34422 T U R K E Y Economic Reform & accession to the European Union Editors Bernard M. Hoekman · Sübidey Togan N°24 N°04 AZER- OF. BAIJAN AZER. TION ISLAMIC REP IRAN E° 44 ARMENIA Hakkari IRAQ FEDERA Igdir Van Kars Agri GEORGIA aruK Lake anV nak Sir Ardahan Bitlis t E° tvin sarA Siir 42 RUSSIAN Ar Mus Tigr si Erzurum Batman huroÇ lö taruM Mardin Rize t BingölBing Diyarbakir Baybur rabzonT Erzincan fa ARAB GümüshaneüGshaneüm unceliT Sanliur tariF Elazig REPUBLIC Giresun ¸ Adiyaman setarhpuE E°8 Ordu SYRIAN Malatya Kelkit Sivas Gaziantep Kilis okatT Samsun E3°6 kerekeC Kahraman liziK MarasnahyeC Osmaniye Amasya Sinop Kayseri nahyeS (Antakya) Adana liziK ozgatY Hatay ÇorumorumÇ Icel (Mersin) E3°4 Sea Nevsehir Nigde Kirsehir E°4 Kastamonou zerveD ÇankiriankiriÇ Kirikkale Aksaray Karaman Black kü zTu Gölü Göksu Konya E3°2 KarabükKarab tin Bar ANKARA Bolu E3°2 Zonguldak Sakarya Aksehir Gölü Baysehir Gölü ya Hoyran Gölü ta of Sea E3°0 Sakar (Adapazari) Eskisehir Ispar Gulf Antalya Afyon suropsoB Kocaeli (Izmit) Bilecik Antalya Burdur E° Istanbul avol tahyaüKKütahya 30 Usak Ya Bursa Denizli E3°8 of mara Sea Mediterranean Mar Kirklareli ne ekirdagT sellenadraD Balikesir nidydinAAy Mugla E3° Manisa 28 Edir E2° 26 BULGARIA 42°N ECEERG anakkaleÇÇanakkale Izmir GREECE °N °N 40 38 36°N Turkey: Economic Reform and Accession to the European Union Turkey: Economic Reform and Accession to the European Union Editors Bernard Hoekman and Sübidey Togan A copublication of the World Bank and the Centre for Economic Policy Research © 2005 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, NW Washington, DC 20433 Telephone 202-473-1000 Internet www.worldbank.org E-mail feedback@worldbank.org All rights reserved. A copublication of the World Bank and the Centre for Economic Policy Research 1 2 3 4 08 07 06 05 The findings, interpretations, and conclusions expressed herein are those of the author(s) and do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The World Bank encourages dissemination of its work and will normally grant permission promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, www.copyright.com. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org. Cover: Design by Tomoko Hirata. Photographs courtesy of the Ministry of Culture and Tourism of Turkey. Library of Congress Cataloging-in-Publication Data Turkey: economic reform and accession to the European Union / edited by Sübidey Togan, Bernard Hoekman. p. cm.--(Trade and development series) Includes bibliographical references and index. ISBN 0-8213-5932-0 (pbk.) 1. Turkey--Economic policy. 2. Turkey--Economic conditions. 3. European Union--Membership. 4. International economic integration. I. Togan, Sübidey. II. Hoekman, Bernard M., 1959- . III. Series. HC492.T8576 2005 330.9561'04--dc22 2004063747 ISBN 0-8213-5932-0 E-ISBN 0-8213-6084-1 DOI 10.1596/978-0-8213-5932-0 Contents Acknowledgments xi List of Contributors xiii Acronyms and Abbreviations xv Overview xvii PART I: MACROECONOMIC POLICIES FOR EU ACCESSION 1 1 MACROECONOMIC POLICIES FOR TURKEY'S ACCESSION TO THE EU 3 Sübidey Togan and Hasan Ersel PART II: AGRICULTURE, MANUFACTURING, SERVICES, AND NETWORK INDUSTRIES 37 2 ANALYSIS OF THE IMPACT OF EU ENLARGEMENT ON THE AGRICULTURAL MARKETS AND INCOMES OF TURKEY 39 Sübidey Togan, Ahmet Bayener, and John Nash 3 INTEGRATION AND THE MANUFACTURING INDUSTRY 87 Sübidey Togan, Hüsamettin Nebiog lu, and Saadettin Dogan 4 ACCESSION OF TURKEY TO THE EUROPEAN UNION: MARKET ACCESS AND REGULATORY ISSUES 123 Joseph Francois 5 THE TURKISH TELECOMMUNICATIONS SECTOR: A COMPARATIVE ANALYSIS 147 Erkan Akdemir, Erdem Bas¸çi, and Gareth Locksley 6 ACCESSION TO THE EUROPEAN UNION: POTENTIAL IMPACTS ON THE TURKISH BANKING SECTOR 161 Ceyla Pazarbas¸ioglu 7 COMPETITION AND REGULATORY REFORM IN TURKEY'S ELECTRICITY INDUSTRY 187 . Izak Atiyas and Mark Dutz 8 INSTITUTIONAL ENDOWMENT AND REGULATORY REFORM IN TURKEY'S NATURAL GAS SECTOR 209 Maria Rita Mazzanti and Alberto Biancardi v vi Contents PART III: ECONOMIC CHALLENGES 221 9 LABOR MARKET POLICIES AND EU ACCESSION: PROBLEMS AND PROSPECTS FOR TURKEY 223 Erol Taymaz and S¸ule Özler 10 TURKEY'S FOREIGN DIRECT INVESTMENT CHALLENGES: COMPETITION, THE RULE OF LAW, AND EU ACCESSION 261 Mark Dutz, Melek Us, and Kamil Yilmaz 11 TURKEY ON THE PATH TO EU ACCESSION: THE ENVIRONMENTAL ACQUIS 295 Anil Markandya PART IV: IMPLICATIONS OF EU ACCESSION FOR TURKEY AND THE EU 309 12 ECONOMIC IMPLICATIONS OF EU ACCESSION FOR TURKEY 311 Sübidey Togan 13 THE IMPACT OF TURKEY'S MEMBERSHIP ON EU VOTING 331 Richard Baldwin and Mika Widgrén 14 ECONOMIC EFFECTS OF TURKEY'S MEMBERSHIP ON THE EUROPEAN UNION 341 Harry Flam INDEX 353 LIST OF BOXES, FIGURES, AND TABLES BOXES 7.1 California's Electricity Crisis 205 11.1 The Experience of the World Bank with Water Utilities in the Baltic States 299 FIGURES 1.1 Inflation and the Growth Rate of Reserve Money: January 1987­September 2004 4 1.2 Inflation and the Rate of Depreciation of Turkish Lira: January 1987­September 2004 4 1.3 Current-Account-to-GDP Ratio, 1975­2004 7 1.4 Real Exchange Rate, 1980­2004 7 1.5 Real Interest Rate, January 1990­October 2003 9 3.1 Average Value of Manufacturing Industry Markup, 1980­2000 116 4.1 Comparison of Regulatory Regimes 138 4.2 Decomposition of Overall Transport Regulation Index 139 4.3 Armington Aggregation Nest 142 4.4 Trading Costs in the Services Sector 143 4.5 Basic Features of the Simulation Model 143 5.1 Telecommunications Revenue in GDP 148 5.2 Households with Fixed-Line Telephone Service 149 5.3 Fixed-Line Penetration Rates 149 5.4 Largest City/Overall Country Teledensity Ratio 149 5.5 Investment in Telecommunications 149 5.6 Mobile Penetration Rates 150 5.7 Households with Internet Access 150 Contents vii 5.8 Regular Users of Internet in Population 150 5.9 Internet Access Costs 150 5.10 Regular Use versus Dial-up Access Costs of Internet 151 5.11 Penetration versus Dial-up Access Costs of Internet 151 5.12 Personal Computer Use 151 5.13 Residential Monthly Access Fee (Including Value Added Tax) for Fixed-Line Telephone Service 152 5.14 Cost (Including Value Added Tax) of a Three-Minute Economy Local Call 152 5.15 Quality of Service 152 5.16 International Telephone Traffic 152 5.17 Basket of National Calls 157 5.18 Basket of International Calls 157 6.1 Turkish Bank Restructuring Strategy 163 6.2 Concentration Ratios of Five Largest Banks, 2003 165 6.3 Share of Assets of State-Owned Banks, 2003 165 6.4 Capital Adequacy Ratios, 2003 165 6.5 Size of Deposits Subject to Insurance, 2003 166 6.6 Average Bank Size, 2003 166 6.7 Number of Branches per Bank, 2003 167 6.8 Number of Personnel per Branch, 2003 167 6.9 Selected Indicators, 2003 167 6.10 Return on Equity of EU Banks by Asset Size, 2003 168 6.11 Return on Equity: Turkey and EU Banking Sectors, 2003 168 6.12 Personnel Expenses to Total Assets, 2003 168 6.13 Personnel Expenses to Total Expenditures, 2003 168 6.14 Total Loans to Total Assets, 2003 169 6.15 Nonperforming Loans (Gross) to Total Loans, 2003 169 6.16 Debt Securities to Total Assets, 2003 169 6.17 Financial Strength Rating of the Sector (Moody's), 2003 170 7.1 Structure of the Electricity Market, Turkey 194 7.2 Electricity Losses of Turkey versus OECD, 1984­2000 198 9.1 Employment Protection Legislation, Selected OECD Countries 245 9.2 Flow into Unemployment and Employment Protection: Selected Countries, 1985­94 246 9.3 Unemployment Duration and Employment Protection: Selected Countries, 1985­94 247 9.4 Unemployment Rate and Employment Protection: Selected Countries, 1985­94 247 9.5a Interindustry Wage Differentials: Selected Countries, 1980­2000 248 9.5b Interindustry Wage Differentials: Selected Countries, 1980­2000 248 9.6 Labor Demand Adjustment Speed and Wage Elasticity: Selected Countries, 1980­97 250 9.7 Sectoral Distribution of Employment, Value Added, and Output: Private Manufacturing Industry, Turkey, 2000 254 9.8 Structure of Value Added in Private Manufacturing: Turkey, 2000 255 10.1 FDI Inflows: Turkey versus Comparator CEE Countries, 1990­2001 264 10.2 M&A-Related Inflows: Turkey versus Comparator CEE Countries, 1990­2001 267 10.3 Privatization Revenues: Turkey versus Comparator CEE Countries, 1990­2000 267 10.4 Case Studies 277 10.5 Areas for Investment Climate Reform 285 12.1 OECD Composite Telecommunications Business Basket, November 2001 323 12.2 OECD Composite Telecommunications Residential Basket, November 2001 323 13.1 Passage Probabilities: European Council, 1957­2004, and after Entry of Bulgaria, Romania, Croatia, and Turkey 332 13.2 Change in Power for EU25, Nice Treaty to Constitutional Treaty Rules 334 viii Contents 13.3 Power Difference between Nice Treaty and Constitutional Treaty Rules for EU29 335 13.4 NBI Values under Nice Treaty and Constitutional Treaty Voting Rules for EU29 336 13.5 Impact of Enlargement on EU25 Power, Nice Treaty Rules 337 13.6 Impact of Enlargement on EU25 Power, Constitutional Treaty Rules 338 14.1 Effects of Migration 342 14.2 Forecast of Turkish Immigrant Population in Germany, 2000­30 345 TABLES 1.1 Estimated Inflation (Monthly) 5 1.2 Structure of Revenues, Expenditures, and Public Sector Borrowing Requirements (PSBR), 1998­2002 8 1.3 Debt and Fiscal Sustainability, 1994­2002 10 1.4 Ratios of Public Sector Borrowing Requirements (PSBR) and Debt to GNP and GDP, 2000­03 11 1.5 Total Tax Revenue as Percentage of GDP, 1998­2000 11 1.6 Revenue from Major Taxes as a Percentage of Total Tax Revenue, 1998 12 1.7 Personal Tax, Corporate Tax, and VAT System: Turkey and EU Countries, 2002 13 1.8 Labor Market Indicators: Turkey, 2001­03 13 1.9 European Monetary Union Convergence Criteria 20 1.10 Estimates of the Sacrifice Ratio 21 1.11 Current Account Sustainability Measures, 1984­2003 25 1.12 Results for Quarterly Instrumental Variable Regression of Ratio of Noninerest Current Account (NICA) to GDP 26 2.1 Land Use in Turkey, 1995 and 2000 40 2.2 Value of Agricultural Production: Turkey, 2000 40 2.3 Agricultural Holdings and Land Engaged in Crop Production, Turkey 41 2.4 Exports and Imports of Agricultural Commodities: Turkey, 1999­2001 42 2.5 Most-Favored-Nation Tariff Rates of EU and Turkey, 2002 46 2.6 Agricultural Supports: Turkey, 1998­2002 49 2.7 Base Period Results of Model for Major Activities 57 2.8a Simulation Results for Adoption of Agenda 2000 without Direct Payments 60 2.8b Simulation Results for Adoption of Agenda 2000 with Direct Payments 60 2.9a Simulation Results for Adoption of Agenda 2000 with Direct Payments at 35 Percent 61 2.9b Simulation Results for Adoption of Free Trade with Direct Payments 61 2.10 Selected Positions of Agricultural Negotiation between Slovak Republic and European Commission (EC) 62 2.11 Simulation Results for Alignment to Agenda 2000 under Positive Supply Response 64 2.12 Structure of Household Expenditures 65 2.13 Simulation of Scenario Effects on Real Income, Selected Household Types 66 2.14 Trade-Related Budget Effects and Direct Payments under Agenda 2000 68 2.15 Contributions to and Revenues from EU Budget 69 2.16 Impact of Changes in Agricultural Policies on Agricultural Incomes 70 2.17 Arrangements Applicable to European Community Importation of Agricultural Products, Other than Fruits and Vegetables Originating in Turkey 76 2.18 Arrangements Applicable to European Community Importation of Fruits and Vegetables Originating in Turkey 78 2.19 Agricultural Products for Which EU Entry Price System Applies 80 2.20 Structure of Household Expenditures 81 Contents ix 3.1 Exports and Imports, Turkey 88 3.2 Exports and Imports, EU 91 3.3 Trade with EU, 1990­2003 93 3.4 Effects of Customs Union between Turkey and EU, 1995­2001 95 3.5 Nominal and Effective Protection Rates, 2002 100 3.6 Frequency Distribution of Protection Rates, 2002 102 3.7 Nominal and Effective Protection Rates, 2002 102 3.8 Products Subject to Antidumping Investigations, 1996­2002 104 3.9 EC Technical Regulation Directives and European Community (EC) Imports, 1995 108 3.10 Trade Coverage of Technical Regulations and of Different Approaches to Their Removal 111 3.11 Sectors with Highest RCA Values in Each Category 113 3.12 Characteristics of Turkish Manufacturing Industries, 2000 115 3.13 Average Profit Margins, Turkey and Belgium 117 3.14 Concentration of Domestic Activity 118 4.1 Structure of EU Free Trade Agreements with Selected Developing Countries 125 4.2 Processed Food Concessions under the EU-Turkey Customs Union 128 4.3 Customs Union Scenario 129 4.4 Summary of Macroeconomic Effects of Customs Union for Turkey 130 4.5 Change in Output by Sector in Turkey 131 4.6 Variables Used from OECD International Regulation Database 133 4.7 Regulation Indexes, Air Transport 135 4.8 Regulation Indexes, Road Transport 136 4.9 Regulation Indexes, Rail Transport 137 4.10 Regulation Indexes, All Transport 138 4.11 Regression Results for Gravity Equation on Cross-Border Trade 140 4.12 Sectoring Scheme of Model 141 5.1 Monthly Residential Access Fee and Local Call Tariffs: 15 EU Member States and Washington, DC, July 1, 2002 158 5.2 Monthly Residential Access Fee and Local Call Charges: 13 EU Preaccession Countries (PAC), March 31, 2002 158 6.1 Initial Fiscal Costs of Turkish Banking Crisis, 2000­01 163 6.2 Results, Quantitative Impact Study 2003 171 6.3 Statistics on Banking Sectors of EU15 and Turkey, 2003 174 6.4 Statistics on Banking Sectors of EU15 and Turkey, 2001 175 6.5 Statistics on Banking Sectors of Enlargement (Candidate) Countries and Turkey, 2003 176 6.6 Statistics on Banking Sectors of Enlargement (Candidate) Countries and Turkey, 2001 177 6.7 Income, Costs, and Profits of EU Banks in Different Size Groups, 2003 178 6.8 Indicators of 50 Major EU Banks, 2002 and 2003 179 6.9 Nonperforming Assets and Provisioning of EU Banks, 2003 179 6.10 Regulatory Capital Ratios and Risk-Adjusted Items of EU15 Banks, 2003 180 6.11 EU Balance Sheet Structure of EU Banks, 2003 180 7.1 Turkey's Electricity Generating Capacity: 2002, 2005, 2010 196 7.2 Retail Prices for Electricity 199 8.1 Existing Gas Agreements, Turkey 212 9.1 Employment Indicators: EU and Selected Group of Candidate Countries, 2000 227 9.2a Income Tax Plus Employees' and Employers' Social Security Contributions, 2002 228 x Contents 9.2b Income Tax Plus Employees' and Employers' Contributions Less Cash Benefits, by Family Type and Wage Level, 2002 229 9.3 EU Directives and Turkish Labor Law 232 9.4 Employment Protection Legislation Index: OECD Countries, Late 1990s 241 9.5 Employment Protection Legislation for Regular Employment, Selected OECD Countries 242 9.6 Employment Protection Legislation for Temporary Employment, Selected OECD Countries 244 9.7 Job Turnover, Selected Countries 249 9.8 Job Turnover in Turkish Manufacturing Industries 249 9.9 Composition of Output in Private Manufacturing: Turkey, 2000 254 9.10 Simulation Results 256 10.1 FDI Summary Data: Turkey versus Comparator CEE Countries 265 10.2 FDI Definition in OECD Countries 266 10.3 FDI Stocks by Industrial Sector, 2000 268 10.4 Largest Affiliates of Foreign Transnational Corporations 269 10.5 FDI Stocks by Country of Origin, 2000 271 10.6 Macroeconomic Indicators, 1995­2001 272 10.7a Infrastructure-Related Factors--Strengths: Turkey versus Comparator CEE Countries 273 10.7b Infrastructure-Related Factors--Weaknesses: Turkey versus Comparator CEE Countries 274 11.1 Comparison of Environmental Costs of EU Accession for Turkey and Other Candidate Countries 297 11.2 Scenarios for Implementation of Environmental Investments for the Acquis 301 11.3 Environmental Accesson Costs for Turkey 302 11.4 Types of Benefits of Compliance with Directives Estimated for Candidate Countries 302 11.5 Estimated Benefits for Turkey from Compliance with Environmental Directives 303 11.6 Costs of Accession for Turkey in First Six Years 304 11.7 Environmental Expenditures in Turkey, 1997­99 305 11. 8 Estimated Annual Spending on Monitoring and Enforcement, Turkey 305 12.1 Impact of Agenda 2000 Policies 312 12.2 Restrictiveness Index Scores and Price Effects for Banking Services, EU and Turkey 313 12.3 Restrictiveness Index Scores for Telecommunications Services 315 12.4 Country Data on European and Turkish Electricity Sectors, 1998 318 12.5 Price Impact of Regulation in Electricity Supply, EU and Turkey 319 12.6 EU Country Data on European Natural Gas Sectors 320 12.7 Retail Prices of Natural Gas and Electricity, 2000 322 12.8 OECD Basket of International Telephone Charges, November 2001 324 12.9 Estimated Tariff Equivalents in Traded Services and Network Industries 324 12.10 Gravity Estimates for Intra-EU15 Trade 329 13.1 Power Indices under Constitutional Treaty Rules 339 13.2 Power Indices under Nice Treaty Rules 339 14.1 EU Budget, 2002 346 14.2 Estimates of EU Budget Contributions/Receipts Equations 348 14.3 Estimated EU Budget Contributions and Receipts 348 14.4 Pooled Panel Gravity Estimates for Intra-EU15 Trade 350 14.5 Forecast of Trade with EU15 350 Acknowledgments The essays in this volume, with the exception of the EuropeanCommissiontoTurkey,andAliDogramaci last three, were discussed at the conference "Turkey: of Bilkent University. Towards EU Accession," held May 10­11, 2003, in As editors of the volume, we would like to express Ankara, Turkey. Among the participants were eco- our gratitude to all the participants in the 2003 con- nomists from Turkey, Britain, Italy, the Netherlands, ference, including the contributors to this volume Central and Eastern European countries, the World and their discussants, for their valuable contribu- Bank, and the Organisation for Economic Co- tions. We also are grateful to the three referees who operation and Development (OECD). The mixed provided constructive suggestions for revision of the composition of the participants--drawn from vari- chapters, to Ines Garcia-Thoumi for helping to find ous Turkish universities; official agencies in Turkey, the resources to allow this book to be published, to including the Ministry of ForeignAffairs,Ministry of Rebecca Martin for her assistance in preparing the Agriculture, Ministry of Environment, Ministry of manuscript, to Thierry Verdier, Riccardo Faini, and Labor, General Secretariat for EU Affairs, Undersec- Stephen Yeo for their support in co-publishing this retariat of Treasury, Undersecretariat of Foreign volume with CEPR, and to Mary Fisk, Santiago Trade, State Planning Organization, Central Bank, Pombo-Bejarano, and Stephen McGroarty in the Banking Regulatory and Supervisory Agency, Office of the Publisher for their management of the Telecommunications Board, and Energy Board; publication process. This volume provides readers European University Institute; Erasmus University; with insights into selected aspects of Turkish acces- the World Bank; and the OECD--allowed a wide- sion to the European Union, and we hope it will ranging discussion of the issues. inspire similar studies. The project was supported by the World Bank, European Commission, Robert Schuman Centre for Advanced Studies at the European University Disclaimer Institute, and Bilkent University. We would like to express our appreciation to the sponsors of All opinions expressed in this volume are strictly the project. We are particularly grateful to Ajay personal and should not be attributed to any gov- Chhibber and James Parks of the World Bank, ernment, official agency, or institution with which Giacomo Luciani and Helen Wallace of the Robert authors are or have been affiliated. Schuman Centre, Hansjörg Kretschmer and Vincent Rey at the European Union Representation of the Bernard Hoekman and Sübidey Togan xi List of Contributors Erkan Akdemir Telecommunications Authority of Turkey Izak Atiyas Sabanci University, Istanbul Richard Baldwin Graduate Institute of International Studies, Geneva, and Centre for Economic Policy and Research (CEPR), London Erdem Bas¸çi Central Bank of Turkey Ahmet Bayener Ministry of Agriculture and Rural Affairs, Ankara Alberto Biancardi Acquirente Unico Spa, Italy Saadettin Dogan Undersecreteriat of Foreign Trade, Ankara Mark Dutz World Bank Hasan Ersel Sabanci University, Istanbul Harry Flam Institute for International Economic Studies, Stockholm Joseph Francois Erasmus University, Rotterdam, and CEPR Bernard Hoekman Groupe d'Economie Mondiale, Institut d'Etudes Politiques, Paris; World Bank; and CEPR Gareth Locksley World Bank Anil Markandya World Bank Maria Rita Mazzanti Italian Electricity and Gas Regulatory Authority John Nash World Bank Hüsamettin Nebioglu Undersecretariat of Foreign Trade, Ankara S¸ule Özler University of California at Los Angeles Ceyla Pazarbas¸ioglu International Monetary Fund Erol Taymaz Middle East Technical University, Ankara Sübidey Togan Bilkent University, Ankara Melek Us Association of Dairy Beef and Food Manufacturers and Producers in Turkey Mika Widgrén Turku School of Economics, Turku, Finland, and CEPR Kamil Yilmaz Koç University, Istanbul xiii Acronyms and Abbreviations ACC agricultural credit cooperatives IACS Integrated Administration and BEPG Broad Economic Policy Guidelines Control System BIPS border inspection posts IMF International Monetary Fund CAP Common Agricultural Policy JAP joint assessment paper CCT Common Customs Tariffs MARA Ministry of Agriculture and Rural CEE Central and Eastern European Affairs (Countries) M&A merger and acquisition CEEP European Centre of Enterprises MFN most-favored nation with Public Participation MRA Mutual Recognition Agreement CEN Comité Européen de Normalisation MRP Mutual Recognition Principle CENELEC Comité Européen de Normalisation MTR mid-term review Electrotechnique NBI normalized Banzhaf index COM Common Organization of the Market ncb national central bank CPI consumer price index OECD Organisation for Economic CUD Customs Union Decision Co-operation and Development EAGGF European Agricultural Guidance PEP Preaccession Economic Programme and Guarantee Fund PPP purchasing power parity ECSC European Coal and Steel PSBR public sector borrowing Community requirements EEA European Economic Area RER real exchange rate EFTA European Free Trade Association SDR special drawing rights EMRA Energy Market Regulatory Authority SEE state economic enterprise EMU Economic and Monetary Union SITC Standard Identification Trade ESA European System of Accounts Classification ECB European Central Bank SPO state Planning Organization ECOFIN Council for Economic and Financial (Turkey) Affairs SSI Shapley-Shubik index EONIA European Over-Night Index Average TBT technical barriers to trade EPL employment-protection legislation TEKEL Tobacco and Tobacco Products, Salt, ESCB European System of Central Banks and Alcohol Industry ETUC European Trade Union TFP total factor productivity Confederation TL Turkish lira EU European Union TSE Turkish Standards Institute FDI foreign direct investment TUBITAK Turkish Scientific and Technical FTA free trade agreement Research Institute FX foreign exchange TT Türk Telecom GATT General Agreement on Tariffs and UME National Metrology Institute Trade UNCTAD United Nations Conference on Trade GDP gross domestic product and Development GFCF gross fixed capital formation UNICE Union of Industrial and Employers' GNP gross national product Confederations of Europe HICP Harmonised Index of Consumer VAT value-added system Prices WTO World Trade Organization xv Overview Turkey first applied for associate membership in which have produced a high degree of protection in the European Union (EU)--then the European both the EU and Turkey. Thus, in terms of further Economic Community (EEC)--in 1959. The appli- liberalization of merchandise trade, accession will cation resulted in an association agreement in primarily have an effect on agriculture. 1963, whereby Turkey and the EU would, in princi- A major development under the customs union ple, gradually create a customs union by 1995 at the was that Turkey implemented the European latest. The customs union was seen as a step toward Union's Common Customs Tariff on imports of full EU membership at an unspecified future date. industrial goods from third countries. It has also The EU unilaterally granted Turkey preferential adopted most of the preferential trade agreements tariffs and financial assistance, but the process of concluded by the EU, as well as other measures staged, mutual reductions in tariffs and nontariff covered by the EU's commercial policy (such as barriers was delayed because of the economic and antidumping). Turkey has adopted EU competition political conditions in Turkey. After pursuing policies, established a Competition Board, adopted inward-oriented development strategies through- EU rules on protection of intellectual and indus- out the 1960s and 1970s, Turkey switched over to a trial property rights, set up a Patent Office, and ini- more outward-oriented policy stance in 1980. The tiated a process of harmonizing technical standards opening up of the economy was pursued in part for industrial products and strengthening internal with the aim of integrating the country into the EU. conformity assessment and market surveillance Turkey applied for full membership in the EU in structures. 1987. The response in 1990 was that accession On December 10­11, 1999, the European Coun- negotiations could not be undertaken at the time cil meeting held in Helsinki produced a break- because the EU was engaged in major internal through in Turkey-EU relations. At Helsinki, changes, and that matters were further complicated Turkey was officially recognized as a candidate state by developments in Eastern Europe and the Soviet for accession, on an equal footing with other candi- Union. However, the EU was prepared to extend date states. The result was the creation of a so-called and deepen economic relations without explicitly Accession Partnership with the EU, which means rejecting the possibility of full membership at a that the EU is working together with Turkey to future date. Thus the plans for a customs union enable it to adopt the acquis communautaire, the were revived. legal framework of the EU. But, in contrast to other On March 6, 1995, it was agreed at an Associa- candidate countries, Turkey did not receive a tion Council meeting in Brussels that a customs timetable for accession. After the approval of the union would be created between Turkey and the EU Accession Partnership by the Council and the adop- as of January 1, 1996, to be fully phased in by 2001.1 tion of the Framework Regulation on February 26, As a result, Turkey currently imposes no quotas or 2001, the Turkish government announced on tariffs on imports of industrial goods from the EU. March 19, 2001, its own National Program for the The associated liberalization for Turkey has been adoption of the acquis communautaire. Progress estimated as implying a 7 percent average reduction toward accession continues along the path set by in tariffs (Harrison, Rutherford, and Tarr 1997). the National Program. The major exception to free trade is agriculture-- In late 2004 another milestone was reached with neither party liberalized completely. The average the recommendation of the European Commission tariff rate on imports of agricultural commodities that the European Council endorse the launching from the EU is 21.4 percent. Agricultural trade is of formal accession negotiations with Turkey also subject to tariff quotas and price regulation, and establish a timetable for accession (European xvii xviii Overview Commission 2004b). In December 2002, the ous regulations, decrees, and circulars detailing Copenhagen European Council had concluded that how these reforms should be implemented. A "if the European Council in December 2004, on the Reform Monitoring Group, under the chairman- basis of a report and a recommendation from ship of the deputy prime minister responsible the Commission, decides that Turkey fulfills the for human rights, was established to supervise Copenhagen political criteria, the European Union the reforms across the board and to solve practi- will open accession negotiations with Turkey with- cal problems, including bureaucratic inertia and out delay." At a December 2004 Council meeting, it bottlenecks at both the central government and was decided to launch negotiations. state government levels (European Commission Although the process has now been launched, 2004c). great uncertainties continue to prevail about However, clearly much remains to be done on whether Turkey will be able to achieve its goal of both the macro- and the microeconomic fronts. accession to the EU.2 Some of these uncertainties Accession entails going beyond the customs union are economic, and they are the subject of this book. for manufactures and integrating the markets for Other uncertainties are more political in nature. agriculture, services, and factors (labor, investment, Some of these are in the hands of the Turkish and capital flows). Until now, liberalization of trade government--for example, realization of the EU has been restricted to industrial goods. Because agri- political and human rights criteria formalized by culture accounts for about 14 percent of Turkey's the European Council in Copenhagen in 1993, and gross domestic product (GDP) and services 60 per- acceptance of restrictions on immigration post- cent, the liberalization of trade to date has thus had accession.3 Others are not. Arguably, the greatest limited implications for three-quarters of eco- uncertainty is whether EU governments and soci- nomic activity. Although this statement is an exag- eties are willing to accept a large secular but geration because autonomous reforms have been nonetheless Muslim state as part of the EU. Time implemented in these sectors of the economy, join- will reveal the ultimate outcome. What matters in ing the EU will require Turkey to adopt and imple- the short to medium term is the impact that con- ment the whole body of EU legislation--the acquis tinued progress toward achieving the conditions communautaire--in all areas. for membership will have on Turkey. The EU is the The purpose of this volume is to highlight cer- focal point for reforms in a large number of policy tain aspects of Turkish accession, with an emphasis areas, and the preaccession process, which has on the implications of integrating fully into the sin- been ongoing for several years, is a unique experi- gle market, adopting the acquis, and meeting the ment in using international harmonization as a Maastricht Treaty criteria for fiscal and monetary tool in implementing a comprehensive reform policy.4 The contributors to this volume focus pri- strategy. marily on the impact of accession on Turkey--only Much has been achieved by Turkey in recent two chapters consider the possible impacts on the years, including progress in implementing the EU. One reason for this emphasis is that in size customs union--which covers many policy areas, Turkey is small relative to the EU as a whole. not just trade but also nontariff barriers and com- Turkey's GDP in 2004 was 240 billion compared petition policies--despite severe macroeconomic with the combined GDP of the EU25 of 10.2 tril- shocks and instability. The 1999 European Coun- lion.5 Thus Turkey would account for only 2.3 per- cil decision affirming that Turkey is a candidate cent of the EU's total output. Most of the adjust- for membership was followed by far-reaching ment burden and potential benefits therefore constitutional and legislative reforms, ranging pertain to Turkey. One major exception, however, is from improved civil liberties and human rights to related to Turkey's large population: the free move- enhanced civilian control of the military. A ment of workers could have a substantial impact on Department for EU Affairs was set up in 2000 to the EU in both economic and political terms, and coordinate all of Turkey's policies related to the the large population of Turkey may also have impli- preaccession process. A series of constitutional cations for decision making in a larger EU. The out- and legislative changes were adopted during come of accession talks on the movement of people 2001­04, some of them major, as well as numer- is very important not only for the EU but also for Overview xix Turkey, because the net benefits of accession will concludes with a discussion of lessons for other depend on the conditions under which Turkey may developing countries that can be drawn from accede to the EU. Turkey's efforts to date to bring its policies into Although the primary interest in this volume is alignment with the acquis. to assess what accession may mean for Turkey and to gauge how far along Turkey is toward meeting Macroeconomic Developments the acquis, the Turkish case is also relevant for and Prospects other countries that may seek to use a strategy of "deep integration" with a large, developed country From 1990 to 2000, economic crises began to affect or common market as a focal point and mecha- the Turkish economy with growing frequency. Peri- nism for undertaking both trade-related and regu- ods of rapid economic expansion alternated with latory reforms. Increasingly, developing countries periods of equally rapid decline. Inflation during are negotiating deeper forms of regional integra- 1990­2000 fluctuated between 55 and 106 percent, tion agreements with high-income trading part- for an average rate of 75 percent. Currently, Turkey ners. Even though most of these agreements do not is in the midst of a determined campaign to turn come close to the depth of cooperation entailed by around decades of weak performance stemming accession to the EU--and in some sectors such as from pervasive structural rigidities and weak pub- agriculture the accession process is unique in that lic finances. The past few years have witnessed it implies integration into a common policy three major attempts at addressing underlying involving direct subsidies and managed trade-- weaknesses. The first, during 2000, was under the close study of the implications of seeking to emu- three-year stand-by agreement with the Interna- late the acquis should be of interest to other coun- tional Monetary Fund (IMF), initiated in Decem- tries contemplating the design of integration ber 1999 after a significant drop in output mostly efforts. caused by external factors, including the 1999 The volume is divided into four parts: earthquake. Despite some notable achievements, a worsening current account and a weak banking · the macroeconomic dimensions of EU accession system led to a liquidity crisis in late 2000. This for Turkey crisis turned into a full-blown banking crisis · sectoral analyses of the effects of integration in February 2001, in which the government into the EU (adoption of the acquis) for the agri- responded by abandoning the crawling peg regime culture, manufacturing, services, and network and floating the currency. In May 2001, the IMF sectors increased its assistance under a new stand-by · the economic challenges of accession for arrangement. Just as the revised program was Turkey's labor market, investment framework, beginning to show results, the terrorist attacks of and environmental policy September 11 in the United States triggered the · an assessment of the net impact for the Turkish reemergence of serious financing problems. In Feb- economy as a whole of the various changes ruary 2002, the IMF approved a new three-year implied by adoption of the acquis in the areas stand-by credit agreement for Turkey to support covered by the other parts of the volume, com- the government's economic program. With the plemented by analyses of the likely implications implementation of the stabilization program, for the EU in three central areas: European deci- Turkey envisaged a gradual but steady improve- sion making and voting after Turkish accession; ment in its economic conditions. In August 2004, international transactions, both trade with and Turkey approached the IMF for what it hoped inward migration from Turkey; and the EU would be a final three-year stand-by agreement budget. that will serve as an exit program from instability and excessive debt. This introduction begins by summarizing the The economic stabilization programs proved themes and key findings emerging from the chap- successful at combating inflation, which fell from ters that follow. It then briefly discusses the likely 54.7 percent during 2000­01 to 10.6 percent in 2004 impacts of Turkey's accession on the EU, and it because of efforts to maintain fiscal and monetary xx Overview discipline. According to the Turkish State Planning required for safety. Third, the labor force participa- Organization (SPO), the fiscal deficit during 2001 tion rate declined from about 57 percent at the amounted to 16.4 percent of the gross national beginning of the 1990s to 48.7 percent in 2004, product (GNP)--and 20.9 percent of GNP, accord- mainly because of the discouragement of job seek- ing to the IMF definition. During 2004, the fiscal ers. The policy of keeping the primary fiscal surplus deficit was brought back down to 6.2 percent and at 6.5 percent of GDP over the coming years will the government ran a primary surplus of 6.9 per- constrain the use of fiscal policy to drive down the cent of GNP. After contracting by 9.5 percent in unemployment rate in the economy. But unless 2001, real GNP expanded by 7.9 percent in 2002, employment growth picks up, continually high 5.9 percent in 2003, and 9.9 percent in 2004. The unemployment and low participation rates could growth was driven by strong productivity gains undermine the social and political support for and by robust private consumption, investment, reforms. and exports, and it has not been hindered by cuts As discussed in greater depth by Sübidey Togan in government consumption and investment. The and Hasan Ersel in chapter 1, the macroeconomic unemployment rate fell from 11.5 percent in the challenges for Turkey remain substantial. Besides first quarter of 2002 to 10.3 percent in 2004, and solving the problems summarized in this introduc- the average interest rate on government debt tion, during the preaccession period Turkey needs declined from 63.8 percent in 2001 to 25.7 percent to reduce its annual inflation rate to about 3 per- during 2004. Ratios of debt to GNP are still high, cent, keep the debt-to-GDP ratio below 60 percent, but they have been falling. The net public debt-to- and achieve stable growth in real income over time. GNP ratio has decreased from 90.5 percent in 2001 Unless Turkey's growth performance does improve, to 63.5 percent in 2004. This decline reflects signif- its real per capita GDP will never converge with the icant income growth during 2002­04, attainment EU average and the accession of Turkey might cre- of sizable primary surpluses over the last three ate unmanageable stresses. In addition, the authors years, and appreciation of the real exchange rate note that to avoid the risk of speculative attacks on (RER). its currency over the coming years, Turkey should Although these are positive developments, it is continue to follow policies aimed at establishing a too early to determine to what extent the rebound sound fiscal framework, a robust banking sector, reflects a transition to sustainable growth. Substan- and sustained price stability. Turkey also must take tial risks remain. First, during 2002­04 the RER measures to increase the national savings rate from appreciated to what is arguably an unsustainable its rather low level of 22 percent in 2004 (China's level. Although the appreciation of the RER helped savings rate is 44 percent) and reverse the apprecia- to reduce the inflation rate and the debt-to-GDP tion of the real exchange rate. To attain sustainabil- ratio, it led to a widening current account deficit. ity of the current account, the real exchange rate The annual deficit in 2004 reached US$15.4 bil- has to depreciate gradually over time to its long- lion,6 and the current account-deficit-to-GDP ratio run equilibrium level. After accession, Turkey will increased to 5.1 percent. Because foreign direct be expected to join the Exchange Rate Mechanism investment (FDI) inflows remain weak, the deficit (ERM II) for at least two years and to meet the is funded by additional foreign debt, raising con- Maastricht conditions for monetary and fiscal con- cerns about the sustainability of the current vergence before a bid for membership in the Euro- account. Second, the public sector debt remains far pean Economic and Monetary Union (EMU) is too high for comfort. Assuming trend economic considered. Once admitted to the EMU, Turkey growth of 5 percent and a primary fiscal surplus of would replace its domestic currency with the euro 6.5 percent of GDP, the debt ratio will fall over time at an irrevocably fixed exchange rate, confer the as long as real interest rates remain below 15 per- bulk of its reserves to the European Central Bank, cent. Currently, the real rates on domestic debt are and be bound by the Stability and Growth Pact. about 11 percent. But shocks to credibility could Togan and Ersel argue that for Turkey the problem easily push them higher and lead to concerns about is not how to stay out of the EMU but, to the con- the sustainability of fiscal policy.7 A primary fiscal trary, how to reap the net benefits expected of surplus of 6.5 percent remains the minimum monetary integration by fulfilling the Maastricht Overview xxi criteria as soon as possible. Finally, the authors tected. Turkish exports of vegetables and fruits note that the benefits of integration can only be receive export subsidies. The EU, by contrast, has derived at some cost, and the costs of fulfilling the granted imports from Turkey preferential treat- Maastricht criteria, including the conditions for ment. Import barriers exist mostly in the form of sustainability of the current account when esti- tariff-quota schemes, in which imports within the mated by expected output losses, could turn out to quota benefit from preferential treatment. Togan be quite substantial. and his colleagues estimate that about 70 percent of imports from Turkey enter the EU duty-free and are not subject to any other import barriers. Sectoral Reform Challenges As a result, most of the adjustment after integra- Achieving and sustaining macroeconomic stability tion of Turkish agriculture into the CAP will fall will depend importantly on structural reforms, on Turkey. especially removal and reduction of subsidies and Agricultural support has been important in price controls, and the imposition of hard budget Turkey, imposing a large burden on taxpayers. In constraints on enterprises owned by the public 2003 the total support of agriculture, including the sector. Agriculture has been a heavily distorted higher prices paid by consumers, was equivalent to sector of the economy, accounting for a significant 4.4 percent of GDP (OECD 2004a). This figure is share of the public sector deficit. The banking much higher than the comparable one for agricul- sector was at the heart of the 2001 crisis--better ture in the EU--1.3 percent of GDP. These num- regulation and noninterference in lending deci- bers suggest that Turkey's accession to the EU is sions are needed to reduce the probability of likely to have important social, distributional, another crisis requiring bailouts or recapitaliza- and political effects, unless these transfers are tion of the system. Privatization of state-owned maintained under a common agricultural policy, firms is the most direct means of imposing hard which is unlikely. Indeed, adoption of CAP-type budget constraints. These and many other issues policies--something Turkey is already in the are addressed in the sectoral chapters that explore process of doing--will reduce the overall level of the effects of integration into the EU on agricul- support, even if Turkey becomes eligible for the ture and on the manufacturing, services, and net- current CAP levels of financial support. work industries. Since 1993, the CAP has been gradually shifting away from price support to income support, with the result that prices in the EU are now closer (but Agricultural Markets and Incomes still above) world market­clearing prices and farm- In chapter 2, Sübidey Togan, Ahmet Bayener, and ers are compensated by direct income payments. John Nash study the impact of EU accession on The structure of the CAP is such that it favors the Turkey's agricultural markets and incomes. In main agricultural products (and farmers) of the Turkey, agriculture accounts for a large share original six EU members: Belgium, Germany, of total output (14 percent) and employment France, Italy, Luxembourg, and the Netherlands. (33 percent). The corresponding figures for the Those products are grains, sugar beets, dairy prod- EU15 are 1.7 percent and 4.3 percent. In absolute ucts, and beef. Fruits, vegetables, poultry, and numbers, Turkey employs about the same number pork--important products of the newer, southern of people in agriculture as the EU15, or more than members--receive less or no support. In prepar- 7 million. Trade in agricultural products between ing for the accession of the Central and Eastern the EU and Turkey is a relatively small part of European (CEE) countries, the EU decided that their total trade, because it is not part of the cus- farmers from the CEE countries would not be toms union and so is subject to duties, quotas, and excluded from direct income support payments, price regulations. Turkey applies high specific but that such payments would be lower: equivalent duties to the commodities supported by the EU's to 25, 30, and 35 percent of the system prevailing in Common Agricultural Policy (CAP): cereals and 2004­06. After 2006, direct payments will be processed cereals, sugar and sugar products, dairy increased gradually in order to achieve parity with products, and meat. Olive oil is also highly pro- the original EU15 in 2013. xxii Overview Turkish agriculture will confront major reforms generate substantial changes in the agricultural in the preaccession period. In Turkey, the most incomes of producers, the welfare levels of con- important part of agricultural policy has been price sumers, and the budget revenues of the govern- support. State economic enterprises and agricultural ment. The authors estimate that, in the medium to sales cooperatives have been commissioned to buy long term, EU-like policies will lead to a 1.9 per- cereals, tobacco, tea, and sugar beet from farmers at cent increase in real household incomes in Turkey. prices determined by the government. These prices, Lower-income households (rural households) will which are higher than world market prices, have experience an even larger increase in real income. been protected by import tariffs. The second most But adoption of the CAP will require substantial important component of Turkey's agricultural pol- adjustments on the part of Turkish farmers. The icy is the various subsidies, grants, and exemptions effect on farmers' incomes will be driven mainly by lowering the cost of inputs, including capital, fertil- the amount of CAP-like compensation payments izer, seed, pesticides, and water. The output of they obtain. Their income will decrease consider- tobacco,hazelnut,tea,and sugar beet production has ably under Agenda 2000 policies without direct been controlled in various ways. Services to farmers, payments, but will increase under Agenda 2000 such as research, training, and extension and inspec- policies with direct payments. The budgetary costs tion services, have been provided free or at low cost. to Turkey of adopting EU-like agricultural policies Turkey is implementing significant reforms to will depend on whether Turkey receives compen- move it toward more decoupled and targeted forms sation from the EU budget for introducing these of support. Under the government's reform pro- policies. Without compensation, the cost will gram, output price supports, import tariffs and amount to 3 billion under Agenda 2000 policies input subsidies and grants are gradually being with direct payments similar to those applied in replaced by direct payments to farmers based on the EU and to 1.2 billion if the payments equal their holdings of land and animals. Income support only 35 percent of what is granted in the EU mem- has been capped. Privatization of state enterprises ber countries. in the agricultural sector is also part of the pro- gram. The end goal is that Turkey will have an agri- Manufacturing cultural policy similar to what is now being pur- sued by the EU in its reforms of the CAP: high In chapter 3, Sübidey Togan, Hüsamettin Nebioglu, intervention prices and protection from the world and Saadettin Dogan study the effects of EU inte- market will have been replaced by direct income gration on the Turkish manufacturing sector. support, lower protection, and prices approaching After reviewing developments in the trade in those on the world market. In chapter 4, Joseph manufactures and in particular the effects of the Francois uses a global general equilibrium model to customs union with the EU, they analyze tariffs assess the quantitative effects of completion of the and nontariff barriers in trade with the EU and customs union by extending its coverage to agri- third countries. Because tariffs are now largely a culture. He concludes that despite the importance nonissue, they focus more on nontariff barriers, of the agricultural sector for Turkey, the overall especially technical barriers to trade (product aggregate welfare gain associated with completion standards). They conclude that challenges lie of the customs union is limited, although resources ahead for both Turkish firms and the govern- will be pulled into agriculture. Commodity-specific ment. Both must apply a large number of EU impacts are small, with the largest adjustment norms. For example, Turkey has adopted all of effects in the more protected sectors, such as grains the 23 new approach directives that require affix- and meat, and expansion in the sectors that are ing the CE conformity marking, but only 18 of highly subsidized in the EU, such as sugar. these directives entered into force up to the present The Turkish reforms have emerged from the time. As a result of these directives, the number of prospect of accession, as well as the need to reduce mandatory EU standards decreased from 1,150 in public expenditure. In the short run they will lead 1999 to less than 500 in 2004 (European Commis- to considerable gains in efficiency. According to sion 2004c). The Turkish Standards Institute Togan and his colleagues, adoption of the CAP will (TSE) is presently concentrating its activities on Overview xxiii the transposition of the European and interna- on advanced technologies that contribute to envi- tional standards and on achieving full membership ronmental and safety objectives; to improve the in the European Committee for Standardization functioning of the single market in order to promote (CEN) and the European Committee for Elec- efficiency and choice; and to improve transport links trotechnical Standardization (CENELEC).8 between the European Union and third countries. Many of the requirements of the acquis in this The common transport policy places a major area revolve around accreditation and conformity emphasis on the strict application of competition assessment, in which a large number of government rules and state aid disciplines.Challenges range from bodies establish criteria as part of regulatory over- physical integration to harmonization of infrastruc- sight activities and the Turkish Accreditation ture, vehicle, environmental, and other standards; Agency (TÜRKAK) accredits the inspection service development of logistics networks; and improve- providers. Here a major challenge is for TÜRKAK ment of border crossings and trade facilitation poli- itself to become accredited and recognized in the cies (such as modernization of customs facilities). EU. Currently, its certifications are not recognized, The EU is concentrating on greater liberalization requiring double accreditation for providers or of rail transport, landing rights/access to airports redundant inspection on entry of goods into the (allocation of slots), gradual abolition of the queu- EU. Progress is also needed on the introduction of ing system for certain inland waterway markets, and mutual recognition clauses in national legislation improved application of the rules on work practices and the acceptance and adoption of simplified pro- in the road haulage sector (European Commission cedures for the import of products bearing the 2004c). An overall goal is a more level playing field CE (Conformité Européene) marking. In 2003 toys, through the application of competition principles, medical devices, and other products bearing the CE including the use of state aid and cross-subsidies.9 marking were entitled to enter the Turkish market Railways are a major fiscal burden for the freely with no further check on the technical Turkish state. Turkish State Railways (TCDD), dossiers (European Commission 2004c). Such manages Turkey's seven largest ports and its rail- measures will facilitate trade and reduce costs for ways, locomotive and carriage manufacturers, and traders. Indeed, it has been reported that during the repair workshops. During the 1980s and 1990s, rail period after the decision was made to accept the CE operation cost the Turkish government more than label, customs authorities sent numerous consign- $10.5 billion in constant 2002 U.S. dollars. As noted ments to the TSE for inspection, arguing that they by the World Bank's Trade and Transport Facilita- were not able to assess the risks related to the mini- tion Web page on Turkey,10 TCDD needs to be mum safety requirements. Numerous studies of the restructured, the railway network scaled down, impacts of a customs union have argued that the service improved, and prices increased. The acquis abolition of such real trade costs is likely to generate in this sector requires that TCDD separate out and significant gains for Turkey. Full implementation of report on the results of each of its activities (to the EU acquis on technical barriers to trade, with identify cross-subsidies), and that it end cross- the accompanying institutional strengthening, will subsidies from ports to rail and from freight to constitute the major change from the status quo in passenger traffic by shifting to a system of direct the nonagricultural merchandise trade with the EU. subsidies for passenger services (motivated by social objectives such as universal service). The much more stringent fiscal discipline associated Market Access and Regulatory Issues with implementing the acquis will have a beneficial In chapter 4, Joseph Francois complements the effect on resource allocation and the use of trans- analysis of the impacts of extending the customs port services. Existing cross-subsidization of the union to include agriculture by a discussion of the railways by the ports suggests that port authorities implications of EU accession for regulatory reform should be subjected to greater scrutiny by regula- in Turkey, focusing in particular on the transporta- tors and the competition authorities, because in tion sector. For this sector, the acquis revolves other countries (the threat of) competition by around the EU's common transport policy, which other (new) terminal operators has been shown to seeks to develop integrated transport systems based be an effective source of market discipline. xxiv Overview Francois explores both the quantitative and the main Turkish legislation and its implementation qualitative implications of Turkish accession to and compare them to those in the EU member and the EU for the transport sector. He adopts an candidate countries.They argue that the main prob- innovative methodology using data provided by the lems facing Turkey are related to the implementa- Organisation for Economic Co-operation and tion of the new legislation,especially in areas such as Development (OECD) to determine how far access to the network. Turkey is from "best practice" as defined by the EU Their conclusion was confirmed by the Euro- standards for this sector--not just in the regulatory pean Commission's 2004 assessment, which found domain but also in terms of "performance." In part, that only limited progress has been achieved in this involves applying numerical estimates of the acquis alignment to date, despite the fact that the economy-wide and sector-specific impacts of acces- remaining monopoly rights of the state-owned sion (given the preexistence of the customs union incumbent operator, Türk Telekom, were legally for goods) on the transport sector. This process is abolished at the end of 2003, including those related complemented by an assessment of the prevailing to national and international voice telephony and regulatory regime, using factor analysis (principal the establishment and operation of telecommuni- components) to identify commonalities across cations infrastructure. Thus the market has been countries and regulations. Francois concludes that open to new entrants since January 2004. However, there is little support for the claim that accession is the authors argue that the (regulatory) measures exerting significant pressure on Turkey to restruc- needed to facilitate market entry are not yet fully in ture in view of either general market access condi- place, including on matters such as numbering, tions or regulatory convergence requirements. interconnection, conditions of access to the net- Notwithstanding this conclusion, as noted above, work, and facility sharing, implying that there are Turkey confronts numerous policy changes in still de facto barriers to new entry. adopting the acquis in the transport area. Banking Telecommunications Sector In chapter 6, Ceyla Pazarbas¸ioglu describes the Chapter 5 by Erkan Akdemir, Erdem Bas¸çi, and impact of EU accession on the Turkish banking sec- Gareth Locksley examines the Turkish telecommu- tor. One of the primary causes of the 2001 currency nications services from the perspective of EU acces- crisis was the unhealthy structure of the sector, sion. Turkey is the last OECD country to liberalize stemming from several factors.11 its fixed-telephone services. Likewise, its privatiza- tion of the public monopoly in fixed lines has been · First, there were problems with state banks. delayed significantly. Yet Turkey, in the medium Governments have used these banks for noncom- term, will need to adopt the new set of directives mercial objectives such as agricultural support; approved and published by the European Parliament income redistribution; and industrial, urban, and and the European Council in 2002. In chapter 5 the physical infrastructure development. As a result, authors consider the framework directive, access the banks faced unrecovered costs from mandates directive, authorization directive, and universal carried out on behalf of the government called service directive. "dutylosses."Thestatebankscoveredtheirfinanc- In June 2001, Turkey and the other EU candidate ing needs by borrowing at very high interest rates countries signed the eEurope+ Action Plan, by and at short maturities from the capital markets. which Turkey committed itself to achieving certain · Second, the banking sector faced problems cre- measurable goals in the electronic communications ated by high public sector deficits. As private sector. Akdemir and his colleagues provide a banks found the financing of public deficits detailed comparison of the current Turkish and increasingly profitable, government domestic European statistics and practices in the telecommu- securities as a share of total assets of domestic nications industry. They discuss licensing, price reg- banks increased considerably, making the banks ulation, access regulation, and universal service vulnerable to changes in interest rates. Further- dimensions. For each dimension, they also describe more, during the 1990s banks began to borrow Overview xxv funds from abroad and use the funds to buy of government funds, and measures were taken to government bonds.12 Thus banks also became facilitate bank mergers and prepare the state banks vulnerable to exchange rate risk. for privatization. · Third, in 1994 as part of an effort to prevent an In addition, the regulation of existing banks was economic collapse following a fear of a bank run, greatly strengthened. Currently, banks are required the government introduced full (100 percent) to maintain an 8 percent capital adequacy standard state guarantees for deposits. Before 2001, fear of ratio, on both a consolidated and unconsolidated a renewed banking crisis prevented the authori- basis. The maximum open foreign exchange posi- ties from replacing this supposedly temporary tion was reduced from 30 percent to 20 percent. measure with a more reasonable deposit insur- Steps have also been taken to correct flaws such as ance scheme. weak loan loss provisioning and the lenient large · Fourth, Turkey lacked competent supervisory exposure and related lending limits. Tighter limits authorities, a good regulatory framework, and an were imposed on both on- and off-balance sheet effective legal and institutional infrastructure. commitments to related parties, and especially to companies belonging to the same group as a bank. Since 1999, Turkey has taken measures to reform Bank shareholders and managers are now personally the regulatory and institutional framework of its liable for the mismanagement and abuse of bank banking sector and restructure the state and private resources. The BRSA requires that banks introduce banks. The acquis in this area requires, among other internationally recognized accounting and auditing things, an independent central bank that, as a pri- standards. All in all, as of 2004 Turkish prudential mary task, maintains price stability. It also prohibits requirements were in general in conformance direct central bank (or public sector bank) financ- with those in the EU for capital adequacy standards, ing of the government deficit. Accession entails loan classification and provisioning requirements, acceptance of the objectives of the EMU, although limits on large exposures, limits on lending to compliance with the convergence criteria is not related parties, and requirements for liquidity and necessarily a precondition. However, because those market risk management. criteria are indicative of a macroeconomic policy The objective of the legislative and regulatory geared to achieving stability, all member states reform has been to bring the regulatory and super- must in due course comply with them on a perma- visory regime for the Turkish financial sector up to nent basis. the level of international practice in line with EU In 1999 the Turkish Parliament passed a new standards. This objective has been achieved to a banking law, which mandated the creation of an large extent. Pazarbas¸ioglu argues that Turkey has independent Banking Regulation and Supervision fulfilled most of the conditions necessary for Agency (BRSA). The BRSA took over the bank reg- attaining compliance in the banking sector with ulatory and supervisory responsibilities previously the EU integration process. She stresses that the fulfilled by the Treasury and the Central Bank. For Turkish banking sector will be exposed to certain state banks, the Treasury provided floating rate costs during and after accession in the form of notes to those banks securitizing their "duty losses," competitive pressures from EU banks that have a and it strengthened their capital base. A law was strong capital base and risk management skills. also introduced prohibiting state banks from run- However, the Turkish banking system has become ning more duty losses--that is, any support pro- more resilient and sounder since the extensive vided to the state banks will henceforth have to be restructuring program and implementation of budgeted. The state banks were also required to international standards. This restructuring process comply fully with all banking regulations. Private came at a large implied fiscal cost estimated to banks that had incurred significant losses in the have reached close to one-third of GDP in the aftermath of the currency crises were either taken initial stages. over by the Savings Deposit Insurance Fund (SDIF) A major remaining issue that needs to be solved is or asked to strengthen their net worth and balance the privatization of state banks. In 2003 Turkey sheet structure. The capital base of banks under decidedtoprivatizethetwolargeststatebankswithin SDIF management was enhanced by the injection three years, to withdraw the banking license of xxvi Overview another state bank, and to resume the privatization efficiency, and nuclear energy (European Commis- process of another large state bank as soon as market sion 2004c). conditions allowed.13 The data on the Turkish bank- In chapter 7, Izak Atiyas and Mark Dutz describe ing sector reveal that in 2004 private domestic competition and regulatory reform in the Turkish banks held about 57.6 percent of the total assets of electricity industry. After reviewing the physical the banking sector, with the five largest banks peculiarities of the electricity industry and dis- accounting for 60 percent of total assets. The share cussing how those characteristics have shaped the of state banks was 34.6 percent, while that of banks evolution of its industrial organization, Atiyas and managed by the SDIF was 0.6 percent. Foreign Dutz present an overview of regulatory reform in banks' share of total banking assets amounted to the EU, the key directives, and the recent proposals 3.5 percent. Thus foreign banks, in terms of their for amendment advanced by the European Com- shares of total credits and deposits, remain insignif- mission. They also identify five main challenges icant in Turkey. associated with adoption of EU norms in this area: With Turkish accession to the EU, competition in market opening, unbundling, third-party access, the financial sector will increase as Turkey recognizes public service obligations, and regulation. the competence of the supervisory authorities of the Historically, the Turkish electricity sector has EU member states and incorporates the principle of been dominated by state-owned enterprises that home country control in its legislation. According provide distribution, generation, trading, and to Claessens, Demirgüç-Kunt, and Huizinga (1998), transmission services. However, privatization has foreign bank assets as a share of total bank assets over been widespread for some time. Privately owned 1988­95 averaged 77 percent in Greece,31 percent in firms have entered the industry through build- Spain, 61 percent in Hungary, and 51 percent in the operate-transfer (BOT) or auto-generator schemes. Czech Republic. Thus, with the liberalization of They account for about 21 percent of electricity gen- financial markets, the penetration rates of foreign eration. In addition, firms have been bidding com- banks in Turkey will increase substantially, causing petitively on build-operate-own (BOO) contracts adjustment costs in the sector. Increased competi- for electricity generation. Transfer of operating tion will improve the quality and availability of rights contracts (TOORs) have been awarded for financial services in the domestic market, enable eight thermal plants and 14 distribution regions. the application of modern banking skills and tech- Privatization of generation assets is envisaged to nology, enhance the country's access to interna- start in 2006 and to be completed in 2011. All assets tional capital, lower prices for consumers, and lead in the distribution sector will be divested by mid- to a larger variety of financial instruments. Some of 2006 (European Commission 2004c). the Turkish banks will benefit from larger markets Many of the benefits of privatization come with by concentrating on activities in which they have a the transfer of risk. When private companies comparative advantage. Other Turkish banks may bear risk, privatization can be expected to lead to be forced to merge with foreign banks or leave the efficiency gains. Under the current regulations in market altogether. Turkey, the private owners in the electricity sector bear construction and operating cost risks. The pri- vate operator signs a long-term power purchase Energy agreement with the state-owned generation enter- Chapters 7 and 8 examine Turkey's energy sector. prise in which the latter commits itself to buy the The objectives of the EU's energy policy include output of the plant for a period of, say, 20 years at a improving competitiveness, securing energy sup- fixed price in foreign currency. In BOT projects, the plies, and protecting the environment. The energy price has ranged on average from between $.08 and acquis consists of rules and policies, notably on $.09 per kilowatt-hour for the first five to 10 years competition and state aid (including in the coal of operation. The BOO projects tend to have lower sector), the internal energy market (for example, prices. The BOO contract, guaranteed by the Trea- opening up of the electricity and gas markets, pro- sury, assures the investor that the project will be motion of renewable energy sources, crisis manage- profitable irrespective of the future demand for ment, and oil stock security obligations), energy power. As a result, the government retains the Overview xxvii commercial risks. Significant problems have arisen They focus on Turkey's natural gas market and the with these arrangements. The high-cost electricity measures adopted to liberalize the sector and to purchase agreements have exposed the state comply with EU requirements for accession. As in providers to significant losses and contingent liabil- the electricity industry, the main challenge con- ities. The financial position of these firms is poor fronting Turkey is to increase competition in the partly because of high-cost BOT contracts that market while dealing with the legacy of past deci- involve purchase costs to the Turkish Electricity sions, in this case the long-term take-or-pay con- and Transmission Company (TEAS¸) in excess of the tracts signed by Turkey's Petroleum Pipeline Corpo- subsequent sales prices to the Turkish Electricity ration (BOTAS¸). This government-owned company Distribution Company (TEDAS¸) set by the govern- dominates the natural gas sector in Turkey, control- ment. The associated subsidies and cross-subsidies ling the pipeline infrastructure for oil and gas trans- will have to be removed as a result of accession. mission, liquefied natural gas (LNG) terminals, and A new electricity law passed in 2001 provides for gas distribution. BOTAS¸ has monopoly rights on the establishment of an independent Energy Mar- gas imports and exports and on wholesale trading, ket Regulatory Authority (EMRA) to take over reg- transmission, and storage activities. ulatory functions from the Ministry of Natural The 2001 natural gas market law (No. 4646) calls Resources. Standard regulatory functions include for liberalization of the gas market and the creation tariff setting, market monitoring, and settlement of of a financially sound, stable, and transparent mar- disputes concerning access. With this law, the gov- ket (Article 1), including the removal of the import ernment is introducing a market model along EU monopoly. As noted in World Bank (2004:1), lines that will transfer most of the task of supplying progress in the three years following adoption of and distributing electricity and the associated the law was slow: "Industry structure remains market risks to the private sector, eliminate the monolithic, with no separation of functions other need for additional state-guaranteed power pur- than some distribution. Cost transparency, largely chase agreements, and minimize costs through due to the existing industry structure, remains defi- competitive pressures on producers and distribu- cient. Competition has not developed in the whole- tors, again along the EU model (see chapter 7). The sale sector. International investors remain con- government, then, will largely withdraw from the cerned by the delays." The 2001 law requires electricity generation and distribution businesses. BOTAS¸ to conduct tenders to transfer to other Electricity generation companies will sign contracts market players its existing contractual obligations for power directly with distribution companies on natural gas purchases and sales until its imports without government guarantees. The government's fall to 20 percent of annual consumption (the so- future role will be largely confined to determining called gas release program). Little progress has been sector policy, owning the transmission system, and made to date on implementing this requirement, ensuring that the rules are respected and that prices and Mazzanti and Biancardi argue that enforcement are determined competitively. The implication is of measures to limit the market power of the that, once the law is fully implemented, the regula- incumbent will be an important determinant of tory and supervisory regime for the electricity gains to Turkey from reform as well as a require- sector will have been brought up to the level of ment for satisfying the acquis in this area. Competi- international practice in line with EU standards. tion in the natural gas industry is impeded by long- Although the various BOT and BOO contracts term investments and contracts in the upstream signed in the past imply that the establishment of a activities (gas contracts and infrastructures). Gas competitive environment may take quite a long tends to be purchased on the basis of long-term time, once the system begins to operate Turkey can contracts with take-or-pay clauses that require the expect to derive efficiency gains in the sector result- gas purchaser to pay 70­90 percent of the con- ing in price reductions and improvements in the tracted capacity whether it receives the natural gas quality of the service. or not; the reason is that extractors must invest In chapter 8, Maria Rita Mazzanti and Alberto huge amounts mining and transporting the gas and Biancardi analyze the institutional endowment and thus confront very high up-front fixed (sunk) costs regulatory reform in Turkey's natural gas sector. and almost zero marginal costs. xxviii Overview Breaking up the upstream and downstream inclusion of handicapped people in the workforce. (wholesale) monopoly of BOTAS¸ is a precondition In all of these areas, EU social legislation lays down for the emergence of competition in the sector. minimum requirements that must be met by mem- Mazzanti and Biancardi note that the targets set by ber states. the law for BOTAS¸ shares (no more than 20 percent Adoption of the EU acquis will bring radical of imports and the wholesale market) are very changes in the functioning of the labor market in ambitious, and much more so than the targets set Turkey, with vital consequences for firms, workers, by EU member states. They also argue that the gas and the long-term performance of the economy. release provisions of the law--which have also been The main impact will fall on the informal sector. used by EU states in introducing competition-- Taymaz and Özler note that the Turkish labor mar- could have a beneficial impact, as long as they are ket is currently quite flexible, because the formal designed appropriately.14 and informal sectors have very different wage- setting mechanisms. The informal sector is largely free from labor regulation and avoids most of the The Complementary Implications taxes and related charges. Job insecurity is perva- and Challenges of Reform sive, and workers receive very few benefits from Although much has been achieved in sector- their employers. By contrast, in the formal sector specific regulation and reform, much remains to be labor regulations are observed, and taxes and done in some areas, especially energy and trans- related charges such as social security contributions port. Other economic reform challenges are associ- and payments to various funds are paid. Because ated as well with accession and realizing gains from the informal sector accounts for some 40 percent of the process. Chapters 9­11 consider three impor- manufacturing jobs, applying EU regulations to tant "horizontal" areas: the labor market, (foreign) this part of the labor market will have major effects. investment policy, and EU regulations pertaining to Taymaz and Özler estimate that when all infor- the environment. The first two complement the mal sector firms in the manufacturing sector begin financial (banking) sector as critical determinants to pay taxes and social security contributions at the of the effects of accession. Labor market regulations same rates applied in the formal sector, the firms will affect the incentives to invest, the costs to work- affected will lose half of their market shares as their ers of layoffs, as well as the overall cost structure of costs rise. As a result, employment in the manufac- doing business in Turkey. FDI is an important turing sector will decline by 9 percent, or some source of knowledge, employment, and competitive 300,000 jobs. As noted by Togan in chapter 12, the pressure on incumbent firms. Finally, environmen- effect of this policy change on employment will be tal regulation has the potential to enhance social even more drastic when one considers its effects on welfare by ensuring that firms and consumers con- employment in agricultural and services sectors as front the appropriate (social) prices of their eco- well. The policy implication is that if a massive nomic activities, but it also raises the danger of increase in unemployment is to be avoided, com- excessively costly regulation that may not be appro- prehensive labor market reform will be required priate to Turkey's circumstances and preferences. that includes both substantial decreases in tax rates In chapter 9, Erol Taymaz and S¸ule Özler look at on wage income, tax-related charges, and payments the labor market. They argue that one of the most to various funds, and reductions in layoff costs. important issues for Turkey in adopting and imple- Such measures will also increase the flexibility of menting the EU acquis is related to the labor mar- the formal market. Such flexibility will benefit the ket regulations and employment policies that pre- economy overall, because it will remove a disincen- vail in the EU. The acquis in this area includes EU tive for firms to grow and become part of the for- legislation covering health and safety at work, labor mal sector--a step that requires access to the capital law and working conditions (working hours, part- markets and banking system, which, in turn, time work, collective redundancies, worker protec- implies becoming subject to taxation. An impor- tion in case of bankruptcy and closure of plants, tant corollary not discussed by any of the contribu- child labor--minimum working age), gender tions in this volume is that other policies in the area equality (equal pay and opportunities), and social of taxation and support for the private sector are Overview xxix rendered neutral with respect to the size of firms-- will probably have major repercussions for Turkey. in Turkey, as in many other countries, tax and Joining the EU will require implementing the entire related policies tend to discriminate de facto if not body of EU legislation and standards on environ- de jure against small firms (Hoekman and Javorcik mental protection. This step, in turn, implies sub- 2004). stantial investments by the public and private Chapter 10 by Mark Dutz, Melek Us, and Kamil sectors, as well as changes in regulations and Yilmaz turns to Turkey's FDI challenges. The supporting institutions. EU policy in this area is authors conclude that Turkey would benefit signifi- based on integration of environmental policy with cantly from EU accession, largely because the acces- the sectoral policies of the EU, prevention meas- sion process would help Turkey to overcome its ures, implementation of the "polluter pays" princi- rule-of-law and competition-related constraints to ple, and measures to address environmental exter- FDI inflows. More rapid and consistent implemen- nalities at their source. The acquis comprises some tation of the rules and regulations that ensure a 200 legal instruments covering a wide range of level playing field for all companies would be areas, including water and air pollution, manage- assisted by the EU accession process; this process, in ment of waste and chemical products, biotechnol- turn, would enable Turkey to take full advantage of ogy, radiation protection, and nature conservation. investment-related benefits. Markandya breaks down the potential costs of During the 1980s, Turkey made frequent use of adopting the acquis based on three scenarios: a investment and export incentives and also relied "base case" in which no special reforms are made heavily on state-owned enterprises. The Turkish and the public sector remains much as it is today; a public enterprise sector has been and still is very "medium reform" case in which the private sector's large. The state-owned enterprises have shown, in share is increased modestly and reforms in pricing general, poor economic performance because of the proceed to reduce the demand for some of the envi- soft-budget constraints they have faced. They are ronmental cleanup services; and a "high reform" not confronted with the threat of bankruptcy and case in which the private sector's role is somewhat have benefited from government subsidies in the greater and environmental reforms are imple- form of direct transfers, equity injections, and debt mented with more rigor. consolidation. In recent years, Turkey has elimi- Consider just one representative area subject to nated most investment and export incentives, but environmental regulation in the EU: wastewater similar progress could not be achieved for the pub- collection and treatment. According to the EU lic enterprises. Although privatization has become urban wastewater directive (91/271/EEC), all urban a prominent part of the Turkish reforms, it gained areas with a total wastewater discharge of 2,000 momentum only after the 2001 crisis and the asso- population equivalent must be connected to the ciated reforms, because it was recognized that state- sewer system, and discharges must receive at owned firms and the related structure of subsidies least secondary treatment except for towns with and soft-budget constraints were a part of the populations of less than 10,000 and in cases in problem underlying the large nonperforming assets which such treatment would produce no environ- of the banks. Turkey recognizes that it will have mental benefit or would involve excessive cost. to stop subsidizing the public enterprises at the Because the majority of the Turkish population prevailing rates, align its state aid policies with lives in municipalities that are not connected to those of the EU, apply the same competition poli- sewer treatment, and because only a very small cies to all firms whether private or public, and pri- number of municipalities have wastewater treat- vatize the public enterprises. Greater FDI can play ment facilities, the implementation costs associated an important role in this transition, as it has in the with meeting this EU regulation will be very large CEE countries. indeed. How large will depend in part on negotia- In chapter 11, the final major cross-cutting or tions with the EU to determine its interpretation of horizontal issue chapter, Anil Markandya looks at what is allowed in view of the flexibility provisions the costs, especially in the public sector, Turkey is embodied in the regulation. But rough estimates of likely to incur in meeting the environmental acquis. the investment costs of compliance run up to more In this area, as in the labor market, the EU acquis than $10 billion. Adding the additional operating, xxx Overview maintenance, and replacement costs would further an analysis is needed to determine where the case increase this amount. for investment is strongest and where it would be Wastewater collection and treatment is just one better to delay making investments (and negotiate of the relevant directives; others include EU regula- extensions or agree on different sequencing with tions on drinking water, industrial pollution, dan- the European Commission). gerous chemicals, fuel standards, air quality, and waste management. Markandya estimates that the total investment will run between 28 billion and Toward an Assessment: Net Effects on Turkey 49 billion. Although this estimate is very high, he also notes that the costs will be spread over many What will be the net impact on Turkey of all the vari- years--he assumes 17 years. Annual investments ous policy reforms involved in EU accession? In would amount to about 2 billion to 3 billion in chapter 12,Sübidey Togan attempts to go beyond the the high reform (i.e., low-cost) case and 3 billion merchandisetradeliberalizationanalysisundertaken to 5 billion in the medium reform (i.e., high-cost) by Francois in chapter 4 and quantify the impacts on case. In the initial years, this investment would those areas identified by the chapter authors as amount to 1­1.5 percent of GDP in the low-cost requiring the implementation of concrete policy case and 1.5­2.5 percent in the high-cost case. To changes. Specifically, Togan considers the welfare this one would have to add the extra annual operat- effects of integration with the EU associated with ing costs that will be incurred, which would be in policy changes in the agriculture, banking, telecom- the range of 5 billion to 8 billion. Because munications, transportation, electricity, and natural Turkey's capital investment spending on environ- gas sectors.He concludes that a conservative estimate mental areas is about 0.5 percent of GDP, accession of the resulting net increase in the real income of will imply an increase of anywhere from a factor of Turkish households is some 3.6 percent of GDP.15 two to four or more. However, many of these invest- Integration with the EU will remove numerous dis- ments would probably be made in any event by tortions in the price system and improve the business Turkey, although perhaps not as fast insofar as the climate for private sector development, which, in EU directives do not correspond to Turkey's priori- turn, will increase the allocative efficiency of the ties at its current stage of development. Important Turkish economy. Because these achievements will here is the extent to which there is "wiggle room" in make Turkey a better place to invest, investment, the various directives, as well as flexibility on the including foreign direct investment, can be expected part of the European Commission in assessing to increase, bringing with it associated employment whether achievement of the acquis in all of the vari- opportunities. The allocative efficiency gains from ous areas is a necessary condition for accession. integrationwillbeboostedbyinducedcapitalforma- Also important will be the extent to which fund- tion. But these welfare gains will have a price: the ing for some of these investments will be provided adjustment costs associated with attaining macro- by EU member states--although it must be recog- economic stability, adopting EU labor market rules nized that the money is fungible and that the Turk- and regulations, and complying with EU environ- ish government must determine for itself where mental directives. grants and loans should be allocated for the highest No assessment of costs and benefits should social rate of return. Indeed, determining this allo- ignore the opportunity costs associated with the cation and deciding what trade-offs to make will accession strategy. Indeed, one can and should ask perhaps be one of the greatest challenges con- what the counterfactual is to accession. Any process fronting successive Turkish governments as the of regional integration by definition excludes other accession process proceeds. In making this determi- options--going it alone or relying more intensively nation, the government must compare cost esti- on multilateral approaches as the focal points and mates with benefit estimates that evaluate the gains anchors for reform. Clearly, the political decision from the implementation of the directives. Under- has already been made to pursue the accession taking such a cost-benefit analysis is critical. One path, but that decision does not take away the strong conclusion that emanates from Markandya's importance of determining whether alternative chapter, as well as others in this volume, is that such strategies might not be superior in economic terms. Overview xxxi It is very difficult, however, to address this question. gradual convergence in areas where this is likely to Virtually everything that is being done and will be be appropriate in view of Turkey's initial conditions. done by Turkey could be done unilaterally. Many of In part, the cost-benefit ratio will depend on the the benefits from the reforms undertaken to date extent to which additional grants are made available were gained autonomously--for example, the steps to Turkey that otherwise would not be forthcom- to exert greater macroeconomic discipline, the ing. Accession implies access to the CAP and Struc- measures to strengthen the banking system, and the tural Funds, and, as a poor country, Turkey will be a introduction of greater fiscal discipline for agricul- net recipient of such transfers. It is not possible at ture and state-owned firms. How much the tem- this point to determine how large this net flow will plates provided by the EU model have helped is not be. The structure of the present system of EU rev- possible to determine. Clearly, however, the prospect enue and expenditure is such that rich member of accession played a role in the pursuit of some of states transfer resources to poorer members. these reforms. The key dimensions of accession Because Turkey is poor relative to the EU25 (even as an anchor and focal point for reforms are as though the difference will be smaller than it was follows: before the accession of the 10 new members), acces- sion will clearly have budgetary effects for the EU if · the availability of the EU "model" to follow and the current criteria are maintained for transfers implement among EU members. Allocations are determined in · the prospect of eventual free access to the EU for part by voting power (in turn, a function of popula- Turkish workers tion and size of the economy) as well as relative · the assistance granted to Turkey by the EU. poverty, and so there is a possibility that the rules of the game will be changed before Turkey accedes in Does the EU model (the acquis) make sense for order to manage the fiscal and redistributive reper- Turkey? When it comes to disciplines associated cussions of its accession. In addition, it is projected with the single market, we would argue the answer that by 2020 Turkey's population will be larger than is yes. The agenda here revolves around introducing that of any other EU25 member. This projection market disciplines, controlling state aids, and may raise concerns about the decision-making pro- encouraging competition in markets for goods and cedures of the EU, as well as worries about possible services. Integrating transport and energy markets immigration effects. also makes good economic sense, as do measures aimed at increasing the contestability of these mar- Effects of Turkey's Accession kets and removing competition-distorting cross- on the EU subsidies. This is not to say that the EU model in these areas is perfect--EU trade policy, for exam- The effects of Turkey's accession on the EU will ple, and the CAP most obviously are not very good depend importantly on what accession will entail examples of efficiency-maximizing policies. But the for EU transfers to Turkey, EU governance (deci- point is that they are better than the status quo ante sion making), and trade and factor flows, espe- prevailing in Turkey, and their adoption therefore cially migration.16 Because the trade in goods, improves the expected policy stance in these areas. services, and capital has already been either cov- Other dimensions of the acquis leave room for ered by the customs union or addressed unilater- doubt. Although much of what is being pursued ally by both parties in terms of bilateral flows, the through the EU directives in the social and envi- effects on the EU in these dimensions are likely to ronmental areas is justifiable and will bring bene- be limited in the sense that they will have already fits, the costs of implementing regulation in these occurred at the time of any accession decision. In areas can be high. It is not clear that benefits will any event, the aggregate impacts on intra-EU trade always outweigh costs, suggesting that these are will be small. Production and trade in agricultural areas in which greater care and attention are goods will be affected by accession, but the major required to sequence implementation appropriately. effects will be in Turkey, not in the EU, because As emphasized before, however, the accession import barriers are relatively low for Turkish agri- process will take a long time, allowing for a more cultural exports. xxxii Overview Decision Making $7,000--and income disparities within the country are great. The population in the southeast has less In chapter 13, Richard Baldwin and Mika Widgrén than half the average national income, and the large evaluate the impact of Turkey's membership on EU rural population is generally much poorer than the voting. They analyze the EU's decision-making effi- urban population. As discussed by Harry Flam in ciency (its capacity to act, as measured by the prob- chapter 14, these facts have implications for both ability of proposals passing a vote) and the distribu- the EU budget and for emigration from Turkey. tion of power in the EU's leading decision-making If the existing rules for contributions to and body, the Council of Ministers. They also compare receipts from the EU budget remain unchanged-- two alternative Council voting rules: those accepted including the Common Agricultural Policy--Flam in the Treaty of Nice and implemented by the estimates that Turkey would receive a net transfer accession treaty of the 10 new entrants in 2004 and of 12 billion from the EU, corresponding to about the rules laid down in the draft Constitutional 14 percent of the present EU budget. The overall Treaty (CT). The latter are conditional on the ongo- net contribution to the 10 new entrants in 2004 and ing ratification process. Turkey is projected to correspond to about 60 per- Baldwin and Widgrén conclude that, in terms of cent of the present budget. Flam concludes from capacity to act, the enlargement will likely have rel- this that it is unlikely that current rules will remain atively little impact, as long as the CT voting rules unchanged in the face of such large increases in net come into effect. In particular, Turkey's member- transfers from richer to poorer countries. ship will have only a negligible effect on the EU's As noted earlier, the major trade impacts of capacity to act--in large part because moving from Turkish accession on the EU are likely to be in the 27 members (the EU25 plus Bulgaria and Romania) movement of labor. The decision to emigrate to 29 (Turkey and Croatia) does not change much. depends on a variety of factors, but real wage differ- The answer, however, is quite different if the CT is entials are clearly important, as are social networks, rejected and the Nice Treaty rules remain in place. culture, language, and geographic distance.17 It will Under the Nice Treaty voting rules, the enlargement take decades for Turkey to attain an income level would substantially lower the EU's ability to act. comparable with that of the EU15, implying that These findings confirm earlier conclusions by the income differentials will be a strong incentive for authors that an enlarged EU cannot function well migration from Turkey to the EU. The prospect of under the Nice Treaty rules. They also suggest that if large-scale immigration from Turkey (as well as the CT is rejected, the Nice Treaty voting rules must from new members and other candidate countries) be reformed before further enlargement takes place. is a source of considerable concern among the As for the distribution of power, they find that EU15. This was a major factor in the French deci- Turkish accession will have a big impact. Under both sion to subject approval of Turkish accession to a the Nice Treaty and CT rules, Turkey would be the referendum. Fears that immigrants will depress second most powerful member of an EU29. Under wages, boost unemployment, and cause social fric- the CT rules, Turkey would be substantially more tion and political upheavals prevail in many EU powerful than countries such as Britain and Italy; member states. Clearly, free migration will not be under the Nice Treaty rules the power differences allowed immediately upon full membership. For among the countries with a population of more the 2004 new EU members, the length of the transi- than 50 million would be small. This situation sug- tion period was seven years, as it was for Greece, gests that the acceptability of the Constitutional Portugal, and Spain. For Turkey, the period may be Treaty and the probability of Turkey's membership longer, and it may be subject to longer-term con- may well be negatively affected. trols. However, because accession is unlikely to occur before 2012, this is an issue that would only Migration and the EU Budget come into play in 2020. By that time, Turkey should Turkey is likely to have a population larger than have converged more toward the average income Germany's 82 million by 2020, if not earlier. Turkey levels of the EU25, reducing migratory pressures. is poor by European standards--PPP (purchasing As noted by Flam, the strength of the incentive to power parity)-adjusted per capita income is roughly move and the total number of people who might Overview xxxiii move are also a function of how rapidly wages rise in ment about the impact of greater trade on labor mar- Turkey. As workers leave and the supply of workers ket outcomes), there is agreement that immigration declines in Turkey, wages will go up. Conversely, will have much greater impacts than expanded trade immigration will have a depressing effect on wages between poor and rich countries. One reason is that in the EU--albeit much smaller because the EU migrants will seek employment in all sectors,not just labor market is much bigger. The net impact on the tradables.19 Turkish economy will be determined by the extent to which capital owners are affected in Turkey, the Implications for Other Developing impact of the loss of (qualified) workers on Turkish Countries GDP, the extent to which earnings in the EU are remitted, and the magnitude and impact of reverse The requirements for accession to the EU provide a movements as people of Turkish origin relocate ready-made template, if a constantly evolving and upon retirement and repatriate capital. Much also expanding one, for countries seeking to implement will depend on the skill levels of the people who far-reaching structural reform programs. What is move. Unskilled migrants are more likely to be com- the relevance of the Turkish experience? What les- plementary to more skilled nationals in the host sons can be drawn for other countries with a start- economy because they will allow the latter to increase ing point similar to that of Turkey that will not be their productivity and thus their real wages. able to accede because they are not part of Europe? Whatever the specific impacts,overall welfare will A first lesson is that the prospect of accession is increase as a result of migration, but there will be a not a panacea. What matters are the autonomous redistribution of income. Turkish GDP will decline, decisions on economic policy made by govern- andtheEU'sGDPwillrise.EUfirms(capitalowners) ments. Although Turkey's accession to the EU was and more highly skilled workers are likely to benefit already under discussion in the 1960s, very little from the increased supply of less-skilled workers. progress was made in converging toward EU norms Turkish migrants will gain from the move, and less- until the early 1990s. A related lesson is that much of skilled EU workers will lose. The overall welfare what is associated with accession can be pursued by increase will stem from a more efficient allocation of countries that will not be able, or may not desire, to labor; Turkish laborers become more efficient when accede. The EU acquis is a public good in the sense they move to European countries, and the optimal that any country can avail itself of that body of leg- allocation is achieved when the marginal productiv- islation and regulation. What matters is implemen- ity of labor is equalized across EU members. tation, which, in turn, requires commitment and the Flam concludes that the Turkish immigrant pop- relevant institutions to apply the standards. The reg- ulation in Germany may rise by some 60 percent by ular monitoring and interaction between the Euro- 2030. About 3 million people of Turkish origin are pean Commission and the partner government, presently in the EU, the overwhelming majority in facilitated by the provision of technical and finan- Germany, which implies a total movement of some cial assistance, can help to maintain progress. How- 1.8 million Turks.18 Although this is a highly specu- ever, accession does not have to be part of the equa- lative exercise--as stressed by Flam, much depends tion for countries to obtain such assistance--a very on the parameters assumed in the model--these similar structure is available in the form of the numbers are manageable in view of the current association and economic partnership agreements overall EU25 population of 450 million. However, that many countries have signed with the EU. Flam's projections assume no restrictions are placed Such agreements can have major potential on migration--a strong assumption. downsides if they involve asymmetric liberaliza- What such immigration will imply for wages and tion of trade in favor of the EU, while keeping bar- employment in the receiving countries is even more riers to imports from the rest of the world at high speculative. While those who have investigated the levels. For this reason, the standard policy advice to impacts of immigration suggest that it is likely to be governments implementing such discriminatory limited, it should be noted that in contrast to the trade agreements is to pursue a parallel strategy of debates between the proponents and opponents of lowering most-favored-nation protection rates as trade integration (where there is significant disagree- well (Schiff and Winters 2003). Turkey, because it xxxiv Overview formed a customs union with the EU, has adopted factors.A long history of macroeconomic instability the common external tariff, which tends to imply a and high-cost services will lower the interest of an low average level of protection, at least for manu- investor, especially in light of the fact that the Cen- factures.20 Assuming the problem of trade diver- tral and Eastern European countries offer an alter- sion is addressed through the adoption of low, and native location. Administrative barriers to FDI ideally uniform, levels of external protection, the (including red tape) have also been high in the past. EU model of regulatory principles has much to Finally, slow progress on privatization helps to offer countries that are similar to Turkey--that is, explain low FDI. emerging markets that have extensive state involve- A similar situation prevails in neighboring ment in the economy, limited competition in serv- countries, although with one major difference: ice markets, and weak banking systems. A process most Arab countries have experienced macroeco- of "conversion à la carte" is, by definition, not feasi- nomic stability. Administrative barriers to FDI, ble when it comes to accession, but it is possible in monopoly provision of services, state-owned enter- the context of partnership agreements. Indeed, this prises, and slow privatization all reflect political option was made explicit by the EU in its 2004 decisions. It is an open question to what extent European Neighborhood Policy, which offers part- trade agreements that do not involve the prospect ner countries that do not have the prospect of of accession could assist countries that want to pur- accession the opportunity to adopt parts of the sue an investment and services liberalization acquis and through this harmonization share the agenda, although the Turkish experience suggests benefits associated with the relevant elements of that even in a context of possible accession, the EU's Internal Market. The challenge for part- progress on this overall agenda can be slow. How- ner countries is to determine where such approxi- ever, the deepening of accession efforts in the future mation-cum-harmonization will be beneficial and will, by necessity, imply that much of the "behind where not. The Turkish case and its experience the border" reform agenda must be implemented offer valuable guidance on what part of the "EU for accession to become feasible. This may or may package" would be beneficial to adopt and emulate not be true for association agreements that include (with assistance from the EU in the context of such services and investment policies. Much tends to be agreements) and which parts are best left on the made of the fact that bilateral and regional trade shelf for the future. agreements are increasingly covering these areas, The Turkish experience--as well as those of the but there is little experience with actual implemen- CEE countries that acceded to the EU--reveals tation. In principle, again, reforms in this area can clearly that trade policy is important, in that the lib- and should be implemented unilaterally. Trade eralization of trade with the EU led to significant agreements may help by allowing gradual commit- improvements in productivity and trade perform- ments to be made in a more credible manner, but ance, but that in itself is not sufficient. In an envi- much depends on the substance of the reforms. A ronment characterized by limited, if any, competi- key requirement (precondition) for the network tion in the key network services industries--energy, services industries and the financial sector is appro- telecom, transport--a weak financial sector, and priate regulation to ensure efficiency, to guard limited fiscal discipline (and thus extensive cross- against systemic risks, and to achieve social or subsidization and transfers), trade liberalization equity objectives (e.g., universal service obliga- needs to be complemented by measures to harden tions). These are complex areas. Much can be budget constraints and to enact pro-competitive learned from the experience of other countries-- regulation. The limited stock of inward FDI--a such as in the natural gas sector (see chapter 8 phenomenon that also characterizes neighboring by Mazzanti and Biancardi)--but what matters countries in the Middle East and is in striking first and foremost is clear objectives. Also impor- contrast to the situation in CEE countries--is tant is the establishment of an effective, general indicative: foreign investors either perceive the competition authority and mechanisms to assess attractiveness of locating in Turkey to be limited or the impacts and effects of reforms.21 Indeed, an perceive the barriers to FDI to be prohibitive. In important policy decision is to what extent a coun- practice, the answer is likely to be a mix of these two try should rely on general competition law to Overview xxxv discipline the behavior of enterprises, including Eurasia, and the Middle East, Turkey has the poten- dominant firms in the network services industries, tial to act as a major link between these markets. as opposed to sector-specific regulatory bodies. With harmonization of commercial legislation, EU companies will be able to use Turkey as a joint investment and export base for the Middle East and Conclusion Eurasia. Istanbul is already emerging as a base for To join the EU, Turkey will have to attain macro- transnational corporations operating in the Cauca- economic stability, adopt the EU's Common Agri- sus and Central Asia. Finally, Turkish membership cultural Policy, and liberalize its services and could help to secure stability and security in the network services industries. Integration will be Balkans and Caucasus, thereby increasing EU beneficial for Turkey, because it will remove many energy security. distortions in the price system, boosting the alloca- Although the potential net gains for Turkey and tive efficiency in the economy and, in turn, making the EU members are significant, Turkey faces major the country a more attractive place to invest. With challenges in implementing the acquis. Major chal- accession, Turkey will also be eligible for EU Struc- lenges also must be overcome in realizing the poten- tural Funds, with the resulting increase in infra- tial gains associated with increased labor flows from structural investments further contributing to Turkey--even if they will probably be relatively prospects for economic growth. In addition, Turkey small compared with the size of the EU labor force. will reap benefits from monetary integration, as The same is true of decision making and manage- well as from migration of Turkish labor to the EU. ment of the net annual budgetary cost of Turkish However, the welfare gains derived by Turkey from membership to the EU. The Baldwin-Widgrén integration will have a price: the adjustment costs analysis in chapter 13 points to the importance of associated with attaining macroeconomic stability, passage of the EU Constitutional Treaty and the adopting the CAP, liberalizing services and the net- acceptance by existing members of a significant role work industries, and complying with EU environ- for Turkey in decision making. Estimates reported mental directives. by Flam in chapter 14 and in Togan (2004) suggest According to the European Commission (2004a), that budgetary costs will be quite high unless the 71 percent of the Turkish population supports EU rules on the CAP and Structural Funds are membership. This high percentage of support can changed--constituting yet another challenge that be explained in part by the economic benefits that will have to be negotiated successfully before Turkey expects to derive from membership. Equally accession. important is the recognition in Turkey that the sys- tem of governance of a rule-based society, as in the Notes EU with its many institutions, may provide better 1. Decision No. 1/95 of the EC-Turkey Association Council prospects for meeting the demands of various of December 22, 1995, on implementing the final phase of the groups in society.22 Support for EU membership customs union (96/142/EC). also stems from the process of Westernization and 2. "By [their] very nature, [accession negotiations are] an from geostrategic considerations.23 open-ended process whose outcome cannot be guaranteed beforehand" (European Commission 2004b: 10). Turkish accession will also affect the welfare of 3. The Copenhagen criteria for membership were established current members of the EU. Welfare will increase in preparation for the eastern enlargement and cover political because of the further specialization, reflected in and human rights as well as economic criteria. Membership cri- teria include "stability of institutions guaranteeing democracy, trade, capital, and labor flows, as well as the likely the rule of law, human rights and respect for and protection of growth effects of integration. The empirical minorities." As noted by many observers, such as Flam (2003), research on the economic effects of immigration Turkey confronts serious problems in meeting the political and human rights criteria: they imply placing the military under indicates fairly small and on the whole positive political control and ridding it of its power in the judicial effects.24 There will also be political gains for the system, and they have direct implications for recognizing indi- EU. Turkey is a large and fast-expanding market. It vidual and collective cultural rights for minorities (i.e., the is, in fact, the largest market in its neighborhood Kurds). In its recommendation to launch accession negotiations, the Commission argued that in "order to guarantee the sustain- and has a GDP that amounts to 55 percent of that ability and irreversibility of the political reform process, the EU of Russia. Located at the crossroads of Europe, should continue to monitor progress of the political reforms xxxvi Overview closely, on the basis of an Accession Partnership setting out pri- 15. This is equivalent to about a 2.8 percent increase in real orities for the reform process. The Commission will, following GDP. the analysis in the Regular Report, propose to revise the Acces- 16. The 2004 European Commission recommendation sion Partnership in spring 2005. On this basis, a general review states: "The negotiations will be complex and reflect . . . the need of the way in which political reforms are consolidated and for provisions facilitating the harmonious integration of Turkey broadened will take place on a yearly basis starting from the end into the EU. The application in Turkey of the common agricul- of 2005. The pace of the reforms will determine the progress in tural policy and the cohesion policy are two examples. The rules negotiations. In line with the Treaty on European Union and the regarding the free movement of persons are a third. It is likely Constitution for Europe the Commission will recommend the that there will be, as in previous enlargement rounds, a need for suspension of negotiations in the case of a serious and persistent substantial and specific arrangements and in some areas long breach of the principles of liberty, democracy, respect for human transition periods. In the case of free movement of persons per- rights and fundamental freedoms and the rule of law on which manent safeguards can be considered. . . . The EU will need to the Union is founded. The Council should be able to decide on prepare itself because . . . the Union's capacity to absorb new such recommendation by a qualified majority." See European members, while maintaining the momentum of European Commission (2004c, 6). integration, is also an important consideration in the general 4. The European Commission reports on Turkey provide an interest of both the Union and the candidate countries. . . . In extensive list of actions taken by the government (European any event, the EU will need to define its financial perspective for Commission 2004b, 2004c). the period from 2014 before the financial implications of certain 5. In this volume, EU15 refers to the 15 members of the EU negotiating chapters can be tackled" (European Commission prior to the 2004 enlargement in which 10 more countries 2004b: 7­8). became members, creating the EU25. The 15 original member 17. For a survey, see Ghatak, Levine, and Wheatley Price countries were Austria, Belgium, Denmark, Finland, France, (1996). Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, 18. Flam obtains a number of 1.3 million for Germany, based Portugal, Spain, Sweden, and the United Kingdom. Those added on an initial Turkish-origin population there of 2.2 million. The during the enlargement were Cyprus, Czech Republic, Estonia, number in the text takes into account the additional 800,000 Hungary, Latvia, Lithuania, Malta, Poland, Slovak Republic, and Turks in the rest of the EU as of 2002. Slovenia. 19. Borjas, Freeman, and Katz (1992, 1997) found that 6. All dollar amounts are U.S. dollars unless otherwise unskilled immigrants, particularly from Mexico, increased the indicated. ratio of unskilled to skilled workers in the United States by some 7. The short maturity of debt stock and the large share of 20 percent, whereas trade flows were found to have increased the foreign currency­linked securities imply particularly high rates (implicit) ratio by only 4 percent. Freeman (2004) notes that of rollover on domestic and international markets, increasing industries that export still hire a sizable number of unskilled the vulnerability to interest rate and currency rate shocks. workers, while import-competing industries have large numbers 8. The major standards-setting bodies in the EU are CEN, of skilled workers. He also observes that the evidence that immi- CENELEC, and the European Telecommunication Standards gration has a larger impact on the ratio of skilled to unskilled Institute (ETSI). workers does not necessarily mean that large wage impacts are 9. The competition authorities have an important role to associated with immigration. Even large-scale inflows of work- play. The Turkish Competition Authority has taken action in the ers into specific locations are not found to have big effects on transport sector, such as investigating a price-fixing cartel in wages (Borjas, Freeman, and Katz, 1996). Black Sea maritime shipping (see OECD 2004b). 20. In principle, any country can choose to adopt the com- 10. See http://inweb18.worldbank.org/ECA/Transport.NSF/ mon external tariff of the EU, so that even if a customs union is Countries/Turkey? Opendocument. not on the table any country with a free trade agreement with 11. The ratio of nonperforming loans to gross loans of the the EU could emulate the Turkish solution in this dimension. banking system in Turkey reached about 22 percent in 2001. But better than adopting the idiosyncrasies of the EU political The situation improved during 2002 due to acceleration of economy of protection would be to move toward a system of low out-of-court settlements and voluntary debt restructuring and uniform tariffs. arrangements. 21. The Turkish experience, like that elsewhere in the world, 12. The average excess return on Turkish government bonds illustrates the need for a competition authority. The Black Sea over the London Interbank Offered Rate, or LIBOR (both meas- maritime case of restrictive business practices (see note 10) is a ured in U.S. dollars), amounted to only 4 percent over the period case in point. 1990­93, but was 22.9 percent over the period 1995­November 22. This may explain the support provided to EU member- 2000. In chapter 6, Pazarbas¸ioglu argues that the fiscal cost of the ship by followers of the Islamist political parties as well as by 2001 financial crisis has initially amounted to 50 billion (some representatives of different minority groups. 34 percent of GDP). If Turkey had adopted the legislative, regu- 23. During the Tanzimat period (1839­77), Westernizing latory, and institutional framework of the EU banking system at reforms were responsible for the adoption of a series of Western the beginning of the 1990s and had enforced these rules, then law codes, creation of a judicial organization with secular law the cost of the crisis would have been much smaller. courts, introduction of French-style provincial administration 13. The state banks to be privatized within three years are (1864), and use of the so-called millet system, which made it Ziraat Bank and Halk Bank. The government has withdrawn the possible for the Christian minorities to have their own religious banking license of Emlakbank, and it will resume the privatiza- autonomous administration with representative councils. These tion process of Vakifbank as soon as market conditions allow. liberal reforms culminated in the declaration of a constitution 14. See World Bank (2004) for an in-depth discussion of the and the convocation of a parliament in 1876­77. The process of challenges in and policy options for introducing greater compe- reforms continued after the national War of Independence tition into the Turkish natural gas market, including an analysis of 1919­23. Under Mustafa Kemal Atatürk's leadership, the of the sector's strengths and weaknesses. newly founded Republic of Turkey carried out an extensive and Overview xxxvii comprehensive program of modernization and secularization. European Commission. 2004a. "Euro Barometer 2004," Public Atatürk believed that total Westernization of the country was an Opinion in the Candidate Countries, Brussels. absolute precondition for Turkey's becoming a member of the --------. 2004b. "Recommendation of the European Commis- Western family of nations. He succeeded in forging a modern sion on Turkey's Progress towards Accession." COM(2004) nation out of a failing empire and a traditional community, 656 final, Brussels. based on the model of the Western countries. Turkey's --------. 2004c. "Regular Report on Turkey's Progress towards aspiration to membership in the EU stems from the process of Accession--2004." COM(2004) 656 final, Brussels. modernization and Westernization, the roots of which may be Flam, Harry. 2003. "Turkey and the EU: Politics and traced to Atatürk's reforms designed to establish a secular order Economics of Accession." CESifo Working Paper 893, March. in a country with a predominantly Muslim population. The http://www.cesifo.de. Turkish elite consider membership in the EU a natural, desir- Freeman, Richard. 2004. "Trade Wars: The Exaggerated Impact able, and inevitable step in this process. Furthermore, Turkey of Trade in Economic Debate." World Economy. realizes that it sits strategically at the edge of three regions of Ghatak, S., P. Levine, and S. Wheatley Price. 1996. "Migration conflict--the Balkans, the Middle East, and the Caucasus. Theories and Evidence: An Assessment." Journal of Economic Because of the complexity of its security, Turkey seeks to culti- Surveys 159­98. vate stability in order to minimize the potential for conflict. For Haisken-De New, J., and K. F. Zimmerman. 1996. "Wage and Turkey, EU membership can help to secure this stability and Mobility Effects of Trade and Migration." CEPR Discussion contain conflict, particularly in the Balkans. Furthermore, the Paper No. 1318, Centre for Economic Policy Research, EU and Turkey have a mutual interest in preventing and con- London. taining any instability that could arise in the Commonwealth of Harrison, G. W., T. F. Rutherford, and D. G. Tarr. 1997. "Eco- Independent States (CIS) region. nomic Implications for Turkey of a Customs Union with the 24. In addition to chapter 14 by Flam, see the studies by European Union." European Economic Review 41: 861­70. Zimmerman (1995), Haisken-De New and Zimmerman (1996), Hoekman, B., and Beata Smarzynska Javorcik. 2004. "Policies Winter-Ebmer and Zimmerman (1998), and Storesletten (2000). Facilitating Firm Adjustment to Globalization." Oxford Review of Economic Policy 20 (3): 457­73. OECD (Organisation for Economic Co-operation and Develop- References ment). 2001. Market Effects of Crop Support Policies. Paris: OECD. Boeri,T.,and H.Brucker.2000.The Impact of Eastern Enlargement --------. 2004a. OECD Agricultural Policies 2004. Paris: OECD. on Employment and Labour Markets in the EU Member States: --------. 2004b. "Anticompetitive Practices in the Maritime Final Report. Berlin: European Integration Consortium. Transport Industry in Turkey." COM/DAFFE/TD(2004)63, Borjas, G. 1995. "The Economic Benefits from Immigration." September. Journal of Economic Perspectives 9: 3­22. Schiff, Maurice, and L. Alan Winters. 2003. Regional Integration Borjas, George, Richard B. Freeman, and Lawrence F. Katz. 1992. and Development. Washington, DC: World Bank and Oxford "On the Labor Market Effects of Immigration and Trade." In University Press. Immigration and the Work Force: Economic Consequences Storesletten, K. 2000. "Sustaining Fiscal Policy through Immi- for the United States and Source Areas, ed. G. Borjas and gration." Journal of Political Economy 108: 300­23. R. Freeman. Chicago: University of Chicago Press for Togan, S. 2004. "Turkey: Toward EU Accession." World Economy National Bureau of Economic Research. 27: 1013­45. --------. 1996."Searching for the Effect of Immigration on the Winter-Ebmer, R., and K. F. Zimmerman. 1998. "East-West Labor Market." American Economic Review 86: 246­51. Trade and Migration: The Austro-German Case." IZA Dis- --------. 1997. "How Much Do Immigration and Trade Affect cussion Paper No. 2. http://www.iza.org. Labor Market Outcomes?" Brookings Papers on Economic World Bank. 2004. "Turkey: Gas Sector Strategy Note," Report Activity, 1­90. No. 30030-TR. Washington, DC, September. Claessens, S., A. Demirgüç-Kunt, and H. Huizinga. 1998. "How Zimmerman, K. F. 1995. "Tackling the European Migration Does Foreign Entry Affect the Domestic Banking Market?" Problem." Journal of Economic Perspectives 9: 45­62. Working Paper, World Bank, Washington, DC. Part I Macroeconomic Policies for EU Accession 1 1 Macroeconomic Policies for Turkey's Accession to the EU Sübidey Togan and Hasan Ersel This chapter investigates the macroeconomic poli- Despite some notable achievements, a worsening cies appropriate for Turkey both before and after its current account and a fragile banking system led in accession to the European Union (EU).1 The first late 2000 to a liquidity crisis that turned into a full- section of the chapter considers the recent macro- blown banking crisis in February 2001. In response, economic developments in Turkey, and the second the government decided to abandon the crawling examines the macroeconomic policy framework for peg regime and floated the currency. In May 2001, EU membership. The third section analyzes the the International Monetary Fund (IMF) increased macroeconomic challenges faced by Turkey,empha- its assistance to Turkey under a new standby sizing the issues related to inflation, fiscal policy, arrangement. But just as the revised program was public debt, sustainability of current account, and beginning to show results, the terrorist events of exchange rate regimes. The final section offers September 11, 2001, in the United States triggered conclusions. the reemergence of serious financing problems. In February 2002, the IMF approved a new three-year standby credit for Turkey to support the govern- Macroeconomic Developments ment's economic program. With the implementa- in Turkey tion of the stabilization program, Turkey envisages Over the past decade, economic crises began to a gradual but steady improvement in its economic affect the Turkish economy with increasing fre- conditions. In August 2004 Turkey approached the quency. Periods of economic expansion alternated IMF for a final three-year standby agreement--an with periods of equally rapid decline. Although exit program from instability and excessive debt. inflation during the period 1990­2000 fluctuated between 54.9 percent and 106.3 percent, the average Monetary Developments and Inflation inflation rate amounted to 75.2 percent. Currently, Turkey is in the midst of a determined campaign to During the past two decades,Turkey has experienced turn around decades of weak performance stem- high and variable inflation. There is strong evidence ming from pervasive structural rigidities and weak that, in the medium and long term, a close correla- public finances. The past few years have witnessed tion exists between the rate of growth of monetary three major attempts at addressing underlying aggregates and inflation. This correlation appears in weaknesses. The first was during 2000 under the figure 1.1 between the monthly series of annual con- three-year standby agreement initiated in Decem- sumer price index (CPI) inflation and the monthly ber 1999 after a significant drop in output caused by series of the annual growth rate of base money mostly external factors, including the earthquake. over the period January 1987­September 2004. 3 4 Turkey: Economic Reform and Accession to the European Union FIGURE 1.1 Inflation and the Growth Rate of Reserve Money: January 1987­September 2004 Growth rate 140 Price level 120 Reserve money 100 80 60 40 20 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Source: Central Bank of Turkey. FIGURE 1.2 Inflation and the Rate of Depreciation of the Turkish Lira: January 1987­September 2004 Growth rate 300 Price level 250 Exchange rate 200 150 100 50 0 50 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Source: Central Bank of Turkey. A close relation also exists between the annual infla- In equation 1.1, the relation between total tion rate and the annual rate of change in the demand and supply is proxied by the output gap. exchange rate on a monthly basis over the same Almost all researchers agree that, besides the output period (see figure 1.2).2 gap, public sector deficits play a significant role in Recent empirical studies of Turkish inflation explaining inflation in Turkey. We model the effect have drawn attention to a set of factors that affect of public sector deficits on inflation through two inflation in Turkey.3 Besides the obvious relation variables. The first variable is the noninterest between the aggregate demand and supply, public expenditures. In contrast to interest expenditures, sector deficits and exchange rate developments this portion of the public expenditures is deter- seem to be the major factors affecting the rate of mined by the government and is the major factor inflation. behind the changes in public sector deficits. The Macroeconomic Policies for Turkey's Accession to the EU 5 TABLE 1.1 Estimated Inflation (Monthly) Coefficient t-Statistic Constant 0.01 1.872 Public price (d log(ppublic)) 0.31 14.35 Exchange rate (d log(E) + d log(E(-1)) 0.04 2.753 Output gap (OG) 0.033 2.567 Noninterest expenditures (NIEXP) 0.012 1.822 Base money (d log (M(-1)) + d log(M(-2)) 0.025 1.963 CPI inflation (d log(CPI(-12))) 0.192 4.282 Dummy -0.016 -6.072 AR(1) 0.463 6.364 R-squared: 0.802 Adjusted R-squared: 0.792 Durbin Watson statistic: 1.884 Note: The dependent variable was d log(CPI), and the estimation period was January 1990­November 2003. The diagnostic tests for this regression indicate that there is no evidence of deviation from normality, autocorrelation, and heteroscedasticity. Source: The authors. second variable is the public sector component of the monthly industrial production index from its the wholesale price index. The movement of this trend, NIEXP the moving average of the consoli- variable is almost totally determined by administra- dated budget noninterest expenditures over the past tive decisions. Adjustments in these prices, regard- 12 months, M the base money supply, and Dummy less of their relation with public sector deficits, have the dummy variable taking the value of 1 during an impact on inflation. Because most of the goods the summer months of June, July, and August of and services produced by the public sector are used each year and 0 otherwise. When we checked all the as inputs, changes in these prices have an impact on variables used in the estimation for unit roots, we private sector costs.Yet as these changes are publicly learned that the series as used in the equation are all announced, they have a signaling effect. In this stationary. The results of the estimation are pre- sense, the role of public sector prices is very similar sented in table 1.1. to that of the exchange rate. The third variable To deal with the problem of identifying the influencing inflation in the equation is the exchange long-run determinants of inflation, we carried out rate, which affects the prices of imported commodi- the Johansen cointegration test with the variables ties. Fourth, in this equation the effect of monetary that were significant in the short-term inflation expansion on inflation is captured by movements in equation and that were found to be I(1)--that is, the base money. Thus one can now estimate Turkish CPI, NIEXP, M, ppublic, and E.4 The significant coin- inflation by using monthly data to solve tegration equation found among four of these vari- (1.1) d log(CPI) = ables can be expressed as 0 + 1dlog(ppublic) + 2(dlog(E) (1.2) CPI = -2.234 + 0.000357 M + dlog(E(-1))) + 3OG(-1) + 0.279695 ppublic + 0.000315 E + 4NIEXP + 5(dlog(M(-1)) As one would expect from economic theory, base + dlog(M(-2))) + 6dlog(CPI(-12)) money and exchange rate play an important role in + 6 Dummy explaining inflation in the long run. By contrast, the where CPI denotes the consumer price index, ppublic presence of the public sector component of the the public sector component of the wholesale price wholesale price index reflects an invariant charac- index, E the Turkish lira/U.S. dollar exchange rate, teristic of policymaking in Turkey. The rather popu- OG the output gap measured by the difference of lar political instrument used to achieve short-term 6 Turkey: Economic Reform and Accession to the European Union objectives seems to have had a strong inflationary deteriorated considerably. The large public sector impact in the long run. deficits were financed by borrowing from the mar- ket at very high real interest rates. Significant capital flowed into the country because it was offering not Real Exchange Rate and Current Account only high real interest rates but also the prospect of Until the end of the 1970s, Turkey followed a fixed steady real appreciation of the exchange rate. Thus and multiple exchange rate policy while experienc- the government's implicit commitment to the RER ing relatively high inflation rates. The policy led to appreciation insured the private sector, domestic a loss of competitiveness and eventually to the and foreign, against currency risk. It encouraged foreign exchange crisis of the late 1970s. The gross capital inflows from abroad and lending to the national product (GNP) shrank by 0.5 percent in public sector, giving rise to the phenomenon of 1979 and by 2.8 percent in 1980. With the stabiliza- large, arbitrage-related, short-term capital inflows. tion measures of 1980, Turkey devalued its lira by The policy pursued during the first half of the 100 percent and eliminated the multiple exchange 1990s was not sustainable. By 1993 the current- rate system, except for imports of fertilizers and fer- account-deficit-to-GDP (gross domestic product) tilizer inputs. After May 1981, the exchange rate was ratio had reached 3.6 percent. In 1994 the country adjusted daily against major currencies to maintain faced balance of payments crises from which the the competitiveness of Turkish exports. Multiple GDP shrank by 5.5 percent. But with the introduc- currency practices were phased out during the first tion of stabilization measures, the trend in the RER two years of the 1980 stabilization program, and reversed. The RER depreciated by 64 percent dur- the government pursued a policy of depreciating ing January 1994 and April 1994. The country had the real exchange rate (RER)--on average by about to reverse its economic policies, however, because 6 percent annually over the period 1980­88.5 of the relatively weak coalition governments. The In January 1984, domestic commercial banks RER began to appreciate again after April 1994, and were allowed to engage in foreign exchange opera- by September 1995 it had appreciated by about tions within certain limits, and restrictions on for- 23.5 percent. eign travel and investment from abroad were eased Between 1995 and 1997, the economy went and simplified. Determination of the exchange rate through a boom period of above-trend growth, was further liberalized by permitting banks to set only to find itself badly hit in 1998 by the Russian their own rates within a specified band around the crisis. In August 1999, a severe earthquake hit the central bank rate. In August 1988, major reform Marmara area of Turkey, and another large shock was introduced, and a system in which the market hit the Bolu area in November 1999. Because of set foreign exchange rates was adopted. In 1989 for- these shocks, real GDP shrank by 4.7 percent in eign exchange operations and international capital 1999. At the end of that year, Turkey embarked on movements were liberalized entirely.6 an ambitious stabilization program. Central to the A drawback of the RER depreciation policy pur- program has been the policy of using a predeter- sued during the 1980s was the decline in real wages, mined exchange rate path as a nominal anchor for measured in terms of foreign currency.7 By the sec- reducing inflationary expectations. ond half of the 1980s, popular support for the gov- During 2000, the RER appreciated considerably, ernment had begun to fall off. In the local elections which aggravated further the current account of March 1989, the governing political party suf- deficits, leading to concerns about the sustainability fered heavy losses. To increase political support, the of the exchange rate regime. The current-account- government conceded substantial pay increases deficit-to-GDP ratio reached 4.9 percent in 2000. during collective bargaining in the public sector. This episode ended with a severe currency crisis in Pressure then built up in the private sector to arrive February 2001. There was a serious run on the at similarly high wage settlements, real wages began Turkish lira (TL), interest rates skyrocketed, and to increase, and the RER started to appreciate. foreign exchange reserves began to decline rapidly. According to the government, the appreciation The government decided to abandon the crawling of the RER after 1989 stemmed from market peg regime and to float the currency. The exchange forces. During the 1990s, Turkey's public finances rate then depreciated sharply. Macroeconomic Policies for Turkey's Accession to the EU 7 On May 15, 2001, the IMF increased its assistance FIGURE 1.4 Real Exchange Rate, 1980­2004 under a new standby arrangement. This program RER aimed to strengthen the balance of public finances in 160 a way that would prevent deterioration in the future. 140 During 2001, Turkey introduced a set of structural reforms. But the terrorist attacks of September 11, 120 2001, threatened the progress of the reforms. Turkey 100 responded with a strengthened medium-term pro- gram intended to clean up the banking sector, con- 80 solidate fiscal adjustments, and achieve disinflation, 60 and in February 2002 the IMF approved a three-year 40 standby credit for Turkey to support the govern- ment's economic program. During 2001, the GNP 20 contracted by 9.5 percent, and the loss in employ- 0 ment was put at more than 1 million.8 Toward the end of 2001, the RER began to appreciate again. 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 With the appreciation of the RER, considerable eco- Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. nomic recovery was observed during 2002­04. Note: An increase in the real exchange rate indicates Figure 1.3 shows developments in the current its depreciation. account-to-GDP ratio over the period 1975­2003. Source: The authors. Currency crises arose in the late 1970s, 1994, and 2001. The figure indicates that the probability of a Figure 1.4 shows the time path of the RER over balance of payments crisis increases in Turkey as the past two decades, and it reveals four episodes of the current-account-deficit-to-GDP ratio increases RER developments. After the foreign exchange cri- above the critical level of 5 percent.9 By October sis of the late 1970s, the RER began to depreciate 2004, the annual current account deficit had sharply in response to the stabilization measures of reached $14.17 billion, and the current-account- 1980. It continued to depreciate until 1988, when it deficit-to-GDP ratio had increased to about 5 per- began to appreciate--that is, until 1994, when the cent by the third quarter of 2004. country was faced with another currency crisis. In 1994 the RER depreciated sharply, but it appreci- ated again from April 1994 to February 2001, when the country was faced with yet another currency FIGURE 1.3 Current-Account-to- crisis. After the sharp depreciation of the RER from GDP Ratio, 1975­2004 February 2001 to April 2001, it began to appreciate, Ratio especially after October 2001. It appreciated until 3 March 2004 by about 36.3 percent. During March 2004 and May 2004, the RER depreciated by about 2 11 percent, and thereafter it stayed relatively con- 1 stant until October 2004. 0 1 Fiscal Developments 2 Table 1.2 shows the structure of the revenues and 3 expenditures of the public sector from 1998 to 4 2002. The public sector consists of the central gov- 5 ernment, revolving funds, social security institu- 6 tions, extrabudgetary funds, local governments, and state economic enterprises (SEEs). The table reveals 1970 1975 1980 1985 1990 1995 2000 2005 that, on average, during 1998­2002 revenues made Source: Central Bank of Turkey. up 29.24 percent of GNP, expenditures 42.4 percent 8 TABLE 1.2 Structure of Revenues, Expenditures, and Public Sector Borrowing Requirements (PSBR), 1998­2002 Share of Total Revenue Share of Total Expenditure Nontax Factor Social Privatization Current Investment Interest Other Stock Taxes Income Income Funds Revenues Expenditures Expenditures Payments Transfers Changes Fund Revenue/GNP Expenditure/GNP PSBR/GNP 1998 80.62 4.94 19.93 -9.27 3.78 31.63 19.43 35.88 9.89 3.16 25.56 34.99 9.42 1999 87.01 5.93 18.60 -11.84 0.31 32.45 16.17 37.21 10.82 3.35 25.57 41.09 15.52 2000 82.51 7.37 11.41 -6.30 5.00 29.19 16.34 41.30 11.07 2.10 30.45 42.23 11.78 2001 81.64 6.63 16.31 -7.34 2.76 26.41 11.21 49.31 9.80 3.27 33.26 49.65 16.39 2002 76.60 9.74 23.38 -10.24 0.53 28.74 14.21 44.66 10.82 1.57 31.38 44.06 12.68 Average 81.67 6.92 17.93 -9.00 2.48 29.68 15.47 41.67 10.48 2.69 29.24 42.40 13.16 Source: Turkish State Planning Organization. Macroeconomic Policies for Turkey's Accession to the EU 9 of GNP, and public sector borrowing requirements external and foreign exchange (FX) indexed debt had (PSBR) 13.16 percent of GNP. Taxes are the main reached 59.4 percent of total debt. source of revenues, forming about 81.67 percent of The evolution of public debt is best explained by the total; indirect taxes make up about 70 percent of decomposing the annual change in debt into vari- tax revenue. Although factor incomes generated by ous components as shown in table 1.3. Concentrat- the profits of SEEs have constituted, on average, ing on developments during the past two years, the 17.93 percent of total revenues, the social funds World Bank (2003) notes that the debt-to-GNP have not generated revenue; they have been subsi- ratio in 2001 alone rose by 37.6 percent. Although dized from the budget. On the expenditures side, the country ran a primary surplus of 5.5 percent of current expenditures and investments constitute, its GNP with the introduction of the IMF stabiliza- on average, 29.68 percent and 15.47 percent of total tion program, three factors mainly contributed to expenditures, respectively. The most important the increase in the debt-to-GNP ratio: (1) the high expenditure item during the period 1998­2002 was interest rates prevailing in the country; (2) depreci- the interest payments--on average, they were ation of the real exchange rate, leading to increases 41.67 percent of total expenditures. in the ratio of FX-denominated debt to GNP; and (3) the costs of the banking crisis. In response to Public Sector Borrowing Requirements and Public the banking crisis, the government issued new Debt During the 1990s, the PSBR amounted on bonds in order to recapitalize failing banks. The average to 12 percent of GNP. The high deficit bonds issued for this purpose amounted to 20 per- incurred during the period was financed by borrow- cent of GNP (table 1.3). In 2002 the debt picture ing from the market at very high real interest rates,as improved, but this time it stemmed mainly from shown in figure 1.5.10 Table 1.3 reveals that between the real appreciation of the real exchange rate. the end of 1995 and the end of 2001 Turkey's debt The PSBR-to-GNP and debt-to-GNP ratios stock more than doubled in terms of the debt-to- given earlier are based on data from Turkey's State GDP ratio and reached 95 percent at the end of 2001. Planning Organization (SPO). Two other sets of In 2002 the debt stock shrank somewhat, but it data on the PSBR-to-GNP ratio, and thus on the remained at almost twice its level in 1995. By 2002 debt-to-GNP ratio in Turkey, are also available-- the first from the IMF and the second from the EU, consistent with the European System of Accounts FIGURE 1.5 Real Interest Rate, 1995 (ESA 95) codes. The differences among the January 1990­October 2003 three sets of data are mainly attributable to the Real interest rate large duty losses. During the 1990s, the state banks 160 faced unrecovered costs from duties carried out on 140 behalf of the government, and they covered their 120 financing needs from markets by borrowing at very 100 high interest rates and at short maturities. The 80 direct subsidies given through the state banks to 60 farmers and small business were not shown in the government budget figures of the SPO; instead, 40 they were shown on state banks' balance sheets as 20 performing assets accruing interest income. The 0 PSBR-to-GNP ratios of the SPO do not reflect the 20 subsidy components given through the state banks, 40 whereas the figures estimated by the IMF and EU do. A close look at the data in table 1.4 will reveal 19901991199219931994199519961997199819992000200120022003 Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. that the public sector, according to the IMF defini- tion, ran a deficit equal to 18.9 percent in 2000, Note: Some data are missing in this figure because 21.1 percent in 2001, 12.1 percent in 2002, and auctions could not be held during the indicated months. 10 percent in 2003. As a result, the net debt-to-GNP Source: The authors. ratio, according to the IMF definition, increased 10 TABLE 1.3 Debt and Fiscal Sustainability, 1994­2002 1994 1995 1996 1997 1998 1999 2000 2001 2002 Stock of public debt (% of GNP) Domestic debt 14.0 12.2 20.5 20.4 24.4 40.9 39.1 57.2 47.7 FX-denominated/indexed 2.7 20.4 15.3 Floating rate 28.6 20.5 External debt 30.7 29.1 26.0 22.5 19.3 20.1 18.3 37.7 32.1 External + FX-denominated/indexed 30.7 29.1 26.0 22.5 19.3 20.1 21.0 58.1 47.4 Total debt 44.7 41.3 46.5 42.9 43.7 61.0 57.4 95.0 79.8 Public debt dynamics (% of GNP) Change in debt -3.4 5.2 -3.6 0.8 17.3 -3.6 37.6 -15.2 Debt-creating items Interest payments 7.3 10.0 11.0 16.2 22.1 21.9 23.5 16.3 Debt-reducing items Primary balance 2.7 -1.2 -2.1 0.9 -2.0 2.7 5.5 3.9 Growth effect 1.7 1.5 2.0 0.9 -1.8 2.4 -3.9 4.8 Inflation effect 6.5 5.3 9.2 8.8 8.7 13.8 13.0 11.2 Revaluation effect 4.4 1.9 1.6 2.5 -1.2 3.8 -13.2 10.1 Seigniorage 3.0 2.4 2.9 2.4 3.2 1.8 1.4 1.5 Other 0.0 0.0 0.1 0.5 0.1 1.6 -18.1 -1.8 Privatization 0.0 0.0 0.1 0.5 0.1 1.6 1.9 0.1 Cost of financial sector bailout 0.0 0.0 0.0 0.0 0.0 0.0 -20.0 -1.9 Source: World Bank 2003. Macroeconomic Policies for Turkey's Accession to the EU 11 TABLE 1.4 Ratios of Public Sector Borrowing Requirements (PSBR) and of Debt to GNP and GDP, 2000­03 PSBR/GNP PSBR/GDP Debt/GNP Debt/GDP SPO IMF EU SPO IMF EU 2000 11.8 18.9 9.8 57.5 57.4 65.4 2001 16.4 21.1 15.9 91.0 93.9 102.6 2002 12.8 12.1 13.6 78.7 79.2 89.5 2003 9.4 10.0 10.1 70.5 70.9 80.2 Note: The debt/GNP figures of the IMF refer to the net debt of the public sector as a ratio of centered GNP, where centered GNP is defined as the sum of quarterly GNP in the last two quarters of the year and in the first two quarters of the next year. The debt/GDP figures of the EU refer to the ratio of the gross debt of the public sector to GDP. Sources: IMF 2004; Turkish State Planning Organization (SPO) 2004; http://www.treasury.gov.tr. from 57.4 percent in 2000 to 93.9 percent in 2001, TABLE 1.5 Total Tax Revenue as Percentage and then decreased to 79.2 percent in 2002 and to of GDP, 1998­2000 70.9 percent in 2003. Public debt, according to the IMF definition, is a net debt that is measured in 1998 1999 2000 percent of centered GNP, defined as the sum of Austria 44.3 44.1 43.7 quarterly GNP in the last two quarters of the year Belgium 45.8 45.4 45.6 and in the first two quarters of the following year.11 Denmark 50.1 51.2 48.8 By contrast, the EU measures the debt in gross Finland 46.1 46.8 46.9 terms. Thus total gross public debt, according to France 45.1 45.7 45.3 the EU definition, decreased from 102.6 percent of Germany 37.1 37.8 37.9 GDP in 2001 to 89.5 percent in 2002 and 80.2 per- Greece 35.6 36.9 37.8 cent in 2003. Ireland 31.7 31.3 31.1 Italy 42.5 43.3 42.0 Luxembourg 39.8 40.9 41.7 Structure of Taxes Because taxes constituted Netherlands 40.0 41.2 41.4 about 80.25 percent of total revenues during Portugal 33.3 34.1 34.5 2000­02, this section will consider the tax burden Spain 34.0 35.0 35.2 in Turkey, compare the composition of tax rev- Sweden 51.6 52.0 54.2 enues in Turkey with that of tax revenues in the EU, United Kingdom 36.9 36.4 37.4 and compare the main features of personal, corpo- Turkey 28.4 31.3 33.4 rate, and value added tax (VAT) systems in Turkey and the EU. Source: OECD 2003. Turkey is an upper-middle-income country, whose per capita income falls at the lower end of it is comparable with that of Ireland (see table 1.5), those of this group of countries. A comparison of but it is still below the tax/GDP figures in the mem- the central government tax revenues of Turkey with ber countries of the EU.12 those of other countries reveals that Turkey has a Table 1.6, which shows the composition of tax relatively high tax burden in its per capita income revenues in Turkey and the EU, reveals that EU group (see World Bank 2003). When compared countries obtain a significantly larger percentage of with those of lower-middle-income countries, tax revenues from social security and payroll taxes Turkey's tax burden is markedly above the revenue (32.7 percent) compared with Turkey (14.3 per- average of 13.6 percent of the lower-income group. cent). In Turkey, the share of taxes on goods and It is also significantly above the average of 21.3 per- services (35.7 percent) is higher than the similar cent for all upper-middle-income countries. In fact, share in the EU (28.8 percent). 