Abstract
Cyprus is a divided island. Despite the lack of a comprehensive peace agreement reunifying the country, in 2004 trade commenced across the Green Line that separates the Greek and Turkish Cypriot communities. The volume of trade has grown steadily since, but has it reached its full potential? First, a gravity equation is estimated by using an ‘out-of-sample’ estimation strategy to predict potential trade for the period from 2004 to 2009. We observe a sizable gap between potential and actual volumes of trade. We then attempt to account for this gap by analyzing economic, legal, and social-psychological barriers that can explain this difference. It is found that (1) actual trade has only reached around 10% of its potential, with (2) legal constraints accounting for 35% of the missing trade, (3) extra transportation costs for about 5%, and (4) unmeasurable and social-psychological barriers for a significant amount of between 48% and 60%, depending on the year. The findings suggest that attention must be paid to the objective barriers to trade as well as the subjective interpersonal and intercommunal perceptions that can affect trade and ultimately, peaceful resolution of the conflict. These findings have implications for other conflicts in which divided communities with the potential for trading across a shared border seek to maximize the joint economic and political gains of emerging interdependence.
Introduction
Economic interdependence is widely seen as a deterrent to violent conflict. It is argued that states focus on the absolute gains from trade and lay aside concerns about relative gains when they are not in conflict (Morrow, 1997), and they stay focused on the prospect of continued future gains from economic interdependence, thus avoiding violent conflict (Copeland, 1996). Nonetheless, the relationship between economic interdependence and conflict is a complex one (for general reviews, see for example Barbieri & Schneider, 1999; Oneal, Russet & Burbaum, 2003). The existing literature has been advanced through large-N studies on interstate trade, conflict, and peace, and it has been less focused on intrastate conflicts. This article contributes to the debate on the relationship between economic interdependence and conflict by focusing on a case of internal, protracted conflict: the case of Cyprus.
The island of Cyprus remains divided along the Green Line, a United Nations-monitored buffer zone between the ceasefire lines that are a legacy of the 1974 partition of the island. For well over 35 years, the Green Line has divided the northern and the southern parts of Cyprus and stood as both a symbolic and real obstacle to interaction and peacebuilding between the two communities (UNFICYP, 2010). The Greek and Turkish communities of Cyprus hence behave like de facto separate states even though they remain part of the same island and – at least de jure – of the same country. Trade and civilian traffic across this border has been virtually nonexistent until the northern side unilaterally opened gates on the Green Line in 2004. Trade has grown ever since at an average annual rate of 35.9%. In this article, we ask whether the volume of trade between the two sides has reached its full potential. And if not, how do economic, legal, and social-psychological barriers impact trade between northern and southern Cyprus? By examining in depth the case of emerging trade between intrastate adversaries, Turkish Cypriots (TC) and Greek Cypriots (GC), we attempt to shed some light on these questions by conducting a two-step analysis.
The remainder of the article is organized as follows. In the following section, we determine the difference between actual and potential levels of trade for the period from 2004 to 2009. To do so, we first estimate a benchmark gravity equation of trade for the European Union to model the patterns of dyadic trade within the EU as a function of factors such as economic sizes, population, distance, and a set of cultural, historical, and political variables. This model is then used to calculate projections for trade between northern and southern Cyprus. The difference between these estimates of potential trade levels and the actually observed ones is then examined in order to determine factors that function as impediments to trade and thus may account for the gap. We differentiate between objective, quantifiable restrictions, as well as subjective and non-quantifiable constraints. 1 We find that a ‘culture of conflict’ exists throughout the island that impedes ‘mutually productive interchange’ (Fisher, 2001: 322) and sketch out how this may play a role – alongside the classic objective barriers to trade – in maintaining the gap between predicted and realized intra-island trade.
