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OPINION

On the Economic Impacts of Reunification in Cyprus

June 23, 2017

Dirk Reinermann

In late 2015, leaders from both the Greek Cypriot Community and the Turkish Cypriot Community, as well as the United Nations, requested World Bank technical assistance on the economic aspects of the ongoing reunification negotiations. The assistance provided by the World Bank includes an in-depth analysis of the economic impacts of reunification in Cyprus.

Below are answers to questions from two journalists, one representing a news agency in the Greek Cypriot Community (GCC) and the other an agency in the Turkish Cypriot Community (TCC). The questions were answered by Mr. Dirk Reinermann, Country Manager for Southern Europe, and a team of senior economists at the World Bank.

Q 1. Has the World Bank calculated the economic cost of a potential resolution to the problem, and under which scenarios this cost might change? Can you be specific?

Ultimately, the benefits outweigh the costs, as the entire island stands to gain from reunification. First, a reunified Cyprus could become an “island of stability” in what has unfortunately become an increasingly volatile region and would benefit from its centuries-old cultural and economic ties to all neighbors around the Eastern Mediterranean and beyond. Second, the status quo of an already small economy that is divided into two smaller economies amplifies the challenges - and potentially reinforces the increased per capita income gap between the GCC and the higher income economies of the EU.

Third, if reunification is well managed, the benefits of a larger economy, greater public and private investment, and increased domestic and international trade could create many jobs across the island. Enhanced domestic connectivity for energy, transport, and water could generate about €1.1 billion-worth of investment opportunities within the next 2-3 years. There would be income convergence within the island and a catchup with the advanced economies of the EU. Realizing these opportunities is currently significantly hampered by the division of the island and the various economic distortions, uncertainties, and costs this imposes on the economy.

Continuation of the status quo is costing Cyprus. Reunification, on the other hand, would generate significant benefits for the economy -  as long as it is accompanied by sound policy and institutional decisions, effective implementation, and careful management of the property issue.     

Q 2. There is much discussion in Cyprus on the cost of the resolution and more precisely on the cost of the restoration of property and on the cost of the relocation. What data do you have that could assure us that the economic costs derived from the property issue won’t cause a collapse of the new Federal State?

We fully realize that the settlement of the property issue touches the lives of almost all Cypriot families. Also, it is well known that the amount of compensation for a settlement of the property issue and its financing are among the key economic questions to be solved.

The negotiations on this particular topic are ongoing. We have provided our analysis on the property issue to the negotiating teams and it is up to them to agree on the final parameters and to speak about the details. However, what we can say at this time is that, after careful review, we find that - with the right institutional choices and instruments - it is technically feasible for Cyprus to resolve the property issue in a way that would be fair and just for all citizens, fiscally sustainable, and with minimal impact on property and financial markets as well as on inflation. Because well-defined property rights are one of the pillars of economic success, resolving the property issue would help enhance the business climate in Cyprus, while allowing one third of the island’s territory to be fully developed to bring about greater wealth.    

Q 3. How much do you think bi-communal trade could be increased over the years after a resolution of the problem in Cyprus? And, in your opinion, what factors are essential to promoting trade and attracting investments within the island?

Increased trade, primarily with the rest of the EU and Turkey, would allow Cypriot firms to reap economies of scale and become larger and more competitive in the world economy. This will provide opportunities to domestic investors, and the resulting growth would generate more jobs for the entire island. The experience of economies that have joined the EU shows that those that have benefited most from the integration of their economies are those which have embraced integration.

If managed well, reunification is expected to increase sales of goods and services not only within the island, but also with the rest of the EU, with Turkey and the rest of the world. Under the status quo, sales across the Green Line are significantly below potential, due to unique features of the tax systems and different product standards. Harmonized tax systems and product standards following reunification, however, would support increased intra-island commerce. Our simulations indicate that intra-island commerce could more than triple. An enhanced business climate, a stronger financial sector, and a stable macroeconomic-fiscal framework would help the Cypriots grab these opportunities.

Q 4. Greek Cypriots fear that their economic prosperity will decline if there is a resolution of the problem, as there will be a downward pressure (ex. via wages) to converge with Turkish Cypriots. What do you think about it?

As per capita incomes are different across the island under the status quo, there is already an incentive for labor movement across the Green Line. Following reunification, we expect this gap to close and per capita incomes for the entire island to increase as the Cyprus economy better integrates with the rest of the EU and the world. Therefore, any surge in intra-island labor mobility would likely be temporary and generate positive net effects. After some adjustment, the existing social protection systems in Cyprus will have the capacity to cushion the structural transformation that is likely to take place in the entire Cypriot economy.  Provided the peace dividends are well managed, reunification will result in a “bigger pie” to be shared by both sides.

