2 percent of GDP.
- Increase in debt resulted from a 7.3 percent deterioration in the primary balance and a debt-increasing snowball effect due to GDP contraction; stock flow adjustments also contributed.
- April 2010 Stability Programme projects reduction of overall deficit to 2.5 percent of GDP by 2013 through expenditure reductions and enhanced revenues (some measures need stakeholder or parliamentary approval).
- On May 12, 2010 the European Commission initiated an Excessive Deficit Procedure (EDP) for Cyprus.

### Fiscal developments in 2009 — key statistics (Percent of GDP)
- Revenue: 2008 43.5 ; 2009 40.3 ; 2010 41.6
- Expenditure: 2008 42.6 ; 2009 46.4 ; 2010 47.6
- interest: 2008 2.8 ; 2009 2.5 ; 2010 2.3
- Balance: 2008 0.9 ; 2009 -6.1 ; 2010 -6.3
- Primary balance: 2008 3.7 ; 2009 -3.6 ; 2010 -3.7
- Output gap: 2008 4.3 ; 2009 0.6 ; 2010 -1.3
- Cyclical balance: 2008 1.7 ; 2009 0.2 ; 2010 -0.5
- Cyclically adjusted PB: 2008 2.1 ; 2009 -3.8 ; 2010 -3.2
- Fiscal impulse: 2008 -3.2 ; 2009 -5.9 ; 2010 0.6
- Source: WEO.

### Government consolidation plans and measures (targets and assessed impacts)
- Government plans to reduce deficit to 3 percent of GDP in 2012.
- EU under EDP requested Cyprus bring deficit to 4.5 percent GDP in 2011 and 3 percent in 2012; Cyprus to report back in January 2011.
- Steps already taken:
  - Reduction in public employment by 500 in 2010 with further reductions planned for 2011–12.
  - Zero general wage increase for public employees in 2010–11.
  - Imposition of an excise tax on petroleum imports.
  - Expiration in 2011 of temporary reductions in tourism sector VAT rates.
- Assessment: these measures will help stabilize the deficit, but further and as yet unidentified measures will be needed to reach 2011 and 2012 targets.

- Fiscal consolidation measures and impacts (Annual Revenue Impact; Millions of euros / Percent GDP):
  - Revenue measures (2010 / 2011 / 2012):
    - VAT on food and pharmaceuticals: 0 / 35 / 35
    - Tax relief for tourism sector expires: 0 / 40 / 40
    - Excise on petroleum: 40 / 75 / 75
    - Water pricing: 0 / 10 / 10
    - Town planning amnesty: 20 / 15 / 15
    - Tax avoidance/compliance: 20 / 20 / 30
    - Tax relief for airports expires: 0 / 36 / 36
  - Expenditure measures (2010 / 2011 / 2012; Percent GDP):
    - Total expenditure measures: -6 / -3.8 / -5.0
    - Employment decrease of 500: -6 / -1.8 / -3.0
    - Social payments targeting: 0 / -0.2 / -0.2
  - Projected deficit with measures: 2010 6.0 ; 2011 5.6 ; 2012 5.5
  - Deficit target: 2010 6.0 ; 2011 4.5 ; 2012 3.0
  - Additional measures needed to reach targets: 2010 1.1 ; 2011 2.5
  - Sources: Ministry of Finance; and IMF staff estimates.

### Social security, pensions, and long-term fiscal sustainability
- Social security system currently in surplus of 3-4 percent of GDP despite 2009 reform.
- Projections to 2060: pension outlays projected to rise by some 10 percentage points.
- Unless other government spending curtailed, rising pension outlays would raise total government spending to some 60 percent of GDP in 2060.
- SSF reserves projected to turn negative from 2033 onwards.
- Accumulating debt obligations projected to increase up to 182 percent of GDP by 2060.
- Under post-reform scenario, April 2010 SGP forecasts SSF assets over 10.1 percent of GDP in 2060; under pre-reform scenario liabilities projected at 182.1 percent of GDP.
- 2009 reforms include gradual contribution increases by 1.3 percentage points every five years beginning April 2009 until January 2039, increase of minimum contribution requirement from three to ten years, stricter eligibility rules, and higher presumptive incomes for self-employed.

### Pension drivers and projections (2007–2060)
- Total pension expenditure increases by 11.4 percentage points (2007–2060).
  - 10.8 points due to increase in dependency ratio.
  - 1.6 points due to increase in coverage ratio.
- Table 2 excerpt (Percent of GDP): Total spending: 2.8 1.9 2.1 2.7 2.2 11.4 ; Dependency ratio: 1.7 2.1 3.2 2.9 2.8 10.8 ; Coverage ratio: 0.9 0.3 0.3 0.2 0.2 1.6 ; 1/Employment rate: -0.5 0.1 0 -0.5 ; Benefit ratio: 0.5 -0.4 0.3 -0.2 -0.5 -0.3 (Source: European Commission).
- Projected Gross Pension Spending (Percent of GDP) sample values: Total spending: 6.3 8.9 10.8 12.8 15.5 17.7 2060 ; Old age and early pensions: 4.8 6.7 8.2 10 12.4 14.2 2060 ; Other pensions: 1.4 2.2 2.6 2.8 3.1 3.5 2060.

### Financial sector assessment and exposures to Greece
- Banking sector relatively unscathed by international turmoil due to limited exposure to complex securitized products.
- Central Bank of Cyprus (CBC) expresses confidence in banks’ ability to withstand pressures; supported by stress test results.
- Preserving financial sector stability through early detection of risks is a top priority.
- Supervision of cooperative credit societies needs urgent strengthening; moving to a single independent supervisor desirable but not politically advanced.

- Banking sector scale and capital (as of end-May 2010 / end-March 2010 where noted):
  - Total banking system assets: 176,339 (Millions of euros) ; Percent of GDP 1041 (Central Bank of Cyprus, as of end of May, 2010).
  - Local banks assets: 108,282 (Millions of euros) ; Percent of GDP 639
  - Subsidiaries of foreign banks: 60,873 (Millions of euros) ; Percent of GDP 359
  - EU branches: 1,188 (Millions of euros) ; Percent of GDP 7
  - Non-EU branches: 5,996 (Millions of euros) ; Percent of GDP 35
  - Risk-weighted capital adequacy ratio (CAR) of commercial banking system: 11.9 percent at end-March 2010.
  - Commercial banks NPLs: 4.9 percent at end-March 2010 compared with 3.6 percent at end-2008.
  - Cooperative banks NPLs: 9.2 percent at end-March 2010 (270-day definition).

