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Cyprus: Staff Report for the 2014 Article IV Consultation

Author(s):
International Monetary Fund. European Dept.
Published Date:
October 2014
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Background

A. Crisis and Immediate Policy Response

1. Cyprus accumulated large imbalances in the run-up to the 2008 global crisis. An annual growth rate of 4 percent in the decade preceding the crisis masked the build-up of unsustainable imbalances and vulnerabilities. Following EU entry and the removal of capital account restrictions in 2004, significant foreign inflows led to a rapid expansion of the banking sector to seven times GDP. Easy credit fuelled a housing boom and an increase in private-sector indebtedness1 to over 300 percent of GDP by 2008, one of the highest levels in the euro-area. The financial sector became deeply interlinked with that of neighboring Greece, accumulating significant Greek loans and sovereign debt. Surging imports and an erosion of external competitiveness as wage growth exceeded productivity led to a widening of the current-account deficit to about 16 percent of GDP at end-2008.

2. The imbalances eventually culminated in a banking-sector collapse (Figure 1). As foreign inflows slowed and bank credit growth shrunk, the housing boom turned to bust, and output fell in 2009. In response, fiscal policy was loosened, which led to a rapid deterioration in the budget balance and public debt. Domestic weaknesses, compounded by tight sovereign-bank links and an intensification of the Greek crisis, resulted in a loss of market access in May 2011. The explosion of Cyprus’s main power station in July added to the economic distress. And the decision to restructure Greek sovereign debt in late 2011 dealt a severe blow to the two largest Cypriot banks, which lost a combined 25 percent of GDP. As a result, one bank had to be recapitalized through state support (10 percent of GDP) in 2012. Deposit outflows intensified, and reliance on Emergency Liquidity Assistance (ELA) rose to 60 percent of GDP by end-2012.

Figure 1.Cyprus: From Boom to Bust

Sources: Cystat, CBC, OECD, Ministry of Finance; and IMF staff estimates.

3. In March 2013, the authorities took unprecedented measures to stem the crisis. Cyprus requested official assistance from the EU/IMF in mid-2012. However, negotiations were protracted, due to difficulties in addressing the large capital needs of the banking sector—estimated at about 60 percent of GDP—without endangering debt sustainability (Box 1), as well as to the impending presidential election in early 2013. Following the elections, the new government moved aggressively, resolving the two systemic and by-then economically insolvent banks2, recapitalizing the resulting institution at no fiscal cost through bail-in of bank creditors (including uninsured depositors) and selling the banks’ Greek operations. Domestic and external payment restrictions were imposed (the latter comprising both capital controls and some exchange restrictions) to prevent a bank run.

Box 1.Addressing the Banking Crisis

Huge challenges… Cyprus had an outsized banking sector, which was found severely undercapitalized, with the two largest banks found economically insolvent. Capital needs (excluding the 2012 recapitalization bond and after bail in of junior debt) were initially estimated by PIMCO at just over €10 billion, large not only relative to Cyprus’s GDP but also in historical comparison.

Capital needs as of February 2013

(percent of GDP)

Source: PIMCO and IMF staff estimates.

Fiscal cost of banking crises

(Percent of GDP)

Source: Laeven and Valencia, “Systemic Banking Crises Database an Update”, 2012.

…and limited options… Bank recapitalization with public funds would have rendered public debt—already close to 90 percent of GDP at end-2012—unsustainable. Moreover, rather than addressing the problem at its root by dealing with economic insolvency in the largest two banks, this would have shifted the burden to the public-sector balance sheet, putting a daunting burden on the Cypriot taxpayer. Given the significant share of public debt held by the official sector and banks, debt restructuring was also not feasible. Direct bank support by the ESM could have minimized fiscal costs and reduced sovereign-bank links, but was not available.

Bail-in Amounts

(Billions of euros)

BoCLaikiTotal
Uninsured deposits3.947.9
Senior debt00.10.1
Subordinated debt0.60.81.4
Total4.54.99.4
Source: CBC.
Source: CBC.

…led to an unprecedented policy response in March 2013.1,2 A first attempt to recapitalize the banking sector through the imposition of a levy on all bank deposits (equivalent to around two years of interest earnings, and differentiated by size) was rejected by parliament on March 19 and was followed by a bank run, as the proposal was perceived to violate deposit insurance. With financial stability endangered, the authorities imposed a bank holiday, and on March 25 intervened the two economically insolvent banks. Following a purchase-and-assumption transaction, the resulting institution was recapitalized at no fiscal cost, through bail in of bank creditors, including uninsured deposits, which were converted into equity. Following the bank holiday, the authorities imposed restrictions on domestic and external payment flows.

Cyprus’s response to the crisis entailed difficult but unavoidable decisions. Bank economic insolvency was addressed upfront and debt sustainability was protected, thus limiting the burden on the Cypriot taxpayer.

1 See Box 1 in Country Report No. 13/125.2 Also see Section I of Selected Issues Paper “Cyprus’s Banking Sector: The Crisis and its Aftermath.”

4. This paved the way for an agreement on an adjustment program supported by official financing. The three-year program—underpinned by financial support of €10 billion (60 percent of Cyprus’s GDP) from European partners and the IMF—aimed at stabilizing the financial sector and ensuring sustainable public finances. The financial sector strategy focused on: (i) completing the recapitalization and restructuring of the banking sector, including the cooperative credit (coop) sector; (ii) implementing a debt-restructuring framework to address rising non-performing loans (NPLs) and private indebtedness; (iii) developing a roadmap for the gradual relaxation of payment restrictions; and (iv) strengthening bank regulation and supervision and the implementation of the AML/CFT framework. Fiscal policy aimed to achieve an ambitious yet well-paced consolidation, balancing short-term cyclical and longer-term sustainability concerns, complemented by comprehensive structural reforms.

B. Recent Economic Developments

5. The correction of imbalances resulted in a deep but unavoidable recession. Output declined by 5.4 percent in 2013, as high macroeconomic uncertainty, the large shock to income and wealth, and ongoing fiscal consolidation depressed consumption and investment. All sectors contracted, with construction and financial services—which had expanded rapidly before the crisis— declining sharply. Nevertheless, the recession was less deep than that projected at the onset of the program (8.7 percent), as households used savings to smooth consumption. In the first half of 2014, output contracted by a further 3.2 percent year-on-year, with private consumption stabilizing in the second quarter, and the tourism and trade sectors growing (Figure 2).

Figure 2.Cyprus: High Frequency Indicators

Sources: Cystat; Eurostat; MoF; and IMF staff estimates.

Contributions to GDP Growth

(Percentage points)

Sources: Cystat; Eurostat; and IMF staff estimates.

Contributions to GDP Growth

(Percentage points)

Sources: Cystat; Eurostat; and IMF staff estimates.

6. The downturn has been partially mitigated by price and wage flexibility (Figure 3). Prices declined in the second half of 2013 and early 2014, with inflation averaging -0.3 percent in the first eight months of 2014. Wages also adjusted, due to public-sector wage cuts and a renegotiation of contracts in the private sector. This helped contain the rise in unemployment, which peaked at about 16 percent in 2013 before moderating slightly due to a decline in labor-force participation.

Figure 3.Cyprus: Labor Market and Price Developments

Sources: Cystat; ECB; Eurostat; and IMF staff estimates.

Labor Market

(Percent, y-o-y change)

Sources: Cystat; ECB; Eurostat; and IMF staff estimates.

7. Private sector deleveraging has been slow (Figure 4). Bank credit to the domestic private sector fell by 5.4 percent in 2013, and by a further 1 percent y-o-y by end-August 2014. Private-sector debt remains among the highest in Europe, at 410 percent of GDP at end-2013. Nevertheless, households’ net financial-asset position has declined but remains large and positive (140 percent of GDP), while that of corporates is large and negative (-200 percent of GDP). Housing prices continued to adjust in 2013–14, and are now 25 percent below their 2008 peak, pointing to a large deterioration in the private sector’s non-financial asset position.

Figure 4.Cyprus: Private Sector Balance Sheet Developments

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

Private Sector Indebtedness, 2013

(Percent of GDP)

Sources: Haver; and IMF staff estimates.

Mark is for the overall level in 2012.

8. The external current account has adjusted (Figure 5). The current account deficit declined to about 2 percent of GDP in 2013 from a peak of 15.6 percent of GDP in 2008. The trade balance registered a 2 percent-of-GDP surplus, driven by contracting imports, which more than offset falling exports. The income balance remained in deficit, reflecting the large negative international investment position (−86 percent of GDP at end-2013). Import growth turned positive in mid-2014, and goods exports and tourist arrivals have risen.

Figure 5.Cyprus: External Indicators

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

Current Account

(Percent of GDP)

Source: Central Bank of Cyprus.

9. The fiscal deficit has declined on the back of an ambitious consolidation (Figure 6). The authorities implemented 4.5 percent of GDP of adjustment measures in 2013. These helped reduce the primary deficit to 2 percent of GDP in 2013 from 3.2 percent of GDP a year earlier, despite the deep recession. The 2014 budget included additional adjustment measures of 2.3 percent of GDP. In July, the cumulative primary surplus reached 2.1 percent of GDP relative to an expected balance, reflecting both lower primary spending and better-than-expected revenues, although the latter was partly affected by seasonality related to corporate-tax payments. Preliminary August figures point to continued overperformance.

Figure 6.Cyprus: Recent Fiscal Developments 1/

(Cumulative percent of GDP difference relative to previous year)

Citation: 2014, 313; 10.5089/9781498340793.002.A001

Sources: Ministry of Finance; and IMF staff estimates.

1/ Based on cash data and the national classification, which unlike ESA do not cover local governments and semi-government entities.

Estimated Yield of Implemented Program Fiscal Measures (2013–16)

(Percent of GDP)

Source; IMF Staff Estimates

10. Cyprus returned to the sovereign-bond market in mid-2014 after a three-year hiatus. Due to improved market sentiment in the region, but also to progress in addressing the crisis, Cypriot bond yields declined from close to 25 percent in March 2013 to under 5 percent in September 2014. In June 2014, Cyprus issued a five-year €750 million Eurobond. The proceeds were used to repay part of the 2012 recapitalization bond held by BoC. This helped smooth the debt-maturity profile, complementing measures taken in 2013 to extend the maturity of €1 billion of domestic debt and restructure a bilateral Russian loan maturing in 2016.

Government Bond Yields

(Percent)

Source: Bloomberg.

Cyprus Medium- and Long-Term Debt Maturity Profile

(Billions of euros)

Source: Cyprus Public Debt Management Office.

11. The core domestic financial sector has been downsized, recapitalized, and restructured. Following the March 2013 measures, the disposal of non-core bank assets, and further loan-book deleveraging, the domestic banking sector declined to 315 percent of GDP in March 2014 from 550 percent at end-2012 (foreign banks add another 160 percent of GDP). Its CET1 capital ratio is estimated to have increased to close to 14 percent of risk-weighted assets at end-August 2014 (from 3.5 percent at end-2012), as a result of: (i) BoC’s recapitalization at no fiscal cost in 2013 and an additional private placement of €1 billion completed in September 2014, (ii) the recapitalization of Hellenic Bank through private funds in late 2013; and (iii) the injection of public funds (€1.5 billion) in the coop sector in early 2014. The latter was also consolidated from 93 entities into 18.

Total Assets of Domestic Banking System

(Billions of euros)

Source: CBC.

