Via IMF (Den Internationale Valutafond)

Cyprus: IMF Staff Concluding Statement of the 2019 Article IV Mission

September 26, 2019

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Cyprus has made significant progress in recovering from the
financial crisis. Real GDP has now surpassed its pre-crisis peak
and the unemployment rate has declined rapidly coming close to the
pre-crisis level.
Large disposals of non-performing loans (NPL) have strengthened bank
stability, and sizable fiscal surpluses have lowered risk premia and
reduced financing risks.

Challenges remain however in sustaining the relatively robust growth
momentum. Given still-high NPLs, recent efforts to undo key reform
initiatives are undermining the hard-won gains in restoring
macro-financial stability. Increasing external headwinds are slowing
near-term growth, while a sizable debt overhang and weak productivity
growth also hold back medium-term growth potential.

Policies should focus on reforms to secure financial stability and
raise the growth potential of the economy. Priorities are to
steadfastly implement the strengthened legal tools to lower NPLs and
private debt and to build bank capital buffers; to reduce public debt
by ensuring strict spending discipline and improving the efficiency of
public spending; and to increase productivity through institutional
reforms and the promotion of technology adoption.

Outlook and Risks

  1. Cyprus has made significant strides in recovering from the
    financial crisis and in addressing its legacy challenges

    . With economic growth averaging about 4½ percent over the past
    three years, the pace of recovery in Cyprus has been more rapid
    than many other euro area post-crisis economies. The
    unemployment rate has declined although it is still above the
    pre-crisis level. Efforts to address high NPLs and banking
    system vulnerabilities also gained momentum.

    The disposal of large NPL portfolios, supported by a strengthened
    foreclosure and insolvency framework last year, and the resolution
    of Cyprus Cooperative Bank paved the way for a more consolidated
    and deleveraged banking system. GDP levels have now surpassed
    pre-crisis levels, while in the banking system, NPLs as a share of
    GDP have declined by nearly two-thirds from its post-crisis peak.
    Although public debt has spiked in the process, strict spending
    discipline and large fiscal surpluses have helped Cyprus to
    capitalize on favorable market conditions and reduce debt

  2. While economic growth is gradually moderating, the near-term
    economic outlook remains favorable

    . Growth is expected to decelerate to around 3 percent in 2019–20
    on weaker external demand, from nearly 4 percent last year.
    Investment is expected to remain strong, driven by housing and
    infrastructure construction projects that are primarily foreign
    financed, while robust labor market recovery and rising income
    continue to support private consumption. The current account
    deficit is expected to widen, reflecting slowing growth among
    trading partners and continued high construction-related imports.
    Over the medium term, growth is expected to slow to its
    long-run potential growth rate of around 2½ percent, as the
    transitory effect of the investment boom gradually dissipates.

  3. Risks to the outlook are mainly on the downside
    . Delays in NPL resolution could negatively affect the capital
    position of banks and weigh on availability of credit. Realization
    of fiscal contingent liabilities could slow the pace of debt
    reduction, eroding confidence and raising risk premiums. The high
    level of external debt makes the economy vulnerable to interest
    rate and growth shocks. External risks from rising protectionist
    trade policies, a sharper-than-expected slowdown in euro area
    growth or a hard Brexit could affect tourism and shipping revenues
    and foreign direct investment (FDI) flows.

    A negative assessment on Anti-Money Laundering/Combating
    Financial Terrorism (AML/CFT) compliance risks could affect
    confidence and deter investments.


    On the upside, exploitation of offshore gas deposits and energy
    sector investments could boost growth over the longer term.

