Statement by Jeroen J.M. Kremers, Executive Director for Cyprus and Lucian Croitoru, Senior Advisor to Executive Director

This 2004 Article IV Consultation highlights that economic growth in Cyprus has begun to rebound following a more modest performance in 2002–03, recovering in real terms to about 3½ percent in 2004, mainly driven by an increase in domestic demand. Real per capita income has continued to rise, now reaching above 80 percent of the average European Union 25 income level when adjusted for purchasing power. Looking ahead, growth is estimated at close to 4 percent in 2005, reflecting an improved external environment.

Abstract

This 2004 Article IV Consultation highlights that economic growth in Cyprus has begun to rebound following a more modest performance in 2002–03, recovering in real terms to about 3½ percent in 2004, mainly driven by an increase in domestic demand. Real per capita income has continued to rise, now reaching above 80 percent of the average European Union 25 income level when adjusted for purchasing power. Looking ahead, growth is estimated at close to 4 percent in 2005, reflecting an improved external environment.

The broad picture

The Cypriot authorities appreciate the staff report, which accurately assesses the country’s performance and provides a realistic view of the policy challenges. The authorities agree that the key macroeconomic challenges are a credible fiscal consolidation and the strategy for adopting the euro. The authorities also broadly agree with staff recommendations.

Macroeconomic developments are encouraging, supported by sound macroeconomic policies. Growth has begun to rebound following two years of relatively weak performance, recovering to about 3½ percent in 2004, and the authorities expect a growth of 4 percent in 2005. Consumption was the main engine of growth, fed by fiscal easing in 2003 and a possible confidence effect from the EU accession. Reforms that will be brought forward in the process of adaptation to EU institutions and regulations are expected to set the stage for enhanced economic growth. Tourism has picked up, unemployment remains very low even by European standards, and the current account deficit has not exceeded 4½ percent of GDP for several years. A moderate increase in the current account deficit is expected for 2004, in part due to one-off items, such as the higher than expected increase in the imports of cars due to the significant reduction of excise duties in November 2003. Inflation has crept upward on rising energy prices, but is expected to remain in the vicinity of 2½ percent as a result of the continued restrained stance of monetary policy. The central bank has left the interest rates high since April, when it raised them in response to modest outflows in the weeks preceding the EU accession, outflows that are now reversed. As a start of fiscal consolidation that the authorities are committed to implement over the medium term, the 2004 budget deficit was brought to 4.3 percent of GDP, well below the 4.8 percent target, and down from 6.3 percent of GDP in 2003. It is budgeted to be below the Maastricht threshold of 3 percent of GDP as of 2005. The increase of debt-to-GDP ratio beyond the Maastricht threshold was led mainly by technical reasons rather than above the line deficit-inducing transactions, and a downward trend is foreseen as of 2005.

Looking forward, the authorities remain committed to implementation of the adjustments needed for an early accession in the monetary union. Although it was not among the group that joined ERM2 in June 2004, Cyprus intends to be one of the first new members to adopt the euro. The authorities acknowledge that delivering a strong fiscal adjustment is a prerequisite for joining ERM2 in the first part of 2005 and for an early euro adoption. In addition, to support competitiveness and have a strong performance in the monetary union, the authorities will strengthen structural reforms.

Fiscal policy

Acknowledging that medium-term fiscal sustainability depends on further fiscal consolidation, the authorities adopted an ambitious Convergence Program (CP) in May 2004. The main features of the CP consist of targeting a significant adjustment (from a deficit estimated at that time at 5.2 percent of GDP in 2004 to 2.9 percent of GDP in 2005 and 0.9 percent of GDP in 2008), and implementing a number of politically difficult measures, including parametric reforms to both the public and general pension systems (there already are preliminary agreements with the relevant trade unions on the increase of the retirement age for employees in the public sector). Under the CP, public debt is expected to decline rapidly to 60 percent of GDP by 2009.

The authorities have begun restoring credibility in implementing fiscal adjustment after the fiscal slippages of the past. Their fiscal prudence was reflected in a lower than envisaged deficit for the first 10 months of 2004, and in December the authorities approved an update to the CP that is more ambitious than the May program. As noted above, they overperformed relative to the revised program by 0.5 percent of GDP. Based on the revised CP and on the 2005 budget, the Ecofin Council concluded on January that Cyprus has taken effective action to correct its fiscal imbalances, and no other steps are necessary under the excessive deficit procedures. Even more, recognizing the existence of downside risks to growth and their potential fiscal impact, the authorities are ready to consider additional measures if the CP may fall short to deliver the envisaged fiscal adjustment, and indicated that they would be prepared to consider most of the measures proposed by staff.

To consolidate policy credibility over the medium term, the authorities are willing to consider a medium-term fiscal framework. As a preparatory step, they have already limited the practice of approving many supplementary budgets to revise upward the spending ceilings during the year, and requested a fiscal ROSC for 2005.

