Cyprus
Background Paper
Author:
International Monetary Fund
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Publication Date:
15 Mar 1996
eISBN:
9781451809787
Language:
English
Keywords:
ISCR; CR; Cyprus pound; liquidity ratio; balance of payments; capital formation; real wage
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This paper provides background information to the report for the 1995 Article IV Consultation with Cyprus. It reviews developments in the real, fiscal, monetary, and external sectors during the 1990s. The effects of wage indexation when the economy faces an adverse terms-of-trade shock in the context of the IMF staff’s medium-term projections are illustrated. The paper analyzes the fiscal effects of financial liberalization by estimating government revenues from financial repression and seignior age, and summarizes other countries’ experiences with financial liberalization and their implications for Cyprus.

Abstract

This paper provides background information to the report for the 1995 Article IV Consultation with Cyprus. It reviews developments in the real, fiscal, monetary, and external sectors during the 1990s. The effects of wage indexation when the economy faces an adverse terms-of-trade shock in the context of the IMF staff’s medium-term projections are illustrated. The paper analyzes the fiscal effects of financial liberalization by estimating government revenues from financial repression and seignior age, and summarizes other countries’ experiences with financial liberalization and their implications for Cyprus.

I. Introduction

Following the recovery in Europe and the attendant sharp increase in tourist arrivals, Cyprus entered a cyclical upswing in 1994-95. Full employment was maintained, while inflation continued to decline and reached EU levels in early 1995. The authorities took advantage of the economic upturn to continue the effort of consolidating the public finances that they had started in 1993, as well as to persuade the social partners to moderate wage increases. Thus, the fiscal balance improved not only due to the natural effect of the economic expansion on revenues, but also due to restrained growth in public employment and contained wage increases and defense expenditures. Wages in the economy increased at a lower pace in 1994-95 than in previous years, which helped arrest the declining trend in profitability. Monetary policy continued to be based on the exchange rate peg to the ECU. Following the reduction in interest rates coordinated by the Central Bank in early 1994, the sharp rebound of activity increased credit demand sharply--with a lag--in 1995. Banks accommodated this increase, and the credit expansion turned the current account surplus of 1993-94 into a deficit in 1995, which was reflected into a loss of gross official reserves. As this fall in reserves was from a very high initial level, it did not pose a threat to the peg.

This paper provides background information to the report for the 1995 Article IV consultation with Cyprus. It reviews recent developments in the real, fiscal, monetary, and external sectors and, to complement the policy analysis, contains four appendices on specific issues. Appendix I illustrates the effects of wage indexation when the economy faces an adverse terms of trade shock in the context of the staff’s medium-term projections. Appendix II analyzes the fiscal effects of financial liberalization by estimating government revenues from financial repression and seigniorage, and summarizes other countries’ experiences with financial liberalization and their implications for Cyprus. Appendix III examines the role of credit cooperatives in the financial system and their implications for the conduct of monetary policy. Appendix IV explores factors that may underlie the secular decline of investment in Cyprus. Finally, this paper contains the customary appendices on the exchange and trade system and on Cyprus’s financial relations with the Fund.

II. The Domestic Economy

1. Overview

During the 1990s, Cyprus continued to converge to income levels in the EU but at a slower pace than in the 1980s, partly due to adverse external shocks (Chart 1). Its macroeconomic performance continued to be good. After a peak in 1992, partly explained by the introduction of VAT, inflation fell, and reached EU levels in 1995. Inflation is now well below rates in Greece, Portugal, and Spain (Chart 2). Full employment conditions continued to prevail in the labor market, despite a rigid wage-setting system: in 1994-95, the unemployment rate was nearly constant at about 2½ percent. The growth rate of wages, however, was slower than in the early 1990s due to the social partners’ concerted effort to arrest rising unit labor costs and falling profitability.

CHART 1
CHART 1

CYPRUS International Comparisons of Selected Economic Indicators 1/

(In Percent)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Sources: IMP, International Financial Statistics; WEO; and data provided by the authorities.1/ In 1995, data for Cyprus are official estimates; 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 countries weighted by the U.S. dollar value of their respective GDPs.
CHART 2
CHART 2

CYPRUS Growth and Tourism 1/

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Data provided by the authorities.1/ In 1995, data are official estimates.2/ Share of tourism receipts in exports of goods and services.3/ Share of real value added in the sector of trade, restaurants, and hotels in real GDP (factor cost) excluding the government and other services.

2. Demand and production

The growth of real GDP slowed from 6 percent per year in the 1980s to 4½ percent in the 1990s due to a secular decline in domestic investment, as well as adverse external shocks. These reflected Cyprus’s increased openness and the growing importance of tourism: the Gulf war in 1991 and the European recession of 1993 affected tourism flows and induced downturns in economic activity. Reflecting a turnaround in Europe and the attendant large rebound in tourist arrivals in Cyprus, the economy recovered in 1994 and grew at 5.6 percent. This trend continued in 1995 with growth of 4.5 percent, as the slowdown in tourism after the rebound in 1994 was only partly offset by a surge in private consumption and a recovery of investment (Tables 1 and 2).

Table 1.

Cyprus: Aggregate Demand

(At constant 1985 prices)

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Source: Ministry of Finance.
Table 2.

Cyprus: Aggregate Demand

(At current prices)

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Source: Ministry of Finance.

The growth of real private consumption fell from an annual average of 6 percent in the 1980s to an annual average of 5½ percent in the 1990s (Table 3). Real private consumption increased by 5 percent in 1994 and it surged to 9.6 percent in 1995 owing to several factors: (i) continued favorable economic conditions that boosted consumer confidence, albeit with a lag; (ii) an expected increase in VAT rates (which, however, did not take place); (iii) the strength of the Cyprus pound against the U.S. dollar; (iv) the natural cycle of consumer durables; 1/ and (v) an accommodating credit policy. As a result of the consumption boom, the private consumption propensity increased from 70 percent in 1993 to 75 percent in 1995. After a sharp drop in 1993, public consumption also recovered somewhat in 1994 and 1995; this was mostly due to backdated salary increases to civil servants for 1992-94 paid in 1994, as well as higher defense-related expenditures in 1995.

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 48.4 million and £C 17.4 million in 1992 and 1993 respectively. Total may not equal the sum of individual components due to rounding.

Investment was sluggish during the 1990s, with average growth of less than 1 percent (Chart 3). This was in sharp contrast with annual growth rates of over 10 percent during the 1980s. This fall in investment was primarily due to the secular decline in residential investment as the post-invasion reconstruction effort was completed, as well as tighter limits on hotel construction, particularly in coastal areas, due to environmental concerns (Table 4) (for a full discussion, see Appendix IV).

CHART 3
CHART 3

CYPRUS Financing and Composition of Investment 1/

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Ministry of Finance, Economic Studies Division.1/ In 1995, data are official projections.2/ Net imports of goods and nonfactor services.
Table 4.

Cyprus: Composition of Gross Fixed Capital Formation

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Source: Ministry of Finance.

Gross capital formation fell by 4.1 percent in real terms in 1994 and increased by 3.4 percent in 1995. The increase in 1995 was the result of higher investment in dwelling, construction, and machinery reflecting credit availability and improved investors’ confidence. The increase in dwelling and construction also reflected a new special financing scheme for rural housing, a relaxation of eligibility criteria for refugees, and an expansion of the residential construction area permitted from 150m2 to 200m2. The modest overall increase in fixed investment in 1995 was not sufficient to arrest the continued decline in the share of fixed investment in GDP (from 19.9 percent in 1994 to 19.6 percent in 1995). However, an increase in inventories for a second consecutive year pushed up total investment from 22.7 percent of GDP in 1994 to 23 percent in 1995.

After being in the double digits in the first half of the 1980s, when the reconstruction effort was underway, foreign savings (defined as net imports of goods and nonfactor services) averaged 5½ percent of GDP in the last 10 years. After falling to less than 1 percent of GDP in 1993-94, foreign savings rose to 4 percent of GDP in 1995. This level of foreign savings helped finance the rise in investment, while private domestic savings were reduced as a result of the consumption boom (Chart 3).

On the supply side, real GDP at factor cost rose by 4½ percent in 1994 and 4 percent in 1995, recovering from sluggish growth in 1993 (Tables 5 and 6). The largest contribution to this growth was made by the business sector (GDP excluding government services), which expanded by 4.6 percent in 1994 and 4 percent in 1995, recovering from a fall in 1993. In contrast, the growth of public services slowed further in 1994 and 1995, reflecting the fiscal consolidation underway. Within the business sector, there were substantial differences in the performance of the various subsectors in 1995: agriculture rebounded sharply from a fall in the previous year, while growth in industry was slow, and the services sector grew at the same pace as total output.

Table 5.

Cyprus: Origin of Groas 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.

The growth of value added in agriculture declined from 6½-7 percent of GDP in the 1980s to 5.3 percent in 1995, reflecting the diminishing importance of this sector for the economy. Production was adversely affected by poor weather conditions in 1994, which affected particularly crop and fruit-tree production. As a result, total agricultural production fell by 14 percent in 1994, but recovered by 13 percent in 1995. The government has already started the effort of harmonizing agricultural policy in Cyprus with the EU’s Common Agricultural Policy (CAP). In this context, it increased in 1994-95 subsidies to certain products, such as citrus, and progressively changed the base of agricultural subsidies from production to area cultivated. It is likely that in the future, subsidies to the agricultural sector will increase further.

Industry, which is the second most important sector after services, expanded moderately in real terms in 1994-95. As with agriculture, however, this increase did not arrest the declining share of industry in GDP. Manufacturing activity, in particular, suffered a secular decline during the 1980s and 1990s, which continued in 1994-95. In the last two years, however, performance within manufacturing varied (Table 7). Traditional sectors, such as textiles and leather, declined as they suffered from growing international competition and a loss in competitiveness. Similarly, the construction sector continued to shrink because of low investment in tourist accommodations. In contrast, activity expanded in nontraditional sectors, such as chemicals and plastic products, due to stronger foreign demand.

Table 7.

Cyprus: Gross Manufacturing Output by Major Industrias

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Source: Central Bank of Cyprus.

Including cottage industries.

Activity in the services sector continued to expand in the 1990s, and the sector’s share reached over 50 percent of GDP in 1994-95. Services grew by 7½ percent in 1994 and by a moderate 4½ percent in 1995, mirroring the performance of tourism, which dominates this sector. Finance expanded rapidly reflecting, in part, the growing offshore activity in Cyprus. With a share in GDP at 16.3 percent in 1995, finance is the second largest service subsector after trade, restaurants, and hotels, whose share in that year stood at 19.4 percent.

The European economic recovery was the main impetus for the 12½ percent growth in tourist arrivals in 1994, despite the limited expansion of tourist accommodations in recent years (Table 8). Bed capacity utilization increased by 6.6 percentage points to 59.4 percent, and the rate of hotel occupancy rose by 3.8 percentage points to 63.2 percent in 1994. This has perhaps contributed to the slower growth of tourist arrivals in 1995 (4.9 percent). At the same time, as labor shortages in the sector accelerated wage growth but, due to tougher competition from other countries, prices were not raised, profitability in tourism declined in 1994-95.

Table 8.

Cyprus: Tourist Arrivals and Receipts

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Source: Cyprus Tourism Organisation.

Excluding Israel.

3. Labor market

The salient feature of Cyprus’s labor market is the chronic labor shortage: employment has followed broadly the growth of the labor force, and there has been little variation in the unemployment rate over time (Table 9). The growth rate of the labor force slowed from an average 2.6 percent per year during the 1980s to 1.6 percent in the 1990s. The growth of employment also fell from 3.2 percent in the 1980s to 2 percent in the 1990s. Consequently, unemployment declined from a 3 percent average in the 1980s to 2½ percent in the 1990s. During the 1994-95 upturn, the labor force and employment rose in tandem, leaving the unemployment rate stable at 2.6-2.7 percent. The services sector continued to absorb an increasing share of total employment, which reached almost 60 percent in 1995, at the expense of agriculture and industry (Chart 4). In particular, the share of employment in tourism-related activities increased from one-fifth of the total in the 1980s to one fourth in the 1990s. After agreement with the social partners, the government allowed a significant increase in the number of foreign workers in 1994: the share of foreign workers in total employment thus reached 6.3 in 1994. About one-fourth of them were employed in offshore companies, another fourth were employed as housekeepers, and the rest mostly in hotels and restaurants.

Table 9.

Cyprus: Labor Force and Employment by Sector

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Source: Ministry of Finance.

Includes employees of British military authorities and the national guard.

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

CHART 4
CHART 4

CYPRUS Composition of Employment and Profitability 1/

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Sources: IMF, International Financial Statistics; and staff calculations.1/ In 1995, data are official projections.2/ Includes transport, trade and hotels, and finance and insurance.3/ Includes manufacturing, construction, and utilities.4/ Includes community, social, and personal services.5/ Ratio of GDP deflator at factor cost (excluding government services) to economy-wide unit labor cost.

The conditions of full employment described above are to a large extent associated with the institutional flexibility of Cyprus’s labor market: there are few hiring and firing restrictions, minimum wages are not binding, and the duration of unemployment benefits is short and the amount is low. Legislation is relatively limited, covering essentially the right of workers and employers to form associations, to bargain collectively, and to strike. 1/ Furthermore, the high degree of centralization (80 percent of all workers belong to unions and most employers to industrial associations) facilitates consensus-building and the enforcement of decisions on labor issues.

Despite these flexible aspects of the labor market, the wage determination system is relatively rigid. The system currently separates between the cost of living allowance (COLA), which is not subject to negotiation, and additional wage increases. The COLA provides full backward-looking indexation of wages to the CPI, and adjustments are made twice a year. Additional wage increases are negotiated at the industry level, and the duration of contracts is 2-3 years. This system has led to real wage increases even in the face of negative output (and therefore productivity) shocks, such as those of 1991 and 1993, with an attendant fall in profit margins. A break in this trend occurred in 1994-95, when average real wages increased by 3.3 percent per year, in contrast to an average of 4.2 percent in 1990-93 (Table 10). The slower real wage growth of 1994-95 was the result of tripartite negotiations under pressure from the government to arrest the decline in profitability and cost competitiveness. Negotiations in 1995 formalized the link between wage increases (in excess of COLA) and productivity growth. Indeed, for wage increases in 1995-97, the social partners agreed to be bound by a benchmark productivity growth of 3.2 percent per year, which was computed as the average of productivity growth in the previous three years. Furthermore, unions, employers, and the government started in April 1995 negotiating a broader reform of the wage bargaining process. These negotiations have two parts: one that reviews the current COLA system with a view to reducing the degree and coverage of indexation; and one that reviews the possibility of a link between wage increases and productivity growth. At the time of the discussions, the negotiations had not yet yielded an agreement.

Table 10.

Cyprus: Wage and Productivity Indicators

(Percentage change over previous year)

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Source: Ministry of Finance.

Including basic wages or salaries, coat of living and other allowances bonuses, gratuities, and payments in kind. Data exclude overtime payments and are gross of income tax and social security deductions.

Total gross weekly earnings, including overtime.

Based on average earnings.

Deflated by the GDP deflator.

Deflated by the manufacturing deflator.

The moderation of wage awards combined with the cyclical increase in productivity in 1994-95 had an important impact on unit labor costs (ULC). On average, ULC increased by 4½ percent in 1994-95, down from an average 6.8 percent in the previous four years. The decline was most pronounced in 1994 due to both larger productivity gains and lower real wage increases than in 1995. This improvement in cost conditions arrested a declining trend in profitability, which in turn reflected the fact that in Cyprus, the fixed exchange rate regime and large tradeable sector prevent the pass-through of cost increases onto prices.

4. Prices

In 1993, the upward trend in inflation since 1986 was reversed. This decline was continued in 1994 and, by 1995, the inflation rate had reached the average EU level, despite the expansion in aggregate demand and the full-year impact of the 1993 VAT increase: inflation declined from 4.9 percent in 1993 to 4.7 percent in 1994 and a projected 3.1 percent in 1995 (Table 11). Based on data through September, however, it is possible that inflation in 1995 may be around 2.7 percent, well below current official projections. Wage moderation and exchange rate stability were the main factors behind the fall in inflation in 1994 and 1995. The pattern of the reduction in these two years, however, was influenced by two special factors. The pass-through to prices of an increase in the VAT rate in October 1993, and bad weather conditions that pushed up the prices of locally produced agricultural goods in the last three months of the year kept inflation relatively high in 1994. In turn, the unwinding of these effects helped reduce inflation rapidly in 1995.

