Journal Issue
Share
Article

Cyprus

Author(s):
International Monetary Fund
Published Date:
November 2011
Share
  • ShareShare
Show Summary Details

BACKGROUND

A. Pre-Crisis

1. Before the 2008 crisis, Cyprus enjoyed a long period of high growth, low unemployment, and sound public finances. The unemployment rate reached a low of 3.6 percent in 2008, with rapid wage and employment growth attracting an inflow of foreign workers. The main growth drivers were services exports, including financial, legal, accounting, and shipping services, which were attracted by an educated English-speaking workforce, low corporate tax rates, double-tax treaties with strategic partner countries, a stable macroeconomic environment, and Cyprus’ favorable geographic location. Although declining in relative terms, tourism contributed 10 percent of GDP in 2008. Meanwhile, the public debt ratio was well below the euro area average at 48 percent of GDP at end-2008.

Exports of Services

(Percent of GDP, 2000-2010 average)

Sources: Statistical Office of the European Communities; and IMF staff calculations.

2. However, vulnerabilities were building in the form of widening external shortfalls, rapid credit growth, a real estate boom, and the large exposure of Cypriot banks to Greece. Current account deficits, which had previously been modest and mostly covered by FDI, started to widen after EU accession in 2004, reflecting a sharp drop of private savings (Box 1). The current account deficit hit a peak of 17 percent of GDP in 2008, which was largely financed by inflows of nonresident deposits to the banking system and external borrowing by banks. Rapid credit growth fueled a housing boom. Meanwhile, strong domestic demand, supported by foreign financing, contributed to rapid wage increases in excess of productivity gains.

Sources: CBC; Cystat and IMF staff calculations.

Cyprus in Regional Perspective

Sources: Statistical Office of the European Communities; and IMF staff calculations.

Box 1.Savings and Investment

After EU accession in 2004 and the run-up to adopting the euro in 2008, savings declined sharply, contributing to the rapid increase in the current account deficit. This likely reflected optimism about growth prospects as a full-fledged member of the euro area, as well as the easy availability of external credit that also led to lower savings in other peripheral euro area countries. Between the accession year of 2004 and the onset of the financial crisis in 2008, the saving rate dropped from 15 to 7 percent of GDP. Meanwhile, the investment rate increased from about 19 to 23 percent of GDP between 2004 and 2008, also contributing to the current account deficit. The private sector accounted for most of the saving decline and investment increase, while public saving and investment stayed largely constant.

Almost all of the increased investment between 2004 and 2008 went into the construction sector (investment in construction increased by 3.5 percent of GDP, while investment in machinery and equipment increased by only 0.3 percent of GDP). Much of the construction boom was driven by foreign demand for vacation homes (especially from the UK).

Sources: IMF, WEO, April 2011; and IMF staff calculations.

Sources: IMF, WEO; AMECO; and IMF staff calculations.

B. Impact of Crisis

3. The crisis hit Cyprus through a drop in services exports and an abrupt slowdown in construction, whose impact was softened by a large fiscal expansion. Cyprus experienced the mildest recession in the euro area in 2009, with a drop in GDP of 1.9 percent. A sizable fiscal stimulus played a major role in cushioning demand. The relatively low reliance on manufacturing exports (which are more cyclical than service exports) and on wholesale bank funding also softened the impact of the crisis on exports and credit growth. Nonetheless, the recession triggered a sharp fall in consumption and a significant increase in unemployment. Growth recovered modestly in 2010, despite the dampening effects of increasing unemployment and high household leverage. Contraction in the construction sector and weak tourism remained important drags on the economy.

4. The current account deficit adjusted sharply, but remained at high levels compared to other euro areas countries. The current account deficit improved from 16.8 to 7.5 percent of GDP between 2008 and 2009, mainly due to weaker import demand and lower commodity prices. It remained stable in 2010, as a recovery of services exports was offset by a weaker goods balance due to higher oil prices. FDI provide the main source of financing over 2009-10, covering 65 percent of the current account deficit.

5. The fiscal deficit deteriorated sharply in 2009 due to both structural and cyclical reasons, and narrowed somewhat in 2010 as a result of one-off factors and a small revenue package. A stimulus package of 4 percent of GDP was implemented in 2009 to cushion the impact of the crisis. The main measures were permanent increases in wages and salaries (1.6 percent of GDP), social transfers (1.6 percent of GDP), and public investment (1.4 percent of GDP). Automatic stabilizers were also allowed to operate, and a sharp decline (2.5 percent of GDP) in construction/real estate related revenues was largely accommodated. The result was a swing from a surplus in 2008 to a deficit of close to 6 percent of GDP in 2009. In 2010, one-off central bank-related revenues (0.5 percent of GDP), and a hike in petroleum excises and tax compliance measures (0.5 percent of GDP), contributed to a modest narrowing of the deficit.

Fiscal Indicators
200820092010
Overall balance0.9-5.9-5.3
Cyclically adjusted fiscal balance-0.2-5.6-4.8
Structural fiscal balance-2.2-5.9-5.3
Output gap2.8-0.8-1.2
Source: IMF staff estimates.
Source: IMF staff estimates.

CURRENT VULNERABILITIES AND OUTLOOK

6. Financial conditions have deteriorated rapidly since late 2010, to the point where Cyprus is now effectively shut out of long-term sovereign debt markets. Starting in late 2010, ratings agencies launched a series of downgrades and investors increasingly focused on the large exposure of the country’s banks to Greece. Conditions worsened over the summer in tandem with adverse Greek developments and fiscal slippage in Cyprus. By mid-2011, 10-year government bond yields exceeded 10 percent and Cyprus had lost access to long-term sovereign debt markets. Meanwhile, bank stock prices plummeted, with the Cyprus Stock Exchange index (in which the three large banks account for over 90 percent of market capitalization) down 61 percent to date in 2011.

Cyprus 10-year Goverment Bond Yield

Sources: Bloomberg; and IMF staff calculations.

7. The destruction of a key power plant in July and its political fallout deepened the sense of economic uncertainty. On July 11, a huge cache of confiscated munitions stored at a military base exploded, causing significant loss of life and destroying the next-door Vassilikos power plant, which supplied half the island’s power. Reconstruction costs estimated at €300-700 million and are expected to be covered by the power company and insurance proceeds. The fallout included rolling blackouts in the summer months, with adverse effects on output and government revenues, and a weakening of support for the government. In early August, the President appointed a new cabinet, including a new finance minister. However, the centrist DIKO party left the governing coalition, leaving the ruling left wing AKEL party with a minority in parliament.

8. Growth is expected to be zero in 2011. The gradual recovery that started in 2010 was derailed by the loss of production and confidence stemming from the destruction of the power plant and weaker external demand, as well as increasing uncertainty and tighter financial conditions related to worsening prospects in Greece. The construction sector continues to retrench from the excesses leading up to the crisis. House prices and rents have been on a declining trend since the market peaked in 2008 and show no sign of recovery so far (Box 2). Tourism is one of the few bright spots, with revenues up 16 percent through August and on track to regain its 2008 level.

Box 2.Cyprus: The Housing Market

The housing market in Cyprus experienced a boom over 2006-08. The central bank price index shows an increase of over 50 percent over that period, followed by a decline of 12 percent. Buyers from abroad contributed to the run-up and subsequent drop, with the UK accounting for, 70 percent of foreign buyers. Since end-2008, weak UK (and global) growth and the depreciation of the pound against the euro have depressed foreign demand.

Residential Property Price Index

(2006 Q1 = 100)

Sources: CBC; and IMF staff calculations.

The future development of housing prices will have an important impact on demand and growth of the broader economy, as well as on bank balance sheets. Evidence on whether housing prices remain overvalued and subject to further correction is mixed. On two common indicators, the price-to-rent and the price to per capita GDP ratios, Cyprus does not exceed the European median1.

Source: Global Property Guide, October 2011

Another approach is to model the equilibrium housing price, which shows some overvaluation. We adopt the approach used in the fall 2004 WEO, which estimated the determinants of house prices in advanced countries using a dynamic panel model. Fundamental factors that were found to drive house prices are affordability (price-to-income ratio), income per capita, short-term interest rates, credit growth, population growth, and stock prices. Assuming that at the beginning of 2006 house prices in Cyprus were in line with economic fundamentals, their subsequent path follows qualitatively the same direction as predicted by the model, but with significantly higher increases. This methodology suggests prices may have remained overvalued in mid-2011 relative to their fundamental value, despite over two years of declines.

Cyprus: Predicted Versus Actual House Price

(Index, 2006 Q1 = 100)

Sources: IMF, WEO September 2004; Haver Analytics; Central Bank of Cyprus; and IMF staff calculations.

