Abstract
This paper discusses Cyprus' Eighth Review Under the Extended Arrangement Under the Extended Fund Facility and Request for Modification of Performance Criteria (PC). Cyprus continues to recover from the crisis, and program performance remains generally strong. Risks to the program remain, although their impact would likely be manageable. The domestic political situation remains a challenge to policy implementation. Despite the reduced real and financial linkages between Greece and Cyprus, developments in Greece have the potential to affect Cyprus through the confidence channel. Based on the continued progress under the program and policy commitments going forward, the IMF staff supports the completion of the eighth review and the proposed modifications of PCs.
We thank staff for their constructive assessment of the eighth review under the Extended Fund Facility for Cyprus. The paper appropriately captures the economic developments since the last reviews and also covers topics of relevance for future reforms during the remainder of the program and beyond.
With two reviews remaining, it is important to mention that the current program, underpinned by the authorities’ firm commitment, is bearing results and laying the foundation for sustained growth and improved living standards for the people of Cyprus. Evidently, political ownership of and commitment to the program objectives, supported by broad social support remains strong, as the authorities share their international partners’ vision for a strategy to render the Cyprus economy in a healthy state.
The economic recovery that started earlier this year has continued, despite a challenging external environment. The financial situation of the three largest banks has strengthened; with encouraging evidence that loan restructuring is proceeding at a faster pace. The improved macroeconomic environment together with comprehensive reform of the insolvency and foreclosure laws will support a further acceleration of restructuring, in line with bank specific targets.
Fiscal performance has exceeded expectations and, with that, all end-June and continuous performance criteria have been met. Despite some delays, progress has been made on the program’s structural reform agenda, with all but one of the structural benchmarks implemented in full. The only partial implementation refers to the legislation to accelerate the transfers of title deeds, which has already been adopted by Parliament, and a decision by the Council of Ministers to address title deed transfers in non-legacy and new property transactions is expected to be adopted by end-October.
Macroeconomic developments
The economic performance continues to exceed expectations. Economic indicators point to a moderate expansion in the second quarter of 2015, following positive growth in the first quarter, after almost four years of recession. It is important to mention that there have been no appreciable spillovers to the real economy from the events in Greece. On the financial sector, the three largest banks continue on the path to normalization and sovereign debt yields have declined further, benefitting from purchases by the Euro system’s bond-buying program started in July. However, the unemployment rate remains elevated, but has stabilized at around 16 percent over the first half of 2015.
Fiscal
In spite of the delicate environment, the program’s fiscal performance continues to be strong. As staff confirms, the fiscal adjustment continues to advance well ahead of schedule. For the first half of the year, the primary surplus stood at 0.7 percent of GDP ahead of the program target. This has also allowed Cyprus to tap into the international bond market in April 2015, the second market issuance since the country was shut out of international financial markets as from May 2011, totaling 1,750 million.
For 2015, the authorities increased the primary balance target to 1.3 percent of GDP, locking in fiscal savings that resulted from the stronger performance in the first half of the year. Despite the favorable revenue outturn through June, the authorities will maintain a prudent stance in light of the temporary nature of some of the factors behind this outturn, and the uncertainty associated with the external environment. Nevertheless, there remains an unwavering commitment to keep up with the strong track record observed since the inception of the program for 2015 and the coming years as well.
The public debt and contingent liabilities are still significant. Improving the public debt position therefore represents a priority for the authorities, who are committed to continue their prudent budget execution, while ensuring support for both growth-enhancing public spending and the social safety net. It should be noted that the debt trajectory could turn out to be significantly more favorable than now forecasted by staff due to the fact that the substantial program buffer will be used for liability management operation and will not lead to a debt increase.
Financial Sector
Notwithstanding the marked improvement in the economic environment, the authorities deem the program’s level of success to ultimately run through the financial sector’s revival. Since the adoption of the insolvency and foreclosure regimes earlier this year, the authorities have made encouraging progress on the next steps in the roll-out of the new private debt restructuring framework.
