Public Information Notice: IMF Concludes Article IV Consultation with Cyprus

August 14, 1998

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.

The IMF Executive Board on July 24, 1998 concluded the 1998 Article IV consultation1 with Cyprus.


Cyprus’ economic performance during the last decade has been remarkable, but a string of adverse shocks dampened growth in 1996–97. During the early 1990s, output grew by more than 4 percent a year, with near-full employment conditions and relatively low inflation. Growth has been volatile, however, reflecting the ups and downs of the large tourism sector, which accounts for 20 percent of GDP, 20 percent of employment, and 40 percent of foreign exchange earnings. Output growth slowed to about 2 percent per annum in 1996–97: disturbances along Cyprus' "Green Line" induced a significant fall in tourism receipts in 1996, and a severe drought that began in 1996 has continued through 1997 and into 1998. Food price increases pushed inflation up from 3 percent in 1996 to 3.6 percent in 1997. However, by May 1998, declining commodity prices had helped lower the 12-month increase in the CPI to 2.5 percent.

Cyprus' external current account shifted from a balanced position on average in the period 1993–95 to a deficit of 5 percent of GDP in 1996–97. This deterioration reflects chiefly the effects of expansionary aggregate demand policies and the adverse shocks to tourism and agricultural exports, but it has also been accompanied by negative trends in cost competitiveness and export market shares since the early 1990s. Unit labor costs have risen faster in Cyprus than in partner and competitor countries, inducing first a fall and then, most recently, a stagnation in the export market share of the important services sector. Labor cost increases stem in part from a rigid wage formation system, with wages fully indexed to past inflation. However, with the Cyprus pound pegged to the European currency unit (ECU) (within margins of plus or minus 2¼ percent), the recent appreciation of the U.K. and U.S. currencies has helped maintain the CPI-based real effective exchange rate almost unchanged. Despite the widening of the external current account deficit, foreign debt remains relatively low: public external debt stands at 21 percent of GDP, and private debt at 9½ percent. Gross official reserves are equivalent to 5½ months of imports.

Prior to 1996, the government’s medium-term fiscal objective was to observe the Maastricht criteria, but, faced with adverse influences on output, the course of policies shifted in 1996. The fiscal deficit rose from 1 percent of GDP in 1995 to 5.1 percent in 1997, driven by increased spending on defense, transfers, and wages. Revenues remained fairly stable as a share of GDP, despite trade liberalization reducing customs revenues by 1½ percentage points of GDP. The debt-to-GDP ratio increased by 4 percentage points, to 55½ percent at end-1997.

The fiscal outlook has deteriorated further in 1998. The authorities have sent a strong fiscal package to parliament for consideration in October—including a rise in the value-added tax rate from 8 to 12 percent; increases in excise taxes; and cuts in filling vacant and new civil service positions. The proposed measures, if adopted, are expected to reduce the deficit to 5–5½ percent. This would entail a further rise in the debt-to-GDP ratio.

In terms of monetary policy, the central bank’s strategy has been geared to maintaining the peg to the ECU, but extensive capital controls have allowed policy to respond to domestic demand conditions. Monetary policy management shifted from direct to indirect credit controls in January 1996, but the legal interest rate ceiling of 9 percent on lending remained. To support the recovery, in March 1997, the central bank administratively reduced deposit and lending rates by 50 basis points, to 6½ and 8 percent, respectively. Credit and broad money rose rapidly during 1997, by 12 and 11 percent, respectively.

Executive Board Assessment

Executive Directors commended the authorities for the pursuit of policies that had produced an enviable growth record over most of the past two decades. They noted, however, that policies had turned unduly expansionary since 1996 in an effort to offset adverse shocks to tourism and agriculture, and that the fiscal position and the external current account had deteriorated. Directors stressed that corrective policies were now needed to address domestic and external imbalances, especially if the benefits of the planned financial and capital account liberalization were to be maximized. Directors also stressed that structural measures were needed to broaden the economic structure to reduce the reliance on tourism and banking.

Directors noted the relatively positive outlook for tourism receipts in 1998, which was expected to help contain the current account deficit and raise output growth to above 4 percent. Lower commodity prices were also set to facilitate a modest reduction in inflation. Economic conditions were thus propitious for fiscal adjustment and the initiation of structural reforms to harmonize with European Union policies.

