By Leslie G. Manison*
With the exit from the economic adjustment programme agreed with the International Monetary Fund (IMF) and European Union (EU) institutions in March 2016, and the recent election of new House of Representatives, key decision-makers in the executive and legislative branches of Government will need to effect profound changes in economic policies and institutional capacity to achieve sustained economic growth.
Indeed, the key challenges of alleviating the very high levels of unemployment and non-performing loans (NPLs) can only be effectively dealt with in large part by durable economic development. The Government should not display complacency by arguing that the return to positive economic growth over the last year, and the eventual implementation of the structural reforms agreed in the memorandum of understanding (MOU) will render any need for any fundamental changes in economic policies as redundant.
In this respect it is noted that the higher economic growth experienced in late 2015 and in the first part of 2016 may be temporary as it emanated mainly from a sharp increase in tourist arrivals reflecting security problems in competitor countries such as Egypt, Turkey and Tunisia. Other factors include higher-than-expected private consumption that was supported by lower energy prices, the continued marked rundown of saving balances and the non-payment of debt and other obligations including taxes. Moreover, it is argued below that the implementation of key structural reforms and the generation of investment-led growth will require substantial changes in institutional capacity and competence.
The recent financial crisis in Cyprus was caused mainly by the wasteful use of bank funds reflected largely in excessive and speculative investments in property, dubious outlays for Greek Government bonds, and unaffordable purchases of real estate and consumer durables by households.
It resulted also from the squandering of resources by public sector entities including the excessive payments on personnel and the failure of the central government to absorb and make productive use of the ample funds available from the EU in fixed investments such as for waste management projects.
The crisis that culminated in the “deposit haircut” and fiscal austerity measures has been associated with a steep contraction of the Cyprus economy evidenced most strikingly by huge falls in private and public sector investments.
In fact, the ratio of fixed capital formation excluding net ship registrations to gross domestic product (GDP) declined from its peak of 26.2 per cent in 2008 to 14.3 per cent in 2012 and further to under 12 per cent in 2015. This fall in investment together with the emigration of talented Cypriots abroad and/or their under- employment and unemployment are substantially depleting the productive capacity of the economy to generate and sustain economic growth, especially of high value-added industries.
Accordingly, it is contended that a substantial and prolonged increase in productive investments by the private and public sectors is required to launch the economy on a path of sustained growth. However, as discussed in a recent working paper by Manison and Savvides (http:/ssrn.com/abstract=2784802) some of the important conditions necessary for raising productive investments in Cyprus are currently deficient.
While there appears to be sufficient funds available for investments, especially from EU institutions such as the European Investment Bank, the lack of institutional capacity and a relatively unfriendly and uncompetitive business environment constitute major obstacles for the implementation of high-quality investments. Furthermore, weak domestic demand at present is diminishing incentives for the private sector to undertake investments.
Currently the Cyprus economy is burdened by a huge volume of debt that seriously inhibits the ability of enterprises to undertake investments. Non-financial corporations at the end of 2015 had debt of €40bn euro or nearly 230 per cent of GDP with over 55 per cent of this debt classified as NPLs. Many business enterprises have not been able to service their debts or are devoting much of their revenue to debt repayments and accordingly do not have the funds and/or can’t secure the financial resources to undertake new investments.
If there is a restructuring of debt repayments of these enterprises at a rapid pace most of them will still not have the capacity to execute new capital formation and at best many enterprises would survive, but just at their current levels of activity, with little prospect for expansion to contribute to the growth of the Cyprus economy. Even debt-laden hoteliers who are currently experiencing full capacity use of their premises will need to carry out large investments in order to generate a sustained increase in their accommodation capacity so that the tourist industry can spearhead economic growth.
However, with individual banks not having the capacity to engineer in complex financing arrangements and to competently evaluate the economic viability of projects to finance, especially in the cases where enterprises are indebted to many creditors and have pledged an array of collateral , it has been argued by Manison and Savvides that an institution with expertise in project financing be set up so as to provide the institutional support for elevating the level of productive investments in Cyprus. This new institution could assist enterprises obtain long-term funding including the conversion of bank debt into minority equity holdings on the condition that they enhance their productive capacity.
A newly created “Development Finance Agency” modelled along similar lines to the ones in Ireland and the Netherlands could serve as a financier and investment advisor to industry as well as assisting in evaluating public investment projects and Private Public Partnerships (PPPs). And given the past and ongoing unprofessional and politically-tainted practices in Cyprus for selecting and implementing numerous public sector projects, the input from an independent and professional organisation in carrying out feasibility and detailed risk analysis on major government investments (projects above €10m in Ireland) would seem most beneficial for enhancing the quality of public investments.