Capitalization of the core banks is appropriate, as per the ECB’s comprehensive assessment. The average common equity tier 1 capital level for the domestic bank currently stands at 14.3 percent (end-June 2015), ensuring that the banking system can withstand significant headwinds.
After abolishing all capital controls in April 2015, deposits in core domestic banks increased by 3 percent in the first eight months of 2015, despite a moderation of the deposit rates. This is noteworthy because this pattern was not observed for deposits in the Greek-owned subsidiaries which experienced significant outflows from the beginning of 2015 to early July 2015 but this outflow largely stopped following the Euro-summit agreement on Greece in July.
Measured at end-June liquidity buffers of domestically-owned banks have increased since end-2014. Those of foreign-owned locally active banks (mostly Greek-owned subsidiaries) were 30 percent (€1.2 billion) lower over the same period. Notwithstanding this, substantial buffers remained at these banks even though in certain cases there was a breach of the regulatory liquidity requirements. ELA funding in the Bank of Cyprus has further declined to €5.4 billion at end-August compared to €7.4 billion at end-2014.
Addressing the high level of NPLs in the banking system is a priority for the authorities. They have a comprehensive approach to address it, aimed at encouraging voluntary debt restructuring and increasing the pace of durable solutions, with the ultimate objective of expediting the cleanup of private sector balance sheets and reviving credit growth.
Structural reforms
The authorities have always tried to use the crisis as a window of opportunity to lay the foundations for a more viable and sustainable growth model. As such, the authorities continue to implement difficult, yet necessary structural reforms that span across the whole economy. Much has already been done, inter alia, in a wide range of the goods and services market, public administration, public financial management, housing market, health, and energy. With the economy stabilized and its urgent needs having been addressed, the attention is now shifting towards the remaining structural reforms that will address longstanding inefficiencies that historically hampered growth, reduced productivity incentives and fostered unjustified social imbalances.
In their effort to further improve the management of fiscal risks, in particular those arising from guarantees (currently equivalent to about 20 percent of GDP), the authorities have adopted a new government guarantee management framework. The Council of Ministers has also recently approved public investment guidelines. Parliament will adopt pending regulations and the law regulating the functioning, oversight, and governance of the SOEs by end-October, in order to ensure the full implementation of the Fiscal Responsibility and Budget System Law.
To better control the growth of the public sector wage bill (after conclusion of the program) and to increase the efficiency of the public sector, the authorities are now performing a significant public administration reform. The draft legislation ruling on public wage increases, promotions, and mobility has been approved by the Council of Ministers and is expected to be adopted by Parliament by the end of this year.
Special attention is given to the privatization of state-owned enterprises and the process is moving ahead despite some delays. The Council of Ministers has approved legislation to corporatize the telecommunication company CyTA. The transfer of the company to private hands is envisaged to happen within a few months after the end of the program. Bids for the commercial activities of the Limassol Port are due by the end of the year, with the goal to finalize the transaction in early 2016.
Conclusion
Cyprus will continue much of the adjustment program, which for the previous two and a half years has yielded positive momentum. Through decisive action to address its economic difficulties and restore stability, the authorities continue to meet their commitments to the international partners despite their strained capacity. After almost four years of recession and the embarkation upon a difficult adjustment program, the economy recorded positive growth as from the first half of 2015. The latest indicators are pointing towards continuous steady growth, rendering staff’s forecasts somewhat pessimistic. Fiscal performance continues to exceed expectations, the financial system is now stable and, absent all domestic restrictions as from April 2015, international debt markets have opened up a second time for Cyprus.
Notwithstanding this generally positive backdrop, the authorities are aware that significant challenges remain. Determined to leave the crisis behind and ensure that the emerging recovery gathers pace, the Government will keep working through the necessary reforms that will in turn ensure that the return to market-based funding is durable and sustainable in a post program setting.