Table 11.

Cyprus: price Indices

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Source: Ministry of Finance.

Averages for January-September over the same period in 1994.

Components may not sum to totals due to rounding.

The GDP deflator increased by 4.1 percent in 1994 and 3.2 percent in 1995 (Table 12). Bad weather conditions had a sharp impact on the agricultural sector deflator, which increased by 13 percent in 1994. Export prices rose in line with the GDP deflator in 1994 and below it in 1995, reflecting the competitive environment in export markets. The import deflator increased rapidly in 1994 reflecting inflation in partner countries, and fell in 1995 mainly due to the appreciation of the Cyprus pound vis-à-vis the U.S. dollar.

Table 12.

Cyprus: Implicit Deflators

(Annual percentage changes)

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Source: Ministry of Finance.

The government has gradually reduced the number of price controls in recent years. After the elimination of controls on 20 products in April 1994, there are currently 41 products remaining on the price control list; however, many of these controls are not binding. The government is considering lifting controls on 20 additional products, which are mostly agricultural and include sugar, rice, beans, and coffee. Thereafter, products that would remain on the list would include only utilities, such as electricity, water, and transportation, where more complex regulatory issues would need to be addressed before price controls could be lifted. There are no rent controls, except those that are applied to commercial and residential establishments built before, 1983. For those establishments, the law allows rents to be adjusted by up to a maximum of 14 percent per year.

III. Public Finances

1. General trends

During the 1990s, the deficit-to-GDP ratio of the consolidated central government averaged 3.9 percent, about the same level as in the second half of the 1980s, but revenues and expenditures both increased by 3 percentage points of GDP. 1/ Behind this average, however, fiscal performance in the 1990s has varied significantly (Table 13 and Chart 5). Specifically, after relatively large deficits in 1990-92, the public finances improved markedly in 1993-95, reflecting the new government’s fiscal adjustment effort, which is aimed at containing the deficit at or below 3 percent of GDP (the Maastricht target). The deficit shrank from 5.7 percent of GDP in 1990-92 to 1.5 percent in 1994, the lowest deficit since 1971 (Table 14). In 1995, official estimates at the time of the discussions, based on data for the first semester, showed the deficit rising to 2.7 percent. However, data for the third quarter suggest that the final outcome would be at the 2-2½ percent of GDP range, on account of buoyant revenues and continued delays in realizing development and defense expenditures, The sharp improvement in the public finances in 1994 was mostly the result of an increase in revenues of the Ordinary Budget. The partial reversal of 1995, instead, is the result of increased expenditures on defense, investment, and transfers to displaced persons, despite continued buoyancy of revenues and surpluses in the Social Insurance Funds (Table 15).

Table 13.

Cyprus: Consolidated Central Government Budget

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Official estimate at the time of the discussions. Does not reflect data for the third quarter released subsequently.

Euro-commercial paper.

CHART 5
CHART 5

CYPRUS Consolidated Central Government Finances 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Ministry of Finance.1/ Inclusive of all defense related expenditure after 1987. 1995 figures are official estimates.2/ Excluding inter-governmental debt.* Indicates break in the series.
Table 14.

Cyprus: Consolidated Central Government Budget

(In percent of GDP)

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Source: Ministry of Finance.

Official estimate at the time of the discussions. Does not reflect data for the third quarter released subsequently.

Table 15.

Cyprus: Consolidation of Central Government Budgets

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Official estimate at the time of the discussiens. Does not reflect data for the third quarter released subsequently.

2. The Ordinary Budget

The upward trend in revenues during the 1980s and early 1990s steepened in 1994 and 1995 (Table 16): in these two years, Ordinary Budget revenues rose by over 2 percentage points to 22 percent of GDP. This increase was due to three main factors: first, growth accelerated, affecting particularly direct taxes; income taxes rose by almost 1 percentage point to 7 percent of GDP in 1995; second, the VAT standard rate was raised in October 1993 from 5 percent to 8 percent, pushing VAT revenues to about 5 percent of GDP in 1995; and third, tax administration improved, due to the increased collection efficiency and cross-checking resulting from the introduction of the VAT in 1992. At the same time, there was a substantial redistribution of revenues from different sources within the Ordinary Budget. The trend increase in the ratios of direct taxes and VAT to GDP, which deepened in 1994-95, was accompanied by a decline in revenues from import duties and other taxes on goods and services. The fall in revenues from import duties was the consequence of the implementation of the Customs Union Agreement with the EU. The fall in revenues from selective excise taxes, which was not as pronounced, represented a natural substitution away from this form of taxation toward VAT.

Table 16.

Cyprus: Central Government Ordinary Budget

(In million of Cyprus pound)

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Source: Ministry of Finance.

Official estimate at the time of the discussions. Does not reflect data for the third quarter released subsequently.

Expenditures of the Ordinary Budget were also on a rising trend during the 1990s, increasing by some 3 percentage points of GDP between 1990 and 1995. Most recently, however, the growth in expenditures was contained, reflecting the policy to check the growth of wages and salaries, which take up almost half of total Ordinary Budget expenditures. This policy encountered a serious obstacle in 1994, when the government had to honor retroactive pay increases for 1992-94 awarded by the previous government prior to the October 1993 elections, which enlarged the wage bill by 15 percent. To offset the impact on the budget, the government imposed a real wage freeze for 1995-97 for permanent employees (who are about 70 percent of the civil service), and reduced public employment growth from 3.2 percent per year in 1991-93 to around one percent in 1994-95. Further, in 1995 the government froze new entry positions and initiated a public sector reform, whose main objectives are to increase productivity and arrest the increasing trend of public employment (see below). These measures, and the real wage freeze in place, 1/ are projected to reduce the growth of expenditures on wages and salaries in 1995 to 5.2 percent, below nominal GDP growth.

In contrast to the progress in containing wage expenditures, transfers rose sharply--by almost 50 percent--in 1994-95, to reach almost 18 percent of total expenditures. Transfers increased due to two main factors. First, pension expenditures of the civil service rose significantly. The civil service pension system is generous (with pensions equivalent to three-fourths of the salary of the last year worked), and recent incentives for early retirement have adversely impacted the system’s costs. Second, the government transferred £C 14 million to the Cyprus Tourism Organization (CTO) in compensation for the abolition of a hotel tax that financed the CTO until 1993. Interest payments also increased in 1994-95 to reach 23 percent of total expenditures, mostly as a result of the growing share of long-term debt. But as these growing expenditures were more than offset by larger revenues, the Ordinary Budget surplus doubled from 0.7 percent of GDP in 1993 to 1.4 percent in 1994 and 1.5 percent in 1995.

3. The rest of the central government

Expenditures of the Development Budget were maintained at 3½ percent of GDP in 1994, but were projected to rise to 3.9 percent in 1995 due to the allocation of £C 17 billion for land expropriation to carry out public projects (Table 17). Such expenditures had not been made in the first ten months of the year and they could be delayed until 1996, in which case the 1995 outcome would be better than projected. Over two-thirds of the Development Budget spending is directed to roads, water, and rural development.

Table 17.

Cyprus: Central Government Development Budget

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Official estimates at the time of the discussions. Does not reflect data for the third quarter released subsequently.

The Social Insurance Funds maintained their overall surplus of around l½ percent of GDP in 1994-95 (Table 18). Despite the deceleration of wage increases, revenues from contributions rose in proportion to GDP due to the favorable impact of the economic cycle on employment. Moreover, the steady rise in interest earned on the Funds’ assets continued. Expenditures rose at a similar pace to revenues, after the reduction in the retirement age for men from 65 to 63 years in January 1993. There were no other policy changes affecting pensions or other benefits provided by the Funds, but the government instituted the “social pension”, which is paid out of general revenues. The social pension is for people 68 years of age or older with no other source of income, and it is equivalent to the minimum pension. The annual cost of this program is estimated at around £C 19 million (½ percent of GDP), although the cost in the Ordinary Budget in 1995 was much lower because the program became effective in June.

Table 18.

Cyprus: Social Insurance Funds 1/

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Includes the Social Insurance Fund, Unemployment Benefit Account, Central Holiday Fund, and the Redundancy Fund.

Official estimate at the time of the discussions. Does not reflect data for the third quarter released subsequently.

The finances of the Defense Fund remained balanced in 1994, as in 1993, but shifted to a deficit of £C 27 million (0.7 percent of GDP) in 1995 (Table 19). After having been compressed for two years due to the postponement of certain bulky outlays, defense expenditures are set to rise by almost 50 percent in 1995, to 3.4 percent of GDP; this level would still be some 2 percentage points of GDP below the 1990 level. Data for the first semester of 1995, however, did not show a significant increase over 1994. Further delays in defense expenditures may contribute to reducing the consolidated central government budget deficit in 1995 below current projections.

Table 19.

Cyprus: Defence Fund

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Official estimate at the time of the discussions. Does not reflect data for the third quarter released subsequently.

Finally, with regard to the other components of the central government, the deficit of the Relief Fund for Displaced Persons continued to rise, from negligible amounts in 1990-92 to 0.8 percent of GDP in 1994 and, further, to 1.1 percent of GDP in 1995 (Table 20). This was the result of declining revenues from the temporary refugee levy on imports, which fell in line with other import duties; as well as increased expenditures due to the relaxation of the eligibility criterion in 1994. The composition of expenditures changed in 1994, when capital transfers increased and net lending fell because the government decided to grant as transfers support to refugees formerly given as housing loans. Finally, the Public Loans Fund registered small surpluses (£C 1.4 million) in 1994-95 (Table 21).

Table 20.

Cyprus: Accounts of Relief Fund for Displaced Persons

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Official estimate at the time of the discussions. Does not reflect data for the third quarter released subsequently.

Table 21.

Cyprus: Public Loans Fund

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Official estimate at the time of the discussions. Does not reflect data for the third quarter released subsequently.

4. Financing of the fiscal deficit and debt

Following the practice of the last few years, the government in 1994-95 relied entirely on domestic sources to finance its deficit, while reducing exposure to foreign debt. However, there were important variations in the sources of domestic funding during the last two years. In 1994, most of the domestic financing was from the non-bank public, while in 1995 the main source was the Central Bank. The financing policy of 1994 was the reflection of the government’s attempt to lengthen the maturity structure of its debt by issuing Development Stock (long-term bonds) while, in contrast, short-term borrowing from the Central Bank was less than 0.1 percent of GDP. The size of Central Bank lending facilities to the government are subject to ceilings prescribed by law. In late 1994, the ceiling on direct advances was reduced by 2½ percent to 40 percent of estimated ordinary revenues; the ceiling on development stock holdings by the Central Bank was reduced by 7½ percent to 30 percent of the Central Bank’s total sight liabilities; and the ceiling on treasury bill holdings was reduced by 2½ percent to 45 percent of ordinary revenues. While keeping well within these limits, as in recent years, borrowing from the Central Bank increased sharply in 1995 due to the larger deficit and a fall in non-bank financing. In addition, delays in obtaining Parliament’s approval for external borrowing hindered the government’s plan to borrow long-term in foreign markets, leading to larger net external repayments in 1995 than in 1994.

Public debt increased consistently during the 1980s and 1990s. Indeed, the average debt-to-GDP ratio for the first half of the 1980s stood at 35 percent, while the average for the 1990s was 55 percent. During the 1990s, public debt rose steeply to a peak of 59 percent of GDP in 1993, but fiscal consolidation allowed a reversal of this trend in 1994 and 1995, with public debt falling to 55 percent of GDP in 1994 and remaining at that level in 1995, well below the Maastricht criterion which the government has adopted as a target (Table 22). 1/ 2/ Regarding the composition of the debt, as a result of the government’s efforts to reduce external debt, the share of external debt to GDP fell to 12.2 percent in 1995, less than half of its level in 1991. Regarding the maturity of the debt, domestic debt is mostly short-term, mainly in the form of Treasury bills (Table 23). In contrast, external debt is mostly long-term, despite the government’s net drawings from the Eurocommercial paper (ECP) market in 1994. In addition to debt directly owed by the government, there were some £C 300 million of government guarantees on external debt in 1995. Almost all of these were for debt of semi-government organizations, including Cyprus Airways, with 30 percent of the outstanding guarantees. No government debt guarantees have been called in recent years, and none of the outstanding guarantees are expected to be called in the foreseeable future.

Table 22.

Cyprus: Government and Government-Guaranteed Net Debt 1/

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Source: Ministry of Finance.

Excludes intragovernmental debt.

Excludes short-term liabilities of the Central Bank.

Table 23.

Cyprus: Total Gross Public Debt by Instrument and Lender 1/

(In million of Cyprus pounds)

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Source: Ministry of Finance.

Includes intragovernmental debt and short-term liabilities of the Central Bank.

Intragovernmental debt.

5. Policies for 1996

The government maintains its commitment to keeping the budget deficit at or below 3 percent of GDP and the debt-to-GDP ratio within the Maastricht limit of 60 percent of GDP. The main policies to attain these fiscal objectives in the medium term are tax harmonization with the EU, public sector reform, and continued restraint on defense expenditures.

The 1996 budget envisages an increase in the deficit to 4.1 percent of GDP. Budgetary procedures in Cyprus, however, contain conservative revenue projections, and overestimate expenditures. Fiscal outcomes in 1994 and 1995 were 2 to 2½ percentage points of GDP better than the original budget targets. The 1995 budget contains no new taxes and, against the background of a projected nominal GDP growth of 7.3 percent, it envisages: (i) an increase in expenditures on wages and salaries of almost 12 percent, due mainly to the legal obligation to budget for vacant posts; (ii) a 15 percent increase in capital expenditures, assuming full implementation of investment projects while, in recent years, the implementation rate of the development budget has been 75-80 percent; and (iii) a 23 percent rise in expenditures on goods and services, which are traditionally overestimated, because they include maintenance costs of development projects expected to be completed. Correcting for these factors, and assuming that the policies of hiring restraint and real wage freeze remain broadly in place, the staff has estimated that the 1996 deficit would remain at its 1995 level.

There are several additional policy initiatives that are not included in the 1996 budget. First, the government has announced measures to reduce income taxation, stimulate industry, and harmonize Cyprus’ agricultural policies with those of the EU. Specific measures include the provision of income tax relief; the elimination of double taxation of dividends; grants and subsidized loans for industries to upgrade, restructure and invest; and increased subsidies on grains and citrus products. Although the budgetary impact of these measure depends, inter alia, on their precise form and timing, their cost could reach up to 1 percent of GDP. Second, a further important policy change planned for 1996 is the auctioning of Treasury bills starting in January and, later in the year, the auctioning of longer-term government paper. This change will facilitate the phased reduction of Central Bank financing of the government. Finally, the government intends to accelerate the implementation of its public sector reform plan, initiated in 1995. The plan covers the central government, and aims at enhancing efficiency, improving the level of services, and reducing staff. Among other measures, the plan envisages rapid computerization, limiting and eventually abolishing unfilled vacant posts, increased staff mobility and training, and redefining the areas of labor relations in the civil service that are subject to negotiations with the public sector unions. There is a detailed action plan and timetable, and the government intends to have completed the first major steps of the plan by early 1997. In the government’s view, this will allow some savings already in 1996.

IV. Money and Credit

1. Overview

Cyprus’s financial system has traditionally been constrained by a wide array of controls: there is a statutory 9 percent ceiling on all lending interest rates, deposit rates are subject to guidelines, and the yield on government paper is set administratively. Controls on various capital account transactions have been relaxed somewhat recently, but domestic interest rates remain sheltered from external pressures. In this context, the Central Bank of Cyprus (CBC) has relied on the liquidity ratio as the main instrument of monetary policy, although it has occasionally resorted to direct bank-by-bank credit controls for brief periods of time (most recently in 1992). However, the credibility and effectiveness of the liquidity ratio has been compromised by the non-enforcement of penalties on violating banks.

Because the framework described above is inconsistent with EU membership, the authorities have started a gradual process of financial liberalization. Beginning in 1996, together with the planned introduction of auctions of government paper, the CBC, is to modify substantially the instruments of monetary policy (see below). These measures will be taken--at least initially--in the presence of the 9 percent ceiling on interest rates.