12 Turkey: Economic Reform and Accession to the European Union TABLE 1.6 Revenue from Major Taxes as a Percentage of Total Tax Revenue, 1998 Personal Corporate Social Security Goods and General Income Income and Other Payroll Property Services Consumption Taxes Austria 22.5 4.8 40.3 1.3 27.9 18.7 Belgium 30.7 8.5 31.5 3.2 24.9 15.3 Denmark 51.6 5.6 3.9 3.6 33.2 19.6 Finland 32.3 9.0 25.2 2.4 30.7 18.5 France 17.4 5.9 39.5 7.3 26.6 17.5 Germany 25.0 4.4 40.4 2.4 27.4 17.9 Greece (1997) 13.2 6.4 32.3 3.8 41.0 22.6 Ireland 30.9 10.7 13.8 5.2 38.7 22.2 Italy 25.0 7.0 29.5 4.8 27.4 14.2 Luxembourg 18.8 19.7 25.6 8.4 26.1 13.7 Netherlands 15.2 10.6 39.9 4.9 27.7 16.9 Portugal 17.1 11.6 25.5 2.9 41.3 23.3 Spain 20.8 7.3 35.2 6.0 29.4 16.6 Sweden 35.0 5.7 33.5 3.7 21.6 13.6 United Kingdom 27.5 11.0 17.6 10.7 32.6 18.1 EU 23.9 7.1 32.7 5.4 28.8 17.2 Turkey 27.0 5.8 14.3 2.8 35.7 30.0 Source: Noord and Heady 2001. Table 1.7 compares for 2002 the personal tax, population of 70.7 million and a labor force partici- corporate tax, and VAT systems of Turkey and the pation rate of 48.3 percent in 2003, has created jobs EU countries. The table reveals that the average for about 21 million people. During 2003, 33.9 per- income tax and social security contribution rate on cent of the labor force was employed in agriculture, gross labor income in Turkey amounts to 43.2 per- 18.2 percent in industry, and 47.9 percent in serv- cent, whereas the same tax rate is 25.8 percent in ices. The unemployment rate was 10.5 percent. The Ireland and 29.7 percent in the United Kingdom. average unemployment rate during 1990­2000 was The corporate income tax in Turkey is 44.1 percent, 7.6 percent, but it increased considerably with the whereas it is 16 percent in Ireland and 30 percent financial crisis of 2001. in United Kingdom. By contrast, the VAT rate in These figures indicate that Turkey must create Turkey is 18 percent, whereas it is 15 percent in jobs for its unemployed workers, as well as for those Luxembourg and 16 percent in Germany and entering the labor force for the first time at the Spain. According to the table, tax rates are in gen- average rate of 900,000 persons a year. In addition, eral very high in Turkey. With such high tax rates, Turkey has to increase the labor force participation Turkey should have achieved a much higher total- rate from its current low level of 48.3 percent to the tax-to-GNP ratio than the 31.8 percent achieved levels that prevailed at the beginning of the 1990s. in 1999. Currently, the country has a large share At that time, the labor force participation rate was of employment declared to be at the minimum 56.5 percent. By contrast, the comparable level in wage because of attempts by both employees and the EU was about 63 percent. Job creation, then, is a employers to reduce their tax burden, and it has rel- major challenge that Turkey must meet over time. atively large employment in the informal sector. As The Turkish labor market is extremely flexible a result, Turkey's tax base is rather narrow. because of the country's formidable informal sector, whose wage-setting mechanism is quite different from that of the formal sector. The informal sector Employment and Growth is largely free from most types of labor regulation, Table 1.8, which shows developments in the labor and it does not pay most taxes and related charges. market for 2001­03, reveals that Turkey, with a Activities in this sector rely largely on the provision Macroeconomic Policies for Turkey's Accession to the EU 13 TABLE 1.7 Personal Tax, Corporate Tax, and VAT System: Turkey and EU Countries, 2002 Marginal Income Average Income Tax and Social Tax and Social Security Contribution Security Contribution Corporate Standard Rate on Gross Rate on Gross Income Tax VAT Labor Income Labor Income Rate Rate Austria 55.3 44.7 34.0 20.0 Belgium 66.7 55.6 40.2 21.0 Denmark 50.4 44.2 30.0 25.0 Finland 57.4 45.9 29.0 22.0 France 53.0 48.3 -- 19.6 Germany 63.9 50.7 38.9 16.0 Greece 44.1 36.0 -- 18.0 Ireland 33.9 25.8 16.0 21.0 Italy 54.5 46.2 -- 20.0 Luxembourg 47.9 34.2 30.4 15.0 Netherlands 51.0 42.3 34.5 19.0 Portugal 39.4 32.5 33.0 19.0 Spain 45.5 37.9 35.0 16.0 Sweden 50.4 48.6 28.0 25.0 United Kingdom 39.2 29.7 30.0 17.5 Turkey 45.6 43.2 44.1 18.0 -- Not available. Note: The first two columns report marginal and average personal income tax and social security contribution rates for a single person without dependents at 100 percent of the average production wage. The corporate income tax rate for Turkey refers to the total effective tax burden of a nonpublicly owned company. In the case of a publicly owned company, the tax burden goes down to 36.7 percent. Source: OECD tax database (http://www.oecd.org). TABLE 1.8 Labor Market Indicators: Turkey, 2001­03 2001 2002 2003 Population (thousands) 68,610 69,626 70,712 Population 15 and over (thousands) 47,158 48,041 48,912 Labor force (thousands) 23,491 23,818 23,640 Participation ratio (%) 49.8 49.6 48.3 Civilian employment (thousands) 21,524 21,354 21,147 Unemployment (thousands) 1,967 2,464 2,493 Unemployment rate (%) 8.4 10.3 10.5 Employment by sector (thousands) Agriculture 8,089 7,458 7,165 Industry 3,774 3,954 3,847 Services 9,661 9,942 10,135 Sectoral distribution of employment (%) Agriculture 37.6 34.9 33.9 Industry 17.5 18.5 18.2 Services 44.9 46.6 47.9 Source: Treasury statistics, 1980­2003. 14 Turkey: Economic Reform and Accession to the European Union of labor without formal employment contracts. Job interest rate convergence, budget deficits, govern- insecurity is pervasive, and workers receive very few ment debt, and exchange rate stability.17 benefits from their employers. Because wages in the informal sector are determined by demand and sup- Macroeconomic Policy Framework ply conditions, the informal sector itself is flexible. for EMU Members By contrast, the formal sector observes labor regula- tions, and it pays all taxes and related charges such On January 1, 1999, 11 of the 15 member countries as social security contributions and payments to of the EU entered the third and final stage of the various funds. Thus, this sector is not as flexible as process leading to the formation of the EMU. At the informal sector. Until now, Turkey has success- that time, the exchange rates among the currencies fully solved the unemployment problem by means of the participating countries were irrevocably of its large informal sector.13 Indeed, over time this fixed in relation to the new single currency, the sector has grown considerably through the lax euro, and the newly formed European Central Bank enforcement of tax, social security, and labor laws. (ECB) had taken over responsibility for monetary But the current system of formal and informal sec- policy in the Euro Area. Individual member coun- tors, with the informal sector accounting for about tries of the EMU therefore no longer have control 60 percent of total employment, does not seem to be over either monetary policy or exchange rate sustainable in the long run.14 policy; they have surrendered their sovereignty in As for the growth of GDP, over the period monetary and exchange rate policy to the suprana- 1950­2002, GDP increased at an average annual tional authority, the ECB. rate of 4.9 percent.15 However, over the same period the average growth rate declined. The growth rate Monetary Policy The European System of Cen- of GDP was 7.1 percent during 1950­59, 5.4 per- tral Banks (ESCB) is composed of the European cent during 1960­69, 4.7 percent during 1970­79, Central Bank and the national central banks 4.1 percent during 1980­89, and 3.6 percent over the (NCBs) of all 15 EU member states.18 Because not period 1990­2002. Besides experiencing decreasing all members joined the monetary union from the average growth rates of real income, Turkey has outset, the term Eurosystem was adopted to recently faced greater economic volatility, because describe the ECB and the NCBs of the 11 member economic crises have begun to affect the Turkish states that have adopted the euro. All decisions economy with increasing frequency. As noted ear- related to the Eurosystem are made by the decision- lier, during the last decade periods of economic making bodies of the ECB, the Executive Board, expansion have alternated with periods of equally and the Governing Council. The Executive Board rapid decline. comprises the president and the vice president of the ECB and four other members. It implements monetary policy in accordance with the guidelines Macroeconomic Policy Framework and decisions laid down by the Governing Council. for EU Membership The Governing Council comprises the members of Upon accession, Turkey, according to Article 122 of the Executive Board and the governors of the NCBs the treaty establishing the European Community participating in the Euro Area. It is the primary (hereafter known as the "Treaty"), will be treated as decision-making body of the ECB. a "Member State with a derogation" until it fulfills The Treaty specifies that the main task of the the convergence criteria.16 The Central and Eastern Eurosystem is to deliver price stability (Article 105). European (CEE) countries, when signing the acces- According to Article 107 of the Treaty, the Eurosys- sion treaty, have accepted the goal of monetary tem is solely responsible for the Euro Area's single union as part of the acquis communautaire, the monetary policy, and it is to pursue the goal of entire body of legislation of the European Commu- price stability free from political pressure by EU nities and Union. To become members of the institutions, interest groups, or individuals. The European Economic and Monetary Union (EMU), Treaty does not precisely define price stability. The the CEE countries must fulfill the convergence cri- Eurosystem interprets it as a year-to-year increase in teria, which involve conditions on price stability, the Harmonised Index of Consumer Prices (HICP) Macroeconomic Policies for Turkey's Accession to the EU 15 for the Euro Area of below 2 percent (European The second way in which control is exercised over Central Bank 2003b), which is to be maintained EONIA is ECB auctions, usually weekly, with a over the medium term. The phrase "below 2 per- maturity of two weeks at a rate the ECB chooses. cent'' delineates the upper bound for the rate of These auctions, called refinancing operations, pro- measured inflation in the HICP. vide the liquidity needed by the banking system, and To achieve price stability, the Eurosystem uses the chosen interest rate serves as a guide for EONIA. two pillars. The first pillar is what the Eurosystem Transactions related to weekly tenders are conducted calls "economic analysis." It consists of a broadly by the NCBs in the form of standard (fixed-rate or based assessment of the outlook for price develop- variable-rate) tenders. The NCBs are responsible for ments and the risks to price stability in the Euro collecting the tender offers and transmitting them to Area as a whole. The assessment concentrates on the ECB. They also inform credit institutions about the medium impact of the current conditions of the results of the tenders and arrange the settlement inflation. The second pillar is an assessment of the aspects--that is, receiving the collateral and provid- evolution of monetary aggregates (M3) and credit. ing the liquidity. Both the ECB and the NCBs con- It analyzes the longer-run impact of monetary duct longer-term refinancing operations monthly, aggregates on inflation. The two perspectives offer with a maturity of three months. These operations complementary analytical frameworks to support provide the financial sector with additional longer- the Governing Council's overall assessment of risks term liquidity. In addition, the NCBs may carry out to price stability. The inflation forecast is published structural open-market operations. The Governing twice a year. If the forecast exceeds the target (i.e., Council can authorize fine-tuning, outright transac- the 2 percent definition of price stability), the pre- tions of securities, foreign exchange swaps, and the sumption under an inflation targeting strategy is collection of deposits to be conducted, in excep- that monetary policy will be tightened. Although tional circumstances, by the ECB itself. the Eurosystem's strategy resembles inflation tar- Although in conducting monetary policy the geting, the Eurosystem does not want to give the Eurosystem uses mainly short-term interest rates, it appearance that it acts mechanically. is the long-term interest rate that affects the econ- In conducting monetary policy, the Eurosystem omy. Indeed, households and firms borrow for rel- uses mainly short-term interest rates and focuses on atively long periods. Thus central banks control the the overnight rate EONIA (European Over-Night short maturity, while it is the long maturity that Index Average, a weighted average of overnight really matters. Yet these banks do influence the lending transactions in the Euro Area's interbank long-term rates by being clear about their longer- market). Control over EONIA is achieved in two run aims and intentions. ways. First, the Eurosystem has two facilities at its Overall, the Eurosystem constitutionally enjoys disposal: a marginal lending facility and a deposit considerable independence, both in defining its facility. These facilities operate under overnight objectives and in deciding how to conduct mone- maturity and are available to counterparties at their tary policy. The ECB is accountable to the European own initiative. They are administered on a decen- Parliament. tralized basis, with their features harmonized across the Eurosystem. Overnight liquidity is provided at a Fiscal Policy The Euro Area does not have a cen- prespecified interest rate against eligible collateral. tral fiscal authority.19 There is a budget for the EU In normal circumstances, the interest rate on the as a whole, but it is relatively small. Spending marginal lending facility defines the ceiling for amounts to only a little over 1 percent of GDP, EONIA in the market. Similarly, the deposit facility devoted mostly to common agricultural policy and defines the floor for overnight market rates. All the structural funds, and deficit financing is pro- financial institutions fulfilling the general eligibility hibited. Thus, budgetary decisions in the Euro Area criteria may access this facility. Access is granted will remain almost exclusively the province of through the NCB in the country in which the finan- member states, albeit subject to surveillance by the cial institution is established and on all days that the EU as a whole in the context of the requirements set national payment and securities settlement systems out in the Maastricht Treaty and subsequently the are operational. Stability and Growth Pact. 16 Turkey: Economic Reform and Accession to the European Union For countries seeking to qualify for EMU mem- tions and of the main economic policy measures bership and those already members, the Maastricht the country intends to take to achieve the targets; Treaty and the SGP established certain targets on and, second, that the European Council, on a rec- the size of debt and deficits and other obligations. ommendation from the Commission, must deliver For countries already in the EMU, the targets were an opinion on each program and its yearly updates intended to achieve and maintain "sound" budget- and, if deemed necessary, a recommendation. ary positions and to avoid harsh penalties. Article Three types of recommendations are possible. First, 104 of the Treaty establishes that "member states the Council could issue a recommendation that the shall avoid excessive government deficits" and that program be adjusted if deemed deficient in some compliance with budgetary discipline will be respect. Second, if after approving the program judged on the basis of two criteria: the Council identifies a "significant divergence of the budgetary position from the medium- (a) whether the ratio of the planned or actual term budgetary objective, or the adjustment path government deficit to gross domestic product towards it," the Commission can issue a recom- exceeds a reference value, unless either the ratio mendation (early warning) in accordance with has declined substantially and continuously and Article 103(4). Third, if the divergence persists, the reached a level that comes close to the reference Council can issue a recommendation to take cor- value, or, alternatively, the excess over the refer- rective action, and can make the recommendation ence value is only exceptional and temporary and public. the ratio remains close to the reference value Regulation No. 1467/97 first tries to make more (b) whether the ratio of government debt to precise the notion of "exceptional and temporary" gross domestic product exceeds a reference excess of the deficit over the 3 percent of GDP value, unless the ratio is sufficiently diminishing threshold, as introduced by Article 104 of the and approaching the reference value at a satis- Treaty. Article 2(1) of the regulation specifies that factory pace. an "exceptional and temporary" excess of the deficit As is well known, these two reference values were is allowed "when resulting from an unusual event set at 3 percent and 60 percent, respectively. outside the control of the Member State concerned The SGP was designed to provide concreteness and which has a major impact on the financial to several provisions of the Treaty on economic position of the general government or when result- policies in the EU. It consists of a resolution of ing from a severe economic downturn." Arti- the European Council and of two regulations cles 2(2) and 2(3) further specify that a deficit will (No. 1466/97 and No. 1467/97) of the Council for be considered exceptional "if there is an annual fall Economic and Financial Affairs (ECOFIN).20 The of real GDP of at least 2 percent" or if a member resolution reaffirms the commitment to fiscal disci- state can argue successfully that the circumstances pline and introduces the notion that the "medium- are "exceptional," based on "the abruptness of the term budgetary objective of positions close to downturn or on the accumulated loss of output balance or in surplus" should be respected by mem- relative to past trends." The regulation then clarifies ber states in order to "allow all Member States to the "excessive deficit procedure" set out in Arti- deal with normal cyclical fluctuations while keep- cle 104 of the Treaty, including the imposition of ing the government deficit within the reference fines. value of 3 percent of GDP." The medium term is Countries found exceeding the 3 percent of understood to represent about three years. GDP limit must take corrective action"as quickly as Regulation No. 1466/97 clarifies the procedures possible after [its] emergence." The timing of the to be followed in implementing the surveillance of policy decisions and the rhythm at which the Com- the Stability and Growth Pact, as envisioned in gen- mission, which monitors the process, prepares its eral terms in Article 99 of the Treaty. In particular, reports imply that a country can run deficits in it establishes, first, that member states must every excess of 3 percent of GDP for two years in a row year submit an update to the stability program that without incurring sanctions. If a country fails contains a medium-term objective for the budget- to take corrective action and to bring its deficit ary position, as well as a description of the assump- below 3 percent of GDP by the deadline set by the Macroeconomic Policies for Turkey's Accession to the EU 17 Council, it is sanctioned. The sanction takes the Italianer (2002), the requirements of the legislation form of a nonremunerated deposit. The deposit are starts at 0.2 percent of GDP and rises by 1/10th of · Completion of the orderly liberalization of capi- the excess deficit, up to a maximum of 0.5 percent tal movements (Article 56) of GDP. Deposits are imposed each year until the · Prohibition of any direct public sector financing excessive deficit is corrected. If the excess is not cor- by the central bank (Article 101) rected within two years, the deposit is converted into a fine; otherwise, it is returned.21 · Prohibition of privileged access of the public sector to financial institutions (Article 102) · Alignment of the national central bank statutes Exchange Rate Policy The exchange rate of the with the Treaty, including the independence of euro in relation to other currencies such as the dol- the monetary authorities (Articles 108 and 109). lar and the yen is determined by the market, although market misalignments and excessive The first requirement--that capital movements exchange rate fluctuations are corrected through a be completely liberalized--underpins the efficient combination of economic policy dialogue, the allocation of resources in the internal market.24 The occasional use of interventions, and verbal exchange second and third requirements are related to central rate management. bank economic independence, which rests on the condition that operating procedures not be restricted by government policies. Traditionally, the Macroeconomic Policy Framework greatest threat to central bank economic independ- for Accession Countries ence is pressures to monetize the fiscal deficit. As a Based on the Treaty, three distinct phases for the result of the second and third requirements, the adoption of the EMU acquis by accession countries central bank is prohibited from having primary can be identified: (1) the preaccession period, dealings with the fiscal authorities. Essentially, this (2) the period from accession to the adoption of the prohibition means no automatic overdraft facility euro, and (3) the Euro Area phase, after adopting for treasuries and no central bank purchases of debt the euro.22 directly from the government. The prohibition of privileged access complements the prohibition of Preaccession Phase During the preaccession central bank financing, imposes market discipline phase, accession countries carry out the economic in public sector borrowing, reinforces freedom of reforms and policies needed to fulfill the Copen- capital movements, and gets rid of the distortions in hagen economic criteria, which are the existence of the allocation of financial resources toward the pub- a market economy and the capacity to cope with lic sector. The two requirements force the market to competitive pressure and market forces within the establish the relevant price, thereby making conces- EU.23 In this context, countries have to establish sionary finance more difficult, and they make trans- functioning property rights, competition, free price actions more visible, thereby making the monitor- formation, and a well-developed financial sector. If ing of central bank performance much easier. The a country is to be able to cope with international fourth requirement related to central bank inde- competition and if capital is to be channeled pendence prepares the national central bank for its smoothly within a country, it is of paramount future assignment of seeking price stability, and it importance that the domestic banking and finan- reinforces fiscal discipline. cial sector are efficient. Such efficiency requires a Policy coordination in the preaccession phase high degree of financial intermediation, liquid cap- between the EU and the accession country is ital markets, banks with a sufficient capital base, a achieved through (1) preparation of an annual Pre- functioning system of banking and securities accession Economic Programme (PEP) by the supervision, and a sound payments system. In accession country, (2) annual evaluation of the PEP addition, the accession countries must adopt the by the European Commission, (3) a fiscal notifica- EMU legislation in order to acquire the status of tion system, (4) a report on the macroeconomic and "Member State with a derogation," which they need financial sector stability developments in candidate to adopt the euro (Article 122). According to countries, (5) macroeconomic forecasts by the 18 Turkey: Economic Reform and Accession to the European Union Commission, (6) meetings between the ECB and · Treatment of economic policies as a matter of candidate countries aimed at bringing financial and common concern and coordination of eco- payment systems in line with those in the Eurosys- nomic policies between the member states tem, and (7) the Commission's regular reports on through participation in Community proce- progress toward accession. dures (Articles 98 and 99) The PEP concentrates on the economic reforms · Avoidance of excessive government deficits and needed for EU accession, and the PEP procedure adherence to the relevant provisions of the SGP offers an opportunity to develop the institutional (Article 104) and analytical capacity necessary to participate in · Further adaptation of the national central bank's the EMU upon accession, particularly in the areas of statutes with a view toward integration into the economic analysis and medium-term policy plan- European System of Central Banks (Article 109) ning. The PEP consists of four parts: (1) a review of · Progress toward achieving a high degree of sus- recent economic developments, (2) a detailed tainable convergence (Article 121). macroeconomic framework, (3) a discussion of public finance issues, and (4) an outline of the With accession, the common macroeconomic structural reform agenda. It places special emphasis policy framework becomes more constraining, with on public finance by presenting the medium-term a strong reinforcement of fiscal discipline and the fiscal objectives in terms of the general government integration of other economic policies. Budgetary deficit, the primary balance, and the public indebt- policy and outcomes become subject to the excessive edness. Moreover, the candidate countries specify deficit procedure and the nonpunitive parts of the and explain the factors underpinning their choice of SGP.The Maastricht Treaty specifies that these coun- objectives, and the programs undertaken to achieve tries will have to make progress toward fulfillment of the objectives should demonstrate the feasibility of the Maastricht criteria, and, under the conditions of the government's fiscal objectives by means of a the SGP, they will have to endeavor to avoid excessive projection of the main fiscal aggregates. Shortly deficits. Furthermore, the exchange rate policy after submission of the PEP, the Commission evalu- becomes a matter of common interest.This develop- ates the program. The evaluation does not make an ment means that, to protect the smooth functioning assessment of whether a country has made progress of the single market, competitive devaluations are toward meeting the Copenhagen criteria--this is not allowed. Thus, new member states must avoid provided on an annual basis by the Commission's policies leading to excessive fluctuations of the regular report on progress toward accession. Yet the exchangerate.ParticipationintheERMIIisexpected accession countries report to the Commission sometime after accession. Such participation implies through the fiscal notification system the debt and setting the central rate to the euro and the fluctuation deficit figures calculated in accordance with the bands within ±15 percent by mutual agreement. EU methodology based on the ESA 95 system of Because the economic policies of the accession national accounts. These notifications use the same countries become a matter of common concern, format as the fiscal notifications provided by mem- these policies will be subject to policy coordination ber states in the framework of the excessive deficit and multilateral surveillance procedures. Shortly procedure (see European Commission 2002). after accession, the new member states will be required to submit a full notification of govern- From Accession to Adoption of the Euro Phase ment debt, deficit, and associated data. New mem- Upon accession, the new member state will have ber states also will have to prepare convergence the status of "Member State with a derogation" programs, which will set out their budgetary strate- granted in the accession treaty. It will have to show gies for the coming years, in particular with respect adherence to the aim of economic and monetary to the medium-term objective of reaching a budg- union and compliance with the relevant parts of etary position "close to balance or surplus." The Title VII of the European Commission Treaty and European Council will examine the programs, and, the other EMU acquis. These parts are based on the Commission's recommendation, will · Treatment of exchange rate policy as a matter of adopt an opinion on each of the programs. common interest and, eventually, participation In addition to the convergence programs, in the exchange rate mechanism (Article 124) economic and fiscal policy coordination and Macroeconomic Policies for Turkey's Accession to the EU 19 surveillance in the EU are achieved through the will no longer be permitted. The EU expects each of Broad Economic Policy Guidelines (BEPG). These the acceding countries to join the ERM II--that is, guidelines, which are prepared on an annual basis, to agree to an exchange rate arrangement between present the member states' consensus opinion on the euro and each country's currency. This phase macroeconomic and other structural economic will last at least two years. The test period for the policies in the medium term. Each year, the Euro- exchange rate criterion will probably be from May 1, pean Commission reviews in its annual economic 2004, to April 30, 2006. It is crucial that a country report the implementation of the guidelines by the avoid devaluation within the two-year test period, member states.25 because that country would fail the exchange rate Participation in the Euro Area will be the ulti- criterion. mate goal for each new member state. A favorable During the second half of 2006, the convergence decision is made when the conditions for adoption test will probably be conducted by the ECB and the of the single currency are met, after determining European Commission. The decision on acceptance whether a new member state has achieved a high into the EMU will be made by ECOFIN on the basis degree of sustainable convergence. Prior to acces- of a proposal of the European Commission and sion, there is no requirement that the EU assess after consultation with the European Parliament progress made on convergence criteria, or that can- and after a discussion in the European Council. The didates for accession meet the criteria. As it was for examination of the budget and of government debt the present member states, adoption of the euro will likely be based on the data for 2005 or the latest occurs when a high degree of sustainable conver- available figures. In January 1, 2007, the euro will gence has been demonstrated within the internal probably be adopted as national currency. The cen- market. tral bank governor of each new EMU country then becomes a member of the Governing Council, the Euro Area Phase The adoption of the euro will main decision-making body of the ECB.26 add two key elements to the macroeconomic framework of "Member States with a derogation." The Macroeconomic Challenges One is the single stability-oriented monetary policy Facing Turkey and the ensuing single exchange rate policy. The second is implementation of the sanction provi- Turkey realizes that, in the long run, price stability sions of the SGP, by which member states surpass- and fiscal discipline create the best conditions for ing the 3 percent ceiling in their deficit will be sustained, robust economic growth, but currently subjected to substantial fines. The aim is to allow the situation is problematic. The data in table 1.9 the ECB to conduct an independent monetary show the EMU convergence criteria for Turkey and policy supported by prudent national fiscal poli- the Central and Eastern European countries. The cies, which are subjected to the SGP and policy table reveals that the CEE countries are about to coordination. The Treaty does not specify any satisfy the criteria, but that Turkey is far from satis- mandatory timetable for fulfillment of the condi- fying the conditions. In 2003 the inflation rate in tions for introduction of the euro. In other Turkey was 25.3 percent, compared with a reference words, although the economic policies of the new value of 2.7 percent for the EU; the budget deficit as member states will have to pursue a high degree a percentage of GDP was 8.8 percent, compared of sustainable convergence, the speed at which with a reference value of 3 percent for the EU; the this should happen is left undetermined by EU debt-to-GDP ratio was 80.2 percent, compared legislation. with a reference value of 60 percent for the EU; and interest rates were 28.5 percent, compared with a Prospects for Central and Eastern European reference value of 6.2 percent for the EU.27 Countries The Central and Eastern European The challenge facing Turkey is how to move countries that acceded to the EU on May 1, 2004, from the current state of affairs to one in which the will have to coordinate their economic and fiscal Maastricht criteria will be satisfied. The main issues policies with the Community in the ECOFIN are reducing the inflation rate to about 3 percent Council. They must submit annual convergence over time and reducing the debt-to-GDP ratio to programs, and restrictions on capital movements 60 percent over time, while attaining sustainability 20 TABLE 1.9 European Economic and Monetary Union Convergence Criteria, 2000­03 Interest Exchange Rates, Rate against Inflation Rate (%) Budget Deficit (% of GDP) Government Debt (% of GDP) 10Y Bonds Parity 2000 2001 2002 2003 2000 2001 2002 2003 2000 2001 2002 2003 (last) (max, 2Y) Currency Regime Czech Rep. 3.9 4.7 1.8 0.1 -4.0 -3.2 -4.6 -6.6 29.2 29.0 22.4 37.6 5.1 -5.0 Managed float (EUR) Estonia 4.0 5.8 3.6 1.3 -0.7 1.1 1.2 2.4 6.6 6.2 5.4 5.1 2.3 -0.4 Currency board (EUR) Hungary 9.8 9.2 5.3 4.7 -3.5 -5.0 -9.6 -5.7 56.1 51.5 50.4 58.6 8.4 -9.3 Target zone (EUR) Latvia 2.7 2.5 1.8 2.9 -2.8 -1.9 -2.7 -1.6 10.0 12.2 13.9 16.3 7.4 -9.9 Peg (SDR) Lithuania 1.0 1.3 0.3 -1.2 -2.8 -1.4 -2.8 -1.7 28.3 29.0 25.0 23.6 6.4 0.2 Currency board (EUR) Poland 10.1 5.5 1.9 0.7 -2.7 -6.3 -5.4 -4.5 43.8 38.0 48.0 51.0 7.3 -17.2 Float Slovakia 12.0 7.3 3.3 8.5 -6.8 -7.2 -1.9 -3.6 32.9 42.7 32.0 42.8 5.1 -6.3 Managed float (EUR) Slovenia 8.9 8.5 7.5 5.6 -1.4 -1.3 -1.1 -1.4 25.1 25.4 32.2 26.8 4.0 -4.3 Managed float (EUR) Bulgaria 10.1 7.9 5.8 2.3 -1.1 -1.0 0.2 0.0 83.8 72.5 60.9 53.7 5.4 -0.8 Currency board (EUR) Romania 45.7 34.5 22.5 15.3 -4.1 -3.7 -1.7 -2.3 29.2 31.2 25.7 26.2 17.3 -19.2 Managed float (US$) Turkey 54.9 54.4 45.0 25.3 -6.1 -29.8 -12.6 -8.8 65.4 102.6 89.5 80.2 28.5 16.3 Float Reference value 2.8 3.3 3.0 2.7 -3.0 -3.0 -3.0 -3.0 60.0 60.0 60.0 60.0 6.2 +/- 15% Note: Parity refers to the last three-year average exchange rate against the euro. In the case of Turkey, the interest rate is the annual compound interest rate obtained in the auction of treasury bills and government bonds during November 2004. SDR = special drawing rights. Sources: Deutsche Bank Research, EU Enlargement Monitor, April 2002, and EU Monitor, September 2004; State Planning Organization 2004; Central Bank of Turkey (http://www.tcmb.gov.tr). Macroeconomic Policies for Turkey's Accession to the EU 21 of the current account and decreasing the unem- commonly used measure of the costs of disinflation ployment rate in the economy. is the "sacrifice ratio," which can be defined as the number of percentage points of lost output associ- Inflation ated with a policy-induced 1 percent reduction in As of November 2004, the annual inflation rate in inflation. Following Ball (1994), we identify disin- Turkey was 9.8 percent, and the government was flation episodes as the time range within which aiming to reduce the inflation rate to 8 percent in trend inflation falls substantially and define trend 2005. To satisfy the Maastricht criteria on inflation, inflation as a centered five-quarter moving average Turkey must reduce the inflation rate further, to of the actual inflation rate.29 During the time period 3 percent. The annual inflation rate in Turkey has between the first quarter of 1987 and the third quar- been reduced in recent years through strict imple- ter of 2003, we identify in Turkey two disinflation mentation of the IMF economic program, which episodes. The first episode starts at the fourth quar- calls for controlling the growth of base money. ter of 1994 and ends during the fourth quarter of Another factor leading to a lower inflation rate has 1996. The second episode starts at the first quarter been the decrease in the cost of imported goods, of 1998 and ends during the first quarter of 2001. achieved as a result of real appreciation of the The trend inflation rate decreases by 29.62 percent Turkish lira. But reducing the inflation rate over during the first episode and by 43.05 percent dur- time through real appreciation of the currency is ing the second episode. We assume that output is at not sustainable in the long run, because the real its potential level at the start of the disinflation appreciation of the currency will lead to problems episode. For potential output and output gap pro- of sustainability of the current account. Current jections, we consider the estimates provided by the account sustainability in Turkey as of December Turkish State Planning Organization (SPO).30 They 2004 requires that the real exchange rate be depre- have estimated the potential output using the linear ciated to its long-run equilibrium level.28 Yet reduc- method, the Hodrick-Prescott method, and the ing the inflation rate by reducing the public sector production function method (see State Planning component of the wholesale price level, ppublic, is Organization 2003). The sacrifice ratio is then cal- also not sustainable, because this policy will lead to culated by the formula increases in the ratio of the public sector borrowing Z+4 requirement to GDP, leading, in turn, to problems (1.3) SR = (yt - yt ) (t - t ) related to the sustainability of fiscal policy. Thus -1 t=S ppublic should be increased at least at the same rate as the inflation rate in the economy. The only policy where yt stands for the natural logarithm of real option for reducing the rate of inflation is therefore output, yt for the natural logarithm of potential to control the growth rate of base money. output, t -1 for the trend inflation rate at the To reduce the inflation rate from its current level beginning of the episode, t for the trend inflation of 9.8 percent to around 3 percent, Turkey will rate at the end of the episode, and the disinflation probably go through a disinflation period. But dis- episode starts at period S and ends at period Z. The inflation in general entails costs, and the most calculations are presented in table 1.10. In the table, TABLE 1.10 Estimates of the Sacrifice Ratio Production Linear Episode HP Filter Function Method April 1994­April 1997 0.000 0.000 -0.013 April 1994­April 1996 0.005 0.006 -0.003 January 1998­January 2002 -0.001 -0.001 -0.001 January 1998­January 2001 0.005 0.005 0.007 Source: The authors. 22 Turkey: Economic Reform and Accession to the European Union the first line of each episode denotes the estimate of the real rate of interest by r, the foreign real interest the sacrifice ratio obtained under the assumption rate by r, the real exchange rate by q, the rate of that output returns to its potential level four quar- depreciation of the real exchange rate by , and the ters after the end of an episode, as in Ball (1994). By velocity of money by V, we get the equation deter- contrast, the second line of each episode denotes mining the time path of the total-debt-to-GDP the estimate of the sacrifice ratio obtained under ratio dt = bt + bt : the assumption that output returns to its potential level right at the end of the episode. (1.5) dt = -pst + (1 + g) (1 + r) bt The table reveals that the estimates of the sacri- -1 fice ratio in Turkey are not very much different from zero,31 which indicates, in turn, that disinflation in + (1 + r)(1 + )bt (1 + g) -1 Turkey will entail relatively little output cost. The result probably stems from the extreme flexibility of 1 - g + + g the Turkish labor market.32 But the output costs of V (1 + )(1 + g) disinflation will increase as the Turkish labor mar- -privt + fsbt ket becomes less flexible.33 Thus it would be advis- able for Turkey to follow the disinflationary policies The equation shows that debt-to-GDP ratio as long as the labor market is flexible. decreases with increases in the primary-surplus-to- GDP ratio ps, the growth rate of real GDP g, the privatization-revenues-to-GDP ratio priv, and Public Debt and Fiscal Policy the seigniorage-revenues-to-GDP ratio, defined as To analyze the issues associated with reducing the 1 g++g . By contrast, the debt-to-GDP ratio V (1+)(1+g) debt-to-GDP ratio from 80.2 percent in 2003 to increases with increases in the real domestic inter- 60 percent over time, we consider the government est rate r, the real foreign interest rate r, the rate of budget constraint represented by depreciation of the real exchange rate , and the (1.4) Gt - Tt + it Bt financial-sector-bailout-to-GDP ratio fsb. -1 + iEtBt + FSBt = (Bt - Bt Over 2000­03, seigniorage and privatization -1 ) + Et(Bt - Bt -1 -1 ) + Mt - Mt revenues were running at about 1.3 and 1.7 percent -1 + PRIVt of GDP, respectively. The crucial parameters deter- where G refers to government expenditures exclud- mining the time path of the debt-to-GDP ratio turn ing the interest payments, T government revenues, out to be the primary-surplus-to-GDP ratio, the B the TL-denominated debt stock of the public domestic and foreign real rates of interest, and the sector, B the FX-denominated debt stock of rate of real exchange rate depreciation. Turkey is the public sector, i the nominal interest rate on committed to the primary surplus target of 6.5 per- the TL-denominated government debt, i the cent of GNP over the next few years. In 2004 the interest rate on the FX-denominated government domestic real interest rate was running at about debt, E the exchange rate, FSB the public expen- 12 percent and the foreign real interest rate at about diture for the financial sector bailout, M the 8 percent (see OECD 2002 and IMF 2004). Finally, it monetary base, and PRIV privatization revenues. is noteworthy that Turkey, after appreciating the Let Yt = pt, yt be the nominal GDP, p the GDP real exchange rate by 13 percent in 2002, appreci- deflator, and y real GDP. Denoting the primary- ated the real exchange rate by a further 23.8 percent surplus-to-GDP ratio by pst = (Tt - Gt)/Yt , the in 2003. All these factors have contributed to reduc- TL-denominated debt-to-GDP ratio by bt = ing the debt-to-GDP ratio. But even under these (Bt/Yt), the FX-denominated-debt-to-GDP ratio favorable circumstances, it will take quite a long by bt = (Et Bt )/Yt, the privatization-revenues-to- time to reduce the debt-to-GDP ratio from its level GDP ratio by privt = (PRIVt/Yt), the financial- of 80.2 percent in 2003 to 60 percent and below. sector-bailout-to-GDP ratio by fsbt = (FSBt/Yt), Here three issues deserve careful analysis. the domestic rate of inflation by , the foreign rate First, the real appreciation of the exchange rate of inflation by , the growth rate of real GDP by g, contributed substantially to the reduction in the Macroeconomic Policies for Turkey's Accession to the EU 23 debt-to-GDP ratio during 2002 and 2003. But this the economy, which was 9.5 percent during the policy is not sustainable in the long run, because third quarter of 2004. That constraint may have the real appreciation of the currency will lead to serious political implications, unless the country problems of sustainability in the current account, tries to broaden its tax base, reduce the tax burden as explained later in this chapter in some detail. of economic units in the formal sector, and Second, EU accession will entail costs for Turkey improve tax compliance in the country. that must be identified and financed. These costs will include the social consequences of economic Sustainability of Current Account restructuring, such as those in the agriculture sec- The basic presumption of our approach is that the tor, where restructuring presents particular prob- current account is sustainable. If not, Turkey could lems for small farmers. The process of adopting the face an exchange rate collapse or an external debt acquis communautaire entails, among other things, default, which, in turn, would imply a reduction in comprehensive structural reforms of the public real income and employment, deviating from the administration and the productive sectors, as well long-run growth path. Starting from the notion as extensive investment in human resources and the that under current account sustainability the coun- environment. From a budgetary perspective, the try must satisfy its lifetime budget constraint, we fiscal costs of EU accession in the other accession contend that the current policies are sustainable if countries have been estimated to be over 3 percent continuation of the current government policy of GNP annually. Turkey would also face significant stance and private sector behavior into the future fiscal costs--costs that would have to be financed in the context of continuing fiscal adjustment.34 does not entail a drastic policy shift or lead to a cur- rency or balance of payments crisis. This situation implies either a reduction in the Here we emphasize the points stressed earlier by primary-surplus-to-GDP ratio by the same amount considering the balance of payments relation, or further increases in the revenues of the public which can be written as sector. Third, to reduce the debt-to-GDP ratio from its (1.6) TB$t - iDt -1 + FDIt + Dt - Dt -1 level of 80.2 percent in 2003 to 60 percent over - Rt = 0 time, Turkey, even in the face of the higher costs of where TB$ denotes the noninterest current account EU accession, must stick to the primary surplus tar- (NICA), i the foreign rate of interest, D the stock of get of at least 6.5 percent of GNP over the next few foreign debt, FDI the net foreign direct investment, R years. Any downward deviation from the target will theforeignexchangereservesof thecountry,and Rt postpone achievement of the 60 percent debt-to- the change in reserves. Also, (TBt - iDt $ -1) = GDP ratio. Achievement of the primary surplus Current Accountt and (FDIt + Dt - Dt -1) = Capi- target of at least 6.5 percent of GNP over time tal Accountt. All variables are measured in terms of requires that Turkey increase its tax revenue by foreign currency. If dt = Et Dt is the foreign-debt- broadening its tax base. In this context, Turkey pt yt Et T Bt $ could introduce, like Russia and Ukraine, a flat tax to-GDP ratio, tbt = the noninterest-current- pt yt on income at a relatively low rate. The introduction account-to-GDP ratio, fdit = FDItEt the FDI-to- pt yt of such a flat tax at a low rate would improve tax GDP ratio, and rt = ( Rt)Et the change-in- compliance and efficiency,35 and it would increase pt yt reserves-to-GDP ratio, the equation determining the tax base and thus the tax revenue, as long as the the time path of dt can be written as necessary steps are taken simultaneously to mod- ernize the tax administration and improve tax (1 + r)(1 + ) (1.7) dt = -tbt + dt-1 compliance.36 Such measures also will help to 1 + g decrease the share of the informal sector in the - fdit + rt economy. where r denotes the foreign real rate of interest Finally, the government's desire to achieve a pri- and the rate of depreciation of the RER. The mary surplus target of at least 6.5 percent of GNP equation reveals that the external-debt-to-GDP over the next few years will constrain its use of fis- ratio decreases with increases in the noninterest- cal policy for decreasing the unemployment rate in current-account-to-GDP ratio tb, the FDI-to-GDP 24 Turkey: Economic Reform and Accession to the European Union ratio fdi, and the growth rate of GDP g. By contrast, t + n, we assume that the values of tbt +i and fdit+i the debt-to-GDP ratio increases with increases in for i = 1, ... , n will remain unchanged at their the foreign real interest rate r, rate of depreciation initial values of tbt and fdit. Thus we assume that of the RER , and changes in the reserves-to-GDP the government, private sector, and rest of the ratio r . world will not change the policies they pursue in Following the approach of von Hagen and period t over the time period t + 1 and t + n. Harden (1994), we solve this expression forward for A look at Turkey's annual GDP growth rate over n periods and obtain the period 1980­2003 reveals that the average growth n rate of GDP amounted to 4.1 percent during (1.8) dt = tt dt ,n +n + t t At ,i +i i=1 1980­1989 and to 3.7 percent during 1990­2003. where Thus for the growth rate of GDP over the time period k t to t + n we take the figure of 4 percent. By con- t 1 + gi ,k trast, the foreign real interest rate is to equal 8 per- i=1(1 + ri )(1 + i) cent. Finally, we assume in the following calculations and that r = 0 for each year of the period t to t + n At = tbt + fdit - rr . and that over the same period equals zero. Followingtheapproachof vonHagenandHarden Here, t ,k can be interpreted as the "k-periods (1994),the current account is not sustainable if ahead" discount factor used to calculate the present (1.9) value of assets and liabilities in period t + k for S(n) = dt - t dtt ,n +n n period t. txt+k denotes the period t expectation of = t t At ,i +i < 0. the variable x in period t + k. The equation shows i=1 that current-debt-to-GDP ratio equals the expected This is a rather mild sustainability condition. Here discounted present value of foreign debt outstand- dt denotes the actual debt-to-GDP ratio in period t, ing in period t + n relative to GDP, plus the sum of and At +i = (tbt + fdit) for i = 1, ..., n. The all discounted At's between period t and period result of the calculations for n = 10, n = 20, and t + n. Theoretically, the intertemporal budget n = 25 are shown in table 1.11. constraint requires that lim tt dt ,n +n 0 as n The table reveals that during 1993 the current becomes very large, so that foreign debt remains accountwasunsustainableinthesensethattheactual bounded relative to GDP. If the intertemporal debt-to-GDP ratio in 1993 fell short of the expected budget constraint were violated, private investors discounted present value of foreign debt outstanding would realize that the government's liabilities inperiod2003relativetoGDPby14.03percentwhen would eventually exceed its revenue-raising capa- n = 10 and that the actual debt-to-GDP ratio in bilities. As a result, the price of the debt of the 1993 fell short of the expected discounted present country would fall to zero, and the country would value of foreign debt outstanding in period 2018 rel- see itself barred from international capital markets. ative to GDP by 27.26 percent when n = 25. This To translate the intertemporal budget constraint finding indicates that the current account needed into a practically more relevant requirement, we adjustment in the NICA-to-GDP and FDI-to-GDP consider the above relation for a limited period of ratios. During 1994, Turkey increased the NICA-to- time n and add the condition that the discounted- GDP ratio considerably, but there was not much debt-to-GDP ratio at the end of period t + n change in the FDI-to-GDP ratio. The table indicates should not exceed the debt-to-GDP ratio at time t. that the policy was successful; the sustainability We use actual data on dt, tbt, and fdit for any year measure was positive thereafter. The warning signals during the time period 1984­2003. For each year t for the 2001 currency crisis were evident in the nega- of the time period, we estimate the expected dis- tive figures of the sustainability measure for the year counted present value at time t of foreign debt out- 2000. The situation improved after the crisis, when standing in period t + n relative to GDP, plus the the sustainability measure increased and became sum of all discounted At's between period t and positive at the end of 2001. Although the current period t + n. As for the government policy stance account was sustainable in 2001 and 2002,the system and the private sector behavior over the period t to was not sustainable again in 2003. Macroeconomic Policies for Turkey's Accession to the EU 25 TABLE 1.11 Current Account Sustainability level of 0.03 percent, we next turn to the study of Measures, 1984­2003 the determinants of noninterest-current-account- (values of S (n*), percent) to-GDP ratio.37 Using quarterly data from 1988 (first quarter) to 10 Years 20 Years 25 Years 2003 (second quarter) we note that one of the main 1984 1.55 2.61 3.00 determinants of this ratio is the RER. A second fac- 1985 6.53 11.01 12.69 tor that strongly affects the NICA-to-GDP ratio is 1986 4.85 8.18 9.43 the aggregate demand for domestic goods and serv- 1987 12.30 20.73 23.89 ices, consisting of total consumption plus invest- 1988 39.31 66.27 76.38 ment demand in the home country as well as the 1989 29.16 49.15 56.65 rest of the world. As the aggregate domestic 1990 2.20 3.71 4.28 demand for goods and services in the home coun- 1991 19.12 32.23 37.15 try increases, it triggers imports, and, other things 1992 11.54 19.46 22.43 being equal, the NICA-to-GDP ratio is expected to 1993 -14.03 -23.65 -27.26 1994 36.46 61.45 70.83 decline. Similarly, as aggregate domestic demand 1995 3.00 5.06 5.83 for goods and services increases in the rest of the 1996 1.74 2.93 3.38 world, it triggers imports of the foreign country, 1997 3.06 5.16 5.95 and, other things being equal, the NICA-to-GDP 1998 21.57 36.37 41.91 ratio in the home country is expected to increase. 1999 9.89 16.67 19.21 To explain the developments in the NICA, the 2000 -25.41 -42.83 -49.36 following equation is estimated: 2001 58.32 98.31 113.31 2002 12.70 21.40 24.67 (1.10) (NICA/GDP) 2003 -8.79 -14.81 -17.07 = 0 + 1 dlog(ADD) + 2 dlog(ADDF) + 3 RER + 4DQ3 Source: The authors. + 5 D1999 + 6 D93ST + 7 D2000 where d log(ADD) denotes the annual growth rate A look at the sustainability measure for 2003 with of real aggregate domestic demand in the home n = 25 reveals that the actual-debt-to-GDP ratio country; d log(ADDF) the annual growth rate of real in 2003 fell short of the expected discounted present aggregate domestic demand in the rest of the world; value of foreign debt outstanding in the period 2028 DQ3 the third-quarter seasonal dummy; D1999 the by 17.07 percent. The system is not sustainable. The recession and earthquake dummy for the year 1999, sustainability of the current account requires that taking the value of 1 for the second, third, and fourth the value of the sustainability measure be increased quarters of 1999 and 0 otherwise; D93ST the struc- so that it becomes positive. This goal can be achieved tural break dummy in 1993, taking the value of 1 either through an increase in the NICA-to-GDP after 1993 and 0 otherwise; and D2000 the exchange ratio tbt or through an increase in the FDI-to-GDP rate­based stabilization measures, taking the value ratio fdit during each year of the period 2004­28 or of 1 for all quarters of 2000 and 0 otherwise. The through a combination of increases in both the D93ST dummy refers to the structural break in NICA-to-GDP and FDI-to-GDP ratios during the Turkey's balance of payments that took place after same time period. During 2003, the actual value of the liberalization of the capital account in 1990. At = (tbt + fdit) was -1.08 percent. For Turkey to Because economic agents respond with lag to such achieve the minimal condition for external sustain- decisions, a series of tests were conducted to identify ability, the value of At during each time period of the the structural break resulting from this decision. All interval 2004­29 would have to be 0 percent. Thus of the variables used in the estimation were checked Turkey has to increase the sum of its noninterest- for unit roots, and it was learned that the series are current-account-to-GDP ratio and its FDI-to-GDP all stationary. Because of the simultaneity problems ratio during each period of the interval 2004­29 by faced in the model, we use instrumental variable at least 1.08 percent. Supposing that fdit during the techniques to estimate the parameters.38 The results time period 2004­28 remains constant at its 2003 of the estimation are presented in table 1.12. 26 Turkey: Economic Reform and Accession to the European Union TABLE 1.12 Results for Quarterly Instrumental Variable Regression of Ratio of Noninerest Current Account (NICA) to GDP Variable Coefficient t-Statistic C -2.56863 -1.41186 d log (aggregate domestic demand, home country) -29.89038 -12.12362 d log (aggregate domestic demand, foreign country) 38.84045 1.95129 Real exchange rate 0.03719 1.97118 DQ3 1.84541 4.52182 D1999 -3.82977 -4.34096 D93ST -0.91545 -2.34142 D2000 -2.72463 -3.18816 R-squared 0.82106 Adjusted R-squared 0.79787 Durbin-Watson statistic 2.14602 Source: The authors. The coefficients of the variables are all statisti- the RER, = d NICA/GDP RER . Then starting cally significant, and all have the expected signs. An d RER NICA/GDP from initial trade balance we derive that increase in the growth rate of aggregate domestic demand in the home country reduces the NICA-to- = (im + exp - 1), GDP ratio; an increase in the growth rate of aggre- where im and exp denote the import and export gate domestic demand in the rest of the world elasticities with respect to the RER. Estimates based increases that ratio. The ratio increases as the RER on estimated Turkish import and export functions depreciates. The coefficient of the structural change range quite widely. Here we consider the estimates dummy is negative, which indicates that liberaliza- of Tansel and Togan (1987) who determine the tion of the capital account had a negative impact on export price elasticity as 0.933 and import price the NICA-to-GDP ratio, as expected. elasticity as 0.472. Thus, = 0.405. Considering the The above considerations reveal that the NICA- ratio of exports to GDP of 19.6 percent, the param- to-GDP ratio can be increased by decreasing aggre- eter values imply that a reduction of the ratio of gate demand for domestic goods and services and/or noninterest-current account-to-GDP of 1 percent by depreciating the RER. Decreasing the aggregate requires a depreciation of the RER by 12.6 percent. demand for goods and services requires that the Thus sustainability of the current account follow- country aims for a more ambitious fiscal objective ing the approach of von Hagen and Harden (1994) than the constant primary surplus of 6.5 percent of requires that the RER at the end of 2003 be depreci- GDP. But this will be very painful after so many ated by 13.6 percent. failed stabilization attempts. The alternative is to An alternative specification of the sustainability depreciate the RER and keep the RER at its "long- condition requires that the ratio of the stock of for- run equilibrium level" over time.39 eign liabilities to GDP stay constant over time at its To determine the extent of depreciation in the initial value in time period 2003. In that case, the RER,we consider the regression equation reported in equation determining the time path of the debt-to- table 1-12.But,this equation yields rather high levels GDP ratio d can be solved for the equilibrium value of required rates of depreciation of the RER for alter- of the sum of tb and fdi, under the assumption that native specifications of the sustainability condition. r = 0, as We therefore consider a different approach in order to determine the extent of the required rate of depre- (g - r - - r) (1.11) (tb + fdi) = - d ciation of the RER for achieving current account sus- (1 + g) tainability. We consider the elasticity of the ratio of Assuming that equals 0 and setting the values of noninterest-current account-to-GDP with respect to g = 0.04, r = 0.08, and d = 0.612 of the year Macroeconomic Policies for Turkey's Accession to the EU 27 2003, the equilibrium value of (tb + fdi) is deter- and expected, that influences the perceived returns mined to be 2.354 percent. Because in 2003 the and risks associated with investment in terms of actual value of (tbt + fdit) equaled -1.08 percent, both quantity and productivity of investment Turkey must increase the sum of its noninterest- flows. Investment climate thus defined depends on current-account-to-GDP and FDI-to-GDP ratios a wide array of factors that can be grouped under over time by 3.4 percent. Suppose again that fdit the headings of (1) macroeconomic and trade poli- over time stays constant at its 2003 level of 0.03 per- cies, (2) infrastructure, and (3) governance and cent. Then the increase in tbt, and thus in At over institutions. time, can be achieved by depreciating the RER by Although Turkey had an open trade regime over about 42.8 percent and maintaining it at about that the past two decades, it was unable to attract large level over time. FDI inflows. One of the main culprits behind this Finally, following the suggestion of Reinhart, failure was the uncertain macroeconomic environ- Rogoff, and Savastano (2003), we consider cases in ment, which, along with the uncertainties stem- which the country tries to decrease its ratio of stock ming from domestic politics and the ensuing high of foreign liabilities to GDP from its initial value of real interest rates, produced a very erratic growth 0.612 to 0.5 and 0.4 over a period of 10 years. In performance. Throughout the past two decades, those cases, Turkey has to increase the sum of its Turkey put on hold many decisions that could help noninterest-current-account-to-GDP ratio and its foreign investors cope with high inflation. One of FDI-to-GDP ratio over time by 4.3 and 5.2 percent, the critical measures that Turkey did not introduce respectively. This change, under the assumption was the inflation accounting framework in the that fdit over time stays constant at its 2003 level, context of the highly inflationary environment. requires that the RER be depreciated by 54.2 per- Infrastructure-related factors were at play as well. cent and 65.5 percent, respectively. Although the quantity and quality of Turkey's Consider now the issue of increasing the FDI- broadly defined infrastructure--including its geo- to-GDP ratio. A striking feature of foreign direct graphic and demographic endowments and its investment flows to Turkey is that the level is too physical and financial infrastructure--help to posi- low compared with that of FDI flows to developing tion Turkey as a potentially powerful magnet for countries with similar levels of GDP per capita. In FDI inflows, these factors were ineffective in particular, the FDI flows to Central and Eastern Turkey's effort to increase those flows. The main European countries are much larger than those to bottlenecks, as emphasized by Dutz, Us, and Yilmaz Turkey. However, in terms of population, Turkey's in chapter 10 of this volume, seem to have been is larger than that of Poland, the Czech Republic, insufficient respect for the rule of law and weak and Hungary combined. In terms of GDP, Turkey's competition in local markets, reinforced by an economy is four times larger than that of the Czech uneven application of bureaucratic red tape. Republic or Hungary, and one-quarter larger than To attract higher levels of FDI flows in the future, that of Poland in 2000. In terms of gross fixed capital Turkey must therefore not only improve its macro- formation, Turkey's investments during 2000 were economic environment, but also increase respect three to four times larger than those of the Czech for the rule of law, increase competition in local Republic and Hungary and roughly a sixth larger markets, and reduce the bureaucratic red tape. than those of Poland. In terms of average annual Once Turkey is able to attract higher levels of inflows of FDI during the 1990s, Turkey attracted FDI into the country, it does not need to depreciate inflows valued at US$800 million, which is roughly its RER by as much as before in order to attain sus- one-fifth of the US$4.1 billion in FDI inflows to tainability in its current account. With increases in Poland and significantly lower than the inflows to the FDI-to-GDP ratios, the calculated required the Czech Republic and Hungary, each of which rates of depreciation of the RER decreases. When attracted about US$2.1 billion per year. the net FDI-to-GDP ratio increases by 1.08 percent An explanation of the factors determining the to 1.11 percent of GDP while the non-interest- FDI flows must begin with a definition of the current-account-to-GDP ratio stays constant at its investment climate in the country. It is the policy, 2003 value of -1.11 percent, then the system institutional, and behavioral environment, present becomes sustainable under the approach of von 28 Turkey: Economic Reform and Accession to the European Union Hagen and Harden (1994) with no change in the increasing the fiscal deficits. The country has to RER. For increases in net FDI-to-GDP ratio below introduce tax reforms that will aim to lower the 1.08 percent, the required rate of depreciation of personal income and social security taxes, while the RER will be positive but less than 13.6 percent. broadening the tax base through, for example, the In the second case when sustainability requires that introduction of a relatively low flat tax and simulta- debt-to-GDP ratio stays constant over time the neously modernizing the tax administration. system becomes sustainable with no change in RER Achieving a relatively high but sustainable when the net FDI-to-GDP ratio increases by 3.4 per- growth rate of GDP is also a challenge for Turkey. cent while the non-interest-current-account-to- According to a recent study by Togan (2003), the GDP ratio stays again at its 2003 value of -1.11 per- problem can be analyzed in terms of the growth of cent. In this case for increases in net FDI-to-GDP productivity and the growth of employment.41 ratio below 3.4 percent, the required rate of depre- Noting that Turkey achieved annual productivity ciation of the RER will again be positive but less growth of 3.12 percent over the period 1950­99, than 42.8 percent. Finally, under the third approach Togan emphasizes that the percentage contribution when sustainability requires that debt-to-GDP of the three sources of growth to productivity ratio decreases over a period of 10 years from its growth were (1) 38.1 percent from growth in the initial value of 0.612 to 0.4, the system becomes amount of capital per worker in the economy (cap- sustainable with no change in RER when the net ital deepening), (2) 25.15 percent from improve- FDI-to-GDP ratio increases by 5.2 percent while the ments in labor quality, and (3) 36.75 percent from non-interest-current-account-to-GDP ratio stays at total factor productivity (TFP) growth.42 Thus if its 2003 value of -1.11 percent. For increases in net Turkey wants to achieve higher growth rates of FDI-to-GDP ratio below 5.2 percent, the required GDP than the 3.6 percent a year achieved over the rate of depreciation of the RER again be positive but period 1990­2002, it has to increase, on the one less than 65.5 percent. hand, the productivity growth rate--through capi- tal deepening, improvements in labor quality, and increases in the growth rate of the TFP--and, on Employment and Growth the other hand, the growth rate of employment.43 As emphasized earlier in this chapter, the unem- Togan (2003) points out that Turkey, to increase ployment rate in 2003 was high in Turkey. The the amount of capital per worker, has to increase employment challenge facing the country is to cre- not only its investment ratio but also its domestic ate jobs for those unemployed, to create new jobs savings rate, because too much reliance on foreign for those entering the labor force for the first time savings over considerably long periods of time may at an average rate of 900 thousand persons per year, lead to problems of solvency and sustainability of and to increase the labor force participation rate the current account. In addition, Turkey has to from its low level of 48.3 percent. increase its investment in human capital formation. To solve the unemployment problem over time, It must increase not only the proportion of the Turkey has to preserve the flexibility of the labor adult population with primary, secondary, and market and achieve a relatively high but sustainable higher education, but also the quality of education growth rate of GDP over the next decades. Turkey at each of these levels. Turkey also must increase can no longer sustain the flexibility of the labor TFP growth. Because the sources of TFP growth are market through the lax enforcement of laws on tax- better technology, better organization, specializa- ation and social security, because such enforcement tion, and innovations on the shop floor, Turkey has tends to create different problems for Turkish soci- to increase the channels of acquiring knowledge, ety.40 Instead, the country has to attack the root of as well as the competitive pressure in the economies the problem, which is the large wedge between under consideration. Besides creating the knowl- labor costs and workers' disposable income because edge itself through strict enforcement of intel- of the high labor taxes. Such a high tax wedge raises lectual property rights, Turkey can adopt the labor costs, discourages work in the formal econ- knowledge created by others, mainly through inter- omy, and contributes to high nonemployment in national trade, FDI, and licensing. Finally, various the working-age population. The challenge facing economists have shown that trade liberalization Turkey is to reduce the high labor taxes without affects productivity change positively.44 TFP Macroeconomic Policies for Turkey's Accession to the EU 29 growth also depends on the macroeconomic poli- of productivity growth, GDP growth depends posi- cies followed. tively on the growth rate of employment, and the To elaborate statistically the relationship between level of employment in the economy is determined the TFP and trade and macroeconomic policies, we largely by the flexibility in labor markets. Increases follow the approach of Burnside and Dollar (2000) in labor market flexibility increase employment in which and reduce the unemployment rate in the econ- omy. Thus, GDP increases until labor is fully (1.12) TFP = 0 + 1 INFLATION employed with increases in labor market flexibility. + 2 OPEN In summary, to increase the growth rate of its + 3 BUDGET SURPLUS GDP, Turkey must (1) increase not only its invest- ment ratio but also its domestic savings rate, where INFLATION refers to the rate of inflation (2) increase its investment in human capital forma- measured by the GDP deflator, OPEN to the trade tion, (3) follow outward-oriented and prudent indicator, and BUDGET SURPLUS to the ratio of macroeconomic policies, and (4) increase the flexi- budget surplus to GDP. In the equation, the second bility in the labor market. The pursuit of these term indicates the effect of instability in macro policies, however, should not jeopardize the sus- policies. It is hypothesized that instability in tainability of fiscal policy or the sustainability of macroeconomic policies negatively influences the the current account. TFP and that its coefficient should therefore be negative. The third term refers to trade policies measured by the ratio of exports and imports to Exchange Rate Policy GDP. The coefficient would be positive if trade lib- As for an appropriate exchange rate regime, the eralization contributes to increases in the TFP. Maastricht criteria do put restrictions on the per- Finally, it is hypothesized that a budget surplus pos- missible exchange rate regime after accession. itively influences the TFP. Insolvent debt paths Floating within a band or target zone measuring no characterized by large budget deficits will require more than 15 percent from a euro central rate, with monetization of debts and thus inflation, leading to intervention at or within margins of the band, is instability in the economy. Uncertainty from insta- permissible. Even without adopting a formal target bility reduces both the willingness and the capabil- zone, the country could manage to maintain its ity of economic units to take a long-term view exchange rate within 15 percent of some euro toward increasing efficiency, which eventually central rate. Definitely permissible under the decreases the TFP. Furthermore, falling budget Maastricht exchange rate criterion are a conven- deficits will lead to greater private use of private tional fixed exchange rate regime and a currency savings, leading to increases in the TFP. board with the euro. Furthermore, any of the previ- Based on annual data for 1951­99, the estima- ous regimes could be combined with the adoption tion yields of the euro as a parallel currency. Under such a (1.13) TFP = 0.593 - 0.0713 INFLATION scheme, the euro would be joint legal tender with (0.477) (­2.741) the domestic currency. However, full, unilateral + 0.2454 OPEN euroization, with the abolition of the domestic cur- (2.693) rency, is not compatible with the Maastricht criteria for joining the EMU. The argument is that, once + 0.6832 BUDGET SURPLUS the domestic currency has been abolished, the (1.996) Council of Ministers can no longer determine n = 49 (1951­99); R2 = 0.311; DW = 2.2686. the conversion rate at which the candidate EMU The variables have the expected signs. Instability in member's currency eventually joins the EMU. macroeconomic policies proxied by the inflation Before we turn to the question of what the rate negatively influences the TFP. Yet trade liberal- exchange rate arrangement for Turkey ought to be ization and budget surplus positively affect the TFP. during the preaccession period, a quick glance The factors just mentioned determine produc- at current practice by the 10 new members and tivity and its growth rate, which, in turn, influence candidate countries is useful. Table 1.9 character- the growth rate of GDP. However, for a given level izes the current exchange rate regime of each of 30 Turkey: Economic Reform and Accession to the European Union these countries. Among the 10 CEE countries, tions, the Eurosystem's monetary policy will not Bulgaria, Estonia and Lithuania have currency change, and real depreciation will call for a lower boards with respect to the euro; Latvia has a fixed price level in the accession country. Thus if prices exchange rate regime with a peg against the special and wages are downward inflexible in the accession drawing rights (SDR); Hungary has a target zone country, higher unemployment or capacity utiliza- with a central rate fixed against the euro and a 15 per- tion may result--a situation that might be avoided cent fluctuation band on either side; the Czech if the accession country conducted its own mone- Republic, Slovakia, Slovenia, and Romania have tary policy and devalued it currency in nominal managed float; Poland has floating currency. terms. Yet as long as the accession country conducts The countries under consideration had opted a large share of its trade with countries in the Euro during the early 1990s for different exchange rate Area, the likelihood of the country being hit hard regimes. Although most of them chose some kind by an external shock originating from a country or of fixed exchange rate arrangements, others such as region outside the EU is rather small. A high degree Slovenia opted for more flexible solutions. Since of real factor mobility can be an effective substitute then, most of these countries have moved toward for nominal exchange rate adjustments in the face more flexible exchange rate arrangments. For of sysmmetric shocks. Real factors, whose mobility example, Poland now has fully flexible exchange matters, are labor and physical capital. Finally, the rates. Meanwhile, in all of these countries except existence of international (and supranational) fis- Romania inflation is under control, and as of 2003 cal tax transfer mechanisms with serious redistrib- five countries satisfied the Maastricht condition on utive powers spanning the member countries of the inflation (the Czech Republic, Estonia, Lithuania, currency area will ensure compensation of the loss Poland, and Bulgaria). All of these countries are of the exchange rate instrument if the accession interested in adopting the euro as early as possible. country were to give up monetary autonomy. According to Nuti (2002), the benefits of early The optimum currency area literature empha- adoption of the euro include greater exchange rate sizes that during the period in which the conditions certainty, greater policy credibility, lower transac- just stated are not satisfied, it is advisable for the tion costs, lower interest rates, greater macroeco- accession country to adopt a flexible exchange rate nomic stability, and greater economic integration regime. Clearly, any individual CEE country should through both trade and investment. The costs of have doubts about the net advantage of giving up euroization are loss of seigniorage, loss of a lender national monetary independence. The migration of of last resort, and, more generally, loss of monetary workers is not free, and all the candidate countries policy. are relatively small compared with the Euro Area, According to the optimum currency area litera- with the exception of Poland and Romania, and then ture of Mundell (1961) and McKinnon (1963), the only in terms of population.The candidate countries costs will exceed the benefits of joining the cur- are all very open to the EU, and the diversification of rency area as long as the country exhibits a high exports to the EU is growing. As for the instruments degree of nominal rigidity in domestic prices and to absorb asymmetric shocks in the absence of inde- costs, a relatively large size in terms of GDP and low pendent monetary and exchange rate policies, the degree of openness to trade in real goods and serv- picture for the CEEs does not look worse than that ices, a high incidence of asymmetric (nation- for the existing EMU members.45 Maurel (2002) specific) shocks as opposed to symmetric shocks, notes that one cannot assess ex ante the optimal cur- a less diversified structure of production and rency area criteria, because the mere fact of entering demand, a low degree of real factor mobility across a monetary union also influences the way in which national boundaries, and an absence of significant those criteria are satisfied. Corricelli (2002) empha- international (and supranational) fiscal tax transfer sizes that the 10 candidate countries would incur rel- mechanisms. Consider the case of asymmetric atively small losses from asymmetric shocks and that shocks and assume that the monetary policy of the the CEE countries do qualify to join the EMU. Eurosystem does not take into account the business Buiter and Grafe (2002) point out that only two cycle in the accession country. Also assume that exchange rate regimes are sustainable in the long a shock calls for depreciation of the accession run. These are the free-floating exchange rate and a country's real exchange rate. Under these assump- symmetric monetary union, which is defined to be Macroeconomic Policies for Turkey's Accession to the EU 31 a monetary union with a monetary authority that primary surplus target of at least 6.5 percent of GNP, satisfies the following conditions: (1) its mandate even in the face of the increased costs of EU acces- spans the entire monetary union, (2) it acts as sion for a considerable period of time. Any down- lender of last resort on the same terms in every ward deviation from the target will postpone union member state, (3) seigniorage is shared fairly achievement of the 60 percent debt-to-GDP ratio. among all union member states, and (4) it is The primary surplus target of at least 6.5 should be accountable to the legitimate political representa- achieved within the context of a fiscal reform that tives of the citizens of the whole union. To join a will broaden the tax base by reducing the tax burden monetary union with a fixed exchange rate, a coun- substantially on both labor and capital. try must resolve its fiscal problems, attain price sta- bility, achieve a sound banking sector, and ensure Notes its current account is sustainable. Until these condi- tions are satisfied, Turkey should avoid adopting 1. The authors thank Juergen von Hagen and seminar partic- a fixed exchange rate regime. Currency board ipants at the Center for European Integration Studies (ZEI) in Bonn for their useful comments. They are particularly in debt to arrangements and euroization should not be alter- anonymous referees, whose comments helped them to correct natives for Turkey.46 Because participation in the several errors in an earlier draft. Sübidey Togan thanks ZEI for EMU is a must for Turkey, it will ultimately be part its hospitality and the Alexander von Humboldt Stiftung for of a symmetric monetary union.47 But during the financial support while this paper was written. 2. The value of the correlation coefficient between the period before accession, Turkey could pursue an monthly series of annual CPI inflation and the monthly series of exchange rate policy with central bank interven- the annual growth rate of base money is 0.7572, and that between the monthly series of annual CPI inflation and the tions aimed at attaining the long-run equilibrium monthly series of the annual rate of change in the exchange rate value of the RER. In the terminology of the IMF's is 0.7698. "Exchange Arrangements and Exchange Restric- 3. See, for example, Metin (1995, 1998), Lim and Papi tions Annual Report," we thus refer to "Crawling (1997), and Kibritçioglu (2002). 4. The output gap, which has been found to be stationary, Band" with a +/- 10 percent width.48 The country and the dummy variable have been included in the Johansen could pursue this policy until it resolves its fiscal cointegration test as exogenous variables. problems, attains price stability, and achieves sound 5. Anyone constructing real exchange rate indices is faced with choosing the price index, the currency basket, weights, and banking sector and sustainability in the current a mathematical formula. In formulating the RER, we use the account. CPI, because these data are available on a monthly basis for a large number of countries. For the currency basket, we consider countries that are major competitors of Turkey in world mar- Conclusion kets, as well as major suppliers of imported commodities to Turkey. These countries are the following: Western Europe: The criteria for accession to the EMU include a ceil- Belgium, France, Germany, Greece, Italy, the Netherlands, ing for the permissable rate of inflation one year Portugal, Spain, Switzerland, and the United Kingdom; America: Brazil, Canada, Mexico, and the United States; Middle East and prior to accession and a constraint on the permit- North Africa: Egypt, Iran, Syria, Tunisia; Central and Eastern ted variations of the nominal exchange rate-- European and Commonwealth of Independent States countries: membership in the ERM for a two-year period prior Czech Republic, Hungary, Poland, Russia; Asia: China, Indonesia, Japan, Republic of Korea, Malaysia, Taiwan (China), to accession while observing the normal fluctuation Thailand. To determine the weights of different countries, we limits of the ERM. This constraint means that use the approach developed by Zanello and Desruelle (1997), in Turkey would be free to choose the exchange rate which overall trade weights are derived by combining the bilateral import weights with the double export weights, using regime until accession. During this period, the risk the relative size of Turkish imports and exports in overall of speculative attacks on the Turkish currency will be Turkish trade to average both sets of weights. In formal terms, unavoidable, unless Turkey establishes a sound fiscal the import weight can be expressed as wi = (Mi /M), the m framework, achieves a sound banking sector, and export weight as ensures that its real exchange rate equals its long-run equilibrium level. In addition, Turkey should pursue wi = x Xi yi i a policy of maintaining the real exchange rate at X yi + Xh h around its long-run equilibrium level. By contrast, a look at fiscal issues reveals that Turkey, to reduce its Xik Xik debt-to-GDP ratio from its 2003 level of 80.2 per- + k=i X yk + Xh k cent to 60 percent over time, must stick to the h 32 Turkey: Economic Reform and Accession to the European Union and the overall weight as 9. In addition to the size of the current account deficits, the quality of the sources of financing the deficit is important. A M X wi = m x high percentage of short-term debt increases the probability that X + M wi + X + M wi sudden capital outflows will lead to a crisis. It is recognized that foreign direct investment (FDI) is by far the surest form of exter- where Mi denotes Turkish imports from country i, M the total nal financing. But FDI flows into Turkey have been rather low. value of Turkish imports, Xi Turkish exports to country i, X the Thus external sustainability is an important issue for Turkey. total value of Turkish exports, yi the value of domestic manufac- 10. Real interest rate is defined as turing production for the home market of country i, and Xi k exports of country k to country i. The formula used to estimate it the RER is + r1 = 1 100 1 + t - 1 100 100 RER = CPIi /Ei wi CPI/E where it denotes the annual rate of interest on government bonds and treasury bills, attained as the weighted average rate in where stands for the product sign, i for the index that runs auctions during the month t weighted by total sales during the over the country's trade partners, Ei for the exchange rate month, and t denotes the expected annual rate of inflation at defined as domestic currency per unit of U.S. dollar of country i, E for the Turkish lira/U.S. dollar exchange rate, and wi for the time t over the period t to t + 12. In the calculations of the real interest rate, we set the expected annual rate of inflation at time competitiveness weight attached by Turkey to country i, calcu- t over the period t to t + 12 equal to the actual annual rate of lated using the method of Zanello and Desruelle (1997). inflation over the period t to t + 12. The average level of real 6. Turkey opened the capital account in 1989 before it had interest rates over the period February 1994 to October 2003 was taken measures to upgrade banking and financial market super- 25.5 percent. vision and regulation, adopt international auditing and 11. Net debt figures are from IMF (2004), measured in per- accounting standards, strengthen corporate governance and cent of centered GNP, defined as the sum of quarterly GNP in shareholder rights, and modernize bankruptcy and insolvency the last two quarters of the year and in the first two quarters of procedures. The 1994 and 2001 crises occurred while the coun- the following year, in line with the IMF definition. try was facing large fiscal deficits, public debts, and high infla- 12. Consideration of total tax revenues, including social tion rates. Problems of competitiveness led to substantial cur- security contributions, reveals that total tax receipts in Turkey rent account deficits. In addition, the currency and maturity amounted in 1999 to 31.3 percent of GDP, compared with gen- mismatches on the balance sheets of the banks had left the eral government receipts of 40.7 percent in EU countries. authorities with little leeway for using either interest rate or According to Noord and Heady (2001), the unweighted average exchange rate adjustments to restore balance without under- of total tax revenue as a percent of GDP in the EU is 42.1 per- mining the stability of the banking sector. Finally, there was an cent, and the GDP weighted average is 40.7 percent. excessive dependence on short-term foreign borrowing to 13. Other factors contributing to the country's relatively finance the current account deficits. These weaknesses con- low unemployment rate are labor migration from the country tributed substantially to the balance of payments crisis of 1994 and the achievement of relatively high growth rates of GDP and 2001. 7. Let p E/p be the RER where p denotes the gross domes- over time. 14. Various methods can be used to estimate the size of the tic product (GDP) deflator in the foreign country, E the informal sector in the labor market. exchange rate, and p the GDP deflator in the home country, and let py = wL + rK be the nominal GDP where y stands for real Castells and Portes (1989) define informal employment as GDP, w the nominal wage rate, L total employment, r the return the sum of unpaid family workers, domestic servants, and the self-employed, minus professionals and technicians. on capital, and K the stock of capital. Expressing the capital income in this equation as rK = (wL), where stands for the An alternative approach to determining the size of the infor- mal sector considers the coverage of workers by social security profit margin, the RER can be written as institutions (Assaad 1997). Workers are divided into two groups: E p y E w(1 + ) those who are covered by a social security program and those = L who are not. The covered workers are considered to be part of p y (1 + )w - the formal sector and uncovered workers to be part of the infor- L mal sector. where (y/L) denotes labor productivity in the home country, A third approach to determining the size of the informal sec- (y/L) labor productivity in the foreign country, the profit tor is provided by Bulutay (1999). He considers the data pro- rate in the foreign country, and w the wage rate in the foreign vided by Turkish Household Labour Force Survey Results on country. Thus for given values of productivities and profit rates "employed persons by size of workplace and status in employ- in the two countries, depreciation of the RER leads to a decrease ment." As he defines the informal sector, it consists of (1) the in wages measured in foreign currency (w/E). self-employed, (2) unpaid family workers, (3) employers who 8. The severity of the 2001 crisis when compared with the employ two or three workers, and (4) regular and casual effect of the previous foreign exchange crisis is explained by the employees in private sector work places that employ one to three fact that by 2001 Turkey had a high level of "liability dollarization," workers. with high public and private foreign debt denominated in foreign In his estimation of informal employment, Togan (1997) currencies, and a high share of foreign currency­denominated defines employment in the informal sector as the sum of bank deposits. The sharp depreciation caused a large increase in employment in the agricultural sector and in the private, non- both the gross and the net indebtedness of the economy, which agricultural informal sector. He determines employment in more than offset the positive effect of depreciation on the demand the private, nonagricultural informal sector by deducting from for exports. regular and casual employers in the nonagricultural sector Macroeconomic Policies for Turkey's Accession to the EU 33 (reported by the State Institute of Statistics) the number of reg- achieved stability of institutions guaranteeing democracy, the istered wage earners reported by the Ministry of Labor. rule of law, human rights and respect for and protection of A fifth estimation method used to determine the size of the minorities, the existence of a functioning market economy as informal sector considers the share of subcontracting activity in well as the capacity to cope with competitive pressure and mar- the economy. ket force within the Union. Membership presupposes the candi- Calculations by each of these methods reveals that, on aver- date's ability to take on the obligations of membership including age, informal labor makes up about 60 percent of total employ- adherence to the aims of political, economic and monetary ment in Turkey. union" (European Council 1993). These criteria have from then 15. The growth rate of GDP at time period t is calculated as on been referred to as the Copenhagen criteria. [GDP(t) - GDP(t - 1)]100/GDP(t - 1). The average annual 24. With the entry into force of the Treaty on European growth rate over the time period under consideration is then the Union on November 1, 1993, the principle of full freedom of average of these growth rates over the indicated time period. capital movements was incorporated into the treaty. As of Janu- 16. According to Italianer (2002), there are two formal rea- ary 1, 1994, which corresponds to the start of the second stage of sons a new member state has this status. First, the procedures the economic and monetary union, Articles 73a­73g of the foreseen in Article 121(1) for assessment of the conditions for Treaty on European Union introduced new arrangements for adoption of the euro cannot be applied before accession. Sec- capital movements. Article 73a states that as of January 1, 1994, ond, one of these conditions cannot possibly be met upon acces- Articles 67­73 of the Treaty of Rome no longer apply and are sion, because it requires participation in the Exchange Rate replaced by Articles 73b­73g of the Maastricht Treaty.Article 73b Mechanism (ERM II), which is not open to nonmembers. More introduces the principle of full freedom of capital movements important, the economic rationale for the construction of the and payments, both between member states and between EMU presupposes participation in the internal market before member states and third countries. This article is directly appli- adoption of the euro. The free movement of goods, the freedom cable. Article 73c introduces the possibility of maintaining cer- to provide services, the free movement of persons, and full liber- tain existing restrictions vis-à-vis third countries.Article 73d sets alization of capital movements are expected to be accomplished out the areas in which member states can maintain information, before adoption of the euro, except for negotiated transition prudential supervision, and taxation requirements without capi- periods in a limited number of areas. tal movements being hindered. Article 73e provides for the dero- 17. Price stability requires that, over a period of one year gations adopted prior to the entry into force of the Treaty on before the examination, a country's inflation rate not exceed the European Union to be maintained for a transitional period. Arti- average rate of the three best-performing EU member states in cle 73f provides for the possibility of taking safeguard measures if price stability by more than 1.5 percentage points. Interest rate movements of capital to or from third countries cause serious convergence requires that the average long-term interest rate not difficulties for the operation of the economic and monetary exceed that of the three EU countries with the best inflation per- union. Article 73g allows the European Community or a mem- formance by more than two percentage points. The budget ber state to take measures on movements of capital to or from deficit criterion requires that the ratio of general government third countries for security or foreign policy reasons. deficit to GDP not exceed 3 percent. The government debt crite- 25. In addition, member states participating in the Euro Area rion requires that the ratio of general government debt to GDP have to prepare yearly stability programs that will report on the not exceed 60 percent. Finally, the exchange rate stability crite- medium-term budgetary objectives and on measures the mem- rion requires that the country observe the normal fluctuation ber states intend to take toward fiscal convergence. margins of the ERM II for at least two years without devaluing. 26. On voting modalities in the Governing Council after In the ERM II, the euro is the anchor currency. Although the enlargement, see European Central Bank (2003a). standard fluctuation band for the exchange rates of the partner 27. The figures for the government-deficit-to-GDP ratio and countries is ±15 percent around the central rate, narrower the debt-to-GDP ratio were obtained from State Planning Orga- bands are possible. nization (2004). These figures have been harmonized with the 18. This section is largely based on Mottiar (1999). deficit and debt definitions of the EU. 19. This section is based mainly on the work of Gali and 28. Consideration of current account sustainability in Perotti (2003). Turkey reveals that under perfect capital mobility there will 20. ECOFIN, a formation of the Council of the European always be an unavoidable risk of speculative attacks on the Turk- Union, is made up of the ministers responsible for economic ish currency, unless the country resolves its fiscal problems, affairs and finance in the EU countries. attains price stability, achieves a sound banking sector, and 21. In late 2003, France, Portugal, and Germany faced exces- brings its real exchange rate equal to the RER's long-run equilib- sive deficit proceedings after violating the 3 percent limit for rium level. Currently, Turkey is trying hard to satisfy the first three years in a row. In January 2004, this situation culminated three conditions, but its RER is, as emphasized later in this chap- in the European Commission taking legal action against the ter, overvalued. council of finance ministers over the latter's decision to suspend 29. Ball (1994) defines trend inflation as a centered nine- the SGP. These events have led to substantial public debate on quarter moving average of the actual inflation rate. In our calcu- the effectiveness of the SGP for ensuring fiscal discipline, and lations, we start with the monthly consumer price index series on the wider issue of the optimal institutional structure for fiscal and determine the quarterly CPI series as the average of the three policy within the EU. See, for example, Fatas and others (2003). monthly CPI series. Thereafter, we determine the annual quar- 22. This section draws heavily on European Commission terly inflation rate as (p(t) - p(t - 4))100/p(t - 4), where p(t) (1998), European Parliament (1999), and Italianer (2002). denotes the CPI value during quarter t. The trend inflation is 23. At the Copenhagen summit of June 1993, the EU mem- then defined as the average of inflation rates between (t - 2) and ber states agreed that "accession will take place as soon as an (t + 2). associated country is able to assume the obligations of member- 30. We are grateful to Zafer Mustafaoglu of the SPO for ship by satisfying the economic and political conditions providing the estimates of potential output and output gap required. Membership requires that the candidate country has projections. 34 Turkey: Economic Reform and Accession to the European Union 31. Similar results were obtained by Yavuz and Çetinkaya and (2002). Q = q + L 32. As emphasized earlier, the reason for this flexibility lies in where Q denotes the growth rate of output, q the growth rate of the existence of a formidable informal sector, whose wage- labor productivity, A the growth rate of technical progress, k the setting mechanism is quite different from that of the formal growth rate of the capital-to-labor ratio, H the growth rate of sector. labor quality, L the growth rate of employment, and the out- 33. As Turkey begins to enforce the labor, tax, and social put elasticity with respect to capital. security laws within the economy, labor market flexibility will 44. See, for example, Özler and Yilmaz (2003). Yet many decrease, unless the country decreases the tax and social security economists argue to the contrary. They maintain that if trade contribution rates substantially and changes the labor law liberalization reduces the domestic market shares of domestic accordingly. producers, the incentives of those producers to invest in superior 34. For estimates of the costs of EU accession for Turkey, see technologies might decrease as protection is lifted. Furthermore, in this volume chapter 2 on agriculture, chapter 9 on labor mar- they stress that liberalization of trade under asymmetric infor- kets, and chapter 11 on the environment. mation in markets may prove fragile for developing economies. 35. A flat tax on income of 13 percent was introduced in 45. On the similarity of business cycles of countries in the Russia in 2001. The income tax revenue growth then outstripped Euro Area and the accession countries, see European Forecasting the rates of economic growth and inflation in both 2001 and Network (2003). 2002. The flat tax has also boosted the share of total tax revenue 46. Before the collapse of its currency regime in 2001, Turkey held by the personal income tax. After the adoption and success did have a regime very close to the currency board. But the sys- of the flat tax in Russia, Serbia, Slovakia, and Ukraine adopted it, tem failed, because Turkey had neither a sound fiscal framework and other countries are in the process of adopting it as well. nor a sound banking sector and had not attained price stability. 36. If tax rates are reduced and the tax system is simplified Furthermore, it did not have a graceful exit strategy. but taxes cannot be effectively enforced in the private sector, the 47. The European Monetary Union is such a symmetric country may find itself facing major revenue shortfalls. monetary union that has strict conditions on fiscal policy. The 37. During 2003, inward and outward FDI flows amounted budgetary decisions by member countries are subject to surveil- to 0.23899 percent and 0.20990 percent of GDP, respectively. lance by the EMU as a whole in the context of the requirements Thus the net FDI inflow was 0.0290946 percent of GDP. set out in the Maastricht Treaty and subsequently the Stability 38. To deal with the simultaneity problem in a simple way, a and Growth Pact. four-quarter lagged value of RER is used as the instrumental 48."Crawling pegs" refers to pegs with central parity period- variable. ically adjusted in fixed amounts at a preannounced rate or in 39. The literature basically includes two approaches to deter- response to changes in selected quantitative indicators. "Crawl- mining the long-run equilibrium value of the RER. According to ing band" refers to crawling pegs combined with bands larger Williamson (1994) andWren-Lewis and Driver (1998),the funda- than 1 percent. "Managed Floating with no Preannounced mental equilibrium exchange rate (FEER) is the real exchange rate Path for the Exchange Rate" refers to regimes in which the that would exist when the economy is at full employment (internal monetary authority intervenes in the foreign exchange market balance) and in current account equilibrium (external balance). without precommitment to a preannounced path for the Thus the FEER is the RER that will bring the current account into exchange rate. Finally, "Independent Floating" refers to regimes equality with the "sustainable" capital account, where home and in which the exchange rate is market-determined, with any foreign aggregate outputs are set at their full employment values. foreign exchange intervention aimed only at preventing exces- By contrast, the model of a behavioral equilibrium exchange rate sive volatility in the exchange rate movement. For a system of (BEER) by Clark and MacDonald (1998) analyzes the actual classification of exchange rate regimes different from that of the behavior of the RER using econometric techniques, where the IMF, see Reinhart and Rogoff (2002). reduced form equation is estimated with assumed longer-term fundamentals and short-term variables using cointegration analy- sis. MacDonald and Stein (1999) and Hinkle and Montiel (1999) References consider productivity and net foreign assets as fundamental vari- ables.Other variables identified in the literature include real inter- Assaad, R. 1997. "Explaining Informality: The Determinants of est differentials, measures of openness of trade and the exchange Compliance with Labor Market Regulations in Egypt." Paper system, and size of fiscal balance. Finally, Stein and Allen (1995) presented at the Economic Research Forum Fourth Annual distinguish between medium- and long-term factors influencing Conference, Beirut, Lebanon, September 7­9. the RER. The approach developed in this chapter can be consid- Ball, L. 1994."What Determines the Sacrifice Ratio?"In Monetary ered an extension of the FEER approach. The latter approach Policy, ed. N. G. Mankiw. Chicago: University of Chicago. requires that the NICA-to-GDP ratio be sustainable. Buiter,W. H., and C. Grafe. 2002."Anchor, Float or Abandon Ship: 40. The economic units may begin to assume they can avoid Exchange Rate Regimes for Accession Countries." Discussion the rule of law. Paper No.3184,Centre for Economic Policy Research,London. 41. Productivity is defined as GDP measured at constant Bulutay, T. 1999. "Giri¸s: Türkiye'de Azörgütlü Kesim." State prices, Q, divided by employment, L--that is, Q/L. Institute of Statistics, Ankara. 42. Letting Q stand for GDP, K for capital, L for labor, and Burnside, C., and D. Dollar. 2000. "Aid, Policies and Growth." H for the index of labor quality, total factor productivity, American Economic Review 90: 847­68. using the Cobb-Douglas production function, is defined as Castells, M., and A. Portes. 1989. "World Underneath: The Q/[K (H L)(1 -) ], where denotes the output elasticity with Origins, Dynamics, and Effects of the Informal Economy. In respect to capital. The Informal Economy, ed. A. Portes, M. Castells, and L. A. 43. Symbolically, the relations can be expressed by the Benton. Baltimore: Johns Hopkins University Press. equations Clark, P., and R. MacDonald. 1998. "Exchange Rates and Eco- q = A + k + (1 - )H nomic Fundamentals: A Methodological Comparison of Macroeconomic Policies for Turkey's Accession to the EU 35 BEERs and FEERs." Working Paper 98/67, International Metin, K. 1995. "An Integrated Analysis of Turkish Inflation." Monetary Fund, Washington, DC. Oxford Bulletin of Economics and Statistics 57: 513­31. Corricelli, F. 2002. "Exchange Rate Policy during Transition to --------. 1998. "The Relationship between Inflation and the the European Monetary Union: The Option of Euroization." Budget Deficit in Turkey." Journal of Business, Economics and Economics of Transition 10 (2): 405­17. Statistics 16: 412­22. European Central Bank. 2003a. "The Adjustment of Voting Mottiar, R. 1999."Monetary Policy in the Euro Area: The Role of Modalities in the Governing Council." European Central National Central Banks." Central Bank of Ireland Quarterly Bank Monthly Bulletin (May): 73­83. Bulletin (winter): 57­69. --------. 2003b. "Editorial." European Central Bank Monthly Mundel, R. A. 1961. "A Theory of Optimum Currency Areas." Bulletin (May): 8. American Economic Review 657­75. European Commission. 1998. "Reports on Progress towards Noord, P. van den, and C. Heady. 2001. "Surveillance of Tax Accession by each of the Candidate Countries." Composite Policies: A Synthesis of Findings in Economic Surveys." Eco- paper, Brussels: EC. nomics Department Working Paper No. 303, Organisation --------. 2002. "Enlargement Paper 13." Brussels. for Economic Co-operation and Development, Paris. European Council. 1993. "Conclusions of the Presiding." Nuti, D. M. 2002."Costs and Benefits of Unilateral Euroization in European Council meeting, Copenhagen, June 21­22, Central Eastern Europe." Economics of Transition 10: 419­44. SN 180/1/93 REV 1. OECD (Organisation for Economic Co-operation and Develop- European Forecasting Network. 2003. "EFN Report on the Euro ment). 2002. OECD Economic Surveys: Turkey. Paris: OECD. Area Outlook: Autumn 2003." http://www.efn.uni-bocconi.it. Özler, S¸., and K. Yilmaz. 2003. "Does Foreign Ownership Matter European Parliament. 1999. "EMU and Enlargement: A Review for Survival and Growth? Dynamics of Competition and of Policy Issues." Directorate General for Research Working Foreign Direct Investment." Paper presented at the 10th Paper, Economic Affairs Series ECON 117, European Parlia- Annual Conference of the Economic Research Forum for the ment, Luxembourg. Arab Countries, Iran and Turkey, Marrakesh, December Fatas, A., J. von Hagen, A. Hughes Hallet, R. Strauch, and A. 16­18. Sibert. 2003. "Stability and Growth in Europe: Towards a Reinhart, C., K. S. Rogoff, and M. Savastano. 2003. "Debt Intol- Better Pact." In Monitoring European Integration 13. London: erance." Brookings Papers on Economic Activity, 1­74. Centre for Economic Policy Research. State Planning Organization. 2003. Pre-Accession Economic Gali, J., and R. Perotti. 2003. "Fiscal Policy and Monetary Inte- Programme 2003. Ankara: SPO. gration in Europe." Discussion Paper No. 3933, Centre for --------. 2004. Pre-Accession Economic Programme 2004. Economic Policy Research, London. Ankara: SPO. Hinkle, L., and P. Montiel. 1999. Exchange Rate Misalignments: Stein, J., and P. Allen. 1995. Fundamental Determinants of Concepts and Measurements for Developing Countries. Exchange Rates. Oxford: Clarendon Press. Washington, DC: World Bank. Tansel,A.,andS.Togan.1987."PriceandIncomeEffectsinTurkish IMF (International Monetary Fund). 2004. Various issues. Foreign Trade."Weltwirtschaftliches Archiv 123: 521­34. Exchange Arrangements and Exchange Restrictions Annual Togan, S. 1997. "Türkiye'de Is¸gücü Piyasasinda Esneklik." In Report. Washington, DC: IMF. Türk Is¸gücü Piyasasi ile Ilgili Temel Gelis¸meler, ed. T. Bulutay. --------. 2004. Turkey: "Seventh Review under the Stand-By Ankara: State Institute of Statistics. Arrangement, and Requests for Waiver of Applicability and --------. 2003. "Labor Market Flexibility in Turkey." In Com- Nonobservance of Performance Criteria, Rephasing of petitiveness in the Middle Eastern and North African Coun- Purchases, and Extension of Arrangement." Staff report, tries, ed. S. Togan and H. Kheir-El-Din. ERF Research Report Washington, DC. Series. Cairo: Economic Research Forum for the Arab Coun- Italianer, A. 2002. "The Macroeconomic Policy Framework for tries, Iran and Turkey. EU Membership and Euro Area Participation--The Role of Undersecretariat of the Treasury. 2003. Kamu Borç Yönetimi Budget Policy." Paper presented at Conference on "EU Raporu. Ankara: Hazine Müstes¸arligi. Accession--Developing Fiscal Policy Frameworks for von Hagen, J., and I. J. Harden. 1994. "National Budget Process Sustainable Growth, Brussels, May 13­14. and Fiscal Performance." European Economy. Reports and Kibritçioglu, A. 2002. "Causes of Inflation in Turkey: A Litera- Studies 3. Towards Greater Fiscal Discipline.311­93.European ture Survey with Special Reference to Theories of Inflation." Commission: Directorate General for Economic and Finan- In Inflation and Disinflation in Turkey, ed. A. Kibritçioglu, L. cial Affairs. Rittenberg, and F. Selçuk. Aldershot, UK, and Burlington, Williamson, J. 1994. Estimating Equilibrium Exchange Rates. VT: Ashgate. Washington, DC: Institute for International Economics. Lim, C. H., and L. Papi. 1997. "An Econometric Analysis of the World Bank. 2003. Turkey Country Economic Memorandum: Determinants of Inflation in Turkey." Working Paper Toward Macroeconomic Stability and Sustained Growth. No. WP/97/170, International Monetary Fund, Washington, Report No. 26301-TU. Washington, DC: World Bank. DC. Wren-Lewis, S., and R. Driver. 1998. Real Exchange Rates for the MacDonald, R., and J. Stein. 1999. Equilibrium Exchange Rates. Year 2000. Washington, DC: Institute for International Boston: Kluwer Academics. Economics. Maurel, M. 2002. "On the Way of EMU Enlargement towards Yavuz, D., and A. Çetinkaya. 2002. "Calculation of Output- CEECs: What Is the Appropriate Exchange Rate Regime?" Inflation Sacrifice Ratio: The Case of Turkey." Working Discussion Paper No. 3409, Centre for Economic Policy Paper No. 11, Central Bank of Turkey, Ankara. Research, London. Zanello, A., and D. Desruelle. 1997. "A Primer on the IMF's McKinnon, R. I. 1963. "Optimum Currency Areas." American Information Notice System." IMF Working Paper WA/97/71. Economic Review 717­25. Washington, DC: International Monetary Fund. Part II Agriculture, Manufacturing, Services, and Network Industries 37 2 Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey Sübidey Togan, Ahmet Bayener, and John Nash Integration into the European Union (EU) is one of gross domestic product (GDP), while the corre- Turkey's central foreign policy priorities.1 As a part sponding figure for the EU15 is 1.7 percent.2 of this integration, Turkey will have to adopt an Although the Turkish GDP grew at 4 percent per agricultural policy and institutional framework year over the period 1980­2003, the growth rate of compatible with the EU's Common Agricultural agriculture was only 1.1 percent per year, and it Policy (CAP) and accept the full body of the legisla- fluctuated widely over the period. As a result, the tion and policies on agriculture in the EU as it exists sector shrank as a share of the economy, from on the date of accession. For Turkey, the adoption of 25 percent in 1980 to 12 percent in 2003. The sector EU-like agricultural policies will constitute a signif- still accounts for a very large share of employment, icant modification of current policies, and such although this share has also fallen considerably. policies will have enormous implications for the Between 1980 and 2003, the number of people incomes of both farmers and the wider population. employed in agriculture fluctuated between 7.2 mil- The purpose of this chapter is to explore these lion and 9.2 million, but because of a steady increase issues of EU enlargement to Turkey. The chapter is in employment in other sectors,agriculture's share in organized as follows. The first section reviews the civilian employment dropped from 54.2 percent agricultural situation in Turkey. The second and in 1980 to 33.9 percent in 2003. third sections consider the agricultural policies in Turkey has a total land area of 78 million Turkey and in the EU, respectively, as they are now hectares (see table 2.1 for land use in Turkey). The and as they may evolve in line with changes recently total agricultural area of 39 million hectares con- proposed formally by the European Commission sists of arable land (24 million hectares), the area (the administrative arm of the EU government). used for permanent crops (2.5 million hectares), The impact of introducing the CAP is analyzed in and permanent meadows and pastures (12.7 mil- the fourth section using a partial equilibrium model lion hectares). Fallow land makes up more than of the agricultural sector. The fifth section discusses 20 percent of total arable cropland. In addition, issues related to institutional development. Conclu- Turkey has slightly more than 20 million hectares sions are presented in the final section. of forested land. The total irrigated area is about 4.5 million hectares, or 19 percent of total arable area. It is estimated that the country can potentially Agricultural Situation irrigate about 8.5 million hectares. Agriculture is an important part of the Turkish Turkey's agricultural land, exposed to both mar- economy; it contributes about 12 percent to the itime and continental weather conditions, tolerates 39 40 Turkey: Economic Reform and Accession to the European Union TABLE 2.1 Land Use in Turkey, 1995 and 2000 1995 2000 (thousand Percentage (thousand Percentage hectares) Distribution hectares) Distribution Arable land 24,373 31.5 23,826 30.8 Area sown 18,464 23.8 18,207 23.5 Vegetable gardens 785 1.0 793 1.0 Fallow land 5,124 6.6 4,826 6.2 Permanent crops 2,461 3.2 2,553 3.3 Vineyards 565 0.7 535 0.7 Orchards 1,340 1.7 1,418 1.8 Olive groves 556 0.7 600 0.8 Permanent meadows and pastures 12,659 16.3 12,671 16.4 Total agricultural land 39,493 51.0 39,050 50.4 Forests and woodland 20,199 26.1 20,703 26.7 Other land 17,271 22.3 17,210 22.2 Total land area 76,963 99.3 76,963 99.3 Total area 77,482 100 77,482 100 Source: Food and Agriculture Organization Statistical Database. TABLE 2.2 Value of Agricultural number of small farms. The 2001 census revealed Production: Turkey, 2000 that 83.4 percent of farms had less than 10 hectares of land. The average size of farm holdings was Value Percentage 6.1 hectares (see table 2.3).3 Product (US$ millions) Distribution An examination of Turkey's foreign trade in the Crops 28,163 68.48 agricultural commodities HS (Harmonized Sys- Livestock 10,600 25.77 tem) 01­24, HS 41.01­41.03, HS 51.01­51.03, and Forestry 1,101 2.68 HS 52.01­52.03 reveals that over the period Fishing 1,246 3.03 1999­2001 the average annual agricultural exports Total 41,129 100.00 amounted to US$4.06 billion, or about 14.2 percent of total exports.4 Turkey's agricultural exports to Source: Turkish State Planning Organization. the EU of $1.8 billion made up about 12 percent of its total exports to the EU. By contrast, Turkey's a wide range of crops. Climate and geography also total agricultural imports amounted on average to have an important bearing on the location and type $2.7 billion, or about 6.2 percent of total imports. of animal husbandry carried out in Turkey. Accord- Agricultural imports from the EU, valued at ing to table 2.2, which shows the value of agricul- $0.7 billion, made up about 3.2 percent of Turkey's tural production during 2000, crops account for total imports from the EU. 69 percent of production value, livestock products Table 2.4 shows that the three agricultural com- for 26 percent, forestry for 3 percent, and fishing modities with the highest shares of total agricul- products for 3 percent. tural exports were edible fruits and citrus fruits, In Turkey, the family-owned farm is the basic 28.5 percent; foods made of vegetables, fruits, and unit of agricultural production, and family mem- other plants, 13.0 percent; and processed tobacco bers provide most of the farm labor. The number and substitutes, 12.2 percent. The three agricultural and size of holdings are inferred from agricultural commodities with the highest shares of exports to censuses, which are conducted every 10 years on the EU, of total agricultural exports to the EU, were the basis of small sample surveys. The picture edible fruits and citrus fruits; foods made of vegeta- that emerges from these censuses is that of a large bles, fruits, and other plants; and processed tobacco Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 41 TABLE 2.3 Agricultural Holdings and Land Engaged in Crop Production, Turkey Average Size Holdings Total Area of Farm Size of Holdings Holdings (decares) Number Percent Decares Percent (decares) Less than 5 177,893 5.89 481,605 0.26 3 5­9 290,327 9.61 1,951,672 1.06 7 10­19 539,507 17.86 7,374,515 4.00 14 20­49 950,539 31.46 29,523,341 16.02 31 50­99 559,999 18.54 38,123,216 20.68 68 100­199 327,330 10.83 43,881,626 23.81 134 200­499 153,688 5.09 42,076,313 22.83 274 500­999 17,431 0.58 11,218,554 6.09 644 1,000­2,499 4,198 0.14 5,476,930 2.97 1,305 2,500­4,999 222 0.01 695,541 0.38 3,133 5,000 + 56 0.00 3,526,174 1.91 62,967 Total 3,021,190 100 184,329,487 100 61 Note: The figures on the number of holdings and area are from the 2001 census. Source: Turkish State Institute of Statistics. and substitutes. Yet the three agricultural com- importer of commodities such as cotton and modities with the highest shares of exports to the oilseeds, various seeds and fruits, and industrial EU, of total sectoral exports, were other animal plants. By contrast, in its trade with the EU, Turkey products, 95.3 percent; products made from meat, is a net exporter of edible fruits and citrus fruits; fish, and crustacea, 83.9; and plants and floriculture foods made of vegetables, fruits, and other plants; products, 76.1. Overall, exports of agricultural and processed tobacco and substitutes. It is a net commodities to the EU formed 44.3 percent of all importer of hides and skin, cotton, and various of Turkey's agricultural exports. foods. As for imports of agricultural commodities, the three commodities with the highest shares of total Agricultural Policies in Turkey agricultural imports were cotton, 19.0 percent; ani- mal or vegetable oils and fats,13.6 percent; and cere- The main objectives of agricultural policies in als, 12.0 percent. The three agricultural commodi- Turkey are set out in the government's five-year de- ties with the highest shares of imports from the EU, velopment plans. These objectives are to (1) ensure of total agricultural imports from the EU, were adequate levels of nutrition, (2) increase yield and cotton, hides and skin, and animal or vegetable oils output, (3) reduce the vulnerability of production and fats. Finally, the three agricultural commodities to adverse weather conditions, (4) raise levels with the highest shares of imports from the EU, of of self-sufficiency, (5) provide adequate, stable total sectoral imports, were plants and floriculture incomes for those working in the agricultural products, 89.4 percent; cereal products, wheat flour, sector, (6) increase exports, and (7) develop rural and pastries, 89.3 percent; and vegetable lacquers, areas. In pursuit of these objectives, the government resins, and balsams, 86.4 percent. Overall, imports has implemented various measures. In the crops of agricultural commodities from the EU made up sector, government interventions have primarily 25.7 percent of all agricultural imports. taken the form of price supports, augmented by Table 2.4 further reveals that Turkey is a net high tariffs. In the livestock sector, quantitative exporter of commodities such as edible fruits and restrictions and tariffs have been the main mecha- citrus fruits; foods made of vegetables, fruits, and nism used to support prices. In addition, farmers other plants; and sugar and sweets. It is a net were given input subsidies and credits to improve 42 TABLE 2.4 Exports and Imports of Agricultural Commodities: Turkey, 1999­2001 Net Exports Exports Exports Exports Imports Imports Net in Trade to EU, from from EU, Imports from Exports, with EU, Average, Average EU as a Average, Average EU as a Average Average Harmonized 1999­2001 1999­2001 Share of 1999­2001 1999­2001 Share of 1999­2001 1999­2001 System (HS) (US$ Percentage (US$ Total (US$ Percentage (US$ Total (US$ (US$ Code Description thousands) Distribution thousands) Exports thousands) Distribution thousands) Imports thousands) thousands) Live animals and animal products 01 Live animals 19,159 0.47 1,471 7.68 26,326 0.98 15,467 58.75 7,168 13,996 02 Meat and edible offal 13,916 0.34 708 5.09 418 0.02 64 15.41 13,498 643 03 Fish and sea products 54,154 1.33 38,532 71.15 22,508 0.83 12,378 54.99 31,647 26,154 04 Milk and dairy products; eggs; 35,301 0.87 6,316 17.89 30,824 1.14 20,828 67.57 4,477 14,512 honey 05 Other animal products 36,423 0.90 34,701 95.27 18,860 0.70 2,516 13.34 17,563 32,185 Vegetable products 06 Plants and floriculture products 15,262 0.38 11,613 76.09 16,203 0.60 14,490 89.43 941 2,877 07 Vegetables, plants, roots, tubers 304,529 7.50 100,117 32.88 75,451 2.80 6,605 8.75 229,079 93,512 08 Edible fruits; citrus fruits 1,159,461 28.54 743,676 64.14 57,082 2.12 6,103 10.69 1,102,379 737,573 09 Coffee, tea, spices 58,123 1.43 22,574 38.84 27,450 1.02 3,135 11.42 30,673 19,439 10 Cereals 203,561 5.01 33,582 16.50 323,726 12.00 57,506 17.76 120,165 23,923 11 Products of the milling industry 82,013 2.02 26,202 31.95 5,175 0.19 4,431 85.61 76,838 21,772 12 Oilseeds, various seeds/fruits; 52,430 1.29 28,351 54.07 233,454 8.66 31,223 13.37 181,024 2,872 industrial plants 13 Vegetable lacquers, resins, 1,341 0.03 145 10.84 14,110 0.52 12,194 86.42 12,770 12,049 balsams 14 Vegetable plaiting materials 16,471 0.41 10,819 65.68 2,695 0.10 62 2.28 13,776 10,757 Animal or vegetable oils and fats 15 Animal or vegetable oils and 241,189 5.94 81,999 34.00 366,550 13.59 74,579 20.35 125,361 7,419 fats Foodstuffs, beverages, tobacco 16 Products made from meat, 34,964 0.86 29,342 83.92 830 0.03 369 44.43 34,134 28,973 fish, crustacea 17 Sugar and sweets 258,178 6.36 25,237 9.77 14,019 0.52 9,125 65.09 244,158 16,112 18 Cocoa and cocoa products 81,023 1.99 12,256 15.13 68,351 2.53 22,007 32.20 12,672 9,751 19 Cereal products, wheat flour, 116,732 2.87 13,538 11.60 30,841 1.14 27,544 89.31 85,891 14,006 pastries 20 Foods made of vegetables, 528,298 13.00 352,375 66.70 17,542 0.65 12,057 68.73 510,757 340,319 fruits, and other plants 21 Various foods 93,845 2.31 11,226 11.96 101,011 3.75 81,416 80.60 7,165 70,190 22 Alcoholic and nonalcoholic 38,877 0.96 18,984 48.83 14,331 0.53 12,365 86.28 24,546 6,619 beverages 23 Residues of food industry; 13,271 0.33 357 2.69 167,152 6.20 17,820 10.66 153,881 17,463 fodders 24 Processed tobacco and 496,247 12.22 145,360 29.29 308,653 11.45 11,652 3.77 187,594 133,708 substitutes Hides, wool, and cotton 4101­4103 Hides and skin 21,519 0.53 209 0.97 199,473 7.40 106,243 53.26 177,954 106,035 5101­5103 Wool and animal hair 6,553 0.16 3,255 49.67 42,362 1.57 1,905 4.50 35,809 1,350 5201­5203 Cotton 79,630 1.96 46,330 58.18 511,392 18.96 129,916 25.40 431,762 83,586 Total 4,062,470 100.00 1,799,277 44.29 2,696,790 100.00 694,001 25.73 1,365,680 1,105,276 Source: The authors. 43 44 Turkey: Economic Reform and Accession to the European Union yields and income and to counterbalance the loans from the Turkish Bank of Agriculture have implicit protection given to domestic input indus- been significantly negative in real terms. In addi- tries through border measures. Finally, administra- tion, the unpaid loans of the ASCUs have been rou- tive controls have been applied to the production of tinely covered as "duty losses" of the Treasury. a few important crops. The domestic manufacturers and consumers of fertilizers have received subsidies since 1961. The subsidy was set until recently as a percentage of Output Price Supports, Input Subsidies, and Supply market price, with the percentage varying consider- Control Measures ably over the years. In 1996 and 1997, the subsidy Output price supports, input subsidies, and supply was about 40­50 percent of the market price, control measures are three important components depending on the type of fertilizer. In November of agricultural support policies. Government price 1997, the government decided to fix the fertilizer supports for most major crops (such as grains, subsidy at a nominal amount of Turkish lira (TL) oilseeds, cotton, sugar beet, tobacco, hazelnut, and per kilogram. This shift in policy has reduced the tea) have in the past been announced by decree fertilizer subsidy substantially in real terms, and each year, but this practice is changing because of inflation has eroded its value. the reform program discussed later in this section Agriculture has also received substantial subsi- on agricultural policies. Related state-owned enter- dies through irrigation projects. The Turkish gov- prises (SOEs) and agricultural sales cooperative ernment has been investing heavily in irrigation, unions (ASCUs) were commissioned to buy at the financing the associated capital investments largely announced floor prices. Crops could also be sold to through the budget. Farmers have paid no fee for independent buyers. For some crops, a system of the resource value of water they have used for irri- "deficiency payments" or premiums was intro- gation, whether privately extracted or supplied by a duced in 1993 in place of floor prices. The High public scheme, even though farmers who grew Planning Council announced a target price for crops on irrigated land did contribute to the cost of those crops as well as an intervention price, and the operating and maintaining the infrastructure. But target price moved in parallel with the world prices. even in this situation the bulk of operating and Farmers selling their crop to ASCUs or commodity maintenance costs were financed through budget exchanges received the difference between the price allocations. obtained and the target price in the form of a pay- Supply control measures, the third component of ment directly from the state-owned Turkish Bank Turkish agricultural policies, have been used to of Agriculture. The payment was then reimbursed control the fiscal cost of support policies. Tobacco, by the Treasury. The deficiency payments were hazelnuts, and tea have been under area or produc- implemented for sunflower seed, soybean, cotton, tion control. Sugar beet output has been indirectly and olive oil. Tea growers were also fully compen- controlled to some extent by the state-owned sugar sated for the costs incurred in implementing the company (S¸eker) through contracts with growers. strict pruning requirements to control supply. Tobacco farmers have received payments to com- Direct payments were, until recently, only a minor pensate for the area controls, and tea producers to part of the agricultural support system. The main compensate for lost production from pruning. types of direct payments were natural disaster Agricultural producers have also received gen- relief, the return on sugar beet pulp, deficiency eral services either free or at subsidized prices. The payments for oilseeds and cotton, and incentive measures taken to improve the production basis premiums for milk and meat. of agriculture were mainly research, training and Input subsidies are a second important compo- extension services, inspection, pest and disease nent of agricultural support policies. The most control, and land improvements (including capital important have been the credit, fertilizer, and irri- investments in small-scale irrigation works). In gation subsidies. Short-term and investment credit addition, only the large farms are required to pay for agriculture has long been subsidized by the gov- income tax. In all transactions related to agricul- ernment at interest rates well below inflation and ture, a 5 percent sales tax is applied at the point of commercial rates. The result is that interest rates on sale. Consumers have not benefited from subsidies Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 45 directly. They are protected indirectly through price with the MFN tariff rates shown in table 2.5 for the controls, market intervention, and a lower value- other agricultural commodities, reveals that the added tax on food. three sectors with the highest simple average tariff rates are meat and edible offal (HS 02), with a tariff rate of 116.52 percent; milk and dairy products Agricultural Trade Policy (HS 04), 99.60 percent; and products made from Table 2.5 shows the applied most-favored-nation meat, fish, and crustacea (HS 16), 76.90 percent. (MFN) tariff rates for the major agricultural com- The three sectors with the highest weighted average modity groups during 2002. The table reveals that tariff rates applied on imports from the EU are edi- the agricultural sector is highly protected in Turkey. ble fruits and citrus fruits (HS 08) with a tariff of The three sectors with highest simple average tariff 120.17; milk and dairy products (HS 04), 101.79; rates applied to imports from third countries are and meat and edible offal (HS 02), 71.40 percent. the products made from meat, fish, and crustacea The preferential regime applied by the EU to (HS 16) with a tariff rate of 132.70 percent; meat and imports of agricultural products originating in edible offal (HS 02), 116.52 percent; and milk and Turkey is determined by Decisions No. 1/72, 1/80, dairy products (HS 04), 105.20 percent. The three and 1/98 of the EC­Turkey Association Councils of sectors with the highest weighted average tariff 1972, 1980, and 1998, respectively. Under these rates applied to imports from third countries are decisions, almost all of the agricultural commodi- products made from meat, fish, and crustacea (HS ties originating in Turkey are imported by the 16) with a tariff rate of 124.08 percent; sugar and European Community free from ad valorem duties, sweets (HS 17), 124.08 percent; and edible fruits and the EU applies tariff quotas only for a relatively and citrus fruits (HS 08), 120.17 percent. The table small number of commodities (see chapter annex also reveals that Turkey, upon becoming a member tables 2.17 and 2.18). These tables reveal that those of the EU, could have to change its tariff schedule commodities made up about 30 percent of Turkish on agricultural commodities substantially. To align exports to the EU during 1999. In addition, the EU its tariff schedule with the current EU schedule, applies an entry price system for about 30 fruits and Turkey would have to increase its tariffs on cereals; vegetables such as tomatoes, artichokes, courgettes, processed tobacco and substitutes; residues of the tangerines, lemons, and apples. For these com- food industry and fodders; alcoholic and nonalco- modities, specific duties are applied as long as the holic beverages; vegetable lacquers, resins, and bal- value of consignment falls below the entry price. sams; cotton; and vegetable plaiting materials. In all These commodities, shown in annex table 2.19, other categories, Turkey would have to decrease its made up about 4.8 percent of Turkish agricultural tariff rates. exports to the EU during 1999. As for the market access conditions for agricul- Finally, a sanitary ban on the import of livestock tural commodities imported from the EU, the pref- and meat products has remained in place. Export erential regime applied by Turkey to imports of subsidies, applied to a number of products and agricultural products originating in the EU is limited to a maximum of between 10 percent and determined by Decision No. 1/98 of the EC­Turkey 20 percent of the export values and between 29 per- Association Council of 1998. Under this decision, cent and 100 percent of the quantities exported, Turkey must grant a large number of commodities have continued for processed fruits and vegetables, duty-free access to the Turkish market up to the fruit juices, olive oil, potatoes, apples, poultry meat, quota limits specified in the decision. A look at the and eggs. quota levels and trade data for the agricultural The considerations just described reveal that commodities specified in Decision No. 1/98 of the substantial border measures still affect trade be- EC­Turkey Association Council reveals that for tween the EU and Turkey and that the external most of the commodities the quota limits have tariffs applied by the EU and Turkey to third coun- been exceeded. Thus "out of quota" tariff rates are, tries' imports differ significantly. Completion of the in general, applicable to imports of these com- customs union between the EU and Turkey to cover modities from the EU. Consideration of the "out of agricultural products implies the abolition of all quota" tariff rates for these commodities, together border measures and the adoption of the EU external 46 TABLE 2.5 Most-Favored-Nation Tariff Rates of EU and Turkey, 2002 Tariff Rates Tariff Rates Tariff Rates Tariff Rates Tariff Rates Tariff Rates Applied by EU Applied by Turkey Applied by EU Applied by Turkey Number of Applied by Turkey Applied by Turkey to Imports from to Imports from to Imports from to Imports from HS Tariff to Imports from to Imports from Third Countries Third Countries Third Countries Third Countries Code Description Lines EU (simple) EU (weighted) (simple) (simple) (weighted) (weighted) Live animals and animal products 01 Live animals 27 27.85 1.72 19.72 27.85 56.69 1.72 02 Meat and edible offal 10 116.52 71.40 55.89 116.52 68.55 71.40 03 Fish and sea products 89 38.90 19.61 11.39 78.30 11.61 37.60 04 Milk and dairy products; 72 99.60 101.79 55.16 105.20 69.17 103.22 eggs; honey 05 Other animal products 30 2.50 7.00 0.35 2.80 0.11 7.09 Vegetable products 06 Plants and floriculture 37 17.90 7.49 9.25 18.50 12.90 8.46 products 07 Vegetables, plants, roots, 78 22.20 20.44 13.30 22.30 13.80 20.44 tubers 08 Edible fruits; citrus fruits 93 48.10 120.17 8.56 48.10 12.15 120.17 09 Coffee, tea, spices 45 37.70 46.13 6.11 38.00 4.32 47.27 10 Cereals 39 25.60 16.97 66.35 25.70 79.15 16.97 11 Products of the milling 40 36.30 28.86 35.87 36.70 44.47 29.65 industry 12 Oilseeds, various seeds/ 88 16.40 5.29 3.65 17.20 0.98 5.55 fruits; industrial plants 13 Vegetable lacquers, resins, 29 1.40 1.54 2.88 2.60 2.76 2.06 balsams 14 Vegetable plaiting materials 14 0.00 0.00 0.10 0.00 0.01 0.00 Animal or vegetable oils and fats 15 Animal or vegetable oils 107 18.10 17.74 15.49 20.20 22.90 17.86 and fats Foodstuffs, beverages, tobacco 16 Products made from meat, 39 76.90 65.27 21.32 132.70 22.79 124.08 fish, crustacea 17 Sugar and sweets 53 58.90 63.18 22.79 79.70 48.46 124.08 18 Cocoa and cocoa products 24 38.60 22.38 7.12 99.30 3.06 51.11 19 Cereal products, wheat 66 58.20 54.45 26.05 83.90 22.88 78.96 floor, pastries 20 Foods made of vegetables, 173 58.50 62.41 25.47 60.80 27.59 73.92 fruits, and other plants 21 Various foods 54 25.20 28.64 13.42 42.02 15.89 42.37 22 Alcoholic and nonalcoholic 41 11.90 2.01 22.52 17.04 13.87 6.27 beverages 23 Residues of food industry; 49 6.30 1.12 18.03 7.81 26.96 2.84 fodders 24 Processed tobacco and 17 14.70 0.22 51.55 33.78 51.01 23.98 substitutes Hides, wool and cotton 4101­4103 Hides and skin 44 0.00 0.00 0.00 0.00 0.00 0.00 5101­5103 Wool and animal hair 36 0.00 0.00 0.00 0.00 0.00 0.00 5201­5203 Cotton 15 0.00 0.00 0.18 0.00 0.01 0.00 Source: The authors. 47 48 Turkey: Economic Reform and Accession to the European Union tariff applied to third countries.5 As a result, the · To privatize most state enterprises in agriculture prices of agricultural products for which border and to turn the agricultural sales cooperative measures still exist would become much closer in unions (ASCU) into true private sector unions the EU and Turkey, with the remaining differences of producer-owned cooperatives in order to due to quality and to transportation and marketing reduce government involvement in the market- costs. Such a development would, however, require ing and processing of agricultural products. that the parties harmonize their agricultural price · To introduce a unified national program of policies. direct income support (DIS). These reforms are intended to increase the efficiency of the agri- cultural sector and thereby help Turkey meet the Agricultural Reform Implementation Project preconditions for accession to the EU. The overly generous system of agricultural support policies pursued until the late 1990s was fiscally Implementation of ARIP began in 2000 with a expensive and unsustainable, and they encouraged pilot program of income support payments applied waste and abuse (World Bank 2000). They did not to four regions. An important part of the pilot pro- provide a cost-effective way for addressing policy gram was preparation of a farm registry and testing objectives such as alleviation of rural poverty and of the eligibility conditions. All agricultural land regional development, and the "duty loss" system users received $50 per hectare of agricultural land, of administration burdened the Treasury with up to a maximum of 20 hectares per farmer. The enormous debts. There were other problems as program was extended nationwide in 2001­02. well. Support and administered prices were Table 2.6 shows the intervention prices and direct announced only after key production decisions had payments for selected commodities over the period been made, and payments were delayed by inter- 1998­2002. The table reveals how the government vention agencies. These problems confirm the dif- has tried to compensate for the drop in interven- ficulties inherent in trying to administer outcomes tion prices with increases in direct payments. in a dynamic, complex market. Neither the overall The intention of direct income support is not to demand-supply balance nor the equilibrium in the fully compensate every farmer for income lost by very complex intertemporal, spatial, and quality removal of the old subsidy system, but rather to dimensions could be achieved. The Turkish gov- cushion the blow and continue to provide adequate ernment recently tried to replicate the market by support to the agricultural sector in an incentive- establishing more quality-differentiated prices. But neutral way. Within the existing legal framework, success in duplicating the price flexibility of freely the DIS payments should be usable as collateral, functioning commodities market was limited. thereby giving farmers enhanced access to credit. In the late 1990s, Turkey decided to reform its Payments under the DIS system will be ongoing but agricultural policies. Beginning in late 1999, with should become more explicitly targeted or merged support from the International Monetary Fund with the general social safety net system. Thus DIS (IMF) and the World Bank, the government devel- allows the government to disengage from its current oped the Agricultural Reform Implementation support mechanism in a politically acceptable and Project (ARIP) to phase out current production- and humane way. The government is also easing the input-oriented support and replace it with area- transition for growers of certain crops that were based income support payments during the 2001­04 grossly overproduced (i.e., tobacco and hazelnut) period.ARIP was intended to achieve following: by making onetime payments to farmers to cover their cost of switching to alternative activities. This · To phase out the unsustainable and distor- program is distinct from, and in addition to, DIS. tionary system of subsidies for fertilizer--credit After the policy change, the fertilizer subsidy and price supports that disproportionately ben- decreased from 31 percent in 1999 to almost 20 per- efited large farmers, placed a regressive tax on centbytheendof 2000,anditwasphasedoutin2002. consumers, and cost about $5 billion a year. By 2002, credit subsidies channeled through Ziraat ARIP was determined to link domestic prices to Bank, as well as most other input subsidies, were also world prices. phased out. In addition, price supports for grains Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 49 TABLE 2.6 Agricultural Supports: Turkey, 1998­2002 (US$ millions) 1998 1999 2000 2001 2002 Market price support Cereals 425.8 356.7 183.0 27.8 0.0 Tobacco 276.9 146.6 81.8 43.3 26.7 Sugar beet 245.2 141.6 70.5 40.1 0.0 Payments based on inputs used Fertilizer 476.7 238.6 153.4 60.5 0.0 Pesticides 33.0 24.7 19.2 14.7 0.0 Seed 6.6 3.4 4.6 0.8 0.0 Development of animal husbandry 0.0 0.0 19.2 31.9 50.1a Incentive premiums Milk 31.5 25.6 19.2 9.8 0.0 Compensation payment Tea 13.8 7.1 25.2 22.1 26.7 Natural disaster relief 29.7 37.2 22.4 0.0 0.0 Credit subsidy 1,663.2 1,675.3 562.7 274.8 0.0 Deficiency payments 0.0 265.8 298.2 280.5 145.1 Direct income support 0.0 0.0 0.0 68.1 1,159.0 Total 3,202.4 2,922.6 1,459.6 874.4 1,357.5 a. The figure includes the milk premium. Source: Turkish Ministry of Agriculture and Rural Affairs. were reduced, with the aim of eliminating the sup- 2002. Payments based on input use are the other ports completely by 2002.Even though grain support category of support to producers. This category as a priceswerenotannouncedbyadecreebythegovern- share of total support decreased from 22 percent in ment in 2002, the Turkish Grain Board (TMO) 1999 to 8 percent in 2001, and further to 2 percent announced its purchasing prices based on produc- in 2002. By contrast, the total transfers to the agri- tion,its stocks,and expected market conditions. cultural sector measured by the total support esti- mate (TSE) amounted to $13.84 billion in 1998 Estimates of Support in Agriculture (6.9 percent of GDP) and $12.1 billion in 1999 (6.6 percent of GDP). The TSE decreased to Agricultural production in Turkey is protected. $5.4 billion (3.6 percent of GDP) in 2001, but According to the official estimates of the Organisa- increased again to $7.7 billion (4.1 percent of GDP) tion for Economic Co-operation and Development in 2002. At the same time, the corresponding fig- (OECD), total transfers from consumers and ures for all OECD countries fell from 1.39 percent taxpayers to agricultural producers, as measured by of GDP in 1998 and 1999 to 1.2 percent in 2002. the producer support estimate (PSE), amounted to The TSE for the EU fell from 1.52 percent of GDP a peak of $9.955 billion in 1998 (almost 25 percent in 1999 to 1.3 percent in 2002. Over the same of producers' receipts) and fell slightly to $6.8 bil- period, the PSE in the EU, as a percentage of pro- lion (21 percent) in 2000. As a result of the reform ducers' receipts, fell from 43 percent to 36 percent. efforts, the PSE decreased to $2.251 billion (10 per- cent) in 2001, but increased to $6.1 billion (23 per- The Common Agricultural cent) in 2002. According to the OECD (2003a), Policy of the EU market price support remained the most important type of support, for a share of 69 percent of total The Common Agricultural Policy (CAP) of the support to producers in 2001 and 75 percent in European Union, which was set up against the 50 Turkey: Economic Reform and Accession to the European Union backdrop of the food shortages and rations that role in setting prices and allow prices to be closely followed World War II, had five founding aims: linked to world prices, while compensating farmers (1) higher productivity, (2) a fair standard of living for income losses with area-based direct payments for farmers, (3) stable markets, (4) regular food that would not be linked to output or input use. supplies, and (5) reasonable prices for consumers. Under the Agenda 2000 agreement, some interven- It was based on the principles of a single market in tion prices were set at levels so low that they would farm products with common prices and the free be binding only in years of very low world prices, movement of agricultural goods within the com- and other intervention prices were reduced greatly, munity, preference for community members, and with producers compensated by direct income sup- shared costs. Its main mechanisms were support port payments. The agreement represented a signif- prices set above world price levels and the use of icant shift from price supports to direct payments, import taxes, nontariff barriers to imports, and and it helped to reduce the economic distortions of export subsidies to maintain the higher internal the CAP. It will go some way toward helping agri- prices. As production responded to higher prices, culture to meet the challenges of further trade lib- surpluses became chronic and increasingly expen- eralization and enable the formulation of an inte- sive. As a result, the CAP has been subjected to var- grated EU rural development policy that shifts the ious reforms. In particular, production has been emphasis from production support to environmen- artificially constrained by mechanisms such as milk tal and rural economy measures in the future. But, quotas and compulsory set-asides for arable crops; as described in the rest of this section, further prices have been cut, and producers have normally reforms also are under way. been given direct payments in compensation; and more emphasis has been put on rural development and encouraging farmers to look to markets and Common Organization of Market diversified forms of income to reduce their depend- Within the CAP framework, the Common Organi- ence on subsidies. zation of Market (COM) is the basic instrument The CAP is financed by the European Agricul- used to manage agricultural production and to sta- tural Guidance and Guarantee Fund (EAGGF), bilize markets in accord with the declared objec- which is an integral part of the EU's budget. In the 2003 EU budget of 99.69 billion, appropriations tives of the CAP. COMs, which were introduced for the EAGGF accounted for about 44.78 billion. gradually, now cover most EU agricultural prod- ucts, accounting for 90 percent of the final agricul- In addition to budget costs, the CAP imposes a cost tural output of the European Community. The on EU consumers through higher food costs. The essential features of the current CAP under Agenda additional cost to consumers varies according to 2000 reform is summarized in the following sections movements in world prices, but in 2003 it was esti- mated by the OECD at about 55.5 billion. (see Europarl 2002 and Csaki and others 2002). In the EU, like in Turkey, it eventually became clear that price supports, import tariffs and nontar- COM for Cereals In the past, at the core of the iff barriers, export subsidies, and the other govern- COM for cereals was a state intervention system ment interventions required by the CAP were creat- based on guaranteed prices, but after the 1993/94 ing unsustainable pressures on the EU budget and marketing year, compensation payments per friction in international trade relations. Further- hectare became the main mechanism.6 The inter- more, they were not achieving the social objectives vention price was set at a very low level to serve as of environmental preservation and equity. The EU only a safety net in years of extremely low world therefore embarked on a far-reaching reform pro- prices. It was 101.31 per metric ton from the gram for CAP that is still under way. The reform 2001/02 marketing year, and it would decline fur- began with the McSharry reforms of 1992 and was ther, to a little over 90 per metric ton under the accelerated with the Agenda 2000 agreement, which CAP Mid-term Review proposals described later in was approved at the Berlin Council in March 1999. this chapter. This intervention price applies to a The underlying principle of the reform was the predefined "standard quality" that meets the regu- same as that of ARIP: to minimize the government's lations on moisture content and specific weight. Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 51 Direct area payments to cereal producers, set in Organization (WTO), the EU can levy an import euros per metric ton, were introduced to compen- duty on cereal imports from third countries, which sate farmers for reductions in price supports. To is payable by the European Community importer. receive such compensation, farmers must withdraw Within the limit of the agreement, the duty cannot 10 percent of their land from production. Small exceed the intervention price, increased by 55 per- farmers with a total output of less than 92 metric cent less the representative CIF (cost, insurance, tons are exempt from set-aside as a compulsory freight) price. Under these rules, the EU is allowed requirement to receive compensation payments. to vary the tariffs for cereals over time. For the 2001/02 marketing year, these direct pay- ments were fixed at 63 per metric ton of the his- COM for Oilseeds The McSharry reforms torical yield. For durum wheat, the supplementary removed the system of institutional prices for direct area­based income payment per hectare oilseeds (i.e., rapeseed, sunflowers, and soybeans), amounts to 344.5 in traditional areas (traditional but since the 1993/94 marketing year their produc- durum wheat aid) and 138.9 in other areas (well- ers also qualify for compensatory payments.11 established durum wheat aid). These payments are aligned with the one applicable To apply for direct area payments, each member for cereals (63 per metric ton of reference yield state must draw up a regionalization plan by taking since 2002). The area grown with oilseeds is taken into account specific factors that influence yields into account in determining the individual farmer's such as soil fertility. The area concerned must not set-aside obligation as described under the regula- exceed the region's "base area"--that is, the average tions for cereals. As a prerequisite for the imposi- number of hectares in the region allocated to grow- tion of specific oilseed production provisions, pro- ing crops or set aside within the context of the pub- duction area constraints for the member countries lic assistance scheme in 1989, 1990, and 1991.7 If have been implemented under the Blair House the total eligible claims exceed the base area, then agreement. This agreement includes a system of all claims are reduced proportionately. Article 9 of reduced aids for regions where the predetermined Council Regulation No. 1251/1999 states that the agricultural area is exceeded. For nonedible oilseeds base areas of future member states will be estab- for industrial use, specific regulations apply and lished by the European Commission. Finally, aid for require that set-aside areas, for example, be planted the production of "traditional durum wheat" is with several oil-bearing crops for industrial pur- limited to certain regions that are mentioned in poses. Currently, there is no regulatory levy on Annex II to Council Regulation No. 1251/1999, and imports, and the Common Customs Tariff rates per member state a maximum area that may be eli- apply. gible for the "traditional durum wheat aid" is fixed in Annex III of that regulation.8 COM for Sugar Beet The EU sugar market is According to Article 3 of Council Regulation highly protected.12 Besides protection at the border, No. 1252/1999, the historical reference yield for the CAP on sugar is implemented through a mar- cereals should be the average of the median three keting quota system. Sugar beet quotas are allo- years of the five-year period 1986/87­1990/91.9 For cated to and administered through sugar refineries maize, a specific yield can be set, possibly distin- on the basis of equity shares. The intervention price guishing between irrigated and nonirrigated areas. for refined beet sugar is set, since the 1998/99 mar- In the areas thus defined, per hectare payments are keting year, at 631.9 per metric ton for white sugar calculated by multiplying the basic amount per and 523.7 per metric ton for raw sugar in order to metric ton by the historical average cereal yield for guarantee a basic price for sugar beet of 47.67 per the area. Article 7 of Council Regulation No. 1252/ metric ton. Intervention is provided for limited 1999 states that applications for payments may not quantities corresponding to a production quota for be made for land that on December 31, 1991, was which there is an almost total guarantee (quota A) under permanent pasture, permanent crops, or and a quota with a partially guaranteed price trees, or was used for nonagricultural purposes.10 (quota B). For net importers, quota A equals net As for import duties, export taxes, and export production, and quota B equals 10 percent of quota refunds, under commitments to the World Trade A. For net exporters, quota A equals that part of net 52 Turkey: Economic Reform and Accession to the European Union production consumed domestically, and quota B and processors. The aid level is fixed per hectare of equals net exports. The EU insists that the total of specialized area harvested, on the basis of the aver- quotas A and B should not exceed internal con- age yield per hectare of the area concerned. sumption plus the quantity that can be exported within the limits of the WTO commitments. Fur- COM for the Wine-Growing Sector The com- thermore, the COM is based on a system of sugar mon market organization for wine (Council Regu- and isoglucose production levies to cover the cost lation No. 1493/1999) aims to maintain a balance of storage and production refunds for the manu- between supply and demand in the European Com- facture of certain chemical products. The regula- munity market, thereby giving producers a chance tions are complemented with import tariffs and to bring production into line with market develop- warrants of export refunds. Agricultural areas ments and to allow the sector to become competi- planted with sugar beets are not eligible for com- tive. This goal is pursued by financing the restruc- pensatory area payments and are not subject to set- turing of a large portion of the present vineyards, aside obligations. and it should give rise to products in demand at home and abroad. The Common Customs Tariff COM for Fruits and Vegetables In late July 1996, rates apply to imports of wine into the European the European Council reached a political agreement Community. To prevent imports from having to reform the fresh and processed fruit and vegetable adverse effects, and subject to compliance with the sector.13 The reform was intended to improve the rules of the WTO, an additional import duty may organization of supply by strengthening producer be imposed. organizations (POs), tightening up the criteria for recognizing POs, and setting up an operation fund COM for Milk and Dairy Products The market co-financed by the EU for promotion and quality for milk and dairy products is one of the most campaigns and the cessation of farming operations important (about 18 percent of the total value of that are not covered by European Community com- agricultural production) and most regulated mar- pensation schemes, which, with this reform, will kets in the EU.14 The current market regime com- provide on-retributive compensation--that is, they prises the target price for milk (2000­05, 309.80 will not encourage production. Based on the first per metric ton), intervention price for butter year's experience, some rules were modified in 2001 (2000­05, 3282.00 per metric ton), interven- to simplify the regime, to make it more flexible, and tion price for skimmed milk powder (2000­05, to increase producer responsibility. 