1 House prices and rents are for a 100 square metres residential housing unit in premier locations of the most important city of each country.

9. Staff projects an economic contraction of 1 percent in 2012 and a gradual recovery in outer years. The key drivers behind the expected downturn include yet tighter financial conditions as banks curtail their lending (or even shrink their balance sheets) in order to preserve capital and liquidity buffers; the negative short-term impact of fiscal adjustment measures; and a worsening growth outlook in the euro area and beyond. Unemployment is expected to peak at 8½ percent in 2012, while inflation is projected to decline to 2½ percent due to stabilization of commodity prices and subdued demand. Domestic demand is expected to recover over the medium term as both internal and external conditions normalize.

10. The current account deficit is projected to narrow further in 2011-12. The dampening impact of slow growth on imports, together with strong tourism (including a 50 percent increase in visitors from Russia), are expected to more than offset the impact of higher energy prices in 2011. As a result, the current account deficit is expected to decline from 7.8 percent of GDP in 2010 to 7.2 percent in 2011. The deficit is projected to narrow further in 2012, as the expected downturn depresses domestic demand, fiscal adjustment raises public sector savings, and commodity prices ease. Service exports are projected to remain subdued with only modest further gains in tourism receipts and sluggish shipping and international business services due to a worsened external environment. Box 3 provides an assessment of competitiveness.

11. The downside risks to growth are sizable. A key risk to the baseline projection arises from developments in the euro area. If financial turbulence were to intensify and prospects for Greece to worsen, this could have a large impact on Cypriot banks, leading to even tighter financial conditions with negative implications for confidence and demand. Further, an adverse shock to world trade would affect Cyprus through services exports, which account for close to half of GDP. Finally, the fiscal consolidation planned for 2012-13 could have a larger than anticipated contractionary impact. If these risks were to materialize, 2012 growth could be considerably lower than the baseline projection.

Box 3.Competitiveness and Structural Issues

Standard price-based real exchange rate measures show modest appreciation since 2000, with unit labor cost (ULC) based measures showing more significant appreciation. The overall ULC appreciation in Cyprus was higher than the euro area average. However it was broadly in line with other peripheral euro area countries, albeit with less downward flexibility around the period of the crisis. In particular, the ULC-based exchange rate for the manufacturing sector appreciated more than elsewhere. The manufacturing sector is small (currently at 7 percent of GDP) and has decreased as the economy has transitioned towards specialization in services, and the ULC-based appreciation may have helped to speed that transition.

Source: European Commission.

CGER estimates suggest that the real exchange rate is modestly overvalued. For the last decade, the real appreciation has been associated with persistent current account deficits above the norm predicted by economic fundamentals. CGER-based estimates suggest that the real exchange rate is overvalued by 9 to 10 percent. Although Cyprus CGER estimates is mostly an exporter of services rather than goods, staff analysis shows that the real exchange rate plays a similar role in both goods and services exports (see Selected Issues Paper).

CGER estimates
MacroeconomicEquilibrium realPurchasing
Measurebalanceexchange ratepower parity
CAB gap1/-2.8
REER gap 2/9.99.28.5
Source: IMF staff estimates.

Difference between actual current account balance (CAB) and the estimated equilibrium CAB in percent of GDP (the medium term average).

Percentage difference between the actual and the estimated equilibrium REER (the medium term average).

Source: IMF staff estimates.

Difference between actual current account balance (CAB) and the estimated equilibrium CAB in percent of GDP (the medium term average).

Percentage difference between the actual and the estimated equilibrium REER (the medium term average).

A. Fiscal policies and Financing

Fiscal Policies

12. The government has launched a new initiative aimed at reversing fiscal slippage and restoring market confidence. Staff projects that the deficit will widen from 5.3 percent of GDP last year to 7 percent in 2011, bringing public debt to 68 percent of GDP, due to cyclically weak revenues and the failure to contain spending. To reverse the slippage, the government has announced fiscal savings targets of €150 million (0.8 percent of GDP) in 2011, €650 million (3.6 percent of GDP) in 2012, and €400 million (2.2 percent of GDP) in 2013. Its stated goals are to reduce the fiscal deficit to 2.8 percent of GDP in 2012 and achieve a balanced budget by 2014.

  • Parliament passed a first package of measures in late August that the authorities estimate will yield savings of €109 million in 2011 and €152 million in 2012. Main measures include an increase in the permanent contribution of 4.25 percent by public sector workers toward their pensions, an increase in the withholding tax on interest income from 10 to 15 percent, and a flat levy on businesses. The government has also closed the public service pension system to new employees (who will participate instead in the national pension system).

  • A second package of measures was sent to Parliament in mid-October. According to the authorities, it would largely achieve the remaining savings targeted for 2012 but would leave the bulk of 2013 and 2014 savings for future legislation. Key measures include an increase in the VAT rate from 15 percent (the lowest in the EU) to 17 percent, a 6-month freeze of cost of living adjustments (COLA) for public servants (in addition the government will seek consensus by end-2011 on a permanent reform of the COLA that aims to achieve further fiscal savings), and improved targeting of social transfers based on income criteria. The authorities also announced that they would take additional measures in the event that realized fiscal savings from the measures fall short of the targeted amounts.

13. The proposed measures would be an important step towards addressing the high public sector wage bill and poorly targeted social transfers. At 15.4 percent of GDP in 2010, Cyprus has the largest public sector wage bill in the euro area. This was exacerbated in 2009 when wage increases pushed the wage bill up by 1.5 percent of GDP. Together with an array of poorly targeted social benefits (5.5 percent of GDP in 2010), these two categories consume 45 percent of total general government spending.

Compensation of General Government Employees, 2010

(Percent of GDP)
Non-contributory Social Transfers, 2010
Social welfare1.4
Child grants0.9
Special grants to pensioners0.8
Housing grants0.5
Educational grants0.5
Social pensions0.3
Health care local and abroad0.3
Easter allowance0.2
Scholar ship benefit0.1
Mother’s allowance0.1
Sight impaired allowance0.1
Other social transfers0.1
Total non-contributory social
transfers (percent of GDP)5.6
Source: Ministry of Finance.
Source: Ministry of Finance.

14. To support their fiscal consolidation goals and improve budget processes, the authorities plan to implement an agenda of structural fiscal reforms. These include:

  • (i) introduction of fiscal rules and a medium-term budget framework into national legislation, consistent with EU directives;

  • (ii) passage of a new public debt management law to improve debt and cash management;

  • (iii) accounting and statistics reforms to expand coverage and increase timely data availability; (iv) strengthening revenue and expenditure forecasting to increase transparency and reduce biases in projections.

15. Age-related outlays pose a major long-term challenge to public finances. Pension expenditures, including both the national scheme managed by the Social Security Fund (SSF) and the pension scheme for public workers, are projected to become one of the highest in the euro area by 2050. Health expenditures are also projected to increase by 1 percent of GDP by 2050.

Projected Pension Expenditure in 2050 SSF and Public Employees

(Percent of GDP)

Source: European Commission.

  • The SSF deficit is estimated at about 0.5 percent of GDP in 2010 (excluding government contributions and interest on government debt held in pension fund reserves). Spending of the SSF is projected to increase by about 8 percentage points of GDP by 2050, to about 14 percent of GDP, as the population ages and the relatively new system matures. Contributions from employees and employers are scheduled to rise by only about 3 percent of GDP, based on contribution increases scheduled to take place every 5 years from 2014 until 2039. As a result, transfers from the budget would need to increase by roughly 5 percentage points of GDP to meet SSF obligations.

  • Public employee pension expenditures net of contributions are expected to increase from about 3 percent of GDP in 2010 to 5 percent of GDP in 2050, according to a recent actuarial study. The study suggests that an average contribution rate exceeding 40 percent would be needed to fully fund benefits through 2060, compared to the 5 percent employee contribution at present. The system remains generous by international standards even after recent reforms. Some groups (such as teachers and police) have low retirement ages. Benefits are based on the final salary instead of the career average, and a full pension can be accrued with fewer years of service than in the national scheme. Benefits are indexed to both general wage increases in the public sector and the consumer price index. In addition to the pension, workers receive a lump sum benefit at retirement that can exceed 5 times the annual pension.

Financing

16. Although the government has lost access to long-term sovereign debt markets, it will likely be able to meet remaining financing needs for 2011 through issuance of short-term debt and use of deposits. The amount of long-term debt maturing in the last quarter of 2011 is minimal. Provided the government can issue a small amount (€244 million, or 1.3 percent of GDP) of net new short-term debt, and that it does not need to provide financial support to its banks, it will be able to meet its financing needs through year-end, with the help of deposits equaling 1.2 percent of GDP.

