Cyprus: Staff Concluding Statement of the 2018 Article IV Mission
IMF News, October 5, 2018
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- Published: October 5, 2018
Key findings and recent developments
- Five years after the financial crisis, the Cypriot economy has turned the page on its recovery path: growth momentum is strong and fiscal performance is robust.
- The economy grew by over 4 percent in 2017 and the first half of 2018, supported by tourism, professional services, and construction.
- Wages and property market prices are rising after an extended period of stagnation, but the pace remains very gradual, contributing to low underlying inflationary pressures.
- Increased domestic demand has boosted imports, widening the underlying current account deficit.
- Economic growth has been largely supported by external financing because the banking sector remains hamstrung by weak balance sheets.
- Important strides were made in addressing banking-sector vulnerabilities:
- Resolution of the government-owned Cyprus Cooperative Bank (CCB), the second-largest bank, albeit at a high cost to the public purse.
- Passage of a legislative package to strengthen insolvency and foreclosure frameworks.
- These measures have catalyzed bank balance-sheet cleanup and contributed to a sovereign ratings upgrade to investment grade status.
- Notwithstanding progress, the economy is weighed down by very high private and public debt and NPL ratios that, while declining, remain among the highest in Europe.
Outlook and risks
- Near-term growth:
- Growth is expected to exceed 4 percent in 2018–19, driven by domestic demand.
- Private consumption growth is expected to decelerate as borrowers step up debt servicing.
- Investment is expected to pick up further, reflected in a pipeline of construction projects in residential properties, education, health and tourism infrastructure.
- These import-intensive projects, plus slowing tourism growth in some source markets, will somewhat widen the current account deficit.
- Medium-term outlook:
- Over the medium term, as the transitory effects of the investment boom and euro area cyclical growth dissipate, growth is expected to slow towards a potential growth rate of around 2½ percent.
- Sustaining medium-term growth requires progress in structural reforms to lower systemic financial risks and catalyze productivity-enhancing investments.
- Risks (tilted to the downside):
- Delays in NPL resolution and limited strengthening of payment discipline will weigh on investor sentiment and growth potential.
- Increase in moral hazard and realization of contingent liabilities from publicly supported schemes could weaken the fiscal position and raise risk premiums, especially under tightening global financial conditions.
- High dependence on Citizenship-by-Investment (CbI) financed investments could pose risks to sustainability.
- External risks include escalating trade tensions, a sharper-than-expected slowdown in euro area growth, or a hard Brexit.
- Upside risk:
- Prospect of offshore hydrocarbon development.
- Faster progress in dealing with NPLs could attract additional FDI, increase credit flows, and strengthen economic growth.
Policy priorities — Financial sector: lowering NPL and private debt overhang
- Steady reduction of NPLs and high corporate and household debt is a priority.
- Recent legal and institutional changes:
- Amendments to foreclosure and insolvency legislation, the sales of loans law, and adoption of a law on securitization enhance tools for addressing NPLs.
- Strengthened foreclosure framework intended to act as a credible threat against strategic default and improve payment discipline.
- Implementation and complementary measures:
- Steadfast implementation of the enhanced frameworks is essential to facilitate timely enforcement and ensure durable resolution.
- Structural reforms are needed to strengthen institutions, in particular the court system, and to remove uncertainties related to title deeds.
- Regulatory and governance needs for credit-acquiring companies and CAMC:
- Central bank should develop a regulatory and supervisory framework for credit-acquiring companies, including reporting requirements, on-site inspections, and off-site monitoring.
- Governance framework for the government-owned Cyprus Asset Management Company (CAMC) needs to balance operational independence with public accountability and transparency, with a clear mandate, operational targets, an independent board, and skilled, performance-based management compensation.
- Design of the proposed subsidy scheme (Estia):
- Estia should be better targeted to those most in need; tighter eligibility criteria and clearer communication would help avoid moral hazard.
- Appropriate assessment of borrowers’ capacity to repay restructured debt on a sustained basis is important.
- Banks should maintain adequate provision coverage and promptly utilize foreclosure and insolvency frameworks to address re-defaults.
- The scheme’s design and impact assessment should be informed by a detailed analysis of borrower data.
- Other bank-strengthening measures:
- Continue efforts to diversify income sources and consolidate operations to improve cost-income ratios.
- Focus on bank lending policies, sustainability of restructurings, adequacy of provisioning coverage, and debt-to-asset swap policies to encourage sound risk management.
Policy priorities — Fiscal policy: safeguarding fiscal space and reducing risks to public debt sustainability
- Fiscal stance and risks:
- Cyprus is projected to maintain large primary fiscal surpluses that should reduce public debt going forward (despite a large one-off increase this year due to the CCB transaction).
- Reversal of crisis-era wage cuts and interest levy, introduction of the Estia scheme, and likely increases in health expenditures following the rollout of the National Health System starting next year imply a modest structural loosening.
- With the output gap closed, a procyclical fiscal stance could increase wage pressures and weigh on competitiveness.
- Recommended fiscal rules and constraints:
- Strict spending discipline should be maintained given already elevated public debt.
- Transitory revenues from cyclical gains and one-off measures should not finance permanent spending initiatives.
- Expenditure rises should be capped by medium-term GDP growth (adjusted for permanent revenue changes).
- Keep the public wage bill envelope within nominal GDP growth.
- Health sector transition:
- Transition to public insurance in health needs careful management; phasing in and fine-tuning of the regulatory framework for service provision and reimbursement mechanisms may take time to control incentives for over-provision.
- Complementary fiscal structural reforms:
- Implement spending reviews, public administration reform, local government reform, and governance improvements for state-owned enterprises to minimize fiscal risks.
Policy priorities — Structural reforms: improving the investment climate and inclusive growth
- Judicial reform and enforcement of commercial claims:
- Increase court efficiency, clear case backlogs, and speed enforcement of commercial claims to reduce cost of capital and improve access to financing and investment.
- Add judges, reform the civil procedure code, and introduce an e-justice system to reduce length of court procedures.
- Address persistent delays with issuance and transfer of title deeds, focusing on clearing the backlog and preventing recurrence.
- Public sector governance and public administration effectiveness:
- Strengthen public financial management through better internal controls and monitoring of risks from local government and public bodies.
- Improve corporate governance of commercial state-owned enterprises: strengthen financial oversight, implement a more effective planning and reporting framework with greater disclosure and transparency, and introduce a code of conduct consistent with OECD principles.
- Legislation to reform assessment and promotion in the civil service would facilitate greater mobility and efficiency.
- Local government reform would improve service delivery.
- Expedite legislative efforts to strengthen the governance and autonomy of the Central Bank of Cyprus.
- Promoting inclusive growth:
- Address high youth unemployment and low employment rates for recent tertiary graduates due to skills mismatch.
- Promote Active Labor Market Policies (ALMPs) targeting youth and other vulnerable groups, strengthen education to better link work-based and school-based programs, and encourage investment in high value-added sectors.
Staff thanks the Cypriot authorities and interlocutors for informative discussions and cooperation during the mission.