Cyprus
Recent Economic Developments
Author: International Monetary Fund
Publication Date:
02 Jan 1995
eISBN:
9781451809770
Language:
English
Keywords:
ISCR; CR; capital formation; liquidity ratio; central bank; fixed capital; private sector; economic activity; aggregate demand; GDP deflator; market share
Download PDF (5.6 MB)

This paper reviews economic developments in Cyprus during 1990–95. Economic growth slowed down and became more volatile in the early 1990s compared with the 1980s. External shocks, compounded by unfavorable domestic developments, kept GDP growth at unusually low levels in 1991 and 1993. Inflation, which had remained below the European Union (EU) average throughout the 1980s, edged over it since 1991. The price deceleration in 1993 and 1994 was insufficient to bring Cypriot inflation in line with falling inflation in the EU, mostly on account of the introduction of value-added tax in 1992.

Abstract

This paper reviews economic developments in Cyprus during 1990–95. Economic growth slowed down and became more volatile in the early 1990s compared with the 1980s. External shocks, compounded by unfavorable domestic developments, kept GDP growth at unusually low levels in 1991 and 1993. Inflation, which had remained below the European Union (EU) average throughout the 1980s, edged over it since 1991. The price deceleration in 1993 and 1994 was insufficient to bring Cypriot inflation in line with falling inflation in the EU, mostly on account of the introduction of value-added tax in 1992.

Cyprus: Basic Data

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Source: IFS and data provided by the authorities. ceicyp.tab

Adjusted for methodological problems related to the introduction of VAT in 1992, GDP growth is 9.4 percent, 0.4 percent, and 3.8 percent; and the GDP deflator increased by 6.0 percent, 4.5 percent and 5.1 percent respectively, in 1992, 1993, and 1994.

Percentage change over preceeding 12 months.

Actual data as of May 1994.

I. Introduction

Following a strong recovery from the effects of the Gulf war in 1992, GDP growth decelerated in 1993 to its lowest level in two decades, mainly as a result of a significant drop in tourist arrivals associated with the recession in Europe and with cost competitiveness losses. As in 1991, a fall in productivity coupled with wage increases—predetermined by wage contracts signed in the previous year and by wage indexation—led to a sharp increase in unit labor costs. This time, however, firms reacted by squeezing profits, and the government adopted a more conservative policy stance, with the fiscal deficit halved to 2.4 percent of GDP. As a result, the external current account improved dramatically, recording a surplus for the first time since 1967, and inflation fell after seven years of price acceleration.

The positive developments of 1993 are broadly envisaged to continue in 1994, and growth is projected to resume following the economic recovery in Europe. Inflation has further decelerated, the budget deficit is expected to stay close to its medium-term target, and the current account is projected to remain in surplus. However, cost competitiveness has not recovered, and profit margins and investment activity remain low.

This report provides background information for the Article IV consultation with Cyprus. Section II describes recent developments in aggregate demand, production, prices, and the labor market; section III examines fiscal developments; section IV deals with monetary developments; and section V provides details on the evolution of the balance of payments and competitiveness.

The report also contains five appendices focusing on specific economic issues. Appendix I provides medium-term scenarios illustrating the potential effects of alternative policies; Appendix II estimates a demand function for tourism and examines the role of relative prices in determining tourist arrivals; Appendix III describes the labor market institutions and evaluates the flexibility of the Cypriot labor market; Appendix IV examines the relationship between monetary aggregates and inflation; and Appendix V describes in detail the exchange and trade system.

II. Domestic Economy

Economic growth slowed down and became more volatile in the early 1990s, as compared to the 1980s (Chart 1). External shocks, compounded by unfavorable domestic developments, kept GDP growth at unusually low levels in 1991 and 1993. However, even these lower rates exceeded on average those of EU countries, fostering a continuation of Cyprus’ real convergence with the EU (Chart 2). On the other hand, inflation, which had remained below the EU average throughout the 1980s, edged over it since 1991. The price deceleration in 1993 and 1994 was insufficient to bring Cypriot inflation in line with falling inflation in the EU, mostly on account of the introduction of VAT in 1992.

