Belgium, Cyprus, Malta and Poland took effective action to correct deficit while Hungary's measures are insufficient

Brussels, 11 January 2012- The European Commission concluded that Hungary has not made sufficient progress towards a timely and sustainable correction of its excessive deficit. The European Commission proposes to move to the next stage of the Excessive Deficit Procedure (EDP) and recommends that the Council of Ministers decides that no effective action has been taken to bring the deficit below 3% of GDP in a sustainable manner. Subject to this Council decision (under Article 126(8) of the EU Treaty), the Commission will then propose to the Council new recommendations addressed to Hungary (under Article 126(7) of the Treaty) with a view to bringing to an end its excessive government deficit.

Belgium, Cyprus, Malta and Poland - the other countries that were at risk of not meeting their deadlines of 2011 or 2012 to correct their excessive deficit - have taken effective action. Therefore, the Commission considers that no further steps in the excessive deficit procedure are necessary for these four countries, though it will continue to monitor budgetary developments closely. This is the first time the European Commission has applied the new rules of the strengthened Stability and Growth Pact (SGP), which are part of the so-called "six-pack" on economic governance, which entered into force on 13 December 2011.

Olli Rehn, the European Commission Vice-President for Economic and Monetary Affairs and the Euro said: "Today's report shows that the six-pack is already delivering. It has given the European Commission teeth to act when countries fail to bring their deficits under control and reduce their debt. Fiscal discipline is crucial to reinforce confidence in our public finances. I stand by my word: I am determined to fully use this new powerful set of tools from Day One."

For Belgium, Cyprus, Hungary, Malta and Poland, the Commission's Autumn Forecast of 10 November 2011 showed that these countries were at clear risk of not meeting their obligations to correct their excessive deficits. The next day, Vice-President Rehn sent letters to the Finance Ministers concerned making clear that, in the absence of corrective measures, further steps under the EDP, with the possibility of prompting sanctions, would become unavoidable. All four countries have since taken measures that appear sufficient to ensure a sustainable correction of the excessive deficit.

The budget balance in Hungary, in contrast, is heavily influenced by one-off revenues that do not result in a sustainable deficit correction. Although in 2011, Hungary formally respected the 3% of GDP reference value, this is only thanks to one-off measures worth some 10% of GPD, this budgetary outcome masks, however, a severe deterioration in the underlying structural balance.

In fact, the structural budgetary position deteriorated in 2010 and 2011 by an estimated cumulative 2¾% of GDP in stark contrast to the recommended cumulative fiscal improvement of 0.5% of GDP. Also, in 2012, the general government deficit would remain below 3% of GDP only thanks to one-off revenues. Consequently, in 2013, the deficit is projected to reach 3¼% of GDP, even without taking into account possible negative effects of a worsening in the macroeconomic scenario and rising bond yields, thus breaching the reference value of the Treaty. In sum, the correction of the excessive deficit in 2011 is not of a sustainable nature. This leads to the conclusion that Hungary has not taken effective action in response to the Council Recommendation of July 2009.

For further information:

MEMO/11/898

MEMO/11/364

MEMO/11/627

Contacts : Amadeu Altafaj Tardio (+32 2 295 26 58) Vandna Kalia (+32 2 299 58 24) Catherine Bunyan (+32 2 299 65 12)

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Cyprus.Selected Issues Paper

The most salient risks come from commercial banks domiciled in Cyprus. These banks have the strongest links with the local economy, are most heavily exposed to significant haircuts on Greek government bonds, and are likely to experience further deterioration of their loan portfolios in both Greece and Cyprus. Risks from other financial institutions operating in Cyprus should not be overlooked, but they are not the main focus of this report.

Cyprus banks face capital needs estimated at €3.6 billion on a preliminary basis by the EBA. Cyprus banks would need this much of a buffer against losses on
sovereign debt holdings in order to reach a core Tier 1 capital ratio of 9 percent. In the event of additional shocks such as acceleration in the pace of NPL formation, capital needs could increase.

It is unclear how banks will raise necessary capital. They are expected to de-lever balance sheets, issue contingent convertible securities, retain profits and cut costs. If these sources prove inadequate, they would need the support from the government or external sources.

The system appears capable of absorbing moderate funding shocks at the aggregate level, but individual banks could face pressures. In the event of rapid and persistent loss of deposits, liquidity buffers would eventually be depleted.        

This paper was prepared based on the information available at the time it was completed on November 4, 2011. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Cyprus or the Executive Board of the IMF. The policy of publication of staff reports and other documents by the IMF allows for the deletion of market-sensitive information. © 2011 International Monetary Fund November 2011. IMF Country Report No. 11/332

Cyprus.Selected Issues Paper

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Cyprus:2011 International Monetary Fund Consultation

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.

Cyprus: 2011 Article IV Consultation - Staff Report; Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Cypruss

IMF Executive Board Concludes 2011 Article IV Consultation with Cyprus

Public Information Notice (PIN) No. 11/145. November 29, 2011

On 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.

IMF Executive Board Concludes 2011 Article IV Consultation with Cyprus