EUROPEAN COMMISSION Brussels, 26.2.2020 SWD(2020) 512 final COMMISSION STAFF WORKING DOCUMENT Country Report Cyprus 2020 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2020 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2020) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the MIP in-depth review 4.Reform priorities 4.1.Public finances and taxation 4.2.Financial sector 4.3.Labour market, education and social policies 4.4. Competitiveness, reforms and investment 4.5.Environmental sustainability Annex A: Overview Table Annex B: Commission debt sustainability analysis and fiscal risks Annex C: Standard Tables Annex D: Investment guidance on Just Transition Fund 2021-2027 for Cyprus Annex E: Progress towards the Sustainable Development Goals (SDGs) References LIST OF Tables

Table 1.1:Key economic and financial indicators – Cyprus Table 2.1:Assessment of the 2019 country-specific recommendations implementation Table 3.1:Macroeconomic imbalance procedure assessment matrix – Cyprus Table 4.2.1:Financial soundness indicators, all banks in Cyprus Table 4.4.1:Selected indicators on digitalisation of businesses, 2019 (% of enterprises) Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth Table E.1:Indicators measuring Cyprus’ progress towards the SDGs LIST OF Graphs Graph 1.1: Real GDP growth and contributions Graph 1.2: Tourism arrivals and revenues Graph 1.3: New and pure new loans for house purchase Graph 1.4: Housing price developments Graph 1.5: Key labour market developments Graph 1.6: Real effective exchange rates

Graph 1.7: General government budget balance and gross debt Graph 2.1: Overall multiannual implementation of 2011-2019 CSRs to date Graph 4.1.1: Government debt projection (% GDP) Graph 4.1.2: Revenue from environmentally-related taxes Graph 4.2.1: Private debt, percentage of GDP Graph 4.2.2: Private debt stocks Graph 4.2.3: Changes in private debt-to-GDP ratio and breakdown Graph 4.2.4: Private debt stock and NPLs stock Graph 4.2.5: Breakdown of households indebtedness Graph 4.2.6: Current account balance components Graph 4.2.7: Net international investment position Graph 4.2.8: Net Lending/ Borrowing by Sector Graph 4.2.9: Household savings rate Graph 4.2.10: Demand, output and trade balance Graph 4.3.1: Temporary, part-time and self-employment (without employees) - proportion in employment Graph 4.3.2: The proportion of people at risk of poverty and social exclusion (2005-2018) Graph 4.3.3: Risk of poverty and social exclusion for children below the age of six (%) (2010-2018) Graph 4.3.4: Adult learning participation per ISCED levels. (2010-2018) Graph 4.3.5: Distribution of out-of-pocket payments for healthcare Graph 4.4.1: Investment by category

Graph 4.4.2: Productivity factors LIST OF Boxes Box 2.1: Commission Structural Reform Support Programme in Cyprus Box 2.2: EU funds and programmes to address structural challenges and to foster growth and competitiveness in Cyprus Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 4.4.1: Investment challenges and reforms in Cyprus Box 4.5.1: Transition to a more sustainable and decarbonised growth model (in particular in the electricity and transport sectors) Executive summary Cyprus’ economy is still characterised by large economic imbalances, which, unless addressed, may impede its medium-term economic prospects. Cyprus’ large imbalances are a legacy of the 2013 crisis and include high stocks of private, public and external debt and non-performing loans. In this context, there is also a need to step up reforms in key areas to attract productivity-enhancing investments, diversify the economy and help foster inclusive and environmentally sustainable growth in the long term. ( ) Economic growth has remained resilient so far, but is expected to slow down in the coming years. GDP growth, projected to be 3.2%% in 2019, has remained strong, supported by resilient domestic demand. Meanwhile, net exports had a negative impact, reflecting a less supportive external environment. The economy is expected to continue growing — albeit at a slower pace — by around 2.8%% in 2020 and 2.5% in 2021, in view of the anticipated weakness of the global economy. The current account deficit is significantly negative, and is set to worsen to around 10%% of GDP in 2019-2021 due to lower exports and increased imports in the context of strong domestic demand. Unemployment fell to 7.5%% in 2019, the lowest level since 2011, and is expected to fall further. Inflation remained low, and this trend is projected to continue over the next couple of years. Cyprus is expected to record a significant budget surplus in 2019. The headline budget balance is set to return to surplus in 2019 (above 3.5%% of GDP) and to remain in surplus in 2020 and 2021, which would enable considerable debt reduction. To safeguard fiscal sustainability going forward expenditure developments should be carefully monitored, especially in the light of possible future risks to the robustness of revenues. The long-term sustainability of the growth model of Cyprus is put at risk by rising external uncertainties and pending structural reforms. Growth relies heavily on specific sectors, such as tourism, foreign-funded residential construction and services linked to foreign companies, which are vulnerable to potential negative external developments. There is a need to improve the environmental sustainability of tourism and to diversify the sector further. More generally, investment lags behind in areas that could strengthen Cyprus’ economic structure and increase its potential growth, such as digital transformation, R&D, renewable sources of energy, sustainable transport and the circular economy. At the same time, to ensure that growth benefits all groups of the population, more investment is needed in vocational education and training, adult learning, early childhood education and care, and health. Overall, Cyprus has made limited ( ) progress in addressing the 2019 country-specific recommendations. There has been some progress:

-in improving the governance of state-owned enterprises; -in facilitating the reduction of non-performing loans; -in strengthening the effectiveness of the public employment services and getting more young people into jobs and training; -on the National Health Insurance System; -on energy efficiency and renewable energy; -in improving R&D; and -in improving access to finance for small and medium-sized enterprises. Cyprus has made limited progress: -in improving the efficiency of the public administration and local governments; -in tackling aggressive tax planning; -in reforming the education system; and in increasing employers' engagement and learners' participation in vocational education and training; -in improving the affordability of childhood education and care; -in focusing investment-related economic policy on sustainable transport, waste and water management, digitalisation and digital skills; -in improving the effectiveness of the justice system and payment discipline; -in setting up a reliable system to issue and transfer immovable property rights; and -in accelerating anti-corruption reforms and safeguarding the independence of the prosecution. Cyprus has made no progress: -on privatisations. Cyprus faces a few challenges according to the indicators of the Social Scoreboard supporting the European Pillar of Social Rights. Youth unemployment and the number of young people not in employment, education or training remain at significantly high levels. Moreover, the gender employment gap remains wide. The real gross disposable household income (GDHI) per capita is still below the 2008 levels and significantly lower than the EU average in 2018. The guaranteed minimum income scheme helped to reduce income inequalities. Further efforts should be made in developing digital skills and encouraging upskilling and reskilling. Cyprus has made some progress in reaching its national targets under the Europe 2020 strategy. It met its targets for R&D spending and the share of renewable energy in the total energy mix. Cyprus exceeded its targets on higher education attainment and on reducing the school drop-out rate (‘early school leaving’). However, the energy consumption remained unchanged, and in the absence of additional measures, this affects Cyprus’ capacity to achieve its targets for greenhouse gas emissions. The employment rate increased, and poverty and social exclusion decreased, but the target seems to be unattainable.

