EUROPEAN COMMISSION Brussels, 27.2.2019 SWD(2019) 1012 final COMMISSION STAFF WORKING DOCUMENT Country Report Cyprus 2019











Including an In-Depth Review on the prevention and correction of macroeconomic imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2019 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(2019) 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 Annex A: Overview Table Annex B: Commission Debt Sustainability Analysis and fiscal risks Annex C: Standard Tables Annex D: Investment Guidance on Cohesion Policy Funding 2021-2027 for Cyprus References LIST OF Tables Table 1.1:Key economic and financial indicators – Cyprus Table 2.1:Assessment of the 2018 country-specific recommendations implementation

Table 3.1:Macroeconomic imbalance procedure assessment matrix - Cyprus Table 4.2.1:Financial soundness indicators for domestic and foreign banks 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 LIST OF Graphs Graph 1.1: Real GDP growth in Cyprus and the EU Graph 1.2: Residences price developments by region Graph 1.3: Labour underutilisation (% of the active population, 15-74) Graph 1.4: Real effective exchange rates Graph 1.5: Current account developments by special purpose entities status Graph 1.6: Developments of the net international investment position Graph 1.7: General government budget balance and gross debt Graph 2.1: Cyprus - Level of implementation today of 2011-2018 country-specific recommendations Graph 4.1.1: Government debt projections Graph 4.1.2: Value-added tax revenue growth and its main sector contributors

Graph 4.1.3: Main receivers from and contributors to government redistribution by decile (average 2005-2016) Graph 4.2.1: Private sector indebtedness Graph 4.2.2: Non-financial corporations debt decomposition Graph 4.2.3: Bank loans to non-financial corporations by sector Graph 4.2.4: Changes in private debt-to-GDP ratio Graph 4.3.1: Key labour market developments Graph 4.3.2: Ratio of the monthly minimum wage over the average wage (2014) Graph 4.3.3: Collective bargaining coverage by sector and working hours (2014) Graph 4.3.4: Active labour market policies participants (lhs) and expenditure (rhs) (2016) Graph 4.3.5: The proportion of people at risk of poverty and social exclusion Graph 4.3.6: Impact of the guaranteed minimum income scheme on the at-risk-of-poverty rate and the relative median at-risk-of-poverty gap in 2018 (% change) Graph 4.4.1: Labour productivity Graph 4.4.2: Labour productivity by sector - period averages Graph 4.4.3: Investment by category LIST OF Boxes Box 2.1: Technical support by the Structural Reform Support Service in Cyprus Box 2.2: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Cyprus Box 4.2.1: The Cyprus Cooperative Bank exit from the banking sector 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 Executive summary Cyprus’ robust economic recovery has created favourable conditions to correct excessive macroeconomic imbalances and carry out key structural reforms to sustain growth in the long term. Cyprus continues to have significant macroeconomic imbalances in several areas, namely high stocks of private, public and external debt and non-performing loans. The economy is growing rapidly, creating the right conditions to repay the debt. The economic upswing is also an opportunity to reform key areas, such as the business environment, the public sector, the justice system, education and the labour market to attract investments that increase productivity, diversify the economy and help to sustain robust and inclusive growth in the long term.( ) Economic growth has continued to be solid and the labour market has markedly improved. However, the long-term sustainability of Cyprus’ growth model is a key challenge. Strong growth in 2018, projected at 3.8 %, was supported by both domestic and external demand. The economy is expected to continue growing by around 3.3 % in 2019. Employment is rising and unemployment rate fell to 8.4 % in the third quarter of 2018, nearly half of its peak during the crisis. Inflation remains low. Despite this positive picture, growth remains concentrated in only a few sectors of the economy. This, together with the previously mentioned imbalances, makes the Cypriot economy vulnerable, particularly to the external environment. Cyprus’s public finances improved significantly in recent years. The general government headline balance turned from a deficit of 5.1% of GDP in 2013 to a surplus of 1.8% in 2017, supported by favourable macroeconomic conditions and fiscal consolidation. The headline balance is expected to remain in surplus in the medium term. However, there are risks to the fiscal outlook. Investment in environment, energy, digitalisation, workers’ skills and innovation is crucial for increasing productivity and making Cyprus’ growth model less vulnerable to the external environment. Investment has recently recovered, but it remains concentrated in less productive sectors. Cyprus needs to significantly improve its waste management system and the circular economy. It can also make much better use of its renewable energy sources— particularly solar— and address current energy inefficiencies. Investing in the digital economy and in improving workers’ digital skills is essential for bolstering productivity. To ensure that growth benefits all of society, more investment is needed in vocational education and training, adult learning, childcare and health. In addition, more investment in research and development (R&D) would increase the currently low innovative capacity of the economy. Annex D identifies key priorities for support by the European Regional Development Fund, the European Social Fund Plus and the Cohesion Fund for 2021-2027 in Cyprus, building on the analysis of investment needs and challenges outlined in this report. Overall, Cyprus has made some progress in addressing the 2018 country-specific recommendations. It has made substantial progress: ·on non-performing loans, as work on implementing a comprehensive strategy, including adopting strengthened legal frameworks on insolvency, foreclosure and the sale of loans, has advanced. It has made some progress: ·on access to finance for small and medium-sized enterprises, as financial instruments supported by EU funds are expected to be launched soon; and ·on health, as work for the first phase of the National Health System implementation have advanced, e.g. the reform of the outpatient services has begun. Cyprus has made limited progress: ·in reforming the public sector, as key legislation for the public administration, the local government and the governance of State-owned enterprises has been delayed; ·on privatisation, as only a few privatisation projects are under way and progressing slowly; ·in the justice system, as the specialisation of courts is only at an initial stage and, although some efforts are being made to revise the civil procedures and introduce e-justice, progress is slow; ·in setting up a reliable system to issue and transfer immovable property (e.g. buildings and land) rights, as there is still a large backlog in cases of buyers who paid the full amount for a property and have yet to receive their legal ownership documents. The reform of the local government, which could simplify the procedures, has not yet been adopted; ·in strengthening the effectiveness of the public employment services and increasing outreach to young people who are not in jobs, education or training, as the effectiveness of the public employment services is still weak, despite the increase in staff, the evaluation of the active labour market policies is still pending and implementation of the action plan to get young people into employment, education or training is slow; and

·on education, as a concrete proposal to improve the evaluation system of teachers has not yet been announced. Cyprus has made no progress: ·in integrating and strengthening the supervision of insurance companies and pension funds, as relevant laws are still being prepared; and ·in reducing burdensome procedures for strategic investors, as the relevant legislation is still to be adopted. Cyprus has made some progress in reaching its national targets under the Europe 2020 strategy. It met its target for research and development (R&D) spending. However, the energy consumption has increased alongside the economic recovery and the proportion of renewable energy in the total energy mix has only moderately improved. In the absence of additional measures, this affects Cyprus’ capacity to reach its greenhouse gas emissions and renewable energy targets and improve its energy efficiency. Cyprus exceeded its targets on higher education attainment and on reducing early school leaving. It also made some progress on increasing the employment rate. However, although there was some improvement in reducing poverty and social exclusion, the target seems to be beyond reach. Cyprus faces several challenges with regard to a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. The proportion of young people who are not in employment, education or training remains high. Within this group, the proportion that has completed post-secondary education (almost one in three) is higher than the rest of the EU. Outreach measures and prompt tailor-made assistance for young people are limited, as confirmed by the low number of young people in relevant employment and training schemes. The incidence of early school leaving is rising. The level of the gross domestic household income is still low compared to that of 2008. The main findings of the in-depth review contained in this report and the related policy challenges are as follows: ·Cyprus has taken major steps to reduce non-performing loans, but using all the effective tools available would ensure further progress. Non-performing loans decreased markedly in 2018 mainly due to the sale and wind down of the Cyprus Cooperative Bank, which moved a significant portfolio of bad assets from the banking system to a separate public entity. In addition, the authorities improved the insolvency and foreclosure frameworks and the sale of loans law, and adopted a securitisation of loans law. Implementing the laws decisively is therefore the next step. The ESTIA scheme, designed to address non-performing loans, collateralised by primary residences, is to be implemented in 2019. The scheme has raised concerns about moral hazard and fairness. The prompt use of all available tools together with an efficient judicial system might mitigate some of these risks, and ultimately strengthen the payment culture. The scheme’s medium and long-term effects remain to be seen. ·The banking sector returned to profitability in the first half of 2018, but the high stock of non-performing loans and low interest margins continue to weigh on banks’ performance. Banks hold large stocks of non-performing loans, even after significant disposals. Net interest margins continue to decline, while the operating cost-to-income ratio almost doubled in the first half of 2018. ·Private sector debt remains very high, though it is decreasing. Private debt-to-GDP is going down, but it remains among the highest in the EU. The decrease in 2018 was due to the strong GDP expansion, inflation, cash repayments, write-offs of non-performing loans and debt-to-assets swaps. The improved legal frameworks for insolvency and foreclosure and the ESTIA scheme should help to reduce the private sector debt. ·Public debt is set to increase in 2018 due to the public support measures for the sale of the Cyprus Cooperative Bank, but to steadily decline after that. Due to the government’s support in the sale and orderly winding down of the Cyprus Cooperative Bank, public debt is estimated to reach 105 % of GDP in 2018, partly reversing the decrease of 2017. Public debt is projected to steadily decline in 2019-2020, due to the expected continuation of strong performance in public finances. However, according to the Commission’s latest fiscal sustainability analysis, risks remain. In particular, public debt is among the highest in the EU, making Cyprus vulnerable to potential financial or economic shocks. These risks are