The financial sector is mostly comprised of the banking sector, which largely provides insurance and asset management services. A large part of banking system assets relates to subsidiaries and branches of foreign banks. The banking sector poses risks by virtue of its size and concentration. The Cypriot banking system has weathered the crisis better than many other euro zone area countries. Significant headwinds for the overall banking system are expected, and the cooperative banks appear particularly vulnerable.

Abstract

The financial sector is mostly comprised of the banking sector, which largely provides insurance and asset management services. A large part of banking system assets relates to subsidiaries and branches of foreign banks. The banking sector poses risks by virtue of its size and concentration. The Cypriot banking system has weathered the crisis better than many other euro zone area countries. Significant headwinds for the overall banking system are expected, and the cooperative banks appear particularly vulnerable.

II. External Competitiveness Assessment1

Cyprus’ persistent current account deficits over the last decade point to competitiveness problems. This note reviews price and non-price indicators to assess the existence of a competitiveness gap in Cyprus and the factors underlying it. Results show that, while productivity growth has been higher in Cyprus than in the euro area, wages growth outstripped productivity gains. As a result, unit labor costs grew more rapidly than in peer countries, implying a steady loss of competitiveness vis-à-vis Cyprus’ trading partners. A solid labor market and a dynamic service sector have somehow preserved Cyprus productivity but action to restore a healthy competitive business environment is needed. Structural measures to enhance efficiency and labor market flexibility, and a revision of the current wage indexation system would increase the capacity of the economy to adjust to external shocks and curb unit labor cost growth, while curtailing government consumption expenditure would increase national saving thereby reducing the current account deficit and lessen real exchange rate appreciation.

A. Introduction

1. Cyprus experienced persistently negative current account balances since 19952 suggesting weak competitiveness. Increasingly negative goods trade balance have been only partially offset by surpluses in the services balance, resulting in average trade deficits of 6 percent of GDP since 1995. Although the impact on macroeconomic stability of large current account deficits has been reduced since Cyprus adopted the euro, recurrent deficits point to potential competitiveness problems. Moreover, the financing of the current account imbalances has been guaranteed by sustained capital inflows mostly in the form of short-term non-resident deposits with domestic financial institutions. This exposes the country to external vulnerabilities since the volatile nature of these inflows creates uncertainties with regard to Cyprus’ balance of payments sustainability.

A02ufig01

Current Account

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

A02ufig02

Financing of Current Account

(Percent of GDP, 4-quarter rolling avg.)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

2. Safeguarding competitiveness is a focal challenge within the context of a monetary union in the absence of exchange rate flexibility. The performance and flexibility of its labor market as an adjustment channel to asymmetric shocks has become critical for the successful participation of Cyprus in the economic and monetary union (EMU) and even more in the context of the current economic downturn. A competitive and flexible economy can also facilitate the stabilizing role of fiscal policy which is the primary macroeconomic policy tool that is retained by members of a monetary union.

3. This note reviews Cyprus’ price and non-price competitiveness indicators and draws some tentative conclusions as regards the existence of a competitiveness gap, its underlying factors and the structural reforms needed to restore external competitiveness. The rest of the note is organized as follows. Section B reviews Cyprus competitiveness performance by looking at the main price and non-price indicators and a series of comprehensive indicators developed by international institutions. Section C looks at labor market developments. Section D discusses the wage indexation mechanism and its implications for competitiveness. Section E elaborates on the role of the Service sector. Section F concludes and discusses policy implications.

B. Measuring Competitiveness

Export Market Share Indicators

4. Cyprus market share in goods has been on a declining trend since the early1990s with the decline accelerating since the mid 1990s on the backdrop of a rapidly increasing share of service exports on international markets. As the increasingly service oriented economy has caught up with income levels in more advanced economies, rising labor costs in Cyprus have eroded its earlier comparative advantages in some labor intensive manufacturing sectors. More recently, Cyprus’ closer integration to the EU economy during the years prior to EU accession has increased competition in the export market for goods contributing to losses in Cypriot market shares in the EU and global market.

A02ufig03

Foreign Trade Balances

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

A02ufig04

Market Share of Good Export

(Percent of world exports)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Sources: WEO; and Eurostat.