Gross Financing Requirement, 2011—2013

(Millions of euros and percent of GDP)1/

2011 2/Pct. of GDP2012Pct. of GDP2013Pct. of GDP
Total Gross Financing Requirement (TGFR)5833.23,20817.43,97321.3
Rollover of current obligations3612.02,46313.43,61519.4
Deficit Financing after use of deposits2211.27454.03591.9
Financing need assuming 100 percent rollover of short term debt2441.31,96710.72,73214.7
Memorandum item:
Central Government Deposits (millions of euros) 3/367
Source: Public Debt Management Office; Central Bank of Cyprus; and IMF staff estimates.

Short term domestic paper refers to treasury bills, Long term domestic paper refers to Government Registered Development Stock, and Short term foreign instruments refer to Euro commercial paper and 1 year Eurobonds.

Refers to the period October- December 2011.

Balance as of September 23, 2011. A minimum balance of € 150 million is normally kept as a liquidity cushion. € 210 million were assumed to be used to cover the deficit financing needs in 2011.

Source: Public Debt Management Office; Central Bank of Cyprus; and IMF staff estimates.

Short term domestic paper refers to treasury bills, Long term domestic paper refers to Government Registered Development Stock, and Short term foreign instruments refer to Euro commercial paper and 1 year Eurobonds.

Refers to the period October- December 2011.

Balance as of September 23, 2011. A minimum balance of € 150 million is normally kept as a liquidity cushion. € 210 million were assumed to be used to cover the deficit financing needs in 2011.

17. Government financing will be a major challenge in 2012 absent non market financing. Long-term debt maturities include a €550 million domestic bond maturing in January 2012 and a €550 million Eurobond maturing in February. Financing needed to cover all maturing long-term debt and the fiscal deficit in 2012 totals roughly €2 billion.

B. Financial Sector

18. A large banking system with heavy exposure to Greece is a major vulnerability of the Cypriot economy. Bank assets total €152 billion (835 percent of GDP), while assets of commercial banks with Cypriot parents are €92 billion (500 percent of GDP). Exposure of these banks to Greece totals €29 billion, or 160 percent of GDP, including both Greek government bonds and loans to Greek residents. They also hold €1.6 billion of Cypriot government bonds but minimal amounts of sovereign debt of other peripheral euro area countries.

19. The largest risk comes from commercial banks with Cypriot parents, although other banking groups also pose potentially significant risks (Box 4). NPLs at these banks have risen on both their local loan portfolios and their branches’ Greek loan books, and provisioning ratios have declined. Only the non-collateralized portions of NPLs are provisioned, which leaves banks exposed to further losses in the event of significant declines in collateral value.

Non-performing Loan Ratios and Loan Loss Provisions
Dec-09Dec-10Mar-11Jun-11
NPLs at local banks 1/9.812.11213.9
NPLs on loans in Greece7.811.11213.9
Provisions (consolidated,
pct. of all loans 90 days or
more in arrears)61565654
Source: Central Bank of Cyprus.

Loans past due by 90 days or more, as percent of total loans.

Source: Central Bank of Cyprus.

Loans past due by 90 days or more, as percent of total loans.

Cyprus: Structure Of The Banking System(Billions of euros)
Loans (net ofCyprusCyprusLoans inSecuritiesOf which:Of which:InterbankTotalPercentage
provisions)loans toloans toGreeceand othersovereignGreekassetsassetsof GDP
residentsnon-investmentsbondsgovernment
residentsbonds
System91.443.217.823.428.714.77.224.8152.0835
Branches of foreign banks2.10.41.80.00.50.20.04.87.642
Subsidiaries of foreign banks16.56.110.40.011.54.02.46.435.3194
Cooperative banks12.412.40.00.02.32.10.11.116.993
Commercial banks60.324.35.623.414.38.44.712.492.1506
Total depositsCyprusCyprusDepositsLiabilitiesInterbankCapitalTotalPercentage
depositsdepositsraised into parentLiabilities (exandliabilitiesof GDP
fromfrom non-Greecebanksparent)reserves
residentsresidents
System93.837.333.817.321.118.614.2152.0835
Branches of foreign banks5.50.84.60.00.91.00.27.642
Subsidiaries of foreign banks10.04.25.80.020.22.71.935.3194
Coops13.813.60.20.00.01.11.516.993
Commercial Banks64.518.623.117.30.013.810.692.1506
Source: Central Bank of Cyprus (June 30, 2011).
Source: Central Bank of Cyprus (June 30, 2011).

20. Cypriot banks face significant capital needs to meet the new European Banking Authority requirements. The EBA calculations released on October 26 indicate that Cypriot banks require additional capital estimated at €3.6 billion (20 percent of GDP) on a preliminary basis to attain a 9 percent core Tier 1 capital ratio and create a buffer against mark-to-market losses on their sovereign debt holdings. An updated diagnostic could possibly reveal larger capital needs.

Box 4.Structure of Cypriot Banking System

Banks can be grouped into four main categories: Cypriot commercial banks (with domestic and international operations), foreign branches, foreign subsidiaries, and savings cooperatives.

  • Commercial banks with Cypriot parents hold €92 billion (505 percent of GDP) in assets, dominated by three large banks (Bank of Cyprus, Marfin Popular Bank, and Hellenic Bank) which together account for 97 percent of total assets of this group. They have large foreign operations through branches and subsidiaries, primarily through the Marfin and Bank of Cyprus branches in Greece. They hold €23 billion (130 percent of GDP) in loans to Greek residents and €5 billion of Greek government bonds. Loans to residents outside Greece through foreign affiliates (including in south-east Europe, Russia, Ukraine, and the UK) total €7 billion.

  • Foreign branch assets total some €8 billion (42 percent of GDP). They are attracted to Cyprus largely for tax reasons and their interaction with the Cypriot economy is limited, as they receive minimal funding from and hold minimal claims on Cypriot residents. This low degree of interaction would likely help shield the Cypriot banking system from problems at these branches (or their parents), although reputational risks to the broader banking sector are possible.

  • Foreign subsidiary assets total €35 billion (195 percent of GDP). Similar to foreign branches, they are located in Cyprus largely for tax and regulatory reasons. Their interaction with the Cypriot economy is only a share of their total assets, with €4 billion in deposits from Cypriot residents and €6 billion in loans to residents. They are predominantly Greek (Alpha, Eurobank, Piraeus, and NBG) and also include the subsidiary of a Russian state bank. They largely rely on parent funding and their parents hold much of the credit risk on their assets. However, the risk to Cyprus would be larger than for foreign branches due to their greater interactions with the Cypriot economy and their legal status as subsidiaries participating in the national deposit insurance scheme.

  • Some 100 savings cooperatives hold €17 billion (92 percent of GDP) in assets. Their assets are dominated by loans to residents and they are funded predominantly by resident deposits. Cooperatives are regulated separately from banks, by the Authority for Supervision and Development of Cooperative Societies.

21. Funding pressures are another significant vulnerability. Cypriot banks rely mostly on deposits for funding, with a loan-to-deposit ratio of 93 percent. Capital market refinancing needs are low, at €550 million in 2011-13, and reliance on interbank financing is modest. However, three sources of funding vulnerability stand out.

  • First, non-resident deposits (NRD) in Cypriot banks (excluding deposits raised abroad by foreign affiliates) are €23 billion (125 percent of GDP), most of which are short-term at low interest rates. These could prove unstable in the event of further confidence shocks. This risk is partly mitigated by the 70 percent liquid asset requirement against the €12 billion in NRD in foreign currency), and the 20 percent requirement for the €11 billion in euro-denominated NRD).

  • Second, €17 billion in deposits collected in the Greek branches of the three largest Cypriot-owned banks could be subject to outflows in response to difficult conditions in Greece. Outflows in the first half of 2011 were close to €3 billion (nearly 15 percent of the total), although a portion of these returned to the Cypriot parents as NRD. While the system as a whole could handle continued moderate outflows, individual banks could face liquidity shortages.

  • Third, funding pressures could also arise from loss of access to ECB liquidity. The ECB currently provides some significant liquidity to the system, most of which must eventually be replaced by market funding. Moreover, further market losses on Greek (as well as Cypriot) government debt would reduce the value of collateral eligible for ECB funding. Should Cyprus be downgraded to below investment grade, its government securities could no longer be eligible as collateral for ECB refinancing facilities under current rules.

POLICY DISCUSSIONS

22. Discussions focused on the need for large and credible fiscal adjustment, financial sector contingency planning, and the challenge of securing fiscal financing. Staff argued that a strong fiscal effort was essential to restore sound public finances and regain access to sovereign debt markets. Staff highlighted the large risks facing Cypriot banks, in particular from their Greek exposures, and urged the authorities to engage in contingency planning and ensure that they have all the legal tools required to take prompt corrective action if necessary. Staff emphasized that fiscal financing in 2012, including repayment of significant long-term debt maturities, presented a major challenge. The authorities broadly shared the staff assessment.

