## _cr11331

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---

### Background — Pre‑Crisis
- Long period of high growth, low unemployment, and sound public finances prior to 2008.
- Unemployment: 3.6 percent in 2008.
- Tourism: contributed 10 percent of GDP in 2008.
- Public debt ratio: 48 percent of GDP at end-2008.
- Main growth drivers: services exports (financial, legal, accounting, shipping) supported by an educated English-speaking workforce, low corporate tax rates, double-tax treaties, a stable macroeconomic environment, and favorable geographic location.
- Emerging vulnerabilities prior to the crisis:
  - Current account deficit peaked at 17 percent of GDP in 2008.
  - Rapid credit growth and a real estate boom.
  - Large exposure of Cypriot banks to Greece.
  - Private saving rate dropped after EU accession in 2004.
- Savings and investment (Box 1):
  - Saving rate: dropped from 15 to 7 percent of GDP between 2004 and 2008.
  - Investment rate: rose from about 19 to 23 percent of GDP between 2004 and 2008.
  - Composition: increased investment between 2004 and 2008 largely into construction — investment in construction increased by 3.5 percent of GDP, machinery and equipment increased by 0.3 percent of GDP.

### Background — Impact of the Crisis
- 2009 recession: GDP fell 1.9 percent.
- 2009 fiscal stimulus: 4 percent of GDP.
  - Main measures: permanent wage/salary increases 1.6 percent of GDP, social transfers 1.6 percent of GDP, public investment 1.4 percent of GDP.
  - Construction/real estate revenue decline accommodated: -2.5 percent of GDP.
  - Overall balance (2008, 2009, 2010): 0.9, -5.9, -5.3.
  - Cyclically adjusted fiscal balance (2008, 2009, 2010): -0.2, -5.6, -4.8.
  - Structural fiscal balance (2008, 2009, 2010): -2.2, -5.9, -5.3.
  - Output gap (2008, 2009, 2010): 2.8, -0.8, -1.2.
- External adjustment:
  - Current account deficit improved from 16.8 to 7.5 percent of GDP between 2008 and 2009.
  - FDI financed 65 percent of the current account deficit over 2009–10.

### Current Vulnerabilities and Outlook (mid‑2011)
- Financial conditions deterioration since late 2010:
  - By mid-2011, 10-year government bond yields exceeded 10 percent; Cyprus lost access to long-term sovereign debt markets.
  - Cyprus Stock Exchange index down 61 percent to date in 2011 (three large banks account for over 90 percent of market capitalization).
- July 11 event:
  - Explosion destroyed the Vassilikos power plant (supplied half the island’s power).
  - Reconstruction costs estimated at €300–700 million; expected to be covered by the power company and insurance proceeds.
  - Resulted in rolling blackouts, adverse effects on output and government revenues, and political fallout.
- Growth and sectoral developments:
  - Growth expected: 0 in 2011.
  - Construction continues to retrench; house prices and rents declining since 2008 peak.
  - Tourism revenues up 16 percent through August 2011; visitors from Russia up 50 percent.
- Housing market (Box 2):
  - Central bank price index: increase of over 50 percent during 2006–08, followed by a decline of 12 percent.
  - UK buyers accounted for 70 percent of foreign buyers.
  - Dynamic panel model suggests some overvaluation in mid-2011 relative to fundamentals.
- Staff projections:
  - Economic contraction of 1 percent in 2012.
  - Unemployment peak: 8½ percent in 2012.
  - Inflation: projected to decline to 2½ percent.
- Current account projections:
  - Current account deficit: 7.8 percent of GDP in 2010 → 7.2 percent in 2011; projected to narrow further in 2012.
- Downside risks:
  - Intensification of euro-area turbulence or further deterioration in Greece could sharply impact Cypriot banks.
  - Adverse shock to world trade would affect services exports (close to half of GDP).
  - Fiscal consolidation in 2012–13 could have larger-than-anticipated contractionary impact; 2012 growth could be considerably lower than baseline if risks materialize.

### Fiscal outlook and announced consolidation measures
- Staff projects deficit widening from 5.3 percent of GDP last year to 7 percent in 2011; public debt to 68 percent of GDP.
- Government fiscal savings targets:
  - €150 million (0.8 percent of GDP) in 2011.
  - €650 million (3.6 percent of GDP) in 2012.
  - €400 million (2.2 percent of GDP) in 2013.
- Government goals: reduce fiscal deficit to 2.8 percent of GDP in 2012 and achieve a balanced budget by 2014.
- First package (late August) — authorities estimate savings of €109 million in 2011 and €152 million in 2012. Main measures:
  - Increase permanent contribution of 4.25 percent by public sector workers toward pensions.
  - Increase withholding tax on interest income from 10 to 15 percent.
  - A flat levy on businesses.
  - Closure of public service pension system to new employees (new employees participate in national pension system).
- Second package (mid‑October) — authorities state it would largely achieve remaining savings targeted for 2012. Key measures:
  - Increase VAT rate from 15 percent to 17 percent.
  - 6‑month freeze of COLA for public servants; pursue permanent COLA reform by end-2011.
  - Improved targeting of social transfers based on income criteria.
  - Authorities announced additional measures if realized fiscal savings fall short.

### Fiscal composition and near‑term projections
- Public sector wage bill: 15.4 percent of GDP in 2010 — largest in the euro area.
- Wage increases in 2009: pushed wage bill up by 1.5 percent of GDP.
- Poorly targeted social benefits: 5.5 percent of GDP in 2010.
- Public sector wages and poorly targeted social benefits together: consume 45 percent of total general government spending.
- Non‑contributory social transfers (2010, percent of GDP components):
  - Social welfare 1.4
  - Child grants 0.9
  - Special grants to pensioners 0.8
  - Housing grants 0.5
  - Educational grants 0.5
  - Social pensions 0.3
  - Health care local and abroad 0.3
  - Easter allowance 0.2
  - Scholarship benefit 0.1
  - Mother's allowance 0.1
  - Sight impaired allowance 0.1
  - Other social transfers 0.1
  - Total non-contributory social transfers 5.6
- Staff baseline: planned fiscal savings of 6.6 percent of GDP over 2011–13 (3.6 percent in 2012) strike an appropriate balance.
- Under staff baseline, adjustments would stabilize the public debt ratio in 2013 and reduce it to 60 percent of GDP by 2016.

### Structural fiscal reforms and budget processes
- Planned reforms:
  - Introduce fiscal rules and a medium-term budget framework into national legislation (consistent with EU directives).
  - Pass new public debt management law to improve debt and cash management.
  - Accounting and statistics reforms to expand coverage and improve timeliness.
  - Strengthen revenue and expenditure forecasting to increase transparency and reduce biases.

### Age‑related long‑term fiscal pressures (pensions)
- Pension expenditures projected to become one of the highest in the euro area by 2050.
- Health expenditures projected to increase by 1 percent of GDP by 2050.
- SSF specifics:
  - SSF deficit estimated at about 0.5 percent of GDP in 2010 (excluding government contributions and interest on government debt held in pension fund reserves).
  - SSF spending projected to increase by about 8 percentage points of GDP by 2050, to about 14 percent of GDP.
  - Contributions scheduled to rise by only about 3 percent of GDP (scheduled increases every 5 years from 2014 until 2039).
  - Result: transfers from budget would need to increase by roughly 5 percentage points of GDP to meet SSF obligations.
- Public employee pensions:
  - Net expenditures expected to increase from about 3 percent of GDP in 2010 to 5 percent of GDP in 2050 (recent actuarial study).
  - Study indicates average contribution rate exceeding 40 percent would be needed to fully fund benefits through 2060, compared to the 5 percent employee contribution at present.
  - System characteristics: low retirement ages for some groups; benefits based on final salary; full pension with fewer years of service than national scheme; benefits indexed to general wage increases and CPI; lump sum benefit at retirement can exceed 5 times the annual pension.