Common Equity Tier 1 Capital Ratio in the Domestic Banking Sector

(Percent)

Sources and Notes: CBC. The Core Tier 1 ratio is reported for December 2012.

12. NPLs, however, have risen to very high levels (Figure 7). Although the recession has been less deep than expected, the NPL ratio of the core domestic sector increased sharply from 20 percent at end-2012 to 57 percent at end-July, broadly in line with the due-diligence projections under the stress scenario. Corporate NPLs stood at 50 percent and were highly concentrated, with construction NPLs now at over 73 percent. NPLs on primary-residence mortgages are around 40 percent. Provision coverage remains relatively low, at 34 percent compared to the European average of 46 percent.

Figure 7.Cyprus: Non-Performing Loans

Source: Central Bank of Cyprus, and IMF staff estimates.

Notes: The “all banks, local operations” category includes Cyprus operations only, i.e. it excludes overseas operations (branches and subsidiaries situated abroad) of the Cyprus-based banking groups.

Nonperforming Loans and Provisions in Core Domestic Banking Sector

(Percent)

Sources and Notes: CBC and Fund staff calculations. Core domestic banking sector includes BoC, Coops, and Hellenic Bank.

13. Deposit outflows have slowed, and domestic payment restrictions were fully eliminated. After falling by about 16 percent (excluding bailed-in amounts) during March-December 2013, system-wide deposits declined by a further 1.4 percent in the first eight months of 2014. The authorities gradually relaxed domestic payment restrictions, which were fully eliminated in May, and unfroze BoC’s uninsured deposits. External payment restrictions remain in place, given still tight bank liquidity, with BoC’s reliance on short-term central bank and ECB funding at about 55 percent of GDP and limited collateral buffers as asset quality deteriorates.

Total Deposits in Banking System

(March 29, 2013 = 100)

Sources: CBC, Fund staff calculations

C. Context for the Discussions

14. In the context of their adjustment program, the authorities have implemented an ambitious package of reforms (Figure 8). Policy recommendations included in the last Article IV consultation have been adopted, although some only after the crisis hit. These include an ambitious fiscal consolidation during 2012–14, measures to shore up the banking sector and strengthen supervision, and reforms of the public-sector wage-indexation mechanism (COLA) and the pension system. The authorities went beyond these to also reform the welfare system and the revenue administration, and introduce a new privatization framework, among others.

Figure 8.Main Reform Initiatives since the 2011 Article IV Consultation

15. Delays in program implementation have recently emerged. Following the break-up of the governing coalition in February 2014, the government lost its majority in parliament. Since then, political opposition to the program has risen, signs of reform fatigue have emerged, and vested interests have been gaining traction. As a result, the authorities have encountered difficulties in implementing key elements of the debt-restructuring legal framework to address NPLs, with parliament having approved foreclosure legislation that is not in line with program objectives (some of the bills were subsequently referred to the Supreme Court for a decision on their constitutionality, expected later in October). In light of these developments and ensuing legal uncertainty, the completion of the fifth review has been delayed.

16. European policies remain broadly supportive. Since the crisis, key policy initiatives have been put in place at the euro-area level, which Cyprus is expected to benefit from. The upcoming transition to the Single-Supervisory Mechanism (SSM) will harmonize supervisory and regulatory standards across the region, and the possibility of direct ESM support to banks could help limit sovereign-bank links. The ECB’s recent policy rate cut is in line with Cyprus’s cyclical position, although deposit rates in Cyprus remain elevated, reflecting a still-high risk premium. The new TLTRO and asset-purchase schemes to support lending are also welcome, although to achieve more than a limited effect in Cyprus, where asset quality has been deteriorating, the ECB would have to further relax its requirements. Further progress with completing the monetary and fiscal union could help support Cyprus’s efforts to normalize bank-funding conditions, remove external-payment restrictions, and preserve fiscal sustainability.

Policy Discussions

17. Discussions focused on the policy agenda to support the recovery. They covered three main areas: (i) macroeconomic fundamentals—including an assessment of consumption-saving dynamics, housing prices, competitiveness, and long-term potential growth—and risks; (ii) financial sector policies to address high NPLs and establish conditions to revive lending and normalize external payment flows; and (iii) fiscal and structural policies for sustainable public finances. Discussions highlighted the importance of an appropriate policy mix to support the recovery through a gradual fiscal adjustment minimizing the negative fiscal impulse together with financial policies reducing NPLs, facilitating private-debt restructuring, and strengthening bank capital and liquidity to revive lending. Over the medium-term, boosting depositor confidence and gradually lifting external payment restrictions, together with lowering public debt, are essential to restoring external stability.

A. Outlook and Risks

18. The recession is expected to continue this year. Output is projected to fall by a further 3.2 percent in 2014 (somewhat better than the fourth program review projection), bringing the 2013–14 recession to a cumulative 8.6 percent. This is 4 percentage points less than initially projected, reflecting consumption smoothing and more gradual deleveraging.3 Private consumption and investment are projected to further decline, albeit at lower rates, as deleveraging continues and the housing market adjusts. Unemployment is projected to reach 16.6 percent, and the price level to stabilize. The macroeconomic baseline is predicated on rapidly overcoming delays in program implementation.

Selected Economic Indicators
201320142015201620172018
Projection
(Percent change, unless otherwise indicated)
Real GDP−5.4−3.20.41.62.02.2
Consumption−5.6−2.9−0.60.51.31.5
Private consumption−5.7−2.4−0.11.51.71.9
Public consumption−5.0−4.7−2.1−3.2−0.6−0.3
Fixed investment−21.6−13.41.33.94.64.9
Inventory accumulation 1/−2.40.00.00.00.00.0
Foreign balance 1/5.01.00.80.70.40.3
HICP (period average)0.40.00.71.31.51.7
Unemployment rate EU stand. (percent)15.916.616.115.013.712.5
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.

19. A modest recovery is expected next year. Output is projected to grow by 0.4 percent and expand gradually thereafter. Private consumption will remain subdued, as households reduce debt, rebuild financial wealth, and adjust to lower non-financial wealth (house prices are projected to fall by a further 5–15 percent before reaching equilibrium).4 The household-saving rate is expected to further fall before rising to over 10 percent over the medium term.5 Given the large deleveraging needs of the corporate sector (30–60 percent of GDP), investment will recover only gradually. The recovery is expected to be credit-less and led by service sectors less dependent on credit, such as tourism and non-financial business services.6 Inflation will remain subdued relative to trading partners, facilitating a further modest depreciation of the real-exchange rate and an improvement in competitiveness.

Cyprus: Household Saving Rate

(Year-on-year percentage change)

Sources: Cystat; and IMF staff estimates.

20. Over the medium term, potential growth is expected to remain well below pre-crisis levels.7 The crisis will likely have a long-lasting impact on Cyprus’s potential growth, due to physical capital becoming idle and eventually obsolete, human capital shortfalls owing to hysteresis effects, and to individuals leaving the labor force after long unemployment spells. As a result, long-term potential growth is estimated at 2 percent, half its pre-crisis level, driven by modest growth in the labor force— underpinned by long-term demographic trends—and education-led productivity improvements, while capital accumulation remains subdued, as resources shift away from construction toward tourism and non-financial services, where Cyprus has a comparative advantage.

Potential Output Growth

(Contributions to potential growth, percentage points)

Sources: Haver; Eurostat; and IMF staff estimates.

21. Risks to the medium-term outlook are tilted to the downside (Annex 1).

  • Domestic risks: Prolonged delays in program implementation due to political tensions could have adverse implications for confidence and the recovery. Specifically, difficulties in addressing NPLs, including as a result of an inadequate debt-restructuring legal framework, and delays in meeting potential bank-capital needs following the comprehensive assessment could reignite negative bank-sovereign-real-sector feedback loops. Moreover, on the fiscal front, resistance to consolidation and reform fatigue could compromise debt sustainability. Even if the authorities manage to put the program back on track, deeper and more prolonged private sector deleveraging, exacerbated by the impact of persistently low inflation on indebtedness, could weigh on domestic demand and endanger debt sustainability (Annex 2). Long lasting external-payment restrictions could damage confidence and FDI, while a too rapid relaxation may exhaust liquidity buffers and endanger financial stability.

  • External risks: Weaker euro-area recovery would hurt Cyprus’s exports. Relatively lower euro-area inflation could hinder the envisaged improvement in competitiveness (Annex 3). An increase in world oil prices due to geopolitical tensions would boost imports and intermediate costs, dampening activity. While spillovers from the conflict in Ukraine have not been observed so far, a further escalation of sanctions and retaliatory measures could negatively affect Cyprus through three channels: (i) trade could suffer, given that service exports to Russia account for over 20 percent of Cyprus’ total exports (mostly tourism); (ii) the service sector could be hit by a departure of Russian companies registered in Cyprus, which make use of Cypriot business services; and (iii) fiscal revenues would decline if off-shore companies leave Cyprus (they contribute 1–2 percent of GDP in corporate income-tax revenue).

  • Mitigating factors: A continuation of gradually improving quarterly national-accounts trends could result in higher growth this year, while investment associated with the exploitation of natural gas could boost growth over the medium term.

22. The authorities broadly concurred with the outlook and saw some upside potential. They argued that households may save less, given still low confidence in the banking sector, which could boost consumption in the medium term. Regarding the housing market, they considered that prices are bottoming out and could modestly increase by next year, given emerging signs of renewed domestic and foreign demand. Finally, they saw upside to medium-term output, including due to the recent gas discoveries. The authorities agreed that a prolonged delay in program implementation could have adverse implications for the macroeconomic framework and concurred with staff’s views on external risks.

B. Public Debt and External Sustainability

23. Public debt is high and vulnerable to shocks (Annex 2). Public debt rose to 112 percent of GDP at end-2013, due to the large official financing and the sharp fall in output. Debt is projected to peak at about 126 percent of GDP in 2015 and to decline gradually thereafter toward 100 percent by 2020. Contingent liabilities associated with government guarantees on bank loans (20 percent of GDP) and still-large implicit liabilities associated with the banks’ reliance on central bank financing (55 percent of GDP) increase its vulnerability to shocks. In particular, a growth/interest rate/primary-balance shock or a shock to growth combined with a materialization of contingent liabilities could push debt to very high levels. In these cases, additional financing measures and commitments from European partners would be needed to protect debt sustainability.

Debt Sustainability: Baseline and Selected Shocks

(Percent of GDP)

Source: IMF staff estimates.

24. Cyprus’s external position is also highly vulnerable (Annex 3). Although external debt has declined, it remains high, at 350 percent of GDP at end-2013. Financial-sector liabilities—mainly non-resident deposits—are large and unstable, requiring the maintenance of external-payment restrictions. Reliance on official financing is high and rising, while external liabilities of the central bank with the Euro-system remain significant. The external net international-investment position (-86 percent of GDP at end–2013) is significantly weaker than that consistent with medium-term fundamentals. Restoring external stability critically hinges on a restoration of the health of the financial sector and a reduction in public debt, which are expected to take time. But it would also likely require a more depreciated real-exchange rate (REER) over the medium term, a little beyond the 0-8 percent adjustment implied by standard fundamentals-based models.

External Debt

(Percent of GDP)

Source: Central Bank of Cyprus.

25. The authorities broadly agreed with the risks posed by public and external debt. Nevertheless, they considered that public sector debt projections remain conservative, given the assumption of full disbursement of the program buffer and the stringent growth and inflation projections. They also noted that expected upward revisions to the output level later this year (to conform to ESA2010 standards) will bring down the debt-to-GDP ratio. They concurred with the external stability assessment, including the need for moderate medium-term REER adjustment.

