Participants: Delia Velculescu, Mission Chief for Cyprus Ángela Gaviria, Communications Department

MS. GAVIRIA: Hello, everyone. Welcome to this conference call on the 2014 Article IV Consultation with Cyprus. Let me explain a bit what this is to avoid confusion.

The Article IV is an overall review of a country’s economy, which the IMF does usually on an annual basis for all its members. In countries with financial assistance, which is the case of Cyprus, this review takes place less frequently. The last one done for Cyprus was in 2011, and you can find that on our website. Now, the preliminary findings of this consultation are the ones published this morning under embargo. The same team that did the program review last week, stayed for a few more days to do the consultation. That team will return to Washington and then prepare a full report, which will be sent to the Executive Board. They will discuss it and after that the report will be published. Now, the Article IV Consultation is separate from the program review, although, of course, the issues are related. As you know, we published a joint statement with the European Commission and the ECB last week on the conclusions for the fifth review of the program. So that’s separate, but if you have questions regarding that as well, the speaker today, Delia, will be happy to answer those.

And finally let me remind you all that the statement that is in the Press Center and this conference call are both under embargo until 9 a.m. Washington time, which is in about one hour. Now, you know Delia. She doesn’t need much introduction, but she’s the main speaker today. Delia Velculescu is the Mission Chief for Cyprus. She’ll have some brief remarks and then she’ll be happy to take your questions. Delia?

MS. VELCULESCU: Thank you, Angela, and thank you all for participating in this call. As Angela explained, we have just finished our visit to Cyprus, which covered not only the fifth review of the IMF-supported program, which was concluded at staff level last Friday, but also the Article IV Consultation. The conclusion of our Article IV Consultation is that Cyprus has made impressive progress in addressing the large imbalances that were exposed in the crisis last year. Nevertheless, the road ahead remains difficult, and addressing the remaining challenges will take time and determination.

Let me explain. In the years preceding the crisis, large imbalances were accumulated. The banking sector expanded to over eight times the size of the economy. Credit was easy, and massive borrowing led to individuals and companies building very large debts. The housing market experienced a bubble. And on the fiscal side, after 2008, the deficit and debt deteriorated rapidly.

Last year the authorities embarked on an ambitious adjustment program aimed at tackling these imbalances. Since then, much has been achieved. In the financial sector, the banks were resolved, restructured, and recapitalized consistent with maintaining debt sustainability. To safeguard financial stability, domestic and external payment restrictions were necessary, although in the meantime domestic measures have been fully eliminated. In the fiscal area, the authorities implemented measures of around 7 percent of GDP to contain the deficit, consistently beating their fiscal targets even as the economy entered into a deep recession.

Indeed, the adjustment of imbalances now underway has had a large, but unavoidable economic cost, with the economy contracting by 5.5 percent last year, and unemployment rising to very high levels. Still, the macroeconomic outcomes so far have been better than projected, with private consumption declining by less than projected, and tourism remaining resilient. We do expect the recession to continue this year, followed by very modest growth next year and only gradually increasing toward 2 percent over the long term. Risks to the outlook remain very high, and the road to recovery is still fraught with obstacles that will need to be overcome.

In the financial sector, the key obstacle is the high and rising level of nonperforming loans--NPLs. While banks have strengthened their policies and capacity to deal with nonperforming loans, and the central bank has developed a framework to guide loan restructuring, in practice, progress has been too slow. Putting in place the necessary debt restructuring legal framework -- which includes new foreclosure and insolvency legislation -- is urgently needed to set incentives for borrowers and lenders to negotiate. Ultimately the responsibility lies with both banks and the borrowers to agree on sustainable solutions for the benefit of all.