### Financing needs and near‑term government financing
- Government lost access to long-term sovereign debt markets but likely able to meet remaining 2011 financing needs through short-term debt issuance and use of deposits, provided no bank support is required.
- Small net new short-term debt needed: €244 million (1.3 percent of GDP).
- Deposits available: equal to 1.2 percent of GDP; minimum liquidity cushion normally kept: €150 million.
- Financing challenge in 2012 absent non-market financing:
  - Long-term maturities include €550 million domestic bond maturing in January 2012 and €550 million Eurobond maturing in February.
  - Financing needed to cover all maturing long-term debt and the fiscal deficit in 2012 totals roughly €2 billion.
- Gross Financing Requirement table entries (as reported):
  - Total Gross Financing Requirement (TGFR): 2011: 5833.23, 2012: 3,20817.4, 2013: 3,97321.3
  - Rollover of current obligations: 2011: 3612.0, 2012: 2,46313.4, 2013: 3,61519.4
  - Deficit Financing after use of deposits: 2011: 2211.2, 2012: 7454.0, 2013: 3591.9
  - Financing need assuming 100 percent rollover of short term debt: 2011: 2441.3, 2012: 1,96710.7, 2013: 2,73214.7
  - Memorandum item: Central Government Deposits (millions of euros) 3/367 (balance as of September 23, 2011). A minimum balance of € 150 million is normally kept as a liquidity cushion. € 210 million were assumed to be used to cover the deficit financing needs in 2011.

### Banking system structure and vulnerabilities
- Bank assets total €152 billion (835 percent of GDP); assets of commercial banks with Cypriot parents: €92 billion (500 percent of GDP).
- Exposure to Greece: €29 billion, or 160 percent of GDP, including Greek government bonds and loans to Greek residents.
- Cypriot banks hold €1.6 billion of Cypriot government bonds.
- NPLs and provisions (reported):
  - NPLs at local banks (loans past due by 90 days or more, percent of total loans): Dec-09 9.8, Dec-10 12.1, Mar-11 12, Jun-11 13.9.
  - NPLs on loans in Greece: Dec-09 7.8, Dec-10 11.1, Mar-11 12, Jun-11 13.9.
  - Provisions (consolidated, pct. of all loans 90 days or more in arrears): Dec-09 61, Dec-10 56, Mar-11 65, Jun-11 54.
- EBA capital needs (October 26 calculation): preliminary estimate of additional capital required: €3.6 billion (20 percent of GDP) to attain 9 percent core Tier 1 capital ratio and create buffer against mark-to-market losses on sovereign debt holdings; updated diagnostic could reveal larger capital needs.
- Banking system asset composition (June 30, 2011, billions of euros and percent of GDP):
  - System total assets: 152.08 (835 percent of GDP)
  - Commercial banks (total assets): 92.15 (506 percent of GDP)
  - Subsidiaries of foreign banks total assets: 35.31 (194 percent of GDP)
  - Branches of foreign banks total assets: 7.64 (42 percent of GDP)
  - Cooperative banks total assets: 11.69 (93 percent of GDP)
- Box 4 — four main bank categories (key exposures):
  - Commercial banks with Cypriot parents: €92 billion (505 percent of GDP); three large banks account for 97 percent of this group’s assets; €23 billion (130 percent of GDP) in loans to Greek residents and €5 billion of Greek government bonds; €7 billion in loans to residents outside Greece through foreign affiliates.
  - Foreign branch assets: ~€8 billion (42 percent of GDP); limited interaction with Cypriot economy.
  - Foreign subsidiary assets: €35 billion (195 percent of GDP); €4 billion in deposits from Cypriot residents and €6 billion in loans to residents; predominantly Greek parents.
  - Savings cooperatives: ~100 cooperatives hold €17 billion (92 percent of GDP) in assets; assets dominated by loans to residents; funded predominantly by resident deposits; regulated by the Authority for Supervision and Development of Cooperative Societies.

### Funding vulnerabilities
- System loan-to-deposit ratio: 93 percent.
- Capital market refinancing needs low: €550 million in 2011–13.
- Three funding vulnerabilities:
  - Non-resident deposits (NRD) in Cypriot banks (excluding deposits raised abroad by foreign affiliates): €23 billion (125 percent of GDP), most short-term at low interest rates.
    - Mitigation: 70 percent liquid asset requirement against the €12 billion in NRD in foreign currency, and 20 percent requirement for the €11 billion in euro-denominated NRD.
  - €17 billion in deposits collected in Greek branches of the three largest Cypriot-owned banks could be subject to outflows; outflows in H1 2011 were close to €3 billion (nearly 15 percent of the total). Some returned to Cypriot parents as NRD.
  - Loss of access to ECB liquidity risk: ECB provides significant liquidity that must eventually be replaced by market funding; further market losses on Greek and Cypriot government debt would reduce eligible collateral value; downgrade below investment grade could make Cypriot government securities ineligible as collateral for ECB refinancing under current rules.

### Policy discussions and staff recommendations
- Fiscal policy:
  - Staff advised a large, front-loaded, and credible fiscal adjustment in a multi-year framework to restore sustainability and regain market access.
  - Planned fiscal savings of 6.6 percent of GDP over 2011–13 (3.6 percent in 2012) seen as appropriate in size, but staff cautioned against over-optimistic outcomes.
  - Credibility: be conservative in fiscal savings estimates and identify contingency measures.
  - Staff viewed authorities’ projection of reducing the fiscal deficit to below 3 percent of GDP in 2012 as too optimistic (authorities’ starting deficit assumed 6.5 percent of GDP in 2011; staff expects about 7 percent of GDP; authorities assume 0.2 percent growth in 2012; staff expects a contraction).
  - Multi-year framework: pass legislation for specific measures within a credible 2012–14 consolidation plan; adopt additional measures to achieve €400 million savings targeted for 2013 and balance budget in 2014.
- Banking sector contingency planning and recapitalization:
  - Strengthen crisis management procedures and legal powers for prompt corrective action and bank resolution.
  - Work with banks to raise the preliminary €3.6 billion in capital by June 2012 to meet EBA requirements; potential sources include new equity, conversion of hybrid capital, restricting profit distributions and bonuses, asset sales, and, if private sources insufficient, government or official external support.
  - Cooperatives: subject to same regulatory/supervisory regime as commercial banks; monitor closely given size and elevated NPL rates; harmonize frameworks and publish same data as commercial banks.
- Structural reforms and competitiveness:
  - Expenditure-based consolidation recommended: freeze COLA for two years, eliminate automatic salary increments, target social transfers by income, reform national and public employee pension systems.
  - Contingency: prepare for an additional 1 point increase in VAT to 18 percent and reprioritize public investment if current-expenditure measures fall short.
  - Labor market reforms: reduce wage rigidities, consider eliminating COLA in public sector, contain public sector wages and benefits, reduce public employment.
  - Pension reform options: introduce early retirement penalty; increase retirement age gradually to 67 and link to life expectancy; index pensions to inflation only; adjust accrual rates and accelerate contribution increases.
  - Fiscal institutions: implement EU fiscal framework directives, introduce medium-term budgetary framework, pass debt management law, improve forecasting and budget classifications, reorganize revenue administration, manage fiscal risks from extra budgetary entities and PPPs.
  - Competitiveness weaknesses: R&D at 0.4 percent of GDP (well below EU target of 3 percent); low ICT usage among enterprises; Cyprus ranks 40th in Ease of Doing Business and 47th in Global Competitiveness Report.
- Staff appraisal (priorities):
  - Immediate actions required to reverse widening fiscal deficits and put public debt on a downward path.
  - Focus on expenditure reductions, containment of public sector wages and benefits, improved targeting of social transfers, and moderate VAT increase.
  - Require banks to prepare robust plans to achieve higher capital ratios per new EBA requirements and identify liquidity needs; pass bank framework law and amend banking act to enhance recapitalization/resolution powers.
  - Reform national pension scheme, introduce medium-term budgetary framework, and implement EU fiscal directives.

