Staff teams from the European Commission (EC), European Central Bank
(ECB), and the International Monetary Fund (IMF) visited Nicosia during
July14-25, 2014 for the fifth review of Cyprus's economic program, which
is supported by financial assistance from the European Stability
Mechanism (ESM) and the IMF. Cyprus’s program seeks to ensure the
recovery of economic activity to preserve the welfare of the population
by restoring financial sector stability, strengthening public finance
sustainability, and adopting structural reforms to support long-run
growth.
Staff-level agreement was reached on policies that could serve as a
basis for completion of the fifth review. The authorities have continued
to meet the fiscal targets with significant margin in the first half of
the year, as a result of prudent budget execution. In the financial
sector, banks are advancing with their restructuring plans and capital
raising while supervisory monitoring of their actions and operational
capacity to address non-performing loans has been enhanced. Structural
reforms are proceeding: the authorities have implemented a welfare
reform providing a guaranteed minimum income for all those in need, have
commenced the integration of the revenue administration, and have
strengthened the administration’s powers to fight tax evasion.
The macroeconomic outlook remains broadly unchanged compared to the
fourth review. Output in 2014 is expected to contract by 4.2 percent,
with growth in the tourism sector cushioning weak activity in other
sectors. Unemployment remains very high, although signs of stabilization
are emerging. Growth in 2015 is projected at 0.4 percent, with the
recovery constrained by the high level of private sector debt. Risks
remain significant, related to constraints to the supply of credit, as
well as to the ongoing crisis in Ukraine...
Reversing the rising trend of non-performing loans is critical to
restoring credit, economic growth, and the creation of jobs. Putting in
place without delay an effective legal framework for foreclosure and
insolvency is essential to ensuring adequate incentives to borrowers and
lenders to collaborate to reduce the level of non-performing loans.
Moreover, the debt-restructuring supervisory framework needs to be
further strengthened. Ongoing efforts by banks to proactively raise
capital in the private markets are welcome. Such efforts will also be
conducive to a smooth transition to the Single Supervisory Mechanism
following the completion of the pan-European comprehensive assessment
and should therefore help to strengthen the banks’ resilience to shocks
and ability to revive lending.
Banks and the coop sector should continue to implement their
restructuring plans. Further reducing operational costs, ensuring stable
funding, strengthening arrears management capacity and processes, and
improving governance are key ingredients for a healthy banking sector
that can support the economy and allow for the gradual relaxation of
capital controls according to a revised milestone-based roadmap. To
prevent vulnerabilities from reemerging and preserve the integrity of
the financial sector, the authorities need to further strengthen
supervision and regulation and step up the implementation of the Anti
Money-Laundering (AML) framework, in particular with respect to AML
supervision of banks.
The authorities have pursued a cautious fiscal policy, which helped
allow them to over-achieve fiscal targets consistently. Such prudence
should continue, in light of lingering risks. In particular, next year’s
budget needs to be based on conservative assumptions, ensure the fiscal
neutrality of the new welfare reform, and help achieve a smooth path
towards the medium-term primary fiscal surplus target of 4 percent of
GDP in 2018 that will put public debt on a sustained downward path.
The authorities should maintain the structural reform momentum. With
the welfare reform adopted, the authorities must focus on its
implementation to ensure that vulnerable groups are protected during the
downturn. They also need to advance the implementation of the revenue
administration reform by taking further steps toward the integration of
the two tax departments under a unified and more effective
administration. This should be complemented by continued efforts to
combat tax evasion and non-compliance and strengthen the management of
public debt and of fiscal risks. Timely implementation of the
privatization plan is necessary to increase economic efficiency, attract
investment, and reduce public debt.
Given still high 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. The matter is expected to be considered by the
Eurogroup, the ESM Board of Directors, and the Executive Board of the
IMF in late September. Their approvals would pave the way for the
disbursement of €350 million by the ESM, and about €86 million by the
IMF.