The Cyprus Peace Dividend Revisited A productivity and sectoral approach

Abstract

In the day after series published between 2008 and 2010, Mullen, Antoniadou Kyriacou and Oğuz-Çilsal made the first substantive attempt to quantify the commercial opportunities of a Cyprus settlement. these included the recurring (permanent) benefits (Mullen, Oğuz, & Antoniadou Kyriacou, 2008); the combined recurring and solution-related benefits(Antoniadou Kyriacou, oğuz, & Mullen, 2009); and the benefits that would accrue to turkey and Greece (oğuz-Çilsal, Antoniadou Kyriacou, & Mullen, 2010). Much has happened to the economic environment since then: the Lehman Brothers crash of September 2008 that has had a long-term effect on economic growth in the world and the euro zone in particular; the economic crisis culminating in the March 2013 bailout that continues to affect the economy in the Greek Cypriot community (GCC economy); and the weaker Turkish lira that is affecting the economy in the Turkish Cypriot community (TCC economy). on the other hand, natural gas finds offshore have also changed long-term prospects. taking these recent developments into account, the Cyprus peace dividend revisited takes a fresh look at the likely boost to economic activity that would take place as a result of a settlement of the Cyprus problem. our research takes as a working assumption that the settlement comes into force in 2016 (year 1) and that a united Cyprus will be a based on a bi-communal, bi-zonal federation with political equality as outlined in the February 2014 joint declaration. documents in the public domain suggest that the two communities have expended considerable efforts during the negotiations to date to avoid the kind of deadlocks that arose in the 1960s; therefore our working assumption is that a united Cyprus will have a functioning government system, albeit with new challenges, which we also address. these same documents suggest that attempts will be made to minimize debt-financed property compensation, therefore we also assume that the property settlement will not lead to a ballooning of the already high debt of the state. our research found that the economies in both parts of the island are currently significantly under performing. Moreover, this was the case even before the recent crisis. in the period 2005-12, growth in total factor productivity (TFP)—a measure of the long-term prospects for growth—was negative in the north, at -0.742% and barely positive in the south, at 0.008%. As a result of such weak TFP productivity, both sides of the island suffer from competitiveness problems, which in turn create risky imbalances such as high current-account deficits and rising debt. Moreover, a low TFP growth points to a continued future of very weak overall economic growth and high unemployment. the long path to raising TFP growth is investment in human and physical capital through training and education, the use of technology and enhancing energy efficiency. yet the existing division hampers the ability of the communities to capitalize on their achievements in areas such as higher education. Both sides of the island, therefore, would benefit from what economists call the positive shock that would come from a settlement. this “peace dividend” will come from two sources: recurring benefits and settlement-related investment. recurring benefits mean the permanent gains that come from opening up the Turkish market of 74m people to Greek Cypriots and the European union market of 500m people to Turkish Cypriots. A settlement of the Cyprus problem would attract new tourists to holy sites and ancient sites on both sides of the island, such as the hala sultan tekke mosque in larnaca and the church and monastery of st Barnabas in Famagusta, or the ancient ruins of Kourion near Limassol and salamis near Famagusta. shipping, including cruise tourism, would be liberated from current constraints and there will suddenly be more options for natural gas exploitation. peace would allow the established universities on the island, which on both sides are typically connected with universities abroad and already teach in English, to create a single united Cyprus brand that would have a chance of becoming one of the most important educational centers in the region. new flight connections will allow Cyprus to become the regional hub it has always sought to be, a true business nexus centered on the professional services sector, especially if a solution is accompanied by double taxation and bilateral investment treaties with turkey. the removal of legal impediments to property will support the real estate sector, which will also enjoy a strong boost from the above-mentioned factors and from normalization of inter communal relations. the boost to the real estate and construction sectors will help significantly alleviate the problems faced by banks with respect to non-performing loans and liquidity. last but not least, construction can be expected to enjoy a boom as a result of settlement specific investments. A solution of the Cyprus problem could allow the construction of an energy pipeline to turkey. this would be possible even with today’s level of gas volumes, which is currently not the case for a liquefied natural gas plant (lNG) or a pipeline to Greece. it should be noted that a pipeline to turkey would be in addition to and not instead of an lNG plant, which would remain a desirable goal. A pipeline to turkey would generate €1.3bn in additional gross investment. More importantly, it would yield much earlier government gas revenues than would be the case without a solution. rejuvenating Famagusta, including Varosha and Famagusta port, could generate, in a low-investment scenario, €5bn. however, sector specialists informed us that a big-vision idea, such as a state-of-the-art eco-city that integrated the whole of Famagusta, could generate investment of up to €15bn. Whichever option is chosen, it would need to be done primarily with private-sector investment. importantly, however, specialists told us that a state-of-the-art idea would attract considerably more private finance than the low-investment scenario. however, we have taken the lower scenario in our assumptions. A solution of the Cyprus