  4. Important challenges remain in sustaining the growth momentum
    over the longer term

    . Private sector deleveraging has been lagging given ongoing
    challenges in debt workouts. The NPL ratio has declined from more
    than half of loans at end-2017 to less than one-third today but
    remains among the highest in Europe, and banks suffer from low
    profitability, constraining credit and investment growth. In this
    context, the amendments to the foreclosure framework, which were
    recently approved by the Parliament but have not entered into
    effect and are currently being reviewed by the Supreme Court, are a
    setback creating uncertainties for NPL reduction and deleveraging
    of the economy. Longer-term economic growth potential is hindered
    by weak productivity growth, reflecting financial sector weakness
    as well as broader institutional bottlenecks and a slow pace of
    technology diffusion. Policies should thus focus on reforms to
    secure financial stability and strengthen growth potential by
    enhancing efficiency and productivity.

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Policy Priorities

Financial Sector Policy: Supporting Deleveraging and Strengthening
Financial Sector

  1. NPL resolution and sustainable debt workouts remain key

    . Efforts should focus on ensuring a well-functioning NPL
    resolution toolkit through restructuring, foreclosure, and
    insolvency. To this end, the recent amendments to the legislation
    risk reducing the effectiveness of foreclosure as a credible threat
    against strategic default, thereby weakening prospects for
    collateral recovery and increasing the need for additional
    provisioning. Adequate supervisory oversight of durable
    restructuring is crucial. The finalization of the framework for
    electronic auctions and continued progress with complementary
    judiciary reforms aimed at reducing backlogs will also be key to
    improve collateral execution and incentives for debt workouts.

  2. Strengthening of the supervisory and regulatory framework of
    credit acquiring companies (CACs) should continue.

    While progress has been made on multiple fronts, including
    staffing, on-site inspections and off-site monitoring,
    strengthening of data reporting and analysis will be crucial given
    that a sizable stock of NPLs is now held by CACs. It is also
    important to swiftly finalize the state-owned Cyprus Asset
    Management Company’s (CAMC) governance and operational structure,
    business strategic plan, and performance measurement framework,
    with an appropriate sunset clause and a clear mandate to maximize
    recovery, while balancing operational independence with public
    accountability and transparency.

  3. Efforts should be made to address the moral hazard risks
    inherent in the Estia subsidy scheme

    . Close monitoring to prevent potential abuse of the scheme and
    timely reassessment of borrower eligibility will be needed, to
    ensure that taxpayers are not called on to subsidize individuals
    who are capable of servicing their mortgages. Any complementary
    schemes for vulnerable primary owners deemed unviable under Estia should ensure further burden sharing and be
    well-targeted with a full cost-benefit analysis undertaken to
    control fiscal and implementation costs.

  4. More broadly, efforts to further improve bank profitability and
    capitalization are crucial.

    Narrowing interest margins and excess liquidity in a declining
    interest rate environment are creating pressures on profitability,
    which is being further weighed down by an inefficient cost
    structure with excess staffing levels and branch networks in the
    banking system. Banks should continue to maintain adequate
    provisions and capital buffers to insulate against potential
    further losses from NPL sales and workouts and reduce property
    holdings to targeted levels. Policies should encourage lowering of
    cost-to-income ratios through rationalization of operational costs,
    diversifying income sources, and undertaking of digitization

  5. Macro-financial risks from the property market appear limited
    for now but warrant close monitoring.

    The segmented nature of the property market calls for close
    monitoring of sectoral developments, for example, to ensure that
    any overheating in the luxury segment is not fueled by domestic
    credit, or that concentration of future sales of repossessed
    collateral properties does not lead to fire-sales. Macroprudential
    measures tailored to the market segment should be undertaken if

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Fiscal Policy: Mitigating Risks to Debt Sustainability and Enhancing

  1. Fiscal performance is strong, but risks remain
    . Cyprus is projected to maintain large primary surpluses that
    will allow public debt to decline rapidly over the medium term.
    However, this outlook is subject to risks, including from
    court-mandated increases in the public wage bill reversing
    crisis-era measures, higher-than-expected spending under the
    newly introduced National Health System (NHS)—particularly from
    lagging competitiveness of the public health sector vis-à-vis
    the private sector—and contingent liabilities from public
    entities, as well as the Asset Protection Scheme and weak asset
    quality in the financial sector.

