STABILITY VS. THE CANCER OF INFORMALITY

UNCLAS SECTION 01 OF 03 ISTANBUL 002095

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E.O. 12958: N/A
TAGS: EINV BEXP ECON ECIN OECD TU
SUBJECT: STABILITY VS. THE CANCER OF INFORMALITY

REF: PARIS 7395

NOT FOR INTERNET DISTRIBUTION CONTAINS REPORT OF OECD MEETING.


1. Summary: On November 6, at the Organization of Economic
Cooperation and Development (OECD) Global Forum on
Investment, an OECD Country Roundtable examined Turkey's
recent experience with strategies to enhance the investment
environment and the dramatic improvement in foreign
investment in Turkey over the last five years. The main
focus was on the impact of regulatory reform on Turkey's
investment climate. The session began with a series of
welcoming remarks, the highlight of which was a speech by
Economics Minister Ali Babacan which was televised live by
most major Turkish networks. The roundtable itself consisted
of remarks by Karl Sauvant, Columbia School of Law; Andrew
Vorkink, World Bank Country Director, Cavit Dagdas, Deputy
Undersecretary of Treasury, and Ferit Sahenk, Chairman of
Dogus Holding, followed by a short question and answer
period. End Summary.

Stability, Stability, Stability
--------------


2. Economics Minister Ali Babacan repetedly stressed the
need for both economic and poitical stability as the
indispensable foundationfor all of the conditions needed for
a positive nvestment climate. He attributed mch of
Turke's progress over the last for year to a ruing pary
with a strong parliametary majority able to implement stable
and realistic macroeconomic policies. Babacan, who is also
Turkey's chief EU accession negotiator, described the
long-term future of Turkey as linked to full EU membership.
This vision has been a primary focus over the past four years
and will be a defining force for the next five to fifteen
years, he noted, describing the level of predictability
provided by Turkey's EU anchor as the primary difference
between Turkey and other emerging markets.


3. Turkey's economy has improved greatly over the last four
years with greater than 7.5% annual growth paralleled by
diminishing inflation for most of the period. Babacan
explained that the Government of Turkey (GOT) had focused on
bringing high, unpredictable inflation under control and on
de-linking growth and inflation. Turkey missed its inflation
target this year, but was focused on meeting its 4% target
for 2007. He explained that the GOT recognized that tight
monetary policy and budgetary discipline were vital to
macroeconomic stability and noted that Turkey had achieved
the first of the Maastricht Criteria (budget deficit under
3.5%.) Declining interest rates contribute to the reduction
of the debt burden with debt to GDP ratios of 90% in 2000
falling to 55% in 2005 and 50% in 2006.


4. Babacan described several areas in which structural
reforms had contributed to macroeconomic success. Banking
sector reform undertaken with the support of the IMF has
greatly improved the legal framework as well as regulation
and put Turkey on the path to Basel II. Social Security
remains a very serious problem, he acknowledged, with both
legal reforms as well as a restructuring of the health
insurance system yet to be completed. The GOT is working
with the World Bank on reforms that would reduce
unemployment. These reforms must parallel the EU accession
process and should include both the education system and the
manpower market. Tax reform is ongoing with corporate taxes
recently reduced to 20%. Privatization has seen more
reforms in the past 4 years than ever before he claimed.
Finally the GOT is working to simplify regulations related to
founding companies, reducing red tape and national treatment
of joint venture companies that should make Turkey a more
attractive location for foreign direct investors.

Quality, Competition, the Cancer of Informality and Other
Roundtable Topics
-------------- --------------


5. Sauvant made a general presentation on world FDI noting
that over the next four years (2006-2010) annual flows should
stabilize in the region of $1.2 - $1.4 trillion with inflows
to emerging markets hovering in the range of $410 - $430
billion during the same period. This scenario has important
implications for Turkey and other emerging markets in three
areas: regulation and institutions, incentives and the
nature of FDI. With FDI flows more or less stable in the
near term regulatory competition is likely to compete. As
FDI regimes become more similar quality will become
increasingly important, particularly in the area of
post-investment services and administration. More
sub-national entities will offer incentives with the
attendant possibility of "incentive wars." Governments must
rationalize internal competition at the national level and
focus on incentives that will add value ("quality
incentives") not just to the foreign direct investor but also
to local firms in the surrounding area, such as
infrastructure improvements. Finally Sauvant stressed the
need for emerging markets to attract quality FDI, in other
words FDI that contributes to economic development such as
tech intensive higher-value-added FDI in manufacturing and
services.


