We thank staff for a well laid out Article IV report and the detailed supplementary papers. The Article IV report appropriately captures the grim story of the island’s recent economic history. Looking back, it will hopefully serve as yet another useful reminder of how a twist of unforeseen events, mixed with lingering vulnerabilities, policy indecisiveness but also broader politics, can fester into a treacherous combination that can bring a country to its knees in an instant.
In the years leading to the start of the global financial crisis in 2008, Cyprus had been posting strong growth rates of around 4 percent, the unemployment rate was hovering close to 4 percent, inflation was at low levels, the public finances were in surplus and the debt-to-GDP ratio was below 50 percent. However, with a booming economy came complacency, and serious fragilities were quietly being amplified in the background while policy responses were either timid or absent. Rapidly rising property prices contributed to an overdependence of public finances on the property sector, leading to a wealth effect that gradually started to hamper competitiveness. When the property bubble burst, the first cracks in the banking system started to emerge while persistent reluctance to correct long standing imbalances and continued lax fiscal and macro prudential policies had started taking their toll on the country’s ability to refinance its debt at rates compatible with long term fiscal sustainability. These imbalances became increasingly more evident in 2011 when the large exposure of the country’s banks to a then fragile Greece led to a series of rating agency downgrades. By mid-2011, Cyprus had lost access to long-term sovereign debt markets.
Even by then, these imbalances were arguably still manageable, if prompt action had been taken: the economy was still growing q-o-q and the banks were still solvent and capitalized. However, the unforeseen events that followed accelerated and exacerbated the island’s problems. In July 2011, a catastrophic explosion of a huge cache of confiscated munitions stored at a naval base destroyed Cyprus’s nearby power plant which supplied power to half of the island, and led to a then estimated burden of over €2 billion on the government’s ailing budget. The fallout included systematic electricity blackouts, with adverse effects on output and government revenues while deepening the sense of economic uncertainty. By that point in time, the economy was thrown into recession. Three months later, in October, 2011, the decisions taken on the Greek PSI wiped out overnight more than €4.5 billion in bank assets (over 25% of GDP) with an ensuing substantial loss in bank capital. Within just a few months, these two events sunk the economy deep into unchartered territory. Failing to request immediate assistance at that point, Cyprus’s fate became gloomier by the day. In the meantime, the banking sector, now undercapitalized, was increasingly cut off from international market funding.
It was not until June 2012 that Cyprus requested official support in the form of a combined European and IMF package. However, upcoming elections caused delays in concluding an assistance package, and negotiations were caught up in a broader unfavorable political nebula. By early 2013, statements and rumors in the press regarding deposit haircuts and the consequent fall in confidence led to accelerated and substantial deposit outflows. Against the background of these severe economic and financial disturbances, on March 16 and 25, 2013, an agreement was forged with the newly elected government on an EU-IMF supported program.
In an unprecedented manner, beyond the core elements of an officially supported program, depositors of the island’s two largest banks were bailed-in. Uninsured depositors of Laiki bank and Bank of Cyprus were bailed in using 100 percent and 47.5 percent of their deposits over €100 000 respectively. With the conclusion of the exercise, a total of €9.4 billion was affected, including €1.5 billion of debt. Amidst financial turmoil and public outcry, a two week bank holiday was imposed, followed by the introduction of capital controls and restrictions on cash withdrawals in a bid to prevent a bank run. Cyprus was in a state of paralysis and some market commentators, in their own right, believed the island’s euro exit was inevitable and imminent.
Developments since the onset of the program and review status
A year and a half later, following a vast array of bold fiscal, structural and financial sector policies, the economy is mending at a rapid pace and well beyond what was expected at the program inception. Landmark reforms included a fiscal consolidation of over 10 percent of GDP between 2013 and 2014, reform of the General Social Insurance and the Government Pension Scheme, reform of the wage indexation system, adoption of the Fiscal Responsibility and Budget Systems Law, the introduction of the Medium Term Budget Framework, the modernization and refinement of the social welfare system, the unification and empowerment of tax departments and the introduction of the privatization framework. In the financial sector, following the bail-in of uninsured depositors and the imposition of restrictive measures, key policies included the merger of 93 coops into 18 entities, the unified supervision of banks and coops under the Central Bank, the recapitalisation of the cooperative sector, the strengthening of the AML/CFT framework and policies targeting the areas of governance, loan origination and arrears management. Progress is being made, inter alia, with a wide range of the goods and services market such as regulated professions, public administration review, public financial management, housing market, health, tourism and energy. With over 200 completed actions in four reviews, Cyprus has begun to reap the benefits of steadfast program implementation.
