Cyprus: Institutional Quality and Economic Performance

Research articles contend that the quality of institutions can have a strong positive effect in raising the economic performance of countries[1]. In this note it is argued that the shortcomings of the Government institutions of Cyprus in providing an enabling environment for broad-based growth and in assessing the success of economic performance based primarily on the growth of GDP is hindering the advance in the well-being of the majority of its population.

Institutional Quality

Rule of Law and Corruption

In Cyprus the quality of institutions and resultant economic performance are seriously undermined by the failure to enforce laws and regulations strictly and even-handedly. The willingness of the legal authorities and regulators to allow or implicitly encourage certain interest groups to evade laws and regulations encourages corruption and the inefficient allocation of resources. If many property developers were forced legally to meet their debt and tax obligations it is unlikely that they would be continuing to over-supply Cyprus with towering apartment buildings. Moreover, in the face of lax application of property and contractual rights and the growing reputation of Cyprus as a hotbed of corruption potential investors are deterred from undertaking productive investments.

Government Bureaucracy  

The weakening quality of the Government bureaucracy in Cyprus appears to have contributed to increased inefficiency in the provision of decent public services including education and healthcare. And more broadly there is the question of whether Government institutions have the resources and competence to effectively implement official plans and policies? In particular, does the Directorate of European Programmes, Coordination and Development in the Ministry of Finance have the expertise to evaluate, prepare and help implement many of the projects to be undertaken under the much-trumpeted Recovery and Resilience plan? Or will the politically-tainted government bureaucracy continue to award numerous contracts for investments and business licenses on the basis of criteria other than those of allocative and technical efficiency. Unfortunately, it seems at present that the Government is deteriorating the quality of the public services by just adding more employees to its payroll for mainly political purposes. Indeed, what is the purpose of the rising number of advisors recently appointed to the Presidential palace and the various Ministries?

Assessing Economic Performance

Failure to assess competently economic performance leads to poor forecasts and misguided policies. Undeniably, many policymakers are obsessed with using the growth of GDP as the prime measure in assessing economic performance. But, GDP is just a single number derived from calculating the total level of economic activity. It tells us nothing about whether most citizens of a nation are experiencing improvements in their economic well-being or whether the fruits of growth are just being distributed to specific groups. In particular, we need to evaluate how the real incomes of lower and middle-class workers are developing to make a better assessment of economic performance and its contribution to raising the standard of living of most of the population.

Figures on GDP growth per se reveal little about how growth is being created. Prior to the financial crisis of 2012/13 GDP growth in Cyprus, for example, was built largely on the shaky foundation of spiraling and unproductive debt upon which there was minimum focus until the crisis erupted. Currently, the Minister of Finance of Cyprus celebrates the high growth rate of GDP and the considerable fall in the unemployment rate despite Cyprus remaining the most heavily indebted country in the EU with Government debt including that owed to the Social Security Fund plus private debt totaling over 90 billion euro or nearly 420% of GDP. And is the much-publicized decline in the unemployment rate attributable to the change in the registration system and is it associated with the creation of decent jobs, the latter being the best way for narrowing income and wealth inequalities?

Also, GDP figures tell us little about the quality of investments in the economy in terms of whether they are helping to create good job opportunities and deliver the capacity to provide good services to the public including high-quality healthcare and education. In Cyprus it is shocking that investments in the over-supplied property market, especially in constructing “luxurious” apartments, continue to expand, while investments in meeting the mounting demand for beds and high-quality facilities in hospitals and competent healthcare workers are grossly deficient. This means among other things that medical-operations for non-Covid patients are being increasingly delayed, while ambulances to transport patients to hospitals for urgent treatment are in short supply.  In this context the only broad expenditure item in the implantation of the Government budget for 2021 so far that has shown a distinct decrease is outlays on public investment projects including that on healthcare facilities and equipment.

Policies and reforms

Poor and misleading diagnosis of country’s economic performance can lead to policy mistakes and a neglect to address its underlying problems such as the heavy debt burden of businesses which severely hamper their ability to invest in new technologies and even continue operations. With their excessive focus on real GDP growth and the official unemployment rate policymakers in Cyprus contend that their business model based on the recovery and further expansion of the tourist and property sectors backed by buoyant public (including expanding employment in Government institutions) and private consumption is working. But this model as indicated above is built importantly on the fragile foundation of a huge amount of outstanding debt. Eventually, a considerable portion of this debt will need to be written-off resulting in large losses for banks and suppliers and/or be repaid contributing to a significant fall in domestic demand and a so-called balance sheet recession as savings to repay debt replaces expenditure.

Furthermore, in their assessment and publicity of economic performance the Cyprus authorities neglect disturbing developments in the external sector highlighted by a very large current account deficit running at an annual rate of around 10% of GDP. And at a time when foreign exchange receipts from tourism and investments in Cyprus property are very subdued there will be difficulty in financing the current account deficit with non-EU countries.  

The quicker the economic policy of the Cyprus moves to seriously addressing the problem of the excessive indebtedness of the private sector, moving away from promoting property development, especially of luxury apartments and villas, and ironing out corruption, the less the eventual damage to the economy will be. Much delay could lead to a full-blown financial crisis with little rescue assistance from international institutions.

While continuing to pursue the aforementioned business model the Cyprus authorities have committed to implementing the Recovery and Resilience plan based on the implementation of 134 targeted measures, 58 reforms and 76 development investment projects. However, deficiencies in institutional quality including the lack of strict and even-handed law enforcement and competent government managers and employees are likely to hinder the effective undertaking of investment projects, while the reluctance of politicians to agree promptly to execute much-needed reforms including those for the legal system and government services can be expected to seriously delay efforts to enhance institutional capacity.

Thus, the Cyprus authorities need to engage in a virtuous circle by making a realistic assessment of the economic situation of Cyprus taking account of the festering underlying problems that would induce meaningful policy actions and reforms including combatting corruption leading to a significant improvement in institutional quality and in turn to better economic performance.