Mission Concluding Statement 

Cyprus: Staff Concluding Statement of the 2023 Article IV Mission

March 30, 2023

Washington, DC: An International Monetary Fund (IMF) mission met with the Cypriot authorities from March 16–28, 2023 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:

Activity held up better than expected in 2022, but is projected to decelerate this year, before picking up again in 2024. Growth last year was supported by pent-up domestic demand, strong tourism revenues despite a significant drop in arrivals from Russia and Ukraine, and an expanding Information and Communication Technology (ICT) sector. High energy prices contributed to inflation, transmitting to core prices amid a tight labor market. Lower disposable income and tighter financial conditions are expected to slow growth this year. Policies should focus on locking-in the gains achieved over the last decade—including by continuing prudent fiscal policies and safeguarding financial stability—while resolving remaining legacy issues, especially high non-performing loans (NPLs) through effective implementation of the foreclosure framework. The reforms embedded in the Recovery and Resilience Plan (RRP) continue to provide an anchor to progress further on strengthening governance, addressing skill mismatches, closing the digital divide, and greening the economy.

Context and outlook

1. Cyprus’s economy has proved resilient to the fallout from Russia’s invasion of Ukraine, but surging energy prices pushed up inflation. Output grew by 5.6 percent in 2022 as consumption recovered on the back of post-COVID pent-up demand, tourist arrivals rebounded (despite the impact of the war on arrivals from Russia and Ukraine), and the ICT sector continued expanding supported by an influx of new companies. Employment has recovered to pre-COVID levels and unemployment has dropped to a post-financial-crisis low. However, high energy prices contributed to a pickup of inflation, transmitting to other prices amid the tight labor market.

2. Real GDP growth is projected to decelerate this year, but the medium-term outlook is robust. Growth is projected to slow to around 2½ percent in 2023, reflecting mostly the expected erosion in households’ disposable income from inflation, tighter financial conditions, and a delayed impact from sanctions against Russia on financial and professional services. Growth will gradually pick up from 2024 and average 3 percent in the medium-term, supported by public investments and structural reforms under the RRP, large ongoing and planned private investment projects, and a further expansion of the ICT sector.

3. High inflation is expected to gradually recede, but pressures remain. With the normalization of energy prices, headline inflation is projected at around 4 percent this year and 2½ percent in 2024. Core inflation is expected to be stickier on account of elevated short-horizon inflation expectations, the gradual closing of the positive output gap, and labor market tightness generating wage pressures.

4. Risks are tilted to the downside for growth and to the upside for inflation. A recession in Europe could adversely impact tourism. Intensification of the war in Ukraine and additional sanctions against Russia could weigh on sentiment and services exports, while another spike of energy prices would increase import costs. Should inflation expectations rise further and the pass-through to wages intensify, risks of a wage-price spiral will increase. Despite high liquidity and solid capital buffers, tightening of financial conditions could amplify macro-financial risks given high private sector debt and material exposures to the real estate sector.

Rebuilding fiscal buffers

5. The fiscal policy response to war-related pressures struck the right balance between providing much-needed support and safeguarding sustainability. Measures to address the cost-of-living crisis were mostly well-targeted and came at a limited cost to the budget (below 1 percent of GDP). Thanks to higher-than-projected revenue collection and contained expenditures, the primary balance reached 3.8 percent of GDP (from 0.1 in 2021), and public debt declined to below 87 percent of GDP.

6. In the near-term, fiscal policies should aim at helping to contain price pressures while safeguarding social cohesion:

• Spending plans in the 2023 budget remain appropriate. Under current spending plans, the mission projects a moderately lower primary surplus than in 2022, but given the projected slowdown in GDP growth, the mission considers the fiscal stance 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 are scheduled to expire later this year, the authorities may want to consider adjusting the Minimum Guaranteed Income to improve its effectiveness and protect the purchasing power of vulnerable households, while any remaining horizontal measures (such as the reduction of excise taxes effective until April this year) should be terminated.
• In case downside risks materialize, automatic stabilizers should be allowed to operate and further targeted support provided to vulnerable groups. If necessary, any extension of energy support measures should be temporary, targeted and not distort price signals. The fiscal policy stance should be relaxed only if sizeable slack emerges.

7. Over the medium term, fiscal policy should aim at maintaining the public debt ratio on a firm downward path. Prudent fiscal management in the past created fiscal space that later helped cushion the impacts from the COVID-19 pandemic and from Russia’s invasion of Ukraine. Rebuilding this space by maintaining the public debt ratio on a downward path would be commensurate with challenges that Cyprus may face in the future given its size, reliance on services exports to a few markets, and remaining vulnerabilities in private sector balance sheets. Key policy objectives include keeping the public sector wage bill under control and piloting the National Health System (NHS) with a view to ensuring financial sustainability.