### Gross exposure to Greece and stress estimates
- Trade and tourism channels: Greece accounted for 6.2 percent of tourist arrivals in 2009 and 18 to 20 percent of total exports; exports of goods account for less than 6 percent of GDP.
- Banking channel — gross exposures (not including interbank loans):
  - Overseas operations of Bank of Cyprus, Marfin Popular Bank and Hellenic Bank represented 45 percent, 63 percent and 24 percent of their consolidated group assets, respectively.
  - Loans and advances by these banks to Greek customers reached 38 percent, 53 percent, and 22 percent of total group loans, respectively, corresponding to direct lending of €23 billion.
  - Local commercial banks held €5.5 billion of Greek government bonds and €0.5 billion of Greek bank bonds as of March 2010.
  - Subsidiaries of foreign banks exposures to Greece: €1.3 billion in direct loans, €6.6 billion of Greek government bonds and €6.5 billion in Greek bank bonds.
  - Local commercial banks have €1.5 billion interbank exposure to Greece; subsidiaries of foreign banks have €11 billion interbank exposure.
  - Overall gross exposure to Greece, not including interbank loans, is estimated to be 260 percent of GDP.
- Stress estimate: staff estimates suggest under an adverse scenario cumulative losses on Greek exposure for local banks could be of the order of €2.0 billion (equivalent to about 12 percent of GDP and 30 percent of equity) by 2013.
- 2014 estimate: direct loans cumulative loss estimated as €1.6 billion; losses for subsidiaries of foreign banks on Greece exposure estimated at €0.2 billion; aggregate total securities & loans ... 2.0 (as presented).

### Stress tests, capital adequacy and buffers
- CBC regular stress tests indicate commercial banks can absorb further shocks; resilience of cooperative societies harder to assess.
- CBC: average CAR would remain above regulatory minimum even if NPLs doubled and recovery rate assumed 50 percent.
- EU-wide stress test (2010) bank-level Tier 1 ratio changes:
  - Bank of Cyprus: 10.5 percent (end-2009) → 9.4 percent in 2011 (baseline); with additional sovereign risk scenario an extra 1.4 percentage points impact to 8.0 percent.
  - Marfin Popular Bank: 9.4 percent (end-2009) → 8.5 percent in 2011; with additional sovereign risk scenario would drop a further 1.4 percentage points to 7.1 percent.
  - Hellenic Bank: 9 percent (end-2009) → 8.9 percent in 2011; after additional sovereign risk scenario decreases to 8.3 percent.
  - All Greek banks operating through subsidiaries in Cyprus passed the stress tests.

### Government contingent support and fiscal risk
- Government issued close to €3.0 billion worth of bonds to banks (equivalent to about 18 percent of GDP, but only 2 percent of the assets of eligible institutions) against high-quality collateral consisting of performing loans which must be replaced if they become non-performing.
- These bonds recorded as a securities lending transaction; if losses for the government become large or scheme is extended, bonds may have to be recorded in government debt.

### External position, competitiveness and vulnerabilities
- Current account deficit moderated to -8.3 of GDP in 2009 from a peak of -17.5 percent in 2008.
- Staff projects current account deficit to follow a gradually improving trend over the medium term after a realignment of more than 9 percent of GDP in 2009.
- Reliance on short-term bank-related inflows, including non-resident deposits, makes external position highly vulnerable to shifts in market sentiment.
- CGER-type estimates presented indicate negative current account gaps and substantial exchange rate overvaluation:
  - CAB gap 1/: -4.88 and -5.77 (as presented).
  - REER gap 2/: 17.94, 21.23, 12.11, 11.86 (as presented).
- Service-export orientation mitigates some exchange rate interpretation issues.

### Outlook and macro projections
- Growth: staff forecasts a further -0.2 percent contraction in 2010 (series: Staff -1.7 -0.2 1.8 implying 2009 -1.7, 2010 -0.2, 2011 1.8); Ministry of Finance projects positive growth to resume in 2010; CBC is less sanguine.
- Inflation: HICP expected to increase to 2.2 percent in 2010.
- Labor market: unemployment climbed to 5.6 percent in 2009; expected to rise to 7.8 in 2010 and stay above historical average for some time; elsewhere reported unemployment 7.3 percent in June 2010.
- Current account and external financing: imports affected by commodity prices in 2010; exports expected to turnaround with foreign demand recovery; continued reliance on bank-related short-term capital inflows underscores need for fiscal consolidation and high capital buffers.

### Key downside risks
- Spillovers from Greece due to high exposure of financial sector to Greek assets (about 260 percent of GDP).
- Fiscal consolidation required to reverse structural deterioration could weigh on domestic demand; failure to implement could undermine confidence and financing.
- Rebound in tourism and construction may fail if demand from UK and Russia remains tepid.
- Medium- and long-term growth could weaken if 2009 recession structurally lowered potential growth.
- Public debt levels could increase significantly if government securities issued to banks had to be recorded in government debt.

### Policy implications and IMF staff recommendations
- Adopt a credible medium-term fiscal consolidation strategy to meet deficit targets: reduce deficit to 4.5 percent of GDP in 2011 and 3 percent in 2012; achieving targets would stabilize debt at 63 percent of GDP in 2012.
- Recommended expenditure-focused measures:
  - Reduce government wage bill and better target social transfers.
  - Adjust incremental salary step increase schedule and COLA for public workers.
  - Introduce contributions by government employees toward their unfunded pension benefits.
  - Reduce lower priority capital expenditure (boosted by 1.4 percent of GDP in 2009 and remains 1 percent of GDP above pre-crisis level).
  - Restraint on other goods and services.
  - If needed, increase VAT from 15 percent to 16 percent (would contribute some 0.6 percent of GDP).
- Illustrative impact of possible measures on 2012 fiscal balance (Millions of euros):
  - Freeze COLA in 2011 and 2012 108
  - Freeze salary increments in 2011 and 2012 68
  - 4 pct pension contribution for govt workers, 2012 70
  - 5 pct reduction in goods and services, 2011 and 2012 49
  - Prioritize investment spending 70
  - VAT increase from 15 to 16 percent 90
  - TOTAL 455 ; Percent of GDP 2.5
- Enhance early detection of financial sector problems, strengthen supervision of cooperative credit societies, align NPL definitions and reporting, and consider a single independent supervisor in the longer term.
- Bolster deposit insurance facility proactively; present facilities €100 million for commercial banks and €20 for cooperative credit societies.
- Pursue cross-border supervisory cooperation and pass draft law facilitating government intervention in financial crisis; develop operational manual at CBC.
- Implement structural reforms to boost competitiveness: restrain public sector wages and employment, phase out COLA or link wages more closely to productivity, increase labor market flexibility, streamline regulation, reduce red tape, and support active labor market policies targeted at young workers and low skilled immigrants.
- Further pension reform: lower replacement rates and increase retirement age to bring outlays more in line with contributions.

### Staff appraisal — conclusions
- Foremost policy challenge is reversing large structural fiscal deficit to preserve favorable legacy, protect debt sustainability, and provide space to guard against financial sector risks.
- Official fiscal target of 3 percent of GDP deficit in 2012 is appropriate; government needs to confront hard choices and take further action to put debt ratios on a declining path.
- Further pension reforms needed beyond 2009 measures.
- Banking sector remains sound for now but risks have risen; continued vigilance, cross-border cooperation, enhanced contingency planning, and urgent strengthening of cooperative credit societies’ supervision are priorities.
- Structural reform to preserve competitiveness and enhance potential growth is important.
- Recommendation that next Article IV consultation take place on the standard 12-month cycle.

