Statement by Mr. Menno Snel, Executive Director for Cyprus, and Mr. Ektoras Kanaris, Advisor to the Executive Director, March 28, 2014

Cyprus’s Third Review Under the Extended Arrangement Under the Extended Fund Facility focuses on strong ownership and implementation of its program. Despite the difficult environment in which the authorities operate, the political commitment remains strong while every effort is being made to maintain strong social cohesion. Steadfast implementation has produced tangible results with indications that the healing process is already under way. Although a difficult adjustment is still ahead, with the guidance of EU and IMF staff, Cyprus has placed itself in a good position to continue along the agreed path.


Cyprus’s Third Review Under the Extended Arrangement Under the Extended Fund Facility focuses on strong ownership and implementation of its program. Despite the difficult environment in which the authorities operate, the political commitment remains strong while every effort is being made to maintain strong social cohesion. Steadfast implementation has produced tangible results with indications that the healing process is already under way. Although a difficult adjustment is still ahead, with the guidance of EU and IMF staff, Cyprus has placed itself in a good position to continue along the agreed path.

Exactly a year ago from today, the events of March 2013 left Cyprus faced with a shattered banking system, its citizens in despair and a future that looked grim, laden with uncertainty. Twelve months later, with the help of Cyprus’s international partners, outlines of recovery may be faint, but are now visible. The authorities, through firm and ambitious reforms, have been abiding strictly to the terms of the EU-IMF memoranda, which are viewed as the necessary steps to correct the island’s weaknesses, setting the stage for sustainable growth. In implementing these reforms, the society has held together, with social cohesion proving to be an invaluable asset in the country’s endeavours.

The third review shows that Cyprus continues to perform strongly under the programme, which remains on track and well financed, with all performance criteria observed with considerable margins. All structural benchmarks, but one, were observed by the time of this review, with the remaining one on track to be completed by end-April 2014. The Cypriot authorities remain committed to their goal of restoring the economy to a sustainable footing through the painful, but necessary, structural reforms taken to date and going forward.

On March 4, 2014 the politically sensitive, large-scale privatisation programme was approved by parliament. While the latter was faced with significant headwinds, the parliament tackled the issue with soberness and despite a breakup of the governing coalition a few days earlier. Staff rightly points out that this development may weaken the government’s ability to advance its reform agenda, as policy makers may seek to find more common ground and build consensus. Nevertheless, this example along with other extremely difficult decisions of the past, evidence the authorities’ abilities to implement program policies even under difficult political circumstances.

Clearly, the fundamentals, when seen on their own, are not flattering for the state of the economy. Cyprus is in the midst of a deep recession, unemployment is high and the banking sector is still unable to support the economy. However, they conceal the considerable successes of the last year. The reforms to date have been bold and numerous, the economy did not shrink as much as was originally feared and the banking system has been fully recapitalised and is now in the process of an ambitious restructuring. In turn, society’s expectations have been steadily improving. The Economic Sentiment Indicator has been on the rise every month since April 2013 and is now at the highest level since mid-2011. The improved market perceptions of Cyprus’s financial position have also been reflected in sovereign bond yields which have declined to the lowest level since May 2011, while rating agencies have started reversing a long trend of successive downgrades. These developments are promising, even as the report is rightly mindful of the outlook’s fragility.

Macroeconomic developments

The economic situation remains difficult, but the outturn continues to over perform relative to programme expectations. According to the latest flash estimate, real GDP contracted by 5.4 percent in 2013, against the newly revised programme projection of -6 (down from a programme forecast of -7.7 during the last review and -8.7 percent at the start of the programme). Indeed, Cyprus’s economy has so far proved more resilient than expected. The over performance was largely attributed to better than envisaged private consumption reflecting households’ efforts to smooth consumption. At the same time, a number of indicators such as retail sales, tourism receipts, and professional services have also proven to be relatively rigid. External demand made a positive contribution to GDP as the deceleration of imports was larger than that of exports.

Looking forward, a significant deleveraging process is expected to take place through the banking sector, which together with the fiscal adjustment already underway, will entail a drag on growth. At the same time, the banking system’s constrained liquidity renders the banks apprehensive to the provision of credit. Overall, growth is expected to be about -4.8 percent in 2014 before picking up to 0.9 percent in 2015 mainly from export growth. Restoration of confidence in the banking system and a potentially more comfortable liquidity position in the future could gradually loosen the tight credit conditions and provide more upside in the outlook. Clearly, the baseline is subject to risks which are well articulated by staff and we agree with their analysis in that regard. We note that medium-term growth projections do not yet incorporate the potential upside from the exploitation of natural gas resources, including related forthcoming infrastructure investments.

