Institute of Applied and Social Sciences

NEAR EAST UNIVERSITY

INSTITUTE OF APPLIED AND SOCIAL SCIENCES

‘THE APPROPRIATENESS OF CENTRAL BANK OF NORTHERN CYPRUS TO THE EUROPEAN SYSTEM OF CENTRAL BANKS’

HAKAN TOKGÖZ

Master Thesis

Supervisor: Assist. Prof. Dr. Erdal Güryay

Department of Economics

Nicosia – 2006 Hakan Tokgöz: ‘The Appropriateness of the Central Bank of Northern Cyprus to the European System of Central Banks’

Approval of Head of the Institute

Prof. Dr. Fakhraddin Mamedov

We certify that this thesis is satisfactory for the award of a degree in Master in Economics

Examining Committee in Charge

Chairman of the Committee Assist. Prof. Dr. Hüseyin Özdeşer Chairman, Department of Economics – NEU

Assist. Prof. Dr. Erdal Güryay Chairman, Department of Business Administration - NEU (Supervisor)

Assist. Prof. Dr. Okan Şafaklı Department of Banking & Finance - NEU i ACKNOWLEDGEMENT

I would like to thank to Assist. Prof. Dr. Erdal Güryay for supervising me in the preparation of this thesis and in all the studies leading to this thesis. I would also like to thank to Assist. Prof. Dr. Hüseyin Özdeşer for all the classes he teaching us about European Monetary Union. ii ABSTRACT The purpose of this study is to produce appropriate suggestions to increase the appropriateness of the Central Bank and the local commercial banks of Turkish Republic of North Cyprus (TRNC) to the framework of Eurosystem. This study will therefore focus on the European System of Central Banks and the single monetary policy. "The successful development of the “euro” is core to the realisation of a Europe in which people, services, capital and goods can move freely." The history of the EURO is the largest monetary changeover the world has ever seen. The Treaty of Rome (1957)1 declared a Common European Market as a European objective with the aim of increasing economic prosperity and contributing to "an ever closer union among the peoples of Europe".Instigated by the German Chancellor Helmut Schmidt and the French President Valéry Giscard d'Estaing, the Brussels Summit of December 19782 decided to set up a European Monetary System (EMS). It aimed to create a zone of monetary stability in Europe by reducing fluctuations between the currencies of the participating countries. It was put into operation in March 1979.The Single European Act (1986)3 and the Treaty on European Union (1992)4 have built on this introducing "Economic and Monetary Union (EMU) "and laying the foundations for"single currency." In April 1989 the report of the Delors Committee5 envisaged the achievement of EMU in three stages: 1. The objective set for the first stage, between June 1990 and January 1992, was to step up cooperation between central banks; 2. The second stage included the establishment of a European System of Central Banks (ESCB) and the progressive transfer of decision-making on monetary policy to supranational institutions; 3. In the third stage,the national currencies would have their convergence rates irrevocably fixed and would be replaced by the European single currency.

1 www.http://en.wiki pedia.org./wiki/European_Union, Wikipedi Free Encyclopedia!s Article on European Union (22 Jun 2005) 2 http://aei.pitt.edu/archive/00001424/01/Brussels_dec_1978.pdf,The European Council [Brussels Summit 1978], Brussels, 4-5 December 1978. 3http://en.wikipedia.org./wiki/Category:European_Union, Articles in Category”European Union” (22 Jun 2005) 4 İbid 5 http://aei.pitt.edu/archive/00001007/ “Report on economic and monetary union in the European Community”. Presented April 17, 1989 (commonly called the Delors Plan or Report)deposited 25 February 2004 (26 Jun 2005) The Economic and Monetary Union (EMU) is built on two foundations. 1. The Council of Economics and Finance Ministers (ECOFIN) 2. The European System of Central Banks (ESCB). The former is responsible for determining the broad guidelines of the economic policy of the European Union (EU) and the latter is responsible for its monetary policy.ESCB was in charge of in the third stage of the Economic and Monetary Union (EMU). But it was built on the frame of the European Monetary Institude (EMI). As recently as fifteen years ago the idea of merging the European Union’s national monetary systems seemed a fantacy. On January 4th 1999 this remarkable vision became a reality: the currencies of the 12 participating members of Europe’s Economic and Monetary Union were irrevocably fused. The institution at the very heart of European economic policy is now the European Central Bank.The European System of Central Banks (ESCB) comprises the European Central Bank (ECB) and the National Central Banks (NCB) of the Member States which have adopted the Euro. In designing EMU, the architects laid great emphasis both on the independence of the European Central Bank and on the simplicity and severity of its anti-inflation objective. It undoubtedly has faced (even is facing) many challenges. These stem from institutional debates over policy direction and statistical methods, and from the diverse political standpoints of the cultures of the states that it represents.

iii CONTENTS Acknowledgement i Abstract ii Contents iii Abbreviations v List of Tables vi List of Figures vii List of Graphs viii Introduction ix

