Cyprus: Second Review Under the Extended Arrangement Under the Extended Fund Facility and Request for Modification of Performance Criteria

EXECUTIVE SUMMARYExtended Arrangement: On May 15, 2013, the Executive Board approved a three-yearExtended Arrangement under the Extended Fund Facility in the amount of SDR 891million (563 percent of quota; about €1 billion). Two purchases of amounts equivalent toSDR 74.25 million (about €86 million) each have been made so far, and anotherpurchase of the same amount is proposed to be released upon completion of thesecond review. The European Stability Mechanism has released €4.5 billion since theprogram approval (of €9 billion committed).Recent Economic Developments: The recession through September, though deep, hasnot been as large as expected. Private consumption has been relatively resilient,economic sentiment continues to improve, and exports, including tourism, have held up.Nevertheless, the situation remains difficult, with unemployment on the rise anddisposable incomes falling. Banks are curtailing credit as asset quality continues todeteriorate, and private sector indebtedness remains very high. In this context, thegrowth forecast for 2013 has been revised upwards modestly, but a deeper contractionin 2014 is now envisaged, consistent with a more gradual private sector deleveragingprocess.Policy Implementation: The program is on track. Fiscal performance continued toexceed targets comfortably, and the 2014 budget is more ambitious than envisaged atprogram approval. All structural benchmarks were met, albeit with a modest delay inone case. Significant progress has been made in restructuring and recapitalizing thebanking sector, including with foreign participation in the share capital of one domesticbank. Looking forward, efforts must concentrate on ensuring full implementation ofbanks' restructuring plans to clean up balance sheets and pave the way for a return ofcredit to the private sector. Fiscal structural reforms are proceeding, but strong resolve isneeded to kick-start the privatization process. The program remains subject to largeuncertainty given lingering financial sector vulnerabilities and continued challenges topolicy implementation.