rational exuberance and the reunification of cyprus(quasi-final

8/9/2019 Rational Exuberance and the Reunification of Cyprus(Quasi-Final

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Rational Exuberance and the Reunification of Cyprus1a:

An Economic analysis

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

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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 economyshould alert us to the fact that the economy of the northern part of Cyprus is in a precariousposition.

The state is stifling the economy with its expansive involvement in it; it promotes adverseselection in the banking sector by providing both easy and profitable outlays for savings andindirect but large subsidies, and it crowds out private investment through the financing of largedeficits. State institutions offer high wages, raising the salary base in the economy above thelevels that productivity levels would justify. Additionally, are so inefficient that they onlysurvive 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 areprovided only through aid, and they are both inadequate and expensive.

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

The real economy itself is functioning under tax-based protectionism. Its main sectors areinward-looking, and the data corroborates the World Bank assessment that an increase in trade isunlikely to counter the above problems. Industry is faced with low capacity and high costs, not tomention low productivityb. 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 thoseinterested 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, forexample, cannot (and shouldnotc) be equalized until the productivity gap is covered, and, in thislight, expecting wage convergence until 2014 is, to say the least, overly optimistic3. Productivitycannot 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 wagedifferentials, 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

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RECOMMENDATIONS

Immediate concerns

Even before a reunification agreement is implemented, certain problems need to be tackled. Onepolitically viable way of doing this, is to present them as part of "EU harmonization," therebylifting some of the main political obstacles to reform, and, in the eyes of the public, insulating itfrom the reunification negotiations themselves. TAIEX assistance in institution building shouldalso turn towards the long-term survivability of both the state and the banking sector, as shouldmore 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 soon. Even its partial lifting has had some positive effects on the economy of the northern part ofCyprus. The lifting of the isolation, however, is neither a panacea, nor without its dangers, as thedata and the analysis demonstrate. EU programs must turn more keenly towards institutional andpolicy improvements.

Under the heading of the Sustainable Economic Development and ICT Sector Programme, forexample, it would be more urgent to introduce such expedients as a computerized tax-collectionor a budgetary management system, than to address "all sectors of society". In the context ofICT, stronger statistical capacity of the state is more urgent than other private sector needs. Thecart, at it were, should not be placed ahead of the horse. Under the same heading, addressingprivate sector growth without addressing at the same time the extensive and profound economicdistortions 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 realneeds 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, theprogram has not seriously looked at budgeting, financial sector regulation and oversight, fiscalstructures, or any of the other pathologies of the fundamentals. The Commission notes both thewillingness of officials to learn from the EU and its norms, andtheir low absorption capacity. Itis precisely this absorption capacity that needs to be addressed. Although such areas as thephytosanitary acquis do have an immediate value and should be pursued, their total contributionto 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

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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 theirown 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-likeconditionality on aid. This would, on the one hand, maintain the solvency of the state, and, onthe other, establish a procedure by which eventual independence will be achieved. It would alsoend soft budget constraints and address adverse selection in credit extensions.

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

Revenue distribution and public debt arrangements between the federal structures and the

states comprising the federation need to be clearly and unambiguously established. Externalfinancial lending, contributions and donations must be clearly arranged and agreed frombeforehande. In the light of the severe problems identified in the northern part of Cyprus, and theinsolvency of the state, debt arrangements must be agreed before a solution is implemented onthe ground.

In the same context, a comprehensive plan for reduction of deficits and servicing of debtshould be put in place. A good model would be for the authorities to submit a document alongthe lines of aNational Reform Programme or a Stability Programme as part of the managementprocess 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 politicallypossible. Retiring loans taken from private banks should be a priority, as should (on the mediumrun) the consolidation of the budget (look below). Debt restructuring (e.g. by extending thematurity of state debt or gradual lowering of interest rates) will buttress bank asset-sides if donecarefully.

Both sides must agree to a solution to theproperty issuef. Options do exist, even some that arevaguely fair. Whatever the agreement may be, property rights must be established clearly andunambiguously. The agreement will be inevitably complex, so it must be communicated to thepublic -and especially investors- in as clear and thorough a way as possible. Investor and creditorworkshops should be examined as an option. Communication with business elites before theagreement is "taken" to the public will be politically expedientg.

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 willnot only be a key issue in the negotiations, but, on the short-to-medium run, will also be the key issue in theeconomy as well.g Communicating clearly with the business elites will be important, as they will lead public opinion on whether theagreement on a difficult, complex and emotionally chargedissue, is acceptable or not. These elites should beinformed before the general public opinion is, allowing those best able to judge the agreement, to lead publicopinion.

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In any case, absolutely indispensable will be seminars and workshops for bankers and bankingsector 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 politicallyviable way of doing this, is to cover it under the guise of "EU Harmonization" and allow EUvetting 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 alsourgently needed on the amount of credit that banking institutions can extend to the state and forconsumption. Regulatory forbearance should also become risky for supervisors (with personalliability, for example). The possibility of an annual, in camera evaluation of bank supervisorsthemselves by the legislature, should be examined.

As far as regulations that are at the discretion of the Central Bank go, auditing rules should beimproved 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 legislativeaction is taken4. 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 beextended beyond the five and three year term respectively, and become disconnected from achange 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 thefinancial system as a whole (including, for example, offshore banks). Other supervisinginstitutions should also be consolidated into independent institutions with an own budget,thereby taking the supervisory authority away from politicians.