2,055.20 per metric ton), a producer quota sys- EU-wide aid schemes are in place to assist pro- tem, support of prices by the imposition of tariffs ducer organizations supplying tomatoes, peaches, on dairy products, warrant of export subsidies, the pears, and citrus fruits. This aid is granted for the guaranteed purchase and storage of butter and fresh produce delivered during prescribed periods. skimmed milk powder through intervention agen- Aid is paid to recognized producer organizations, cies, and a milk quota system introduced in 1984 which then pay out to the growers. Delivery (117.49 million metric tons, EU total). Farmers to approved processors is based on contracts who exceed this reference amount of their quota specifying the quantities they cover, the price, are subject to a payable levy. Since 1998, milk quo- and the schedule of supply. These contracts require tas have been transferable from one individual to the processor to process the products delivered. another within one EU member state through sale, The minimum characteristics of the raw material lease, or inheritance. Also related to these measures supplied for processing and the minimum quality are a public intervention scheme, private storage, requirements for the finished products are defined. production aids for using milk in animal feedstuffs Annual EU thresholds have been established to and processing milk into casein, special measures to limit the total volume of aid, and there are penalties reduce stocks, and some aids for reducing or ceas- for overrunning thresholds. Aid per hectare is avail- ing production. Import levies and export refunds able to growers of grapes for use as dried muscatel are also applied. grapes, sultanas, and currants, within a maximum From 2005 on, intervention prices for butter and guaranteed area. Contracts must be concluded skimmed milk powder will be reduced by 15 per- between the producer or producer organizations cent in three equal steps of 5 percent each. In the Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 53 final stages of reform, they will amount to July 2002 by a basic price for storage, fixed at 2,224 2,789.70 per metric ton and 1,746.90 per metric per metric ton. The payment for private storage is ton, respectively. According to the EU's impact granted when the average Community market price analyses, these changes will put the intervention level is less than 103 percent of the basic price. As of price after 2007 below the expected world price lev- July 2002, producers also could benefit from a safety els. Benefits for farmers will be provided by three net intervention system. When the average market complementary measures: (1) increasing available price for bulls or steers in a member state falls to less milk quotas by 1.5 percent in three equal steps over than 1,560 per metric ton of carcass weight, the three years in parallel with the price reductions EU buys beef into intervention stores. starting in 2005, (2) retaining a crop premium for Since 2002, steer and bull premiums have been silage cereals, and (3) implementing a new yearly set at 150 and 210 per head, and the premium for payment for dairy cows. The payment for dairy suckler cows at 200 per year.Although the bull pre- cows is to be paid on a flat rate basis per metric ton mium is paid once a lifetime for bulls older than of the quota held in the 1999/2000 marketing year nine months or at a minimum carcass weight of and amounting to 17.24 per metric ton in the 185 kilograms, the steer premiums are paid twice a final stages of reform. lifetime, at the age of 9 months and after 21 months. On June 26, 2003, EU farm ministers adopted a The suckler cow premium is granted per calendar fundamental reform of the CAP. With the reform, year and per holding within the limits of regional the intervention price for butter will be reduced by ceilings for not more than 90 animals. These premi- 25 percent over four years, which is an additional ums are granted provided that the stocking density price cut of 10 percent compared with that of on the holding is not more than two livestock units Agenda 2000 reforms. per unit of forage area used for these animals. In addition to these premiums, a slaughter premium COM for Beef and Veal In 1999 the beef support applicable at slaughter or export to a third country "regime" was altered significantly as part of the of 80 has been introduced for bulls, steers, suckler Agenda 2000 CAP reform process; the practice of cows, and heifers over the age of eight months, and EU-subsidized purchases of surplus beef from the of 50 for calves more than one and less than seven market (intervention buying) was reduced to a min- months in age (with an upper limit of 160 kilo- imal"safety net."In return for this reduction in mar- grams).15 The slaughter premium is paid directly to ket price support, farmers received direct aid in the the farmer, provided that the eligible animals have form of premiums based on the number of cattle been held for a minimum period of two months. they held in a reference period. Extensive production (stocking density less than Direct aid includes various types of direct 1.4 livestock units per hectare) may qualify for an farmer support measures (Council Regulation [EC] additional payment of 100 per premium granted.16 No. 1254/1999 and Commission Regulation [EC] The reform of the CAP agreed to in June 2003 No. 2342/1999). They are designed to compensate changes the way the EU supports its farm sector. In for the reductions in the intervention price January 1, 2005, a single-payment scheme replaced (slaughtering premium and the special beef pre- most of the direct aid payments currently offered to mium), support the incomes of producers who are farmers, and it is not linked to what a farmer specialized in beef production (suckler cow produces. The amount of the payment is calculated premium), encourage producers to undertake on the basis of the direct aids a farmer received in a extensive farming (extensification payment), assist reference period (2000­02). Member states may producers in less favored areas or in member states delay implementation of this scheme up to 2007,but highly specialized in beef production (additional by 2007, at the latest, all member states must have at suckler cow premium), balance the market least introduced the scheme. Full decoupling is the throughout the year (deseasonalization premium), general principle from 2005 onward. However, and permit member states to support specific pro- member states may decide to partially implement duction systems (national expenditure envelopes). the single-payment scheme and grant additional The intervention price was set for the 2001/02 payment to the beef producers by way of choosing marketing year at 3,013 per metric ton of carcass from the options for partial decoupling of direct weight (for R3 classification) and was replaced in payments. Under such partial decoupling, member 54 Turkey: Economic Reform and Accession to the European Union states may opt to keep up to 100 percent of the Mid-term Review of the CAP in January. The thrust slaughter premium for calves. However, member of the reforms is to continue to reduce the reliance of states may also opt to keep up to 100 percent of the theCAPonmarket-distortingmeasuressuchasprice suckler cow premium and up to 40 percent of the supports and to channel more of the support given to slaughter premium for calves coupled.Alternatively, farmers through payments linked to environmental, they could keep up to 100 percent of the slaughter food safety, general rural development, and animal premium coupled or,instead,up to 75 percent of the welfare objectives (i.e., to receive direct income pay- special male premium. ments, farmers would have to comply with the con- The relatively high internal price supports are ditions tied to these objectives). The catchphrase for complemented by measures affecting imports of this refocusing of the mechanisms of support is beef and veal to the EU and by refunds on EU "support for producers, not for production." The exports to third countries.A basic import tariff (less reform program is supposed to be budget-neutral. than 20 percent for most beef products) and an The key elements of the reforms are as follows:18 additional variable levy (ranging from 180 to 390 percent) are imposed. Exports are subsidized, and · Most support will take the form of a single the refunds are set by the European Commission, decoupled farm payment for EU farmers, inde- depending on world market conditions, the present pendent from production, with member states and anticipated condition of the EU market, and allowed to maintain limited coupled elements the competitive environment in third-country mar- (up to 25 percent of the value of current pay- kets. Under the WTO Uruguay Round agreement, ments) to avoid abandonment of production. these levels are to be reduced in the future. · This payment will be linked to the respect for environmental, food safety, animal and plant COM for Ovine Meat This COM comprises a health, and animal welfare standards, as well safety net intervention system and a direct payment as to the requirement to keep all farmland in for ewes of 21 (16.8 for female goats and for good agricultural and environmental condition ewes kept for milk production) per head and year ("cross-compliance"). since 2002.17 Each member state has an upper limit · There will be a strengthened rural development on the number of animals eligible for direct pay- policy with more EU money and new measures ment for ewes. to promote the environment, quality, and The reform of the CAP agreed to in June 2003 animal welfare and to help farmers meet EU means that this simplified premium system will be production standards starting in 2005. incorporated into a new support structure. Full · Direct payments for bigger farms will be reduced decoupling will be the general principle from 2005 ("modulation") to finance the new rural devel- onward. However, member states may decide to opment policy. maintain a proportion of direct aids to farmers in · A mechanism will be implemented for financial their existing forms, notably where the states discipline to ensure that the farm budget fixed believe agricultural markets may be disturbed or until 2013 is not exceeded. production may be abandoned because of the move · Specific revisions to the market policy of the to the single-payment scheme. Fifty percent of the CAP include: sheep and goat premiums under the 2001 system -- Making asymmetric price cuts in the milk sec- can continue to be granted as coupled payments. tor, with the intervention price for butter Future Evolution of the CAP reduced, as noted earlier, by 25 percent over fouryears.Forskimmedmilkpowder, a15per- Although the Agenda 2000 reforms made the CAP cent reduction over three years,as agreed on in much more efficient, it is recognized that the budg- Agenda 2000,is retained. etary pressures of accession and international trade -- Reducing the monthly increments in the obligations will require further reform in the same cereals sector by half while maintaining the direction. current intervention price. Reforms from the Mid-term Review and Future -- Implementing reforms in the rice, durum Directions In June 2003, the EU endorsed a series wheat, nuts, starch potatoes, and dried fodder of additional reforms that had been proposed in the sectors. Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 55 According to the Mid-term Review, the reforms European countries would have for an unreformed have the following objectives: CAP--the reforms would have other salutary effects outside the EU. Most important, they will · First, enhance the competitiveness of EU agricul- reduce the need to rely on export subsidies to dis- ture by setting intervention as a real safety net pose of surplus production, and they will provide measure, allowing EU producers to respond to an alternative way to support farmers' incomes market signals (i.e., world prices), while protect- without high domestic prices. Thus the reforms ing them from extreme price fluctuations. The will increase the EU's flexibility to agree in the reforms as adopted by the member states did not Doha negotiations to phase out export subsidies go as far as was proposed in the Mid-term Review, and increase market access (i.e., to reduce tariffs which had included further reduction in the sup- and nontariff barriers). This point is important, port price for cereals, but they still represented because the EU is almost alone in its position-- progress toward this goal. maintained throughout the WTO's Cancun minis- · Second, promote market-oriented, sustainable terial meeting in September 2003--that export agriculture by completing the shift from product subsidies should not be phased out (only reduced) to producer support with the introduction of a under the Doha Round agreement. Most other decoupled system of payments per farm,based on WTO members interpret the Doha Declaration's historical references and conditional upon cross- wording that export subsidies would be reduced compliancetoenvironmental,animalwelfare,and "with a view to eliminating" them as meaning that food quality criteria.Again, the Mid-term Review the eventual agreement will require that these sub- proposal was more ambitious than the program sidies eventually be totally eliminated. actually adopted, because it will allow member Although the magnitudes have not been esti- states to pay up to 25 percent of support (or more mated definitively, the reform process would also for durum wheat and certain kinds of beef pay- lead to some direct improvements in international ments) as coupled payments if necessary to avoid market conditions for developing country (and abandonment of production. It is expected, how- other) producers. The European Commission's ever,that few states will use this exception. simulations estimate that by 2009­10 EU exports of · Third, strengthen rural development by transfer- cereals will fall by 3.8 percent and exports of beef ring funds from the first pillar (payments to by 60 percent. Eurocare estimates that the EU will producers) to the second pillar (funding to become a net importer of beef. Other simulations promote rural development) of the CAP. This indicate an effect on world cereal prices of 2 per- transfer process is known as "dynamic modula- cent or less, although, because it would entail a tion." Payments under the second pillar will be move from a very trade-distorting mechanism increased to 30 percent of the CAP budget from of support to one with relatively small trade- its current 10 percent. Because small farmers distorting effects,19 there is some reason to think will be exempt from modulation, it would affect that the impact may be more substantial. 25 percent of farmers, who now receive about 80 percent of the direct payments. Funds saved Beyond the Mid-term Review The adoption of by "modulation" will be redistributed to the the proposals in the Mid-term Review would member states based on several criteria, and the essentially decouple payments from production in southern states are expected to be the net gain- the grain and oilseed markets and partially decou- ers. The reform will also expand the scope of the ple them in beef, but some important sectors are currently available instruments for rural devel- not touched by the reforms, including sugar and opment to promote food quality, meet higher tobacco. The same motivations for reform are standards, and foster animal welfare. present in these sectors, and other pressures will be operating to ensure that these sectors also are Although this reform process is being eventually reformed, using much the same model driven largely by the internal needs of the EU-- used for grains and oilseeds. One of these motiva- particularly the need to simplify the CAP and tions is the Doha negotiations. As noted, the EU control the potentially explosive budgetary impli- will be under tremendous pressure to agree to the cations that accession of the Central and Eastern elimination of export subsidies. Another very 56 Turkey: Economic Reform and Accession to the European Union important motivation--especially for sugar--is · Cotton. Sixty percent of the current coupled pay- the "Everything but Arms" (EBA) initiative. Under ments would be converted into single-farm pay- the EBA, the EU has eliminated tariff and nontariff ments. The other 40 percent would be retained barriers20 to the imports of all products from the as an area-based payment, based on cotton hec- developing countries. For most products, this sys- tarage. Thus this 40 percent would remain fully tem has been in effect since 2001, but for rice, coupled, though based on area rather than pro- bananas, and sugar there are phase-in periods. For duction. The new area payment would be given sugar, the phase-in period is until 2009, but after for a maximum number of hectares, but admin- 2009 sugar will enter the EU duty- and quota-free istered in the same way as current blue box from developing countries, clearly ending the measures, with area ceilings set on a regional sugar regime under the CAP. Before the regime basis and any excess in the region resulting in a ends, sugar prices in the EU will have to fall to reduction in payments to all farmers in the something much closer to world prices, and pro- region.21 This situation implies that the measure ducers may have to be brought under the direct may not be very effective in controlling the area payment system. The EU is also currently negotiat- planted, because farmers have little incentive to ing Economic Partnership Agreements with many stay below the ceiling. other developing countries. Although it is not clear · Sugar. There is no specific proposal but rather what form these agreements will take, the basic two options: (1) relatively small changes in the intention is that essentially they will be reciprocal current system, or (2) radical reform, with free trade agreements. Such agreements will put domestic prices lowered to world market levels even more pressure on the CAP to complete the and direct support payments increased in com- transition to a regime of very low import barriers pensation. In view of the pressures facing the for products that can be produced in developing CAP sugar regime, it seems likely that some- countries and a regime in which farmers are com- thing close to the second option will have to be pensated for income losses by decoupled direct adopted. payments. In September 2003, the European Commission Impact of Introducing the Common tabled its proposal for reforms in the cotton, Agricultural Policy in Turkey tobacco, sugar, and olive oil sectors. The main fea- tures of the proposals are the following: This section employs a partial equilibrium model of the Turkish agricultural sector to simulate the · Tobacco. The production-coupled premium on effects of introducing the CAP.22 The model pro- tobacco would be completely eliminated, with vides information about the likely impact of the most of it rolled into the decoupled single-farm CAP on farmers' and consumers' incomes and payment and the rest put into a fund for restruc- its budgetary implications. Because the CAP has turing tobacco-producing areas. been a "moving target," the model does not incor- · Olives. The current system of production-linked porate the most recent reforms, but rather uses the payments would be eliminated. For farms under Agenda 2000 scenario. Subsequent reforms have 0.3 hectares, coupled payments would be elimi- been of the same variety as those in the Agenda nated and replaced with only single-farm pay- 2000 program, but they have moved further in ments. For large farms, 60 percent of their cou- reducing support prices and distributing support as pled payments would be converted into decoupled payments. These later reforms could single-farm payments. The rest of the budget then be generally expected to result in lower that would have funded the coupled payments domestic producer and consumer prices than those for these farms would be converted into pay- produced by Agenda 2000 reforms, but with higher ments based on hectares or number of trees to direct payments. ensure the permanence of olive trees in marginal The model considers 11 major agricultural prod- areas or low-output olive groves. This measure ucts: wheat, barley, maize, sunflower, sugar beet, may act as a production incentive, but it is potato, grapes, milk, beef, poultry, and ovine meat. intended to be an environmental measure. Table 2.7 shows the base period results for the major TABLE 2.7 Base Period Results of Model for Major Activities Border Equivalent Quantity VA, Inclusive Actual Price Price Produced GOV Direct (thousand TL (thousand TL (thousand GOV (billions Share Payments VA Share per metric ton) per metric ton) metric tons) of TL) (percent) (billions of TL) (percent) Wheat 97,325 73,412 15,866.67 1,544,223.37 18.10 781,454.26 16.16 Barley 80,765 56,850 6,189.17 499,868.64 5.86 284,464.38 5.88 Maize 90,000 64,475 2,152.33 193,709.97 2.27 74,848.48 1.55 Sunflower 292,692 141,069 816.67 260,259.67 3.05 205,825.27 4.26 Sugar beet 36,612 20,585 16,807.79 618,223.98 7.25 543,851.74 11.25 Potato 132,444 100,017 5,081.33 672,992.07 7.89 595,596.29 12.32 Grapes 280,139 222,260 3,250.67 910,638.60 10.67 847,373.01 17.52 Milk 167,041 97,945 7,466.33 1,450,093.01 16.99 682,852.63 14.12 Beef 2,153,528 1,085,793 444.67 1,086,378.40 12.73 326,386.03 6.75 Poultry 748,350 469,748 725.00 542,553.75 6.36 180,598.86 3.73 Sheep 2,244,433 1,762,319 237.67 753,628.09 8.83 312,353.42 6.46 Intermediate Intermediate VA, Border Inputs, Inputs, Border VA, Actual Price NPR on Actual Price Price Equivalent Price Equivalent Tradable (thousand TL (thousand TL (thousand TL (thousand TL NPR EPR Inputs per metric ton) per metric ton) per metric ton) per metric ton) (percent) (percent) (percent) Wheat 48,074 45,462 49,251 27,949 32.57 76.22 5.74 Barley 34,803 32,153 45,962 24,697 42.07 86.10 8.24 Maize 55,224 52,335 34,776 12,140 39.59 186.45 5.52 Sunflower 66,654 59,687 252,031 81,381 107.48 209.69 11.67 Sugar beet 4,425 4,243 32,357 16,342 77.86 98.00 4.29 Potato 15,231 13,486 117,213 86,531 32.42 35.46 12.94 Grapes 19,462 19,684 260,677 202,576 26.04 28.68 -1.13 Milk 102,760 76,925 91,458 47,712 70.55 91.69 33.59 Beef 1,709,127 1,301,899 734,001 83,372 98.34 780.39 31.28 Poultry 499,248 382,865 249,102 86,882 59.31 186.71 30.40 Sheep 1,856,693 1,370,015 1,314,248 1,350,414 27.36 2.68 35.52 Note: Gross output value (GOV) comprises the output value from main products and, if applicable, from by-products. Consequently, value added (VA) is calculated on the basis of these gross output values. All variables are measured in terms of 2000 prices. TL = Turkish liras; NPR = nominal protection rate; EPR = effective protection rate. 57 Source: The authors. 58 Turkey: Economic Reform and Accession to the European Union activities carried out under the agricultural policies livestock). Agricultural policies with an impact on followed during 2000.23 From the table it follows input prices, output prices, or other direct monetary that wheat, milk, and beef are the most important transfers translate into changes in the value added, commodities considered, because these commodi- defined as the difference between the value of gross ties have the highest shares of total gross output. But output and the value of intermediate inputs, or, in the order changes to grapes, wheat, and milk when terms of factor payments, the return to land, labor, we consider the value added shares, and to grapes, and owned capital. This effect is computed using the wheat, and potato when we consider the value effective protection rate (EPR).26 Table 2.7 displays added shares measured at border price equiva- the value added of the analyzed activities at domestic lents.24 The table reveals that crop products consti- prices in relation to value added at border price tute 68.93 percent of total value added generated by equivalents. As expected, the levels of effective pro- the 11 commodities and that animal products tection are more pronounced than those of nominal account for 31.07 percent of the total value added. protection. The incomes of producers of crop and livestock products are all implicitly subsidized under the agricultural policies followed during 2000 except Impact on Producers for the incomes of producers of sheep. The extent of The domestic prices of the commodities shown in relative subsidization measured by the EPR is highest table 2.7 diverge considerably from the border price for beef, and this measure decreases for sunflower, equivalents. Examination of the profile of nominal poultry, maize, sugar beet, milk, barley, wheat, protection rates (NPRs)25 reveals the height of pro- potato, and grape production. Sheep production has tection in agriculture in Turkey observed earlier in a negative EPR, with an absolute value less than 100, table 2.5 for aggregates such as cereals and oilseeds. indicating the comparative advantage of the country Table 2.7 shows a similar picture for the 11 com- in the production of sheep. modities analyzed. The NPRs of these commodities are all positive, and NPR exceeds 100 percent for Alternative Agricultural Policy Options sunflower. Indeed, the NPRs lie between 50 percent for Turkey and 100 percent for beef, sugar beet, milk, and poultry, and are between 20 percent and 50 percent We assume that, as a new entrant, Turkey will have to for barley, maize, wheat, potato, sheep, and grapes. adjust to the EU and accept its legislation and poli- To examine the effects of agricultural policies on cies. Accession negotiations will therefore focus on farmers' incomes, we consider first the NPRs of how long Turkey will have to adopt the EU legisla- purchased intermediary inputs to agriculture. Con- tion and how it will do so. However, agricultural pol- sider, for example, wheat production. Although the icy in the EU is also evolving beyond the changes cost of intermediate inputs per metric ton of wheat introduced under the McSharry reforms andAgenda amounts to TL 48.074 million, the cost of interme- 2000. Because it is not easy to anticipate what EU diate inputs evaluated at border price equivalents agricultural policies will be at the time of Turkey's amount to TL 45.463 million. Thus, the intermedi- accession, we use a simulation approach to analyze ate inputs are taxed on average by 5.74 percent. the potential impacts, using the following scenarios: Among the inputs, the most important cost posi- tions are fertilizers (28.2 percent), seeds (25 per- · Scenario A1: partial adoption of Agenda 2000 cent), and fuel (21.4 percent). A comparison of the without direct payments domestic prices of each of these inputs with their · Scenario A2: complete adoption of Agenda border price equivalents reveals an implicit taxa- 2000, including direct payments equal to those tion of 32.6 percent for seed and subsidization of currently applied in the EU 3.4 percent for fertilizers. · Scenario B: adoption of the European Commis- Farmers' income is determined by the difference sion proposal similar to that given CEE coun- between input costs and revenues originating from tries, including direct payments at a level of the sale of agricultural produce, and by any non- 35 percent of payments granted in the EU mem- price-related monetary transfers to farmers (e.g., per ber countries hectare payments for crops or per head payments for · Scenario C: free trade with direct payments. Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 59 Simulation results for Scenario A1 are presented following the EU proposals for Central and Eastern in table 2.8a. When Turkey adopts Agenda 2000 European countries, on a level of 35 percent of without direct payments, domestic prices decrease direct payments granted to agricultural producers substantially for all commodities except grapes, in the EU. The final results of the introduction of milk, and poultry. For example, the price of wheat the CAP will depend on the positions taken by the decreases from TL 97,325,000 per metric ton in the government of Turkey and the European Commis- base case scenario to TL 73,412,000 per metric ton. sion. Because the negotiations have not yet started, Similarly, the prices of barley, maize, sunflower, we analyze only the effects of the introduction of sugar beet, potatoes, beef, and sheep fall signifi- direct payments at the rate of 35 percent of EU lev- cantly. With the decrease in output prices, the gross els.27 Table 2.10 shows the positions taken in agri- output value decreases for all commodities under cultural negotiations between the Slovak Republic consideration except poultry and milk. Similar con- and the European Commission. The table reveals siderations hold for the value added; it decreases for that the main issues in the agricultural negotiations all commodities except grapes, milk, poultry, and will be the shares of compensation payments for sheep. Relative to the base case scenario, the largest crops and livestock as a percentage of the EU direct decreases occur for sunflower, beef, and wheat. payments, the level of reference yield for crop com- Finally, the share of crop products in total value pensation payments, the level of quotas for sugar added generated by the 11 commodities decreases and milk, slaughter premiums, suckler cow premi- from 68.93 percent in the base case scenario to ums, and ewe ceilings. 62.66 percent in Scenario A1. In Scenario B, the value added generated in the In Scenario A2 Turkey adopts Agenda 2000 in full production of wheat, barley, maize, sunflower, and introduces direct payments to agricultural pro- milk, beef, and sheep decreases considerably com- ducers equal to those applied in the EU (table 2.8b). pared with the value added generated in Scenario Because prices are basically the same as in Scenario A2. The change in value added compared with the A1, only those activities to which the direct payment base case becomes negative for wheat, maize, and schemes apply will be affected. Among the produc- beef production, indicating the extreme vulnerabil- tion activities considered are wheat, barley, maize, ity of the sectors to changes in direct payments. The sunflower, milk, beef, and sheep. As a result of the share of crop products in total value added gener- direct payments, the value added relative to the base ated by the 11 commodities decreases now from period increases as shown in table 2.8b by 71.42 per- 68.93 percent in the base case to 62.52 percent in cent for barley,57.72 percent for beef,and 48.06 per- Scenario B. cent for sheep. For sunflower, the decline in value Table 2.9b presents the results of Scenario C-- added in Scenario A2 (Agenda 2000 with direct pay- removal of current trade interventions but with ments) is smaller than that in Scenario A1 (Agenda direct payments as under Agenda 2000. In the free 2000 with no direct payments). For wheat, barley, trade scenario with direct payments, the value maize,and beef,the decline in value added turns into added increases compared with the base case for increases in value added.Whereas wheat production wheat, barley, beef, and sheep production. For all declines by 41.78 percent in Scenario A1, it increases other commodities, the value added decreases. in Scenario A2 by 38.62 percent relative to the base The share of crop products of total value added run. Similar considerations apply for barley, maize, generated by the 11 commodities remains almost and beef. The increase in milk production goes up unchanged. from 24.47 percent in Scenario A1 to 45.82 percent in ScenarioA2,and the increase in sheep production Effects of Policies on Producers' Incomes goes up from 6.28 percent in Scenario A1 to in the Medium Term: Adjusting for Supply 48.06 percent in ScenarioA2.As for the share of crop Response Effects products generated by the 11 commodities, in total value added, it decreases from 68.93 percent in the The discussion so far has been based on the base case to 62.32 percent in Scenario A2. assumption that the output levels for all analyzed Table 2.9a displays the results of Scenario B. In activities remain constant (i.e., the assumption of this scenario, direct payments are introduced, but, totally inelastic supply). This is a simplifying 60 TABLE 2.8a Simulation Results for Partial Adoption of Agenda 2000 without Direct Payments (Scenario A1) Domestic NPR, Quantity GOV Change NPR, VA Change Price Main Produced GOV Relative Intermediary VA VA Relative (thousand TL Outputs (thousand (billions to Base Run Inputs (billions Share EPR to Base Run per metric ton) (percent) metric tons) of TL) (percent) (percent) of TL) (percent) (percent) (percent) Wheat 73,412 0.00 15,867 1,164,796 -24.57 -1.60 455,001 10.17 2.60 -41.78 Barley 74,155 30.44 6,189 458,955 -8.18 5.56 248,900 5.56 62.84 -12.50 Maize 76,283 18.31 2,152 164,187 -15.24 1.97 49,326 1.10 88.78 -34.10 Sunflower 141,069 0.00 817 115,206 -55.73 -2.70 67,777 1.52 1.98 -67.07 Sugar beet 26,867 30.52 16,808 451,569 -26.96 0.98 379,559 8.48 38.19 -30.21 Potato 100,017 0.00 5,081 508,220 -24.48 -3.14 441,846 9.88 0.49 -25.81 Grapes 376,586 69.43 3,251 1,224,157 34.43 -1.13 1,160,892 25.95 76.29 37.00 Milk 180,301 84.08 7,466 1,512,916 4.33 15.43 849,966 19.00 138.60 24.47 Beef 1,614,137 48.66 445 846,529 -22.08 15.97 175,193 3.92 372.56 -46.32 Poultry 888,077 89.05 725 643,856 18.67 19.13 313,190 7.00 397.21 73.42 Sheep 2,055,348 16.63 238 708,689 -5.96 15.69 331,980 7.42 3.44 6.28 TABLE 2.8b Simulation Results for Adoption of Agenda 2000 with Direct Payments (Scenario A2) Quantity Direct GOV Change VA Change Domestic Price Produced Payments GOV Relative to VA VA Relative to (thousand TL (thousand (billions (billions Base Run (billions Share EPR Base Run per metric ton) metric tons) of TL) of TL) (percent) of TL) (percent) (percent) (percent) Wheat 73,412 15,867 628,217 1,793,013 16.11 1,083,218 17.85 144.26 38.62 Barley 74,155 6,189 238,716 697,671 39.57 487,616 8.04 219.01 71.42 Maize 76,283 2,152 41,339 205,526 6.10 90,665 1.49 246.98 21.13 Sunflower 141,069 817 70,112 185,318 -28.80 137,889 2.27 107.47 -33.01 Sugar beet 26,867 16,808 0 451,569 -26.96 379,559 6.26 38.19 -30.21 Potato 100,017 5,081 0 508,220 -24.48 441,846 7.28 0.49 -25.81 Grapes 376,586 3,251 0 1,224,157 34.43 1,160,892 19.13 76.29 37.00 Milk 180,301 7,466 145,791 1,658,707 14.39 995,757 16.41 179.52 45.82 Beef 1,614,137 445 339,577 1,186,106 9.18 514,770 8.48 1288.54 57.72 Poultry 888,077 725 0 643,856 18.67 313,190 5.16 397.21 73.42 Sheep 2,055,348 238 130,488 839,176 11.35 462,468 7.62 44.09 48.06 Note: All variables are measured in terms of 2000 prices. TL = Turkish liras; NPR = nominal protection rate; GOV = gross output value; VA = value added; EPR = effective protection rate. Source: The authors. TABLE 2.9a Simulation Results for Adoption of Agenda 2000 with Direct Payments at 35 Percent (Scenario 2B) Border GOV Change VA Change Equivalent NPR Domestic Quantity Direct Relative NPR Relative Price Main Price Produced Payments GOV to Base Intermediary VA VA to Base (thousand TL Outputs (thousand TL (thousand (billions (billions Run Inputs (billions Share EPR Run per metric ton) (percent) per metric ton) metric tons) of TL) of TL) (percent) (percent) of TL) (percent) (percent) (percent) Wheat 73,412 0.00 73,412 15,867 219,876 1,384,672 -10.33 -1.60 674,877 13.41 52.18 -13.64 Barley 56,850 30.44 74,155 6,189 83,550 542,506 8.53 5.56 332,451 6.61 117.50 16.87 Maize 64,475 18.31 76,283 2,152 14,469 178,656 -7.77 1.97 63,794 1.27 144.15 -14.77 Sunflower 141,069 0.00 141,069 817 24,539 139,745 -46.31 -2.70 92,316 1.83 38.90 -55.15 Sugar beet 20,585 30.52 26,867 16,808 0 451,569 -26.96 0.98 379,559 7.54 38.19 -30.21 Potato 100,017 0.00 100,017 5,081 0 508,220 -24.48 -3.14 441,846 8.78 0.49 -25.81 Grapes 222,260 69.43 376,586 3,251 0 1,224,157 34.43 -1.13 1,160,892 23.07 76.29 37.00 Milk 97,945 84.08 180,301 7,466 51,027 1,563,943 7.85 15.43 900,993 17.91 152.92 31.95 Beef 1,085,793 48.66 1,614,137 445 118,852 965,381 -11.14 15.97 294,045 5.84 693.16 -9.91 Poultry 469,748 89.05 888,077 725 0 643,856 18.67 19.13 313,190 6.22 397.21 73.42 Sheep 1,762,319 16.63 2,055,348 238 45,671 754,360 0.10 15.69 377,651 7.51 17.67 20.90 TABLE 2.9b Simulation Results for Adoption of Free Trade with Direct Payments (Scenario 2C) Domestic Quantity Direct GOV Change VA Change Price Produced Payments GOV Relative to VA VA Relative to (thousand TL (thousand (billions (billions Base Run (billions Share EPR Base Run per metric ton) metric tons) of TL) of TL) (percent) of TL) (percent) (percent) (percent) Wheat 73,412 15,867 628,217 1,793,013 16.11 1,071,679 24.17 141.66 37.14 Barley 56,850 6,189 238,716 590,568 18.14 391,569 8.83 156.17 37.65 Maize 64,475 2,152 41,339 180,111 -7.02 67,468 1.52 158.21 -9.86 Sunflower 141,069 817 70,112 185,318 -28.80 136,573 3.08 105.49 -33.65 Sugar beet 20,585 16,808 0 345,981 -44.04 274,666 6.20 0.00 -49.50 Potato 100,017 5,081 0 508,220 -24.48 439,691 9.92 0.00 -26.18 Grapes 222,260 3,251 0 722,494 -20.66 658,508 14.85 0.00 -22.29 Milk 97,945 7,466 145,791 1,076,369 -25.77 502,024 11.32 40.93 -26.48 Beef 1,085,793 445 339,577 955,562 -12.04 376,650 8.50 915.98 15.40 Poultry 469,748 725 0 340,567 -37.23 62,990 1.42 0.00 -65.12 Sheep 1,762,319 238 130,488 777,044 3.11 451,437 10.18 40.66 44.53 Note: All variables are measured in terms of 2000 prices. TL = Turkish liras; NPR = nominal protection rate; GOV = gross output value; VA = value added; 61 EPR = effective protection rate. Source: The authors. 62 Turkey: Economic Reform and Accession to the European Union TABLE 2.10 Selected Positions in Agricultural Negotiation between the Slovak Republic and European Commission (EC) Slovak EC Proposal Proposal Share of compensation payments for crops and livestock (% of EU)a 35 100 Reference yield for crop compensation payments (cereal metric ton per hectare)b 4.16 4.99 Sugar quota--type A (metric tons)c 189,800 190,000 Sugar quota--type B (metric tons)c 19,000 45,000 Milk quota (metric tons) 946,150 1,235,000 Slaughter premium--adults (head)d 204,062 260,000 Slaughter premium--calves (head)d 62,841 60,000 Suckler cow premium (head)d 39,708 50,000 Ewe ceilings (head)d 219,360 370,000 a. As percent of payments granted to farmers in EU member countries. b. Reference yield used in calculation of compensatory payments for crops. c. Sugar beets used to produce sugar up to the A quota secure a higher price (about 46.72 per metric ton in 2000). Sugar beets used to produce sugar above the A quota and up to the B quota secure a slightly lower price (about 32.42 per metric ton in 2000). Sugar production exceeding the sum of both quotas has to be exported at world market prices (i.e., without export refunds). It is known as C sugar. d. Number of head eligible for compensation payments. Source: Csaki and others 2002. assumption, but one that presumably captures the large farmers, under Agenda 2000 the payments per essence of short-run effects. However, after some hectare for cereals and oilseeds have been progres- time producers would begin to adjust to the new sively aligned, and by the end of the Agenda 2000 price situation, readjusting the output mix and the period they will be virtually equal.30 Thus the pay- overall level of resource intensity. The medium- to ments will not affect whether a large farmer long-term supply response in the model is deter- chooses to plant, say, wheat or sunflower, or the mined by the elasticities of supply.28 farmer's decision on how much seed or fertilizer to When supply effects are taken into considera- use. They will, however, affect the amount of arable tion, modeling the impact of introducing the CAP land in cultivation. In this sense, the direct pay- with direct payments becomes tricky for the follow- ments do have an impact on agricultural produc- ing reason: the direct payments are made per tion, but they do not have as much of an effect on hectare currently planted, with the amount per incentives to plant individual crops as would addi- hectare computed by multiplying a basic per metric tional income from higher prices for the products. ton payment amount by a historical regional yield This factor makes it difficult to model the pay- for the 1986­91 baseline period. The payments are ments' effects. In the simulations, we first treat the not based on the individual farmer's current levels payments as if they do not come from higher prices. of production (yield). For this reason, the direct The resulting supply response should then be payment should not affect the farmer's cultivation regarded as a lower bound (Case I).31 In Case I, the decisions,29 but it does affect the farmer's decision payments do not produce any supply response, but on how many hectares to plant. Under Agenda they do increase value added. Next, we treat the 2000, these payments were originally crop-specific payments as if they come from higher prices and for large farmers (the "professional farmer" thus generate an increase in production. The result- scheme) and non-crop-specific for small farmers ing supply response should be regarded as an upper (the "small producer" scheme). However, even for bound (Case II). Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 63 We adjust the medium-run supply elasticities, ei, under inelastic supply and by 44.36 percent under to capture the difference in the ratio of value added the elastic supply assumption. Note that in Scenario to price. In particular, the adjusted elasticities, i , C, the value added increases despite the lower prices are calculated (as emphasized by Valdes 1973) by for wheat, barley, beef, and sheep. As a result, the multiplying the unadjusted elasticities with the quantity produced increases under elastic supply ratio of value added to product price so that and Case II--5.26 percent for wheat, 4.50 percent = eivi, where vi is the ratio of the per unit value for barley, 1.78 percent for beef, and 15.64 percent added at base run prices to the base period price. for sheep production. In all other cases, the quantity The supply response is then computed by applying produced decreases by 0.53 percent for maize, the relation 4.64 percent for sunflower, 14.87 percent for sugar beet, 21.78 percent for potato, 2.07 percent for qj VAjA 2 (2.1) = - 1 grapes, 17.11 percent for milk, and 40.75 percent qj VAjBase for poultry. where qj indicates the quantity of product j, VAjA 2 the value added generated in the production of Impact on Consumers commodity j in Scenario A2 (Agenda 2000 with direct payments), and VAjBase the value added gen- Changes in agricultural output prices also have an erated in the production of commodity j in the base impact on consumers through food prices. Lower case. Here we first incorporate the direct payments food prices lead to a decrease in consumer spend- under Agenda 2000 as part of the value added; ing on food. A consumer with a fixed, nominal dis- thereafter we abstract from considering direct pay- posable income (i.e., a fixed amount of money ment as part of value added. available for consumption) is able to increase his or Table 2.11 shows the effects of the alignment to her overall consumption of total goods and services Agenda 2000 under alternative elasticities of sup- by a percentage derived from multiplying the ply. For each commodity, the first column shows absolute value of the percentage decrease in food the results under the assumed medium-run supply expenditure by the share that food expenditure elasticities and the second column the results under makes up of total consumption. This increase in the the assumption of a completely inelastic supply consumer's ability to purchase goods and services is response. The table reveals that output quantities equivalent to an increase in his or her real income. under the Agenda 2000 scenarios decrease, on aver- The relative increase in real consumer incomes is age, by 3.7 percent for Scenario A1 and increase by highest for households with low disposable 2.5 percent for Scenario A2 under Case II. As incomes, because poor households allocate a higher expected, the introduction of direct payments gives share of expenditures to food products. In the incentives to increase the output relative to the case medium to long term, consumers will adjust to in Scenario A1. the new set of relative prices, moving away from the Furthermore, the changes in total value added in consumption of foods that have become relatively the simulations with a supply response are larger more expensive as a result of the policy changes. than under a totally inelastic response. Similarly, The medium- to long-term impact on income, Case II results in higher changes in total value added therefore, is expected to be more moderate than the compared with Case I. Consider, for example, wheat short-run impact. The exact amount will be deter- production. Whereas total value added generated in mined by the price elasticity of demand for each wheat production increases by 38.62 percent in Sce- product, which regulates the extent of consumers' nario A2 (Agenda 2000 with direct payments) under adjustments to changes in food prices. the inelastic response assumption and Case II, the To trace the effects of changes in output prices increase goes up to 46.20 percent under the elastic on consumers, we start with the information on supply assumption and Case II. By contrast, under expenditure given in table 2.12 and annex table 2.20 elastic supply the value added under Case I increases for the average consumer and for the average by only 30.41 percent. Under free trade with direct consumer in urban and rural areas, respectively. payments (Scenario C) and Case II,value added gen- Consider a commodity such as bread. Annex table erated in wheat production goes up by 37.14 percent 2.20 reveals that for the average consumer the 64 TABLE 2.11 Simulation Results for Alignment to Agenda 2000 under Positive Supply Response (percent change relative to 2000 base run) Wheat Barley Maize Sunflower Sugar Beet Potato Grapes Milk Beef Poultry Sheep Elastic Inelastic Elastic Inelastic Elastic Inelastic Elastic Inelastic Elastic Inelastic Elastic Inelastic Elastic Inelastic Elastic Inelastic Elastic Inelastic Elastic Inelastic Elastic Inelastic Scenario A1 Alignment, excluding direct compensatory payments Price change 24.57 24.57 8.18 8.18 15.24 15.24 51.80 51.80 26.62 26.62 24.48 24.48 34.43 34.43 7.94 7.94 25.05 25.05 18.67 18.67 8.42 8.42 Quantity change 5.92 0.00 1.49 0.00 1.84 0.00 9.24 0.00 9.08 0.00 21.48 0.00 3.44 0.00 15.81 0.00 5.37 0.00 45.94 0.00 2.21 0.00 GOV change 29.04 24.57 9.56 8.18 16.80 15.24 59.82 55.73 33.59 26.96 40.70 24.48 39.06 34.43 20.83 4.33 26.26 22.08 73.19 18.67 3.89 5.96 Total VA change 45.22 41.78 13.81 12.50 35.31 34.10 70.11 67.07 36.54 30.21 41.75 25.81 41.72 37.00 44.15 24.47 49.21 46.32 153.09 73.42 8.63 6.28 Scenario A2(a) Complete alignment, including direct compensatory payments (Case I) Price change 24.57 24.57 8.18 8.18 15.24 15.24 51.80 51.80 26.62 26.62 24.48 24.48 34.43 34.43 7.94 7.94 25.05 25.05 18.67 18.67 8.42 8.42 Quantity change 5.92 0.00 1.49 0.00 1.84 0.00 9.24 0.00 9.08 0.00 21.48 0.00 3.44 0.00 15.81 0.00 5.37 0.00 45.94 0.00 2.21 0.00 GOV change 9.24 16.11 37.49 39.57 4.14 6.10 35.37 28.80 33.59 26.96 40.70 24.48 39.06 34.43 32.47 14.39 3.32 9.18 73.19 18.67 13.81 11.35 Total VA change 30.41 38.62 68.85 71.42 18.90 21.13 39.20 33.01 36.54 30.21 41.75 25.81 41.72 37.00 68.88 45.82 49.25 57.72 153.09 73.42 51.33 48.06 Scenario A2(b) Complete alignment, including direct compensatory payments (Case II) Price change 24.57 24.57 8.18 8.18 15.24 15.24 51.80 51.80 26.62 26.62 24.48 24.48 34.43 34.43 7.94 7.94 25.05 25.05 18.67 18.67 8.42 8.42 Quantity change 5.47 0.00 8.53 0.00 1.14 0.00 4.55 0.00 9.08 0.00 21.48 0.00 3.44 0.00 29.60 0.00 6.69 0.00 45.94 0.00 16.88 0.00 GOV change 22.46 16.11 51.48 39.57 7.31 6.10 32.03 28.80 33.59 26.96 40.70 24.48 39.06 34.43 48.25 14.39 16.48 9.18 73.19 18.67 30.15 11.35 Per unit VA change 38.62 38.62 71.42 71.42 21.13 21.13 33.01 33.01 30.21 30.21 25.81 25.81 37.00 37.00 45.82 45.82 57.72 57.72 73.42 73.42 48.06 48.06 Total VA change 46.20 38.62 86.05 71.42 22.52 21.13 36.05 33.01 36.54 30.21 41.75 25.81 41.72 37.00 88.99 45.82 68.27 57.72 153.09 73.42 73.06 48.06 Scenario C(a) Free trade with direct payments (Case I) Price change 24.57 24.57 29.61 29.61 28.36 28.36 51.80 51.80 43.78 43.78 24.48 24.48 20.66 20.66 41.36 41.36 49.58 49.58 37.23 37.23 21.48 21.48 Quantity change 6.13 0.00 5.53 0.00 3.52 0.00 9.33 0.00 14.87 0.00 21.78 0.00 2.07 0.00 30.90 0.00 10.27 0.00 40.75 0.00 0.97 0.00 GOV change 9.00 16.11 11.61 18.14 10.29 7.02 35.44 28.80 52.36 44.04 40.93 24.48 22.31 20.66 48.71 25.77 21.08 12.04 62.81 37.23 4.10 3.11 Total VA change 28.73 37.14 30.04 37.65 13.03 9.86 39.84 33.65 57.01 49.50 42.25 26.18 23.90 22.29 49.20 26.48 3.55 15.40 79.34 65.12 45.92 44.53 Scenario C(b) Free trade with direct payments (Case II) Price change 24.57 24.57 29.61 29.61 28.36 28.36 51.80 51.80 43.78 43.78 24.48 24.48 20.66 20.66 41.36 41.36 49.58 49.58 37.23 37.23 21.48 21.48 Quantity change 5.26 0.00 4.50 0.00 0.53 0.00 4.64 0.00 14.87 0.00 21.78 0.00 2.07 0.00 17.11 0.00 1.78 0.00 40.75 0.00 15.64 0.00 GOV change 22.22 16.11 23.46 18.14 7.52 7.02 32.10 28.80 52.36 44.04 40.93 24.48 22.31 20.66 38.47 25.77 10.47 12.04 62.81 37.23 19.24 3.11 Total VA change 44.36 37.14 43.84 37.65 10.34 9.86 36.72 33.65 57.01 49.50 42.25 26.18 23.90 22.29 39.06 26.48 17.46 15.40 79.34 65.12 67.14 44.53 Note: GOV = gross output value; VA = value added. Source: The authors. Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 65 TABLE 2.12 Structure of Household Expenditures (1994 prices, Turkish liras) Average Rural Urban Total expenses per household 111,044,759 66,698,941 167,764,049 Food, beverages, and tobacco per household 39,552,432 30,202,155 51,511,644 Food and nonalcoholic beverages per household 36,457,528 28,287,252 46,907,494 Expenditure shares (% of total expenditure) Cereals and pasta 7.24 9.54 6.07 Meat and meat products 5.18 5.69 4.92 Milk, dairy products, and eggs 4.61 5.84 3.99 Fat 3.00 4.76 2.10 Fruit, fresh or dried 7.82 9.65 6.89 Sugar and sugar products 1.95 3.07 1.38 Other food and nonalcoholic beverages 3.03 3.86 2.61 Alcoholic beverages 0.34 0.30 0.36 Tobacco 2.45 2.57 2.39 Total food, beverages, and tobacco 35.62 45.28 30.70 Source: Turkish State Institute of Statistics. expenditure share for bread is 3.5371 percent. expenditure, F for food expenditure in the base Next, we consider the value share of the primary case, and F for food expenditure evaluated commodity in bread, wheat. Multiplying the expen- at Agenda 2000 prices, F can be defined as diture on bread with this share, we obtain the value E = F + (E - F ). The effect on consumer wel- of the analyzed primary commodity (wheat) in the fare is then calculated as (E - E )100/E .32 bread expenditure. Considering the price relation Table 2.13 summarizes the main results of the pi = pi (1 + NPRi), where pi denotes the domes- simulations. For each scenario, we estimated the tic price, pi the Agenda 2000 price of wheat, and impact of changes in food prices on, first, the nom- NPRi the nominal protection rate on wheat, we inal expenditure (change of food expenditure obtain the relation pi = Pi 1+NPRi . We then normalize relative to the base period food expenditure) and the domestic price so that pi = 1 for wheat in the second, consumers' real income (reduction in pur- base case. By means of the NPR, we determine chasing power of nominal income induced by the foreign price of wheat. Then, by multiplying the changes in the expenditure on food). The table expenditure on bread in the form of wheat with the reveals that, on average, the price changes under the foreign price, we can determine the value of the pri- Agenda 2000 scenario (Scenarios A and B) produce mary commodity (wheat) evaluated at foreign a 5.91 percent decrease in the expenditure on food, prices in the bread expenditure. By adding the value beverages, and tobacco. As for the expenditure on of the contents of bread other than wheat, we arrive food and nonalcoholic beverages only, consumers at the value of bread evaluated at Agenda 2000 would have to spend 6.41 percent less than under prices. Based on the expenditure of the average the current base period market conditions. In the income group on bread evaluated at base year Agenda 2000 scenario, the greatest decreases in prices and the expenditure on bread evaluated at expenditure occur in the groups fat (30.53 percent), Agenda 2000 prices, we determine the effect of sugar and sugar products (13.44 percent), and meat Agenda 2000 on the bread expenditure in percent- and meat products (9.48 percent). Because of the age terms. Once we conduct similar calculations for significant price changes in the main agricultural all the commodities under consideration, we obtain products of the Agenda 2000 scenario (compared the expenditure on food, beverages, and tobacco with the prevailing prices in Turkey), decreases in evaluated at Agenda 2000 prices. If E stands for total expenditure were recorded for all food product 66 Turkey: Economic Reform and Accession to the European Union TABLE 2.13 Simulation of Scenario Effects on Real Income, Selected Household Types Inelastic Demand Own Price Elasticities Reference Scenario (removal of all divergences) Average Rural Urban Average Rural Urban Change in real income 5.50 8.09 4.23 3.91 5.97 2.89 Change in nominal expenditure (%) Food, beverages, and tobacco 14.64 16.53 13.23 10.56 12.45 9.14 Food, and nonalcoholic beverages 15.88 17.64 14.52 11.45 13.29 10.03 Cereals and pasta 13.21 18.41 9.06 12.04 16.90 8.16 Meat and meat products 29.12 27.79 29.90 13.20 12.63 13.54 Fish and fish products 0.00 0.00 0.00 0.00 0.00 0.00 Milk, dairy products, and eggs 25.85 26.44 25.40 18.75 19.14 19.82 Fat 37.10 37.11 37.10 29.16 28.56 29.86 Fruits, fresh and dried 0.00 0.00 0.00 0.00 0.00 0.00 Vegetables and potatoes 2.54 3.01 2.15 2.34 2.78 1.98 Sugar and sugar products 22.10 24.39 19.51 20.68 22.82 18.24 Other food and nonalcoholic beverages 0.00 0.00 0.00 0.00 0.00 0.00 Alcoholic beverages 1.08 1.09 1.08 0.87 0.88 0.87 Tobacco products 0.00 0.00 0.00 0.00 0.00 0.00 Inelastic Demand Own Price Elasticities Agenda 2000 Scenario Average Rural Urban Average Rural Urban Change in real income 2.15 3.43 1.51 1.87 3.03 1.28 Change in nominal expenditure (%) Food, beverages, and tobacco 5.91 7.32 4.85 5.14 6.49 4.13 Food, and nonalcoholic beverages 6.41 7.82 5.33 5.58 6.93 4.53 Cereals and pasta 8.03 11.19 5.51 7.22 10.11 4.91 Meat and meat products 9.48 9.44 9.50 5.20 4.86 5.41 Fish and fish products 0.00 0.00 0.00 0.00 0.00 0.00 Milk, dairy products, and eggs 4.96 5.07 4.88 2.87 2.92 2.83 Fat 30.53 29.36 31.88 27.96 27.14 28.91 Fruits, fresh and dried 0.00 0.00 0.00 0.00 0.00 0.00 Vegetables and potatoes 2.54 3.01 2.15 2.34 2.78 1.98 Sugar and sugar products 13.44 14.83 11.86 12.44 13.73 10.98 Other food and nonalcoholic beverages 0.00 0.00 0.00 0.00 0.00 0.00 Alcoholic beverages 0.12 0.14 0.11 0.10 0.11 0.09 Tobacco products 0.00 0.00 0.00 0.00 0.00 0.00 Source: The authors. groups under the assumptions of Scenarios A and B reveal an increase in consumers' real income of except for milk and dairy products. Scenario C (free 2.15 percent as an impact of food price changes on trade with direct payments) also induces a decrease average households. The increase is more pro- in consumers' expenditure on food, beverages, and nounced in the lower-income group,the rural sector. tobacco of about 14.64 percent. Expenditures for Because food makes up a higher share of their total almost all product groups will be reduced. expenditures and because their food consumption The results in table 2.13 of the simulated intro- basket has a different mix, lower-income households duction of EU-type agricultural policies in Turkey experience a more significant change in real income Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 67 than the average of all groups. The immediate intro- imported commodities such as sunflower. For duction of Agenda 2000 in Turkey would increase exported commodities, the product can be consid- the real incomes of the households with the lowest ered the decrease in export subsidies, as long as the incomes by 3.43 percent, which is significantly base period domestic price exceeds the Agenda higher than the increase of 1.51 percent for house- 2000 price, such as for wheat. Finally, for poultry holds with the highest income--that is, the urban the Agenda 2000 price exceeds the base period sector. domestic price. Because poultry is an imported Columns 4­6 of table 2.13 present the results of commodity, the product is considered to be an the simulation of changes in consumers'real income increase in tariff revenue. and in nominal expenditures under the elastic Table 2.14 shows that after adoption of the demand assumption.33 As expected, the effects of Agenda 2000 policies Turkey will incur a net trade- the "elastic" scenarios are substantially lower than related revenue loss of 226 million. In the longer those of the "inelastic" scenarios. Under the Agenda term, the losses could become even greater as pro- 2000 scenario, real income increases in the elastic ducers and consumers adjust to the new price lev- variant are 1.87 percent instead of 2.15 percent in els. These results account only for expenditure on the inelastic demand. The pattern of impacts on the the commodities analyzed in this study. Thus they different groups of households under the elastic are likely to underestimate the true trade-related variant is principally the same as just described. budgetary effects of an implementation of CAP- type market regimes in Turkey. The budgetary effects of direct income transfers Impact on the State Budget can be determined for each agricultural commod- In addition to the implications for farmers' incomes ity such as wheat, barley, maize, and beef. For and for consumers, the implementation of EU poli- wheat, direct income support can be determined cies would have wide budgetary implications. The from the relation [direct payments (euros/metric most important budgetary effects are the direct ton)] [exchange rate (lira/euro)] [historical effectsoninternalpricesupportmeasures(e.g.,inter- grain yield for the EU compensatory area payments vention purchases and border measures) and those (metric tons/hectare)] [quantity of wheat pro- stemming from direct income transfers. duced (metric tons)]/[actual yield in 2000 per When estimating the effects of the policy changes hectare (metric tons/hectare)]. The direct income on tariff revenues and export refunds, we assume support for other commodities can be similarly that before accession Turkey will adopt the EU-like determined. A close look at the figures in table 2.14 agricultural policies on its own and will not receive reveals that direct payments to agriculture will any compensation from the EU budget for doing so. amount to 2.772 billion under Scenarios A1 and Under this assumption, we suppose that any subsi- A2 and to 970 million under Scenario B. dies to agriculture resulting from adoption of the Overall, the budgetary costs to Turkey of EU-like agricultural policies will have to be financed adopting EU-like agricultural policies when from the Turkish Treasury.34 Later, we relax this uncompensated by the EU budget for introducing assumption by considering the case in which Turkey those policies will be 2.998 billion under Scen- would receive compensation from the EU budget for ario A policies and 1.196 billion under Scenario B introducing the EU-like agricultural policies. It policies. should be noted that the total trade-related budget- After accession to the EU, Turkey will be eligible ary effects under Scenarios A1,A2, and B are similar, for payments under the EU's Structural Funds and because the level of domestic support prices is the Cohesion Fund. But after accession, Turkey will also same for all scenarios under consideration. have to contribute to the EU budget in the form of The trade-related budgetary implications of VAT-based and GNP-based contributions.TheVAT- adopting EU-like agricultural policies are analyzed based contribution is determined by the relation by multiplying the net traded quantity by the dif- 0.008522 0.55 GDP, where the value of 0.008522 ference between the base period domestic price and denotes the proportion used in calculation of the the Agenda 2000 price. Whenever the base period VAT-based contribution, and the parameter value domestic price exceeds the Agenda 2000 price, the of 0.55 is derived from the relation that the VAT product determines the loss in tariff revenue for base may not exceed 55 percent of national GDP. 68 Turkey: Economic Reform and Accession to the European Union TABLE 2.14 Trade-Related Budget Effects and Direct Payments under Agenda 2000 Agenda 2000 Net Exports, Trade-Related Direct 1999­2001 Effects on Payments Average Budget (billions of TL) (metric tons) (billions of TL) Scenario A Scenario B Wheat EX 617,845 16,729 628,217 219,876 Barley EX 160,508 1,061 238,716 83,550 Maize IM 881,072 12,085 41,339 14,469 Sunflower IM 394,310 66,002 70,112 24,539 Sugar beet IM 31,675 309 0 0 Potato EX 91,237 3,467 0 0 Grapes EX 470,095 45,339 0 0 Milk IM 146,669 1,945 145,791 51,027 Beef IM 69,392 37,429 339,577 118,852 Poultry IM 374 52 0 0 Sheep EX 42,162 7,972 130,488 45,671 Total 129,939 1,594,239 557,984 Total ( millions) 226 2,772 970 Total budgetary cost ( millions): Scenario A 2,998 Scenario B 1,196 Note: Because of the prevailing sanitary ban by Turkey on imports of livestock and meat products, the 1990­96 average of net exports for beef, sheep, and poultry is used. TL = Turkish liras; EX = export; IM = import. Source: The authors. Table 2.15 shows that Turkey's VAT-based contribu- countries, trade-related net subsidies from the EU tion will amount to 1.023 billion. The GNP-based will be 23 million. The payments under the Struc- contribution is determined by the relation 34.46 tural Funds that Turkey may receive from the EU (exchange rate) (share of Turkish GDP in EU after accession can be calculated, assuming that GDP), where 34.46 denotes the amount measured Turkey falls under Objective 1 of the Structural in terms of billions of euros that must be met by the Funds.36 According to the European Commission EU budget requirement by the GNP-based contri- (2002), per capita payments under Objective 1 cur- bution.35 From table 2.15, we note that Turkey's rently amount to 217 per inhabitant per year. GNP-based contribution will be 878 million. Therefore, assuming Objective 1 applies to Turkey, After accession, Turkey will receive from the EU the country would receive about 14.6 billion-- budget direct income support payments, trade- that is, about 6.75 percent of the 2000 GDP. Turkey's related net subsidies, payments under the Structural potential gains from the Cohesion Fund have Funds and Cohesion Fund. The direct income sup- been estimated on the basis of the payments port will amount to 2.772 billion in Scenarios A1 granted to Greece, Ireland, Portugal, and Spain. and A2 and to 970 million in Scenario B. Trade- Cohesion Fund payments are granted to countries related net subsidies, consisting of subsidies on with a per capita GNP of less than 90 percent of the exports minus tariff revenues on imports, are deter- EU average. The total amount to be spent in 2002 mined by multiplying the net traded quantity was about 45 per inhabitant. If Turkey receives (exports minus imports) from third countries by equal payments, it could expect to receive about the difference between the Agenda 2000 price and 3 billion. the border price. Basing the calculations on the The calculations just presented are optimistic, average 1999­2001 net trade figures with third because, according to EU rules, transfers from the Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 69 TABLE 2.15 Contributions to and Revenues from EU Budget Turkish Liras Euros (billions) (millions) Contributions to EU budget VAT-based contribution 588,682 1,023 GNP-based contribution 505,112 878 Total contribution 1,093,793 1,902 Revenues from EU budget Direct payments to agriculture Scenario A 1,594,239 2,772 Direct payments to agriculture Scenario B 557,984 970 Trade-related budgetary effects 13,473 23 Structural Funds 8,421,079 14,641 Cohesion Fund 1,746,307 3,036 Total revenue Scenario A 11,775,099 20,472 Total revenue Scenario B 10,738,843 18,670 Net revenue from EU budget Unrestricted Scenario A 10,681,305 18,570 Unrestricted Scenario B 9,645,050 16,768 Structural operations (restricted) Agenda 2000 4,983,338 8,664 Restricted Scenario A 5,497,258 9,557 Restricted Scenario B 4,461,002 7,755 Source: The authors. Structural Funds and Cohesion Fund cannot are located in a member state covered by the exceed 4 percent of GDP. Thus this requirement Cohesion Fund, the European Community contri- places an upper bound on the amount that Turkey bution may rise, in exceptional cases, to a maxi- can receive from the EU under these funds. For mum of 80 percent of the total eligible cost. The Turkey, this requirement is binding, and therefore second ceiling is a maximum of 50 percent of the the payments under the Structural Funds and total eligible cost and, as a general rule, is at least Cohesion Fund cannot exceed 8.664 billion. 25 percent of the eligible public expenditure for The total annual net revenue that Turkey can measures carried out in areas covered by Objec- receive from the EU under accession will therefore tives 2 and 3. Assuming that Turkey will qualify for be about 9.557 billion under Scenario A and assistance under Objective 1 and the Cohesion 7.755 billion under Scenario B. Fund, and assuming an EU participation rate (on Furthermore, an assessment of Turkey's poten- average) of 75 percent, the EU's contribution of tial gains from the Structural Funds must bear in 8.664 billion would have to be accompanied by a mind that funding of projects under the priority Turkish co-financing share of about 2.9 billion objectives are subject to a co-financing mecha- from the national budget. nism. The amount just estimated therefore consti- tutes the EU's share of project funding and must Welfare Effects be complemented by funds from the national budget. The EU's contribution to structural fund- The situation just described reveals that, in Turkey, ing is subject to two ceilings. The first is a maxi- integration into the EU will lead to substantial mum of 75 percent of the total eligible cost and, as changes in the agricultural incomes of producers, general rule, is at least 50 percent of the eligible the welfare levels of the consumers, and the budget public expenditure for measures carried out in the revenues of the government. On the effects of inte- regions covered by Objective 1. When the regions gration into the EU, we have five observations. 70 Turkey: Economic Reform and Accession to the European Union TABLE 2.16 Impact of Changes in Agricultural Policies on Agricultural Incomes Value Added Gross Agricultural Inclusive Direct Output Payments (billions of TL) (billions of TL) Base run with current policies 8,532,570 4,835,604 Agenda 2000 without direct payments 7,799,080 4,473,629 Agenda 2000 with direct payments 9,393,319 6,067,868 Agenda 2000 with 35 percent direct payments 8,357,064 5,031,613 Free trade with direct payments 7,475,246 4,433,256 Note: All variables are measured in terms of 2000 prices. TL = Turkish liras. Source: The authors. First, the impact on farmers' incomes of the intro- sumers' real income. In fact, the model estimates duction of EU-type agricultural policies (Scenarios that, in the medium to long term, EU-like policies A1, A2, B, and C) will be driven mainly by the (Scenarios A1, A2, and B) will lead to a 1.87 percent amount of CAP-like compensation payments increase in real household incomes in Turkey. This granted to the farmers (see table 2.16), and the impact is higher (2.15 percent) in the short term, impact will be greater in the medium to long term before consumers can adjust to the higher prices for as farmers adjust to the new policies. The largest some food products. Therefore, although farmers reduction in farmers' incomes is produced by as a group could lose from the new policies, Agenda 2000 policies without direct payments depending on the amount of direct payments, the (Scenario A1). From the point of view of the farm- population as a whole stands to gain from the ers, the best alternative among the various EU poli- introduction of these policies. Furthermore, cies considered is the Agenda 2000 scenario with because food makes up a higher share of their total direct payments given at the EU levels. expenditures and their food consumption basket Second, the impact will not be uniformly dis- has different mixes, lower-income households (i.e., tributed across all agricultural products; some rural households) experience a more significant farmers will gain and others will lose from the increase in real income. reforms as a result of changes in relative rates of Fifth, the budgetary costs to Turkey of adopting protection. EU-like agricultural policies (when Turkey will not Third, EU-type agricultural policies will reduce receive any compensation from the EU budget for agricultural prices substantially in Turkey, leading introducing these policies) will amount to 2.998 to lower food prices. In the short term, food expen- billion under Scenario A policies and to 1.196 ditures are projected to fall by as much as 5.91 per- billion under Scenario B policies. Yet after the EU cent compared with the current base period condi- accession, Turkey will be a net recipient of funds tions. In the medium to long term, EU-like changes from the EU; it can expect to receive from the EU in agricultural policies (Scenarios A1, A2, and B) 9.557 billion in net transfers under ScenarioA and would induce a 5.14 percent average drop in food 7.755 billion in net transfers under Scenario B.37 expenditures. Expenditures are projected to fall for the major food product groups, with the largest Institutional Development decreases projected for fat products (30.53 per- and EU Accession cent), sugar and sugar products (13.44 percent), and meat and meat products (9.48 percent). The institutional and human capital enhancements Fourth, because Turkish households spend on implied by EU membership require significant average about 36 percent of their disposable effort and investment during the preaccession income on food and beverages, policy reforms that period. Not only is the alignment of legislation affect food prices will undoubtedly affect con- necessary; Turkey also must develop the judicial Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 71 and administrative capacity to implement and a subsidized price later in the year, which has been enforce the acquis communautaire. In preparation the case in the past. TMO's new purchase and sales for joining the EU and adopting regulations and pricing policies have been very successful in elimi- policies of the EU, Turkey will have to strengthen nating its deficit (TMO 2002). some institutions and create others. This section The Turkish Bank of Agriculture is, as explained first outlines Turkey's key institutions for agriculture early in this chapter, the principal supplier of agri- in the context of implementation of the acquis and, cultural credit for crop and livestock production. It in particular, the mechanisms to operate the CAP. was the channel through which the bulk of the The section then briefly discusses Turkey's status credit was extended to farmers through the agricul- and ability to adopt and implement the acquis. tural credit cooperatives (ACCs) and the agricul- tural sales cooperatives unions (ASCUs). Virtually all of these loans carried negative real interest rates, Implementing Agencies for Agricultural Policies with losses covered by the Treasury. The ACCs pro- The Ministry of Agriculture and Rural Affairs vided short- and medium-term credit in the form (MARA), Ministry of Industry and Trade, Turkish of a limited cash payment (up to 25 percent of the Bank of Agriculture, and Treasury are the main total loan) plus production inputs (e.g., seed, fertil- organizations responsible for the formulation and izer, feed, and machinery.). The ACC system was a implementation of agricultural policy in Turkey. retail network of the Turkish Bank of Agriculture The main task of MARA is to assist in the elabora- for the distribution of subsidized credit in kind to tion and implementation of agricultural policies, small farmers, with some independence from the particularly services such as research and develop- government since 1995. It was the only source of ment, quarantine and inspection, rural develop- production credit for smallholder farmers. Because ment, and small-scale irrigation works. almost all of the financial requirements were pro- MARA also carries out commercial functions vided by the Turkish Bank of Agriculture, the cost- through the Turkish Grain Board (TMO), an affili- effectiveness of the ACCs was never a concern. ated state economic enterprise. For more than six Recently, the Turkish Bank of Agriculture was com- decades, the TMO has functioned as a buffer stock mercialized (about 500 branches were closed in agency in order to stabilize the grain prices received rural areas), and the credit subsidy was eliminated. by producers and paid by consumers. The board Since then, an alternative arrangement for provid- announces the purchase prices, which are later re- ing small farmers with credit has not yet been determined based on market conditions. The TMO established. uses its stock capacity to regulate the market, so In the past, the ASCUs operated under the con- that prices in the bread and pasta industries are sta- trol of the Ministry of Industry and Trade.They were bilized, and so producers and consumers do not face authorized to set prices for members' commodities high price fluctuations (MARA 2002). Under the and to implement support purchases from produc- Agricultural Reform Implementation Project, ers on behalf of the state. They also were authorized the prices of the TMO will be increasingly linked to set up facilities such as warehouses and primary to the world price (with a margin equal to the tariff) processing and packing plants and to market com- in order to allow state procurement to function only modities in accordance with wholesale and retail as a "buyer of last resort," which is now the case in market practices. Today, within the framework of the EU. The TMO also declares a sales price for the Agricultural Reform Implementation Project grain no less than either (1) the TMO's purchase (ARIP), financial aid is granted to assist the restruc- price plus the storage cost up to the date of sale, turing and transformation of ASCUs into genuine including imputed interest charges on stocks, or (2) cooperative organizations--that is, independent, the tariff-inclusive import parity price for grain of financially autonomous, self-managed cooperatives equivalent quality as of the time the grain is sold. that sell and process members'production. Prices increase in general to take into account the Financial aid is also provided for improving pub- depreciation of the Turkish lira. This system dis- lic services to facilitate reform implementation.Reg- courages wheat buyers from letting the TMO incur ulations are in place to control water and soil pollu- all of the storage costs and then buying the grain at tion and to protect wetlands. National and regional 72 Turkey: Economic Reform and Accession to the European Union plans distribute information on ways to combat balance through a system of production quotas like desertification and reduce discharges of nutrients. that used in the EU. In the tobacco sector, the Turk- The government plays a large role in investment in ish Parliament adopted a new law restructuring the infrastructure, especially irrigation works. Directorate General for the Tobacco and Tobacco Products, Salt and Alcohol Industry (TEKEL). The Status of Implementation of the Acquis law converts TEKEL from a monopoly to a com- in Agriculture mercial enterprise that will operate under free- This section examines Turkey's status and ability to market conditions. Parliament also adopted new assume the obligations of EU membership. regulations on tobacco, tobacco products, and alco- holic beverages. The processing facilities of TEKEL Adoption of the Common Market Organizations are to be privatized. In January 2002, a tobacco law The markets policy is the most important instru- was adopted that aimed to end state-subsidized ment of the CAP. As noted earlier, it places products tobacco purchases as of 2002 and to introduce auc- or a group of products under a particular regime, tion sales, individual purchasing contracts between the Common Organization of the Market (COM), producers and buyers, and liberalization of the so that common rules govern production and trade. market. The CAP is seeking to gradually reduce institutional In this restructuring, some firms were liqui- prices toward the world market levels, while consol- dated, such as the Turkish Agricultural Supply idating direct aid as the basic support mechanism Corporation, the state firm responsible for input for European Community farming. The acquis supply. Although the achievements described are requires that the intervention agencies be capable of considerable, Turkey, according to the European carrying out tasks such as regular market and price Commission (2004), lags behind in adopting the monitoring, buying-in, public storage, and sales EU's common market organizations. and stock control in premises that meet Commu- nity standards. Furthermore, the acquis specifies Implementation of the Integrated Administra- precise rules for producer organizations, which tion and Control System of Payments Accord- must be fulfilled if such an organization is to ing to the acquis, the administrative structures benefit from Community support. Finally, the and systems needed for handling the CAP expendi- COMs require specific administrative structures for ture under the Guarantee Section of the European operation of the Community supply-management Agricultural Guarantee and Guidance Fund must instruments such as production quotas in the sugar, meet certain requirements. In particular, the pay- dairy, and starch sectors. ing agencies must be accredited and must offer During late 1990s, Turkey, with the introduction sufficient guarantees that the admissibility of of ARIP, completely reformed its prevailing output claims and compliance with European Community price support and input subsidy policies. The rules are checked before payment is authorized ASCUs were restructured, and the TMO was down- and that the payments effected are correctly and sized. The TMO will preserve the assets needed to fully recorded in accounts. To help combat fraud carry out a minimum level of purchases and stor- and ensure that the direct payments scheme is age and will liquidate the rest of its assets. effectively applied, the EU introduced the Inte- In addition, a process of privatizing the agricul- grated Administration and Control System. Farm- tural state economic enterprises has begun. The ers wishing to claim direct payments must com- sugar law adopted on April 19, 2001, opens the plete detailed IACS forms, which are designed to market to competition, reduces state interference, ensure that only eligible land is entered into the and aims to maintain stable and self-sufficient scheme and that only one claim is made on any sugar production. The state-owned sugar company individual piece of land. According to the acquis, will operate on a commercial basis, and sugar mills the IACS must have a computerized database, an will be transferred to the Privatization Agency. In alphanumeric identification system for agricultural addition, a sugar board was established. The sugar parcels, and a system for identifying and recording law aims to maintain the demand and supply animals. Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 73 Turkey realizes that direct income support is at registration system in Turkey developed under the the heart of ARIP and that registration of farmers is DIS is certainly a start on an IACS. It includes a a critical part of the DIS program. Two approaches very comprehensive audit and financial manage- have been used to build an adequate registry of ment system that is in line with the kind of control farmers in Turkey. The first approach is based on system mentioned earlier. the existing land registry records (cadastre), and By the end of 2004, all EU member states will the second is based on certificates of farmers. Land be required to use a land register and parcel identi- registry was used where it exists, but it was comple- fication control system based on GIS analysis of mented by farmer certificates. In addition, MARA digital images. Turkey could adopt this system developed a farm registry system in collaboration from the outset. Over time, GIS maps of the whole with related organizations. The database of this sys- territory of Turkey should be prepared. Such a sys- tem includes information on the number of farm- tem will derive the basic data from the cadastre ers, their demographic characteristics and assets, map of the Turkish territory, which needs to be the number and the size of land parcels, and land digitized. The cadastre data will then be superim- use. This information is more accurate than formal posed with ortho-photomaps, which will allow statistics, and to access it, all provinces and districts identification of the exact borders of cultivated are provided an online connection to the MARA agricultural land and of less favored areas. The Registration Center. The 2.6 million farmers regis- processed ortho-photomaps, along with other rele- tered hold a total of 16.4 million hectares of land, of vant cadastre data (on disadvantaged areas, pro- which 16.3 million hectares are eligible for direct tected areas, environmentally sensitive areas, and income support. The number of parcels registered so forth), will be given to an institution in charge is 15.5 million. In 2001, direct payments of about of the data processing, and the result is expected to TL 500 trillion were made, paid in two installments. be an entirely new register of land use. Because DIScontinuedin2002withapaymentof TL135mil- introduction of the IACS and establishment of an lion ($85) per hectare of land up to 50 hectares. agency to disburse direct payments and other sub- Transition payments to help farmers divert from sidies to farmers are prerequisites for the function- hazelnut and tobacco increased in 2002 to $0.2 mil- ing of the CAP, it appears that Turkey must extend lion, and transition payments were to be granted the present system in order to develop the land until 2004. In addition to the farmer registry, a register and parcel identification control system Geographic Information System (GIS) and Remote like those of the EU and establish the associated Sensing Department was established within MARA payment agency. to classify and map agricultural land, estimate production and production capacity for various Food Safety and Quality Standards Food safety products, and create a database for land use plan- issues in the EU are spread over food, veterinary, ning purposes. phytosanitary, and animal nutrition legislation. These are considerable achievements. Yet, Food legislation includes general rules for hygiene according to the European Commission (2004), and control, food labeling, food additives, food Turkey has achieved little progress in introducing packaging, and genetically modified foods. Veteri- an IACS for payments. This situation is particularly nary legislation addresses animal health, animal serious because the data required for IACS are not welfare, animal identification and registration, easily available. It requires a uniform, centralized internal market control systems, external border database that would allow payments control at the controls, and public health requirements for central level, and an integrated system of on-the- establishments in relation to animal products. spot controls needs to be developed. According to Phytosanitary legislation includes plant health EU legislation, the individual member states are (harmful organisms, pesticides), seeds and propa- obliged to control areas that have at least 5 percent gating material, and plant hygiene. Finally, animal of applicants for payments. Fifty percent of the feed legislation includes the safety of feed materials requested area must be verified--one part on-site and additives, labeling, contaminants in feed, con- and one part perhaps from aerial photography. The trols, and inspections. 74 Turkey: Economic Reform and Accession to the European Union The acquis requires that each member state have inspection. Turkey has formally adopted a number appropriate administrative structures to inspect and of typical elements of food safety regulations and control the implementation of all food legislation. control systems by adopting some of the EU rules In particular, the various hygiene control officials and regulations. In particular, Turkey has started to must be trained in inspection and in the Hazard set up the Rapid Alert System for Food and Feed, Analysis and Critical Control Point (HACCP) sys- and has revised the regulation on the Establishment tem. Food operators must implement HACCP, and and Duties of Province Control Laboratories. laboratories used in hygiene and foodstuff analysis Accreditation has been initiated for some of the must comply with the European Community sys- laboratories involved in the ring test organized by tem on accreditation, method of sampling, and the Food Analysis Performance Assessment Scheme analysis.38 In the realm of plant and animal health and Turkish Scientific and Technical Council. Fif- and nutrition, the acquis requires that appropriate teen provincial laboratories have been brought up inspection arrangements be available at the site of to EU standards. The Plant Health Regulations, origin,that nondiscriminatory checks be performed which are the Turkish equivalent of the basic during transport and at the destination point, and Council Directive 2000/29/EC, dating back to 1991, that satisfactory testing arrangements be available. were amended in 2003. HACCP control instruc- A recent white paper on food safety stated that tions have been prepared to improve food process- the commission is determined to set the highest ing. In the veterinary area, Turkey amended the standards of food safety (see European Commis- Law on Animal Health and Surveillance in 2004, sion 2000). The white paper proposes the follow- creating the legal bases for banning the administra- ing: (1) establishment of an independent European tion of certain substances to animals and imposing Food Authority with responsibility for independent sanctions in this regard. It has also upgraded the scientific advice on all aspects of food safety, opera- control performance of the veterinary service, tion of rapid alert systems, and communication of including the implementation of residue monitor- risks; (2) an improved legislative framework cover- ing plans.40 ing all aspects of food products "from farm to table"; (3) greater harmonization of national con- Trade and Border Control Implementation of the trol systems; and (4) dialogue with consumers and CAP requires the establishment of effective customs other stakeholders. According to the white paper, control for trade with third countries. Because imported foodstuffs and animal feed should meet Turkey's borders will become EU borders at the point health requirements at least equivalent to those set of accession, Turkey will have to protect its long bor- by the European Community for its own products. ders and ensure, for example, an adequate veterinary The white paper on food safety also states that it is infrastructure to manage livestock inspection and essential that the EU candidate countries imple- control disease. Thus Turkey needs to assess the cur- ment the basic principles of the treaty establishing rent conditions and to design technical specifications the European Community, pass food safety legisla- for construction of other veterinary and phytosani- tion, and put in place control systems equivalent to tary border crossings along its future EU border. those in place within the European Community. EU controls on third-country imports require Similar considerations will certainly apply to that a system of border inspection posts (BIPs) be Turkey. Because the EU will not take any risks that completed to EU standards at external borders with might lead to lower food safety standards or affect third countries. Currently, some 283 EU BIPs are EU consumers, it is of prime importance that operated by national authorities. Most of these are Turkey comply with the EU's acquis on food safety. at ports and airports; others are at road or rail links In Turkey, food legislation has been updated located, in particular, on the eastern borders of continually since 1985. The harmonization of the EU. "Good Agricultural Practices" has been completed, The accession of Turkey will extend the EU's east- and the regulation on agricultural quarantine has ern frontier with Georgia, Armenia, Iran, Iraq, and been in force, and regularly strengthened, since Syria. Veterinary checks on imports at the BIPs 1991.39 A food act was passed in 1995, according to include documentary, identity, and physical checks which all stages of food production are targeted for of the animals or animal products.After these checks Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 75 at the first border crossing into the EU, animals and One important difference between Turkey and products can in principle circulate freely in the inter- the accession countries of Central and Eastern nal market. It is therefore essential that BIP facilities Europe is that in most of the latter, agricultural andproceduresareadequatetomaintainanimaland prices were lower than those in the EU at the time public health safety. Setting up border inspection those countries began accession negotiations. In posts for veterinary and other controls in the new Turkey, the converse is true, which implies that the member states requires that buildings, equipment, prices for many major agricultural products in and staff be in place to carry out the required border Turkey will have to be reduced at some point checks. EU legislation sets out minimum standards between now and accession. As quantified in this for BIP facilities,depending on the types of products chapter, such a reduction would be of great benefit to be checked. to Turkish consumers, especially the poor. It would, however, require adjustments on the part of Turkish farmers. Under its current reform pro- Conclusion gram, ARIP, Turkey has made a good start in this Accession to the EU implies some major changes, adjustment process. The way in which it has done both in the incentive structure for agricultural pro- this--by partially compensating farmers by means duction and in the institutions of the sector. This of an incentive-neutral, WTO-compatible direct chapter modeled and quantified the probable income support system--is fully consistent with changes in the incentive structure and examined the mechanisms of the CAP. By bringing agricul- their implications for the structure of production, tural prices in Turkey more in line with world value added in primary agriculture, and welfare of prices, the reforms will begin to make Turkish agri- producers and consumers. It also investigated qual- culture more efficient. This improvement, in turn, itatively what changes will be needed in major would help Turkey to meet one of the EU's pri- institutions by comparing those existing currently mary criteria for accession countries--that its pro- in Turkey with those of the EU's Common Agricul- ducers be able to compete in the unified market tural Policy. that follows from membership. Of course, an The results of any modeling exercise should be important lesson from other reform-minded taken with a grain of salt, and that is even truer of countries is that to realize the benefits of the those in this chapter. One reason is that the CAP is a reform program in increased competitiveness, pro- moving target undergoing fundamental reforms. ducers must be supported by having the appropri- The general direction of the reform program is clear, ate infrastructure and services, as well as continued but how far it will have gone by the time of Turkey's sectoral and economy-wide reforms. accession is not. It is quite possible--some would As for institutions, Turkey has made a good start argue likely--that the price structure in the EU will in some areas, but it still has a long way to go in in another 5­10 years be very close to that prevailing others. The DIS system in Turkey lays the founda- in world markets, but this development depends on tion for a system to administer direct payments some future political decisions,and so is by no means under the CAP, and the financial management sys- certain. Clearly, however, prices will be much lower tem of the DIS should be a good basis on which to than they are at present.Because of the uncertainties, build the Integrated Administrative and Control this chapter modeled several different scenarios, but System of payments. But some improvements will all results should be interpreted as indicative of gen- clearly be needed. For example, the system will have eral orders of magnitude rather than as precise to be based on GIS analysis of digital images, numerical forecasts. If the model were run using the implying that GIS maps will have to be prepared for scenario of the recently adopted reform program all of Turkey. Food safety and quality standards will that is an extension of Agenda 2000, Turkey's have to be improved, as will veterinary border producers and consumers would face lower prices. posts. But with a good investment program and Turkish consumers would gain even more than they support from the EU and international commu- would under the Agenda 2000 scenario, and produc- nity, Turkey should find it feasible to complete ers would lose more in price supports but would the improvements in the period leading up to receive substantially higher direct payments. accession. 76 Annex TABLE 2.17 Arrangements Applicable to European Community Importation of Agricultural Products, Other than Fruits and Vegetables Originating in Turkey Ad Valorem Duty Specific Duty Tariff Rates on Imports from Turkey on Imports from Turkey Over- 1999 Applied by EU Tariff Tariff Quota Duty Turkish Exports on Imports from Ad Valorem Quota In-Quota Quota on Imports HS Description to EU (US$) Third Countries Duty (metric tons) Duty (metric tons) from Turkey 0204 Meat of sheep or goat 123,880 78.10­157.20 0 -- 0 200 020725 Frozen turkeys -- 20.85 1,000 02072510 -- ECU/t 170 02072590 -- ECU/t 186 020727 Frozen cuts of turkeys -- 27.64 02072730 -- ECU/t 134 02072740 -- ECU/t 93 02072750 -- ECU/t 339 02072760 -- ECU/t 127 02072770 -- ECU/t 230 040690 Cheese 67.76 04069029 338 0 1,500 ECU 67.19/100 kg 04069031 804,042 04069050 -- 04069086 -- 04069087 -- 04069088 -- 0811 100 08111011 Frozen strawberries 125,928 25.27 0 -- 0 08112011 Frozen raspberries -- 19.89 0 -- 0 08119019 Other fruits, frozen 1,122 18.93 0 -- 0 10020000 Rye -- 103.90 Reduction according to Article 3(4) 1107 Malt 1,538 110710 50.40 Reduction of ECU/t 6.57 11072000 29.30 Reduction of ECU/t 6.57 1509 Olive oil 15091010 -- 81.30 10% reduction 15091090 121,068,014 81.30 10% reduction 15099000 -- 69.90 5% reduction 151000 Other olive oil 15100010 -- 79.20 10% reduction 15100090 2,201,779 79.20 5% reduction 2002 Prepared tomatoes 8,000 200210 3,622,783 16.80 0 20029011 485,353 16.80 0 20029019 78,337 16.80 0 2002 Prepared tomatoes 20029031 12,924,543 16.80 0 30,000 t 20029039 4,760,473 16.80 0 20029091 5,718,862 16.80 0 20029099 256,187 16.80 0 2007 20079130 Prep. of citrus fruit, with sugar -- 32.50 0 -- 0 100 20079939 Other preparations with sugar 1,000,696 39.26 0 -- 0 100 200850 Apricot pulp 600 ex 20085092 481,445 25.39 0 ex 20085094 27,604 25.39 0 2204 Wine 220410 Sparkling wine 32,099 9.80 0 -- 220421 Other wine, 2 liters or less 4,196,588 8.70 0 -- 220429 Other 2,224,958 17.70 0 -- 220600 Other fermented beverages 2,358 8.51 0 -- ex 2007 Undenatured ethyl alcohol -- 28.00­39.26 0 -- 200900 Vinegar and substitutes -- 0 -- Note: ECU/t = European currency unit per metric ton. Source: Decision 1/98 of the EC-Turkey Association Council of February 25, 1998. 77 78 TABLE 2.18 Arrangements Applicable to European Community Importation of Fruits and Vegetables Originating in Turkey Tariff Rates Applied by EU 1999 Tariff Rates on Imports from Turkish Exports Applied by EU Turkey during Tariff to EU on Imports from Specified Quota HS (US$) Third Countries Time Period Time Periods (metric tons) ex 070190 Potatoes 805,142 13.85 January 1­March 31 0 -- 070310 Onions 444,377 11.20 ex 07031011 February 15­May 15 0 -- ex 07031019 February 15­May 15 0 -- ex 07031011 May 16­February 14 0 2,000 ex 07031019 May 16­February 14 0 2,000 070820 Beans 460,017 13.37 ex 07082020 November 1­April 30 0 -- ex 07082095 November 1­April 30 0 -- ex 07089000 July 1­April 30 0 -- 070930 Aubergines 1,546,945 14.90 ex 070930 January 15­April 30 0 -- ex 070930 May 1­January 14 0 1,000 070940 Stick celery 8,598 14.90 ex 07094000 January 1­April 30 0 -- 070990 Fresh or chilled vegetables NES 179,561 13.08 07099071 Courgettes December 1­end of February 0 -- ex 07099073 Courgettes December 1­end of February 0 -- ex 07099079 Courgettes December 1­end of February 0 -- 070990 Fresh or chilled vegetables NES 500 ex 07099073 Courgettes March 1­November 30 0 -- 07099075 Courgettes March 1­November 30 0 -- 07099077 Courgettes March 1­November 30 0 -- ex 07099079 Courgettes March 1­November 30 0 -- ex 07099090 Pumpkins and courges December 1­end of February 0 -- ex 07099090 Other wild onion February 15­May 15 0 -- 080221- 22 Fresh or dried hazelnuts 354,662,275 3.70 08022100 3 -- 08022200 3 -- 080610 Fresh table grapes 21,850,312 16.10 08061021 Nov. 15­April 30, June 18­July 31 0 -- ex 08061029 Nov. 15­April 30, June 18­July 31 0 -- 08061030 Nov. 15­April 30, June 18­July 31 0 -- ex 08061040 Nov. 15­April 30, June 18­July 31 0 -- ex 08061050 Nov. 15­April 30, June 18­July 31 0 -- 08061061 Nov. 15­April 30, June 18­July 31 0 -- 08061069 Nov. 15­April 30, June 18­July 31 0 -- 080711 Watermelon 784,893 ex 08071100 April 1­June 15 0 -- ex 08071100 June 16­March 31 0 14,000 080719 Melons 1,437,680 ex 08071900 November 1­May 31 0 -- 080940 Plums 1,278,413 ex 08094010 May 1­June 15 0 -- ex 08094020 May 1­June 15 0 -- Note: NES = not elsewhere classified. Source: Decision 1/98 of the EC-Turkey Association Council of February 25, 1998. 79 80 Turkey: Economic Reform and Accession to the European Union TABLE 2.19 Agricultural Products for Which EU Entry Price System Applies 1999 Turkish Exports to EU HS Description (US$) 07020000 Tomatoes 2,306,800 07070005 Cucumbers 1,303,757 07091000 Artichokes 9,307 07099070 Courgettes 1,417,562 08051030 Oranges 5,191,270 08051050 Oranges 174,027 08052010 Clementine 439,670 08052030 Satsumas 69,803 08052050 Mandarins -- 08052070 Tangerines -- 08052090 Citrus hybrids 8,010,676 08053010 Lemons 13,367,259 08061010 Grapes 21,834,061 08081000 Apples -- 08081050 Apples--Granny Smith 1,735 08081090 Other Apples 5,350 08082010 Pears -- 08082050 Other pears 1,520,560 08091000 Apicots 674,115 08092005 Sour cherries 189,787 08092095 Table cherries 37,176,175 08093010 Peaches -- 08093090 Other peaches 310,744 08094005 Plums 1,270,287 20096011 Fruit juices -- 20096019 Fruit juices--grapes 410,950 20096051 Fruit juices--grapes 271,163 20096059 Fruit juices--grapes 768 22043092 Wine of fresh grapes -- 22043094 Wine of fresh grapes -- 22043096 Wine of fresh grapes -- 22043098 Wine of fresh grapes 16,965 Total 95,972,791 Source: Turkish State Institute of Statistics. Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 81 TABLE 2.20 Structure of Household Expenditures (1994 prices, Turkish liras) Average Rural Urban Total expenses per household 111,044,759 66,698,941 167,764,049 Food, beverages, and tobacco per household 39,552,432 30,202,155 51,511,644 Food and nonalcoholic beverages per household 36,457,528 28,287,252 46,907,494 Expenditure shares (% of total expenditure) Cereals and pasta Rice 0.7659 1.1584 0.5663 Flour 1.6416 3.9502 0.4677 Bread 3.5371 2.6741 3.9759 Bread and bread products Pasta 0.3113 0.5020 0.2144 Other bread products 0.4088 0.7150 0.2532 Confectionary products Rolls (fancy cake) 0.2885 0.1857 0.3408 Rolls (ordinary) 0.0634 0.0730 0.0585 Rolls (durable) 0.2251 0.2840 0.1952 Meat and meat products Meat Pork Veal 1.5659 1.2013 1.7513 Beef 0.5351 0.8484 0.3758 Sheep, lamb, and goat 1.5581 2.1953 1.2341 Poultry 0.7116 0.6450 0.7454 Subproducts and edible offal 0.1471 0.1772 0.1318 Smoked products 0.2997 0.2515 0.3243 Canned meat products Fish and fish products Fresh and frozen fish 0.3588 0.3698 0.3532 Processed fish Other water animals 0.0011 0.0016 0.0008 Fish ready-to-cook and fish dishes Milk, dairy products, and eggs Milk Fresh milk 1.0733 1.2479 0.9845 Dry (powder) and condensed milk 0.8019 1.2451 0.5765 Dairy products Cheese and curd 1.9321 2.4456 1.6710 Ice cream 0.0758 0.0290 0.0996 Other dairy products 0.0205 0.0395 0.0109 Eggs 0.7103 0.8310 0.6489 Fat Vegetable fat Vegetable oil 1.6869 2.6487 1.1977 Margarine 0.7650 1.0891 0.6001 Animal fat Dairy butter 0.5337 0.9984 0.2974 Lard/fat 0.0117 0.0193 0.0078 82 Turkey: Economic Reform and Accession to the European Union TABLE 2.20 (Continued) Average Rural Urban Fruit, fresh or dried Fresh fruit Fresh fruits, temperate zones 2.2800 2.4176 2.2101 Fresh fruits, tropical zones 0.1158 0.0812 0.1333 Dried fruit and nuts 0.4174 0.4317 0.4101 Fruit, canned Frozen fruit 0.0068 0.0084 0.0060 Bottled fruit Jam, marmalade, and jelly 0.2569 0.3638 0.2026 Fruit juices, syrups, and nectars 0.0845 0.0528 0.1006 Vegetables and potatoes Fresh vegetables and mushrooms 3.0108 3.6075 2.7073 Dried vegetables 1.0826 1.7756 0.7302 Frozen vegetables 0.0587 0.0962 0.0396 Potatoes Potatoes 0.5085 0.8146 0.3529 Potato products 0.0013 0.0007 0.0017 Sugar and sugar products Sugar 1.3920 2.4582 0.8498 Sugar products--nonchocolate 0.2004 0.2435 0.1785 Chocolate products 0.1588 0.0993 0.1891 Honey 0.1953 0.2680 0.1583 Other food and nonalcoholic beverages 3.0312 3.8650 2.6072 Coffee, tea and cocoa Coffee--all sorts 0.0840 0.0541 0.0991 Tea, including dried herb and others 1.0452 1.7319 0.6961 Cocoa 0.0067 0.0058 0.0071 Other food 1.5310 1.8555 1.3659 Soft drinks Fizzy soft drinks 0.3415 0.2098 0.4085 Mineral water 0.0228 0.0078 0.0305 Alcoholic beverages Spirits 0.2095 0.1852 0.2218 Wine 0.0151 0.0121 0.0166 Beer 0.1132 0.1017 0.1190 Tobacco Cigarettes 2.4142 2.4970 2.3721 Tobacco products 0.0352 0.0749 0.0150 Source: Turkish State Institute of Statistics. Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 83 Notes 15. Ceilings have been established per member state on the basis of slaughterings and exports registered in 1995. Where the 1. The authors are grateful to Mr. Antonio Nucifora for his national ceiling is exceeded, the premiums are reduced propor- assistance and advice on the model used in this paper to quanti- tionately. tatively estimate the effects of adopting the Common Agricul- 16. In particular, member states may choose between two tural Policy of the European Union. formulas for granting additional extensification premiums on 2. EU15 refers to the 15 members of the EU prior to the 2004 suckler cows and special beef payments: (1) a simple supplement enlargement in which 10 more countries joined the EU. The of 100 per premium where the stocking intensity is less than 15 countries are Austria, Belgium, Denmark, Finland, France, 1.4 livestock units per hectare; or (2) as of 2002, 40 where the Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, stocking intensity is between 1.8 and 1.4 livestock units per Portugal, Spain, Sweden, and the United Kingdom. hectare and 80 if less than 1.4 livestock units per hectare. 3. The last agricultural census was carried out in 2001, but the 17.OvinemeatisgovernedbyRegulation(EC)No.2529/2001. results of this census are still not available. The large number of 18. More information on the reforms is available at multiparcel agricultural land holdings, the landless peasants in http://europa.eu.int/comm/agriculture/mtr/index_en.htm. some parts of eastern Turkey, and the feudal structures in eastern 19. Even decoupled payments involve some distortion as and southeasternAnatolia are three of the major problems in Turk- they are currently administered. But, according to an analysis by ish agriculture. The land fragmentation is in part a consequence of the OECD, this distortion is very small. See OECD (2001) and the inheritance provisions of the 1926 Civil Code, which is pat- Dewbre, Anton, and Thompson (2001). terned after the Swiss Civil Code. To attack the problem of landless 20. This elimination of barriers does not include food safety, peasants, the government has pursued various agrarian reforms sanitary, and phytosanitary requirements, and it is subject to since the formation of the Republic, but more work needs to be rules of origin. done.Finally,thelocallord'shegemonyineasternandsoutheastern 21. In WTO terminology, subsidies in general are identified Turkey is a peculiarity of the Turkish agricultural setting. by "boxes" given the colors of traffic lights: green (permitted), 4. All dollar amounts are U.S. dollars unless otherwise amber (slow down--that is, will be reduced), and red (forbid- indicated. den). The Uruguay Round agreement on agriculture has no red 5. A review of the tariff binding commitments of Turkey and box, although domestic support exceeding the reduction the EU under the World Trade Organization (WTO) on agricul- commitment levels in the amber box is prohibited. A blue box tural products reveals that by 2004 Turkey's tariff bindings will refers to an amber box with conditions designed to reduce dis- all be almost above the EU final bound levels under the Uruguay tortions. Subsidies that are tied to programs that limit produc- Round agreement, which will be further reduced by the ongoing tion are included in the blue box. Doha Round negotiations. Thus, under the accession process, 22. For a discussion of the modeling methodology, see Csaki Turkey will have to conform to the lower EU levels. and others (2002). 6. For the COM on cereals, see Council Regulations (EC) No. 23. The policies have been projected using the 2000 price 1251/1999 and No. 1253/1999. and cost situation, because complete data for later periods were 7. See Article 2 of Council Regulation No. 1251/1999. In the not available at the time of preparation of this chapter. Central and Eastern European (CEE) countries, the arable base 24. The exchange rates used in the study for 2000 were TL area for each accession country has been determined by taking 624,325 to the U.S. dollar and TL 575,179.98 to the euro. the average for the years 1997, 1998, and 1999. 25. Given the domestic price of commodity i, pi, and its bor- 8. In the CEE countries, aid for durum wheat applies to the der equivalent price, pi , the nominal protection rate (NPR) is durum wheat used to produce pasta. The glassiness of the vari- defined as ety grown should be higher than 73 percent. Furthermore, Pi durum wheat must have been grown for a minimum of some NPRi = - 1 100 20 years to qualify for aid. Finally, aid is contingent on the area Pi under durum wheat production constituting at least 2 percent of 26. The effective protection rate (EPR) is computed on the the total area under cereal production. basis of the ratio of value added in the production of i measured 9. For CEE countries, the reference yields have been deter- at domestic prices (VAi ) over such value added at border prices mined as the average of the median three years of the period (VAi ) and is shown by 1994/95­1998/99. The reference yields have been set at 4.26 met- VAi ric tons per hectare for Hungary, 2.96 tons per hectare for EPRi = - 1 100 Poland, and 4.16 tons per hectare for Slovakia. VAi 10. For CEE countries, the date is December 31, 2000. EPR > 0 implies direct protection of domestic producers of the 11. The regulations that apply to sunflower seed are gov- commodity; EPR < 0 implies underlying disincentives to erned by Council Regulation (EC) No. 1251/1999 amending domestic producers of the commodity; and EPR = 0 implies a Regulation No. 3405/93. neutral structure of net incentives. 12. Sugar beets are governed by Council Regulation (EC) 27. We do not consider the effects of the imposition of quo- No. 1260/2001. tas on sugar and milk production by the EU. 13. Fruits and vegetables, including grapes, are governed by 28. The assumed output supply elasticities, taken largely Regulation (EC) No. 2699/2000 amending Council Regulation from Koç, Uzunlu, and Bayaner (2001), are 0.28 for wheat, 0.21 (EC) No. 2200/1996, No. 2201/1996, and No. 2202/1996. for barley, 0.14 for maize, 0.16 for sunflower, 0.34 for sugar beet, 14. Milk and dairy products are governed by Council Regu- 0.94 for potato, 0.10 for grapes, 1.18 for milk, 0.34 for beef, 1.88 lation (EC) No. 1255/1999 on the COM for milk and dairy prod- for poultry, and 0.60 for sheep. ucts. Also applicable is Council Regulation (EC) No. 1256/1999 29. This is why these kinds of payments are classified under amending Regulation (EEC) No. 3950/1992 establishing an WTO rules as "green box"--that is, payments that minimally additional levy in the milk and milk products sector. distort trade. 84 Turkey: Economic Reform and Accession to the European Union 30. For a description of the direct payments and an estimate ensure the elimination of any harmful microbes. Fourth, estab- of their effects, see OECD (2003b). lish procedures to monitor the critical control points. Such pro- 31. In Case I, there is a negative supply response to the drop cedures might include determining how and by whom cooking in prices due to the alignment with Agenda 2000 prices (except time and temperature should be monitored. Fifth, establish the grapes, the price of which increases), and no compensating corrective actions to be taken when monitoring shows that a crit- increase in price or production from the direct payments. In ical limit has not been met--for example, reprocessing or dis- Case II, the negative effect of alignment with Agenda 2000 prices posing of food if the minimum cooking temperature is not met. is offset by the direct payments. Sixth, establish procedures to verify that the system is working 32. Note that this approach determines the equivalent varia- properly--for example, testing time and temperature recording tion in consumer income. Alternatively, one could determine the devices to verify that a cooking unit is working properly. Seventh, change in consumer surplus. establish effective recordkeeping to document the HACCP sys- 33. The assumed price elasticities of demand, taken largely tem. This documentation would include records of hazards and from Koç, Uzunlu, and Bayaner (2001), are 0.12 for bread and their control methods, the monitoring of safety requirements, pasta, 0.81 for beef, 0.7 for sheep meat, 1.23 for poultry, 0.5 for and action taken to correct potential problems. Each of these milk, 0.3 for dairy products, 0.2 for fat, and 1.09 for butter. principles must be backed by sound scientific knowledge--for 34. This assumption helps to highlight the impact of EU-like example, published microbiological studies on time and temper- agricultural policies on the state budget. ature factors for controlling food-borne pathogens. 35. Note that the EU budget must be balanced during each 39."Good Agricultural Practices" refers to applying available fiscal year. So this value of 34.46 will change from year to year by knowledge to use of the natural resource base in a sustainable the requirements of the budget during that year. way for the production of safe, healthy food and nonfood agri- 36. Structural Funds allow the EU to grant financial assis- cultural products in a humane manner, while achieving eco- tance to resolve structural economic and social objectives. nomic viability and social stability. Objective 1 of the Structural Funds is the main priority of the 40. See chapter 10 of Oskam and others (2004) for a discus- EU's cohesion policy. The EU aims to narrow the gap between sion of animal and plant health issues in Turkey. the development levels of the various regions. "Objective 1 regions" refers to areas lagging behind in their development and References in which GDP is below 75 percent of the European Community average. Objective 2 of the Structural Funds aims to revitalize all Çagatay, S., C. Saunders, and R. Amor. 2001."The Impact on the areas facing structural difficulties, whether industrial, rural, Agricultural Sector of the Potential Extension of the Cus- urban, or dependent on fisheries. Objective 3 covers the entire toms Union Agreement to Cover Agricultural Commodi- EU territory outside of areas covered by Objective 1 and serves ties." Unpublished paper, Lincoln University, New Zealand. as a reference framework for all measures to promote human Çakmak, E. H., and H. Kasnakoglu. 2001. "Tarim Sektöründe resources in the member states. It takes account of the title on Türkiye ve Avrupa Birligi Etkiles¸imi: Türkiye'nin AB'ye employment in the Treaty of Amsterdam and the new European Üyeliginin Analizi" [The Turkey­European Union Interac- strategy for employment. tion in Agricultural Sector: Analysis of Turkey's of EU Mem- 37. For alternative quantitative analyses of the effects of bership]. Working Paper, Agricultural Economics Research adopting the CAP, see Çakmak and Kasnakoglu (2001); Çagatay, Institute, Ministry of Agriculture and Rural Affairs, Ankara. Saunders, and Amor (2001); Grethe (2004); and Oskam and Csaki. C., A. Nucifora, Z. Lerman, T. Herzfeld, and G. Blaas. others (2004). Whereas Çakmak and Kasnakoglu (2001) study 2002. Food and Agriculture in the Slovak Republic: The Chal- the impact of the CAP on producers, consumers, and foreign lenges of EU Accession. Washington, DC: World Bank. trade, Çagatay, Saunders, and Amor (2001) concentrate only on Dewbre, J. H., J. Anton, and W. Thompson. 2001. "The Transfer the effects on producers and foreign trade. Both papers abstract Efficiency and Trade Effects of Direct Payments." American from consideration of the impact on the state budget. According Journal of Agricultural Economics 83: 1204­15. to Çakmak and Kasnakoglu (2001), adoption of Agenda 2000 Europarl. 2002. "European Parliament Fact Sheets." http://www. policies with direct payments equal to those currently applied in europarl.eu.int/factsheets/default_en.htm. the EU will lead to reductions in producers' welfare, which is European Commission. 2000. "White Paper on Food Safety." contrary to our results summarized in table 2.16. The compre- COM (1999) 719 final. Brussels: EC. hensive study by Oskam and others (2004) analyzes the likely --------. 2002. "Regional Policy Interim Report." http://www. consequences for Turkey's agricultural and agrifood sectors europa.eu.int/comm/regional_policy/sources/docoffc/ should it become an EU member in 2015. official/reports/pdf/interim1/report_en.pdf. 38. HACCP is a system that establishes process control --------. 2004. "2004 Regular Report on Turkey's Progress through identification of the production points most critical to Towards Accession." COM (2004) 656 final. Brussels: EC. controlling and monitoring the production process. It involves Grethe, H. 2004. "Turkey's Accession to the EU: What Will the seven principles. First, analyze hazards. Potential hazards associ- Common Agricultural Policy Cost?" Humboldt University ated with a food and measures to control those hazards are iden- Working Paper 70/2004. Berlin. tified. The hazard could be biological such as a microbe, chemi- Koç, A., V. Uzunlu, and A. Bayaner. 2001. "Türkiye'de Tarimsal cal such as a toxin, or physical such as ground glass or metal Ürün Projeksiyonlari 2000­2010" [Forecasts for Agricultural fragments. Second, identify critical control points. These are Products in Turkey for the Period 2000­2010]. Agiicultural points in a food's production--from its raw state through pro- Economics Research Institute, Ankara. cessing and shipping to consumption by the consumer--at MARA (Ministry of Agriculture and Rural Affairs). 2002. "Data which the potential hazard can be controlled or eliminated. files." Research Planning and Coordination Council, MARA, Examples are cooking, cooling, packaging, and metal detection. Ankara. Third, establish preventive measures with critical limits for each OECD (Organisation for Economic Co-operation and Develop- control point. For a cooked food, for example, this might include ment). 2001. "Market Effects of Crop Support Policies." setting the minimum cooking temperature and time required to OCED, Paris. Analysis of the Impact of EU Enlargement on the Agricultural Markets and Incomes of Turkey 85 --------. 2003a. "Agricultural Policies in OECD Countries: TMO (Turkish Grain Board). 2002. TMO files. http://www. Monitoring and Evaluation."OECD, Paris. tmo.gov.tr. --------. 2003b. "Risk Related Non-price Effects of the CAP Valdes, A. 1973. "Trade Policy and Its Effects on the External Arable Crop Regime: Results from an FADN Sample." Agricultural Trade in Chile, 1945­1965. American Journal of AGR/CA/APM(2002)14/REV1, Directorate for Food, Agri- Agricultural Economics 55: 154­64. culture, and Fisheries, February 27. World Bank. 2000. "Turkey Country Economic Memorandum: Oskam, A., A. Burrell, T. Temel, S. van Berkum, N. Lonworth, Structural Reforms for Sustainable Growth." Report No. and I. M. Vilchez. 2004. "Turkey in the European Union: 20657-TU, World Bank, Washington, DC. Consequences for Agriculture, Food, Rural Areas and Struc- tural Policy." Wageningen University, Wageningen. 3 Integration and the Manufacturing Industry Sübidey Togan, Hüsamettin Nebioglu, and Saadettin Dogan This chapter studies the effects of European Union 1996, to adopt by 2001 all of the preferential trade (EU) integration on the manufacturing sector.1 The agreements the EU has concluded over time, first section describes the main developments in and to implement on the commercial policy side Turkey's trade regime and trade performance, and measures similar to those of the European the second examines the structure of protection- Community's commercial policy. Adhering to the ism. Market access issues emphasizing contingent stipulations of the Customs Union Decision, protectionism and the issues related to technical Turkey maintained rates of protection above those barriers to trade are the subjects of the third and specified in the CCT for certain "sensitive" prod- fourth sections. The fifth section analyzes condi- ucts until 2001. In order to adopt EU's preferential tions of competition, and the final section offers trade agreements, Turkey signed FTAs with the conclusions. European Free Trade Association countries, Israel, and the Central and Eastern European (CEE) countries. FTAs are being discussed with the Main Developments in Turkey's Mediterranean countries. As for export subsidies, Trade Regime Turkey joined the Tokyo Round Agreement on In 1994 Turkey signed the agreement establishing Subsidies and Countervailing Duties of the the World Trade Organization (WTO), and a cus- General Agreement on Tariffs and Trade (GATT), toms union was created between Turkey and the agreeing to eliminate export subsidies by 1989. EU as of January 1, 1996. According to the Customs Recently, Turkey eliminated most of the export Union Decision (CUD) of 1995, all industrial incentives that were introduced during the 1970s goods, except products of the European Coal and and 1980s. Within this context, GATT legal subsi- Steel Community (ECSC), that comply with the dies such as research and development subsidies European Community norms could circulate freely and subsidies to facilitate the adaptation of plants between Turkey and the EU as of January 1, 1996. to new environmental regulations were introduced For ECSC products, Turkey signed a free trade in 1995. agreement (FTA) with the EU in July 1996, and as Basic data on Turkey's merchandise trade are a result, ECSC products have received duty-free shown in table 3.1. The table reveals that in 2003 treatment between the parties since 1999.2 Turkish merchandise exports amounted to US$47.2 The Customs Union Decision required Turkey billion and merchandise imports to $69.3 billion.3 to implement the European Community's Com- Exports to the EU15 made up 49.7 percent of total mon Customs Tariffs (CCTs) on imports of indus- exports, and imports from the EU made up trial goods from third countries as of January 1, 42.8 percent of total imports.4 The table further 87 88 TABLE 3.1 Exports and Imports, Turkey, 1990­2003 Annual Annual Total Percentage Growth Rate Exports Percentage Share of Growth Rate of Exports, Distribution, of Exports, to the EU, Distribution, Exports to EU Exports to EU, 2003 Total 1990­2003 2003 Exports of Sectoral 1990­2003 SITC Commodity (US$ millions) Exports (percent) (US$ millions) to EU Exports (percent) Agricultural products 0 + 1 + 4 + 22 Food 4,735 10.03 2.01 1,949 8.31 41.17 2.32 2 - 22 - 27 - 28 Agricultural raw materials 522 1.11 2.56 220 0.94 42.24 0.41 Mining products 27 + 28 Ores and other minerals 572 1.21 4.23 246 1.05 42.95 2.56 3 Fuels 980 2.08 7.93 211 0.90 21.53 -0.31 68 Nonferrous metals 457 0.97 8.64 222 0.94 48.45 9.03 Manufactures 67 Iron and steel 3,342 7.08 5.12 939 4.00 28.09 16.52 Chemicals 51 Organic chemicals 171 0.36 1.53 107 0.46 62.55 4.28 57 + 58 Plastics 545 1.15 9.20 112 0.48 20.50 5.40 52 Inorganic chemicals 230 0.49 5.99 80 0.34 34.68 5.38 54 Pharmaceuticals 220 0.47 10.28 72 0.31 32.64 17.99 53 + 55 + 56 + 59 Other chemicals 726 1.54 10.19 65 0.28 8.97 4.00 6 - 65 - 67 - 68 Other semimanufactures 4,143 8.77 12.52 1,645 7.01 39.70 12.21 Machinery and transport equipment 71 - 713 Power generating 246 0.52 24.80 85 0.36 34.47 22.77 machinery 72 + 73 + 74 Other nonelectrical 1,566 3.32 18.16 537 2.29 34.29 17.73 machinery 75 + 76 + 776 Office machines and 1,978 4.19 17.99 1,569 6.68 79.30 17.27 telecommunications equipment 77 - 776 - 7783 Electrical machinery 2,076 4.40 16.83 999 4.26 48.14 14.64 and apparatus 78 - 785 - 786 + Automotive products 4,928 10.44 24.42 3,139 13.38 63.70 29.30 7132 + 7783 79 + 785 + 786 + Other transport 1,542 3.27 20.70 853 3.63 55.31 23.07 7131 + 7133 + equipment 7138 + 7139 65 Textiles 5,262 11.14 10.14 2,340 9.97 44.48 7.50 84 Clothing 9,962 21.10 7.21 7,079 30.17 71.07 5.94 8 - 84 - 86 - 891 Other consumer goods 2,675 5.67 16.37 954 4.06 35.66 12.44 9 + 891 Other products 335 0.71 30.17 44 0.19 13.02 16.10 Total 47,211 100 9.01 23,466 100 49.70 8.56 Annual Annual Total Percentage Growth Rate Imports Percentage Share of Growth Rate, Imports, Distribution, of Imports, from EU, Distribution, Imports from EU Imports from EU, 2003 Total 1990­2003 2003 Imports of Sectoral 1990­2003 SITC Commodity (US$ million) Imports (percent) (US$ million) from EU Imports (percent) Agricultural products 0 + 1 + 4 + 22 Food 2,789 4.03 3.29 548 1.85 19.65 1.70 2 - 22 - 27 - 28 Agricultural raw materials 2,471 3.57 6.42 894 3.01 36.19 6.76 Mining products 27 + 28 Ores and other minerals 2,262 3.26 4.58 670 2.26 29.61 -0.05 3 Fuels 11,575 16.71 8.06 460 1.55 3.97 7.71 68 Nonferrous metals 1,411 2.04 9.55 308 1.04 21.80 4.23 Manufactures 67 Iron and steel 3,282 4.74 5.46 1,232 4.15 37.53 1.91 Chemicals 51 Organic chemicals 2,102 3.03 7.39 1,059 3.57 50.39 6.83 57 + 58 Plastics 2,837 4.09 12.80 1,645 5.54 58.00 11.57 52 Inorganic chemicals 543 0.78 2.82 178 0.60 32.78 0.99 54 Pharmaceuticals 2,302 3.32 17.09 1,546 5.21 67.14 17.05 53 + 55 + 56 + 59 Other chemicals 2,643 3.82 7.00 1,560 5.26 59.03 7.65 6 - 65 - 67 - 68 Other semimanufactures 3,489 5.04 8.27 2,245 7.56 64.33 7.66 Machinery and transport equipment 71 - 713 Power generating 758 1.09 12.52 382 1.29 50.34 12.44 machinery 72 + 73 + 74 Other nonelectrical 7,250 10.46 5.21 4,607 15.52 63.54 4.18 machinery 75 + 76 + 776 Office machines and 4,166 6.01 10.95 1,618 5.45 38.83 12.15 telecommunications equipment 77 - 776 - 7783 Electrical machinery 2,065 2.98 6.82 1,175 3.96 56.93 5.75 and apparatus 78 - 785 - 786 + Automotive products 6,209 8.96 11.67 5,150 17.35 82.95 13.91 7132 + 7783 79 + 785 + 786 + Other transport 1,012 1.46 1.80 711 2.40 70.29 4.88 7131 + 7133 + equipment 7138 + 7139 65 Textiles 3,441 4.97 13.03 1,185 3.99 34.43 13.49 84 Clothing 422 0.61 24.93 204 0.69 48.26 21.68 8 - 84 - 86 - 891 Other consumer goods 3,540 5.11 10.07 1,910 6.44 53.96 9.27 9 + 891 Other products 2,714 3.92 27.10 391 1.32 14.42 18.75 Total 69,283 100 8.27 29,678 100 42.84 8.06 89 Note: SITC = Standard International Trade Classification. Source: The authors. 90 Turkey: Economic Reform and Accession to the European Union reveals that the three export commodities with of total EU exports, and imports from Turkey were the highest shares of total exports were clothing, also 2 percent of total EU imports. The table fur- 21.1 percent; textiles, 11.1 percent; and automotive ther reveals that the three export commodities with products, 10.4 percent. The three import commodi- the highest shares of total EU exports were other ties with the highest shares of total imports were nonelectrical machinery, 12.1 percent; other con- fuels, 16.7 percent; other nonelectrical machinery, sumer goods, 10.3 percent; and automotive 10.5 percent; and automotive products, 9 percent. products, 10 percent. The three import commodi- Similarly, the three export commodities with the ties with the highest shares of total EU imports highest shares of exports to the EU were clothing, were office machines and telecommunications 30.2 percent; automotive products, 13.4 percent; equipment, 14.3 percent; fuels, 14.1 percent; and and textiles, 10 percent. The three commodities other consumer goods, 10.3 percent. During the with the highest shares of imports from the EU period 1990­2001, total EU exports grew at an were automotive products, 17.4 percent; other non- annual rate of 8.2 percent and total imports at the electrical machinery, 15.5 percent; and other semi- rate of 7.5 percent. The export commodities with manufactures, 7.6 percent. the highest growth rates were office machines During the period 1990­2003, Turkey's total and telecommunications equipment, 15.4 percent; exports grew at an annual rate of 9 percent and pharmaceuticals, 14.2 percent; and organic chemi- total imports at a rate of 8.3 percent. The export cals, 11 percent. The three import commodities commodities with the highest annual growth rates with the highest growth rates were pharmaceuticals, were other products, 30.2 percent; power generat- 12.4 percent; electrical machinery and apparatus, ing machinery, 24.8 percent; and automotive prod- 12.1 percent; and office machines and telecommu- ucts, 24.4 percent. The import commodities with nications equipment, 11.8 percent. Examination of the highest growth rates were other products, 27.1 Turkey's share of total sectoral EU exports reveals percent, clothing, 24.9 percent; and pharmaceuti- that the highest shares of exports to Turkey are held cals, 17.1 percent. Similarly, the export commodi- by ores and other minerals, 5.7 percent; plastics, ties to the EU with the highest growth rates were 5 percent; and agricultural raw materials, 4.6 per- automotive products, 29.3 percent; other transport cent. Among the sectors considered, food, clothing, equipment, 23.1 percent; and power generating and fuels have the lowest shares of exports to machinery, 22.8 percent. The imported commodi- Turkey. The three sectors with the highest shares of ties from the EU with the highest growth rates were imports from Turkey of sectoral EU imports are clothing, 21.7 percent; other products, 18.8 percent; textiles, 11.7 percent; clothing, 11.2 percent; and and pharmaceuticals, 17.1 percent. iron and steel, 6.4 percent. Among the sectors con- A look at the EU's share of total sectoral exports sidered, fuels, pharmaceuticals, and other chemi- reveals that the highest shares of exports to the EU cals have the lowest shares of imports from Turkey are held by office machines and telecommunica- of sectoral EU imports. tions equipment, 79.3 percent; clothing, 71.1 per- As noted earlier, as of January 1, 1996, Turkey cent; and automotive products, 63.7 percent. and the EU entered a customs union. Table 3.3 Among the sectors considered, other chemicals, shows the evolution of Turkish trade with the EU other products, and plastics have the lowest shares. over the period 1990­2003. The data reveal that The three sectors with the highest EU shares of sec- with the formation of the customs union, the share toral imports are automotive products, 83 percent; of imports from the EU of total imports went up other transport equipment, 70.3 percent; and phar- from 47.2 in 1995 to 53 percent in 1996, but then maceuticals, 67.1 percent. Among the sectors con- began to decrease, reaching 45.4 percent in 2003. sidered, fuels, other products, and food have the Comparison of the growth rate of Turkish imports lowest EU shares of sectoral imports. from the EU prior to formation of the customs Table 3.2 shows similar information for the EU. union with that observed after formation of the It reveals that in 2001 the EU's merchandise exports customs union shows that the average growth rate amounted to ECU (European currency unit) of imports from the EU has even declined, from 982.6 billion and merchandise imports were ECU 9.1 percent during 1990­95 to 1.5 percent during 1,028 billion. Exports to Turkey made up 2 percent 1996­2003. On the other hand, annual average TABLE 3.2 Exports and Imports, EU, 1990­2001 Total Annual Exports Share of Total Annual Imports Share of Exports, Growth Rate to Turkey, Exports to Turkey Imports, Growth Rate from Turkey Imports from 2001 of Exports, 2001 of Sectoral 2001 of Imports, 2001 Turkey in Sectoral (thousands Percentage 1990­2001 (thousands Exports, (thousands Percentage 1990­2001 (thousands Imports, SITC Commodity of ECU) Distribution (percent) of ECU) 2001 of ECU) Distribution (percent) of ECU) 2001 Agricultural products 0 + 1 + 4 + 22 Food 54,042,390 5.50 4.80 378,968 0.70 66,571,904 6.48 4.52 2,094,348 3.15 2 - 22 - 27 - 28 Agricultural raw 10,740,870 1.09 7.48 491,794 4.58 23,074,732 2.24 1.14 228,864 0.99 materials Mining products 27 + 28 Ores and other 4,860,506 0.49 5.76 275,558 5.67 17,659,307 1.72 5.50 270,064 1.53 minerals 3 Fuels 23,892,389 2.43 7.25 311,131 1.30 144,980,806 14.10 5.81 246,383 0.17 68 Nonferrous metals 11,936,772 1.21 6.99 197,170 1.65 23,351,448 2.27 6.51 239,103 1.02 Manufactures 67 Iron and steel 19,976,063 2.03 2.97 667,511 3.34 14,075,992 1.37 4.47 905,075 6.43 Chemicals 51 Organic chemicals 33,838,441 3.44 11.04 676,813 2.00 20,696,334 2.01 9.25 89,717 0.43 57 + 58 Plastics 20,724,369 2.11 7.67 1,027,062 4.96 10,758,582 1.05 4.68 114,084 1.06 52 Inorganic chemicals 5,388,087 0.55 4.72 81,981 1.52 6,264,051 0.61 7.71 128,624 2.05 54 Pharmaceuticals 43,908,279 4.47 14.16 915,569 2.09 22,620,592 2.20 12.37 42,924 0.19 53 + 55 + 56 + 59 Other chemicals 38,460,679 3.91 7.48 1,229,805 3.20 17,193,103 1.67 7.44 44,913 0.26 6 - 65 - 67 - 68 Other semimanufactures 87,731,435 8.93 8.24 1,509,193 1.72 68,710,081 6.68 5.46 1,509,363 2.20 Machinery and transport equipment 71 - 713 Power generating 34,903,182 3.55 9.54 595,281 1.71 24,777,213 2.41 11.57 92,876 0.37 machinery 72 + 73 + 74 Other nonelectrical 118,584,299 12.07 6.77 2,719,502 2.29 53,724,194 5.23 6.99 404,780 0.75 machinery 75 + 76 + 776 Office machines and 96,408,088 9.81 15.37 1,909,617 1.98 146,734,704 14.27 11.75 1,005,984 0.69 telecommunications equipment 77 - 776 - 7783 Electrical machinery 50,751,415 5.17 10.10 896,479 1.77 47,678,281 4.64 12.06 845,547 1.77 and apparatus 78 - 785 - 786 + Automotive products 97,777,703 9.95 9.16 1,920,099 1.96 50,701,618 4.93 8.21 1,892,016 3.73 7132 + 7783 91 92 TABLE 3.2 (Continued) Total Annual Exports Share of Total Annual Imports Share of Exports, Growth Rate to Turkey, Exports to Turkey Imports, Growth Rate from Turkey Imports from Turkey 2001 of Exports, 2001 of Sectoral 2001 of Imports, 2001 in Sectoral (thousands Percentage 1990­2001 (thousands Exports, (thousands Percentage 1990­2001 (thousands Imports, SITC Commodity of ECU) Distribution (percent) of ECU) 2001 of ECU) Distribution (percent) of ECU) 2001 79 + 785 + 786 + Other transport 63,162,827 6.43 10.38 972,860 1.54 56,327,638 5.48 10.78 706,280 1.25 7131 + 7133 + equipment 7138 + 7139 65 Textiles 24,739,564 2.52 6.07 978,099 3.95 19,178,029 1.87 5.02 2,242,208 11.69 84 Clothing 17,559,440 1.79 4.29 218,928 1.25 53,910,204 5.24 8.05 6,060,245 11.24 8 - 84 - 86 - 891 Other consumer 101,086,773 10.29 7.32 1,443,680 1.43 106,259,111 10.34 8.11 867,501 0.82 goods 9 + 891 Other products 22,106,890 2.25 2.54 398,968 1.80 32,781,100 3.19 2.83 124,630 0.38 Total 982,580,462 100 8.23 19,816,069 2.02 1,028,029,024 100 7.48 20,155,528 1.96 Note: SITC = Standard International Trade Classification; ECU = European currency unit. Sources: Data provided by Eurostat; the authors. TABLE 3.3 Trade with EU, 1990­2003 Growth Rate Growth Rate Growth Rate Growth Rate Total Imports from of Total of Imports Share of Imports Total Exports to of Total of Exports Share of Exports Trade Balance Real Imports EU Imports from EU from EU of Exports EU Exports to EU to EU of with EU Exchange (US$ millions) (US$ millions) (percent) (percent) Total Imports (US$ millions) (US$ millions) (percent) (percent) Total Exports (US$ millions) Rate 1990 22,302 9,898 -- -- 44.38 12,959 7,177 -- -- 55.38 -2,721 99.67 1991 21,047 9,987 -5.63 0.90 47.45 13,594 7,348 4.90 2.38 54.05 -2,639 96.66 1992 22,870 10,656 8.66 6.70 46.59 14,719 7,937 8.28 8.02 53.92 -2,719 100.94 1993 29,429 13,875 28.68 30.21 47.15 15,348 7,599 4.27 -4.26 49.51 -6,276 91.59 1994 23,270 10,915 -20.93 -21.33 46.91 18,105 8,635 17.96 13.63 47.69 -2,280 124.35 1995 35,708 16,861 53.45 54.48 47.22 21,636 11,078 19.50 28.29 51.20 -5,783 116.72 1996 43,627 23,138 22.18 37.23 53.04 23,224 11,549 7.34 4.25 49.73 -11,589 116.67 1997 48,559 24,870 11.30 7.49 51.22 26,261 12,248 13.08 6.05 46.64 -12,622 110.32 1998 45,921 24,075 -5.43 -3.20 52.43 26,974 13,498 2.72 10.21 50.04 -10,577 100.42 1999 40,687 21,417 -11.40 -11.04 52.64 26,589 14,349 -1.43 6.30 53.97 -7,068 94.30 2000 54,509 26,610 33.97 24.25 48.82 27,775 14,510 4.46 1.12 52.24 -12,100 85.17 2001 41,399 18,280 -24.05 -31.30 44.16 31,334 16,118 12.81 11.08 51.44 -2,162 106.33 2002 51,554 23,321 24.53 27.57 45.24 36,059 18,459 15.08 14.52 51.19 -4,863 96.11 2003 69,340 31,496 34.50 35.05 45.42 47,253 24,350 31.04 31.92 51.53 -7,146 88.23 Average 1990­95 8.31 9.13 46.62 9.90 7.46 51.96 Average 1996­2003 4.20 1.46 50.38 8.39 9.30 50.68 -- Not available. Note: An increase in the real exchange rate (RER) indicates depreciation of the RER. Source: State Planning Organization (http://www.dpt.gov.tr); the authors. 93 94 Turkey: Economic Reform and Accession to the European Union growth rate of Turkish exports to the EU, which 1999, the Marmara area of Turkey was hit by a was 7.5 percent prior to formation of the customs severe earthquake, which was followed by a further union, increased to 9.3 percent over the period large shock in the Bolu area in November 1999. As a 1996­2003. Similarly, the share of exports to the EU result of these shocks, real GNP shrank by 6.1 per- of total exports increased from 51.2 percent in 1995 cent in 1999. At the end of 1999, Turkey embarked to 54 percent in 1999, but thereafter the share upon a stabilization program, but a severe banking declined to 51.5 percent in 2003. Finally, table 3.3 crisis arose in November 2000. Developments in reveals as well that Turkey has run a trade deficit February 2001 led to a total loss of confidence in with the EU during every year of the period the government's stabilization program and a seri- 1996­2003 and that the deficit has been substantial ous run on the Turkish lira. With the floating of its by any standard. It reached $12.6 billion in 1997 currency, the country faced its severest economic and $7.1 billion in 2003. crisis. The loss of income and wealth and the associ- These findings reveal that the formation of the ated social and political stresses were unprecedented. customs union between Turkey and the EU did not As a result of these developments, the country saw lead initially to considerable increases in trade with substantial decreases in import demand during the EU. Substantial increases in trade with the EU 1994, 1999, and 2001. were achieved only during the period 2002­03. The Fourth, with the substantial reductions in trade reasons vary. First, the formation of the customs barriers on the Turkish side during 1996,the increase union did not lead to considerable reductions in in imports was inevitable, so long as it was not trade barriers on the EU side, because the EU had accompanied by a real devaluation of the Turkish abolished the nominal tariff rates on imports of lira. As table 3.3 reveals, there was no change in the industrial goods from Turkey on September 1, real exchange rate during 1996, and it then began to 1971, long before the formation of the customs appreciate until the currency crisis of 2001. The real union. But at that time certain exceptions were appreciation of the Turkish lira stimulated the made. The European Community had retained the import growth and hampered the growth of exports, right to charge import duties on some oil products leading to higher trade balance deficits. Also during over a fixed quota and to implement a phased the period 2001­03, the euro appreciated against the reduction of duties on imports of particular textile U.S. dollar, leading to increases in the dollar value of products. Moreover, the trade in products within EU exports, which was then reflected in the higher the province of the ECSC have been protected by dollar trade values of Turkish imports from the EU the Community through the application of nontariff and of exports to the EU. barriers and, in particular, antidumping meas- Table 3.4 shows the commodity composition of ures. With the formation of the customs union, Turkish exports to the EU and imports from the quotas applied by the EU were abolished, but the EU, as well as the shares of Turkish exports to the EU retained the right to impose antidumping EU of total EU imports and the shares of Turkish duties. imports from the EU of total EU exports over Second, not until 2003 did Turkey incorporate the period 1995­2001. The table reveals that in into its internal legal order the European Commu- absolute terms Turkey achieved large increases nity instruments related to removal of technical in exports for clothing, automotive products, tex- barriers to trade that would allow Turkish industrial tiles, other semimanufactures, office machines and products to enter into free circulation in the EU. telecommunications equipment, and iron and steel. Third, during the 1990s economic crises began For these commodities, Turkey experienced consid- to affect Turkey with increasing frequency. Periods erable increases in the shares of its exports to the of economic expansion alternated with periods of EU of total EU imports. As for Turkish imports, equally rapid decline. After a year of severe reces- again in absolute terms, large increases in imports sion in 1994 when the gross national product were observed for chemicals, office machines and (GNP) shrank by 6.1 percent, the economy went telecommunications equipment, automotive prod- through a boom period of above-trend growth ucts, and other consumer goods. For those com- between 1995 and 1997. Then, in 1998, the econ- modities, the shares of Turkish imports from the omy was badly hit by the Russian crisis. In August EU of total EU exports also increased. TABLE 3.4 Effects of Customs Union between Turkey and EU, 1995­2001 (thousands of ECU) Turkish Exports to EU SITC Commodity 1995 1996 1997 1998 1999 2000 2001 Agricultural products 0 + 1 + 4 + 22 Food 1,488,476 1,551,769 1,812,357 1,780,063 1,907,213 1,841,607 2,094,348 2 - 22 - 27 - 28 Agricultural raw 179,233 205,765 216,488 210,663 213,382 213,457 228,864 materials Mining products 27 + 28 Ores and other 221,117 212,143 237,159 239,314 243,109 322,824 270,064 minerals 3 Fuels 128,412 122,060 125,193 81,415 127,553 191,871 246,383 68 Nonferrous metals 86,544 97,097 99,635 157,722 152,601 216,471 239,103 Manufactures 67 Iron and steel 294,209 229,501 371,900 545,231 592,639 791,231 905,075 5 Chemicals 237,583 198,285 258,291 274,909 297,999 386,476 420,262 6 - 65 - 67 - 68 Other semimanufactures 572,754 638,208 776,036 879,443 979,327 1,234,435 1,509,363 Machinery and transport equipment 71 - 713 Power generating 31,551 48,097 73,328 81,867 86,265 89,163 92,876 machinery 72 + 73 + 74 Other nonelectrical 106,447 129,455 175,601 211,566 261,858 330,166 404,780 machinery 75 + 76 + 776 Office machines and 167,685 214,597 388,026 688,309 671,934 936,482 1,005,984 telecommunications equipment 77 - 776 - 7783 Electrical machinery 301,881 386,368 449,078 574,577 614,099 714,463 845,547 and apparatus 78 - 785 - 786 + Automotive products 270,766 357,760 301,337 389,917 995,122 1,212,181 1,892,016 7132 + 7783 79 + 785 + 786 + Other transport 391,498 625,377 485,647 670,554 665,531 675,812 706,280 7131 + 7133 + equipment 7138 + 7139 65 Textiles 1,013,714 1,110,291 1,440,550 1,663,269 1,774,158 2,041,595 2,242,208 84 Clothing 3,434,992 3,636,313 4,175,655 4,632,190 4,808,707 5,576,756 6,060,245 8 - 84 - 86 - 891 Other consumer goods 271,714 347,685 403,340 442,251 582,351 679,154 867,501 9 + 891 Other products 45,150 48,420 54,352 75,862 69,906 74,247 124,630 Total 9,243,725 10,159,191 11,843,971 13,599,124 15,043,754 17,528,392 20,155,528 95 96 TABLE 3.4 (Continued) Turkish Imports from EU SITC Commodity 1995 1996 1997 1998 1999 2000 2001 Agricultural products 0 + 1 + 4 + 22 Food 615,174 607,284 632,062 605,447 501,142 579,811 378,968 2 - 22 - 27 - 28 Agricultural raw 393,666 459,321 589,606 447,182 379,080 533,469 491,794 materials Mining products 27 + 28 Ores and other 487,556 528,444 462,002 269,811 152,588 261,142 275,558 minerals 3 Fuels 119,124 227,392 264,755 271,988 387,760 763,082 311,131 68 Nonferrous metals 183,778 228,589 260,355 224,136 180,355 253,115 197,170 Manufactures 67 Iron and steel 586,834 694,789 845,798 641,451 479,250 880,515 667,511 5 Chemicals 2,043,193 2,441,128 3,184,322 3,213,593 3,465,937 4,569,685 3,931,231 6 - 65 - 67 - 68 Other semimanufactures 978,841 1,339,036 1,568,580 1,567,096 1,400,645 1,912,605 1,509,193 Machinery and transport equipment 71 - 713 Power generating 178,837 252,654 393,062 555,062 442,280 545,555 595,281 machinery 72 + 73 + 74 Other nonelectrical 2,372,464 3,786,516 3,994,368 3,678,348 2,596,553 3,538,331 2,719,502 machinery 75 + 76 + 776 Office machines and 765,742 1,023,595 1,523,088 1,995,757 2,799,791 4,055,137 1,909,617 telecommunications equipment 77 - 776 - 7783 Electrical machinery 546,930 769,613 1,065,654 1,226,264 1,059,906 1,300,772 896,479 and apparatus 78 - 785 - 786 + Automotive products 1,237,308 1,909,360 3,201,332 2,866,472 2,304,918 5,568,748 1,920,099 7132 + 7783 79 + 785 + 786 + Other transport 690,618 1,214,031 968,872 941,586 946,855 1,032,438 972,860 7131 + 7133 + equipment 7138 + 7139 65 Textiles 584,726 786,038 997,564 946,855 859,326 1,063,715 978,099 84 Clothing 64,034 122,894 171,487 205,098 174,845 248,766 218,928 8 - 84 - 86 - 891 Other consumer goods 808,246 1,041,430 1,324,120 1,391,441 1,331,107 1,750,501 1,443,680 9 + 891 Other products 690,158 514,377 185,256 447,875 406,893 567,749 398,968 Total 13,347,228 17,946,494 21,632,282 21,495,462 19,869,232 29,425,136 19,816,069 Share of Imports from Turkey of EU Imports SITC Commodity 1995 1996 1997 1998 1999 2000 2001 Agricultural Products 0 + 1 + 4 + 22 Food 2.955 2.948 3.225 3.075 3.327 2.966 3.146 2 - 22 - 27 - 28 Agricultural raw materials 0.871 1.151 1.067 1.058 1.099 0.850 0.992 Mining products 27 + 28 Ores and other minerals 1.767 1.718 1.597 1.650 1.778 1.798 1.529 3 Fuels 0.198 0.155 0.147 0.132 0.163 0.129 0.170 68 Nonferrous metals 0.531 0.719 0.586 0.885 0.889 0.855 1.024 Manufactures 67 Iron and steel 2.942 2.754 4.000 4.424 5.813 5.454 6.430 5 Chemicals 0.552 0.447 0.501 0.495 0.506 0.542 0.542 6 - 65 - 67 - 68 Other semimanufactures 1.490 1.578 1.688 1.816 1.827 1.861 2.197 Machinery and transport equipment 71 - 713 Power generating machinery 0.349 0.438 0.529 0.497 0.439 0.360 0.375 72 + 73 + 74 Other nonelectrical machinery 0.371 0.413 0.500 0.529 0.605 0.618 0.753 75 + 76 + 776 Office machines and 0.245 0.290 0.440 0.681 0.584 0.581 0.686 telecommunications equipment 77 - 776 - 7783 Electrical machinery and apparatus 1.251 1.530 1.491 1.736 1.632 1.392 1.773 78 - 785 - 786 + Automotive products 1.278 1.555 1.024 1.073 2.309 2.506 3.732 7132 + 7783 79 + 785 + 786 + 7131 + Other transport equipment 1.797 2.549 1.458 1.665 1.407 1.219 1.254 7133 + 7138 + 7139 65 Textiles 7.796 8.397 9.287 10.134 11.041 10.800 11.692 84 Clothing 11.049 10.863 10.768 11.306 10.999 10.878 11.241 8 - 84 - 86 - 891 Other consumer goods 0.487 0.580 0.578 0.589 0.702 0.662 0.816 9 + 891 Other products 0.282 0.284 0.300 0.332 0.310 0.217 0.380 Total 1.695 1.749 1.761 1.914 1.929 1.696 1.961 97 98 TABLE 3.4 (Continued) Share of Exports to Turkey of EU Exports SITC Commodity 1995 1996 1997 1998 1999 2000 2001 Agricultural Products 0 + 1 + 4 + 22 Food 1.488 1.399 1.296 1.286 1.078 1.101 0.701 2 - 22 - 27 - 28 Agricultural raw materials 4.901 5.835 6.835 5.484 4.259 4.812 4.579 Mining products 27 + 28 Ores and other minerals 14.852 15.620 10.797 8.375 4.228 5.376 5.669 3 Fuels 0.893 1.469 1.544 1.941 2.337 2.564 1.302 68 Nonferrous metals 2.635 3.061 3.021 2.716 2.190 2.122 1.652 Manufsactures 67 Iron and steel 3.532 3.959 4.475 3.625 3.204 4.515 3.342 5 Chemicals 2.781 3.081 3.414 3.349 3.250 3.529 2.762 6 - 65 - 67 - 68 Other semimanufactures 1.764 2.225 2.327 2.339 1.998 2.247 1.720 Machinery and transport equipment 71 - 713 Power generating machinery 1.139 1.427 1.815 2.232 1.723 1.808 1.706 72 + 73 + 74 Other nonelectrical machinery 2.889 4.141 3.951 3.663 2.744 3.225 2.293 75 + 76 + 776 Office machines and 1.825 2.169 2.550 3.143 3.913 4.014 1.981 telecommunications equipment 77 - 776 - 7783 Electrical machinery and apparatus 1.945 2.417 2.899 3.228 2.715 2.700 1.766 78 - 785 - 786 + Automotive products 2.339 3.306 4.764 4.075 3.220 6.166 1.964 7132 + 7783 79 + 785 + 786 + 7131 + Other transport equipment 1.966 3.280 2.153 1.945 1.918 1.729 1.540 7133 + 7138 + 7139 65 Textiles 3.480 4.376 4.947 4.667 4.269 4.532 3.954 84 Clothing 0.561 0.953 1.235 1.450 1.275 1.565 1.247 8 - 84 - 86 - 891 Other consumer goods 1.354 1.611 1.781 1.865 1.701 1.833 1.428 9 + 891 Other products 6.328 3.878 1.296 2.557 1.965 2.486 1.805 Total 2.328 2.866 3.000 2.931 2.614 3.126 2.017 Note: For abbreviations, see table 3.2 Source: Data provided by Eurostat; the authors. Integration and the Manufacturing Industry 99 Structure of Protection sector j, M j total imports of sector j, and k the To study the structure of applied tariffs, we con- number of commodities in sector j ( j = 1, . . . , 68). Table 3.5 shows the nominal and effective pro- sider tariff and tariff-like charges on imports in tection rates for the 68 tradable sectors of the 1996 trade with the EU, with countries with whom the input-output table prepared by Turkey's State Insti- EU has free trade agreements, and with third coun- tute of Statistics. The table reveals that the weighted tries. In each case, we use the 12-digit Harmonized average nominal protection rate (NPR) during Commodity Description and Coding System (HS) 2002 in trade with the EU is 1.95 percent; in trade data on customs duties and the mass housing fund tax.5 Let tc denote the rate of customs duty on com- i with Romania, a representative country among the economies with which Turkey has free trade agree- modity i and tis the ad valorem equivalent of the ments, 1.76 percent; and in trade with third coun- mass housing fund tax rate. The relation between tries, 5.3 percent. By contrast, the weighted average domestic prices and foreign prices is written as pi = (1 + tc + tis ) E pi , where pi denotes the i $ effective protection rate (EPR) is 11.24 percent.6 Table 3.6 shows the frequency distribution of domestic price of commodity i, pi the foreign $ the NPRs and EPRs. Forty-eight out of 68 sectors price of commodity i, and E the nominal exchange have zero NPRs in trade with the EU and in trade rate. To calculate the ad valorem equivalent of the with the countries with which Turkey has FTAs. In mass housing duty, we let Mi denote the CIF (cost, trade with the EU, five sectors have NPRs larger insurance, freight) value of the import of commod- than 50 percent, and seven sectors have NPRs of ity i measured in Turkish liras; mi the quantity of between 10 percent and 50 percent. Similar consid- the import of commodity i measured in units (the erations apply for NPRs in trade with countries U.S. dollar­denominated housing fund tax is reported); FUNDi1 the U.S. dollar­denominated with which Turkey has FTAs. The NPRs in trade with third countries are larger than 50 percent in mass housing fund tax rate on commodity i; seven sectors, between 10 percent and 50 percent FUND2 the ad valorem housing fund tax rate on i in 10 sectors, and positive but less than 5 percent in commodity i; and E the exchange rate (Turkish lira 38 sectors. Concomitant with the relatively low per U.S. dollar). NPRs are the low EPRs. Six sectors have EPRs above The base of the customs duty is the CIF price. Therefore, this duty is calculated as tc Mi. The mass i 50percent,andsixsectorshaveEPRsbetween10per- cent and 50 percent. In 20 sectors the EPRs are neg- housing fund tax levy is usually specific. For those taxes, the ad valorem equivalents of the specific ative but larger than -100. The EPR is less than rates must be calculated. Given the foreign price of -100 in only one sector. the commodity, p$j = Mj Table 3.5 shows that NPRs in trade with the EU , the Turkish lira equiva- mj E and with countries with which Turkey has FTAs are lent of the U.S. dollar­denominated levy is calcu- lated as FUNDi1mi E = (Mi(FUNDi1/pi )). The ad $ all zero for industrial commodities and positive for agricultural and processed agricultural commodi- valorem mass housing fund tax rate is given by FUNDi2Mi. The sum total of all the above taxes and ties. For trade with third countries, the average NPRs are high for food products, 11.1 percent for surcharges is denoted by iron and steel, 10.92 percent for wearing apparel, 10.28 percent for footwear, 7.01 percent for textiles, (3.1) ti = tc + FUNDi1 pi i $+ FUNDi2 and 6.74 percent for plastics. The most protected sectors measured in terms of EPRs are the manu- Next we consider the tradable sectors in the 1996 facture of sugar; manufacture of bakery products; input-output table. The average applied tariff in processing and preserving of fruits and vegetables; sector j is then calculated as growing of fruits, nuts, beverage and spice crops; and manufacture of cocoa, chocolate, sugar confec- k tionary, and other food products. The sectors indi- (3.2) applied tariff j = tij Mij M j i=1 cating a clear-cut comparative advantage include the manufacture of textiles; casting of metals; man- where ti denotes the applied tariff rate on commod- j ufacture of fabricated metal products; manufacture ity i of sector j, Mi the import of commodity i into j of furniture; manufacture of office, accounting, 100 Turkey: Economic Reform and Accession to the European Union TABLE 3.5 Nominal and Effective Protection Rates, 2002 (percent) NPR, NPR, NPR, I-O Code Sector EU EU with FTAs Other EPR 01 Growing of cereals and other crops NEC 8.83 8.84 8.84 9.93 02 Growing of vegetables, horticultural 14.37 16.00 16.00 17.74 specialties, and nursery products 03 Growing of fruit, nuts, beverage and 74.23 70.49 78.46 82.18 spice crops 04 Farming of animals 2.33 2.29 2.74 -2.60 05 Agricultural and animal husbandry service 21.82 26.35 26.35 48.50 activities, except veterinary activities 06 Forestry, logging, and related service activities 0.22 0.28 0.28 0.08 07 Fishing 30.10 12.80 56.06 50.42 08 Mining of coal and lignite 0.00 0.00 0.00 -0.17 09 Extraction of crude petroleum and natural gas 0.00 0.00 0.00 -0.17 10 Mining of metal ores 0.00 0.00 0.77 0.05 11 Quarrying of stone, sand and clay 0.00 0.00 0.00 -0.27 12 Mining and quarrying NEC 0.00 0.00 0.02 -0.16 13 Production, processing, and preserving 1.51 1.52 1.52 -1.52 of meat and meat products 14 Processing and preserving of fish and 14.25 9.48 28.48 19.92 fish products 15 Processing and preserving of fruit, 55.54 46.79 65.09 90.68 and vegetables 16 Manufacture of vegetable and animal 13.82 9.37 14.59 18.24 oils and fats 17 Manufacture of dairy products 107.61 107.46 109.49 a 18 Manufacture of grain mill products, starches, 21.71 17.12 24.78 46.99 and starch products 19 Manufacture of prepared animal feeds 6.36 6.36 6.57 -0.08 20 Manufacture of bakery products 83.23 8.72 109.61 b 21 Manufacture of sugar 78.49 78.49 78.49 b 22 Manufacture of cocoa, chocolate, sugar 34.64 12.16 55.61 54.49 confectionery and other food products NEC 23 Manufacture of alcoholic beverages 2.73 2.90 4.03 0.86 24 Manufacture of soft drinks; production 0.11 0.01 9.03 -5.47 of mineral waters 25 Manufacture of tobacco products 2.01 17.29 17.29 11.37 26 Manufacture of textiles 0.00 0.01 7.01 -2.95 27 Manufacture of other textiles 0.00 0.00 3.02 -0.07 28 Manufacture of knitted and crocheted 0.00 0.00 10.25 3.70 fabrics and articles 29 Manufacture of wearing apparel, except 0.00 0.00 10.92 7.01 fur apparel 30 Dressing and dyeing of fur; manufacture 0.00 0.00 2.05 0.62 of articles of fur 31 Tanning and dressing of leather; manuf. of 0.00 0.00 1.17 -0.85 luggage, handbags, saddlery, and harnesses 32 Manufacture of footwear 0.00 0.00 10.28 8.87 33 Sawmilling and planing of wood 0.00 0.00 0.71 -0.41 34 Manufacture of wood and of products of 0.00 0.00 4.95 3.23 wood and cork 35 Manufacture of paper and paper products 0.00 0.00 1.49 0.18 36 Publishing 0.00 0.00 1.53 0.55 37 Printing and service activities related to 0.00 0.00 2.18 0.88 printing Integration and the Manufacturing Industry 101 TABLE 3.5 (Continued) NPR, NPR, NPR, I-O Code Sector EU EU with FTAs Other EPR 38 Manufacture of coke, refined petroleum 0.00 0.00 2.91 1.96 products 39 Manufacture of basic chemicals, plastics in 0.01 0.01 6.31 2.79 primary forms and synthetics rubber 40 Manufacture of fertilizers and nitrogen 0.00 0.00 6.49 4.00 compounds 41 Manufacture of pesticides, other 0.00 0.00 6.00 2.92 agrochemicals and paints, and varnishes 42 Manufacture of pharmaceuticals, medicinal 0.00 0.00 0.97 0.12 chemicals, and botanical products 43 Manufacture of cleaning materials, cosmetics, 0.01 0.02 4.29 1.07 and other chemicals and manmade fibers 44 Manufacture of rubber products 0.00 0.00 3.61 1.38 45 Manufacture of plastic products 0.00 0.00 6.74 3.30 46 Manufacture of glass and glass products 0.00 0.00 4.90 2.32 47 Manufacture of ceramic products 0.00 0.00 4.76 2.63 48 Manufacture of cement, lime, and 0.00 0.00 1.94 0.87 plaster-related articles of these items 49 Cutting and finishing of stone and man. of 0.00 0.00 1.21 0.40 other nonmetallic mineral products NEC 50 Manufacture of basic iron and steel 0.00 0.00 11.10 6.23 51 Manufacture of basic precious and 0.00 0.00 3.40 1.54 nonferrous metals 52 Casting of metals 0.00 0.00 0.00 -1.89 53 Manufacture of fabricated metal products, 0.00 0.00 2.29 -0.87 tanks, reservoirs, and steam generators 54 Manufacture of other fabricated metal 0.00 0.00 2.55 -0.06 products; metalworking service activities 55 Manufacture of general-purpose machinery 0.00 0.00 2.53 0.16 56 Manufacture of special-purpose machinery 0.00 0.00 1.65 -0.06 57 Manufacture of domestic appliances NEC 0.00 0.00 2.55 0.61 58 Manufacture of office, accounting, and 0.00 0.00 0.06 -0.35 computing machinery 59 Manufacture of electrical machinery and 0.00 0.00 2.77 0.58 apparatus NEC 60 Manufacture of radio, television, and 0.00 0.00 2.95 1.25 communication equipment and apparatus 61 Manufacture of medical, precision and optical 0.00 0.00 1.81 0.32 instruments, watches, and clocks 62 Manufacture of motor vehicles, trailers, 0.00 0.00 4.33 1.71 and semitrailers 63 Building and repairing of ships, pleasure 0.00 0.00 0.25 -0.22 and sporting boats 64 Manufacture of railway and tramway 0.00 0.00 1.69 0.48 locomotives and rolling stock 65 Manufacture of aircraft and spacecraft 0.00 0.00 0.00 -0.02 66 Manufacture of transport equipment NEC 0.00 0.00 4.03 1.60 67 Manufacture of furniture 0.00 0.00 1.14 -0.66 68 Manufacturing NEC 0.00 0.00 3.29 1.36 Average 1.95 1.76 5.30 11.24 Note: I-O = input-output table; NPR = nominal protection rate; FTA = free trade agreement; EPR = effective protection rate; NEC = not elsewhere classified. a. Less than -100. b. More than 100. Source: Turkish State Institute of Statistics; the authors. 