Cyprus-2006 Article IV Consultation

Preliminary Conclusions
Nicosia, November 6, 2006

1. Cyprus's distinctive geographical location and EU membership provide it with unique opportunities. As the eastern-most country in the EU, Cyprus can serve as a beacon of prosperity and tranquility for the region. Moreover, it is naturally placed to become a gateway to the East and emerge as a hub of business operations in the region.

2. Since the last IMF consultation in 2004, per capita income has increased steadily toward EU levels, and economic growth has recovered despite high oil prices and shocks to the tourism sector. Robust economic activity has been safeguarded by prudent economic policies, with the reduction in the fiscal deficit laying the foundation for a flourishing Cypriot economy. Income convergence with the EU will continue as economic growth is expected to outpace that of the EU in the near future. However, safeguarding the economy against adverse shocks and taking full advantage of the opportunities available to Cyprus will require continued efforts to address short term risks and medium term pressures. Against this background, we wish to highlight four issues that the Cypriot economy faces.

A. Adopting the Euro

3. Cyprus is well placed to benefit from adopting the euro. The euro area is Cyprus's largest trading partner, and trade linkages with the euro area are set to strengthen further with the introduction of the euro. The range of profitable business opportunities will expand as transaction costs and exchange rate risks decline. Moreover, economic activity can benefit from the boost provided by lower interest rates. Indeed, the authorities' efforts to adopt the euro have already benefited the economy through reduced interest rates and increased FDI and other capital inflows.

4. We support the authorities' target to adopt the euro on January 1, 2008. Preparations are well underway with the establishment of a number of committees devoted to the task. The public information campaign, spearheaded by the National Advisory Committee for Euro Changeover, is set to shift into high gear as the process moves forward. In this connection, there is a need to address the public's concern about rounding up of prices. The experience in the euro area countries is clear: rounding-up was limited, contained to prices in certain categories, such as, restaurants, cafes, and hairdressers in a few countries. Abusive price behavior can be limited by the planned dual display of prices before and after the euro changeover. Also, fostering vigorous domestic competition can help drive abusive retailers out of the market.

5. A number of issues need to be addressed in the run up to euro adoption. The experience in ERM2-which follows the economy's successful operation under a similar exchange rate mechanism since 1992-has so far been smooth. The targeted adoption date implies that Cyprus would be evaluated against the Maastricht criteria sometime in the first half of 2007, with the exchange rate locked in at a rate determined in consultation with the European Council. Various studies, both by the authorities and independent analysts, suggest that the exchange rate is broadly in line with its equilibrium rate. Accordingly, the key for Cyprus to thrive in the euro area lies in adopting reforms that would prevent lapses in productivity and boost competitiveness. Regarding macroeconomic policies, there is no room for complacency. Although inflation has declined recently, policies must be geared toward containing inflationary pressures. In this regard, since the scope for monetary policy is limited by Cyprus's participation in ERM2, fiscal policy must take center stage.

B. Safeguarding Fiscal Consolidation

6. Fiscal consolidation has proceeded resolutely, and the Convergence Program envisages further reductions in the fiscal deficit. The fiscal deficit was cut in half in two years to under 3 percent of GDP in 2005, and it is expected to fall below 2 percent of GDP in 2006. Tight fiscal policy has enabled public debt to return to a sustainable path and resulted in the cancellation of the Excessive Deficit Procedure in July. Cyprus thus became the first new EU member country to achieve this distinction. It is essential, however, to safeguard and build on these accomplishments.

7. In the short term, fiscal consolidation will require keeping public expenditure under tight control. Any higher-than-expected revenue should be saved and used to reduce public debt, which will be facilitated by the authorities' decision to discontinue the use of supplementary budgets starting in 2007. Besides allowing automatic stabilizers to operate, this decision would help resist pressures for additional expenditure before the 2008 presidential elections. Moreover, quicker fiscal consolidation can help contain inflationary pressures and address the long term fiscal challenges related to aging of the population.

8. Looking forward, besides targeting further consolidation, the 2008 budget will see the welcome full implementation of a Medium Term Budgetary Framework (MTBF). It is envisaged to cover a rolling three-year horizon-the budget and two additional years-with binding expenditure ceilings in each year. The MTBF will help rationalize, prioritize and control public expenditure, and is part of a much needed broader reform aiming at strengthening financial management, including that of public investment.

9. The ambitious public investment plan could jeopardize the hard-won fiscal consolidation. Effective ex ante cost benefit analysis (CBA) is needed to inform the decision to undertake a particular project. Moreover, value-for-money considerations, not budgetary expediency, must guide the judgment of whether to carry out a project as a Private Public Partnership (PPP) or by traditional methods of procurement. In this regard, we support the authorities' decision to halt all new PPP projects until the proper legal framework for PPPs and the required institution reforms are in place. The authorities intend to delegate to the Planning Bureau the role of carrying out effective ex ante CBA. This, together with the establishment of a PPP unit and a control and monitoring (gateway) system for PPP projects, will provide the needed institutional framework.

10. The key long term fiscal issue in Cyprus is the aging-related expenditure pressure. Since the current social security system was introduced about 25 years ago, rising life expectancy and a reduction in the retirement age in early 1990s have increased the average retirement period from 10 to 17 years. Moreover, declining fertility rates have contributed to a demographic shock that is expected to result in sharply higher dependency ratios. Although in the course of our discussions we found a growing awareness among social partners of the need to reform the system, the challenge is to move from diagnosis to action.

11. In this connection, the social security system needs to catch up with demographic trends and keep up with these developments in the future. Specifically, this will require:

• Increasing the retirement age back to 65 years for all employees. Early retirement should be addressed in an actuarially neutral manner, and exceptions for those whose occupations are particularly dangerous should be limited.

