IMF Executive Board Concludes 2010 Article IV Consultation with 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.


Following the economic downturn of 2009 when the global crisis began to affect Cyprus, the economy is projected to bottom out in 2010, giving way to a mild recovery in 2011 and stronger growth thereafter. After experiencing average growth of 4¼ percent over 2004-08, the economy contracted by 1.7 percent in 2009 as trade partners became increasingly affected by the global slowdown, leading to a sharp contraction of the tourism and construction sectors. Looking forward, increased unemployment along with decelerating consumer credit and the negative confidence shock will weigh on private consumption; investment is expected to be subdued due to continued weakness in the property market and construction sector; and public consumption will be restrained due to fiscal consolidation. Growth is expected to be flat in 2010, followed by a modest recovery in 2011 and a gradual acceleration in later years. The current account deficit, which was cut by more than half in 2009, will likely stabilize in 2010, and decline gradually toward more sustainable levels over the medium term.

The fiscal deficit widened sharply in 2009, mostly reflecting structural factors. In particular, expenditures rose sharply 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, reflecting the economic downturn and the unwinding of exceptional revenues associated with the real estate boom of the preceding years. The cyclically adjusted primary balance declined by some 6 percentage points in 2009, imparting a large fiscal stimulus and resulting in a fiscal deficit of 6.1 percent of gross domestic product (GDP). Consequently, Cyprus was placed under the Excessive Deficit Procedure of the European Union, which prompted the government to adopt a program of fiscal consolidation aimed at reducing the fiscal deficit to 4.5 percent of GDP in 2011 and below 3 percent in 2012. The government has already taken steps to stabilize the deficit in 2010; additional measures will be needed to reach the 2011 and 2012 fiscal targets.

The financial sector has continued to weather the impact of challenging regional and global market conditions relatively well due largely to a traditional business model for banks, which is based on lending mostly funded by deposits; relatively high banking system capital and liquidity; and strong supervision by the Central Bank of Cyprus (CBC). However, although the outlook for the sector has weakened somewhat over the past year owing to a deterioration of loans granted in Cyprus and in foreign markets (particularly Greece), stress tests suggest that they have the capacity to absorb further shocks. While cooperative credit societies would only be affected by conditions in Cyprus, a combination of weak underwriting standards and lower overall levels of capital suggests that risks for that sector are higher than for commercial banks.

In the absence of a legal framework for covered bonds in Cyprus, the government has facilitated banks’ and co-operative credit societies’ access to liquidity by issuing government bonds to them against high-liquidity collateral. Banks and co-operative credit societies have used these bonds to access funding by the European Central Bank (ECB), in part to lower their average cost of funds, at a time when deposit rates in Cyprus are higher than the euro zone average.

Growth of wages and labor costs in excess of productivity increases has eroded competitiveness particularly in the manufacturing and tourism sectors. Furthermore, the steady growth of public sector wages and employment poses risks for the low tax environment that is needed to attract investment and generates wage pressures in the economy. These developments point to the need to promote wage settings mechanisms which link wages to productivity developments rather than the current inflation-indexed wage adjustment mechanism, starting with the public sector.

Executive Board Assessment

Directors welcomed signs that the Cypriot economy is beginning to bottom out in 2010, leading to a modest recovery in 2011. The near-term outlook is still fragile as global financial risks remain elevated and growth prospects in trading partners muted, while a positive inflation differential with the euro area has reopened. Returning the economy to its potential growth depends critically on a credible fiscal consolidation, continued market confidence in the financial sector, and structural reforms to improve competitiveness and the business climate.

Directors agreed that the immediate policy challenge is to reverse the large structural fiscal deficit following the sizeable stimulus in 2009, with a view to preserving debt sustainability and creating fiscal space to guard against financial sector risks. They welcomed the government’s commitment to reduce the deficit to below 3 percent of GDP by 2012, consistent with its EU obligations. Noting that this would require more forceful action, Directors encouraged the authorities to lay out specific measures to achieve their goal. Containing the wage bill and better targeting social transfers were seen as important elements. More fundamental reforms of the pension system would also be needed to lessen the burden on public finances, through lower replacement rates and higher retirement age.