Cyprus performs relatively poorly in achieving the Sustainable Development Goals. More specifically, Cyprus underperforms with regard to the environment (SDG 2, 6, 7, 12, 13, 15), gender equality (SDG 5), and education (SDG 4) except for tertiary education attainment. Cyprus performs relatively well when it comes to good health and well-being (SDG 3) ( ). The main findings of the in-depth review contained in this report and the related policy challenges are as follows: ·Despite the considerable progress made over the last two years, the stock of non-performing loans remains high. In mid-2019, The share of non-performing loans accounted for 33.5% of the total loans in the banking sector, which is still one of the highest proportions in the EU. The effective use of the legal framework, including for foreclosures and insolvency, is essential to reducing non-performing loans further, enhancing the payment discipline and addressing strategic defaulters. Non-performing loans, including the growing proportion held outside of the banking sector, need to be resolved. This is, in particular, the case for the loans held by the state-owned asset management company (KEDIPES) where delays and organisational set-up challenges need to be addressed to ensure a successful performance. Strengthening the supervision of credit-acquiring companies is also important. ·The banking sector’s profitability remains under significant pressure. While sales of non-performing loans are expected to reduce the proportion of bad loans held by the banks in 2020, low interest margins, excess liquidity and high operating costs still dampen banks’ profitability. ·Private sector debt remains high, although it is decreasing. Both households’ and non-financial corporations’ debt ratios are decreasing. The reduction is helped by nominal GDP growth, write-offs of bad loans, cash repayments, and debt-to-asset swaps. The legal frameworks for insolvency and foreclosure, and the ESTIA scheme should help reduce the private sector debt. The introduction of e-auctions in 2019 should facilitate the foreclosure process. The housing market recovery could help reduce private debt, but the existing inefficiencies in the system of issuing and transferring title deeds complicates foreclosure procedures and hinders the sale of properties held as collateral. ·Government debt is projected to steadily decline steadily from 2019 onwards. After increasing in 2018 because of the measures to support the sale and orderly winding down of the Cyprus Cooperative Bank, the debt-to-GDP ratio is set to decrease to 82%% of GDP by 2021, mainly due to expected sizeable headlines surpluses and solid economic growth. However, the Commission’s fiscal sustainability analysis shows that risks remain. In particular, the still high level of public debt and the combination of a large current account deficit and high private debt make Cyprus vulnerable to potential financial and economic shocks. However, relatively modest medium-term financing needs mitigate the risks somewhat. ·Despite some improvement, the net international investment position (NIIP) remains a key vulnerability, in particular as the current account deficit is widening considerably. The position remains very negative and a widening current account deficit hampers further improvement. The position is even more negative when one excludes its components that could be affected by large negative valuation effects in the case of a global downturn (net foreign direct investments and net portfolio equity). ·Potential growth is expected to increase over the medium term. The projected increase of the labour force and increased investment are set to be the main drivers of higher growth potential. Technological progress is also expected to make a small positive contribution after performing negatively for a long period. However, the continued focus on residential investment, small and medium sized enterprises’ ongoing difficulties in accessing finance, the high level of private sector’s debt, and the shortcomings in the business environment could hamper growth and productivity in the longer term. A number of other key economic issues analysed in this report point to particular challenges to the Cypriot economy, namely: ·Key challenges remain in relation to environmental sustainability. The country’s weak environmental performance is a major concern. Waste and water management is inefficient and the transition towards a circular economy has barely begun. Despite some action, Cyprus remains vulnerable to climate change due to droughts and water scarcity. At the same time, Cyprus is among the Member States with the highest green-house gas emissions per person. Sustainable mobility is key for Cyprus owing to the large and growing share of transport emissions. Despite the country’s vast potential in renewable sources of energy, notably solar energy, investment in this area is considerably lagging way behind, and the economy heavily relies heavily on fossil fuels. Decisive efforts to transition to a more climate-friendly growth model are essential to improving the competitiveness and the long-term potential of the economy. The Commission’s proposal for a Just Transition Mechanism under the next multi-annual financial framework for 2021-2027, includes a Just Transition Fund, a dedicated just transition scheme under InvestEU, and a new public sector loan facility with the European Investment Bank. It is designed to ensure that the transition towards EU climate neutrality is fair by helping Cyprus to address the social and economic consequences. Key priorities for support from the Just Transition Fund are identified in Annex D, building on the analysis of the transition challenges outlined in this report. ·The justice system continues to face serious inefficiencies that undermine the enforcement of contracts. Lengthy court proceedings and weak enforcement of judgements harm the business environment and hinder banks from using the available legal tools to reduce non-performing loans. Addressing these inefficiencies would also help to strengthen the payment discipline in the country. Preparations for the justice system reform are advancing but there are still no tangible results. ·The housing market as a whole has seen a recovery, but the sector is segmented. The housing market has been recovering, supported by buoyant foreign demand for new luxury residences stemming mainly from the residence and citizenship by investment schemes. In contrast, domestic demand for housing and demand for existing properties remain low. This is also reflected in differences in housing price trends developments between new and existing residences and between regions. ·The labour market is still facing challenges. Despite measures undertaken in this area, there is still scope for bringing the public employment services into line with best EU practices. Furthermore, the public employment services’ effectiveness is at risk as additional recruitments are only on short-term contracts. Further progress to reduce undeclared work is hindered by a lack of resources and the fact that legislation is still pending. ·Reforms of the education and training systems face considerable challenges. The relatively high public spending on education is not reflected in observed outcomes, as highlighted by the recent results from the Programme for International Student Assessment. The weak support for early childhood education and care undermines potentially high long-term benefits of quality childcare, and hinders people from working or looking for a job. Improving educational achievements and skills, as well as increasing participation in adult learning and vocational education and training are essential for fostering sustainable growth in the future. ·The health sector is undergoing a fundamental reform. The new National Health Insurance System is expected to make the health sector more efficient and affordable, but some operational challenges remain. It provides a pivotal opportunity for targeted investments to improve public healthcare and develop e-health, among other things. The reform needs to be carefully implemented to reduce the fiscal risks. ·Economic evidence suggests that Cyprus’ tax rules are used for aggressive tax planning purposes. The absence of withholding taxes, the design of the Cypriot corporate tax residence rules, and the residence and citizenship by investment schemes, are a cause for concern. In addition to the implementation of European and internationally agreed initiatives, Cyprus has announced some unilateral measures. These include the introduction of withholding taxes on dividend, interest and royalty payments to countries on the EU list of non-cooperative jurisdictions on tax matters, the introduction of a tax residency test based on incorporation, and the reviewing of the transfer pricing framework to take into account the transfer pricing recommendations from the OECD base erosion and profit shifting project. ·Inefficiencies in the public sector are harming the business environment. Key reforms to improve the efficiency of the public administration and the local government are still pending. The impact of the efforts made to improve the governance and financial monitoring of state-owned enterprises remains to be seen. Private investment, including in key utilities, could be facilitated through privatisations and simplifying procedures. Corruption is perceived as a problem by businesses, and adopting pending key anti-corruption legislation, as well as stepping up the implementation of the adopted action plan are essential for improving the business environment. 1. Economic situation and outlook Economic growth Economic growth remains strong, although it is slowing down amid an increasingly challenging international environment. After a solid expansion of 4.1%% in 2018, real GDP slowed in the first three quarters of 2019 to 3.3%% (seasonally adjusted), reflecting a weakened international environment, while domestic demand remained solid. According to the Commission’s 2019 Winter Forecast (European Commission, 2020a), economic growth is estimated to moderate further in the fourth quarter of 2019, due to external headwinds and a full-year growth is projected to reach %3.2% (see Graph 1.1.). Graph 1.1:Real GDP growth and contributions Source: European Commission

Private and public consumption support growth. Household consumption continued to rise on the back of strong employment growth and moderately increasing wages. Low inflation also supported households’ real purchasing power. Private consumption is expected to continue supporting growth in the medium term. Public consumption is also set to increasingly boost growth over the forecast period. This is driven by the gradual reinstatement of the public wages’ cuts implemented during the crisis and the government expenditure in relation to the newly established National Health Insurance System (NHIS). Investment remains robust, albeit skewed towards residential construction. Since 2015, the investor citizenship scheme (Cyprus investment programme) has been boosting residential construction activity. According to estimates of the Ministry of Finance, the proportion of real estate / construction investment through the scheme in total investment in these sectors increased significantly from 19.5%% in 2015 to 37.7%% in 2018 (Ministry of Finance, 2019a). Based on the same study, the direct impact of the scheme on GDP is estimated to be relatively small, while being quite substantial in terms of added value and employment in the construction sector. ()%%The revision of the scheme in May 2019 ( ), which makes the conditions more stringent and the investment potentially less attractive, may lead to a slowdown of demand for new high-end residences in the coming years. Other construction investment has also been buoyant, especially in relation to tourism. This sector is also mainly foreign-funded, but is not linked to the investor citizenship scheme. Investment in machinery and equipment is recovering after the crisis, pointing to some increase in productivity-enhancing investments. Investment in transport equipment is very volatile and difficult to predict due to the activities of special purpose entities related to registration/deregistration of ships. ( ) Domestic banks so far seem to have limited links with the buoyant activity in the construction sector as mortgage lending remains low compared to the pre-crisis level (see Graph 1.3). Nevertheless, the developments in construction investment warrant close monitoring, in particular for a potential slowdown in foreign demand and increasing domestic lending. Net exports have become a drag on the economy, as tourism momentum moderates. Exports of services notably tourism — a key component of total exports — are estimated to considerably slowed down in 2019. The sector has recently