somewhat mitigated by the fairly contained medium-term financing needs, while the country has recently regained investment grade rating for Cyprus’ debt. ·The net international investment position remains very negative. It decreased in 2018, but remains largely negative at 105.5 % of GDP in the third quarter of 2018. Excluding the external debt of special purpose entities, the negative net international investment position is much smaller. In the third quarter it stood at -30.4 % of GDP, compared to the benchmark of -35 % of GDP. This nevertheless highlights Cyprus’ dependency on foreign financing sources and its vulnerability to shifts in international financial market sentiment. The current account deficit is large and warrants monitoring. ·Potential growth is expected to increase somewhat over the medium term supported by recovering investment. The projected expansion of the labour force and increased investment are expected to raise growth potential. However, focus on investment in construction and ship registration, difficulty to access finance domestically and the shortcomings in the business environment could hamper long-term growth and productivity. ·Persisting inefficiencies in the justice system weaken the enforcement of claims. Outdated civil procedure rules, lengthy court proceedings and weak enforcement of claims impede the business environment and deter banks from using the available legal tools to reduce non-performing loans and ultimately strengthen the payment culture in the country. A comprehensive reform of the judicial system is under way. It focuses on the most urgent issues, namely the specialisation and digitalisation of courts, the clearance of the large backlog and the lifelong training of judges. ·The housing market continues its recovery supported by foreign demand. Residential property prices increased for the third year in a row, albeit moderately, and housing sales continued to increase significantly, supported by the residence and citizenship by investment schemes. The recovery in the housing market could reduce private debt, but the existing inefficiencies in the system of issuing and transferring title deeds complicates foreclosure procedures and deters the liquidation of collaterals. A number of other key economic issues analysed in this report point to particular challenges to the Cypriot economy, namely: ·Employment is rising and unemployment is falling, but much more can be done to support labour and social recovery. There is significant scope for bringing public employment services in line with best EU practices. They could for example: (i) strengthen their outreach; (ii) improve their administrative efficiency and personalised guidance and (iii) improve participation in active labour market policies, focusing on vulnerable groups in particular. ·Reforms in the education and health sectors are under way, but challenges remain. In education, the relatively high public spending is not reflected in observed outcomes. Progress on crucial education reforms such as improving teachers’ appointments and evaluation is uneven. Skills mismatches and poor educational achievements continue to restrict potential growth and relatively few people participate in adult learning and vocational education and training. Putting in place the universal national health insurance system is an opportunity to increase efficiency by reforming public hospitals, developing e-health and focusing more on health promotion. ·Weaknesses remain in enforcing environmental and climate regulations. 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. Cyprus is also lagging behind on renewable energy generation and it is still heavily dependent on fossil fuels. ·Cyprus’ tax rules appear to be used in aggressive tax planning structures, but some steps are being taken to limit such practices. Some elements that may facilitate tax planning include the absence of withholding taxes on interests, royalties and dividends, the corporate tax residence rules, or the residence and citizenship by investment schemes. However, Cyprus has taken steps to amend aspects of its tax system to curb aggressive tax planning, in particular by implementing European and internationally agreed initiatives.

·Inefficiencies in the public sector are harming the business environment. Although planned reforms to modernise and improve the efficiency of the public administration have not yet started, efforts are being made to expand e-government services. The governance framework for State-owned enterprises is still not equipped to improve their performance. This may lead to build-up of public contingent liabilities and hinder investment in key utilities such as telecoms and energy. Cyprus needs to significantly simplify the procedures for obtaining permits for strategic investments. The local government reform that could improve services for local residents has not yet started. Corruption is perceived as a problem by both businesses and citizens and the pace of anti-corruption reforms is slow. The independence of prosecution and the capacity of law enforcement to carry out corruption investigations remain weak. 1. Economic situation and outlook GDP growth Cyprus continues to enjoy strong cyclical growth as it rebounds from the sharp contraction experienced during the crisis. After 2 years of remarkable growth, the Cypriot economy continued to expand solidly in 2018. Real GDP over the first three quarters of the year grew at around 4 % on annual terms, one of the strongest growth rates in the euro area. In 2018, it is expected to have surpassed pre-crisis peak level (see Graph 1.1). Graph 1.1:Real GDP growth in Cyprus and the EU Source: European Commission Growth is increasingly driven by investment and private demand. In 2016-2017, investment was the main contributor to growth, funded by hefty inflows of foreign capital. These flows financed tourism infrastructure, residential construction ( ) and investments by special purpose entities (SPEs) ( ), including registration of ships in Cyprus. In 2018, consumption increasingly became a major driver for growth. Upbeat sentiment and rapidly improving situation in the labour market encouraged private consumption, which is expected to continue to perform strongly. Public consumption has also risen, partly due to the increase in wages and hiring by the government. Net exports weigh negatively on growth. Net exports were a drag on economy in 2017, as rising exports were nevertheless outweighed by imports. In early 2018, exports have markedly risen, temporarily reversing the trend, but this strong performance was heavily influenced by the sizeable ship de-registration (which statistically increased the exports of goods). Apart from this one-off improvement, the net exports are expected to further weaken. The tourism sector, which has been the main driver of rising service sector exports in recent years, now faces headwinds: stronger competition from neighbouring countries (where safety concerns are abating) and the lower purchasing power of tourists visiting Cyprus (predominantly British and Russian) as a result of their currency depreciations. In parallel, imports are projected to rise in line with the increasing domestic demand. Growth is expected to remain strong and above potential in the short to medium term. It is projected to reach 3.8 % in 2018 and then slow to 3.3 % in 2019 and to 2.7 % in 2020. This implies that growth is set to remain above the potential throughout this period, as the latest estimates project Cyprus’ potential growth at around 2 %. Cyprus’ key challenges mostly relate the long-term sustainability of its growth model. The country’s fast growth over recent years appears to have been largely determined by the performance of tourism-linked sectors, the revival of the construction sector and the sectors linked to the setting and servicing of foreign companies under the special purpose entities’ regime. Tourism, amid increasing competition and certain market saturation ( ), is expected to consolidate gains and plateau. The new tourism strategy is in place and will influence the future growth of the sector. The construction sector prospects are very good in the short term, but its heavy reliance on foreign funding increases vulnerabilities. Potential changes in the international corporate tax framework could challenge Cyprus’ role as a business service hub. Inflation Inflation remains very low. Following a 0.7 % rise in the Harmonised Indices of Consumer Prices (HICP) indicator in 2017, inflation stayed equally low in 2018 at 0.8 %, although there was a substantial variation throughout the year, ranging from deflation in the first quarter to nearly 2 % inflation in the last quarter. Oil prices, transmitted with a lag to energy prices, and the unprocessed food prices accounted for this volatility. Core inflation in Cyprus continued to fluctuate around zero, as falling prices in non-energy industrial goods were partly offset by the modest increase in the price of services. Inflation is expected to remain very low in 2019, at 0.7 %, due to the dampening effect of oil prices but increase moderately in 2020 on the back of households’ higher disposable incomes. Housing market The residential real estate market continues to recover. Residential property prices moderately increased for the third year in a row (see Graph 1.2). In 2018, they rose by 1.6 % annually, according to the latest available data of the Central Bank (2018Q2). In terms of valuation, European Commission house-price valuation methods do not point to significant undervaluation (the overall valuation gap is estimated at -4.6 percentage points).( ) Housing sales continued to expand at doubledigit growth rates. The housing market recovery is largely driven by the inflow of foreign funds. An increasing number of acquisitions is made by foreigners: they bought nearly half (48 %) of all property sold in 2018. The mandatory acquisition of personal immovable property under the residence and citizenship by investment schemes has been one of the key drivers of the real estate market recovery, adding to the traditional foreign demand for second homes in a holiday destination. It also contributed to the regional differences in price trends: real estate prices in Limassol, where the foreign, predominantly Russian, community is concentrated, rose much more strongly than elsewhere. Meanwhile, house purchases by Cypriots continue to be restricted by limited bank lending. Therefore, despite the improving economic situation for Cypriot households, locals bought fewer properties than in the previous year. Graph 1.2:Residences price developments by region Source: Central Bank of Cyprus The supply of real estate is accommodating the higher demand. Construction has steadily increased since mid-2016 as evidenced by the number of new properties. Construction is reportedly shifting towards the luxury segment to adapt to the changing demand and to enable construction companies to benefit from funding from pre-sales. This pre-sale funding is still the major source of funding, as bank credit continues to be extremely limited. The real estate supply may also increase if properties acquired to obtain citizenships are put up for sale. ( ) Furthermore, the sale of non-performing loans by Cypriot banks to specialised managers (see Section 4.2.1) may result in the more rapid sale of the underlying collateral, releasing a large stock of real estate to the market. Labour market The labour market conditions continue to improve thanks to robust economic growth. Employment is expected to grow by 3.8 % in 2018, almost among all sectors, following a similar strong increase 3.9 % in 2017. Unemployment rate continued to fall, reaching 8.4 % in 2018Q3, but it is still slightly above the EU average (6.8 %). Youth unemployment also remains higher than the EU average. In addition, the proportion of young people not in education, employment or training is among the highest in the EU. The proportion of underemployed part-time workers remains relatively high, which points to a persisting labour market slack (see Graph 1.3). ( ) On labour market developments see Section 4.3.

