According to the IMF report, the global crisis is beginning to affect Cyprus. The economy has been relatively shielded from the crisis so far, recording positive growth in the first quarter of 2009, well above the euro area. The financial sector has not required public capital injections. The IMF believes that the so-far relative resilience to the downturn is due to the elimination of exchange rate risk following euro adoption, conservative financial sector practices with limited exposure to toxic assets and strict supervision, and a domestic demand-based growth with less reliance on manufacturing exports. However, the economy is beginning to slow in response to the global crisis. Growth is projected to fall sharply to 0.5% in 2009 as banks and the private sector restructure balance sheets. On current policies, a tepid but uncertain recovery is expected to begin starting 2010.

With regard to fiscal policy, the IMF noted that Cyprus’s largely revenue-based fiscal consolidation has started unwinding. According to the IMF, this is due to softening growth, the lapse of temporary revenue-generating factors, and increases in untargeted social spending starting 2008. Recently enacted pension reforms were criticized within the report; the IMF warned that the reforms' reliance on contribution increases meant that they failed to address large ageing-related increases in pension expenditures. The IMF notes that fiscal policies could potentially become unsustainable if current policies, which significantly increase the inelastic component of budget spending (especially payroll), are implemented.

In its recommendations, the IMF Executive Board noted that Cyprus has weathered the crisis well. The overheating of the economy in 2007–08 has given rise to certain risks that would need to be managed carefully as the economy slows, the IMF added. The IMF endorsed the government’s objective to achieve a balanced budget over the medium term. It noted that, based on strengthened policies, the budget deficit will need to decline by about 0.5−0.75% of GDP a year with a significant upfront correction to avoid unfavourable debt-deficit dynamics going forward.

The Executive Board emphasized that fiscal adjustment should rely on reducing public consumption, particularly the wage bill, and on broader public administration reforms. The IMF noted that the temporary stimulus measures should be allowed to expire once the recovery sets in, and the social support measures should be carefully targeted to the needy. The IMF welcomed the passage of pension reforms. A few of the Executive Board Directors considered that additional pension reforms may be necessary in future, including raising the retirement age and better aligning public and private benefits.

The IMF has recommended the adoption of a medium-term budget framework and more effective management of public sector liabilities. The government’s recent initiative in this area could be further enhanced, the IMF advocates, by monitoring contingent liabilities and minimizing the possibility of moral hazard and adverse selection in public sector aid programs.