102 Turkey: Economic Reform and Accession to the European Union TABLE 3.6 Frequency Distribution of Protection Rates, 2002 (percent) NPR, NPR, NPR, EU EU with FTAs Other EPR 50.00 5 3 7 6 10.01­50.00 7 7 10 6 5.01­10.00 2 5 8 4 0.01­5.00 6 5 38 31 0 48 48 5 0 -0.01­100.00 0 0 0 20 -100.00 0 0 0 1 Total 68 68 68 68 Note: For abbreviations, see table 3.5. Source: The authors. TABLE 3.7 Nominal and Effective Protection Rates, 2002 (percent) NPR, NPR, NPR, EU EU with FTAs Other EPR Commodity groups Primary commodities 18.23 18.06 20.21 25.57 Mining and energy 0.00 0.00 0.08 -0.17 Manufacturing 3.07 2.07 6.11 4.50 Trade categories Export industries 11.64 10.06 22.26 21.54 Export- and import- competing industries 0.53 0.36 5.89 1.81 Import-competing industries 3.90 3.90 5.73 3.82 Non-import-competing industries 24.62 20.12 28.72 27.03 Note: For abbreviations, see table 3.5. Source: The authors. and computing machinery; manufacture of basic Calculations presented in the upper part of precious and nonferrous metals; manufacture of table 3.7 reveal that primary commodities receive the basic iron and steel; and mining products.7 most protection, contrary to the tendency for pro- Now we move from the structure of protection at tection to escalate from the lower to higher stages of the industry level to a more aggregate level. Table 3.7 fabrication. The lower part of the table shows that presents the NPR and EPR for broad industry the most protected sectors are the export industries groups. In the upper part of this table, industries and the non-import-competing industries. have been classified into three industry groups. In the lower part, they have been divided into Contingent Protectionism four trade categories: export, export and import competing, import competing, and non-import Article 36 of the Customs Union Decision of 1995 competing.8 specifies that as long as a particular practice is Integration and the Manufacturing Industry 103 incompatible with the competition rules of the on levels. These products were cotton yarn, poly- customs union as specified in Articles 30­32 of the ester fibers and yarns, semifinished products of decision and "in the absence of such rules if such alloy steel, and asbestos cement pipes. After 1996, practice causes or threatens to cause serious preju- the EU opened new investigations involving dice to the interest of the other Party or material Turkish exports of cotton fabrics, bed linen, iron injury to its domestic industry," the European and steel products, paracetamol, color television Community or Turkey may take the appropriate receivers, and hallow sections. By contrast, at the measures. Article 42 allows antidumping actions as end of 1995 Turkey had imposed duties on three long as Turkey fails to implement effectively the commodities: benzoic acids, printing and writing competition rules of the customs union and other papers, and polyester. After 1996, Turkey opened relevant parts of the acquis communautaire. In such two new investigations involving imports of ball cases, Article 47 of the Additional Protocol signed bearings and polyvinyl chloride from the EU and in 1970 between Turkey and the European Com- imposed antidumping duties in the case of the munity remains in force. According to the article, latter. the Association Council, if it finds dumping, will Both the EU and Turkey have been active users of address recommendations to the persons with contingent protection measures, but the EU even whom such practices originate. The injured party more so. The results indicate that the formation of may take suitable measures if the Council has made the customs union does not grant protection from no decision within three months and if the dump- antidumping by the European Community. The EU ing practices continue. In the event a party needs an has continued to protect its sensitive sectors immediate action, it may introduce an interim pro- through contingent protection measures and has tection measure such as antidumping duties for a protected the sectors most where Turkish penetra- limited duration. But the Council may recommend tion measured by the share of Turkish exports of EU the abolition of those interim measures. Finally, imports was highest (see table 3.2). With Turkey's Article 61, which addresses safeguards, states that accession to the EU, the contingent protection safeguard measures specified in Article 60 of the measures will no longer be available to both parties. Additional Protocol will remain valid. According to Article 60, the Community or Turkey may take the Technical Barriers to Trade necessary protective measures if serious distur- bances occur in a sector of the economy of the Technical barriers to trade are said to exist as long Community or Turkey or if they prejudice the as the EU and Turkey impose different technical external financial stability of one or more member regulations as conditions for the entry, sale, and use states or Turkey, or if difficulties arise that adversely of commodities; as long as the two parties have dif- affect the economic situation in a region of the ferent legal regulations on health, safety, and envi- Community or Turkey. ronmental protection; and as long as the parties Table 3.8 shows the products that were subject to have different procedures for testing and certifica- definitive antidumping and antisubsidy measures tion to ensure conformity to existing regulations or by both parties at the end of 1995 and those subject standards.9 The different country requirements for to antidumping and antisubsidy investigations dur- the entry, sale, and use of commodities can be ing the period 1996­2002. The table reveals that at imposed by governments in the form of technical the end of 1995, eight products exported from regulations and by nongovernmental organizations Turkey were subject to definitive antidumping and in the form of standards. Technical regulations that antisubsidy measures by the EU. Ad valorem duties relate to either technical specifications or testing or were imposed in five cases, a duty and "undertak- certification requirements are mandatory, and the ings" were imposed in one case, and in the remain- product must comply with the specifications to ing cases undertakings were imposed. In undertak- which it is subjected. However, standards are volun- ings, the Turkish firms must commit themselves to tary, not legally binding, and arise from the desire raising the export prices in the European Commu- of producers or consumers to improve the infor- nity market to agreed-on levels or to restrict the mation in commercial transactions and to ensure quantities exported to the Community to agreed- compatibility between products. 104 TABLE 3.8 Products Subject to Antidumping Investigations, 1996­2002 Commodity OJ Reference Measure Investigations by EU Definitive antidumping and antisubsidy measures in force as of December 31, 1995 Cotton yarn L82, 27.03.1992 and L289, 24.11.1993 Duties Cotton yarn L182, 27.07.1994 Duties Polyester fibers and yarns L272, 28.09.1991 Undertakings (countervailing) Polyester yarns (man-made staple fibers) L88, 3.04.1992 Duties Polyester yarns (POY and PTY) L347, 16.12.1988 Duties Semifinished products of alloy steel L182, 2.07.1992 Duties and undertakings Synthetic textile fibers of polyester L306, 22.10.1992 Duties Asbestos cement pipes L209, 31.07.1991 Undertakings New investigations after January 1, 1996 Cotton fabrics, unbleached C50, 21.02.1996 Provisional duty imposed, but no definite measure imposed Cotton fabrics, unbleached L295, 20.11.1996 Provisional duty imposed Cotton fabrics L42, 20.02.1996 Terminated without the imposition of measures Bed linen L171, 07.05.1996 Terminated without the imposition of measures Cotton fabrics, unbleached C210, 11.07.1997 Terminated without the imposition of measures Steel wire rod C144, 22.05.1999 Terminated without the imposition of measures Steel ropes and cables C127, 05.05.2000 Duties Paracetamol C134, 13.05.2000 Terminated without the imposition of measures Colour television receivers C202, 15.07.2000 Terminated without the imposition of measures Welded tubes and pipes, of iron and nonalloy steel C183, 29.06.2001 Duties Flat rolled products of iron and nonalloy steel C364, 20.12.2001 Pending Steel ropes and cables L34, 03.02.2001 and L211, 04.08.2001 Undertakings Hallow sections C249, 16.10.2002 Pending Investigations by Turkey Definitive antidumping and antisubsidy measures in force as of December 31, 1995 Benzoic acids 14.08.1991 Duties Printing and writing papers 20.05.1992 Duties Polyester ELYAF 08.01.1993 Duties New investigations after January 1, 1996 Ball bearings 26.12.1998 Terminated without the imposition of measures Polyvinyl chloride 02.11.2001 Duties Note: OJ = Official Journal of the EU. Sources: Undersecretariat of Foreign Trade and various issues of the reports of the Commission on Anti-Dumping and Anti-Subsidy Activities. Integration and the Manufacturing Industry 105 Technical barriers have two aspects: (1) the con- Court of Justice, as set out in the 1979 Cassis de tent of the norms (regulations and standards), and Dijon judgment. In this ruling, the court stated that (2) the testing procedures needed to demonstrate Germany could prohibit imports of a French bever- that a product complies with the norm. The techni- age (cassis de Dijon) only if it could invoke manda- cal barriers to trade (TBTs) thus come in two basic tory requirements such as public health, protection forms, content-of-norm TBTs and testing TBTs. In of the environment, and fairness of commercial either case, the costs of the product design adapta- transactions. In other words, the court introduced a tions, reorganization of production systems, and very wide definition of Article 28 (ex 30) of the multiple testing and certification needed by Treaty of Rome, which prohibits quantitative exporters can be high. These costs are both up- restrictions on imports between member states and front and onetime--for example, learning about "all measures having equivalent results." As a result the regulation and bringing the product into of this ruling, the European Commission stated conformity--and ongoing, such as periodic testing. that a product lawfully produced and marketed in TBTs are said to distort trade when they raise the one member state shall be admitted to other mem- costs of foreign firms relative to those of domestic ber states for sale, except in cases of mandatory firms. As emphasized by Baldwin (2001), liberaliza- requirements (the Mutual Recognition Principle). tion requires closing the gap between the costs of Thus, the basic EU approach under the MRP has the foreign and domestic firms. The two main been to promote the idea that products manufac- dimensions to such a step are content of norms and tured and tested in accordance with a partner conformity assessment. Liberalization of the con- country's regulations could offer levels of protec- tent of norms involves making product norms tion equivalent to those provided by corresponding more cosmopolitan and thus narrowing the cost domestic rules and procedures. Mutual recogni- advantage of domestic firms. Liberalization of the tion, in other words, reflects the existence of ex ante second involves lowering the excess costs that for- trust between the trading partners. eign firms face in demonstrating the compliance of The European Commission (1998) divides the their goods to accepted norms. The European traded products into regulated and nonregulated Commission (1998) has pointed out that the commodities. The regulated products are those removal of technical barriers to trade will lead to whose commercialization is governed by the regu- four types of benefits: (1) economies of scale; lations of member states, and the nonregulated (2) rationalization of products or production, products are those for which no regulations have increased efficiency, and price reductions as a result an impact on commercialization. The regulated of increased competition; (3) restructuring of products are further divided into commodities industry (e.g., plant closures, mergers, reorganiza- under the harmonized sphere and those under the tion, relocation) to gain comparative advantage; nonharmonized sphere. Products under the har- and (4) innovation, stimulated by the dynamics of monized sphere are covered by European rules for the single market. the harmonization of regulations and mandatory specifications. Commodities under the nonhar- monized sphere are governed by national rules. The EU Approach to Technical Barriers to Trade The MRP is considered the first line of defense The basic objective of the EU policy and against technical barriers in the regulated nonhar- approaches to removing technical barriers to trade monized sphere. is to achieve free trade within the European Com- The principal examples of success of the MRP munity. Currently, this policy has two approaches: are those regulations that are new and have been enforcement of the Mutual Recognition Principle notified to the European Community under the (MRP) and harmonization of technical regulations. 83/189 procedures, but then they have been negoti- ated away or had specific mutual recognition Mutual Recognition Principle Mutual recogni- clauses inserted into the regulations.10 Any problem tion refers to the principles enshrined in the Treaty in implementation of the MRP is harder to identify, Establishing the European Economic Community because it relies on complaints from firms or trade (Treaty of Rome), interpreted by the European associations. 106 Turkey: Economic Reform and Accession to the European Union In its relations with third countries, the European health, consumer protection, environmental, or Community has advocated the use of mutual recog- other regulations at whatever level it deems neces- nition agreements (MRAs) in many regional or sary, as long as they comply with international bilateral forums. These agreements are based on the obligations. These obligations require that each mutual acceptance of test reports, certificates, and side have full confidence that the certification marks of conformity issued by conformity assess- process on the other side can wholly satisfy its ment bodies of one of the parties to the agreement, requirements. in conformity with the legislation of the other party. Such agreements were signed with Australia,Canada, Harmonization of National Regulations and Israel, Japan, New Zealand, Switzerland, and the Standards The EU legislation on harmonizing United States. The European Community also nego- technical specifications has followed two distinct tiated protocols to the Europe Agreements on Con- approaches, the old approach and the new formity Assessment and Acceptance of Industrial approach. The old approach was based on the idea Products (PECAs) with some of the then-candidate that the EU would become a unified economic area countries. PECAs represent recognition of the functioning like a single national economy. It dealt progress made in adopting and implementing the with the content-of-standards issue using negoti- relevant Community legislation on industrial prod- ated harmonization, and it sought adoption of a ucts and in creating the necessary administrative single standard that laid out in detail technical reg- infrastructure. The agreements cover a wide range ulations for single products or groups of products. of sectors, from medical devices to pressure vessels The regulations were implemented by the directives and electrical equipment. of the European Council, and the designated bodies In 1992 the European Economic Area (EEA) in EU nations performed the conformity assess- Agreement was signed between the European Free ments. Technical regulations were harmonized Trade Association (EFTA) countries and the EU. In using the old approach for products such as chemi- extending the EU Single Market to the EFTA coun- cals, motor vehicles, pharmaceuticals, and food- tries, the EU felt that ongoing and effective surveil- stuffs. Under this approach, the Council issued lance and enforcement were essential. Accordingly, directives such as Directive 70/220/EEC on the har- the EFTA Court of Justice and the EFTA Surveil- monization of the member states' laws related to the lance Authority were established in 1992. Through measures to be taken against air pollution caused by the EEA Agreement, the EFTA countries Iceland, gases from positive-ignition engines of motor vehi- Lichtenstein, and Norway participate fully in the cles. The directive detailed EU specifications apply- EU internal market and thus in the establishment ing to the related products and their testing require- of common product requirements and methods of ments. Under the old approach, European standards conformity assessment. Outside the areas covered institutions such as CEN (Comité Européen de by EEA legislation related to product requirements, Normalisation) and CENELEC (Comité Européen EEA states are permitted to introduce national de Normalisation Electrotechnique) were not man- product requirements, if it can be proved that such dated to draw up supplementary technical specifica- requirements are needed to meet public health, tions. But over time, the need was recognized to environmental, safety, and other social considera- reduce the intervention of the public authorities tions. To ensure transparency, the EEA states are prior to a product being placed on the market. So required to notify the EFTA Surveillance Authority the "new approach" was adopted and applied to and the European Commission of all draft national products that have "similar characteristics" and that technical rules for products. Finally, the EEA Agree- have been subject to a widespread divergence of ment forces the EFTA countries to accept future technical regulations in EU countries. European Council directives on the Single Market Under the new approach, only"essential require- without formal participation into the formation of ments"are indicated. This approach gives manufac- these new laws. turers greater freedom on how they satisfy those In summary, MRAs seek to facilitate trade while requirements by dispensing with the "old" type of safeguarding the health, safety, and environmental exhaustively detailed directives. Directives under objectives of each party. Each party is free to set its the new approach provide for more flexibility by Integration and the Manufacturing Industry 107 using the support of the established standardiza- manufactured in conformity with the requirements tion bodies--CEN, CENELEC, and the national of the directive, but also that the manufacturer has standards bodies. The standardization work is eas- followed all the prescribed procedures for conform- ier to update and involves greater participation ity assessment. It ensures free access to all of the EU. from industry. Meanwhile, the manufacturer or its local represen- Under the new approach, the European Coun- tative is required to keep all necessary technical cil issues a directive that lays down "essential documentation as proof for the relevant authorities requirements"--the 1989 machinery directive is that the requirements have been satisfied.11 one example. So far, 23 directives have been The final stage of implementation of the new adopted on the basis of this approach. Examples of approach system consists of market surveillance product sectors regulated in accordance with the procedures that develop a common approach to new approach are toys, machines, construction enforcement. Market surveillance consists of the products, medical equipment, telecommunications control that the relevant authorities in the member terminal equipment, and recreational craft. Once a states are required to carry out to ensure that the new approach directive has been issued, member criteria for CE marking have been satisfied--after states must conform their national laws and regula- the products have been placed on the market. The tions to it. The European Commission is empow- control is intended to prevent misuse of the CE ered to determine whether the national measures marking, to protect consumers, and to secure a are equivalent to the essential requirements. The level playing field for producers. Basically, market Council refers the task of formulating detailed surveillance is carried out in the form of random standards meeting the essential requirements to inspections to ensure that the technical documen- CEN, CENELEC, and the European Telecommuni- tation as required by the directive is available, but it cations Standards Institute. also may include examination of the documenta- tion or the product itself. Conformity Assessment and Market Surveillance To ensure that products meet the requirements laid Coverage of EC Technical Regulations Table 3.9 down in the new approach directives, special provides crude estimates of the sectoral value conformity assessment procedures have been estab- added covered under the old approach and the new lished. They describe the controls to which prod- approach. A large proportion of European Com- ucts must be subjected before they are considered munity value added in manufacturing has been compatible with the essential requirements and covered by the Community's technical regulations thus placed on the internal market. The extent of policy: 33 percent by the old approach directives the controls a product must undergo varies accord- and 42 percent by the new approach directives, ing to the risk attached to use of the product. with each approach dominating different sectors. Requirements may range from a declaration by the Finally, columns four and five show the share that manufacturer stating that certain standards have each sector holds in intra-EC trade and world been applied, to extensive testing and certification trade. The table reveals that sectors dominated by by independent, third-party conformity assessment the old approach represent 29 percent of EC value bodies (notified bodies). In 1993 Council Decision added, 26 percent of intra-EC trade, and 17 percent 93/465/EEC was adopted in connection with the of EC imports from the rest of the world. Sectors new approach directives. It provides an overview of dominated by the new approach represent 33 per- all the conformity assessment procedures available cent of EC value added, 43.5 percent of intra-EC under the directives, divided up into modules and trade, and 56 percent of EC imports from the rest grouped by category of risk. of the world. For products regulated by the new approach directives, a CE (Conformité Européne) marking Turkish Policies and Approaches confirms conformity with the essential require- ments of the directives and is required for a product With the formation of the EU-Turkey customs to be placed on the internal market. The CE mark- union, Turkey has removed all customs duties and ing indicates not only that the product has been equivalent charges as well as quantitative restrictions 108 Turkey: Economic Reform and Accession to the European Union TABLE 3.9 EC Technical Regulation Directives and European Community (EC) Imports, 1995 Coverage of EC Technical Regulations (percent of Import Structure sectoral value added) (percent) Old New Intra-EC ISIC Manufacturing Sector Approach Approach Total Imports World 200 Mining 96 0 96 0.4 2.4 311­312 Agribusiness 100 0 100 5.8 3.8 313 Beverages and sugar 63 37 100 3.2 1.1 321 Textiles 0 59 59 3.6 4.2 322 Clothing 0 77 77 2.3 5.6 323 Leather goods 0 0 0 0.4 1.0 331 Wood and wood products 0 100 100 1.9 2.2 341 Paper and paper products 63 0 63 4.7 2.5 351­352 Chemicals 22 76 98 14.7 9.2 353 Petroleum refineris 100 0 100 1.5 1.6 354 Petroleum and coal products 0 100 100 0.8 8.5 355 Rubber and rubber products 54 0 54 3.7 2.1 361 Pottery, china, etc. 0 79 79 0.3 0.6 369 Nonmetallic products 11 55 66 1.9 1.0 371 Iron and steel 0 24 24 6.9 7.1 381 Metal products 0 43 43 3.1 2.2 382 Machinery 0 93 93 14.0 16.5 383 Electrical and electronic goods 18 82 100 10.0 13.5 384 Transport equipment 74 19 93 15.6 8.3 Other manufactured goods 0 62 62 5.3 6.7 All sectors 33 42 75 100.0 100.0 Note: Coverage of EC technical regulation is measured in percentage value added. ISIC = International Standard Industrial Classification. Source: Messerlin 2001. on industrial products.12 Thus industrial products meantime, the number of instruments that Turkey move freely between the EU and Turkey--with the has to incorporate into its legal order has increased exception of contingent protection measures and to 560, and Turkey has incorporated 276 of them. technical legislation. According to Decision 1/95 of Thus, progress has been rather slow. the EC-Turkey Association Council establishing the Turkey also must establish the so-called quality customs union, Turkey must harmonize its techni- infrastructure, a generic term encompassing the cal legislation with that of the EU. Decision 2/97 of operators and operation of standardization, testing, the Association Council listed the areas in which certification, inspection, accreditation, and metrol- Turkey must align its legislation. This work should ogy (industrial, scientific, and legal). In the EU, have been finalized before the end of 2000, but, national quality infrastructures that function unfortunately, it was not completed until the begin- according to the same principles and obey the same ning of 2005. According to Annex II of Decision rules are a critical element of the free circulation of 2/97, Turkey was supposed to incorporate into its goods in the Single Market. Turkey, as a member of internal legal order 324 instruments that corre- a customs union with the EU and as a candidate spond to various European Economic Community country, has to align its national quality infrastruc- or European Community regulations and directives. ture to the European one. Products manufactured Currently, Turkey has incorporated into its legal in a future EU member state must satisfy the same order only 203 of these 324 instruments. In the requirements prevailing in the EU, and conformity Integration and the Manufacturing Industry 109 to these requirements must be demonstrated in the prepared to select notified bodies, they made same "harmonized" way and according to the same accreditation one of the criteria for their selection principles. by signing protocols with the Turkish National Recently, Turkey has taken major steps to align Accreditation Body, TURKAK.15 However the fact with the acquis. Law 4703 on the Preparation and that TURKAK has been a member of European Implementation of Technical Legislation on Prod- Accreditation Agency since 2003 and yet has not ucts, which entered into force in January 2002, has signedanymultilateralagreementwiththeEuropean been supplemented by secondary legislation. This partners makes its accreditation non-functional. framework law provides the legal basis for harmo- Thus, even though TURKAK has given accreditation nization with the EC legislation. It defines the prin- to potential notified bodies, this accreditation is ciples for product safety and for implementation of meaningless in the eyes of national accreditation the old and new approach directives, including the bodies of the EU. conditions for placing products on the market; the Because of this the market is also reluctant to obligations of the producers and distributors, con- use TURKAK, because TURKAK accreditation is formity assessment bodies, and notified bodies; not accepted within the EU. This situation presents market surveillance and inspection; withdrawal of Turkish conformity assessment bodies with a dis- products from the market; and notification proce- advantage. The relatively large Turkish firms wish- dures.13 The legislation on market surveillance, use ing to obtain CE marking for products exported to and affixing of the CE conformity mark, working the EU market usually contact local subsidiaries of principles and procedures for the conformity European notified bodies that use their European assessment bodies and notified bodies, and notifi- laboratories for testing. But for other Turkish com- cation procedures between Turkey and the EU for panies this process seems to be expensive and slow. technical regulations and standards which apply to The small and medium-size enterprises (SMEs) non-harmonized regulated area entered into force that export products find it particularly difficult to during 2002.14 Furthermore, Turkey has adopted all pay the high costs. In Turkey, marking and certifi- of the 23 new approach directives that require affix- cation parallel to the EU system are implemented ing the CE conformity marking, and 18 of the only in the automotive sector, which is subject to directives entered into force up to the present time. the old approach directives. Istanbul Technical Uni- They cover commodities and product groups such versity (ITU) does automotive testing under the as low-voltage equipment, toys, simple pressure authorization of the Ministry of Industry and vessels, construction products, electromagnetic Trade, and it performs acoustic, emissions, and compatibility, gas appliances, personal protective other tests. The Turkish Standards Institute (TSE),16 equipment, machinery, medical devices, nonauto- Tofa¸s-Fiat, and Ford-Otosan also have engine and matic weighing instruments, telecommunications emissions test facilities; Seger has an audible warn- terminal equipment, hot water boilers, civil explo- ing devices laboratory; Tam-Test is implementing sives, lifts, and recreational crafts. testing and certification in the case of agricultural Overall, then, Turkey has advanced the harmo- tractors; Fren Teknik has test facilities for brakes nization of its technical legislation both on a sec- and Brisa has a pneumatic tires laboratory. Turkey toral (vertical) basis and at a horizontal level. It is in is implementing all relevant automotive EC direc- the process of establishing the necessary structures tives via these facilities.17 Crash tests, electromag- on conformity assessment and market surveillance. netic compatibility (EMC), and other tests on com- By now Turkey has the legal basis on which accred- plete cars are largely conducted abroad; as of May itation could be based. In order to assign the noti- 2003 the National Metrology Institute (UME) was fied bodies that would deal with the certification of able to run the EMC tests on vehicles.18 products, the ministries have established the crite- Other than for the automotive sector, as of 2005 ria for the selection of such bodies for the prod- Turkey is suffering from a lack of certification bod- ucts covered by certain new approach directives. ies (see European Committee for Standardization Although in Europe, as in Turkey, accreditation is 2003). To make its conformity assessment compati- not mandatory to be appointed as a notified body, ble with that in the EU, Turkey has opened up the since the Turkish Ministries did not feel adequately certification, testing, and calibration market to 110 Turkey: Economic Reform and Accession to the European Union other Turkish actors. However, Turkish firms are these the TSE occupies a monopoly position, and reluctant to enter the market for conformity assess- for 500 of them TSE certification is mandatory. For ment bodies as long as uncertainties prevail regard- these mandatory standards, manufacturers mostly ing the acceptance of notified bodies by the Euro- need first a TSE certificate and then a Ministry of pean Commission. Some of the Turkish firms in Industry and Trade license to put the products on cooperation with the notified bodies in the EU have the market. entered the Turkish market. Over time competition The system in use in Europe, for those areas will ensure lower costs for conformity assessment. under the new approach directives, is in-market The expense, time, and unpredictability incurred in control. Under this system, the responsibility for obtaining approvals can then be reduced by having placing a product on the market is left to the pro- products evaluated in Turkey once the Turkish ducer, so long as it is certified that the product sat- notified bodies are accepted by the European Com- isfies the minimum requirements set under the mission and joint ventures with notified bodies in directives. Market surveillance, the safeguard of the the EU increase. These savings can be particularly system, is the responsibility of public authorities. important where rejection of products in the EU The market surveillance authorities carry out their can create delays and necessitate additional ship- operations in an impartial and nondiscriminatory ping or other costs. In addition, the SMEs can ben- way. They shall have the power, competence, and efit from procedures in which all testing and certifi- resources to regularly visit commercial, industrial, cation steps are carried out locally at lower costs. and storage facilities; to regularly visit, if appropri- Turkish firms, and in particular the SMEs, can then ate, workplaces and other premises where products be expected to increase their competitiveness in the are put into service' to organize random and spot EU market checks; to take samples of products and subject Although, in principle, standards are voluntary them to examination and testing, and to require all in Turkey, in the absence of a proper market sur- necessary information. Through this system, meas- veillance system the technical ministries and the ures are taken in the EU to ensure that products Undersecretariat of Foreign Trade have turned the meet the requirements of the applicable directives, standardization regime and licensing before pro- that action is taken to bring noncompliant prod- duction into a mandatory regime in order to pro- ucts into compliance, and that sanctions are tect the market and the consumers. This pre- applied when necessary. Member states are free to market control system gives the TSE a great deal choose the type of sanction they are going to use. power. According to the European Committee for The only requirement is that the penalties be effec- Standardization (2003), the TSE has misused its tive, proportionate, and dissuasive. power in several cases of imports and has created technical barriers to trade. The TSE asked for the Technical Barriers and Trade between technical files of the imported products when they the EU and Turkey entered the Turkish market, and the processing of the files took an usually long time. There are also To determine those sectors and products in which cases in which products bearing the CE marking technical regulations are important for Turkish were asked for further inspection. Yet the Turkish exporters, we used data produced by a study under- internal market is regulated largely through taken by the European Commission (1998). This mandatory standards and marking issued by the study provides information, at the three-digit level TSE.Since2004productscoveredbydirectivesontoy of the NACE (Nomenclature Générale des Activités safety, medical devices, active implantible medical Économiques dans les Communautés Européennes) devices, low voltage electrical equipment, electro- classification, about whether trade is affected by magnetic compatibility and machinery are not sub- technical regulations and the dominant approach ject to mandatory controls when imported and used by the European Commission to remove used in the internal market. But products covered such barriers in the EU.19 It classifies the technical by the remaining 12 new approach directives are regulations as follows: those in which barriers are subject to mandatory controls. overcome using mutual recognition, old approach, In Turkey, 500 standards are mandatory for the new approach, and those in which there are no domestic market as well as for imports. For all of technical barriers. Integration and the Manufacturing Industry 111 TABLE 3.10 Trade Coverage of Technical Regulations and of Different Approaches to Their Removal, 1990­2001 (percent) Subject to Technical No Technical Old Approach Mutual Recognition New Approach Barriers Barriers Manufacturing Imports of EU 1990 24.507 28.463 29.869 82.838 17.162 1991 23.662 29.839 29.187 82.689 17.311 1992 23.550 29.692 29.165 82.407 17.593 1993 21.970 30.615 28.662 81.248 18.752 1994 21.925 29.543 30.041 81.508 18.492 1995 19.078 30.497 31.459 81.034 18.966 1996 18.593 31.266 31.331 81.189 18.811 1997 18.700 32.269 30.435 81.404 18.596 1998 18.795 32.990 30.632 82.418 17.582 1999 18.663 33.245 30.627 82.535 17.465 2000 17.407 31.318 33.835 82.560 17.440 2001 18.108 31.602 32.538 82.248 17.752 Manufacturing Exports of Turkey to EU 1990 8.815 63.561 14.911 87.287 12.713 1991 9.436 66.096 10.349 85.881 14.119 1992 8.735 66.411 10.694 85.840 14.160 1993 7.334 68.648 9.470 85.452 14.548 1994 9.048 64.839 10.607 84.494 15.506 1995 10.029 61.501 12.685 84.215 15.785 1996 10.143 61.589 12.267 83.998 16.002 1997 10.096 58.503 13.465 82.064 17.936 1998 12.474 56.552 13.042 82.069 17.931 1999 16.432 52.961 13.545 82.939 17.061 2000 17.634 50.762 14.332 82.728 17.272 2001 20.707 47.358 14.887 82.951 17.049 Note: The variables show the percentages of different approaches to the removal of technical barriers to trade in total manufacturing imports for the EU and in Turkish manufacturing exports to the EU. Source: The authors. Table 3.10 shows the overall trade coverage of The table demonstrates that a very high propor- technical regulations and of the different tion of EU manufacturing imports and of Turkish approaches to their removal in the EU and to their manufacturing exports to the EU are subject to application to Turkish exports to the EU. Here we technical barriers. The average value of the propor- aggregated, following the approach of Breton, tion over the period 1990­2001 is 82.0 percent for Sheehy, and Vancauteren (2001), the value of man- the EU and 84.2 percent for Turkey. In the EU, ufacturing imports across the four-digit Standard sectors subject to old approach directives make up Identification Trade Classification (SITC) cate- on average 20.4 percent; mutual recognition and gories, which are subject to old approach directives, new approach directives, 31 percent each; and sec- new approach directives, mutual recognition, and a tors subject to no technical barriers, 18.0 percent. residual.20 We then identified the proportion of total For Turkish exports to the EU, the average values of imports value in sectors subject to old approach the shares are 11.7 percent for old approach prod- directives, new approach directives, mutual recogni- ucts; 60.0 percent, mutual recognition; 12.5 per- tion, and a residual. cent, new approach products; and 15.8 percent, 112 Turkey: Economic Reform and Accession to the European Union sectors subject to no technical barriers. Sectors with also to be quite an efficient producer of goods from no significant technical barriers to trade include the sectors under mutual recognition as well as nonferrous metals, footwear, and sawing and pro- from the new approach sectors. Thus if trade cessing of wood. Old approach products include between Turkey and the EU is constrained by tech- mainly motor vehicles and parts, and new approach nical barriers to trade, then with the accession of products include sectors specified earlier, such as Turkey, competition in the EU for these products machinery. may intensify. Developments in the proportions of sectors sub- This analysis reveals that, for Turkey, sectors ject to technical barriers over the period 1990­2001 subject to technical regulations in the EU account reveal that the proportion of manufacturing for considerable shares of Turkish exports to the imports subject to technical barriers has been rela- EU. The calculations demonstrate that accession tively stable in the EU and that for Turkish exports will affect the exports of Turkish old and new to the EU declined from 87.3 percent in 1990 to approach products to the EU, and that Turkey has a 82.9 percent in 2001. In the EU, the proportion of comparative advantage in sectors subject to new sectors subject to mutual recognition and new approach directives. Therefore, it is of utmost approach directives has increased slightly over importance that Turkey establish the quality infra- time, and the proportion of sectors subject to old structure needed, encompassing the operators and approach directives has correspondingly declined. operation of standardization, testing, certification, As for Turkish exports to the EU, the proportion of inspection, accreditation, and metrology. The sectors subject to the new approach has been rela- Turkish quality infrastructure has to function tively constant. As the share of sectors subject to according to EU principles and obey the same rules the old approach has increased, a corresponding as in the EU. Only then will Turkey be able to par- decline appears in the share of sectors subject to ticipate in the free circulation of goods in the mutual recognition. enlarged Single Market. We now turn to consideration of the index val- ues of revealed comparative advantage (RCA) Conditions of Competition defined as (Xi/X) Over the past few decades, Turkey has used inten- (3.3) RCAi = ln (Mi /MEU) EU sively three tools of industrial policy: investment incentives, export incentives, and a policy of state- where Xi denotes Turkish exports of commodity i to owned enterprises.In using these measures,the gov- the EU, X the total value of Turkish manufacturing ernment has tried to obtain a preferred allocation of exports to EU, Mi EUthe total EU imports of com- resources. The purpose of the investment incentive modity i, and MEU the total value of EU imports. scheme has been to increase investment and over- Equation 3.3 considers the share of commodity i come the barriers imposed by capital market imper- exports to the EU of total Turkish exports to the EU fections to entry into industry. But investment relative to the share of commodity i imports by the incentives in Turkey have also been a barrier to com- EU to total EU imports. If this ratio is greater than petition. Through the incentive system, established 1, the natural logarithm of the variable will be posi- firms have obtained cost advantages that have tive. In that case, the country is said to have a com- helped them to consolidate their market position. parative advantage in producing that product, and Entrants, competing with scarce fiscal resources, the higher the value, the more competitive the have been at a disadvantage relative to well- product. Using the index of revealed comparative informed incumbents. The credit incentives, which advantage, it is possible to determine in which were supposed to promote entry, have often turned product categories Turkey has the greatest compar- into instruments that have reinforced the position ative advantage. Table 3.11 shows the nine sectors of large incumbents. Furthermore, the government, with the highest RCA values by the different EU with its large share of the banking system, has also approaches to technical barriers to trade. The table directly controlled the allocation of credit, and reveals that the highest RCA values are attained in credit from public banks has often been extended the sectors with no technical barriers. Turkey seems on the basis of political considerations. Overall, TABLE 3.11 Sectors with Highest RCA Values in Each Category Turkish Exports to EU, RCA, 1999­2001 Average SITC 1999­2001 (thousands of ECU) Old approach 7831 Public transport-type passenger motor vehicles 3.2198 181,834 5238 Other metallic salts, peroxysalts of inorganic, acids 2.9270 65,203 7611 Television receivers, color, whether or not combined 2.2189 725,383 5323 Synthetic inorganic tanning matter; preparations 1.4908 895 5237 Percarbonates; commercial ammonium carbonate 1.3940 26,140 7139 Parts, NES, for the engines of 7132, 7133 and 7138 1.1439 217,582 5234 Polysulphides, dithionites, sulphites, sulphates 0.8834 5,148 5233 Hypochlorites; chlorites; chlorates; bromates; iodates 0.8047 1,190 8986 Magnetic tapes, recorded 0.7545 4,692 Mutual recognition 6534 Fabrics, woven, 85% synthetic staple fibers, mixed 3.1060 101,494 8462 Panty hose, socks, and other hosiery, knitted 2.5733 285,684 or crocheted 6542 Fabrics, woven, 85% wool or fine animal hair 2.4675 29,022 8454 T-shirts, singlets and other vests, knitted 2.4476 984,273 or crocheted 6529 Other woven fabrics of cotton 2.4372 4,265 8442 Suits, ensem., dresses, skirts, trousers, knitted, 2.3862 349,327 women 6513 Cotton yarn, other than sewing thread 2.3166 235,351 6524 Other woven fabrics > 85% cotton, 2.2850 85,496 weight 200 g/m2 6536 Fabrics, woven, 85% artificial staple fiber 2.2635 21,646 (excluding pile) New approach 7753 Dishwashing machines of the household type 3.4565 11,569 6624 Nonrefractory ceramic bricks and similar products 2.7997 117,996 6762 Rods (excluding 6761), iron, steel, hot-rolled, 2.6528 188,512 hot-drawn 6761 Bar and rods, hot-rolled, irregular wound coils, 2.4310 114,585 iron, steel 6612 Hydraulic cements, whether or not colored, clinkers 2.4192 160,431 8121 Boilers (excluding 711), radiators, etc., not electrical 2.2241 83,012 6794 Other tubes, pipes, and hollow profiles of iron, steel 2.1659 132,205 7752 Household-type refrigerators and food freezers 2.0630 152,836 6652 Glassware for domestic use 1.8532 105,440 (excluding 66511, 66592, 66593) No technical barriers 7753 Dishwashing machines of the household type 3.4565 11,569 6581 Sacks and bags of textile materials, for packing goods 2.8222 109,778 6579 Special products of textile materials 2.5383 39,282 6564 Tulles and other net fabrics; lace, in the piece 2.5145 10,051 8122 Ceramic sinks and similar sanitary fixtures 2.3625 58,256 6584 Bed, table, toilet, and kitchen linen 2.3485 471,456 6112 Composition leather, basis of leather, slabs, sheets 2.0423 1,380 6931 Stranded wire, ropes, slings, and the like, of metal 1.9921 44,441 6252 Other knitted or crocheted fabrics, noncoated, etc. 1.7149 70,236 Note: RCA = revealed comparative advantage; SITC = Standard International Trade Classification; NEC = not elsewhere classified. Source: The authors. 113 114 Turkey: Economic Reform and Accession to the European Union established firms benefit from the investment incen- icy is not fully integrated into the general policy tive schemes such as investment allowances, but new framework for regulation. Turkey's competition entrants do not, because to benefit from devices law has no rule equivalent to Article 86 of the such as investment allowances, they must show pos- Treaty Establishing the European Community to itive profits in their income statements first. govern the permissible operations of monopolies In Turkey, the investment incentive scheme has providing public services. Nevertheless, special been used while no specific competition legislation rules limit competition in some sectors such as the or competition policy has been enforced in the financial sector, tobacco industry, mineral prod- country. To promote competition within the coun- ucts, agriculture, and postal services. In addition, try, Turkey eliminated quantitative restrictions in Turkey has to control its anticompetitive state aid foreign trade during the 1980s and substantially policy.21 decreased the levels of nominal and effective pro- It could be said, then, that Turkey has achieved tection rates. With the formation of the customs considerable progress in the fields of investment union with the EU, all of the tariff barriers on and export incentives, but it has not achieved simi- imports of industrial commodities from the EU lar progress in dealing with public enterprises. were completely eliminated, as noted earlier. Although privatization has become a prominent On the export side, over the 1980s Turkey used part of the Turkish structural adjustment program, various export incentive measures. But in 1985 it since 1983 privatization has not gained momentum. agreed to eliminate export subsidies by 1989. After Table 3.12 presents basic data on Turkey's man- 1989, Turkey eliminated most of the export incen- ufacturing sector for 2000. The data are taken from tives, introduced GATT legal subsidies, and two surveys, "Annual Manufacturing Industry reduced substantially the nominal and effective Statistics" and "Small Manufacturing Industry Sta- export subsidy rates. The reduction in the nominal tistics," published by the State Institute of Statistics. and effective protection and subsidy rates was not The first survey covers all firms in the public sector sufficient, however, to ensure proper functioning of and private firms employing 10 or more employees. markets in Turkey. During the 1950s, a similar situ- The second survey covers all private firms employ- ation in Europe had led to the adoption of compe- ing less than 10 employees. The table reveals that tition policies aimed at ensuring effective competi- the sectors with the highest shares of total value tion, allocating resources efficiently, and creating added of the manufacturing sector were petroleum the best possible climate for fostering innovation and coal, 12.49 percent; textiles, 12.29 percent; food and technical progress. processing, 11.45 percent; and chemicals, 9.71 per- In June 1989, Turkey adopted the law titled cent. The sectors with the highest shares of total On the Prevention of Unfair Competition in manufacturing employment were textiles,18.56 per- Importation, containing both antidumping and cent; food processing,15.41 percent;wearing apparel antisubsidy provisions. Turkey adopted its compe- and footwear, 9.62 percent; and metal products, tition policy during December 1994 with the Law 7.98 percent. The sixth column of the table gives on the Protection of Competition. The key provi- the share of 1998 public sector value added of the sions of the competition law are based on the EU's total value added of the corresponding manufac- competition law: agreements, decisions, and con- turing subsector. From the table, it follows that the certed practices in constraint of competition; abuse average share of public sector value added of the of dominant position; and mergers and acquisi- total manufacturing industry value added was tions. The statute contains not only rules on forbid- 18.91 percent. Petroleum and coal had the highest den practices and provisions against the abuse of share with 89.83 percent, followed by the tobacco a dominant market position, but also regulations industry with 78.25 percent, and the beverages on acquisitions and mergers. The Competition industry with 50.58 percent. Authority responsible for the implementation and The seventh and eighth columns of table 3.12 enforcement of the prohibitions set out in the law indicate exposure to international trade. Column opened its doors in October 1997. As indicated by seven provides a measure of competitiveness on the OECD (2002) competition policy, institutions in domestic market measured by the rate of import Turkey are in place and active, but competition pol- penetration. If Q, X, and M stand, respectively, for TABLE 3.12 Characteristics of Turkish Manufacturing Industries, 2000 Rate of Share of Share of Public Sector Share of Public Exposure Value Sector of Sector of Value Sector of Import Export to International Added Total Manuf. Total Manuf. Added Total Sectoral Penetration Ratio Competition (US$ millions) Value Added Employment Employment (US$ millions) Value Added (percent) (percent) (percent) ISIC Sector (1) (2) (3) (4) (5) (6) (7) (8) (9) 311 + 312 Food processing 4,687.9 11.45 255,437 15.41 609.8 13.01 7.47 9.44 16.20 313 Beverages 908.2 2.22 11,194 0.68 459.4 50.58 0.77 1.98 2.74 314 Tobacco 1,063.8 2.60 18,951 1.14 832.4 78.25 1.97 5.28 7.15 321 Textiles 5,030.6 12.29 307,689 18.56 56.0 1.11 17.31 39.88 50.29 322 + 324 Wearing apparel and footwear 1,533.9 3.75 159,561 9.62 19.1 1.25 30.70 86.35 90.54 323 Fur and leather products 110.8 0.27 10,358 0.62 0.0 0.00 50.93 38.19 69.67 331 Wood and cork products 526.7 1.29 67,688 4.08 0.0 0.01 12.03 3.99 15.54 332 Furniture and fixtures 449.2 1.10 72,072 4.35 0.0 0.01 53.63 44.26 74.16 34 Paper and products 1,314.5 3.21 56,459 3.41 111.5 8.48 27.49 5.30 31.33 351 + 352 Chemicals 3,977.7 9.71 59,537 3.59 287.9 7.24 49.13 13.66 56.08 353 + 354 Petroleum and coal 5,112.4 12.49 9,882 0.60 4,592.3 89.83 17.08 2.34 19.02 355 + 356 Rubber and plastic products 1,574.5 3.85 60,577 3.65 4.3 0.27 9.01 8.90 17.11 36 Nonmetallic minerals 2,712.5 6.62 92,160 5.56 23.1 0.85 9.01 20.84 27.98 37 Basic metals 2,216.0 5.41 65,729 3.96 454.8 20.52 40.04 27.04 56.25 381 Metal products 1,946.2 4.75 132,276 7.98 50.2 2.58 15.95 11.20 25.36 382 Machinery 1,822.5 4.45 100,594 6.07 96.5 5.29 63.39 18.98 70.34 383 Electrical machinery 2,218.8 5.42 68,616 4.14 44.4 2.00 62.00 38.25 76.53 384 Transport equipment 3,218.6 7.86 84,358 5.09 82.0 2.55 48.87 25.22 61.76 385 Professional and sci. measuring equip. 251.1 0.61 11,327 0.68 12.0 4.80 69.28 11.23 72.73 39 Other manufacturing industries 271.9 0.66 13,647 0.82 5.9 2.16 56.67 61.23 83.20 3 Manufacturing 40,947.8 100.00 1,658,112 100.00 7,741.6 18.91 33.10 21.78 47.67 Note: ISIC = International Standard Industrial Classification. Source: Annual manufacturing industry statistics and small manufacturing industry statistics provided by Turkish State Institute of Statistics. 115 116 Turkey: Economic Reform and Accession to the European Union sectoral output, exports, and imports, the domestic FIGURE 3.1 Average Value of Markups for demand D will be equal to D = Q ­ X + M, and Manufacturing, 1980­2000 the rate of import penetration will equal 600 [M 100/D]. A low level of penetration does not Turkey necessarily mean that there are barriers to entry. Belgium 500 The table reveals that the professional and scientific measuring equipment sector had the highest 400 import penetration with 69.28 percent, followed by the machinery sector with 63.39 percent and elec- 300 trical machinery with 62.00 percent. Column eight 200 of table 3.12 gives the export ratio, defined as [X 100/Q]. From the table, it follows that the 100 wearing apparel and footwear sector had the highest export ratio at 86.35 percent, followed by 0 other manufacturing industries at 61.23 percent, furniture and fixtures at 44.26 percent, and textiles 1975 1980 1985 1990 1995 2000 2005 at 39.88 percent. Finally, column nine gives the rate of exposure to international competition, defined (ISIC 353 + 354); other manufacturing (ISIC 39); as [(export ratio) + [1 ­ (export ratio/100)] import and wood and products of wood (ISIC 331). The penetration]. The construction of this indicator lowest average markups in Turkey relative to those rests on the idea that the exported share of produc- in Belgium, [(1 + )/(1 + )], are found in the tion is 100 percent exposed and that the share sold sectors paper and paper products (ISIC 341); on the domestic market is exposed in the same pro- leather, leather products, and footwear (ISIC 323 + portion as the penetration of the market. The table 324); and nonferrous metals (ISIC 372). Figure 3.1 reveals that the wearing apparel and footwear sec- plots the average value of the markup for the man- tor had the highest exposure to international com- ufacturing industry over the period 1980­2000. On petition with an index value of 90.54 percent, fol- the other hand, defining the markup as lowed by the other manufacturing industries sector (output - labor cost - material cost) with an index value of 83.20 percent and the elec- (3.5) = (labor cost + material cost) trical machinery sector with an index value of 76.53 percent. we note from the last two columns of table 3.13 that Defining the markup by the relation the markups in Turkey exceed those in Belgium except in the sectors electrical and optical equip- (value added - labor cost) (3.4) = ment (ISIC 383 + 385); iron and steel (ISIC 371); labor cost and publishing, printing, and reproduction of we note from the first two columns of table 3.13 recorded media (ISIC 342). The average markup in that the markup calculated for three-digit Interna- Turkey relative to that in Belgium, [(1 + )/ tional Standard Industrial Classification (ISIC) sec- (1 + )], is now highest in the sectors tobacco tors in Turkey are much higher than the markup in products (ISIC 314); other nonmetallic mineral Belgium, a small open economy considered to be products (ISIC 36); and coke, refined petroleum the benchmark country in the analysis. The data in products, and nuclear fuel (ISIC 353 + 354). The this table were obtained from the "Annual Manu- results are striking. They indicate the lack of com- facturing Industry Statistics" of the State Institute petition in the Turkish manufacturing sector. of Statistics for the period 1999­2000 for the Turk- To further illustrate the arguments about the ish economy, and from the OECD STAN Database conditions of competition in the Turkish manufac- for Belgium for the period 1997­99. The table turing sector, we consider in table 3.14 the four-firm shows that the markups in all other sectors in concentration ratios. The table reveals that the con- Turkey exceed those in Belgium, and that the aver- centration ratios are relatively high and that the age markup in Turkey relative to that in Belgium, most concentrated sectors are the manufacture of [(1 + )/(1 + )], is highest in the sectors coke, coke coal and briquettes (ISIC 3542), manufacture refined petroleum products, and nuclear fuel of sporting and athletic goods (ISIC 3903), Integration and the Manufacturing Industry 117 TABLE 3.13 Average Markups, Turkey and Belgium (percent) Markup I Markup II Turkey, Belgium, Turkey, Belgium, ISIC Commodity 1999­2000 1997­1999 1999­2000 1997­1999 31 Food and beverages and tobacco 311 + 312 + 313 Food products and beverages 347.52 80.03 46.49 29.66 314 Tobacco products 362.79 100.54 74.76 19.78 32 Textiles, apparel, and leather 321 Textiles 268.62 53.29 52.69 37.66 322 Wearing apparel, dressing, 252.56 45.01 45.73 26.52 and dyeing of fur 323 + 324 Leather, leather products, 211.08 55.45 49.84 47.96 and footwear 33 Wood products 331 Wood and products of 427.71 51.09 59.09 39.72 wood and cork 332 Furniture; manufacturing NEC 381.65 45.59 66.02 43.22 34 Paper, paper products 341 Paper and paper products 215.81 71.33 57.24 47.09 342 Publishing, printing, and 312.06 60.19 54.77 61.46 reproduction of recorded media 35 Chemical products 353 + 354 Coke, refined petroleum 1,628.89 174.81 52.48 14.53 products, and nuclear fuel 351 + 352 - 3522 Chemicals, excluding 384.18 80.80 67.88 43.63 pharmaceuticals 3522 Pharmaceuticals 404.26 115.64 107.81 76.67 355 + 356 Rubber and plastics products 312.54 66.59 66.74 42.76 36 Nonmetallic minerals 36 Other nonmetallic 387.83 60.35 109.65 56.55 mineral products 37 Basic metals 371 Iron and steel 202.95 37.78 34.65 38.63 372 Nonferrous metals 196.86 44.10 30.97 19.69 38 Fabricated metal 381 Fabricated metal products, 290.62 42.38 74.69 49.58 except machinery and equipment 382 Machinery and equipment NEC 239.35 50.04 62.49 54.58 383 + 385 Electrical and optical equipment 274.18 39.49 55.84 59.07 384 Transport equipment 274.78 36.18 47.63 24.37 39 Other manufacturing 39 Manufacturing NEC 479.38 51.03 49.40 37.72 Note: ISIC = International Standard Industrial Classification; NEC = not elsewhere classified. Sources: OECD STAN Database and annual manufacturing industry statistics provided by the Turkish State Institute of Statistics. manufacture of aircraft (ISIC 3845), manufacture of In summary, with the formation of the EU- watches and clocks (ISIC 3853), tire and tube indus- Turkey customs union Turkish industries became tries (ISIC 3551), and petroleum refineries (ISIC subject to greater competition. But markups and 3530). The most competitive sectors are manufac- concentration ratios are still high compared with ture of wearing apparel (ISIC 3222); spinning, those in benchmark countries such as Belgium.22 weaving, and finishing textiles (ISIC 3211); manu- It seems that Turkey has to complete the harmo- facture of plastic products (ISIC 3560); and knitting nization of technical regulations, privatize its mills (ISIC 3213). public enterprises, liberalize entry and exit into 118 Turkey: Economic Reform and Accession to the European Union TABLE 3.14 Concentration of Domestic Activity, 1997­2000 (four-firm concentration ratios) ISIC Rev 2 Commodity 1997 1998 1999 2000 3111 Slaughtering, preparing, and preserving meat 34.15 29.64 32.45 31.13 3112 Manufacture of dairy products 51.54 50.25 51.55 49.57 3113 Canning and preserving of fruits and vegetables 19.08 17.34 16.16 18.90 3114 Canning, preserving, and processing of 91.72 89.85 81.40 84.98 fish and crustacea 3115 Manufacture of vegetable and animal oils and fats 46.66 42.28 43.25 43.92 3116 Grain mill products 17.01 17.97 25.46 24.30 3117 Manufacture of bakery products 29.52 30.37 31.30 34.81 3118 Sugar factories and refineries 39.14 33.43 35.94 31.62 3119 Manufacture of cocoa, chocolate and sugar 58.61 49.26 51.03 53.03 confectionery 3121 Manufacture of food products NEC 25.47 28.75 21.88 24.94 3122 Manufacture of prepared animal feeds 22.66 26.41 27.40 28.95 3131 Distilling, rectifying, and blending spirits 60.97 66.08 71.99 74.50 3132 Wine industries 74.24 74.21 80.89 75.16 3133 Malt liquors and malt 74.56 80.12 69.04 76.49 3134 Soft drinks and carbonated waters industries 63.17 64.82 60.90 66.06 3140 Tobacco manufactures 54.81 58.92 57.64 70.82 3211 Spinning, weaving, and finishing textiles 9.90 7.68 9.44 11.08 3212 Manufacture of madeup textile goods, 21.74 22.99 24.71 25.32 except wearing apparel 3213 Knitting mills 14.93 12.20 22.89 13.95 3214 Manufacture of carpets and rugs 43.34 41.66 43.84 39.65 3215 Cordage, rope, and twine industries 82.12 88.77 70.69 95.91 3219 Manufacture of textiles NEC 67.88 65.07 66.28 65.04 3221 Manufacture of fur and leather products 23.98 23.95 22.03 24.89 3222 Manufacture of wearing apparel, except 12.03 7.45 8.79 9.21 fur and leather 3231 Tanneries and leather finishing 21.42 30.47 19.40 19.42 3233 Manufacture of products of leather and 58.23 68.77 57.75 61.04 leather substitutes 3240 Manufacture of footwear, except vulc. or 34.04 32.18 38.43 28.27 molded rubber 3311 Sawmills, planing, and other wood mills 37.98 34.23 38.27 35.16 3312 Manufacture of wooden and cane containers 61.99 47.05 64.11 51.02 and small cane ware 3319 Manufacture of wood and cork products NEC 67.83 60.53 63.29 60.22 3320 Manufacture of furniture and fixtures, except 45.99 44.06 44.37 49.66 primarily of metal 3411 Manufacture of pulp, paper, and paperboard 55.42 42.42 39.29 38.82 3412 Manufacture of containers and boxes of paper 24.46 25.52 27.95 26.09 and paperboard 3419 Manufacture of pulp, paper, and paperboard articles 45.79 41.45 56.87 47.00 3421 Printing, publishing, and allied industries 63.28 40.42 50.08 45.55 3511 Manufacture of basic industrial chemicals, 47.00 53.20 54.64 67.81 except fertilizers 3512 Manufacture of fertilizers and pesticides 56.58 54.43 55.28 54.65 3513 Manufacture of synthetic resins, plastic materials 92.64 88.30 90.34 86.91 3521 Manufacture of paints, varnishes, and laquers 49.15 45.49 39.82 38.84 3522 Manufacture of drugs and medicines 31.28 31.59 29.74 33.37 3523 Manufacture of soap and cleaning preparations, 62.17 66.35 71.32 63.36 perfumes 3529 Manufacture of chemical products NEC 37.67 44.02 44.98 43.68 3530 Petroleum refineries 97.81 97.86 97.51 97.39 Integration and the Manufacturing Industry 119 TABLE 3.14 (Continued) ISIC Rev 2 Commodity 1997 1998 1999 2000 3541 Manufacture of asphalt paving and 88.54 73.54 72.19 92.33 roofing materials 3542 Manufacture of coke coal and briquettes 100.00 100.00 100.00 100.00 3543 Compounded and blended lubricating 87.51 85.54 79.22 88.25 oils and grease 3544 Liquid petroleum gas tubing 88.96 84.60 87.49 84.17 3551 Tire and tube industries 97.88 98.03 98.24 99.08 3559 Manufacture of rubber products NEC 28.85 22.80 25.84 23.66 3560 Manufacture of plastic products NEC 18.01 16.38 16.48 14.41 3610 Manufacture of pottery, china, and earthenware 74.71 58.05 60.97 69.81 3620 Manufacture of glass and glass products 43.64 40.68 42.21 39.51 3691 Manufacture of structural clay products 47.09 43.91 41.59 42.78 3692 Manufacture of cement, lime, and plaster 31.23 29.52 33.68 34.95 3699 Manufacture of nonmetallic mineral products 27.70 26.82 25.89 20.08 3710 Iron and steel basic industries 32.29 31.76 36.69 32.91 3720 Nonferrous metal basic industries 40.27 42.40 44.92 49.06 3811 Manufacture of cutlery, hand tools, and 28.72 33.58 20.19 24.52 general hardware 3812 Manufacture of furniture and fixtures, primarily 49.40 43.18 45.58 40.87 of metal 3813 Manufacture of structural metal products 23.59 24.04 24.80 24.41 3819 Manufacture of fabricated metal products 26.31 25.96 27.67 23.85 3821 Manufacture of engines and turbines 92.31 88.68 86.78 92.53 3822 Manufacture of agricultural machinery 81.46 81.59 79.93 80.73 and equipment 3823 Manufacture of metal and wood working machinery 46.89 45.84 37.63 35.70 3824 Manufacture of special industrial machinery 26.99 26.61 21.65 21.16 and equipment 3825 Manufacture of office, computing, and accounting 75.13 86.06 82.19 90.88 machinery 3829 Machinery and equipment, except electrical 51.73 49.54 54.52 48.10 3831 Manufacture of electrical industrial machinery 58.63 56.01 57.51 53.22 and apparatus 3832 Manufacture of radio, television, and communication 75.40 69.75 64.74 62.37 equipment 3833 Manufacture of electrical appliances and housewares 48.54 51.99 51.95 45.45 3839 Manufacture of electrical apparatus and supplies 27.08 24.94 29.73 26.14 3841 Ship building and repairing 50.28 46.01 48.48 52.18 3842 Manufacture of railroad equipment 98.04 98.78 96.62 94.21 3843 Manufacture of motor vehicles 40.81 40.60 46.44 47.32 3844 Manufacture of motorcycles and bicycles 78.79 77.45 80.31 76.12 3845 Manufacture of aircraft 100.00 100.00 100.00 99.78 3849 Manufacture of transport equipment NEC 94.08 95.81 94.22 100.00 3851 Controlling equipment NEC 34.87 43.34 36.34 55.93 3852 Manufacture of photographic and optical goods 62.06 76.78 81.98 84.30 3853 Manufacture of watches and clocks 100.00 100.00 100.00 98.73 3854 Other 79.65 81.46 65.87 65.64 3901 Manufacture of jewelery and related articles 48.80 46.02 47.12 53.39 3902 Manufacture of musical instruments 100.00 100.00 -- -- 3903 Manufacture of sporting and athletic goods 100.00 100.00 100.00 100.00 3909 Manufacturing industries NEC 31.38 32.74 39.74 45.58 -- Not available. Note: For abbreviations, see table 3.13. Source: Turkish State Institute of Statistics. 120 Turkey: Economic Reform and Accession to the European Union various sectors of the economy, and impose hard implement the whole body of EU legislation--that budget constraints on all public and private enter- is, the acquis communautaire, and in particular the prises. Further integration with the EU will then rules on competition, intellectual, industrial, and remove the distortions in the price system, which, commercial property rights, and the whole body of in turn, will boost the allocative efficiency in the technical legislation on a sectoral as well as a hori- economy. zontal level. Conclusion Notes Although customs duties and equivalent charges, as 1. The authors wish to thank their discussant, Bernard well as quantitative restrictions on industrial prod- Hoekman, and anonymous referees for helpful comments. Ibrahim Yilmaz and Harun Çelik provided excellent research ucts, were eliminated with the formation of the support. customs union in 1996 between Turkey and the EU, 2. For a discussion of the trade regime during the 1980s, see the free movement of industrial products between Togan (1994). the parties could not be established until 2003. The 3. All dollar amounts are U.S. dollars unless otherwise indicated. two remaining issues are contingent protectionism 4. EU15 refers to the 15 members of the EU prior to the 2004 and technical barriers to trade. Article 44 of the enlargement in which 10 more countries joined the EU. The Customs Union Decision allows the EU to impose 15 countries are Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, antidumping measures until Turkey implements Portugal, Spain, Sweden, and the United Kingdom. effectively the competition rules and the rules on 5. The mass housing fund tax is a specific tariff imposed the intellectual, industrial, and commercial prop- mainly on agricultural commodities. 6. The average rates of nominal protection were derived by erty rights of the customs union. Similar considera- weighting nominal rates estimated as applied rates for the sec- tions apply for Turkey. Since 1996, both parties tors by sectoral outputs valued at world prices. The average rates have been active users of these measures. of effective protection were obtained by weighting effective rates On another front, under Decision 2/97 of the estimated for the sectors by sectoral value addeds evaluated at world market prices. Association Council, Turkey had to incorporate 7. These are the sectors with negative EPRs and with values into its internal legal order, before the end of 2000, greater than -100. 324 instruments corresponding to various Euro- 8. The classification of the sectors into four trade groups fol- lows the same rule adopted by Balassa and others (1982). The pean Economic Community and European Com- export category includes sectors whose exports amount to more munity regulations and directives on technical leg- than 10 percent of domestic production and whose imports islation. But the work has still not been completed. account for less than 10 percent of domestic consumption. For sectors classified as export and import competing, both of these In addition, Turkey has to align its national quality shares exceed 10 percent. The import-competing and non- infrastructure to the European one. Products man- import-competing categories include sectors whose exports ufactured in Turkey must satisfy the same require- amount to less than 10 percent of domestic production. In sec- ments as those prevailing in the EU, and the tors in the import-competing category, imports exceed 10 per- cent of domestic consumption. In sectors in the non-import- demonstration of conformity to these require- competing category, imports are less than 10 percent of ments must be done in the same "harmonized" way domestic consumption. and according to the same principles as in the EU. 9. The authors are grateful to Ela Yazici Inan for her contri- butions to this section. On technical barriers to trade, see Sykes Recently, Turkey has taken major steps to align its (1995). legislation with the acquis. But it still has to estab- 10. Directive 83/189/EEC, amended by Directive 98/34/EC, lish the operators and operation of standardization, established the requirements that member states notify draft regulations and that national standards bodies notify work on testing, certification, inspection, accreditation, and new standards. metrology according to the same principles and 11. Consider the machinery directive that applies to all obeying the same rules as in the EU. Once these machinery and to safety components. The directive defines a problems are solved, competition will increase in machine as "an assembly of linked parts or components, at least one of which moves." Annex I of the directive gives a compre- the economy, leading to decreases in markups and hensive list of the hazards that may arise from the design and concentration ratios, provided it is complemented operation of machinery, and gives general instructions on what with privatization and adoption of appropriate hazards must be avoided. The directive requires the machine manufacturer to produce a "technical file" of documentary evi- competition policies. Thus, to benefit from free dence that the machinery complies with the directive, the form trade between the parties, Turkey has to adopt and and content of which is dictated in the directive. Machinery Integration and the Manufacturing Industry 121 meeting the requirements of the directive is required to have the Scientific and Technical Research Council (TUBITAK) the CE symbol clearly affixed to indicate compliance. An item of power to accredit are still in force. equipment may only display the CE mark when the equipment 16. The TSE was established in 1954 to draw up standards for satisfies all relevant directives--for example, machines with all kinds of products and services. electrical controls must also comply with the requirements of 17. For automotive products, the "e" sign confirms the low voltage and electromagnetic compatibility (EMC) direc- conformity. tives. For most items of machinery, the manufacturer (or its 18. UME is organized as part of TUBITAK. UME has cali- authorized representative) can self-certify--that is, it designs its bration laboratories in mechanics, physics, electricity, ionizing products to meet the requirements of the directive and signs a radiation, and chemicals. The laboratories under construction Declaration of Conformity. This declaration of conformity must include EMC, acoustics, and liquid flow. be backed up with the technical file. The file must be retained for 19. We use four-digit SITC trade data and correspondences a period of 10 years after the manufacture of the machine (or the between the NACE, International Standard Industrial Classifica- last machine of a production run). For certain especially danger- tion, and Standard Identification Trade Classification classifica- ous items of machinery (known as Annex IV machines), justifi- tions provided by the Eurostat's Classification Server (http:// cation of use of the CE mark must be independently verified by europa.eu.int/comm/eurostat/ramon/). a recognized authority (called an "approved body" or "notified 20. Manufactures are defined as consisting of sectors under body"). Manufacturers of Annex IV machines are required to SITC sections 5, 6, 7, and 8 minus division 68 and group 891. compile a technical file that shows how the machinery has been 21. Although Turkey realizes that the major pillars of a com- constructed to meet the requirements of the directive. The file is petition policy must comprise privatization, liberalization of then audited by the notified body to confirm that the directive's entry and exit, imposition of hard budget constraints on all pub- requirements have indeed been met, and a sample of the lic and private enterprises, and a very liberal trade regime, it machinery is examined to confirm that it is constructed as faces difficulties in implementing these principles. described in the file. If a harmonized standard for a particular 22. For concentration ratios in Slovakia and Belgium, see type of Annex IV machine exists, the manufacturer can avoid Djankov and Hoekman (1998). the expense of type examination by manufacturing the machine fully in accordance with the standard. All that is then required is References that the file be lodged with a notified body, but the notified body does not have to give an opinion on the machine--it simply acts Balassa, B. 1982. Development Strategies in Semi-Industrial as an independent repository for the file. This procedure can Economies. Baltimore: Johns Hopkins University Press. only be applied to machines that are manufactured fully in Baldwin, R. E. 2001. "Regulatory Protectionism, Developing accordance with the harmonized standard. If there are any devi- Nations and a Two-Tier World Trade System." Brookings ations from the standard (e.g., a light guard is fitted where the Trade Forum 3: 237­80. standard says a physical guard is required), the full type approval Breton, P., J. Sheehy, and M. Vancauteren. 2001."Technical Barri- route must be followed. ers to Trade in the European Union: Importance for Accession 12. This section reports the state of affairs on technical barri- Countries." Journal of Common Market Studies 39: 265­84. ers to trade in Turkey as of 2003. Djankov, S., and B. Hoekman. 1998. "Conditions of Competi- 13. Law 4703 is based on Council Directive 92/59/EEC on tion and Multilateral Surveillance." World Economy 21: general product safety, Council Regulation 85/C 136/01 on the 1109­28. new approach to technical harmonization and standards, and the European Commission. 1998. Technical Barriers to Trade. Vol. 1, Council resolution of December 1989 on the global approach to Subseries III, Dismantling of Barriers, The Single Market conformity assessment. Review. Luxembourg: Office for Official Publications of the 14. The legislation on market surveillance was prepared using European Communities (OOPEC). Council Directive 92/59/EEC on general products safety, the --------. 2000. Guide to the Implementation of Directives based Council resolution of December 1989 on the global approach to on the New Approach and the Global Approach. Brussels. conformity assessment, Council Directive 88/378/EEC on the --------. 2002. 2002 Regular Report on Turkey's Progress approximation of the laws of the member states on the safety of towards Accession. Brussels. toys, and on a European Commission implementation guide European Committee for Standardization. 2003. Support to the (2000). The legislation on working principles and procedures for Quality Infrastructure in Turkey: Country Report 2003. the conformity assessment bodies and notified bodies was pre- Brussels: CEN. pared using the material in chapter 6 of the European Commis- Messerlin, P. A. 2001. Measuring the Costs of Protection in Europe: sion guide (2000). The legislation on the use and affixing of the European Commercial Policy in the 2000s. Washington, DC: CE conformity mark is based on Council Decision 93/465/EEC Institute for International Economics. on the modules for the various phases of the conformity assess- OECD (Organisation for Economic Co-operation and Develop- ment procedures and the rules for affixing and the use of the CE ment). 2002. Turkey: Crucial Support for Economic Recovery. conformity marking. Finally, the legislation on notification pro- OECD Reviews of Regulatory Reform. Paris: OECD. cedures between Turkey and the EU for technical legislation and Sykes, A. O. 1995. Product Standards for Internationally Integrated standards is based on Council Directive 98/34/EC, laying down a Goods Markets. Washington, DC: Brookings Institution. procedure for the provision of information in the field of techni- Togan, S. 1994. Foreign Trade Regime and Trade Liberalization in cal standards and regulations and the relevant section of Decision Turkey during the 1980's. Avebury, UK: Ashgate Publishing. 2/97 of the EC-Turkey Association Council. Undersecretariat of Foreign Trade. 2002. "Türkiye'nin AB Teknik 15. Under a law published on October 27, 1999, TURKAK is Mevzuatina Uyumu--Çerçeve Kanun, Uygulama Yönet- the national accreditation body in all fields. But the regulations melikleri" [Harmonization of Turkish Regulations on Tech- that gave the Turkish Standards Institute (TSE) and Turkish nical Barriers to Trade to EU Approaches]. Ankara: UFT. 4 Accession of Turkey to the European Union: Market Access and Regulatory Issues Joseph Francois The European Union (EU) has been at the center of tions of EU regulation for the sector. The first sec- a recent explosion in regional trading schemes. A tion discusses the context of membership, espe- combination of economic and political factors-- cially the Customs Union between the EU and including greater peace and stability in the EU hin- Turkey, but also the other protocols agreed to and terland, support for democratic reforms in devel- under negotiation between the EU and Turkey. oping countries, greater trade and investment That section is followed by a brief quantitative dis- liberalization in developing countries, and access to cussion of the likely impact of full membership on new markets for EU exports--have been advanced trade and on the transport sector itself. Because the as motives for the EU to conclude such agreements. customs union covers many of the steps needed for For developing countries, the attraction has been membership, the incremental impact of the last preferential access to the large EU market and the necessary steps for the transport sector is relatively prospect of increased EU aid. The reality is that minimal. Other possible effects are then identified everybody, except the North American and high- through a detailed assessment of the regulatory income Asian economies, now seems to have pref- regime in Turkey for transport as compared with erential access to the EU.1 the one in effect for the rest of the EU. Here, too, For those countries that are immediate neigh- the major steps have already been taken, implying bors of the EU, the big prize has been the promise that EU membership will have little direct impact, of accession to the EU (see Baldwin and Francois institutionally or economically, on the domestic 1997). Turkey is no exception. Although Turkey was transport sector. Effects may be related to EU struc- not included in the list of new members for the tural funds (which was the case in Spain and Portu- next round of accession, an ongoing process (with a gal), but in view of the size of the looming enlarge- very long history) is supposed to lead eventually to ment, such funds are likely to be limited. EU membership. This chapter explores the implications of even- The Customs Union tual Turkish accession to the EU. The potential impacts of regulatory reform under such a process The primary difference between the current list of are examined by focusing on the transport sector, new EU members and membership for Turkey is the broadly defined to include air, land, rail, and other. depth and long history of trade integration in place Two issues studied are the linkage between trade between the EU and Turkey. The EU-Turkey cus- effects and the transport sector, and the implica- toms union has been a long time in the making. In 123 124 Turkey: Economic Reform and Accession to the European Union 1963 the Treaty of Ankara envisaged Turkey becom- Article XXIV of the General Agreement on Tariffs ing a full member of the EU, with preparation and Trade (GATT) of 1994, particularly Section 8 occurring over a series of stages. In 1970 a protocol requiring coverage of "substantially all trade" and to this Ankara agreement outlined a framework of the Understanding on Article XXIV (especially the the customs union between the EU and Turkey. preamble, which states that "no major sector is Even though Turkey's 1987 application for full excluded"). The EU seeks to resolve this dilemma membership in the EU was rejected, it continued to by interpreting World Trade Organization (WTO) pursue unilateral trade liberalization with the EU. rules as requiring free trade to be established on As a result, when the customs union was finally 90 percent of total bilateral trade flows. established for industrial products on January 1, Because EU tariffs on most industrial products 1996, after a transition period of 22 years, much of are zero or very low (exceptions are, for example, the required tariff changes for industrial products clothing and motor vehicles), the EU has little diffi- had already been implemented. culty in liberalizing imports of all, or practically all, The existence of the customs union, along with industrial products. Moreover, because imports of the protocols that go with it, has important impli- agricultural and fisheries products are limited by cations for the discussion that follows of the likely (sometimes prohibitive) border protection, they effects of full EU membership. The average reduc- account for only a small proportion of existing tion in tariffs required by the CU for Turkey has total imports from the partner country. As a result, been estimated to be only 7 percent (Harrison, the EU is able to make a sufficient contribution to Rutherford, and Tarr 1997). The combination of the fulfillment of the 90 percent criterion by liber- adopting the Common Customs Tariff (CCT) alizing only around 60 percent of its imports of structure and Uruguay Round commitments agricultural products. Similar calculations, it is should have produced a trade-weighted average argued by the EU, also enable the partner country tariff on industrial goods of 3.5 percent by 2001 to protect sensitive industrial and agricultural (WTO 1998). In theory, the objective of the sectors of its economy while remaining within customs union agreement is to prepare Turkey the EU's interpretation of the requirements of for full membership in the EU, and the agree- Article XXIV. ment is, therefore, not only deeper than the EU's Given these constraints, the pattern of tariff free trade agreements, but also goes well beyond reductions in the developing country usually takes the basic requirements of a customs union agree- the form of abolishment of the duties on capital ment. In particular, it requires Turkey to introduce and intermediate goods before duties on final con- a wide range of legislation covering all aspects sumer goods, which are also subject to significantly of trade; competition law; industrial, commer- higher initial duties and which are liberalized only cial, and intellectual property rights; and to adopt toward the end of the transitional period. It is in EU technical standards.2 In this sense, the the area of trade in agricultural and fisheries prod- customs union agreement carries with it many of ucts that the agreements fall significantly short of the consequences that would follow from full EU free trade. The EU routinely excludes products such membership. as beef, sugar, a range of dairy products, some cere- Table 4.1 compares the current EU arrangement als and cereal products, rice, some fresh fruits and with Turkey with recent and ongoing agreements vegetables, some cut flowers, and fisheries prod- (in the form of free trade agreements, FTAs) with ucts. The partner developing country also excludes selected developing countries and regions. Behind a range of agricultural products, not least to protect all of these agreements is a mix of politics and eco- its agriculture from imports of subsidized agricul- nomics. A basic dilemma facing EU negotiators of tural goods from the EU, such as beef, sugar, dairy these free trade agreements is that, according to products, and cereals. As a result, in the agreement their negotiating mandate, they must not under- with Mexico only 62 percent of bilateral trade in mine the finely tuned border protection of the agricultural products is fully liberalized. In the EU's Common Agricultural Policy (CAP) and the agreement with South Africa, 62 percent of EU Common Fisheries Policy. At the same time, they imports are liberalized, while South Africa fully lib- must ensure that agreements are compatible with eralizes 82 percent of its imports from the EU. No Accession of Turkey to the European Union: Market Access and Regulatory Issues 125 TABLE 4.1 Structure of EU Free Trade Agreements with Selected Developing Countries Egypt South Africa Mexico Turkey Rationale: EU Security Reinforce Access to NAFTA; Customs union democracy; regional hub agreement in regional hub industrial products; objective of membership in EU Partner Maintain Improve access to Reduce preferences; EU market; dominance of lock in reforms; attract FDI; lock United States; attract FDI in reforms improve access to EU market; attract FDI Transitional period: EU Immediate 10 years 10 years Turkey's customs legislation now Partner 12­15 years 12 years 10 years almost same as that of EU Industry coverage: EU All Almost all, most All by 2003 All by 2006 Partner All, less than half 87% and All by 2007, most All by year four, end-weighted by 2003 end-weighted on most protected Agricultural coverage: EU Approx. 60%+ of imports, entry prices, plus preferences Separate preferen- with tariff quotas tial agreement covering range of products, some with tariff quotas Partner Very limited; Substantial; some Some, such as some duty wines subject to dairy, tobacco, reductions tariff quotas processed foods within tariff quotas Rules of origin: EU EU rules; bilateral cumulation with EU; derogations EU rules can be requested. Partner Part MEDA Full SACU Relaxation in some cumulation an cumulation; sectors due to objective partial SADC lack of raw cumulation with materials and one country components Safeguards Standard EU clause for both parties plus transitional EU rules arrangements for partner Antidumping Standard WTO rules Intellectual Protected under TRIPS plus list of Special committee TRIPS plus list of property rights international agreements to solve international difficulties agreements 126 Turkey: Economic Reform and Accession to the European Union TABLE 4.1 (Continued) Egypt South Africa Mexico Turkey Competition rules Outlaws collusion/ Each retain own Own laws; EU policy abuse of rules; outlaws detailed dominant collusion/abuse statement on position of of market cooperation; enterprises, power, etc.; technical which distorts cooperation assistance competition in plus EU trade (except assistance for ECSC products) State aids Must not distort competition in trade between EU and partner, but are permissible for public or policy objectives (EU Article 92) Public procurement Consultation "Fair, equitable and National Agreement to be with aim of transparent" treatment and reached in liberalization nondiscrimina- future tion phased in over 10 years, except some public utilities and transport Rights of GATS plus possibility of further Trade in most National establishment liberalization services treatment; and services liberalized plus services most modes of agreement supply by 2004; under transitional negotiation as period of part of customs 10 years; union national treatment Capital movements Free movement of capital relating Program of Export of large to direct investment plus interest liberalization sums from profits and dividends relating to Turkey unclear investment plus protection of investment Standards Aim of reducing differences (especially Cooperation; Working toward SPS) and mutual recognition Special implementation Committee on of EU rules SPS Measures Custom For example, exchange of information, introduction of single EU commercial cooperation administration document, simplification of controls and policy and rules procedures for clearance, cooperation on rules of origin Aid, economic MEDA programs Multiannual n.a. MEDA plus EIB development (grants) to indicative preaccession cooperation support all programs of loan facility Euro-Med grants and agreements; loans three-year rolling national indicative programs Institutions Joint EU/Partner Association/Cooperation Council at Association Council; ministerial level supported by committees (high official) CU Joint and technical working groups Committee; Joint Consultative Committee Accession of Turkey to the European Union: Market Access and Regulatory Issues 127 Egypt South Africa Mexico Turkey Dispute settlement Association Cooperation Joint Committee Association Council by Council or or arbitration; Council or "decision" or arbitration; rules for arbitration by arbitration stages time procedures, binding on limited; no time-limited, both parties; enforcement stages, no time limit or procedures compensation enforcement procedures General Political dialogue; social and cultural cooperation; democratic principles and respect for human rights; scientific, technical, and technological cooperation Other Money Wine and spirits Turkey to adopt laundering; agreement; all of EU's drug trafficking; fisheries (not preferential migrant workers concluded); trade and illegal regional agreements immigration; cooperation regional integration n.a. Not applicable. Note: NAFTA North American Free Trade Agreement; FDI foreign direct investment; MEDA is the financial instrument of the Euro-Mediterranean Partnership; SACU South African Development Community; SADC South African Development Community; WTO World Trade Organization; TRIPS Agreement on Trade-Related Aspects of Intellectual Property Rights; ECSC European Coal and Steel Community; GATS General Agreement on Trade in Services; SPS sanitary and phytosanitary; EIB European Investment Bank; CU Customs Union. Source: Francois, McQueen, and Wignaraja 2003. comparable figures are published for trade in agri- The customs union agreement is part of the cultural products with Egypt or Turkey. more general program of preparation for EU mem- Agricultural products are not included in the bership, signaled in particular by the Helsinki customs union agreement with Turkey, but because agreement to include Turkey as a candidate coun- the objective is full membership in the EU, both try for accession to the EU and by Turkey's adop- parties have agreed to progressively improve their tion on March 19, 2001, of the "National Pro- preferential regime in the agricultural sector with gramme for the Adoption of the Acquis" (the the aim of allowing Turkey to adapt its agricultural acquis communautaire is the entire body of legisla- policy to the EU's Common Agricultural Policy. tion of the European Communities and Union). However, no time frame has been applied to this This program includes the economic aspects of the process, and the system of preferences does not acquis, in particular the "four freedoms" (related to "restrict in any way the pursuance of the respective goods, persons, services, and capital) that form the agricultural policies of the Community or Turkey."3 basis for the operation of the internal market. As In addition, both countries have a safeguard clause discussed in other chapters in this volume, these that can be activated if "either quantities or the economic aspects have immediate implications for prices of imported products from the other Party in services trade. respect of which a preferential regime has been cre- ated, causes or threatens to cause a disturbance of A Quantitative Assessment the Community or Turkish market." The European Commission estimates that 93 percent of Turkey's As noted earlier, the customs union between the agricultural exports to the EU and 33 percent of EU EU and Turkey already covers most, if not substan- agricultural exports to Turkey are covered by the tially all, trade. To analyze the impact of Turkey's 1998 scheme of preferences. accession to the EU, this section describes the 128 Turkey: Economic Reform and Accession to the European Union application of a global general equilibrium model favored-nation (MFN) duties have been abolished (the model, which is described in annex 2, is based for live bovine (pure breeding animals) and meat on Francois, McQueen, and Wignaraja 2003). The or fish unfit for human consumption. For a fairly policy experiments involve a summary of the esti- short list of other products, duties are abolished mated economic effects of the customs union and within small tariff quotas, including products listed of its extension, under membership, to cover all in table 4.2. trade. Turkey has undertaken "far-reaching structural The EU-Turkey customs union agreement is and legislative reforms within the framework of really designed for industrial products; the final the customs union agreement" (WTO 1998). The stage was completed in 2000. As such, there is unre- adoption of the CCT has meant that Turkey's level stricted trade in all industrial products between of border protection on industrial products and the two countries, and Turkey applies the CCT to the industrial component of processed foods has imports of industrial products from third countries. declined significantly. As a result, even though Agriculture is largely excluded from the agreement, there may be some concerns about the possibility although there is a preferential trade regime for a of relative trade diversion, the absolute level limited range of agricultural products (see table 4.2 of imports from third countries should have for a summary). increased, not only because border measures of EU imports of products not listed in table 4.2 protection have declined significantly, but also are exempt from ad valorem duties, but they are because the adoption of EU customs regulations still subject to specific duties and quotas. Even has provided exporters with greater certainty of where preferences are given for some food products treatment. Turkey illustrates as well some of the (fruits and vegetables), they are only available substantial difficulties that developing countries between certain dates. Turkey has liberalized even experience in implementing far-reaching structural less in the area of food and agriculture. Most- reforms even when, like Turkey, they have both the TABLE 4.2 Processed Food Concessions under the EU-Turkey Customs Union EU Concessions Turkey Concessions Tomato paste Live bovine animals Poultry meat Frozen meats Sheep and goat meat Butter Olive oil Cheese Cheese Vegetable and flower seeds Some fresh fruit and vegetables Flower bulbs Hazelnuts Apples and pears Fruit juices Potatoes Marmalade and jams Cereals Refined/raw vegetable oil Sugar Tomato paste Some alcoholic beverages Some animal foods Note: Products not listed by the EU are exempted from ad valorem duties, but they are still subject to quotas and specific duties. Examples are beef and sugar. Turkey has liberalized some agricultural tariffs within very narrow tariff-rate quotas. Source: Francois, McQueen, and Wignaraja 2003. Accession of Turkey to the European Union: Market Access and Regulatory Issues 129 incentive of full membership in the EU and the the current level of discrimination against their backing of substantial financial and technical exports. resources. Agriculture is, however, an important sector of Because the customs union reflects political sen- the Turkish economy, accounting for about 11.4 sitivities in the EU and Turkey, areas of significant percent of its gross domestic product and 34 per- potential (agricultural) trade have been excluded cent of employment. The omission of this sector by both parties to the agreement. Reflecting the from the customs union agreement must produce customs union as just described, the scenario for significant distortions in the allocation of resources application of the computable general equilibrium in the economy and in the economic effects of the (CGE) model is summarized in table 4.3.4 agreement. Of immediate interest here is the sectoral impact The macroeconomic effects of the customs of the actual customs union and of a full free trade union are summarized in table 4.4. Consider first scenario. The omission of the agricultural sector national welfare (measured as current welfare from the customs union agreement almost cer- derived from economy-wide consumption pat- tainly means that the agreement does not conform terns). The customs union, as currently constructed, with Article XXIV of the GATT. Interestingly, this yields a boost in Turkish welfare (measured as a per- issue was raised in the WTO review of the report centage of base national income) of over 1.3 percent of the Trade Policy Review Board (TPRB) on relative to the baseline with MFN industrial tariffs. Turkey (no response by Turkey was recorded), but Based on 1997 values, this gain is comparable to a no WTO member state has so far challenged the boost in real GDP of US$2.2 billion.5 The static agreement, presumably because those states feel effect is slight, adding less than 0.1 percent to that adoption of the CAP by Turkey would increase welfare through induced capital accumulation. TABLE 4.3 Customs Union Scenario Full Partial No Liberalization Liberalization Liberalization Grains Turkey EU Other agriculture EU, Turkey Mining EU, Turkey Other primary production EU, Turkey Sugar Turkey EU Dairy Turkey EU Meats EU, Turkey Processed foods EU, Turkey Textiles EU, Turkey Clothing EU, Turkey Leather EU, Turkey Wood and paper EU, Turkey Chemicals EU, Turkey Refineries EU, Turkey Steel EU, Turkey Nonferrous metals EU, Turkey Motor vehicles EU, Turkey Electronics EU, Turkey Other machinery EU, Turkey Manufactures, NEC EU, Turkey Note: Partial liberalization is modeled as 50 percent. NEC not elsewhere classified. Source: Author's definition of model aggregation. 130 Turkey: Economic Reform and Accession to the European Union TABLE 4.4 Summary of Macroeconomic Effects of Customs Union for Turkey A B C A B D Long-Run Effects of Long-Run Actual Effects of Static Dynamic Customs Full EU Effects Effects Union Membership Welfare (% of national income) 0.91 0.4 1.31 1.36 Welfare (millions of US$) 1,558.92 678.31 2,237.23 2,335.73 Terms of trade (%) 2.64 0.91 1.73 1.95 Value of exports (%) 10.6 3.46 14.06 15.21 Unskilled worker wages (%) 2.02 0.22 2.24 2.62 Skilled worker wages (%) 1.28 0.43 1.71 1.72 Capital stock (%) 0.00 1.24 1.24 1.24 Value of GDP in dollars (%) 3.17 0.36 2.81 3.01 Real exchange rate (%)a 3.05 1.1 1.95 2.16 GDP quantity index (%) 0.11 0.74 0.85 0.84 a. Real exchange rate is the dollar price of the base period GDP basket. Source: Author's calculations. A comparable improvement appears in Turkey's misses substitution effects in production and con- terms of trade through static effects--the gap sumption--but it is a common metric for govern- between export and import prices widens by over ment monitoring of economic climate. The 2.5 percent. However, there is an interaction changes in both the value and quantity of GDP between long-run capital accumulation and the (based on a fixed 1997 basket of goods and serv- terms of trade that erodes terms-of-trade gains over ices) fail to track welfare gains in any meaningful the medium run. The agreement, as modeled, way. yields a considerable boost in the capital stock How does the actual customs union compare (1.24 percent).Normally,a large boost in real income with a full customs union? A comparison of the would follow. In fact, the quantity index for GDP last two columns of table 4.4 reveals the differ- does expand. But because of the erosion in the ences. The EU-Turkey customs union does not terms of trade in the medium to long run, the value cover all potential EU-Turkey trade, but Turkey is of GDP (in dollar terms) falls somewhat. Even so, at a stage of development where critical market the initial terms-of-trade gains are strong enough access revolves around manufactured goods rather to outweigh these effects. than agriculture. As a result, the actual customs Consider next the impact on wages. Both skilled union does cover enough trade to generate gains and unskilled workers gain from the agreement, that are broadly similar to those of a full cus- with a 2.2 percent and 1.7 percent boost, respec- toms union. The differences between the two tively, to real incomes (net of changes in the con- columns are within the margin of error for this sumer price index, CPI) over the long run. Such kind of modeling exercise. Broadly speaking, the wage changes are considerable, given that they table does not reveal a significant difference, in are realized in the context of a trade agreement. terms of welfare, between a full customs union and The positive wage effects imply that, overall, the the EU-Turkey customs union. But there is some customs union will not make labor market condi- expansion of trade (primarily in food) under full tions worse. membership. The next set of indicators reported in table 4.4 Although the overall macro effects of the actual relate to real exchange rates and GDP. GDP is not customs union are comparable with those of a full an appropriate measure of economic welfare--it customs union, some slight differences emerge at Accession of Turkey to the European Union: Market Access and Regulatory Issues 131 TABLE 4.5 Change in Output by Sector in Turkey (percent) A B C A B D Long-Run Long-Run Effect of Effect of Static Dynamic Actual Full EU Sector Effects Effects FTA Membership Grains 0.76 0.67 0.09 1.18 Other agriculture 0.89 0.78 0.11 2.3 Mining 4.14 0.65 3.49 4.67 Other primary production 0.28 0.34 0.62 0.4 Sugar 0.4 0.61 0.21 4.6 Dairy 0.09 0.39 0.48 0.09 Meats 0.77 1.03 0.26 2.96 Processed foods 0.84 1.06 1.9 1.61 Textiles 21.81 4.43 26.24 25.46 Clothing 49.16 6.46 55.62 54.86 Leather 0.81 3.92 4.73 4.88 Wood and paper 0.76 0.05 0.71 0.87 Chemicals 2.31 1.21 1.1 1.14 Refineries 0.85 0.97 0.12 0.1 Steel 3.93 0.74 3.19 3.67 Nonferrous metals 7.09 2.23 4.86 5.5 Motor vehicles 17.12 2.05 15.07 15.73 Electronics 11.6 1.46 13.06 12.7 Other machinery 6.35 1.81 4.54 5.08 Manufactures, NEC 1.0 0.39 0.61 0.81 Transport 0.43 0.87 0.44 0.35 Construction 3.47 2.77 0.7 0.64 Business services 3.71 1.83 1.88 2.13 Other services 1.07 0.78 0.29 0.41 Note: NEC not elsewhere classified. Source: Author's calculations. the sectoral level (see table 4.5). Under a full motor vehicle sector in the EU applied strong pres- customs union, EU grain production squeezes sure on the motor vehicle and parts sector in Turkey, Turkey's production, with a projected drop in out- which shrank by 15 percent. Another sector that put of 1.18 percent. However, under the actual benefits is (consumer) electronics, which enjoyed a agreement this sector is largely sheltered, with pro- 12 percent increase in production. duction projected to drop only 0.09 percent from The sector-level results also point to no real baseline levels. A similar story holds for meat pro- great adjustment pressures within Turkey, except duction, which is largely insulated under the current in heavy manufacturing. The motor vehicle, agreement. machinery, and equipment sectors are squeezed. Outside of food production, the largest effects This situation is consistent with expectations about are in textiles, clothing, and motor vehicle produc- Turkey's comparative advantage, with an advantage tion. Textiles and clothing have benefited tremen- in lighter manufactures and a relative disadvantage dously from improved EU access. Production is in some heavy manufacturing sectors. 25 percent and 50 percent higher, respectively, than The trade results largely mirror the results for without preferred access. At the same time, the production. One outlier is motor vehicles.Although 132 Turkey: Economic Reform and Accession to the European Union production is squeezed and imports go up substan- the EU.This would follow from roughly $100 million tially, exports also go up substantially. Mexico's in additional services imports from the EU. experience with the North American Free Trade Agreement (NAFTA) was similar. The motor vehicle A Factor Analysis of Regulatory sector is forced to restructure, and in the process it Structures becomes more deeply integrated with the European industry. As a result, significant growth is projected Membership in the EU involves not only market in both imports and exports in the sector relative to a access, but also community rules and regulations. baseline with continued MFN protection for the sec- In this section, the regulation database of the tor.Theresultforsugarunderthefullcustomsunion Organisation for Economic Co-operation and reflects the subsidies to EU production and a large Development (OECD) is used to examine the struc- increase in a small export base for Turkey (small ture of competition and regulation in the transport changes in small flows can lead to large percentage sector across OECD countries. The goal is to com- changes). In the actual customs union agreement, pare the regulatory status of Turkey's transport sec- these effects are sterilized. tor with those of EU members. In the end, it turns What happens to the transport sector under the out that the Turkish regulatory regime is not at all customs union? The static effect is contraction, as inconsistent, by these measures, with the broad pat- resources are pulled out of the sector and into manu- tern observed within the EU. This finding may facturing. However, because the customs union is reflect the long, ongoing process of Turkish integra- estimated to have positive investment effects (i.e.,the tion. In any event, it suggests that the sector may capital stock expands),there is a projected expansion require little overall realignment of regulation in of thesectorinthemediumtermof roughly0.44per- view of what is currently allowed within the EU. cent. Because the agreement is already in place, the The 2000 OECD International Regulation Data- interpretation is that the transport sector is almost a base includes more than 1,100 variables for each half percent larger than it would be otherwise. OECD member on both economy-wide product What happens to the transport sector under market regulation and regulation at the sector level. actual EU membership (the focus here is on the For the purposes of this study, it includes data trade-related effects)? Again, the impact is positive on regulation in road transport, national and inter- relative to no preferential trade at all. However, national air transport, and rail transport (see because full membership would extend access to the Nicoletti, Scarpetta, and Boylaud, 1999, for a EU food markets (food production is a large share of detailed description of the data). In general, the Turkey's economy), resources would be pulled out data of interest here are centered around 1998. of the service sectors and into agriculture. The OECD database may contain over 1,100 vari- Finally, what happens to direct trade in trans- ables, but only a limited number apply to transport. port services? The Global Trade Analysis Project In addition, many remain unanswered by a large (GTAP) database reveals that Turkey's trade in number of members, and many others simply defy transport services is relatively small, with imports quantification. For this reason, the full set of trans- of roughly $1.207 billion in 1997. Based on gravity port questions has been reduced to the set covered in estimates of services trade barriers, the import tar- table 4.6. The 18 variables listed for air transport are iff equivalent for cross-border transport service classified into domestic competition, international imports into Turkey is roughly 8.9 percent (see competition, and government ownership and regu- annex 1). Assuming an import demand elasticity of lation. The 15 variables for road transport and the ­3.9 (equal to the import substitution elasticity in six for rail are roughly classified into domestic com- demand in the GTAP model for this sector) and petition and government ownership and regulation. deadweight trade costs, a back-of-the-envelope cal- Within each set of variables, the assigned values culation yields gains of roughly $126 million per year range from 0 to 6 (so that for dummies, yes is gener- from full trade liberalization in the sector. The EU ally 6 and no is 0),and the assigned weights are based accounts for roughly 25 percent of this total, or only on the number of variables in a sector:category set. about $30 million per year in welfare gains in the sec- In this factor analysis of the variables, the result of tor from direct trade related to liberalization vis-à-vis this scaling is a set of regulatory indexes ranging Accession of Turkey to the European Union: Market Access and Regulatory Issues 133 TABLE 4.6 Variables Used from OECD International Regulation Database Data Set OECD Survey Variable Question No. Question Name 17 Does national, state, or provincial government hold equity stakes in ATOR1 business company? 7,131 air transport carriers 52 Do national, state, or provincial laws or other regulations restrict in at ATOR2 least some markets the number of competitors allowed to operate a business? 7,131 air transport carriers 547 Air travel/national market structures: domestic market share of the largest ATDC1 airline (incl. subsidiaries) (more than 500,000 passengers a year) 548 Air travel: market structure: domestic routes (all routes): share of traffic ATDC2 (passengers/km) of the incumbent carrier 558 Air travel: market structure: international routes (all routes): share of ATIC1 traffic (passengers/km) of the largest carrier in the international traffic of national carriers 566 Air travel: Is the largest operator in international routes also the largest ATIC2 operator in domestic routes? (all routes) 567 Air travel/national market structures: share of 100 international routes ATIC3 with more than three carriers 572 Air travel/national regulations and government ownership: government ATOR3 ownership in largest airline (%) 573 Air travel/national regulations and government ownership: government ATOR4 golden share in a major airline 579 Air travel/national regulations and government ownership: government ATOR5 loss makeups in major airlines in the past five years 580 Air travel/national regulations and government ownership: the largest ATOR6 airline has public service obligations 611 Air travel/national regulations and government ownership: domestic ATOR7 market deregulated 612 Air travel/national regulations and government ownership: Open Sky ATIC4 agreement with United States 613 Air travel/national regulations and government ownership: Open Sky ATIC5 agreement older than six years 618 Air travel/national market structures: international market share of the ATIC6 largest airline (incl. subsidiaries) (more than 500,000 passengers a year ) 619 Air travel/national market structures: Herfindahl concentration index in ATDC3 domestic market 620 Air travel/national market structures: Herfindahl concentration index in ATIC7 international market (%) 1120 Air travel: ceiling on foreign ownership allowed in national air transport ATOR8 carriers 13 Does national, state, or provincial government hold equity stakes in RTOR1 business company? 7,114 road freight 48 Do national, state, or provincial laws or other regulations restrict in at RTDC1 least some markets the number of competitors allowed to operate a business? 7,114 road freight 492 Road freight: Is there a firm in the road freight sector that is publicly RTOR2 controlled (i.e., national, state, or provincial governments hold the largest single share)? 493 Road freight: Is registration in any transport register required in order to RTOR3 establish a new business in the road freight sector? 494 Road freight: In order to operate a national road freight business (other RTOR4 than for transporting dangerous goods or goods for which sanitary assurances are required) do you need to be granted a state concession or franchise by any level of government? 134 Turkey: Economic Reform and Accession to the European Union TABLE 4.6 (Continued) Data Set OECD Survey Variable Question No. Question Name 495 Road freight: In order to operate a national road freight business do you RTOR5 need to obtain a license (other than a driving license) or permit from the government or a regulatory agency? 496 Road freight: In order to operate a national road freight business do you RTOR6 need to notify any level of government or a regulatory agency and wait for approval before you can start operation? 505 Road freight: Does the regulator, through licenses or otherwise, have any RTDC2 power to limit industry capacity? 513 Road freight: Are there any regulations setting conditions for driving RTOR7 periods and rests? 515 Road freight: Do regulations prevent or constrain: backhauling? RTDC3 516 Road freight: Do regulations prevent or constrain: private carriage? RTDC4 517 Road freight: Do regulations prevent or constrain: contract carriage? RTDC5 520 Road freight: Within the last five years, have laws or regulations removed RTOR8 restrictions on: commercial, for-hire shipments? 521 Road freight: Are retail prices of road freight services in any way regulated RTOR9 by the government? 522 Road freight: Does the government provide pricing guidelines to road RTDC6 freight companies? 10 Does national, state, or provincial government hold equity stakes in RROR1 business company? 7,111 railways 45 Do national, state or provincial laws or other regulations restrict in at least RRDC1 some markets the number of competitors allowed to operate a business? 7,111 railways 528 Railways: freight transport: total number of operators RRDC2 538 Railways: Please indicate if the government has any liability for losses made RROR2 by a railway company (excluding subsidies related to service obligations). 539 Railways: Did the government in the past five years make up for any losses RROR3 made by railway companies? 540 Railways: Are companies operating the infrastructure or providing railway RROR4 services subject to universal service requirements (e.g., obligation to serve specified customers or areas)? Note: Questions have generally been rescaled from 0 to 6, with 0 being a positive indicator (more competition, less regulation, less participation by government through ownership, golden shares, price setting, and so forth). Questions have also been assigned inverse weights (i.e., if there are four domestic competition questions for air, each gets a 1/4 weighting for the domestic competition for air transport factoring and scoring exercise). Source: OECD International Regulation Database, 2001. from 0 (generally open, competitive regimes with Factor analysis is applied first to the regulatory minimal regulation) to 6 (generally more regulated, variables grouped by sector and type of regulation, with less or no competition). thereby yielding a set of indicators for road trans- Multivariate factor analysis is a standard tech- port, air, and rail, which are listed in tables 4.7, 4.8, nique for summarizing patterns in regulatory data and 4.9. The critical point to pick up from these (see Nicoletti, Scarpetta, and Boylaud 1999 and indexes is that in all three transport sectors Turkey's Boylaud 2000). Factor analysis yields factors that are regulatory regime is fully consistent with the linear combinations of the variables observed and regimes of current EU members. For example, that, in theory, identify latent variables or indicators the road transport regime in Turkey has fewer limits that lurk behind the observed data. In the present on competition (including pricing guidelines) than context, this approach allows the construction of Germany, Greece, Finland, and the Netherlands. indexes of regulatory frameworks in the sample. Overall,theroadtransportsectorcomparesfavorably TABLE 4.7 Regulation Indexes, Air Transport Public International Service Public Service Reservation Obligation, Government Regulation Obligations for Dominant Competition Regulation of Regulated Government Ownership or Government and Limits on and Custom Domestic International Domestic and Price Industry Customer Ownership Overall Management Bailouts Restructuring Guarantees Competition Competition Carrier(s) Air Road Rail Regulation Structure Access and Bailouts United States 2.1 2.5 2.7 1.7 0.8 1.1 2.4 3.7 2.1 1.4 2.6 0.827486135 0.639225018 0.373642805 0.451764654 Japan 3.6 2.5 2.6 1.3 0.9 2.2 4.7 3.8 3.6 1.2 1.7 1.608383946 0.398000994 0.440217734 0.397295435 Germany 4.6 2.7 2.5 2.7 1.5 3.4 5.9 4.0 4.6 1.6 1.2 2.001897264 0.760787878 0.464155476 0.478902558 France 3.8 4.7 3.5 2.1 1.3 2.5 5.7 3.4 3.8 1.0 1.9 1.648319644 0.690636245 0.58446881 0.551299765 Italy 4.1 4.6 3.5 2.1 2.2 3.1 5.8 3.5 4.1 2.1 2.0 1.802392871 0.653592598 0.710903353 0.539211452 United Kingdom 3.7 2.7 1.7 2.3 2.8 1.9 4.7 4.4 3.7 1.9 0.9 1.41077272 0.838287495 0.998012427 0.190062094 Canada 3.4 2.5 1.9 0.7 1.2 2.3 4.7 3.2 3.4 1.4 1.8 1.634645345 0.316644254 0.4247025 0.304681501 Finland 4.0 4.4 1.4 2.4 1.2 3.4 6.0 2.8 4.0 2.1 1.9 1.854702305 0.722343477 0.560720801 0.32557426 Greece 4.2 4.7 3.4 1.5 2.2 3.8 5.9 3.0 4.2 2.4 2.1 1.95420938 0.461873888 0.714813349 0.543616231 Mexico 2.1 4.2 3.5 1.7 1.1 2.0 3.4 1.8 2.1 1.0 1.3 1.353502801 0.694882568 0.570964691 0.522586274 Netherlands 4.0 4.0 2.2 3.7 0.2 3.6 5.4 3.2 4.0 1.8 1.6 1.768005014 1.039911684 0.309726703 0.337963967 New Zealand 4.5 2.7 2.7 3.5 1.2 3.7 6.0 3.0 4.5 2.8 0.7 2.010288982 0.905292063 0.478973959 0.385442689 Norway 3.3 4.3 1.4 2.4 1.1 2.2 5.6 1.9 3.3 2.8 1.9 1.550070023 0.703961664 0.571637512 0.309285763 Portugal 4.2 4.7 3.4 1.5 2.2 3.9 5.9 3.1 4.2 1.4 1.9 1.927716035 0.537816601 0.712804139 0.52197316 Spain 3.7 4.7 3.6 2.9 1.0 2.5 5.6 3.1 3.7 1.2 1.9 1.682086662 0.927405698 0.473408351 0.55497655 Sweden 4.0 4.2 2.1 2.8 0.7 3.1 6.0 2.9 4.0 1.7 1.9 1.836297304 0.773933652 0.427582084 0.399262966 Switzerland 4.2 3.7 1.4 1.6 0.5 3.5 6.0 3.0 4.2 2.2 1.9 1.90027128 0.545283018 0.315114694 0.280302128 Turkey 4.1 4.8 1.3 1.6 2.2 3.7 5.8 3.3 4.1 2.3 1.9 1.740053875 0.631766305 0.758792739 0.343861905 Czech Rep. 3.8 4.7 1.3 1.7 1.3 3.8 5.9 1.9 3.8 1.5 1.4 1.976677595 0.599534062 0.47354244 0.250246189 Hungary 2.8 4.4 1.3 1.8 1.1 2.6 4.9 1.0 2.8 2.1 1.9 1.512782968 0.653479446 0.495375794 0.162857349 Korea, Rep. of 3.9 2.6 2.5 2.1 1.5 3.2 4.8 3.6 3.9 0.6 0.3 1.830529419 0.767582267 0.66823034 0.245312432 Poland 3.7 4.9 1.3 1.6 1.3 3.7 5.7 2.1 3.7 1.4 1.7 1.875180579 0.60420922 0.557323214 0.26365386 Note: Indexes, which range from 0 to 6, are based on rotated factor loadings. The overall index is based on the first factor for the summary indexes, with 90 percent of the variance explained. Source: Author's calculations. 135 136 TABLE 4.8 Regulation Indexes, Road Transport Limits on State Backhauling, Limits on Concession Regulatory Private Competition State Requirements Approval Carriage, and (Including Government Ownership/ and Price Required for Other Contract Price Overall Licensing Concessions Regulation Establishment Regulations Carriage Guidelines) United States 1.4 4.7 1.9 1.3 1.8 1.2 0.8 1.7 Japan 1.2 4.7 1.4 2.3 0.6 1.4 0.5 1.7 Germany 1.6 4.6 2.3 1.2 2.1 1.3 1.2 2.4 France 1.0 4.9 3.5 1.1 0.3 1.3 0.5 1.7 Italy 2.1 4.4 1.6 3.9 1.8 2.0 0.7 1.5 United Kingdom 1.9 4.6 1.8 1.4 1.7 2.1 0.9 1.7 Canada 1.4 4.7 1.9 1.3 1.8 1.2 0.8 1.7 Finland 2.1 4.4 2.2 1.3 1.2 2.2 1.2 3.9 Greece 2.4 4.4 1.6 3.9 1.8 2.0 0.7 4.1 Mexico 1.0 4.8 1.7 1.2 1.8 0.2 0.7 3.4 Netherlands 1.8 4.5 1.8 1.4 1.0 2.1 0.8 2.9 New Zealand 2.8 3.0 1.8 1.4 2.7 2.1 0.0 1.7 Norway 2.8 3.2 3.9 1.1 2.2 2.3 0.2 2.1 Portugal 1.4 4.7 1.9 1.3 1.8 1.2 0.8 1.7 Spain 1.2 4.6 1.9 1.3 1.1 1.2 0.8 1.8 Sweden 1.7 4.5 1.8 1.4 1.0 2.1 0.8 1.7 Switzerland 2.2 1.8 1.8 1.6 0.6 1.4 0.9 3.4 Turkey 2.3 1.8 2.3 1.5 1.6 1.5 1.4 1.7 Czech Rep. 1.5 4.6 4.2 2.6 1.9 1.1 1.1 1.7 Hungary 2.1 4.6 1.8 1.4 1.7 2.1 0.9 3.2 Korea, Rep. of 0.6 4.7 1.7 1.2 1.1 0.2 0.6 1.7 Poland 1.4 4.5 4.2 2.6 1.2 1.1 1.0 1.7 Note: Indexes, which range from 0 to 6, are based on rotated factor loadings. The overall index is based on the first factor for the summary indexes, with 90 percent of the variance explained. Source: Author's calculations. Accession of Turkey to the European Union: Market Access and Regulatory Issues 137 TABLE 4.9 Regulation Indexes, Rail Transport Government Financial/ Operational Government Domestic Overall Interventions Ownership Competition United States 2.6 1.9 1.7 0.2 Japan 1.7 1.7 1.8 1.3 Germany 1.2 1.7 1.8 1.9 France 1.9 3.4 1.8 1.3 Italy 2.0 3.4 1.8 1.2 United Kingdom 0.9 2.2 0.3 1.3 Canada 1.8 1.9 1.7 1.2 Finland 1.9 1.3 2.2 1.3 Greece 2.1 3.0 2.2 1.3 Mexico 1.3 1.7 1.8 1.8 Netherlands 1.6 2.3 1.4 1.3 New Zealand 0.7 1.3 1.1 1.9 Norway 1.9 1.3 2.2 1.3 Portugal 1.9 3.4 1.8 1.3 Spain 1.9 3.4 1.8 1.3 Sweden 1.9 1.3 2.2 1.3 Switzerland 1.9 3.4 1.8 1.3 Turkey 1.9 3.4 1.8 1.3 Czech Rep. 1.4 3.4 1.8 1.9 Hungary 1.9 3.4 1.8 1.3 Korea, Rep. of 0.3 2.2 0.3 1.9 Poland 1.7 1.9 1.7 1.3 Note: Indexes, which range from 0 to 6, are based on rotated factor loadings. The overall index is based on the first factor for the summary indexes, with 90 percent of the variance explained. Source: Author's calculations. with that of the EU,as does air and rail (see figure 4.1, important summary indictor is competition and which compares Turkey with 21 other OECD price regulation (37.4 percent), followed by regula- members on the overall sector indexes). tion of industry structure (23.2 percent), public Another set of indicators, for the transport sec- service obligations and regulation of customer tor broadly defined, is presented in table 4.10. Like access (22.5 percent), and indicators of government those in tables 4.7, 4.8, and 4.9, these indicators are ownership and bailouts (16.9 percent). based on a factor analysis of the regulatory vari- The indexes in table 4.10 are summarized in fig- ables. In table 4.10, however, the full set of sector ure 4.2. The figure presents a breakdown (based on indicators in the previous three tables are combined the weights in table 4.10) of the contribution of to yield a set of four factors used to construct the each factor to the total index. Note the level of composite index--that is, a set of overall regulatory Turkey in relation to the average level for the EU. It indicators for competition, regulation of industry reveals for all of transport, as it was for the individ- structure, public service obligations, and financial ual subsector indicators, a rough congruence involvement of government--as well as an overall between the Turkish regulatory regime and the index, based on these four factors and aggregated range of regimes tolerated by the European Union. using rotated factor loadings. These four factors What do these indicators say? Overall, the regime explain roughly 90 percent of the regulatory vari- in Turkey appears to be consistent with regimes able variance, because they are constructed from existing within the EU, including, for example, sector indicators. For the overall index, the most Greece, Spain, Italy, Germany, and Portugal. Thus, 138 Turkey: Economic Reform and Accession to the European Union FIGURE 4.1 Comparison of Regulatory Regimes 5.0 Air transport Road transport Rail transport 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 of Italy States Japan France Spain Sweden Turkey Poland Germany KingdomCanadaFinlandGreeceMexico ZealandNorwayPortugal Republic HungaryRep. Netherlands United Switzerland New United Czech Korea, Source: The author. TABLE 4.10 Regulation Indexes, All Transport Public Service Obligation, Competition Regulation of Regulated Government and Price Industry Customer Ownership and Overall Regulation Structure Access Bailouts United States 2.3 2.2 2.8 1.7 2.7 Japan 2.8 4.3 1.7 2.0 2.4 Germany 3.7 5.3 3.3 2.1 2.8 France 3.5 4.4 3.0 2.6 3.3 Italy 3.7 4.8 2.8 3.2 3.2 United Kingdom 3.4 3.8 3.6 4.4 1.1 Canada 2.7 4.4 1.4 1.9 1.8 Finland 3.5 5.0 3.1 2.5 1.9 Greece 3.7 5.2 2.0 3.2 3.2 Mexico 3.1 3.6 3.0 2.5 3.1 Netherlands 3.5 4.7 4.5 1.4 2.0 New Zealand 3.8 5.4 3.9 2.1 2.3 Norway 3.1 4.1 3.0 2.5 1.8 Portugal 3.7 5.2 2.3 3.2 3.1 Spain 3.6 4.5 4.0 2.1 3.3 Sweden 3.4 4.9 3.3 1.9 2.4 Switzerland 3.0 5.1 2.3 1.4 1.7 Turkey 3.5 4.6 2.7 3.4 2.0 Czech Rep. 3.3 5.3 2.6 2.1 1.5 Hungary 2.8 4.0 2.8 2.2 1.0 Korea, Rep. of 3.5 4.9 3.3 3.0 1.5 Poland 3.3 5.0 2.6 2.5 1.6 Weight 0.374 0.232 0.225 0.169 Note: Indexes, which range from 0 to 6, are based on rotated factor loadings. The overall index is based on the first factor for the summary indexes, with 90 percent of the variance explained. Source: Author's calculations. Accession of Turkey to the European Union: Market Access and Regulatory Issues 139 FIGURE 4.2 Decomposition of Overall Transport Regulation Index 4.0 EU average 3.5 3.0 2.5 index 2.0 1.5 Composite 1.0 0.5 0.0 of Italy States Japan France Spain Sweden Turkey Poland Germany KingdomCanadaFinlandGreeceMexico ZealandNorwayPortugal Republic HungaryRep. Netherlands United Switzerland New United Czech Korea, Competition and price regulation Regulation of industry structure Public service obligation, regulated Government ownership and bailouts customer access Source: The author. given what is tolerated within the EU, there is no threats of pressure for restructuring, surges in clear indication that Turkey will need to realign its imports, or, as a consequence, significant income regulatory stance upon accession to the EU. This gains from the sector. The second set of issues situation probably reflects, in part, the country's involves regulatory convergence. Here, factor analy- already long history of regulatory alignment. sis of a database of regulatory variables indicates that, overall, the two regimes (Turkey and the EU) Summary and Conclusions are broadly consistent in their regulatory stance (e.g., degree of competition, price regulation, gov- This chapter has explored the possible implications ernment financial intervention). This consistency of Turkish accession to the EU, particularly regula- most likely reflects the long process of negotiation tory issues in the transport sector in Turkey. The and regulation that has accompanied evolution of transport sector is important to the general condi- the customs union. It means as well that pressure to tions for economic performance and growth. restructure for broad regulatory reasons may be Because it serves as an important intermediate minimal. input, both nationally and internationally, changes in the trade and regulatory regime of the sector can Annex 1: Tariff Equivalents have important economic effects. The chapter has for Transport Services addressed two sets of issues. The first is the quanti- tative impact, through direct trade and economy- This annex describes a basic methodology for the wide effects, of full membership. These effects have estimation of sector-specific gravity equations in been examined through reference to computable relation to global trade levels. The results are general equilibrium analysis and partial equi- reported in table 4.11. Basically, services trade data librium analysis. Because of the existence of the are fitted to a simple gravity model of total imports EU-Turkey customs union, deeper integration by country. These equations have been estimated at along this front does not appear to carry significant the level of transport services. 140 Turkey: Economic Reform and Accession to the European Union TABLE 4.11 Regression Results for Gravity Equation on Cross-Border Trade Regression Statistics Multiple R 0.967335 R-square 0.935736 Adjusted R-square 0.926556 Standard error 0.179688 Observations 25 ANOVA df SS MS F Significance F Regression 3 9.872914 3.290971 101.9261 1.12E-12 Residual 21 0.678044 0.032288 Total 24 10.55096 Coefficients Standard Error t Statistic Intercept 2.48491 1.213893 2.04706 log(POP) 0.901064 0.064715 13.92348 LOG (PCGDP) 1.43188 0.693996 2.063239 log(PCGDP)sq 0.0585 0.098696 0.59275 Source: Author's calculations. The gravity equations are estimated using ordi- cross-border trade in the sector at the EU15 level-- nary least squares with the variables that is, including all 15 member states. Barriers may emerge, however, at the level of individual member (4.1) Xi a1 ln(POPi) a2 ln(PCGDP)i states (see Francois, van Meij, and van Tongeren a3 ln(PCGDP)i 2 i forthcoming). where Xi represents imports from the world, POP represents population, and PCGDP per capita Annex 2: The Model income in the importing country. In the regressions, Hong Kong (China) is broken This annex describes the basic structure of the stan- out as a free trade"benchmark."Deviations from pre- dard multiregion computable general equilibrium dicted imports, relative to this free trade benchmark, model used in this study. The model is imple- are taken as an indication of barriers to trade. These mented in GEMPACK, a software package designed tariff equivalent rates are then backed out from a con- for solving large applied general equilibrium mod- stant elasticity import demand function as follows: els.6 It is solved as an explicit nonlinear system of equations, using techniques described by Harrison, T1 M1 1/e (4.2) = Horridge, and Pearson (2000).7 The national T0 M0 accounts data were organized into 24 sectors and Here, T1 is the power of the tariff equivalent (1 29 regions. The sectors and regions for this 24 29 t1) such that in free trade T0 1, and [M1/M0] is the aggregation of the data are detailed in table 4.12. ratio of actual to predicted imports (normalized rel- The data were taken from various sources. Data ative to the free trade benchmark ratio for Hong on production and trade are based on national Kong). In this reduced form, actual prices and con- accounting data linked through trade flows and stant terms drop out because ratios are formed. The drawn directly from the GTAP Version 5 dataset term e is the demand elasticity (taken to be 3.9). (GTAP 2001; also see Reinert and Roland-Holst, This approach yields an estimated tariff equiva- 1997, for a discussion of the organization of such lent for Turkey's imports of transport services of data for CGE models).The GTAPVersion 5 dataset is 8.9 percent, and the EU data reveal no barriers to benchmarked to 1997 and includes detailed national Accession of Turkey to the European Union: Market Access and Regulatory Issues 141 TABLE 4.12 Sectoring Scheme of Model Model Regions Model Sectors Australia and New Zealand Grains China Other agriculture Hong Kong (China) Mining Japan Other primary production Korea Sugar Taiwan Dairy Other ASEAN Meats Vietnam Processed foods Bangladesh Textiles India Clothing South Asia Leather Canada Wood and paper Mexico Chemicals United States Refineries Caribbean Basin Initiative countries Steel Andean Trade Pact Nonferrous metals MERCOSUR Motor vehicles Chile Electronics Other Latin America Other machinery European Union (EU15) Manufactures, NEC Central European Associates Trade, transport, communications Turkey Construction SACU Business services Botswana Other services Malawi Mozambique Rest of Southern Africa North Africa and Middle East Rest of world Note: ASEAN Association of South East Asian Nations; MERCOSUR Southern Cone Common Market (Mercado Común del Sur); SACU Southern African Customs Union; NEC not elsewhere classified. Source: Author's definition of model aggregation. input-output, trade, and final demand structures. land, labor, and capital and combining these with Significant modifications were made to the basic intermediate inputs. Firm output is purchased by GTAP database. The basic social accounting and consumers, government, the investment sector, trade data were supplemented with trade policy and other firms. Firm output also can be sold for data,including additional data on tariffs and nontar- export. Land is employed only in the agricul- iff barriers. The dataset was also updated to better tural sectors, while capital and labor (both skilled reflect actual import protection for goods and serv- and unskilled) are mobile between all production ices (for example, the basic GTAP database includes sectors. Moreover, capital is fully mobile within no information at all on trade barriers for services). regions. However, capital movements between regions are not modeled, but rather are held fixed in all simulations. Labor mobility is discussed below. General Structure All demand sources combine imports with The general conceptual structure of a regional domestic goods to produce a composite good, as economy in the model is represented in figure 4.3. indicated in figure 4.3. These are Armington Withineachregion,firmsproduceoutput,employing composites. 142 Turkey: Economic Reform and Accession to the European Union FIGURE 4.3 Armington Aggregation Nest taxes can be placed on domestic or imported inter- mediate inputs and may be applied at differential Armington rates that discriminate against imports. Where composite relevant, taxes are also placed on exports and on pri- mary factor income. Finally, where relevant (as indi- CES cated by social accounting data), taxes are placed on final consumption and can be applied differentially to consumption of domestic and imported goods. Domestic Composite Trade policy instruments are represented as goods imports import or export taxes/subsidies. This includes applied most-favored-nation tariffs, antidumping CES duties, countervailing duties, price undertakings, export quotas, and other trade restrictions. The one exception is services sector trading costs, which are M1 M2 MR discussed in the next section. Note: CES constant elasticity of substitution. The basic data on current tariff rates are taken Source: The author. from the UN Conference on Trade and Develop- ment (UNCTAD) and WTO data on applied and bound tariff rates, and they are integrated into the core GTAP database. These data are supplemented Dynamics with those from the U.S. Trade Representative (USTR) and U.S. International Trade Commission An important feature of the model is a dynamic (USITC) on regional preference schemes in the link, whereby the static or direct income effects of Western Hemisphere. For agriculture, protection is trade liberalization induce shifts in the regional based on OECD and U.S.Department of Agriculture pattern of savings and investment. These effects (USDA) estimates of agricultural protection, as have been explored extensively in the trade litera- integrated into the GTAP core database. Tariff and ture, including Baldwin and Francois (1999), Smith nontariff barrier estimates are further adjusted to (1976, 1977), and Srinivasan and Bhagwati (1980). reflect the remaining Uruguay Round commit- Several studies of the Uruguay Round have also ments, including the phasing out of the remaining incorporated variations on this mechanism. Such textile and clothing quotas under the Agreement on effects compound initial output welfare effects over Textiles and Clothing (ATC).Data on post­Uruguay the medium run and can magnify income gains or Round tariffs are taken from recent estimates losses. How much these "accumulation effects" will reported by Francois and Strutt (1999), which are supplement static effects depends on various fac- taken, in turn, primarily from the WTO's integrated tors, including the marginal product of capital and database, with supplemental information from the underlying savings behavior. This application World Bank's recent assessment of detailed pre­ and employs a classical savings-investment mechanism post­Uruguay Round tariff schedules. All of this (Francois, McDonald, and Nordstrom 1997), which tariff information was concorded to the model sec- means modeling medium- to long-run linkages tors. The services trade barriers are based on the between changes in income, savings, and invest- estimates described in Annex 1. ment. The results reported here therefore include changes in the capital stock and the medium- to long-run implications of such changes. Trade and Transport Costs International trade is modeled as a process that Taxes and Policy Variables explicitly involves trading costs, which include both Taxes are included in the theory of the model at sev- trade and transportation services. These trading eral levels. Production taxes are placed on interme- costs reflect the transaction costs of interna- diate or primary inputs, or on output. Some trade tional trade, as well as the physical activity of trans- taxes are modeled at the border. Additional internal portation itself. Those trading costs related to the Accession of Turkey to the European Union: Market Access and Regulatory Issues 143 international movement of goods and related logis- the services sector. These costs represent the real tic services are met by composite services purchased resource costs associated with producing a service from a global trade services sector in which the for sale in an export market instead of the domestic composite "international trade services" activity is market. Conceptually, a linear transformation tech- produced as a Cobb-Douglas composite of regional nology was implemented between domestic and exports of trade and transport services. Trade cost export services. This technology is represented in margins are based on reconciled free on board figure 4.4. The straight line AB indicates, given the (FOB) and cost, insurance, and freight (CIF) trade resources needed to produce a unit of services for data, as reported in Version 5 of the GTAP dataset. the domestic market, the feasible amount that can A second form of trade costs, known in the liter- instead be produced for export using those same ature as frictional trading costs, is implemented in resources. If there are no frictional barriers to trade in services, this line has a slope of 1. This free trade FIGURE 4.4 Trading Costs in the Services case is represented by the line AC. As trading costs Sector fall, the linear transformation line converges on the SDomestic free trade line, as indicated in the figure. Production Structure A The basic structure of production is depicted in fig- ure 4.5. Intermediate inputs are combined, and this composite intermediate is in turn combined in fixed proportions with value added. This yields sec- tor output Z. Composite Household and Final Demand Final demand is determined by an upper-tier SExport Cobb-Douglas preference function that allocates B C income in fixed shares to current consumption, Source: The author. investment, and government services. This process FIGURE 4.5 Basic Features of the Simulation Model Specification of production in a representative sector Production and trade flows Output Domestic Exports Leontief production Final demand Value Intermediate Primary Composite added inputs factors goods CES Leontief Imports Land Labor Capital Composite goods Note: CES constant elasticity of substitution. Source: The author. 144 Turkey: Economic Reform and Accession to the European Union yields a fixed savings rate. Government services are 3. Decision No. 1/98 of the EC­Turkey Association Council, produced by a Leontief technology, with house- February 25, 1998, on the trade regime for agricultural produc- tions (98/223/EC). hold/government transfers being endogenous. The 4. See Francois, McQueen, and Wignaraja (2003; technical lower-tier nest for current consumption is also annex) for a detailed discussion of the model. Also see the specified as a CDE (constant difference of elastici- related background report cited therein. 5. All dollar amounts are U.S. dollars unless otherwise indi- ties) demand function. The regional capital mar- cated. kets adjust so that changes in savings match 6. See Hertel (1996: chap. 2) for a detailed discussion of the changes in regional investment expenditures. (Note basic algebraic model structure represented by the GEMPACK code. The capital accumulation mechanisms are described in that the Cobb-Douglas demand function is a spe- Francois, McDonald, and Nordstrom (1996). cial case of the CDE demand function, as is the CES 7. More information can be obtained at http://www. or constant elasticity of demand specification. The monash.edu.au/policy/gempack.htm. Social accounting data are Cobb-Douglas version of the CDE is implemented based on Version 5 of the GTAP dataset (GTAP 2001), with an update to reflect post­Uruguay Round protection. through GEMPACK parameter files.) References Labor Markets Baldwin, R. E., and J. F. Francois. 1997. "The Costs and Benefits The default closure involves modeling labor markets of Eastern Enlargement: The Impact on the EU and Central as clearing with flexible wages. This fits with the Europe." Economic Policy 12 (24): 125­76. --------. 1999. Applied Issues in Dynamic Commercial Policy "long-run"approach in which labor markets tend to Analysis. Cambridge: Cambridge University Press. be more flexible.A situation is specified in which the Boylaud, O. 2000. "Regulatory Reform in Road Freight and basic structural rigidities of labor markets (and the Retail Distribution." Economics Department Working Paper No. 225, Organisation for Economic Co-operation and aggregate employment levels implied) are unaf- Development, Paris, August. fected by the simulations in the long run. However, Casas, F. R. 1984. "Imperfect Factor Mobility: A Generalization in implementation the mobility of labor between and Synthesis of Two-Sector Models of International Trade." Canadian Journal of Economics 17(4). sectors is slightly "sluggish" in the sense that there is Francois, J. F., and A. Strutt. 1999. "Post Uruguay Round not a perfectly linear transform technology for the Tariff Vectors for GTAP Version 4." Manuscript, Erasmus movement of labor between sectors. The implemen- University. tation of sluggish factor mobility represents the Francois, J. F., B. McDonald, and H. Nordstrom. 1996. "Trade Liberalization and the Capital Stock in the GTAP Model." assumption that, for institutional reasons (and GTAP consortium technical paper, http://www.agecon. because some skills are sector-specific), labor is not purdue.edu/gtap/techpapr/tp-7.htm. fully flexible in its application across sectors. This --------. 1997. "Capital Accumulation in Applied Trade Mod- els." In Applied Methods for Trade Policy Analysis: A Hand- representation of labor markets seems reasonable. book, ed. J. F. Francois and K. A. Reinert. Cambridge: To the extent that wage rigidities are important, the Cambridge University Press. direction of aggregate employment effects may be Francois, J. F., M. McQueen, and G. Wignaraja. 2003. "An Overview of EU FTAs." Paper presented at the Vienna World inferred from wage effects. (Hertel, 1996, refers to Economics Institute Workshop on WTO Issues, April. this as "sluggish" factor movements). A theoretical Francois, J. F., H. van Meij, and F. van Tongeren. 2005. "Trade discussion of factor mobility, along the lines devel- Liberalization under the Doha Round." Economic Policy oped in Hertel and employed here, can be found in 20(42): 349­390. GTAP (Global Trade Analysis Project). 2001. "The GTAP Ver- Casas (1984). In practice, the transformation elastic- sion 5 Dataset." Centre for Global Trade Analysis, Purdue ities are set very high (25.0), but not infinitely so. University. This effectively allows for almost full mobility. Harrison, G., D. Rutherford, and D. Tarr. 1997. "Economic Implications for Turkey of a Customs Union with the European Union." European Economic Review 41 (3­5): Notes 861­70. Harrison, W. J., J. M. Horridge, and K. Pearson. 2000. "Decom- 1. One might say that, in the eyes of the EU, when it comes to posing Simulation Results with Respect to Exogenous trading partners, "Everybody is special and unique, just like Shocks." Computational Economics 15: 227­49. everybody else." Hertel, T., ed. 1996. Global Trade Analysis. Cambridge: 2. The procedures for implementing the final phase of the Cambridge University Press. customs union in industrial products are set out in the Official Nicoletti, G., S. Scarpetta, and O. Boylaud. 