Cyprus:Fifth, Sixth, and Seventh Reviews Under the Extended Arrangement Under the Extended Fund Facility; Request for Waiver of Nonobservance of a Performance Criterion; and Rephasing of Access

EXECUTIVE SUMMARY Economic developments have been encouraging. The recession in 2014 was milder than expected and GDP growth was positive in the first quarter of 2015 for the first time in almost four years. The fiscal outturns have exceeded program projections by a large margin. Liquidity and solvency in the banking system have improved, allowing the removal of all external payment restrictions. Program performance has been generally strong. Compliance with quantitative conditionality has been good and the authorities have advanced structural reforms. The reviews were held up by delays in establishing a private sector debt restructuring framework, but the new insolvency and foreclosure frameworks are now in place. Further efforts are needed to put Cyprus’s economy on a sound footing. Effective implementation of the new private debt restructuring framework will be essential to address the high level of non-performing loans and, hence, to consolidate financial stability and boost growth. The authorities should maintain prudent public finances given the still-high public debt, and continue their structural reforms, which are critical to support the sustainability of public finances and growth. Maintaining the reform momentum will be challenging. A difficult political environment could continue to complicate passage of important pending reforms. Completion of the reviews would make available SDR 222.75 million (about €280 million). Total access under the arrangement is SDR 891 million (563 percent of quota, about €1 billion). The European Stability Mechanism has released €5.7 billion (of €9 billion committed); an additional €100 million will be disbursed upon completion of this review cycle.

Abstract

EXECUTIVE SUMMARY Economic developments have been encouraging. The recession in 2014 was milder than expected and GDP growth was positive in the first quarter of 2015 for the first time in almost four years. The fiscal outturns have exceeded program projections by a large margin. Liquidity and solvency in the banking system have improved, allowing the removal of all external payment restrictions. Program performance has been generally strong. Compliance with quantitative conditionality has been good and the authorities have advanced structural reforms. The reviews were held up by delays in establishing a private sector debt restructuring framework, but the new insolvency and foreclosure frameworks are now in place. Further efforts are needed to put Cyprus’s economy on a sound footing. Effective implementation of the new private debt restructuring framework will be essential to address the high level of non-performing loans and, hence, to consolidate financial stability and boost growth. The authorities should maintain prudent public finances given the still-high public debt, and continue their structural reforms, which are critical to support the sustainability of public finances and growth. Maintaining the reform momentum will be challenging. A difficult political environment could continue to complicate passage of important pending reforms. Completion of the reviews would make available SDR 222.75 million (about €280 million). Total access under the arrangement is SDR 891 million (563 percent of quota, about €1 billion). The European Stability Mechanism has released €5.7 billion (of €9 billion committed); an additional €100 million will be disbursed upon completion of this review cycle.

Background

1. Cyprus has come a long way since the 2013 crisis, and despite delays in completing program reviews, has made significant progress in restoring financial stability and growth. The recession in the last two years was sharp but milder than expected, and GDP growth was positive in the first quarter of 2015 for the first time in almost four years. The fiscal outturns have exceeded program projections by a large margin. Liquidity and solvency in the banking system have improved significantly, allowing the removal of all payment restrictions. Important structural reforms have been implemented. However, program reviews were held up by delays in establishing a modernized private debt restructuring framework, in particular reformed insolvency and foreclosure regimes, which encountered technical and political challenges.

2. New insolvency and foreclosure legislation has now been adopted, paving the way for the completion of the fifth, sixth, and seventh reviews under the EFF-supported program. Central to the success of the program is the need to reduce Cyprus’s extremely high level of non-performing loans (NPLs), which reached 59 percent of total loans for the core domestic banks at end-December 2014. However, this objective was hampered by delays in the introduction of the key components of the private debt restructuring legal framework. While the foreclosure law was passed last September by Parliament, it was then suspended, thereby preventing completion of the fifth review under the EFF arrangement. The suspension reflected, in part, concerns in Cyprus that this law would benefit creditors by accelerating foreclosures, but without adequate safeguards in place for vulnerable borrowers in the absence of an updated insolvency framework.1 In turn, the package of insolvency laws (a structural benchmark for end-December 2014) was delayed due to its technical complexity and lengthy political deliberations. The insolvency legislation was eventually adopted in April, at which point the suspension of the foreclosure law was lifted. The implementing regulations for the foreclosure law—necessary for actually carrying out foreclosures—were then adopted in mid-May. Some provisions introduced during the parliamentary process could weaken the effectiveness of the insolvency and foreclosure frameworks. The frameworks will in any case need to be adjusted over time based on practical experience. Nevertheless, their adoption is a crucial step towards establishing a modern legal framework to deal with the NPLs. The authorities’ reform progress in these areas matches the sequence envisaged under the schedule of reviews.

