Mission Concluding Statement 

Cyprus: Staff Concluding Statement of the 2017 Article IV Mission

October 6, 2017

The Cypriot economy has achieved an impressive turnaround since the 2012-13 banking crisis . GDP growth has accelerated for three consecutive years; unemployment is on a declining trend; the underlying current account deficit has narrowed sharply alongside improved external price competitiveness; the fiscal balance has swung from a large deficit to a small surplus; emergency bank liquidity has been fully repaid and bank deposits are rising; and property prices have begun to edge up following a large correction. These results were underpinned by generally prudent macroeconomic and financial policies and progress on structural reforms that enabled the sovereign to access capital markets on increasingly favorable terms, accompanied by a series of upgrades to the credit rating, which now stands close to investment grade.

While much has been achieved, important legacies from the earlier boom-bust cycle have yet to be erased . Private sector debt remains extremely high, with banks’ nonperforming loans (NPLs) relative to total loans or GDP among the highest in the world. Although several years of robust GDP growth has improved the repayment capacity of many borrowers, progress on reducing NPLs remains slow. Public sector debt also remains elevated. High debt and NPLs renders the economy more vulnerable to adverse shocks, including a tightening of global financial conditions.

Recent developments, outlook and risks

The economic recovery gathered speed on robust external demand . GDP grew by 3.6 percent (year-on-year) in H1:2017, accelerating from 2.8 percent in 2016. This lifted output to 5 percent below its pre-crisis peak and narrowed the output gap to about 2 percent below its potential. Strong foreign demand propelled tourism, construction and professional services, while the ongoing contraction in domestic financial intermediation—reflecting deleveraging by banks—was a drag. On the expenditure side, rising disposable incomes and employment, together with tourism and (albeit undesirable) non-servicing of debt by a large fraction of borrowers, is fueling consumption growth. While still well-below pre-crisis levels, fixed investment is growing by more than 14 percent (with housing construction rising by 23 percent) since mid-2016, supported by a range of tax and other incentives, and directly contributed one half of GDP growth.

The current dynamic growth momentum is expected to persist for the next few years, before gradually easing . This forecast is underpinned by two forces: the existing pipeline of large, mainly foreign-financed, construction projects that will take several years to complete, and continued weak payment discipline that is assumed to keep private consumption growing broadly in line with income. As a result, growth is expected to average around 3¾ percent during 2017-18, and to gradually moderate thereafter as investment projects are completed. The high import intensity of investment will cause some re-widening of the current account deficit despite sustained tourism demand. New construction will alleviate capacity constraints in tourism, helping to lift longer-term growth to 2½ percent. Nonetheless, output is expected to overshoot potential within the next few years, exerting some upward pressure on prices and productivity-adjusted wages. Despite the projected pickup in incomes, NPL recovery is likely to remain subdued in the absence of improved payment discipline.

Further moderate upside surprises to growth are possible, but downside risks could be sizable . Growth could remain elevated for longer if the current momentum in foreign-financed construction is sustained. However, this could make the economy more prone to a new boom-bust cycle if external financing was to slow suddenly—possibly in response to risk-off sentiment triggered by faster-than-expected policy tightening by major central banks—or if the supply of new properties was to significantly outstrip final demand. Continued slow resolution of NPLs could keep financial sector vulnerabilities elevated. If fiscal discipline is eroded, higher external financing costs could weaken growth. Cyprus’s role as a business and financial hub could be adversely affected if new international initiatives are agreed on corporate taxation, as well as retrenchment of cross border financial intermediation by foreign correspondent banks. On the other hand, growth prospects could be significantly boosted if development of offshore hydrocarbon deposits proves financially viable.

Key policy priorities

The economic achievements of recent years should be consolidated and extended by: significantly reducing, in a non-disruptive manner, excessive private indebtedness and banks’ NPLs; ensuring that economic growth remains broad-based and avoids undue dependence on external financing; avoiding procyclicality in public spending; speeding up the legal process for enforcement of commercial claims; and enhancing competition and governance.

Achieving sustainable deleveraging and NPL reduction

Eliminating the private sector debt overhang and banks’ excessive NPLs is essential to support balanced and sustainable growth . Nonbank sources of liquidity—including nonpayment of debt service obligations and foreign equity financing—are supporting growth, although these may be finite or unreliable. Moreover, given the high private indebtedness and NPLs, opportunities for prudent new lending by banks are limited, affecting banks’ profit potential and concentrating investment and growth into a relatively few sectors that are self-funded or appeal to foreign investors.

The current period of strong growth provides a good opportunity to reduce private sector debt and banks’ NPLs . Cleaning up banks’ portfolios while leaving borrowers saddled with high debt would not be sustainable for banks or the economy. Relying mainly on rising incomes to grow out of debt and NPLs would unlikely be successful in the presence of weak payment discipline. Moreover, attempting to sustain very rapid GDP growth while remaining highly leveraged could be subject to adverse shocks.

