Journal Issue

Statement by Mr. Menno Snel, Executive Director for Cyprus, and Mr. Ektoras Kanaris, Advisor to the Executive Director

International Monetary Fund. European Dept.
Published Date:
December 2013
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We thank staff for their comprehensive second review of the Extended Arrangement for Cyprus. The report clearly indicates that programme implementation remains strong, with all quantitative targets met and all structural benchmarks achieved. We agree with the thrust of the staff report which recognizes the Cypriot authorities’ achievements despite the difficult environment in which they operate in, while setting out in detail the remaining risks and vulnerabilities.

The authorities’ performance so far clearly demonstrates their resolve and determination to fully deliver on programme conditionality and beyond. In fact, despite an over performance in the fiscal targets, the 2014 budget, which was submitted to the parliament on December 12, goes beyond programme requirements reinforcing Cyprus’s commitment to an ambitious fiscal programme. The budget will bring the total fiscal adjustment for 2013-14 to 9.4 percent of GDP. Furthermore, significant progress has been achieved on the politically sensitive issue of privatizations. The decision by the Council of Ministers is a milestone that enables Cyprus to move forward and decisively with the process. Finally, the Cypriot authorities remain committed to undertaking the structural reforms necessary to return to sustainable growth, while at the same time seeking to maintain social cohesion.

Commitment, however, rarely translates into quick results. Indeed, the economy remains in deep recession while unemployment stands at historical peaks of around 17%. Nevertheless, there are encouraging signals from the first nine months of the program. First, we take positive note of the economy’s stronger resilience than was initially assumed and that important growth levers, while negatively impacted, have not lost their momentum. The successful implementation of the programme has been reflected in improved market perceptions of Cyprus’s financial position. Ratings agencies have also taken notice, with Standard & Poor's recently upgrading its long-term sovereign debt rating on Cyprus, the first ratings upgrade following a series of steep downgrades in the last three years. In the financial sector, there was a strong vote of confidence arising from the oversubscribed share capital increase of Hellenic Bank, including through foreign direct investment. Although the road ahead remains long and challenging, these developments are promising.

Macroeconomic developments

The economic situation remains difficult, but the outturn so far has been somewhat better than anticipated. Real economic growth has been revised to -7.7 percent in 2013, as compared with an initial estimate of -8.7 percent. A more favourable outcome for the year should be expected as the annualized growth for the first three quarters was -5.5 percent. Indeed, a number of indicators such as retail sales, tourism receipts, and professional services have proven to be relatively resilient, while recent sentiment indicators point to a gradually improving confidence. Specifically, the Economic Sentiment Indicator (ESI) for November 2013 increased further, registering its seventh consecutive monthly increase. Though much uncertainty underlies any growth forecast at present, looking forward, a significant deleveraging process is expected to take place through the banking sector, which together with the fiscal adjustment already underway will entail a drag on growth. At the same time, sparse liquidity in the system, in addition to the low level of confidence and ongoing capital controls, has rendered the banks apprehensive to the provision of credit. As a result, growth is expected to be about -4.8 percent in 2014, and 0.9 percent in 2015. As in the past, medium-term growth projections do not incorporate the potential upside from the exploitation of natural gas resources, including related forthcoming infrastructure investments.

Although the most recent figures in November show that the labour market is showing some signs of stabilization, unemployment remains unacceptably high at around 17 percent. Wages in both the public and private sectors have been reduced considerably and are contributing towards improving competitiveness. Nonetheless, the rapid increase in youth and long-term unemployment remains very worrying.

The significant adjustment of Cyprus’s current account, which has moved to a surplus of 7.4 percent of GDP in the second quarter compared with a deficit of 4 percent of GDP a year ago, indicates the economy’s ability to adjust. While most of the current account adjustment has emanated from lower imports, the modest recovery in the eurozone has contributed to increased trade, evidencing Cyprus’s highly open economy.

Public Finances

The authorities remain determined to restore Cyprus’s public finances to a sustainable footing, continuing their strong record of compliance with fiscal targets. Good progress has been made in that regard enabling the general government primary balance to reach a surplus of €110 million during the period under review (January –September 2013), comparing favourably with the forecast of a deficit of €402 million. As a percentage of GDP, the primary balance recorded a 0.7 percent surplus compared with a forecast deficit of 2.4 percent, an over performance of 3.1 percent. This was due to a better-than-expected revenue collection and prudent execution of discretionary spending. In light of the fiscal outturn to date, the end-year primary deficit target for the general government has been revised to 2.6 percent of GDP from 3.3 percent, locking in some of the over-performance during the first nine months of this year.

For 2014, the authorities are targeting a primary deficit of 3.3 percent. This is 1 percent of GDP less than envisaged under the original programme, reflecting the net effect on revenues (0.7 percent of GDP) of a higher 2013 base. This more than offsets the weaker growth in 2014, but also provides some additional high quality permanent measures beyond the program requirements (0.3 percent of GDP).

Financial Sector

Even though significant efforts have been made towards restoring confidence in the sector and progress has indeed been made, the state of affairs remains fragile. Confidence in the system is still low although there has been a distinct deceleration in deposit outflows since end-September 2013.

Stabilizing the financial sector remains the authorities’ key priority. To this end, important strides have been made since end July, when Bank of Cyprus was fully recapitalized and exited the resolution process. In particular, a new Board of Directors for Bank of Cyprus was elected in September, soon followed by the appointment of a new Chief Executive Officer. Subsequently, the bank’s restructuring plan was assessed favourably, in compliance with the programme’s structural benchmark. The plan aims at cleaning up the bank’s balance sheet including, most importantly, managing effectively non performing loans, returning the bank to profitability, maintaining adequate capitalization, and ensuring stable funding over the medium term. The plan is broadly consistent with the programme assumptions and includes a strategy to deal with troubled borrowers through the creation of specialized units inside the bank.