The capitalrequirement 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 andstate finances need to start immediately. The authorities of the northern part of Cyprus cannot doit on their own, however, and it is incumbent on the authorities of the republic of Cyprus, and allthose 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. Designatingthem as "medium run", however, does not mean that they can be put aside; it means that,

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

The state budget should be consolidatedto include all state institutions, including themunicipalities 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 torationalize spending. Indeed, municipalities reflect a very large under-the-line item on stateexpenditures. Implicit and contingent liabilities must be taken into account, and budgeting shouldtake a multi-year outlook.

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

Apart from tackling the lack transparency and accountability, the severe data collectionproblems must be addressed. An upgraded statistical service could assist the central bank in thiseffort, 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 andaccurate planning. Terms like loans past due, paid-up capital and exposure should also beaccurately defined.

Informational asymmetries also exist between banks and their clients. In the absence of solidand dependable corporate information, credit and risk assessment by the banks will remainproblematic. Setting up a new Credit Bureau to collect such information as credit defaults or firmhealth "would be of high value.5" Today, the only such body is a Risk Center within the CentralBank6.

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

The tax system must be improved. The multiple VAT rates should be minimized and taxcascading should be tackled to lower the tax burden andincrease revenues. Modern techniquesand technology is also needed in tax collection. The property tax, currently "little more than anuisance tax7" should be restructured and improved as it harms disposable income less thanpersonal income tax and VAT. It will also boost municipality budgets.

Protectionism must slowly be lifted. The current policy of trade-limiting measures, followed byineffective 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, thetrade regime must come in line with WTO rules and the acquis.

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

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, areindicative of what needs to be done. The aim of this note has been very simple: to point out thatthere are serious problems in the financial sector of the northern part of Cyprus, and point to thefact that both sides of the divide in Cyprus are obligated to their people to work together inorder to remedy these problems before a solution is implementedthat is, provided that theygenuinely wish to see the island reunited, and provided that they wish to see the reunification ofthe 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 urgentnecessity 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 ofcrisis a particularly disturbing realization in the light of the conclusions of this note. This notewas authored in the hope of contributing to the efforts of those who can no longer toleratepolitical inertia on these admittedly difficult issues.

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CLARIFICATIONS

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

These dangers, however,can be dealt with; in fact, the very purpose of writing this notewas to underline the need to tackle these problems as soon as possible, beforereunification, and preferably within the context of EU "harmonization". What is clear isthat tackling these problems now, is an obligation of our leaders. Indeed, what becomesclear 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 thePhilippines, in South Korea, in Thailand, in Malaysia, and elsewhere.

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

The analysis presented here is deliberately non-political, although the politicalramifications of the analysis are both far-reaching and profound.

However, it should be underlined that, while a federal solution will be economicallydangerous, both the maintenance of thestatus quo and asingle-state solution will entailmuch 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 predictgreat economic growth in Cyprus after the solution arenot refuted by the data. What thedata do bring to question is how immediate and automatic the growth will be, notwhether such potential exists. In fact, the recommendations can be read as suggestionsas to how these expectations can be realized.

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B. Economic Analysisi

1. Introduction:

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

Four years after the rejection of the Anan Plan for the reunification of Cyprus, new momentum isgathering towards a solution to the Cyprus Problem. The Agreement of 21 March 2008 betweenMr. Christofias, the President of the Republic of Cyprus and Mr. Talat, the Turkish Cypriotleader, 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 (orbackground) for another some say the last - round of proximity negotiations between the twosides.

In the meantime, since the rejection of the Annan Plan in 2004, the economy of the Northern partof 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 ensuingboom in construction and tourism. The result has been an unprecedented rate of growth, both inthe GDP and the per capita income of Turkish Cypriots, and a subsequent improvement in livingconditions 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 tocomplacency 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 parochialobjectives reign supreme: indeed, most analysts concentrate on the potential that reunificationwill 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 beneither immediate nor automatic nor inevitable. Medium run gains are potentially big, but shortterm dangers are even greater and the gains will only become feasible and realistic if some verysignificant institutional, regulatory and policy changes are implemented in the northern part ofCyprus 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 bya chronic scarcity of empirical data. This is a fact which is recognized by all research on theNorths economyj. Like much of the existing literature, many of the conclusions will have to bedrawn by deduction and inference. In this light, all data and graphs used in this note should beseen as indicative and approximatek.

i We have chosen to keep the values of graphs and references in their original denominations. Thus, some graphs arein "TL", or "old" Turkish Lira, and some in "YTL", the new (yeni) Turkish lira, maintaining the denominations inthe original sources. 1 YTL corresponds to 1 million TL. None of the data in the graphs have been translated toEuro, mainly because of the inconsistency of the exchange rates over time. All options in transforming the values toEuro 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.kAvailable data is only used if more than one source is available, andif the sources provide similar figures.Alternatively, figures are used if they have been accepted by reputable sources like the Economist Intelligence Unitor the World Bank.

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These caveats notwithstanding, the data do help in drawing a number of telling conclusions: firstof these is the clear inadequacy of the state machinery in terms of regulatory oversight andprudential supervision. The scarcity of dependable empirical data itself points to the danger thatthe 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 onthis point10. It should be noted, however, that conclusions especially those drawn from theshapes of the graphs, overall trends and the interplay between the various conclusions- will onlybe cited when they are found to be dependable.

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

Whilst not attempting to provide panacea-type answers, this paper will simply attempt todetermine what theproperquestionsare in order to determine the desirable policy responses thatwill 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 economicstructures of the northern part of Cyprus can only make the otherwise desired reunification ofthe 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 thepreparation for the eventual solutionof the Cyprus Problem. It is, essentially, an expression ofconcern about the day after, with some suggestions about how the dangers can be averted. Theurgency of reform and the pace of developments make such analysis both relevant and necessaryfor the future of Cyprus.

