Restoring Cypriot competitiveness

[Accountancy Cyprus, No. 115, June 2014.]

The divergent path taken by the Eurozone’s economies since the new currency’s inception is one of the fundamental underlying causes of the recent crisis. A number of European countries – mostly in the north - pursued policies aimed at raising productivity and improving their competitiveness. Several other countries – mostly in the south – experienced rapid credit expansion that fueled asset price inflation (primarily in the form of housing bubbles) and led to large current account deficits and a decline in competitiveness. Cyprus falls into the latter category. It has had a current account deficit every year since 1999; the deficit has exceeded 5% every year from 2004 to 2010 and it averaged a staggering 12% between 2007 and 2010. 

The OECD defines competitiveness as “a measure of a country's advantage or disadvantage in selling its products in international markets.” It is a relative notion that depends on a country’s productivity relative to the productivity of other countries. As such, it is closely related to what in everyday language we call “value-for-money”. A more competitive economy – just like a more productive company – can deliver greater value (quality) at a given price. A loss of competitiveness results from a combination of insufficient investment – which keeps quality stagnant – and excessive wage increases, which push prices upwards. This is what happened in Cyprus over the last 15 years before the crisis. Wages consistently rose faster than productivity, eroding the country’s competitiveness and leading to enormous current account deficits.

Cyprus’ malaise was the result of a credit-induced boom and dominant unions in the public and banking sectors. Essentially Cyprus in the 2000s suffered from Dutch disease. Excessive activity and economic rents in the banking, construction and real estate sectors drove up wages and the prices of goods, services and assets. This led to a deterioration of the country’s competitive position and made it difficult for other sectors to compete internationally. Tourism is a prime example. While the rest of the economy was booming, a deteriorating tourist infrastructure meant that Cyprus was offering declining quality at an increasing price. Unable to compete with newly emerging destinations, it was forced to rely on cheap, imported labor, which further exacerbated quality problems.

Countries with their own currency can quickly and effectively restore their competitiveness by allowing their currency to depreciate. Greece and Italy have often used this tool, much to the frustration of their trading partners. Cyprus, on the other hand, never used the devaluation option, opting instead for a stable currency policy. Of course, this option is no longer available as the country is now a member of the Eurozone. Countries that do not control their currency can only boost competitiveness by raising the quality and/or decreasing the price of their goods and services. The latter can be achieved by cutting costs, including wages in the process known as internal devaluation. But cost-cutting has its limits and reducing wages has negative repercussions on social welfare and can strain the financial system as borrowers are unable to pay off their loans. The alternative of increasing quality is a much more appealing strategy but it is no quick fix as it requires productive investments and structural reform. The former are difficult to finance in times of crisis and the latter are politically difficult to implement; both take time to bear fruit.

The Cypriot economy has proven quite flexible. An internal devaluation is taking place, with prices and wages following a downward trend since the events of March 2013. This flexibility has allowed for a somewhat smoother and speedier adjustment than what was widely expected, but internal devaluation alone will not solve the competitiveness problem. In the longer term, this issue has to be addressed in two ways.

First, Cyprus needs productive investments (as opposed to investments in financial assets or real estate) that will expand the country’s productive capacity and improve productivity. As credit from the domestic financial sector will be tight for the next few years, such investments will have to come from overseas. It is imperative therefore that Cyprus cuts down bureaucratic red tape and makes itself a friendly destination for investors and entrepreneurs.

Second, the wage determination system must be radically changed. Union power in the public and banking sectors must be curtailed. Automatic wage increases must be abolished and wages should be linked to productivity, not to prices. In the public sector, for example, wage increases could be indexed to GDP growth. In the banking sector, collective bargaining must be done at the individual bank level rather than the sectoral level. This will reduce union power and foster healthier competition as banks can differentiate themselves in an effort to attract talent. The same principle should apply to all sectors, at least for large companies.

Cyprus must invest to improve the quality of the goods and services it sells to the outside world and it must keep costs in check so that it can offer an attractive price. It is really a very simple recipe.