International Monetary Fund.November 29, 2011. Country Report No. 11/331.The economy is still burdened by the legacy of the imbalances that preceded the global crisis, including high leverage of the private sector and a real estate boom. A worsening outlook for global growth, unsettled financial conditions in the euro area, and the large exposure of Cypriot banks to Greece have created new obstacles to recovery. Meanwhile, deterioration in public finances has taken a toll on investor confidence. As a result of these factors, Cyprus has lost access to sovereign debt markets.
The two key challenges are to put in place a large and credible fiscal consolidation that will reverse the increase in the public debt ratio and help restore investor confidence; and to ensure that the banks and their supervisors are well-prepared to respond to possible adverse developments. Even with these actions, it may take time to regain market access, and covering public financing needs in the period ahead will be challenging.
The authorities are focused on implementing strong fiscal consolidation measures that would culminate in a balanced budget by 2014, and on closely monitoring developments in the financial sector while stepping up their contingency planning. They are hopeful that they will be able to borrow from non-market sources, which would provide a bridge until they can regain market access.
IMF Executive Board Concludes 2011 Article IV Consultation with Cyprus
Public Information Notice (PIN) No. 11/145. November 29, 2011On November 18, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cyprus.1
Background
The Cypriot economy faces strong headwinds and downside risks due to financial turbulence in the euro area, the large exposure of Cypriot banks to Greece, and the need for substantial fiscal consolidation to stabilize public finances. Reflecting these developments, the government has lost access to international capital markets and confronts the challenge of accessing financing to meet its fiscal needs in 2012 and beyond.
Following a weak recovery in 2010, staff expects no economic growth this year and a modest contraction in 2012. Factors that will weigh upon growth include tight credit and a climate of uncertainty, continued downsizing of the construction sector after past excesses, slowing external demand, and planned fiscal consolidation. Downside risks are dominant, in light of the potential for external conditions to worsen and for adverse feedback loops between fiscal imbalances and bank balance sheet vulnerabilities.
Fiscal balances have deteriorated sharply over the past three years, reflecting in large part underlying structural factors. Adjustment measures planned for 2011 fell short of target, and staff expect the deficit to widen to some 7 percent of GDP in 2011. The authorities have renewed their commitment to restore sound public finances. They have passed a first package of adjustment measures and are seeking passage of a second and larger set of measures that would yield fiscal savings of some 4 percent of GDP in 2012, if fully implemented. Additional measures will be required to reduce the deficit further and achieve the government’s target of a balanced budget by 2014. Over the longer-term, the public pension system will generate another source of fiscal pressures, as population aging and rising dependency ratios feed through to large increases in pension outlays.
The large banking sector, with assets totaling over 8 times GDP by the broadest measure, and with significant exposure to Greece, is a significant vulnerability. Banks face significant capital needs to reflect mark to market valuations on their sovereign bond holdings and to achieve a 9 percent core tier one capital ratio, as mandated by the European Banking Authority. Non-performing loans are increasing, and further loan deterioration could add to recapitalization needs. Meanwhile, the system is also vulnerable to an outflow of deposits in the event of adverse circumstances. Cypriot banks receive significant liquidity support from the European Central Bank.
Executive Board Assessment
Executive Directors noted that Cyprus faces daunting economic challenges in the face of faltering external demand, growing exposure to the turmoil in the euro area, particularly in Greece, and worsening domestic financial conditions. Directors thus urged the authorities to act forcefully to restore sound public finances and safeguard the stability of the banking system. Steadfast implementation of fiscal and structural reforms on several fronts would also be critical for a return to durable growth over the medium term.
Directors agreed that an ambitious and credible fiscal adjustment is essential to regain access to the international capital markets and put the public debt ratio on a downward path. They supported the authorities’ plans to achieve fiscal balance over the next three years as an appropriate strategy for undertaking the necessary fiscal correction without unduly damaging growth prospects. Directors considered that front-loading the adjustment with measures to reverse recent increases in public sector wages and poorly targeted transfers would provide a credible signal of the authorities’ commitment to medium-term consolidation and bolster investor confidence. Reforms of the cost-of-living allowance system would also be important for achieving the fiscal targets and improving real wage flexibility and competitiveness.
Directors underscored the importance of other fiscal reforms to underpin the consolidation efforts. Priorities should include the introduction of a medium-term budget framework and the adoption of fiscal rules consistent with EU directives. Directors also highlighted the need for reforming the national pension and healthcare systems, which threaten to put unsustainable pressures on the budget as the population ages.
Directors expressed concern about the vulnerabilities arising from Cyprus’s large banking sector and the possibility of adverse feedback loops with the public finances and the real economy in the context of weakening balance sheets. They stressed the importance of building prudent capital buffers and of ensuring adequate liquidity in the financial system. These actions should be supported by contingency planning and the immediate passage of legislation to provide the authorities with full powers to recapitalize or resolve banks, if necessary. Cooperative credit institutions should also be watched closely and brought under the same regulatory and supervisory frameworks as banks.
