Cyprus: Staff Concluding Statement of the 2022 Article IV Mission

March 30, 2022

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Washington, DC : An International Monetary Fund (IMF) mission met virtually with the Cypriot authorities from March 11–28, 2022 to discuss recent economic developments and policy priorities. At the conclusion of the visit, Mr. Wojciech Maliszewski, IMF mission chief for Cyprus, made the following statement:

The key near-term challenge is to calibrate a policy response to the economic fallout from the war in Ukraine. With automatic stabilizers allowed to operate, the 2022 budget provides sufficient fiscal support in the baseline. But additional discretionary support may be needed if the impact of the shock is larger than expected; such support should be temporary, targeted, and not hinder reallocation of labor to expanding sectors. In the medium-term, a gradual fiscal adjustment should aim to rebuild buffers by bringing the budget close to balance by 2024. To reduce financial vulnerabilities, the mission recommends a more forceful implementation of the existing deleveraging strategy: removing uncertainties in the implementation of the foreclosure framework; improving the working environment for credit acquiring companies; and using examinership and restructuring tools for viable business. Structural reforms—to strengthen governance, make the judicial system more efficient, and address skills gaps and mismatches and infrastructure gaps—are key to improve growth prospects.

Context and Outlook

1. Despite a reduction in exposures to Russia, Cyprus is highly vulnerable to the economic fallout from the war in Ukraine. Output and employment returned to pre-Covid levels last year (and Covid-related policy support has largely been phased out), but tourism has not fully recovered, and the sector is highly dependent on arrivals from Russia (about 20 percent of the total). The pandemic has had a limited impact on private balance sheets overall, but it appears to have weakened the financial position of some debtors, which may deteriorate further with the war-related shocks. The direct impact on the financial sector from sanctions will likely be limited given that exposures to Russia have diminished since the financial crisis and even more so after winding down operations of RCB Bank.

2. Growth will slow sharply before recovering in the medium term. Growth is projected to slow from 5½ percent in 2021 to around 2 percent in 2022 reflecting mainly the impact of the war and sanctions on export of services (including indirect from slower growth in Europe), and the negative terms-of-trade shock from higher energy and food prices. The recovery should regain momentum in 2023 if the situation normalizes, and it is projected to continue in the medium term with potential growth gradually increasing (from 2½ percent to about 3 percent by 2027), supported by investments and structural reforms in the Recovery and Resilience Plan. Inflation is expected to rise this year and then start declining but will remain elevated in 2023 and beyond given the prolonged pass-through.

3. Risks are tilted to the downside. The key risk is an escalation and longer duration of the war and the sanctions. Additionally, uncontrolled Covid outbreaks could lead to new lockdown measures, further disrupting the recovery of services and external demand. Globally, an abrupt monetary tightening in advanced economies could cause fiscal distress due to a rise in risk premia and undermine fiscal sustainability. Additionally, higher-than-expected credit default rates could strain banks’ balance sheets and disrupt credit supply.

Gradually Rebuilding Fiscal Buffers

4. Fiscal policy should continue providing support as needed but aim to gradually rebuild buffers. Fiscal policy was able to support the economy during the pandemic thanks to buffers built since the financial crisis. There is room, if needed, to provide further support in the face of the war-related shocks (especially considering a stronger-than-expected fiscal position last year, with the deficit declining to 1¾ percent of GDP from 5¾ percent in 2020). But given the post-pandemic elevated public debt level (104 percent at end-2021), policy should aim at restoring buffers through a gradual fiscal adjustment. The government fiscal target of a ¾ percent of GDP surplus in 2024 is consistent with this strategy but achieving it might be challenging given the war-related shocks.

5. This year’s budget provides sufficient support, but policies may need to be adjusted as more clarity emerges on the impact of the war-related shocks.

  • Automatic stabilizers should be allowed to operate fully . Given that Cyprus has a robust social safety net based on a Guaranteed Minimum Income scheme, automatic stabilizers will, by themselves, cushion the most vulnerable from the impact of the shock.
  • Additional discretionary support may be needed if the shock (or its impact) is larger or longer-lasting than expected. Additional discretionary support should be temporary, targeted, and not hinder reallocation of labor to expanding sectors. Such support could be provided by further strengthening the social safety net (e.g., by extending unemployment benefits and tying them to labor market activation and job search requirements), which could be accompanied by scaling up active labor market policies. There may be a need to provide support to viable businesses affected by the war-related shocks, especially in tourism. But such support may be less needed if growth in other segments or sectors absorbs idle workers.
  • Cushioning the impact of higher energy prices. The mission recommends stricter targeting through temporary transfers and avoiding pushing the cost of protecting households onto the energy sector.

