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Title:

‘The Cypriot economic collapse: More than a conventional South European failure’

Author:

Adonis Pegasiou (PhD)

Email: a.pegasiou@eucrc.ac.cy

Research Associate EUC Research Centre

Visiting Fellow LSE Hellenic Observatory

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Abstract:

In trying to assess the causes behind Cyprus’s request for a financial bailout, the paper takes a

step back and reviews the economy of the island within a comparative political economy

framework. With reference made to Varieties of Capitalism (VoC) literature, the paper sets a

twofold target. Initially, by introducing Cyprus in the VoC literature, it attempts to underline the

limitations of existing literature in allowing for a smooth categorisation of Cyprus under the

Mediterranean model of capitalism, and, subsequently, it seeks to explain the economy’s near

collapse, highlighting that Cyprus is not merely another piece of the sovereign debt crisis mosaic

covering the European Southern periphery.

Key words: Cyprus, South Europe, Financial crisis, VoC

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Main text:

I. Introduction

After more than a year of being shut out of international bond markets, in June 2012 Cyprus

became the fifth Eurozone member to request an EU bailout, shifting international attention on

the island for the first time for reasons besides the ‘Cyprus problem’. Given the country’s

geographical location, Cyprus has merely been considered by some as one more piece of the

sovereign debt crisis mosaic covering the European Southern periphery; one more economy

operating within the conventional framework of South European capitalism that has neared or

suffered financial collapse. This paper rejects such a simplistic hypothesis and argues that

Cyprus’s dire financial situation cannot be adequately explained by its geographical proximity

with other troubled European states and by its increasing, yet still below EU average, national

debt1. Such an approach, for instance, does not provide for the country’s disproportionate

banking sector (around eight times the GDP of the country) that has undoubtedly exacerbated

financial woes on the island.

In trying to assess the causes behind the derailment of the economy, the paper takes a step back

and reviews the economy within a comparative political economy framework. With reference

made to Varieties of Capitalism (VoC) literature, the paper sets a twofold target. Firstly, by

introducing Cyprus in the VoC literature it attempts to underline certain limitations in allowing

for its smooth categorisation and, secondly, with reference to these findings, it seeks to explain

the economy’s problematic situation.

The paper selectively gives emphasis on those models of capitalism which apply to South

European countries and are offered as an alternative to the binary division of capitalist

economies into liberal and coordinated market economies (Hall and Soskice, 2001). It primarily

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attempts to identify whether Cyprus may fit the taxonomy and be placed under an alternative

South European (or Mediterranean) model. In doing so, the paper assesses that despite the

numerous commonalities with other South European countries, certain ambiguities of the

Cypriot model render the theoretical South European variety of capitalism inadequate in

providing a complete picture of Cyprus’s political economy. For instance, historical specificities

for Cyprus (i.e. British ‘colonial’ heritage, the strong historical and ethnic ties between Greece

and Cyprus and the events of 1974 with the resulting de facto division of the island) and even

the actual micro-state status of Cyprus have shaped the political economy of the country to a

great extent and in a particular way.

It is important to note that while highlighting the particularities of Cyprus, the paper does not

seek to undermine the importance of grouping countries under capitalist models and

acknowledges the importance of the VoC approach in explaining developments in capitalist

economies, such as the on-going financial crisis in the Eurozone (Hall 2012). Yet the paper also

recognises that no country can fit under a proposed model of capitalism in an absolute manner.

For instance, Cyprus undoubtedly has many Mediterranean characteristics that have practically

shaped the economy of the country, nevertheless, one needs to look beyond the conventional

Mediterranean traits to develop a complete picture of the country’s economy and thus explain

its current precarious position.

The structure of the paper will be shaped accordingly in trying to support the above

propositions. First of all a critical review will be offered of the available VoC literature, placing

emphasis on the particular traits assigned to the South European/Mediterranean model of

capitalism. With reference to this review, an overall picture of Cyprus’s political economy will

then be provided, bringing to the surface those aspects of the Cypriot model that are in line with

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other Mediterranean states and those that make it a particular case among them. In light of the

review on Cyprus’s political economy, the conclusion of the paper attempts to examine the

reasons behind Cyprus’s lost credibility in international financial markets that has rendered the

country incapable of financing its own debts and subject to foreign assistance in order to avoid

bankruptcy.

II. Theoretical Framework of the paper

The binary division between capitalist economies offered by Hall and Sockice (2001)

distinguishes countries into Liberal Market Economies (LMEs) (e.g. UK and USA) and Coordinated

Market Economies (CMEs) (e.g. Germany, Netherlands), highlighting the prominent role of the

firm as a common characteristic to both models. On the one hand, LMEs are cases where there

is limited state intervention and market institutions provide for a highly effective means for

coordinating the endeavours of economic actors, while on the other hand, CMEs rely mostly on

non-market forces to achieve coordination of relevant socioeconomic actors and equilibriums

reached are the result of strategic interaction and not market-led forces.

Hall and Soskice (2001) based their categorisation on the institutional characteristics each

capitalist economy has and their response to external pressure. The firm, being the most

prominent actor in an economy, develops comparative institutional advantages based on how it

reacts in five distinct spheres of interaction (industrial relations; corporate governance; inter-

frim relationships; employee relationships; and vocational training and education).