Despite of improving labour market conditions, disposable household income remains below the pre-crisis level. The long period of wage restraint, which has supported employment growth and competitiveness gains since 2013, is expected to ease as renegotiated collective agreements in key sectors, including the public sector, provide for a gradual increase in wages and a partial adjustment to the price indexation. However, these increases are expected to be only moderate as labour market slack continues and job creation is mainly concentrated in labour intensive, low-paying sectors such as construction and tourism. In 2018, nominal compensation per employees is expected to have increased by around 1.5 % remaining below the rate consistent with economic fundamentals. ( ) Real wage growth is expected to remain broadly stable and below real GDP growth in the near future limiting the increase in real disposable household income, which in 2017 was at 84.6 % of the pre-crisis level. On the upcoming increases in social contributions see Section 4.1. Graph 1.3:Labour underutilisation (% of the active population, 15-74) Source: Eurostat Social developments Poverty and inequality continues to decrease according to indicators, almost reaching the pre-crisis levels. The percentage of people at risk-of-poverty or social exclusion declined further to 25.2 % in 2017 (though this is somewhat above the EU average), compared to 27.7 % in 2016. It was mainly due to a steep decline in severe material deprivation and in the proportion of individuals living in very low work intensity households. In 2017, the richest 20 % of the population had an income 4.6 times higher than that of the poorest 20 %, which was below the EU average gap. The guaranteed minimum income scheme has contributed to the observed decline in poverty and income inequality (see also Sections 4.1.3 and 4.3.2). However, according to the latest available data (2014), overall wealth inequality in Cyprus is still among the highest in the euro area ( ) and wealth is disproportionately concentrated in the wealthiest 10 % of households (European Commission, 2018a, Sections 1 and 4.1.3). The recent recovery in economic growth has nonetheless been relatively non-inclusive, as the real gross disposable income of households per capita is still well below 2008 levels. Inequality of opportunity also remains relatively high in Cyprus compared to the EU average (see Section 4.3). Competitiveness The real effective exchange rate started to appreciate, reducing cost competitiveness. After strong depreciation during the crisis years (see Graph 1.4), the rate is on an upswing. As the euro appreciated against major currencies in 2017, its adjustment has come to a halt and it increased by 1.6 % in 2018. Cyprus is particularly vulnerable to the exchange fluctuations of the UK pound and the Russian rouble, due to trade and investment links. Turkey, which competes with Cyprus for tourists, experienced sharp lira depreciation in 2018, gaining substantial advantage over Cyprus from a cost perspective. Graph 1.4:Real effective exchange rates Source: European Commission Labour productivity ( ) and unit labour cost have recovered only moderately since the crisis. As from 2014, labour productivity began to moderately increase. However, it has decreased between the last quarter of 2017 and the first half of 2018 (see Section 4.4.1). Unit labour costs started to increase from mid-2017, but the increase was relatively modest and followed a long downward adjustment. In 2019, an increase in social security contributions may increase unit labour costs. External position Cyprus’ current account deficit is large, although a large part of it is associated with the activities of the special purpose entities. The current account deficit widened to 8.4 % of GDP in 2017. Activities of special purpose entities accounted for -5.2 % of GDP ( ) (see Graph 1.5). In the first half of 2018, the headline current account deficit contracted for the special purpose entities’ component (de-registration of ships), while the part not related to the special purpose entities recorded a deficit of slightly more than 3 % of GDP. The combination of robust domestic demand and the government's efforts to attract shipping activity suggests that the current account deficit is set to widen further. The overall current account deficit is larger than the one required to stabilise the net international investment position over 10 years (estimated at -4.5 % of GDP), and larger than the current account ‘norm’ ( ) explained by fundamentals (estimated at -1.6 % of GDP), whilst noting that the current account balance in Cyprus has never been in positive territory. The net international investment position remains very negative but is slowly narrowing. Nearly two thirds of the negative net international investment position is attributable to the presence of special purpose entities (see Graph 1.6). As of 2018Q3, the special purpose entities’ share was -75.1 % of GDP, compared to the total net international investment position of 105.5 % of GDP. This slightly mitigates the risks of the very negative overall net international investment position, as links of the special purpose entities to the real economy are perceived to be limited. Since 2014, sectors not related to special purpose entities led the correction of the net international investment position, which is a positive sign. In the first three quarters of 2018, the negative net international investment position contracted significantly, by 16 percentage points. Graph 1.5:Current account developments by special purpose entities status Source: Central Bank of Cyprus Graph 1.6:Developments of the net international investment position Source: Central Bank of Cyprus Financial sector Although banks have ample liquidity, they face profitability and asset quality challenges. Following losses in 2017, profitability turned positive in the first half of 2018. However, poor quality assets and low interest margins continue to weaken banks’ performance. The non-performing loans stock and ratio declined significantly in 2018 compared to the past, but Cyprus continues to have one of the highest non-performing loans ratio in the euro area. Cyprus Cooperative Bank’s exit from the banking market was the sector’s key development in 2018 (see Section 4.2). New lending from the domestic financial sector to the real economy remains very limited in light of still very high debt stocks. Therefore, the private sector has to rely more on internal resources and external funding. According to data from the Central Bank of Cyprus, the gross volume of new loans to domestic residents reached EUR1.4 billion in the first half of 2018, similar to the amount provided in the first 6 months of 2017. The new loans were mostly channelled towards non-financial corporations, in sectors where debt stocks and non-performing loans are still very high. Household indebtedness continues to be high despite ongoing deleveraging, while net credit flows to the household sector remain negative. Public finances Public finances improved significantly over the last years, supported by a favourable macroeconomic outlook and consolidation of government spending. Since the start of the economic adjustment programme in 2013, Cyprus’ fiscal position has improved markedly (see Graph 1.7). The general government headline balance moved from a deficit of 5.1 % of GDP in 2013 to a surplus of 1.8 % of GDP in 2017. This improvement was the result of both budgetary consolidation implemented during the programme years and favourable macroeconomic conditions. The sizeable improvement in the government headline balance was the main reason behind Cyprus reducing public debt by 2017. The budget balance is expected to remain in surplus in the medium term. The Commission 2018 autumn forecast projects that the general government surplus will increase to 2.5-3.0 % of GDP in 2018-2020. Buoyant tax revenue growth underpinned by strong underlying economic growth and an improved labour market is expected to continue to outpace expenditure growth. This forecast excludes the potential deficit-increasing (one-off) impact on the general government balance in 2018 from the banking support measures related to the Cyprus Cooperative Bank (see Section 4.1.2). The structural balance is expected to maintain a surplus of above 1 % of GDP in 2018-2020 (above the medium-term budgetary objective of 0 % of GDP), although it is expected to decrease from 2019 onwards as the positive output gap widens.

Graph 1.7:General government budget balance and gross debt Source: European Commission There are risks to the fiscal outlook. Fiscal risks are mainly due to: (i) the potential realisation of explicit contingent liabilities regarding the measures related to the sale of the Cyprus Cooperative Bank; (ii) increasing spending pressures; and (iii) the sustainability of the strong tax revenue performance as presented in Section 4.1. Due to the government’s support in the Cyprus Cooperative Bank sale, public debt is projected to increase from 96.1 % of GDP in 2017 to 105 % in 2018, but to steadily decline after that. The increase in 2018 is mainly due to the issuance of a series of government bonds in April and July 2018, to facilitate the sale of the State-owned Cyprus Cooperative Bank (see Section 4.2.1). The net proceeds from the bond issuances, which totalled EUR 3.5 billion (17 % of GDP) after the addition of some cash, were deposited with the Cyprus Cooperative Bank and have been kept in its asset-management company legacy (see Box 4.2.1). The transaction represents a level-shift upwards in Cyprus’ public debt. However, public debt is projected to significantly decrease again to 98.4 % in 2019 and to 91 % in 2020 (the latter is about 13 percentage points above the projected EU average). The decrease reflects the projected continued strong fiscal performance and a favourable contribution of the interest rategrowth rate differential (see Section 4.1.1 and Annex B for an analysis of debt sustainability). Table 1.1:Key economic and financial indicators – Cyprus Source: Eurostat and ECB as of 31-1-2019, where available; European Commission for forecast figures (Winter forecast 2019 for real GDP and HICP, Autumn forecast 2018 otherwise) 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 63 % of all country-specific recommendations addressed to Cyprus have recorded at least ‘some progressʼ. ( ) 37 % of these country-specific recommendations recorded ʻlimitedʼ or ʻno progressʼ (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 country-specific recommendations made in 2011 and 2012. As regards the country-specific recommendations made after the programme’s completion, these mostly cover persisting challenges, which are also reflected in the 2018 country-specific recommendations. Graph 2.1:Cyprus - Level of implementation today of 2011-2018 country-specific recommendations 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 have helped in ensuring transparency and sustainability of the public finances. The pension system was reformed to ensure its 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 financial sector underwent significant reforms, notably through the harmonisation and integration of the supervision of banks and cooperative credit institutions. New insolvency and foreclosure frameworks were adopted, which were further strengthened in 2018. Sector-specific obstacles to the establishment and free provision of services have been mostly 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, long-term unemployed and receivers of guaranteed minimum income and policies to upgrade worker’s skills. Some measures were also undertaken to improve the attractiveness of the vocational education system. The longstanding recommendation regarding the reform of the national healthcare system has made progress in 2017 with the adoption of the necessary legislative framework. However, implementation is still pending. Cyprus has made so far some ( ) progress in addressing the 2018 country-specific recommendations (see Table 2.1). Reforms related to the efficiency of the public administration, the local government and the State-owned enterprises have begun, but very slowly. Although some measures to improve the efficiency of the judicial system were announced or introduced, the implementation of the comprehensive reform needs to be stepped up and in particular measures related to the handling of financial disputes. A reliable and efficient system to issue and transfer immovable property rights is still pending and progress is slow. A comprehensive strategy is being implemented to help accelerate the reduction of non-performing loans, including the strengthening of the insolvency and foreclosure frameworks, but its overall effect will be assessed over time. The action plan for growth is gradually being implementing, focussing on improving the business environment, in line with the euro area recommendation 1, and access to finance for small and medium-sized enterprises. Improving the performance of the State-owned enterprises and implementing the planned privatisation projects has proved challenging to progress. The capacity of the public employment services was strengthened, but with regards to its effectiveness, announced measures are still pending. The outreach efforts for young people not in employment, education or training have recorded only limited progress. The education reform is progressing unevenly and without concrete results on the evaluation of teachers. Finally, some measures were adopted and implemented for the first phase of the healthcare reform and in an effort to prepare the ground for full implementation of the National Health System in 2020, as planned.

