Transcript of a Teleconference Call on Cyprus 2006 Article IV PIN, Staff Report, and Selected Issues paper

February 21, 2007

Washington, D.C., February 21, 2007

Teleconference call with:
Mr. Alexander Hoffmaister, Assistant to the Director, European Department, and Mission Chief for Cyprus.

MS. GAVIRIA: Good morning and good afternoon to those joining us from Cyprus. I am Ángela Gaviria with the External Relations Department and I am happy to welcome you to this conference call based on the Public Information Notice (PIN), the Staff Report, and the Selected Issues paper on the 2006 Article IV Consultation for Cyprus. These documents, that we posted in the Online Media Briefing Center (OMBC), and the contents of this conference call are embargoed until 10 a.m. Washington time today.

Here with me is Alexander Hoffmaister. He is Assistant to the Director in the European Department and the Mission Chief for Cyprus. He will be reading some remarks and then he will be happy to take your questions. Alexander?

MR. HOFFMAISTER: Thank you. I welcome all of you to this, our first conference call for Cyprus to discuss the Fund's Public Information Notice (PIN) and related documents. In my press conference in Nicosia on November 6, we had the opportunity to discuss the vast views on the Cypriot economy, and you will find these further elaborated in the Staff Report that we have written since we have come back, and on the Selected Issues paper. These formed the basis of the discussion of the Executive Board of the Fund and are summarized in this PIN. Today I would like to highlight the views of the Board on Cyprus, but before turning to the PIN, I would like to provide a brief update on three matters, all of which are positive.

First, on the fiscal side, strong revenue collection through December, boosted by the strength of the economy, suggests that the general government deficit has declined to about 1½ percent of GDP in 2006. This compares with 1.9 percent of GDP, which is in the report in our documents here today.

Second, reflecting considerable lower oil prices, inflation is now projected to ease in 2007-2008. In this two-year period, the Fund's new World Economic Outlook (WEO) baseline, which was updated about a month ago, shows oil prices that are about 15 percent lower than they were in early December. As a result, inflation, measured by the Harmonized Index of Consumer Prices, is now projected to fall to about 2.1 percent in 2007-2008, and this compares to 2½ percent in the Staff Report. At this stage in the WEO exercise, it is early to tell by how much lower oil prices will cut EU inflation and how this will affect the Maastricht inflation criterion.

Third, a lower fuel bill should also imply a faster-than-envisaged narrowing of the current account deficit in 2007-2008. A mechanical calculation of the impact of lower oil prices reduces the current account by about 1 percent of GDP to roughly 4½ percent of GDP in 2007 and 2008. These estimates will be refined, however, in the forthcoming WEO exercise.

Now let me turn to the PIN that, as I said, arises from the Executive Board discussion on Cyprus, which was held on January 26. I would like to center my comments on the Executive Board assessment and will organize my brief summary of this assessment into four broad areas.

Let me start with euro adoption in 2008. Directors welcomed the progress that the Cypriot authorities have made in addressing macroeconomic imbalances, specifically in lowering the fiscal deficit and reforming the economy. Indeed, Cyprus became the first new member of the EU to have its executive deficit procedure abrogated by the EU. Directors noted that continued observance of the Maastricht criteria, in particular the inflation criterion, and a smooth Euro adoption will lay the groundwork for sustained growth going forward. This will require both fiscal and wage restraint, along with policies fostering domestic competition and continued vigilance of monetary policy.

The second area discussed by the board was fiscal policy, which can be subdivided into short-term issues (2006-2007), medium-term issues, and pension reform. In the short term, Directors welcomed a favorable fiscal outturn in 2006 and the focus on durable fiscal measures in the 2007 budget. They encouraged the authorities to remain ambitious in their fiscal adjustment efforts to safeguard against inflation risks by doing three things: observing spending limits; avoiding supplementary budgets; and saving any higher-than-envisaged revenue.

In the medium term, Directors supported the authorities' intention to balance the budget by 2010 and stressed that high-quality fiscal adjustment should be ensured by keeping current expenditure in check. They welcomed the planned full implementation of the medium-term budget framework in 2008, as it will provide the institutional framework to rationalize, prioritize, and control public expenditure. Directors also considered the suspension of the ambitious public investment program to be appropriate to allow a proper legal framework and institutional setting for private-public partnership. This will help bring economic considerations to bear on the selection and procurement of public investment projects.

On pension reform, Directors called on the authorities to implement pension reforms that would allow the social security system to deal with adverse demographic trends. Prompt action would allow a more gradual phasing in of reforms and grandfathering of the rights of employees. They also noted the need to avert rising health care costs when the National Health Insurance System is introduced in 2008 and encouraged the authorities to consider adequate incentives to this end, such as user fees.