Subsequently, certain institutional complementarities develop that prove to be path-dependent

thus making any significant path-shifting or equilibrium breaking behaviour on the part of actors

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that can potentially produce a fully-fledged shift from one variety to another, highly unlikely

(Hancke et al. 2007:5)

The dichotomy offered by Hall and Soskice (2001) has not been free of criticism (see Crouch

2005, 2006). Even Hall and Soskice acknowledge certain limitations and in their initial

contribution they accept that certain countries (namely Mediterranean states such as France,

Italy, Spain, Portugal, Greece and Turkey) cannot easily fit the two ideal-types of capitalism,

paying attention to the possibility of another category to accommodate for these countries.

Along these lines, in explaining the financial crisis with a VoC approach, Hall (2012) highlights

that the roots of the crisis lie in the structural strains generated when different types of political

economies adopted a common currency, grouping Portugal, Spain, Italy and Greece together, as

opposed to group of northern countries led by Germany and including countries such as

Netherlands, Austria, Denmark and Finland.

Going back to the limitations of the initial dichotomy, Featherstone (2008: 10) notes that,

specifically, for countries located at the European Southern periphery, scholars have been left

uncomfortable (at various degrees) with an approach that:

Downplays the imperative role of the state in the economy and instead highlights the

centrality of the firm and its myriad of relationships, seeing them as the key agents of

change, contrasting with the distinct market structures and histories of southern Europe

Neglects other forms of non-market relationships such as clientelism and corruption

Has difficulty in fully accounting for the distorted (or disjointed) nature of the parallel

welfare regimes of Southern Europe

Understates the relevance of the EU dimension to domestic reform and development in

small, marginal economies

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Therefore, as an alternative to the parsimonious and rigidly dualistic framework, more pluralistic

approaches have been adopted introducing more than two models, thus accommodating for

possible misfit cases by adding explanatory capacity yet with a less ambitious institutional

coverage (among other see Schmidt 2002, 2003; Amable 2003; Gospel and Peddleton 2004;

Molina and Rhodes 2007).

When examining such approaches that go beyond the notion of the dual dichotomy, even

though it has been suggested that a geographical and cultural based denomination may be too

simplistic to explain the coherence of the different types of capitalism, de facto, the

geographical aspect remains evident in the taxonomy of capitalist models (Amable 2003: 14). As

a result, effectively, such approaches have been consistent in grouping the capitalist economies

located at the European Southern periphery under one category.

Molina and Rhodes (2007), without challenging the framework of Hall and Soskice and by

looking into the cases of Italy, Spain, Portugal and France, advocate for an alternative third

model named Mixed Market Economies (MMEs) (Hall and Gingerich 2004; Molina and Rhodes

2007). Key characteristics of the model include, among other, the highly influential role of the

state, lack of efficient coordination in collective bargaining, numerous domestic veto points that

can potentially oppose domestic reform and weak social protection relative to employment

protection. Table 1 outline the MME’s main traits relative to LMEs and CMEs.

[Table 1]

Alternatively, Schmidt (2003) names state-capitalism as a third distinct variety, in addition to

Market Capitalism (akin to LME, e.g. UK and US) and Managed Capitalism (akin to CME, e.g.,

Germany, Netherlands and Sweden). Schmidt’s analysis draws mainly from the French example

and, through a comparison with Germany and the UK, the prominent role of the state in relation

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to the firm is highlighted, something that is manifested in all aspects of the French economy.

The overarching state is evident as it organises business relationships; directs business-

government and labour relations and mediates inter-firm relations; provides finance to

enterprises over other options such as banks or the markets; and determines wage-bargaining.

Such a state omnipresence is a key trait of the Cypriot economy as well.

Otherwise, Amable (2003), in an empirically-based study of institutional differences among

OECD capitalist economies, offers an analysis of the diversity of modern capitalist economies -

from America to Korea - and identifies five different models: the market-based Anglo-Saxon

model; Asian capitalism; the Continental European model; the social democratic economies; and

the Mediterranean model. Each of these types of capitalism is characterized by specific

institutional complementarities. Specifically, of interest to this paper is the Southern European

model, the main characteristics of which include the involvement of the State in market

competition; a dual labour market with a ‘flexible’ fringe of employment in temporary and part-

time work, possible conflicts in industrial relations and centralisation of wage bargaining; high

banking concentration, bank-based corporate governance and a low sophistication of the

financial markets which leads to low corporate reliance on them; weak social versus

employment protection which favours job security; and, regarding education, low enrolment

rates in tertiary education, weak higher education systems, poor vocational training and limited

lifelong learning. Many of these characteristics may apply to the Cyprus, however, there are

aspects that diverge from what is considered the norm. For example, Cyprus has overall enjoyed

peaceful industrial relations while it also has one of the most educated and qualified labour

forces in Europe.

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Furthermore, Ferrera (1996) examines the welfare state and social protection in the Southern

European periphery which he finds distinct to other countries and adds the ‘southern model’ to

the three worlds of Welfare Capitalism initially introduce by Epsing-Andersen (1990) (namely the

Liberal, Corporatist-Statist and Social Democratic). In the same vein, Gal (2010) offers an analysis

of an extended family of Mediterranean welfare states, with specific reference to Cyprus.

Overall, the welfare system in Southern Europe is seen as fragmented, unevenly developed and

subject to politicisation and clientelism with a mix of Beveridgian and Bismarckian traits (Ferrera

et al. 2000; Gal 2010). In addition, these studies highlight the role of insiders and outsiders (i.e.

privileged and non-privileged employees) in fragmented labour markets and the importance of

the Mediterranean family and the church as reliable providers of welfare that cover the

limitations of the state.