Table 2.1:Assessment of the 2018 country-specific recommendations implementation Source: European Commission Box 2.1: Technical support by the Structural Reform Support Service in Cyprus The Commission can provide tailor-made technical support upon a Member State's request via the Structural Reform Support Programme to help Member States implement growth-sustaining reforms to address challenges identified in the European Semester process or other national reforms. The Cypriot authorities have benefitted from support from the Commission in the area of judiciary reform, in particular to review the functioning of the Court system and the Attorney General's Office, and to prepare for the introduction of an electronic system in Courts. The Commission is also supporting the Supreme Court in modernising the rules of civil procedures, designing training programmes and establishing criteria for the selection and promotion of judges, and assessing the feasibility of introducing a digital audio recording system in Courts. Cyprus is also drawing on technical support for its reform of the public administration. This includes the design of a workforce planning system to align the government’s human resources management with the country’s strategic priorities, as well as a functional review of the operations in the Cypriot public administration. Support is also provided to the authorities to improve web presence of the government and to consolidate the information technology infrastructure in the Ministry of Labour. The Cypriot authorities are working with the Commission to improve the regulatory framework for insolvency and restructuring practitioners in the areas of licensing, remuneration, training, monitoring, supervision and discipline. A project was also launched to improve the efficiency and effectiveness of the operations of the Insolvency Service. In the area of access to finance, support is provided to improve the management of financial instruments In the area of growth and business environment, the Commission has assisted the authorities in strengthening the administrative capacity for public investment management and public private partnerships. Technical support was also provided to increase participation to EU competitive programmes, and to produce the first annual Competitiveness Report for Cyprus. In the area of energy, the authorities have received support to help develop renewable energy and energy efficiency, draft the integrated National Energy and Climate Plan, as well as training and expertise on a range of topics related to the internal energy market. In the area of health, Cyprus has benefitted from technical support for the design, financing and management of the National Health Insurance System, business continuity and disaster recovery in the Health Insurance Organisation, implementation of the EU General Data Protection Regulation, identification of a negotiation strategy with healthcare providers, and capacity planning in the healthcare sector. In the area of education, the Commission provided technical support to assess the feasibility of introducing a student loan scheme in Cyprus, as well as for the reorganisation of school boards, and the development of a reform of the special education system with the aim of making it more inclusive. In the area of public finances, Cyprus received technical support to finalise a capacity-building exercise of a value-for-money review, and for the preparation of reviews of State-owned enterprises. The Commission also assisted the authorities for the implementation of international public sector accounting standards. In addition, the Cyprus Tax Department received support to prepare the procurement of a new integrated tax administration system. A new project has recently started to support change management for the implementation phase of this new system. Box 2.2: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Cyprus Cyprus is a beneficiary of European Structural and Investment Funds (ESI Funds). Cyprus achieved the best execution rate of European Regional Development Fund funds (46 %) and European Social Funds funds (50 %) for 2018. In addition, Cyprus improved in the execution of the Cohesion Fund, and achieved the second highest rate in the EU (33.3 %). Financial allocation from European Structural and Investment Funds aimed to support Cyprus in facing development and social challenges, amounts to approximately EUR 917 million in the current Multiannual Financial Framework for 2014-2020, equivalent to around 0.7 % of GDP annually and 26 % of all public investment per year on average. As of the end of 2018, an estimated EUR 730 million (around 80 % of the total) was already allocated to specific projects, among which EUR 36.3 million to critical interventions for youth through the Youth Employment Initiative. In addition, EUR 54.8 million was allocated to strategic EU TEN-Transport projects through the dedicated EU funding instrument, the Connecting Europe Facility. Furthermore, numerous Cypriot research institutions, innovative firms and individual researchers benefited from other EU funding instruments, notably Horizon 2020 which provided EUR 134.2 million. EU funding has helped address policy challenges and implement country-specific recommendations. The European funding has paved the way for some 1 700 enterprises to be supported, achieving so the creation of some 1 320 full time equivalent new direct jobs. 80 innovative enterprises are also supported in introducing new products to the market and 2 800 people are trained to meet labour market needs. By the end of the period, it is expected that public support in research and innovation will leverage some additional EUR 12 million of private investments and. Investments are also scheduled for additional 13 600 people equivalent to benefit from modern waste water treatment. Thanks to the European Social Fund, additional 4 800 people, including unemployed, long-term unemployed, and 1 800 people below 29 years of age will have been supported in their integration to the labour market. With the support from the EU funds, some 2 100 households will be able to improve their energy performance and the energy consumption of public buildings will annually reduce by 3 million kWh and some 1 100 people from jobless households will be integrated to the labour market or will be better skilled to do so. Over 100 000 sqm of open spaces will be created or rehabilitated for the improvement of urban mobility as well as 32 000 sqm of open spaces will be created or rehabilitated in urban areas and 1 300 people from disadvantaged groups will be supported with a view to promoting equal opportunities and active participation. Out of the EU financing, EUR 40 million is to be delivered via financial instruments to support small and medium-sized enterprises and projects in the fields of energy efficiency and renewable energy sources both for the public and private sector (households and enterprises) i.e. twice the amount delivered in the 2007-2013 period. Cyprus’ total financing under the European Fund for Strategic Investments (EFSI) amounts to EUR 45 million and is set to trigger EUR 81 million in additional private and public investments. The country ranks 27th as to the overall volume of approved operations as a share of GDP. In the Infrastructure and Innovation window, 1 project was approved and financed by the European Investment Bank with the European Fund for Strategic Investments backing for approximately EUR 35 million, set to trigger EUR 53 million in total investment. The small and medium-sized enterprises component, instead, saw 2 approved agreements with intermediary banks financed by the European Investment Fund with the European Funds for Strategic Investments backing of EUR 10 million, set to trigger around EUR 28 million in investments with some 125 small and medium-sized enterprises and mid-cap companies expected to benefit from improved access to finance. More information at: https://cohesiondata.ec.europa.eu/countries/CY 3. Summary of the main findings from the MIP in-depth review Introduction The 2019 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, 2018c). In winter 2018, Cyprus was identified as having excessive macroeconomic imbalances. The imbalances identified related in particular to the high share of non-performing loans (NPLs) in total loans and the significant stock of private, public, and external debt. This is in a context of high, even though declining, unemployment and weak potential growth. This section summarises the findings of the analyses in the context of the macroeconomic imbalance procedure in-depth review that is contained in various parts of this report. ( ) Imbalances and their gravity The non-performing loans (NPL) ratio in the banking sector declined significantly in 2018 but it remains one of the highest in the EU. The NPL ratio dropped to 45 % of total loans in mid-2018, and it is expected to fall significantly further by the end of 2018 to approximately 37 % of total loans. The large decrease was due to the removal of the Cyprus Cooperative Bank’s sizeable NPLs portfolio from the banking system in September 2018, when the bank surrendered its banking licence. Another key development that contributed to the downward trend was the Bank of Cyprus’ sale of a large volume of NPLs (EUR 2.7 billion) to an international private equity firm, Apollo Global, although this transaction is pending approval from the Single Supervisory Mechanism (see Section 4.2.1). Private sector debt is on a downward path, though it remains well above the fundamental and prudential benchmarks. The private debt-to-GDP ratio decreased from 337.8 % in 2016 to 316.3 % in 2017 and then to below 300 % in mid-2018. This reduction is mainly driven by the strong GDP expansion, pick-up in inflation, cash repayments, NPL write-offs and debt-to-assets swaps. Non-financial corporations debt is inflated by the foreign debt of special purpose entities. However, even when excluding the special purpose entities, the corporate debt is very high. In 2017, the overall stock of debt of non-financial corporations remained stable compared to the previous year, whereas the household sector stock of debt declined more significantly. New lending, while limited, is largely channelled towards non-financial corporations, to business sectors such as wholesale and retail trade, accommodation and food service activities, construction and real estate activities. These sectors already account for a large share of the banks’ loan portfolio, and have a high incidence of non-performing loans. The household sector does not have positive net credit flows. Both the corporate and household sector remain overly indebted and thus, vulnerable to economic shocks. Everything else constant, the deleveraging process is bound to slow down once growth starts to converge towards potential (see Section 4.2.2). Following an increase in 2018, public debt exceeds now 100 % of GDP, making Cyprus vulnerable to economic shocks. Due to the government’s support in the sale of the Cyprus Cooperative Bank (see Section 4.2.1), public debt is projected to increase to 105 % of GDP in 2018, partly reversing the sharp decrease in 2017. High public debt makes Cyprus vulnerable to financial or economic shocks, namely a potential sharp increase in interest rates. However, the recently regained investment grade rating for Cyprus’ debt and relatively contained — despite the one-off increase due to the sale of the Cyprus Cooperative Bank — mediumterm financing needs mitigate refinancing risks. Given also the fact that the large proportion of long-term lowinterest debt was provided by external creditors during the economic adjustment programme, Cyprus’ debt servicing costs are relatively low for its level of debt (see Section 4.1.1). The country’s net international investment position remains a source of vulnerability, as at 105.5 % of GDP in 2018Q3 it was one of the most negative in the EU and well beyond the estimated prudential and fundamental thresholds, of 54 % and 43 %, respectively ( ). The risk is moderated thanks to the larger part (75.1 % of GDP) of the negative position being accounted for by the non-financial special purpose entities registered in Cyprus, which appear to have limited links to the real economy. The net international investment position excluding the share of the special purpose entities was much smaller (-30.4 % of GDP) and within the benchmark.

