M croeconomics, Tr de & Investment TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY A Macroeconomic Monitoring Note SPECIAL ISSUE: ENHANCING COMPETITIVENESS AND PROMOTING ECONOMIC INTEGRATION March 2022 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY M croeconomics, Tr de & Investment TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY SPECIAL ISSUE: ENHANCING COMPETITIVENESS AND PROMOTING ECONOMIC INTEGRATION March 2022 Document of the World Bank This report is part of the Economic Analysis Programme for Growth and Sustainable Development which is funded through the European Union’s aid regulation ‘Council Regulation (EC) No. 389/2006’ of February 27, 2006. The opinions expressed in this study do not reflect any official opinion by the European Commission and the World Bank’s Board of Executive Directors, nor do they in any way constitute recognition of boundaries or territories. l i TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY © 2022 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 +1 202-473-1000 www.worldbank.org Disclaimer The contents of this document are the sole responsibility of its authors and should in no way be taken to reflect the official views of the World Bank or the European Commission financing this report. The term ‘Turkish Cypriot community’ refers, solely for the purposes of this study, to the areas in which the Government of the Republic of Cyprus does not exercise effective control. If reference is made in the report to any ‘ministries’, ‘departments’, ‘services’, ‘bodies’, ‘organizations’, ‘institutions’, and ‘authorities’ in the areas not under the effective control of the Government of the Republic of Cyprus, or respective acronyms or abbreviations are used, this is done to allow a clear factual understanding of the administrative structures in the Turkish Cypriot community and shall not imply recognition of any public authority in the areas other than the Government of the Republic of Cyprus. Similarly, comparisons between the areas where the Government of the Republic of Cyprus exercises effective control and those areas where it does not are factual only. ii l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY TABLE OF CONTENTS Table of Contents...............................................................................................................................iii Acknowledgements............................................................................................................................v Abbreviations and Acronyms............................................................................................................ vii Executive Summary........................................................................................................................... ix Chapter 1: Recent Economic Developments and the Short-term Outlook............................................1 1.1 A slow recovery amidst numerous shocks............................................................................. 1 1.2. The macroeconomic-fiscal framework under pressure..........................................................9 1.3. Women and youth continue to bear the brunt of the crisis................................................ 12 1.4. The struggle of Turkish Cypriot firms to recover..................................................................14 1.5. The outlook, risks and way forward.....................................................................................17 Chapter 2: Special Issue: Enhancing competitiveness and promoting economic integration..............23 2.1 The opportunities for Greek Cypriot and Turkish Cypriot firms...........................................23 2.2 The case of halloumi/hellim.................................................................................................29 2.3 Policy options to promote economic integration.................................................................33 References .....................................................................................................................................34 l iii TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY iv l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY ACKNOWLEDGEMENTS T his report was prepared by Natasha Rovo (Economist, World Bank) and Stefano Curto (Senior Economist, World Bank), with contributions from Metin Nebiler (Economist, World Bank), İzge Arısal (Local Technical Coordinator, World Bank), Ehab Tawfik, Domenico Viganola, Fabio Artuso, and Mertkan Hamit (all Consultants, World Bank). The Special Issue is based on two background papers that investigate the competitiveness of the Turkish Cypriot economy: the paper “Stronger together: Opportunities for mutual learning, economic integration, and productive sophistication between the Republic of Cyprus and the Turkish Cypriot economy” by Flávio L. Pinheiro, Elena Bucea, and Dominik Hartmann (forthcoming); and the paper “An analysis of competitiveness of the Turkish Cypriot economy” by Gianluca Santoni (forthcoming). The team is grateful to Jasmin Chakeri (Practice Manager, World Bank) and Goran Tinjic (Program Manager for Southern Europe, World Bank) for their guidance in the preparation of this report. The team is also thankful to Julie Biau (Operations Officer, World Bank), Xueling Li (Agriculture Economist, World Bank), and to the peer reviewers Pinar Yasar (Senior Economist, World Bank) and Ran Li (Economist, World Bank) for their helpful comments. The team is also grateful to Suay Anıl and İlke Erdal, who supported the team to gather necessary data and information, and to Peter Kjaer Milne for editorial support. The team would also like to thank Oya Koçak Barçın (European Commission) for useful comments and feedback, and Tuğyan Atıfsoy from the European Union Coordination Centre for his support to the preparation of this report. The team is also grateful for the strong collaboration with the Turkish Cypriot administration and business chambers in the preparation of this report, including the Chamber of Commerce, the Chamber of Industry, and the Chamber of Shopkeepers and Artisans. l v TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY vi l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY ABBREVIATIONS and ACRONYMS CIT Corporate Income Tax CPI Consumer Price Index EC European Commission ECI Economic Complexity Index EPRT Exchange-Rate Pass-Through ES Enterprise Survey EU European Union GC Greek Cypriot GDP Gross Domestic Product GL Green Line iRCA Import Revealed Comparative Advantage LCB Local Community Body PCI Product Complexity Index PDO Protected Designation of Origin PIT Personal Income Tax PTA Preferential Trade Agreement RCA Revealed Comparative Advantage RoC Republic of Cyprus RTA Regional Trade Agreement TC Turkish Cypriot TCc Turkish Cypriot community TCe Turkish Cypriot economy TL Turkish lira US$ United States Dollar VAT Value-Added Tax yoy Year-on-year l vii TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY viii l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY EXECUTIVE SUMMARY The Turkish Cypriot economy (TCe) has rate volatility. As a small open economy, struggled to recover since the onset of the the TCe has an unbalanced external ‘trade’ COVID-19 pandemic in early 2020. With a structure, with strong reliance on ‘imports’ for contraction of 16.2 percent in GDP in 2020, final consumption and intermediate goods. In when the COVID-19 pandemic first took contrast, the share of ‘exports’ is small, at just hold, the TCe experienced the most severe 3 percent of GDP, hence limiting the benefits recession in its history, and also the most arising from a TL depreciation. Moreover, the severe recession among the economies of dependence on Turkey as a trading partner Europe. Moreover, just as other economies contributes to the overall vulnerability of the were beginning to recover, in 2021 the TCe TCe, as 50 percent of ‘exports’ are destined for underwent a phase of exceptional political Turkey. The composition of the ‘import’ basket, uncertainty and numerous exogenous shocks, as well as the invoicing currency, may also testing its resilience. With the emergence explain the TCe’s significant vulnerability to of new variants of the virus, the COVID-19 exchange rate shocks, with ‘imports’ covering pandemic continued to adversely impact the a greater proportion of its consumption, TCe throughout 2021, with cases reaching agricultural inputs, and investment goods than a new peak at the end of 2021 despite the is the case in Turkey. Turkish Cypriot (TC) administration’s efforts to The TL depreciation and the associated high prevent the spread of the virus, together with inflation affect not only the purchasing power its support for the health system, households, of TC households but also the competitiveness and companies. Furthermore, a new record of TC firms vis-à-vis their Turkish competitors. low in average precipitation in 2021, a series The increase in domestic inflation, triggered of earthquakes at the beginning of 2022, and by the TL shock, has a negative impact on weak energy security, with a recent series of households’ welfare, with poverty and power outages experienced across the island, inequality expected to increase further in the have all revealed the intrinsic vulnerabilities TC community (TCc). The TL shock also has a of the island to climate change and natural double-sided impact on TC firms. From the disasters. cost/supply perspective, the higher inflation The end of 2021 was marked by record high faced by TC firms compared with Turkish firms, inflation, driven by a major depreciation of albeit triggered by a common shock, puts TC the Turkish lira (TL), the ‘official’ currency firms at a disadvantage. From the demand used in the TCe. Following the depreciation perspective, since the Turkish market is by far of the TL, together with a global surge in the most important market for TC products, commodity prices, the average annual TC companies cannot take advantage of the inflation rate in the TCe reached 21 percent TL depreciation. Instead, Turkish companies in 2021. The full extent of the impact of the can benefit from increased competitiveness of depreciation of the TL, which is still unfolding their own products and boost their exports to other markets. and exacerbated by the effect of the war in Ukraine that started on February 24, 2022, is As a result, GDP growth is estimated to have expected to be significant on households and reached barely 4 percent in 2021. Contrary firms, hampering the economic recovery. The to other economies, some of which even transmission of the TL depreciation into TC managed to rebound to their pre-crisis income inflation has been strong, and much stronger levels in less than a year, not only was the than the impact that the same shock has had recession severe in the TCe, but the recovery on the Turkish economy itself. There are several that followed has been muted. At the current channels through which the structure of the pace, it will take several years before the TCe may amplify the impact of the exchange TCe’s income returns to its pre-crisis level. Key l ix TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY sectors; such as ‘tourism’ have benefited from force participation and employment rates the reopening of the economy and renewed both declined significantly, while the number mobility but remain well below their pre- of inactive people increased dramatically. crisis performance. The ‘higher education’ When looking at sectors, services experienced sector has also benefited from an increase a dramatic decline in the number of workers, in enrolments compared with 2020, in followed by industry, reflecting the subdued particular from foreign students. Conversely, recovery experienced by these two sectors, the agriculture sector was affected by record and only slightly compensated for by an low precipitation in 2021 and the volume of increase in the number of workers seen ‘exports’ of key products such as citrus fruit in the agriculture sector. Women and the has dropped by 12 percent compared with youth continue to bear the brunt of the 2020 figures as of September 2021. crisis. Women comprised for 76 percent of job losses in 2020 and the unemployment The socio-economic impact of the ongoing rate for women remains well above both the crisis may require extended support for European Union (EU) average and that of households and firms at a time of mounting the Republic of Cyprus (RoC). The situation fiscal pressures. As a result of the 2021 TL may be exacerbated in the near future by key depreciation, the average annual inflation for sectors with high female representation, such 2021 reached a record 21 percent. Prices have as services, lagging behind. In addition, the continued to the rise in early 2022, driven situation remains dire for the youth, with the largely by food and transport, and also as a youth unemployment rate about three times consequence of the war in Ukraine. The increase higher than the total unemployment rate, and in food inflation is particularly worrisome due well above the EU and RoC rates. to potentially large welfare and distributional effects, as it can push some households into Before the TL depreciation hit the TCe, poverty if their incomes fail to rise in tandem. companies were already struggling to Transfer programs, such as the “Poor in Need”, recover, relying on cuts in labor and delays and programs for disability, education, and in making payments to stay afloat. Firms that health-care, should (continue to) support low- have managed to weather the crisis are now income families to offset the adverse impacts on their way to recovery, but at a significant of rising prices. Improving targeting and cost to employment. According to the latest consolidating transfers into a single program World Bank Enterprise Survey (ES) from April could help increase the effectiveness of the 2021, the change in employment levels for system, given limited resources. Firms dealing the average firm in the TCe is significant, at with the effects of TL depreciation, together more than 20 percent, compared with pre- with increasing uncertainty and the energy pandemic. Medium-sized firms have incurred crisis, may also need extended support. the brunt of the downsizing, followed by However, this need for extended support small and large firms. The financial distress comes at a time when ‘public’ finances are among firms has continued to increase, already under considerable stress dealing with such that one of the consequences of the the consequences of the COVID-19 pandemic widespread reduction in liquidity has been and inflation. Given that the largest share of an increasing share of firms that have been ‘public’ spending (i.e., wages and pensions) forced to postpone the payment of some of is indexed to inflation, this is expected to put their obligations. While firms report access to ‘public’ finances under pressure, compressing ‘public’ support, women-led firms have been the fiscal space needed to support the left behind. The TL depreciation and persisting economy during these difficult times. uncertainties may further delay the recovery of the private sector, suppressing business and Despite a decline in the official unemployment consumer confidence. rate, both the labor force participation rate and the employment rate highlight the major The near-term outlook is weaker than impact of the crisis, particularly on women previously projected, owing to recurrent and the youth. While the unemployment COVID-19 flare-ups, the direct and indirect rate declined compared with 2020, the labor consequences of the war in Ukraine, together x l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY with increasing inflation, uncertainties, and foreign currency, ‘public’ finances may weaken risks. The extremely high level of uncertainty further due to continuous TL depreciation. regarding future weakness of the TL and the impact this could have on inflation are casting The recovery is expected to continue to be a long shadow over the forecast for 2022 GDP not only subdued, but also uneven, with growth. The ongoing war in Ukraine is also income gaps further widening both within expected to have direct and indirect economic the TCe and across the island. The expected impacts on the TCe, mostly through the trade subdued growth may also further widen the channel, with increased prices and uncertainty. gap between TC and GC per capita income. Output is expected to remain below the pre- The poor economic performance of the TCe is, pandemic trend, and a convergence of per however, a reflection not only of the economic capita income with the RoC and economies structure, but also of the limited capacity of in the EU is not expected to occur in the macro-fiscal policies to promote resilience near future. The downgrade of the forecast and respond to shocks. As discussed, the COVID-19 pandemic and the TL depreciation also depends on the expected withdrawal have had a major impact on the TCe. The of fiscal support, due to limited fiscal space economic structure of the TCe is heavily tilted and declining aid, as a consequence of the toward ‘tourism’—the sector hardest hit current economic situation and mounting by the 2020 crisis—which accounted for 22 fiscal pressures in Turkey, together with the percent of the TCe’s pre-COVID-19 pandemic weakening of external demand. According to GDP. At the same time, the TC economy is the latest projections,1 growth in 2022 in Turkey highly vulnerable to external shocks due to is expected to decelerate significantly from its low level of diversification, both in terms 11 in 2021 to 2 percent in 2022. Meanwhile, of products and trading partners, with Turkey economies in the Euro area, including the RoC, accounting for 50 percent of ‘exports’ and and in the Middle East and North Africa, may almost 80 percent of ‘tourist’ arrivals. The experience sustained growth, but at a lower current macroeconomic framework, which level than anticipated as a consequence of entails the use of the TL as the ‘official’ the war in Ukraine. Key risks to the outlook currency, is transmitting macroeconomic include both domestic and external factors. volatility and inflation into the TCe rather than On the one hand, a further resurgence of the providing a nominal anchor. In an economy pandemic, financial stress, rising inflation, without an independent monetary policy, fiscal in particular for food and energy, and fiscal policy is the only lever to mitigate the impact pressures, pose substantial domestic risks to of shocks. However, fiscal policy is increasingly the downside. And financial risks are expected procyclical, amplifying the cycle with booms to grow due to increasing financial liabilities and busts, to the detriment of its effectiveness. in key economic sectors. Climate risks and Spending is heavily tilted towards rigid items, exposure to natural disaster risks, as well as particularly ‘public’ wages, creating structural energy security, also constitute significant deficits and further reducing the fiscal space downward risks to the outlook. On the other to counteract the emergence of a new crisis or hand, any further escalation of the war in to promote diversification. For example, at 1.1 Ukraine and deteriorating external conditions percent of GDP, the generous and ineffective also risk jeopardizing the recovery through agriculture subsidies are putting increasing subdued ‘exports’ of goods and services. pressure on the budget and diverting precious Additional stress on the Turkish economy could resources away from priority spending, such be further amplified in the TCe. With high as infrastructure. inflation, the wage bill, pensions and transfers increase fiscal pressures and require higher Implementing a coherent macro-fiscal domestic financing, in case of an expected framework for a resilient economy is a key decline in Turkish support due to the current priority going forward. A key priority for fragility of the Turkish economy. Given that the administration going forward should be most of the ‘public’ debt, albeit declining, is in the amendment of fiscal policy objectives 1 World Bank. 2022. Turkey Economic Monitor. Sailing Against the Tide. Washington, D.C. World Bank. l xi TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY and stance, as well as the composition of The 2021 Protected Designation of ‘public’ spending, to promote the creation of Origin (PDO) registration for halloumi/ a more resilient economy. In the short term, hellim2 provides a unique opportunity. A this includes: (i) conducting a fully-fledged successful implementation of the PDO will ‘public’ finance review, including tax policy help agricultural firms in the TCe to benefit and tax expenditure, ‘public’ expenditure, from greater access to the EU market and fiscal incidence, and the incentive system; provide positive spill-overs throughout the (ii) designing and introducing a cyclical- rest of the economy. But perhaps even more adjusted fiscal rule and fiscal council to help importantly, the PDO also represents a unique monitor and guarantee fiscal sustainability opportunity for the TC administration to put and macroeconomic management; (iii) in place a comprehensive sectoral strategy enhancing domestic mobilization by reforming with efficient and effective policies that can be income tax and broadening the revenue subsequently replicated in other sectors. The base of the Local Community Bodies (LCBs), TC administration, and the ‘public’ sector at including through reforming property taxes; large, now has an opportunity to demonstrate (iv) improving ‘public’ debt management by its role in providing a conducive environment developing a servicing plan for the ‘public’ that facilitates and eases rather than prevents debt and mitigating exchange rate risks; and firms operating in this sector from doing (v) taking stock of arrears and contingent business, providing a blueprint for other liabilities, and developing a reporting and sectors to follow. Long-term diversification monitoring mechanism to avoid their future to mitigate vulnerabilities and long-term build-up. In the medium term, a broader sustainable growth to resume income and standard of living convergence will only be reform of both the revenue and spending possible by shifting the focus from a short-term frameworks, together with a broader strategy reactive approach to a long-term proactive to support private sector development, is strategy. needed to achieve for a more growth-friendly and sustainable fiscal policy. The Special Issue in Chapter 2 investigates both the opportunities and challenges in Addressing the sources of vulnerability will building a more competitive and diversified also make the TCe and its private sector more economy through deeper economic competitive. The effects of fiscal and monetary integration with the Greek Cypriot (GC) policies filter down through all levels of the economy, with a deep dive on halloumi/ economy, affecting businesses and consumers. hellim. Despite the potential economic and At the same time, the business environment social benefits, the GC and TC economies in which TC firms operate can play a key role, have relatively low economic integration, and not only in enhancing productivity, creating the 2004 Green Line (GL) Regulation aims at good job, and attracting investment, but setting out the terms under which locally also for economic diversification, reducing produced goods can cross the GL. However, the vulnerabilities to external shocks due to due to the regulatory and non-regulatory a narrow production base. Addressing the constraints —which will be the scope of future prolonged neglect of much needed structural analysis— current GL trade, both in trems reforms is paramount for the TCe to seize of its volume and composition, is arguably the opportunities that the global economy an insignificant share of the productive offers, particularly the EU. Structural reforms capabilities and possibilities for trade between are key to unlocking the full potential of the the GC and TC economies, which is therefore private sector. Such reforms would help the the scope of this analysis. Despite being structural transformation of the economy, located on the same island in the eastern and allow human and financial capital to flow Mediterranean Sea, and thus having similar into sectors where the TCe has comparative climate conditions and distances to trade advantages, and into firms within sectors that partners, such as the EU and the Middle East, are more productive and innovative. the two economies have significantly different 2 Halloumi or hellim is a semi-hard, unripened cheese made from a mixture of goat’s and sheep’s milk, and partly also cow’s milk. xii l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY trade partners and product structures. The terms of more stability and social cohesion, TCe is more closely integrated with emerging less external dependence, and new trade economies, especially Turkey, while the RoC partners and growth opportunities. is more closely integrated with high-income economies, especially those of the EU. As will For example, halloumi/hellim, the most be discussed later, preferential/regional trade important agricultural product of the agreements and other frictions have played a island, could unlock new opportunities, key role in developing different trade patterns subject to addressing key constraints to for the two economies, particularly since competitiveness and key vulnerabilities 2004. On the product space, the TCe produces that stem from ineffective macroeconomic less complex and sophisticated products than policies. Halloumi/hellim offers opportunities the RoC. Building on bilateral trade data, it for technological cooperation and economic is possible to identify those products that integration, joint growth opportunities, and could provide opportunities for economic mutual learning. For instance, currently the integration: (i) the most complex and related TCe ‘imports’ dairy machinery mainly from products from which either side can learn outside Cyprus, while the RoC has a revealed from the other, by acquiring the productive comparative advantage for this product. capabilities associated with those products Thus, both sides could gain from an increase in which the other economy has comparative of the trade in dairy machinery across the advantage — the knowledge spillover channel; GL. Moreover, ‘trade’ of halloumi/hellim is (ii) those products that are currently imported well below its potential for TC producers, from third economies but could be supplied both in terms of volume, being seven times more efficiently within the island — the within- less than GC exports of halloumi/hellim, and island trade integration and sophistication in terms of value, given the income of its channel; and (iii) the complementary trading partners. The reasons for this include productive capabilities that would allow the low competitiveness of the TCe, and key both economies to move into more complex vulnerabilities related to its ineffective ‘trade’ products — the synergy channel. and monetary policies. While it is difficult to assess the TCe’s potential of removing these Both GC and TC companies could benefit policy impediments, a counterfactual analysis from stronger economic integration. First, shows that if GC companies were facing the there are more than 200 products currently same frictions as TC companies their current produced and exported by GC companies exports could be reduced by as much as 75 that TC companies could learn from. While percent. This points to the importance of the the number of similar learning opportunities TCe upgrading its policies to fully benefit from is much smaller for GC companies, with only deeper integration with the EU. 14 products, GC companies can largely benefit by supplying TC companies with products Beyond addressing macro-fiscal vulner- currently supplied from other economies. abilities, the new administration should Addressing regulatory and non-regulatory focus on reducing the administrative burden obstacles to trade across the GL would unlock and facilitating GL trade, while building the within-island trade, providing a cost-effective dialogue between GC and TC private sectors solution for both TC and GC companies’ on solutions that would benefit all. A shift production, also promoting socio-economic in the paradigm is needed by overhauling integration and knowledge spillovers/transfer. the current fiscal incentive framework, Finally, by joining forces in the value chain, the which today no longer serves the original island as a whole could move toward more intent of protecting producers, especially advanced products that could also help in small farmers. Today, fiscal incentives not creating more and better jobs for all Cypriots. only subtract precious fiscal resources that While further work is necessary to fully assess could be channeled to more effective use, the potential wage and employment effects, but also generate distortions in the economy, this study shows that significant gains in creating rents in sectors that do not need potential economic complexity are possible support to thrive, or protecting sectors and for the TCe, as well as for both economies in products that are not economically viable. l xiii TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Building a competitive private sector would ‘imports’, on top of regulatory uncertainty and require reforming business regulations and other cumbersome procedures, contribute to procedures that are under the mandate of the increasing prices, penalizing consumers, and TC administration, and that should be aligned eroding domestic competitiveness. A dialogue with international best practices and the EU framework between GC and TC private sectors Acquis, irrespective of the broader context of could be established to support solutions to the political economy. Special attention should the long-standing constraints that have been be devoted to the regulation concerning impeding business cooperation across the GL, ‘imports’ and GL trade. Pre-permits and for the benefit of all Cypriots. licenses imposed by the TC administration on xiv l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Chapter 1: Recent Economic Developments and the Short-term Outlook 1.1 A slow recovery amid marked by another severe shock for the TCe, following the depreciation of the Turkish lira numerous shocks (TL), which led, amid a global surge in prices, In 2021 and early 2022, the Turkish Cypriot to a record high inflation rate of 46.09 percent economy (TCe) was confronted with in December 2021 year-on-year (yoy) (Figure numerous shocks, testing its resilience. With 1.2). The negative impact on households the emergence of new variants of the virus, and firms, as well as on ‘public’ finances, is the COVID-19 pandemic has continued to expected to be significant, although it is as yet adversely impact the TCe, with cases reaching still to be quantified. Moreover, both 2021 and a new record at the end of 2021. The Turkish 2022 have been years in which the fragility Cypriot (TC) administration has reacted of the island to natural shocks has also been through the implementation of additional exposed. In 2021, a new low was recorded measures to prevent the spread of the virus, in terms of average annual precipitation, and support for the health system, households, continuing a worrisome declining trend (Figure and companies, and most importantly through 1.3). In addition, at the start of 2022, in less the vaccination campaign. The number of than one month, three earthquakes exceeding doses administered has surpassed 800,000, 4.5 in magnitude shook the island, the latest reaching one of the highest levels per capita in a series of severe earthquakes over the past globally (Figure 1.1).3 Fatality rates in the TCe, century (Figure 1.4). Finally, a series of power as well as in the Republic of Cyprus (RoC), are outages has hit the island, affecting daily among the lowest in the world, at around activities and business operations, exposing 0.2 per 100 cases.4 The end of 2021 was also the limited energy security. Figure 1.1: COVID-19: New cases and Figure 1.2: Exchange rates and annual average vaccination inflation 8000 600000 50 100,00 7000 45 85,00 500000 40 6000 70,00 400000 35 5000 30 55,00 4000 300000 25 40,00 3000 20 25,00 200000 15 2000 10,00 100000 10 1000 5 -5,00 0 0 0 -20,00 Dec-18 Dec-19 Dec-20 Dec-21 Apr-18 Aug-18 Oct-18 Apr-19 Aug-19 Oct-19 Apr-20 Aug-20 Oct-20 Apr-21 Aug-21 Oct-21 Feb-18 Feb-19 Feb-20 Feb-21 Jun-18 Jun-19 Jun-20 Jun-21 2021m10 2021m11 2021m12 2021m1 2021m2 2021m3 2021m4 2021m5 2021m6 2021m7 2021m8 2021m9 TCC y-o-y inflation rate (%) Exchange rate y-o-y change, TL/EUR (%)(right axis) Monthly cases Exchange rate y-o-y change, TL/$US (%)(right axis) Doses administered, cumulative since 2021m6 (rhs) Source: World Bank staff estimates; TC ‘Ministry of Source: TC ‘Statistics Office’, Central Bank of Turkey Health’; COVID-19 Data Repository by the Center for Systems Science and Engineering (CSSE) at Johns Hopkins University 3 https://covidvax.live/ consulted on March 6, 2022. Data for RoC indicate more than 1.7 million doses administered. 