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

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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 prospectof a solution to the Cyprus Problem, which would loosen the isolation of the economy and thesubsequent limits to trade, confidence has remained high. High confidence and higher disposableincomes have naturally boosted consumption.

GNP (USD, million)Source:"State Planning Bureau"

0

500

1000

1500

2000

2500

3000

3500

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 theNew Turkish Lira- Yeni Turk Lira, YTL) as legal tender in its area. See earlier comment on YTLThe 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 ofthis volatility was an uncertain economic environment that did not permit the exploitation of theinherent 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 arelikely to create some inflationary pressures likely to mitigate otherwise marked improvements.

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Private Consumption (YTL)Source: State Planning Bureau

0

500.000.000

1.000.000.000

1.500.000.000

2.000.000.000

2.500.000.000

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 ofconcern. There have been some notable improvements in recent years, but the institutionalframework remains inadequate. In the wake of the 2000-2001 banking crisis, new and improvedlegislation was introduced, including a particularly important Banking Law11 and a much

needed Savings Deposit Insurance Fund Law by which modern standards were introduced interms of deposits insurance. The rather problematic Offshore banking Law12 was also thinlyimproved in 2001. The Central Bank law13, discussed below, was also introduced at this time.

Other critically important legislation, such as the law concerning money laundering14 (a majorinternational concern) and one on Currency and Foreign Exchange 15 appear to have undergoneno amendments in view of the crisis, as both preceded it.

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

burdened with excessive current expenditures in the form of wages and salariesto civil servants and various transfers in the form of subsidies and socialbenefits granted in many cases out of political considerations. Wages andsalaries exceed 14% of the GDP, while the financial position of other publicinstitutions is not known.16

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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 GDP18 and last year stateemployees negotiated a 10% pay rise19. These expenditures, a major drain on the state budget,reflect the costs of a civil service that has become too big, overstaffed and inefficient20 and

evokes clientelism and rent seeking.

In total, current expenditures are some 19.6% of GDP, while transfers are a further 18.3% ofGDP.

Peronnel and Transfers (%Total State Expenditure)Source: "State Planning Bureau"

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2001 2002 2003 2004 2005 2006 2007

Okan Safakli also notes that there is no efficient and coordinated control on publicexpenditures, and that a chronic public deficit exists21. Again, updated data confirm theevaluation. The deficit is not only large, but it is understated, as aid from Turkey, some 7% of theentire GDP, is discounted from the deficit figures. The "State Planning Bureau" in fact recordsaid from Turkey as part of normal revenues of the state. In the most recent Protocol signedbetween 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, intheory, will be paid back22.

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 debtrepayment, and it is expected to be eventually ...written off.23" (Foreign debt essentially refers todebt 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 fromTurkey, (amounting to 4% of the GDP) to the aid figures. The State Planning Bureau wouldsurely dread the thought of foregoing the aid and credit, some 11.7% of GDP in 2007, -

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especially since, as noted below, banks hold the bulk of their assets in the form of loans andcredits to the statel.

Stated and Actual Budget Deficit (YTL)

Source: "State Planning Bureau"

-800.000.000

-700.000.000

-600.000.000

-500.000.000

-400.000.000

-300.000.000

-200.000.000

-100.000.000

0

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

Nominal Deficit

Deficit (Discounting Credits from Turkey)

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 GDPdespite foreign aid from the Republic of Turkey25 (around US $ 83.4 million), the state is also burdened by the costs of servicing the large volume of loans that State Enterprises andInstitutions have received from the banking system.m Vassiliou et al note that although noofficial data are available, they estimate[d] interest payments to reach Euro 33.4 million in200426. It can only be higher today, especially as deficits have ballooned. As most analystsnote, payment on these amounts cannot be depended on, unless government subsidies arecredited towards it. In any case, the total explicit liabilities of the state, stood at approximatelyEuro 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 246million) in 2004. In the absence of data, more recent estimates are not possible, but four years ofdeficit 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 Billsm These loans are reported by the "TRNC Central bank" to amount to Euro 368 598 877 in the latest recorded date(30 November 2007).

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

This figure, again, excludes contingent liabilities and implicit costs of the state. Vassiliou et al27estimated the total cost of the states liabilities to stand at Euro 577 million in 2004, which

includes only current expenditures, excluding the costs of interest payments, contingentliabilities and servicing of loans to the State and to State Enterprises and Institutions. Had theabove costs been included, the state expenditure figures would have been even higher (althoughthey 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 notyield accurate numbers at all, but they do draw an accurate picture: the debt is high; the deficit isincreasing each year despite (marginally) increased revenuesn. Since deficits are financed largelyby loans, and since much of the debt is held by banks, these figures are a cause for concern. Thisburden on the banks, on the real economy and on society, appears to be very heavy indeed: Theonly 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"

0,0

100.000.000,0

200.000.000,0

300.000.000,0

400.000.000,0

500.000.000,0

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%.

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

For the realization of the growth rate targets set in the long-term plans andannual programs, Turkish Republic of Northern Cyprus was badly in need of

financial aid, so certain giant infrastructural projects such as the constructionof the airports, sea ports, dams, derivation canals, highways, power plantsand the improvementofthe telecommunication systems were all financed bythe Republic of Turkey29.

