Rational Exuberance and the Reunification of Cyprus 1a:

An Economic analysis

a
None of the terms used in this paper should be interpreted to have any political significance. Terms were chosen
exclusively for the sake of brevity, convenience and consistency with the sources.

1
 A. Summary and Recommendations

“People only accept change when they are faced with necessity,
and only recognize necessity when crisis is upon them 2 "

The general overview of state finances, the banking sector and the structure of the economy
should alert us to the fact that the economy of the northern part of Cyprus is in a precarious
position.

The state is stifling the economy with its expansive involvement in it; it promotes adverse
selection in the banking sector by providing both easy and profitable outlays for savings and
indirect but large subsidies, and it crowds out private investment through the financing of large
deficits. State institutions offer high wages, raising the salary base in the economy above the
levels that productivity levels would justify. Additionally, are so inefficient that they only
survive through subsidies from the republic of Turkey. The tax system has been improved, but
remains problematic, while budget expenditures are continuing their upward trend, driven by
"salaries and wages" and transfers. In turn, this means that infrastructure and basic needs are
provided only through aid, and they are both inadequate and expensive.

The banking system is poorly supervised and implicitly guaranteed. It has poor risk management
methods, and it survives by extending "personal/consumer" loans and holding debt of state
enterprises -all of which is of questionable quality, as the analysis shows. It has no incentives to
rationalize its operations and increase efficiency, nor does it face incentives to attract deposits
and make serious decisions on the loans it extends.

The real economy itself is functioning under tax-based protectionism. Its main sectors are
inward-looking, and the data corroborates the World Bank assessment that an increase in trade is
unlikely to counter the above problems. Industry is faced with low capacity and high costs, not to
mention low productivity b . Trade capacity is concentrated in agriculture and processed foods.
Additionally, services, which look robust, are based on a booming tertiary education sector,
which, although very healthy, appears to be near capacity.

Under such conditions, analyses talking of an explosive potential for growth after reunification,
need to be qualified: their expectations are not falsified by the data presented here but all those
interested in the reunification of the island need to become more aware of the immediate, short-
run dangers, rather than concentrate only on medium-term potential. Wage differentials, for
example, cannot (and should not c ) be equalized until the productivity gap is covered, and, in this
light, expecting wage convergence until 2014 is, to say the least, overly optimistic 3 . Productivity
cannot rise as much as it needs to as long as investment is driven by perverse incentives.

b
Another clear conclusion form the data is that “convergence”, whether measure by productivity or wage
differentials, must be allowed to converge through the open market rather than legislate higher wages that do not
jibe with productivity. This is another lesson from Germany.
c
As, after all, we leanred from German reunification

2
 RECOMMENDATIONS

Immediate concerns

Even before a reunification agreement is implemented, certain problems need to be tackled. One
politically viable way of doing this, is to present them as part of "EU harmonization," thereby
lifting some of the main political obstacles to reform, and, in the eyes of the public, insulating it
from the reunification negotiations themselves. TAIEX assistance in institution building should
also turn towards the long-term survivability of both the state and the banking sector, as should
more EU aid funds.

▪ The European Commission needs to understand that its implicit diagnosis, by which all
problems are attributed to isolation, may be politically anodyne, but it also incomplete.
"Isolation" does contribute to the limitation of trade, the introduction of new technologies, and so
on. Even its partial lifting has had some positive effects on the economy of the northern part of
Cyprus. The lifting of the isolation, however, is neither a panacea, nor without its dangers, as the
data and the analysis demonstrate. EU programs must turn more keenly towards institutional and
policy improvements.

Under the heading of the Sustainable Economic Development and ICT Sector Programme, for
example, it would be more urgent to introduce such expedients as a computerized tax-collection
or a budgetary management system, than to address "all sectors of society". In the context of
ICT, stronger statistical capacity of the state is more urgent than other private sector needs. The
cart, at it were, should not be placed ahead of the horse. Under the same heading, addressing
private sector growth without addressing at the same time the extensive and profound economic
distortions that are caused by policy choices, is to treat the symptoms but not the disease.

Similarly, TAIEX activities need to come to the fore and to become better attuned to the real
needs of the Turkish Cypriot Community. Currently, the program is severely under-funded d .
Additionally, while introduction of new legislation comprises the bulk of its activity, the
program has not seriously looked at budgeting, financial sector regulation and oversight, fiscal
structures, or any of the other pathologies of the fundamentals. The Commission notes both the
willingness of officials to learn from the EU and its norms, and their low absorption capacity. It
is precisely this absorption capacity that needs to be addressed. Although such areas as the
phytosanitary acquis do have an immediate value and should be pursued, their total contribution
to sustained economic growth will be limited. Institutional capacity must become the first
priority and prime concern.

▪ Even with restructuring, the inheritor structure of what is today the "TRNC" will be dependent
on Turkish aid, at least for some time. Greek Cypriots will want guarantees that the Turkish

d
TAIEX has been allocated Euro 6.5 million out of the total Euro259 million

3
Cypriot constituent state will not be financially (or otherwise) dependent on Turkey, and will -
justifiably- want to see state finances restructured. Turkish Cypriots will need guarantees of their
own that their constituent state will not be abruptly cut off from the very aid that keeps it solvent.
The two will have to be reconciled before a solution is agreed.

Several options do exist; one way would be to negotiate the introduction of IMF-like
conditionality on aid. This would, on the one hand, maintain the solvency of the state, and, on
the other, establish a procedure by which eventual independence will be achieved. It would also
end soft budget constraints and address adverse selection in credit extensions.

Prerequisites for releasing tranches of aid should include, for example, a ceiling on the total
amount the state can spend on personnel or a moratorium on hiring. It should also include
measures to rationalize state enterprises and the introduction of new, improved banking laws and
bank supervision.

▪ Revenue distribution and public debt arrangements between the federal structures and the
states comprising the federation need to be clearly and unambiguously established. External
financial lending, contributions and donations must be clearly arranged and agreed from
beforehand e . In the light of the severe problems identified in the northern part of Cyprus, and the
insolvency of the state, debt arrangements must be agreed before a solution is implemented on
the ground.

▪ In the same context, a comprehensive plan for reduction of deficits and servicing of debt
should be put in place. A good model would be for the authorities to submit a document along
the lines of a National Reform Programme or a Stability Programme as part of the management
process of EU funds and aid. Such a document should pay particular attention to state finances.
Such measures could be placed under the rubric of EU harmonization to make them politically
possible. Retiring loans taken from private banks should be a priority, as should (on the medium
run) the consolidation of the budget (look below). Debt restructuring (e.g. by extending the
maturity of state debt or gradual lowering of interest rates) will buttress bank asset-sides if done
carefully.

▪ Both sides must agree to a solution to the property issue f . Options do exist, even some that are
vaguely fair. Whatever the agreement may be, property rights must be established clearly and
unambiguously. The agreement will be inevitably complex, so it must be communicated to the
public -and especially investors- in as clear and thorough a way as possible. Investor and creditor
workshops should be examined as an option. Communication with business elites before the
agreement is "taken" to the public will be politically expedient g .

e
On this recommendation, we defer to the analysis and positions of Constantinos Lordos.
f
This will clearly be one of the most -perhaps the most- difficult issue in the negotiations. The property issue will
not only be a key issue in the negotiations, but, on the short-to-medium run, will also be the key issue in the
economy as well.
g
Communicating clearly with the business elites will be important, as they will lead public opinion on whether the
agreement on a difficult, complex and emotionally charged issue, is acceptable or not. These elites should be
informed before the general public opinion is, allowing those best able to judge the agreement, to lead public
opinion.

4
In any case, absolutely indispensable will be seminars and workshops for bankers and banking
sector decision makers.

▪ Amendment of the banking laws is also imperative. Comprehensive new legislation is not
necessary on the short run, but certain aspects of the laws need to be improved. One politically
viable way of doing this, is to cover it under the guise of "EU Harmonization" and allow EU
vetting of the banking laws. With proper transition periods afforded, the Central Bank should
become more transparent and more independent, but also more responsible. Rules are also
urgently needed on the amount of credit that banking institutions can extend to the state and for
consumption. Regulatory forbearance should also become risky for supervisors (with personal
liability, for example). The possibility of an annual, in camera evaluation of bank supervisors
themselves by the legislature, should be examined.

▪ As far as regulations that are at the discretion of the Central Bank go, auditing rules should be
improved and procedures should comply with IFRS standards. Risk management and collateral
evaluation methods also need to be improved. Legislation is not immediately necessary for these;
the Central bank can issue circulars/directives to this effect, as a first step before legislative
action is taken 4 . The Central Bank must also place rules on risk evaluation.

▪ The term of service of the Central Bank Governor and the Board of Directors should be
extended beyond the five and three year term respectively, and become disconnected from a
change in government. Parliamentary approval and assent for appointments is also necessary.

▪ The remit of the Central Bank should be expanded, and it should be placed in charge of the
financial system as a whole (including, for example, offshore banks). Other supervising
institutions should also be consolidated into independent institutions with an own budget,
thereby taking the supervisory authority away from politicians.

▪ The capital requirement for banks should be increased to USD5 million, from USD2 million,
to comply with EU standard practice.

▪ In general, Basel II criteria must gradually be introduced.

The authorities need to put their house in order. Efforts to restructure the banking system and
state finances need to start immediately. The authorities of the northern part of Cyprus cannot do
it on their own, however, and it is incumbent on the authorities of the republic of Cyprus, and all
those genuinely interested in reunification, to assist the Turkish Cypriot authorities actively.
Failure to do so amounts to taking a stance against the eventual solution.

Medium term concerns

Medium term concerns address those problems that cannot be immediately solved. Designating
them as "medium run", however, does not mean that they can be put aside; it means that,

5
although they should be tackled immediately, their final settlement should not be expected before
reunification, but soon after.

▪ The state budget should be consolidated to include all state institutions, including the
municipalities which are responsible for the provision of many public services, but are too small
to provide them efficiently. Voluntary cooperation and pooling of resources are not enough to
rationalize spending. Indeed, municipalities reflect a very large under-the-line item on state
expenditures. Implicit and contingent liabilities must be taken into account, and budgeting should
take a multi-year outlook.

▪ While the budget needs to be consolidated, it also needs to be more thoroughly itemized, so that
hard budget constraints can be imposed on individual bodies and institutions.

▪ Apart from tackling the lack transparency and accountability, the severe data collection
problems must be addressed. An upgraded statistical service could assist the central bank in this
effort, as would new legislation that foresees better disclosure and transparency rules. Both the
availability of data and their trustworthiness are a serious impediment to proper diagnosis and
accurate planning. Terms like “loans past due”, “paid-up capital” and “exposure” should also be
accurately defined.

▪ Informational asymmetries also exist between banks and their clients. In the absence of solid
and dependable corporate information, credit and risk assessment by the banks will remain
problematic. Setting up a new Credit Bureau to collect such information as credit defaults or firm
health "would be of high value. 5 " Today, the only such body is a Risk Center within the Central
Bank 6 .

▪ The process of privatization of state enterprises should start as soon as possible. At the very
least, public Enterprises should become exposed to market forces. Implementation of state aid
and Internal Market acquis is an excellent launching point for this effort. This will put a hold on
ever rising overstaffing and excessively high salaries, while it will also force these enterprises to
increase productivity and invest in new technologies.

▪ The tax system must be improved. The multiple VAT rates should be minimized and tax
cascading should be tackled to lower the tax burden and increase revenues. Modern techniques
and technology is also needed in tax collection. The property tax, currently "little more than a
nuisance tax 7 " should be restructured and improved as it harms disposable income less than
personal income tax and VAT. It will also boost municipality budgets.

