## 1. Addressing the Banking Crisis (_cr14313) ## Source details **Canonical URL:** [1. Addressing the Banking Crisis (_cr14313)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14313.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14313.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14313.pdf.json) --- ### A. Crisis, immediate response, and recapitalization approach - Background and imbalances: - Annual growth rate of 4 percent in the decade preceding the crisis masked unsustainable imbalances. - Banking sector expanded to seven times GDP following EU entry and removal of capital account restrictions in 2004. - Private-sector indebtedness rose to over 300 percent of GDP by 2008. - Current-account deficit widened to about 16 percent of GDP at end-2008. - Financial-sector linkages and losses: - Deep interlinkages with Greece; restructuring of Greek sovereign debt in late 2011 inflicted losses on the two largest Cypriot banks equal to a combined 25 percent of GDP. - Banking collapse and liquidity stress: - One bank recapitalized through state support equal to 10 percent of GDP in 2012. - Deposit outflows and Emergency Liquidity Assistance (ELA) reliance rose to 60 percent of GDP by end-2012. - Capital needs and constraints: - Capital needs of the banking sector estimated at about 60 percent of GDP (Box 1). - Public recapitalization would have rendered public debt—already close to 90 percent of GDP at end-2012—unsustainable. - Direct bank support by the ESM was not available; debt restructuring not feasible given creditor composition. - March 2013 bail-in sequence and outcomes: - Initial deposit levy proposal rejected by parliament on March 19, generating a bank run. - Bank holiday imposed; on March 25 authorities intervened in the two economically insolvent banks. - Resulting institution recapitalized at no fiscal cost through bail in of bank creditors, including uninsured deposits converted into equity. - Restrictions on domestic and external payment flows were imposed; domestic restrictions fully removed in May 2014, external restrictions remained. - Bail-in amounts (Billions of euros): - Uninsured deposits: 3.9 / 4.7 / 9.4 (BoC / Laiki / Total) - Senior debt: 0.0 / 0.1 / 0.1 - Subordinated debt: 0.6 / 0.8 / 1.4 - Total: 4.5 / 4.9 / 9.4 ### B. Program agreement, strategy, and early implementation - Program financing and objectives: - Three-year adjustment program agreed with official financing of €10 billion (60 percent of Cyprus's GDP). - Financial-sector strategy: complete recapitalization and restructuring (including coop sector), implement debt-restructuring framework for rising NPLs, roadmap for gradual relaxation of payment restrictions, strengthen bank regulation and AML/CFT. - Fiscal strategy: ambitious yet well-paced consolidation, complemented by comprehensive structural reforms. - Program measures implemented (selected): - Adjustment measures of 2.5 percent of GDP in 2012; 4.5 percent of GDP implemented in 2013; 7.5 percent of GDP implemented (2013-16) including public wage cuts of 9-15%; freeze of public sector wages until 2016; reduction in public sector employment by 4,500; standard VAT rate increase of 2%; increases in contributions on earnings and pensions and increases in CIT, withholding, property and excise taxes. - Reforms: COLA indexation (2012); General Social Insurance Scheme and Government Pension Scheme (2013); Fiscal Responsibility and Budget Systems Law (2013); strengthened AML/CFT framework (2013-14); modern bank-resolution framework (2013-14); supervisory unification (2013-14). ### C. Recent economic developments and indicators - Output and labor market: - Output declined by 5.4 percent in 2013. - Recession less deep than initially projected (8.7 percent) due to households using savings to smooth consumption. - Output contracted a further 3.2 percent year-on-year in the first half of 2014. - Unemployment peaked at about 16 percent in 2013 and moderated slightly thereafter; unemployment rate EU standard: 15.9 (2013), 16.6 (2014). - Prices, wages, and household balance sheets: - Inflation averaged -0.3 percent in the first eight months of 2014; HICP (period average) 0.4 (2013), 0.0 (2014). - Housing prices 25 percent below 2008 peak by 2013–14. - Private-sector debt remained high at 410 percent of GDP at end-2013; households’ net financial-asset position 140 percent of GDP; corporates’ net position -200 percent of GDP. - Bank credit to domestic private sector fell by 5.4 percent in 2013 and a further 1 percent y-o-y by end-August 2014. - External adjustment: - Current account deficit declined to about 2 percent of GDP in 2013 from 15.6 percent of GDP in 2008. - Trade balance registered a 2 percent-of-GDP surplus in 2013. - Net IIP remained -86 percent of GDP at end-2013. - Fiscal performance: - Authorities implemented 4.5 percent of GDP of adjustment measures in 2013. - Primary deficit reduced to 2 percent of GDP in 2013. - 2014 budget included additional adjustment measures of 2.3 percent of GDP. - Cumulative primary surplus in July 2014 reached 2.1 percent of GDP relative to an expected balance; preliminary August figures point to continued overperformance. - Fiscal consolidation implemented included measures totaling 7 percent of GDP in 2013–14. ### D. Banking sector size, capital, deposits, and NPLs - Size and capitalization: - Core domestic financial sector downsized from 550 percent of GDP at end-2012 to 315 percent of GDP in March 2014 (foreign banks add another 160 percent). - CET1 capital ratio increased to close to 14 percent of risk-weighted assets at end-August 2014 (from 3.5 percent at end-2012); BoC market recapitalization boosted CET1 to 15 percent. - Coop sector received €1.5 billion in public funds; coop consolidation from 93 into 18 entities. - Market access and yields: - Cyprus returned to sovereign-bond market mid-2014; yields declined from close to 25 percent in March 2013 to under 5 percent in September 2014. - June 2014: five-year €750 million Eurobond issued to repay part of 2012 recapitalization bond held by BoC. - Non-performing loans (NPLs): - NPL ratio of core domestic sector rose from 20 percent at end-2012 to 57 percent at end-July 2014. - Corporate NPLs 50 percent; construction NPLs over 73 percent. - NPLs on primary-residence mortgages around 40 percent. - Provision coverage 34 percent compared to European average of 46 percent. - Deposits and liquidity: - System-wide deposits fell about 16 percent (excluding bailed-in amounts) March-December 2013, and a further 1.4 percent in first eight months of 2014. - BoC’s reliance on short-term central bank and ECB funding about 55 percent of GDP. - ELA reliance reduced but still significant; Executive Board approved retention of existing exchange restrictions for twelve months. ### E. Program delays, political context, and implementation risks - Political developments: - Break-up of governing coalition in February 2014; government lost majority in parliament. - Heightened political opposition, vested-interest influence, and signs of reform fatigue. - Legal and implementation delays: - Difficulties implementing key elements of the debt-restructuring legal framework to address NPLs; parliament approved foreclosure legislation not fully aligned with program objectives; some bills referred to the Supreme Court. - Completion of the fifth review delayed due to legal uncertainty and implementation delays. - IMF staff warning: - Authorities urged to redouble efforts to put program back on track to achieve durable recovery and exit from official financing. ### F. Macroeconomic outlook and projections (selected exact figures) - Real GDP (percent change): -5.4 (2013), -3.2 (2014), 0.4 (2015), 1.6 (2016), 2.0 (2017), 2.2 (2018). - Consumption (percent change): -5.6 (2013), -2.9 (2014), -0.6 (2015), 0.5 (2016), 1.3 (2017), 1.5 (2018). - Private consumption: -5.7 (2013), -2.4 (2014), -0.1 (2015), 1.5 (2016), 1.7 (2017), 1.9 (2018). - Public consumption: -5.0 (2013), -4.7 (2014), -2.1 (2015), -3.2 (2016), -0.6 (2017), -0.3 (2018). - Fixed investment: -21.6 (2013), -13.4 (2014), 1.3 (2015), 3.9 (2016), 4.6 (2017), 4.9 (2018). - HICP (period average): 0.4 (2013), 0.0 (2014), 0.7 (2015), 1.3 (2016), 1.5 (2017), 1.7 (2018). - Unemployment rate EU standard (percent): 15.9 (2013), 16.6 (2014), 16.1 (2015), 15.0 (2016), 13.7 (2017), 12.5 (2018). - Outlook caveats: - Baseline assumes rapid resolution of implementation delays; risks are tilted to the downside. - Recovery expected to be credit-less and led by tourism and non-financial business services. - House prices projected to fall a further 5–15 percent before equilibrium; household-saving rate expected to fall then rise to over 10 percent over the medium term. - Long-term potential growth estimated at 2 percent. ### G. Risks and Risk Assessment Matrix (selected entries) - Risk 1 — Protracted slower growth in advanced economies: Relative Likelihood High High; policy response: additional fiscal adjustment needed. - Risk 2 — Regional geopolitical risks (Russia/Ukraine, Middle East): Relative Likelihood Medium High; policy response: allow fiscal automatic stabilizers, intensify structural reforms. - Risk 3 — Sovereign stress re-emerges due to program delays or bank assessment outcomes: Relative Likelihood High High; policy response: intensify program delivery, build bank capital buffers. - Risk 4 — Financial sector stress reemerges from insufficient NPL resolution or too rapid relaxation of external restrictions: Relative Likelihood Medium High; policy response: adjust strategy, consider additional financing. - Risk 5 — Weak domestic demand and inability to reduce debt: policy response: intensify NPL resolution and medium-term fiscal consolidation. - RAM interpretation note: staff’s subjective likelihood categories—“low” <10 percent, “medium” 10–30 percent, “high” ≥30 percent. ### H. Public debt sustainability: baseline, stress tests, and contingent-liability scenarios - Baseline public-debt path: - Public debt in 2013: 111 percent of GDP (staff); public debt projected to peak at about 126 percent of GDP in 2015 and decline toward 100 percent by 2020. - Program baseline assumes full utilization of program buffers (over €2 billion, 13 percent of GDP). - Key baseline and historical table highlights (selected exact figures): - Nominal gross public debt (percent of GDP): 2012: 64.0; 2013: 86.6; 2014: 111.5; 2015: 117.4; 2016: 126.0; 2017: 122.5; 2018: 116.4; 2019: 111.1; 2020: 106.5; 2021: 102.6; 2022: 98.9. - Public gross financing needs (percent of GDP): 2012: 14.0; 2013: 18.9; 2014: 19.2; 2015: 16.4; 2016: 16.2; 2017: 9.8; 2018: 14.4. - Real GDP growth (percent): 2012: 2.5; 2013: -2.4; 2014: -5.4; 2015: -3.2; 2016: 0.4; 2017: 1.6; 2018: 2.0. - Primary balance (percent of GDP): 2012: 0.1; 2013: 3.2; 2014: 1.9; 2015: 1.0; 2016: 1.0. - Stress-test scenarios (selected outcomes): - Growth risk (decline by two historical standard deviations, ~7 percentage points for 2015–16): debt increases to 167 percent of GDP by 2016 and 152 percent of GDP by 2020. - Primary balance shock (50 percent reduction in planned fiscal adjustment 2015–18): debt increases to 126 percent of GDP in 2016 and 111 percent of GDP by 2020. - Interest rate shock (real rate +3 percentage points annually 2015–20): debt reaches 124 percent of GDP in 