2. Monetary policy in 1994 and 1995

In late 1993, while the economy was still in recession, the CBC sought a moderate reduction in domestic interest rates. In addition to adjusting to the cycle, the interest rate reduction was considered a first step toward greater interest rate flexibility which, in turn, would garner political support for eventually removing the interest ceiling. To this end, despite the fact that banks had excess liquidity, the CBC decided to leave the liquidity ratio for 1994 unchanged at its historically low 1993 level (an average of 27 percent for the year as a whole).

In the event, due to the interest rate rigidity in the system, the substantial excess bank liquidity did not bring about the expected reduction in rates in early, 1994. 1/ Thus, on May 1 the CBC took on a more active role and coordinated a reduction in interest rates: banks and cooperatives would not pay more than 7 percent on deposits, 2/ and maximum loan rates would come down on September 1 from 9 percent to no more than 8.5 percent. As consumption and investment growth continued to be sluggish in 1994 despite the economic recovery, this reduction in interest rates was not followed by a perceptible increase in credit demand. Overall, the targets set in the monetary program were broadly met: at 13½ percent, private sector credit growth was only slightly above the target, while total domestic credit and M2 growth (8.1 percent and 12.2 percent, respectively), were below target (Table 24). Moreover, at end-1994 bank liquidity was still above the liquidity ratio (Tables 25 and 26).

Table 24.

Cyprus: Targets and Outturns for Monetary and Credit Aggregates

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Source: Central Bank of Cyprus.

In calculating growth rates and ratios for 1991, data for Lombard Natwest Bank Ltd. at the end of 1990 were included in the category of DMBs.

Adjusted for government foreign borrowing.

Table 25.

Cyprus: Liquidity of All Banks

(Period average)

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Source: Central Bank of Cyprus.

Includes cash, Central Bank balances, and treasury bills.

Includes foreign currency checks, bills, and net short-term balances with foreign banks.

Excluding “special deposits”.

Excluding compulsory contributions to the Fund for Financing Priority Projects.

Table 26.

Cyprus: Liquidity of All Banks

(End of period)

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Source: Central Bank of Cyprus.

Includes cash, central bank balances, and domestic treasury bills.

Includes foreign currency checks, bills, and net short-term balances with foreign banks.

Excluding “special deposits.”

Excluding compulsory contributions to the Fund for financing priority projects.

In setting the liquidity ratio for 1995, although the CBC acknowledged the increasing risks of a rapid expansion in credit demand for its monetary program, it considered the current level of domestic interest rates to be broadly appropriate for the economic conditions at the time, especially given the declining inflation rate and the level of interest rates abroad. Thus, the CBC left the liquidity ratio unchanged from 1994.

The lagged surge in private consumption and imports in 1995, which banks accommodated by running down their excess liquidity, generated credit growth rates well above those in the CBC’s projections: private sector credit grew by 17 percent in the 12 months to June, against an original end-year target of 11 percent. Personal loans and domestic and foreign trade-related credit explained about two-thirds of this increase in private sector credit (Table 27).

Table 27.

Cyprus: Credit by Deposit Money Banks to the private Sector

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Source: Central Bank of Cyprus, Annual Report, various issues

January-June, 1995.

In these circumstances, forcing banks to observe the original 11 percent credit target for the year as a whole would have implied a serious credit crunch during the second half of 1995. Hence, the CBC revised upwards the end-year credit target to.14 percent in September, but warned banks that if they did not observe the new target they would be forced to pay penalties on their liquidity shortfalls. 1/ This measure had some effect: during the fourth quarter, credit expansion slowed down (from an annualized rate of over 20 percent at end-September to about 18 percent at mid-November), and banks struggled to raise the needed funds to meet the liquidity ratio.

As in 1992, when credit to the private sector surged driven by a large increase in personal and trade-related loans, the rapid expansion of credit in 1995 leaked almost entirely through the current account of the balance of payments, leading to a fall in the banking system’s net foreign assets in the first half of the year (Chart 6); this fall was partially reversed in subsequent months. Unlike in the previous episode, however, the fall in official reserves exceeded the fall in net foreign assets of the banking system, reflecting a shift of foreign assets from the Central Bank to commercial banks (Tables 28 and 29).

CHART 6
CHART 6

CYPRUS Banking System: Domestic Credit and Foreign Assets

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Data provided by the authorities.1/ Data for 1995 are through September.2/ Data for 1995 are official projections.
Table 28.

Cyprus: Monetary Survey

(In millions of Cyprus pounds: end of period)

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Source: Central Bank of Cyprus.

As from 1991 Lombard Natwest Bank Ltd. is classified as a D.M.B.

Includes holdings of SDRs, government holdings of foreign exchange, and reserve position in the IMF.

Nominal GDP/average of money stock at beginning and end of year.

Data exclude the operations of the Cooperative Central Bank, which is included in the monetary survey.

Table 29.

Cyprus: Reserve Money

(In billion of Cyprus pounds: end of period)

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Source: Central Bank of Cyprus.

Includes holdings of SDRs, but excludes government holdings of foreign exchange end reserve position in the IMF.

Includes a small amount of government securities.

Includes credit extended to banks by the Fund for Financing of Priority Projects.

3. Prospects for 1996

In 1996, the CBC expects output and consumption growth to slow down. Lower consumption growth would not only be cyclical, but also the result of the lapsing of the one-time factors that increased consumption in 1995, such as expectations of a VAT rate hike and the natural cycle in the consumption of durable goods (see Chapter II). Thus, given also that banks’ excess reserves are now depleted, the CBC expects credit growth to slow down considerably in 1996 relative to 1995. On this basis, and given the continuing deceleration of inflation and low levels of international interest rates, the CBC considers the current level of interest rates to be broadly appropriate for 1996.

At an operational level, the CBC plans to continue announcing guidelines for M2 and private sector credit growth but, beginning on January 1, to introduce a new set of instruments of monetary policy (see box).

New Instruments of Monetary Policy

  • Abolition of the liquidity ratio.

  • Reduction of the reserve requirement ratio to 7 percent, to be met only with cash deposits at the CBC. A two-week averaging period will be used, and banks will be given up to one week to meet the reserve requirements.

  • Unification of all bank accounts at the Central Bank into a single operational account; deposits to meet reserve requirements would be remunerated at 6 percent, while the excess balances in this account would not be remunerated.

  • Creation of a Lombard facility at a fixed rate (to be set approximately equal to the highest rate currently prevailing in the interbank market), to be used only in connection with government paper auctioned in the primary market; banks would have automatic access to this facility but would be subject to individual borrowing limits equivalent to 1 percent of their deposits.

  • Auctions of repos and reverse repos by the CBC in the interbank market to regulate monetary conditions; repos would be done only with auctioned T-bills.

  • Finally, as a transitional measure for 1996 only, the CBC would offer a special deposit facility remunerated at a fixed interest rate (5 percent).

To prevent a substantial increase in liquidity as a result of the introduction of new instruments of monetary policy (in particular, the abolition of the liquidity ratio and reduction of the reserve requirement ratio), the CBC intends to freeze bank liquidity in an amount equivalent to 20 percent of the 1995 average of bank deposits, and to keep it in the form of 3-month Treasury bills. These Treasury bills would be automatically renewed upon maturity, and would be gradually unfrozen (in equal fractions) during a five-year period. These special Treasury bills would also be accepted in. interbank repo transactions for a transitional 5-6 month period.

The freezing of 20 percent of deposits in the form of Treasury bills would require a net increase in bank holdings of government paper of about 3 percent of deposits (some 2½ percent of GDP); this is because at the end of 1995, commercial banks will be subject to a 29 percent liquidity requirement, of which only 17 percent would be in government paper. The proceeds from this purchase will be transferred to the government.

4. Other issues

a. The banking system

The quality of banks’ portfolios in Cyprus continued to be good. The percentage of “doubtful” or “sub-standard” credits in the portfolio of Cypriot banks remained unchanged in 1994 relative to 1993 at just over 4 percent of total loans. 1/ Bank provisions, however, also increased in 1994 from very low levels in 1993, and are now at a level that the CBC considers fully adequate for covering against bad loans. More specifically, provisions in the last three years were as follows:

Banks’ Provisions: 1992-94

As a percentage of:

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As regards the financial sector regulatory framework, three important changes were introduced recently: (i) relaxation of regulations on the use of foreign exchange deposits by banks: since mid-1994, banks are no longer required to hold 100 percent of their foreign exchange deposits in liquid assets (usually bonds purchased abroad); they can now lend (domestically or abroad) up to 40 percent of these deposits; (ii) liberalization of banks’ foreign exchange working balances: banks are now free to allocate the totality of their foreign exchange working balances (subject to the rule on foreign exchange deposits above), whereas previously they were required to deposit 40 percent of those balances at “premium banks” abroad; branches of foreign banks operating in Cyprus, however, are still subject to the old requirement, but this is considered a prudential measure against foreign exchange exposure; and (iii) liberalization of rules governing off-shore banks: off-shore banks are now allowed to use (lend) domestically deposits of non-resident aliens (e.g., British military personnel) as well as Cypriot repatriates; 2/ also, repatriates are allowed to retain in foreign exchange their earnings abroad.

b. The draft banking law

The purpose of the draft banking law is to unify various pieces of legislation that regulate financial activities, and to harmonize Cyprus’s legislation with that in the EU. The draft law is currently with the Minister of Finance and, after approval by the Council of Ministers, it is to be submitted to the House of Representatives.

Once passed, the draft banking law would eliminate the possibility that non-licensed banks raise deposits, 1/ and would extend regulations to nonbank financial services (e.g., insurance). The law would also create a deposit insurance scheme, leaving the specifics of coverage and financing of the scheme to be defined later. 2/

The draft law enhances the ability of the CBC to control banks vis-à-vis the current legislation, which provides only for the closure of a bank in case of violation of the law. It also includes general provisions authorizing the CBC to advise banks, prevent the taking of deposits, prevent the extension of credit, take over a bank, or revoke a license. However, the law does not introduce any changes to existing prudential regulations. The changes that will be needed in order to adapt these to a financially liberalized environment are being currently studied by the CBC in consultation with commercial banks.

The draft banking law is largely based on the EU’s First and Second Banking Directives. However, two differences with those Directives remain:

  • The draft law has retained the concept of “economic need” as one of the criteria for licensing new banks. In practice, this allows the CBC to limit the number of banks in operation. In the CBC’s view, the current number of banks is broadly appropriate and, in the absence of any reciprocity agreements with other countries, there would be few benefits stemming from allowing more foreign banks to operate domestically.

  • The draft law does not contain the “four eye” principle, which establishes that at least two persons should be in charge of activities such as management, control, and direction of a bank.

c. Cooperative credit institutions

For the first time in several years, the share of cooperative societies’ loans in the loan market declined in 1995, due to the fast expansion of commercial bank credit to the private sector. Through June 1995, the 12-month growth rate of credit extended by cooperatives reached 15.4 percent, compared with 16.6 percent for commercial banks (Chart 7). Nevertheless, the sector’s share in total deposits increased somewhat.

CHART 7
CHART 7

CYPRUS The Credit Cooperative Sector

(In percent)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Department of Cooperative Development; and Central Bank of Cyprus.1/ Data for June.

There were no changes in the regulatory framework of cooperatives in 1994-95. However, as in the past, there were substantial liquidity shortfalls in relation to the guideline prescribed by the Commissioner of Credit Cooperatives. In July 1995, the cooperative sector as a whole had an average liquidity ratio of 18.7 percent, against the prescribed 25 percent.

Appendix III contains a description of the cooperative societies’ activities, their regulatory and supervisory environment, as well as their role in the conduct of monetary policy.

V. The External Sector

1. Overview

The overall balance of payments had a £C 63 million surplus (about 14 percent of GDP) in 1994 and an estimated deficit of a similar magnitude in 1995 (Chart 8). The 1994 outcome resulted from surpluses in both the current and the capital account. The capital account surplus was maintained in 1995, but the current account switched into a deficit estimated at 2.4 percent of GDP. Two main events determined the sharp swing in the current account: first, after a strong rebound in 1994, tourism receipts increased only moderately in 1995; and second, private consumption and imports boomed in 1995, partly aided by the excess liquidity in the money market. Fiscal consolidation in 1994-95 also affected the balance of payments by reducing external public indebtedness. The peg of the Cyprus pound to the ECU remained constant, inducing a small real effective appreciation of the pound. Finally, there were several regulatory changes that eased access to foreign exchange for travel and investment abroad.

CHART 8
CHART 8

CYPRUS Balance of Payments 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Central Bank of Cyprus.1/ Data for 1995 are official estimates.2/ Excluding errors and omissions.3/ Changes in the net foreign asset position of commercial banks are included below the line.* Indicates break in the series

2. Exchange rate developments and competitiveness

Since June 1992, the Cyprus pound has been pegged to the ECU at a fixed rate with a small margin of fluctuation. 1/ There was little use of the margin during 1994-95 (Table 31). Despite the currency turbulence in international markets in early 1994, the fluctuations of the Cyprus pound vis-à-vis the currencies of major European trading partners were narrower than in 1993 (Chart 9). Wider exchange rate fluctuations occurred again in the first three quarters of 1995, reflecting the depreciations of the U.S. dollar and the Italian lira. The pound depreciated marginally against the DM, but appreciated against all other major European currencies. In nominal effective terms, the Cyprus pound appreciated by 5.6 percent during 1994 and 4.4 percent during the first three quarters of 1995.

Table 30.

Cyprus: Selected Interest Rates

(In percent per annum)

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Source: Central Bank of Cyprus.

Beginning in April 1992 a rate of 8 percent is paid on the top 2 percent of the minimum reserve requirements.

7.5-8.0 percent during January-May; 7.25-7.5 percent during June-December.

Applies to balances of up to £C 15,000.

Applies to balances of up to £C 5,000 which requires seven days’ notice for withdrawal.

Applies to balances over £C 50,000 deposited for one year or more.

As from September 1, 1994.

As from May 1, 1994.

Table 31.

Cyprus: Nominal and Real Exchange Rate Indices

(1985-100)

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Source: IMF, International Financial Statistics.

INS trade weights, excluding Brazil.

CHART 9
CHART 9

CYPRUS Exchange Rate Developments 1/

(1984=100)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: IMF, International Financial Statistics.1/ In 1995, data are averages for January - September.2/ Using IFS trade weights, excluding Brazil.

Relative unit labor costs increased in 1994 and 1995, in line with the trends recorded since 1991. The ULC-based real effective exchange rate (REER) increased by a cumulative 19 percent between 1990 and 1995. On average, the pace of real appreciation was the same in 1994-95--around 3.6 percent per year--as in 1991-93 (Chart 10). Under the fixed exchange rate regime, however, these labor cost increases were not passed through to prices: the consumer price-based REER appreciated by only a cumulative 4.4 percent between 1990 and 1995 and by 1.1 percent per year in 1994-95.

CHART 10
CHART 10

CYPRUS Real Effective Exchange Rates 1/

(1984 = 100)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

1/ In 1995, data for Cyprus are official projections; data for the other countries are WEO and OECD projections.2/ Trade weighted, excluding Brazil.3/ Weighted average of CPI in a common currency. Competitors’ (Greece, Italy, Portugal, Spain) weights are based on tourism receipts in 1993.4/ Weighted averages of CPI in a common currency. Competitors’ (Egypt, Greece, Malta, Spain, Portugal, Turkey) weights are based on tourism receipts in 1993.5/ Unit labor costs in Cyprus, expressed as a ratio to a trade weighted average of unit labor costs, in a common currency, of the 10 largest industrial trade partners (Belgium, France, Germany, Greece, Italy, Japan, the Netherlands, Spain, the United Kingdom, and the United States).

Despite the loss of competitiveness in tourism, in particular, tourism continued to account for a high share of current account receipts (42 percent in 1994-95), and Cyprus’s market share in tourism continued to grow in 1994-95. The concomitant rise in prices and increase in market share may reflect the success of efforts to upgrade and increase the quality of tourism services provided in Cyprus.