▪ Protectionism must slowly be lifted. The current policy of trade-limiting measures, followed by
ineffective trade-promoting measures should be replaced by a single framework of open trade.
Export and import licenses and preferential taxation need to be abolished. At the very least, the
trade regime must come in line with WTO rules and the acquis.

6
▪A prerequisite of the above lifting will be the ending of policies like preferential lending to
specific sectors (for example through the Development Bank), which distort resource allocation
and harm competitiveness h .

▪ A new institution should be created along the lines of the Bank Restructuring Authorities that
have been created in other countries that have faced a crisis. The power of auditing, regulating
and supervising banks should be placed in an authority with its own budget, and should be
separated from the Central Bank. Asset restructuring should also be part of this process. Such an
institution should have strong powers within its limited scope, and a limited lifespan. It could
potentially then be transformed into a banking oversight agency.

▪The lengthy default procedures must also be addressed. Faster collection of collateral and
closing of outstanding loans will significantly help in improving bank asset positions. A
specialized judicial body, as well as out-of-court solutions and other types of creditor-debtor
intermediation would be one way of dealing with this, especially as long as bank credits are
highly collateralized and risky.

▪ Promote the interbank market and check clearing processes. Also provide incentives for bank
mergers and other measures to counter the increasing number of banks.

While in most countries this restructuring hinges on corporate restructuring, in this case the
counterpart is the state, who is the major debtor to the banking system. In the light of this, asset
restructuring should entail preventing State Enterprises and Institutions from continuously
borrowing from the Banking System as well as a comprehensive restructuring of state finances.

The state is virtually insolvent. More extensive restructuring should take a long-term approach,
especially on certain issues such as pensions reform. Today, pensions and benefits represent a
very large part of implicit and contingent liabilities of the state, and are only about to increase.
There already exists a policy for restructuring the public sector, and officials state that they are
"moving slowly" rather than follow a big-bang approach 8 . In fact, they are not moving at all. The
stated interest and initial planning for restructuring do exist, however, and further efforts should
use this as a starting point. Bringing an end to the soft budget constraints of the state and state
enterprises is a necessary prerequisite, however.

All in all, we should to treat the North as if it is immersed in a crisis, rather than wait for a post-
reunification crisis to erupt. The crisis does not manifest itself only because of the artificiality of
the system. The banks should be recapitalized, but their recapitalization should be escorted by
new regulations on bank governance, credit and risk evaluation and management and operational
structure. It should also be done carefully, so bank asset-sides do not collapse in the process.

h
All those who are genuinely interested in better resource allocation and increased productivity should also show
much more interest in lifting barriers to Greek Cypriot investment in the north. This is the best way to introduce
market forces in resource allocation, thus raising productivity and minimizing income differentials.

7
If the state becomes able to function without constant borrowing, banks will no longer have an
effective guarantee on their profitability. Therefore, they will be forced to devise means to ensure
profitability

This is by no means a conclusive list of necessary changes. The list of needed changes is
certainly beyond the scope of the conclusion of this note. These suggestions, however, are
indicative of what needs to be done. The aim of this note has been very simple: to point out that
there are serious problems in the financial sector of the northern part of Cyprus, and point to the
fact that both sides of the divide in Cyprus are obligated to their people to work together in
order to remedy these problems before a solution is implemented –that is, provided that they
genuinely wish to see the island reunited, and provided that they wish to see the reunification of
the island succeed rather than sink the country into chaos.

The sad fact of the matter, however, is that too often no action is taken unless there is an urgent
necessity to do so and that the necessity for change is not recognized until a crisis breaks out.
The brewing crisis may not be tackled until it blows in the hands of the political leaders of the
island; as Jean Monnet noted, the necessity for change is often only recognized in the midst of
crisis –a particularly disturbing realization in the light of the conclusions of this note. This note
was authored in the hope of contributing to the efforts of those who can no longer tolerate
political inertia on these admittedly difficult issues.

8
 CLARIFICATIONS

This note has been based on a running assumption that reunification of the island will
take place, and that it will take place under a bizonal, bicommunal regime. The note
reaches the conclusion that reunification will entail significant problems, and will bring
about great economic dangers.

These dangers, however, can be dealt with; in fact, the very purpose of writing this note
was to underline the need to tackle these problems as soon as possible, before
reunification, and preferably within the context of EU "harmonization". What is clear is
that tackling these problems now, is an obligation of our leaders. Indeed, what becomes
clear from the data and the recommendations is that tackling these problems is a
challenge for politicians, not economists. The economists’ task is relatively simple.
Their task is not new; we have seen it in Mexico, in Argentina, in Ecuador, in the
Philippines, in South Korea, in Thailand, in Malaysia, and elsewhere.

The know-how exists; the illness –and its treatment- have been studied thoroughly, albeit
it different conditions.

The analysis presented here is deliberately non-political, although the political

ramifications of the analysis are both far-reaching and profound.

However, it should be underlined that, while a federal solution will be economically

dangerous, both the maintenance of the status quo and a single-state solution will entail
much greater problems and dangers.

A close reading of the data will corroborate this.

Additionally, one of the main conclusions of this note is that those analyses that predict
great economic growth in Cyprus after the solution are not refuted by the data. What the
data do bring to question is how immediate and automatic the growth will be, not
whether such potential exists. In fact, the recommendations can be read as suggestions
as to how these expectations can be realized.

9
 B. Economic Analysis i

1. Introduction:
"...but how do we know if irrational exuberance has unduly escalated asset values which then
become subject to unexpected and prolonged contractions...? 9 "

Four years after the rejection of the Anan Plan for the reunification of Cyprus, new momentum is
gathering towards a solution to the Cyprus Problem. The Agreement of 21 March 2008 between
Mr. Christofias, the President of the Republic of Cyprus and Mr. Talat, the Turkish Cypriot
leader, has led to the creation of “technical committees” which look into the so-called “day-to-
day” issues of the potential solution. The aim of these committees is to prepare the ground (or
background) for another – some say the last - round of proximity negotiations between the two
sides.

In the meantime, since the rejection of the Annan Plan in 2004, the economy of the Northern part
of Cyprus has experienced a spectacular boom, with the opening of the Green line, a de facto
partial alleviation of the international isolation of the northern part of Cyprus, and an ensuing
boom in construction and tourism. The result has been an unprecedented rate of growth, both in
the GDP and the per capita income of Turkish Cypriots, and a subsequent improvement in living
conditions with important political ramifications in terms of the Cyprus problem.

The contention of this paper is that these conditions, desirable in themselves, seem to have led to
complacency among pundits, analysts, and, most dangerously, political leaders on both sides.
There is little concern over the post-solution economic conditions in the north, and parochial
objectives reign supreme: indeed, most analysts concentrate on the potential that reunification
will unleash, concentrating on the admittedly very large gains to be reaped by the solution. This
paper will not attempt to counter these claims. It will however argue that such gains will be
neither immediate nor automatic nor inevitable. Medium run gains are potentially big, but short
term dangers are even greater and the gains will only become feasible and realistic if some very
significant institutional, regulatory and policy changes are implemented in the northern part of
Cyprus before a solution is effected on the ground.

This note, like much of the analyses on the situation in the northern part of Cyprus, is buffeted by
a chronic scarcity of empirical data. This is a fact which is recognized by all research on the
North’s economy j . Like much of the existing literature, many of the conclusions will have to be
drawn by deduction and inference. In this light, all data and graphs used in this note should be
seen as indicative and approximate k .

i
We have chosen to keep the values of graphs and references in their original denominations. Thus, some graphs are
in "TL", or "old" Turkish Lira, and some in "YTL", the new (yeni) Turkish lira, maintaining the denominations in
the original sources. 1 YTL corresponds to 1 million TL. None of the data in the graphs have been translated to
Euro, mainly because of the inconsistency of the exchange rates over time. All options in transforming the values to
Euro created problems in comparing the values over time.
j
Eichengreen et al note that data from the northern part of Cyprus are " scant and of questionable quality”.
k
Available data is only used if more than one source is available, and if the sources provide similar figures.
Alternatively, figures are used if they have been accepted by reputable sources like the Economist Intelligence Unit
or the World Bank.

10
These caveats notwithstanding, the data do help in drawing a number of telling conclusions: first
of these is the clear inadequacy of the ‘state’ machinery in terms of regulatory oversight and
prudential supervision. The scarcity of dependable empirical data itself points to the danger that
the –in any case inadequate- regulatory framework is not properly implemented, that serious
analysis is lacking, and that regulatory inertia is endemic. There is consensus in the literature on
this point 10 . It should be noted, however, that conclusions – especially those drawn from the
shapes of the graphs, overall trends and the interplay between the various conclusions- will only
be cited when they are found to be dependable.

Going against the conventional wisdom among observers that have adopted a rather negative and
pessimistic attitude on the economic prospects of a reunification of Cyprus as a symptom of their
desire to forewarn against a solution (any solution), this note will underline problems in the
economic infrastructure of the North will the opposite aim: through the identification of existing
shortfalls and gaps, we aim to fill a substantial, and, as the data will show, critical, gap in the
debate -not the abandonment of all effort.

Whilst not attempting to provide panacea-type answers, this paper will simply attempt to
determine what the proper questions are in order to determine the desirable policy responses that
will make the reunification of the island economically tolerable -or at least viable. It should be
by now abundantly clear that the absence of serious and informed debate on the economic
structures of the northern part of Cyprus can only make the otherwise desired reunification of
the island an even more difficult and painful task than it in any case be, not only in sociopolitical,
but also in economic terms.

The aim of this note is, therefore, to raise the questions that I believe are vital for the
preparation for the eventual solution of the Cyprus Problem. It is, essentially, an expression of
concern about the “day after”, with some suggestions about how the dangers can be averted. The
urgency of reform and the pace of developments make such analysis both relevant and necessary
for the future of Cyprus.

In order to do this, it will provide an overview of the economy, with emphasis on state finances
and their effects on the economy in general, and the banking sector in particular. It will then
provide an overview of the banking system. The next section will examine the (new) Banking
Law and the Central bank Law, in order to determine whether, and where, improvements are
necessary.

11
 2. General Economic Conditions and State Finance

Since 2004, the economy in the northern part of Cyprus has experienced an unprecedented boom.
GDP growth has virtually exploded, driven by a boom in the construction and tourism sectors.
With high demand in holiday homes and in bed capacity in tourism, and boosted by the prospect
of a solution to the Cyprus Problem, which would loosen the isolation of the economy and the
subsequent limits to trade, confidence has remained high. High confidence and higher disposable
incomes have naturally boosted consumption.

GNP (USD, million)

Source:"State Planning Bureau"

3500

3000

2500

2000

1500

1000

500

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Inflation rates have followed those of Turkey, as the North uses the Turkish Lira (and now the
New Turkish Lira- Yeni Turk Lira, YTL) as legal tender in its area. See earlier comment on YTL
The volatility of the Turkish Lira has affected the North to a great extent, and has led to high,
unpredictable and variable inflation rates, before becoming somewhat more stable. The effect of
this volatility was an uncertain economic environment that did not permit the exploitation of the
inherent economic endowment of the North.

In the last few years, however, the situation has clearly improved. From some 77% in 2001,
inflation was reduced to 9.4% in 2007, and appears to be stabilizing close to double-digit figures.
In this respect, international trends, rising prices and particularly the rising price of inputs are
likely to create some inflationary pressures likely to mitigate otherwise marked improvements.