1999. "Summary Journal of the European Communities 13.02.95 L 035, and in a Indicators of Product Market Regulation with an Extension to bilateral steel agreement. Employment Protection Legislation."Economics Department Accession of Turkey to the European Union: Market Access and Regulatory Issues 145 Working Paper No. 226, Organisation for Economic Co- --------. 1977."Capital Accumulation in the Open Two-Sector operation and Development, Paris. Economy." Economic Journal 87 (June): 273­82. Reinert, K. A., and D. W. Roland-Holst. 1997."Social Accounting Srinivasan, T. N., and J. N. Bhagwati. 1980."Trade and Welfare in Matrices." In Applied Methods for Trade Policy Analysis: A a Steady-State." In Flexible Exchange Rates and the Balance of Handbook, ed. J. F. Francois and K. A. Reinert. New York: Payments, ed. J. S. Chipman and C. P Kindelberger, chap. 12. Cambridge University Press. Amsterdam: North-Holland Publishing. Smith, M. A. M. 1976. "Trade, Growth, and Consumption in WTO (World Trade Organization). 1998. Trade Policy Review: Alternative Models of Capital Accumulation." Journal of European Union 1997. Geneva: WTO. International Economics 6 (November): 385­88. 5 The Turkish Telecommunications Sector: A Comparative Analysis Erkan Akdemir, Erdem Bas¸çi, and Gareth Locksley The telecommunications industry has many inter- The second and third aspects of the telecom- esting aspects.1 First, it is a network industry, with munications industry--its rapid technological high fixed costs and low marginal costs. Second, it progress and its role in providing the infrastructure is subject to rapid technological progress. Third, it for the information society and knowledge econ- serves as the infrastructure for the information omy--are central to investments and economic society and knowledge economy. Finally, it provides development. Private investments are becoming the direct utility to the end users of telecommunica- main source of technology development and capac- tions services. ity building in the telecommunications industry. The first aspect--the telecommunications in- Licensing and privatization are the two main chan- dustry as a network industry--has been a challenge nels to attracting initial private capital and paving to both economic theorists and policymakers in the way for further investments. Human capital for- general. How to maintain an efficient outcome by mation and innovation are facilitated by means of an appropriate mix of competition and regulation sharing knowledge at almost no cost. The easy inter- policies is still an active research area (e.g., Baumol action between universities and research institu- and Sidak 1994; Laffont and Tirole 1996, 2000; tions also encourages research and innovation. Armstrong 1997, 1998; Shy 2001). The legal and Moreover, easy access to networks promotes social regulatory arrangements have been evolving quite cohesion and inclusiveness. Finally, government- fast in the last decade as well (e.g., World Bank citizen and government-business relations are sim- 2000; OECD 2003; 1997 and 2002 acquis commu- plified through e-government projects. In this area, nautaire of the European Union on telecommuni- Turkey has signed the eEurope+ 2003 Action Plan cations services). Turkey has already adopted the along with other EU candidate countries. Some 1998 acquis of the European Union (EU) in tele- progress has been made in areas of liberalization communications, and it has shown some progress and licensing, but very little progress has been made in regulatory capacity building and liberalization of in privatization. mobile phone (GSM) services. A crucial milestone The fourth aspect of the telecommunications was reached in May 2004, when the first licenses for industry--its direct utility to the end users of the provision of voice telephony services by alter- telecommunications services--can be measured native operators were issued. roughly by the share of telecommunications 147 148 Turkey: Economic Reform and Accession to the European Union spending of households as a fraction of gross domes- A Quantitative Comparison tic product (GDP). Other indicators are per capita Broadly speaking, the Turkish telecommunications number of fixed plus mobile lines (teledensity) and sector is comparable with those of the accession Internet use and the urban-rural teledensity ratio. In countries2 that have with a similar level of GDP. some of these measures, Turkey has shown substan- Turkey scores better in terms of total teledensity tial progress; in others, it is still lagging behind. and the urban-rural teledensity ratio, but lags The focus in recent years, however, has shifted behind in Internet usage. from building infrastructure to regulatory and The total expenditure on telecommunications market structure issues. For example, using data services constitutes a significant portion of GDP in from 23 Organisation for Economic Co-operation both EU members and candidate countries. Fig- and Development (OECD) countries over the ure 5.1 shows this statistic to be about 3 percent for 1991­97 period, Boylaud and Nicoletti (2000) find both Turkey and candidate countries and slightly significant price, quality, and productivity effects lower for EU members. for both prospective and effective competition. They Figure 5.2 shows that in terms of fixed-line tele- measure prospective competition by the number of phones per household, Turkey scores better than years remaining until liberalization and measure both the candidate countries and the EU. However, effective competition by the share of new entrants in terms of the fixed-line penetration rate (i.e., the or by the number of competitors. Legal competi- number of fixed lines per 100 inhabitants) Turkey tion in fixed lines became effective in Turkey as of seems to lag behind (figure 5.3). The striking differ- January 2004. ence between figures 5.2 and 5.3 can be attributed Likewise, a recent paper by Fink, Mattoo, and to the large families in Turkey. Therefore, the rela- Rathindran (2002) based on data from 86 develop- tively low penetration rate in fixed lines need not be ing countries finds that both the privatization and seen as a deficiency. liberalization of fixed lines significantly increase The urban-rural teledensity ratio (Istanbul ver- mainline penetration and productivity. They also sus the rest of the country) is shown in figure 5.4. show that competition without privatization is not This figure reflects the fact that most of the invest- significant on these two performance measures. ments of Türk Telekom were carried out with the The sequencing also matters. According to Fink and implicit understanding that it would provide uni- his colleagues, simultaneous privatization and com- versal service throughout the country. The figure petition have a greater impact on mainline penetra- also is indicative of the significant investments tion than the privatization-before-competition scenario. The estimated quantitative impact of FIGURE 5.1 Telecommunications complete reform is 8 percent higher mainline pene- Revenue in GDP tration and 21 percent higher productivity com- Percent of GDP pared with the case of no reform. 4 This chapter is organized as follows. The first 3.4 section gives a quantitative comparison of recent 3.1 indicators for price, quantity, and quality of various 3 services for Turkey, EU member countries, and EU 2.6 accession countries. The second section summarizes developments in the liberalization and regulation of 2 the sector, and the third discusses the brief history of the privatization process for Türk Telekom. 1 A comparison of the legal infrastructure and insti- tutional aspects of Turkey's telecom sector with those of the EU follows in the fourth section. The 0 concluding section provides an overview of needs Turkey Candidate EU average assessment in market structure, legislative, regula- countries average tory, and taxation issues in light of EU accession and the eEurope+ Action Plan. Source: ITU 2001. The Turkish Telecommunications Sector: A Comparative Analysis 149 FIGURE 5.2 Households with Fixed-Line FIGURE 5.4 Largest City/Overall Country Telephone Service Teledensity Ratio Percent Ratio 100 2.0 90 87 86 1.7 80 77 1.5 1.5 70 1.2 60 50 1.0 40 30 0.5 20 10 0 0.0 Turkey Candidate EU average Turkey Candidate EU average countries countries average average Source: eEurope+ 2003. Source: ITU 2001. FIGURE 5.3 Fixed-Line Penetration Rates FIGURE 5.5 Investment in (fixed lines per 100 inhabitants) Telecommunications Number of lines Percent of revenue 80 40 29.7 60 57 30 23 40 36 20 29 11.9 20 10 0 0 Turkey Candidate EU average Turkey Candidate EU average countries countries average average Source: eEurope+ 2003. Source: ITU 2001. made by Türk Telekom during the 1980s. In 1980 Figure 5.5 also supports the investment slow- the ratio of Türk Telekom investments to the gross down reported by Yilmaz (2000). The slowdown national product (GNP) was about 0.3 percent. can be attributed largely to the financial squeeze in This ratio steadily increased to 1 percent of GNP in the government's budget and the use of TT profits 1987. Afterward, it sharply declined and fell back to contribute to the primary budget surplus of the on average to about 0.3 percent during the second general government under the International Mone- half of the 1990s (Yilmaz 2000). The significant tary Fund (IMF) program. slowdown in investments by TT brought stagnation The mobile penetration rate is also significant. in improvements in the fixed-line teledensity. According to figure 5.6, Turkey has a mobile 150 Turkey: Economic Reform and Accession to the European Union FIGURE 5.6 Mobile Penetration Rates FIGURE 5.8 Regular Users of Internet (per 100 inhabitants) in Population Number of mobile phones Percent 80 100 76 80 60 60 39 40 48 30 40 20 20 15 3 0 0 Turkey Candidate EU average Turkey Candidate EU average countries countries average average Source: eEurope+ 2003. Source: eEurope+ 2003. FIGURE 5.7 Households with Internet FIGURE 5.9 Internet Access Costs Access (purchasing power standard [PPS]­adjusted) Percent 100 Euros per hour 6 80 60 4 3.1 40 38 2 1.7 20 11 7 0.7 0 Turkey Candidate EU average 0 countries Turkey Candidate EU average average countries average Source: eEurope+ 2003. Source: eEurope+ 2003. penetration rate comparable with that of the candi- date countries. Given Turkey's population, this rate price of Internet services, and the second is related translates into a large mobile market in Europe. to the availability of Internet facilities--that is, data In line with the 2002 acquis and the eEurope+ lines and personal computers (PCs). 2003 Action Plan, Internet use and related data Figure 5.9 shows that the cost of connecting to services are also important. Figures 5.7 and 5.8 the Internet is significantly lower in Turkey than in indicate that both the Internet availability per the other countries. Connection prices are less than household and Internet use per individual are low half of the EU average and less than a quarter of the in Turkey compared with the rates even in the can- candidate countries' average. Thus the only possible didate countries. There are two possible explana- obstacle to use of the Internet in Turkey would tions for this observation. One is related to the be the availability of PCs. Although significant The Turkish Telecommunications Sector: A Comparative Analysis 151 progress has been achieved in recent years, mobile FIGURE 5.12 Personal Computer Use Internet technologies serve a niche market and do (estimated number of PCs per not seem to contribute to Internet penetration. 100 inhabitants) Likewise, figures 5.10 and 5.11 show Turkey as Number of PCs an outlier to the negatively sloped demand curve 35 33 on cost versus use of the Internet. 30 In Turkey, the PC penetration is low--only about 4 PCs per 100 persons, compared with about 25 FIGURE 5.10 Regular Use versus Dial-up 20 Access Costs of Internet (cost per hour, PPS­adjusted) 15 13 Euros 10 4.0 5 4 3.1 Candidate countries 0 3.0 Turkey Candidate EU average countries average 2.0 Source: eEurope+ 2003. 1.7 EU 1.0 13 PCs for candidate countries and 33 PCs for the 0.7 Turkey EU member states (figure 5.12). Therefore, low Internet use can be linked to low PC penetration 0.0 0 10 20 30 40 50 60 rates in Turkey. The 2002 "Progress Report" of 3 16 48 eEurope+ 2003 (2003) elaborates on the low PC use Regular users (percentage of population) in primary, secondary, and higher education in Turkey. The same document also points out that Source: eEurope+ 2003. Turkey does not have any public Internet access FIGURE 5.11 Penetration versus Dial-up points (PIAPs or telecenters).3 Access Costs of Internet As for the prices of fixed-line telephone services, (cost per hour in euros, both Turkey and other candidate countries have rel- PPS­adjusted) atively high call rates and relatively low fixed Euros monthly fees (see figure 5.13 for a comparison of 4.0 the fixed monthly access fees). Turkey, with an aver- age monthly fee of about 4, is below the averages of 3.12 Candidate countries both the EU and candidate countries. The country- 3.0 specific fixed access fees are reported in tables 5.1 and 5.2 in the chapter annex. Figure 5.14 compares local call rates. Turkey's 2.0 EU 1.70 price is slightly above the average for the candidate countries and significantly above the EU average. 1.0 Turkey's position can be attributed to Türk 0.68 TR Telekom's monopoly in fixed-line services. The country-specific local charges are given in tables 5.1 0.0 and 5.2 in the chapter annex as well. 0 5 10 15 20 25 30 35 40 One measure of quality of service is faults per 7 11 38 100 main lines per year. In this area, Turkey scores Percentage of households with Internet access worse than both the candidate and EU countries Source: eEurope+ 2003. (see figure 5.15). 152 Turkey: Economic Reform and Accession to the European Union FIGURE 5.13 Residential Monthly Access FIGURE 5.15 Quality of Service Fee (Including Value Added (faults per 100 main lines per year) Tax) for Fixed-Line Telephone Number of faults Service 75 Euros 20 56 50 15 14.5 29 10 25 7.2 8 5 4.3 0 Turkey Candidate EU average 0 countries Turkey Candidate EU average average countries Source: ITU 2001. average Source: World Bank 2002. FIGURE 5.14 Cost (Including Value Added FIGURE 5.16 International Telephone Traffic Tax) of a Three-Minute (minutes per subscriber) Economy Local Call Number of minutes Euros 280 0.20 253 240 200 0.15 0.129 160 0.107 0.10 120 115 80 0.05 0.05 39 40 0 0.00 Turkey Candidate EU average Turkey Candidate EU average countries countries average average Source: ITU 2001. Source: World Bank 2002. In the final measure--international calling-- liberalize its sector. To this end, in 1998 the Turkish Turkey, possibly because of its high international government had committed itself, in accordance tariffs, ranks far behind both the candidate and EU with World Trade Organization (WTO) guidelines, countries. to liberalize its fixed-line telephone network and services no later than the end of 2004. However, the telecommunications law (No. 4502) enacted in Competition Policy and Regulation January 2000 shifted the liberalization timetable to As of January 2004, Turkey's telecommunications the end of 2003. sector was fully open to competition, making After taking the important step of opening Turkey the last of the OECD countries to fully up fixed lines for competition, the government The Turkish Telecommunications Sector: A Comparative Analysis 153 addressed the institutional capacity of the inde- · As a state-owned corporation, Türk Telekom pendent Telecommunications Authority (TA), would find it difficult to undertake risky and Telekomünikasyon Kurumu. The TA was established ambitious projects and restructuring plans. by the 2000 telecommunications law. Some criticism was directed at the authority's initial composition Since 1994, when the postal and telecommuni- and the excessive amount of power that it was given cations services of the General Directorate of Post, to apply sanctions if national security or public Telegraph, and Telephone (PTT) were separated, order were imperiled (OECD 2002; Goldstein 2003). various attempts have been made to privatize Türk Nevertheless, the secondary legislation was broadly Telekom. Earlier attempts were turned down by the completed by the TA before January 2004. Supreme Court. After addressing the legal issues In fact, limited competition had been under way more carefully, the government offered a tender in in mobile phone services since 1994, when two pri- 2000 that left 51 percent of the shares with the Trea- vate firms, Turkcell and Telsim, were given the sury, but it was not successful in part because of rights to offer GSM services through revenue- poor market conditions in the telecommunications sharing agreements with Türk Telekom. In 1998 the sector worldwide. Law No. 4673 of May 2001 left a government sold the two operators licenses, by golden share of Türk Telekom to the Treasury, means of a concession agreement, to operate their which means, in fact, to one strong member of the GSM 900 networks for 25 years in return for board of directors. Türk Telekom employees are US$500 million apiece.4 entitled to 5 percent of the shares, and the remain- In April 2000,the Ministry of Transportation ten- ing are available for block sale or for initial public dered two new GSM 1800 licenses by means of con- offerings (IPOs). The restriction on foreign owner- cession agreements. A third license was reserved for ship was removed by the foreign direct investment Türk Telekom at the price of the first auction. law of 2004. Because of the auction design, only one of the In December 2003, the Council of Ministers licenses was sold, but. the revenue generated was adopted a new privatization plan for Türk Telekom. higher than expected. Is¸bank-Telecom Italia Mobile The plan called for a block sale of 51 percent of (TIM) consortium (Aria) won the first auction with shares in 2004. Since then, the valuation committee a bid of $2.5 billion. This number was then the min- and the tender committee have been preparing for imum price for the second auction,and thus the auc- that sale. Law No. 5189 of July 2004 provided tion attracted no bidders.5 Türk Telekom decided to further amendments to foster the privatization launch its own GSM 1800 operator, Aycell. As of the process. end of 2003, the four GSM operators--Turkcell, Telsim, Aria, and Aycell--had market shares of 68 percent, 18 percent, 7 percent, and 7 percent, Legal and Institutional respectively. The two small operators, Aria and Comparisons with the EU . Aycell, merged in 2004 under TT-Is¸bank-TIM with The most recent legal development in the EU is the the brand name Avea. acceptance of the 2002 acquis in telecommunica- tions. The European Parliament and the European Council approved and published a set of new direc- Privatization of Türk Telekom tives in 2002. The directives considered here are the The already delayed privatization of Türk Telekom framework directive, authorization directive, access bears urgency, because competition between the directive, and universal service directive. This sec- company and potential private entrants will not be tion, in light of the EU directives, describes the easy. Some of the difficulties facing Türk Telekom recent progress of Turkey in each area. It also com- in its competition with others are as follows: pares price regulation practices in EU and Turkey. · Turkey's Treasury does not permit the state- Framework owned corporation to borrow funds for invest- ments. The purpose of the 2002 EU legislation is to pro- · Only a small fraction of net profits can be used vide a common regulatory framework and compe- for investments.6 tition principles and practices for the electronic 154 Turkey: Economic Reform and Accession to the European Union communications sector, comprising telecommuni- conformity with Article 46(1) of the Treaty, in cations, media, and information technology serv- particular, measures regarding public policy, ices (the framework does not regulate content). public security and public health. (Emphasis The purpose of introducing the new directives is added.) to address the technological convergence observed A general authorization is available for every serv- in these three sectors. Under the framework ice provider. Yet the member states may at most directive, require a notification from the service provider. Other than the notification, no permissions or · Member states are to guarantee the independ- other administrative barriers to entry will be ence of the national regulatory authority (NRA). imposed (Article 3.2). In cases in which there is a · Telecommunication service providers have the technical need to limit the number of rights of use right of appeal against NRA decisions. granted, such as the allocation of radio frequencies, · NRAs are responsible for the gathering and dis- the selection criteria must be objective, transparent, semination of sector-related information. nondiscriminatory, and proportionate. Time limits · All potential service providers have the right to are imposed on the administration to finalize the install facilities in a timely, nondiscriminatory, applications (Articles 5.2, 7.4). and transparent manner. Although obtaining a general authorization is as · Facility sharing among service providers is nor- simple as it can be, an undertaking that does not mally voluntary, but the NRAs can also make it comply with the general conditions laid down compulsory under exceptional circumstances. by the NRAs may be subject to financial penalties · NRAs are responsible for identifying service and even be prevented from providing service providers that have a "significant market power" (Article 10). in the relevant market. In Turkey, the government monopoly on fixed- · In cases in which significant market power is line services dates back to 1924 and the telegram identified, the NRAs are supposed to impose and telephone law (No. 406). This monopoly regulations ex ante on the company with signifi- ended, however, at the beginning of 2004 under the cant market power. telecommunications law (No. 4502). Licensing was · If access and interconnection negotiations mentioned in legal arrangements for the first time between companies fail, the NRA resolves the in 1995, when a value added telecommunications dispute within four months. services regulation was enacted.In 2000 the telecom- munications law brought with it a new approach to In Turkey, an important reform process began in licensing. Based on this approach, the Ministry of 2000 in the telecommunications sector. The previ- Transportation issued a new telecommunications ous legislation, which dates back to 1924, was services regulation. amended. The new legislation is broadly compati- In May 2001, by means of Law No. 4673, the right ble with the EU perspective. In June 2001, Turkey, to issue licenses was transferred to the Telecom- along with the other EU candidate countries, was a munications Authority. Accordingly, the TA pub- signatory to the eEurope+ Action Plan by which it lished a Licensing Communiqué in 2002. The committed itself to achieving certain measurable communiqué states the conditions to be met by goals in the electronic communications sector. applicants, the time limits, and the other procedural details for issuing licenses. The minimum license fees Authorization are determined by the Council of Ministers. These fees are broadly consistent with the average adminis- The most recent EU document on licensing and trative fees set in the EU. related issues is the authorization directive In 2002, new licenses were issued by the TA. (2002/20/EC). The objective of the directive is These were general authorizations and telecommu- to create a legal framework to ensure the freedom nications licenses for some existing Internet serv- to provide electronic communication networks ice provider, very small aperture terminal, and and services, subject only to the conditions laid satellite platform operators. The licenses for long- down in this Directive and to any restrictions in distance telephony operators have been issued since The Turkish Telecommunications Sector: A Comparative Analysis 155 May 2004. Although some applications for telecom- fixed public telephone network connecting the munications services, such as fixed wireless access, network termination point at the subscriber's are outstanding, the TA is expected to issue licenses premises to the main distribution frame or equiva- in the fourth quarter of 2004. lent facility." The 2000 telecommunications law contains The access directive establishes the rights and clauses on licensing with four types of authoriza- obligations of operators regarding interconnec- tion: (1) authorization agreement, (2) concession tions and access. It also defines the NRA objectives agreement, (3) telecommunications license, and and procedures regarding access. The main points (4) general authorization. The approach in the EU are as follows: is general authorization and allocation rules for individual licenses for radio frequencies based on · Private negotiations between undertakings for competitive principles. In Turkey, the four different interconnections cannot be restricted by mem- arrangements for licensing are confusing and diffi- ber states. cult to implement. · Operators cannot be obliged to discriminate The latest telecommunications services reg- between different undertakings for equivalent ulation should be updated to reflect changes in service. legislation (mainly Law No. 4502 and No. 4673). · Operators are obliged to negotiate interconnec- Authorization agreements and concession agree- tion when others ask for it. ments could be converted to individual licenses, · The NRAs can impose, when necessary, obliga- and telecommunications licenses could be con- tionsonanoperatortofacilitateinterconnections. verted to general authorizations or permits. Rev- · Theobligationsmaybeimposedonlyonanobjec- enue share agreements also could be converted to tive, transparent, proportionate, and nondis- licenses. There is no genuine license concept in cur- criminatory basis. rent arrangements because the TA can change · With the permission of the European Commis- license conditions unilaterally. sion, the NRAs can impose additional measures related to access on operators with significant market power. Access The most recent EU documents regulating access to Likewise, the local loop unbundling regulation the network of other firms are the access directive aims to facilitate access to the "least competitive (2002/19/EC) and the regulation on unbundled segments of the liberalized telecommunications access to the local loop (No. 2887/2000). The access market." It is recognized that the new entries will be directive defines access as "the making available of difficult, given the high costs of fixed-line infra- facilities and/or services, to another undertaking, structure, and that the existing infrastructure has under defined conditions, on either an exclusive or been financed by monopoly rents.Yet the eEurope+ non-exclusive basis, for the purpose of providing Action Plan, in order to substantially reduce the electronic communication services" and intercon- costs of using the Internet, identifies unbundled nection as access to the local loop as a short-term priority. According to the local loop unbundling regula- the physical and logical linking of public com- tion, the NRA has the following responsibilities: munications networks used by the same or a dif- ferent undertaking in order to allow the users of · To identify notified operators (NOs) as those that one undertaking to communicate with users of have significant market power in fixed public the same or another undertaking, or to access telephone networks services provided by another undertaking. . . . · To ask NOs to publish a reference offer for unbun- Interconnection is a specific type of access imple- dledaccesstotheirlocalloopsandrelatedfacilities mented between public network operators. · To supervise NOs in their cost-based pricing and Local loop unbundling is based on the definition in in providing other operators with transparent, the local loop regulation in which the "`local loop' fair, and nondiscriminatory unbundled access to is the physical twisted metallic pair circuit in the the local loop. 156 Turkey: Economic Reform and Accession to the European Union The clauses in Turkey's Law No. 4502 on inter- Thus the main and secondary legislation for uni- connection and roaming are in harmony with the versal service needs to be put in place, and new pro- EU acquis. The law also includes a dispute resolu- grams should be developed for a low-user scheme tion mechanism for interconnection via the TA. and special needs. As for financing the burden of However, no direct legal basis exists for local loop the universal service organization, a fund or a unbundling. The secondary legislation for national budgetary mechanism must be established. roaming, interconnection, and local loop unbundling were put in place in 2002, 2003, and Price Regulation 2004, respectively. According to the EU acquis, only firms with signifi- cant market power can be regulated. The same Universal Service principle carries over to the telecommunications Universal service is defined in the 2002 acquis as services. National regulatory authorities are sup- "the provision of a defined minimum set of serv- posed to define the relevant markets and then, in ices to all end-users at an affordable price." The EU each relevant market, determine the presence of views universal service as an obligation of its mem- firms with SMP. Where SMP exists, the NRA would ber states (see Article 3.1 of the universal service implement price regulation. directive). However, care is taken not to distort the The economics literature discusses two possible market mechanism while safeguarding the public waysof priceregulation:pricecapregulationandrate interest (Article 3.2). of return (or cost plus) regulation. For price cap reg- The minimum service requirements in the uni- ulation,theregulatordeterminesa"reasonableprice" versal service directive can be summarized as the for the base year and then for the following years provision of applies a consumer price index (CPI) inflation - X percent adjustment on the base year's price.Price cap · Access to a fixed telephone at every reasonable regulation is desirable because it provides an incen- fixed location tive for a firm to find ways to cut its production cost. · Directory inquiry services and directories The disadvantages are a greater need to regulate the · Public pay phones quality of services and the difficulty encountered in · Special measures for disabled users setting the base price and the X factor--that is, the · Affordable tariffs expected growth in productivity (see Weisman 2002 · Adequate quality of service for an interesting discussion). Rate of return regula- · Number portability. tion also has negative aspects. First, the NRA must be cautious about the costs reported by the firm. How much of the obligation of universal service Second, the incentives to improve productivity and that should be allocated on the service providers thus cut costs are not there. has been greatly debated (see, e.g., Choné, Flochel, The trend in Europe, as well as in Australia, the and Perrot 2002 for a theoretical investigation). The United States, and South America, over the past universal service directive of the 2002 acquis 15 years has been toward implementing price cap imposes certain obligations on all undertakings, regulation (Weisman 2002: 350). In Turkey, the including the competitive ones, but it imposes extra price cap method is also used. Turkish telecom law obligations on firms with significant market power has several clauses on price regulation. The 2001 (Articles 16­19). Nevertheless, the financing of an Pricing (Tariff) Regulation and 2001 Price Cap important part of the universal service obligations Communiqué for SMP operators are in force. GSM is left to the member states (Articles 12­14). tariffs are subject to price regulation based on the In Turkey, universal service is covered by various operators' concession agreements. But their X laws, but no explicit mechanism is in place. The factor is fixed at 3 percent (CPI ­ 3 percent [CPI]), Ministry of Transportation is responsible for uni- which is much lower than that of Türk Telekom. versal service policy, and the burden is carried Türk Telekom is subject to price regulation as mostly by Türk Telekom. As for the rights of users, well. For the years 2002­03, the voice telephony the legislation contains no solid regulation, except services of TT were subject to an X factor of 7.5 per- for the general consumer rights protection law. cent, which was changed to 4 percent in 2004. By The Turkish Telecommunications Sector: A Comparative Analysis 157 contrast, the leased-line tariffs price cap method that the TA be strengthened in its technical, legal, was used for 2002. The TA approved cost-based and economics capabilities. Finally, after full liberal- tariffs for leased lines in 2004, which were in force ization of the sector, the successful privatization of by June 2004. Türk Telekom would benefit not only the sector but Another important issue lagging behind sched- also significantly benefit the Turkish economy. ule for the TA and Türk Telekom is the rebalancing of the local, long-distance, and international prices of TT. Rebalancing is central to price regulation. Annex: Price Comparisons The new structure, which is based on a monthly FIGURE 5.17 Basket of National rental fee and a reduction in the tariffs of national Calls and international calls in order to eliminate cross Euros per month subsidy, came into effect in August 2004. A whole- 90 sale tariff is needed for resale and new entrants. For GSM operators, the inconsistency between 80 their concession agreements and tariff regulation 70 should be removed. For operators with significant 60 market power, a flexible price regulation similar to 50 the one in the EU should be followed. 40 30 Conclusion and Recommendations 20 The liberalization of telecommunications services Business, excluding value added tax 10 Residential, including value added tax in the EU has had a substantial impact. During 0 1998­2002, the prices of telecommunications serv- 1998 1999 2000 2001 2002 ices fell substantially, ranging from 14 percent in Note: Figure shows estimates of the average monthly residential national calls to 70 percent in interna- spending by a typical "European business/residential tional business calls (see figures 5.17 and 5.18 in the user" for fixed national calls. chapter annex). Turkey is also expected to benefit Source: European Commission 2002. from a reduction in prices and increase in quality by adopting the EU regulatory framework and by liberalizing the market for fixed lines. This chapter has shown that Turkey scores rea- FIGURE 5.18 Basket of International Calls sonably well when compared with the EU candi- Euros date countries in terms of the significance of 1.8 telecommunications services in GDP, the mainline and mobile penetration rates, the urban to rural 1.6 penetration rates (i.e., universal service), and Inter- 1.4 net service prices. However, performance needs to 1.2 be improved in some areas. Examples are invest- 1.0 ments in fixed lines such as fiber cables, Internet usage, tariff rebalancing by means of higher fixed 0.8 access fees and lower marginal fees, and the quality 0.6 of services offered by Türk Telekom. 0.4 Therefore, a clear need exists for a new, single Business, excluding value added tax 0.2 telecommunications act that would update the Residential, including value added tax 0.0 century-old telegraph and telephone law (Law 1998 1999 2000 2001 2002 No. 406), eliminate conflicting clauses in the amend- ing laws, and harmonize with EU regulations. The Note: Figure shows the average price of a single call from the originating country to all other OECD desti- main problems facing Turkey are related to the nations. A full description of the methodology can be implementation of the new legislation and, by impli- found in OECD 1990. cation, the quantitative targets. It is also important Source: European Commission 2002. 158 Turkey: Economic Reform and Accession to the European Union Annex: TABLE 5.1 Monthly Residential Access Fee and Local Call Tariffs: 15 EU Member States and Washington, DC, July 1, 2002 Monthly Residential Cost of Three-Minute Local Access Fee, Including Value Economy Call, Including Country Added Tax (euros) Value Added Tax (euros) Austria 17.44 0.09 Belgium 16.20 0.12 Denmark 15.74 0.08 Finland 13.79 0.16 France 12.55 0.13 Germany 12.69 0.05 Greece 11.77 0.09 Ireland 19.60 0.04 Italy 14.88 0.07 Luxembourg 18.40 0.05 Netherlands 16.42 0.07 Portugal 14.10 0.17 Spain 13.54 0.08 Sweden 13.25 0.08 United Kingdom 15.51 0.05 EU average 14.46 0.05 Washington, DC 10.67 0.05 (Verizon), low-user, flat fee per call (excluding tax of $2.69 and other charges and levies of $6.00) Source: World Bank 2002. TABLE 5.2 Monthly Residential Access Fee and Local Call Charges: 13 EU Preaccession Countries (PAC), March 31, 2002 Monthly Residential Cost of Three-Minute Local Access Fee, Including Value Economy Call, Including Country Added Tax (euros) Value Added Tax (euros) Bulgaria 3.00 0.022 Cyprus 9.50 0.076 Czech Republic 9.70 0.136 Estonia 5.90 0.096 Hungary 12.30 0.111 Latvia 6.30 0.143 Lithuania 5.50 0.130 Malta 5.30 0.132 Poland 11.80 0.970 Romania 3.50 0.940 Slovakia 5.90 0.141 Slovenia 9.90 0.084 Turkey 4.30 0.129 PAC average 7.15 0.107 Source: PWC Consulting 2002. The Turkish Telecommunications Sector: A Comparative Analysis 159 Notes Fink, C., A. Mattoo, and R. Rathindran. 2002. "Liberalizing Basic Telecommunications: Evidence from Developing Countries." 1. The authors would like to thank Izak Atiyas, Andrea Paper presented at the OECD-World Bank Services Experts Goldstein, Sübidey Togan, Kamil Yilmaz, Tolga Kiliç, and S¸ahin Meeting, Organisation for Economic Co-operation and Ardiyok for their comments and encouragement. The usual dis- Development, Paris. claimer applies. Goldstein, A. 2003. "The Political Economy of Regulatory 2. In this chapter, the term accession or candidate countries Reform: Telecoms in the Southern Mediterranean." Paper refers to the 10 countries that joined the EU in May 2004, presented at the Fourth Mediterranean Social and Political together with Bulgaria and Romania. Research Meeting, Florence-Montecatini Terme. 3. PIAPs are government-initiated centers within the context ITU (International Telecommunications Union). 2001. "World of universal service policies. Telecommunications Indicator." March. 4. All dollar amounts are U.S. dollars unless otherwise Klemperer, P. 2002. "How (Not) to Run Auctions: The European indicated. 3G Telecom Auctions." European Economic Review 46: 5. The auction design for mobile phone service licenses is 829­45. heavily discussed in the literature, especially after the so-called Laffont, J. J., and J. Tirole. 1996. "Creating Competition through UMTS auction tragedy in Europe (UMTS is a third-generation Interconnection: Theory and Practice." Journal of Regulatory mobile system). See Klemperer (2002) and van Damme (2002) Economics 10: 227­56. for possible reasons why the UMTS auctions in Europe during --------. 2000. Competition in Telecommunications. 2000 and 2001 produced incredibly different outcomes. Cambridge, MA: MIT Press. 6. See the paper by Li, Qiang, and Xu (2001) for cross- Li, W., C. Z. Qiang, and L. C. Xu. 2001. "The Political Economy country evidence that supports the "cash cow" hypothesis, of Privatization and Competition: Cross Country Evidence among other reasons, for delayed privatization of the telecom- from Telecommunications Sector." World Bank, Washing- munications sector. ton, DC. OECD (Organisation for Economic Development and Co- operation). 2002. "Regulatory Reform in the Turkish References Telecommunications Industry." In Review of Regulatory Reform in Turkey. Paris: OECD. Armstrong, M., 1997. "Competition in Telecommunications." --------. 2003. Communications Outlook. Paris: OECD. Oxford Review of Economic Policy 13: 64­82. PWC Consulting. 2002. "1st Report on Monitoring of EU --------. 1998. "Network Interconnections." Economic Journal Candidate Countries (Telecommunication Services Sector)." 108: 545­64. July 25, Brussels. Baumol, W. J., and G. Sidak. 1994. Toward Competition in Local Shy, O. 2001. The Economics of Network Industries. Cambridge: Telephony. Cambridge, MA: MIT Press. Cambridge University Press. Boylaud, O., and G. Nicoletti. 2000. "Regulation, Market Struc- van Damme, E. 2002. "The European UMTS-Auctions." Euro- ture and Performance in Telecommunications." Economics pean Economic Review 46: 846­58. Department Working Paper No. 237, Organisation for Weisman, D. L. 2002."Is There`Hope' for Price Cap Regulation?" Economic Co-operation and Development, Paris. Information Economics and Policy 14: 349­70. Choné, P., L. Flochel, and A. Perrot. 2002. "Allocating and World Bank. 2000. Telecommunications Regulation Handbook. Funding Universal Service Obligations in a Competitive http://www.infodev.org/projects/314regulationhandbook. Market." International Journal of Industrial Organization --------. 2002. European Universal Service Atlas. Washington, 1247­76. DC: World Bank. eEurope+ 2003. 2003. "eEurope+ Progress Report." Prepared by Yilmaz, K. 2000. "Türk telekomünikasyon sektöründe reform: the EU membership candidate countries with the assistance özelles¸tirme, düzenleme ve serbestles¸me" [Reform in the of the European Commission, Ljubljana, June 3­4, 2002. Turkish Telecommunications Sector: Privatization, Regula- European Commission. 2002. "Eighth Report from the Com- tion and Liberalization]. In Devletin Düzenleyici Rolü [The mission on the Implementation of the Telecommunications Regulatory Role of the State], ed. Izak Ati yas. Istanbul: Regulatory Package. COM(2002) 695. Brussels. TESEV Yayinlari. 6 Accession to the European Union: Potential Impacts on the Turkish Banking Sector Ceyla Pazarbas¸ioglu Turkey's prospects of accession to the European initial fiscal costs of the resolution of the Turkish Union (EU) are highly dependent on the progress banking crisis were about 50 billion (about made with political and economic reforms.1 Of 34 percent of the gross domestic product, GDP), these reforms, financial sector­related issues are an which, with servicing costs, implies an annual cost important component of the criteria associated of 5 billion. These restructuring costs must be with full membership. Most of the issues are con- taken into account in an assessment of the potential centrated in the banking sector, because banks costs to the Turkish banking sector of EU accession. account for more than 90 percent of the total assets In effect, much of the adjustment costs have already of the Turkish financial system. been borne because of the major bank restructur- Turkey adopted a comprehensive disinflation ing that took place during 2001­03. program, supported by the International Monetary In implementing structural reforms, Turkey has Fund (IMF), at the beginning of 2000. Before met nearly all of the conditions set for the banking adoption of this program, macroeconomic instabil- sector so that it complies with EU norms.Indeed,the ity, crowding out by the public sector, systemic dis- sector has made the necessary amendments as dic- tortions created by state banks, inadequate risk tated by the Turkish"National Program,"which puts assessment and management systems, and a lack of forth the criteria for accession to the EU.Setting cap- independent and effective supervision were all fac- ital adequacy standards, redefining "own funds" and tors contributing to the major structural weak- subsidiaries,setting related lending limits,regulating nesses of the Turkish banking system. In September accounting practices, and ensuring transparency of 2000, the Banking Regulation and Supervision financial reporting are among the issues addressed Agency (BRSA), an independent institution with in the recent regulations that have been adopted and responsibility for regulating and supervising the that are in full compliance with EU principles. banking sector, began operations. Soon after its for- Despite the relatively small asset size and low mation, the BRSA had to manage a major banking degree of intermediation of the Turkish financial crisis brought on by the escalating political uncer- system, Turkey's potential and its regional situation tainties, the loss of credibility by the exchange rate make it an attractive market. The entry of foreign regime, and, finally, the abolition of the pegged banks into Turkey's financial markets is expected to exchange rate system in February 2001. enhance competition in the financial sector and As in many other countries, the restructuring of improve the quality of banking services and finan- Turkey's banking sector has been very costly. The cial products. Furthermore, the Turkish banking 161 162 Turkey: Economic Reform and Accession to the European Union system, with its high-technology systems and The exchange rate­based disinflation program regulatory compliance, is a strong candidate for introduced in January 2000 had a major impact on becoming a member of the EU financial system. banks' balance sheets. Deposit and lending rates fell The remainder of this chapter is organized as sharply during the initial stages of the program's follows. The next section provides an overview of implementation phase. Funding in foreign currency the major reforms undertaken in restructuring the became cheaper because of the preannounced Turkish banking sector during 2001­03 and the exchange rate and the real appreciation of the associated costs.2 That overview is followed by a Turkish lira.As a result, banks borrowed short term, comparison of the Turkish banking sector with leading in turn to a maturity mismatch because those of the EU member states and other EU acces- outstanding loans had longer durations. Moreover, sion countries in order to evaluate the impact of the open foreign currency positions increased sharply. greater competition that may result from joining The financial crises of November 2000 and February the EU. The chapter then summarizes the current 2001 led to the abolition of the pegged exchange situation in relation to compliance with EU bank- rate system and triggered another severe hit on the ing legislation. The final section is devoted to an Turkish banking sector. assessment of the general findings. The Bank Restructuring Strategy The Restructuring of the Turkish The Banking Regulation and Supervision Agency, Banking Sector and Related Fiscal Costs established in 2000, is a financially and administra- tively independent institution funded by the pre- Intheearly1980s,theTurkisheconomyunderwenta miums collected from Turkish banks. Before the significant policy shift from financial repression formation of the BRSA, the Undersecretariat of toward liberalization. Compared with its stance Treasury was responsible for preparing and issuing before the 1980s, Turkey became an outward- prudential banking regulations and conducting oriented economy and experienced significant bank examinations under the Banks Act, and the changes in foreign trade and external capital move- Central Bank of the Republic of Turkey conducted ments. During the same period, Turkey also experi- off-site monitoring of banks under the Central encedhighinflation,coupledwithhighpublicsector Bank Act. deficit financing. High real interest rates and greater In May 2001, in the aftermath of the crises, the macroeconomic instability became the defining BRSA announced the Banking Sector Restructuring features of the Turkish economy after the 1980s. Program (see BRSA 2001). The main objective of Turkey's banks therefore found themselves oper- the program was to eliminate distortions in the ating in an environment of macroeconomic insta- financial sector and adopt regulations to promote bility, characterized by high and volatile inflation an efficient, globally competitive, sound Turkish rates and fragile external capital flows. Because of banking sector (see figure 6.1). The restructuring the high interest rates resulting from the high program was based on four main pillars: (1) restruc- public sector deficits, banks invested in risk-free turing the state banks, (2) seeking prompt resolu- government securities. The systemic distortions tion of the intervened banks, (3) strengthening the created by the state banks and the inadequate risk private banks, and (4) strengthening the regulatory management and internal control procedures of and supervisory framework. Despite various chal- the sector exacerbated the vulnerability of the lenges, much progress has been achieved in all of banks to financial crises. In the aftermath of the these areas. 1994 financial crisis, the strength of the Turkish As in many other countries, the costs of re- banking sector was severely tested. The recovery structuring the banking sector have been high (see that began in 1995 was negatively affected by the table 6.1). During the restructuring of the state East Asian and Russian crises of 1997­98. The dev- banks (the first pillar), the Treasury issued govern- astating earthquakes of 1999 also had negative ment bonds worth about 18 billion in 2001 to effects on the Turkish economy in general and the securitize the state banks' losses arising from subsi- banking sector in particular. dized lending (so-called duty losses). At the same Accession to the European Union: Potential Impacts on the Turkish Banking Sector 163 FIGURE 6.1 Turkish Bank Restructuring Strategy State bank reform Strong capital Sound banking base Banking Sector Cost Restructuring efficiency Strong Program economy and sustainable Efficient growth supervision environment Market discipline and transparency Corporate Structural reform restructuring · Macroeconomic stability Source: The author. TABLE 6.1 Initial Fiscal Costs of Turkish Operational restructuring was a very important Banking Crisis, 2000­01 component of the overall restructuring of the state banks. The number of branches was reduced from Cost in 2,494 as of December 2000 to 1,685 as of December 2001 Ratio of Cost (billion to 2001 2002, and the number of personnel was reduced euros) GDP (%) to 30,399 from 61,601. State banks became more efficient in organization, technology, human State banks' duty 18.5 12.8 losses resources, financial control, planning, and risk Capital support to 2.9 2.0 management, so that they can operate in line with state banks the requirements of modern banking and interna- Resolution of SDIF 27.1 18.7 tional competition. banks The second pillar of the restructuring strategy Public resources 24.6 17.0 was the resolution of the banks taken over by the Private resources 2.5 1.7 Savings Deposit Insurance Fund (SDIF). The SDIF, Total costs 48.5 33.5 run by the Central Bank of Turkey since 1983 with the mandate to insure saving deposits, was also Source: Banking Regulation and Supervision charged with resolving insolvent banks in 1994. It Agency of Turkey. was transferred to the BRSA on August 31, 2000. time, legislation was introduced to prevent the Twenty banks were transferred to the SDIF during future accumulation of duty losses. Meanwhile, the 1997­2002. An Asset Management Unit was created banking license of the third largest state bank and charged with recovering the value of the assets (Emlak) was revoked, and the management of the of the banks taken over by the SDIF. As of the date remaining two state banks, Ziraat and Halk, was of transfer, the total liabilities of the banks taken strengthened through the establishment of a joint over were 33 billion, and the total losses of these board of management. The total resources trans- banks amounted to about 18 billion. ferred to the state banks to eliminate duty losses The funds needed for the resolution of the banks and to provide capital support amounted to about in which the SDIF intervened were met by govern- 22.5 billion as of the end of 2001. ment bonds issued by the Treasury (18.5 billion) 164 Turkey: Economic Reform and Accession to the European Union and the SDIF's own resources (5 billion). The schedules and statements focused on four areas: main source of the SDIF revenues were premiums (1) capital adequacy, (2) credit portfolio and coun- collected from the banking sector, as well as pro- terpart risk, (3) risk groups to which the bank ceeds from the sale and collection of the assets of belongs, and (4) structured transactions and other the intervened banks. Thus the private sector also income recognition issues. shared the burden of the costs of restructuring. In preparation of the financial statements the fol- To avoid even greater losses and to accelerate the lowing central issues were taken into consideration: resolution process, the SDIF has subjected the trou- bled banks to an intensive financial and operational · Inflation accounting restructuring. The speed of the resolution has been · Consolidated reporting very rapid compared with the international experi- · Inclusion of material changes to financial state- ence. As of May 2003, only two banks remained ments after December 2001 under management of the SDIF. One was a bridge · Special issues related to the assessment bank used for asset management purposes; the · Loan portfolio assessment and provisioning other bank was put up for sale. · Evaluation of derivative instruments The third pillar of the restructuring strategy was · Evaluation of swap bonds the establishment of a sound private banking sec- · Valuation of foreign currency accounts. tor. The financial structure and profitability of the private banks deteriorated sharply in the aftermath The bank recapitalization phase began with the of the crises. During the first stage of the restruc- BRSA's notification to the banks. During this phase, turing program, measures were put in place to ordinary general assemblies were convened, and the recapitalize the private banks, limit foreign cur- financial situation of the banks, as determined dur- rency open positions, and encourage mergers and ing the assessment phase, was presented to the acquisitions. In line with the program, important shareholders. The shareholders made the required steps were taken toward strengthening the capital resolutions for the recapitalization of the banks base of the private banks with their own resources. whose capital adequacy ratio fell below the 8 per- The deeper-than-expected recession in 2001 cent minimum required. and the general global economic conditions high- The public recapitalization phase was designed to lighted the need to further bolster the private banks provide public capital support for solvent banks by strengthening their capital through public sup- that did not satisfy the minimum capital adequacy port if necessary, by resolving the nonperforming ratio (8 percent) on a pari passu basis with the loans of the banking sector through the Istanbul majority shareholders. The public support took the Approach,3 and by establishing asset management form of a capital injection or subordinated debt companies. with the appropriate contingencies and safeguards. The recapitalization program consisted of three phases.4 During the assessment phase, the financial Banking Sectors in the EU status of all private commercial banks using inter- and Turkey: A Comparison national accounting standards was obtained by of Structural Indicators means of a three-phase audit procedure carried out This section presents an overview of the structural on a fair and impartial basis. An independent audit characteristics of the Turkish banking sector and company appointed by the bank undertook the first compares these characteristics with those of the audit. A second audit was conducted by another banking sectors of the EU member countries as independent audit company to ensure that the first well as the countries included in the EU enlarge- audit was carried out according to the agreed-on ment process.5 principles. The BRSA conducted the final audit. This multiphase auditing procedure was utilized to Concentration Ratio, Entry to the Sector, Public increase transparency and credibility. The audits Share, and Capital Adequacy were based on the financial statements of the banks, as well as on the supplementary reporting The five largest Turkish banks have a market share schedules completed, based on the detailed instruc- of 60 percent of total assets, which is similar to the tions of the BRSA. The supplementary reporting average for the EU's five largest banks (see figure 6.2 Accession to the European Union: Potential Impacts on the Turkish Banking Sector 165 FIGURE 6.2 Concentration Ratios of Five FIGURE 6.3 Share of Assets of State-Owned Largest Banks, 2003 Banks, 2003 (percent) (percentage of total assets) Percent Percent 72 70.8 35 32.7 70 30 68 25 66 64 20 62.8 62 15 60.0 60 11 10 7.6 58 5 56 54 0 EU average Candidate Turkey EU average Candidate Turkey countries (June 2004) countries (June 2004) average average Sources: World Bank, and the Banking Regulation and Sources: World Bank, and the Banking Regulation and Supervision Agency of Turkey. Supervision Agency of Turkey. and annex 1).6 This ratio is a little higher for the EU FIGURE 6.4 Capital Adequacy Ratios, 2003 candidate countries, reflecting the entry of large (percent) foreign banks in the financial markets of these Percent countries. The concentration of the large Turkish 30 banks is significantly higher than in the late 1990s 25.42 because of the significant merger and acquisition 25 activities, as well as the state's intervention into the failed banks. The launching of negotiations with 20 16.67 the EU and thus the expected "convergence play" 15 are likely to generate more consolidation in the 12.5 banking industry and increased interest by both 10 domestic and foreign participants. The 11 million in capital required to license a 5 bank in Turkey is in line with the EU average of 12 million (see annex 1, table 6.3). Licensing 0 requirements have become much more onerous in EU average Candidate Turkey countries (June 2004) Turkey since the bank failures of 2000­01. average Although the withdrawal of the state from the banking sector in many EU member countries is Sources: World Bank, and the Banking Regulation and Supervision Agency of Turkey. significant, state banks still play a dominant role in Turkey, accounting for one-third of total assets as of June 2004 (see figure 6.3). However, a key pillar ratio that measures a bank's capital as a percentage of the bank restructuring strategy (as discussed in of its risk-weighted assets--is a regulatory require- the earlier section) is the restructuring and privati- ment intended to ensure that banks maintain ade- zation of state banks. quate capital to support their risk exposures. The The average capital adequacy ratio of the Turkish capital adequacy ratio of a bank is a good indication banking system is high compared with the EU aver- of its vulnerability to potential shocks and thus the age and that of the candidate countries (see fig- health of that bank. The capital adequacy regula- ure 6.4). A minimum capital adequacy ratio--the tions in Turkey are in line with those of the EU. 166 Turkey: Economic Reform and Accession to the European Union Deposit Insurance as of the end of 2003 an EU member country had on average 500 banks with 11,500 branches and An explicit full deposit guarantee for the banks in 140,000 employees (see annex 1, table 6.3). As of which the state intervened was extended to avoid end of June 2004, Turkey had 49 banks with 6,000 the deposit runs that occurred during the 2001 branches and 126,000 employees. financial crisis in Turkey. However, because of the An average EU bank is almost twice as large as distortions and the moral hazard such a blanket an average Turkish bank. The average asset size per guarantee creates, the BRSA subsequently imple- bank (calculated as total assets divided by number mented a partial deposit guarantee system in line of banks) in EU countries is about 5.3 billion, with EU regulations. This system was put into place compared with about 3.1 billion in Turkey. The in 2004 with a one-year notice period. average asset size of banks in the candidate coun- Compared with the GDP and per capita national tries is about 1 billion (see figure 6.6). income of the EU countries,it can be argued that the level of protection of deposits in Turkey--27,000 An average bank in Turkey has 125 branches, per account holder--is very high.7 Although the much higher than the comparable number for EU member and EU candidate countries. In the EU level of deposit protection (guarantee or insurance) varies between 20,000 and 60,000 in the EU member countries, the average number of branches per bank is 36, and the average number of employ- countries, the average amount of insured deposits is about 29,000 (figure 6.5). The average deposit ees per branch is 27 (see figures 6.7 and 6.8). Simi- guarantee amounts to nearly 13,000 in the candi- lar figures apply to the EU candidate countries. The date countries.8 average number of personnel per branch in Turkey is 21, which is comparable to that of EU member and candidate countries. Number of Banks, Average Size, and the Staff Employed Asset, Deposit, and Loan Indicators Compared with EU averages, the Turkish banking system has fewer banks that have a high-density net- The total asset size of the banking system of Turkey works and a high level of employment. Although is about 152 billion, compared with the EU aver- there is wide variance among EU member countries, age of 1.7 trillion. One of the large banks in FIGURE 6.5 Size of Deposits Subject to FIGURE 6.6 Average Bank Size, 2003 Insurance, 2003 (total assets per number of banks, in (euros) millions of euros) Euros Value (millions of euros) 40,000 6,000 5,323 35,000 5,000 30,000 28,973 27,691 4,000 25,000 3,113 20,000 3,000 15,000 12,892 2,000 10,000 1,024 1,000 5,000 0 0 EU average Candidate Turkey EU average Candidate Turkey countries (June 2004) countries (June 2004) average average Sources: World Bank, and the Banking Regulation and Sources: European Banking Federation and Banking Supervision Agency of Turkey. Regulation and Supervision Agency of Turkey. Accession to the European Union: Potential Impacts on the Turkish Banking Sector 167 FIGURE 6.7 Number of Branches FIGURE 6.9 Selected Indicators, 2003 per Bank, 2003 (percent) Number of branches Percent 140 450 422 125 EU average 400 120 Candidate countries average 350 Turkey (June 2004) 100 300 80 250 60 200 169 147 150 40 36 33 111 100 64 69 55 20 50 40 20 0 0 EU average Candidate Turkey Assets/GDP Deposits/GDP Loans/GDP countries (June 2004) average Sources: World Bank, Banking Regulation and Supervision Agency of Turkey, European Banking Sources: European Banking Federation and Banking Federation, and Eurostat. Regulation and Supervision Agency of Turkey. 147 percent in the EU member countries and 55 per- FIGURE 6.8 Number of Personnel cent in candidate countries.Similar observations can per Branch, 2003 be made about deposit mobilization (figure 6.9). Number of personnel 30 27 Profitability 25 25 The return on equity of Turkish banks has been 21 20 very volatile, reflecting the macroeconomic devel- opments. For example, the ratio of the term profit9 15 of the Turkish banking sector to total equity (return on equity) was -80 percent as of December 2001,10 10 reflecting the financial crises of 2000­01 and the adoption of inflation accounting (figure 6.10). 5 During 1995­2000, this ratio averaged about 22 percent. However, these figures are estimated to 0 be close to the 8­10 percent levels under inflation EU average Candidate Turkey countries (June 2004) accounting. The average return on equity of the EU average member countries' banks was about 10 percent Sources: European Banking Federation and Banking (after deduction of tax and extraordinary items) in Regulation and Supervision Agency of Turkey. 2003 (see figure 6.11 and annex 1).11 However, the return on equity of the large-scale banks is much higher than that of the other bank segments. Europe, Deutsche Bank, had total assets of about 803 billion as of December 2003, which is five and a half times larger than that of the whole Turkish Income, Expenditure, and Cost Structure banking sector. In terms of the ratio of loans to GDP, Turkey fares In banks in the EU countries, net interest income poorly, reflecting the crowding out of the real sector accounts for almost 60 percent of total income, but by the government. The loans-to-assets ratio was it accounts for only 14 percent of the total income 20 percent in Turkey in June 2004, compared with of Turkish banks. The share of other operating 168 Turkey: Economic Reform and Accession to the European Union FIGURE 6.10 Return on Equity: Turkey and FIGURE 6.12 Personnel Expenses EU Banking Sectors, 2003 to Total Assets, 2003 (percent) (percent) Percent Percent 15 0.90 0.88 0.88 0.86 9.87 10 0.84 8.03 6.75 0.82 0.80 5 0.79 0.78 0.76 0 0.74 European Turkey Turkey European Union Turkey (June 2004) Union (June 2003) (June 2004) Sources: EU Banking Sector Stability (European Central Sources: EU Banking Sector Stability (European Central Bank 2004) and Banking Regulation and Supervision Bank 2004) and Banking Regulation and Supervision Agency of Turkey. Agency of Turkey. Figure 6.13 Personnel Expenses to Total Expenditures, 2003 FIGURE 6.11 Return on Equity of EU Banks (percent) by Asset Size, 2003 (percent) Percent 80 Percent 20 61.43 60 15 40 10.89 9.87 10 8.73 6.2 20 12.51 5 0 European Union Turkey (June 2004) 0 All banks Large- Medium- Small- Sources: EU Banking Sector Stability (European Central scale scale scale Bank 2004) and Banking Regulation and Supervision Agency of Turkey. Source: EU Banking Sector Stability (European Central Bank 2004). Asset Quality The ratio of nonperforming loans to total loans in income (net) is the largest item in the total income Turkish banks (6.3 percent) is more than double that of Turkish banks. for the average EU bank (figures 6.14 and 6.15).With The staff expenses of EU banks constitute about the onset of the severe financial crises in Turkey in 61 percent of total expenditures (figures 6.12 and 2000­01, the quality of the assets of Turkish banks 6.13), whereas such expenses account for only deteriorated sharply, with the ratio of nonperform- 13percentof thetotalexpendituresof Turkishbanks. ing loans reaching about 22 percent in 2001. The Accession to the European Union: Potential Impacts on the Turkish Banking Sector 169 FIGURE 6.14 Total Loans to Total Assets, FIGURE 6.16 Debt Securities to Total 2003 Assets, 2003 (percent) (percent) Percent Percent 50 50 45 41.5 40 40 32 30 30 22.61 20 20 10 10 0 0 European Union Turkey (June 2004) European Union Turkey (June 2004) Sources: European Banking Federation and Banking Sources: EU Banking Sector Stability (European Central Regulation and Supervision Agency of Turkey. Bank 2004) and Banking Regulation and Supervision Agency of Turkey. FIGURE 6.15 Nonperforming Loans (Gross) to Total Loans, 2003 percent for the EU banks when nongovernment (percent) securities are included, indicating the dominance Percent of the real sector in the securities portfolio (fig- 7 ure 6.16). The nongovernment securities holdings 6.3 of Turkish banks are about 1.5 percent of total assets. 6 5 Financial Strength Ratings 4 Turkish banks have much lower financial strength 3.1 3 ratings than banks in the EU member countries. In a study conducted by Moody's Investors Service in 2 March 2003, all countries were rated by their finan- cial strength by assigning weights to their assets 1 (figure 6.17). E was the lowest rating and A was the 0 highest. The average rating mark of the EU mem- European Union Turkey (June 2004) ber states was B­; the average rating mark of the Sources: European Banking Federation and Banking candidate countries was D; and Turkey's rating Regulation and Supervision Agency of Turkey. mark was D­ (figure 6.17). situation improved during 2002­03 because of the Foreign Bank Entry acceleration of out-of-court settlements and volun- tary debt restructuring arrangements. The low share of foreign banks in Turkey (less than 10 percent) offers a striking contrast with the shares of foreign banks in newly liberalized or liberalizing Share of Government Debt Securities Central and Eastern European countries (close to Government debt securities held by Turkish banks 70 percent). Persistent macroeconomic instability amounted to 40 percent of total assets as of June appears to be the main reason for the very small 2004, compared with less than 2 percent for EU share of foreign banks in Turkey. A positive correla- banks at the end of 2003. This ratio increases to 22.6 tion exists between the volume of foreign direct 170 Turkey: Economic Reform and Accession to the European Union FIGURE 6.17 Financial Strength Rating of the area of EU directives. Several initiatives have the Sector (Moody's), 2003 been taken in the context of the ongoing regulatory 10 efforts of the EU. B­ After establishing the BRSA,12 Turkey increased its effort to harmonize Turkish legislation with the 8 related EU directives. The new Banks Act and the regulations issued by the BRSA are in line with 6 international standards, and the Turkish banking legislation in force is almost fully in compliance D 4 with the EU in many areas. D­ The remaining pieces of legislation that need to 2 be introduced or amended in order for Turkey to achieve full alignment with the EU legislation are on the agenda, and they are expected to be realized 0 EU average Candidate Turkey within the framework of the National Program that countries is currently being revised by the Secretariat General average for the EU in cooperation with the related Turkish Source: Moody's Investors Service authorities, including the BRSA. The comprehen- (http://www.moodys.com). sive table in annex 2 of this chapter describes both the legislation in force in banking in the EU and the corresponding Turkish legislation to give a picture investment and foreign bank expansion in the host of the current state of play in legislative compliance. country originating from the same parent country. In 2003 the net foreign direct investment in Turkey was about $1 billion. In addition to macroeco- Adoption of the Capital Adequacy Directive nomic instability, the delays in implementing Parallel with the consultative process of the Basel financial sector reforms in Turkey have prevented Committee on Banking Supervision for the final- foreign investors from entering the Turkish market. ization of the New Basel Accord (Basel II), the Host country regulations also determine foreign European Union released an advance draft of a new bank entry. Foreign banks prefer countries with directive on the EU capital framework known fewer regulatory restrictions for investment. as Capital Adequacy Directive 3 (CAD 3), which Since completion of the Turkish bank restruc- translates Basel II into EU legislation and applies turing program, the banking sector has become Basel-type provisions to investment firms and more resilient to economic shocks, regulations have domestic credit institutions as well as to interna- been streamlined with international standards, and tional banks. Unlike Basel II, which addresses inter- overall bank soundness has improved. As a result, nationally active banks, CAD 3 will be applied to all the interest of foreign investors in Turkish banks credit institutions in the EU (including building has begun to increase. Ongoing efforts to decrease societies). It also will be applied to nonbank invest- high intermediation costs and implement limited ment firms authorized under the Investment Ser- deposit insurance are expected to accelerate foreign vices Directive (ISD). The directive will take effect entry. in 2007. In parallel with CAD 2 principles, the commu- Compliance with EU Banking niqué on capital adequacy was amended in February Legislation 2001 to cover market risks,and further amendments Because of the European Commission's work in par- were made in January 2002 to include options and to allel with the Basel Committee on Banking Supervi- address some other specific issues, such as the inclu- sion, Turkey's efforts to prepare changes in the sion of Tier 3 capital and structural positions. The banking system regulations serve both bodies' pro- regulation requires banks to incorporate their mar- posals (and thus directives). Specifically, Turkey's ket risks into their regulatory capital calculation, compliance with EU banking legislation is mainly in and it stipulates that banks must separate their Accession to the European Union: Potential Impacts on the Turkish Banking Sector 171 books into a banking book and a trading book. The one of Basel II. The results of the study, in which calculation of market risk covers the interest rate participant Turkish banks have applied simpler risk and equity risk of the trading book, and the for- approaches for credit and operational risks,13 have eign exchange risk covers both the trading book and been shared with the QIS Working Group of the the banking book. Banks are permitted to use either Basel Committee on Banking Supervision. the standard approach or the model approach to The results of the QIS 3, in which 365 banks calculate their market risks. Banks implementing from 43 countries participated, convey significant the internal model approach will calculate their information about the potential impact of Basel II market risk­based capital requirements on the basis on Turkey as well as other on participant countries. of their their value-at-risk (VaR) figure. Banks are The results are generally in line with the Basel also required to conduct a regular stress testing pro- Committee's objectives: the minimum capital gram. Whether a bank can use the model approach requirements would be broadly unchanged for is determined by compliance with the qualitative large, internationally active banks under the inter- and quantitative criteria defined in the regulation. nal ratings­based (IRB) approach, and the propos- Currently, all banks are using the standard approach als would offer an incentive for internationally to report their market risk capital charges on both a active banks to adopt more sophisticated solo basis (since January 2002) and on a consoli- approaches. The summary of worldwide results, dated basis (since July 2002). which reflects the impact of the last consultative The BRSA has prepared a draft "Circular paper of Basel II (Consultative Paper 3), is pre- Regarding the Evaluation of Risk Measurement sented in table 6.2. Models of Banks by the Agency," which sets out the The results show that under three different principles and procedures for assessment of the risk approaches for credit risk (standardized approach, measurement models to be used for regulatory foundation IRB approach, and advanced IRB reporting purposes by banks. Whether a bank can approach), both the G-10 countries and the EU use the model is determined on the basis of a care- countries have lower capital requirements.14 How- ful and comprehensive set of checks to grant per- ever, other countries incur a small increase in credit mission for its use. risk capital requirements under the standardized To gauge the impact of Basel II (and CAD 3), six approach. For operational risk capital charges, all of the top 10 Turkish banks (ranked by asset size) banks incur on average nearly an 8­10 percent participated in the third Quantitative Impact Study increase in risk-weighted assets. (QIS 3) under the guidance of the BRSA (Basel The table also reveals that there is considerable Committee 2003). The study focused on the pro- variation in the extent to which capital requirements posed minimum capital requirements under pillar will rise or fall under Basel II for different banks. TABLE 6.2 Results, Quantitative Impact Study, 2003 (percent) Foundation IRB Advanced IRB Standardized Approach Approach Approach Average Max Min Average Max Min Average Max Min G-10 Group 1 11 84 15 3 55 32 2 46 36 Group 2 3 81 23 19 41 58 EU Group 1 6 31 7 4 55 32 6 26 31 Group 2 1 81 67 20 41 58 Other Groups 1 12 103 17 4 75 33 and 2 Note: IRB internal ratings­based approach; for definition of G-10 countries, see note 14. Sources: Quantitative Impact Study Results, Basel Committee on Banking Supervision, 2003. 172 Turkey: Economic Reform and Accession to the European Union This variation reflects the differences between bank banks of the Banks Association of Turkey, was portfolios. The variation in results for the standard- formed in February 2003 to prepare a road map for ized approach also largely stems from the relative the adoption and implementation of Basel II and importance of retail portfolios for different banks. CAD 3 principles by the Turkish banking sector. Moreover, the level of specialization in different lines of activities will imply different capital charges Conclusion for operational risk between banks. The results of the third quantitative impact Turkey has fulfilled most of the conditions required study (QIS 3) imply that the implementation of for the banking sector to comply with the integra- new capital adequacy regulations will mean that tion process for the EU. Within the National Pro- Turkish banks must incur significant costs to meet gram, the necessary legislation on various issues their credit and operational risk capital require- has been amended or enacted in line with EU direc- ments and the cost of funding. Even though the tives. Examples are indirect loans; definitions of said effects have been verified by the QIS 3, the capital and subsidiary; related lending limits; prin- potential effects of CAD 3 are not expected to be ciples on the establishment and operations of significantly different from the effects of Basel II. banks and special finance houses; regulation on This expectation is based on the assumption that accounting practices; steps to ensure transparency there is a negligible difference between CAD 3 and on financial reporting; principles on bank mergers Basel II, in view of the fact that CAD 3 has so far and acquisitions; the issues surrounding decreasing suggested Basel-type provisions. Because the new the public share within the financial sector; steps to directive requires additional inputs and new ensure the efficiency of supervision and surveil- methodologies for capital adequacy, the inherent lance in cross-border banking; capital adequacy, costs appear in three main areas: input gathering, including market risk; and risk management and system design, and additional charges for capital internal control systems.15 requirements and cost of funding. The BRSA has revised the regulations on deposit Contrary to the relatively low data intensiveness insurance in line with international standards; the of CAD 2, which basically requires the location of introduction of the new scheme was announced in the counterparty (whether it is an Organisation for 2004 (with a one-year transition period). Areas that Economic Co-operation and Development country need further improvements in regulations are the or not) and the type of collateral, CAD 3 requires a business of electronic money institutions and sup- comprehensive amount of technical data, such as plementary supervision of financial conglomerates. external ratings, probability of default or of a loss- Various directives such as the one for cross-border given event for credit risk, and a new type of data payments in euros will become effective with full for operational risk (such as event data or gross EU membership. Thus the preparation at this stage income by business lines). Providing this data will is restricted to the technical evaluations. obviously be a difficult task for Turkish banks and Despite the adverse macroeconomic conditions, banks elsewhere and will require modifications in the core Turkish banking sector proved to be the accounting and reporting framework and resilient. Many of these banks are comparable to information technology restructuring. New data their European counterparts in terms of selected requirements can be met only by means of an effi- indicators, such as high quality of human resources, cient infrastructure such as the existence of a well- technological infrastructure, a nationwide branch functioning rating system and liquid markets for network, and high-quality service provided in a collaterals. variety of financial products. However, it will be dif- The BRSA aims to implement CAD 3 by 2007. ficult for Turkish banks to compete with the larger This target also includes working on the potential European banks with their large assets and capital effects of Basel II and CAD 3, as well as clarification strength.Thus the initiation of negotiations with the of the provisions of CAD 3 by taking the country- EU and the expected"convergence play"are likely to specific issues into consideration. To serve this pur- generate more consolidation in the banking indus- pose, a steering committee, pioneered by the BRSA try and increased interest of both domestic and for- and consisting of representatives of the member eign participants. Accession to the European Union: Potential Impacts on the Turkish Banking Sector 173 Because of the crowding out by the government, be competitive in the EU banking sector, or at the share of consumer and corporate loans of total least to form partnerships based on solid ground assets or deposits is very low. However, under a with EU banks, Turkish banks must further convergence scenario it is clear that the Turkish strengthen their equity structures during the tran- financial sector has important future growth sition period. potential. The convergence to the EU implies not The Turkish banking system has become more only convergence of the capital structure, prof- resilient and sound since the extensive restructur- itability, and management techniques, but also of ing program and implementation of international accounting standards, transparency guidelines, and standards. This development inevitably implied a corporate structure.16 large fiscal cost in which the initial fiscal burden of There is no doubt but that the Turkish banking the bank restructuring reached levels close to one- sector will be exposed to certain costs during third of GDP. Thus a large portion of the cost that integration with the EU. EU banks tend to keep will emerge from full membership and full conver- their profitability high through restructuring their gence to the EU banking sector has already been activities and improving their risk management borne. Furthermore, the confidence that will result techniques. Competitive pressure on the Turkish from the convergence to the EU is expected to have banking sector may arise from EU banks that are significant positive externalities on the banking sec- well known for their strong capital base and their tor that should at least partially offset the impact of capability for managing risks. It appears that, to competition from strong EU banks.17 174 Annex 1: Banking Sector Statistics--The EU, New Member States, and Turkey TABLE 6.3 Statistics on Banking Sectors of EU15 and Turkey, 2003 Percentage Percentage of Banking of Banking System's System's Concen- Assets Assets Deposit Scale tration Minimum Risk- in Banks in Banks Insurance Moody's Corres- Ratio of Capital Entry Number Number Number Adjusted 50% or More 50% or More per Total Total Total Rating ponding to Five Largest Requirement of of of CAR Capital Government- Foreign- Account Assets Deposits Credit GDP (March Moody's Banks (%) ( millions) Banks Branches Staff (%) Ratio (%) Owned Owned () ( billions) ( billions) ( billions) ( millions) 2003) Rating Austria -- 5 896 4,401 62,674 8 -- 0.0 -- 20,000 605 370 288 199,603 C+ 8 Belgium 88.0 62.5 109 4,935 72,210 8 12.7 0.0 -- 20,000 891 420 397 269,546 B 10 Denmark 90.0 5 198 2,014 38,740 8 9.7 0.0 0.0 47,728 312 125 126 187,951 B 10 Finland 99.5 5 343 1,527 23,372 8 10.5 0.0 6.2 25,000 177 64 81 142,518 B- 9 France 60.0 7 925 25,789 -- 8 -- 0.0 -- 70,000 3,779 978 1,196 1,557,245 B- 9 Germany 20.0 5 2,465 36,599 712,000 8­12.5 10.6 42.2 4.3 20,000 6,471 2,448 3,025 2,128,200 C 6 Greece 73.9 18 59 3,095 61,074 8 13.6 22.8 10.8 20,000 200 116 101 153,045 D+ 5 Ireland -- 6.3 91 856 42,126 8 -- -- -- 20,000 575 160 249 134,786 B- 9 Italy 51.2 6.3 788 30,502 337 8 13.4 10.0 5.7 -- 2,170 596 1,039 1,300,926 C+ 8 Luxembourg 27.9 8.7 169 200 22,529 8 12.7 5.1 94.6 20,000 656 218 118 23,956 B- 9 Netherlands 88.1 5 147 4,000 144,000 8 11.5 3.9 2.2 -- 1,911 1,263 1,096 454,276 B+ 11 Portugal 79.8 17.5 52 5,431 54,089 8 9.5 22.8 17.7 -- 318 139 181 129,908 C+ 8 Spain 53.2 18 265 39,506 240,210 8 13.0 0.0 8.5 -- 1,430 807 813 744,754 B 10 Sweden 62.0 5 126 1,900 38,200 8 19.9 0.0 -- 27,000 287 123 123 267,251 B 10 U.K. 23.0 5 356 11,624 455,500 8 -- 0.0 46.0 -- 6,786 3,493 3,283 1,591,412 B+ 11 EU average 62.8 12 466 11,492 140,504 8 12.5 7.6 20 28,973 1,771 755 808 619,025 B- 9 Turkey 60.0 11.1 49 6,126 126,274 8 25.4 32.7 3.2 27,691 152.5 95 48 237,723 D- 3 -- Not available, not applicable, or negligible. Note: In June 2004, 1 euro = TL 1,805.605; in December 2003, 1 euro = TL 1,757.480. Sources: Data on concentration, minimum capital, capital adequacy ratio (CAR), public share, foreign share, deposit insurance: "2003 World Bank Banking Survey," http://www.worldbank.org; other banking indicators: European Banks Federation (FBE), http://www.fbe.org; GDP figures: Eurostat, http://www.europa.eu.int. Unless otherwise stated, data on Turkey are from national sources. Concentration, number of banks, number of branches, realized capital ratio data are as of June 2004, http://www.bddk.org.tr. Turkish data can be found in BRSA 2004. TABLE 6.4 Statistics on Banking Sectors of EU15 and Turkey, 2001 Personnel per Number of Branches Total Assets/ Total Deposits/ Total Credit/ Deposits/Credit Credit/Assets Assets/Number of Branch per Bank GDP (%) GDP (%) GDP (%) (%) (%) Banks ( millions) Austria 14 5 303 185 144 128 48 675 Belgium 15 45 331 156 147 106 45 8,173 Denmark 19 10 166 67 67 100 40 1,577 Finland 15 4 124 45 57 80 46 517 France -- 28 243 63 77 82 32 4,085 Germany 19 15 304 115 142 81 47 2,625 Greece 20 52 130 76 66 114 51 3,384 Ireland 49 9 427 119 185 64 43 6,321 Italy 0 39 167 46 80 57 48 2,754 Luxembourg 113 1 2,737 912 491 185 18 3,880 Netherlands 36 27 421 278 241 115 57 13,002 Portugal 10 104 245 107 139 77 57 6,110 Spain 6 149 192 108 109 99 57 5,395 Sweden 20 15 107 46 46 100 43 2,278 U.K. 39 33 426 220 206 106 48 19,061 EU average 27 36 422 169 147 100 45 5,323 Turkey 21 125 64 40 20 196 32 3,113 -- Not available, not applicable, or negligible. Note: In June 2004, 1 euro = TL 1,805.605; in December 2003, 1 euro = TL 1,757.480. Sources: Banking indicators: European Banks Federation (FBE), http://www.fbe.org; GDP figures: Eurostat, http://www.europa.eu.int. Unless otherwise stated, data on Turkey are from national sources. Concentration, number of banks, number of branches, realized capital ratio data are as of June 2004, http://www.bddk.org.tr. Turkish data can be found in BRSA 2004. 175 176 TABLE 6.5 Statistics on Banking Sectors of Enlargement (Candidate) Countries and Turkey, 2003 Percentage Percentage of Banking of Banking System's System's Assets Assets Deposit Concentration Minimum Risk- in Banks in Banks Insurance Moody's Scale Ratio of Capital Entry Number Number Number Adjusted 50% or More 50% or More per Total Total Total Rating Corresponding Five Largest Requirement of of of CAR Capital Government- Foreign- Account Assets Deposits Credit GDP (March to Moody's Banks (%) (millions) Banks Branches Staff (%) Ratio (%) Owned Owned (euros) ( billions) ( billions) ( billions) ( millions) 2003) Rating Bulgaria 56.52 Lev 10 35 727 21,434 12 31.1 17.6 74.6 6,843 9 6 5 15,793 D- 3 (approx. US$5.40) Cyprus 89.2 £C 3 13 940 10,300 10 14.0 4.2 12.7 -- 36 28 20 11,645 D+ 5 Czech Rep. 69 CZK 500 35 1,647 39,004 8 15.4 3.8 90.0 No limit 78 52 31 80,097 D 4 Estonia 98.9 EEK 75 7 206 4,018 8 15 0.0 98.9 20,000 7 3 5 125,832 C- 6 Hungary 62.5 Ft 2,000 38 1,126 27,200 8 15.6 9.0 88.8 No limit 51 31 32 73,213 C- 6 Latvia 66.2 5 23 206 8,895 12 14.2 3.2 65.2 -- 9 6 4 9,868 D 4 Lithuania 87.9 5 13 485 7,027 10 15.7 12.2 78.2 10,000 6 4 4 16,271 -- Malta 84.13 Lm 2 15 106 3,407 8 18.4 0.0 60.0 16,488 18 8 8 4,333 D+ 5 Poland 57.4 5 660 4,394 151,257 8 15.1 23.5 68.7 -- 104 61 44 185,227 D 4 Romania 42.8 Rol 370 000 38 2,921 46,535 11 20.3 41.8 47.3 No limit 14.7 10.23 7.27 47,936 D- 3 Slovak Rep. 66.5 Sk 500 21 553 19,797 8 13.4 4.4 85.5 11,129 24 17 9 28,822 E+ 2 Slovenia 69 SIT 1,100 20 636 11,397 8 11.9 12.2 20.6 No limit 21 14 11 24,576 D+ 5 (approx. US$5.10) Candidate countries average 70.8 -- 77 1,162 29,189 9 16.67 11 66 12,892 31 20 15 51,968 D 4 Turkey 60 11.1 49 6,126 126,274 8 25.42 32.7 3 27,691 152.5 95 48 237,723 D- 3 -- Not available, not applicable, or negligible. Note: In June 2004, 1 euro = TL 1,805.605; in December 2003, 1 euro = TL 1,757.480. Sources: Concentration, minimum capital, capital adequacy ratio (CAR), public share, foreign share, deposit insurance: "2003 World Bank Banking Survey," http://www.worldbank.org; other banking indicators: European Banks Federation (FBE), http://www.fbe.org; GDP figures: Eurostat, http://www.europa.eu.int. Unless otherwise stated, data on Turkey are from national sources. Concentration, number of banks, number of branches, realized capital ratio data are as of June 2004, http://www.bddk.org.tr. Turkish data can be found in BRSA 2004. TABLE 6.6 Statistics on Banking Sectors of Enlargement (Candidate) Countries and Turkey, 2001 Personnel per Number of Branches Total Assets/ Total Deposits/ Total Credit/ Deposits/ Credit/ Assets/Number of Branch per Bank GDP (%) GDP (%) GDP (%) Credit (%) Assets (%) Banks ( millions) Bulgaria 29 21 56 39 29 134 52 253 Cyprus 11 72 307 238 171 139 56 2,750 Czech Rep. 24 47 97 64 38 167 40 2,229 Estonia 20 29 5 3 4 76 69 931 Hungary 24 30 70 43 43 99 62 1,350 Latvia 43 9 87 57 46 124 53 372 Lithuania 14 37 37 24 22 112 58 462 Malta 32 7 412 189 195 97 47 1,191 Poland 34 7 56 33 24 140 42 157 Romania 16 77 31 21 15 141 49 387 Slovak Rep. 36 26 83 59 31 193 37 1,140 Slovenia 18 32 87 57 44 130 50 1,069 Candidate 25 33 111 69 55 129 51 1,024 countries average Turkey 21 125 64 40 20 196 32 3,113 Note: In June 2004, 1 euro = TL 1,805.605; in December 2003, 1 euro = TL 1,757.480. Sources: Banking indicators: European Banks Federation (FBE), http://www.fbe.org; GDP figures: Eurostat, http://www.europa.eu.int. Unless otherwise stated, data on Turkey are from national sources. Concentration, number of banks, number of branches, realized capital ratio data are as of June 2004, http://www.bddk.org.tr. Turkish data can be found in BRSA 2004. 177 178 Turkey: Economic Reform and Accession to the European Union TABLE 6.7 Income, Costs, and Profits of EU Banks in Different Size Groups, 2003 All Change 2002­03 2003 Large Medium Small (% of total assets) Income Net interest income -0.02 1.38 1.22 1.64 2.54 Fees and commissions (net) -0.02 0.64 0.65 0.57 0.84 Trading and foreign exchange results 0.04 0.20 0.25 0.06 0.09 Other operating income (net) 0.00 0.17 0.16 0.17 0.31 Total income 0.00 2.38 2.28 2.44 3.78 Expenses Staff costs -0.03 0.88 0.86 0.84 1.47 Other -0.01 0.11 0.09 0.13 0.28 Total expenses -0.07 1.44 1.37 1.43 2.62 Profitability Profits I (operating profits) 0.08 0.94 0.91 1.00 1.16 Specific provisions -0.02 0.36 0.32 0.44 0.47 Funds for general banking risks (net) 0.00 0.01 0.00 0.01 0.02 Profits II (before tax and extraordinary items) 0.10 0.59 0.59 0.56 0.67 Extraordinary items (net) -0.02 0.01 -0.01 0.05 0.08 Tax charges 0.03 0.18 0.18 0.20 0.27 Profits III (after tax and extraordinary items) 0.05 0.41 0.40 0.42 0.48 (% of Tier 1 capital) Return on equity Profits III (after tax and extraordinary items) 1.08 9.87 10.89 8.73 6.20 (% of total income) Income structure Net interest income -0.71 58.05 53.48 67.29 67.15 Fees and commissions (net) -1.02 26.80 28.55 23.42 22.22 Trading and foreign exchange results 1.42 7.33 9.64 2.34 2.28 Other operating income (net) 0.11 6.94 6.88 6.79 8.22 (% of total expenses) Expenditure structure Staff costs 0.94 61.43 63.02 58.84 56.28 Administrative costs -0.68 31.10 30.42 32.19 33.33 Other -0.26 7.47 6.56 8.97 10.51 Cost-to-income ratio -3.18 60.39 60.15 58.89 69.31 Source: European Central Bank 2004. Accession to the European Union: Potential Impacts on the Turkish Banking Sector 179 TABLE 6.8 Indicators of 50 Major EU Banks, 2002 and 2003 (percent) 2002 2003 Profitability Cost-to-income ratio 67.9 64.5 Return on assets (after tax and extraordinary items) 0.4 0.4 Return on equity A9 (after tax and extraordinary items) 8.0 8.7 Net interest income/total assets 1.4 1.3 Net noninterest income/total assets 1.2 1.2 Noninterest income/total operating income 48.9 47.5 Solvency Tier 1 ratio 6.7 6.7 Total capital ratio 9.6 9.9 Note: The sample of large banks in table 6.8 differs from that in table 6.7. Table 6.8 covers the weighted average figures for 50 major banks of EU15 countries. Source: European Central Bank 2004. TABLE 6.9 Nonperforming Assets and Provisioning of EU Banks, 2003 (percent) All Change from 2002 2003 Large Medium Small Nonperforming and doubtful loans (gross; -0.1 3.1 2.7 3.6 6.5 % of loans and advances) Nonperforming and doubtful loans (gross; -1.9 51.1 46.6 55.7 61.6 % of own funds) Nonperforming and doubtful loans (net; -1.9 16.7 12.1 22.7 28.3 % of own funds) Provisioning (stock; % of nonperforming 2.3 67.4 74.1 59.1 54.0 and doubtful assets) Source: European Central Bank 2004. 180 Turkey: Economic Reform and Accession to the European Union TABLE 6.10 Regulatory Capital Ratios and Risk-Adjusted Items of EU15 Banks, 2003 Change All Banks from 2002 Tier 1 ratio 8.8 0.3 Overall solvency ratio 12.4 0.4 Overall solvency ratio below 9% Number of banks 98 -74 Asset share (% of total banking sector assets) 0.7 -1.26 Risk-adjusted items (% of total risk adjusted assets) Risk-weighted assets 82.3 -0.16 Risk-weighted off-balance-sheet items 11.1 0.0 Risk-adjusted trading book 6.6 0.1 Source: European Central Bank 2004. TABLE 6.11 EU Balance Sheet Structure of EU Banks, 2003 All Banks Change from (% of total assets) 2002 (%) Assets Cash and balances with central bank 1.24 0.1 Treasury bills 1.0 0.0 Loans to credit institutions 15.8 -0.2 Debt securities (public bodies) 7.8 0.8 Debt securities (other borrowers) 10.5 0.1 Loans to customers 50.6 -0.4 Shares and participating interests 3.3 0.0 Tangible assets and intangibles 1.6 0.0 Other assets 8.0 -0.2 Liabilities Amounts owed to credit institutions 30.4 0.1 Amounts owed to customers 41.9 -0.2 Debt certificates 20.7 0.1 Accruals and other liabilities 8.8 0.0 Fund for general banking risks 0.14 0.0 Provisions for liabilities and charges 1.2 0.0 Subordinated liabilities 1.8 0.0 Equity capital 4.2 0.0 Other liabilities 0.5 0.0 Profit/loss for financial year 0.4 0.1 Selected off-balance-sheet items Credit lines 14.2 0.7 Guarantees and other commitments 6.5 0.7 Source: European Central Bank 2004. Accession to the European Union: Potential Impacts on the Turkish Banking Sector 181 Annex 2: EU Banking Directives in Force, Main Issues EU Banking Turkish Directives in Force The Directive . . . Equivalent Directive No. 2002/87/ · Lays down rules for supplementary supervision No corresponding EC of European of "regulated entities" that are part of a regulation. The intro- Parliament and financial conglomerate. duction of compliant European Council, · Defines the term regulated entity as a credit legislation may bring December 16, 2002, on institution, an insurance undertaking, or an about some costs the supplementary investment firm. because of reorganiza- supervision of credit · Defines the term financial holding company as a tion and related institutions, insurance financial institution, the subsidiary undertak- changes at the institu- undertakings, and ings of which are either exclusively or mainly tional level, but it is investment firms in a credit institutions or financial institutions. expected that the financial conglomerate ultimate overall · Makes it compulsory for all financial outcome is likely to conglomerates that are subject to produce efficiency supplementary supervision to have a gains for the banking coordinator appointed from among the sector and the whole competent authorities involved. The economy. coordinator does not affect the tasks and responsibilities of the competent authorities as provided for by the sectoral rules, but works in cooperation and exchanges information with these authorities. · Specifies that the activities of a group occur mainly in the financial sector if the ratio of the balance sheet total of the regulated and non- regulated financial sector entities in the group to the balance sheet total of the group exceeds 40 percent. Sets out the thresholds for identifying a financial conglomerate, taking into account the regulated entities and the other undertakings and their significance among the whole. · Sets out that regulated entities shall be subject to supplementary supervision. · Requires regulated entities to have in place adequate capital adequacy policies and lays down the rules for the supplementary supervision of the capital adequacy of the regulated entities. · Requires regulated entities to report on a regular basis and at least annually to the competent authority any significant risk concentration at the level of financial conglomerate. · Requires regulated entities to report on a regular basis and at least annually to the coordinator all significant intragroup transactions and requires the supervisory overview of these transactions to be carried out by the coordinator. · Requires regulated entities to have adequate risk management process and internal control mechanisms. · Requires the member states to decide or give their competent authorities the power to decide according to which sectoral rules asset management companies shall be included in the consolidated or supplementary supervision. 182 Turkey: Economic Reform and Accession to the European Union Annex 2: (Continued) EU Banking Turkish Directives in Force The Directive . . . Equivalent · Amends Directives No. 93/6/EC and No. 2000/12/EC. Regulation (EC) · Lays down rules on cross-border payments in No need for any No. 2560/2001 of euros to ensure that charges for these national implementing European Parliament payments are the same as those for payments legislation, because the and European Council, in euros within a member state. EU regulation becomes December 2001, on · Applies to cross-border payments in euros up binding and directly cross-border payments to 50,000 within the European Community. applicable upon full in euros · Specifies that cross-border payments made membership. Its imple- between institutions for their own account are mentation is not not covered. expected to incur a major cost for the · Specifies that the charges levied for banking sector. cross-border payments and for payments effected within the member state shall be transparent. · Requires that prior to exchanging currencies into and from euros, customers be informed about the exchange charges the institutions propose to apply and about the various charges that have been applied. Directive No. 2001/24/ · Applies to credit institutions and their branches Banks Act as amended EC of European set up in member states other than those in by Act No. 4743. Parliament and which they have their head offices. European Council, April · Stipulates that the administrative or judicial 4, 2001, on the reor- authorities of the home member state shall be ganization and winding the sole authority to decide on the implemen- up of credit institutions tation of reorganization measures. · States that the home member state shall without delay inform the competent authorities of the host member state of decisions on reorganization. · Calls for the home member state to publish an extract from the decision to adapt a reorgani- zation measure in the Official Journal of the European Communities to facilitate the exercise of right of appeal. · Mandates that the administrative or judicial authorities of the host member state of a branch of a credit institution having its head office outside the community shall without delay inform the other authorities of their decision to adopt any reorganization measure. · Specifies that the home member state shall be the sole authority to decide on the opening of winding-up proceedings. · Calls for the home member state to, without delay, inform the competent authorities of the host member state of its decision to open winding-up proceedings. · Sets out that where the opening of winding-up proceedings is decided after the failure of reorganization measures, the authorization of the institution shall be withdrawn. Accession to the European Union: Potential Impacts on the Turkish Banking Sector 183 EU Banking Turkish Directives in Force The Directive . . . Equivalent Directive No. · Defines an electronic money institution as an No corresponding 2000/46/EC of undertaking or any other legal person, other Turkish legislation. The European Parliament than a credit institution, that issues means of introduction of such and European Council, payment in the form of electronic money. legislation would enrich September 18, 2000, · Restricts the business activities of electronic the scope of financial on the taking up, money institutions, other than the issuing of services. pursuit, and prudential electronic money, to the provision of closely supervision of the related financial and nonfinancial services and business of electronic to the storing of data in electronic devices money institutions on behalf of other undertakings or public institutions. · Sets out the redeemability of the bearer of electronic money during the period of validity and depending on the contract between issuer and bearer. · Sets out that electronic money institutions should have initial capital of not less than 1 million. · Specifies that the maximum storage amount of the electronic storage device shall not exceed 150. Directive No. 2000/12/ · Defines the term credit institution as an · Banks Act as EC of European undertaking whose business is to receive amended by Act Parliament and deposits or other repayable funds from the No. 4743. European Council, public and to grant credits for its own account. · Regulation on the March 20, 2000, on the · Prohibits undertakings other than credit institu- Establishment and taking up and pursuit of tions from carrying on the business of taking Operations of Banks. the business of credit deposits or other repayable funds from the · Regulation on institutions public and makes it compulsory for credit insti- Measurement and tutions to obtain authorization from member Assessment of Capital states before commencing their activities. Adequacy of Banks. · Stipulates that credit institutions should possess their separate own funds and that the initial capital for access to the taking up of credit institutions should be equal to or greater than 5 million. · States that the competent authorities shall not grant authorization (1) unless at least two persons are effectively directing the business of the credit institution and (2) before they have been informed of the identities of the share- holders or members. · Calls for any natural or legal person who proposes to hold, directly or indirectly, a qualifying holding in a credit institution to first inform the competent authorities. · Permits the competent authorities of the host member state to, in emergencies, take any precautionary measures necessary to protect the interests of depositors, investors, and others to whom services are provided. · Specifies that the state is responsible for the prudential supervision of a credit institution. · States that the competent authorities of the member states concerned shall collaborate closely in order to supervise the activities of the credit institutions operating. 184 Turkey: Economic Reform and Accession to the European Union Annex 2: (Continued) EU Banking Turkish Directives in Force The Directive . . . Equivalent · Specifies that the solvency ratio expresses own funds as a proportion of risk-adjusted total assets and off-balance sheet items, and requires the competent authorities to ensure that the ratios are calculated not less than twice each year, either individually or consolidated, where required. · Requires credit institutions to permanently maintain the solvency ratio at a level of at least 8 percent, but the competent authorities may prescribe any higher minimum ratios they consider appropriate. · Limits a credit institution's large exposure to a client or group of connected clients to 25 percent of its own funds and limits the large exposures in total to 800 percent of the credit institution's own funds. · States that no credit institution shall have a qualifying holding, the amount of which exceeds 15 percent of its own funds, in an undertaking that is neither a credit institution nor a financial institution. · Limits the total amount of a credit institution's qualifying holdings in undertakings other than credit institutions and financial institutions to no more than 60 percent of its own funds. · Subjects every credit institution that has a credit institution or a financial institution as a subsidiary or that holds a participation in such institutions to supervision on the basis of its consolidated financial situation. · Sets up a Banking Advisory Committee alongside the European Commission in order to ensure the proper implementation of this regulation and to assist the Commission in the preparation of new proposals to the European Council. Directive No. 94/19/EC · Defines deposit as any credit balance that Decree No. 2000/682 of European Parliament results from funds left in an account or on Savings Deposit and European Council, from temporary situations deriving from Insurance and May 30, 1994, on normal banking transactions, which a credit Premiums Collected by deposit guarantee institution must repay under the legal and the Saving Deposit schemes contractual conditions applicable, and any Insurance Fund. debt evidenced by a certificate issued by a credit institution. · Specifies that the scheme does not cover deposits made by other credit institutions on their own behalf, all instruments that fall within the definition of own funds, and deposits arising out of transactions in connection with which there has been a criminal conviction for money laundering. · Permits credit institutions authorized in a member state to take deposits only if they are members of such a scheme. Accession to the European Union: Potential Impacts on the Turkish Banking Sector 185 EU Banking Turkish Directives in Force The Directive . . . Equivalent · States that the aggregate deposits of each depositor shall be covered up to 20,000 European currency units (ECUs). · States that this regulation shall not preclude the retention or adoption of provisions that offer a higher or more comprehensive cover for deposits. · Allows deposit guarantee schemes to, on social considerations, cover certain kinds of deposits in full. · Calls for depositors to be informed of the provisions of the deposit guarantee. Notes 11. Because consistent data for candidate countries are not available, comparisons are made only between the EU countries 1. This chapter was written while the author was vice presi- and Turkey in the rest of this chapter. dent of the Banking Regulation and Supervision Agency of 12. The BRSA was established by the Banks Act (Law No. Turkey. She is grateful to Münür Yayla and Serdar Özdemir for 4389), issued on June 23, 1999. their contributions to this chapter. The views expressed in it are 13. They applied the standardized approach for credit risk hers and do not necessarily represent those of the Banking Reg- and the basic indicator and standardized approaches for opera- ulation and Supervision Agency of Turkey. tional risk. 2. Details of the restructuring program can be found in 14. The Group of Ten is made up of 11 industrial countries-- "Banking Sector Restructuring Program--Progress Reports of Belgium,Canada,France,Germany,Italy,Japan,the Netherlands, BRSA" at http://www.bddk.org.tr. Sweden, Switzerland, the United Kingdom, and the United 3. The Istanbul Approach is a voluntary corporate debt States--that consult and cooperate on economic, monetary, and restructuring scheme based on the London Approach. It was financial matters. The ministers of finance and the central bank introduced by amendments to the Banks Act. A Financial governors of the Group of Ten usually meet once a year in con- Restructuring Framework Agreement was prepared and submit- nection with the fall meetings of the Interim Committee of the ted to the banks by the Banks Association of Turkey on May 24, International Monetary Fund. The governors of the Group of 2002. The agreement was signed by 25 banks and 17 financial Ten normally meet bimonthly at the Bank for International institutions and approved by the BRSA on July 4, 2002. Settlements. 4. Detailed explanations about and the results of the audit 15. For recent information on actions taken to satisy acces- and assessment phases of the program have been released to sion requirements, see "Monitoring the Implementation of the the public through the "Introductory Report" and "Progress National Program," http://www.abgs.gov.tr. Report." These reports are available on the BRSA Web site, 16. It is believed that an assessment of new organizational http://www.bddk.org.tr. models, such as a financial holding company, within the same 5. The description of the EU banking sector in this study is scope will be useful. based on the report EU Banking Sector Stability (European 17. In fact, the economic criteria that are a precondition for Central Bank 2003a). EU membership will independently be an important develop- 6. Data for the figures that follow are reported in annex 1 ment for ensuring confidence and stability in the markets. Mem- and were drawn from World Bank (http://www.worldbank.org), bership might further strengthen this confidence. European Central Bank (2003a, 2003b; see http://www.ecb.int), and European Banking Federation (http://www.fbe.be) sources. These data are based on Banking Supervision Committee (BSC) References sources. The banks of current member countries are classified by asset size as large, medium, and small. The data on banks Basel Committee on Banking Supervision. 2003. "Quantitative cover 99 percent of the credit institutions in EU countries. Impact Study 3: Overview of Global Results." Bank for Large, medium, and small banks account for 66 percent, 30 per- International Settlements, Basel. cent, and 4 percent of total assets, respectively. The data for 2003 BRSA (Banking Regulation and Supervision Agency of Turkey). cover 57 large banks, 968 medium banks, and 3,600 small banks. 2001. Towards a Competitive Turkish Banking Sector. June. 7. The euro­Turkish lira exchange rate for June 2004 was --------. 2003. Banking Sector Assessment Report. Various used in these calculations. issues. 8. These figures should be considered with caution, because --------. 2004. "Banking Sector Evaluation Report." Ankara: data were not available for five of the candidate countries. BRSA. 9. Based on the historical cost and for the whole banking sec- European Central Bank. 2003a. EU Banking Sector Stability. tor, including the intervened banks. Frankfurt: ECB, February. 10. For the same period, this ratio is -33 percent for state --------. 2003b. Report on EU Banking Structure. Frankfurt: banks, -132 percent for privately owned banks, -12 percent for ECB. development and investment banks, -242 percent for SDIF --------. 2004. EU Banking Sector Stability. Frankfurt: ECB, banks, and 1.6 percent for foreign banks. November. 7 Competition and Regulatory Reform in Turkey's Electricity Industry . Izak Atiyas and Mark Dutz Turkey has begun a major overhaul of the legal and Characteristics and Evolution regulatory framework surrounding its electricity of the Industry industry.1 The reform program entails liberalization The electricity industry is made up of three main as well as a radical restructuring of the industry-- interrelated segments. Electricity is generated in that is, its generation, transmission, and distribu- plants by harnessing the flow of water or the power tion segments, including its wholesale and retail of the wind, sun, or earth (geothermal); burning activities. The purpose of this chapter is to review fossil fuels (thermal); or capturing nuclear fission. and assess the new regulatory regime, identify the Distribution refers to supplying residences or busi- main competition-related challenges the industry is nesses with electricity through lower-voltage wires likely to face, and discuss future prospects. The and transformers. The transmission of electricity chapter will attempt to evaluate the reform process refers to the actual transportation of higher-voltage in light of the regulatory framework established at electricity between generation plants and distribu- the level of the European Union (EU) and the cur- tion facilities, the interconnection of geographically rent debate on the proposals about its amendment. dispersed generation plants, their scheduling, and The chapter is organized as follows. The first orderly dispatch. The operation and commercial section reviews the physical peculiarities of the principles of related wholesale and retail supply electricity industry and discusses how they have activities are quite similar; both involve metering, shaped the evolution of its industrial organization. computing, and billing. An important distinction The second section presents an overview of regula- is that the wholesale trade business is carried tory reform in the EU, the electricity directive out mostly at the transmission level on a larger issued by the European Parliament in 1996, and the scale, and the retail trade business is carried out recent proposals for amendment advanced by the through the distribution system at the end user European Commission. The pre-and postreform level with both smaller business and household structure of the electricity industry in Turkey and customers. the main features of the new regulatory regime are Several characteristics of the electricity industry featured in the third section. The fourth section distinguish it from other industries. For one thing, identifies the main challenges that the industry is there is no economical way to store electricity. This likely to face in the process of developing effective situation implies that the demand for and supply of competition. A final section discusses possible electricity must be balanced almost continuously competition-enhancing solutions. 187 188 Turkey: Economic Reform and Accession to the European Union in real time. In addition, the demand for electricity strong economies of scale (in the sense that varies hourly and daily, as well as across months duplication of lines would be economically waste- and seasons. Consumers can obtain electricity as ful), there is little scope for competition in these seg- long as they are connected to the network, because ments of the industry. By contrast, the generation of there is no cost-effective way to establish physical electricity is now regarded as potentially competi- contact between specific consumers and genera- tive, especially with the advent of the smaller-scale tors. Rather, electricity from generating plants combined-cycle gas turbine (CCGT) technology. flows to a common pool and is retrieved by con- Generation is generally believed to exhibit increas- sumers from that pool. In the short run, the price ing returns of scale at low levels of production and elasticity of demand is very low. Because generat- constant returns to scale otherwise (Armstrong, ing plants have rigid, nonflexible capacity con- Cowan, and Vickers 1994: 282). Armstrong and straints, supply is relatively inelastic, especially at others report Joskow and Schmalensee's estimate of peak demand times. In addition, several physical minimum efficient scale for fossil-based plants at constraints, such as voltage, have to be met. The 400-megawatt capacity. most binding constraint affecting system opera- In the last 10­15 years, the predominant view tions is the limitation on the power-carrying has evolved to favor the introduction of competi- capacities of lines and transformers. Congestion tion into generation and retail supply activities. resulting from this constraint can, in principle, so Some countries, such as Chile and the United severely limit system operation that it could Kingdom, were pioneers, but the wave of liberaliza- impede the transfer of production from a least-cost tion has been widespread, covering developing and plant to a load, even though both parties would developed economies alike. like to make the requisite sales agreement. Thus, balancing supply and demand requires coordinat- ing and scheduling the production of different Regulatory Reform in the EU plants, taking the existing capacity of lines and transformers into account. The use of generators The European Commission's effort to liberalize will allow the system to respond to changes in electricity markets in the EU was driven primarily demand or supply. The generators must hold a by the quest for a single market, but it was met with minimum level of reserve capacity to keep the resistance by many national governments.2 In 1991 probability of system failure below an acceptable the Commission proposed allowing third-party threshold. Failure at one point in the network (e.g., access within the electricity markets of all member failure of a generation plant) can have serious states, but the Council of Ministers rejected the repercussions for the whole network if not man- proposal. By 1993 the concept of negotiated (as aged properly. Thus there are strong externalities in opposed to full or regulated) third party access terms of network security. was being presented as one of the options under The need to coordinate generation and supply discussion. In 1994 France introduced the single on an almost minute-by-minute basis is an incen- buyer model as an alternative to negotiated third tive to integrate these two activities vertically. party access. Eventually, in 1996, an agreement Indeed, in most countries electricity services his- was reached on a timetable for liberalization, and torically have been supplied through vertically inte- each member state was given a choice between grated enterprises encompassing generation, trans- the three alternatives for access. The agreement cul- mission, and distribution activities. In Europe, such minated in the European Parliament's electricity enterprises have been organized as monopolies directive.3 under public ownership. In the United States, the Liberalization of the electricity sector was predominant form of industrial organization has strongly supported by the Competition Directorate been privately owned but regulated franchises with General of the European Commission (the former monopoly rights to serve specific geographic DG IV) through its threats that no liberalization regions. would call for tougher action on the basis of Arti- Because the transmission and distribution of cles 81 and 82 of the Treaty Creating the European electricity involve large sunk capital costs with Community (Pollitt 1999: 50). Competition and Regulatory Reform in Turkey's Electricity Industry 189 The Electricity Directive of 1996 Unbundling To prevent discrimination, cross subsidization, and distortion of competition, the The basic idea behind the electricity directive is directive obliged integrated operators to separate to introduce competition to the potentially com- the management of the generation, transmission, petitive segments of the electricity industry-- distribution, and nonelectricity activities and to generation and retail supply--and to regulate trans- keep separate accounts for each. To ensure nondis- mission and distribution, which retain natural crimination, it envisaged creation of an independ- monopoly characteristics. This section examines ent authority for dispute settlement. four aspects of the directive: market opening, Each member state was required to specify a unbundling, third party access, and public service transmission system operator (TSO), whose task obligations and regulation was to ensure dispatch of a generation plant under fair and transparent rules that did not favor plants Market Opening On the demand side, the direc- owned by the same company as the TSO. The tive envisaged market opening targets on the basis unbundling of the TSO was deemed crucial (man- of consumers being designated to have freedom to agement, legal, or ownership unbundling). contract their consumption of electricity (so-called As for distribution, the system was to operate on eligible customers). Thus, according to the direc- the same nondiscriminatory basis as transmission. tive, each member state would "open" a given and increasing percentage of its market over the next six Third Party Access One of the main objectives of years. That percentage was to be calculated as the the directive was to enable independent generators share, in overall European Community consump- to have access to the transmission and distribution tion, of final customers consuming more than networks in order to supply final customers. The 40 gigawatt-hours per year. The threshold was to directive prescribed three types of access arrange- be reduced to 20 gigawatt-hours in the second ments (but member countries could also choose stage (within three years) and 9 gigawatt-hours in hybrid arrangements): the third step (within six years). Those thresholds · Negotiated third party access (nTPA). Consumers have been estimated to correspond to market share and producers contract directly with each other openings equal to 27 percent, 28 percent, and 33 percent, respectively, in 1999, 2000, and 2003.4 and then negotiate with the transmission and distribution companies for access to the net- Each member state was to designate its own set of work. eligible customers, but consumers with more than · Regulated third party access (rTPA). Access prices 100 gigawatt-hours of consumption were to be are not negotiated, but rather are published by definitely included in that designation. To address the regulator. problems that might arise if the degree of market · Single buyer model (SBM). There is a single opening differed across states, the directive included wholesale buyer of electricity. Competition in provisions for reciprocity: a member state has the generation is allowed, but retail competition is right to refuse access for companies from states that limited. Eligible consumers not tied to a specific have not liberalized to an equal extent. distributor or retailer can still contract with pro- On the supply side, the directive provided for ducers. The single buyer pays the producer its two mechanisms for the development of new regulated sales price minus network charges. capacity in generation, both aimed at introducing The producer can then compensate the con- competition: sumer so that the consumption prices become · Authorization. Companies offer to build new equal to the contract price. power plants under an open and impartial pro- cedure that decides whether they should go Public Service Obligations (PSOs) The directive ahead. also recognized that some objectives deemed desir- · Tendering. An authority decides what new able from a social point of view may not be achieved capacity is required. It solicits tenders, which through unfettered competition. To achieve these are then assessed through an impartial objectives, the directive provided that member procedure. states may impose such obligations on electricity 190 Turkey: Economic Reform and Accession to the European Union undertakings.The objectives mentioned in the direc- and five countries chose ownership unbundling. tive were security (including security of supply), Thus effective access required further strengthening regularity, quality, price, and environmental pro- of unbundling. tection. The obligations would be defined by the The communication underlined the benefits of member states. progress in competition. Prices for industrial users had come down in all member states, but larger price decreases occurred in countries where liberal- Progress with Implementation and ization was 100 percent. Household prices fell, Proposed Amendments though to a lesser extent overall than prices for In March 2001, the European Commission issued a industrial users. Overall, larger reductions occurred communication that assessed the progress in devel- in countries in which customers were free to opment of the internal market for electricity and change suppliers and in which changing suppliers the effects of implementation of the 1996 directive was actually easy to do. (European Commission 2001a) and proposed a The communication also raised concerns about series of amendments (European Commission the pace of cross-border trade: "The objective of 2001b). The communication underlined the impor- the Electricity and Gas Directives is the creation of tance of fully opening energy markets to improving one truly integrated single market, not fifteen more Europe's competitiveness. According to the Com- or less liberalized but largely national markets." It mission, the effects of market opening were posi- pointed out that even though the number of cus- tive. However, it also stated that to complete the tomers who switched suppliers rose overall, most internal market, further measures were necessary. customers tended to opt for national suppliers. In The key points of the communication are described general, cross-border trade was limited. Its expan- in this section. sion would require developing appropriate rules on By 2000 the average market openness in the the pricing of this trade, developing rules for the European Community had reached 66 percent--a allocation and management of scarce interconnec- figure higher than the thresholds established in the tion capacity, and, where necessary, increasing such directive. However, progress was very uneven across capacity. countries. Some countries had full market opening; In short, the Commission indicated that there in others, market opening was limited to 30 per- were "several weaknesses in the current legal frame- cent. It also was observed that the reciprocity provi- work which needed to be remedied if a fully opera- sions of the directive had proved unable to address tional internal market for gas and electricity is to be problems of unevenness in the competitive envi- achieved" (European Commission 2001a: 6). On ronments between member states. There was con- the basis of these findings, the Commission devel- cern that if this unevenness persisted over a longer oped proposals to amend the directive (European period, a level playing field would not develop Commission 2001b). The most important pro- within the internal market. posed amendments were as follows: For access, 14 member states had chosen rTPA; only Germany had selected the nTPA regime. Italy · Market opening. Allow all electricity customers and Portugal had chosen SBM for captive (i.e., freedom to choose suppliers (end domestic cus- noneligible) customers and rTPA for eligible cus- tomer franchise monopoly) by January 1, 2005. tomers. Most member states had chosen authoriza- This was called the quantitative proposal. tion as the procedure to elicit additions to genera- · Unbundling. Strengthen unbundling to legal and tion capacity. However, the ultimate goal of functional separation of transmission from gen- nondiscriminatory access to the network was not eration (thus management separation alone was fully achieved. The absence of standard and pub- no longer sufficient, and ownership separation lished third party access tariffs was thought to be a is now appropriately promoted as a form of significant barrier to entry. Another barrier was unbundling stronger than legal separation). the absence of effective unbundling in member · Access. Strengthen access by requiring rTPA with states. Germany and France chose management published tariffs. Do not permit the single buyer unbundling,sevencountrieschoselegalunbundling, model. Competition and Regulatory Reform in Turkey's Electricity Industry 191 · Public service obligations. Make explicit mention motivation was both the general disposition toward of the obligation that member states should the private sector that emerged in the 1980s and fis- ensure universal service, defined as "supply of cal constraints, purportedly to ease the investment high quality of electricity to all customers in load on the general budget. This effort was con- their territory," as well as protection of vulnera- strained, however, by the constitutional regime that ble customers and final consumers' rights. interpreted the provision of electricity as a public · Regulation. Establish an independent regulatory service--that is, something that had to be supplied authority to approve tariffs and conditions for by the government. Instead of responding directly access to transmission and distribution net- by seeking to remove this constitutional challenge, works ex ante and to monitor and report to the the governments of the 1980s and 1990s chose to Commission on the state of the electricity mar- create shortcuts7 through various private sector kets (especially supply-demand balances). participation models short of privatization. The first law setting up a framework for private partici- The proposals did not prescribe a specific model pation in electricity was enacted in 1984 (Law for organization of wholesale activities. Some of the No. 3096).8 This law forms the legal basis for pri- proposals initially met with opposition. In particu- vate participation through build-operate-transfer lar, Germany opposed the requirement for an (BOT) contracts for new generation facilities, independent regulator and ex ante regulation of transfer of operating rights (TOOR) contracts for access prices and conditions (Newbery 2002a). The existing generation and distribution assets, and the principles of nondiscriminatory access to the net- autoproducer system for companies wishing to work, based on transparent and published tariffs, produce their own electricity. Under a BOT conces- and the establishment of independent regulators sion, a private company would build and operate a were adopted by the Barcelona European Council in plant for up to 99 years (later reduced to 49 years) March 2002 (European Commission 2002b). The and then transfer it to the state at no cost.9 Under a Barcelona council also pointed out the need to take TOOR contract, the private enterprise would oper- measures on PSO, in particular for remote areas and ate (and rehabilitate, where necessary) an existing vulnerable groups. During their November 2002 government-owned facility through a lease-type meeting,EU energy ministers agreed that full market arrangement. opening would be achieved in 2004 for nonhouse- In 1994 Law No. 3996 and Implementing Decree hold customers and in 2007 for household cus- 5907 were enacted to enhance the attractiveness of tomers (European Commission 2002a).Unbundling BOT projects. The laws authorized the Undersecre- was to be achieved by July 2004 for transmission and tariat of the Treasury to grant guarantees and pro- 2007 for distribution. The proposed amendments vided tax exemptions (as well as extended the were finally adopted in June 2003.5 purview of the model to other public services such as water and wastewater, transport, and communi- The Current Structure of Turkey's cations).10 An additional law was enacted in 1997 Electricity Industry for private sector participation in the construc- tion and operation of new thermal power plants As in many European countries until recently, the through a licensing system rather than concession Turkish electricity industry was dominated by a state-owned vertically integrated company, TEK.6 award. The build-operate-own (BOO) law (Law No. 4283) again provided guarantees by the Trea- In 1993, in an attempt to prepare TEK for priva- sury. Under the BOO model, investors retain tization, the government separated TEK into the ownership of the facility at the end of the contract Turkish Electricity and Transmission Company period. (TEAS) and the Turkish Electricity Distribution A typical BOT, BOO, or TOOR generation con- Company (TEDAS). tract, signed between the private party and TEAS or TEDAS, includes exclusive "take-or-pay" obligations Background with fixed quantities and prices (or price formulas) Beginning in the 1980s, the government sought to over 15­30 years. Thus it does not provide a frame- attract private participation in the industry. Its work for competition in the market, but only 192 Turkey: Economic Reform and Accession to the European Union potentially for competition for the market if the A large number of BOT proposals or projects contracts are granted through a competitive have not been completed.13 Initially, the main process in which the lowest-cost proposals are constraint was the prevailing interpretation of accepted. The main benefits, in principle, of such Turkey's constitution--that is, that even though private sector participation contracts arise from Law No. 3996 stated that BOT contracts would be (1) transferring those risks to the private sector subject to private law, the Constitutional Court that is best able to manage them (including most decided that electricity was a public service and commercial risk during the operating phase), that therefore the BOTs were to be considered as (2) accessing strong and effective private sector concessions under public administrative law. This commercial and managerial skills for reduced ruling meant that the development and eventual operational costs and improved service quality, and completion of a BOT contract required interven- (3) spurring adoption of innovation at both the tion and approval from a multitude of government design and implementation phases of projects. Such agencies, including the Ministry of Energy and efficiency-related benefits are only likely to arise, Natural Resources (MENR), the High Planning however, from competitively tendered projects. Council (referred to by its Turkish initials, YPK), Unfortunately, no rigorous framework was in place the State Planning Organization (SPO), and the to ensure implementation of competitive tendering. Treasury. In addition, the public law character of On the contrary,under the Turkish BOT model there the contract meant that investors did not have was no requirement for prequalification, nor for a recourse to international arbitration and that con- competitive open tender,nor even for a closed tender tracts had to be reviewed by Danis¸tay, the Council (the"method of sealed bid from selected companies" of State, which was a lengthy process. merely requires that at least three interested compa- In August 1999, a constitutional amendment nies submit their offers). Unsolicited bids could be opened the way for privatization in the electricity brought forward and negotiated solely on the basis of sector, for the application of private law to con- an investor-completed feasibility study (through tracts, and for limits to the scope and duration of "the method of negotiation"). the Danis¸tay review.14 Although the constitutional Compounding these problems, under the amendment (and the subsequent Law No. 4501 of Turkish BOT, BOO, and TOOR generation models January 2000, which implemented these changes) the government has retained most of the commer- simplified the legal framework for private partici- cial risks while providing the private sector with pation, the new obstacle to the development of substantial rewards. Under these contracts, the BOT contracts was the unwillingness of the Trea- Treasury has provided guarantees to cover critical sury to provide new guarantees in light of the commercial take-or-pay payment obligations, such implied contingent liabilities. as minimum electricity generation levels and mini- By the end of the 1990s, it had become clear that mum quantities of gas in power station gas pur- quasi-privatization with Treasury guarantees was chase contracts, at associated predetermined prices not going to be feasible because of the rapidly dete- in U.S. dollars over the life of the contracts.11 riorating fiscal stance. In addition, there was wider Although the fixed-price nature of the contracts appreciation that these types of contracts, which creates incentives for cost efficiencies, the contracts locked generation companies into long-term exclu- preclude any possibility of making consumers share sive sale agreements with predetermined, fixed in any efficiency gains: all cost savings are appropri- prices,did not serve the overall objective of develop- ated by the generator. In addition to the relatively ing competition in electricity markets. Several gov- high electricity cost of many of these projects, the ernment agencies (e.g., MENR, SPO, the Treasury) BOT and TOOR contracts are heavily front-end were already working on the design of a competitive loaded with higher capacity charges in the first electricity sector regulated through an independent years of operation to allow for early recovery of agency. In 2001 Law No. 4628 (the electricity market investment costs (OECD 2002). As discussed below, law, or EML) provided a new and radically different the current structure of these contracts acts as a legal framework for the design of electricity markets major barrier to the development of competition in and established a new, independent Energy Market the generation sector.12 Regulatory Authority (EMRA). Competition and Regulatory Reform in Turkey's Electricity Industry 193 The Current Model companies. These costs must be reflected in con- sumer tariffs. As of May 2003, the estimated eligible The main drivers for liberalization in Turkey were customers above 9 gigawatt-hours per year were very different from those that preoccupied the EU 103 at the transmission level and 507 at the distri- or the leaders of electricity liberalization such as the bution level, accounting for 13.5 percent of overall United Kingdom. The EU was primarily concerned consumption (Sevaioglu n.d.).16 This number is with creating an internal market. Countries such as likely to increase, however, because additional the United Kingdom were motivated by the ineffi- industrial users are expected to enroll as eligible ciency of public enterprises (the ownership dimen- customers through demand aggregation, with users sion) and the opportunities generated by techno- having similar demand characteristics. logical changes that made competition possible in generation (the market structure dimension).15 In On the supply side, the authorization-type licensing framework established in the new regime Turkey, the main driver of and the public justifica- also appears to be fully compatible with the direc- tion for private participation under the pre-2001 tive. It provides entry opportunities into the gener- regime, and liberalization under the new regulatory ation (independent power producers, or IPPs, and regime, were rapid growth in demand, combined autoproducers who can sell up to a maximum of with the inability of the government to meet that 20 percent of their annual production to consumers demand through public investments or Treasury- other than their shareholders), wholesale trade, guaranteed private investments because of the distribution, retail trade, import, and export of deteriorating fiscal situation. electricity. Distribution companies may also oper- Still, the degree of competition envisaged in the ate as retail sales companies in their regions by new framework is more advanced than the EU obtaining a retail sales license and may import elec- directive of 1996. In most respects, it is compatible tricity if allowed in their license. Distribution com- with (if not more competitive than) the proposed panies may establish joint ventures with generation amendments to the directive currently under dis- companies or set up generation units (not exceed- cussion. As described in the next section, the main ing a market share of 20 percent). Transmission challenge for Turkey is that, the competitive frame- remains a state monopoly, but private generators work notwithstanding, the actual development of can establish private direct transmission lines. The competition is likely to take some time because of only limitation is that the EMRA's granting of gen- the legacy of Turkey's recent past: the current struc- eration licenses is conditional on no congestion in ture of ownership (dominance of state-owned the transmission-distribution link connecting the assets in generation) and even more problemati- new plant to the grid or directly to customers. cally the uncompetitive, tied nature of the contracts According to EMRA, congestion in the transmis- governing the privately operated assets. sion network is most likely to be resolved through The new regime contained in primary legislation some type of auctions among the companies that and implementing regulations emphasizes competi- would benefit from the transmission investments tion in ordering the market. The main principles of (Sevaioglu n.d.). the EML, and their status in relation to the 1996 directive, are as follows. Unbundling TEAS has been further unbundled into the Turkish Electricity Generation Company Market Opening On the demand side, customers (EUAS), Turkish Electricity Wholesale Company that consume more than 9 gigawatt-hours per year (TETAS), and Turkish Electricity Transmission are designated as eligible consumers who are free to Company (TEIAS), each organized as a separate choose their suppliers--a measure that meets the legal entity. Thus, the degree of unbundling between targets of the directive. The main operational diffi- generation, transmission, and distribution envis- culty in market opening is estimating the number aged and carried out under the EML goes beyond of expected eligible customers, because higher the minimum directive requirements of manage- numbers mean more measuring, telemetering, and ment separation and unbundling of accounts. The computing hardware and software, which means secondary legislation regulating these activities is larger investments by wholesale and retail being prepared by EMRA. 194 Turkey: Economic Reform and Accession to the European Union FIGURE 7.1 Structure of the Electricity Market, Turkey Market structure EUAS Kepez & Mobile IPPs and All hydros BOTs BOOs TOOR (gen.) CEAS Hydro producers autoproducers EUAS EUAS portfolio Portfolio TETAS (thermal) generation co. 2 generation (thermal) TEIAS Balancing System operator market Settlements administrator TOOR (D) Distributor 1 Distributor 2 Distributor 3 Independent (incl. supply) (incl. supply) (incl. supply) retailer 1 Captive Eligible consumers consumers Source: Modified from Draft Electricity Market Implementation Manual (see EMRA 2003). Under the new structure, EUAS will take over, Third Party Access EML requires the rTPA operate, or close down the state's existing power regime for access to transmission and distribution. plants that are not transferred to the private sector. An independent regulatory authority was created TETAS is created to carry out wholesale operations. that, among other things (see later discussion), will It will take over all existing energy sale and purchase settle disputes between parties. agreements from TEAS and TEDAS (distribution). TEIAS is responsible for transmission assets, for sys- Market Design As highlighted in figure 7.1, at the tem operation and maintenance, for planning of heart of the new regime is a bilateral contracts new transmission investments and building of new market in which generation companies contract transmission facilities, and, critically, for the balanc- with wholesale trade companies (TETAS and any ing and settlement procedure that will balance the eventual new entrants), distribution companies, power transactions among parties, both physically any new independent retail companies, and eligible and financially. Thus, in the words of the directive, customers (EMRA 2003). On the generation side, TEIAS is the transmission system operator. It is EUAS is likely to be split into a hydro generator envisaged that all transmission facilities owned and (holding all state-owned hydro plants transferred operated by other companies will be transferred to from DSI, the Directorate General of State Water TEIAS under the EML. In line with this require- Works) and a small number of affiliate portfolio ment, the transmission facilities that had been generation companies (holding the state-owned awarded to private investors through concessions to thermal plants and mobile plant contracts). EUAS the two companies Kepez Elektrik (Antalya region) also will hold the physical assets associated with any and Cukorova Elektrik, or CEAS (Adana, Mersin, TOOR (generation) contracts. For any excess Hatay, and Osmaniye regions), were seized by the capacity, existing and new autoproducers (genera- Ministry of Energy17 and handed over to TEIAS in tion by industrial facilities for own use) will June 2003, because the companies had failed to compete with other generators for contracts with hand them over by February 2003 as required.18 distribution companies and independent retailers, Competition and Regulatory Reform in Turkey's Electricity Industry 195 and directly with eligible consumers. As illustrated transition to competitive markets and to improve in figure 7.1, the dominant state-owned wholesaler the predictability of revenues during this transi- TETAS also holds all previous BOO, BOT, and tion. The contracts remain with the companies TOOR (generation) contracts and will assume when they are privatized--the private buyer pays other stranded costs such as the debts and employ- for the company and its package of contracts. Vest- ment liabilities of EUAS and TEIAS.19 In fact, deal- ing contracts are intended to cover a large portion ing with stranded costs is one of the main reasons of sales (90­100 percent) of each supplier initially. for the creation of TETAS. This share is reduced gradually in later years and As for end users, eligible customers may buy replaced by freely negotiated bilateral contracts as electricity from their regional distributor/retailer the vesting contracts expire. or TOOR distributor, but they also may buy Vesting contracts are expected to include pur- directly from a wholesaler, from a new independent chases by TETAS from all EUAS hydro plants, sales retailer, or from an independent generator. Captive from TETAS to all distribution companies and dis- customers, by contrast, must buy their electricity tribution TOORs to cover franchise captive con- from a distributor/retailer in their region, but they sumer demand (with part of hydro capacity avail- have the right to buy from any retailer carrying out able for the balancing market), and sales from the same commercial activity in the region--that is, affiliate portfolio generation companies to all dis- either their existing regional distributor or retailer tribution companies. or TOOR distributor or any other new retailer in The main objectives of vesting contracts are as the region. follows (OECD 2002, EMRA 2003): The current market design does not envisage a · Avoid large physical imbalances or large finan- centralized pool or power exchange. Therefore, cial risks to participants. dispatch is separated from the operation of the · Avoid chaotic prices. wholesale market. The actual real-time equality of · Ensure that distribution companies are not demand and supply, given the bilateral contracts, overexposed in the balancing market. will be carried out by the system operator through · Allow a period of time for learning how the purchases and sales in a balancing market. For this bilateral market works before distribution com- purpose, a market System Balancing and Settle- ment Center20 is to be established within TEIAS. panies undertake their own contracting. · Allow companies to be privatized with a set of In principle, it is expected that the balancing matching purchase and sale contracts so that market will make up a small percentage of total potential buyers can value them. demand and will be used for adjustments at the · Allow government to influence the portfolio margin. mix of generation purchased by each distributor Privatization The new regime envisages eventual to ensure reasonable regional balance. direct privatization in generation and distribution. · Allow determination of a reasonable flow of Transmission assets are to remain under govern- funds between companies (e.g., minimum sales ment ownership. Foreign investors cannot assume a levels for generation companies). controlling interest in the generation, transmission, and distribution sectors. Public Service Obligations The EML under the The details of licensing procedures, market consumer support section of Article 13 and the tar- operation, tariffs, vesting contracts, privatization, iff regulation under Article 20 allow for an explicit and stranded cost mechanisms have been left to cash subsidy: direct cash refunds to consumers secondary legislation and decisions. without affecting the price structure and the prices Vesting Contracts Vesting contracts are an initial "in cases where consumers in certain regions set of bilateral contracts put in place by the govern- and/or in line with certain objectives need to be ment between companies it owns (or between supported." The mechanism for allocation of these state-owned companies and private companies direct cash refunds ("amount, procedure and such as independent retailers when the government principles") has not been defined in the primary decides the contract structure and when the retailer legislation; it will be established by the Council of decides whether to buy it) to provide a smooth Ministers upon proposal by the MENR. 196 Turkey: Economic Reform and Accession to the European Union The Independent Regulatory Authority The Main Challenges new regime establishes the independent Energy The actual development of competition in the Market Regulatory Authority, which is governed by its own board.21 The main functions of the author- Turkish electricity market is likely to take time because of various challenges and difficulties, espe- ity include: cially those related to the exit from the old system. · Applying and overseeing the new licensing Primary among these challenges is the fact that framework most generation capacity is currently either under · Preparing and publishing secondary legislation government ownership or tied up in take-or-pay on electricity and natural gas markets22 contracts that leave no room for competition. · Enforcing regulated third party access Additional challenges lie in the financial difficulties · Applying a new transmission and distribution that may persist in distribution. Finally, liberaliza- code tion will entail significant tariff rebalancing, which · Determining eligible customers over time may pose serious political challenges. · Regulating tariffs for transmission and distribu- tion activities (connection and use of system), as Stranded Costs and Competition well as provision of retail services to noneligible in the Generation Market customers, and the wholesale tariff of TETAS · Performing tenders for city gas distribution As of 2002, private generators in Turkey accounted networks for a total of about 37 percent of capacity, including · Following the performance of all actors in the 12 percent for autoproducers (table 7.1). Under cur- market rently committed BOO, BOT, and TOOR contracts · Following and protecting customer rights (see table)--assuming no privatization in genera- · Applying sanctions to parties violating the tion, a significant increase in autoproduction capac- established rules. ity, but little additional new entry for the foreseeable TABLE 7.1 Turkey's Electricity Generating Capacity: 2002, 2005, 2010 2002 2005 2010 Megawatts Percent Megawatts Percent Megawatts Percent Non-EUAS plant Build-own-operate (BOO) 3,830 11.3 5,810 14.4 5,810 13.5 Build-own-transfer (BOT) thermal 1,450 4.3 1,450 3.6 1,450 3.4 BOT hydro and wind 899 2.7 899 2.2 899 2.1 Transfer of operating rights 650 1.9 650 1.6 650 1.5 (TOOR) transferred Mobile 623 1.8 823 2.0 823 1.9 Kepez and CEAS 1,120 3.3 1,120 2.8 1,120 2.6 Autoproduction 3,944 11.7 5,344 13.2 6,844 15.9 Subtotal 12,516 37.0 16,096 39.8 17,956 41.7 EUAS plant Natural gas 3,983 11.8 3,983 9.8 3,983 9.3 Hydro 10,326 30.6 11,685 28.9 12,762 29.7 Coal/lignite and fuel oil 6,972 20.6 8,692 21.5 8,692 20.2 Subtotal 21,281 63.0 24,360 60.2 25,437 59.1 Total capacity 33,796 100.0 40,455 100.0 43,032 100.0 Note: The forecasts in the table exclude additional hydro plants with signed intergovernmental protocols scheduled for 2007 and after. Source: ECA 2002. Competition and Regulatory Reform in Turkey's Electricity Industry 197 future--the public sector's share of capacity will factors and thus lower revenues than required to remain at about 60 percent in 2010. Publicly owned recover full costs. Surplus generating capacity may hydro assets alone account for about a third of total have been driven at least in part by overly opti- generation capacity. mistic demand forecasts, a natural occurrence in a Because a significant share of privately operated system in which the costs of substantial publicly assets are tied to contracts entailing fixed amounts promoted overbuilding are not apparent, and the and prices, those assets will not be deployed under costs of underbuilding are immediately obvious competitive forces. As highlighted in table 7.1, as of and extremely high. The two earthquakes and the 2002 the three BOO plants in operation accounted economic crises that Turkey suffered in recent years for the largest share. Total energy sold by the BOO also play a significant role in explaining the devia- plants in 2002 was 36.4 gigawatt-hours, or 34.3 per- tion between initial demand forecasts and actual cent of the total energy purchased by TETAS in 2002. demand. The second main source of stranded costs Four natural gas plants, 17 hydroelectric plants, is the long-term power purchase contracts between and two wind BOT plants are already in operation. the state and private producers with especially high These BOT projects sold 12.7 gigawatt-hours of front-end costs. The high cost of electricity from energy in 2002, which accounted for an additional many of these contracts makes it difficult to generate 11.9 percent of total TETAS consumption. There- the required revenues to service these contracts with- fore, 46.2 percent of all purchases made by TETAS is out increasing average wholesale and retail prices. based on existing tied BOO and BOT contracts. The long-term, Treasury-guaranteed generation Procedures are not complete for an additional contracts and associated stranded costs have two 30 BOT projects with a capacity of 2,771 mega- important implications. The first relates to compe- watts, and their legal status is still not clear. The tition. The prospects for competition among gener- anticompetitive nature of these contracts and their ators are poor for the immediate future unless there apparent high cost have roused public reaction is new entry by IPPs or autoproducers. However, against them. As for TOORs, two generators (one new entry may exacerbate the problem of stranded lignite and one hydro) are operating. TOOR con- costs, because generation capacity is already tracts accounting for an additional 3,926 mega- expected to be in substantial surplus. Furthermore, watts have not been transferred; their legal status is the existing finalized BOT, BOO, and TOOR not clear (and their transfer would have little effect (generation) contracts adversely affect the possibil- on available capacity, because they represent exist- ities of market liberalization by preserving an ing production). uneven playing field (in which favored generators Stranded costs--that is, the costs incurred benefit from state guarantees, privileged trading within the previous market structure that cannot relationships, and noncompetitive pricing, and be economically recovered within a competitive thereby face substantially fewer market risks), by market structure--include the high operating costs preventing pressures on prices from new entry, and of old and inefficient generators, long-term power by preventing flexible price and quantity adjust- purchase agreements with high prices, removal of ments to unanticipated market shocks (such as the production subsidies, and high staffing costs (pay- recent macro crisis). ments of redundancies resulting from the transfer The second implication has to do with the con- of operations to the private sector, including pen- tingent liabilities created for the government. If rev- sion liabilities for workers able to retire). Stranded enues to the electricity sector do not cover payments costs create uncertainty for new investors and risk to the Treasury-guaranteed generators, then the stifling competition. guarantees would be activated and payments from Stranded costs have two main sources. The first the government's constrained budgetary resources is the substantial surplus generating capacity. would be needed to subsidize electricity (whether it Reserve margins were over 60 percent in 2002 and is actually used or not). The substantial state-owned may remain substantially above the minimum hydro resources that have been developed to date go 25 percent or so required for system security for the some way toward minimizing these potential liabil- next few years, depending on the evolution of ities, because the low cost of hydro can be consid- demand. This substantial level of excess capacity cre- ered a "stranded benefit" that can be used to help ates a situation in which facilities have low capacity offset the sizeable transition-related stranded costs. 