Overview: Turkey's quest for stable growth

Turkey began taking serious steps to liberalize and strengthen its economy a full 20 years ago. Before this reform program was instituted, tariff barriers were high, state ownership prevailed in key sectors, and competition was strangled by regulation. Today Turkey has plenty of modern, high-performing companies that hold their own against international competition. Many foreign companies, attracted by a relatively cheap but well-educated and skilled workforce, proximity to important markets, and the absence of major regulatory barriers, have also performed well there. So great has the country's economic progress been that it now has its sights set on becoming a member of the European Union. If Turkey succeeds in its ambition—and the EU is set to decide at the end of next year whether to begin entry negotiations—it is, based on current demographic projections, destined to be the bloc's largest member¹ and the only one with a predominantly Muslim population.

One barrier to EU accession may be Turkey's failure to achieve stable economic growth. During the 1980s, GDP grew strongly, at an average rate of 5.2 percent a year, thanks principally to the new wave of liberalization and increased competition. However, in the following decade growth fell to an average of 3.4 percent a year—lower than it was before liberalization began.

Turkey's economy was battered repeatedly during the 1990s, by the Persian Gulf War of 1991, currency crises in 1994 and 1997, a devastating earthquake in 1999, and a near economic meltdown in 2001 (when GDP contracted by almost 10 percent). Some of these developments were clearly beyond the control of any government. Yet a study by the McKinsey Global Institute (MGI)² suggests that the state can do a good deal to build the foundation of strong, sustainable economic expansion. In Turkey, as elsewhere, GDP growth depends heavily on the rate of productivity increase, and our study of 11 sectors of the economy shows that it is performing at only a little more than half of its potential productivity level.³ To put the facts another way, Turkish productivity currently stands at just 40 percent of the US level, but we believe that it could reach 70 percent (Exhibit 1).⁴

If Turkey took measures to realize its full productivity potential, it could create six million additional jobs by 2015 and achieve annual GDP growth as high as 8.5 percent. This would greatly improve the living standards of Turkey's 67 million people, with GDP per capita rising from around 30 percent of today's average EU per capita income (adjusted by purchasing power parity) to around 55 percent. Such convergence would substantially improve Turkey's chances for EU membership.

Compared with many other developing countries, which face dozens of barriers to productivity, Turkey is in a promising position. Thanks to economic reforms set in motion in the 1980s and to a customs union agreement with the EU in the mid-1990s,⁵ many barriers to productivity evident in other countries we have studied don't exist in Turkey. It has relatively few specific product market regulations, such as pricing or product content laws, that stifle competition. We found little evidence that Turkey's labor market is handicapped by regulations, infrastructure, corporate-governance provisions, or the education of the labor force. Turkey's level of foreign direct investment is lower than that in many other developing markets but not, we believe, because of regulatory barriers (see sidebar, "Foreign investment: A poor record").

Turkey's productivity suffers from three specific problems: a large informal economy, macroeconomic and political instability, and government ownership. Together, we estimate, the three problems account for 93 percent of the gap between Turkey's current and potential productivity (Exhibit 2). These are major issues, and tackling them will take sustained resolve, but at least Turkey has the comparative luxury of being able to focus on a limited number of areas for reform, and the fruits of doing so are potentially substantial.

A two-track economy

Before analyzing the root causes of Turkey's low average productivity levels and what should be done to tackle them, it's important to recognize that this is a sharply divided economy.

In every sector, modern companies have adopted cutting-edge technologies, developed many best-practice operations, and managed to attain real economies of scale. Overall, the average productivity of such modern companies is 62 percent of the US level. However, alongside these effective performers, Turkey has many traditional entities that drag down its overall productivity.⁶ They employ half of the labor force in the sectors we studied, and their average productivity is less than a quarter that of the average US enterprise. Traditional companies are typically small or midsize and tend to make relatively poor use of available technologies. Their products and services tend to be of low quality, they have few standardized production processes, and most are hampered by a lack of economies of scale.

