The Selected Issues Paper focuses on Cyprus' banking sector vulnerabilities and its pension system. The most salient risks for the banking sector come from commercial banks domiciled in Cyprus. These banks have the strongest links with the local economy and are likely to experience further deterioration of their loan portfolios in both Greece and Cyprus. The paper reveals that, in 2011, Cypriot banks face capital needs estimated at €3.6 billion on a preliminary basis.


The Selected Issues Paper focuses on Cyprus' banking sector vulnerabilities and its pension system. The most salient risks for the banking sector come from commercial banks domiciled in Cyprus. These banks have the strongest links with the local economy and are likely to experience further deterioration of their loan portfolios in both Greece and Cyprus. The paper reveals that, in 2011, Cypriot banks face capital needs estimated at €3.6 billion on a preliminary basis.

IV. External Competitiveness1

Cyprus’ service exports driven growth model is facing challenges in terms of weakened external demand and increasing competition from other countries in the region. The question of external competitiveness boils down to whether Cyprus has the potential to continue growing at current real exchange rates. This question has now gained importance and urgency as the economy is facing numerous shocks that are likely to hamper domestic demand for an extended period. To put the economy back on a growth path, policies to reduce wage rigidities and enhance productivity are vital to boost export performance and growth.

A. Introduction

1. Persistent current account deficits expose Cyprus to increasing vulnerabilities as recent distress in financial markets makes foreign financing more uncertain. The current account deficit, which had been averaging 3 percent of GDP up until 2004, has been steadily widening since accession to the EU and currently stands at over 7 percent of GDP. While its financing has not been a problem in the past, given large inflows of FDI and non-resident deposits, the availability of these resources is not guaranteed going forward, as repeated downgrades of the sovereign and deteriorating macro risks have seriously diminished Cyprus’ attractiveness for foreign investment, at the same time as continued slowdown in the rest of Europe exacerbates the decline in foreign demand and FDI inflows. Non-financial corporations are highly indebted to banks and make the private sector highly vulnerable to banks’ lending capacity and interest rate changes.

2. While growth in service exports has been partially compensating for the negative merchandize trade balance, their continued dynamism is not guaranteed. In the context of rapid unit labor cost growth and the associated real exchange rate appreciation, Cyprus’ goods have been increasingly priced out of international markets since the early 1990s, contributing to a goods trade deficit of 20-30 percent of GDP in the last decade. Services exports, in particular business services, shipping and financial intermediation have been partially offsetting this trend. However, continued dynamism of these sectors needs to be supported by measures to strengthen Cyprus’ price competitiveness and reforms to enhance productivity.

3. This note reviews the development of Cyprus’ services sector and its contribution to external trade, analyzes empirically the role of relative prices for service export growth, and examines other factors that determine Cyprus’ capacity to compete in the world markets. The note is structured as follows. Section B puts Cyprus labor market indicators into regional perspective. Section C lays out recent trends in exports, focusing in particular on the role of service exports. Section D provides an empirical analysis of the role of relative prices for service export dynamics. Section E discusses other aspects of competiveness and section F concludes.

B. Labor Market Indicators

4. Cyprus has a history of very low unemployment rates and short unemployment durations, in contrast to many other peripheral Euro area countries. Unemployment averaged around 4 percent from 2000 to 2008. In fact, the economy was faced with labor shortage and relied heavily on immigrant inflows to cover the shortage, particularly in low skill sectors. Within the EU, the net migration rate of 11 percent over the period from 2000 to 2009 was only second to Spain. The labor market also did not show signs of significant structural unemployment, as is reflected in the lowest rate of long-term unemployment in the Euro area. However, the crisis has not left Cyprus’ labor market unscathed: its unemployment currently stands at 7.6 percent, still below the Euro average of 9.9 percent but historically at the highest level for Cyprus.

5. Cyprus has a low tax wedge on labor, low replacement rate, and duration of unemployment benefits, and hence does not suffer from financial disincentives to labor participation. Cyprus’ average tax wedge on labor, at 14 percent for the average single wage earner, is by far the lowest within the EU2. Likewise, Cyprus’ unemployment benefits are among the least generous in the EU. Although the initial net replacement rate of 58 percent lies in the range of other EU countries, the benefit duration of only 5 months is extremely short. Unlike in many countries, where lower but more long-term unemployment assistance is often available after the expiration of the unemployment insurance payment, such a scheme does not exist in Cyprus.