A. Fiscal Policies and Financing

23. Staff argued that a large, frontloaded, and credible fiscal adjustment, in the context of a multi-year framework, was essential to restore sustainability of public finances and regain market access.

  • Size of adjustment. Staff advised that Cyprus does not have the option of back-loading adjustment to protect growth, given its lack of access to financing and the need to restore confidence. The size of adjustment in 2012-13 needs to be sufficient to put the budget on a firm path towards balance by 2014, with a substantial down payment in 2012. Staff agreed with the authorities that their planned fiscal savings—6.6 percent of GDP over 2011-13, of which 3.6 percent of GDP is slated for 2012—strike an appropriate balance between the need for a sizable adjustment and the need to avoid fiscal cuts so large that they would undermine growth prospects and create negative dynamics for investor confidence and bank balance sheets. Under the staff baseline scenario, these adjustments would stabilize the public debt ratio in 2013 and reduce it to 60 percent of GDP by 2016.

  • Credibility. Staff emphasized the importance of being conservative in estimates of the fiscal savings from adjustment measures and identifying additional contingency measures in case savings fall short of target. The need for conservative estimates is all the more important in light of the projected outcome for this year, which compares unfavorably to the deficit target of 4 percent of GDP in the 2011 budget. While endorsing the authorities’ targets for fiscal savings over 2011-13, staff viewed the authorities’ projection that this would reduce the fiscal deficit to below 3 percent of GDP in 2012 as too optimistic. First, it takes as a starting point a deficit of 6.5 percent of GDP in 2011, whereas in staff’s view the outcome will be about 7 percent of GDP (the difference is due to more conservative staff assumptions on the savings yield of adjustment measures). Second, it is based on a projection of 0.2 percent growth in 2012, whereas staff expects a contraction due to financial sector deleveraging, weak external demand, and the negative short-term impact of fiscal cuts on output. A more realistic deficit path over the next 3-4 years, underpinned by well-defined fiscal savings, would enhance credibility. Moreover, staff viewed implementation risks around the planned measures as considerable—both from potential watering down of the measures and because they could fail to achieve the targeted savings.

  • Multi-year framework. The government should move quickly to pass into legislation specific measures in the context of a credible multi-year consolidation plan for 2012-14. After passage of the second package of measures needed to secure the targeted savings in 2012, additional measures need to be adopted to achieve the €400 million in savings targeted for 2013 and to balance the budget in 2014. Up-front measures rather than promises of future actions are needed to establish credibility and regain investor confidence. In the event that economic growth recovers more quickly than expected and revenues exceed projections, excess revenues should be used to reduce the deficit further.

Deficit Projections Assuming Realization of Official Targets for Fiscal Savings in 2012-2013(Percent of GDP)
201120122013
Authorities6.52.80.5
Staff7.04.01.9
Sources: Ministry of Finance; and IMF staff estimates.
Sources: Ministry of Finance; and IMF staff estimates.

24. Staff recommended that additional measures to reach the 2013 fiscal targets should be predominantly expenditure-based. International evidence suggests that expenditure-based consolidation is more reliable in securing savings. In addition, it is important to preserve a favorable tax climate to protect Cyprus’ appeal as an international business center, and Cyprus has ample remaining room for reducing the public wage and pension bill and targeting social transfers (especially after the large increases in 2009). Specific areas should include freezing the COLA for two years as an interim measure pending more fundamental reform of the COLA system; eliminating automatic salary increments; targeting social transfers based on income criteria; and reforms to the national and public employee pension systems. While achieving €400 million with these measures should be feasible, staff recommended preparing for an additional 1 point increase in the VAT rate to 18 percent and savings from reprioritizing public investment as a contingency in case measures related to current expenditure do not yield the intended savings.

Selected Economic Indicators under the Baseline (B) and Downside (D) Scenarios(Percent of GDP, unless otherwise indicated)
20122013201420152016
BDBDBDBDBD
Real GDP growth (percent)-1.0-3.00.8-2.02.01.02.82.53.03.5
Inflation (percent)2.41.02.30.52.21.02.11.52.12.0
General government fiscal deficit-4.0-5.9-1.9-5.80.0-4.40.0-3.60.0-3.1
Public debt67.572.068.781.066.384.763.585.460.484.1
Source: IMF staff estimates.
Source: IMF staff estimates.

25. In the event that downside risks to growth materialize, staff recommended keeping the magnitude of the planned 2011-13 fiscal savings unchanged, while taking measures to safeguard fiscal sustainability in the outer years. Additional consolidation measures in a weaker economy should be avoided provided sufficient funding is available, since they would further depress demand and growth, which could have an adverse impact on investor confidence. In an illustrative scenario with lower growth and inflation but the same fiscal savings, the public debt ratio would peak at 85 percent of GDP in 2015. To protect fiscal debt sustainability, it would thus be important to implement consolidation measures over the longer term, including deeper reforms to the national and public employee pension systems.

26. The government expressed its commitment to achieving fully the savings targets, and to taking additional measures in the event of shortfalls. They agreed that delays in taking effective adjustment measures had resulted in the loss of valuable time and damaged credibility. They remained more optimistic than staff on both the 2011 deficit outcome and 2012 growth, and thus believed they would be successful in reducing the deficit to below 3 percent of GDP in 2012, en route to a balanced budget by 2014. The authorities were mindful of the need to move quickly on measures to secure fiscal savings in 2013-14, and emphasized the need for social dialogue to achieve the needed consensus. They were sympathetic to the benefits of expenditure-based consolidation and believed that there was significant room for further rationalization of public spending.

27. Staff highlighted the vulnerability posed by the loss of access to sovereign debt markets. Even with full implementation of the authorities’ fiscal adjustment plans, it would take time to regain market access in light of uncertain external economic and financial conditions and the need to establish a track record of successful consolidation. The authorities were confident that they would receive a low interest loan of €2.5 billion from Russia before the end of the year. In their view, this would allow them to meet a substantial portion of their 2012 gross financing needs and provide time to implement fiscal consolidation and restore market confidence.

B. Financial Sector

28. Staff encouraged the authorities to take measures to strengthen the capacity of the banking system to weather adverse shocks including by:

  • Strengthening crisis management procedures and engaging in contingency planning. This includes priority passage of legislation to give the authorities adequate powers to provide financial support through fast-track procedures and to resolve banks if needed (under current law the authorities lack powers to liquidate or sell insolvent banks without shareholder approval or going through lengthy legal procedures); planning for various scenarios of capital and liquidity shortages in different parts of the banking system, including foreign branches of Cypriot banks and foreign subsidiaries operating in Cyprus; and coordinating closely with foreign supervisors and EU banking authorities.

  • A plan to achieve higher capital levels and to ensure adequate funding. The authorities need to work with the banks to agree on a plan to raise the preliminary estimate of €3.6 billion in capital by June 2012 to meet the recently announced strengthened EBA capital requirements. Potential sources include new equity investments, conversion of existing hybrid capital to eligible convertible capital, restricting profit distributions and bonuses, and sale of assets such as foreign subsidiaries. It remains unclear whether it will be possible to raise the additional capital from private sources. If not, the envisaged recapitalization would require government or official external support. Before injecting capital into a bank, the authorities should make a positive assessment of it solvency. The authorities should also evaluate bank liquidity needs and work with EU banking authorities, as necessary, to secure access to term funding.

29. The authorities acknowledged that there were gaps in their powers to resolve and recapitalize banks. They are in the process of drafting legislation to remedy these gaps, and asked for technical assistance in this endeavor (in particular on legislation to provide bank resolution powers) from the Fund. In response, a Fund technical assistance team visited Cyprus the week of October 24.

30. Staff recommended that cooperatives should be subject to the same regulatory and supervisory regime as commercial banks. While the cooperatives do not have significant exposure to Greek or other foreign borrowers, they should be monitored closely in light of their large size (over 90 percent of GDP) and elevated NPL rates. The authorities should review the regulatory and supervisory structure of the cooperatives and identify any disparities with the regime for commercial banks that could give rise to regulatory arbitrage or market distortions. Staff also reiterated its long-standing advice that supervision and regulation of banks and cooperatives should be unified, and that as an intermediate step the regulatory frameworks should be harmonized. Staff also called for greater transparency, including publication of the same data as available for commercial banks.