Directors observed that the banking sector remains sound and retains a capacity to absorb further shocks, as suggested by stress test results, including those conducted in the context of the EU-wide exercise. However, risks have risen significantly both in Cyprus and in the region. In light of the relatively large size and external exposure of Cyprus’ financial sector, these risks call for continued vigilance, close cooperation with foreign supervisors, and an enhanced framework for crisis management and contingency planning, including for cross-border banks. Consideration could be given to enlarging the deposit insurance facility. Directors also highlighted the urgency of strengthening the supervision and transparency of cooperative credit societies. The recent modification of the definition of nonperforming loans for cooperative credit societies was a welcome step toward aligning it to the norm in place for commercial banks. Directors encouraged further progress in creating a level playing field in the financial sector.

In light of the still large current account deficit, Directors stressed that structural reforms aimed at boosting competitiveness would be crucial for supporting the recovery and enhancing growth potential. Key priorities include restraining public sector wages and employment to free resources for the private sector, and phasing out the wage indexation system to allow wages to reflect productivity gains. Active labor market policies, aimed particularly at addressing skill mismatches, should help reduce unemployment.

Public Information Notices (PINs) form part of the IMF’s efforts to promote transparency of the IMF’s views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

Cyprus: Selected Economic Indicators, 2005–10

(Annual percentage change, unless otherwise indicated)

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

Data for 2010 are projections.

Excludes special government bonds issued at the end of 2009 as a liquidity support measure for the financial sector in an amount equivalent to 18 percent of GDP.

Since 2008, data refer to the average of MFI interest rates on new-business deposits up to 1 year.

Since 2008, data refer to the average of MFI interest rates on new-business loans up to 1 year.

Age Bakker, Executive Director for Cyprus, and Yoav Friedmann, Senior Advisor to Executive Director for Cyprus, submitted the following statement:

The Cypriot authorities would like to thank staff for fruitful discussions in Nicosia. The authorities share many of staff’s views and broadly agree with the staff appraisal.

The hurricane that hit the global economy has only mildly affected Cyprus directly, but its repercussions for the Cypriot economy are significant and pose substantial challenges to the Cypriot policy makers. Preserving the pre-crisis potential growth in Cyprus requires a credible fiscal consolidation and structural reform package, which will maintain the confidence in the economy and Cyprus’ competitiveness in the global markets. The authorities are aware of these challenges and are making their best efforts to achieve these goals within the Cypriot political environment.

The economy of Cyprus depends strongly on its external sector. In the long-run, its success depends on the ability to maintain competitiveness in the global markets (the supply side), while in the short-run, Cyprus’ growth depends heavily on economic developments in its trading partners (the demand side). The recent developments in the EU and other trading partners leave uncertainty regarding the pace of recovery of the Cypriot economy in the coming months.

The Ministry of Finance projects positive growth for 2010, while the Central Bank of Cyprus (CBC), like staff, is less optimistic regarding the growth figure for 2010. For 2011, the Ministry of Finance growth projection (1.5 percent) and the CBC’s growth projection (1.3 percent) are somewhat lower than staff’s forecast, based on the assumption that some of the downside risks staff mentions in the report will materialize. That said, the authorities do not see fiscal consolidation as weighing on growth. Cyprus is a small open economy that suffered in the last two years a deteriorating structural fiscal balance. Hence, fiscal consolidation aimed at enhancing growth could have a confidence-boosting effect with a positive growth outcome even in the short run. There is increased confidence that negative spillover effects from Greece are now being contained owing importantly to the joint IMF–EU program concluded with Greece.

Fiscal Policy

The authorities are committed to reduce the fiscal deficit to 4.5 percent of GDP in 2011 and below 3 percent by 2012. Cyprus’ track record shows that this goal can be achieved, although there is no political consensus yet on the necessary measures to achieve this. The authorities agree with staff that the new fiscal measures, to be spelled out as part of the 2011 budget, need to add up to around 2¾ percentage points of GDP over the next two years. They expect that a widespread consensus on the fiscal consolidation path will be reached as part of the budget approval process in parliament. The authorities plan to include measures on both the expenditure and revenue sides.