Accordingly, Directors welcomed the proposed corrective fiscal package recently sent to parliament. Given the parliamentary delay—to October 1998—in consideration of this package, however, they underscored the need for the government to develop a plan of action to cut spending, relying on administrative measures to the extent necessary, and limiting public wage increases to no more than the cost of living adjustment. In this connection, Directors noted that, in the absence of corrective policies, the fiscal deficit could widen even further in 1998, leading to a sharply higher debt/GDP ratio, weaker current account prospects, and potentially a loss of investor confidence during a crucial phase of financial liberalization.

Directors supported the authorities’ medium-term goal of fiscal consolidation, which would be adopted in the five-year plan under formulation. They regarded a medium-term fiscal deficit target of about ½ of 1 percent of GDP as appropriate, as this would allow the full play of automatic stabilizers. While noting that such a target would be facilitated by the required harmonization of value-added tax rates with the EU, Directors placed much greater emphasis on spending restraint so as to preserve Cyprus’ lean and efficient government.

Directors supported the authorities’ intention to shift the exchange rate peg from the ECU to the euro in January 1999, at the current implied parity. They emphasized that the medium-term sustainability of the peg depended crucially on curbing domestic cost pressures. This called for greater wage flexibility and a move to forward-looking wage determination. Shifting to a more flexible wage determination system was even more important now that Cyprus’ efforts to integrate with Europe were being stepped up. Directors also saw a need to consider raising interest rates in the period ahead, if parliamentary approval of the corrective fiscal package is not forthcoming.

Directors warmly welcomed the authorities’ intention to lift the interest rate ceiling in fall 1998. Directors also supported the gradual and cautious approach toward capital account convertibility. They cautioned, however, that opening the capital account at the short end at the outset of the liberalization process would increase vulnerability. Directors thus encouraged the authorities to take steps to further strengthen the financial system’s regulatory and supervisory framework prior to liberalizing short-term flows. They welcomed the steps already taken in this area, such as the approval of the banking law by parliament last year, which had importantly reinforced the central bank’s supervisory capabilities. Much remained to be done, however, in the supervisory and regulatory framework that applies to credit cooperatives, as they have less stringent prudential standards than commercial banks. It was stressed that the credit cooperatives needed to have sufficient capital and be properly supervised to preserve the soundness of the financial system as a whole in a newly liberalized environment.

Directors commended the authorities for having accelerated the pace of trade liberalization in recent years, and encouraged them to continue liberalizing trade in agriculture.

Cyprus: Selected Economic Indicators

  1994 1995 1996 1997 1998 1/

Real economy (change in percent)  
Real GDP 5.8 5.6 2.0 2.3 4.2
Domestic demand 6.6 9.2 3.7 0.8 4.0
CPI (year average) 4.7 2.6 3.0 3.6 3.0
Unemployment rate (in percent) 2.7 2.6 3.1 3.4 3.1
Gross domestic saving (percent of GDP) 26.5 23.9 21.0 19.8 19.9
Gross domestic investment (percent of GDP) 25.5 26.4 26.5 24.8 24.2
Public finance (consolidated central government, percent of GDP)  
Overall balance -1.4 -1.0 -3.4 -5.1 -5.3
Primary balance 3.7 4.1 1.9 0.2 0.2
Debt 53.5 51.8 53.1 55.6 59.8
Money and Credit (End of year, percent change)  
Domestic credit 10.9 14.8 13.7 11.9 ...
M2 12.5 11.5 11.0 11.0 11.0
Interest rates (percent)  
Interbank money market rate2 7.5 7.4 6.9 4.8 4.6
Government bond yield3 7.0 7.0 7.0 6.9 7.2
Balance of payments (percent of GDP)  
Trade balance -24.6 -24.9 -25.8 -25.3 -24.9
Current account 1.0 -2.3 -5.4 -4.5 -4.0
External debt 28.5 24.7 22.1 25.0 ...
Official reserves (US$ billion)4 1,427 1,079 1,505 1,357 1,253
Reserve cover (months of imports of GNFS) 5.8 6.2 5.6 5.4 ...
Exchange rate  
Exchange rate regime Pegged to the ECU
Present rate (June 16,1998-US$/£C) 1.89
Nominal effective exchange rate (1990=100)4 109.66 113.8 116.0 116.9 121.4
Real effective exchange rate (1990=100)4 105.6 106.7 107.0 106.8 107.7

Sources: Information provided by the Cypriot authorities; and IMF staff estimates.

1 Staff projections.
2 For 1998, average of first four months.
3 For 1998, average of first five months.
4 For 1998, data
correspond to April.

1Under 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 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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