5. The rapid increase in several categories of high value service exports has crowded out the market share of good exports and only partially compensated the increase in good imports, resulting in a recurrently negative balance of trade in goods and services. Diversification in ship transportation and construction as well as financial and other business services has more than offset the decline in tourism revenues thus enabling Cyprus to increase its market share of exports of services. However, persistent surpluses in the services balance have not squared with increasingly negative deficits in the balance on goods thus generating persistently negative trade balances over time.

Productivity and Price Indicators

6. Labor productivity in Cyprus grew slightly faster than in the euro area over the last decade. Robust growth, sustained by strong labor supply and a friendly business taxation environment has allowed Cyprus to achieve high productivity rates and embark in a successful real convergence with the EU and accession to the euro. Cyprus real GDP has been growing at an annual average rate of almost 4 percent since 1995, compared to 1.7 in the euro area while employment grew by 2.2 percent, sustained by inflows of foreign workers and a historically low unemployment rate.

A02ufig05

Labor Productivity per Person

(Percent change)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Source: Eurostat.

7. However, prices and wages grew faster. The consumer price index (CPI) as well as the producer price index (PPI) and labor costs exhibit steadily positive gaps with respect to euro area. While the CPI may result in an inaccurate indicator of external competitiveness since it includes a significant share on non-traded consumption goods, and is subject to distortions owing to taxes and subsidies, PPI and labor costs are better indicators of competitiveness in the tradable sector.3 Both these indicators suggest a persistent competitive disadvantage of Cyprus with respect trade partner countries in the Euro area. However, wage increases reflect to some extent the labor shortages and low unemployment rates that prevailed before the crisis.

A02ufig06

Producer Price Inflation

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

A02ufig07

Labor Cost Inflation

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Sources: Eurostat; and IMF staff calculations.

8. As a result, unit labor costs (ULC) grew more rapidly than in the euro area, implying a steady loss of competitiveness vis-à-vis Cyprus’ trading partners. Real ULC have accelerated since 2001, while they were on a decreasing path in the euro area. After falling lower than the euro area ULC in 2008 as Cyprus economy was booming, the gap has reopened in 2009 as a consequence of the global economic downturn which hit Cyprus with a lag. However, developments in ULC may not provide an accurate indication of the competitive position of the Cypriot economy as a whole since the economy is strongly service oriented and the manufacturing sector contributes for less than 10 percent of GDP.

A02ufig08

Real Unit Labor Cost

Index, 2000=100

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Source: Eurostat.

Exchange Rate Based Indicators

9. Since 2000 real effective exchange rate (REER) measures have exhibited an appreciation trend broadly in line with the other Southern euro area countries. The real appreciation is mostly hurting the manufacturing sector as high wages in the growing financial and real estate sectors due to high productivity in those sectors put upward pressures on wages in the rest of the economy. When looking at the price deflator of exports, however, the real appreciation has been milder in Cyprus than in peer countries, reflecting the high share of high value services exports.

A02ufig09

REER ULC-based

Index, 1999=100

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

A02ufig10

REER ULC-based, Manufacturing

Index, 1999=100

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

A02ufig11

REER- based on Price Deflator of Exports of Goods and Services

Index, 1999=100

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Source: European Commission

10. The REER appreciation seems to be largely driven by rapidly growing ULC. A comparison with the nominal effective exchange rate shows that after 2003 the appreciation of the REER based on the HCPI and the deflator of export is mainly due to a nominal appreciation, while ULC point at a steeper deterioration on competitiveness. This evidence has to be considered on the backdrop of a period of wage moderation over the past five years, in the context of achieving the macroeconomic convergence criteria for Cyprus’s successful integration into the EMU. While such moderate stance was not enough to preserve Cyprus’ competitiveness vis-à-vis its trade partner, in 2008 pay increases at sectoral level were substantially higher compared with the previous years, and in April 2008 the government decided to further increase minimum wages for the five occupational groups covered by the Minimum Wages Law.

A02ufig12

Nominal and Real Effective Exchange Rates

(1999 = 100)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Source: European Commission

11. CGER-type estimates show that Cyprus is facing a significant competitive disadvantage. All estimates indicate the same directional conclusion, with negative current account gaps and substantial exchange rate overvaluation, consistent with recent development in wages and the competitive deterioration in the manufacturing sector. However, the large current account swing in 2009 (from -17.5 to- 8.3 percent of GDP) suggests that significant current account adjustments can occur in Cyprus without major changes in the exchange rate (or slower growth relative to trading partners). Moreover, CGER type analysis needs to be interpreted with care for services export-oriented economies, since service exports may be less responsive to exchange rate dynamics.