  2. Spending should be firmly controlled to reduce risks to debt
    sustainability, while the composition of expenditure should
    seek to enhance efficiency

    . Expenditure growth should be capped by nominal medium-term output
    growth to keep debt firmly on a downward path. Prioritizing public
    spending to support structural reform efforts would help achieve
    faster and more inclusive medium-term growth. To this end, growth
    of the wage bill should be contained below that of nominal GDP, to
    create space for more productive expenditure. There is scope to
    improve the efficiency of education spending, including by
    reallocation towards investment in innovation and human capital. To
    contain risks from the NHS, strict monitoring and finetuning of the
    regulatory framework for controlling incentives and costs of
    services, together with improving the competitiveness of the public
    health sector, will be important.

Structural Reforms: Improving Productivity and Strengthening Growth

  1. Productivity enhancing structural reforms are key for
    bolstering medium-term growth potential

    . While Cyprus has maintained its cost competitiveness, it suffers
    from low labor productivity growth and faces challenges to
    investment and economic efficiency. These include difficulties with
    access to finance, costly and lengthy judicial processes,
    inefficiency of government administration, low investment in new
    innovations, and skills mismatches.

  2. Policies to support greater market diversification,
    competition, and technology adoption are needed to enhance

    . Greater investment in Information and Communications Technology
    infrastructure, intangibles such as science, technology,
    engineering and mathematics training, research and development
    innovation and easier access to finance are needed to facilitate
    technological diffusion. Given strong reliance on services exports,
    reducing remaining restrictions in implementing the EU Market
    Services Directive could facilitate competition and attract FDI.
    These reforms would enable greater market diversification, which
    would support faster economic growth and reduce volatility. Other
    competitiveness-enhancing policies could focus on strengthening
    business linkages and external connectivity to international

  3. Ongoing efforts to improve efficiency of the judiciary should
    continue, in order to better enforce commercial claims, support
    deleveraging and reduce the cost of doing business

    . The recent specialization of selected judges in financial
    litigation, the ongoing recruitment of additional judges, and work
    on establishing a court of appeals should be complemented by
    reforms of the rules for civil procedures, clearance of the backlog
    of cases and introduction of the e-justice system. Strengthening
    the institutional framework for the insolvency service and
    insolvency professionals is also important. Efforts are needed to
    create a more efficient system of issuing and transferring title
    deeds and accelerate the clearance of the backlog.

  4. Efforts to reform public sector governance and efficiency
    should be renewed

    . Approval of pending legislation to reform the assessment of
    candidates for appointment and promotions and the structure of the
    civil service would facilitate greater mobility and enhance
    effectiveness. Legislative efforts to strengthen the governance and
    autonomy of the Central Bank of Cyprus should also be expedited.
    Successful implementation of local government reforms would
    streamline procedures and improve service delivery. Fiscal
    institutional measures for strengthening governance of state-owned
    enterprises, public financial management controls at the local
    government level and reforms in tax administration would help
    contain risks while improving public efficiency.

  5. Ensuring that growth is inclusive is key to sustaining growth

    . While unemployment is rapidly declining, the share of youth not
    in employment, education or training and long-term unemployment
    remain high, partly reflecting skill mismatches. Programs focused
    on job retraining and improving linkages between educational and
    job opportunities would help reduce this gap.

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We thank the Cypriot authorities and our other interlocutors, including
from the private sector, for informative discussions and their
cooperation and generous hospitality. We also thank the European
Commission, the European Central Bank, and the European Stability
Mechanism for their collaboration during part of the mission



A report by MONEYVAL (the Committee of Experts on the Evaluation of
Anti-Money Laundering Measures and the Financing of Terrorism, a
permanent monitoring body of the Council of Europe) is expected
later this year.

IMF Communications Department


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