4 https://coronavirus.jhu.edu/data/mortality consulted on March 6, 2022. l 1 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.3: Average precipitation, 1901–2021 Figure 1.4: Earthquakes above 4.5 magnitude, 1900–20226 750 700 650 600 Precipitation (mm) 550 500 450 400 350 300 250 1901 1907 1913 1919 1925 1931 1937 1943 1949 1955 1961 1967 1973 1979 1985 1991 1997 2003 2009 2015 2021 Source: WDD. Source: usgs.gov These shocks have derailed TCe efforts to academic year. The overall number of students achieve a rapid recovery from the severe enrolled for the 2021/22 academic year is 5 recession in 2020. With a contraction of 16.2 percent higher than the previous year, with the percent in GDP in 2020, the TCe experienced number of foreign students up by 17 percent. the most severe recession in its history, and the With the resumption of in-person activities, most severe recession among the economies this is expected to contribute positively to in Europe, followed by Montenegro, which economic activity. However, agriculture, recorded a contraction of 15.3 percent. Not underperformed in 2021 due to unfavorable only was the recession severe, but the rebound climate conditions. As of September 2021, thereafter has been muted, in contrast to other the volume of ‘exports’ of key products, such economies, some of which have managed to as citrus fruit, had dropped by 12 percent return to their pre-crisis income levels. As a compared with the same period in 2020. result, in 2021, GDP is estimated to grow by 4 percent (Figure 1.5).5 By the end of 2021, the Turkish lira (TL) depreciation had wiped out about 40 percent ‘Tourism’, an important driver of growth of the currency’s value and is having a major and source of foreign exchange, has partially impact on TC inflation. The episode of TL recovered from 2020, but remains well below depreciation against the US dollar that began its pre-crisis performance. The number of in September 2021 has a similar trajectory Green Line (GL) crossings, excluding Turkish to that seen in the crises of 1994, 2001, and Cypriots, which reached almost 500,000 in 2018 (Figure 1.7). One transmission channel August 2019, dropped to a record low of 108 in May 2020. Subsequently, as restrictions started of the TL depreciation on the TCe is through to be lifted, crossings increased reaching more its effect on domestic prices, namely the than 270,000 in October, albeit still well below exchange rate pass-through (ERPT). In fact, their pre-crisis level (Figure 1.6). Similarly, consumer prices in the TCe have historically the higher-education sector, which was also moved with the exchange rate (Figure 1.8). By severely impacted by the COVID-19 pandemic, means of econometric tools, it is possible to has recovered slightly, with an increase in the estimate the ERPT to inflation (see Box 1.1 for number of students enrolled for the 2021/22 a methodological explanation). 5 The map shows the island of Cyprus, where dots correspond to earthquakes exceeding 4.5 in magnitude that have occurred since 1900. 2 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.5: Real GDP growth Figure 1.6: Green Line crossings, % change compared with the same month in 2019 12 11,0 40 Percentage Change in GL crossings (other than 20 22 7 5,3 20 5,2 5,2 4,0 3,1 3,0 2,1 1,6 0 TCs) with respect to 2019 1,3 1,8 -0 2 0,9 0,2 -20 Percent -25 -40 -30 -3 -34 -47 -60 -5,2 -60-58 -6,4 -8 -80 -69 -74 2018 2019 2020 2021e -100 -100 -100 -100 -97-96-95-94-95-97 -100 -100 -99-99-98 -13 -120 Jan 20 Feb 20 Mar 20 Apr 20 20 Jun 20 July 20 Aug 20 Sep 20 Oct 20 Nov 20 Dec 20 Jan 21 Feb 21 21 Apr 21 May 21 Jun 21 July 21 Aug 21 Sep 21 Oct 21 Nov 21 21 Jan 22 Tem.20 Tem.21 May.20 Ara.20 May.21 Ara.21 Oca.20 Oca.21 Oca.22 Şub.20 Nis.20 Haz.20 Şub.21 Nis.21 Ağu.20 Haz.21 Ağu.21 Mar.20 Eyl.20 Eki.20 Mar.21 Kas.20 Eyl.21 Eki.21 Kas.21 May Mar Dec -16,2 -18 TCe RoC Turkey Euro Area Source: World Bank staff estimates, TC ‘Statistics Office’, EC Source: TC ‘Tourism Planning Department’. Autumn 2021, World Bank GEP January 2022. Exchange rate shocks tend to be far stronger estimated to increase inflation by 1.83 and have a more prolonged impact on and 2.066 percent month-on-month in the inflation in the TCe than in Turkey. Figure TCe, while the same exchange rate shocks 1.9 shows the results from the econometric result in only a 0.47 and 0.567 percent analysis of the ERPT: increase in inflation month-on-month in Turkey.8 • At impact, a 10-percentage point depreciation of the exchange rate is Figure 1.7: Turkish lira per US dollar, Figure 1.8: Turkish Lira exchange rate 1994M1-2012M12 (Index=100 at t=10, depreciation and inflation in the TCe +=appreciation) 130 80 120 120 70 100 110 100 60 80 90 50 80 60 40 70 40 60 30 50 20 20 40 0 10 30 20 0 -20 10 -10 -40 0 2002M1 2003M1 2004M1 2005M1 2006M1 2007M1 2008M1 2009M1 2010M1 2011M1 2012M1 2013M1 2014M1 2015M1 2016M1 2017M1 2018M1 2019M1 2020M1 2021M1 t+0 t+2 t+4 t+6 t+8 t+10 t+12 t+14 t+16 t+18 t+20 t+22 t+24 t+26 t+28 t+30 t+32 t+34 t+36 TUR episode start 1994M2 TUR episode start 2001M1 TCc CPI inflation (LHS, in percent, y/y) Lira/USD (RHS, in percent, y/y) TUR episode start 2018M3 TUR episode start 2021M9 Lira/Euro (RHS, in percent, y/y) Sources: IMF International Financial Statistics, Central Bank of Turkey, TC ‘Statistics Office’. Note: The Turkish lira/US dollar January 2022 data point is an average up to January 10, 2022. 6 Respectively for Turkish lira/USD – Turkish lira/euro shocks 7 Respectively for Turkish lira/USD – Turkish lira/euro shocks 8 Quarterly estimations yield similar results. l 3 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.9: Exchange rate pass-through, by currency and economy TRNC EURO ERPT TRNC USD ERPT Turkey EURO ERPT Turkey USD ERPT 4,5 4,0 3,5 Cumultaive ERPT 3,0 2,5 2,0 1,5 1,0 0,5 0,0 1 2 3 4 5 6 7 8 9 10 11 12 Month of Shock Source: World Bank staff calculations. • At the 12-month horizon, a 10-percentage amounting overall to 43 percent of GDP over point depreciation of the Turkish lira vis- the period 2010–2019. Conversely, the average à-vis the US dollar leads to an increase in share of ‘exports’ in the same period is small, inflation of 4.51 percentage points for the at just 3 percent of GDP, hence limiting the TCe and 2.32 percentage points for Turkey, benefits arising from a depreciation. In contrast, while a 10-percentage point depreciation Turkey has a relatively more balanced external of the Turkish lira vis-à-vis the euro leads to trade structure with average exports of goods an increase in inflation of 5.05 percentage of 19 percent of GDP and average imports points for the TCe and 2.78 percentage of 25 percent of GDP over the same period. points for Turkey. In additon, both fiscal stance and financial development play a key role in shaping the There are several channels through which ERPT. On the one hand, as detailed in Section the structure of the TCe may amplify the 1.2, fiscal policy through its highly procyclical ERPT. As a small open economy, the TCe has stance has amplified economic volatility in the an unbalanced external ‘trade’ structure, TCe. With high inflation and high financing with strong reliance on ‘imports’ for final costs, coupled with wage indexation, the high consumption and intermediate goods,9 wage bill and, the interest burden significantly 9 While a flexible exchange rate regime tends to be the preferred choice for open economies because of its shock absorption properties, over-reliance on imports such as in small islands makes flexible exchange rate regimes less effective at shock absorption because of a high ERPT to inflation. The use of a fixed exchange rate regime, or a more stable currency in small island economies, is a more apt choice (IMF, 2021). 4 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY limit the space for fiscal policy. On the other higher in Turkey.11 In addition, in response to hand, the low development of the financial an exchange rate shock, inflation increases market in the TCe contributes further to shock more rapidly in the TCe than in Turkey, amplification, as access to finance becomes particularly for goods such as transportation significantly more expensive and restrictive and food. When looking at CPI components, at those times, when the economy is most in transportation and food—the two largest need of finance. components of the consumer basket—are the goods whose prices reflect any exchange Not only does the close economic relationship rate shocks most and at the fastest pace. The between the TCe and Turkey contribute to highest ERPT is on transportation prices, which the vulnerability of the TCe, but it also puts include the sale of vehicles and fuel.12 TC companies at a disadvantage vis-à-vis Turkish companies. The asymmetric impact Not surprisingly, the 2021 TL depreciation due to different ERPTs, albeit due to a common resulted in a record high inflation rate shock, has asymmetric consequences for TCe of 46.09 percent in December 2021 yoy, competitiveness vis-à-vis Turkish producers. with transportation and food showing the Moreover, 60 percent of goods accessing highest rates. The rates of price inflation in the TCe are ‘imported’ from Turkey and 50 transportation (77.7 percent), food (58.2 percent of the ‘exported’ goods are destined percent), and housing (25.7 percent) have a for Turkey.10 This strong ‘trade’ linkage makes particularly high impact on poor households, the TCe highly exposed to Turkey’s business since these goods comprise a larger share of their budgets (Figure 1.10). Poor households cycle. Firms are affected on the cost side tend to spend around two-thirds of their but are unable to fully benefit from more consumption expenditure on food (23.2 competitive ‘exports’, contrary to Turkish percent of their budget), housing (27.2 percent firms. It is estimated that it takes 6 months of their budget) and transportation (14.7 for the depreciation to be fully transmitted percent of their budget) combined, while this into TCe inflation compared with 12 months share is only half among non-poor households for Turkey, giving Turkish exporters more time (World Bank, 2019). to benefit from a more competitive currency than their TC peers. Therefore, the TL volatility The substantial increase in food inflation is negatively impacts the competitiveness of the of considerable concern, as it has potentially TCe. significant welfare and distributional effects. Food price inflation in the TCe is on the rise and Finally, the composition of the ‘import’ basket reached 77.5 percent in February 2022 yoy. and, to some extent, the invoicing currency This is the highest food price inflation observed are other important factors that explain among European economies, followed by the sizable ERPT. A higher ERPT for the TCe, Turkey at 64.5 percent. Other economies independent of the selected exchange rate, is experienced high double-digit inflation, such not surprising given that a greater proportion as Moldova, Ukraine and Serbia, but all (still) of domestic consumption, agricultural inputs, between 13 and 20 percent (Figure 1.9). The and investment goods relies on ‘imports’ than ongoing war in Ukraine could likely translate in Turkey (World Bank, 2018). Paradoxically, into a further increase in prices, especially for however, and at least for Turkey for which food products. Exchange rate depreciation is data on invoicing currencies of imports are the main reason of higher food prices in both available, US dollar invoiced imports are much the TCe and Turkey. larger than euro invoiced imports. As such, it is expected that the US dollar ERPT is much 10 In 2019. 11 One explanation could be that the consumer basket used for the CPI calculation in Turkey relies on a higher proportion of euro-invoiced content than is in total imports. 12 Additional high ERPT components include “furniture, home appliances and home care”, “alcoholic beverages and tobacco” and “entertainment and culture”. However, these have very small weights in the headline consumer price index. All other CPI components seem to have a lower ERPT than the ERPT to headline CPI. l 5 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Box 1.1: Estimation of the exchange-rate pass-through: data and methodology The methodology estimates four bi-variate Structural Vector Auto Regression (SVAR) models, with two models for Turkey (one for Turkish lira/US dollar depreciations and another for Turkish lira/euro depreciations) and two models for TCe (one for Turkish lira/US dollar depreciations and another for Turkish lira/euro depreciations).14 Data for TCe were obtained from the TC ‘Statistics Office’.15 CPI and exchange rate data for Turkey and Euro area were obtained from the IMF’s International Financial Statistics database. The data span the period 2001M1 to 2021M11 and are seasonally adjusted. All series enter their SVARs as month-over-month log differenced to ensure stationarity. The exchange rate depreciation variable is most exogenous in all SVAR models. The lag length is set based on the Akaike Information Criterion. In the TCe SVARs, the TC inflation variable is assumed to have no contemporaneous nor lagged effects on Turkish Lira exchange rate depreciations and inflation coefficients are restricted to zero in the exchange rate depreciation equations. For each economy, the ERPT is calculated as the accumulated impulse response of inflation to an exchange rate depreciation shock divided by the accumulated impulse response of the exchange rate to a 10-percentage point shock in the exchange rate itself. Rising food prices (and also prices in adverse impacts of rising prices. – During general)13can deepen the extent of deprivation the pandemic, several support programs among poor and vulnerable households and for households were provided, including force them to use unsafe coping strategies cash transfers, support for social security (i.e., skipping meals, selling assets, etc.), contributions for formal workers, and wage with14potentially severe and long-lasting support for employees of businesses that consequences.15 were closed during the lockdowns. However, Transfer programs should (continue to) direct income support was not continuous, support low-income families to offset the but instead offered as a one-off payment. The Figure 1.10: Twelve-month inflation in the TCe in December 2021, by consumption groups Index Values Rate of Change According To Previous December (%) Expenditure shares, poor households (%) Food and Non-alcoholic Beverages 80 Alcoholic Beverages and Tobacco 70 60 58,2 Miscellaneous Goods and Services 50 Clothing and Footwear 40 30 20 16,1 35,4 27,8 Housing, Water, Electricity, Gas and Restaurants and Hotels 10 56,9 Other Fuels 0 25,7 31,9 19,6 60,4 Furnishings, Household Equipment and Education 36,5 Routine Household Maintenance 38,6 Recreation and Culture Health 77,7 Communication Transport Source: TC ‘Statistics Office’. 13 Based on the SVAR methodology in “Turkish Cypriot Community: Coping with the Turkish Lira Depreciation Shock”, World Bank, November 2018. 14 TCE CPI series are spliced by interpolating two observations as the average month-over-month inflation between the preceding and following month (2010M1 and 2017M1). 15 Borde et al., 2020, Baez et. al., 2021. 6 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.11: Food inflation in European economies, January* 2022 90 80 70 60 50 40 30 20 10 0 Turkey (Feb 22) Portugal (Jan 22) United Kingdom (Jan 22) RoC (Feb 22) Finland (Jan 22) Bulgaria (Jan 22) Ireland (Jan 22) Slovenia (Dec 21) Greece (Jan 22) Luxembourg (Jan 22) Italy (Jan 22) Belgium (Jan 22) Netherlands (Jan 22) Albania (Jan 22) Montenegro (Dec 21) Poland (Jan 22) Slovakia (Jan 22) Latvia (Jan 22) Hungary (Jan 22) Kosovo (Jan 22) Norway (Jan 22) Sweden (Jan 22) Lithuania (Jan 22) Switzerland (Feb 22) France (Feb 22) Iceland (Jan 22) Serbia (Jan 22) Ukraine (Jan 22) Czech Republic (Dec 21) European Union Spain (Jan 22) Austria (Jan 22) Estonia (Dec 21) Macedonia (Dec 21) Malta (Jan 22) Romania (Jan 22) Croatia (Jan 22) TCc (Feb 22) Denmark (Jan 22) Germany (Jan 22) Russia (Jan 22) Belarus (Dec 21) Bosnia and Herzegovina (Dec 21) Moldova (Jan 22) -10 Cyprus Source: TC ‘Statistics Office’ and Eurostat for other economies. *Note: for some economies, including the TCe, February data are available. coverage rate of the main social assistance significantly lower than in other developing programs – including the “Poor in Need” and developed economies. Local Community program, disability transfers, education Bodies (LCBs) also provide support schemes, scholarships, and free health-care services but these are rather unsystematic and vary for the poor – remains low, at only 17 percent across LCBs. These programs are therefore for the bottom quintile according to latest likely to have only a limited impact on available poverty measures (2015), and mitigating the adverse impact of the pandemic Figure 1.12: Fiscal accounts: revenues, expenditures and balance (percent of GDP) 60,0 12,0 10,0 50,0 TRANSFERS 8,0 40,0 6,0 DEFENSE (CURRENT YEAR) 30,0 CAPITAL EXPENDITURES 4,0 20,0 2,0 OTHER CURRENT EXPENDITURES /1 10,0 0,0 WAGES AND Percent of GDP COMPENSATION -2,0 FOREIGN AID AND GRANTS 0,0 -4,0 FUND REVENUES -10,0 -6,0 OTHER INCOME -20,0 -8,0 INDIRECT TAX -10,0 -30,0 DIRECT TAX -12,0 -40,0 Budget balance (RHS) -14,0 Budget balance w/o grants -50,0 -16,0 (RHS) -60,0 -18,0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021e /1 Residual category. Total-wages and compensation-capital expenditures-defense-transfers Source: World Bank staff, TC ‘Ministry of Finance’. l 7 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.13: External financing from Turkey (percent of GDP) 10% Private Sector Grants Investment Grants 9% Defense Grants Loans 8% 7% 6% Percent of GDP 5% 4% 3% 2% 1% 0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021e Source: World Bank staff, TC ‘Ministry of Finance’. on families in need, and may require improved by wages and compensation at 32 percent, targeting and consolidation into a single and capital expenditure at 13 percent. The transfer to increase effectiveness, given the share of defense spending remains high limited resources available. at 7 percent of total expenditures, close The current account balance, excluding to the historical average. Meanwhile, local grants from Turkey, is projected to remain in revenues reached almost TL 7.6 billion, mostly negative territory. Based on the available data driven by income tax revenue collection and as of September 2021, merchandise ‘exports’ value-added-tax (VAT) on ‘imports’, which in the period January-September 2021 were together make up about 45 percent of local 30 percent higher than in the same period of revenues. Aid received from Turkey in the 2020, while ‘imports’ increased by 44 percent form of grants constitutes the most important compared with the corresponding period in source of funding in alleviating the financing 2020. The current account balance, excluding gap between local revenues and budget grants from Turkey, is projected to remain in expenditures, amounting to TL 1.3 billion, of negative territory. which half is in the form of defense grants High inflation has resulted in mounting fiscal (Figure 1.13). Loans from Turkey amounted to pressures and the deficit is projected to remain TL 491 million. ‘Public and publicly guaranteed’ high (Figure 1.12). Because of indexation, high debt is expected to remain high, but below the inflation is expected to increase the wage historical average due to high inflation (Table bill and pensions substantially, worsening 1.1). However, further TL depreciation could the fiscal situation. In an environment of inflate debt service costs and thus increase high uncertainty over the continuation of the rollover risk, given that most of the ‘public’ Turkish support due to the current fragility debt is denominated in foreign currency. The of the Turkish economy, access to financing financial situation of the LCBs is also expected from the domestic market will be challenging to deteriorate, given that their budgets are and costly due to high inflation and the risk highly dependent on transfers from the central premium. In 2021, spending surpassed TL TC administration. 