Unsurprisingly, unemployment has been taking the brunt of the adjustment, increasing sharply from 11.9% in 2012 to 16% in 2013, reaching 17.2% during the 4th quarter of 2013, the third highest in the EU. The authorities have been looking for ways to promote employment within their limited policy space. Nevertheless, the labour market is also proving to be more flexible than the indications at the beginning of the programme. By the last review, some nascent signs of stabilization had started to emerge, which have since been more persistent. Specifically, the unemployment increase had been gradually decelerating towards the end of 2013, before changing direction and decreasing to 16.8 percent in January 2014. Moreover, wages in both the public and private sectors have been reduced considerably. While the cost of adjustment is painful, it is contributing towards improved competitiveness. According to Eurostat’s latest publication, Cyprus saw a decline in its labour costs of 6.5 percent in Q4 2013, the sharpest adjustment across the eurozone.1 At the same time, the public sector workforce was significantly reduced over the last year, with the sector’s employees numbering at their lowest level since 2007. The public sector is expected to be further reduced going forward through early retirement schemes as the SOEs gear up for privatisation.

Cyprus’s small size and open economy facilitated the adjustment of the current account, which moved to a small surplus of 0.3 percent of GDP in the third quarter of 2013 compared with a deficit of 5.7 percent of GDP a year ago. This was largely due to a notable decline in the import of goods and better export performance, though at a lower rate than in the previous quarter. The higher tourism receipts were partly offset by further decline in the export of financial and other business services.

Public Finances

Fiscal consolidation remains a cornerstone of the domestic adjustment strategy, evidenced by the authorities’ continued strong record of compliance with their fiscal targets and beyond. The 2014 budget, which envisaged even more consolidation on top of programme requirements, will bring the total fiscal adjustment for 2013-14 to around 10 percent of GDP. Performance through end December has exceeded expectations, reaching a primary balance of -1.7 percent of GDP for 2013, comparing favourably with an adjusted forecast of -3.2 percent of GDP. While this outcome was positively influenced by the milder than expectedrecession, it was largely due to the sizeable consolidation measures undertaken by the authorities, coupled with strong execution and tight expenditure control.

For 2014, the primary deficit target was reduced to 2 percent of GDP from 3.3 percent of GDP to reflect the over-performance in 2013 as well as high expected dividend income. Considering Cyprus’s hard earned credibility in identifying and delivering on fiscal measures, staff’s suggestion, to temporarily accommodate shortfalls should the overperformance in 2013 prove to be temporary, appears prudent. Even so, this will have to be balanced with the authorities’ strategy to stay ahead of the curve and will be discussed with Cyprus’s international partners further into the year should the need arise. For the time being, the latest available numbers for January 2014 are reasonably encouraging, pointing to a primary surplus of 1 percent of GDP compared to a programmed 0.4 percent of GDP.

Financial Sector

Programme success ultimately runs through the stabilization of the financial sector which remains the authorities’ key concern and priority. To this end, strong action has been taken over the last year with confidence in the sector, while still hampered, gradually improving. The significant moderation of deposit outflows serves as a useful proxy. According to the latest published data from the Central Bank, the deposit base was €46.9 billion in January from €47 billion in December and €47.2 billion in November. More importantly, the relative stability of deposits following the release of about €1 billion of previously frozen deposits at end-January was another encouraging signal.

These developments were likely supported by the authorities’ and credit institutions’ comprehensive reform strategy. Since the last review, the Central Bank and the European Commission approved the restructuring plan of Bank of Cyprus (BoC) and the Cooperative Sector respectively. The latter offered a strong vote of confidence, confirming that the measures will enable the sector to become viable in the long term without continued state support. Moreover, this triggered the injection of €1.5 billion of state funds into the Cooperative Central Bank, bringing the entire core domestic financial sector’s capital to around 16 percent of risk weighted assets. In the meantime, fundamental restructuring of the banking sector continues apace with branch closures, voluntary staff redundancy schemes and wage cuts contributing to the reduction of operating costs.

In the area of private debt restructuring, the banks are establishing specialized units to deal with troubled borrowers while the authorities are revamping their legal and operational framework to provide tools that will facilitate the voluntary workout of non-performing loans. The insolvency reform and revised foreclosure procedures are part of a broader Government strategy for dealing with mortgage arrears and should assist in cleansing unrecoverable loans from banks’ balance sheets. This complements the Central Bank’s Mortgage Arrears Management Framework, the Code of Conduct for borrowers and creditors, and the loan origination directive which was issued to address some major causes for the build-up of NPLs in the sector.

