2010 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Cyprus

Economic conditions have stabilized, and the economy is projected to bottom out in 2010, giving way to a mild recovery in 2011 followed by stronger growth. The foremost policy challenge is to achieve the official fiscal consolidation targets so as to put debt ratios on a declining path and provide more space to guard against risks to the financial sector. Further old-age pension reform is also essential. Structural reforms are needed to preserve competitiveness and enhance medium-term growth. The government largely shared the IMF staff’s assessment.


Economic conditions have stabilized, and the economy is projected to bottom out in 2010, giving way to a mild recovery in 2011 followed by stronger growth. The foremost policy challenge is to achieve the official fiscal consolidation targets so as to put debt ratios on a declining path and provide more space to guard against risks to the financial sector. Further old-age pension reform is also essential. Structural reforms are needed to preserve competitiveness and enhance medium-term growth. The government largely shared the IMF staff’s assessment.

I. The Context: Macroeconomic Imbalances Building Up Prior To The Crisis1

1. Cyprus is being affected by the global crisis with a lag, as it entered into recession in early-2009, about a year after the euro area as a whole. In the wake of euro adoption in early 2008, domestic consumption remained strong, buttressed by buoyant credit growth—mainly channeled to a booming real estate market—and a relaxation in the fiscal stance (Box 1). The banking sector weathered the financial turmoil relatively unscathed due to limited exposure to complex securitized products, but as trade partners became increasingly affected by the global slowdown, the tourism and construction sectors contracted sharply. As a consequence, Cyprus entered a shallow recession in early 2009, just as the euro area as a whole was bottoming out (Figure 1).

Figure 1.
Figure 1.

Cyprus’ Relative Performance During the Crisis

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: IMF, GFSR; Central Bank of Cyprus; IMF, WEO; and Eurostat.

GDP Growth

(q-o-q percent change)

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Source: Eurostat

2. Home-grown imbalances are set to weigh on the recovery. Prior to the crisis, rapid credit growth drove private sector indebtedness up (Figure 2) and led to overheating.2 Above euro-area average real wage and price dynamics exacerbated external imbalances and the related loss in competitiveness and necessary adjustment in saving patterns will moderate growth going forward. Meanwhile, tax revenue buoyancy during the upturn, especially related to asset prices, proved cyclical and the fiscal position took a sharp turn for the worse in 2009.

Figure 2.
Figure 2.

Cyprus: Household and Corporate Sector.

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Central Bank of Cyprus; and IMF, WEO.

Cyprus: Fiscal Developments in 2004–2009

During the period 2004-08, following EU accession and in preparation for euro adoption, Cyprus made significant progress in consolidating public finances turning an overall deficit of 6.3 percent of GDP in 2003 into surpluses of 3.4 and 0.9 percent respectively in 2007 and 2008. This translated into a parallel improvement of the structural balance, from a deficit of 7.6 percent in 2003 to a surplus of 2.2 percent in 2007. General government debt also declined from 68.9 to 48.4 percent of GDP in 2008. This virtuous path was supported by favorable cyclical conditions and tax-rich activities from the real estate sector. Sizable one-off deficit-reducing measures, especially between 2003 and 2005 also contributed to the adjustment. With regard to gross debt levels, a debt-reducing stock flow adjustment associated with the use of the sinking fund deposits led to a decline of debt levels by about 10 percent of GDP.


General Government

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: WEO; and Eurostat.

Most of the consolidation was reversed in 2009, following a 7 percent deterioration in the overall balance compared to 2008, pushing up gross debt to 56.2 percent of GDP. The increase in debt resulted from a 7.3 percent deterioration in the primary balance and a debt increasing snowball effect due to GDP contraction. Stock flow adjustments also contributed to the increase, following accumulation of government assets at the end of 2008 to meet financing needs in early 2009 (Table). Beside less favorable cyclical conditions, resulting in falling tax revenue and increasing expenditures due to the activation of the automatic stabilizers and public investment and the fading away of the asset boom, the reversal was the result of a highly expansionary expenditure policy. In addition to a deliberate fiscal stimulus through higher investment spending of 1.4 percent of GDP, higher wages and social transfers led to a 4.1 percent increase in total expenditure. However, a reduction in the overall surplus occurred already in 2008—when the economy was still overheating—driven by a marked decrease in total revenues as the tax-rich real estate and tourism sectors were hit from the global crisis affecting the main foreign counterparts, namely UK and Russia.


General Government Debt Decomposition

(Percent of GDP)

Sources: Eurostat; and IMF staff projections.

Note: The table shows contributions to the change in gross public debt according to the following decomposition: DtYt -Dt1Yt1 =PDtYt + (Dt1Yt1 *ityt1+yt) +SFtYt Where D, Y, PD and SF indicate the stock of public debt, real GDP, the primary balance, and the stock flow adjustment respectively, and i and y are the cost of debt and nominal GDP growth.

The April 2010 Stability Programme projects a reduction of the overall deficit to 2.5 percent of GDP by 2013. The consolidation is based on expenditure-reducing measures (i.e., a significant reduction in personnel and operational expenses and better targeting of social schemes) and the enhancement of revenues through improved tax compliance and a town planning amnesty. Some of the measures, however, still need to be agreed with stakeholders or have not yet been passed by the Parliament. On May 12, 2010 the European Commission initiated an Excessive Deficit Procedure (EDP) for Cyprus based on the consideration that the current deficit, although exceptional given the adverse cyclical conditions, cannot be considered temporary, and the debt ratio could not be considered as sufficiently diminishing and approaching the reference value of 60 percent at a satisfactory pace.