Turning to the third area addressed by the Board, the financial sector, two points were made by directors. First, they noted that commercial banks are profitable and well capitalized. Nonetheless, nonperforming loans, while declining, remained high. Rapid credit growth and brisk house price increases could become sources of risk, and the authorities should stand ready to take appropriate measures if the pace of credit growth does not abate. Second, Directors welcomed improvements in financial sector supervision, while encouraging steps to consolidate the supervision of commercial banks and cooperative credit institutions. They reiterated that, irrespective of the institutional framework, supervisors should have clear responsibilities and objectives, operational independence, professional staff, and adequate resources.

The fourth and final area discussed at the Board was sustaining economic growth by safeguarding external competitiveness. In this regard, Directors recognized that the current wage-setting process had helped smoothen labor relations, but concurred that continued high real wage increases point to the need to move towards a mechanism that will better align real wage increases with productivity developments. They welcomed progress in opening the telecommunications and energy sectors, and saw scope for further progress to enhance competition in these markets.

Let me conclude my brief summary by noting what is clear from reading the PIN: The Fund's Executive Board broadly endorsed staff's recommendations for Cyprus. I stand now ready to answer your questions.

QUESTIONER: I wonder if you have done any analysis on whether Cyprus is reaching dangerous levels for house price affordability. I know that other organizations have, this has been sort of a measuring stick for whether we are about to have a house price (inaudible). My gut instinct is that we are not there yet in Cyprus, but it will be good to know if anyone has done any analysis on that.

MR. HOFFMAISTER: As you are aware, housing prices have been an issue in a number of countries in Europe, particularly in the UK but in other countries as well. And one of the things that is important to realize is that often the indicators that we have for house prices are quite limited. Cyprus in this regard is no exception, and the price index that we have in our report suffers a number of limitations. The authorities are actually in the process of putting together a much more comprehensive measure of house prices. Having said that, I think I would have to agree with you that although prices have been increasing, these increases, compared to other countries, are more recent and of a smaller magnitude. Still, we are always looking at potential for an issue to arise, and this is what I mentioned in my opening remarks, that financial supervision has been improved in Cyprus. The key is to make sure that these mortgage loans and the risks that they eventually may pose to the financial sector are limited. And so far this is the case.

QUESTIONER: I am looking at a report in Politis newspaper on the 10th of February where it's reported that the auditor-general of Cyprus reported to the Parliament of Cyprus that the potential liability of the Republic of Cyprus states for (inaudible) expropriated could be as much as 500 million Cyprus pounds, which if I'm not mistaken is about 8 percent of GDP. At the moment the Republic of Cyprus government says we do not need to pay this until the Cyprus problem is solved. There may be an issue if some of these cases go to the European Courts of Human Rights and they say no, you must pay now. Is this an issue which the IMF has looked at?

MR. HOFFMAISTER: The short answer is no, we have not looked at that. The solution of the Cyprus problem has remained elusive for 30-odd years now; it is a very difficult situation. I do not claim to be an expert on the ins and outs of the political nuances of the problem, and I really do not have much more to say about that.

QUESTIONER: I think this might have been in the Selected Issues paper. You spoke about (inaudible) pensions issue, and obviously one way is taxing labor and another is taxing consumption. Could you explain why it is harmful to tax labor rather than consumption?

MR. HOFFMAISTER: Yes, this we have looked at in our Selected Issues, and we have also discussed it with the authorities. The short answer is labor taxes or payroll taxes fall disproportionately on people who are working and, hence, they will change the supply of labor, and this is where the negative effect arises from. Consumption taxes, the burden of which is spread more broadly across the economy, do not have a nefarious effect on the labor market and labor supply and, hence, on output growth and other macroeconomic variables. That is essentially why we recommend avoiding the use of payroll taxes. But this also goes back to a broader issue, that is, the level of benefits that are provided and how best to improve the quality of a pensioner's life, once the person leaves the work force, and this burden-sharing is very important to bear in mind. 

QUESTIONER: Does that mean that you would not favor an increase in social security contributions, a popular debate going on in Cyprus right now?

MR. HOFFMAISTER: That is right. When I referred to payroll taxes before, I was just using a different name for social security contributions.

QUESTIONER: How urgent is an overhaul of the Cypriot pension system? What is the IMF's opinion of the reforms as suggested by the government in its convergence report to the EU?

MR. HOFFMAISTER: Let me turn to your first question on urgency. It is quite urgent that the measures be put in place to reform the pension system. This is because the demographic shock, and the pressures that they will place on the economy, are quite acute in Cyprus and, hence, they require deep reforms in the pension reform system. By moving ahead promptly, the authorities will be able to, and in the general society will be able to, phase in reforms over a longer period of time. This would allow people to adjust their patterns of consumption and savings and labor supply, and would also allow the grandfathering of rights of employees under the current system.

On your second question about the measures in the convergence program, our Selected Issues paper presents our assessment of how these policies can affect the economy and, as I mentioned a little bit earlier, the chief weakness that we see in this is relying on increases in payroll taxes (social security contributions). What we propose is to address this issue by increasing other taxes, but just as importantly by adjusting the pension rule. What we are proposing is to increase the retirement age, which needs to go up to 65 years of age, and continuing increasing the retirement age, the effective retirement age, in line with gains in life expectancy.