10 billion, with almost 40 percent of total expenditure destined to transfers, followed 8 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY 1.2. The macroeconomic- effectiveness. Spending is mostly concentrated on rigid items, particularly ‘public’ wages fiscal framework is under and transfers, creating structural deficits and pressure further reducing the fiscal space for a response In recent years, the macroeconomic-fiscal in the aftermath of a new crisis and the capacity framework in the TCe has shown the limits. The to support long-term economic diversification. use of the Turkish lira as the ‘official’ currency In addition, as most of the TCe’s ‘public’ debt is in foreign currency, this further increases in the TCe has not acted as a stable nominal the vulnerability of its ‘public’ finances to anchor, but has on the contrary transmitted exchange rate depreciations. macroeconomic volatility and inflation into the TCe. Moreover, fiscal policy —the only The analysis of ‘public’ spending and revenue lever to mitigate the impact of shocks in an trends throughout the business cycle helps to economy without an independent monetary deepen understanding of the effectiveness policy— has not only failed to counteract of fiscal policy. Fiscal policy is defined as shocks but has exacerbated the impact of procyclical (countercyclical) if it is expansionary shocks and volatility, amplifying the cycle with (contractionary) during boom times and/or booms and busts, to the detriment of its own contractionary (expansionary) during crisis Figure 1.14: Cyclicality of revenues and spending in the TCe a. Cyclicality of revenues in different periods b. Cyclicality of spending in different periods Cyclicality of TCc Spending with respect to TCc Output, 1977-2019 Cyclicality of TCc Revenues with respect to TCc Output, 1977-2019 (Correlation coefficients between cyclical components of real TCc output and real TCc spending) (Correlation coefficients between cyclical components of real TCc output and real spending) Total revenue Tax revenue Aid from Turkey Total spending Current spending Defense Investment 1,00 1 0,78 0,80 0,72 0,8 0,69 0,64 0,63 0,59 0,58 0,60 0,54 0,6 0,47 0,37 0,40 0,31 0,4 0,28 0,26 0,22 0,20 0,2 0,12 0,00 0 -0,20 -0,12 -0,2 -0,13 -0,16 -0,21 -0,25 -0,40 -0,4 -0,60 -0,6 -0,53 -0,80 -0,8 -1,00 -1 1977-2019 1977-1999 2000-2019 1977-2019 1977-1999 2000-2019 c. Cyclicality of revenues depending on cycle d. Cyclicality of spending depending on cycle Cyclicality of Revenues in Good and Bad Times /1, 1977-2019 Cyclicality of Spending in Good and Bad Times, 1977-2019 (Correlation coefficient relative to output gap) (Correlation coefficient relative to output gap) Total spending Current spending Total revenues Tax revenues Aid from Turkey Defense spending Investment spening 1,0 1,0 0,8 0,68 0,73 0,8 0,73 0,64 0,6 0,48 0,6 0,39 0,41 0,42 0,4 0,26 0,4 0,28 0,23 0,24 0,22 0,2 0,2 0,0 0,0 -0,2 -0,2 -0,19 -0,4 -0,4 -0,6 -0,6 -0,8 -0,8 -1,0 -1,0 Good times Bad times Good times Bad times Source: World Bank staff calculations based on the Authorities’ data. Based on methodology in Abdih, Y, et. al. (2010). /1 Good times are defined as periods of postive output gaps, while bad times are defined as periods of negative output gaps. l 9 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY periods.16 Procyclical fiscal policies tend to been procyclical in the TCe since 1977, and be associated with lower welfare, as they procyclicality has increased over time. On the tend to increase macroeconomic volatility by revenue side while the procyclical nature of amplifying the business cycle, creating stop- tax revenue represents a positive feature as it and-go investment, which reduces potential acts as an automatic stabilizer of the business growth. Procyclical fiscal policies also tend cycle, the procyclicality of aid is detrimental to to be less effective, as the fiscal multipliers— short- and long-term growth, given that more namely, the impact that policy measures have aid is received when the economic activity on GDP, for example an increase in spending is at full potential. In this context, aid from or a cut in taxes—are much lower at the peak Turkey has turned from being countercyclical of the business cycle, limiting the impact on to procyclical, hence contributing further to the real economy and generating inflation. economic volatility in the TCe (Figure 1.14a and Fiscal policy should therefore actively try to 1.14c). On the spending side, all components smooth the business cycle by lowering taxes tend to be highly procyclical, with the only and increasing expenditure in bad times, exception being defense spending, which hence supporting aggregate demand, while tends to be countercyclical, decreasing in good increasing savings in good times. times (Figure 1.14d). The combination of these factors has resulted in more volatile economic Fiscal policy in the TCe has been increasingly cycles and less fiscal space to counteract them. procyclical, with spending ramped up during booms and slashed during downturns. Figure Procyclicality in fiscal policy in the TCe has 1.14 shows the correlation coefficients between reduced its effectiveness as a policy lever to the cyclical component of real GDP and the reduce macroeconomic volatility. To assess cyclical component of revenues, expenditures, whether the TC administration responds and subcategories. A positive coefficient proactively to the business cycle, the automatic indicates that the selected variable moves in features built into the tax and expenditure the same direction as the output gap (namely, systems (such as a fall in tax revenues or a rise increasing during boom times and decreasing in unemployment benefits when the economy during bad times). As shown in Figures 1.14a is in crisis), known as automatic stabilizers, and 1.14b, both revenues and spending have should be distinguished from the discretionary Figure 1.15: Fiscal stance in the TCe TCc Fiscal Stance: Fiscal Impulse, Automatic Stabilization, and Output Gap (In percent of GDP, unless otherwise stated) Inverted Scale 14% -12% 12% -10% 10% -8% 8% -6% 6% -4% 4% 2% -2% 0% 0% -2% 2% -4% 4% -6% 6% -8% 8% -10% -12% 10% -14% 12% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 RHS: Fiscal impulse (Δ cyclically adjusted primary balance) /1 RHS: Automatic stablizers (residual: Δ primary balance - Δ cyclically adjusted primary balance) /2 LHS: Output gap (real output gap in percent of potential real GDP) 16 A simple way to evaluate this, is to compute the correlation between the cyclical component of the different fiscal instruments (revenue and spending) and the cyclical component of real GDP throughout time. Good times are defined as periods of positive output gaps, bad times are defined as periods of negative output gaps. 10 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.16: Fiscal stance in the TCe TCc: Cyclically Adjusted Primary Balance (In percent of potential output) 2% 2% 0% 0% -2% -2% -4% -4% -6% -6% -8% -8% -10% -10% -12% -12% -14% -14% -16% -16% -18% -18% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Sources: TCe Authorities’ data and WB staff calculations. Note: Methodology based on Abdih, Y., Lopez-Murphey, P., Roitman, A., and R. Sahay (2010), “The Cyclicality of Fiscal Policy in the Middle East and Central Asia: Is the Current Crisis Different”, IMF Working Paper.. actions, namely the fiscal impulse.17 As shown revenues should display a more countercyclical in Figures 1.15 and 1.16, fiscal impulses stance to help the economy. In the case of (in red) have often been positive when the the TCe, aid from Turkey, for example, has economy was booming already, and negative become increasingly procyclical (Figure 1.17). when the economy was in a downturn (the The combination of aid procyclicality and the exemplary case being 2020), hence ending up strong synchronization of the business cycle in accentuating cycles. Automatic stabilizers (in the TCe with the Turkish business cycle (Figure green) should by nature react to the business 1.18) makes the support of these grants and cycle, with revenues decreasing and some loans ineffective.18 Because of its procyclicality, spending increasing in times of crisis. However, the TCe often receives aid resources when it the procyclical fiscal stance has outweighed does not need them, but is often deprived of the effect of automatic stabilizers, which these resources when it needs them most, have been small in size and in some instances further accentuating cyclicality. In other words, delayed in their response. This has reduced in good times the TCe has extra resources their effectiveness as a policy lever, pointing to that feed into more spending during periods the need to reinforce the automatic features of an already accelerating economy, creating of the tax and expenditures systems. excess demand and inflation. When Turkey is in downturn, the TCe follows suit because of Fiscal policy has been driven by the increasingly the existing ‘trade’ and financial linkages. The procyclical nature of aid from Turkey. While resulting economic difficulties may require tax revenues are intrinsically procyclical more resources for the TC administration and act as automatic stabilizers, given that to sustain economic activity. However, this personal income tax (PIT), corporate income is when aid from Turkey is most likely to be tax (CIT), and to some extent VAT, are linked reduced because of Turkey’s own challenging to economic activity and consumption, other fiscal and economic situation. 17 The fiscal impulse is defined as the change in the cyclically adjusted primary balance. When it is negative (positive), it means the cyclically adjusted primary balance has decreased (increased), including if it goes from a deficit to a larger (smaller) deficit, reflecting an expansionary (contractionary) fiscal position caused by fiscal policy with relatively less (more) tax revenue and relatively more (less) spending. 18 In general, the TCe experiences a recession whenever Turkey is in recession. There are only two episodes in which the two business cycles diverge: (i) in 1998, after the earthquake in Turkey, when the TCe did not go through a recession; and (ii) in 2020, when the TCe experienced a severe recession, while Turkey’s GDP growth remained in positive territory. l 11 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.17: Cyclicality of aid from Turkey Figure 1.18: Synchronized economic cycles, (Correlation coefficient of cyclical components 1977–2020 of TCe GDP and aid from Turkey, 10-year (Output gap in percent of potential output) moving window) TCc Output Gap Turkey Output Gap 1,0 20.0 0,8 Pro-cyclical 15.0 0,6 0,4 10.0 0,2 5.0 0,0 0.0 -0,2 -0,4 -5.0 -0,6 -10.0 -0,8 Counter-cyclical -1,0 -15.0 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Source: TCc Authorities and staff calculations. Sources: TCc Authorities, World Bank WDI, IMF WEO (Vintage Source: World Bank staff calculations based on TC ‘Ministry Source:2021) October, World Bank and staff WB staff calculations based on TC calculations. of Finance’ ‘Statistics Office’; World Bank WDI (Vintage October 2021) While loans and grants from Turkey have the basic rate of TL 1.3 per m2. Despite this been declining steadily over the past decade, increase, a typical 100 m2 home built after they remain one of the most volatile revenue 1985 would still face an annual tax bill of sources. As previously shown in Figure 1.13, aid only about US$16. On the expenditure side, from Turkey has declined over time, reaching it is largely due to high personnel costs and a record low after the 2018 TL depreciation budgeting for capital investments that were not episode and the related crisis, followed by a affordable. The result is arrear accumulation new record high set in 2020 to provide support and heavy reliance on transfers from the during the COVID-19 crisis. Moreover, almost central administration. For example, in 2019, third-quarters of the support in the past 10 fiscal transfers accounted for 54 percent of years has been in the form of defense grants, Nicosia’s recurrent revenues, 60 percent of while loans have been the primary source of Famagusta’s, 41 percent of Karavas/Alsancak’s, financing the budget deficit. Unfortunately, and 24 percent of Trikomo/Iskele’s. The recent these loans are denominated in US dollars TL depreciation has further exacerbated fiscal and, because of the continual weakening pressures facing the LCBs. In particular, local of the Turkish lira to the US dollar, so the spending on goods and services is affected sustainability of ‘public’ debt is increasingly at by the exchange rate developments, as a risk. significant proportion of goods are ‘imported’ The recent crises have exacerbated fiscal from countries other than Turkey. pressures facing the LCBs. Already prior to the global pandemic, the LCBs had been 1.3. Women and the youth under significant financial stress. On the continue to bear the brunt of revenue side, this is partly due to centrally the crisis imposed ceilings on the level of local fees and taxes, and because of the low capacity of the Despite a decline in the official unemployment LCBs to fully exploit the revenue-generating rate, both the labor force participation rate opportunities that were available within the and the employment rate highlight the major current revenue assignments. For example, impact of the crisis, particularly on women the basic rate for property tax, a potential key and the youth. While the unemployment rate revenue source for the LCBs, was not adjusted declined compared with 2020 (7.8 percent in according to inflation in the first 12 years of 2021 versus 10.1 percent in 2020), the labor its existence. Effective from January 1, 2021, force participation and employment rates both the TC administration increased the basic declined significantly, while non-participants rate by 30 percent. Thus, all houses (except in the labor force increased drastically (Figure those built before 1985) are now assessed at 1.19). The decline in labor force participation 12 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.19: Labor market statistics Figure 1.20: Employment by sector 60 20.000 110.000 51,3 51,1 50 50,9 17.500 107.500 107.518 108.125 48,1 105.112 47,3 45,9 43,8 40 40,4 15.000 105.000 12.042 13.787 12.500 13.603 102.500 30 12084 10884 10.000 10.906 100.000 20 10.104 9.303 98293 7.500 97.500 10,1 10 6,9 6,3 7,8 5.000 5.620 95.000 4478 0 4.066 2.500 3.547 92.500 2018 2019 2020 2021 0 90.000 2018 2019 2020 2021 Labor Force participation rate Employment rate Agriculture Industry Construction Services Unemployment rate Source: LFS 2021 is particularly acute in urban areas such as brunt of the crisis. Labor participation among Nicosia and Famagusta compared with rural women remains extremely low, at 35 percent, areas. When looking at sectors, services and is heavily concentrated in the services experienced a dramatic decline in number sector, where it is more than 90 percent. of workers, followed by industry, reflecting Compared with the pre-pandemic period, the the subdued recovery experienced by number of women employed has decreased these sectors, while this was only slightly the