6. Medium term fiscal adjustment to rebuild buffers will require maintaining strict fiscal discipline. Key challenges are keeping the public sector wage bill under control and strengthening finances of the National Health System (NHS). The NHS has safeguards to ensure its financial viability, but the authorities should address irregularities emerging in the system and continue with the plan to ensure financial self-sufficiency of public hospitals by [2024]. While controlling spending should be sufficient to reach the budget targets, reinstating the immovable property tax would help offset spending pressures in case they prove larger than in the baseline. The additional tax revenues could alternatively be used to scale up public investment to address growth bottlenecks.

7. Funds from the Next Generation EU (NGEU) should smooth the adjustment and support an economic transition. The total budget of Cyprus’s RRP amounts to €1.2 billion (over 5 percent of 2021 GDP). The RRP is expected to play a key role in implementing pro-growth reforms and facilitating the transition towards a greener, digital, and more sustainable economy. Absorption could be challenging though and would be helped by strengthening public investment management.

Safeguarding Financial Stability

8. Financial system has stayed resilient, but challenges remain. The impact of the pandemic on banks has been contained, with liquidity staying high and capital ratios broadly stable. But, despite recent declines, ‘stage 2’ loans—performing exposures with significantly deteriorated credit quality—have remained elevated post-pandemic. Banks have made significant progress in offloading legacy NPLs but resolving these NPLs—now residing mostly in credit acquiring companies (CACs) and the public asset management company (KEDIPES)—has been slow.

9. The worsened outlook calls for enhanced monitoring and addressing asset quality. Banks have been actively restructuring loans post-pandemic, but the problem loans appear to be concentrated in tourism-related sectors, which will likely be most affected by the war-related shocks. In addition to risk monitoring, the use of insolvency tools will be key to enable timely restructuring of viable businesses in financial difficulties. This includes timely implementation of the EU Directive on Preventive Restructuring and Second Chance.

10. Resolving legacy NPLs requires more forceful implementation of the existing tools. An effective foreclosure framework remains critical for addressing strategic defaulters and providing incentives for borrowers to engage in restructurings. A weakening of the framework would obstruct NPL resolution and pose risks for financial stability and, in this context, any uncertainties arising from the implementation of the 2019 amendments of the Foreclosure Law should be addressed. Further improvements to the working environment for CACs, including their access to the land registry database, are also important for effective NPL workouts, while their oversight should continue to be strengthened .

11. Support measures to protect living conditions of vulnerable borrowers should be well-targeted. As an alternative to foreclosure, the authorities plan to transfer primary residences and business premises with a market value below €350,000 used as collateral to NPLs (after performing a debt-to-asset swap) to KEDIPES, and introduce a subsidized mortgage-to-rent scheme for vulnerable borrowers. To avoid further weakening credit discipline, the scheme should be limited to the most vulnerable households strictly on a means-tested basis. Other safeguards should include making the support timebound; a robust transfer pricing mechanism to minimize fiscal costs and risks; and a strong governance framework with emphasis on transparency and accountability.

Structural Reforms and Green Transition

12. The RRP offers an opportunity to press ahead with reforms to address impediments to growth. Competitiveness indicators show that Cyprus has a relatively dynamic business sector, and flexible labor and product markets. But weaknesses in governance, skills gaps and mismatches, and digital and infrastructure gaps weigh on growth prospects. The RRP includes reforms to enhance the rule of law (recruiting and training judges and improving processing with a view to gradually reducing the backlog of cases); control of corruption (including the recently passed legislation on whistle-blower protection and a new independent anti-corruption agency); and government efficiency (promoting e-government, the long outstanding public service reform, and steps toward administrative decentralization). The measures to address skills gaps and mismatches include improving teaching quality, enhancing digital skills at all levels of education, and strengthening vocational education. The plan also includes public investments in digital infrastructure and steps to improve the functioning of the e-communications market. The mission recommends faster implementation of these well-targeted reforms.

13. The mission discussed plans to achieve Cyprus’s ambitious emissions reduction target. The authorities target a reduction of 32 percent for the sectors not included in the EU Emissions Trading Scheme (ETS) by 2030 (relative to 2005). To achieve the target, Cyprus aims to reduce energy dependency and enhance energy efficiency by promoting electricity generation from cleaner sources, improving electricity connectiveness, increasing energy efficiency in the residential sectors, and enhancing public transport. The government also plans to introduce a carbon tax on fuels used in non-ETS sectors. The planned measures would go a long way toward meeting the target, but financing needs to be identified and additional measures (such as feebates) may be needed to fully achieve it.

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