_Source: IMF staff report — EXECUTIVE SUMMARY and related chapters (data and discussions through July 15, 2010); IMF Public Information Notice No. 10/123._

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Background and outlook
- Economic conditions have stabilized, and the economy is projected to bottom out in 2010, giving way to a mild recovery in 2011 followed by stronger growth.
- Global financial risks remain elevated and muted growth prospects in trading partners weigh on the outlook.
- The government has taken steps to stabilize the fiscal deficit, but further measures will be needed to reach the official deficit target for 2012 of 3 percent of GDP.
- Staff projects slightly negative growth for 2010 to turn only moderately positive in 2011.
- The current account deficit moderated but remained high, at above 8 percent of GDP.

### Key macroeconomic developments and vulnerabilities
- After average growth of 4¼ percent over 2004-08, the economy contracted by 1.7 percent in 2009.
- Private consumption growth evaporated amid leveraged balance sheets, rising unemployment, and slowing household credit growth.
- Fixed investment contracted sharply; the inventory cycle was pronounced as firms reacted with delay to the slowdown in trade partners’ economies.
- Inflation moderated to ¼ percent in 2009 from 4½ percent in 2008.
- Wage growth slowed to 4.1 percent from 5.8 in 2008.
- The unemployment rate rose by 1.7 percentages point to 5.3 percent.
- The output gap is estimated to have turned negative in the second quarter of 2009, but a positive inflation differential with the euro area reopened since the beginning of 2010 owing to price developments in the non tradable sectors.
- Real wage growth remained above euro area levels in 2009, in part because wage contracts did not incorporate the entire drop in inflation due to the backward looking inflation-indexed wage adjustment mechanism (COLA).

### Pre-crisis imbalances and balance-sheet indicators
- Prior to the crisis, rapid credit growth drove private sector indebtedness up, contributing to overheating.
- Households hold debt of about 130 percent of GDP at end-2009.
- Corporate debt is among the highest in Western Europe and had increased during the boom years, although a reversal was initiated as the economy entered recession.
- Nonperforming loans began to rise in 2009, including in the real estate sector.
- Private saving rates rose from lows reached in 2008 as agents reacted to falling asset prices and rising uncertainty.

### Public finance dynamics and recent fiscal history (2004–09)
- During 2004-08, Cyprus moved from an overall deficit of 6.3 percent of GDP in 2003 to surpluses of 3.4 and 0.9 percent in 2007 and 2008 respectively; structural balance improved from a deficit of 7.6 percent in 2003 to a surplus of 2.2 percent in 2007.
- General government debt declined from 68.9 to 48.4 percent of GDP in 2008.
- Most consolidation was reversed in 2009: overall balance deteriorated by 7 percent relative to 2008, pushing gross debt to 56.2 percent of GDP.
- The increase in debt resulted from a 7.3 percent deterioration in the primary balance and a debt-increasing snowball effect due to GDP contraction; stock flow adjustments also contributed.
- The April 2010 Stability Programme projects a reduction of the overall deficit to 2.5 percent of GDP by 2013 based on:
  - expenditure-reducing measures (significant reduction in personnel and operational expenses and better targeting of social schemes),
  - enhanced revenues through improved tax compliance and a town planning amnesty.
- Some measures still need stakeholder agreement or parliamentary approval.
- On May 12, 2010 the European Commission initiated an Excessive Deficit Procedure (EDP) for Cyprus.

### Financial sector assessment and priorities
- The banking sector weathered international financial turmoil relatively unscathed due to limited exposure to complex securitized products.
- The Central Bank of Cyprus (CBC) expressed confidence in the ability of banks to withstand pressures; this is supported by stress test results.
- Preserving financial sector stability through early detection of risks remains a top priority given the difficult economic and financial environment.
- Supervision of cooperative credit societies needs to be strengthened as a matter of urgency.
- Moving to a single independent supervisor for all credit institutions is a desirable objective but not on the political agenda; strengthening supervision of cooperative credit societies seems feasible.

### Policy challenges and staff views
- The foremost policy challenge is to achieve the official fiscal consolidation targets so as to put debt ratios on a declining path and provide more space to guard against risks to the financial sector.
- Further old-age pension reform is essential.
- Structural reforms are needed to preserve competitiveness and enhance medium-term growth.
- Early detection of financial sector problems and strengthened supervision of cooperative credit societies are urgent priorities.

### Authorities’ views
- The government largely shared the staff’s assessment, while projecting growth to turn positive as soon as 2010 and being more confident that the fiscal targets can be met through general spending restraint with less focus on the public payroll.
- The CBC is confident in banks’ resilience, supported by stress test results.
- Political constraints limit progress toward a single independent supervisor for all credit institutions, though supervisory strengthening for cooperative credit societies seems politically feasible.

### Mission
- Mission team: B. Laurens (Head), W. McGrew, V. Flamini (all EUR) and M. Saiyid (MCM) visited Cyprus during June 25-July 5, 2010. Y. Friedman (OED) and a representative from the European Commission also attended.
- Meetings included Minister of Finance Stavrakis, Governor Orphanides, senior public sector and parliamentary officials, private banks and businesses, and labor unions.
- A press conference was held and the concluding statement published.

*IMF staff report — EXECUTIVE SUMMARY (data and discussions through July 15, 2010).*

### 6.      The fiscal deficit widened sharply in

### _cr10291 - 6.      The fiscal deficit widened sharply in

### Fiscal developments in 2009
- Expenditures rose by some 4 percent of GDP driven by higher wages and salaries, social transfers, and investment spending; these increases were for the most part permanent rather than one-off or cyclical.
- Revenues fell by 3 percent of GDP, reflecting the economic downturn and the unwinding of exceptional revenues associated with the real estate boom.
- The result was a fiscal deficit of 6.1 percent of GDP in 2009 — a 7 percent of GDP widening over 2008.
- The cyclically adjusted primary balance declined by some 6 percentage points in 2009, imparting a large fiscal stimulus.

- Key fiscal indicators (Percent of GDP):
  - Revenue: 2008 43.5 ; 2009 40.3 ; 2010 41.6
  - Expenditure: 2008 42.6 ; 2009 46.4 ; 2010 47.6
  - interest: 2008 2.8 ; 2009 2.5 ; 2010 2.3
  - Balance: 2008 0.9 ; 2009 -6.1 ; 2010 -6.3
  - Primary balance: 2008 3.7 ; 2009 -3.6 ; 2010 -3.7
  - Output gap: 2008 4.3 ; 2009 0.6 ; 2010 -1.3
  - Cyclical balance: 2008 1.7 ; 2009 0.2 ; 2010 -0.5
  - Cyclically adjusted PB: 2008 2.1 ; 2009 -3.8 ; 2010 -3.2
  - Fiscal impulse: 2008 -3.2 ; 2009 -5.9 ; 2010 0.6
  - Source: WEO.

### Government consolidation plans and measures
- The government plans to reduce the deficit to 3 percent of GDP in 2012, consistent with EU obligations.
- Under the Excessive Deficit Procedure (EDP), the EU has asked Cyprus to bring its fiscal deficit down to 4.5 percent GDP in 2011 and 3 percent of GDP in 2012. Cyprus is due to report back to the EU in January 2011 on its plans for achieving this consolidation.
- Steps already taken:
  - Reduction in public employment by 500 in 2010 with additional reductions planned for 2011‒12.
  - Zero general wage increase for public employees in 2010‒11 (proposals to temporarily hike the corporate income tax rate from 10 to 11 percent and raise property taxes were rejected by parliament).
  - Imposition of an excise tax on petroleum imports.
  - Expiration in 2011 of temporary reductions in tourism sector VAT rates.
- Assessment: While these measures will help stabilize the deficit, further and as yet unidentified measures will be needed to reach the deficit targets for 2011 and 2012.

