Public Information Notice No. 10/123

IMF Executive Board Concludes 2010 Article IV Consultation with Cyprus

September 2, 2010

On August 27, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cyprus.¹

Background

Following the economic downturn of 2009 when the global crisis began to affect Cyprus, the economy is projected to bottom out in 2010, giving way to a mild recovery in 2011 and stronger growth thereafter. After experiencing average growth of 4¼ percent over 2004-08, the economy contracted by 1.7 percent in 2009 as trade partners became increasingly affected by the global slowdown, leading to a sharp contraction of the tourism and construction sectors. Looking forward, increased unemployment along with decelerating consumer credit and the negative confidence shock will weigh on private consumption; investment is expected to be subdued due to continued weakness in the property market and construction sector; and public consumption will be restrained due to fiscal consolidation. Growth is expected to be flat in 2010, followed by a modest recovery in 2011 and a gradual acceleration in later years. The current account deficit, which was cut by more than half in 2009, will likely stabilize in 2010, and decline gradually toward more sustainable levels over the medium term.

The fiscal deficit widened sharply in 2009, mostly reflecting structural factors. In particular, expenditures rose sharply on the back of higher wages and salaries, social transfers, and investment spending. These increases were for the most part permanent rather than one-off or cyclical. Meanwhile revenues fell, reflecting the economic downturn and the unwinding of exceptional revenues associated with the real estate boom of the preceding years. The cyclically adjusted primary balance declined by some 6 percentage points in 2009, imparting a large fiscal stimulus and resulting in a fiscal deficit of 6.1 percent of gross domestic product (GDP). Consequently, Cyprus was placed under the Excessive Deficit Procedure of the European Union, which prompted the government to adopt a program of fiscal consolidation aimed at reducing the fiscal deficit to 4.5 percent of GDP in 2011 and below 3 percent in 2012. The government has already taken steps to stabilize the deficit in 2010; additional measures will be needed to reach the 2011 and 2012 fiscal targets.

The financial sector has continued to weather the impact of challenging regional and global market conditions relatively well due largely to a traditional business model for banks, which is based on lending mostly funded by deposits; relatively high banking system capital and liquidity; and strong supervision by the Central Bank of Cyprus (CBC). However, although the outlook for the sector has weakened somewhat over the past year owing to a deterioration of loans granted in Cyprus and in foreign markets (particularly Greece), stress tests suggest that they have the capacity to absorb further shocks. While cooperative credit societies would only be affected by conditions in Cyprus, a combination of weak underwriting standards and lower overall levels of capital suggests that risks for that sector are higher than for commercial banks.

In the absence of a legal framework for covered bonds in Cyprus, the government has facilitated banks’ and co-operative credit societies’ access to liquidity by issuing government bonds to them against high-liquidity collateral. Banks and co-operative credit societies have used these bonds to access funding by the European Central Bank (ECB), in part to lower their average cost of funds, at a time when deposit rates in Cyprus are higher than the euro zone average.

Growth of wages and labor costs in excess of productivity increases has eroded competitiveness particularly in the manufacturing and tourism sectors. Furthermore, the steady growth of public sector wages and employment poses risks for the low tax environment that is needed to attract investment and generates wage pressures in the economy. These developments point to the need to promote wage settings mechanisms which link wages to productivity developments rather than the current inflation-indexed wage adjustment mechanism, starting with the public sector.

Executive Board Assessment

Directors welcomed signs that the Cypriot economy is beginning to bottom out in 2010, leading to a modest recovery in 2011. The near-term outlook is still fragile as global financial risks remain elevated and growth prospects in trading partners muted, while a positive inflation differential with the euro area has reopened. Returning the economy to its potential growth depends critically on a credible fiscal consolidation, continued market confidence in the financial sector, and structural reforms to improve competitiveness and the business climate.

Directors agreed that the immediate policy challenge is to reverse the large structural fiscal deficit following the sizeable stimulus in 2009, with a view to preserving debt sustainability and creating fiscal space to guard against financial sector risks. They welcomed the government’s commitment to reduce the deficit to below 3 percent of GDP by 2012, consistent with its EU obligations. Noting that this would require more forceful action, Directors encouraged the authorities to lay out specific measures to achieve their goal. Containing the wage bill and better targeting social transfers were seen as important elements. More fundamental reforms of the pension system would also be needed to lessen the burden on public finances, through lower replacement rates and higher retirement age.

Directors observed that the banking sector remains sound and retains a capacity to absorb further shocks, as suggested by stress test results, including those conducted in the context of the EU-wide exercise. However, risks have risen significantly both in Cyprus and in the region. In light of the relatively large size and external exposure of Cyprus’ financial sector, these risks call for continued vigilance, close cooperation with foreign supervisors, and an enhanced framework for crisis management and contingency planning, including for cross-border banks. Consideration could be given to enlarging the deposit insurance facility. Directors also highlighted the urgency of strengthening the supervision and transparency of cooperative credit societies. The recent modification of the definition of nonperforming loans for cooperative credit societies was a welcome step toward aligning it to the norm in place for commercial banks. Directors encouraged further progress in creating a level playing field in the financial sector.

In light of the still large current account deficit, Directors stressed that structural reforms aimed at boosting competitiveness would be crucial for supporting the recovery and enhancing growth potential. Key priorities include restraining public sector wages and employment to free resources for the private sector, and phasing out the wage indexation system to allow wages to reflect productivity gains. Active labor market policies, aimed particularly at addressing skill mismatches, should help reduce unemployment.