most, dropping by 11 percent compared compensated for by an increase in the number with the 2019 level, while total employment of workers in the agriculture sector. However, among men dropped by 8 percent. The as observed in other economies, there is a unemployment rate for women remains well widespread increase of self-employment, above both the EU average and the RoC. In with the share of self-employed increasing additon, the situation remains dire for the by 2 percentage points compared with 2020, youth, with youth unemployment still above reaching 18.1 percent in 2021. its pre-pandemic level, and about three times higher than the total unemployment rate, Women and the youth continue to bear the much higher than in the EU and the RoC. Figure 1.21: Employment by gender Figure 1.22: Unemployment rate, 2021 25 100.000 89.270 87.955 21,4 90.000 84.256 81.898 20 80.000 16,5 70.000 14,3 15 60.000 48.155 49.169 11 50.000 44.930 43.841 40.000 10 7,3 7,8 30.000 6,3 6,6 6,6 20.000 5 10.000 0 0 Male Female EU27 RoC Tce 2018 2019 2020 2021 Total Women Youth Source: LFS 2021, eurostat l 13 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY 1.4. The struggle of Turkish increased their online business activities, and more than two firms out of five reported having Cypriot firms to recover started or increased the delivery or carry-out Among the TC firms that have managed to of goods or services (Figure 1.24). These shares weather the crisis, about half adapted to found in the TCe are almost double those of GC the new normal through the use of online companies. With the data currently at hand, it business activities, deliveries, or remote is not possible to disentangle whether firms in work for their employees. According to the the TCe have reacted more dynamically to the World Bank Enterprise Survey (ES) Follow-Up crisis than GC firms, or whether their starting conducted in 2021 (see Box 1.2) more than one levels were significantly lower. This pattern year after the COVID-19 outbreak, 3.4 percent is not confirmed when focusing on the share of private firms in the TCe were confirmed to of firms that started or increased remote have permanently closed since the pandemic working: percentages are higher for GC firms (41.7 percent) than for TC firms (31.7 percent). was first declared (Figure 1.23). Slightly more than half of private firms in the TCe started or Box 1.2: Enterprise Survey and Follow-Ups - Methodology The World Bank conducted three rounds of follow-up surveys to its Enterprise Survey (ES) aimed at measuring the evolving impact of the COVID-19 pandemic on the TC private sector. Using the data collected in the ES over three rounds of follow-up surveys, it is possible to monitor the effects of the COVID-19 crisis more than one year after the declaration of the pandemic by the World Health Organization. Understanding the impact of the crisis on businesses, and subsequently understanding how firms are recovering, provides insights into the overall health of the economy. Business owners and senior managers of 120 establishments were interviewed between January 2019 and May 2019 as part of the standard ES. Follow-up interviews were conducted in June 2020 (round 1), between November and December 2020 (round 2), and in April 2021 (round 3) by telephone and internet. The universe of inference of the ES includes all registered establishments with five or more employees that are engaged in one of the following activities defined using the International Standard Industrial Classification developed by the United Nations (ISIC Rev. 3.1): manufacturing (group D); construction (group F); wholesale and retail trade, repair of motor vehicles, motorcycles and personal and household goods (group G); hotels and restaurants (group H); transport, storage, and communications (group I); and information technology (division 72 of group K). The universe excludes firms with 100 percent ‘public’ ownership and cooperatives. Establishments are selected to participate in the ES using a stratified random sampling methodology: all population units are classified within homogeneous groups, determined on the basis of establishments’ size and sector, and simple random samples are selected within each group. An establishment’s size is defined in terms of its full-time equivalent workforce as follows: small establishments (5 to 19 employees), medium establishments (20 to 99 employees), and large establishments (100+ employees). The follow-up interviews were implemented via Computer Assisted Telephone Interviews (CATI) and Computer Assisted Web Interviews (CAWI). March 2021 is the reference month for most of the questions of the third round of the impact survey. All the interviews were conducted in the Turkish language with an average duration of 18 minutes. In total, 87 establishments were re-contacted to complete the third round of the follow- up surveys, of which five had permanently discontinued their business activities and two 14 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY were temporarily closed. The realized sample of establishments that completed the follow- up survey comprises 43 small establishments, 36 medium establishments, and eight large establishments. In terms of business activities, 29 establishments are manufacturing firms, while 58 are service providers (of which 19 are retailers and four are hotels or restaurants). Survey weights are calculated and applied to all statistics discussed below. Weights ensure that estimates are inferences with a pre-determined level of precision to the universe of the ES. The full dataset is available on the Enterprise Survey web portal. Timeline of Enterprise Survey Follow-Ups Figure 1.23: Share of firms confirmed Figure 1.24: Adapting to the new normal permanently closed for TC and GC economies 8 60 54,3 50 42,6 41,7 6 40 30,0 31,7 4,3 30 3,7 20,8 4 3,4 3,4 20 2,5 10 2 0,9 0 0,2 0,0 0,0 0,0 0,2 % of firms that started or % of firms that started or % of firms that started or 0 increased online business increased delivery of goods, increased remote work Overall Small Medium Large Manuf. Serv. activity services or carryout TC Economy ROC Economy TC Economy ROC Economy Source: World Bank Enterprise Survey. Firms that have managed to weather the of the downsizing, followed by small size crisis are now on their way to recovery, but at and large firms. Manufacturers experienced a significant cost to employment. While in the higher staff reductions than service providers first round of the survey the average change (Figure 1.26). Direct and indirect factors have in sales was registered at -30.2 percent, the contributed to the shrinking of the permanent revenue losses had halved in 2021, at only full-time workforce: beyond the effects -17.1 percent compared with pre-crisis (Figure caused by the health crisis on family needs, 1.25). However, the change in employment restrictions on mobility due to health risks, as levels for the average firm is significant, at well as unemployment or under-employment more than 20 percent, compared with pre- due to decreased economic activity, have pandemic. Medium-sized firms bore the brunt reshaped the workforce. l 15 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.25: Average change in monthly sales Figure 1.26: Percentage change of permanent compared with prior year for the three rounds of full-time workers since December 2019 the surveys (percent) TC Economy Small Medium Large Manuf. Services 0 TC Economy Small Medium Large Manufacturing Services 0 -5 -2,0 % Change in sales -10 -5 -10 -20 -14 -11 -17 -20 -15 -30 -24 -23 -22 -22 -26 -24 -28 -24 -16,6 -40 -30 -32 -31 -20 -18,2 -39 -50 -25 -22,7 R-1 R-2 R-3 -30 -35 -32,5 -40 -36,2 Source: World Bank Enterprise Survey. The financial distress among firms in the reaching 69 percent (Figure 1.27). Looking at TCe has continued increasing, especially for the categories that suffered lengthier receipt small firms and manufacturers, as payments of payments, it emerges that the payments have been delayed along the value chain. to suppliers are the ones delayed by the The reduction of cash flow availability has majority of firms, followed by payments to tax been nearly ubiquitous, with 93.5 percent authorities and to landlords (Figure 1.28). of firms experiencing decreased liquidity since the start of the pandemic. One of the In line with other economies, policymakers consequences of the widespread reduction with support from development partners have in liquidity is an increased share of firms that introduced measures aimed at countering the have had to postpone the payment of some economic effects of the pandemic, but these of their obligations. With the only exception measures have been limited and ineffective. being large firms, the share of firms unable Looking at the cumulative support received— to make payments without delays increased or expected in the three months following considerably in the first quarter of 2021, the interview—between the outbreak and Figure 1.27: Share of firms delaying payments Figure 1.28: Percentage of firms delaying for more than one week due to the pandemic payments to suppliers, landlords, and tax (%) by rounds authorities TC Economy 80 69 73 75 72 74 56 66 65 68 56 60 57 58 60 59 60 52 54 Services 34 Small(5-20) 56 53 42 42 37 35 26 40 31 32 14 7 17 20 32 7 22 56 63 0 Manufacturing Medium(20-99) TC Economy Small Medium Large Manufacturing Services 54 R-1 R-2 R-3 Large(100+) Suppliers Landlords Tax Authorities Source: World Bank Enterprise Survey. 16 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY April 2021, more than four firms out of higher than those of men-led firms. Moreover, five benefited from at least one measure, women-led businesses were less likely to including cash transfers for businesses, report receiving central or local ‘public’ deferral of credit payments, suspension of assistance, with only 54.8 percent among interest payments, access to new credit, tax women-led firms versus 84.2 percent among deferrals or reduction, wage subsidies, and men-led firms reporting receiving ‘public’ technical support for the adoption of digital assistance. technologies.19 No significant differences emerge between sectors, although smaller 1.5. The outlook, the risks firms tend to benefit less from ‘public’ support and the way forward than medium and large firms. However, most of the measures introduced in 2020 have now The near-term outlook is weaker than been phased out,20 with the exclusion of loan previously projected, owing to recurrent support, support to social security payments, COVID-19 flare-ups, the direct and indirect and sector-specific support, which have been consequences of the war in Ukraine, and maintained throughout 2021 and into 2022. increasing inflation, uncertainties, and The EU made available €7.2 million grant risks. The extremely high level of uncertainty support for small and medium enterprises regarding the future weakness of the Turkish (SMEs) in two phases through the Innovative lira and the impact this could have on inflation Entrepreneurship program implemented by are casting a long shadow over the forecast the NI-CO team, in addition to support to for 2022. The ongoing war in Ukraine is also micro businesses.21 Turkey made available expected to have direct and indirect impacts TL 9 million (equivalent to €0.4 million) on the TCe, mostly through the trade channel, grant support for SMEs. The Call for Proposals and increased prices and uncertainty (see Box was launched by the ‘Ministry of Economy’ in cooperation with the Republic of Turkey 1.3). Output is expected to remain below the Development and Economic Cooperation pre-pandemic trend, and a convergence of per Office (KEI) in three priority areas, namely: (i) capita income with the RoC and EU economies, enhancing competitiveness; (ii) improving already diverging since 2011 (Figure 1.29), ‘tourism’ potential; and (iii) agriculture and is not expected to occur in the near future. rural development.22 The downgrade of the forecast also depends on the expected withdrawal of fiscal support Women-led firms have experienced a higher due to limited fiscal space and declining aid likelihood of exiting the market and a lower as a consequence of the current economic likelihood of receiving ‘public’ support situation and mounting fiscal risks in Turkey,23 measures. Fifteen firms out of the 87 that completed the third round of data collection together with the weakening of external in the TCe are managed by women (three demand. According to the latest projections24 manufacturers, two retailers, and 10 providers growth in 2022 in Turkey is expected to of other services). Given the small sample, decelerate significantly from 11 to 2 percent. these statistics should be considered indicative Economies in the Euro area, including the and should not be used to draw conclusive RoC, and in the Middle East and North Africa, inferences. However, the confirmed exit rates are expected to experience sustained growth among women-led firms tend to be 14 percent at 4.2 and 4.4 percent, respectively,25 but 19 In terms of the type of benefit received, wage subsidies have been the modal measure more often granted (76.6 percent), followed by fiscal relief (38.5 percent), access to new credit (16.5 percent), deferral of payments (11.3 percent), and cash transfers (2.1 percent). 20 The 2021 Macroeconomic Monitoring Report provides a detailed list of measures adopted during the pandemic. 21 For more details: https://www.inovatif.eu/activity/safeguarding-and-creating-employment-package/ 22 For more details: https://kei.gov.tr/cka-destekli-hibe-programlari 23 World Bank. 2022. Turkey Economic Monitor. Sailing Against the Tide. Washington, DC: World Bank. 24 World Bank. 2022. Turkey Economic Monitor. Sailing Against the Tide. Washington, DC: World Bank. 25 World Bank. 2022. Global Economic Prospects, January 2022. Washington, DC: World Bank. World Bank. l 17 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 1.29: Income convergence between TCe and other economies Income convergence GNI per capita, Atlas method($US) 14 50 Binler 12 45 10 40 8 Percent 35 6 30 4 2 25 0 20 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 TC income per capita High-income threshold Upper middle-income threshold TC-GC relative per capita income(right) TC-EU relative per capita income(right) Source: World Bank staff calculations. projections are likely to be revised downward points above the average observed in the as the consequences of the recent war in pre-pandemic period, thereby contributing Ukraine unfold. significantly to the observed, yet modest, recovery. However, in 2022, low economic The recovery is expected to remain not only growth, continued TL depreciation, and high subdued, but also uneven, with income inflation may further erode the real incomes gaps further widening both within the TCe of Turkish consumers, reducing their spending and across the island. Women comprised ability.26 76 percent of the job losses in 2020 due to the pandemic, and they continue to bear Key risks to the outlook include both domestic the brunt of the crisis in 2021. The situation and external factors. Meanwhile, a further may be exacerbated in the near future by resurgence of the pandemic, financial stress, key sectors with high female representation, rising inflation, in particular for food and energy, such as services, lagging behind. Expected and fiscal pressures pose substantial domestic subdued growth may also further widen the risks to the downside. And the financial gap between TC and GC per capita income. risks are expected to grow due to increasing financial liabilities in key economic sectors. In While the ‘tourism’ sector may benefit from the context of continued TL depreciation and restored mobility and TL exchange rate rising inflation, non-performing loans may also depreciation, proceeds may be reduced by increase, and be higher than accounted for. high inflation. With the acceleration of vaccine The increased debt burden may put additional rollouts and assuming no new restrictions financial pressure on households and firms. on international mobility, ‘tourism’ may Climate risks, exposure to natural disaster, contribute significantly to the rebound in the and energy security also constitute signifcant TCe. However, the return to the pre-COVID-19 downward risks to the outlook. An escalation level of tourist arrivals – as observed in the of the war in Ukraine – may lead to further month of January 2022 – may not be sufficient weakening of external demand, as well as a to restore the overall revenues from the further increase in prices and uncertainty. sector. Further TL depreciation may compress Deteriorating external conditions and renewed the purchasing power of ‘tourists’ from geopolitical uncertainty risk jeopardizing the Turkey, who accounted for two thirds of all recovery through subdued ‘exports’ of goods overnight stays in 2021. This is 20 percentage and services, and through declining private 26 World Bank. 2022. Turkey Economic Monitor. Sailing Against the Tide. Washington, DC: World Bank. 18 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Box 1.3: The economic impact of the war in Ukraine