In June 2007, the Economist Intelligence Unit corroborates this admission. In its monthlyUpdate, reporting the aid Protocol signed with Turkey, it notes that the funds will go to "defenseand grants", "loans and subsidies", and, finally, "infrastructure". Elsewhere, it calls the aid"infrastructural30". Given that the deficits are increasing at a time of economic boom, and thatthey are the result of high running costs, it is clear that, with some structural changes, the statecan become much healthier than today. This is good news: treatment for the patient will be

painful but possible. Although restructuring state finances can neverbe easy, we must at leastpoint out that

there is significant room for reallocation within budget categories thatwould allow the northern part of C yprus to be financially independent of

external aid within the medium run31.

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

In the recent years, tax reform has brought some positive results, with indirect taxationincreasing the tax base32. Driven by GDP growth and high consumption, tax revenues haveincreased considerably. This has allowed the "TRNC" to take some of its own costs in terms ofinfrastructure projects and investment.

This increase, however, is clearly not enough; expenditures, driven by "salaries and wages" andtransfers, are increasing faster. Additionally, the potential for further increase in state revenueswill remain limited because of the combination of reliance on indirect taxes and a quiteconsiderable 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 quitevisible. Some estimates place it as high as 60% of all economic activity35. The size of theunofficial 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 reforms36.Additionally certain characteristics of the tax system need to be addressed; for example, theexistence of 6 different VAT rates is excessive. It is cumbersome to administer especially for aninefficient tax collection system- and expensive to collect. It also encourages tax evasion 37, asdoes 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

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economy, although, with high growth, an exuberant mood, and booming consumer credit, this isnot 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 willalso decline and contingent liabilities will increase, while bank assets (much of which is in theform of credits to the state) will be hit, thus aggravating bank positions.

Budget revenue and Expenditure (YTL)Source: "State Planning Bureau"

0

500.000.000

1.000.000.000

1.500.000.000

2.000.000.000

2.500.000.000

3.000.000.000

3.500.000.000

4.000.000.000

4.500.000.000

2001 2002 2003 2004 2005 2006 2007

Budget Expenditures

Budget Revenues

Even without bank distress, however, there still exist reasons for concern. Inefficient andexcessive spending and inadequate revenue have created a large financing gap. Unlike othercases, where the states financing gap is caused by such expenditures as restructuring the socialsecurity system or undertaking major infrastructure projects, the states expenditures in this caseneither lead to healthier fundamentals, nor increase total value added. The state, in this sense, isdeadweight 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


19/53

Private investments have been covering the resource financing gap. Consumption has not beenaffected, especially as GDP has grown rapidly due to the construction and tourism boom (andconsumer credit has boomed with it), but the financing of public deficits has clearly affected thesustainability of growth. The economy is being chocked. The financing gap diverts theeconomys 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 andmunicipal debt. The large GDP growth figures should not mislead us into believing that thisdeadweight on the economy is of little consequence. Growth figures, apart from their othercharacteristics, also represent natural growth in a virtually virgin land for investment. Also, theyoverstate growth because of the small size of the economy.

Net Savings (YTL)Source: "State Planning Bureau"

-600.000.000

-500.000.000

-400.000.000

-300.000.000

-200.000.000

-100.000.000

0

100.000.000

200.000.000

300.000.000

400.000.000

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

Private S-I

Public S-I

Crowding out is evidenced in a number of facts: the large percentage of total credits that areextended to state enterprises and institutions; the fact that, on top of these, Treasury Bills makeup a major part of bank assets; finally, through the high interest rates. (Deposit rates are ashigh as 25%). Safakli notes that there are large spreads between deposit and lending rates,particularly on treasury bills39. Although information on lending rates is too varied to be cited, itcertainly is above the shocking figure of 25%40.

These high figures point unmistakably, not only to crowding out, but also to adverse selectionand moral hazard. The World Bank notes that these high deficits, largely covered through aidand credit from Turkey are not a problem in themselves but have serious adverse effects becauseof 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 forrationalization and productivity improvements in the sprawling State Enterprises and Institutionsthat have crawled across the economy. Thirdly, the tendency of the state to spread over the

19


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economy, using its strengthened "purchasing power...relative to the rest of the economy41", alsoexacerbates the tendency towards state interventionism42.

A fourth problem is that "even when funds are directed toward private enterprise, they result in"market distortions" and "perverse incentives43" 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 forrent-seeking behavior and politically-motivated decisions. This is especially true when the statepicks winners for preferential tax treatment and government-backed loans under a systemcharacterized by "bureaucratic discretion"45.

Private savings exceed private investment, covering the part of the resource finance gap that theRepublic 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 notcrowded out this investment by using up private savings for its running costs. In its effect, the

phenomenonamounts to disintermediationp

.The above observations are in line with the general diagnosis of the political conditions in thenorthern part of Cyprus; patronage, disregard for procedure, and irregularities are ubiquitous.Rent-seeking behavior on behalf of politicians is also endemic. The states weakness, togetherwith its large scope of action, has played a major role on the stagnation of the economy. Weakstates attempting to function over a large scope are inevitably inefficient; they essentially try todo more than they are capable of doing46. Indeed, Charalambous goes as far as to say that theisolation of the North since 1974 has only been a secondary cause of the complete stagnation ofthe economy, and that the primary cause has been the fact that the North is a weak statefunctioning over a large scope47. Although Charalambous conclusion might be overdrawn, itdoes 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 thecore of the challenges facing the northern part of Cyprus48. We would add that policy and thelegislative framework are equally crucial a challenge.

