Staff teams from the European Commission (EC), European Central Bank
(ECB), and the International Monetary Fund (IMF) visited Nicosia during
January 29-February 11, 2014 for the third review of Cyprus's economic
program, which is supported by financial assistance from the European
Stability Mechanism (ESM) and the IMF. The objectives of Cyprus’s
program are to restore financial sector stability, strengthen public
finance sustainability, and adopt structural reforms so as to support
long-run growth, while protecting the welfare of the population.
Discussions with the authorities during this visit focused on policies
to restore confidence on the financial system and implementation of the
structural reform agenda.
Cyprus’s program remains on track, with the macro-fiscal outturn
better than expected. Fiscal targets for 2013 have been met with
considerable margin, due to both continued prudent budget execution and a
less severe recession than anticipated. Output in 2013 is estimated to
have contracted by about 6 percent in real terms, which, while
significant, is almost two percentage points better than forecasted at
the time of the last review. Private consumption contracted, although by
less than expected, while tourism and professional services have proven
resilient. The financial sector is also showing signs of stabilization.
The economy is adjusting flexibly as prices and wages are declining,
helping to cushion the full impact of the recession on jobs. Still,
unemployment remains very high.
The outlook remains challenging. Output is projected to contract by
4.8 percent in 2014, with domestic demand weighed down by the need for
an adjustment of private and public sector debt from currently high
levels. A return to positive but modest growth of around 1 percent is
expected in 2015, led by non-financial services. Nonetheless, risks to
the outlook are substantial.
In the financial sector, the first challenge is dealing with the high
level of non-performing loans. With the two largest banks now
recapitalized and the cooperative credit sector expected to be
recapitalized shortly, the authorities need to ensure that banks and
coops effectively implement their restructuring plans. This requires
putting in place adequate arrears management frameworks and carefully
monitoring progress toward reducing loans in arrears. For coops, it is
also important to complete planned mergers and strengthen governance. To
facilitate the clean-up of banks’ balance sheets and the reduction of
private sector indebtedness—both of which are needed to restore credit
and sustainable growth—an appropriate debt-restructuring framework is
necessary. In this regard, the authorities need to reform the insolvency
legislation to offer balanced incentives that can prevent strategic
defaults while providing solutions for voluntary debt restructuring for
viable borrowers.
A second challenge is the need to normalize payment flows in the
economy while safeguarding financial stability. With key milestones in
the authorities’ roadmap now completed, the second phase of gradual
relaxations of restrictions is expected to start shortly. Finally,
efforts also need to continue to strengthen implementation of banking
sector regulation and supervision as well as of the anti-money
laundering framework...
Building on the strong fiscal performance to date, the authorities
will need to continue to implement their budget prudently. As agreed at
the onset of the program, an additional adjustment will be necessary in
the outer years to attain the long run objective of a sustained four
percent of GDP primary surplus, which is needed to place public debt on a
sustainable downward path.
The implementation of structural reforms needs to be accelerated. A
key priority is the reform of the social welfare system. This will
consolidate existing welfare benefits and introduce a guaranteed minimum
income scheme, so as to provide adequate social protection of
vulnerable households during the current downturn. To improve the
efficiency of revenue administration the authorities need to take steps
to advance the merger of the two main tax collection agencies. Moreover,
efforts need to be intensified to protect revenue collections in the
short term, including by fighting tax evasion. Public financial
management should be strengthened by adopting without delay and
implementing the fiscal responsibility and budget systems law.
Finally,
privatization of state-owned enterprises is essential to increase
economic efficiency, attract investment, and as a means to reduce public
debt. In this regard, the adoption of the framework law for
privatization is a key step to kick-start the process.
While the program remains on track, Cyprus still faces significant
risks. Continued full and timely policy implementation remains essential
for the success of the program.
Conclusion of this review is subject to the approval process of both
the EU and the IMF and is expected to be considered by the Eurogroup,
the ESM Board of Directors, and the Executive Board of the IMF by early
April. Its approval would pave the way for the disbursement of €150
million by the ESM, and about €86 million by the IMF.