3. The current account

The current account in Cyprus was in deficit during the 1980s and up to 1992. In the early years, this reflected high post-invasion investment rates. As the reconstruction effort slowed down, current account deficits tended to decline. The recession of 1993 depressed imports and produced for the first time a surplus in the current account. The surplus persisted in 1994--albeit at a lower level--due to the strong rebound of tourism receipts (Table 32). But in 1995, the current account switched back into deficit because of a slowdown in the growth of tourist arrivals and a surge in imports that mirrored that of consumption (Table 33).

Table 32.

Cyprus: Balance of payments Summary

(In million of Cyprus pounds)

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Source: Central Bank of Cyprus.

Excluding ship-stores.

Bulk items include aircraft purchases for Cyprus Airways valued at £C 16.3 million, £C 48.4 and £C 17.4 million in 1990, 1992 and 1993, respectively.

Table 33.

Cyprus: Composition of Imports

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Source: Staff calculations based on data provided by the Central Bank of Cyprus.

Total merchandise exports as a ratio to GDP fell during the 1990s, although they recovered somewhat in 1995, when they rose to 14 percent, against almost 17 percent in 1990. This fall was entirely due to declining domestic exports, while re-exports (mostly cigarettes and consumer electronic goods sold in the Middle East and Eastern Europe) remained constant at around 7 percent of GDP. As a result, the share of re-exports in total exports increased from 40 percent in 1990 to 53 percent in 1995 (Table 34). There was an important change in the direction of exports during the 1990s: Cyprus’s exports to the EU fell from over half in 1990 to 40 percent of the total in 1994, while exports to Eastern Europe tripled to one-fourth of the total in 1994 (Table 35).

Table 34.

Cyprus: Merchandise Trade 1/

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Source: Central Bank of Cyprus.

Based on customs data. Quarterly figures do not necessarily add up to annual figures because valuation adjustments are only made at end of the year.

Includes sales of domestic shipstores.

Includes sales of foreign shipstores.

Includes imports of between £C 2-4 million per year by foreign embassies and military bases.

Over preceding year, or over the same period in the previous year.

Includes aircraft valued at £C 16.3 million.

Includes aircraft valued at £C 48.4 million.

Includes aircraft valued at £C 17.4 million.

Table 35.

Cyprus: Direction of Trade 1/

(In Percent of total trade)

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Source: Central Bank of Cyprus.

Data on a customs basis. Do not include imports of military equipment.

Includes re-exports.

For the years prior to 1992, data are for the territory of the former Federel Republic of Germany.

Imports from France in 1990, 1992 and 1993 include bulk imports of aircraft.

Improved economic conditions in Middle Eastern markets and the economic recovery in Europe increased the demand for Cyprus’s manufactured exports in 1994 (Table 36). This increase, however, was not sufficient to arrest the declining share of manufacturing in total exports. Furthermore, the performance of different categories of manufactured exports was uneven: most categories of exports grew in 1994, but the shares of traditional manufactured exports, such as clothing and footwear, fell. The main reasons for the long-term decline in the share of manufactured exports are the significant domestic cost increases and growing international competition from emerging markets in Central and Eastern Europe. The share of agricultural exports rose by 9 percent in 1994, mostly due to higher potato prices.

Table 36.

Cyprus: Exports by Commodity 1/

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Source: Central Bank of Cyprus.

Data on a customs basis.

Includes quarrying materials.

As with exports, the share of imports in GDP also fell during the 1990s, although there were wide fluctuations reflecting the economic cycle: in 1995, imports-to-GDP stood at 40 percent, against 45 percent in 1990. In 1994, the value of imports grew by 13 percent, and in 1995 by a further 15 percent. These important increases were associated with the economic recovery. In 1995, in particular, in addition to the recovery, the rapid growth of imports was also caused by the natural cycle in the consumption of consumer durables, and speculation about a VAT rate increase (which did not take place) that pushed up imports of cars. In addition, imports for re-export also grew at a fast pace in 1994-95. Largely because of price movements, oil imports fell in 1994 and increased by only 5½ percent in 1995. Reflecting the overall import performance, import propensity with respect to domestic demand rose from a low of 40 percent in 1993 to 43½ percent in 1995.

The geographical composition of imports (c.i.f. basis) continued to be concentrated in the EU, which accounted for over half of total imports (excluding imports of military equipment). Cyprus’s long-standing trade association with Europe was enhanced by the Customs Union Agreement, which resulted in lower import tariffs for EU products by a cumulative 72 percent since 1987. The United Kingdom remained Cyprus’s largest trading partner, with 12 percent of total imports in 1994. Outside the EU, Japan’s market share fell and the United States’ increased sharply, mainly reflecting exchange rate movements.

The commodity composition of imports reflected the pattern and character of the economic recovery. Both consumer good and capital good imports increased in 1994 (Table 37), while the rise in imports of transportation and military equipment, as well as intermediate goods, was less pronounced, resulting in a reduction in their share in total imports. Data for the first half of 1995, however, show a significant expansion of consumer good imports (20 percent on a year-on-year basis). Imports of transport equipment, particularly cars, rose by more than 35 percent in the first half of 1995.

Table 37.

Cyprus: Imports by Commodity 1/

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Source: Central Bank of Cyprus.

Data on a customs basis; excluding imports of foreign embassies and military bases.

Including aircraft imports of £C 80.8 million.

Including aircraft imports of £C 16.3 million.

Including aircraft imports of £C 17.4 million.

The surplus in the invisibles balance remained stable at almost 26 percent of GDP in 1994 and fell to 25 percent in 1995, reflecting the pattern of tourism growth (Table 38). Tourism receipts swelled by 15 percent in 1994, as a result of a 12.4 percent increase in tourist arrivals and a modest rise in expenditures per person. The increase in tourism receipts in 1994 was partially offset by a rise in the expenditures of residents traveling abroad, however, and on a net basis, tourism income rose by 13.4 percent. 1/ Due to slower growth in tourist arrivals in 1995, tourism receipts grew by 5 percent only, and net tourist income by 4 percent. About 80 percent of tourists that visit Cyprus are from Europe. The predominance of the United Kingdom as a country of origin declined further in 1994-95, partly due to a shakeout among major British travel operators. In contrast, tourist arrivals from Belgium, Germany, Norway, and Denmark increased strongly.

Table 38.

Cyprus: Invisible Transactions

(In millions of Cyprus pounds)

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Source: Central Bank of Cyprus.

Includes expenditures of Cypriot students abroad.

Includes net profit remittances.

The off-shore sector continued to expand in 1994-95, and its share in the invisibles surplus rose to 15 percent in 1995, up from 9 percent in 1990. Expenditures of off-shore companies increased by 25 percent in 1994 and 14 percent in 1995, while their number rose by 32.5 percent in 1994 and 18 percent in 1995. 1/ This buoyant performance sustained growing surpluses in the balance of “other services”, offsetting the declining foreign exchange receipts from foreign military expenditures in Cyprus and from emigrant workers’ remittances.

4. The capital account, external debt, and reserves

Following a net outflow in 1993, the capital account registered surpluses of about 1 percent of GDP in 1994 and 1995 (Table 39). Due to the widespread capital controls, capital movements were heavily influenced by government transactions. The government’s policy of net repayment of foreign long-term loans was reflected in a net outflow of total long-term capital in 1994 and a very small inflow in 1995. Long-term external borrowing by public corporations fell slightly in 1994-95, mostly due to reduced external borrowing by Cyprus Airways, and despite increased borrowing from the Cyprus Port Authority. Finally, inflows of short-term capital rose substantially in 1994 and then fell in 1995, reflecting the government’s issuance of short-term paper in the Eurocommercial market in 1994 and its repayment in 1995.

Table 39.

Cyprus: Capital Account

(In millions of Cyprus pounds)

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Source: Central Bank of Cyprus.

Includes loans received by Cyprus Airways and Cyprus Development Bank amounting to £C 19.3 million and £C 13.3 million, respectively.

Includes loans received by Cyprus Airways and Electricity Authority of Cyprus amounting to £C 45.4 million and £C 25.7 million, respectively.

Includes loans received by Cyprus Airways, Cyprus Ports Authority, Cyprus Development Bank, and Sewage Board amounting to £C 22.2 million, £C 14.8 million, £C 11.5 million and £C 6.6 million, respectively.

Includes loans received by Cyprus Airways, Cyprus Ports Authority, and Sewage Board amounting to £C 18.3 million, £C 18.1 million, and £C 12.9 million, respectively.

Includes loans received by Cyprus Ports Authority and Electricity Authority of Cyprus amounting to £C 23.4 million and £C 22.7 million, respectively.

Drawings refer to payments by the government for imports of military equipment and by Cyprus Airways for imports of aircraft. Repayments refer to the difference between the value of goods imported and the actual payments for these imports (excluding prepayments).

Includes net issues of Eurocommercial paper by the government, and trade credits.

During 1994-95, Cyprus took several steps gradually to reduce the scope of capital controls. 2/ First, the Central Bank increased the amount of transfers abroad from blocked accounts from £C 10,000 to £C 50,000 per year. Second, the Central Bank increased allowed transfers by non-residents following the sale of their houses. Third, the government approved a new policy that allows 30-40 percent of foreign participation in the ownership of existing and new hotels, and 100 percent of foreign ownership of marinas, golf courses, and theme parks. Finally, there were some minor changes to regulations governing outward foreign direct investment. In the years ahead, the government intends to complete the gradual liberalization of the capital account, starting with the deregulation of inward and outward foreign direct investment. This liberalization, which is necessary in view of Cyprus’s objective to join the EU, would, of course, evolve hand-in-hand with the liberalization of the domestic financial sector.

The ratio of external debt to GDP fell from 38 percent in 1993 to an estimated 304 percent at end-1995 (Chart 11). This reduction was entirely due to the government’s policy of reducing its foreign exposure, through fiscal consolidation and an increase in the share of domestic financing. The private sector’s external debt (excluding short-term liabilities of the banking system) remained unchanged at about 10 percent of GDP (Table 40). Reflecting the fall in debt and increased tourism receipts, the debt service ratio fell from 14.1 percent of current account receipts in 1993 to 9.3 percent in 1995. The syndicated loan market (mostly the Resettlement Fund of the Council of Europe) remained the primary supplier of funds for the government, while financial markets were the major source of funding for public corporations and the private sector (Table 41).

CHART 11
CHART 11

CYPRUS External Debt 1/

(In Percent)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Central Bank of Cyprus.1/ In 1995, data are official projections.2/ In percent of exports of goods and services.
Table 40.

Cyprus: Outstanding External Debt and Debt Service 1/

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Source: Central Bank of Cyprus.

Changes in the level of outstanding external debt as recorded in the external debt statistics tables differ from capital flows as recorded in the balance of payments table because of valuation adjustments not recorded in the balance of payments table, and as a result of timing differences in the registration of operations in both sets of data.

Excludes short-term liabilities of the banking system.

Medium- and long-term.

Table 41.

Cyprus: Medium- and Long-Term Outstanding External Debt by Debtor end by Creditor

(In millions of Cyprus pounds: end of period)

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Source: Central Bank of Cyprus.

Resettlement Fund of the Council of Europe.

Includes IFC.

Among the most important creditors are the Governments of Germany, France, Kuwait, and the United Kingdom.

Includes suppliers’ credits and commercial banks’ lines of credit.

Reflecting the strong balance of payments performance in 1994, net international reserves increased to SDR 423 million at year-end, but the deterioration of the current account in 1995 produced a sharp fall in net reserves to SDR 223 million in June (Table 42). Gross assets increased sharply in 1994 to over 13 months of imports, and changed little up to June 1995. However, there was a difference in the movement of official and banks’ reserves. Both increased in 1994, but in the first half of 1995 gross official reserves fell while banks’ gross assets increased. By November, gross official reserves had recovered by almost SDR 140 million from the low in June, aided by the seasonality of tourism receipts.

Table 42.

Cyprus: Net International Reserves

(In millions of SDRs: end of period)

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Source: Central Bank of Cyprus.

Gold valued at SDR 35 per ounce.

APPENDIX I The Effects of a Terms of Trade Shock Under Wage Indexation 1/

This appendix simulates the effects of a terms of trade shock under the current policy setting, notably full backward-looking wage indexation, in the context of the staff’s medium-term scenario. Under any circumstances, a sizeable deterioration in the terms of trade would inevitably tend to reduce output and the real wage and lead to a depreciation of the real exchange rate. Wage indexation curtails price flexibility by introducing inertia into the price-setting mechanism. This prolongs the adjustment by maintaining the real wage and real exchange rate above their post-shock equilibrium values, and causes a larger-than-otherwise deterioration in the current account. In a country with a fixed exchange rate like Cyprus, if the period of adjustment is very protracted and the misalignment of prices sizeable, a persistent and large current account deficit could threaten the stability of the exchange rate peg.

In this appendix, the adverse effects of wage indexation in case of a terms of trade shock are examined against a baseline scenario with no terms of trade shock. In the baseline scenario, growth continues at about the rate of growth of potential output, with sustained price stability. In such an environment--as in recent years--wage indexation is non-binding, because it yields real wage increases that are at or below productivity growth.

The appendix is structured as follows: section 1 presents the medium-term simulation model and the baseline scenario; section 2 reviews the economic literature on wage indexation; section 3 presents a simple analytical framework to trace the dynamics of real wages and the real exchange rate under wage indexation in a fixed exchange rate regime; and section 4 incorporates this framework into the medium-term simulation model to illustrate the possible effects of a terms of trade shock in Cyprus.

1. The baseline scenario

The simulation model is based on a simple macroeconomic accounting framework with four main blocks: the balance of payments, public finances and debt, the labor market, and the demand side of the national accounts. 2/

The baseline scenario assumes that Cyprus’s real convergence to EU income levels will continue for the rest of the century. The pace of convergence, however, is expected to be slower than in the 1980s and the first half of the 1990s. During the projection period, output is targeted to grow at a potential growth rate of just above 4 percent per year, down from 6 percent in the 1980s and 5 percent in the first half of the 1990s (Table 1). This is the result of slower growth in tourism and a lower level of investment, in line with the trends of the last decade (see Appendix IV). Furthermore, the baseline scenario assumes that the stability of the peg and moderate wage growth contribute to the continuing convergence of the inflation rate to industrial country levels during the projection period. The assumptions concerning the external environment (prices, interest rates, foreign demand) correspond to the forecasts of the September 1995 WEO. The key projection for growth in tourist arrivals--of 4 percent per year--is generated by a forecasting model, 1/ while expenditure per tourist is assumed to grow by 4 percent per year as well.

Table 1.

Cyprus: Staff Medium-Term Projections: Baseline Scenario

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Source: Staff projections.

Defined as real per capita consumption.

End-of-period stock of reserves over average imports in t and t+1.

The baseline scenario assumes that fiscal policy remains consistent with the announced objective of keeping the deficit-to-GDP ratio below the 3 percent of GDP Maastricht target. This requires continued restraint in discretionary spending (notably the wage bill and defense); an unchanged development budget in relation to GDP; but no substantial additional measures. It is, of course, implicitly assumed that any new expenditures or tax cuts (like the ones announced in late 1995--see Chapter III) are offset by revenue increases or expenditure cuts. This fiscal policy results in a sustained fall in the debt-to-GDP ratio, from an estimated 55 percent at end-1995 to 51 percent in 2000.

The government’s wage policy is both an instrument to achieve the fiscal objectives and a signal to the rest of the economy. Thus, given the assumption of continued wage restraint in the government, the baseline scenario assumes that wage bargaining in the private sector yields real wage awards averaging 2.1 percent per year, at or below productivity gains. This allows a small but sustained increase in profitability (by an average 0.7 percent per year), and the wage indexation (COLA) system remains compatible with full employment and sustained growth.

The baseline scenario assumes that monetary policy continues to be geared toward preserving the peg of the Cyprus pound to the ECU, while financial liberalization unfolds gradually, according to the current government plans. In line with the staff’s analysis in Appendix II, the projections assume that interest rates do not increase significantly as a result of financial liberalization.

