February 2007 Growth, Convergence and Reunification: Are the Dynamics Encouraging? Max Watson (Oxford University, Adviser to the European Commission) This paper does not represent views of the European Commission

The Convergence Concept In Cyprus, convergence refers to 3 principles, with the potential to be mutually reinforcing: Convergence of incomes: CY => EU average Convergence of incomes: north => south Convergence of the real economy and of institutional frameworks: north => south Economic dimensions not everything, but affect political dynamics via incentives (referenda)… Context for EU aid, Green Line, Technical talks

Operational Questions Focus here on recent income trends, and then 4 issues on which we may stand at crossroads: Role of economics in Spring 2004 failure? Are there major synergies to unlock in a converging intra-Cyprus economy? Can economic reform approaches contribute importantly to convergence? If we miss present opportunity, will economic gravity pull in divergent directions?

Recent Income Trends South North Since 2002, convergence has accelerated intra- Cyprus and vis-à-vis EU: Real GDP (% change) Policy frameworks in south: Maastricht, Lisbon Policy frameworks in north: Mixed incentives

Intra-Cyprus Income Gap Image during UN discussions also needs to be revised as regards levels: Perception of a steep, persistent gap added to tensions on convergence strategy/federalism Ayres 2003, while warning on measurement hazards, cited EIU p.c of $6k v. $13k Mehmet 2004 assumed starting disparity 60% Eichengreen et al 2004 Report on Annan Plan assumed 60% & project (benign) 38% in 2020

World Bank PPP Estimates of n/s Gap Nominal WB Atlas PPP (US dollars 000s) North North – rev. base South Ratio (north: south) Ratio (rev. base n.) Gap n:s (rev. base) Ratio (n: EU rev. base) Is PPP factor right? And north receives large transfers (15-20% of GDP). Size of informal economy (20-35%)

Medium-term Challenges Sustainability/competitiveness challenge - some parallels, but far more serious in north: Short- to medium-term fiscal adjustment Address long-term social security imbalance Achieve continuing shift to higher value added exports, with growing globalisation of services and monetary union with competitive partners =>Reforms in north not underway: so bottlenecks, as well as distortions to trade and investment

Economics and the 2004 Talks There was little time to prepare underlying Issues - and are we using time well now: Income gap; convergence strategy; framework Credible fiscal federalism in EU framework Reunification cost (including resettlement, balance sheet issues in north – which cannot be left unresolved if incentives are to go right) But not neglecting market dynamics: winners & losers among corporate & labour market groups

Intra-Cyprus Synergies The island faces a huge strategic opportunity as well as new competitive challenges: It is an EU service sector hub in the Eastern Mediterranean… exploiting scope to upgrade value added in a globalised service economy So concept not intra-Cyprus complementarity but synergy in services (tourism; education; and a very wide range of business services) …& continued restructuring in manufacturing

Economic Reforms & Convergence The north will be compelled to embark on far- reaching reforms by a range of pressures… Economic history points to role of effective frameworks – or risk distortions affecting all Acquis communautaire offers an opportunity to shape this process & realise externalities But reforms such as social security need more co-ordination, and help set market framework Plus other public finance, competition reforms

Economic Gravity Intra-Cyprus convergence or divergence will play out on the ground in several markets, eg: Labour market: Integrating, but over which areas? Framework? Net skill flows? Tensions? Goods: Distorted and underperforming? Services: Tourism: gridlocked by property, psychology? Health: hazardous integration? Financial flows: Same gridlock? Real estate: Problematic, & pervasive impact

Constituencies for Reunification Economic exchanges may embed interests in rent-seeking distortions, or open-market flows So pattern of exchange in markets can affect strength of constituencies for reunification Clearest in property holdings, trade channels Also, Turkey reforms change many trade-offs Economic convergence across Cyprus – in frameworks/structures as well as income levels – as a pervasive Confidence Building Measure

Opportunities & Dynamics At present time, risks of creeping political economic divergence need to be squarely faced… Can evolving initiatives be steered in a ways that lead toward greater convergence not just in incomes but in economic & cultural life? Can economic exchanges, including reform ideas embed constituencies for reunification? How fully can communities in Cyprus realise the immense promise of their regional role?

End of Presentation