CHART 1
CHART 1

CYPRUS Real GDP Growth, Tourist Arrivals and Contributions of Domestic Demand and Foreign Balance 1/

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Data provided by the authorities.1/ In 1994, data are official projections.
CHART 2
CHART 2

CYPRUS International Comparisons of Selected Economic Indicators 1/

(In percent)

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Sources: IMF, International Financial Statistics; WEO; and data provided by the authorities.1/ In 1994, data for Cyprus are official projections; data for the other countries are WEO projections.2/ Includes Greece, Portugal and Spain. The composite indicators are averages of the indicators for the individual countires weighted by the U.S. dollar value of their respective GDPs.

In the early 1990s, the labor market was characterized by a surge in unit labor costs. While the unemployment rate increased somewhat in periods of recession, real wages continued to rise leading to a sharp decline in profit margins, a decrease in domestic exports and, since 1993, lower investment. The service sector was the most dynamic, while the share of manufacturing and agriculture in GDP shrank.

1. Demand and production

Real GDP growth in 1993 is officially estimated at 1.5 percent (Table 1), the lowest growth rate since 1975 with the exception of 1991—the year of the Gulf War. 1/ This slow growth reflected a fall in both domestic and external demand which was only partially cushioned by a decline in import propensity.

Table 1.

Cyprus: Aggregate Demand

(At constant 1985 prices)

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Source: Ministry of Finance.

Both private and public consumption plunged, leading to the first decline in overall consumption since 1975. Private consumption propensity returned to its level of the late 1980s, after reaching unusually high levels in 1991 and the first half of 1992 in anticipation of the introduction of VAT (Table 2). This decline was fully accounted for by the fall in households’ imports of cars and imports of durable and semi-durable consumer goods which, for the most part, do not have domestic substitutes. The decline in public consumption is related to lower imports of defense equipment.

Table 2.

Cyprus: Aggregate Demand

(At current prices)

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Source: Ministry of Finance

Fixed capital formation fell sharply in 1993, in part reflecting the decline in profitability, and tougher enforcement of restrictions on hotel construction. Although the negative contribution of investment to domestic demand growth in 1993 is somewhat overstated by the boom of aircraft imports in 1992 (Table 3), even after adjusting for aircraft imports, real investment in 1993 was lower than in any of the preceding four years. However, the effect of the decline in gross capital formation on GDP growth was lower than its effect on domestic demand, since about 75 percent of this decline was accounted for by items that are almost exclusively imported, such as machinery and equipment, motor vehicles, and aircraft (Table 4).

Table 3.

Cyprus: Contributions to Growth of Real GDP 1/

(In percent)

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Source: Ministry of Finance.

Bulk items include aircraft purchases for Cyprus Airways valued at £C 80.8 million, £C 16.3 million, £C 48.4 million and £C 17.4 million in 1989, 1990, 1992 and 1993 respectively. Total may not equal the sum of individual components due to rounding.

Table 4.

Cyprus: Composition of Gross Fixed Capital Formation

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Source: Ministry of Finance.

Owing to the decline in investment and to the increased availability of domestic savings, the absorption of foreign-savings fell to an historical low (Chart 3). As a result, the external balance contribution to growth was positive for the first time in six years, despite a decline in exports of goods and services. 2/ Reflecting the recession in Europe and a loss of competitiveness, tourist arrivals fell from the record high reached in 1992 and domestic exports shrank for the third consecutive year.

CHART 3
CHART 3

CYPRUS Financing and Composition of Investment 1/

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Ministry of Finance, Economic Studies Division.1/ In 1994, data are official projections.2/ The sum of domestic and foreign savings may not add up to total investment due to statistical discrepancy.3/ Excluding purchases of aircrafts and ships.

