Cyprus -- 2010 Article IV Consultation: Preliminary Conclusions
IMF News, July 6, 2010
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- Published: July 6, 2010
Overview
- IMF mission presents preliminary findings and main recommendations of the 2010 Article IV surveillance mission.
- Key messages:
- Economic conditions have started to stabilize after the downturn; the economy is poised to return to modest growth in 2011.
- Global financial risks remain elevated and growth prospects in main trading partners remain muted, weighing on Cyprus’s outlook.
- Pressures in Euro area sovereign debt markets have intensified.
- Cyprus should act forcefully and with greater urgency to reverse high fiscal deficits to safeguard public financing sustainability and increase scope for private sector growth.
- Banking sector remains sound overall, but growth in non-performing loans calls for vigilance.
- Containing public spending growth and enhancing wage flexibility are needed to boost productivity and improve medium-term growth.
IMF Mission Concluding Statement, Cyprus — 2010 Article IV Consultation (July 6, 2010).
Economic outlook
- Crisis impact and recent developments:
- The global crisis hit Cyprus in the second half of 2009.
- Conservative financial sector practices, strict supervision, and euro adoption initially sheltered the economy.
- Deteriorating international conditions and close links with the U.K. and Russia exposed Cyprus to sharp corrections in housing demand and declines in tourism and service revenues.
- Downturn led by declines in private consumption and fixed investment and significant destocking.
- External balance:
- Current account deficit fell by more than half in 2009, to 8.5 percent of GDP.
- The current account deficit will likely stabilize in 2010 and decline gradually toward more sustainable levels over the medium term as external demand recovers.
- Growth outlook:
- The economy is projected to bottom out in 2010 and give way to a mild recovery in 2011 and stronger growth in following years.
- The mission expects growth to be around zero or slightly below in 2010, followed by a modest recovery in 2011 and a gradual acceleration in later years.
- Headwinds include sizeable increase in unemployment, declining consumer borrowing, negative confidence shock, subdued investment due to weak property and construction sectors, and restrained public consumption because of fiscal consolidation needs.
Fiscal policy
- Main challenge:
- Foremost policy challenge is reversing the large structural fiscal deficit that has emerged in recent years.
- Drivers of the deficit:
- Rapid growth in public sector wages and employment.
- Expansion of social spending, much of which was not well-targeted.
- End of the real estate boom causing enduring loss of associated revenues.
- Fiscal position and targets:
- Cyprus has moderate levels of public debt relative to many other Euro area countries, but must act to preserve this legacy and protect debt sustainability.
- Government targets reducing the deficit to below 3 percent of GDP by 2012, which would put the public debt ratio on a declining path, are appropriate but require bold measures.
- Recent measures (gradual reduction in public sector employment; foregoing general public sector wage increases) will help stabilize the deficit near last year’s levels of 6 percent of GDP, but further actions are needed to meet official targets.
- Recommended measures to reduce expenditures while keeping tax rates low:
- Reduce the wage bill and better target social transfers, given the large size of the public sector (close to half of GDP).
- Consider adjustments to incremental salary step increases.
- Introduce contributions of government employees toward their unfunded government pensions.
- Reform the cost of living adjustment to increase wage flexibility while protecting lower paid workers.
- Pensions:
- Further pension reforms are needed; last year’s reforms helped prolong solvency, but as workforce matures pension outlays will rise and outstrip contributions.
- Long-term solution will require bringing pension outlays more in line with contributions through some combination of lower replacement rates and higher retirement age.
Financial sector
- Overall assessment:
- Banking sector remains sound, helped by focus on traditional banking activities and conservative balance sheet management.
- Predominant reliance on more stable retail funding, negligible exposure to complex securities, high liquidity, and strong supervision helped shield the sector.
- Recent and ongoing stress tests by the Central Bank of Cyprus indicate the system has capacity to absorb further shocks.
- Deposits have continued to grow.
- Bank and supervisory responses:
- Banks are securing funding, preserving high liquidity, retaining a greater proportion of earnings, and tightening risk management.
- Supervisors have stepped-up vigilance and strengthened the regulatory framework.
- Significant progress in implementing European Union Directives and recommendations from the IMF’s 2008 Financial Sector Assessment Program.
- Forthcoming introduction of a legal framework for covered bonds should improve access to liquidity from markets and the European Central Bank.
- Draft law on crisis management should facilitate preemptive addressing of potential insolvency problems.
- Risks and priorities:
- Preserve stability through continued strong supervision and early detection of risks.
- Economic downturn has negatively affected bank profitability, non-performing loan ratios, and capital buffers; these pressures likely to persist until recovery.
- Large size of banking sector relative to economy and high concentration ratios mean sector problems could escalate to systemic proportions with spillovers to the economy and public finances.
- Pursue cross-border cooperation with Greece and other Southeastern European supervisors given extensive international financial linkages.
- Cooperative credit societies:
- Improve transparency and supervision to prevent undetected problems:
- Impose uniform definitions of non-performing loans across commercial banks and cooperative credit sectors.
- Apply the same stress testing framework used for commercial banks to cooperatives.
- Full and timely reporting of financial system indicators by the Authority for Supervision and Development of Cooperative Societies consistent with commercial bank requirements.
- Over the medium term, establish a single independent supervisor for all credit institutions operating in Cyprus to enhance efficiency, reduce risks, and create a level playing field.
Structural reforms
- Objectives:
- Preserve competitiveness to support near-term recovery and enhance longer-term growth potential.
- Challenges:
- Growth of wage and labor costs in excess of productivity has reduced competitiveness, particularly in manufacturing and tourism.
- Medium-term potential growth likely to be permanently lower due to the global crisis, fading construction and real estate boom, and convergence toward per capita income levels of other Eurozone countries.
- Recommended structural measures:
- Improve labor market flexibility.
- Streamline regulatory framework, reduce red tape, and improve the business climate.
- Reverse steady growth of public sector wages and employment to free resources for growth and reduce wage pressures while protecting a low tax environment.
- Implement active labor market policies:
- Training programs for low skilled and immigrant workers.
- Measures to reduce the high gender gap to ease labor market segmentation and increase productivity.
- Promote flexible forms of employment to enhance market flexibility and employment conditions.
- Reduce incentives for early retirement to enhance long-term fiscal sustainability and support labor supply in view of demographic aging.
IMF Mission Concluding Statement, Cyprus — 2010 Article IV Consultation (July 6, 2010).