This Selected Issues paper identifies key challenges among households in reducing nonperforming loans (NPL) further in Cyprus, namely, low repayment capacity, particularly among a certain group of debtors; and weak repayment discipline owing to strategic behavior. Despite some revival of lending activity, the role of bank credit as a funding source remains limited. External inflows, drawdown of savings, use of own funds, and unpaid debt service obligations are contributing to financing economic activities, but these sources may not be sustainable over the medium term. Addressing NPLs to lower borrowing costs and reviving credit supply will be important for supporting longer-term growth. Since 2017, bank credit has provided only a moderate amount of new financing. The reduction in credit-to-GDP ratio has been almost entirely achieved by NPL write-offs and sale or transfer of loans out of the banking system, and through denominator effect. As of 2017, credit demand appears moderately strong, in line with robust economic growth, while credit supply remains broadly unchanged, reflecting continued risk averseness by banks. These trends suggest that while deleveraging is expected to continue through clean-up of bank balance sheets, growth in credit flows (pure new loans) are likely to remain at a moderate level until NPL recovery and repayment discipline improves significantly.
This 2009 Article IV Consultation highlights that despite its resilience so far, the economy of Cyprus is slowing down and risks are increasing. The expected slowdown will increase credit risk in banks, which, in some plausible but unlikely extreme scenarios, could have systemic implications given the size and concentration of the banking sector. Executive Directors have endorsed the government’s objective to achieve a balanced budget over the medium term. Directors have also recommended the adoption of a medium-term budget framework and more effective management of public sector liabilities.
The financial sector is mostly comprised of the banking sector, which largely provides insurance and asset management services. A large part of banking system assets relates to subsidiaries and branches of foreign banks. The banking sector poses risks by virtue of its size and concentration. The Cypriot banking system has weathered the crisis better than many other euro zone area countries. Significant headwinds for the overall banking system are expected, and the cooperative banks appear particularly vulnerable.
Economic conditions have stabilized, and the economy is projected to bottom out in 2010, giving way to a mild recovery in 2011 followed by stronger growth. The foremost policy challenge is to achieve the official fiscal consolidation targets so as to put debt ratios on a declining path and provide more space to guard against risks to the financial sector. Further old-age pension reform is also essential. Structural reforms are needed to preserve competitiveness and enhance medium-term growth. The government largely shared the IMF staff’s assessment.
The Selected Issues Paper focuses on Cyprus' banking sector vulnerabilities and its pension system. The most salient risks for the banking sector come from commercial banks domiciled in Cyprus. These banks have the strongest links with the local economy and are likely to experience further deterioration of their loan portfolios in both Greece and Cyprus. The paper reveals that, in 2011, Cypriot banks face capital needs estimated at €3.6 billion on a preliminary basis.
1. Following an uneven start, Cyprus’s recovery compares favorably to those of other euro area economies affected by the financial crisis. Real GDP has now surpassed its pre-crisis peak, while the unemployment rate has declined significantly. Large NPL disposals and resolution of a systemic bank last year has helped strengthen bank balance sheets. While public debt jumped in the process, strict fiscal discipline and overall good progress with reforms have helped Cyprus regain its investment grade status and reduced risk premia to historical lows (Annex I).
1. The Cypriot economy was undergoing a strong recovery from the 2012–13 financial crisis before the onset of the COVID-19 pandemic. Real GDP growth, while gradually decelerating, remained strong, supported by the services and construction sectors, and financed by foreign direct investment. The unemployment rate and income inequality declined to close to pre-crisis levels. Underscoring the strong economic recovery, Cyprus repaid early the remaining balance of the outstanding credit to the Fund at end-February 2020 and successfully exited the Fund’s Post-Program Monitoring.
This paper discusses Cyprus' Eighth Review Under the Extended Arrangement Under the Extended Fund Facility and Request for Modification of Performance Criteria (PC). Cyprus continues to recover from the crisis, and program performance remains generally strong. Risks to the program remain, although their impact would likely be manageable. The domestic political situation remains a challenge to policy implementation. Despite the reduced real and financial linkages between Greece and Cyprus, developments in Greece have the potential to affect Cyprus through the confidence channel. Based on the continued progress under the program and policy commitments going forward, the IMF staff supports the completion of the eighth review and the proposed modifications of PCs.