2016 and 110 percent of GDP in 2020. - Combination of growth, interest rate, and primary-balance shocks: debt ratio 167 percent of GDP in 2016 and 157 percent of GDP in 2020. - Deflation shock: debt increases to 127 percent of GDP in 2016 and 113 percent in 2020. - More protracted recession: debt rises to 134 percent of GDP in 2016 and 125 percent in 2020. - Contingent-liability scenarios: - Bank recapitalization within program buffer (€2 billion, 13 percent of GDP) → no impact on debt sustainability. - If bank needs exceed buffer by 10 percent of GDP combined with a deeper recession (by 5 percentage points) → debt increases to 147 percent of GDP in 2016 and 137 percent of GDP by 2020. - Full materialization of government guarantees (all €3 billion called) → debt reaches 129 percent of GDP in 2016 and 112 percent of GDP in 2020. - Key message: debt trajectory vulnerable to shocks; severe adverse scenarios would require additional financing measures and European partner commitments. ### I. External debt, REER, and external sustainability - External debt developments and projections: - Total external debt fell from 448 percent of GDP in 2012 to 348 percent of GDP in 2013. - External debt (percent of GDP) selected: 2009 544.1; 2010 491.9; 2011 468.2; 2012 448.5; 2013 348.0; 2014 353.2; 2015 353.6; 2016 340.9; 2021 287.5. - External gross financing needs (US$ billions): 2009 50.9; 2010 103.0; 2011 93.2; 2012 79.9; 2013 81.1; 2014 46.3. - Net international investment position: -86 percent of GDP at end-2013 (2010 IIP was -35 percent of GDP). - REER and valuation diagnostics: - Since 2009 REER depreciated about 10 percent; at end-2013 it remained 3 percentage points higher than long-run historical average (1980–2008). - CGER-type outcomes: - REER approach: overvaluation of up to 7.9 percent over the medium term. - Macro-balance approach: undervaluation of -0.7 percent (current account norm -3.8 percent of GDP vs projected underlying -0.2 percent of GDP). - External sustainability approach (stabilize IIP at -35 percent of GDP): undervaluation of -0.5 percent. - Policy implication: restoring external stability likely requires further depreciation beyond standard-model implications and prolonged current-account surpluses. - External adjustment requirement: - Reducing IIP from -86 percent of GDP to -35 percent of GDP requires running current account surpluses on the order of 5 percent for a prolonged period (10 years). ### J. Strengthening liquidity, supervision, AML/CFT, and exit from restrictions - Liquidity and exit from external payment restrictions: - BoC’s capital increase and disposal of foreign operations reduced ELA; full normalization of funding will take significant time. - Measures to improve liquidity and collateral quality: accelerate NPL resolution, further deleverage abroad, seek market (junior) funding without excessive cost. - Gradual relaxation of external restrictions recommended, underpinned by data analysis and clear communication; CBC to monitor via supervisory inspections. - Restrictive measures as of end-September 2014 (Euros): transactions within normal business without Committee approval: 1,000,000; living expenses per quarter as tuition fees: 5,000; payments via debit or credit card (per month): No limit; exports of euro notes or foreign currency per person per journey: 3,000; monthly transfer of deposits/funds abroad regardless of the purpose: 5,000. - Prudential supervision and AML/CFT priorities: - Steps taken: directives on provisioning, NPL disclosure, loan origination; country-wide credit register; unified supervision of banks and coops; strengthened resolution authority; revised AML/CFT legal framework; strengthened CBC AML/CFT resources. - Remaining priorities: ensure adequate supervision during transition to the SSM; enhance AML/CFT implementation via staff capacity, coordination with prudential supervision, inspection processes, risk-based tools, and enforcement. - CBC to complete AML/CFT investigation of FBME branch (intervened in July 2014). ### K. Fiscal policy objectives, required adjustments, and recommendations - Fiscal targets: - Authorities aim for a primary surplus of 4 percent of GDP by 2018 to lower public debt to around 100 percent of GDP by 2020; primary surpluses will need to be maintained beyond 2020 to reach pre-crisis debt (50–60 percent of GDP). - Consolidation achieved and additional needs: - 7 percent of GDP of measures implemented in 2013–14. - To attain 4 percent primary surplus by 2018, additional measures of about 3.4 percent of GDP will be needed under the current macroeconomic baseline. - Projected primary deficit declines to about 1 percent of GDP in 2014 and remains around 1 percent in 2015. - Policy recommendations and contingent actions: - Ensure fiscal neutrality of welfare reform via permanent measures of 0.3 percent of GDP focused on targeting social benefits. - If welfare reform costs exceed expectations, offset during 2015 with high-quality measures. - Allow automatic stabilizers if macro outcomes deteriorate. - From 2016 onward, additional adjustment should be growth-friendly and reverse pre-crisis statutory spending increases. - Rationalize wage bill to prevent rapid rise after unfreezing; review social benefits increased 2008–12; improve targeting of education subsidies and increase tertiary-education fees. - Debt management: - Monitor fiscal risks from government guarantees (20 percent of GDP) and implicit liabilities (55 percent of GDP from banks’ reliance on central bank financing). - Medium-term debt-management strategy to address concentrated redemptions (40 percent of GDP during 2017–20) and enable exit from official assistance. ### L. Structural reforms and growth strategy priorities - Recent and planned reforms: - Implement GMI reform (expected to reduce relative and extreme poverty by 17 and 70 percent, respectively); be prepared for ~20 percent expansion in coverage and build national benefit registry. - Integrate VAT and direct-tax departments; set up large taxpayers’ office; develop new tax procedure code. - Implement Fiscal Responsibility and Budget Systems Law secondary legislation; strengthen budget processes. - Growth strategy priorities: - Open closed professions; remove barriers to competition; reduce red tape; privatize state-owned enterprises; strengthen legal system; foster innovation. - Structural reforms estimated to provide upside to medium-term growth of up to 1.5–3 percentage points. - Implementation cautions: - Sequence medium-term reforms to avoid capacity overload; manage transitions (revenue administration, welfare, privatization) prudently. ### M. Staff appraisal and conclusions (summary) - The 2013 shock exposed large vulnerabilities culminating in one of the largest banking collapses on record. - Authorities responded with exceptional measures: resolution of two largest banks, bail-in of creditors including uninsured depositors, payment restrictions, and ambitious fiscal consolidation and structural reform efforts. - Progress made: recapitalization consistent with fiscal sustainability; financial-sector downsizing and restructuring; liberalization of domestic payment flows; re-access to international markets. - Remaining challenges: high and rising NPLs, tight liquidity and capital buffers in some banks, incomplete bank restructuring, large contingent and implicit liabilities, political opposition and reform fatigue. - Key staff recommendations reiterated: address NPLs and insolvency/foreclosure frameworks; maintain and strengthen capital buffers per comprehensive assessment; prudently manage external payment restrictions with a transparent milestone-based roadmap; strengthen supervision and AML/CFT; continue growth-friendly fiscal consolidation and structural reforms. *International Monetary Fund — Cyprus: staff report and annexes as provided in content unit _cr14313* ### 1. Addressing the Banking Crisis ____________________________________________________________________ 6 ### 1. Addressing the Banking Crisis ### A. Crisis and Immediate Policy Response — Background and Key Findings - Cyprus accumulated large imbalances in the run-up to the 2008 global crisis: - Annual growth rate of 4 percent in the decade preceding the crisis masked unsustainable imbalances. - Following EU entry and removal of capital account restrictions in 2004, foreign inflows led to a rapid expansion of the banking sector to seven times GDP. - Private-sector indebtedness rose to over 300 percent of GDP by 2008. - Current-account deficit widened to about 16 percent of GDP at end-2008. - Financial-sector vulnerabilities and contagion: - Financial sector became deeply interlinked with Greece, accumulating significant Greek loans and sovereign debt. - The restructuring of Greek sovereign debt in late 2011 inflicted losses on the two largest Cypriot banks equal to a combined 25 percent of GDP. - Banking collapse and fiscal consequences: - One bank recapitalized through state support equal to 10 percent of GDP in 2012. - Deposit outflows intensified and reliance on Emergency Liquidity Assistance rose to 60 percent of GDP by end-2012. - Capital needs and options: - Capital needs of the banking sector were estimated at about 60 percent of GDP (Box 1). - Public recapitalization would have rendered public debt—already close to 90 percent of GDP at end-2012—unsustainable. - Direct bank support by the ESM was not available, and debt restructuring was not feasible given creditor composition. ### Box: Addressing the Banking Crisis — Measures Taken and Bail-in Details - Sequence of events in March 2013: - Initial proposal to recapitalize through a levy on all bank deposits was rejected by parliament on March 19, generating a bank run. - Authorities imposed a bank holiday and on March 25 intervened in the two economically insolvent banks. - The resulting institution was recapitalized at no fiscal cost through bail in of bank creditors, including uninsured deposits, which were converted into equity. - Restrictions on domestic and external payment flows were imposed following the bank holiday. - Summary assessments: - Bank economic insolvency was addressed upfront and debt sustainability was protected, limiting the burden on the Cypriot taxpayer. - Bail-in Amounts (Billions of euros) — as presented in the source: - BoCLaikiTotal - Uninsured deposits3.947.9 - Senior debt00.10.1 - Subordinated debt0.60.81.4 - Total4.54.99.4 ### Program Agreement and Strategy (March 2013) - A three-year adjustment program was agreed with official financing of €10 billion (60 percent of Cyprus's GDP). - Financial sector strategy focused on: - Completing recapitalization and restructuring of the banking sector, including the cooperative credit (coop) sector. - Implementing a debt-restructuring framework to address rising non-performing loans (NPLs) and private indebtedness. - Developing a roadmap for gradual relaxation of payment restrictions. - Strengthening bank regulation and supervision and implementation of the AML/CFT framework. - Fiscal strategy: - Ambitious yet well-paced consolidation to balance short-term cyclical concerns and longer-term sustainability, complemented by comprehensive structural reforms. ### B. Recent Economic Developments — Impact and Indicators - Output and recession: - Output declined by 5.4 