31. Staff discussed the outcome of the recent MONEYVAL (the financial action task force-style regional group of which Cyprus is a member) anti-money laundering and combating the financing of terrorism (AML/CFT) mutual evaluation report, with an emphasis on international cooperation and supervision. The report’s recommendations pertaining to international cooperation are particularly important, given the size of the international services sector, and the potential for adverse spillovers on other economies.

C. Structural Reforms

Pension Reform

32. Staff recommended that the authorities initiate a reform of the national pension system to put it on a sustainable long-term financial footing. While the fiscal burden of the pension system is limited at present, it will grow over time. Action at an early juncture can spread out necessary adjustments over time, making them easier to absorb. Staff recommended a number of reform options that could be explored, including (i) introducing an early retirement penalty; (ii) increasing the retirement age gradually to 67 years and linking it to increases in life expectancy; (iii) moving gradually towards indexing pensions to inflation only; and (iv) reducing the imbalance between contributions and benefits by gradually adjusting the pension accrual rate and accelerating planned contribution rate increases for employees and employers (see Selected Issues Paper). The authorities welcomed the staff analysis and agreed on the importance of reforms to ensure the long-term sustainability of the system. They explained that they were preparing to release an actuarial study that would evaluate the system’s long-term finances, which would provide an opportunity to explore reform options.

33. Staff welcomed the introduction of higher contributions by public sector workers towards their pensions and encouraged the authorities to pursue deeper reforms. To rationalize costs, staff recommended a set of reform options, including adoption of the same retirement age as the national scheme; a gradual extension of the period used to compute benefits to the full career average; a gradual move towards indexing pensions to the CPI; and a gradual phase-out of the lump sum benefit at retirement (See Selected Issues Paper).

Structural Fiscal Reform

34. Staff encouraged the authorities to push ahead on structural fiscal reforms to support the introduction of a medium-term budgetary framework. EU directives relating to the fiscal framework should be expeditiously implemented, including the one that mandates the introduction of fiscal rules in national legislation. Swift passage of national fiscal rules will signal the authorities’ commitment to sound public finances, although a transition regime will be needed for their full implementation. Staff encouraged the authorities to improve core budget processes such as strengthening forecasting, simplifying budget classifications, and increasing the flexibility to reallocate spending across different categories, which would help to reduce the need for supplementary budgets (see Selected Issues Paper). Staff also advised reorganizing the revenue administration by combining the separate departments responsible for different taxes and strengthening the exchange of information. Finally, staff welcomed the authorities’ intention to pass a new debt management law. The authorities agreed on the importance of structural fiscal reforms and indicated that they would seek Fund technical assistance in priority areas.

35. Staff advised the authorities to improve the management of fiscal risks from extra budgetary entities and Public-Private Partnerships (PPPs). In the short term this can be achieved by closely monitoring the finances of the largest extra budgetary entities by the Ministry of Finance. In the medium term, consideration should be given to divesting suitable entities, liquidating entities that are no longer needed, and bringing back into the budget entities that carry out government functions and lack adequate rationale for operating as autonomous entities. With respect to PPPs, staff recommended reform of the framework to ensure the proper evaluation of financial risks to the budget and to put in place procedures that empower the Ministry of Finance to stop PPP projects that do not meet appropriate standards (see Selected Issues Paper).

Competitiveness

36. Reducing wage rigidities is the most important structural reform needed to address the competitiveness challenge. The current crisis is an opportunity to undertake significant reform or even eliminate the cost of living adjustment system in the public sector (which would be expected to lead to reduced use of the COLA in the private sector). By linking wages automatically to inflation rather than productivity, the COLA reduces the flexibility of relative wage levels across different firms and sectors, which hinders the ability of the economy to adjust to variations in productivity or demand. At an economy-wide level, the COLA also impedes the flexibility of wages to adjust to shocks such as the 2008 financial crisis or commodity price swings. It also contributes to high public sector wage levels, which makes it more difficult for the private sector to attract skilled workers. For these reasons, few countries in the euro area have automatic adjustments mechanisms such as the COLA, and Fund staff has generally advised against their use.

37. Cyprus has made some progress in improving its regulatory environment, with more yet to be done. Cyprus ranks 40th among 183 countries worldwide in the World Bank Ease of Doing Business indicator, and 47th among 142 economies in terms of broader competitiveness as measured by the World Economic Forum’s Global Competitiveness Report. Measures taken have included simplifying the administrative procedures to set up new business (one-stop shop). Further measures are needed to improve the business environment. Cyprus ranks only 39 out of 48 high income countries in the World Bank’s Ease of Enforcing Contracts index, reflecting the numerous procedures and long waiting times to resolve disputes in court. Moreover, some key transport services are severely restricted in terms of working hours (e.g., ports, warehouses) or access to license to operate (e.g., trucks).

38. Investment in R&D and the rate of adoption of new technologies by businesses are very low relative to other euro area countries, including those with similar size and industry structure. Cyprus ranks low in terms of its capacity for innovation and R&D, one of the dimensions of competitiveness defined by the Lisbon Strategy.1 Aggregate spending on R&D, at 0.4 percent of GDP, is far below the EU target of 3 percent of GDP and is almost exclusively carried out by the public sector. Information and communication technologies usage by enterprises ranks among the lowest in the EU, according to survey data from Eurostat.

39. Reforms to further improve the business climate by reducing red tape and removing obstacles to technology upgrading would increase potential growth in the medium and long term. The authorities should identify the regulatory hurdles affecting the business environment discussed above and lay out appropriate reforms. They should explore what obstacles hinder more widespread technology adoption. Initial measures to support Cypriot businesses in their efforts to upgrade technology and enhance productivity have been included in the National Reform Program.

STAFF APPRAISAL

40. The Cypriot economy faces a very difficult economic outlook as it confronts new external challenges while still working to overcome the legacy of the 2008 crisis. Externally, the exposure of Cypriot banks to Greece and worsening prospects for external demand pose the main challenges. Domestically, the foremost challenge is to restore sound public finances, and to regain access to sovereign debt markets.

41. The situation calls for immediate action to reverse the widening fiscal deficits and put public debt on a downward path. The pace of adjustment must be ambitious but realistic to build credibility. If the economy evolves as anticipated under staff’s baseline scenario, it should be possible to bring the deficit below 3 percent of GDP by 2013. Measures should focus mostly on expenditure reductions, which are more durable and reliable than revenue increases. Priority areas for fiscal savings include containment of public sector wages and benefits and further improvements in the targeting of social transfers towards the less well-off, as well as a moderate increase in VAT rates. Fiscal savings should be based on conservative assumptions and implemented without slippage. These are preconditions for restoring confidence and ensuring the government can access markets to meet its financing needs.

42. The government has set ambitious targets that would deliver a large reduction in the deficit in 2012 and a balanced budget within three years. This timeframe strikes an appropriate balance between the need for up-front savings and the benefits of avoiding an excessive contraction in demand. The government should now move quickly to pass into legislation specific measures, in the context of a credible multi-year consolidation plan, and prepare additional measures that can be rapidly put in place to address contingencies.

43. In view of unsettled external conditions, utmost vigilance and careful contingency planning are required for the financial sector. The authorities should require banks to put in place robust plans to achieve higher capital ratios consistent with new EBA requirements, and to identify and address potential liquidity needs. They should move quickly to enhance their powers so that they can take prompt corrective action to recapitalize or resolve banks, if necessary. To this end, passage of the bank framework law and amendments to the banking act, preferably at the same time, should be an immediate priority. Greater attention should be paid to cooperative credit institutions, to ensure that their regulation and supervision is on par with that for banks and to detect any problems at an early stage.

44. The top priority in the area of structural reform is to improve the flexibility of labor markets in order to improve the prospects for growth and employment. Containing public sector wages and benefits, sustained reductions in the size of public employment, and significant reform to the cost of living allowance mechanism will make an important contribution by increasing wage flexibility and augmenting the flow of highly qualified workers to the private sector.

45. Reforming the national pension scheme is key to long-term fiscal sustainability. Although the fiscal burden of the system is limited at present, it will grow quickly as the system matures. This is a good time to initiate reform of the system to ensure its financial equilibrium over the longer term. If reforms are agreed soon, they can be phased in gradually, avoiding the disruption that would result if they were postponed until the mounting costs of the system demand immediate action.

46. Reform of budget institutions is needed to support fiscal consolidation while also promoting greater accountability, transparency, and efficiency of public finances. Key areas include introduction of a medium-term budgetary framework and the full implementation of EU fiscal framework directives, including the introduction of fiscal rules.

47. The Cypriot economy faces large risks that demand a strong policy response. Bold corrective actions can set the stage for resumption of economic growth, based on the underlying strengths of the economy, including a highly educated workforce and diversified international service economy.