In light of the authorities’ recognition that fiscal consolidation, going forward, is of utmost importance, and, in order to contain the 2010 fiscal deficit, the government began to restrain expenditures already at the beginning of 2010. The number of public sector employees was reduced in the first half of 2010 by 500 and is expected to be reduced by another 500 employees by the end of 2010. The government’s goal is to reduce the total public sector employment by another 1000 employees per year in the following two years. The implementation of this decision is expected to have a significant effect on the total public sector wage bill. In addition to the efforts made to contain the total expenditure, the government imposed excise taxes on fuels at the minimum EU level prescribed by the acquis as of mid 2010. Stimulus measures that were part of the countercyclical policy in 2009 will be withdrawn in 2011, in line with the ECOFIN and European Council Decisions.

Results of the government efforts to reduce the deficit in 2010 can already be seen. The fiscal deficit for 2010 is now projected by the Ministry of Finance to be at most 6 percent of GDP, lower than the 7 percent projected in the budget under a no policy change scenario. This mainly reflects the reduction in intermediate consumption, a freeze in general contractual wages and salaries, a reduction in public sector employment, and a one-off Central Bank dividend income.

Fiscal consolidation efforts focus also on dealing with the medium to long-term challenges. One of the important challenges for Cyprus, as for many other countries in Europe and elsewhere, is to address the issue of population ageing. The authorities realize that the long-term trends may develop a large burden on the fiscal budget, and hence gradual steps to reduce this burden need to be taken. One such reform is the 2009 reform of the social security benefit scheme. According to the reform there will be a gradual increase of the contribution rate over the next 30 years, and an increase in the required years of contribution in order to become eligible for the old-age pension or the old-age lump-sum. A limit on the number of education/training credits that can be granted was also imposed. The reform is estimated to extend the actuarial equilibrium by at least thirty years.


Cyprus’ 12-month harmonized consumer price index inflation remains low (2.7 percent in July 2010), but since November 2009 it has been somewhat higher than in the euro area. The re-opening of the inflation gap between Cyprus and the euro area in 2010 reflects the imposition of excise taxes on fuels and increases in electricity prices in Cyprus, and the fact that economic activity in the euro area remained subdued. Excluding energy, inflation in Cyprus during the 12 months to July 2010 was 0.1 percentage point lower on average than in the euro area.

Particularly in view of its importance in affecting competitiveness, inflation is being monitored closely by the authorities. Even though, as the staff point out, services exports, which are important for Cyprus, may be less responsive to exchange rate dynamics, recent developments in the current account deficit underline the need to improve Cyprus’ competitiveness as well as the role of fiscal consolidation and structural reforms.

The Financial Sector

Resilience of the Financial Sector

The banking sector is sound and resilient and remained profitable despite the global crisis. As banks are broadly based on a traditional banking business model, the rise in NPLs was the main channel through which the crisis negatively affected the banks. The Cypriot banks did not invest in “toxic assets” and, in fact, the confidence in the healthy banking sector and the deterioration of some economies in the region, have led to a continued growth in non-resident deposits in Cypriot banks. Anticipating the rise in potential losses due to the rise in NPLs, banks have reduced the share of profits distributed as dividends from around 50 percent before the crisis to about 30 percent in 2009. Stress tests conducted by the CBC, and in the context of the EU-wide exercise, show that the banks can withstand a significant increase in NPLs arising from further deterioration in economic activity, including spillover effects from Greece. Furthermore, CBC conducts, twice a year, stress tests under scenarios involving withdrawals of a high percentage of both resident and non-resident deposits. It is also noted that Cypriot banks are not dependent on interbank markets funding.