Potential versus actual volumes of trade
After the failure of the UN-led mediation between the two Cypriot communities, the Republic of Cyprus (RoC) acceded to the EU on 4 May 2004 without resolution of the communal division. In response, the EU modified the Treaty of Accession with conditions laid out in Protocol 10 addressing the accession of Cyprus as an internally partitioned member. The application of the acquis communautaire has since been suspended in areas where the government of the Republic of Cyprus ‘does not exercise effective control’ – namely, northern Cyprus (as well as certain areas used as UK military bases).
Protocol 10 also establishes special rules concerning Green Line regulation trade (GLRT) – the crossing of goods and services from northern to southern Cyprus. 2 However, since the EU does not regard the Green Line as the external border of the Union, goods entering areas not effectively under control of the RoC are not subject to customs, duties, or charges, nor are they subject to customs declaration; the quantities of goods, however, have to be registered. Goods may only enter the RoC this way if they were wholly obtained in the areas not effectively under the control of the RoC, or if they underwent their last, substantial, economically justified process in areas not effectively under the control of the RoC. Goods crossing the Green Line are to be accompanied by a document issued by the Turkish Cypriot Chamber of Commerce (TCCC), which is authorized by the EU to ensure that the guidelines detailed above, as well as quality and health standards, are met (Council Regulation, 2004).

Potential versus actual annual Green Line Regulation Trade (in million Euros), 2004–09
As Figure 1 illustrates, Green Line regulation trade has steadily grown since the implementation of the protocol in 2004. Starting from goods valued at 1.13 million Euros in 2004, GLRT peaked at 7.17 million in 2008, with an average annual growth rate of 39.5% over the period from 2004 to 2009. 3 Given these increasing figures, the question arises whether the volume of trade between the two sides has reached its full potential or whether there is still room for trade expansion.
We construct a Green Line trade possibility frontier to estimate potential trade levels in order to shed some light on this question. To do so, we first estimate a gravity equation of trade for the European Union to model the patterns of trade within the EU between 2004 and 2009.
The model
Pioneered by Linnemann (1966), Pöyhönen (1963a,b) and Tinbergen (1962), the gravity model of trade holds that the level of trade between two countries is an increasing function of the economic size of each state and a decreasing function of trade costs, usually modelled as the distance between the two. Over the years, theoretical frameworks have been developed in order to adapt the model to different trade theories. The gravity model has since become a workhorse not only in the estimation of trade flows, but also in related areas such as foreign direct investments or migration flows. 4 It has also proved useful in explaining trade frictions that inhibit the free flow of goods and services be they natural, such as geographic particularities of a country (see for example Anderson & van Wincoop, 2004; Hummels, 2007), or man-made, such as currency unions (Baldwin, 2006; Rose, 2000), trade and integration agreements (Baier & Bergstrand, 2007; Egger et al., 2011), or conflict (Polachek & Seiglie, 2007; Reuveny & Kang, 2003).
A general gravity equation for trade between two entities may be expressed as:
where T ijt represents exports from country i (exporter) to j (importer) at time t, Y it and Y jt are the economic sizes of countries i and j at time t, D ij is the distance between i and j, di and dj are dummies identifying the exporter and importer, α0, α1, α2, α3, θ i, and θ j are unknown parameters.
Most studies log-linearize Equation 1 and estimate the parameters by using ordinary least squares (OLS) regression techniques. However, as has been pointed out repeatedly over recent years (e.g. Egger, 2002; Egger & Pfaffermayr, 2003; Santos Silva & Tenreyro, 2006), using OLS leads to biased estimates given that a log-linear version cannot handle zero-values for trade and also suffers from problems of heteroskedasticity due to country- and time-specific effects. Santos Silva & Tenreyro (2006) have proposed a Poisson Pseudo-Maximum Likelihood (PPML) estimator as a remedy for these estimation problems, which has since been found to yield overall unbiased, robust and accurate estimation results (Santos Silva & Tenreyro, 2010, 2011). Hence, we estimate the following equation using the PPML estimator adding exporter-time and importer-time fixed effects as suggested by Bergstrand & Egger (2011):
where ln is the natural logarithm; pop is the population of the exporter/importer at time t; language is a dummy that accounts for a common language spoken in countries i and j; border is a dummy that accounts for a border between i and j; samecountry is a dummy that takes the value of 1 if exporter and importer once belonged to the same country; landlocked is a dummy that takes the value of 1 if the exporter/importer is landlocked; EU is a dummy for EU membership of the exporter/importer at time t; Euro is a dummy for Euro membership of the exporter/importer at time t; and η ijt is an error term.