percent in 2013. - The recession was less deep than initially projected at the onset of the program (8.7 percent) due to households using savings to smooth consumption. - In the first half of 2014, output contracted by a further 3.2 percent year-on-year. - Prices, wages, and labor market: - Inflation averaged -0.3 percent in the first eight months of 2014. - Wages adjusted via public-sector wage cuts and renegotiation of private-sector contracts. - Unemployment peaked at about 16 percent in 2013 and moderated slightly thereafter owing in part to a decline in labor-force participation. - Private sector deleveraging and balance sheets: - Bank credit to the domestic private sector fell by 5.4 percent in 2013, and by a further 1 percent y-o-y by end-August 2014. - Private-sector debt remained high at 410 percent of GDP at end-2013. - Households’ net financial-asset position remained large and positive at 140 percent of GDP; corporates’ net position was large and negative at -200 percent of GDP. - Housing prices were 25 percent below their 2008 peak by 2013–14. - External adjustment: - Current account deficit declined to about 2 percent of GDP in 2013 from a peak of 15.6 percent of GDP in 2008. - Trade balance registered a 2 percent-of-GDP surplus in 2013, driven by contracting imports more than offsetting falling exports. - Income balance remained in deficit, reflecting a large negative international investment position (-86 percent of GDP at end-2013). - Import growth turned positive in mid-2014; goods exports and tourist arrivals rose. - Fiscal consolidation: - Authorities implemented 4.5 percent of GDP of adjustment measures in 2013. - These measures helped reduce the primary deficit to 2 percent of GDP in 2013. *International Monetary Fund — Cyprus: 1. Addressing the Banking Crisis* ### 3.2 percent of GDP a year earlier, despite the deep ### _cr14313 - 3.2 percent of GDP a year earlier, despite the deep ### Fiscal developments and recent cash performance - The 2014 budget included additional adjustment measures of 2.3 percent of GDP. - In July, the cumulative primary surplus reached 2.1 percent of GDP relative to an expected balance, reflecting both lower primary spending and better-than-expected revenues (partly affected by seasonality related to corporate-tax payments). - Preliminary August figures point to continued overperformance. - Increasing tax revenues as a share of GDP are mainly responsible for the improvement in revenue and grants. - Composition of tax-revenue improvements: - Improved direct and indirect tax revenue. - Evolution of primary expenditures: - The increase in primary spending has been mainly due to higher levels of social security payments because of accelerated processing of unemployment and redundancy benefits. - Goods and services and other current expenditure were lower than last year. - Fiscal consolidation implemented: - Adjustment measures of 2.5% of GDP in 2012. - Adjustment measures of 7.5% GDP implemented (2013-16), including: public wage cuts of 9-15%; freeze of public sector wages until 2016; reduction in public sector employment by 4,500; streamlining social transfers and public employee allowances; standard VAT rate increase of 2%; increases in contributions on earnings and pensions and increases in CIT, withholding, property and excise taxes. ### Private sector balance-sheet and credit developments - The pace of domestic credit contraction has moderated. - Loan and deposit rates remain high. - Household financial assets declined sharply in 2013, but household liabilities also declined, mainly related to housing loans. - Corporate financial assets fell modestly in 2013, while the decline in liabilities was partly compensated by an increase in equity and other accounts payable. - Cumulative changes of household financial assets and bank loans show large negative movements in 2013 relative to end-2012 (figures shown in billions of euros for assets and millions of euros for loans in the source charts). ### External indicators and trade - Goods exports have been driven by non-EU demand, although there was a slowdown in July. - The EU remains the main destination for Cyprus's exports. - Imports rebounded strongly in the second quarter as domestic demand recovers. - The net IIP remains large and negative, with a reduction in both foreign assets and liabilities. - The real effective exchange rate has adjusted down towards its longer-term average. ### Banking sector, capital, deposits, and NPLs - The core domestic financial sector downsized from 550 percent of GDP at end-2012 to 315 percent of GDP in March 2014 (foreign banks add another 160 percent of GDP). - CET1 capital ratio increased to close to 14 percent of risk-weighted assets at end-August 2014 (from 3.5 percent at end-2012) because of: - BoC’s recapitalization at no fiscal cost in 2013 and an additional private placement of €1 billion completed in September 2014. - Recapitalization of Hellenic Bank through private funds in late 2013. - Injection of public funds (€1.5 billion) in the coop sector in early 2014; coop sector consolidated from 93 entities into 18. - Cyprus returned to the sovereign-bond market in mid-2014; Cypriot bond yields declined from close to 25 percent in March 2013 to under 5 percent in September 2014. - In June 2014, Cyprus issued a five-year €750 million Eurobond used to repay part of the 2012 recapitalization bond held by BoC. - NPLs increased sharply: - NPL ratio of the core domestic sector rose from 20 percent at end-2012 to 57 percent at end-July (broadly in line with due-diligence projections under the stress scenario). - Corporate NPLs stood at 50 percent and were highly concentrated; construction NPLs now at over 73 percent. - NPLs on primary-residence mortgages are around 40 percent. - Provision coverage is 34 percent compared to the European average of 46 percent. - Deposit dynamics and payment restrictions: - After falling by about 16 percent (excluding bailed-in amounts) during March-December 2013, system-wide deposits declined a further 1.4 percent in the first eight months of 2014. - Authorities gradually relaxed domestic payment restrictions, fully eliminating them in May, and unfroze BoC’s uninsured deposits. - External payment restrictions remain in place given still tight bank liquidity, with BoC’s reliance on short-term central bank and ECB funding at about 55 percent of GDP and limited collateral buffers as asset quality deteriorates. ### Policy reforms, program implementation, and delays - Authorities implemented an ambitious package of reforms, including: - Reform of COLA indexation (2012). - Reform of General Social Insurance Scheme and Government Pension Scheme (2013). - Adoption of Fiscal Responsibility and Budget Systems Law (2013), introducing medium-term budget framework, fiscal rules, and fiscal-risk management framework. - Reforms legislated in 2014: social welfare system, privatization law, and revenue administration reform (including strengthening enforcement powers). - Strengthened AML/CFT framework (2013-14). - Modern bank-resolution framework implemented (2013-14). - Supervisory unification and strengthening for banks and coops (2013-14). - Implementation delays and political context: - Following the break-up of the governing coalition in February 2014, the government lost its majority in parliament. - Political opposition to the program increased; signs of reform fatigue and vested-interest influence have emerged. - Difficulties emerged implementing key elements of the debt-restructuring legal framework to address NPLs; parliament approved foreclosure legislation not aligned with program objectives (some bills referred to the Supreme Court for constitutionality decisions expected later in October). - In light of legal uncertainty and delays, the completion of the fifth review has been delayed. ### Macroeconomic outlook and risks - The recession is expected to continue in 2014. - Output projection: - Real GDP projected to fall by a further 3.2 percent in 2014, bringing the 2013–14 recession to a cumulative 8.6 percent. - This cumulative contraction is 4 percentage points less than initially projected, reflecting consumption smoothing and more gradual deleveraging. - Selected economic indicator projections (percent change, unless otherwise indicated): - Real GDP: -5.4 (2013), -3.2 (2014), 0.4 (2015), 1.6 (2016), 2.0 (2017), 2.2 (2018). - Consumption: -5.6 (2013), -2.9 (2014), -0.6 (2015), 0.5 (2016), 1.3 (2017), 1.5 (2018). - Private consumption: -5.7 (2013), -2.4 (2014), -0.1 (2015), 1.5 (2016), 1.7 (2017), 1.9 (2018). - Public consumption: -5.0 (2013), -4.7 (2014), -2.1 (2015), -3.2 (2016), -0.6 (2017), -0.3 (2018). - Fixed investment: -21.6 (2013), -13.4 (2014), 1.3 (2015), 3.9 (2016), 4.6 (2017), 4.9 (2018). - Inventory accumulation (contribution to growth): -2.4 (2013), 0.0 (2014), 0.0 (2015), 0.0 (2016), 0.0 (2017), 0.0 (2018). - Foreign balance (contribution to growth): 5.0 (2013), 1.0 (2014), 0.8 (2015), 0.7 (2016), 0.4 (2017), 0.3 (2018). - HICP (period average): 0.4 (2013), 0.0 (2014), 0.7 (2015), 1.3 (2016), 1.5 (2017), 1.7 (2018). - Unemployment rate EU standard (percent): 15.9 (2013), 16.6 (2014), 16.1 (2015), 15.0 (2016), 13.7 (2017), 12.5 (2018). - Outlook caveats and policy implications: - Private consumption and investment are projected to further decline, albeit at lower rates, as deleveraging continues and the housing market adjusts. - Unemployment projected to reach 16.6 percent in 2014, and the price level to stabilize. - The macroeconomic baseline is predicated on rapidly overcoming delays in program implementation. *International Monetary Fund* ### 19. A modest recovery is expected next year. Output is ### _cr14313 - 19. A modest recovery is expected next year. Output is ### Outlook and growth projections - Output is projected to grow by 0.4 percent and expand gradually thereafter. - Private consumption will remain subdued as households: - reduce debt, - rebuild financial wealth, and - adjust to lower non-financial wealth (house prices are projected to fall by a further 5–15 percent before reaching equilibrium). - The household-saving rate is expected to further fall before rising to over 10 percent over the medium term. - Given large deleveraging needs of the corporate sector (30–60 percent of GDP), investment will recover only gradually. - The recovery is expected to be credit-less and led by service sectors less dependent on credit, such as tourism and non-financial business services. - Inflation will remain subdued relative to trading partners, facilitating a further modest depreciation of the real-exchange rate and an improvement in competitiveness. - Long-term potential growth is estimated at 2 percent, half its pre-crisis level, driven by: - modest growth in the labor force (underpinned by long-term demographic trends), - education-led productivity improvements, - subdued capital accumulation as resources shift away from construction toward tourism and non-financial services. ### Risks to the medium-term outlook - Risks are tilted to the downside. - Domestic risks: - Prolonged delays in program implementation due to political tensions could have adverse implications for confidence and the recovery. - Difficulties in addressing NPLs, including from an inadequate debt-restructuring