We thank staff for their constructive assessment of the fifth, sixth and seventh reviews under the Extended Arrangement for Cyprus. The paper appropriately captures the economic developments since the last review and covers topics of relevance for future reforms.
The set of reviews comes after a pause in the program’s flow due to a single, yet extensive and crucial, reform. This relates to the modernization of the private debt restructuring framework which, after more than a year of deliberations due to its technical and political complexity, was eventually legislated and enacted. We feel it is important to highlight at the outset that despite the review process being hinged on this complicated reform, the bulk of the program’s objectives continued to be met resolutely, per the timelines prescribed in the associated reviews. This is well corroborated by the report, and further supported by the dramatically improved market sentiment throughout this time.
Program performance remains well on track with all but one performance criteria observed with considerable margins, with the remaining one on track to be completed in Q3 2015. Despite an ambitious structural reform agenda, the requirements of structural conditionality are also being faithfully adhered to. Even as minor delays in some were inevitable, the requirements for all relevant structural benchmarks for the combined reviews were observed, while one of them was rendered obsolete and is being redesigned.
As we elaborate further on, Cyprus has indeed come a long way since the 2013 crisis. The financial sector is stable and on the mend, the public finances are on a very healthy footing and there are clear signs that the underlying economic fundamentals have changed for the better. Among the most notable developments is the country’s return to economic growth in the first quarter of 2015, after 14 consecutive quarters of deep recession. The authorities have also tapped into the international bond markets for the second time since the crisis, further establishing the conditions for a smooth program exit. The sustained effort and determination continue to be recognized by all major rating agencies as the ratings/outlook have undergone several upgrades over the last year. Moreover, all capital controls have been abolished earlier this year, and the transition to unrestricted capital flows has been smooth despite the volatile regional environment. Finally, the authorities note and welcome staff’s recognition that the program buffers will not be needed for bank recapitalization needs. This has in turn led to a steep downward shift in the country’s baseline debt profile, which should further nourish the positive market sentiment.
Recent GDP numbers have been very encouraging. In the first quarter of this year Cyprus returned to growth for the first time since it slipped into recession in 2011, expanding by 1.5 percent on a quarter-on-quarter basis (0.2 year-on-year). Compared with the previous quarter, this was among the highest growth rates recorded among EU Member States. For 2014, the growth also surprised on the upside, contracting by almost 2 percentage points less than the fourth review estimate. These developments happened during a period of significant regional headwinds from – particularly to Cyprus – important economies, and reaffirm the economy’s resilience exhibited since the onset of the program. The lower oil prices, euro depreciation, the ECB’s asset purchase program and the European Commission’s Investment Plan are also expected to foster stronger growth over the short term. Like the Fund forecasts, the authorities assume a modest rebound in 2015. They also concur that the main risk to the macro outlook stems from regional headwinds which could hurt the service sector in particular. Staff makes a valid point that completion of the reviews would further insulate Cyprus from broader contagion risks.
Several other developments point towards a promising outlook. For example, the business operating environment shows signs of stabilization given that lending to non-financial corporations is marginally positive and interest rates are in decline. The economic sentiment indicator increased by 4 points in April 2015 compared to the previous month and continues to run above its long-term average. This came about largely due to the improvement in the business climate in all sectors and the strengthening of the consumer economic confidence. Notably, exports of goods increased by 45.5 percent in January-March 2015 compared to January-March 2014. Tourism results point towards another strong year, as arrivals increased by 13.7 percent in January-April 2015 compared with the same period last year.
Finally, while unemployment still remains high, it appears to be on a declining trend since its peak in 2013. The unemployment rate in April 2015 stood at 15.6 percent, down from 16.0 percent recorded in March 2015. Compensation per employee in 2014 declined by around 4.7 percent compared to 2013, the steepest correction in the EU, contributing to a decline of nominal unit labor cost and improving cost competitiveness further. This is expected to diffuse any remaining unemployment pressures.
In spite of the recessionary environment over the last four years, the program’s fiscal targets have consistently been met with considerable margins. In 2013, for example, Cyprus delivered a primary deficit of 1 percent of GDP against an original target of 3.3 percent of GDP. In 2014, a surplus of 2.8 percent of GDP was recorded against an originally targeted deficit of 2 percent of GDP. Underlining the authorities’ commitment to do whatever it takes to adhere to the quantitative conditionality, the savings relative to the targets were prudently locked in throughout the program. Moreover, as staff confirms, these outcomes reflect largely permanent factors. For the period until April 2015, the primary balance remained in surplus in the order of 0.6 percent of GDP. From a broader perspective these developments, in the context of the recent increase in activity, signify that fiscal consolidation can coexist with GDP growth.
For 2015, a primary balance target of 1 percent of GDP is envisaged, despite considerable negative one-off factors amounting to almost 2 percent of GDP. These are detailed in the staff report. Should downside risks to growth materialize, we note staff’s view that flexibility may be required. Nevertheless, there remains an unwavering commitment to keep up with the strong track record for 2015 and the coming years.
