Public Information Notice: IMF Concludes Article IV Consultation with Cyprus

August 24, 2000

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On August 3, 2000, the Executive Board concluded the Article IV consultation with Cyprus.1


Cyprus’s economic performance in the past quarter century has been impressive, but as the economy has increasingly come to rely on tourism as the main engine of growth, it has become more vulnerable to external shocks. Per capita GDP has more than tripled since 1974, and is now nearly 80 percent of the EU average, above that in several current EU members. Good economic management has until recently ensured full employment and low inflation. Since the mid-1980s, the fiscal deficit has averaged 4 percent of GDP, the Cyprus pound has been kept within a ±2¼ percent band around the central parity with the ECU (the euro since 1999), inflation has averaged 3.5 percent, and the unemployment rate has remained below 4 percent (below 3 percent for most of the 1990s). At the same time, significant distortions remain, including financial and capital market controls, full wage indexation (excluding recent excise tax increases), and extensive government involvement in the economy.

Growth has remained strong in recent years, with 5.0 percent real GDP growth in 1998, 4.5 percent in 1999, and 4.8 percent projected in 2000. Unemployment remains below 4 percent. Wage moderation kept inflation at low levels for most of 1999 (CPI inflation averaged 1.8 percent), but inflation accelerated sharply in late 1999 and early 2000 owing to higher energy and food prices, as well as the depreciation of the euro to which the Cyprus pound is pegged. The hike in the VAT rate from 8 to 10 percent on July 1 will trigger a new round of price increases. In addition, trade data suggest that the composition of demand in 2000 is shifting toward domestic consumption: the value of consumer goods imports rose by nearly 12 percent in the first three months of 2000 compared to the same period in 1999, while that of capital goods rose by less than 3 percent. This consumption possibly stems from wealth effects related to gains on the Cyprus Stock Exchange, which registered explosive growth in 1999, peaking in November before falling sharply.

Following a record 5.5 percent of GDP in 1998, the fiscal deficit was reduced to 4.1 percent of GDP in 1999, thanks to postponements in defense-related outlays and small indirect tax increases. The ratio of consolidated government debt to GDP reached 61 percent at end-1999, up from less than 52 percent in 1995. The long-delayed VAT rate hike took effect in July 2000, but its impact on the fiscal balance this year is to be fully offset by increased social transfers and tax cuts. Slow progress in addressing the fiscal imbalance and the rising debt burden were cited as the main factors behind S&P’s December 1999 downgrade of Cyprus’s debt rating and Moody’s May 2000 shift to a negative ratings outlook, though both ratings remain well within the investment grade range.

Financial market restrictions, including the interest rate ceiling, limit the ability of the Central Bank of Cyprus to manage liquidity. The Central Bank of Cyprus (CBC) in mid-1999 imposed ceilings to slow credit growth toward its 10 percent end-year target. Credit and broad money (M2) continued to grow rapidly in 2000 (20 percent and 18 percent in the year to April, respectively), leading the CBC in May 2000 to again impose credit ceilings for the second half of 2000 (for an aggregate credit growth target of 12 percent during the year) and increase the reserve requirement by 1 percentage point to 8 percent. Moreover, while leaving its official intervention rates unchanged, the CBC has limited refinancing to banks.

Capital and financial market liberalization are planned to be implemented by the time of EU accession. Partial liberalization has taken place for foreign direct investment (FDI) outflows by Cypriots and most FDI inflows and portfolio investments by EU residents. Parliament has approved legislation abolishing the interest rate ceiling as of January 1, 2001, and this would be accompanied by liberalization of foreign borrowing by Cypriots. Complete liberalization of short-term capital flows is to coincide with EU accession, for which the Cypriot authorities plan to be ready by January 1, 2003.

Executive Board Assessment

Executive Directors commended Cyprus’s strong record of economic growth, low inflation, and low unemployment over the last 25 years, and welcomed the wide spectrum of reforms underway to prepare its membership of the European Union (EU). Directors noted, however, that limited progress in fiscal consolidation and long-standing structural rigidities, notably backward-looking wage indexation, has contributed to the recent increase in the public debt-to-GDP ratio and to the risk of inflation. They stressed the need for the authorities to take advantage of the current strong cyclical position to reduce the fiscal deficit and adopt an appropriate medium-term fiscal policy framework that will ensure a sustainable reduction in the fiscal deficit and debt-to-GDP ratio. A few Directors noted the lack of domestic political consensus, which made it difficult to achieve further fiscal consolidation at the present time. Maintaining and reinforcing a firm stance of macroeconomic policies over the medium term, in the context of ongoing structural reforms and efforts to diversify the economy, will also be key to averting balance-of-payments pressures.

Directors noted the authorities’ intention to keep the fiscal deficit to no more than 4 percent of GDP in 2000, but stressed that sustainable fiscal consolidation will require more lasting measures. In this context, they regretted that additional revenues from the recent increase in value-added tax (VAT) rates have been offset by higher expenditures. With further rises in VAT and excise taxes required prior to EU entry, Directors viewed the ambitious reduction in the deficit to 2-2.5 percent of GDP by 2002, in line with the Finance Ministry’s Strategic Plan, as both desirable and feasible. Directors also noted that formal endorsement of this plan by the Cabinet and by the House of Representatives would greatly enhance its role as a medium-term framework for the conduct of fiscal policy.