12
 Private Consumption (YTL)
Source: State Planning Bureau

2.500.000.000

2.000.000.000

1.500.000.000

1.000.000.000

500.000.000

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

The legal framework, whose problems are admittedly often overstated, is also a matter of
concern. There have been some notable improvements in recent years, but the institutional
framework remains inadequate. In the wake of the 2000-2001 banking crisis, new and improved
legislation was introduced, including a particularly important Banking Law 11 and a much
needed Savings Deposit Insurance Fund Law by which modern standards were introduced in
terms of deposits insurance. The rather problematic Offshore banking Law 12 was also thinly
improved in 2001. The Central Bank law 13 , discussed below, was also introduced at this time.

Other critically important legislation, such as the law concerning money laundering 14 (a major
international concern) and one on Currency and Foreign Exchange 15 appear to have undergone
no amendments in view of the crisis, as both preceded it.

Compounding the problems rooted in the regulatory framework is the seemingly ineradicable
inefficiency of the state machinery. Data is again limited, but the various commentators are
unanimous in their assessments. Vassiliou et al note that the state budget is

“burdened with excessive current expenditures in the form of wages and salaries
to civil servants and various transfers in the form of subsidies and ‘social
benefits’ granted in many cases out of political considerations. Wages and
salaries exceed 14% of the GDP, while the financial position of other public
institutions is not known. 16 ”

13
This evaluation is corroborated by the data: around three quarters of all state expenditures go to
personnel expenses and "transfers" 17 . State personnel expenditure (what Vassiliou et al call
"wages and salaries") has since risen to an astounding 16.4% of GDP 18 and last year state
employees negotiated a 10% pay rise 19 . These expenditures, a major drain on the state budget,
reflect the costs of a civil service that has become “too big, overstaffed and inefficient 20 ” and
evokes clientelism and rent seeking.

In total, current expenditures are some 19.6% of GDP, while transfers are a further 18.3% of
GDP.
Peronnel and Transfers (%Total State Expenditure)
Source: "State Planning Bureau"

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%
2001 2002 2003 2004 2005 2006 2007

Okan Safakli also notes that “there is no efficient and coordinated control on public
expenditures,” and that a “chronic public deficit exists 21 .” Again, updated data confirm the
evaluation. The deficit is not only large, but it is understated, as aid from Turkey, some 7% of the
entire GDP, is discounted from the deficit figures. The "State Planning Bureau" in fact records
aid from Turkey as part of normal revenues of the state. In the most recent Protocol signed
between Turkey and the "TRNC", the former agreed to extend Euro 0.8billion (USD1.3billion)
over the period 2007-2009. This figure reflects "aid" and appears to exclude "credits", which, in
theory, will be paid back 22 .

The Economist Intelligence Unit, in its Country Profile 2008, reports that past trends, by which
debt to Turkey is not paid back, seem to continue: "There has been a moratorium on foreign debt
repayment, and it is expected to be eventually ...written off. 23 " (Foreign debt essentially refers to
debt to Turkey). The World Bank found the same to be true in 2005. 24

This means that, in order to get a clear picture of the deficit, we should add the credits from
Turkey, (amounting to 4% of the GDP) to the “aid” figures. The “State Planning Bureau” would
surely dread the thought of foregoing the aid and credit, some 11.7% of GDP in 2007, -

14
especially since, as noted below, banks hold the bulk of their assets in the form of loans and
credits to the state l .

Stated and Actual Budget Deficit (YTL)

Source: "State Planning Bureau"
-800.000.000
Nominal Deficit
Deficit (Discounting Credits from Turkey)

-700.000.000

-600.000.000

-500.000.000

-400.000.000

-300.000.000

-200.000.000

-100.000.000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
0

The high deficits raise two issues: First, with deficits accumulating over time, what is the debt
level? Apart from accumulating debt that in 2003 was estimated to have “reached 6.9 % of GDP”
despite foreign aid from the Republic of Turkey 25 (around US $ 83.4 million), the state is also
burdened by the costs of servicing the large volume of loans that State Enterprises and
Institutions have received from the banking system. m Vassiliou et al note that although “no
official data are available”, they “estimate[d] interest payments to reach Euro 33.4 million in
2004 26 .” It can only be higher today, especially as deficits have ballooned. As most analysts
note, payment on these amounts cannot be depended on, unless government subsidies are
credited towards it. In any case, the total explicit liabilities of the state, stood at approximately
Euro 261 million in 2004.

Adding the estimated accumulated debt of the state and the outstanding loans of state enterprises
and institutions, total outstanding debt of the state was approximately 25% of GDP (Euro 246
million) in 2004. In the absence of data, more recent estimates are not possible, but four years of
deficit have certainly increased this amount. The total recorded deficits of the last four years has

l
counting both direct loans and other instruments, such as Treasury Bills
m
These loans are reported by the "TRNC Central bank" to amount to Euro 368 598 877 in the latest recorded date
(30 November 2007).

15
 amounted to Euro 846 million, although how much this has been serviced, remains an open
question.

This figure, again, excludes contingent liabilities and implicit costs of the state. Vassiliou et al 27
estimated the total cost of the state’s liabilities to stand at Euro 577 million in 2004, which
includes only current expenditures, excluding the costs of interest payments, contingent
liabilities and servicing of loans to the State and to State Enterprises and Institutions. Had the
above costs been included, the state expenditure figures would have been even higher (although
they cannot be estimated with any accuracy with the data available).

In any case, a series of calculations, estimations based on older data, and assumptions may not
yield accurate numbers at all, but they do draw an accurate picture: the debt is high; the deficit is
increasing each year despite (marginally) increased revenues n . Since deficits are financed largely
by loans, and since much of the debt is held by banks, these figures are a cause for concern. This
burden on the banks, on the real economy and on society, appears to be very heavy indeed: The
only relatively recent source (November 2006) of any confidence, reports a budget deficit-to-
GNP ratio of 30%, and a debt-to-GDP ratio of 118% 28 .

Public Deficit (YTL)

Source: "State Planning Bureau"

500.000.000,0

400.000.000,0

300.000.000,0

200.000.000,0

100.000.000,0

0,0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

n
By some estimates, tax revenue has increased, but an unidentified category of “non-tax revenues” has decreased.
Net revenue increase is estimated at 2%.

16
The most worrying part of this is that this debt only marks “running costs” of the state. The State
Planning Bureau itself, noted in 2004 on its website:

“For the realization of the growth rate targets set in the long-term plans and
annual programs, Turkish Republic of Northern Cyprus was badly in need of
financial aid, so certain giant infrastructural projects such as the construction
of the airports, sea ports, dams, derivation canals, highways, power plants
and the improvement of the telecommunication systems were all financed by
the Republic of Turkey 29 .”

In June 2007, the Economist Intelligence Unit corroborates this admission. In its monthly
Update, reporting the aid Protocol signed with Turkey, it notes that the funds will go to "defense
and grants", "loans and subsidies", and, finally, "infrastructure". Elsewhere, it calls the aid
"infrastructural 30 ". Given that the deficits are increasing at a time of economic boom, and that
they are the result of high running costs, it is clear that, with some structural changes, the state
can become much healthier than today. This is good news: treatment for the patient will be
painful but possible. Although restructuring state finances can never be easy, we must at least
point out that

“there is significant room for reallocation within budget categories that

would allow the northern part of Cyprus to be financially independent of
external aid within the medium run 31 ”.

The political choices necessary for this to happen should become a priority, although we should
keep in mind the political courage that this will require.

In the recent years, tax reform has brought some positive results, with indirect taxation
increasing the tax base 32 . Driven by GDP growth and high consumption, tax revenues have
increased considerably. This has allowed the "TRNC" to take some of its own costs in terms of
infrastructure projects and investment.

This increase, however, is clearly not enough; expenditures, driven by "salaries and wages" and
transfers, are increasing faster. Additionally, the potential for further increase in state revenues
will remain limited because of the combination of reliance on indirect taxes and a “quite
considerable” informal sector in the economy. 33 The EIU reports that tax evasion is "rife 34 ".
Although the size of the informal sector remains an open question, its omnipresence is quite
visible. Some estimates place it as high as 60% of all economic activity 35 . The size of the
unofficial economy will remain large as long as the risk of tax evasion is lower than its benefits.

Tax collection is also very inefficient, limiting income from taxation, even after reforms 36 .
Additionally certain characteristics of the tax system need to be addressed; for example, the
existence of 6 different VAT rates is excessive. It is cumbersome to administer –especially for an
inefficient tax collection system- and expensive to collect. It also encourages tax evasion 37 , as
does the tax cascading that characterizes the system, and the high income tax burden, which,
according to some estimates, may be (on aggregate) as high as 49% 38 . This is stifling the

17
economy, although, with high growth, an exuberant mood, and booming consumer credit, this is
not visible today.

In any case, the reliance on indirect taxes means that state revenues will decline with recession,
while expenditure will not be affected -except for increased pressure for higher pay for civil
servants, and a further increase in minimum wage o . Additionally, if, as predicted in this note,
there is banking distress or a banking crisis in the short run after reunification, state revenues will
also decline and contingent liabilities will increase, while bank assets (much of which is in the
form of credits to the state) will be hit, thus aggravating bank positions.

Budget revenue and Expenditure (YTL)

Source: "State Planning Bureau"

4.500.000.000
Budget Expenditures
Budget Revenues
4.000.000.000

3.500.000.000

3.000.000.000

2.500.000.000

2.000.000.000

1.500.000.000

1.000.000.000

500.000.000

0
2001 2002 2003 2004 2005 2006 2007

Even without bank distress, however, there still exist reasons for concern. Inefficient and
excessive spending and inadequate revenue have created a large financing gap. Unlike other
cases, where the state’s financing gap is caused by such expenditures as restructuring the social
security system or undertaking major infrastructure projects, the state’s expenditures in this case
neither lead to healthier fundamentals, nor increase total value added. The state, in this sense, is
deadweight on the economy. That the state is running large, persistent, and increasing deficits at
a time when the economy is growing robustly, should certainly be enough to raise eyebrows.

o
According to “TRNC Central Bank” data, the legal minimum wage has been rising rapidly in recent years.
Although this is difficult to quantify, even a cursory look will show that minimum wages increase much faster than
productivity.

18
Private investments have been covering the resource financing gap. Consumption has not been
affected, especially as GDP has grown rapidly due to the construction and tourism boom (and
consumer credit has boomed with it), but the financing of public deficits has clearly affected the
sustainability of growth. The economy is being chocked. The financing gap diverts the
economy’s resources to such expenses as civil servant salaries and pensions and to large transfers
to municipal authorities for spending on statues, national honor programs, social benefits and
municipal debt. The large GDP growth figures should not mislead us into believing that this
deadweight on the economy is of little consequence. Growth figures, apart from their other
characteristics, also represent natural growth in a virtually virgin land for investment. Also, they
overstate growth because of the small size of the economy.

Net Savings (YTL)

Source: "State Planning Bureau"

400.000.000

300.000.000
Private S-I
Public S-I
200.000.000

100.000.000

0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

-100.000.000

-200.000.000

-300.000.000

-400.000.000

-500.000.000

-600.000.000

Crowding out is evidenced in a number of facts: the large percentage of total credits that are
extended to state enterprises and institutions; the fact that, on top of these, Treasury Bills make
up a “major part” of bank assets; finally, through the high interest rates. (Deposit rates are as
high as 25%). Safakli notes that there are large spreads between deposit and lending rates,
particularly on treasury bills 39 . Although information on lending rates is too varied to be cited, it
certainly is above the shocking figure of 25% 40 .