The traditional operators' importance to the economy varies. In automotive parts, for example, they represent only 31 percent of all employment, so their drag on the productivity of the sector isn't massive; indeed, the sector's preponderance of efficient companies demonstrates how competitive intensity drives productivity (see "Auto parts: Miles to go"). But in the retailing of fast-moving consumer goods, traditional firms account for 88 percent of all labor. Although this sector's modern players achieve 75 percent of the US productivity level, the average of the sector as a whole is therefore only 29 percent. In telecommunications, electricity generation, and retail banking—all with high capital requirements—traditional operators aren't present at all. Exhibit 3 shows the extent to which traditional companies drag down productivity in sectors they dominate.

Clearly, the traditional companies have ample room to improve. We estimate that their doing so would close half of the gap between the country's current and potential productivity.⁷ But the problems are hardly confined to traditional operators. Modern companies also underperform, for three main reasons.

First, weak organization of business processes is common. Tackling this problem offers the biggest opportunity to improve productivity. Many retailers of fast-moving consumer goods, for example, don't have sophisticated logistics-management systems, so sales losses are high. In banking, lengthy credit checks are the norm even when they are clearly unnecessary. And government-owned monopolies—particularly the electricity and wireline telephone businesses—are overstaffed. Almost half of the employees in the electricity industry aren't needed. Second, low capacity utilization, due to overestimates of demand and to a lack of competition, leads to high prices and dampened demand. The third reason for the underperformance is a lack of investment in technology. The state-owned wireline company Türk Telecom, for example, has failed to invest sufficiently in high-speed value-added services and hasn't automated its management of faults.

If the modern companies tackled these problems and raised their productivity to 95 percent of the levels of their US counterparts, the other half of the gap between Turkey's current and potential productivity levels could be closed.

Root causes

We have identified several causes of low productivity in both the traditional and the modern sectors, but companies aren't taking the necessary steps to correct the problem. Why don't modern companies invest more in technology, and why don't traditional ones upgrade their operations? The answer lies in the three underlying causes of Turkey's low productivity.

1. The informal economy

In Turkey as in other emerging economies, traditional companies that have failed to take measures to improve their performance are going out of business in the face of increased competition from more efficient players. Yet the scale of corporate failure is much more limited than would be expected given the extent of the operational inefficiency in sectors such as confectionery (see "Confectionery: Too many cooks"). The reason is that a lot of traditional companies derive a cost advantage by flouting tax, labor, and product market regulations. Many, for example, fail to remit value-added-tax (VAT) or social-security payments, to adhere to hygiene or product quality standards, or to pay minimum wages.

The size and impact of this cost advantage vary among industries. In the retailing of fast-moving consumer goods, not paying tax remittances could more than double a retailer's monthly income. That isn't enough in the long run to outweigh the overall cost advantage modern retailers enjoy thanks to their superior productivity. However, it is sufficient to enable some companies to survive a few more years even as turnover erodes. The low productivity of traditional retailers ought to imply a 10 or 20 percent annual decline in their numbers; the actual rate is 5 or 6 percent. In the dairy business, the bankruptcy rate is even lower, with some informal operators enjoying a cost advantage of as much as 20 percent, helping even the most inefficient to stay afloat.

Furthermore, the substantial cost advantages of the informal economy not only protect traditional firms from going out of business but also act as a disincentive to improving their productivity. For example, the Bakkalim project attempted by Migros Turk, the country's biggest grocery retailer, involved efforts to organize smaller stores under an umbrella brand that would give them extra purchasing, logistics, and merchandising muscle. Because membership required participants to comply with tax and social-security regulations, few grocers were willing to sign up.

Cracking down on informal operators does have a short-term cost: in developing countries, they provide work for large groups of unskilled laborers who migrate to urban centers, and many of these jobs could be lost. But in the long term, higher productivity would create far more jobs. We estimate that 33 percent of the gap between Turkey's current and potential productivity is due to the informal economy. No doubt, there would be a time lag between job losses and job creation, and the transition wouldn't be easy. Much of the pain could be ameliorated with targeted programs, however, and we contend that tackling the problem of the informal economy will pay very worthwhile long-term dividends.

Since we found no evidence in Turkey of regulatory loopholes that allow companies to avoid tax and other social obligations and to violate product market rules, the first step is to ensure stricter enforcement of existing laws. Poor enforcement is largely the result of weak processes and systems: tax offices are understaffed and poorly organized, for instance, and penalties for evasion negligible. Political decisions exacerbate the problem. Since 1963, Turkey has issued ten tax amnesties, most of which permitted delinquent parties who came forward to pay back taxes in installments and to use old Turkish lira values—a fabulous offer in a country where inflation averaged more than 60 percent a year during the 1990s. Not surprisingly, many people prefer to bide their time until the next tax amnesty rather than make their payments on time.