48. It is proposed that the next Article IV consultation take place on the standard 12-month cycle.

Figure 1.Cyprus: Short-Term Indicators

Sources: Cyprus Statistical Office; Central Bank of Cyprus, Cyprus Ministry of Finances, Eurostat, and European Commission.

1/ The industrial production and, and retail sales data as of July 2011 touristarrivals data are as of August 2011.

2/ Values greaterthan 100 indicate an above-average economic sentiment, where as values below 100 indicate a below-average position.

3/ All confidence indicators are balances, meaning the difference between the percentages of respondents that have positive and negative expectations for the next 12 months. A negative number means that more respondents were pessimistic than optimistic. The higher the negative number, the more pessimistic the respondentsare.

Figure 2.Cyprus: Economic Indicators, 2004-2012

Sources: Cystat; IMF WEO; and IMF staff estimates.

1/ Includes bank loans to domestic residents. Non-financial corporate and household debt in gross terms.

Figure 3.Cyprus: Financial Indicators

Sources: Bloomberg; Central Bank of Cyprus; ECB; IMF, IFS; and IMF staff calculations.

1/ Includes only the assets of the banks residing in side Cyprus.

2/ Average of rates for loans up to and over euro 1 million. Break in EA data from July 2010.

Figure 4.Cyprus: Fiscal Sector

(Percent of GDP)

Sources: Cyprus Ministry of Finance; and IMF staff calculations.

Figure 5.Cyprus: Public Debt Sustainability: Bound Tests 1/2/

(Public debt in percent of GDP)

Sources: International Monetary Fund, country desk data, and staff estimates.

1/ Shaded areas representactual data. Individual shocks are permanent one standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead. All individual shock scenarios assume a 1 standard deviation shock.

3/ Permanent 1 standard deviation shocks applied to real interest rate, growth rate, and primary balance.

4/ 10 percent of GDP shock to contingent liabilities occur in 2011.

Figure 6.Cyprus: External Sector

Sources: IMF, Direction of Trade Statistics; Eurostat; and IMF, WEO.

Figure 7.Cyprus: External Debt Sustainability: Bound Tests 1/2/

(External debt, percent of GDP)

Sources: International Monetary Fund; Country desk data and IMF staff estimates.

1/ Shaded areas representactual data. Individual shocks are permanentone-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.

3/Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and current account balance.

4/ One-time real depreciation of 30 percent occurs in 2011.

Figure 8.Cyprus: Labor Market

Table 1.Cyprus: Selected Economic Indicators, 2005-2016
200520062007200820092010201120122013201420152016
Proj.
Real Economy(Percent change, unless otherwise indicated)
Real GDP3.94.15.13.6-1.91.10.0-1.00.82.02.83.0
Domestic demand3.35.78.87.9-6.91.0-0.3-3.6-1.01.72.52.9
Consumption3.45.27.87.4-4.82.00.8-2.2-0.70.42.12.7
Private consumption3.54.710.27.8-7.52.41.0-1.50.21.32.22.7
Public consumption3.47.0-0.85.66.20.60.1-4.8-4.5-3.41.82.7
Fixed investment4.110.213.46.0-9.7-6.9-5.9-5.0-5.04.55.05.2
Inventory accumulation 1/-0.2-0.4-0.10.9-1.40.70.0-1.00.50.6-0.1-0.2
Foreign balance 1/0.5-1.9-4.4-5.46.50.11.02.81.80.30.30.0
Exports of goods and services4.93.66.2-0.1-11.06.13.22.23.03.94.24.4
Imports of goods and services3.76.813.48.6-18.75.11.0-3.0-0.53.33.54.2
Potential GDP growth3.73.63.22.41.71.51.31.01.01.31.52.0
Output gap (percent of potential GDP)-0.8-0.31.62.8-0.8-1.2-2.4-4.3-4.5-3.8-2.6-1.6
HICP (period average)2.02.22.24.40.22.64.02.42.32.22.12.1
HICP (end of period)1.41.53.71.81.61.94.51.92.32.22.12.1
Unemployment rate EU stand. (percent)5.34.64.03.65.46.47.68.58.07.47.26.8
Employment growth (percent)2.52.75.81.3-0.41.00.3-0.21.01.52.02.0
Gross national savings (percent of GDP)14.214.010.67.212.511.310.911.511.212.112.212.4
Gross capital formation (percent of GDP)20.120.922.324.020.219.018.016.516.317.417.717.9
Public Finance(Percent of GDP)
General government balance 2/-2.5-1.23.40.9-5.9-5.3-7.0-4.0-1.90.00.00.0
Revenue40.941.744.642.539.741.240.341.042.142.042.342.2
Expenditure43.442.941.241.645.646.547.245.044.042.042.342.2
General government debt68.864.158.048.257.860.764.067.568.766.363.560.4
Balance of Payments(Percent of GDP)
Current account balance-5.8-6.9-11.7-16.8-7.8-7.7-7.2-5.0-5.1-5.3-5.5-5.5
Trade Balance (goods and services)-2.6-4.0-6.5-11.0-5.1-5.1-4.4-2.2-2.3-2.5-2.6-2.7
Exports of goods and services47.346.746.944.639.542.143.244.744.644.745.445.8
Imports of goods and services49.950.753.455.644.647.247.646.846.947.248.148.4
Goods balance-24.9-27.0-29.5-31.9-24.9-26.8-24.3-23.5-23.9-24.5-24.9-25.0
Services balance22.323.023.020.919.821.719.921.321.622.022.322.4
Income, net-3.7-4.0-5.1-5.6-1.6-2.7-2.7-2.7-2.7-2.7-2.7-2.7
Transfers, net0.51.10.0-0.2-1.10.0-0.1-0.1-0.1-0.1-0.1-0.1
Capital account, net0.50.20.00.00.40.20.10.10.10.10.10.1
Financial account, net4.36.811.916.48.08.07.14.95.05.35.45.4
Direct investment3.75.24.5-1.35.94.44.34.34.44.44.34.3
Portfolio investment-0.8-0.9-2.0-72.1-67.0-8.21.0-0.2-0.5-2.0-2.5-3.0
Other investment5.67.98.088.268.610.71.80.81.12.93.64.1
Reserves (- inflow; + outflow)-4.2-5.41.41.70.51.10.00.00.00.00.00.0
Errors and omissions1.0-0.1-0.30.4-0.6-0.40.00.00.00.00.00.0
Savings-Investment Balance
National saving14.214.010.67.212.511.310.911.511.212.112.212.4
Government1.22.67.34.7-0.6-0.2-1.91.23.35.05.25.3
non-government13.111.33.32.413.011.512.810.37.97.17.17.1
Gross capital formation20.120.922.324.020.219.018.016.516.317.417.717.9
Government3.63.83.93.85.45.15.15.25.25.05.25.3
Non-government16.417.018.420.114.814.013.011.211.012.412.512.6
Foreign saving-5.8-6.9-11.7-16.8-7.8-7.7-7.2-5.0-5.1-5.3-5.5-5.5
Memorandum Item:
Nominal GDP (billions of euros)13.514.616.017.317.017.518.218.418.619.320.121.2
Sources: Eurostat, Central Bank of Cyprus, and IMF staff estimates.

Contribution to growth.

Sources: Eurostat, Central Bank of Cyprus, and IMF staff estimates.

Contribution to growth.