These high figures point unmistakably, not only to crowding out, but also to adverse selection
and moral hazard. The World Bank notes that these high deficits, largely covered through aid
and credit from Turkey are not a problem in themselves but have serious adverse effects because
of the way they are managed. Firstly, "block-grant" aid creates soft budget constraints,
encouraging over-employment and waste in the state machinery and exacerbating deficits.
Secondly, apart from "overexpansion" of the public sector, it has masked the need for
rationalization and productivity improvements in the sprawling State Enterprises and Institutions
that have crawled across the economy. Thirdly, the tendency of the state to spread over the

19
economy, using its strengthened "purchasing power...relative to the rest of the economy 41 ", also
exacerbates the tendency towards state interventionism 42 .

A fourth problem is that "even when funds are directed toward private enterprise, they result in
"market distortions" and "perverse incentives 43 " and they are counter-productive “to official
intentions to improve fiscal discipline 44 ”. Large funds available to the state for "transfers" or
preferential treatment of certain firms in the economy provide a perfect opportunity for rent-
seeking behavior and politically-motivated decisions. This is especially true when the state
‘picks winners’ for preferential tax treatment and government-backed loans under a system
characterized by "bureaucratic discretion" 45 .

Private savings exceed private investment, covering the part of the resource finance gap that the
Republic of Turkey does not. There is a large growth in deposits, where most private savings go.
However, these bank deposits are channeled into public spending, in the form of loans to SE&Is.
This means that private investment is kept lower than it would have been had the state not
crowded out this investment by using up private savings for its “running costs.” In its effect, the
phenomenon amounts to disintermediation p .

The above observations are in line with the general diagnosis of the political conditions in the
northern part of Cyprus; patronage, disregard for procedure, and irregularities are ubiquitous.
Rent-seeking behavior on behalf of politicians is also endemic. The state’s weakness, together
with its large scope of action, has played a major role on the stagnation of the economy. Weak
states attempting to function over a large scope are inevitably inefficient; they essentially try to
do more than they are capable of doing 46 . Indeed, Charalambous goes as far as to say that the
isolation of the North since 1974 has only been a secondary cause of the complete stagnation of
the economy, and that the primary cause has been the fact that the North is a weak state
functioning over a large scope 47 . Although Charalambous’ conclusion might be overdrawn, it
does take note of an important element of the economy of the North: even without "isolation",
the economy can only grow to a certain extend.

Al of the above data justifies the assessment of the World Bank that “Public finance is at the
core of the challenges facing the northern part of Cyprus 48 ”. We would add that policy and the
legislative framework are equally crucial a challenge.

The economy

The economy is largely driven by tourism. Not only have revenues (and arrivals) increased
considerably in the last few years, but increased demand has also driven the construction boom.
Both hotel bed capacity and holiday homes have grown robustly, feeding the economic boom,
which, in turn, has increased consumption and demand for home ownership. A real estate boom,
with high asset prices, is clearly observable.

p
It is worth noting the observation that the deposit-to-GNP ratio appears to be approximately one; the level of
intermediation of the economy, however, is highly overstated by this ratio, because most of the intermediation is
between the financial sector and nonproductive sectors, which do not increase real value-added in the economy.

20
Tourism, however, is slowing. Capacity is increasing, but hotels remain half-empty. As the
graphs show, occupancy rates have not exceeded 40%, while tourism has been in decline since
2004. Construction has also declined rapidly between 2006 and 2007. Although declining
occupancy has been attributed to increased purchases of holiday villas by foreigners 49 , the fact
remains that capacity has been created, and will be difficult to fill. These investments do not
produce value and their financing is clearly problematic. We have no dependable data as to
whether their financing was driven by debt or equity, but even if the latter has been the case,
assets are bloated. Anecdotal evidence refers to capital inflows from abroad also financing these
investments q .

Only recently, the "Minister of Tourism", Erdogan Sanligad, announced a further increase in
capacity to 18000 beds, up from 15000. The EIU reports that this statement was met "with
scorn 50 " by hoteliers, who have trouble filling their capacity. Similar complaints were voiced in
the previous season, as well 51 . Additional problems relate to the poor quality of construction,
which “does not meet standards in terms of health, safety and environmental standards required
by European tourists 52 ,” poor service quality and infrastructure that is “inadequate and high
cost 53 ”. On top of these, the high travel costs of visiting a relatively remote island by air, act as
an additional cap on the potential of tourism, especially at a time when the world economy is
slowing r .

q
This is important; it points towards increase risk of capital flight, as, for example, happened in the Southeast Asian
crises.
r
Another problem, also shared with the South, is the rise of very competitive alternatives, whose quality is excellent
but prices are competitive. The Asia Minor coasts in Turkey, the Peloponnese and Crete are but a few examples.
Growth in quality across the Mediterranean is observed.

21
 Real Growth Rate (% change on previous year)
Source: "State Planning Bureau"

70,0
Construction
Hotels and Tourism
60,0

50,0

40,0

30,0

20,0

10,0

0,0
2000 2001 2002 2003 2004 2005 2006 2007

-10,0

-20,0

-30,0

Bed Occupancy rate in Tourism (%)

Source: "State Planning Bureau"

45

40

35

30

25

20

15

10

0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

22
 Number of Employees in Tourism Sector
Source: "State Planning Bureau"

3.500
Employees in "Restaurants etc"
Employees in Hotels etc

3.000

2.500

2.000

1.500

1.000

500

0
1999 2000 2001 2002 2003 2004 2005

With the international economy slowing, thereby contracting demand, and with property rights
becoming increasingly uncertain as negotiations for reunification proceed, the boom will likely
turn into a bust. The latest dependable data show that house-building, the very sector that, driven
by tourism in turn drives the economy, reported a 14% decline in sales through 2007 54 . At the
same time, employment in tourism does not show the increase that one would expect, with
increase reported only in restaurants. This probably reflects the general rise in consumption
rather than a boom in tourism s .

Indeed, from this data it appears that, while the exuberance was originally rooted in the growth
in tourism, it has been sustained by the growth in tourism capacity. It truly seems irrational.

The economy is certainly slowing in the last two years, "mainly owing to the unwinding of the
house-building boom" 55 . Behind the construction/tourism-driven boom, stands an economy
which, while very robust in its potential, is buffeted by a series of problems.

Trade is hampered, on the one hand, by the political situation and the political isolation caused
by the non-recognition of the “TRNC”. On the other, there do exist a string of significant
structural problems, such as low productivity, especially in industry and manufactures and high
concentration in agriculture and processed foods (74-75% of exports). Although the isolation of
the area is slowly being remedied (at least partially), the structural problems need to be further
addressed. Upon reunification, which will entail implementation of the acquis, certain

s
A credit boom driven by Consumer loans clearly implies that household debt is rising rapidly, another reason for
concern.

23
protectionist measures will have to be scrapped. For example, a flat 15% VAT rate on imports
(as opposed to 5% base VAT tax on locally produced goods and services) will no longer be
allowed 56 . This raises questions relating to competitiveness and the ability of the economy to
cope with free trade conditions. The received wisdom that, with the “lifting of the isolation”,
trade will automatically grow, should be examined a little more carefully than hitherto. This
assumption appears to hold true with respect to agricultural products. However, state policies
that distort resource allocation and limit trade, as well as the condition of state finances, are
stifling the general economy, and manufactures, industry and services in particular.

This conclusion is strongly supported by the data collected by the EU Commission on goods and
services crossing the Green Line since the implementation of the Green Line Regulation 57 . The
Commission finds that between May 2006 and April 2007 58 , the value of goods crossing the
Green line amounted to some € 3.4 million, not a negligible amount. However, Commission
reports do show clearly that this trade is limited to primary goods: vegetables comprised 35% of
trade, with "wooden products", "raw materials" and "Aluminium/PVC" trailing. This data
corroborates the fact that, while lifting the political impediments to trade has -and will probably
continue to- release the potential of the economy that has hitherto been untapped, this potential
does have its limits on the medium and long run.

If the Green Line regulation can prove anything, that is that, while impediments to trade have
limited the growth of the primary sector, industry, manufactures and services have not been able
to contribute to the increase in trade t . As this note underlines, there are significant policy-
induced obstacles to the development of these sectors. It is these impediments precisely that
analysts and decision makers have neglected. This raises serious doubts that trade without better
policies and public finances can contribute to sustainable growth beyond the short run.

t
The 2005 Report shows similar results.

24
 Other
19%

Vegetables
35%

Building/articles of stone
9%

Aluminium /PVC products

10%

Wooden products /furniture

Raw metal11,4
15%
12%

Copied from: Annual Report on the Implementation of Council Regulation (EC) 866/2004 of 29 April 2004 and the
situation resulting from its application, COM 2007(553)FINAL, Brussels, 21.09.2007, http://eur-
lex.europa.eu/Result.do?T1=V5&T2=2007&T3=553&RechType=RECH_naturel&Submit=Search

Another important piece of data that needs to be more carefully analyzed by policy makers is the
fact that, as trade impediments are lifted, trade and current account deficits balloon. In fact, some
commentators have underlined that protectionism has been increasing together with the lifting of
trade impediments 59 .

This is not to say, of course, that trade impediments have a positive effect on the economy of the
northern part of Cyprus u . It does say, however, that policy and regulatory changes must take
place together with the lifting of political impediments to trade. Past lessons from the
international economy have given us ample warning. The fact that political decision makers in
Nicosia, Ankara and Brussels have shied away from the political courage that this requires is
understandable, but it is also both regrettable and dangerous.

u
Neither do we examine whether the reasons behind these impediments are legitimate.

25
 Current Account Deficit (YTL)
Source: State Planning Bureau

400.000.000,0

350.000.000,0

300.000.000,0

250.000.000,0

200.000.000,0

150.000.000,0

100.000.000,0

50.000.000,0

0,0
1999 2000 2001 2002 2003 2004 2005 2006 2007

-50.000.000,0

The services sector looks very robust. Although there are concerns about the quality of the
tertiary education system 60 , it does attract many foreign students, and it does create a population
with high rates of tertiary education, so productivity should be prepped up -at least partially 61 .

In general, the economy can be said to pack a great deal of potential. The severe productivity
gaps with the south, for example, can be partially remedied with better resource allocation and
more capital per worker. The arguments put forth by a number of analysts concerning the
medium-term impact of reunification also seem to be perfectly justified. For this potential to
unravel, however, four things must happen: first, the state must stop acting as a break to the
economy, crowding out private investment and taking over from the private sector areas of
activity in which the latter can perform better. Indeed, most of the misallocation of resources “to
less efficient areas of the economy” is “caused by the pull-effects of the aid-supported public
sector wage premium, subsidies to P[ublic] E[nterprises], and subsidies to agriculture 62 ”.
Second, the expansive state enterprises must be reined in (and preferably privatized). Third, the
state must stop picking winners and treating them preferentially, thereby stifling other firms and
sectors of the economy.

Lastly, trade must be finally allowed to take place freely. The isolation of the economy from
international markets aside, there are lingering residues of import-substitution policies, for
example administrative controls, ‘special’ (read discriminatory) tax regimes and licensing
requirements for both imports and exports. As noted, these "residues" seem to be increasing as
political impediments to trade are lifted. The World Bank notes that: “Bureaucratic micro-

26
management combined with widely divergent procedures applied on domestic and foreign
products is administratively expensive and creates opportunities for rent-seeking 63 ”.