198 Turkey: Economic Reform and Accession to the European Union Indeed,the idea behind initially contracting all state- FIGURE 7.2 Electricity Losses of Turkey owned hydro assets to TETAS is to enable it to cover versus OECD, 1984­2000 a substantial part of the stranded costs through the Percent profits on sales at market levels of this low-cost 25 power. However, under some low demand scenarios, Turkey even with hydro fetching the very low price of OECD average 20 US$0.002 per kilowatt-hour,23 TETAS may be faced with a substantial revenue deficit. Under the worst- 15 case but not necessarily zero-probability scenarios, Economic Consulting Associates calculates these deficits to be between $100 million and $800 million 10 annually (adding to a total of $4.1 billion) between 2003 and 2010 (ECA 2002: table 29).24 5 Revenue Deficits, Technical Losses, and Private 0 Participation in Distribution 19841985198619871988198919901991199219931994199519961997199819992000 The main challenge in distribution when trying to Source: OECD 2002. create competition is to ensure the creation of cred- itworthy entities that can act as counterparts to jeopardizing distribution privatization and possibly incumbents and potential entrants on the genera- resulting in nonsalable assets. In 2003 most of those tion side. contracts were canceled by the Council of State. Turkey presently has 33 distribution areas. In a The distribution sector suffers from growing few regions (including those served by Kepez and operating revenue deficits, which are driven by elec- CEAS, concessions that had permitted operation of tricity theft and nonpayment (about 14 percent of the networks by private investors have been total energy purchased by TEDAS with large regional cancelled. Additional tenders for TOORs were held variation), technical losses (about 7 percent), and a for other regions in 1996. Bidding occurred free or unbilled electricity supply (4 percent, espe- through offers of distribution tariffs over the con- cially street lighting). In member countries of the cession period, with the lowest bidder winning. Organisation for Economic Co-operation and Thus, as for the fixed-price BOT, BOO, and TOOR Development (OECD), the average of electricity generation contracts, any efficiency gains over the losses (which are driven mainly by technical losses) is franchise period will not be passed on to con- about 8 percent (figure 7.2). Theft and nonpayment sumers. In addition, winners had to commit to are fundamentally a political economy and distri- reducing technical electricity losses; gains or losses bution problem that has implications for rebalanc- generated by changes in electricity losses would be ing tariffs. appropriated fully by the company. An additional problem with distribution TOOR contracts is that Tariff Rebalancing, Social Protection, they may prevent the subsequent imposition of a and Industrial Competitiveness harsh efficiency-enhancing, incentive-based tariff formula, because these companies would then lose Industrial prices are almost as high as household profits relative to the initially promised fixed- prices, unlike in more liberalized markets where cost-plus tariffs, and they would therefore seek industrial prices are often less than half those of (and have grounds for) compensation. Finally, to households (lower industrial prices reflect the the extent that the desirable distribution regions lower unit cost of delivery of large amounts of were cherry-picked through the TOOR process, electricity to industrial customers). According to sufficiently marketable and competitive groupings data on end-user prices, Turkish industry faces could not be formed from the remaining regions, one of the highest costs in Europe. However, and the most desirable subregions could not be equally noteworthy is that Turkish household matched with least desirable subregions, thereby prices are not particularly high, in the lower end of Competition and Regulatory Reform in Turkey's Electricity Industry 199 TABLE 7.2 Retail Prices for Electricity reflect these costs in user tariffs. This issue of tariff (US¢ per kilowatt-hour) rebalancing toward cost-reflective tariffs, if not properly handled, could jeopardize the entire Electricity Electricity reform effort by creating political pressures for for for Industry Households backtracking. Rebalancing will have effects on poverty and relocation incentives--poorer house- EU12 holds in the east are likely to see their prices rise Austria 9.21 12.14 most in the short term, while already overpopu- Belgium 4.77 13.23 lated cities in the west with more efficient distribu- Denmark 5.97 19.53 tion systems will face somewhat less steep tariff Finland 3.94 7.89 increases. And it will have effects on employment France 3.58 10.17 and industrial competitiveness--business users Germany 7.90 16.66 with annual consumption below the threshold, Greece 4.31 7.75 Ireland 4.62 9.57 including all small and medium-size enterprises Italy 9.30 13.42 (SMEs), will also likely see substantial price rises. Portugal 6.59 11.77 The recent difficulties over the creation of distri- Spain 5.58 14.33 bution regions reflected the income distribution United Kingdom 4.96 10.10 dilemma faced by the authorities. The agreement Central and Eastern reached ultimately among EMRA, MENR, TEDAS, Europe and the Treasury after months of work was rejected Czech Republic 4.68 6.11 by the government because of intense pressures Hungary 5.21 6.98 from localities that did not want to be included in Poland 4.76 8.34 regions designated as high-cost areas. EMRA Slovak Republic 4.35 6.28 responded by proposing instead province-based, North America cost-reflective retail tariffs. The highest proposed tariff was for Hakkari, which is both one of the Canada 3.86 6.01 poorest provinces and the one with the highest United States 4.27 8.50 incidence of theft (Radikal, March 3, 2003). Turkey 8.05 8.49 Source: IEA 2002. Wholesale Market Concentration and the Dominant Role of TETAS the range for Europe. Out of 32 countries listed in In the design of the new market model, the role of the International Energy Agency (IEA) report Key TETAS is critical as an instrument to help resolve World Energy Statistics 2002, Turkey is the only transitional stranded costs through market mecha- country (apart from India) in which consumer nisms, and thereby help protect captive consumers prices are so close to industrial prices (IEA 2002). from sudden and large increases in wholesale Consumer prices are more than double industrial prices. It is with this purpose in mind that TETAS prices in 8 of the 12 EU countries in table 7.2 and was designated to hold all legacy state-owned in Denmark they are three times higher. The num- contracts and liabilities--including BOT, BOO, bers in table 7.2 suggest that, although large indus- and TOOR contracts as well existing import and trial users are likely to see substantial price export contracts--and play a key role as a whole- decreases from increased competition, households saler trader of electricity. The EML requires TETAS and smaller industrial users are likely to see sub- to be financially viable and authorizes TETAS to stantial price increases. charge a wholesale price sufficient to cover its This large cross subsidy to households will not stranded cost obligations (based on the weighted survive with liberalization, because eligible con- average costs of the generation plants selling to it, sumers are entitled to switch to lower-cost sources including BOT, BOO, and TOOR plants). However, under bilateral agreements, and because less effi- there is no requirement for profitability on a year- cient or higher-cost regional distribution systems by-year basis. Rather, surpluses and deficits must 200 Turkey: Economic Reform and Accession to the European Union balance over a reasonable period. The initial con- electricity market for the foreseeable future and tracting to TETAS of all state-owned hydro plants how more room could be made for additional com- is intended to help it meet this financial viability petition, and that articulates a well-defined end criterion. state for the industry and a strategy for achieving it. As the holder of the majority of generation con- tracts, TETAS will be the dominant seller in the Possible Competition-Enhancing market for the foreseeable future. Through its Solutions rights to hydro capacity, TETAS also will be the Evidence of the benefits of electricity reform is dominant participant in the balancing market. rather recent, and most of the detailed studies con- Given its dominant position, it will be critical that centrate on well-known cases such as the United TETAS be effectively regulated. In the absence of States, United Kingdom, and Scandinavian coun- effective regulation, TETAS has no incentive to tries. Some studies do not provide strong conclu- keep its costs as low as possible, because it passes its sions. For example, a recent study by the OECD costs fully to captive customers. (Steiner 2002) fails to find that regulatory variables In practice, the ability of TETAS to raise the such as third party access and unbundling have a wholesale price to cover its stranded cost obliga- significant effect on industrial prices. Such vari- tions is constrained by the prices that could be ables are found to have an impact on the ratio of offered by new entrants (such as the cost of elec- industrial to residential prices, but this finding may tricity from a new gas-fired CCGT power plant), to be capturing the impact of rebalancing rather than the extent that new developers are willing to take the impact of the other components of reform. the risk of building new power plants over the next Privatization is found to increase industrial prices. few years. If the TETAS wholesale price is above the Yet the same regulatory variables are found to have price offered by IPPs, then distribution companies a positive impact on a proxy for efficiency. and eligible consumers will choose to buy from Nevertheless, there is a general consensus IPPs, causing TETAS's sales to fall. However, among analysts that the key to welfare-enhancing because TETAS's costs have a large take-or-pay electricity reform is adequate competition in gener- component from BOT, BOO, and TOOR plants, ation. Efficiency gains, especially those stemming those costs will remain high as TETAS's market from cost reduction, are easiest to obtain in this share falls, forcing the company to recover its fixed segment of the industry. However, enhanced costs over a lower level of sales. To avoid such a competition is necessary for those efficiency gains vicious cycle of falling sales and required higher to be passed on to consumers. The rest of this sec- wholesale prices, TETAS cannot afford to charge a tion discusses some options that can accelerate wholesale price significantly above that offered by a the development of competition in the Turkish new gas-fired plant. context. Interinstitutional Coordination and a National Transitional Regimes for Tackling Stranded Costs Electricity Policy In minimizing and addressing stranded costs, the Turkey's electricity policy lacks the strong, central- government will have to consider several options. ized leadership needed to take an overall perspec- Lowering and more rapidly resolving stranded tive of the electricity reform program--including costs will have benefits--in particular, allowing the tariffs, market structure, promotion of competi- more rapid introduction of competition. Such a tion, and privatization issues--and to ensure coor- step also would allow a more rapid release of hydro dination of the eight or more entities with separate plants for privatization, which would have the management teams: MENR, EMRA, PA (Privatiza- added benefits of enabling generators and retailers tion Authority), EUAS, TETAS, TEIAS, TEDAS, and to offer more valuable contract shapes and of the Treasury. It would be highly desirable to achieve providing flexible energy to the balancing market. consensus among all main national stakeholders Possible options include around a national electricity policy that presents a coherent strategy for market structure, that out- · A final resolution of all outstanding nonfinalized lines what is meant by competition in Turkey's BOT and TOOR generation contracts that does Competition and Regulatory Reform in Turkey's Electricity Industry 201 not increase stranded costs. In view of the poten- market price; and (4) volume risk transfer, com- tial costs to the economy and the electricity sec- pensating the estimated revenue loss when the tor in both additional fiscal costs and foregone company fails to find customers paying the same competition benefits, it appears to be in the price as agreed to in the initial take-or-pay public interest not to provide Treasury guaran- clause. The potential for outsiders to challenge tees for most of the nonfinalized BOT and any such negotiated solution should be minimal, TOOR projects, while remaining open to nego- so long as project sponsors are no better off than tiated win-win solutions subject to this con- they were prior to the renegotiation. Stranded straint. The basic strategy of EMRA has been to costs also could be reduced by agreeing to lower encourage project sponsors to apply for generat- the gas prices charged in individual contracts by ing licenses and to act according to the dictates BOTA¸S, the state-owned national gas company. of the new market model. Because of the poten- · Postponing or canceling of nonfinalized intergov- tial reputational costs to Turkey as a destination ernmental protocols on hydro. Intergovernmental for foreign direct investment (FDI) inflows from protocols refer to commitments between two or such a unilateral government decision, the gov- more sovereign governments for specific invest- ernment should remain open to negotiating ments. To help lower the extent of excess genera- with project sponsors on a case-by-case basis to tion capacity on the system, authorities should seek acceptable solutions that do not burden consider altering the existing pipeline of country- Turkey with additional expensive and unneeded to-country protocols. Because such protocols are power. The broader international impact should political undertakings rather than established not be too negative, as long as the underlying private contractual rights, modifications in line public policy reasons are clearly explained and with unexpected public policy imperatives may the initially agreed-upon contractual terms are be easier to achieve. met, including the appropriate compensation · Low pricing of TETAS-contracted, state-owned being offered after arbitration if a negotiated hydro generation assets. By pricing hydro at its solution is not possible. operations and maintenance cost, TETAS could · Voluntary win-win renegotiation of tariffs. The reduce the revenues required to pay the stranded existing BOT contracts are heavily front-loaded costs. However, depending on the demand with higher capacity charges in the first scenario, low pricing of hydro may not be ade- 5­10 years of operation. By exploring the scope quate on its own. for nonunilateral improvements to the contracts · Stranded cost levy. A levy or additional surcharge in the spirit of the basic principles of the EU's could be applied in various ways to obtain 1996 directive, the government could lower the revenue to cover any deficit, but the simplest level of stranded costs. Possible win-win modifi- way would be to apply it to final electricity cations include lowering the average tariff level consumption. Imposing the levy on final con- over time and flattening the tariff slope in sumption ensures that eligible consumers and exchange for removing the"T" (transfer require- distribution companies cannot avoid the levy ment) in BOT or using alternate approaches to when they buy power from sources other than providing an equity return over a longer period. TETAS. A stranded cost levy may be the easiest To facilitate negotiations, the following potential and best solution from an economic point of win-win modifications that would transform the view. However, the levy would result in an existing BOT contracts into IPPs should be increase in prices to end consumers: the unbundled and discussed separately (Sevaioglu approach suffers from the obvious drawback n.d.): (1) tariff smoothing, flattening the pay- that the tariff would raise. ment curve by retarding the higher payments of · Sale of hydropower plants. Selling (or leasing) the first years; (2) ownership transfer, transform- hydropower plants to the private sector and ing the BOT to a BOO model by subtracting the using these sales revenues to cover the stranded value of the assets from the tariff profile; cost deficits is an option that also should be (3) price risk transfer, removing the take-or- considered. This would have an impact similar to pay condition by compensating the difference that produced by diluting the high BOT, BOO, between the agreed-on and estimated stabilized and TOOR generation costs with low-cost hydro, 202 Turkey: Economic Reform and Accession to the European Union but the advantages would be twofold. First, rev- as a social safety net). Such support has fiscal impli- enues would be realized immediately, at a time cations for forthcoming budgets. It also requires when Treasury resources are particularly con- the implementation of workable eligibility and strained. Second, such an approach would allow delivery mechanisms. market liberalization to go ahead more rapidly. As part of a possible policy solution, the EML However, an important consideration for the and the tariff regulation allow an explicit cash sub- government is whether adequate revenues would sidy under a mechanism to be established by the be realized from the sale of what are potentially Council of Ministers. Provisional Article 12 of the extremely valuable assets in the balancing mar- licensing regulation allows vesting contracts, which ket in the immediate term, or whether higher could be bundled in order to offer lower-cost revenues could be realized once the market contracts to higher-cost distribution regions and begins functioning, once experience accumu- thereby ease cross-regional adjustment. One addi- lates on how the new market would value hydro tional mechanism that might help to ease the cost plants and hydro electricity, and once investor burden on residents in the eastern part of Turkey is confidence increases with additional regulatory the use of meters with a three-term tariff structure. oversight experience. Yet the benefit of more By using such meters, the electricity sector could rapid liberalization or at least a staged privatiza- offer extremely low prices during off-peak periods tion approach with annual auctions for some and thereby help to reduce illicit utilization. hydro (either for capacity in, say, 1-megawatt tranches of all hydro or for all of a specific plant for one-year leases) may well outweigh the fore- Cross-Border Trade and the Benefits gone higher revenue proceeds of a later sale, in of EU Accession particular if the earlier prospect of privatization EU countries have reported benefits from adopting helps to spur better regulatory oversight and the electricity directive, but problem areas remain other market-friendly policy decisions during (European Commission 2002c): the shorter preprivatization period (driven by the pressures of an incipient privatization). · Differential rates of market liberalization. By 2002, five countries had implemented 100 per- cent market liberalization, but the rest had Tariffs and Universal Service opened up less than 60 percent of their markets. Indeed, Denmark, France, and Greece had Under the electricity reforms, industrial tariffs are opened up only 35 percent of their markets. expected to fall, and household tariffs are expected · Disparities in access tariffs between network oper- to increase from tariff rebalancing. However, in any ators. Because of a lack of transparency caused assessment of the impact of overall tariff changes by insufficient unbundling (e.g., management on consumer welfare, it is important to take into or accounting but not legal or ownership sepa- account the decrease in the prices of all goods in the ration) and inefficient regulation, these dispari- household consumer basket that will result from ties may form a barrier to competition. the lower cost of this key intermediate input. · The high level of market power among existing More generally, efficiency gains from cost-reflective generating companies associated with a lack of liq- prices are expected throughout the economy. uidity in wholesale and balancing markets. Such To mitigate the effect of rising household tariffs, high market power impedes new entrants. For the first priority should be to reduce costs by elimi- example, only in three member states do the top nating theft and nonpayment rather than by three companies have less than 50 percent mar- adjusting household tariffs upward by the full ket share; in nine member states the top three margin required to cover costs (inclusive of theft companies have more than 75 percent market and nonpayment). In addition, a means-tested sys- share. Large divergences in prices continue to tem is needed to provide support to those who can- exist across member states. not afford the higher retail prices and are eligible for such social protection (in part replacing the A central implication of the full internal market current reliance on theft and nonpayment of bills is that an important source of competition in Competition and Regulatory Reform in Turkey's Electricity Industry 203 countries where the generation market is con- border transactions is not yet very well devel- centrated would be cross-border transactions. oped, so it is still organizationally and economi- However, the ratio of import capacity to installed cally difficult for individual electricity customers capacity is more than 25 percent in only four out to choose suppliers situated in another EU of the 15 EU countries to date. A heavier reliance member state, although proposals for more on cross-border transactions requires better cross- refined systems of cross-border pricing are being border arrangements. The problem is insufficient developed. interconnection infrastructure between member · Technological transmission losses over distance. states and, where congestion exists, unsatisfactory Absent a DC (direct current) direct transmission methods for allocating scarce capacity. But it is link (like the one between Greece and Italy), the encouraging that participants in the sixth Florence cost of running electricity through intermediary forum in September 2001 agreed on common transmission networks makes shipping elec- guidelines on congestion management. There has tricity from Turkey to France or the United been more progress on cross-border tariffication. Kingdom prohibitive. Therefore, trade in the Since the adoption of a temporary mechanism for medium term will remain fairly localized, possi- cross-border electricity exchanges in March 2002, bly including Greece, Italy, and Bulgaria- EU market players involved in cross-border Romania. Because Turkey has lower-cost exchanges no longer have to pay a series of uncoor- endowments than neighboring countries, it is dinated charges to transmission networks ("pan- likely that the eventual flow will be from Turkey caking") because all transit and import charges to neighboring countries, implying a gradual have been removed. Under the new regime, only a increase in Turkish prices as low-cost assets are single export charge is allowed (1 per megawatt- fully utilized. hour). Nevertheless, the European Commission remains worried about the pace of development of Without a doubt, one of the most significant cross-border trade. By the end of 2000, four years benefits of EU accession for Turkey in the electric- after adoption of the electricity directive, the physi- ity sector would be the stability provided by cal cross-border trade in electricity did not exceed anchoring Turkish regulations and practices to EU 8 percent of total consumption, which left "the norms and practices. Because of the degree of polit- EU far from a real, competitive internal market" ical instability in Turkey (especially, until recently, (European Commission 2002c: 22) the predominance of coalition governments and the As for Turkey, obstacles to increased cross- short tenure of governments), and because in the border trade include: past the discretionary authority of the state has not · Operating standards and interconnector capacity. always been used in the clear interest of the public Currently, Turkey does not comply with the (the existing stranded contracts in electricity are an main continental European UCPTE (Union for example), the European anchor will provide a the Coordination of Production and Transmis- strong signal of discrete and irreversible regime sion of Electricity) operating standards, and change from past practices that may have caused therefore it cannot connect its network synchro- concern among both foreign and domestic players nously. In 2006 Turkey is expected to be part of in the electricity industry. The confidence-boosting the UCPTE network. A 400-kilowatt overhead effect on potential investors, who otherwise may line to Greece is expected to be commissioned continue to be reluctant to enter the Turkish elec- by 2006 (with a subsea cable connecting Greece tricity market, is likely to be significant. with Italy and the Western Europe network). A connection exists with Bulgaria when a portion Privatization and Entry Promotion Strategies of the Turkish network in Thrace is discon- for Generation and Distribution Assets nected (according to the OECD, imports from Bulgaria account for 3 percent of domestic It has been asserted that one of the worst fea- consumption). tures of EU electricity reforms until the recent · Cross-border transmission pricing and settlement proposals was the continued presence of vertical coordination. The tariff framework for cross- integration--in Europe, common ownership of 204 Turkey: Economic Reform and Accession to the European Union generation and distribution is increasing. Vertical unbundled structure: a high price shifts profits to ownership separation or unbundling of distri- generators and away from the retailing business, bution from generation at the time of privatiza- and a low price benefits retailing at the expense of tion seems to have become the consensus approach generators. This risk can be reduced by vertical in the rest of the world; it has been adopted integration in which generators are assured of a successfully in England/Wales, Latin America captive market. Vertical integration also reduces the (Argentina, Bolivia, Chile, Colombia, El Salvador, transaction costs of contracting, as well as the risk Guatemala, and Peru as the most-cited examples), of failing to find a buyer and thus being forced into several transition economies, and Australia and a distress sale in the short-term balancing market. New Zealand. Malaysia and many EU countries are Yet the larger the share of the market covered by exceptions to this pattern. vertically integrated companies, the harder new The recent crisis in California, however, raised entry will be and the more disadvantaged will be doubts, including in Europe, about the stability those companies that remain nonintegrated. and viability of unbundled electricity markets (Newbery 2001, 2002a). It has been argued that gen- Developing Competition Where Possible If a erating companies in California had the incentives key objective of reform is to stimulate the stable and ability to behave strategically, withhold capac- provision of low-cost, low-priced electrical energy, ity, and thereby manipulate and increase wholesale international evidence suggests that sufficient com- prices (although other factors were at work as well, petition is the best means to achieve it. A negative including flawed market design--see box 7.1). By aspect of vertical integration is that the monopolist contrast, it is argued that integration of generation distributor will, in many circumstances, be able to with distribution eliminates these incentives and increase its profits (together with delayed innova- creates a more stable market structure. tion) at the expense of society by favoring its own An assessment of which way to go must include integrated generating companies over more efficient weighing the benefits of mitigating the wholesale (existing and potential that may not enter) genera- price risk that vertical integration can provide tors. Ownership separation removes the incentive against the costs of foregone competition and fore- for market foreclosure. Although there remain gone effective regulation. The arguments point to economies of scope between generation and trans- vertical separation as the preferred initial configu- mission/distribution that may suggest benefits from ration, allowing markets to reconfigure assets at a full vertical integration, there is also substantial evi- later stage if desirable (subject to oversight by dence that the benefits of unbundled competition the competition authorities). Whether Turkey's may be substantial. A telling example is the early state-owned thermal generation plants should be experience of Scotland, where the two producers privatized as a small number of bundled portfolio were privatized as vertically integrated companies, companies or sold as separate units depends at least and England/Wales, where there was strict vertical in part on how geographically apart from each separation at the time of privatization. Prior to the other they are. reforms in 1990, prices in Scotland were about 8 percent lower than those in England/Wales. In Mitigating Wholesale Price Risk The recent rush 2000, Scottish prices were 5 percent higher, a swing toward vertical mergers in England/Wales has been of 13 percent (OECD 2001). driven at least in part by their move from a compul- sory, single-price power pool to a bilateral contracts Facilitating Effective Regulation If the regula- framework in which there would no longer be a tors of the distribution monopolies are unable to single price for the delivery of electricity at any detect or prevent discriminatory treatment toward particular time but rather directly negotiated prices favored generators, many of the benefits of compe- between buyers and sellers (and substantial penal- tition would be lost, casting doubt on the benefits ties for generators and customers who deviate of the overall liberalization project. Vertical owner- from their contracted levels). The wholesale price ship separation facilitates the job of the regulator risk that arises in a bilateral contracting environ- by removing incentives for nontransparent transfer ment translates directly into profit risk in an pricing, differential quality of access to the wires, or Competition and Regulatory Reform in Turkey's Electricity Industry 205 BOX 7.1 California's Electricity Crisis In 1996 the California electricity industry under- interest groups (bits and pieces from different went a fundamental restructuring. Before designs) rather than a well-thought-out strategy. reforms, three vertically integrated utilities It also was very complicated. The design relied owned and operated generation, transmission, more on individual generator owners to make and distribution assets. Retail prices were regu- commitment and dispatch decisions and to lated by the state, and wholesale prices were manage congestion based on their self-interests regulated at the federal level by the Federal (in that sense, it was closer to the "New Trading Energy Regulatory Commission (FERC). Prices Arrangements" in the United Kingdom than the were higher than U.S. averages, a situation that previous pool system). Meanwhile, serious was blamed on the vertically integrated structure episodes of horizontal market power problems and long-term contracts with independent power began to emerge: because of the rigid capacity producers (IPPs). Thus, the public demanded constraints, small amounts of withheld capacity reform. resulted in large price increases. But the The most important features of the Restruc- buildup of new capacity turned out to be very turing Law of 1996 were as follows: slow, and California found itself also experienc- ing a rapid increase in demand. In response, · Customers could choose a competitive the IOUs became increasingly reliant on the electricity service provider (ESP) or buy spot market. Customer switching to ESPs was default service from the local utility distri- slower than expected, which meant large bution company (UDC). default service obligations for the IOUs. The · Incumbents were required to provide com- ban on hedging contracts made their situation peting generators, wholesale marketers, even more difficult. As a result, a large portion and ESPs with open access to their trans- of demand was served through the volatile mission and distribution networks at regu- wholesale market. lated prices. The meltdown of the system was triggered · The UDC default service price was set equal by dramatic increases in the wholesale prices to the wholesale spot market prices deter- that utilities had to pay. The main reasons for the mined in the day-ahead real-time markets. increase were rising natural gas (input) prices, a · A retail rate freeze of a maximum of four large increase in demand (due to abnormally years was set to recover the stranded costs hot weather, high economic growth), reduced of generating assets (the assumption was imports, and rising prices for nitrogen oxide that wholesale prices would be lower than emissions credits. In addition, there were serious frozen retail levels). market power problems. It has been estimated · The California Independent System Opera- that about a third of price increases were attrib- tor (ISO) and California Power Exchange utable to market power and strategic behavior by were created. players. High prices also further distorted incen- · The two largest investor-owned utilities tives. For example, ESPs lost incentives to sell in (IOUs) were ordered to divest at least half the retail market because they could increase of their fossil fuel generating capacity. profit by selling in the wholesale market. · The IOUs were required to meet default Because retail prices were frozen, the utilities service obligations by purchasing from the began to experience financial problems and spot market (i.e., they had to sell power creditworthiness declined. Their requests to from their remaining assets and then buy it increase retail prices were turned down by the back to meet their default service state regulator. Finally, they went bankrupt. The demand). They were "short" for the differ- state government practically took over supply. ence between what they could sell and Bad luck played an important role in the what they had to meet in terms of default Californian crisis in the sense that a large num- demand; and they were not allowed to ber of adverse events jointly triggered wholesale hedge by forward contracts with genera- prices. However, flawed design and existence of tors, because it was feared that such con- market power made the system vulnerable to tracts could be anticompetitive. adverse shocks. Market design represented a series of inco- Sources: Joskow 2001; Cabral 2002. herent and fragmented compromises between 206 Turkey: Economic Reform and Accession to the European Union other discriminatory treatment between distribu- However, the weight of tied generation assets that tors and generators, and thereby making it easier have been contracted to private parties through for regulators to get information about the true BOT, BOO, and TOOR contracts may continue to underlying costs and to secure fair access to the net- prevent sufficient competition from emerging for works. The much more difficult task of effectively some time, particularly to the extent that hydro regulating vertically integrated companies, if that is assets also remain contracted to TETAS over the to be an outcome preferred by the markets at a sub- medium term to ensure its financial viability. In sequent stage, should only be attempted by more this area, bold policy measures that reduce stranded seasoned regulators after a significant period of costs and allow earlier hydro release to the market learning-by-doing in an unbundled environment. could yield substantial benefits. As for sequencing, it is appropriate first to priva- An alternate but complementary way in which tize distribution companies and ensure commercial to increase competition and reduce market power management of those assets. This approach will in generation markets is through policies that work allow the creation of financially viable companies on the demand rather than the supply side by that, in turn, allow private generators to structure increasing the elasticity of demand--that is, by bankable projects without government guarantees. promoting stronger customer response to price According to Newbery (2002a, 2002b), four con- changes. Traditionally, all customers pay fixed ditions must be met for unbundled electricity mar- prices (for industrial customers, these are based on kets to create socially beneficial outcomes. The first annually negotiated fixed-price contracts) that may is that potential suppliers must have access to the vary in a mutually agreed-upon manner on a daily transmission system. Access is best achieved by or weekly basis, but independent of fluctuations in unbundling transmission from generation and wholesale prices. As a result, the drop in demand in securing third party access, both of which are satis- response to a rise in market price is negligible, fied in the Turkish design. greatly facilitating the exercise of market power. The second condition is the existence of ade- The key here is to induce customers to reduce con- quate and secure supplies of electricity, which sumption when prices rise. Two options are possi- implies the existence of adequate transmission and ble. For the first, interruptible contracts, which give generation capacity. This condition also seems to the electricity supplier the right to curtail supply or be satisfied in the Turkish case, at least in the short to ripple off specific appliances for short periods to medium term, because of the substantial of time when price exceeds some level, could be amounts of excess capacity available at present. promoted--if necessary through subsidies because The third condition is the presence of a suffi- of their positive externality--for customers who cient number of untied generation companies, so can switch to other fuels or self-generation. But that generation is truly competitive. This situation the preferred option, again promoted through is perhaps the most problematic in the current subsidies if necessary because of their positive Turkish context because of the sizable amount of spillover, is to subject customers, especially the generation capacity that is either state-owned or largest, to real-time (time-of-use) metering and has tied quantities and prices through long-term billing. Once end users receive the technology not contracts. Thermal generation assets under public only to observe but also to respond to real-time ownership can, in principle, be regrouped prior to prices, they are empowered to modify their pur- privatization to create a number of viable compa- chasing habits accordingly. nies. These affiliate portfolio generation companies A powerful additional mechanism for enhanc- can be granted managerial and financial independ- ing customer response to price changes is the pro- ence so that they can perform their activities in motion of competition in retail activities. As dis- accordance with more competitive conditions even cussed earlier, the EML allows for several retail prior to privatization. This situation would be companies to undertake activities in a distribution desirable in any case in order to put at least a mini- region along with the retailer that belongs to the mum amount of structurally based competitive distribution company. pressure on existing state-owned thermal plants for Newbery's fourth and final condition is that the increased productive efficiency and lower costs. liberalized markets should be adequately regulated. Competition and Regulatory Reform in Turkey's Electricity Industry 207 This condition means,among other things,that reg- 3. Directive 96/92/EC of the European Parliament and of the ulation should not be limited to naturally monopo- Council of 19 December 1996 Concerning Common Rules for the Internal Market in Electricity. The text of the directive, as listic segments, but also should include wholesale well as the accompanying explanatory memorandum and markets. The argument here is that relying solely on proposed amendments (discussed later in this chapter), can ex post competition policy remedies to discipline be found at http://europa.eu.int/comm/energy/en/elec_single_ market/index_en.html. strategic behavior in wholesale markets may be 4. See the guide to the electricity directive at http:// insufficient for preventing large welfare losses. europa.eu.int/comm/energy/en/elec_single_market/memor.htm. Instead, regulators may need competition powers to 5. See "Directive 2003/54/EC of the European Parliament and of the Council of 26 June 2003 Concerning Common Rules for ensure that pricing in wholesale markets does not the Internal Market in Electricity and Repealing Directive deviate too much for too long from costs.25 This area 96/92/EC." The new directive is available at http://europa.eu.int/ seems to have been overlooked in the proposed comm/energy/electricity/legislation/index_en.htm. amendments to the electricity directive in Europe. 6. For background on the Turkish electricity sector, see Kulali (1997), Zenginobuz and Ogur (2000), and OECD (2002). In the Turkish market design, the wholesale tar- 7. OECD (2002) calls this "policy work-arounds." iff applicable to electricity sales by TETAS will be 8. The law is titled Law Concerning the Authorization of regulated to reflect TETAS's average purchase Enterprises Other than Turkish Electricity Authority for the Pro- duction, Transmission, Distribution and Trade of Electricity. prices as well as its financial obligations (see Provi- 9. In practice, most BOT contracts have been for 20 years. sional Article 1 of the electricity market tariff regu- 10. Law No. 3996 is titled Law for Certain Investments and lation). In addition, the vested contracts discussed Services to be Carried Out under the Build-Operate-Transfer Model.The scope of the BOT model under this new law (Article 2) earlier should prevent high volatility as the non- appears to limit its application to greenfield projects and to TETAS segment of the market develops. Because of require TOOR projects for existing assets to be governed by the the initial monopolistic structure of the wholesale privatization law (Law No. 4046, also dated 1994). The electric- market in Turkey, it is appropriate that the behavior ity sector was removed from the domain of Law No. 3996 in 1994 (through Law No. 4047), but was reinstated in 1999 of TETAS be closely regulated. However, as noted (through Law No. 4493). earlier, it may be desirable that the regulator be 11. The take-or-pay element of the contracted gas varies granted additional oversight powers over the from contract to contract, but on average it is 80 percent, imply- ing, for example, that in 2005 some 33 billion cubic meters of gas wholesale market even as the dominant power of must be purchased whether needed or not (ECA 2002). TETAS dissipates over time. 12. Although there now is general agreement that these con- tracts are not in the best public interest, it is still not clear why they were awarded in the first place. One explanation, men- Conclusion tioned earlier in this chapter, is that the government saw an urgent need to attract private investors (both to deal with fiscal It will take some time before electricity reform in constraints and to reduce state dominance), and that it had to Turkey starts showing benefits that are appreciated pay high risk premiums because of macroeconomic uncertainty and, in general, weak protection of property rights. Others argue by consumers. In fact, in the short run some that that view is naïve, and they point to lobbying and capture by consumers may be adversely affected as measures investor groups and weaknesses in checks and balances. are undertaken to correct for past mistakes. Yet the 13. The evolution of BOT and TOOR projects in generation and distribution is further discussed later in this chapter. slow pace of market development may be turned 14. Law No. 4446 Regarding Amendments on Certain Arti- into a blessing. Electricity reform of the Turkish cles of the Constitution of the Republic of Turkey, published in type is radical and entails huge uncertainties. The the Official Gazette on August 14, 1999. 15. Many authors also point to the Conservative Party's slow pace of liberalization stemming from inherited overall--ideological--dislike of government intervention in the stranded costs should allow market players and reg- economy (see, e.g., Newbery 2001). ulators alike to experiment and adjust the rules 16. Data provided by Osman Sevaioglu, board member, wherever necessary. EMRA, May 11, 2003. 17. EML Article 2.b states that TEIAS is to take over all "pub- licly owned" transmission facilities. A communiqué issued by EMRA in November 2002 envisaged the transfer of all transmis- Notes sion assets to TEIAS by December 31, 2002. This deadline was moved a month by the decision of the board of EMRA (Com- 1. The authors are grateful for extremely helpful written muniqué on the Amendments of Contracts of Undertakings comments on an earlier draft provided by Osman Sevaioglu, Active in More than One Market and on Transfer of Transmis- board member of Turkey's Energy Market Regulatory Authority, sion Activities and Activities Which Are to Be Withdrawn and for additional feedback from conference participants. From). Apparently, CEAS and the government disagree about 2. This section builds on Pollitt (1999) and Newberry the ownership of transmission facilities that were operated by (2002b, 2002c). CEAS. 208 Turkey: Economic Reform and Accession to the European Union 18. All production, distribution and commercial facilities of --------. 2001b. Proposal for a Directive of the European Parlia- these two companies were also seized in June 2003, on grounds ment and the Council Amending Directives 96/92/EC and that the companies persistently violated provisions of the TOOR 98/30/ECConcerningRulesfortheInternalMarketsinElectricity concession agreements that they had signed with the govern- and Natural Gas. COM(2001)125 final, March 13, 2001. ment to run the power stations and distribute electricity. http://europa.eu.int/comm/energy/en/elec_single_market/ 19. Stranded costs are those incurred within the previous index_en.html. market structure that cannot be economically recovered within --------. 2002a. "Energy Council: Loyola de palacio. European a competitive market structure. Energy Market Revolutionized." EC Press Release, IP/02/ 20. In the English translation available on EMRA's Web site, 1733, November 26. it is called the Market Financial Reconciliation Center. --------. 2002b. "Presidency Conclusions Barcelona European 21. The EML provided for an authority responsible for regu- Council 15 and 16 March 2002." EC Press Release, C/02/930, lating the electricity sector. This provision was changed, how- March 20. ever, through Law No. 4646 (the natural gas market law), which --------. 2002c. "Second Benchmarking Report on the Imple- designated a single authority for both the electricity and gas mentation of the Internal Electricity and Gas Market." SEC sectors. (2002)1038, Brussels, January 10. 22. For the electricity market, EMRA has issued, among IEA (International Energy Agency). 2002. Key World Energy other things, regulations on licensing, tariffs, exports and Statistics 2002. Paris. imports, and eligible consumers, as well as a grid code and a dis- Joskow, Paul. 2001. "California's Electricity Crisis." Oxford tribution code. These are available at http://www.epdk.gov.tr/ Review of Economic Policy 17(3): 365­88. english/regulations/electricity.htm. Kulali, Ihsan. 1997. Elektrik Sektöründe Özelles¸tirme ve Türkiye 23. All dollar amounts are U.S. dollars unless otherwise Uygulamasi [Privatization in the Electricity Sector and indicated. Application to Turkey]. Ankara: DPT Uzmanlik Tezi. 24. The worst-case scenario entails demand growth at levels Newbery, David M. 2001. "Regulating Unbundled Network projected by the Organisation for Economic Co-operation and Utilities." http://www.econ.cam.ac.uk/dae/people/newbery/ Development (OECD), which are lower than those projected by files/dublin.pdf. MENR and with all pending BOT and TOOR projects going --------. 2002a. "Mitigating Market Power in Electricity Mar- ahead. In addition to assumptions on demand, results also are kets." http://www.econ.cam.ac.uk/dae/people/newbery/files/ sensitive to the assumed level of wholesale prices that might rome.pdf. emerge with new entry (lower wholesale prices will create larger --------. 2002b. "Problems of Liberalising the Electricity operating deficits for the relevant generation plants selling to Industry." European Economic Review 46: 919­27. TETAS) and to the assumed minimum unavoidable costs of the --------. 2002c. "Regulatory Challenges to European Electric- state-owned plants that must be covered (sustainable operating ity Liberalization." Department of Applied Economics cost levels, rather than those required just to cover operations Working Paper No. 0230, University of Cambridge. and maintenance, fuel, and debt service costs, could lead to rev- OECD (Organisation for Economic Co-operation and Develop- enue deficits even with the higher MENR demand levels). ment). 2001. OECD Review of Regulatory Reform, UK. Paris. 25. For example, in the United States FERC has a statutory --------. 2002. "Regulatory Reform in Electricity, Gas and responsibility to ensure that prices are "just and reasonable," Road Freight Transport." Background paper for OECD which gives it the authority it needs to replace market- Review of Regulatory Reform: Regulatory Reform in Turkey. determined prices with regulated prices. See the discussion in http://www.oecd.org/regreform/backgroundreports. Newbery (2002b). Pollitt, Michael. 1999. "Issues in Electricity Market Integration and Liberalization." In A European Market for Electricity, ed. Lars Bergman, Gert Brunekreeft, Chris Doyle, Nils-Henrik M. References von der Fehr, David M. Newbery, Michael Pollitt, and Pierre Regibeau. London: Centre for Economic Policy Research. Armstrong, Mark, Simon Cowan, and John Vickers. 1994. Regu- Sevaioglu,Osman.n.d."Discussion Notes on the Paper:`Competi- latory Reform: Economic Analysis and British Experience. tion and Regulatory Reform in the Turkish Electricity Sector.'" Cambridge, MA: MIT Press. Middle East Technical University. Cabral, Luis. 2002. "The California Energy Crisis." Japan and the Steiner, Faye. 2002. "Regulation, Industry Structure and World Economy 14: 335­39. Performance in the Electricity Supply Industry." Economics ECA (Economic Consulting Associates). 2002. "Turkey Power Department Working Paper ECO/WKP(200)11, Organisa- Sector Review Study." Draft, October. tion for Economic Co-operation and Development, Paris. EMRA (Energy Market Regulatory Authority). 2003. Electricity Zenginobuz, Ünal, and Serhan Ogur. 2000. "Türkiye Elektrik Market Implementation Manual. Ankara. Sektöründe Yeniden Yapilanma, Özelles¸tirme ve Regülasyon" European Commission. 2001a. Communication from the Commis- [Restructuring, Privatization and Regulation in the Turkish sion to the Council and the European Parliament: Completing the Electricity Sector]. In Devletin Düzenleyici Rolü [The Regu- Internal Energy Market. COM(2001)125 final, March 13, 2001. latory Function of the State], ed. Izak Atiyas. Istanbul: http://europa.eu.int/comm/energy/en/elec_single_market/ TESEV Publications. index_en.html. 8 Institutional Endowment and Regulatory Reform in Turkey's Natural Gas Sector Maria Rita Mazzanti and Alberto Biancardi This chapter focuses on Turkey's natural gas mar- The Present Situation in the ket and the regulatory reforms recently adopted to Turkish Gas Market liberalize the sector and comply with European The Turkish natural gas market is still an emerging Union (EU) requirements for accession.1 To this one. Turkey has limited gas resources, and it began end, the first section of the chapter analyzes the production and distribution only in 1976. A con- present situation of the gas market from the point siderable part of the country is still not served by of view of its structural parameters--that is, the natural gas. structure of its demand and supply and the present The use of natural gas by industry is also rela- status of its import and export interconnections tively new. It began in 1989--after the initiation of and national networks, as well as its future develop- gas imports from the Russian Federation and is ment. The section then goes on to analyze the rapidly growing. Demand in the power generation issues related to the long-term take-or-pay con- sector is expected to grow even more rapidly, dou- tracts by the national transportation company and bling between 2001 and 2010. In 2001 total gas their impact on liberalization. The second section demand was 15.5 billion cubic meters. Of this, the of this chapter addresses questions related to the power industry accounted for about 10.6 billion present ownership and industry structure, and it cubic meters, followed by residential demand at compares the Turkish case with that of some EU about 2.7 billion cubic meters and industry demand countries. In doing so, the section discusses simi- at 2.0 billion cubic meters.2 larities with other emerging gas markets as well as Between 1990 and 1998, the average annual differences with more mature markets. The third primary gas demand increased by 15.3 percent, section is devoted to regulatory reforms. It analyzes with peak growth of 18.4 percent in 1999. Past the new Turkish gas law and compares it with the government forecasts had predicted that demand solutions adopted in selected EU countries, with would grow by almost 26 percent per year between particular reference to the gas release program and 1999and2005;forthenext15yearsitwasexpectedto measures that might be taken to limit the market grow at a rate of between 3.5 percent and 4 percent. power of the incumbent. A concluding section Figures published recently by Turkey's state-owned follows. 209 210 Turkey: Economic Reform and Accession to the European Union gas company, BOTAS¸, indicate that the company the Ambarli Power Plant in August 1988, and expects the Turkish gas market to double in size over Ankara for residential and commercial purposes in the next years, with 55 cities receiving natural gas for October 1988. In 1996, the transmission pipeline the first time. Many independent observers have was extended to the western Black Sea region via expressed doubts about these figures, however. They the Izmit-Karadeniz Eregli line (209 kilometers); believe BOTAS¸'s demand forecasts were overly opti- the main customers are the Eregli Iron and Steel mistic and point to the fact that subsidies and Works plants. In the same year, the main transmis- below-cost pricing would have to be phased out dur- sion line also was extended to Çan. ing the process of liberalization of the energy sector. The Bursa-Çan Natural Gas Transmission Line was completed in 1996 for the purpose of supply- ing natural gas to the Çanakkale Ceramic Factory, Import and Export Infrastructure together with other industrial establishments along and Future Developments the route. In 2000, the Çan-Çanakkale Natural Gas The state-owned company, BOTAS¸, has enjoyed Transmission Line was completed. monopoly rights for oil and gas pipeline trans- In 1998, BOTAS¸ signed an agreement with Russia portation, as well as for import, export, and whole- to import 8 billion cubic meters per year of natural sale trading, since 1987. BOTAS¸ owns seven natural gas from the West through TURUSGAZ--a gas pipelines and related facilities: Russian BOTAS¸, GAZPROM (Russia), and GAMA (Turkey, Federation­Turkey Natural Gas Main Transmission civil contractor) joint venture. Another agreement Line, Marmara Ereglisi Liquefied Natural Gas was signed with the Russian Federation on Decem- (LNG) Import Terminal, Izmit-Karadeniz Eregli ber 15, 1997, to import 16 billion cubic meters of Natural Gas Transmission Line, Bursa-Çan Natural gas per year through a pipeline beneath the Black Gas Transmission Line, Çan-Çanakkale Natural Gas Sea. A joint venture was also established by Transmission Line, Eastern Anatolia Natural Gas GAZPROM and ENI (Italy) to lay the "Blue Main Transmission Line, and Karacabey-Izmir Nat- Stream" pipeline, and on December 29, 2002, the ural Gas Transmission Line. first Blue Stream pipeline gas from Russia entered In view of the expected rapid increase in natural Turkey, crossing the Black Sea at a depth of down to gas consumption, in 1984 the government of 2,150 meters. Deliveries were expected to amount Turkey signed an intergovernmental agreement to 16 billion cubic meters by 2007 in accordance with the former Soviet Union. Consequently, in with the natural gas sale and purchase agreement. 1986 BOTAS¸ and SOYUZGAZEXPORT signed a In August 1996, Turkey and the Islamic Republic natural gas sale and purchase agreement for a of Iran signed a 25-year natural gas sale and pur- 25-year period. Natural gas began flowing to chase agreement that called for the delivery of nat- Turkey in 1987, and the volume transported gradu- ural gas to start at a volume of 3 billion cubic ally increased, reaching 6 billion cubic meters per meters per year, to reach 10 billion cubic meters per year in the plateau period in 1993. yearintheplateauperiodin2007.Theagreementwas The 842-kilometer Russian Federation­Turkey then amended in August 2000. A dedicated pipeline, Natural Gas Main Transmission Line enters Turkey the Eastern Anatolia Natural Gas Main Transmission at Malkoçlar at the Bulgarian border and then fol- Line, running between Dogubayazit on the Turkish- lows the Hamitabat, Ambarli, Istanbul, Izmit, Iranian border and Ankara/Seydisehir (Konya) was Bursa, Eskis¸ehir route to reach Ankara. The main completed at the end of 2001 after some delay. On dispatching center is located in Yapracik-Ankara. December 2001, the delivery of natural gas began Construction of the pipeline began on October 26, through the Eastern Anatolia line. In April 2002 the 1986, and the line reached Hamitabat on June 23, construction works of the Karacabey-Izmir Natural 1987. Since then, imported natural gas has been Gas Transmission Line were completed, and the line used together with domestic gas for power genera- became operational. tion at the Trakya Combined Cycle Power Plant in In 1999, BOTAS¸ signed an agreement with Turk- Hamitabat. The pipeline reached Ankara in August menistan for the purchase of 16 billion cubic 1988. The Istanbul Fertilizer Industry Company meters of natural gas per year. The Turkmen gas (IGSAS¸) began to receive natural gas in July 1988, would be transported to Turkey for a period of Institutional Endowment and Regulatory Reform in Turkey's Natural Gas Sector 211 30 years. On February 19, 1999, the Turkmen The natural gas could reach Italy by means of an government commissioned project studies to a offshore connection, where it could eventually consortium comprising PSG­General Electric compete with Algerian and Libyan natural gas. Capital and Bechtel. Shell joined this consortium Another possibility is to export gas to Bosnia and on August 6, 1999. This project involves construc- Herzegovina. A further possibility could be the tion of a pipeline from Turkmenistan to Turkey, construction of a pipeline to Austria through running parallel to the Baku-Tbilisi-Ceyhan crude Bulgaria, Romania, and Hungary. oil pipeline until it joins the Eastern Anatolia Nat- In fact, in November 2002 five companies signed ural Gas Main Transmission Line near Erzurum. an agreement to carry out a joint feasibility study Gas imports were expected to begin between 2002 on the construction of a natural gas pipeline from and 2004; however, no progress has been made on Turkey to Austria via Bulgaria, Romania, and this gas pipeline. Meanwhile, the Turkish Petro- Hungary. Participants in the project are BOTAS¸, leum Corporation (TPAO) has conducted the rele- (Turkey),Bulgargaz(Bulgaria),Transgaz(Romania), vant studies needed to join the international con- MOL (Hungary), and OMV Erdgas (Austria). The sortium that will develop and produce gas from six study received approval from the EU in July 2003. dedicated gas fields (including the Körpece, Zeagli, At the beginning of 2004, the Nabucco Company Darvaza, Garacaovlak, and Malay fields) to feed the began its financial and market studies, and the final Trans-Caspian gas pipeline. report of the feasibility study is due by the begin- In April 2002, after two years of planning, ning of 2005. The construction phase is scheduled Turkey and Greece signed a memorandum of to start in mid-2006, and operations are expected understanding for a gas pipeline linking the two to begin at the end of 2009. Once contracted, the countries. The Ankara­Dedeagac link, which forms pipeline will stretch about 3,400 kilometers, with part of the EU's INOGATE (Interstate Oil Gas total capacity from Turkey of 25 billion to 30 billion Transport to Europe) program, will feed Iranian cubic meters per year. The expected offtake in tran- gas through western Turkey to the Greek frontier. sit countries would be 8 billion to 10 billion cubic INOGATE is a technical assistance program of the meters per year, and the total capacity to Austria's EU (covering central and eastern Europe, including Baumgarten region would be 17 billion to 20 bil- the newly independent states) that seeks to inte- lion cubic meters per year. Total costs are projected grate the hydrocarbon transport networks between to be about 4.4 billion. The idea behind the proj- the Caucasus, central Asia, and central and eastern ect is that Turkey would act as an "energy corridor" Europe. Start-up is planned for 2005, with an initial for the export of Caspian oil and gas. Turkey finds capacity of 0.5 billion cubic meters per year, rising the idea attractive, because it would allow the coun- to a plateau of 3.6 billion cubic meters per year. The try to reduce the gas surplus it seems to be facing in link is capable of carrying 13 billion cubic meters of the near future. In view of its geographic position, gas per year, with Turkey's share set to plateau at Turkey could, in fact, play a pivotal role in enhanc- 10 billion cubic meters per year in 2007. The ing the security of supply and competition in the pipeline will connect Karacabey in western Turkey EU, connecting the Caspian gas reserves with the to Komotini city in northeast Greece, enabling Mediterranean region and Europe. Turkey to sell Greece some of the gas surplus. The cost of this project is estimated at 250 million, and Long-Term Purchase Contracts it should be completed in 2005. An economic feasi- bility study for the project, conducted by Société BOTAS¸ has signed eight long-term sales and pur- Générale, was funded equally by DEPA (the chase contracts with six different supply sources. Greek national gas company) and the European Six contracts are presently in effect. Of these, three Commission. Countries that could be interested are with Russia for plateau volumes of 6 billion in selling gas to the European market via this cubic meters per year, 16 billion cubic meters per pipeline include Azerbaijan, the Islamic Republic of year, and 8 billion cubic meters per year, respec- Iran, Kazakhstan, Turkmenistan, and Uzbekistan. tively, through the Blue Stream pipeline across the In particular, Iran hopes to export the extra 3 bil- Black Sea; one is with Iran for 10 billion cubic lion cubic meters per year to the European market. meters per year; and two are liquefied natural gas 212 Turkey: Economic Reform and Accession to the European Union TABLE 8.1 Existing Gas Agreements, Turkey Amount (billion cubic meters per year) Signature Date Duration (years) Russian Federation (West) 6 February 1986 25 Algeria (LNG) 4 April 1988 20 Nigeria (LNG) 1.2 November 1995 22 Islamic Republic of Iran 10 August 1996 25 Russian Federation (Black Sea) 16 December 1997 25 Russian Federation (West) 8 February 1998 23 Turkmenistan 16 May 1999 30 Azerbaijan 6.6 March 2001 15 Source: BOTAS¸, http://www.botas.gov.tr/. (LNG) contracts--one with Algeria for 4 billion In addition to long-term contracts, BOTAS¸ has cubic meters per year and the other with Nigeria for also purchased natural gas on the spot market. The 1.2 billion cubic meters per year. These agreements first spot LNG was from Australia within the scope are summarized in table 8.1. of an agreement signed with North West Shelf LNG Of the two contracts that are not yet in effect, in 1995. Spot LNG was also purchased from Qatar one was signed with Turkmenistan for 16 billion and Algeria under two different agreements signed cubic meters per year, and the Shah Deniz contract with Qatar Gas and SONATRACH in 1998. with Azerbaijan is for 6.6 billion cubic meters per In 2001 BOTAS¸ purchased a total of 16,368 mil- year, starting in 2005 (see table 8.1). It is likely, lion cubic meters of natural gas.The Russian Federa- however, that these two contracts will prove mutu- tion was the main natural gas supplier with 10,931 ally incompatible. Although progress has been million cubic meters,followed byAlgeria (3,985 mil- reported on imports from Azerbaijan, the pipeline lion cubic meters) and Nigeria (1,337 million cubic project from Turkmenistan appears to be stalled. meters). Iran provided 115 million cubic meters On December 26, 1996, a framework agreement (BOTAS¸ 2001). was signed between Iraq and Turkey to pipe 10 bil- BOTAS¸ justified signing these long-term pur- lion cubic meters of Iraqi gas per year to Turkey chase contracts by pointing to the expected rapid after development of the gas fields in Iraq. On the growth in the Turkish gas market; it predicted that Turkish side, BOTAS¸, TPAO, and TEKFEN have gas demand would reach 55 billion cubic meters in been involved in this project. ENI was designated as 2010 and 83 billion cubic meters in 2020. As noted coordinator of the upstream activities. earlier, however, most observers believed the ambi- Finally, a natural gas sale and purchase agree- tious BOTAS¸ demand forecasts were overly opti- ment was initialed on March 31, 2001, by BOTAS¸ mistic, and they cautioned as well about the coun- and EMG (Eastern Mediterranean Gas Company) try's economic crisis. Some analysts foresee that in of Egypt to supply Turkey with 4 billion cubic 2010 Turkey will have surplus gas of 10 billion to meters per year of natural gas. 25 billion cubic meters, increasing to 50 billion To diversify natural gas supply sources, BOTAS¸ cubic meters in 2020 (Hafner 2002). entered into a 20-year LNG sale and purchase Oversupply also seems to be the basis of the dis- agreement with SONATRACH (Algeria) in 1988. In pute that arose between Turkey and Iran in 2001 in order to receive the imported LNG, BOTAS¸ began connection with a natural gas purchase agreement construction of the Marmara Ereglisi LNG Import for 10 billion cubic meters per year signed in 1996. Terminal in September 1989. The terminal, which Under the contract, Iran was to export to Turkey a began operations in 1994, is used both as a LNG total of 192 billion cubic meters of Iranian gas over regasification plant and as a storage facility for 22 years, with deliveries starting in January 2000. imported LNG. However, when deliveries were scheduled to start, Institutional Endowment and Regulatory Reform in Turkey's Natural Gas Sector 213 BOTAS¸ had not completed the necessary import In order to become "a Bridge to Europe" and infrastructure, and an amendment to the original boost its internal demand, Turkey will have to deal was negotiated under which first gas was improve its national transmission and distribution delayed to July 2001, and the duration of the con- network. Five projects are already under study and tract was extended to 25 years. The total contractual slated to become operational in 2005: the Southern volume was also increased to 228 billion cubic Natural gas transmission line project; the Konya- meters, with annual volumes scheduled to reach I·zmir natural gas transmission line project; the their plateau level of 10 billion cubic meters per year eastern Black Sea gas transmission line project; the in 2007. But again, when the July 2001 date arrived, western Black Sea natural gas transmission line proj- BOTAS¸ claimed that Iran had not constructed the ect; and the Georgian border­Erzurum (Horasan) necessary border metering facilities, and gas did not natural gas transmission line project. actually start flowing until December 2001. The Southern Natural gas transmission line In June 2002, BOTAS¸ announced that gas project is aimed at meeting natural gas demand in imports from Iran had been halted because of an the southern and southeastern regions of Turkey by alleged quality problem. Iran accused Turkey of transmitting natural gas through a branch line to using the quality issue as a pretext, and said that the be extended from the Eastern Anatolia Natural Gas real reason for the halt was that Turkey was not in a Main Transmission Line near Sivas. The total position to consume the gas. The dispute was length of this 40-inch pipeline from Sivas to resolved after a reduction in the contract price (in Mersin via Malatya, Kahramanmaras¸, Gaziantep, line with the reduction that BOTAS¸ agreed to with Osmaniye, and Adana will be 565 kilometers. the Blue Stream consortium--about 9 percent) and By means of the Konya-I·zmir natural gas trans- in the take-or-pay level (down from the original mission line project, the Eastern Anatolia Natural 87 percent of annual contract quantity to 70 per- Gas Main Transmission Line will be extended from cent, which means that BOTAS¸ will need to take Konya to Izmir, and will supply natural gas to cities only 7 billion cubic meters per year at the plateau). such as Burdur, Isparta, Denizli, and Nazilli. The 618-kilometer 40-inch line will have branches to the cities in the vicinity of Afyon and Antalya. National Networks and Future Development The eastern Black Sea gas transmission line proj- Residential users in Ankara began receiving natural ect will supply Hopa,Artvin, Rize, Trabzon, Giresun, gas in 1988. In 1992 Istanbul and Bursa also began Ordu, and Samsun via Bayburt and Gümüs¸hane by to receive supplies of natural gas; Izmit and extending a branch from the Eastern Anatolia Eskis¸ehir received supplies in 1996. The distribu- Natural Gas Main Transmission Line at Erzincan. tion of natural gas is undertaken by local distribu- The plan is to supply natural gas to Gümüs¸hane, tion companies; EGO in Ankara, IGDAS¸ in Istanbul, Bayburt, Trabzon, and Rize as the first stage of the IZGAZ in Izmit, and BOTAS¸ in Bursa and Eskis¸ehir. project. Through the western Black Sea gas trans- The distributors are owned or co-owned by the mission line project, natural gas will be supplied to municipalities they serve, except in Bursa and Bartin, together with the industrial and residential Eskis¸ehir. The gas supply continues to be restricted sectors along the route via Zonguldak, Devrek, and to limited areas of western Turkey, but there are Çaycuma, by extending a branch from Karadeniz plans to extend the system. Eregli. It is foreseen that the 141-kilometer line will The city distribution networks have been consist of a 78-kilometer line of 16-inch pipe and a enlarged over the years, parallel with demand. In 63-kilometer line of 12-inch pipe. In addition, a 2001 the number of consumers increased to 65-kilometer loop line of 16-inch pipe will be con- 197,303 in Bursa and 76,484 in Eskis¸ehir because of structed on the Izmit-Karadeniz Eregli Natural Gas the work under way to enlarge the city distribution Transmission Line. networks in these cities. In view of the growth sce- To transport Turkmenistan and Azerbaijan natu- nario described earlier, BOTAS¸ has planned to con- ral gas within Turkish territories, an approximately nect local distribution networks in 55 new cities. 225-kilometer pipeline will be constructed from the The connection dates for all of these projects are Georgian border of Turkey to Erzurum (Horasan). in 2002­04. This line will be connected to the Eastern Anatolia 214 Turkey: Economic Reform and Accession to the European Union Natural Gas Main Transmission Line at Horasan. Natural Gas Distribution, Trade and Contracting The project includes a commercial metering station Corporation (ESGAZ). and a compressor station. BOTAS¸'s monopoly rights to natural gas import, distribution, sales, and pricing, granted by Decree No. 397 of February 9, 1990, were abolished by the Ownership and Industry Structure natural gas market law (No. 4646) enacted on May 2, This section addresses questions related to the pres- 2001, to establish a stable and transparent natural ent ownership and industry structure of Turkey's gas market based on competitive rules. The new law natural gas sector, with the goal of comparing the covers the import, transmission, distribution, stor- Turkish case with that of some EU countries. In age, wholesale trading, and export of natural gas, doing so, the section discusses similarities with and the transmission and distribution of com- other emerging gas markets as well as differences pressed natural gas (CNG), as well as the rights and with more mature markets. obligations of all real and legal persons related to these activities. Under the law, BOTAS¸ will compet- itively tender and release the import contracts to Turkey new private entrants until its import share falls Turkey's natural gas sector is dominated by below 20 percent by the year 2009. The company BOTAS¸. BOTAS¸ Petroleum Pipeline Corporation must auction at least 10 percent of its gas purchase was established as an affiliated company of the rights a year, starting from the enactment date of Turkish Petroleum Corporation on August 15, the law. BOTAS¸ will also undergo further restruc- 1974, to transport Iraqi crude oil to the Gulf of turing, and separate companies will be established Iskenderun. In 1995 the company was restruc- for trade, transmission, and storage after the year tured as a state economic enterprise (SEE) by 2009. Decree of the Council of Ministers No. 95/6526, The 2001 natural gas market law also set the thereby obtaining the status of an independent minimum annual consumption limit for qualifica- company. Since 1987, BOTAS¸ has expanded its tion as an eligible consumer to 1 million cubic original mission of transporting crude oil through meters, which corresponds to a market opening of pipelines to cover the natural gas transportation approximately 80 percent (European Commission and trading activities. In 1995 all kinds of 2003). petroleum-related activities such as exploration, drilling, production, transportation, storage, and EU Emerging Gas Markets refining for the purpose of providing crude oil and natural gas from sources abroad was added to Within the European Union, Greece and Portugal BOTAS¸'s activities. are considered to be emerging gas markets. As a BOTAS¸ is made up of a series of sectoral and result, both countries obtained derogation to the lib- provincial organizations: Petroleum Operations eralization schedule foreseen in Directive 98/30/EC Management, Natural Gas Operations Manage- of the European Parliament and of the Council of ment, LNG Operation Management, Dörtyol June 22, 1998, on common rules for the internal Operation Management, Kayseri Operation Man- market in natural gas. agement, Istanbul Operation Management, Bursa Operation Management, and Eskis¸ehir Operation Greece Greece is not directly linked to the inter- Management. connected system of any other member state, and By Decision of the High Planning Council it has only one main external supplier of imported No. 2002/T-15 of June 6, 2002, the Bursa and gas, Russia, which has a market share of more than Eskis¸ehir Operation Managements were restruc- 75 percent. So far, Greece has only a vertically tured and transformed into affiliate companies of integrated gas company, DEPA (Public Gas Corpo- BOTAS¸ that took the form of joint stock compa- ration). Plans are under way to separate DEPA's nies. The new companies were the Bursa City activities into transmission and supply. At present, Natural Gas Distribution, Trade and Contracting there is no unbundling of gas supply and high- Corporation (BURSAGAZ) and the Eskis¸ehir City pressure transmission. Institutional Endowment and Regulatory Reform in Turkey's Natural Gas Sector 215 Low-pressure gas distribution is performed (for equivalent of 13 years of production at current lev- individuals and small industrial consumers) by els. Imports fulfill most of the country's require- three independent private companies, each cover- ment (just under 80 percent), and their share is ing a specific geographic area. An energy regulatory expected to cover 88 percent of the total require- authority was established by Law No. 2773/99. ment by 2005 and 90 percent by 2010. As for Greece has an LNG terminal, which may serve as imports, the ENI Group is again the dominant storage. No underground gas storage is yet in oper- operator, accounting for about 85 percent of the ation. The opening of the Greek gas market is total in 2001. The second importer after ENI is Enel scheduled for 2006. SpA (the former electricity monopoly), with about 11 percent of imports in 2001. Portugal The Portuguese gas market is very In 2004, Italy started importing gas from Libya, small. Transgas, the main operator for the high- and in 2007 the operator Edison will begin import- pressure network, was set up in 1993, and its major ing liquefied natural gas from Qatar upon the con- shareholder is Gas de Portugal, which previously struction of a regasification terminal in the upper was in charge of supply and transmission. Indus- Adriatic. The import contracts that are signed will trial and commercial consumers with a gas con- satisfy expected requirements until 2010. sumption profile of over 10,000 thousand cubic The contracts for the vast majority of imports meters are served directly by Transgas, along with are long term; in 2001 they accounted for the four distribution companies in Portugal (Gas about 98 percent of the imported volume. Nearly de Lisboa for the capital city, Portgas for the north- 93 percent of imported gas is transported by ern region, Lusitania Gas for the central region, and pipeline to entry points in Italy. The transporta- Set Gas for the southern region). These four com- tion rights paid by importers on foreign pipelines panies sell, in turn, to smaller distribution compa- serving the national gas system go mainly to com- nies (less than 2,000 cubic meters purchased annu- panies of the ENI Group, which was responsible ally). To promote investment in the enlargement of for constructing and funding the infrastructure. the three provincial distribution networks, the Snam Rete Gas SpA3 owns 96 percent of the trans- Portuguese government conducted in the 1990s an portation capacity in Italy in terms of invested international tender to select strategic investors for capital. The network of the second operator, each network. Italgas, a subsidiary of ENI, was Edison, is geographically complementary to that of selected as the strategic investor for two out of three Snam Rete Gas, especially in the central part of the (Lusitania Gas and Set Gas). country. The section of pipeline passing under In 2000 the government merged the state- the territorial waters of the Channel of Sicily is owned oil and gas operators with the intention of also part of the national system. It is owned by privatizing them. A holding was then set up (Galp- Transmediterranean Pipeline Company Limited SGPS) in which Eletricidade de Portugal is the (TMPC, an Italian-Algerian company in which major shareholder. ENI took 33 percent of the cap- SONATRACH and ENI hold equal stakes). ital. As an emerging market, Portugal has applied Access to Italy's transportation networks is regu- for derogation; therefore, the EU natural gas direc- lated in accordance with Legislative Decree tive will not be implemented before 2007. 164/2000 implementing the EU directive on the internal market for natural gas. Tariffs, access crite- ria, and the obligations to be met by the transporta- EU Mature Gas Markets: The Italian Case tion companies are set by the Electricity and Gas Italy produces only about one-fifth of its internal Regulatory Authority. gas consumption, and production is falling, in Legislative Decree 164/2000 also defined the absolute and relative terms, in relation to needs. In national network of gas pipelines, which is made up the production sector, ENI is the dominant opera- of import pipelines, connections to storage facilities tor (in 2001 it accounted for 88 percent of total and the principal interregional pipelines. For this production), followed by Edison T&S SpA (12 per- network, as defined and updated by ministerial cent of total production). Proven overall reserves decree, access has been regulated since October 2001 amount to about 215 billion cubic meters, the along entry-exit lines. 216 Turkey: Economic Reform and Accession to the European Union The Italian storage system consists of depleted Distribution is a public service activity. The fields. The storage sites currently in operation are service is entrusted to a concessionaire through an managed by Stoccaggi Gas Italia SpA (Stogit), a open tendering process for a period not exceeding company set up in 2001 by the ENI Group, after 12 years. The local authorities that grant the con- hiving off its storage branch, and Edison. Stogit cession are entrusted with the orientation, supervi- manages eight storage facilities, and Edison has two sion, and control powers, and their relation with storage facilities. The energy authority sets the tar- the distributors are regulated on the basis of a stan- iffs, criteria, access priorities, and obligations that dard contract prepared by the regulatory authority storage companies are required to respect. The only and approved by the Ministry of Productive regasification terminal in Italy at present is the one Activities. at Panigaglia, which is run by Snam Rete Gas. Its The legislative decree implementing the EU capacity is presently entirely taken up. Six new ter- directive completely transformed the structure of minals are planned. the gas sector in Italy and provided a new impetus The Italian market has been fully open since Jan- to the reorganization of the sector. The major uary 1, 2003. Article 1 of Legislative Decree 164/00 energy companies acquired many distribution implementing European Commission Directive companies so that they could increase their market 98/30/EC on common rules for the internal natural share and create new consortia. Companies that use gas market provides that the importation, exporta- gas have also set up consortia with a similar goal of tion, transportation, dispatch, distribution, and purchasing gas on competitive terms. sale of natural gas are free. The Italian case represents a median case of lib- Imports from non-EU countries are subject to eralization in the EU context. The U.K. market is authorization by the Ministry of Industry on the considerably more competitive than the Italian basis of objective, nondiscriminatory published one, because the country has, until recently, been criteria on technical and financial capabilities; self-sufficient in natural gas. In almost all other EU assurances about the origin of the gas; the availabil- countries, the market is less competitive: in ity of strategic storage capacity in Italy in propor- Germany, a regulatory authority has not yet been tion to the quantity of gas imported annually; and introduced, although it was recently decided to the ability to contribute to the development and introduce one; in France, the incumbent controls safety of the system or to the diversification of the market almost completely; in Spain, competi- supply. LNG imports are facilitated through the tion is facilitated by the presence of multiple regasi- reduction of strategic storage obligations. Two fication terminals, and a model gas release program transitional annual constraints have been intro- was implemented to reduce the share of the incum- duced to facilitate the entry of new operators: a bent, Gas Natural. ceiling on the national consumption level that can be served by a single company from 2003 to 2010 Regulatory Reform in Turkey (50 percent) and a ceiling on the deliveries to the national network by any single company from 2002 On May 15, 2001, the executive board of the Inter- to 2010 (initially 75 percent of national consump- national Monetary Fund (IMF) approved a new tion, with a reduction of 2 percentage points per three-year standby arrangement for Turkey year, to 61 percent). amounting to US$19 billion. As part of the package Transportation and dispatch are public service of economic measures, which were a condition of activities, with connection and network access obli- IMF support, Turkey passed new electricity and gations according to the criteria and tariffs laid gas laws. down by the energy authority. Storage is conducted The new natural gas market law (Law No. 4646) on a licensing basis lasting no more than 20 years, was adopted on May 2,2001.The law came into force and is subject to access obligations under the immediately,but its implementation was subject to a criteria, priorities, and tariffs laid down by the 12-month transition period, extendable to a maxi- authority. Storage and exploitation activities must mum of 18 months. The transitional period was in be separated. fact extended until November 2002. Implementing Institutional Endowment and Regulatory Reform in Turkey's Natural Gas Sector 217 legislation on gas market licensing was issued in The rights of BOTAS¸ on existing participations September 2002. are preserved. The law is intended to establish a competitive gas · To ensure security of supply, gas importers and market and to ensure independent regulation of the wholesalers must inform the Energy Market sector. The law also seeks to harmonize Turkish leg- Regulatory Authority (EMRA) about the source islation with EU law in view of Turkey's future acces- and security of their gas imports, and they must sion. The main features of the law are the following: store 10 percent of the gas they import in five years. Importers also must prove that they can · All legal entities can carry out import, export, contribute to the improvement and security of wholesale trade, transportation, distribution, the national transmission system. storage, and CNG transmission and distribution · Transportation companies that own transporta- activities under license from the energy market tion networks and the owners and operators of regulator. LNG and storage facilities are to offer services at · The natural gas activities of BOTAS¸ are to be nondiscriminatory conditions. unbundled. BOTAS¸ is to be split into three state · Third parties also will be allowed to build economic enterprises after the year 2009, pipelines. BOTAS¸ and other potential grid oper- responsible for trading, storage, and transmis- ators are to undertake investment, which is sub- sion, respectively. The two local distributors ject to EMRA's approval. The regulatory agency owned by BOTAS¸ in Bursa and Eskis¸ehir will is to control this investment, along with service later be corporatized and privatized. quality. Existing and planned national transmis- · No importer will be allowed to import more sion networks as well as transmission networks than 20 percent of Turkey's gas consumption under construction remain under the ownership during any one year. BOTAS¸ will be required to of BOTAS¸. sell part of its gas import contracts to comply · Eligible consumers will be free to select the sup- with this provision. This sale will be accom- plier of their choice. Eligibility will be deter- plished through a series of annual competitive mined by the regulator. Consumers purchasing tenders to sell existing import contracts to new more than 1 million cubic meters of natural gas importers for no less than 10 percent of total a year and users unions (consortia), power gen- imports each year. No new natural gas purchase erators, and cogenerators are considered eligible. agreement can be executed by any import com- · Distribution rights for cities and municipalities pany with countries that have existing contracts must be awarded under a tender. Once a distrib- with BOTAS¸. This limitation shall apply for the utor has won a tender, it applies the unit service entire duration of the agreement. and the amortization price as specified in the · No legal entity is allowed to sell more than tender announcement. After this period, its 20 percent of annual gas consumption. Only prices and conditions will be reviewed every national gas producers may sell more than year by the regulator. Distributors must con- 20 percent of annual gas consumption in the struct, operate, and extend distribution equip- domestic market, provided that the amount sold ment as specified in the license. Once the license directly to eligible consumers does not exceed for a distribution area has been awarded, the 20 percent. The remaining gas could be sold selected operator has to allow the local govern- through importers, distributors, or wholesalers. ment to participate up to 20 percent in the com- · Gas companies will not be allowed to establish pany capital. The size of public participation, to another company in the same field of activity, be remunerated at the nominal share price, is to but will be allowed to own participations in a be determined by the regulator. Distribution company operating in another field. They may companies may hold a license for no more than not, however, directly or indirectly hold the two cities within the country. majority of the capital or commercial assets of · EMRA has to develop five different categories of the company, nor do they have the right to use gas prices: for connection, transmission, storage, the majority of voting rights of the company. wholesale sales, and retail sales. Prices for 218 Turkey: Economic Reform and Accession to the European Union connection will be determined between the and that the prices for industrial consumers will regulator and distribution companies. Network probably go down as a result of liberalization. tariffs will be based mainly on distance and vol- Secondary legislation on licensing procedures and ume. Storage tariffs will be freely determined on network operation rules to be determined by between storage companies and users. Trans- transmission companies was also adopted. mission and storage companies will have an obligation to prove to the regulator that their Comparative Analysis of Turkey's Gas Legislation services are economical and safe. Wholesale prices will be negotiated by the trading parties, EventhoughTurkeyisanemergingmarket,itsindus- but the regulator will maintain some oversight try structure does not differ considerably from that of wholesale prices. The distribution companies of other countries of the EU, including more mature must prove that they provide gas from the markets. Furthermore, its new legislation goes even cheapest source, and they must operate effi- further than the laws in force in many EU countries. ciently and safely during their license period. AlthoughliberalizationwaspostponedinGreeceand Distributors' retail sales prices for captive con- Portugal until 2006 and 2007, respectively, in Turkey sumers are subject to rate-of-return regulation. the threshold of 1 million cubic meters per year for eligibility represents a market opening of approxi- The Energy Market Regulatory Authority, which mately 80 percent. This figure may, however, be a opened its doors in November 2001, was estab- result of the structure of the demand,mainly consist- lished to meet a condition of the IMF's support for ing of large consumers. The average market opening Turkey. EMRA is an independent, administratively within the EU is about 78 percent. and financially autonomous public administration As for unbundling, the obligation imposed on related to the Ministry of Energy and Natural BOTAS¸ to divest all distribution activities, in addi- Resources. According to Article 4, paragraph 3, of tion to separating trading and transmission activi- the electricity market law (No. 4628), "The head- ties, is more stringent that that found in other EU quarters of the Authority shall be located in Ankara countries. In Italy, for example, ENI has substantial and the ministry to which it is related shall be the interest in distribution (100 percent of Italgas Ministry of Energy and Natural Resources. The through Snam Rete Gas) and was not requested to Authority may establish representative offices in divest its distribution arm, which owns 35 percent distribution regions in order to carry out customer of the distributors. In Spain, Gas Natural is strongly relations." Most of the technical specialists have so linked to Enagas and Repsol. In Germany, Ruhrgas far been recruited through temporary assignments has a minority interest in regional companies from various public administrations, including the and distributors at least sufficient to influence Ministry of Energy and Natural Resources, BOTAS¸, them. RWE Gas and E. ON cover the whole chain, the former Turkish Electricity and Transmission including small production interests. In France, Company (TEAS), the Treasury, and public banks. over 90 percent of distribution is undertaken by By March 2003, its overall personnel, including EdF-GdF. In Austria, the regional gas companies support staff, totaled 270. Its budget is 4.3 million. may be connected with their distributors. EMRA has begun to develop some of the sec- The limit on BOTAS¸'s share of imports is much ondary regulation for the liberalization of the more stringent than what is imposed in Italy and in energy sector. In September 2002, EMRA issued a Spain. No limit was imposed in France or Germany. regulation on principles and procedures pertaining Likewise,thelimitonBOTAS¸'sdomesticmarketshare to connection, transmission and dispatch, storage, is more stringent than what was imposed on Snam and wholesale and retail sale tariffs. In January Rete Gas in Italy. The 10 percent storage obligation is 2003, the new transmission tariff was announced. similar to that existing in Italy. However, Turkey's sit- The tariff--the maximum that system operator uation is different because it is a transit country that BOTAS¸ can charge to shippers--is a flat rate postal eventually will have access to much more gas than it tariff equivalent to $0.4 per million Btus. This tariff consumes domestically, but it has little opportunity is lower than many expected, indicating that EMRA to create underground storage sites (which instead seriously intends to create a competitive market are available"downstream,"in the Balkans). Institutional Endowment and Regulatory Reform in Turkey's Natural Gas Sector 219 The most interesting feature of the new gas law, the second year--albeit including some multiple however, is the gas release program. If managed bids), who paid BG (British Gas) a price equal wisely, the program has the potential to create real to BG's weighted average cost of gas. Previous competition within the country. The natural gas attempts by the British government to introduce law states (temporary article 2) that every year until supply side competition through voluntary com- the aggregate of the annual import amount falls to mitments by BG (including the 90/10 rule under 20 percent of the annual consumption amount, which BG would contract no more than 90 percent BOTAS¸ shall release part of its contracts to com- from new fields, leaving 10 percent to other compa- petitors by means of a tender. However, it is not yet nies) were less effective than hoped, because most clear how such a system will work in practice. of the 10 percent gas contracts were bought for new BOTAS¸ has a final say on the winner of the tender power generation rather than competing in the procedure. If BOTAS¸ is left free to choose the oper- industrial market. ator to whom it will cede its purchase agreements, One example of a competition-enhancing the program may turn out to be not too effective. release program was undertaken in Spain. By Royal Also, in view of the Italian experience, it would be Decree Law 6/2000 of June 23, 2000, and by an preferable that the gas be released by means of a order of June 29, 2001, the Spanish government tendering procedure based on objective criteria. conducted a gas release program for 25 percent of Italian legislation implementing the EU direc- the gas supplies that Spain received from Algeria tive introduced two constraints on the incumbent, through the Maghreb pipeline from October 2001 ENI, to facilitate the entry of new operators. The to January 1, 2004--that is, for about 26 months. first is a ceiling on the national consumption level This program, like the gas release program in the that can be served by a single company from 2003 United Kingdom, was based on the principle of to 2010 (50 percent). This measure, however, keeping the incumbent neutral. excludes gas for self-consumption.4 The second is a The release was designed to give competitors to ceiling on the deliveries to the national network by Gas Natural access to gas, so that customers in the any single company from 2002 to 2010 (initially large industrial market would receive offers from 75 percent of national consumption, with a reduc- alternative suppliers. Trading companies with a tion of 2 percentage points a year, to 61 percent). market share of more than 50 percent of the market ENI was left free to decide how to resell part of were excluded from the bidding. Fourteen bids the gas for which it had already contracted through were made by different company groups (the total long-term take-or-pay contracts. The result was bid was for two and a half times the amount of gas that only Italian companies (Plurigas SpA, Dalmine being offered). Bids could be made for only up to Energia, and Energia SpA) benefited from the 25 percent of the total volume offered. The average measure; major international gas companies, espe- price paid by bidders was equivalent to Gas cially producers, were not offered an opportunity Natural's purchasing cost (oil-related gas price) to enter the market. plus a fixed management fee. The solution adopted in Italy thus, in the end, The final awards were made on October 22, 2001. reinforces the position of some weak competitors Among the winning applicants were three Spanish that represent no real threat to the incumbent, but it companies--Iberdrola Gas (25 percent), Unión does not seem very effective as a means of reducing Fenosa Gas Comercializadora (20 percent), and prices and building competition. The three compa- Endesa Energía (18 percent)--and two interna- nies that benefited from the measure are too small to tional companies--BP Gas (25 percent) and Shell effectively compete with ENI. On the contrary, it is (2 percent)--through their Spanish subsidiaries. more likely in practice that smaller firms will adjust Spanish imports from Algeria by pipeline their prices to be in line with that of the incumbent. totaled 6.54 billion cubic meters in 2001; total In the United Kingdom, competition effectively imports were almost 17.5 billion cubic meters. started only in the early 1990s, when a gas release Spain's gas release program was therefore equal to program was introduced. Each year, the release gas about 16 percent of Spanish consumption, whereas was allocated on a pro rata basis to successful appli- the planned gas release for Turkey will be for cants (32 in the first year and an additional 70 in 80 percent of total imports. 220 Turkey: Economic Reform and Accession to the European Union Conclusion Notes Turkey plays a central role as a transit country for 1. The authors wish to thank the participants in the confer- ence "Turkey: Towards EU Accession" for their comments, and oil and gas from the Caspian Sea, Black Sea, and especially Ahmet Aydin, who sent them detailed comments and Central Asia regions to the EU. Because of its strate- additional information that allowed them to substantially gic position, Turkey can help to improve natural improve the first draft of this chapter. gas supply diversification and security in Europe as 2. These numbers were provided by the state-owned gas company, BOTAS¸. well as to enhance competition. It is expected that 3. In 2001 both Snam Rete Gas and Edison were separated the EU will have a gas supply deficit of about from their respective vertically integrated groups (ENI and 13 percent in 2010 and about 28 percent in 2020 Edison) in compliance with the provisions of Legislative Decree 164/2000 on the unbundling of activities in the gas (European Commission 2002). sector. At the end of 2001, 40.24 percent of the shares of Snam To perform this role effectively, Turkey will have Rete Gas were floated, with ENI continuing to own the remain- to develop its national infrastructure and stimulate ing stake. 4. The fact that gas for self-consumption has been excluded internal gas demand. The development of distribu- from the ceiling means that Snam can minimize the amount of tion networks is important to maintain market gas it releases by entering the electricity market through the growth, which itself will be vital if the gas that construction of gas-fired power generators, thus reducing BOTAS¸ has contracted is to be absorbed and if the the effect of the program. country is to attract international investors. In that References respect, clear regulations on access rules, tariffs, and BOTAS¸. 2001. 2001 Annual Report. http://www.botas.gov.tr/ new investments are vital. Experience in other raporlar/Botas/index.htm. countries reveals that uncertainty over the applica- European Commission. 2002. "Discussion Document on Long- ble regime may seriously prevent investments. Term contracts, Gas Release Programmes and the Availabil- ity of Multiple Gas Suppliers." Draft paper for discussion of To develop the internal market, regulators the Fifth Meeting of the European Gas Regulatory Forum, should also enact the appropriate secondary legisla- January 22. tion that will allow prices to domestic consumers to --------. 2003. "Second Benchmarking Report on the Imple- go down while maintaining good quality standards. mentation of the Internal Electricity and Gas Market." Com- mission Staff Working Paper SEC (2003) 448, July 4. Time limits must be imposed on the licensing sys- http://www.europa.eu.int/comm/energy/gas/benchmarking/ tem for distribution. doc/2/sec_2003_448_en.pdf. Finally, the release program must be imple- Hafner, Manfred. 2002. "Future Natural Gas Supply Options and Supply Costs for Europe." Observatoire Méditerranéen de mented soon to increase the number of market l'Energie, Workshop on the Internal Market for Gas, Brussels, participants. November 7­8. Part III Economic Challenges 221 9 Labor Market Policies and EU Accession: Problems and Prospects for Turkey Erol Taymaz and S¸ule Özler The process of European Union (EU) accession has medium term, removal of all forms of discrimina- provided a strong stimulus for various institutional tion, adoption of EU legislation in the field of labor changes in Turkey. The recognition of Turkey as a law, effective implementation and enforcement of candidate state for accession by the European the social policy and employment acquis, and Council at Helsinki on December 10­11, 1999, was preparation of a national employment strategy an important turning point in this process.1 The with a view toward later participation in the Euro- Accession Partnership (AP), which followed the pean Employment Strategy (EES). These institu- Helsinki summit, identified the short-term and tional changes are expected to enhance Turkey's medium-term priorities, intermediate objectives, capacity to develop and implement, together with and conditions on which accession preparations the European Community, strategies for "employ- must concentrate in light of the political and eco- ment and particularly for promoting a skilled, nomic criteria. One of the most important issues trained and adaptable workforce and labour mar- for Turkey in adopting and implementing the EU kets responsive to economic change" (Treaty Estab- acquis communautaire (the entire body of legisla- lishing the European Community, Article 125; also tion of the European Communities and Union) is see the EU's Official Journal, C 325, December 24, labor market regulations and employment policies. 2002). Adoption of the EU acquis will certainly bring radi- Adoption of the EU acquis on employment and cal changes to the functioning of the labor market social affairs is likely to put a burden on the firms in Turkey, with vital consequences for firms, and workers that need to adapt themselves to the workers, and the long-term performance of the new competitive environment. The adverse effects economy. of this process of transformation would be mini- As noted, the Accession Partnership identified mized if the government, the private sector, and short-term and medium-term priorities and objec- labor understand what needs to be changed and tives in employment and social affairs. In the short then adopt effective policies and strategies. The term, Turkey was expected to strengthen efforts to main aim of this study is to provide, for use by tackle the problem of child labor, to ensure that these agents, information on the employment and the conditions are in place for an active and labor market issues that are important during the autonomous social dialogue, and to support the EU accession process. A study of labor markets in social partners' capacity-building efforts to develop the process of EU membership is crucial for Turkey, and implement the acquis. The AP envisaged, in the because, as in all other European countries, the 223 224 Turkey: Economic Reform and Accession to the European Union labor market is the single largest market whose effi- organizations such as the OECD have pointed to cient operation has significant repercussions for the inefficient and inflexible labor markets as a reason performance of the whole economy. Moreover, for the high and, in many cases increasing, unem- being a social institution, the labor market, and the ployment in European countries. The concept of rules and regulations defining how it should oper- "labor market flexibility" has played a key role in ate, have a direct impact on the lives of almost all these discussions.2 citizens. The concept of labor market flexibility refers to Because the topic is rather broad, this study con- the functioning of labor markets ("external flexibil- centrates on the possible effects of the adoption of ity"), and it focuses mainly on wage and numerical the employment acquis regulating work and flexibility. Wage flexibility refers to the speed of employment conditions, and it ignores some issues adjustment in wages in the labor market. What is such as child labor, discrimination, and social pro- usually meant by wage flexibility is the downward tection. The chapter thus focuses on employment flexibility of real or nominal wages. Specific wage- protection and labor market flexibility issues. It setting institutions (centralized collective bargain- begins by briefly summarizing the literature on ing, wage indexation, and minimum wage legisla- labor market policies, institutions, and economic tion) and tax and social spending policies (such as performance. It then presents basic employment high unemployment benefits, high nonwage labor indicators for Turkey, the EU, and some accession costs, and high marginal tax rates) are blamed for countries to set the background for the study. The reducing wage flexibility. Numerical flexibility refers next section compares EU and Turkish labor law to how fast and at what cost a firm can adjust the and discusses the main characteristics of the ration- composition and the number of workers it employs ale and implementation of the European Employ- by hirings, layoffs, and firings. Employment protec- ment Strategy. The sections that follow analyze the tion legislation (EPL) is one of the main institutions measurement of labor market flexibility and the that determines numerical flexibility. Because flexibility of the Turkish labor market and describe numerical and wage flexibility are closely related (as the impact of the accession process and the adop- will be discussed later--rigidities in EPL may lead to tion of the acquis. The final section summarizes the higher wages), in this chapter we use only the term basic findings and policy proposals. labor market flexibility to cover both aspects of external flexibility. In the 1990s, some researchers emphasized Labor Market Policies, Institutions, the importance of functional (or "internal") and Economic Performance flexibility--that is, flexibility in job description and Although the link between labor market institu- job design for multiskilled workers. Although tions and economic performance has received con- external and internal flexibility could be substitutes, siderable attention in the literature beginning with or options, for alternative corporate strategies, we the classical economists, since the mid-1970s it has do not study the issue of internal flexibility. become a major contentious issue among econo- As noted earlier, Article 125 of the Treaty Estab- mists and policymakers. The member countries of lishing the European Community calls for a coordi- the Organisation for Economic Co-operation and nated strategy for promoting a "skilled, trained and Development (OECD) experienced a rapid increase adaptable workforce and labour markets responsive in inflation and unemployment rates in the second to economic change." The concept of adaptability half of the 1970s. Almost all the OECD countries is certainly broader than the concept of flexibility. (with a major exception, Turkey) were successful in For example, it is suggested in a report financed curbing the inflation, but high unemployment rates by the European Commission that adaptability have persisted in European countries. refers to "the broad process by which labour mar- The difference in the labor market performances kets adjust to exogenous developments over a of the United States and European countries period of time." whereas flexibility is now used has instigated an intensified debate on the link to refer to the "short-term response of wages and between labor market institutions and economic labour costs, in particular, to variations in the performance. Many economists and international demand for labour relative to supply, or to the Labor Market Policies and EU Accession: Problems and Prospects for Turkey 225 ability of employers to adjust their work force to Although there is almost a consensus on the changes in economic activity." Therefore, "[w]hile effects of EPL on the composition and rate of flexibility defined in these terms may be an impor- unemployment among neoclassical economists, tant part of the wider concept of adaptability, it is another group of researchers suggests that excessive far from being the only aspect of labour market labor market flexibility may hinder investment in behavior which is of significance. Indeed, a high training and innovative activities, diminish the degree of flexibility so defined may not only con- accumulation of human and knowledge capital, flict with the achievement of wider objectives than and thus have a negative impact on growth and simply the maintenance of a high level of employ- employment in the long run. According to Michie ment but might also make it more difficult to secure and Sheehan (2003), "The sort of `low road' labor longer-term growth objectives" (Algoé Consultans flexibility practices encouraged by labor market 2002: 2). Keeping in mind these differences, this deregulation--short term and temporary con- study focuses on labor market flexibility, especially tracts, a lack of employer commitment to job secu- on changes needed in the EPL during the accession rity, low levels of training, and so on--are nega- process in Turkey. tively correlated with innovation." Firms that rely Researchers disagree about the effects of labor on labor market flexibility to be more competitive market flexibility on economic performance. One will have weak incentives for conducting innovative group claims that labor market flexibility is activities. Moreover, reduced innovative activities required for the good functioning of competitive will, in turn, have a negative impact on employ- markets and thus for the efficient allocation of ment and company profits because "(1) lower wage resources. Because employment protection and increases will lead to a slower replacement of the rigidities in wage setting are costs incurred by capital stock, (2) lower wages prevent the Schum- firms, they have profound effects on firms' deci- peterian process of creative destruction, and sions (OECD 1994a, 1994b, 1999; Salvanes 1997; (3) lower wages will lead to a lack of effective Blanchard 2000; Scarpetta and Tressel 2002; demand" (Kleinknecht 1998).3 Patterns of sectoral Heckman and Pagés 2004). These researchers specialization also may be influenced by labor mar- suggest, first, that stricter labor market regulations ket flexibility. For example, Bassanini and Ernst may lead to higher unemployment (and lower (2002) show in an empirical study that "countries output) and change the composition of unemploy- with coordinated industrial relations systems and ment, because they affect the flows to and from strict employment protection tend to specialize in employment--that is, hiring and layoffs. EPL costs industries with a cumulative knowledge base affect layoffs directly, because these costs are added because coordinated industrial relations and employ- to the cost of layoffs, and the cost of hiring indi- ment protection encourage firm-sponsored train- rectly, because firms will take into consideration the ing as well as the accumulation of firm-specific (potential) costs of layoffs (including EPL costs) in competencies." their hiring decisions. If the second effect domi- Rigidities and frictions in the labor market may nates the first one, then the unemployment rate will reduce labor flows and lead to wage compression be higher. EPL will also increase unemployment (lower wage differentials). These factors, however, duration because of the decrease in the exit rate may induce firms to provide more training for their from unemployment. employees and contribute to the accumulation of Second, strict EPL is likely to strengthen the bar- human capital, both at the firm level and at the gaining power of workers and, depending on the economy level (see, e.g., Acemoglu and Pischke structure of product and labor markets, may lead to 1998, 1999; Agell 1999; Ballot and Taymaz 2001). wages higher than the market-clearing wages and The stability of the employment relationship, com- higher unemployment. Moreover, EPL provides plementarities between training and innovation protection for insiders, those workers who have activities, and wage compression all make training regular jobs in the formal sector. Thus, strict EPL activities more profitable. Thus, firms will achieve may cause a widening gap between insiders and higher productivity and a higher rate of growth in outsiders and may encourage firms to operate in productivity as a result of employing more skilled the informal sector. and well-educated employees. 226 Turkey: Economic Reform and Accession to the European Union Although the issue of the effects of labor market Labor Market Indicators for Turkey institutions on economic performance has yet to be Turkey, with its population of 64 million, is the resolved, some remarkable contributions in recent largest of the 13 accession and candidate coun- years have improved understanding of how labor tries.4 Its eventual membership in the EU will have market institutions function. For example, Belot, a profound impact on both Turkey and the EU Boonez, and van Ours (2002) have developed a countries, and the impact of membership will be model that proves that there is an optimal degree of determined, to a large extent, by the peculiarities of employment protection. In other words, both the structure of the population and labor markets excessive and limited labor market flexibility could in Turkey. be detrimental to economic growth. More impor- One of the most important characteristics of the tant, it has been shown that the impact of labor population of Turkey is its age composition. The market regulations and institutions depends on share of young people is relatively high because of other market and technology conditions (Scarpetta the country's high birthrate. The birthrate is declin- and Tressel 2002). Blanchard has developed models ing, but it is predicted to remain higher than the in which he studies the interactions between labor European average in the coming decades (the pop- and product markets (e.g., Blanchard 2000). He ulation growth rate was about 1.8 percent in the shows that institutions play a more important role 1990s). The high proportion of young people could in the process of wage setting if product markets be an advantage for Turkey because it includes a are monopolistic or oligopolistic, because only in high share of active population, but it imposes a those markets would workers be able to bargain heavy burden on the educational system and makes over rents. Therefore, (de)regulation of labor and employment generation one of the main social product markets must be implemented together. issues. Finally, Belot (2002) develops the idea that labor The employment rate as a percentage of market flexibility itself could be an endogenously working-age population (aged 15­64) is lower in determined variable, and he shows in a model that Turkey than in the EU and other candidate countries. countries with low migration costs and high eco- In 2000 the employment rate was only 48.2 percent nomic heterogeneity (such as the United States) in Turkey, whereas it was 63.2 percent in the EU and may prefer no employment protection. well above 50 percent in all candidate countries (see Numerous empirical studies have attempted to table 9.1 for data on Turkey, the EU, and candidate test the effects of labor market flexibility on eco- countries with more than 5 million population). nomic performance.Most of these studies show that One of the main reasons for the low employment the effect on the composition of unemployment is rate in Turkey is the fact that the participation rate is unambiguous: employment protection increases also low, especially for urban women. Turkey is the duration of unemployment by slowing down the expected to experience an increase in its participa- flows through the labor markets (more long-term tion rate in the future,which may intensify pressures unemployment and less short-term unemploy- for employment generation. ment), but the effect on the rate of unemployment Self-employment rates and part-time and fixed- and output is ambiguous. Labor market flexibility term employment rates5 seem to be quite high in has an adverse impact on specific groups of workers Turkey (24.5 percent, 20.7 percent, and 10.0 per- such as youth and marginal groups (for extensive cent, respectively). However, the majority of the surveys, see Nickell and Layard 1999; Addison and self-employed and part-time employed are working Teixeira 2001; Baker and others 2002; Heckman and in agriculture, and the fixed-term employment is Pagés 2004).As for growth and productivity, Nickell dominant in the construction sector. Therefore, and Layard (1999) suggest that"there seems to be no these rates basically reflect sectoral specificities and evidence that either stricter labor standards or the importance of these sectors (agriculture and employment protection lowers productivity growth construction) in total employment. rates. If anything, employment protection can lead In Turkey, the share of agriculture in total to higher productivity growth if it is associated with employment is extremely high (34.5 percent); other measures taken by firms to enhance the sub- among all candidate countries, it is second to that stantive participation of the workforce." Labor Market Policies and EU Accession: Problems and Prospects for Turkey 227 TABLE 9.1 Employment Indicators: EU and Selected Group of Candidate Countries, 2000a Turkey EU Bulgaria Hungary Poland Romania Total population (thousands) 64,059 370,914 6,832 9,927 30,535 22,338 Population aged 15­64 (thousands) 41,147 247,708 5,502 6,760 25,652 15,213 Total employment (thousands) 20,579 165,537 2,872 3,807 14,518 10,898 Employment rate (% population aged 15­64) 48.2 63.2 51.5 55.9 55.1 64.2 FTE employment rate (% population 49.3 57.9 50.3b 56.0 53.0b 63.8 aged 15­64)c Self-employed (% total employment) 24.5 15.0 14.7 14.5 22.5 25.4 Part-time employment (% total employment)c 20.7 17.8 3.4b 3.6 10.6 16.4 Fixed-term contracts (% total employment)c 10.0 13.6 5.7b 5.8 4.2 1.6 Employment in services (% total employment) 47.3 69.0 54.0 59.8 50.3 29.0 Employment in industry (% total employment) 18.2 26.7 32.8 33.8 31.1 25.8 Employment in agriculture 34.5 4.3 13.2 6.5 18.7 45.2 (% total employment) Unemployment rate (% labor force) 6.6 7.9 16.2 6.6 16.3 7.0 Youth unemployment rate (% labor force 13.2 15.5 33.3 12.3 35.7 17.8 aged 15­24) Long-term unemployment rate 1.3 3.7 9.5 3.1 7.3 3.4 (% labor force) Note: FTE full-time equivalent. a. Candidate countries with more than 5 million population in 2000. b. Data for 2001. c. Calculated from Turkish State Institute of Statistics; Household Labour Force Statistics (SIS 2000b). Sources: Turkey: SIS 2000b; all other countries: European Commission DG for Employment and Social Affairs 2002. of Romania (45.2 percent). Because the share of cent in Poland, and 3.4 percent in Romania. The agriculture is expected to decline in the future, this proportion of long-term unemployed in total transformation may tend to lower the participation unemployed in Turkey is also very low, only 20 per- rate (the participation rate for urban women is cent in 2000. Among all large candidate countries, much lower than that for rural women) and add the lowest rate after Turkey is observed in Poland another source of demand for urban male jobs, (45 percent), and the EU average is about 47 per- mainly in the services sector. The share of services cent. These data seem to suggest that Turkey has in total employment in Turkey is much lower than maintained a high rate of labor market flows so that, that in the EU and candidate countries, but again in spite of a huge youth population and the growing with the exception of Romania where the agricul- demand for new jobs, the rate of long-term unem- tural sector is predominant. ployment remains relatively low. In other words, The unemployment data reveal that there could Turkey has quite a dynamic labor market. be substantial differences between the labor markets The labor market indicators summarized in in Turkey and the EU. The unemployment rate in table 9.1 also reveal that employment generation is a Turkey is relatively lower. Moreover, the youth major issue in Turkey. The demand for labor must unemployment rate is significantly lower, especially increase at a high rate to keep the rate of unemploy- compared to major candidate countries, in spite of a ment at the existing level. One of the main determi- huge influx of the young people into the labor force. nants of labor demand is, of course, the cost of Most interesting, the long-term unemployment labor. Table 9.2a presents the data on labor costs, rate6 (as a percentage of labor force) is very low, only income tax, and employees' and employers' social 1.3 percent, although it is 3.7 percent in the EU, 9.5 security contributions (SSCs) for a single individual percent in Bulgaria, 3.1 percent in Hungary, 7.3 per- without children in OECD countries in 2002. 228 Turkey: Economic Reform and Accession to the European Union TABLE 9.2a Income Tax Plus Employees' and Employers' Social Security Contributions, 2002a (percent of labor costs) Social Security Contributions Labor Income Tax Employee Employer Total Costs (US$)b Australia 24 0 0 24 33,964 Austria 8 14 23 45 34,030 Belgium 21 11 24 55 43,906 Canada 18 6 7 31 34,793 Czech Rep. 8 9 26 43 18,631 Denmark 32 11 1 43 36,690 Finland 20 5 20 45 35,513 France 9 9 29 48 32,856 Germany 17 17 17 51 42,197 Greece 0 12 22 35 20,570 Hungary 13 9 24 46 11,934 Iceland 21 0 5 26 25,379 Ireland 10 4 10 24 27,775 Italy 14 7 25 46 35,709 Japan 6 9 10 24 32,287 Korea, Rep. of 2 6 8 16 32,116 Luxembourg 7 12 12 32 37,573 Mexico 2 1 13 16 10,295 Netherlands 6 19 10 36 36,019 New Zealand 20 0 0 20 26,629 Norway 19 7 11 37 36,262 Poland 5 21 17 43 16,268 Portugal 4 9 19 32 15,376 Slovak Rep. 5 9 28 42 13,249 Spain 10 5 23 38 27,156 Sweden 18 5 25 48 33,345 Switzerland 9 10 10 30 37,710 Turkey 12 12 18 42 17,367 United Kingdom 14 7 8 30 32,557 United States 15 7 7 30 34,650 a. Single individual without children at the income level of the average production worker. Note that such workers do not receive family benefits. b. Annual labor cost per worker, U.S. dollars with equal purchasing power. Source: OECD 2002. Table 9.2b presents the same data for various family close to the EU average and lower than the one types and wage levels. observed in most of the candidate countries. Three striking observations about Turkey emerge Second, the tax wedge does not differ much in from the data presented in tables 9.2a and 9.2b.First, Turkey across family types and wage levels. For the average labor cost for employers is substantially example, the lowest tax wedge exists for an individ- lower in Turkey than in the developed OECD coun- ual without any children earning 67 percent of the tries, but it is relatively higher than in some major average wage rate (41.3 percent) and the highest for candidate countries (Hungary, Poland, and the an individual without any children earning 167 per- Slovak Republic). The tax wedge (the proportion of cent of the average wage rate (44.3 percent); the income tax and employers' and employees' SSCs in difference is only 3 percentage points. In all EU labor cost) for a single individual without children is countries (with the exception of Greece), the tax Labor Market Policies and EU Accession: Problems and Prospects for Turkey 229 TABLE 9.2b Income Tax Plus Employees' and Employers' Contributions Less Cash Benefits, by Family Type and Wage Level, 2002 (percent of labor costs) Single, Single, Single, Single, Married, Married, Married, Married, Family Type No Child No Child No Child 2 Children 2 Children 2 Children 2 Children No Child Wage Levela 67 100 167 67 100­0 100­33b 100­67b 100­33b Australia 19.7 23.6 32.0 10.5 14.7 16.8 19.2 20.3 Austria 39.9 44.8 50.0 16.3 29.6 31.9 34.4 42.5 Belgium 48.9 55.3 61.1 32.9 40.1 42.5 48.5 49.8 Canada 26.8 30.8 31.8 4.6 20.9 24.5 27.4 27.9 Czech Rep. 41.8 43.5 45.8 18.0 28.7 35.4 39.3 42.3 Denmark 40.4 43.4 51.2 15.8 30.9 35.7 38.4 40.5 Finland 40.4 45.4 51.2 26.7 38.5 37.4 39.3 42.5 France 37.8 47.9 50.5 30.1 39.2 37.8 39.9 43.0 Germany 45.9 51.3 55.8 29.1 32.5 38.7 43.0 45.9 Greece 34.3 34.7 40.2 34.3 35.1 34.9 34.8 35.3 Hungary 42.0 46.3 54.8 17.7 30.2 32.1 34.9 44.2 Iceland 19.4 25.8 31.0 6.4 1.9 12.3 19.0 19.4 Ireland 16.6 24.5 34.4 13.3 9.0 13.5 16.9 19.1 Italy 42.7 46.0 49.9 25.4 34.0 39.3 41.8 42.9 Japan 23.2 24.2 27.1 20.4 20.3 21.8 22.6 23.3 Korea, Rep. of 14.8 16.0 20.3 14.4 15.4 15.0 15.3 15.3 Luxembourg 27.3 31.5 39.0 1.3 9.0 12.8 15.4 25.9 Mexico 11.4 16.1 22.4 11.4 16.1 13.4 14.2 13.4 Netherlands 37.2 35.6 40.4 18.2 25.2 29.1 32.6 33.6 New Zealand 18.8 20.0 25.7 1.6 18.2 19.2 19.5 19.2 Norway 33.8 36.9 43.5 14.0 27.2 29.2 31.4 34.5 Poland 41.4 42.7 43.8 36.5 37.7 41.4 42.2 41.4 Portugal 29.5 32.5 38.0 18.9 23.4 24.6 27.1 30.2 Slovak Rep. 40.3 41.4 44.7 23.8 29.6 34.1 35.9 40.5 Spain 33.9 38.2 41.9 28.3 31.4 34.5 34.7 35.7 Sweden 45.9 47.6 52.0 35.3 40.5 41.3 42.7 46.6 Switzerland 27.0 29.6 33.8 12.6 18.1 20.5 23.6 27.3 Turkey 41.3 42.4 44.3 41.3 42.4 41.7 41.9 41.7 United Kingdom 24.7 29.7 32.9 10.8 18.2 18.0 22.4 24.7 United States 27.3 29.6 35.2 5.0 17.6 22.7 25.0 27.8 a. Percentage of the wage rate for an average production worker. b. Two-earner family. Source: OECD 2002. wedge differences between various categories of 8 percent in Austria. In other words, there are sub- workers are much wider. These figures show that stantial intercountry differences in the composition income tax and social security structures in Turkey of cuts on labor costs. do not have a social policy component that favors These observations indicate that anyone making disadvantaged groups. intercountry comparisons should be extremely Third, significant differences appear across careful. There are significant differences in the countries in terms of the shares of income taxes institutional setups: different institutions may have and SSCs. For example, the tax wedge is almost the similar functions, and there may be complementar- same for Denmark and Austria, but the share of ities or substitutions between various institutions income tax is 32 percent in Denmark and only and functions. Therefore, issues such as labor 230 Turkey: Economic Reform and Accession to the European Union market flexibility must be studied within a larger lex/en/treaties/index.htm). The Treaty of Amster- framework that encompasses all institutions inter- dam, which was signed by the heads of state or gov- acting with each other. ernment of the member states on October 2, 1997, and entered into force on May 1, 1999, promoted a Turkey and EU Labor series of social policy priorities at European Com- Market Policies munity level, especially in the area of employment. Turkey must fulfill the accession criteria and adopt The change in emphasis on employment is the regulatory framework required for EU member- reflected in the fact that the employment articles ship. This process will lead to a rather dramatic are included in the treaty as a title (like the mone- transformation in the Turkish labor market through tary and economic articles), not as a mere chapter. two channels. First, the membership process implies The employment title (Title VIII of the treaty) lays economic integration with the EU, and competition down the principles and procedures for developing in all markets will be intensified. Indeed, Turkey a coordinated strategy for employment. Article 125 should ensure "the existence of a functioning mar- sets the basic objectives as follows: ket economy as well as the capacity to cope with Article 125: Member States and the Community competitive pressure and market forces within the shall, in accordance with this title, work towards Union"to satisfy the economic criteria for member- developing a coordinated strategy for employ- ship--that is, the so-called Copenhagen criteria. ment and particularly for promoting a skilled, Second,Turkey is required to apply fully theacquis of trained and adaptable workforce and labour the EU in force,7 including all rules and regulations markets responsive to economic change with a in the field of employment and social policy that view to achieving the objectives defined in Arti- form Chapter 13 in accession negotiations. cle 2 of the Treaty on European Union and in Turkey has had a customs union with the EU Article 2 of this Treaty. since 1996. Therefore, the impact of the process of membership on the labor market through changes The treaty maintains the commitment to in product markets could be expected to be limited. achieving a high level of employment as one of the The adoption of the acquis would have a direct key objectives of the EU, and it calls attention to impact on the labor market, because it requires a promoting "a skilled, trained and adaptable work- new institutional setup and a new way of forming force and labour markets responsive to economic policy. In this section, we compare the labor law in change." This objective is an issue of "common con- Turkey with the EU directives and assess the effects cern" for all member states. of adopting the acquis. We focus on the labor law The Treaty of Amsterdam, like earlier treaties, and issues related to labor market flexibility.8 We leaves the implementation of employment policy to also briefly analyze how employment policies are the member states, but it obliges member states and formed in the EU (the European Employment the Community to work toward developing a Strategy) and how the candidate countries are "coordinated strategy for employment," because expected to adjust employment policies and coor- the labor market policies of a member state will dinate them with the EU during the membership have a direct impact on other member states as process.9 well. Article 128 sets out the specific steps leading to the formulation of such a strategy, including, on The EU Law an annual basis, guidelines for employment, possi- ble recommendations to the member states, and a The EU law is composed of three different types of joint report by the Council of the European Union legislation: primary legislation, secondary legisla- and the Commission to the European Council tion, and case law. These types of legislation com- that describes the employment situation in the pose the acquis communautaire.10 European Community and the implementation of Primary Legislation Primary legislation includes the guidelines. Each member state is to provide the the treaties establishing the European Union and Council of the European Union and the Commis- other agreements having similar status. The treaties sion with an annual report on the principal meas- have been revised several times (for all treaties, ures taken to implement its employment policy in see the EU Web site, http://europa.eu.int/eur-lex/ light of the guidelines for employment. Labor Market Policies and EU Accession: Problems and Prospects for Turkey 231 Finally, the treaty provides a legal base for the [u]nder article 226 EC (ex article 169 EC) the analysis, research, exchange of best practices, and European Commission or a Member State may promotion of incentive measures for employment bring a complaint, alleging the failure by a (Article 129), and it establishes permanent, consti- Member State to fulfil an obligation under the tutionally based institutional structures (Article Treaty, before the European Court of Justice 130, Employment Committee) that will help to (ECJ or the Court). Grounds for a complaint develop employment policies. may be, for example, the lack of transposition of a binding Directive, or the non repeal of a Secondary Legislation The EU secondary legisla- national rule that is not consistent with the tion is based on the treaties and takes the following Treaty or a Directive. If the Court finds that the forms: obligation has not been fulfilled, the Member State concerned must comply without delay. If, · Regulations, which are directly applicable and after new proceedings are initiated by the Com- binding in all member states without the need mission, the Court finds that the Member State for any national implementing legislation. concerned has not complied with its judgment, · Directives, which bind member states as to the it may impose a fixed or a periodic penalty. objectives to be achieved within a certain time (Bronstein 2003)11 limit while leaving to the national authorities the choice of form and means to be used. Directives have to be implemented in national legislation Case Law Case law includes judgments of the in accordance with the procedures of the indi- European Court of Justice and of the European vidual member states. Court of First Instance, for example, in response to · Decisions, which are binding in all their aspects referrals from the Commission, national courts of for those to whom they are addressed. Thus, the member states, or individuals. In this study, decisions do not require national implementing we do not cover the case law on employment legislation. A decision may be addressed to any regulations. or all member states, to enterprises, or to individuals. Council Directives on Employment and · Recommendations and opinions, which have no the Turkish Labor Law binding force. The Commission can make a rec- Turkey has begun to change its laws and regulations ommendation for a party to behave in a particu- in accordance with the acquis. In this section, we lar way without any legal obligation, or it can compare the European Council directives on deliver an opinion to assess a given situation or employment with the Turkish labor laws, both the development in the Community or individual new Labor Law No. 4857 enacted by the Turkish member states. Parliament on May 22, 2003, and the former Labor The EU secondary legislation on employment is Law No. 1475 that regulated the labor market for mainly regulated through European Council direc- decades. We compare both the former and new tives, which bind member states to the objectives to labor laws because the new law has been in force for be achieved within a certain time limit but leave a few months and the agents in the labor market are them the choice of form and means to be used. In in the process of adapting to the new circum- other words, the directives are implemented in stances. This comparison will also make it possible national legislation in accordance with the proce- to show how far the new law goes in adopting the dures of the individual member states. Most of acquis. As mentioned earlier, we focus only on the employment directives can be implemented employment directives and not on directives on through collective agreements, provided such other labor-related issues such as discrimination, agreements apply to all workers that the directive free mobility of workers, and health and safety reg- intends to cover or to protect. ulations (for a comprehensive study of all directives The secondary legislation, like the treaty itself, as of 2001, see Hermans 2001). Table 9.3 compares directly confers certain individual rights on the cit- the EU directives,12 the existing labor law, and the izens of member states under the protection of the former labor law.13 It summarizes the main issues judicial system. Moreover, and regulations addressed in each directive. 232 TABLE 9.3 EU Directives and Turkish Labor Law Directive Date of Issue Former Labor Law No. 1475 New Labor Law No. 4857 (Entry into Force) Issues/Regulations (Relevant Articles) (Relevant Articles) 93/104 Organization of · Normal weekly work · · (45 hours) working time · Maximum week time · · November 23, 1993 · Minimum period of daily rest · · (November 23, 1996) · Minimum period of weekly rest · · · Minimum period of annual leave · · · Shift work · · · Night work (information/health) · (excl. men) · · Patterns of work · · (Articles 41, 43, 49, 61­65, 73) (Articles 41, 46, 53­70) 99/70 Framework agreement · Definition of fixed-term work No specific clause on · on fixed-term work · Definition of "comparable fixed-term work · ? (UNICE/CEEP/ETUC) permanent worker" June 28, 1999 · Abuse arising from the use of · ? (no limit) (July 10, 1999) successive fixed-term contracts · Rights of fixed-term workers · · Information/training · ? / - (Article 8 defines only temporary (Articles 11­12) and permanent work) 97/81 Framework agreement · Definition of fixed-time work No specific clause on · on part-time work · Definition of "comparable part-time work · ? (UNICE/CEEP/ETUC) full-time worker" December 15, 1997 · No shift from full-time to part-time · (January 20, 2000) work without consent · Rights of part-time workers · · Information/training · ? / - (Article 8 defines only temporary (Article 13) and permanent work) 98/59 Collective redundancies · Definition of collective redundancy · / (changed by Law No. 4773) · July 20, 1998 · Information and consultation · / (changed by Law No. 4773) · (excl. A 2.3.b.v and vi) (September 1, 1998) · Procedure · / (changed by Law No. 4773) · (Article 24) (Article 29) 2001/23 Employees' rights in · Employees' rights · · the event of transfers · Employers' liabilities · · March 12, 2001 · Information and consultation (Articles 14, 53; · (April 12, 2001) Law No. 2822, Article 8) (Article 6) 80/987 Protection of employees · Claims No specific clause (Law No. 2004 · in the event of insolvency · Guarantees (guarantee on bankruptcy, Article 206; · (Amended by 2002/74) institution) workers' claims have priority in Oct. 20, 1980/Sept. 23, 2002 · Coverage the event of insolvency) · (Oct. 28, 1983/Oct. 8, 2002) (Article 33) 94/33 Protection of young · Definition of "young" · · people at work · Employers' obligations · · June 22, 1994 · Restrictions · · (to be regulated by (June 22, 1996) (Article 67; also regulated by the MESS) law on apprenticeship and (Articles 71­73, 85, 87) vocational training, No. 3308) 91/533 Information for · Information content · ? · ? employees · Time limits · · October 14, 1991 · Enforcement · · (June 30, 1993) (Articles 9 and 11) (Article 8) 2002/14 Consultation and · Information content · · employee representation · Coverage · · March 11, 2002 · Procedures/enforcement · · (March 23, 2005/2007) Note: A positive mark (+) for a labor law indicates that it is in conformity with the directive. A negative sign (-) indicates either that the law does not satisfy the requirements set by the directive or that the issue is not addressed in the law. A question mark (?) indicates that the issue is not addressed in a well-defined way or that there are some differences between the law and the directive. The third and fourth columns refer to relevant articles of the new labor law. UNICE = Union of Industrial and Employers' Confederations of Europe; CEEP = European Centre of Enterprises with Public Participation; ETUC = European Trade Union Confederation; MESS = Ministry of Employment and Social Security. Source: The authors. 