On November 1, Hellenic Bank increased its share capital from private sources, including foreign participants, thus satisfying two structural benchmarks for this and the next review. In addition, the bank secured the conversion of €255 million of junior bonds into CT1 eligible instruments, thus exceeding the capital requirements determined by the PIMCO due diligence exercise under the adverse scenario by around 20 percent.

At the Cooperative Central Bank (CCB), a new Board of Directors has been elected and, on the basis of a draft restructuring plan, the authorities have started consolidating the sector by merging 38 cooperative credit institutions into 9 entities. As a prior action, the Ministry of Finance has agreed on the terms governing the relationship framework with the CCB, on the basis of international best practices, to ensure that the bank operates on a commercial basis. Furthermore, supervision and regulation of the cooperative credit institutions have been transferred to the Central Bank of Cyprus (CBC).

Finally, the CBC completed the review of banks’ practices regarding loan origination processes, asset impairment and provisioning and the treatment of collateral in provisioning. At the same time, the authorities are resolutely reforming the framework to facilitate the all important area of private debt restructuring in the following manner. First, the Central Bank has already finalized an Arrears Management Framework and a Code of Conduct for borrowers and creditors in line with international best practice. Second, banks are establishing specialized units to deal with NPLs, and third, a review aimed at strengthening the insolvency framework is underway, already enriched with technical assistance by the Fund.

Looking forward, the authorities will build on these steps to ensure that credit institutions can effectively support the economic recovery. At the same time the CBC remains committed to taking appropriate measures to maintain sufficient liquidity in the system in line with Eurosystem rules.

Building on initial signs of improving confidence in the banking sector and concluding the first stage of the roadmap on capital controls, during August-October 2013 the authorities further relaxed restrictions on wire transfers and the opening of new accounts. Following the submission of the cooperative sector’s final restructuring plan, the second phase of relaxations can begin, including the abolition of remaining restrictions requiring the automatic renewal of fixed-term deposits and the elimination of limits for the free transfer of deposits within the domestic banking system. To ensure that further relaxations do not jeopardize financial stability, the CBC will fine-tune its technical impact assessment of relaxation measures on banks’ liquidity. Furthermore, to assess market confidence in order to proceed with relaxations in the context of financial stability, the CBC will study current market conditions, including through well-targeted surveys and focus groups, by end January 2014. At present experts from the Austrian National Bank are in Cyprus assisting the CBC in the design of a banking survey.

Structural reforms

The authorities continue to advance their ambitious structural reform agenda. As outlined in the report, the government is steadfastly moving forward with a comprehensive social welfare reform aimed at protecting vulnerable groups during the downturn. The scheme, which introduces a general minimum income for vulnerable groups, will be financed by consolidating and better targeting other social benefits to remain within the 2014 envisaged envelope.

Substantial progress is also being made in the area of revenue administration, aimed at supporting the consolidation efforts. More specifically, steps are being taken toward the integration of the Inland Revenue Department and VAT services into a new function-based tax administration while, as a more short-term response, a work programme of targeted joint audits is being prepared to be undertaken by the Internal Revenue Department and VAT Services. In the area of public financial management the authorities completed the drafting of the Fiscal Responsibility and Budget Systems Law which provides the legal basis for the efficient management of public investment projects, the establishment of a Fiscal Council, and establishes transparent management of natural resource revenues through the budget.

Finally, despite its political sensitivity, the Cyprus Privatization Plan was unanimously approved by the Council of Ministers on December 5. This has been a landmark decision which enables the authorities to embark on the privatization process. Following from this decision, the Government intends to further detail the asset-specific timelines and intermediate steps for all state-owned enterprises envisaged for privatization. In parallel, the legal and institutional framework for the privatization process will be finalized. The plan will be adjusted at regular intervals to reflect market developments with a view to maximizing revenues in line with the envisaged timelines as well as potentially attracting foreign direct investment.

Overall, the government places great emphasis in the area of structural reforms and has already embarked on an overhaul, inter alia, of public administration, the health system and tax administration. In conjunction with an ambitious privatization program, these reforms will create the conditions for Cyprus to regain its competitiveness and generate the foundation for a sustainable economic model.


In summary, Cyprus has taken decisive action to address its economic difficulties and restore stability, meeting its commitments under the program in terms of policy reforms as well as quantitative targets. As noted earlier, steadfast implementation has produced tangible results with indications that the process of recovery is taking place. These developments give some room for cautious optimism. Nevertheless, the authorities have no room for complacency and are aware that there are major challenges to be overcome. The adjustment remains painful in the face of a deep recession, high unemployment and an impaired banking system that is reluctant to provide any credit. To this end, it is encouraging to see that European institutions are not passive observers of these exceptional circumstances under which the Cypriot economy is operating, as recently evidenced by the EIB’s approval of new financing instruments for Cyprus, for an amount of up to EUR 150 million. In this context the authorities would like to express their appreciation for efforts like this one which provide the impetus for continued commitment and execution as the programme unfolds. At the same time, the authorities look forward to continuing discussions on how the sustainability of Cyprus’s well performing programme can be improved.

In conclusion, it should be noted that Cyprus’s strong implementation record so far is equally attributed to staff’s good programme design, by way of carefully balancing ambitious conditionality with the institutional capacity limitations that small economies face. While staff’s overall guidance throughout this process has been instrumental in helping the authorities keep up, continued vigilance on this sensitive exercise will be crucial for continued success. Finally, credit must be handed to Fund management, the relevant area departments, and the EU’s “Support Group for Cyprus” for generously offering, structuring and making possible the extensive technical assistance that Cyprus has received and will continue to receive across a vast number of areas.

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