II. Recent Developments and the Outlook

A. Macroeconomic Developments

3. The economic slowdown has only partially corrected existing imbalances (Figure 3). After experiencing average growth of 4¼ percent over 2004-08, the economy contracted by 1.7 percent in 2009, weighed down by a correction in the real estate market and a sharp decline in the tourism sector. Private consumption growth, the main driver of the expansion in the recent past, evaporated, reflecting leveraged balance sheets, rising unemployment and slowing household credit growth. In the backdrop of weakening demand prospects and deteriorating financing conditions, fixed investment contracted sharply. The inventory cycle was particularly pronounced, as firms reacted with delay to the slowdown in trade partners’ economies. Nonetheless, the domestic correction was partially cushioned by a substantial fiscal relaxation and the reversal in the net export contribution; the current account deficit moderated—although it remained high, at above 8 percent of GDP.

Figure 3.
Figure 3.

Cyprus: Economic Indicators, 2004-2011

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Cystat; IMF WEO; and IMF staff estimates.1/ Includes bank loans to domestic residents.

4. Slack has emerged but cost dynamics have not fully responded to the recession (Figures 4 and 5). Inflation moderated substantially to ¼ percent in 2009 from 4½ percent in 2008, as the economy slowed and oil prices plummeted. The labor market lost pace, with wage growth slowing down to 4.1 percent from 5.8 in 2008 and the unemployment rate rising by 1.7 percentages point to 5.3, although from a level substantially below the euro area average. While the output gap is estimated to have turned negative in the second quarter of 2009, a positive inflation differential with the euro area has reopened since the beginning of 2010 owing to price developments in the non tradable sectors. Real wage growth, which had exhibited significant buoyancy since 2004, moderated in 2009, but remained above euro area levels as wage contracts did not incorporate the entire drop in inflation due to the backward looking inflation-indexed wage adjustment mechanism (COLA, Box 2).

Figure 4.
Figure 4.

Cyprus: Price Developments

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Eurostat; and European Commission, Consumer Survey.1/ Balances are the difference between positive and negative answering options, measured as a percent of total answers.
Figure 5.
Figure 5.

Cyprus: Labor Market

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Eurostat; Cystat; IMF, WEO; and European Comission.

5. The recovery has so far remained elusive, and staff projects slightly negative growth for 2010 to turn only moderately positive in 2011. Short-term indicators suggest that the turnaround in activity has only started to materialize (Figure 6): the construction sector remains depressed; firms continue to be reluctant to invest, constrained both by soft orders and tighter lending conditions; and green shoots in the tourism sector and industrial production have only emerged recently.

Figure 6.
Figure 6.

Cyprus: Short-Term Indicators

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Cyprus Statistical Office; Central Bank of Cyprus, Cyprus Ministry of Finances, Eurostat, and European Commission.1/ The substantial drop in consumer credit growth in January 2010 is due to a major reclassification from consumer credit to other lending causing the reported negative rate for consumer loans. Taking this reclassification into account, consumer credit growth decelerated but remained positive, reaching 3.8 percent in June 2010.
Source: WEO.

B. Public Sector

6. The fiscal deficit widened sharply in 2009, mostly reflecting structural factors (Figure 7). Expenditures rose by some 4 percent of GDP on the back of higher wages and salaries, social transfers, and investment spending. These increases were for the most part permanent rather than one-off or cyclical. Meanwhile revenues fell by 3 percent of GDP, reflecting the economic downturn and the unwinding of exceptional revenues associated with the real estate boom of preceding years. The result was a fiscal deficit of 6.1 percent of GDP—a 7 percent of GDP widening over 2008. The cyclically adjusted primary balance declined by some 6 percentage points in 2009, imparting a large fiscal stimulus.

Figure 7.
Figure 7.

Cyprus: Fiscal Sector

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: European Commission, 2009 Ageing Report; Eurostat; IMF, WEO; Central Bank of Cyprus, Cyprus Ministry of Finance; and Bloomberg.1/ Auction average yields.

Cyprus: Cost-of-Living Allowance (COLA) System

An important element of the wage determination process in Cyprus is the cost-of-living allowance (COLA). Through COLA salaries in the public sector and many salaries in the private sector are linked to average CPI inflation (excluding excise tax increases since the second half of 1999) in the preceding six months twice a year, on January 1 and on July 1. The share of “COLA employees” in the private sector has been on a downward trend, in particular due to an increasing number of foreign workers not covered by the COLA; recent estimates by the Central Bank of Cyprus place at approximately 50 percent the overall share of such employees.

The COLA system is a fairly controversial issue in Cyprus, and it is only in times of real crisis, such as after the military conflict in 1974, that a temporary suspension of the COLA has been possible. COLA is strongly supported by the trade unions, and considered as having contributed to long-term contracts and labor market peace. On the other hand, employer organizations have argued that it has resulted in large increases in real wages and deterioration in competitiveness of domestic firms due to second round inflationary effects, and have expressed concerns that the system undermines flexibility and competitiveness as it impedes relative wage adjustments across firms and sectors in line with productivity differentials. The COLA also imparts inertia to the public sector wage bill, making it more difficult to reverse the excessive growth of public sector wages and salaries. Finally, while there is no firm evidence that COLA contributed to wage-prices spirals, this might have been a result of the prevailing stable inflationary environment of the last years.

The shortcomings of the COLA become more evident in the current low-growth economic environment. By linking wages to CPI rather than productivity, COLA undermines competitiveness and labor flexibility, in addition to exacerbating the level and persistence of price shocks. In addition, downward wages stickiness resulting from the COLA may become an impediment to the economy’s ability to respond to the current low-growth environment. In particular, in the presence of long-duration wage contracts the COLA constrains the markets’ ability to correct an overshooting of wages that may result from too optimistic an outlook at the time of the contract’s inception.