Bolstering enforcement of a range of regulations across many industries simultaneously would be a massive undertaking. It would be more practical to focus initially on a single area. We believe that this area should be tax evasion, which accounts for the largest portion of the informal operators' cost advantage. Moreover, better tax enforcement should enable the government to lower tax rates, thereby encouraging more companies to join the formal economy. In the retailing of fast-moving consumer goods, for example, the state collects only some 64 percent of the VAT revenue owed. If that could be increased to 90 percent, the VAT rate could be lowered to 13 percent, from 18 percent, with no decrease in state revenues.

Turkey should consider following the lead of Poland, which under strong pressure from the European Union began tackling its informal economy in 1993 by focusing on VAT evasion in the retail sector. A combination of comprehensive audits, substantial monetary penalties, and, particularly, a change in cash register requirements to keep better track of sales had a significant impact, according to Polish experts.

If need be, Turkey could narrow its initial effort even further, to the retailing of fast-moving consumer goods. Enforcing VAT has the advantage that compliance by any single company makes enforcement possible both upstream and downstream.⁸ The retailing of fast-moving consumer goods is an appropriate sector to choose not only because almost all retail outlets in Turkey are registered and thus easy to identify⁹ but also because the product range within this sector is quite broad. As much as 20 percent of total Turkish economic activity is connected with it at some level.

Tougher enforcement of tax and social obligations and of product market rules will compel traditional firms to join the formal economy

Tougher enforcement of tax and social obligations and of product market regulations is the stick that will encourage traditional companies to join the formal economy and to modernize their operations. A carrot too is needed. Many small and midsize enterprises lack the know-how to modernize, so government and private-enterprise associations ought to educate them. For a start, Turkey should aggressively exploit and even try to deepen the assistance the European Union already offers to implement programs (styled after EU models) that help such companies improve their technology, increase their operating efficiency, and access export markets.

2. Macroeconomic and political instability

The sine qua non for sustained economic progress in Turkey is macroeconomic and political stability. Analysts have shown how the debilitating economic contractions of the past decade—too often caused by weak and short-lived governments—have led to high interest rates, high inflation, and high government debt. But the effect of economic instability on productivity has received little attention. Our study indicates that almost half of the gap between Turkey's current and potential productivity is due to economic volatility, which hurts modern companies most and largely accounts for their failure to improve business processes, their low capacity utilization, and their insufficient investment in technology.

Instability hampers productivity in three ways. First, high real interest rates often mean that more money can be made, more easily, from treasury operations than from productivity improvements, particularly in cash-oriented businesses. In the 1990s, real interest rates averaged around 20 percent but were frequently much higher; immediately after the currency devaluation in early 2001, they shot up to 90 percent.

Exhibit 4 demonstrates the importance of nonoperating income for a single large retailer and for retail banks. In 2001, when the Turkish economy contracted by almost 10 percent, this retailer earned no net income from operations but had $60 million in nonoperating income. Under these conditions, it is hard to blame a retailer's owner or manager for spending much more time negotiating payment terms with manufacturers and managing cash than worrying about core operational improvements. We believe that this behavior, rather than a lack of management know-how, explains the limited use of advanced practices in the retail sector. In retail banking, most operators have made so much money from treasury operations that they haven't felt the need to become efficient in their core business.

The second effect of economic volatility is that high real interest rates make borrowing expensive, so investment in technology and automation is reduced; confectionery companies, for example, don't buy equipment to prepare dough or to automate packaging. And high real interest rates are a massive disincentive to borrowing for houses—Turkey has no mortgage market, because of prohibitively high (and volatile) real interest rates—and this problem weakens the construction industry.

Third, violent and sudden swings in demand make planning a nightmare; the automobile assembly and cement industries, for example, added substantial capacity in the late '80s and early '90s in anticipation of strong growth that never materialized. It is incredibly difficult to adjust labor and plant capacity effectively in the face of such macroeconomic uncertainty. After the financial crisis of 2001, loan activity was virtually nonexistent, but banks were reluctant to lay off employees, as they had no idea how long the crisis would last.