legal framework, and delays in meeting potential bank-capital needs following the comprehensive assessment could reignite negative bank-sovereign-real-sector feedback loops. - Resistance to fiscal consolidation and reform fatigue could compromise debt sustainability. - Deeper and more prolonged private sector deleveraging, exacerbated by persistently low inflation, could weigh on domestic demand and endanger debt sustainability. - Long lasting external-payment restrictions could damage confidence and FDI, while too rapid relaxation may exhaust liquidity buffers and endanger financial stability. - External risks: - A weaker euro-area recovery would hurt Cyprus’s exports. - Relatively lower euro-area inflation could hinder envisaged improvement in competitiveness. - An increase in world oil prices due to geopolitical tensions would boost imports and intermediate costs, dampening activity. - Further escalation of sanctions and retaliatory measures related to the conflict in Ukraine could negatively affect Cyprus through: - trade channels (service exports to Russia account for over 20 percent of Cyprus’ total exports, mostly tourism), - departures of Russian companies registered in Cyprus that use Cypriot business services, - fiscal revenue declines if off-shore companies leave Cyprus (they contribute 1–2 percent of GDP in corporate income-tax revenue). - Mitigating factors: - Gradually improving quarterly national-accounts trends could result in higher growth this year. - Investment associated with the exploitation of natural gas could boost growth over the medium term. - Authorities’ view: - Broad concurrence with the outlook and some upside potential: households may save less, housing prices may be bottoming out and could modestly increase by next year, and recent gas discoveries could add upside to medium-term output. ### Public debt and external sustainability - Public debt: - Public debt rose to 112 percent of GDP at end-2013. - Debt is projected to peak at about 126 percent of GDP in 2015 and to decline gradually thereafter toward 100 percent by 2020. - Contingent liabilities associated with government guarantees on bank loans amount to 20 percent of GDP. - Implicit liabilities associated with the banks’ reliance on central bank financing amount to 55 percent of GDP. - Growth/interest rate/primary-balance shocks or a shock to growth combined with materialization of contingent liabilities could push debt to very high levels, requiring additional financing measures and commitments from European partners. - External position: - External debt remains high at 350 percent of GDP at end-2013. - The external net international-investment position was -86 percent of GDP at end-2013. - Financial-sector liabilities—mainly non-resident deposits—are large and unstable, requiring maintenance of external-payment restrictions. - Restoring external stability hinges on restoring financial-sector health, reducing public debt, and likely a more depreciated real-exchange rate (a little beyond the 0–8 percent adjustment implied by standard fundamentals-based models). - Authorities’ view: - Broad agreement on risks posed by public and external debt. - Considered public debt projections conservative given assumptions of full disbursement of the program buffer and stringent growth and inflation projections. - Noted expected upward revisions to the output level later this year (to conform to ESA2010 standards) will bring down the debt-to-GDP ratio. ### Financial sector policy — key challenges and policy directions - Overall assessment: - Banking sector is smaller and better capitalized. - Domestic payment restrictions have been eliminated (progress noted), and deposits have broadly stabilized. - High and rising NPLs, limited capital buffers in some banks, incomplete bank restructuring, narrow liquidity buffers, and still-large ELA exposure require continued attention and maintenance of some external payment restrictions. - Need to enhance bank supervision ahead of the transition to the SSM and strengthen AML/CFT implementation. - Challenge 1 — Addressing NPLs: - NPLs are very high in historical and cross-country context; they exceed what could be explained by unemployment alone. - Banks have established restructuring units; a state-backed AMC was not created given debt-sustainability concerns limiting ability to provide direct state funding or government guarantees. - The Central Bank of Cyprus (CBC) published an Arrears-Management Framework (AMF) and Code of Conduct (CoC) and developed a supervisory framework to monitor banks’ capacity and progress. - Reform needs: - Foreclosure legislation needs prompt implementation to allow a balanced but swift process without interference from government agencies; recently adopted legislative package includes important elements but also introduces obstacles (processes to delay foreclosures, moratoria, and debt-write-offs irrespective of viability) that should be removed. - Foreclosure law implementation for primary residences should be aligned with new personal-bankruptcy legislation and safety-net reform protecting those most in need. - Modernized corporate and personal-insolvency legal framework is needed to facilitate debt restructuring for viable debtors, speedy liquidation of non-viable companies, and a “fresh start” for individuals without capacity to repay. - Supervisory strengthening: - CBC should follow up on its review of banks’ operational capacity and ensure deficiencies are addressed. - The voluntary AMF and CoC should be further refined; implementation must be monitored and enforced through supervisory action. - Leverage supervisory bank-monitoring framework to encourage proactive NPL restructuring. - Consider measures to address legal and other barriers hampering sale and servicing of bank loans by third parties. - Authorities’ stance: - Recognized importance of addressing NPLs but emphasized need for adequate safeguards for households and balanced process to protect vulnerable groups. - Agreed to further refine AMF and CoC and stressed importance of supervisory enforcement. - Challenge 2 — Putting in place conditions to revive lending: - Financial sector needs strong capital buffers. - Banks were recapitalized under conservative assumptions, but stronger buffers are needed given lingering downside risks and low provisions. - The pan-European comprehensive assessment’s methodological assumptions and stress-test scenario are somewhat more stringent than those underlying initial recapitalization. - Recent developments: - Market recapitalization of Bank of Cyprus (BoC) boosted its CET1 capital ratio to 15 percent. - Hellenic Bank indicated intention to proactively increase its share capital. - Authorities should stand ready to provide additional support to the coop sector if needed, in line with the program envelope. - Mitigants for risks: commercial banks’ renewed access to markets, availability of ESM direct bank recapitalization support (under stringent conditions), and the program buffer (in excess of 10 percent of GDP). - Bank restructuring progress: - Banks and coops cut cost-to-income ratios to 40 and 50 percent, respectively, well below the European average (60 percent). - BoC finalized operational integration with Laiki and disposed of non-core activities abroad; focus should remain on overseas deleveraging and normalizing funding. - Coops should centralize management of NPLs and early arrears and strengthen governance while avoiding excessive centralization that could jeopardize franchise and business model. - Authorities’ view: - Agreed strong capital buffers and restructuring progress are key to reviving lending. - Noted high bank-funding costs—reflecting elevated risk premium due to low depositor confidence—hamper credit resumption. - Emphasized need to bolster confidence and expeditiously address any capital shortfalls identified by the comprehensive assessment. - Challenge 3 — Normalizing external flows: - Domestic payment restrictions imposed during the crisis have been gradually and successfully relaxed per the authorities’ published roadmap as key bank-recapitalization and restructuring milestones were achieved. - However, due to: - short deposit-maturity structure, - significant foreign deposits (close to 40 percent of the total), - large reliance of BoC on ELA, and - lack of other market funding, external restrictions remain in place and limit outflows, hampering trade credit and affecting overall confidence. - Restrictive measures as of end-September 2014 (Euros): - Transactions within normal business without Committee's approval: 1,000,000 - Living expenses per quarter as tuition fees: 5,000 - Payments via debit or credit card (per month): No limit - Exports of euro notes or foreign currency per person per journey: 3,000 - Monthly transfer of deposits/funds abroad regardless of the purpose: 5,000 - Policy recommendation: - Relax external restrictions gradually, taking into account depositor confidence and bank liquidity; underpin approach with careful analysis of deposit and liquidity trends and clear communication for a transparent and predictable process. - CBC should carefully monitor the effectiveness of restrictions through supervisory monitoring and inspections. *IMF staff report as presented in the source document.* ### 36. Strengthening bank liquidity will be critical to the eventual exit from external payment ### 36. Strengthening bank liquidity will be critical to the eventual exit from external payment restrictions ### Strengthening bank liquidity and exit from payment restrictions - BoC’s recent capital increase has helped improve its liquidity position and boost depositor confidence. - Disposal of foreign operations and partial redemption of the Laiki recapitalization bond have allowed a reduction in ELA. - It will take significant time to fully normalize BoC’s funding. - Measures to improve liquidity and collateral quality: - Accelerate resolution of NPLs to improve the quality of collateral and generate additional cash flow. - Further deleverage operations abroad. - Seek market (junior) funding to boost confidence, ensuring this funding does not come at an excessive cost. - Further Euro-system support to ensure adequate access to liquidity and a normalization of funding remains essential. - Authorities agreed to manage remaining restrictions cautiously: - Given heightened uncertainty associated with the comprehensive assessment, they extended existing restrictions until after the successful completion of the assessment and transition to the SSM. - Subsequent relaxations need to be gradual and based on data analysis, with recognition of the difficulty of assessing and predicting deposit behavior. - Authorities remained optimistic that relaxations could be achieved within a reasonable timeframe. - The Executive Board has recently approved retention of the existing exchange restrictions for twelve months. ### Prudential supervision and AML/CFT (Challenge 4) - Background on weaknesses: - Relaxed supervisory standards before the crisis allowed excessive credit growth, weak bank governance and risk-management practices, and fragmented standards across banks and coops. - Weaknesses in the implementation of the AML/CFT framework may have contributed to unsustainable growth of the financial sector. - Steps