Q 5. What is the situation of the banking sector in the north part of the island? Have you applied any stress tests on that issue, or not yet? If yes, what are the outcomes? Do you think that T/C banks will need new capitals at the end, and how much? What are the major strengths of the T/C banks, and what are their weaknesses? 

The World Bank has been focusing on the legal, regulatory and supervisory framework and financial infrastructure of the TCC’s banking sector in an effort to support its convergence with the norms and standards required by the EU and applied in the GCC. The reunification of the island would require a review of the TCC’s banking sector to ensure that it meets the requirements of the EU acquis and Euro area, which is expected to take some time and a concentrated effort. The integration of the TCC’s banking sector is unlikely to increase systemic risks in a unified Cyprus due to the size and structure of the TCC banking sector: the largest bank in the TCC, which accounts for 20 percent of the TCC’s banking sector, makes up less than 2 percent of total banking sector assets in the GCC.

The GCC’s banking sector has made significant progress on its recovery path, following the financial crisis. However, persistent high levels of private sector indebtedness and nonperforming loans require continued efforts going forward in order to mitigate risks. 

The integration of the financial sectors presents considerable opportunities if both financial sectors manage to address their respective challenges. It could allow financial institutions from both communities to join forces and advance Cyprus’ positioning in the region as a safe and reliable economic and financial hub.

Q 6. Will there be a federal social security system, after a solution, or will the two communities be responsible for sustaining their own social security systems on both sides?

It is up to each side to decide how the existing social insurance systems of the island should evolve after reunification, starting from two parallel systems. What we can say is that – typically - small federations have one single social insurance system. This supports labor mobility, allows for the pooling of risk, and reduces administrative costs, compared to having multiple systems. Having said this, we find that the maintenance of multiple social insurance systems in Cyprus would not distort economic incentives, given the similarity between the parameters governing the two schemes. A caveat, however, is the need to enhance the existing schemes to allow portability of benefits from one scheme to the other, which would support labor mobility.

Q 7. For the sake of convergence of the two economies on both sides, how will the infrastructural investment funds be allocated?

Reunification would open up productive infrastructure investment opportunities across the entire island. On the one hand, there would be a need to enhance intra-island connectivity and connectivity to global markets through investments to transport infrastructure, so as to realize the gains from reunification related to commerce and trade.  Enhancing energy and water connectivity would allow a much more efficient use of available resources in times of excess capacity and during emergencies, by directing them to the needed areas at times of high-demand and by avoiding waste.

Public investment requirements to reconnect infrastructure across the island are estimated at €580 million for transport, €325 million for water, and €180 million for energy. It will be important to make the most of domestic and foreign private financing, as well as public financing, including from European Structural and Investment Funds. The experience of lagging regions in other EU economies indicates that the main challenge will be one of absorption. It will therefore be particularly important to enhance the administrative capacity at different levels of the government, including municipalities to link productive investment opportunities to available public funds, and to develop a conducive business environment to attract private financing.            

Q 8. Public sector debts and budget deficits are real concerns on both sides. How will this issue be handled in a federal system?

As the GCC is still recovering from a financial crisis in 2013, it faces significant fiscal challenges. Public debt is high relative to the economy’s income. Even though recent improvements in the budget balance put the debt level on a downward trajectory, it is still vulnerable to fiscal risks. In the TCC, the level of public debt is also high and rising, despite declining budget deficits.

Looking at the experience of Federations globally, in terms of subnational fiscal arrangements there would be a menu of options available for a unified federal Cyprus to choose from. Whatever institutional design is agreed upon, however, would need to be complemented by a prudent fiscal policy that would help Cyprus reduce the existing fiscal vulnerabilities and manage the risks as a member of the EU and Euro area at all levels of the government. For instance, Cyprus already spends a sizable part of its fiscal revenues on the public sector wage bill. Therefore, a united federal Cyprus should aim to avoid increasing the wage bill, and instead explore efficiency gains within the existing budget envelope.         

As a final thought, as economists working for an institution that promotes the eradication of poverty and greater prosperity worldwide, we applaud the courage and the great efforts of the two leaders, of their technical teams and indeed of all Cypriots to grasp the opportunity for Cyprus to emerge as a shining example to the global community for how historic conflicts can be resolved to the benefit of all citizens. And we want to thank them for their trust and the close collaboration we have enjoyed over these past months.

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Originally published in local languages by the following news outlets:

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