### Downside scenario guidance and illustrative risks
- If downside growth risks materialize:
  - Keep magnitude of planned 2011–13 fiscal savings unchanged; avoid additional consolidation in a weaker economy provided sufficient funding is available.
  - Illustrative outcome: with lower growth and inflation but same fiscal savings, public debt ratio would peak at 85 percent of GDP in 2015.
  - To protect sustainability, implement consolidation over longer term including deeper pension reforms.
- Selected economic indicators under Baseline (B) and Downside (D) Scenarios (percent unless indicated — source: IMF staff estimates):
  - Real GDP growth (series, presumably 2012–2016 from table): -1.0 -3.0 0.8 -2.0 2.0 1.0 2.8 2.5 3.0 3.5
  - Inflation (percent): 2.4 1.0 2.3 0.5 2.2 1.0 2.1 1.5 2.1 2.0
  - General government fiscal deficit: -4.0 -5.9 -1.9 -5.8 0.0 -4.4 0.0 -3.6 0.0 -3.1
  - Public debt: 67.5 72.0 68.7 81.0 66.3 84.7 63.5 85.4 60.4 84.1

### Short‑term activity, indicators, and outlook (figures and tables summary)
- Tourism picked up considerably while retail trade and industry have yet to recover.
- Credit growth slowed across sectors; confidence indicators deteriorated (Economic Sentiment below Euro area; Consumer Confidence negative as of Jul-11).
- Real GDP growth historical and projections (percent change): 3.9 (2005), 4.1 (2006), 5.1 (2007), 3.6 (2008), -1.9 (2009), 1.1 (2010), 0.0 (2011), -1.0 (2012 proj), 0.8 (2013 proj), 2.0 (2014 proj), 2.8 (2015 proj), 3.0 (2016 proj).
- Fiscal figures (percent of GDP, selected years and projections):
  - Revenue: 40.9 (2005) ... 40.3 (2011) ... 42.1 (2013 proj) ... 42.2 (2016 proj).
  - Overall balance: -2.5 (2005), 0.9 (2008), -5.9 (2009), -5.3 (2010), -7.0 (2011), -4.0 (2012 proj), -1.9 (2013 proj), 0.0 (2014–2016 proj).
  - Public debt: 48.2 (2008), 57.8 (2009), 60.7 (2010), 64.0 (2011), 67.5 (2012 proj), 68.7 (2013 proj), 60.4 (2016 proj).
- Financial Soundness Indicators (selected):
  - Regulatory capital to risk-weighted assets: 10.6 (2008 Q4) ... 12.9 (2011 Q2).
  - Core tier 1 capital to risk-weighted assets (banks for which CBC is home supervisor): 7.3 (2008 Q4) ... 8.6 (2011 Q2).
  - Non-performing loans net of provisions to capital: 16.1 (2008 Q4), 34.8 (2011 Q2).
  - Return on assets: 1.0 (2008 Q4) ... -0.5 (2011 Q1).
  - Liquid assets to total assets: 36.5 (2008 Q4) ... 27.0 (2011 Q2).

### Public and external debt sustainability diagnostics
- Public sector debt (baseline series, percent of GDP): 48.2 (2008), 57.8 (2009), 60.7 (2010), 64.0 (2011), 67.5 (2012 proj), 68.7 (2013 proj), 60.4 (2016 proj).
- Gross financing need (percent of GDP): 14.0 (2009), 18.8 (2010), 13.3 (2011), 17.4 (2012 proj), 21.3 (2013 proj).
- External debt (percent of GDP): 368.6 (2008), 505.9 (2009), 446.9 (2010), 462.4 (2011), 453.4 (2012 proj), 432.4 (2016 proj).
- Gross external financing need (in billions of US dollars): 23.5 (2006), 31.0 (2007), 52.6 (2008), 65.2 (2009), 92.9 (2010), 68.5 (2011), 71.0 (2012 proj).
- External debt largely reflects non-resident deposits; stress tests show vulnerability to growth, interest rate, contingent liability, and depreciation shocks.

### Annex I — Fund relations (as of September 30, 2011)
- Membership: Joined December 21, 1961; Article VIII.
- General Resources Account (SDR):
  - Quota: 158.20 (SDR Million) — 100.0 percent.
  - Fund holdings of currency: 99.72 (SDR Million) — 63.03 percent.
  - Reserve Tranche Position: 58.52 (SDR Million) — 36.99 percent.
- SDR Department:
  - Net cumulative allocation: 132.80 (SDR Million) — 100.00 percent.
  - Holdings: 139.46 (SDR Million) — 105.01 percent.
- Outstanding Purchases and Loans: None.
- Financial Arrangements: None.
- Projected obligations to Fund (SDR million): 0.00 for 2010–2014.
- Exchange rate arrangement: Adopted the euro on January 1, 2008; currency floats freely; Article VIII obligations accepted.
- Article IV cycle: 12-month cycle; previous mission June 24 – July 5, 2010; staff report CR/10/291 discussed August 27, 2010.
- FSAP and ROSCs: FSAP mission Sept 23–Oct 6, 2008; technical notes and FSSA published in 2009.
- Technical assistance missions: listed across departments and years (selected entries in source).

### Additional 2011–2012 financing, legal, and institutional measures
- Remaining financing needs to end‑2012 (estimated): EUR 700 million (taking into account fiscal consolidation plans).
  - Expected to be covered by short-term debt and/or long-term domestic debt.
  - New debt management legislation being prepared in collaboration with the World Bank.
- Pensions and PFM:
  - Draft law to introduce medium-term budgetary framework; IMF staff invited to review draft and advise on implementation.
  - Authorities considering IMF TA on natural resources contracts taxation, natural resources revenue management, and revenue administration.
  - Government reviewing new actuarial study of national pension scheme; IMF study expected to provide input.
- Financial sector legal and institutional strengthening:
  - Supervisor required Cypriot banks to build available adequate core tier 1 capital of at least 8 percent plus an additional amount reflecting the ratio of total assets to GDP by end-2014.
  - Additional EBA requirements: mark sovereign exposures to market; increase core tier 1 capital ratio to 9 percent by June 2012.
  - Authorities expect banks to cover capital needs per new EBA requirements; expect some contingent convertible capital instruments to be eligible for sovereign buffer.
  - Draft Law on Establishment and Operation of the Independent Financial Stability Fund under discussion — will be financed by bank/cooperative contributions and, when required, fund bank resolution tools.
  - Financial Crisis Management Law and amendments to Banking Law under parliamentary consideration to strengthen resolution powers; expected submission by end of month.
- Authorities monitoring liquidity, rigorous stress testing, contingency planning, and strengthening legal framework with Fund TA; expect publishing of final capital buffer figures per EBA requirements.

*Italic: IMF staff report: CYPRUS 2011 ARTICLE IV REPORT (excerpts).*

### 2011. Staff representatives comprised W. McGrew (mission chief),

### CYPRUS 2011 ARTICLE IV REPORT

### Background — Pre-Crisis
- Cyprus experienced a long period of high growth, low unemployment, and sound public finances before the 2008 crisis.
- Unemployment reached a low of 3.6 percent in 2008.
- Tourism contributed 10 percent of GDP in 2008.
- Public debt ratio was 48 percent of GDP at end-2008.
- Main growth drivers: services exports (financial, legal, accounting, shipping) supported by an educated English-speaking workforce, low corporate tax rates, double-tax treaties, a stable macroeconomic environment, and favorable geographic location.
- Emerging vulnerabilities prior to the crisis:
  - Widening external shortfalls and a current account deficit that peaked at 17 percent of GDP in 2008.
  - Rapid credit growth and a real estate boom.
  - Large exposure of Cypriot banks to Greece.
  - Drop in private savings after EU accession in 2004 (see Box 1).
- Savings and investment (Box 1):
  - Saving rate dropped from 15 to 7 percent of GDP between 2004 and 2008.
  - Investment rate rose from about 19 to 23 percent of GDP between 2004 and 2008.
  - Almost all increased investment between 2004 and 2008 went into construction: investment in construction increased by 3.5 percent of GDP, while investment in machinery and equipment increased by only 0.3 percent of GDP.