C. Financial Sector Policy

26. While the authorities took decisive action to address the crisis, important challenges remain. The banking sector is now smaller and better capitalized, domestic payment restrictions have been eliminated, and deposits have broadly stabilized. However, left unaddressed, high and rising NPLs would pose a threat to the banking system’s long-term viability and the economic recovery. Capital buffers in some banks are limited, and bank restructuring remains incomplete, hampering the resumption of credit and growth. Narrow liquidity buffers and still-large ELA exposure require the maintenance of external payment restrictions. Finally, the authorities need to further enhance bank supervision ahead of the transition to the SSM and strengthen the implementation of the AML/CFT framework.

Challenge 1: Addressing NPLs

27. Early policy initiatives have not managed to curb the rising NPL trend. NPLs are very high both in a historical and cross-country context. This reflects not only the severe recession, but also increasing strategic default. Indeed, NPLs exceed what could be explained by unemployment, especially given the large and positive asset position of households. To facilitate the restructuring of troubled loans, banks have put in place restructuring units. (A state-backed asset-management company (AMC) was not created given debt-sustainability concerns limiting the ability to provide either direct state funding or government guarantees.8) The Central Bank of Cyprus (CBC) published an arrears-management framework (AMF) and Code of Conduct (CoC) to guide the loan-restructuring process and developed a supervisory framework to monitor banks’ capacity and progress against operational and restructuring indicators. Still, progress has been slow, as incentives are lacking, and banks need time to build capacity to handle the many NPLs.

Peak NPL Ratios

(Percent of Total Loans)

Sources: IMF, Laeven and Valencia (2013)

Peak NPL Ratios and Unemployment Rates in Select Episodes

(Percent)

Sources: IMF staff estimates.

28. Reforming the debt-restructuring legal framework is urgent. The inability to reach restructuring solutions is largely due to a lack of incentives for borrowers and lenders to negotiate, including a foreclosure process that takes 10–15 years and outdated corporate-restructuring and personal-bankruptcy procedures. In this regard:

  • Foreclosure: The authorities need to implement without delay foreclosure legislation allowing for a balanced but swift process without interference from government agencies. While a recently adopted legislative package includes important elements, it also introduces a number of new obstacles, including processes to delay foreclosures, moratoria, and debt-write-offs irrespective of viability considerations. These obstacles should be removed to protect the payment culture and provide incentives for debt restructuring. Indeed, banks are expected to use the law sparingly and mainly as a negotiation tool, as potentially declining collateral values due to foreclosures would affect their capital. To protect vulnerable groups, implementation of the foreclosure law for primary residences should be aligned with the new personal-bankruptcy legislation, and the authorities should ensure adequate implementation of the new safety-net reform protecting those most in need.

  • Insolvency: The foreclosure law will need to be complemented by a modernized corporate and personal-insolvency legal framework facilitating debt restructuring for viable debtors, and allowing for speedy liquidation of non-viable companies and for a “fresh start” for individuals without capacity to repay.

29. Supervisory tools also need to be strengthened. Banks need stronger capacity and better incentives and tools to proactively restructure NPLs to spearhead the recovery. The CBC needs to follow up on its review of banks’ operational capacity and ensure that remaining deficiencies are being addressed. Moreover, the new voluntary Arrears-Management Framework and Code of Conduct will need to be further refined and their implementation monitored and enforced through supervisory action. The authorities should also further leverage the supervisory bank-monitoring framework as a tool to encourage banks to restructure NPLs. Finally, to facilitate the disposal and workout of NPLs, the authorities could consider other measures to address legal and other barriers hampering the sale and servicing of bank loans by third parties.

30. The authorities recognized the importance of addressing NPLs, but emphasized the need for adequate safeguards for households. They agreed that the insolvency and foreclosure legal framework needs strengthening, but stressed that the process should be balanced and vulnerable groups adequately protected. They also noted risks from potential sharp declines in property prices as a result of foreclosures. They agreed to further refine the AMF and CoC to better standardize restructuring processes and tools, emphasizing the importance of adequate supervisory enforcement of the framework.

Challenge 2: Putting in place the conditions to revive lending

31. The financial sector needs to maintain strong capital buffers. While banks have been recapitalized under conservative assumptions (including for housing prices, which were projected to further fall broadly in line with staff’s baseline scenario) given lingering downside risks and low provisions, stronger capital buffers would help deal with potential shocks, address high NPLs proactively, and allow for new lending to support viable investment. Moreover, Cypriot banks need to ensure adequate buffers in light of the pan-European comprehensive assessment, whose methodological assumptions and stress-test scenario are somewhat more stringent than those underlying the banks’ initial recapitalization. The recent market recapitalization of BoC, which boosted its CET1 capital ratio to 15 percent, is a welcome step, and the bank should ensure that any additional needs can be covered through market sources, if necessary. Hellenic Bank also indicated its intention to proactively increase its share capital. The authorities should stand ready to provide additional support to the coop sector, if needed, in line with the program envelope. Commercial banks’ renewed access to markets, the availability of ESM direct bank recapitalization support (albeit under stringent conditions), and the program buffer (in excess of 10 percent of GDP) can help mitigate risks.

32. Bank restructuring should continue. Banks and coops are progressing with the implementation of their restructuring plans. They cut their cost-to-income ratios to 40 and 50 percent, respectively, well below the European average (60 percent). BoC finalized its operational integration with Laiki and disposed of non-core activities abroad. Looking forward, given that BoC’s operational restructuring plan is broadly on track, the bank’s efforts need to focus on continuing overseas deleveraging and normalizing funding. Regarding the coops, with the new organizational structure in place, efforts should focus on ensuring efficient and consistent management of information, processes, and risks across the sector, including by centralizing the management of NPLs and early arrears and by further strengthening governance arrangements.

33. The authorities agreed that strong capital buffers and progress with restructuring are key to reviving lending. They noted that high bank-funding costs—reflecting an elevated risk premium due to still-low depositor confidence—hamper the resumption of credit. They agreed that the normalization of funding conditions and lending rates requires further efforts to bolster confidence, including by expeditiously addressing any capital shortfalls identified by the comprehensive assessment. Regarding the restructuring of coops, while they concurred with the need to strengthen and unify management practices across the sector, they noted that excessive centralization could jeopardize the sector’s franchise and business model.

Challenge 3: Normalizing external flows

34. Safeguarding financial stability requires prudent management of payment restrictions. Domestic payment restrictions imposed during the crisis have been gradually and successfully relaxed on the basis of the authorities’ published roadmap, as key milestones in the bank recapitalization and restructuring strategy were achieved. However, owing to the short deposit-maturity structure, significant foreign deposits (close to 40 percent of the total), large reliance of BoC on ELA, and the lack of other market funding, external restrictions remain in place. While restrictions do not apply to fresh foreign inflows into Cyprus, they limit outflows, hampering trade credit and affecting overall confidence.

Restrictive Measures as of End-September 2014 (Euros)
Cashless payments/transfers w/o justification to institutions abroad (per day per account)
Transactions within normal business w/o Committee’s approval1,000,000
Living expenses per quarter as tuition fees5,000
Payments via debit or credit card (per month)No limit
Exports of euro notes or foreign currency per person per journey3,000
Monthly transfer of deposits/funds abroad regardless of the purpose5,000
Source: Central Bank of Cyprus / Ministry of Finance Cyprus
Source: Central Bank of Cyprus / Ministry of Finance Cyprus

35. The authorities should relax external restrictions gradually, paying attention to shifts in both depositor confidence and bank liquidity. A gradual approach is needed to manage restrictions in line with the banks’ ability to normalize funding conditions, taking into account the need to maintain depositor confidence, in particular given delays in program implementation. The approach needs to be underpinned by careful analysis of deposit and liquidity trends and be clearly communicated to provide for a transparent and predictable process. In the meantime, the CBC will need to carefully monitor the effectiveness of restrictions through supervisory monitoring and inspections.

36. Strengthening bank liquidity will be critical to the eventual exit from external payment restrictions. BoC’s recent capital increase has helped improve its liquidity position and boost depositor confidence. And the disposal of foreign operations and partial redemption of the Laiki recapitalization bond have allowed a reduction in ELA. Still, it will take significant time to fully normalize BoC’s funding. Efforts to accelerate the resolution of NPLs and to further deleverage operations abroad can help improve the quality of collateral and generate additional cash flow. BoC could also seek market (junior) funding, which can further boost confidence, although it will need to ensure that this funding does not come at an excessive cost. Further Euro-system support to ensure adequate access to liquidity and a normalization of funding remains essential.

37. The authorities agreed with the need to manage remaining restrictions cautiously. Given heightened uncertainty associated with the comprehensive assessment, they extended existing restrictions until after the successful completion of the assessment and transition to the SSM. 9 They agreed that subsequent relaxations need to be gradual and based on data analysis, but stressed the difficulty of assessing and predicting deposit behavior. They remained optimistic that relaxations could be achieved within a reasonable timeframe.

Challenge 4: Ensuring adequate prudential and AML/CFT supervision

38. The authorities have taken steps to address weaknesses in the bank supervision and AML/CFT frameworks. Relaxed supervisory standards before the crisis allowed for excessive credit growth, weak bank governance and risk-management practices, and fragmented standards across banks and coops. Moreover, weaknesses in the implementation of the AML/CFT framework may have contributed to the unsustainable growth of the financial sector. The authorities took steps to address supervisory shortcomings, including by issuing new directives on provisioning, NPL disclosure, and loan origination, putting in place a country-wide credit register, unifying the supervision of banks and coops, and strengthening the resolution authority. They also revised the AML/CFT legal framework to improve compliance with international standards, strengthened the CBC’s AML/CFT supervisory resources, and developed risk-based tools.

39. Efforts must continue to further strengthen bank supervision and the implementation of the AML/CFT framework:

  • Supervision: The two largest Cypriot banks and the coops, representing 80 percent of the sector, will come under the supervision of the SSM in November. Although the transition to the SSM, including the ongoing comprehensive assessment, are putting strains on the CBC’s capacity, the CBC should ensure adequate supervision while the banking sector is in a critical restructuring phase. Future supervisory priorities will need to be coordinated within the SSM, and Cypriot ownership will be key to ensuring an effective oversight of the sector.

  • AML/CFT: The authorities need to build on progress to date to step up implementation of the risk-based framework for AML/CFT supervision for banks and service providers, including by: (i) further enhancing institutional and staff capacity, (ii) improving coordination with prudential bank supervision, (iii) strengthening inspection processes, risk-based tools, and the quality of reports, and (iv) improving enforcement, including by applying appropriate sanctions as needed. The CBC also needs to complete its AML/CFT investigation of FBME branch operating in Cyprus, which was intervened in July following the bank’s designation by the U.S. Treasury as an institution of primary money-laundering concern.

40. The authorities agreed with the need to strengthen prudential and AML/CFT supervision. While they looked forward to enhancing coordination of overall policies and bank-specific supervisory work with European practices, they noted that the practical details of the integration with the SSM still need to be clarified and implemented, which could take time and resources. While they considered that their AML/CFT framework is at least comparable to that of other countries, they agreed with the need to further strengthen its implementation, especially with respect to banks and service providers, as a way to rebuild Cyprus’s reputation as a strong and sustainable financial and business center.

