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How do we maximise the Cyprus peace dividend?

03 June, 2014

 * The key economic challenges need to be frontloaded if we are to reach a settlement *

By Fiona Mullen, Director Sapienta Economics
Last week, Alexander Apostolides, Mustafa Besim and I presented our co-authored “The Cyprus Peace Dividend Revisited”, published by the Peace Research Institute Oslo (PRIO). Copies of the report can be downloaded from the events section of the PRIO Cyprus Centre website http://cyprus.prio.org .
We found that a solution to the longstanding Cyprus problem could raise per capita incomes by approximately EUR 12,000, expand the size of the economy by around EUR 20 bln and add on average 2.8 percentage points to real GDP growth every year for 20 years.
However, as we note in the report, it would be naïve to suggest that such growth rates are guaranteed. Important preparatory work needs to be done to ensure that these growth rates are possible.
The following are edited highlights from section 9 of our report, entitled “Maximising the growth potential: key challenges.” Here, we identify key areas of technical assistance needed.

Circumstances are very different from 2004
One of the reasons for our recommendations is that circumstances have changed radically in the past ten years.
• The economy of the Greek Cypriot community (GCC economy) is considerably weaker than it was ten years ago, while the economy of the Turkish Cypriot community (TCC economy) also has significant structural problems.
• EU institutions have much more extensive powers over eurozone member state budgets than in the past, while larger banks will soon come under the direct supervision of the European Central Bank.
• The GCC economy’s borrowing from the European Support Mechanism (ESM) and IMF could complicate some previous understandings reached to date, such as on debt-service obligations.
• In a weaker property environment, the property and territory settlement will also bring new challenges.

Technical assistance required to address the economic challenges
The economy is therefore the new elephant in the room.
In the past, economic issues were treated as if they could be dealt with after all the political details had been ironed out. Today, I believe that the reverse is true.
If the negotiators have economy worries in the back of their minds while negotiating governance, property, territory or transitional issues, I fear they will never be able to reach an agreement.
But they need technical assistance to do so. In our report, we identify the key requirements as follows:
1. Technical assistance on matching resource to competences
Federations typically involve complex distribution mechanisms from one level of government to the other. Naturally, since the issue involves taxpayers’ money, these mechanisms are also the subject of intense debate in all federations. They are likely to be more so in Cyprus.
Whether the distribution is from federal to state (constituent state) government or the other way round will depend a great deal on how tax-raising powers are distributed.
If it is decided, for example, that big budget services such as education, healthcare and social security are competences of the constituent states, then the constituent states will need enough resources to be able to provide those services at least to the same level of quality that they have provided to date.
This will either mean sufficient tax-raising powers at constituent state level or a distribution mechanism from the federal government revenues to the constituent states.
At the same time, controlling expenditure of big budget items such as healthcare is one of the greatest challenges facing developed economies today. Wherever the competence of healthcare is placed, and whatever the mechanism for funding it, significant controls need to be in place to ensure that spending does not spiral out of control.
Rather than leave these questions to those who have no experience of federations, and thus risk the economic viability of a settlement, we recommend that expert technical assistance be sought on these issues well in advance. Both the IMF and the World Bank have considerable expertise in this area (see, for example the list of authors in the Handbook of Fiscal Federalism by Ahmad et al).
2. Minimising debt finance for the property and territory settlement
On the assumption that the property and territory settlement will involve a certain amount of compensation, exchange and reinstatement that will lead to the displacement of those currently using the property, work needs to be done on:
• identifying non-debt forms of financing;
• ensuring that displaced communities are moved in ways that allow them to sustain a livelihood;
• ensuring that the property market is not hampered for decades by unresolved claims.
As regards financing, given the high indebtedness of most developed countries these days, and growing unwillingness among EU voters to finance other countries’ debt, as witnessed in the “bail-in” of March 2013 in the GCC economy, it would be too easy to assume that resettlement and property compensation costs will be financed by foreign donors, especially given the sums involved.
It would be wiser to seek solutions that provide incentives for private (domestic and foreign) investment to take an active role in taking on such projects. In such a way one can avoid burdening the state with further debt in the beginning of the post-solution period.