7. The government plans to reduce the deficit to 3 percent of GDP in 2012, consistent with its EU obligations. Under the Excessive Deficit Procedure (EDP), the EU has asked Cyprus to bring its fiscal deficit down to 4.5 percent GDP in 2011 and 3 percent of GDP in 2012. Cyprus is due to report back to the EU in January 2011 on its plans for achieving this consolidation.

8. The authorities have taken steps to stabilize the deficit, but additional and as yet unidentified measures will be needed to reach the fiscal targets. The government has taken some initial steps toward consolidation, including reduction in public employment by 500 in 2010 with additional reductions planned for 2011“12, and zero general wage increase for public employees3 in 2010–11 (its proposals for a temporary hike in the corporate income tax rate from 10 to 11 percent and higher property taxes were rejected by parliament). The budget will also benefit from the imposition of an excise tax on petroleum imports and the expiration in 2011 of temporary reductions in tourism sector VAT rates. While these measures will help to stabilize the deficit, further actions will be needed to reach the deficit targets for 2011 and 2012.

Annual Revenue Impact of Measures

(Millions of euros)

Sources: Ministry of Finance; and IMF staff estimates.

9. While the social security system is currently in surplus, despite the 2009 reform it is unsustainable over the long term (see Annex), and even in the medium term declining surpluses will put pressure elsewhere in the budget. The social security system surplus is currently 3-4 percent of GDP, as contributions by employers, workers, and the government exceed outlays. Over the coming decades to 2060, pension outlays are projected to rise by some 10 percentage points as the system matures and demographic changes play out. Unless other area of government spending are curtailed, this would raise total government spending to some 60 percent of GDP in 2060—a very high level that could be sustained only with a heavy increase in the tax burden.

10. Pressures in Euro zone sovereign debt markets have spilled over to some extent to Cyprus, but the risk of imminent financing pressures appears contained. There has been a modest widening of credit spreads over the past year, though by less than Greece, Portugal, and Spain. Also, adverse market conditions led the authorities to postpone until late 2010 a European Medium Term Note (EMTN) issuance originally planned for the summer. The authorities do not view sovereign funding pressures as a significant risk, in light of a relatively light amortization schedule. They are also confident that, if external markets remain difficult, they can issue domestic debt to the local financial sector. Staff broadly share this assessment, although access to domestic funding sources could become more difficult if risks to the financial sector from exposure to Greek assets (Box 3) and to the local real estate market materialize.

Public Debt Rollover Requirements

(Millions of euros)

Sources: Ministry of Finance; and IMF staff estimates.



10 Year Bond Spread Versus Germany


Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Bloomberg; and IMF staff calculations.

C. Financial Sector

11. Cyprus’ banking sector—the core of the financial sector—is complex owing to its role as an international and regional financial center. It poses risks by virtue of its size and concentration, but its capitalization appears adequate. Only a small number of commercial banks have Cyprus as their home country; the rest are branches or subsidiaries of foreign banks (predominantly from Greece). Local banks, banks whose home country is Cyprus, have assets equivalent to 639 percent of GDP; three of them incorporated locally but operating internationally dominate the sector. The risk-weighted capital adequacy ratio (CAR) of the commercial banking system is adequate (11.9 percent at the end of March 2010), but profitability has declined due to low interest margins (partly induced by competition on deposit rates with Greek banks and, more recently with cooperative credit societies, Figure 8), mark-to-market losses on assets, and provisions for non-performing loans (NPLs).

Figure 8.
Figure 8.

Cyprus: Financial Indicators

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Bloomberg; Central Bank of Cyprus; ECB; IMF, IFS; and IMF staff calculations.1/ Cyprus Stock Exchange.2/ Average of rates for loans up to and over euro 1 million.3/ Only non resident deposits for Cyprus.

Cyprus: Banking System Structure

(Millions of euros, unless noted otherwise) 1/

Source: Central Bank of Cyprus.

As of end of May, 2010.

Cyprus: Spillovers from Greece

While the Cypriot economy is exposed to developments in Greece through several channels the main spillovers will be felt through the banks’ balance sheets.

  • Trade channel. Greece is Cyprus’s third-largest tourism market and the largest market for exports of goods. However, the trade effects are expected to be limited given that Greece only accounted for 6.2% of tourist arrivals in 2009 and while it accounted for 18 to 20 percent of total exports, exports of goods account for less than 6 percent of GDP.

  • Interest rate spreads channel. Greek banks have a significant and growing presence in Cyprus. As they have had to compete with the high interest rates offered by their own government for funds, they have increased interest rates on deposits, both in Greece and in Cyprus. In order to maintain market share, the Cypriot banks have also had to respond with higher rates, which has contributed to higher deposit rates in Cyprus compared with the euro zone average.

  • Banking sector channel. The main spillovers will be felt through the banks’ balance sheets in view of the high level of cross-border activities. As of end of 2009 overseas operations of Bank of Cyprus, Marfin Popular Bank and Hellenic Bank represented 45 percent, 63 percent and 24 percent of their consolidated group assets, respectively. Moreover, loans and advances granted by these banks to Greek customers reached 38 percent, 53 percent, and 22 percent of total group loans, respectively, corresponding to direct lending of €23 billion. Additionally, local commercial banks were holding €5.5 billion of Greek government bonds and €0.5 billion of Greek bank bonds as of March 2010. Furthermore, subsidiaries of foreign, mostly Greek, banks have high exposures to Greece as well: these are €1.3 billion in direct loans, €6.6 billion of Greek government bonds and €6.5 billion in Greek bank bonds. Finally, local commercial banks have €1.5 billion worth of interbank exposure to Greece, while subsidiaries of foreign banks have €11 billion of such exposure representing placements with their parents. Overall gross exposure to Greece, not including interbank loans, is estimated to be 260 percent of GDP.

