Having Overcome 1974 Upheaval, Cyprus Now Boasts Healthy Economy, Anticipates EU Membership

By Janet McMahon

Like most of his colleagues, Sofronis Eteocleous, economic director for the Cyprus Ministry of Finance, works in what were meant to be temporary quarters, but which have been home to most government agencies in Nicosia since 1974. These modest offices attest to the choices that confronted the Republic of Cyprus in the face of some 400,000 refugees—homeless and jobless overnight—as well as the sudden loss of the country’s key tourist, manufacturing and agricultural areas, and the revenues they generated. Fancy—not to mention permanent—offices for government bureaucrats was not an item high on the list of priorities.

It is because of those priorities, however, that today the per capita income in Cyprus is higher than that of Greece or Portugal, both of them members of the European Union, and that the Republic of Cyprus, which currently accounts for only 60 percent of the island’s total area and has had to virtually rebuild its economy in the past quarter-century, ranked 27th worldwide on the 1999 United Nations Human Development Index.

Last year the economy of Cyprus grew at a rate of 5 percent, representing a strong recovery from 1996-97’s unstable consumer and investment climate, Eteocleous told the Washington Report. The forecast for 1999 is a growth rate of 4 percent, and first-quarter indicators were encouraging, he said.

The economic director described the economy of Cyprus as “small, open and service-oriented,” with imports and exports about equal, and services accounting for 73.5 percent—and growing—of the country’s gross domestic product. The bulk of service sector activity is in tourism, “a mainstay for jobs and [hard] currency,” Eteocleous said.

In 1998 some 2,265,000 tourists visited Cyprus. With a population of 750,000, this means that there were 3.4 tourists per Cypriot—a ratio difficult to ignore in theory or in fact! Most visitors are from Europe, with slightly more than 40 percent from the U.K., reflecting what Eteocleous generously described as the two countries’ “traditional links” (otherwise known as colonialism). Other tourists come from Russia and Israel, and there is increasing representation from eastern Europe as well.

Another component of the service sector are offshore companies, which by definition are wholly owned by non-residents and may not sell their products in Cyprus. (For example, McDonald’s could set up an “offshore” administrative office in Cyprus to oversee its European or Middle East operations, as opposed to a local Cypriot-owned McDonald’s franchise.)

According to Dr. George Georgiou, an officer with the Central Bank of Cyprus’ International Business Sector, Cyprus benefits directly from the offices physically located there, which pay rent, employ Cypriot workers, hire lawyers and accountants, etc. Other offshore companies, equally legal, may consist of no more than a post office box or brass plate on a door.

Dr. Georgiou said offshore companies historically constitute “a way to attract foreign investment after a period of economic difficulty”—in his country’s case, the events of 1974. He enumerates among Cyprus’ attractions to offshore investors the country’s low taxes (4.25 percent for foreign investors vs. the local rate of 25 percent), its European environment and lifestyle, advanced infrastructure and telecommunications services, and the ready availability of educated, bilingual workers. Unlike countries which specialize in offshore industries—Bermuda in insurance, for example, or Bahrain and Luxembourg in banking—Cyprus has not targeted any one sector for its offshore enterprises.

Looming over the horizon, however, is the European Union which, as Dr. Georgiou puts it, “takes a dim view of low taxation.” EU membership could well have an adverse impact on Cyprus’ offshore businesses. While acknowledging this probability, the Cypriot banker maintains that, being an “important component of the economy, the offshore sector cannot cease to function overnight.” He is hopeful that it will be possible to “negotiate an extension of the [offshore] regime for a few years and extend the period of deregulation to maintain the sector as long as possible.”

Precedents for this do exist, he notes: “The EU allowed Italy to establish an offshore zone in Trieste for banking with Slovenia,” and Ireland has been allowed to establish a lower tax rate for foreign investors than have other EU countries. Clearly, however, admission into the European Union will ultimately cause this sector of the Cypriot economy to shrink.

Agriculture represents a mere 4.6 percent of the country’s economy, and even that small share is declining, as Cypriots move to better jobs, often in the tourism industry concentrated in the coastal areas. The farming which does take place is typically small-scale and often part-time. Major crops include potatoes, citrus fruits, wines (“the reason there have been so many conquerors” of Cyprus, Finance Ministry official Eteocleous observed sagely), and vegetables.

Although Cyprus’ customs union agreement with the EU and its membership in the World Trade Organization have resulted in increased competition and further reductions in agricultural output, Eteocleous pointed out that these developments have also led to pressure for increased governmental subsidy of agriculture, with EU support levels as a model. Ultimately, he believes, agriculture will benefit from Cyprus’ membership in the EU.