Private-sector property and resettlement solutions need to be fleshed out
Private sector solutions for tackling these issues have already been suggested. These include assessing options for maximising the currently depressed values of Greek Cypriot property in the north and the Turkish Cypriot property in the south.
For example, Greek Cypriot properties currently attract a lower price than original Turkish Cypriot property with the same features. This is because the market recognises that there is an encumbrance on the title, or in layperson’s terms, there is a risk of lawsuits from the Greek Cypriot dispossessed owner.
In the south, the value of Turkish Cypriot property is depressed because of lack of liquidity (it is barely traded at all), and some Turkish Cypriot land lacks basic infrastructure such as water and electricity. Carefully planned development of this property could have considerable upside potential for an increase in price.
How best to leverage the value of properties in ways that might raise funds for compensation needs to be fleshed out in more detail with experts in asset-backed financing and real estate development who have experience of these kinds of large-scale projects.
One suggestion for compensation is that, in cases where the “current user” gets to keep the property, he/she will be taxed over time on the increase in value that he/she enjoys as a result of obtaining an unencumbered title. This debt would be legally binding, would come with a state guarantee (perhaps from Turkey) and could act as a lien on the property.
As for the property in the south, assuming that there is not a mass desire by Turkish Cypriots to move back to the south, a not-for-profit real estate investment trust, with strict guidelines about phased, environmentally responsible development could develop these properties over time, which in turn could support the overall property settlement and help finance compensation.
In order to prevent an inflationary gush of liquidity into the economy that might come about if compensation were paid in lump-sums, there are also ways in which one might create incentives for those owners who are compensated to opt for money over time, or compensation in kind (such as education vouchers), rather than immediate cash.
Finally, there are precedents from class action suits from abroad to give guidance on how to resolve the claims as quickly as possible. If a considerable portion of the property market is locked in legal disputes, this can only damage property values in the short term and the economy as a whole in the long term.
Given that both the property settlement and the management of territorial adjustment will involve property development, it makes sense to handle the financing and management of these issues together.
These are issues for which it would be valuable to gain the input of large private-sector real estate development companies, financial institutions such as banks and insurance companies, as well as institutions like the World Bank or European Bank of Reconstruction and Development (EBRD) that have managed large-scale relocation, development and stakeholder participation in other areas of the world.
3. Preparing the TCC economy for competition and the EU acquis
While we recognise the sensitivities surrounding how this issue is addressed in the negotiations, it is clear that technical assistance will be needed to integrate the TCC banking system smoothly into the eurozone European System of Central Banks, to support producers of foodstuffs such as dairy products harmonising with EU standards and to prepare TCC businesses more generally for the onset of new competition and the adoption of EU norms.
The more ready Turkish Cypriot businesses are for competition, the faster Turkish Cypriot incomes will converge with the Greek Cypriot incomes (in our current model, it takes 20 years, which with better planning could be shortened).

The need for front-loading technical assistance
We recommend that all of these challenges be addressed in detail with technical assistance well before a settlement is reached, in order to increase trust in the viability of a settlement.
How these issues are addressed are of course sensitive. But if the negotiators have economic worries while discussing the distribution of powers (and by implication, revenues), if they have not worked out how to finance the property and territory settlement, if the Turkish Cypriots fear competition because they have not started to prepare for the acquis communautaire, it will be far more difficult to reach a political agreement.
But if these issues are addressed and managed well, they will help the negotiators reach an agreement. Moreover, voters in both communities will be reassured that these issues are being handled professionally and will not constitute a risk to the post-settlement economy.
More importantly, handling these issues well in advance of a settlement will reduce the risk of post-settlement infighting that could lead to economic and political destabilisation.


*Fiona Mullen is Director of Sapienta Economics and author of the monthly Sapienta Country Analysis Cyprus at https://sapientaeconomics.com/