Turkey Investment Climate Assessment: From Crisis to Private Sector Led Growth

Report No. 54123-TR

May 2010

Europe and Central Asia Region

TURKEYInvestment Climate AssessmentFrom Crisis to Private Sector Led Growth

CURRENCY EQUIVALENTSCurrency Unit New Turkish Lira (TL)

EXCHANGE RATEMay 12, 2010 TL 1.53= USD 1.00

WEIGHTS AND MEASURESMetric System

FISCAL YEARJanuary 1 December 31

Vice President :Country Director :

Sector Director :

Sector Manager :Task Manager :

Philippe H. Le HouerouUlrich ZachauFernando Montes-Negret Gerardo CorrochanoLalit RainaDonato De Rosa

ACRONYMS AND ABBREVIATIONS

ABGS

ABGEM

ACTAL

BILGE

BRSA

CBRT

CC

CEDPL2

CGF

CIF

CMB

CPRR

DA

D&Q

DB

ECA

EFCAS

EIF

ES

EU

EURADA

FDI

FOB

FX

GDP

GERD

GoT

GOV

GVA

GVC

IAC

ICA

ICS

ICT

IFRS

IIPR

ISE

ISO

ISPAT

JASME

KADIM

KKB

Secretariat General for EU Affairs

EU Turkish Business Centers

Dutch Advisory Board on Administrative Burden

Computerized Customs Activity

Banking Regulation and Supervision Agency

Central Bank of Turkey

Commercial Code

Second Competitiveness and Employment Development Policy Loan

Credit Guarantee Fund

Cost, Insurance & Freight

Capital Markets Board

Japanese Council for the Promotion of Regulatory Reform

Development Agency

Design and Quality

Doing Business

Europe and Central Asia

Enterprise Financial Crisis Assessment Survey

European Investment Fund

Enterprise Survey

European Union

European Association of Regional Development Agencies

Foreign Direct Investment

Free on Board

Foreign Exchange

Gross Domestic Product

Gross Expenditures on R&D

Government of Turkey

Governance

Gross Value Added

Global Value Chains

Investment Advisory Council of Turkey

Investment Climate Assessment

Investment Climate Survey

Information and Communication Technologies

International Financial Reporting Standards

Intellectual and Industrial Property Rights

Istanbul Stock Exchange

International Organization for Standardization

Investment Support and Promotion Agency of Turkey

Japan Finance Corporation for Small and Medium Enterprises

Struggle against Unregistered Employment Project

Credit Bureau of Turkey

KOSGEB

KSS

MAS

MEKSA

MEP

MLT

MNC

MPM

MTP

NIS

NPAA

NPL

NSC

OECD

OLS

OSB

PMR

R&D

RIA

SBA

SCM

SIC

SME

SPO

TASB

TESK

TFP

TFRS

TOBB

TOSYOV

TPI

TSI

TUBITAK

TRKAK

TURKSTAT

USPTO

VEDOP

WDI

WFE

WIPO

YOKK

Small and Medium Enterprises Development Organization

Small Industrial Estates

Manufacturing Advisory Services

Training and Small Industry Support Foundation of Turkey

Manufacturing Extension Partnership

Medium- and long-term

Multinational Corporation

National Productivity Center

Medium Term Program

Networks and Innovation Survey

National Plan for Adoption of the Acquis

Non-Performing Loans

National Steering Committee

Organization for Economic and Cooperation Development

Ordinary Least Squares

Organized Industrial Zones

Product Market Regulation

Research and Development

Regulatory Impact Analysis

Small Business Administration

Standard Cost Model

Standard Industrial Classification

Small and Medium Enterprise

State Planning Organization

Turkish Accounting Standards Board

Merchants and Artisans Confederation of Turkey

Total Factor Productivity

Turkish Financial Reporting Standards

Union of Chambers and Commodity Exchanges of Turkey

Small and Medium Industry Owners and Managers Foundation of Turkey

Turkish Patent Institute

Turkish Studies Institute

Scientific and Technological Research Council of Turkey

Turkish Accreditation Agency

Turkish Statistical Institute

United States Patent and Trademark Office

Tax Offices Automation Project

World Development Indicators

World Federation of Exchanges

World Intellectual Property Organization

Coordination Council for the Improvement of the Investment Environment

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ACKNOWLEDGMENTS

This report was prepared in close cooperation with the YOKK Secretariat. Preliminary and intermediate findings of the report were presented to YOKK Steering Committee meetings on June 11 and November 13 2009. Intermediate findings were presented to various stakeholders in a series of roundtables held in November 2009. The World Bank team also performed field visits to Izmir and Adana, where it greatly benefited from discussions with local stakeholders.

The World Bank team was led by Donato De Rosa and included Dragana Pajovic, Paulo Correa, Murat eker, Federica Saliola, Delia Rodrigo, Carlos Piera, Jorge Pea, Alvaro Escribano, Manuel de Orte, Bar Diner, rem Geri, Selma Karaman, Aye Seda Aroymak, Zeynep Lalik, Erkan Erdil, Murat Uer. The report was undertaken under the guidance of Ulrich Zachau, Fernando Montes-Negret, Gerardo Corrochano, Lalit Raina and Keiko Sato. Indispensable contribution and insight came from brahim H. anakc, Undersecretary of Treasury, Cavit Dada, Deputy Undersecretary of Treasury, Berrin Bingl, Murat Alc, Mehmet Dndar, zge Dumlupnar, Serenay Usta, Gamze zdurgutlu, Gnl Bakr Kartal, Bahar Konak, Baak nal and Can Grlek (Undersecretariat of Treasury team). In addition to the Treasury team, recognition is extended to all YOKK member institutions. Willem van Eeghen and Stefka Slavova (World Bank) and Rauf Gnen (OECD) were peer reviewers for the report. In addition, the team received helpful comments and suggestions from Mark Roland Thomas, Cihan Yalcin, Kamer Karakurum-zdemir, Mediha Aar, Muammer Kmrcolu, Jesko Hentschel, Cristobal Ridao-Cano, Raif Can, Steen Byskov, Jean-Louis Racine, Cemile Hacbeyolu, Andres Federico Martinez, Mahesh Uttamchandani and Anthony Ody.

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TABLE OF CONTENTS

Investment Climate Assessment

iv Investment Climate Assessment

vInvestment Climate Assessment

vi Investment Climate Assessment

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EXECUTIVE SUMMARY

This Investment Climate Assessment draws on the analysis of firm-level survey data collected during April 2008-January 2009, supplemented by other sources, to provide a comprehensive and up-to-date description of the investment climate facing Turkish firms of all size classes, including the impact of government regulations and recent reforms. An important feature of the analysis is extensive use of data from comparable countries to benchmark Turkeys performance. Beyond description, the report seeks to identify key priority areas where further policy reform and institutional development could help strengthen Turkish firms performance in such areas as productivity, export competitiveness and employment creation. A special aspect of the report is its focus on Turkeys small and medium scale enterprise (SME) sector.

Since late-2007, global conditions have taken their toll on the Turkish business sector. Turkeys economy contracted by 4.7 percent, with unemployment reaching 14 percent in 2009. Sustainable growth in the post-crisis environment will require continuation of reforms aimed at promoting healthy business sector development.

Continued commitment to business environment reforms will help support a sustainable recovery. Building on recent reforms, actions to improve the regulatory framework need to be sustained to reduce incentives for firms to remain informal. Business registration has been simplified, but administrative procedures still impose a high time tax on firms. Improved availability of skilled labor will be crucial for improving productivity. Sustained encouragement of firm-level innovation would also have positive effects on enterprise performance. The availability of credit to the corporate sector, especially SMEs, has been negatively affected by the crisis. With a competitive global environment expected in the post-crisis period, the report identifies three priority areas to help the economy achieve sustainable, broad-based growth that incorporates SMEs and is more evenly distributed across the country.

A first key priority is to alleviate the, mainly financial, obstacles that constrain SMEs growth, thus preventing the largest portion of the enterprise sector from reaping scale economies. A healthy SME sector could improve employment opportunities and promote regional development. SMEs grow more slowly than micro or large firms in Turkey, unlike SMEs in comparator countries. Existing policies and regulations may impact SMEs more than either micro or large firms. Access to finance appears to be the single most important constraint to SME growth. Enhancing banks ability to assess borrowers creditworthiness, plus a more active Credit Guarantee Fund, should help ease lending to SMEs.

