The coronavirus and the efforts to combat its devastating impact have brought into sharper focus the inequalities, fragilities and structural weaknesses of the economy
By Les Manison
The devastating economic effects stemming from the spread of the coronavirus have exposed the underlying inequalities and fragilities as well as the structural weaknesses of the Cyprus economy. Indeed, the disproportionate adverse effect of the economic crisis on the poorer and less-privileged segments of society has heightened inequalities.
In addition, the economic repercussions of the coronavirus have shown that Cyprus, with its highly concentrated allocation of resources, is very vulnerable to shocks. Furthermore, structural weaknesses highlighted by a heavily indebted private sector and a poorly administered and narrowly based tax system are likely to hinder efforts to produce a sustained and equitable recovery from the coronavirus-induced recession.
While not as bad as in the United States, Cyprus suffers from profound inequalities in the distributions of disposable income and wealth, disparities which are underestimated in official statistics. These statistics show that in 2017 the top five per cent of household incomes accounted for 16 per cent of total disposable incomes, the same as earned by the bottom 33 per cent. And it is those employees with low-paid occupations in the private sector, such as service and sales workers, that have registered the largest increases in unemployment over the last three months. Additionally, it is these same workers employed in the retail trade and accommodation and food services sectors that earn the lowest wages in Cyprus and which have been and will be on the front line in being exposed to the coronavirus. According to the latest statistics for 2018, the average monthly earnings for all employees in these two private services sectors was 1,253 euros, which compares with an average of over 2,800 euros for public sector employees.
Indeed, one of the most striking of inequalities in Cyprus is the very large and widening disparity between the incomes, benefits and job security of public sector employees as compared with those of private sector workers. Most public sector employees are paid much more than their counterparts performing similar jobs (administrators, clerks, messengers, nurses etc.) in the private sector. In addition, the contributions of public sector employees to the social security insurance scheme are less than those of private sector employees, while hardly any public servant is ever laid-off because of poor performance (most are appraised excellent every year) or made redundant because of difficult economic conditions.
Reflecting the shutdown of businesses, unemployment of private sector employees increased by around 3,800 between February and May 2020, that is, roughly 73 per cent higher than in May 2019, whereas unemployment of persons registered as public sector employees increased by a mere 200 persons over the last three months and by just 5.1 per cent compared with May 2019.
Cyprus entered the period of the staggered Covid-19 related world-wide business lockdowns with a fragile and vulnerable economy highlighted by a concentration of resources in the tourist sector, the provision of offshore financial services, and the selling of Cyprus passports under the so-called naturalisation scheme.
The excessive reliance of the Cyprus economy on tourism has meant that the shutdown in the hospitality sector of Cyprus and of countries from where most tourists originate as well as airline travel will reduce substantially the number of tourists coming to Cyprus. This could lower GDP growth by as much as 10 percentage points and possibly decrease export receipts by up to 2 billion euros in 2020.
The lockdown period has shown that business activity and the external accounts are also vulnerable to sudden falls in receipts and capital inflows stemming from falling demand for offshore financial services and Cyprus/EU passports under the naturalisation scheme. Indeed, periodic international crack-downs on the illegal activities of money launderers and tax evaders, can be expected to at times abruptly halt the capital inflows required to finance large balance of payments current account deficits and property development/construction activity.
A large number of Cyprus households and corporations are heavily indebted, many with non-performing loans. This means that heavily indebted business entities facing deteriorating business conditions arising from the impact of the coronavirus will struggle to continue/resume their operations, let alone undertake new investments. Providing so-called liquidity support to these businesses through new bank loans would just lumber them with more debt and add substantially to the existing huge pile of non-performing bank loans, that would in turn have required taxpayers unfairly to bail out banks with government guarantees under the previously proposed “Plan A”.
Thus, the very weak state of private sector’s finances characterised most strikingly by excessive debt should prevent banks from attempting to support the struggling private sector to any significant degree by extending new productive bank loans on the basis of repayment ability as good banking practice mandates. In this respect, banks can at best only temporarily assist the private sector by providing debt relief through the restructuring of loans and/or debt write-offs.
A major structural weakness of the Cyprus economy is its poorly administered and narrowly based tax system, which has deprived the government of the budgetary resources and capacity to respond effectively to the economic damage arising from the coronavirus. In 2018 Cyprus collected taxes and social security contributions equivalent to 33.8 per cent of GDP whereas tax receipts in other euro area members averaged 41.8 per cent of GDP. This divergence is explained largely by the relatively low receipts from taxes on income and wealth which amounted to just 3.2 per cent of GDP in 2018 compared to an average of 9.6 per cent of GDP for other euro area countries.
Furthermore, in its efforts to support the private sector the Cyprus government has temporarily suspended payments of income taxes and VAT for businesses as well as lowering the VAT rate for hotels. In fact, with this drastic shrinking of the tax base actual tax collections are falling precipitously, resulting in such receipts in April 2020 declining by 35 per cent compared with April 2019. Moreover, with shortfalls in tax revenue and a reluctance to cut its large wage and salary bill, the government has not been able and willing to quickly support households and businesses with adequate grants. Instead, it has sought to further raise its cash reserves by borrowing large sums from abroad, and effectively delaying the disbursement of additional grants to private sector entities until after mid-2020 and not beginning interest rate subsidies until March 2021.
The coronavirus and the efforts to combat its devastating impact have brought into sharper focus the inequalities and fragilities as well as the structural weaknesses of the Cyprus economy. These distinguishing features are likely to hinder the equitable and sustained recovery of the Cyprus economy. From the expenditure side heightened income and wealth inequalities will result in most private sector employees and their families having insufficient incomes and very limited access to credit to help boost demand to pre-crisis levels, while the higher income and wealthy households will continue to accumulate savings with their cautious behaviour and limited travel and in the process keep demand subdued. And with the heavy concentration of resources in fragile areas such as tourism, offshore financial services and the sale of Cyprus passports, the Cyprus economy is vulnerable to sudden falls in external demand as the recent lockdown period has demonstrated, and consequently these areas of economic activity cannot be relied upon to support uninterrupted growth over the medium to longer-term.
A substantial overhaul of the design and administration of the tax system is needed to reduce income and wealth inequalities and to raise budgetary resources so as to diversify and make the economy more resilient, while building up funds for future debt repayments. To be compatible with all other euro area members there is a need to reintroduce a progressive wealth tax on immovable property that, among other things, would impact disproportionately, but fairly, on those households least affected by the coronavirus. And serious efforts must be undertaken to combat tax evasion, which with the official suspensions of tax payments is likely to intensify.
Finally, potentially viable businesses need to be assisted with grants, while those that are heavily indebted, but viable, should be accorded debt relief on a case-by-case basis. Conversely, extending more loans to struggling businesses would eventually overwhelm them and lead to a depletion of equity. This should be avoided as it would render the prospect of sound recovery more difficult when business conditions improve.
Leslie G Manison is an economist and financial analyst. He is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus finance ministry and a former senior advisor at the Central Bank of Cyprus