6. Vorkink discussed steps to improve Turkey's investment
climate, noting even if Turkey sustains FDI at $15 billion
per year, Turkey will still be receiving less than 3% of GDP
in FDI, less than key competitors and what is needed to
sustain growth. He noted that privatization as well as
mergers and acquisitions in the financial sector are not a
sustainable source of FDI in the medium- to long-term and
that competition for greenfield investment is key. Turkey
must grow faster than EU countries to converge with EU income
levels and will need to invest 8-10% of GDP to sustain that
level of growth, he argued. At the same Turkey needs FDI to
finance its chronic current account deficit. There is room
for improvement and the GOT is considering a program that
would make many of the necessary reforms, he noted.


7. Vorkink described a broad challenge stemming from "the
cancer of informality." Vorkink described a workforce with
over half of all participants (53%) in the informal sector.
This is damaging to both the formal sector, which is taxed to
provide government services to the informal sector, as well
as to the informal sector, which is consistently less
productive because enterprises are small-sized, cannot
benefit from economies of scale and lack access to financial
markets. A large part of public sector expenditures are
non-discretionary and produce low returns (debt serve, public
sector wages, social security) making it difficult for the
government to lower taxes. Vorkink argued the only way out
of this vicious cycle is attract more FDI through fiscal
reforms, improvements to the investment climate, labor market
reform, increasing financial sector efficiency and
competitiveness, as well as fostering innovation and
improving technology absorption. Vorkink singled out
educational reform as Turkey's single most important reform
both for the EU and for attracting FDI.


8. Dagdas returned to the themes of stability and
predictability as enunciated earlier by Minister Babacan.
Noting that competition would increase within emerging
markets he stressed the need for both economic and political
predictability as well as an investor friendly legal
structure. He cited the GOT's ongoing economic and
structural reform program and noted that the GOT worked
closely with the private sector, mainly industry groups and
chambers of commerce to vet laws and regulations prior to
their introduction. He expressed great interest in the OECD
Policy Framework for Investment (PFI),the subject of the
sessions immediately following the Turkey Country Roundtable.
He noted that adherence to the PFI would involve a
restructuring of how the GOT looks at the investment climate
because the PFI incorporates infrastructure, public
governance and responsible business conduct while the current
GOT structural reform program does not.


9. Sahenk stressed the tremendous change in mindset that had
occurred in Turkey as it chose to embrace globalization and
"be a part of the world." Turkey has adopted two very
challenging reform programs, he explained, linked to the EU
accession process and a very difficult IMF program. These
reforms have established regulatory bodies, made the Central
Bank independent and implemented changes that affect the
entire social structure. Meanwhile, the reduction of
inflation and interest rates means that investors can focus
on the real economy in a way that was not possible in the
90's. He noted that political and economic stability was
vital but that Turkey still had a long way to go. Citing the
automotive sector as an example, he explained that
multinational companies now use Turkey as a manufacturing hub
not just for the region but for the world. In 1980 Turkey's
annual vehicle production capacity was approximate 50,000
vehicles. Today annual production capacity is 1, 260,000
vehicles. Turkey is a young, dynamic country with a
"demographic gift" but it must educate youth and create jobs.
If it succeeds, Turkey will be a regional economic power,
Sahenk argued. Turkey is an export-oriented, industrial
society with a rapidly developing information society, but
the GOT needs to develop a 5 - 10 year strategic plan that
focuses on the strengths that come from a young population
and strong productive capabilities and identify potential
export markets and attract high quality FDI.

Comment
--------------


10. Turkey has indeed made remarkable progress since the
2001 financial crisis. Attracting enough FDI to sustain
growth remains a challenge. Over the next few years the
massive post-crisis privatization campaign will wind down and
the rapid pace of mergers and acquisitions in the financial
sector will cool off. In order to sustain annual FDI at the
better than $15 billion figure cited by Vorkink in his
presentation the GOT must look long and hard at the steps it
needs to take to become globally competitive for
high-quality, greenfield FDI. End Comment.

JONES