Mission Concluding Statements
Cyprus and the IMF
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INTERNATIONAL MONETARY FUND
Cyprus -- 2002 Article IV Consultation
Preliminary Conclusions of the Mission
Nicosia, November 4, 2002
1. Since the last IMF Article IV consultation in 2000, the Cypriot economy has performed well, and is fast approaching average income levels in the European Union. Growth in 2000 and 2001 was robust, and the weakening in economic activity in the course of the current year has mainly reflected the global slowdown. Substantial progress has been achieved in many areas. Fiscal consolidation reduced the budget deficit to 3 percent in 2001. A major tax reform was implemented in 2002, aligning indirect taxation more closely with European Union standards and lowering direct taxation. Interest rate controls were removed; the central bank was made independent; and the capital account was further liberalized, without jeopardizing monetary and external stability. Financial sector legislation is being strengthened, in line with European Union directives; and structural reform has proceeded to some extent. These achievements have been recognized by the European Union in its latest Progress Report, which judges the Cypriot economy ready for EU membership.
2. Despite these impressive achievements, Cyprus still faces significant policy challenges, complicated by the unsettled international environment. Economic growth in 2002, which we expect to be around 2 percent, has been affected by the sharp decline in tourism. Prospects for 2003 are more favorable, and absent negative external events growth should rebound above 3 percent. However, significant external risks remain-increased instability in the Middle East, the concurrent risk of an increase in oil prices, the impact of terrorist acts on people's propensity to travel, and further delays in the recovery of the European economy. Because of its small size, external openness, and geographical location, Cyprus would be particularly affected by such developments. Consequently, this is no time for complacency. Indeed, continued firm commitment to sound economic policy and further structural reform is crucial to successfully cope with these challenges.
3. The policy agenda should focus on strengthening economic performance, while maintaining macroeconomic stability and making the economy less vulnerable to external shocks. The multi-pronged strategy outlined in Cyprus's Pre-Accession Program is designed to achieve these objectives. In particular, there is a need to (i) build on the results achieved so far in fiscal consolidation, so as to ensure a sizable reduction in the ratio of public debt to GDP; (ii) strengthen the external accounts, thereby reducing Cyprus's exposure to adverse external developments; (iii) maintain low and stable inflation; (iv) ensure high standards of financial sector supervision and closely monitor financial sector vulnerabilities, as remaining capital account restrictions are removed; and (v) move decisively forward on structural reform so as to strengthen competition and increase productivity.
A. Fiscal policy challenges
4. The mission supports the fiscal consolidation strategy laid out in the 2002 Pre-Accession Program, and welcomes the authorities' commitment to its implementation. Fiscal consolidation in general, and the government target of reaching a broadly balanced budget by 2005 in particular, are appropriate in many respects:
· Fiscal consolidation will allow Cyprus to comfortably satisfy the fiscal criteria it would be subject to upon EU accession. A durable strengthening of public accounts would reduce the ratio of public debt to GDP and allow the budget deficit to remain well below the Maastricht ceiling during cyclical downturns, when public accounts worsen due to the reduced tax intake. In addition, the targeted balanced budget would be in line with the Stability and Growth Pact.
· Fiscal consolidation will help reduce Cyprus's external imbalances. Historically, Cyprus has relied on foreign saving as an important source of investment financing. While the balance of payments position and level of foreign exchange reserves are comfortable and the large size of the current account deficit in 2002 reflects in part temporary factors, a reduction in net external borrowing is desirable and would help reduce exposure to external risk. Fiscal adjustment would free up domestic saving, thereby reducing reliance on foreign saving to finance domestic investment.
· A balanced budget over the medium term is an appropriately prudent policy stance given the expenditure pressures that population aging will entail. As in other European countries, demographic trends imply that spending on pensions and health is going to increase in Cyprus. Although its population is young by the standards of EU countries, the impact of aging on public finances will still be substantial. Consequently, a forward-looking policy of containing current expenditures and reducing the public debt will ease the financing of future expenditure increases, by reducing the interest burden.