D. Fiscal Policy

41. The policy objective is to unwind the imbalances accumulated before the crisis and put public debt on a firmly downward path. The loose fiscal policies initiated in 2008, unwinding of the property-market boom, and deep recession dealt a severe blow to the fiscal balance, which went from an overall surplus of 1 percent of GDP in 2008 to average annual deficits of 6 percent of GDP during 2009–12. This, together with the 2012 public support to Laiki bank, led to an almost doubling of public debt during this period. The authorities aim to achieve a primary surplus of 4 percent of GDP by 2018—similar to the level reached in 2008—to lower public debt to around 100 percent of GDP by 2020. Primary surpluses will need to be maintained beyond 2020 to bring debt to its pre-crisis level (50–60 percent of GDP). While achieving and sustaining primary surpluses of such magnitude can be challenging, a number of countries have done so successfully.10

Episodes of Large and Sustained Primary Surpluses

Source: ECB June 2011 Monthly Bulletin, Box 8.

42. The challenge is to achieve a credible but balanced fiscal adjustment over time. The authorities aim for a gradual improvement in the primary balance, taking into account short-term cyclical and long-term sustainability concerns. The 7 percent of GDP of measures implemented in 2013–14 are expected to help unwind some of the spending increases undertaken before the crisis (e.g. on public-sector wages and social transfers), and partially compensate for the loss of real-estate revenue following the housing-market bust, while ensuring that the negative fiscal impulse remains manageable.11 However, to attain the primary-surplus target of 4 percent of GDP by 2018, additional measures of about 3.4 percent of GDP will be needed under the current macroeconomic baseline.

Revenue, Primary Spending, and Primary Balance, 2013–2018

(percent of GDP)

Sources: Ministry of Finance and IMF staff estimates.

43. Given the consolidation to date, the primary deficit is projected to decline to about 1 percent of GDP this year. This represents one-third of the 2012 level and is better than expected at the onset of the program by about 3 percent of GDP. While the level of spending has been largely as anticipated, revenues have over-performed due to the better-than-projected macroeconomic outcome, lower-than-expected elasticities, but also some one-off factors. Consequently, the fiscal impulse resulting from the lower deficit is not thought to have negatively affected the economy beyond what was expected at the start of the program. The projected primary deficit is well within the authorities’ program target established during the 4th review (1.6 percent of GDP).

Primary Balances, 2012–2015

(percent of GDP)

Sources: Ministry of Finance and IMF staff projections.

44. In 2015, the primary deficit is projected to remain around at 1 percent of GDP. This represents a modest improvement in the primary balance net of one-offs, given the over-performance in 2013–14 and the weak expected recovery in 2015. To ensure the fiscal neutrality of the new welfare reform, the authorities need to implement permanent measures of 0.3 percent of GDP, which should be focused on improving the targeting and rationalization of other social benefits. Should costs of the welfare reform turn out to be higher than expected, the authorities should be prepared to offset these during 2015 with high-quality measures. However, if macroeconomic outcomes deteriorate beyond expectations, automatic stabilizers should be allowed to operate.

45. Additional adjustment measures are needed over the medium term to ensure fiscal sustainability. The adjustment should start in 2016, be growth-friendly and balanced over time, and focus on reversing the statutory spending increases that took place before the crisis.12 To prevent a rapid rise in public-sector wages following their expected unfreezing after the program period, the wage bill needs to be further rationalized, including by revising current wage levels and pay scales, eliminating automatic increases, reducing employment in overstaffed areas (i.e. education), and rationalizing public-pension lump-sum payments.13 The authorities could also review social benefits increased during 2008–12 and improve the targeting of education subsidies, while increasing tertiary-education fees.

Public Sector Compensation of Employees, Euro Area Countries, end-2013 1/

(Percent of GDP)

Source: Eurostat.

1/ Cyprus compensation of employees is divided by the 2012 GDP given the unusually low 2013 GDP due to the crisis.

46. The authorities had a more favorable view of fiscal prospects. They expected a better fiscal outturn in 2014 and considered that a more modest fiscal effort will be required to attain the 2018 primary-surplus target, given the over-performance to date and a likely stronger economic recovery. While they saw merit in reforming the public wage-setting framework to better link wages with productivity, they did not agree with further reducing wage levels. They saw scope for further rationalization of social benefits, pension gratuities, and education spending, but were reluctant to consider specific measures beyond those required to ensure fiscal neutrality of the welfare reform.

E. Structural Reforms

47. Recently-legislated structural reforms should be followed through and fully implemented. Building on the 2012 reforms of the pension system and the wage-indexation (COLA) framework, the authorities initiated additional reforms aimed at: (i) improving the targeting, coverage, and administration of the welfare system; (ii) unifying the revenue administration and enhancing its collection powers; (iii) enhancing public financial management by allowing for medium-term budget formulation, performance-based budgeting, and fiscal risk management; and (iv) facilitating privatization of state-owned assets. To reap their long-term benefits, reforms need to be followed through by implementing remaining secondary legislation, reorganizing resources and building capacity to meet the new needs, monitoring reform outcomes, and adjusting reform parameters as needed. Additional medium-term reforms—such as to healthcare and public administration—need to be appropriately sequenced to avoid capacity overload and to ensure that fiscal risks are minimized.

48. Making the new welfare system operational is critical to ensuring that vulnerable groups are protected during the downturn. The recently-legislated reform, unifying previously fragmented public-assistance benefits under a single guaranteed minimum income (GMI), brings Cyprus’s welfare system in line with best practice in Europe and is expected to improve both the coverage and adequacy of public assistance, reducing relative and extreme poverty by 17 and 70 percent, respectively.14 Following the adoption of the new law in mid-2014, the authorities need to ensure adequate capacity to cope with the expansion in coverage (by about 20 percent) and to carefully monitor the implementation of the new system. To better identify and prevent abuse, they are building a national benefit registry, cross-checked with other databases, to review beneficiaries’ profiles and eligibility. This could help achieve a more equitable system and generate cost savings.

Minimum Income (MI) Schemes - coverage and adequacy

Sources: Figari et al (2013) using EUROMOD

49. Careful execution of the revenue administration reform is needed to support the fiscal consolidation effort. The reform aims to increase the effectiveness of tax collections by integrating the two tax departments (VAT and direct taxes) under a unified function-based structure. With the new legal structure in place, the authorities should focus on timely implementation of reform steps, —including setting up a large taxpayers’ office and developing a new tax procedure code—with a view to achieving full integration of the tax departments over the medium-term. They will need to manage the transition carefully, to ensure that revenue collections are being protected during the transition period, including by making use of new collection-enforcement powers and continuing with joint audits of large and high-risk taxpayers.

Revenue Administration Reform Plan

50. The authorities should manage fiscal risks prudently and fully implement their new public financial management framework. Given fiscal risks related to government guarantees (amounting to 20 percent of GDP), the authorities need to monitor them and put in place a government-guarantee management framework. To address these and other risks related to the debt structure—including sizeable redemptions concentrated immediately after the program period (40 percent of GDP during 2017–20) and a dysfunctional domestic debt market—a medium-term debt-management strategy is needed to provide strategic focus and address operational weaknesses to allow for an eventual exit from official assistance and a full return to markets. Finally, to implement the new fiscal responsibility and budget systems law (FRBSL), the authorities should press ahead with secondary legislation and guidelines and strengthen budget processes.

Government Guarantees

(Billions of euros)

Source: Ministry of Finance

51. Looking forward, a growth strategy could help boost Cyprus’s competitiveness and economic potential. Cyprus ranks relatively favorably on structural indicators compared to other countries: it ranked 58th (out of 148) in the World Bank’s 2013–14 global-competitiveness index and 22nd (out of 153) in the 2013 Freedom of the World report. Still, there is room for improvement, and the authorities are developing a strategy to address bottlenecks to growth. The strategy should focus on areas where Cyprus lags relative to best practice and where the impact on growth is the largest, including: (i) opening up of closed professions by streamlining licensing restrictions; (ii) removing barriers to competition, including protection of firms and price controls; (iii) reducing red tape; (v) privatizing state-owned enterprises; (vi) strengthening the legal system; and (vi) fostering innovation. Indeed, structural reforms in these areas are estimated to have a significant impact on growth (which could provide an upside to medium-term growth of up to 1.5–3 percentage points). 15

Sources: IMF staff estimates based on data from OECD, World Bank Doing Business, Economic Freedom of the World, and World Economc Freedom databases.

1/ Relative distance is defined as the difference between Cyprus’ index and that of the top 5 in the world, divided by Cyprus’s index.

52. The authorities agreed with the identified structural reform needs and priorities. They concurred that careful implementation of the GMI is essential to build credibility for the new reform and were confident that the system will generate cost savings through enhanced scrutiny of eligibility. They acknowledged the heightened risks during the transition to the integrated revenue administration, but also stressed risks related to the immediate and full implementation of the new powers to collect tax debt. They also noted that capacity constraints may pose challenges to their strategy to collect tax debt and monitor government guarantees. They agreed with the need to develop a long-term growth strategy.

Staff Appraisal

53. The Cypriot economy was buffeted by an unprecedented shock in 2013. This exposed large vulnerabilities and imbalances, which culminated in one of the largest banking sector collapses on record. In response, the authorities took exceptional measures, including the resolution of the two largest banks, both of them economically insolvent; recapitalization of the resulting institution through the bail in of creditors, including uninsured depositors; and the imposition of sweeping payment restrictions.

54. The authorities have come a long way in addressing the crisis. In the context of an ambitious adjustment program supported by international financial assistance, they completed the recapitalization of the banking sector consistent with fiscal sustainability, downsized and restructured financial institutions, and liberalized domestic payment flows. These achievements, complemented by ambitious fiscal consolidation and structural reforms, helped Cyprus re-access international markets earlier this year.

55. But overcoming the legacy of the crisis will be challenging. The crisis has imposed a large cost on the economy and on the population. A painful but unavoidable recession is underway, and unemployment remains very high. Both the private and public sectors remain heavily indebted. And the banking sector remains vulnerable, given high and rising NPLs, tight liquidity and capital buffers, and the need to maintain external payment restrictions to protect financial stability.

56. The authorities need to overcome recent delays in the implementation of their adjustment program. Heightened political opposition, entrenched vested interests, and reform fatigue are taking a toll on the program, which has been delayed after eighteen months of strong implementation. The authorities need to redouble their efforts to put the program back on track to achieve a durable economic recovery and an eventual exit from official financing.

57. Addressing high NPLs is essential for the financial sector’s viability and the economy’s recovery. To encourage loan restructuring and restore the payment culture, the authorities need to implement without delay legislation to streamline foreclosures. This should be complemented by a comprehensive reform of the legal framework for insolvency. They should also strengthen supervisory incentives for banks to proactively restructure NPLs and attain sustainable solutions.

58. Adequate capital buffers and further bank restructuring are key to reviving lending. The recent recapitalization of Bank of Cyprus is an encouraging sign of the return of confidence in the financial sector. The authorities should stand ready to further strengthen capital buffers consistent with the pan-European comprehensive assessment, and ensure that banks and the coop sector continue with restructuring, including by strengthening processes and governance.

59. External payment restrictions should be managed prudently to safeguard financial stability. Relaxing these restrictions should be predicated on a normalization of bank funding. The approach should be gradual and underpinned by a transparent milestone-based roadmap. Staff supports the request to extend existing exchange restrictions under the IMF’s Article VIII. Adequate support by the Euro-system to normalize bank funding and liquidity is essential.