Real GDP at factor cost rose by 0.4 percent in 1993, the lowest growth rate since 1975 (Table 5). Public services accounted for the largest contribution to growth, increasing their share in GDP by more than 1 percentage point (Table 6). Business sector activity (GDP excluding government services) declined by 0.2 percent, reflecting historically low growth of both the industrial sector (which contracted by 2.2 percent) and the services sector. However, despite the broad-based slowdown in activity, there were substantial differences in the performance of various sub-sectors.

Table 5.

Cyprus: Origin of Gross Domestic Product

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Source: Ministry of Finance.
Table 6.

Cyprus: Origin of Gross Domestic Product

(At current prices)

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Source: Ministry of Finance.

Agricultural production increased by 3.1 percent, following its recovery in 1992. The increase was due to a substantial expansion of livestock production, while value added in the crop sub-sector declined marginally. Favorable weather conditions facilitated record cereal production and a significant rise in grape output, but this increase was offset by a decline in citrus and olive production. The production of potatoes—the major agricultural export commodity—remained roughly unchanged.

Industrial production decreased in absolute terms for the first time in the post-invasion period, and its share in GDP continued to decline reaching 26 percent—more than 7 percentage points below its 1980 peak. Real value added in manufacturing fell by 5.2 percent, reflecting the recession in export markets and difficulties in competitiveness. Most noticeable was the 14 percent plunge of gross output in the textiles, clothing, and leather sector (Table 7), caused by a substantial reduction in external demand and tougher competition in the domestic market as a result of tariff reductions in the context of the customs union agreement with the EU. Construction activity also subsided, reflecting lower investment in tourist accommodations and stagnant investment in dwellings. The only expanding sub-sector in industry was the utilities sector, which benefitted from the completion of several infrastructure projects and rising demand for electricity.

Table 7.

Cyprus: Gross Manufacturing Output by Major Industries

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Source: Central Bank of Cyprus.

Including cottage industries.

Growth in services decelerated considerably but remained positive, despite a substantial decline in tourist arrivals (Table 8). Indeed, the financial sector expanded by 2.7 percent, driven by an increase in offshore banking activity. This expansion, while substantially lower than in the previous two years, raised the share of the financial sector in GDP for the fourth consecutive year. This development, combined with increases in the value added in transport and communications and personal services, was sufficient to offset the 6.2 percent decline in the tourism-sensitive trade, restaurants, and hotels sector.

Table 8.

Cyprus: Tourist Arrivals and Receipts

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Excluding Israel.

The decline in tourism resulted in a substantial drop in the efficiency indicators of the hotels sector, especially as a result of the continued—albeit decelerating—expansion of capacity. Occupancy rates fell from 65 percent in 1992 to 53 percent in 1993, as bed capacity increased by about 5 percent while nights spent in tourist accommodations dropped by 12 percent. Labor productivity declined even more sharply as the number of employees increased by 8.5 percent, increasing the ratio of hotel employees to tourists by almost 20 percent. Combined with high wage increases (see below), lower productivity led to a decline in profitability and to a substantial reduction in the number of beds under construction. Stricter conditions for granting hotel construction permits further constrained investment in the tourism sector.

2. Labor market

Employment declined for the first time in recent history, owing to the stagnation in economic activity (Table 9). Layoffs in manufacturing, construction, and agriculture were the major reasons for this decline, while employment in services expanded, continuing the trends in the composition of employment that emerged during the 1980s (Chart 4). Excluding foreign workers—whose numbers declined by 3 percent—employment increased marginally, but this increase was not sufficient to prevent a rise in the unemployment rate from 1.8 percent in 1992 to 2.6 percent in 1993. On a monthly basis, unemployment increased throughout the year, reaching 3.1 percent in November. The rise in unemployment was contained, however, by the slowdown in the growth of the labor force in 1993, perhaps reflecting the worsening of employment opportunities.

Table 9.

Cyprus: Labor Force and Employment by Sector

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Source: Ministry of Finance.

Includes employees of British military authorities and national guard.

In percent of the population ages 15–64 in government-controlled area.