5. In light of current trends, achieving the fiscal goals set forth in the PEP will require a firm policy stance. Data for the first eight months of the year indicate that the general government deficit is running at a higher rate than projected, mainly reflecting expenditure overruns. With strict expenditure management and help from one-off revenues, such as the proceeds from the fine to the CYTA, the budget deficit could be maintained close to 3 percent of GDP, broadly the same as last year. However, these underlying expenditure increases will exert their impact on the budget balance next year, threatening progress on fiscal consolidation and hence the achievement of the 2003 deficit target.
6. Maintaining the fiscal targets is critical for policy credibility, and prompt remedial action should be taken to address budgetary shortfalls. Such action should preferably take the form of durable current expenditure savings. In this respect, pressures for additional expenditures should be resisted; in the event further outlays are approved, they should be financed by offsetting deficit-cutting measures, so as to leave the budget balance unaffected. Should growth be considerably weaker than currently envisaged by the mission, automatic stabilizers should be allowed to play a role. Looking forward, the credibility of fiscal policy can be enhanced by establishing a multi-year fiscal framework, based on prudent macroeconomic objectives, with annual expenditure targets broken down by major spending categories. Such a framework would provide the basis for choosing among competing spending priorities in a transparent and efficient manner.
7. Early policy action designed to limit the impact of population aging on future health and pension expenditures would strengthen fiscal sustainability. Based on current policies, the long-term increase in expenditure on pensions and health driven by an aging population would require a drastic future increase in social security contributions and other taxes to finance pension payments. Policy action to address these future problems should be taken promptly, because reforms in this area take a long time to yield results, and the necessary adjustment is smaller, the earlier action is taken. Reform options, also outlined in the latest actuarial report on the social insurance scheme, include a gradual increase in the pensionable age, in particular in the public sector, changes to the indexation scheme of pensions to wages, and a gradual increase in contributions. In this regard, caution must be exercised in raising entitlements-over-generous concessions during `good' times are at the root of many of the problems in containing aging-related expenditures currently facing advanced industrial countries. To avoid a sharp future increase in the tax burden, the growth rate of other public expenditure categories, in particular wages and salaries, should be contained.
B. Monetary and exchange rate policy
8. Monetary policy has successfully kept inflation under control-excluding the impact of VAT and excise tax increases, the rate of inflation is in line with the level prevailing in the euro area. Significant progress has also been achieved with the abolition of the interest rate ceiling in January 2001, the further liberalization of capital movements, and on the institutional front, the legal independence granted to the Central Bank in July 2002. With the widening of the exchange rate band vis-à-vis the euro in August 2001, the Central Bank has appropriately highlighted to economic agents the increased risk of foreign currency borrowing-as capital flows are further liberalized, exchange rate fluctuations within the band may well increase.
9. The recent decision of the Monetary Policy Committee to keep interest rates unchanged is appropriately prudent. The increase in inflation due to VAT and excise tax increases is not, in principle, a cause for concern, given that core inflation remains low. However, inflationary pressures are likely to arise next year, as the wage indexation mechanism will automatically transmit to wages the increase in prices caused by VAT increases. Hence, wage moderation is essential to prevent higher inflation and further losses in competitiveness.
10. Surplus liquidity conditions indicate that monetary policy is not acting as a constraint on economic recovery. This increase in liquidity has arisen because of the strong capital inflows in the first half of 2001 and the government's ample recourse to central bank advances in the early part of 2002. Close coordination between the government's security auctions and the Central Bank's open-market operations, together with the development of efficient primary and secondary markets for government securities, would play a useful role in easing liquidity management in the future. The establishment of an ad-hoc committee on debt management between the government and the Central Bank is a useful first step in this direction.
C. Financial market liberalization and external vulnerability
11. Cyprus is well placed to take full advantage of the opportunities for international portfolio diversification that capital account liberalization provides. With its large financial sector, educated workforce, international orientation, efficient legal system, and strategic position, Cyprus is an attractive destination for foreign capital, and the dismantling of capital controls will allow domestic residents to diversify their portfolios internationally, reducing their exposure to domestic risk.