### Background — Impact of the Crisis
- Cyprus experienced a mild recession in 2009 with GDP falling 1.9 percent.
- Fiscal stimulus played a major role in cushioning demand in 2009:
  - Stimulus package of 4 percent of GDP implemented in 2009.
  - Main measures: permanent increases in wages and salaries (1.6 percent of GDP), social transfers (1.6 percent of GDP), and public investment (1.4 percent of GDP).
  - A sharp decline of 2.5 percent of GDP in construction/real estate related revenues was largely accommodated.
  - Result: swing from a surplus in 2008 to a deficit close to 6 percent of GDP in 2009.
- Fiscal developments and one-offs in 2010:
  - One-off central bank-related revenues of 0.5 percent of GDP.
  - A hike in petroleum excises and tax compliance measures totaling 0.5 percent of GDP.
  - Overall balance (2008, 2009, 2010): 0.9, -5.9, -5.3.
  - Cyclically adjusted fiscal balance (2008, 2009, 2010): -0.2, -5.6, -4.8.
  - Structural fiscal balance (2008, 2009, 2010): -2.2, -5.9, -5.3.
  - Output gap (2008, 2009, 2010): 2.8, -0.8, -1.2.
- External adjustment:
  - Current account deficit improved from 16.8 to 7.5 percent of GDP between 2008 and 2009, mainly due to weaker import demand and lower commodity prices.
  - FDI financed 65 percent of the current account deficit over 2009–10.

### Current Vulnerabilities and Outlook
- Financial conditions deteriorated rapidly since late 2010:
  - Ratings downgrades and investor focus on banks’ Greek exposure.
  - By mid-2011, 10-year government bond yields exceeded 10 percent and Cyprus had lost access to long-term sovereign debt markets.
  - Cyprus Stock Exchange index (three large banks account for over 90 percent of market capitalization) was down 61 percent to date in 2011.
- July 11 event and fallout:
  - Explosion destroyed the Vassilikos power plant (supplied half the island’s power).
  - Reconstruction costs estimated at €300–700 million; expected to be covered by the power company and insurance proceeds.
  - Resulted in rolling blackouts, adverse effects on output and government revenues, and political fallout that weakened the governing coalition.
- Growth and sectoral developments:
  - Growth expected to be zero in 2011.
  - Construction sector continues to retrench; house prices and rents have been declining since the market peak in 2008 (Box 2).
  - Tourism revenues up 16 percent through August 2011 and on track to regain 2008 level; visitors from Russia up 50 percent.
- Housing market (Box 2):
  - Central bank price index shows an increase of over 50 percent during 2006–08, followed by a decline of 12 percent.
  - UK buyers accounted for 70 percent of foreign buyers.
  - Price-to-rent and price-to-GDP-per-capita ratios: Cyprus does not exceed the European median on these indicators, but a dynamic panel model suggests some overvaluation in mid-2011 relative to fundamentals.
- Staff projections:
  - Economic contraction of 1 percent in 2012.
  - Unemployment expected to peak at 8½ percent in 2012.
  - Inflation projected to decline to 2½ percent.
- Current account projections:
  - Current account deficit expected to decline from 7.8 percent of GDP in 2010 to 7.2 percent in 2011.
  - Deficit projected to narrow further in 2012 as domestic demand weakens, fiscal adjustment raises public saving, and commodity prices ease.
- Downside risks:
  - Intensification of euro-area financial turbulence or further deterioration in Greece could sharply impact Cypriot banks and tighten financial conditions.
  - An adverse shock to world trade would affect services exports (close to half of GDP).
  - Fiscal consolidation planned for 2012–13 could have a larger-than-anticipated contractionary impact; 2012 growth could be considerably lower than the baseline if risks materialize.

### Fiscal Policies and Financing (overview as presented)
- Key fiscal figures and measures referenced above:
  - 2009 stimulus: 4 percent of GDP (wages and salaries 1.6 percent, social transfers 1.6 percent, public investment 1.4 percent).
  - Revenue shortfall from construction/real estate: -2.5 percent of GDP in 2009.
  - 2010 one-offs: central bank-related revenues 0.5 percent of GDP; petroleum excise and compliance measures 0.5 percent of GDP.
  - Fiscal balances and output gap series for 2008–2010 provided in IMF staff estimates (Overall balance: 0.9, -5.9, -5.3).

_Italic: IMF staff report: CYPRUS 2011 ARTICLE IV REPORT (excerpts)._

### 12.      The government has launched a new

### _cr11331 - 12.      The government has launched a new

### Fiscal outlook and announced consolidation measures
- Staff projects the deficit will widen from 5.3 percent of GDP last year to 7 percent in 2011, bringing public debt to 68 percent of GDP, due to cyclically weak revenues and the failure to contain spending.
- Government fiscal savings targets: €150 million (0.8 percent of GDP) in 2011, €650 million (3.6 percent of GDP) in 2012, and €400 million (2.2 percent of GDP) in 2013.
- Government stated goals: reduce the fiscal deficit to 2.8 percent of GDP in 2012 and achieve a balanced budget by 2014.
- First package passed in late August (authorities estimate savings of €109 million in 2011 and €152 million in 2012). Main measures:
  - Increase in the permanent contribution of 4.25 percent by public sector workers toward their pensions.
  - Increase in the withholding tax on interest income from 10 to 15 percent.
  - A flat levy on businesses.
  - Closure of the public service pension system to new employees (new employees to participate in the national pension system).
- Second package sent to Parliament in mid-October (authorities state it would largely achieve remaining savings targeted for 2012 but leave bulk of 2013 and 2014 savings for future legislation). Key measures:
  - Increase in the VAT rate from 15 percent to 17 percent.
  - A 6-month freeze of cost of living adjustments (COLA) for public servants; government will seek consensus by end-2011 on a permanent COLA reform.
  - Improved targeting of social transfers based on income criteria.
  - Authorities announced additional measures would be taken if realized fiscal savings fall short of targets.

### Fiscal composition and near-term projections
- At 15.4 percent of GDP in 2010, Cyprus has the largest public sector wage bill in the euro area.
- Wage increases in 2009 pushed the wage bill up by 1.5 percent of GDP.
- Poorly targeted social benefits were 5.5 percent of GDP in 2010.
- Together, public sector wages and poorly targeted social benefits consume 45 percent of total general government spending.
- Non-contributory social transfers, 2010 (percent of GDP components as reported):
  - Social welfare 1.4
  - Child grants 0.9
  - Special grants to pensioners 0.8
  - Housing grants 0.5
  - Educational grants 0.5
  - Social pensions 0.3
  - Health care local and abroad 0.3
  - Easter allowance 0.2
  - Scholarship benefit 0.1
  - Mother's allowance 0.1
  - Sight impaired allowance 0.1
  - Other social transfers 0.1
  - Total non-contributory social transfers (percent of GDP) 5.6
- Staff baseline: planned fiscal savings—6.6 percent of GDP over 2011–13, of which 3.6 percent of GDP is slated for 2012—strike an appropriate balance between size of adjustment and growth concerns.
- Under the staff baseline scenario, these adjustments would stabilize the public debt ratio in 2013 and reduce it to 60 percent of GDP by 2016.

### Structural fiscal reforms and budget processes
- Authorities plan structural fiscal reforms including:
  - Introduction of fiscal rules and a medium-term budget framework into national legislation, consistent with EU directives.
  - Passage of a new public debt management law to improve debt and cash management.
  - Accounting and statistics reforms to expand coverage and increase timely data availability.
  - Strengthening revenue and expenditure forecasting to increase transparency and reduce biases in projections.

### Age-related long-term fiscal pressures
- Pension expenditures (SSF and public employees) projected to become one of the highest in the euro area by 2050.
- Health expenditures projected to increase by 1 percent of GDP by 2050.
- SSF specifics:
  - SSF deficit estimated at about 0.5 percent of GDP in 2010 (excluding government contributions and interest on government debt held in pension fund reserves).
  - SSF spending projected to increase by about 8 percentage points of GDP by 2050, to about 14 percent of GDP.
  - Contributions scheduled to rise by only about 3 percent of GDP, based on contribution increases scheduled to take place every 5 years from 2014 until 2039.
  - Result: transfers from the budget would need to increase by roughly 5 percentage points of GDP to meet SSF obligations.
- Public employee pension expenditures net of contributions expected to increase from about 3 percent of GDP in 2010 to 5 percent of GDP in 2050 (recent actuarial study).
  - Study indicates an average contribution rate exceeding 40 percent would be needed to fully fund benefits through 2060, compared to the 5 percent employee contribution at present.
  - System characteristics: low retirement ages for some groups; benefits based on final salary; full pension with fewer years of service than national scheme; benefits indexed to general wage increases and CPI; lump sum benefit at retirement can exceed 5 times the annual pension.