Public debt and broader financing and sustainability developments have been among the most positive. Long-term bond yields continued to drop in April and May, largely attributable to the enactment of the foreclosure and insolvency legislation which set expectations for completion of the reviews and possible access to the ECB’s asset purchase program. Taking advantage of the improved conditions, Cyprus successfully placed a new seven-year Eurobond on April 2. As in the past, the amount will be used to repay more expensive outstanding debt, resulting in a lower interest bill and a smoother repayment profile over the medium term. Finally, debt sustainability has improved markedly upon the recognition, inter alia, that the program buffers – about 12 percent of GDP – are now unlikely to be used for new financing. This has led to a steep downward shift in the debt profile relative to the last staff update. More importantly, already as of this year, debt is on a declining trajectory and a year earlier than what the program envisaged.
IMF Staff Debt/GDP profile revision
Notwithstanding the marked improvement in the economic environment, the authorities deem the program’s level of success to ultimately run through the financial sector’s revival. Following two years of deep-rooted reforms the sector’s recovery was epitomized by three events.
First, the conclusion of the ECB’s comprehensive assessment verified that no further bank recapitalization by the State was necessary. With one of the highest average core tier 1 capital levels in Europe (14.2 percent at end 2014) the banking system is able to withstand significant headwinds. Moreover, the Q1 2015 reporting season marked all three major credit institutions’ return to profitability.
Second, on the back of the positive outcome of the ECB’s comprehensive assessment and a sustained improvement in liquidity and funding conditions, the authorities abolished all capital controls on April 5 2015. Even though this was done in a period that the regional economic environment was faltering, the level of deposits has increased since then. Notably, this was achieved just over two years since the bail-in of unsecured deposits and the imposition of the controls.
Lastly, despite several political and technical hurdles, the Foreclosure Law, the Insolvency Framework and the relevant Regulations, which are vital for addressing the Non-Performing Loans, have been enacted by the House of Representatives on April 17 2015. This was the product of a momentous effort by the authorities, in close cooperation with our program partners, establishing the legal and regulatory infrastructure capable of effectively addressing arrears, accelerating sustainable restructurings and advancing the banks’ deleveraging process. While certain provisions introduced during the Parliamentary discussions may weaken its efficiency, under no circumstance should they diminish the significance and value of these new legislative tools. In addition, the authorities will implement and monitor the performance of the insolvency and foreclosure frameworks and have agreed to make adjustments, if necessary.
The authorities have also been working on other measures to speed up the resolution of the NPLs, notably with regards to the sale of loans(facilitating the resolution of non-performing loans by permitting banks to sell part of their distressed assets portfolio to investors and specialized companies) and to the transfer of issued title deeds (this will enable buyers to obtain a legal title to the property rapidly and will enhance NPLs management and the practical implementation of foreclosure and insolvency frameworks). Draft legislation has recently been submitted to the program partners. In the meantime, the Central Bank is creating a framework that monitors NPL management and incentivizes banks to expedite and improve their processes and policies with a view to increasing the pace of restructurings.
The authorities have always seen the crisis as a window of opportunity to lay the foundation for a viable and sustainable growth model. Much has already been done, inter alia, widely ranging from the goods and services market, public administration review, public financial management, housing market, health, tourism and energy. With the economy
stabilized and its urgent needs having been addressed, the attention is now shifting towards the remaining structural reforms that will address longstanding inefficiencies that historically hampered growth, reduced productivity incentives and fostered imbalances in the labor conditions.
Having already implemented a ground shifting reform of the welfare system, the government sees as priority the completion of the public administration reform which will permanently ensure the affordability of the public wage bill and address any remaining distortions in public sector compensation and staffing. Within these priorities, privatizations and reform in the corporate governance of state-owned enterprises remain high on the list, not for their cash-raising merits, but for the associated benefits such as increased competitiveness and foreign investment. While this is proving to be more politically challenging than hoped for, the authorities are determined to pursue this, starting with the telecoms, ports and the state lottery. The Privatization Unit has appointed all relevant investment advisers for the telecom privatization and has made progress on its corporatization law. The authorities are aiming for the law to be adopted by the Council of Ministers in the next few weeks and by Parliament soon after the summer.
Two years into a difficult adjustment program, the economy is at last signaling that the authorities’ efforts and the people’s sacrifices have not been in vain. Notwithstanding this generally supportive backdrop, the authorities are aware that significant challenges remain. With this in mind, the authorities wish to reiterate that the recent economic uptick does not in any way signify that the problems are over. On the contrary, it provides the impetus to keep working meticulously through the remaining challenges that will cement the island’s promising prospects.
Despite the delays in bringing these reviews to the Board, the report clearly shows that overall program performance has been strong. While some setbacks have proved inevitable, these were associated with the difficulty in navigating an ambitious reform agenda with a minority government. The authorities wish to express their appreciation to their international partners for the understanding and constructive help that has been demonstrated throughout this process.