A second priority is to increase Turkish SMEs competitiveness by enhancing their ability to adopt and use knowledge. Diffusion of the sources of growth beyond firms that are already sufficiently competitive to be direct exporters (and beyond already-successful manufacturing poles) will increase Turkeys resilience to future external shocks in global demand and ensure that the productive base of Turkish manufacturing is more evenly distributed geographically. The local business and institutional environment combines with country-wide features to determine firms incentives to adopt innovative modes of production and organization. Analysis of Turkish production networks indicates that the absorptive capacity of local suppliers is key for successful participation in global markets. Existing government programs aimed at increasing the operational capabilities and absorptive capacity of SMEs could be improved at the local level in line with international best practice.

A third priority is to further reform and strengthen the regulatory capacity of the government. Turkeys recent important steps in establishing institutions and mechanisms for regulatory reform could be made more effective by refining their strategic vision, improving horizontal and vertical coordination, and enhancing consultation with the private sector. The establishment of Development Agencies (DAs) offers an opportunity to ease investment climate constraints through actions at the local level.

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OVERVIEW AND POLICY OPTIONS

1. Since late-2007, adverse changes in global conditions have taken their toll on Turkeys previously booming economy and business sector. Prior to the global economic crisis, Turkeys economy had been thriving. Following the 2001 banking crisis associated with a sharp recession and a restructuring of the financial sector, Turkish GDP growth averaged nearly 7 percent per annum between 2002 and 2007. An important engine of growth was private investment, in part driven by large capital inflows, which contributed to a trebling of private sector Gross Fixed Capital Formation between 2002 and 2008. Since 2008, though, the external economic environment has deteriorated markedly, with falls in external demand and international capital flows and associated declines in domestic demand and credit availability. Turkeys economy is expected to contract by 6 percent, with unemployment estimated to have increased to 14 percent in 2009. The corporate sector, in particular, has been hard hit by the slowdown in global demand. A survey carried out by the World Bank in the summer of 2009 shows that most enterprises experienced a sharp contraction in sales, with reported declines between 2008 and 2009 in the region of 40 percent. Almost half of the firms surveyed (46 percent) reported restructuring their liabilities, while one-third delayed payments to tax authorities and suppliers.

Tough global conditions heighten the need to attack constraints to firms productivity and growth.

2. Turkish firms cite a number of external constraints to their own performance. According to a survey conducted between April 2008 and January 2009, a majority of Turkish firms see themselves as held back by problems with access to finance (some 26 percent of firms cited this as their single most important constraint). Tax rates (18 percent) and political instability (18 percent) rank second and third, while other important factors are competition from the informal sector and an inadequately educated workforce (15 and 9 percent respectively). Analysis of survey data confirms a significant association between the quality of the investment climate and performance in areas like productivity, job creation, export competitiveness and attractiveness for foreign investment. Productivity analysis shows that almost one-third of variation in the performance of the business sector in Turkey is explained by investment climate factors.

Figure 1: Top Five Investment Climate Obstacles

Source: Turkey ES 2008

3. The regulatory environment is the area of the investment climate with the largest relative contribution to productivity. Other relevant investment climate areas include infrastructure bottlenecks, access to finance and corporate governance, the availability of skilled labor and innovation. Aggregate productivity in Turkey appears to have increased since 2005, driven by improved allocation of resources towards firms with higher productivity. This has widened the gap between low and high productivity establishments, with larger firms appearing to benefit

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Figure 2: Share of firms facing informal competition


from the more positive aspects of the investment climate and smaller and less productive firms bearing the costs of its less positive features.

4. Analysis of survey data indicates that firm-level productivity in Turkey is negatively associated with a number of features of the regulatory environment. Some of these include formal bureaucratic requirements, such as the number of inspections to which businesses are subjected, the number of compulsory certificates required and the time necessary to obtain them, as well as time consuming customs procedures for imports. Burdensome regulatory requirements constitute fertile breeding ground for the negative consequences of cor-ruption, as it is exemplified by the negative association between productivity and informal payments to obtain power supply or a contract with the government. Inefficient regulations also provide incentives for firms to remain partially informal. Firms that are subject to competition from informal establishments are, in turn, associated with lower levels of productivity.

5. Problems for Turkish firms posed by tax rates and tax administration seem to have declined in importance since 2005, at least partly reflecting the impact of recent reforms. When examining firms perceptions, the relative importance of tax rates in a ranking of obstacles has dropped, from being the largest obstacle in 2005, to where a relatively low 18 percent of firms in 2008 perceived tax rates as the single most relevant impediment to business operations. The share of enterprises identifying tax rates as a major or very severe constraint decreased from 81 percent in 2005 to 50 percent in 2008. Tax administration, viewed as a major constraint by 59 percent of manufacturing firms in 2005, had dropped to 19 percent by 2008. These improvements between 2005 and 2008 can, at least in part, be ascribed to tax reforms introduced since 2006. Notable among the reforms are the intro-duction of a new corporate tax code, the reduction of corporate income tax from 30 to 20 percent, and lower taxa-tion on interest. On another front, despite the lower tax rates introduced with recent reforms and the fall in the headline measure of informality from 53 percent to 44 percent between 2004 and 2008 the share of surveyed firms complaining about informal competition increased from 44 percent in 2005 to 52 percent in 2008.

6. Turkey has made significant reforms in some areas of the regulatory climate, including easing business registration, but red tape still imposes significant costs on businesses. The Government has made progress to-wards facilitating the process of business registration. According to Doing Business 2010, recent Turkish reforms have reduced the time it takes to register a business from 13 required steps in 2004, down to six steps in 2009. The Government has initiated e-Judicial Registrations and Online Company Registration procedures, with a draft act currently being evaluated by the Prime Ministers Office and expected to be adopted in the National Assembly in early 2010. Manufacturing firms interviewed in the 2008 enterprise survey reported that the time it takes to acquire an operating license had decreased from 66 days in 2005 to 62 days in 2008. Even after the improvement,

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though, this is still higher than in comparator countries. More broadly, compliance with administrative proce-dures remains problematic for business operation. There is no clear framework for streamlining administrative procedures for businesses, and operating licenses are issued by various Ministries, each responsible for different business areas. Additionally, in overall terms the perceived time tax the share of management time spent deal-ing with government regulation appears to have increased sharply since 2005, from 9 to 27 percent. The time tax is largest for medium and large enterprises (32 percent and 34 percent respectively), whereas managers in small firms report spending 23 percent of their time dealing with red tape.

7. A specific area of improvement has been in the cost and time invested in construction of business premis-es. According to the Doing Business measure of the time involved in building a warehouse, Turkish firms were able to shorten their average site development time by 44 days between 2005 and 2009. This said, the time to obtain building permits varies significantly between Turkish cities, with firms in Istanbul seeming to struggle with construction permits more than firms located elsewhere. Additionally, a variation is notable by firm size, with SMEs spending nearly twice the time as large firms dealing with construction permits (60 versus 32 days).

8. Business inspections appear to be somewhat less burdensome in Turkey than in comparator countries. The average time all employees in a company spend with inspections per year is 6.6 days, which puts Turkey ahead of several comparator economies. The survey results are similar when firms are asked about the number of inspec-tions taking place in their organization: the average annual frequency of inspectors visits has diminished from 4 in 2005 to 2 in 2008. When examining the time that each firm spends on inspections, medium size firms seem to be more affected. Additionally, regional comparisons show significant variations in inspection times and duration. In general, the large regional variations observed for licenses, permits and inspections are a consequence of the fact that municipalities, often lacking adequate capacity, are frequently responsible for implementing regulations that are established at the central level. This institutional setup tends to create a burden for businesses and indi-viduals, when having to comply with procedures established locally without prior agreement at the central level.

Better availability of skilled labor would help improve Turkish firms productivity.

9. Firms with a higher share of staff with university education tend to show higher productivity, according to econometric analysis. Survey results show that larger firms are in a better position to afford skilled staff with university education.

10. Education levels in Turkey lag behind other OECD countries. OECD data show that 26 percent of the Turkish adult population holds secondary education diplomas. This is well below the OECD average of 69 percent and

Figure 3: The time tax


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the EU19 average of 70 percent. Graduates with tertiary education in Turkey are also scarce, and the entry rate to higher education programs (tertiary education) is low by international standards. Only 29 percent enroll in higher education in Turkey, compared to a 56 percent average in the OECD countries. Nearly a quarter of Turkish firms rate the education and skills levels of the workforce as a major or very severe constraint on operations and growth (See Figure). Although this is an improvement from the 33 percent in 2005, the high rate still requires the attention of policymakers and shows that measures need to be taken to better coordinate labor supply with the demands in the business sector.

Figure 4: Education of workforce as an obstacle

Source: Enterprise Surveys 2008

11. The share of Turkish firms offering formal training to their employees has increased slightly. Some 24 percent of manufacturing businesses reported offering training to their employees in 2005, and this number had risen to 29 percent three years later. The share of large firms offering training is three times higher than that among small businesses. Enterprises with exporting activities are also more active in offering training to work-ers.