problem, via the property and territorial settlement, would create demand for new housing, which we estimate would generate gross investmentof €2bn. in total, investment in infrastructure and housing that is specifically related to the settlement could reach €10bn. it is important to note that €10 bn of construction investment is not the same as value-added recorded for national accounts and GDP purposes. thus, €10 bn of mainly construction investment will lead to value-added ranging from roughly €4bn to €5bn. it will therefore account for between a fifth and a quarter of the peace dividend. How much of the cost of revitalizing Famagusta and implementing the property and territory settlement falls on the taxpayer will depend to a great degree on how carefully these issues are planned and managed. As we discuss in the report, if planned with international private-sector expertise in large-scale development, the cost to the taxpayer should be substantially reduced. in the past, the costs and benefits of a solution have been seen in a static way: there was an appreciation of the immediate costs, but there was little understanding of the dynamic benefits. For example, if an economy is growing rapidly, an increase in the available land supply and property does not mean that property prices will fall. Indeed, the reverse is likely to be the case. We have considered the economic impact of peace in two ways: from a top-down and a bottom-up approach. In the first case we put emphasis on the macroeconomic environment and the boost to the economy through capital and productivity enhancement, using a methodology known as Growth Accounting. In the second, we build Gdp by aggregating each sector of the economy. The results are informative in different ways. In growth accounting the real productivity benefits that might arise through peace can be appreciated, while the sectoral breakdown allows an analysis of the benefits to each sector of the economy. We made revisions to the first draft of our forecasts following input from peer reviewers as well as from senior business leaders who attended the PRIO Cyprus peace dividend revisited conference held in Brussels on 6-7 March 2014. Their input was invaluable in cross-checking our assumptions and in understanding their opinion of challenges and opportunities. Using the two methodologies outlined above, we were able to calculate the “peace dividend”: for the Greek Cypriots, the Turkish Cypriots and the economy of the whole island. Assuming a solution will be implemented from 1 January 2016 and using the geometric mean of these two results, we found that, with a solution to the Cyprus problem, all-island Gdp (at constant 2012 prices) would rise from just over €20bn in 2012 to just under €45bn by 2035, (that is, in year 20 after the settlement) compared with around €25bn without a solution. In other words, the accumulated peace dividend over 20 years would be approximately €20bn. the annual average peace dividend, that is, the average peace dividend every year, would be just over €2bn on average in the first five years after a solution, just under €5bn in the first ten years and just over €10bn the first 20 years. This will also translate into higher incomes. Gdp per capita, that is, the additional income to individuals due to peace, would rise from approximately €17,000 in 2012 to just over €28,000 in 2015, compared with approximately €16,000 without a solution. Thus, annual incomes, at constant 2012 prices, would be €12,000 higher by year 20 with a solution than without one. The annual average growth rate would be 4.5% on average over 20 years, compared with just 1.6% without a solution, with the peak growth rates coming in the first ten years. The lift to real Gdp growth rates would therefore be 2.8 percentage points on average each year. in the sector-specific forecasts, we estimate that in a united Cyprus, value-added in the tourism sector will rise from €1.3bn in 2012 to €2.9bn in 20 years, with additional income creation of approximately €550m per year at constant prices. We estimate that the all-island construction sector in a no-solution scenario, which in the GCC economy is expected to continue shrinking in 2014-15 after a 30% decline in 2012, would recover to only €730m at constant prices compared with just over €1bn in 2012. However, in a united Cyprus this sector would expand much faster, reaching €2.1bn in 2035 and yielding an annual average peace dividend of €725 million per year for the two communities. Growth in these two sectors will create spillover effects for wholesale and retail trade, which we expect to rise from just over €2bn in 2012 to €5bn in constant prices in 20 years, compared with only €2.8bn without a solution. Financial and insurance activities would grow from €1.7bn in 2012 to €2.7bn in 2035, with an annual average peace dividend of €380m, while professional services would increase from €1.3bn to €3.7bn and enjoy an annual average peace dividend of just over €1bn. Transport (mainly shipping) would increase from just under €900m in 2012 to €2.3bn in 2035, with an annual average peace dividend of €761m. Higher education has significant potential and we estimate that the total size of the sector will grow from €1.3bn in 2012 to €2.4bn in 20 years, yielding an annual average peace dividend of just under €270m in constant prices. These positive developments will also help eliminate the per-capita income disparity between the two communities with converging incomes. We forecast that TCC per capita income, with the average of the two approaches employed, will be 91% of GCC incomes in 20 years (that is, not far from full convergence), compared with just 60% of GCC incomes today. Preliminary estimates suggest that this kind of lift to economic activity will bring the unemployment rate in the GCC economy down to less than 5% within ten years compare with an unemployment rate of well over 10% without a solution. The €20bn boost to the economy will reduce high public debt and should offset a large proportion of any solution related costs. Moreover, elimination of the disparity problem between the two communities will also have positive long-term political benefits, by supporting a well-functioning federation.