Staff estimates suggest that under an adverse scenario cumulative losses on Greek exposure for local banks could be of the order of €2.0 billion (equivalent to about 12 percent of GDP and 30 percent of equity) by 2013-2014. This estimate is based on cumulative loan losses in combination with market losses on securities, based on the latest available CBC data with 23.5 percent of securities are held at fair value. For direct loans to Greek households and corporates, a cumulative loss is estimated as €1.6 billion, based on a projection that NPLs could double from the present level of 7 percent by 2013-2014, and assuming a recovery rate of 50 percent. For securities, mark-to-market (MTM) losses are estimated based on changes in pricing of Greek securities held at fair value over October 2009 through July 2010. Losses for subsidiaries of foreign, mostly Greek, banks on Greece exposure are estimated at a further €0.2 billion. These banks are only holding 1. 5 percent of securities at fair value.

Estimated Exposure of Local Commercial Banks to Greece 1/

Sources: Central Bank of Cypus; dealer reports; and IMF staff estimates (July 2010).

Excludes interbank loans. In billion of euros unless otherwise indicated.

Estimated Exposure of Cyprus Subsidiaries of Greek Banks to Greece 1/

Sources: Central Bank of Cypus; dealer reports; and IMF staff estimates (July 2010).

Excludes interbank loans. In billion of euros unless otherwise indicated.

12. While the banking sector has continued to weather the crisis relatively well NPLs are rising. Despite recent decline in profitability return on equity remains high compared to other euro area banking sectors. Liquidity ratios also appear comfortable. A business model with high reliance on retail deposits has helped to shield the sector from the global crisis and in recent months banks have gained non-resident deposits largely owing to weaker conditions in Greece. Nevertheless, negative growth in Cyprus has led to rising NPLs in commercial banks (4.9 percent at end March 2010 compared with 3.6 percent at end-2008), and they may rise further until growth resumes. Furthermore, exposure to Greece is significant (estimated to be at least as high as 260 percent of GDP) which creates additional pressure on NPLs. NPLs reported by cooperative banks (9.2 percent at end-March 2010) are higher, and weaker classification norms than for commercial banks strongly suggest that they are significantly understated.4

13. In anticipation of deteriorating asset portfolios banks have acted defensively. They have lowered dividend payout ratios, although the tax regime favors dividend payouts over retained earnings; cut operational costs, strengthened non-interest margins, and bolstered fee-based activities to support net income; increased loan loss provisions and tightened underwriting standards; and have been able to attract deposits from Greece owing to perceived safety of the banking system.

14. The government has facilitated the securing of cheap ECB funding by issuing to the banks close to €3.0 billion worth of bonds (equivalent to about 18 percent of GDP, but only 2 percent of the assets of eligible institutions) against high-quality collateral consisting of performing loans which must be replaced if they become non-performing. The bonds, which banks have pledged at the ECB in part to obtain cheap funding and lower their average cost of funds, are recorded as a securities lending transaction. In the event that the loss for the government becomes large, or if the scheme is extended beyond its original date, the bonds may have to be recorded in the government debt.

15. Regular stress tests conducted by the CBC indicate that commercial banks have the capacity to absorb further shocks,5 but the resilience of the cooperative credit societies is harder to assess. According to the CBC, the average CAR would remain above the regulatory minimum even in the event of a doubling of NPLs and assuming a 50 percent recovery rate, which is slightly lower than current levels. On the other hand, stress tests carried out by the supervisor for cooperative credit societies are less stringent and results are difficult to compare with those for commercial banks due to the differences in the definition of NPLs, the size of the shocks, and recovery rate assumptions.

16. Progress in strengthening financial supervision, crisis management and contingency planning has been uneven. The deposit insurance schemes were strengthened in July 2009, placing them on a par with similar schemes in the EU; a number of improvements in the supervisory framework for commercial banks have been adopted; a draft law facilitating government intervention in case of a financial crisis is expected to be passed in early 2011. However, no progress was made regarding a previous Fund recommendation to move to one single independent supervisor for banks and cooperative credit societies.

D. External Position

17. The current account deficit moderated to -8.3 of GDP in 2009 as the economy contracted, from a peak of -17.5 percent in 2008. Although temporary and technical factors6 partly explain the large headline numbers in 2008, the foreign trade figures in 2009 reflect the weakness of domestic import demand and lower global commodity prices as well as sluggish demand from Cyprus’s main trading partners. As a result the goods trade deficit improved substantially and the service trade surplus worsened. The value of imports for domestic consumptions fell by 21.1 percent with the steepest decline recorded by transport equipment, fuels, and intermediate goods, reflecting a decline in car registration and lower international oil prices compared to 2008. Total exports fell by 11.9 percent, with construction and information services accounting for most of the drop in the services balance while insurance and financial services increased.

18. Persistent current account deficits point to competitiveness problems while the reliance on short-term bank-related inflows to finance the deficit is a source of macro-financial vulnerabilities. While Cyprus’ market share in the export of services has remained broadly constant, large surpluses in the service sectors have only partially offset persistently large goods trade deficits. The rapid rise in labor cost has hurt manufacturing production more than the services sector. Bank related inflows, including non-resident deposits with resident financial institutions, have been the main source of financing of the current account deficit, thus making the external position highly vulnerable to a shift in market sentiment towards Cyprus.