- Fiscal consolidation measures and impacts (Annual Revenue Impact of Measures; Millions of euros / Percent GDP):
  - Revenue measures (2010 / 2011 / 2012):
    - VAT on food and pharmaceuticals: 0 / 35 / 35
    - Tax relief for tourism sector expires: 0 / 40 / 40
    - Excise on petroleum: 40 / 75 / 75
    - Water pricing: 0 / 10 / 10
    - Town planning amnesty: 20 / 15 / 15
    - Tax avoidance/compliance: 20 / 20 / 30
    - Tax relief for airports expires: 0 / 36 / 36
  - Expenditure measures (2010 / 2011 / 2012; Percent GDP):
    - Total expenditure measures: -6 / -3.8 / -5.0
    - Employment decrease of 500: -6 / -1.8 / -3.0
    - Social payments targeting: 0 / -0.2 / -0.2
  - Projected deficit with measures: 2010 6.0 ; 2011 5.6 ; 2012 5.5
  - Deficit target: 2010 6.0 ; 2011 4.5 ; 2012 3.0
  - Additional measures needed to reach targets: 2010 1.1 ; 2011 2.5
  - Sources: Ministry of Finance; and IMF staff estimates.

### Social security and long-term fiscal sustainability
- The social security system is currently in surplus, with a surplus of 3-4 percent of GDP despite the 2009 reform.
- Projections: Over the coming decades to 2060, pension outlays are projected to rise by some 10 percentage points as the system matures and demographic changes play out.
- Unless other areas of government spending are curtailed, rising pension outlays would raise total government spending to some 60 percent of GDP in 2060 — a level that could be sustained only with a heavy increase in the tax burden.
- Declining surpluses over the medium term will put pressure elsewhere in the budget.

### Fiscal risks, debt outlook, and financing
- Public debt in percent of GDP is projected to increase substantially over 2009-15.
- Sources of increase in government debt between 2008 and 2015 include:
  - Automatic stabilizers: 1.5 percent of GDP
  - Fiscal stimulus: 3.4 percent of GDP
  - Other: 41.2 percent of GDP
- The authorities have so far managed to finance the deficit relatively easily, with only modest widening of credit spreads over the past year (less than Greece, Portugal, and Spain).
- The authorities postponed an EMTN issuance until late 2010 due to adverse market conditions.
- The authorities consider sovereign funding pressures not a significant risk given a relatively light amortization schedule and the ability to issue domestic debt to the local financial sector; IMF staff broadly share this assessment but note domestic funding could become more difficult if financial sector risks from exposure to Greek assets and to the local real estate market materialize.

### Financial sector context and spillovers from Greece
- Banking sector characteristics:
  - Local banks (home-country Cyprus) have assets equivalent to 639 percent of GDP; three locally incorporated but internationally operating banks dominate the sector.
  - Risk-weighted capital adequacy ratio (CAR) of the commercial banking system: 11.9 percent at the end of March 2010.
  - Profitability has declined due to low interest margins, mark-to-market losses on assets, and provisions for non-performing loans (NPLs).
- Public debt rollover and banking system scale:
  - Total banking system assets: 176,339 (Millions of euros) ; Percent of GDP 1041
  - Local banks assets: 108,282 (Millions of euros) ; Percent of GDP 639
  - Subsidiaries of foreign banks: 60,873 (Millions of euros) ; Percent of GDP 359
  - EU branches: 1,188 (Millions of euros) ; Percent of GDP 7
  - Non-EU branches: 5,996 (Millions of euros) ; Percent of GDP 35
  - Source: Central Bank of Cyprus (as of end of May, 2010).

- Box 3: Spillovers from Greece — key exposures and channels
  - Trade channel: Greece accounted for 6.2 percent of tourist arrivals in 2009 and 18 to 20 percent of total exports; exports of goods account for less than 6 percent of GDP.
  - Interest rate spreads channel: Greek banks’ higher funding costs contributed to higher deposit rates in Cyprus; Cypriot banks responded with higher rates, contributing to higher deposit rates compared with the euro zone average.
  - Banking sector channel — gross exposures (not including interbank loans):
    - Overseas operations of Bank of Cyprus, Marfin Popular Bank and Hellenic Bank represented 45 percent, 63 percent and 24 percent of their consolidated group assets, respectively.
    - Loans and advances by these banks to Greek customers reached 38 percent, 53 percent, and 22 percent of total group loans, respectively, corresponding to direct lending of €23 billion.
    - Local commercial banks were holding €5.5 billion of Greek government bonds and €0.5 billion of Greek bank bonds as of March 2010.
    - Subsidiaries of foreign banks exposures to Greece: €1.3 billion in direct loans, €6.6 billion of Greek government bonds and €6.5 billion in Greek bank bonds.
    - Local commercial banks have €1.5 billion interbank exposure to Greece; subsidiaries of foreign banks have €11 billion interbank exposure (placements with their parents).
    - Overall gross exposure to Greece, not including interbank loans, is estimated to be 260 percent of GDP.
  - Stress estimate:
    - Staff estimates suggest that under an adverse scenario cumulative losses on Greek exposure for local banks could be of the order of €2.0 billion (equivalent to about 12 percent of GDP and 30 percent of equity) by 2013.

### Policy implications and priorities (implicit from text)
- Further fiscal consolidation measures need to be identified and implemented to meet 2011 and 2012 deficit targets under the EDP.
- Containing the growth of the wage bill and social transfers is critical, given structural increases observed in 2008-09.
- Addressing long-term pension vulnerabilities is necessary to avoid very large increases in public spending by 2060.
- Vigilance is required on financial sector risks from large exposures to Greece and the domestic real estate market, as they could impair domestic funding sources and complicate deficit financing.

*Source: IMF staff analysis and Cyprus staff reports as presented in the supplied content.*

### 2014. This estimate is based

### _cr10291 - 2014. This estimate is based

### Estimated losses and bank exposure to Greece
- Estimate based on cumulative loan losses combined with market losses on securities using latest available CBC data with 23.5 percent of securities are held at fair value.
- Direct loans to Greek households and corporates:
  - Cumulative loss estimated as €1.6 billion.
  - Projection assumes NPLs could double from the present level of 7 percent by 2013-2014.
  - Assumes a recovery rate of 50 percent.
- Securities:
  - Mark-to-market (MTM) losses estimated from changes in pricing of Greek securities held at fair value over October 2009 through July 2010.
- Losses for subsidiaries of foreign, mostly Greek, banks on Greece exposure estimated at a further €0.2 billion. These banks are only holding 1. 5 percent of securities at fair value.
- Aggregate figure shown: Total securities & loans ... 2.0 (as presented in source table).