The positive side-effects of this effort were broad based. By now, the financial system finds itself closer to a stable state, underscored by the normalization of deposit flows, even as all domestic restrictions have been absent since May 2014. At the same time, rating agencies have been reversing a long trend of successive downgrades and sovereign bond yields have been on a steady downward trend. In June 2014, Cyprus tapped the international bond markets after three years of absence- and a year ahead of schedule- through a heavily oversubscribed five year paper issuance. The banking system has also received the attention of foreign funds. In November 2013, Hellenic Bank was recapitalized by new private investors who have also indicated their intention to cover any potential capital needs following the conclusion of the ECB’s comprehensive assessment. More recently, in September 2014, Bank of Cyprus has successfully undergone a 1 billion share capital increase through foreign participation. The latter boosted its CET1 capital ratio to 15 percent. The bank has also been able to reduce its ELA dependence by another €800 million.
While Cyprus has adhered to and consistently overperformed the program’s quantitative conditionality, the completion of the 5th review, originally scheduled to take place in September 2014, has been delayed due to one incomplete prior action. The government, which lost the House majority in February 2014, has been working hard to fulfill the prior action on the foreclosure law and build on its excellent track record. However, the smooth transition into the new foreclosure framework proved somewhat too ambitious. While the actual foreclosure law was passed – and is actually currently active - the House majority voted some side-legislation rendering the effectiveness of the foreclosure law’s objectives weaker. Since then, most of the associated bills have been referred to the Supreme Court to review their constitutionality with a final decision to be expected in early November. Importantly, however, the government’s efforts throughout this process underscore once again its commitment to abide to program conditionality. In the same context, the authorities’ prudent fiscal management has given Cyprus the benefit of time since the accumulated fiscal buffers have eliminated any imminent financing threats. Nonetheless, the authorities are in complete agreement with staff views regarding the necessity of a well-functioning foreclosure framework complemented by a modernized insolvency regime as the best way to promote debt restructurings and address the high NPLs. Their efforts, irrespective of the ensuing delays, should be acknowledged.
The real economy also delivered positive surprises. To put this into perspective, at program inception, growth estimates for 2013 ranged from -8.7 percent (program estimates) up to -20 percent (market analysts), with the year ending with drop in output of -5.4 percent. For 2014, program estimates stood at -4.8 percent (3rd review) with the latest revised forecast envisaging a 3.2 percent drop in output. The authorities do not expect the economy to contract more than 3.0 percent. Indications to date point indeed towards such an outcome as the annualized growth for the first half of the year was -2.5 percent. Moreover, the second quarter’s -0.3 percent q-o-q growth rate was the lowest quarterly contraction since the aforementioned naval base blast in July 2011. Regarding the outlook, the staff report accurately captures the authorities’ views which point to somewhat more positive medium term outcomes.
There are several reasons contributing to these better-than-expected outcomes, not least the price and wage flexibility exhibited by the economy. Wages in both the public and private sectors have been subject to a large downward adjustment. While the cost of adjustment is painful, it is contributing towards improved competitiveness. Cyprus saw a decline in its labour costs of 6.5 percent in Q4 2013. The adjustment continued well into 2014 with Eurostat’s latest publication indicating another 3.9 decrease by Q2 2014 compared with the same quarter of the previous year. At the same time, the public sector workforce was significantly reduced over the last years and by Q2 2014, the number of broad public sector employees stood at levels last seen in 2007, representing a decrease of around 10 percent from their peak in 2011. Inevitably, unemployment was a victim of the adjustment effort, peaking at 16 percent in 2013. However, with the recession moderating, the growth in unemployment is now reversing, falling to 15.4 percent in August, and constituting the fourth consecutive monthly drop. In terms of price developments, inflation averaged -0.3 percent in the first eight months of 2014. While having a positive impact on competitiveness, these levels warrant caution as they also impede the authorities’ efforts to resume growth and reduce the debt overhang.
Cyprus continues to achieve -and surpass- all its fiscal targets, as it has done since the beginning of the program. This has been despite the deep recession, evidencing the authorities’ intent and determination to meet their fiscal balance objectives for the coming years. It is also useful to recall that the 2014 budget, on the authorities’ own initiative, included additional fiscal consolidation that went beyond program requirements. As a result of prudent management, public finances are running almost two years ahead of the original program profile. As staff correctly identifies, preliminary August figures point to continued overperformance. To specify, there is a primary surplus of +2.9 percent of GDP for the first eight months of 2014. In fact, where the target for 2014 is for a primary deficit of -1.6 percent of GDP (4th review), the authorities expect to end the year with a primary surplus.