60. Effective prudential and AML/CFT supervision is needed to prevent vulnerabilities from re-emerging. The authorities should maintain tight supervisory oversight of the banking sector as they restructure. At the same time, they need to coordinate closely with the SSM to ensure a smooth transition to the new pan-European supervisory framework. Implementation of the AML/CFT framework should continue to be strengthened.

61. Additional medium-term fiscal consolidation will be needed to ensure debt sustainability. The authorities implemented an ambitious fiscal adjustment which, together with prudent budget execution, helped to reduce the deficit. But with public debt high and rising, an additional medium-term fiscal effort is required to put debt on a sustained downward path. The consolidation should be carefully paced, rely on permanent measures, and be focused on unwinding the spending increases preceding the crisis.

62. With important structural reforms initiated, the focus needs to be on implementation. The authorities recently legislated key reforms to the welfare system, public financial management, and revenue administration. They should ensure that reform implementation continues and manage the transition period prudently. Privatization efforts should be stepped up. Growth-enhancing structural reforms could help increase the economy’s long-term potential.

63. The next Article IV Consultation is expected to be held on a 24-month cycle in accordance with the Decision on Article IV Consultation Cycles (Decision No. 14747-(10/96) (9/28/2010)).

Table 1.Cyprus: Selected Economic Indicators, 2008–20
2008200920102011201220132014201520162017201820192020
Projections
Real Economy(Percent change, unless otherwise indicated)
Real GDP3.6−1.91.30.4−2.4−5.4−3.20.41.62.02.22.11.8
Domestic demand8.0−7.01.9−1.5−3.8−10.1−4.3−0.40.91.71.92.01.7
Consumption7.4−4.61.41.0−2.4−5.6−2.9−0.60.51.31.51.61.2
Private consumption7.8−7.51.51.3−2.0−5.7−2.4−0.11.51.71.91.81.4
Public consumption6.16.81.0−0.3−3.8−5.0−4.7−2.1−3.2−0.6−0.30.50.6
Fixed investment6.0−9.7−4.9−8.7−18.3−21.6−13.41.33.94.64.94.94.8
Inventory accumulation 1/0.9−1.51.8−0.71.3−2.40.00.00.00.00.00.00.0
Foreign balance 1/−5.16.0−0.72.01.65.01.00.80.70.40.30.20.2
Exports of goods and services−0.5−10.73.84.4−2.5−4.20.41.52.83.13.33.02.9
Imports of goods and services8.5−18.64.8−0.2−5.4−14.1−1.8−0.11.52.52.82.82.7
Potential GDP growth2.41.71.61.7−1.5−5.4−3.1−0.20.51.01.61.91.8
Output gap (percent of potential GDP)2.8−0.8−1.2−2.4−3.3−3.3−3.4−2.8−1.8−0.9−0.3−0.10.0
HICP (period average)4.40.22.63.53.10.40.00.71.31.51.71.91.9
HICP (end of period)1.81.61.94.21.5−1.30.00.71.31.51.71.91.9
Unemployment rate EU stand. (percent)3.65.46.37.911.915.916.616.115.013.712.511.310.3
Employment growth (percent)1.70.01.4−1.5−3.3−5.2−2.80.21.41.61.71.61.5
Public Finance(Percent of GDP)
General government balance0.9−6.1−5.3−6.3−6.4−4.9−4.4−3.9−1.3−0.80.60.2−0.1
Revenue43.140.140.939.939.441.542.341.842.141.541.741.941.9
Expenditure42.146.246.246.345.846.446.745.743.342.341.141.742.0
Primary Fiscal Balance3.8−3.6−3.0−4.0−3.2−1.9−1.0−1.01.72.54.04.04.0
General government debt48.958.561.371.586.6111.5117.4126.0122.5116.4111.1106.5102.6
Balance of Payments(Percent of GDP)
Current account balance−15.6−10.7−9.8−3.4−6.9−1.9−1.1−0.8−0.3−0.1−0.2−0.2−0.2
Trade Balance (goods and services)−11.4−5.5−6.2−4.3−3.11.92.63.23.84.14.34.24.2
Exports of goods and services45.040.241.342.942.943.945.546.346.947.347.647.948.2
Imports of goods and services56.445.747.547.246.042.042.843.143.043.243.443.644.0
Goods balance−32.4−25.5−26.8−24.3−21.8−17.8−16.7−16.4−16.2−16.2−16.3−16.4−16.5
Services balance21.019.920.620.118.719.719.319.720.120.320.520.620.7
Income, net−3.9−4.1−2.22.0−2.6−2.7−2.7−3.1−3.2−3.3−3.5−3.5−3.5
Transfer, net−0.4−1.1−0.7−1.1−1.2−1.0−1.0−1.0−1.0−1.0−1.0−1.0−1.0
Capital account, net0.00.30.20.30.11.50.20.20.20.20.20.10.1
Financial account, net16.110.99.54.44.8−26.3−11.4−16.8−2.20.00.40.70.9
Direct investment−5.213.20.40.76.81.00.54.44.73.13.04.04.0
Portfolio investment−74.2−101.1−11.132.230.171.115.6−5.2−1.6−2.21.610.03.0
Other investment93.898.219.0−28.8−32.4−98.6−27.4−16.0−5.3−1.0−4.3−13.3−6.0
Reserves (− inflow; + outflow)1.70.61.10.20.30.20.00.00.00.00.00.00.0
Program financing0.00.00.00.00.029.312.317.52.30.0−0.3−0.6−0.8
European Union0.00.00.00.00.027.810.215.41.80.00.00.00.0
IMF0.00.00.00.00.01.52.12.10.50.0−0.3−0.6−0.8
Errors and omissions−0.5−0.50.2−1.32.0−2.70.00.00.00.00.00.00.0
Savings-Investment Balance
National saving7.78.610.013.28.38.68.69.110.010.811.311.812.4
Government4.9−0.6−0.1−1.8−2.6−1.9−0.7−0.31.92.33.73.33.0
Non-government2.89.210.015.010.910.59.39.48.28.57.68.59.3
Gross capital formation23.319.419.816.615.210.59.79.910.410.911.512.012.6
Government5.05.15.05.05.36.15.15.14.54.23.94.24.4
Private18.314.314.811.69.94.44.64.85.96.77.67.88.3
Foreign saving−15.6−10.7−9.8−3.4−6.9−1.9−1.1−0.8−0.3−0.1−0.2−0.2−0.2
Memorandum Item:
Nominal GDP (billions of euros)17.216.917.417.917.716.515.815.916.417.117.818.519.2
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, 2008–20 1/

(Percent of GDP)

2008200920102011201220132014201520162017201820192020
Projections
Revenue43.140.140.939.939.441.542.341.842.141.541.741.941.9
Current revenue43.040.040.839.939.341.542.341.842.141.541.741.941.9
Tax revenue30.626.426.526.425.926.226.926.827.127.027.227.227.3
Indirect taxes17.715.215.414.614.914.515.415.515.615.715.815.815.8
Direct taxes12.911.211.111.711.111.611.511.311.411.311.411.411.5
Other taxes (capital taxes)0.00.00.00.00.00.00.00.00.00.00.00.00.0
Social security contributions7.88.78.98.88.59.09.49.49.49.59.59.69.6
Other current revenue4.64.95.44.84.86.36.15.55.65.05.15.15.0
Sales2.92.42.62.42.72.72.62.82.92.92.92.92.9
Other1.82.52.82.32.23.63.42.72.72.12.22.22.1
Capital revenue0.00.10.10.10.00.00.00.00.00.00.00.00.0
Expenditure42.146.246.246.345.846.446.745.743.342.341.141.742.0
Current expenditure38.240.740.941.742.043.443.042.140.239.238.038.638.8
Wages and salaries14.616.215.816.115.915.615.014.714.214.013.913.613.4
Goods and services5.05.45.65.34.94.74.74.74.54.24.04.04.0
Social Transfers12.213.514.414.714.715.717.016.815.915.314.714.714.8
Subsidies0.40.20.40.50.50.60.60.60.60.50.50.50.5
Interest payments 2/2.82.62.22.43.23.03.42.93.03.33.43.84.1
Other current expenditure3.12.92.52.82.73.82.32.32.11.81.61.92.1
Capital expenditure 3/4.05.55.24.53.82.93.73.63.13.13.13.13.1
Overall balance 4/0.9−6.1−5.3−6.3−6.4−4.9−4.4−3.9−1.3−0.80.60.2−0.1
Statistical discrepancy0.00.00.00.00.00.00.00.00.00.00.00.00.0
Financing0.9−6.1−5.3−6.3−6.4−4.9−4.4−3.9−1.3−0.80.60.2−0.1
Net financial transactions0.9−6.1−5.3−6.3−6.4−4.9−4.4−3.9−1.3−0.80.60.2−0.1
Net acquisition of financial assets−4.42.7−0.65.38.713.6−3.95.8−1.2−2.30.00.00.0
Currency and deposits−4.51.9−1.34.7−3.64.10.00.00.00.00.00.00.0
Securities other than shares 5/0.00.00.00.00.09.1−9.50.00.00.00.00.00.0
Loans0.20.60.71.11.70.00.00.00.00.00.00.00.0
Shares and other equity−0.30.00.00.010.50.411.95.8−1.2−2.30.00.00.0
Other assets0.20.30.0−0.40.00.1−6.30.00.00.00.00.00.0
Net incurrence of liabilities−5.38.84.711.715.118.50.49.70.0−1.6−0.6−0.20.1
Currency and deposits0.00.00.00.00.00.00.00.00.00.00.00.00.0
Securities other than shares−8.39.24.87.61.8−10.3−5.7−6.71.61.40.31.01.5
Loans3.0−0.30.04.012.728.86.116.5−1.6−3.0−0.9−1.2−1.4
Other liabilities0.10.00.00.00.60.00.00.00.00.00.00.00.0
Memorandum items:
Primary balance 6/3.8−3.6−3.0−4.0−3.2−1.9−1.0−1.01.72.54.04.04.0
Public debt48.958.561.371.586.6111.5117.4126.0122.5116.4111.1106.5102.6
Sources: Eurostat; and IMF staff estimates.

Historical fiscal statistics until 2012 are based on Eurostat and are thus reported on an accrual basis. For 2013 and projections, and to be consistent with the cash basis of the program, the fiscal statistics are reported on a cash basis.

In 2014 and from 2017 onwards, part of the interest bill previously capitalized is projected to be paid annually.

Capital expenditure in 2014, 2015, and 2016 include payments for already called guarantees and those that are expected to be called in the corresponding years which are recorded as capital transfers under ESA.

Projections for 2015-18 include unspecified additional fiscal measures as agreed under the program. In 2015, unspecified measures are all included in social transfers. For 2016-2018, 70 percent are assumed on the spending side and the rest on the revenue side.

The composition of net acquisition of financial assets was corrected in 2013 by increasing securities other than shares and reducing shares and other equity to reflect the holdings of ESM bonds rather than the purchase of equity in the coops which occured in 2014. The operation is correspondingly reversed in 2014 reflecting the purchase of equity in the coops with the ESM bonds.

Primary fiscal balances in 2015 and 2016 include expected dividends of €0.2 billion, to be distributed by the CBC in line with CBC’s duties under the Treaties and the Statute.

Sources: Eurostat; and IMF staff estimates.