Finally, the stabilization of deposit outflows helped banks to improve somewhat their liquidity buffers. Similarly, the ECB’s accommodative monetary policy stance and collateral policies have been broadly supportive in this process. At the same time, the authorities would welcome renewed support for unlocking cheaper liquidity that would further increase the prospect of a successful programme. In turn, this could significantly boost confidence, reduce fragmentation of the financial system and would ultimately provide new impetus to the banks’ efforts to effectively support the economic recovery. In the interim, in order to provide for unexpected outflows, domestic liquidity was complemented by the authorities’ approval of the issuance of guarantees of up to EUR 2.9 billion on January 27, as contingency collateral in case of need. Nevertheless, low liquidity buffers restrict the provision of credit to the private sector which had accelerated to about -10 percent y-o-y by January 2014.

In February 2014, the authorities completed the last milestone related to the second stage of relaxations under the capital controls. Building on signs of improved confidence in the banking sector, including indicators of liquidity and investor confidence, the authorities proceeded with the second stage of relaxation steps, allowing for the abolition of the measure that forced the automatic renewal of fixed-term deposits upon maturity and further increases in the limits for domestic transfers. The third stage should see all restrictive measures relating to cash withdrawals and the prohibition in the opening of new accounts removed. This is now pending on tangible progress with the implementation of BoC’s restructuring plan as the other criterion, merging the 93 Coops into 18 institutions, was completed as of March 24.

Structural reforms

The implementation of the structural reform agenda has also advanced. As outlined in the report, the government is steadfastly moving forward with a comprehensive social welfare reform aimed at protecting vulnerable groups during the downturn. The scheme, inter alia, introduces a general minimum income for vulnerable groups and will be financed by consolidating and better targeting other social benefits to remain within the 2014 envisaged envelope. The authorities intend to roll out the scheme by June 2014. Notable progress was also observed in the area of revenue administration, aimed at supporting the consolidation efforts. The reform plan, which was drawn up with the support of technical assistance from the Fund, will improve the efficiency of collection by integrating the Inland Revenue Department and VAT services into a new function-based tax administration. The enabling legislation to formally establish the new integrated tax agency will be adopted by July 2014. As a more short-term response, and to enhance voluntary compliance, a work programme of targeted joint audits that will run through the year is already in place. Moreover, on March 20, legislation was submitted to the Parliament, providing the revenue administration with the authority to seize assets, including property and bank accounts, while prohibiting the alienation or use of assets in cases of noncompliance.

In the area of public financial management the House adopted the Fiscal Responsibility and Budget Systems Law in mid-February as a prior action for this review. The Law, which is a leap toward the enhancement of transparency and accountability, provides among other things the legal basis for macro-fiscal policy-making, budget formulation approval and execution, as well as the establishment of a Fiscal Council.

Finally, despite its political sensitivity, the Cyprus Privatization Plan was adopted by the House earlier this month. This has been a landmark decision which enables the authorities to embark on the privatization process. Already, around two weeks after parliament gave the green light, the Council of Ministers launched the privatisation procedures for the Limassol port by liberalizing the port’s commercial arm. A unit to manage the privatization process will be established by mid-May while financial advisors for the major transactions, relating to the largest state-owned enterprises, will be appointed by end-September. Overall, the government places great emphasis in the area of structural reforms and has already embarked on an overhaul, beyond the above, of the goods and services market, public administration, the pension system, the healthcare system and more. These reforms will create the conditions for Cyprus to regain its competitiveness and generate the foundation for a sustainable economic model.


Cyprus continues to demonstrate strong ownership and implementation of its programme. Despite the difficult environment in which the authorities operate in, the political commitment remains strong while every effort is being made to maintain strong social cohesion. Steadfast implementation has produced tangible results with indications that the healing process is already underway. While significant challenges remain as staff rightly point out, success does not seem out of reach. Numbers are ahead of profile, market perceptions have improved, banks have been fully capitalized under prudent assumptions and the authorities are investing in the future by addressing structural challenges. In terms of financing, 2014 needs are more than covered as the government has been building on its deposits while, at the same time, the significant program buffer remains intact which is conservatively embedded in the debt forecasts. The latter could comfortably cover additional fiscal needs even under a severe growth shock.

While a difficult adjustment is still ahead, with the guidance of EU and IMF staff, Cyprus has placed itself in a good position to continue along the agreed path. In support of the continuing efforts by the government and the people of Cyprus, the authorities are requesting the Board’s approval of the completion of the third review and associated modifications of performance criteria.