CGER-type Estimates

article image
Source: IMF staff estimates.

Difference between actual current account balance (CAB) and the estimated equilibrium CAB in percent of GDP

Percentage difference between the actual REER and the estimated equilibrium REER. A positive result suggest overvaluation.

Other Indicators of Competitiveness

12. Non price indices and survey data used for global ranking give mixed signals about the competitiveness of the Cypriot economy. Several institutions evaluate competitiveness performance using a comprehensive approach based on hard as well as survey data. Cyprus’ position in selected rankings is reported below:

  • The Global Competitiveness Index (GCI), published annually by the World Economic Forum (WEF) captures macroeconomic and microeconomic fundamentals of national competitiveness which are conducive to a healthy business environment and sustainable level of productivity. The GCI considers 12 main determinants of competitiveness, including structural factors; it ranks Cyprus 34th out of 133 countries in 2009–10, with an improvement with respect to the 2008 edition where Cyprus was ranked 40th. Compared to other “innovation driven economies”, Cyprus underperforms in market size, innovation and technological readiness. Survey results point to the following most problematic factors for doing business in Cyprus: (i) inefficient government bureaucracy; (ii) access to financing; (iii) adequate supply of infrastructure; and (iv) restrictive labor regulation.

  • The Index of Economic Freedom published annually by The Heritage Foundation and The Wall Street Journal covers 183 countries across 10 specific freedoms—such as trade, business, investment freedom, and property rights—and assigns a grade to each using a scale from 0 to 100, where 100 represents the maximum freedom. The 10 component scores are then averaged to give an overall economic freedom score for each country. Cyprus’ economic freedom score is 70.9, making its economy the 24th freest in the 2010 Index. The overall score is almost unchanged from last year, with significant declines in property rights and labor freedom balanced by improvements in business freedom and freedom from corruption. Cyprus is ranked 13th out of 43 countries in the Europe region, and its overall score is higher than the regional and global averages.

  • The Doing Business Index published annually by the World Bank investigates the regulations that enhance business activity and those that constrain it. It presents quantitative indicators of business regulations and protection of property rights affecting different stages of the life of a business, from starting a business to enforcing contracts and closing a business. Cyprus is ranked 40th out of 186 countries on the 2010 report, with a deterioration compared to the 2009 report which ranked Cyprus 36th.

  • The Logistic Performance Index (LPI), also published by the World Bank is based on a worldwide survey of operators on the ground (global freight forwarders and express carriers), providing feedback on the logistics friendliness of the countries in which they operate and those with which they trade. Feedback from operators is supplemented with quantitative data on the performance of key components of the logistics chain in the country of work. The overall LPI score for Cyprus is 3.13 in a scale from 1 to 5, ranking the Country 46th out of 130, with lower scores on timeliness and logistic competence.

  • The Competitive Industrial Performance Index (CIP) developed by the United Nations Industrial Development Organization (UNIDO) combines four main dimensions of industrial competitiveness: industrial capacity, manufactured export capacity, industrialization intensity and export quality. The CPI ranked Cyprus 41th over 122 countries in 2005, up 18 places compared to 2000, with a significant improvement in export quality and manufactured export capacity mainly driven by a substantial increase of high technology exports as a share of manufactured exports.

  • The Business Environment Outlook Index developed by the Economist Intelligence Unit, averaged 6.8 out of 10 in 2005–09 ranking Cyprus 34th out of 82 countries. While no significant change is expected in Cyprus’s business environment score in 2010-14, improvements in some other countries will result in Cyprus’s global ranking falling two places to 36th. The country’s relatively low ranking reflects the small market size and the distance to the main EU market, no market access to Turkey, a culture of cronyism and the division of the island.

  • The Lisbon Reform Scorecard created by the Center for European Reform assesses individual EU countries’ performances relative to their Lisbon targets. The scorecard is based on EU structural indicators which measure performance in economic, social and environmental categories; it provides an overview of EU countries’ record on economic reform. In the 2009 scorecard Cyprus ranks 14th over 27, up one position compared to 2008. Empirical evidence shows that there is a close relationship between the reform scorecard and current account positions across countries. This suggests that Cyprus should speed the implementation of structural reforms to improve nonprice competitiveness.