12. Turkeys rate of labor force participation, at less than 50 percent, is low by international standards and has decreased somewhat since 2005. This places Turkey around 20 percentage points below OECD and EU-15 aver-ages. The employment rate for women is particularly low, standing at 26.7 percent in 2007, far below the OECD and EU-15 averages of 61.3 percent and 65.3 percent respectively. The 2008 Enterprise Survey shows that on average only 16 percent of production employees and four percent of non-production employees are female.

13. The 2008 survey found firms in Turkey less likely to regard labor regulations as a serious obstacle than they had been in 2005, probably an effect of the timing of the survey. Turkeys score on this indicator appears to have improved substantially vis--vis the average for the Europe and Central Asia region. The survey results require cautious interpretation, however, as the inflexibility of labor regulations is still mentioned by enterprises in face to face interviews as the overarching constraint facing firm operation and growth. While firms perceptions in the 2008 survey might have been influenced by labor reforms initiated in early-2008, it is also possible that the timing of the survey (from April 2008 to January 2009) found business more preoccupied with other, more imme-diate issues e.g. loss of market share requiring downsizing or problems with access to finance thus decreas-ing the perceived relative importance of labor regulations. These concerns may resurface as a major constraint for sustainable recovery.

Productivity and exports would benefit from policies encouraging innovation.

14. Turkish firms that invest in Research and Development (R&D) tend to show higher productivity levels, ac-cording to analysis of the 2008 survey of Turkish enterprises. Firms that had re-organized production processes

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to take advantage of outsourcing were also found to be more productive. Employment, exports and FDI are all positively associated with innovation at the firm level. Econometric analysis also points to a positive association between employment levels and the use of ICT in communication with customers and suppliers. Firms with qual-ity certifications are also more likely to have a larger workforce. Finally, there is a significantly positive correlation between variables reflecting innovation (such as quality certification and the use of ICT) and the probability of exporting.

15. Turkeys total investment in R&D has nearly doubled over the past ten years, reaching 0.73 percent of GDP in 2008. This is also reflected in the relative high number of Turkish firms (23 percent) that perform R&D expen-ditures (See Figure).Nonetheless, Turkey still lags behind other middle income countries and the OECD, which presented an average of 2.29 percent in 2007, compared to 0.71 percent for Turkey in the same year.

16. Turkeys application of international quality standards (ISO 9001) has shown remarkable improvement over the past decade, with more than 13,200 certificates issued by the end of 2008. This performance compares relatively well to that of other economies. Firm surveys in 2008 found 30 percent of Turkish firms reporting having an internationally recognized quality certification. This puts Turkey ahead of other middle-income countries, such as Brazil (26 percent), Bulgaria (20 percent) and Poland (17 percent). Certifications among small firms lag far behind medium and large companies: about 55 percent of large firms hold a quality certification, which is three times the share of small firms.

17. The Government has taken steps to encourage the use of ICT. With the implementation of the e-Transfor-mation Turkey Project, the expansion of ICT in public services has received a boost. The Government has also stepped up initiatives to raise awareness of ICT among citizens and businesses. Further support is planned for enterprises in their use of ICT, as well as increased competition in the electronic communication sector.

Credit availability to firms, especially SMEs, has suffered during the crisis.

18. Turkish firms with good access to finance tend to show higher productivity. Analysis from 2008 indicates that higher productivity was related to several variables representing financial soundness (e.g., firms with a higher share of sales paid for before delivery, and firms with the ability to finance a higher proportion of fixed assets purchases with internal funds).

19. Turkeys financial sector is relatively small by comparative standards. According to a recent study by the Banks Association of Turkey, the ratio of financial assets to GDP in 2007 was 150 percent in Turkey, compared to 246 percent for emerging market economies and a global average of 421 percent. This said, according to the

Figure 5: Share of firms with R&D spending

Sources: Enterprise Surveys

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Figure 6. Share of firms with loans

Source: Enterprise Surveys

2008 enterprise survey, 57 percent of Turkish firms had access to a loan, which compares fairly well to other mid-dle income economies (see Figure). Nonetheless, firms of all size categories perceive access to finance as their single most severe obstacle, with medium-sized firms appearing to be particularly affected (34 percent), followed by micro (26 percent), small (24 percent) and large firms (19 percent). Turkish firms rely more on bank loans for investment financing (38 percent) than do firms in other countries. This is especially true for medium-sized firms, for which bank finance accounts for 47 percent of total investment funding. Collateral requirements appear par-ticularly onerous for SMEs, compared to both micro and large firms, amounting to 100 percent of loan value for small firms and 91 percent for medium firms. The share of loan applications that is rejected is also substantially higher for SMEs (17 percent) compared to large firms (12 percent).

20. The credit crunch following the global financial crisis has affected lending to the SME sector. Starting in late 2007, SMEs share in total credit declined by about 5 percentage points to just over 20 percent, while SMEs share in total corporate credit dropped from about 52 percent to some 44 percent. While growth in total banking sector credit remained relatively high until the escalation of the global crisis in late 2008, SME credit growth started to decelerate as early as the beginning of 2008. Between December 2006 and November 2009, cumulative growth in SME credit amounted to some 35 percent, which was only about half the rate of growth in other (non-SME) cor-porate credit. Non-performing loans SMEs rose from below 4 percent in the middle of 2008 to almost 8 percent.

Actions in three priority areas will support broader-based growth that incorporates SMEs and is better distrib-uted geographically.

A first key priority is to alleviate the, mainly financial, obstacles that constrain the growth of Turkish SMEs.

21. Difficult access to finance prevents the largest element in the Turkish enterprise sector from reaping scale economies. SMEs account for 79.4 percent of employment, 44.6 percent of total investments, 25-30 percent of total exports, 57.3 percent of total value added and 25 percent of bank credit (indeed, given data limitations and the size of the informal sector, the contribution of SMEs to the economy may well be somewhat underestimated). Given SMEs scale, the development of a more productive and more outward-oriented SME sector is a crucial development challenge for Turkey. A healthy SME sector can not only provide increased employment opportuni-ties for a rapidly increasing workforce and promote regional development, but is also crucial to increasing the resilience of the economy to future external shocks.

22. Turkish SMEs grow more slowly than other firms, the opposite of international experience. Analysis of firm dynamics indicates that small (11-50 employees ) and, especially, medium firms (51-250 employees) grow more slowly than all other size categories, with employment growth 16 percent lower than micro firms and 5 percent

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lower than large firms. This is contrary to what is observed in comparator countries, where SMEs grow faster than large firms. Comparison with other countries also shows that SMEs in Turkey are, on average, older. This is especially true for medium-sized firms, with 60 percent in Turkey being more than 16 years old, compared to 20 percent in the EU-10. This might indicate that SMEs in Turkey face barriers to their expansion that force them to remain at a smaller and suboptimal scale of operations. By contrast, the demographics of Turkeys large firms are in line with values in other countries. The slower growth of Turkish SMEs suggests that existing poli-cies and regulations may have more distortionary effects for SMEs than for either micro or large firms. It seems likely that SMEs have neither the capacity of large firms nor the flexibility of micro firms to cope with the effects of these policies.

23. Problems with access to finance seem to be the most important constraint to the growth of SMEs. Accord-ing to econometric analysis, one percent more usage of external finance for investment is related with 0.3 percent higher employment growth. The association of a loan or a line of credit with employment growth is even stronger and is estimated to have an effect on employment growth of 33 percent.

24. Improved ability on the part of banks to assess borrowers creditworthiness, plus targeted interventions to ease collateral requirements, could help ease financial constraints to SME growth. Structural measures to enhance the ability of banks to assess the creditworthiness of SME borrowers appear necessary to help SMEs to tap into bank credit. Such measures would include (i) encouraging the expansion of coverage of existing credit bureaus, the Credit Registry of the Central Bank and the Credit Bureau of Turkey (KKB), and (ii) accelerating the adoption of the new Commercial Code, in order to enable SMEs to benefit from a simplified set of financial report-ing standards.

25. Enhancing the role of the Credit Guarantee Fund (CGF) may also help improve SMEs credit access. The CGF has played an important role in facilitating SMEs access to credit by easing collateral requirements (especially since its recapitalization in 2007). The new CGF model, with Treasury involvement for a period of two years, is a positive initiative that expands the capacity of the CGF to serve the financing needs of SMEs following the credit crunch in the aftermath of the crisis. Considering ways to make the new CGF scheme more active would, hence, be a priority. Furthermore its scope could be enhanced to better target the needs of medium-sized firms. In fact, since 1994, the bulk of credit guarantees provided by the CGF has benefited micro and small enterprises, with only 11 percent of the guarantee fund being used by medium-sized firms.