The current-account deficit is high, while sustained current account surpluses are necessary to bring the net international investment position to safer levels. Amid strong cyclical upswing, the current account remains deeply negative. In 2017, the current account was -8.4 % of GDP, and it remained in high deficit in 2018, at -7.5 % of GDP as of Q3. Activities of the special purpose entities, notably ship registration and de-registration, have a major impact on current account. Excluding special purpose entities, the current account in 2017 and 2018 (as of Q3) was at around -3 % of GDP. However, this is still below the current account ‘norm’ ( ) implied by fundamentals (-1.6 %). Moreover, Cyprus would need a current account balance of close to zero and a trade balance of close to 5 % to reduce its net international investment position to its threshold of -35 % of GDP over the next 20 years (without accounting for the presence of special purpose entities). The strong increase in job creation has substantially improved the country’s labour market conditions. Most indicators improved considerably as unemployment is expected to drop to 8.2 % in 2018. Long-term and youth unemployment also decreased significantly, reducing the gravity of the problem (see Sections 1 and 4.3.1). Potential growth is expected to increase somewhat over the medium term, helping to slowly unwind the accumulated stock imbalances. Recovering investment, the return of discouraged workers to the labour force and lower unemployment are expected to increase growth potential. Potential growth is estimated at around 2 % in 2017-2021 but is expected to decline thereafter. The concentration of investment into construction and ship registration does not favour long-term growth and productivity (see Sections 1 and 4.4). Evolution, prospects and policy responses The Cypriot authorities devised and started implementing a three-pillar policy strategy to reduce non-performing loans (NPLs). The strategy comprised of: (i) a legislative package, including amendments to the foreclosure and insolvency frameworks and to the sale of loans law, and the adoption of a securitisation law; (ii) the sale of the Cyprus Cooperative Bank, which struggled with a high volume of NPLs, putting its residual entity into a wind down mode; and (iii) the setting-up of a temporary State support scheme (ESTIA) for addressing the NPLs collateralised by primary residences, the most challenging part of NPLs. Under the first pillar — strengthening of the legal and regulatory framework — the legal amendments aim to remove some impediments to NPLs resolution. The second pillar was implemented in September 2018, when the Cyprus Cooperative Bank surrendered its banking licence. Therefore, its impact on NPLs materialized already, with a big portion of bad loans having been carved out of the banking sector. Under the last pillar, the design of the ESTIA scheme was finalised in early November 2018 and is expected to be implemented in the first part of 2019 (see Section 4.2.1). The planned reform of the judicial system aims to strengthen contract enforcement and ultimately improve the country’s payment culture (see Section 4.4.3). In addition, the performance of the ESTIA scheme greatly depends on the judicial system’s efficiency in enforcing foreclosure procedures to re-defaulters and non-eligible borrowers. Private sector deleveraging may accelerate in the light of the legal changes to the foreclosure and insolvency frameworks and due to the ESTIA scheme. Both households and non-financial corporations' debt ratios are on a declining path. Valuation effects and GDP growth contributed greatly to the deleveraging of both sectors in the first part of 2018 (see Section 4.2.2). The strengthened foreclosure framework could further facilitate the reduction of private debt by foreclosing on assets pledged as collateral, while the amended insolvency framework could increase debt-workouts. In addition, the ESTIA scheme, which provides very attractive terms (including debt reductions) to defaulted borrowers, may also decrease private indebtedness, provided that the foreclosure procedure is implemented effectively upon re-default to contain moral hazard. Currently, the slow progress in setting up a reliable system for transferring and issuing property rights complicates foreclosure procedures and deters the liquidation of collateral. Public debt is projected to fall steadily in 2019-2020, underpinned by the expected continuation of strong fiscal performance. Based on a ‘nopolicy-change’ assumption, Cyprus’ public debt is projected to drop by an average of 7 percentage points in 2019 and 2020. This is mainly due to projected high structural primary surpluses, at an average of 3.3 % of GDP, although lower than achieved in 20162018. However, downside risks to fiscal sustainability are significant (see Section 4.1.1 and Annex B). Cyprus’ net international investment position narrowed but still remains deeply negative. The net international position improved from -121.5 % of GDP at the end of 2017 to -105.5 % in Q3 2018. The more pronounced contraction in 2018 was mainly due to the reduction of liabilities in two categories: currency and deposits, and debt instruments. Meanwhile, increasing equity and investment fund shares contributed to widening of the net international investment position. The further adjustment is expected to be limited, as the current account is forecast to remain in substantial deficit in 2018 and 2019. This is against an estimated annual surplus of 3.1 % of GDP necessary to bring the net international investment position to its estimated prudential level of -54 % over a 10-year period. The structure of external liabilities over 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 and ship registrations, as opposed to green field investments. The net external debt to GDP meanwhile contracted from 144.3 % at the end of 2017 to 103.0 % in Q3 of 2018, according to the Cyprus Central Bank's data. Recent policy measures aimed at improving the business environment should contribute to improving competitiveness. This was mainly in the area of administrative simplification, e-governance and entrepreneurship. Measures have also been taken to attract foreign investors and improve competitiveness by addressing issues related to internationalisation of small and medium-sized enterprises, improving workers’ skills and strengthening innovation. The planned measures to reform the justice system and improve the efficiency of courts are expected to further improve the business environment in the long-term. Labour productivity decreased slightly in 2016-2017 but is set to improve as of 2018. The weak performance in 2016 and 2017 is mostly cyclical, due to the high rate of job creation in labour intensive sectors such as tourism-related services and construction. The forecasted recovery as of 2018 is based on expectations for a less strong and more broad-based increase in employment. 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 of the labour force are essential to raise productivity in the long-term (see Section 1 and 4.4). Labour market outcomes continue to improve rapidly with unemployment forecast to drop to 6.3 % by 2019. Unemployment dropped from 11.1 % in 2017 to a provisionally estimated 8.2 % in 2018, supported by strong employment growth. This positive trend is expected to continue though at a slower pace. The activity rate also improved and long-term unemployment decreased substantially. As labour market indicators improve, there is no evidence yet of wage overheating, as a large part of the employment growth is skewed to low-wage sectors and labour market slack is still in place. Action is being taken to improve the efficiency of the public employment services and promote active labour market policies (see Section 4.3.1) Overall assessment Stock imbalances remain high, mainly in terms of non-performing loans, private, public and external debt. Despite the recent improvement, Cyprus’ vulnerabilities, which are mostly because of long-lasting stock-imbalances, continue to be significant. The government, private and external debt ratios are still high. The large, albeit decreasing, level of non-performing loans (NPLs) and weak profitability highlight vulnerabilities in the banking sector. Adjustment issues in the labour market have largely been resolved, as reflected by the strong employment growth and the fall in unemployment. Remaining risks in this area are mostly linked to the low labour productivity, which remains a major weakness of the Cypriot economy. The composition of risks has shifted over the past year and some imbalances have been reduced while others have increased. In terms of flows, many imbalances are decreasing, helped by the cyclical upswing. This is particularly the case for employment conditions, which have improved significantly, with unemployment rate now at an eight year low. The deleveraging in the private sector is also progressing, mostly because of strong GDP growth, non-performing loans write-offs, cash repayments and debt-to-assets swaps. Non-performing loans have been reduced significantly, as a large volume was carved out of the banking sector upon market exit of the Cyprus Cooperative Bank. However, this also led to a substantial increase in public debt in 2018, though this is expected to start decreasing again in 2019. Implementing effectively the policy measures in place and addressing any remaining inefficiencies are essential for further reducing the imbalances. Some progress has been made on implementing the measures that address macroeconomic imbalances, particularly the high stock of non-performing loans (see also Sections 2, 4.1 and 4.2 and Annex A). However, reform commitments are still pending in several areas, for example the justice system reform (notably the handling of non-performing loans in the courts and the improvement of contract enforcement) and setting-up a reliable system for issuing and transferring title deeds. The running of the Insolvency Service and the information on borrowers still need to be improved. Continued fiscal discipline is also crucial for 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 short-term fiscal sustainability is a cause for concern due to potential spill-overs from macroeconomic, financial and competitiveness imbalances, recently exacerbated by increased government debt. The indicator-based analysis ( ) signals risks of fiscal stress in the short term (within 1 year), based on the most recent data and the Commission’s autumn 2018 forecast (see Annex B). As in the past, the high value of the indicator is driven by short-term risks on the financial-competitiveness side, this time in the context of a sharp increase in government debt in 2018 due to one-off banking support measures. In particular, the financial-competitiveness sub-index points to short-term vulnerabilities notably due to the negative net savings of households, the large negative net international investment position and the high