on the TCe The impact of the war in Ukraine is expected to percolate through the TCe directly due to its ‘trade’ exposure to the Russian Federation and Ukraine, and indirectly through the effect on key trading partners’ economies. The still fragile recovery and weak fiscal situation expose the TCe to vulnerabilities from a potential slowdown of the economies of key trading partners, such as the RoC and Turkey, with significant implications for households and firms. Direct impact. Disruptions to the supply of food, energy and commodity imports from Ukraine and the Russian Federation are expected to lead to a further increase in prices. On the ‘import’ side, the TCe depends on Ukraine and the Russian Federatiıon for key imports: animal feed is the fourth most important import in 2021. Other relevant food imports from the affected areas are barley, corn and wheat. Moreover, the impact of the increase in fuel prices is expected be substantial in the TCe, since more than 90 percent of electricity is generated by using oil fuels.27 In February 2022, annual food inflation reached 77.5 percent, and petrol and electricity prices recorded a 29.1 and 115 percent (on average) rise since January, respectively. On the ‘export’ side, almost 10 percent of TC ‘exports’ are destined for the Russian Federation, particularly agricultural products such as citrus fruit. Finally, ‘tourism’ will also be affected, with the Russian Federation accounting for 7 percent of ‘tourist’ arrivals in the TCe in 2019. Indirect impact. The TCe is also vulnerable to the depressed demand of key trading partners, also highly affected by the war in Ukraine, as well as to reduced purchasing power because of high inflation. In particular, both the RoC and Turkey are highly exposed to Ukraine and to the Russian Federation, not only through the trade channel but also through the financial channel. Turkey’s financial sector, in particular, is exposed to significant indirect risks, including flight-to-safety risks resulting in bond yield increases, equity market volatility, and further TL depreciation and inflation. The combination of the above channels is expected to significantly decelerate growth with a heterogenous impact across the population. The poor are expected to be disproportionately impacted, especially from higher energy and food prices. Those sectors and firms that are most exposed to ‘trade’ and ‘tourism’ are also expected to bear the brunt of the crisis. Macro- fiscal implications are also expected to be significant. Fiscal balances will be affected, not only by reduced revenue but also by increased spending to support affected households and firms, especially as energy prices continue to rise. With a high wage bill and wage indexation, increased inflation will push spending even more up, squeezing fiscal resources for ‘public’ investment and other development priorities. Contingent liabilities are expected to increase. Further TL depreciation, increased spending, reduced growth, and increased interest rates will likely offset the impact of high inflation on ‘public’ debt. investment. Additional stress on the Turkish Implementing a coherent macro-fiscal economy could be further amplified in the framework for a resilient economy is a TCe. While the ‘tourism’ sector may benefit key priority going forward. The COVID-19 pandemic and the TL depreciation have had from restored mobility, revenues may be a major impact on the TCe. The economic reduced by the exchange rate depreciation structure of the TCe is heavily tilted toward and high inflation. 27 ‘tourism’—the sector hardest hit by the 2020 27 https://www.kibtek.com/wp-content/uploads/Statistikler/2021statistic.pdf) l 19 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY crisis—which accounted for 22 percent of fiscal incidence, and the incentive system; (ii) the TCe’s pre-COVID-19 pandemic GDP. Not designing and introducing a cyclical-adjusted only ‘tourism’ has a strong direct relevance fiscal rule and fiscal council to help monitor for the TCe, but also strong indirect linkages and guarantee fiscal sustainability and with other sectors of the economy, as proven macroeconomic management; (iii) enhancing by the fact that the TCe’s GDP growth shows domestic mobilization, including through a significant correlation with gross value- reforming income tax and broadening the added growth of ‘tourism’, with a correlation revenue base of the LCBs, including through coefficient of 90 percent. At the same reforming property taxes; (iv) improving time, the TCe economy is highly vulnerable ‘public’ debt management by developing to external shocks, due to its low level of a servicing plan for the ‘public’ debt and diversification both in terms of products and mitigating exchange rate risks; and (v) taking trading partners, with Turkey accounting for stock of arrears and contingent liabilities, 690 out of 705 ‘imported’ products in 2018, 50 and developing a reporting and monitoring percent of ‘exports’ and almost 80 percent of mechanism to avoid their future build-up. In ‘tourist’ arrivals. However, the poor economic the medium term, a broader reform of both the performance of the TCe is a reflection not revenue and spending frameworks, together only of the economic structure but also of with a broader strategy to support private the limited capacity of macro-fiscal policies sector development, is needed to achieve for to promote resilience and respond to shocks. a more growth-friendly and sustainable fiscal The current macroeconomic framework, policy. which entails the use of the Turkish lira is transmitting macroeconomic volatility and A reform of the incentive system should be inflation into the TCe rather than providing part of a broader strategy to promote private a nominal anchor. In an economy without an sector development. Instead of focusing independent monetary policy, fiscal policy on comprehensive reform of the business is the only lever to mitigate the impact of environment, the TC administration has used shocks. However, fiscal policy is increasingly subsidies to compensate for the poor business procyclical, amplifying the cycle with booms climate and, in particular, limited access to and busts, to the detriment of its effectiveness. finance. This has proven to be ineffective Spending is heavily tilted toward rigid items, and costly, with an adverse impact on market particularly ‘public’ wages, creating structural dynamics, resulting in lower productivity and deficits and further reducing the fiscal space competitiveness. It is paramount to develop to counteract the emergence of a crisis and to a system to track business incentives and promote diversification. For example, at 1.1 their beneficiaries, accompanied by periodic percent of GDP, well above the EU average expenditure reports on the incentive structure of 0.36 percent, generous and ineffective cost. It is also important to set a consistent agriculture subsidies are placing an increasing monitoring and evaluation framework to track pressure on the budget and diverting precious progress, and to assess the costs and benefits resources away from priority spending, such of both current and proposed programs. as infrastructure.28 Going forward, reforming the incentive system should aim at consolidating and aligning them A key priority for the administration going to the EU Acquis. forward should be the amendment of the objectives, stance and composition of A rules-based fiscal framework should be fiscal policy to promote the creation of a designed that is tailored to the TCe’s specific more resilient economy. In the short term, circumstances. Fiscal rules are long-term this includes: (i) conducting a fully-fledged numerical constraints on fiscal aggregates, ‘public’ finance review, including tax policy such as the ‘public’ debt or deficit, or growth and tax expenditure, ‘public’ expenditure, of its spending, or spending components. 28 Please refer to the World Bank, 2021 Macroeconomic Monitoring Report for the TCe for further details. 20 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Based on the available information at the could help strengthen the LCBs’ finances. IMF Database,29 the number of economies A reform to expand the property tax base, that have adopted at least one fiscal rule rose through an increase in the tax rate, as well as from nine in 1985 to 109 in 2021. The average a switch to property valuation as a tax basis, number of fiscal rules per economy has also combined with a reform of the transfer system, increased during the past two decades, could be a first step toward stronger local with about three fiscal rules per economy, finances. A reform of the property tax system particularly in Europe, where many economies is an attractive solution in ensuring a stable have adopted their own national rules along source of revenue for the LCBs, especially for with the supranational rules. Economies financing municipal services, alleviating budget design fiscal rules tailored to their own specific pressures, and reducing the need for transfers. circumstances. The most common rule is a Further work would be needed to implement combination of a debt rule with operational this reform, including improving the quality of limits on annual budget aggregates. Fiscal land registration and ensuring the availability councils represent another pillar of the rules- of up-to-date information on property values. based fiscal framework, with a mandate Concerning inter-‘governmental’ transfers, to assess fiscal plans and performance, the total amount to be distributed is currently evaluate macroeconomic and budgetary determined as a percentage of projected forecasts, and monitor the implementation central administration domestic revenues, of fiscal rules and the cost of the measures. This is at present equal to 9.25 percent of Although put under stress by the COVID-19 central administration domestic revenues and pandemic, and unable to fully prevent large is distributed among the LCBs on the basis of and persistent debt build-ups, fiscal rules have population, as determined by the 2011 census. allowed economies to respond to the crisis. A reform of the transfer system toward a In particular, economies with a good track multi-dimension, performance-based model is record regarding fiscal rules seem to be able to also needed to strengthen the LCBs’ finances respond more aggressively during a crisis.30 A as well as address regional disparities among phased approach could be adopted in the TCe the LCBs. that would help define the appropriate design. Addressing the sources of vulnerability will For example, a medium-term fiscal framework also make the TCe and its private sector to: (i) plan budget beyond the current fiscal more competitive. The effects of fiscal and year; and (ii) a reserve/contingency fund monetary policies filter down through all levels with the specific purpose of supplementing of the economy; businesses and consumers fiscal resources in case of a crisis and with are affected, on the one hand, by spending resources accumulated during economic and taxation decisions and, on the other booms through a fiscal rule that would limit hand, through interest and exchange rates. specific components of recurrent spending or At the same time, the business environment aggregates could be initial steps toward a rule- in which TC firms operate plays a key role, based fiscal framework. A phased and tailored not only in enhancing productivity, creating approach would also contribute toward good jobs, and attracting investment but building the ownership in, and credibility, of also for economic diversification, reducing the framework, both essential characteristics vulnerabilities to external shocks that stem for it to work, while providing the framework from a narrow production base. Addressing with the adequate flexibility needed by an the prolonged neglect of much needed economy that is highly vulnerable to external structural reforms is paramount for the TCe shocks. to seize the opportunities that the global A reform of the property tax and the economy offers, particularly the EU. Structural introduction of a modern transfer system reforms are key to unlocking the full potential 29 https://www.imf.org/external/datamapper/FiscalRules/map/map.htm 30 Davoodi H. R., P. Elger, A. Fotiou, D. Garcia-Macia, X. Han, A. Lagerborg, W.R. Lam, and P. Medas. 2022. Fiscal Rules and Fiscal Councils: Recent Trends and Performance during the Pandemic. IMF Working Paper No.22/11, International Monetary Fund, Washington, DC. l 21 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Table 1.1: Key economic indicators of the TC economy 2018 2019 2020 2021e 2022f Real economy Real GDP, % change 1.3 0.2 -16.2 4.0 0.4 Agriculture, % volume change 2.6 2.7 1.8 -4.0 2.0 Industry, % volume change -12.4 -14.6 -15.0 3.5 -5.0 Services, % volume change 3.2 1.4 -18.4 5.2 1.0 CPI (pa), year average, % change 23.1 19.5 11.7 21.1 50.0 Fiscal accounts     Revenues, % GDP 29.8 34.6 35.5 33.2 28.8 Expenditures, % GDP 29.8 35.9 40.6 38.5 35.6 Capital, % GDP 2.3 1.1 3.3 5.0 2.9 Fiscal Balance, % GDP 0.1 -1.3 -5.2 -5.3 -6.9 excluding foreign aid, % GDP -2.4 -4.0 -10.1 -10.3 -9.8 Local Balancea, % GDP 0.9 -0.5 -3.5 -2.8 -4.0 Financing, percent GDP -0.1 1.3 5.2 5.3 6.9 External, % GDP 0.2 0.0 2.6 1.8 3.2 Internal, % GDP -0.3 1.3 2.5 3.5 3.7 Public and public guarantees debt, % GDP 110.8 96.2 101.3 85.8 71.4 Internal, % GDP 33.4 29.9 32.4 29.3 25.7 Balance of Payments     Current Account Balance, % GDP 5.7 5.9 -12.4 -13.6 -16.0 Excl. foreign grants, % GDP 3.3 3.2 -17.4 -18.6 -19.0 Net merchandise ‘exports’, % GDP -45.3 -40.1 -36.7 -46.6 -54.9 Net services ‘exports’ and other transfers, % GDP 50.9 45.9 24.3 33.0 38.9 Source: ‘SPO’, ‘Statistics Office’ and World Bank staff. Note: e=estimate; f=forecast Forecast may be subject to revision as data for 2022 become available. a Local Balance is computed as the difference between local revenues (total revenues, excluding grants from Turkey) and local expenditures (total expenditures, excluding the ones financed by Turkey). of the private sector by helping the structural of building competitiveness, as well as transformation of the economy and allowing promoting economic integration with the human and financial capital to flow into sectors GC economy, with a deep dive on halloumi/ in which the TCe has comparative advantages, hellim. Section 2.3 concludes with a focus on and into those firms within sectors that are which specific policies could be put in place to more productive and innovative. Chapter 2 support the private sector. investigates the opportunities and challenges 22 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Chapter 2: Special Issue: Enhancing competitiveness and promoting economic integration31 2.1 The opportunities for apply reciprocal restrictions on a number of products. For instance, the RoC continues to Greek Cypriot and Turkish not authorize the crossing of TC commercial Cypriot firms 31 vehicles above 7.5 tons or processed food Despite the potential in terms of economic products due to health concerns. The TCe and social benefits, the GC and TC economies also applies similar restrictions on goods have a relatively low level of economic accessing the TCe from the RoC. Moreover, integration, with the 2004 Green Line (GL) goods can only be traded from RoC-controlled Regulation setting out the terms under areas to the TCe once a licence or permit which locally produced goods in the TCe have been issued. This regime is, however, can cross the GL separating the two. The GL not always consistently applied. Finally, there Regulation (Council Regulation No. 866/2004 is a considerable level of smuggling of goods, on April 29, 2004) came into effect on May 1, reflecting the difficulty of controlling irregular 2004, and defines the terms under which the movements across the GL. For these reasons, provisions of EU law apply to the movement current GL trade (and related data), both its of persons, goods, and services across the volume and composition, represents a small Green Line from the TCe to the RoC. With fraction of the productive capabilities and respect to the movement of goods, the GL possibilities for trade between the GC and TC Regulation both: (i) defines regulations and economies. restrictions on trade across the GL from the Increased economic integration could TCe to RoC; and (ii) aims to promote trade bring many opportunities. With increased between both areas of the island for the sake economic integration, both the GC and TC of regional economic integration. According to economies could expand intra-island trade, as the available statistics, the total trade value of well as trade with external trading partners, goods with accompanying documents crossing and move into new products. Moreover, while the GL in 2020 was low, at only €4.7 million. both the TCe and the RoC could ultimately Plastic products were the most traded item, benefit from a reduction of the negative followed by fresh fish, construction materials, effects of socioeconomic separation, the and prefabricated containers. Although not TCe has significant opportunities to catch up covered by the scope of the