experienced several setbacks. After record increases in previous years, tourist arrivals moderated and revenues declined in 2019 (see Graph 1.2), as a result of the subdued external environment, the bankruptcy of airlines and travel companies ( ) and increasing competition from neighbouring countries. Given the uncertainty surrounding the future trade relations between the EU and the UK — Cyprus’ largest tourist market —, as well as the expected subdued economic prospects in the EU, the downward path is expected to continue in the near term, while a slight recovery is projected in 2021. Imports are expected to continue increasing in line with solid domestic demand. Graph 1.2:Tourism arrivals and revenues Source: Statistical Service of Cyprus Diversifying the tourism sector and ensuring its environmental sustainability is crucial. So far, the expansion of tourism-related services in Cyprus has come at a price to the island’s natural environment. Despite some efforts to increase the share of eco-friendly tourism services, such as agro-tourism, the bulk of the investment flowed into accommodation and infrastructure that put the environment at risk. If decisive efforts are not made urgently to ensure that the tourism sector is environmentally sustainable in the long term, then the sector risks losing its appeal and, ultimately, its profitability. It is therefore also essential to address challenges related to the green energy transition, effective waste and water management and the protection of nature and biodiversity (see Section 4.5). Furthermore, the reliance of the sector on a limited number of markets makes - UK, Russia and Israel account for more than 60%% of tourist arrivals –makes the sector vulnerable to potential adverse economic developments. Increased market diversification would help mitigate these risks. In this respect, addressing bottlenecks in air travel connections is key. Downside risks cloud the economic outlook. These risks are primarily external, notably the slowing global demand coupled with increased competition in the tourism sector. In this context, the real GDP is expected to edge down further to 2.8%% in 2020 and 2.5%% in 2021 (European Commission, 2020a). This path reflects a gradual move towards the estimated potential growth of around 2.5%% in the medium term. Diversification of Cyprus’ growth model remains a key challenge. Growth is heavily resilient on sectors vulnerable to external developments notably tourism, foreign-funded construction activity, in particular residential construction, and services in connection with the setting up and providing services to foreign companies under the special purpose entities’ regime. To a certain extent, this is to be anticipated for a small, open, service-oriented economy. However, to increase the country’s potential growth and to improve its resilience to economic developments, diversifying the economy to mitigate these risks is essential. Moreover, Cyprus is vulnerable to potential changes in the international corporate tax framework, which could jeopardise its role as a business service hub. There are new emerging sectors, such as tertiary education, ICT and energy, but so far their impact on growth has been limited. It would be important to support the development of these sectors, which also have the potential to raise the country’s future productivity. At the same time, it is important to ensure that growth benefits all of society. Despite solid economic growth since 2015, many young people still stay out of employment, education or training and a high number of women remain out of the labour market due to care responsibilities. Furthermore, the proportion of involuntary part-time workers, though decreasing, remains one of the highest in the EU. Addressing care facilities’ gaps, skills mismatches, and upskilling and re-skilling needs, in particular in digital and green transformation, would help to ensure that all groups of the population are benefitting from growth (see Sections 4.3.3 and 4.5). It is essential that the new long-term growth strategy takes diversification, social and environmental considerations duly into account. The new long-term strategy for the sustainable growth of Cyprus economy is currently under preparation and provides good opportunity to re-orient the country’s economic development. While tourism is expected also in the future to be the pillar of the economy, it is key for Cyprus’ economy to become more diversified by focussing on more innovative sectors that would increase productivity, ensuring, at the same time, environmental sustainability and social inclusion. Inflation Inflationary pressures remain subdued. In 2019, HICP inflation was 0.5%, lower than 2018, 0.8%. This development was attributed to the decline in energy prices, owing to the reduction of excise duties on the main fuels (as from December 2018) and the lower price of oil in 2019 compared to 2018. The continuous decline in prices of non-energy industrial goods also contributed to low inflation in 2019. More specifically, global competition has been affecting the price of imports, while increasing competition among supermarkets in Cyprus, more internet sales and the liberalisation of shop opening hours and periods for sales have also been pushing prices down further. Energy prices are expected to decrease further in 2020 and 2021 reflecting declining oil prices. Inflation is expected to average at 0.8% and 1.2% in 2020 and 2021 respectively (European Commission, 2020a). Housing market Foreign demand for high-end new residences has been the key driver of the housing market’s recovery in the aftermath of the crisis. From 2014 to 2017, sales of properties rose in double digits. In 2019 and 2018, sales of properties increased by 12.2% and 5.8%, respectively. Foreigners, predominately non-EU nationals, accounted for almost 50% of the total properties sold since 2014. The sales were concentrated in the coastal areas and concern mainly luxury apartments and villas. In the first half of 2019, a spike of sales was observed reflecting the surge of applications to the investor citizenship scheme following the announcement in May 2019 of revisions to the scheme. The compulsory purchase by a resident of a property worth at least €500,000 under the scheme coupled with the traditional foreign demand for second homes in a holiday destination are the main drivers of the housing market’s recovery after the crisis. In contrast, domestic demand for housing and demand for existing properties remains low. Domestic demand is still hindered by the housing debt overhang and the limited demand for existing properties, which is also reflected in the moderate price increases in this segment of the market (see Graph 1.4). This weighs on the ability of over-indebted borrowers to sell their properties (used as collateral against their loans) to repay their debt and on the ability of banks to offload real estate from their balance sheets (see Section 4.2.1). Although new mortgage lending has been increasing, it is still well below pre crisis level (see Graph 1.3). Real estate activity is set to slowdown in the medium term. The registration of contracts for property sales considerably decelerated during the second half of 2019, 0.7% year-on-year, compared to 24.4% in the first half, possibly reflecting the slowdown of applications for the investor citizenship scheme. This points to a modest expansion of the sector in the near term as there is only a slight upturn in domestic demand. Residential property prices are picking up, but so far remain contained. Housing prices increased for a fourth year in a row (see Graph 1.4), but remain below the pre-crisis levels. The rise is greater for new residences, with foreign demand leading to substantial price differences among regions. In terms of valuation, European Commission house price valuation methods do not point to significant undervaluation (the overall valuation gap is estimated to be -4.6 percentage points), but the analysis does not take into account the market segmentation. ( ) A possible slowdown in foreign demand and re-sale of properties acquired through the investor citizenship scheme after the compulsory holding period, as well as rising sales of collaterals by banks and by credit-acquiring companies (see Section 4.2.1) should also curb housing prices rises in the medium term. Graph 1.3:New and pure new loans for house purchase (1)New loans include restructured loans (2)Data available until November 2019 Source: Central Bank of Cyprus Rental prices are increasing and the market is highly segmented. Rental prices increased by 3.4% in 2019. The rental market consists of two categories of properties and two sets of rules. Properties that were built before 2000 are subject to a rental control law that cap rental increases. Initially, the law allowed for a rental increase of up to 14% every two years, but since the crisis, any increase in rent is prohibited. For properties built from 2000 onwards, rental conditions are defined by the market, i.e. the terms of the rental contract are not subject to any restrictions. The increasing housing cost, mainly in coastal areas stemming from the investor citizenship scheme has put pressure on the government to announce policies for affordable housing and to increase rent allowances for vulnerable groups of the population (see Section 4.3.2). Graph 1.4:Housing price developments Source: Eurostat Labour market

Strong economic growth has been reflected in positive labour market developments. In 2018, employment rose by 4.1% increasing the employment rate to 73.9% and above the EU average of 73.2%, as reflected positively in the Social Scoreboard and the SDG 8. Employment is expected to rise further during the forecast period (2019-2021) albeit at a slower pace. The unemployment rate continued its downward path falling to 7.5% in 2019 and is expected to fall gradually to 5.7% in 2021, thus approaching its pre-crisis level. Long-term unemployment also fell to 2.7% in 2018 and is now below the EU average of 2.9%. However, youth unemployment and the proportion of young people not in education, employment or training (NEETs), although decreasing, remain high and are above the EU average, at 20.2% and 13.2%, respectively in 2018, compared to 15.2% and 10.5% in the EU. This may weigh on current and future equality of opportunities (see Graph 1.5 and Section 4.3.1). Wages have gradually increased, while disposable income remains below pre-crisis levels. Even though GDP has been back at the pre-crisis level since 2017, the real gross disposable income per head is still well below 2008 levels. The moderate increase in wages in the private sector is explained by several factors such as remaining unemployment, a decline in unionisation and a relatively high number of workers in low skilled and low-paying sectors, such as, trade, tourism and construction. Productivity is still stagnant, which also points to moderate wage increases. Wage renegotiations between employers and trade unions in several key sectors (banking, construction and hotels) in 2019 are expected to result in wage increases in the coming years. Wage increases are greater in the public sector, because in addition to the annual wage increases owing to inflation indexation and seniority increments, the government will gradually phase out the wage cuts made during the crisis period by 2023. Graph 1.5:Key labour market developments Source: Eurostat Social developments Poverty and income inequality are improving, but for certain vulnerable groups the risk of poverty is still high. The at-risk-of-poverty or social inclusion (AROPE) indicator and its sub-components ( ) keep decreasing (see Section 4.3.2) as a result of strong economic growth and the social protection reforms introduced since 2014. Currently, Cyprus is one of the best performers in the EU in terms of the net income of minimum income recipients and of low wage earners as a percentage of the at-risk-of-poverty threshold. For minimum income recipients the proportion is 86.7% compared to 59.1% in the EU and for low wage earners, 72.7% compared to 42.6% in the EU. Income inequality returned to the pre-crisis level. However, the share of poorest people is increasing and the risk of poverty or social exclusion is higher for children, people with disabilities and non-EU born people (see Section 4.3.2). External position The net international investment position improved, but remains very negative. The position decreased gradually from -127% of GDP in 2017 to around -115% in the third quarter of 2019, supported mostly by increasing nominal GDP (denominator effect) and valuation changes. The position remains well below the prudential and fundamental levels. Cyprus’ current account deficit is widening, exceeding the prudential thresholds. The current account deficit widened considerably in the