The economy

The economy is largely driven by tourism. Not only have revenues (and arrivals) increasedconsiderably 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 ofintermediation 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


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Tourism, however, is slowing. Capacity is increasing, but hotels remain half-empty. As thegraphs show, occupancy rates have not exceeded 40%, while tourism has been in decline since2004. Construction has also declined rapidly between 2006 and 2007. Although decliningoccupancy has been attributed to increased purchases of holiday villas by foreigners49, 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 towhether 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 theseinvestmentsq.

Only recently, the "Minister of Tourism", Erdogan Sanligad, announced a further increase incapacity to 18000 beds, up from 15000. The EIU reports that this statement was met "withscorn50" by hoteliers, who have trouble filling their capacity. Similar complaints were voiced inthe previous season, as well51. 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 highcost53. On top of these, the high travel costs of visiting a relatively remote island by air, act asan additional cap on the potential of tourism, especially at a time when the world economy isslowingr.

q This is important; it points towards increase risk of capital flight, as, for example, happened in the Southeast Asiancrises.rAnother 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


22/53

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

-30,0

-20,0

-10,0

0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

2000 2001 2002 2003 2004 2005 2006 2007

Construction

Hotels and Tourism

Bed Occupancy rate in Tourism (%)

Source: "State Planning Bureau"

0

5

10

15

20

25

30

35

40

45

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

22


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Number of Employees in Tourism SectorSource: "State Planning Bureau"

0

500

1.000

1.500

2.000

2.500

3.000

3.500

1999 2000 2001 2002 2003 2004 2005

Employees in "Restaurants etc"

Employees in Hotels etc

With the international economy slowing, thereby contracting demand, and with property rightsbecoming increasingly uncertain as negotiations for reunification proceed, the boom will likelyturn into a bust. The latest dependable data show that house-building, the very sector that, drivenby tourism in turn drives the economy, reported a 14% decline in sales through 200754. At thesame time, employment in tourism does not show the increase that one would expect, withincrease reported only in restaurants. This probably reflects the general rise in consumptionrather than a boom in tourisms.

Indeed, from this data it appears that, while the exuberance was originally rooted in the growthin 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 thehouse-building boom"55. Behind the construction/tourism-driven boom, stands an economywhich, 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 highconcentration in agriculture and processed foods (74-75% of exports). Although the isolation ofthe area is slowly being remedied (at least partially), the structural problems need to be furtheraddressed. 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 forconcern.

23


24/53

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 beallowed56. 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 policiesthat distort resource allocation and limit trade, as well as the condition of state finances, arestifling 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 andservices crossing the Green Line since the implementation ofthe Green Line Regulation57. TheCommission finds that between May 2006 and April 200758, the value of goods crossing theGreen line amounted to some 3.4 million, not a negligible amount. However, Commissionreports do show clearly that this trade is limited to primary goods: vegetables comprised 35% oftrade, with "wooden products", "raw materials" and "Aluminium/PVC" trailing. This datacorroborates 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 potentialdoes have its limits on the medium and long run.

If the Green Line regulation can prove anything, that is that, while impediments to trade havelimited the growth of the primary sector, industry, manufactures andservices have not been ableto contribute to the increase in tradet. As this note underlines, there are significant policy-induced obstacles to the development of these sectors. It is these impediments precisely thatanalysts and decision makers have neglected. This raises serious doubts that trade without betterpolicies and public finances can contribute tosustainable growth beyond the short run.

t The 2005 Report shows similar results.

24


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Vegetables

35%

Wooden products/furniture

15%Raw metal11,4

12%

Aluminium/PVC products10%

Building/articles of stone

9%

Other

19%

Copied from:Annual Report on the Implementation of Council Regulation (EC) 866/2004 of 29 April 2004 and thesituation 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 thefact that, as trade impediments are lifted, trade and current account deficits balloon. In fact, somecommentators have underlined thatprotectionism has been increasing together with the lifting oftrade impediments59.

This is not to say, of course, that trade impediments have a positive effect on the economy of thenorthern part of Cyprusu. It does say, however, that policy and regulatory changes must takeplace together with the lifting of political impediments to trade. Past lessons from theinternational 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 isunderstandable, but it is also both regrettable and dangerous.

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

25
http://eur-lex.europa.eu/Result.do?T1=V5&T2=2007&T3=553&RechType=RECH_naturel&Submit=Searchhttp://eur-lex.europa.eu/Result.do?T1=V5&T2=2007&T3=553&RechType=RECH_naturel&Submit=Searchhttp://eur-lex.europa.eu/Result.do?T1=V5&T2=2007&T3=553&RechType=RECH_naturel&Submit=Searchhttp://eur-lex.europa.eu/Result.do?T1=V5&T2=2007&T3=553&RechType=RECH_naturel&Submit=Search


26/53

Current Account Deficit (YTL)Source: State Planning Bureau

-50.000.000,0

0,0

50.000.000,0

100.000.000,0

150.000.000,0

200.000.000,0

250.000.000,0

300.000.000,0

350.000.000,0

400.000.000,0

1999 2000 2001 2002 2003 2004 2005 2006 2007

The services sector looks very robust. Although there are concerns about the quality of thetertiary education system60, it does attract many foreign students, and it does create a populationwith high rates of tertiary education, so productivity should be prepped up -at least partially61.

