September 26, 2019

Cyprus has made significant progress in recovering from the financial crisis. Real GDP has now surpassed its pre-crisis peak and the unemployment rate has declined rapidly coming close to the pre-crisis level. Large disposals of non-performing loans (NPL) have strengthened bank stability, and sizable fiscal surpluses have lowered risk premia and reduced financing risks.

Challenges remain however in sustaining the relatively robust growth momentum. Given still-high NPLs, recent efforts to undo key reform initiatives are undermining the hard-won gains in restoring macro-financial stability. Increasing external headwinds are slowing near-term growth, while a sizable debt overhang and weak productivity growth also hold back medium-term growth potential.

Policies should focus on reforms to secure financial stability and raise the growth potential of the economy. Priorities are to steadfastly implement the strengthened legal tools to lower NPLs and private debt and to build bank capital buffers; to reduce public debt by ensuring strict spending discipline and improving the efficiency of public spending; and to increase productivity through institutional reforms and the promotion of technology adoption.

Outlook and Risks

1. Cyprus has made significant strides in recovering from the financial crisis and in addressing its legacy challenges . With economic growth averaging about 4½ percent over the past three years, the pace of recovery in Cyprus has been more rapid than many other euro area post-crisis economies. The unemployment rate has declined although it is still above the pre-crisis level. Efforts to address high NPLs and banking system vulnerabilities also gained momentum. The disposal of large NPL portfolios, supported by a strengthened foreclosure and insolvency framework last year, and the resolution of Cyprus Cooperative Bank paved the way for a more consolidated and deleveraged banking system. GDP levels have now surpassed pre-crisis levels, while in the banking system, NPLs as a share of GDP have declined by nearly two-thirds from its post-crisis peak. Although public debt has spiked in the process, strict spending discipline and large fiscal surpluses have helped Cyprus to capitalize on favorable market conditions and reduce debt vulnerabilities.

2. While economic growth is gradually moderating, the near-term economic outlook remains favorable . Growth is expected to decelerate to around 3 percent in 2019–20 on weaker external demand, from nearly 4 percent last year. Investment is expected to remain strong, driven by housing and infrastructure construction projects that are primarily foreign financed, while robust labor market recovery and rising income continue to support private consumption. The current account deficit is expected to widen, reflecting slowing growth among trading partners and continued high construction-related imports. Over the medium term, growth is expected to slow to its long-run potential growth rate of around 2½ percent, as the transitory effect of the investment boom gradually dissipates.

3. Risks to the outlook are mainly on the downside . Delays in NPL resolution could negatively affect the capital position of banks and weigh on availability of credit. Realization of fiscal contingent liabilities could slow the pace of debt reduction, eroding confidence and raising risk premiums. The high level of external debt makes the economy vulnerable to interest rate and growth shocks. External risks from rising protectionist trade policies, a sharper-than-expected slowdown in euro area growth or a hard Brexit could affect tourism and shipping revenues and foreign direct investment (FDI) flows. A negative assessment on Anti-Money Laundering/Combating Financial Terrorism (AML/CFT) compliance risks could affect confidence and deter investments. [1] On the upside, exploitation of offshore gas deposits and energy sector investments could boost growth over the longer term.

4. Important challenges remain in sustaining the growth momentum over the longer term . Private sector deleveraging has been lagging given ongoing challenges in debt workouts. The NPL ratio has declined from more than half of loans at end-2017 to less than one-third today but remains among the highest in Europe, and banks suffer from low profitability, constraining credit and investment growth. In this context, the amendments to the foreclosure framework, which were recently approved by the Parliament but have not entered into effect and are currently being reviewed by the Supreme Court, are a setback creating uncertainties for NPL reduction and deleveraging of the economy. Longer-term economic growth potential is hindered by weak productivity growth, reflecting financial sector weakness as well as broader institutional bottlenecks and a slow pace of technology diffusion. Policies should thus focus on reforms to secure financial stability and strengthen growth potential by enhancing efficiency and productivity.

Policy Priorities

Financial Sector Policy: Supporting Deleveraging and Strengthening Financial Sector

1. NPL resolution and sustainable debt workouts remain key priorities . Efforts should focus on ensuring a well-functioning NPL resolution toolkit through restructuring, foreclosure, and insolvency. To this end, the recent amendments to the legislation risk reducing the effectiveness of foreclosure as a credible threat against strategic default, thereby weakening prospects for collateral recovery and increasing the need for additional provisioning. Adequate supervisory oversight of durable restructuring is crucial. The finalization of the framework for electronic auctions and continued progress with complementary judiciary reforms aimed at reducing backlogs will also be key to improve collateral execution and incentives for debt workouts.

2. Strengthening of the supervisory and regulatory framework of credit acquiring companies (CACs) should continue. While progress has been made on multiple fronts, including staffing, on-site inspections and off-site monitoring, strengthening of data reporting and analysis will be crucial given that a sizable stock of NPLs is now held by CACs. It is also important to swiftly finalize the state-owned Cyprus Asset Management Company’s (CAMC) governance and operational structure, business strategic plan, and performance measurement framework, with an appropriate sunset clause and a clear mandate to maximize recovery, while balancing operational independence with public accountability and transparency.