Data
Following Egger (2002), we use panel data on dyadic export flows between the current 26 EU member countries for the years from 2004 to 2009. We exclude the country for which we estimate trade potentials (Cyprus) from the sample, and thus utilize an ‘out-of-sample’ estimation strategy.
Data on unilateral exports and population come from the IMF Direction of Trade Statistics and GDP data from Eurostat. Data on geodesic distances between each country’s most populated cities as well as dummy variables for landlockedness, historic country origin, border, and common language are from CEPII’s GeoDist database (Mayer & Zignago, 2011). The EU and Euro dummies are self-constructed. In total this yields a dataset with 3900 observations (26 exporters x 25 importers x 6 years).
Estimation results
In line with the findings of Santos Silva & Tenreyro (2006: 650), our PPML estimates confirm that the coefficients for GDP and distance are not close to 1 and –1 respectively, as has previously often been suggested, but rather around 0.6. Overall, the results are very much in line with findings reported by earlier studies, both in terms of the size of the coefficients and their signs, underlining the robustness of the model. Inserting the coefficents into Equation 2 yields the benchmark gravity equation that is employed to project potential Green Line regulation trade:
Projecting potential GLRT
We use income and population statistics for northern and southern Cyprus from the respective statistical offices for our projections. Yet, measuring the distance between the two entities poses challenges. The most common measure of distance, geodesic distance between capitals or most populous cities, is not an option in this case since both communities share a divided capital city, Nicosia. We thus use two alternative measures of distance derived from the literature on intranational trade. The first is based on Wei’s (1996) method of taking a quarter of the distance to the economic center of the nearest trading partner. In our case this would be Beirut, which is located about 244 km from Nicosia, yielding a score of 61 km for our distance variable. The second measure is derived from Leamer (1997) who suggests taking the radius of a circle whose area is the area of the country. From an overall area for Cyprus of 9250 km2, we calculate a radius of 54.26 km. Based on the rough average of these rather similar approximations we use 57.5 km as our measure of distance between northern and southern Cyprus.
Green Line Regulation Trade: Realized versus unrealized
Inserting these statistics into Equation 3 allows us to calculate potential GLRT. We derive trade potential at values of 33.7, 41.6, 48.7, 56.4, 60.8, and 56.7 million Euros for the years from 2004 to 2009, respectively. 5 In other words, as is summarized in Table I, the actual trade level in 2004 reached only 3.4% of the prediction, a figure that increased to 10.6% in 2009, with a peak of 11.8% in 2008.
Explaining unrealized trade potential
Although trade across the Green Line has grown since 2004 both in absolute numbers and relative to its potential, the overall level remains rather low at just over 10% of the predicted level in the peak year 2008. In the following, we develop a set of factors that we identify as relevant causes for this persistent gap. The first factor limits trade directly by product exclusion. Thus (1) trade restrictions currently in place prohibit important product categories such as citrus fruits, dairy products, and live animals except fish from being traded across the Green Line. An additional set of factors related to (2) transportation acts as cost drivers in that they impose excessive additional costs and thereby present an important obstacle to trade. These factors include (a) licensing requirements for drivers hauling over a certain weight, (b) costs linked to shipping and transportation, including high insurance rates, and (c) standstill time at the border. Additionally, we discuss two non-quantifiable explanations, specifically (3) the legal and taxation structure associated with GLRT and (4) the extent of mistrust, a socio-psychological consequence of divided communities living with an unresolved political conflict.