6. Cyprus has a very high share of employment in service sectors and a large public sector. The high service content of production, employment and exports is one major characteristic that sets Cyprus apart from the rest of the region. The most dynamic service sector is financial intermediation, whose value-added already exceeds that of tourism. Although a transition from agriculture/manufacturing to services is typical for countries during the process of convergence and modernization, Cyprus’ service intensity still stands out when compared with either a large mature economy like the UK, or small open economies like Malta or Luxembourg, which all have large banking systems as well. Another salient feature of the Cypriot economy is the large share of the public sector. Spending on wages by the general government makes up almost 15 percent of GDP, the highest level in the EU. One important implication of such a dominant public sector is that wages set for government employees act to a large degree as an anchor for wage developments in the private sector. This has been one reason why wages in Cyprus have often not been in line with productivity dynamics.

7. Real wages rose during the downturn in 2009 at one of the highest rate in the Euro area and do not co-move with cycles in economic activity. As the crisis hit in 2009, Cyprus experienced its first downturn in more than 30 years. Yet, average real wages increased by 3.6 percent, one of the highest growth rates in Europe.3 The fact that a major negative shock to growth and employment did not trigger a downward adjustment in wages points towards a lack of flexibility to cushion the contraction. But also looking at the correlation of wage and GDP growth during an extended period before the crisis, Cyprus shows a large negative correlation, meaning that changes in wage growth in general do not move in tandem with changes in the business cycle.

Figure 1.
Figure 1.

Cyprus Labor Market in Regional Perspective

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A004

Sources: Eurostat; OECD Taxing Wage; European Commission; AMECO; and European Commission, Labor Market Developments in Europe, 2011.

C. The Evolution of Service Exports

8. Cyprus is a small open economy specializing in exports of services and relying on imports of goods and commodities. With a trade share of over 50 percent of GDP, the trade balance contributes substantially to variation in GDP growth. In the years leading up to the crisis, the trade balance was mainly driven by deficits in the goods balance (fuel, equipment, vehicles), which was only partially offset by positive net exports in services (tourism and business services).

Sources: IMF, WEO; Ministry of Finance; and IMF staff calculations.

9. The goods trade balance has been persistently negative at over 20 percent of GDP since the mid 1990s, reflecting the steady erosion of market shares. While many countries in Southern Europe have been facing losses in export market shares due to deteriorating competitiveness upon joining the EU, the pace of loss for Cyprus has been among the fastest. At the same time, market share of service exports has been largely constant, with a spike in 2008-2009, when Cyprus service exports contracted less than elsewhere in the world.

Sources: IMF, Direction of Trade Statistics; Eurostat; and IMF, WEO.

10. Service exports are increasingly driven by business and financial services, while the contribution of tourism has been declining. Traditionally, tourism has been the main export sector due to Cyprus’ favorable geographic location and climate. Over the last decade however, its share in total GDP has halved from 20 to less than 10 percent, while that of exports of business services and financial intermediation has increased from 10 to almost 29 percent of GDP. The expansion builds on Cyprus’ low corporate tax rates and double-tax treaties, which attracted international offshore companies, creating demand for local legal and accounting services. Additionally, demand for vacation homes by foreigners has led to a boom in real estate related services in the run-up to the crisis.


Service Exports Composition

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A004

Sources: Statistical Office of the European Communities ; and IMF staff calculations.

11. While the UK and Germany have been traditionally the main destinations for Cypriot service exports, Russia has rapidly gained importance in recent years. Exports volatility has been strongly influenced by demand conditions in Europe and the US, Cyprus’ main trading partners. The large drop in tourism in 2009 was driven by external demand slowdown, particularly in the UK, which accounts for about half of total tourism. However, the increasing presence of Russian travelers, real estate investors, and offshore companies, and the relative buoyancy of Russian demand compared to that in the EU have provided some positive impulse in 2011, leading to a substantial recovery in tourism. In 2009, Russia overtook the UK as the largest export market for Cypriot services. In June to August 2011, tourism revenues from Russia rose 52 percent (year-on-year) compared to a 16 percent increase overall.


Distribution of Top 10 service export destinations

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A004

Source: Eurostat.

12. The drop in Cyprus’ exports at the peak of the crisis in 2009 was mild compared to other Euro zone countries, as was its recovery in 2010, likely due to lower reliance on manufacturing exports. Although tourism activity did decline substantially, exports of other services (transport, financial and business) held up relatively well during the downturn in 2009. At the same time, exports across all sectors staged only a weak recovery in 2010. This largely mirrors the fact that countries which have a relatively high service share in total exports tend to be less sensitive to swings in external demand. While the subdued cyclicality of service exports might have protected Cyprus against the slowdown in external demand, it also poses limits to an export-led recovery once external conditions improve.

Sources: Eurostat; and IMF staff calculations.