19. Although Cyprus real exchange rate appreciation follows the trend in Southern Europe (Figure 9), it was particularly harmful for the manufacturing exports and also affected the tourism industry. Wages have outstripped productivity gains in recent years, leading to an appreciation in the ULC-based real exchange rate and pricing Cypriot goods out of international markets. However, wage increases reflect to some extent the labor shortages and low unemployment rates that prevailed before the crisis. Tourism exports are also on a declining trend, reflecting comparatively high prices, heavy dependence on a weakened British market and increased competition from other destinations in the Mediterranean. However, other services sectors, including finance and shipping, continue to be competitive and profitable.

Figure 9.
Figure 9.

Cyprus: Competitiveness

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Central Bank of Cyprus; IMF, Driection of Trade Statistics; and European Comission.

Harmonized CPI


Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001


REER ULC-based, Manufacturing

Index, 1999=100

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001


REER ULC-based

Index, 1999=100

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Source: European Commission

20. CGER type estimates suggest that Cyprus is facing a competitive disadvantage, although there are mitigating factors. All estimates indicate the same directional conclusion, with negative current account gaps and substantial exchange rate overvaluation, consistent with recent development in wages and the competitive deterioration in the manufacturing sector. However, the large current account swing in 2009 (from -17.5 to- 8.3 percent of GDP) suggests that significant current account adjustments can occur in Cyprus without major changes in the exchange rate (or slower growth relative to trading partners). Moreover, CGER type analysis needs to be interpreted with care for services exported-oriented economies, since service exports may be less responsive to exchange rate dynamics.

CGER-type Estimates

Source: IMF staff estimates.

Difference between actual current account balance (CAB) and the estimated equilibrium CAB in percent of GDP

Percentage difference between the actual REER and the estimated equilibrium REER. A positive result suggest overvaluation.

E. Outlook and Risks

21. Modest growth is projected to resume in the second half of 2010. Staff forecasts a further 0.2 percent contraction of activity in 2010, with below-potential growth returning in 2011. The Ministry of Finance (MoF) projects positive growth to resume in 2010 but the CBC is less sanguine. The domestic recovery is likely to be driven by the global economic upturn, private consumption and investment. Domestic demand growth would remain modest, though, as private balance sheets remain leveraged, leaving little buffer against future shocks. In particular, while households’ debt servicing capacity remains relatively adequate, it could rapidly deteriorate if downside risks to growth and the labor market outlook were to materialize, and at the corporate level a combination of weak profits and high leverage is a source of vulnerability. As a consequence, demand for foreign goods is expected to remain subdued.


Real GDP growth

(Year on year percent change)

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Eurostat; and IMF staff projections.

Real GDP (Percent change)

Sources: Commission Services’ spring 2010 forecasts; Stability Programme of Cyprus 2009-2013; and IMF staff projections.

22. Inflation is projected to accelerate in 2010 driven by the higher cost of imported oil and commodity prices, against the backdrop of a still depressed domestic demand. Despite a widening negative output gap in 2010, harmonized consumer price inflation is expected to increase to 2.2 percent due to a base effect, the increase in oil and commodity prices, rising health and education costs. Such factors, along with Cyprus’ high dependency on imported energy will drive headline inflation higher in Cyprus than the expected level for the euro area. While the reopening of the inflation differential with the euro area (Figure 4) will erode the competitiveness of Cyprus, given last year’s near zero inflation and the backward looking inflation-indexed wage adjustment mechanism, wage inflation should remain subdued in 2010.

23. Staff forecasts the current account deficit to follow a gradually improving trend over the medium term after a realignment of more than 9 percent of GDP in 2009. Although commodity prices will contribute to inflate imports in 2010, import volumes are projected to decrease due to declining domestic demand while the recovery in foreign demand will induce a turnaround in exports. If the exchange rate overvaluation persists, however, a shift from domestic to foreign goods and services, with consequent trade balance deterioration, cannot be ruled out. Unless market sentiment towards Cyprus were to deteriorate significantly, bank related short-term capital inflow can be expected to provide the necessary current account financing based on actual developments in the first quarter of 2010, where Cyprus benefited from increased short-term capital inflows, in particular from residents of the euro area. However, such a structurally precarious nature of current account financing reinforces the need for fiscal consolidation, as well as high capital buffers in the financial sector to anchor foreign investors’ confidence.

24. Medium-term growth may suffer from deterioration in potential output following the global crisis, and it is expected to remain sluggish. Subdued private consumption and investment, in tandem with hesitant foreign demand for Cyprus’ exports, will weigh on growth. Cyclical conditions are projected to feature negative output gaps until 2015 as growth return to its potential. The latter, however, is likely to have suffered from the fall in economic activity in 2009, reflecting a decrease in labor contribution and lower capital stocks as a result of obsolescence and the drop in investment. Unemployment, which climbed to 5.6 percent in 2009, is expected to rise to 7.8 in 2010 and stay above its historical average for some time. Fixed investment growth is forecasted to remain in negative territory this year after plummeting in 2009. Productivity, on the other hand, is unlikely to positively contribute to potential growth given its pro-cyclical nature and the already low levels of private investment on R&D in Cyprus due to the small size and service orientation of the economy.

25. Staff sees downside risks to the outlook on account of five main risk factors. First, the projected recovery for 2011 is vulnerable to spillovers from Greece due to the high exposure of the financial sector to Greek assets (about 260 percent of GDP). Second, the fiscal consolidation that is needed to reverse the structural deterioration will weigh on an already sluggish domestic demand. On the other hand, if the consolidation measures proposed by the government were not to materialize, increased levels of public debt in the current market environment could undermine investors’ confidence about fiscal sustainability, in turn making it difficult for the government to finance the deficit. Third, a rebound in the tourism and construction sector (which contributed significantly to growth in recent years) could fail to materialize if the demand from UK and Russia residents remained tepid due to a weaker than anticipated recovery in these countries. Fourth, medium- and long-term growth prospects could weaken if the 2009 recession has structurally lowered potential growth, and Cyprus could be facing years of more subdued potential as well as actual growth. Finally, public debt levels could increase significantly if the government securities that have been issued to the banks had to be recorded in the government debt.