12. As capital account liberalization is completed, supervisory authorities need to monitor closely financial sector vulnerabilities, particularly private sector foreign exchange exposure. The Central Bank has been appropriately vigilant in this area, emphasizing in particular the risks inherent in foreign currency borrowing. It is important to monitor developments in all sectors, and to take quick action if imbalances occur. Banks are well capitalized, but their portfolio has been affected by the bursting of the stock market bubble and the economic slowdown. Initiatives already underway to strengthen supervision, enhance credit institutions' internal risk management and credit allocation procedures, and align financial sector legislation to international standards-including for insurance and the stock market-should be swiftly implemented. In this respect, we also welcome the authorities' prompt action to address issues identified last year in the generally favorable offshore sector assessment by an IMF team of experts, and the ongoing reforms to adopt the relevant EU directives on financial sector regulation.
13. In order to effectively accomplish these tasks, strict coordination and cooperation between the several financial sector supervisory authorities is crucial. There are strong linkages between banking, insurance, financial services, and securities' markets, and difficulties in one area can quickly spread to other areas. The Memorandum of Understanding recently signed by the Central Bank, the Securities and Exchange Commission, and the Insurance supervisory authority is an important step in this direction. Further reforms are needed to strengthen the resilience of the financial sector and its ability to cope with increased external exposure and competition. In particular,
· The supervision of Cooperative Credit and Savings Societies should be enhanced, their capital base should be strengthened and consolidation in the sector should be encouraged. These steps are important not only in light of the requirement for credit cooperatives to comply with the EU directives for credit institutions by 2007, but also to enhance their ability to cope with market pressures and shocks in the near future.
· Strengthening legislation and enhancing supervision can help restore confidence in the stock market, which was battered by the bursting of the bubble in 2000-2001. In this respect, it is important for the government to clearly signal that stock market investment losses will not be covered ex post by the public sector or by a forced private sector bailout. Undue expectations of such an outcome may delay the resolution of the problems caused by the bursting of the bubble, and could encourage reckless risk-taking in the future.
D. Structural reform and the labor market
14. Cyprus is well advanced in meeting the requirements of the acquis communautaire, but progress on structural reform has been uneven. While anti-trust legislation and enforcement has been strengthened, more remains to be done to foster competition in sectors such as air travel, electricity, and telecommunications, where progress has been slow. Increasing competition would benefit the Cypriot economy as a whole: consumers would pay lower prices and have access to better products and services; entrepreneurs would face increased opportunities for investment and growth; and workers would see real wages rise as competition would spur productivity. Together with measures to promote competition, privatization of remaining government holdings would also strengthen the market base of Cyprus's business sector. In addition, remaining price controls and cross-subsidization should be phased out, and water pricing should appropriately reflect resource scarcity, to encourage conservation.
15. With near full employment conditions, labor markets have performed well, but there is scope for policies to increase labor supply. Labor shortages have arisen in some sectors, and the labor market is likely to tighten further as growth picks up. Enhancing flexibility would reinforce the ability of the labor market to successfully cope with these problems. Flexibility would be promoted by facilitating the use of part-time and fixed-term employment, thereby raising labor force participation, particularly by women; and strengthening the link between educational training and the requirements of the labor market, to improve job matching.
16. The centralized wage bargaining system in Cyprus has fostered social dialogue and wages have grown in line with productivity, but the wage formation mechanism can increase the persistence of inflationary shocks. In this context, the automatic indexation of wages to past inflation fails to exclude the impact on prices of VAT increases, and will therefore unduly cause second-round inflationary effects next year. The increase in indirect taxation is compensated by the reduction in direct taxes and the increase in social transfers that were enacted with the tax reform, and is therefore not associated with a reduction in the purchasing power of workers. Wage moderation should offset the inflationary impact of this automatic wage adjustment, as workers would be affected negatively from a further erosion in Cyprus's competitiveness.
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17. The Cypriot economy is undergoing a period of momentous change on its way to EU accession. In recent years, a strong effort has been undertaken to improve macroeconomic management, reduce structural impediments to competition, and strengthen institutions, which has been endorsed by the European Union. Further momentous changes may lie ahead, and redoubling the efforts to make the economy stronger, yet more flexible, is the best investment Cyprus can make to ensure success in meeting these challenges.
18. In concluding its visit, the mission wishes to sincerely thank the authorities for their full cooperation and warm hospitality.
IMF EXTERNAL RELATIONS DEPARTMENT