A New PFM Reform Strategy for Cyprus

Posted by George Panteli[1]

The government of Cyprus recently launched a radical reform plan for modernizing the country’s public financial management (PFM) system. The reforms are crucial to the implementation of the economic and financial recovery program on which we are now engaged with the help of the European Union, the European Central Bank and the International Monetary Fund. It will enable Cyprus to bring its budget process into line with best practice in the EU region, and enforce the fiscal rules and financial discipline that are necessary to comply with our Treaty obligations. At the same time, it will create an opportunity for line ministries to enjoy a new-found flexibility in managing their staff and other resources and to focus efforts on improving the quality of education, health and other public services that in many cases lag behind out counterparts in Europe. The strategy encompasses both traditional aspects of the budget system and emerging topics such as project evaluation processes, the management of fiscal risks including public-private partnerships (PPPs) and the future development of a sovereign wealth fund.  

The reform plan is challenging and a realistic timeline is required since the plan will take several years to implement. What are the plan’s main components?  

First, to enforce aggregate budget discipline, we will introduce ceilings on nominal expenditure that are binding both in the first year to which the annual budget relates, and eventually in the two “out-years” covered by the medium-term budget framework (MTBF). These ceilings will be fully consistent with meeting the overall fiscal targets agreed under the EU/ECB/IMF-supported program. “Binding” in this context means: binding on the Council of Ministers and binding on the good faith of the government. The only exception to these binding ceilings will be where the cost of servicing loans increases as a result of higher market interest rates that are outside the control of the government. Other developments that may impact on public spending - including changes in unemployment, inflation, or other macroeconomic indicators - will normally have to be accommodated within the existing ceilings. Strict enforcement of this rule is essential if we are to meet the stringent financial conditions we have set ourselves in the years ahead.   

Second, we are in the process of preparing, with support from the IMF, a comprehensive new legal framework for budgeting – the Fiscal Responsibility and Budget Systems Law (FRBSL).  The new law – which is the centerpiece of the PFM reform strategy - will be presented to parliament later this year. Since the FRBSL will incorporate provisions taken from the EU treaties, it will have a “superior” status to other laws. It will contribute in several important ways to strengthening our fiscal position. It will set out a broad framework of fiscal rules, fiscal discipline and fiscal transparency. It will set the budget process in a medium-term framework consistent with a strategic approach to planning both domestic as well as EU and other externally financed resources. And it will allow line ministries to play a greatly enhanced role in planning and executing the budget in the policy areas for which they are responsible.

Third, an independent Fiscal Council with three members will be established at the beginning of 2015. The Council will be responsible for overseeing the implementation of fiscal rules, analyzing fiscal policy developments, and evaluating the macro-economic and fiscal forecasts prepared by the government.

Fourth, starting in 2014, line ministries will be given significantly greater flexibility to decide the details of their own budgets by defining budgetary envelopes at a much higher level of aggregation. Instead of each ministry having to manage as many as 3,000 line items, the number of sub-heads in the budget will be reduced substantially over a period of years. Transfers between and within the main heads of expenditure dealing with wages and salaries and capital investment spending will not be permitted under the new rules. However, for all other transfers of spending within the new broad spending categories, ministries will be free to reallocate resources during the budget year without seeking permission from the finance ministry.

Fifth, line ministries will also be free to transfer unspent funds, within certain limits, from one budget year to another. As an initial step, within the category of non-wage current expenditure, up to one-half of any spending that remains unspent at the end of the budget year may be transferred to each ministry’s budget for the following year, subject to approval by the finance ministry. Such transfers will be in addition to the appropriation approved by the parliament in the ministry’s budget for the new fiscal year. Many other advanced countries have adopted a similar mechanism for transferring funds at the end of the fiscal year with beneficial effect on smoothing the profile of spending within the year. If the scheme proves successful, the finance ministry could consider increasing the amount of carry-over that is permitted in future years, and broadening its scope to include capital investment as well as recurrent spending. Introduction of these new rules, however, will need to be reconciled with the hard yearly budget ceilings under the EU/ECB/IMF-supported program. They will also require proper scrutiny by the Ministry of Finance to ensure that under-spending by line ministries does not reflect a lack of budget realism or inefficient execution of the budget rather than efficiency gains.

Sixth, with greater freedom comes the need for greater accountability. Flexibility will be increased only gradually and to the extent that line ministries have established a track record of prudent behavior. Strong overall control of spending, including the wage bill, will need to be maintained while the country is undergoing deep fiscal consolidation. Starting with the budget for 2015, we will ask all line ministries to present with their MTBF proposal a comprehensive statement of the strategic objectives of their sector, the outputs and outcomes they wish to achieve over the medium term, and the key performance targets they are aiming to achieve. These statements of ministerial strategy and performance will be evaluated by officials of the finance ministry along with the other documents submitted with each ministry’s budget proposal. Future funding for the key projects and programs financed by the ministry will be subject to an assessment of how the ministry is performing against its key performance indicators (KPIs).

Seventh, to take advantage of these enhanced responsibilities, line ministries will need to strengthen their capacity in budgeting and financial management, by establishing strong budget and finance directorates similar to those found in many other EU Member States. The new directorates would be headed by a Chief Budget and Finance Officer (CBFO) reporting directly to the Permanent Secretary of the ministry, as its Controlling Officer. The CFO would advise the Permanent Secretary both on the development of strategic plans and the medium-term budget for the ministry, and also on the execution of the budget, monitoring the performance of the various directorates, departments and units, and the preparation of regular financial reports.

Eighth, the changes outlined above will require line ministries to develop new skills in critically important areas such as strategic and corporate planning, developing and monitoring KPIs, making medium-term projections of baseline spending, analyzing the implications of new spending proposals, and subjecting new investment projects to economic and financial appraisal on a systematic basis. This challenging agenda would need to be implemented over a period of years.

Ninth, providing greater flexibility to line ministries in managing the resources under their control will only be possible if the additional powers apply to all resources, including personnel, which is by far the most important numerically. Currently, public service law and procedures in Cyprus are among the most rigid and inflexible in Europe, with the result that transferring human resources from one use to another, within or between ministries and agencies, is often extremely difficult. Without significant modifications to these practices, it will be difficult to achieve the full benefit of the reforms outlined above. As an important step to identifying the required changes, the government is launching, with the support of the World Bank and the U.K. government, a Public Administration Review which will review, among other issues, the public service law and evaluate the work practices and staffing levels of key functions of government, including planning, budgeting and financial management.

Finally, the changes described above will take commitment and much hard work across government to implement, and will need to be sustained over several years. They will require active leadership from the MoF and the full cooperation of line ministries and other stakeholders if they are to succeed. To ensure the necessary degree of inter-agency commitment, a PFM Reform Committee, chaired by the Permanent Secretary/Finance and including representatives of line ministries and other stakeholders, will be set up to oversee the work and monitor the implementation of the key deliverables and milestones of the strategy.