III. Policy Discussions

26. The main policy priorities should be to stabilize public debt at a more prudent level and boost competitiveness, while safeguarding the stability of the financial sector. Cyprus entered the crisis in a position of strength, including public debt below 50 percent of GDP and a positive net international investment position (IIP). But to continue to benefit from euro area membership and prepare for aging-related spending pressures will require reversing the recent structural deterioration in public finances, rebalancing the private saving–investment disparity, and addressing the structural causes of the competitiveness gap. Strong financial sector oversight and early detection of problems is also needed given the size of the banking sector in relation to the economy and a weakened outlook for the sector. Structural reforms are needed to preserve competitiveness and enhance medium-term growth.

A. Adopt a Credible Medium-Term Fiscal Consolidation Strategy

27. Staff believe the authorities’ goal of reducing the fiscal deficit to 4.5 percent of GDP in 2011 and 3 percent in 2012 is appropriate. This consolidation is needed to minimize the risk that fiscal financing pressures will emerge, provide more space to guard against risks to the financial sector, and stabilize debt ratios. Further action will be needed to put debt ratios on a declining path.

  • Public debt (56 percent of GDP in 2009) is moderate relative to the Euro area average (79 percent of GDP), but it has risen sharply over the past two years. Achieving the fiscal targets would stabilize debt at 63 percent of GDP in 2012. Further consolidation in future years would be needed to put it on a downward path.

  • Although public financing pressures do not appear to be an imminent threat, the growing pressures in Euro area sovereign debt markets and the increased focus of investors on fiscal imbalances argue for decisive consolidation.

  • The large size of the financial sector and risks to its balance sheet suggest the government should maintain fiscal space so that it is positioned to provide support to banks, if needed.

Structure of Public Expenditure, 2010

Sources: Ministry of Finance; and IMF staff estimates.

28. To achieve the authorities’ fiscal targets, staff advised that additional measures focus on public expenditure, in particular through reductions in the government wage bill and better targeting of social transfers. The relatively large size of the public sector (close to 50 percent of GDP), the gradual increase of pension outlays as the system matures and the population ages, and the need to maintain a favorable tax regime to attract investment (Box 4) all argue for a focus on expenditure measures. Given the dominant share of government wages and salaries and social transfers in the budget, these sectors will need to absorb the bulk of adjustment. Options that should be pursued include adjustments to the incremental salary step increase schedule and to the COLA for public workers; the introduction of contributions by government employees toward their unfunded pension benefits; reducing lower priority capital expenditure (which was boosted by 1.4 percent of GDP in 2009 as a stimulus measure and remains one percent of GDP above its pre-crisis level); and restraint on other goods and services. Finally, if expenditure measures are inadequate to close the gap, an increase in the VAT from 15 percent (the lowest in the EU) to 16 percent would contribute some 0.6 percent of GDP.

Impact of Possible Measures on 2012 Fiscal Balance

(Millions of euros)

Sources: Ministry of Finance; and IMF staff estimates.

29. The authorities recognized the need for additional measures to reach their targets, but they had not yet formulated a specific strategy. They also were more optimistic that consolidation could be met through general spending restraint, with less focus on the public payroll.

B. Enhance Early Detection of Problems in the Financial Sector

30. The outlook for the financial sector has weakened. There was broad agreement that commercial banks are exposed to further deterioration of loan portfolios in Cyprus and in foreign markets. However, stress test results suggest that they have the capacity to absorb further shocks. Furthermore, information provided by the systemically important commercial banks indicates that managers have incorporated in their business plans a significant increase in NPLs and are taking appropriate actions (see paragraph 13) in response to deteriorating market conditions which should support capacity for credit extension.

31. Cooperative credit societies may be more at risk than commercial banks. While they would only be affected by conditions in Cyprus, a combination of weak underwriting standards as evidenced by high NPLs using a weak definition, lower overall CAR, and significantly higher NPLs ratios net of provisions suggest that risks for the sector are higher than for commercial banks.

32. The authorities are confident that the banks should be in a position to exit ECB funding smoothly. They indicated that the use of the special government bonds had been limited to 7 percent of individual banks’ customer deposits. They noted that the special government scheme was designed to help banks secure cheap ECB funding in the absence of covered bond legislation at a time when banks in other euro area countries had been able to use covered bonds to access funding from markets or the ECB. Covered bond legislation is expected to be passed in late 2010, allowing Cypriot banks to avail themselves from such funding sources and providing for an exit strategy to unconventional ECB funding.

Cyprus: Tax Regime

Cyprus’ favorable tax regime, together with an open stance toward foreign investors, is a key feature of the country’s business model. It has been an important factor behind the transformation of the economy from an agricultural base in the 1960s, to an industrial base until the mid-1980s, and a services base economy thereafter, with services accounting for 79.3 percent of GDP in 2009. Key features of the tax regime are as follows:

  • Personal income tax. Cyprus has a personal income tax with a progressive rate structure. The top rate of personal income tax is low, at 30 percent, and the tax-free threshold for income is high, at €19,500. Capital gains, dividends, interest income and income from the sale of securities are exempt from income tax. Dividends and interest are taxed under the Special Contribution for the Defense of the Republic Law and a capital gain tax is levied on the realized profit from the disposal of immovable property in the Republic and/or securities.

