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Significant risks for Cyprus remain

IMF-buildingTHE EXISTENCE of significant risks, leaves no room for implementation slippages, the International Monetary Fund (IMF) points out in the second review of Cyprus’ performance under the financial adjustment programme imposed to the country by its international lenders.

According to the review, a more protracted recession, with knock on effects on the fiscal and financial sectors, could lead to additional financing needs and put debt sustainability at risk. Reform fatigue and prolonged internal tensions could impede key reforms and prevent a needed increase in confidence.

The IMF notes that the impact of the banking crisis on the economy remains uncertain and that confidence in the banking system remains weak and may take time to recover, delaying a return of deposit growth and associated credit growth. The deleveraging process could be more protracted, leading to a more prolonged recession and to a slower recovery, which could negatively affect bank asset quality and profitability resulting in additional capital needs.

“Delays in the removal of payment restrictions would negatively affect activity, while a premature removal may jeopardize financial sector stability”, it is said.

The Fund also mentions that prolonged tensions between the executive power and the central bank, and within the top management of the bank, may lead to delays in policy implementation in the critical financial sector area. Moreover, it is said, rising unemployment and deteriorating social conditions could call into question the fiscal consolidation path, and vested interests may impede structural reforms and privatization efforts.

According to IMF there are also litigation risks, as a number of legal claims for compensation related to resolution losses in Laiki and BoC have been filed at the Supreme Court and in district courts, and prospective legal claims related to the recapitalization of Hellenic bank.

Pointing out that there are factors mitigating these risks, the Fund says that BoC and Hellenic Bank are now fully capitalized above minimum requirements and under prudent assumptions, providing some margin for additional deterioration of asset quality.

At the same time, the program buffer remains sizeable and could cover comfortably additional fiscal needs even under a severe growth shock, or, alternatively, more than a doubling of state aid needs for the coop sector, if needed.

At the same time IMG projects that the program will be fully financed through the next year and there are good prospects that there will be adequate financing thereafter. Debt service to the Fund as a percentage of exports or GDP is expected to remain manageable.

The review also mentions that the authorities have established a good early track record of policy implementation, and the challenge is to maintain the momentum going forward.

It also notes the significant progress been made with restructuring and recapitalizing the financial Sector, adding that the next key step is to finalize the recapitalization and restructuring of coops.

It also points out that decisive action to deal with non-performing assets is essential to restore credit to the economy.

The IMF suggests that payment restrictions need to continue to be relaxed in line with the authorities’ roadmap, while safeguarding financial stability and that the authorities need to continue to strengthen supervision, regulation, and the Anti – Money Laundering framework.

Giving credit to Cyprus’ authorities for pursuing prudent fiscal policies, targeting lower deficit levels than originally envisaged, the IMF says that fiscal efforts need to be complemented with steps to advance structural reforms and jump-start the privatization process.

On March 25, 2013 Cyprus and the Troika (European Commission, European Central Bank, International Monetary Fund) agreed on a €10 billion financial assistance which featured an unprecedented haircut on uninsured deposits in a bid to recapitalize the Bank of Cyprus, the island’s largest lender. The bail-in also provided that Cyprus Popular Bank, the island’s second largest bank would be wound down with its good part absorbed by the Bank of Cyprus.

Further reading

IMF Country Report No.13/374 – Second Review under the Extended Arrangement under the Extended Fund Facility and Request for Modification of Performance Criteria (December 2013)