18 September 2013

ECFIN Occasional Paper: First review of the economic adjustment programme for Cyprus

Following a request by Cyprus on 25 June 2012, the European Commission, the European Central Bank and the International Monetary Fund finally agreed an economic adjustment programme with the Cypriot authorities on 2 April 2013. The programme aims to address the financial, fiscal and structural challenges facing the economy in a decisive manner and should allow Cyprus to return to a sustainable growth path. The programme was agreed by the euro area Member States on 24 April 2013 and by the IMF Board on 15 May 2013. It covers the period 2013-2016. The financial package will cover up to EUR 10 billion, including €1 billion from the IMF.

The team consisting of experts from the European Commission, the ECB and the IMF found that the Cyriot authorities have taken decisive steps to stabilise the financial sector and have been gradually relaxing deposit restrictions and capital controls. The fiscal targets have been  met as a result of significant fiscal consolidation measures underway and prudent budget execution.

Structural reforms have been taken forward in important areas, although delays and partial compliance were observed in a number of cases. While the programme has been implemented with determination so far, downside risks remain substantial. Continued full and timely policy implementation is essential for the success of the programme. 

The short-run economic outlook remains difficult and subject to considerable uncertainty. Recent indicators support the programme’s projections of a contraction in output of about 13 per cent cumulatively during 2013-2014. Encouragingly, business and, to a lesser extent, consumer confidence indicators, have improved somewhat from the troughs in April. However, the labour market has weakened, and unemployment is rising faster than anticipated in the spring. Growth is expected to recover modestly starting in 2015, driven by revamped and more competitive non-financial service sectors.

Financial sector policies have been geared toward restoring confidence in the banking system, aiming at supporting economic activity. Confidence in the banking sector deteriorated in the first part of the year, and deposits have gradually left the banking sector. Therefore, the authorities have taken difficult but necessary steps to fully recapitaise Bank of Cyprus, thus allowing it to exit resolution and return to normal operations. The authorities have also set out a clear agenda to restructure and recapitalise the cooperative credit sector, before the end of 2013, using programme resources where necessary, and without involving depositors. A milestone-based roadmap for the gradual removal of capital controls and administrative restrictions was agreed to ensure an orderly and predictable exit. Banking sector regulation and supervision are also being strengthened.

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