Macro-economic Convergence

in Cyprus

By By Dr. Mustafa BesimDr. Mustafa Besim

Member of the Economic Committee in the Member of the Economic Committee in the Cyprus TalksCyprus Talks

ECONOMIC ECONOMIC CONVERGENCE CONVERGENCE

AND A AND A CYPRUS SETTLEMENTCYPRUS SETTLEMENT

6 February 2007LONDON SCHOOL OF ECONOMICS

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Objective & Scope of the Objective & Scope of the PresentationPresentation

• Focus will be on the macro-economic Focus will be on the macro-economic convergence and its contribution to a convergence and its contribution to a settlementsettlement

• The scope will cover:The scope will cover:– Convergence and its link to settlementConvergence and its link to settlement– Recent history on the economies (up to 2000) : Recent history on the economies (up to 2000) :

Convergence or Divergence ?Convergence or Divergence ?– Contribution of Economics to the ReferendaContribution of Economics to the Referenda– Integration and convergenceIntegration and convergence– Does convergence contribute to a settlement? Does convergence contribute to a settlement?

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Convergence Concept for Convergence Concept for SettlementSettlement

• Convergence:Convergence:– of incomes of citizens within an economy and of incomes of citizens within an economy and

with other economies;with other economies;– of institutions, sectors ( interdependence), of institutions, sectors ( interdependence),

macro-prudential indicators and market macro-prudential indicators and market structures;structures;

– criterions of EU for those members recently criterions of EU for those members recently acceded to EU acceded to EU ( i.e. inflation, interest, budget ( i.e. inflation, interest, budget deficit) deficit)

• The model for convergence for Cyprus:The model for convergence for Cyprus:– importance of economic integration within the importance of economic integration within the

islandisland– Model that would improve economic Model that would improve economic

interractions interractions

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Economic History of Economic History of CyprusCyprus

• (1960)- Republic of Cyprus : A Power sharing (1960)- Republic of Cyprus : A Power sharing partnership between two ethnic communities, partnership between two ethnic communities, Greek Cypriots (G/C) and Turkish Cypriots (T/C)Greek Cypriots (G/C) and Turkish Cypriots (T/C)– Rapid growth mainly in the agricultural economy, Rapid growth mainly in the agricultural economy,

export orientedexport oriented• ((1963)- Inter-communal conflict led to collapse of 1963)- Inter-communal conflict led to collapse of

the partnership. T/C set up a separate the partnership. T/C set up a separate administrationadministration – Income gap started to widen as T/C Income gap started to widen as T/C did not have did not have

much access to be active in economics much access to be active in economics as the G/C as the G/C • (1974)- Up to 1974 there was one economy(1974)- Up to 1974 there was one economy::

– GDPGDP : : $ 6$ 600 M00 M with per capita with per capita incomeincome close to $1,000 for close to $1,000 for G/C andG/C and

– Among T / C per capita income was $500 Among T / C per capita income was $500 • Following a G/CFollowing a G/C coup d’etat coup d’etat with backing from with backing from

Military junta in Greece, Turkey militarily Military junta in Greece, Turkey militarily intervened and divided the island into two: G/C in intervened and divided the island into two: G/C in South and T/C in the NorthSouth and T/C in the North

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South Cyprus EconomySouth Cyprus Economy • Moved from agriculture-based towards service-Moved from agriculture-based towards service-

oriented structure; tourism, shipping and oriented structure; tourism, shipping and financial activities including “off-shore” sector.financial activities including “off-shore” sector.

• Low interest and inflation rates. Low interest and inflation rates. Highly Highly developed financial sector with a credible developed financial sector with a credible exchange regime from fixed to a currency exchange regime from fixed to a currency basket and now towards EURO. basket and now towards EURO.

• A flexible labour market; shortages and wage A flexible labour market; shortages and wage pressures overcomed by seasonal immigrants.pressures overcomed by seasonal immigrants.