### Banking sector performance, asset quality, and buffers
- Nonperforming loans (NPLs):
  - Commercial banks: 4.9 percent at end March 2010 compared with 3.6 percent at end-2008.
  - Cooperative banks: 9.2 percent at end-March 2010; compiled on the basis of a 270-day rather than 90-day delinquency rate.
  - CBC notes cooperative NPLs are likely significantly understated due to weaker classification norms.
- Banks’ defensive actions:
  - Lowered dividend payout ratios.
  - Cut operational costs; strengthened non-interest margins; bolstered fee-based activities.
  - Increased loan loss provisions and tightened underwriting standards.
  - Attracted deposits from Greece owing to perceived safety of the banking system.
- Government support and contingent exposure:
  - Government issued to the banks close to €3.0 billion worth of bonds (equivalent to about 18 percent of GDP, but only 2 percent of the assets of eligible institutions) against high-quality collateral consisting of performing loans which must be replaced if they become non-performing.
  - These bonds are recorded as a securities lending transaction; if losses for the government become large or the scheme is extended, the bonds may have to be recorded in the government debt.
- Stress tests and capital adequacy:
  - CBC regular stress tests indicate commercial banks have capacity to absorb further shocks, but resilience of cooperative societies harder to assess.
  - CBC: average CAR would remain above the regulatory minimum even in the event of a doubling of NPLs and assuming a 50 percent recovery rate.
  - EU-wide stress test (2010) results (Bank-level):
    - Bank of Cyprus: estimated consolidated Tier 1 capital ratio would change to 9.4 percent in 2011 compared to 10.5 percent as of end of 2009.
    - Marfin Popular Bank: would change to 8.5 percent in 2011 compared to 9.4 percent as of end of 2009.
    - An additional sovereign risk scenario would have a further impact of 1.4 percentage points on the estimated Tier 1 capital ratio of Bank of Cyprus, bringing it to 8.0 percent at the end of 2011 and 1.4 percentage points to 7.1 percent for Marfin Popular Bank.
    - Hellenic Bank announced its Tier 1 ratio would change to 8.9 percent compared to 9 percent at the end of 2009; after additional sovereign risk scenario it would decrease to 8.3 percent.
  - All the Greek banks operating through subsidiaries in Cyprus passed the stress tests.

### Financial supervision, crisis management, and contingent arrangements
- Reforms and gaps:
  - Deposit insurance schemes strengthened in July 2009 to align with similar EU schemes.
  - A number of improvements in supervisory framework for commercial banks adopted.
  - A draft law facilitating government intervention in case of a financial crisis expected to be passed in early 2011.
  - No progress made on previous Fund recommendation to move to one single independent supervisor for banks and cooperative credit societies.
- Contingency and recording risk:
  - The government bond facility used to secure ECB funding is recorded as securities lending; if losses materialize or scheme is extended, these bonds may have to be recorded in government debt, creating fiscal risk.

### External position and competitiveness
- Current account:
  - Current account deficit moderated to -8.3 of GDP in 2009 from a peak of -17.5 percent in 2008.
  - Staff projects the current account deficit to follow a gradually improving trend over the medium term after a realignment of more than 9 percent of GDP in 2009.
- Financing vulnerability:
  - Reliance on short-term bank-related inflows, including non-resident deposits, makes external position highly vulnerable to shifts in market sentiment.
  - Bank-related inflows have been the main source of financing of the current account deficit.
- Competitiveness:
  - Real exchange rate appreciation followed Southern Europe trends and was particularly harmful for manufacturing exports and tourism.
  - CGER-type estimates indicate negative current account gaps and substantial exchange rate overvaluation:
    - CAB gap 1/: -4.88 (one estimate) and -5.77 (another estimate) as presented.
    - REER gap 2/: 17.94, 21.23, 12.11, 11.86 (as presented in source table).
  - Service-export orientation mitigates some exchange rate interpretation issues.

### Outlook and macroeconomic projections
- Growth:
  - Staff forecasts a further 0.2 percent contraction of activity in 2010, with below-potential growth returning in 2011.
  - Staff projection series (as presented): Staff -1.7 -0.2 1.8 (implying 2009 -1.7, 2010 -0.2, 2011 1.8).
  - Ministry of Finance projects positive growth to resume in 2010; CBC is less sanguine.
- Inflation:
  - Harmonized consumer price inflation expected to increase to 2.2 percent in 2010, driven by higher cost of imported oil and commodity prices and rising health and education costs.
- Labor market and potential output:
  - Unemployment climbed to 5.6 percent in 2009; expected to rise to 7.8 in 2010 and stay above its historical average for some time.
  - Medium-term potential output likely to remain subdued; negative output gaps projected until 2015 as growth returns to potential.
- Current account and external financing:
  - Imports projected to be inflated by commodity prices in 2010 but import volumes expected to decrease; exports expected to turnaround with recovery in foreign demand.
  - Continued reliance on bank-related short-term capital inflows underscores need for fiscal consolidation and high capital buffers in financial sector.

### Key downside risks identified
- Five main risk factors to the outlook:
  1. Spillovers from Greece due to the high exposure of the financial sector to Greek assets (about 260 percent of GDP).
  2. Fiscal consolidation required to reverse structural deterioration could weigh on already sluggish domestic demand; failure to implement consolidation could undermine investor confidence and government financing.
  3. A rebound in tourism and construction could fail to materialize if demand from UK and Russia remains tepid.
  4. Medium- and long-term growth prospects could weaken if the 2009 recession has structurally lowered potential growth.
  5. Public debt levels could increase significantly if the government securities issued to banks had to be recorded in government debt.

### Structure of public expenditure, 2010 (as presented)
- Pct. of GDP / Pct. of total:
  - Wages and salaries: 15.8 / 33.3
  - Social transfers: 14.4 / 30.2
  - Goods and services: 5.6 / 11.8
  - Other current: 4.8 / 10.2
  - Capital expenditure: 4.6 / 9.7
  - Interest: 2.3 / 4.8
  - Total: 47.6 / 100.0

*Source: IMF staff estimates and Central Bank of Cyprus data as presented in the source document.*

### 26.       The main policy priorities should be to stabilize public debt at a more prudent

### _cr10291 - 26.       The main policy priorities should be to stabilize public debt at a more prudent

### A. Adopt a Credible Medium-Term Fiscal Consolidation Strategy
- Authorities’ fiscal targets:
  - Reduce the fiscal deficit to 4.5 percent of GDP in 2011 and 3 percent in 2012.
  - Achieving the fiscal targets would stabilize debt at 63 percent of GDP in 2012.
- Public debt and risks:
  - Public debt: 56 percent of GDP in 2009; Euro area average: 79 percent of GDP.
  - Further consolidation in future years would be needed to put debt ratios on a downward path.
  - Growing pressures in Euro area sovereign debt markets argue for decisive consolidation.
  - Large size of the financial sector and risks to its balance sheet suggest government should maintain fiscal space to provide support to banks, if needed.
- Recommended expenditure-focused measures:
  - Reduce government wage bill and better target social transfers.
  - Adjust incremental salary step increase schedule and COLA for public workers.
  - Introduce contributions by government employees toward their unfunded pension benefits.
  - Reduce lower priority capital expenditure (boosted by 1.4 percent of GDP in 2009 and remains one percent of GDP above its pre-crisis level).
  - Restraint on other goods and services.
  - If expenditure measures are inadequate, increase VAT from 15 percent to 16 percent (would contribute some 0.6 percent of GDP).
- Impact of Possible Measures on 2012 Fiscal Balance (Millions of euros):
  - Freeze COLA  in 2011 and 2012 108
  - Freeze salary increments in 2011 and 2012 68
  - 4 pct pension contribution for govt workers, 2012 70
  - 5 pct reduction in goods and services, 2011 and 2012 49
  - Prioritize investment spending 70
  - VAT increase from 15 to 16 percent 90
  - TOTA L455
  - Percent of GDP2.5
- Authorities’ stance:
  - Authorities recognized need for additional measures but had not yet formulated a specific strategy.
  - Authorities were more optimistic that consolidation could be met through general spending restraint, with less focus on the public payroll.