Of course, our assessment is based on projections on population and its effects on the expenditure of the pension system; these are inherently uncertain. So, what we conclude from this is that the system should be reformed in a way so that it is adjusted periodically and automatically to trends as these develop over time. Thus, you do not get ahead of yourself or get behind. This is where the pension problem in Cyprus has arisen: the system has fallen behind the demographic trend. And now we need to institute reforms-increase the retirement age to 65 years for everyone-to catch up with those demographic trends, and then to introduce periodic and automatic adjustments to keep up with the demographic trends so that a problem does not arise in the future.

QUESTIONER: I think you mentioned in the Selected Issues paper on pensions that there was an issue about the way pensions are index linked. Is it correct that they are currently linked to wages? And I think you were recommending they should be linked to consumer prices instead, is that right?

MR. HOFFMAISTER: The pension system has two basic components. There's one for the private sector, which is called the General Social Insurance Scheme, and that one has two parts, the basic pension and the supplementary pension. The basic pension that is indexed to wages in the private sector. The public sector has a different regime called the Government Employee's Pension Scheme. Public sector employees also have a basic pension, which, as in the private sector, is linked to wages. But in addition, they have another part, which is also linked to wages.

Let me explain this a little better. In the public sector, both the basic and the other pension are indexed to wages. What we are recommending is to switch all of the benefits to be indexed to prices.

There is another element in the pension reform, which perhaps has not been discussed as much in Cyprus, arising from the relative generosity of the public system versus the private system. In the public system, at the time a person retires from the public sector, the net present value of the pension income that he or she would receive is 80 percent higher of that of a comparable person in the private sector. And so, as part of our reforms, we are also recommending addressing this mismatch in the generosity by reducing a third element that the public sector employees receive, which is a lump sum payment at the time of retirement—this can equal up to 28 times their final monthly salary; it is prorated if people have served less than the required amount. By reducing this element, we can rebalance this relative generosity and also address this age-related pension expenditure.

QUESTIONER: Just a comment on what you last said, that it would be interesting to see what the impact on house prices would be if you took away that huge lump sum payment everybody's parents get. But on another issue, the comments about the population growth figures from the governments assume quite a high level of immigration. Does that mean that you believe they are a bit overoptimistic in the amounts of immigrants expected to come to Cyprus?

MR. HOFFMAISTER: Immigration flows are a much broader issue in Europe, as you are aware. A number of countries are experiencing dramatic outflows and also some of the more advanced countries are receiving significant inflows of workers as the EU has become a larger entity. Now, we do not know, which is what I said earlier, with precision what the population will be 50 years from now or a hundred years from now. So, the important thing in reforming the pension system is that it be robust to errors in our projections, which are inherent in very long-run projections of population. In considering the uncertainty, we are thinking more along the lines of life expectancy, that is, the uncertainties of how effective new medical techniques will be in giving a person an increase in the life expectancy of individuals. But also uncertain is the fertility rate in Cyprus, and there is some discussion on how to boost it. A third element of uncertainty, which is the one you are bringing up, is immigration. All of these elements will combine to determine a projection for population. What is important, I think, is that the system be set up so it is robust to our errors and, hence, that it be adjusted automatically and periodically so that it does not fall behind the trends. If immigration flows are less than expected, then there will be a mechanism by which the system will be able to address that issue. If fertility rates are higher than expected or medical advanced are slower, then the system would be in line regardless of what happens. Let me just emphasize that it is important that the reforms catch up with the demographic shock, and once it is caught up, that it keep up with demographic trends.

QUESTIONER: I think that you said that the exchange rates, the current central (inaudible) rates of the Cyprus pound to the euro are appropriate and that you would expect it to be locked at that rate in a few months' time. Is that correct?

MR. HOFFMAISTER: As you're aware of, adopting the euro is a very extensive process. If I recall correctly, last week the authorities sent in their official request to join the euro in 2008. You can see that the track record on the fiscal front, as well as compliance with the Maastricht criteria, leads us to believe that there is very little uncertainty about Cyprus' ability of adopting the euro. But we must recognize that it's the European Commission that makes this determination, and we expect Cyprus to be judged against the Maastricht criteria in the first half of this year. And subject to a positive assessment, the Cypriot pound would be locked in sometime in the middle of 2007; the actual lock-in rate will be determined in line with the relevant Treaty provisions.

More broadly, if you look at the history of Cyprus' exchange rate, it has been fluctuating around this central parity not just for the ERM2 period, the two years that are part of the Maastricht criteria, but going back to the early 1990s—I think the exact year was 1992—without a major problem. This is why we are confident that Cyprus will be able to join and thrive in the euro area.

Let me touch on this last part, just to finish up my comments, that is very important. For the economy to thrive in the euro area, the authorities must continue with their structural reforms to improve the flexibility of the economy, particularly of the labor market, and also of reforming and making more efficient the public sector, including some of the large institutions that dominate key markets in Cyprus.

MS. GAVIRIA: Since we do not have anymore questions, we end here the conference call. I would like to thank everybody for listening in and participating.


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