• As the EU membership approached the As the EU membership approached the liberalization process speeded up, transforming liberalization process speeded up, transforming the economy into a modern, market-based and the economy into a modern, market-based and liberal economy.liberal economy.

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Growth Rate in South Growth Rate in South Cyprus (2)Cyprus (2)

•Stable growth with close to 5% between 1977-2000Stable growth with close to 5% between 1977-2000•Main source of growth have been tourismMain source of growth have been tourism,, construction, construction, business and business and financial servicesfinancial services•The challenge ahead: Sustainability of the growth and the The challenge ahead: Sustainability of the growth and the macroeconomic macroeconomic stability: control of the budget stability: control of the budget deficit....stability and growth pact and adoption of Euro.deficit....stability and growth pact and adoption of Euro.

0

5

10

15

20

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Years

Gro

wth

Ra

te (

%)

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North Cyprus Economy North Cyprus Economy (1)(1)• After 1974, Northern Cyprus did not fulfil its After 1974, Northern Cyprus did not fulfil its

potentialspotentials::– External factors: non-recognition, economic isolation, External factors: non-recognition, economic isolation,

trade mainly with Turkey.trade mainly with Turkey.– Decision of the European Court of Justice limited the Decision of the European Court of Justice limited the

trade trade of of agriculture products (citrus, potatoes) agriculture products (citrus, potatoes) (Certificate of origin).(Certificate of origin).

– No trade integration, economy was not liberalised No trade integration, economy was not liberalised and market conditions were very much distortedand market conditions were very much distorted

– Depended on the aid from Turkey, which was in fact Depended on the aid from Turkey, which was in fact helping to enlarge the public sector.helping to enlarge the public sector.

– Admistration did not push for a Admistration did not push for a proper institutional proper institutional settings for the private sector and governancesettings for the private sector and governance

– Market based but economy has been relying on Market based but economy has been relying on public sector; public has been the producer as well public sector; public has been the producer as well as the employer, crowding out private sector.as the employer, crowding out private sector.

– Poor political willPoor political will to have a private sector driven to have a private sector driven economyeconomy

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North Cyprus Economy North Cyprus Economy (2)(2)

• Private and public (infrastructure) investments were not Private and public (infrastructure) investments were not sufficient....uncertainty, weak banking sectorsufficient....uncertainty, weak banking sector

• Using TL =Using TL = High and unstable inflation and interest High and unstable inflation and interest ratesrates

Inflation Rate in North Cyprus

0

10

20

30

40

50

60

70

80

90

100

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Years

Infl

ati

on

rate

(%

)

Inflation Rate (% Change in CPI) in North

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Growth Rates in North Growth Rates in North Cyprus (3)Cyprus (3)

Most shocks originating from Turkish economyMost shocks originating from Turkish economyAfter the crises between 1999-2001 and the After the crises between 1999-2001 and the stabilization of TL,stabilization of TL, the growth started to pick-up as high as 10%sthe growth started to pick-up as high as 10%sExport oriented services: tourism, universities Export oriented services: tourism, universities and construction and construction turned out to be major turned out to be major sources of incomesources of income

-10

-5

0

5

10

15

20

Years

Gro

wth

rat

e (%

)

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Meanwhile: Economic Meanwhile: Economic relations relations

between T/C and G/C..... between T/C and G/C..... Inter-communal conflicts in 1963 have worsen the Inter-communal conflicts in 1963 have worsen the

economic conditions for T/Ceconomic conditions for T/C By the time of By the time of de factode facto division (1974) per capita division (1974) per capita

GDP in the North was about half that in the South. GDP in the North was about half that in the South. For almost 30 years, Green-Line stood as the For almost 30 years, Green-Line stood as the

internal border with no traffic and/or trade at all internal border with no traffic and/or trade at all High volume of smuggling through certain High volume of smuggling through certain

channels: Mainly through Pile and Sovereign Base channels: Mainly through Pile and Sovereign Base Area of BritainArea of Britain

Commuting workers with permission Commuting workers with permission T/C haT/C haveve been very depended on trade with been very depended on trade with

Turkey, whereas G/C have been trading with the Turkey, whereas G/C have been trading with the worldworld

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Diverging EconomiesDiverging Economies ! ! No freedom of No freedom of

movement. No grounds movement. No grounds for economic for economic interaction.interaction.

