February 2007

Growth, Convergence and Reunification:

Are the Dynamics Encouraging?

Max Watson(Oxford University, Adviser to the European Commission)

This paper does not represent views of the European Commission

The Convergence ConceptIn Cyprus, convergence refers to 3 principles,

with the potential to be mutually reinforcing:

• Convergence of incomes: CY => EU average

• Convergence of incomes: north => south

• Convergence of the real economy and of institutional frameworks: north => south

Economic dimensions not everything, but affect

political dynamics via incentives (referenda)…

Context for EU aid, Green Line, Technical talks

Operational QuestionsFocus here on recent income trends, and then

4 issues on which we may stand at crossroads:

• Role of economics in Spring 2004 failure?

• Are there major synergies to unlock in a converging intra-Cyprus economy?

• Can economic reform approaches contribute importantly to convergence?

• If we miss present opportunity, will economic gravity pull in divergent directions?

Recent Income Trends

2001 2002 2003 2004 2005South 4.1 2.1 1.9 3.8 3.9North 5.4 6.9 11.4 15.4 10.6

Since 2002, convergence has accelerated intra-

Cyprus and vis-à-vis EU:

Real GDP (% change)

Policy frameworks in south: Maastricht, Lisbon

Policy frameworks in north: Mixed incentives

Intra-Cyprus Income GapImage during UN discussions also needs to be

revised as regards levels:

• Perception of a steep, persistent gap added to tensions on convergence strategy/federalism

• Ayres 2003, while warning on measurement hazards, cited EIU p.c. 2000 of $6k v. $13k

• Mehmet 2004 assumed starting disparity 60%

• Eichengreen et al 2004 Report on Annan Plan

assumed 60% & project (benign) 38% in 2020

World Bank PPP Estimates of n/s Gap

Nominal WB Atlas PPP (US dollars 000s)North 8.1 7.2 14.8North – rev. base 9.2 8.2 16.9 South 19.4 17.6 22.3Ratio (north: south) 42 41 66Ratio (rev. base n.) 48 47 76Gap n:s (rev. base) 52 53 24Ratio (n: EU rev. base) 40 39 64Is PPP factor right? And north receives large transfers (15-20% of GDP). Size of informal economy (20-35%)

Medium-term ChallengesSustainability/competitiveness challenge - some

parallels, but far more serious in north:

• Short- to medium-term fiscal adjustment

• Address long-term social security imbalance

• Achieve continuing shift to higher value added exports, with growing globalisation of services

and monetary union with competitive partners

=>Reforms in north not underway: so bottlenecks, as well as distortions to trade and investment

Economics and the 2004 TalksThere was little time to prepare underlying

Issues - and are we using time well now:

• Income gap; convergence strategy; framework

• Credible fiscal federalism in EU framework

• Reunification cost (including resettlement, balance sheet issues in north – which cannot

be left unresolved if incentives are to go right)

But not neglecting market dynamics: winners &

losers among corporate & labour market groups

Intra-Cyprus Synergies

The island faces a huge strategic opportunity

as well as new competitive challenges:• It is an EU service sector hub in the Eastern

Mediterranean… exploiting scope to upgrade value added in a globalised service economy

• So concept not intra-Cyprus complementarity

but synergy in services (tourism; education;

and a very wide range of business services)

• …& continued restructuring in manufacturing

Economic Reforms & Convergence

The north will be compelled to embark on far-

reaching reforms by a range of pressures…

• Economic history points to role of effective frameworks – or risk distortions affecting all

• Acquis communautaire offers an opportunity

to shape this process & realise externalities

• But reforms such as social security need more

co-ordination, and help set market framework

• Plus other public finance, competition reforms

Economic GravityIntra-Cyprus convergence or divergence will

play out on the ground in several markets, eg:

• Labour market: Integrating, but over which areas? Framework? Net skill flows? Tensions?

• Goods: Distorted and underperforming?

• Services: Tourism: gridlocked by property, psychology? Health: hazardous integration?

• Financial flows: Same gridlock?

• Real estate: Problematic, & pervasive impact

Constituencies for Reunification

Economic exchanges may embed interests in

rent-seeking distortions, or open-market flows • So pattern of exchange in markets can affect

strength of constituencies for reunification

• Clearest in property holdings, trade channels

• Also, Turkey reforms change many trade-offs

• Economic convergence across Cyprus – in frameworks/structures as well as income levels

– as a pervasive Confidence Building Measure

Opportunities & Dynamics

At present time, risks of creeping political

economic divergence need to be squarely faced…

• Can evolving initiatives be steered in a ways

that lead toward greater convergence not just in incomes but in economic & cultural life?

• Can economic exchanges, including reform

ideas embed constituencies for reunification?

• How fully can communities in Cyprus realise

the immense promise of their regional role?

End of Presentation