third quarter of 2019 to 7.4% (around 4% in cyclically adjusted terms) from 4.4% in 2018 (or -1% cyclically adjusted). The deterioration reflects the worsening of the international environment with an adverse impact on revenues from tourism (see Graph 1.2). This coupled with solid demand for imports point to a further deterioration of the current account during the period 2019-2021. For more analysis, including information on adjusted statistics for special purpose entities see Sections 3 and 4.2.4. Competitiveness Cyprus is set to maintain cost-competitiveness from 2019 onwards, but market shares are decreasing. After a significant depreciation during the crisis, the real effective exchange rate increased in 2018, while from 2019 onwards it is estimated to continue depreciating (see Graph 1.6). Despite that, in 2019, the market shares are estimated to have fallen reflecting intensified cost-competition by neighbouring countries, such as the significant depreciation of the Turkish lira over the last years. This trend is expected to continue in the coming years. Furthermore, fluctuations in the Russian rouble and the UK pound also influence the Cypriot economy due to the strong trade and investments links. Increased social contributions elevate labour costs. While in 2018, the unit labour costs remained broadly constant and below the euro area average, they increased in 2019 owing to the higher social security contributions coupled with the introduction of contributions to the National Health Insurance System (NHIS). This is set to continue in 2020 and 2021 partly due to the additional increases of NHIS contributions in 2020 and expected moderate increases in wages in the coming years. The introduction of universal health coverage could have a positive impact on labour force participation and productivity leading to higher GDP per capita (OECD, 2019a), however it may initially deteriorate the competitiveness of labour costs. Graph 1.6:Real effective exchange rates Source: Eurostat, Bruegel Financial sector The banking sector continues to be profitable, but profits are weaker than in the previous year and asset quality remains a challenge. Following losses in 2017, the banking sector returned to profitability in 2018 and remained profitable in the first half of 2019. Overall, banks are still finding it difficult to generate profits owing to low interest margins, excess liquidity, high operating costs and large stocks of non-performing loans. Throughout 2019, progress in reducing non-performing loans slowed down. Future asset disposals are expected to materialise in 2020, significantly reducing the stocks of bad loans in the banking sector (see Section 4.2.3). In turn, the stocks of non-performing loans held by the credit-acquiring companies are expected to increase. Enhancing payment discipline, including improving financial literacy ( ) would help underpin a sustainable workout of bad loans and sustain deleveraging. New lending to domestic residents increased in 2019 compared to the previous year. The private sector continues to rely on internal resources and foreign funding, as new lending from domestic banks is contained by large proportions of non-performing loans, elevated debt and tighter credit standards. Nevertheless, in the first half of 2019 new lending increased by 6% year-on-year (the gross volume of new loans reached €1.53 billion in 2019, up from €1.44 billion in 2018). Just as in the previous year, the bulk of the new lending went to non-financial corporations, whereas the housing loans constituted slightly more than 25% of the total new loans. Public finances After a temporary general government deficit in 2018 owing to one-off support measures for the sale of the Cyprus Cooperative Bank, Cyprus is expected to record a significant budgetary surplus in 2019. The Commission 2019 autumn forecast projects that the headline budget balance will return to surplus in 2019, at 3.7% of GDP (see Graph 1.7). The deficit of 4.4% of GDP recorded in 2018 was caused exclusively by one-off operations to support the banking sector. Public finance performance in Cyprus has improved significantly since 2014, when it recorded a deficit of 8.7% of GDP, reflecting the budgetary consolidation measures implemented during the crisis, notably to limit expenditure growth, combined with buoyant tax revenue. The budgetary performance is expected to remain strong but the structural balance is set to deteriorate. The headline balance is forecast to record a surplus of over 2.5% of GDP in 2020 and slightly below 2.5% in 2021 as increasing current expenditure will outpace revenue growth (see Section 4.1.2). The structural balance is expected to remain positive but is set to decline from above 1% in 2019 to below 1% in 2020 and 0.4% in 2021 driven by a large output gap and increasing expenditure. The declining structural balance emphasises the need to carefully monitor expenditure developments, especially in light of possible future risks to the robustness of revenues, as described in Section 4.1. The public debt-to-GDP ratio is projected to decline substantially in the coming years. After increasing in 2018 owing to the banking support measures, the debt-to-GDP ratio is expected to decrease substantially, from 101% of GDP in 2018 to 94% of GDP in 2019, and to 82% in 2021 (see Section 4.1.1 and the debt sustainability analysis presented in Annex B). Graph 1.7:General government budget balance and gross debt Source: European Commission

Downside risks to the fiscal outlook remain. Key risks include: (i) expenditure pressures related to the wage bill, (ii) the financial sustainability of the new National Health Insurance System (NHIS), (iii) the potential realisation of contingent liabilities from the banking sector, and (iv) uncertainty concerning the sustainability of strong tax revenue performance. Positive cash balances from the Asset Management Company (KEDIPES), dealing with the residual entity of the CCB are an upside risk. Progress on sustainable development goals Cyprus performs relatively poorly in achieving the Sustainable Development Goals, especially regarding the environmental goals. According to Eurostat’s Sustainable Development Goals (SDGs) indicators (see Annex E), over the past 5 years Cyprus has been making rather uneven progress. Cyprus performs well with regard to good health and well-being (SDG 3) despite the fact that most of the health determinants indicators are below the EU average. Cyprus is performing below EU average when it comes to environmental impact of agriculture (SDG 2), clean water and sanitation (SDG 6), affordable and clean energy (SDG 7), responsible consumption and production (SDG 12), climate action (SDG 13) and life on land (SDG 15). Many of the indicators in those areas are further deteriorating from already sub-par levels and this is particularly the case for nitrate in groundwater and soil sealing index, which seems consistent with the fact that Cyprus scores below the EU average and has further deteriorated when it comes to generation and recycling rate of waste. Cyprus has also further deteriorated when it comes to final energy consumption, resource productivity, and climate mitigation, which does not bode well for its environmental outcomes in the future. Apart from environment, Cyprus is also underperforming when it comes to gender equality (SDG 5) and the situation is further deteriorating when it comes to gender gap for tertiary educational attainment, gender gap for employment rate of recent graduates and gender gap in inactive population due to caring responsibilities. On the other hand, some improvement is observed when it comes to gender pay gap and the number of leadership positions held by women. Finally, Cyprus is also underperforming in quality education (SDG 4) despite the fact that it scores above EU average when it comes to tertiary educational attainment. The situation is further deteriorating with respect to underachievement in reading and adult participation in learning. Table 1.1:Key economic and financial indicators – Cyprus Source: Eurostat and ECB as of 4-2-2020, where available; European Commission for forecast figures (Winter forecast 2020 for real GDP and HICP, Autumn forecast 2019 otherwise) 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 56% of all country-specific recommendations addressed to Cyprus have recorded at least ‘some progress’. ( ) 44% of these country-specific recommendations (CSRs) recorded ‘limited’ or ‘no progress’ (see Graph 2.1). Full implementation and substantial progress have been achieved in a wide range of reforms, in particular fiscal and financial ones supported by the 2013-2016 European Union-International Monetary Fund economic adjustment programme. These reforms address most of the CSRs made in 2011 and 2012. As regards the CSRs made after the programme’s completion mostly cover persisting challenges, which are also reflected in the CSRs for 2019. Graph 2.1:Overall multiannual implementation of 2011-2019 CSRs to date Source: European Commission Public financial management and the budgetary framework were significantly strengthened with the adoption and implementation of the Financial Responsibility and Budget Framework Law, which has helped in ensuring the transparency and sustainability of the public finances. The pension system and retirement age were reformed to ensure the system’s long-term sustainability. The country-specific recommendations on social benefits and the high ‘at- risk- of- poverty’ rate among the elderly were addressed by introducing the guaranteed minimum income, which allows for more efficient and targeted social benefits. The reform has helped reduce income inequalities. On the financial sector, significant reforms were undertaken notably during the implementation of the macroeconomic adjustment programme 2013-2016 mainly through the harmonisation and integration of the supervision of banks and cooperative credit institutions. Furthermore, since 2018 the authorities have been working on a comprehensive strategy to reduce non-performing loans. The strategy is comprised: (i) the adoption in 2018 of a legislative package, including amendments to the foreclosure and insolvency frameworks and to the Sale of Loans Law and a new Securitisation Law; (ii) the sale of the Cyprus Cooperative Bank, which struggled with a high volume of non-performing loans (completed in 2018), and (iii) the setting-up of a temporary State support scheme (ESTIA) aimed at reducing non-performing loans collateralised by primary residences (ongoing). Key challenges in the sector remain. Most sector-specific obstacles to the freedom of establishment and the freedom to provide services have been removed. Some measures were introduced to promote renewable energy production and diversify the energy mix as recommended. However, energy production is still heavily dependent on fossil fuels. Measures to improve the labour market situation have been put in place through a reform of wage indexation, active labour market policies to reduce unemployment, notably among young people, the long-term unemployed and receivers of the guaranteed minimum income, and policies to the upgrade workers’ skills. Some measures were also undertaken to make the vocational education system more attractive. Since 2017, progress has been made on the long-standing recommendation regarding the reform of the national healthcare system with the adoption of the necessary legislative framework in 2017, the launching of the first phase in 2019 and the ongoing preparations for full implementation in 2020. Cyprus has so far made limited progress in addressing the 2019 country-specific recommendations (see Table 2.1). Reforms related to the efficiency of the public administration and local governments are still pending enactment. Some measures were adopted concerning the governance of State-owned enterprises, but their efficacy has yet to be assessed. Limited progress was recorded on addressing aggressive tax planning, since the transposition of relevant EU Directives is still in the process, and additional measures such as the introduction of a withholding tax on dividend, interest, and royalty payments to countries in Annex I of the EU List of Non-cooperative jurisdictions on tax matters are only announced. Some measures to help reduce non-performing loans (NPLs), notably the ESTIA scheme (for addressing NPLs collateralised by primary residences) and e-auctions (for properties subject to foreclosure proceedings) are being implemented. Cyprus is also progressing, albeit slowly, with addressing the challenges faced by the state-owned asset management company, KEDIPES. For example, the setting-up of the governance structure of the State-owned asset management company is facing delays. Some efforts are under way to improve payment discipline, but their effectiveness remains to be seen. The