16 May 2013

DG ECFIN report: The Economic Adjustment Programme for Cyprus

The Programme aims to address the financial, fiscal and structural challenges facing the economy in a decisive manner, and should allow Cyprus to return to a sustainable growth path. This report provides a background to the Programme and builds on the documents agreed with the Cypriot authorities.

Executive Summary

Following a request by Cyprus on 25 June 2012, the European Commission (EC), the European Central Bank (ECB) and the International Monetary Fund (IMF) finally agreed an Economic Adjustment Programme with the Cypriot authorities on 2 April 2013. The Programme aims to address the financial, fiscal and structural challenges facing the economy in a decisive manner and should allow Cyprus to return to a sustainable growth path. The Programme was agreed by the euro area Member States on 24 April 2013 and by the IMF Board on 15 May 2013. It covers the period 2013-2016. The financial package will cover up to €10 billion, including €1 billion from the IMF.

In the last decade, Cyprus was increasingly faced with serious challenges in terms of unsustainable external and internal macro-economic imbalances. While some imbalances have only emerged following the sharp recession and the collapse of the domestic credit boom, others have been building up over the past decade. Cyprus enjoyed strong growth in the first decade of the millennium, twice that of the euro area. Growth took place in conditions of almost full employment, low inflation and rising real disposable income. The latter largely benefited from wage increases significantly higher than in the rest of the euro area. Economic performance during this period was driven mainly by buoyant domestic demand, which was supported by a surge in credit growth. The fall in risk premia, financial integration, capital liberalisation and excess liquidity in the banking sector, which was linked to large inflows of foreign deposits, contributed to the credit expansion.

Furthermore, the dynamic activity in the real estate sector and asset re-pricing, particularly of land, coupled with the positive confidence effect of EU accession and subsequent euro adoption, augmented the build-up of the asset boom. In parallel, persistently high current account deficits were recorded. Lagging exports went hand in hand with significant losses of price/cost and non-price/cost competitiveness. Private sector indebtedness, in both the corporate and the household sectors, increased rapidly, resulting from more favourable financing conditions and the steady increases in housing prices. A strong inflow of foreign capital (mainly deposits) allowed the current account deficit to keep growing, while further fuelling credit growth in the domestic economy.

Financial soundness indicators for Cypriot banks started to deteriorate in 2010, revealing vulnerabilities with respect to their capital buffers and liquidity positions. The banking sector was increasingly cut off from international market funding and major financial institutions recorded substantial capital shortfalls against the backdrop of the exposure to the Greek economy and deteriorating loan quality in Cyprus. Bank credit policy, poor risk management practices and insufficient supervision were recognised as partly responsible for the prevailing imbalances. On the fiscal front, the policy stance was found to have been insufficiently prudent during the economic boom years, while the subsequent counter-cyclical policy action to mitigate the effects of the global economic crisis produced a back-loaded fiscal consolidation strategy that was ineffective in correcting the excessive budget deficit. Amidst consecutive downgradings of Cypriot sovereign bonds by credit rating agencies, the country became unable in mid-2011 to refinance itself at rates compatible with long-term fiscal sustainability.

Against this background of increasing pressure in financial markets, due to concerns about the sustainability of its public finances and a weakened financial sector, the Cypriot authorities requested financial assistance from euro area Member States and the IMF on 25 June 2012. The situation in the banking sector worsened further in early 2013, due to a drop in confidence leading to continuous and substantial deposit outflows. In March 2013, the Eurogroup reached a political agreement on the key elements of an Economic Adjustment Programme for Cyprus with a financial envelope of up to €10 billion, including the restructuring and substantial downsizing of the banking sector and the reinforcement of efforts on fiscal consolidation, structural reforms and privatisation. An important element of the agreement was the contribution of uninsured bank depositors towards the recapitalisation needs of the two largest banks. Following financial turmoil, a bank holiday of 10 days was imposed, during which the sector was downsized substantially through the resolution and restructuring of banks and the separation of the Greek operations of Cypriot banks. On 2 April 2013, an agreement at technical level was reached in respect of a comprehensive policy package to be implemented in a three-year Economic Adjustment Programme; the key objectives, measures and outcomes were laid down in a draft Memorandum of Understanding (MoU) between the Commission and the Republic of Cyprus.

The Programme aims at restoring financial market confidence, re-establishing sound macro-economic balances and enabling the economy to return to sustainable growth. To achieve these goals, the Programme builds on three pillars:

(1) Ambitious measures to address the deep banking crisis, with efforts to address capital and liquidity shortfalls. The authorities have already taken decisive action to cope with the capital needs of two of the major banks without recourse to taxpayer money. Restructuring and downsizing of banking is underway and the Programme aims to complete this process, to return speedily to free financial transactions and to preserve the soundness of financial institutions. Regulatory provisions and governance of the financial sector will be strengthened.

(2) Determined action to continue the on-going process of fiscal consolidation. This will be an ambitious fiscal consolidation strategy, building on the consolidation efforts intiated in 2012, in particular through measures to reduce current primary expenditure, enhance government revenues, improve the functioning of the public sector and maintain fiscal consolidation in the medium-term. The aim is to correct the excessive general government deficit as soon as possible and to put the gross public debt-to- GDP ratio on a firm downward path in the medium term.

(3) Ambitious structural reforms to support competitiveness and sustainable and balanced growth, allowing for the unwinding of macro-economic imbalances. The aim is to overcome the macro-economic imbalances that accumulated before and during the crisis and to re-establish solid foundations for a sustabinable growth path.

An important feature of the Programme is the mitigation of any adverse social effects, while addressing fiscal, banking and structural imbalances. In particular, the reforms of the wage indexation mechanism cost-of-living allowance (COLA) and the pension system, and the targeting of social benefits are designed so as to minimise the impact on the lowest income groups.

Full paper

See also DG Internal Policies Economic Dialogue: Background information on the implementation of EU financial assistance programmes (as of 6 May 2013)

© European Commission