On the external front, the policies described above yield a current account deficit just under 2 percent of GDP. Import growth is slightly above GDP growth and, within current receipts, non-tourism services grow in importance. This level of foreign saving plus moderately rising private saving and positive public saving allow a small increase in investment from 23 percent of GDP in 1995 to 24 percent in 2000. 1/ This level of investment, albeit much lower than historical levels, is adequate for supporting the potential growth rate of 4-4½ percent per annum postulated above. Capital account flows are expected to increase with the gradual financial liberalization. Hence, the current account deficit is financed entirely with non-debt creating capital inflows. Finally, the real exchange rate appreciates modestly during the projection period, while inflation remains low. This appreciation is validated by growing productivity and rising demand (and prices) for domestic goods and services.

This baseline scenario should not be seen as a forecast of the Cypriot economy for the next five years. Rather, it should be taken as a conditional projection under the assumption of continuing good economic policies domestically and the current WEO forecasts of economic conditions abroad. This view was also shared by the authorities during the 1995 Article IV consultations discussions.

2. A survey of the literature on wage indexation

In 1807, John Wheatley, an English writer on monetary economics, proposed indexation as a device to counter general price level uncertainties. More recently, Milton Friedman (1974) defended indexation enthusiastically when he argued that full indexation would transform the short-run Phillips curve into a vertical straight line, thus eliminating the output-inflation trade-off and all the negative output effects of anti-inflationary policies.

Gray (1976) and Fischer (1977) first analyzed formally the effects of indexation under nominal and real shocks. They found that Friedman’s proposal of full indexation was optimal (in terms of minimizing output variability) when the economy suffered from nominal shocks. In contrast, if the economy was subject to real or productivity shocks that had long-run output and relative price effects, then the optimal degree of indexation was zero. 2/

This result was further refined by Fischer (1988), who showed that even in the event of nominal shocks indexation had negative effects. This was because in practice, indexation tended to be ex post rather than ex ante, while his and Gray’s earlier models had assumed ex ante indexation. With backward-looking ex post indexation, the behavior of the price level during the contract period was a key determinant of the purchasing power of wage earners. Thus, monetary policy could now have real effects (which was ruled out in earlier models), and wage indexation introduced inertia into the inflationary process, distorted relative prices, and added to, instead of minimizing, output variability following shocks.

Since then, the policy debate has shifted toward de-indexation and, in particular, the optimal degree of de-indexation, that is, mechanisms to modify indexation formulae so as to minimize output variability. New arguments have also been advanced in favor of indexation. First, indexation may moderate demands for higher wages based on the worst possible price forecasts by workers (see, for example, Kouri 1985). And second, indexation may reduce the dispersion of wages across sectors with different contract duration, and thus help reduce labor market tensions. These arguments hold even in the presence of real shocks (McNelis 1988). 1/

Partial de-indexation is currently under debate in Cyprus. The social partners are considering whether to exclude certain items (such as, for example, indirect tax increases or imported fuel price increases) from the price index used in COLA. Similar experiences in other countries abound. Some countries have excluded certain items from the price index used to determine wage increases, others have indexed minimum wages only, others have allowed indexation only after inflation crosses certain threshold, and still others have reduced the frequency of wage adjustments or suspended wage adjustments in response to adverse real shocks. 2/

Full de-indexation has also been implemented in many countries in a variety of different circumstances. Brazil’s Cruzado plan in 1986 replaced wage indexation by a wage and price freeze in a stabilization package to stop rampant inflation. In contrast, the sharp decline in inflation after the Korean War had as a result the abolition of indexation in Australia.

3. Full wage indexation in a fixed exchange rate regime 1/

This section presents a simple two-sector model that tracks the effects of full backward-looking wage indexation on inflation, real wages, and the real exchange rate in an economy with a fixed exchange rate regime. 2/

P ∧ t   =   α   P ∧ T t   +   ( 1 − α )   P ∧ N t ( 1 )
P ∧ T t   =   E ∧ t   +   P ∧ T t * ( 2 )
D N   [ ( P N / P T ) t ,   Z t ]   =   S N   [ ( W / P N ) t ] ( 3 )
W ∧ t   =   δ P ∧ t − 1 ( 4 )
e t   =   P t / E t   P T t * ( 5 )

A hat over a variable denotes a rate of change. In equation (1), the price index Pt is expressed as the weighted average of tradable prices, PTt, and nontradable prices, PNt, with weights α and (1-α). Equation (2) represents the law of one price for tradable goods, where Et is the exchange rate and PTt* is the international price of tradable goods. Equation (3) is the equilibrium condition in the nontradable goods market. The demand for nontradables, DN, depends negatively on relative prices and positively on aggregate real expenditure, Zt. The supply of nontradables depends negatively on the product wage rate (W/PN)t. Equation (4) describes the wage indexation rule. In Cyprus, nominal wage increases are equal to past price increases, so that δ = 1. Equation (5) defines the real exchange rate.

The price that clears the nontradable goods market is as follows:

P ∧ N t   =   [ η η + ɛ ]   P ∧ T t   +   [ ɛ η + ɛ ]   W ∧ t   −   [ γ ɛ + η ] Z ∧ t ( 6 )

where η and γ are the price and real expenditure elasticities of the demand for nontradables, and ε is the supply elasticity of nontradables (η>0; ε<0; γ>0).

Combining (6) with (1), assuming that the exchange rate is fixed (E∧t=0) and, for simplicity, that there are no demand pressures (Z∧t=0), the inflation rate may be expressed as:

P ∧ t   =   [ α ɛ + η η + ɛ ]   P ∧ T t *   +   [ ( 1 − α ) ɛ η + ɛ ]   P ∧ t − 1 ( 7 )

Equation (7) illustrates the inertia of the domestic inflation rate during its convergence to international levels. The speed of convergence will depend on the magnitude of the coefficients α, ε and η. Furthermore, during the period of inflation convergence to international levels, real wages will increase in a manner unrelated to productivity growth, as illustrated in equation (8):

W ∧ t   −   P ∧ t   =   [ α ɛ + η η + ɛ ]   ( P ∧ t − 1   −   P ∧ T t * ) ( 8 )

This increase in real wages will squeeze profitability in the tradable goods sector, as shown by the ensuing real exchange rate appreciation:

e ∧ t   =   ( 1 − α ) ɛ η + ɛ   ( P ∧ t − 1   −   P ∧ T t * ) ( 9 )

This model suggests that a shock that increases the price of tradables will increase inflation directly as well as indirectly, through its effect on the nontradable goods market: the demand for nontradables will increase as people substitute away from the more expensive tradable goods. Real wages initially decline because of the increase in inflation. In following periods, however, real wages increase as the indexation rule allows for full catch up to past inflation, while current inflation begins to decline. Similarly, despite an initial real depreciation, the pass-through to prices of wage increases in the nontradables sector produces a protracted real appreciation of the exchange rate.

4. Alternative medium-term scenario: A terms of trade shock in conditions of full wage indexation

This section simulates the effects of a 20 percent increase in import prices in 1996. 1/ The framework developed in the previous section is incorporated into the medium-term macroeconomic simulation model. The main assumptions are as follows. First, the weight of tradable goods in the price index is 47.5 percent (this corresponds to the actual weight of imported goods in the Cypriot wholesale price index). Second, the relative price elasticity of the demand for nontradables is assumed equal to one-half, as tradable and nontradable goods are less than perfect substitutes. Third, the supply elasticity of nontradable goods is assumed unitary. 1/ Finally, wage adjustments are made once a year. 2/

The long-term effects of the terms of trade shock are a lower real wage level and a more depreciated real exchange rate, as prices must reflect the fact that domestic output is exchanged for a more expensive foreign output. The initial impact of the shock, however, is to reduce output growth by almost 2½ percentage points with respect to the baseline. The fall in output is not only due to higher prices, but also to the shock’s effects on private consumption and investment (Chart 1). The shock also increases inflation to 14 percent, almost five times the baseline rate, which induces an initial fall in the real wage rate and the real exchange rate (Table 2). Subsequently, inflation inertia produced by wage indexation maintains real wages and the real exchange rate at an artificially high level. Misaligned relative prices reduce profitability, with adverse effects on investment and growth. The prolonged period of adjustment means that growth recovers slowly and inflation does not fully converge to industrial country levels by the end of the projection period.

CHART 1
CHART 1

CYPRUS The Medium–Term Outlook

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: 1990–95 data provided by the authorities, and staff simulations.1/ Simulation of a 20 percent increase in import prices in 1996.
Table 2.

Cyprus: Staff Medium-Term Projections: Terms of Trade Shock and Wage Indexation

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Source: Staff projections.

Defined as real per capita consumption.

End-of-period stock of reserves over average imports in t end t+1.

The terms of trade shock increases the government deficit and debt-to-GDP ratio, as the economic downswing produces a stagnation in revenues-to-GDP. Although wage expenditures decline in relation to GDP due to the real wage fall, interest costs rise and total expenditures increase. The higher interest bill is due to an increase in interest rates parallel to that of inflation. 3/ Thus, the deficit peaks at 3.8 percent of GDP in 1998 and remains well above the Maastricht target by the end of the projection period.

After the shock, the private sector attempts to smooth consumption by reducing savings. As savings fall by more than investment, the current account deficit widens. Initially, the current account deficit increases to over 4 percent of GDP and falls only gradually to around 2½ percent by the end of the projection period. These higher current account deficits are fully financed by lower international reserves.

The protracted period of an overvalued real exchange rate and large current account deficits could well trigger a confidence crisis. In such a situation, the public might question the sustainability of the peg, inducing capital outflows that would further undermine the external position and eventually force the authorities to abandon the peg. The simulations presented here, however, do not lead to this extreme outcome. It is assumed instead that social partners agree to adjust wages by COLA only, and forego additional increases for three years; and that the strong external position prior to the terms of trade shock and Cyprus’s record of prudent policies lend credibility to the peg, minimizing sharp swings in confidence after the shock. These assumptions are not arbitrary: they reflect the fact that, as in the past, in case of an economic emergency, Cyprus’s social cohesiveness and successful economic performance thus far will help contain the damage.

Nevertheless, although the worst is avoided, this scenario presents a much bleaker outlook than the baseline: growth is lower, inflation is higher, and the current account and government deficits are higher through most of the projection period. The permanent terms of trade deterioration would inevitably produce these effects, but full backwards wage indexation prolongs and aggravates the adjustment.

References

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APPENDIX II The Fiscal Effects of Financial Liberalization 1/

This appendix evaluates the fiscal implications of financial liberalization in Cyprus. The assessment is based on estimates of government revenue from financial repression, which the government will lose when interest rate ceilings and capital controls are lifted; and of seigniorage, which may fall as the menu of financial assets available to domestic residents widens. The discussion is placed in an international context, by setting Cyprus against a number of countries which have liberalized their financial systems, and comparing their initial conditions with these in Cyprus today.

The main findings of this appendix are that: (i) despite the interest rate ceilings and high reserve requirements, government revenue from financial repression has been relatively small in Cyprus during the period 1980-94; and (ii) government revenue from seigniorage has decreased substantially, and currently represents only a small fraction of total government revenues. Therefore, financial liberalization is not expected to have a sizeable effect on the public finances. This does not imply, of course, that fiscal measures need not be taken to offset some revenue loss; but the estimations suggest that the fiscal effects of financial liberalization can be offset with a very moderate fiscal adjustment.

Financial repression revenue is a good proxy of the fiscal impact of financial liberalization only if the domestic interest rates that prevail in the post-liberalization environment are dictated by (uncovered) interest rate parity. This, however, was not the case for many of the well-documented cases of financial liberalization. The survey of other countries experience, however, suggests that it is unlikely that in Cyprus’s current economic conditions financial liberalization would trigger a hike in domestic interest rates.

The appendix is organized as follows: section 1 describes the methodology used to estimate the revenue derived from financial repression and seigniorage; section 2 shows estimates of seigniorage and financial repression revenue for Cyprus, and compares them with estimates for other European countries; section 3 discusses the possibility of a surge in real interest rates following financial liberalization in the context of the international experience; and section 4 concludes.

1. Financial repression revenue and seigniorage

Two sources of revenue are likely to be either eliminated or reduced by financial liberalization: financial repression and seigniorage. In a financially repressed environment, the government’s ability to borrow at below-market interest rates (usually through compulsory purchases of low-interest government debt by the banking sector) amounts to an implicit form of revenue. Giovannini and de Melo (1993) have proposed to estimate this financial repression revenue (ø) as:

ɸ   =   ( i F   −   i D )   D G D P ( 1 )

where iF is the cost of borrowing in international markets (converted into domestic currency terms), is the nominal effective interest rate on domestic borrowing, and D is the stock of domestic debt. Thus, financial repression can be thought of as a tax, whose rate is given by the difference between the government’s cost of borrowing abroad and the interest rate it actually pays domestic lenders, and whose base is given by the stock of domestic debt. In a financially liberalized environment, the government is unable to keep a wedge between domestic and foreign interest rates, and this source of revenue is no longer available.

Unlike financial repression revenue, seigniorage will continue to be a source of revenue after liberalization. However, to the extent that financial liberalization brings about a wider menu of assets available to domestic residents, the demand for domestic money may fall, leading to a reduction in the amount of seigniorage that can be collected at a given rate of money creation. The concept of seigniorage used here is the real purchasing power of newly-created base money. Seigniorage (σ) is thus estimated as the ratio of the change in base money (MO) during a given year net of interest paid on base money (interest on various bank deposits (RB) at the central bank) to GDP:

σ   =   M ˙ 0   −   i B   R B G D P ( 2 )

where iB is the average interest rate paid by the central bank on bank deposits.

This measure of seigniorage may yield negative values in years when the effective interest rate paid on base money exceeds the rate of base money creation, or whenever the stock of base money contracts--for example as a result of a reduction in reserve requirements. This can be illustrated by rewriting equation (2) as:

σ   =   ( μ   −   i M )   M 0 G D P ( 3 )

where μ is the rate of growth of base money and iM is the ratio of interest paid on reserves to total base money. If financial liberalization induced a one-time portfolio adjustment away from domestic money, seigniorage would fall immediately as μ would likely be negative. In addition, there would be a permanent (negative) effect in the form of a lower ratio of base money to GDP.

2. Estimation

For the purpose of estimating revenue from financial repression, the interest rate on domestic debt was computed as a weighted average (weights given by the maturity composition of the debt) of coupon rates on government paper, while the interest rate on foreign debt was determined as the sum of LIBOR on 6-month deposits denominated in DM; a 20 basis points country risk/fee component; and an expected depreciation term, computed as a 1-year moving average of the actual rate of depreciation of the Cyprus pound vis-à-vis the DM. To compute seigniorage, interest payments on bank reserves were estimated as the product of the CBC’s published rate of remuneration applied to the reserve requirement account; total bank deposits at the CBC; and a “coverage” coefficient set at 80 percent. 1/ The results are shown in Table 1.

Table 1.

Cyprus: Government Revenue from Seigniorage and Financial Repression

(In percent of GDP)

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Source: Central Bank of Cyprus and Fund staff estimates.

End-of-period stock of base money was adjusted in 1989.

There is no information on the amount of interest actually paid by the CBC on reserves; thus, an estimate is constructed using published rates on remuneration of deposits at the CBC. This coefficient is used to capture the effect of factors such as lower payments due to noncompliance with the minimum reserve requirements.

Average interest rate on domestic debt held outside the Central Bank.

LIBOR or 6-month DM deposits plus a fee of 20 basis points. A 1-year moving average of the actual depreciation of the Cyprus pound vis-à-vis the DM was used to compute the expected depreciation of the Cyprus pound.

Excludes debt with the Central Bank (advances plus holdings of T-bills).

Financial repression revenue increased slightly throughout the 1980-94 period, but even in recent years it has been quite low (less than 3 percent of total central government revenues). 2/ It averaged 0.3 percent of GDP in 1980-84, 0.6 percent in 1985-89, and 0.8 percent in 1990-94, with the increase reflecting a growing stock of domestic debt, and not a widening interest rate differential. Throughout this period, revenue has been substantially smaller than the averages found by Giovannini and de Melo (op. cit.) for Greece and Portugal prior to these countries’ liberalization episodes: financial repression revenue averaged 2.2 percent of GDP in Portugal in 1978-86, and 2.5 percent of GDP in Greece in 1974-85 (Table 2).

Table 2.

Seigniorage and Financial Repression Revenue: International Comparisons

(In percent of GDP)

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Source: Data for Cyprus provided by the Cyprus authorities and Fund staff estimates.

Interest rate differential in domestic currency terms.