D. The Role of Relative Prices

13. The real exchange rate has been appreciating since 2000 in line with other peripheral Euro zone countries. The unit labor cost (ULC) based real effective exchange rate appreciated rapidly ahead of the EU accession, mainly driven by fast growth in labor costs as the CPI-based real exchange rate measure appears more stable. Unlike in other Euro area countries, there was hardly any real depreciation in the ULC-based measure in response to the downturn in 2010. The apparent lack of downward flexibility of the exchange rate is likely caused by wage rigidities imposed by the cost of living adjustment (COLA), which indexes wages to past inflation. Downward wage and price flexibility is particularly important given lack of nominal exchange rate flexibility within the monetary union.


REER CPI-based

(Total economy, 1999=100)

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A004


REER ULC-based

(Total economy, 1999=100)

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A004

Sources: European Commission and IMF staff calculations.

14. A cross-country regression exercise suggests that exports of services are less sensitive to external demand, but respond similarly to real exchange rate movements as goods exports. Being a service economy, one might expect Cyprus to respond differently to fluctuation in world trade activity than countries specializing in goods and commodity exports. One might also think that service exports are less substitutable and hence less sensitive to exchange rate movements than goods exports. To approach this question, a cross-country panel regression was used to estimate an export demand equation for goods and services separately and statistically test for differences in their behavior. The sample includes both EU and non-EU European countries, as well as the US, Australia and New Zealand, covering the period from 1994 to 2010. In the baseline specification, export volume is assumed to depend on external demand, measured by a weighted average of trading partners’ income (Y*), the real effective exchange rate, CPI-based (REER) and ULC-based (ULCRE), structural break due to the Euro (EUR) adoption, and unobservable country and year fixed effects (µi and µt) 4:


The estimation results are summarized in Table 1. Two main findings stand out:

  • Goods exports are highly dependent on external demand, but services exports less so: A 1 percent increase in trading partner growth is associated with a 2 percent increase in real export growth for goods. The demand elasticity for services has less than half the magnitude and is not statistically significant.

  • Both goods and service exports respond significantly to real exchange rate movements, measured either by the CPI-based or the unit labor cost-based real effective exchange rate. Moreover, the magnitude of the exchange rate elasticity is similar for goods and services: a 1 percent real appreciation leads to a 0.16 to 0.26 decrease in export growth, depending on the specification. In fact, a formal Wald test cannot reject the hypothesis that the exchange rate elasticity is equal for both goods and service exports.

Table 1.

Regression Results 1/

article image
Sources: Eurostat; European Commission; and IFS.

All regressions include a full set of country and time fixed effects and a Euro dummy for countries and years with Euro adoption; robust standard errors are in parantheses; ***, **, * denote statistical significance at the 1, 5, and 10 percent level respectively.

For Cyprus, this finding is consistent with analyses of the tourism sector which report that its main weakness is the deteriorating price competitiveness reflected in high prices for transport, accommodation and general living costs (see WEF, 2011a).

15. The euro adoption is associated with a stronger sensitivity of goods exports to real exchange rate movements.

  • The sample includes euro and non-euro area countries, and for the former, years prior to joining the currency union. Therefore, it is possible to test whether the adoption of the common currency made member countries’ exports more or less sensitive to relative price fluctuations, compared to the control group of non-euro countries and/or years. We estimate the euro effect by interacting each measure of the real exchange rate with a dummy variable that, for each country, equals one from the year it adopts the euro. This additional term, measuring the euro “treatment” effect is added to the baseline regression equation. The results are summarized in Table 2 for the whole sample.

  • The estimates for the euro treatment effect are significant and negative for exports of goods. That is, upon joining the euro area, a country’s goods exports become more sensitive to real exchange rate changes - a real appreciation of 1 percent now has a negative effect of -0.5 to -0.7 percent on exports growth (more than double the average effect of -0.2 to -0.25). This finding has been reported in other recent studies (e.g. Bayoumi et al., 2011). A possible reason for this increased sensitivity to exchange rate movements could be financial and product market liberalizations that occurred with the euro adoption. Liberalization removed many non-price barriers to trade and gave relative prices a stronger signal of competitiveness. Moreover, as the euro adoption was preceded by a period of reduced exchange rate volatility for countries in the ERM, uncertainty about the future path of the exchange rate, and hence about the permanence of changes in competitiveness was lowered. This as well could enhance the signaling effect of relative prices.

Table 2.

Regression Results with Interaction Terms 1/

article image
Sources: Eurostat; European Commission; and IFS.

All regressions include a full set of country and time fixed effects and a Euro dummy for countries and years with Euro adoption; robust standard errors are in parantheses; ***, **, * denote statistical significance at the 1, 5, and 10 percent level respectively.

Joining the euro area does not seem to change the sensitivity of service exports to exchange rate movements. Relative to product markets, services markets are more regulated at the national level, hence subject to more non-trade barriers even after Euro adoption.