### B. Enhance Early Detection of Problems in the Financial Sector
- Outlook and vulnerabilities:
  - Outlook for the financial sector has weakened; commercial banks exposed to further deterioration of loan portfolios in Cyprus and in foreign markets.
  - Stress test results suggest banks have capacity to absorb further shocks.
  - Systemically important commercial banks have incorporated a significant increase in NPLs into business plans and are taking appropriate actions.
- Cooperative credit societies:
  - May be more at risk than commercial banks.
  - Weak underwriting standards evidenced by high NPLs using a weak definition, lower overall CAR, and significantly higher NPLs ratios net of provisions.
- ECB funding and covered bonds:
  - Use of special government bonds limited to 7 percent of individual banks’ customer deposits.
  - Covered bond legislation expected to be passed in late 2010 to allow banks to access funding and provide exit strategy to unconventional ECB funding.
- Deposit insurance considerations:
  - Increase in insured deposits from €20,000 to €100,000 per depositor per bank and extension of coverage to deposits denominated in all currencies and to deposits of non-euro area residents.
  - Present size of deposit insurance facilities: €100 million for commercial banks and €20 for cooperative credit societies.
  - Present facilities are below a threshold of 1 percent of coverage provided (a guiding principle).
  - Authorities indicated banks may be requested to pay additional capital, which would raise the size of the facility to 3 percent of coverage provided; staff suggested proactive steps to bolster the facility.
- Supervisory and contingency priorities:
  - Preserve banking sector stability through continued strong supervision and early detection of risks.
  - Pursue cross border cooperation with Greece and other Southeastern European supervisors, including procedural mechanisms for coordination of cross-border resolution actions, information sharing, and rules to determine lead jurisdiction in resolving cross-border banks.
  - Pass the draft law facilitating government intervention in case of a financial crisis and develop an operational manual at the CBC.
  - Bolster supervision and transparency of cooperative credit societies: align NPL definition, stress test, and financial reporting frameworks with those for commercial banks.
  - Ultimately consider a single independent supervisor for all credit institutions operating in Cyprus.

### Box 4. Cyprus: Tax Regime (key features)
- Economy and role of tax regime:
  - Services accounted for 79.3 percent of GDP in 2009.
  - Cyprus’ favorable tax regime and open stance toward foreign investors are key features of the business model.
- Personal income tax:
  - Progressive rate structure; top rate: 30 percent.
  - Tax-free threshold: €19,500.
  - Capital gains, dividends, interest income and income from the sale of securities are exempt from income tax.
  - Dividends and interest taxed under the Special Contribution for the Defense of the Republic Law; capital gain tax on realized profit from disposal of immovable property in the Republic and/or securities.
- Corporate income tax:
  - Flat corporate tax rate: 10 percent.
  - Seventy percent of undistributed corporate profits of year t-2 are subject to a 15% tax.
- Value-added tax (VAT):
  - Standard VAT rate raised to the EU minimum of 15 percent in 2003 for most categories.
  - In 2009 VAT on hotels and restaurants reduced from 8 to 5 percent on a temporary basis; in 2010 reduced rate still applies to hotels only.
  - VAT on certain locally produced labor intensive services lowered to the reduced rate of 5% on a permanent basis.
  - Under EU rules, Cyprus was due to introduce VAT on residential land during 2008 but has yet to implement legislation.
  - Cyprus is due by 2011 to introduce the reduced VAT rate on foodstuffs and pharmaceutical that are currently zero rated.
- Social security contributions:
  - Employers’ contribution rate: 8.5 percent of gross wages (Social Security Fund, redundancy fund, central holiday fund, Human Resource Development Fund).
  - Employers must pay payroll tax: 2 percent of gross wages to the social cohesion fund (not deductible for corporate income).
  - Employees pay 6.8 percent of their salary; self-employed pay 12.6 percent of their notional income.
  - Social security contributions of employed and self-employed augmented by a 4.3 percent payment of the state; total contributions will rise by 1.3 percent every five years until 2039.
- Other tax features:
  - Cyprus International Trusts exempt from tax in Cyprus; no taxation on dividends for non-residents.
  - Special tax regime for shipping companies.
  - Cyprus has double taxation agreements with over 40 countries.
- Source for Box 4: staff analysis based on data from The Economist Intelligence Unit, Country Forecast Report, May 2010; and European Commission, Taxation trends in the European union, 2010 Edition.

### C. Implement Structural Reforms to Boost Competitiveness
- Competitiveness and wage dynamics:
  - Growth of wages and labor costs in excess of productivity increases has reduced competitiveness, particularly in the manufacturing and tourism sectors.
  - Need to reverse steady growth of public sector wages and employment to protect low tax environment and reduce wage pressures.
  - Promote wage setting mechanisms that ensure a closer link between wages and productivity than current COLA system.
- Labor market and business climate:
  - Increase labor market flexibility, streamline regulatory framework, reduce red tape, and enhance business climate to bolster medium-term potential growth.
  - Improve labor market functioning through active labor market policies targeted to young workers and low skilled immigrants to address current increase in unemployment and support long-term growth potential.
  - Reduce the high gender pay gap to improve overall business climate.
  - Authorities’ policy agenda includes measures to support employment, raise expenditure in R&D, increase share of population having completed tertiary education, reduce early school leavers, and enhance energy efficiency.

### IV. STAFF APPRAISAL — Key conclusions and recommendations
- Fiscal challenge:
  - Foremost policy challenge is to reverse the large structural fiscal deficit that has emerged.
  - Cyprus compares favorably to other euro area countries but must act forcefully to preserve favorable legacy, protect debt sustainability, and provide space to guard against financial sector risks.
  - Official fiscal target of a 3 percent of GDP deficit in 2012 is appropriate; government needs to confront hard choices to realize objective and stabilize debt ratios.
  - Further action will be needed to put debt ratios on a declining path over the medium term.
- Pension reform:
  - Further reforms of the pension system are needed beyond the 2009 reform.
  - A lasting solution requires bringing outlays more in line with contributions through lower replacement rates and higher retirement age.
- Banking sector vigilance:
  - Banking sector remains sound for now, but risks have significantly risen.
  - Continued efforts needed for early detection of problems, close cooperation with other supervisors, and enhanced contingency planning.
  - Supervision and transparency of cooperative credit societies need to be strengthened urgently to put in place a regulatory regime consistent with commercial banks and to ensure a level playing field.
  - Ensuring a level playing field would help lower deposit rates, reduce incentives for recourse to ECB liquidity, and contain unhealthy competition for deposits.
- Structural reform importance:
  - Structural reform to preserve competitiveness will support recovery and enhance growth potential.
  - Key elements include restraining public sector wages and employment and ensuring real wage flexibility to address exchange rate overvaluation.
  - Improving labor market functioning through active policies will help address the increase in unemployment.
- Consultation scheduling:
  - It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

*Sources: Ministry of Finance; and IMF staff estimates.*

### Box 5. Cyprus: Comparison with Selected Euro Area Countries

### Box 5. Cyprus: Comparison with Selected Euro Area Countries

### Real economy performance and labor market
- Cyprus GDP growth has averaged 3.2 percent since 2000 versus 1.4 percent in the overall Euro area (EA).
- Unemployment: 4.4 percent in Cyprus (since 2000 average) versus 8.4 percent in the EA.
- During the global financial crisis:
  - Cyprus unemployment increased to 5.4 percent in 2009 from 3.7 percent in 2008; EA unemployment was 9.4 percent in 2009.
  - Real GDP decrease: -1.7 percent in Cyprus in 2009 versus -4.1 percent in the EA.

