Cyprus: Staff Concluding Statement of the 2018 Article IV Mission

October 5, 2018

Five years after the financial crisis, the Cypriot economy has turned the page on its recovery path. The growth momentum is strong. Fiscal performance is robust. A set of legislative reforms aimed at addressing the crisis legacy of non-performing loans (NPLs) has been approved, catalyzing the cleanup of bank balance sheets. Nevertheless, challenges remain. Risks have partially been transferred to the public sector as part of the bank clean-up strategy, but high debt will remain a burden on the private sector until NPLs, which constrain investor confidence and growth prospects, are resolved.

The key policy priorities are therefore to achieve further private and public balance sheet repair by steadfastly implementing the recently amended legal tools to lower NPLs and the private debt overhang; safeguarding fiscal space and reducing risks to public debt sustainability by maintaining strict spending discipline; and enacting structural reforms, especially in the judiciary and public administration, to attract further investment and enhance productivity. These policies are critical to reduce vulnerabilities and reinvigorate medium-term growth potential. The current phase in the electoral and economic cycle provides an opportunity to advance this policy agenda.

Outlook and Risks

The Cypriot economy continues its rapid recovery from the 2012–13 financial crisis. The growth momentum has been strong over the past three years, bringing real GDP back to its pre-crisis level. The economy grew by over 4 percent in 2017 and the first half of 2018, supported by tourism, professional services, and construction. Consumption picked up further amidst a sharp decline in unemployment. After an extended period of stagnation, wages and property market prices are rising, although the pace remains very gradual, contributing to low underlying inflationary pressures. Increased domestic demand has boosted imports, widening the underlying current account deficit. With the banking sector hamstrung by weak balance sheets, economic growth has been largely supported by external financing.

Important strides were made in addressing key vulnerabilities in the banking sector . Notwithstanding the strong economic recovery, the Cypriot economy is weighed down by very high private and public debt. NPL ratios, while declining, are among the highest in Europe. The recent resolution of the government-owned Cyprus Cooperative Bank (CCB), the second-largest bank, and the passage of a long-delayed legislative package to strengthen the insolvency and foreclosure frameworks, have mitigated near-term risks to financial stability. While the resolution of the CCB has come at a high cost to the public purse, it marks a decisive step in dealing with the crisis legacy of a large NPL overhang and achieving consolidation in the banking system, which in turn has boosted confidence and earned Cyprus a sovereign ratings upgrade to investment grade status.

The near-term outlook remains favorable, although challenges remain on the horizon . Growth is expected to exceed 4 percent in 2018–19, driven by domestic demand. While private consumption growth is expected to decelerate as borrowers step up debt servicing, investment is expected to pick up further, as reflected in the pipeline of ongoing and new construction projects in residential properties, education, health and tourism infrastructure. These import-intensive projects, coupled with slowing tourism growth owing to the recent depreciation in some competitor and source markets, will somewhat widen the current account deficit. Over the medium term, as the transitory effects of the investment boom and the euro area cyclical growth gradually dissipate, growth is expected to slow towards a potential growth rate of around 2½ percent. Sustaining this medium-term growth will require progress in structural reforms, which are crucial for lowering systemic financial risks and catalyzing productivity-enhancing investments.

Risks to the outlook are tilted to the downside . While NPLs have now partially shifted from the banking system to the public balance sheet as a result of bank cleanup operations, progress in resolving NPLs and in strengthening payment discipline is still limited. In this context, delays in NPL resolution will continue to weigh on investor sentiment and growth potential until they are adequately addressed. An increase in moral hazard and realization of contingent liabilities from publicly supported schemes could weaken the fiscal position and raise risk premiums, particularly under tightening global financial conditions. High dependence on Citizenship-by-Investment (CbI) financed investments to propel growth could pose risks for its sustainability. External risks arising from escalating trade tensions, a sharper-than-expected slowdown in euro area growth or a hard Brexit could also affect export revenues and FDI. Upside risks to growth include the prospect of offshore hydrocarbon development. Faster progress in dealing with NPLs could attract additional FDI, increase credit flows, and strengthen economic growth.

Policy Priorities

Financial Sector Policy: Lowering NPL and private debt overhang

Steady reduction of NPLs and high corporate and household debt remains a priority. The recent amendments to the foreclosure and insolvency legislation, the sales of loans law, and the adoption of a law on securitization all enhance the toolkit available to borrowers and creditors to address NPLs on a durable basis. By acting as a credible threat against strategic default, the strengthened foreclosure framework should also help to improve payment discipline and incentivize borrowers to engage with banks in reaching sustainable restructuring solutions. Steadfast implementation of the enhanced frameworks will be key to facilitate this process and ensure timely enforcement. The new frameworks should be supplemented by structural reforms aimed at strengthening institutions, in particular the court system, and removing uncertainties related to title deeds.

