Cyprus’s banking sector should brace for further turbulence as deposits continue to shrink and bad loans look set to multiply, the country’s international creditors warned Wednesday.

The European Commission, in its first review of Cyprus’s 10 billion euro ($13.36 billion) bailout, said the Cypriot government was doing what it should in terms of cutting public spending.

But the radical shake-up of the banking sector coupled with unprecedented restrictions on the movement of capital in and out of the tiny island have left it vulnerable to economic shocks.

The International Monetary Fund, which contributes one-tenth of the bailout, said in its own report also released Wednesday that the effects of the banking crisis on the real economy could be worse than expected.

Confidence in Cyprus’s banks has plunged after the bail-in of depositors, culminating in the gradual flight of deposits despite the government’s imposition of capital controls to stem the outflow, the report said. It didn’t provide specific data on the volume of fleeing deposits.

European experts stood by their spring forecast that the Cypriot economy would shrink 8.7% in 2013 and a further 3.9% in 2014, but raised their unemployment forecasts sharply. They said that 17% of the Cypriot workforce would be out of a job this year, up from an original projection of 15.5%, while unemployment will hit 19.6% in 2014, not 16.9% as previously thought.

“A further worsening of labor market conditions may lead to a more prolonged loss of business and consumer confidence,” the report said.

Cyprus’s banking meltdown in March brought it to the brink of leaving the euro and revived investor anxiety about the euro-zone debt crisis. After tense, marathon negotiations between the nation’s government and its euro-zone peers and the IMF, a decision was reached to restructure the banking sector.

This involved shutting down the country’s No. 2 lender, Cyprus Popular Bank, and appropriating all uninsured deposits above EUR100,000 to pay for the bank’s resolution. The biggest lender, Bank of Cyprus, underwent a long, deep restructuring, during which 47.5% of uninsured deposits were blocked and then converted into shares in the new bank.

The country’s No. 3 bank, Hellenic Bank, was able to raise capital and shield itself without bailout cash. Dozens of cooperative banks–small local lenders–are about to undergo a series of closures and mergers to shrink the entire sector dramatically. A total of EUR1.5 billion from the bailout will be used to recapitalize them.

The commission said Cyprus’s central bank and Finance Ministry are putting together a fortified legal and practical framework to handle loans in the red and requests to ease the terms on household and business loans.

“The largest challenge for the banks is to deal with deteriorating asset quality. The key here will be to develop plans to ensure that all banks achieve a return of confidence and a return to profitability,” said Delia Velculescu, IMF Mission Chief for Cyprus.

While the report applauded the Cypriot government’s efforts to stick to the bailout program, an EU official said this wasn’t necessarily reason to rejoice.

“When I say it’s positive news, I mean it’s not worse than expected,” he told reporters at a briefing of the report on condition of anonymity.

The commission’s review said bank credit was bound to continue shrinking, but that this was a “necessary adjustment of the previous excessive credit expansions.” It said the process of turning the Cypriot banking sector around had taken “more time than initially foreseen due to the complexity of the situation.”

It did acknowledge that lending to small and medium-size enterprises and households has all but dried up, while pointing out that “almost all businesses in Cyprus are SMEs.”

Euro-zone finance ministers approved the disbursement of EUR1.5 billion from the bailout to Cyprus last week, while the IMF unblocked its contribution of EUR84.7 million on Monday


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