### External sector: current account and international investment position (IIP)
- Cyprus recorded recurrent current account deficits over 2000–08 averaging -6.9 percent of GDP versus -0.2 percent in the Euro zone.
- Current account developments:
  - Deteriorated to 17.5 percent of GDP during the economic boom in 2008.
  - Narrowed to 8.3 percent of GDP in 2009 when the crisis hit Cyprus.
  - In 2009 the current account deficit as a percent of GDP was -0.75 percent in the Euro zone (international comparison note).
- Cyprus IIP remained positive at 4 percent (IIP 2008), compared to significantly negative IIPs in other EA countries.

### Fiscal position and public debt
- Fiscal deficits and public debt:
  - Fiscal deficit increased significantly in 2009 due to rapid growth of government spending and aftermath of the real estate boom, but remains moderate compared to deficits in most EA countries.
  - Public debt at 56 percent of GDP in 2009 versus EA average of 78.7 percent of GDP.
  - Public debt is on an increasing path due to projected primary deficits and slower GDP growth in coming years.
  - Financing needs are limited due to the small size of the economy.

### Market perception and sovereign spreads
- Assessment: Cyprus appears relatively robust compared to other peripheral EA countries across several indicators of vulnerability.
- This assessment is consistent with market perceptions as reflected by comparatively low sovereign spreads (10 Year Bond Spread versus Germany data shown for Cyprus, Spain, Portugal, Greece).

### Data and indicators referenced in the box
- Key exact numeric references preserved from the source:
  - Cyprus GDP growth average since 2000: 3.2 percent.
  - Euro area GDP growth average since 2000: 1.4 percent.
  - Cyprus unemployment (since 2000 average): 4.4 percent.
  - EA unemployment (since 2000 average): 8.4 percent.
  - Cyprus unemployment 2008: 3.7 percent.
  - Cyprus unemployment 2009: 5.4 percent.
  - EA unemployment 2009: 9.4 percent.
  - Cyprus real GDP change 2009: -1.7 percent.
  - EA real GDP change 2009: -4.1 percent.
  - Current account average 2000–08 for Cyprus: -6.9 percent of GDP.
  - Current account average 2000–08 for Euro zone: -0.2 percent of GDP.
  - Cyprus current account 2008: 17.5 percent of GDP (deterioration during boom).
  - Cyprus current account 2009: 8.3 percent of GDP (narrowing with crisis).
  - Cyprus IIP (2008): positive at 4 percent.
  - Public debt (Cyprus) 2009: 56 percent of GDP.
  - Euro area public debt average 2009: 78.7 percent of GDP.

*Source: IMF staff box “Box 5. Cyprus: Comparison with Selected Euro Area Countries.”*

### 6.      The increase in pension expenditure is mostly explained by the deterioration in the

### 6. The increase in pension expenditure is mostly explained by the deterioration in the dependency ratio

### Main findings on pension expenditure drivers
- Total pension expenditure increases by 11.4 percentage points (2007–2060).
- Of the 11.4 percentage point increase in total pension expenditure:
  - 10.8 points are due to the increase in the dependency ratio.
  - 1.6 points are due to the increase in the coverage ratio.
- Offsetting contributions:
  - A negative contribution from a small increase in the employment rate as a result of high expected employment growth, particularly for females in the first decade.
  - A marginal decrease in the benefit ratio, primarily due to price indexation on benefits in the longer term.
- Explanation for the coverage ratio rise:
  - An expected increase in the percentage of females who meet qualifying conditions for receiving a pension at age 63 due to greater labor force participation and longer contribution periods.
- Note on benefit dynamics:
  - In the first couple of decades, as the supplementary part of the social insurance scheme matures, the annual average level of new pensions is expected to increase at a rate higher than that of productivity.

### Employment, contributors, and support ratio
- The increase in employment is mainly due to:
  - Net immigration flows.
  - Increase in female labor force participation, both sizeable over the period.
- A similar increase in the number of contributors will occur in line with the employment trend.
- The support ratio (the ratio of the number of contributors to the number of people aged more than 65) will decline significantly primarily due to the ageing effect.

### Quantitative projections and tables (as presented)
- Table 2. Factors Behind the Public Pension Expenditures Between 2007 and 2060 (Percent of GDP)
  - Total spending: 2.8 1.9 2.1 2.7 2.2 11.4
  - Dependency ratio: 1.7 2.1 3.2 2.9 2.8 10.8
  - Coverage ratio: 0.9 0.3 0.3 0.2 0.2 1.6
  - 1/Employment rate: -0.5 0.1 0 -0.5
  - Benefit ratio: 0.5 -0.4 0.3 -0.2 -0.5 -0.3
  - (Source: European Commission.)

- Additional projection highlights (text and chart excerpts):
  - Projected Gross Pension Spending (Percent of GDP) — sample values in the source:
    - Total spending: 6.3 8.9 10.8 12.8 15.5 17.7 2060
    - Old age and early pensions: 4.8 6.7 8.2 10 12.4 14.2 2060
    - Other pensions: 1.4 2.2 2.6 2.8 3.1 3.5 2060
  - Pension Fund Assets (Percent of GDP) chart and related commentary are presented in the source.

### Reserves, liabilities, and sustainability
- SSF reserves are projected to turn negative from 2033 onwards.
- Accumulating debt obligations will increase up to 182 percent of GDP by 2060.
- A positive sustainability factor noted: the low level of social security contributions.

### Recent reforms (2009 measures) and their features
- Reforms aim primarily at increasing revenue through higher contributions and higher investment returns and, to a lesser extent, reducing expenditure through stricter eligibility conditions to old-age pension.
- Specific measures adopted in 2009:
  - Gradual increase of contributions by 1.3 percentage points every five years beginning in April 2009 until January 2039.
  - Increase of the minimum contribution requirement from three to ten years of paid contributions.
  - Stricter eligibility conditions to receive unemployment benefits and old-age lump-sum payments.
  - Increase of presumptive incomes of self-employed workers to better reflect real incomes.

