Cyprus
Background Paper

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.