Interview by Phileleftheros Newspaper of Cyprus with Christine Lagarde

June 25, 2014

Published in Phileleftheros, June 8, 2014

1. How do you see the economic program one year after its start?

Cyprus is to be congratulated for an impressive program performance. Without a doubt, it has been a very difficult year, requiring deep sacrifices by society to adjust to new and challenging circumstances. But the determination of the Cypriot people to deal swiftly with the crisis and move forward contributed greatly to Cyprus being now in a much stronger position than a year ago.

For example, the progress in recapitalizing and restructuring banks and coops has already restored a sense of stability to the financial system, which has allowed for the full liberalization of domestic payment flows. Fiscal targets have been met with comfortable margins throughout the program, including in the first quarter of this year. And there have been steps to start important reforms of the social safety net, public financial management, and tax administration.

Yet, unemployment is too high and there are many hardships. The recession has been less severe than projected, but the recovery will only be gradual. The economy is still weighed down by high debt. There is still a lot of work left to do, and the full and timely implementation of reforms will be essential for the return of growth and jobs to Cyprus.

2. Which are the next steps that the Cypriot Government should implement in order to put the economy on the right track?

To restore growth and create jobs, we see three key challenges ahead. The first one is to restore the health of the banking system so that it can get back to financing investment. A key element of this is reforming the insolvency framework to spur borrowers and lenders into negotiations to restructure non-performing loans. Also, the supervisory authorities need to intensify their monitoring of banks’ actions to collect and restructure debt.

A second challenge is to maintain the health of the public finances. There has been good progress in this area, and prudent budget execution needs to be maintained, given still high risks. More efforts will be needed to bring revenues in line with spending and ensure that the very high public debt will be gradually reduced. 

The third and last challenge is to strengthen institutions to help the public sector meet the needs of the Cypriot people. For example, there is much room to improve the administration of social benefits, and I am comforted by plans to introduce a guaranteed minimum income scheme to protect all those in need. But the authorities also need to redouble their efforts to fight tax evasion and ensure that the tax burden is equally shared. And the example of many other countries shows that privatization can help reduce public debt and attract much needed foreign investment, while making the economy more efficient, which ultimately benefits all Cypriots.

3. Do you believe that Cyprus may need additional financial aid in the future?

We expect the available financial support from the European Stability Mechanism and the IMF, which totals €10 billion over three-years, to be sufficient to put Cyprus back on its feet.  But Cyprus has to do its part and implement policies under its program to address remaining weaknesses and reduce the economy’s vulnerability to shocks.

4. According to IMF forecasts, when would Cyprus return to the markets and achieve growth?

An ultimate goal of the program is indeed that Cyprus can move away from international financial assistance and finance itself in the markets. We expect modest economic growth to resume next year, and then to pick up gradually to reach 2 percent over the long run, based on stronger tourism and business services, where Cyprus can be a strong international competitor. As the economy recovers and confidence is gradually rebuilt, and assuming the program stays on track, we think that Cyprus should be able to return to capital markets in a sustained manner toward the end of the program period, provided that market conditions continue to normalize.  

5. Are the severe measures over for Cyprus or should people be prepared for more taxes and reforms the next two years of the program?

Cyprus needs to build on the progress and success achieved during the past year. Bank balance sheets will need to be further strengthened, and the reform of the debt restructuring framework is a key element in this respect. As agreed in the program from the start, additional fiscal measures will be needed in the medium-term to bring public spending in line with revenues. This will help to reduce debt and ensure that public finances remain sustainable.

6. Is the IMF concerned about the fact that banks do not have any instruments for the collection of NPLs? Why is this legislation taking so long?

At over 160 percent of GDP, or half of total bank loans, non-performing loans are a heavy burden on the Cypriot economy. As long as banks’ balance sheets are weighed down with these loans, banks cannot concentrate on providing new financing to the economy. And without financing, firms cannot operate, invest, and create new jobs. So dealing with this problem is absolutely essential not just for the banks, but also for firms and workers.  

How can non-performing loans be reduced? There are a number of tools that can be deployed. Banks have put in place policies and specialized units to deal with them. Supervisory authorities are monitoring banks’ capacity and progress with collecting these loans. And a reform of the debt restructuring legal framework is being developed according to international best practice to introduce incentives to facilitate debt restructuring. The sooner this can be completed, the sooner it will start paying dividends for employment and growth. 