In general, the economy can be said to pack a great deal of potential. The severe productivitygaps with the south, for example, can be partially remedied with better resource allocation andmore capital per worker. The arguments put forth by a number of analysts concerning themedium-term impact of reunification also seem to be perfectly justified. For this potential tounravel, however, four things must happen: first, the state must stop acting as a break to theeconomy, crowding out private investment and taking over from the private sector areas ofactivity in which the latter can perform better. Indeed, most of the misallocation of resources toless efficient areas of the economy is caused by the pull-effects of the aid-supported publicsector 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, thestate 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 frominternational markets aside, there are lingering residues of import-substitution policies, forexample administrative controls, special (read discriminatory) tax regimes and licensingrequirements 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


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28/53

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 beattributed, 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 ofstructural solutions that can go a long way towards remedying the problems.

The untrustworthiness -and dearth- of data, and the level at which this complicates empiricalanalysis 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 oftencannot be evaluated. Definitional problems are also widespread; past-due loans remainsundefinedv, for example. Past analyses must be relied on more than one would like. In suchmurky conditions, one must use whatever data is available, always taking all due precautions toreach the best level of accuracy possible, and the safest conclusions possible. For the purposes ofthis note, only those sets of data that are reasonably dependable will be used.

Deposit boomFirstly, the banking system is under no pressure to attract deposits, and hence under no pressureto compete for them64. Even as the banking crisis unfolded in 2001, deposits remained relativelyhigh -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"

0

500.000.000

1.000.000.000

1.500.000.000

2.000.000.000

2.500.000.000

3.000.000.000

3.500.000.000

4.000.000.000

4.500.000.000

5.000.000.000

31Jan.

200

1

31May/2

001

30Sep

.200

1

31Jan.

200

2

31May/2

002

30Sep

.200

2

31Jan.

200

3

31May/2

003

30Sep

.200

3

31Jan.

200

4

31May/2

004

30Sep

.200

4

31Jan.

2005

31May

2005

30Sep

.2005

31Jan.

200

6

31May

200

6

30Sep

.200

6

31Jan.

2007

31May

2007

30Sep

.2007

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

28


29/53

Deposits themselves were driven by a variety of factors: Firstly, the economy has experiencedrobust growth in the last years. Secondly, in the midst of high GDP growth, and the absence of adeveloped capital market that would attract savings, the excess capital has had few other outlaysexcept the banking system. This is especially true when disposable incomes rise, drivingconsumption 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 insolventbanks were either taken over or allowed to fail, succeeded in boosting confidence in the bankingsystem. Fourth, many residents of the republic of Turkey have been attracted to the Northern partof Cyprus in an effort to avoid paying higher taxes65.

Lastly, high deposits are driven by the very high deposit interest rates applied by banks, whichnaturally 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 theTurkish Lira (and, to a lesser degree, the New Turkish Lira). This explanation, however, does notjibe 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"

0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

2002 2003 2004 2005 2006 2007

Real Deposit Rate (Deposit ReateMinus Inflation)Euro Deposits

YTL Depostis

Inflation Rate

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, arevery high indeed. This raises the question: with introduction of the Euro as legal tender, willthese 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-monthdeposits naturally dwarfing all others. This suggests that, should a crisis occur (as the

29


30/53

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"

50%

55%

60%

65%

70%

75%

80%

85%

90%

31Jan

.200

3

30Apr

.200

3

31Jul

.200

3

31Oct

.200

3

31Jan

.200

4

30Apr

.200

4

31Jul

.200

4

31Oct.200

4

31Jan

.200

5

30Apr

.200

5

31Jul

.200

5

31Oct

.200

5

31Jan

.200

6

30April2

006

31July20

06

31Oct.200

6

31Jan

.200

7

30Apr

.200

7

31Jul

.200

7

31Oct

.200

7

Noteworthy is also the fact that foreign currency deposits are about half of total, a fact thatcorroborates increased risk of flight should the economy send adverse signals. The fact thatlocals account for a larger (but unclear) part of foreign currency deposits than usual does notreduce the risk of flight.

Credit boom and adverse selectionThe banking sector as a whole has never had to consider ways by which to improve itsprofitability or attract "good" loans, especially as spreads between deposit and lending rates (andspreads 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 Thisamounts to bank protection from failure, which, together with a deposit boom, appears to haveencouraged 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 beenfinding it easy to nominally increase their assets by extending loans of questionable quality68to State Enterprises and Institutions.

30


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

0

500.000.000

1.000.000.000

1.500.000.000

2.000.000.000

2.500.000.000

31 Jan.

2002

31 Jul.

2002

31 Jan.

2003

31 Jul.

2003

31 Jan.

2004

31 Jul.

2004

31 Jan.

2005

31 Jul.

2005

31 Jan.

2006

31 July

2006

31 Jan.

2007

31 Jul.

2007

Although these loans have declined in the last three years, from 50% of total credits to around athird, 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 obligations69

. This steady stream of nominal increase in bank assets, coupledwith constant subsidies from the state, corroborate Safaklis argument that banks do not need toaggressively pursue profits. In any case, the very volume of loans to SE&Is is in itself anindication ofresource misallocation in the economy.

The extent to which credits are offered to SE&Is, coupled with the fact that Treasury Bills andother financing instruments appear to be "a major part" of bank assets, suggestsmoral hazard: aslong as obligations of the (insolvent) state are a vital part of bank assets, and as long as theseassets guarantee profits, banks have an incentive to take risks. They are virtually (if implicitly)guaranteedon the one hand, and under-regulatedon the other, a recipe for a banking crisis thatlooks 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 crises70

.

