Public Information Notice No. 05/39

Public Information Notice: IMF Executive Board Concludes  2004 Article IV Consultation with Cyprus

March 22, 2005

On February 18, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cyprus.¹

Background

The Cypriot economy has seen substantial changes since the last IMF Article IV consultation in 2002. Chief among these is accession to the European Union, the full impact of which is only gradually making itself felt. In a sense, Cyprus ceased to be an island on May 1, 2004. While these changes pose significant challenges for the authorities and for the private sector, they also offer substantial opportunities to enhance economic growth in Cyprus.

Economic growth has begun to rebound following a more modest performance in 2002-03, recovering in real terms to about 3½ percent in 2004 mainly driven by an increase in domestic demand. Real per capita income has continued to rise, now reaching above 80 percent of the average EU 25 income level when adjusted for purchasing power, unemployment remains low by European standards, and inflation has been kept at bay, although rising energy prices have exercised some upward pressures in 2004. Looking ahead, growth is estimated at close to 4 percent in 2005 reflecting an improved external environment. Over the medium term, growth prospects are subject to a significant degree of uncertainty given oil price volatility and a lack of clarity on reunification, as well as the ultimate impact of EU accession.

Following a significant fiscal slippage in 2003, with the general government deficit rising to 6.3 percent of GDP amid expenditure overruns, the authorities have recently adopted an ambitious and detailed Convergence Program aimed at consolidating the fiscal accounts and bringing the deficit and debt levels down to levels compatible with the Maastricht criteria. The authorities have also stated their readiness to take additional measures in case the program does not yield the expected impact. The general government deficit is now targeted at 4.8 percent of GDP in 2004 and at 2.9 percent in 2005; meanwhile, public debt is expected to peak at 72 percent of GDP in 2004 before starting to decline, reaching close to 60 percent of GDP by 2009.

Substantial progress with structural reforms has been achieved in a number of areas, mainly in response to efforts to conform with the acquis communautaire. In particular, indirect taxation has been aligned more closely with EU standards, direct taxes have been lowered, the capital account has been liberalized, and financial sector legislation has been strengthened in line with EU directives.

The fiscal consolidation envisaged in the Convergence Program will enable the authorities to achieve their strategy of adopting the euro as soon as possible, including by joining the ERMII in the first half of 2005. The current parity is deemed appropriate. Further fiscal consolidation and deeper structural reforms, in particular labor market reforms, would be appropriate ways to prevent further erosion of competitiveness.

Executive Board Assessment

Directors welcomed the Cypriot authorities' long record of good policy performance, which has led to low inflation, near full employment and, in 2004, a rebound in growth. They observed that accession to the EU has prompted many important structural reforms, helping to lay the foundation for sustained economic growth into the future. Directors noted the authorities' plans to join the ERMII in 2005 and adopt the euro thereafter, and cautioned that this will require determined and sustained fiscal adjustment and structural reform. In this regard, they welcomed the authorities' ambitious and updated Convergence Program and urged its full implementation. They commended the authorities' efforts to build national support for the Program.

Directors noted the significant fiscal slippage in 2002-03, and stressed that fiscal adjustment is now the key economic priority for Cyprus. They welcomed the appreciable progress made in this regard during 2004, and considered the 2005 overall deficit target of 3 percent of GDP to be achievable with continued scrupulous implementation of the Convergence Program measures. Directors welcomed the better-than-expected revenue yield of some measures, but stressed that key expenditure containment measures-including raising the retirement age in the public sector and limiting public sector wage increases-remain necessary. They also encouraged the authorities to follow up, if needed, on their stated readiness to take further measures to ensure the fiscal targets are achieved.

Directors noted that mounting demographic pressures reinforce the need for fiscal restraint and a reduction of the public debt over the medium term. In that light, Directors welcomed plans to target primary fiscal surpluses beginning in 2005, in part through caps on current and capital spending. Of particular importance will be reforms to the health care and pensions systems and the freeze on new government positions. Directors urged the authorities to adopt an explicit medium-term fiscal framework, which would bolster policy formulation and credibility. Such a framework should also eliminate the need for supplementary budgets during the year. In this context, they welcomed the authorities' recent request for a fiscal Reports on the Observance of Standards and Codes assessment.

Directors supported the central bank's cautious monetary policy stance, stressing the need for vigilance in the face of possible inflationary pressures in the run-up to euro adoption. They agreed that the current exchange rate parity remains appropriate. However, a number of Directors urged reform of the wage-setting mechanism. While acknowledging that automatic, backward-looking wage indexation has contributed to harmonious labour relations in Cyprus, these Directors also noted that it has increased the pass-through of inflationary shocks, limited the ability of employers to provide performance-based merit pay increases, and reduced external competitiveness.

Directors stressed the importance of a strong structural reform effort to enhance competitiveness. They welcomed the reforms in electricity distribution, air transport and water management, and encouraged the authorities to modernize corporate governance in the public enterprises and consider eventual privatization of these enterprises where appropriate.

Directors welcomed the strengthening of financial sector regulations in recent years with a view to aligning them to EU norms. At the same time, they called for vigilance over the financial system's growing exposure to the real estate market and its interaction with the offshore sector. Directors also stressed the importance of effective supervision of the cooperative sector, and encouraged consolidation of their supervision under one institution. Directors looked forward to the Offshore Financial Center assessment update later this year, and encouraged the authorities to seek an evaluation under the IMF's Financial Sector Assessment Program.

Directors hoped that an agreement could be reached that would allow Fund staff to provide technical assistance, in the IMF's areas of expertise, to the Turkish Cypriot community in northern Cyprus.

Cyprus's macroeconomic statistics remain adequate for IMF surveillance purposes, but Directors noted that further improvements would be facilitated by the process of subscription to the Special Data Dissemination Standard.