3. Program performance in other areas has been generally strong. Economic and fiscal outcomes have been significantly better than expected at the time of the fourth review, reflected in all but one of the performance criteria (PC) being comfortably met. 2 The authorities have made good progress on their structural reform agenda, implementing most structural benchmarks, even if with some delays.

4. A difficult political environment could continue to complicate passage of important reforms during the remainder of the program. The authorities’ commitment to the program and its objectives remains high. However, with the governing party in a minority position in Parliament and the May 2016 legislative elections already in sight, securing sufficient support will be difficult. This poses challenges for reforms in the areas of privatization and public administration and for further steps to assist clean-up of private sector balance sheets.

Recent Economic Developments

5. Cyprus returned to positive growth in the first quarter of 2015 after almost four years of contraction. Despite a weak second half of 2014 due to headwinds from Russia and uncertainty about the prospects of the authorities’ program, the contraction last year was milder than expected. Output declined by 2.3 percent (compared to a 4.2 percent decline envisaged during the fourth review and 3.2 percent projected at the time of the 2014 Article IV Consultation), reflecting more resilient private consumption. On the supply side, construction and financial services contributed most to the contraction (text figure). The preliminary estimate for the first quarter of 2015 indicates that the economy expanded by 0.2 percent year-on-year (1.6 percent quarter-on-quarter) on the back of a positive performance of the service sector, reversing the weakness seen in the latter part of 2014 (Figure 1). The unemployment rate has remained high (15.6 percent in April), but below the fourth review forecast (Figure 2 and Box 1). Deflation accelerated to 1.7 percent in April, reflecting declining energy prices but also still-weak economic conditions, with core inflation at -0.8 percent. The external current account deficit widened in 2014, reflecting a deteriorating trade balance, due mainly to a recovery of imports (Figure 3).

Figure 1.
Figure 1.

Cyprus: High Frequency Indicators

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources: Cystat; Eurostat; MoF; and IMF staff estimates.
Figure 2.
Figure 2.

Cyprus: Employment and Inflation Developments

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources: Cystat; ECB; Eurostat; and IMF staff estimates.
Figure 3.
Figure 3.

Cyprus: External Indicators

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources: Eurostat; Central Bank of Cyprus; and IMF staff estimates.
A01ufig01

GDP Growth

(Percent)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Source: Cystat.
A01ufig02

Contributions to GDP Growth-Demand Side

(Percentage points)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources: Cystat; Eurostat; and IMF staff estimates.
A01ufig03

Contributions to GDP Growth-Supply Side

(Percentage points)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

6. The banking system has continued to stabilize, but the high level of NPLs remains a key weakness (Figures 4 and 5):

  • External payment restrictions. The external restrictions introduced in 2013 in the wake of the banking crisis were gradually relaxed starting in December 2014 and were fully eliminated in April.

  • Capitalization. Banks have been adequately capitalized relative to the adverse macroeconomic scenario of last year’s comprehensive assessment performed by the ECB (encompassing an asset quality review and stress tests), including through the injection of €1 billion and €0.2 billion from private sources into Bank of Cyprus (BoC) and Hellenic Bank, respectively. The average core tier 1 (CET1) ratio of the system at end-2014 was 14.2 percent compared to 12.1 percent at end-2013. The adequacy of capital buffers remains contingent on continued progress in resolving NPLs.

  • Deposits. The banking system as a whole has experienced small deposit inflows this year. Deposits in the core domestic banks have increased, reversing the trend of previous years, although subsidiaries of Greek banks (representing about 14 percent of total deposits) have experienced moderate outflows in recent months. The elimination of external restrictions had no material impact on deposit flows.

  • Liquidity. Overall system liquidity has improved significantly. Buffers of domestic banks at end-March were 10 percent higher (€0.9 billion) than at end-2014. In addition, reliance by BoC on ELA has declined by €4.9 billion (about 28 percent of GDP) relative to its peak in 2013Q1, although it remains high at 37 percent of GDP. The Greek subsidiaries remain liquid and maintain only a small exposure to Greek assets and counterparties.

  • Non-performing loans. The NPL ratio in the core domestic banking system (59 percent of gross loans at end-2014, or 134 percent of GDP) was largely unchanged in the last quarter of last year, and loan restructuring has proceeded slowly across the core banks. Provision coverage of NPLs remained at 37 percent for core domestic banks. While this ratio is lower than the European average of 46 percent, it is in part offset by the higher capital buffers (text chart).