taken by authorities: - Issued new directives on provisioning, NPL disclosure, and loan origination. - Put in place a country-wide credit register. - Unified the supervision of banks and coops. - Strengthened the resolution authority. - Revised the AML/CFT legal framework to improve compliance with international standards. - Strengthened the CBC’s AML/CFT supervisory resources and developed risk-based tools. - Remaining priorities and recommendations: - Supervision: - The two largest Cypriot banks and the coops, representing 80 percent of the sector, will come under the supervision of the SSM in November. - Ensure adequate supervision while the banking sector is in a critical restructuring phase despite strains on the CBC’s capacity from the transition to the SSM and the ongoing comprehensive assessment. - Coordinate future supervisory priorities within the SSM; Cypriot ownership will be key to effective oversight. - AML/CFT: - Build on progress to step up implementation of the risk-based framework for AML/CFT supervision for banks and service providers by: - (i) further enhancing institutional and staff capacity, - (ii) improving coordination with prudential bank supervision, - (iii) strengthening inspection processes, risk-based tools, and the quality of reports, - (iv) improving enforcement, including by applying appropriate sanctions as needed. - CBC needs to complete its AML/CFT investigation of FBME branch operating in Cyprus, which was intervened in July following the bank’s designation by the U.S. Treasury as an institution of primary money-laundering concern. - Authorities’ view: - Agreed with the need to strengthen prudential and AML/CFT supervision and to enhance coordination with European practices. - Noted that practical details of integration with the SSM need clarification and implementation, which could take time and resources. - Considered their AML/CFT framework at least comparable to other countries but agreed on the need to strengthen implementation for banks and service providers to rebuild Cyprus’s reputation. ### Fiscal policy: objectives, progress, and required adjustments - Policy objective: - Unwind pre-crisis imbalances and put public debt on a firmly downward path. - Authorities aim to achieve a primary surplus of 4 percent of GDP by 2018 to lower public debt to around 100 percent of GDP by 2020. - Primary surpluses will need to be maintained beyond 2020 to bring debt to its pre-crisis level (50–60 percent of GDP). - Context and past deterioration: - Fiscal balance went from an overall surplus of 1 percent of GDP in 2008 to average annual deficits of 6 percent of GDP during 2009–12. - 2012 public support to Laiki bank contributed to almost doubling public debt during this period. - Consolidation to date and projected balances: - The 7 percent of GDP of measures implemented in 2013–14 are expected to help unwind some pre-crisis spending increases and partially compensate for the loss of real-estate revenue. - To attain the primary-surplus target of 4 percent of GDP by 2018, additional measures of about 3.4 percent of GDP will be needed under the current macroeconomic baseline. - Given the consolidation to date, the primary deficit is projected to decline to about 1 percent of GDP this year (representing one-third of the 2012 level and better than expected at the onset of the program by about 3 percent of GDP). - Projected primary deficit is well within the authorities’ program target established during the 4th review (1.6 percent of GDP). - In 2015, the primary deficit is projected to remain around at 1 percent of GDP. - Policy recommendations and contingent actions: - To ensure fiscal neutrality of the new welfare reform, implement permanent measures of 0.3 percent of GDP focused on improving targeting and rationalization of other social benefits. - If welfare reform costs exceed expectations, be prepared to offset these during 2015 with high-quality measures. - If macroeconomic outcomes deteriorate beyond expectations, allow automatic stabilizers to operate. - Additional adjustment measures needed from 2016 onward should be growth-friendly, balanced over time, and focus on reversing statutory spending increases before the crisis. - Rationalize the wage bill to prevent a rapid rise in public-sector wages after unfreezing, including: revising current wage levels and pay scales, eliminating automatic increases, reducing employment in overstaffed areas (i.e. education), and rationalizing public-pension lump-sum payments. - Review social benefits increased during 2008–12 and improve targeting of education subsidies while increasing tertiary-education fees. - Authorities’ perspective: - Expected a better fiscal outturn in 2014 and considered a more modest fiscal effort may be required to attain the 2018 primary-surplus target given over-performance to date and a likely stronger recovery. - Saw merit in reforming public wage-setting to better link wages with productivity but did not agree with further reducing wage levels. - Were reluctant to consider specific measures beyond those required to ensure fiscal neutrality of the welfare reform. ### Structural reforms and implementation priorities - Recent reforms and objectives: - Follow through and fully implement recently-legislated structural reforms, building on 2012 reforms of the pension system and wage-indexation (COLA) framework. - Recent reforms aim to: - (i) improve targeting, coverage, and administration of the welfare system; - (ii) unify the revenue administration and enhance its collection powers; - (iii) enhance public financial management by allowing for medium-term budget formulation, performance-based budgeting, and fiscal risk management; - (iv) facilitate privatization of state-owned assets. - Implementation requirements: - Implement remaining secondary legislation, reorganize resources and build capacity, monitor reform outcomes, and adjust reform parameters as needed. - Sequence additional medium-term reforms (e.g., healthcare and public administration) appropriately to avoid capacity overload and minimize fiscal risks. - Guaranteed Minimum Income (GMI) reform: - The unified GMI is expected to improve coverage and adequacy of public assistance, reducing relative and extreme poverty by 17 and 70 percent, respectively. - After adoption of the new law in mid-2014, authorities need to ensure adequate capacity to cope with the expansion in coverage (by about 20 percent) and carefully monitor implementation. - Build a national benefit registry cross-checked with other databases to review beneficiaries’ profiles and eligibility to prevent abuse and generate cost savings. - Revenue administration reform: - Integrate the two tax departments (VAT and direct taxes) under a unified function-based structure. - With the new legal structure in place, focus on timely implementation steps, including setting up a large taxpayers’ office and developing a new tax procedure code, aiming for full integration of tax departments over the medium-term. - Manage the transition carefully to protect revenue collections, using new collection-enforcement powers and continuing joint audits of large and high-risk taxpayers. - Fiscal risk management and debt strategy: - Monitor fiscal risks related to government guarantees (amounting to 20 percent of GDP) and put in place a government-guarantee management framework. - Address debt-structure risks, including sizeable redemptions concentrated immediately after the program period (40 percent of GDP during 2017–20) and a dysfunctional domestic debt market, via a medium-term debt-management strategy to enable eventual exit from official assistance and full return to markets. - Implement the new fiscal responsibility and budget systems law (FRBSL) by pressing ahead with secondary legislation and guidelines and strengthening budget processes. - Growth strategy priorities: - Develop a growth strategy focused on areas where Cyprus lags and where impact on growth is largest, including: - (i) opening up closed professions by streamlining licensing restrictions; - (ii) removing barriers to competition, including protection of firms and price controls; - (iii) reducing red tape; - (v) privatizing state-owned enterprises; - (vi) strengthening the legal system; - (vi) fostering innovation. - Structural reforms in these areas are estimated to have a significant impact on growth, providing an upside to medium-term growth of up to 1.5–3 percentage points. - Authorities’ view: - Agreed with identified structural reform needs and priorities. - Emphasized careful implementation of the GMI to build credibility and expected cost savings through enhanced scrutiny. - Acknowledged heightened risks during transition to integrated revenue administration and risks related to immediate/full implementation of new powers to collect tax debt. - Noted capacity constraints may challenge efforts to collect tax debt and monitor government guarantees. - Agreed on the need to develop a long-term growth strategy. ### Staff appraisal (summary) - The Cypriot economy was buffeted by an unprecedented shock in 2013, exposing large vulnerabilities and imbalances that culminated in one of the largest banking sector collapses on record. - Authorities responded with exceptional measures, including resolution of the two largest banks (both economically insolvent), recapitalization of the resulting institution through bail-in of creditors including uninsured depositors, and imposition of sweeping payment restrictions. *Source: IMF staff report text provided in content unit _cr14313 - 36. Strengthening bank liquidity will be critical to the eventual exit from external payment restrictions* ### 54. The authorities have come a long way in addressing the crisis. In the context of an ### _cr14313 - 54. The authorities have come a long way in addressing the crisis. In the context of an ### Progress in crisis response - Recapitalization of the banking sector completed "consistent with fiscal sustainability". - Financial institutions were downsized and restructured. - Domestic payment flows were liberalized. - Ambitious fiscal consolidation and structural reforms complemented financial measures and "helped Cyprus re-access international markets earlier this year." - Recent recapitalization of Bank of Cyprus cited as "an encouraging sign of the return of confidence in the financial sector." ### Remaining challenges and macro-financial vulnerabilities - The crisis imposed "a large cost on the economy and on the population." - A "painful but unavoidable recession is underway, and unemployment remains very high." - Both the private and public sectors "remain heavily indebted." - The banking sector remains vulnerable due to: - "high and rising NPLs" - "tight liquidity and capital buffers" - the need to "maintain external payment restrictions to protect financial stability" ### Implementation risks to the adjustment program - Recent delays in program implementation attributed to "heightened political opposition, entrenched vested interests, and reform fatigue." - The authorities are urged to "redouble their efforts to put the program back on track to achieve a durable economic recovery and an eventual exit from official financing." - The next Article IV Consultation is "expected to be held on a 24-month