Staff
teams from the European Commission (EC), European Central Bank (ECB),
and the International Monetary Fund (IMF) visited Nicosia during
January 29-February 11, 2014 for the third review of Cyprus's
economic programme, which is supported by financial assistance from
the European Stability Mechanism (ESM) and the IMF.
The objectives of
Cyprus’s programme are to restore financial sector stability,
strengthen public finance sustainability, and adopt structural
reforms so as to support long-run growth, while protecting the
welfare of the population. Discussions with the authorities during
this visit focused on policies to restore confidence in the financial
system and implementation of the structural reform agenda.
Cyprus’s
programme remains on track, with the macro-fiscal outturn better than
expected. Fiscal targets for 2013 have been met with considerable
margin, due to both continued prudent budget execution and a less
severe recession than anticipated. Output in 2013 is estimated to
have contracted by about 6 percent in real terms, which, while
significant, is almost two percentage points better than forecasted
at the time of the last review. Private consumption contracted,
although by less than expected, while tourism and professional
services have proven resilient. The financial sector is also showing
signs of stabilisation. The economy is adjusting flexibly as prices
and wages are declining, helping to cushion the full impact of the
recession on jobs. Still, unemployment remains very high.
The
outlook remains challenging. Output is projected to contract by 4.8
percent in 2014, with domestic demand weighed down by the need for an
adjustment of private and public sector debt from currently high
levels. A return to positive but modest growth of around 1 percent is
expected in 2015, led by non-financial services. Nonetheless, risks
to the outlook are substantial.
In the
financial sector, the first challenge is dealing with the high level
of non-performing loans. With the two largest banks now recapitalised
and the cooperative credit sector expected to be recapitalised
shortly, the authorities need to ensure that banks and coops
effectively implement their restructuring plans. This requires
putting in place adequate arrears management frameworks and carefully
monitoring progress toward reducing loans in arrears. For coops, it
is also important to complete planned mergers and strengthen
governance. To facilitate the clean-up of banks’ balance sheets and
the reduction of private sector indebtedness—both of which are
needed to restore credit and sustainable growth—an appropriate
debt-restructuring framework is necessary. In this regard, the
authorities need to reform the insolvency legislation to offer
balanced incentives that can prevent strategic defaults while
providing solutions for voluntary debt restructuring for viable
borrowers.
A
second challenge is the need to normalise payment flows in the
economy while safeguarding financial stability. With key milestones
in the authorities’ roadmap now completed, the second phase of
gradual relaxations of restrictions is expected to start shortly.
Finally, efforts also need to continue to strengthen implementation
of banking sector regulation and supervision as well as of the
anti-money laundering framework.
Building
on the strong fiscal performance to date, the authorities will need
to continue to implement their budget prudently. As agreed at the
onset of the programme, an additional adjustment will be necessary in
the outer years to attain the long run objective of a sustained four
percent of GDP primary surplus, which is needed to place public debt
on a sustainable downward path.
The
implementation of structural reforms needs to be accelerated. A key
priority is the reform of the social welfare system. This will
consolidate existing welfare benefits and introduce a guaranteed
minimum income scheme, so as to provide adequate social protection of
vulnerable households during the current downturn. To improve the
efficiency of revenue administration the authorities need to take
steps to advance the merger of the two main tax collection agencies.
Moreover, efforts need to be intensified to protect revenue
collections in the short term, including by fighting tax evasion.
Public financial management should be strengthened by adopting
without delay and implementing the fiscal responsibility and budget
systems law. Finally, privatisation of state-owned enterprises is
essential to increase economic efficiency, attract investment, and as
a means to reduce public debt. In this regard, the adoption of the
framework law for privatisation is a key step to kick-start the
process.
While
the programme remains on track, Cyprus still faces significant risks.
Continued full and timely policy implementation remains essential for
the success of the programme.
Conclusion
of this review is subject to the approval process of both the EU and
the IMF and is expected to be considered by the Eurogroup, the ESM
Board of Directors, and the Executive Board of the IMF by early
April. Its approval would pave the way for the disbursement of €150
million by the ESM, and about €86 million by the IMF.
