IMF Executive Board Concludes 2009 Article IV Consultation with Cyprus

Public Information Notice (PIN) No. 09/108
August 17, 2009

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2009 Article IV Consultation with the Cyprus is also available.

On August 5, 2009 the Executive Board of the International Monetary Fund (IMF) concluded the 2009 Article IV consultation with Cyprus.1


The global crisis is beginning to affect Cyprus. The economy has been relatively shielded from the crisis so far, recording positive growth in the first quarter of 2009, well above the euro area. The financial sector has not required public capital injections. The relative resilience is due to the elimination of exchange rate risk following euro adoption, conservative financial sector practices with limited exposure to toxic assets and strict supervision, and a domestic demand-based growth with less reliance on manufacturing exports. However, the economy is beginning to slow in response to the global crisis. Growth is projected to fall sharply to ⅓ percent in 2009 as banks and the private sector restructure balance sheets. On current policies, a tepid but uncertain recovery is expected to begin starting 2010.

Despite its resilience so far, the economy is slowing down and risks are increasing. The overheating of the economy in 2007–08 has left the private sector highly leveraged, and banks and households exposed to the property market. The expected slowdown will increase credit risk in banks, which, in some plausible but unlikely extreme scenarios, could have systemic implications given the size and concentration of the banking sector. The government and the Central Bank of Cyprus (CBC) have taken action to ensure the soundness of the banking system. There has been significant progress in implementing EU Directives and recommendations made by the recent Financial Sector Assessment Program (FSAP). In particular, deposit insurance coverage and funding has increased; a crisis management law is being drafted to empower the government to preemptively address liquidity or insolvency problems; and a legal and regulatory framework for covered bonds has been initiated to facilitate the availability of refinancing under the ECB’s facilities. Nevertheless bank soundness indicators are being adversely affected by the economic environment.

Large current account deficits partly indicate competitiveness problems especially in the manufacturing and tourism sectors. In particular, the backward-looking automatic indexation mechanism (COLA) has recently contributed to wages outstripping productivity increases. The external position would therefore be vulnerable if the current sources of financing—foreign direct investment and non-resident deposit flows into the banking system—were to decline. While there has been progress—albeit slow—in implementing the wide-ranging structural reforms of the government’s National Reform Programme, reforming the COLA is not part of the agenda at this juncture.

The largely revenue-based fiscal consolidation has started unwinding. This is due to softening growth, the lapse of temporary revenue-generating factors, and increases in untargeted social spending starting 2008. Although important pension reforms were recently enacted, they rely mainly on contribution increases and do not yet fully address the large ageing-related increases in pension expenditures. Fiscal policies could potentially become unsustainable if current policies, which significantly increase the inelastic component of budget spending (especially payroll), are implemented.

Executive Board Assessment

The Executive Directors noted that Cyprus has weathered the crisis well. The overheating of the economy in 2007–08 has given rise to certain risks that would need to be managed carefully as the economy slows. Policies would need to mitigate short-term risks while ensuring medium-term sustainability.

Directors endorsed the government’s objective to achieve a balanced budget over the medium term. They noted that, based on strengthened policies, the budget deficit will need to decline by about ½−¾ percent of GDP a year with a significant upfront correction to avoid unfavorable debt-deficit dynamics going forward. Directors emphasized that fiscal adjustment should rely on reducing public consumption, particularly the wage bill, and on broader public administration reforms. They considered that the temporary stimulus measures should be allowed to expire once the recovery sets in, and the social support measures should be carefully targeted to the needy. Directors welcomed the passage of pension reforms. A few Directors considered that additional pension reforms may be necessary in future, including raising the retirement age and better aligning public and private benefits.

Directors recommended the adoption of a medium-term budget framework and more effective management of public sector liabilities. The government’s recent initiative in this area could be further enhanced by monitoring contingent liabilities and minimizing the possibility of moral hazard and adverse selection in public sector aid programs.

Directors were reassured that financial sector risks appear to be manageable. Nonetheless, given the size and concentration of the financial sector, they expressed concern that problems can potentially become systemic, underscoring the importance of early detection of risks and intervention to preserve financial sector stability. They encouraged the Central Bank of Cyprus (CBC) to enhance monitoring of banks’ funding, cross-border exposures, and counterparty risk management. With the potential for a further deterioration in asset quality, the CBC should require higher capital buffers, particularly from systemically-important banks.

Directors recommended that supervision and the safety net be further improved over the medium term. They noted that Cyprus’ reputation as a financial center relies on continued effective supervision by an independent and accountable central bank. In the view of most Directors, a single supervisor for all credit institutions and a more integrated supervisory structure in the CBC should be considered. The stress-testing framework should be enhanced and supervisory and financial stability resources bolstered. Directors welcomed Cyprus’ participation in a Financial Sector Assessment Program (FSAP), and called for implementation of its recommendations.

Directors underlined the importance of improving competitiveness to assist the recovery and support external viability. They encouraged the authorities to reverse the deterioration in productivity and unit labor costs by implementing the broad-ranging National Reform Program, including cutting red tape, streamlining the bureaucracy, and implementing other structural reforms. Directors supported eliminating the automatic wage indexation mechanism (COLA) or mitigating its impact through productivity improvements and better targeting.

Cyprus: Selected Economic Indicators, 2005–09
(Annual percentage change, unless otherwise indicated)

  2005 2006 2007 2008 2009 1/

Real economy


Gross domestic product

3.9 4.1 4.4 3.6 0.3

Domestic demand (contribution to annual growth)

3.2 5.7 7.7 9.3 -2.7

Harmonized index of consumer prices (period average)

2.0 2.2 2.2 4.4 0.9

Unemployment rate (percent)

5.3 4.6 3.9 3.7 5.6

Public finances (general government, percent of GDP)


Overall balance

-2.4 -1.2 3.4 0.9 -3.9

Primary balance

1.1 2.1 6.5 3.8 -1.5

Gross public debt 2/

69.1 64.6 59.4 49.4 52.7

Interest rates (percent)


Deposit rates 3/

3.7 3.6 4.4 5.4 3.3

Lending rates 4/

6.7 6.8 6.3 7.0 6.9

Balance of payments (percent of GDP)


Trade balance

-25.4 -27.7 -30.3 -32.8 -26.6

Current account balance

-5.9 -7.1 -11.8 -18.3 -10.3

Fund Position (June 30, 2009)


Holdings of Currency (percent of quota)


Holdings of SDR's (percent of allocation)


Quota (millions of SDR)


Exchange rates


Exchange rate regime

Euro Area Member

Present rate (July 13, 2009)

US$ 1.44 per euro

Nominal effective exchange rate (CPI, 2000=100) 5/

100.0 100.5 101.2 104.7 106.2

Real effective exchange rate (CPI, 2000=100) 5/

100.0 100.2 100.2 103.8 104.9

Sources: Ministry of Finance; Central Bank; World Bank, World Development Indicators; and IMF staff estimates.
1/ Data for 2009 are projections.
2/ Excludes intragovernmental debt and short-term liabilities of the Central Bank.
3/ Since 2007, data refer to the average of MFI interest rates on euro-denominated deposits up to 1 year. Data for 2009 are as of May.
4/ Since 2007, data refer to the average of MFI interest rates on euro-denominated loans. Data for 2009 are as of May.
5/ Data for 2009 are as of April.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.


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