IMF: Progress in Cyprus economy, but challenges remain

The IMF has noted progress in the Cyprus economy but urged continues efforts to address challenges relating to high NPLs, fiscal risks and an anticipated slowing of growth momentum.

Its concluding statement released on Thursday followed a visit by an IMF team as part of its third post-programme monitoring discussions. These are part of the organisation’s regular monitoring of countries with significant outstanding IMF credit and focus on risks to capacity to repay the IMF.

“Economic growth has been strong, supported by construction, tourism and professional services. Unemployment has declined further. The underlying budget remains in a large surplus. Banks’ balance sheets are being strengthened: non-performing loans (NPLs) have declined sharply following transfers of sizeable loan portfolios out of the banks,” it said.

But it said that while this progress is welcome, continued efforts are needed to address challenges that remain from elevated public and private indebtedness, still high level of bank NPLs, large fiscal risks, and increasing headwinds to sustained growth.

Growth momentum is expected to slow gradually but remain strong. Real GDP growth is projected to reach a still-robust 3–3½% in 2019–20, from 3.9% in 2018, led by foreign direct investment.

Private consumption growth is expected to remain solid, supported by rising jobs and wage increases, but will gradually decelerate as borrowers step up debt servicing.

Domestic credit is expected to remain weak, however, constrained by the NPL overhang in the banking sector. The high import content of investments and lower exports growth, reflecting a slowdown in Europe, will keep the current account deficit elevated. In the medium-term, growth is expected to ease to its potential rate of around 2½%.

Cyprus’s capacity to repay the Fund is adequate under this baseline. Public debt service—interest plus principal—is expected to remain broadly constant over the coming years. Strong economic growth and a sizeable primary fiscal balance are expected to support a durable decline in gross public debt and continued favourable market borrowing terms.

However, repayment capacity could be weakened if growth slows significantly or if some specific risks materialise from banks’ still weak asset quality; the realisation of fiscal guarantees; or unexpected spending, including from court cases. This could be exacerbated in the event of weaker than expected growth in Europe, or a hard Brexit.

Policies can help mitigate these vulnerabilities and strengthen capacity to repay:

1. Facilitating deleveraging, reducing NPLs and strengthening bank profitability: Further efforts are needed to address the troubled legacy assets—which remain among the highest in Europe. Steadfast implementation of the foreclosure framework, including e-auctions, is key to lowering debt. Banks are encouraged to continue maintaining appropriate capital and provisioning levels and reducing NPLs and real estate property holdings to targeted levels. Diversifying income sources while maintaining high quality underwriting standards and consolidating operations would help address the system’s inefficient cost structure. An appropriate governance structure for the state-owned asset management company should be put in place expeditiously to maximise recovery. Ensuring ongoing compliance with the eligibility requirements for the Estia scheme is crucial to prevent abuse of taxpayer resources.
2. Avoiding procyclical fiscal policy and maintaining debt sustainability: Spending growth should be firmly maintained at a pace below that of medium-term GDP and cyclical and windfall revenues should be saved, to ensure a neutral fiscal policy stance, build up buffers, and anchor public debt on a firmly downward path. Keeping growth of the wage bill below nominal GDP growth is particularly important given the gradual reversal of crisis-era public wage and pension cuts. Reforms aimed at making the public health sector more competitive and managing incentives for providers and patients adequately are crucial to mitigate fiscal risks from the introduction of a public health insurance system.
3. Strengthening structural reforms: Ongoing judicial reforms to increase the efficiency of courts and accelerate enforcement of commercial claims should help address the legacy of the crisis and improve the investment climate. Reforms of the civil procedure code and introduction of the e-justice system should be completed. Despite some progress with the issuance and transfer of property titles, a substantial backlog remains: its clearance should be accelerated. Continuing efforts to mitigate AML/CFT risks remains a priority to reduce risks to growth. Improving corporate governance of commercial state-owned enterprises and reforming local government will help reduce contingent fiscal liabilities and raise productivity. Amendments to the Central Bank of Cyprus legislation should be expedited to strengthen its governance.