A02ufig13

Global Competitiveness Index

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Source: World Economuc Forum, The World Competiveness Report 2009-2010.

Cyprus

article image
Source: World Bank
A02ufig14

Current Account Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Sources: International Monatary Fund, World Economic Outlook; and Center for European Reform, The Lisbon Scorecard X. The road to 2020.
Figure II-1.
Figure II-1.

Competitiveness Indicators, 2009

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A002

Sources: World Economic Forum, Global Competitiveness Index 2009-2010; World Bank, Doing Business 2010; The Heritage Foundation, 2010 Index of Economic Freedom; Industrial Development Report 2009, Competitive Industrial Performance Index; Economic Intelligence Unit, Country Forecats March 2010; and World Bank, Logistic Performance Index.

C. Labor Market Developments

13. Assessed vis-à-vis the usual macroeconomic and Lisbon benchmarks the Cypriot labor market performs well and better than the EU average. The labor market has historically been characterized by conditions of almost full employment and high job creation. Unemployment is particularly low partly due to sustained GDP growth and an efficient unemployment insurance system, characterized by relatively low benefits of short duration. Over the last ten years, the unemployment rate averaged at 4.3 percent; it fell to 3.6 percent in 2008. Employment has been growing by 2.5 percent, accelerating to 3.3 during 2003–07, and has been benefiting from sizeable inflows of foreign workers. Long-term unemployment has remained very low, less than 1 percent of the labor force. However, while the employment rates for females and older workers fulfill the relative Lisbon target, the gender pay gap currently stands at 23.1 percent, which is one of the largest, if not the largest, gap among the EU Member States.

D. The Role of Wage Indexation

14. The current system of wage determination in Cyprus provides for the automatic adjustment of wages on the basis of general changes in price levels (the Cost-of-living adjustment—COLA system). Specifically, the gross earnings of workers are revised at the end of every six months—that is, on January 1 and July 1—on the basis of the consumer price index percentage of the preceding six-month period. The COLA system has been in operation since 1944. Until recently, it has been considered as a nonnegotiable issue during collective bargaining, enjoying the strong support of trade unions and governments as a catalyst to the harmonization of the relationship between labor and management, despite opposition from the employer organizations.

15. The uniform application of the COLA does not allow wages to reflect productivity differences across economic sectors while the second-round inflationary effects undermine flexibility and erode competitiveness. Although there is no empirical evidence that the COLA has contributed to a self-perpetuating inflationary spiral,4 it is possible that this might have been due to the low inflationary conditions that have prevailed in Cyprus so far. At times of strong inflationary pressures, the COLA can impede the stabilizing role of fiscal policy, which is a major drawback within the context of a monetary union and the related absence of exchange rate flexibility.

16. The shortcomings of the COLA become also more evident in the current low-growth economic environment. By linking wages to CPI rather than productivity, COLA undermines competitiveness and labor flexibility, in addition to exacerbating the level and persistence of price shocks. In addition, downward wages stickiness resulting from the COLA may become an impediment to the economy’s ability to respond to the current low-growth environment. In particular, in the presence of long-duration wage contracts the COLA constrains the markets’ ability to correct an overshooting of wages that may result from too optimistic an outlook at the time of the contract’s inception.

17. Another issue raised against the COLA is that it is applied irrespective of the level of wages. As a consequence, it increases wage differentials between employees at the lower and higher scales, in particular in the public sector, thus contributing to enhancing inequalities as well as to eroding its labor market peace enhancing benefits. The share of employees in the private sector that benefits from COLA has been on a downward trend. Recent estimates by the CBC place at approximately 50 percent the overall share of such employees.

E. Developments in the Service Sector

18. Sectoral analyses of the labor market reflect a steady transformation of the Cypriot economy characterized by the increasing importance of the services sector. The Services sector, which contributed 69.5 percent to GDP in 2008, exhibits strong dynamism, reflected in high rates of growth, an increase in their share to value added and an expansion of their shares in international markets. Specifically, the sectors of banking and other financial services, international business services, and shipping appear to have successfully exploited Cyprus’ comparative advantages in terms of geographic location, infrastructures, and highly educated human capital.

