Damaging Consequences of Cyprus Capitalism

In this note it is argued that key characteristics in the operation of the capitalistic system of Cyprus are adversely affecting the economy and society.

Capitalism, also called a free market economy, is an economic system dominating the Western world in which most means of production are privately owned and production is guided and income distributed largely through the operation of markets with the intent of making profits.

Beginning with Adam Smith it has been contended that a capitalist system requires genuine competition in order for market forces to produce an efficient allocation of resources enabling nations to increase their wealth[1]. In so far as most existing economies, including Cyprus, are mixed combining elements of free markets with state intervention, free competition is distorted.

In practice and more specifically in Cyprus, not only state intervention to provide public goods and services distorts competition, but a combination of crony capitalism and debt-fueled rent-seeking and financial capitalism interfere with the operation of free markets producing damaging effects on the economy and society. Most notably, innovation and risk-taking entrepreneurship are stifled leading to an inefficient allocation of productive resources and lack of decent jobs, while rentier capitalism channels income to the owners of property---- physical, financial and intellectual--------at the expense of society. In addition, wages stagnate as capitalists exploit their market power, and labor markets are transformed by automation, outsourcing and the online-demand economy, widening inequalities and increasing the precariousness of many individuals[2].

This note Is confined to how the impact of the functioning of the capitalist system of Cyprus is affecting the allocation of the economy’s resources, while its impact on labor market developments including the distribution of income will be addressed in a subsequent piece.  

Crony Capitalism

It has been stated that “the central problem of modern capitalism is the tendency of great wealth to transform itself into political power that corrupts the political process and generates laws and regulations favoring the wealthy”[3]. This view captures the essence of how the capitalist system operates in Cyprus, with the caveat that it is also the biased and weak enforcement of laws and regulations to favor the rich and powerful that is a salient feature of the political economy of Cyprus.

 Crony capitalism associated very much with rent-seeking is prevalent in Cyprus and characterized by individuals and businesses with political connections and influence seeking and being favored with tax breaks, subsidies, awards of public sector contracts and jobs, and other forms of government intervention in ways seen as suppressing and distorting open competition in a free market so as to gain an unfair advantage. Indeed, in Cyprus it is the nexus between the business elite and the ruling political classes that contributes to impeding and distorting the efficient allocation of resources.

Weaknesses and inefficiencies in the justice system and the public services including tax administration are gladly tolerated by the ruling class with laws and regulations deliberately designed, selectively applied and bypassed in order to favor particular business entities and politically connected individuals. Most importantly, lengthy politically tainted court proceedings and judgements contribute to weak contract enforcement including that for property rights.

Furthermore, developers and hoteliers are often explicitly or stealthily permitted to violate environmental regulations such as in the construction of buildings in nature-protected areas.

And over recent years the Tenders Review Authority appears to blatantly favor certain contractors in the award of public works projects!

The uneven application of the grossly inefficient tax system of Cyprus contributes importantly to an unlevel playing field and deprives the government of the revenue resources required to provide high quality public services and infrastructure. And with very lengthy delays in the assessment of tax returns (five to six years after personal income tax filings), endless appeal procedures, small penalties for tax delinquency, and generous tax amnesties, tax evasion implicitly tolerated by the government has become huge.

However, it is the failure of the Cyprus government, especially its legal authorities, to investigate and deal with blatant cases of corruption, nepotism, and conflicts of interest that characterize most strikingly the crony capitalism of Cyprus. Government bureaucrats who have been bribed to give generous concessions to companies in the contracting of Public Private Partnership projects, such as those involving waste management, have not been penalized for their corrupt behavior. And top government personnel taking their close relations on official overseas trips so that the latter can undertake private business escape prosecution for their conflicting actions.

With certain businesses in Cyprus given unfair advantages through their political connections, such as being able to effectively default on their tax and debt obligations, market competition has been substantially distorted making it difficult for smaller businesses to succeed. This has led to a concentration of wealth and power in the hands of a few individuals and companies. And with larger businesses in a dominant position and facing diminished competition these firms are less inclined to undertake innovation and engage in risk-taking entrepreneurial activities.

As a result, investments in new activities and technologies are limited making the Cyprus economy much less productive in use of capital and skilled labor than its potential. Indeed, the crony capitalism of Cyprus with its impact on resource allocation is contributing importantly to the country becoming a low value-added and wage economy dependent increasingly on mass tourism, consumerism and the excessive construction of non-social properties.

Financial Capitalism

Banks and other financial institutions in their activities have been responsible as well in contributing to the inefficient allocation of the economy’s resources. Indeed, it was the unproductive lending of banks to politically connected business entities, especially property developers, that was a major factor in causing the 2012/13 financial crisis and in the piling-up of a huge amount of Non-Performing Loans (NPLs) that have burdened the economy ever since.

Powerful developers have not only continued to receive loans on very favorable terms, but have been allowed to effectively violate loan contracts through generous debt write-offs, often in exchange for over-valued property, and/or in the lenient rescheduling of their loan repayments.

And in recent years banks have largely failed to use their abundant amount of loanable funds productively in financing investments the real economy. By end-2022 Cyprus banks held cash and cash balances at Central Banks totaling 24.8 billion euro, more than their loans and advances outstanding of 24.3 billion euro.

 Furthermore, by shifting away from their traditional role of mediating funds between savers and investors Cyprus banks have become increasingly preoccupied with removing NPLs from their balance sheets with foreclosures of the properties of many smaller businesses and households and selling such loans and their property collateral to third parties. However, a great multitude of households and non-financial corporations remain heavily lumbered with debt. At the same time Cyprus banks in selling foreclosed properties at huge discounts to mainly rich investment and equity funds make considerable profits and engage in the transfer of wealth rather than creating wealth through the financing of real production.

Remedial Measures and Reforms

To iron out the crony capitalism in Cyprus reform of the justice of the tax administration systems to make them more efficient and less politically tainted and corrupt is paramount. And the legal authorities, police and tax administrators must have the political backing to strictly and even-handedly enforce laws and regulations.

To help stamp out corruption often associated with rent-seeking there is an urgent need to provide the Anti-Corruption Authority established in mid-2022 with the resources and political support to promptly investigate alleged cases of corruption and bribery. And for cases involving politicians in which this body has found reasonable evidence of corruption there should be legislation so that these cases can be passed onto not only the politically-appointed Attorney General, but also to two other legal experts in order to decide on whether to go ahead and prosecute such cases.

Moreover, in addressing issues related to crony capitalism including corruption Cyprus needs to substantially improve transparency and accountability in its political and economic system. Transparency on government contracts and subsidies given should be enhanced including providing detailed information on contracts awarded by the Tenders Review Authority being made public. And the fight against corruption can be helped by requiring accurate transparency on political donations, lobbying activities, and wealth declarations by politically exposed persons.

Furthermore, the media and investigative journalism can play an important role in exposing corruption and bringing about legal, political and penal action against it as the Al Jazeera documentary did with the Cyprus golden passport scandal.

In order to guard against political pressures and the influence of the rich and powerful the independence of regulatory bodies including those for the financial sector needs to be strengthened. Independent competent persons should be appointed to head and manage these institutions rather than the loyalists of ruling political parties.

And to mitigate against the activities and the unproductive lending of financial institutions as well their role in facilitating corruption, such as banks allowing money laundering transactions enabling illegal purchasing of passports and property, there is a compelling need to strengthen the regulations of and supervision by financial institutions. The Central Bank of Cyprus should put into practice its promise of instituting macro-prudential policies to deal with excessive bank lending to the property sector and introduce measures to regulate the sale of foreclosed properties to predatory third parties.