Overall, there are apparent and strong commonalities regarding political economy traits of the

Mediterranean model of capitalism and Cyprus. However, evident commonalities are not

sufficient to allow for a smooth categorisation of Cyprus in the VoC literature. It is for this reason

that the paper, by thoroughly reviewing all aspect of the Cypriot economy, goes one step further

and identifies those characteristics that make Cyprus a rather ambiguous case among

Mediterranean countries. Such an approach allows for a comprehensive picture of the Cypriot

economy to be formed and adds explanatory capacity in the quest to assess the country’s

current economic distress. In the following section the economy of Cyprus is introduced in VoC

literature and its key characteristics are examined separately.

III. Introducing Cyprus in the VoC literature

The omnipresence of the State

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The state in Cyprus can be described as being ‘pervasive’, having a central, direct and influential

role in the country’s economy, though without necessarily implying either efficiency or optimum

productivity. It has been both a direct producer of goods and a regulator, playing a key role in

both ownership and control of a significant group of large firms, while also being responsible for

correcting any coordination failures, as the case is for other south European states (Gospel and

Pendleton 2004: 14). This multifaceted role of the state, overstretching in most fields of the

economy, is in line with what Schmidt (2002) calls ‘state-capitalism’.

Looking at the country’s short history, in 1960 Cyprus inherited from the colonial administration

those ‘initial conditions’ – i.e. relatively coherent infrastructure, adequate institutional

framework and qualified manpower – which, essentially, positively affected the future economic

growth of the country (Orphanides and Syrichas 2012: 7-8). Nevertheless, it is commonly

accepted that, since independence, the performance of the state has gradually deteriorated,

being hampered by inefficient procedures and with an excessive growth in civil servants,

resulting from the politicisation of the sector and an absence of innovativeness (Matsis 2001:

448). The overblown broad public sector, apart from the core civil service/central government,

includes the so called ‘semi-governmental’ public utility organisations which are entirely owned

by the state. Among these organisations are the electricity and telecommunications authorities,

while, in addition, the state has a majority share-holder status in the national flag carrier, thus

making it one of the most prominent and influential entrepreneurs in the Cypriot economy. The

prospect of privatising the profit-making government-owned public utility organisations has

been at large considered an anathema in Cypriot society.

Over the years the increase in the number of employees in the Broad Public Sector has been

astounding. The number has increased by 71 per cent between 1960 and 1980, and more than

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doubled from 1980 to 2010 (from 32,639 to 66,460), revealing the state’s prominent role as

employer (Vasiliou and Paschalis 2011). The uninterrupted steady increase in staff numbers

cannot be convincingly explained by the state’s administrative and organisational needs

(Faustmann 2010). Indicative, out of the total labour force (around 410,500) in 2010 around 17%

worked in the public sector (Cyprus Statistical Service 2011).

In terms of the compensation of employees in the public sector, as a percentage of total

government expenditure, Cyprus has the second highest percentage in the EU (15.9%), well

above the European average (11.1%), and with the biggest absolute increase over the past 10

years (European Commission (EC) 2011). Importantly, Cypriots have enjoyed an automated

wage indexation that has kept wages in line with inflation and thus contributed to the steady

increases in the government’s payroll. Standard and Poor’s recently made specific reference to

the government’s personnel expenditures as a structural inefficiency, due to its high proportion

in relation to public spending (Standard & Poor’s 2011).

Faustmann (2010), when attempting to explain the costly size of the Broad public sector, has

been highly critical of the political patronage in Cyprus which has led to a ‘Cyprus Consensus’

between political parties, individual politicians, a large number of citizens and, this article will

argue, trade union leaders as well. This understanding reached, sustains and perpetuates the

firmly entrenched structures and widespread clientelistic practices, undermining meritocracy

and leading to the establishment of an oversized, privileged, albeit expensive, wider public

sector. In a comparative context, he comments that Cyprus is no exception to other South

European countries, since the execution of state power has been extensively used to distribute

favours to the supporters of the ruling parties in more than one ways, in contrast to Western or

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Central European countries like Germany and Britain which share a different administrative

tradition.

Of course what needs to be clarified is that given the job security and the relative high

remuneration the public sector guarantees, it has managed to attract many well qualified

individuals over the years, and in conjunction with certain practices and structures originating

from the time of British administration, the contribution of the civil service to the economy

should not be underestimated. On the contrary, at times the civil service has been commended

for its role in strategic planning, while a more recent example is the efficient and successful way

in which it managed the Cypriot Presidency of the Council of the European Union in the second

semester of 2012.

The Cypriot corporatist model under pressure

Industrial relations for South European states are set to be inefficient, with interests being

weakly articulated by fragmented and antagonistic social partners who may, nevertheless, enjoy

considerable political influence and veto power (Molina and Rhodes 2007). In effect this leads to

a counter-productive environment, hindering economic growth prospects, and as Featherstone

and Papadimitriou (2008: 48-49) conclude for Greece, the ‘disjointed’ or ‘parentela’ character of

interest mediation along with the low ‘social capital’, lead to a climate of antagonism and

mistrust, making coordination and consensus extremely difficult to manage. As a result, labour-

management relations tend to be mostly adversarial allowing for a greater role for the state –

for instance wage bargaining is largely determined and often imposed by the state (Scmhidt

2002).

