Cyprus: Staff Concluding Statement of the 2023 Article IV Mission
IMF News, March 30, 2023
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- Published: March 30, 2023
Context and outlook
- Output grew by 5.6 percent in 2022, supported by pent-up domestic demand, rebounding tourism (despite a significant drop in arrivals from Russia and Ukraine), and an expanding Information and Communication Technology (ICT) sector.
- Employment recovered to pre-COVID levels and unemployment dropped to a post-financial-crisis low.
- High energy prices pushed up inflation and transmitted to core prices amid a tight labor market.
- Real GDP growth is projected to slow to around 2½ percent in 2023, reflecting erosion in households’ disposable income from inflation, tighter financial conditions, and delayed impacts from sanctions against Russia on financial and professional services.
- Growth is expected to pick up from 2024 and average 3 percent in the medium-term, supported by public investments and structural reforms under the Recovery and Resilience Plan (RRP), large ongoing and planned private investment projects, and further expansion of the ICT sector.
- Headline inflation is projected at around 4 percent in 2023 and 2½ percent in 2024; core inflation is expected to be stickier due to elevated short-horizon inflation expectations, gradual closing of the positive output gap, and labor market tightness generating wage pressures.
- Risks: downside for growth (e.g., a recession in Europe, intensification of the war in Ukraine, additional sanctions, another spike in energy prices) and upside for inflation (risk of rising inflation expectations and wage-price spiral). Tightening financial conditions could amplify macro-financial risks given high private sector debt and material exposures to the real estate sector.
Fiscal position and recommendations
- Fiscal outcomes and recent measures:
- Primary balance reached 3.8 percent of GDP (from 0.1 in 2021).
- Public debt declined to below 87 percent of GDP.
- Cost-of-living measures were mostly well-targeted and came at a limited cost to the budget (below 1 percent of GDP).
- Near-term fiscal guidance:
- Spending plans in the 2023 budget are judged appropriate; under current spending plans the mission projects a moderately lower primary surplus than in 2022, but the fiscal stance is considered sufficiently tight to help contain inflation pressures from aggregate demand.
- Support policies should fully leverage Cyprus’s well-targeted social protection system.
- As energy-related support measures expire later this year, consider adjusting the Minimum Guaranteed Income to improve effectiveness and protect vulnerable households’ purchasing power.
- Terminate remaining horizontal measures (such as the reduction of excise taxes effective until April this year).
- If downside risks materialize, allow automatic stabilizers to operate and provide further targeted support to vulnerable groups; any extension of energy support measures should be temporary, targeted and not distort price signals.
- Relax fiscal stance only if sizeable slack emerges.
- Medium-term fiscal priorities:
- Aim to maintain the public debt ratio on a firm downward path.
- Key objectives: keep the public sector wage bill under control and pilot the National Health System (NHS) to ensure financial sustainability.
- RRP implementation:
- Positive preliminary assessment of meeting the first set of milestones paved the way for payment of €85 million of grants in December 2022.
- Strengthen administrative capacity for verification procedures to ensure smooth absorption of next tranches.
- Explore amending detailed investment milestones where supply bottlenecks may render some unattainable.
Financial sector resilience and risks
- Banking sector strengths and vulnerabilities:
- Banks remain highly liquid and capital ratios are comfortably above regulatory requirements.
- Profitability improved due to higher interest rates and progress in lowering fixed costs through voluntary staff exits.
- Challenges remain: still-high NPL ratios, high household and corporate sector indebtedness (although on a declining trend) among the highest in the euro area, and material exposures to the real estate sector.
- Monitoring and policy actions:
- Enhanced monitoring is needed given likely increases in credit risk from high inflation and gradually rising borrowing costs.
- Banks should proactively use all available tools to enable timely restructuring of viable businesses in financial difficulties; recent transposition of the EU Restructuring Directive into national legislation should assist.
- The Foreclosure Law is now in effect; effective and uninterrupted operation of the foreclosure framework is critical to address strategic defaulters and incentivize borrower engagement in restructurings.
- The planned mortgage-to-rent scheme for vulnerable households—with safeguards to minimize fiscal risks—may help resolve socially-sensitive NPLs.
- Improve transparency and data disclosure by publicly disclosing Credit Acquiring Company (CAC) statistics and data; granting online access to land registry databases for CACs and Credit Servicers is a positive step.
- Macroprudential policy:
- The Central Bank of Cyprus (CBC) increased the countercyclical buffer (CCyB) rate from zero to ½ percent (beginning end-November 2023).
- The initial CCyB rate is somewhat lower than in other jurisdictions with positive neutral CCyBs; increasing the rate and buffers over time—considering bank capital-generating capacity—could provide more policy space during periods of stress.
- The CBC’s holistic approach to assessing cyclical risks—based on a range of indicators, including credit dynamics and real estate developments—provides a good basis for guiding macroprudential policy decisions.
Structural reforms and competitiveness
- Cost-of-Living Allowance (CoLA):
- The mission recommends against any upward revision to the CoLA mechanism, which would weaken economic resilience and competitiveness.
- Rationale: further increases in the public sector wage bill would reduce fiscal space; a stronger automatic link between wages and inflation would make fiscal policy more pro-cyclical. In the private sector, CoLA does not account for productivity developments, reduces adjustment capacity to adverse shocks, and deepens labor market duality (it mostly benefits public sector employees and around a third of private sector employees covered by collective agreements).
- RRP and broader structural reforms:
- RRP reforms are aligned with ‘Vision 2035’ and focus on strengthening governance and the rule of law, combating corruption, improving judicial services to reduce the backlog, and strengthening the AML/CFT framework.
- Government efforts include strengthening governance and accountability of state-owned enterprises.
- Education reforms aim to modernize the education system, address skill mismatches, and enhance digital skills to future-proof the workforce.
- Improve business environment by overcoming capacity constraints and procedural hurdles in immigration to attract foreign companies; address related housing affordability concerns with supply-side measures such as strategic rezoning and reinstatement of the immovable property tax.
- Energy and climate:
- Integration into the regional electric grid and expansion of renewables underpin energy security and greener growth.
- Cyprus has an ambitious strategy for regional electricity interconnections and expanding renewable energy capacity.
- Planned measures go a long way to achieve Cyprus’s emissions reduction targets, but financing plans should be firmed up in the context of the ongoing review of the National Energy and Climate Plan.
Key statistics and figures (as reported)
- 5.6 percent: GDP growth in 2022.
- around 2½ percent: projected GDP growth in 2023.
- 3 percent: average GDP growth in the medium-term.
- around 4 percent: projected headline inflation in 2023.
- 2½ percent: projected headline inflation in 2024.
- 3.8 percent of GDP: primary balance in 2022 (from 0.1 in 2021).
- below 87 percent of GDP: public debt level.
- below 1 percent of GDP: cost of living measures’ budgetary cost.
- €85 million: grants paid in December 2022 following a positive preliminary assessment.
- CCyB increased from zero to ½ percent (beginning end-November 2023).
International Monetary Fund. Cyprus: Staff Concluding Statement of the 2023 Article IV Mission.