Data for Greece, Italy, Portugal, and Spain, taken from Gross and Vandille (1995).

Reliance on seigniorage has decreased substantially from very high levels in the early 1980s to levels consistent with those in EU countries with similar inflation rates in the 1990s. As base money growth decelerated substantially, seigniorage declined from an average of 4.3 percent of GDP in 1980-84, to 1.5 percent in 1985-89, and 0.7 percent in 1990-94. Seigniorage in the 1990s represented only about 2 percent of government revenues, suggesting that even a strong fall in the demand for money would not have a serious fiscal impact.

The estimates discussed above suggest that the magnitude of the resources that the government would lose should it liberalize the financial system would be below 1 percent of GDP.

3. Financial liberalization and domestic interest rates

The estimates presented in the previous section are based on the assumption that domestic interest rates in the post-liberalization environment will be in line with international rates. This assumption may not seem very realistic in light of the experience of various countries, which had very high interest rates after liberalization. This section, however, argues that Cyprus’s overall economic outlook compares favorably with that of most of those countries prior to financial liberalization. Thus, an appropriately sequenced liberalization coupled with enhanced supervision of financial institutions is unlikely to be followed by a surge in domestic interest rates.

Table 3 shows three groups of countries that implemented financial liberalization at different speeds, and starting from very different initial conditions: (i) Latin America’s Southern Cone (Argentina, Chile and Uruguay), which undertook swift financial liberalizations in the context of substantial macroeconomic disequilibria; (ii) a group of Asian countries (Korea, Malaysia, Philippines and Thailand) that liberalized gradually in the context of relative macroeconomic stability; and (iii) the more recent experiences of Greece and Portugal, in which financial liberalization was accompanied by macroeconomic stabilization.

Table 3.

Conditions Prior to Interest Rate Liberalization

(Period averages)

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Source: IFS unless otherwise indicated.

According to Galbis (1993), Tseng and Corker (1991), and staff estimates.

End-of-period stock of gross reserves in months of current-year imports (cif).

Argentina’s deficit figure is taken from Corbo and de Melo (1987) and corresponds to the average of the period 1973-75.

Malaysia’s deficit figure overestimates the actual deficit as it excludes the Employee’s Provident Fund, which runs sizeable surpluses.

All these countries experienced high real interest rates in the post- liberalization era, although the levels reached in the Latin American countries largely exceeded those observed in the other cases (Chart 1). Also, the high real rates in the Asian countries coincided with the high rates prevailing in international markets in the first half of the 1980s. Although the factors behind the increases in interest rates in these countries differ, it seems that none of them is present in the case of Cyprus today.

Chart 1
Chart 1

Financial Liberalization and Real Interest Rates 1/

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: International Financial Statistics.1/ Periods of deregulation of domestic interest rate are shaded. Data for the pre-liberalization and liberalization periods are not available for Argentina and Chile.

Galbis (1993) classifies the causes of high interest rates in post- liberalization episodes into two groups: (i) macroeconomic disequilibria, including persistence of high inflationary expectations, risk of rapid depreciation, and an unbalanced fiscal/monetary policy mix; and (ii) structural problems in the financial sector, such as oligopolistic behavior of financial institutions, distress borrowing by nonfinancial enterprises, and moral hazard. He argues that a combination of these factors was what pushed interest rates up in the liberalizing countries.

Indeed, most of the factors mentioned above were present in the Southern Cone countries--see, for example, Corbo and de Melo (1987). High real interest rates in these countries in the aftermath of financial liberalization can be linked to persistently high inflationary expectations and exchange rate risk as the government’s exchange rate policy lost credibility. In addition, because of poor banking supervision, distress borrowing by nonfinancial enterprises in Chile (Velasco 1991) and collusion among banks in Argentina (Galbis 1993) helped maintain the high level of interest rates. 1/

Relatively high post-liberalization real interest rates were also observed in the Asian countries, but the increases were generally moderate (despite the fact that in all cases, real rates were negative at the beginning of the liberalization period) and were likely related to external developments. Real interest rates increased at different stages of the liberalization process: early during the process in Korea and Thailand, soon after in Malaysia, and a few years later in the Philippines. However, in all cases real interest rates peaked around 1985, when international interest rates were also high. 2/ Except for the Philippines, where a surge in inflation in 1984 led to significantly negative real interest rates, real rates followed a similar pattern in all these countries, declining from high levels in the mid-1980s and stabilizing at moderately positive levels thereafter.

Greece and Portugal also experienced relatively high real rates in the post-liberalization period, which were associated mainly with rigidity of nominal interest rates and, more recently, an unbalanced monetary/fiscal policy mix. In Greece, real interest rates increased as the ceilings on various deposit and loan categories were lifted in the late 1980s, but did not reach very high levels then. However, as the country’s disinflation efforts began to rely increasingly on a tight exchange rate-based monetary policy while, at the same time, large fiscal deficits persisted, domestic real interest rates increased substantially. In Portugal, the behavior of real interest rates during the post-liberalization period is explained to a great extent by the rigidity of nominal interest rates in the face of rapidly declining inflation; for the same reason, real rates fell in 1989 as inflation increased, and increased again with the sharp disinflation of the 1990s. An unbalanced policy mix since 1993 has also played an important role in keeping real interest rates relatively high (Corkill 1993).

The experiences discussed above show that the largest increases in interest rates following interest rate liberalization have been observed in countries with the most unfavorable initial macroeconomic conditions, including substantially negative real interest rates prior to liberalization. The Asian countries, which engaged in financial liberalization with a relatively positive macroeconomic outlook, experienced a temporary and moderate increase in real rates, which roughly coincided with high international interest rates. The dynamics of interest rates in Portugal and Greece in recent years illustrate the effects of an unbalanced monetary/fiscal policy mix in the post-liberalization period.

None of the macroeconomic factors observed in the Latin American and Southern European cases is likely to arise in Cyprus. Cyprus’s current economic outlook compares favorably with these countries prior to their financial liberalization: the public finances are under control, inflation has been low in recent years, and the country has a good record of exchange rate stability. Moreover, real interest rates have been positive in recent years, and the degree of banking intermediation (proxied by the ratio of M2 to GDP) is higher than that in all the countries examined above, providing an additional element of financial stability. In these conditions, it would seem unlikely that a well-structured program of financial liberalization, coupled with enhanced supervision of all financial institutions, would lead to a surge in domestic interest rates in Cyprus.

4. Conclusion

Based on estimates of financial repression revenue and seigniorage, this appendix shows that the fiscal effects of financial liberalization are not likely to be significant in Cyprus. Interest rates on domestic debt do not seem to be significantly different from the government’s cost of raising funds abroad, and reliance on seigniorage as a source of revenue has been reduced to a very small fraction of government revenues. Given Cyprus’s good overall macroeconomic outlook, it also seems unlikely that financial liberalization would trigger a significant upward surge in domestic interest rates.

References

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APPENDIX III Cooperative Financial Institutions 1/

The cooperative sector is an important part of Cyprus’s financial system: throughout the early 1990s, the share of cooperatives in total private sector credit fluctuated around 32 percent, while the share in total deposits exceeded 36 percent. Cooperatives operate in a market segment that is different than that of banks: they have a regular flow of deposits from their members’ payrolls, and most of their loans are for house mortgages. Also, their supervision and regulation is under the purview of a special agency; the Central Bank of Cyprus (CBC) does not have jurisdiction over credit cooperatives, and the current instruments of monetary policy do not apply to them. Finally, cooperatives enjoy certain fiscal privileges. This appendix reviews the main characteristics of the cooperative sector in Cyprus, including its regulatory and tax regime, and its impact on the conduct of monetary policy.

1. The cooperative societies

The financial system in Cyprus comprises, in addition to on-shore and offshore banks, the cooperative sector. This sector includes about 350 Cooperative Credit Societies (CCS) and Cooperative Savings Banks (CSB), which operate under the Cooperative Societies Law. 2/ These institutions are administered by committees elected by their members every three years. They accept deposits and extend loans to their members (exclusively individuals) in local currency; they are not authorized to engage in foreign exchange transactions. Most cooperatives are small, although a few of them have total assets larger than those of some banks. Moreover, the sector is concentrated: in 1993, 20 cooperatives accounted for 58 percent of deposits and 61 percent of loans of the sector.

Cooperatives operate differently than commercial banks. Unlike banks, for which noninterest income is an important source of revenue, cooperatives are almost exclusively in the business of raising deposits and making loans. The cooperatives’ deposit base is fed by automatic deposits out of the salaries paid to their members, as well as government deposits (via the Cooperative Central Bank--CCB) used to finance cooperatives’ loans to local farmers. Their assets are also different than those of banks: at present, about 70 percent of the cooperatives’ loans are for housing, and the rest are mainly infrastructure-related loans to farmers and consumer loans.

Cooperatives charge a flat interest rate on their loans and do not levy additional risk fees. However, they do perform risk evaluations, and at times reject loan requests that are deemed to be risky. Exposure is limited by the ceilings that exist on the amount that a single cooperative member can borrow, although these ceilings vary with the size of the cooperative (the ceiling is currently £C 50,000 for the largest cooperative). Two institutional elements not present in regular commercial banks reduce the scope for disorderly loan servicing to cooperatives: (i) borrowers are members of the cooperatives and bear unlimited liability with respect to the losses of the cooperatives; and (ii) members’ salaries are regularly deposited at the cooperative by their employers, and may be used by the cooperative for automatic repayment of arrears.

2. The Central Bank of Cooperatives (CCB)

The CCB acts as the clearing house of the cooperatives. Cooperatives are required to hold between 10 and 15 percent of their deposits at the CCB, with the specific ratio varying across cooperatives. Their balances in excess of £C 1,000 at the CCB earn 2 percent interest. Cooperatives are not allowed to borrow from or make deposits to each other (or to commercial banks) without the permission of the Commissioner of Cooperatives. Since 1989, cooperatives with excess liquidity have been asked to place it in government paper.

The CCB experienced financial difficulties in the late 1970s and a few years later was declared technically insolvent by an investigating committee set up by the government. The origin of the problem had been bad lending policies and a dangerous concentration of its portfolio on a small number of borrowers. As a result, in 1980 depositors had to be bailed out by the government (at an estimated cost of £C 10.5 million). In addition, the government covered the CCB’s daily shortfalls at the Central Bank’s interbank clearing. Following the crisis, a new framework was enacted (Law No. 22 of 1985 and Law No. 68 of 1987) and, in practice, the CCB was put under the supervision of the Central Bank. 1/

In the late 1980s, the CCB experienced financial difficulties again, mainly as a result of the non-recovery of a £C 70 million loan from a development project in Paphos. Law 244 of 1988 was passed authorizing a loan of £C 60 million for recapitalization of the CCB, but the loan did not take place until 1990, when an amended law authorized the disbursement of £C 66.5 million.

3. Regulatory framework

The Commissioner of Cooperative Societies, who is the head of the Department of Cooperative Development of the Ministry of Commerce, Industry and Tourism, is in charge of the supervision of all cooperatives in operation. In practice, the supervisory activities are carried out by a body comprised of the Commissioner, two representatives of the Confederation of Cooperatives, and one representative of the largest cooperative. They audit the balance sheets of the credit cooperatives on an annual basis and monitor the cooperatives’ liquidity on a daily basis. 1/ The Commissioner has a wide authority over cooperatives, including the power to call a meeting of the Board of Directors or even dissolve the Board of Directors of a cooperative society.

The Commissioner of Credit Cooperatives has requested that cooperatives maintain a 25 percent liquidity ratio for prudential reasons. However, only few cooperatives are routinely meeting the liquidity ratio, while many have sometimes significant liquidity shortfalls: in 1993, 73 of the largest 98 cooperatives did not meet the liquidity ratio.

4. Cooperatives and monetary policy

Although monetary policy in Cyprus has on the whole been successful in supporting the exchange rate peg, thus contributing to low and declining inflation, the fact that credit cooperative societies have been exempt from its main instrument thus far (the liquidity ratio) has inevitably affected its conduct and overall effectiveness. First, it has directly limited the ability of the CBC to control credit expansion in the economy as a whole; this problem has grown in importance as the share of the cooperative sector in total private sector credit has expanded over the years. Second, because of the segmentation of the financial sector between banks and cooperatives, the CBC has often been wary of enforcing the penalties for violations of the liquidity ratio on banks, in order not to exacerbate the differential impact of the current regime on profits of financial institutions. This attitude has lowered the credibility of the liquidity ratio as a monetary policy instrument. However, the planned introduction of market-based monetary policy instruments in early 1996 would largely address these problems.

5. Cooperatives and fiscal policy

Credit cooperatives enjoy a privileged tax status relative to commercial banks. They are not subject to withholding taxes on the interest they earn on government paper, and they are not subject to the 25 percent corporate income tax that applies to commercial banks. In addition, they also enjoy an advantage over commercial banks in terms of the implicit taxation resulting from the asymmetric application of the liquidity ratio, as discussed above. Cooperatives need not hold government paper (to the same extent as banks) with yields below lending rates. Finally, cooperatives play a key role in the implementation of the government’s agricultural policy, being the intermediary between government and farmers for cheap agricultural loans: cooperatives extend these loans to local farmers with the funds provided directly at low rates by the government through the CCB.

APPENDIX IV Investment in Cyprus 1/

In the case of Cyprus, the behavior of investment is important not only for explaining economic growth, but also for understanding current account movements. Unlike in other countries, national saving and investment do not seem to be strongly correlated in Cyprus (Chart 1), 2/ and the current account balance has fluctuated widely to cover the investment-saving gap.

CHART 1
CHART 1

CYPRUS Savings and Investment

(In Percent of GDP)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: IMF, International Financial Statistics; and Government Finance Statistics.1/ Consolidated central government overall balance plus public investment.2/ Acquisition minus sales of fixed capital assets.

These movements of the current account balance have been determined mainly by the behavior of domestic investment, while saving--especially after the late 1970s--has remained relatively constant. The top panel of Chart 1 shows domestic (nominal) investment and national saving as a percentage of (nominal) GDP from 1970 to 1994. After a sharp decline caused by the 1974 invasion, the shares of saving and investment in GDP rebounded sharply during the immediate post-invasion period. Since 1980, however, the saving ratio has remained unchanged, while the investment ratio has shown a declining trend, reflected in the current account movements.

The private sector has been the main actor behind the behavior of domestic investment. The share of public investment in GDP has remained nearly constant over the last 25 years, and it was changes in the share of private investment in GDP that determined the movements of total domestic investment (bottom panel of Chart 1).

This appendix focuses on the behavior of private domestic investment in Cyprus. The appendix is organized as follows: section 1 analyzes private investment by type and sector, and examines two exogenous factors that caused large fluctuations in investment in the period under consideration; section 2 discusses other factors possibly associated with the behavior of private investment; and section 3 concludes.

1. The behavior of fixed investment in Cyprus

The share of total investment in GDP has declined since 1980, following the post-invasion reconstruction boom. The top panel of Chart 2 shows (gross) total domestic investment and fixed investment in real terms as a percentage of real GDP. The share of total domestic investment in GDP dropped by 15 percentage points from a peak of 36.4 percent in 1980 to 21.5 percent in 1995, the lowest figure of the last quarter century, except in the period 1974-75, when the invasion, and war disrupted economic activity. A similar pattern was observed for real fixed investment.

CHART 2
CHART 2

CYPRUS Real Investment

(In Percent of GDP in Real Terms)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Central Bank of Cyprus, Bulletin; and Ministry of Finance, Historical Data on the Economy of Cyprus.

Regarding the type of investment, the ratios of residential and transport and machinery investment to GDP showed substantial fluctuation reflected in the movements of the ratio of total fixed investment to GDP (middle panel of Chart 2). After a decline of some 10 percentage points of GDP during the invasion of 1974, residential investment swelled to 15 percent of GDP during 1975-79, and subsequently declined gradually. Investment in transport and machinery followed a similar pattern, but showed sharp increases in 1984, 1989, and 1992, as a result of bulk imports (aircraft for Cyprus Airways).