3. Efforts should be made to address the moral hazard risks inherent in the Estia subsidy scheme . Close monitoring to prevent potential abuse of the scheme and timely reassessment of borrower eligibility will be needed, to ensure that taxpayers are not called on to subsidize individuals who are capable of servicing their mortgages. Any complementary schemes for vulnerable primary owners deemed unviable under Estia should ensure further burden sharing and be well-targeted with a full cost-benefit analysis undertaken to control fiscal and implementation costs.

4. More broadly, efforts to further improve bank profitability and capitalization are crucial. Narrowing interest margins and excess liquidity in a declining interest rate environment are creating pressures on profitability, which is being further weighed down by an inefficient cost structure with excess staffing levels and branch networks in the banking system. Banks should continue to maintain adequate provisions and capital buffers to insulate against potential further losses from NPL sales and workouts and reduce property holdings to targeted levels. Policies should encourage lowering of cost-to-income ratios through rationalization of operational costs, diversifying income sources, and undertaking of digitization solutions.

5. Macro-financial risks from the property market appear limited for now but warrant close monitoring. The segmented nature of the property market calls for close monitoring of sectoral developments, for example, to ensure that any overheating in the luxury segment is not fueled by domestic credit, or that concentration of future sales of repossessed collateral properties does not lead to fire-sales. Macroprudential measures tailored to the market segment should be undertaken if warranted.

Fiscal Policy: Mitigating Risks to Debt Sustainability and Enhancing Efficiency

1. Fiscal performance is strong, but risks remain . Cyprus is projected to maintain large primary surpluses that will allow public debt to decline rapidly over the medium term. However, this outlook is subject to risks, including from court-mandated increases in the public wage bill reversing crisis-era measures, higher-than-expected spending under the newly introduced National Health System (NHS)—particularly from lagging competitiveness of the public health sector vis-à-vis the private sector—and contingent liabilities from public entities, as well as the Asset Protection Scheme and weak asset quality in the financial sector.

2. Spending should be firmly controlled to reduce risks to debt sustainability, while the composition of expenditure should seek to enhance efficiency . Expenditure growth should be capped by nominal medium-term output growth to keep debt firmly on a downward path. Prioritizing public spending to support structural reform efforts would help achieve faster and more inclusive medium-term growth. To this end, growth of the wage bill should be contained below that of nominal GDP, to create space for more productive expenditure. There is scope to improve the efficiency of education spending, including by reallocation towards investment in innovation and human capital. To contain risks from the NHS, strict monitoring and finetuning of the regulatory framework for controlling incentives and costs of services, together with improving the competitiveness of the public health sector, will be important.

Structural Reforms: Improving Productivity and Strengthening Growth Potential

1. Productivity enhancing structural reforms are key for bolstering medium-term growth potential . While Cyprus has maintained its cost competitiveness, it suffers from low labor productivity growth and faces challenges to investment and economic efficiency. These include difficulties with access to finance, costly and lengthy judicial processes, inefficiency of government administration, low investment in new innovations, and skills mismatches.

2. Policies to support greater market diversification, competition, and technology adoption are needed to enhance competitiveness . Greater investment in Information and Communications Technology infrastructure, intangibles such as science, technology, engineering and mathematics training, research and development innovation and easier access to finance are needed to facilitate technological diffusion. Given strong reliance on services exports, reducing remaining restrictions in implementing the EU Market Services Directive could facilitate competition and attract FDI. These reforms would enable greater market diversification, which would support faster economic growth and reduce volatility. Other competitiveness-enhancing policies could focus on strengthening business linkages and external connectivity to international markets.

3. Ongoing efforts to improve efficiency of the judiciary should continue, in order to better enforce commercial claims, support deleveraging and reduce the cost of doing business . The recent specialization of selected judges in financial litigation, the ongoing recruitment of additional judges, and work on establishing a court of appeals should be complemented by reforms of the rules for civil procedures, clearance of the backlog of cases and introduction of the e-justice system. Strengthening the institutional framework for the insolvency service and insolvency professionals is also important. Efforts are needed to create a more efficient system of issuing and transferring title deeds and accelerate the clearance of the backlog.

4. Efforts to reform public sector governance and efficiency should be renewed . Approval of pending legislation to reform the assessment of candidates for appointment and promotions and the structure of the civil service would facilitate greater mobility and enhance effectiveness. Legislative efforts to strengthen the governance and autonomy of the Central Bank of Cyprus should also be expedited. Successful implementation of local government reforms would streamline procedures and improve service delivery. Fiscal institutional measures for strengthening governance of state-owned enterprises, public financial management controls at the local government level and reforms in tax administration would help contain risks while improving public efficiency.

5. Ensuring that growth is inclusive is key to sustaining growth . While unemployment is rapidly declining, the share of youth not in employment, education or training and long-term unemployment remain high, partly reflecting skill mismatches. Programs focused on job retraining and improving linkages between educational and job opportunities would help reduce this gap.

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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 .