Statement by the staff of the European Commission and the European Central Bank following the fourth post-programme surveillance (PPS) mission to Cyprus

European Commission staff, in liaison with staff from the European Central Bank (ECB), visited Cyprus from 19 to 23 March to conduct the fourth post-programme surveillance (PPS) mission. The mission was coordinated with an International Monetary Fund (IMF) post program monitor (PPM) mission. Staff from the European Stability Mechanism (ESM) also participated in the mission on aspects related to the ESM's Early Warning System.

The ongoing strong recovery and the renewed reform mandate following the presidential elections provide a window of opportunity to reduce the key vulnerabilities of the Cypriot economy. Growth in 2017 outpaced projections and should remain robust, albeit somewhat decelerating over the medium term. Growth was broad-based, with buoyant tourism and construction benefitting other sectors of the economy. Consumption and investment were the main drivers of growth. The labour market situation continued to improve, with employment increasing across most sectors and unemployment rapidly falling. Despite the very favourable economic conditions, the share of non-performing loans (NPLs), private and public debt as well as youth unemployment remain high, albeit on a declining trend, while inflationary pressures continue to be weak. In addition, the persisting current account deficit warrants close monitoring, given the high level of external debt and negative households' savings.

The positive macroeconomic environment combined with prudent fiscal policy have resulted in a remarkably strong fiscal position, yet a continued prudent fiscal stance remains warranted given the still-high level of public debt and risks to the fiscal outlook. Fiscal performance once more outperformed projections in 2017, mainly driven by buoyant tax revenues and, to a lesser extent, lower-than-expected expenditure. However, uncertainties and risks remain, such as contingent risks from the banking sector and the fiscal impact of the healthcare reform. A continuous prudent budgetary policy remains essential to ensure that temporary revenue windfalls do not give rise to permanent increases in expenditure and to safeguard fiscal sustainability in line with the requirements of the preventive arm of the Stability and Growth Pact.

Addressing challenges in the banking sector should remain a policy priority due to the still high level of NPLs and negative profitability. The stock of NPLs has declined gradually but remains one of the highest in the EU and the progress made among the banks has been uneven. Loan restructuring continues, albeit becoming more challenging as the pool of NPLs for which negotiation is an option is dwindling. Bank profitability remains weak amid the need for provisioning for NPLs. On the other hand, new lending is recovering, supported by the strong macroeconomic environment. The mission highlighted the pressing need to accelerate NPL reduction across banks and in particular in the ones lagging behind. In this context, it is of utmost importance to improve the payment culture and that new schemes initiated by the authorities contribute in this respect and are in line with international best practices. It is also urgent to introduce the necessary legal amendments to make full use of all available tools, including to the insolvency and foreclosure frameworks, and to create conditions for a well-functioning secondary market of loans and loan securitisation. Tangible progress in all these areas is crucial for the banking sector to leave legacy issues behind and adequately support the real economy. In this respect, it is important that the recently initiated search for investors in Cyprus Cooperative Bank proceeds in a transparent and orderly manner.

Renewed structural reform commitment by all national stakeholders is necessary to maintain growth over the medium term and safeguard fiscal sustainability. Given its overarching impact on the functioning of the economy and its strong link to the reduction of NPLs, a swift completion of the justice system reform is needed, including the establishment of a commercial court, the update of the civil procedure rules and the adoption of legislation on improving claim enforcement. Moreover, the completion of the reform of the public administration would enhance the efficiency of the public sector and support fiscal sustainability. The mission also encouraged the authorities and other stakeholders to step up progress in other essential areas, including the implementation of the national healthcare system in a fiscally-sustainable way, the on-going reform of the electricity market, and the establishment of an efficient title deeds issuance and transfer system. Moreover, the mission underlined the importance of continuing efforts to enhance the economy`s growth potential, notably through improving the business environment and attracting further growth-enhancing investment, as well as prioritising key measures included in the action plan for growth.

The mission would like to thank the Cypriot authorities for their constructive and open discussions and IMF and ESM staff for their cooperation. The next PPS mission will take place in autumn 2018.

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