GL Regulation, economically with the productive capabilities trade from the RoC to the TCe decreased by and knowledge-intensiveness of the RoC. around 7 percent in 2020, reaching around While many studies have concluded that €0.7 million, and equivalent to about 15 economic integration could benefit both sides percent of the trade in the opposite direction in terms of political stability, reduced external (COM, 2021). vulnerability, and economic development, there is little discussion of how economic A set of local restrictions (in addition to the integration could actually be promoted and GL Regulation) significantly hampers the which opportunities should be supported. amount and type of trade across the GL. Local trade barriers stemming from logistics, At the product-level, there is a need to finance, taxation, phyto-sanitary standards, quantify the opportunities by identifying and entry restrictions severely constrain the those products that would help achieve a movement of goods from the RoC and the greater level of economic integration. First, TCe (COM, 2021). Both the RoC and the TCe there are the most complex and related 31 The Special Issue is based on the paper “Stronger together: Opportunities for mutual learning, economic integration, and productive sophistication between the Republic of Cyprus and the Turkish Cypriot Economy” by Flávio L. Pinheiro, Elena Bucea, and Dominik Hartmann (forthcoming) and on the paper “An analysis of competitiveness of the Turkish Cypriot Economy” by Gianluca Santoni (forthcoming). l 23 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Box 2.1: Definitions 1. Complexity: This is a measure of the knowledge intensity associated with a product (Product Complexity Index, or PCI), or a basket of products produced and exported by an economy (Economic Complexity Index, or ECI), using information on whether many economies are able to produce such a good/basket of goods or only a few highly diversified and sophisticated economies have such a capacity. The PCI is determined by calculating the average knowledge intensity of economies that make a specific product, while the ECI is the average knowledge intensity of the products that an economy exports, providing an indication of how diversified and sophisticated the production structure of an economy is. 2. Product Space: The product space is a network connecting pairs of products that economies tend to export together and it helps visualize what an economy is able to make, what products are nearby (at a short distance) that depend on similar know- how to that which currently exists, and to define paths to diversification. By using export data over time, the shape of the product space tells also how diversification works in practice, with economies moving from things they know how to do, to things that are, in general, related. Promoting wrong activities in the wrong moment—e.g. simple products in the periphery of the product space or promoting highly unrelated activities at low stages of development — can be both costly and undermine long- term development prospects (Pinheiro et al., 2021). 3. Relatedness: This is a measure of how close a new potential product is to the current export basket (and production structure) of an economy. It has been shown that economies and regions do not randomly jump into new products but tend to move into related products that have similar technologies and productive capabilities to existing products that an economy has already mastered. It is measured by estimating the density or the number of products in an economy’s export basket that are connected to a potential new product. 4. Revealed Comparative Advantage, or RCA and import RCA (iRCA): An economy is considered to have an RCA in a product if the share of that product in its export portfolio is greater than the selected product’s global export share, or if the ratio between the two shares is greater than or equal to 1. A similar measure is used to define the most relevant imports for an economy, by comparing the weight of imports of a specific product in an economy compared with the world share. The background paper provides detail on the methodology to compute each of the above- mentioned measures. More information is also available at: https://atlas.cid.harvard.edu/ glossary products from which either side can learn that would allow both economies to move from the other, by acquiring the productive into more complex products — the synergy capabilities associated with those products channel. Box 2.1 provides the key definitions in which the other economy has comparative of the main concepts/variables used in this advantage —the knowledge spillover analysis. channel; second, there are those products that are currently imported from other third Currently, the two economies differ economies that could be supplied within the significantly in terms of trading partners. island — the within-island trade integration Despite being located on the same island in and sophistication channel; and, third, there the eastern Mediterranean Sea, and thus are the complementary productive capabilities having similar climate conditions and distances 24 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Box 2.2: Data International trade data, including those relating to the RoC, come from the Harvard Atlas of Economic Complexity (http://atlas.cid.harvard.edu/). At the time of writing this report, the dataset covers between 1995 and 2018 and provides information on the volume of exports of 238 economies aggregated by product. Products are classified using the 4-digit HS6 revi- sion 1992 classification. The dataset includes a total of 1,242 different products. To obtain comparable and robust results, the analysis is limited to the 130 economies reported in the ATLAS economy complexity ranking of 2014. After applying this filter, the dataset covers 94.9 percent of world trade in 2014. This dataset will be used to estimate the share of each prod- uct in world trade and the Product Complexity Index (PCI). The latter will be used to estimate the Economic Complexity Index (ECI) of the TCe and the RoC. Bilateral ‘trade’ data at prod- uct-level compiled for the TCe are provided by the TCe ‘Department of Trade’ and span from 2014 to 2018, in alignment with timespan of the used international data from the dataset available at Harvard Atlas of Economic Complexity. Products are classified using the 4-digit HS6 revision 1992 classification. For this analysis based on economic complexity, Green Line trade data are excluded for several reasons, including that current GL trade is strongly affect- ed by regulations, policies, and entry barriers and, as a result, it cannot be assumed that GL trade represents fully the productive capabilities of either side. to trade partners, such as those in the EU The RoC exports a significantly larger number or the Middle East, the two economies have of products with an RCA than the TCe, namely significantly different trade partners. The TCe 228 versus 35 products, respectively. While is more strongly integrated with Turkey, while the TCe is more reliant on simple agricultural the RoC is more closely integrated with the EU or processed products, such as cheese, liquors, and other economies worldwide. building stones or men’s shirts, the RoC shows The number of products in which the RoC a greater variety of more complex products, has a revealed comparative advantage (RCA) including some chemical and manufacturing is 6.5 times higher than for the TCe, while products. Despite the RoC’s higher relative the overall economic complexity is almost level of economic complexity (Figure 2.1), 4 times higher. Not only do their trading its product space also shows a high level of partners differ significantly, but so do the type fragmentation and significant dependence and complexity of products in which the two on low to intermediately complex products. economies have an RCA. As described in Box As such, the RoC is still far from achieving 2.1, an economy is considered to have an RCA the productive focus of more advanced in a product if the share of that product in economies, such as Germany, the Republic of its export portfolio is greater than the select South Korea, or Singapore, on mainly complex product’s export share in the world market. products. l 25 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 2.1: The product space of the RoC and the TCe, 2018 Turkish Cypriot (2018) Wool Scrapped Iron Non-knit Men’s Shirts Eggs Legend Metals Mineral Products Wood Products Weapons Cheese Machines Instruments Poultry Meat Hard Liquor Raw Tobacco Buiding Stone Stone and Glass Greek Cypriot (2018) Precious Metals Chlorides Sound Arts and Antiques Scrap Iron Recordings Surveying Equipment Ceramic Foodstuffs Tableware Footwear & Headweear Cement Paper Goods Perfume Plants Vegetable Products Animal & Vegetable Bi-Products Animal Hides Miscellaneous Plastics & Rubbers Chemical Products Animal Products Textiles Sound Recording Liquid Dispersing Equipment Machines Scrap Plastic Textille Footwear Transportation Dairy Machines Source: Authors’ calculations. Note: Products in which each region has RCAs are colored according to the Leamer (1984) product classification system. For visualisation purposes, the network only contains 846 of the 1,242 products considered in the analysis. 26 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 2.2: Economic complexity ranking of the RoC, the TCe, and other economies Source: Economic complexity, authors’ calculations. The TCe could learn from more than 200 not. In other words, there are 207 learning products in which GCe has RCA, and this opportunities for TC companies to learn from would increase the overall complexity and GC companies. However, not all products are sophistication of the goods produced by equally feasible. First, only for a subset of the TCe. While the TCe currently only has 15 these 207 products does the TCe display any products with an RCA that could be learned by comparative advantage in producing these the RoC, it has significant potential to acquire products. Second, not all products would bring the necessary knowledge, technologies the same gains in terms of increased economic and productive capabilities to diversify its complexity that would unlock the possibility production structure and become more to move up the value chain, especially as the complex. There exist 207 products for which economic structure of the TCe is tilted toward the RoC has an RCA, while the TCe does simpler goods. Table 2.2, for example, shows Table 2.1: Learning candidates for the RoC from the TCe that would bring the highest gains, measured in terms of increased relatedness to complex activities. Description Relatedness Product Complexity RCA Gains Metal Signs 0,195 0,407 0,032 0,54% Preserved Meat 0,196 0,318 0,218 0,54% Ceramic Bricks 0,208 -0,048 0,000 0,49% Glazed Ceramics 0,203 -0,684 0,000 0,45% Scrap Rubber 0,220 -0,483 0,823 0,44% Ice Cream 0,227 -0,145 0,866 0,44% Eggs 0,223 -0,541 0,323 0,42% Pickled Foods 0,230 -0,789 0,901 0,38% Building Stone 0,205 -0,942 0,457 0,37% Buckwheat 0,233 -1,285 0,412 0,33% Prepared Explosives 0,233 -0,984 0,000 0,31% Non-Knit Men’s Shirts 0,218 -1,430 0,066 0,29% Raw Tobacco 0,235 -1,730 0,072 0,25% Wool 0,217 -1,653 0,921 0,21% Source: Authors’ calculations. Note: Relatedness measures how close a new potential product is to the current export basket (and production structure) of an economy, with a range 0-1 (the higher, the closer). Product complexity measures the knowledge intensity associated with the product, with positive (negative) values associated with more (less) complex. RCA is a proxy of the competitiveness of an economy of producing a selected product, measured as the share of that product in its export portfolio compared with the selected product’s global export share. The economy has a revealed comparative advantage if RCA>1. Finally, gains are measured in terms of increased relatedness to complex products l 27 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Table 2.2: Learning candidates for the TCe from the RoC that would bring the highest gains, measured in terms of increased relatedness to complex activities, or would be the most feasible Highest Gains Description Relatedness Product Complexity RCA Gains Shaped Paper 0,026 0,602 0,000 3,97% Other Furniture 0,030 0,538 0,006 3,93% Chemically Pure Sugars 0,021 0,460 0,000 3,92% Plastic Building Materials 0,035 0,464 0,000 3,79% Centrifuges 0,026 0,962 0,000 3,66% Most Feasible Description Relatedness Product Complexity RCA Gains Animal Organs 0,042 -0,801 0,962 3,17% Flavored Water 0,051 -0,414 0,479 2,53% Fruit Juice 0,051 -1,014 0,382 2,66% Plastic Pipes 0,041 -0,154 0,233 2,88% Pure Olive Oil 0,034 -0,863 0,120 2,06% Source: Authors’ calculations. Note: Relatedness measures how close a new potential product is to the current export basket (and production structure) of an economy, with a range 0-1 (the higher, the closer). Product complexity measures the knowledge intensity associated with the product, with positive (negative) values associated with more (less) complex. RCA is a proxy of the competitiveness of an economy of producing a selected product, measured as the share of that product in its export portfolio compared with the selected product’s global export share. The economy has a revealed comparative advantage if RCA>1. Finally, gains are measured in terms of increased relatedness to complex products. the Top 5 products that would provide the percent of gains in their relatedness to complex highest gains for the TCe in terms of capturing activities. Conversely, GC companies can the necessary knowledge, technologies benefit from a greater degree by supplying TC and productive capabilities to build its companies with products currently imported comparative advantages and become capable by other third economies. In particular, there of producing more sophisticated and complex are 58 products in which the RoC has an RCA new products in the future. The bottom part and are relevant imports for the TCe (i.e., in of the table shows the Top 5 products in which which the TCe has an import RCA). Table 2.3 the TCe already has an RCA and therefore provides a list of the most relevant imports are the most feasible to produce today, given for the TCe—namely those goods that are in the TCe’s current knowledge, technologies higher demand in TCe than expected given the and productive capabilities. However, while world’s average, in other words with a positive these products are the most feasible, they import RCA. There could be potential for some will provide fewer gains in terms of acquiring of these products to be supplied by the RoC. knowledge, technologies and productive Moreover, activities that could be sourced capabilities. from the RoC to the TCe have a comparatively higher level of product complexity than the GC companies would primarily benefit from ones that the TCe can supply to the RoC. supplying products to TC companies and, In principle, increasing within-island trade to lesser extent, from learning from some could be cost-effective by reducing transport TC companies. As shown in Table 2.1, there costs, while at the same time promoting are only 14 products that could be learning socioeconomic integration and knowledge candidates for GC companies, of which the Top spillovers/transfer resulting from trade flows 5 would bring an increase of only around 0.5 and spatial proximity. 