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Financial implications of a Cyprus settlement

By Marios Zachariadis

The election last May of a politician like Mustafa Akinci demonstrates that a large proportion of Turkish Cypriots are not happy with the current situation and seek a compromise. The election clearly reflected and created better conditions for a proper solution to the Cyprus problem. This article aims to highlight some of the possible economic implications of a political solution to the Cyprus problem.


Immediate positive results

On the part of the Greek Cypriots, a solution to the Cyprus problem in view of the deepest crisis of ur recent economic history, would be the trigger the economy needs to accelerate the exit route from the crisis. The massive reconstruction of buildings and other infrastructure and the positive psychology created for local and foreign investors would be some of the reasons why the solution of the Cyprus problem would act as an effective expansionary economic policy, with immediate positive results.

For example, it could be a quick cure for high unemployment. The improved prospects and the recovery will significantly ease the problem of bad loans facing the banking sector and hence be positive for the economy of Cyprus. The increase in demand for loans resulting from new investment opportunities, which is especially important after such a deep banking crisis, would further reinforce both the banking sector and the real economy. The solution of the Cyprus problem would also constitute a single lifeline for the construction sector that has irretrievably collapsed based on existing data, and will create new opportunities in the tourism sector.

Finally, the exploitation of physical proximity to the large Turkish market and potential cooperation with an economically important country would open new opportunities for existing and new sectors, with a positive impact on long-term economic growth.

Some other implications are perhaps less visible, and these are tackled exclusively below.


Budgetary challenges

A key problem that will arise after the solution of the Cyprus problem relates to the budget. Suppose that the federal government had no direct financial obligations to plug public finance holes that appear in one constituent state or the other. Systematic public finance problems due to the economic structure on one side would also create social unrest and systematic socio-economic instability for the federal Cypriot state.

More specifically, the Turkish Cypriot economy has been based for decades on disproportionately large public sector employment as well as other direct or indirect subsidies from Turkey. That is, for many years an unsustainable economy has been sustained by another state. The unsustainability of public finances is a big problem in itself, but the long-term dependence on Turkey has created additional bad habits in the Turkish Cypriot public sector and more widely in the Turkish economy. This perpetuates a chronic infantalist situation, where prosperity does not rely on productivity but on subsidy within a relationship of dependency.

The Turkish Cypriot economy should therefore resolve the severe fiscal problems that will become particularly visible once it becomes politically independent from Turkey. The solution of the Cyprus problem will create a better economic outlook for the Turkish Cypriots, but the necessary fiscal adjustment will be enormous. If you make such an adjustment suddenly, there will probably be a strong social reaction on the part of the Turkish Cypriots that will create political instability during the initial stages of a federal Cypriot state.


Support from elsewhere

On the other hand, if the structural problems are not resolved, then they will be a repeated source of systematic instability for the federal Cypriot state. Finally, even if Turkey chose to solve the immediate fiscal problem with a write-down of debt, and then paid part of the public-sector costs even after the solution of the Cyprus, it would retain a disproportionate influence over the Turkish Cypriots, while the constant budget deficits would breach the financial rules of the European Union.

The European Union should bear part of the financial cost for a time, and oversee technocratic and fiscal adjustment with the Turkish Cypriots. In this way the impact on them will be smaller and less abrupt and this will contribute to the sustainability and functionality of a federal Cypriot state.

In any case, the above should be taken into account in any agreed solution of the Cyprus problem, so that the federal Cypriot state does not assume disproportionate and probably unbearable responsibilities, and so that we do not find ourselves surprised by the first recession. It is well known that recessions interact negatively with institutional and structural weaknesses and deepen any budgetary problems. This is especially needed as Greek Cypriots have a prohibitive debt level, and Turkish Cypriots have a huge budgetary hole.


Fiscal freedom with reform

The solution of the Cyprus problem should allow for a sufficient degree of fiscal autonomy in the initial phase, in order to create the right economic incentives on each side. It also needs to build institutions that will control any tendencies for pro-cyclical economic policy and political business cycles.

In conclusion, a solution needs to be found in the short and medium term to address the fiscal problems of the Turkish Cypriot economy. This would involve major reforms, substantial financial assistance from the European Union for development and direct budgetary purposes as well as debt write-off from Turkey.

At the same time, the need for fiscal adjustment at a time of major prospects for economic growth and social development after a solution should be widely understood within Turkish Cypriot society.

The opportunity presented to the Cypriots is a great one, but special attention is needed to build a federal Cypriot state on firm economic foundations as well as institutions that are consistent with long-term economic and political stability and sustainability.

The writer is Associate Professor of Economics at the University of Cyprus

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