In an effort to counter this anti-export bias the state has also adopted trade-promoting policies.
These measures to counter the anti-export policies are ineffective and expensive, but also
disallowed by the WTO, and will eventually need to be scrapped. On the whole, anti-export
measures, followed by ineffective export-promoting offsets, only lead to barriers to trade, costs
to the state budget and, finally, to market distortions and rent-seeking behavior. The latter is
especially true as “bureaucratic discretion” is a characteristic of the decision-making process. In
any case, trade-limiting measures, countered by trade-promoting measures designed to offset
them, is, on the whole, an absurd policy.

27
 3. Structural characteristics of the banking sector

Every aspect of the pathology of the banking sector -the connected lending, the high exposures,
the adverse selection, the incestuous relationship with the state, above all, the insolvency- can be
attributed, at least partly, to its structural characteristics. The existence of these structural
problems, points, on the one hand, to system-wide weakness. On the other, it points to set of
structural solutions that can go a long way towards remedying the problems.

The untrustworthiness -and dearth- of data, and the level at which this complicates empirical
analysis make it virtually impossible to look into a variety of important parameters. For example,
capital adequacy and debt-to-equity ratios can only be estimated, while qualitative analyses often
cannot be evaluated. Definitional problems are also widespread; “past-due loans” remains
undefined v , for example. Past analyses must be relied on more than one would like. In such
murky conditions, one must use whatever data is available, always taking all due precautions to
reach the best level of accuracy possible, and the safest conclusions possible. For the purposes of
this note, only those sets of data that are reasonably dependable will be used.

Deposit boom
Firstly, the banking system is under no pressure to attract deposits, and hence under no pressure
to compete for them 64 . Even as the banking crisis unfolded in 2001, deposits remained relatively
high -and growing. Banks found that they could now afford to extend more loans; in this sense,
the credit boom that is still taking place is the direct result of a continued influx of deposits.

Total Deposits in the Banking Sector (YTL, million)

Source: "TRNC Central bank"

5.000.000.000

4.500.000.000

4.000.000.000

3.500.000.000

3.000.000.000

2.500.000.000

2.000.000.000

1.500.000.000

1.000.000.000

500.000.000

0
07
05

06

07
01

02

03

04

05

06
01

02

03

04

05

06

07
01

02

03

04

20
20

20
20

20

20

20

20
20

20

20

20

20
20

20
20

20
20

20

20

20

p.
ay
ay

ay
/

/
p.

p.

p.

p.

p.
p.

n.
n.

n.

n.

n.
n.

n.
ay

ay

ay

ay

Se
Se
Se

Se

Se

Se
Se

Ja
Ja

Ja

Ja

Ja
Ja

Ja

M
M

30
31

31

31
31
31

31

31

31
31

31

30
30

30

30

30

30
31

31

31

31

v
The term "past-due loans" appears to refer to loans that are 12 months overdue, but this is not entirely certain.

28
Deposits themselves were driven by a variety of factors: Firstly, the economy has experienced
robust growth in the last years. Secondly, in the midst of high GDP growth, and the absence of a
developed capital market that would attract savings, the excess capital has had few other outlays
except the banking system. This is especially true when disposable incomes rise, driving
consumption and savings upwards. The international isolation has contributed to this effect
significantly. Third, the 2001 banking laws, on the heel of the banking crisis in which insolvent
banks were either taken over or allowed to fail, succeeded in boosting confidence in the banking
system. Fourth, many residents of the republic of Turkey have been attracted to the Northern part
of Cyprus in an effort to avoid paying higher taxes 65 .

Lastly, high deposits are driven by the very high deposit interest rates applied by banks, which
naturally increased the opportunity cost of holding assets in cash or investing in alternatives.
Many analysts have excused these rates, citing the high and volatile inflation levels of the
Turkish Lira (and, to a lesser degree, the New Turkish Lira). This explanation, however, does not
jibe with the fact that, even discounting for inflation, the interest rates applied very high.

Inflation and Maximum Interest Rate on 1-month Deposits (%)

Sources: State Planning Bureau and "TRNC Central Bank"

70,0
Real Deposit Rate (Deposit Reate
Minus Inflation)
Euro Deposits

60,0 YTL Depostis

Inflation Rate

50,0

40,0

30,0

20,0

10,0

0,0
2002 2003 2004 2005 2006 2007

In 2007, the maximum deposit rate was 15.6% higher than inflation for deposits maturing at 1-
month (by far the largest category). Effective rates remain high; they are well above inflation,
and hinged on the Turkish Central Bank's rates. Even deposits in Euro, at 7% interest rate, are
very high indeed. This raises the question: with introduction of the Euro as legal tender, will
these banks be able to attract deposits?

Another characteristic that should inspire concern is that most deposits are short term deposits.
Almost 90% of total deposits mature at 3 months or less, with sight deposits and 1-month
deposits naturally dwarfing all others. This suggests that, should a crisis occur (as the

29
characteristics of the banking system suggest is likely if the system is opened up under "normal"
market conditions) a run on the banks is very likely.

ST Deposits (%Total)
Source: "TRNC Central Bank"

90%

85%

80%

75%

70%

65%

60%

55%

50%

06
06
03

04

05

6
3

07

7
4

6
03

7
04

05

07
00

00

00

00
00

00
00

00

00

00
20

20
20

20

20
20

20
20

20

20
.2

.2

.2
.2

.2
.2

.2

.2

.2
ly
il
n.

n.

n.

n.
l.

n.
l.

l.

l.
pr

pr

pr
ct

pr
ct

ct

ct

ct
pr
Ju

Ju

Ju

Ju
Ju
Ja

Ja

Ja

Ja

Ja
O

O
A

A
A
31

31

31

31
31
30

30

30
31

30
31

31

31

31
31

31

31

31

31
30

Noteworthy is also the fact that foreign currency deposits are about half of total, a fact that
corroborates increased risk of flight should the economy send adverse signals. The fact that
locals account for a larger (but unclear) part of foreign currency deposits than usual does not
reduce the risk of flight.

Credit boom and adverse selection

The banking sector as a whole has never had to consider ways by which to improve its
profitability or attract "good" loans, especially as spreads between deposit and lending rates (and
spreads between deposits and government debt instruments) remained high, 66 ensuring profits.
Although unquantified, high-interest Treasury Bills make a “major part" of bank assets. 67 ” This
amounts to bank protection from failure, which, together with a deposit boom, appears to have
encouraged credit rapid growth.

In extending more and more loans, however, the banks found that the demand for loans from
State Enterprises and Institutions (SE&Is) is virtually insatiable. Banks, therefore, have been
finding it easy to nominally increase their assets by extending loans “of questionable quality 68 ”
to State Enterprises and Institutions.

30
 Total Credits (TL, million)
Source: "TRNC Central Bank "

2.500.000.000

2.000.000.000

1.500.000.000

1.000.000.000

500.000.000

0
31 Jan. 31 Jul. 31 Jan. 31 Jul. 31 Jan. 31 Jul. 31 Jan. 31 Jul. 31 Jan. 31 July 31 Jan. 31 Jul.
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007

Although these loans have declined in the last three years, from 50% of total credits to around a
third, they still account for a relatively very large percentage of total credits. This is significant,
not only because it has important implications concerning the structural health of the economy,
and indicates a severe case of crowding out, but also because SE&Is have a very poor record of
paying back their obligations 69 . This steady stream of nominal increase in bank assets, coupled
with constant subsidies from the state, corroborate Safakli’s argument that banks do not need to
aggressively pursue profits. In any case, the very volume of loans to SE&Is is in itself an
indication of resource misallocation in the economy.

The extent to which credits are offered to SE&Is, coupled with the fact that Treasury Bills and
other financing instruments appear to be "a major part" of bank assets, suggests moral hazard: as
long as obligations of the (insolvent) state are a vital part of bank assets, and as long as these
assets guarantee profits, banks have an incentive to take risks. They are virtually (if implicitly)
guaranteed on the one hand, and under-regulated on the other, a recipe for a banking crisis that
looks eerily similar to the conditions we observed in the banking crises of the late 1990s-early
2000s, especially in the so-called "third wave" of banking crises 70 .

Another factor that points towards adverse selection in the banking sector is the ubiquitous
connected lending. Most analysts underline the problem 71 , and the literature invariably treats
this problem as 'particularly acute'. This problem was only half-heartedly addressed by the 2001
Banking Law.

31
It is in this context that one must note that, apart from the credits extended to the state, the other
large category of credits are the so-called "Personal" (or "consumer") loans. These loans have
since the second quarter of 2006 become the largest category of loans, with credits to SE&Is a
close second. This is the category in which intense competition is taking place, with connected
lending and adverse selection most likely. The poor regulatory framework, together with a
virtual guarantee on a large part of bank assets, render the likelihood of risky behavior in the
category of personal/consumer loans extremely likely -especially when these are the very loans
for which banks compete.

Loans: Personal and to SE&Is ( %Total)

Source: "State Planning Bureau"

90%
Loans to SE&Is (% Total) "Personal" Loans (% Total) Total "Personal" and to SE&Is

80%

70%

60%

50%

40%

30%

20%

10%

0%
2000 2001 2002 2003 2004 2005 2006

Together with SE&Is, these "personal" loans account for a staggering 75% of all credits (in
value). Indeed, only “trade” as a category even approaches the volume of SE&Is and “Personal”
loans, with approximately 20% of loans. Construction, tourism, manufacturing and Small
Businesses, together account for no more than 4 or 5% of all loans.

32
 Loans: Major Categories and total (YTL)
Source: "State Planning Bureau"

2.500.000.000
SE&Is
Personal
Trade
TOTAL
2.000.000.000

1.500.000.000

1.000.000.000

500.000.000

0
2000 2001 2002 2003 2004 2005 2006

These findings should at the least procure curiosity. Firstly, if SE&Is, personal loans and trade
together account for about 95% of all loans, then the received wisdom that the credit boom is
financing construction, must be false, unless "Personal" loans finance construction in their
entirety. Although some of these loans must end up in tourism and in construction, these sectors
are clearly not entirely financed by the banking sector's credit boom. No adequate empirical data
exist to support any explanation, but these loans presumably finance tourism through small
businesses, such as restaurants. They also finance the general economy through increased
consumption. (In fact, the Central Bank explicitly re-designates these "Personal Loans" as
"Consumer Loans" in its Quarterly Bulletins 72 ). In this respect, personal loans do hold the
economy afloat, as they allow households to finance their consumption though debt. This
indicates that, while loans to SE&Is are largely hollow, much of the credit given out in the form
of “personal loans,” is also hollow. Household indebtedness is another social and economic evil
lurking in the northern part of Cyprus.

Secondly, these figures reveal a structural problem, in that most loans go to sectors that do not
increase total value-added in the economy. Intertemporal transformation of credit through the
banking system is not taking place. If GDP growth is driven by construction and tourism, and if
credits to these sectors account for a minute fraction of total credits extended by the banking
system, then the credit boom cannot be excused as a "natural aspect of high growth". The
banking system does not carry out its intermediation or risk-diversification functions as it should.

One may assume that the driving sectors are being financed through equity. The unanimous
assessment of the capital market as weak and hollow, however, disputes this. Most of the
financing of these sectors comes though government instruments (such as the Development

33
 Bank) which provide preferential loans, and where "political connections 73 " are necessary. This
is an additional indication of resource misallocation and rent-seeking. Additionally, as far as the
banking sector goes, this indicates that "good" clients are taken over by the state, leaving only
state debt and consumer loans to the banks.