Table 2.Cyprus: Fiscal Developments and Projections, 2005-2016(Percent of GDP)
200520062007200820092010201120122013201420152016
Proj.
Revenue40.941.744.642.539.741.240.341.042.142.042.342.2
Current revenue40.941.644.542.539.541.240.240.942.142.042.242.2
Tax revenue26.727.932.230.326.226.325.926.527.227.227.327.3
Indirect taxes16.417.118.417.515.015.315.215.516.116.116.216.2
Direct taxes9.310.913.712.811.111.010.711.011.111.111.111.1
Other taxes (capital taxes)0.90.00.00.00.00.00.00.00.00.00.00.0
Social security contributions8.37.97.57.78.69.69.810.110.110.010.010.0
Other current revenue5.95.84.84.54.75.34.54.44.84.84.94.9
Capital revenue0.10.10.10.00.10.00.00.00.00.00.00.0
Expenditure43.442.941.241.645.646.547.245.044.042.042.342.2
Current expenditure39.839.137.337.840.241.542.239.838.837.137.136.9
Wages and salaries15.015.014.314.215.715.415.414.814.113.413.413.4
Goods and services4.95.34.54.74.95.25.15.15.04.84.84.8
Social Transfers13.012.511.612.113.414.814.913.713.212.712.812.8
Subsidies0.70.50.40.40.20.20.40.30.30.20.20.2
Interest payments3.63.33.02.82.52.22.52.83.03.13.02.9
Other current expenditure2.62.43.43.73.53.73.93.23.12.92.92.9
Capital expenditure3.63.83.93.85.45.15.15.25.25.05.25.3
Overall balance 1/-2.5-1.23.40.9-5.9-5.3-7.0-4.0-1.90.00.00.0
Overall balance excl. one-offs-3.4-3.2-1.1-1.1-6.2-5.8-7.1-4.1-1.90.00.00.0
Statistical discrepancy-0.10.00.00.00.00.00.00.00.00.00.00.0
Financing-2.4-1.23.40.9-5.9-5.3-7.0-4.0-1.90.00.00.0
Net financial transactions-2.4-1.23.40.9-5.9-5.3-7.0-4.0-1.90.00.00.0
Net acquisition of financial assets0.8-0.82.9-4.32.8-0.7-1.20.00.00.00.00.0
Currency and deposits0.3-0.32.4-4.42.0-1.4-1.20.00.00.00.00.0
Securities other than shares0.00.00.00.00.00.00.00.00.00.00.00.0
Loans0.2-0.60.10.20.50.70.00.00.00.00.00.0
Shares and other equity0.00.00.2-0.30.00.00.00.00.00.00.00.0
Other financial assets0.30.10.30.20.30.00.00.00.00.00.00.0
Net incurrence of liabilities3.20.4-0.4-5.28.84.65.84.01.90.00.00.0
Currency and deposits0.00.00.00.00.00.00.00.00.00.00.00.0
Securities other than shares2.40.2-1.0-8.39.14.75.8-6.6-12.80.00.00.0
Loans0.60.10.53.0-0.3-0.10.010.714.70.00.00.0
Other liabilities0.20.00.00.10.00.00.00.00.00.00.00.0
Memorandum items:
Financing need to be covered with
non market/unidentfied financing1/10.714.7
Cyclically adjusted overall balance-2.2-1.12.7-0.2-5.6-4.8-6.0-2.4-0.21.51.00.6
Cyclically adjusted overall balance,
excl. one-offs-3.1-3.1-1.8-2.2-5.9-5.3-6.1-2.5-0.21.51.00.6
Cyclical balance-0.3-0.10.61.1-0.3-0.5-0.9-1.7-1.8-1.5-1.0-0.6
Cyclically adjusted primary
balance, excl. one-offs0.50.21.30.6-3.4-3.1-3.60.32.94.64.03.6
Primary balance1.12.16.43.7-3.4-3.1-4.4-1.21.13.13.02.9
One-offs0.92.04.52.00.30.50.10.10.00.00.00.0
Public debt68.864.158.048.257.860.764.067.568.766.363.560.4
Sources: Eurostat, and IMF staff estimates.

Fiscal financing needs assuming no rollover of long term debt in 2012-2013. This does not include any fiscal outlays for recapitalizing banks.

Sources: Eurostat, and IMF staff estimates.

Fiscal financing needs assuming no rollover of long term debt in 2012-2013. This does not include any fiscal outlays for recapitalizing banks.

Table 3.Cyprus: Public Sector Debt Sustainability Framework, 2006-2016(Percent of GDP, unless otherwise indicated)
ActualProjections
20062007200820092010201120122013201420152016
Debt-
stabilizing
primary
balance 9/
Baseline: Public sector debt 1/64.158.048.257.860.764.067.568.766.363.560.4-0.1
Of which: foreign-currency denominated0.00.00.00.00.00.00.00.00.00.00.0
Change in public sector debt-4.7-6.1-9.89.62.93.33.51.2-2.3-2.8-3.1
Identified debt-creating flows (4+7+12)-3.4-9.2-5.67.03.54.23.51.2-2.3-2.8-3.1
Primary deficit-2.1-6.4-3.73.43.14.41.2-1.1-3.1-3.0-2.9
Revenue and grants41.744.642.539.741.240.341.042.142.042.342.2
Primary (noninterest) expenditure39.638.238.843.144.344.742.241.039.039.339.3
Automatic debt dynamics 2/-1.3-2.8-1.93.60.4-0.22.32.30.70.2-0.1
Contribution from interest rate/growth differential 3/-1.3-2.8-1.93.60.4-0.22.32.30.70.2-0.1
Of which contribution from real interest rate1.30.20.02.71.1-0.21.62.82.11.91.7
Of which contribution from real GDP growth-2.6-3.0-1.90.9-0.60.00.6-0.5-1.3-1.8-1.8
Contribution from exchange rate depreciation 4/0.00.00.00.00.0
Other identified debt-creating flows0.00.00.00.00.00.00.00.00.00.00.0
Privatization receipts (negative)0.00.00.00.00.00.00.00.00.00.00.0
Recognition of implicit or contingent liabilities0.00.00.00.00.00.00.00.00.00.00.0
Other (specify, e.g. bank recapitalization)0.00.00.00.00.00.00.00.00.00.00.0
Residual, including asset changes (2-3) 5/-1.33.1-4.12.5-0.6-0.90.00.00.00.00.0
Public sector debt-to-revenue ratio 1/153.7130.2113.3145.7147.2158.9164.7163.1157.8150.2143.2
Gross financing need 6/11.65.64.814.018.813.317.421.311.815.614.8
Billions of U.S. dollars1.30.70.61.72.51.72.32.81.62.32.3
Scenario with key variables at their historical averages 7/64.063.462.862.261.560.9-0.3
Scenario with no policy change (constant primary balance) in 2011-201664.070.777.582.787.491.6-0.2
Key Macroeconomic and Fiscal Assumptions Underlying Baseline
Real GDP growth (percent)4.15.13.6-1.91.10.0-1.00.82.02.83.0
Average nominal interest rate on public debt (percent) 8/5.15.25.25.23.94.44.44.54.64.74.8
Average real interest rate (nominal rate minus change in GDP deflator, percent)2.20.50.25.51.9-0.42.64.23.23.12.8
Nominal appreciation (increase in US dollar value of local currency, percent)-9.5-8.16.8-6.710.4
Inflation rate (GDP deflator, percent)3.04.65.1-0.32.04.71.90.31.51.62.0
Growth of real primary spending (deflated by GDP deflator, percent)3.91.05.09.33.80.5-6.5-2.0-3.13.63.1
Primary deficit-2.1-6.4-3.73.43.14.41.2-1.1-3.1-3.0-2.9

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Table 4.Cyprus: Balance of Payments, 2005-20161/
200520062007200820092010201120122013201420152016
Proj.
(Millions of Euros)
Current account balance-788-1,005-1,865-2,907-1,319-1,355-1,308-919-943-1,025-1,098-1,157
Trade balance (Goods and Services)-356-582-1,040-1,903-870-884-795-401-420-483-532-563
Goods balance-3,372-3,932-4,710-5,519-4,232-4,681-4,429-4,323-4,441-4,724-5,014-5,297
Exports1,2291,1121,0831,1959951,1511,2041,2821,3151,3751,4691,567
Imports-4,601-5,044-5,794-6,714-5,227-5,833-5,633-5,605-5,755-6,098-6,483-6,864
Services Balance3,0163,3513,6713,6163,3623,7983,6333,9214,0214,2404,4814,734
Exports5,1635,6876,4046,5265,7266,2166,6796,9396,9867,2447,6758,114
Imports-2,147-2,337-2,733-2,910-2,365-2,418-3,046-3,018-2,965-3,004-3,193-3,381
Current income, net-503-589-818-961-265-474-494-499-504-522-545-573
Current transfers, net72165-7-43-1842-18-18-19-19-20-21
Private53831741-9179616263656871
Public1983-24-84-93-76-80-80-81-84-88-92
Capital account, net6926666128999101011
Financial account, net5839871,9012,8381,3531,4031,2999099341,0151,0881,147
Direct investment498755720-229998763785792819848866910
Portfolio investment-106-132-323-12,483-11,393-1,430182-37-93-385-503-635
Other investment7621,1511,28415,25911,6561,870332155208553725872
Reserves (- inflow; + outflow)-570-78722029192200000000
Errors and omissions135-8-4264-95-76000000
(Percent of GDP)
Current account balance-5.8-6.9-11.7-16.8-7.8-7.7-7.2-5.0-5.1-5.3-5.5-5.5
Trade balance (goods and services)-2.6-4.0-6.5-11.0-5.1-5.1-4.4-2.2-2.3-2.5-2.6-2.7
Goods balance-24.9-27.0-29.5-31.9-24.9-26.8-24.3-23.5-23.9-24.5-24.9-25.0
Exports9.17.66.86.95.96.66.67.07.17.17.37.4
Imports-34.0-34.6-36.3-38.8-30.7-33.4-30.9-30.4-30.9-31.7-32.2-32.4
Services balance22.323.023.020.919.821.719.921.321.622.022.322.4
Exports38.239.140.137.733.735.536.637.737.537.638.138.4
Imports-15.9-16.1-17.1-16.8-13.9-13.8-16.7-16.4-15.9-15.6-15.9-16.0
Current income, net-3.7-4.0-5.1-5.6-1.6-2.7-2.7-2.7-2.7-2.7-2.7-2.7
Current transfers, net0.51.10.0-0.2-1.10.0-0.1-0.1-0.1-0.1-0.1-0.1
Private0.40.60.10.2-0.50.50.30.30.30.30.30.3
Public0.10.6-0.1-0.5-0.5-0.4-0.4-0.4-0.4-0.4-0.4-0.4
Capital account, net0.50.20.00.00.40.20.10.10.10.10.10.1
Financial account, net4.36.811.916.48.08.07.14.95.05.35.45.4
Direct investment3.75.24.5-1.35.94.44.34.34.44.44.34.3
Portfolio investment 2/-0.8-0.9-2.0-72.1-67.0-8.21.0-0.2-0.5-2.0-2.5-3.0
Other investment 2/5.67.98.088.268.610.71.80.81.12.93.64.1
Reserves (- inflow; + outflow)-4.2-5.41.41.70.51.10.00.00.00.00.00.0
Errors and omissions1.0-0.1-0.30.4-0.6-0.40.00.00.00.00.00.0
Sources: Eurostat; Central Bank of Cyprus; and IMF staff estimates.