Two diverged economy. Two diverged economy. North not converging to North not converging to South and to EU. South South and to EU. South converging to EU.converging to EU.

No convergence of No convergence of institutional and market institutional and market structures between structures between North and South. North and South.

Economics did not have Economics did not have incentives for incentives for supporting a political supporting a political solution. solution.

Diverged economies Diverged economies stoned separation stoned separation

19951995 20002000

GNP TGNP T//CC (Cyp (Cyp M)M)

367367 659659

GGDDP G/C (Cyp P G/C (Cyp M)M)

4,0894,089 5,405,4077

GNP T/C Per GNP T/C Per CapitaCapita

2,0272,027 2,652,6500

GGDDP G/C Per P G/C Per CapitaCapita

6,2836,283 7,797,7911

TC / GC TC / GC

per Capita per Capita IncomeIncome

32 %32 % 34%34%

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New Economic New Economic Environment for CyprusEnvironment for Cyprus

• November 2002, UN proposal for a November 2002, UN proposal for a Comprehensive settlement (Annan Plan)Comprehensive settlement (Annan Plan)

• Rallies led to opening of the gates (23 April Rallies led to opening of the gates (23 April 2003)2003)

• T/C demonstrated explicitly their will for a T/C demonstrated explicitly their will for a united Cyprus in EU united Cyprus in EU

• Free movement of people have allowed Free movement of people have allowed considerable amount of economic interaction considerable amount of economic interaction even without any institutional setupeven without any institutional setup– RetailingRetailing– Services (Tourism, casino, hospitals)Services (Tourism, casino, hospitals)– Labour (commuting workers)Labour (commuting workers)

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Economics Did not Economics Did not Contribute to ReferendaContribute to Referenda

• UN Plan (1.Versin November 2002) did UN Plan (1.Versin November 2002) did not pay enough attention to economics..not pay enough attention to economics..(2003 wasted) ....but by 2004 with revised (2003 wasted) ....but by 2004 with revised versions more economics were included. versions more economics were included.

• Four sub-economic committees prepared Four sub-economic committees prepared tremendous work tremendous work and and had most of what had most of what needed to run a Federal State. needed to run a Federal State.

• Since there was no work or proper studies Since there was no work or proper studies done at all before the UN talks, and no done at all before the UN talks, and no interaction between economies, it was interaction between economies, it was very difficult to observe the cost but more very difficult to observe the cost but more importantly the benefits of a settlement.importantly the benefits of a settlement.

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Economics and the Economics and the Referenda......Referenda......

• Economics uncertainties and risks,Economics uncertainties and risks, such as:such as:– ““who will pay the bill?” for a united who will pay the bill?” for a united

Cyprus (Territorial adjustments, fiscal Cyprus (Territorial adjustments, fiscal federalism)federalism)

– How would businesses be affected from How would businesses be affected from such a settlement? (Competitiveness of such a settlement? (Competitiveness of the tourism and other industries)the tourism and other industries)

– The income gap myth!The income gap myth!• From the economic perspective only the cost and From the economic perspective only the cost and

risks of unification were challenged not benefits at risks of unification were challenged not benefits at allall

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After the Referenda: NonAfter the Referenda: Non--recognized State with a recognized State with a

Legal StatusLegal Status• UN plan did not enter into force due to the Greek Cypriots solid UN plan did not enter into force due to the Greek Cypriots solid ‘NO’ vote in their referendum‘NO’ vote in their referendum

• Protocol Protocol 10 is suspended the application of EU 10 is suspended the application of EU acquisacquis, in North, in North• However, Article 3 provides that “nothing in this Protocol shall However, Article 3 provides that “nothing in this Protocol shall

preclude measures with a view to promoting the economic preclude measures with a view to promoting the economic development of the North Cyprusdevelopment of the North Cyprus

• Legal statues of the Turkish Cypriots are defined as the areas Legal statues of the Turkish Cypriots are defined as the areas where the “where the “Government of ROC” does not exercise effective Government of ROC” does not exercise effective controlcontrol

EU Council on 26 April 2004 invited Commission to bring EU Council on 26 April 2004 invited Commission to bring forward proposals:forward proposals: Green Line RegulationGreen Line Regulation: Intra-trade (In action since August : Intra-trade (In action since August

2004)2004) Financial support RegulationFinancial support Regulation (In action recently) (In action recently) Direct Trade RegulationDirect Trade Regulation enabling the North to trade directly enabling the North to trade directly

with the EU countries. Important challenge for business with the EU countries. Important challenge for business people as well as public to succeed institutional convergence. people as well as public to succeed institutional convergence. (Not in action yet)(Not in action yet)

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Integration Triggered Integration Triggered the Growththe Growth

o Even though technical, legal problems still exists, green Even though technical, legal problems still exists, green line regulation is in action and contributing a lot especially line regulation is in action and contributing a lot especially to the North economy to the North economy

• A very first step towards a modest economic integration A very first step towards a modest economic integration between non-recognised entity and EU.between non-recognised entity and EU.

• The Annan Plan process, opening of the North to the The Annan Plan process, opening of the North to the world, even with modest integration has reflected world, even with modest integration has reflected significantly to the economics significantly to the economics

20020011

20022002 20032003 20042004 20052005 2006*2006*

SoutSouthh

4.14.1 2.12.1 1.91.9 3.83.8 3.93.9 4.04.0

NortNorthh

5.45.4 6.96.9 11.411.4 15.415.4 10.610.6 7.07.0

Real GDP Growth Rates in N/C and S/C

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No indication of change in No indication of change in the share of economic the share of economic activities relative to whole activities relative to whole economic size of the island economic size of the island from 1980 to 2000from 1980 to 2000> North’s economic size have > North’s economic size have shown tremendous increase shown tremendous increase recording a 12.5% of whole recording a 12.5% of whole islandisland

Economic Sizes (1980-1990)

8.8%

91.2%

Economic sizes (1991-2000)

South Cyprus91.09%

North Cyprus8.91%

91.1%

8.9%

Economic Sizes (2005)

12.1%

87.9%

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Converging Converging EconomiesEconomies

- The substantial increase in the income of the North reduced the The substantial increase in the income of the North reduced the gap tremendouslygap tremendously

- Integration has helped not only incomes to converge but to an Integration has helped not only incomes to converge but to an extend to retail prices as well. Some convergence of institutional extend to retail prices as well. Some convergence of institutional and market structures between North and South (Göçekuş, 2006)and market structures between North and South (Göçekuş, 2006)

- Economics do have incentives for supporting a political solution. Economics do have incentives for supporting a political solution. With a more converged incomes shed some light to a settlement. With a more converged incomes shed some light to a settlement.

19951995 20020022 20052005

GNP TGNP T//CC (M $ ) (M $ ) 756756 941941 2,3282,328

GNP G/C ( M $)GNP G/C ( M $) 8,2348,234 10,56810,568 16,95816,958

GNP T/C Per CapitaGNP T/C Per Capita 4,1674,167 4,4094,409 10,56710,567

GNP G/C Per CapitaGNP G/C Per Capita 12,65312,653 14,91314,913 21,57121,571

T/C / GC per Capita T/C / GC per Capita IncomeIncome

32 %32 % 30%30% 49%49%

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Steep ConvergenceSteep Convergence