Regarding the distribution of private fixed investment by sector, the sector of finance and real estate, which accounted for the largest share, was most severely affected by the 1974 invasion and its aftermath: the ratio of investment to GDP in this sector plunged in 1974-75, rebounded until 1979, and declined subsequently (bottom panel of Chart 2). This behavior was closely related to the pattern of residential investment (middle and bottom panel of Chart 2), suggesting that most investment in this sector was undertaken in the category of real estate, rather than in the category of finance. Since 1984, however, investment in finance and real estate has been declining by less than residential investment, as a result of the expansion of investment in finance.

The behavior of investment in trade and hotels is closely related to investment in non-residential building. The constant ratio of investment to GDP in non-residential building during the 1980s reflected the expansion of tourism and attendant construction of hotels and restaurants even after the post-invasion reconstruction effort was over. However, investment activity in this sector dropped in 1993, in part reflecting the slump in tourism, as well as tougher enforcement of restrictions on new hotel construction.

In manufacturing, the share of fixed investment in GDP has shown a declining trend since 1977. In contrast, in the sector of transportation and communication, the ratio of investment to GDP has remained roughly constant during the post-invasion period, except in 1984, 1989, and 1992, when it increased sharply owing to the bulk imports of aircraft.

This preliminary analysis shows that the fluctuations in the ratio of investment to GDP during 1974-94 were influenced, inter alia, by two significant exogenous factors: (1) the impact of the 1974 invasion and the post-war reconstruction effort, and (2) bulk imports. For these reasons, these two factors should be considered separately from other underlying factors affecting investment.

To adjust for the first factor, residential investment was excluded from real fixed investment. The top panel of Chart 3 shows real fixed investment as a share of real GDP with and without residential investment. The Chart shows that the extent of post-invasion investment boom is much smaller when residential investment is excluded. Nevertheless, the declining path in investment after 1980 is still present. To adjust for bulk imports, real fixed investment was recalculated by excluding investment in construction and transport and communication. The bottom panel of Chart 3 shows that the sharp increases in 1984, 1989, and 1992 disappear when these subsectors are excluded from total private Investment. But as Chart 3 shows, even after both adjustments are made, the declining trend in investment is still present, suggesting that other factors are at work in explaining the secular decline of investment in Cyprus.

CHART 3
CHART 3

CYPRUS Real Fixed Investment

(In Percent of GDP in Real Terms)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Central Bank of Cyprus, Bulletin; and Ministry of Finance, Historical Data on the Economy of Cyprus.1/ Excluding construction, transportation and communication.2/ Excluding construction, transportation and communication, and finance and real estate.

2. Possible factors associated with the decline in investment

What factors could explain the decline in the underlying share of investment in GDP, after correcting for the post-war reconstruction effort and bulk imports? In many countries with a similar experience, private investment was crowded out by the public sector. As Chart 1 shows, however, the level of public dissaving in Cyprus has remained low and constant, and has recently turned positive without apparent affects on private investment; thus, this explanation does not seem to apply in the case of Cyprus.

Considering the rapid pace of growth in Cyprus during the two decades under consideration, it is plausible to assume that capital deepening reduced progressively the scope for new investment, leading to a natural slowdown in investment and growth. In that case, one would expect to see a decline in the return to capital in Cyprus closer to international levels. Although data on return to capital are not available, profitability is under certain conditions, a reasonable proxy.

Indeed, as Chart 4 shows, private sector profitability has been on a more-or-less constant decline since 1976, although its level in the early 1990s was still comparable to that in the pre-invasion period. The Chart also shows profitability by subsector. In construction, the level of profitability doubled between 1974 and 1976--as could be expected, given the massive destruction of buildings during the war and the attendant rise in the return to capital in this sector. Although it has weakened since 1977, profitability in construction has remained high throughout the period 1980-94. In contrast, profitability in four other major sectors (manufacturing; finance and real estate; trade and hotels; and transport and communication) has declined more-or-less continuously. Profitability in trade and hotels, in particular, deteriorated sharply in the 1990s, declining by 20 percent between 1990 and 1994. Profitability in finance and real estate declined consistently throughout the period 1972-1994, while that in transport and communications only in the l980s.

CHART 4
CHART 4

CYPRUS Profitability by Sector 1/

(Index 1972 = 100)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Central Bank of Cyprus, Bulletin; and Ministry of Finance, Historical Data on the Economy of Cyprus.1/ Profitability is definded as the index of the sectoral deflator divided by unit labor cost.

The relationship between profitability and real fixed investment can been seen more clearly if we consider the three main sectors that are relatively free from the impact of the reconstruction effort and the bulk imports: manufacturing, trade and hotels, and construction. These sectors are also the most important in terms of output and employment (Chart 5).

CHART 5
CHART 5

CYPRUS Output and Employment in the Private Sector

(In Percent)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Central Bank of Cyprus, Bulletin; and Ministry of Finance, Historical Data on the Economy of Cyprus;

In manufacturing, where output and employment have dropped relative to the other sectors during 1975-94, a decline in the ratio of investment to GDP appears to be strongly correlated with the decline in profitability (top panel of Chart 6). The faster decline in the ratio of investment to GDP than in the level of profitability suggests that this sector has allocated a smaller share of its profits to investment.

CHART 6
CHART 6

CYPRUS Investment and Profitability

(1972 = 100)

Citation: IMF Staff Country Reports 1996, 016; 10.5089/9781451809787.002.A001

Source: Central Bank of Cyprus, Bulletin; and Ministry of Finance, Historical Data on the Economy of Cyprus.

In the sector of trade and hotels, where both output and employment have expanded compared to the other sectors during 1975-92, the decline in profitability was modest during the 1980s (middle panel of Chart 6), due to the high level of investment in tourism. More recently, however, there is a clearer correlation between a sharply declining profitability and a dropping ratio of investment to GDP. It is important to recall that the pattern of investment in this sector has also been significantly affected by exogenous factors, notably the stronger enforcement of restrictions on hotel construction in recent years.

Finally, although construction is a much smaller sector than the other two, it also shows a strong correlation between profitability and investment, at least during the 1980s (bottom panel of Chart 6). In this sector, however, unlike in manufacturing, the fall in investment as a ratio to GDP has not been as sharp as that in profitability.

3. Conclusions

  • After the sharp decline caused by the 1974 invasion, investment rebounded sharply during the reconstruction period. Since 1980, however, investment has been on a declining trend. The private sector has been the main agent behind this behavior of investment.

  • The pattern of private investment in the period under consideration reflected to a great extent two exogenous factors: the postwar reconstruction effort, which has affected primarily residential investment; and bulk (aircraft) imports. Even after correcting for these factors, however, there is still a (smaller) decline in underlying private investment after 1980.

  • This fall in investment after 1980 does not seem to be the consequence of crowding out by the government.

  • Investment trends--at least in three key sectors--seem to be associated with profitability trends. This lends prima facie support to the hypothesis that capital deepening in Cyprus has reduced the rate of return to capital, leading to a natural slowdown in investment.

APPENDIX V Exchange and Trade Arrangements

(Position as of October 20, 1995)

1. Exchange arrangement

The currency of Cyprus is the Cyprus Pound, the external value of which is pegged to a basket based on the European Currency Unit (ECU) at ECU 1,7086 per £C 1, within margins of ± 2.25 percent around the ECU central rate. On December 31, 1994, the official buying and selling rates for the U.S. dollar, the intervention currency, were £C 0.4759 and £C 0.4778 respectively, per US$1. The Central Bank of Cyprus also quotes daily buying and selling rates for the ECU, deutsche mark, the Greek drachma, and the pound sterling. These rates are subject to change throughout the day. It also quotes indicative rates for other foreign currencies 1/ on the basis of market rates in international money market centers. Subject to certain limitations, including a limit on spreads between the buying and selling rates, authorized dealers (banks) are free to determine and quote their own buying and selling rates. There are no taxes or subsidies on purchases or sales of foreign exchange.

Authorized dealers are allowed to trade in the forward market at rates that may be freely negotiated with their customers. For U.S. dollars and pounds sterling, however, forward rates may not differ by more than the premiums or discounts that are applied by the Central Bank for cover for a similar period. Authorized dealers are allowed to purchase forward cover from the Central Bank at prevailing rates or to conduct forward operations between two foreign currencies for cover in one of the two currencies. The Central Bank offers authorized dealers facilities for forward purchases of U.S. dollars and pounds sterling for exports for periods of up to 24 months. Cover for imports is normally provided for up to 6 months. When justified (for example, payments for imports of raw materials or capital goods), rates are quoted for up to 15 months. Forward contracts must be based on genuine commercial commitments. Forward cover may also be provided for up to 12 months to residents for specific financial commitments.

Cyprus formally accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund Agreement, on January 9, 1991.

2. Administration of control

Exchange controls are administered by the Central Bank in cooperation with authorized dealers. Authority to approve applications for the allocation of foreign exchange for a number of purposes has been delegated to authorized dealers.

3. Prescription of currency

Payments may be made by crediting Cyprus pounds to an external account, or in any foreign currency; 1/ the proceeds of exports to all countries may be received in Cyprus pounds from an external account, or in any foreign currency.

4. Resident and nonresident accounts

Residents of countries outside Cyprus may open and maintain with authorized dealers nonresident accounts in Cyprus pounds, designated external accounts, or foreign currency accounts. These accounts may be credited freely with payments from nonresidents of Cyprus (such as transfers from other external accounts or foreign currency accounts), proceeds from sales of any foreign currency by nonresidents (including declared bank notes), and the entire proceeds, including capital appreciation, from the sale of an investment made by a nonresident in Cyprus with the approval of the Central Bank and with authorized payments in Cyprus pounds. External accounts and foreign currency accounts may be debited for payments to residents and nonresidents, for remittances abroad, for transfers to other external accounts or foreign currency accounts, and for payments in cash (Cyprus pounds) in Cyprus. Authorized dealers are allowed to grant medium-and long-term foreign currency loans to nonresidents up to 20 percent of their deposit liabilities in foreign currencies. In addition they are allowed to grant short-term loans and credits to offshore companies up to 10 percent of their deposit liabilities in foreign currencies. Companies registered or incorporated in Cyprus that are accorded nonresident status (generally designated as offshore companies) by the Central Bank as well as their nonresident employees may maintain external accounts and foreign currency accounts in Cyprus or abroad, as well as local disbursement accounts for meeting their payments in Cyprus. Resident persons and firms dealing with transit trade or engaged in manufacturer-exporter activities or in the hotel business may open and maintain foreign currency accounts subject to certain requirements. Residents dealing with transit trade may deposit up to 95 percent of sale proceeds in these accounts and use balances to pay for the value of traded goods. Residents engaged in manufacturer-exporter activities may deposit up to 50 percent of export proceeds in these accounts and use balances to pay for imports of raw materials used in production. Both transit traders and manufacturers-exporters are, however, required to convert into Cyprus pounds at the end of each year and balances in excess of the amount that is necessary for payments of the value of traded goods or raw materials during the following three months. Resident hoteliers may deposit in foreign currency accounts that part of their receipts in foreign currency which they need to make imminent installment payments on foreign currency loans. Cypriot repatriates may keep in foreign currency or external accounts with banks in Cyprus, or in accounts with banks abroad, all of their foreign currency holdings and earnings accruing from properties they own abroad. Resident persons temporarily working abroad may maintain their foreign currency earnings in foreign currency or external accounts with banks in Cyprus, or in accounts with banks abroad.

Blocked accounts are maintained in the name of nonresidents for funds that may not immediately and in their entirety be transferred outside Cyprus under the existing exchange control regulations. Blocked funds may either be held as deposits or be invested in government securities or government-guaranteed securities. Income earned on blocked funds is freely transferable to the nonresident beneficiary or may be credited to an external account or foreign currency account. In addition to income, up to £C 50,000 in principal may be released annually from blocked funds for transfer outside Cyprus. Funds can also be released from blocked accounts to meet reasonable expenses in Cyprus of the account holder and his family, including educational expenses, donations to charitable institutions in Cyprus, payments for the acquisition of immovable property in Cyprus, and any other amounts authorized by the Central Bank.

5. Imports and import payments

Most imports are free of licensing requirements. An import license is required for certain commodities such as fresh fruits, fresh vegetables, fresh meat, and other goods produced or manufactured locally.

The Minister of Commerce and Industry may amend the list of commodities subject to licensing as deemed necessary to regulate the importation of goods for the encouragement of local production and manufacture, and for the improvement of the balance of payments. Exchange is allocated freely and without restriction through authorized dealers to pay for imports, provided that documentary evidence of shipment or actual importation of goods is available.

Advance payments before shipment require the prior approval of the Central Bank, except for imports whose value does not exceed £C 20,000. Authorized dealers are allowed to sell to departing residents of Cyprus foreign exchange up to £C 20,000 for purchases and for the importation of goods into Cyprus; foreign exchange in excess of this limit may be sold to departing residents with the approval of the Central Bank.

6. Payments for invisibles

Payments for invisibles abroad require the approval of the Central Bank, but approval authority for certain types of payments has been delegated to authorized dealers. Profits, dividends, and interest from approved foreign investments may be transferred abroad without limitation, after payment of any due charges and taxes. Insurance premiums owed to foreign insurance companies may be remitted after all contingencies have been deducted. Nonresidents who are temporarily employed in Cyprus by resident firms or individuals and are paid in local currency may deposit with authorized dealers up to £C 500 off their monthly remuneration in external or foreign currency accounts, the balance of which may be freely transferred abroad without reference to the Central Bank; deposits or transfers of greater amounts need the specific approval of the Central Bank.

Allowances are granted to residents for study abroad at colleges, universities, or other institutions of higher education, and certain lower-level institutions of learning. Exchange allowances are based on the cost of living which is reviewed yearly, and cover the full amount of tuition fees plus living expenses for the student. The current annual allowance for living expenses for studies in Western European countries is £C 5,500. For Greece, the allowance is £C 3,600; for Canada and the United States it is £C 6,600; for Australia it is £C 4,000; and for all other countries it is £C 3,600. There is no limit on the remittance of foreign exchange for payment of tuition fees.

Authorized dealers are allowed, without any reference to the central bank, to sell to resident travelers foreign exchange up to £C 1,000 a person a trip for tourist travel; the Central Bank approves applications for allocations of additional foreign exchange without limitation to cover genuine travel expenses. The allowance for business travel is not fixed but depends on the length of stay abroad. Authorized dealers are empowered to provide up to £C 150 a day with a maximum of £C 1,500 a trip, or £C 80 a day with a maximum of £C 800 a trip if the traveler holds and international business card (see below); additional amounts may be granted with the approval of the Central Bank on proof of need. Authorized dealers are also empowered to sell to departing residents foreign exchange up to £C 5,000 for medical expenses abroad; unlimited additional amounts are provided with the approval of the Central Bank.

Authorized dealers may issue personal cards valid abroad to any resident, except for residents studying abroad or temporarily living abroad for any reason. These cards, which are designated as international personal cards, may be used abroad for payments to hotels and restaurants, payments for transportation expenses, payments to doctors, clinics or hospitals, and international telephone calls without limit, as well as payments abroad or from Cyprus up to £C 300 per transaction for the following purposes: examination fees, subscription to professional bodies or societies, fees for enrollment in professional or educational seminars or conferences, and hotel reservation fees. Authorized dealers may also issue company cards valid abroad (designated as international business cards) to resident business people and professionals who are involved in international trade of goods or services and travel abroad on business. Moreover authorized dealers may issue special personal cards valid abroad (designated as special international personal cards) to certain categories of residents, such as public officials and university professors. Holders of special international personal cards and holders of international business cards are entitled to charge the following, in addition to the expenses allowed for holders of international personal cards: cash withdrawals up to £C 100 a trip and any other expenses up to £C 300 a trip, as well as mail orders of books (in the case of special international personal cards) or books and equipment for the company (in the case of international business cards) up to £C 1,000.

Authorized dealers may approve, without reference to the Central Bank, applications by resident travel agents to pay foreign travel agents and hotels up to £C 10,000 a trip. The Central Bank approves applications for higher amounts to cover genuine expenses without limitation. Authorized dealers may carry out, without prior reference to the Central Bank, payments of fares and freights by order of resident airlines, agents of foreign airlines, shipping agents or other resident transport companies in favor of foreign airlines, shipping or other transport companies; if the payment exceeds £C 5,000 documentary evidence must be subsequently submitted to the Central Bank.