Boosting bank capital buffers and continuing with bank restructuring are also essential to deal with NPLs and ultimately to ensure banks’ long-run viability so that they can support the economy over the medium term. We welcome Bank of Cyprus’ recent announcement regarding its successful raising of €1 billion in the private markets and look forward to the completion of this transaction, which will be an important milestone toward further strengthening confidence in Cyprus’s banking sector. Enhanced confidence, together with strong capital buffers and the normalization of bank funding, are necessary conditions to allow for the gradual relaxation of external capital controls while safeguarding financial stability.

Turning to public finances, with public debt high and still rising, significant medium-term fiscal consolidation is needed to achieve the authorities’ primary surplus target of 4 percent of GDP by 2018, required to place debt on a sustained downward path. The adjustment would need to be gradual, of a permanent nature, and growth friendly, focusing on reversing the increases in statutory spending prior to the crisis. This should be complemented by resolute implementation of structural reforms now underway, including of the welfare system, public administration, and public financial management. The authorities also need to continue their privatization efforts and begin to identify and implement structural measures to boost growth and competitiveness.

To sum up, Cyprus has made impressive progress since the start of the program. But the road ahead is difficult, and the authorities need to stay the course in program implementation.

MS. GAVIRIA: Thank you, Delia. We’re ready for questions now.

QUESTIONER: Just two questions very quickly. There’s been some resistance to the foreclosure law, as you know. Just want to know, wanted to ask, how confident you are that this will pass and if it doesn’t, what happens next?

Also, Part B of that question is, seeing that the IMF is proposing to target more cuts to the public sector, I wanted to know if you could quantify that. What percentage are we talking about? How much more needs to be cut from the payroll for the public sector? Basically that’s it, thanks.

MS. VELCULESCU: On your question related to the foreclosure law, indeed we expect this to be finalized and passed prior to the conclusion of the fifth review by the IMF Executive Board. This law is essential to provide the incentives for both lenders and borrowers to come to the table and renegotiate in good faith solutions to reestablish loan repayment in line with the borrowers’ capacity to do so. Again, we would expect this law to be passed prior to completing the fifth review.

As to the second question, the primary fiscal balance is still in deficit, and there is a gap to the authorities’ target of 4 percent of primary surplus by 2018. We expect that additional measures will be needed to bridge this gap. The adjustment needs to be balanced in terms of timing, taking into account both short-term cyclical and long-term sustainability concerns. There is some flexibility on the timing, given that there is still some time until 2018 to reach that target, and the authorities are not yet ready to quantify and specify measures for each individual year. What they should focus on is the overall need for measures during this period, with a clear emphasis on statutory spending that was expanded prior to the crisis; that could involve the public sector wage bill, among others. The focus should be on permanent measures.

QUESTIONER: It seemed to me like the last review was a bit harder than the previous ones. Is my impression correct and if yes, what was the reason? I ask because there were some reports or comments that the honeymoon with IMF and the troika has ended and now the tough period starts for Cyprus.

MS. VELCULESCU: During each review, we are assessing the implementation of program measures that were agreed in previous reviews. So every time we look backward to see what has been achieved and what remains to be done. This has been the case in this review as well, which identified a number of elements that need to be tackled. The main one is the NPL problem and the urgency of addressing it, given that NPLs are very high and still rising. IN this regard, reestablishing payment discipline as soon as possible is critical. So I would say it’s not a question of honeymoons, but rather a question of priorities for Cyprus and what needs to be done to actually address the problem that the country now faces.

QUESTIONER: Even though this question has been already asked, I wanted to get your answer. The thing is that the political parties have reacted negatively regarding the legislation for the foreclosures. There is a serious chance that the parliament will vote against it. What will happen in such a scenario?

MS. VELCULESCU: As I said earlier, this is a precondition for the conclusion of the fifth review with Cyprus. If the law is not passed, the review would not be concluded and we may need to come back to Cyprus and discuss again the situation.

QUESTIONER: Two quick questions. You referred to a lack of incentives both to borrowers and to lenders in terms of dealing with NPLs. I was wondering if you could comment on the level of provisioning towards that respect and, more generally, on what exactly you think is the problem with the incentives to the lenders in terms of foreclosing.