Another factor that points towards adverse selection in the banking sector is the ubiquitous connected lending. Most analysts underline the problem71, and the literature invariably treatsthis problem as 'particularly acute'. This problem was only half-heartedly addressed by the 2001Banking Law.

31


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It is in this context that one must note that, apart from the credits extended to the state, the otherlarge category of credits are the so-called "Personal" (or "consumer") loans. These loans havesince the second quarter of 2006 become the largest category of loans, with credits to SE&Is aclose second. This is the category in which intense competition is taking place, with connectedlending 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 thecategory of personal/consumer loans extremely likely -especially when these are the very loansfor which banks compete.

Loans: Personal and to SE&Is ( %Total)Source: "State Planning Bureau"

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

2000 2001 2002 2003 2004 2005 2006

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

Together with SE&Is, these "personal" loans account for a staggering 75% of all credits (invalue). Indeed, only trade as a category even approaches the volume of SE&Is and Personalloans, with approximately 20% of loans. Construction, tourism, manufacturing and SmallBusinesses, together account forno more than 4 or 5% of all loans.

32


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

0

500.000.000

1.000.000.000

1.500.000.000

2.000.000.000

2.500.000.000

2000 2001 2002 2003 2004 2005 2006

SE&Is

Personal

Trade

TOTAL

These findings should at the least procure curiosity. Firstly, if SE&Is, personal loans and tradetogether account for about 95% of all loans, then the received wisdom that the credit boom isfinancing construction, must be false, unless "Personal" loans finance construction in theirentirety. Although some of these loans mustend up in tourism and in construction, these sectorsare 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 increasedconsumption. (In fact, the Central Bank explicitly re-designates these "Personal Loans" as"Consumer Loans" in its Quarterly Bulletins72). In this respect, personal loans do hold theeconomy afloat, as they allow households to finance their consumption though debt. Thisindicates that, while loans to SE&Is are largely hollow, much of the credit given out in the formof personal loans, is also hollow.Household indebtedness is another social and economic evillurking in the northern part of Cyprus.

Secondly, these figures reveal a structural problem, in that most loans go to sectors that do notincrease total value-addedin the economy. Intertemporal transformation of credit through the

banking system is not taking place. If GDP growth is driven by construction and tourism, and ifcredits to these sectors account for a minute fraction of total credits extended by the bankingsystem, then the credit boom cannot be excused as a "natural aspect of high growth". Thebanking 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 unanimousassessment of the capital market as weak and hollow, however, disputes this. Most of thefinancing of these sectors comes though government instruments (such as the Development

33


34/53

Bank) which provide preferential loans, and where "political connections73" are necessary. Thisis an additional indication of resource misallocation and rent-seeking. Additionally, as far as thebanking sector goes, this indicates that "good" clients are taken over by the state, leaving onlystate debt and consumer loans to the banks.

Given such exposures, one feels compelled to examine the rates and trends of non-performingloans. On the one hand, past-due loans (as they are called by the TRNC Central Bank), remainrelatively low compared to the total volume of credits extended. In the last two years or so, theyaccount 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 lastthree years. Unfortunately, provisions for PDLs, set aside by the banks, account forapproximately 55% of PDLs themselves and cannot cover losses should a crisis strike. PDL datado 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"

0

50.000.000

100.000.000

150.000.000

200.000.000

250.000.000

300.000.000

31Jan

.200

4

30Apr

.200

4

31Jul

.200

4

31Oct

.200

4

31Jan

.200

5

30Apr

.200

5

31Jul

.200

5

31Oct

.200

5

31Jan

.200

6

30/04/20

06

31July20

06

31Oct

.200

6

31Jan

.2007

30Apr

.2007

31Jul

.2007

31Oct

.2007

PDL

Provisions for PDL

34


35/53

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

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

31Jan

.20

04

31/03/20

04

31/05/20

04

31Jul.20

04

30Sep.2

004

30Nov.20

04

31Jan

.20

05

31/03/20

05

31/05/20

05

31Jul.20

05

30Sep.2

005

30Nov.20

05

31Jan

.20

06

31/03/20

06

31/05/20

06

31July20

06

30Sep.2

006

30Nov.20

06

31Jan

.20

07

31/03/20

07

31/05/20

07

31Jul.20

07

30Sep.20

07

30Nov20

07

Past-due Loans (TL million)Source, "TRNC Central Bank"

100.000.000

120.000.000

140.000.000

160.000.000

180.000.000

200.000.000

220.000.000

240.000.000

31 Jan.2004

30 Apr.2004

31 Jul.2004

31 Oct.2004

31 Jan.2005

30 Apr.2005

31 Jul.2005

31 Oct.2005

31 Jan.2006

30 April2006

31 July2006

31 Oct.2006

31 Jan.2007

30 Apr.2007

31 Jul.2007

31 Oct.2007

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

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

31Jan

.200

3

30Apr

.200

3

31Jul

.200

3

31Oct

.200

3

31Jan

.200

4

30Apr

.200

4

31Jul

.200

4

31Oct

.200

4

31Jan

.200

5

30Apr

.200

5

31Jul

.200

5

31Oct

.200

5

31Jan

.200

6

30/04/20

06

31July20

06

31Oct

.200

6

31Jan

.2007

30Apr

.2007

31Jul

.2007

31Oct

.2007

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

Secondly, PDLs are still low, but the housing and construction boom is only just beginning toslow. In the face of an international slowdown, which decreases both demand in holiday homepurchases and tourist arrivals, the continued increase in capacity is bound to slow down evencome 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 beexpected to rise. Additionally, as reunification looks increasingly likely, and as the issue ofproperty rights comes to the fore as a core issue in the negotiations, the status of property rightswill 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 mostimportant means of supporting the state, and, thence, the solvency of the banks. With analystsnoting that SE&Is have a poor record in paying back their obligations 74, the conclusion ofEichengreen et al is disquieting:

Indeed, it is not clear what keeps these institutions operating today, probably a combination of a lack of transparency and governmentsubsidies allowing them to meet their current payment obligations 75

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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 recyclingprocess, 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 institutionsw. In any case, it islikely that PDLs are hidden behind these transfers, which cover -directly or indirectly- at leastpart of the outstanding debt of SE&Is.