On leaving Cyprus, resident travelers may take out with them up to £C 100 in Cypriot bank notes. There is no limit on the amount of foreign bank notes that departing residents may take out of the country as part of any of their foreign exchange allowance. Nonresident travelers may take out any amount of Cypriot or foreign bank notes they declared on arrival (see text under proceeds from invisibles). Nonresidents may also export up to £C 1,000 in Cypriot or foreign bank notes which they imported, even if they did not declare them on arrival. In addition, nonresident travelers may take out with them up to £C 100 in Cypriot bank notes. Furthermore, authorized dealers may convert up to £C 100 into foreign currency for departing nonresidents and are permitted to issue to departing nonresidents as well as to departing resident employees of offshore companies any amount of foreign currency notes against external funds.

7. Exports and export proceeds

All exports whose value exceeds £C 1,000 are subject to exchange control monitoring to ensure the repatriation of the sale proceeds. Export proceeds must be surrendered to authorized dealers without delay. Exports of potatoes and carrots are carried out by the respective marketing boards, and exports of wheat, barley, and maize are carried out by the Cyprus Grain Commission.

8. Proceeds from invisibles

Receipts from invisibles must be sold to an authorized dealer. Persons entering Cyprus may bring in any amount of Cypriot or foreign bank notes. Nonresidents entering Cyprus should declare to customs any Cypriot or foreign bank notes that they plan to re-export, or to deposit with authorized dealers, or to use to purchase immovable property or goods to export.

9. Capital

Transfers abroad of a capital nature require authorization from the Central Bank. Direct investment abroad by residents is permitted, provided that the proposed. Investments will promote exports of goods and services or will benefit the Cypriot economy. Outward portfolio investment by residents is not permitted, except for insurance companies (up to 20 percent of their reserves), Cypriot repatriates and residents temporarily working abroad who may hold foreign currency or external accounts, and resident employees of multinational enterprises who may participate in the employee stock purchase plan offered to them by their employer.

Investment in Cyprus by nonresidents require the prior approval of the Central Bank, which, in considering applications, gives due regard to the purpose of the investment, the extent of possible foreign exchange savings or earnings, the introduction of know-how, and, in general, the benefits accruing to the national economy. Foreigners may own up to 100 percent of the capital of enterprises engaged in the manufacturing of goods exclusively for export. Foreign participation of up to 49 percent is allowed for manufacture of new products, certain tourist activities, and other industrial projects. Inward investment is particularly welcome in projects which upgrade the tourist product (e.g., marinas, golf courses, and theme parks). In sectors of specific treatment such as banking and finance, applications are examined on a case-by-case basis. Foreign direct investment is discouraged in saturated sectors such as trading, real estate development, travel agencies, restaurants, and local transportation. Foreign participation in inward portfolio investment in listed company securities is permitted up to a limit of 30 percent generally and 40 percent in investment companies and mutual funds. Foreigners are allowed to purchase government securities in domestic currency. Annual profits and proceeds from the liquidation of approved foreign investments, including capital gains, may be repatriated in full at any time after payment of taxes. The Central Bank and the government are currently reviewing their policy as regards nonresident investments in Cyprus, with the aim of implementing a far more liberal policy.

Commercial credits from abroad with a maturity of less than 200 days and commercial credit from Cyprus with a maturity of less than 180 days may be negotiated freely. With the permission of the Council of Ministers, nonresident aliens may acquire immovable property in Cyprus for use as a residence or holiday home; they must, however, purchase such property with foreign exchange. The sales proceeds of such property are transferable abroad up to the original purchase price of the property; the remaining balance is transferable at an annual rate of £C 50,000 plus interest. The same treatment is accorded to nonresident Cypriots purchasing a holiday home in Cyprus.

Residents of Cyprus (Cypriot or foreign nationals) who take up residence outside Cyprus may immediately transfer abroad up to £C 50,000 per household; any excess amount is deposited in a blocked account and released at the rate of £C 50,000 a year. The transfer abroad of funds from estates and intestacies and from the sale of real estate, other than that referred to in the preceding paragraph, is limited to £C 50,000, with any excess amount to be credited to a blocked account and also released at the rate of £C 50,000 a year. Interest earned on a blocked account can be freely transferred abroad.

Transactions in foreign securities owned by residents require prior permission from the Central Bank. In principle, all securities held abroad by residents are subject to registration.

10. Gold

Residents may hold and acquire gold coins in Cyprus for numismatic purposes. Residents other than the monetary authorities, authorized dealers in gold, and industrial users are not allowed to hold or acquire gold in any form, other than jewelry, at home or abroad. Authorized dealers in gold are permitted to import gold only for the purpose of disposing of it to industrial users. The exportation of gold requires the permission of the exchange control authorities.

11. Changes during 1995

Payments for Invisibles

March 1. The amount of foreign exchange that authorized dealers may sell to departing residents, for tourist travel abroad, without reference to the Central Bank was increased from £C 750 to £C 1,000 a person a trip.

April 6. The Central Bank empowered authorized dealers to carry out, without subsequent reference to the Central Bank, payments of fares and freights by order of resident airlines, agents of foreign airlines, shipping agents or other resident transport companies in favor of foreign airlines, shipping or other transport companies up to £C 5,000.

May 26. The Central Bank issued an order which allows nonresident travelers to export any amount of Cypriot bank notes they imported and declared to customs on arrival. The order also allows nonresident travelers to take out up to the equivalent of USD 1,000 in Cypriot of foreign bank notes which they imported, even if they did not declare them on arrival. In addition, the order allows both resident and nonresident travelers to take out with them up to £C 100 in Cypriot bank notes. Prior to the issue of the order, the amount of Cypriot bank notes that a resident or nonresident traveler could export was limited to £C 50. Furthermore, the order allows authorized dealers to send any amount of Cypriot bank notes to foreign banks without reference to the Central Bank.

June 13. The Central Bank empowered authorized dealers to approve without reference to the Central Bank applications by resident travel agents to pay foreign travel agents and hotels up to £C 10,000 a trip.

July 1. The amount of foreign exchange that authorized dealers may sell to departing residents for medical expenses abroad without reference to the Central Bank was increased from £C 3,000 to £C 5,000.

The Central Bank empowered authorized dealers to issue personal cards valid abroad to any resident, except for residents studying abroad or temporarily living abroad for any reason. These cards, which are designated as international personal cards, may be used abroad for payments to hotels and restaurants, payments for transportation expenses, payments to doctors, clinics or hospitals and international phone calls without limit, as well as payments abroad or from Cyprus up to £C 300 per transaction for the following purposes: examination fees, subscriptions to professional bodies or societies, fees for enrollment in professional or educational seminars of conferences, and hotel reservation fees.

July 10. The amount that may be paid through special international personal cards or international business cards for mail orders of books or equipment was increased from £C 300 to £C 1,000.

Proceeds from Invisibles

May 26. The Central Bank issued an order which abolished restrictions on the import of Cypriot bank notes.

APPENDIX VI Cyprus: Fund Relations

(As of October 31, 1995)

I. Membership Status: Joined 12/21/61; Cyprus has accepted the obligations of Article VIII, Sections 2,3, and 4 on January 9, 1991.

II. General Resources Account:

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III. SPR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements:

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VI. Projected Obligations to Fund (SDR Million; based on existing use of resources and present holdings of SDRs):

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VII. Exchange Arrangements

In June 1992, the peg of the Cyprus pound changed from a broad basket of currencies to the ECU. The central rate was set at 1.7086 ECU/£C with a margin of 2.25 percent on either side. The U.S. dollar rate of the ECU is used daily to calculate the Cyprus pound equivalent in U.S. dollars. Official quotations for other currencies are determined daily on the basis of official rates between the U.S. dollar and the currencies concerned. The spread between the selling and buying rates is set at 0.4 percent.

VIII. Article IV Consultation

The last Article IV consultation discussions were held in September 1994 and the staff report (SM/94/268, 11/3/94) was discussed by the Executive Board on December 7, 1994.

IX. Technical Assistance

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X. Resident Representative: none

List of Recent Fund Studies

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1/

Car purchases increased by almost 30 percent in the year to June 1995, after substantial declines in the previous two years.

1/

In 1995, the government proposed new legislation to limit strikes in some essential social services.

1/

The consolidated central government excludes the local authorities. The local authorities’ deficit has been stable around 0.4 percent of GDP; their debt totals 1 percent of GDP, all of it is owed to the banking system, and is guaranteed by the central government.

1/

Contractual employees (about 30 percent of total) are not affected by the real wage freeze. In mid-1995, the government agreed to paying them COLA plus 3.2 percent per year for the next three years.

1/

This definition of government debt, labeled “net debt” in Table 22, excludes intergovernmental debt, i.e., the substantial Treasury bill holdings of the Social Insurance Funds. It also excludes Sinking Fund deposits, which are government deposits with the banking system that are being accumulated for future amortization of Development Stock and foreign debt. Table 23 presents debt data including intragovernmental debt.

2/

The increase in debt tends to surpass the financing needs of the consolidated central government because of the accumulation of government deposits into the Sinking Fund. The Fund’s assets reached 7½ percent of GDP in 1995.

1/

The actual liquidity ratio exceeded the prescribed ratio by at least 3 percentage points in the first two quarters of 1994.

2/

In practice, this amounted to agreeing to comply with the existing CBC guideline of 7 percent, which had not been observed in the past.

1/

By mid-October, the average liquidity ratio for the banking system was estimated to be 26.6 percent, against an annual average ratio of 27 percent.

1/

These terms correspond to those used by the United States’ FDIC. The CBC uses this system as part of its regular procedures for monitoring the quality of banks’ portfolios.

2/

Domestic use of these funds is still be subject to approval from the CBC.

1/

This is currently feasible due to a loophole in the existing legislation.

2/

Except for the financial difficulties faced by the Cooperative Central Bank in the late 1980s, there have been no bank failures in Cyprus. On that occasion, and in the absence of a deposit guarantee scheme, the cost of the bailout (some £C 60 million) was assumed by the central government.

1/

The central rate is ECU 1.7086 per Cyprus pound with a margin of fluctuation of plus or minus 2.25.

1/

In 1994-95, there were two changes in foreign exchange control regulations affecting the invisibles balance. First, the Central Bank increased travel allowances per person from £C 750 to £C 1,000 per trip (higher allowances are granted following proof of longer stays abroad). Second, allowances for medical treatment and studying abroad were also raised.

1/

More than 80 percent of offshore companies originate in Europe.

2/

For a full description of the trade and exchange system, see Appendix V.

1/

Prepared by Maria Carkovic.

2/

For a detailed description of the framework, see SM/94/282, Appendix I.

1/

The model was presented in SM/94/282, 11/23/94, Appendix II. It assumes unchanged real effective exchange rates against Cyprus’s major tourism competitors and uses WEO projections for growth of real consumption in the countries of origin of tourists.

1/

The increase in investment-to-GDP also results from sustained profitability gains during the projection period.

2/

Prior to the first oil price shock, inflationary processes were often depicted as the result of purely nominal shocks. After the oil shock, academics and policy makers came to see nominal disturbances as the exception rather than the norm.

1/

There have been additional arguments in favor of indexing financial assets, but the scope of this section is narrowly defined to cover wage indexation only.

2/

For a review of indexation practices and stabilization in Brazil, see Arida and Lara Resende (1985). For a review of the contribution of wage indexation to the collapse of the exchange rate regime Chile in 1982, see Edwards and Edwards (1987). For a review of Europe’s experiences with indexation, see Emerson (1983). For a review of Israel’s indexation, see Fischer (1985), for an analysis of Argentine’s case, see Krieger-Vasena and Szewach (1985), and for a review of Australia’s case, see McNelis (1988).

1/

This section draws on Edwards and Edwards (1987).

2/

This model has come to be known as the Scandinavian model of price formation, and is mainly attributed to the work of Calmfors and Lindbeck in the late 1970s.

1/

Bruno (1978) computes that the mean import price increase in 16 OECD countries during 1970-72--the first oil shock--was 23 percent.

1/

A lower supply elasticity would deepen the domestic price impact of a terms of trade shock.

2/

This is a simplifying assumption, because COLA adjustments are granted twice a year. More frequent adjustments impart greater inertia to the price level as real wages are better protected from rising inflation. For an examination of the effects of higher frequency indexing in Brazil, see Simonsen (1983), Macedo (1983) and Dornbusch (1985).

3/

Contrary to what was assumed in the baseline scenario, financial liberalization here is associated with a rise in interest rates. This is the result of higher inflation than in the baseline scenario.

1/

Prepared by A. Javier Hamann.

1/

In the absence of accurate data on interest payments by the central bank or a breakdown of bank deposits by type of deposit, this adjustment coefficient was used to reflect the fact that deposits in accounts other than reserve requirements earn a lower interest rate (4½-5 percent).

2/

This result is consistent with the findings in Sachinides (1994).

1/

As explained by Velasco (1991), an artificial demand for credit, stemming from nonfinancial enterprises troubled by the initial increase in interest rates, played an important role in pushing interest rates up.

2/

This was true even in Korea and Thailand, where interest rates were still managed when they peaked. For Thailand, in particular, see Johnston (1991).

1/

Prepared by A. Javier Hamann, based on information collected by Fund staff during the Article IV consultation and technical assistance missions, and on Ch. 6 of K. Phylaktis, The Banking System in Cyprus, Macmillan Press Ltd., London (1995).

2/

At mid-1995, there were 364 registered cooperations.

1/

Unlike commercial banks, which operate under the Law on Banking Business, the Central Bank of Cooperatives was established under the Law on Cooperative Societies and, thus, was initially not subject to the conditions imposed by the Inspector of Banks. It is now treated as a commercial bank.

1/

The total staff involved in the supervisory activities is 38, allowing for a ratio of 1 supervision officer for every 25 cooperative societies.

1/

Prepared by Sayuri Shirai.

2/

This impression is also borne out by the statistics. The domestic investment share was regressed on the national saving rate for the period 1970-94 and the estimate results are as follows (t-statistics in parenthesis):

( I / Y )   =   0.16 ( 4.7 )   +   0.56 ( 3.7 )   ( S / Y ) R 2   =   0.34

1/

Australian dollars, Austrian schillings, Belgian francs, Canadian dollars, Danish kroner, Finnish markkaa, French francs, Italian lire, Japanese yen, Netherlands guilders, Norwegian kroner, Portuguese escudos, Spanish pesetas, Swedish kronor, Swiss francs.

1/

Foreign currencies are all currencies other than the Cyprus pound.

Same Series

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Cover IMF Staff Country Reports
Cyprus: Background Paper
Author:
International Monetary Fund
Volume/Issue:
Volume 1996: Issue 016
Publisher:
International Monetary Fund
ISBN:
9781451809787
ISSN:
1934-7685
Pages:
132
DOI:
https://doi.org/10.5089/9781451809787.002
CHART 1

CYPRUS International Comparisons of Selected Economic Indicators 1/

(In Percent)
CHART 2

CYPRUS Growth and Tourism 1/
CHART 3

CYPRUS Financing and Composition of Investment 1/
CHART 4

CYPRUS Composition of Employment and Profitability 1/
CHART 5

CYPRUS Consolidated Central Government Finances 1/

(In percent of GDP)
CHART 6

CYPRUS Banking System: Domestic Credit and Foreign Assets
CHART 7

CYPRUS The Credit Cooperative Sector

(In percent)
CHART 8

CYPRUS Balance of Payments 1/

(In percent of GDP)
CHART 9

CYPRUS Exchange Rate Developments 1/

(1984=100)
CHART 10

CYPRUS Real Effective Exchange Rates 1/

(1984 = 100)
CHART 11

CYPRUS External Debt 1/

(In Percent)
CHART 1

CYPRUS The Medium–Term Outlook
Chart 1

Financial Liberalization and Real Interest Rates 1/
CHART 1

CYPRUS Savings and Investment

(In Percent of GDP)
CHART 2

CYPRUS Real Investment

(In Percent of GDP in Real Terms)
CHART 3

CYPRUS Real Fixed Investment

(In Percent of GDP in Real Terms)
CHART 4

CYPRUS Profitability by Sector 1/

(Index 1972 = 100)
CHART 5

CYPRUS Output and Employment in the Private Sector

(In Percent)
CHART 6

CYPRUS Investment and Profitability

(1972 = 100)