Statement by the staff of the European Commission and the European Central Bank following the second post-programme surveillance mission to Cyprus

European Commission staff, in liaison with staff from the European Central Bank (ECB), visited Cyprus from 27 to 31 March to conduct the second post-programme surveillance (PPS) mission. The mission was coordinated with an International Monetary Fund (IMF) Post-Programme Monitoring (PPM) mission. Staff from the European Stability Mechanism (ESM) also participated in the mission on aspects related to the ESM's Early Warning System.

Cyprus is currently benefiting from robust growth and improving conditions in the financial sector. To sustain growth in the future, continued fiscal discipline and a renewed structural reform momentum are crucial. Fiscal consolidation has helped strengthen the credibility of the policy framework and facilitate market access of the sovereign. Important structural reforms adopted in recent years have allowed Cyprus to turn the corner, with growth returning and the labour market situation improving. At this juncture, it is crucial to safeguard and build upon these hard earned achievements. On the fiscal side, the increased expenditure pressure should be resisted, allowing for the creation of fiscal space for growth-enhancing public spending. On the structural side, the reform momentum has weakened noticeably. The mission encouraged the authorities and other key stakeholders to renew their efforts to improve Cyprus's growth potential and attract more productivity-enhancing investment.

Growth picked up in 2016 and is expected to remain strong in 2017, while moderating thereafter. Growth is becoming more broad-based, driven by private consumption, investment and strong tourism. Labour market conditions have improved overall in 2016, though the unemployment rate remains high, particularly among the young. Real GDP growth is expected to be close to 2½% in 2017. However, limited productivity-enhancing investment, insufficient structural reforms, and the persistently high level of private debt continue to weigh on growth prospects.

While fiscal performance has been stronger than expected, supported by robust economic growth, pressures for fiscal relaxation are rising. Despite this continued growth, the budget for 2017 targets a decline in the primary surplus. This is partly due to the abolition of the Immovable Property Tax, which has narrowed the tax base. The mission underlined that the authorities should resist the pressure for fiscal relaxation as medium-term fiscal risks remain significant and the downward path of public debt has not yet been firmly anchored. In this context, the authorities should ensure the compliance with the provisions under the preventive arm of the Stability and Growth Pact. Strengthening fiscal sustainability also implies the need to contain the public sector wage bill, including by introducing a permanent mechanism to moderate wage growth. A thorough fiscal impact analysis should accompany draft legislation on reforms, including the healthcare reform, to ensure consistency with the existing fiscal space. Looking forward, it will be crucial to increase fiscal space to allow for additional growth-enhancing measures, including higher productivity-enhancing public investment and research and development spending. This could be achieved by broadening the tax base and better prioritising public expenditures.

Important, but uneven progress has been made in resolving non-performing loans (NPLs), which remain very high. Strengthening confidence has allowed banks to broaden their deposit base and to improve liquidity and capital buffers. A noteworthy positive development is also the full repayment in January 2017 of the Emergency Liquidity Assistance that had been granted to Cypriot banks. New lending is picking up from a low base, but the outstanding stock of credit to the economy continues to contract due to necessary balance sheet deleveraging. Banks' profitability is constrained by pressure on net interest margins and the need for additional provisioning. The mission recommended more forceful loan restructuring efforts, notably by making full use of all available tools, in order to accelerate the pace of NPL reduction. Moreover, the prevalence of restructurings of already restructured loans suggests that the quality of restructuring solutions needs to be further enhanced. More vigorous efforts by the authorities and the banks are also necessary to increase the implementation and use of the insolvency and foreclosure frameworks. These frameworks have created incentives for borrowers to repay or to seek cooperative restructuring solutions. Nevertheless, a more forceful application would further strengthen these incentives and contribute to reducing strategic defaults. The mission notably highlighted the need to make insolvency-related legal proceedings more efficient, in order to accelerate the deleveraging process.

Renewing the structural reform momentum should be high priority to enhance long-term growth and fiscal sustainability. The House of Representatives has rejected key reforms, such as the comprehensive reform of the public administration and the privatisation of major state-owned entities. In the view of the mission, these should remain policy priorities to support fiscal sustainability and long-term growth. To further improve the business environment and attract more investment, progress needs to be made in several essential areas, most notably the modernisation of the justice system, including by establishing a commercial court. Other priorities include a more forceful implementation of the government's action plan for growth, the reform of the electricity market, and the creation of a sustainable and efficient title deeds issuance and transfer system.

The mission would like to thank the Cypriot authorities, the IMF and the ESM staff for their constructive and open discussions. The next PPS mission will take place in fall 2017.

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