private sector debt, a significant fraction of which is short-term. However, the S0 indicator value for Cyprus has just reached its critical threshold, as some other fiscal variables are positively oriented in the country. This is particularly the case for the large primary surplus, which should enable a significant reduction of government debt in 2019. However, financial markets’ perceptions of Cyprus’ sovereign risk have improved recently. The short-term risks to fiscal sustainability are somewhat mitigated by the recent upgrade of the rating of Cyprus bonds to ‘investment grade’ by three major rating agencies and a significant increase in the cash buffer (covering all financing needs until the third quarter of 2019). Despite fluctuations in the sovereign yield spread in 2018 mainly due to the sale of the Cyprus Cooperative Bank and external events, 10-year sovereign yield spread in relation to the German 10-year ‘bund’ was contained recently, at 2.0 % in January 2019. Graph 4.1.1:Government debt projections Source: European Commission (Fiscal Sustainability Report 2018) Given its initial high government debt stock, Cyprus faces medium fiscal sustainability risks in the medium term. Debt sustainability analysis shows that, under normal economic conditions with no fiscal policy change (baseline scenario), the general government debt-to-GDP ratio would fall to around 62 % by 2029, still slightly above the critical 60 % threshold (see Graph 4.1.1). The projected significant decrease of 29.5 percentage points between 2020 and 2029 would be driven by the continued strong fiscal performance assumed under the no fiscal policy change scenario (with a structural primary balance unchanged at 2.9 % of GDP ( )) and be supported by favourable snow-ball effects (interest rate-growth rate differential) and decreasing ageing costs over most of the next decade. The medium risk assessment is confirmed by alternative and stress test scenarios, including stochastic projections ( ). The S1 sustainability indicator, which measures sustainability risks until 2033, indicates a low medium-term risk (European Commission, 2019a). Cyprus’ long-term fiscal sustainability risk is also assessed as medium. The analysis of the sustainability gap indicator S2 points to limited risk (see Annex B). With a value of -0.9 percentage points of GDP, it indicates that under the baseline scenario the debt-to-GDP ratio would stabilise over the long term given an assumed continuation of the structural primary surplus. This result is due to the favourable initial budgetary position, which more than offsets the projected rise in ageing costs in the long run, mainly driven by pension expenditure ( ). The debt sustainability analysis discussed above, points to medium risk in the long term, due to vulnerabilities linked to the high debt burden. Contingent risks remain in the banking sector, notably in the short term, mainly due to a high ratio of non-performing loans. According to the Commission’s systemic model of banking originated losses (SYMBOL), Cyprus is the Member State most exposed to short-term fiscal risks in a severe stress scenario of a repeat of the recent financial crisis. On the basis of the current level of non-performing loans and conservative loss assumptions, a recapitalisation of Cyprusʼ banks by public funds to 10.5 % of their risk-weighted assets could increase sovereign debt by 3.1 % to 17.5 % of GDP depending on the scenario ( ) in the short term (2019 Q1). Contingent risks are considered more significant in the short term, since safety nets in the form of increasing capital requirements, bail-in and national and supranational resolution funds are still being put in place. However, the country’s exposure to implicit contingent liability risks from the banking sector is expected to decrease to below 0.5 % of GDP by 2029, given that the safety nets will have been fully phased in and assuming that the effect of non-performing loans will become negligible in the long term ( ) (European Commission, 2019a). The nature of contingent risks from the banking sector changed after the sale of the publicly-owned Cyprus Cooperative Bank. On the one hand, the sale and wind-down of the Cyprus Cooperative Bank — the second largest bank in the country and burdened by a high portfolio of non-performing loans — reduced the implicit contingent liabilities in relation to the banking sector. On the other hand, to facilitate the sale of the bank, the State adopted public support measures at a high cost to public finances (see Section 1 and Section 4.1.2). Amongst others, the State’s exposure to explicit contingent liabilities, in the form of government guarantees, increased. This was mainly due to the creation of asset protection schemes agreed as part of the sale of the Cyprus Cooperative Bank. The sovereign wealth fund could improve the long-term sustainability of public finances, but the legislative proposal is still pending adoption by the House of Representatives. The draft sovereign wealth fund law sets out the conditions for collecting, managing and using future resources from hydrocarbon exploitation and stipulates that the government will be able to use part of the revenue to reduce government debt. The House of Representatives is still discussing some proposed amendments to the bill. Adoption of the legislation would contribute to ensuring the sustainable use of revenue from the exploitation of hydrocarbon reserves and in turn to improving the outlook for public debt sustainability. 4.1.2.Fiscal framework and policy challenges* Fiscal framework A rigorous implementation of the budgetary framework is essential to contain risks of fiscal relaxation. Currently, the focus is on implementing the secondary legislation of the Fiscal Responsibility and Budget System Law rigorously, in particular not exceeding the expenditure ceilings set in the medium-term budget framework. Furthermore, in March 2018, the government approved a decision accompanying the Fiscal Responsibility and Budgetary Framework Law to fully transpose the Budgetary Frameworks Directive (EU 2011/85). The adopted changes clarified the responsibilities for assessing the macroeconomic and budgetary forecasts so as to improve the transparency of public finances. In particular, in its semi-annual reports the Fiscal Council is requested to compare the official macro-fiscal projections with the Commission’s most recent forecasts, while the Ministry of Finance is responsible for explaining any significant differences between these projections. The Fiscal Council’s mandate on the ex-post evaluation of the accuracy of the government’s macro-fiscal forecasts is set to cover at least four consecutive years. Policy challenges Public expenditure has accelerated since 2017. At 37.5 % of GDP in 2017, total public spending in Cyprus is below the EU average of 46.6 %. However, public primary expenditure (i.e. excluding interest) growth in Cyprus was higher than the nominal potential growth in 2017 (at around 4.9 % vs 3.3 %). This growth rate in public spending was due to both increased current expenditure and public investment. While the pace of public expenditure has accelerated recently, it has been outpaced by buoyant tax revenue growth underpinned by strong underlying economic growth. A prudent fiscal policy would avoid risks associated with using the additional temporary revenue generated by tax buoyancy effects to finance increases in long-term expenditure. With the positive macroeconomic outlook, deficit-increasing measures have been adopted recently. Public employees’ salaries are projected to gradually increase further in 2018-2023 thanks to the government’s measure to reverse wage cuts implemented since the crisis. This measure is expected to increase the overall public wage bill, but to remain below nominal GDP growth, as set by the collective agreement on public wage indexation between the government and the unions. The collective agreement, which was set to expire at the end of 2018, will continue to be in effect in the absence of any amendments. Furthermore, a recent Court decision deeming the pensions cuts in the public sector implemented since the crisis to be unconstitutional is likely to have an additional fiscal impact. ( ) The government’s support measure for low-income pensioners as part of a social dividend pay-out and a voluntary retirement scheme for employees of the Cyprus Tourism Organisation as of January 2019 ( ) are also expected to increase public expenditure. Capital transfers are expected to rise as a result of the introduction of the ESTIA scheme, which involves State support for loan repayment of eligible borrowers with non-performing loans backed by primary residences (see Section 4.2.1). Despite the measures adopted, pressure to further increase public spending is mounting. The ongoing discussions between the government and the unions to create a provident fund for public sector employees recruited after October 2011 and on contracts of indefinite duration might create additional incremental fiscal costs. Furthermore, the agreement in principle between the government and other political parties on introducing a State support scheme for borrowers who have their primary residence as collateral and are servicing their loans, with criteria similar to the ESTIA scheme, would also weigh negatively on the budget balance. The potential fiscal impact of the healthcare reform remains uncertain, in particular the public hospitals reform might create additional budgetary pressures. The national health insurance system has been designed to have a balanced budget in the long term, thanks to the legislated contributions to the system and the expected improved efficiency of public healthcare providers. ( ) However, as mentioned in Section 4.3.2, the law on the new Organisation of public hospitals stipulates that the State will subsidise any potential deficit of public healthcare providers in the first 5 years of the operation of the system (as of June 2019). In the meantime, public healthcare providers are expected to gradually adjust their labour and cost structure to raise their productivity, improve the quality of services and maintain a certain amount of demand for public healthcare service. The governance capacity of public hospitals needs to be carefully monitored to ensure the future sustainability of the system. Some uncertainty remains on the overall fiscal impact of the banking support measures related to the sale of the Cyprus Cooperative Bank. The impact of these measures on the general government balance in 2018 will be reported in the April 2019 Excessive Deficit Procedure notification and subject to further verification by Eurostat. The general government accounts for the third quarter of 2018 were recently published, including the fiscal impact of these measures, in agreement with Eurostat.( ) The potential realisation of explicit contingent liabilities regarding the measures related to the sale of the Cyprus Cooperative Bank is a risk to the fiscal outlook.

