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An aerial view of the embankment at Paphos, a popular tourist destination. Cyprus was particularly exposed to the economic impact of the pandemic due to its high reliance on tourism. (photo: DedMityay by Getty Images)

• IMF Country Focus

A Three-Point Plan to Tackle the Pandemic in Cyprus

June 16, 2021

Cyprus entered the COVID-19 crisis in a strong position, but the economy’s dependence on tourism and its high public and private debt levels made it especially vulnerable to the pandemic shock. Nevertheless, the country has avoided widespread defaults and high unemployment, thanks in part to prompt policy support and a strong capital cushion accumulated before the pandemic.

The near-term outlook points to a gradual but uneven recovery, with significant risks. Growth is projected to recover moderately to 3 percent in 2021 after output fell by 5.1 percent in 2020. However, the pace of vaccinations and potential new waves of infection remain key uncertainties.

Given this outlook, Cyprus can help guide its economic recovery from the pandemic through a three-point plan focused on financial policies, fiscal support, and measures to improve productivity.

• Address problem loans to strengthen bank balance sheets and support credit growth. While Cyprus has reduced nonperforming loans substantially, the ratio of these loans remains among the highest in the euro area. Sizable exposure to vulnerable contact-intensive sectors such as tourism and retail also poses a risk. A significant share of loans to these sectors were protected under a loan repayment moratorium, which could test the capacity of banks to cope with a possible new wave of borrower distress.
  

  Bank supervisors should encourage continued close monitoring of borrowers’ repayment capacity to ensure prompt recognition and adequate provisioning of potential loan losses. Macroprudential buffers should be used flexibly to support both restructuring and the ability of banks to supply credit. Stronger debt restructuring and insolvency tools are vital for timely debt resolution so that firms under debt distress remain viable as policy support is gradually withdrawn. Complementary reforms in the judicial sector are also crucial to facilitate this process.

• Focus on mitigating the impact of the crisis while maintaining debt sustainability. Cyprus entered the crisis with high public debt, but also a sizable fiscal surplus. In 2021, the budget provides for continued policy support while aiming for a small improvement in the fiscal balance and a decline in the public debt ratio.

In the near term, fiscal policy should focus on fighting the pandemic and containing its economic impact. A premature withdrawal of fiscal support should be avoided. The focus on viable firms to minimize scarring should increase. Support measures that rely on assessments by banks would help with targeting viable firms. Policies that incentivize more equity investments would also support this objective.

When the recovery is firmly underway, the focus should gradually shift to maintaining fiscal sustainability by putting debt on a downward path and promoting more growth-enhancing policies. This includes mobilizing revenues through more efficient tax collection and new tax sources, such as carbon taxes, and reorienting expenditures toward greater investments in digitalization and a green recovery. Maintaining transparency on the use of COVID-19-related spending is crucial to build public support.

• Support the reallocation of resources to strengthen future growth and make it more inclusive. The pandemic has affected businesses unevenly, severely impacting contact-intensive sectors. The degree of long-term scarring hinges on the success of efforts to preserve capacity and facilitate the reallocation of resources.

It will be crucial for labor market policies to support the economic adjustment after COVID-19. Policies will need to transition from preserving jobs toward promoting efficient labor reallocation. Specifically, active labor market policies such as retraining and public employment services need to increase. Spending on training and direct job creation in Cyprus has been among the lowest in the European Union.

Minimizing the impact of the crisis on inequality to ensure a more inclusive recovery should be a priority. Job losses are distributed unevenly, with young people and women facing a greater setback. Policies should pursue an increase in the participation of women in the labor force by improving childcare and flexible working arrangements. For young people, policies need to focus on job search assistance, incentives for part-time work, and payroll subsidies for newly-hired staff.