The MGI study doesn't aim to prescribe specific measures to stabilize Turkey's macroeconomic and political environment, though it should be noted that the financial prerequisites of macroeconomic stability are well understood and that loans from the International Monetary Fund are contingent upon them. However, this study should provide an incentive for sustained macroeconomic reforms, since it clearly demonstrates the enormous impact that a greater degree of stability would have on productivity and thus on economic growth.

3. Government ownership

Previous MGI work shows that, with few exceptions, state-owned enterprises are less productive than privately owned ones. In Turkey as elsewhere, managers in the state sector lack incentives to increase profits, while restructuring is politically difficult because of job losses. Our study found that government ownership accounted for one-sixth of the gap between Turkey's current and potential productivity.

The electricity and retail-banking sectors clearly suffer from excess labor, and retail banking and wireline telecommunications are held back because they don't experience enough pressure to offer new services that could increase output. The textbook response is privatization and liberalization, and Turkey has plans for both in the electricity, wireline telecom, and retail-banking sectors. To ensure the desired benefits, it will be important to stage and manage the transfer of assets within a carefully constructed regulatory framework. Particularly in telecommunications and electricity, the country's regulatory framework falls well below the bar (see "Electricity: Unplugging the state").

Turkey's telecom industry provides a cautionary tale. The wireline sector has yet to be liberalized and suffers from a lack of incentives. Its productivity¹⁰ stands at 66 percent of the US level. Startlingly, however, productivity in the liberalized wireless sector is actually lower—59 percent. Part of the reason was the bad design of liberalization: the government insisted that the second wave of new mobile license holders build base-station networks covering the entire country instead of ensuring that newcomers and incumbents signed roaming agreements. The result has been that much of the new capacity is now redundant, which has dragged down capital productivity.

This experience shouldn't deter Turkey from undertaking further privatization and liberalization; it just serves to emphasize that reform needs to be carried out carefully. If the government hits on the right combination of privatization and liberalization, we estimate that labor productivity could double in telecommunications and triple in electricity generation.

It's make-or-break time for Turkey. If it has the resolve to undertake the reforms outlined here, it can double the living standards of its people within a decade and move that much closer to fulfilling its dream of joining the European Union. If it balks at the task, its economy will continue to underperform. The country has already come a long way, and many of its companies have become efficient and productive. It would be a terrible waste if Turkey now failed to grasp the opportunity to transform its entire economy.

Foreign investment: A poor record

Turkey's level of foreign direct investment is lower in the sectors we studied than the level in many other emerging markets and much lower than one would expect for a country of its size and importance (exhibit). Foreign direct investment is crucial not only because of its impact on the input side of the productivity equation but also because foreign companies usually force local ones to be more competitive.

It has been argued that the bureaucracy is to blame for Turkey's low foreign direct investment. Red tape can certainly be onerous; for example, 19 different administrative steps, several of them superfluous in the light of international standard practices, are required to establish a company. But our interviews suggest that this isn't a fundamental barrier to productivity: it affects all players, foreign and domestic alike, and therefore doesn't distort competitive intensity. Some foreign managers say that certain elements of red tape are just as bad elsewhere, both in developed and developing economies.

Instead, Turkey's poor record on foreign direct investment appears to be due to the same three factors that explain the country's low productivity. The informal economy, for one thing, hampers foreign investors' growth prospects. Nestlé and Danone, for example, both invested in Turkey's dairy market after the liberalization of raw-milk sourcing, in the early 1990s, but capacity utilization in the modern producers' plants is almost 30 percent lower than the US average because informal players, with their unearned cost advantages, have clung to a disproportionate share of the market.

Moreover, the high real interest rates resulting from macroeconomic and political instability have warped investment decisions. Until very recently, foreign banks participated in the Turkish market only to a limited extent because of the high valuations Turkish banks enjoyed on the strength of their treasury profits. Foreign banks weren't prepared to pay such high prices to enter the market. Last, state ownership of capital-intensive sectors such as telecommunications and electricity has deterred foreign investors from putting their money into Turkey, though they have poured funds into the same sectors in other developing economies.

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