Cyprus: Staff Concluding Statement of the 2017 Article IV Mission
IMF News, October 6, 2017
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- Published: October 6, 2017
Overview and recent achievements
- The Cypriot economy has achieved an impressive turnaround since the 2012-13 banking crisis.
- Key outcomes achieved:
- GDP growth has accelerated for three consecutive years.
- Unemployment is on a declining trend.
- The underlying current account deficit has narrowed sharply alongside improved external price competitiveness.
- The fiscal balance has swung from a large deficit to a small surplus.
- Emergency bank liquidity has been fully repaid and bank deposits are rising.
- Property prices have begun to edge up following a large correction.
- Sovereign access to capital markets improved and the credit rating was upgraded to close to investment grade.
Recent developments, outlook, and risks
- Recent developments and indicators:
- GDP grew by 3.6 percent (year-on-year) in H1:2017, accelerating from 2.8 percent in 2016.
- Output lifted to 5 percent below its pre-crisis peak and narrowed the output gap to about 2 percent below its potential.
- Fixed investment is growing by more than 14 percent (with housing construction rising by 23 percent) since mid-2016.
- Fixed investment directly contributed one half of GDP growth.
- Domestic financial intermediation is contracting, reflecting deleveraging by banks, which is a drag on activity.
- Current dynamic growth momentum driven by large, mainly foreign-financed, construction projects and assumed weak payment discipline sustaining private consumption.
- Outlook and projections:
- Growth is expected to average around 3¾ percent during 2017-18, and to gradually moderate thereafter as investment projects are completed.
- Longer-term growth is expected to lift to 2½ percent as new construction alleviates capacity constraints in tourism.
- Output is expected to overshoot potential within the next few years, exerting upward pressure on prices and productivity-adjusted wages.
- NPL recovery is likely to remain subdued absent improved payment discipline.
- Risks and scenarios:
- Upside: growth could remain elevated if foreign-financed construction momentum is sustained.
- Downside: sizable risks if external financing slows abruptly (e.g., due to faster-than-expected policy tightening by major central banks) or property supply outstrips demand, potentially triggering a new boom-bust cycle.
- Continued slow NPL resolution could keep financial sector vulnerabilities elevated.
- Erosion of fiscal discipline could raise external financing costs and weaken growth.
- Cyprus’s role as a business and financial hub could be affected by international initiatives on corporate taxation or retrenchment by foreign correspondent banks.
- Growth could be significantly boosted if development of offshore hydrocarbon deposits proves financially viable.
Key policy priorities (summary)
- Consolidate achievements by:
- Significantly reducing, in a non-disruptive manner, excessive private indebtedness and banks’ NPLs.
- Ensuring growth is broad-based and avoids undue dependence on external financing.
- Avoiding procyclicality in public spending.
- Speeding up the legal process for enforcement of commercial claims.
- Enhancing competition and governance.
Achieving sustainable deleveraging and NPL reduction
- Context and challenges:
- Private sector debt remains extremely high; banks’ NPLs relative to total loans or GDP are among the highest in the world.
- Nonbank sources of liquidity (including nonpayment of debt service obligations and foreign equity financing) are supporting growth but may be finite or unreliable.
- High private indebtedness and NPLs limit prudent new bank lending and concentrate investment in a few sectors.
- Policy recommendations:
- Implement comprehensive and ambitious strategies to deliver sizable deleveraging.
- Ensure banks remain adequately provisioned and capitalized.
- Incentivize borrowers to engage with banks by strengthening legal and restructuring measures.
- Simultaneously adopt a combination of tools—debt-asset (D-A) swaps, borrowers’ repayments using their own funds, use of banks’ provisions, and lower spending by borrowers—to reduce debt and NPLs with limited GDP dampening given strong external demand.
- Improve payment discipline by:
- Further strengthening the foreclosure framework to better deter strategic default.
- Promoting use of new debt restructuring tools for corporates and individuals.
- Continuing transfer of property titles to eligible trapped buyers.
- Adopting the planned credit scoring system by the Credit Registry.
- Maintain prudent lending and loan classification standards; step up supervision of banks’ risk management practices and conduct targeted inspections of loan restructuring practices (focus on classification accuracy, frequency of re-restructurings and adequacy of provision coverage).
Fiscal policy: avoiding procyclicality
- Fiscal outlook:
- The headline fiscal position is expected to continue to strengthen during 2017-19 on strong revenue collection.
- Gross public debt relative to GDP would begin declining in 2017 and then fall significantly thereafter, while a sizable cash buffer would still be maintained to help pre-fund scheduled debt repayments.
- Forecast incorporates the planned net-neutral fiscal impact of the new National Health Service (NHS), scheduled to be rolled out in mid-2019.
- Adjusting for the economy’s cyclical position and one-offs, the structural fiscal balance would remain largely unchanged during the next few years.
- Policy recommendations:
- Cap fiscal spending by medium-term GDP growth to avoid perceiving temporary or cyclical revenue as permanent.
- Set an annual ceiling for nominal spending that increases in line with medium-term GDP growth, with downward adjustment to compensate for future tax cuts or narrowing tax bases.
- Institute a durable mechanism to keep the public-sector wage bill in check, accompanied by broader civil service reforms, while making room for growth-enhancing spending.
- Closely monitor the cost of the NHS (including establishing an arrears monitoring system).
- Improve financial oversight of municipal and local governments, semi-government organizations and state-owned enterprises; reform their governance structures.
- Further strengthen revenue administration by legislating the Tax Procedure Code.
Balanced and sustainable growth: sectoral priorities
- Real estate and construction:
- Risks of potentially unsustainable increase in construction activity, supported earlier by investment incentives including the citizenship-by-investment (CbI) scheme.
- Policy recommendations:
- Decouple the CbI scheme’s eligibility requirements from real estate to avoid concentration and risk of over-supply of luxury properties.
- Streamline procedures for issuing and transferring title deeds for new properties; ensure timely transfer of titles to buyers.
- If luxury market construction relies on domestic credit or spills over to other segments, tighten bank lending standards and raise macroprudential capital requirements.
- Consider reinstating the recently rescinded immovable property tax and raising transfer duty on immovable property to provide additional countercyclical tools.
- Enforcement of commercial claims:
- Strengthen effectiveness of commercial claims enforcement and increase efficiency of the courts to improve the investment climate and support NPL reduction.
- Policy recommendations:
- Review and update the civil procedure law.
- Modernize rules for appeals and interim injunctions to limit undue delays.
- Consider introducing a streamlined procedure for enforcement of small claims.
- Establish a commercial court and introduce specialization of judges in the lower courts for more expeditious case handling.
- Competition and governance:
- Improve the investment climate through efficiency-enhancing reforms to attract capital into innovative sectors and diversify investment beyond traditional sectors.
- Policy recommendations:
- Introduce expedited procedures for investment.
- Restart the privatization agenda and allow entry into protected sectors to increase competition and raise productivity.
- Strengthen governance and operational efficiency in key public and private sectors, including through pending reforms to state-owned enterprises and restarting privatization.
- Allow firms to absorb the 6-percentage point increase in the tax wedge on employment for funding the new NHS through improved efficiency and competition.
Cyprus: Staff Concluding Statement of the 2017 Article IV Mission — October 6, 2017.