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Cyprus, contrary to the South European norm, has overall enjoyed peaceful and cooperative

industrial relations within the framework of an effective corporatist model, akin to the three

distinguishing traits of corporatism identified by Katzenstein (1985: 32): an ‘ideology of social

partnership’ expressed at the national level; a relatively centralised and concentrated system of

interest groups; and voluntary and informal coordination of conflicting objectives through

continuous political bargaining between interest groups, state bureaucracies and political

parties. The success of the Cypriot system rests primarily on the voluntary cooperation between

the social partners in a tripartite system which includes both the employers and employees

(both represented collectively) and the government, which has more of a coordinating and

mediating role.

The events of 1974 contributed to a sense of solidarity and unity, stemming from the effort

undertaken by all to overcome the unprecedented harsh economic situation which resulted

from the tragic events of that year. Trade Unions at the time consented to a voluntary reduction

on wages and salaries reaching 25%, while Cypriot entrepreneurs proved to be decisive, dynamic

and willing to take risks in exploiting any opportunities arising. Such an accommodating attitude

set the foundations for the future cooperation between social partners and assisted in achieving

remarkable rates of economic growth there on (see Table 2) that even allowed for the

automated wage indexation to carry on, despite practices adopted in other European countries.

Favourable economic growth rates prevented the economy from becoming an issue of

confrontation in the domestic political discourse. Controversy and political debates loomed

almost exclusively over the unresolved national problem.

[Table 2]

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The peaceful industrial relations environment has, however, been under intense pressure in

recent years. Importantly, certain developments have altered the nature of the labour market in

Cyprus, bringing to the surface an on-going fragmentation, akin to what exists in other South

European countries. Labour market fragmentation into ‘outsiders’ and ‘insiders’ is a common

trait for South European countries (Ferrera 1996). ‘Insiders’ form a group of hyper-protected

beneficiaries (typically public employees, white collar workers and specific private wage-earners

with high union protection, working on full contract and enjoying job security, generous

replacement benefits for short-term risks and high earning related pensions) while ‘outsiders’

consist of under-protected workers whose working conditions are far less advantageous (Gal

2010). As globalisation pressures have intensified there has been a positively related expansion

of the flexible employment sector, consisting of the less-privileged ‘outsiders’ that are engaged

in temporary, part-time or informal employment and, importantly, are not covered by collective

agreements (Amable 2003 and Hancke et al. 2007: 30).

In the case of Cyprus, traditionally, the labour market has been highly unionised, enjoying union

densities that exceeded 75%, with some sectors having a unionisation rate near 100%

(specifically the public and the banking sectors). In recent years, however, union density, while

still high relative to other European countries, has dropped to a record low of around 55%2. This

can be explained, especially in post-EU accession period, by the increasing inflow of migrant

workers which are often at the margins of the labour market and not well-integrated in Cypriot

society (Natali and Pochet 2010). Also, importantly, an increasing number from the local

population is now employed in private enterprises where trade unions have relative weaker

presence. Wages for the ‘outsiders’ in the private sector are usually lower than the public sector

(see Table 3) while further downward pressures on wages are experienced because of the

abundant availability of migrant workers willing to work for less. The reluctance of these

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workers to join the local trade unions has added further pressures to the working conditions in

the private sector, where unions have most evidently been losing power and influence.

[Table 3] 3

On the contrary, the traditionally highly-unionised sectors have succeeded in retaining high

union densities, thus allowing for their members (‘insiders’) to enjoy favourable working

conditions. For many Cypriots, professionally the ‘Cyprus dream’ became synonymous with a

place in these sectors (i.e. broad public sector and to an extent the banking sector), due to the

unparalleled terms of employment. Specifically these have to do with well-paid jobs (see Table

3), a secure career progress relying mostly on the years of service and not productivity; steady

wage increases (guaranteed by the automated wage indexation); favourable working hours; and

life-time job security. Having the backing of their appeased members, the unions in these

sectors ended up being powerful and influential organisations with political clout and often with

agenda-setting powers in social dialogue.

Importantly, there is a further fragmentation within the private sector, with the emergence of a

professional elite made up of accountants and lawyers that deal exclusively with the rapidly

expanding corporate sector and provide financial, accounting and legal services. For them,

remuneration is on average more rewarding, yet the duties and responsibilities are tough and

highly-demanding. This group of professionals disassociates with the trade unions, they prefer

individual arrangements rather than collective bargaining and they are content with being

‘outside’ the highly unionised sectors. All initial signs of fragmentation in the labour market are

becoming more and more evident as the financial crisis hits further the Cypriot economy, while

the expected signing of a memorandum will possibly bring a new era in industrial relations and

its complete overhaul.

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Financial Services and the Banking Sector (how Cyprus differs from conventional Mediterranean

capitalism)

Corporate finance in Cyprus, similarly to other South European countries, is bank-based rather

than equity-based and this is related to the nature of the enterprises active on the island.

Importantly, the state either owns or controls certain important large scale organisations (e.g. in

telecommunications, electricity, aviation) which have in effect been financed by the state or by

banks with the backing of state guarantees. Beside these large-scale corporations, and given

that Cyprus never actually experienced an industrialisation process that could have resulted in

heavy-industry corporations in the private sector, the majority of the private enterprises are

small and medium and they rely on the banks and the still very popular credit cooperative

corporations for obtaining finance. Family and high ownership concentration (linked with a

reliance on banks for finance) remain key characteristics for companies in Cyprus, in line with

other South European countries (Gospel and Peddleton 2004: 25).