cycle in accordance with the Decision on Article IV Consultation Cycles (Decision No. 14747-(10/96) (9/28/2010))." ### Financial sector policy recommendations - Addressing Non-Performing Loans (NPLs): - Implement without delay "legislation to streamline foreclosures." - Complement foreclosure reform with "a comprehensive reform of the legal framework for insolvency." - "Strengthen supervisory incentives for banks to proactively restructure NPLs and attain sustainable solutions." - Capital buffers and bank restructuring: - "Stand ready to further strengthen capital buffers consistent with the pan-European comprehensive assessment." - Ensure continued restructuring of banks and the coop sector "including by strengthening processes and governance." - External payment restrictions: - Manage prudently to "safeguard financial stability." - Relaxation should be "predicated on a normalization of bank funding." - Approach should be "gradual and underpinned by a transparent milestone-based roadmap." - Staff "supports the request to extend existing exchange restrictions under the IMF’s Article VIII." - "Adequate support by the Euro-system to normalize bank funding and liquidity is essential." - Supervision and AML/CFT: - Maintain "tight supervisory oversight of the banking sector as they restructure." - Coordinate closely with the SSM to "ensure a smooth transition to the new pan-European supervisory framework." - Continue to strengthen implementation of the AML/CFT framework. ### Fiscal and structural policy recommendations - Fiscal consolidation: - "Additional medium-term fiscal consolidation will be needed to ensure debt sustainability." - Consolidation should be "carefully paced, rely on permanent measures, and be focused on unwinding the spending increases preceding the crisis." - Reforms implementation: - Key reforms legislated recently include the welfare system, public financial management, and revenue administration. - Authorities should "ensure that reform implementation continues and manage the transition period prudently." - "Privatization efforts should be stepped up." - "Growth-enhancing structural reforms could help increase the economy’s long-term potential." ### Key program implementation detail - Program implementation experienced "eighteen months of strong implementation" prior to recent delays. *Source: IMF staff report content as provided in the supplied PDF excerpt.* ### Annex 1. Cyprus: Risk Assessment Matrix ### Annex 1. Cyprus: Risk Assessment Matrix ### Summary of key risks, transmission channels, expected impacts, and policy responses - Risk 1 — Protracted period of slower growth in advanced economies - Relative Likelihood and Transmission Channels: High High - Description: Lower-than-anticipated potential growth and persistently low inflation due to a failure to fully address legacies of the financial crisis, leading to secular stagnation. Significant trade linkages with the EU would weaken growth in Cyprus through lower exports and tourism and adverse confidence effects. Stagnation and low inflation could complicate public debt sustainability and private sector deleveraging and negatively impact banks’ balance sheets. - Policy Response: Additional fiscal adjustment needed to attain medium-term primary fiscal surplus targets and ensure debt sustainability needs to be carefully balance to avoid a large and negative impulse in the short run. - Risk 2 — Regional geopolitical risks from increasing tensions surrounding Russia/Ukraine and the Middle East - Relative Likelihood and Transmission Channels: Medium High - Description: A sharp increase in geopolitical tensions surrounding Russia/Ukraine that creates significant disruptions in global financial, trade and commodity markets. A sharp rise in oil prices, with negative spillovers to the global economy due to tensions in the Middle East. An escalation of sanctions could reduce growth in Cyprus given strong real and financial links with Russia. High oil prices would spillover into reduced growth in Cyprus and increased external financing needs for energy-related imports. - Policy Response: Fiscal automatic stabilizers should be allowed to operate in the short run. Efforts to advance structural reforms to promote growth should be intensified. - Risk 3 — Sovereign stress re-emerges due to prolonged delay in program implementation and unanticipated outcomes from the comprehensive bank assessment - Relative Likelihood and Transmission Channels: High High - Description: Bank-sovereign-real economy links could re-intensify because of stalled or incomplete delivery of policy commitments at the national or euro-area level. Financial sector stability, growth prospects, and debt sustainability would be severely affected. Pressure on banks in the euro area could extend to Cypriot banks and reignite deposit outflows. Cyprus’s recently restored access to the capital markets could be lost again. - Policy Response: Efforts need to be intensified to put the program back on track. Banks should build capital buffers. The banking union should be strengthened and completed. - Risk 4 — Financial sector stress could reemerge due to insufficient progress in addressing NPLs or to a too rapid relaxation of external payment restrictions - Relative Likelihood and Transmission Channels: Medium High - Description: A sovereign-bank negative feedback loop could be reignited due to concerns about bank viability given high NPLs. A rapid relaxation of external payment restrictions could exhaust liquidity buffers. Deposit outflows could re-intensify. Financial sector stability could be affected, with strong repercussions on economic activity and debt sustainability. - Policy Response: The strategy supported by the EFF would need to be adjusted. Additional financing measures may be required. - Risk 5 — Weak recovery of domestic demand and inability to reduce public and private sector debt - Relative Likelihood and Transmission Channels: (implied Medium High in table layout) - Description: Debt overhang could imply low private consumption and investment for an extended period. Lower growth and increased opposition to further austerity would prolong Cyprus’s high debt problem and would hurt balance sheets. - Policy Response: Intensify efforts to reduce NPLs and promote private sector debt-restructuring. Implement medium-term fiscal consolidation. ### RAM methodology and interpretation note - The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). - The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). - The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. *Annex 1. Cyprus: Risk Assessment Matrix* ### Annex 2. Public Sector Debt Sustainability Analysis ### Annex 2. Public Sector Debt Sustainability Analysis ### Overall assessment and baseline projections - Full implementation of the program can maintain Cyprus’s debt on a sustainable trajectory, but high debt levels, downside growth risks, and large contingent and implicit liabilities make the debt trajectory vulnerable to shocks. - Key baseline projections and relevant facts: - Public debt projected to peak at 126 percent of GDP in 2015 before gradually declining toward 100 percent of GDP by 2020. - Public debt in 2013 was 111 percent of GDP. - The rise in debt in 2014–15 (from 111 percent of GDP in 2013) reflects primary fiscal deficits combined with a continued recession in 2014 and only a slight recovery in 2015. - In 2014, effects are offset by the expected conclusion of a €1 billion (6 percent of GDP) swap of debt held by the CBC for government-owned land. - Medium-term decline assumes continued fiscal consolidation under the program and a gradual pick-up in activity. - Baseline debt projections were revised up for 2014 and down for 2015 to reflect a re-phasing of ESM disbursements; path from 2016 onwards slightly revised up due to a downward revision of nominal GDP more than offsetting interest savings from partial repayment of the Laiki recapitalization bond. ### Risk assessment and debt vulnerabilities - Baseline debt level exceeds the 85 percent of GDP benchmark above which risk of debt distress is assessed to increase. - Under most adverse and combined shocks (growth, inflation, primary balance), debt could reach between 130 and 160 percent of GDP by 2020. - Market and financing signals: - Several indicators such as spreads and external financing needs point to a high-risk classification for Cyprus. - Five-year bond yields are at around 5 percent in secondary markets, compared to yields above 10 percent in 2013. - External gross financing needs remain vulnerable to growth and contingent liability shocks. - Debt structure mitigating factors: - External gross financing needs largely reflect repayment of maturing short-term debt and uninsured foreign deposits. - External payment restrictions mitigate abrupt outflow risks. - Relatively low and fixed interest rate of official liabilities combined with long-term maturity mitigates interest rate and financing risks. ### Forecasting performance and realism of assumptions - Forecasting performance has been mixed; current macroeconomic baseline remains conservative relative to macroeconomic outturns to date. - Specific projection comparisons: - 2013 real GDP outturn was -5.4 percent versus programmed projection of -8.7 percent: a 3.3 percentage points better outcome. - 2013 primary balance was -1.9 percent of GDP versus projected -2.4 percent of GDP: 0.5 percentage points better. - Medium-term projections (revised down during the fourth review) remain conservative relative to other countries that suffered banking crises and credit-less recoveries. - The projected fiscal adjustment is ambitious; cyclically-adjusted primary balance level is borderline realistic, but the authorities’ disciplined implementation in 2013–14 provides some comfort. ### Stress-test scenarios and quantitative impacts - Growth risk: - Decline in growth by two historical standard deviations (~7 percentage points) for 2015 and 2016, with non-interest revenue deterioration 0.4 percent per percentage point of growth reduction and deflator decline 0.25 percentage points per point of growth, recovering thereafter → debt increases to 167 percent of GDP by 2016 and 152 percent of GDP by 2020. - Primary balance risk: - Shock reducing planned fiscal adjustment in 2015–18 by 50 percent → debt increases to 126 percent of GDP in 2016 and 111 percent of GDP by 2020. - Interest rate risk: - Shock increasing real interest rate by 3 percentage points each year during 2015–20 → debt reaches 124 percent of GDP in 2016 and 110 percent of GDP in 2020. - Combination of macro-fiscal risks: - Combination of the growth, interest rate, and primary balance shocks above → debt ratio of 167 percent of GDP in 2016 and 157 percent of GDP in 2020. - Deflation shock: - Lower deflator growth (faster pass-through of downward wage pressures) → debt increases to 127 percent of GDP in 2016 and 113 percent of GDP in 2020. - More protracted recession: - Slower prolonged deleveraging combined with lower deflator (0.25 pt per point of growth) → debt rises to 134 percent of GDP in 2016 and to 125 percent of GDP by 2020. - Risks related to asset swap and privatization proceeds: - If 2014 debt swap not carried out → debt in 2020 would increase by about 6 percentage points of GDP. - If