CYPRUS needs to take urgent action to shore up its economy, the IMF warned yesterday, saying the island needed to intensify efforts to avoid fiscal slippage caused in part by its exposure to Greece.
An existing austerity drive by authorities to contain pensions costs and better target social benefits was the minimum that could be done to get the situation in order, said assistant director in the European Department Erik Jan de Vrijer.
“We think the situation at the moment is very serious. The fact that the government cannot access the capital markets is very serious and the risks to the banking sector compound that,” he said. “The first priority for Cyprus is to do all it can to avoid that these problems get out of hand.”
Worries have grown since a July munitions explosion that crippled its largest power plant that Cyprus’s tiny economy could be the fourth in the euro zone to need a bailout.
Asked about the IMF’s evaluation of the risk Cyprus may require a bailout, De Vrijer said: “I think that there is time, and there is opportunity for the government to take decisive action to avert the possibility of these problems getting worse and worse.”
“We are saying the situation is serious and it demands a strong policy response,” said De Vrijer, who was on an IMF consultation mission to Cyprus.
Cyprus’s credit ratings have been cut this year as a result of the exposure of its banking sector to Greek debt and fiscal slippage domestically, pushing up its cost of borrowing on financial markets.
Last week, the cabinet said it had given the finance minister the go-ahead to take a 2.5 billion euro loan from Russia to refinance maturing debt.
IMF mission leader Wes McGrew said yesterday that the unsettled external environment meant vigilance and careful contingency planning was required for Cypriot banks, which have a large exposure to Greece.
“(Authorities) should undertake rigorous stress tests to identify potential capital and liquidity shortfalls under adverse scenarios, and require banks to strengthen buffers accordingly where needed,” he said.
Cooperative credit institutions, which have a sizeable market share in Cyprus, also require careful oversight and should be subject to stress testing and planning similar to banks, the IMF said in a preliminary report.
Co-ops are not under the supervision of the Cypriot central bank and have their own authority.
De Vrijer said the best way authorities for restore confidence would be to make a “large upfront reduction” in the country’s fiscal deficit next year.
The IMF expects a deficit of 4.0 per cent of GDP in 2012, compared with a government target of 2.3 per cent. Authorities have trimmed public sector salaries and plan to cut spending on child benefits and student grants.
Measures to achieve fiscal savings should focus mostly on expenditure reductions, which experience has shown provide more durable savings than tax increases, the IMF said.
The Fund expected “little if any growth” this year, and to register a small contraction in 2012, it said.
In February, the IMF had issued a markedly more upbeat scenario of growth of between 1.5 and 2.0 per cent for this year.
Asked what had prompted the radical revision, De Vrijer said the July 11 munitions blast which destroyed Cyprus’s largest power station had an impact.
“But far the most important one is the financial turbulence in Europe and the diminished growth prospects in North America and Europe (which) are having an impact on Cyprus,” he said.
Highlights from the IMF report
THE situation demands a strong and immediate policy response. Decisive and credible measures to reverse fiscal slippage and put the public debt ratio on a declining path are essential to restore access to capital markets, safeguard the confidence of investors that underpins Cyprus’ role as an international financial centre, and protect the competitiveness of the economy.
IN THE financial sector, the authorities should remain vigilant to detect liquidity pressures at an early stage, engage in rigorous stress testing and contingency planning, and ensure that appropriate legal powers are in place to address potential problems.
BOLD corrective actions can set the stage for resumption of economic growth, based on the underlying strengths of the Cypriot economy. These include a successful international services sector.
REVERSING the large deterioration in public finances is an urgent priority. Reducing the deficit of some 7 per cent of GDP in 2011 is needed to halt the rapid increase in public debt over the past three years.
THE PACE of adjustment must be fast to restore confidence. Measures to achieve fiscal savings should focus mostly on expenditure reductions. The large increases in public expenditure in the past three years, in particular in public sector wages and benefits and in untargeted social transfers, indicate that there is ample room to contain spending.
THE government has set ambitious targets that would deliver a large reduction in the deficit in 2012 and a balanced budget within three years. The measures passed in August were an encouraging first step. Additional measures are being considered. These measures should comprise actions to contain public sector wages and benefits, such as a freeze of the cost of living allowance; targeting of social transfers, while protecting the social safety net for the most vulnerable; and an increase in the value-added tax rate to 17 per cent, which is still be well below the EU median level of 20 per cent.
TO RESTORE confidence, the government should now move quickly to pass into legislation specific measures in the context of a credible multi-year consolidation plan for 2012-14. It should ensure that the magnitude of the measures is fully sufficient to achieve the target of fiscal balance by 2014.
CYPRIOT banks have a number of strengths, including limited exposure to securitised assets and predominant reliance on deposits rather than wholesale market funding. Nevertheless, the financial turbulence in the euro area and the large exposure of Cypriot banks to Greece have had a negative impact on asset performance, profitability, and capital and liquidity buffers.
THE authorities should be prepared for the possibility of further negative shocks. They should undertake rigorous stress tests to identify potential capital and liquidity shortfalls under adverse scenarios, and require banks to strengthen buffers accordingly where needed.
THE authorities should enhance their legal and regulatory powers to ensure they are fully equipped to take prompt action to recapitalise or resolve banks, if necessary. In this context, passage of the framework law and amendments to the banking act should be an immediate priority.
REFORM of the national pension system is key to address long-term fiscal challenges. Although the fiscal burden of the pension system is presently limited, the system will become unsustainable as it matures and the population ages.
CYPRUS has taken initial steps towards budgetary reform, but further actions are necessary. More accurate revenue and expenditure estimates and fewer budget rigidities will reduce the need for supplementary budgets. Reorganisation of the revenue administration to combine separate departments that administer different taxes with limited exchange of information, will improve efficiency.
