* Exposure to Greece weak link in economy *
Cyprus must take immediate steps to start reducing public debt and its banks remain badly exposed to debt-crippled Greece, the International Monetary Fund warned in a report on Tuesday.
Externally, the exposure of Cypriot banks to Greece and worsening prospects for external demand pose the main challenges to its struggling economy, the Fund said in its 2011 staff report.
Domestically, the foremost challenge is to restore sound public finances, and to regain access to sovereign debt markets, it said.
"The situation calls for immediate action to reverse the widening fiscal deficits and put public debt on a downward path," it said.
On the policy front, measures should primarily focus on expenditure reductions. Priority areas for fiscal savings included containment of public sector wages; at 15.4% of GDP, Cyprus had the highest public sector wage bill in the euro zone, the IMF said.
The government is negotiating a two-year freeze on pay in the broad public sector and an additional tax on earnings in the private sector from 2012.
The IMF said banking assets totalled 152 bln euros, or 835% of GDP, while assets of Cypriot banks were 500% of GDP.
Cypriot bank exposure to Greece, including both sovereign debt and to Greek residents, totaled 29 bln euros, or 160% of Cypriot GDP.
The two dominant banks have sizeable holdings in Greek debt. Preliminary assessments by the European Banking Authority suggest a 3.6 bln euro capital boost to provide them with adequate buffer, although, according to the Central Bank of Cyprus, the final figure is likely to be much less.
Cypriot authorities needed to strengthen crisis management procedures and engage in contingency planning, including the passage of legislation to give authorities powers to provide financial support through a fast-track procedure, the IMF said.
Staff projected an economic contraction of 1% in 2012. The main driver behind the expected downturn included even tighter financial conditions as banks curtailed their lending in order to preserve capital and liquidity buffers and the negative short-term impact of fiscal adjustment measures, the IMF said.
A worsening growth outlook in the euro area and beyond was also weighing on prospects, it said.