Sound Banking Supervision

Comfortable capital buffers and a high liquidity position of the banks is a result of internal practices as well as banking supervision requirements. Cyprus’ large banking sector dictates a strict banking regulatory framework and a proactive banking supervision to ensure the banks’ health and resilience to shocks. Three examples of this framework are a) the 20 percent liquidity requirement for all euro customer deposits plus other short term (up to 12 months) euro obligations, in addition to the maximum mismatch ratios for maturity time bands, up to 7 days and up to 1 month, calculated on a contractual basis; b) the 70 percent liquidity requirement on foreign currency deposits (these are mainly from non-residents); and c) strict limits on banks’ open positions in foreign exchange.

The banking supervision closely monitors the banks’ assets and liabilities portfolios and promptly reacts to changes that raise the banks’ vulnerabilities to shocks. An example of such prudent response is the imposition of a maximum LTV ratio of 70% for property financing (80% for the permanent residence) that was triggered by the increase in such financing by the banks since 2003. Also the banking supervision is currently considering ways to address the issue of liquidity requirements for non-resident deposits in euro. That was triggered by the recent sharp increase in these deposits which mainly reflects temporary weaknesses in the economic situation of neighboring countries but also the use of euro as a deposit currency by those non-resident depositors that in the past were using exclusively foreign currencies.

Covered Bond Legislation

The covered bond legislation, which would facilitate in making liquid the illiquid bank assets, is expected to be passed by the end of the year. In the interim, and in order to enhance liquidity in the economy, the government issued close to €3.0 billion worth of bonds to the banks that could be used as collateral for obtaining liquidity via the Eurosystem monetary operations. The bonds were issued to the banks against a fee and collateral with a haircut, which depends on the quality of the collateral. The government as well as the CBC see the risk of having to record the special government bonds as part of the government debt as negligible, as the risk for the government that the bonds will not be returned is very small due to the arrangements in place for the valuation and substitution of the assets provided in exchange for the special government bonds.

FSAP recommendations

The authorities have been making many efforts to fulfill the 2008 FSAP recommendations, and indeed, many key recommendations were achieved. Regarding the recommendation to unify the banking supervision authorities, the Ministry of Finance agrees that this may have some advantages on the banking supervision in Cyprus, however, it is of the view that the consensus in Cyprus is for maintaining the status quo. The CBC, like staff, is of the view that unifying the banking supervision authorities would significantly strengthen banking supervision and enhance the financial stability of the banking sector, especially during a time of financial turmoil. In the current framework, commercial banks are supervised by the Bank Supervision and Regulation Department at the central bank and the cooperative credit societies are supervised by the Co-operatives Societies’ Supervision and Development Authority (CSSDA). The regulation framework is almost fully harmonized, and the CSSDA is committed to adopting the CBC’s definition of NPLs by the end of this year. The CBC and the CSSDA closely collaborate and jointly monitor (on-site and off-site) individual cooperative banks. That said, it is noted that the CBC in not empowered to supervise directly individual cooperative credit institutions and cannot take remedial action against individual institutions.

Contingency Planning

Contingency planning is crucial in enhancing confidence in the financial sector. To enable a swift government intervention in case of an insolvent bank, a draft law setting up a comprehensive framework of such an intervention was prepared and submitted to the parliament for approval. Establishment of the framework would enable the Cypriot Council of Ministers, taking into account the opinion of the Governor of the CBC, and with the approval of the parliament, to implement measures intended to address liquidity or insolvency problems affecting financial institutions. It is agreed that parliament will examine such a request by the Council of Ministers in a speedy procedure.

Regarding the staff recommendation to seek written commitments from other regional supervisors regarding their responsibilities in a crisis, there are extensive provisions in the EU directives on home / host banking supervision cooperation both in normal and in crisis situations, and the issue of crisis management arrangements for failing cross border banks in EU is currently debated. Therefore, at the current stage, the bank supervisory authority is of the view that it is premature to raise such an issue.

Exposure to Greece

While staff estimates the overall exposure of the banking system to Greece (not including interbank loans) to be at a high level, we note that a large part of the exposure to Greece cited relates to Greek subsidiaries and are the result of transactions booked in Cyprus for tax reasons. These transactions are fully financed by the parent banks and, should a loss arise, it will be borne by the parent banks (through a set-off against the amount currently due to them).


Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summings up can be found here:

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