Directors welcomed the authorities’ commitments to remove the statutory ceiling on interest rates in January 2001 and to gradually relax controls on capital movements prior to EU accession. Abolition of the interest rate ceiling and central bank independence will be crucial to enable the Central Bank of Cyprus to conduct monetary policy more flexibly and effectively. At the same time, they stressed the need to ensure that the financial sector is prepared for interest rate and capital account liberalization. Directors noted that, while the commercial banking sector appears to be strong and well-supervised, the prudential and supervisory standards applied to cooperative credit and savings societies are in need of strengthening, if these institutions are to continue to be engaged in the full range of banking business. They also observed that the recent dramatic increases in volume and volatility in the equity market underline the need to improve regulatory capacity and market infrastructure. Directors encouraged the authorities to request a Financial Sector Assessment Program (FSAP) to identify potential areas of weakness in the domestic financial sector.

Directors viewed the current central parity as being in line with fundamentals and welcomed the authorities’ intention to move to a wider exchange rate band in the context of capital account liberalization. While the latter step will help the authorities cope with the likely increase in capital volatility, a wider band should, in the view of most Directors, be combined with increased central bank independence to set interest rates in order to ensure external stability. In this connection, Directors cautioned that the use of indirect controls in 2000 might create a liquidity overhang requiring neutralization through interest rate action after the abolition of the ceiling.

Directors commended the authorities for their efforts to improve the oversight of the offshore financial sector, noting that it is subject to the same overall legal framework as the domestic banks. They welcomed the authorities’ commitment to phase out the preferential tax treatment of offshore companies. Noting the positive evaluation recently given to Cyprus for its efforts to guard against money laundering by the Financial Action Task Force, Directors urged the authorities to remain vigilant in protecting the integrity of the financial sector. They welcomed the authorities’ intention to seek the Fund’s assistance in assessing the supervision of offshore banks.

Although the labor market in Cyprus is relatively flexible, Directors encouraged the authorities to reform the current Cost of Living Allowance (COLA) system by introducing a forward-looking wage-setting system. While welcoming the recent exclusion of excise taxes from the calculation of the COLA, a number of Directors regretted the inclusion of the recent VAT increases in the indexation mechanism, as this risks exacerbating inflation.

Directors noted that macroeconomic statistics are adequate for surveillance in Cyprus, but important shortcomings remain, particularly in the timeliness of some indicators in the publication of national accounts and balance-of-payments statistics. In addition, changes in the collection of balance-of-payments statistics will be necessary as a result of the liberalization of the capital account.

Cyprus: Selected Economic Indicators

  1995 1996 1997 1998 1999 2000

Real economy            
Real GDP 6.1 1.9 2.4 5.0 4.5 4.8
Tourist arrivals 1.5 -7.1 7.1 6.5 9.5 10.9
Gross domestic investment (percent of GDP) 21.9 22.3 19.7 19.6 18.8 19.0
Unemployment rate (in percent) 2.6 3.1 3.4 3.4 3.6 3.5
Consumer prices (percent change, end-period) 1.6 2.5 3.9 1.0 3.7 5.5
Consumer prices (percent change, period average) 2.6 3.0 3.6 2.2 1.8 5.4
Real wages 3.0 2.8 2.7 2.8 2.0 2.2
Public finance            
Consolidated central government 1/            
Overall balance -1.0 -3.4 -5.3 -5.5 -4.1 -4.5
Debt net of intragovernment debt 51.4 52.9 57.2 59.6 60.9 61.6
Money and Credit 2/            
Broad money 11.4 10.5 11.0 8.3 15.4 12.6
Domestic credit 14.8 13.7 12.0 11.8 10.3 10.7
Interest rates            
13-week T-bill 3/ 6.0 6.1 5.4 5.6 5.6 5.5
10-year domestic bonds 3/ 7.0 7.0 6.9 7.1 7.2 7.4
Balance of payments            
Trade balance -24.7 -25.7 -25.2 -27.5 -26.2 -28.4
Current account -1.9 -5.3 -3.9 -6.7 -2.6 -3.4
Official foreign exchange reserves 1,837 1,713 1,527 1,513 1,976 1,902
(in months of GNFS imports) 5.0 4.3 4.2 3.7 5.5 5.3
Exchange Rates            
Pounds per U.S. dollar (end-period) 3/ 0.46 0.47 0.53 0.50 0.57 0.60
Pounds per euro (end-period) 3/ 0.59 0.59 0.58 0.59 0.58 0.58
Nominal effective (1995=100) 4/ 100.0 102.0 102.8 108.3 106.0 102.2
Real effective (CPI, 1995=100) 4/ 100.0 100.3 100.1 103.3 99.8 97.3

Sources: Cypriot authorities; and IMF staff projections under the assumption of unchanged policies.

1/ Central government (excludes local government); corresponds to the authorities’ “consolidated” budget; staff projection for 2000 assumes no additional measures are taken as of the time of the consultation discussions.
2/ Deposit money banks only; does not include credit cooperatives.
3/ Data for 2000 are the latest available, July 5.
4/ Data for 2000 are for April.

1 Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. In this PIN, the main features of the Board’s discussion are described.


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