### Financing needs and near-term government financing
- Although the government has lost access to long-term sovereign debt markets, it will likely be able to meet remaining financing needs for 2011 through issuance of short-term debt and use of deposits.
- Minimal long-term debt maturing in last quarter of 2011. Provided the government can issue a small amount (€244 million, or 1.3 percent of GDP) of net new short-term debt, and that it does not need to provide financial support to its banks, it will be able to meet financing needs through year-end, with the help of deposits equaling 1.2 percent of GDP.
- Government financing challenge in 2012 absent non-market financing:
  - Long-term debt maturities include a €550 million domestic bond maturing in January 2012 and a €550 million Eurobond maturing in February.
  - Financing needed to cover all maturing long-term debt and the fiscal deficit in 2012 totals roughly €2 billion.

- Gross Financing Requirement table entries (as reported):
  - Total Gross Financing Requirement (TGFR): 2011: 5833.23, 2012: 3,20817.4, 2013: 3,97321.3
  - Rollover of current obligations: 2011: 3612.0, 2012: 2,46313.4, 2013: 3,61519.4
  - Deficit Financing after use of deposits: 2011: 2211.2, 2012: 7454.0, 2013: 3591.9
  - Financing need assuming 100 percent rollover of short term debt: 2011: 2441.3, 2012: 1,96710.7, 2013: 2,73214.7
  - Memorandum item: Central Government Deposits (millions of euros) 3/367 (balance as of September 23, 2011). A minimum balance of € 150 million is normally kept as a liquidity cushion. € 210 million were assumed to be used to cover the deficit financing needs in 2011.

### Banking system structure and vulnerabilities
- Bank assets total €152 billion (835 percent of GDP); assets of commercial banks with Cypriot parents are €92 billion (500 percent of GDP).
- Exposure of these banks to Greece totals €29 billion, or 160 percent of GDP, including Greek government bonds and loans to Greek residents.
- Cypriot banks also hold €1.6 billion of Cypriot government bonds.
- Non-performing Loans (NPLs) and provisions (reported):
  - NPLs at local banks (loans past due by 90 days or more, percent of total loans): Dec-09 9.8, Dec-10 12.1, Mar-11 12, Jun-11 13.9
  - NPLs on loans in Greece: Dec-09 7.8, Dec-10 11.1, Mar-11 12, Jun-11 13.9
  - Provisions (consolidated, pct. of all loans 90 days or more in arrears): Dec-09 61, Dec-10 56, Mar-11 65, Jun-11 54
- EBA capital needs (October 26 calculation): Cypriot banks require additional capital estimated at €3.6 billion (20 percent of GDP) on a preliminary basis to attain a 9 percent core Tier 1 capital ratio and create a buffer against mark-to-market losses on sovereign debt holdings. An updated diagnostic could reveal larger capital needs.
- Banking system asset composition (June 30, 2011, billions of euros and percent of GDP as reported):
  - System total assets: 152.08 (835 percent of GDP)
  - Commercial banks (total assets): 92.15 (506 percent of GDP)
  - Subsidiaries of foreign banks total assets: 35.31 (194 percent of GDP)
  - Branches of foreign banks total assets: 7.64 (42 percent of GDP)
  - Cooperative banks total assets: 11.69 (93 percent of GDP)

- Box 4 summary: four main bank categories and key exposures
  - Commercial banks with Cypriot parents: hold €92 billion (505 percent of GDP) in assets; three large banks account for 97 percent of this group’s assets; hold €23 billion (130 percent of GDP) in loans to Greek residents and €5 billion of Greek government bonds; loans to residents outside Greece through foreign affiliates total €7 billion.
  - Foreign branch assets: ~€8 billion (42 percent of GDP); limited interaction with Cypriot economy.
  - Foreign subsidiary assets: €35 billion (195 percent of GDP); €4 billion in deposits from Cypriot residents and €6 billion in loans to residents; predominantly Greek parents; greater risk to Cyprus than branches due to interaction and legal status.
  - Savings cooperatives: ~100 cooperatives hold €17 billion (92 percent of GDP) in assets; assets dominated by loans to residents; funded predominantly by resident deposits; regulated by the Authority for Supervision and Development of Cooperative Societies.

### Funding vulnerabilities
- System loan-to-deposit ratio: 93 percent.
- Capital market refinancing needs low: €550 million in 2011–13.
- Three funding vulnerabilities highlighted:
  - Non-resident deposits (NRD) in Cypriot banks (excluding deposits raised abroad by foreign affiliates): €23 billion (125 percent of GDP), most short-term at low interest rates. Mitigation: 70 percent liquid asset requirement against the €12 billion in NRD in foreign currency, and 20 percent requirement for the €11 billion in euro-denominated NRD.
  - €17 billion in deposits collected in the Greek branches of the three largest Cypriot-owned banks could be subject to outflows; outflows in H1 2011 were close to €3 billion (nearly 15 percent of the total). Some returned to Cypriot parents as NRD.
  - Loss of access to ECB liquidity risk: ECB provides significant liquidity that must eventually be replaced by market funding; further market losses on Greek and Cypriot government debt would reduce value of collateral eligible for ECB funding; a downgrade below investment grade could make Cypriot government securities ineligible as collateral for ECB refinancing under current rules.

### Policy discussions and staff recommendations
- Discussions emphasized need for large and credible fiscal adjustment, financial sector contingency planning, and securing fiscal financing.
- Staff advised a large, front-loaded, and credible fiscal adjustment in context of a multi-year framework to restore sustainability and regain market access.
  - Size: Cyprus cannot back-load adjustment; 2012–13 adjustment needs to be sufficient to put budget on firm path toward balance by 2014, with substantial down payment in 2012.
  - Staff agreed that planned fiscal savings of 6.6 percent of GDP over 2011–13 (3.6 percent in 2012) strike an appropriate balance, but cautioned against over-optimistic outcomes.
  - Credibility: be conservative in estimates of fiscal savings and identify contingency measures if savings fall short. Staff viewed authorities’ projection of reducing fiscal deficit to below 3 percent of GDP in 2012 as too optimistic:
    - Authorities’ starting deficit assumed 6.5 percent of GDP in 2011; staff expects about 7 percent of GDP.
    - Authorities’ projection assumes 0.2 percent growth in 2012; staff expects a contraction.
  - Multi-year framework: government should pass legislation for specific measures within a credible multi-year consolidation plan for 2012–14. After passage of the second package needed to secure 2012 savings, additional measures should be adopted to achieve €400 million in savings targeted for 2013 and to balance the budget in 2014. Up-front measures preferred to promises of future actions.
  - If economic growth recovers more quickly and revenues exceed projections, excess revenues should be used to reduce the deficit further.
- Staff emphasized need for contingency planning for banking sector risks, legal tools for prompt corrective action, and the major challenge of fiscal financing in 2012 given significant long-term debt maturities.

*International Monetary Fund — Cyprus: 2011 Article IV Report (content unit _cr11331 - 12).*

### 24.      Staff recommended that additional

### _cr11331 - 24.      Staff recommended that additional

### Fiscal consolidation: main recommendations
- Additional measures to reach the 2013 fiscal targets should be predominantly expenditure-based.
- Rationale: International evidence suggests that expenditure-based consolidation is more reliable in securing savings.
- Preserve a favorable tax climate to protect Cyprus’ appeal as an international business center.
- Areas for expenditure-based savings:
  - Freeze the COLA for two years as an interim measure pending more fundamental reform of the COLA system.
  - Eliminate automatic salary increments.
  - Target social transfers based on income criteria (especially after the large increases in 2009).
  - Reforms to the national and public employee pension systems.
- Expected savings and contingency planning:
  - While achieving €400 million with these measures should be feasible, staff recommended preparing for an additional 1 point increase in the VAT rate to 18 percent and savings from reprioritizing public investment as a contingency in case measures related to current expenditure do not yield the intended savings.