Other typical characteristics of Mediterranean countries such as a low sophistication of the

financial markets and the limited protection offered to share-holders (Amable, 2003) are also

traced in Cyprus, with the unsuccessful setting of the stock exchange in 1997 strongly

highlighting them (Featherstone 2000: 151). The subsequent stock market crash, only a few

years after its establishment, confirmed a weak and ineffective regulatory framework, where

the relevant institutions were unable to protect the average investor. As a result, the local banks

verified their position as the prime provider of finance for enterprises and as one of the most

prominent and influential actors in the Cypriot economy and society.

Beyond the nature of corporate finance in Cyprus, there are other outstanding finance-related

characteristics that distinguish Cyprus from other Mediterranean countries and can assist in

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explaining Cyprus’s distinctiveness but also its recent economic collapse. Particularly, these

stem from the globalisation of finance and Cyprus’s success in following international trends and

diversifying its economy to develop into a reputable global financial centre. This consequently

resulted, among other, in a disproportionate expansion of the banking sector, the size of which

is unique compared to other Mediterranean states, apart from Malta.

Topical research has attempted to codify the main characteristics of countries offering financial

services to international companies and has rejected the notion and popular image that they are

simply tax havens facilitating tax evasion (Dharmapala 2008; Dharmapala and Hines 2009).

Specifically such countries tend to have:

stronger governance institutions (better political and legal systems and lower levels of

corruption)

relatively sophisticated communications infrastructure

poor endowments of natural resources

legal origins most likely linked to the British system

English as an official language

Small size

Cyprus seemingly fits the above characteristics since it has managed to provide: an ideal

business environment due to its preferential tax regime4 (currently the 10% corporate tax is the

lowest in Europe) which is in full compliance with the EU and OECD requirements5, while

according to the Basel Institute of Governance Country Risk Ranking, at an international level

the country achieves a low place regarding money laundering / terrorism financing, and other

related factors such as corruption and political risk6; an extensive system of double-treaties; a

legal, accounting and banking framework based on British standards (remnant of colonial

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heritage); a qualified labour force, well-educated and endowed with internationally recognised

legal and accounting skills (also remnant of British rule); good geographical location and

communications infrastructure; a reliable telecommunication system; its micro-state status; and

a ready supply of office and accommodation of a high standard (IMF 2001: 5; PWC 2011).

The permits granted to international business companies up to 2001 (Table 4), show Cyprus’s

success in attracting such companies. Even more, post 2001, when the distinction between

offshore and onshore was no longer valid, the success story continued. The total companies

registered in 2002 was 8,497 increasing steadily to 14,494 in 2005 and averaging 21,444 per year

in the period 2006-2011 (Source: Department of the Registrar of Companies and Official

Receiver (D.R.C.O.R.) of the Republic of Cyprus)

[Table 4]

Many are the benign spill-over effects that spiral from Cyprus’s establishment as an attractive

financial centre. Cyprus for instance ranked eighth in the world for inward FDI performance

according to United Nations Conference on Trade and Development (UNCTAD) in 2010 (UNCTAD

2011). In addition, government revenue has also been boosted directly from taxes on profits.

Furthermore, the expansion of certain local law and accounting firms, responsible for the legal,

accounting and administrative practices of international companies, has enhanced employment

prospects on the island7. To the above mentioned one may add the overall indirect multifaceted

effects touching sectors such as hotels and restaurants, the transport industry, retail trade, real

estate and other, which are not easily quantifiable but have undoubtedly benefited from the

arrival of international business on the island.

Last and certainly not least, special reference needs to be made to the disproportionate growth

experienced by the banking sector in Cyprus. Undoubtedly an accommodating global

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environment along with policy measures by the state to promote the country as an international

financial centre, have benefited the banking sector (Stephanou 2011), while even more, the

local banks benefited from operating within an oligopolistic and loosely regulated environment,

a trait common for south European countries. The leading three banks (Bank of Cyprus, Popular

and Hellenic) accounted for 97% of total assets of banks with Cypriot parents and overall

controlled 55.6% of domestic deposits and 48% of domestic loans (IMF 2011).

Such a highly concentrated environment led to an acquiring of disproportionate power by the

local banks, which allowed them to become an influential partner in the prevailing political and

economic setting. Political influence and clientelistic relationships between political parties and

local banks became a common feature and even made newspaper headlines, with reference

being made to the writing-off of debts, granting of favourable loans, and other dubious actions

between the two (Drousiotis 2012; The Cyprus Mail 2012). In addition, suspicion over the

influence of banks over mass media and the intertwined and inter-reliant relationship between

certain local media, the established major commercial banks and political parties has been also

an issue of concern (Panayiotou 2012). Unfortunately, such realities and practices were not

touched by the supervisory and regulatory authorities of the state institutions, which essentially

allowed for certain vague and potentially harmful practices and tactics to persist.

The huge expansion of the Cypriot banking sector is reflected from a comparative analysis with

the other European states. In 2010, Cyprus came second in Europe in terms of the size of the

banking sector relative to its GDP and along with Luxembourg (extreme outlier), Ireland and

Malta they stand out in comparison to other European countries (See Table 5).

[Table 5]

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The latest figures of IMF (2011) illustrate that growth of the banking sector has continued, with

total bank assets reaching an alarming 835% of GDP in 2011, with an uneven exposure to the

Greek market which accounts to €29 billion or 160% of GDP.