  • Corporate income tax. With a flat corporate tax rate of 10 percent, Cyprus (together with Bulgaria), has the lowest corporate tax rate in the EU. Seventy percent of undistributed corporate profits of year t-2 are subject to a 15% tax.

  • Defense Contribution. All residents are subject to the Defense Contribution, which is applied with different rates on dividends, interest and rental payments.

  • Value-added tax (VAT). In 2003 the standard VAT rate was raised to the EU minimum of 15 percent for most categories of goods and services. But in 2009 VAT on hotels and restaurants was reduced from 8 to 5 percent on a temporary basis and in 2010 the reduced rate still applies to hotels only; to alleviate the negative effects of the crisis on the tourism sector; airport landing fees levied on airline companies were decreased; and overnight stay fees levied by local authorities cancelled. VAT rate on certain locally produced labor intensive services was lowered to the reduced rate of 5% on a permanent basis. Under EU rules, Cyprus was due to introduce VAT on residential land during 2008 but has yet to implement the legislation. Cyprus is also due by 2011 to introduce the reduced VAT rate on foodstuffs and pharmaceutical that are currently zero rated.

  • Social security contributions. Employers’ social security contributions are due for the Social Security Fund, redundancy fund, central holiday fund and for the Human Resource Development Fund. Altogether, the employers’ contribution rate amounts to 8.5 percent of gross wages. Employers must also pay a payroll tax (2 percent of gross wages) to the social cohesion fund, which is not deductable for corporate income purposes. Employees pay 6.8 percent of their salary and the self-employed pay 12.6 percent of their notional income. Social security contributions of employed and self-employed are augmented by a 4.3 percent payment of the state, although total contributions will rise by 1.3 percent every five years until 2039.

  • Other features of the tax regime that have attracted foreign companies include the fact that Cyprus International Trusts, a type of offshore holding company, are exempt from tax in Cyprus, and there is no taxation on dividends for non-residents. A special tax regime applies to shipping companies.

  • Cyprus also has double taxation agreements with over 40 countries.

Source: staff analysis based on data from The Economist Intelligence Unit, Country Forecast Report, May 2010; and European Commission, Taxation trends in the European union, 2010 Edition.

33. The authorities may wish to consider boosting the size of the deposit insurance facilities in view of the recent increase in coverage. Given the increase in the size of insured deposits from €20,000 to €100,000 per depositor per bank, and the extension of coverage to deposits denominated in all currencies and to deposits of non-euro area residents, the present size of the deposit insurance facilities, €100 million for commercial banks and €20 for cooperative credit societies, are below a threshold of 1 percent of coverage provided, which is generally used as a guiding principle. The authorities have indicated that, in case of need, banks may be requested to pay additional capital, which would raise the size of the facility to 3 percent of coverage provided. However, the authorities may wish to take steps to bolster the size of the facility proactively.

34. Staff and the authorities agreed that preserving the stability of the banking sector through continued strong supervision and early detection of risks should remain a top priority. Given the large size of the banking sector relative to the economy if problems emerged they could escalate to systemic proportions with spillover to the economy and to public finances. Policies should therefore focus on addressing areas of potential concern early. The following points were noted:

  • Ongoing initiatives for cross border cooperation with Greece and other Southeastern European supervisors should be pursued purposefully. In that context, supervisors should agree to procedural mechanisms for the coordination of cross-border resolution actions, including procedures for information sharing and rules to determine which jurisdiction’s competent authorities would assume a lead role in resolving a particular cross-border bank.

  • The draft law facilitating government intervention in case of a financial crisis submitted to Parliament should be passed as soon as possible; an operational manual spelling out the process to be followed in a crisis situation should be developed at the CBC.

  • Measures to bolster the supervision and transparency of the cooperative credit societies are needed to help reduce risks and to ensure a level playing field in the financial sector. That should include aligning the definition of NPLs, and the stress test and financial reporting frameworks in place for cooperative credit societies with the regime applied to commercial banks. Ultimately, a single independent supervisor for all credit institutions operating in Cyprus would help achieve these objectives.

C. Implement Structural Reforms to Boost Competitiveness

35. The authorities agreed with staff that growth of wages and labor costs in excess of productivity increases has reduced competitiveness, particularly in the manufacturing and tourism sectors. They also acknowledged the need to reverse the steady growth of public sector wages and employment so as to protect the low tax environment needed to attract investment, and reduce wage pressures in the economy. Staff also noted that wage settings mechanisms ensuring a closer link between wages and productivity development than currently provided by the COLA system should be promoted.

36. Staff noted that measures to increase labor market flexibility, streamline the regulatory framework, reduce red tape and enhance the business climate would bolster potential growth over the medium term. In particular, improving the functioning of the labor market through active labor market policies targeted to young workers and low skilled immigrants would help address the current increase in unemployment and support long-term growth potential, while measures to reduce the high gender pay gap would contribute to improve the overall business climate. The authorities’ policy agenda in this regard includes measures to support employment, raise expenditure in R&D, increase the share of population having completed tertiary education, and reduce early school leavers. The authorities are also implementing measures to enhance energy efficiency.

IV. Staff Appraisal

37. The foremost policy challenge is to reverse the large structural fiscal deficit that has emerged. Cyprus compares favorably compared to other euro area countries (Box 5), in particular with relatively moderate public debt levels, but it must act forcefully to preserve this favorable legacy, protect debt sustainability, and provide more space to guard against risks to the financial sector. While the official fiscal target of a 3 percent of GDP deficit in 2012 is appropriate, the government needs to confront the hard choices required to realize this objective so as to stabilize debt ratios, and to build public support for the necessary measures. Further action will be needed to put debt ratios on a declining path over the medium term.

