Introduction

The authorities thank the staff for helpful discussions in Cyprus and for their thorough analysis, which they broadly share. In view of the adverse external developments, they are vigilant and have agreed to remain in close contact with the staff so as to keep them abreast of the impact of these developments in Cyprus and to discuss policy responses, including in the context of technical assistance.

Cyprus has a history of stable economic growth and responsible fiscal policies. A business-friendly environment and a well-educated population have contributed to its economic success over the years. Following a recession in 2009, positive real growth was registered in 2010. For 2011, the government had projected 1.5 percent growth and the outcomes in the first two quarters of this year were in line with this projection. However, a deteriorating external environment and the tragic explosion on 11^th July that destroyed the Vasiliko power plant have had a negative effect on the outlook. Moreover, the worsening situation in Greece has negatively affected economic confidence in Cyprus, where banks have high exposure to Greece. Rating agencies have highlighted the interrelatedness of the large Cypriot banking sector with the Greek economy together with deteriorated fiscal performance as the main factors for their recent downgrades of the Cypriot sovereign. Since June, Cyprus has effectively lost access to international sovereign debt markets. The authorities are fully aware of the seriousness of this situation and have focused their efforts on strongly improving the fiscal position in an effort to attract external financing and to ensure financial sector stability. The government which emerged following the reshuffle of August is committed to achieving these objectives.

Economic and fiscal outlook

The economic impact of the Vasiliko-explosion appears less pronounced than was feared at first. Especially the services sector is performing better than foreseen. The government now expects growth for 2011 to turn out at around 0.5 percent, at the higher end of the post-Vasiliko projections. For 2012, the government’s preliminary projections point to a possible 0.2 percent growth, mainly on account of promising prospects for tourism and in general for the services sector, as evidenced by forward-looking indicators. They acknowledge the highly uncertain global environment and particularly the risks related to the European debt crisis. For the medium to longer term, potential gas reserves offshore Cyprus constitute an upside potential for economic growth prospects.

Fiscal outcomes in the first half of this year were significantly worse than budgeted. This is explained by some one-off factors, but also by factors of a more structural nature such as higher outlays for unemployment benefits and, admittedly, by delays in the implementation of corrective measures. However, fiscal performance has somewhat stabilized in the last months despite the deteriorated economic environment. Performance has been helped by the less pronounced fall in growth, better than forecast corporate tax revenues and the effect of the first package of corrective measures adopted on August 26th. Fiscal outcomes for the months of August and September were close to the original forecast (the deficit for 2011 was originally forecast at 4 percent). On this basis, the government’s latest projection is that the fiscal deficit for 2011 will be substantially higher than budgeted, but will remain somewhat below 6 percent of GDP.

Fiscal consolidation

The government is firmly committed to fiscal consolidation and to addressing market concerns. In the House of Representatives, where the government does not have a majority, broad consensus exists on the need for large fiscal consolidation. However, there are differences on some aspects of the fiscal consolidation package.

The government aims to reach a deficit below 3 percent for 2012 and a balanced budget by 2014 and has already proposed two sets of measures that should achieve the bulk of this effort. Together, these packages are estimated to reduce the deficit by approximately 4 percent of GDP. The largest part of the adjustment will be on the expenditure side. The measures will primarily address wage dynamics and the public wage bill through a front-loaded adjustment, and are mostly of a structural and permanent nature. Targeting of social measures is another important element, which should preserve social fairness. The authorities welcome staff’s encouragement that this is an ambitious, but appropriate pace of consolidation. A first package of measures was approved by Parliament in August, and a second package is currently in Parliament as part of the proceedings for the 2012 budget.

As for the specific measures taken, the following are especially worth noting: The first package introduced for the first time in Cyprus a contribution by employees to the public pension scheme, and the abolition of the separate occupational public pension for new entrants. Revenue enhancing measures were also part of this package, including an increase of the withholding tax on interest, the introduction of a levy on all registered companies, and an increase in the highest marginal income tax rate. The second package, which is currently in Parliament, includes further measures to contain the public sector wage bill such as the abolition of all vacant posts, a reduction of personnel in the broader public sector (one recruitment for every four retirements), as well as a 10 percent reduction of salary scales for newly recruited personnel, the impact of which will grow over time. The importance of the agreement on the freeze in the cost-of-living adjustment (COLA) during the first half of 2012 should not be underestimated, as the COLA has been a deeply embedded element of the labor market framework in Cyprus. Targeting of social benefits based on income and other economic criteria and, on the revenue side, an increase in the standard VAT rate from 15 percent to 17 percent are the other main elements of this second package. The proposed VAT rate increase is the most debated element in parliament.

Importantly, in addition to these elements discussions with the social partners have started on reform of the COLA. This discussion is expected to be finalized by the end of this year. One of the options being considered is to keep the COLA payments constant above a certain threshold as a permanent arrangement.