28 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Table 2.3: The most relevant imports of the TCe TCe RoC Product Description Complexity Imports Exports Relatedness iRCA RCA RCA iRCA (US$ million) (US$ million) Barley 0,13 0,038 28,55 41,17 0,00 1,59 2,20 8,09 Cement -1,42 0,059 25,40 22,92 0,00 39,19 31,82 2,19 Dairy Machinery 0,82 0,032 3,99 18,61 0,00 1,35 6,15 3,30 Water -0,83 0,042 5,76 15,32 11,90 0,93 2,21 4,15 Aluminum Bars 0,02 0,037 22,35 12,76 0,00 2,69 1,46 1,94 Hard Liquor -0,65 0,045 39,81 12,57 68,61 16,48 4,89 2,59 High-voltage Protection 0,72 0,024 9,90 11,57 0,00 1,90 2,01 0,20 Equipment Gypsum -1,30 0,047 1,12 8,85 0,00 8,43 62,39 0,79 Seed Oils -1,05 0,043 7,54 7,79 0,00 2,11 1,85 2,34 Source: Authors’ calculations Note: Relatedness measures how close a new potential product is to the current export basket (and production structure) of an economy, with a range 0-1 (the higher, the closer). Product complexity measures the knowledge intensity associated with the product, with positive (negative) values associated with more (less) complex products. RCA is a proxy of the competitiveness of an economy of producing a selected product, measured as the share of that product in its export portfolio compared with the selected product’s global export share. The economy has a revealed comparative advantage if RCA>1. iRCA measures the relevance of a product as an import for the economy (the higher, the more relevant) and is measured as the share of that product in the import portfolio compared with the selected product’s global import share. Finally, by joining forces, the island as a whole dependence and increased fiscal gains, and could move toward producing more advanced new trade partners and growth opportunities. products that could also help to create more and better jobs for all Cypriots. The overall 2.2 The case of halloumi/ export portfolio, economic complexity, and sophistication opportunities of a joint hellim economy would be close to the RoC portfolio, Halloumi/hellim is the most important but with a much larger capacity to produce agricultural product of the island of Cyprus, and export products. This would apply not only and it carries considerable cultural and with the EU, but also with the current trading economic significance for the island. In the partners of the TCe, which are currently not TCe, halloumi/hellim32 is produced in large fully exploited by companies in the RoC. The volumes and the production sector is diverse. Top 10 most complex opportunities for the The annual production has been stable at combined economy include products related about 10,000 tons for the past five years. The to photographic functions and machinery. recent registration of halloumi/hellim as a While potential wage and employment effects PDO and the prospect of lifting prohibitions on as well as actual feasibility/convenience its movement across the GL bring significant on a product-by-product basis may require opportunities but also challenges for the TCe. additional analysis, from an economic Besides providing a useful marketing tool in the complexity perspective, there are significant EU and globally, and legal protection against gains in potential economic complexity for the imitations or misuse of the product name, the TCe, as well as for both sides in terms of more PDO registration will enable TCe value chain stability and social cohesion, less external actors to benefit from access to the high-value 32 Trade data are not available specifically for halloumi/hellim specifically, but for a category “cheese” (HS 40690), which includes cheese except fresh, grated, processed or blue veined. In this case, export data about this type of cheese are used to proxy for halloumi/hellim, being halloumi/hellim the main type of cheese produced on the island. l 29 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Figure 2.2: Volume of exports of halloumi/ Figure 2.3: RCA in halloumi/hellim for the RoC hellim by the RoC and the TCe (US dollars) and the TCe Source: Authors’ calculations. EU market that they are currently unable to integration, joint growth opportunities, and access. These benefits are expected to secure mutual learning. For instance, so far, the higher incomes for value chain actors in return TCe mainly supplies dairy machinery from for their efforts to improve quality. However, outside Cyprus, while the RoC has an RCA in the PDO requires that the proportion of sheep this product. Thus, both sides could gain from or goat’s milk or the mixture thereof must an increase in the trade of dairy machinery always be greater than the proportion of across the GL and the average economic cow’s milk, and the milk used for production complexity index of the RoC could increase. must meet the stringent standards set Moreover, business exchanges between dairy by EU regulations. Under Annex III of the machinery suppliers and the TCe’s halloumi/ Commission Implementing Decision (EU) hellim producers could also contribute toward 2021/586, the TC administration is expected knowledge exchange and help TC producers to work to establish the ‘Animal Health Status’ to improve their managerial and operational according to internationally agreed standards practices. of the World Organization for Animal Health. Finally, increased economic integration via Moreover, the same Decision establishes that halloumi/hellim could help TC producers to the TC administration must prepare an annual gain from access to the EU market. While the program for the monitoring of residues, export volume and RCA of the RoC increased based on data of milk production. Significant between 2013 and 2018, this was not the case adaptation among all value chain actors in the for the TCe (Figures 2.2 and 2.3), despite the TCc is therefore needed before they can fully TCe having similar (slightly higher) comparative benefit from the PDO.33 advantages. In 2018, TC producers ‘exported’ The PDO is expected to increase the demand almost 5 times less than the total exports of the and price for this traditional Cypriot cheese, RoC.34 While RCA for TC companies is slightly and provide new opportunities for integration higher than for GC companies—because of and economic growth in both economies. the higher reliance on cheese ‘exports’ by the Halloumi/hellim offers opportunities for former compared with the latter—the overall technological cooperation and economic estimated competitiveness—a synthetic 33 Please refer to the World Bank forthcoming report on agri-value chains for details on opportunities and difficulties with PDO implementation. 34 In the case of Figure 2.2, in the year 2018, the gap between RoC and TCC is about 0.7 (in log10 scale), meaning that ROC exports about 5 times more than TCC. Likewise, in Figure 2.3, in the year of 2018, the gap between TCC and ROC is about 0.8 (in log10 scale), meaning that TCC has a comparative advantage that is more than 6 times larger than ROC. This is simply explained by the higher weight of this product in the Tc ‘export’ basket compared with the GC export basket. 30 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Box 2.3: A gravity model for halloumi/hellim The gravity model is perhaps the most widely used econometric model of international trade patterns.36 An econometric model uses historical data to estimate and test the robustness of a hypothesized economic relationship. According to the gravity model, the volume of trade between two economies depends on their economic size, on their respective competitive- ness, and on their respective frictions. Typical frictions include geography, namely bilateral distance or a common border; history, such as common language or colonial ties; and trade policy, such as sharing a Regional Trade Agreement (RTA) or being part of a currency union. The analysis estimates a gravity model for the TCe and the RoC, using trade data at 6-digit HS classification for the period from 2010 to 2019 covering the 241 commodities currently ‘exported’ by the TCe. The estimation sample covers 152 exporting economies and 164 im- porting markets. International data and data for the RoC are from ComTrade, while data for the TCe are from the TC ‘Department of Trade’. All the gravity controls are from CEPII-Gravity Database (Head and Mayer, 2010, 2014). Results confirm that bilateral friction due to geography/bilateral distance (where distance computed as the population-weighted distance between most populated cities) and histo- ry (a dummy variable for common language if a common language is spoken by at least 9 percent of the population; a dummy variable for colonial ties, if two economies were ever in a colonial relationship; and common border); and to trade policy, all have a strong role in shaping the network of international trade flows.37 In particular, two economies sharing an RTA trade almost 50 percent more on average, while two economies sharing an RTA/PTA within a currency union trade above 60 percent more on average. Similar results hold for the product-specific gravity models, which are estimated for hallou- mi/hellim, carob and olive oil, individually.38 As expected, the magnitude and the precision of the effect of each friction varies across individual commodities. While trade for halloumi/ hellim could increase by 14 percent, trade for carob and for olive oil could increase by 55 and 48 percent, respectively, if the TCe were to achieve its potential, given current frictions, and with currently served trading partners. measure of the competitiveness of an economy Frictions in the TCe are holding back as a production location, evaluated through a its ‘export’ potential, especially to new weighted economy’s share of world markets destination markets. The volume of trade in selected ‘export’ categories—is actually between one economy and a selected trading much lower for the TCe than for the RoC. Thus, partner is proportional to their economic size further increasing exports of cheese, not only and their relative frictions, such as geography, in quantity but also in price, could significantly history, trade and monetary policy, as well as contribute to growth and employment in the competitiveness (see Box 2.3 for a description TCe.35 36 37 of the underlying econometric model). If the TCe were to reach its potential, given the 35 Structural gravity defines a particularly flexible environment; being estimation based does not rely on external parameters and does not need to assume explicit functional forms for some important relationships, like production function or demand structure. Thanks to the bilateral structure of the data both the supply and demand side determinants for a given product are flexibly absorbed by fixed effects. However, being in a partial equilibrium setting, we cannot include cross-product linkages and second order effects as one would do in an agricultural system model (for a recent review see Jones et al 2017). 36 As for the geography controls (i.e. distance and contiguity) we impose the same values for RoC and TCe; for the historical controls (colonizers and language) we use the same values for TCe and TUR. 37 Results for carob and olive oil are available upon request. l 31 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Table 2.4: Estimation of export potential of the RoC, applying TCe frictions for select products: halloumi/hellim, carob flour and olive oil Estimated export Estimated export for the RoC for the RoC if TCe’s Observed Trade if TCe’s bilateral trade frictions competitiveness for RoC apply applies (US$ million) Monetary Trade Policy Competitiveness Policy Product: (1) (2) (3) (4) Cheese (HS 40690) 251.96 53.62 65.33 31.84 Top destinations: United Kingdom 32.078 16.788 32.078 13.440 Sweden 10.449 5.469 10.449 4.363 Germany 6.072 6.072 1.995 2.544 Australia 5.165 5.165 5.165 2.164 Austria 3.516 3.516 1.155 1.467 Greece 3.217 3.217 1.057 1.343 Denmark 2.661 1.393 2.661 1.119 Saudi Arabia 2.541 2.541 2.541 1.061 United States 2.137 2.137 2.137 0.898 Finland 1.873 1.873 0.615 0.786 Aggregate, all products 390.63 208.18 236.76 83.49 (241 HS 6-digit codes) Percentage change to (1) -46.7% -39.4% -78.6% Source: Calculation based on ComTrade and TC ‘Department of Trade’ data; classification HS1996 at 6-digit. currently served markets and the above- with its currently served markets, of which mentioned frictions, sales of halloumi/hellim almost 90 percent are EU markets, could be to other economies would increase by almost reduced as much as 75 percent if bilateral 14 percent. ‘Exports’ of halloumi/hellim would frictions currently facing TC producers were increase instead by more than 20 percent to applied. In particular, the predicted export the 14 destination markets currently served by would be significantly less: US$54 million both companies in the TCe and RoC, if the TCe instead of US$252 million, if the RoC were were to align its trade policy with the RoC and to adopt the same trade policy as the TCe achieve the same level of competitiveness. (Column 2, Table 2.4); 74 percent less for the However, the largest gains in the TCe would currency framework (Column 3, Table 2.4); come from reaching new and richer market and almost 90 percent less if GC firms had the destinations. It is challenging to assess this same competitiveness as TC firms (Column potential for the TCe, given the currently 4, Table 2.4). This shows that frictions in the insignificant or absent ‘trade’ with most of TCe, such as its trade and monetary policies, these markets. However, a counterfactual as well as its low competitiveness, are holding analysis shows the current and estimated back its ‘export’ potential, especially to new trade volume of halloumi/hellim for the RoC destination markets. 32 l TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY Reforms that aim to reduce bilateral frictions distortive will also be essential in supporting that prevent TC producers from accessing and promoting innovation. broader markets are crucial. Considering Moreover, special attention should be that, on average, the competitiveness of devoted to regulations concerning goods TC producers lags significantly behind their arriving in the TCe and GL trade. Pre- neighboring competitors, implementing permits and licenses imposed by the TC these critical reforms that reduce trade administration on goods arriving to the TCe, frictions through the adoption of harmonized on top of regulatory uncertainty, contribute to regulations is paramount if TC domestic increasing prices, also penalizing consumers producers are to achieve their full potential and eroding domestic competitiveness. Since and to access high-end markets. 2018, significant reforms have been achieved 2.3 Policy options to promote in select departments. However, further reductions in the administrative burden on TC economic integration companies, as well as on GL trade, are necessary Significant effort will be required to transform steps to support the competitiveness of TC the productive structures of both economies producers, to ensure that consumer prices are toward producing more complex products. in line with peer economies, and to facilitate Significant opportunities exist for both sides integration between GC and TC companies. to move toward more complex economic Meanwhile, restrictions on the crossing of activities and new trading partners. Deeper commercial vehicles and processed food cooperation, expanded within-island trade, should be removed. and further economic integration could help in Building a framework for dialogue between this regard. Both TC and GC economies stand the GC and TC private sectors will help to gain considerably from reducing structural exploit the opportunities from economic constraints and external vulnerability that integration. Dialogue between respective are characteristics of relatively small island business organizations, and at the level of economies. Moreover, deepened economic all other relevant stakeholders, structured integration would also help to attract greater and grounded on basic rules for engagement international investment. and the elaboration of a work program, In the TCe a major constraint for TC including to secure support from technical businesses is the high administrative burden experts, is needed to identify solutions to of interacting with the TC administration. current problems, based on international best Specifically, the high regulatory barriers for practices. Main problems include the following: market entry, the lack of transparency, and the (i) the limitation by the GL Regulation of the misallocation of resources create significant type of products that can be traded; (ii) the distortions across sectors and uncompetitive restrictive interpretation by the RoC authorities conditions within sectors. ‘Public’ policies have of the GL Regulation; (iii) a lack of banking heavily focused on the provision of incentives facilities supporting commercial operations and other forms of ‘public’ payments, rather across the GL; (iv) problems encountered than improving the business environment by TC operators regarding certification of and supporting competitiveness. Reforming EC standards and quality requirements; (v) business regulations and procedures that fall restrictions for TC commercial vehicles to cross under the mandate of the TC administration, the GL for the delivery of the products being and that should be aligned with international traded between the TC and GC companies; good practices and the EU Acquis, is a priority. and (vi) double taxation for VAT on products Eliminating red tape by simplifying and traded from the RoC to the TCe. Opportunities automating the administration of business could be explored to introduce a number of procedures will benefit TC producers, while exceptions to the current restrictions, in order reducing the costs for the TC administration, to test bi-communal cooperation on “Special freeing up much needed resources, given Confidence-Building Business Ventures”. A its limited capacity. Reforming subsidies to dispute resolution mechanism could also be ensure that they are better targeted and not established. l 33 TESTING THE RESILIENCE OF THE TURKISH CYPRIOT ECONOMY References Abdih, Y., Lopez-Murphey, P., Roitman, A., and Pinheiro, F. L., D. Hartmann, R. Boschma, and R. Sahay. 2010. The Cyclicality of Fiscal Policy C. Hidalgo. 2021. The Time and Frequency of in the Middle East and Central Asia: Is the Unrelated Diversification. Research Policy, Current Crisis Different. IMF Working Paper 104323. doi: https://doi.org/10.1016/j. respol.2021.104323 Baez, Javier E.; Inan, Osman Kaan; Nebiler, Metin. 2021. Getting Real? The Uneven Pinheiro F.L., E. Bucea, and D. Hartmann. Burden of Inflation across Households in (Forthcoming). Stronger together: Turkey. Policy Research Working Paper; No. Opportunities for mutual learning, economic 9869. 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