Given such exposures, one feels compelled to examine the rates and trends of non-performing
loans. On the one hand, past-due loans (as they are called by the “TRNC Central Bank”), remain
relatively low compared to the total volume of credits extended. In the last two years or so, they
account for approximately 10% of total loans and around 4% of total banking assets. However,
this means, that, given the credit boom, the total value of PDLs has more than doubled in the last
three years. Unfortunately, provisions for PDLs, set aside by the banks, account for
approximately 55% of PDLs themselves and cannot cover losses should a crisis strike. PDL data
do not procure concern on face value, but their face value does not tell the entire story.

PDL and Provisions for PDL (TL, million)

Source: "TRNC Central bank"

300.000.000
PDL
Provisions for PDL

250.000.000

200.000.000

150.000.000

100.000.000

50.000.000

0
06
04

05

05

06

07

7
04

05

07

7
06
00

00
00

00

00

00
20
20

20

20

20

20
20

20

20
20
.2

.2
.2

.2

.2

.2
4/

ly
r.
n.

l.

n.

l.

n.

n.

l.
pr

pr
ct

ct

ct

ct
Ju

Ju

Ju
Ap

/0

Ju
Ja

Ja

Ja

Ja
O

O
O

O
A

A
30
31

31

31
31
30

30

30
31

31

31

31
31

31

31

31

34
 Past-Due Loans (%Total Credits)
Source: "TRNC Central Bank"

18%

16%

14%

12%

10%

8%

6%

4%

2%

0%

06

07
4

7
06

07
05
04

07
05
4

07

07
06

06
05

05
04

04

00
00

00
00

00

00

00
00

20

20
20

20
20
20

20
20

20

20
20

20
20

20
20

20

.2
.2

.2
.2

.2
.2

.2
2

3/

5/
3/

5/
3/

5/
3/

5/

ly

ep

ov
n.
n.
n.
n.

l.
l.
l.

ep
ep
ep

ov
ov

ov

Ju
Ju
Ju

/0

/0
/0

/0
/0
/0

/0

/0

Ju

Ja
Ja
Ja
Ja

N
S
N
N
N

S
S
S

31

31
31

31
31

31
31

31

31
31
31

31

30

30
31
31
31
31

30

30
30

30
30

30

Past-due Loans (TL million)

Source, "TRNC Central Bank"

240.000.000

220.000.000

200.000.000

180.000.000

160.000.000

140.000.000

120.000.000

100.000.000
31 Jan. 30 Apr. 31 Jul. 31 Oct. 31 Jan. 30 Apr. 31 Jul. 31 Oct. 31 Jan. 30 April 31 July 31 Oct. 31 Jan. 30 Apr. 31 Jul. 31 Oct.
2004 2004 2004 2004 2005 2005 2005 2005 2006 2006 2006 2006 2007 2007 2007 2007

35
 Provisions for PDLs (% Total PDLs)
Source: "TRNC Central Bank"

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%
03

04

05

07

7
03

04

05

06

06

07
03

04

05

07
06
00

00

00

00
00
20

20

20

20

20
20

20

20

20

20
20

20

20

20

20
.2

.2

.2

.2

.2
4/
r.

r.

r.

ly

r.
n.

l.

n.

l.

n.

l.

n.

n.

l.
ct

ct

ct

ct
ct
Ju

Ju

Ju

Ju
/0
Ap

Ap

Ap

Ap
Ju
Ja

Ja

Ja

Ja

Ja
O

O
O

30
31
31

31
31

31

31
30

30

31

30

31

31

30

31
31

31

31

31

31
Firstly, and related to the unanimous estimation of bank governance, we need to look at the
extent of evergreening. With inadequate supervision and regulation, and intense competition
between banks, it is very likely that such practices abound. To the extent that evergreening does
take place, PDLs are understated, and, hence, bank assets are overstated. There no adequate
empirical data to quantify this, however.

Secondly, PDLs are still low, but the housing and construction boom is only just beginning to
slow. In the face of an international slowdown, which decreases both demand in holiday home
purchases and tourist arrivals, the continued increase in capacity is bound to slow down –even
come to a halt, in the face of excess capacity. Real estate values will have to stop rising, and,
very possibly, even deflate. The slowdown is already becoming evident; PDLs should be
expected to rise. Additionally, as reunification looks increasingly likely, and as the issue of
property rights comes to the fore as a core issue in the negotiations, the status of property rights
will become more uncertain, thus putting downward pressure of purchases of holiday homes.

Lastly, one also observes a rather peculiar phenomenon in the relationship between banks and
the state. Continuous subsidies and transfers from the Republic of Turkey remain the most
important means of supporting the state, and, thence, the solvency of the banks. With analysts
noting that SE&Is have a poor record in paying back their obligations 74 , the conclusion of
Eichengreen et al is disquieting:

“Indeed, it is not clear what keeps these institutions operating today,

probably a combination of a lack of transparency and government
subsidies allowing them to meet their current payment obligations 75 ”

36
Since "credits to SE&Is" does not include state debt instruments like Treasury bills and bonds,
which, according to some analysts account for an important part of bank assets 76 , this recycling
process, by which lower bank assets are supported through subsidies transmitted to the "TRNC",
keeps bank assets artificially high. Indeed, one feels compelled to wonder why these subsidies
are not used to cover outstanding loans of state institutions directly; the answer remains elusive,
although it is probably related to the structure of the state and its institutions w . In any case, it is
likely that PDLs are hidden behind these transfers, which cover -directly or indirectly- at least
part of the outstanding debt of SE&Is.

1) Banks
extend loans
to SE&Is

2) SE&Is 4) State Republic of

cannot repay subsidizes Turkey
some of losses finances the
incurred by Losses
banks

3) Banks face
Asset loss
from bad loans
to SE&Is

Liquidity
That the credit boom has been driven by a deposit boom is clearly evident from a comparison
between total deposits and total credits. Indeed, while total credits amounted to approximately
30% of total deposits (in value) in the beginning of 2004, that figure has risen to 50% by the
beginning of 2008 77 . Although on first reading may not seem to be significant, it does
corroborate the analysis of Nil Gunsel, who recently noted that the liquidity ratios are high and
that they indicate that "banks in Northern Cyprus face unexpected deposit runs, which increases
the probability of failure 78 ". In its Quarterly Bulletin (3rd Quarter 2007), the "TRNC Central
Bank" notes a decrease (2.34%) in the liquid assets of the banking sector 79 .

Assessment
The Banking system is highly exposed and, indeed, insolvent. In 2004, Eichengreen et al noted
that:

w
Apart from infrastructure and projects, they probably go to municipal and other local authorities, which use them
to pay back current obligations, rather than pay SE&I debt directly. This relieves the state budget, and allows some
of the SE&I debt to be serviced.

37
 “reasonable capital for a banking system this size would be US $ 150 million,
assuming an adequacy ratio...slightly in excess of the Basle minimum.
Unfortunately, actual capital appears to be close to zero 80 ”

Continuing, they added that "it is not clear what keeps these institutions operating today 81 ".

The high exposure to sovereign risk, the poor banking governance and structures, the protection
from alternative destinations for savings, the very high interest rates and the high spreads that
ensure profits, all solicit concern. Not only has the sector never been weaned from the state, but
there is an ever increasing interdependence between them. The state is guaranteed an endless
source of credit, most of which covers current expenses, while banks are able to maintain the
impression that their assets are higher than they are in reality. This is a sobering realization.

One of the few ratios that are possible to extract from the available data is the asset-to-profit
ratio. It is noteworthy that, while profits are both high and erratic, the ratio remains low, barely
rising above 1.5%.

Profit (% of Assets)
Source: "TRNC Central bank"
5,0%

4,5%

4,0%

3,5%

3,0%

2,5%

2,0%

1,5%

1,0%

0,5%

0,0%
31 May/ 2004

31 May 2005

31 May 2006

31 May 2007
30 Sep. 2006

31 Jan. 2007

30 Sep.2007
31 Jan. 2004

30 Sep. 2004

31 Jan. 2005

30 Sep. 2005

31 Jan. 2006

-0,5%

-1,0%

-1,5%

In effect, the fact that the banking system transforms a large influx of deposits into credits (of
one form or another) to a state that is in perpetual deficit indicates that one of the most important
functions of the banking sector, financial intermediation, is not being carried out. More worrying
still, is the fact that these banks seem to be surviving under current conditions out of pure
circumstance: state support on the one hand, and lack of alternatives for both debtors and
creditors, on the other. One must wonder what would happen if these circumstances changed -
say, if Cyprus were reunified.

38
 4. The regulatory framework and banking laws

A wave of banking laws that were passed in 2001 has gone a long way towards improving the
banking conditions in the North. Many of the lax requirements on banks have been tightened,
while limits were also placed on risky bank behavior like connected lending. Nonetheless, not
only is "the level of public-sector debt carried on the balance sheets" of banks "one of the risks
remaining 82 " after the banking crisis, but bank governance is another important "remaining risk".

There are many loopholes in the legislation, and there is excessive dependence on the discretion
of the Central Bank to manage the nature and structure of the banking sector. Perhaps the most
serious problem of the new framework is that the Central Bank is charged with regulating and
supervising the banking sector, with little direction and very wide powers. This extensive
authority given the Central Bank, which includes auditing, licensing and punishment, raises
many questions, not the least because of problems that the Central Bank itself faces.

All discussion of the Central bank itself, and of the regulatory framework in general, should be
informed by the fact the "TRNC Central bank" is essentially an instrument of government policy.
As noted below, its independence is only nominal, while its relationship with other instruments
of government (not "state") policies, is delineated by very murky lines. It is only within this
context that any discussion will be meaningful. The central bank needs to be more independent
and with a smaller scope. Its discretionary powers should be absolute, but in a smaller spectrum
of decisions, which should be set by law.

One concern is whether the Central Bank has the institutional capacity to carry out this wide
spectrum of operations. There is no such indication anywhere in the relevant legislation, and it is
highly unlikely that the Central Bank has undergone the necessary reorganization to meet the
additional burdens of carrying out its duties as regulator and supervisor of the Banking sector.
Although "hard" facts are difficult to come by, a number of indications are available x . There is
no sign that such hiring and organizational restructuring have taken place since the passage of
the law, but the information in scant.

A more disturbing problem is that such excessive power, concentrated in the hands of a single
body, makes the Central Bank a fertile ground for corruption. It is desirable to provide the
Central Bank with the power to define terms (like Non-Performing Loans) and conditions (like
what would make a manager “fit and proper”). However, one should bear in mind that the
northern part of Cyprus is a very small country, which makes corruption virtually inevitable
because of the personal and social contact that exists between bankers, economists, businessmen
and politicians, so its discretion should be limited by law. Without some kind of oversight over
the Central Bank, and with and Central Bank unlimited power over banks, there is a danger of
forbearance or preferential treatment of some banks. The oversight should, of course, be limited
to certain aspects of the central bank's work, and its purpose should be to allow oversight by the

x
For example, Quarterly Bulletins are neither on time, nor contain all the elements required under the Central bank
Law; its website has had pages that have been "under construction" since 2004; the data and even information it
does provide is sometimes contradictory; the Central bank itself uses different notations for identical inputs, and so
on.

39
political opposition on how decisions are made. A regular (annual) in camera parliamentary
hearing, in which the central bank is obliged to explain certain aspects of its decision making
process, would probably go a long way.

