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ESM: Robust programme implementation but risks remain for Cyprus

20 June, 2014

Overall, despite the robust programme implementation in Cyprus, risks remain to the stabilisation of the economy, with the greatest challenge lying with the health of the financial sector, the European Stability Mechanism points out in its report for 2013.

The report notes that `the programme’s objectives are to restore financial sector stability, strengthen public finance sustainability, and implement structural reforms in order to support sustainable and long-run growth`.

`Under the Financial Assistance Facility Agreement signed between the ESM and Cyprus, an amount of up to €9 billion is available to the country in order to finance debt redemption, fiscal deficits and the recapitalisation of the financial sector. In addition, the IMF contributes up to €1 billion to cover the country’s financing gap. From May 2013 until March 2014, a total of €4.6 billion was provided to Cyprus by the ESM, after ensuring compliance with prior actions and programme conditionality defined in the Memorandum of Understanding`, it says.

According to the ESM, `the recession in 2013 was severe (-5.4%), but less steep than expected at the beginning of the programme`.

`The better than expected macroeconomic performance is attributable to the dynamics of private consumption and the contributions of tourism and professional business services. Overall, consumption fell by 5.6%, while investment declined sharply by 21.6%. The external sector contributed positively to GDP trends, with imports declining more (-14.1%) than exports (-4.2%)`, it says.

It adds that `fiscal developments were better than expected in 2013, with the government reaching the deficit targets by a considerable margin`.

`The overall deficit is expected to be 5.5% of GDP, while the primary deficit is seen at 1.8% of GDP. The fiscal outturn is attributed to better than expected macroeconomic developments, as well as to the expenditure constraint, which more than offset the slight underperformance in revenues`, the report notes.

On the banking system, it says it `is burdened by very high level of Non-Performing Loans (NPL)` and that, `despite the significant restructuring that has taken place in the banking sector, the level of problematic loans is very high (NPL ratio at 47.6% as of February 2014) compared with other programme countries`.

`Effective management of NPLs is critical to restore banks’ ability to finance domestic economy`, it adds.

In the financial sector, the main policy measure adopted in 2013 included the bail-in of uninsured depositors and the imposition of restrictive measures in the economy, in order to safeguard financial stability in the domestic economy. Fiscal consolidation focused on reducing expenditure growth on the public sector wage bill and social benefits, while the authorities successfully implemented some important revenue side measures (for example, an increase in immovable property taxes).

Regarding structural reforms, important steps have been taken on revenue administration, reforming the social welfare system and preparing for privatisations.

The report notes that, `overall, despite the robust programme implementation, risks remain to the stabilisation of the economy`.

`The greatest challenge lies with the health of the financial sector; key policy issues are NPL management, private sector debt restructuring and ensuring that banks’ restructuring plans are fully implemented. Success in bank restructuring will contribute to depositor confidence and pave the way to lifting the restrictive measures in accordance with the agreed roadmap. On the upside, progress in negotiations on the Cyprus reunification issue would have a profound impact on the programme`, it says.