A second priority is to enhance SMEs ability to adopt and use knowledge.

26. Access to the sources of higher efficiency needs to be extended to a wider share of firms. Turkey needs to open up the sources of growth beyond firms that are already sufficiently competitive to be direct exporters (and beyond already-successful manufacturing poles). Success in this effort will increase the resilience of the Turkish

Figure 7: Growth rates (percent) of Turkish SMEs relative to SMEs in other countries (2004-2007)


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economy to future shocks in global demand. It will also ensure that the productive base of Turkish manufacturing is more evenly distributed across Turkish regions. Since the 1980s, the liberalization of the Turkish economy has offered new opportunities related to the general rise in trade in intermediate goods and in international capital mobility. Integration into global trade and investment flows has been accompanied by a significant spatial trans-formation of the Turkish economy, characterized by the emergence of a number of new industrial agglomerations far from the earlier manufacturing regions. These new centers are the so-called Anatolian Tigers. Clusters of industries have formed in various parts of the country, with specialization in both traditional and more technologi-cally advanced sectors, and have become the core of manufacturing and exporting activities. In response to these developments, the government has activated a number of instruments to foster the ability of SMEs to participate in global markets. The rationale of several such interventions has been to remove obstacles to the competitive-ness of SMEs related to the business environment. For instance, SMEs in the manufacturing sector have been encouraged to locate in appropriately planned small industrial estates (KSS) and organized industrial zones (OSB) that can ease investment climate constraints by providing a number of advantages in terms of infrastruc-ture services and regulation of business activity.

27. The local business and institutional environment combines with country-wide features to determine firms incentives to adopt and use innovative modes of production and organization. The availability of a research base at the local level can, for example, encourage innovative behavior, if contacts exist between firms and local research organizations. The availability of a skilled workforce is also highly dependent on the quality of the local higher education and vocational training. The ease of access to bank finance is, on its part, conditional on the development of the local banking sector, as well as on personal contacts that may facilitate relational lending practices. Local conditions also influence the effect that the regulatory environment has on firm operations, since a large number of operating licenses are awarded at the local level. As a result, the effects in terms of knowledge transfer of linkages between globally connected firms and local suppliers may vary widely depending on local conditions. Analysis of Turkish production networks indicates that the absorptive capacity of local suppliers, es-pecially SMEs i.e. their ability to adopt and use knowledge is key for successful participation in global markets. Specifically, together with a more efficient regulatory environment and easier access to finance for investment, the availability of technical skills and capacity to handle technology is conducive to more knowledge-intensive value chain arrangements.

28. In addition to wider investment climate reforms, scope exists to improve local-level programs aimed at in-creasing the operational capabilities and absorptive capacity of SMEs. Several governmental and non-govern-mental organizations provide support to firms, especially SMEs, with the objective of increasing their operational capabilities and absorptive capacity. The largest government program is offered by the Small and Medium Scale Enterprises Development Organization (KOSGEB), while the Union of Chambers and Commodity Exchanges of Turkey (TOBB) also provides such services to its associates. Following international best practices, the govern-ment could aim at reforming existing support programs by: (i) advancing the implementation of a flexible and decentralized management model to better serve the needs of SMEs on a local level; (ii) ensuring that the serv-ices on offer are not already available on market terms to SMEs, in order not to crowd out private providers; (iii) rationalizing the services on offer to create a single entry-point which could help SMEs better understand their business needs and opportunities; (iv) expanding the scope of support schemes beyond micro firms to better cater to the needs of larger SMEs.

A third priority is to further reform and strengthen the regulatory capacity of the government.

29. Turkey has taken important steps to improve the regulatory environment. The Government has paid par-ticular attention to establishing institutions and mechanisms for regulatory reform; enacting legal reforms con-ducive to simplification of the legal framework; and introducing, through pilot projects, a number of regulatory tools to improve the quality of regulations. In this process, achieving EU harmonization has been a key driver of reform and Turkey has partially embraced the EU Better Regulation agenda in a number of areas. As a result,

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Turkey has established solid pillars of a regulatory system that have the potential to develop into a whole-of-government approach to regulatory management and reform. The Coordination Council for the Improvement of the Investment Environment (YOKK) has become a key structure where the private sector makes contributions to the process of improving the investment climate. The Council conducts its agenda with the help of 12 Technical Committees working on specific issues with participation of both public and private institutions. However, the dif-ferent responsibilities allocated to institutions are not always linked towards a single regulatory reform strategy. This creates difficulties when it comes to establishing priorities and taking the lead for reform, and it often also results in overlapping responsibilities within and across levels of government that make implementation cumber-some, thus directly affecting business operation.

30. Building on recent progress, regulatory reform could aim at a clearer strategic vision, improved horizontal and vertical coordination among levels of government, and enhanced consultation with the private sector. In order for regulatory reform to produce substantial effects on the regulatory burden experienced by the business sector, a number of steps are necessary. First, there is a need for support at the highest political level that is translated into a clear, coherent and comprehensive strategy for regulatory reform (country-wide and includ-ing all components of a regulatory system). Second, coordination among different institutions and of different initiatives with similar objectives could be improved. Third, there is a need to link regulatory reform to clear and measurable economic targets and objectives in the medium and long term. Fourth, capacity building across the administration remains a crucial element for success. Efforts in different directions to train officials in the use of modern regulatory tools testify to the need to dedicate resources to this goal. Fifth, consultation with private sector stakeholders should be mandatory and institutionalized, with the existing YOKK platform offering a good starting point.

31. Complementing other reforms, the establishment of Development Agencies (DA) could offer an opportu-nity to ease investment climate constraints by providing an interface for businesses at the local level. The Gov-ernment, through the State Planning Organization, is currently in the process of making Development Agencies operational, with the goal of having 26 DAs that will cover the entire country. DAs are potentially well placed to be an interface between business and government, provided that they can preserve a light organizational structure and remain at arms length from the government, with the objective of minimizing the risk of capture by local interests. Additionally, an essential condition for DAs to be able to perform their tasks will be the existence of internal Government regulations recognizing their formal role vis--vis central and local government. Looking ahead, DAs could perform a number of useful functions. First, as already intended by the Government, they could act as one-window shops. Even short of radical reform of responsibilities for the issuance of licenses and per-mits, DAs could perform a useful facilitator role between issuing agencies and firms. Second, DAs could act as information points for businesses, in close cooperation with TOBB as well as with Government agencies, such as KOSGEB and TBITAK. The objective would be to rationalize financial and non-financial support initiatives es-pecially for SMEs who normally face high information costs available at the local level. Third, the FDI promotion function via Investment Support Offices could be carried out in close coordination with ISPAT, the national FDI promotion agency.

xviiInvestment Climate Assessment

Summary of Policy Objectives and Options

Objectives Options

Ease constraints on the ability of SMEs to grow in size and generate

employment

Encourage the expansion of coverage of existing credit bureaus.

Accelerate adoption of the new Commercial Code in order to enable

SMEs to benefit from a simplified set of financial reporting standards.

Consider ways to make the new CGF scheme more active, expand its

reach, and allow it to better reach the medium-sized firm segment.

Advance the implementation of a flexible and decentralized

management model for SME support programs.

Ensure that the services on offer are not already available on market

terms to SMEs in order not to crowd out private providers of such

services.

Create a single entry-point for the various SME support programs,

possibly in cooperation with DAs, in order to help SMEs better

understand their business needs and opportunities.

Expand the reach of support programs beyond micro-enterprises, to

better serve the needs of larger SMEs.

Map current regulatory reform initiatives in a single strategic document

setting priorities and sequencing of reforms.

Strengthen the institutionalization of regulatory reform by creating

a single oversight body for regulatory reform in the Prime Ministers

office.

Strengthen YOKKs role to improve the business environment and

advocate for regulatory reform.

Design a comprehensive administrative simplification strategy

with clear objectives, targets and review criteria for lower levels of

regulation to improve the business environment.

Improve coordination mechanisms inside the administration when

preparing laws and regulations.

Strengthen coordination and cooperation among levels of

government.

Make consultation with stakeholders compulsory for the preparation

of new and amended laws and regulations.

Continue implementation of Regulatory Impact Analysis (RIA).

Use existing e-government strategies to support regulatory reform

and simplification efforts.

Development Agencies (DAs) could serve as

one-window shops, without radical reform of competences for the

issuance of licenses and permits.

information point for businesses, in close cooperation with business

associations with a local presence, such as TOBB, as well as with

Government agencies, such as KOSGEB and TBITAK, etc.

FDI promotion, with Investment Support Offices acting in close

coordination with ISPAT.