The State’s exposure to explicit contingent liabilities has increased, mainly due to the measures related to the sale of the Cyprus Cooperative Bank. Unlike implicit contingent liabilities ( ) (see Section 4.1.1), explicit contingent liabilities are government obligations as recognised by a law or a contract. According to Eurostat, government guarantees in 2017 amounted to around 8.7 % of GDP (EUR 1.7 billion). Most of these liabilities concerned State-owned enterprises, including the sewerage boards ( ), private corporations, local authorities and retail exposures. Cyprus’ government guarantees further increased in 2018 due to the government’s contingent obligations in relation to financial institutions, particularly the establishment of asset protection schemes related to the sale of the Cyprus Cooperative Bank (see Box 4.2.1). According to the authorities (Ministry of Finance of Cyprus, 2018, p. 36), government guarantees are projected to increase to 22.5 % of GDP in 2018, of which 13.4 % are related to the financial sector. An improved corporate governance of State-owned enterprises and further progress on privatisation projects would reduce the State’s exposure to contingent liabilities from public companies. The draft law on the governance of State-owned enterprises is at standstill since its submission to the House of Representatives in 2015. This law would improve the corporate governance of State-owned enterprises and ensure that they are monitored more effectively. Progress on individual privatisation projects has been limited (see Section 4.4.3). Further progress on the privatisation projects could reduce the State’s exposure to contingent liabilities from public companies (including implicit ones, which are difficult to quantify) and attract further foreign investment in Cyprus. 4.1.3.Taxation* Tax revenues increased significantly in 2017, although uncertainties remain about whether the increase can be sustained. In terms of GDP, indirect tax revenue in Cyprus was well above the EU average in 2017 (15.9 % vs 13.5 %), while revenue from direct taxes and social contributions (9.4 % and 8.7 %, respectively) continue to remain below the EU average (13.4 % and 12.2 %, respectively). Total tax revenues stood at 34 % of GDP in 2017, below the EU average of 39 %. In nominal terms, tax revenues increased by 9.3 % in 2017 compared to the year before. This was the result of sizeable increases in all tax revenue categories and in particular thanks to an increase in value-added tax revenues (by 11.3 %) and a strong increase in corporate tax revenues (by 6.1 %). However, it is unclear whether the strong tax revenue performance from value-added tax and corporate income tax can be sustained. Corporate tax revenue may pose sustainability risks, since it is prone to volatility. In particular, this volatility might stem from possible relocation decisions by (large) companies benefiting from Cyprus’ tax jurisdiction, for instance if changes in the international corporate tax framework would cut out incentives for aggressive tax planning. To safeguard fiscal sustainability, it is important that temporary or volatile revenues are not used to fund additional current spending. Graph 4.1.2:Value-added tax revenue growth and its main sector contributors Source: Ministry of Finance The recent significant increase of value-added tax revenues might weaken in the future, as it is largely due to the current positive economic cycle and the strong construction activity. While most sectors increased their contributions to value-added tax revenues in 2017, a few sectors stood out (see Graph 4.1.2). Half of the total value-added tax revenues in 2017 stem from the following four sectors: (i) wholesale and retail trade; (ii) construction; (iii) professional activities; and (iv) information and communication. The construction sector significantly increased its value-added tax collection for the second consecutive year, as a result of the strong construction activity. Tax revenue might not continue to increase at the same rate in the future due to changes in the economic cycle and a projected slowdown in construction activity. Cyprus’ tax structure remains more growth- and environment-friendly than that of the EU on average. As mentioned in the 2018 Country Report for Cyprus (European Commission, 2018a, Section 4.1.3), the tax burden on labour is low, while consumption and environmental tax revenues are high, in line with euro area recommendation 3. In the medium term, the tax burden on labour is expected to remain below the EU average, despite the legislated rises in social contributions in relation to the pension system in 2019 (European Commission, 2017a) and the introduction of compulsory health insurance contributions to finance the recently adopted national health insurance system in 2019 and 2020 (see Section 4.1.2). Consumption and environmental tax revenues in terms of GDP are also expected to remain above the EU averages ( ), in spite of some policy measures envisaged on environmentrelated taxation. Moreover, as in other EU countries, Cyprus’ corporate tax system favours debt over equity financing (i.e. is subject to the ‘debt bias’). This debt bias may lead to excessive leverage and make companies more vulnerable to economic shocks. However, such bias is lower in Cyprus compared to the EU average ( ). Although the effective corporate income tax rate is below the EU average (13 % vs 20 % in 2017), the tax on capital revenue in Cyprus is similar to the EU average (8.6 % of GDP in 2016) mainly due to relatively high corporate income tax revenue ( ). There is further scope for redesigning in a socially fair manner the structure of environmental taxation to improve climate and environmental policy in Cyprus. This is particularly true in view of the challenges Cyprus is likely to face in meeting its greenhouse gas emissions targets in 2020 and 2030 (see Section 4.4.1). The recently approved measure to reduce the excise duties on fuel as of mid-December 2018 as part of a social dividend pay-out will make meeting the greenhouse gas emissions targets even more difficult. Yet, its impact is estimated by the authorities to be relatively limited (at 0.2 % of GDP). Alternative tax measures could further improve cost-efficiency of climate and environmental policy in Cyprus. To that end, the government plans a revision of the vehicle taxation through changes to road tax and abolition of vehicle excise duties, which are based on CO2 emissions (Ministry of Finance of Cyprus, 2018, pp. 10-11). While the overall fiscal impact of the reform is expected to be very limited, with potential revenue losses of 0.03 % of GDP, it is aimed at promoting the introduction of environmentally-friendly (i.e. low-emission) vehicles. Removing environmentally harmful tax expenditures such as the exemption of excise duties on fossil fuels for power generation could also facilitate meeting the relevant targets, notably for primary energy consumption. The redistributive power of the Cypriot tax and benefit system has more than offset the post-crisis rise in income inequality in 2015-2016. In 2004-2012, Cyprus’ income inequality after taxes and benefits was at around the EU average level, even though the redistributive power of the tax and benefit system was among the lowest in the EU.( ) Since the 2012-2013 crisis, income inequality has increased somewhat in Cyprus. In 2015-2016, income inequality after taxes and benefits decreased significantly thanks to the higher impact of taxes and the improved government redistribution policy with respect to social benefits. The latter could be related to the introduction of guaranteed minimum income ( ) (see Section 4.3.2). Graph 4.1.3:Main receivers from and contributors to government redistribution by decile (average 2005-2016) Source: European Commission Joint Research Centre, based on EU-SILC data The large progressivity of taxes and the current social pension scheme have helped to reduce income inequality in Cyprus. Public pensions contribute to reducing income inequality in Cyprus thanks to its social pension scheme. ( ) However, public pensions in general are not primarily aimed at income redistribution, but to lifetime social contributions. Aside from public pensions, both social transfers and taxes play a significant role in reducing income inequality in Cyprus. In 2016, the tax effect on income inequality stood at 8 % (above the EU average of 7.4 %) and the benefit effect stood at 12.1 % (below the EU average of 15 %) as measured by Gini. The relatively high tax effect is due to the progressivity of taxes, in particular for the personal income tax (European Commission, 2018a, Section 4.1.3). As shown in Graph 4.1.3, the tax and benefit system in Cyprus supports income redistribution to the low-income households, as net transfers ( ) are positive for low- and middle-income (i.e. they are net receivers) and close to zero for high-income households. The high levels of inward and outward foreign direct investment, in addition to the high levels of dividend and interest payments as a percentage of GDP, ( ) may indicate that Cyprus’ tax rules are used by companies and individuals that engage in aggressive tax planning. Possible risk areas involving aggressive tax planning include the absence of withholding taxes, ( ) the design of the Cyprus tax residence rules and the residence and citizenship by investment schemes. Due to the absence of withholding taxes, the outbound payment of dividends, interest, and royalties from Cyprus-based companies to nonEU jurisdictions may lead to double non-taxation if these payments are not taxed in the recipient jurisdiction. Another risk is that the proceeds of contributions to foreign companies are recognised as capital, despite no shares being issued in return (a practice known as ‘non-returnable capital contributions’). In 2018, Cyprus tightened the conditions to recognise non-returnable capital contributions, but the effects of this on aggressive tax planning remain to be seen ( ). Furthermore, the Cyprus tax residence rules are based on the management and control test, so that a company may be incorporated in Cyprus but not be tax-resident there. This has the potential to create a mismatch that could also be exploited for tax planning purposes. Aggressive tax planning can also occur in combination with the avoidance of social security contributions and the facilitation of undeclared work through artificial intermediaries in Cyprus (European Platform Undeclared Work, 2017). Also, in 2015 Cyprus introduced a Notional Interest Deduction scheme, which needs to be closely monitored to ensure that it is not misused for aggressive tax planning and harmful 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, also known as ‘golden visas’) 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 the jurisdiction offering the scheme. 