19. Such sectoral shift is mostly welcome since the services sector is a key element in the adjustment mechanism within a currency union, and developments in services play an important role for the macroeconomic performance of the entire economy. Services are increasingly used as inputs in manufacturing and other non-service sectors and can have a positive impact on the economic performance of other sectors. Moreover, most services are relatively labor intensive implying that a strong growth performance of these sectors will better absorb the unemployed. Finally, price rigidities in the service markets may hinder the necessary adjustment essential to facilitate adjustment to shocks while efficiency gains in services may contribute to lower inflation rates5.

20. However, the tourism sector has been growing below potential in recent years and its contribution to growth shrank in 2009, while financial and business services have been growing rapidly. Tourism is the single most important sector in Cyprus once the restaurant and hotel sector is combined with the effect of tourism on transport, construction and retail. The competitiveness of Cyprus’ tourism sector have been falling in recent years, reflecting comparatively high prices and increased competition from other Mediterranean destinations as well as the heavy dependence on a severely weakened UK market. On the other hand, low barriers to business establishment, a favorable corporate tax rate and strong telecommunication infrastructures have favored financial and business services, which have been playing an increasingly important role in the economy.

21. While Cyprus’ road, electricity, water and telecommunications networks are of good quality, air transport liberalization has been slow and public transportation is poor. The relative absence of budget airlines as a byproduct of delayed liberalization, and the infrequency of direct flights to some key destinations have hampered Cyprus’ aim to become a regional hub for airlines. The currently poor bus service network and reliability is the origin of the problem of traffic congestion in towns, especially at the beginning and end of the public sector working day. The government has plans to increase the use of public transport (from the current 2 percent of total transport) by improving the quality of public transportation while there are no plans to develop a railway system.

F. Conclusions

22. Cyprus competitiveness has suffered from high growth rates in wage and labor costs notwithstanding solid productivity trends and labor market developments and the good performance of the services sector. In light of Cyprus accession to the euro area in 2008 the need to preserve competitiveness in the absence of exchange rate flexibility is paramount. The above analysis suggests that there is room for improving competitiveness with policy measures designed to reduce rigidities, control labor cost increases and raise national saving.

23. Action to preserve competitiveness includes structural reforms aimed at increasing efficiency and reducing structural rigidities. Increasing the quality of human capital and the flexibility of product market, streamlining the regulatory environment, improving transport and communication infrastructure, and financial and services support for exports would help stimulate economic activity and external competitiveness. Efforts to reduce the pay gap between men and women are also desirable to buttress a flexible and efficient labor market. There is also room to increase labor participation in view of the challenges of an ageing population by encouraging part-time work and flexible working practices.

24. In view of the higher growth in labor costs compared to Cyprus’ trade partners the automatic wage indexation mechanism should be better targeted to reflect sectoral productivity gains or eliminated. Current efforts to set up a medium-term budgetary framework present an opportunity to revisit and address the issue of wage setting in the public sector, which accounts for most of the employees benefited by the COLA system. The objective would be to adopt a framework allowing wages to reflect productivity gains and correct the structural rigidities induced by the current system. Allowing wages to reflect sectoral or firm level productivity gains would be conducive to a more efficient allocation of labor. On the other hand, well targeted social measures for those in need of protection could be implemented to counteract any adverse impact that such reform may have on the most vulnerable fraction of the labor force.

25. Containing government consumption spending is mostly recommended as an action to raise national savings thus reducing the large current account deficit. Reducing government consumption expenditure is also particularly recommended given empirical evidence that increases in government consumption tend to increase the relative price of nontradables and leads to real appreciation of the exchange rate6. Moreover, such a policy squares with the need to reduce the current fiscal deficit and restore the sustainability of the government balance.

26. Overall, there is need to invest in service infrastructure to upgrade the country’s overall business environment and attract higher-spending tourists. Efforts to improve the quality of the tourism product and to diversify into sports and business tourism should help to halt the recent decline in competitiveness and attract higher income tourists. The prioritization of investment in transport infrastructure would also enhance the overall business environment and attract non-Cypriot customers and labor force.

References

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1

Prepared by Valentina Flamini (EUR).

2

The only exception was 1998, with a surplus of 3.1 percent of GDP.

3

The underling basket of PPI includes a wide range of intermediate goods that are subject to international competition, and labor costs capture differences in wages and other related costs.

Cyprus: Selected Issues
Author: International Monetary Fund