Increase the absorptive capacity of SMEs at the local level

Improve the regulatory environment for businesses

Improve access to information on regulatory requirements and government support programs

1Investment Climate Assessment

Chapter 1. CHALLENGES FACING THE TURKISH BUSINESS SECTOR

1.1 The global crisis is posing new challenges to the Turkish business sector. The external economic environ-ment for developing countries has deteriorated markedly since 2008. World economic growth in 2009 was nega-tive (-0.6 percent), with the Euro Area, Turkeys main export market, expected to experience a contraction in GDP of -4.1 percent.1 As a result, the demand for Turkish exports has fallen dramatically with serious consequences for industrial production. Exports fell by 23 percent in 2009 and industrial production by 9.6 percent compared with a year earlier. In addition to slowing demand for exports, capital flows to Turkey have fallen dramatically from USD 50.3 billion in 2007 to USD 14.7 billion in 20082 and risk premia have escalated significantly, as shown by the CDS spread for Turkey from 167 basis points end 2007 to 200 in late 2009 (Figure 1-1). During the period of high growth from 2002-07 Turkey relied heavily upon net capital inflows. The corporate sector now faces major challenges in continuing to attract external finance and in rolling-over its short term external debt, as shown by Figure 1-2.

Figure 1-2: Short-term external corporate debt in Turkey, million USD

Source: CBRT

Figure 1-1: 5-year CDS spreads, Jan 2007-Dec 2009

Source: Bloomberg

1 IMF World Economic Outlook Database, April 20102 Capital inflows including net errors and omissions, excluding change in official reserves and IMF credits (World Bank data).

2 Investment Climate Assessment

3 On September 16, 2009, the government announced its new Medium-Term program (MTP). The MTP was followed on September 18 by the more detailed Medium-Term Fiscal Plan. The MTP gives aggregate fiscal targets for the period 2009-12.

1.2 Effects on the growth prospects of the Turkish economy are likely to be durable. Turkeys economy con-tracted by 4.7 percent in 2009, and unemployment increased to 14 percent from 11 percent in the previous year. The Governments Medium-Term Program (MTP) sets out a realistic macroeconomic framework that, conserva-tively, foresees a rather slow recovery scenario.3 This mirrors projections for the world economy and for Turkeys major trading partners, and foresees a return to potential growth of the order of 5 percent only by 2012. This growth is associated with a decline in unemployment of only 1.5 percentage points from the peak of 14 percent in 2009. Economic activity is projected to recover weakly to 3.5 percent in 2010, 4.0 percent in 2011, and 5.0 percent in 2012. The growth process is expected to be led by the private sector, with an expected pick-up in private gross fixed capital formation to 8 percent in 2010.

1.3 Continued reform of the investment climate is key to mitigating the effects of the crisis and closing the in-come gap with more developed countries. The MTP outlines a post-crisis reform agenda for shared growth that follows the development axes established by the Ninth Development Plan for 2007-2013. Many of the planned ac-tions aim at making the investment climate more conducive to private sector led growth, based on the notion that the investment climate the set of location-specific factors shaping the opportunities and incentives for firms to invest productively, create jobs and expand, as defined in World Bank (2005) can significantly impact pro-ductivity, growth and economic activity. Important investment climate reforms contemplated in the MTP include further labor-market reform, tax administration reform, increased effectiveness of credit guarantees, expansion of education and vocational training and increased credit access for SMEs. Continued commitment to such re-forms is crucial to narrow the income gap between Turkey and more developed OECD economies, which, despite sustained economic growth since 2002, remains wide (Box 1-1).


Box 1-1: Turkeys Income GapWhereas Turkey has been successful since 2001 in securing a reasonable level of macroeconomic stability, convergence to the per capita income levels of OECD countries has been slow. In 2007, income per capita was 18 percent of the US level, up from 17 percent in 1960, while the gap relative to the EU15, as European coun-tries were converging to US levels, has actually widened, with income per capita relative to the average of the EU15 economies decreasing from 26.5 percent in 1960 to 21.6 percent in 2007.

The evolution of income per capita is driven by labor productivity and labor force participation (Figure A).4

Whereas low labor force participation appears to be the main driver of slow convergence in per capita in-comes (Panel 2), labor productivity convergence has also been slow, especially when compared to countries, such as Korea, that had similar levels of labor productivity and income per capita until the 1970s (Panel 1). Capital intensity and total factor productivity (TFP) are the drivers of labor productivity and are affected by the incentives to invest and innovate associated with the policy and institutional framework (the investment climate) in which the business sector operates.

Figure A

Source: Penn World Table Version 6.3

Source: WDI

4 Labor productivity is measured as real GDP per worker in 2005 constant prices, USD, as share of U.S. value. Labor force participation rate is measured as the proportion of the population ages 15 and older that is economically active: all people who supply labor for the produc-tion of goods and services during a specified period.


Box 1-2: Recommendations in key reform areas from the 2007 Investment Climate AssessmentRegulatory environment

Streamlining of business entry and exit Reform of the firm registration, licensing and inspections regimes Reform of taxation Reform of access to land for business Streamlining of public institutions involved in customs procedures

Labor market and skills Reform of the fiscal and institutional framework governing labor Increasing the flexibility of labor market regulations Reform of the education and training system, in order to match workers skills with the needs of en-

terprisesInnovation, technology adoption and ICT

Legal and institutional reform of the National Innovation System Reform of the IPR legislation and alignment with the EU Reform of the telecommunications sector

Adoption of quality standards and certification Improving the legal and institutional framework governing firm access to and enforcement of stand-

ards Access to finance and corporate governance

Strengthening financial reporting and credit information on firms Increasing the use of collateral for lending transactions Enhancing the legal and institutional framework for corporate governance

Access to infrastructure Institutional reforms and capital investments in the electricity and transport sectors Institutional reforms affecting the availability of trade-related services

1.5 Both in 2004-05 and 2008-09 total factor productivity in Turkey is highly correlated with the investment climate. Analysis of firm-level data collected in 2008 and 2009 and presented in this report finds a strong as-sociation between firm-level productivity and the investment climate, confirming the results of the 2007 Invest-ment Climate Assessment based on 2004 and 2005 data. Both assessments pinpoint reforms aimed at improving the business environment by analyzing a number of key economic variables productivity, employment, wages, exports and FDI in relation to a number of investment climate variables. The 2007 study also identified labor productivity as the most critical challenge for the convergence of Turkeys income per capita, showing how it accounts for 80 percent of the per capita income gap between Turkey and the EU-15. Labor productivity improve-ments, in turn, are achieved by increasing: (a) capital per laborer, that is, investments in physical assets such as machinery, infrastructure, and buildings, and (b) TFP, the residual contribution from factors such as technology adoption, labor skills, educational achievement, and competition among and management of firms.

1.4 The objective of this report is to explore empirically the role of the investment climate in determining the business sectors economic performance. The report uses the information contained in a 2008-2009 enterprise survey of Turkish enterprises to estimate the effects of the business environment on firm-level productivity and various measures of enterprise performance, such as the ability to generate employment or the probability to ex-port and attract foreign capital. The main advantage of this type of surveys is that information is gathered directly from firms managers on the quality of the physical and institutional infrastructure, as well as on basic economic performance measures at the firm level. Improved business sector performance, in turn, translates into aggre-gate economic improvements, with increased firm-level productivity and capital intensity translating into higher aggregate productivity, thus contributing to the reduction of income per capita differences.


1.6 Investment climate reforms implemented since 2007 acquire renewed significance in the wake of the re-cent crisis. Consistent with the Ninth Development Plan (2007-2013) and with the recommendations of the pre-vious investment climate report (Box 1-2) the Government has undertaken a number of structural reforms in several areas of the business environment. Notable measures have included (i) tax simplification accompanied with a reduction of the corporate income tax rate from 30 percent to 20 percent; (ii) streamlining of procedures for firm start-up; (iii) adoption of a modern FDI promotion strategy coupled with the restoration of legal certainty for land ownership by foreigners; (iv) simplification of customs procedures and e-transformation of customs offices with the introduction of a Computerized Customs Activity System (BILGE); (iv) planned enactment of a new Com-mercial Code improving corporate governance, as well as the protection of investors and minority shareholders rights; (v) reform of R&D legislation aimed at increasing the private sector share of R&D; (vi) first phase of labor market reform geared to lower non-wage labor costs, accompanied by actions to strengthen the development of a competency-based skill-building system and continued reforms of curricula in secondary school. These reforms acquire renewed significance for the business sector in the current macroeconomic environment.

1.1 Macroeconomic Setting

1.7 In the aftermath of the 2001 crisis sound macroeconomic management and abundant global liquidity un-derpinned steady growth. After a banking crisis in 2001 that led to a sharp recession and a restructuring of the financial sector, GDP growth averaged nearly 7 percent per annum between 2002 and 2007 (Table 1-1). An impor-tant engine of growth was private investment, in part driven by large capital inflows, which contributed to trebling Gross Fixed Capital Formation by the private sector between 2002 and 2008 (from TL 43 billion, or less than USD 30 billion, to TL 152 billion, or USD 117 billion).