Furthermore there is a need to reform public sector bodies such as the Directorate for European Programmes for Coordination and Development of the Ministry of Finance and the Tenders Review Authority (TRA) which have failed in helping to generate adequate levels of high-quality investments, resulting in the low absorption of EU funds available to Cyprus for structural reforms and strategic investments. It is noted that appeals to the TRA against the initial successful bidder for a government project can be unlimited, requires only a relatively small fee (for example, €15,000 for a €50m project), and without any explicit reasons for the appeal, a cumbersome process that severely delays the implementation of many EU funded projects including those in the area of waste management.
While the financial and institutional capacity for undertaking productive investments are essential requirements, economically viable investments are only likely to materialise if there is a business friendly and competitive environment and if sufficient expected demand to induce such investments exists. However, the business environment in Cyprus is characterised by excessive regulations and an inadequate licensing framework. There are hindrances to healthy competition, especially in the professional services, as well as lax and selective application of regulations and weak enforcement of contract and property laws that seriously deter both foreign and domestic investments.
Indeed, the new Parliament should assign urgent attention to considering and approving measures stemming from the President’s Office and incorporated in a “growth action plan” that aim at improving the business environment through promoting better regulation, streamlining administrative procedures, modernising the way the public sector operates and enhancing entrepreneurship, that are line with European Council recommendations for Cyprus. The Cyprus authorities need also to take measures to reform the woefully inefficient judicial system that among other things is contributing greatly to the extremely slow alleviation of the NPL problem.
The current dearth of investment opportunities or of potentially viable investment projects constitutes a main obstacle to generating a sustained increase in productive investments in Cyprus. Bankers argue that there is a shortage of viable investment projects of creditworthy customers to finance.
More generally, weak domestic demand reflected by Cyprus having the highest rate of deflation in the Euro area is dampening private sector opportunities. In this respect entrepreneurs need confidence that there will be demand for their products in order to undertake investments in the first place. In fact recent research by economists at the Banque de France (www.banque-france.fr,working paper No.571, September 2015) has indicated that insufficient expected demand has been the main determinant of weak business investment in advanced economies since the global financial crisis, while capital costs have been of lesser importance.
Although in view of the fragile domestic demand conditions it is important that policies to promote investment-led economic growth should focus on boosting foreign demand through enhancing the competiveness of exportable goods and services, there is a need also to raise domestic demand. It is contended that under the economic adjustment programme, government expenditure and deficits were reduced by much more than necessary to place Cyprus on a path to achieving public debt sustainability.
Particularly in 2014 and 2015, injections of Government funds into the economy were much lower than planned according to the MOUs, and the considerable tax evasion practiced especially by the “elite” and self-employed professionals was allowed to continue to flourish. Accordingly, there would seem to be scope and indeed motivation for fiscal action to increase demand to be financed in large part from revenue derived from serious efforts to combat tax evasion.
While the above analysis calls for a substantial increase in outlays for productive investment projects it is recommended also that personal income tax rates be reduced to raise household consumption. These rates could be lowered in favour of lower and middle income households which have suffered disproportionately from the crisis and which have a higher propensity to consume.
And with the Government being on course to achieve its fiscal targets and after securing upgrades in its credit ratings, consideration could be then given to decreasing the standard value added tax rate so as to further stimulate private spending and to improve investment prospects.
It is concluded that generating sustained economic growth offers the best way of addressing the key challenges facing the Cyprus economy, specifically, the need to significantly alleviate the current very high levels of NPLs and unemployment. This will require the resolute implementation of structural reforms to construct a business friendly and competitive environment as well as rebuilding the institutional foundations to support economic growth based on a sustained increase in productive investments.
Indeed, it was the wasteful use of investible funds by private sector institutions including banks and business enterprises and Government institutions that was the main cause of the crisis. Hence the institutional capacity of economic agents to execute productive investments needs to be strengthened and it is proposed that an institution with expertise in project financing and evaluation be set up for helping to achieve this objective.
Moreover, the Government and the new House of Representatives can’t afford to be complacent in addressing economic policy matters and in implementing urgently needed structural reforms and in rebuilding the institutional foundations required to support productive investments. Otherwise, the Cyprus economy could at best muddle through with sluggish growth continually hobbled by fragile banks and burdened with heavy debt and at worst experience another financial crisis characterised strikingly by a debt- deflation downward spiral.
(*) Ex-senior economist at International Monetary Fund, ex-advisor at Cyprus’s Ministry of Finance and the Central Bank of Cyprus.
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