Financial integration in small Islands: The case of Cyprus

Abstract

The following paper assesses the degree to which two small island economies, the Republic of Cyprus (RC) and the Turkish Republic of Northern Cyprus (TRNC), are financially integrated with their respective 'motherlands' of Greece and Turkey. Specifically, we investigate whether there is a long-run relationship between the RC and Greece and between the TRNC and Turkey, in terms of inflation, interest rates, money supply, and foreign direct investment (FDI). The paper contributes to the literature by examining financial integration in the unique case of Cyprus, where two separate, small economies each operate in a monetary union with their respective mainland partners. The results of our analysis indicate the strong integration of the financial markets of the TRNC and Turkey, and of the RC and Greece. We also demonstrate that financial-market indicators in the TRNC and the RC are largely driven by mainland-partner economies, further advancing the literature on financial integration.