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Prepared by Claudio Paiva.
The current account deficit declined from 5.4 percent of GDP in 1996 to 4½ percent of GDP in 1997. The cyclically adjusted current account deficit, however, continued to rise, as will be explained in paragraph 5.
The direct impact of these shocks on the cumulative value of exports earnings is estimated at 3⅓ percent of GDP: the drop in tourism receipts from 1995 to 1996 was equivalent to 2¼ percentage points of GDP, and the drop in agriculture exports from 1995 to 1996-97 is estimated at 1.1 percentage points of GDP.
Notwithstanding the large issuance of public bonds in the European market in 1997, there was a marked decrease in the overall debt ratio. Public foreign debt as a percentage of GDP decreased from 23 percent in 1990 to 11½ percent in 1997.
The table on page 19 shows the income elasticities used to adjust the values of exports and imports of goods and services to the levels that would have prevailed were output to equal potential output for both Cyprus and its trading partners.
The average investment to GDP ratio fell from 20.9 percent in 1993-95 to 18.8 percent in 1996-97. The average saving to GDP ratio dropped from 20.9 percent to only 12.9 percent.
Cyprus has however benefited greatly from the opening of the Eastern European economies, which have become an important market for Cypriot exports, especially reexports.
This framework was developed by the IMF’s Coordinating Group on Exchange Rate Issues (CGER) and is regularly used to estimate equilibrium exchange rates for industrialized countries. See International Monetary Fund (1997).
The long-run elasticities were estimated using annual data for the period 1970-97. The estimation procedure utilized was suggested by Engle and Yoo and described in Cuthberston, Hall, and Taylor (1992). This same procedure was applied by Ito and others (1996) to estimate income and real exchange rate elasticities of trade for 15 countries of the APEC region.
Since Cyprus was not among the countries considered in the panel-data estimations, the country-specific constant term (which corresponds to the general constant plus a fixed-effect dummy variable) for Cyprus was taken as the one that minimizes the squared errors between the observed current account deficits and the deficits predicted by the model coefficients.
The structural fiscal deficit in 1997 was estimated at 4.4 percent of GDP, against an average of 1½ percent in industrialized countries; Cyprus’ dependency ratio was approximately 56 percent, against an industrial country average of 66 percent; and finally, Cyprus’ potential GDP per capita was 50 percent of that of the United States, against an industrial-country average of 84½ percent.
The index is weighted by the countries’ participation in Cyprus’ total tourist arrivals.
VEC models do not provide estimates of structural parameters but rather unconstrained estimates of the relationships among the variables in the system, so that individual coefficients should be interpreted with caution. For further details see Hamilton (1994) and Agénor (1995).
When estimating impulse response functions and variance decompositions, the order in which the variables are entered into the system affects the outcome of the estimation. Such ordering must follow a progression of exogeneity of the variables, with the “most exogenous” (or those less affected by contemporaneous values of the other variables) being listed first and so on. In our case, exogeneity suggests the ordering PCGDP, RULCS, XSERV, TIS.
The simplicity of the model, with only three exogenous variables, and the relatively small sample size are probably behind the fact that a significant share of the variance of XSERV is explained by its own lagged values. When the variables are entered into the system in a different order, with TIS being allowed to explain contemporary changes in export volumes, the variance decomposition shows a much lower degree of persistence in XSERV, and investments in the service sector become the main explanatory variable in the long run. Nonetheless, the relative importance of external demand and relative ULC is not affected by this different ordering.