Ultimately, the resolution of non-performing loans comes down to all parties showing good faith. Borrowers are responsible for making good on their obligations. And lenders need to actively and constructively work with viable borrowers who are in real difficulty to find solutions that make repayment feasible.    

7. What is your opinion about the matter of primary residence protection in Cyprus?

This is an important issue that needs to be addressed within the reform of the debt restructuring framework. On one hand, the reform should provide feasible debt repayment solutions for viable borrowers, with the aim of preserving, where possible, the primary residence. On the other hand, the reform needs to discourage those who can pay from choosing not to do so, a behavior that imposes a cost not just on the banks but on everyone. As I just said, this requires negotiations in good faith by all parties involved, including full disclosure of borrowers’ financial conditions and adequate application of existing regulations by the lenders.

8. What are your expectations about the economy in the Eurozone?

The euro area is finally emerging from recession and we project a modest economic recovery in 2014 on account of a smaller fiscal drag, stronger external demand and a gradual improvement in lending conditions to the private sector. But inflation is worryingly low, unemployment is unacceptably high, and financial fragmentation persists. This damage from the crisis—high unemployment, debt overhang, and low inflation—can only be repaired by much stronger growth. The focus needs to be on four complementary areas:  more accommodative monetary policy, well-paced and credible fiscal strategies, sound implementation of bank reform and a banking union, and structural reforms that promote growth. 

9. Also how does IMF plan to face high unemployment in the Eurozone?

Unemployment is a major concern. Youth and long-term unemployment are at extremely high levels in many countries in the euro area. There is no “silver bullet” for how best to create jobs, but we know that employment growth comes with economic growth. An additional percentage point of real GDP growth in advanced countries is estimated to lower unemployment there by about ½ percentage point, pulling over 4 million people back into work. We also think that it is essential to support demand. In this regard, more monetary easing is necessary and unconventional measures targeted at SME lending could help reduce financial fragmentation. Where possible, fiscal adjustment should be paced to avoid hurting growth. And labor and product market reforms can strengthen resilience, making economies better placed to absorb future shocks.

10. In Europe, how do you see banking union progressing, when will its benefits be felt by the population, and how will countries benefit from it?

A banking union can bring more safety and stability to the financial system of the euro area as a whole, and this is essential to boost growth and prosperity. Let me explain. Prior to the crisis in the euro area, banks and financial institutions operated with ease across countries, but the framework underpinning the safety of the system stopped at each border. The mechanisms to ensure financial stability—supervision, resolution, and safety nets—were nationally based. During the crisis, governments in many countries could not provide timely or cost effective solutions, and the framework proved inadequate to deal with the risks across Europe’s financial system. This is what a banking union needs to avoid.

There has been much progress lately in strengthening the financial framework in Europe, particularly with the creation of the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). We have strongly welcomed this progress. Looking forward, to make the banking union even stronger, one would need a common fiscal backstop to make sure that there are adequate resources to isolate and deal with problems in specific banks without involving further costs for the taxpayer.

11. How is the crisis in Ukraine affecting Europe and Cyprus?

The geopolitical tensions between Ukraine and Russia could possibly have an impact in some emerging economies and neighbouring countries, and of course on the Ukrainian and Russian economies themselves. This is mainly because investor confidence can be hurt. One should note that any impact would be felt mostly in the immediate vicinity, given their strong trade, investment and remittances channels with Ukraine and Russia. For other European countries, given that Russia supplies about one-third of Europe's natural gas, supply disruptions could have an adverse impact for both producers and users, especially if they last for an extended period.

Turning to Cyprus, while not geographically close Russia, it is linked to it through strong trade and investment channels. One fifth of total exports from Cyprus go to Russia, especially tourism services, and large investment flows between Cyprus and Russia are indicative of significant presence of Russian companies registered in Cyprus, which make use of Cypriot business services. An economic slowdown and depreciation of the currency in Russia as well as repatriation of Russian companies could affect negatively the tourism and service sectors in Cyprus, which in turn could hamper the economic recovery. So far, we have not seen any negative impact but are monitoring developments closely.


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