38. Further reforms of the pension system are needed. The 2009 reform was a first step, but absent more fundamental reforms, the pension system will be a growing strain on public finances. A lasting solution requires bringing outlays more in line with contributions, through lower replacement rates and higher retirement age.

39. The banking sector remains sound for now, but risks have significantly risen. This calls for continued efforts on the part of the authorities for early detection of problems, close cooperation with other supervisors, and enhanced contingency planning. The supervision and transparency of the cooperative credit societies need to be strengthened as a matter of urgency with a view to put in place a regulatory regime that is consistent with that for commercial banks. Until this is achieved, it will be difficult to assess the risks to the economy that the sector generates as well as the actions that may be warranted to mitigate those risks. Furthermore, ensuring a level playing field in the financial sector would help contain the potential for unhealthy competition for deposits, contribute to lowering deposits rates in Cyprus, and reduce the incentives for recourse to ECB liquidity.

40. Structural reform to preserve competitiveness will support the recovery and enhance growth potential. A key part of this agenda will be restraining public sector wages and employment. Ensuring real wage flexibility is also essential to deal with the current exchange rate overvaluation. Improving labor market functioning through active policies will help address the increase in unemployment.

41. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

Cyprus: Comparison with Selected Euro Area Countries

This box compares Cyprus to Euro area averages and other peripheral Euro area (EA) countries whose sovereign debt markets have come under stress. It concludes that Cyprus compares favorably on balance across several indicators of vulnerability.

Since 2000, including during the global financial crisis, Cyprus GDP growth and unemployment developments compared favorably with other countries in the Euro zone. Cyprus GDP growth has averaged 3.2 percent since 2000 against 1.4 percent in the overall EA and unemployment was at 4.4 percent compared to 8.4 in the EA. Even during the global financial crisis, Cyprus outperformed its peers: unemployment increased to 5.4 percent in 2009 from 3.7 in 2008, compared to 9.4 percent in the EA, and the decrease in real GDP was only 1.7 percent versus 4.1 in the EA.

Despite large current account deficits in international comparison, Cyprus IIP remains positive. Cyprus current account has recorded recurrent deficits over the last decade — -6.9 percent of GDP on average in 2000-08 versus -0.2 in the Euro zone — and it deteriorated significantly (to 17.5 percent of GDP) during the economic boom in 2008, and narrowed to 8.3 percent when the crisis hit Cyprus in 2009. While the current account deficit as a percent of GDP was high in international comparison in 2009 (-0.75 percent of GDP in the Euro zone), Cyprus IIP was still positive at 4 percent versus significantly negative IIPs in other EA countries.


Unemployment Rate


Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: WEO; and IMF staff calculations.

Real GDP Growth


Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001


Current Account Balance and IIP

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: WEO; and IMF staff calculations.

Fiscal Balance and Public Debt, 2009

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: WEO; and IMF staff calculations.

10 Year Bond Spread Versus Germany


Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: Bloomberg; and IMF staff calculations.

Relatively small fiscal deficits and moderate public debt levels differentiate Cyprus from some of the most vulnerable euro area countries. Although the fiscal deficit increased significantly in 2009 due to the rapid growth of government spending and the aftermath of the real estate boom, it is moderate compared to fiscal deficits in most EA countries. At 56 percent of GDP in 2009, public debt is also well below the EA average of 78.7, although on an increasing path due to projected primary deficits and slower GDP growth in coming years. Financing needs are also limited due to the small size of the economy.

All in all, Cyprus appears relatively robust compared to other peripheral EA countries. This assessment is consistent with market perceptions of the economy as reflected by comparatively low sovereign spreads.

Figure 10.
Figure 10.

Cyprus: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2010, 291; 10.5089/9781455206414.002.A001

Sources: International Monetary Fund, country desk data, and 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. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.
Table 1.

Cyprus: Selected Economic Indicators, 2005–2015

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

Contribution to growth.

Does not include special government bonds issued at the end of 2009 as a liquidity support measure fior the financial sector, in an amount equivalent to 18 percent of GDP.

Table 2.

Cyprus: Fiscal Developments and Projections, 2005–2015

(Percent of GDP)

Sources: Eurostat, and IMF staff estimates.

Does not include special government bonds issued at the end of 2009 as a liquidity support measure fior the financial sector, in an amount equivalent to 18 percent of GDP

Table 3.

Cyprus: Balance of Payments, 2005–2015

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

2008-09 data reflect the transitions between Greek banks and their subsidiaries in Cyprus.

Table 4.

Cyprus: Financial Soundness Indicators, 2005–2010 1/


Sources: Central Bank of Cyprus; and Authority for the Supervision and Development of Cooperative Credit Societies.

Data for 2005 onwards are for deposit-takers compiled on a domestically-controlled, cross-border consolidation basis do not include the cooperative credit societies and foreign-controlled banks.

Data for 2008 and onwards are for deposit-takers compiled on a cross-border and cross-sector for all domestically incorporated institutions. Due to methodological changes the data for 2008 and onwards is not comparable with historical data.

The numbers are not fully comparable over time. The threshold for classifying loans as non-performing was changed from 6 months in arrears to 3 months in 2006. Data 2005 onwards are compiled according to the methodology and specifications provided in the IMF “Compilation Guide on Financial Soundness Indicators.” The decline in nonperforming loan (NPL) ratios since 2005 reflects stricter lending criteria, repayments and write-offs of NPLs as well as denominator effects (growth in capital/loans).

Non-performing loan dat