17 May 2013

IMF Country Report on Cyprus: Request for an arrangement under the Extended Fund Facility

Cyprus built significant internal and external imbalances in the run up to  the global crisis. These were exacerbated by an oversized and weak banking sector (with assets of over 800 per cent of GDP) heavily exposed to Greece, which posed large contingent liabilities onto the sovereign. The Greek debt restructuring, together with realised and prospective loan losses in both Cyprus and Greece, resulted in an assessment that the two largest banks were insolvent, triggering a loss of confidence and culminating in a banking crisis. The authorities responded through bold and unprecedented steps to address the banking problems upfront. Troubled banks were resolved or restructured and recapitalised through participation of bank creditors, including uninsured depositors. This helped to ensure burden sharing and minimise fiscal costs. Nevertheless, these actions required the imposition of temporary administrative controls to preserve financial stability. A deep recession of about 13 per cent is thus expected, and time will be needed for the economy to adjust to the deep structural changes to its financial sector and adapt its business model.

Main elements of the programme:

• Financial sector policies: These aim to restore financial stability and resumption of credit to support economic activity. The programme builds on the recent actions to complete the financial sector restructuring and recapitalisation process, gradually restore normal financial flows, deal with private sector debt restructuring, reform bank and cooperative supervision and regulation, and strengthen the AML framework.
• Fiscal policy: The programme entails an ambitious and well-paced fiscal adjustment that balances short-run cyclical concerns and long-run sustainability objectives, while protecting vulnerable groups. The consolidation will be anchored in a long-run primary fiscal surplus target of 4 per cent of GDP needed to achieve a debt level of close to 100 per cent of GDP by 2020. This requires the upfront implementation of 2¼ per cent of GDP  of measures in addition to 5 per cent of GDP already underway for 2013-15, and a further effort of 4¾ per cent of GDP to be implemented during 2015-18. Structural fiscal reforms to budget frameworks, revenue administration, and pensions will complement the adjustment, and a privatisation programme will help to reduce financing needs.
• Risks: Macro-economic risks remain unusually high, given the uncertain impact of the banking crisis and fiscal consolidation on economic activity and the adaptation of the business model. Financial sector risks to the programme are particularly acute, including lingering concerns about the high reliance of the largest bank on central bank support, the system‘s rising non-performing loans, and the future impact of administrative restrictions, but also the potential consequences of their premature lifting. Political resolve to implement all aspects of the policy programme could falter, adding to risks. Materialisation of these risks could lead to a higher debt trajectory and the need for additional financing measures to ensure debt sustainability. Programme design—including additional financing buffers and equally-phased Fund disbursements—help to contain risks for the Fund.

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