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Financial Times (London) October 9, 2002
2002-10-09 15:43:53

HEADLINE: Good potential for expansion: ECONOMIC TRENDS by Kerin Hope:
Beyond tourism, the country seeks further diversification with new services
Cyprus has sharply reduced this year's economic growth target in response to a 13 per cent decline in first-half tourist arrivals and uncertainty over prospects for the final quarter.

The revision has underlined the country's dependence on persuading increasing numbers of foreign visitors to take holidays on the island, in spite of efforts to diversify its services sector.

The shrinking of Cyprus's agricultural and manufacturing sectors during the 1990s may have smoothed Cyprus's path to EU accession by eliminating potential disputes with Brussels over farm subsidies and protection of local industry.

But with services accounting for more than three-quarters of output, Cyprus is among the enlargement candidates most exposed to the effects of a prolonged economic downturn in northern Europe. The finance ministry has cut this year's GDP growth forecast from 4 per cent to 2.0-2.5 per cent. Recovery is projected in 2003, with growth to reach 4.5 per cent of GDP. Andreas Haralambous, the senior finance ministry economist, says the economy has the potential to expand by about 5 per cent yearly after accession, if the international environment is favourable.

But if international tension over Iraq intensifies, next year's tourist bookings are bound to suffer. "The economy rebounded very fast after the Gulf war in 1991. But the international situation may be different this time," Mr Haralambous says.

However, Cyprus has made good progress, with its self-imposed aim of fulfilling the Maastricht requirements ahead of accession. While these are not a condition of EU entry for the 10 enlargement candidates, the government has been determined to outperform accession-related economic targets wherever possible in order to cement its claim to membership.

Cyprus has also set a priority on joining the EU's exchange rate mechanism, the waiting room for entry to the eurozone, at the earliest possible date after accession.

The budget deficit has halved since the start of accession negotiations, thanks to tighter fiscal policies and more efficient tax collection. It is projected to shrink marginally this year from 2.8 per cent to 2.7 per cent of GDP - short of the official target of 2.0 per cent of GDP but still within the Maastricht limit.

In spite of a hike in value added tax from 10 per cent to 13 per cent in July, annual average inflation is not expected to exceed 3 per cent. But inflation is projected to reach 3.5 per cent next year as the impact is felt of a second increase in VAT to 15 per cent, the EU's minimum rate.

One result of Cyprus's success in containing inflationary pressures is that the Commission has relaxed an earlier demand for the abolition of the index-linked wage system, known as COLA. Real wage increases have been modest, averaging 2.8 per cent yearly over the past five years. The government has argued successfully that COLA underpins social consensus while still maintaining relative flexibility in wage settlements.

However, the latest version of Cyprus's pre-accession economic programme provides for a delay in achieving a balanced budget. Mr Haralambous says: "Because of the difficult external environment and the impact of a new tax structure, our goal is a balanced budget in 2005 rather than in 2004."

The government has launched a bold tax reform in a bid to keep afloat its offshore business sector, the second-biggest source of foreign exchange after tourism. A change was required to comply with EU rules on fair competition, as offshore businesses with a base on the island paid tax at 4.5 per cent compared with 25 per cent for onshore companies.

By setting a uniform tax rate of 10 per cent for both onshore and offshore companies, the finance ministry aims to give Cyprus a competitive edge after accession as an international business location. For onshore companies, the rate will, in effect, be 19-20 per cent because of provisions for additional taxation on income considered an undistributed dividend. But the difference from the previous rate is seen as big enough to increase the island's attraction for outside investors.

"The rate was set to be low enough to prevent good quality offshore businesses from leaving, and attract service-oriented companies to set up onshore. These companies would see other advantages here - a well-educated workforce and the widespread use of English in business," says Sofronis Eteocleous, chief economist at Popular Bank of Cyprus.

At present, the government faces comparatively little pressure to encourage job-creation outside tourism. Cyprus still enjoys near-full employment, with a jobless rate of about 3 per cent. With university graduates accounting for 30 per cent of workers, the island can boast having one of the best-educated workforces in Europe, although many graduates are obliged to work in fields unrelated to their degree courses.

Immigrants on short-term contracts, mainly from east Europe and Asia, help cover a shortfall of less-skilled workers. Mr Eteocleous says foreigners make up 10 per cent of the labour force "but the presence of more than 30,000 immigrants does not cause social tensions because most are allowed to stay only five or six years and only a few become permanent residents."

In the medium-term, Cyprus aims to promote investment in information technology, financial and medical services and private education at institutions teaching in English. The island already has by far the highest rate of internet penetration in southern Europe.

Andreas Trokkos, an economist at the government planning bureau says: "We can see a small but steady increase in the share of non-tourism related services in GDP that is expected to rise after Cyprus becomes part of a bigger European services market."

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