### Post-reform projections and authorities’ estimates
- Under the post-reform scenario, the April 2010 SGP forecasts:
  - The SSF will hold assets over 10.1 percent of GDP in 2060.
  - Under the pre-reform scenario, liabilities are projected at 182.1 percent of GDP.
- Authorities estimate that, despite adopted parametric reforms:
  - Pension spending will still increase considerably over the next 50 years, albeit by around 1 percentage point of GDP less than before the reform.
  - Total annual contributions will increase by 3.5 percent points of GDP under the post-reform scenario.

*Prepared by IMF staff representatives — informational content extracted from the specified PDF chapter.*

### 4.      Other developments:

### 4.      Other developments:

### Inflation and labor market
- HICP inflation for July 2010 reached 2.7 percent compared to 2.1 percent in June 2010 and -0.8 percent in July 2009.
- The unemployment rate increased to 7.3 percent in June 2010 from 7.1 in May.
- Cyprus’ 12-month harmonized consumer price index inflation was 2.7 percent in July 2010; excluding energy, inflation in Cyprus during the 12 months to July 2010 was 0.1 percentage point lower on average than in the euro area.
- The re-opening of the inflation gap with the euro area in 2010 reflects the imposition of excise taxes on fuels and increases in electricity prices in Cyprus, together with subdued economic activity in the euro area.

### Economic outlook and growth
- After experiencing average growth of 4¼ percent over 2004-08, the economy contracted by 1.7 percent in 2009.
- The economy is projected to bottom out in 2010, with growth expected to be flat in 2010, followed by a modest recovery in 2011 and gradual acceleration thereafter.
- Factors weighing on near-term private demand: increased unemployment, decelerating consumer credit, negative confidence shock; investment expected to be subdued due to weakness in the property market and construction sector; public consumption restrained by fiscal consolidation.
- The current account deficit was cut by more than half in 2009, likely to stabilize in 2010 and decline gradually toward more sustainable levels over the medium term.

### Fiscal developments and policy stance
- The cyclically adjusted primary balance declined by some 6 percentage points in 2009, resulting in a fiscal deficit of 6.1 percent of GDP in 2009.
- Cyprus was placed under the Excessive Deficit Procedure of the European Union; the government adopted a program to reduce the fiscal deficit to 4.5 percent of GDP in 2011 and below 3 percent in 2012.
- The government has taken steps to stabilize the deficit in 2010; additional measures will be needed to reach the 2011 and 2012 fiscal targets.
- The Ministry of Finance projects the fiscal deficit for 2010 to be at most 6 percent of GDP, lower than the 7 percent projected in the budget under a no policy change scenario; this mainly reflects reduction in intermediate consumption, a freeze in general contractual wages and salaries, a reduction in public sector employment, and a one-off Central Bank dividend income.
- Authorities’ planned fiscal measures: new fiscal measures need to add up to around 2¾ percentage points of GDP over the next two years to meet targets.
- Public sector employment reductions: 500 employees reduced in the first half of 2010; expected reduction by another 500 by end-2010; goal to reduce total public sector employment by another 1000 employees per year in the following two years.
- Policy actions: imposition of excise taxes on fuels at the minimum EU level as of mid-2010; withdrawal of 2009 countercyclical stimulus measures in 2011 in line with ECOFIN and European Council Decisions.
- Long-term fiscal reform: 2009 reform of the social security benefit scheme—gradual increase of the contribution rate over the next 30 years, increase in required years of contribution for old-age pension or lump-sum, limit on education/training credits; reform estimated to extend actuarial equilibrium by at least thirty years.
- Executive Board recommendation highlights: reverse large structural fiscal deficit, preserve debt sustainability, create fiscal space for financial sector risks; contain wage bill; better target social transfers; more fundamental pension reforms (lower replacement rates and higher retirement age).

### Financial sector resilience and supervision
- Banking sector characteristics supporting resilience: traditional business model funded mostly by deposits; relatively high banking system capital and liquidity; strong supervision by the Central Bank of Cyprus (CBC).
- Stress tests (CBC and EU-wide) suggest banks have capacity to absorb further shocks, including significant increases in NPLs and spillovers from Greece.
- Banks reduced dividend payout ratio from around 50 percent pre-crisis to about 30 percent in 2009 in anticipation of higher potential losses.
- Noted risks: deterioration of loans in Cyprus and foreign markets (particularly Greece); higher risks in cooperative credit societies due to weaker underwriting standards and lower capital compared with commercial banks.
- Supervisory framework and requirements cited:
  - 20 percent liquidity requirement for all euro customer deposits plus other short term (up to 12 months) euro obligations, in addition to maximum mismatch ratios for maturity time bands up to 7 days and up to 1 month (contractual basis).
  - 70 percent liquidity requirement on foreign currency deposits (mainly non-residents).
  - Strict limits on banks’ open positions in foreign exchange.
- Supervisory actions: imposition of a maximum LTV ratio of 70 percent for property financing (80 percent for the permanent residence).
- CBC conducts twice-yearly stress tests including scenarios with large withdrawals of resident and non-resident deposits.
- Cypriot banks are not dependent on interbank markets funding.

### Liquidity support and covered bonds
- In absence of covered bond legal framework, government issued close to €3.0 billion worth of bonds to banks as collateral for Eurosystem liquidity operations; bonds issued against a fee and collateral with a haircut depending on collateral quality.
- Covered bond legislation expected to be passed by the end of the year (as stated in the source).
- Government and CBC assess the risk of these special government bonds being recorded as part of government debt as negligible given valuation and substitution arrangements.

### Financial sector policy recommendations and contingency planning
- Directors urged continued vigilance, close cooperation with foreign supervisors, and enhanced framework for crisis management and contingency planning, including for cross-border banks; consideration could be given to enlarging the deposit insurance facility.
- Urgency of strengthening supervision and transparency of cooperative credit societies; CSSDA to adopt CBC’s definition of NPLs by the end of the year.
- Draft law submitted to parliament to set up comprehensive framework for swift government intervention in case of an insolvent bank, enabling Cypriot Council of Ministers, with CBC opinion and parliamentary approval, to implement liquidity or insolvency measures; parliament agreed to examine such requests in a speedy procedure.
- On seeking written commitments from regional supervisors about crisis responsibilities, authorities note extensive EU directives on home/host banking supervision cooperation; bank supervisory authority views raising the issue as premature at current stage.

### Exposure to Greece
- Staff estimates overall exposure of the banking system to Greece (not including interbank loans) to be at a high level.
- Authorities note a large part of the exposure relates to Greek subsidiaries and transactions booked in Cyprus for tax reasons; these transactions are fully financed by parent banks and potential losses would be borne by parent banks through set-off against amounts currently due to them.

### Executive Board assessment — key points
- Directors welcomed signs that the economy is beginning to bottom out in 2010 with modest recovery in 2011 but emphasized the fragility of the near-term outlook due to elevated global financial risks and muted growth prospects in trading partners.
- Returning the economy to potential growth depends on credible fiscal consolidation, continued market confidence in the financial sector, and structural reforms to improve competitiveness and the business climate.
- Structural reform priorities: restrain public sector wages and employment, phase out the wage indexation system to link wages to productivity, and implement active labor market policies to address skill mismatches and reduce unemployment.

*IMF Public Information Notice (PIN) No. 10/123 — IMF Executive Board Concludes 2010 Article IV Consultation with Cyprus (September 2, 2010).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10291.pdf_