### Downside scenario guidance
- If downside risks to growth materialize:
  - Keep the magnitude of the planned 2011–13 fiscal savings unchanged, while taking measures to safeguard fiscal sustainability in the outer years.
  - Avoid additional consolidation measures in a weaker economy provided sufficient funding is available, since they would further depress demand and growth and could harm investor confidence.
  - Illustrative outcome: In a scenario with lower growth and inflation but the same fiscal savings, the public debt ratio would peak at 85 percent of GDP in 2015.
  - To protect fiscal debt sustainability, implement consolidation measures over the longer term, including deeper reforms to the national and public employee pension systems.

### Selected economic indicators under the Baseline (B) and Downside (D) Scenarios
- Real GDP growth (percent)-1.0-3.00.8-2.02.01.02.82.53.03.5
- Inflation (percent)2.41.02.30.52.21.02.11.52.12.0
- General government fiscal deficit-4.0-5.9-1.9-5.80.0-4.40.0-3.60.0-3.1
- Public debt67.572.068.781.066.384.763.585.460.484.1
- Source: IMF staff estimates.
- (Percent of GDP, unless otherwise indicated)
- Selected Economic Indicators under the Baseline (B) and Downside (D) Scenarios
- 20122013201420152016

### Government position and commitments
- The government expressed commitment to achieving fully the savings targets and to taking additional measures in the event of shortfalls.
- Authorities agreed delays in taking effective adjustment measures had lost valuable time and damaged credibility.
- Authorities were more optimistic than staff on both the 2011 deficit outcome and 2012 growth, believing they would reduce the deficit to below 3 percent of GDP in 2012 and reach a balanced budget by 2014.
- Authorities emphasized the need for social dialogue and were sympathetic to expenditure-based consolidation and rationalization of public spending.

### Financial sector: recommended actions
- Strengthen crisis management procedures and engage in contingency planning:
  - Passage of legislation to give authorities powers to provide financial support through fast-track procedures and to resolve banks if needed (current law lacks powers to liquidate or sell insolvent banks without shareholder approval or lengthy legal procedures).
  - Plan for scenarios of capital and liquidity shortages across the banking system, including foreign branches and subsidiaries; coordinate with foreign supervisors and EU banking authorities.
- Achieve higher capital levels and ensure adequate funding:
  - Work with banks to raise the preliminary estimate of €3.6 billion in capital by June 2012 to meet strengthened EBA capital requirements.
  - Potential sources: new equity investments, conversion of existing hybrid capital to eligible convertible capital, restricting profit distributions and bonuses, sale of assets such as foreign subsidiaries.
  - If private sources are insufficient, envisaged recapitalization would require government or official external support.
  - Before injecting capital, authorities should make a positive assessment of a bank’s solvency and evaluate liquidity needs; work with EU banking authorities to secure term funding as necessary.
- Cooperatives:
  - Cooperatives should be subject to the same regulatory and supervisory regime as commercial banks.
  - Monitor cooperatives closely given their large size (over 90 percent of GDP) and elevated NPL rates.
  - Review regulatory and supervisory structure of cooperatives to identify disparities and avoid regulatory arbitrage; harmonize frameworks and publish the same data as for commercial banks.
- AML/CFT:
  - Emphasize international cooperation and supervision in response to MONEYVAL mutual evaluation report recommendations, given the size of the international services sector and potential spillovers.

### Structural reforms: pensions, fiscal institutions, competitiveness
- Pension reform:
  - Initiate reform of the national pension system to ensure sustainable long-term finances.
  - Reform options to explore:
    - Introduce an early retirement penalty.
    - Increase the retirement age gradually to 67 years and link it to increases in life expectancy.
    - Move gradually towards indexing pensions to inflation only.
    - Reduce the imbalance between contributions and benefits by gradually adjusting the pension accrual rate and accelerating planned contribution rate increases for employees and employers.
  - Public sector pension options:
    - Adopt the same retirement age as the national scheme.
    - Gradually extend the period used to compute benefits to the full career average.
    - Gradually move towards indexing pensions to the CPI.
    - Gradual phase-out of the lump sum benefit at retirement.
- Structural fiscal reform:
  - Implement EU directives relating to the fiscal framework, including the directive that mandates introduction of fiscal rules in national legislation; a transition regime will be needed for full implementation.
  - Improve core budget processes: strengthen forecasting, simplify budget classifications, increase flexibility to reallocate spending to reduce need for supplementary budgets.
  - Reorganize revenue administration by combining separate departments responsible for different taxes and strengthening exchange of information.
  - Pass a new debt management law.
  - Improve management of fiscal risks from extra budgetary entities and PPPs: monitor largest extra budgetary entities, consider divesting or liquidating unsuitable entities, bring functions back into the budget where rationale is lacking; reform PPP framework to ensure proper evaluation of financial risks and empower the Ministry of Finance to stop non-compliant PPP projects.
- Competitiveness:
  - Reduce wage rigidities—most important structural reform to address competitiveness challenge.
  - Consider eliminating the COLA in the public sector (linking wages automatically to inflation rather than productivity reduces flexibility and impedes adjustment).
  - Cyprus ranks 40th among 183 countries in World Bank Ease of Doing Business and 47th among 142 economies in World Economic Forum Global Competitiveness Report.
  - Specific business environment issues: Ease of Enforcing Contracts (rank 39 out of 48 high income countries), restrictions on transport services working hours and licensing.
  - R&D and technology adoption are low:
    - Aggregate spending on R&D at 0.4 percent of GDP, far below EU target of 3 percent of GDP, almost exclusively public sector.
    - Information and communication technologies usage by enterprises ranks among the lowest in the EU.
  - Authorities should identify regulatory hurdles, remove red tape, and support technology upgrading; initial measures included in the National Reform Program.

### Staff appraisal: summary of priorities
- The Cypriot economy faces a very difficult outlook with external exposure (banks’ exposure to Greece, weak external demand) and domestic challenges (restore public finances, regain sovereign market access).
- Immediate action is required to reverse widening fiscal deficits and put public debt on a downward path; pace of adjustment must be ambitious but realistic to build credibility.
- If the economy evolves as anticipated under staff’s baseline scenario, deficit could be brought below 3 percent of GDP by 2013.
- Measures should focus mostly on expenditure reductions, with priority areas:
  - Containment of public sector wages and benefits.
  - Improvements in targeting of social transfers towards the less well-off.
  - A moderate increase in VAT rates.
- Government should move quickly to pass into legislation specific measures within a credible multi-year consolidation plan and prepare rapid contingency measures.
- Financial sector vigilance: require banks to prepare robust plans to achieve higher capital ratios per new EBA requirements, identify and address liquidity needs; enhance authorities’ powers to recapitalize or resolve banks (pass bank framework law and amend banking act).
- Top structural reform priorities:
  - Improve labor market flexibility, contain public sector wages and benefits, reduce public employment, and reform COLA to augment mobility of skilled workers to private sector.
  - Reform national pension scheme now to phase in adjustments and avoid larger disruptive measures later.
  - Reform budget institutions: introduce medium-term budgetary framework and fully implement EU fiscal framework directives, including fiscal rules.
- Bold corrective actions can set the stage for resumption of economic growth, leveraging strengths such as a highly educated workforce and a diversified international service economy.

*Source: IMF staff estimates.*

### 48.      It is proposed that the next Article

### _cr11331 - 48.      It is proposed that the next Article

### Next Article IV consultation timing
- It is proposed that the next Article IV consultation take place on the standard 12-month cycle.