Historical fiscal statistics until 2012 are based on Eurostat and are thus reported on an accrual basis. For 2013 and projections, and to be consistent with the cash basis of the program, the fiscal statistics are reported on a cash basis.

In 2014 and from 2017 onwards, part of the interest bill previously capitalized is projected to be paid annually.

Capital expenditure in 2014, 2015, and 2016 include payments for already called guarantees and those that are expected to be called in the corresponding years which are recorded as capital transfers under ESA.

Projections for 2015-18 include unspecified additional fiscal measures as agreed under the program. In 2015, unspecified measures are all included in social transfers. For 2016-2018, 70 percent are assumed on the spending side and the rest on the revenue side.

The composition of net acquisition of financial assets was corrected in 2013 by increasing securities other than shares and reducing shares and other equity to reflect the holdings of ESM bonds rather than the purchase of equity in the coops which occured in 2014. The operation is correspondingly reversed in 2014 reflecting the purchase of equity in the coops with the ESM bonds.

Primary fiscal balances in 2015 and 2016 include expected dividends of €0.2 billion, to be distributed by the CBC in line with CBC’s duties under the Treaties and the Statute.

Table 3.Cyprus: Balance of Payments, 2008–20 1/
2008200920102011201220132014201520162017201820192020
Projections
(Millions of Euros)
Current account balance−2,679−1,808−1,711−602−1,217−310−169−134−54−20−35−45−48
Trade balance (Goods and Services)−1,954−929−1,084−763−546313418512632701757784815
Goods balance−5,556−4,291−4,665−4,349−3,856−2,941−2,628−2,620−2,666−2,768−2,893−3,032−3,173
Exports1,1901,0021,1371,4111,4401,5011,5821,6601,7461,8291,9202,0092,101
Imports−6,746−5,293−5,802−5,760−5,296−4,442−4,211−4,280−4,412−4,597−4,813−5,041−5,274
Services Balance3,6023,3623,5813,5853,3103,2533,0463,1323,2983,4693,6503,8163,988
Exports6,5385,7796,0496,2626,1675,7505,5865,7145,9596,2436,5536,8567,169
Imports−2,936−2,417−2,468−2,676−2,857−2,497−2,540−2,582−2,661−2,773−2,903−3,041−3,181
Current income, net−662−685−379357−456−452−432−493−525−559−614−645−664
Current transfers, net−63−193−116−196−215−171−155−152−161−163−178−184−199
Private23−107−56−101−155−127−180−176−179−181−188−196−203
Public−86−86−60−94−60−442624181810125
Capital account, net65036462324427272727272727
Financial account, net2,7651,8351,647781847−4,333−1,791−2,676−356−164130181
Direct investment−8902,224651321,19716979699779537534741769
Portfolio investment−12,722−17,039−1,9345,7535,34011,7342,453−831−270−3712911,845574
Other investment16,08516,5583,313−5,146−5,748−16,266−4,323−2,545−865−166−761−2,455−1,162
Reserves (− inflow; + outflow)291932004357300000000
Program financing04,8381,9332,783383−7−56−112−161
European Union04,5851,6002,4503000000
IMF025333333383−7−56−112−161
Errors and omissions−92−7831−225346−4390000000
(Percent of GDP)
Current account balance−15.6−10.7−9.8−3.4−6.9−1.9−1.1−0.8−0.3−0.1−0.2−0.2−0.2
Trade balance (goods and services)−11.4−5.5−6.2−4.3−3.11.92.63.23.84.14.34.24.2
Goods balance−32.4−25.5−26.8−24.3−21.8−17.8−16.7−16.4−16.2−16.2−16.3−16.4−16.5
Exports6.95.96.57.98.19.110.010.410.610.710.810.810.9
Imports−39.3−31.4−33.3−32.2−29.9−26.9−26.7−26.9−26.8−26.9−27.1−27.2−27.4
Services balance21.019.920.620.118.719.719.319.720.120.320.520.620.7
Exports38.134.334.835.034.834.835.535.936.336.636.837.037.3
Imports−17.1−14.3−14.2−15.0−16.1−15.1−16.1−16.2−16.2−16.2−16.3−16.4−16.5
Current income, net−3.9−4.1−2.22.0−2.6−2.7−2.7−3.1−3.2−3.3−3.5−3.5−3.5
Current transfers, net−0.4−1.1−0.7−1.1−1.2−1.0−1.0−1.0−1.0−1.0−1.0−1.0−1.0
Private0.1−0.6−0.3−0.6−0.9−0.8−1.1−1.1−1.1−1.1−1.1−1.1−1.1
Public−0.5−0.5−0.3−0.5−0.3−0.30.20.10.10.10.10.10.0
Capital account, net0.00.30.20.30.11.50.20.20.20.20.20.10.1
Financial account, net16.110.99.54.44.8−26.3−11.4−16.8−2.20.00.40.70.9
Direct investment−5.213.20.40.76.81.00.54.44.73.13.04.04.0
Portfolio investment 2/−74.2−101.1−11.132.230.171.115.6−5.2−1.6−2.21.610.03.0
Other investment 2/93.898.219.0−28.8−32.4−98.6−27.4−16.0−5.3−1.0−4.3−13.3−6.0
Reserves (− inflow; + outflow)1.70.61.10.20.30.20.00.00.00.00.00.00.0
Program financing0.029.312.317.52.30.0−0.3−0.6−0.8
European Union0.027.810.215.41.80.00.00.00.0
IMF0.00.00.00.01.52.12.10.50.0−0.3−0.6−0.8
Errors and omissions−0.5−0.50.2−1.32.0−2.70.00.00.00.00.00.00.0
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 transactions 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 transactions between Greek banks and their subsidiaries in Cyprus.

Table 4.Cyprus: Monetary Survey, 2008–20

(Billions of euros, unless otherwise indicated, end of period)

2008200920102011201220132014201520162017201820192020
Projections
Aggregated Balance Sheet of Monetary Financial Institutions (MFIs)
Assets118.1139.4135.0131.4128.190.391.089.688.987.988.689.791.0
Claims on Central Bank of Cyprus1.33.12.32.93.92.72.62.62.62.62.72.72.8
Claims on Cypriot resident other MFIs3.35.45.65.04.63.34.44.54.64.85.05.25.4
Claims on Cypriot resident non MFIs47.250.354.058.260.655.052.952.351.349.649.349.449.7
General government3.74.64.55.36.55.44.95.45.44.14.14.14.1
Private sector excluding brass plates 1/39.442.746.548.649.346.545.143.943.042.542.242.342.6
Households19.120.622.523.523.922.321.821.421.020.620.420.420.5
Non-financial corporations19.721.523.324.124.423.422.621.821.321.121.021.121.3
Non-bank financial intermediaries0.60.60.71.01.00.80.80.80.70.70.70.70.7
Brass plates 2/4.13.03.04.44.83.12.92.93.03.03.03.03.0
Claims on non-residents63.476.969.361.355.925.326.125.926.226.827.528.228.9
Other assets2.93.83.83.93.23.95.04.44.24.24.24.24.2
Liabilities118.1139.4135.0131.6128.190.391.089.688.987.988.689.791.0
Liabilities to the Central Bank of Cyprus and Eurosystem4.77.65.55.59.811.28.27.87.05.04.54.24.0
Liabilities to Cypriot resident other MFI3.35.35.54.94.53.13.53.53.73.84.04.14.3
Deposits of Cypriot resident non MFIs39.541.045.443.743.333.031.531.131.131.632.333.234.1
General government0.30.40.50.50.50.40.40.40.40.40.40.40.4
Private sector excluding brass plates33.434.536.837.437.529.928.628.228.228.729.430.331.2
Households23.424.625.426.026.423.322.322.022.022.422.923.624.3
Non-financial corporations6.36.16.76.75.73.93.73.73.73.83.94.04.1
Non-bank financial intermediaries3.63.94.74.65.42.72.62.62.62.62.72.82.9
Brass plates5.76.18.15.85.32.62.52.52.52.52.52.52.5
Deposits of non-residents51.766.660.656.551.324.522.622.022.022.322.723.023.3
Debt securities5.64.82.42.61.70.50.50.50.50.50.50.50.5
Capital and reserves10.010.812.811.315.116.423.023.023.023.023.023.023.0
Other liabilities3.43.32.87.12.41.61.81.81.81.81.81.81.8
Money and Credit
General government sector credit, net4.55.35.25.37.25.54.45.05.03.73.73.73.7
Private sector credit excluding brass plates39.542.746.548.649.346.545.143.943.042.542.242.342.6
Brass plates credit4.13.03.04.44.83.12.92.93.03.03.03.03.0
Cypriot resident broad money (M2)40.642.246.645.044.634.532.932.632.733.234.034.935.9
Cypriot resident narrow money (M1)9.110.410.611.111.510.410.210.210.510.911.311.712.1
(Percent of GDP)
General government sector credit, net26.431.630.129.440.433.528.231.230.321.820.719.919.1
Private sector credit excluding brass plates230.0253.6267.2272.1278.1281.9286.4275.8261.5248.7237.1228.2221.3
Brass plates credit23.917.517.424.327.018.618.618.518.017.416.816.315.8
Cypriot resident broad money (M2)236.7250.2267.4251.7251.9208.9208.8204.7198.8194.6191.0188.7186.5
Cypriot resident narrow money (M1)53.061.861.262.264.863.064.963.963.663.763.363.162.8
(Annual percentage change)
General government sector credit, net17.4−1.60.436.2−22.9−19.511.80.3−25.5−0.8−0.30.1
Private sector credit excluding brass plates8.38.84.61.3−5.6−3.0−2.6−2.2−1.2−0.70.20.7
Brass plates credit−28.12.344.09.9−35.7−4.50.20.50.60.70.70.6
Cypriot resident broad money (M2)3.910.4−3.4−0.8−22.8−4.6−0.80.11.72.32.92.7
Cypriot resident narrow money (M1)14.52.34.43.2−9.4−1.7−0.32.64.13.53.73.5
Memorandum items:
Deposits from Cypriot private sector excluding brass plates (y-o-y percent change)3.46.51.70.3−20.2−4.5−1.3−0.11.72.43.12.9
Brass plates deposits (y-o-y percent change)6.233.8−28.3−9.4−50.4−4.50.10.30.30.30.30.3
Sources: European Central Bank; Central Bank of Cyprus; and IMF staff estimates.

Includes public entities classified outside the general government. The data excludes brass plates, which are companies with a physical presence in Cyprus and, therefore, treated as residents but with limited interaction with the domestic economy.

Data on brass plates only became available from July 2008 onwards.

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

Includes public entities classified outside the general government. The data excludes brass plates, which are companies with a physical presence in Cyprus and, therefore, treated as residents but with limited interaction with the domestic economy.

Data on brass plates only became available from July 2008 onwards.

Table 5.Cyprus: Financial Soundness Indicators, 2010–14 1/

(Percent, unless otherwise specified)

20102011201220132014
Capital Adequacy
Total risk asset ratio11.97.26.111.711.8
Tier I risk asset ratio10.56.05.311.311.5
Core Tier I risk asset ratio8.13.23.410.611.1
Risk weighted assets (billions of euro)69.267.862.436.937.8
Asset Quality
Non-performing loans to total gross loans 2/12.416.225.546.251.1
Provisions to nonperforming loans61.249.447.931.034.4
Earnings and Profitability
Return on assets0.4−4.4−4.8−1.70.2
Return on equity7.5−75.0−113.1−24.92.9
Cost to income ratio53.748.958.834.4
Net interest margin1.92.42.42.93.5
Liquidity
Liquid assets to total assets10.09.48.66.87.6
Customer deposits to total (non-interbank) loans113.8101.196.873.974.4
Market Indicators (end period)
Cyprus Stock Exchange (CSE) General Index (Mar 2004=1000)1055.2295.9114.9103.3118.4
Market capitalization (CSE) (percent of GDP)29.224.49.98.710.8
Sources: CBC; and IMF staff calculations.