The Minister of Finance has publicly announced that the government will look into passing new measures, beyond those passed in August and those included in the 2012 budget. In this context, the government intends to start a dialogue with social partners on a wage freeze. Moreover, the authorities are committed to taking further measures in order to reach the fiscal consolidation targets set for the 2013 and 2014 budgets in the context of the Three Year Budgetary Plan, which will be revised early next year. Windfall revenues will be used for deficit reduction.

Financing

The government’s policies set out in this Buff are aimed at regaining access to international capital markets within a reasonable timeframe. For the near future, however, the lack of access to international sovereign bond markets poses important challenges for securing adequate financing beyond 2011. The government has secured a EUR 2.5 billion loan from Russia, which will be disbursed in three tranches between the end of this year and April 2012. The remaining needs for financing the deficit and rolling over maturing debt until the end of 2012 are estimated at EUR 700 million (taking into account fiscal consolidation plans). This is expected to be covered by short-term debt and/or long-term domestic debt.

The authorities follow the developments with respect to the European debt crisis closely, and consider their options in case these would have prolonged negative effects on the country’s financing abilities. It is worth noting that the authorities have advanced plans for improving their debt management framework. New legislation dealing with all aspects of debt management is being prepared in collaboration with the World Bank.

Pensions, Public Financial Management

The government is preparing a draft law that will introduce a medium-term budgetary framework and ensure compliance with the EU fiscal framework Directives. The IMF staff has been invited to review the draft and to advise on practical implementation issues. The authorities are considering to request Fund technical assistance in the fields of natural resources contracts taxation; (for the medium term) natural resources revenue management; and revenue administration.

The government furthermore is currently reviewing the new actuarial study of the national pension scheme and its implications for fiscal sustainability. In this context the study of the IMF on the pension system in Cyprus will provide a helpful input.

Financial sector

The Cypriot financial sector is large in terms of GDP, and has been an important pillar of the economic model. Cypriot banks conduct mainstream banking (mostly deposit taking and loan granting). They have low dependency on wholesale funding. The regulatory framework is conservative, as is illustrated by strict liquidity requirements and the relatively high minimum capital ratios (minimum core tier 1 capital of 8 percent of risk-weighted assets). The two largest banks already comply with the Basel III minimum capital ratios. Moreover, the supervisor has required Cypriot banks to build up available adequate core tier 1 capital of at least 8 percent plus an additional amount reflecting the ratio of their total assets to the Cypriot GDP by the end of 2014. However, the interconnectedness of the banking sector with the Greek economy and the recent downgrades by rating agencies have made the sector vulnerable. The private sector involvement in the Greek program that was agreed on the 26 October Euro Area Summit, implies high costs for Cypriot banks. Additional needs come from the new EBA requirements for banks to mark sovereign exposures to market and to increase their core tier 1 capital ratio to 9 percent by June 2012. The figures reported by the EBA already include mark-to-market valuation for Greek government bonds.

In response to these developments, the authorities continue to monitor the situation very closely and take preventive measures. They monitor liquidity and undertake rigorous stress testing (including scenarios for significant increases in NPLs and bad debt provisions) on a regular basis, are developing contingency plans, and are strengthening the legal framework, including with the help of Fund TA. The authorities expect to publish in the second half of this month the final figures for the expected capital buffer for individual banks according to the new EBA requirements. They expect that the shortfalls will be lower than the preliminary figure announced by the EBA, the difference being explained inter alia by the specific characteristics of each bond (where the EBA necessarily had to make certain common assumptions). At this stage, the authorities expect the banks to be in a position to cover their capital needs according to the new EBA requirements. The supervisor will work with the banks on plans to meet the requirements. The authorities note that Cyprus banks have substantial contingent convertible capital instruments, which are compliant with Basel III and with the relevant CEBS guidelines. Therefore, they expect that these instruments will be eligible to cover part of the sovereign buffer required by the EBA.

The authorities have undertaken to strengthen the legal framework by the following three elements: First, the draft Law on Establishment and Operation of the Independent Financial Stability Fund is being discussed in parliament. Once approved, this law will enable the establishment and running of a Financial Stability Fund. This Fund will gradually be built up by bank and cooperative credit institutions’ contributions and, when required, will finance the implementation of the appropriate bank resolution tools by the competent authority. A second draft law, the Financial Crisis Management Law, is also in parliament. It aims to provide the Council of Ministers, upon a recommendation by the Central Bank of Cyprus, with the powers needed to effectively manage a financial crisis and maintain financial stability as well as public confidence in Cyprus’s financial system. Thirdly, the current bank resolution regime is being strengthened through amendments in the Banking Law that will reinforce the powers of the Central Bank of Cyprus to take specific resolution measures vis-à-vis credit institutions. These draft law amendments will be submitted to parliament for approval by the end of this month.

Finally, the authorities thank the staff for very helpful technical assistance and advice in these areas.