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Cyprus needs to deal with NPLs, says IMF report

02 April, 2014

“2013 recession not as severe as anticipated”

Signs of stabilisation are emerging in the banking sector, however, the outlook remains challenging, with rising unemployment, falling credit, and increasing non-performing loans, the International Monetary Fund said in its report on Cyprus.
The report said that while deep, the 2013 recession was not as severe as anticipated.
“The adjustment is occurring through both quantities and prices and signs of stabilization are emerging in the banking sector. However, the outlook remains challenging, with rising unemployment, falling credit, and increasing non-performing loans,” it noted in its executive summary.
In this context, growth projections remain unchanged, with a deep contraction expected in 2014 and a modest and credit-less recovery taking hold in mid- 2015.
The IMF said that the EUR 10 bln rescue programme remains on track and fiscal targets were met with considerable margins, the coop sector was recapitalised, and additional relaxations of payment restrictions are being implemented. Delays in the implementation of structural reforms have recently been overcome.
Looking forward, the report said policies will need to focus on dealing with the high level of non-performing loans, further normalising payment flows, maintaining fiscal prudence, and stepping up the implementation of the ambitious fiscal structural reform agenda.
“Risks to programme implementation remain significant, including due to remaining financial sector vulnerabilities and diminished political support following the breakup of the governing coalition,” it said.
The IMF noted that all end-December and continuous performance criteria (PCs) were met, in some cases with significant margins. Compliance with structural conditionality, however, was mixed.
On the one hand, the structural benchmark (SB) on fulfilling the preconditions for injection of state aid in the cooperative sector was met, and the sector was recapitalised. The authorities also met the SB on strengthening anti-money laundering (AML) supervision of banks. On the other hand, remaining SBs were not met on time.
Legislation on budget systems and privatisation were eventually fulfilled as prior actions for the completion of the third review, the IMF report said, adding that the authorities also committed to implement structural requirements to combat tax evasion. They requested more time to entrust the voting rights of legacy Laiki’s equity stake in Bank of Cyprus (BoC) to an independent entity.
The IMF pointed out that European policies and initiatives are broadly supportive of Cyprus’s situation.
“The ECB’s accommodative monetary policy stance and collateral policies are helpful, although Cyprus could benefit from further ECB action to reduce fragmentation of the financial system and relax bank collateral requirements, and deflation remains a risk,” it added.
Furthermore, it said that the upcoming introduction of the Single Resolution and Supervisory Mechanisms (SRM, SSM) in the Euro-area will help to strengthen supervision of Cypriot banks and coops. Additional efforts toward European backstops, such as ESM direct recapitalisation, could further help to reduce remaining concerns regarding the strength of Cypriot banks should negative risks materialise
As regards the macroeconomic framework, it noted that it has been slightly modified to incorporate recent developments.

GROWTH PROJECTIONS UNCHANGED
Growth projections for 2014 and beyond remain unchanged, and given limited new data for this year, the 2014 growth projection was maintained at -4.8%.
“This is consistent with a slowing rate of output decline during this year, as the uncertainty and immediate effects of the crisis are wearing off, domestic payment restrictions are gradually lifted, and the negative fiscal impulse declines relative to last year,” it said.
The IMF noted that both private consumption and investment are projected to continue to contract, albeit at a lower rate than last year, with the contribution of the foreign balance moderating. The modest recovery, projected to take hold by mid-2015, is expected to be credit-less, led by tourism and other service sectors, which are relatively less indebted, exhibit lower NPLs, and are likely to finance activity and exports through generation of positive cash flow.
As regards unemployment and inflation, these were revised down modestly, it said. In 2014, the average unemployment rate was revised down to 19.2% from 19.8% to account for the 2013 outturn and for the deceleration in the rate of increase in recent months.
Inflation was lowered to 0.4% from 1%, reflecting the lower outturn in 2013.
“Despite the negative inflation seen in recent months, [IMF] staff expects average inflation in 2014 to remain around last year’s level, with recent downward pressures to be offset by a stabilisation of utility prices and by the pass-through to prices of VAT increases taking effect this year.”
In 2013, the current account deficit was also revised slightly down and is projected to reach 1.7% of GDP, on account of a somewhat smaller decline in imports than originally anticipated, given the better than expected domestic demand outturn. In 2014, the current account was correspondingly revised down from a small surplus to broad balance.

DOWNSIDE RISKS
The IMF said that a change in depositor sentiment, in the context of important relaxations of payment restrictions underway, could risk destabilising the system and exacerbating the recession. The risk of a deflationary spiral has also increased.
“While lower prices can help improve competitiveness, a prolonged decline could weigh down on private sector balance sheets, with rising debt burdens posing a drag on economic growth. Continued deleveraging by the private sector, coupled with further tightening of liquidity conditions for companies and an exhaustion of liquidity buffers of consumers could lead to a more protracted recession and slower recovery,” it noted.
Finally, the IMF said that the Ukraine crisis may lead to capital flight from non-resident depositors of foreign banks, which may affect the business service sector.
On the upside, if trends of economic activity observed in the second half of 2013 continue, growth in 2014 and beyond could be better than anticipated.
Prospects for the exploitation of gas reserves and for reunification of the island could raise the economy’s long-term growth potential.