Cyprus is the only country in the euro area to record positive growth in the first quarter of 2009, and among those that have not required public capital injections into its financial sector. Given that Cyprus' key economic partners, the UK, Greece, and Russia, are already facing economic difficulties, the IMF forecasts growth to fall sharply to 0.33% in 2009 followed by a mild recovery to some 1% in 2010. The IMF cannot rule out a worse outcome and expects medium-term recovery to be tepid unless competitiveness is enhanced.

According to the IMF, this deterioration will worsen credit risk in the banking sector which will bear monitoring and make current fiscal policies unsustainable without a policy correction. Given the large size of the banking sector relative to the economy and high concentration ratios, problems in this sector can quickly escalate to systemic proportions with serious repercussions for the economy, warns the IMF. However the IMF regards it as more a question of 'nipping problems in the bud'. Cyprus’s reputation as a financial center depends on effective and arm's-length supervision by an independent and accountable central bank. Since liquidity risk can rise quickly in response to international developments, the IMF encourages the Central Bank of Cyprus (CBC) to make use of EU initiatives on monitoring developments in bank funding, cross-border exposures, and counterparty risk management. The IMF point out that loan to value ratios on second homes may need to be reviewed in line with property price developments.

Past budget surpluses, low public debt, and the long-awaited enactment of pension reforms have sustained investor confidence, as evidenced by a successful sovereign bond issue in June 2009. However the budget deficit has increased sharply due to recent inelastic spending increases in combination with declining revenues and the IMF consider that fiscal stimulus is less likely to be effective given high import elasticities for a small open economy like Cyprus. It therefore thinks that investor confidence in a conservative fiscal stance is more beneficial and applauds the government objective to reduce the budget deficit below 3% of GDP in 2009-10 and achieve a balanced budget over the medium-term.

On current spending plans, the IMF estimate that the general government deficit will reach 3.9% of GDP in 2009, a sharp reversal from the surpluses of 2007-08. Without significant course correction in 2009-10, the IMF fear this could be the beginning of an expansionary debt-deficit cycle which will soon be unsustainable. On IMF estimates, the budget deficit would need to decline by some 0.5-0.75% of GDP a year to achieve fiscal balance over the medium-term.

According to the government's Stability Program, public consumption should be curtailed alongside productivity-enhancing investments, structural reforms and social spending restraint. All well and good according to the IMF, but it points out that measures identified so far are all on the revenue side, with relatively small and temporary effects on the budget deficit. Furthermore the envisaged hiring plans and wage increases and untargeted social support measures introduced in past years will permanently increase public consumption and the IMF think that productivity-enhancing investments have been slow to get off the ground, and that plans to expedite private investment approvals have not been effective.

The IMF would like to see more of a focus on the wage bill which accounts for a third of total spending. It suggests an extension of the 'flexicurity' concept (labour flexibility but without undue loss of job security) from the private sector to the public sector. These measures would control the wage bill, reduce crowding out of the private sector in the labour market, improve social cohesion, and increase productivity, in the view of the IMF. The IMF prefer to see social support measures targeted to reach the truly needy, so that untargeted schemes implemented in 2008 may need to be revisited. It is also concerned that temporary stimulus measures be reversed when the economy recovers.

With regard to Public sector asset-liability and cash management, the IMF indicates that accounting for contingent liabilities could be more transparent and may need more monitoring. The IMF also appears a little sceptical about the way public sector aid programs are selected and their effects on competition. The IMF commend long-delayed pension reforms which increase contribution rates, tightened eligibility criteria, and the inclusion of an independent body to manage assets. Real reserves are being accumulated in the Social Investment Fund with periodic reviews to assess the Fund’s viability and take necessary corrective actions. The IMF suggest the government may like to consider increasing the retirement age in line with other euro area countries; indexing benefits to prices to reduce spending pressures, and improving alignment between public and private pension benefits.

The IMF also indicate structural reform related to labour productivity is desirable now that the adoption of the Euro limits scope for adjustments through the exchange rate mechanism. Manufacturing and tourism face competitiveness problems, and wage growth has outstripped productivity increases. Cyprus will also need to replace jobs lost in construction, stated the report. The IMF welcomed the willingness of labour unions, government, and businesses to follow through with wage cuts determined by the automatic wage indexation mechanism (COLA) in the second half of 2009. However it is still concerned that COLA hampers competitiveness and may need reform, possibly through more effective targeting.