By Michele Kambas
NICOSIA (Reuters) - The IMF said on Friday that risks for Cyprus were "unusually high" given its weak banking sector and economy and the island's full adoption of an economic austerity plan was imperative.
The island's 17.5 billion euro economy faced risks from the uncertain impact of the crisis in its banking sector and the possibility that its economic contraction could be deeper than projected, the IMF said in a staff report.
"Given substantial risks to the outlook and debt sustainability, there is no room for implementation slippages," it said.
The Fund said the impact of Cyprus's debt crisis on its economy will last longer than for other euro zone members that have had debt problems, with the exception of Greece.
The International Monetary Fund is lending Cyprus $1.3 billion for three years as part of a 10 billion euro bailout the island secured from the European Union and the IMF in March.
The Fund, in the report, said financial sector risks in Cyprus were particularly acute due to the banking sector outlook as well as the risk of capital controls being eased prematurely and the possibility that the government's resolve to implement its policy program could falter.
"Materialization of these risks could lead to a higher debt trajectory and the need for additional financing measures to ensure debt sustainability," the IMF said.
Under the bailout, Cyprus has agreed to cut its budget deficit to 2.4 percent of GDP in 2016, from an estimated 5.9 percent this year.
Cyprus, a euro zone minnow with a population of less than 1 million, has been in recession since 2011. It teetered on the brink of economic meltdown in March after its European Union partners, as a condition of the bailout, imposed losses on deposits in the island's two largest banks.
Cypriot authorities subsequently imposed capital controls, a first in the history of the euro zone, to avert a run on the island's other banks.
The island has already adopted many measures to contain spending and is due to embark on a privatization program. The IMF also notes that there is scope to cut the public sector wage bill, now accounting for 67 percent of total government expenditure, as Cypriot civil servants get paid significantly more than the EU average.
The Fund forecasts Cyprus's economy will shrink 8.7 percent this year and 3.9 percent in 2014, before seeing a modest recovery of 1.1 percent growth in 2015. But, it said the crisis was likely to have a lasting impact and hamper growth until the economy adapts its business model.
By 2020 the economy will be growing by only 1.75 percent, the IMF predicted, much lower than the 4 percent annual average of the past 30 years.
"Compared to recent crisis episodes, Cyprus's output loss is expected to be larger than most, except Greece over the long run," it said.
(Reporting By Michele Kambas; Editing by Susan Fenton)