The heavy exposure of Cyprus in Greece requires particular analysis based on a two-fold

approach. Firstly, Cypriot-owned banks, in an attempt to attain a greater share of the market

and having abundant liquidity from deposits (both from local residents and foreigners), open-

handedly offered loans to Greek companies and households, through their aggressively and

rapidly expanding networks in Greece, and, secondly, they made huge and undiversified

investments in Greek sovereign bonds. The loss from the latter has already materialised,

following the voluntary Private Sector Involvement (PSI) in the Greek debt hair-cut in February

2012 as part of the Eurogroup agreement. Up to 75 per cent of the value of the bonds was lost

over night and for Cyprus this equated to around 4.5 billion euros, close to 25 per cent of the

country’s GDP. At the same time the losses from non-performing loans remain to be seen and

the amount is expected to be detrimental for the banks and, in effect, for the government who

is required to cover for the losses, taking the national debt of the country to unprecedented and

unmanageable levels. In response to these developments, there has been a strong public

sentiment against the bankers whose short-sighted decisions, based on acquiring short-term

overblown profits, ultimately proved to be catastrophic and with long-term toxic effects for the

whole economy.

It is interesting at this point for one to try to assess the particular and non-business related

reasons behind what seems to be an irrational and limitless exposure in Greece. The Greek

market has traditionally been the obvious strategic step for successful companies based in

Cyprus. Strong historical, national and ethnic ties (dating back thousands of years), cultural and

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religious commonalities and a common language, among other, allowed for a good

understanding of the Greek domestic environment and consumer rationale that eased the way

for Cypriot companies wishing to expand abroad. As a result, companies from different

industries (telecommunications, television, aviation, retail and other) extended their operations

in Greece, without being driven exclusively by rational business motives. This distinctive

relationship between the two states has shaped commercial relationships, creating strong and

long-lasting links between Greek and Cypriot markets, with the banking sector being by no

means an exception to the rule.

An inadequate and politicised welfare state

Gal (2010) links inefficient central states in Mediterranean countries with ineffective

bureaucracy and government-controlled institutions that are highly vulnerable to partisan

pressure. Such weaknesses translate in a social system that is: unevenly developed, fragmented,

politicised and subject to clientelism; has a mix of Beveridgian and Bismarckian traits; prioritises

employment protection over social protection; offers low levels of welfare provision with peaks

of generosity for certain sectors and macroscopic gaps of protection for other (Ferrera 1996;

Ferrera et al. 2000; Amable 2003).

Looking at comparative European figures it is evident that, overall, for South European

countries, social protection is below the EU average. Cyprus is no exception and the available

figures illustrate a rather meagre social protection system in Cyprus with a relative small amount

devoted for this cause (Table 6). Even with a catching-up witnessed between the years 2000 and

2005 Cyprus still has a relatively low social special spending-GDP ratio (Bazant and Schubert

2009).

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[Table 6]

Furthermore, the fragmentation and politicisation of the system hampers an efficient allocation

of the otherwise limited resources allocated for this cause. Analytically, the overall responsibility

for the development and maintenance of social protection on the island is divided between

three different ministries (Labour and Social Insurance (MLSI), subdivided into three

departments; Health (MoH); and Finance (MoF)) (Pashardes 2003).

The Department of Social Insurance of the MLSI is responsible for the Social Insurance Scheme.

Importantly, in 1980 the Scheme was transformed from a flat-rate to an earnings-related

scheme, i.e. a shift from a Beveridgean to a Bismarckian approach. Practically, however, this

shift has not taken place since the Social Insurance Fund has been an object of politicisation,

lending the entire sum of the contributions it receives to the government. As a result, the

payments of the Fund to the entitled beneficiaries are obtained from the government budget,

on a pay as you go basis8. The Fund practically has zero value and the government, as the sole

receiver of the Fund in the form of a loan, has the responsibility over the payments the Fund

needs to make but with no firm commitment to repay the amount it owes the fund.

Otherwise, in a rather complicated arrangement, the MLSI and the MoF are responsible for

various other government grants and benefits that are financed directly via taxes. Health

services are also funded out of general taxation, with the exception of a small part financed

from charges imposed on some services. Those entitled to free health care are all civil servants,

while for others it depends on their income and demographic characteristics.

The structure of the welfare system is complex and fragmented, with a lack of central control

over social policy that has allowed for it to be prone to manipulation and politicisation. The

social policy gap has required the involvement of the ‘Cypriot family’ and the Church, acting as

23

reliable social safety nets and covering for the state’s deficiencies (Ferrera et al. 2000; Shekeris

et al. 2009). Given its relatively limited budget, it is essential for the state to step in and make it

better targeted, using higher poverty and social exclusion as criteria for eligibility to social

assistance benefits (Pashardes and Polycarpou 2011).

Cyprus’s outstanding education levels

Last but not least, specific reference must be made to one of Cyprus’s most prominent

comparative advantages, the high levels of educational and professional qualifications attained

by the local population. This contradicts Amable’s (2003) findings where Mediterranean

countries are associated with low enrolment rates in tertiary education. Since independence

(1960), but most notably after the events of 1974, the country has put considerable emphasis on

education, as one of the strong beliefs of Cypriot planners was the importance of investment in

human capital through education (Matsis 2001: 430-433).

