An IMF team headed by Wes McGrew visited Cyprus February 9-15. The purpose of the visit was to review economic conditions and policies. The IMF team would like to thank the Cypriot authorities for their gracious hospitality and open discussions.

A gradual economic recovery is underway, with growth likely to reach the 1½-2 percent range this year and favorable prospects for a continued upturn in 2012. Underlying inflation remains subdued, although higher fuel prices will have an impact on headline inflation. This generally favorable outlook remains subject to unusually high risks, in particular from ongoing financial turbulence elsewhere in Europe, which calls for extra caution in economic policies.

The foremost challenge of economic policy is to reduce the fiscal deficit from the high levels of the past two years and to reverse the associated trend of rising public debt ratios. Long-term prosperity in Cyprus depends in large part on its continued growth as an international business and financial center, which rests upon a foundation of sound public finances. Durable improvement in public finances will require structural measures to contain the growth in expenditure, including public sector wages and pensions. Countries across Europe are pursuing far-reaching reforms to correct fiscal imbalances and preserve investor confidence, and Cyprus should also seize this opportunity.

In this context, we welcome the government’s plans to bring fiscal balances into line with European Union norms over the next two years, although it would be preferable to base adjustment more on structural expenditure restraint and less on revenue. We are encouraged by the commitment over the medium term to contain expenditure through wage moderation and reduction in public sector employment, to put public pensions on a more sustainable footing, and to improve the targeting of social transfers. These are important first steps that will help to ensure sustainable public finances, and we encourage the government to move forward forcefully with these reforms.

The Cypriot banking system has weathered the economic difficulties well and appears to be in sound overall condition. It has benefited from reliance on deposits rather than less stable sources of financing, conservative lending practices, close attention to capital and liquidity buffers, and vigilant supervision. These factors have helped shield the banking system from the pressures that are prevalent in many other countries. The ongoing risks in international financial markets call for a continuation of conservative balance sheet management and careful supervision.