1) Banksextend loansto SE&Is

2) SE&Iscannot repay

3)Banks faceAsset lossfrom bad loansto SE&Is

4)Statesubsidizessome of lossesincurred bybanks

Republic ofTurkeyfinances theLosses

LiquidityThat the credit boom has been driven by a deposit boom is clearly evident from a comparisonbetween total deposits and total credits. Indeed, while total credits amounted to approximately30% of total deposits (in value) in the beginning of 2004, that figure has risen to 50% by the beginning of 200877. Although on first reading may not seem to be significant, it doescorroborate the analysis of Nil Gunsel, who recently noted that the liquidity ratios are high andthat they indicate that "banks in Northern Cyprus face unexpected deposit runs, which increasesthe probability of failure78". In its Quarterly Bulletin (3rd Quarter 2007), the "TRNC CentralBank" notes a decrease (2.34%) in the liquid assets of the banking sector79.

Assessment

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

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

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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 zero80

Continuing, they added that "it is not clear what keeps these institutions operating today81".

The high exposure to sovereign risk, the poor banking governance and structures, the protectionfrom alternative destinations for savings, the very high interest rates and the high spreads thatensure profits, all solicit concern. Not only has the sector never been weaned from the state, butthere is an ever increasing interdependence between them. The state is guaranteed an endlesssource of credit, most of which covers current expenses, while banks are able to maintain theimpression 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-profitratio. It is noteworthy that, while profits are both high and erratic, the ratio remains low, barelyrising above 1.5%.

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

-1,5%

-1,0%

-0,5%

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

4,5%

5,0%

31Jan.

2004

31May/2004

30Sep.

2004

31Jan.

2005

31May2005

30Sep.

2005

31Jan.

2006

31May2006

30Sep.

2006

31Jan.

2007

31May2007

30Sep.2

007

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

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4. The regulatory framework and banking laws

A wave of banking laws that were passed in 2001 has gone a long way towards improving thebanking 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 risksremaining82" 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 discretionof the Central Bank to manage the nature and structure of the banking sector. Perhaps the mostserious problem of the new framework is that the Central Bank is charged with regulating andsupervising the banking sector, with little direction and very wide powers. This extensiveauthority given the Central Bank, which includes auditing, licensing and punishment, raisesmany 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 instrumentsof government (not "state") policies, is delineated by very murky lines. It is only within thiscontext that any discussion will be meaningful. The central bank needs to be more independentand with a smaller scope. Its discretionary powers should be absolute, but in a smaller spectrumof decisions, which should be set by law.

One concern is whether the Central Bank has the institutional capacity to carry out this widespectrum of operations. There is no such indication anywhere in the relevant legislation, and it ishighly unlikely that the Central Bank has undergone the necessary reorganization to meet theadditional 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 isno sign that such hiring and organizational restructuring have taken place since the passage ofthe 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 forcorruption. It is desirable to provide theCentral Bank with the power to define terms (like Non-Performing Loans) and conditions (likewhat would make a manager fit and proper). However, one should bear in mind that thenorthern part of Cyprus is a very small country, which makes corruption virtually inevitablebecause of the personal and social contact that exists between bankers, economists, businessmenand politicians, so its discretion should be limited by law. Without some kindof oversight overthe Central Bank, and with and Central Bankunlimitedpower over banks, there is a danger offorbearance or preferential treatment of some banks. The oversight should, of course, be limitedto 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 bankLaw; its website has had pages that have been "under construction" since 2004; the data and even information itdoes provide is sometimes contradictory; the Central bank itself uses different notations for identical inputs, and soon.

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political opposition on how decisions are made. A regular (annual) in camera parliamentaryhearing, in which the central bank is obliged to explain certain aspects of its decision makingprocess, 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 therehas been unequal treatment. Conversely, Parliament should set limits to certain decisions of theCentral Bank, especially those it takes under its power to establish proper punishments andprocedural matters. More preferably, the northern part of Cyprus appears to be one of those caseswhere bank supervision should be separated from the Banker of the State83. Legislative provision of what the central bank may, and may not, do, is necessary. Article 13 (1) of theBanking Law (39/2001) affords the Central Bank the power to decide the measures that will betaken in those cases in which banks do not conform with regulations, as deemed necessary, butthe framework of such measures is largely set by the Central Bank itself. Paragraph (2) alsogives 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, whicheasily leads to the kind of "soft corruption" that locals call rousfet, roughly translated as theexchange of favors. Although the relevant legislation does provide that banks whose positionsare found inappropriate are given a period not exceeding three months for making necessaryarrangements84, 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 ofaccountability, illegal use of funds, lack of transparency and risky investments with lowreturns85" have not been addressed. Although the law does address "connected lending" and"accountability," this is clearly not enough. In terms of accountability, employees and managersare only liable if, through illegal action, the

rational exuberance and the reunification of cyprus(quasi-final

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