1.8 Sustained GDP growth failed to make a visible impact on the unemployment rate inherited from the 2001 crisis. Capital and exports intensive economic growth, combined with a rapidly growing and young labor force (an estimated 700,000 workers join the labor force each year), led to a decline in labor force participation, from 49.6 in 2002 to 46.9 percent in 2008, compared to an OECD average of 70.8 percent.5 Low labor force participation in Tur-key reflects particularly low participation among the female population. Only 26.7 percent of women participated in the labor force in Turkey in 2008, compared to an OECD average of 61.3 percent and 65.3 percent of women in EU15.

1.9 Since 2008, the global turmoil has placed strains on Turkeys economy. Turkish manufacturing has been hard hit by the drop in global demand, with the effects felt in terms of unemployment, economic hardships at the household level and poverty. The Turkish economy had already begun to slow down from 2007. Annual growth in 2007 fell to 4.7 percent from 6.9 percent in 2006. This slowdown was reflected in, among other things, a build-up of inventories by Turkish firms in the order of 2 percent of GDP between the first quarter of 2007 and the third quarter of 2008. Unemployment has also risen sharply. After remaining stable at levels below 10 percent for sev-eral years, the unemployment rate in 2009 averaged 14 percent.

1.10 The current account deficit and inflation persistence have now diminished in immediate importance while the fiscal challenge has increased. Turkeys current account deficits are not expected to return to pre-crisis levels in the medium term, although higher oil prices could still pose a challenge. Inflation persistence appears to have receded, with inflation in 2009 still below the inflation target. The monetary framework has not been altered and will continue to pursue unchanged inflation targets (6.5 percent in 2010 and 5.5 percent in 2011), in line with the framework in place since 2006. On the other hand, public debt and the budget deficit have increased as a re-sult of the global crisis the budget deficit stands at -2.1 percent of GDP in 2009 compared to 3.1 percent in 2007 and public sector debt at 7.8 percent. This has sharpened the challenge to fiscal management and underlined the central importance of the MTP and the associated budgets to reduce economic uncertainty.

5 OECD Employment Outlook (2009) and World Bank calculations.


Table 1-1: Turkey: Key Economic Indicators, 2002-2009

Source: CBRT, IMF, OECD, SPO, Turkstat, World Bank.1 May 2009


1.11 Concerns over external financing were prominent before and as the global crisis hit. Since the 2001 cri-sis, the Turkish Treasury has pursued a conservative strategy of financing itself largely using domestic currency debt instruments, removing much of the foreign exchange risk from the public debt portfolio. After declining in 2001-05, the external debt-to-GDP ratio increased by more than 4 percentage points in 2006, driven by corporate sector external borrowing. External debt-to-GDP stood at 43.9 percent at end-2009. However, the subsequent sharp contraction in economic activity has reduced the overall need for foreign financing in 2009, while at the same time most large corporations have either retained market access or been able to draw on their own FX holdings. Turkeys foreign financing needs have fallen but will remain high in 2010-12. The current account deficit is contracted from USD 41.9 billion in 2008 to USD 14 billion in 2009. A sharp contraction in domestic investment has cut the demand for medium- and long-term (MLT) borrowing by the private sector, which has been reflected in lower rollover ratios. Repayments are also lower beyond 2010. The overall financing gap was USD 6 billion in 2009, and thus should easily be financed through reserves, which were USD 74.8 billion in 2009. Turkey should be in a position to attract further FDI given privatization efforts and the potential for mergers and acquisitions. Similarly, net portfolio flows are assumed to be positive, consistent with continued Eurobond issuance and the potential of the domestic capital market to raise financing. Projections on capital inflows are of course conserva-tive if compared to the pre-crisis period of record global liquidity.

Figure 1-3: GDP by sector in Turkey, 1998-2009, current prices, billion TL

Source: WDI

Figure 1-4: Value added as share of GDP by sector, 2008

1.12 The services sector has not only been the fastest growing in the past decade, but is also hit by the eco-nomic crisis to a lesser extent than the manufacturing sector. Since 1998, the services sector has grown rapidly, with an average 30 percent annual growth and increased relative contribution to GDP from 51 percent in 1998 to


Figure 1-5: Turkeys exports by industry 2000-2009

Figure 1-6: Turkeys exports by partner country, 2000-2009

62 percent in 2008 (Figures 1-3 and 1-4). Meanwhile, the industry sector in Turkey remains small, both in relation to the domestic services sector as well as when comparing to other emerging economies. Merely 28 percent of Turkeys GDP came from the manufacturing sector, with a real decrease from USD 58 billion in 2008 to USD 53 billion one year on.

1.13 Following high export growth since 2002, changed global demand conditions appear to have affected the destination of Turkish exports. Turkish exports averaged 20 percent annual growth in the period 2000-2008 (Table 1-1). Exports continue to be dominated by manufactured goods as well as machinery and transport equip-ment, each taking up 28 percent of total exports, with a total value of USD 4.8 billion in 2009. The machinery and transport equipment sector in particular has increased its relative share of exports, from 21 percent in 2000. For a considerable time, the majority of Turkish exports have been targeting the EU-market, with the relative share of total exports going to the EU27 region averaging 58 percent in the years 2000-2007. This flow has however expe-rienced a significant drop to 46.3 percent in 2009. A similar negative development has been noticed in exports to the United States, with a decline from 11.3 percent in 2000 to 3.1 percent in 2009. Instead, the shares of exports to the Middle East and Africa have increased from 8 to 16.5 percent and from 4.9 to 9.9 percent respectively in the same period.

Source: OECD


1.14 The technology content of Turkish exports remains dominated by low-technology manufactures with recent increases in medium- and high-technology products.6 Turkeys medium- and high-technology exports have increased significantly, with real values reaching 26.5 billion in 2008, a 360 percent increase since the turn of the century. Nonetheless, exports with higher technology content are a relatively low contributor to Turkeys GDP, averaging 3.4 percent for the past five years. Medium- and high-technology imports on the other hand contributed with 8 percent of GDP in 2008, creating a substantial trade deficit for higher technology goods and suggesting the need for further actions in reforming export flows from Turkey.

1.15 Inward FDI remains weak in an international comparison, with a recent shift away from telecommu-nication and finance. Net inflows of FDI into Turkey reached USD 7.6 billion in 2009, an inflow well below the USD 15.4 billion recorded in 2008 as well as the pre-crisis level in 2007 (USD 19.1 billion). The sharp decline is to a large extent a combination of the negative impact that the financial crisis has had on overall international investment flows and the stagnation of the large-scale privatizations that took place in Turkey in the years 2005 and 2006.7 Most FDI inflows during this period were in the financial services and telecommunications sectors. Three years on, the relative significance of FDI in these industries has diminished and instead, electricity, gas and water supply as well as manufacturing hold the largest shares of investments from non-residents (33 percent and 28 percent respectively). Within manufacturing, the most significant increase in FDI in the first ten months of 2009 compared to the same period one year prior was in the chemicals and motor vehicles sectors (from USD 89 million to USD 306 million and USD 64 million to USD 208 million respectively). Meanwhile, the manufacturing industry has experienced a decline of FDI inflows into the sectors other manufacturing (USD 1,689 million to USD 382 million) and food and beverages (from USD 939 million to USD 120 million).8 The recent adoptions of a modern FDI promotion strategy by the Turkish government, along with the restoration of legal certainty for land ownership by foreigners, are steps in the right direction to improve investment levels in the country.

Figure 1-7: Exports by technology level, share of GDP, 1996-2008

Source: UN COMTRADE, staff calculation

6 Technology level of exports is here defined according to UNIDOs methodology classifying manufactured goods into four sub-categories: resource-based, low-, medium- and high-tech exports, based on the Standards International Trade Classification (SITC) Revision 3. Exam-ples of resource-based goods include: beverages, cut gems and glass, petroleum/rubber products, prepared meats/fruits, vegetable oils and wood products. Examples of low-tech manufactures include: clothing, footwear, furniture, headgear, leather manufactures, plastic products, pottery, simple metal parts/structures, textile fabrics, toys, and travel goods. Examples of medium-tech manufactures include: chemicals and paints, engines, fertilizers, industrial machinery, iron, motors, pipes/tubes, plastics, ships, switchgear, synthetic fibers, vehicles and watches. Examples of high-tech manufactures include: aerospace, cameras, office/data processing/telecom equipment, optical/measuring instruments, pharmaceuticals, power generating equipment, transistors, turbines and TVs. For detailed technological classifications of exports, see UNIDO (2009).