The state in fact covers education from pre-school until university, while Cypriot students of

tertiary institutions both in Cyprus and abroad receive an annual grant from the government,

recently made subject to financial criteria. Apart from public options, there are also many local

private schools and in recent years private universities as well, though studying in universities

abroad has traditionally been a long-lasting and preferred option for Cypriots. The emphasis

placed on education in Cyprus is reflected in the Report covering ‘The Bologna Process in Higher

Education in Europe’ (EC 2009) where Cyprus enjoys the highest share of tertiary education

graduates in the age-group 25-34.

24

Overall, the commitment of Cypriots in education and the expansion of tertiary education

systems (offering both professional and academic qualifications in compliance with international

standards) have complemented accordingly the needs of the labour market and the rapid

expansion of the services sector on the island. Providing credible financial and legal services to

an international clientele requires specific knowledge and expertise and the success of the local

firms in doing so has rested greatly on the highly qualified personnel abundant in Cyprus.

IV. Conclusion

In light of the above analysis, it is evident that Cyprus’s economy has certain interrelated

characteristics that are close to a typical Mediterranean variety of capitalism. These include the

prominent and multi-faceted role of the state; the oversized public sector (with a high and

inelastic government personnel and administrative cost) that is subject to a great extent to

political party pressures and nepotism; the weak welfare state that is fragmented and

politicised; powerful unions with veto-power status that cover a high, yet decreasing, proportion

of the labour force, thus leading to the creation of insiders and outsiders in the labour market; a

low sophistication of financial markets which have been inadequately regulated and supervised;

and an oligopolistic and highly concentrated banking system. Such features may cause labour

market rigidities affecting competitiveness, shape public expenditure in an inelastic manner,

with adverse effects on the national debt, and, in effect, hinder economic growth prospects.

These traits, can however, at best, provide only an incomplete and static picture of the country’s

economy over the past decades. The post-1974 Cypriot ‘economic miracle’ (Sepos, 2008: 83) has

been linked to, among other, stable economic growth, manageable national debt levels,

peaceful industrial relations and low unemployment levels, features that have experienced a

25

sudden and abrupt derailment. As a result, this paper placed specific reference on the

ambiguities evident in Cyprus, not foreseen by the conventional MME of VoC theory. These

ambiguities have mostly stemmed out of historical specificities related to Cyprus.

Analytically, these specificities have been related to the British colonial rule, the events of 1974

and the multidimensional chronic ties with Greece. Initially these characteristics have allowed

for Cyprus to gain certain comparative advantages and diversify domestic production in such a

way that it stands out among other Mediterranean states. In relation to more recent

developments, these specificities can also shed light on the reasons behind the current financial

situation on the island.

Firstly, the effects of 1974 have been pivotal since, besides the immediate adverse effects

resulting from a war and the loss of land, a sense of solidarity was cultivated among Cypriots in

their struggle for survival. This allowed the social partners to more readily overcome any

industrial disputes, thus enabling for growth in the economy to progress uninterrupted.

Undoubtedly, this remarkable economic growth and the low levels of unemployment on the

island oiled the system. At the same time, underlying inefficiencies were side-lined. Indeed, it

now remains to be seen whether the current situation that has put they system under

unprecedented pressure will affect the nature of industrial relations on the island.

Secondly, the ‘colonial heritage’ from the British rule (not evident in Spain, Portugal, Italy or

Greece), positively affected the civil service which placed emphasis on strategic planning and

has succeeded in providing, at least to a great extent, the necessary infrastructure for locally

based business. Furthermore, the highly educated labour force of Cyprus is accustomed to the

use of the English language, widely used since the time of the British administration, and many

are those that hold UK university degrees and other related qualifications that allow them to

26

operate within a legal and accounting framework, based on internationally recognised

standards. Importantly, successive governments have tactically succeeded in signing double-tax

treaties and maintaining an attractive corporate tax regime, ensuring the establishment of

Cyprus as an international financial centre. Consequently, as a result of the flourishing services

sector, there has also been a related expansion of the banking sector, nevertheless, in a weakly

regulated and politicised environment. The actual size of the banking sector has been unique

relative to other south European states (with the exception of Malta) and with a potential

impact factor on the economy not accounted for in any other south European state which falls

under the relevant VoC model.

Finally, the long-lasting ties with Greece have also played a pivotal role in shaping the local

economy. Initially the banks and other enterprises were tempted to expand their operations in

the friendly Greek environment, taking advantage of the possibilities offered in a bigger market,

and were overall successful in doing so. Nevertheless, such an expansion, at least for the banks,

turned out to be a boomerang. The undiversified exposure of the disproportionately large and

inadequately supervised banking sector in the Greek market (either via lax offering of loans over

the years or through the uneven purchase of Greek government bonds more recently), has been

for many the lethal blow for the economy, as the financial assistance required by banks cannot

be handled without foreign assistance. With reference to one of the latest reports by Moody’s

(2012), essentially, the banking sector’s difficulties and the reduction of domestic credit growth

has subsequently severely constrained the country’s growth potential and exacerbated the

existing economic and institutional weaknesses of the local economy that are akin to other

Mediterranean countries.

27

In conclusion, in trying to particularly explain why Cyprus has been caught in a downward

financial spiral, the national specificities examined in the paper have enabled for a better and

more comprehensive understanding. In doing so the paper has initially acknowledged those

common traits Cyprus has with fellow south European states that form the core of the relevant

Mediterranean model of capitalism. While such traits indisputably need to be dealt with via the

necessary structural changes, they nevertheless, cannot fully explain the abrupt end to the

earlier economic growth experienced on the island. Consequently, the paper has stressed that

the imprudent decisions in recent years from those managing a disproportionate banking sector,

that has operated within a loose framework, and the special relationship of Cyprus with Greece

(specific traits not covered by conventional VoC theory), may have actually been the particular

detrimental factor for Cyprus, with the resulting ruinous and destructive consequences.