These factors will be assessed in more detail in the following section. It should, however, be noted that while it is possible to quantify the effects of legal constraints and costs associated with transporting goods, it is more difficult to quantify socio-psychological barriers and other technical aspects that may deter trade. Our analysis is based on the observable, quantifiable barriers, and when taken together, accounts for a variable portion of the unrealized trade. There is a residual portion of unrealized trade that we believe is correlated to such non-quantifiable factors.
Product restrictions and transportation costs
A number of products, such as citrus fruits and animal-derived goods, are not allowed to cross the Green Line due to sanitary and health concerns. To account for these product restrictions affecting the volume of trade, we examine the national account and trade statistics for northern Cyprus. For the years 2004 to 2009, export revenues from goods that are allowed to cross the Green Line constitute on average 65% of the total export revenues of northern Cyprus to the rest of the world. In other words, 35% of the overall export revenues of northern Cyprus are due to exports in products that are barred from GLRT. Correspondingly, we assume that a GLRT gap of 35% is attributable to the product restrictions that are placed on some types of tradable goods.
Transportation issues play a substantial role in constricting trade across the Green Line. One aspect driving up transportation costs is driver-licensing requirements that differ profoundly between the two sides. The RoC requires commercial drivers to hold special licenses to operate vehicles exceeding a certain weight (European Commission, 2011). Currently the only way to obtain these licenses is to pass a test given by the government of the RoC. In 2005, every TC that took the test failed (Donmezer & Apostolides, 2006). On occasion freight drivers have not been allowed to cross from northern Cyprus into southern Cyprus with their cargo due to improper licensing. This results in the need for companies in northern Cyprus to hire two sets of drivers. Hiring a second driver also means the goods have to be transferred at the Green Line onto different trucks. The unloading, reloading, and standstill time associated with the process add to the costs. The RoC also enforces a weight limitation on commercial vehicles coming from northern to southern Cyprus (European Commission, 2011). This restriction necessitates shipping in smaller quantities per truckload, also increasing costs. Additionally, insurance issues arise, with each side charging extra fees for vehicles registered in the other area. As the goods become more expensive to ship and trade, the overall benefits from trade for both communities are lowered, further reducing their incentives to engage in trade with one another.
We conducted interviews with 15 Turkish Cypriot business people engaging in GLRT to gather information in order to be able to quantify the additional transportation costs. In sum, the persons interviewed unanimously described the process of shipping goods as becoming more cumbersome due to the time consuming process of having to unload and reload goods at the Green Line. Asked how they would quantify the additional costs they usually incur due to this, most put the premium attached to GLRT at between 20% and 50%. Accordingly, we conservatively increased the distance measure used in our gravity model by 25% to account for the impact of extra transportation costs. 6 Thus, instead of the 57.5 km used in our base model we enter 71.9 km to capture this effect.
Incorporating the effects of additional product constraints and transportation costs into our model yields the results reported in Table I. Given our assumption that legal constraints can be quantified as the share of those goods restricted from GLRT of the overall exports of northern Cyprus, we assign a constant effect of 35% to product restrictions. The extra transportation costs account for an increasing part of potential trade that remains unrealized during the period under observation here, ranging from 1.5% in 2004 up to 5.4% in 2008.
After incorporating the effects of these two quantifiable barriers into our estimations we retain a sizable ‘residual’ of between 60.1% (2004) and 47.8% (2008) that can be ascribed to factors outside of the model as developed so far (see Table I). These aspects that we define as non-quantifiable barriers – whether non-quantifiable due to their nature or because appropriate measures are unavailable – are discussed next. 7
Non-quantifiable barriers
VAT restrictions, origin requirements, and banking facilities
The main restrictions in the structural and legal category in addition to the sectoral limitations are regulations on value-added taxation (VAT), origin requirements, and payment difficulties. 8 If these problems were addressed and eliminated, trade would likely increase between the two sides. 9 However, even the elimination of these problems would not resolve the underlying social-psychological issues that impede economic interaction, which we explore separately below.
