On December 13, 2017, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Cyprus.
The Cypriot economy has achieved an impressive turnaround since the 2012–13 banking crisis. GDP growth has been accelerating for three consecutive years on strong foreign demand, reaching 3.8 percent (year-on-year) during the first nine months of 2017. Rising labor demand has sharply lowered the unemployment rate to 10.3 percent as of September. Emergency liquidity assistance to banks has been fully repaid. Gains in cost competitiveness and strong foreign demand have narrowed the underlying current account deficit (excluding large one-off imports). The fiscal primary balance has swung from a large deficit to a surplus of 3.0 percent of GDP in 2016, supported by earlier reforms and revenue from the robust recovery, and is expected to increase further this year. However, crisis legacies in the form of extremely high private sector debt and nonperforming loans (NPLs) and elevated public debt have yet to be eliminated.
The current strong growth momentum is expected to persist for the next several years, underpinned by ongoing large construction projects and (albeit undesirable) weak payment discipline alongside slow progress with NPLs that will support consumption. Rising import intensity of activity is expected to rewiden the current account deficit, while output is forecast to grow above capacity and give rise to a positive output gap. Continued primary surpluses will help to reduce public debt.
This strong growth cycle could be threatened by excessive concentration of activity into construction and real estate and by potentially-volatile capital flows. Persistently slow resolution of NPLs would keep financial sector vulnerabilities elevated. Growth prospects could be significantly boosted if development of offshore hydrocarbon deposits proves financially viable.
Executive Board Assessment [2]
Executive Directors commended the authorities for the Cypriot economy’s impressive recovery from the 2012–13 banking crisis, facilitated by prudent macroeconomic policies and progress on structural reforms, together with strong foreign demand. Directors observed, however, that progress on reducing nonperforming loans has been tepid, and that private and public debt remain high. They urged the authorities to take advantage of the current strong growth momentum to resolve legacy problems and generate a broader basis for future growth.
Directors urged the prompt implementation of a comprehensive deleveraging plan, supported by measures to improve payment discipline. Simultaneously reducing excessive private debt and banks’ weak loan portfolios would help protect macro-financial stability. Directors recommended using an array of restructuring tools, in combination with burden-sharing, to limit the short-term dampening effect on GDP growth. They also called for improving payment discipline through a strengthening of the legal framework for resolving problem loans.
Directors stressed the need for banks to adopt ambitious and credible strategies to reduce nonperforming loans, underpinned by long-term capital plans and realistic assumptions on recovery rates and the required provisioning. They cautioned banks against warehousing properties on their balance sheets that were acquired through debt-to-asset swaps, and underscored the need to preserve prudent standards for new lending and loan classification.
Directors welcomed the significantly improved fiscal position and urged safeguarding these gains to achieve a rapid reduction in public debt. They agreed that the authorities’ plan to set a ceiling on fiscal spending that increases in step with medium-term GDP growth would help contain spending pressures and limit the risk that cyclical or one-off revenue is spent. To help keep spending within the ceiling, Directors recommended adopting the civil service reform law and closely monitoring the cost of the planned National Health Scheme. Completing pending revenue administration and public expenditure reforms would also create space for growth-enhancing spending.
Directors called for reinvigorating the structural reform agenda. They advised a tightening of lending standards to avoid excessive concentration of economic activity and to protect financial stability. They stressed in this context the need to safeguard the integrity of the citizenship-by-investment program by ensuring compliance with AML/CFT standards. Directors also called for strengthening competition and productivity to attract investment and help diversify the economy. Restarting the privatization program and undertaking governance reforms in the public and private sectors will also be important. In this regard, Directors recommended establishing a dedicated commercial court to strengthen the enforcement of commercial claims.
[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.
[2] 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. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm .
