Cyprus
Recent Economic Developments
Author:
International Monetary Fund
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Publication Date:
02 Jan 1995
eISBN:
9781451809770
Language:
English
Keywords:
ISCR; CR; capital formation; liquidity ratio; central bank; fixed capital; private sector; economic activity; aggregate demand; GDP deflator; market share
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This paper reviews economic developments in Cyprus during 1990–95. Economic growth slowed down and became more volatile in the early 1990s compared with the 1980s. External shocks, compounded by unfavorable domestic developments, kept GDP growth at unusually low levels in 1991 and 1993. Inflation, which had remained below the European Union (EU) average throughout the 1980s, edged over it since 1991. The price deceleration in 1993 and 1994 was insufficient to bring Cypriot inflation in line with falling inflation in the EU, mostly on account of the introduction of value-added tax in 1992.

Abstract

This paper reviews economic developments in Cyprus during 1990–95. Economic growth slowed down and became more volatile in the early 1990s compared with the 1980s. External shocks, compounded by unfavorable domestic developments, kept GDP growth at unusually low levels in 1991 and 1993. Inflation, which had remained below the European Union (EU) average throughout the 1980s, edged over it since 1991. The price deceleration in 1993 and 1994 was insufficient to bring Cypriot inflation in line with falling inflation in the EU, mostly on account of the introduction of value-added tax in 1992.

Cyprus: Basic Data

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Source: IFS and data provided by the authorities. ceicyp.tab

Adjusted for methodological problems related to the introduction of VAT in 1992, GDP growth is 9.4 percent, 0.4 percent, and 3.8 percent; and the GDP deflator increased by 6.0 percent, 4.5 percent and 5.1 percent respectively, in 1992, 1993, and 1994.

Percentage change over preceeding 12 months.

Actual data as of May 1994.

I. Introduction

Following a strong recovery from the effects of the Gulf war in 1992, GDP growth decelerated in 1993 to its lowest level in two decades, mainly as a result of a significant drop in tourist arrivals associated with the recession in Europe and with cost competitiveness losses. As in 1991, a fall in productivity coupled with wage increases—predetermined by wage contracts signed in the previous year and by wage indexation—led to a sharp increase in unit labor costs. This time, however, firms reacted by squeezing profits, and the government adopted a more conservative policy stance, with the fiscal deficit halved to 2.4 percent of GDP. As a result, the external current account improved dramatically, recording a surplus for the first time since 1967, and inflation fell after seven years of price acceleration.

The positive developments of 1993 are broadly envisaged to continue in 1994, and growth is projected to resume following the economic recovery in Europe. Inflation has further decelerated, the budget deficit is expected to stay close to its medium-term target, and the current account is projected to remain in surplus. However, cost competitiveness has not recovered, and profit margins and investment activity remain low.

This report provides background information for the Article IV consultation with Cyprus. Section II describes recent developments in aggregate demand, production, prices, and the labor market; section III examines fiscal developments; section IV deals with monetary developments; and section V provides details on the evolution of the balance of payments and competitiveness.

The report also contains five appendices focusing on specific economic issues. Appendix I provides medium-term scenarios illustrating the potential effects of alternative policies; Appendix II estimates a demand function for tourism and examines the role of relative prices in determining tourist arrivals; Appendix III describes the labor market institutions and evaluates the flexibility of the Cypriot labor market; Appendix IV examines the relationship between monetary aggregates and inflation; and Appendix V describes in detail the exchange and trade system.

II. Domestic Economy

Economic growth slowed down and became more volatile in the early 1990s, as compared to the 1980s (Chart 1). External shocks, compounded by unfavorable domestic developments, kept GDP growth at unusually low levels in 1991 and 1993. However, even these lower rates exceeded on average those of EU countries, fostering a continuation of Cyprus’ real convergence with the EU (Chart 2). On the other hand, inflation, which had remained below the EU average throughout the 1980s, edged over it since 1991. The price deceleration in 1993 and 1994 was insufficient to bring Cypriot inflation in line with falling inflation in the EU, mostly on account of the introduction of VAT in 1992.

CHART 1
CHART 1

CYPRUS Real GDP Growth, Tourist Arrivals and Contributions of Domestic Demand and Foreign Balance 1/

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Data provided by the authorities.1/ In 1994, data are official projections.
CHART 2
CHART 2

CYPRUS International Comparisons of Selected Economic Indicators 1/

(In percent)

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Sources: IMF, International Financial Statistics; WEO; and data provided by the authorities.1/ In 1994, data for Cyprus are official projections; data for the other countries are WEO projections.2/ Includes Greece, Portugal and Spain. The composite indicators are averages of the indicators for the individual countires weighted by the U.S. dollar value of their respective GDPs.

In the early 1990s, the labor market was characterized by a surge in unit labor costs. While the unemployment rate increased somewhat in periods of recession, real wages continued to rise leading to a sharp decline in profit margins, a decrease in domestic exports and, since 1993, lower investment. The service sector was the most dynamic, while the share of manufacturing and agriculture in GDP shrank.

1. Demand and production

Real GDP growth in 1993 is officially estimated at 1.5 percent (Table 1), the lowest growth rate since 1975 with the exception of 1991—the year of the Gulf War. 1/ This slow growth reflected a fall in both domestic and external demand which was only partially cushioned by a decline in import propensity.

Table 1.

Cyprus: Aggregate Demand

(At constant 1985 prices)

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Source: Ministry of Finance.

Both private and public consumption plunged, leading to the first decline in overall consumption since 1975. Private consumption propensity returned to its level of the late 1980s, after reaching unusually high levels in 1991 and the first half of 1992 in anticipation of the introduction of VAT (Table 2). This decline was fully accounted for by the fall in households’ imports of cars and imports of durable and semi-durable consumer goods which, for the most part, do not have domestic substitutes. The decline in public consumption is related to lower imports of defense equipment.

Table 2.

Cyprus: Aggregate Demand

(At current prices)

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Source: Ministry of Finance

Fixed capital formation fell sharply in 1993, in part reflecting the decline in profitability, and tougher enforcement of restrictions on hotel construction. Although the negative contribution of investment to domestic demand growth in 1993 is somewhat overstated by the boom of aircraft imports in 1992 (Table 3), even after adjusting for aircraft imports, real investment in 1993 was lower than in any of the preceding four years. However, the effect of the decline in gross capital formation on GDP growth was lower than its effect on domestic demand, since about 75 percent of this decline was accounted for by items that are almost exclusively imported, such as machinery and equipment, motor vehicles, and aircraft (Table 4).

Table 3.

Cyprus: Contributions to Growth of Real GDP 1/

(In percent)

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Source: Ministry of Finance.

Bulk items include aircraft purchases for Cyprus Airways valued at £C 80.8 million, £C 16.3 million, £C 48.4 million and £C 17.4 million in 1989, 1990, 1992 and 1993 respectively. Total may not equal the sum of individual components due to rounding.

Table 4.

Cyprus: Composition of Gross Fixed Capital Formation

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Source: Ministry of Finance.

Owing to the decline in investment and to the increased availability of domestic savings, the absorption of foreign-savings fell to an historical low (Chart 3). As a result, the external balance contribution to growth was positive for the first time in six years, despite a decline in exports of goods and services. 2/ Reflecting the recession in Europe and a loss of competitiveness, tourist arrivals fell from the record high reached in 1992 and domestic exports shrank for the third consecutive year.

CHART 3
CHART 3

CYPRUS Financing and Composition of Investment 1/

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Ministry of Finance, Economic Studies Division.1/ In 1994, data are official projections.2/ The sum of domestic and foreign savings may not add up to total investment due to statistical discrepancy.3/ Excluding purchases of aircrafts and ships.

Real GDP at factor cost rose by 0.4 percent in 1993, the lowest growth rate since 1975 (Table 5). Public services accounted for the largest contribution to growth, increasing their share in GDP by more than 1 percentage point (Table 6). Business sector activity (GDP excluding government services) declined by 0.2 percent, reflecting historically low growth of both the industrial sector (which contracted by 2.2 percent) and the services sector. However, despite the broad-based slowdown in activity, there were substantial differences in the performance of various sub-sectors.

Table 5.

Cyprus: Origin of Gross Domestic Product

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Source: Ministry of Finance.
Table 6.

Cyprus: Origin of Gross Domestic Product

(At current prices)

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Source: Ministry of Finance.

Agricultural production increased by 3.1 percent, following its recovery in 1992. The increase was due to a substantial expansion of livestock production, while value added in the crop sub-sector declined marginally. Favorable weather conditions facilitated record cereal production and a significant rise in grape output, but this increase was offset by a decline in citrus and olive production. The production of potatoes—the major agricultural export commodity—remained roughly unchanged.

Industrial production decreased in absolute terms for the first time in the post-invasion period, and its share in GDP continued to decline reaching 26 percent—more than 7 percentage points below its 1980 peak. Real value added in manufacturing fell by 5.2 percent, reflecting the recession in export markets and difficulties in competitiveness. Most noticeable was the 14 percent plunge of gross output in the textiles, clothing, and leather sector (Table 7), caused by a substantial reduction in external demand and tougher competition in the domestic market as a result of tariff reductions in the context of the customs union agreement with the EU. Construction activity also subsided, reflecting lower investment in tourist accommodations and stagnant investment in dwellings. The only expanding sub-sector in industry was the utilities sector, which benefitted from the completion of several infrastructure projects and rising demand for electricity.

Table 7.

Cyprus: Gross Manufacturing Output by Major Industries

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Source: Central Bank of Cyprus.

Including cottage industries.

Growth in services decelerated considerably but remained positive, despite a substantial decline in tourist arrivals (Table 8). Indeed, the financial sector expanded by 2.7 percent, driven by an increase in offshore banking activity. This expansion, while substantially lower than in the previous two years, raised the share of the financial sector in GDP for the fourth consecutive year. This development, combined with increases in the value added in transport and communications and personal services, was sufficient to offset the 6.2 percent decline in the tourism-sensitive trade, restaurants, and hotels sector.

Table 8.

Cyprus: Tourist Arrivals and Receipts

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Excluding Israel.

The decline in tourism resulted in a substantial drop in the efficiency indicators of the hotels sector, especially as a result of the continued—albeit decelerating—expansion of capacity. Occupancy rates fell from 65 percent in 1992 to 53 percent in 1993, as bed capacity increased by about 5 percent while nights spent in tourist accommodations dropped by 12 percent. Labor productivity declined even more sharply as the number of employees increased by 8.5 percent, increasing the ratio of hotel employees to tourists by almost 20 percent. Combined with high wage increases (see below), lower productivity led to a decline in profitability and to a substantial reduction in the number of beds under construction. Stricter conditions for granting hotel construction permits further constrained investment in the tourism sector.

2. Labor market

Employment declined for the first time in recent history, owing to the stagnation in economic activity (Table 9). Layoffs in manufacturing, construction, and agriculture were the major reasons for this decline, while employment in services expanded, continuing the trends in the composition of employment that emerged during the 1980s (Chart 4). Excluding foreign workers—whose numbers declined by 3 percent—employment increased marginally, but this increase was not sufficient to prevent a rise in the unemployment rate from 1.8 percent in 1992 to 2.6 percent in 1993. On a monthly basis, unemployment increased throughout the year, reaching 3.1 percent in November. The rise in unemployment was contained, however, by the slowdown in the growth of the labor force in 1993, perhaps reflecting the worsening of employment opportunities.

Table 9.

Cyprus: Labor Force and Employment by Sector

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Source: Ministry of Finance.

Includes employees of British military authorities and national guard.

In percent of the population ages 15–64 in government-controlled area.

CHART 4
CHART 4

CYPRUS Composition of Employment and Profitability 1/

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Sources: IMF, International Financial Statistics; and staff calculations.1/ In 1994, data are official projections.2/ Including construction and utilities.3/ Ratio of GDP deflator of factor costs (excluding government services) to economy-wide unit labor costs.

The economic stagnation did not affect wages significantly. Nominal wage growth was sustained by the contractual increases embodied in the two-or three-year contracts signed in 1992—at a time when employers and labor expected high growth to persist—as well as by the cost of living allowance (COLA). 1/ As a result, real wages grew even faster than in 1992 (Table 10).

Table 10.

Cyprus: Wage and Productivity Indicators

(Percentage change over previous year)

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Source: Ministry of Finance.

Including basic wages or salaries, cost of living and other allowances, bonuses, gratuities, and payments in kind. Data exclude overtime payments and are gross of income tax and social security deductions.

Total gross weekly earnings, including overtime.

Based on average earnings.

Deflated by the GDP deflator.

Deflated by the manufacturing deflator.

Higher real wages coupled with moderate productivity growth led to a rise in unit labor costs by more than 8 percent, and to a severe drop in profit margins. This drop also reflected the gap between consumer and producer prices that emerged from the introduction of VAT in July 1992. 2/ Profit margins are estimated to have fallen by over 10 percent in the early 1990s, a marked departure from the scenario of stable profitability that prevailed throughout most of the 1980s (Chart 4). The steepest decline in profitability occurred in the hotels sector, where the three-year collective agreement awarded wage increases of 5 percent in 1993 (and an additional 2 percent in nonwage benefits). In the manufacturing sector, the increase in real unit labor costs was less dramatic, but prolonged the trend of falling profitability that began in 1989.

3. Prices

Inflation decelerated in 1993 for the first time in seven years reflecting the slowdown in economic activity. Despite the full-year effect of the introduction of VAT in July 1992, the subsequent VAT rate hike of October 1993, and increases in excise taxes—which together accounted for a 2.5 percent increase in consumer prices—the inflation rate fell by 1.6 percentage points (Table 11). Year-end inflation was lower than the annual average, as a result of lower prices for fruits and vegetables caused by exceptional weather conditions in November and December. On average, food prices, which had increased faster than other components of the CPI in the preceding five years, rose by only 2 percent. Utility price increases were also contained, owing to the decline in oil prices in international markets. On the other hand, clothing and footwear prices accelerated in 1993 reflecting, in addition to the effects of VAT, the sharp increase of unit labor costs in this sector.

Table 11.

Cyprus: Price Indices

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Source: Ministry of Finance.

Average for January–August over the same period in 1993.

Components may not sum to totals due to rounding.

The GDP deflator increased by 3.4 percent in 1993 (based on official statistics), 2 percentage points less than in 1992 (Table 12). 1/ Exports prices rose less than domestic goods prices, reflecting the competitive environment in exports markets and in tourism. Import prices continued to have a moderating effect on inflation as a result of lower inflation in trading partners, and the reduction of tariffs in the context of the customs union agreement.

Table 12.

Cyprus: Implicit Deflators

(Annual percentage change)

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Source: Ministry of Finance.

Price controls are still relatively common in Cyprus, but often are nonbinding and have been gradually reduced in recent years. At end-1993, the products subject to price controls (about 60) represented about one third of the CPI basket. In April 1994, about one third of the remaining price controls were lifted; at present, the most important price controls are those on basic food items (certain categories of break, milk, etcetera) and essential consumer goods (such as bus fares).

4. Developments in 1994 2/

Spurred by the economic recovery in Europe, tourist arrivals in 1994 are expected to grow by 12 percent, reaching a record level of over two million. With private consumption rebounding to its 1992 level and government consumption increasing substantially, aggregate demand is projected to expand by 5.7 percent, and GDP to grow by 4.6 percent. Fixed investment, on the other hand, is expected to remain subdued and its share in GDP to fall to a new historic low.

The services sector is expected to account for 75 percent of the increase in GDP (at factor prices), and the government sector for an additional 10 percent. Agricultural output is projected to decline, reflecting unfavorable weather conditions, while industrial production is expected to increase moderately as a result of a recovery in the manufacturing sector—partly due to improved export performance after four years of decline. As a result, the reliance of the economy on services will intensify: the share of non-government services in GDP is anticipated to reach 54.3 percent.

Employment is expected to increase only moderately, and the unemployment rate is projected to edge down to 2.4 percent on average. Wage growth decelerated due to lower COLA payments as inflation declined, and to lower contractual wage settlements in the manufacturing and construction sectors—a development which is consistent with the guidelines on contractual wage growth put forward by the Government in early 1994. Wage increases in the services sector are also decelerating as the effect of the 1992 wage contracts is tapering off. As a result of this deceleration, real unit labor costs for the whole economy are projected to increase only marginally in 1994, thus interrupting the trend observed in 1991–93. However, in some sectors real unit labor cost increases are expected to remain sizable (3.4 percent in manufacturing using the sector’s own value added deflator).

Inflation is projected to come down to 4.2 percent in 1994 reflecting a decline in the prices of agricultural food products, a deceleration of nominal wage increases and the gradual phasing out of the effect of the 1992–93 VAT increases. Import prices are expected to rise faster than the prices of domestic products, as the strong appreciation of the Japanese yen against the Cypriot pound drives up car prices. 1/

III. Public Finances

Despite the significant slowdown in economic activity, the Cypriot public finances improved in 1993. To a great extent, this improvement was the result of measures taken to boost revenues and contain expenditures. Public finances during 1994, on the other hand, benefitted from the stronger-than-expected economy. Thus, the consolidated central government deficit was reduced from 4.8 percent of GDP in 1992 to 2.4 percent in 1993 and an estimated 3.2 percent of GDP in 1994 (or about 3 percent in each year, after correction is made for certain expenditures that were postponed into 1994) (Tables 13 and 14 and Chart 5). As regards the components, the decline in the deficit reflected substantial increases in revenues for the Ordinary Budget and the Social Insurance Funds that more than offset the increase in expenditure of those funds and, at the same time, a substantial decline in expenditures of the Defense Fund (Table 15).

Table 13.

Cyprus: Consolidated Central Government Budget

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Euro-commercial paper.

Table 14.

Cyprus: Consolidated Central Government Budget

(In percent of GDP)

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Source: Ministry of Finance.
CHART 5
CHART 5

CYPRUS Consolidated Central Government Finances 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Ministry of Finance.1/ Inclusive of all defense related expenditure after 1987. Data for 1994 are government projections.2/ The decline in the ratio of foreign debt to GDP in 1993, despite the appreciation of the U.S. dollar, is due to repayment of external debt.* Indicates break in the series.
Table 15.

Cyprus: Consolidation of Central Government Budgets

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

1. Developments in 1993

Despite the slowdown in activity, Ordinary Budget revenue increased sharply from £C 571 million (18.5 percent of GDP) in 1992 to £C 648 million (20 percent of GDP) in 1993 (Table 16). This increase was due to three factors: (i) the full-year impact of the VAT (introduced in June 1992), as well as the impact of its subsequent increase from 5 percent to 8 percent on October 1, 1993; (ii) increases in other excises (notably cigarettes and petrol) in May 1993, which partly offset the decline in other indirect taxes, especially import duties, that were affected by weakening economic activity; and (iii) relatively small increases in income and property tax revenue. Nontax revenue remained broadly constant, while foreign grants increased as a result of the disbursement of the first tranche of a U.K. grant for road projects.

Table 16.

Cyprus: Central Government Ordinary Budget

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Expenditure also increased but more moderately, from £C 554 million (18 percent of GDP) in 1992 to £C 626 million (19.3 percent of GDP) in 1993. This increase was accounted for entirely by current spending, while capital expenditure of the Ordinary Budget declined marginally. Almost all current expenditure categories increased. The wage bill was boosted by a further expansion of government employment (civilian employment increased by almost 3 percent in 1993, compared with broadly similar increases in recent years), 1/ but the increase was more contained than it would otherwise have been, due to an agreement between the government and the civil servants’ union to postpone the payment of the contractual basic salary increases for 1992 and 1993 to 1994. The rise in transfers was due to increased early retirement for civil servants, 2/ while the small increase in subsidies reflected a special payment to cereal producers in 1993 to offset losses resulting from the heavy subsidization of their competitors, especially in EU countries. Thus, the Ordinary Budget balance improved from a surplus of £C 17 million (0.5 percent of GDP) in 1992 to a surplus of £C 22 million (0.7 percent of GDP) in 1993.

Both revenue and expenditure of the Development Budget increased in 1993. The rise in expenditure, in particular, was due to continued capital spending predominantly in road and water projects, as well as continued high current transfers granted to the newly instituted University of Cyprus. The deficit of the Development Budget rose slightly from £C 105 million (3.4 percent of GDP) in 1992 to £C 115 million (3.6 percent of GDP) in 1993 (Table 17).

Table 17.

Cyprus: Central Government Development Budget

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

The position of the Social Insurance Funds was determined by two factors: the impact of the economic slowdown on contributions, and the changes in the social security system introduced on January 1, 1993. The most important among the latter were: (i) the right to a seniority pension for those who were 63 or older, provided they had completed a certain amount of contributions; (ii) the right to postpone retirement until the age of 68; (iii) the shortening of the indexation period for pensions from one year to six months; (iv) increases of 8.4 percent to basic pensions and 6.6 percent to supplementary pensions (excluding indexation); and (v) increases in the contribution rates for all three parties (employees, employers, government) by a total of some 1 percentage point of the wage. As a result, the surplus of the social insurance funds remained unchanged at £C 45 million in 1993 (which represented a decline in terms of GDP from 1.5 percent in 1992 to 1.4 percent in 1993) (Table 18). Revenue from contributions rose by some 16 percent in 1993, as a result of the increases in contribution rates, while interest received also increased reflecting the growing accumulated balances of the funds. Expenditures, on the other hand, increased by over 22 percent primarily on account of the reduction of the eligibility age for seniority pensions and—to a lesser extent—higher Redundancy Fund payments associated with the weaker economic activity.

Table 18.

Cyprus: Social Insurance Funds 1/

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Includes the Social Insurance Fund, Unemployment Benefit Account, Central Holiday Fund, and the Redundancy Fund.

The finances of the Defense Fund improved substantially in 1993 (Table 19): on the one hand, the Defense Levy was increased by one percentage point on May 1, 1993; on the other hand, a substantial amount of defense-related procurement spending was postponed from 1993 to 1994. As a result, the Defense Fund moved from a deficit of £C 90 million (2.9 percent of GDP) in 1992 to balance in 1993.

Table 19.

Cyprus: Defence Fund

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

Finally, as regards the other components of the consolidated central government, the deficit of the Special Relief Fund tripled in 1993 to £C 22 million (0.8 percent of GDP), as a result of the abolition of the Special Contribution Tax (on incomes of self-employed individuals and companies) in June 1993, as well as the decline in revenue from the temporary Refugee Levy on imports, reflecting the slowdown of economic activity and imports (Table 20). The Public Loans Fund, on the other hand, registered a small deficit in 1993 (Table 21).

Table 20.

Cyprus: Accounts of Relief Fund for Displaced Persons

(In millions of Cyprus pounds)

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Source: Ministry of Finance.
Table 21.

Cyprus: Public Loans Fund

(In millions of Cyprus pounds)

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Source: Ministry of Finance.

The financing of the resulting consolidated central government deficit of £C 78 million (2.4 percent of GDP) in 1993 came entirely from domestic sources, primarily the commercial banks and—to a lesser extent—the nonbank public (Table 13). The government reduced its debt to the Central Bank of Cyprus by some £C 57 million. Foreign financing was also negative: drawings of medium- and long-term loans were far below amortization, while short-term financing and suppliers’ net credit was negative.

Despite the reduction in the deficit, central government debt increased in 1993 by £C 177 million to 59.1 percent of GDP at year-end, from 56.2 percent of GDP at end-1992: 1/ domestic debt reached almost 40 percent of GDP, with the rest being foreign debt. This increase in the debt, however, was accounted for mostly by two factors: (i) a substantial increase in Sinking Fund deposits with the banking system (by some £C 53 million); and (ii) valuation effects on the foreign debt (of some £C 55 million) that partly offset the impact of the negative foreign borrowing in 1993; thus, foreign debt (in Cyprus pounds) declined by only £C 37 million.

In addition to this debt, at end-1993 there were outstanding government debt guarantees for about £C 370 million (about 12 percent of GDP). The bulk of these guarantees (£C 259 million) was for foreign debt, almost all of which was debt of semi-government organizations. Cyprus Airways alone accounted for about one third of the guaranteed foreign debt. No government debt guarantees had been called in recent years, and none of the outstanding guarantees were expected to be called in the foreseeable future.

2. Trends in 1994

The description of fiscal developments in 1994 here is based on official estimates made at the time of the preparation of the 1995 budget. Although the estimates of the broad aggregates would most likely turn out to be fairly accurate, estimates of individual components of revenue and expenditures are still subject to a small margin of error.

On the whole, fiscal policy continued to be tight in 1994 relative to 1990–92. Consolidated central government revenue increased relative to 1993, and is estimated to have surpassed for the first time 31 percent of GDP. This reflected almost exclusively the full-year impact of the May 1993 revenue package and, particularly, the VAT rate hike of October 1993, which boosted VAT revenue by an estimated 1 percentage point of GDP. 1/

Expenditures also increased significantly to over 34 1/2 percent of GDP. This was mainly the result of large increases in the wage bill and current transfers. The former were attributed to the bunched payment of basic wage increases for the years 1992–94, while government employment growth, at about 1.8 percent in the year to March 1994, was markedly lower than in recent years. The increase in current transfers was due to a number of factors, most prominent among which were: (i) the costs of UNFICYP, which the UN could no longer cover and the Cypriot government started paying in mid-1993 (estimated at £C 10 million, or about 0.3 percent of GDP in 1994) ; (ii) a subsidy to the Cyprus Tourism Organization (CTO), which the government started paying in 1994 when a special 3 percent tourism surcharge previously accruing to the CTO was abolished, and a special transfer to the CTO in 1994 to finance extraordinary tourism promotion spending (these two amounted to some £C 14 million, or 0.4 percent of GDP); and (iii) increased early retirement of civil servants. Investment expenditures and social security payments also increased somewhat. Defense-related expenditures, on the other hand, continued to be contained, although they were expected to rise as a result of the postponement of some 1993 outlays into 1994. The Defense Fund is estimated to have moved into a small deficit (some £C 8 million), compared with a balance in 1993.

The consolidated central government deficit will likely widen in 1994 to some £C 113 million, or about 3.2 percent of GDP. If an adjustment were to be made, however, for the back payment of 1992 and 1993 basic wage increases, the 1994 deficit would have been about 3 percent of GDP.

As in 1993, the deficit was financed entirely by domestic sources, while net foreign financing is again estimated to have been negative in 1994. As regards the domestic component, nonbank financing is estimated to have increased relative to 1993 to a record £C 51 million, while monetary financing reached an estimated £C 18 million. As regards foreign sources, amortizations of medium- and long-term loans exceeded new drawings, but the government borrowed the equivalent of £C 60 million in the Eurocommercial paper market in order to maintain its presence there.

On this basis, the consolidated central government debt is expected to decline in 1994 to almost 58 percent at year-end. After two years of negative net foreign financing, the share of domestic debt has risen to over 70 percent of total, while that of foreign debt has declined commensurately.

IV. Money and Credit

1. Overview

The effectiveness of monetary policy in Cyprus has been hampered by a number of structural rigidities. All interest rates are subject to a 9 percent legal ceiling, in place since the mid-1940. In addition, the yield of government paper is regulated administratively, and deposit rates are subject to further administrative ceilings. Bank rates have also exhibited strong downward flexibility even in situations of bank excess liquidity. Capital controls have been used to shelter domestic rates from external pressures. Within these constraints, monetary policy has been conducted mainly through changes in the required liquidity ratio, but the effectiveness of this instrument has been hampered by the increasing importance of cooperative banks, whose activities are outside the jurisdiction of the Central Bank.

In 1993 and 1994 monetary policy was relaxed, as indicated by a reduction in the liquidity ratio from an average of 28.8 in 1992 to an average of 27 percent in 1993 and 1994. This expansionary stance did not succeed in preventing a marked slowdown in domestic economic activity in 1993, and was maintained throughout 1994, even after it was becoming evident that banks were holding substantial excess liquidity. This reflected the Central Bank’s intention to induce a reduction in bank rates which, however, did not materialize during 1993. Only in early 1994 the Central Bank managed to coordinate an unprecedented interest rate cut. Commercial banks and credit cooperative lowered deposit rates by 1 percentage point in May, and lending rates by 1/2 of a percentage point in September. The yield on long-term government bonds was also lowered by 1 percentage point.

2. Developments during 1993

In the absence of any evidence of inflationary pressures and with a view to providing a stimulus to the economy, the monetary program for 1993 contemplated increases in broad liquidity and domestic credit of 8.1 percent and 10.9 percent, respectively (Table 24). The target for expansion of credit to the private sector was set at 11.5 percent. The monetary authorities estimated that implementation of the program would require lowering the liquidity ratio by about 2 percentage points to an annual average of 27 percent. The required liquidity ratio was adjusted quarterly in line with seasonal considerations around the targeted annual average of 27 percent. 1/

Table 22.

Cyprus: Government and Government-Guaranteed Net Debt 1/

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Source: Ministry of Finance.

Excludes intragovernmental debt.

Excludes short-term liabilities of the Central Bank.

Table 23.

Cyprus: Total Gross Public Debt by Instrument and Lender 1/

(In million of Cyprus pounds)

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Source: Ministry of Finance.

Includes intragovernmental debt and short-term liabilities of the Central Bank.

Intragovernmental debt.

Table 24.

Cyprus: Targets and Outturns for Monetary and Credit Aggregates

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Source: Central Bank of Cyprus.

Adjusted for government foreign borrowing.

In the event, broad money grew by 16.4 percent—faster than the 13.9 percent registered in 1992—largely exceeding the program’s target despite slower-than-programmed growth in nominal GDP. This outcome mostly reflects the high correlation between changes in quasi-money and private saving, caused by the absence of savings instruments other than bank deposits in Cyprus. In fact, about 90 percent of growth in M2 can be explained by an increase in time deposits (Table 25). Narrow money (Ml), on the other hand, grew by 8.8 percent, only marginally slower than the 9.3 percent registered in 1992. Growth in M1 is explained mostly by the behavior of demand deposits, which increased by 10.4 percent, higher than the 8.8 percent recorded in 1992.

Table 25.

Cyprus: Monetary Survey

(In millions of Cyprus pounds; end of period)

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Source: Central Bank of Cyprus.

Includes holdings of SDRs, government holdings of foreign exchange, and reserve position in the IMF.

Nominal GDP/average of money stock at beginning and end of year.

Data exclude the operations of the Cooperative Central Bank, which is included in the monetary survey.

Domestic credit growth was 9.5 percent, below the program target, and substantially slower than the 15.9 percent registered in 1992. 2/ The slowdown in credit growth is the result of a marked reduction in credit to the public sector, as the improvement in public finances observed in 1993 led to a lower borrowing requirement from the banking system. Credit to the private sector also decelerated from an expansion of 17.5 percent in 1992 to 12.7 percent in 1993, but it was higher than envisaged in the program.

The relatively slower growth in credit to the private sector in relation to 1992 reflects stagnation in both domestic consumption and investment, and was compounded by the unwillingness of banks to increase their exposure given the prevailing negative economic climate. Indeed, despite the large excess liquidity—for the first time in several years the all-bank liquidity ratio exceeded the minimum requirement in every quarter—banks did not reduce their lending rates, thus preventing a full pass-through to the economy of the relaxation of monetary policy.

As for the sectoral distribution of bank credit to the private sector, the share of personal loans and trade-related loans (traditionally the two largest recipients of credit) in new credit fell substantially in 1993, especially in the case of trade-related loans which accounted for 30 percent of new credit in 1992 but only for 15.8 percent in 1993 (Table 26). On the other hand, building and construction, manufacturing, and tourism increased their shares in total new credit. The increase in the share of credit to the tourism sector took place despite the negative developments in that sector during 1993, and reflects mainly rescheduling of previous loans in the face of cash flow problems in the hotel sector. In terms of the outstanding stock of credit, the sectoral distribution exhibited substantially less variations, with personal loans and trade-related loans still accounting for more than 50 percent of the total.

Table 26.

Cyprus: Credit by Deposit Money Banks to the Private Sector

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Source: Central Bank of Cyprus, Annual Report, various issues.

The rapid increase in bank deposits coupled with the slower rate of credit expansion led to a situation of excess liquidity in the banking system, especially in the second half of the year. As a result, the average liquidity ratio increased from 26.8 percent in 1992 to 28.6 percent in 1993, despite the reduction in the average prescribed ratio from 28.8 to 27 percent (Table 27). At year-end the all-bank excess liquidity ratio was 1.6 percent (Table 28). Banks’ excess funds were invested in government Treasury Bills, while bank deposits at the central bank actually fell in relation to their level at end-1992 (Table 29).

Table 27.

Cyprus: Liquidity of All Banks

(Period average)

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Source: Central Bank of Cyprus.

Includes cash, central bank balances, and domestic treasury bills.

Includes foreign currency checks, bills, and net short-term balances with foreign banks.

Excluding “special deposits”.

Excluding compulsory contributions to the Fund for Financing Priority Projects.

Table 28.

Cyprus: Liquidity of All Banks

(End of period)

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Source: Central Bank of Cyprus.

Includes cash, central bank balances, and domestic treasury bills.

Includes foreign currency checks, bills, and net short-term balances with foreign banks.

Excluding “special deposits.”

Excluding compulsory contributions to the Fund for financing priority projects.

Table 29.

Cyprus: Reserve Money

(In millions of Cyprus pounds; end of period)

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Source: Central Bank of Cyprus.

Includes holdings of SDRs, but excludes government holdings of foreign exchange and reserve position in IMF.

Includes a small amount of government securities.

Includes credit extended to banks by the Fund for Financing of Priority Projects.

3. Prospects for 1994

The financial program for 1994 was prepared under the assumption of an increase in nominal GDP of 8.2 percent and a target level of inflation of 4.5 percent. It was estimated that the rates of growth of broad money and private sector credit consistent with those estimates would be 12.9 and 11 percent, respectively. As a result, and with a view to maintaining the necessary conditions for a reduction in interest rates, the central bank decided to keep the quarterly minimum liquidity requirements unchanged from 1993.

In early 1994, with the coordination of the Central Bank, commercial banks and credit cooperative agreed a gradual but sizable decline in interest rates. More specifically, it was agreed that, as of May 1, the yield of deposits would not exceed 7 percent (Table 30); 1/ and that the maximum lending rate would be lowered from 9 to 8.5 percent on September 1. 2/ The yield on long-term government bonds was also lowered from 8 to 7 percent on May 1, (although the rate on treasury bills remained at 6 percent) and it was agreed that loan rates would come down on September 1 to no more than 8.5 percent. 1/

Table 30.

Cyprus: Selected Interest Rates

(In percent per annum)

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Source: Central Bank of Cyprus.

Applies to balances of up to £C 15,000.

Applies to balances up to £C 5,000 which require seven days’ notice for withdrawal.

Applies to balances over £C 50,000 deposited for one year or more.

As of September 1, 1994.

Monetary data as of end-May 1994, show that the broad money stock grew by 15.6 percent over the previous 12 months, slower than the year-on-year rate observed at end-1993 but faster than envisaged in the program. A substantial increase in time deposits—of the order of 18.7 percent on a year-on-year basis—explains more than 90 percent of the increase in M2. Indeed, the growth rate of narrow money was contained to 6 percent. In terms of the sources of monetary expansion, domestic credit accounts for 91.5 percent of the increase in broad money. In particular, credit to the private sector registered an increase of 13.2 percent over the previous 12 months, also higher than programmed and slightly above the rate observed at end-1993.

4. Other developments

a. Banking supervision

The quality of banks’ portfolios deteriorated somewhat in 1993, as a likely reflection of the slowdown in economic activity. Doubtful loans represented 4.4 percent of total loans in 1993, against 3.9 percent in 1992. A qualitative index computed by the central bank reflecting the number of credit facilities for which there is some evidence of weakness also suggested a marginal increase in bad loans. Loan provisions, however, were lower in 1993 than in 1992, mainly due to the fact that in 1992 provisioning was exceptionally high; nevertheless, banks are considered to be sufficiently covered against bad loans.

b. Cooperative credit institutions

The volume of deposits and loans in cooperative credit institutions continued to grow markedly in 1993. However, the rapid growth in their relative position in the domestic financial sector observed during the 1980s seems to be tapering off (Chart 6). Deposits at the cooperatives grew by £C 187.4 million, or 15.3 percent, in 1993 slower than the 17.3 percent registered in the banking system; as a result, their share in total deposits fell from 34.2 to 33.8 percent. The share of loans by cooperatives in total loans, on the other hand, grew slightly from 33.3 to 33.6 percent, as a result of an increase of £C 158.7 million, or 14.4 percent, compared to an increase in bank loans of 12.7 percent. Figures as of May 1994, on the other hand, show that the share of deposits at cooperatives in total deposits was 34.4 percent, higher than in December 1993, while the share of loans by cooperatives in total loans decreased slightly from its end-1993 level to 33.2 percent.

CHART 6
CHART 6

CYPRUS The Credit Cooperative Sector 1/

(In percent)

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Department of Cooperative Development; and Central Bank of Cyprus.1/ In 1994, data are for end-May.

During 1993 there were no changes in the supervisory framework for cooperatives, which are regulated by the Commission of Credit Cooperatives. Available information shows that in 1993 only 25 of the 98 biggest cooperatives met the 25 percent liquidity ratio set by the Commission (12 had ratios below 10 percent, 41 had ratios between 10 and 20 percent, and 20 had ratios between 20 and 25 percent).

V. External Sector

The balance of payments recorded a marked improvement in 1993 (Chart 7) despite the recession in Europe and a loss of cost competitiveness (Chart 8). The trade deficit narrowed by 11 percentage points of GDP, the invisibles balance improved somewhat and, as a result, the current account was in surplus for the first time since the 1960s. Although the capital account turned negative due to net repayment of short-term government debt and a drop in suppliers’ credits, the overall balance of payments registered a surplus, and gross international reserves increased by £C 78 million. The external debt fell by £C 10 million, continuing the decline of the external debt to GDP ratio observed in recent years (Chart 9).

CHART 7
CHART 7

CYPRUS Balance of Payments 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Central Bank of Cyprus.1/ In 1994, data are official projections.2/ Excluding errors and omissions.* indicates break in the series.
CHART 8
CHART 8

CYPRUS Real Effective Exchange Rates 1/

(1983=100)

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: IMF, International Financial Statistics; and staff calculations.1/ In 1994, data are averages for January-June.2/ Largest 22 industrial exports destinations, weighted by their share in 1992 exports.3/ Largest 15 industrial tourist sources, weighted by tourist expenditures in Cyprus in 1992.4/ Costs in Cyprus, expressed as a ratio to a trade weighted average of costs, In a common currency, of the 10 largest industrial trade partners: (Belgium, France, Germany, Greece, Italy, Japan, the Netherlands, Spain, the United Kingdom, and the United States).5/ Trade weighted, based on relative consumer prices.6/ Weighted average of relative unit labor costs in a common currency. Competitors (Greece, Italy, Portugal, Spain) weights are based on the number of tourist arrivals in 1992.7/ Weighted average of relative consumer prices in a common currency. Competitors (Greece, Italy, Portugal, Spain) weights are based on the number of tourist arrivals in 1992.
CHART 9
CHART 9

CYPRUS External Debt 1/

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Central Bank of Cyprus.1/ In 1994, data are official projections.2/ In percent of exports of goods and services.

The improvement in the trade balance was entirely due to a decline in imports from the high level of 1992, while domestic exports fell for the third consecutive year and re-exports stagnated. Tourism revenues remained flat, following a surge in 1992, but increased expenditures by offshore companies and a decrease in freight and insurance payments associated with lower imports improved the invisibles balance.

1. Exchange rate developments and competitiveness

The exchange rate policy in 1993 remained geared toward maintaining the peg of the pound to the ECU. 1/ Despite the appreciation of the pound vis-à-vis several European currencies that left the ERM—notably the pound sterling—the appreciation of the U.S. dollar against the ECU during the year resulted in a slight depreciation (1.3 percent) of the trade-weighted nominal effective exchange rate (Chart 10 and Table 31).

CHART 10
CHART 10

CYPRUS Exchange Rate Developments 1/

(1983=100)

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: IMF, International Financial Statistics.1/ In 1994, data are averages for January-August.2/ Using IFS trade weights, excluding Brazil.
Table 31.

Cyprus: Nominal and Real Exchange Rate Indices

(1985=100)

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Source: IMF, International Financial Statistics.

INS trade weights, excluding Brazil.

Relative unit labor costs in Cyprus increased significantly in 1993, compounding the losses in cost competitiveness recorded since 1991: the ULC-based real effective exchange rate (ULC-REER) appreciated by a cumulative 10 percent during 1991–93. This increase was much greater if tourism—rather than trade—weights are used to calculate the ULC-REER (Table 32).

Table 32.

Cyprus: Indicators of Competitiveness

(Percent change)

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Source: Staff calculations based on IFS, OECD, and World Tourism Organization data; INS weights.

Excluding Brazil.

Largest 22 industrial exports destinations weighted by their share in 1992 exports.

Greece, Italy, Portugal, Spain and Turkey weighted by the number of tourist arrivals in 1992.

The largest 15 industrial source countries; weighted by their share in tourist expenditures in 1992.

Largest 10 industrial trading partners, weighted by their share in 1990 trade.

Greece, Italy, Portugal, and Spain, weighted by the number of tourist arrivals in 1992.

Ratio of domestic exports’ volume (deflated by the imports unit value of trade partners, using INS export weights) to non-oil imports volume in export markets.

Cyprus’s share in tourist arrivals to: Cyprus, Greece, Israel, Italy, Malta, Portugal, Spain, and Turkey.

Cyprus’s share in tourist arrivals in Europe.

Despite this, the compression of profit margins in 1993 contained the loss of price competitiveness: the consumer price-based real effective exchange rate (CPI-REER) remained broadly unchanged during 1993, as slightly higher inflation in Cyprus relative to its trading partners offset the small nominal effective depreciation. This, however, masks a worsening of the competitive position of Cypriot exports: if exports—rather than total trade—are used as weights to calculate the CPI-REER, price competitiveness declined by almost 5 percent.

Indicators of competitiveness in tourism, in particular, which accounted for almost half of current account receipts in 1993 (excluding reexports), worsened significantly in 1993. Devaluations by major competitors and source countries led to a substantial loss of price competitiveness which, together with the containment of labor costs in competitor countries, led to an 8 percent decline in Cyprus’s market share in the southern European tourism market. 1/

2. The current account

The current account registered a surplus for the first time since 1967, following a deficit of 9.6 percent of GDP in 1992 (Table 33), mostly on an account of a decline in defense imports, imports for re-export, and imports of transportation equipment, while current account receipts remained roughly unchanged (Table 34).

Table 33.

Cyprus: Balance of Payments Summary

(In millions of Cyprus pounds)

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Source: Central Bank of Cyprus.

Excluding ship-stores.

Bulk items include aircraft purchases for Cyprus Airways valued at £C 80.8 million, £C 16.3 million, £C 48.4 and £C 17.4 million in 1989, 1990, 1992 and 1993, respectively.

Table 34.

Cyprus: Factors Affecting Imports Volatility 1/

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Source: Staff calculations based on data provided by the Central bank of Cyprus.

In 1994, data are official projections.

Exports fell by 2.6 percent in 1993, reflecting the recession in export markets and a loss of competitiveness (Table 35). The share of the EU in total exports continued to shrink in 1993 (Table 36), while the share of eastern Europe, Asia, and the United States increased. As regards the direction of domestic exports, the same pattern is observed, although the share of the EU in domestic exports is higher (55.4 percent) than in total exports, and the shares of Arab countries (22.3 percent) and of eastern Europe (5.9 percent) are lower.

Table 35.

Cyprus: Merchandise Trade 1/

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Source: Central Bank of Cyprus.

Based on customs data. Include all defense-related expenditure. Quarterly figures do not necessarily add up to annual figures because valuation adjustments are only made at end of the year.

Includes sales of domestic shipstores.

Includes imports of between £C 2–4 million per year by foreign embassies and military bases.

Over preceding year, or over the same period in the previous year.

Includes aircraft valued at £C 80.8 million.

Includes aircraft valued at £C 16.3 million.

Includes aircraft valued at £C 48.4 million.

Includes aircraft valued at £C 17.4 million.

Projections.

Provisional.

Table 36.

Cyprus: Direction of Trade 1/

(In percent of total trade)

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Source: Central Bank of Cyprus.

Data on a customs basis. Does not include imports of military equipment.

Includes re-exports.

For the years prior to 1992, data is for the territory of the former Federal Republic of Germany.

Imports from France in 1989, 1990, 1992 and 1993 include bulk imports of aircraft.

Agricultural exports recovered somewhat from their slump in 1992 but remained well below their 1990–91 level (Table 37). Manufacturing exports continued their slide, which began in 1990, reflecting the decline in the clothing and footwear sectors as well as a sharp drop in cigarette exports. Re-exports stagnated in 1993, following their fast expansion in the previous five years. The domestic value added of re-exports, 2/ however, increased substantially and became positive for the first time since 1986. Traditionally, the major destinations of re-exports have been Greece and the Arab countries, but in recent years the relative importance of eastern European destinations expanded rapidly. About 20 percent of the re-exported goods are either sold by domestic duty-free stores or to ships. The major re-export commodities were tobacco products, televisions and other consumer electronic goods, and fibers.

Table 37.

Cyprus: Commodity Exports by Economic Origin 1/

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Source: Central Bank of Cyprus.

Data on a customs basis.

Includes quarrying materials.

Following an exceptionally high growth in 1992, imports plunged by more than £C 300 million (20.5 percent) in 1993, reaching their 1991 level. Several special factors accounted for most of the decline: (i) a postponement of military equipment imports; (ii) a sharp decrease in aircraft imports by Cyprus Airways; (iii) a drop in motor vehicle imports by households due to the bunching of purchases in 1992 in anticipation of the introduction of VAT; and (iv) a fall in imports for re-export after a substantial rise in 1992. As a result of the above factors and of a fall in import prices in relation to the domestic demand deflator, import propensity with respect to domestic demand, dropped dramatically (to 47.4 percent from 55 percent in 1992).

The geographical composition of imports continued to shift toward the EU, despite the decline in aircraft imports from France. Japan’s market share dropped due to lower car imports, and Germany’s share fell in response to lower investment. As measured against the 1991 benchmark, imports from the EU and the U.S. increased, while imports from all other major country groups decreased, possibly reflecting the effects of tariff reductions required by the Customs Union agreement with the EU.

The composition of imports by economic category shifted away from military and transportation equipment, and toward consumption goods and intermediate inputs (Table 38). Despite a 9 percent decrease in value, the share of consumption goods in imports has increased by more than 8 percentage points since 1989, 1/ as imports for other uses fell at a higher rate. Imports of intermediate inputs declined by 12 percent, predominantly as a result of a 14.3 percent drop in the importation of manufacturing inputs, while the fall in investment pushed capital goods’ imports down by 19 percent, and imports of transport equipment plunged by 40 percent. Fuels and lubricants was the only category of imports that did not register an absolute decline (its share in imports increased by 2 percentage points).

Table 38.

Cyprus: Commodity Import Composition 1/

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Source: Central Bank of Cyprus.

Data on a customs basis; excluding imports of foreign embassies and military bases.

Including aircraft imports of £C 48.4 million.

Including aircraft imports of £C 80.8 million.

Including aircraft imports of £C 16.3 million.

Including aircraft imports of £C 17.4 million.

The surplus in the invisibles balance increased by 4 percent due to a similar rise in the services balance, while net foreign transfers remained unchanged (Table 39). Net tourism income, in particular, declined by £C 5 million, reflecting a continued increase in foreign travel by Cypriots and stagnation in gross tourism revenues. Buoyant expectations in 1992—spurred by the surge in tourist arrivals—and cost pressures, led Cypriot hoteliers initially to announce substantial price increases for the 1993 season. Combined with the recession in Europe and devaluations in important competitor countries, these prices resulted in a marked drop in tourist arrivals during the second quarter of the year (over 17 percent compared with the second quarter in 1992). Downward price adjustments in the sector and a government-financed advertising campaign by the Cyprus Tourism Organization succeeded in containing the decline later in the year, but for the year as a whole tourist arrivals dropped by 7.5 percent. However, an increase in per-capita expenditure by tourists, reflecting the higher average hotel prices and an expansion of intra-hotel services, was sufficient to offset this decline and to keep gross tourism revenues unchanged.

Table 39.

Cyprus: Invisible Transactions

(In millions of Cyprus pounds)

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Source: Central Bank of Cyprus.

Includes expenditures of Cypriot students abroad.

Includes net profit remittances.

The surplus in the “other goods, services, and income” account increased by £C 14 million, reflecting an increase in foreign military expenditure in Cyprus and the continued expansion of the offshore activity. The number of offshore companies registered in Cyprus rose by 29 percent to 13,018, and their domestic expenditure (including expenditure by their expatriate staff) reached £C 112 million. Although offshore companies are not obliged to maintain domestic offices, 87 new offices were opened in 1993 and the number of employees increased by more than 12 percent.

3. Capital account, external debt, and reserves

Following several years in which the capital account recorded substantial surpluses, net capital inflows turned negative in 1993. Both long-term and short-term capital flows were in deficit (Table 40), reflecting the improved fiscal position—which resulted in net debt repayments by the government—and the, decrease in imports. New issues of Eurocommercial paper by the government were £C 16.6 million lower than redemptions, and the government continued to repay long-term foreign debt. Public corporations reduced their net external borrowing by £C 30 million, mostly reflecting reduced borrowing by the electricity authority. Direct foreign investment fell by £C 5 million.

Table 40.

Cyprus: Capital Account

(In millions of Cyprus pounds)

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Source: Central Bank of Cyprus.

Includes loans received by Cyprus Development Bank amounting to £C 13.3 million.

Includes credits received by Cyprus Airways amounting to £C 70.7 million, £C 19.3 million, £C 45.4 million, £C47.2 million, and £C 78.3 million in 1989, 1990, 1992, and 1994, respectively.

Includes loans received by the Electricity Authority of Cyprus amounting to £C 25.7 million.

Repayments of credits extended by the Cyprus Government and public corporations less new drawings.

Includes net issues of Euro commercial Paper by the Government amounting to £C 45.8 million in 1989, £C -17.4 million in 1990, £C 58.4 million in 1991, £C 25.9 million in 1992, £C -16.6 million in 1993, and £C 60 million in 1993, and £C 60 million in 1994.

The net outflow of capital led to a reduction in the external debt (excluding bank deposits), despite valuation effects increasing the domestic value of U.S. dollar and yen-denominated loans (accounting for 50 percent of the stock of debt in 1993). Wider public sector debt remained broadly stable in domestic currency terms (Table 41), but private sector debt decreased by £C 8 million and its composition changed in favor of longer maturities (Table 42). Thus, the debt-to-GDP ratio fell by 2 percentage points in 1993, bringing the cumulative decrease to 8 percentage points since 1989. The debt service ratio, on the other hand, increased in 1993, due to higher debt amortization payments (and flat exports), while interest payments were unchanged from their 1992 level, reflecting a decline of 40 basis points in the average interest rate paid on long-term debt.

Table 41.

Cyprus: Outstanding External Debt 1/

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Source: Central Bank of Cyprus.

Changes in the level of outstanding external debt as recorded in the external debt statistics tables differ from capital flows as recorded in the balance of payments table because of valuation adjustments not recorded in the balance of payments table, and as a result of timing differences in the registration of operations in both sets of data.

Excludes short-term liabilities of the banking system.

Medium- and long-term.

Table 42.

Cyprus: Medium- and Long-Term Outstanding External Debt by Debtor and by Creditor

(In millions of Cyprus pounds: end of period)

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Source: Central Bank of Cyprus.

Includes EIB and the Resettlement Fund of the Council of Europe.

Includes IFC.

Among the most important creditors are the Governments of Germany, France, Kuwait, and the United Kingdom.

Includes suppliers’ credits and commercial banks’ lines of credit.

Net international reserves increased by SDR 59 million (24 percent) despite a depreciation of 7.3 percent of the Cyprus pound against the SDR (Table 43). The increase was entirely due to a rise in official reserves, while the net external position of the commercial banks—which expanded their international activity substantially—decreased. By end-1993, the stock of net international reserves was equivalent to 2.2 months of imports (f.o.b.) and gross official reserves were equivalent to 5,9 months of imports, as compared with 1.3 months and 4.1 months, respectively, at end-1992.

Table 43.

Cyprus: Net International Reserves

(In millions of SDRs: end of period)

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Source: Central Bank of Cyprus.

Gold valued at SDR 35 per ounce.

4. Developments in 1994

The overall balance of payments surplus is expected to increase by £C 120 million in 1994, reflecting a continued surplus in the current account and a substantial increase in net capital inflows. A 14 percent increase in tourism revenue and an 8 percent rise in domestic exports (excluding ship stores) are expected to offset the increase in imports that is likely to take place as a result of higher consumption expenditure (including a recovery in automobile imports), defense-related imports, and imports for re-export.

The economic recovery in Europe together with more moderate pricing by Cypriot hoteliers compared with 1993 (assisted by a two-years’ suspension of the 3 percent tourism tax) contributed to an increase in tourist arrivals beginning in the second quarter of 1994. This trend is expected to be reinforced by the development of new markets in eastern Europe and the former Soviet Union and, as a result, tourist arrivals are projected to grow by 12 percent compared to 1993, exceeding the two million mark for the first time. Domestic exports are expected to expand in line with market growth, with a rise in nontraditional manufacturing exports offsetting the continued decline in clothing and footwear.

Net capital inflows are expected to reach £C 100 million, reflecting a new £C 60 million Eurocommercial paper issue by the government and an increase in suppliers’ credit. Net repayments of long-term loans are expected to fall significantly from their 1993 level, due to higher borrowing by public corporations. Nevertheless, due to the strong projected GDP growth, the debt-to-GDP ratio is expected to decline.

The strong balance of payments position in 1994 was reflected in the increase in international reserves during the first half of the year. As of the end of June, net international reserves had risen by SDR 66 million (21 percent) from their end 1993 level, while gross official reserves were SDR 153 million higher. By year-end, the stock of gross official reserves is projected to reach the equivalent of 6.8 months of imports.

APPENDIX I: Staff Medium-term Projections 1/

The medium-term outlook for a small economy as open to the rest of the world as Cyprus is fraught with uncertainty. Small and unpredictable changes in the international environment can have a major impact on the Cypriot economy, particularly through the tourism sector. Thus, any medium-term projections are necessarily tentative and subject to a wide margin of error.

Nevertheless, the staff has prepared and discussed with the authorities a set of medium-term projections based on the same assumptions about the external environment, but different assumptions about certain key domestic variables. The purpose of these projections is to illustrate the potential gains for the economy of a more restrained wage behavior in the labor market in the next few years. Given the uncertainties referred to above, as well as the hypothetical nature of the assumptions about wage behavior, these projections should be seen as illustrative exercises, rather than forecasts.

The model used for the projections is based on a simple macroeconomic accounting framework with four main blocks: the balance of payments, public finances and debt, the labor market, and the demand side of the national accounts. Three categories of variables are specified: environmental variables, which are given exogenously (and are consistent with the projections of the September 1994 WEO); policy parameters, which are also controlled exogenously; and endogenous variables, generated on the basis of either behavioral equations or accounting identities.

In the balance of payments block, the volume of exports and imports are projected on the basis of external market growth and real GDP growth, respectively (using historical elasticities), while prices are assumed to be given to Cyprus by the world markets. The key projection of tourist arrivals is generated by the analytical framework explained in Appendix II; it assumes unchanged real effective exchange rates against the major tourism competitors, and uses the September 1994 WEO projections for growth of real consumption in the source countries of tourism. Private debt creating capital flows and direct foreign investment are broadly linked to output growth, while capital flows to the government are determined on the basis of the government’s financing needs and policy. In the public finance block, the revenue projections are based on the assumption of the current tax structure remaining unchanged over the medium term. On the expenditure side, both scenarios incorporate similar assumptions about discretionary spending growth (consistent with the government’s target for real growth of about 4 percent per annum). 1/ The resulting deficit is assumed to be financed entirely by domestic sources, in line with recent government policy. In the labor market block, policy-driven assumptions about wage growth in the private and public sector determine unit labor costs and profitability. Finally, in the national accounts block, GDP is determined on the basis of a consumption function, foreign demand, and an exogenous investment path.

The key difference between the two medium-term scenarios, “low growth” and “high growth” is the behavior of wages, which are assumed to prevent a recovery in profit margins in the former, but grow temporarily below productivity in the latter. In addition, the “high growth” scenario implicitly assumes faster structural reform and deregulation, especially in the financial sector, which would improve capital allocation and thus support a higher growth path. The effects of structural reform, however, are very difficult to quantify.

In the “low growth” scenario, in addition to full indexation, real wages in the private sector are assumed to grow broadly in line with productivity in 1995 and beyond, while those in the public sector are assumed to grow by 2 percent per annum during 1995–97 (the period during which the government’s basic wage freeze is supposed to apply) due to maturation and promotions, and productivity plus 2 percent thereafter. As a result, the losses in profit margins of 1991–93 are not recovered, at least immediately. In the medium-term, this would affect national income either through a lower level of investment at the current level of profitability, or through a substantial increase in the equilibrium unemployment rate (if firms decide to raise productivity through layoffs). The first alternative is illustrated here: private gross fixed capital formation recovers very slowly from its historically low level of 1994 and, given the targeted level of public gross fixed capital formation, total investment is correspondingly affected. Thus, real GDP growth slows down to about 2.5 percent by the end of the decade. Inflation performance improves as a result both of a cautious monetary policy stance (including maintaining the present exchange rate peg), which is assumed to continue, and of relatively weak domestic demand.

This “low growth equilibrium” has—at least initially—a positive impact on the balance of payments. Demand for imports is relatively low, while the growth of exports and tourist arrivals is exogenously given. Although the sluggish investment is likely to start constraining export growth and tourism receipts from the supply side (the latter because low investment would prevent quality improvements and the upgrading of the tourism sector), the current account of the balance of payments remains below 1.5 percent of GDP over the projection period. This allows a buildup of reserves to historically high levels (in terms of months of imports) by 1999.

The picture is different, however, in the public finances. Although revenues can be expected to increase marginally in relation to GDP as a result of an overall elasticity slightly greater than one, primary expenditures grow faster, as GDP growth trails behind the rate of growth of discretionary spending. As a result, the central government primary surplus, estimated at almost 2 percent of GDP in 1994, shrinks to almost zero by 1999, while the overall balance, instead of approaching the government’s medium-term objective of 3 percent of GDP, remains well above that and grows towards 6 percent by the end of the projection period. This level of government borrowing makes a decline in the debt impossible: indeed, the debt-to-GDP ratio remains broadly at its 1994 level, and has a clearly rising trend in the outer years.

Although the “low growth” scenario is stable in the projection period examined here, the trends—especially evident in the outer years—are worrying. The declining share of public savings, in particular, unlikely to be matched by an equivalent increase in private savings, would either result in lower investment, thus accelerating the low investment-low growth circle, or in larger external borrowing, leading to a rapid deterioration of the initially favorable balance of payments position.

The alternative “high growth” scenario is predicated on the assumption that real wages in the private sector grow by less than productivity, especially in the first three years of the projection period; public sector wages, on the other hand, are projected to follow the same path as in the previous scenario. This allows a recovery of profit margins adequate to offset the losses of 1991–93 by the end of the period. Although this recovery is only gradual, if it is based on a credible medium-term plan to contain wage growth, it would have a significant effect on investment from the outset: private fixed capital formation recovers strongly from its 1994 low and increases to 21–22 percent of GDP by the end of the projection period. The corresponding level of gross investment (26–27 percent of GDP)—although well below the high rates of the 1980s—combined with full employment can support output growth rates of about 5 percent annually. Labor supply constraints would continue to be eased by controlled importation of foreign labor, as in the past. Thus, under the same cautious monetary policy regime assumed in the previous scenario, inflation performance can be expected to be equally good or better.

Given the level of domestic savings, faster investment and growth would require a higher level of foreign savings. Thus, under the same assumptions about the external environment as before (but assuming a somewhat higher growth of export and tourism earnings in the outer years), the current account deficit is now wider, approaching 2 percent of GDP by the end of the projection period. This deficit is low by historical standards, and can easily be financed by private capital flows, especially if capital movements are liberalized early. Thus, official reserves by the end of the period are in fact slightly higher than those in the previous scenario in terms of months of imports (although much higher, of course, in currency terms).

The higher growth has a positive effect on public finances. The government’s assumed discretionary expenditure policy is now in line with the country’s underlying economic situation, while the projected entitlement spending represents a smaller percentage of GDP. Thus, the central government primary surplus grows slightly from the estimated 1.8 percent of GDP in 1994 to just over 2 percent by 1999. This brings the overall deficit within the government’s medium-term target of 3 percent of GDP. This level of the deficit entails a gradual decrease of the government debt-to-GDP ratio back to the levels of the late 1980s.

Finally, it should be noted that, although real wages in this scenario grow initially by less than in the “low growth” scenario, by the end of the period, improved economic performance and faster growth allow real wages to grow faster. Thus, real per capital consumption is cumulatively higher in the “high growth” case, even in the limited projection period examined here.

Table 1.

Cyprus: Staff Medium-Term Projections: “Low Growth” Case

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Source: Staff projections.

Defined as the margin between the GDP deflator and the unit labor cost; may be slightly different than official data and estimates for 1993 and 1994.

Table 2.

Cyprus: Staff Medium-Term Projections: “High Growth” Case

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Source: Staff projections.

Defined as the margin between the GDP deflator and the unit labor cost; may be slightly different than official data and estimates for 1993 and 1994.

APPENDIX II: A Forecasting Model for Tourist Arrivals in Cyprus 1/

The importance of the tourism industry to the Cypriot economy makes accurate projections of tourist arrivals an essential component of macroeconomic management in Cyprus. This appendix develops an econometric model of tourism demand in Cyprus and identifies the long-term relationship between tourist arrivals, price competitiveness, and consumer expenditures in the source countries. The estimated model provides relatively accurate projections of tourist arrivals in 1992 and 1993—two years of large shifts in demand—and points to the importance of the real effective exchange rate for tourism growth.

1. Demand model and error correction representation

Two major factors are traditionally included in demand functions: (i) the price of the product relative to its close substitutes; and (ii) consumers’ income (or—abstracting from the savings-consumption choices of individuals—consumers’ overall expenditure). Since a direct measure of tourism prices is not available for Cyprus, nor for its major competitors, the overall price level is used instead. This approximation is based on the idea that in a highly competitive market—internationally, as well as domestically—prices will move closely with costs, which in turn are closely correlated with the overall price level. 2/ The variable measuring consumer expenditures is the seasonally adjusted real consumption index in tourism source countries described below.

A third variable was included in the equation to account for the learning process of the market about Cyprus as an emerging tourism destination. 3/ Since such a process is bound to decelerate over time, as the knowledge about a new destination is spread around, the functional form chosen was a log linear trend. Additionally, the equation included dummy variables to capture the effects of the terrorist attack on the cruise ship Achille Lauro in the east Mediterranean (in late 1986) and the Gulf war, as well as quarterly dummy variables.

An unrestricted error correction model was used to test the existence of a long term demand function for tourism, following an approach similar to that explained in Appendix IV, and based on the following equations:

d T t = Σ i = 1 K α i d T t - i + Σ j = 0 K [ ϕ j d p t - j + ξ j d c t - j ] + Γ + δ T R R + β 1 T t - 1 + β 2 T t - 1 + β 3 c t - 1 + ϵ t ( 1 )
Γ = μ 1 D 2 + μ 2 D 3 + μ 3 D 4 + μ 4 D 87 + μ 5 D g + μ 6 D g 1 ( 2 )

Where Tt is the number of tourist arrivals in Cyprus in quarter t, p is the real effective exchange rate against competitor countries, c is real consumption in source countries, and TRR is the log linear trend variable. First differences are denoted by “d.” The expression Γ contains 6 dummy variables that reflect seasonal and security related effects. 1/

2. Data

Quarterly data on tourist arrivals were collected regularly by the immigration authorities since the 1970s. Since January 1993, due to the exemption of EU residents from the requirement to fill arrival cards, only the number of travellers arriving in Cyprus is published by the immigration authorities; and the number of tourists is estimated by the central bank. The data show a continuous increase in the annual number of tourists during the 1980s, with strong seasonality. There was a sharp decline in tourism on two occasions, as a result of the above mentioned security related events (the Achille Lauro incident and the Gulf war).

A quarterly index of real consumption in the source countries of tourism was calculated using data on real consumption (seasonally adjusted) available from the OECD Analytical Database. This data base covers countries accounting for about 87 percent of tourist arrivals in Cyprus. Source country weights were determined by their relative share in tourist expenditures in Cyprus, using data from the annual tourism survey conducted by the Cyprus Tourism Organization.

The relative price index was constructed as a weighted average of the real effective exchange rates (CPI based) of Cyprus against its major competitors in the tourism market (Greece, Italy, Portugal, Spain, and Turkey). Competitors’ weights were determined by a regression equation which included, in addition to the five individual indices, quarterly dummy variables; and by imposing the restriction that the sum of the weights should be equal to 1. The most substantial difference between the regression based weights and using the number of tourists in each competitor country as its weight is the larger weights of Portugal and Greece in the regression based index—at the expense of Spain. However, owing to the similar patterns of the real effective exchange rates of these competitors, the different weighing methods affect the overall index only modestly.

3. Estimation and forecasting

Equation 1 was estimated using OLS on quarterly data for the period 1979–94 (first quarter). 1/ Beginning with a lag length of 5 and eliminating nonsignificant regressors, the equation is scaled down to yield the preferred equation reported in Table 1. The residuals are stationary, and the Q statistic, as well as the individual partial autocorrelations, indicate that there is no significant serial correlation.

Table 1.

Estimated Demand for Tourism 1/

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All variables in logs (except dummies). Estimation period 1979Q1–1994Q1.

A (*) indicates significance at the 5 percent level.

All the lags in Augmented Dickey-Fuller test were not significant at the 5 percent level.

All the coefficients are significant at the 5 percent level and have the expected signs. The low coefficient on the lagged dependent variable (0.37 after reparameterizing the equation to levels) indicates a relatively short adjustment period. The long-run income elasticity is 1.03, indicating that expenditure on tourism is roughly increasing with income. The price elasticity is -1.46, suggesting that tourist arrivals are highly sensitive to real prices, and that increases in the real effective exchange rate can have a substantial negative impact on tourism revenues. Finally, the “discovery” effect is significant with an elasticity of 0.41 (e.g., in 1993 its contribution to tourism growth over 1992 was 3.0 percentage points). 2/

Looking at long-term trends, the estimated coefficients imply that 36 percent of the increase in tourism between 1985 and 1992 reflected the real effective depreciation of the Cypriot pound (due to lower inflation than in competitor countries in the presence of a pegged exchange rate), while only 22 percent resulted from the increase in consumer expenditure. The learning effect accounted for 42 percent of tourism growth during that period.

Using the equation for forecasting results in relatively accurate projections. The equation, estimated for the period 1979–1991, was used to forecast dynamically (i.e., the equation uses projected, rather than actual, values of the lagged dependent variable) tourist arrivals in 1992 and 1993—two years of sharp fluctuations in tourist arrivals. The procedure yields an underestimation of tourist arrivals in 1992 of the order of 3.5 percentage points (as compared to an actual increase of 43 percent), and an overestimation by 2.3 percentage points in 1993 (as compared to an actual decline of 7.5 percent).

4. Conclusion

The econometric model developed in this appendix points to the important role played by price competitiveness in the determination of tourist arrivals to Cyprus. The size of the relative price coefficient in the estimated equation, suggests that the real effective appreciation of the Cypriot pound against the currencies of major competitors in the early 1990s, and the deterioration in relative unit labor costs (see Section V), may result in a substantial slowdown in tourism growth.

The estimated model projected with relatively high precision tourist arrivals in 1992 and 1993. It should be recognized, however, that ex-post projections are not subject to forecasting errors of the explanatory variables which may be substantial in ex-ante forecasting. Also, to the extent that there is a significant structural change in the market—for example development of new sources of tourism—past relationships may not be a good guide for the future. Nevertheless, in the absence of structural changes, this model may be useful in reducing the margins of error in tourism projections.

APPENDIX III: Institutional Characteristics and Flexibility of the Cypriot Labor Market A Critical Evaluation 1/

The recent surge of unit labor costs and the associated loss of competitiveness have drawn attention to the wage bargaining process in Cyprus and its implications for macroeconomic performance. This appendix describes the major labor market institutions, legislation, and procedures; and, in their light, discusses some labor market developments during the last decade and evaluates the degree of labor market flexibility in Cyprus.

1. General features: limited legislation and centralization

The Cypriot labor market is characterized by relatively limited direct legislative intervention in wage determination and employment decisions. The legal supervision of the market is mostly restricted to framework laws that guarantee the right of workers and employers to form associations, to bargain collectively, and to strike (or lock out). These rights may be restricted only in the case of “essential services” whose interruption may threaten the life, health, or safety of the population. The procedural framework for the bargaining process and the guidelines for labor relations are, thus, determined to a large extent by voluntary norms such as collective agreements and codes of conduct, which are not legally binding.

A second characteristic of the Cypriot labor market is its high degree of centralization. Approximately 80 percent of all workers belong to industry based trade unions which are organized in a small number of closely coordinated national federations. 2/ Although public servants, teachers, and bank employees established separate unions which are not affiliated with national centers, they cooperate with the national federations on issues of common interest. Most employers are members of industrial associations, the majority of which belong to the Cyprus Employers and Industrialists Federation (OEB). Many employers also belong to the Chamber of Commerce and Industry.

The existence of highly concentrated representative organizations of labor and employers facilitates the process of tripartism as the main mechanism for discussion of labor issues. The Government consults employers and workers regularly on economic matters, and the framework for sectoral contracts—including the percentage range or formula for wage increases—is set during negotiations between the employers federation and the trade unions with government intermediation when necessary. 1/

2. Negotiation process and labor disputes

The common process in which the terms and conditions of employment are determined is collective bargaining. Negotiations are usually conducted first at a broad sectoral level (e.g., manufacturing and construction) to determine the guidelines for branch discussions, and are then concluded at the branch level where the specifics of the agreement are finalized. Occasionally, bargaining had also taken place at the national level to define a framework for sectoral discussions, or when issues of broad influence such as the indexation of wages and the reduction of working hours were negotiated. Due to the limited scope of labor market legislation, the array of topics covered in the collective agreements is wide and includes, aside from wages, overtime pay, the distribution of working hours through the week, holidays, sickness pay, and provident funds and other retirement benefits. Procedural issues such as the check-off system and recruitment and dismissal rules are also deliberated. In the last decade, the duration of most collective agreements was two years, with the majority of exceptions being one year contracts. In the hotel industry, the duration of contracts was three years.

The framework for collective bargaining is set by the Industrial Relations Code—signed in 1977 by the Cyprus Employers’ Federation and the two largest trade union confederations, and countersigned by the Minister of Labor and Social Insurance. The code contains limitations with regard to the right to resort to industrial action and establishes the principle that certain (unspecified) issues are not negotiable and are to be decided by the employer. 2/ It also assigns to the Government the function of a mediator in labor disputes (Republic of Cyprus, 1977). If a dispute arises during the negotiation of a new collective agreement or during the renewal of an existing one, either party may submit it to mediation of the Ministry of Labor and Social Insurance. If, despite the Ministry’s efforts, no mutually agreeable solution is reached, the Ministry declares a deadlock and either party is free to take any lawful measures of industrial action. Before measures are taken, a ten-day warning must be given to the other party. 3/

Finally, the Industrial Relations Code sets the principles and procedures for the settlement of labor disputes arising from the interpretation and implementation of existing agreements or from personal complaints should be resolved either by negotiations, mediation—usually by the Ministry of Labor—or, as last resort, by binding arbitration. No industrial action may be taken in such disputes unless one side flagrantly violates the provisions of an existing agreement in spite of the Ministry’s advice.

While lengthy at times, until recently the procedures of the Industrial Relation Code had been relatively successful in preventing the loss of working days due to labor disputes (Table 1). The overall number of work days lost to strikes during 1988–91 was much lower than in other southern European countries (except Portugal) and in lower income OECD countries. Moreover, strikes in the public and banking sectors, which are not covered by the code, accounted for a much higher proportion of strikes (55 percent) in Cyprus than in other countries. However, some deterioration seems to have occurred in 1992–93 as the number of workdays lost increased by 50 percent as compared to the 1988–91 average.

Table 1.

Work Days Lost to Labor Disputes per Employed Person

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Sources: ILO, Year Book of Labor Statistics; OECD Analytical Database.

Calculated by dividing the number of man hours lost by the average number of hours per work day.

Excluding public administration.

Data for 1988–89 exclude the Basque region.

Unweighted average of all member countries.

Excluding France, Ireland, Luxembourg, and Iceland.

Excluding Switzerland and Turkey.

Excluding France, Ireland, and Luxembourg.

3. Entry and exit

The Termination of Employment law is less restrictive than in most European countries both in the case of dismissals for redundancy, and dismissals for other reasons (see for comparison Demekas, 1994). In the latter case, an employee with more than 26 weeks of continuous service is entitled, by law, to an advance notice of one to eight weeks, to one day of paid leave per week—up to five days—during the notice period, and to severance pay of up to two years’ salary depending on the cause of dismissal and the length of service (Table 2). 1/ The requirements for advance notice and compensation are waived, however, if the cause for dismissal is misconduct or a serious mistake of the employee. Employees who are dismissed as redundant are not entitled to compensation from the employer, but, instead, are eligible to a lump-sum payment from a central redundancy fund which is financed by regular employer contributions (0.6 percent of the wage bill). Cases of disagreement about the cause of dismissal are referred to the Labor Disputes Court. 2/ The amount of compensation above one year’s earnings, whether granted by the employer (according to the schedule of benefits) or ordered by the court, is also covered by the Redundancy Fund.

Table 2.

Advance Notice of Dismissals and Amount of Compensation

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Source: Republic of Cyprus: Termination of Employment law.

There are virtually no legal restrictions on the cause of dismissal—a major difference from many OECD countries (Emerson, 1988)—but it is forbidden to fire workers on sick leave for less than six months, or employees that were injured in occupational accidents. The permitted causes for redundancy layoffs, which exempt the employer from paying compensation, are broad and include: modernization, change in the line of products, change in the required skills, sales difficulties, credit problems, and a fall in the volume of business. However, an employer who plans redundancy layoffs is required to notify the Ministry of Labor at least four weeks in advance. 1/ The law also requires that employees fired on grounds of redundancy shall have priority when the employer rehires within eight months of the dismissals, while having regard to the enterprise’s requirements. There are no other hiring quotas in the private sector and, despite the high degree of unionization, trade union membership is not a condition for employment in any sector.

Working hours for most categories of employees are set through collective agreements. 2/ The law regulates only the working hours of a few groups of workers—mostly in the non-unionized sectors—and children. Compensation for overtime work is 1.5 times the normal rate, and weekend work is paid at twice the normal rate. Part time employment, although not very common in Cyprus, is permitted without any special restrictions.

The Industrial Relation Code requires consultation with the trade union before an employee can be laid off, and calls for establishing more specific guidelines for dismissals in the collective bargaining process. In practice, the guidelines established in most sectors place relatively tighter criteria on termination of employment for reasons other than redundancy, and impose a “last in first out” rule on redundancy layoffs. During the economic crisis of 1991 unions and employers agreed on temporary layoffs, a procedure that allows dismissed workers to collect payments from the unemployment fund for the duration of redundancy after the employer pays 50 percent of their salaries for 10 days. This practice is also common in the tourism industry where some employers close their business for a few months during the winter.

Unemployment benefits are relatively less generous than in most EU countries, as a relatively high earnings’ replacement rate is more than offset by more stringent duration of benefits. There are two levels of benefits: (1) 60 percent of earnings, up to a threshold level known as basic earnings (currently £C 194 monthly), with supplements of one-third for the first dependent and a one-sixth for each of the second and third dependents; and (2) 50 percent of income above the basic earnings up to a maximum benefit of twice the basic earnings. This structure of benefits implies that low income employees with three dependents or more may enjoy full replacement of their earnings upon the termination of employment. For higher income employees, the share of income covered by unemployment benefits is lower but is still above the prevailing rates in the EU. 1/ Benefits are paid for up to 156 days—compared with 12–36 months in most EU countries (OECD, 1993)—and in order to be renewed require that the individual be reemployed for 26 weeks. This short duration is not unreasonable if one recognizes that the main economic rationale for unemployment benefits is to facilitate an efficient job search (Habor and Murray (1966), Mortensen (1986), and Devine and Kiefer (1990)), and that in a small economy like Cyprus such search could be considerably shorter than in larger economies.

Generally, the unemployment benefits system had not been tested since the early 1980s. Fast economic growth induced a constant decline in the unemployment rate—which is much below EU levels—and a smooth absorption of market entrants into employment. International labor mobility functioned as a safety valve at the margin, initially through the emigration of Cypriots, later through return migration and, in the early 1990s, through the recruitment of foreign labor. Even during the Gulf War crisis employers hesitated to cut employment—with the exception of temporary layoffs—as they expected labor shortages to re-emerge once the hostilities ended.

4. Full indexation, minimum wages, and foreign labor

One of the important components of the wage determination process is the cost of living allowance (COLA) which has guaranteed full indexation of wages to the CPI for decades. 2/ Although the COLA is part of the collective agreement and not a legal requirement, it covers the entire economy including the public sector. Adjustments to the allowance are made twice a year—in January and July—to compensate employees for inflation during the previous six months. There are no provisions to exclude from the COLA price increases that are due to special factors, such as a rise in imported inputs’ prices or indirect tax rates.

Minimum wages in Cyprus are relatively low, and do not constitute an effective constraint on employment—only two percent of the labor force earn wages less than 20 percent above the minimum wage. The legal minimum wage, which applies only to clerks, salespersons, and nursing and child care assistants, is increased annually, roughly in line with the minimum wage set in collective agreements. Since 1992, there are only two types of minimum wages: for workers entering a new job, and for workers with more than six months tenure. In most industries the minimum wage for women was lower than that for men until 1992, but this differential was abolished due to legislation changes.

The importation of foreign labor on a large scale was permitted for the first time in 1992 when significant labor shortages emerged in Cyprus. Employers are obliged to pay foreign workers the same wages as comparable Cypriot workers, to grant them all the social benefits enjoyed by their Cypriot counterparts, and to provide them with appropriate health insurance. Employers are also responsible for all travel costs of the employees, including the cost of repatriation when employment is terminated—either at the end of the contract term or sooner. 1/ The collective agreement bars the employment of foreigners at the time when Cypriot employees are laid-off as redundant.

6. Assessment of labor market flexibility

In many aspects, the labor market in Cyprus is substantially more flexible than those of other economies. Labor market legislation is limited to the minimum, hiring procedures are simple, the constraints on firing are lower than elsewhere, minimum wages are not binding, and unemployment benefits are low (on account of their short duration). Finally, until recently the advantages of the Industrial Relations Code’s procedures in lowering the number of work days lost to labor disputes have been apparent.

There are, however, two aspects that have recently attracted attention as possible sources of rigidity: the centralization of the negotiation process, and wage indexation, particularly in combination with the long duration of wage contracts in some sectors. As to the degree of rigidity implied by the centralization, the judgement is mixed. The negotiation process in Cyprus is certainly more centralized than in most economies (although not as centralized as in the “classical” examples of the Scandinavian economies in the 1970s), but a relatively high degree of centralization is inevitable in a small economy like Cyprus. Moreover, centralization in the labor market is not clearly viewed as a negative phenomenon in economic theory. On the contrary, a centralized wage bargaining process may be viewed as an important factor contributing to calm labor relations, low unemployment rate and moderate inflation during the 1980s. Bruno and Sachs (1985) introduced the conception that a more “corporatist” structure of the labor market facilitates more efficient outcomes of the wage bargaining process; and Calmfors and Driffil (1988) and Freeman (1988) found that economies with either high or low levels of labor market centralization perform better than those with intermediate levels. The rationale of these arguments is that centralized trade unions internalize many of the externalities ignored in a more decentralized process, such as the effects of wage agreements on the overall level of unemployment and on inflation (Calmfors, 1993). Also, by internalizing the benefits of economy wide growth, the unions may be more inclined to allow sufficient profit margins to the employers, in order to foster investment (Hoel, 1990). Furthermore, McCallum’s (1983) findings that economies with a high degree of consensus perform better, point to the potentially important role of tripartism—as a consensus building mechanism—in the economy’s success.

The role of wage indexation in lowering labor market flexibility is, instead, more clearly defined. In their seminal analysis of economies with indexation, Modigliani and Padoa-Schioppa (1978) noted that, when indexation is complete (after a lag), downward flexibility of real wages can be attained only at the cost of permanently raising the rate of inflation. Suppose, for example, that starting with an equilibrium in the labor market, there is a negative productivity shock that lowers the demand for labor at the real wage level of the initial equilibrium. The ensuing disequilibrium between supply and demand of labor cannot be restored by a one-off price increase as, with a lag, wages will catch up. In order to restore labor market equilibrium, a further price increase will be necessary. Eventually, labor market equilibrium can be restored only by avoiding that wages catch up with prices, that is through an inflation process. Moreover, full indexation may exacerbate the inflationary pressure from an increase in imported inputs’ prices or from a hike in indirect tax rates, and may cause a higher unemployment rate—compared with more flexible mechanisms—as a result of such shocks. In the case of a pegged exchange rate regime, an inflationary spiral caused by these factors may also lead to a balance of payments crisis.

Under the favorable macroeconomic conditions of the 1980s the downward stickiness of real wages in Cyprus did not constitute an effective constraint on the wage determination process—as real wages increased with productivity (Table 3) and workers released from industries unable to pay the rising wages were absorbed by other sectors in the expanding economy. However, this rigidity may become a substantial impediment to the economy’s ability to respond promptly and successfully to negative shocks in the more volatile environment that developed in the 1990s. 1/ Particularly, in the presence of long duration wage contracts in some industries, the COLA mechanism constrains the market’s ability to correct an overshooting of wages that may result from too an optimistic outlook at the time of the contracts’ inception.

Table 3.

Wage and Productivity Indicators, 1983–1994

(Percentage change)

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Percentage change of wage rates including basic wages or salaries, cost of living and other allowances, bonuses, graduities and payments in kind. Data exclude overtime payments and are gross of income taxes and social security deductions.

Average earnings refer to the total gross weekly earnings for actual hours worked.

Deflated by the GDP deflator (at factor cost)

Deflated by the manufacturing deflator

APPENDIX IV: Modelling the Demand for Monetary Aggregates in Cyprus 1/

1. Introduction

For a number of years, the Central Bank of Cyprus has followed the practice of preannouncing targets for the expansion of broad money and domestic credit to the private sector. Somewhat puzzling, however, is the fact that although monetary targets have been missed almost consistently by wide margins, inflation has remained remarkably low (Table 1). This fact suggests that the monetary aggregates selected by the authorities as intermediate targets did not meet the essential requirement of being related to the traditional scale and cost variables in a stable fashion.

Table 1.

Targets and Outcomes of Monetary Policy

(In percent)

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The purpose of this appendix is to examine the stability of the demand for narrow and broad monetary aggregates in Cyprus. Given the relative importance of cooperative banks in the Cypriot economy, it was decided to adjust the official definitions of narrow and broad money to include demand and savings deposits held at those banks. More specifically, demand equations were estimated for currency and the adjusted aggregates M1C (adjusted narrow money) and M2C (adjusted broad money). In addition, estimations with M2 (unadjusted broad money) were also carried out since the latter represents one of the intermediate targets of the central bank. It is shown that there is no long-run relationship between either M2 or M2C on the one hand, and real economic activity and the price level on the other, and, consequently, that these aggregates are of limited usefulness as intermediate monetary policy targets. Stable relationships were found for currency and M1C, with the latter performing better under a series of diagnostics tests.

This appendix is organized as follows: Section 2 describes the basic time series properties of the variables used in the analysis; Section 3 outlines the methodology employed in the search for a stable money demand function and explains the results; Section 4 examines the stability properties of the estimated demand functions; and Section 5 concludes. An annex describing the data is also attached.

2. Univariate time series properties

Table 2 shows the results of unit root tests performed on the variables of interest: monetary aggregates, real GDP, and the price level (GDP deflator). 1/ Quarterly observations of these variables for the period 1975:3-1992:4 are used. Since no quarterly national accounts data exist in Cyprus, a quarterly GDP series (GDP1) was constructed on the basis of balance of payments data on tourism; in order to show the robustness of the results to changes in the interpolation method all tests were performed again using two additional series (GDP2 and GDP3)—see the Annex for a description of the interpolation methods.

Given the low power of the unit root tests (and the relatively small sample size), it is not surprising that the results are somewhat ambiguous. As shown in Table 2, the results of simple DF tests are mostly in line with the experience of low inflation countries, depicting all nominal variables as difference stationary—except currency and the GDP deflator in the no-trend case, which were found to be stationary in levels. The DF tests, however, did not yield the common result of a unit root in real output in two of the three measures of real GDP, which were found to be stationary around a deterministic linear trend. The ADF tests, especially when a time trend is included, are more conclusive as the null hypothesis of a unit root in the levels could not be rejected for any variable except the GDP deflator in the no trend case. However, ADF tests could not reject the null hypothesis of a second unit root in currency, M1C, and M2.

In summary, the results described above broadly suggest that real output, the price level and the monetary variables are all difference stationary. With this background, the existence of a long-run relation between money, real income, and the price level, was tested in the context of short-run error correction model.

3. Cointegration and error correction representation

Traditionally, long-run money demand formulations take the following form (all variables except interest rates expressed in logs):

m * = α 0 + α 1 p + α 2 y + α 3 i + α 4 r + μ ( 1 )

where m* represents the desired level of money holdings; p is the price level; y is a scale variable, usually real GDP; i is the own rate of return; and r is the yield of the best alternative asset. In line with economic theory, α1 is expected to be 1, implying long-run neutrality of money; α2 is expected to be positive; and α3 and α4, which are interest rate semi-elasticities, are expected to be positive and negative respectively.

In Cyprus the interest rate on bank deposits has always been administratively determined and its value has not been changed (in terms of equation (1), i is actually a constant). Moreover, financial markets are underdeveloped and no close substitutes to bank deposits are available to the public. In that case the return on real assets, the rate of inflation, represents the opportunity cost of holding money (in terms of equation (1) this amounts to setting r equal to the inflation rate, dp).

The existence of a long-run demand for money is tested in the context of an unrestricted error correction model. Engle and Granger (1987) show that a long-run relationship between nonstationary variables exists if a linear combination of them is stationary. Moreover, if that is the case, the short-run relationship between those variables has an error correction representation. Based on the above discussion, the long-run relation postulated for Cyprus and its error correction representation are:

m ∗ = σ 0 + σ 1 p + σ 2 y + σ 3 d p + μ ( 2 )
d m t = ∑ i = 1 K β i d m t - i + ∑ j = 0 K [ δ i d p t - i + γ i d y t - i ] - λ 1 [ m - m * ] t - 1 + ε t ( 3 )

A common number of lags for the differenced variables (K) is chosen for simplicity. The difference between m and m* represents the error correction term: an excess of money over the amount actually desired tends to be corrected in the following period. The parameters of the long-run and short-run formulations can be estimated simultaneously, by testing an unrestricted error correction model, which may be obtained by replacing equation (2) in (3):

dm t = ∑ i=1 K ψ i dm t-i + ∑ j=0 K [ ϕ j d p t-j + ε j d y t-j ] + ρ 1 m t - 1 + ρ 2 p t - 1 + ρ 3 y t - 1 + ν t ( 4 )

In this unrestricted formulation, the test of whether a cointegrating relation exists between money, income, and prices—as in equation (2)—amounts to a test of whether the coefficients of the lagged levels of the variables m, y and p are all significant. 1/ If cointegration was found to exist, the plausibility of the implied long-run parameters would be assessed by examining the following terms: (i) the correct sign (negative) of the error correction term, ρ1; (ii) the implied long-run price and income elasticities (-ρ2/ρ1 and -ρ3/ρ1 respectively); (iii) and the speed of adjustment of money demand to deviations from its long-run value (-l/ρ1).

4. Estimation

Equation (4) is estimated using OLS, under the assumption of weak exogeneity of prices and output for the parameters in equation (4). Johansen (1992) shows that weak exogeneity ensures that equation (4) can be efficiently estimated using single equation estimation techniques rather than system estimators. 2/ Thus, the approach consisted in searching for a parsimonious representation of equation (4), in the sense of retaining only significant terms among current and lagged values of the differenced variables. Once this parsimonious representation was established, the existence of cointegration was tested by looking at the significance of the error correction terms (lagged values of the variables in levels).

Standard t and F tests were used in the process: typically a set of variables with the lowest (and insignificant) t-values would be selected, and would be dropped if, in addition, their coefficients were not significantly different from zero taken as a group (see Banerjee et al. (1993)). 1/ The lag-length index K was set initially at 5, and the testing down process described above was carried out for money demand equations specified for each of the monetary aggregates (currency, M1C, M2, and M2C), using alternatively the three measures of real GDP in each case. The results of the tests are reported in Tables 3–6.

Table 3 shows the results for currency. Focusing on the estimates obtained with GDP1, the five lags of the increase in nominal currency survived all exclusion tests, as did the contemporaneous value of GDP growth, and the fourth lag of inflation. For the latter two terms the signs were the expected ones. The coefficients of the error correction terms are all significant and have the correct signs. Moreover, the implied long-run elasticities for the price level and real output are approximately 1 and 0.4 respectively, in line with economic theory. 2/ The standard goodness-of-fit statistics are good: R2 of about 93 percent and a standard error of 0.01.

The diagnostics tests applied on equation 1 revealed the presence of some statistical problems. The existence of fourth order autocorrelation could not be rejected at the 10 percent level of significance, and the equation failed the test for normality of the residuals. The residuals of the regression were also tested for fourth order ARCH, heteroscedasticity, and misspecification via the RESET test, in all cases with negative results. Table 3 shows also the results obtained using alternative measures of the GDP. The results with GDP2 are almost identical to those obtained with GDP1, while the results with GDP3 lead to a different dynamic specification but similar results for the long-run elasticities.

The estimates obtained for M1C are shown in Table 4. Focusing again on the results obtained with GDP1, the estimated equation is simpler than that obtained for currency: only three lags of the change in money were found to be significant, while no inflation term could be retained. On the other hand, the contemporary rate of growth of GDP was found to be significant. The error correction terms are all significant and have the correct signs. The long-run elasticities are also plausible: 1.07 for the price level and 0.81 for real income. The equation passed all the diagnostics tests, including those for fourth order autocorrelation and normality of the residuals, which the currency equation failed. As before, the estimates obtained with GDP2 are practically identical to those obtained with GDP1, while cointegration between money, income and prices fails when GDP3 is used.

It is interesting to note that despite the absence of a cost variable the estimated equation still passed all the tests, especially those for misspecification. This seems to be the result of the fact that inflation remained relatively low over the entire sample period, and did not play an important role in the determination of the transactions demand for money. This result is not new and it is broadly in line with the traditional Cagan-type of specification, where the elasticity of money demand depends on the level of the inflation rate—see Cagan (1956).

For M2 and M2C the tests failed to find a stable long-run relation between money, income and prices (Tables 5 and 6). In both cases, after testing down to a parsimonious representation for the lag-differenced terms, the t-tests on the error correction terms failed for at least one of the them—the results are significantly worse for M2C than for M2. Failure to find a cointegrating relation between M2 (or M2C), income and prices should not come as a surprise, since in Cyprus changes in quasi-money, which represent about 80 percent of M2, seem to be driven by the behavior of domestic saving and not real income. Thus, the relevant scale variable in a demand equation for M2 (or M2C) should be wealth rather than income, but unfortunately no information on this variable is available. 1/

5. Stability of the estimated demands

On the basis of the diagnostics tests analyzed in the previous section, the estimated demand for MIC outperformed the currency equation. This section examines the stability of the estimated demand for MIC (using GDP1) on the basis of four different tests, the results of which are shown in Chart 1. The first panel of Chart 1 compares the one-step ahead residuals with an interval of plus/minus two standard deviations (approximately a 95 percent confidence interval) for the period 1982 onwards. Residuals falling outside the boundaries can be interpreted as indicative of parameter instability. None of the 43 residuals falls outside the boundaries.

CHART 1
CHART 1

CYPRUS Demand for M1C: Stability Tests

Citation: IMF Staff Country Reports 1995, 003; 10.5089/9781451809770.002.A001

Source: Staff estimates.

Panels two, three and four compare the estimated significance values of different stability tests with a horizontal line at the 5 percent level; points crossing the 5 percent line indicate that the hypothesis of constancy of parameters is being rejected at that level of significance. Panel two shows the results of one-step ahead Chow tests. For every period starting in 1982:2, the panel shows an F test measuring the significance of the marginal increase in the sum of squared residuals (SSR) due to the one-step forecast error for the following quarter. The test is repeated by successively increasing the sample size and recalculating the SSR with and without the forecast error. A significant change in the SSR leads to rejecting the null hypothesis of constant parameters in that period. As shown in the second panel of Chart 1, in 5 out of 43 cases the null hypothesis of constant parameters is rejected, a frequency somewhat higher than the 5 percent level of significance, suggesting a problem of instability in the estimated parameters.

The results of other two tests are more encouraging. Panel three shows the results of a sequence of break-point Chow tests. Each test compares the change in the SSR of a regression estimated from 1976:4 to 1982:1, caused by adding the forecast errors for the remaining years through 1992:4. The sequence of tests is generated by increasing the estimation sample (and reducing simultaneously the forecasting horizon) gradually up to 1992:3. Panel four shows the results of a related test, where the model is fitted for a fixed period (1976:4–1982:1) and the forecasting horizon is gradually extended through 1992:4. Instability is assessed by examining the evolution of the SSR (inclusive of the forecasting errors) as the forecasting horizon increases. As shown in Chart 1, the 5 percent significance line is never crossed in any of the two tests. Based on the results of the four tests reported here, we conclude that the equation is reasonably stable.

6. Conclusions

The results of this appendix confirm the existence of long-run demands for currency and M1C, but standard diagnostics tests revealed some problems with the currency equation. The equation for M1C, on the other hand, passed all the diagnostic tests and proved to be reasonably stable over the estimation period. A similar procedure failed to find a long-run demand for M2 or M2C. The results are preliminary, but support a case for monitoring M1C and for using the information that it provides about the state of the economy in managing monetary policy. The results also provide preliminary evidence against using M2 as an intermediate target of monetary policy in Cyprus. Finally, these results cast doubts on the use of private credit as an intermediate monetary policy variable, at least until targets for the latter are derived starting from an initial M2 projection.

Failure to find a stable demand for broader monetary aggregates may be related to the fact that national wealth, a potentially important determinant of broad money demand in Cyprus, may be growing at a faster pace than real income. Unfortunately there is no available data on wealth, so the hypothesis that instability in M2 may simply reflect a misspecification of the scale variable could not be tested.

Annex: Data Sources and Definition of Variables

Data for all variables were taken from the IMF’s IFS statistics. The values of Ml and M2 were adjusted in order to include deposits of cooperative banks. Data on these deposits were provided by the Cypriot authorities on a quarterly basis from 1989 onwards, but only on annual basis before then. Consequently, quarterly values were interpolated using as indicator the within-the-year movements in quasi-money at commercial banks.

The available annual figure for real GDP was regressed on annual figures of the real value of exports of nonfactor services—available from the IFS—and a quarterly series for GDP (GDPO) was generated using the quarterly observations of export series. An alternative series (GDP3) was constructed by simple geometric interpolation. The series GDP1 and GDP2 represent “smoothed” series obtained by averaging GDPO and GDP3 using different weights. The quarterly observations of the GDP deflator were obtained on the basis of within-the-year movements of the CPI.

All variables were transformed in logs for the purpose of modelling. No series was seasonally adjusted, but all regressions, including the Dickey-Fuller tests, included seasonal dummies.

APPENDIX IV: Exchange and Trade Arrangements

(Position as of September 15, 1994)

1. Exchange arrangement

The currency of Cyprus is the Cyprus Pound, the external value of which is pegged to a basket based on the European Currency Unit (ECU) at ECU 1.7086 per £C 1, within margins of ±2.25 percent around the ECU central rate. On December 31, 1993, the official buying and selling rates for the U.S. dollar, the intervention currency, were £C 0.5185 and £C 0.5205, respectively, per US$1. The Central Bank of Cyprus also quotes daily buying and selling rates for the ECU, deutsche mark, the Greek drachma, and the pound sterling. These rates are subject to change throughout the day. It also quotes indicative rates for other foreign currencies 1/ on the basis of market rates in international money market centers. Subject to certain limitations, including a limit on spreads between the buying and selling rates, authorized dealers (banks) are free to determine and quote their own buying and selling rates. There are no taxes or subsidies on purchases or sales of foreign exchange.

Authorized dealers are allowed to trade in the forward market at rates that may be freely negotiated with their customers. For U.S. dollars and pounds sterling, however, forward rates may not differ by more than the premiums or discounts that are applied by the central bank for cover for a similar period. Authorized dealers are allowed to purchase forward cover from the central bank at prevailing rates or to conduct forward operations between two foreign currencies for cover in one of the two currencies. The central bank offers authorized dealers facilities for forward purchases of U.S. dollars and pounds sterling for exports for periods of up to 24 months. Cover for imports is normally provided for up to 6 months. When justified (for example, payments for imports of raw materials for exports or capital goods), rates are quoted for up to 15 months. Forward contracts must be based on genuine commercial commitments. Forward cover may also be provided for up to 12 months to residents for specific financial commitments.

Cyprus formally accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund Agreement, as from January 9, 1991.

2. Administration of control

Exchange controls are administered by the central bank in cooperation with authorized dealers. Authority to approve applications for the allocation of foreign exchange for a number of purposes has been delegated to authorized dealers.

3. Prescription of currency

Payments may be made by crediting Cyprus pounds to an external account, or in any foreign currency; 1/ the proceeds of exports to all countries may be received in Cyprus pounds from an external account, or in any foreign currency.

4. Resident and nonresident accounts

Residents of countries outside Cyprus may open and maintain with authorized dealers nonresident accounts in Cyprus pounds, designated external accounts, or foreign currency accounts. These accounts may be credited freely with payments from nonresidents of Cyprus (such as transfers from other external accounts or foreign currency accounts), proceeds from sales of any foreign currency by nonresidents (including declared bank notes), and the entire proceeds, including capital appreciation, from the sale of an investment made by a nonresident in Cyprus with the approval of the central bank and with authorized payments in Cyprus pounds. External accounts and foreign currency accounts may be debited for payments to residents and nonresidents, for remittances abroad, for transfers to other external accounts or foreign currency accounts, and for payments in cash (Cyprus pounds) in Cyprus. Authorized dealers are allowed to grant medium and long-term foreign currency loans to non-residents up to twenty percent of their deposit liabilities in foreign currencies. 2/ Companies registered or incorporated in Cyprus that are accorded nonresident status by the central bank as well as their nonresident employees may maintain external accounts and foreign currency accounts in Cyprus or abroad, as well as local disbursement accounts for meeting their payments in Cyprus. Resident persons and firms dealing with transit trade or engaged in manufacturer-exporter activities or in the hotel business may open and maintain foreign currency accounts subject to certain requirements. Residents dealing with transit trade may deposit up to 95 percent of sale proceeds in these accounts and use balances to pay for the value of traded goods. Residents engaged in manufacturer-exporter activities may deposit up to 50 percent of export proceeds in these accounts and use balances to pay for imports of raw materials used in production. Both transit traders and manufacturers-exporters are, however, required to convert into Cyprus pounds at the end of each year any balances in excess of the amount that is necessary for payments of the value of traded goods of raw materials during the following three months. Cypriot repatriates may keep in foreign currency, in external accounts in Cyprus, or in accounts abroad all of their foreign currency holdings and earnings accruing from properties they own abroad.

Blocked accounts are maintained in the name of nonresidents for funds that may not immediately and in their entirety be transferred outside Cyprus under the existing exchange control regulations. Blocked funds may either be held as deposits or be invested in government securities or government-guaranteed securities. Income earned on blocked funds is freely transferable to the nonresident beneficiary or may be credited to an external account or foreign currency account. In addition to income, up to £C 10,000 in principal may be released annually from blocked funds for transfer outside Cyprus. 1/ Funds can also be released from blocked accounts to meet reasonable expenses in Cyprus of the account holder and his family, including educational expenses, donations to charitable institutions in Cyprus, payments for the acquisition of immovable property in Cyprus, and any other amounts authorized by the central bank.

5. Imports and import payments

Most imports are free of licensing requirements. An import license is required for certain commodities such as fresh fruits, fresh vegetables, fresh meat, and other goods produced or manufactured locally.

The Minister of Commerce and Industry may amend the list of commodities subject to licensing as deemed necessary to regulate the importation of goods for the encouragement of local production and manufacture and for the improvement of the balance of payments. Exchange is allocated freely and without restriction through authorized dealers to pay for imports, provided that documentary evidence of shipment or actual importation of goods is available.

Advance payments before shipment require the prior approval of the central bank, except for imports whose value does not exceed £C 20,000. Authorized dealers are allowed to sell to departing residents of Cyprus foreign exchange up to £C 20,000 for purchases and for the importation of goods into Cyprus; foreign exchange in excess of this limit may be sold to departing residents with the approval of the central bank. An import surcharge of 3.8 percent (2.5 percent for imports from European Union countries) ad valorem is levied on all imports, except food, pharmaceuticals, and goods imported by the Government.

6. Payments for invisibles

Payments for invisibles abroad require the approval of the central bank, but approval authority for certain types of payments has been delegated to authorized dealers. Profits, dividends, and interest from approved foreign investments may be transferred abroad without limitation, after payment of any due charges and taxes. Insurance premiums owed to foreign insurance companies may be remitted after all contingencies have been deducted. Nonresidents who are temporarily employed in Cyprus by resident firms or individuals and are paid in local currency may transfer abroad their remuneration less local living expenses and taxes. 1/

Allowances are granted to residents for study abroad at colleges, universities, or other institutions of higher education, and certain lower-level institutions of learning. Exchange allowances are based on the cost of living which is reviewed yearly, and cover the full amount of tuition fees plus living expenses for the student. The current annual allowance for living expenses for studies in Western European countries, excluding Greece, is £C 4,600; for Greece, £C 3,000; for Canada and the United States, £C 6,600; for Australia £C 4,000, and for all other countries, £C 3,000. There is no limit on the remittance of foreign exchange for payment of tuition fees.

Authorized dealers are allowed, without any reference to the central bank to sell to resident travelers foreign exchange up to £C 750 a person a trip for tourist travel; the Central Bank approves applications for allocations of additional foreign exchange without limitation to cover genuine travel expenses. The allowance for business travel is not fixed but depends on the length of stay abroad. Authorized dealers are empowered to provide up to £C 300 a day with a maximum of £C 3,000 a trip; additional amounts may be granted with the approval of the central bank on proof of need.

Company credit cards valid abroad are issued to resident businessmen and professionals traveling abroad on business. These international credit cards entitle the holders to charge their expenses for hotels, restaurants, and transportation without limit and any other expenses up to £C 400 a trip including cash withdrawals of up to £C 100. If the resident traveler holds’ an international credit card, authorized dealers are allowed to provide an allowance of up to £C 80 a day in foreign exchange with a maximum of £C 800 a trip for business travel. Additional amounts for business travel may be provided with the approval of the central bank. In addition, enterprises may use international credit cards for payments of up to £C 300 for mail orders of books or other items. Authorized dealers are also allowed to issue personal credit cards, valid abroad, to certain categories of residents. Foreign exchange for medical expenses abroad is granted without limit, and authorized dealers are empowered to provide allowances of up to £C 3,000 without reference to the central bank.

On leaving Cyprus, travelers may take out with them up to £C 50 in Cyprus currency notes. There is no limit on the amount of foreign currency notes that departing residents may take out of the country as part of any of their foreign exchange allowances. Nonresident travelers may take out any amount of foreign currency notes they declared on arrival less expenses incurred in Cyprus. Nonresidents entering Cyprus must declare any foreign exchange that they plan to use to purchase goods to export, or to purchase properties, or to deposit with authorized dealers. Nonresidents may export up to $1,000 in foreign currency notes which they imported even if they were not declared on arrival. In addition, authorized dealers may convert up to £C 100 into foreign currency for departing nonresidents and are permitted to issue to nonresidents as well as to resident employees of offshore companies any amount of foreign currency notes against external funds.

7. Exports and export proceeds

All exports whose value exceeds £C 1,000 are subject to exchange control monitoring to ensure the repatriation of the sale proceeds. Export proceeds must be surrendered to authorized dealers without delay. Exports of potatoes and carrots are carried out by the respective marketing boards, and exports of wheat, barley, and maize are carried out by the Cyprus Grain Commission.

8. Proceeds from invisibles

Receipts from invisibles must be sold to an authorized dealer. Persons entering Cyprus may bring in any amount in foreign currency notes and up to £C 50 in Cyprus currency notes.

9. Capital

Transfers abroad of a capital nature require authorization from the central bank. Direct investment abroad by residents is permitted, provided that the proposed investments will promote exports of goods and services or will benefit the Cypriot economy. Outward portfolio investment by residents is not permitted, except for insurance companies (up to 15 percent of their reserves), Cypriots who are allowed to hold foreign currency accounts, and resident employees of multinational enterprises who may participate in the employee stock purchase plan offered to them by their employer.

Investments in Cyprus by nonresidents require the prior approval of the central bank, which, in considering applications, gives due regard to the purpose of the investment, the extent of possible foreign exchange savings or earnings, the introduction of know-how, and, in general, the benefits to the national economy. Foreigners may own up to 100 percent of the capital of enterprises engaged in the manufacture of goods exclusively for export. Foreign participation of up to 49 percent is allowed for manufacture of new products, certain tourist activities, and other industrial projects. Inward investment is particularly welcome in projects which upgrade the tourist product (e.g., marinas, golf courses, and theme parks). In sectors of specific treatment such as banking and finance, applications are examined on a case-by-case basis. Foreign direct investment is discouraged in saturated sectors such as trading, real estate development, travel agencies, restaurants, and local transportation. Foreign participation in inward portfolio investment in listed company securities is permitted up to a limit of 30 percent generally and 40 percent in investment companies and mutual funds. Foreigners are allowed to purchase government securities in domestic currency. Annual profits and proceeds from the liquidation of approved foreign investments, including capital gains, may be repatriated in full at any time after payment of taxes.

Commercial credits from abroad with a maturity of less than 200 days may be negotiated freely. With the permission of the Council of Ministers, nonresident aliens, may acquire immovable property in Cyprus for use as a residence or holiday home; they must, however, purchase such property with foreign exchange. The sales proceeds of such property are transferable abroad up to the original purchase price of the property; the remaining balance is transferable at an annual rate of £C 10,000, plus interest. The same treatment is accorded to nonresident Cypriots purchasing a holiday home in Cyprus.

