The International Monetary Fund predicts that the deficit in 2012 will be around 4%, with slightly negative growth of -1%, and zero growth in 2011.

The IMF urges the government of Cyprus to take such measures that will drastically reduce it and restore confidence in investors.

Answering questions during a press conference at the end of their two-week mission to the island, Eric Jan de Vrijer and head of the mission Wes McGrew urged the government to actually implement the austerity measures it has announced, stressing that action needs to be taken now to get public finances under control to avoid the economy falling into a doom scenario.

Asked what is the IMF’s evaluation of the risk that Cyprus will need a bailout, de Vrijer said “we think the situation at the moment is very serious. The fact that the government cannot access capital markets is very, very serious and the risks to the banking sector are great”.

The first priority, he said, is for Cyprus to do all it can to avoid that these problems get out of hand. “I think that there is time and there is opportunity for the government to take really decisive and large action to avert the possibility of these problems getting worse and worse”, said de Vrijer.

The best way to restore confidence, he added, “is to really make a large upfront reduction in fiscal deficit next year. That means that the packages that the government is talking about, containing the wage and pension bill freezing, the COLA adjustments, better targeting, social benefits and increasing VAT are the minimum necessary in order to make clear that this time the government is serious in getting the public finance situation under control.”

De Vrijer said that since an opportunity last year to reduce the deficit has been lost, it is urgent to make up for this in the coming budget and to actually implement what has been announced.

Asked if he is not ruling out a bailout if things go on the way they are, de Vrijer explained that the situation demands strong policy response.

About the loan that Cyprus intends to get from Russia, McGrew said that “what is important is that when you receive such loans it does not take away from your determination to fix underlying problems”.

The Council of Ministers approved earlier October an agreement with the Russian Federation for a 2.5 billion euro loan with a yield of 4.5%.

To a question why he thinks the Cyprus economy will contract in 2012, McGrew explained that if you look at many sectors of the economy, financial conditions are tight. “And given the pressures that exist, the Eurozone, they are likely to remain tight. Banks are trying to increase their capital, preserve their liquidity, these are the conditions where you have rapid growth in loans and we expect there will be little growth in loans. That”, he added, affects consumption and investment.

The same thing, he remarked, applies globally and in the Eurozone and is likely to have an impact on international business activity. Construction, said McGrew, continues coming down from its peak of 2-3 years ago, there is still a lot of excess capacity, tourism did well for the economy this year, and hopefully it will be again next year.

“However, if you look at different sectors, if you ask yourself what is going to happen, the consumption given this climate of uncertainty, given higher interest rates it’s hard to see much growth there. So if you add all the pieces together they point to this conclusion”.

To a remark that the government is projecting a deficit of 2.3 % next year, McGrew said “our projection at this point will be higher than that and that reflects our assessment of growth prospects, also assessment of the measures that we aware of”.

He did indicate that the government is still in the process of putting together its package of measures that will be submitted to the House of Representatives and “what is critical is that a very, very strong upfront reduction takes place“.

This, however, will require consensus within the government and the parliament and different parties working together. “This is still unfolding and I would say that you should aim for as low as you can, but at this point our projection is somewhere around 4%”, he said.

De Vrijer said that these targets for deficit are extremely important because they will determine in the end the evolution of the public debt. And at the moment, he said, “Cyprus cannot borrow from capital markets to finance its deficit. That is a hard budget constraint. If you cannot borrow, you cannot finance your deficit. So you need to reduce your deficit fast and significantly in order to regain the confidence of investors that are willing to lend you money. That is sort of a hard fact that the Cyprus government has to deal with”.

On the particular numbers for the targets, he added, the 2.3% was said at a time when expectation was that growth in 2011 would be 1.5% and in 2012 would be 2%. At the moment, he said, we are looking at our projections, that growth would be flat, zero in 2011 and will be slightly negative in 2012. We think -1%. So this economic slowdown or downturn will also have an effect on tax revenue and will therefore make this original target no long feasible, the IMF official said.

Finance Minister Kikis Kazamias, presenting the 2012 State Budget before the House of Representatives, last month, predicted that in 2011 the growth rate is projected at zero, whereas 2012 growth rate may exceed 1% reaching 1.5% of GDP.

De Vrije said that instead “of just putting your hands in the air and saying well, the target is no longer feasible, you have to redouble your efforts to have a credible set of measures to tackle the underlying problem that you spend more than you have revenue and there is no way of covering this difference. You need at least the measures in size of the budgetary savings that were announced and these packages need to be implemented fully”.

There is no room, he stressed, “to say let’ s do less reduction in social benefits or let’ s not suspend the COLA or let’ s not reduce the number of civil servants or reduce the weight of the pension bill. At the moment you are still in the position to say that these packages are an important step and appropriate to deal with our problems. If you don’t deal with the problems now, the financing gaps in the future will be even larger and you will have to take more drastic measures. To take measures early will allow you to do it more gradually than if you wait until the ship hits the wall and then have to take much harder measures”.

De Vrije said that “the government has announced measures. It is important in our view that this time these actions are actually taken because there is no margin, there is no room for manoeuver“.

To a remark that when the mission was in Cyprus earlier this year there was a more upbeat conclusion but now there is a “doom scenario” and what has changed so radically in the past eight months, De Vrijer said that a “doom scenario is much more worse than what you see here”. One of the things that we are saying is that the time to take action is now in order to avoid getting into a doom scenario. For an economy as Cyprus, which is small economy with a large banking sector, it is extremely important that public finances are fully under control and instill confidence in investors and also consumers and population.

De Vrije said that what has changed compared to earlier this year are a number of things, one the accident at the Vasiliko power plant disrupting the island’s electricity supply. “But by far the most important one is the financial turbulence in Europe and the diminished growth prospects in North America and Europe that are having an impact on Cyprus. Cyprus is a small open economy so if the rest of the world slows down, then that will have an effect on you as well”, he remarked.

Invited to elaborate on the IMF’s statement that the authorities should be prepared for the possibility of further negative shocks, McGrew said that banks throughout the world engage in stress testing and those tests are designed to ensure they have adequate buffers to stand scenarios that are adverse or may happen. In this case, he said, “those scenarios include deterioration of your loan quality, in particular loans to both in Greece and here as well as reduction in your sovereign net holdings”.

Asked when he estimates the global economic crisis will recover, de Vrijer said that “I think that what seems somewhat clear at the moment is that at the end of 2011, beginning of 2012, there will be less growth than before and I would imagine in the course of 2012, the growth will start to gradually pick up. However before we actually redo our projections it is hard to say what will come out”.

On August 26th the House of Representatives approved the first of two packages of austerity measures aiming at fiscal consolidation. Presenting the 2012 state budget , Finance Minister Kazamias said it contains structural measures aiming to avert negative developments to the Cypriot economy.

It provides for total revenues of 6.22 billion euro, compared with 5.64 billion of 2011 and total expenditures, excluding loan payments, of 7.54 bilion euro compared with 8.01 billion of the 2011 state budget.

The budget also includes provisions for a 10% reduction in entry level salaries for civil servants, abolition of 1100 vacant positions in the civil service, continuation of the freezing of procedures to fill up vacancies and for reducing by 200 million euro social benefits both by lowering the level of benefits and by introducing income criteria for certain benefits.

The IMF delegation held meetings with the Finance Minister, the Governor of the Central Bank, as well as other government officials. It also met also with bank officials as well as representatives of trade unions and employers’ organizations.

The IMF final report on Cyprus will be published at a later stage, after the relevant discussion at the Executive Board expected to take place in November.