By Martin Santa
BRUSSELS (Reuters) - Cyprus has made progress with overhauling its banking sector and pushing through structural reforms but significant risks remain if the economy is to return to growth, the country's international lenders said on Wednesday.
In their first review of Cyprus's bailout programme, experts from the European Commission, the European Central Bank and the international Monetary Fund - together known as the troika - were cautiously upbeat about the steps taken by Nicosia so far, while making clear that a very tough road remains ahead.
"The short-run economic outlook remains difficult and subject to considerable uncertainty," the troika report said.
Cyprus in March became the fifth euro zone country to receive a financial aid package, securing 10 billion euros of loans ($13 billion) in return for reforms and an unprecedented one-off levy on large bank deposits.
Its once vast banking sector -- with deposits more than five times greater than its gross domestic product -- has been decimated, with one major bank, Laika, shut down and Bank of Cyprus restructured with severe losses for major depositors.
That has had a profound impact on the economy, which was heavily dependent on banking and financial services, producing a surge in unemployment and freezing lending to the small and medium sized companies that employ most workers.
The troika said it was pleased that Cyprus had taken the necessary decisive steps to stabilize the financial sector - including imposing capital controls - but said further hard work would be needed to restore economic stability.
"While the programme has been implemented with determination so far, downside risks remain substantial," it said. "Continued full and timely policy implementation is essential for the success of the programme."
Unemployment, which has tripled in the past four years to stand at more than 17 percent, is expected to go on rising in the year ahead as the reverberations from the banking sector restructuring rattle through the economy.
Growth is in freefall, with output forecast to contract by 13 percent in 2013/14, before making a marginal recovery in 2015, the report said.
Those problems combined with poor receipts from the privatisation of state assets and lack of confidence in the once-large banking system means the island faces an extended period of uncertainty before stability returns.
Capital controls, which limit transfers out of the country and withdrawals from ATM machines, are being gradually relaxed, but confidence in the financial sector is only likely to return to pre-crisis levels once they are fully removed.
Cyprus's president told Bloomberg on Wednesday the controls could be fully lifted by January.
"It's very clear and we are fully aware that the situation in Cyprus is extremely difficult." a Commission official said. "We are fully aware this is not a walk in a park, so we need to be vigilant and monitor the situation very closely."
(Reporting by Martin Santa; editing by Luke Baker)