Signs of stabilization are emerging in the banking sector, however, the outlook remains challenging, with rising unemployment, falling credit, and increasing non-performing loans, IMF says in its report on Cyprus.

The report, entitled “Cyprus third International Monetary Fund (IMF) review under the extended arrangement under the extended fund facility and request for modification of performance criteria” says in its executive summary that while deep, the 2013 recession was not as severe as anticipated.

“The adjustment is occurring through both quantities and prices and signs of stabilization are emerging in the banking sector. However, the outlook remains challenging, with rising unemployment, falling credit, and increasing non-performing loans” it is noted.

In this context, growth projections remain unchanged, with a deep contraction expected in 2014 and a modest and credit-less recovery taking hold in mid- 2015.

IMF says that the program remains on track and fiscal targets were met with considerable margins, the coop sector was recapitalized, and additional relaxations of payment restrictions are being implemented. Delays in the implementation of structural reforms have recently been overcome.

According to the report, looking forward, policies will need to focus on dealing with the high level of non-performing loans, further normalizing payment flows, maintaining fiscal prudence, and stepping up the implementation of the ambitious fiscal structural reform agenda.

“Risks to program implementation remain significant, including due to remaining financial sector vulnerabilities and diminished political support following the breakup of the governing coalition”, it is said.

The IMF notes that all end-December and continuous performance criteria (PCs) were met, in some cases with significant margins. Compliance with structural conditionality, however, was mixed.

On one hand, the structural benchmark (SB) on fulfilling the preconditions for injection of state aid in the cooperative sector was met, and the sector was recapitalized. The authorities also met the SB on strengthening AML-related supervision of banks. On the other hand, remaining SBs were not met on time.

Structural and program requirements related to legislation on budget systems and privatization were eventually fulfilled as prior actions for the completion of the third review. The authorities also committed to implement as a prior action

structural requirements to combat tax evasion. They requested more time to entrust the voting rights of legacy Laiki’s equity stake in Bank of Cyprus (BoC) to an independent entity.

It is noted however, that political support for the program is weakening.

IMF further points out that European policies and initiatives are broadly supportive of Cyprus’s situation. “The ECB’s accommodative monetary policy stance and collateral policies are helpful, although Cyprus could benefit from further ECB action to reduce fragmentation of the financial system and relax bank collateral requirements, and deflation remains a risk”, it adds.

Furthermore, it says that the upcoming introduction of the Single Resolution and Supervisory Mechanisms (SRM, SSM) in the Euro-area will help to strengthen

supervision of Cypriot banks and coops. Additional efforts toward European backstops, such as ESM direct recapitalization, could further help to reduce remaining concerns regarding the strength of Cypriot banks should negative risks materialize

As regards the macroeconomic framework, it is noted that it has been slightly modified to incorporate recent developments.

Growth projections for 2014 and beyond remain unchanged, and given limited new data for  this year, the 2014 growth projection was  maintained at  – 4.8 percent.

“This is consistent with  a slowing  rate of output decline during  this year, as the uncertainty and immediate effects of  the crisis  are wearing off, domestic payment restrictions are  gradually lifted , and the negative  fiscal impulse decline s relative to last year” it is stressed.

IMF notes that both private consumption and investment are  projected to continue to contract, albeit at a lower rate than last year, with the contribution of the foreign balance moderating. The modest recovery, projected to take hold by mid-2015, is expected to be credit-less, led by tourism and other service sectors, which are relatively less indebted, exhibit lower NPLs, and are likely to finance activity and exports through generation of positive cash flow.

As regards unemployment and inflation it is noted that they were revised down modestly. In 2014, the average  unemployment rate was revised down  to  19.2 percent  from 19.8 percent to account for the  2013 outturn and for  the deceleration  in the rate of increase  in recent months.

Inflation was lowered to 0.4 percent from 1 percent, reflecting the lower outturn in 2013

“Despite the  negative inflation seen in recent months, staff expects average inflation in 2014 to remain around last year’s level, with recent downward pressures to be offset by a stabilization of

utility prices and by the pass through to prices of VAT increases taking effect this year”.

The current account was also revised slightly down in 2013 and 2014.

In 2013, the current account deficit is projected to reach 1.7 percent of GDP, on account of a somewhat smaller decline in imports than originally anticipated, given the better than expected domestic demand outturn. In 2014, the current account was correspondingly revised down from a small surplus to broad balance.

The outlook is subject to downside risks

IMF says that a change in depositor sentiment,in the context  of  important relaxations of payment restrictions  underway, could risk destabilizing the system and  exacerbating the recession. The risk of a deflationary spiral has also increased.

“While lower prices can help to improve competitiveness, a prolonged decline could weigh down on private sector balance sheets, with rising debt burdens posing a drag on economic growth.

Continued deleveraging by the  private sector, coupled with further tightening of liquidity conditions for companies and an exhaustion of liquidity buffers of consumers could lead to a more protracted recession and slower recovery” it is further noted.

Finally, IMF says that the Ukraine crisis may lead to capital flight from non-resident depositors of foreign banks in Cyprus, which may affect the business service sector.

“On the political front, diminished support for the program  following the breakup of the governing coalition  raises uncertainty  about  program implementation  and could hamper overall confidence” it points out.

On the upside, if trends  of economic  activity  observed in  the second half of  2013 continue, growth in 2014 and beyond could be better  than anticipated.

Prospects for the exploitation of gas reserves and for reunification of the island could raise the economy’s  long-term growth potential.

IMF says that public debt sustainability remains highly vulnerable to shocks, while external debt is also  a source of vulnerability.