  • Credit and interest rates. In line with expected continued deleveraging, credit to the domestic nonfinancial private sector is still falling, although slightly (0.5 percent year-on-year in April). At the same time, in the context of improved liquidity, weak credit demand, and the CBCs decision to decrease the maximum deposit rate by one percentage point, interest rates on loans and deposits have gone down markedly.

Figure 4.
Figure 4.

Cyprus: Credit Developments

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources: Central Bank of Cyprus; Cystat; ECB; and IMF staff estimates.
Figure 5.
Figure 5.

Cyprus: Financial Sector Overview

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources: CBC, ECB; and IMF staff estimates.
A01ufig04

Central Bank Funding as a Share of Credit Institutions Liabilities 1/

(Percent)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Source: ECB.1/ Only euro area countries with nonzero central bank funding are represented.
A01ufig05

Provision Coverage Ratio, by Country

(Percent, as of Q3 2014)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources and Notes: European Banking Authority (EBA). EBA discloses name of country if reporting institutions are more than 3.
A01ufig06

Core Equity Tier 1 Ratio, by Country

(Percent, as of Q3 2014)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

7. Cyprus placed debt in the sovereign market for a second time since the crisis. In late April, Cyprus raised €1 billion through the issuance of a 7-yearbond at a yield of 4 percent. The proceeds will be used to repay more expensive outstanding debt, resulting in a lower interest bill and a smoother repayment profile over the medium term. Adoption of the insolvency legislation package and its positive implications for resumption of program reviews and the prospect of Cyprus’s participation in the ECB’s QE contributed to a decline in Cyprus’s yields, which have decoupled further from Greece’s, but still remain slightly above those of European former program countries. In addition, the T-Bill market has been reactivated, with domestic short-term yields showing significant declines (2.5 percent in the latest auction compared to an average of over 4 percent in 2014).

A01ufig07

Long-Term Government Bond Yields 1/

(Percent)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

1/ 10-year government bonds. For Cyprus, longest maturity availableSource: Bloomberg

Report on the Discussions

8. The discussions focused on the macroeconomic outlook and policy priorities for the last year of the program. The main focus was on (i) promoting NPL workouts through legal and supervisory measures and supporting bank restructuring; (ii) fiscal policy in 2015 and the medium term; and (iii) structural reforms to ensure fiscal sustainability and support growth.

A. Macroeconomic Outlook

9. A gradual recovery is expected to take hold in 2015. Modest growth of 0.2 percent is projected for the current year, with weaker demand from Russia and Greece expected to be offset by an increase in demand from the EU (Box 2). The regional concerns are expected to weigh on private consumption and investment. Conversely, the effect of lower energy prices on households’ purchasing power is expected to support private consumption. Growth is projected to pick up in 2016, and then stay at around 2 percent in the medium term—well below pre-crisis rates of growth. This growth path reflects subdued private consumption and investment growth over the medium-term given the deleveraging needs of the private sector. As discussed in previous reports, the recovery is expected to be credit-less and led by service sectors less reliant on credit, such as tourism and non-financial business services.3

10. The unemployment and inflation projections have been adjusted downwards. Consistent with the lower observed level, the unemployment path has been shifted down relative to previous projections, and a gradual decline is projected for subsequent years as employment picks up. Deflation is expected to moderate as the impact of lower oil prices subsides, averaging 0.8 in 2015. Positive inflation is projected from 2016 onwards as domestic demand and wages gradually recover.

Selected Economic Indicators

(Percent change, unless otherwise indicated)

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

Contribution to growth.

11. Risks to the outlook are balanced:

  • Domestic risks. Slow progress in implementing the new private debt restructuring framework and addressing NPLs could delay balance sheet repair and credit expansion, holding back the recovery and constraining medium-term growth. Persistence of deflation could further weigh on stressed private sector balance sheets. On the upside, some indicators (e.g., consumption related tax collections, market sentiment) as well as the surprisingly strong 2015 first quarter GDP data point to a faster-than-projected pick up of economic activity.

  • External risks. A protracted period of turmoil related to Greece could affect Cyprus through direct spillovers on the financial system, more general confidence effects, or an impact on EU external demand. Notwithstanding any decisive euro-area wide policy response, it would be difficult for Cyprus to avoid altogether adverse effects of developments related to Greece. A deeper recession in Russia and/or further depreciation of the ruble could affect Cyprus’s business and tourism sectors beyond the baseline assumptions. Regarding Greece, while financial links have been significantly reduced, the authorities are monitoring the situation closely. Completing the reviews will be an important step in insulating Cyprus from broader contagion risks by ensuring available financial and liquidity support, and boosting confidence. Upside risks center on more robust external demand or greater compression of yields, for example, due to the positive impact of the ECB’s QE, or if the downturn in Russia is milder than foreseen (Box 2).

