Turkey is awaiting its first-best reforms

Faruk Çelik, minister of labor and social security, announced on Thursday that a final meeting would be held with workers' and employers' unions on Monday aimed at reaching a compromise on the controversial issue of severance pay reform.
Rauf Gönenç, head of Turkey department in OECD Minister Çelik added that if the parties still cannot agree, the reform envisaged by the government will be postponed until a compromise is reached. I bet that there will be no compromise, thus no reform. That outcome is easily predictable. In September, I wrote in this column that “Prime Minister [Recep Tayyip] Erdoğan, by stating that he is waiting for the elusive compromise, has in fact washed his hands of the issue and given up on his political responsibility.” So, another “first-best reform” seems to have been lost. This reform would not only make severance pay effective for millions of workers who are de facto unable to take severance pay, but also enhance productivity, make the labor market more flexible and rapidly expand financial literacy thanks to individual severance pay accounts. Too bad for Turkey, but not surprising! The Justice and Development Party (AK Party) government, despite its high electoral support, is politically incapable of implementing “first-best reforms,” and it tries to plug the gaps with “second-best remedies.” I am borrowing this terminology from Rauf Gönenç, head of the Turkey department of the Organization for Economic Cooperation and Development (OECD). Gönenç made a remarkable presentation at the last İzmir Economic Congress on the issue of economic reform. I would like to summarize the main points he raised. He started with five “simple statements”: 1) Turkey is an entrepreneurial economy of exceptional proportions. 2) Turkey's entrepreneurial engine operates with very limited human capital, at a small scale and with low-productivity business units. 3) Nonetheless, a remarkable “entrepreneurial flourishing” took place in the 2000s. 4) However, this dynamism has not been supported by the existing regulatory framework inherited from earlier times. The mismatch principally concerns labor market rules. 5) Policymakers have made important efforts to offset regulatory obstacles to the growth of enterprises with second-best remedies. These efforts have paid off and helped growth. But first-best structural reforms now seem necessary to support entrepreneurship across the full spectrum of the business sector. Indeed, Turkey is an entrepreneurial economy of exceptional proportions, since employers and the self-employed represent 40 percent of total employment, compared with less than 20 percent in similar countries. This composition of the labor force implies a daily confrontation of participants in the economic process with the disciplines of market competition. This nurtures a very responsive, vibrant and flexible economy. However, Turkey's human capital is quite limited: The share of people of working age with an education below high school level is 70 percent in Turkey, compared with 30 percent in Chile and 10 percent in Poland. The divides are deeper in the “entrepreneurial” sphere of the economy: Turkish employers work with an average of five workers per business, and they themselves have very modest human capital: 40 percent of employers have only a primary education or less. Nevertheless, despite its educational handicaps, Turkey succeeded in reaching the group of “upper-middle income” countries in the 2000s. It now has a GDP per capita level comparable with Poland and Chile. This was largely due to a development of entrepreneurship. From 2003 to 2010, employment in firms of between 20 to 49 workers increased from 500,000 to over 1.2 million. Employment in firms employing between 50 and 249 workers grew from 900,000 to more than 1.7 million. Yet, these developments have taken place in an almost hostile regulatory environment. Labor market regulations in Turkey are typical of a trade-sheltered economy with few dominant firms. Policymakers have tried to reduce the negative effects of these regulations by tolerating informality on a selective basis, notably in certain regions and certain categories of enterprises, and secondly, by cultivating a growing and increasingly sophisticated industrial incentive system to help offset the excess costs of operating under regulations. In conclusion, first-best structural reforms appear highly desirable for the alignment of Turkey's labor, production and capital market regulations and social security with international best practices. This would be preferable to the second-best alternatives of selectively tolerating informality and selectively subsidizing specific types of business.