7 Privatization implementations in Turkey in 2005 and 2006 totaled USD 16.3 billion in domestic and international sales (Undersecretariat of Treasury)

8 See Undersecretariat of Treasury, International Direct Investment Information Bulletin (December 2009)


1.2 Effects of the Global Crisis on the Corporate Sector: Preliminary Evidence

1.16 Four factors appear to have combined to increase the impact of global events on Turkey.9 Although none of these factors is entirely specific to Turkey, their magnitudes and combination go a long way towards explaining the impact of global events on the real economy in Turkey.

1.17 First, the speed of the economic expansion in the preceding five year period had led to a marked inventory and capital build-up in Turkish manufacturing, with inventories accounting for fully one quarter of aggregate GDP growth in 2007 and the first three quarters of 2008, and capital formation growing at an average of 15.5 percent per year in 2002-2007.

1.18 Second, the high level of uncertainty experienced by all emerging markets during the crisis was com-pounded in Turkey by perceived vulnerability to the scarcity of external financing. Turkeys most notable macr-oeconomic challenge in the pre-crisis period, the current account deficit (averaging more than 5 percent of GDP over the five years from 2004-08), had been financed by increasing debt-creating flows to the private sector. By 2009, Turkish corporations needed to roll over total debt amortizations of the order of USD 100 billion. About a third of this total was not true foreign exposure, since it captured offshore lending by Turkish banks to their Turkish clients, and a further (hard to quantify) portion was secured by assets held overseas by Turkish nation-als. Nonetheless, uncertainty over the magnitude of this exposure and its effect on the economy was high at the outset of the crisis.

1.19 Third, Turkeys banking system, having weathered several earlier crises, was quick to cut lending to all but the most creditworthy borrowers. There was no visible slowdown in credit intermediation to the private sector prior to September 2008. Domestic credit then retrenched significantly in late 2008. Turkeys domestic fi-nancial system, although it is well-capitalized and prudential regulations meet modern standards, is shallow for an economy of Turkeys size. After surviving crisis and restructuring in 2001-02, the Turkish banking sector was understandably conservative faced with the high uncertainty of late 2008 and early 2009.

1.20 Fourth, the composition of Turkeys exports exacerbated the demand shock. Turkeys exports concen-trated in hard-hit sectors such as automotive vehicles, consumer durables, and capital goods and machinery made it vulnerable to a dip in export demand. Export volumes in the first half of 2009 were down 11 percent and this combined with price effects to create a loss in export earnings of more than a third (y/y). Exports had continued to perform strongly right up to the crisis: FOB export growth in 2008 (y/y) was 23 percent while imports (CIF) rose by 18 percent. Following the crisis, imports have contracted even faster than exports: as a result, net exports have contributed positively to GDP growth since the onset of the crisis.

Figure 1-8: FDI net inflows/GDP, 2009

* 2009 est. Source: IMF International Financial Statistics

9 Restoring Equitable Growth and Employment Programmatic Development Policy Loan (REGE-DPL), draft December 14, 2009


1.21 A crisis impact survey fielded by the World Bank confirms that the global economic and financial crisis has had a significant impact on the Turkish enterprise sector. The Enterprise Financial Crisis Assessment Sur-vey (EFCAS) was conducted in the summer of 2009 in six countries including Turkey (Box 1-3). Its objective was to identify the channels through which the global economic crisis is affecting the corporate sector and how firms have reacted to the shock.

1.22 The main channel through which Turkish firms have been affected is a drop in demand. While a large majority of firms across countries, including Turkey, declared contraction in demand, the most important effect of the crisis on their business, the share of enterprises citing a combination of supply-side factors in Turkey no-tably input costs, debt levels and access to credit (about 19 percent) was one of the highest among the surveyed countries.

1.23 Reported declines in volumes of sales between 2008 and 2009 have been substantial. Turkish firms reported a significant drop in sales amounting to an average 38.7 percent in June 2009 relative to June 2008, as shown in Figure 1-9. The decline presents wide sectoral variations; with fabricated metal products (32.3 percent) and garments (31.3 percent) being hardest hit compared to the food and textiles sectors that have been the least affected with a drop of 13.2 percent and 16.6 percent respectively. This development is supported by the industrial turnover index for the Turkish manufacturing sector, when measured in the same time period. The sub-sectors of manufacturing showing most significant reduction in industrial turnover coincide with sectors in the survey

Box 1-3: The Enterprise Financial Crisis Assessment Survey (EFCAS)

The Enterprise Financial Crisis Assessment Survey (EFCAS) was carried out in June and July 2009 and covers 1,686 enterprises from Bulgaria, Hungary, Latvia, Lithuania, Romania, and Turkey. In all countries, the EFCAS covers a subsample of the 2008-2009 Business Environment Enterprise Survey (ES), carried out by the World Bank and the European Bank for Reconstruction and Development in 30 economies of Europe and Central Asia. Turkeys EFCAS sample is composed of 514 enterprises.

The ES and EFCAS samples are representative of the universe of non-agricultural private sector formal firms (with at least five employees) in the economy for groups D, F, G, H, I and subgroup 72 of the United Nations Statistics Division ISIC Rev. 3.1. Results are estimated through the application of sampling weights that de-note the inverse of the probability that the observation is included due to the sampling design to the original data. Therefore, results are representative of the non-agricultural private economy in Turkey.

Figure 1-9: Effects of the Crisis

Source: EFCAS


reporting largest drop in sales (basic metals, fabricated metal products and non-metallic mineral products). The overall decline notwithstanding, a significant proportion of firms (about 15 percent) reported increases in sales (25.4 percent on average) in the same period, which may be a first indication that the crisis may be accompanied by structural adjustments, with a redistribution of market shares across firms.

1.24 Foreign currency exposure and short term maturity highlight potential risks for the corporate sector. Confirming the accumulation of foreign debt and the prudent attitude of the banking system towards lending in the wake of the crisis, survey findings in the summer of 2009 indicate that the share of foreign currency debt in the corporate sector is considerable (22 percent), while debt maturity is concentrated in the short-term (66 per-cent).

1.25 Debt restructuring has been the predominant form of adjustment on the part of firms. As a response to the current liquidity constraint, about 33.7 percent of Turkish firms delayed payments to tax authorities and sup-pliers. At the same time, 45.9 percent of surveyed companies attempted to restructure their debt while only 0.2% of firms have filed for insolvency or bankruptcy. A large proportion of firms (25.4 percent) benefited from some form of state-aid.

Figure 1-10: Sales in the corporate sector: June 2008 - June 2009

Source: EFCAS

Source: EFCAS

Figure 1-11: Structure of corporate liabilities


Figure 1-12: Firms survival strategies, forms of adjustment

Source: EFCAS


References

Organization for Economic Cooperation and Development (OECD). 2009. OECD Employment Outlook 2009 Tack-ling the Jobs Crisis. Paris

Republic of Turkey State Planning Organization. 2006. Ninth Development Plan 2007-2013. Decision No: 877

Republic of Turkey State Planning Organization. 2009. Medium Term Programme 2010-2012. Official Gazette No. 27351, 16.09.2009

Republic of Turkey, Undersecretariat of Treasury, International Direct Investment Information Bulletin (December 2009)

United Nations Industrial Development Organization (UNIDO). 2009. Industrial Development Report 2009 Break-ing In and Moving Up: New Industrial Challenges for the Bottom Billion and the Middle-Income Countries. Vienna

World Bank. 2005. World Development Report 2005: A Better Investment Climate for Everyone. Washington, DC

World Bank, Poverty Reduction and Economic Management, Turkey Country Management Unit, Restoring Equi-table Growth and Employment Programmatic Development Policy Loan (REGE-DPL). Draft December 14, 2009


Chapter 2. EVOLUTION OF THE TURKISH INVESTMENT CLIMATE

2.1. Continued reforms of the investment climate are required to ensure that the Turkish enterprise sector remains competitive in a more challenging global environment. Since 2001 the Turkish Government has com-plemented sound macroeconomic management with more or less comprehensive reforms of various aspects of the investment climate including taxation, business registration, customs, FDI promotion, R&D and labor legislation. Since the second half of 2007, changed global conditions characterized by declining domestic and global demand, reduced international capital flows and tighter credit conditions have already taken their toll on the Turkish business sector, as outlined in the preliminary evidence reported in the previous Chapter. Whereas the depth and duration of the aftereffects of the global turmoil are still uncertain, a number of investment climate areas emerge as crucial to make the Turkish business sector more resilient to future shocks and more competi-tive both domestically and internationally. As argued in this report, these are related to facilitating the growth of SMEs, intensifying knowledge flows to Turkish firms, and equipping policymakers with a system capable of ensuring consistent regulatory quality.