new insolvency department is expected to operate more efficiently and effectively and promote the insolvency framework. Efforts to strengthen the supervision of credit-acquiring companies and of insurance companies and pension funds are facing delays as the relevant draft bills are pending for adoption. Some progress has been made on the outreach efforts for young people not in employment, education or training. The capacity of the public employment services was strengthened, but on a short-term basis, thus risking the longer-term sustainability of the services. The education reform is progressing unevenly, and results on the evaluation of teachers are not yet available. Supporting actions for affordable early childhood education and care are still lagging behind. The first phase of the National Health System was introduced in 2019 and preparations are ongoing for the second phase planned for mid-2020. However, fiscal sustainability risks remain. Measures to promote sustainable transport are only at an initial stage. Serious waste and water management inefficiencies remain, and progress is limited. Grant schemes are being implemented for small and medium-sized enterprises and households to encourage energy efficiency and the use of renewables, however challenges remain. Authorities have announced several measures to improve digitalisation and upgrade digital skills, but implementation is still pending. Some progress was recorded on research and innovation as the new strategy is in place and efforts to bring universities and businesses together are moving ahead. There has also been some progress regarding access to finance for small and medium-sized enterprises as several grant schemes and financial instruments are being implemented and an equity fund is being set up. Measures to simplify and shorten the procedures for obtaining the necessary permits for strategic investments are pending enactment. It has proved very challenging to carry out privatisations. Although preparations for a comprehensive reform of the justice system are ongoing, legislation and administrative measures that would improve the efficiency of the system are pending. These include the establishment of commercial courts, the recruitment of judges and the handling of financial disputes. A reliable and efficient system for issuing and transferring immovable property rights (e.g. building and land) is pending and progress is slow. An action plan for anti-corruption reforms is being implemented, but key legislation is pending adoption. The capacity to investigate corruption has been strengthened including with the adoption of the bill on telephone tapping. Some measures regarding the independence of the prosecution are being discussed. Table 2.1:Assessment of the 2019 country-specific recommendations implementation Source: European Commission Box 2.1: Commission Structural Reform Support Programme in Cyprus Upon request from a Member State, the Commission can provide tailor-made expertise via the Structural Reform Support Service to help design and implement growth-enhancing reforms. Since 2015, such support has been provided to Cyprus, including the support provided previously under the special Support Group for Cyprus, to help the country undertake a series of reforms. Up until now, support has been provided for over 120 projects. In 2019, several projects in various policy areas were delivered on the ground. The Commission has been supporting the Cypriot authorities in the area of governance and public administration in the design of a workforce planning system, enabling the alignment of the government’s human resources management with the country’s strategic priorities. Support was also provided for improving the web presence of the government through a study for the design of new information platforms and services. As regards judicial reform, the Commission has supported the development of evaluation criteria for the recruitment and promotion of judges, which has already been used for the recruitment of new judges. In addition, a comprehensive study was delivered in 2019 to assess the feasibility of the introduction of a digital audio recording system in the court proceedings. In the area of growth and business environment, the Commission has supported Cyprus’ efforts to improve environmental inspections, by providing a comprehensive training and development programme. The Cypriot authorities are also benefitting from expertise for developing economic diplomacy. Moreover, a new project was approved in 2019, which will focus on developing a long-term economic strategy for sustainable development and international competitiveness. Another project, which started in 2019, will provide support to the Cypriot authorities in revising the national strategy for the management of municipal waste. Support has also been provided in the area of labour market, social welfare, health and education. In the area of the health sector, Cyprus has benefitted from technical support for capacity planning, leading to the launch of the first phase of the National Health Insurance System (NHIS) in June 2019. Additionally, the Commission supported the Cypriot Health Insurance Organisation in designing a budget negotiation strategy with healthcare providers, based on international best practices. In 2019, a new project was launched to support Cyprus with the completion of the special education reform in order to make the school system more inclusive. Additionally, another education project was initiated, which will focus on addressing student disengagement and school dropouts. The Cypriot authorities have been receiving support in the area of revenue administration, tax policy and public financial management, including support for the management of changes resulting from reforms of the public financial management system. The Commission has also delivered a project to strengthen the administrative capacity of the Ministry of Finance by setting up mechanisms to monitor and evaluate performance in the framework of strategic planning. Additionally, the Cyprus Tax Department received support to prepare the procurement of a new integrated tax administration system. Lastly, the Cypriot authorities are working with the Commission in the area of finance and access to finance to improve the insolvency framework. In 2019, support was delivered to improve the efficiency and effectiveness of the operations of the Insolvency Service of Cyprus and to enhance the overall regulation of insolvency practitioners. This will lead to the establishment of a new Insolvency Department at the Ministry of Energy, Commerce and Industry in early 2020. The Commission has also started work on a new project, which will focus on raising awareness about Cyprus’ insolvency framework and developing a customer service policy for the Insolvency Service of Cyprus.

Box 2.2: EU funds and programmes to address structural challenges and to foster growth and competitiveness in Cyprus Cyprus is one of the countries that benefit significantly from EU support. Cyprus receives €873.6 million from the EU cohesion policy funds ( I ) in the current Multiannual Financial Framework, equivalent to around 0.6% of its GDP. By the end of 2019, Cyprus allocated almost the entirety of this amount to specific projects and had already spent €407.3 million on concrete projects ( II ), showing a level of implementation well above the EU average. While achieving more harmonious development through reducing economic, social and territorial disparities, EU cohesion funding also plays a significant role in addressing structural challenges in Cyprus. The cohesion policy programmes for Cyprus have allocated €188 million for smart growth (including support to research & innovation and to small and medium-sized enterprises), €370 million for sustainable growth (including environmental infrastructure) and sustainable transport and €164 million for inclusive growth (including training and social inclusion). In 2019, following the performance review ( III ), €42.6 million were made available for Cyprus within performing priorities. EU cohesion funding is contributing to major transformations of the Cypriot economy. By 2019, investments driven by the European Regional Development Fund and the cohesion fund have contributed to connecting Limassol Port to the main motorway in the Trans-European Transport Network, and to providing some 5,000 population equivalent with new or improved waste water treatment. Furthermore, the investments supported more than 400 enterprises; generated 975 new direct jobs (full time equivalents) and more than €12 million of private matching funding, and contributed to reducing greenhouse gas emissions by 15,000 tons of CO2. Cohesion Policy is helping Cyprus to achieve the digitalisation of its economy and develop eGovernment. It has helped to develop the IT system for the introduction and support of the new General Healthcare System. The system will perform all the basic functions related to the provision of services within the framework of the System, having allowed some 615 providers to register as personal doctors and more than 1,200 as specialist doctors, as well as around 500 pharmacies to join. Over 80% of the population has also registered as beneficiaries (687,000 people), while more than 1 100 000 visits to personal doctors and some 700,000 visits to specialist doctors have taken place so far. The European Social Fund (ESF) has been contributing to major transformations of the Cypriot labour market. The European Social Fund has supported more than 10,500 unemployed persons, including more than 3,000 long-term unemployed, 5,500 young people, and 500 jobless people above 54 years old. The policy contributes to the upgrading of technical and vocational education and training, and will train almost 3,000 people by 2023. 3,200 people have successfully been employed after participating in such work/training schemes. Agricultural and fisheries funds and other EU programmes also contribute to addressing development needs. As well as receiving support of €132.2 million from the European Agricultural Fund for Rural Development (EAFRD), and €39.7 million from the European Maritime and Fisheries Fund (EMFF), Cyprus also benefits from other EU programmes. The Connecting Europe Facility has allocated €66.5 million to specific projects for strategic transport networks (TEN-T), and Horizon 2020 has provided €231 million for research and innovation, including €72 million for small and medium-sized enterprises. EU funding contributes to the mobilisation of important private investment. European Structural and Investment funds ( IV ) provide programmes with about €40 million in the form of loans and guarantees. EU funds already invest substantial amounts on measures in line with the Sustainable Development Goals (SDGs). In Cyprus the European Structural and Investment Funds support 12 out the 17 SDGs and up to 91% of the expenditure contributes to achieving those goals. 