VAT is an issue that traders on both sides face. The RoC follows standard EU VAT policies, imposing a 15% tax across sectors, while the rates in northern Cyprus depend on sector and product, ranging from 0% to 20%. The RoC requires all exporters to pay VAT and then apply for a refund, but only businesses registered with the GC Chamber of Commerce are eligible to receive refunds. Many TC businesses are not registered with the GC Chamber of Commerce. Thus, TC producers exporting their goods may suffer a 15% tax loss that cannot be recovered. For some goods the original benefits of trade may be negated, rendering the transaction economically unattractive.
Origin requirements are a major technical impediment. Both sides stipulate that only goods ‘originating in or receiving substantial value added in’ the respective area are eligible for trade. Fulfilling these origin requirements involves a time-consuming and costly multiple-step process. It requires documentation approved by the respective chamber of commerce and inspection of the product along with inspection of the facility where it was produced (Donmezer & Apostolides, 2006). At the same time, the product may not contain more than a limited amount of imported materials.
Without a common currency or meaningful business links, banks in the RoC and in northern Cyprus face challenges to interbank coordination, requiring that early trade transactions be paid in cash, further limiting the size of trades. 10 ‘Credit is rare between GC and TC traders, in large part because of the absence of a speedy and reliable mechanism that both sides trust, to recover bad credit. Nor is there a mechanism to arbitrate GL trade disputes’ (Donmezer & Apostolides, 2006: 39).
Mistrust and trade
Further impediments to trade can be found in the attitudes and behaviors of both communities. Earlier research on barriers to trade (Donmezer & Apostolides, 2006) focused on technical barriers, while acknowledging that social-psychological barriers played a role that merited further research. We survey data on the respective communities’ attitudes regarding trust, especially with regard to economic relations across the Green Line. What we find suggests strongly that both communities continue to make important misattributions about the other side that cast a shadow onto current and future cooperation.
Trust is generally low throughout Cyprus. A USAID/UNDP sponsored study found that most Cypriots (76% of GCs, 85% of TCs) believe that ‘only some people can be trusted’ within their own society (CIVICUS, 2005). GC society suffers from ‘widespread intolerance’, as measured by stated unwillingness to have neighbors who differ in terms of religion, ethnicity, immigration status, and other categories, while TC society was found to be only ‘moderately tolerant’ (CIVICUS, 2005).
Kelman (2007) asserted that contact among adversaries, in the absence of other factors, may not improve attitudes, and might worsen them. Despite trade and cross community contact, ‘each community continues to have misperceptions about the other’s true intentions and/or preferences’ concerning the resolution of the political dispute (UNFICYP, 2007). More troubling still are the trust-specific findings: even after the opening of the crossing points, most Cypriots had never had contact with the other community (90% of TCs, 87% of GCs). Since the opening, 45% of GCs said their opinion of people from the other side was either ‘somewhat’ or ‘much’ worse than before. For TCs the corresponding figure is 12%. For large parts of both communities, their respective opinions of each other remained unchanged after crossing the Green Line (41% of GCs, 63% of TCs). 11
The attitudes of Cypriots toward the ultimate resolution of the Cyprus conflict are generally negative. When their respective political leaders finally do conclude an accord, it will be weakened by a great deal of popular mistrust: 63% of GCs and 74% of TCs partly or strongly believe that the other side ‘cannot be trusted to adhere to an agreement’. A more recent study (InterPeace, 2010) presents skepticism and deepening mistrust: 65% of GCs and 69% of TCs are pessimistic about achieving any breakthrough in the peace process while 82% of GCs and 68% of TCs still believe ‘the other side would not honor an agreement and therefore implementation would fail’.
The TC’s inability to gain market share among GCs has socio-psychological origins as well. For example, Donmezer & Apostolides (2006) found that marketing problems for TC businesses are less about technical capacity and more about bias: ‘Only a few GC newspapers, television stations and other media outlets will air or publish ads for TC products and services’.