Even so, it is imperative that a legislative framework be developed in which bank managers can
appeal certain types Central Bank decisions, especially if there are grounds to believe that there
has been unequal treatment. Conversely, Parliament should set limits to certain decisions of the
Central Bank, especially those it takes under its power to establish proper punishments and
procedural matters. More preferably, the northern part of Cyprus appears to be one of those cases
where bank supervision should be separated from the “Banker of the State 83 ”. Legislative
provision of what the central bank may, and may not, do, is necessary. Article 13 (1) of the
Banking Law (39/2001) affords the Central Bank the power to decide the measures that will be
taken in those cases in which banks do not conform with regulations, as “deemed necessary,” but
the framework of such measures is largely set by the Central Bank itself. Paragraph (2) also
gives the Central Bank full discretion to reinstate the license of operation of banks.

The laws provide no legal control against regulatory forbearance on behalf of the Central Bank,
a problem that is aggravated, as noted above, by the small size of the social upper class, which
easily leads to the kind of "soft corruption" that locals call rousfet, roughly translated as the
exchange of favors. Although the relevant legislation does provide that banks “whose positions
are found inappropriate” are given a period “not exceeding three months” “for making necessary
arrangements 84 ,” the implementation of such laws, and the extension of such grace periods,
appear to be common.

Problems that have been identified as root causes of the banking crisis of 2001, such as
"connected lending, credits without adequate collateral, favorism by the management,
inadequate use of funds, dealing in non-financial activities, political interference, lack of
accountability, illegal use of funds, lack of transparency and risky investments with low
returns 85 " have not been addressed. Although the law does address "connected lending" and
"accountability," this is clearly not enough. In terms of accountability, employees and managers
are only liable if, through illegal action, they increase risk and cause bankruptcy. This would
apply, for example, to assets in the form of real estate, beyond the figure mandated by law, but it
says nothing about the way in which loans are approved, credits extended, and risks taken.

Another example of the shortcomings of the 2001 law is the provision for central bank
supervision of best practices in credit evaluation and risk management for banks. Here, the
problem is that there is no mention as to how this applies to loans extended to the state or State
Enterprises and Institutions or to government debt. As noted earlier, the state has a track record
of falling behind in its obligations, for which it makes up by providing subsidies. Additionally,
given that SE&Is make up more than 30% of all loans of the banking sector, the attention of the
legislature in its efforts to improve the banking system should have concentrated on the state’s
finances and the relationship between them and the banks.

In addition to this excessive discretion that is afforded the central bank, it is also important to
note that there are provisions in the legislation against “any action that could damage the
reputation of the Central Bank 86 ”. Such action is punishable with a fine of TL 15 billion

40
(presumably now redefined in terms of New Turkish lira) or up to seven years in prison, or both.
This is a clear disincentive against criticism of central bank policies and actions taken with
respect to regulating and supervising the banking sector. Preferential treatment, politically-
motivated decisions and forbearance are thereby protected, lest the "reputation" of the bank is
"damaged".

Aggravating this matter is the fact that the Governor (and Board) of the Central Bank is
essentially a political appointee, appointed by the Prime Minister, with the approval of the
Cabinet, for a period of five years 87 (the Board for three). Their salaries are left to the discretion
of the Cabinet, and they are employed "on a contractual basis 88 ". Not only is there no ratification
process that would involve Parliament, but the Governor’s tenure lasts only as long as the
government that has appointed him/her (five years, as long as the tenure of government) 89 . The
tenure of the Governor and his Board can be extended with no upper limit on the terms that she
can serve, something that would make the officeholder particularly receptive to political
pressure, thus inviting corruption. The governor’s position therefore amounts to a cabinet seat
with legal insulation from public criticism and no oversight from opposition.

Additionally, in this context, one should underline the fact that decisions on the licensing of
banks are not taken by a unanimous decision in Board of Directors of the Central Bank, but by a
majority decision. This increases the likelihood that decisions will be politically motivated.

Supervision is also seriously hampered by the fragmentation of authority. As seen in the chart
below, several institutions are responsible for supervision and oversight. This minimizes the
effectiveness of supervision in two ways: first, it precludes the creation of a smaller number of
specialized institutions, with technocratic know-how and exclusive but limited competence.
Second, it places responsibility in the hands of political institutions, and, ultimately, elected
officials, where there exist both incentives and opportunities for politically-motivated decisions
and rent-seeking. Indeed, if one considers that the Central Bank Board and the Governor are
appointed for the term of office of government, it becomes clear that all supervisory institutions
are politically accountable, rather than insulated from political influence.

Additionally, the central bank has excessive control over the banking sector, but inadequate
control over the banking system.

Financial Activity 90 Supervising Institution

Commercial Banking Central Bank
Cooperatives Cooperatives Registrar (falls under the
Office of the Prime Minister)
Development Bank Ministry of Economy and Tourism
Offshore Banking Ministry of Economy and Tourism
Insurance Funds Ministry of Finance
Exchange Bureaus Ministry of Finance
Social Insurance Fund Ministry of Labor
Stock Exchange Ministry of Finance

41
As far as the banks themselves go, there are considerable provisions in the law against
overexposure to particular debtors. Banks are also disallowed from conducting commodity trade
operations. These provisions are a marked improvement in the legal framework. However,
banks are still allowed to maintain up to 50% of their capital in the form of real estate 91 , a sector
that is experiencing a bubble at this time. Additionally, banks are allowed to hold up to 60% of
their “own funds” in the form of shares in other companies and securities portfolios. 92

The Banking Law seems to have had some considerable positive effect on the banks, for example
by minimizing the exposure of banks 93 and rendering managers and owners personally liable for
losses from the banks. As noted, however, this does not apply to risky behavior, but only to
violation of law; hardly an improvement worth celebrating. It has also increased capital
requirements from USD119 thousand, to USD2 million 94 , a marked improvement. The
requirement, however, is still low compared to international standards; a USD5 million
requirement would be more up to standard.

Much remains to be improved, including judicial oversight over the implementation of the
banking and central bank laws, and the excessive discretion that the law places in the hands of
the Central Bank. Given the weakness of the state, and the strong track record of failing to
implement legislation, it is highly questionable that the law itself will yield much return. It is,
nevertheless, a good start that had to be made, and on it, a more modern and complete framework
can be built with extensive, but not radical changes in the relevant legislation.

42
 5. Conclusion

Good news…
In the northern part of Cyprus, nominal growth is still robust, the consumption boom -if slower-
is still ongoing, tourism still survives and the excessive increase in capacity still seems justified.
Additionally, recommendations should always be informed by the fact that the entire banking
system is minute compared even to the South. The potential crisis would represent a small
financial burden compared to the banking crises experienced in the past. The Republic of Turkey
not only can afford to bail out the entire system, but, in a sense, does so continuously. Indeed,
the very fact that the Republic of Turkey continues to extend large grants to the northern part of
Cyprus, and that it is even desirable for the public image of Turkish politicians to do so, is a
large part of the reason why these problems were never seriously addressed. With full protection
of banks and state from the likelihood of a crisis, the urgency for change remains hidden behind
the thick veil of GDP growth.

Most analysts follow the logic that, given the very high deposit interest rates, a flight of deposits
to either the South, or Turkey, is not very likely. Although Greek Cypriot and Turkish banks are
much less risky, there are few signs of nervousness on behalf of Turkish Cypriots over the
fragility of their banking system. In a system where concerns over the fragility of the banks are
not evident, and where deposit interest rates are 20% or so higher than most alternatives there is
little reason to expect that the rate of deposits will decline significantly.

On the credit side, the lower lending rates in Greek Cypriot banks are of little importance.
Although these banks will naturally attract customers, they are not likely to be very forthcoming
in extending loans to all but the most creditworthy and largest Turkish Cypriot customers, at
least at first. Therefore, the bulk of personal/consumer loans should not be affected.

Given such a reality, and the implicit guarantees on bank assets held in the form of Treasury
Bills or credits to SE&Is, many analysts do not expect a crisis at all. The state, it is assumed –not
wholly without reason- will not default, neither will loans to SE&Is be allowed to fail.
Additionally, most analyses 95 concentrate on the economic potential that reunification will
release, thereby adding to the generally exuberant mood.

An additional element in those analyses that predict a strong performance of the banking sector
is the proliferation of off-shore banks, a fact that injects proper governance and healthy
competition in the banking sector.

Indeed, the deposit boom will not come to an abrupt end; demand for credits will not flee to the
South, and bank assets will be protected by the state. The economy will eventually take off, with
new opportunities for value added. The isolation of the Turkish Cypriot economy will be lifted,
making exports easier and imported inputs cheaper.

43
…and bad news

Indeed, the exuberance seems to be perfectly rational. As it was in Southeast Asia in 1997; as it
was in the entire "third wave" of banking crises.

In an IMF study that should alert those who see no cause for alarm because of the continued
boom in the Turkish Cypriot economy, Emine Boz has noted emphatically that "It is widely
agreed that overconfidence and informational problems are, at least partially, responsible for
the recent crisis episodes. 96 " In the northern part of Cyprus, overconfidence is widespread and
informational problems endemic, much like the cases analyzed by Boz.

If the patient shows no symptoms, this does not mean that the illness no longer festers. The
fundamentals are still off. The economy is hinged on sectors that are growing with a dizzying
pace, but are unsustainable. Construction is already slowing and uncertainty over property rights
can only cool it further, at least in the short-to-medium run. The sales of holiday villas will be
affected both by property rights uncertainty and by the international slowdown, especially in
countries like the UK, where most of the demand is concentrated. Tourism is taking a similar hit,
with occupancy rates stuck near 40%. Overvalued real estate will likely take a hit –with lower
demand and a construction slowdown, the bubble is bound to burst.

Bank assets, especially Treasury Bills and credits to SE&Is, may be prevented from failing, but
they are still hollow. Increased exuberance may hold consumption, but personal (or "consumer")
loans are still problematic and households are indebted. Only the largest and most creditworthy
bank clients will likely exit to the South as long as deposit interest rates remain so high, but this
exasperates adverse selection. What is more, this will only hold true as long as the new Turkish
Lira remains the official currency. With the introduction of the Euro, interest rates will have to
be adjusted and re-aligned. In a banking system that depends on large (one may say artificial)
spreads for profits, this raises serious questions.

Trade may become easier, but productive capacity remains limited, and is concentrated in
agriculture and processed foods. Despite high food prices, this remains a problem; after all,
agriculture is also faced with higher production costs. Cheaper inputs will only affect a small
segment of the economy, at least in the short-to-medium run. Additionally, even with more
access to international markets, trade distortions caused by government policies, together with
significant misallocation of resources, raises serious doubts about the ability of industry and
manufacturing to cope with international competition. Rising current account deficits corroborate
this fear. This is particularly true as factor productivity is very low and productivity cannot
increase overnight y . Indeed, it will not rise significantly as long as “perverse incentives” are
pervasive in the economy. In an understatement, the World Bank notes that increased trade "may
still be insufficient to elicit sustained growth 97 ".

y
There are even concerns that, with migration to the South, wages in the North may increase without a parallel
increase in productivity. Wages could then increase prices in non-tradables, which will eventually further affect
competitiveness.

44
Off-shore banks have added strength to the banking sector, but are neither allowed to deal in
cash, nor do business with local residents 98 . A new banking law was passed, but it is full of
loopholes and falls short of securing the good health of the banking sector, while the concerns
about its implementation are also legitimate.

Above all, the economy, and the banking system, will have to function, not only in a free
economy 99 z , but an open one, as well. How long will they be able to depend on an insolvent state
that is propped up by another state? And, will this relationship be tolerated by Greek Cypriots
and the federal state after reunification?