3. Summary of the main findings from the MIP in-depth review Introduction The 2020 Alert Mechanism Report concluded that a new in-depth review should be undertaken for Cyprus to assess the persistence or unwinding of the imbalances (European Commission, 2019a). In February 2019, the Commission concluded that Cyprus was experiencing excessive macroeconomic imbalances in particular involving a very high share of non-performing loans, high stocks of private, public and, external debt in a context of still relatively high unemployment and weak potential growth. In the updated scoreboard, a number of indicators remain beyond the indicative thresholds, namely the current account balance, the net international investment position, private sector debt, government debt and the unemployment rate. This chapter summarises the findings of the analyses in the context of the macroeconomic imbalance procedure in-depth review that is contained in various sections in this report. ( ) Imbalances and their gravity The non-performing loans (NPL) ratio declined visibly since its peak but remains one of the highest in the EU. After a significant decline in the NPL ratio in 2018 (from 50.4% at the start of the year to 35.6% at the end of the year) driven by two one-off operations ( ), very limited progress was made with NPL reduction in 2019. In June 2019, the NPL ratio stood at 33.5%, down from 35.6% at the beginning of the year. The largest volume of NPLs belongs to households, amounting to a share of 37.1% of gross loans to households. For non-financial corporations the stocks are lower, equivalent to a NPL ratio of 30.2%. The decline in the stock of NPLs during the first half of the year reflects write-offs, cash repayments, debt-to-asset swaps and curings (migration of non-performing loans into performing categories). Large asset sales are expected to materialise in 2020, accelerating the reduction of bad loan in the banking system. Private sector debt continues to decline, but it is still at high levels. In consolidated terms, the private debt-to-GDP ratio has been falling in the last years, reaching 282.6% of GDP at the end of 2018, compared to an EU average of 138.3% of GDP. Private debt in Cyprus is inflated by the debt of non-financial special purpose entities, which has been relatively stable as a percentage of GDP since 2013 – close to 70% of GDP. Nevertheless, the debt stock of special purpose entities increased from 2015 to 2018 by approximately 15%. Both households and non-financial corporations are over-indebted. In September 2019, households’ debt stood at 91.2% while non-financial corporations’ debt-to-GDP ratio was 169.6% (103.5% excluding special purpose entities). Both are above fundamental and prudential benchmarks, even when excluding special purpose entities (see Section 4.2.3). The public debt ratio remains elevated, although it decreased in 2019. While in 2018 the government debt-to-GDP ratio increased by approximately 7 percentage points to 100.6% (due to one-off factors related to the sale of the Cyprus Cooperative Bank , in 2019 public debt is coming down – close to 94% of GDP (see Section 4.1.1). Cyprus enjoys favourable market access, with low sovereign bond yields and has been given an investment grade rating by all the main rating agencies, apart from Moody’s. The country’s net international investment position (NIIP), particularly concerning net external debt, remains a source of vulnerability. In the third quarter of 2019, the NIIP stood at around ‑115% of GDP — one of the largest in the EU. The ‘defaultable’ part of the NIIP (), which excludes foreign direct investment and portfolio equity shares, amounted to around -160% of GDP, reflecting large external debt liabilities. According to the Central Bank of Cyprus, a part of this around -30% of non-adjusted GDP relates to the debt of non-financial special purpose entities (excluding net foreign direct investment and net portfolio equity shares). Even taking this effect into account, the ‘defaultable part’ of the NIIP is well beyond estimated benchmarks (see Section 4.2.4). Another part of this net external debt (-81%) is in the government sector, the bulk of which is explained by debt to international financial institutions under the macroeconomic adjustment programme, and is less exposed to short-term risks. The large current account deficit is not conducive to external rebalancing. The current account deficit amounted to -7.4% in the third quarter of 2019, reflecting an adverse international environment coupled with continued strong domestic demand. The current account balance is below the current account ‘norm’ ( ) implied by fundamentals and below what would be required to stabilise the NIIP and its ‘defaultable’ part at prudent levels (see Section 4.2.4). Excluding the activities of ship-owning SPEs the current account was still significantly negative at -4.4%. The labour market has improved on the back of solid growth. Most indicators improved markedly and unemployment fell to 7.5% in 2019. Long-term and youth unemployment also decreased significantly, reducing the gravity of the problem (see Sections 1 and 4.3.1). Potential growth is gradually increasing. In 2018, potential growth was estimated at 2%, and is expected to increase to 2.3% in 2019 and to 2.5% in 2020. Labour and gross fixed capital formation continue to be the main drivers of potential growth but total factor productivity is also expected to provide a small positive contribution from 2020 onwards, after 10 years of negative contributions. However, the high dependency on construction investment for residential properties, the remaining debt overhang and insufficient progress with structural reforms constrain potential growth in the longer term (see Sections 1 and 4.4). Evolution, prospects and policy responses The Cypriot government continues to follow the three-pillar strategy aimed at reducing non-performing loans (NPLs) that was introduced in 2018. The first pillar – a legislative package that strengthened the framework for NPL resolution – was implemented already in 2018. However, the amendments to the foreclosure framework approved by Parliament in August 2019 risk weakening this framework, if implemented. The Supreme Court is expected to decide on the constitutionality of these amendments in spring 2020. Under the second pillar, in 2018, the Cyprus Cooperative Bank was sold and KEDIPES, the state-owned asset management company, was established to manage the remaining ‘bad assets’ of the Cyprus Cooperative Bank residual entity. KEDIPES holds approximately €6.8 billion of non-performing loans and is, thus, the largest asset management company in EU relative to the size of the economy. While it has been set up and is operational, progress needs to be stepped-up, including implementing a long-term business plan, a new organizational model and enhancing its governance. The last pillar of the strategy, the ESTIA scheme – for NPLs collateralised with primary residences – was launched in September 2019 (see Section 4.2.1), with the banks’ assessment of applications expected to be completed in spring 2020. The checks and approvals by the competent Ministry are expected to be completed in summer 2020. Other steps have also been taken to reduce the NPLs. Other efforts to facilitate the reduction of non-performing loans include the introduction of e-auctions (in November 2019), strengthening the supervision of credit-acquiring companies, which is under-way, and ongoing judicial reform. The planned reform of the judicial system aims to increase the efficiency of the system, strengthen the enforcement of judgments and ultimately improve the payment culture in the country (see Section 4.4.3).

Private sector debt reduction reflects both strong GDP growth and nominal debt reduction, nevertheless further deleveraging is needed. Both households’ and non-financial corporations’ debt ratios are on a declining path, helped by GDP growth (denominator effect). The nominal debt stocks are also declining (albeit slowly) in both sectors, driven by write-offs of bad loans, cash repayments and debt-to-asset swaps (see Section 4.2.3). In 2018, the deleveraging was led by non-financial corporations excluding special purpose entities, as their debt stock declined faster than households’ stocks. For continuing deleveraging in the future, it is important to maintain the strengthened foreclosure framework. This is even more relevant, given that the take-up of the ESTIA scheme, which provides very attractive terms (including debt reductions) to defaulted borrowers, was lower than expected. Furthermore, the absence of an efficient and reliable system for transferring and issuing property rights hinders foreclosure procedures and makes it difficult to value collaterals (see Section 4.2.3). Private debt reduction may accelerate once the credit-acquiring companies – which now hold a significant share of NPLs – become successful in extracting value from their portfolios of bad loans. Public debt is expected to continue declining in 2020-2021, underpinned by strong projected budgetary surpluses. Cyprus’ debt-to-GDP ratio is forecast to decline by approximately 6 percentage points per year in 2020 and 2021, mainly on the back of high primary surpluses (of above 4% of GDP). As in 2019, the government is engaged in active debt management operations, and plans to repay the IMF loan in the first part of 2020. Despite all this, the downside risks to fiscal sustainability remain significant (see Section 4.1.1). Cyprus’ net international investment position narrowed somewhat, but remains a key vulnerability, as the current account deficit is widening. The net international position improved from ‑121% of GDP at the end of 2018 to ‑115% in the third quarter of 2019. A decline in foreign government debt by about 12.8 percentage points (year-on-year), partly offset by an increase in equity liabilities and long-term debt of other sectors, contributed to the adjustment and has also helped lower the ‘defaultable’ part of the international investment position by around 15 percentage points, from 175% of GDP to -160% of GDP (see Section 4.2.4). Further adjustment is expected to be limited, as it is forecast that the current account will remain in a substantial deficit of around 10% of GDP in 2020 and 2021. The structure of foreign liabilities in the recent years shows a shift from loans and other investments to foreign direct investment. The foreign direct investment in Cyprus, however, mostly involves the financial transactions of holding companies, property sales and ship registrations, as opposed to green field investments and those that have greater potential to enhance productivity. Some policies are in place to improve the business environment and competitiveness, but implementation needs to be stepped up. Most of the progress made concerns e-governance and strengthening entrepreneurship, by also addressing issues related to the internationalisation of small and medium-sized enterprises. A law to facilitate major investments through simplified procedures is expected to be adopted. Some institutional measures were also undertaken to prioritise flagship sectors for Cyprus such as tourism and shipping, with the establishment of competent deputy ministries. Furthermore, regarding digitalisation, a new deputy ministry is expected to be established, which will be responsible for the implementation of a digital transformation strategy and R&D policy. The planned reform of the justice system is crucial for a conducive business environment. In addition, a long-term growth strategy to overhaul Cyprus's growth model is under preparation. However, tangible results of the above measures are only expected in the medium term. Other reforms that would help to improve the efficiency of the public administration and the local governments are pending. Labour productivity remains low. Depressed investment activity during the crisis and the current concentration on residential buildings are not conducive to productivity growth. Weak total factor productivity over a prolonged period of time has also driven labour productivity down. Strong investment in productivity-enhancing areas and continued upskilling and reskilling of workers in particular, in digital skills are essential in raising productivity in the long-term (see Sections 4.3.1 and 4.4.1). Unemployment is rapidly falling. The unemployment rate fell from 8.4% in 2018 to 7.5% in 2019. Unemployment among young people also declined to 17.5% in 2019. While unemployment is still above the pre-crisis period, there are positive signs that unemployment is set to continue falling in the near term (see Sections 1 and 4.3.1). Despite some efforts, more action is needed to improve the efficiency of the public employment services and to promote active labour market policies (see Section 4.3.1). Overall assessment Cyprus continues to experience significant stock imbalances such as a considerable number of non-performing loans, high private and public debt levels and a large stock of foreign liabilities. Despite significant consolidation, the asset quality of the banking sector remains a concern given the large proportion of non-performing loans in total loans. Private debt is still excessive despite its ongoing reduction, with both households and non-financial corporations experiencing a debt overhang. The public debt stock also remains elevated, at above 90% of GDP. Furthermore, Cyprus continues to have a large negative net international investment position, linked in turn with a large current account deficit, which make the country vulnerable to economic shocks, changes in investors’ sentiment and the deterioration of the global environment. The constellation of risks changed in 2019, with some imbalances unwinding while others deteriorated. Private and public debt are decreasing, but from still high levels. Government debt is coming down after the increase in 2018, which reflected government support to the banking sector. The non-performing loans decreased slowly throughout 2019, with more significant progress expected in 2020 assuming that plans for large asset disposals materialise. Nevertheless, despite the off-loading from the banking sector, vulnerabilities associated with NPLs persist, as the bad loans still remain in the economy. Other sources of vulnerabilities stem from the widening of the current account deficit, which does not support the correction of the external debt stock imbalances. The labour market improved significantly, with the unemployment rate declining to a nine-year low. Potential growth is gradually increasing. Steadfast implementation of key policy measures is essential for correcting the excessive imbalances, improving economic resilience