These FSIs cover consolidated accounts of domestic and foreign banks operating in Cyprus. For 2014 data are as of March.

NPLs are defined as loans in arrears for more than 90 days and restructured loans which at the time of restructuring presented arrears for a period of more than 60 days, regardless of tangible or other collateral.

Sources: CBC; and IMF staff calculations.

These FSIs cover consolidated accounts of domestic and foreign banks operating in Cyprus. For 2014 data are as of March.

NPLs are defined as loans in arrears for more than 90 days and restructured loans which at the time of restructuring presented arrears for a period of more than 60 days, regardless of tangible or other collateral.

Annex 1. Cyprus: Risk Assessment Matrix1
RiskRelative Likelihood andExpected Impact of RiskPolicy Response
HighHigh
1. Protracted period of slower growth in advanced economiesLower-than-anticipated potential growth and persistently low inflation due to a failure to fully address legacies of the financial crisis, leading to secular stagnation.Significant trade linkages with the EU would weaken growth in Cyprus through lower exports and tourism and adverse confidence effects. Stagnation and low inflation could complicate public debt sustainability and private sector deleveraging and negatively impact banks’ balance sheetsAdditional fiscal adjustment needed to attain medium-term primary fiscal surplus targets and ensure debt sustainability needs to be carefully balance to avoid a large and negative impulse in the short run.
MediumHigh
2. Regional geopolitical risks from increasing tensions surrounding Russia/Ukraine and the Middle EastA sharp increase in geopolitical tensions surrounding Russia/Ukraine that creates significant disruptions in global financial, trade and commodity markets.

A sharp rise in oil prices, with negative spillovers to the global economy due to tensions in the Middle East.
An escalation of sanctions could reduce growth in Cyprus given strong real and financial links with Russia. High oil prices would spillover into reduced growth in Cyprus and increased external financing needs for energy-related imports.Fiscal automatic stabilizers should be allowed to operate in the short run. Efforts to advance structural reforms to promote growth should be intensified.
HighHigh
3. Sovereign stress re-emerges due to prolonged delay in program implementation and unanticipated outcomes from the comprehensive bank assessmentBank-sovereign-real economy links could re-intensify because of stalled or incomplete delivery of policy commitments at the national or euro-area level.Financial sector stability, growth prospects, and debt sustainability would be severely affected. Pressure on banks in the euro area could extend to Cypriot banks and reignite deposit outflows.

Cyprus’s recently restored access to the capital markets could be lost again.
Efforts need to be intensified to put the program back on track. Banks should build capital buffers. The banking union should be strengthened and completed.
HighHigh
4. Financial sector stress could reemerge due to insufficient progress in addressing NPLs or to a too rapid relaxation of external payment restrictionsA sovereign-bank negative feedback loop could be reignited due to concerns about bank viability given high NPLs. A rapid relaxation of external payment restrictions could exhaust liquidity buffers.Deposit outflows could re-intensify. Financial sector stability could be affected, with strong repercussions on economic activity and debt sustainability.The strategy supported by the EFF would need to be adjusted.

Additional financing measures may be required.
MediumHigh
5. Weak recovery of domestic demand and inability to reduce public and private sector debtDebt overhang could imply low private consumption and investment for an extended period.Lower growth and increased opposition to further austerity would prolong Cyprus’s high debt problem and would hurt balance sheets.Intensify efforts to reduce NPLs and promote private sector debt-restructuring. Implement medium-term fiscal consolidation
Annex 2. Public Sector Debt Sustainability Analysis

This annex presents an analysis of Cyprus’s public debt sustainability. The overall assessment is that full implementation of the program can maintain Cyprus’s debt on a sustainable trajectory. However, high debt levels, downside risks to growth, and large contingent and implicit liabilities make the debt trajectory vulnerable to shocks. In particular, a growth shock, combined with higher interest rates and a worse primary balance, or a deeper recession combined with a materialization of contingent liabilities could push debt to very high levels. Under such scenarios, additional financing measures and commitments from European partners would be needed to protect debt sustainability.

Cyprus’s public debt is projected to peak at 126 percent of GDP in 2015 before gradually declining toward 100 percent of GDP by 2020. The rise in debt in 2014–15 (from 111 percent of GDP in 2013) reflects the prevalence of primary fiscal deficits combined with a continued recession in 2014 and only a slight recovery in 2015. In 2014, these effects are offset by the expected conclusion of a €1 billion (6 percent of GDP) swap of debt held by the CBC for government-owned land. The medium term decline is predicated on the assumption of continued fiscal consolidation as envisaged under the program and a gradual pick-up of economic activity. With respect to the fourth review projections, the baseline debt projections were revised up for 2014 and down for 2015 to reflect a re-phasing of ESM disbursements. The path from 2016 onwards has been slightly revised up, as the downward revision of nominal GDP more than offsets the interest savings resulting from the partial repayment of the Laiki recapitalization bond with the proceeds from the new bond issuance.

Debt projections are highly vulnerable to shocks (Figure A1.1). The baseline debt level is high and exceeds the benchmark above which the risk of debt distress is assessed to increase (85 percent of GDP). Under most adverse and combined shocks—including to growth, inflation, and the primary balance—debt could reach between 130 and 160 percent of GDP by 2020.1 Moreover, several indicators such as spreads and external financing needs continue to point to a high-risk classification for Cyprus. The recent debt management operation has helped smooth the debt maturity profile immediately following the program period and lowered risks associated with shocks to the primary balance, real interest rate, and real exchange rate. Gross financing needs risk indicators remain vulnerable to growth and contingent liability shocks.

While forecasting performance has been mixed—given the materialization of unforeseen tail risks—the current macroeconomic baseline remains conservative relative to macroeconomic outturns to date (Figure A1.2). Growth, deflator, and primary balance projection errors appear optimistic relative to other program countries, especially as 2012 and 2013 growth deviations were significantly outside the inter-quartile range. However, these reflected the effects of the power plant accident in 2011 and the materialization of tail risk of an unprecedented banking sector crisis in 2013—exacerbated by the Greek PSI—which could not have been foreseen in the years preceding the events. Since the onset of the program, growth and fiscal projections have been consistently more conservative than the outturns. For example, growth in 2013 was 3.3 percentage points better than projected at the time of the program request (-5.4 compared to -8.7 percent), and the 2013 primary balance was 0.5 percentage points better than projected (-1.9 compared to -2.4 percent of GDP). Medium-term projections—which were revised down during the fourth review—remain conservative relative to other countries that suffered from banking crises and subsequent credit-less recoveries.2 Nevertheless, as noted in the text, downside medium-term risks remain.

Standard indicators suggest that the projected fiscal adjustment is ambitious, although Cyprus’s strong fiscal track record thus far provides some comfort (Figure A1.2 continued). The level of cyclically-adjusted primary balance is considered borderline realistic, and the three-year adjustment is seen as ambitious. However, such large primary balance adjustments are not without precedent. Moreover, the authorities’ disciplined implementation of adjustment measures in 2013–14 and additional discretionary tightening led to consistent over-performance of program targets. Finally, these indicators should be interpreted with caution, given the unusually high uncertainty surrounding the estimation of the output gap and cyclically-adjusted fiscal balances in the current recession.

Debt structure indicators point to vulnerabilities, but there are mitigating factors. The large external gross financing needs reflect mainly the need to repay maturing short-term debt and the large amount of uninsured foreign deposits. External payment restrictions mitigate the risks of abrupt outflows. The relatively low and fixed interest rate of official liabilities combined with their long term maturity mitigates interest rate and financing risks. Finally, while bond yields and spreads remain higher than in other countries, they have significantly declined since last year. Specifically, five-year bond yields are at around 5 percent in the secondary markets, compared to yields above 10 percent in 2013.

Public sector debt remains vulnerable to adverse macro-fiscal shocks (Figure A1.5, top, and Figure A1.5 continued). The main risks analyzed include:

  • Growth risk. Assuming a decline in growth by two historical standard deviations (i.e. about 7 percentage points) for 2015 and 2016, a corresponding deterioration in non-interest revenue of 0.4 percent per percentage point of growth reduction, recovering to baseline levels in two years thereafter, and a decline of 0.25 percentage points per point of growth of the deflator, the debt ratio would increase to 167 percent of GDP by 2016 and 152 percent by 2020.

  • Primary balance risk. A shock reducing the planned fiscal adjustment in 2015–18 by 50 percent, capturing the risk of reform fatigue, would increase the debt ratio to 126 percent of GDP in 2016 and to 111 percent of GDP by 2020.

  • Interest rate risk. While the growing share of official financing in the coming years considerably reduces interest rate risks, ESM financing and new market financing after the program are still a function of market conditions. A shock increasing the real interest rate by 3 percentage points each year during 2015–20 would lead debt to reach 124 percent of GDP in 2016 and 110 percent of GDP in 2020.

  • Combination of macro-fiscal risks. A combination of the growth, interest rate, and primary balance shocks above would lead to a debt ratio of 167 percent of GDP in 2016 and 157 percent of GDP in 2020.

  • Deflation (Figure A1.5, continued): Deflator growth could be lower than envisaged in the baseline if downward wage pressures pass through to prices faster than anticipated. In this case, debt would increase to 127 percent of GDP in 2016 and 113 percent of GDP in 2020.

  • More protracted recession (Figure A1.5, continued). A slower and prolonged deleveraging could lead to a more protracted recession. In combination with a lower deflator (0.25 pt per point of growth), this would lead debt to rise to 134 percent of GDP in 2016 and to 125 percent of GDP by 2020.

  • Risks related to the asset swap and privatization proceeds (not shown). If the debt swap (envisaged in 2014) were not carried out, debt in 2020 would increase by about 6 percentage points of GDP. If the envisaged privatization starting in 2015 were not implemented, this would increase debt by about 8 percentage points of GDP in 2020.

Contingent liabilities also pose risks to debt sustainability (Figure A1.5, bottom). Additional bank needs, to the extent that they remain within the program buffer (€2 billion, or 13 percent of GDP), would not have an impact on debt sustainability. However, should bank needs exceed the buffer, by say, 10 percent of GDP, and be combined with a deeper recession (by 5 percentage points), this would increase debt to 147 percent of GDP in 2016 and to 137 percent of GDP by 2020. A full materialization of government guarantees (i.e. all €3 billion government guarantees are called) would bring debt to 129 percent of GDP in 2016 and to 112 percent in 2020.

Figure A2.1Cyprus: Public Debt Sustainability Analysis - Risk Assessment

Source: IMF staff.

1/ The cell is highlighted in green if debt burden benchmark of 85% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant. The baseline debt path and the analysis based on it assume the full utilization of program buffers.

2/ The cell is highlighted in green if gross financing needs benchmark of 20% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.

3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are: 400 and 600 basis points for bond spreads; 17 and 25 percent of GDP for external financing requirement; 1 and 1.5 percent for change in the share of short-term debt; 30 and 45 percent for the public debt held by non-residents.

