Growth requires social consensus on reform, by Michalis Sarris

Legacy of the Crisis
Some twenty months after the severe blow of the bail-in of bank depositors, economic activity is showing increasing signs of stability, mostly due to the pragmatism and resilience of Cypriots. Although the shock has caused significant damage, the impact has not been as devastating as many had feared. The international business sector may not be growing, but it has not collapsed either, tourism performance has been impressive and Cyprus still enjoys a relatively high standard of living. Consumer and business confidence is slowly beginning to return.
The severity of the crisis, however, has left a legacy that will continue to burden the economy for years to come. With growth prospects modest at best, unemployment remains high and significant job creation will likely not begin any time soon. While the repair of the banking system has made considerable progress, it is being held back by non-performing loans, which are also keeping lending rates from converging towards the lower EU averages. High household and enterprise debt burden will tend to discourage consumption and limit the effective demand for investment financing. Meanwhile, the need to continue reducing the budget deficit will call for politically demanding choices among competing public expenditure priorities, such as those on the public sector wage bill, health and growth-supporting investments. These choices must support structural reform of public expenditure so as to put the public finances on a sustainable path, while favoring growth-enhancing public spending.

Prospects and Challenges
Growth prospects will continue to be affected by external economic conditions, particularly in the Eurozone, which currently remain uncertain. In the short-term, the political crisis and economic slow-down in Russia will negatively impact the economy. But the key to the return to sustainable growth is to implement without hesitation or delay the structural reform programme, at a minimum as agreed with the Troika, and, if we can master the necessary political courage, go further. This means urgently completing the privatisation agenda, reducing the bureaucratic impediments to private sector initiatives, while combating corruption and improving the efficiency of the public sector. It also means liberalising markets and professions, pursuing active labour market policies such as flex-time, apprenticeships and on-the-job training, restructuring education to improve the quality of outcomes and achieve a better fit with labour market requirements, and reforming labour unions and political parties. These reforms should encourage private sector investment, including foreign direct investment, an essential element of the new growth paradigm.
There is a paradoxical consensus across the full range of the political party landscape and most mass media that the Troika is responsible for the problems of the economy and that we should, therefore, get rid of it as soon as possible. In reality, Cyprus surrendered its economic sovereignty, through the March 2013 bail-in/bail-out, because of a homegrown deadly combination of banking and fiscal irresponsibility, which had already led to serious domestic and external imbalances. In five short years between 2007 and 2012, through unprecedented fiscal laxity, the best fiscal performer in the Eurozone was transformed into one of the worst, and government debt rose sharply from 48% to 75% of GDP. In parallel, poor bank corporate governance, largely unchecked by the Central Bank because of the widespread and ECB-supported philosophy of “light-touch” bank supervision, led to a huge credit expansion, high-risk investments and a large external current account deficit. To complete this negative picture, rising wages, without productivity or quality improvements, led to a significant erosion of external competitiveness.

The Adjustment Programme
An adjustment programme to address these challenges was urgently needed and was put in place together with the Troika after long and harmful delays. The first objective, which was to eliminate the large government budget and external account deficits – indicative of a country living beyond its means – has been largely achieved ahead of the expected timeline. Significant spending cuts in most categories and tax revenue increases are pointing the public finances towards a primary surplus while, mostly through a decline in imports together with a modest increase in exports, the external balance is substantially improved.
Competitiveness has also improved through a reduction in unit labour costs in the private sector, but the reduction in wages in this sector has probably reached its limits and any further improvements in competitiveness will have to come from productivity gains. This correction of past sins has contributed to the increase in unemployment and to hardship in many households and enterprises, but Cyprus’ overall standard of living even in 2013, the worst year of the crisis, as measured by GDP continues to be about twice as high as it was in 2000. In the narrative against the Troika it is often forgotten that Troika financing has allowed Cyprus to continue to have a budget deficit and pay its bills through 2016. Without this facility, the adjustment would have been much more abrupt and painful and the economy would have contracted much more sharply.
None of these early successes in correcting the imbalances, which brought about the crisis in the first place, will have been worthwhile, unless the necessary structural reforms are implemented so that the country can aspire to sustainable recovery and, eventually, economic growth. But for this to happen the reform programme has to be “owned” by the political establishment and society at large. For now, this is not the case. This can be partly explained by the fact that much of the political leadership’s energy is spent on the “blame game” as to who is responsible for the crisis instead of explaining why the proposed measures are for the benefit of the vast majority of society. Also, in refusing to take responsibility for policy mistakes and past excesses, it is easier and more convenient to absolve the local voting population and to blame the “foreigners” who are “imposing” conditions and as such they are an easy target. The people of the Troika themselves could have done a better job in explaining the rationale of the proposed reform programme, through a more active engagement with civil society.