IMF warns Cyprus against fiscal loosening amid persistent inflation

The International Monetary Fund (IMF) has urged Cyprus to maintain fiscal discipline and avoid unbudgeted spending, particularly in public sector wages, as inflation risks remain elevated.

This caution was outlined in the IMF’s concluding statement on Friday following its Article IV consultation mission to Cyprus, held from17 to 28 March.

During a press conference in Nicosia on 28 March, IMF mission chief for Cyprus, Alex Pienkowski, emphasszed the remarkable growth of the Cypriot economy over the past years.

"Over the past five years the Cypriot economy has grown by quite a remarkable 20%. Τhis is really important fit given the shocks hitting the economy. We had the pandemic, the fallout from the sanctions of Russia, the cost-of-living prices," he said.

According to IMF despite Cyprus exhibiting one of the highest growth rates in the euro area driven by foreign investment, a robust tourism sector, and a booming ICT industry, signs of moderate economic overheating are evident. Inflation, while on a downward trajectory, remains above 2%, posing risks to economic stability.

"Growth has been robust, albeit with some signs of moderate overheating. Last year, growth of 3.4 percent was among the highest in the euro area, supported by strong export of services and consumption," it is noted.

Growth is expected to moderate to around 2.5 percent this year and gradually stabilise at 3 percent in the medium term.

The IMF strongly advises Cyprus to prioritise reducing its public debt below 60% of GDP to enhance economic resilience. The country’s primary fiscal surplus stood at 5.8% in 2024, helping to bring public debt down from 74% to 65% of GDP. However, the IMF cautioned against fiscal loosening, particularly in the form of additional cost-of-living allowance (COLA) increases or public sector pay hikes, which could further fuel inflationary pressures.

The government has committed to maintaining fiscal surpluses up to 2028 under the EU’s new economic governance framework. However, the IMF highlighted that rising fiscal pressures such as aging-related expenditures, energy infrastructure costs, and climate adaptation investments require a cautious approach to fiscal policy.

Financial sector resilience and real estate concerns

Cyprus’ financial sector remains strong, with high capital and liquidity buffers and strong profitability. However, the IMF emphasised the need for continued vigilance, particularly in the real estate sector, which plays a significant role in financial stability.

"The real estate sector, particularly its role as collateral, remains a systemic risk that requires ongoing monitoring," Pienkowski said.

Non-performing loans (NPLs) continue to decline, supported by economic growth and the mortgage-to-rent scheme. The IMF recommended that authorities maintain stability in the foreclosure framework and fine-tune macroprudential policies to balance financial stability and credit growth.

Structural reforms for long-term growth

To sustain investment-driven growth, the IMF called for significant improvements in judicial efficiency and labour market policies.

"Structural reforms aimed at improving the efficiency of the judiciary and increasing labor productivity are essential to support long-term growth. With employment already at a high level, capital will become an increasingly important driver of growth. Therefore, policies should ensure a stable and streamlined business environment conducive to investment," it is added.

Labour market policies should focus on addressing skill mismatches, increasing female labor force participation, and further reducing youth unemployment.

Energy reforms and climate commitments

The IMF stressed the importance of expediting key energy projects and market reforms to lower electricity costs, improve energy security, and meet climate targets. Projects such as the Vassiliko LNG terminal and the Great Sea Interconnector are critical in achieving these goals.

Regarding the Great Sea Interconnector, Pienkowski noted that given the project’s high cost, its viability should be assessed from a long-term perspective. He νοτεδthat Cyprus should aim to become a renewable energy hub, making strategic decisions based on long-term sustainability rather than short-term considerations.

The IMF welcomed Cyprus’ ongoing efforts to enhance AML supervision and the planned establishment of a National Sanctions Implementation Unit at the Ministry of Finance.

Government response

The Ministry of Finance welcomed the IMF’s observations and recommendations, acknowledging the economy’s resilience amid successive shocks and the strong fiscal trajectory. In a statement, the Ministry agreed with the IMF’s position that fiscal policy should remain focused on debt reduction and avoid relaxation, in line with the EU’s new economic governance framework.

Regarding the real estate sector, the Ministry assured that it is closely monitored, given its impact on economic stability. On judicial reforms, it reiterated ongoing efforts to improve efficiency and productivity in collaboration with key stakeholders.

On labour market issues, the Ministry noted that while the labor market is less constrained than in previous years, policies should now focus on skills alignment, increasing female employment, and further reducing youth unemployment.

(Source: CNA)