### Short-term indicators and near-term activity
- Tourism has picked up considerably, while retail trade and industry have yet to recover.
- Retail trade, tourist arrivals, and industrial production show divergent year-on-year percent changes (figures presented in Figure 1).
- Credit growth across sectors has slowed significantly:
  - Non-financial corporates, Mortgages, Total credit (year-on-year percent change series shown in Figure 1).
- Overall confidence indicators have deteriorated:
  - Economic Sentiment Indicators show Cyprus below the Euro area (index levels displayed, reference period Jul-11).
  - Consumer Confidence Indicators are negative, implying more respondents pessimistic than optimistic.
- Construction sector prospects remain negative:
  - Construction confidence indicator and cost of building materials (y-on-y percent change) shown for Jul-11 / 2011Q3.

### Real economy: recent performance and projections
- After a mild recession in 2009, Cyprus staged a weak recovery in 2010; projections through 2012 are presented (Figure 2).
- Key historical and projected rates (Table 1, percent change unless noted):
  - Real GDP growth: 3.9 (2005), 4.1 (2006), 5.1 (2007), 3.6 (2008), -1.9 (2009), 1.1 (2010), 0.0 (2011), -1.0 (2012 proj), 0.8 (2013 proj), 2.0 (2014 proj), 2.8 (2015 proj), 3.0 (2016 proj).
  - Domestic demand and its components, exports and imports series are provided in Table 1.
- Contribution to GDP growth by sector shows continued weakness in residential investment and depressed activity in multiple sectors (Figure 2).

### Private sector leverage and external vulnerabilities
- Domestic and external debt indicators (percent of GDP) highlight private agents are highly leveraged, posing further risks to the recovery (Figure 2).
- Banking sector is large relative to the economy (Banks Assets, 2010 percent of GDP shown in Figure 3).
- Cypriot banks carry heavy exposure to Greek government bonds (Greek Government Bond Holdings percent of GDP, Figure 3).

### Financial sector: lending, rates, asset valuations, and soundness
- Lending rates in Cyprus did not decline as much as in the euro area; mortgage and non-financial corporate lending rates series shown (Figure 3).
- Non-performing loans (NPLs) are rising domestically (90-day arrears by sector series, Figure 3).
- Competition with cooperatives and Greek banks contributed to high deposit rates (deposit rates series, Figure 3).
- Bank equity prices and stock exchange indices fell sharply after global crisis and downgrades (index: September 2004=100; domestic banks series in Figure 3).
- Financial Soundness Indicators (Table 6, selected entries, percent unless indicated):
  - Regulatory capital to risk-weighted assets: 10.6 (2008 Q4) ... 12.9 (2011 Q2).
  - Regulatory tier 1 capital to risk-weighted assets: 8.1 (2008 Q4) ... 11.6 (2011 Q2).
  - Core tier 1 capital to risk-weighted assets (banks for which CBC is home supervisor): 7.3 (2008 Q4) ... 8.6 (2011 Q2).
  - Non-performing loans net of provisions to capital: 16.1 (2008 Q4), 34.8 (2011 Q2).
  - Non-performing loans to total gross loans: 4.6 (2008 Q4) ... 8.1 (2011 Q1).
  - Return on assets: 1.0 (2008 Q4) ... -0.5 (2011 Q1).
  - Liquid assets to total assets: 36.5 (2008 Q4) ... 27.0 (2011 Q2).

### Fiscal sector: deficits, revenues, expenditures, and debt
- The fiscal deficit widened in 2009–2010 due to fiscal stimulus and automatic stabilizers and has not been reversed (Figure 4).
- Both direct and indirect taxes declined considerably since 2008 due to falling revenues from construction and real estate.
- Wage bill and social transfers continued to increase.
- Fiscal impulse helped soften the drop in aggregate demand in 2009 but at the expense of a large permanent increase in the structural balance (Figure 4).
- Selected fiscal figures (Table 2, percent of GDP):
  - Revenue: 40.9 (2005), 41.7 (2006), 44.6 (2007), 42.5 (2008), 39.7 (2009), 41.2 (2010), 40.3 (2011), 41.0 (2012 proj), 42.1 (2013 proj), 42.0 (2014 proj), 42.3 (2015 proj), 42.2 (2016 proj).
  - Expenditure: 43.4 (2005) ... 42.2 (2016 proj) series shown.
  - Overall balance: -2.5 (2005), -1.2 (2006), 3.4 (2007), 0.9 (2008), -5.9 (2009), -5.3 (2010), -7.0 (2011), -4.0 (2012 proj), -1.9 (2013 proj), 0.0 (2014–2016 proj).
  - Public debt: 68.8 (2005), 64.1 (2006), 58.0 (2007), 48.2 (2008), 57.8 (2009), 60.7 (2010), 64.0 (2011), 67.5 (2012 proj), 68.7 (2013 proj), 66.3 (2014 proj), 63.5 (2015 proj), 60.4 (2016 proj).

### Public debt sustainability (domestic/public sector)
- Public Debt Sustainability Framework (Table 3, percent of GDP unless indicated):
  - Baseline public sector debt series: 64.1 (2006), 58.0 (2007), 48.2 (2008), 57.8 (2009), 60.7 (2010), 64.0 (2011), 67.5 (2012 proj), 68.7 (2013 proj), 66.3 (2014 proj), 63.5 (2015 proj), 60.4 (2016 proj).
  - Gross financing need (percent of GDP): 11.6 (2006), 5.6 (2007), 4.8 (2008), 14.0 (2009), 18.8 (2010), 13.3 (2011), 17.4 (2012 proj), 21.3 (2013 proj), 11.8 (2014 proj), 15.6 (2015 proj), 14.8 (2016 proj).
- Scenario and stress tests illustrated: growth shock, interest rate shock, primary balance shock, contingent liabilities shock, combined shock. Example scenario box values:
  - No policy change (constant primary balance) in 2011–2016: Baseline:1.8; Scenario:-1.4; Historical:0.3 (contextual boxes in Figure 5).
  - Historical and combined shocks raise public debt substantially (Figure 5).

### External sector, current account, and external debt sustainability
- Current account deficit widened sharply in 2007–2008 but has since stabilized (Figure 6).
- The deficit has been financed mostly by FDI except in 2008 (Financing of the Current Account series).
- Market share in goods trade has fallen, linked to increasing unit labor costs (Market Share in Goods Trade, 2000=100).
- Services exports have grown, driven by business services and financial intermediation (Services Exports percent of GDP series).
- External Debt Sustainability Framework (Table 5, percent of GDP unless indicated):
  - Baseline external debt: 297.7 (2006), 346.1 (2007), 368.6 (2008), 505.9 (2009), 446.9 (2010), 462.4 (2011), 453.4 (2012 proj), 447.2 (2013 proj), 441.3 (2014 proj), 435.5 (2015 proj), 432.4 (2016 proj).
  - Change in external debt: 57.1 (2006), 48.3 (2007), 22.6 (2008), 137.3 (2009), -59.0 (2010), 15.5 (2011), -9.0 (2012 proj), -6.2 (2013 proj), -5.9 (2014 proj), -5.8 (2015 proj), -3.1 (2016 proj).
  - Gross external financing need (in billions of US dollars): 23.5 (2006), 31.0 (2007), 52.6 (2008), 65.2 (2009), 92.9 (2010), 68.5 (2011), 71.0 (2012 proj), 69.1 (2013 proj), 67.3 (2014 proj), 64.7 (2015 proj), 66.8 (2016 proj).
- External stress tests illustrated: interest rate shock, current account shock, combined shock, 30 percent real depreciation shock (Figure 7).
- Note: External debt in Cyprus is made up to a large extent by non-resident deposits; risks from headline external debt are mitigated by their relatively more stable nature and existence of liquidity provisions (Table 5 footnote).

### Labor market
- Employment contracted in 2009–2010, driven by job losses in real estate and tourism sectors (Figure 8).
- Unemployment rate rose significantly from previous low levels:
  - Unemployment rate (percent): Cyprus and Euro area series shown; trend through 2011Q2 indicates notable increase.
- Labor shortages disappeared and real wages growth turned negative (Real Wages and Salaries percent change series).