12. The public debt profile has improved significantly, although risks remain (Annex 2). At end-2014, public debt stood at 107 percent of GDP, compared to the fourth review forecast of 120 percent. The bulk of the improvement derives from (i) a 10 percent upward revision of nominal GDP due to the adoption of the ESA 2010 methodology for national accounts4 and (ii) deferred ESM disbursements in light of the strong fiscal outturn and lower bank recapitalization needs. Going forward, debt is projected to decline gradually to close to 80 percent of GDP by 2020 (compared to an initial program forecast of 105 percent of GDP), reflecting no further bank recapitalization needs.5 However, contingent liabilities associated with government guarantees on bank loans (17 percent of GDP), implicit contingent liabilities associated with the banks’ reliance on central bank financing (48 percent of GDP), and the non-materialization of privatization proceeds and the debt-to-asset swap (12 percent of GDP) are potential risks.

13. External debt has declined further, but remains a source of vulnerability (Figure 7 and Table 11). It dropped to around 300 percent of GDP at end-2014 from 327 percent of GDP the year before (and a peak of 447 percent of GDP in 2010), largely reflecting the decline in ECB financing to the banking sector. Cyprus’s external debt remains sensitive to shocks, in particular to interest rates and growth. The net international investment position (IIP) deteriorated to -84 percent of GDP in 2014 from -78 percent of GDP in the previous year, reflecting mainly a decline in holdings of foreign assets6.

Figure 6.
Figure 6.

Cyprus: Fiscal Developments in 2015 1/

(Cumulative percent of GDP difference relative to previous year)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources: Ministry of Finance; and IMF staff estimates.1/ ESA 2010, cash basis data.
Figure 7.
Figure 7.

Cyprus: External Debt Sustainability Analysis—Bound Tests 1/2/

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 155; 10.5089/9781513546940.002.A001

Sources: Ministry of Finance; CBC; and Fund 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. Five-year historical average for the variable is also shown.2/ For historical scenarios, the historical averages are calculated over the five-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
Table 1.

Cyprus: Selected Economic Indicators, 2010–20

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

Contribution to growth.

Table 2.

Cyprus: Fiscal Developments and Projections, 2010–20 1/

(Percent of GDP)

article image
Sources: Eurostat; and IMF staff estimates.

Historical fiscal statistics until 2012 are based on Eurostat and are thus reported on an accrual basis. For 2013 and projections, and to be consistent with the cash basis of the program, the fiscal statistics are reported on a cash basis.

Capital expenditure in 2016 includes payments for guarantees that are expected to be called that year which are recorded as capital transfers under ESA.

The overall balance in 2014 excludes the 1.5 billion euros recapitalization of the cooperative sector. Projections for 2017–18 include unspecified additional fiscal measures. 70 percent are assumed on the spending side and the rest on the revenue side.

The draw down of ESM bonds received in 2013 to recapitalize the cooperative sector in 2014 is excluded from this line consistent with the exclusion of the recapitalization of the cooperative sector in the overall and primary balance.

The primary fiscal balance in 2014 excludes the 1.5 billion recapitalization of the cooperative sector. Primary fiscal balances in 2015 and 2016 include expected dividends of €0.2 billion, to be distributed by the CBC in line with CBC’s duties under the Treaties and the Statute.

Table 3.

Cyprus: Calculation of Gross Financing Requirements and Sources of Financing, 2013–17

(Millions of euros)

article image
Source: IMF staff estimates.

Medium and long term market financing in 2013 refers to EIB financing. In 2014, it includes EIB financing and the €850 million issued in May and June of 2014. The 2015 figure includes EIB financing, the April 2015 market issuance, and a second expected issuance in 2015Q3.

Refers to additional debt repayments that would be made with privatization proceeds and a debt management operation in 2016 and with privatization proceeds only in 2017 assuming the full disbursement of the program envelope and the full materialization of privatization proceeds.

Table 4.

Cyprus: Balance of Payments, 2010–20 1/

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

Balance of Payments historical data and projections are presented according to the BPM5 methodology, and thus exclude data related to the operations of Special Purpose Entities (entities without a physical presence in Cyprus).

Estimated based on BPM6 data produced by the Central Bank of Cyprus.

Table 5.

Cyprus: External Financing Requirements and Sources, 2012–20

(Millions of Euros)

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

Rollover rate does not include EIB loan.

Table 6.

Cyprus: Monetary Indicators, 2010–20

(Billions of Euros, unless otherwise indicated, end of period)

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

Includes public entities classified outside the general government. The data excludes brass plates, which are companies with a physical presence in Cyprus and, therefore, treated as residents but with limited interaction with the domestic economy.

Includes CBC’s net claims on general government.