and supporting sustainable growth. Some progress has been made on implementing the measures that address macroeconomic imbalances, particularly the high stock of non-performing loans. On this front, the government continues to follow the three-pillar strategy introduced in 2018. However, reform commitments are still pending in several areas. The effective implementation of the judicial reform remains the main priority for the enforcement of claims and for the better functioning of the economy. Setting up a reliable and transparent system to issue and transfer title deeds is important to facilitate the resolution of the non-performing loans and to improve the business environment. Other key structural priorities include the public administration and local government reforms and privatisations. Instead of planned legislative measures, some administrative measures, were taken to address the long-standing pending reform of the governance of the State-owned enterprises. The efficacy of these measures is yet to be assessed. A continued commitment to sound public finances and the safeguarding of fiscal surpluses are essential for ensuring public debt reduction. Table 3.1:Macroeconomic imbalance procedure assessment matrix – Cyprus (Continued on the next page) Table (continued) Source: European Commission 4. Reform priorities 4.1.Public finances and taxation 4.1.1.Debt sustainability analysis and fiscal risks The general government gross debt-to-GDP ratio is projected to decline steadily from 2019 onwards. The government’s support for the Cyprus Cooperative Bank sale increased public debt by about 8% of GDP in 2018, and was financed by several government bonds issued in April and July 2018. The debt reduction trend that started in 2015, when the debt-to-GDP ratio reached 109.2% of GDP, is expected to resume in 2019. From 100.6% of GDP in 2018, the debt-to-GDP ratio is expected to decline to 94% of GDP in 2019, to 88% in 2020 and to 82% in 2021 (European Commission, 2020a). The projected steady decline of the debt-to-GDP ratio is driven by sizeable, but slowly declining headline surpluses, a favourable interest rate and economic growth differential (snow-ball effect) supported by robust real growth and active debt management. Risks to the sustainability of the government’s finances are considered low in the short term but international imbalances expose the country to potential short-term challenges. After one-off operations negatively affected the government’s finances in 2018, the value of the S0 indicator, which is the Commission’s early-detection indicator of fiscal stress, returned to ‘low risk’. This improvement reflects the strong budgetary performance in 2019. However, the S0 indicator is only slightly below the critical threshold, whereas the financial competitiveness sub-index still points to considerable vulnerabilities to international shocks. In particular, it emphasises weaknesses stemming from the widening of the current account deficit in the context of the large negative net international investment position, as well as high private debt, a significant proportion of which is short term (see Section 2 for a summary of the MIP assessment). Despite the large debt-to-GDP ratio, Cyprus is considered to face low fiscal sustainability risks in the medium and long term. The debt sustainability analysis (DSA) indicates that medium-term risk is low under the baseline scenario (see Annex B), which is based on normal economic conditions and assumes a constant structural primary balance based on the last Commission forecast year (2021). The debt-to-GDP ratio is projected to decline below the critical 60% threshold by 2027, and to stand at 48% of GDP by 2030. This corresponds to a reduction of 3.7 percentage points on average per year from 2021 onwards. This substantial decline in government debt would be driven mostly by the continued strong fiscal performance that is assumed under the no fiscal policy change scenario (with the structural primary balance stable at 2.2% of GDP), and would be further supported by favourable snow-ball effects (i.e. the interest rate – growth rate differential) and decreasing costs associated with ageing. The sustainability gap indicator S1 also points to low risk in the medium term. Over the longer run, both the debt sustainability analysis and the S2 indicator point to low risk, as pressures on the government’s finances related to ageing, in particular pensions, are more than compensated by the strong initial budgetary position. Graph 4.1.1:Government debt projection (% GDP) Source: European Commission

Risks relating to the debt structure are low and financing conditions continue to improve. The weighted average maturity of government debt is expected to increase again in 2020 after the issuance in January 2020 of an €1 billion 10-year benchmark and €750 million 20-year benchmark. This recent issuance reflects ongoing efforts to smooth the maturity profile of government debt and to take advantage of favourable financing conditions, following the issuances of international benchmarks bonds (10-year, 15-year and 30-year bonds) since September 2018. In September 2019, a large proportion of government debt was held by non-resident creditors (78%), reflecting the important share of official borrowing from the European Stability Mechanism (31%) and recent additional issuances of foreign bonds, which accounted for 38% of total government debt (Ministry of Finance of Cyprus, 2019b). The yields on Cyprus’ government debt decreased throughout 2019, partly driven by improved sovereign rating of Cyprus since 2018 and by international trends of declining sovereign yields in 2019. ( ) Interest payments are expected to decrease further on account of favourable market conditions and debt reduction. Given the high headline budgetary surpluses, financing risks are thus relatively low in the short and medium term. The early repayment of the Russian loan in September 2019 and the expected early repayment of the remainder of the IMF loan in early 2020 would reduce the country’s financing needs and the annual cost of debt in the coming years. Contingent risks remain a major source of concern, as the ratio of non-performing loans in the economy is still high. The government’s financial support for the orderly winding down of the publicly-owned Cyprus Cooperative Bank (CCB) significantly reduced the level of non-performing loans in the banking sector, as bad assets were transferred to an Asset Management Company (KEDIPES) and consolidated in the general government sector. These operations led to a change in the nature of the contingent liabilities to which the government is exposed. Some implicit contingent liabilities from the large portfolio of non-performing loans from the CCB materialised into government debt in 2018 whereas the asset protection schemes offered to Hellenic Bank in the context of the CCB sale increased the government exposure to explicit contingent liabilities. As a result the explicit public guarantees increased to about 22.6% of GDP in 2018 (Ministry of Finance of Cyprus, 2019c), the bulk of which concern financial sector measures (13.4%). The remainder of explicit public guarantees relate to state-owned enterprises, private corporations, local authorities, and exposure to retail loans. Explicit contingent liabilities linked to the financial sector are expected to have decreased to 11.8% of GDP in 2019 and to 10.5% of GDP in 2020, bringing down total public guarantees to an expected 19.4% of GDP by 2020 (Ministry of Finance of Cyprus 2018. 4.1.2.Fiscal framework and policy challenges Policy challenges The rise in public expenditure growth underlines the need for it to be strictly managed. While public expenditure in Cyprus remains below the EU average, current expenditure growth has risen since 2017. The high pace of public expenditure was offset by buoyant tax revenue, largely caused by the strong macroeconomic and job market conditions. At the same time, the favourable economic and fiscal outlook have increased pressure for a further increase in public expenditure. Future expenditure growth is expected to outpace revenue growth even though the level of revenue would still exceed that of expenditure. Expenditure developments should, thus, be carefully monitored to maintain the favourable fiscal position and debt reduction. This is particularly crucial amid concerns about the sustainability of the recent strong increases in tax revenue (further discussed in Section 4.1.3) and given the deterioration of the international environment which could affect economic growth. Moreover, there is a need to create some fiscal space, possibly by re-prioritising existing expenditure, to support the transition to a greener economy, especially as Cyprus faces several environmental challenges (see section 4.5). The public wage bill continues to grow and the forthcoming court decisions could entail large additional costs. Currently pending court decisions could potentially lead to the reversal of civil service pay cuts implemented during the crisis, thus representing a substantial short-term risk to the government’s finances. The final decision is expected early 2020 and could lead to substantial fiscal costs in addition to already legislated stepwise reversals of wage cuts. Setting up a permanent legal mechanism could allow to safeguard against the growth of the public wage bill. Such a permanent mechanism would secure long-term wage moderation in the public sector, and thereby, would contribute to the sustainability of public finance. The mechanism that was agreed upon in 2016 in order to cap the growth of the public wage bill at nominal GDP growth through collective agreements still applies, but has proven insufficient to stem the growth of the public wage bill. In 2019, wage increments, the resumption of new recruitment, and a revised cost of living allowance indexation system, and most importantly the gradual reversal of wage cuts since the crisis have significantly increased the public sector wage bill. All in all, the public sector wage bill is expected to amount to 12.4% of GDP in 2019 compared to 11.7% in 2018. The impact of the health reform on public finances requires close financial monitoring. The first phase of the reform implementation has thus far been relatively smooth, with encouraging registration rates by citizens and growing enrolment of health providers (also see Section 4.3.4). However, a number of implementation challenges have arisen and need to be addressed promptly to ensure the effectiveness of the system. In particular, the timely charging of public doctors posed challenges and the execution of the budget of public hospitals has been delayed. At the same time, a number of specialists are leaving public hospitals and opting to contracting with the health insurer for outpatient services. This could affect public hospitals' ability to become competitive and therefore financially autonomous. The details of the participation of the private hospitals in the National Health Insurance System (NHIS) are still under negotiation. In addition, there are potential risks to the government’s finances, as the law establishing the NHIS commits the government to funding potential financial losses incurred during the transition towards the autonomous financial management of public hospitals (expected over the first five years of the reform implementation, namely 2019-2024). Revenue administration reforms have progressed slowly. The Council of Ministers approved a legislative amendment in October 2019 criminalising the non-payment of income taxes. However, progress on implementing the integrated tax administration system remains rather slow. Seven chapters of the Tax Procedure Code are awaiting legal vetting, whereas chapters on administrative penalties, criminal provisions and tax collection are still to be agreed. Furthermore, it is expected to take several years for the new tax IT system to become operational. A tender was launched for the implementation of the new tax IT system, which could improve income tax collection. Finally, the creation of a tax portal that will enhance communication between the tax authorities and taxpayers is still underway. 