8. RRP investments in energy connectivity, renewables, and digitalization can unlock a higher growth dividend. The positive preliminary assessment of meeting the first set of milestones paved the way for payment of €85 million of grants in December 2022. Demanding verification procedures may require further strengthening administrative capacity to ensure smooth absorption of the next tranches, and the mission welcomes steps in this direction. The authorities should also explore amending the detailed investment milestones, as supply bottlenecks may well render some of them unattainable.

Safeguarding financial stability

9. Significant progress has been achieved in improving banks’ resilience, but vulnerabilities remain. Banks remain highly liquid, and capital ratios are comfortably above regulatory requirements; higher interest rates, as well as progress in lowering fixed costs through voluntary staff exits, helped raise traditionally low profitability. But the strong capital position is encumbered by still-high NPL ratios, and household and corporate sector indebtedness, although on a declining trend, remain among the highest in the euro area, pointing to borrower-side vulnerabilities.

10. The potential impact of financial tightening on credit quality calls for enhanced monitoring. Spillovers from recent turmoil in international financial markets have so far been muted, thanks to limited exposure and a stable funding base. However, high inflation and gradually rising borrowing costs are likely to increase credit risk amid elevated private sector debt levels, while significant exposure to the real estate sector exposes banks and credit acquiring companies (CACs) to collateral revaluation risks. In addition to risk monitoring, banks should proactively use all available tools to enable timely restructuring of viable businesses in financial difficulties; this should be helped by the recent transposition of the EU Restructuring Directive into national legislation.

11. An effective foreclosure framework remains key to resolving legacy NPLs. The effectiveness of the Foreclosure Law has until now been hindered by repeated suspensions. The law is now in effect, which is critical for addressing strategic defaulters and providing incentives for borrowers to engage in restructurings. Alongside the unperturbed operation of the foreclosure framework, the planned mortgage-to-rent scheme for vulnerable households—with safeguards to minimize fiscal risks—may help resolve socially-sensitive NPLs. Separately, good progress has been made in improving the working environment for CACs and Credit Servicers by granting them online access to land registry databases; transparency should be enhanced by publicly disclosing CAC statistics and data.

12. The mission welcomes the revision of the macroprudential policy strategy. To strengthen banking sector resilience, the Central Bank of Cyprus (CBC) increased the countercyclical buffer (CCyB) rate from zero to ½ percent (beginning end-November 2023) at a time when risks are assessed as broadly neutral. This initial rate is somewhat lower than in other jurisdictions with positive neutral CCyBs, and increasing the rate and buffers over time—considering bank capital-generating capacity—could provide more policy space during periods of stress. Besides, 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 policies to enhance competitiveness and living standards

13. The mission recommends against any upward revision to the Cost-of-Living Allowance (CoLA) mechanism, which would weaken economic resilience and competitiveness. For the public sector, further increases in the relatively high wage bill would reduce fiscal space, while a stronger automatic link between wages and inflation would also make fiscal policy more pro-cyclical. For the private sector, the mechanism does not account for productivity developments and reduces the ability to adjust to adverse shocks, weighing on resilience and competitiveness. Moreover, higher CoLA would deepen duality in the labor market, as it mostly benefits public sector employees and around a third of private sector employees covered by collective agreements.

14. The implementation of structural reforms in the RRP and improving business environment would enhance medium-term growth prospects. Structural reforms in the RRP are aligned with the ‘Vision 2035’—a strategic development plan garnering broad political consensus and a focal point for policies of the new government. Key reform areas include strengthening governance and the rule of law, including by combating corruption, improving judicial services to reduce the backlog of court cases, and strengthening the AML/CFT framework. The government also started efforts to strengthen governance and accountability of state-owned enterprises to exercise public ownership more effectively. In the area of education, reforms aim at modernizing the education system to address skill mismatches and future-proof the workforce, including by enhancing digital skills. Cyprus is already successfully leveraging its strategic location to attract foreign companies, but overcoming capacity constraints and procedural hurdles in immigration would make it a more desirable destination for investors. The related housing affordability concerns emerging in some areas (residential housing prices are generally aligned with economic fundamentals) could be addressed by supply side measures like strategic rezoning and reinstatement of the immovable property tax.

15. Integration of Cyprus into the regional electric grid and expansion of renewables will underpin energy security and greener growth. Cyprus has in place an ambitious strategy to develop regional electricity interconnections and expand its renewable energy capacity. Planned measures go a long way to achieve Cyprus’s ambitious emissions reduction targets, but financing plans should be firmed up in the context of the ongoing review of the National Energy and Climate Plan.

The IMF team would like to thank the Cyprus authorities and other stakeholders for their hospitality, engaging discussions, and productive collaboration.