Comprehensive and ambitious strategies are needed to deliver a sizable deleveraging . Banks should remain adequately provisioned and capitalized, and borrowers should be incentivized to engage with banks by strengthening legal and other restructuring measures. Simultaneously adopting a combination of tools—debt-asset (D-A) swaps, borrowers’ repayments using their own funds, use of banks’ provisions, as well as lower spending by borrowers—could deliver a sizable reduction in debt and NPLs with limited dampening of GDP growth, especially given the cushion from current strong external demand.

Improved payment discipline is critical for a properly functioning economy and sustainable deleveraging . Despite recent reforms to the legal framework, strategic default is enabled by still-lengthy and inefficient procedures for commercial claims enforcement and foreclosure and a perceived blanket protection of primary residences. Strategic default imposes a heavy cost on society by limiting banks’ ability to extend healthy credit and perpetuating financial sector vulnerabilities. Tools to change borrowers’ incentives are therefore needed. To better serve as a deterrent to strategic default, the foreclosure framework should be further strengthened. The use of the new debt restructuring tools for corporates and individuals should also be promoted. Transfer of property titles to eligible trapped buyers should continue. The planned adoption of a credit scoring system by the Credit Registry is welcome.

More generally, prudent standards in lending and loan classification should be maintained . To prevent erosion of underwriting standards in the face of competitive pressures, supervision of banks’ risk management practices should be stepped up. Targeted inspections of loan restructuring practices should focus on classification accuracy, frequency of re-restructurings and adequacy of provision coverage.

Avoiding a procyclical fiscal policy

The headline fiscal position is expected to continue to strengthen during 2017-19 on strong revenue collection . As a result, gross public debt relative to GDP would begin declining in 2017 and then fall significantly thereafter, while a sizable cash buffer would still be maintained to help pre-fund scheduled debt repayments. This forecast incorporates the planned net-neutral fiscal impact of the new National Health Service (NHS) that was recently voted into law and is scheduled to be rolled out in mid-2019. Adjusting for the economy’s cyclical position and one-offs, the structural fiscal balance would remain largely unchanged during the next few years.

Growing spending pressure and the risk that temporary or cyclical revenue is perceived as permanent suggests that fiscal spending should be capped by medium-term GDP growth . Recent buoyant tax revenue may point to faster GDP growth and an output gap that is closing rapidly. Setting an annual ceiling for nominal spending that increases in line with medium-term GDP growth (with downward adjustment to compensate for any future cuts to tax rates or narrowing of tax bases) would avoid procyclical policies, help prevent a structural fiscal loosening and secure a downward path for debt. To underpin this spending cap, while making some room for growth-enhancing spending, a more durable mechanism to keep the public-sector wage bill in check, accompanied by broader civil service reforms, should be instituted. Close monitoring of the cost (including establishing an arrears monitoring system) of the NHS should be undertaken to ensure that public finances are not put at risk. Better financial oversight of municipal and local governments, semi-government organizations and state-owned enterprises, and reforming their governance structures, is advised. Further strengthening revenue administration is needed by legislating the Tax Procedure Code.

Balanced and sustainable growth

Real estate

Policy adjustments may be needed to avoid a potentially unsustainable increase in construction activity . Several investment incentives, including the citizenship-by-investment (CbI) scheme, provided welcome support to construction and the economy more broadly in the aftermath of the crisis, and construction of luxury residential and tourist properties—financed mainly by foreign equity—has been brisk. However, this support has now achieved its goal, and could turn procyclical. Further decoupling the scheme’s eligibility requirements from real estate would help avoid excessive concentration of economic activity, and reduce the risk of over-supply of luxury properties. Procedures for issuing and transferring title deeds for new properties should be streamlined, with timely transfer of titles to buyers. If signs emerge that construction in the luxury market is becoming reliant on domestic credit or activity is spilling over to other segments, tightening bank lending standards and raising macroprudential capital requirements would be appropriate. Reinstating the recently rescinded immovable property tax and raising transfer duty on immovable property would provide additional countercyclical tools.

Enforcement of commercial claims

Strengthening the effectiveness of commercial claims enforcement and increasing the efficiency of the courts are priorities to improve the investment climate and support NPL reduction . Delays in court processes weaken the attractiveness of the country as a business destination. To rectify these issues, the civil procedure law should be reviewed and updated; rules for appeals and interim injunctions should be modernized to limit undue delays; and consideration should be given to introducing a streamlined procedure for enforcement of small claims. The establishment of a commercial court and introducing specialization of judges in the lower courts would allow more expeditious case handling.

Competition and governance

Improving the investment climate across a wide range of sectors requires efficiency-enhancing reforms . Attracting capital into innovative sectors would help expand investment beyond Cyprus’s traditional sectors and create employment for its highly-skilled labor force. The proposal to introduce expedited procedures for investment is therefore welcome. Restarting the privatization agenda and allowing firms to enter protected sectors would increase competition and help raise productivity. Strengthening governance and operational efficiency in key public and private sectors, including through the adoption of pending reforms to state-owned enterprises and restarting privatization, would help modernize the economy and allow firms to absorb the 6-percentage point increase in the tax wedge on employment for funding the new NHS.

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We thank the Cypriot authorities and our other interlocutors, including from the private sector, for informative discussions and their cooperation and generous hospitality. We also thank the European Commission, the European Central Bank and the European Stability Mechanism for their collaboration during part of the mission .