• Switching the indexation to consumer price index from wages (basic earnings) for the benefits under the basic pension and all benefits for public sector employees. This would help contain pension expenditures and set the stage for lower taxes than otherwise possible.

• Introducing a mechanism of periodic adjustments in the retirement age and/or pension benefits that would automatically ensure the sustainability of the social security system.

Also, there is a need to rebalance the generosity of pension benefits of public sector employees in line with those the private sector. Reducing the lump sum payment for public sector employees at the time of retirement would go a long way in reducing this gap.

12. Phasing in these reforms and grandfathering of the rights of employees under the current system are desirable, but require promptly reforming the pension system.

13. In addition, a host of other issues regarding the operation of the social insurance system, while not a substitute for the above reforms, needs to be addressed. These include adjusting the notional salaries of self employed in line with wages observed in the market and improving the collection of overdue social security contributions. Furthermore, some flexibility in the social security fund's investment policy to maximize yields while limiting risks would be desirable.

14. Aging poses challenges for the health care system as well. The National Health Insurance System, to be introduced in 2008, envisages phasing in much needed competition in the provision of health care. Public hospitals will remain sheltered for a period of two to three years, after which free choice of hospitals will be introduced. To ensure that the system is not abused, these reforms need to be supported by introducing user costs and means testing for free access to protect those in need.

C. Strengthening the Financial Sector

15. Prompted by EU accession and, more broadly, by developments in financial markets worldwide, the financial sector has been undergoing substantial transformation in recent years. The strong performance of the Cypriot economy and cost-cutting and remedial measures to improve the quality of banks' portfolios have boosted the Cypriot banking sector's profitability. Potential mergers with foreign banks signal the dynamism of the sector. In the cooperative bank sector, mergers have intensified in anticipation of the full harmonization of capital requirements with EU directives by the end of 2007. Moreover, the recently established dual platform between the Cypriot and Athens stock exchanges will allow investors to access broader markets at lower cost and improve the liquidity of the listed securities.

16. However, the economy is experiencing rapid credit expansion and brisk house price increases, fueled by lower interest rates and capital inflows, that could become sources of risk in the future. Total credit to the private sector has accelerated recently, with mortgage lending-including in foreign currencies, mostly in euros-being an important component of the increase. The Central Bank of Cyprus (CBC) has introduced measures to curtail growth in mortgage lending and continues to closely monitor credit developments. We welcome this vigilance, but the need for additional measures to ensure that risks in the banking sector remain manageable may arise, if the pace the credit does not abate.

17. While the financial sector supervision has improved significantly, challenges remain. Currently, the supervision of commercial banks, cooperative credit institutions, stock market and insurance companies is carried out by four distinct entities: the CBC, the Cooperative Societies' Supervision and Development Authority, the Securities and Exchange Commission, and the Superintendent of Insurance. The IMF recently published its Assessment of Financial Sector Supervision Report for Cyprus, which concludes that supervision and regulation in the commercial banking sector is strong and complies with internationally recognized standards. We understand that the authorities are addressing the weaknesses in the supervision of cooperative banks and stock exchange market identified in the report. However, weaknesses remain in supervision of the insurance market, the root of which is related to severe resource constraints. In particular, limited staffing virtually rule out on-site inspections, designed to verify that adequate risk management and controls are in place. We urge the authorities to address this deficiency without delay.

18. Over time, there will be a need to reexamine the institutional setting of the financial sector supervision. Economies of scale and potential gains from joining the experiences of supervisors point to the desirability of unifying the supervision of commercial banks and cooperative institutions under one roof. Whether further unification is warranted is an open question. Irrespective of the institutional framework, it is imperative that supervisors have clear responsibilities and objectives, operational independence, adequate resources, and professional staff. Also, the recent proposals to change the legislation and regulations to accelerate the lengthy foreclosure process, which artificially inflates nonperforming loans, should be adopted as soon as possible.

19. We welcome the authorities' intention to complete an FSAP in time for the next Article IV consultation.

D. Sustaining Economic Growth through Structural Reforms

20. The EU-accession related reforms have significantly strengthened competitive forces. The National Lisbon Program establishes a strategy to enhance the growth potential of the economy. We support this program, including the authorities' vision to support external competitiveness and increase the flexibility of the economy to withstand shocks. We would like to emphasize the following:

• In the labor market, increased flexibility and strong economic growth have enabled Cyprus to meet the Lisbon Targets for 2005, and prospects for meeting the 2010 targets are good. But long standing rigidities in the market remain. The COLA system combined with the seniority-based rules governing salary increases in the public sector, have contributed to wage increases beyond productivity, particularly in the public sector. A redesign of the wage setting system, which would ensure that wages grow in line with productivity, is overdue.

• In product markets, the authorities have opened up key markets, notably telecommunications and energy. A number of new participants have entered these sectors since 2004, where private sector penetration has increased respectively to about 10 and 14 percent. Still, large public operators dominate and competition seems to be limited. Privatizing public enterprises, or further improving corporate governance of large public incumbents and increasing private sector participation, would enhance competition in these sectors. In this regard, the role of the Commission for the Protection of Competition is central and legislation to further enhance its investigative capacity is in train. Accordingly, it should be provided with adequate resources. More broadly, there is room to increase the efficiency of the public sector.

• In the tourism sector, overall revenues have risen recently, but competition from low cost destinations has intensified. There is an urgent need to continue upgrading and enriching the tourist product, in particular by implementing the Strategic Development Plan for Tourism.

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The mission wishes to thank the authorities for excellent cooperation and warm hospitality.

Mission Team (all from the IMF's European Department):

Mr. Alexander W. Hoffmaister, Assistant to the Director (Mission Chief);

Ms. Michelle Hassine, Economist; and

Mr. Etibar Jafarov, Senior Economist.