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 and have been listed by the OECD as having a potentially high risk for being misused to circumvent the automatic exchange of financial account information by facilitating the concealment of the real jurisdictions of residence, effectively avoiding taxation. Cyprus is acting to curb aggressive tax planning through the implementation of European and internationally agreed initiatives. In line with the rest of the EU, Cyprus has to transpose into national law the two EU Directives on Anti-Tax Avoidance. Member States are expected to complete this transposition by the end of 2018 and 2019. ( ) The Notional Interest Deduction scheme is currently under examination by the Code of Conduct on Business Taxation of the Council. Furthermore, Cyprus has signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, and expects to complete its ratification by the second half of 2019. Cyprus has chosen to apply it to the vast majority of its treaty partners, but has put numerous reservations, not forming part of the minimum standard. The latter significantly limits the effectiveness of implementation of the multilateral convention in Cyprus. A circular issued by the Cyprus Tax Authority amending the rules on the tax treatment of financing companies from 1 July 2017 provides additional guidance on substance and transfer pricing requirements in line with OECD guidelines. The Cyprus Tax Authority is also reviewing the wider transfer pricing legal framework with a view to updating it in mid-2019. The effectiveness of these new measures in limiting the scope for aggressive tax planning and their impact on the corporate income tax revenue in the medium term deserves to be assessed. 4.2. Financial sector* 4.2.1.banking sector DEVelopments * One of the key developments in the Cypriot banking sector in 2018 was the market exit of the Cyprus Cooperative Bank. After struggling with reducing a significant non-performing loans (NPL) portfolio and very weak governance, the second largest bank in the country was ultimately sold to Hellenic Bank. It took over almost the entire performing loan portfolio, all government bonds and all customer deposits. The Cyprus Cooperative Bank surrendered its banking licence on 3 September 2018 and left behind an asset-management company — which took over the bank’s NPL portfolio (EUR 5.7 billion). The Cyprus Cooperative Bank sale and wind-down resulted in a consolidation of the banking sector. It reduced uncertainty in the market, helped stop deposit outflows, and reduced the stock of NPLs in the banking sector (by shifting it to the publicly owned asset management company). More details on the bank sale and its timeline, its asset-management company legacy and the impact on the public finances are presented in Box 4.2.1. Following the acquisition of the Cyprus Cooperative Bank, Hellenic Bank is expected to improve its performance. Hellenic Bank became the second largest bank in Cyprus after the transaction. As a result of the better portfolio mix, the bank expects its NPL ratio to decline significantly and its NPL coverage ratio to increase. The bank’s profitability is also expected to increase significantly, driven by the high interest income from the government bonds. However, integrating a bank that is approximately twice as large in terms of gross loans and deposits, also poses challenges. The integration involves major organisational and managerial challenges and restructuring costs. In addition, in January 2019, Hellenic Bank announced the share capital increase through (i) rights issue of up to EUR 100 million and (ii) a private placement of EUR 50 million and the listing on the Cyprus Stock Exchange of the rights issued. The banking sector returned to profitability in the first half of 2018, but poor asset quality and low interest margins continue to push banks’ performance down. The sector’s aggregate pre-tax profit was EUR 196 million as of September 2018, up from a net loss of EUR 535 million a year ago, but 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. Net interest margins continue to decline, while the operating cost-to-income ratio almost doubled in the first half of 2018, partly due to the servicing arrangements with specialised NPL management companies that several banks have entered into to accelerate their NPL reduction. Provisioning costs (excluding adjustments related to the International Financial Reporting Standards 9 (IFRS 9-related)) declined in the first half of 2018, bringing the banking sector back into profitability, with a return-to-equity of 8.6 % as of September 2018. Capital levels have declined slightly, driven largely by the IFRS 9 related adjustments. ( ) In particular, despite transitional IFRS 9 application, the Common Equity Tier 1 ratio dropped to 14.1 % in September 2018, down from 15.0 % a year ago. Although the capital ratios are higher than the EU averages, Cypriot banks have to maintain higher capital ratios than the minimum levels, as required by their supervisors, to absorb potential shocks associated with a weak asset quality.

Risk provisioning continued to improve. Following supervisory actions in 2017 and the entry into force of the IFRS 9 standards in January 2018, provisioning coverage ratios increased from 46.7 % of gross non-performing loans in June 2017 to 52.3 % in September 2018, staying above the EU average of 45.7 %. Box 4.2.1: The Cyprus Cooperative Bank exit from the banking sector The sale of the State-owned Cyprus Cooperative Bank to Hellenic Bank allowed the bank to make an orderly market exit. The Cypriot authorities initiated a restructuring process of the Cyprus Cooperative Bank in February 2014. Over the following years the bank struggled with large volumes of non-performing exposures (i.e. a non-performing loan (NPL) ratio close to 60 % in the beginning of 2018) and ultimately it was not able to return to viability. In early 2018, the bank faced sizeable deposit outflows linked to souring public opinion and doubts over a successful restructuring. To ease these pressures, on 19 March 2018 the Cypriot authorities initiated the bank’s sale by launching a formal bidding process for a full or partial sale of the bank. To strengthen its balance sheet and thus support the sale, on 3 April 2018 the government made a deposit injection of around EUR 2.5 billion, funded by newly issued government bonds (EUR 2.35 billion) and a small cash addition from the cash buffers (EUR 0.15 billion). The bidding process ended in June with Hellenic Bank emerging as the winning bidder. The European Commission, under the State Aid rules, endorsed the sale agreement on 19 June, approving the public support measures to facilitate the orderly liquidation of the Cyprus Cooperative Bank under the national law. A business transfer agreement between Hellenic Bank and the Cyprus Cooperative Bank was signed on 25 June. As part of the deal, the Cypriot government increased its deposit injection in Cyprus Cooperative Bank from EUR 2.5 billion to EUR 3.5 billion in July 2018. To fund this cash infusion, the government issued a new round of bonds worth EUR 3.2 billion (the proceeds of which redeemed the bonds of 3 April 2018), and provided an additional cash amount of EUR 0.3 billion. The new bonds were placed on the asset side of the balance sheet to match the deposit. In addition to the deposit injection, the Cypriot Republic counter-guaranteed the asset protection schemes provided by the Cyprus Cooperative Bank to Hellenic Bank as part of the sale ( I ). The closing of the sale transaction took place on 3 September 2018, when the bank surrendered its banking licence. Under the terms of the deal, Hellenic Bank took over the sound part of the Cyprus Cooperative Bank ( II ). Cyprus Asset Management Company is Cyprus Cooperative Bank’s legacy. The bank’s residual entity is a State-owned asset management company which has under its perimeter the bulk of Cyprus Cooperative Bank’s NPLs (EUR 5.7 billion) together with the State deposit ( III ). According to the Commission’s State Aid decision, the Cyprus Asset Management Company’s sole activity is to manage its assets such that it maximises recovery and repays the State. Its organisation and its governance still need to be defined ( IV ). Furthermore, it is not clear whether Altamira, which was Cyprus Cooperative Bank’s debt servicer since 2017, will continue to service the asset management company. The state support measures for the Cyprus Cooperative Bank sale and wind-down were costly for the public purse. The aid measures undertaken by the Cypriot authorities increased the country’s public debt (projected at 105 % of GDP for the end of 2018) and increased the government’s exposure to explicit contingent liabilities (namely asset protection schemes). The support measures are also expected to weigh on the budget balance in 2018, depending on the statistical treatment by Cystat and Eurostat, which is still to be determined. The stock and ratio of non-performing loans (NPL) declined significantly in 2018 but remain high. The NPL ratio went down to 44.7 % in June 2018 ( ) and is estimated to decline further to approximately 37 % by the end of the year. Although lower compared to previous years, the ratio is still very high (see Table 4.2.1). The stock of non-performing loans for non-financial corporations contracted the most, having fallen by almost one third in the first half of 2018. In particular, by end of September 2018 the NPL ratio of non-financial corporations stood at 36.8 %, whereas for households it was 38 %. The NPL ratio therefore remains well above the EU average of around 4.0 %. The sale of loans made by Hellenic Bank and Bank of Cyprus were the key contributors of the steady decrease in non-performing loans (NPLs) in the first half of the year. Hellenic Bank’s sale of NPLs, a portfolio worth EUR 140 million, to Norway’s B2Kapital was the first loan sale in Cyprus ( ). The offload of NPLs by Bank of Cyprus was much more significant. The bank agreed with Apollo Global Management on a portfolio worth EUR 2.7 billion of NPLs (Helix portfolio). The completion of the transaction remains subject to regulatory approval, most notably on the significant risk transfer recognition by the Single Supervisory Mechanism. Nevertheless, the sale has already been accounted for in the NPL metrics pro-forma ( ). The portfolio mainly comprised terminated loans (loans, which the bank considers to have no negotiation possibilities). It remains to be seen how the credit acquiring company manages these loans. In particular, whether it will offer additional restructuring and to what extent it will make use of the newly revamped foreclosure framework. These issues will likely determine whether Cypriot NPLs, particularly terminated loans, will continue to be targeted by investors in the future. In the second half of 2018 around one third of non-performing loans (NPLs) were carved out of the banking sector. With Cyprus Cooperative Bank surrendering its banking licence in September 2018, EUR 5.7 billion NPLs were transferred to the publicly owned wind-down entity of the bank (i.e. a State-owned asset management company). Even though they are out of the banking system, the NPLs from the asset-management company will continue to weigh on the economy as the private sector remains heavily indebted. To maximise recoveries from the bad assets, recuperate the public funds placed in this entity, and ultimately help reduce private indebtedness, it is essential that the Cypriot asset management company is managed successfully. An independent governance structure, proper management, full transparency and appropriate supervision, as outlined in the Commission Decision of 19. 06. 2018 (European Commission, 2018e), are essential ingredients for an effective State-owned asset-management company. The organisation of the Cypriot asset management company and its governance should be fully set out during 2019. The House of Representatives approved a series of legal proposals to remove impediments to non-performing loans’ (NPLs) resolution. At the beginning of July 2018, the Cypriot authorities adopted a legislative package that included, among others, amendments to the following acts: the Personal Insolvency Law, the Companies Law, the Insolvency Practitioners’ Regulations, the Bankruptcy Law, the Sale of Loans Law and the Immovable Property (Transfer and Mortgage) Law. The Securitisation Law w