The supervisory and governance framework for credit-acquiring companies—which includes the newly-established Cyprus Asset Management Company (CAMC)—needs strengthening . Sales of NPLs to credit-acquiring companies have already begun, making it urgent for the central bank to develop a regulatory and supervisory framework for these institutions: key elements include reporting requirements, on-site inspections and off-site monitoring. To maximize recovery and contain fiscal costs, the governance framework for the government-owned CAMC needs to adequately balance operational independence with public accountability and transparency, with a clear mandate accompanied by operational targets, an independent board, and skilled management compensated based on performance.

The proposed subsidy scheme (Estia) to encourage distressed borrowers to begin servicing their loans should be better targeted to those most in need of assistance . Tighter eligibility criteria and clearer communication would help avoid moral hazard that would further erode payment discipline by extending benefits to those already capable of servicing their obligations. In addition, appropriate assessment of borrower’s capacity to repay the restructured debt on a sustained basis will be important to be sure that those in need of assistance emerge from the process able to make good on their new obligations. Banks should maintain provision coverage at adequate levels and promptly utilize the foreclosure and insolvency framework to address re-defaults. The design of the scheme and an assessment of its impact should be informed by a detailed analysis of borrower data.

More broadly, efforts to strengthen bank balance sheets should continue. In particular, diversifying income sources and consolidating operations would improve cost-income ratios. Better positioning of banks in anticipation of regulatory changes and in the face of competitive pressures would also be prudent. Furthermore, a focus on bank lending policies, sustainability of restructurings, adequacy of provisioning coverage and debt-to-asset swap policies would encourage sound bank risk management practices.

Fiscal policy: Safeguarding fiscal space and reducing risks to public debt sustainability

While fiscal performance is expected to remain robust, caution is needed against procyclical fiscal pressures . Cyprus is projected to maintain large primary fiscal surpluses that should reduce public debt going forward (despite a large one-off increase this year due to the CCB transaction). Although revenues remain buoyant, the reversal of crisis-era wage cuts and interest levy, the introduction of the Estia scheme, and likely increases in health expenditures following the rollout of the National Health System starting next year imply a modest structural loosening. With the output gap closed, a procyclical fiscal stance could in turn increase wage pressures and weigh on competitiveness.

With public debt already elevated, strict spending discipline should be maintained . Debt dynamics could be adversely affected if some of the large banking sector contingent liabilities were to materialize and growth were to slow more than expected. To mitigate these risks, transitory revenues arising from cyclical gains and one-off measures should not be relied upon to finance permanent spending initiatives, while expenditure rises should be capped by medium-term GDP growth (adjusted for permanent revenue changes). Keeping the public wage bill envelope within the nominal GDP growth will be especially crucial. The transition to public insurance in the health sector will need to be carefully managed, bearing in mind that the phasing in and finetuning of the regulatory framework for service provision and the reimbursement mechanism that keeps incentives for over-provision under control may take time. Complementary fiscal structural reforms for spending reviews, public administration, local government and governance of state-owned enterprises (see below) should be implemented to minimize risks.

Structural reforms: Improving the investment climate and achieving sustainable and inclusive growth

Institutional reforms are needed to further enhance the investment climate, and bolster productivity and medium-term growth potential. Although Cyprus has maintained its external competitiveness, investment in more productive sectors is needed to sustain high economic growth. Key challenges remain in enforcing contracts owing to lengthy judicial processes and weaknesses in government effectiveness reflecting administrative inefficiencies.

Advancing judicial reform and strengthening commercial claims enforcement

Reforms to increase the efficiency of courts, clear the backlog of cases, and speed up enforcement of commercial claims should be pursued to reduce cost of capital and improve access to financing and investment . The addition of judges should be supported by reform of the civil procedure code and introduction of the e-justice system to help reduce the length of court procedures. Persistent delays with issuance and transfer of title deeds should be addressed expeditiously, focusing on clearing the backlog but also on avoiding a recurrence of similar problems in the future.

Strengthening public sector governance and public administration effectiveness

Fiscal structural reforms are needed to lower risks and strengthen service delivery . Public financial management could be strengthened through better internal controls for financial management and monitoring of risks from local government and public bodies. In particular, improving corporate governance of commercial state-owned enterprises, including through strengthening financial oversight, implementing a more effective planning and reporting framework with greater disclosure and transparency, and introducing a code of conduct consistent with OECD principles are key to improve the efficiency of the state-owned sector. The legislation to reform the assessment and promotion of the civil service would facilitate greater mobility and enhance efficiency in public administration. Local government reform would also help improve service delivery. Legislative efforts to strengthen the governance and autonomy of the Central Bank of Cyprus should also be expedited.

Ensuring more inclusive growth

Ensuring inclusive growth is crucial not just to equity but also to the sustainability of the recovery . Youth unemployment remains high and the employment rate for recent tertiary graduates remains below the EU average, mainly due to skills mismatch. Promoting Active Labor Market Policies (ALMPs) targeting the youth as well as other vulnerable groups, strengthening the education system to better link work-based and school-based programs, and encouraging investments in high value-added sectors would help address these challenges.

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We thank the Cypriot authorities and our other interlocutors, including from the private sector, for informative discussions and their cooperation and generous hospitality. We also thank the European Commission, the European Central Bank and the European Stability Mechanism for their collaboration during part of the mission .