2.1 The Investment Climate and Business Sector Performance

2.2. Business sector performance is associated with the quality of the investment climate. Whereas Turkey has been successful since 2001 in securing a reasonable level of macroeconomic stability, convergence to the per capita income levels of OECD countries has been slow. In order to help close the gap in income per capita, it is essential to tackle the underlying policy and institutional framework that constitutes the investment climate conditions in which the business sector operates. Econometric analysis of firm level data collected in 2008 and 2009 (Box 2-1) confirms that productivity, job creation, the ability of exporters to be competitive on international markets and the attractiveness of the economy for foreign investment are significantly associated with the qual-ity of the investment climate. Similar results were obtained by analyzing data of a previous survey, conducted by the World Bank in 2004 and 2005 (World Bank 2007). In addition, the analysis shows that firms with large market shares tend to cope better with the bottlenecks imposed by the investment climate and are even able to benefit from its more positive aspects. The analysis is based on the robust methodology summarized in Table 2-1.

Table 2-1: Summary of econometric methods


Box 2-1: The 2008-2009 Enterprise Survey

This report draws its data from a core enterprise survey that provides a standardized way of measuring and comparing investment climate conditions. Private contractors conduct the Enterprise Surveys on behalf of the World Bank in Turkey and in other countries globally, utilizing a standard instrument that enables com-parisons of investment climate conditions across different regions within a given country, as well as of a country with its peers globally.

Data were collected in Turkey in between April 2008 and January 2009 as part of the fourth round of the Business Environment and Enterprise Performance Survey (ES), a joint initiative of the European Bank for Reconstruction and Development and the World Bank. The objective of the survey is to obtain feedback from enterprises on the state of the private sector as well as to help build a panel of enterprise data that will make it possible to track changes in the business environment over time, thus allowing, for example, impact assessments of reforms. Through interviews with Turkish firms in the manufacturing and services sectors, the survey assesses the constraints to private sector growth and allows estimation of statistically significant business environment indicators that are comparable across countries, across 5 Turkish regions, across in-dustries and firms of different sizes.

The sample for the Turkey survey was selected using stratified random sampling. The whole population, or universe of the study, is the non-agricultural economy. Three levels of stratification were used in Turkey: type of industry, firm size, and geographic region. The universe was stratified into 11 manufacturing industries, 1 retail industry and 6 residual industries. Size stratification was defined following the standardized definition for the rollout: small (5 to 19 employees), medium (20 to 99 employees), and large (more than 99 employees). For stratification purposes, the number of employees was defined on the basis of reported permanent full-time workers. This seems to be an appropriate definition of the labor force since seasonal/casual/part-time employment is not a common practice, except in the sectors of construction and agriculture. Regional strati-fication was defined in 5 regions. These regions are Marmara, Aegean, South, Central Anatolia and Black Sea-Eastern. The Turkey sample contains panel data. The wave 1 panel consisted of 1325 establishments interviewed in 2005. Note that there are additional variables for location (city), industry, and size that reflect more accurately the reality of each establishment.

Table 2-2: The ES 2008-09 Sample


The nature of the sample allows exploration of the effects of the investment climate over time and across regions. Econometric analysis uses the manufacturing subset of the sample (903 establishments). Of these, 425 panel establishments were present in the 2005 survey. This allows assessing the impact for firm perform-ance of the numerous investment climate reforms that have occurred between 2005 and 2008. Furthermore, the regional stratification of the sample will allow drawing statistically significant inferences of the effects of the investment climate across five broadly defined regions (Table 2-2). The regions are sufficiently diverse in terms of institutional settings, economic structure, income per capita and product specialization to warrant a meaningful assessment of the investment climate at the regional level.

The source of the sample frame was twofold. Universe estimates were taken from the TOBB database which contains a full list of establishments in manufacturing sectors. TOBB refers to the Union of Chambers and Commodity Exchanges of Turkey. Universe estimates for service sectors were taken from the Statistical Insti-tute of Statistics (SIS) with additional information based on SIC code from the Turkish Studies Institute (TSI). Comparisons were made between estimates in TOBB and SIS to establish that the two sources are compara-ble and hence can be used side by side.

Three additional modules have been added to the ES survey with interviews of over 800 manufacturing firms in July-August 2009. These modules address (i) the effects of the current global financial crisis referred to in Chapter 1; (ii) firm-level innovation referred to in Chapter 2 and (iii) production networks used in Chapter 4.

2.3. Access to finance is perceived as the most serious obstacle by Turkish firms, a negative development since 2005 and a likely consequence of the credit squeeze in conjunction with the 2008-2009 global crisis. Fig-ure 2-1 depicts average firm responses when asked which elements of the business environment represent the biggest obstacle faced by the establishment. Despite the objective improvement in access to credit documented below, it is noticeable that a majority of firms are obstructed by access to finance in their business (26 percent), a likely effect of the more restrictive credit conditions in the aftermath of the 2008-2009 global economic and finan-cial crisis. Tax rates (18 percent) and political instability (18 percent) rank second and third, while other important factors are informal competition and an inadequately educated workforce (15 and 9 percent respectively). Moreo-ver, firms opinion has shifted since 2005, where tax rates were identified as the main obstacle to operations and access to finance was depicted as the second most relevant.10 Scrutinizing the data by firm size, access to finance as an obstacle becomes even more evident. 29 percent of SMEs consider finance to be the chief obstacle to busi-ness. As will be discussed later in this Chapter, the econometric analysis has shown that many positive effects on productivity, as well as other key performance measures, derive from a sound financial system and wide access to finance for firms. It is therefore essential to recognize the negative development that the survey results present when addressing access to finance in relation to other key variables.

Productivity

2.4. In 2008 the investment climate continues to be strongly associated with productivity. Total factor pro-ductivity (TFP) is an important driver of aggregate GDP growth in Turkey (World Bank, 2007). Several factors may influence the evolution of TFP, in other words the level of efficiency and technological content of production. Amongst these, the investment climate related to the regulatory environment, the availability of skilled labor, the system of incentives to develop new products or experiment with novel production techniques, the ease of access to external finance plays a critical role. This is confirmed by analysis of the 2008 enterprise survey of Turkish manufacturing enterprises. Based on the concept of demeaned TFP, defined as the share of aggregate log-TFP associated exclusively with the investment climate, and normalizing aggregate log-TFP to be 100, an estimated 31.4 percent of TFP is associated with the various aspects of the investment climate and the remaining 68.6 percent with other factors.11

10 Due to methodology differences in 2008 and 2005, a comparison over time is only possible for the two largest obstacles, as perceived by Turkish firms.

11 See Annex 2-A.


2.5. The productivity of Turkish manufacturing is, overall, negatively influenced by the investment climate. Figure 2-2 compares the Olley and Pakes (1996) demeaned decomposition of Turkeys TFP with those of other countries, including Turkey in 2005, for which similar estimates are available. Both in 2008 and in 2005, the ag-gregate log-TFP of Turkish manufacturing industry is, overall, negatively influenced by the investment climate. This does not imply that Turkey is less productive than other countries but that investment climate conditions, on balance, are less conducive to the efficient use of resources. In other words, negative investment climate fac-tors tend to dominate over positive ones, indicating that the investment climate available for doing business is preventing the economy from using resources as efficiently as it could.

Figure 2-1: Major obstacle levels for firms in Turkey

Figure 2-2: The IC and TFP: Cross-country comparison


Source: Staff calculations based on Escribano et al. 2009. See Annex 2-A for details

2.6. The impact of the investment climate is asymmetrical with the productivity of larger firms positively associated with current investment climate conditions. The Olley and Pakes method allows decomposing aggre-gate TFP into an average component and an allocative efficiency component. The former reflects the productivity of the average firm, while the latter provides a measure of the efficiency with which resources are distributed among producers. Both in 2008 and 2005, the Turkish investment climate affects aggregate productivity mostly by negatively affecting the average firm. However, in 2008 the effect of the investment climate on the allocative efficiency component is positive, partially compensating the increased negative effect on the average firm. In other words, the positive effects tend to be concentrated in conceivably larger high market share firms and the negative effects in low market share ones. As discussed in Chapter 3, the need to increase average efficiency emphasizes the importance of policy and institutional mechanisms that stimulate the expansion of small- and medium-sized enterprises.

2.7. Improved allocation of resources appears as the main driver of increased aggregate productiv-ity since 2005. Aggregate log-TFP of the manufacturing sector grew from 2.22 to 2.42 between 2005 and 2008


(Figure 2-3).12 The increase is driven proportionately more by i

Turkey Investment Climate Assessment: From Crisis to Private Sector Led Growth

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