Filenews 31 March 2022
A significant slowdown in the Cypriot economy due to the war in Ukraine is seen by the International Monetary Fund, which stresses that additional support measures may be needed, but the key is to target these measures in order to protect fiscal space given the high public debt.
At the same time, the IMF recommends a fiscal adjustment for a gradual return to balanced budgets, attention to the banking sector for a possible deterioration in asset quality, more dynamic implementation of tools to reduce the stock of NPLs both inside and outside the banking sector and implementation of reforms through the Recovery and Resilience Plan and addressing obstacles to growth.
In a statement on the conclusion of the meetings with the Cypriot authorities in the context of the Article 4 consultation, the IMF notes that despite the decrease in exposure to Russia, "Cyprus remains very vulnerable to the consequences of the war in Ukraine". It refers in particular to the high dependence of tourism on Russia, which accounts for 20% of total arrivals, while the direct impact of the sanctions against Russia on the banking system has been reduced since the 2013 crisis and decreased even more since the closure of RCB Bank's banking activities.
"Economic growth will slow sharply before recovering in the medium term," the IMF says, estimating that growth will decline to 2% this year (from 3.6% forecast in the WEO Outlook in October 2021) and from 5.5% in 2021, reflecting the impact of the war on the export of services, indirectly the slowdown in growth in Europe and trade shocks due to higher energy and food prices.
If the situation normalises, the IMF notes, the recovery will regain momentum in 2023 and is projected to continue over the medium term with potential growth growing from 2.5% of GDP to around 3% by 2027, supported by investment and structural reforms of the Recovery and Resilience Plan.
However, the IMF stresses that the risks are on the downside, with the main risk coming from a possible escalation and longer duration of the war and sanctions. The coronavirus pandemic also remains at risk, while a normalisation of monetary policy in advanced economies could cause fiscal problems through an increase in returns on risk premia, while a higher than expected rate of defaults on loan payments could weigh on banks' balance sheets.
Targeted and temporary support measures
At the same time, the IMF notes that fiscal policy should continue to provide support, but at the same time gradually replenish reserves. Recalling that public finances were able to support the economy during the pandemic, thanks to the reserves that had been built after the financial crisis, the IMF stresses that "there is room, if necessary, for further assistance in the face of war-related shocks, especially considering the stronger-than-expected fiscal position".
"However, given the high public debt after the pandemic, the policy should aim to restore reserves through a progressive fiscal adjustment," the IMF notes, adding that the target of a surplus of 0.75% of GDP in 2024 is in line with this strategy, "but achieving it may be difficult given the war-related shocks."
It also points out that this year's budget provides good support, but that policies may need to be adjusted as the situation surrounding the effects of the war in Ukraine becomes clearer. It notes that Cyprus has a strong protection factor on the basis of the Guaranteed Minimum Income and that automatic stabilisers (the mechanisms through the budget) alone will absorb the impact on the most vulnerable.
"Additional support measures may be needed if the shock (or its impact) is longer or longer than expected," the IMF says, adding, however, that additional support should be temporary, targeted and not hinder the redistribution of labour in sectors that are expanding. It refers in particular to an extension of the unemployment benefit linked to the return to the labour market and requirements for research into employment.
The IMF also points out that strict fiscal discipline will be needed in order to restore fiscal reserves and highlights as significant challenges the public payroll, the strengthening of GHS finances, the confrontation of anomalies in the system and the financial autonomy of state hospitals.
"While spending control is considered sufficient to achieve fiscal targets, the reintroduction of the property tax could offset pressures on government spending, should it turn out to be greater than the baseline scenario," the Fund says, adding that additional tax revenues could be channelled into public investment to address barriers to growth.
The banking system is resilient, the challenges remain
Regarding the banking system, the IMF notes that the impact of the Covid-19 pandemic has been limited, while banks have made significant progress by transferring NPLs to credit acquiring companies, but progress in dealing with them, particularly in the state-owned KEDIPES, remains slow.
It stresses that the deterioration of the economic outlook requires enhanced monitoring and addressing asset quality problems. He estimates that the problem loans appear to be concentrated in the tourism-related sectors, which are likely to be most affected by the war in Ukraine.
The IMF reiterates that an effective foreclosure framework remains crucial to address old NPLs and strategic defaulters and to incentivise borrowers to engage in restructuring.
"A weakening of the framework will prevent NPLs from being addressed and will entail risks to fiscal stability," the Fund adds. In the same context, it notes that uncertainties from the implementation of the amendments made to the framework in 2019 should be addressed, while further improvements in the operating environment of credit acquiring companies are also significant while strengthening their supervision.
Regarding the government's plan to transfer first homes or business premises with a value of up to €350,000 to KEDIPES and the implementation of rent against a mortgage, the IMF points out that in order to avoid weakening the repayment culture, this plan should be limited to the most vulnerable households, while there should be a timetable, a strict transfer pricing mechanism, in order to minimise fiscal risks, and there should be a strong governance framework with an emphasis on transparency and accountability.
Finally, the IMF refers to the "opportunity" offered by the Recovery and Resilience Programme to promote reforms that address obstacles to growth.
Competitiveness indicators show that Cyprus has a dynamic business sector, with flexible working, but weaknesses in governance, gaps in training and gaps in digital infrastructure weigh on growth prospects, he concludes.
