Press Release No. 23/197

IMF Executive Board Concludes 2023 Article IV Consultation with Cyprus

June 5, 2023

Washington, DC: The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Cyprus on a lapse-of-time basis. [2]

Cyprus’s economy has been resilient to the fallout from Russia’s invasion of Ukraine. Output grew by 5.6 percent in 2022, as pandemic-affected pent-up demand boosted consumption, tourist arrivals rebounded, and the ICT sector expanded. Employment recovered and unemployment dropped to a post-Cyprus-financial-crisis low. However, high energy prices contributed to inflation and a larger current account deficit. The fiscal surplus reached 2.3 percent of GDP and public debt declined strongly. Liquidity and capital adequacy ratios in the banking sector have remained high, and profitability improved. Private sector deleveraging continues to be hindered by the slow resolution of legacy non-performing loans (NPLs).

Growth is expected to slow to around 2½ percent in 2023, reflecting an erosion in household incomes, tighter financial conditions, and delayed impacts from sanctions against Russia. But growth is expected to average around 3 percent in the medium-term, supported by public and private investments, structural reforms, and further ICT expansion. High inflation will recede only gradually amid elevated inflation expectations and wage pressures. Tight fiscal policy this year will help contain price pressures from aggregate demand and the public debt ratio is on a firmly declining path. The external current account will improve moderately but remain in sizable deficit.

The outlook is uncertain with risks from an escalation of the war and a possible recession in Europe. Should inflation expectations rise further and the pass-through to wages intensify, inflation could be stickier than expected. Adverse macroeconomic developments could amplify financial risks given high private debt.

Executive Board Assessment

Growth will slow in 2023, facing headwinds from inflation and financial tightening. The rebound in tourism and expansion of the ICT sector is expected to continue, against headwinds from the tightening of financial conditions and persistent inflation pressures. Risks remain to the downside, including from a deeper slowdown in Europe. Growth is forecast to gradually pick up from 2024 and average 3 percent in the medium-term, supported by structural reforms under the RRP. The external position has been weaker in 2022 than implied by fundamentals and desirable policies and is set to strengthen only gradually.

A moderately contractionary fiscal stance in 2023 remains appropriate to contain price pressures and further reduce public debt. The 2023 budget—underpinned by prudent revenue projections and contained expenditures—generates a small negative fiscal impulse of 0.2 percent of GDP in 2023. This is commensurate with the need to contain inflation pressures and a further decline in the public debt-to-GDP ratio. Yet, fiscal policy should stand ready to respond if growth turns out weaker than expected, allowing automatic stabilizers to work, and through targeted and time-bound support measures—relaxing the fiscal stance only if significant slack emerges.

Decisions on wage indexation and support measures should be based on a holistic view on their macroeconomic impact. A fuller automatic adjustment of wages to inflation through the CoLA mechanism should be avoided. It would likely make inflation more persistent, adversely affect competitiveness, and reduce fiscal space. It would also reduce flexibility in response to future shocks. The guaranteed minimum income may need to be carefully recalibrated while strengthening its activation requirements.

The recent shocks have demonstrated that fiscal policy can be a powerful tool to foster resilience, and buffers should be rebuilt over the medium-term. Fiscal policy should aim at sustaining primary surpluses to reduce public debt over time, supported by a risk-based fiscal framework. As buffers are rebuilt, available fiscal space should be directed to productive investments for the green and digital transitions. Putting the NHS on a sound fiscal footing and strengthening governance and accountability of SOEs will help to stay the course with the planned fiscal path.

Despite improved bank resilience, risks remain. So far, higher policy rates have boosted bank profitability, but credit risks are likely to rise with financial tightening—especially given the high private sector indebtedness—and should be monitored. The initiation of a positive neutral CCyB rate will improve resilience, which would be enhanced by building larger buffers over time. Growth of NBFIs is contributing to diversification but requires stronger supervisory framework.

Steadfast implementation of policies to address legacy NPLs would facilitate their faster resolution and private sector deleveraging. The foreclosure framework should be implemented forcefully to address strategic defaulters. Banks should also proactively use all available tools to enable timely restructurings, supported by recent legislative progress. Continued efforts are needed to advance work on the newly envisaged hybrid/out-of-court restructuring procedure. The MtR scheme will help advance the resolution of NPLs from vulnerable borrowers, but efforts should be taken to minimize fiscal risks from the scheme. Further strengthening the AML/CFT framework will help address reputational risks.

Further structural reforms are key to unlock growth potential. Cyprus is well positioned to leverage its well-developed professional services and strategic location but streamlining immigration would help address labor market shortages, while related housing affordability concerns could be addressed by supply-side measures. Reforms in the RRP are critical for overcoming structural bottlenecks, especially by improving governance and future-proofing workers’ skills though education system reforms, which could be usefully accelerated. Investments in digital infrastructure will support the digital transition.

A greener growth model is an important element of reforms. Cyprus aims to become emissions neutral by 2050. Integration into the regional electric grid and the expansion of renewables—together with a liberalization of the domestic electricity market—are key elements of this strategy and will also improve energy security, but require large public and private investments.