Monetary policy

The Central Bank of Cyprus (CBC) will continue to maintain a cautious stance of monetary policy. There are a few reasons that would, at this stage, make a relaxation inappropriate. First, a vigilant monetary policy serves better the authorities’ plans to participate in ERM2 as early as possible in the course of 2005. Secondly, although credit growth slowed from 8 percent in 2002 to 5 percent in 2003, as compared to an annual average of 13 percent during 1999-2001, it rebounded to 6.5 percent in 2004 and is expected to continue increasing slightly in 2005. Thirdly, inflationary pressures have crept up fueled by higher oil prices, and uncertainty regarding oil prices still persists. The authorities’ policy is to keep the monetary stance consistent with other policies. Some monetary policy easing might become possible as the implementation of the fiscal consolidation program progresses and changes in oil prices will have tamed.

The financial sector is sound, with banks being rated beyond the investing grade. Enhanced disclosure rules and listing requirements have been introduced to strengthen the securities market in the wake of the stock market crash of 2000. Progress has been made in strengthening the insurance sector by bringing specific legislation in line with EU requirements in 2003. The same year, capital adequacy requirements and minimum reserve requirements on foreign currency have been raised. The CBC also issued a circular in late 2003 to tighten collateral requirements for real estate lending. Moreover, to have a more realistic view on the magnitude of nonperforming loans (NPL), the authorities have gradually reduced the time threshold for declaring an overdue loan to be nonperforming from 12 percent in 2003 to 3 percent in 2005. This, together with still weak recovery rules kept NPL ratios high, but prudential oversight continues to be strong. Although the CBC and private banks agreed that supervision of financial institutions should be consolidated in one institution, the cooperative and credit societies, which hold a quarter of the financial system’s deposit base, disagree. The offshore sector’s reputation has improved, as ensured by staff, and the authorities plan to request a FSAP after MFD will have updated its 2001 OFC assessment in early 2005.

ERM2 and Cyprus’s competitiveness

Cyprus’s long employed exchange rate regime mirroring ERM2 provides a good basis for joining ERM2 in the first part of 2005 and for adopting the euro as soon as possible. The exchange rate movements have stayed for years within a de facto narrow band around the central parity, which means that ERM2 is, effectively, already there. By setting a near-term target for ERM2, the authorities aim at benefiting from the existing favorable political economy setting for reforms, and also at giving strong support for politically difficult fiscal measures already envisaged in the CP.

The authorities view the actual exchange rate parity as appropriate and it should not be changed for competitiveness purposes. As rightly stressed by staff, the convergence effect has explained most of the pound appreciation over the last decade. It is also worth mentioning that real appreciation has taken place in part due to the rise of inflation owing to the increase in the VAT rate by 5 percent since 2002 an in the rise of other EU harmonization-induced excise taxes. Even with a lower growth differential and a higher inflation differential versus the euro zone in 2002-03, other competitiveness indicators do not suggest that the exchange rate is out of line with fundamentals. Moreover, as stressed by the authorities and agreed by staff, given the openness of the Cypriot economy, any gain in competitiveness from a change in the pound’s parity would be eroded by the pass-through effect. The authorities will protect competitiveness by implementing the envisaged fiscal adjustments and the needed measures in area of structural reforms.

Structural reforms

Although privatization of the remaining public enterprises was not on the agenda, structural reforms have progressed. The authorities were focused on complying with the EU’s acquis communautair, and services and utilities markets have opened up. Looking forward, in view of heightened competition from other carriers, the authorities are considering options to restructure the airline, including by disposing one of its subsidiaries. While the authorities do not see the immediate need to modernize corporate governance of public enterprises through corporatization, fostering competition and promoting efficiency remain among their objectives in area of public enterprise reform.

The authorities consider that the automatic backward-looking wage indexation (COLA) system had worked well, but acknowledge the tendency of real wage growth to outstrip productivity gains, and will limit increases beyond the COLA in the public sector. The authorities also note that the staff assesses the COLA system as a structural rigidity, but they believe that the system has benefits in terms of harmonious labor relations and is not a source of inflationary pressures.

The reunification of Cyprus

The Cyprus authorities do not share the assessment of the staff conveyed in the last sentence of Box 3 (page 17) of the draft report that the Annan Plan was economically and financially viable. They point out that the assessment of the viability of the Annan Plan was not a task of the staff during the 2004 Article IV Consultation with Cyprus and therefore the assessment was not discussed with the Cypriot authorities. Accordingly, the staff views do not represent a recent assessment of the viability of the Annan Plan.

The staff has been informed of the Cyprus authorities’ areas of concern regarding the Annan Plan and detailed papers on this subject have been sent to the staff. Looking forward, the authorities are committed to continued cooperation in finding a solution towards an acceptable and viable reunification plan.