Most worrying of all is the fact that the new Turkish Lira will no longer be the legal tender with
reunification. Euroization will be inevitable, irrespectively of every other aspect of the solution.
This will drive interest rates down to rates comparable to those in the South. Today, deposit
interest rates are hinged on the Turkish Central bank rates. Short term YTL deposits receive up
to 25% interest rate, while Euro deposits receive as much as 7%. With lower deposit rates, the
growing influx of deposits will no longer be reliable, as Greek Cypriot banks will look very
attractive, and less risky. Alternative outlays for excess capital will now exist. This will create
competition for deposits, pushing deposit rates up and lending rates down, eating into the profit
margins. The new alternative of Greek Cypriot banks will also likely attract the most
creditworthy and largest customers of Turkish Cypriot banks, leaving smaller and less
dependable clients in the north.

Higher rates, lower profits and a flight of deposits will aggravate adverse selection. This, at a
time when the sector that drives the economic boom -construction and real estate- will be
experiencing uncertainty over property rights. At a time, also, when there will likely be a decline
in demand from abroad, both for construction and for tourism. Even asset-price deflation cannot
be ruled out, especially in real estate. After all, there is significant mismatch between asset prices
and asset productivity 100 . Both personal/consumer loans -the largest category- and banks' own
fixed assets will come under pressure. Past-due loans look likely to increase, approaching 10%,
the generally accepted level that constitutes banking distress. If, at such a time, reunification puts
a hold on transfers from the Republic of Turkey as well, loans to State Enterprises and
Institutions will also take a hit. All this in a banking system where prudential regulation and bank
governance have always been cause for concern.

The prospects are gloomy.

Further questions arise. With reunification, will Turkey continue to keep the "TRNC" -or its
inheritor state- financially solvent? Will it be willing to bail banks out? Will provisions be made
from beforehand so that Greek Cypriot banks will be allowed to extend credits to the North, aa if
they are willing? Will Greek Cypriot -or any- banks be allowed to take over failing banks? Will

z
Some analysts also note that the economy is becoming less “open”, a sure sign that the lifting of isolation is not
paying off, as long as policies do not also adjust.
aa
Limits are more than likely; the last Comprehensive Solution to the Cyprus Problem, the Annan Plan, placed
limits.

45
there be bailouts, or will banks be allowed to fail? Will mechanisms be put in place -from
beforehand, again- to counter disintermediation at a time of recession, and, probably, asset-price
deflation? Will deposits be fully guaranteed? Will investments from the south be allowed to
counter a credit crunch in the north? If not, will Greek Cypriots tolerate an influx of investments
from abroad, while they are not allowed to invest bb ?

None of the options are very attractive. Indeed, the only good news in this picture, apart from the
small size of the Turkish Cypriot banking sector, is that the likelihood of a currency crisis is
purely exogenous. All other aspects of the system, however, look dim. Even if the above
questions are answered in the affirmative, we would only be trying to limit the depth and
duration of the crisis - not averting one altogether.

The political options will be unpalatable and the political ramifications will be dangerous. The
initial enthusiasm of reunification will die out quickly and the honey-moon will end abruptly.
Extremists on both sides will find fruitful ground to accuse the other side -and, given past
experience- the solution itself. One almost feels compelled to name such leaders, on both sides.

The medium-run economic gains -immense in their potential- will become invisible. Business
(the bulk the die-hard supporters of reunification) will likely become less keen. Growth in the
north will decline; financial disintermediation will bring the economy to a halt even as painful
solutions to the property issue are being implemented. Credit will be unavailable in the north and
not forthcoming in the south for most Turkish Cypriots. Greek Cypriots will have to "pay up"
instead of reaping the economic rewards of the solution -at a time when they will be faced with
painful decisions of their own about their properties and homes in the North. Wage convergence
will become a long term aim, rather than a medium-term expectation 101 , slowly causing
resentments on one side, and unemployment on the other.

All this can be averted, but only with political courage.

bb
Again, past experience shows that this is important for Greek Cypriots. In the debate over the Annan plan, the
discussion concerning the freedom of movement and establishment was not limited to the movement of persons, but
extended to the movement of capital as well. The argument, framed in terms of "rights" and fairness, was that while
foreigners would be allowed to invest in Cyprus, Greek Cypriots would not be allowed to invest "in their own
country".

46
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1
Author: Michalis Persianis, 2009.
2
Jean Monnet, Thought on Europe
3
For example: PRIO Cyprus Centre, Proceedings of the 2nd Annual Conference (in Cooperation with MFC Platis):
Economic Perspectives in Cyprus and the Path towards Reunification and Praxoulla, Antoniadou Kyriakou, Mullen
Fiona and Özlem Oğuz: The day after: Commercial opportunities following a solution to the Cyprus problem, PRIO
Cyprus Centre, 2008
4
For example, under Articles 38 (2) or 51 (1)(J) of the Central bank Law (Law 41/2001)
5
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006 (Look
page 180)
6
As per Law 41/2001, Article 30 (1)
7
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006 (Look
page 32)
8
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
9
Alan Greenspan, Speech: "The Challenge of central banking in a Democratic Society", American Enterprise
Institute, 5 December 1996.
10
For example look: Safakli, Vassiliou et al, Eichengreen et al
11
law Number 39/2001
12
Law Number 46/2000
13
Law Number 41/2001
14
Law Number 55/1999
15
Law Number 38/1997
16
Vassiliou et al, page 14.

50
17
Source: “TRNC Central Bank”
18
State Planning Bureau data.
19
Economist Intelligence Unit, Country Report-Cyprus, June 2007 update
20
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe an Central Asia Region, June 2006 (Look page
105)
21
Safakli, 2003 (Public Sector Finance)
22
Economist Intelligence Unit, Country Report-Cyprus, June 2007 update
23
Ibid.
24
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe an Central Asia Region, June 2006
25
Eichengreen et al, page 21.
26
Vassiliou et al, page 47.
27
Vassiliou et al, page 14
28
PRIO Cyprus Centre, Proceedings of the 2nd Annual Conference (in Cooperation with MFC Platis): Economic
Perspectives in Cyprus and the Path towards Reunification. Look: "Presentation by Mr. Vargin Vaver, Economist"
29
State Planning Office website: "Recent Developments" (2004)
30
Economist Intelligence Unit, June 2007
31
World Bank 12 (bold in the original)
32
Ghafoor, Abdul: The Impact of Value Added Tax on the North Cyprus Economy: A Short Term Assessment,
Dogus Universitesi Dergisi, 6 (1) 2005, pages 98-111
33
Safakli, 2003
34
Country Profile 2008. Also Look: Ghafoor, Abdul: The Impact of Value Added Tax on the North Cyprus
Economy: A Short Term Assessment, Dogus Universitesi Dergisi, 6 (1) 2005, pages 98-111
35
EIU, December 2007 monthly update
36
Safakli, 2003, Eichengreen et al and Vassiliou et al
37
Ghafoor, Abdul: The Impact of Value Added Tax on the North Cyprus Economy: A Short Term Assessment,
Dogus Universitesi Dergisi, 6 (1) 2005, pages 98-111
38
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
39
Safakli
40
On YTL; Source: "TRNC Central Bank", March 2008
41
EIU Country Profile, 2008
42
Ibid.
43
EIU Country Profile 2008, Quoting World Bank Report
44
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
45
Ibid
46
For a strong analysis of this, Look: Francis Fukuyama, Nation Building
47
Charalambous (1993)
48
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
(look page 11)
49
"TRNC Central Bank" Quarterly Bulletin, 3rd Quarter 2007
50
EIU, June Update, 2008
51
EIU, June Update 2007
52
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
(Look page118)
53
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
54
EIU January 2008 update. (Citing a report by KADEM, a market research company)
55
EIU January 2008 update.

51
56
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
(Look page 13)
57
Council Regulation No 866/2004, http://eur-
lex.europa.eu/smartapi/cgi/sga_doc?smartapi!celexplus!prod!CELEXnumdoc&lg=en&numdoc=304R0866R(01)
58
Annual Report on the Implementation of Council Regulation (EC) 866/2004 of 29 April 2004 and the situation
resulting from its application, COM 2007(553)FINAL, Brussels, 21.09.2007, http://eur-
lex.europa.eu/Result.do?T1=V5&T2=2007&T3=553&RechType=RECH_naturel&Submit=Search
59
Look: PRIO Cyprus Centre, Proceedings of the 2nd Annual Conference (in Cooperation with MFC Platis):
Economic Perspectives in Cyprus and the Path towards Reunification
60
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
61
Ibid.
62
Ibid.
63
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
64
Safakli 2003
65
Commentators on the Turkish Cypriot economy agree with this assessment. For example, look: Safakli 2003
66
Safakli 2003
67
Ibid
68
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
69
Vassiliou et al., Safakli, World Bank Report and EIU agree on this assessment.
70
Emine Boz, Daniel Hardy
71
For example: World Bank Report, EIU Country Profiles, Safakli, Vassiliou et al,
72
For example, look: "TRNC Central Bank Quarterly Bulletin", QIII 2007
73
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
74
Vassiliou et al
75
Ibid, page 60
76
Safakli, as above
77
Source: "TRNC Central Bank"
78
"Financial Ratios and the Probabilistic Prediction of Bank failure in North Cyprus", Nil Gunsel, European
journal of Scientific research, Vol. 18, No. 2, (2007), pp 191-200.
79
"TRNC Central Bank" Quarterly Bulletin, Third Quarter, 2007
80
Eichengreen et al, page 59.
81
Ibid.
82
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
(underlined in the original)
83
Central Bank Law (Law 41/2001)
84
Article 12 (2)
85
"A research on the Ethical Dimension of bank Crises in the Turkish republic of Northern Cyprus", Okan Safakli,
EJBO Electronic Journal of business Ethics and Organization Studies, Vol. 10, No. 2(2005)
86
Article 53
87
Law No: 41/2001, Article 13(1)
88
Law No: 41/2001, Articles 15(1) and 20
89
Law No: 41/2001, Article 13(1)
90
Reproduced from World Bank Report
91
Law No: 39/2001, Article 28
92
Law No: 39/2001, Article 26(1)
93
As per Article 23 (2) (A), Ibid.

52
94
Reflecting the volatility of the old Turkish Lira, the law uses references in US Dollars.
95
For example, Vassiliou et al, PRIO Cyprus Centre, Proceedings of the 2nd Annual Conference (in Cooperation
with MFC Platis): Economic Perspectives in Cyprus and the Path towards Reunification and Praxoulla, Antoniadou
Kyriakou, Mullen Fiona and Özlem Oğuz: The day after: Commercial opportunities following a solution to the
Cyprus problem, PRIO Cyprus Centre, 2008
96
"Can Miracles Lead to Crises? The Role of Optimism in Emerging Market Crises" Emine Boz, IMF Working
Paper WP/07/223, September 2007
97
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
98
Offshore Banking Law
99
PRIO Cyprus Centre, Proceedings of the 2nd Annual Conference (in Cooperation with MFC Platis): Economic
Perspectives in Cyprus and the Path towards Reunification
100
World Bank: Sustainability and Sources of Economic Growth in the Northern part of Cyprus, Volume II:
Technical Papers, Poverty Reduction and management Unit, Europe and Central Asia Region, June 2006
101
For example, Praxoulla, Antoniadou Kyriakou, Mullen Fiona and Özlem Oğuz: The day after: Commercial
opportunities following a solution to the Cyprus problem, PRIO Cyprus Centre, 2008

53