In the period prior to the Annan Plan referenda, some GCs opposed reunification on the ground that the TC economy was weak and would burden GC taxpayers. Once the Green Line opened, the TC economy’s increasing strength was then cited by some GCs as a reason not to trade (Donmezer & Apostolides, 2006). More recently, GCs overwhelmingly opposed (81%) any direct trade or commercial flights between TCs and the European Union (InterPeace, 2011). Cypriots espouse the perception that gains from trade are a zero-sum game. This derives from and is strengthened by a zero-sum view of the overarching conflict. While both communities (89% of GCs, 77% of TCs) believe the possibilities of new jobs and business opportunities are important reasons to pursue a political settlement (InterPeace, 2010), these same data reveal that significant parts of both communities are concerned that in an eventual settlement of the conflict their own community would bear the financial burden of implementation (59% of GCs, 40% of TCs), while the benefits of economic growth might go to the other community (45% of GCs, 39% of TCs).
Much of the attitudinal concerns noted above are mutual negative perceptions that are the residue of the unresolved conflict. However, some of it is also attributable to the ‘confusion’ from each community’s leadership regarding the desirability of interdependence (Peace Economics Consortium, 2011). Both Cypriot business communities express fear concerning intercommunal trade. Greek Cypriots fear condemnation by other Greek Cypriots and, when asked, find the subject so taboo that they deny the very existence of intercommunal trade. Turkish Cypriots fear being treated unfairly by their trade partners (Hatay, Mullen & Kalimeri, 2008).
The resulting image overall is that of two communities whose initial economic contacts have been limited by the objective barriers we discuss above, but also by the biases that are the legacy of their political conflict. At the community and individual levels, Cypriots continue to erect subjective barriers toward trade through collective perceptions of each other.
Concluding remarks
Trade has the potential to contribute to peaceful settlement of the Cyprus conflict. But the potential for increased intra-island trade remains unrealized due to the persistence of a number of barriers. We analyze several salient and quantifiable barriers and make predictions about their negative impact on the realization of the trade possibility frontier. Each of them has a measurable impact on GLRT.
Additionally, we discuss how the social-psychological barriers stemming from the intercommunal conflict also contribute to this problem. The prevailing mistrust is not an abstraction: it interacts with technical and structural impediments in ways that significantly impede trade. Communities that do not trust each other and construct tangible barriers to trade will find it difficult to initiate or expand such trade. We conclude that biases that persist after a long conflict can have real and costly economic implications. The expectation of peace-enhancing economic interdependence cannot be taken for granted. The legacy of conflict casts a shadow on the potential interdependence among adversaries. Before the interdependence emerges and reaches its potential, the trade itself must be bolstered by some of the factors that also contribute to the resolution of conflict, including attitudinal and institutional changes that mitigate mistrust.
Our research has relevance to the interplay among trust, trade, and peace in other conflict zones where affected populations have the possibility of trade in the absence of a comprehensive political solution, or who are separated by a ceasefire zone or other barriers. While prior research has asserted that the absence of trust will impede political negotiations in intercommunal conflicts (Fisher, 2001; Pearson, 2001), we assert that this same mistrust will impede the economic interdependence that is supposed to bolster peace. To the extent that scholars and practitioners promote the concept of trade to facilitate peaceful relations among former adversaries, a more thorough understanding of the interaction among quantifiable and non-quantifiable barriers will continue to be required. Rebuilding trust may be a prerequisite for both economic and political interdependence.
Footnotes
Replication data
Acknowledgements
The authors would like to thank Thomas Apolte, Costas Apostolides, Sara Cady, Nele Franz, Adam Godet, Gary Hufbauer, Marie Möller, Mark Rhinard, Bob Schlehuber, and Edward Tower, participants at a Spring 2012 WIN Group roundtable at Johns Hopkins University, including Bill Zartman, Dean Pruitt, Terry Hopmann, and Mauro Galluccio, and three anonymous referees and an editor of the Journal of Peace Research for their helpful comments. All remaining errors are of course ours.
Funding
Gokcekus gratefully acknowledges a URC Summer Research Stipend from Seton Hall University.
Notes
References
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