envisaged privatization starting in 2015 not implemented → debt would increase by about 8 percentage points of GDP in 2020. ### Contingent liability scenarios - Bank recapitalization contingent liabilities: - Additional bank needs within the program buffer (€2 billion, or 13 percent of GDP) would not have an impact on debt sustainability. - If bank needs exceed the buffer by 10 percent of GDP and are combined with a deeper recession (by 5 percentage points) → debt increases to 147 percent of GDP in 2016 and to 137 percent of GDP by 2020. - Government guarantees: - Full materialization of government guarantees (all €3 billion called) → debt reaches 129 percent of GDP in 2016 and 112 percent of GDP in 2020. ### Key indicators and historical table highlights - Selected table values (as presented): - Nominal gross public debt: 2012: 64.0; 2013: 86.6; 2014: 111.5; 2015: 117.4; 2016: 126.0; 2017: 122.5; 2018: 116.4; 2019: 111.1; 2020: 106.5; 2021: 102.6; 2022: 98.9 (in percent of GDP). - Public gross financing needs: 2012: 14.0; 2013: 18.9; 2014: 19.2; 2015: 16.4; 2016: 16.2; 2017: 9.8; 2018: 14.4; 2019: 8.0; 2020: 16.2; 2021: 14.5; 2022: 8.9 (in percent of GDP). - Real GDP growth (percent): 2012: 2.5; 2013: -2.4; 2014: -5.4; 2015: -3.2; 2016: 0.4; 2017: 1.6; 2018: 2.0; 2019: 2.2; 2020: 2.1; 2021: 1.8; 2022: 1.8. - Inflation (GDP deflator, percent): 2012: 3.1; 2013: 1.6; 2014: -1.5; 2015: -1.3; 2016: 0.7; 2017: 1.5; 2018: 1.8; 2019: 1.9; 2020: 2.0; 2021: 2.0; 2022: 1.9. - Effective interest rate (percent): 2012: 5.0; 2013: 4.4; 2014: 3.3; 2015: 2.9; 2016: 2.5; 2017: 2.4; 2018: 2.8; 2019: 3.1; 2020: 3.6; 2021: 4.0; 2022: 4.0. - Change in gross public sector debt (cumulative): 2012: 0.5; 2013: 15.1; 2014: 24.9; 2015: 5.9; 2016: 8.6; 2017: -3.5; 2018: -6.1; 2019: -5.3; 2020: -4.6; 2021: -3.9; 2022: -3.8; 2023: -5.0. - Primary balance (percent of GDP): 2012: 0.1; 2013: 3.2; 2014: 1.9; 2015: 1.0; 2016: 1.0; 2017: -1.7; 2018: -2.5; 2019: -4.0; 2020: -4.0; 2021: -4.0; 2022: -4.0; cumulative through 2023: -10.3. - Note: tables and figures assume public sector defined as general government and the baseline path assumes full utilization of program buffers. ### Implications and contingency needs - Under severe adverse scenarios (growth shock combined with higher interest rates and worse primary balance, or a deeper recession combined with materialized contingent liabilities), debt could reach very high levels (well above 150 percent of GDP). - In such scenarios, additional financing measures and commitments from European partners would be needed to protect debt sustainability. *Source: IMF staff estimates.* ### Annex 3. External Debt Sustainability and Real Exchange Rate ### Annex 3. External Debt Sustainability and Real Exchange Rate Assessment ### External debt developments (finding) - Total external debt fell from 448 percent of GDP in 2012 to 348 percent of GDP in 2013, mainly due to a halving of banking sector liabilities (mostly deposits). - At end-2013, the financial sector represented close to 45 percent of external debt. - The share of general government debt doubled from 9 to 18 percent due to official financing from the ESM and IMF. - Net international investment position (IIP) remained large and negative, at -86 percent of GDP at end-2013; the 2010 IIP level was -35 percent of GDP. ### Medium-term projections and baseline - A gradual decline in external debt is expected over the medium term: projected external debt declines to 287 percent of GDP in 2021. - Projected current account surpluses over the medium term coupled with a pick-up in GDP growth are expected to contribute to the decline in external debt. - Compared with the previous medium-term projection, external debt is expected to be lower by close to 10 percent of GDP reflecting a lower initial level of debt in 2014. - A cumulative inflation differential of about 4 percentage points relative to trading partners during 2014–20 is incorporated into the baseline projections and implies a moderate depreciation of the REER over the medium term. ### Vulnerabilities and scenario analysis - The baseline scenario is vulnerable to shocks. The external debt trajectory is most vulnerable under the historical scenario which assumes key macroeconomic variables revert to levels over the previous five years (this historical period includes the severe shock from 2013). - Alternative scenarios of shocks to growth and interest rates would substantially slow the pace of debt reduction in the medium term. - Bound-test outcomes illustrated: - Historical scenario path (figure): external debt higher than baseline (figure annotations show Historical 482 vs Baseline 287 in a chart). - Individual shocks applied: permanent one-half standard deviation shocks; combined shocks include 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance. ### Real exchange rate assessment (REER) and CGER-type results - Since its peak in 2009 (CPI-based), the REER depreciated by about 10 percent; at end-2013 it remained 3 percentage points higher than its long-run historical average (1980–2008). - Standard CGER-type methodologies suggest mixed results for equilibrium REER: - REER approach (taking into account adjustment in baseline projections): points to an overvaluation of up to 7.9 percent over the medium term. - Macro-balance approach: suggests a small undervaluation of -0.7 percent, underpinned by an estimated current account norm of -3.8 percent of GDP compared with the projected underlying value of -0.2 percent of GDP over the medium run. - External sustainability approach (stabilizing IIP at -35% of GDP, 2010 level): suggests a small undervaluation of -0.5 percent, given that the current account deficit required to maintain the IIP at the 2010 level (-2.7 percent of GDP) is higher than the long-term projected deficit under the macroeconomic baseline. - Restoring external stability likely requires further depreciation of the exchange rate beyond what standard models imply, alongside other measures. ### Policy implications and recommendations - Place the financial sector on a firmer footing: - Rebuild confidence in the financial sector. - Gradually remove external payment restrictions and reduce reliance on foreign deposits. - Fiscal policy: - Achieve and sustain primary fiscal surpluses to put public sector debt on a sustained downward path. - External adjustment: - Current account surpluses will need to be run over a prolonged period to materially improve the IIP: reducing the IIP from -86 percent of GDP to its 2010 level (-35 percent of GDP) requires running current account surpluses on the order of 5 percent for a prolonged period (10 years). - Further depreciation of the exchange rate beyond standard-model implications will likely be needed to help improve the IIP; however, an adjustment of this scale is not expected to be achieved solely through the real exchange rate. ### Key statistics and baseline projections (selected exact figures) - External debt (percent of GDP): 2009 544.1; 2010 491.9; 2011 468.2; 2012 448.5; 2013 348.0; 2014 353.2; 2015 353.6; 2016 340.9; 2017 327.8; 2018 314.2; 2019 301.0; 2020 293.1; 2021 287.5. - Change in external debt (selected): 2009 223.9; 2010 -52.2; 2011 -23.6; 2012 -19.8; 2013 -100.5; 2014 5.2; 2015 0.4; 2016 -12.7; 2017 -13.2; 2018 -13.6; 2019 -13.2; 2020 -8.0; 2021 -5.6. - Identified external debt-creating flows (summed): 2009 2.1; 2010 24.3; 2011 7.0; 2012 -23.7; 2013 59.1; 2014 8.8; 2015 -4.0; 2016 -9.4; 2017 -9.1; 2018 -10.0; 2019 -12.1; 2020 -9.7; 2021 -9.3. - Current account deficit, excluding interest payments (percent of GDP): 2009 2.5; 2010 1.4; 2011 -5.8; 2012 -3.4; 2013 -7.8; 2014 -7.0; 2015 -7.2; 2016 -7.8; 2017 -7.9; 2018 -7.8; 2019 -7.6; 2020 -7.6; 2021 -7.6. - Deficit in balance of goods and services (percent of GDP): 2009 5.5; 2010 6.2; 2011 4.3; 2012 3.1; 2013 -1.9; 2014 -2.6; 2015 -3.2; 2016 -3.8; 2017 -4.1; 2018 -4.3; 2019 -4.2; 2020 -4.2; 2021 -4.2. - Exports (percent of GDP): 2009 40.2; 2010 41.3; 2011 42.9; 2012 42.9; 2013 43.9; 2014 45.5; 2015 46.3; 2016 46.9; 2017 47.3; 2018 47.6; 2019 47.9; 2020 48.2; 2021 48.6. - Imports (percent of GDP): 2009 45.7; 2010 47.5; 2011 47.2; 2012 46.0; 2013 42.0; 2014 42.8; 2015 43.1; 2016 43.0; 2017 43.2; 2018 43.4; 2019 43.6; 2020 44.0; 2021 44.3. - Automatic debt dynamics contributions (percent): 2009 -7.4; 2010 21.1; 2011 20.0; 2012 -7.5; 2013 82.1; 2014 19.4; 2015 6.6; 2016 2.8; 2017 1.6; 2018 1.2; 2019 1.5; 2020 2.5; 2021 2.7. - Contribution from nominal interest rate (percent): 2009 8.2; 2010 8.5; 2011 9.2; 2012 10.3; 2013 9.7; 2014 8.0; 2015 8.0; 2016 8.1; 2017 8.1; 2018 8.0; 2019 7.8; 2020 7.8; 2021 7.9. - Contribution from real GDP growth (percent): 2009 5.7; 2010 -7.3; 2011 -2.2; 2012 10.9; 2013 28.2; 2014 11.4; 2015 -1.5; 2016 -5.3; 2017 -6.5; 2018 -6.8; 2019 -6.3; 2020 -5.3; 2021 -5.2. - Residual, incl. change in gross foreign assets (3/): 2009 221.7; 2010 -76.5; 2011 -30.6; 2012 3.9; 2013 -159.5; 2014 -3.6; 2015 4.3; 2016 -3.3; 2017 -4.1; 2018 -3.6; 2019 -1.1; 2020 1.7; 2021 3.7. - External debt-to-exports ratio (percent): 2009 1,352.4; 2010 1,191.4; 2011 1,091.1; 2012 1,044.8; 2013 792.1; 2014 776.5; 2015 764.2; 2016 727.2; 2017 693.2; 2018 659.5; 2019 628.8; 2020 608.2; 2021 592.0. - Gross external financing need (in billions of US dollars): 2009 50.9; 2010 103.0; 2011 93.2; 2012 79.9; 2013 81.1; 2014 46.3; 2015 41.6; 2016 39.6; 2017 38.5; 2018 39.4; 2019 40.5; 2020 40.1; 2021 38.8. - Gross external financing need (in percent of GDP): 2009 205.0; 2010 424.8; 2011 392.8; 2012 324.1; 2013 382.3. - Key macro assumptions (selected): - Real GDP growth (in percent): 2009 -1.9; 2010 1.3; 2011 0.4; 2012 -2.4; 2013 -5.4; 2014 -1.6; 2015 2.6; 2016 -3.2; 2017 0.4; 2018 1.6; 2019 2.0; 2020 2.2; 2021 2.1. - GDP deflator in US dollars (change in percent): 2009 7.1; 2010 -3.5; 2011 -2.6; 2012 6.5; 2013 -9.0; 2014 -0.3; 2015 6.9; 2016 1.7; 2017 2.5; 2018 2.9; 2019 3.0; 2020 2.9; 2021 3.0. - Nominal external interest rate (in percent): 2009 2.7; 2010 1.5; 2011 1.8; 2012 2.3; 2013 1.9; 2014 2.0; 2015 0.5; 2016 2.3; 2017 2.3; 2018 2.4; 2019 2.5; 2020 2.6; 2021 2.6. - Growth of exports (US dollar terms, in percent): 2009 -6.1; 2010 0.3; 2011 1.7; 2012 4.0; 2013 -11.9; 2014 -2.4; 2015 6.5; 2016 1.9; 2017 4.7; 2018 5.9; 2019 5.9; 2020 6.0; 2021 5.7. - Growth of imports (US dollar terms, in percent): 2009 -14.8; 2010 1.5; 2011 -2.8; 2012 1.3; 2013 -21.3; 2014 -7.2; 2015 10.3; 2016 0.3; 2017 3.4; 2018 4.5; 2019 5.4; 2020 5.7; 2021 5.8. - Current account balance, excluding interest payments (percent of GDP): 2009 -2.5; 2010 -1.4; 2011 5.8; 2012 3.4; 2013 7.8; 2014 2.6; 2015 4.5; 2016 7.0; 2017 7.2; 2018 7.8; 2019 7.9; 2020 7.8; 2021 7.6. *Source: IMF CGER Toolkit; IMF staff estimates (from Annex 3).