The manufacturing sector, characterized by small, family-owned enterprises averaging five or six employees, has declined to its present level of 11.4 percent. “Traditional industries—clothing, footwear, and leather goods—are facing difficulties,” Eteocleous noted, “because they are unprotected and must contend with high labor costs and international competition. The challenge is to adjust, adapt, upgrade technology, and improve quality and productivity.

“Fortunately, the small size of our manufacturers is an advantage in upgrading quality, precisely because we do not have to produce in large quantities. It’s a question,” he concluded, “of finding the right niche in the market.”

Although Cyprus long ago “graduated from the World Bank” and hence does not have a massive international debt, there are “pressures on the country’s current account, resulting from increased consumption and military imports,” according to Eteocleous. A particular problem since 1997 has been the fiscal deficit, which he calls “not sustainable,” and a major contributor to which has been a growing debt service ratio as Cyprus increasingly has resorted to international financial institutions to balance its accounts.

The government’s solution has been to control spending and raise taxes. It has increased the value added tax (VAT) from zero to 5 percent for basic goods, and its proposal to increase the general VAT from 8 to 12 percent is pending.

“We need a social consensus to resolve this deficit issue,” Eteocleous said, adding that he is “optimistic that the various parties will agree” on a strategy.

The country’s top priority, however—and a massive undertaking—is the “harmonization” of its economy with EU laws and requirements. This entails extensive negotiations, which Eteocleous estimated “we are about halfway through, having begun with the easier chapters.” But he anticipated that “the areas of hard negotiation will be relatively few,” and his “working hypothesis” for EU membership is Jan. 1, 2003.

Eteocleous included among the economic implications of EU membership for Cyprus “the liberation of the internal market, with the free movement of capital and abolition of monopolies such as telecommunications. The main issue facing us is what institutional changes are necessary to compete in this new environment, and we are negotiating with our ‘special partners’—trade unions, employers, etc.—to determine the best approach.”

An example of how EU membership will affect individual Cypriots is the required liberalizing of lending rates. A colonial law in effect since the 1940s established a ceiling of 9 percent on interest rates. That ceiling will be abolished with EU membership, and interest rates will rise and fall with the market, with double-digit interest no longer an impossibility. Nevertheless, Cyprus is looking toward the future, and is prepared to make the sweeping changes necessary to become an integral part of Europe and its economy.

A visitor to the Mediterranean’s third largest island (after Sardinia and Majorca) would be hard pressed to disagree with Eteocleous that “Cyprus has a very strong middle class, with no ghettoes, and its people have chances for advancement.” Following the 1974 Turkish invasion, he explained, his compatriots’ “psychological willingness and determination to survive created a consensus around economic measures by the trade unions and government alike.” The results of that consensus speak for themselves, and the country was able to attain its pre-invasion level of economic development by 1978.

Nevertheless, the economy of Cyprus “is still operating under conditions of occupation,” Eteocleous maintained, “and every day imposes a burden.” Tourism would be even stronger, for example, if prime destinations such as Kyrenia and Famagusta had not been lost and new tourist areas developed from scratch. Nor is the infrastructure optimum, he said, with only partial utilization of water resources, for example.

Convinced that EU membership can play a “catalytic role” in finding a solution to the Cyprus problem, Eteocleous maintained that the island’s two communities both would benefit from a solution. For example, foreign workers currently make up approximately 7 percent of the Cypriot workforce and come from Russia, Asia, the subcontinent and the Arab world, with their different cultures and economic systems. “A peaceful solution will open up” these jobs to Turkish Cypriots, as well as provide new opportunities with the rebuilding of the island’s infrastructure, hotels, etc.

Furthermore, the Republic of Cyprus currently spends 4 to 5 percent of its gross domestic product on defense. Eteocleous noted that “President Clerides has pledged that money saved through demilitarization would go to developing the northern area.” Additionally, EU membership would “provide many incentives to Turkish Cypriots, because the EU makes structural funds available to undeveloped regions of its member countries,” he pointed out.

Comparing divided Cyprus with formerly divided Germany, Eteocleous was optimistic. Whereas East and West Germany represented two different economic systems, one a market economy and the other a centralized state system, “occupied Cyprus is still a market economy,” he observed, “although the government plays a larger role” than in the republic.

As EU citizens, Cypriots would be eligible to work in any of the EU member states, and vice versa. Indeed, despite the shortage of professional jobs, the movement has not all been one-way. The Central Bank’s Dr. Georgiou, for example, who was born and raised in London, “immigrated” to Cyprus in 1986. “Nicosia is a very European city,” he observed, “and despite problems with development, crime, etc., it’s still a civilized place to live in compared with many cities in Europe.”

Janet McMahon is the managing editor of the Washington Report.