Absolute and Conditional Convergence in Both Zones of Cyprus: Statistical Convergence and Insitutional Divergence

• Author: Vedat Yorucu,Ozay Mehmet
• Published date: 01 September 2014
• Date: 01 September 2014
• DOI: http://doi.org/10.1111/twec.12170

Absolute and Conditional Convergence in

Both Zones of Cyprus: Statistical

Convergence and Insitutional Divergence

Vedat Yorucu

1

and Ozay Mehmet

2

1

Department of Economics, Eastern Mediterranean University, via Mersin 10, Turkey, North Cyprus,

Gazimagusa, North Cyprus, Turkey and

2

Carleton University, Ottowa, ON, Canada

I. INTRODUCTION

CYPRUS has had two separate economies since 1974, one in the North controlled by Turk-

ish Cypriots and the other in the South by Greek Cypriots. This study compares both

economies, and investigates whether there is any convergence or divergence. Many studies of

convergence of incomes and growth have been undertaken. One was carried out on Cyprus by

Demetriades et al. (2002) using time series analysis for the period of 1977–2000. They specif-

ically measured convergence over time of per capita income, per capita output and total

factor productivity, which provided a 2.3 per cent average speed of catching up and 30 years

to bridge disparities between North and South.

Although the estimation results were consistent with work undertaken by Campell and

Mankiw (1989), Cogley (1990) and Bernard and Durlauf (1995), the sample size used by

Demetriades et al. (2002) was small (24 observations). One of the reasons to revisit this study

is to analyse the effect of the economic boom in North Cyprus during 2003–06. A positive

investment climate caused a massive construction boom due to the referendum to reunite the

island with a comprehensive settlement plan prepared by United Nations experts (the Annan

Plan). It is believed that the North’s economy became closer to the South during 2003–06 as

a result of the boom. We are especially interested in determining empirically whether the

boom shortened the convergence timeframe. To answer this question, we extended the data

range from 1977–2000 to 1977–2008.

The third reason to revisit convergence is that we wish to go beyond statistical conver-

gence and examine whether there is institutional convergence or divergence. It is believed that

more than 50 per cent of the economy in the North is in the informal sector featuring, among

other characteristics, a large influx of cheap labour from Turkey. However, the most notable

characteristic of the informal sector is gate-keeping and rent-seeking, representing political

corruption. We have reason to believe that the informal sector is rapidly growing in the North.

We conclude that while there may be statistical convergence, in fact economic and politica l

institutions in the North, in particular those in the public sector are becoming subservient to

the informal sector, thereby creating institutional divergence.

Our study is organised in seven sections. After this Introduction, Section 2 will provide a

synopsis of the two economies. Section 3 will briefly review the convergence debate in the

related literature. In Section 4, we single out the Solow–Swan model of convergence as the

most appropriate theoretical framework for a two-region case. Section 5 explains our empiri-

cal methodology, data sources and highlights our main findings. Section 6 deals with institu-

tional divergence on the basis of a two-sector model of gate-keeping and rent-seeking in the

case of North Cyprus. Finally, Section 7 highlights our principal conclusions.

©2014 John Wiley & Sons Ltd 1315

The World Economy (2014)

doi: 10.1111/twec.12170

The World Economy

2. SYNOPSIS OF TWO ECONOMIES IN DIVIDED CYPRUS

The economy of the South has shown very impressive growth performance over the last

three decades. It enjoys full political recognition from the international community, is an EU

member, and participates in international trade and monetary system as a legitimate state. By

contrast, the North has suffered from political and economic isolation since 1974. The South

has achieved enormous growth in output, per capita income and total factor productivity. The

North achieved a delayed take-off and institutional development (Mehmet and Yorucu, 2010)

and began to experience significant growth since 2002. Only Turkey has helped North Cyprus

to manage their economy and undertake necessary infrastructural investments.

As shown in Table 1, North Cyprus is poorer than the South. The South’s miracle growth dur-

ing the 1980s and 1990s was built upon expansion of tourism, construction and other service

industries, such as auditing, accounting, taxation and international business companies. GDP in

the South rose from 2,157 million US dollars in 1980 to 24,910 million US dollars in 2008. By

contrast, GDP in the North, increased from 230 million US dollars to 3,957 million US dollars

for the same period. When we compare the economic performance of the two regions, the South is

six times bigger than the North. When we compare the per capita income, the South has been

three to four times richer over the period of 1980–2000. However, this gap has been narrowing

since the Annan Plan referenda in April 2004. In 2008, per capita income in the South was 31,409

US dollars and 14,421 US dollars in the North. The 2008 income disparity of 0.45 has continued

to decline owing to the slowdown of the economy in the South relative to the North (Figures 1–3).

The gap between GDP per worker was more than three times during the period of 1980–

2000, and became almost one and a half during 2000–08. The South has been following an

annual steady state growth path with an average of 4 per cent, whereas the North has regis-

tered highly volatile real growth rate over the last decade.

3. THE CONVERGENCE DEBATE AND APPLICATIONS

The subject of convergence is vast (Islam, 2003). Earlier, the subject was known as income

equalisation theorem. Given perfect competition and factor mobility, the theorem reaches the

policy-rich conclusion that real income per capita between a rich and poor region converges,

relative to a steady state growth pattern. Therefore, poorer regions can ‘catch up’ to richer

ones, achieving absolute convergence.

In the literature, two measures of convergence are recognised. One is Beta convergence,

relating to absolute or unconditional convergence (Islam, 2003). The second is the Sigma con-

vergence, linked to the notion of dispersion of incomes between regions at a point in time, and

how fast this is reduced. There is also conditional or club convergence, which refers to a set of

regions converging not to a single equilibrium level of (common) income, but rather to differ-

ent equilibria conditioned by case-specific technological or policy environments (Islam, 2003).

There are two growth models showing the steady state path of an economy to higher

per capita income: the Solow–Swan neo-classical growth theory, in which growth is exoge-

nously engineered on the basis of factor accumulation, and the endogenous growth model, in

which growth results from enhanced factor efficiency.

In the neo-classical model, growth stimulating Beta convergence is realised exogenously. In

endogenous growth models, the emphasis is not on accumulation of factors but on increasing

returns to scale. Endogenous growth explains growth on the basis of enhanced factor efficiency.

Turning to some of the related empirical studies, several finding evidence of convergence

(Barro and Sala-i-Martin, 1992, 1995). Atkins and Boyd (1998) applied the Solow–Swan

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1316 V. YORUCU AND O. MEHMET