Balance of Payments historical data and projections exclude data related to the operations by entities without a physical presence in Cyprus as data coverage on these entities is still incomplete and subject to substantial revisions. This is also consistent with the treatment of these entities in the National accounts.

2008-09 data reflect the transitions between Greek banks and their subsidiaries in Cyprus.

Sources: Eurostat; Central Bank of Cyprus; and IMF staff estimates.

Balance of Payments historical data and projections exclude data related to the operations by entities without a physical presence in Cyprus as data coverage on these entities is still incomplete and subject to substantial revisions. This is also consistent with the treatment of these entities in the National accounts.

2008-09 data reflect the transitions between Greek banks and their subsidiaries in Cyprus.

Table 5.Cyprus: External Debt Sustainability Framework, 2006-2016(Percent of GDP, unless otherwise indicated)
ActualProjections
20062007200820092010201120122013201420152016Debt-stabilizing
Baseline: External debt297.7346.1368.6505.9446.9462.4453.4447.2441.3435.5432.4-17.4
Change in external debt57.148.322.6137.3-59.015.5-9.0-6.2-5.9-5.8-3.1
Identified external debt-creating flows (4+8+9)-15.8-36.237.480.4-3.2-3.6-5.1-5.6-5.0-5.2-4.4
Current account deficit, excluding interest payments4.09.013.62.82.54.64.44.34.34.04.0
Deficitin balance of goods and services4.06.57.40.01.33.93.73.43.43.03.0
Exports47.147.255.751.150.952.052.653.253.754.154.8
Imports51.153.763.151.152.255.956.256.657.057.257.8
Net non-debt creating capital inflows (negative)-4.3-2.468.264.63.8-5.5-4.1-3.7-2.3-1.7-1.2
Automatic debt dynamics 1/-15.6-42.8-44.413.0-9.5-2.8-5.5-6.2-7.0-7.5-7.1
Contribution from nominal interest rate3.02.73.64.84.54.24.24.24.14.04.0
Contribution from real GDP growth-9.2-12.9-10.86.6-5.4-7.0-9.7-10.3-11.1-11.6-11.1
Contribution from price and exchange rate changes 2/-9.4-32.7-37.21.6-8.7
Residual, incl. change in gross foreign assets (2-3) 3/72.984.5-14.856.9-55.719.1-3.9-0.5-0.9-0.51.2
External debt-to-exports ratio (in percent)632.2733.9662.2990.6878.5889.3862.3841.2822.1804.4788.7
Gross external financing need (in billions of US dollars) 4/23.531.052.665.292.968.571.069.167.364.766.8
in percent of GDP127.4142.2206.6276.2401.010-Year10-Year273.6271.4253.2236.5217.3215.5
Scenario with key variables at their historical averages 5/462.4446.6432.3417.7404.5392.2-23.8
HistoricalStandard
Key Macroeconomic Assumptions Underlying BaselineAverageDeviation
Real GDP growth (in percent)4.15.13.6-1.71.02.82.01.72.22.42.62.72.7
GDP deflator in US dollars (change in percent)4.112.712.4-5.7-2.86.99.06.22.41.81.71.81.4
Nominal external interest rate (in percent)1.31.11.21.20.91.00.21.01.01.01.01.01.0
Growth of exports (US dollar terms, in percent)5.918.737.5-14.9-2.29.714.210.45.85.45.35.45.4
Growth of imports (US dollar terms, in percent)8.924.536.8-24.90.310.216.915.55.34.95.14.85.3
Current account balance, excluding interest payments-4.0-9.0-13.6-2.8-2.5-4.43.9-4.6-4.4-4.3-4.3-4.0-4.0
Net non-debt creating capital inflows4.32.4-68.2-64.6-3.8-10.529.75.54.13.72.31.71.2

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g + r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

6/ Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.7/ External debt in Cyprus is made up to a large extent by non-resident deposits. In light of the more stable nature of these deposits together with the existence of liquidity provisions, risks stemming from external debt are smaller than what the headline debt number may suggest.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g + r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

6/ Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.7/ External debt in Cyprus is made up to a large extent by non-resident deposits. In light of the more stable nature of these deposits together with the existence of liquidity provisions, risks stemming from external debt are smaller than what the headline debt number may suggest.
Table 6.Cyprus Core Financial Soundness Indicators for Deposit Takers 2007- 2011 1/(Percent, otherwise indicated)
Financial Soundness Indicators2008 Q42009 Q12009 Q22009 Q32009 Q42010 Q12010 Q22010 Q32010 Q42011 Q1Provisional

2011 Q2
Regulatory capital to risk-weighted assets10.611.811.511.611.712.212.912.9
Regulatory tier 1 capital to risk-weighted assets8.19.49.810.110.210.711.611.6
Core tier 1 capital to risk-weighted assets 2/7.37.37.77.57.78.19.08.6
Non-performing loans net of provisions to capital16.122.319.820.923.525.826.430.833.434.8
Non-performing loans to total gross loans4.65.96.36.67.27.37.68.1
Non-performing loans to gross loans, alternative9.810.410.712.312.112.013.9
definition 3/
Setoral distribution of total loans:
Residents39.536.737.037.240.038.839.238.638.939.9
Deposit-takers1.40.60.60.71.00.91.01.21.11.1
Central Bank1.30.81.61.13.01.53.21.12.11.0
Other financial corporations1.92.11.91.92.42.42.82.92.43.1
General government1.00.90.90.90.90.90.80.90.90.9
Nonfinancial corporations21.420.520.420.620.420.719.620.220.220.9
Other domestic sectors12.411.911.612.012.312.411.712.312.312.9
Nonresidents60.563.363.062.860.061.260.861.461.160.1
Return on assets1.00.20.40.70.80.20.30.50.60.2-0.5
Return on equity14.52.86.511.114.03.66.69.111.03.1
Interest margin to gross income67.965.266.865.966.772.274.575.975.673.178.0
Non-interest expenses to gross income52.154.451.148.850.650.852.953.453.549.4
Liquid assets to total assets (liquid asset ratio)36.541.146.443.640.139.543.137.132.427.0
Liquid assets to short-term liabilities46.556.463.957.951.251.656.746.540.843.8
Net open position in foreign exchange to capital0.81.20.80.91.01.51.01.01.00.9
Source: IMF, Financial Soundness Indicators (FSI). Data extracted from IMF Data Warehouse on 9/9/2011.

The data used for the first six financial soundness indicators is from the Banking Supervision Department of the Central Bank given its more timely nature. However, the data provided had missing values for Q1 through Q3 2009.

Banks for which CBC is the home supervisor

NPLs of commercial banks on local operations only—including loans fully covered by tangible collateral.

Source: IMF, Financial Soundness Indicators (FSI). Data extracted from IMF Data Warehouse on 9/9/2011.

The data used for the first six financial soundness indicators is from the Banking Supervision Department of the Central Bank given its more timely nature. However, the data provided had missing values for Q1 through Q3 2009.

Banks for which CBC is the home supervisor

NPLs of commercial banks on local operations only—including loans fully covered by tangible collateral.

According to the Lisbon Review 2010, Cyprus ranks 13th out of 27 EU countries in terms of overall competitiveness, but only 21th in terms of the sub-category Innovation and R&D.

Other Resources Citing This Publication