Residents of Cyprus (Cypriots or foreign nationals) who take up residence outside Cyprus may immediately transfer abroad up to £C 20,000; 1/ any excess amount is deposited in a blocked account and released at the rate of £C 10,000 a year. 1/ The transfer abroad of funds from estates and intestacies and from the sale of real estate, other than that referred to in the preceding paragraph, is limited to £C 10,000, 1/ with any excess amount to be credited to a blocked account and also released at the rate of £C 10,000 a year. 1/ Interest earned on a blocked account can be freely transferred abroad.

Transactions in foreign securities owned by residents require prior permission from the Central Bank. In principle, all securities held abroad by residents are subject to registration.

10. Gold

Residents may hold and acquire gold coins in Cyprus for numismatic purposes. Residents other than the monetary authorities, authorized dealers in gold, and industrial users are not allowed to hold or acquire gold in any form, other than jewelry, at home or abroad. Authorized dealers in gold are permitted to import gold only for the purpose of disposing of it to industrial users. The exportation of gold requires the permission of the exchange control authorities.

11. Changes During 1994

a. Capital

April 26. The central bank delegated authority to authorized dealers to grant to nonresidents medium-term and long-term loans in foreign currency up to 20 percent of their deposit liabilities in foreign currencies.

September 1. The central bank announced that, as from January 1, 1995 the amount that may be released annually from blocked accounts for transfer abroad will be increased from £C 10,000 to £C 50,000 and the amount that emigrants may transfer abroad on departure will be increased from £C 20,000 to £C 50,000 per household.

b. Payments for invisibles

April 4. The use of internationally valid cards was widened so as to include payments abroad up to £C 300 for certain additional purposes such as examination fees, fees for the consideration of applications for admission to educational institutions abroad, subscriptions to professional clubs or societies, enrollment fees, reservation fees, etc.

July 13. The amount that nonresidents temporarily employed by residents in Cyprus may deposit in external or foreign currency accounts with authorized dealers, without reference to the central bank, was increased from £C 200 to £C 400 of their monthly remuneration.

References

APPENDIX III: References

  • Bruno, M. and J. Sachs, (1985), “Economics of Worldwide Stagflation,” Harvard University Press.

  • Calmfors, L. (1993), “Centralization of Wage Bargaining and Macroeconomic Performance: A Survey,” mimeo, OECD.

  • Calmfors, L. and J. Driffil (1988), “Bargaining Structure, Corporatism, and Macroeconomic Performance,” Economic Policy, April, pp. 14–61.

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  • Demekas, D. (1994), “Labor Market Institutions and Flexibility in Italy: A Critical Evaluation and Some International Comparisons,” IMF Working Paper WP/94/30, International Monetary Fund.

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  • Devine, T. and N. Kiefer (1990), “Empirical Labor Economics: The Search Approach,” Oxford University Press.

  • Emerson, M. (1988), “Regulation or Deregulation of the Labor Market,” European Economic Review 32, pp. 775–817.

  • Freeman, R. (1988), “Labor Market Institutions and Economic Performance,” Economic Policy, April, pp. 64–80.

  • Habor, W. and M. Murray (1966), “Unemployment Insurance in the American Economy,” Irwin.

  • Hoel, M. (1990), “Local Versus Central Wage Bargaining with Endogenous Investments,” Scandinavian Journal of Economics, vol. 92 (3) pp. 453–469.

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  • International Labour Office (1993), “Year Book of Labour Statistics,” International Labour Office, Geneva.

  • McCallum, J. (1983), “Inflation and Social Consensus in the Seventies,” Economic Journal, 93, pp. 784–805.

  • Modigliani, F. and T. Padoa-Schioppa, (1978), “The Management of an Open Economy with “100% Plus” Wage Indexation,” Essays in International Finance, No. 130, December, Princeton University.

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  • Mortensen, D. (1986), “Models of Search in the Labor Market,” in Ashenfelter, O. and R. Layard: “Handbook of Labor Economics,” North-Holland.

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  • OECD (1993), “Employment outlook,” OECD.

  • Republic of Cyprus (1977), “Industrial Relations Code,” Ministry of Labour and Social Insurance.

APPENDIX IV: Reference

  • Arestis, P. and P. Demetriades. 1991. “Cointegration, Error Correction and the Demand for Money in Cyprus”, Applied Economics, vol. 23, pp. 1417–24.

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  • Banerjee, A., J. Dolado, J. Galbraith, and D. Hendry. 1993. Cointegration, Error Correction, and the Econometric Analysis of Nonstationarv Data. Oxford University Press, New York.

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  • Cagan, P. 1956. “The Monetary Dynamics of Hyperinflation”, in M. Friedman (ed.), Studies in the Quantity Theory of Money. University of Chicago Press.

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  • Dickey, D., D. Jansen, and D. Thornton. 1991. “A Primer on Cointegration with an Application to Money and Income”, Federal Reserve of St. Louis Review, March/April, pp. 58–78.

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  • Engle, R. and C. Granger. 1987. “Cointegration and Error Correction: Representation, Estimation, and Testing”, Econometrics, vol. 55, pp. 251–76.

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  • Ericsson, N. 1992. “Cointegration, Exogeneity, and Policy Analysis: An Overview”, Journal of Policy Modelling, vol. 14, no. 3, pp. 251–80.

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  • Johansen, S. 1992. “Cointegration in Partial Systems and the Efficiency of Single-Equation Analysis”, Journal of Econometrics, vol. 52, pp. 389–402.

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References

Fund sources

  • Fund sources SM/93/175 (8/11/93), Cyprus - Staff Report for the 1993 Article IV Consultation

  • Fund sources SM/93/171 (8/16/93, Cyprus - Statistical Tables

  • Fund sources International Financial Statistics

  • Fund sources Exchange Arrangements and Exchange Restrictions, Annual Report 1994 World Economic Outlook

Cyprus sources

  • Cyprus sourcesCentral Bank of Cyprus, Annual Report, various issues

  • Cyprus sourcesMinistry of Finance

  • Cyprus sourcesRepublic of Cyprus: Termination of Employment Law

List of Staff Studies

List of Staff Studies 1991 SM/91/118 (6/6/91), Cyprus - Recent Economic Developments, Appendix I. Medium-Term Scenarios for the Cypriot Economy.

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1/

Adjusted for the statistical break related to the introduction of VAT, real GDP growth in 1993 is estimated at 0.4 percent.

2/

In addition to the decline in domestic demand for imports, imports of goods for re-export declined by roughly 2 percent of GDP in 1993.

1/

For a detailed discussion of the wage determination process in Cyprus see Appendix III.

2/

Workers were compensated through the COLA for price increases that reflected the introduction of VAT in mid-1992.

1/

According to staff calculations, which include an adjustment for the introduction of VAT, the GDP deflator increased by 4.5 percent in 1993.

2/

References to full year developments are based on official projections as of September 1994.

1/

Over 70 percent of imported cars in Cyprus are Japanese.

1/

In May 1993 the government moved to contain the increase in government employment by tightening the procedures for creating new organic posts in the civil service and by freezing the filling of existing vacant posts as at end-1992. The latter measure, however, was not implemented until early 1994, because Parliament temporarily delayed approval of the relevant bill.

2/

The Ordinary Budget covers pension benefits for civil servants until they reach the age of 65; after that point, their benefits are paid by the Social Security Fund.

1/

This definition of government debt excludes inter-governmental debt (notably the substantial Treasury bill holdings of the social security funds) and short-term liabilities toward the Central Bank. However, although it is described as “net debt” for this reason, it is not net of government deposits with the banking system, particularly the large (and growing) Sinking Fund deposits, which are being accumulated to meet future repayments of development stock (long-term government paper financing Development Budget projects). Table 22 presents the evolution of the “net debt”, and Table 23 presents the detailed breakdown of gross debt, including inter-governmental debt and short-term liabilities of the Central Bank.

1/

Indeed, data on monthly VAT collection by mid-year suggested that for 1994 as a whole, actual receipts may well exceed the annual estimates discussed here.

1/

The required ratios for the four quarters of 1993 were, respectively: 26.0, 25.0, 28.0, and 29.0 percent.

2/

Figures shown in the monetary survey (Table 25) are not necessarily consistent with those used in the monetary program (Table 24). In the latter, figures are adjusted in order to account for the effect of foreign borrowing by the government (in the monetary survey, the latter is classified as borrowing from the Central Bank which acts as an intermediary between the Government and international financial markets). As a result, a different composition between net domestic and net foreign assets arises.

1/

In practice this amounted to agreeing to enforce the existing ceiling of 7 percent, which had not been observed in the past. Actual deposit rates declined by about 1 percent.

2/

Actual rates are substantially higher than the official maximum lending rates, owing to fees charged by banks on several accounts.

1/

An average fee of the order of 0.45 percent over the lending rate is usually charged by banks. The fee, however, varies substantially across customers and banks, and could be as high as 2 percent.

1/

The central rate is ECU 1.7086 per pound, with a margin of fluctuation of ± 2.25 percent.

1/

For an analysis of the effect of Cyprus’s competitive position on tourist arrivals, see Appendix II.

2/

Calculated as the difference between re-exports and imports for the purpose of re-export (imports to bonded warehouses). Additional benefits to the economy from this activity, although difficult to measure, are reflected in the services account in several commissions and fees categories.

1/

This share may be overstated due to the high content of consumption goods in imports for re-export.

1/

Prepared by Dimitri G. Demekas.

1/

These projections had been prepared and were discussed with the authorities at the time of the consultation discussions. Since then, the 1995 draft budget has been released, showing an increase in certain categories of discretionary spending—notably defense-related and investment—above the government’s medium-term target. Were this higher spending to be included in the staff projections, the 1995 deficit would, of course, be correspondingly higher. If the increase in spending, however, is to be only one-time, this would not affect significantly the medium-term path of public finances in the two scenarios.

1/

Prepared by Adi Brender.

2/

Due to excess capacity which persisted throughout the estimation period, the effect of demand fluctuations on prices was limited.

3/

Most of the popular tourism sites in the pre-invasion period were left outside the government controlled area after the war.

1/

D2, D3, and D4 are quarterly dummy variables for the second, third, and fourth quarters, respectively; D87 has a value of 1 in the first quarter of 1987 (reflecting the effects of the Achille Lauro attack); Dg has a value of 1 in the last quarter of 1990 and the first quarter of 1991 (the Gulf war), and Dg1 has a value of 1 in the first quarter of 1991, reflecting the additional effect of the actual fighting in the Gulf.

1/

For a discussion of the validity of the estimation procedure, and a detailed description of the methodological steps, see Appendix IV.

2/

When a time trend variable was included in the equation, in addition to the log trend, it was insignificant and did not affect substantially the significance of the log trend. This supports the hypothesis of a gradual phasing out of the learning process.

1/

Prepared by Adi Brender.

2/

Union membership is much higher in most sectors except retail trade where the majority of employees is not unionized.

1/

The process of tripartism also refers to the Government’s practice of consulting the trade unions and OEB regarding labor market legislation.

2/

It is suggested in the code that these issues will be specified through collective bargaining at the branch level.

3/

The Government is also involved in the labor market as an employer in the public sector and semi-government organizations. Traditionally, wage settlements in these two sectors were linked, although the Government tried, unsuccessfully, to disconnect them in the 1992–94 wage agreement.

1/

The law also safeguards the right of an employee to a longer notice, or higher benefits, if such a right exists on the basis of custom or collective agreement. In some sectors, these agreements provide for a notice period of 3–4 months.

2/

The court panel consists of a presiding judge and representatives of the employers’ association and the trade union.

1/

The law and the Industrial Relations Code do not distinguish between mass layoffs and dismissals of individuals.

2/

The national collective agreement, reached in June 1992, has set the number of normal working hours at 39.5 per week as of October 1993, and provides for a gradual reduction to 38 weekly hours by January, 1998.

1/

For data on unemployment benefits in EU countries see OECD (1993).

2/

The COLA was first introduced as a war bonus to civil servants in 1941 and became a regular part of their remuneration in 1944. In 1947 the COLA was granted to employees in the construction sector, and in 1951 it was extended to cover all employees.

1/

Work permits are granted for periods from several months up to three years depending on the prospects to find Cypriot candidates for the job.

1/

For a discussion of developments in the early 1990s see Section II.

1/

Prepared by Javier Hamann.

1/

Dickey Fuller (DF) and Augmented Dickey Fuller (ADF) tests with and without a linear trend were used. For the ADF, the lag-length was initially set at 6, and was gradually decreased until the t-statistic on the coefficient of the last lag was significant.

1/

Dickey et al., (1991) provide a detailed explanation of this point.

2/

By focusing on a single equation for money, equations analogous to (4) for prices and output are being omitted from the analysis. As a result, equation (4) represents a conditional model of money demand, with the price and output equations representing the marginal models upon which equation (4) is conditioned. Weak exogeneity of prices and output is obtained if the cointegrating relation between money, output and prices—equation (2)—is not a regressor in the omitted equations. A detailed discussion of various concepts of exogeneity and their implications for policy analysis can be found in Ericsson (1992).

1/

Banerjee et al. (1993) show that in a model like (4): (i) the t-statistic of each coefficient individually is asymptotically normally distributed; (ii) F-statistics of joint significance of any proper subset of the set of stationary regressors have standard distributions; and (iii) F-statistics of joint significance of any subset of the nonstationary regressors have nonstandard distributions.

2/

The estimated long-run income elasticity is similar to the one predicted by the traditional Baumol-Tobin model.

1/

In a related study using annual data, Arestis and Demetriades (1991) find cointegration between M2 and income or consumption, with the latter performing better as a scale variable. Their sample, however, runs only through 1988, and also includes the period 63–74, before the invasion, which is not taken into account in this appendix.

1/

Australian dollars, Austrian schillings, Belgian francs, Canadian dollars, Danish kroner, Finnish markkaa, French francs, Italian lire, Japanese yen, Netherlands guilders, Norwegian kroner, Portuguese escudos, Spanish pesetas, Swedish kronor, and Swiss francs.

1/

Foreign currencies are all currencies other than the Cyprus pound.

2/

Additional 10 percent can be granted to non-resident companies registered or incorporated in Cyprus.

1/

As of January 1, 1995, this amount will increase to £C 50,000.

1/

The amount that can be transferred without reference to the central bank is £C 400 per month.

1/

This amount will rise to £C 50,000 as from January 1, 1995.

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Cover IMF Staff Country Reports
Cyprus: Recent Economic Developments
Author:
International Monetary Fund
Volume/Issue:
Volume 1995: Issue 003
Publisher:
International Monetary Fund
ISBN:
9781451809770
ISSN:
1934-7685
Pages:
114
DOI:
https://doi.org/10.5089/9781451809770.002
CHART 1

CYPRUS Real GDP Growth, Tourist Arrivals and Contributions of Domestic Demand and Foreign Balance 1/
CHART 2

CYPRUS International Comparisons of Selected Economic Indicators 1/

(In percent)
CHART 3

CYPRUS Financing and Composition of Investment 1/
CHART 4

CYPRUS Composition of Employment and Profitability 1/
CHART 5

CYPRUS Consolidated Central Government Finances 1/

(In percent of GDP)
CHART 6

CYPRUS The Credit Cooperative Sector 1/

(In percent)
CHART 7

CYPRUS Balance of Payments 1/

(In percent of GDP)
CHART 8

CYPRUS Real Effective Exchange Rates 1/

(1983=100)
CHART 9

CYPRUS External Debt 1/
CHART 10

CYPRUS Exchange Rate Developments 1/

(1983=100)
CHART 1

CYPRUS Demand for M1C: Stability Tests