Note: World Bank reports suggest that the living standards in North is as much as three quarters of the South

30 32

38

49 51

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10

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60

2002 2003 2004 2005 2006

Years

Pe

rce

nta

ge

(%

)

Ratio of TC’s per Ratio of TC’s per

capita income / GC’s capita income / GC’s per capita incomeper capita income

30 32

38

49 51

0

10

20

30

40

50

60

2002 2003 2004 2005 2006

Years

Pe

rce

nta

ge

(%

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Economic Convergence and Economic Convergence and Prospects for a SettlementProspects for a Settlement

• Economics is not everything for a settlement but Economics is not everything for a settlement but converging economies provides fertile grounds for converging economies provides fertile grounds for political dynamics political dynamics

• The convergence have speeded and the income gap The convergence have speeded and the income gap has been shrinking fasthas been shrinking fast

• More focus should be on the economic incentives More focus should be on the economic incentives and opportunities that may be created with a and opportunities that may be created with a settlement. (i.e. tourism, higher education and settlement. (i.e. tourism, higher education and other business services) other business services)

• Willingness for a settlement is positively correlated Willingness for a settlement is positively correlated with more economic incentives and opportunitieswith more economic incentives and opportunities

• This can be eliminating many of the pessimisms This can be eliminating many of the pessimisms that individuals had about the economics of that individuals had about the economics of unificationunification

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The The WWay Ahead: ay Ahead: Challenges and Challenges and OpportunitiesOpportunities (1) (1) Policies and measures that would increase the integration Policies and measures that would increase the integration

process to push for steeper convergence (institutions, process to push for steeper convergence (institutions, markets and income):markets and income):• Labour market is already converging, some frameworks Labour market is already converging, some frameworks

have to be coordinated with South for different types of have to be coordinated with South for different types of benefits and regulations. (Role of trade unions)benefits and regulations. (Role of trade unions)

• Revised GL regulation to allow more flow of goods and Revised GL regulation to allow more flow of goods and servicesservices

• Financial aid; (help adapt Financial aid; (help adapt acquis, acquis, improve infrastructure) improve infrastructure) • Direct trade; (for converging institutions and markets)Direct trade; (for converging institutions and markets)

Economic reform agenda should be to enhance the Economic reform agenda should be to enhance the constituencies for unificationconstituencies for unification

North will have to speed up with adopting the North will have to speed up with adopting the acquisacquis communautaire,communautaire,. This will help North to better convergence . This will help North to better convergence institutionally as well as for market structure. Shadowing institutionally as well as for market structure. Shadowing the the acquisacquis also helps for coordinating reforms. also helps for coordinating reforms.

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The The WWay Ahead: Challenges ay Ahead: Challenges and and OpportunitiesOpportunities (2) (2)

Eliminating the income gap between the G/C and Eliminating the income gap between the G/C and T/C faster contribute to the solution process of the T/C faster contribute to the solution process of the Cyprus issue better.Cyprus issue better.

BUT ! Economic convergence can only contribute to BUT ! Economic convergence can only contribute to a settlement if there is more integration with the a settlement if there is more integration with the Southern economy and EU.Southern economy and EU.

If the present status continues and there is no If the present status continues and there is no better economic integration with South Cyprus and better economic integration with South Cyprus and only per capita convergence is realized to an only per capita convergence is realized to an extend, then this will only be an extend, then this will only be an “Artificial “Artificial convergence”convergence” and will not contribute to a and will not contribute to a settlement at all. ===settlement at all. === divergence divergence

Support to UN initiative (Support to UN initiative ( Gambari’s process) to Gambari’s process) to establish bi-communal technical communities to establish bi-communal technical communities to look into key and operational issues (criminal, legal look into key and operational issues (criminal, legal as well as economics) that may reinforce economic as well as economics) that may reinforce economic integrationintegration

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Thank you …Thank you …