233 234 Turkey: Economic Reform and Accession to the European Union Turkey, like the member states, can comply with the type of activity, and of safety and health the directives either by adopting the laws, regula- requirements, especially as regards breaks during tions, and administrative provisions, or by introduc- working time" (Article 13 of Directive 93/104). ing the required provisions through an agreement Directive 97/81 on part-time work and Directive between the employers' and workers' representa- 99/70 on fixed-term work have adopted the frame- tives. For example, some directives have been intro- work agreements on part-time and fixed-term duced in some member states through collective work, respectively, between the general cross- agreements. However, Turkish lawmakers seem to country organizations UNICE (Union of Industrial prefer to cover almost all provisions of the directives and Employers' Confederations of Europe), CEEP in the new labor law. Therefore, the lack of regula- (European Centre of Enterprises with Public Par- tions in the labor law may require further legislative ticipation), and ETUC (European Trade Union work.14 Confederation). The social partners (UNICE, Council Directive 93/104 on certain aspects of CEEP, and ETUC) recognize that "contracts of an the organization of working time is one of the main indefinite duration are, and will continue to be, the directives regulating working conditions. The general form of employment relationship between directive lays down minimum safety and health employers and workers," but follow the conclusions requirements for the organization of working time; of the Essen European Council on the need to it applies to minimum periods of daily rest, weekly take measures with a view toward "increasing the rest, and annual leave; to breaks and maximum employment-intensiveness of growth, in particular weekly working time; and to certain aspects of by a more flexible organization of work in a way night work, shift work, and patterns of work. The which fulfills both the wishes of employees and the directive brings flexibility to working time by set- requirements of competition." Thus, the main aim ting the minimum requirements for the "average of these directives is to facilitate the development of working time" for a reference period not exceeding part-time and fixed-term work on a voluntary basis four months. Labor Law No. 1475 does not comply and to contribute to the flexible organization of with the directive for the maximum average work working time by providing measures for the removal week (48 hours). Although the proposal for the new of discrimination against part-time and fixed-term law prepared by the Scientific Committee intro- workers and by improving the quality of part-time duced the maximum limit to the average work and fixed-term work. These directives require that, week, Parliament failed to adopt the provisions and in relation to employment conditions, part-time did not set any explicit limit for the weekly working and fixed-term workers not be treated in a less time. This is surprising because the new law was favorable manner than comparable full-time and promoted by its proponents as introducing flexible permanent workers. The former labor law did not working arrangements, including part-time work. specifically define part-time and fixed-term con- The new law also failed to meet the requirement of tracts. Although the new law complies with the the directive on annual leave. Although the direc- directives to a large extent, it does not include the tive states that "every worker is entitled to paid reference to the "applicable collective agreement" in annual leave of at least four weeks," the new law sets the definition of "comparable worker."15 The direc- shorter periods on the basis of a worker's tenure (if tive on fixed-term work explicitly calls for the pre- a worker is employed 1­5 years, annual leave is only vention of abuse arising from the "use of successive 14 days; 6­14 years, 20 days; and more than 14 fixed-term employment contracts or relationships." years, 26 days). The former labor law had a similar The new law, however, does not impose any restric- scheme, but two days shorter leave for all cate- tion on the cumulative duration or the number of gories. Both the new and former labor laws also fail successive contracts, but allows successive fixed- to take the measures necessary "to ensure that an term contracts if there is a "sound reason" (esasli employer who intends to organize work according neden) to do so. to a certain pattern takes account of the general Directive 98/59, which deals with the approxi- principle of adapting work to worker, with a view, mation of the laws of the member states related to in particular, to alleviating monotonous work and collective redundancies, introduced the procedures work at a predetermined work-rate, depending on an employer should follow in contemplating Labor Market Policies and EU Accession: Problems and Prospects for Turkey 235 collective redundancies. The former labor law had relationships, including, provided for by the not envisaged any formal procedure for collective national law, severance pay on termination of redundancies. However, the law on employment employment relationships" (Article 3). The former protection (No. 4773), adopted by Parliament on labor law did not specifically address the issue of August 15, 2002, and effective as of March 15, 2003, employees' rights in the case of insolvency. How- after a lengthy political struggle, replaced Article 24 ever, the law on bankruptcy (No. 2004) assigns pri- in compliance with the directive. Law No. 4773 has ority to workers' outstanding claims. The new law been repealed by the new labor law, which endorses calls for the creation of a Wage Guarantee Fund as a the same procedure for collective redundancies part of the Unemployment Insurance Fund to pro- (Article 29). tect employees' claims, excluding severance pay.16 Directive 2001/23 (which repealed Directive Directive 94/33 provides the measures necessary 77/187) and its amending directive (98/50) are to prohibit work by children (any person under related to the protection of workers' rights in the 15 years of age or who is still subject to compulsory event of transfers of undertakings, businesses, or full-time schooling under national law) and the parts of undertakings or businesses. Directive 80/987 minimum working conditions for young people (which was amended by Directive 2002/74) regu- (any person under 18 years of age). The labor law lates the protection of employees in the event of the prohibits employment of any person under 13 years insolvency of their employers. The directive on of age and restricts employment of people under transfers stipulates that the "transferor's rights and 15. The law on apprenticeship and vocational train- obligations arising from a contract of employment ing (No. 3308) also regulates the employment of or from an employment relationship existing on children and young people. The new law satisfies the date of transfer shall, by reason of such transfer, most of the provisions set by the directive, and be transferred to the transferee," and the transferor refers to the Ministry of Employment and Social and the transferee shall be jointly and individually Security (MESS) for regulation of the employment liable with respect to obligations, including collec- conditions for young people. tive agreements, that arose before the date of trans- Directive 91/533 states that employers have an fer from a contract of employment or from an obligation to provide an employee with informa- employment relationship existing on the date of tion in the form of a written document on the transfer (Article 3). Moreover, both the transferor essential aspects of the contract or employment and the transferee shall be required to inform rep- relationship not later than two months after the resentatives of their respective employees affected commencement of employment. The former labor by the transfer. The labor law and the law on collec- law had a similar clause but did not specify the time tive bargaining agreements (Law No. 2822) have limit in which the information has to be provided provided similar safeguards to protect employees' to the employee. The new law, in accordance with rights. The new labor law complies with most of the the directive, mentions that the document has to be provisions of the directive, with the exception of handed over to the employee within two months if those on "information and consultation" with there is no employment contract signed by the employees (the third chapter). employee and employer. Although the directive Directives 80/987 and 2002/74 set rules to protect requires that any change in the conditions referred employees' claims arising from contracts of to in the written document "must be the subject of employment or employment relationships in the a written document to be given by the employer to event of their employer's insolvency. The directive the employee at the earliest opportunity and not states explicitly that the member states may not later than one month after the date of entry into exclude from its scope part-time employees, work- effect of the change in question," the new law does ers with fixed-term contracts, and workers with a not enforce this requirement. temporary employment relationship. Member Directive 2002/14, published in the EU's Official states "shall take the necessary measures to ensure Journal on March 23, 2002, establishes a general that guarantee institutions guarantee . . . payment framework for informing and consulting employees of employees' outstanding claims, resulting in the European Community. The directive requires from contracts of employment or employment all undertakings employing at least 50 employees, 236 Turkey: Economic Reform and Accession to the European Union or all establishments employing at least 20 employ- gration of national economies, led to a process of ees in any one member state, to adopt practical seeking European solutions through closer cooper- arrangements for exercising the right to informa- ation and convergence of structural policies, tion and consultation at the appropriate level. including the employment and social protection Information and consultation shall cover: policies. The issuance of the EU's famous "Delors' White (a) information on the recent and probable devel- Book" on Growth, Competitiveness and Employment opment of the undertaking's or the establish- in 1993 set the scene for the development of coor- ment's activities and economic situation; dinated employment policies at the EU level. (b) information and consultation on the situation, Inspired by the White Book, the European Council structure and probable development of in Essen in 1994 agreed on five objectives18 and for- employment within the undertaking or estab- mulated the Essen Strategy, which was reinforced lishment and on any anticipatory measures by successive Council conclusions and resolutions. envisaged, in particular where there is a threat A permanent Employment and Labour Market of employment; Committee was created in 1996. The Essen Strategy (c) information and consultation on decisions declared a political commitment to the issue of likely to lead to substantial changes in work employment, but the strategy itself and its imple- organization or in contractual relations. mentation were based on nonbinding conclusions Information shall be provided by the employer of the European Councils. The Treaty of Amsterdam "at such time, in such fashion and with such con- (signed in 1997 and entered into force in 1999) and tent as are appropriate to enable, in particular, the new Title on Employment provided the neces- employees' representatives to conduct and ade- sary legal framework for implementing a coordi- quately study and, where necessary, prepare for nated employment policy. consultation." A related directive (Directive 94/45) TheEuropeanCouncilinLuxembourg(November on the establishment of a European Works Council 1997), which is now known as the Luxembourg Jobs sets the rules and procedures to improve the right to Summit, launched the European Employment information and to consultation of employees Strategy on the basis of the new provisions of specifically in Community-scale undertakings and the employment title of the Treaty of Amsterdam Community-scale groups of undertakings. The new before it entered into force. The following European labor law does not provide any provisions to estab- Councils have provided additional orientations and lish the framework for informing and consulting targets for the EES and reinforced its links with employees within the context of these directives. other EU policies. There are also directives on parental leave The European Council in Lisbon (March 2000) (96/34),17 health and safety conditions (89/391 and set a new strategic goal for the EU for the next 91/383), and working conditions in specific sectors decade ("to become the most competitive and (93/104, 99/63, 2000/34, 2000/79, and others). The dynamic knowledge-based economy in the world, Turkish labor law is in compliance with most of the capable of sustainable economic growth with more provisions of these directives. and better jobs and greater social cohesion") and integrated the EES into a wider framework of pol- icy coordination to achieve this strategic goal. The European Employment Strategy European Council agreed on the objective of The European Council Summits The treaties achieving an employment rate as close as possible establishing the European Community have to 70 percent overall, and exceeding 60 percent for assigned the responsibility for employment and women, on average in the EU by 2010. After the social protection exclusively to the member states. midterm review of the first three years of imple- The role of the European Commission was to pro- mentation, the Council proposed strengthening the mote cooperation between the member states at the EES. EU level. In the early 1990s, persistent European- The European Council in Nice (December wide unemployment and structural problems in 2000) introduced the issue of quality as the guid- the labor markets, together with the increased inte- ing thread of the Social Policy Agenda, and in Labor Market Policies and EU Accession: Problems and Prospects for Turkey 237 particular quality in work as an important objec- and has become gradually embedded in national tive of the EES. policy formulation. Confirming the commitment of the EU and its Beyond the clear convergence towards the member states to the goal of full employment, the active labour market principles of the EES in the European Council in Stockholm (March 2001) earlier years of the strategy, the evaluation shows added two intermediate and one additional target: that other policies were also significantly influ- the employment rate should be raised to 67 percent enced by the EES (notably gender equality and overall by 2005, to 57 percent for women by 2005, social inclusion policies). . . . Over the years, the and to 50 percent for older workers (aged 55­64) by EES has added momentum to longer term struc- 2010. tural reforms in labour markets, not least The Barcelona European Council (March 2002) through the use of recommendations, addressed underlined that the full employment goal in the to individual Member States, adopted by the EU is at the core of the Lisbon strategy and consti- Council on a proposal from the Commission. tutes an essential goal of economic and social poli- The EES also fostered political agreement on cies. It called for a reinforced EES to underpin the new common paradigms, such as lifelong learn- Lisbon strategy in an enlarged EU. After the 2002 ing and quality in work. The need for lifelong evaluation, the Barcelona Council also urged the learning, and the complementarity between Council and the Commission to streamline the education and training systems, has become various policy coordination processes at the EU generally accepted, and Member States are all in level. the process of re-designing their education and The Brussels European Council (March 2003) training policies in a more integrated way. Qual- reiterated that the EES has the leading role in the ity in work appeared as a new priority in the implementation of the employment and labor mar- Employment Guidelines for 2000. ket objectives of the Lisbon strategy, and that it and Streamlining Policy Processes AftertheBarcelona the Broad Economic Policy Guidelines (BEPG) Council, the Commission adopted its communica- should operate in a consistent way. The European tion on streamlining the annual economic and Council called for the guidelines to be limited in employment policy coordination cycles (European number and for them to be results-oriented in Commission 2002a and 2003a). The main idea is to order to allow member states to design the appro- reorganize existing EU coordination processes priate mix of action. around a few key points to make the coordination The 2002 Evaluation of the European Employ- cycle more transparent and intelligible and to ment Strategy The EES, from its inception in strengthen its visibility and impact. In line with the 1997 to its evaluation in 2002, was based on four overall Lisbon strategy, this process is expected to "pillars" (employability, entrepreneurship, adapt- reinforce the focus on the medium term and to ability, and equal opportunities) together with hor- improve policy coherence.Within the new approach, izontal objectives. In its fifth year, an extensive eval- the BEPGs are expected to provide the overarching uation was conducted to give an overview of the economic policy coordination, and the leading role objectives of the EES and to strengthen the policy on employment policy coordination will lie with the formulation and implementation processes. The Employment Guidelines (EGs) and Recommenda- study (European Commission 2002d) noted: tions to Member States. The main building blocks of a better and more The comprehensive approach of the EES gener- clearly articulated policy coordination cycle can be ally strengthened national employment policy briefly described as follows (European Commission coherence and framework. Policies under each 2003c and 2003d): pillar were progressively adjusted and employ- ment priorities were mainstreamed into other (i) Preparation of the Spring European Council. policy areas like taxation and social security. In The Commission would, in its Spring Report, addition, the Strategy has brought about a grad- highlight the main areas where further ual change in priority from managing unem- progress has to be made and the key policy ori- ployment to managing employment growth, entations on which general guidance is 238 Turkey: Economic Reform and Accession to the European Union required from the Spring European Council. ahead of the June European Council and fol- The Spring Report would be complemented lowing the latter's consideration, the relevant and presented together with the Implementa- Council formations would adopt the BEPGs, tion Package (including the Implementation the EGs and the Employment Recommenda- Report on the BEPGs, the draft Joint Employ- tions to member states and/or endorse action ment Report, and the implementation report plans (e.g., the Internal Market Strategy) in on the Internal Market Strategy). The Com- their competence areas. mission's various reports and scoreboards (v) Concentration of implementation review in (including inter alia the Cardiff Report; the Quarter 4. A better streamlined review of state aids, innovation, and enterprise policy implementation requires: scoreboards) will feed into the Implementa- · Systematic information provision by mem- tion Package and the Spring Report. This ber states on the implementation of policies Commission input would assist different agreed on at European level. In this context, Council formations, as well as any other appro- there may be scope for rationalizing and priate actor, in reviewing implementation in streamlining current national reporting their specific policy areas. requirements. Fewer and more comprehen- (ii) The Spring European Council. The Spring sive reports, allowing also for coverage of European Council is a defining moment in the information on newly identified issues annual policy coordination cycle. It reviews (thus avoiding the need to add new reports implementation and, on that basis, gives gen- and procedures), might help in clarifying eral political orientations on the main policy and ensuring the coherence of member priorities. states' responses to policy recommenda- (iii) Commission proposals for new guidelines and tions issued by the Community; these recommendations. On the basis of the Spring reports should ideally be presented together European Council political orientations, the in October at the latest. The National Commission would present its proposals for Employment Plans would be sent as a sepa- further action in the various policy areas rate document around the same time. together in a Guidelines Package (which would · An implementation assessment by the include the Commission drafts for general and Commission. On the basis of the available country-specific policy recommendations as information (through reports, through contained in the BEPGs, the EGs, and the bilateral contacts, and through the results of annual employment recommendations to various benchmarking exercises), the Com- member states). This Package, the first of mission services would assess implementa- which would be issued in April 2003, would, in tion in the various relevant policy areas. principle, cover a three-year period, i.e., up to The Commission will present the findings 2006. The guidelines would continue to be of its review in the form of a new Implementa- issued every year to take account of possible tion Package together with the Commission's major new developments, but should other- Spring Report in mid-January, marking the wise remain stable until 2006, unless circum- start of a new cycle. stances require otherwise. Consistent with the recommendations of the BEPGs and the out- come and conclusions of the Cardiff process, The 10 Commandments, Targets, and Indicators the Internal Market Strategy--which will The European Council has identified and con- accompany the Guidelines Package--would firmed three objectives for the EES: deal with internal market matters at a Commu- nity level up to 2006, and would be adjusted in 1. Full employment. Employment rate overall, the intervening years only if necessary. 67 percent in 2005 and 70 percent in 2010 on (iv) Adoption of new guidelines and recommenda- average; for women, 57 percent in 2005 and 60 tions. After, where appropriate, further prepa- percent in 2010; for older workers, 50 percent in ration by the competent Council formations 2010. Labor Market Policies and EU Accession: Problems and Prospects for Turkey 239 2. Quality and productivity at work. Satisfaction · Eighty percent of persons aged 25­64 to have at with pay and working conditions, health and least upper secondary education by 2010 safety at the workplace, the availability of flexi- · Increased rate of participation of adults in edu- ble work organization, working time arrange- cation and training, to 15 percent on average in ments, and balance between flexibility and secu- the EU and to at least 10 percent in every mem- rity. Full attention is given to increasing ber state by 2010 productivity, in particular through continued · Increased investment by companies in training investment in human capital, technology, and of adults from the existing level of the equivalent work organization. of 2.3 percent of labor costs up to 5 percent of 3. Cohesion and an inclusive labor market. The labor costs on average in the EU by 2010 reduction of unemployment and of the remain- · An increase in the effective average exit age from ing disparities in access to the labor market, the labor market from 60 to 65 years on average both in socioeconomic and regional terms, is a in the EU by 2010 matter of both the equity and efficiency of the · Elimination of gender gaps in employment and EES. halving of gender pay gaps in each member state by 2010 To support these three objectives, the Commis- · Child care places available for 33 percent of chil- sion has identified 10 priorities (10 command- dren aged 0­3 and 90 percent of those from 3 ments) for action in the new guidelines: years to mandatory school age in each member 1. Help unemployed and inactive to find a job, state by 2010 prevent long-term unemployment · Halving of the school dropout rate in each 2. Encourage entrepreneurship and improve cli- member state and reduction of EU average mate for business start-ups dropout rate to 10 percent by 2010 3. Promote adaptability of workers and firms to · Reduction by half in each member state in the change unemployment gaps for people defined as being 4. Provide more and better investment in human at a disadvantage in accordance with national capital definitions by 2010 5. Increase labor supply and promote active aging · Reduction by half in each member state in the 6. Promote gender equality in employment employment gap between non-EU and EU and pay nationals by 2010 7. Combat discrimination against disadvantaged · All job vacancies advertised by national employ- groups ment services accessible and able to be consulted 8. Improve financial incentives to make work pay by anyone in the EU by 2005 9. Reduce undeclared work substantially · National targets to be set for business training, 10. Promote occupational and geographic reduced red tape for start-ups, per capita increase mobility. in public and private investment in human resources, tax burden on low-paid workers, and The Commission has also defined specific tar- undeclared work. gets that could be used as a part of an assessment of progress on implementing the guidelines: EU Labor Market Policies and Enlargement In · Personalized job search plan for all unemployed 1999 the European Commission initiated a cooper- before fourth month of unemployment by 2005 ation process on employment with the candidate · Work experience or training for all unemployed countries. The objective of this process is to before 12th month of unemployment (before six encourage those countries to define employment months for young and vulnerable) by 2005 policies that prepare them for membership of the · Thirty percent of long-term unemployed in EU and progressively adjust their institutions and work experience or training by 2010 policies. Moreover, the financial support for acces- · Reduction of 15 percent in rate of accidents at sion would be directed toward the employment work and a reduction of 25 percent for high-risk policy priorities identified in this cooperation sectors by 2010 process (European Commission 2003b). 240 Turkey: Economic Reform and Accession to the European Union It was agreed that as a first step the candidate indicators, see Nicoletti, Scarpetta, and Boylaud countries and the Commission would analyze the 2000). Because the OECD database allows key challenges for employment policies in Joint researchers to make international comparisons and Assessment Papers (JAPs). The work was started to analyze the impact of labor market regulations with background studies funded by the Commis- on economic performance in a cross-country set- sion in cooperation with the European Training ting, it has led to a surge in empirical studies and Foundation. The first JAPs were signed with the estimation of similar indicators for other countries. Czech Republic, Estonia, Poland, and Slovenia in For example, Riboud, Sánchez-Páramo, and Silva- 2000 and early 2001, followed by Cyprus, Hungary, Jáuregui (2002), Cazes and Nesporova (2003), and Lithuania, Malta, and Slovakia in late 2001 and Heckman and Pagés (2004) have calculated EPL early 2002 and by Bulgaria and Romania in the indicators for Latin American, Central and Eastern fall of 2002. The JAP with Latvia was signed in European (CEE), and transition countries, respec- February 2003. Cooperation with Turkey is at an tively. In a similar fashion, Betcherman, Luinstra, early stage; the background study for the Employ- and Ogawa (2001) present a detailed analysis of ment Policy Review was prepared in early 2003 labor market regulations in 17 countries, including under the auspices of the Turkish Employment Turkey. In this section, we will compare the strin- Organization (IS¸KUR)--see Tunali and others gency of the EPL in Turkey under the former labor (2003). This study will form the basis of the JAP to law (which formed the basis of the OECD indica- be drawn up with the European Commission. tors) and under the new labor law with that in the The candidate countries and the Commission OECD countries. agreed to monitor the implementation of the JAP The second set of measures, which we define as commitments. After signature of the JAPs, the main direct measures, are based on the estimation of var- commitments were discussed in a series of techni- ious aspects of labor market flexibility using the cal seminars between the Commission and repre- data on labor market variables. In this study, we sentatives of different institutions in the candidate use three types of direct measures to assess the countries. The Göteborg European Council of June labor market flexibility in Turkey: wage differen- 2001 asked candidate countries to translate the EU tials, job turnover, and mode-based indicators economic, social, and environmental objectives (employment and wage flexibility). underpinning the Lisbon strategy into their national policies and announced that the Synthesis Employment Protection Legislation Communication 2003 would include information The OECD EPL index, calculated by Nicoletti, about the candidate countries on this subject. Scarpetta, and Boylaud (2000), exploits the raw data published in the OECD Employment Outlook Employment Protection and Labor 1999 (OECD 1999). The data cover two basic ele- Market Flexibility in Turkey ments of the EPL system--restrictions on dis- missals of workers with regular contracts, and The growing interest in labor market flexibility has restrictions on the use of temporary forms of provided an impetus for empirical studies that aim employment contracts--and refer to the situation in at measuring the degree of labor market flexibility, most of the OECD countries in the late 1980s as mainly at the national and regional levels. well as in 1998. Researchers have developed two sets of measures. Regulations for regular contracts (permanent The first set of measures, pioneered by the OECD's employment) cover detailed indicators on influential study on employment protection legisla- tion, is based on indicators of labor market regula- · Procedural requirements (the process that has to tion that summarize the information on the regula- be followed from the decision to lay off a worker tory environments. The OECD has constructed a to the actual termination of the contract) database of internationally comparable data on · Notice and severance pay (for three tenure peri- certain economy-wide and industry-specific prod- ods beyond any trial period) uct market and labor market regulations (for · Prevailing standards and penalties for "unfair" the methodology, the database, and summary dismissals. Labor Market Policies and EU Accession: Problems and Prospects for Turkey 241 The following elements were considered for reg- severance payments after 4 and 20 years of tenure, a ulations for temporary contracts (fixed-term con- trial period before the eligibility arises, and unfair tracts and contracts under temporary work agen- dismissal compensation (20 years of tenure). cies, TWAs): Because the new labor law changes these provi- sions, there is a significant reduction in the EPL · "Objective" reasons under which a fixed-term index values for regular employment. The EPL (or a TWA) contract could be offered index scores for temporary employment are higher · The maximum number of successive renewals than those of the other countries because of the · The maximum cumulated duration of the restrictions on fixed-term contracts and the lack of contract. legal framework for TWAs. The draft labor law had Nicoletti, Scarpetta, and Boylaud (2000) special provisions on the TWAs, but these provi- assigned a score of 0­5 to each indicator, depending sions were left out of the law adopted by Parlia- on the degree of stringency of employment protec- ment. The new labor law allows, with the written tion implied by that indicator, and conducted a fac- consent of the worker, temporary transfer between tor analysis to aggregate the detailed indicators of enterprises belonging to the same holding com- each domain (regular employment and temporary pany, or between different companies if the worker employment) into summary indicators of the strin- gency of regulation by domain. The overall index of stringency of the EPL (EPL index) was obtained by TABLE 9.4 Employment Protection Legislation Index: OECD simply averaging the two summary indicators for Countries, Late 1990s regular and temporary contracts. The factor analy- sis was conducted on the 1998 regulatory indicators EPL Index for 21 OECD countries for which most informa- Regular Temporary tion was available. Average Contracts Contracts Table 9.4 presents the summary indicators for 25 countries (ranked in descending order by the Portugal 3.7 4.3 3.2 Turkey 3.6 2.6 4.6 stringency of the EPL index) for the late 1990s. Greece 3.5 2.6 4.5 Turkey has a very high overall score (ranked sec- Italy 3.3 3.0 3.6 ond), mainly because of its score from the tempo- Spain 3.2 2.8 3.7 rary employment domain (index value 4.6, the France 3.1 2.5 3.7 highest among all countries in the table). Norway 2.9 2.9 2.8 Table 9.5 presents basic indicators--the EPL and Germany 2.8 3.0 2.5 EPL index scores--for regular employment for five Japan 2.6 3.0 2.3 countries: Germany (a leading country case from Austria 2.4 2.8 2.0 the EU, and Turkey's main trade partner), Spain (a Netherlands 2.4 3.2 1.5 latecomer in the EU), Poland (a case for candidate Sweden 2.4 3.0 1.8 countries), the United States (the extreme case Belgium 2.1 1.6 2.6 among the OECD countries), and Turkey. The data Finland 2.1 2.3 1.9 Poland 1.9 2.3 1.4 for Turkey are presented in two columns. The first Czech Rep. 1.7 3.0 0.5 column refers to the situation prevailing under the Denmark 1.5 1.7 1.2 former labor law (No. 1475), and the data were Hungary 1.4 2.2 0.6 taken from Nicoletti, Scarpetta, and Boylaud Switzerland 1.3 1.3 1.2 (2000). The second column refers to the current sit- Australia 1.1 0.9 1.2 uation with the new labor law (No. 4857). The val- Ireland 1.0 1.7 0.3 ues of some indicators are based on our assessment. New Zealand 1.0 1.6 0.5 Table 9.6 presents the same data for temporary Canada 0.6 0.9 0.3 employment. United Kingdom 0.5 0.7 0.3 Table 9.5 reveals that the EPL index scores for United States 0.2 0.1 0.3 regular employment for Turkey are higher than those for other countries mainly because of high Source: Nicoletti, Scarpetta, and Boylaud 2000. 242 TABLE 9.5 Employment Protection Legislation for Regular Employment, Selected OECD Countries United Turkey Germany Poland Spain States L. 1475 L. 4857 Employment Protection Legislation Regular procedural inconveniences Procedures Scale 0­3 2.5 2.0 2.0 0.0 2.0 1.0 Delay to start of notice Days 17.0 13.0 1.0 1.0 1.0 1.0 Notice and severance pay for no-fault individual dismissals by tenure categories Notice period after 9 months Months 1.0 1.0 1.0 0.0 1.0 1.0 4 years Months 1.0 3.0 1.0 0.0 2.0 2.0 20 years Months 7.0 3.0 1.0 0.0 2.0 2.0 Severance pay after 9 months Months 0.0 0.0 0.5 0.0 0.0 0.0 4 years Months 0.0 0.0 2.6 0.0 4.0 0.0 20 years Months 0.0 0.0 12.0 0.0 20.0 0.0 Difficulty of dismissals Definition of unfair dismissal Scale 0­3 2.0 0.0 2.0 0.0 0.0 0.0 Trial period before eligibility arises Months 6.0 1.8 2.5 n.a. 2.0 2.0 Unfair dismissal compensation (20 years) Months 24.0 3.0 22.0 n.a. 26.0 6.0 Extent of reinstatement Scale 0­3 1.5 2.0 0.0 0.5 0.0 0.0 Employment Protection Legislation Index Scores Regular procedural inconveniences Procedures 5.0 4.0 4.0 0.0 4.0 2.0 Delay to start of notice 2.0 2.0 0.0 0.0 0.0 0.0 Notice and severance pay for no-fault individual dismissals by tenure categories Notice period after 9 months 3.0 3.0 3.0 0.0 3.0 3.0 4 years 2.0 4.0 2.0 0.0 4.0 4.0 20 years 4.0 2.0 1.0 0.0 1.0 1.0 Severance pay after 9 months 0.0 0.0 1.0 0.0 0.0 0.0 4 years 0.0 0.0 4.0 0.0 6.0 0.0 20 years 0.0 0.0 4.0 0.0 6.0 0.0 Difficulty of dismissals Definition of unfair dismissal 4.0 0.0 4.0 0.0 0.0 0.0 Trial period before eligibility arises 3.0 5.0 5.0 0.0 5.0 5.0 Unfair dismissal compensation (20 years) 4.0 0.0 4.0 0.0 5.0 1.0 Extent of reinstatement 3.0 4.0 0.0 1.0 0.0 0.0 n.a. Not applicable. Sources: Nicoletti, Scarpetta, and Boylaud 2000; authors' assessment for Law No. 4857. 243 244 TABLE 9.6 Employment Protection Legislation for Temporary Employment, Selected OECD Countries United Turkey Germany Poland Spain States L. 1475 L. 4857 Employment Protection Legislation Fixed-term contracts Valid cases other than the usual objective reasons Scale 0­3 2.5 3.0 1.0 3.0 0.0 2.0 Max. number of successive contracts Number 4.0 2.0 3.0 No limit 1.5 No limit Max. cumulative duration Months 24.0 No limit 36.0 No limit No limit No limit Temporary work agencies (TWAs) Types of work for which TWA employment is legal Scale 0­4 3.0 4.0 2.0 4.0 0.0 4.0 Restrictions on number of renewals Yes/no Yes Yes Yes No limit n.a. n.a. Max. cumulative duration of temporary work Months 12.0 No limit 36.0 No limit n.a. n.a. contracts Employment Protection Legislation Index Scores Fixed-term contracts Valid cases other than the usual objective reasons 1.0 0.0 4.0 0.0 6.0 2.0 Max. number of successive contracts 2.0 4.0 3.0 0.0 5.0 0.0 Max. cumulative duration 3.0 0.0 2.0 0.0 0.0 0.0 Temporary work agencies (TWAs) Types of work for which TWA employment is legal 1.5 0.0 3.0 0.0 6.0 4.0 Restrictions on number of renewals 4.0 4.0 4.0 2.0 n.a. n.a. Max. cumulative duration of temporary work 4.0 0.0 6.0 0.0 n.a. n.a. contracts n.a. Not applicable. Sources: Nicoletti, Scarpetta, and Boylaud 2000; authors' assessment for Law No. 4857. Labor Market Policies and EU Accession: Problems and Prospects for Turkey 245 FIGURE 9.1 Employment Protection because the costs to employers depend on various Legislation, Selected OECD other factors, such as voluntary turnover and the Countries occupational and tenure distributions of the labor EPL index force that define the entitlements for severance pay. 4.0 Second, the coverage of the law and regulations is 3.5 very important. The OECD EPL index almost com- pletely ignores the coverage issue. The EPL index is 3.0 a simple average of the indexes for regular and tem- 2.5 porary employment, although temporary employ- ment accounts for only 20 percent of wage earners 2.0 in Turkey. Moreover, the employment protection 1.5 provisions of the new law do not cover establish- 1.0 ments employing fewer than 30 workers, leaving more than 40 percent of workers registered at the 0.5 Social Insurance Institution (Sosyal Sigortalar 0.0 Kurumu, SSK) without protection (Household Labour Force Survey 2000 data). The law also USA Law Law Poland Spain 1475 4857 excludes certain sectors and activities. Germany Turkey, No. Turkey, No. Third, enforcement and implementation of the RE/Procedural inconvenience TE/Procedures law are a major issue in countries such as Turkey. As RE/Direct cost of dismissals TE/Maximum duration Bertola, Boeri, and Cazes (1999) discuss in detail, RE/Notice and trial period the EPL is enforced to different degrees, and a sim- ple ranking of countries on the basis of legal provi- Note: RE = regular employment; TE = temporary sions may lead to misleading results. employment. Sources: Nicoletti, Scarpetta and Boylaud 2000; Finally, the existing EPL measures do not reflect authors' assessment for Law No. 4857. the links and interactions between the EPL and other labor market institutions, such as unemploy- ment benefit schemes, wage-setting institutions, is employed in a similar position, up to 12 months early retirement, and pensions. Some of these insti- in total. For fixed-term contracts, the law does not tutions could be substitutes, some others comple- impose any restriction on the maximum cumula- mentary. According to Bertola, Boeri, and Cazes tive duration or renewal. Thus the new law provides (2000, p. 13), flexibility, under the OECD definition, for tempo- Protection against job loss is all the more desir- rary employment. able when only scant unemployment insurance Figure 9.1 shows the EPL index for the same is available, and unemployment insurance is group of countries and the contribution of each highly appreciated when weak job security pro- main category (factors) on the EPL index. As evi- visions increase the risk of job loss. Indeed, in dent in the figure, the changes introduced by the some countries job security--especially case law new labor law (No. 4857) have dramatically favourable to employees--does appear to be reduced the EPL index for Turkey, mainly by mak- inversely correlated to the coverage and level of ing temporary employment easier. The index value unemployment insurance (suggesting a trade- would be much smaller had the new law provided off between the strictness of EPL and the unem- the legal basis for TWAs. ployment benefit system, as in Denmark, Italy or Although the EPL measures are used extensively Spain, for example) or other adjustment tools in empirical studies, they have four known short- such as early retirement provisions. comings. First, there are significant measurement problems. As Addison and Teixeira (2001) men- Blanchard (2002) observes that there is an tion, measuring the stringency of employment inverse relation between the degree of employment protection merely from the legal texts may not be a protection and the generosity of the state unem- good indicator of the monetary costs to employers, ployment insurance system in continental Europe. 246 Turkey: Economic Reform and Accession to the European Union He explains this inverse relationship by suggesting predicted by the theory. The Turkish data,19 not that these institutions are two different ways of included in Blanchard's study, are also plotted in addressing the same failures, each one more appro- figures 9.2­9.4. Turkey is an apparent outlier in fig- priate to the circumstances of the country. This is ure 9.2, and in figure 9.3 to a lesser extent. In other exactly the case in Turkey. Unemployment insur- words, the data on flow into unemployment sug- ance legislation was enacted in 1999 (Law No. 4447), gest less strict employment protection than is and it began to provide unemployment benefits for implied by the OECD index. This discrepancy those eligible in 2002. Therefore, severance pay was could be regarded as confirmation of the caveats considered as a kind of protection and insurance about relying on the EPL as an indicator of flexibil- against unemployment in the implementation of ity for a country such as Turkey. the former labor law, and it proved to be easier to change the provisions on severance pay in the new Direct Measures of Labor Market Flexibility labor law after introducing the unemployment insurance system in the country. Rigidities in labor markets are expected to change There is almost a consensus on the impact of the behavior of economic agents and labor market the EPL on flows from and into unemployment outcomes. In this study, we use three measures (Jackman, Layard, and Nickell 1996; Blanchard that could reflect the extent of labor market 2000). On the one hand, stricter EPL decreases rigidities. Because of the lack of internationally hiring, which, in turn, makes it difficult for the comparable data, we focus on the manufacturing unemployed to find a new job and thus increases industries.20 long-term unemployment. On the other hand, Wage differentials tend to be lower in countries stricter EPL also decreases firing and decreases with rigid labor markets, because various labor (short-term) unemployment. The net effect on market institutions, especially labor unions and unemployment is ambiguous. minimum wage legislation, usually aim at wage Blanchard (2000) discovers a negative correla- compression across sectors and different categories tion between flow into unemployment and the of workers. OECD EPL ranking (figure 9.2) and a positive cor- Figure 9.5a depicts the data on the evolution of relation between unemployment duration and the interindustry wage differentials21 for a selected EPL (figure 9.3), but no correlation at all between group of countries for the period 1980­2000. the unemployment rate and the EPL (figure 9.4), as Throughout the period, Turkey had much wider FIGURE 9.2 Flow into Unemployment and Employment Protection: Selected Countries, 1985­94 Flow into unemployment (percent) 3.0 US CAN 2.5 2.0 1.5 TR FIN DEN 1.0 NOR SWE GBR AUS GER SPA 0.5 IRE FRA POR NET BEL GRE ITA 0.0 0 2 4 6 8 10 12 14 16 18 20 Employment protection index Sources: Blanchard 2000; Turkey for 2000­02, authors' calculations from Turkish State Institute of Statistics, Household Labour Force Survey. Labor Market Policies and EU Accession: Problems and Prospects for Turkey 247 FIGURE 9.3 Unemployment Duration and Employment Protection: Selected Countries, 1985­94 Unemployment duration 45 SPA 40 35 30 IRE ITA 25 FRA BEL NET 20 POR GRE 15 GER 10 GBR DEN FIN 5 TR CAN AUS NOR SWE US 0 0 2 4 6 8 10 12 14 16 18 20 Employment protection index Sources: See figure 9.2. FIGURE 9.4 Unemployment Rate and Employment Protection: Selected Countries, 1985­1994 Unemployment rate (percent) 25 20 SPA 15 IRE BEL ITA 10 GBR CAN DEN FRA FIN TR GER GRE US NET 5 AUS POR NOR SWE 0 0 2 4 6 8 10 12 14 16 18 20 Employment protection index Sources: See figure 9.2. interindustry wage differentials than the United wages increased rapidly in the post-military period, States (the benchmark case for flexible labor mar- and they declined in the period of wage depressions kets), Greece and Spain (two EU countries), and in the late 1990s. The same data are presented for Hungary and Poland (two candidate countries). As developed EU countries and the United States in might be expected, Poland and Hungary had rela- figure 9.5b. Among all the developed countries tively low wage differentials in the 1980s, but they depicted in figure 9.5b, the United States has the have experienced a widening gap in interindustry highest wage differentials in the manufacturing wages since the late 1980s because of their transi- industry and the Scandinavian countries have the tion toward a market economy. Wage differentials lowest. The data in figures 9.5a and 9.5b seem to in Turkey increased in the late 1980s when real confirm the widely held belief that the Scandinavian 248 Turkey: Economic Reform and Accession to the European Union FIGURE 9.5a Interindustry Wage Differentials: Selected Countries, 1980­2000 Coefficient of variation of (log) industry wages 0.06 0.05 0.04 0.03 0.02 0.01 Turkey Greece Spain Hungary Poland USA 0.00 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: Authors' calculations from UNIDO data. FIGURE 9.5b Interindustry Wage Differentials: Selected Countries, 1980­2000 Coefficient of variation of (log) industry wages 0.06 Austria Denmark Finland Germany Italy Sweden U.K. USA 0.05 0.04 0.03 0.02 0.01 0.00 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: Authors' calculations from UNIDO data. countries have more equal income and wage distri- turing industry. For all other countries, the data are bution as a result of their specific centralized wage- available for the whole economy. The U.S. data seem setting institutions. to suggest that the job turnover rate is lower in the Rigidities in labor markets make the cost of fir- manufacturing industry than in other sectors. ing, and the potential cost of hiring, higher. Thus The average job turnover rate for the Turkish expansion and contraction of firms will be more manufacturing industry for the period 1980­2000 costly, new firm formation will be limited, and the is 21 percent--that is, the proportion of jobs cre- exit rate will be lower. All those factors will reduce ated and abolished in a year is 21 percent of all jobs job turnover. Table 9.7 presents the data on job available. The rate for Turkey is somewhat higher turnover for selected countries. The rate of job than the one observed in the United States and turnover for Turkey is calculated only for manufac- slightly lower than those in Colombia and Chile. turing establishments employing more than 10 Although cross-country comparisons do present workers.For Chile,Colombia,and the United States, some problems, it could be claimed that the job job turnover data are available only for the manufac- turnover rate in Turkey is high. Table 9.8 presents Labor Market Policies and EU Accession: Problems and Prospects for Turkey 249 TABLE 9.7 Job Turnover, Selected Countries Period Entry Expansion Exit Contraction Turnover Turkey (M) 1980­2000 4.8 6.7 4.1 5.5 21.0 Chile (M) 1980­1995 4.7 9.1 4.7 7.2 25.8 Colombia (M) 1978­1891 5.3 6.6 5.1 6.7 23.8 United States (M) 1984­1988 1.4 6.7 2.7 7.7 18.6 United States 1984­1991 8.4 4.6 7.3 3.1 23.4 Canada 1983­1991 3.2 11.2 3.1 8.8 26.3 France 1984­1991 6.1 6.6 5.5 6.3 24.4 Germany 1983­1990 2.5 6.5 1.9 5.6 16.5 Italy 1987­1992 3.8 7.3 3.8 6.2 21.0 United Kingdom 1985­1991 2.7 6.0 3.9 2.7 15.3 Note: M manufacturing industries. Sources: Bertola, Boeri, and Cazes 1999; authors' calculations from Turkish State Institute of Statistics data. TABLE 9.8 Job Turnover in Turkish Manufacturing Industries (percent) Private Public Small Medium Large Average 1981­90 Entry 1.6 14.5 7.1 3.0 4.4 Expansion 2.8 4.7 9.7 8.5 6.8 Contraction 4.5 8.0 6.3 3.4 4.7 Exit 1.3 14.9 5.4 2.7 3.8 Turnover 10.3 42.1 28.4 17.6 19.7 1991­2000 Entry 0.4 20.2 8.5 3.1 5.2 Expansion 2.1 3.6 8.1 7.7 6.6 Contraction 6.5 10.3 6.8 5.4 6.2 Exit 2.6 17.9 5.7 2.6 4.4 Turnover 11.7 52.1 29.3 18.8 22.3 Source: Authors' calculations from Turkish State Institute of Statistics data. the same data for the public sector and private sec- Fabiani and Rodriguez-Palenzuela 2001; Plasmans tor by size categories for two subperiods, 1980­90, and others 2002). These indicators are based on the and 1990­2000. The job turnover rate is much coefficients of adjustment terms or elasticities in higher in the private sector, especially among small employment or wage equations. establishments, because of high rates of entry and Employment flexibility can be defined as the exit. Job turnover stemming from expansion and speed of adjustment of employment in a labor contraction dominates entry and exit for medium- demand equation. A simple dynamic conditional size and large establishments. There seems to be a labor demand equation can be written as slight increase in the job turnover rate in the 1990s. (9.1) Lt = i + 1Lt- + 2Qt + 3wt + Model-based indicators are extensively used in ,i 1,i ,i ,i t,i empirical studies to assess employment and wage where L, Q, and w refer to the number of employed, flexibility (see, e.g., Nickell and Layard 1999; real output, and real product wage, respectively. All 250 Turkey: Economic Reform and Accession to the European Union variables are in log form. The subscripts t and i military government ruled the country in the early denote time and the cross-sectional unit (industry 1980s, we reestimated the same equation for Turkey or firm), respectively; denotes the usual error for the 1990s. As is the case of almost all other terms. The coefficient of the lagged employment, measures, the United States seems to have a flexible 1, measures the speed of adjustment, and the coef- labor market for the manufacturing industries. The ficient of the wage variable, 3, the wage elasticity of adjustment parameter is small, which implies fast labor demand. adjustment, and the wage elasticity is high. The rate The wage equation can be defined in a similar of adjustment is rather slow in Turkey, but it seems way and can be used to estimate the effects of inde- to gain speed in the 1990s. pendent variables on wages. In real wage equations, Only a few empirical studies measure wage flex- the unemployment rate is usually included in the ibility for Turkey. Onaran (2002), who estimated a model to estimate the degree of real wage flexibility, wage equation by using panel data at the industry because the coefficient of the unemployment level, found that real wages are quite flexible in the term reflects how sensitive real wages are to the post-1980 period.22 The findings by Ilkkaracan and unemployment level. If the rate of unemployment Selim (2002) on the basis of a cross-sectional esti- is higher than the NAIRU (nonaccelerating infla- mation of an individual-level wage equation sug- tion rate of unemployment), then the real wage is gest that there is a statistically significant negative expected to decline to clear the market--that is, a correlation between wages and regional unemploy- statistically significant negative coefficient is ment rates. Separate regressions for men and expected for the unemployment term. The absolute women, however, show a wage curve to exist only in value of the coefficient will indicate how fast the the male labor market. Unemployment elasticity is labor market adjusts. higher in the private sector, supporting the anec- Because of the lack of data, we estimated only dotal evidence that the private sector has more flex- the dynamic labor demand equation for a group of ible employment practices that the public sector. OECD and candidate countries by using panel data The evidence presented here suggests that the at the International Standard Industrial Classifica- EPL in Turkey is "rigid," but the legislation excludes tion (Rev. 2) three-digit level for the period a large part of the economy--legally, small busi- 1980­2000. The GMM (generalized method of nesses and certain sectors, and illegally, the infor- moments) technique is used to estimate the model mal sector. There are enforcement problems in the in difference form. Figure 9.6 plots the adjustment formal sector as well. Some measures studied here parameter against the wage elasticity. Because a show that the labor market for the manufacturing FIGURE 9.6 Labor Demand Adjustment Speed and Wage Elasticity: Selected Countries, 1980­97 Wage elasticity 0.00 0.10 Denmark 0.20 Finland Turkey, Turkey Sweden 1990s Poland 0.30 Spain Italy Hungary 0.40 0.50 US UK 0.60 Austria 0.70 0.20 0.30 0.40 0.50 0.60 0.70 0.80 Adjustment parameter Source: Authors' estimates from UNIDO data. Labor Market Policies and EU Accession: Problems and Prospects for Turkey 251 industry, which is probably the most regulated and The Impact of the New Labor Law unionized sector, is quite flexible. Moreover, the The new labor law (No. 4857) has introduced new labor law provides a legal basis for flexible changes in accordance with the European Commis- employment practices such as part-time and fixed- sion directives, but further reform in the labor law term employment. and related regulations are needed to comply fully with the acquis. The potential effects of the changes Problems and Prospects: introduced by the new labor law can be summa- An Assessment rized as follows. The labor market institutions in Turkey will con- First, the new labor law has provided a legal front four major challenges in the next decade23: basis for "atypical" employment relationships-- that is, part-time and fixed-term employment. 1. Dealing with the continuing decline in the share This is the most welcome aspect of the new law of agriculture in total employment by creating for employers. However, as mentioned early in more jobs, especially in the services sector. this chapter, part-time employment is not wide- 2. Increasing the employment rate--most impor- spread in Turkey (except in the agricultural sec- tant, by increasing the participation rate for tor). Moreover, the average work week is quite urban women. This step will require a substantial long, and the lobbying against implementing the increase in employment opportunities for urban directive's provision (93/104) on the maximum women, especially an increase in part-time jobs. average work week (48 hours) has been effective.24 3. Investing in the education and training of the According to the Household Labour Force Statistics young people in Turkey, whose share of the of the State Institute of Statistics (SIS 2000b), 41.5 population will remain quite high compared percent of all paid workers work 50 hours or with the shares in the EU and candidate coun- longer a week. Therefore, the law is not expected tries. This demographic window of opportunity to have any significant impact on part-time for the Turkish economy can turn into an obsta- employment. Because of the emphasis on labor cle for development if the educational system market flexibility, one might expect a tendency fails to raise the skills level of the young people. toward the increasing use of fixed-term and sub- 4. Eliminating the informal sector that continues contract labor. The directives on part-time and to be an important source of low-quality, low- fixed-term employment require "that, in respect of wage jobs. The informal sector is still a source of employment conditions, part-time and fixed-term survival for a huge number of small and workers shall not be treated in a less favorable medium-size enterprises (SMEs) that enjoy flex- manner than comparable full-time and perma- ible employment practices and are able to avoid nent workers," but it could be difficult to enforce paying taxes, SSCs, and so forth. This sector these provisions in the Turkish context, at least in helps to curb the pressures on employment, but the medium term, because the Turkish labor law at the same time, it hinders the generation of does not provide sufficient safeguards to protect better jobs by the formal sector. part-time and fixed-term employees. Moreover, The prospect of EU membership has sparked the law does not impose any restriction on the changes in Turkey's legal framework and labor cumulative duration or the number of successive market institutions so that it can adopt the Com- contracts. Thus, employers are expected to lower munity acquis. Against the background of these labor costs by gradually switching to fixed-term four challenges, the likely effects of adopting and contracts and subcontract labor. However, this implementing the acquis can be discussed at three strategy, if it is thought to be the main strategy for levels: (1) the impact of the new labor law that has improving competitiveness, could easily turn out introduced various directives (the short term), (2) to be a "low road" labor flexibility practice that the impact of adopting and implementing all might lead to neglect of investment in human employment directives (the medium and long capital. term), and (3) the impact of designing and Second, the new law reduces the cost of layoffs by implementing employment policies in line with the establishing a special Severance Payment Fund objectives and targets of the EES. (SPF).Firms are required to pay a certain proportion 252 Turkey: Economic Reform and Accession to the European Union of the wage bill to the fund, and it then covers all sev- annual leave). These provisions, if implemented, erance payments. Thus the overall effect of the may increase the firms' costs by a few percentage change in the severance pay system is likely to reduce points of the wage bill. firms' (hiring and firing) costs. The most important discrepancy between the Third, the new labor law has included most of Turkish labor law (both the former one and the the articles of the law on employment protection new law) and the EU directives is the complete dis- (No. 4773), but reduced the coverage of employ- regard of any social dialogue, employee participa- ment protection by excluding those establishments tion, and consultation in the Turkish labor law. As employing fewer than 30 workers (Law No. 4773 Table 9.3 demonstrates, the new law does not refer excluded only those employing fewer than 10 work- to the provisions of various directives regarding ers). Therefore, the new labor law has legally pro- informing workers, and it does not address at all vided extensive flexibility to small establishments. Directive 2002/14 on consultation and employee To summarize, the changes introduced by the representation. Although the draft law prepared by new labor law address mainly the short-term the tripartite Scientific Committee referred to concerns of employers about achieving labor mar- employees' representatives, all these referrals were ket flexibility. However, as shown in our earlier omitted in the final version of the law adopted by analysis, even the labor market for the manufac- Parliament. Therefore, it is no surprise that the turing industry seems to be quite flexible. There- European Commission's report on the progress fore, excessive emphasis on labor market flexibility toward accession by candidate countries points out may lead to the adoption of a "defensive strategy" that "[s]teps have been taken in the field of social by firms that ignores the human capital, entrepre- policy and employment [in Turkey], but are not neurship, and innovativeness that the Turkish always in full conformity with the acquis. There is economy needs to tackle the challenges listed ear- an urgent need to develop and strengthen the con- lier. This process may also delay the restructuring ditions for a genuine social dialogue at all levels" of the corporate sector, because it would tilt the (European Commission 2002e). The Regular Report field of competition in favor of less productive on Turkey's Progress towards Accession (European firms that reduce their costs by relying on atypical Commission, 2002c) summarizes what needs to be employment relations and avoiding all social done, as follows: expenditures. The new labor law, by increasing flows from and As regards social dialogue, despite improve- to unemployment, is likely to change the structure ments for trade union rights in free trade zones, of unemployment. The proportion of short-term further progress needs to be made as a matter of unemployment may increase, just as it did, for priority to create the conditions for a free and example, after the labor market reform in Colom- genuine bipartite as well as tripartite social dia- bia (Kugler 1999; Kugler and Cárdenas 1999). logue at all levels in line with the acquis. Turkey should make rapid progress towards establishing full trade union rights that includes elimination The Impact of Adopting and Implementing of restrictive thresholds for forming a trade the Employment Acquis union branch and requirement of 10% threshold Although the new labor law has made some for a trade union to be eligible for collective bar- progress in the field of social policy and employ- gaining at company level. The law on public ser- ment, it is still far from full alignment with the vants' trade unions, which was adopted in June acquis. Therefore, Turkey needs to extensively 2001 and which is not in line with the Commu- amend its laws and regulations in order to comply nity acquis and the relevant ILO Conventions fully with the acquis. As the comparison between ratified by Turkey, has not been amended. The the new labor law and directives indicates, those law contains a number of provisions which provisions that are not yet incorporated into the entail significant constraints on the right to labor law are exactly those that mean additional organise in the public sector. Notably, there are costs for firms (e.g., the provisions on the restrictive provisions relating to the exclusion of maximum work week and minimum period of the right to strike and to collective bargaining. Labor Market Policies and EU Accession: Problems and Prospects for Turkey 253 The percentage of the labour force covered by employment policies. This step requires making collective agreements is extremely low; it is esti- major improvements in the national statistical sys- mated to be below 15%. No social dialogue exists tem, strengthening the Turkish Employment in most private enterprises, which may limit the Organization (IS¸KUR), and so forth.27 Second, it is proper implementation of the Community hoped that Turkey will implement, after decades acquis at enterprise level. . . . Promoting social of neglect and disorientation, consistent and sys- inclusion and developing a national employ- tematic employment policies that bring forward ment strategy in line with the European Employ- long-term objectives. These policies should be in ment Strategy is a matter of priority. conformity with the three objectives of the EES (full employment, quality and productivity at Social dialogue and employee participation are work, and cohesion and an inclusive labor market) crucial for implementation of the acquis, but the that are also priority issues for Turkey. The "10 current emphasis on short-term solutions makes it commandments" (especially the objectives of difficult to establish cooperative relationships between employers and employees.25 more and better investment in human capital, gender equality in employment and pay, the elim- The Copenhagen criteria for membership ination of undeclared work, and the promotion of include the acquis criterion that highlights the occupational mobility) are likely to cause an importance not only of incorporating the acquis upsurge in the short-term adjustment costs of the into national legislation, but also of ensuring its corporate sector, although they would be effective application through the appropriate administrative and judicial structures.26 Effective extremely beneficial in the medium and long run. New employment policies are likely to have a sig- application of the acquis by extending the coverage nificant positive impact on productivity and to include the informal sector would be by far the growth in the long term, if they are accompanied most important impact of the accession process. In by coherent competition, technology, and innova- other words, firms in the informal sector have to be tion policies. forced to abide by laws and regulations--that is, they have to bear the costs of taxes and SSCs, together with the firms that had been complying A Simulation Analysis with regulations. This process is likely to eliminate Because the implementation of laws and regula- some firms operating in the informal sector and tions that cover the informal sector is likely to lead lead to a painful adjustment process in the medium to the most important effect by far in the accession term. With the gradual elimination of the informal process, here we conduct a simple simulation exer- sector, the long-run effect is very likely to be posi- cise to measure the order of magnitude of these tive for productivity, growth, and employment. A effects in the private manufacturing industry. simple quantitative analysis is performed later in The first step in any analysis of the informal sec- this chapter to assess the impact of this process. tor is likely to start with an estimation of its size and characteristics. Because there are almost no The Impact of Coordinating Employment Policies data available for the informal sector, we make the following assumptions: Turkey as a candidate country has committed itself to progressively adjusting its labor market institu- · The SIS's Household Labour Force Survey meas- tions and employment policies and coordinating ures total manufacturing employment. The them with those of the EU. Turkey and the Euro- number of "informal workers" is equal to the pean Commission are expected to analyze the key number of people employed in microenter- challenges for employment policies in a Joint prises. Assessment Paper, and the JAP commitments will · The SIS's Annual Survey of Manufacturing be monitored systematically. This process of coop- Industries (ASMI) reflects the average character- eration and coordination is likely to have two cru- istics of establishments categorized by size. cial effects on policymaking in Turkey. · Informal sector firms do not pay any tax First, Turkey must establish the institutional (including the income tax for employees) and framework needed to design and implement SSCs. 254 Turkey: Economic Reform and Accession to the European Union · Informal sector firms are as productive as manufacturing sector in 2000. Firms are classified "small" formal sector firms that employ 10­24 into four groups: large (employing 150 or more people. people), medium (employing 25­49 people), small (employing 10­24 people), and informal (small Figure 9.7 depicts the distribution of employ- firms and informal sector firms). Under our ment, value added, and output in the private assumptions, the share of informal workers is FIGURE 9.7 Sectoral Distribution of about 41 percent in private manufacturing and 40 Employment, Value Added, and percent in all manufacturing.28 The latter value is Output: Private Manufacturing comparable with the share of informal workers in Industry, Turkey, 2000 Brazilian manufacturing (20.6 percent) and in Percent Colombia (54.0 percent) in the late 1990s (Gold- 45 berg and Pavcnik 2003). 40 The share of the informal sector in total value 35 added (and output) is estimated by assuming that 30 value added per employee in the informal sector is equal to the net value added (value added minus all 25 taxes and social security expenditures) per employee 20 in small formal sector firms (for the composition of 15 output, see table 9.9). Under these assumptions, the 10 informal sector produces only 25 percent of total value added in private manufacturing. 5 Figure 9.8 shows the structure of value added by 0 four categories of firms. Because cumulative Large Medium Small Informal employment is plotted on the horizontal axis, the Employment Value added Output area under the line defines total value added pro- duced by that category. Large firms are the most Sources: Authors' calculations and estimates from Turkish State Institute of Statistics data. productive group. The informal sector firms are TABLE 9.9 Composition of Output in Private Manufacturing: Turkey, 2000 (percent) Large Medium Small Informal Net wage 5.44 4.35 3.97 4.42 Income taxa 1.16 0.78 0.59 0.00 SSC, employees' sharea 1.16 0.91 0.80 0.00 SSC, employers' sharea 1.67 1.30 1.15 0.00 Severance paymentsb 1.59 1.53 1.50 0.00 Total labor cost 11.02 8.87 8.02 4.42 Interest payments 3.91 2.50 1.37 1.53 Taxes 2.55 1.54 1.46 0.00 Profit 22.50 20.84 19.25 21.47 Materials 53.78 61.07 65.09 72.59 Value added (VA) tax 6.24 5.18 4.82 0.00 Total 100 100 100 100 Total VA per employee (millions of Turkish lira) 26,561 14,982 10,149 9,590 Share of VA in output (%) 40.0 33.8 30.1 27.4 VA per employee (large = 1) 1.00 0.56 0.38 0.31 a. Estimated. b. Includes all compensation payments. Sources: Large, medium, and small establishments, SIS 2000a; informal sector, authors' estimates. Labor Market Policies and EU Accession: Problems and Prospects for Turkey 255 FIGURE 9.8 Structure of Value Added in Private Manufacturing: Turkey, 2000 Millions of Turkish lira per employee 30,000 LARGE Potential VA/actual VA 1.63 20,000 MEDIUM 10,000 SMALL INFORMAL 0 0 10 20 30 40 50 60 70 80 90 100 Cumulative employment (percent) Net wage Income tax SSC, employee's share SSC, employer's share Severance payments Taxes Interest payments Profit Source: Large, medium, and small establishments, SIS 2000a; informal sector, authors' estimates. only 31 percent as productive as the larger firms. ernment reduces tax and social security rates so The share of labor costs, including severance pay- that total tax and social security revenue remain the ments, in value added is 27.6 percent for large same. This policy will help formal sector firms by firms, 26.3 percent for medium-size firms, and 26.6 reducing their costs. percent for small firms. The informal sector firms Because the assumption on constant market pay only 16.2 percent of value added as wages to shares is not realistic given the fact that informal their employees. sector firms have to increase their prices, in the If all informal sector firms and workers pay third simulation (Case 3) we assume that the infor- income and corporate taxes and SSCs, their sales mal sector firms lose half of their market shares. prices will increase about 6 percent so that they The next case (Case 4) adds a reduction in tax and earn the same amount of profit and pay the same social security rates to the Case 3 simulation. net wage. The value added tax will add another 5 Finally, in Case 5 we take into consideration the percentage points. In other words, the benefit of long-term effects in Case 4 by assuming that total operating in the informal sector is somewhat output increases by 10 percent (as a result of pro- higher than 10 percent of the sales price (including ductivity increases and other effects). the value added tax). In all simulations, we assume that the structure We conduct five simulations. In the first simula- and level of output remain the same for the for- tion (Case 1), we assume that all informal sector merly formal sector firms. Nominal net wages and firms pay taxes and SSCs, but that there is no profits for the informal sector firms are assumed to change in the nominal output (size) of the manu- remain constant. Thus our analysis is limited to the facturing industry. Therefore, an increase in prices effects of reallocation of output between formal caused by the increase in the costs of informal sec- and informal sector firms within the same industry. tor firms leads to a decline in demand of the same Table 9.10 summarizes the simulation results. proportion. We also assume that the market shares The Base Case shows the current situation. When of four categories of firms do not change. the informal sector firms begin to pay taxes and When the informal sector firms pay taxes and SSCs (Case 1), the immediate impact will be SSCs, the total revenue of the government and observed in a reduction in manufacturing employ- social security institutions will increase to a large ment (4.3 percent; about 150,000 jobs are lost) after extent. Therefore, we assume in Case 2 that the gov- the decline in output. Total wage payments will also 256 Turkey: Economic Reform and Accession to the European Union TABLE 9.10 Simulation Results Case 1 Case 2 Case 3 Case 4 Case 5 Constant + Tax 50% Lost + Tax +10% Mkt. Share Reduction in Informal Reduction Growth Base Case Percentage Change Relative to Base Case Employment 3,394,000 4.3 1.5 8.9 6.0 4.2 Wage billa 6,433,657 3.0 0.0 0.9 2.4 13.5 Social security contributionsa 2,331,012 35.7 0.0 39.2 0.0 0.0 Income taxa 2,754,916 31.6 0.0 36.8 0.0 0.0 Value added taxa 5,347,145 38.3 0.0 40.7 0.0 0.0 Profita 29,538,664 3.2 0.2 2.0 1.3 12.2 Average net wageb 1,896 1.3 1.5 8.7 8.9 9.0 Profit margin 21.3 3.2 0.2 2.0 1.3 2.0 Social sec. contribution ratec 5.1 0.0 28.5 0.0 30.5 37.3 Income tax ratec 6.0 0.0 26.4 0.0 29.4 36.3 Value added tax ratec 11.6 0.0 29.8 0.0 31.3 38.0 a. Billions of Turkish lira. b. Millions of Turkish lira per employee. c. Share in value added. Source: Authors' estimates. decline (3.0 percent), but the average net wage will If the manufacturing industry succeeds in grow- increase, because the informal sector will experi- ing during this period (we assume 10 percent ence the highest employment loss. The share of growth), then employment will increase 4.2 percent profits in total output (the profit margin) will even if half of the informal sector firms are elimi- decline by 3.2 percent. Meanwhile, there will be a nated, and the average wage rate and the profit huge increase in tax and social security revenue margin will increase by 9 percent and 2 percent, (about 35 percent). In the second case, the govern- respectively. The government, to receive the same ment reduces the SSC rate by 28.5 percent, the amount of revenue that it receives in the Base Case, income tax rate by 26.4 percent, and the value must cut tax and social security rates substantially added tax rate by 29.8 percent, so that total revenue (36­38 percent). remains at the base level. The reductions in tax and This simple simulation exercise shows that there social security rates will help to moderate employ- could be significant short-term transitory costs, in ment losses (now only 1.5 percent) and the decline terms of a loss in employment opportunities, in in the profit margin (0.2 percent). eliminating the informal sector. These costs could If the informal sector firms exit en masse from be reduced if the economy achieves a faster rate of the market because of their increasing costs (Case economic growth. 3), the impact on employment will be dramatic: although we assume there is no change in nominal Conclusions and Policy output, the decline in employment will be 8.9 per- Implications cent because of the lower output-to-labor ratio in the informal sector. Because low-wage jobs will be Turkey has embarked on an effort to change its lost,there will be a substantial increase in the average institutional structure for employment and social wage rate (8.7 percent) that will make employees as a affairs. The new labor law has introduced changes group not much worse off. In this case, tax and social in accordance with the European Community security revenue will increase more than in Case 1 directives, mainly the provisions that help to estab- because of higher average wages and income in the lish flexible employment relationships, but further formal sector. A reduction in tax and social security reform is apparently needed in the labor law and rates will again moderate employment losses. other regulations to fully comply with the EU Labor Market Policies and EU Accession: Problems and Prospects for Turkey 257 acquis. Adoption of the remaining regulations of Notes the acquis on employment and social affairs is likely 1. An earlier version of this paper was presented at the Con- to raise the costs of adjustment, especially for infor- ference on Turkey: Towards EU Accession, Bilkent University, mal sector firms. Moreover, it also will require a May 10­12, 2003. The authors would like to thank their discus- sant, Necdet Kenar, then president of the Turkish Employment comprehensive change in the mindset of employers Organization, Cem Somel of Middle East Technical University, if the regulations (such as those on equal treatment and three anonymous referees for their valuable comments and of fixed-term and part-time workers and employee suggestions. participation and consultation) are to be imple- 2. For a synthesis of views on labor market flexibility, see the OECD's influential Jobs Study (OECD 1994a, 1994b). For an mented. Because Turkey needs to address all these overview of the evolution of the concept of labor market flexi- issues in its employment strategy while heeding the bility, see Brodsky (1994). EU's long-term objectives and targets (full employ- 3. Scarpetta and Tressel (2002) claim that "strict regulation may hinder the adoption of existing technologies, possibly ment, quality and productivity at work, and cohe- because it reduces competitive pressures or technology sion and an inclusive labor market), it has an spillovers." opportunity to solve underlying problems that have 4. At the time this chapter was written (summer 2003), there were 10 acceding countries (Cyprus, the Czech Republic, Esto- plagued the processes of economic growth and nia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and employment generation for decades. Four areas of Slovenia) and three candidate countries (Bulgaria, Romania, action need special consideration: and Turkey). 5. Here, part-time employed in Turkey is defined as those 1. Give priority to strengthening Turkey's institu- who work less than 25 hours a week. Casual employment (sea- tional capacity (such as the Turkish Employ- sonal and temporary employment), as defined by the State Insti- ment Organization, IS¸KUR) to develop and tute of Statistics, is used for fixed-term employment. 6. "Long-term unemployed" refers to those unemployed at implement employment strategies. Moreover, least one year. develop an institutional framework that guaran- 7. Except in areas where transitional arrangements will have tees commitment, consistency, and continuity in been granted during the accession negotiations. 8. For detailed descriptions of the legal framework in Turkey employment policies. for the labor market and social protection system, see compre- 2. Reduce the costs of adjustment for the successful hensive studies by Tunali and others (2003) and Adaman (2003). implementation of new regulations and the 9. Although the first pillar of the EU, the European Commu- nity, is analyzed in this study, only the term EU is used for gradual elimination of the informal sector. Tem- convenience. porarily reducing tax and social security rates 10. This section is based on information provided on the for new firms and hiring new workers could be Web site of the European Commission DG for Employment and Social Affairs, http://europa.eu.int/comm/dgs/employment_ helpful in this regard. social/index_en.htm. 3. Encourage, support, and even force firms to 11. Falkner and others (2002) show how this process works adopt competitive strategies based on employ- for labor law. ing a "skilled, trained and adaptable workforce" 12. For Council directives on employment, see http://europa. eu.int/comm/employment_social/soc-dial/labour/index_en. in the spirit of Article 125 of the Treaty Estab- htm. lishing the European Community. These strate- 13. We also analyzed the draft law prepared by the Scientific gies include various support schemes and initia- Committee formed by nine academicians appointed by the gov- tives for on-the-job training29 and technology ernment (the Ministry of Employment and Social Security) and the social partners (the Confederation of Employers' Unions, development, transfer, and diffusion programs TISK, and three confederations of trade unions--Türk-Is¸, Hak- especially designed for SMEs. Is¸, and DISK). Because some minor modifications have been made in the draft, we use the one posted on the Web site of 4. Generate employment and match the demand the confederation of the Turkish employers' unions, http:// and supply for skills--steps important to con- www.tisk.org.tr (downloaded on February 22, 2003). fronting the main challenges summarized ear- 14. The directives usually set the minimum conditions, and lier in this section. Special attention should be the member states may, therefore, introduce laws, regulations, or administrative provisions more favorable for workers. paid to providing part-time jobs (for urban 15. For example, the directive on fixed-term work defines women) by enforcing equal treatment for part- "comparable worker" as a worker with "an employment contract time workers and to strengthening and widen- of relationship of indefinite duration, in the same establishment, engaged in the same or similar work/occupation, due regard ing the scope of active labor market policies. The being given to qualifications/skills. Where there is no compara- establishment of a national qualification and ble permanent worker in the same establishment, the compari- certification system could help to match the son shall be made by reference to the applicable collective agreement, or where there is no applicable collective agreement, demand and supply for skills. 258 Turkey: Economic Reform and Accession to the European Union in accordance with national law, collective agreements or prac- Social dialogue can take place at different levels (company, tice" (emphasis added). sectoral, regional, national, and European). Social dialogue at 16. The draft law prepared by the Scientific Committee the European level has become more structured and has envisaged the establishment of a Wage Guarantee Fund (WGF) increased significantly in importance over time, especially since and required employers to contribute to the fund 0.5 percent of 1991, when the Maastricht Treaty made it possible for the social the gross wage. However, the new labor law adopted by Parlia- partners to conclude European-level framework agreements in ment has transferred the financial burden of the WGF to the the area of individual and collective employees' rights. As a Unemployment Insurance Fund. result, agreements between the European-level social partners 17. Under the parental leave directive (Directive 96/34 of (UNICE, CEEP, and ETUC) on parental leave (1995), part-time June 3, 1996, on the framework agreement on parental leave work (1997) and fixed-term contracts (1999) have been imple- concluded by UNICE, CEEP, and the ETUC), fathers and moth- mented as European directives. However, the level of social dia- ers have an individual right to at least three months of parental logue is far from uniform among the member states. For exam- leave to take care of their (natural or adopted) child. They have ple, the current U.K. Labour government, which emphasizes the the right to return to the same or an equivalent workplace. importance of flexibility in labor markets, seems to be uneasy 18. These included (1) developing human resources through about the way regulations are being implemented at the EU level vocational training, (2) promoting productive investments (for details, see the European Industrial Relations Observatory through moderate wage policies, (3) improving the efficiency of Web site, http://www.eiro.eurofound.ie). Moreover, as Keller labor market institutions, (4) identifying new sources of jobs (2003) explains, after the eastern enlargement of the EU, "the through local initiatives, and (5) promoting access to the world already existing degree of diversity [in the EU] could even of work for some specific target groups such as young people, increase despite the fact that all existing regulations are part of long-term unemployed people, and women. the acquis communautaire that has to be adopted by all candi- 19. The Turkish data were calculated from the Household date countries," because the social partners are either weak or do Labour Force Survey for the period 2000­02. not exist in the accession states (the "social dialogue gap"). For 20. Unless otherwise stated, the data from the United the level of social dialogue in accession countries, see Rychly and Nations Industrial Development Organization (UNIDO) Indus- Pritzer (2003) and EFILWC (2003). trial Statistics Database, at the International Standard Industrial 26. This process may also help to fully implement Interna- Classification (Rev. 2) three-digit level are used throughout this tional Labour Organization (ILO) conventions. For the ILO con- section. ventions ratified by Turkey, see Bronstein (2003). 21. Interindustry wage differential is defined as the coeffi- 27. The law establishing the Turkish Employment Organiza- cient of deviation of (log) industry wages. tion (No. 4904) was enacted by Parliament on June 25, 2003. 22. As Agell and Bennmarker (2002) reveal for the Swedish 28. Because we assume that the number of workers case, it is easier to achieve real wage flexibility in an inflationary employed in the informal sector is equal to the number of peo- environment, even if nominal wages are "rigid." ple employed in microenterprises, the share of the informal sec- 23. In this study, we focus our attention on the challenges tor is likely to be overestimated. during the accession period. However, after the eventual mem- 29. Recall that the EU aims to increase the investment of bership, the conditions in the labor market are expected to be companies in the training of adults (on-the-job training) from quite different because of the provisions on free movement of the existing level of the equivalent of 2.3 percent of labor costs people at the EU level. Although it is difficult to predict the up to 5.0 percent of labor costs on average in the EU by 2010. extent of migration dynamics under the conditions of stable Although no reliable data on firm-sponsored training in Turkey growth in Turkey, one may expect a limited amount of emigra- are available, one could conjecture that the ratio of firm- tion toward other EU countries that could be mutually benefi- sponsored training to labor cost is very small in Turkey. cial for Turkey and the host countries. 24. In the former labor law, the "weekly working time" was 45 hours, which had to be distributed equally over the week. The References new labor law (No. 4857) defines the "normal average weekly working time" for which the worker is paid at the "normal" wage Acemoglu, D., and J. Pischke. 1998. "Why Do Firms Train? The- rate (the average is calculated over two months) as 45 hours. ory and Evidence." Quarterly Journal of Economics (113): The law sets the maximum annual limit for overtime work at 79­119. 270 hours. Thus if a worker works 50 weeks a year, the maxi- --------. 1999. "Beyond Becker: Training in Imperfect Labor mum average weekly working time would be 50.4 hours. Markets." Economic Journal (109): 112­42. 25. In the Laeken Declaration of December 2001 (http:// Adaman, F. 2003. Study on the Social Protection Systems in the www.europa.eu.int/futurum/documents/contrib/cont071201_ 13 Applicant Countries: Turkey Country Study. Study en.pdf), the European-level employers' organizations UNICE financed by the European Commission DG for Employment and CEEP and the trade union confederation ETUC defined the and Social Affairs. concepts of tripartite concertation, consultation, and social dia- Addison, J. T., and P. Teixeira. 2001."The Economics of Employ- logue as follows: tripartite concertation designates exchanges ment Protection." IZA Discussion Paper No. 381, Bonn. between the social partners and European public authorities; Agell, J. 1999. "On the Benefits from Rigid Labour Markets: consultation of the social partners describes the activities of Norms, Market Failures, and Social Insurance." Economic advisory committees and official consultations; social dialogue is Journal (109): 143­64. defined as the bipartite work by the social partners. Agell, J., and H. Bennmarker. 2002. "Wage Policy and Endoge- The distinction between tripartite concertation and bipartite nous Wage Rigidity: A Representative View from the Inside." social dialogue must be emphasized, because the tripartite con- Working Paper No. 2002:12, Institute for Labour Market certation between the social partners and public authorities Evaluation (IFAU), Stockholm. (which, in many cases, is dominated by public authorities) is usu- Algoé Consultans. 2002. The Construction of an Index of Labour ally confused with genuine bipartite social dialogue in Turkey. Market Adaptability for EU Member States. Report of a study Labor Market Policies and EU Accession: Problems and Prospects for Turkey 259 funded by the European Commission and directed by Algoé --------. 2002e. Towards the Enlarged Union: Strategy Paper Consultans in conjunction with Alphametrics Limited. and Report of the European Commission on the Progress Baker, D., A. Glyn, D. Howell, and J. Schmitt. 2002. "Labor Mar- towards Accession by Each of the Candidate Countries. ket Institutions and Unemployment: A Critical Assessment COM(2002) 700 final. Brussels: EC. of the Cross-Country Evidence." Working Paper 2002-17, --------. 2003a. The Future of the European Employment Strat- New School University Center for Economic Policy Analysis egy (EES): "A Strategy for Full Employment and Better Jobs for (CEPA), New York. All." COM (2003) 6 final. Brussels: EC. Ballot, G., and E. Taymaz. 2001."Training Policies and Economic --------. 2003b. Progress on the Implementation of the Joint Growth in an Evolutionary World." Structural Change and Assessment Papers on Employment Policies in Candidate Economic Dynamics (12): 311­29. Countries. COM (2003) 37 final. Brussels: EC. Bassanini, A., and E. Ernst. 2002. "Labour Market Regulation, --------. 2003c. Proposal for a Council Decision on Guidelines Industrial Relations and Technological Regimes: A Tale of for the Employment Policies of the Member States. COM Comparative Advantage." Industrial and Corporate Change (2003)176 final. Brussels: EC. (11): 391­426. --------. 2003d. Recommendation for a Council Recommenda- Belot, M. 2002. "Why Is the Employment Protection Stricter in tion on the Implementation of Member States Employment Europe than in the US?" Unpublished paper, CentER, Policies. COM (2003)177 final. Brussels: EC. Tilburg University. European Commission DG for Employment and Social Affairs Belot, M., J. Boonez, and J. van Ours. 2002. "Welfare Effects of 2002. 2002. Employment in Europe 2002: Recent Trends and Employment Protection." CentER Discussion Paper No. Prospects. Brussels: EC. 2002-48, Tilburg University. Fabiani, S., and D. Rodriguez-Palenzuela. 2001. "Model-Based Bertola, G., T. Boeri, and S. Cazes. 1999. "Employment Protec- Indicators of Labour Market Rigidity." European Central tion and Labour Market Adjustment in OECD Countries: BankWorking Paper No.21,European Central Bank,Brussels. Evolving Institutions and Variable Enforcement." ILO, Falkner, G., M. Hartlapp, S. Leiber, and O. Treib. 2002. Opposi- Employment and Training Paper No. 48, International tion through the Backdoor? The Case of National Non- Labour Organization, Geneva. Compliance with EU Directives. Political Science Series --------. 2000. "Employment Protection in Industrialized No. 83. Vienna: Institute for Advanced Studies. Countries: The Case for New Indicators." Paper presented at Goldberg, P. K., and N. Pavcnik. 2003. "The Response of the the EC workshop on "Concepts and Measurement of Euro- Informal Sector to Trade Liberalization." NBER Working pean Labour Markets Flexibility/Adaptability Indices," Brus- Paper No. 9443, National Bureau of Economic Research, sels, October 26­27. Cambridge, MA. Betcherman, G., A. Luinstra, and M. Ogawa. 2001. "Labor Heckman, J., and C. Pagés. 2004. "Introduction." In Law and Market Regulation: International Experience in Promot- Employment: Lessons from Latin America and the Caribbean, ing Employment and Social Protection." World Bank Social ed. J. Heckman and C. Pagés. Chicago: University of Chicago Protection Discussion Paper Series No. 128, Washington, Press. DC. Hermans, S. 2001. Avrupa Birligi'nin Sosyal Politikasi ve Blanchard, O. 2000. "Employment Protection, Sclerosis, and the Türkiye'nin Uyumu [Social Policy in the European Union Effect of Shocks on Unemployment." LSE Lionel Robbins and Turkey's Adaptation], Turkish translation by H. Lectures, Lecture 3, London, October. Cansevdi. Istanbul: Iktisadi Kalkinma Vakfi. --------. 2002. "Designing Labor Market Institutions." Ilkkaracan, I., and R. Selim. 2002. "The Role of Unemployment Remarks at the conference Beyond Transition, Warsaw, in Wage Determination: Further Evidence on the Wage April. Curve from Turkey." Working Paper 2002-11, New School Brodsky, M. M. 1994. "Labor Market Flexibility: A Changing University Center for Economic Policy Analysis (CEPA), International Perspective." Monthly Labor Review (Novem- New York. ber): 53­60. Jackman, R., R. Layard, and S. Nickell. 1996. "Combatting Bronstein, A. 2003. "Labour Law Reform in EU Candidate Unemployment: Is Flexibility Enough?" Discussion Paper Countries: Achievements and Challenges." Paper presented No. 293, Centre for Economic Performance, London School at the ILO High-Level Tripartite Conference on Social Dia- of Economics. logue and Labour Law Reform in EU Accession Countries, Keller, B. 2003."Social Dialogues--The State of the Art a Decade Malta, February 28­March 1. after Maastricht." Industrial Relations Journal (34): 411­29. Cazes, S., and A. Nesporova. 2003. Labour Market Flexibility and Kleinknecht, A. 1998. "Is Labour Market Flexibility Harmful to Employment Security in Transition Countries. Geneva: Inter- Innovation?" Cambridge Journal of Eocnomics (22): 387­96. national Labour Organization. Kugler, A. D. 1999."The Impact of Firing Costs on Turnover and EFILWC (European Foundation for the Improvement of Living Unemployment: Evidence from the Colombian Labor Mar- and Working Conditions. 2003. Social Dialogue and EMU in ket Reform. International Tax and Public Finance Journal (6): the Acceding Countries. Dublin: European Commission. 389­410. European Commission. 2002a. Communication from the Com- Kugler, A. D., and M. Cárdenas. 1999. The Incidence of Job Secu- mission on Streamlining the Annual Economic and Employ- rity Regulations on Labor Market Flexibility and Compliance ment Policy Co-Ordination Cycles. COM (2002) 487 final. in Colombia. Working Paper R-428, Inter-American Devel- Brussels: EC. opment Bank Research Network. --------. 2002b. Draft Joint Employment Report 2002. COM Michie, J., and M. Sheehan. 2003."Labour Market Deregulation, (2002) 621 final. Brussels: EC. `Flexibility' and Innovation." Cambridge Journal of Econom- --------. 2002c. Regular Report on Turkey's Progress Towards ics (27): 123­43. Accession. SEC (2002) 1412. Brussels: EC. Nickell, S., and R. Layard. 1999. "Labor Market Institutions and --------. 2002d. Taking Stock of Five Years of the European Economic Performance." In Handbook of Labor Economics, Employment Strategy. COM (2002) 416 final. Brussels: EC. Vol. 3, ed. O. Ashenfelter and D. Card. Amsterdam: Elsevier. 260 Turkey: Economic Reform and Accession to the European Union Nicoletti, G., S. Scarpetta, and O. Boylaud. 2000. "Summary Market Performance in Central and Eastern European Indicators of Product Market Regulation with an Extension Countries in the 1990s." World Bank Social Protection Dis- to Employment Protection Legislation." Economics Depart- cussion Paper Series No. 0202, Washington, DC. ment Working Papers No. 226, Organisation for Economic Rychly, L., and R. Pritzer. 2003. "Social Dialogue at National Co-operation and Development, Paris. Level in the EU Accession Countries." Working Paper, Inter- OECD (Organisation for Economic Co-operation and Develop- national Labour Organization, Geneva. ment). 1994a. OECD Jobs Study, Evidence and Explanations, Salvanes, K. G. 1997. "Market Rigidities and Labour Market Part I: Labor Market Trends and Underlying Forces of Change. Flexibility: An International Comparison." Scandinavian Paris: OECD. Journal of Economics (99): 315­33. --------. 1994b. OECD Jobs Study, Evidence and Explanations, Scarpetta, S., and T. Tressel. 2002. "Productivity and Conver- Part II: The Adjustment Potential of the Labor Market. Paris: gence in a Panel of OECD Industries: Do Regulations and OECD. Institutions Matter?" Economics Department Working --------. 1999. OECD Employment Outlook. Paris: OECD. Paper No. 342, Organisation for Economic Co-operation --------. 2002. Taxing Wages. Paris: OECD. and Development, Paris. Onaran, Ö. 2002. "Measuring Wage Flexibility: The Case of SIS (State Institute of Statistics). 2000a. Annual Survey of Manu- Turkey before and after Structural Adjustment." Applied Eco- facturing Industries. Ankara: SIS. nomics (34): 767­81. --------. 2000b. Household Labour Force Statistics. Ankara: SIS. Plasmans, J., H. Meersman, A. van Poeck, and B. Merlevede. Tunali, I., H. Ercan, C. Bas¸levent, and O. Öztürk. 2003. "Back- 2002. "The Unemployment Benefit System and Wage Flexi- ground Study on Labor Market and Employment in Turkey." bility in EMU: Time-varying Evidence in Five Countries." Report prepared for European Training Foundation and Department of Economics Working Paper, University of presented at the special seminar On the Way to Integration Antwerp. with the EU, Labor Market and Employment in Turkey, Riboud, M., C. Sánchez-Páramo, and C. Silva-Jáuregui. 2002. IS¸KUR, Ankara, February 27. http://www.iskur.gov.tr. "Does Eurosclerosis Matter? Institutional Reform and Labor 10 Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession Mark Dutz, Melek Us, and Kamil Yilmaz After following inward-oriented development and to the Middle East, northern Africa, and strategies for 50 years, Turkey switched to outward- Central Asia markets. The recent market­export oriented policies in 1980.The policy of further open- and domestic market­oriented investments in the ing up the economy was pursued with the aim of automobile industry are a clear indication of eventually integrating Turkey into the European Turkey's attractiveness for FDI flows. However, over Union (EU). The European Council's Helsinki the last decade, Turkey lost ground to the Central summit, held on December 10­11, 1999, produced a and Eastern European (CEE) countries in attract- breakthrough in EU-Turkey relations by officially ing foreign investments, especially those from recognizing Turkey as an EU candidate state on an Europe. Although Poland, the Czech Republic, and equal footing with other candidate states.With acces- Hungary together (three countries whose combined sion,Turkey would become part of the European sin- population is smaller than that of Turkey) received gle market. In joining the EU, Turkey will have to US$71 billion1 in FDI flows between 1995 and 2000, adopt and implement the whole body of EU legisla- Turkey received only $5.1 billion over the same tion and standards--the acquis communautaire-- period, almost 14 times less. And it appears from and also participate eventually in the European other countries' experiences that, unless there is a Economic and Monetary Union (EMU). major paradigm shift in a country's or its competi- Over the past four years, Turkey has been under- tors' FDI policies, there is likely to be very little going a series of serious social, economic, and insti- change in FDI inflows. tutional transformations with the clear political This chapter explores how Turkey may be objective of EU membership. The definitive different from most CEE countries, and what any prospect of EU membership should make Turkey differences imply for the appropriate FDI policy in very attractive for foreign direct investment (FDI), light of EU accession prospects. The chapter begins because, among its other strengths, it has a highly by outlining the benefits of FDI through an skilled and adaptable labor force, a large domestic overview of the economic concepts, together with market, and geographic proximity both to Europe an assessment of the Turkish experience. FDI 261 262 Turkey: Economic Reform and Accession to the European Union inflows are not generally considered to be an end upgrade the management and work force, and goal but rather an instrument to create a globally establishes stronger ties between domestic and competitive economy. Through FDI-stimulated international markets. increases in productivity, Turkey seeks to be Because FDI entails the transfer of technology positioned at the higher value added end of the and know-how, it usually has both a direct and an fast-changing worldwide division of labor. In its indirect impact on the economic growth of a analysis of obstacles to foreign investment, this country. And, because FDI involves significant chapter will emphasize competition-related and ownership control as well as the transfer of technol- legal and judicial barriers. ogy, its impact on economic growth takes place After analyzing the benefits from and impedi- through increased productivity, human capital ments to FDI, the chapter reviews what steps have accumulation, research and development activity, been taken to improve the policy and regulatory and technological and productivity spillovers. Its framework in Turkey and then analyzes what impact on economic growth could be even greater if Turkey has yet to do to meet EU requirements and the types of FDI that the country receives to fully benefit from FDI. In summary, Turkey stimulate--in other words, crowd in--domestic should benefit significantly from EU accession in investment activity. terms of a step change in sizable FDI inflows, largely Several studies have established a link between because the accession process would help Turkey to FDI and economic growth. Using data on FDI flows overcome its rule of law and competition-related from industrial countries to 69 developing coun- constraints to foreign direct investment. The EU tries over 1970­89 and using a cross-country accession process will encourage more rapid and regression framework, Borensztein, De Gregorio, consistent implementation of the rules and regula- and Lee (1998) show that FDI flows have a positive tions that ensure a level playing field for all compa- impact on economic growth. They also demon- nies, which, in turn, would enable Turkey to take strate that the impact of foreign investment exceeds full advantage of investment-related benefits. the impact of domestic investment on growth. Not all countries, however, benefit from FDI. According to Borensztein, De Gregorio, and Lee, countries The Benefits of FDI require a minimum stock of human capital to real- As a capital-scarce country, Turkey can benefit ize the growth effects of FDI. In other studies, substantially from injections of foreign capital that Zhang (1999) shows that FDI inflows helped to will expand productive capacity and stimulate job stimulate economic growth in several East Asian creation. countries, and Gruben and McLeod (1998) find that in a sample of 18 countries, FDI had a signifi- cant impact on economic growth, especially in The Role of FDI in Economic Growth Latin American countries. Although foreign direct investment is beneficial, the type of capital inflows matters. Unlike portfolio The Role of FDI in Raising Productivity investments and loans to the private sector, FDI and Stimulating Spillovers inflows involve direct equity ownership plus signif- icant ownership control, and therefore they are One of the important contributions of FDI compa- more stable. They do not easily flee in a domestic nies is to enhance the transfer and diffusion of tech- market downturn. Unlike loans, FDI inflows ensure nology to the host country. A multinational corpo- that business risks are borne by foreign investors. ration undertaking investment in a country brings FDI differs from other forms of capital flows in to that sector its production technology, its access to other crucial aspects. It does not just entail the global production and distribution networks, and transfer of financial resources and the creation of its know-how and experience. Being generally larger new jobs; it is a bundle that involves the transfer of corporations, FDI companies have access to large, fixed assets, technology, know-how, and interna- low-cost investment funds that could be used to tional market access. FDI connects the recipient finance investment in more advanced technology country to international best practices, helps to than is available and accessible in the host country. Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 263 The direct technology transfer effect may not be knowledge through their tenure there. In the realized in all FDI projects, however. If the FDI is an medium to long run, these employees will have an export-oriented investment, the impact on technol- opportunity to transfer this experience and knowl- ogy diffusion will generally be more significant edge to local enterprises. than that made by a domestic market­oriented Other channels through which the presence of investment. The impact of FDI on technology FDI companies affects the local companies mostly diffusion was rather limited in the import substitu- take the form of spillovers. Productivity spillovers tion era, because the main incentive for a foreign from FDI take place when the entry or presence of company to undertake investment was the heavily multinational corporations increases the produc- protected domestic market.In such an environment, tivity of domestic firms in a host country and when foreign companies preferred to transfer old and the multinationals do not fully internalize the value outdated technology to their factories in developing of these benefits. Spillovers may occur when local countries, creating little technology diffusion. firms improve their efficiency by copying technolo- Today, however, FDI decisions cannot focus only gies of foreign affiliates operating in the local on the domestic market. One result of the push for market either by observation or by hiring workers more liberal trade relations throughout the world is trained by the affiliates. Horizontal spillovers to that FDI companies face competition in the domes- other firms in the same sector may be accompanied tic markets of the host country through imports. by vertical spillovers--that is, the presence of FDI Consequently, FDI decisions, especially in the companies may affect local firms in other sectors of manufacturing sector, are often made after seriously the economy. These vertical spillover effects may considering the international competitiveness of take place through backward linkages (purchases of the affiliate firm. That firm must have the techno- inputs from local suppliers) and forward linkages logical capability and the resulting efficiency that (supply of outputs to local downstream purchasers). render it flexible enough to target export markets as In line with findings for other countries, in well as the domestic market. Consequently, one Turkey FDI companies have higher labor produc- would expect to observe higher productivity in tivity than local enterprises.2 In 1991 the average FDI companies when compared with domestic labor productivity of FDI companies was 35 per- enterprises. cent higher than that of all manufacturing plants. The impact of FDI on the host country economy Over time, the productivity gap between FDI com- is not limited to just the direct channels of technol- panies and the sector average was closed slightly, to ogy transfer and diffusion; the presence of multina- 30 percent by 1996. The average labor productivity tionals also may affect local companies through in foreign-owned plants increased from TL several channels. One channel is intensified domes- (Turkish lira) 4.1 million to TL 4.7 million (from tic market competition. As the FDI companies $1,611 to $1,803) in 1990 prices. The average labor become major players in the domestic market, local productivity in all plants, by contrast, increased companies will be forced to adopt newer and more from TL 3.1 million to TL 3.6 million (from $1,189 advanced technologies and to use the existing to $1,550). These numbers are a clear indication resources of the firm more efficiently in order to that the labor productivity gap between foreign- survive (see Blomström and Kokko 1998). This and domestic-owned plants is significant and does channel is similar to the effect of import liberaliza- not vanish over time. tion, even though the impact on local companies These annual average values support the case for may be more significant than imports. The technol- significant labor productivity differences between ogy transfer may take embodied (imports of FDI and local enterprises, but the possibility cannot machinery and equipment) or disembodied (know- be ruled out that these differences stem from plant how, knowledge, licenses) forms. Local enterprises characteristics other than foreign ownership. Based will not find it difficult to organize the transfer on regression results using various measures of for- of embodied technology, but the transfer of disem- eign participation, Yilmaz and Ozler (2004) show bodied technology requires absorption capacity. that plants with foreign partners have higher total However, the workers and engineers employed by factor productivity even after other plant character- FDI companies will gain experience and accumulate istics and sector and time effects are taken into 264 Turkey: Economic Reform and Accession to the European Union account.3 Finally, Yilmaz and Ozler (2004) show than Poland's. And in terms of gross fixed capital that domestic plants tend to have higher total factor formation (GFCF)--the total value of producers' productivity (TFP) in sectors with greater FDI acquisitions of fixed assets--Turkey's investments involvement than in sectors in which FDI involve- during 2000 were three to four times as large as ment is low. All else being equal, as the foreign those of the Czech Republic and Hungary and ownership­weighted sectoral output share of roughly a sixth larger than Poland's. As highlighted foreign-affiliated plants increases by 1 percentage in table 10.1, however, in terms of average annual point, the total factor productivity of local plants in inflows of FDI during the 1990s, Turkey's inflows the same sector increases by 0.82 percentage point. ($800 million) were roughly one-fifth of FDI However, horizontal spillovers from all foreign- inflows to Poland ($4.1 billion) and also signifi- owned plants are not similar. As the output share of cantly lower than those of the Czech Republic and FDI companies with less than 50 percent foreign Hungary (about $2.1 billion per year). participation increases by 1 percentage point, the A second striking feature in comparing Turkey TFP in local firms increases on average by 0.72 per- with Poland, the Czech Republic, and Hungary is cent, and the spillover effect from plants with that the FDI gap did not close throughout the foreign share ownership greater than or equal to 1990s. To the contrary, with the formal announce- 50 percent but less than full foreign ownership ment at the December 1997 European Council jumps by 1.1 percentage point. Finally, fully summit in Luxembourg that EU accession negotia- foreign-owned plants tend to generate external tions would open with Poland, the Czech Repub- benefits that would increase the productivity of lic, and Hungary on March 31, 1998, these coun- local plants in the same sector by 0.4 percent. tries appear to have benefited from a virtuous cycle. The enhanced likelihood of EU accession and further FDI flows improved credit ratings and, The Current State of FDI in turn, attracted more FDI, thereby increasing the Foreign direct investment can have strong, positive difference between those countries and Turkey. effects for national economies. The previous section Table 10.1 and figure 10.1 reveal that average described how FDI in the Turkish manufactur- annual FDI inflows increased during 1997­2000 ing sector has had both direct and indirect productivity-enhancing benefits. The evidence of FIGURE 10.1 FDI Inflows: Turkey these benefits, which is based on plant-level studies, versus Comparator CEE can be viewed as the most reliable evidence avail- Countries, 1990­2001 able. However, this finding and the results discussed (millions of US$) establish only that FDI is desirable for Turkey. The US$ millions next step in the analysis is to characterize the level 10,000 and other features of FDI in Turkey relative to those Turkey 9,000 of comparator countries and explore why FDI is so Czech Republic 8,000 Hungary low despite being highly desirable for the country. Poland 7,000 6,000 FDI in Turkey and in Central and Eastern Europe: 5,000 A Comparison 4,000 The most striking feature of foreign investment 3,000 flows to Turkey is their low level relative to the 2,000 flows of the comparator CEE countries' emerging 1,000 market economies (table 10.1). In terms of popula- 0 tion in 2000, Turkey was larger than Poland, the Czech Republic, and Hungary combined. In terms 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 of gross domestic product (GDP) in 2000, Turkey's Source: United Nations Conference on Trade and economy was four times as large as that of the Development (UNCTAD), World Investment Report, Czech Republic or Hungary and one-quarter larger selected years. Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 265 TABLE 10.1 FDI Summary Data: Turkey versus Comparator CEE Countries Czech Turkey Poland Republic Hungary GDP 2000 (US$ millions) 199,267 157,598 51,433 46,604 GFCF 2000 (US$ millions) 44,542 39,212 14,550 11,269 Population, 2000 (millions) 67.4 38.7 10.3 10.0 FDI inflows, 1991­96 (US$ millions, annual average) 751 2,119 939 2,205 FDI inflows, 1997­2000 (US$ millions, annual average) 878 6,971 4,072 1,957 FDI inflows, 2001 (US$ millions) 3,266 5,713 4,924 2,440 FDI inflows/GFCF, 1991­96 (annual average) 1.9% 10.7% 6.4% 26.8% FDI inflows/GFCF, 1997­2000 (annual average) 1.9% 18.1% 26.5% 17.9% FDI inflows/GFCF, 2001 12.4% 15.0% 30.6% 20.1% FDI stocks, 1996 (US$ millions) 5,825 11,463 8,785 14,193 FDI stocks/GDP, 1996 3.2% 8.8% 15.2% 31.4% FDI stocks, 2000 (US$ millions) 9,335 34,227 21,644 19,804 FDI stocks/GDP, 2000 4.7% 21.7% 42.1% 42.5% FDI stocks, 2001 (US$ millions) 12,601 42,433 26,764 23,562 FDI stocks/GDP, 2001 8.5% 24.1% 47.1% 45.4% Exports of affiliates of foreign TNCs,a 3,684 12,267 10,876b 19,558 2000 (US$ millions) TNC exports/total exports, 2000 7.2% 26.5% 32.7%b 61.1% Imports of affiliates of foreign TNCs, 2000 12,628 23,554 11,107b 22,820 No. of affiliates of foreign TNCs, 2000 5,334 35,840c 71,385d 26,645 Note: GFCF = gross fixed capital formation; TNC = transnational corporation. a. An affiliate is an incorporated or unincorporated enterprise in which an investor, who is resident in another country, owns a stake that permits a lasting interest in the management of that enterprise (an equity stake of 10 percent for an incorporated enterprise or its equivalent for an unincorporated enterprise). b. Foreign trade, 1999. c. Number of affiliates, 1998 (includes all firms with foreign capital). d. Number of affiliates, 1999 (includes joint ventures). Of this number, 53,775 are fully owned foreign affiliates. Sources: International Monetary Fund (IMF), International Financial Statistics (CD-ROM); United Nations Conference on Trade and Development (UNCTAD), World Investment Directory (WID) Country Profiles, 2003; UNCTAD, World Investment Report, selected years. more than threefold in Poland, from $2.1 billion to Turkey adopted the definition of the Organisation almost $7 billion, and more than fourfold in the for Economic Co-operation and Development Czech Republic, from $0.9 billion to over $4 billion. (OECD) for FDI in 2001, and that definition was Meanwhile, in Turkey they remained completely included in the new FDI law of 2003 (see,e.g.,OECD unchanged relative to gross fixed capital formation. 1996, 2003). Table 10.2 compares the elements of It is remarkable that Turkey's announcement of its Turkey's definition of FDI (in both the 1954 and EU customs union in 1996 had no discernable 2003 FDI laws) with those of the definitions used effect on aggregate FDI flows. by other OECD countries, highlighting the omission Anyone comparing FDI inflows across countries ofpreferredstockstradedonthestockexchange,long- should take into account that the FDI definition term loans, other marketable securities and bonds, used by Turkey is much narrower than that of some andfinancialderivativesfromthepreviousdefinition countries and international institutions, leading to (short-term loans, commercial/retail loans, and leas- systematic undervaluation of FDI inflows to Turkey. ing are still not included in the new law). 266 TABLE 10.2 FDI Definition in OECD Countries Preferred Stocks Preferred Stocks Other Kinds of Indirectly Capital Long- Short- Bonds and Traded on Not Traded on Nonpreferred Reinvested Owned FDI in Term Term Commerce/ Marketable Financial Stock Exchange Stock Exchange Stocks Earnings Enterprises Kind Loans Loans Retail Loans Leasing Securities Derivatives Australia Yes Yes Yes Yes Yes No Yes Yes Yes -- Yes Yes Austria Yes Yes No -- No Yes No No No No No No Belgium Yes Yes Yes No No No Yes Yes No Yes No No Canada Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes -- Czech Rep. Yes Yes Yes Yes Yes -- Yes No No -- -- -- Denmark Yes Yes Yes Yes Yes Yes Yes Yes No No No No Finland No Yes Yes Yes Yes Yes Yes Yes No Yes No No France Yes Yes Yes Yes No Yes Yes Yes No No No No Germany Yes Yes Yes Yes No Yes Yes No No No No No Greece Yes Yes Yes Yes No No Yes Yes Yes Yes Yes -- Hungary Yes Yes Yes No No No Yes Yes Yes Yes Yes Yes Iceland No Yes -- Yes Yes -- Yes Yes Yes -- -- -- Ireland Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes -- Japan Yes Yes Yes Yes Yes Yes Yes Yes No No Yes No Korea, Rep. of Yes Yes Yes Yes No Yes Yes Yes No No No No Luxembourg Yes Yes Yes Yes -- No Yes Yes Yes No No No Mexico Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes No No Netherlands Yes Yes Yes Yes No Yes Yes Yes Yes No No -- New Zealand Yes Yes Yes Yes Yes No Yes Yes Yes Yes Yes No Norway Yes Yes Yes Yes Yes Yes Yes Yes No No Yes Yes Poland Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes -- Portugal Yes Yes Yes Yes No Yes Yes Yes Yes Yes Yes No Spain Yes Yes Yes Yes No Yes Yes Yes Yes No No No Sweden Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes No Switzerland Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Turkey (6224) No Yes Yes Yes Yes No No No No No No No Turkey (4875) Yes Yes Yes Yes Yes Yes No No No Yesa Yes England Yes Yes Yes Yes Yes Yes Yes Yes Yes No No No United States Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes -- Not available. Note: Two sets of entries are given for Turkey: one for the 1954 FDI law (No. 6224) and one for the 2003 FDI law (No. 4875). a. Excluding state bonds. Source: OECD 2003. Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 267 In addition, even though the new FDI law may FIGURE 10.2 M&A-Related Inflows: allow certain flows to be included, local statistical Turkey versus data collection and recording practices may pre- Comparator CEE Countries, 1990­2001 clude their inclusion in the official statistics. Capital (millions of US$) in-kind is one such example--statistics are gener- ally not calculated and therefore not included. Even US$ millions 10,000 though the precise figures are not available, for Turkey some big projects Turkey's previous narrower 9,000 Czech Republic definition and statistical processing can underesti- 8,000 Hungary Poland mate FDI inflows by significant orders of magni- 7,000 tude. For example, Turkey has traditionally not 6,000 recorded long-term credits from foreign partners as 5,000 FDI. It has included such flows only if the foreign 4,000 partners' receivables are added to the company's 3,000 capital; otherwise, they are not recorded as an 2,000 increase in FDI but rather as an increase in external 1,000 debt. For the first time, however, because of a par- ticularly large intracompany, long-term foreign 0 credit and in response to internal discussions on 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 the matter, in 2001 it was decided to classify such credits as an FDI flow in conformity with interna- Source: See figure 10.1. tional norms. Therefore, the $1.4 billion credit provided by the mobile phone arm of Telecom . FIGURE 10.3 Privatization Revenues: Italia, the foreign partner of the GSM Is¸-TIM Turkey versus Telekomunikasyon Hizmetleri A.S¸. company, has Comparator CEE Countries, 1990­2000 been included in 2001 inflows. (millions of US$) In terms of type of investment, most of the growth of FDI companies worldwide in the 1990s US$ millions was by cross-border mergers and acquisitions 14,000 Turkey (M&As), in particular the acquisitions by foreign 12,000 Czech Republic investors of privatized state-owned enterprises Hungary Poland rather than greenfield investments. Less than 3 per- 10,000 cent of the total number of global cross-border 8,000 M&As during the 1990s are officially classified as mergers; the rest are different types of acquisitions. 6,000 In terms of ownership, roughly two-thirds of cross- border M&As were full acquisitions, and the 4,000 remaining one-third were minority acquisitions 2,000 (10­49 percent control). In terms of value, 70 per- cent of cross-border M&As are functionally 0 classified as horizontal, between firms in the same 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 industry.4 Figure 10.2 highlights how this global trend was especially critical in driving FDI in Source: See figure 10.1. Poland, but also in the Czech Republic and Hungary, in contrast to its significantly lesser contrast to Turkey. However, although a significant influence in Turkey. Figure 10.3 presents evidence share of FDI in transition economies may have suggesting the importance of privatization in been generated by the privatization process, the fueling M&A-related FDI inflows, and it highlights privatization process in Poland has, notably, the much more important role of privatization involved a sizable amount of stock market flota- in the CEE countries throughout the 1990s in tion, in which privatization-related capital inflows 268 Turkey: Economic Reform and Accession to the European Union would be reported as portfolio inflows rather than have been in the manufacturing sector--the auto- FDI. The Czech Republic has actively promoted motive and auto parts subsector and the petroleum, privatization to local investors, which was usually chemicals, rubber, and plastic products subsector. debt financed and thus linked to either domestic or The subsectoral pattern in the smaller countries, the foreign credit rather than FDI. Czech Republic and Hungary, which do not benefit In terms of industrial subsector allocation, a from as large a domestic internal market, is even majority of FDI inflows to Turkey have been directed more concentrated in the tertiary sector, with all five to the tertiary sector. Table 10.3 illustrates that by the top subsectors dedicated to producing services end of 2000 over 57 percent of total FDI stocks in rather than manufacturing goods. Table 10.4 reports Turkey were dedicated to services, including three of the identity of the largest FDI companies by world- the top five subsectors--transport and communica- wide sales in each of the four economies, highlight- tions,banking and other financial services,and trade ing the important role of the automotive and auto and repairs--in a pattern similar to that of Poland. parts subsector and the petroleum, chemicals, and The other major recipients of FDI inflows to Turkey rubber and plastic sector in Turkey. Nine of the TABLE 10.3 FDI Stocks by Industrial Sector, 2000 (percent) Sector/Industry Turkey Poland Czech Republic Hungary Primary Sector 1.5 0.9 2.0 1.5 Agriculture, hunting, forestry, and fishing 0.8 0.5 0.2 1.1 Mining, quarrying, and petroleum 0.7 0.4 1.9 0.4 Secondary Sector 41.3 38.6 38.1 36.8 Food, beverages, and tobacco 7.3 8.4 4.8 8.9 Textiles, leather, and clothing 1.9 0.7 1.3 1.6 Wood, paper, publishing, and printing 0.3 4.4 3.1 1.9 Petroleum, chemicals, rubber and plastic products 9.5 6.5 6.5 6.8 Nonmetallic mineral products 2.6 -- 5.9 2.3 Basic metal and metal products 2.6 2.0 3.6 2.2 Machinery and equipment 0.2 1.3 1.7 1.9 Electrical machinery and apparatus 3.7 1.2 3.3 7.2 Motor vehicles and other transport equipment 12.1 6.4 6.5 3.6 Precision instruments 0.4 -- 0.7 -- Other manufacturing 0.7 7.8 0.6 0.4 Unspecified secondary 0.0 -- 0.0 -- Tertiary Sector 57.3 60.5 59.8 61.7 Electricity, gas, and water -- 1.2 6.6 9.4 Construction 0.8 6.6 1.5 1.2 Trade and repairs 8.1 16.7 15.0 12.4 Hotels and restaurants 4.4 0.5 0.3 1.8 Transport, storage, and communication 17.0 8.0 11.2 7.7 Finance 16.6 20.0 14.7 11.3 Real estate and business activities -- 7.0 9.2 15.7 Education 0.0 -- -- 0.0 Health and social services 7.5 -- -- 0.1 Other services 2.8 0.5 1.2 1.9 Total 100 100 100 100 -- Not available. Sources: UNCTAD, World Investment Database (WID) Country Profiles, 2003; Turkey General Directorate of Foreign Investors (GDFI) database. TABLE 10.4 Largest Affiliates of Foreign Transnational Corporations Sales Company Home Country Industry (US$ millions) Turkey, 2001 1 Tofas¸ Türk Otomobil Fabrikasi Italy Motor vehicles 875.5 A.S¸. 2 Oyak Renault Otomobil Fabrikalari France Motor vehicles 748.4 A.S¸. 3 Vestel Elektronik San. ve Tic. A.S¸. Netherlands Electronics 690.2 4 Ipragaz A.S¸. France Petroleum products 375.5 5 Sasa Dupont Sabanci Polyester Netherlands Chemicals 333.3 Sanayi A.S¸. 6 Mercedes Benz Türk A.S¸. Germany Motor vehicles 284.9 7 Philsa PhilipMorris Sabanci Sigara- Netherlands Tobacco 264.6 Tütün A.S¸. 8 Bosch Sanayi ve Ticaret A.S¸. Germany Auto parts 245.7 9 Siemens Sanayi ve Ticaret A.S¸. Germany Electrical machinery 231.3 10 Pas¸abahçe Cam Sanayi Saudi Arabia Glass 223.0 11 Ford Otomotiv Sanayi A.S¸. United States Motor vehicles 212.9 12 Goodyear Lastikleri TA.S¸. United States Rubber 193.5 13 Trakya Cam Sanayii A.S¸. United States Glass 192.0 14 Profilo Telra Elektronik Sanayi ve France Electronics 189.0 Tic. A.S¸. 15 BSH Profilo Elektrikli Gereçler Germany Electrical machinery 185.0 Sanayii A.S¸. 16 Alcatel Teletas¸ Telekomünikasyon Neth./Belgium Electronics 176.7 End. 17 Türk Pirelli Lastikleri A.S¸. Italy Rubber 173.7 . 18 Korsa Sabanci Dupont End. Iplik Netherlands Textiles 173.2 San. A.S¸. 19 JTI Tütün Ürünleri Sanayi A.S¸. Japan Tobacco 168.6 . 20 Izmir Demir Çelik Sanayi A.S¸. Saudi Arabia Iron, steel 161.0 Total 6,098.0 Poland, 1999 1 Fiat Auto Poland SA Italy Motor vehicles 1,844.1 2 Makro Cash and Cary Poland Germany Distributive trade 1,544.8 3 Centrum Daewoo Sp ZOO Rep. of Korea Motor vehicles 916.6 4 Volkswagen Poznan Sp ZOO Germany Motor vehicles 661.5 5 Reemtsma Polska SA Germany Tobacco 595.7 6 Thompson Polkolor Sp ZOO France Electrical equipment 439.3 7 Real Sp ZOO Germany Distributive trade 423.7 8 General Motors Poland Sp ZOO United States Motor vehicles 411.3 9 Procter and Gamble Polska United States Distributive trade 400.0 Sp ZOO 10 Geant Polska Sp ZOO France Distributive trade 387.9 11 Unilever Polska SA Netherlands Distributive trade 383.6 12 International Paper Kwidzyn SA United States Paper products 360.7 13 Renault Polska Sp ZOO France Motor vehicles 360.7 14 Kulczyk Tradex Sp ZOO United Kingdom Distributive trade 304.8 15 Auchan Polska Sp ZOO France Distributive trade 297.5 16 Electrocieplownie Warszawkie SA Sweden Electricity 293.0 17 Frantschah Swiecie SA Germany Paper products 289.9 18 Philips Lighting Poland SA Netherlands Electrical equipment 289.4 19 Jeronimo Martins Dystrybucja Portugal Distributive trade 262.0 Sp ZOO 20 British American Tobacco United Kingdom Tobacco 282.9 Polska SA Total 10,749.4 270 Turkey: Economic Reform and Accession to the European Union TABLE 10.4 (Continued) Sales Company Home Country Industry (US$ millions) Czech Republic, 1999 1 Skoda Automobilovi AS Germany Motor vehicles 3,292.5 2 Makro Cr Spol SRO Germany Distributive trade 736.2 3 Rewe Spol. SRO Germany Mach. and equip. 509.2 4 Tabak AS United States Tobacco 416.2 5 Philip Morris United States Tobacco 402.5 6 Jihomoravska Energetica Germany Energy 382.2 7 Tesco Stores Cr AS United Kingdom Distributive trade 335.0 8 IPS AS Finland Construction 327.6 9 Delvita AS Netherlands Distributive trade 318.6 10 Penny Market SRO Germany Distributive trade 294.8 11 Severoceska Energetica Germany Energy 285.0 12 Julius Meinl AS Austria Distributive trade 218.4 13 Siemens Automobilova Germany Motor vehicles 208.6 Technika SRO 14 Stavby Silnic A Zeleznic AS France Construction 207.9 15 Plzensky Prazdroj AS Netherlands Beverages 203.9 16 Autopal SRO United States Motor vehicles 201.3 17 Glaverbel Czech AS Belgium/Japan Nonmetal mineral 196.3 18 Robert Bosch Spol. SRO Germany Motor vehicles 162.6 19 Nestle Cokoladovny AS Switzerland Food 148.7 20 Siemens Elektromotory SRO Germany Mach. and equip. 147.5 Total 8,995.0 Hungary, 2000 1 Audi Hungaria Motor Kft. Germany Motor vehicles 3,190.6 2 Philips Magyarorszag Kft. Netherlands Electronics 2,266.3 3 IBM Storage Products Kft. United States Electronics 2,239.7 4 Matav Rt. Germany Telecom. 1,565.3 5 Panrusgaz Magyar-Orosz Russia Distributive trade 1,027.6 Gazipari Rt. 6 Flextronics International Kft. United States Electronics 868.1 7 Metro Holding Kft. Germany Distributive trade 715.1 8 GE Hungary Rt. United States Electronics 658.1 9 Opel Magyarorszag United States Motor vehicles 629.5 Jarmugyarto Kft. 10 Kromberg Es Schubert Austria Basic metals 628.0 Kabeleket 11 Vogel and Noot Mezogepgyar Kft. Austria Basic metals 584.4 12 Westel 900 Mobil Rt. United States Telecom. 541.9 13 Budapesti Elektromos Muvek Rt. Germany Electricity 483.6 14 Elmu Rt. Germany Electricity 483.6 15 Tesco Global Rt. United Kingdom Distributive trade 447.6 16 Suziki Rt. Japan Motor vehicles 446.4 17 Hungarotabak Tobaccoland Rt. Austria Trade 442.3 18 Shell Hungary Rt. Neth./U.K. Distributive trade 420.5 19 Alcoa Kofem Kft. United States Basic metals 395.1 20 BorsodChem Austria Chemical 393.5 Total 18,427.2 Sources: See table 10.3. Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 271 TABLE 10.5 FDI Stocks by Country of Origin, 2000 (percent) Czech Country of Origin Turkey Poland Republic Hungary Austria 0.5 3.2 11.1 12.2 Belgium and Luxembourg 3.4 2.5 5.4 5.3 Denmark 0.5 2.5 1.2 0.5 Finland 0.1 0.6 0.6 1.6 France 7.3 12.2 4.3 6.5 Germany 14.1 18.9 25.5 25.8 Ireland 0.2 1.2 0.0 0.7 Italy 2.0 4.3 0.8 2.7 Netherlands 31.4 24.6 30.1 22.5 Spain 2.2 1.9 0.2 0.4 Sweden 1.0 3.5 1.4 0.9 United Kingdom 6.0 3.3 3.5 1.1 European Union, total 68.7 78.8 84.0 80.2 Japan 4.4 0.4 0.5 2.1 Korea, Rep. of 0.7 1.3 0.0 1.0 Switzerland 5.4 2.5 4.0 2.1 United States 8.7 9.5 6.5 8.2 Other OECD countries, total 19.2 13.7 11.0 13.4 OECD, total 87.9 92.5 95.1 93.6 Other Eastern European countries 0.4 4.3 1.0 0.4 Israel 0.1 0.0 0.0 0.0 Saudi Arabia 1.1 0.0 0.0 0.0 Panama 3.7 0.0 0.0 0.0 Dutch Antilles 1.2 0.0 0.0 0.0 Other countries 5.4 1.8 2.5 5.0 Total 100 100 100 100 Sources: See table 10.3. top 20 Turkish FDI companies are in these two sub- Republic, which received 79, 80, and 84 percent of sectors, followed by the electronics and electrical their FDI flows, respectively, from EU countries. machinery subsector. The absence of service sector Turkey has, however, received significantly more companies in the Turkish list is explained by the FDI inflows from Japan, Saudi Arabia, and offshore investment-to-sales profile typical of these subsec- locations such as Panama and the Netherlands tors, in which there usually is a lag between the large, Antilles than the three CEE countries. Interestingly, lumpy up-front investments required and the subse- in spite of important investments from the United quent stream of sales revenues generated by the States in the top 20 Turkish FDI companies (motor installed infrastructure service networks. vehicles, rubber, and glass), the relative share of In terms of country of origin, a striking feature U.S. investment is not significantly different in of FDI stocks is the significantly greater concentra- Turkey than in the CEE countries. tion of investment going from EU countries to the officially recognized EU accession countries than Determinants of FDI to Turkey (table 10.5). In 2000, Turkey received only 68.7 percent in FDI flows from EU countries, Investment climate can be defined as the policy, in contrast to Poland, Hungary, and the Czech institutional, and behavioral environment, present 272 Turkey: Economic Reform and Accession to the European Union and expected, that influences the perceived returns inflows. One of the main culprits behind this failure and risks associated with investment in terms of was the uncertain macroeconomic environment. both quantity and productivity of investment With its heavy dose of patronage relations and rent- flows.5 Investment climate depends on a wide array seeking activities, domestic politics never allowed of factors that can be grouped under three broad the creation of a stable macroeconomic environ- headings: macroeconomic and trade policies, infra- ment. Fiscal imbalances continued throughout the structure, and governance and institutions. These 1990s, and were transformed into rather stark debt factors help to explain both the strong potential dynamics by the end of the decade (table 10.6). attractiveness of Turkey as a global location for FDI Public sector borrowing requirements increased and the shortcomings that have led Turkey to fall so from 5 percent of the gross national product (GNP) far below its potential in this area. in 1995 to as high as 15.5 percent in 1999 and 2001. Chronic budget deficits and the rapidly increasing public debt are at the root of the high and chronic Macro Policies, Infrastructure, inflation problem that Turkey has suffered over the and the Automotive Sector last 25 years. During that time, the average con- Macroeconomic and Trade Policies. Since the sumer price inflation rate was 63 percent, and over 1980s, Turkey has undergone significant changes in the last two decades annual inflation has never been its economic relations with the outside world involv- lower than 30 percent. Through the second half of ing its macroeconomic and trade policies. After the 1990s and early 2000s, the real interest rate was quite January 24, 1980, decision to open up Turkey's econ- high. With the exception of 1997 and 2000, the ex omy, the government put great emphasis on an post real interest rates on bonds and Treasury bills export orientation. This first step was followed by were above 20 percent, reaching as high as 36 per- gradual import liberalization, which began in 1984 cent. In addition to the high real interest rates that and finally culminated in the customs union with inhibit domestic and foreign investment, the the EU in 1996. However, despite the gradual exchange rate devaluation risk created an extra removal of trade barriers and the greater export ori- burden on foreign investors who were willing to entation, Turkey was unable to attract large FDI invest in the country with a long-term perspective. TABLE 10.6 Macroeconomic Indicators, 1995­2001 1995 1996 1997 1998 1999 2000 2001 (percent of GNP) Public sector borrowing requirement 5.0 8.6 7.7 9.4 15.6 12.5 15.5 Primary surplus 2.1 1.3 0.0 2.1 -1.9 3.8 6.5 Interest expenditures (consolidated budget) 7.4 10.0 7.7 11.5 13.7 16.3 22.2 Public sector debt stock 37.6 40.3 40.5 41.3 51.8 53.4 97.8 Domestic 14.6 18.5 20.2 21.7 29.3 29.0 66.3 External 23.0 21.8 20.3 19.6 22.5 24.4 31.5 (percent per year) Interest rate on bonds and T-bills (average) 124.2 132.2 107.4 115.5 104.6 38.2 99.6 Inflation (CPI, annual average) 89.0 80.2 85.7 84.6 64.9 54.9 54.4 Ex post real interest rate (CPI-based) 24.4 25.0 12.4 30.7 32.1 -10.5 36.0 GNP growth rate 8.0 7.1 8.3 3.9 -6.1 6.3 -8.5 Real exchange rate (CPI-based index) 100.0 102.7 109.4 118.5 123.1 136.5 112.5 Real exchange rate (WPI-based index) 100.0 101.2 107.0 110.1 107.4 114.3 98.3 Average maturity of borrowings (days) 188.0 186.6 393.5 235.1 502.3 426.8 146.3 Note: CPI = consumer price index; WPI = wholesale price index. Sources: Yilmaz, Akçay, and Alper 2002; Özatay and Sak 2002. Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 273 Because of the uncertainties stemming from including its geographic and demographic endow- domestic politics, the macroeconomic environ- ments and its physical and financial infrastructure, ment, and the ensuing high real interest rates, help to position Turkey as a potentially powerful Turkey experienced very erratic growth perform- magnet for FDI inflows. Turkey enjoys a very spe- ance. After the capital account liberalization in cial location at the crossroads between East and 1989, it was able to attract foreign capital to finance West, overlapping Europe and Asia geographically public sector borrowing requirements and generate and culturally. The proximity to the Balkans and growth rates of about 5 percent. Yet because of the the rest of high-income Europe, as well as to the availability of external funds, successive govern- emerging markets in Russia, Caucasia, and Central ments were "unable" to bring budget deficits, and Asia and the expanding markets of the Middle East thus inflation, under control. As the country's and North Africa, offers the potential of over 1 bil- inability to cope with its economic woes became lion consumers. evident toward the end of the 1990s, the external As highlighted in tables 10.7a and 10.7b, funds dried up and growth rates declined sharply. Turkey's demographic endowments present both The 2001 economic crisis was the final blow that strengths and weaknesses to foreign investors when underlined the need for a new economic policy compared with those of Poland, the Czech Republic, framework in Turkey. and Hungary. Turkey's huge and growing domestic Over the last two decades, Turkey put on hold market compares favorably with those of the com- many decisions that could help foreign investors parator CEE countries. Turkey is projected to con- cope with high inflation. One of the critical meas- tinue to have one of the largest populations in the ures was an inflation accounting framework. In a Middle East and Eastern Europe. The domestic mar- country that has lived with an average of 60 percent ket is predominantly urban, and at least 17 major inflation, it is only now that an inflation accounting cities have a population in. excess of 1 million, led by framework has been implemented. Istanbul, Ankara, and Izmir. The population is much younger than those of European countries; Infrastructure-Related Factors. The quantity and over 60 percent of the population is below the age quality of Turkey's broadly defined infrastructure, of 35. On the negative side, the purchasing power of TABLE 10.7a Infrastructure-Related Factors--Strengths: Turkey versus Comparator CEE Countries Czech Turkey Poland Republic Hungary Demography and business values Population--market size (millions) 67.8 38.7 10.3 10.1 Labor force growth (% change) 2.46 -0.33 -0.04 -0.47 Avg. no. of working hours per year 2,074 1,870 1,976 1,988 Flexibility and adaptability of people (survey) 7.53 4.77 5.83 6.74 Entrepreneurship (survey) 7.03 4.12 6.44 6.74 Availability of competent senior managers (survey) 6.5 5.21 4.92 6.37 Physical and financial infrastructure Internet costs for 20 hours (US$) 11.4 39.16 42.92 42.61 Adequacy of communications (survey) 6.66 4.93 7.17 7.19 Quality of air transport (survey) 7.44 4.55 7.00 5.93 Adequacy of distribution infrastructure (survey) 6.06 3.68 5.67 4.89 No. of credit cards issued (per capita) 0.57 0.13 0.21 0.29 Availability of finance skills (survey) 6.88 5.26 4.78 6.52 Note: The survey measures are all reported on a 0­10 scale, with 10 indicating the most positive perception. Source: All measures are from the Institute of Management Development (IMD) 2002. 274 Turkey: Economic Reform and Accession to the European Union TABLE 10.7b Infrastructure-Related Factors--Weaknesses: Turkey versus Comparator CEE Countries Czech Turkey Poland Republic Hungary Demography and business values GDP per capita (US$ at PPP) 6,175.0 9,151.0 14,485.0 12,663.0 Employment (% of population) 29.1 37.1 45.8 37.4 Adult literacy (% of population over 15 years) 84.6 99.0 99.0 99.0 Secondary school enrollment (% of relevant 51.0 87.0 100.0 97.0 age group) Female labor force (% of total labor force) 26.4 45.1 44.7 44.5 Employee training in companies (survey) 4.03 3.74 5.61 5.78 Physical and financial infrastructure Electricity costs for industrial clients (US$/kWh) 0.082 0.037 0.043 0.050 Adequacy of energy infrastructure (survey) 3.94 5.57 7.94 6.69 Computers per capita (per 1,000 people) 53.0 122.0 179.0 176.0 Technological cooperation between 4.00 4.03 6.17 5.19 companies (survey) Credit flows from banks to business (survey) 2.84 3.39 3.28 4.52 Venture capital for business development (survey) 1.97 3.42 3.17 3.48 Note: The survey measures are all reported on a 0­10 scale, with 10 indicating the most positive perception. PPP = purchasing power parity. Source: All measures are from IMD 2002. the average citizen is still significantly lower than with its comparator CEE countries is its highly that in the CEE countries, with per capita GDP 30 skilled, flexible, and business-oriented labor force. percent less than Poland's and less than half that of As reported in table 10.7a, Turkey's work force is Hungary and the Czech Republic. Yet Turkey's considered to be significantly more flexible, adapt- improving consumption patterns and purchasing able, and entrepreneurial than those of its com- power, along with its growing middle class, are parator countries.6 Yet its levels of actual employ- important positive features of the domestic market. ment, adult literacy, secondary school enrollment, Because Turkey's population growth rate has fallen and female labor force participation are low relative from over 3 percent to under 2.5 percent, it is on the to those of the CEE countries, indicating the strong verge of entering a "golden demographic period" positive role still to be played by more widespread similar to that experienced by East Asia in the and improved nationwide education services. 1980s, in which the productive working population Although Turkey scores comparatively well in terms is largest relative to children and retirees, providing of availability of competent senior managers, train- a critical ingredient for rapid income growth. Only ing of employees is less of a priority in Turkish a few emerging markets in the world have the companies on average than in the CEE countries. potential to attract investment both for export and As for the traditional basic infrastructure meas- for their domestic market. Turkey, however, is in ures, Turkey is again characterized by areas of such a privileged position. It has the potential to strength and weakness (tables 10.7a and 10.7b). In create a "virtuous investment cycle," in which a communications and transport, Turkey stands out more competitive domestic business environment for its relatively low Internet costs--the cost of further strengthens the country as a platform for Internet access in Turkey for a basket of 20 hours at exports, and the exports, in turn, stimulate firms to peak time is the lowest of all countries included in upgrade and better serve the domestic market. the World Competitiveness Yearbook 2002 (IMD In addition to geography and demography, 2002) and is perceived as providing adequate another area in which Turkey compares favorably communications standards. Turkey also is rated Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 275 highly for both air transport quality and internal However, much was at stake. There was already a distribution infrastructure. Yet Turkey lags behind substantial production capacity, coupled with a in its energy infrastructure. Although it recently competitive parts and accessories industry. In passed new laws on its electricity and natural gas addition, domestic business establishments with framework, which are designed to spur significant years of experience in the automotive industry and market-driven improvements in line with Turkey's low-cost but good quality labor induced FDI underlying endowments, effective implementation companies in the automotive sector to increase to yield the expected results will take some time. their investments in Turkey and build new capacity Turkey also lags behind the CEE countries in com- to produce motor vehicles for the European mar- puterization and technological cooperation. Finally, ket. None of the companies just mentioned decided in finance, Turkey stands out in the breadth of its to close shop in Turkey. Only.Opel decided to close private sector­relevant finance skills and access to its small assembly plant near Izmir. credit cards. But Turkey performs less well in areas In the meantime, the auto parts industry was also critical to starting new indigenous businesses not attracting foreign investors. Most of the world lead- connected to existing industrial groups; venture ers in the sector have joint ventures with Turkish capital for business development is not so easily partners. Some of them are big suppliers such available, and credit does not flow very easily from as Robert Bosch, Valeo, Delphi Packard, and banks to businesses. Mannesmann Sachs. Altogether, between 1992 and 2000, the automotive industry realized a total of The Automotive Industry. A natural implication of $3.4 billion in investment. Of this amount, the Turkey's large domestic market is the presence of industry used $750 million for capacity develop- FDI directed largely toward the internal market. ment, $976 million for new model development, However, the automotive industry is a good exam- $497 million for modernization, $300 million for ple of how an initially protected home market can localization, and $195 million for quality improve- be transformed into a competitive and increasingly ment. Moreover, because of the new investment export-oriented industry through FDI inflows. projects directed at the production of new models, During the debate on the customs union, the auto- in 2000­02 this investment amount increased by motive industry was expected to be the industry almost $1 billion. worst affected by lowering protections on EU The success of the automotive industry in attract- imports. However, that prediction was proved ing FDI flows, despite the continuing constraints wrong. Over the last few years, the automotive arising from macroeconomic and governance and industry has become the second largest exporter. institutional factors (see next section), is driven By the mid-1990s, four FDI companies had largely by the relevance of all the positive aspects of more than 20 years of experience in the Turkish trade and infrastructure for this industry--the rea- automotive industry (Fiat, Ford, Mercedes, and son automobile-related multinational corporations Renault).7 In the mid-1990s, with the increasing (MNCs) decided to invest in Turkey. If other obsta- prospects of a customs union agreement with the cles were not present, the Turkish auto industry EU, Japanese and Korean companies (Honda, would likely have attracted far more FDI inflows Hyundai, Isuzu, and Toyota) began investing in than current levels. Turkey in joint ventures with Turkish industrial- ists.8 Perhaps because of the uncertain business Governance and Institutions: Case Studies Bot- environment in Turkey, these companies did not tlenecks related to insufficient respect for the rule initially make substantial investments, and they of law and to weak competition in local markets, built plants with small production capacity. Once reinforced by uneven application of bureaucratic the customs union with the EU went into effect in red tape and of competition rules to all economic 1996, the domestic market gradually opened to actors in the market, profoundly damage any coun- tough competition from the EU. Actually, in the try's investment climate. In these critical areas first couple of years of the customs union, the requiring improved governance and more effective sector struggled with wild fluctuations in domestic institutions, Turkey, unfortunately, compares unfa- demand as well as with competition from imports. vorably with the comparator CEE countries, as 276 Turkey: Economic Reform and Accession to the European Union reflected in the perceptions of the global investors Normandy Madencilik A.S¸. (formerly Eurogold, and experts who compiled the following rankings. but later purchased by Australia-based Normandy According to the Heritage Foundation's economic Mining Limited) was registered in 1989 as a 100 per- freedom index 2003, Turkey ranks 105th (with a cent FDI company. It found total reported gold score of 3.3), in contrast to Poland, 45th (2.7), and reserves of 24,000 metric tons (and another 24,000 the Czech Republic and Hungary, both tied at 32nd metric tons of silver) near the village of Ovacik, . (2.4). In PricewaterhouseCoopers' opacity index Bergama, in Izmir province. Under the initial appli- 2001, Turkey ranks 74th, compared with the Czech cation, the mine was to be operated for eight years, Republic at 71st, Poland at 64th, and Hungary at if no more reserves were discovered in the interim. 50th. Finally, in Transparency International's cor- The ore would be mined by both open pit and ruption perception index 2002, Turkey ranks 64th underground mining methods, followed by cyanide (with a score of 3.2), in contrast to the Czech leaching. Gold and silver doré metal were to be the Republic at 52nd (3.7), Poland at 45th (4.0), and final products. In response to a request by the com- Hungary at 33rd (4.9). pany in August 1991, the Ministry of Environment To help illustrate what may be the central under- issued a letter of no objection in October 1994, lying factors accounting for Turkey's poor perform- indicating no health and environmental drawbacks ance in these widely cited indices, the rest of this sec- and allowing the mining and processing facility to tion presents three case studies that reflect the recent operate. The company also secured the required experiences of actual foreign investors. The case permit for mining activities from the Ministry of studies represent the primary sector (Normandy's Energy and Natural Resources, and related permits, experience in gold mining), the secondary manufac- licenses, and investment certificates from relevant turing sector (Cargill's experience in agroprocess- government entities. The amount of total invest- . ing),and tertiary services (Is¸-TIM's experience in the ment was $100 million. As part of its application in mobile telecom market). Figure 10.4 summarizes 1991, Normandy prepared an environmental the main facts of the case studies.A discussion of the impact assessment (EIA) report. After enactment of common elements across the case studies follows. a formal EIA regulation in 1993, Normandy agreed to meet the new discharge limits, even though it The Eurogold Investment. Because of its complex was exempt from the EIA because the mining rights geology, Turkey possesses a diverse and rich array were granted before the regulation took effect. of minerals. It is a major world producer of boron Accordingly, the waste material from the facility minerals (it has two-thirds of the world's borate would be stored in a water retention-type tailings reserves), marble, copper and chrome ores, dam, lined with clay and geo-membrane liners, feldspar, magnesite, and others. Its total mineral with no discharge to the environment. industry revenues (primary and secondary mineral The judicial problems facing Normandy began production, including cement, glass, refined petro- with a court case initiated by the inhabitants of leum products, steel, and certain inorganic chemi- Ovacik and some nongovernmental organizations cals) are estimated to account for roughly 10 per- (NGOs) in 1994, based on a suit to annul the origi- cent of GDP. The mining sector is still nal Ministry of Environment decision authorizing overwhelmingly controlled by state-owned compa- the project. Long-lasting and repeated legal proce- nies, although some public companies have been dures followed. In 1997, after a long judicial process placed in the privatization process. Since enact- and just as construction of the facility had been ment of the mining law (No. 3213) in 1985, the completed and the mine was ready to operate, peak points in the value of FDI approvals in the Turkey's highest relevant court, the Council of State sector have occurred with the following major (Danis¸tay), overturned the initial government investments: in 1990 in the Omya calcite mine, a authorization and ordered the mine and processing joint venture involving the Swiss company of the plant to be sealed by 1999. The ruling stated that the same name; in 1991 in the Ovacik gold deposit by facility's proposed use of cyanide posed risks for Eurogold; and in 1995 in an Eskis¸ehir magnesite health and environment and thereby violated Article mine by Magnesit A.S¸., a subsidiary of the Dutch- 17 of the constitution, which granted all citizens the based Société d'Interets Magnesiens. right to live in a healthy and balanced environment. Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 277 FIGURE 10.4 Case Studies The Eurogold Investment MARKET HISTORY EUROGOLD COMPANY · Turkey possesses a rich and diverse array of minerals. · Formerly Eurogold but subsequently purchased by Normandy Mining Ltd. · Enactment of Mining Law in 1985 · Registered in 1989 as 100% FDI company · Environmental Impact Assessment (EIA) regulation enacted in 1993 · Found gold reserves of 24,000 metric tons · Licences granted in 1991 Dynamics of Eurogold case OPERATING Local inhabitants of Ovacik Long-lasting and repeated legal procedures UNDER SPECIAL region went to litigation. PERMIT: Permanent solution not achieved The Cargill Investment MARKET HISTORY CARGILL, Incorporated · 29 companies in traditional beet sugar production · U.S.