(Reuters) - Cyprus's efforts to extricate itself from its massive debt could weigh on output for the next decade, the IMF warned on Monday, in a review in which it said the island was well on track in its economic adjustment program.
The Mediterranean island nation is following a three-year austerity program after it almost went bankrupt in March. The International Monetary Fund and the European Union have provided it with 10 billion euros in aid.
In its second progress review, the IMF said the program was on track and Cyprus's recession, although severe, was shallower than expected. A modest economic recovery in the euro zone was helping through increased trade.
The fund in early December trimmed its forecast for the island's contraction to 7.7 percent from 8.7 percent. But it stuck by its initial forecast for a cumulative economic contraction of 13 percent for the 2013-2014 period.
Years of fiscal slippage and a banking system heavily exposed to debt-crippled Greece took Cyprus to the brink of financial meltdown. Its banks chalked up massive losses on an EU-endorsed restructuring of Greek sovereign debt, to make that country's debt mountain more manageable, but exacerbating Cyprus's problems.
Cyprus shut down one insolvent bank and confiscated deposits to boost the capital buffers at another when the IMF and the EU refused to use taxpayers' money to recapitalize the lenders. It was the euro zone's first such 'bail-in' process, in which depositors were forced to help bail out their banks. The 10 billion euros in aid is mainly for fiscal purposes.
The IMF said the fall in Cyprus's gross domestic product was expected to be steeper, and the subsequent recovery slower, than in most other euro zone program countries.
That reflects the need for both households and corporates to deleverage, it said, as their combined debt stood at 280 percent of GDP at the end of 2012 - among the highest in the euro area.
"Deleveraging is expected to pose a drag on growth over the next five to ten years," it said in its report.
Cyprus says it will embark on a privatization plan for its telecoms, ports and electricity assets to raise about 1.4 billion euros by 2018. Domestic political support for some elements of the program, including selloffs, was "spluttering" the IMF said.
But it also expressed some concern about simmering tension between the Cypriot government and the governor of the island's central bank, an independent official. The Cypriot president has said publicly that he wants the central bank chief removed.
The issue was "complicating decision making" and was not conducive to a return of market confidence, the IMF said.
(Reporting By Michele Kambas; Editing by Hugh Lawson)