Babacan is not happy

At the İstanbul Finance Summit last Wednesday, Ali Babacan, deputy prime minister for economic affairs, made critical assessments of the challenges the Turkish economy is facing.
What impressed me most among these assessments was Babacan's confession about the nature of Turkey's ongoing economic growth. He is not happy with its quality. Me neither. Let me quote what he said about this controversial topic. Vice Prime Minister Ali Babacan worried about the quality of growth “When you look at the growth figures by themselves the picture isn't bad, but we have worries about the quality of growth. … We grew by 4.4 percent in the second quarter but the major source of this growth was domestic consumption and a little bit of public spending. We observe decreases in private investment as well as in net exports. … This picture is not one we would like to see. In fact, we would like to see the opposite. We want to have growth based on both private investment and exports. Yes, we grew by 4.4 percent, but what made up this growth doesn't make us happy. When growth is based on these factors [private investment and exports], the impact of growth on the current account deficit [CAD] is positive. However, when the growth is based on consumption, the current account deficit widens.” Babacan added that the government will make efforts to improve the quality of growth. Before explaining why this assessment, which in fact simply repeats the well-known problem of ongoing growth, seems critical to me, let me remind you of some misperceptions regarding Turkey's second-quarter growth. As I tried to explain in my Sept. 9 column (“Two different narratives of growth”), the causes of the second-quarter growth vary depending on the analytical perspective. Babacan is looking at yearly growth (the change in gross domestic product [GDP] from the second quarter of 2012 to the second quarter of 2013), and what he says is true. Nevertheless, quarterly growth (from the first quarter to the second quarter) is different in two respects: Private investment contributed positively, albeit quite moderately, to growth, while public expenditure has significantly slowed. However, let me add that negative net exports continued to widen the CAD. Of course, those nuances don't change the global picture: Turkey's real economic growth is basically based on private consumption and the CAD is widening at a time when the international liquidity glut will be ending sooner or later. The Fed's recent decision to leave the quantity of its asset purchases unchanged only postponed the end of the party for a few months. The only virtue of the Turkish economy's current situation is the government's insistence on fiscal discipline. Babacan underlined this insistency once again at the financial summit, saying that the government has never compromised on fiscal discipline during elections and won't compromise this time, either. He warned that if a widening budget deficit is added to the already widening CAD, then Turkey's economic and financial stability will be damaged. This was a long digression, I admit. So let's get back to the quality of economic growth. At the moment, the Turkish economy is unable to base its growth on exports for various reasons. Turkish industry isn't competitive enough in terms of costs or technology. Hence, it is quite natural that private consumption, fueled by the liquidity glut, is the main engine of economic growth. But this growth regime excessively hollowed out domestic savings and widened the CAD. At the beginning of the 2000s, the CAD-GDP ratio was about 3 percent. It is over 7 percent now. Moreover, as recent Betam research points out (see my Aug. 30 column, “Turkey on the brink of middle income trap”), labor productivity is almost null. For two years, growth has been driven exclusively by capital stock and employment increases. Babacan is right: Under these circumstances, the Justice and Development Party (AK Party) government should make great efforts to shift the unsustainable growth regime to a more balanced one in which exports, on the demand side, and productivity, on the supply side, play a determining role. These efforts -- in other words, the necessary structural reforms (in education, the labor market, the fiscal system, etc.) -- are well known, and as Babacan pointed out, they are written in “the official documents” (development plans, etc.). But where is the political will -- and the decisiveness?

Turkey in the global competitiveness index

The World Economic Forum (WEF) published its 2013-2014 Global Competitiveness Index (GCI) this week. Turkey is ranked 44th among 148 countries, though it had been ranked 43rd out of 144 countries in the previous year's GCI.
It is clear that Turkey has essentially stagnated. The answer is simple: Economic reforms have been postponed, and the growth of the gross domestic product (GDP) declined sharply while the macroeconomic environment deteriorated. PM Erdoğan in WEF-Davos The GCI is not just a simple competitiveness indicator as its label implies. Its scope is very comprehensive, encompassing performance measurements of 12 areas -- or “pillars” as WEF calls them. The index is computed on scores estimated according to performance in areas like institutions, infrastructure, macroeconomic environment, health, education, market efficiency, labor and financial markets, technological readiness and innovation, market size and business sophistication. So, the GCI is more than a simple cost-price competitiveness indicator. Rather, it evaluates the welfare state of an economy as well as its potential per capita income growth. Though it is a valuable means for ranking not only a country in the world economy from these two criteria, it also allows for evaluating the strong and weak features of an economy. The overall score of Turkey in the 2013-14 GCI is computed at 4.5. Let me point out that the maximum score is 7, and the score of Switzerland, ranked first, is 5.72. The table below shows the scores of Turkey in each area. These results constitute a fair evaluation of the performance of the Turkish economy in recent years, as well as a strategic roadmap for the structural reforms to be done in the future. Regarding health and primary education -- which is compulsory for all children for at least eight years -- Turkey made considerable progress in the 2000s. The high increase of income per capita and the continued opening of the economy since the 1980s, as well as the diversification of foreign export markets in recent years, increased the overall market size tremendously, which, for the GCI, is considered an important factor in measuring an economy of scales. Macroeconomic stability has not yet been achieved; inflation and the current account deficit are still high, as well as the volatility of both the exchange and growth rates, but the public fiscal stance is in very good shape. The competiveness in good markets is quite acceptable, thanks to the customs union with the EU that introduced the rules and the culture of modern competition, but it is not sufficient nor is it yet at a desired level. Notable investments in infrastructure and the open skies policy have improved transportation, but the WEF says that there are still gridlocks in seaports and the railway network is well backward. In the areas above, more reforms are certainly needed for improvement. But priorities must also be set elsewhere. Regarding two areas, innovation and labor market efficiency, Turkey is absolutely far behind its competitors. Improvement in innovation needs a comprehensive strategy, while the labor market needs radical reforms that aim to introduce more flexibility. Faithful readers of this column will better understand why I am so critical of the rigidities that prevail in the Turkish labor market. Another priority is institutions. Recent arguments in the economic development theory, like those of Daron Acemoğlu and Dani Rodrik, prove that well-functioning political, economic and legal systems; property rights; and a transparent and efficient bureaucracy are necessary for high and sustainable economic growth. The GCI score in this area (4.1) shows clearly that Turkey has a lot of ground to cover. Last but not least, Turkey needs real education reform that makes a jump in the quality of education at the high school and university levels. The number of universities in Turkey is actually close to 200, but the quality leaves much to be desired. That said, the basic question remains the same: Is the Justice and Development Party (AK Party) government politically able to make all those difficult reforms? Strong and weak features of Turkish economy: GCI scores Scores above or equal to overall score of 4.5 Health & Primary Education Market Size Macroeconomic Environment Goods Market Efficiency Infrastructure 5.9 5.3 4.6 4.5 4.5 Scores below overall score of 4.5 Innovation Labor market Efficiency Technological Readiness Institutions Higher Education & Training Financial Market Development Business Sophistication 3.5 3.7 4.1 4.1 4.3 4.4 4.4