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Cablegate: Tackling Turkey's Productivity Gap: Micro Matters

This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 02 ISTANBUL 000777

SIPDIS


SENSITIVE


STATE FOR E, EUR AND EB
TREASURY FOR U/S TAYLOR AND OASIA - MILLS
NSC FOR QUANRUD AND BRYZA


E.O. 12958: N/A
TAGS: ECON EINV PGOV TU
SUBJECT: TACKLING TURKEY'S PRODUCTIVITY GAP: MICRO MATTERS

Sensitive but Unclassified - not for internet distribution.


1. (SBU) Summary: While most attention in Turkey remains
focused on the country's macroeconomic fundamentals, a new
McKinsey Global Institute report is directing attention to
the productivity gap that separates Turkey from the U.S. and
Europe and the microeconomic reforms that must be taken to
close it. Highlighted are the need to reduce the high level
of informality in the Turkish economy, to ensure that
liberalization of utilities occurs only in a "robust"
regulatory and judicial environment, and to redouble efforts
to smooth economic volatility. End Summary.


2. (SBU) Lagging Productivity: The McKinsey study, 15 months
in the making, estimates that overall productivity levels in
Turkey are just one-half of their potential, averaging 40
percent of U.S. levels for labor, and 50 percent overall.
The estimate reflects both low total factor productivity (at
Korea's level) and a declining level of total factor inputs
(more akin to Brazil) over the last decade. The overall
figure masks the key attribute of the Turkish economy,
however: bi-modality, whereby modern and traditional/informal
sectors uneasily coexist in particular industries. In the
modern sector productivity can approach 65 percent of the
U.S. level, in traditional areas it is less half that.
Normally such inefficient firms would be squeezed out of the
market, but because of the "unfair" advantages they receive
by operating "informally" and avoiding tax, social security
and regulatory requirements, they are able to stay in
business. While conceding that structural impediments make
it unrealistic for Turkey to reach U.S. productivity levels
in the medium term, the report argues that Turkey could reach
70 percent of U.S. levels if it adopted the correct policy
mix. Such a course, McKinsey argues, could unleash growth
averaging 8.5 percent a year from 2005-2015, and create 6
million new jobs (coincidentally matching the number a recent
TUSIAD report estimated must be created to put Turkey's
worsening unemployment dynamics on a positive track).


3. McKinsey's Action Plan: Arguing that Turkey is fortunate
in that it does not suffer "death from a thousand cuts,"
McKinsey argues that its three highlighted factors explain
over 90 percent of Turkey's productivity shortfall. To
address them, it pushes for the following:


-- Informality: McKinsey recommends a carrot and stick
approach to give firms now operating in the shadow economy an
incentive to move into the modern sector. While Turkey's
ability to offer "carrots" is constrained by its need to
maintain a strong primary surplus to support the IMF reform
package (though the study notes that if VAT fulfillment rose
from 64 to 90 percent, the rate could be lowered from 18 to
13 percent without any impact on revenue), McKinsey
recommends the government facilitate enterprise access to
information and know-how, modelled on current EU programs
that support SME's. As a stick, the report pushes for
stricter and more effective enforcement of company
obligations, but concedes that this cannot be done across the
board, but must instead be targeted at specific sectors. It
suggests starting with the VAT in the retail sector, and then
moving upstream and downstream.


-- Monopoly Market Liberalization: McKinsey reiterates the
need for Turkey to liberalize its monopoly sectors--
especially telecommunications and electricity-- but stresses
that this must be done in an effective and "unambiguous"
regulatory and judicial framework. It points to Telecom
Italia Mobile's recent difficulties as an example of how a
weak regulatory structure has permitted sector incumbents to
block a competitive challenge, and the improved productivity
such a challenge would bring.


-- Macroeconomic and political stability: McKinsey highlights
the distortions that Turkey's recent instability have brought
to business operations, and the way in which it has hampered
productivity. While at the simplest level Turkey's shifts
over the last decade from boom to contraction have made
capacity planning virtually impossible, the resultant high
interest rates and inflation that have characterized the
economy have skewed managerial priorities, putting a higher
premium on cash-flow management, for instance, than on
operational or productivity improvements. (One contact in
the food sector notes that supermarkets in Turkey have
routinely earned profits above 20 percent, 2/3's of which
stems from their ability to impose 120-day payment terms on
their suppliers, rather than from any innate efficiency.)


4. (SBU) Positive Reaction: In a meeting with P/E Chief on
April 30, McKinsey Director David Meen indicated that
reaction to the report in business and industrial circles had
been uniformly positive, and that its analysis and
conclusions were widely accepted. He conceded that the
report had had less impact in Ankara than McKinsey had hoped,
given that it appeared in the run-up to the Iraq war, when
the capital's attention was directed elsewhere. However, he
indicated that the firm has had fruitful contacts with both
State Minister Babacan and the Energy and Transportation
Ministries regarding its specific regulatory suggestions.
Babacan, he said, was particularly intrigued by the
suggestions on informality. To raise the report's profile
further, Meen said that McKinsey will soon organize a series
of conferences in Ankara, with the assistance of the Union of
Chambers of Commerce (TOBB). He emphasized, however (and
reiterated the point in a May 8 speech at the "Forum
Istanbul" conference), that he is waiting to be convinced
about the government's commitment to transform words into
actions.


5. (SBU) Comment: The McKinsey report is well timed, and
reaffirms from a productivity standpoint the importance of
getting Turkey's macro fundamentals right, while also
outlining a number of micro steps that can also bridge
another significant part of Turkey's productivity shortfall.
Some question whether taking on the informal sector is a wise
policy choice, given the important role it has played in
cushioning the impact of recent economic crises. But
McKinsey makes a convincing case that the virtuous cycle
created by reducing informality and improving productivity
would ultimately produce income and jobs far outweighing
those lost through the informal sector's contraction. End
Comment.


ARNETT

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