Secondly, you’re talking about the AML framework. I was wondering if you could elaborate on that and could you discuss the issue in light of the recent developments with FBME Bank? How do you feel that Cyprus has responded, especially the central bank, regarding the AML capacity?

MS. VELCULESCU: On your first question regarding incentives, indeed we see that part of the problem, which manifests itself in a rising trend of NPLs, is a lack of adequate incentives for both borrowers and lenders. If borrowers who can pay choose not to do so -- and there is some anecdotal evidence to that regard -- then the problem will only swell and the burden will need to be ultimately borne by everyone in Cyprus. This is clearly not an outcome that Cyprus can afford. Therefore, both banks and the borrowers will need to do their fair share to address this problem. We see the foreclosure legislation as the first step in the direction to provide such incentives. The second step will be the insolvency framework that the authorities need to first finalize and then to put into legislation. This framework will help, for example, viable individuals whose ability to pay is there, but may have been affected by the crisis. The framework will develop restructuring solutions for these borrowers under the insolvency umbrella, which will be based on strict criteria.

On your second question about AML, the program has looked into this issue from the start. There were a number of deficiencies to the legal framework that were identified upfront, and those have already been addressed in legislation. Since then, the focus has been on implementation of the legal framework. The authorities have taken a number of steps in this regard, including strengthening the supervisory capacity of the central bank in the area of AML, and improving their risk-based supervisory tools. On this basis, they have developed and started to implement an AML supervisory plan. As to the recent case of FBME Bank, the Cypriot authorities have acted resolutely and quickly to address the identified problem. We are working with them to further strengthen their capacity in the AML area.

QUESTIONER: I was going to ask about foreclosures, but you’ve made yourself pretty clear on that. I wanted to ask if there’s any IMF response to this controversy about the PIMCO study that underlies some of the framework of the bailout and the BlackRock critique of it, basically saying that PIMCO said banks needed more money than they actually did. What does the IMF think of that? Do they stand behind the PIMCO study and what can you say about this?

MS. VELCULESCU: At the onset of the program, the authorities undertook an independent assessment of capital needs in the banking sector. This has been usual practice in all of the other program cases. Countries decided on individual independent assessors, which have been different in different countries. PIMCO was chosen in Cyprus. The assessment was done independently and in accordance with general standard principles, while specific methodologies belong to the company that undertook the analysis. The assessment has proven fair and the assumptions sufficiently conservative. Indeed, the reality that has borne out since then appears to have been in line with the assessment.

QUESTIONER: So just to be clear, you don’t (inaudible) BlackRock is wrong?

MS. VELCULESCU: BlackRock was not the chosen firm to undertake the assessment in Cyprus. As mentioned earlier, PIMCO was the independent firm that was chosen to undertake this assessment in Cyprus. So the recapitalization that was undertaken under the program was done in accordance to the PIMCO exercise. BlackRock was, as I understand, the assessor in another country; other firms undertook similar assessments in several other countries.

QUESTIONER: What about the incentives on the lender side rather than the borrowers? We have these strategic defaults, but what about the incentives from the side of the banks to which you referred? And I was wondering if that relates to the level of provisioning?

MS. VELCULESCU: Clearly the banks have taken provisions to cover for NPLs. In addition, banks are expected to approach borrowers and renegotiate loans in line with the repayment capacity of the borrowers, as I’ve noted above. TO this end, the banks have strengthened operational capacity by establishing specific units with dedicated staffing and defining policies to deal with NPLs. The central bank has provided guidance through an arrears management and code of conduct framework that was developed late last year. They have put in place enhanced supervisory measures to strengthen incentives on the lender side, including monitoring of the banks’ capacity and efforts toward meeting targets on restructuring. Finally, as noted earlier, the insolvency framework will be another element to strengthen incentives on the lender side.

MS. GAVIRIA: If there are no more questions, we end this conference call here. Thank you all very much. Good bye.

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