Acknowledgments:

This paper is part of a post-doctoral research programme funded by the Research Promotion

Foundation (Republic of Cyprus). The author would like to thank Professor Kevin Featherstone

(LSE), Professor Dimitris Papadimitriou (University of Manchester) and Associate Professor

Bambos Papageorgiou (European University Cyprus) for their invaluable help and the

constructive feedback provided.

28

1 For the period 2006-10, the Cypriot debt to GDP level was 58.4 per cent for Cyprus while the EU average was 67.5

per cent (source: Eurostat)

2 The rate of union density fell from 76.16% in 1990 to 58.06% in 2006 (European Industrial Relations profile Online

(EIRO) - http://www.eurofound.europa.eu/eiro/country/cyprus_3.htm

3 A series of austerity measures have been passed by the parliament as part of negotiations with TROIKA which

aim to correct to some degree the imbalance between the level of pay in the public and private sector

4 Offshore companies prior to compliance with EU accession requirements had been taxed at a 4.25 per cent

corporate tax rate compared to 20-25 per cent for local firms. In July 2002 the Parliament approved of a uniform

10 per cent corporate tax rate to apply to all companies.

5 Though Cyprus had been temporarily included in the annual reviews of the Financial Actions Task Force of the

OECD (though never given the label of a non-cooperative state) it was taken off the list in June 2000, for having ‘a

comprehensive anti-money laundering system’ by implementing the internationally agreed tax standard (Mullen

2011: 72).

6 For the complete ranking of the Basel Country Risk Ranking see

http://index.baselgovernance.org/Index.html#ranking 7 Indicative is the number of qualified accountants registered in Cyprus: comparing 2010 (2,899) with 1985 (233),

the number has increased by more than ten times (Source: Institute of Certified Public Accountants of Cyprus)

8 Entitled beneficiaries are limited to those gainfully employed which contribute to the financing of the Scheme.

Employers and government complete the tripartite system of contributors (Shekeris et al. 2009: 91).

29

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List of Tables:

Table 1: The three Varieties of Capitalism – Molina and Rhodes

CMEs LMEs MMEs

Dominant form of coordination of micro-interactions

Autonomous coordination Market; arms’ length interactions

Mixed (autonomous + market) with a higher impact of regulation and state mediation

Source of complementarities

Bottom-up induced Market-induced Coherence across policy arenas

State regulatory changes aimed at correcting coordination failures may be dysfunctional

Reinforcing mechanisms (mechanisms of stability)

High permeability of political system to domestic coalitions

High penetration of policymaking by exogenous economic forces

Gate-keeping role of the state: veto power of domestic actors

Time Horizons Long-term Short-term State-regulation may perpetuate long-term inefficient equilibriums

Investment in specific assets

High Low Medium-low

Organisational characteristics of interest associations

Employers: strong and well-organised in sectors Unions: politically strong and well-articulated organisations

Employers: Fragmented Unions: Strong firm-level, but fragmented and politically weak

Employers: fragmented Unions: politically strong but fragmented and weakly articulated

Role of the state Enabling: protects collective goods

Minimum state: guarantees the effective functioning of the market

Pervasive state: direct production and regulation + correction of coordination failures

Expected reform coalitions

Cross-class Producer groups, multinational industrial, and financial groups

Class conflict; fragmented cross-class coalitions (sectoral reform coalitions)

Source: Molina and Rhodes (2007: 229)

36

Table 2 Average annual real GDP growth rates for given period

Period 1976-79 1980-84 1985-89 1990-94 1995-99 2000-04 2005-09

Average annual GDP Growth Rate

12,9% 5,9% 6,4% 4,8% 4,0% 3,4% 3,0%

Source: Iosif (2010)

37

Table 3: Structure of public relative to the private sector wages (2012)

Occupational Category Salaries in public as % to

private sector

Managers, senior officers 82%

Other professionals 103%

Teachers 210%

Technicians, Associates 120%

Clerks, cashiers 129%

Services/sales workers 136%

Skilled Workers 119%

Unskilled workers 210%

All 146%

Source: Economic Research Centre University of Cyprus (2012)

38

Table 4: Number of International Business Companies registered in Cyprus in given time period

Period 1976-80 1981-85 1986-90 1991-95 1996-00 2001

No. of companies 900 2,698 3,218 15,400 25,249 5,858

Source: Central Bank of Cyprus (CBC) (2002)

39

Table 5: Size of banking sector: Total assets of credit institutions as percentage to GDP (2009)

Country Ireland Greece Spain Italy Cyprus Luxembourg Malta Portugal

Percentage 809.3% 206.4% 326.6% 242.8% 822.4% 2,118.4% 721.0% 310.3%

Source: ECB (2010)

40

Table 6: Expenditure on social protection: as a percentage of GDP (2009)

Country EU27 EuroArea Greece Spain Italy Cyprus Malta Portugal

Percentage 29.5% 30.2% 28.0% 25.0% 29.8% 20.9% 20.0%1 27.0%

Source: Eurostat webpage

(http://epp.eurostat.ec.europa.eu/portal/page/portal/social_protection/data/main_tables)