US embassy cable - 03ISTANBUL777

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, Istanbul 
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