Chapter I. The History Of The Euro,EMU and EMI I.1 The History Of The Euro 1 I.1.1 The Historical Development Of Monetary Integration 2 I.1.2 The European Monetary System (EMS) 4 I.1.3 The Stages Of Economic And Monetary Union 9 I.1.4 The Process Of Introducing The Euro 29 I.2. The Impacts Of EMU 33 I.2.1 Possible Impacts of EURO As A Common Currency 34 I.2.2 The Economics of a Single Currency 65 I.2.3 Euro and The Banking System of TRNC 71 I.3 The European Monetary Institute (EMI) 73 I.3.1 Monetary Financial Institutions (MFIs) 76

Chapter II. The ESCB II..1 The ESCB 80 II.1.1 The ECB 81 II.1.2 NCBs 84 II.1.3 Strategy Of the ESCB 85 II.2 An Outlook On Monetary Policy In General 93

iv Chapter III. Institutional Framework and Legal Status of Central Banks In EU and In TRNC (a comparison) III.1 The Obligatory Directives Of Legal Status Of ESCB According To The Union 105 Agreement III.1.1 A Comparative Summary Of The European Uniıon’s Basic Banking Directives 106 And The Banking Law of TRNC III.1.2 A General Outlook Of The Central Bank Of TRNC 113 III.1.3 The Independence Of Central Banks 121 III.2 As The City of London is one of the World’s Leading International Finance 129 Sector an eligible Governance Organization of The Bank of England “The Framework Of The Bank Of England” III.3 The Explicit Weakness of the Commercial Banks and Other 133 Financial Institutions of TRNC III.4 The Ways To Strengthen the Banks In Unrestricted Competition Area (Mergers) 142 III.5 A Short Outlook to the Strong Structure of the Financial Institutions 151 In South Cyprus as Being the Nearest Rivals. III.6 A Strategy for Strengthen the Central Bank and Banking Sector for TRNC. 155

Conclusion 161 v ABBREVIATIONS CCBS: Centre For Central Banking Studies CDP: Common Defense Policy CFSP: Common Foreign And Security Policy ECB: European Central Bank ECOFIN: Economic And Financial Affairs Council EMCF: Europen Monetary Cooperation Fund EMI: European Monetary Institute EMS II: New Exchange Rate Mechanism EMS: European Monetary System EMU: European Monetary Union EP: European Parliament ERM I: Exchange Rate Mechanism ESCB: European System Of Central Bank ESDI: European Defense And Security Idendity EU: European Union FSA: Financial Services Authority FSC: Financial Stability Committee GNP: Gross National Products IMF: International Monetary Fund LOLR: Lender Of Last Resort MA: Monetary Analysis MFIs: Monetary Financial Institutes MMFs: Monetary Market Funds MPC: Monetary Policy Committee NATO: North Atlanthic Treaty Organization OECD:Economic Organization Of Developing Countries RTGS: Real Time Gross Settlement TARGET: Trans-European Automated Real-Time Gross Settlement Express Transfer TRNC: Turkish Republic Of Northern Cyprus WEU: Western European Union

vi List of Tables Table 1.1 The Capital Of ECB 23 Table I.2 Key Macroecenomic Polciy Parameters of Euro Are Between 2003-2006 41 Table 1.3 Share of National Currencies in Total Identified Official Holdings of 48 Foreign Exchange by Central Banks, End of Year (in percent) Table 3.1 Institutional Framework Of The Central Banks Of EU Member States 109-112 Table 3.2 The Comparative Presentation Of The Balance Sheets 116 of the Central Bank of TRNC And The Bank Of Cyprus As Of 31.12.2003 Table 3.3 The Comparative Consolidated Active-Oassive Balance of All 118 Banks in TRNC and The Bank Of Cyprus As Of 31.12.2003 Table 3.4 The Political Independence Of The Central Banks In EU 125 Table 3.5 The Economic Independence Of The Central Banks In EU 127 Table 3.6 The Capitals of All Banks In TRNC As Of 31.12.2003 138 Table 3.7 The Deposits of All Banks In TRNC As Of 31.12.2003 139 Table 3.8 The Loans Given of All Banks In TRNC As Of 31.12.2003 140 Table 3.9 The Cash Values of All Banks In TRNC As Of 31.12.2003 141 Table 3.10 Horizontal Bank Mergers In EU Between 1988-1992 149 Table 3.11 Horizontal Bank Mergers Between Regions In EU Between 1988-1992 149 Table 3.12 The Number Of People Per Bank In Most Of EU States 157