E. Other Aspects of Competitiveness

16. Administrative inefficiencies and severe regulations still pose obstacles to the business environment. Cyprus currently ranks 40th among 183 countries worldwide in terms of the Ease of Doing Business as measured by the World Bank (World Bank, 2012), and 47th among 142 countries in terms of broader competitiveness as measured by the World Economic Forum (WEF, 2011b). Notwithstanding recent reforms to improve the regulatory environment, which include the set-up of one-stop shop for new business registration and strengthened investor protection through greater corporate disclosure, serious impediments remain. Compared with other advanced countries, Cyprus ranks only 39th out of 48 for its ease of enforcing contracts, due to numerous procedures and long waiting times to resolve disputes in courts. The private sector also complains about severe restrictions in key transport sectors in terms of working hours (e.g., ports, warehouses) and access to license to operate (e.g., trucks).


ICT Usage for External Functions

(Percent of all enterprises)

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A004

Source: Eurostat.

17. While envisaging further transition to high value-added services, Cyprus still lags in terms of technological innovation and adoption. In spite of the high quality of the education system, Cyprus ranks weakly in terms of its capacity for innovation and R&D, a critical dimension for competitiveness defined by the Lisbon Strategy.5 Aggregate spending on R&D, at 0.4 percent of GDP, is the lowest in the EU and far below the EU target of 3 percent of GDP. As for adoption of existing technology, the share of enterprises using information and communication technologies (ICT) for external business functions (e.g., supply, financial, client management) is the lowest in the euro zone.

F. Conclusion

18. Cyprus competitiveness derives from its service exports, which have enjoyed strong growth thanks in large part to a favorable tax regime and an educated English speaking workforce. Along the steady transition towards a service economy, there has been a gradual shift to business and financial services away from traditional manufacturing and tourism. At the same time, new markets (predominantly Russia) have provided additional impulse for export expansion in recent years. Prior to the crisis, this growth model contributed to strong labor market performance, but was accompanied by a rapid expansion of the public sector and fast increase in labor cost.

19. Going forward, efforts to reduce wage rigidities are central to preserve competitiveness, in particular in the absence of nominal exchange rate flexibility. Although reliance on the business friendly tax regime has proved successful in the past, its potential for further benefit is limited given increasing tax competition from other countries, as well as limits posed by government finances and EU-wide regulations. Going beyond the tax regime, relative prices are an important determinant of service exports, as shown by empirical evidence. Absent control over nominal exchange rates and commodity prices, wages need to be sufficiently flexible to adjust to shocks such as the recent crisis and facilitate reallocation of factors across sectors. The most effective way to reduce wage rigidities is to reform or eliminate the COLA. This would also direct more skilled workers into the private sector as the COLA contributes to high public sector wages.

20. To ensure ongoing dynamism as Cyprus continues its transition to high value-added services, there is need for improved business climate and technological sophistication. The authorities should identify regulatory hurdles affecting contract enforcement and the efficient functioning of transport services discussed above and lay out appropriate reforms. They should explore what obstacles hinder more widespread technology adoption by businesses. Initial measures to support Cypriot firms in their efforts to upgrade technology and enhance productivity have been included in the National Reform Program.


Data sample underlying estimations in Table 1 and 2:

  • - Countries: all current EU-27 countries, plus Croatia, Iceland, Norway, Switzerland, Unites States, Canada, Australia, New Zealand, Turkey.

  • - Years: 1994 – 2010.

  • - Variables and sources:

    • exp: exports of goods/services in constant prices, from WEO, IFS (IMF) and Eurostat.

    • Y*: External Real GDP weighted by exports to all partner countries, from

      WEO (IMF).

    • REER: CPI-based real effective exchange rate, from INS Database (IMF).

    • ULCRE: Unit labor cost based real effective exchange rate, from European Commission.


  • Bayoumi, R., R. Harmsen and J. Turunen (2011), “Euro Area Export Performance and Competitiveness”, IMF Working Paper No. 11/140.

  • WEF (2011a), The Travel and Tourism Competitiveness Report 2011, World Economic Forum, Geneva.

  • WEF (2011b), The Global Competitiveness Report 2011-2012, World Economic Forum, Geneva.

  • World Bank (2012), Doing Business 2012, The World Bank and International Finance Corporation, Washington DC.


Prepared by Mai Chi Dao (EUR)


Data is as of 2007, taken from Labour Market Developments in Europe, 2011.


Although in Ireland, real wages rose by more than 4 percent, almost all of that increase was driven by the deflation that Ireland suffered during the downturn, while nominal wages hardly budged,


See the appendix for variable definition, sources and sample coverage.


According to the Lisbon Review 2010, Cyprus ranks 13th out of 27 EU countries in terms of overall competitiveness, but only 21th in terms of the sub-category Innovation and R&D.

Cyprus: Selected Issues Paper
Author: International Monetary Fund