4.1.3.Taxation* While the tax structure in Cyprus seems favourable to growth, the tax base remains narrow, depending heavily on consumption and corporate income taxes. Tax revenue in 2018 amounted to 33.8% of GDP, which remains lower than the EU average of 39.2%. Consumption taxes are the major contributor to tax revenues in Cyprus, mainly due to the substantial revenues from value added tax (VAT), which accounts for 9.9% of GDP. Also corporate income taxes represent a significant source of revenue. They amounted to 5.5% of GDP in 2018, largely exceeding the EU average of 2.7% of GDP, although the effective average corporate income tax rate is lower than the EU one (13% vs 19.8%). Revenue from taxes on labour amounted to 11.9% of GDP in 2018, well below the EU average of 19.6%. The tax system’s potential for growth and its general tax base narrowed in 2017, when the recurrent tax on immovable property was abolished. In addition, households’ capital income is virtually untaxed. Strong tax revenue growth in recent years might have been caused by temporary factors. Tax revenue started to recover in 2016 and increased by 20% in 2016-2018, amounting to an increase of more than 4% as a proportion of nominal GDP. The strong revenue growth has partially reflected the economic upswing and strengthening job market conditions. While the cycle remains favourable, there are risks that the strong growth of revenue may not continue in the future because it is mainly due to two specific potentially volatile revenue items. About 58% of the increase in tax revenue observed in 2016-2018 is due to increasing value added tax revenue, which is concentrated in a few sectors (e.g. construction, information and communication). Corporate income tax revenue growth accounted for another 17% of the total increase in tax collection in 2016-2018. However, large companies that benefit from Cyprus’ tax jurisdiction might decide to relocate this corporate income tax revenue, for example in the case of changes in the international corporate tax framework. Despite increasing social contributions, the tax burden on labour will remain comparatively low compared to the EU average. The tax burden on labour is among the lowest in the EU, which is reflected in a tax wedge ( ) of 18.7% compared to 42.9% in the EU in 2018. The tax wedge is however set to increase substantially in 2019 and 2020 due to the pre-legislated increases in the social security contribution rate in 2019 and the introduction of compulsory health contributions to finance the National Health Insurance System in 2019 and 2020. Nevertheless, even after these changes, tax revenue from labour and the tax wedge are expected to remain well below the EU average. While revenues from environmentally-related taxes are above the EU average, there is scope to adjust the tax system in order to better support environment and climate policy objectives. In 2018, environmental taxes accounted for 2.8% of GDP and for 8.2% of total tax revenues, whereas the EU average amounted, respectively, to 2.4% of GDP and to 6.2% of total tax revenues. Although energy taxes are the major contributor to environmental tax revenues, excise duties on fuels do not reflect the carbon emissions and therefore do not foster the most energy-efficient technologies. In particular, circulation and registration taxes are not differentiated according to CO₂ emissions and vehicle usage. Excise duties on fossil fuels used for heating (gas oil, natural gas, etc.) are low. Despite considerable progress made on reducing the ‘diesel differential’ (difference in the excises on diesel versus petrol) since 2005, excises duties on those transport fuels remain low as compared to other Member States. There are several examples of sound fiscal measures on environment, such as the domestic and irrigation water pricing policy, supported by environmental non-governmental organisations and academia. However, Cyprus remains one of the few Member States that does not appear to have a landfill tax nor an incineration tax for waste management (European Environment Agency, 2016). Cyprus intends to introduce a Carbon Tax and a Digital Tax. Consultations are being carried out to introduce a Digital Advertising Tax of 3%. The Carbon Tax is intended to be fiscally neutral and is expected to be introduced gradually from 2021. In order to ensure that the transition to a green, climate-neutral economy leaves no one behind, the effects of environmental taxation on the distribution of wealth and income and corresponding compensatory measures for the most vulnerable households should be taken into account (see European Commission, 2019b). Consultations are being carried out to introduce a Digital Advertising Tax of 3%. Graph 4.1.2:Revenue from environmentally-related taxes Source: Eurostat The economic evidence ( ) suggests that Cyprus’ tax rules are used by companies and individuals that engage in aggressive tax planning. Eurostat data show that, on average, 90% of total dividend payments from Cyprus were sent to non-EU countries over the period 2013-2017. Cyprus does not provide information on the country destination of the dividends. The rules identified as being of particular concern include: the absence of withholding taxes ( ), the design of the Cypriot corporate tax residence rules, and the residence and citizenship by investment schemes. Owing to the absence of withholding taxes, the outbound payment of dividends, interest, and royalties from Cyprus based companies to non-EU jurisdictions could lead to little or no taxation if these payments are not taxed, or taxed at a low level, in the recipient jurisdiction. The Cypriot corporate tax residence rules are based on the management and control test, so that a company may be incorporated in Cyprus without being a Cypriot tax-resident. This has the potential to create a mismatch that could also be exploited for tax planning purposes. In 2015, Cyprus introduced a notional interest deduction regime in order to deal with the debt-equity bias. However, in 2019 the Code of Conduct on Business Taxation Group decided this regime needs to be amended to bring it into line with the agreed EU rules on tax competition. Finally, the ‘Citizenship’ and ‘Residence by investment’ schemes operated by Cyprus (Citizenship by Investment: Scheme for Naturalisation of Investors in Cyprus by Exception and Residence by Investment Scheme) give access to a low personal tax rate on income from foreign financial assets and do not require an individual to spend a significant amount of time in Cyprus. Although individuals are subject to tax on a worldwide basis, non-domiciled taxpayers are exempt from tax on dividends and interest. These measures can create the potential for misuse when used as tools to hide assets held abroad from reporting. According to the Organisation for Economic Co-operation and Development, there is potentially a high risk that they could be misused to circumvent the automatic exchange of financial account information by helping to conceal the real jurisdictions of residence. Cyprus is acting to curb aggressive tax planning through the implementation of European and internationally agreed initiatives as well as unilateral measures. Cyprus is in the process of transposing into national law the first EU Directive on Anti-Tax Avoidance. Cyprus plans to introduce a withholding tax on dividend, interest, and royalty payments to countries in Annex I of the EU List of Non-cooperative jurisdictions on tax matters. The design and timeline of this measure will need to be examined. Cyprus intends to introduce a further corporate tax residency test based on incorporation. This test would be in addition to the existing “management and control” test and would bring Cyprus into line with other jurisdictions and could reduce the potential for tax planning. Required changes to the notional interest deduction regime are expected to be adopted by Parliament in the first quarter of 2020 in order to bring it into line with the Code of Conduct on Business Taxation of the Council. Cyprus has ratified the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting and has chosen to apply it to the vast majority of its treaty partners. However, it has introduced numerous reservations, not forming part of the minimum standard which significantly limits the effectiveness of implementation of the multilateral convention in Cyprus. Cyprus is in consultations with the OECD in order to deal with concerns relating to the ‘Citizenship’ and ‘Residence by investment’ schemes. The Cyprus tax authority is reviewing the wider transfer pricing legal framework with a view to update the law taking into account the OECD BEPS project transfer pricing recommendations in the Organisation for Economic Co-operation and Development’s project on base erosion and profit shifting. The effectiveness of these planned and new measures in limiting the scope for aggressive tax planning and their impact on the corporate income tax revenue in the medium term will need to be assessed. 4.2. Financial sector

4.2.1.Banking sector developments* Considerable progress has been made with deleveraging and de-risking banks’ balance sheets. Following the carve-out of the distressed assets of the Cyprus Cooperative Bank (CCB) during its liquidation, and major sales of non-performing loans (NPLs) by commercial banks, the banking sector shrank to below 300% of GDP in mid-2019, compared to 338% at the end of 2017, and more than 700% before the financial crisis of 2013. Performing CCB assets were acquired by Hellenic Bank, which benefits from an asset protection scheme. ( ) There has been an overall reduction in the importance of subsidiaries of Greek banks in Cyprus, which were once a channel of contagion, although in some cases they still have a high level of non-performing loans. Correspondent banking relations that were previously under pressure have stabilised. ( ) The largest domestic bank, the Bank of Cyprus, continues its efforts to improve asset quality. In March 2019, the bank disposed of a small portfolio of terminated loans (with a gross value of €245 million) to APS Loan Management (a foreign investor in NPLs). The Bank of Cyprus’s direct real estate exposure remains large, primarily on account of debt-to-asset swaps and the repossessions of foreclosed assets. In the short term, the sale of the Helix II portfolio (up to €2.8 billion of NPLs) in the first half of 2020, with ongoing additional sales of unsecured loans and collateralised loans granted to foreigners, together with additional reductions in NPLs due to the ESTIA scheme, should help improve asset quality further. At the same time, cost reduction is ongoing, as the latest voluntary redundancy scheme reduced staff numbers by 470, equivalent to more than 10% of total staff. Following the acquisition of the CCB’s performing assets, the business model and risk profile of the Hellenic Bank have changed significantly. The incorporation of CCB’s assets made the Hellenic Bank the second largest bank in Cyprus. The operational integration of the acquired parts of CCB (including the migration to a common IT infrastructure) was finalised in September 2019. The gap between the salary structure of former CCB employees and Hellenic Bank employees is an important challenge. Pressures on profitability remain significant. Profits in 2019 have benefited significantly from the conversion of deferred tax assets to deferred tax credits (DTCs) for Bank of Cyprus. ( ) However, the high stock of NPLs still weighs heavily on bank profitability and the overall stability of the banking sector, even after the disposals of bad assets. Enhancing efficiency and diversifying investment could support bank profitability. All major banks are engaging in measures to reduce their physical footprint. At 62% in June 2019, the system-wide cost-to-income ratio remains above the EU average and is, in fact, artificially lowered by including the accrued interest income on impaired assets and excluding the offsetting provisioning charges. Furthermore, staff costs can only be reduced slowly and in a delayed manner. Although the larger banks have already invested in enhanced internet banking capacities, there is still significant potential for improvement, especially in the case of the online marketing of products. In addition, the declining, but still high level of private debt, severely constrains the pool of bankable investment projects. Better investment opportunities for banks, firms and retail savers may be supported by improved NPL resolution actions and broader measures to improve the investment climate. Bank profitability prospects are adversely affected by excess liquidity. With a regulatory liquidity buffer of €21.7 billion (around one-third of the total assets), Cypriot banks continue to maintain significant excess liquidity. Several banks attempted to reduce the size of customer deposits by lowering interest rates, which are at historical lows of 0.3%-0.5%. These efforts have not been successful to date, partly as there are no alternative low-risk investment opportunities available to retail savers. As a further step, some banks already charge negative rates on large corporate deposits, but these have not yet been extended to retail depositors. Capital levels have increased slightly. Recent NPL reductions, the injection of capital in Hellenic Bank and the one-off conversion of deferred tax assets into deferred tax credits have strengthened the aggregate capital position to 16.3%, up from 14.8% at end-2018