* ### 1. This supplement provides information that has become available since the ### This supplement provides information that has become available since the issuance of the staff report on October 3, 2014. ### GDP revision for 2013 - Cyprus’s nominal GDP level for 2013 was revised up by about 10 percent. - The revision follows: - the adoption of ESA2010 methodology, - the incorporation of new data (such as the results of the 2011 population census), - and other improvements in data compilation. - Despite the shift in the level of GDP, its growth rate since 2008 was largely unchanged. - All demand components were revised, in particular: - fixed capital formation, - exports of goods & services, - imports of goods & services. - The revision was the largest among euro-area countries, and significantly larger than the euro-area average of 3 percent. - Sizes of Revision, 2013 (exact figures): - Gross Domestic Product (GDP): 9.8 percent; 1,615 (mln) - Private consumption: 7.6 percent; 865 (mln) - Fixed capital formation: 26.9 percent; 516 (mln) - Exports of goods & services: 23.9 percent; 1,779 (mln) - Imports of goods & services: 22.0 percent; 1,578 (mln) - Sources of Revision, 2013 (exact figures): - Adoption of ESA 2010: 1.0 (percent) - Incorporation of new data: 6.4 (percent) - Improved methods of compilation: 2.4 (percent) - In total: 9.8 (percent) ### Implications for macroeconomic ratios and projections - The sizeable GDP revision implies a reduction in key macroeconomic ratios due to the higher denominator: - 2013 debt-to-GDP ratio: 102 percent of GDP (rather than 112 percent) - 2013 fiscal deficit-to-GDP ratio: 4.4 percent of GDP (compared to 4.9 percent) - Private sector indebtedness: 370 percent of GDP (rather than 410 percent) - End-2013 current account deficit-to-GDP ratio: 1.7 percent of GDP (rather than 1.9 percent) - External-debt-to-GDP ratio: 317 percent of GDP (rather than 348 percent) - Public debt projections would correspondingly shift downward following the GDP level revision. *Source: Cystat; Eurostat; and IMF staff estimates.* ### 4. Other data revisions are expected later this year, that could further affect key ### _cr14313 - 4. Other data revisions are expected later this year, that could further affect key ### Data revisions and methodological changes - The adoption of the ESA2010 methodology for the fiscal accounts is expected in the last quarter of the year. - On the BoP side, the authorities are expected to switch to BPM6 in November. - These methodological changes are expected to lead to further changes to the fiscal and external accounts, which may partly offset the effect of the GDP level increase. ### Executive Board assessment — main findings and priorities - Directors commended measures to recapitalize and restructure the banking sector, liberalize domestic-payment flows, consolidate public finances, and initiate structural reforms. - Full and timely implementation of the adjustment program supported by the IMF’s Extended Fund Facility remains critical for a durable recovery. - Priority policy areas highlighted: - Address the high level of non-performing loans (NPLs) to revive credit and support growth. - Establish an effective and fair foreclosure regime, complemented by insolvency-framework reforms to facilitate debt restructuring and preserve payment culture. - Maintain capital buffers in line with the outcome of the European Central Bank’s comprehensive assessment. - Strengthen bank supervision and regulation during transition to the Single Supervisory Mechanism. - Enhance implementation of the anti money-laundering framework. - Prudently manage external-payment restrictions; relaxation should be gradual and transparent. - Continue ambitious fiscal consolidation while basing adjustment on permanent measures aimed at reversing the pre-crisis increase in spending. - Implement reforms of revenue administration, public financial management, and the welfare system; privatize state-owned enterprises and develop a strategy to boost competitiveness and potential growth. ### Macroeconomic outlook and recent developments - Recent history and program context: - Large imbalances accumulated prior to the global financial crisis culminating in the collapse of Cyprus’s banking system in early 2013. - Program supported by international financial assistance of about €10 billion, of which about €1 billion is provided by the IMF under the Extended Fund Facility arrangement, and €9 billion by the European Stability Mechanism. - About €5.75 billion has already been disbursed under the program by the IMF and the ESM. - Near-term outlook and performance: - The economy contracted sharply in 2013; output is expected to decline this year by a further 3.2 percent before recovering modestly next year. - Authorities do not expect the economy to contract more than 3.0 percent in 2014; annualized growth for the first half of the year was -2.5 percent. - Second quarter 2014 quarter-on-quarter growth rate was -0.3 percent. - Adjustment and competitiveness: - Labour costs declined by 6.5 percent in Q4 2013. - Eurostat indicated another 3.9 decrease in labour costs by Q2 2014 compared with the same quarter of the previous year. - Public sector workforce by Q2 2014 stood at levels last seen in 2007, representing a decrease of around 10 percent from their peak in 2011. - Unemployment peaked at 16 percent in 2013; fell to 15.4 percent in August 2014 (fourth consecutive monthly drop). - Inflation averaged -0.3 percent in the first eight months of 2014; HICP (period average) for 2014 projected at 0.0. ### Public finances — progress and perspectives - Fiscal performance: - Preliminary August figures point to continued overperformance; primary surplus of +2.9 percent of GDP for the first eight months of 2014. - Program target for 2014 (4th review) was a primary deficit of -1.6 percent of GDP; authorities expect to end the year with a primary surplus. - Authorities reaffirm intention to achieve a 4 percent primary surplus by 2018, while projecting a more modest fiscal effort than staff. - Debt projections and methodological caveats: - Staff expects Cyprus public debt to GDP to peak in 2015 at 126.2 per cent. - Authorities note possibility that debt to GDP may peak in 2014 and at much lower levels. - Staff’s DSA assumes full disbursement of the buffer at over €2 billion (13 percent of GDP); authorities consider this not a realistic baseline by now. - Output level revision scheduled later this year to conform to ESA2010 standards is expected to further decrease the debt-to-GDP ratio by a sizeable amount. ### Financial sector — actions and remaining challenges - Measures taken and results: - Depositors of the island’s two largest banks were bailed-in: uninsured depositors of Laiki bank bailed in using 100 percent of deposits over €100 000; uninsured depositors of Bank of Cyprus bailed in using 47.5 percent of deposits over €100 000. Total affected: €9.4 billion, including €1.5 billion of debt. - Two-week bank holiday, capital controls, and restrictions on cash withdrawals were imposed during peak turmoil; all domestic restrictions absent since May 2014. - Hellenic Bank recapitalized by new private investors in November 2013; Bank of Cyprus completed a €1 billion share capital increase in September 2014 boosting its CET1 capital ratio to 15 percent and reducing ELA dependence by another €800 million. - Merger of 93 coops into 18 entities; unified supervision of banks and coops under the Central Bank; recapitalisation of the cooperative sector; strengthened AML/CFT framework; Central Bank’s Arrears Management Framework (AMF); Code of Conduct (CoC) for borrowers and creditors; loan origination directive. - Ongoing vulnerabilities and needs: - High and rising NPLs remain a threat; many NPLs reflect strategic defaulters beyond effects of unemployment. - Need for an effective foreclosure and insolvency framework to complete the arrears resolution toolkit. - Central Bank intends to further improve the AMF and CoC upon conclusion of the SSM transition and the comprehensive assessment. ### Selected economic indicators (highlights from Cyprus: Selected Economic Indicators, 2008–20) - Real GDP (percent change): 2008 3.6; 2009 -1.9; 2010 1.3; 2011 0.4; 2012 -2.4; 2013 -5.4; 2014 -3.2; 2015 0.4; 2016 1.6; 2017 2.0; 2018 2.2; 2019 2.1; 2020 1.8. - Domestic demand (percent change): 2008 8.0; 2009 -7.0; 2010 1.9; 2011 -1.5; 2012 -3.8; 2013 -10.1; 2014 -4.3; 2015 -0.4; 2016 0.9; 2017 1.7; 2018 1.9; 2019 2.0; 2020 1.7. - Unemployment rate EU stand. (percent): 2008 3.6; 2009 5.4; 2010 6.3; 2011 7.9; 2012 11.9; 2013 15.9; 2014 16.6; 2015 16.1; 2016 15.0; 2017 13.7; 2018 12.5; 2019 11.3; 2020 10.3. - HICP (period average): 2008 4.4; 2009 0.2; 2010 2.6; 2011 3.5; 2012 3.1; 2013 0.4; 2014 0.0; 2015 0.7; 2016 1.3; 2017 1.5; 2018 1.7; 2019 1.9; 2020 1.9. - General government balance (percent of GDP): 2008 0.9; 2009 -6.1; 2010 -5.3; 2011 -6.3; 2012 -6.4; 2013 -4.9; 2014 -4.4; 2015 -3.9; 2016 -1.3; 2017 -0.8; 2018 0.6; 2019 0.2; 2020 -0.1. - General government debt (percent of GDP): 2008 48.9; 2009 58.5; 2010 61.3; 2011 71.5; 2012 86.6; 2013 111.5; 2014 117.4; 2015 126.0; 2016 122.5; 2017 116.4; 2018 111.1; 2019 106.5; 2020 102.6. - Current account balance (percent of GDP): 2008 -15.6; 2009 -10.7; 2010 -9.8; 2011 -3.4; 2012 -6.9; 2013 -1.9; 2014 -1.1; 2015 -0.8; 2016 -0.3; 2017 -0.1; 2018 -0.2; 2019 -0.2; 2020 -0.2. - Nominal GDP (billions of euros): 2008 17.2; 2009 16.9; 2010 17.4; 2011 17.9; 2012 17.7; 2013 16.5; 2014 15.8; 2015 15.9; 2016 16.4; 2017 17.1; 2018 17.8; 2019 18.5; 2020 19.2. *Source: IMF staff report and accompanying data in the provided content.* ### Conclusion ### Conclusion ### Issues raised by the Cyprus case - Modern bank resolution: the case has raised important policy issues in the area of modern bank resolution. - Program design and timing: questions about program design and timing have been highlighted. - Size of financial systems/institutions: concerns about the size of financial systems/institutions were underscored. - Corporate governance: the need to address corporate governance issues was emphasized. - Surveillance and early warnings: the inability of regulators or other international economic surveyors – including the Fund – to ring louder bells in the years leading to this was noted. - Policy inaction consequences: the island’s story serves as another stark example of how inaction can lead to severe economic dislocations. - Policy boldness: in a still fragile environment, timid policies will only postpone underlying problems which will come to haunt the country later on; firm upfront action can lead to a faster adjustment than otherwise. ### Assessment of the authorities’ response - Unprecedented shock: Cyprus faced an unprecedented economic shock in the island’s modern history. - Progress made: the authorities have come a long way in addressing the crisis. - Implementation timeframe: following eighteen months of strong implementation Cyprus finds itself in a good place to continue along the agreed path. - Vigilance: the authorities are cognizant that the achievements to date will be jeopardized if there is a hint of complacency and are therefore determined to push through their commitments even as headwinds have emerged. ### Remaining challenges and outlook - Continued challenges: as staff concludes, a number of challenges remain. - Need for guidance and careful design: with continued guidance from staff and careful policy design for the remainder of the program, the authorities are confident that Cyprus will soon return to growth and broad-based economic prosperity. - Conditional optimism: the balance of past progress and remaining risks suggests that sustained policy effort is required to secure the recovery. *Source: _cr14313 - Conclusion* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14313.pdf_