4/ Long-term bond spread over German bonds, an average over the last 3 months, 13-Jun-14 through 11-Sep-14.

5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.

Figure A2.2Cyprus: Public Debt Sustainability Analysis - Realism of Baseline Assumptions

Source: IMF Staff.

1/ Plotted distribution includes program countries, percentile rank refers to all countries.

2/ Projections made in the spring WEO vintage of the preceding year. The 2012 spring WEO forecast did not factor in extreme tail risks which materialized in March 2013.

3/ Not applicable for Cyprus.

4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.

Figure A2.3Cyprus: Public Debt Sustainability Analysis - Baseline Scenario

(In percent of GDP unless otherwise indicated)

Source: IMF staff estimates.

1/ Public sector is defined as general government.

2/ Based on available data.

3/ Long-term bond spread over German bonds.

4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.

5/ 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).

6/ The real interest rate contribution is derived from the denominator in footnote 5 as r - π (1+g) and the real growth contribution as -g.

7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).

8/ For projections, includes exchange rate changes during the projection period. In 2014, the residual refects the Euro 1 billion asset swap and the pre-payment of a bond maturing in 2017.

9/ 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.

Figure A2.4Cyprus: Public Debt Sustainability Analysis - Composition of Public Debt and Alternative Scenarios 1/

Source: IMF staff estimates.

1/ Inflation in the tables refer to GDP deflator growth.

Figure A2.5Cyprus: Public Debt Sustainability Analysis - Stress Tests 1/

Source: IMF staff estimates.

Figure A2.5Cyprus: Public Debt Sustainability Analysis - Stress Tests

Source: IMF staff estimates.

Annex 3. External Debt Sustainability and Real Exchange Rate Assessment

External sector debt fell substantially in 2013 (Table A3.1). Total external debt fell from 448 percent of GDP in 2012 to 348 percent of GDP in 2013 mainly due to a halving of banking sector liabilities (mostly deposits). At end-2013, the financial sector represented close to 45 percent of external debt, while the share of general government debt doubled from 9 to 18 percent due to official financing from the ESM and IMF.

Table A3.1.Cyprus: External Debt Sustainability Framework, 2009-2021

(Percent of GDP, unless otherwise indicated)

ActualProjectionsDebt-stabilizing
2009201020112012201320142015201620172018201920202021non-interest current account 6/
Baseline: External debt544.1491.9468.2448.5348.0353.2353.6340.9327.8314.2301.0293.1287.5-7.1
Change in external debt223.9−52.2−23.6−19.8−100.55.20.4−12.7−13.2−13.6−13.2−8.0−5.6
Identified external debt-creating flows (4+8+9)2.124.37.0−23.759.18.8−4.0−9.4−9.1−10.0−12.1−9.7−9.3
Current account deficit, excluding interest payments2.51.4−5.8−3.4−7.8−7.0−7.2−7.8−7.9−7.8−7.6−7.6−7.6
Deficit in balance of goods and services5.56.24.33.1−1.9−2.6−3.2−3.8−4.1−4.3−4.2−4.2−4.2
Exports40.241.342.942.943.945.546.346.947.347.647.948.248.6
Imports45.747.547.246.042.042.843.143.043.243.443.644.044.3
Net non-debt creating capital inflows (negative)7.01.8−7.2−12.8−15.2−3.6−3.3−4.4−2.7−3.3−6.0−4.6−4.4
Automatic debt dynamics 1/−7.421.120.0−7.582.119.46.62.81.61.21.52.52.7
Contribution from nominal interest rate8.28.59.210.39.78.08.08.18.18.07.87.87.9
Contribution from real GDP growth5.7−7.3−2.210.928.211.4−1.5−5.3−6.5−6.8−6.3−5.3−5.2
Contribution from price and exchange rate changes 2/−21.319.913.0−28.644.3
Residual, incl. change in gross foreign assets (2–3) 3/221.7−76.5−30.63.9−159.5−3.64.3−3.3−4.1−3.6−1.11.73.7
External debt-to-exports ratio (in percent)1352.41191.41091.11044.8792.1776.5764.2727.2693.2659.5628.8608.2592.0
Gross external financing need (in billions of US dollars) 4/50.9103.093.279.981.146.341.639.638.539.440.540.138.8
in percent of GDP205.0424.8392.8324.1382.35-Year5-Year221.6193.6176.0163.0158.7155.1147.8137.7
Scenario with key variables at their historical averages 5/353.2372.9387.4401.7417.2436.9457.5482.013.9
Key Macroeconomic Assumptions Underlying BaselineHistorical AverageStandard Deviation
Real GDP growth (in percent)−1.91.30.4−2.4−5.4−1.62.6−3.20.41.62.02.22.11.81.8
GDP deflator in US dollars (change in percent)7.1−3.5−2.66.5−9.0−0.36.91.72.52.93.02.93.02.01.9
Nominal external interest rate (in percent)2.71.51.82.31.92.00.52.32.32.42.52.62.62.72.8
Growth of exports (US dollar terms, in percent)−6.10.31.74.0−11.9−2.46.51.94.75.95.96.05.74.64.6
Growth of imports (US dollar terms, in percent)−14.81.5−2.81.3−21.3−7.210.30.33.44.55.45.75.84.64.6
Current account balance, excluding interest payments−2.5−1.45.83.47.82.64.57.07.27.87.97.87.67.67.6
Net non-debt creating capital inflows−7.0−1.87.212.815.25.39.53.63.34.42.73.36.04.64.4
Source: IMF staff estimates.

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.

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.

Source: IMF staff estimates.

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.

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.

A gradual decline in external debt is expected over the medium term. Projected current account surpluses over the medium term coupled with a pick-up in GDP growth is expected to result in a decline in external debt to 287 percent of GDP in 2021. Stabilization in the banking sector and a gradual fiscal adjustment are also expected to contribute to a substantial decline in gross financing needs relative to the pre-crisis period. Compared with the previous medium-term projection, external debt is expected to be lower by close to 10 percent of GDP reflecting a lower initial level of debt in 2014.

The baseline scenario is vulnerable to shocks. The external debt trajectory is most vulnerable under the historical scenario which assumes that key macroeconomic variables, including GDP growth, interest rates and the current account, revert to levels over the previous five years. Since this includes the severe shock from 2013, this scenario is unlikely. Alternative scenarios of shocks to growth and interest rates would substantially slow the pace of debt reduction in the medium term.

Restoring external stability requires placing the financial sector on a firmer footing and lowering public debt. Despite the sale of banks’ Greek operations in 2013—which reduced both liabilities and assets abroad—the IIP remained large and negative, at -86 percent of GDP at end-2013. Reducing it to its 2010 level (-35 percent of GDP) requires running current account surpluses on the order of 5 percent for a prolonged period (10 years). An adjustment of this scale is not expected to be achieved solely through the real exchange rate. However, further depreciation of the exchange rate beyond what standard models imply (see below) will likely be needed to help improve the IIP. More importantly, given the large share of banking and public sector liabilities in the IIP, measures are needed to rebuild confidence in the financial sector, gradually remove external payment restrictions and reduce reliance on foreign deposits, and achieve and sustain primary fiscal surpluses to put public sector debt on a sustained downward path.

Although the current account has adjusted, further moderate depreciation in the real effective exchange rate (REER) is projected over the medium term. The collapse in domestic demand following the crisis led the trade balance to a surplus in 2013 for the first time since 2001, mainly due to a sharp compression of imports. Due to wage adjustment, economy-wide unit labor costs have fallen by 12 percent in the first quarter of 2014 relative to their peak in 2011. And falling prices relative to trading partners resulted in a depreciation of the REER by about 10 percent since its peak in 2009 (CPI-based). Still, at end-2013, it remained 3 percentage points higher than its long-run historical average (1980–2008), suggesting that a further moderate adjustment can be expected over the medium term. Such adjustment—namely a cumulative inflation differential of about 4 percentage points relative to trading partners during 2014–20—is incorporated into the baseline projections.

Standard CGER-type methodologies for assessing the equilibrium exchange rate suggest that REER would be broadly in line with fundamentals in the medium-to long-term. Taking into account the adjustment incorporated in the baseline projections, the REER method points to an overvaluation of up to 7.9 percent over the medium term. The macro-balance approach, on the other hand, suggests a small undervaluation of 0.7 percent. This is underpinned by an estimated current account norm of -3.8 percent of GDP, reflecting the large net foreign asset position and negative oil trade balance, compared with the projected underlying value of -0.2 percent of GDP over the medium run. Similarly, the external sustainability approach suggests a small undervaluation of 0.5 percent, given that the current account deficit required to maintain the IIP at the 2010 level (2.7 percent of GDP) is higher than the long-term projected deficit under the macroeconomic baseline.

Current account (Percent of GDP)Estimated over/ undervaluation
Macro-balance approach−3.80%−0.70%
REER approach7.90%
External sustainability approach (Stabilizing IIP at -35% of GDP, 2010 level)−2.70%−0.50%
Source: IMF CGER Toolkit.
Source: IMF CGER Toolkit.

Figure A3.1Cyprus: External Debt Sustainability- Bound Tests 1/2/

(Percent of GDP)

Sources: Ministry of Finance; CBC; and Fund staff estimates.

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

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

3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.

Private sector indebtedness indicators include brass plates.

Economically insolvent institutions are defined here as those institutions identified by the independent due-diligence exercise as having negative capital under the forward-looking baseline and stress scenarios.

See Box 4 of Country Report No. 13/125 for an initial analysis of the potential impact of the crisis on economic activity.

See the companion Selected Issues Papers, “The Housing Market in Cyprus: From Boom to Bust”.

See the companion Selected Issues Papers, “The Cypriot Household Saving Rate”.

See Country Report No. 13/374 for an analysis of private sector balance sheet deleveraging on growth (Box 1) and Country Report No. 14/92 for a sectoral analysis of the expected credit-less recovery in Cyprus (Box 1).

See the companion Selected Issues Paper, “Estimating Cyprus’s Potential Output Growth”.

Moreover, commercial real-estate related NPLs which are the prime candidate for transfers to an AMC are concentrated in one bank, limiting the potential benefits of an AMC to achieve economies of scale. For a discussion of cross-country experience with AMCs, see Section IIA of Selected Issues Paper “Cyprus’s Banking Sector: The Crisis and its Aftermath”.

The Executive Board has recently approved retention of the existing exchange restrictions for twelve months.

See Box 8 of ECB Monthly Bulletin, June 2011.

See Box 4 of IMF Country Report No.13/374.

See Selected Issues Paper “Achieving a Durable Fiscal Consolidation.”

Box 2 of IMF Country report No 14/169 suggests that small open economies that achieved larger reductions in their wage bill were relatively more successful in improving primary balances and reducing their debt.

See Box 4 of IMF Country Report No.14/180. The relative poverty gap it is measured as the relative distance between the income of the poor and the poverty threshold (60 percent of median equivalent income.).

See Cheptea C. and Velculescu D., “A Disaggregated Approach to Prioritizing Structural Reforms for Growth and Employment” in Schindler M. et al., “Jobs and Growth: Supporting the European Recovery,” IMF, 2014.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more. The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

The parameters of the asymmetric distribution were calibrated to capture the predominance of downside risks in the medium term on growth and the primary balance due to a prolonged deleveraging and fiscal adjustment fatigue. Consistent with this, upside growth shocks were limited to 1 percentage point and upside primary balance shocks to 2 percentage points.

See Box 1 of Country Report No 13/374.

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