Troika found Cyprus economy worse than expected, report says

International lenders assessing Cyprus’s bailout needs found the economy in a «worse state than expected» and in need of painful adjustment in coming months, according to documents seen by Reuters.

Officials from the International Monetary Fund, the European Commission and the European Central Bank – known as the «troika» – have visited the island twice since Cyprus asked for financial aid on June 25, the fifth euro zone member state to do so.

They told Cypriot lawmakers on July 27 that challenges to the island’s economy did not only stem from its banking sector, which is heavily exposed to Greece, but to fiscal imbalances which needed to be addressed.

Cyprus’s two main banks suffered heavy losses from a write-down of Greek sovereign debt earlier this year which was backed by all EU member states, including Cyprus.

The lenders said they expected the island to be in recession in 2012 and 2013 and highlighted the need to slash an expensive state payroll. They said they did not expect a conclusion to the bailout negotiations until September at the earliest.

The comments are the first public insight into the troika’s thinking about Cyprus, whose tiny economy accounts for just 0.2 percent of euro zone output.

The disclosures were contained in an official transcript seen by Reuters of a closed meeting of the Cypriot parliament’s finance committee. Cypriot media ran excerpts of the discussion at the weekend.

“What we have seen is that your fiscal system is worse than we expected … prospects for growth are lower than what we expected, and as a result, there is a huge gap between your income and expenditure,» European Commission representative Maarten Verwey was quoted as saying at the meeting.

Verwey, whose comments were made in English and translated into Greek for the record, said ‘significant increase and reinforcement’ of banking supervision was required.

He said any suggestion of bailout amounts was premature.

Another member of the troika, Delia Velculescu of the IMF, was quoted as saying solving Cyprus’s problems would be painful.

“It would have been easier to have fixed them when times were good. Today it is harder because of difficult times, and worst (days) that lie ahead,» she said.

Popular Bank and Bank of Cyprus racked up huge losses on their holdings of Greek sovereign debt, causing a 2.3 billion euro combined shortfall in their regulatory capital they asked the state to fill.

The government turned to its EU partners for aid after having been effectively shut out of international debt markets since May 2011. It has also sought aid elsewhere, taking a 2.5 billion euro loan from Russia and has said it may do so again.

Verwey said that for the island to regain market access, it would need to narrow the gap between revenues and expenditure.

“You cannot maintain your present lifestyle if this continues … The government will not be able to pay salaries, so there is an urgent need for adjustment,» he was quoted as saying.

The island’s wage bill, which lawmakers heard was proportionately the highest in the euro zone, needed to be reduced, public benefits revamped, wage indexation modified and changes made to the public pensions system. [Reuters]