The authorities clearly share staff’s view about the need for a credible but balanced fiscal adjustment over time, as evidenced by their track record. They also concur with the need to ensure the fiscal neutrality of the new welfare reform. The Guaranteed Minimum Income, which is now operational, has been designed in a way that improves targeting and reduces benefit abuse. These goals appear to have been met as the new refined selection process appears to have contained benefit abuse bringing in associated savings relative to what was expected. Regarding the calls for additional adjustment measures over the medium term, the authorities’ share the objectives behind staff’s proposals presented in the Selected Issues. Indeed, they wish to reaffirm their intention to do what is necessary to achieve the 4 percent primary surplus by 2018. It should be pointed out that the authorities project a more modest fiscal effort than that envisaged by staff. Further measures will of course need to be balanced against the still recessionary and fragile environment, future macroeconomic outcomes, the broader external environment and the added value/loss of pushing the economy more than may really be necessary. In each review so far, the authorities’ internal projections presented in mission discussions have consistently outperformed those of staff.
The authorities take note of the accompanying Public Sector Debt Sustainability Analysis. While staff expects Cyprus public debt to GDP to peak in 2015 at 126.2 per cent, the authorities wish to reveal the possibility that debt to GDP may peak this year and at much lower levels. While staff’s DSA assumes full disbursement of the buffer at over €2 billion (13 percent of GDP), the authorities consider that this prospect does not constitute a realistic baseline scenario by now. The authorities would also expect the baseline scenario to be updated with any new information following the completion of the ECB’s comprehensive assessment on October 26. Moreover, the output level revision scheduled later this year to conform to ESA2010 standards is expected to further decrease the debt-to-GDP ratio by a sizeable amount.
As a general remark, while conservative assumptions have their benefit, they could also mislead broader market participants with a direct (miscalculated) impact on future policy.
The authorities are acutely aware of the remaining challenges outlined by staff. The report correctly highlights the criticality of addressing the high level of NPLs which may pose a threat to the banking system’s long-term viability. The authorities share staff views that NPLs exceed what could be explained by unemployment. As such, the rise in NPLs can be largely explained by a large number of strategic defaulters. The latter is being fuelled by the uncertainty created regarding the treatment of NPLs, and the lack of tools to lay the foundations and incentives for healthy debt restructurings. In response, as outlined earlier, significant efforts have been put into building the necessary framework to effectively address arrears and accelerate sustainable restructuring. This was an exercise that involved reform at many levels including banks, supervision, legislation and civil institutions. So far, banks have established specialized units to deal with troubled borrowers and have been gradually building capacity with the help of external consultants. The process was complemented by the Central Bank’s Arrears Management Framework (AMF), the Code of Conduct (CoC) for borrowers and creditors, and the loan origination directive. The authorities agree that where implementation reveals weaknesses, these tools should be refined accordingly. As such, the Central Bank intends to further improve the AMF and CoC accordingly upon the conclusion of the SSM transition and the comprehensive assessment, both of which have been straining the Central Bank’s operational capacity. Finally, the authorities agree than in the absence of an efficient foreclosure and insolvency framework, the exercise remains incomplete. They will continue to push this forward with the same determination shown thus far.
The Cyprus case has raised important policy issues, not least in the areas of modern bank resolution, program design and timing, the size of financial systems/institutions, corporate governance as well as the inability of regulators or other international economic surveyors – including the Fund – to ring louder bells in the years leading to this. Even as some of these issues feature prominently in international fora, including last week’s Annual Meetings, some of the answers remain elusive. The island’s story also serves as another stark example of how inaction can lead to severe economic dislocations. In a still fragile environment such as the current one, it is a timely reminder that timid policies will only postpone underlying problems which will come to haunt the country later on. As the story unfolds itself, it may also prove that firm upfront action can lead to a faster adjustment than otherwise.
Faced with an unprecedented economic shock in the island’s modern history, the authorities have come a long way in addressing the crisis. As staff concludes, a number of challenges remain. Nevertheless, following eighteen months of strong implementation Cyprus finds itself in a good place to continue along the agreed path. The authorities are cognizant that the achievements to date will be jeopardized if there is a hint of complacency and are therefore determined to push through their commitments even as headwinds have emerged. With continued guidance from staff and careful policy design for the remainder of the program, the authorities are confident that Cyprus will soon return to growth and broad-based economic prosperity.