### Key macro-fiscal-assumption highlights (from debt sustainability tables)
- Key baseline macro assumptions (Table 3 and Table 5):
  - Real GDP growth baseline path: 4.1, 5.1, 3.6, -1.7, 1.0, 2.8, 2.0, 1.7, 2.2, 2.4, 2.6, 2.7 (series across 2006–2017 horizon in Table 5 key assumptions).
  - Average nominal interest rate on public debt (percent): 5.1, 5.2, 5.2, 5.2, 3.9, 4.4, 4.4, 4.5, 4.6, 4.7, 4.8 (Table 3).
  - Inflation (GDP deflator): 3.0, 4.6, 5.1, -0.3, 2.0, 4.7, 1.9, 0.3, 1.5, 1.6, 2.0 (Table 3).

### Summary diagnostics and risks
- Recovery remains weak and uneven: tourism improving, but retail trade, industry, construction, and residential investment remain depressed.
- High private sector leverage and a large banking sector relative to GDP create significant vulnerabilities.
- Rising NPLs and bank exposure to Greek government bonds increase financial fragility.
- Fiscal position deteriorated in 2009–2010 and public debt is elevated; stress tests show vulnerability to growth, interest rate, and contingent liability shocks.
- External debt is very large in headline terms but partly reflects non-resident deposits; gross external financing needs remain sizable (gross external financing need series provided).

*Source: CYPRUS 2011 ARTICLE IV REPORT — informational content and figures as presented in the supplied document.*

### ANNEX I: CYPRUS—FUND RELATIONS

### ANNEX I: CYPRUS—FUND RELATIONS (As of September 30, 2011)

### Membership and Status
- Joined December 21, 1961; Article VIII

### General Resources Account (SDR)
- Quota: 158.20 (SDR Million) — 100.0 percent
- Fund holdings of currency: 99.72 (SDR Million) — 63.03 percent
- Reserve Tranche Position: 58.52 (SDR Million) — 36.99 percent

### SDR Department
- Net cumulative allocation: 132.80 (SDR Million) — 100.00 percent
- Holdings: 139.46 (SDR Million) — 105.01 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 Principal / Charges/Interest
  - 2010: 0.00 / 0.00
  - 2011: 0.00 / 0.00
  - 2012: 0.00 / 0.00
  - 2013: 0.00 / 0.00
  - 2014: 0.00 / 0.00
- Total
  - 2010: 0.00
  - 2011: 0.00
  - 2012: 0.00
  - 2013: 0.00
  - 2014: 0.00

### 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: June 24 – July 5, 2010.
- Staff report (CR/10/291) discussed by the Executive Board on August 27, 2010.

### FSAP Participation and ROSCs
- FSAP mission: September 23 - October 6, 2008.
- FSAP Technical Notes published in May 2009 (CR/09/167 and CR/09/171).
- Financial System Stability Assessment (FSSA) published in October 2009 (CR/09/308).

### Technical Assistance and Resident Representation
- Resident Representative: None.

- Technical assistance missions (Dept. — Purpose — Date):
  - MAE — Government debt management — February-March 1989
  - FAD — VAT training program — June-October 1992
  - MAE — Financial sector liberalization — November-December 1993
  - MAE — Reform of government securities — April-May 1994
  - STA — Special Data Dissemination Standard — August 1997
  - STA — Balance of Payments — March 1999
  - STA — Balance of Payments — May-July 2001
  - STA — Balance of Payments — November 2001-March 2002
  - STA — Balance of Payments — April-June 2002
  - FAD — Public Investment and PPPs — March-April 2006
  - FAD — Medium-term Budget Framework — May 2006
  - FAD — Medium-term Budget Framework — October 2007
  - STA — Special Data Dissemination Standard — May 2007
  - STA — Special Data Dissemination Standard — March 2009
  - STA — Balance of Payments — July 2011

*Source: _cr11331 - ANNEX I: CYPRUS—FUND RELATIONS (As of September 30, 2011)_

### 2012. The remaining needs for financing the deficit and rolling over maturing debt until the

### _cr11331 - 2012. The remaining needs for financing the deficit and rolling over maturing debt until the 

### Financing needs and debt management
- Remaining needs for financing the deficit and rolling over maturing debt until the end of 2012 are estimated at EUR 700 million (taking into account fiscal consolidation plans).
- This financing is expected to be covered by short-term debt and/or long-term domestic debt.
- Authorities follow developments in the European debt crisis closely and consider options in case of prolonged negative effects on the country’s financing abilities.
- New legislation dealing with all aspects of debt management is being prepared in collaboration with the World Bank.
- Authorities have advanced plans for improving their debt management framework.

### Pensions and public financial management
- Government is preparing a draft law to introduce a medium-term budgetary framework and ensure compliance with the EU fiscal framework Directives.
- IMF staff has been invited to review the draft and to advise on practical implementation issues.
- Authorities are considering requesting Fund technical assistance in:
  - natural resources contracts taxation;
  - (for the medium term) natural resources revenue management;
  - revenue administration.
- Government is reviewing a new actuarial study of the national pension scheme and its implications for fiscal sustainability.
- The IMF study on the pension system in Cyprus is expected to provide helpful input.

### Financial sector stability and vulnerabilities
- Cypriot financial sector is large in terms of GDP and has been an important pillar of the economic model.
- Cypriot banks conduct mainstream banking (mostly deposit taking and loan granting) and have low dependency on wholesale funding.
- Regulatory framework is conservative, illustrated by strict liquidity requirements and the relatively high minimum capital ratios (minimum core tier 1 capital of 8 percent of risk-weighted assets).
- The two largest banks already comply with the Basel III minimum capital ratios.
- Supervisor has required Cypriot banks to build up available adequate core tier 1 capital of at least 8 percent plus an additional amount reflecting the ratio of their total assets to the Cypriot GDP by the end of 2014.
- Interconnectedness with the Greek economy and recent downgrades by rating agencies have increased sector vulnerability.
- Private sector involvement in the Greek program agreed on the 26 October Euro Area Summit implies high costs for Cypriot banks.
- Additional needs stem from new EBA requirements to:
  - mark sovereign exposures to market;
  - increase core tier 1 capital ratio to 9 percent by June 2012.
- The figures reported by the EBA already include mark-to-market valuation for Greek government bonds.

### Authorities’ monitoring, assessments, and expected outcomes
- Authorities monitor liquidity, undertake rigorous stress testing (including scenarios for significant increases in NPLs and bad debt provisions) on a regular basis, are developing contingency plans, and are strengthening the legal framework (including with the help of Fund TA).
- Authorities expect to publish in the second half of this month the final figures for the expected capital buffer for individual banks according to the new EBA requirements.
- Authorities expect that the shortfalls will be lower than the preliminary figure announced by the EBA, the difference being explained inter alia by the specific characteristics of each bond (where the EBA necessarily had to make certain common assumptions).
- At this stage, authorities expect the banks to be in a position to cover their capital needs according to the new EBA requirements.
- Supervisor will work with the banks on plans to meet the requirements.
- Cyprus banks have substantial contingent convertible capital instruments, which are compliant with Basel III and with the relevant CEBS guidelines; authorities expect these instruments will be eligible to cover part of the sovereign buffer required by the EBA.

### Legal and institutional strengthening measures
- Draft Law on Establishment and Operation of the Independent Financial Stability Fund is being discussed in parliament; once approved, it will enable establishment and running of a Financial Stability Fund.
  - The Fund will gradually be built up by bank and cooperative credit institutions’ contributions and, when required, will finance implementation of appropriate bank resolution tools by the competent authority.
- Financial Crisis Management Law is also in parliament; it aims to provide the Council of Ministers, upon recommendation by the Central Bank of Cyprus, with powers needed to effectively manage a financial crisis and maintain financial stability and public confidence.
- Current bank resolution regime is being strengthened through amendments in the Banking Law to reinforce the powers of the Central Bank of Cyprus to take specific resolution measures vis-à-vis credit institutions.
- These draft law amendments will be submitted to parliament for approval by the end of this month.

*Source: _cr11331 - 2012. The remaining needs for financing the deficit and rolling over maturing debt until the*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11331.pdf_