vii List Of Figures Figure 1. European Monetary System 8 Figure 2. Stages Of Monetary Union 14 Figure 3. Managerial Organs Of ECB 18 Figure 4. European System Of Central Banks 26 Figure 5. Possible Impacts Of Euro 63 Figure 6. Key Areas of The Impacts Of Euro On Business 64 Figure 7. Adjustment Mechanisms For Non-Optimum Currency Areas 71 Figure 8. Monetary Financial Institutions 76 Figure 9. Four Basic Tasks For ESCB 83 Figure 10. Legal Reqirements For The NCBs 85 Figure 11. Guiding Principles 88 Figure 12 The Original Five Possible Strategies For ESCB 89 Figure 13. Organization Of The Central Bank Of TRNC 122 Figure 14. Organization of The Bank Of England 133 Figure 15. The Causes Of The Mergers Of Banks 147 Figure 16. The Types Of Euro Area Banking Instutitions 153 viii List of Graphs Graphic 1.1: Consumer Price Inflation in the Euro Zone between Jan-2000 40 and Jan 2004 Graphic 1.2: Euro Zone Interest Rates between Jan-99 and Jan-04 42 Comparative with Taylor Rate Coridor Graphic 1.3: GDP Growth in the Euro Zone between 1999-2004 43 Graphic 1.4: Euro Are Household Saving Rate in Cyclical Downturns 44 in % of Disposable Income Graphic 1.5: Euro Zone Houshold Actual and Simulated Consumption 45 (in billion of 1995 Euro) ix INTRODUCTION

The Aim Of The Study: The aim of this study is to analyse the appropriatness of the Central Bank and local commercial banks of Turkish Republic of Northern Cyprus (TRNC) to the framework of Eurosystem by focusing on the European System of Central Banks (ESCB) and the single monetary policy.

The Hypothesis of this study : The hypothesis of this thesis is; the present economic and financial structure of North Cyprus needs to be restructured and re-organize to converge with the economic and financial norms of European Union (EU). In order to achieve this objective, institutional and legal infrastructure have to be changed according to the norms of EU as the primary goal and skilled and well educated personel has to be employeed. In TRNC the amount of the personel, who are expert on the economic norms and institutions of EU, are very limited. There are different (specially undeveloped) institutions, statistical methods, culture, economic, financial and governmental systems in TRNC. The Central Bank can only do the payments of the Treasure as a cashier of it.It has got a very single administration and decision making framework which is open all kinds of interventions. There are only limited number of financial institutions in TRNC. There are a few Local Commercial Banks (the majority shares of some of the biggest banks belong to the government and the rest of the biggest ones are the branches of the foreing banks), and very limited number of other credit institutions (already most of them are predominantly giving only hire-purchase credits and are subsidiaries of local commercial banks) and a few exchange offices.

Scope of the Study: This study includes the story of the European Monetary Union (EMU) and of course the Euro as a natural result of it with the chronological development of the main financial institutions of the European Monetary System (EMS). The stages from the European Monetary Institute (EMI) to the ESCB , the main tasks and aims of these institutions and possible impacts of the Euro and EMU on the whole economy of the world were x introduced detailed and chronological. Institutional Framework of The Central Banks Of EU Member States and TRNC with the financial structure of Central Bank and other local commercial banks in TRNC were presented. The proposals for reorganize the Central Bank Of TRNC and the proposed mergers and reconstruction studies of Local Commercial Banks in TRNC, constitutes the last chapter of the thesis.

Method of the Study : This presentation begins however with a short introduction to the EMI and its institutions which are known as “Monetary Financial Institutions (MFIs)”, its organization, tasks, decision-making bodies. Then, since it is presently the main decision-making o organ in the single monetary policy, the way to the establishment of the ESCB. Its tasks, its main decision-making organs, the strategy of the single monetary policy and the instruments and procedures used for market operations. Follwing this introduction, the present organization of the Central Bank of TRNC, its competences and decision-making organs the existing financial structures of the local commercial banks were presented. Then it was tried to underline the disability of the Central Bank and other local retail banks to dominate and control the markets, monetary base and all kind of investments, which can be seen from the realized balance sheets of these institutions which were listed in the tables. On the other hand, according to the regulations of the releated rules of the Maastricht Agreement, re-organized structures of the central banks of some of the member states of EU (spesifically The Bank Of England ) were also explained with the helps of the tables and organization figures. By the help of the comparative tables it was tried to emphasize the necessity of restructuring on the frame- works of the banks and the central bank of TRNC. Finally the proposals to restructure and to appropriate the local financial institutions into EMU were presented.

Limitations : The “capital adequacy ratio” is the most important indicator for the banks in determining the strength of them. Especially the amount of the warranted assets increase and/or decrease the capital ratio of a bank or any kind of a credit institution. But unfortunatly it

xi couldn’t be possible to obtain such kind of data either from banks themselves or from the central bank.

Structure of Study In Chapter I, the research begins with an introduction of the “Euro” and the stages of the EMU with its goals and ecocnomic and social impacts both on the euro area and on the world outside of the EU. Then follows an introducing about “European Monetary Institute and ıts Institutions”as the fundamental framework of European System Of Central Banks (ESCB) The ESCB, ECB and “the single monetary policy” of it were presented in Chapter II. Chapter III includes the introduction of the Legal Status and Institutional Framework of the Central Banks in EU and Central Bank Of TRNC with a comparative summary of the European Union’s Basic Banking Directives and The Banking Law of TRNC.Beside this, the existing financial and administrative structures of the commercial banks in North and South Cyprus were presented in this chapter. A brief Outlook on the Types of Euro Area Banking Institutions and the Kinds of The Mergers of The Banks and Bank Mergers formed in EU and in USA were also presented in this Chapter.