-based but Dutch registered · 80% of beet sugar capacity state-owned · Began starch-based sugar production in 1990 · 5 private companies in starch-based sugar production · US$90 million investment at Orhangazi, January 1998 Dynamics of Cargill case OPERATING · Lobbying from beet sugar producers 4 pending court cases since 2001 on construction, UNDER SPECIAL · Inappropriate permission of High PERMISSION: discharge, and emission Planning Board Permanent legal solution required Regulatory body unable to Unpredictable introduction of quotas Undercapacity create a level playing field production Is¸-TIMMobile Telecom Investment MARKET HISTORY IS¸-TIM ARIA COMPANY MARKET SHARES · Revenue share agreements between Türk · Third GSM operator of Turkey (by end of 2002) Telekom and Turkcell and Telsim in 1994 · Consortium of Is¸bank and Telecom Italia Mobile · Turkcell 64.3% · Telecommunications Regulatory Authority · Paid license fee of US$2.5 billion · Telsim 30.2% established by Law No. 4502 in 2000 · Began operations in March 2001 · Aria 4.7% · Third GSM license allocated to Is¸-TIM in 2000 · Aycell 0.8% · Another GSM license granted to Aycell (state-owned) Dynamics of Is¸-TIM case Rulemaker unable to create a Roaming agreement could not be signed level playing field ARBITRATION Source: The authors. 278 Turkey: Economic Reform and Accession to the European Union Some lawyers have criticized Danis¸tay's decision in supporting industries. The acquisition of that the technical method for mining was hazardous Normandy Mining Limited by U.S.-based Newmont to human health. They argue that setting the rules Mining Corporation was completed in February on such a technical issue and prohibiting the use of a 2002. technical method are not the responsibility of This case study highlights the problems for Danis¸tay; rather, that responsibility resides with the investors arising from the insufficient clarity of and related ministries or government institutions. lack of respect for the rule of law in Turkey. In this In response to this ruling, Normandy took addi- instance, Normandy followed established rules and tional safety measures in 1998 and reapplied to the procedures.The initial government authorization by Ministry of Environment for administrative the Ministry of Environment based on Normandy's permission, adding a cyanide destruction system adherence to the prescribed rules did not protect the for effluents from the facility, a sealed tailings pond, company from successive legal challenges. After the and a zero discharge system for wastewater. With first order for plant closure, subsequent authoriza- these measures, the Ovacik facility became known tions based on the company observing newly as one of the better examples of environmental prescribed rules (the new EIA regulation) by the protection in the world (see, e.g., Arol 2002). The Ministry of Environment, the Prime Ministry, and Ministry of Environment, in turn, consulted with TUBITAK again were overturned, and the plant was the Prime Ministry. The Prime Ministry appointed ordered to be closed for a second time in August a team of scientists under the governance of the 2004. Since the plant shut down, the government has Turkish Scientific and Technical Research Institute not issued a technical standard on the permitted (TUBITAK) to evaluate the process. Based on a methods for gold mining and specifically for cyanide positive report from TUBITAK, the company was leaching. Moreover, the government has adopted allowed to operate the facility for a one-year trial new regulations on sectoral licensing authorizing period, and it began operations in June 2001. the Ministry of Health and the provincial governors, Normandy has been operating the facility since along with the Ministry of Environment, to issue then and publicizing the results of periodic operating licenses. Faced with insurmountable legal independent environmental monitoring showing problems and the constantly changing regulations, results well within national and international the parent company, Newmont Mining Corpora- limits. tion, sold Normany Mining to a Turkish company in Project opponents have continued to challenge early February and withdrew from Turkey. government decisions in various administrative . courts in Izmir, with at least 10 separate court cases Cargill Starch-Based Sugar Investment. Turkey's filed since August 2000 by local plaintiffs; defen- sugar production can be divided into traditional dants are the Prime Ministry, Ministry of Environ- beet sugar (sucrose or ordinary table sugar) ment, Ministry of Health, and Ministry of Forestry. processed from crushed sugar beets and starch- In late February 2002, an administrative court in based sugar (glucose and fructose), a lower-cost . Izmir ruled that the trial permit was violating the alternative processed from maize. Although public good and issued an injunction against the fructose can be used as a substitute for sucrose facility, ordering it to close on April 2, 2002. How- (because it is sweeter and metabolizes more slowly, ever, the government passed a special permit for it is often used in food products designed for Normandy to continue operations. people with diabetes), glucose cannot be used as a Normandy's involvement in Turkey has benefited substitute, even though both are used as important the Turkish mining sector in terms of improving sweetener inputs in food processing industries. The environmental standards in the sector, applying more traditional beet sugar is produced by 29 com- state-of-art technology in gold mining and process- panies in Turkey, with state-owned production ing, and improving local technical training. Since capacity accounting for 80 percent of the total. the start of operations in June 2001, the facility has Starch-based sugar is produced by five private com- provided direct employment for 250 persons and panies, of which three are MNCs. In 2001 Turkey indirect employment for an additional 1,200, produced 2 million metric tons of beet sugar, over including through the formation of new businesses five and a half times more than the privately Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 279 produced 360,000 metric tons of starch-based and emission permits. The plaintiffs, supported by sugar (235,000 of fructose, 125,000 of glucose). The the Bar Association of the city of Bursa, various sugar industry is characterized by substantial excess professional chambers of Bursa, and some national capacity, with total production capacity of 2.25 mil- members of Parliament from Bursa, undertook lion metric tons of beet sugar and 930,000 metric these actions against the Prime Ministry, the tons of starch-based sugar. However, given the Governorship of Bursa, and the Ministry of Public uncompetitively high local production costs of beet Works and Housing. Although a case in the Sixth sugar, even current levels of beet sugar production Administrative Chamber of the Council of State are feasible only with extremely high nominal rates was decided unanimously in favor of Cargill and of protection of 78.5 percent and effective rates of the government, it was appealed by the plaintiffs. protection of 1,500 percent. The excess capacity of Eventually, the initial decision was overruled, and starch-based sugar is not market based, however. the plaintiffs then sought cancellation of the It was artificially created by the new sugar law original discharge and emission permits. A sepa- (No. 4634) announced in April 2001, which rate ruling found that the High Planning Board imposed a quota limiting starch-based sugar gave inappropriate permission for facility con- production to 10 percent of total beet sugar pro- struction on "first priority agricultural land"-- duction in response to pressure from beet sugar that is, it was claimed that the permission was in farmers and processors. (This quota can be contradiction of the constitution. It was, therefore, increased to 15 percent by the Council of Ministers. ruled that the Orhangazi facility must be torn The actual quota has always been 15 percent.) down. For a while, the company operated under U.S.-based but Dutch-registered Cargill Incor- special permission by the government. Then, in porated began starch-based sugar production in 2004, the government enacted a new law for the Turkey in 1990. It obtained the required investment establishment of "industrial zones." The law certificates (10 separate certificates between 1990 authorizes the Council of Ministers to designate and 1997) for a wet corn milling (starch) process- certain regions or already existing plant locations ing plant in Pendik, Istanbul, with a capacity of as industrial zones in which construction, dis- 220,000 metric tons. Based on the success of that charge, and emission permits are not obligatory. plant, Cargill obtained an additional investment Cargill has applied to the Industrial Zone Coordi- certificate for a $90 million investment in a second nation Board for industrial zone status for the facility at Orhangazi, in Bursa province in January Orhangazi facility, and it is likely to be granted. 1998, again with a capacity of 220,000 metric tons. However, no one, including government officials, Like the first facility, this plant was constructed in knows what will happen when the court cases are full compliance with all the relevant legislation in finalized. force, and it has obtained all the necessary consents, The second problem is related to the unpre- permits, licenses, and authorizations (with a special dictable introduction of quotas on starch-based condition within the foreign investment certificate sugar production in 2001. The initial government recognizing the High Planning Board decision policy was to create substantial additional capacity transferring the former agricultural area land into by promoting starch-based production to substitute industrial area land). Significantly, 800 families and for higher-cost beet sugar. Although the initial 4,000 people in the region were making their living quota for the period 2002­03 was restricted to out of the Orhangazi facility between 1998 and 234,000 metric tons, it was increased by 50 percent 2002, and 70 percent of the maize processed in the by a subsequent Council of Ministers decision. facility in 2002 was purchased from domestic However, the government's decision to increase the growers. production quota has been ineffective so far, In response to intense lobbying from the more because it has not been implemented by the respon- expensive beet sugar producers, the Orhangazi sible independent regulatory board (the newly insti- facility has, since 2001, faced two separate but tuted Sugar Board). To add to the already existing related problems. First, four court cases, still pend- chaos, the government abolished some articles of ing, commenced in 2001 challenging the govern- the sugar law at the end of 2004. With this move, the ment's initial granting of construction, discharge, Sugar Administration was abolished. Now the Sugar 280 Turkey: Economic Reform and Accession to the European Union Board legally exists, but it does not have an institu- end its monopoly in fixed-voice telephony by tion to represent. A lawsuit is being prepared for December 31, 2003. The third mobile license was cancellation of the decree on the grounds that the allocated on the basis of a competitive tender in government does not have the authority to change April 2000, with the condition that the minimum the law unless there are international commitments. bid for a fourth license be equal to that paid by . This case highlights problems for investors simi- the third operator. Is¸-TIM, a consortium of . lar to those encountered in the Eurogold invest- domestic Is¸bank and the mobile phone arm of ment, again arising from insufficient clarity of and Telecom Italia Mobile (TIM) operating under the the lack of respect for the rule of law. Cargill, too, Aria brand, won the third tender with an unex- followed the established rules and procedures. The pectedly high bid price of $2.525 billion, sus- initial government authorization granted in 1998 pected to have been an attempt to prevent a (supported by a High Planning Board decision) fourth operator from entering.9 The tender offer after Cargill followed the prescribed rules again did for a fourth license failed, and the fifth license was not protect the company from successive legal chal- granted to Türk Telekom (through a newly lenges, nor did subsequent support by the govern- created subsidiary, Aycell) at the same price paid . . ment (Prime Ministry, Ministry of Public Works by Is¸-TIM. Is¸-TIM entered the market in March and Housing, Governorship of Bursa) protect the 2001 and Aycell in December 2001. By the end of company from plaintiffs eager to find legal loop- 2001, the mobile penetration rate had reached holes to force plant closure (and, again, the legal 28.7 per 100 inhabitants, surpassing that in the problems have still not been solved permanently). fixed-telephony market. By the end of 2002, In addition, this case highlights the negative impact Turkcell had a market. share of 64.3 percent, on investments arising from the lack of a level play- Telsim 30.2 percent, Is¸-TIM 4.7 percent, and ing field for all firms. In effect, unpredictable and Aycell 0.8 percent. Unlike Eurogold and Cargill, . uneven changes in rules with the introduction of which are 100 percent FDI companies, Is¸-TIM is a highly restrictive quotas on some market players joint venture investment in which TIM owns and not on others, together with the biased and 49 percent and the domestic partner is one of the anticompetitive decision of the Sugar Board in largest banks and holding companies in Turkey. . favor of entrenched local incumbents, have a The main problem facing Is¸-TIM since its entry negative effect on investments not only by efficient into the Turkish market has arisen from its companies in the sugar industry but also by inability to conclude mutually acceptable roaming efficient companies in all sectors. agreements with the incumbent competitors, Turkcell and Telsim. After the parties failed to . Is¸-TIM Mobile Telecom Investment. The move to resolve the tariff dispute among themselves, in . liberalize the Turkish telecommunications indus- March 2001 Is¸-TIM asked the TA to intervene. The try's state-run monopoly began in 1994 with legis- regulator determined the terms, conditions, and lation to corporatize (as a state economic enter- tariffs for roaming in October 2001, but Turkcell prise) the sole fixed-line operator, Türk Telekom and Telsim obtained preliminary injunction (TT) and remove telecom services from direct decisions in November 2001 with the aim of government involvement. Also in 1994, the mobile suspending implementation of these terms and telecommunications market was opened to limited conditions, and they applied to international arbi- competition from two private operators, Turkcell tration. In March 2002, the TA adopted the Regula- and Telsim, which began business under revenue- tion on the Procedures and Merits concerning the sharing agreements with Türk Telekom. These Execution of National Roaming Agreements, but duopoly providers were granted 25-year licenses in Turkcell and Telsim again obtained preliminary 1998, although this initial assignment of spectrum injunction decisions and applied. to international was not competitively determined. In January arbitration for a second time. Is¸-TIM raised an 2000, new legislation (Law No. 4502) established objection against both injunction decisions as the an independent authority, the Telecommunications third party suffering from the decision, but its . Authority (TA), and Türk Telekom was granted objections were rejected. Is¸-TIM sent a letter as a independence in business operations, but it was to last warning to the TA in February 2003 and filed a Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 281 . lawsuit against the TA with the International Court concession agreement between Is¸-TIM and the TA. of Arbitration of the Paris-based International The article requires the regulator "to provide a Chamber of Commerce on March 31, 2003, seek- necessary, sufficient and fair competitive environ- . ing nearly $3 billion in damages as a result of the ment since Is¸-TIM entered the market," although it negative response to its letter (the full value of the also specifies that "the coverage area of the [new] paid license fee plus valued added tax, because companies should cover 50 percent of the popula- Turkey did not make available the roaming rights it tion of the country in three years and 90 percent in had purportedly promised). On May 13, after nego- five years by investments exclusively made by the tiations involving Italian Prime Minister Silvio operators themselves without any national roaming Berlusconi. and Turkish Prime Minister Yilmaz support." The presumed shortcoming of the TA is Erdogan, Is¸-TIM announced a merger with Aycell that it has been late in coming up with its own regu- (TIM and Türk Telekom each to hold 40 percent of lations on roaming, that standard interconnection . the merged provider, with Is¸bank holding the tariffs based on the long-run incremental cost remaining 20. percent). With the announcement of accounting methodology have not yet been estab- the merger, Is¸-TIM withdrew its lawsuit, because lished, and that no requirement is in place ensuring . the merger is expected to furnish Is¸-TIM with that regulatory decisions remain in force while national roaming capacity, given Aycell's sizable court proceedings are undertaken. . network of base stations. The Turkish government The Is¸-TIM case, like the Cargill case, highlights accepted the merger of the two companies to pre- the negative impact that lack of a level playing field vent any further damage to Turkey's already poor for all firms has on investments. Although the rele- reputation with foreign investors. The merger was vant regulatory body in the sugar industry made an completed in February 2004. The new company is anticompetitive decision in favor of entrenched local called TT-TIM and is operating under the Avea incumbent enterprises, the anticompetitive impact brand, with a market share of 16 percent. in this instance arose from the inability of the TA to In the meantime, on June 9, 2003, Turkey's impose a pro-competitive decision about roaming Competition Board fined Turkcell $15.4 million rights on Turkcell and Telsim in a timely manner. and Telsim $6.1 million (1 percent of the compa- The origins of the problem in this case are related to . nies' net sales in 2001) for refusing to allow Is¸ -TIM the too-slow evolution of rules and regulations in access to their networks. The Competition Board the telecommunications sector and the lack of ruled that Turkcell and Telsim have been deliber- authority of the regulatory body, driven no doubt at ately stifling competition in the mobile services least in part by a natural learning process of the TA. market. The Competition Board also urged the TA to provide the requisite remedy by better regulating Common Governance- and Institutions-Related the market in order to end competition rule Constraints. One of the common features of the violations of this kind. three cases examined is the lack of credible indus- The request for arbitration arose out of the right trial policy framework statements that could give that national operators have to national roaming investors confidence in the expected rules of the . and the presumption by Is¸-TIM that this right was game in each industry. In fact, no such document is not adequately guaranteed by the TA. The right of available for any industry. Even the changes made . Is¸-TIM to benefit from national roaming is included in the legislative framework for telecommunica- in Article 6 of Law No. 4502, which requires mobile tions in May 2001 that gave more power to the TA operators "to satisfy reasonable, economically were made without a clearly articulated policy proportionate and technically feasible roaming framework. Thus, they hardly form the basis for requests of other operators working in the same giving investors confidence about the government's field" and requires the regulator "to issue regula- long-term vision for the industry and for the econ- tions setting out the principles of implementation omy as a whole. To help give credibility to such of this provision and the details to which standard policy framework statements, related legislation, reference tariffs, interconnection and roaming including implementing decrees in line with the agreements are subject." National roaming rights policy statements, are essential, as is the subsequent are also presumed to arise out of Article 35 of the consistent implementation of such legislation. 282 Turkey: Economic Reform and Accession to the European Union The case studies highlight two distinct but the failure of the relevant regulatory body to rap- related classes of constraints that account for idly enforce a pro-competitive order has sent nega- Turkey's poor performance in attracting FDI: (a) tive signals for future investments by existing or the legal and judicial constraints related to the new, potentially efficient enterprises. It is, of course, insufficient clarity of and lack of respect for the rule natural for entrenched local incumbents, whether of law, and (b) competition constraints related to in primary, secondary, or tertiary sectors, to seek to the absence of a level playing field for all firms. Lack maintain market power and prevent new investors of clarity refers to insufficiently defined, missing, from challenging their local dominance. However, incoherent, or changing rules. Lack of respect for it is the role of properly enforced competition the rule of law refers to the practice of decision policies, both through the independent regulatory making based not on ex ante defined rules but on bodies and through the Competition Board, to opportunistic motives irrespective of the prevailing ensure that incumbent companies only do so by rules. It also refers to both a reluctance to apply lowering their costs and offering improved prod- rules when they should be applied and a tendency ucts rather than by seeking to dull the competitive to allow loopholes and ambiguities to persist in the market process, either on their own or through legal framework. Lack of respect for the rule of law alliances with organs of government. creates an environment in which multiple appeals This analysis of governance- and institutions- are common and in which successive appeals related constraints in Turkey is consistent with a attempt to overrule the previous court's or public broader analysis of politics and democracy in authority's ruling. The ineffectiveness of many of Turkey as populist patronage--allowing people the recently established regulatory boards intensi- greater access to the resources of the state through fies the adverse effects of this constraint on foreign the help of political parties (see, e.g., Kalaycioglu investors. In such an environment, it is only natural 2001). In a cultural environment in which interper- for investors to lack confidence that established sonal trust is low, regional solidarity ties, blood rights will be respected by the courts. relations, clientelistic networks, favoritism, and In each of the presented cases, the government nepotism have deeply influenced and molded the as rulemaker has not been able to solve the underly- political culture.10 For patronage to thrive, authori- ing problems in a timely manner. In those instances ties must distribute favors to their clientele, which in which the government has strived to help the is difficult to do if allocation of contracts and con- investor, its attempts have been met with judicial tract monitoring, recruitment, promotion, tariff challenges. These judicial challenges, when circum- decisions, and expansion of new entrants are con- vented by the government such as in the Eurogold ducted purely on meritocratic grounds and and Cargill cases, were carried out without address- through transparent procedures as required by EU ing the underlying legal bottlenecks. This funda- standards. Only when rules and laws are applied mental problem of unaddressed underlying legal evenly for all market participants (and not directly ambiguities appears to be one of the most critical modified for politically influential firms) will non- problems. It raises the question of whether lack of market-based favoritism be overcome and more clarity in the underlying rule of law is intentional, substantial investments driven by underlying effi- so that public decision makers have the freedom ciencies be forthcoming. required to grant special treatment and exemptions whenever politically convenient. Unfortunately, FDI-Related Policies and the substantial cost of such unpredictability in the Institutions and EU Accession rule of law in terms of forgone current and future investments amplifies the impact of distortions Turkey scores better than its competitors along stemming from government allocations based on many of the dimensions of FDI just described (also personal connections. see tables 10.7a and 10.7b). A huge and growing In the face of competition-related constraints, domestic market, skilled and cost-effective labor, state-owned, local, joint venture, and fully foreign- strong local companies, and access to other expand- owned companies are not able to compete on an ing markets are all strengths of Turkey. Further- . equal footing. In both the Cargill and Is¸-TIM cases, more, Turkey has had a liberal legal framework for Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 283 FDI since 1954 and a convertible currency for The 2003 accession partnership report for Turkey almost 15 years, far earlier than its competitors. has, for the first time, clauses related to FDI policy However, relatively low levels of FDI inflows over (European Commission 2003). The two require- past years reveal that Turkey has not been able to ments, which are explicitly stated in the AP docu- translate these competitiveness-related strengths ment, both as short-term priorities, are that Turkey into a sufficiently large number of concrete FDI should "facilitate and promote the inflow of FDI" projects. In comparison with other candidate coun- (in the Economic Criteria section) and "remove all tries, Turkey's EU candidacy has not positively restrictions affecting FDI [originating from the EU] affected its inflow of FDI, and figures show that even in all sectors in Turkey" (in the Free Movement of the customs union has had a negligible effect.11 Capital section). The policies Turkey must follow to foster its As for broader EU requirements for FDI, the future competitiveness have to include all the tradi- 2002 "Regular Report" contains criticism of the lim- tional components needed to attract more FDI, such itations on foreign ownership in some sectors, of the as the further harmonization of trade and industrial authorization system for investment, and of the policies and the adoption of related legislation and obligation to pay $50,000 to establish a company or administrative procedures. However, these compo- open a branch in Turkey (European Commission nents are not sufficient conditions for a more com- 2002). As for the restrictions on foreign ownership petitive economy and will not automatically result in in certain sectors, such as civil aviation, maritime increased inflows of FDI.All EU candidate countries transport, port enterprises, radio and television have applied the acquis, but each country also has broadcasting, telecommunications, and mining and country-specific rules, policies, and institutions to energy, the government argues that most of the seek FDI. In addition to meeting EU requirements other candidate countries still have similar restric- in a broad range of traditional harmonization- tions and that Turkey should not remove them until related areas, Turkey must attempt to improve its a more definite road map for EU accession is agreed legal/judicial and competition-related environment on. However, it is also argued that these restrictions in order to ensure predictable respect for the rule of should be removed not only to comply with the EU law and a level playing field for all firms, not only on acquis, but also to develop a more competitive paper but also in terms of implementation. investment environment for Turkey. EU Requirements Reform Efforts to Date Turkey's EU candidacy status and obligations as a Turkey adopted an ambitious structural reform memberof thecustomsuniondonotdirectlyimpose program in 2001 to lay the foundation for sustain- EU requirements on Turkey's FDI policy. Until 2003, able growth, driven by private investments and no explicit clause on FDI policy appeared in the supported by a smaller but more effective govern- accession partnership (AP) report or the "Regular ment. The main pillars of the government's Report on Turkey's Accession,"even though Turkey's economic program related to development of the limits on foreign ownership for certain sectors were private sector include an improved investment criticized in the context of freer movement of capital climate; a smaller, more transparent, effective pub- (European Commission 2003, 2002). However, FDI lic sector; a sound and competitive financial sys- aswellasdomesticinvestmentsareverymuchrelated tem; accelerated privatization; and a more efficient to the overall business environment and policy deci- business infrastructure, with a particular focus on sions on taxes and state aids, intellectual property communications and energy. The ongoing reform rights, sectoral licenses, customs, and standards. efforts are closely linked to Turkey's objective to Furthermore, broader areas of competition policy accede to the EU. The government realizes that have a direct impact on how a country performs in Turkey has fallen behind many other developing attracting FDI.Thus the previousAP documents and countries in its effective liberalization, enforcement the national program of Turkey had included a long practice, legal, and judicial reforms. Pushing ahead list of legislation to be amended, which, in turn, with the ongoing reforms is crucial to the country's could positively affect the investment climate. economic future. 284 Turkey: Economic Reform and Accession to the European Union Currently, Turkey is implementing a major fiscal tive procedures appear to be among the most adjustment program to increase the effectiveness of important disincentives to investment, and they the public sector while reducing its size. Fiscal and can discourage investors, despite other attractive public sector reforms are imperative to ensure a features that a country might have to offer. Taking sustainable domestic public debt profile, which is into account the findings and recommendations of itself critical to establishing macroeconomic stabil- a diagnostic study and a project on administrative ity with low inflation. These actions are essential to barriers to investment, conducted jointly by the allowing lower interest rates, facilitating long-term government and the Foreign Investment Advisory investment planning, and promoting more robust Service (FIAS, a joint facility of the International private sector growth. To complement these Finance Corporation and the World Bank), the gov- reforms and ensure their sustainability, Turkey also ernment enacted a "Decree on Improving the is undertaking fundamental reforms of its expendi- Investment Climate in Turkey" on December 11, ture and taxation systems. The banks act in 1999 2001, as part of a national strategy to increase the established the Banking Regulation and Supervi- overall level of income and productivity and to sion Agency (BRSA) as an independent authority to raise the level of competitiveness of firms operating regulate and supervise the banking sector. The in Turkey (see FIAS 2001). BRSA has implemented a comprehensive banking The challenge facing the government was how to restructuring program to promote more efficient implement this reform vision in a manner that financial intermediation for the enterprise sector. would streamline administrative procedures while To strengthen the scope for private sector incorporating private sector feedback on the meas- investment in telecoms, Turkey passed an amend- ures to be taken. Within this framework, a three- ing law in 2000 to create, as noted earlier, the phase strategy was designed and then launched to Telecommunications Authority, an independent facilitate the reform process. In the first phase, a regulatory body responsible for licensing, tariffs, clear vision and a consistent direction for the spectrum allocation, and other supervisory activi- reform were embodied in the December 2001 min- ties. Similarly, to strengthen the scope for private isterial decree in order to demonstrate political sector investment in energy, separate electricity and commitment and consensus behind the reform natural gas laws in 2001 established the independ- scheme. The decree established the Coordination ent Energy Market Regulatory Authority. In August Council for the Improvement of the Investment 1999, Turkey's constitution was amended to estab- Climate (YOIKK), a coordinating body composed lish the legal basis for privatization and to allow of senior public and private sector decision makers public services to be performed under private law. with the mandate to identify and remove regulatory Importantly, the amendments also allow the inter- and administrative barriers to private investment. national arbitration of disputes. A new public pro- The second phase entailed formulating a clear and curement law also was enacted in 2002. Although precise action plan defining priorities, timing, and all these policy announcements are desirable and in responsibilities for attracting more FDI flows. In the right direction, the government must ensure the third phase, YOIKK was scheduled to hold that these policies will be implemented carefully, regular monthly meetings in order to monitor consistently, and promptly so that business expec- progress made, with quarterly reports submitted to tations will not be adversely affected. the Council of Ministers. To address feedback received from international As shown in figure 10.5, key areas of reform have investors about Turkey's troublesome investment been identified and grouped under nine technical climate, the government in 2001 launched a reform committees to deal with the following constraints: process to improve administrative procedures. The idea behind the Reform Program for Improving the · Company registration. The goal is to eliminate Investment Climate was that administrative barri- time-consuming, unnecessary, and duplicative ers can make the difference between the perception transactions. that a location is an attractive one for investment · Employment. Problems are related to short-term and the perception that it is not competitive. work visas, employment of special groups, and Indeed, complex and time-consuming administra- high social contributions by employers. Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 285 FIGURE 10.5 Areas for Investment Climate Reform Coordination Council for Council the Improvement of the of Ministers Investment Climate (YOIKK) Monthly Progress Quarterly Reports Progress Reports Customs and Taxation and Small and Medium- Land Access Technical Standards Incentives Size Enterprises Company Sectoral Licensing FDI Law Registration Intellectual Investment Employment Property Rights Promotion Source: Undersecretariat of the Treasury. · Sectoral licenses. Licensing procedures are · FDI legislation. Legislation on FDI at the time unnecessarily complicated in various industries, of the formation of YOIKK was based on the primarily because of overlapping authorities, 1954 law. highly centralized approval procedures, and little involvement by the private sector. The first YOIKK meeting, held in March 2002, · Location. Access to public lands and site devel- set targets and timelines for these technical com- opment by the private sector are very time- mittees. One core dimension of the reform process consuming and subject to some restrictions. has been private sector involvement in all efforts · Taxes and incentives. The corporate income tax through disseminating the information and shar- rate is comparatively high, and the system is ing the results obtained over time. This emphasis is complex. Incentives should be aligned with the in line with the government's conviction that joint EU state aids regime, and the process should be evaluation of the needs and identification of appro- simplified and automatic where possible. priate solutions are of utmost importance for the · Customs and standards. Despite major reform success of the reform initiative. initiatives, customs procedures still cause some The reports of the technical committees have delays because of the significant documentation been quite positive. The government already has requirements, lengthy testing procedures, taken several steps in compliance with the recom- delayed valued added tax (VAT) reimbursement, mendations of the committees. Even though there and discretionary decision making with inci- were elections and change in government, the dences of corruption. reform program has proved to be effective, and var- · Intellectual property rights. Protection of patents, ious legislative changes have been made and draft trademarks, and copyrights is insufficient, laws prepared. After the November 2002 elections, mainly because of remaining gaps in the existing the new government amended the Council of Min- legislation, weak implementation and enforce- ister's decree to include another technical commit- ment of laws, and cumbersome procedures. tee on small and medium-size enterprises. To · Investment promotion. No one single entity increase the influence of YOIKK, the government effectively conducts targeted investment promo- decided to head it with a minister. Laws enacted as a tion and policy advocacy. direct result of the YOIKK process to date include 286 Turkey: Economic Reform and Accession to the European Union (1) a new, up-to-date FDI law that serves as a ensure effective implementation of the regulations declaration to foreign investors of their rights and on the protection of intellectual and industrial that will enable a shift from an ex ante, control- property rights. based "investment permission system" to a "promo- Finally, land acquisition and site development tion and facilitation approach" with minimal ex for investment are critical issues for both local and post monitoring to continuously improve the foreign investors. A very useful discussion forum investor climate in conformity with international involving public and private sector representatives best practices; (2) a law that redesigns the company has led to the creation of a priority list of problems registration process by diminishing the prior 19 and measures to be taken in this field. The technical required steps to three and by reducing turnaround committee working on this issue will begin by for- from two and a half months to one day; (3) a law on mulating solutions to the most urgent problems. employment of foreign personnel; and (4) a law on the investment allowance system, which enables Outstanding Priorities a shift to an automatic state aids system in line Although current efforts have focused largely on with EU requirements. Among the drafted laws that introducing new laws in pre-identified areas to spur have been sent either to the Prime Ministry or to administrative reforms, predictable implementa- Parliament are a law on the duties and responsibities tion of existing and new legislation is far more of the Patent Institute, which will enable the insti- important. As for competition-related reforms, it is tute to deal with intelllectual property rights issues vital that all investors--existing producers and new in a more professional way, and a law on the estab- entrants, whether local, joint venture, or wholly lishment of an investment promotion agency. foreign-owned--face a level playing field in the way Although some investment promotion initia- that laws, regulations, and administrative proce- tives are being undertaken by several public and dures are implemented. Certain critical problems private institutions, Turkey at present does not have still exist for investors in these areas, as highlighted an agency that has a strong and clear mandate,setup, by the case studies. and budget to carry out effective investment pro- motion, including functions such as investor serv- icing, investment generation, and policy advocacy, Legal and Judicial Reforms Improvements on the and that is governed jointly by the public and pri- legislative front, many of which were achieved in the vate sectors. Work is still under way on establishing last few years, were necessary but not sufficient to an appropriate institution to carry out these tasks. create an attractive legal framework for foreign YOIKK's efforts also have borne fruit in several investors. Improvements in FDI legislation in the other areas, such as recruitment of expatriates, sec- narrow sense fall into this category of the necessary toral licensing, customs, and intellectual and indus- but not sufficient changes required to generate sus- trial property rights. As for customs reform, the tainable increases in FDI inflows. One of the critical Undersecretariat of Customs has been implement- outstanding impediments to investment is that ing an ambitious reform program to improve its implementation of the laws in both the executive administrative efficiency and effectiveness. The and judicial branches of government is fraught with customs automated system has been rolled out to problems for investors. The most important, but 99 percent of all customs offices and has been fur- also probably the most difficult, reforms needed in ther enhanced to assist customs in controlling move- this area are basic changes in the legal and judicial ment of goods. Important steps taken include mod- systems and in the way that administrative proce- ernizing customs laws, regulations, and procedures dures more generally are implemented. in line with those of EU legislation and simplifying The way in which the legal and judicial systems and harmonizing forms, procedures, and control work is a critical determinant of FDI--especially techniques in line with those internationally rec- high-value FDI destined for export markets that ommended by the World Customs Organization. can go anywhere and that need a reliable, hassle- The legislation necessary to strengthen the capacity free environment. Lengthy, nontransparent proce- and infrastructure of the Turkish Patent Institute dures, combined with unpredictable outcomes, in has been submitted to Parliament. The intent is to both the executive branch of government and the Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 287 courts, are among the main problems in this area. time to pass between the adoption of laws and their Incomplete reforms and poor implementation of implementing legislation and to seek maximum laws and regulations are the overarching issues. input from private sector participants, both local Adopted laws are often not implemented on time. and foreign, at the legal preparation phase. Best All this contributes to the general perception of an practice would be to draft implementing regula- unpredictable legal framework. Not only are the tions in parallel with the law, or at least to have a administrative procedures time-consuming, but detailed draft ready at the time the law is adopted also enforcement procedures for commercial cases on what the implementation will look like. Seeking in the courts take much longer than in many other significant input from business associations before countries. The heavy workload of judges is the laws and regulations are adopted will result in major reason for these delays. Often, court cases in adequate legislation that reflects the concerns of the Turkey consume more than a year. In the survey private sector. This procedure, common practice in carried out by FIAS, another point frequently most OECD countries, increases the knowledge raised by investors was their lack of confidence in base on which legislation is drafted. the impartiality and quality of the commercial courts (FIAS 2001). Even if the legal issue appears Competition-Related Reforms The general goal clear, foreign investors routinely state that the judg- of creating a more competitive environment in ments are still much more unpredictable than they Turkey has been dealt with as part of the process of would be in their home country. Foreign compa- meeting basic EU accession requirements. Turkey nies and larger companies are very visible, and laws developed its competition law while negotiating its may be applied more strictly to them than to customs union with the EU. The law was adopted in domestic and smaller companies. Although the 1994, taking the EU treaty as its substantive basis. laws themselves respect the principle of equal treat- The Competition Board has been actively applying ment stipulated in the 1954 law on foreign capital Turkey's competition law since the end of 1997. and the new foreign direct investment law, imple- However, industrial policy, company law, free move- mentation often has been different. ment of goods, capital and service provision, taxa- The government is taking steps to reform the tion, sectoral policies, regional policies, and policy judicial system and enhance its predictability as a on small and medium-size enterprises (SMEs) are component of Turkey's EU accession program. The also all related to competition. Progress in all of commitments made in this area, as well as the these areas to comply with the EU acquis will help short- to medium-term plans, are reflected in the Turkey to achieve a better competitive environment. national program. These targets will require some As for enforcing the competition law, a few years to achieve; however, these reforms should outstanding issues are crucial to effective private help to improve the perception of Turkey in foreign sector development. In particular, the current legis- investors' eyes. One desirable step would be for lation does not allow the Competition Board to Turkey to institute a comprehensive legal and judi- apply competition rules to all public undertakings, cial review to identify and address important items including those with special or exclusive rights, and in existing private sector­related laws that are in to other entities of public administration. It is in contradiction or that are not clearly defined. Fur- Turkey's interest to change this situation and to thermore, a specific institution should be entrusted include the equivalent of Article 86 of the Treaty of with improved oversight responsibilities to reduce Rome (1957), which established the European the likelihood of such recurrences in the future. Community. As privatization progresses and public Such a review should also include in its terms of participation withdraws, care should be given to reference the removal of detailed sectoral issues-- better aligning the specific sectoral laws with the such as those related to the allocation of land, first- 1997 Competition Act in order to ensure the effi- priority agricultural land, privatization, and cient enforcement of competition rules. Therefore, arbitration--from the constitution and their intro- it is essential that the government grant the Compe- duction instead into the appropriate laws. Two tition Board enhanced powers to act during the pri- related recommendations that could be acted on vatization process and in the regulated infrastruc- immediately are to refrain from allowing so much ture sectors. In this respect, closer coordination 288 Turkey: Economic Reform and Accession to the European Union should be secured between the Competition Board Another key area of competition policy with an and special sectoral regulatory authorities. The sec- unfinished agenda is state aids. Turkey has been toral regulatory authorities should focus more on criticized by the EU for not aligning its state aids ex ante regulation, and the Competition Board system with that of the EU, even though such a step should concentrate on ex post regulation. After has been a commitment of Turkey under the cus- such "specialization," the current state of competi- toms union. Progress has been made in this area, tion between these two types of institutions will but legislative changes and an independent moni- diminish, laying a stable foundation for coopera- toring authority have not yet been established. tion and coordination. This need for improved Moreover, the current attempts to align the state coordination is evident in the Cargill case, where aids rules cover only the aids given to the private quotas imposed by the Sugar Board have adversely sector, whereas public sector incentives also should affected private sector parties by inhibiting compe- be covered to ensure a competitive environment. . tition, and also in the Is¸-TIM case, where earlier The broader EU requirements shed light on coordination would have helped to address the other issues on which Turkey should focus in seek- situation sooner. ing a more competitive environment. These include A recent study carried out by experts from the alignment with the acquis on intellectual and Competition Board on legislation not compatible industrial property rights (company law) and the with competition supports the view that the gov- removal of limitations for foreign ownership in ernment is not consistent in its application of com- certain sectors (free movement of capital). petition policy principles (Ekdi and others 2002). The study lists various laws and regulations from The Benefits of Full EU Accession Turkey's even- different sectors that contradict the enacted com- tual EU membership is very crucial for FDI inflows. petition law, and almost all of these sectors are Regardless of the many characteristics that render it dominated by public enterprises. Although such an attractive place for foreign investment, Turkey inconsistencies might be understandable for legis- cannot attract as much FDI as its competitors in lation that dates back to when the government Central and Eastern Europe unless the government applied an import-substitution strategy and the takes further steps toward full EU membership. public sector was the driving force of the economy, Actually, Turkey would not have to wait very long there is no economic rationale for such contradic- to start reaping the benefits of an eventual EU tions in legislation adopted after approval of the accession. With the opening of EU accession nego- Competition Act. Such contradictions are most tiations, Turkey is already likely to attract larger glaring for regulatory bodies. As discussed in the sums of FDI, and there are many reasons to expect Cargill case, the Sugar Board should not have uni- such a development to take place. lateral authority to impose anticompetitive quotas. The opening of EU negotiations in October More generally, there should be enhanced oversight 2005 is expected to act as a strong signal that of competition policy to ensure that the decisions Turkey will eventually become a full member of the of regulatory boards do not contradict competition EU, assuming that the government continues on principles. A strong case can be made for the desir- the current path of structural reforms with a clear ability of strengthening the traditional competition focus on the sustainability of public debt. Such a advocacy responsibilities of the Competition decision would assure foreign investors that the Board, including granting the board the power to Turkish economy will follow a stable growth path introduce or amend new laws to promote competi- for the foreseeable future. Equally important, the tion, the power to modify existing laws that are opening of EU accession negotiations would pro- anticompetitive in their impact, the oversight vide all investors with enhanced confidence that the responsibility to ensure that relevant institutions legal and judicial environment will improve across do not perform an anticompetitive role, and the all relevant areas of the common acquis and that power to review whether decisions of all regulatory implementation of all required secondary legisla- institutions are in the public interest, with the man- tion also will improve, because the accession date to submit their reports to Parliament and process in Turkey's case requires not only progress other appropriate public oversight entities. in enacting laws but also progress in implementing Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 289 them. For Turkey, stability, together with institu- building (see chapter annex, which describes the tional reforms that will improve application of the functions of an IPA). According to UNCTAD rule of law and enhance competition, would have (2000), more than 160 national and over 250 sub- the benefit of convincing foreign investors to chan- national IPAs are in place worldwide. A recent nel more funds to Turkey for domestic as well as empirical study on the effectiveness of IPAs in export market­oriented projects. Especially with its 58 countries revealed that FDI inflows are domestic market potential, Turkey would be very positively correlated with investment promotion attractive for FDI in nontraded sectors. Because the activities, and that the quality of the investment average size of investments in these sectors is in climate and the level of development have a signif- general larger, it is likely that they would attract icant effect on IPA performance (see Morisset significant FDI inflows immediately after the open- 2003). This finding suggests that countries are well ing of negotiations. advised to focus on basic improvements in the The attractiveness of Turkey for foreign investors investment climate first, and then consider intro- will continue to increase as the accession negotia- ducing an IPA, at a minimum, concurrently with tions proceed, allowing it to close the gap with the serious efforts to improve the investment climate. CEE countries in attracting FDI. Meanwhile, Turkey Political visibility and participation of the private will continue to take steps toward harmonization sector appear to be two elements critical to the suc- with the EU framework. At one step, even before cess of an IPA. Worldwide experience shows that becoming a full member, Turkey will be in a posi- IPAs are more effective when they are autonomous tion to accept the authority of EU agencies in the from the government (though subject to policy resolution of any problems that may arise between oversight by the public sector) and when they are a foreign investors and the Turkish government. This product of a genuine joint effort by the private and step will further ease some of the reservations that public sectors.12 foreign investors may still have in relation to Turkey. Turkey does not presently have an IPA. The After all, EU rules and regulations and the ways they government has been carrying out promotion are implemented are well known and predictable to activities on a negligible budget. Those activities foreign investors. It is at this stage that one of the consist mainly of publications, limited advertising, most important benefits from EU accession will be and participation in seminars and trade investment realized by Turkey: the rule of law and competition- fairs. It is difficult to claim that Turkey has a coher- related constraints will be eased even further, with ent promotion policy when it is compared with concomitant increases in private investment flows. those of many other countries. Nor is it possible to claim that the budget allocated to promotion is The Role of Proactive Investment Promotion sufficient. Under the YOIKK reform program, the Policies In each of the anticipated stages in the Technical Promotion Committee is still working to accession process, a critical question is what shape set up an appropriate institution that could should the most appropriate set of investment perform the key IPA functions. In addition to the promotion policies, best adapted to the evolving public sector's oversight role in establishing an Turkish reality, take? Another question is, in appropriate institutional framework, a government addition to focusing on those elements of the also has a key role to play in articulating an overall investment climate most critical to moving from investment policy and specific FDI policy actions. one stage to the next in the accession process, what Ideally, a government should first decide on an else should Turkey be doing on the policy side? overall investment and FDI policy and then use From these questions emerges one about the incentives where appropriate as tools to achieve the desirability of more targeted FDI policies. The stated objectives. The use of incentives will differ by experiences of both developed and developing country, but the World Trade Organization (WTO) countries demonstrate the potential benefits of has specified some general rules that each country specific policies to stimulate investment and of an should obey. For Turkey, additional rules stem from investment promotion agency (IPA) that will the customs union agreement with the EU. As part engage in activities such as investment generation, of cross-national efforts to abolish barriers to policy advocacy, investor servicing, and image investment, bilateral or international agreements 290 Turkey: Economic Reform and Accession to the European Union are signed between countries to protect mutual further strengthening. In addition to enhanced investments, with clauses ranging from admission legal/judicial implementation and more effective and establishment to standards of treatment and competition across markets, Turkey would benefit dispute settlement mechanisms. from a coherent overall investment and FDI policy Attracting more FDI per se should not necessar- that clearly articulates how specific policies and ily be the main target of a country's FDI policy. Just more activist promotion are intended to achieve as important are questions of how the country can stated objectives. benefit more from any specific level of FDI and how to prevent any negative effects of FDI. Ideally, FDI Conclusion policies should provide incentives for investors to act in ways that will contribute most to the This chapter has examined the main challenges country's development process. In order to get currently facing Turkey in attracting foreign direct the most from FDI, countries can try to build local investment. The setting of the analysis is that FDI capabilities, using local suppliers and upgrading can in principle be highly beneficial for a country's local skills, technological capabilities, and infra- growth and development prospects. The available structure (UNCTAD 2003). Typically, policymakers evidence suggests that FDI would indeed highly attempt to understand the potential and attractive- benefit the Turkish economy as a whole, based on ness of their country before designing a policy its significant direct and indirect benefits for pro- accordingly. The sectoral and regional capabilities of ductivity in the manufacturing sector. the country, the needs of specific investors--be they Despite its beneficial effects, however, recorded market seeking or resource seeking--and the devel- FDI inflows to Turkey have been extremely low opment level of specific sectors relative to global compared with those of the CEE countries. The trends should all be taken into consideration. Even main FDI challenges facing Turkey, therefore, are developed countries apply specific policies to attract determining why FDI inflows have remained so low FDI, and Germany's use of special incentives to and how Turkey can increase the inflows to desir- attract investment in information-communication able levels. But to what extent do recorded inflows technologies is an example of this practice. fully reflect actual inflows? This chapter provides Despite the general shift in attitudes in favor of preliminary evidence that understatements may be FDI, significant concerns remain about its possible significant in some years, though changes in the negative effects. Crowding out of local firms and new 2003 FDI law, coupled with improved statisti- products, transfers of polluting activities or tech- cal recording, should help to alleviate discrepancies nologies, and concessions made to investors in from international common practice. special zones that allow them to skirt labor and One of the major culprits behind Turkey's laggard environmental regulations are examples of these performance in FDI inflows is the country's long- negative effects (UNCTAD 2003: 88). running fiscal problems and the ensuing macroeco- Given the benefits that could accrue to Turkey nomic uncertainty.Turkey's current efforts to imple- from significantly higher levels of FDI, there is ment a major fiscal adjustment, if sustained, should indeed more that Turkey could and should do on help to achieve lower inflation and macroeconomic the policy side--subject to WTO and EU customs stability. The introduction of inflation accounting union constraints. Indeed, Turkey has negotiated will no doubt be a welcome interim measure for local investment agreements with 79 countries and and foreign investors alike. Besides macroeconomic signed 66 of these agreements, and it has signed uncertainty, specific infrastructure-related weak- "double taxation agreements" with 49 countries. It nesses also continue to diminish Turkey's attractive- also has taken part in the WTO negotiations for an ness to investors. Although Turkey benefits from its international investment agreement, and it has skilled, adaptable, and entrepreneurial work force, participated in FDI-related issues in platforms such and communications and transport do not appear to as UNCTAD, OECD, WTO, and the European be major problem areas, it lags behind in its energy Commission. However, a comparison of Turkey's infrastructure, its level of computerization, and potential with its actual levels of FDI inflows the availability of credit for the private sector. suggests that the policies implemented to date need Turkey's recently passed electricity and natural gas Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 291 framework laws,to the extent that they are effectively boards should yield more rapid pro-competitive implemented,should spur significant improvements outcomes. in line with Turkey's underlying endowments in the The EU accession process itself should provide energy area. Successful implementation of the Turkey with significant benefits in the way of FDI adjustment program will ensure that more funds inflows by helping to ease further the rule of law will be channeled to the private sector,rather than be and competition constraints. The expected EU used to fund the huge public sector deficit, at low decision to begin negotiations on full membership real interest rates. for Turkey will be crucial to finally convincing Perhaps the most important contribution of this larger numbers of foreign investors to invest in chapter is its examination of the standing rule of Turkey. Finally, in addition to aligning Turkey's law and competition-related impediments to investment climate more closely with that of the investment through three detailed case studies EU, Turkey also should follow a more proactive from the primary, secondary (manufacturing), and approach by implementing more specific FDI poli- tertiary (services) sectors. Based on these studies, cies and by undertaking active promotion. we argue that the main unaddressed obstacles to increased FDI in Turkey are governance and institutions-related problems related to the rule of Annex: Functions of an Investment Promotion Agency law and competition. The most important legal and judicial constraints are the insufficient clarity of The groupings of the different functions of an IPA and lack of respect for the rule of law. In each of the can differ for developed and developing countries analyzed cases, the government as rulemaker has or from one country to another. The four-part failed to address the underlying legal ambiguities in grouping proposed by Wells and Wint (2001) and a timely fashion, raising the question of whether used for the studies carried out for the Turkish IPA lack of clarity in the underlying rule of law is inten- is described in this annex. tional in order to give public decisionmakers the Image building is the function of creating the per- degrees of freedom needed to grant special treat- ception of a country that is an attractive site for ment and exemptions whenever politically conven- international investment.Activities commonly asso- ient. Unfortunately for the country as a whole, the ciated with image building include focused advertis- resulting unpredictability has resulted in substantial ing, public relations events, and the generation of forgone current and future investments. Competi- favorable news stories by cultivating journalists. tion constraints, in turn, are related to the absence Investor servicing and facilitation refer to the of a level playing field for all companies. In two of range of services provided in a host country that the cases examined, the failure of the relevant regu- can help an investor to analyze investment deci- latory body to rapidly enforce a pro-competitive sions, establish a business, and maintain it in good ruling also has sent negative signals for future standing. Activities in this area include the provi- investments. sion of information, one-stop shopping services As for future policy priorities, we argue that pre- aimed at expediting approval processes, and dictable and uniform implementation of existing various forms of assistance in obtaining access to and new legislation is of utmost importance. In the sites and utilities. legal and judicial area, reforms should focus on Generating investment entails targeting specific removing legal ambiguities by addressing all pri- sectors and companies with a view toward creat- vate sector laws and their implementing regulations ing investment leads. Activities include identifying that are in contradiction or are not sufficiently potential sectors and investors and undertaking clearly defined. In the competition area, it is in direct mailings, telephone campaigns, investor Turkey's interest to empower the Competition Board forums and seminars, and individual presentations to apply competition rules to all public undertak- to targeted investors. These activities can be carried ings, aligning its competition law to Article 86 of the out both at home and overseas. Treaty of Rome and its state aids system to that of Policy advocacy consists of the activities through the EU. Improved coordination between the Com- which the agency supports initiatives to improve petition Board and other independent regulatory the quality of the investment climate and identifies 292 Turkey: Economic Reform and Accession to the European Union the views of the private sector on each relevant investors face in entering the domestic market without an topic. Activities include surveys of the private insider on board. This argument is strengthened by the fact that the other two multinational corporations (MNCs) retained their sector, participation in task forces, policy and legal local partners, because they continued to target the local market. proposals, and lobbying. Anadolu Isuzu focuses on light trucks and midibuses and mainly The emphasis of the IPA facility depends on the targets the local market. Hyundai Assan also sells half of its pro- duction to the local market. purpose of the FDI policy; how much promotion is 9. It is known that as part of the final communications prior . needed depends on the kind of FDI to be attracted to the bid, Is¸-TIM received a verbal promise from the Ministry of and the basic attractions of the host country. A Tranport about roaming privileges. 10. Among the 44 countries included in the World Values large and dynamic economy promotes itself less Survey of 1989­90, Turkey ranks the lowest, with less than than a small one. The bulk of the massive inflows of 10 percent of its population believing that most fellow human FDI to China were not the result of active FDI pro- beings are trustworthy. See Kalaycioglu (2001). motion. And promotion can only go so far. If the 11. The customs union agreement does not send as strong a signal to investors as the prospects of full EU membership, economic base is weak and unstable, no amount of because it entails only market integration, without ensuring the persuasion can attract large and sustained FDI deeper political, social, and legal transformations that would flows (UNCTAD 2003). bring greater comfort to investors. 12. The key functions of a well-designed IPA are summa- Of the main investment promotion functions rized in the annex to this chapter. that all countries consider, image building and investor servicing and facilitation are typically the ones best left entirely to the separate public-private References IPA. Arol, Ali Ihsan. 2002."Current Status of FDI and Environmental Issues in Mining in Turkey." Paper presented at the OECD Global Forum on FDI and the Environment, February. Notes Blomström, Magnus, and Ari Kokko. 1998. "Multinational Cor- porations and Spillovers." Journal of Economic Surveys 12 1. All dollar amounts are U.S. dollars unless otherwise (2): 1­31. indicated. Borensztein, Eduardo, Jose De Gregorio, and Jong-Wha Lee. 2. This analysis is based on plant-level data collected by the 1998."How Does Foreign Direct Investment Affect Economic Turkish State Institute of Statistics (SIS) through annual manu- Growth?" Journal of International Economics 45:115­35. facturing surveys. However, the data have limitations. They cover Ekdi, Baris¸, Ebru Öztürk, H. Hüseyin Ünlü, Kürs¸at Ünlüsoy, and . only a small portion of the FDI companies active in the Turkish Serpil Çinaroglu. 2002. "Rekabet Kurallari Ile Uyumlu economy, and so reflect only a subset of manufacturing-related Olmayan Mevzuat Listesi" [A List of Regulations Contra- FDI.Although the records of the Undersecretariat of the Treasury dicting the Rules of Competition]. Rekabet Dergisi [The indicate that 581 FDI companies were active in the Turkish Competition Journal] 9 (March). manufacturing sector in 1991, increasing to 922 by 1996, the SIS European Commission. 2002. "Regular Report on Turkey's manufacturing survey includes only 210 plants, increasing to 273 Accession." COM 2002, 700 final, Brussels. plants by 1996, as partially or fully owned by foreigners. --------. 2003. "Council Decision on Accession Partnership 3. Variables used to control for other characteristics that with Turkey." COM 2003, Brussels. could affect productivity include firm size as measured by FIAS (Foreign Investment Advisory Service). 2001. Turkey: A employment, imported license use, percent share of output Diagnostic Study of the FDI Environment. Washington, DC: exported, imported machinery and equipment use, whether the FIAS, February. firm is incorporated, subcontracted input use and subcon- Gruben, William C., and Darryl McLeod. 1998. "Capital Flows, tracted output sale, measures of agglomeration at the provincial Savings, and Growth in the 1990s." Quarterly Review of Eco- level, and share of skilled production workers. nomics and Finance 38 (fall). 4. For a detailed description of this trend worldwide, see IMD (Institute of Management Development). 2002. World UNCTAD (2000). Competitiveness Yearbook 2002. Geneva: IMD. 5. For this definition, see Stern (2002). Kalaycioglu, Ersin. 2001. "Turkish Democracy: Patronage versus 6. Many of these measures are based on surveys, which in Governance." Turkish Studies 2 (spring): 54­70. this context are arguably the most appropriate measures, Morisset, Jacques. 2003. "Does a Country Need a Promotion because they reflect the perceptions of actual investors. In 2002, Agency to Attract Foreign Direct Investment?" Policy 3,532 executives responded to the World Competitiveness sur- Research Working Paper 3028, World Bank, Washington, vey, which gauges widespread business knowledge about each D.C., April. country and cross-country international experience. OECD (Organisation for Economic Co-operation and Develop- 7. Other producers were, however, active in the domestic ment). 1996. OECD Benchmark Definition of FDI, 3d ed. market. The four listed had the largest market presence in the Paris: OECD. automotive industry at the time. --------. 2003 Foreign Direct Investment Statistics: How Coun- 8. Of these four, Honda and Toyota became the sole owners tries Measure FDI. Paris: OECD. of their production units once they decided to direct their pro- Özatay, Fatih, and Guven Sak. 2002. "The 2000­2001 Financial duction toward the European rather than the domestic market. Crisis in Turkey." Central Bank of the Republic of Turkey This situation is an example of the difficulty that foreign and Ankara University. Turkey's Foreign Direct Investment Challenges: Competition, the Rule of Law, and EU Accession 293 Stern, Nicholas. 2002. "Dynamic Development: Innovation and Yilmaz, Kamil, and S¸ule Özler. 2004. "Foreign Direct Invest- Inclusion." Munich Lectures in Economics, Ludwig Maxim- ment and Productivity Spillovers: Identifying Linkages ilian University, Munich, November 19. through Product-based Measures." Koç University, Istanbul, UNCTAD (United Nations Conference on Trade and Develop- Mimeograph. ment). 2000. World Investment Report: Cross-Border Mergers Yilmaz, Kamil, Cevdet Akçay, and Emre Alper. 2002. Enflasyon ve and Acquisitions and Development. New York: United Nations. Büyüme Dinamikleri: Gelis¸mekte Olan Ülke Deneyimleri --------. 2003. World Investment Report: FDI Policies for Devel- Is¸iginda Türkiye Analizi [Inflation and Growth Dynamics: An opment: National and International Perspectives. New York: Analysis of Turkey in the Light of Developing Country Experi- United Nations. ences]. TUSIAD (Turkish Industrialists' and Businessmen's --------. World Investment Directory: Country Profiles. Accessi- Association) Publication (December). ble at www.unctad.org. Zhang, Kevin H. 1999. "FDI and Economic Growth: Evidence Wells, Louis T., Jr., and Alvin G. Wint. 2001."Marketing a Coun- from 10 East Asian Economies." Economia Internationale try: Promotion as a Tool for Attracting Foreign Investment." (November). Occasional Paper 13, Foreign Investment Advisory Service (FIAS), Washington, D.C. 11 Turkey on the Path to EU Accession: The Environmental Acquis Anil Markandya In December 1999, the European Council con- 15 years. Thus, the period of investment to meet the firmed that Turkey is a candidate state destined to required standards is long, and the fiscal implica- join the European Union (EU) on the basis of the tions of accession depend significantly on the terms same criteria applied to the other candidate states.1 of derogation. The fiscal impacts are also sensitive A precondition of membership is that candidate to which parties undertake the investments--the countries must align their national laws, rules, and greater the share that can be borne by the private procedures, including those relevant to the envi- sector, the less the fiscal burden--and to how much ronmental sector, with those of the EU in order to funding can be obtained from EU sources. give effect to the entire body of law contained in the This chapter looks at the likely costs to Turkey of acquis communautaire. In October 2004, the Euro- meeting the environmental acquis, with special pean Commission recommended opening acces- focus on the costs to the public sector. Fortunately, sion talks with Turkey, which gives even more considerable data are available from the latest impetus to the alignment process. group of accession countries, and particularly from This process, also known as the approximation large ones such as Poland, which has already met process, requires that (1) all relevant EU require- part of the EU's environmental requirements and ments be transposed into legal legislation (legal has prepared detailed plans to 2017 for the rest. transposition), (2) the appropriate institutional These countries' experiences also are good guides structures with sufficient budgets be established in to approximating how much support can be order to administer the national legislation (practi- obtained from EU funds. cal implementation), and (3) the necessary controls The chapter is structured as follows. The first and penalties be put in place to ensure full compli- section reviews the estimates from previous studies ance with the laws (enforcement). Most of these of the costs of EU membership for Turkey and steps have to be undertaken prior to membership other countries, and on this basis some "best guess" in the EU. At the same time, public and private estimates of meeting the environmental acquis are sector entities in Turkey will have to undertake a derived for Turkey. An important factor in making significant investment program to meet the EU such estimates is that these costs depend on the requirements for environmental protection and policies pursued, and the breakdown of the costs provision of environmental services. This program between the public and private sectors depends on typically begins in earnest about three to four years the extent to which key water and energy services prior to membership, and continues for up to are provided by the private sector. 295 296 Turkey: Economic Reform and Accession to the European Union The second and third sections discuss how the · Further detailed studies undertaken by the 10 total costs of compliance with the environmental countries that joined the EU in 2004. Of these, acquis can be kept to a minimum and how the bur- the estimates for Poland are given in table 11.1. den on the state and local budgets can be reduced. · Estimates for Turkey undertaken by Carl Bro The fourth section gives a more detailed break- International as part of the EU-MEDA (Euro- down of costs based on three scenarios: (1) a base Mediterranean Partnership) funded initiative case in which no special reforms are made and the (Carl Bro International 2002).3 public sector remains much as it is today; (2) a medium reform case in which the private sector's The data from these disparate sources are sum- share of the costs of compliance with the acquis is marized in table 11.1, presented as costs per capita. increased modestly and in which reforms in pricing The following observations are worth noting: reduce the demand for some of the cleanup serv- ices; and (3) a high reform, or fast reform, case in · The range of estimates in the earlier studies (EDC which the private sector's role is somewhat greater, 1997) was quite wide in per capita terms. The and in which the reforms discussed in the first sec- highest estimates were five to 10 times higher tion are implemented more vigorously. than the lowest estimates. This situation arises in The fifth section compares the cost estimates part from the fact that national programs to with some benefit estimates--that is, the possible comply with the acquis have a "fixed-cost" ele- gains from implementation of the environmental ment, so smaller countries tend to have higher directives in terms of, among other things, reduced costs, and in part from the fact that countries health problems, increased recreational use of the have different gaps to fill in meeting the direc- natural environment, and less damage to ecosys- tives. The average per capita cost is about 1,260, tems. This comparison will reveal where the case but the range is from 580 to 3,600. for spending is strongest and where a case can be · The estimates from more recent studies are not made for delaying the investments on the grounds notably lower than the earlier estimates. For that the benefits are considerably less than the costs. example, the estimate for Poland in the study The sixth section presents a more detailed, noted earlier was 988, while the estimate in the short-term assessment of the three scenarios pre- national calculations of costs was about 1,170. sented earlier, as well as a time profile of invest- Part of the reason for the increase is the addition ments by sector that covers the first six years of the of the Integrated Pollution Prevention and Con- program. As noted, the first three to four years of trol (IPPC), nitrate, and other directives, which the program to comply with the environmental were not covered in the first round of studies. acquis are typically implemented prior to member- After these are removed, the estimate for Poland ship. These investment needs are compared with in the national study is 878 versus 988, or a current environmental spending and with the cur- reduction of about 11 percent. rent budgetary resources available. The final sec- · For Turkey, the figures in the Carl Bro study tion looks at what mechanisms can be developed were considerably lower. This difference reflects to mobilize more public sector financing for the in part the different situation in Turkey with environment. respect to some directives. For example, the water supply directive will cost less in Turkey, because it mandates only an increase in quality Estimated Costs of the Environmental for those who are already connected to a piped Acquis: Turkey and Other water system; it does not require an increase in Accession Countries connections. Because in Turkey only 35 percent Estimates of the capital costs of the environmental of the population is connected to piped water, acquis have been made in the following studies: the per capita costs of meeting the directive across the whole population are lower. The Carl · Those undertaken as part of the first assessment Bro study did not cover all directives, however. of the costs for 10 potential candidate countries2 The notes to table 11.1 indicate which directives (Ifo Institute 1994; EDC 1997). were not covered by the Carl Bro study. In those TABLE 11.1 Comparison of Environmental Costs of EU Accession for Turkey and Other Candidate Countries (euros per capita in 2001 prices) Turkey, Turkey, Turkey, Turkey, Range State Turkey, Total Total Total Poland, Mid-value Nonstate Low Mid-value High Mid-value CEEC10 Minimum Maximum Water supplya 12.0 0 9.0 12.0 15.0 41.5 187.4 32.7 385.2 Wastewaterb 212.1 0 159.1 212.1 265.2 217.1 354.9 117.6 1085.0 Airc 83.9 49.4 100.0 133.3 166.6 294.0 508.1 297.2 1240.1 Wasted 25.1 74.4 74.6 99.4 124.3 325.4 210.1 132.7 854.9 IPPCe 5.8 47.3 39.8 53.1 66.4 184.7 -- -- -- Nitratesf 44.1 16.3 45.3 60.5 103.4 103.4 -- -- -- Otherg 5.1 0.9 4.5 6.0 7.5 7.7 -- -- -- Total 432.3 576.4 748.2 1173.8 1260.6 580.1 3565.3 -- Not available. Note: Low and high values for Turkey are, respectively, 25 percent lower and 25 percent higher than the mid-values. a. Water supply estimate is based on Carl Bro study for Turkey. It is lower in per capita terms than those of other countries because only 35 percent of the population is connected to the water supply. b. Wastewater estimate is based on Carl Bro study for Turkey. Directive 76/464 is excluded. Estimate is taken from data on Poland. c. Carl Bro estimate is taken for electricity large combustion plants (LCPs). Not included are other LCPs, directive 98/70 on quality of petrol, directive 99/32 on sulfur content of liquid fuels, directive 94/63 on volatile organic compounds (VOCs) from gas stations, and directive 94/67. Estimates for directives not included are minimum estimates from studies of Poland. d. Caro Bro estimates are not specifically based on assessment of directives but on an earlier World Bank/METAP (Mediterranean Environmental Technical Assistance Program) study that was undertaken in the context of EU directives. Directives 96/59 on PCBs, 94/62 on packaging waste, and 75/439 on oil waste disposal are excluded. Estimates for these are taken from Poland and the Baltic states. Estimate is likely to be at lower end. e. Carl Bro looked at only a limited number of public enterprises. Most of the expenditure will be in the private sector. Private sector estimates are based on data on Poland. f. Because no nitrate estimates are available for Turkey, detailed estimates for Poland are used. g. "Other" includes Directives 97/403 (nuclear safety) and 2000/53 (end of life vehicles). Sources: Various--see text. 297 298 Turkey: Economic Reform and Accession to the European Union instances, the estimates were based on previous important for Turkey is to prepare detailed plans, studies (mainly Poland, because that study had covering periods of three to six years, that ensure the best and most comprehensive data). compliance with the agreements arrived at under · Based on the data from the Carl Bro study, the the environmental chapter and to do so in a way cost of the environmental directives for Turkey that minimizes the costs and ensures that the under- is between 432 and 748 per capita for the lying financing arrangements are sustainable. 2000 population of 65.3 million. The range is Indeed, although the acquis communautaire is pre- based on a middle value calculated from the esti- scriptive on environmental standards, it leaves con- mates provided, a lower value that is 25 percent siderable latitude on how to meet them. The price of lower, and a higher value that is 25 percent complying varies accordingly. higher. This range represents the extent to which Savings in investment costs can be achieved in costs can be reduced, depending on adoption of several ways5: the appropriate policies, or raised in the absence of a shift to more efficient delivery systems for · By following a least-cost investment plan, espe- environmental services. It is based on previous cially in energy-related investments. This plan studies that have looked at the scope for reduc- can, in turn, be promoted by the use of economic ing costs. Note that the lower end of the cost instruments such as bubbles and permit trading. range is from the studies for the 11 Central and · By increasing the efficiency with which munici- Eastern European (CEE) countries. palities make investment decisions. Opening up procurement to international tender and under- What do these per capita figures imply for taking careful project appraisal in evaluating the total costs? The total amount is between 28 billion design of schemes will reduce costs significantly. and 49 billion--an enormous sum. But the outlay · By designing investments to take account of the is over some 17 years, so the annual amount is more lower demand for some services when future manageable. As noted later in this chapter, annual service charges will have to recover capital and investments amount to about 2 billion to 3 bil- operating costs. The World Bank has had stark lion for the high reform, or fast reform, case (i.e., experience with such lower demand in the low-cost case) and 3 billion to 5 billion for the wastewater projects it has funded in the Baltic base case entailing slow reform (i.e., high-cost case). states. The level of capacity is turning out to be In the initial years, these investments would amount substantially in excess of demand as a result of to 1­1.5 percent of GDP in the low-cost case and the large increase in volume-based charges (see 1.5­2.5 percent in the high-cost case. In addition, box 11.1). extra annual operating costs would be incurred, · By allowing for the fact that new investments are which are difficult to estimate for the early years likely to reduce total operating costs, because but would eventually be on the order of 80 billion the operation and maintenance costs of new to 120 billion per capita or 5 billion to 8 billion. equipment will be lower than those of the To put these figures in perspective, the Organisation equipment it replaces. This gain has not been for Economic Co-operation and Development fully accounted for in the current cost figures (OECD) estimated Turkey's capital spending on the presented earlier. environment in 1999 to be about $US1 billion, or · By taking into account that the present value of 0.5 percent of its GDP.4 At the very least, this spend- total costs will fall if the more expensive items ing would have to double, or more likely increase by are scheduled later in time. This approach would a factor of three or four once the EU accession pro- be all the more justifiable when the ensuing ben- gram was initiated. In addition, a much higher level efits are comparatively low. of current spending would be required. · By accounting for the fact that environmental mitigation costs may not expand at the same pace as income. With growth and convergence, How to Reduce the Total countries should therefore be better able to meet Investment Costs the acquis. The demand for services such as The total cost figure is useful only to get some energy and transport and the related costs are idea of the overall size of the task. What is more likely to rise in tandem, but the demand for Turkey on the Path to EU Accession: The Environmental Acquis 299 BOX 11.1 The Experience of the World Bank with Water Utilities in the Baltic States The World Bank has provided financing for five · Water quality problems in potable water water and wastewater projects in the Baltics: one networks. in Estonia, two in Latvia, and two in Lithuania, at The central lesson learned is that, while draft- a total cost of US$134 million. The upgraded ing financial and economic forecasts, the project plants are now in operation. The wastewater teams should be conservative in their assump- plants meet Helsinki Commission standards tions of the critical variables that have the great- (HELCOM protects the Baltic marine environ- est impact on revenues and costs. These fore- ment as mandated under the Helsinki Conven- casts tend to be too optimistic, and in the long tion), and the drinking water plant also meets run the projects are likely to experience lower the highest standards. Although the projects than anticipated economic and financial rates of have met many criteria, one of the most serious return. Project appraisal should ensure that the problems has been the drop in demand for assumptions are realistic and that contingency water and in the generation of wastewater. The plans are drawn for coping with deviations from projects were planned under the assumption the most likely outcomes. The range of possible that demand would stabilize at a moderate level outcomes, with their respective probabilities, of consumption similar to that in other compa- although subjective, should be listed in the rable countries. Yet such consumption has not appraisal document. materialized, and the actual level has been as Price escalations also tend to be greater than much as 50 percent lower than anticipated. This expected (in real terms) because of the elimina- extreme decline in demand has led to: tion of existing market distortions and price dis- · Overdimensioning of systems (i.e., making equilibria that were present in the economies them larger than required) during the early transition process. This situation · Overinvestment in systems is another important reason for the dramatic · Higher than optional operations and mainte- reduction in water sales. Tariffs have had to nance costs increase more than anticipated. services such as water may not increase propor- budget to match the EU accession funds available tionately. The resulting increase in total costs under the Pre-Accession Structural Instrument may therefore be substantially less than the (ISPA), PHARE, and the Special Accession Pro- growth in national income. gramme for Agriculture and Rural Development · By relaxing statutory standards (particularly for (SAPARD). Indeed, the slow rate of development of water treatment), if it can be shown (1) that the projects for such funding can be partly attributed investment is seriously uneconomical (e.g., if to this factor (as well as to the lack of administra- the community served will decline dramatically tive capacity to implement the acquis). in the next few years) and (2) that the savings in The problem that many countries are having in costs that can be achieved by reducing the meeting the local cost share of investments is attainment level by a small percentage will allow unlikely to be solved merely by increasing the allo- more plants to be built, thereby making a higher cation from the public budget for the environment. overall contribution to meeting the ambient envi- Other solutions also must be found. ronmental goals.6 The scope for moving some items out of the public budget is quite large.7 As for investment in the manufacturing sector, the more of the sector Reducing the Share of Costs Borne that is privatized, the less will be the burden of the by the Public Sector acquis on the public budget. Experience has shown Although some CEE countries have now concluded that successful privatization of some of the larger the environmental chapter of the negotiations, it is and more polluting industries requires a clear fair to say that they have not fully established how understanding of the liability for past environmen- these investments will be funded. Indeed, the front- tal damages through an internationally acceptable line CEE countries have ongoing concerns about audit, accompanied by a legal agreement with the the availability of co-financing from the national government on the new owner's responsibility for 300 Turkey: Economic Reform and Accession to the European Union cleanup. If internationally credible investors are to practices prevail (and they are still quite common), be attracted to bidding for such enterprises, these the institutional mechanism of commercialization issues have to be addressed. Furthermore, the state's for taking environmental costs off budget will still responsibilities have to be backed by a credible pro- leave some budgetary burden. gram of investment in remediation. Otherwise, the The commercialization of utilities has, however, uncertainty of the private party will result in a fail- opened the door to their raising charges for their ure to bid, or in an offer that reflects the increased services to a level that at least recovers the costs of risk. This situation illustrates one in which it may the new investments. The higher charges will result pay for the state to undertake investment in reme- in reduced levels of demand, thus saving the budget diation with a view toward making the privatiza- the cost of the subsidies the utilities receive for tion effort more successful and generating higher ongoing operations. The same increase in charges revenues from the sale of state assets. will also reduce the size of the investment needed The same is true to a large extent of public utili- (box 11.1).9 Another way in which commercializa- ties and infrastructure. A Czech study has shown tion can save costs is through a rationalization of that as much as half of the big-ticket items could be provision, because many utilities are currently too shifted out of the public budget under certain small to make cost-effective investments or manage assumptions (World Bank 1999). To date, however, operations in an efficient manner. the detailed national plans for adoption of the acquis have paid limited attention to the role of the Breakdown of the Share of Investments private sector, and there has been mixed progress by Sector in Turkey on the ground. Hungary has transferred all power Based on the discussion in the two previous sec- generation to the private sector, Poland has moved tions, table 11.2 offers a more detailed description 9 of its 27 generation stations into private hands, and other countries have moved none.8 of the three scenarios--base case, medium reform, and high reform. The changes in parameter values Privatization is not, however, the only way of in the table are only rough estimates, based on sharing the burden of upgrading environmental judgments about the scope for reform and the standards. Another is to commercialize the enter- potential impacts it would have. Nevertheless, they prises even when they are nominally state-owned offer a useful guide to what can be expected if the and to raise the financing for the investment reforms are made as indicated. The resulting costs through commercial loans. This strategy is being for the state and nonstate sectors are shown in followed widely in many of the candidate coun- table 11.3, which shows state expenditures ranging tries. It was successfully adopted, for example, by from 32 billion in the base case to 15 billion in Poland in the power generation sector. When the high reform case, a fall of 52 percent. Of this Poland privatized nine generation stations, the fall, 42 percent can be attributed to cost savings in financing for investing in pollution control equip- general from the reforms and 10 percent to the ment came from commercial loans, backed by increased share of the private sector in providing power purchasing agreements between the com- the environmental services. The biggest shift arises mercialized generating units and the state electric- for the water supply and wastewater sector, fol- ity authority. The same strategy has been adopted lowed by the waste sector. In the base case, the share in municipalities dealing with water supply and of state expenditures is 65 percent, and in the high wastewater in various countries, including the reform case it is 54 percent. In the medium reform Baltic states. Although it is successful in taking the case, it is 59 percent. direct investment cost off the budget, this approach suffers from the problem that the borrowing is invariably guaranteed by the government and Comparing the Costs and Benefits of the Environmental Directives therefore forms part of the consolidated national debt. There is also the issue in such cases of subsi- In comparing the costs and benefits of the environ- dies to these enterprises, through working capital mentaldirectives,onecan,fortunately,relyonastudy and loans from state-owned banks, being given at undertaken by the European Commission, which below commercial rates. To the extent that these made initial estimates of these benefits (ECD 1997). Turkey on the Path to EU Accession: The Environmental Acquis 301 TABLE 11.2 Scenarios for Implementation of Environmental Investments for the Acquis Scenario Policy Base Case Medium Reform High Reform Pricing of utilities' Slow progress toward Moderate progress Rapid progress to services cost recovery in water toward full-cost full-cost recovery and waste sectors. recovery and some and volume-based volume-based pricing. pricing. Use of market-based Existing charges on Existing charge levels Existing and new instruments effluent continue and raised and new instruments new charges on carbon; charges introduced introduced rapidly, some products more rapidly at with rates that introduced slowly higher rates. have incentive at low rates. effects. Private sector Virtually no participation Moderate participa- Substantial participa- participation in of private sector in tion, with tion, with water sector delivery of services. investment going investment going up to 10% of total. up to 20% of total. Private sector Virtually no participation Moderate participa- Substantial participa- in waste of private sector in tion, with tion, with management delivery of services. investment going investment going up to 20% of total; up to 30% of total some recycling and significant programs effective. recycling programs. Reforms in energy Current ownership of Private sector takes Private sector takes sector energy sector over up to 20% of over up to 30% of enterprises implies plants needing to plants needing to about 37% of all respond to LPC; respond to LPC; expenditures will be in reforms introduce reforms introduce the nonstate sector; all more renewable more renewable large plant combustion sources and sources and (LPC) investments in increase efficiency. increase efficiency public sector. faster. Reforms in Current estimate is based In both of these cases, the share of private industrial sectors on 90% of expendi- sector investment under the Integrated tures being undertaken Pollution Prevention and Control (IPPC) by private sector. goes up to 95%. Source: The author. The study explored the benefits of compliance in diseases are avoided (also known as "quantitative three steps: benefits")? · Value of benefits. What is the economic value of · Type of benefits. What types of benefits arise the avoided costs--for example, how much from implementing the acquis, and what are would the reduced emissions and damages some examples of these benefits in the candidate avoided by implementing EU directives be countries--for example, health impacts or worth (also known as "monetarized benefits" and impacts on agriculture, buildings (also known as given in millions of euros)? "qualitative benefits")? · Extent of benefits. What is the extent of the The types of benefits included in the study are benefits--that is, how much are emissions summarized in table 11.4.10 The monetary value of reduced and how many cases of respiratory the benefits was estimated using a large body of 302 Turkey: Economic Reform and Accession to the European Union TABLE 11.3 Environmental Accession Costs for Turkey (millions of euros, in 2001 prices) State Nonstate Total Base case Water supply 976 0 976 Wastewater 17,315 0 17,315 Air 6,848 4,031 10,879 Waste 2,046 6,071 8,117 IPPC 474 3,860 4,334 Nitrates 3,603 1,333 6,749 Other 420 70 490 Total 31,682 15,365 48,860 Medium reform Water supply 703 78 781 Wastewater 12,467 1,385 13,852 Air 4,382 4,320 8,703 Waste 1,309 5,184 6,493 IPPC 270 3,197 3,467 Nitrates 2,882 1,066 3,948 Other 336 56 392 Total 22,350 15,287 37,637 High reform Water supply 469 117 586 Wastewater 8,311 2,078 10,389 Air 2,876 3,651 6,527 Waste 859 4,011 4,870 IPPC 205 2,395 2,600 Nitrates 2,162 800 2,961 Other 252 42 294 Total 15,134 13,094 28,228 Sources: Author's calculations. TABLE 11.4 Types of Benefits of Compliance with Directives, Estimated for Candidate Countries Type of Benefit Air Drinking Water Wastewater Solid Waste Health benefits Avoided Household access Reduced risk of None respiratory to cleaner poisoning and assessed illnesses and drinking water accidents due to premature methane leakage from deaths landfills Resource Avoided Cleaner bathing Reduced input of None benefits damage to water and primary material assessed buildings and cleaner water crops for companies Ecosystems Avoided global Improved river Avoided global Protected warming from water quality warming from areas and CO2 emissions methane emissions species Source: ECOTEC and others 2001. Turkey on the Path to EU Accession: The Environmental Acquis 303 TABLE 11.5 Estimated Benefits for Turkey from Compliance with Environmental Directives (millions of 2001 euros) Directives Relating to Present Value of Costs Present Value of Benefits Water supply 586­976 1,500­26,050 Wastewater 10,400­17,300 7,140 Air 6,500­10,900 > 21,000 Waste 4,900­8,100 800­18,000 Source: ECOTEC and others 2001 and this study. Both benefits and costs are discounted at 4 percent in real terms. past and ongoing research on economic valuation. approximation, ensuring that the national legal The results of the estimation for Turkey are given in framework is consistent with the EU legislation. table 11.5, where the benefits are compared with Next in priority is the institutional strengthening of the cost figures in table 11.3. The exercise is only supervisory bodies and environmental agencies. All possible for a few areas: air, drinking water, waste- this is expected to be completed before accession. water, and solid waste. The investment program necessary for compliance Although the data on benefits are subject to con- for those joining in 2004 has a completion date of siderable uncertainties, table 11.5 nevertheless 2015, with interim targets for key directives. For reveals some useful findings. First, investments in example, Lithuania must comply with the directive water supply and reductions in air pollution are on the sulfur content of petrol and diesel by 2005, amply justified in terms of benefits, even taking the the large urban wastewater directive by 2010, and upper end of the costs and the lower end of the so on (Republic of Lithuania 2001). The Baltic benefits. Second, investments in wastewater are not states, Poland, and the other 2004 accession candi- justifiable given the measurable benefits. This does dates commended their investment programs in not mean that all individual projects for building 1999/2000 (see World Bank 2002, 2003). wastewater treatment have negative net benefits; Taking the cue from these countries, Turkey some almost certainly will be of high priority. But it would have to start its program in earnest three to does mean that as a program, with a time profile for four years before entry and negotiate the deroga- investments more or less like the one in the 2004 tion of the items that have a high cost but that gen- candidate countries, the net benefits are likely to be erate have relatively modest benefits, following the negative. Because these results are based on Euro- analysis presented in the previous section. pean Commission­supported data, they should The time profile that the present accession prove useful in arguing for derogation for a large countries have negotiated indicates the costs of part of the wastewater treatment directives. Third, accession in the first six years of the program. for solid waste the question of whether benefits Table 11.6 was derived from this profile (giving exceed costs is unresolved; it depends on where the the share of total costs in the first six years and the benefits lie in the range that has upper values share of the six-year total by year) and from the 20 times the lower values.11 total estimated costs for Turkey. The table also includes estimates of the external funding agreed to for this period. It is reported separately and is The Medium Reform Scenario assumed to reduce the part of state expenditure for EU Accession for Turkey that has to be financed from domestic sources. Those countries that have closed the environmental The table reveals an important point, that funds chapter have committed themselves to comply- such as ISPA and SAPARD will provide only between ing with the acquis by the agreed-on dates. The 25 percent and 30 percent of the "state" spending-- highest priority in all cases is being given to legal that is, the"state from domestic"plus the"state from 304 Turkey: Economic Reform and Accession to the European Union TABLE 11.6 Costs of Accession for Turkey in First Six Years (millions of 2001 euros) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total Base case State 1,253 1,636 2,422 2,546 2,703 2,773 13,334 Domestic nonstate 1,215 1,317 1,560 1,656 1,728 1,712 9,187 External 474 617 822 853 910 938 4,613 Total 2,942 3,571 4,804 5,054 5,340 5,423 27,134 Medium reform State 807 1,055 1,561 1,641 1,742 1,787 8,593 Domestic nonstate 1,148 1,245 1,474 1,565 1,633 1,618 8,683 External 332 433 576 598 638 658 3,235 Total 2,288 2,732 3,611 3,804 4,013 4,063 20,511 High reform State 560 731 1,082 1,138 1,208 1,239 5,958 Domestic nonstate 962 1,043 1,235 1,311 1,368 1,355 7,275 External 221 288 383 397 424 437 2,150 Total 1,743 2,062 2,700 2,846 3,000 3,032 15,383 Source: Author's calculations. external." Thus the domestic state sources will have was for investment. Total spending was about to undertake a significant expenditure; in table 11.6 1 percent of government expenditure in 1997,but this expenditure increases from 1.2 billion in year it had fallen to 0.6 percent in 1999. 1 to 2.8 billion in year 6 under the base case and · Spending by municipalities amounted to 0.6 billion in year 1 to 1.2 billion in year 6 under 1,200 million in 1997 and 1,500 million in the high reform case. 1998. Of this, about 30­34 percent was for The differences between the base case and the investment. other cases depend on how much of the reform · Manufacturing sector environmental invest- actions can be undertaken prior to the actual start ments (available only for 1997) were only of the formal program. Without prejudging the 52 million. date of accession for Turkey, it is possible to say that · Investment by thermal power plants amounted a rapid program of reform over the next five years to 294 million in 1997, 61 million in 1998, would place it in a position in which the esti- and 104 million in 1999. mated state expenditures in table 11.6 could be · The total investment in all sectors amounted to considered realistic. If, however, reforms do not 2.2 billion or 1.4 percent of GDP. take place prior to the accession period, which If municipalities and thermal power plants are starts three to four years before the date of acces- included as part of public sector spending, the total sion, then the estimates under the reform scenarios amount of investment by the state sector amounted will be too low. to about 1 billion in 1997 and in 1998. The com- How do these estimates of environmental parison in table 11.6 of this figure with the required spending compare with current spending on the investment by the state sector reveals that, in fact, environment? Unfortunately, data are available the amounts needed in state investments are not only for the period 1997­99 and then, except for very different from the actual levels in 1997­98. 1997, not for all the categories--see table 11.7. The State investment, after accounting for EU funds, table shows that ranges from 0.6 billion to 1.3 billion in year 1, · Spending by government organizations was but rises sharply in the next six years (table 11.6). about 480 million in 1997, of which three- Although this comparison does not establish quarters was for investment.By 1999 the total had firmly that the actual investments in the environ- fallen to 420 million, of which only 55 percent ment were of the right amount to meet the first year Turkey on the Path to EU Accession: The Environmental Acquis 305 TABLE 11.7 Environmental Expenditures in Turkey, 1997­99 1997 1998 1999 1997 1998 1999 (TL billions) ( millions) Government organizations Current 20,898 35,941 85,401 121.3 123.1 191.2 Investment 62,602 115,342 105,989 363.5 395.0 237.2 As % of budget 1.0% 0.9% 0.6% 1.0% 0.9% 0.6% Municipalities Current 147,576 287,864 -- 856.9 985.8 -- Investment 62,542 148,269 -- 363.1 507.8 -- Manufacturing Current 11,499 -- -- 66.8 -- -- Investment 8,871 -- -- 51.5 -- -- Thermal power plants Current 26,913 4,455 -- 156.3 15.3 -- Investment 50,605 17,747 46,502 293.8 60.8 104.1 Total Current 206,886 -- -- 1201.2 -- -- Investment 184,620 -- -- 1071.9 -- -- As % of GDP 1.4% -- -- 1.4% -- -- -- Not available. Note: Data for 1998 are not confirmed. Sources: Turkish State Institute of Statistics and International Monetary Fund. TABLE 11. 8 Estimated Annual Spending on Monitoring and Enforcement, Turkey Expenses of Regulator Directive ( millions) Comments Integrated Pollution 2.2 Recoverable from industry on a Prevention and Control IPPC purchasing power parity (PPP) basis Air quality 19.6 Monitoring in 287 towns with more than 25,000 inhabitants Water quality 14.2 26 teams in each of 26 water basins Nitrates 2.2 4 teams, one for each affected catchment Conservation of habitats 0.9 Monitoring of habitats of wild birds and protection of animals used in experiments Total 39.1 Source: Carl Bro International 2001. of the EU accession investment program (the cover- much below what would be required. Table 11.6 gives age and priorities may not have been the same), it a figure of 1 billion to 1.2 billion for the first year, does suggest that if state investment spending could whereas actual spending for the one year for which be maintained at 1997­98 levels and if the external data are available (1997) was 52 million. funds are forthcoming, the amount will at least be Finally, an allowance also must be made for an enough to start the accession program. The big gap increase in the budgets needed for monitoring and appears to be in private sector spending, which is very compliance enforcement. Table 11.8 provides the 306 Turkey: Economic Reform and Accession to the European Union figures estimated by Carl Bro International for this scenarios that reflect different rates of reform and purpose, which amount to about 39 million a different rates of increase in the involvement of the year. This figure does not include an increase in the private sector in the provision of environmental analytical and management capacity of the Min- services. The resulting costs for the state sector istry of Environment, which has not been estimated range from 32 billion in the base case to 15 bil- but requires an increase in the ministerial staff of lion in the high reform case, a drop of 52 percent. about 20 percent. This drop is made up of 42 percent from cost sav- ings from the reforms and 10 percent from the increased share of the private sector in providing Conclusions the environmental services. This chapter has looked at the environmental The costs of accession can also be compared dimension of EU accession for Turkey. As a country with its potential benefits by drawing on a major now in accession talks with the EU, Turkey has European Commission study that included Turkey. actively begun to prepare for the approximation Although the data on the benefits of the water sup- process, and the environmental component is a ply, wastewater, air, and solid waste directives are major part of the process. The time period required subject to considerable uncertainties, the results for most of the approximation process is about reveal the following: three to four years before accession and 15 years after accession. Based on estimates of the invest- · Investments in water supply and a reduction in ment costs of accession made for other candidate air pollution are amply justified in terms of ben- countries and (partly) for Turkey, the total cost efits, even taking the upper end of the costs and comes out between 28 billion and 49 billion. the lower end of the benefits. This range looks frightening, but, spread over · Investments in wastewater are not justifiable 18­19 years, it amounts annually to 1­2.5 percent given the measurable benefits. This finding does of GDP for Turkey. This amount is more than the not mean that all individual projects for building country has been investing in the environmental wastewater treatment have negative net benefits; sector, which is about 0.5 percent of GDP. The some almost certainly will be of high priority. investment must come from various sources: the But it does mean that as a program, with a time state, municipalities, state enterprises, and the pri- profile for investments more or less like that in vate sector. The analysis shows that, whereas the the 2004 candidate countries, the net benefits are first three (which are consolidated into the state likely to be negative. Because these results are sector) have current investment at a level similar to based on European Commission­supported that required by the approximation, private sector data, they should prove useful in arguing for spending is woefully short. This situation implies derogation for a large part of the wastewater that the appropriate regulations will have to be put in treatment directives. place to ensure compliance by the private sector in · For solid waste, the issue of the program is unre- accordance with the agreement on investment solved; it depends on where the benefits lie in a reached with the EU. range in which the upper values are 20 times the The costs of the environmental acquis are not lower values. predetermined and depend on policy choices and reforms. This chapter has identified those actions This chapter has described a possible medium- that can, first, reduce the costs and, second, shift the term accession program for Turkey (i.e., covering costs from the state sectors to the private sector. the first six years). Based on the time profiles for Reducing costs will require a more careful assess- investment in the candidate countries, external ment of the least-cost options, better procurement funds such as ISPA and SAPARD will provide only in public spending, and better assessment of future between 25 and 30 percent of the "state" spending. demand as prices increase. The whole process of Thus domestic state sources will have to provide a commercialization and privatization has a major significant amount of the expenditure, which role to play in shifting costs from the state sectors to increases from 1.2 billion in year 1 to 2.8 billion the private sector. This chapter has provided three in year 6 under the base case and from 0.6 billion Turkey on the Path to EU Accession: The Environmental Acquis 307 in year 1 to 1.2 billion in year 6 under the high 8. A comprehensive status of privatization in the energy and utility sectors for the CEE countries does not appear to be avail- reform case. There is also an urgent need to able and is being prepared by the World Bank. increase the budget and resources available to the 9. The constraints on raising charges, however, are real and Ministry of Environment if the program is to be raise issues of affordability for the poorer customers. Most realized. An EU study has estimated this amount to countries adopt some lifeline rates to get around such a be about 39 million annually. situation, although adoption of the rates tends to be done in an ad hoc fashion and is not based on a careful assessment of a In summary, Turkey faces an enormous chal- structure that meets specified targets at least cost. lenge in meeting the environmental acquis, but not 10. The results from the exercise are reported as the net pres- ent value of benefits, discounted at a real rate of 4 percent. In one that is beyond its capabilities. By adhering to a actual practice, countries may use higher discount rates, if only vigorous reform program and adopting increased to ensure that they give priority to those investments that will incentives for the private sector to make the neces- yield earlier benefits for the populations. 11. Benefits from the waste directives arise largely from the sary investments, it should be able to achieve the landfill directive, which reduces methane emissions as well as goals in much the same way as the other candidate amounts of waste subject to disposal. The benefit range is so countries--by a combination of good manage- wide because the benefits depend on how much recycling takes ment, good luck, and a little help from its friends. place and how much incineration is carried out. The higher the recycling and the less the amount incinerated, the greater are the benefits. Notes References 1. The views in this paper are those of the author and do not necessarily reflect the official position of the World Bank. Adler, A., and others. 1994. Economic Costs and Legislation in 2. The countries are Bulgaria, the Czech Republic, Hungary, Western and Eastern Europe, Munich: Ifo Institute. Poland, Romania, the Slovak Republic, Slovenia, Estonia, Latvia, Carl Bro International. 2002. Analysis of Environmental Legisla- and Lithuania. tion in Turkey. Project Number LOHAN-23-MEDA/TUR/ 3. The estimates by Carl Bro International are undiscounted ENLARG/D4-01. European Commission: DG Enlargement, costs over the period of up to 18 years. In the figures presented Brussels. here, a real rate of 4 percent has been applied to a typical profile ECOTEC, IEEP, Metroeconomica, TME, and Candidate Counter of costs. For Turkey, this approach would imply a nominal rate Experts. 2001. The Benefits of Compliance with the Environ- today of about 35 percent. mental Acquis for the CEECs.Brussels:European Commission. 4. Details of the OECD estimate were not obtainable, but EDC (Environmental Development Consultants). 1997. Compli- earlier data confirm a similar figure for 1997 (see the final ance Costing for Approximation of EU Legislation in the section of this chapter). CEEC. European Commission: DG Environment, Brussels. 5. Total costs may also fall over time as manufacturers drop Hager, W. 2000. "Environmental Investment in the CEEC their prices for capital equipment in response to the larger level Preparing for Accession." World Bank, Washington, DC. (Ifo of production (Hager 2000). Institute 1994; EDC 1997). 6. The marginal costs of standards rise with the standards Republic of Lithuania. 2001. "National ISPA Strategy: Environ- themselves, and this observation holds true particularly in the ment Sector." Ministry of Environment, Vilnius. area of wastewater treatment. World Bank. 1999."Czech Republic: Towards EU Accession: Sum- 7. The increased level of private sector activity implies a mary Report."World Bank Country Study, Washington, DC. greater effort by the state to ensure compliance. This effort, in --------. 2002. "Expenditure Policies toward EU Accession." turn, requires investment in capital equipment for monitoring Technical Paper No. 533, Washington, DC. and testing, among other things. Funding for this can be --------. 2003. "Poland: Toward a Fiscal Framework for obtained from ISPA, if the demands can be bundled to meet the Growth." Report No. 25033-POL, Washington, DC. 5 million threshold. Part IV Implications of EU Accession for Turkey and the EU 309 12 Economic Implications of EU Accession for Turkey Sübidey Togan With accession to the European Union (EU), the gains to Turkey will amount to 1.1 percent of its Turkey will complete the harmonization of its tech- gross domestic product (GDP) per year. If liberaliz- nical regulations, liberalize entry and exit into vari- ing trade in industrial goods can affect the GDP, ous sectors of its economy, impose hard budget then there should be comparable gains from liber- constraints on all of its public and private enter- alizing agriculture and also services. prises, adopt the EU's Common Agricultural Policy (CAP), liberalize its trade with the EU in services, Agriculture and join the European single market. Furthermore, joining the EU will require Turkey to adopt and Because Togan, Bayener, and Nash thoroughly implement the whole body of EU legislation and study in chapter 2 of this volume the impact of EU standards--the acquis communautaire. According enlargement to Turkey on Turkey's agricultural to the EU membership criteria, new members must markets and incomes, this section only briefly sum- be able to demonstrate the "ability to take on the marizes the main points presented by the authors. obligations of membership including adherence to According to Togan and his colleagues, adoption of the aims of political, economic and monetary the CAP will lead to substantial changes in the agri- union." Thus Turkey is expected to adopt the euro cultural incomes of producers, the welfare levels of when it is ready to do so, but not immediately upon consumers, and the budget revenues of the govern- accession. ment. Because the prices for many major agricul- tural products in Turkey will have to be reduced at some point between now and accession, consumers Welfare Effects of Integration will derive great benefits. The authors estimate that, Any study of the effects of integration on the in the medium to long term, EU-like policies will Turkish economy must keep in mind that the cus- lead to a 1.87 percent increase in real household toms union in industrial goods between the EU and incomes in Turkey, which is equivalent to about Turkey was established in 1996 and that a period of 2.92 billion. Lower-income households (rural perhaps 10 years or more will precede full member- households) will experience an even more signifi- ship and Turkish participation in the internal mar- cant increase in real income. ket. Harrison, Rutherford, and Tarr (1997), who Yet adoption of the CAP will require substantial have calculated the impact of the customs union in adjustments on the part of Turkish farmers, and the industrial goods on Turkish welfare, estimate that effect on farmers' incomes will be driven mainly by 311 312 Turkey: Economic Reform and Accession to the European Union TABLE 12.1 Impact of Agenda 2000 Policies currency crisis. The cost of this crisis in terms of its (millions of euros) effect on the banking sector has been estimated at US$46 billion,1 or about 27­30 percent of the Effect on real income 2,916 Turkish GDP (the crisis and its effects are described Effect on agricultural value added in more detail by Pazarbas¸ioglu in chapter 6). After Direct payments equal to 2,145 the crisis, Turkey changed its legislative, regulatory, those applied in the EU Direct payments at 35 percent 341 and institutional framework. As of 2004, Turkish of payments granted in EU prudential requirements related to capital adequacy countries standards, loan classification and provisioning Effect on government budget -2,998 requirements, limits on large exposures, limits on connected lending, and requirements for liquidity Source: Chapter 2 of this volume. and market risk management were generally in conformity with those of the EU. The welfare effects of policies followed by the amount of CAP-like compensation payments Turkeyinthebankingsectorareilluminatedbycom- granted to farmers. Farmers' incomes will decrease paring a base case--the Turkish economy operat- considerably under Agenda 2000 policies without ing under the rules and regulations that prevailed direct payments and will increase under Agenda in the banking sector during the latter half of the 2000 policies with direct payments. Table 12.1 1990s--with a case in which Turkey adopts and shows that agricultural value added will increase by implements in the banking sector all of the rules 2.15 billion under Agenda 2000 policies with and regulations of the EU. direct payments equal to those applied in the EU The effects of the adoption of EU rules and regu- and by 0.34 billion under Agenda 2000 policies lations in the banking sector on the price of bank- with direct payments equal to 35 percent of pay- ing services are illuminated by a study by McGuire ments granted in the EU member countries. and Schuele (2000) in which they develop index The budgetary costs to Turkey of adopting EU- values of restrictiveness in financial services for sev- like agricultural policies will depend on whether eral countries. McGuire and Schuele, in extending Turkey receives compensation from the EU budget the work of McGuire (1998), base their analysis on for introducing these policies. If Turkey does not 1997 data and distinguish between prudential and receive any compensation from the EU budget, the nonprudential requirements. The authors note that cost will amount to 3 billion under Agenda 2000 prudential requirements aimed at ensuring the sta- policies with direct payments equal to those applied bility of the banking system by preserving solvency, in the EU and to 1.2 billion under Agenda 2000 limiting risks, and protecting bank deposits are, in policies with direct payments equal to 35 percent of general, similar across economies. Therefore, they payments granted in the EU member countries. abstract from consideration of prudential require- ments and concentrate on nonprudential require- ments. The index values of the nonprudential vari- Services and Network Industries ables considered by McGuire and Schuele (2000) To join the EU,Turkey must liberalize its services and are shown in table 12.2; scores range from 0 (least network industries. This section considers the bank- restrictive) to 1 (most restrictive). In the table, the ing, telecommunications, transportation, electricity, restrictions have been divided into two groups: and natural gas sectors as representative of those those affecting "commercial presence" and "restric- making up Turkey's services and network industries. tions on ongoing operations." The first group indi- cates the restrictions on the movement of capital, Banking Sector Before 1999, Turkey lacked the and the second group is modeled as restrictions on crucial components of financial markets: compe- trade in banking services. The commercial presence tent supervisory authorities, a regulatory frame- restrictions group covers restrictions on licensing, work, and a legal and institutional infrastructure. direct investment, joint venture arrangements, and In addition, regulations in Turkey were lax and the permanent movement of people. The other poorly enforced. In February 2001, Turkey faced a group covers restrictions on raising funds, lending Economic Implications of EU Accession for Turkey 313 TABLE 12.2 Restrictiveness Index Scores and Price Effects for Banking Services, EU and Turkey Restrictiveness Index Price Effect (%) EU Turkey EU Turkey Licensing of banks 0.0100 0.2000 0.7515 16.8479 Direct investment 0.0100 0.0100 0.7515 0.8424 Joint venture arrangements 0.0050 0.0525 0.3758 4.4226 Permanent movement of people 0.0085 0.0119 0.6403 1.0025 Restrictions on establishment total 0.0335 0.2744 2.5191 23.1154 Raising funds by banks 0.0075 0.0075 0.5636 0.6318 Lending funds by banks 0.0075 0.0075 0.5636 0.6318 Other business of banks--insurance and 0.0050 0.0525 0.3758 4.4226 securities services Expanding the number of banking outlets 0.0025 0.0131 0.1879 1.1056 Composition of board of directors 0.0119 0.0120 0.8973 1.0126 Temporary movement of people 0.0028 0.0074 0.2131 0.6213 Restrictions on ongoing operations total 0.0373 0.1000 2.8013 8.4257 Index value 0.0708 0.3744 5.3203 31.5410 Source: Australian Productivity Commission (http://www.pc.gov.au). funds, providing other lines of business, expanding columns of table 12.2 for the EU countries and banking outlets, composition of the board of direc- Turkey. The table reveals that, as a result of restric- tors, and the temporary movement of people. Based tions in the banking sector, the net interest margin on the scores shown in table 12.2 for each variable in the EU increases relative to the free trade net considered, the authors assign weights to the vari- interest margin by 5.32 percent, and that the ables and obtain first restrictiveness index values for increase amounts to 31.54 percent for Turkey. One the two groups and then the overall restrictiveness could thus infer that the net interest margin in index values for the economies considered. Turkey will decrease by 26.22 percent when Turkey Table 12.2 reveals that the Turkish banking sys- adopts and implements the EU rules and regula- tem is more restrictive than the banking system in tions on banking services. the EU. Kalirajan and others (2000) use this infor- mation to study the effects of restrictions in the Telecommunications The telecommunications banking sector on performance indicators. The industry in Turkey has been dominated by Türk authors note that banks provide a wide range of Telekom, a national monopoly with exclusive financial services, including deposit taking, lend- rights to all fixed-line voice operations. It also ing, insurance, and securities. But they emphasize provides cable services, and so also has been that, although banks are diversified entities, their responsible for the radio and television transmit- core business remains matching depositors and ters. Türk Telekom has a monopoly on the provi- lenders. Thus the price of banking services can be sion of international calls, and prices for local calls measured by the net interest margin--that is, the through fixed lines were cross-subsidized by difference between the interest rate banks charge on national long-distance and international calls. their loans and the rate they pay on their deposits. Reforms since the early 1990s have led to the Restrictions on trade in banking services is introduction of four new mobile telephone com- expected to increase the interest margin. The effect panies and a series of private companies that pro- of these restrictions in the banking sector on the vide value added services such as Internet access net interest margin is shown in the third and fourth and cable television. 314 Turkey: Economic Reform and Accession to the European Union Akdemir, Bas¸çi, and Locksley note in chapter 5 of establishment, restrictions on direct investment in this volume that the Turkish Parliament approved fixed and mobile network services, and restrictions legislation to reform the telecommunications sector on ongoing operations. For each type, Warren in 2000 and that the legislation was amended in derives index values, for which the higher values May 2001. The reform program was quite successful indicate greater restrictions. The index of restric- in transforming the Turkish telecommunications tions on cross-border trade captures policies that system into a modern one. The objective of the leg- discriminate against all potential entrants (domes- islative and regulatory reform was to bring the regu- tic and foreign) seeking to supply cross-border latory and supervisory regime for the Turkish telecommunications services, and the index of telecommunications sector up to the level of inter- restrictions on establishment captures policies that national practice in line with EU standards. The discriminate against all potential entrants (domestic objective has been achieved partially by opening the and foreign) seeking to supply telecommunications mobile telecom market to competition. With acces- services via investment in the country. The index of sion to the EU, Turkey will have to introduce full restrictions on direct investment is designed to cap- competition in telecommunications, and it will ture policies that discriminate against potential for- have to adopt and implement the EU legislative eign entrants seeking to supply telecommunications measures centering on liberalization of all telecom- services via investment in the country. Finally, the munications services and infrastructures, adoption index of restrictions on ongoing operations cap- of open network provision measures to the future tures policies that discriminate against potential competitive environment, maintenance and devel- foreign entrants seeking to supply cross-border opment of a minimum supply of services, and defi- telecommunications services. Based on the index nition of common principles for financing the uni- values derived from an international survey under- versal service. taken by the International Telecommunications The welfare effects of policies followed by Turkey Union (1998) for 136 countries, Warren (2000b) in the telecommunications sector are studied here by estimates first the impact of impediments to trade comparing the situation of the Turkish economy and investment in telecommunications services on in the base case--the Turkish economy operating the penetration of fixed and mobile telecommuni- under the rules and regulations that prevailed in the cations network and thereafter the price impact. telecommunications sector during the latter half of The results are shown in table 12.3. The table the 1990s--with the case in which Turkey adopts and reveals that Finland and the United Kingdom fol- implements in the telecommunications sector all of low liberal trade and investment policies in the rules and regulations of the EU. The effects of telecommunications and that, as a result of restric- adoption of EU rules and regulations in the telecom- tions in the trade of telecommunications services, munications sector on the price of telecommunica- Turkish telecommunications prices are 33.53 per- tions services are examined as well. The telecommu- cent higher than the prices in Finland and the nications sector is a heterogeneous service industry United Kingdom. just like the banking sector, and its services include fixed-line voice services (e.g., local, domestic, and Transportation In the transportation sector, one international long-distance telephony), mobile serv- can distinguish broadly between three different ices (mobile access, calls, and messaging services), modes of transport: land transport (including rail Internet services (e.g., dial-up and Web hosting), and road transport), maritime transport, and air data services (e.g., leased lines, asynchronous trans- transport. In Turkey, road transport constitutes the fer mode [ATM] services, and public data network significant portion of transport services. Roads services), and content services (e.g., pay TV and carry an estimated 90 percent of domestic freight online information and entertainment). Thus the volumes and 40 percent of international freight val- price of telecommunications will be an index of all ues. The sector is competitive domestically; there these prices. are many competing firms; and access to the roads Warren (2000a) considers four types of impedi- is relatively simple. Conditions in the international ments to trade in telecommunications services: segment of the market are very different from restrictions on cross-border trade, restrictions on those in the domestic freight segment, however. TABLE 12.3 Restrictiveness Index Scores for Telecommunications Services Restrictiveness Index Price Effect (%) Restrictions on Establishment Restrictions on Ongoing Operations Restrictions on Establishment Restrictions on Ongoing Operations Restrictions Restrictions on Direct on Direct Investment in Investment Fixed and Restrictions in Fixed and Restrictions Mobile Restrictions on Restrictions on Ongoing Mobile Restrictions on Restrictions on Ongoing Network Establishment on Cross- Operations Index Network Establishment on Cross- Operations Price Services Total Border Trade Total Value Services Total Border Trade Total Effect Austria 0.1333 0.1333 0.0000 0.0000 0.1333 0.8480 0.8480 0.0000 0.0000 0.8480 Belgium 0.1334 0.1334 0.0667 0.0667 0.2001 0.8710 0.8710 0.4353 0.4353 1.3063 Denmark 0.0333 0.0333 0.0000 0.0000 0.0333 0.1985 0.1985 0.0000 0.0000 0.1985 Finland 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 France 0.2100 0.2100 0.0000 0.0000 0.2100 1.4298 1.4298 0.0000 0.0000 1.4298 Germany 0.0493 0.0493 0.0000 0.0000 0.0493 0.3195 0.3195 0.0000 0.0000 0.3195 Greece 0.1609 0.1609 0.3000 0.3000 0.4609 1.5778 1.5778 2.9424 2.9424 4.5202 Ireland 0.3533 0.3533 0.0000 0.0000 0.3533 2.6655 2.6655 0.0000 0.0000 2.6655 Italy 0.1369 0.1369 0.0000 0.0000 0.1369 1.0019 1.0019 0.0000 0.0000 1.0019 Luxembourg 0.1667 0.1667 0.0000 0.0000 0.1667 1.0458 1.0458 0.0000 0.0000 1.0458 Netherlands 0.0300 0.0300 0.0000 0.0000 0.0300 0.2025 0.2025 0.0000 0.0000 0.2025 Portugal 0.1100 0.1100 0.4000 0.4000 0.5100 1.3473 1.3473 4.8992 4.8992 6.2465 Spain 0.1793 0.1793 0.2333 0.2333 0.4127 1.7099 1.7099 2.2247 2.2247 3.9346 Sweden 0.1000 0.1000 0.0000 0.0000 0.1000 0.6530 0.6530 0.0000 0.0000 0.6530 U.K. 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 Turkey 0.3987 0.3987 0.4000 0.4000 0.7987 16.7384 16.7384 16.7944 16.7944 33.5328 Note: The restrictiveness index scores range from 0 to 1. The higher the score, the greater are the restrictions for an economy. Source: Australian Productivity Commission (http://www.pc.gov.au). 315 316 Turkey: Economic Reform and Accession to the European Union Operations between countries are regulated by a 1980s. In this sector, Turkey will need to harmonize web of bilateral and multilateral agreements that its regulations with those of the EU on civil avia- restrict quantity and capacity by limiting the num- tion licenses, civil aviation rules and procedures, air ber of permits available for a truck to make a jour- carrier liability in the event of accidents, allocation ney between jurisdictions. Bilateral agreements of slots, ground handling at airports, aviation generally prohibit cabotage.2 Thus the domestic safety, and traffic management. But, overall, the Turkish market is reserved for Turkish firms. By existing structure will satisfy the requirements of contrast, the road freight market within the EU for the acquis on air transport services with relatively EU national firms is highly liberalized, including little alignment. cabotage freight. Effectively, it is a single market in Francois's study in chapter 6 of this volume is which the only entrance requirement is a national helpful in determining the tariff equivalent of trade license from an EU country that permits unre- barriers in transportation services. Francois asserts stricted international and domestic carriage within that the tariff equivalent is roughly 8.9 percent. the EU irrespective of the country of origin of the carrier within the EU. Ultimate access to the EU Electricity The Turkish electricity sector is domi- would largely solve the access problems of the nated by state-owned enterprises. The two largest Turkish industry, but it would also lead to increased firms are the Turkish Electricity and Transmission competition from abroad. Company (TEAS¸) and the Turkish Electricity Dis- As for rail transport, Turkish Railways is a tribution Company (TEDAS¸). Recently, TEAS was national monopoly with exclusive rights to the separated into three companies covering generation, transport of passengers and freight by rail in trading, and transmission activities. Some privately Turkey. By contrast, the EU acquis in the rail trans- owned firms have entered the industry through port sector has been designed to improve the com- build-operate-transfer (BOT), build-operate-own petitiveness of the rail transport sector and to (BOO), or auto-generator schemes. Today, these liberalize rail transport markets. Harmonization of firms account for more than 21 percent of electric- the current rules in the rail transport sector with ity generation. Under the regulations prevailing in the EU acquis requires that access rights be Turkey, the private operators signed long-term extended and that different organizational entities power purchase agreements with the state-owned be set up for rail operations and infrastructure generation enterprise in which the enterprise com- management in the rail transport sector. Functions mitted itself to buying the output of the plants for a such as rail capacity allocation, infrastructure period of, say, 20 years at a fixed price in foreign cur- charging, and licensing will have to be separated rency. In these contracts, the price has been on aver- from rail operators. In addition, the financial rela- age between $.08 and $.09 per kilowatt-hour for the tions between different parties and activities must first 5­10 years of operation. These contracts, guar- be clearly defined by separation of accounts to anteed by the Treasury, assured investors that the enable the cost of operations to be accurately estab- projects would be profitable irrespective of the lished and to avoid cross-subsidization. demand for power. Maritime transport is another area in which Recently, the government of Turkey passed, as compliance with the EU acquis requires major noted by Atiyas and Dutz in chapter 7 of this vol- changes in the sector. The EU acquis covers freedom ume, a new electricity law. The law provides for the tosupplyservices,therequirementsforcompetition, establishment of a new independent Energy Market pricing practices,and the conditions to be applied to Regulatory Authority. With this law, the government vessels carrying dangerous or polluting goods. As in is introducing a market model, like the one in the road transportation, access to the Turkish maritime EU, that will transfer most of the task of supplying transportation market is restricted. With accession, and distributing electricity and the associated mar- access problems will be solved, and the sector will ket risks to the private sector, eliminate the need for face increased competition from abroad. additional state-guaranteed power purchase agree- Finally, in the air transport sector Turkey has ments, and minimize costs through competitive taken major steps toward liberalizing air transport pressures on producers and distributors along the services. Major reforms were introduced during the EU model. Economic Implications of EU Accession for Turkey 317 The welfare effects of policies followed by firm and "fair" rate of return. By contrast, under Turkey in the electricity sector are studied here by price cap regulation, prices are indexed to a moving comparing the situation of the Turkish economy in indicator, such as the producer price index, less a the base case--the Turkish economy operating portion that provides incentive for innovation and under the rules and regulations that prevailed in improved efficiency. Under this type of regulation, the electricity sector during the latter half of the firms could realize negative returns in the short run 1990s--with the case in which Turkey adopts and if they are operating inefficiently. Table 12.4 reveals implements in the electricity sector all of the rules that Finland and Germany have introduced and regulations of the EU. The effects of regulation cost-based pricing and that the United Kingdom on the price of electricity are examined by means of favors price cap regulation, but that Turkey did not table 12.4, which summarizes the status of the reg- have an explicit transmission pricing regulation ulatory environment and market structure in the during 1998. electricity sector in selected EU countries and The separation of generation and transmission, Turkey as of 1998. In the electricity markets, com- in tandem with expanded TPA, is crucial to encour- petition can be secured as long as the principle of age competition. Without separation, the network third party access (TPA) is observed. This principle owner has very high incentives to preclude, or at is based on the idea that the owner of the network least limit, the access of competitors in the down- is obliged to give access to all delivery requests stream market, thereby eliminating liberalization. If through the network by production and sales the network owner does not participate in the operators. The table shows that by 1998 Finland, downstream markets, it is neutral toward the appli- Germany, and the United Kingdom had liberalized cants. Thus "unbundling" is important. The alloca- access to transmission and distribution networks, tion of transmission rights must be separated from and that access liberalization in Finland and Britain transactions between upstream and downstream had taken the form of regulated TPA, which is a firms. Where generation and transmission have legal obligation to provide network access under been unbundled, there may be either an accounting nondiscriminatory conditions. Germany has cho- separation, a legal separation, or a propriety separa- sen the negotiated TPA arrangement, in which con- tion into different companies. Accounting separa- sumers and producers contract directly with each tion is the weakest form of separation, and legal other and then negotiate with the transmission and separation is achieved through the creation of distribution companies for access to the network. different companies under a common holding. Turkey, by contrast, had not observed the principle Propriety separation is the preferred alternative. of TPA by 1998, and it introduced this principle Table 12.4 shows the degree of overall only in 2001 under the regulated TPA regime. integration--from generation through transmis- But TPA alone will not secure competition in sion and distribution to supply--as well as the pres- the electricity sector. The owner of the network ence and type of separation of generation from could charge high access prices, which would put transmission in each of the countries considered. the competitors in the final market at a disadvan- Finland and the United Kingdom have separated tage. The achievement of competition requires that generation and transmission into legally distinct the access charge be nondiscriminatory and cost- firms, whereas Germany has introduced accounting reflective and that it give the network owner the separation. The table also shows that, distinct from appropriate incentives to maintain and develop the liberalization, countries vary as well in the degree of infrastructure so that the system avoids bottleneck private ownership that has developed over time, as problems. The two dominant models for this well as in the decision made about privatization at approach are cost-based (rate of return) pricing the time of liberalization. Indeed, it reveals the cur- and loosely regulated prices (the model more rent status of ownership in the generation segment prevalent in countries with a decentralized electric- of the electricity sector, and it provides details about ity supply industry and a tradition of regulation privatization in electricity generation at the firm and control on a more local level). Under rate of level for the countries selected. The decision to pri- return regulation, the government sets the trans- vatize does not necessarily correlate with the degree mission prices so that they effectively guarantee a of liberalization. Germany has mixed ownership in 318 TABLE 12.4 Country Data on European and Turkish Electricity Sectors, 1998 Finland Germany United Kingdom Turkey Regulatory reform Third party access (TPA) Regulated TPA Negotiated TPA Regulated TPA None Electricity market Finnish Electricity Exchange (1995) None English and Wales market (1990) None Transmission price regulation Cost-based Cost-based Price cap n.a. Consumer choice thresholds 1995, 500 kW; 1997, 0 kW 1998, 0 kW 1990, 1 MW; 1994, 100 kW; No choice 1998, 0 kW Vertical integration in the industry Degree of vertical integration Unbundled Unbundled Unbundled Integrated Generation separate from Separate companies Accounting separation Separate companies Integrated transmission Ownership in the industry Mostly public Mixed Private Mostly public Privatization in electricity generation 2/1/1997, Komijoki Oy, 25% 7/5/1994, Rhein-Main 3/6/1991, National Power, 60% Private participation Donau, 75.5% 3/6/1991, Power Gen, 60% 12/31/1995, Neckar, 99% 3/1/1995, National Power, 40% 3/1/1995, Power Gen, 40% 7/19/1996, British Energy, 87.73% n.a. Not applicable. Sources: Steiner 2000 and the author. Economic Implications of EU Accession for Turkey 319 the industry; the United Kingdom has made priva- TABLE 12.5 Price Impact of Regulation tization a central feature of reform. in Electricity Supply, EU A further requirement for liberalization of elec- and Turkey (percent) tricity markets is the "opening of the demand side." This principle promotes the idea that eligible cus- Impact on Price tomers have the right to seek the most convenient supplier. The table reveals that Finland and the Austria 13.2 United Kingdom introduced consumer choice ini- Belgium 15.4 tially for large consumers and then gradually Denmark 8.5 phased in full consumer choice, that Germany Finland 0.0 France 16.0 introduced full consumer choice immediately in Germany 8.3 1998, and that Turkey had not opened the demand Greece 16.6 side by 1998. Ireland 13.9 Finally, competition requires the existence of Italy 17.1 exchange markets, which should yield prices in line Luxembourg 13.8 with marginal costs covering fixed costs. By 1998 Netherlands 15.5 Finland and the United Kingdom had introduced Portugal 17.9 such markets for electricity and allowed the prices Spain 9.5 and quantities traded to be determined by the Sweden 0.0 equivalence of supply and demand. Germany and U.K. 0.0 Turkey did not have such a market by 1998. Turkey 20.7 Steiner (2000), basically using the information provided in table 12.4, extends it to 19 Organisa- Source: Doove and others 2001. tion for Economic Co-operation and Development (OECD) economies over the period 1986­96 and develops indexes of regulatory indicators, which he trading. In 2000, domestic consumption was then uses to investigate empirically the linkages 14.6 billion cubic meters, with imports accounting among regulatory regimes, market environments, for 96 percent of consumption. Demand growth and performance in electricity supply. Using the was about 17 percent a year between 1990 and productive efficiency of generation plants and retail 1999. The distribution of natural gas is carried out electricity prices as indicators of performance, by local companies that are owned either by the Steiner concludes that unbundling of generation municipalities or by BOTAS¸. Pricing was deter- and transmission, expansion of the TPA, and intro- mined by BOTAS¸, with indirect influence by the duction of electricity markets reduce the industrial government. In May 2001, the Turkish government end user prices. The results obtained by Steiner passed, as described by Mazzanti and Biancardi in (2000) were later extended by Doove and others chapter 8 of this volume, a new gas law. With this (2001) by increasing the number of countries con- law, the government plans to establish a competi- sidered from 19 to 50. The results are shown in tive market like the one in the EU and encourage table 12.5. As a result of restrictions, Turkish elec- private sector participation through a phased pol- tricity prices are 20.7 percent higher than the prices icy. The Energy Market Regulatory Authority, in Finland and the United Kingdom, which follow which regulates both the gas industry and the elec- liberal policies in the electricity sector. tricity industry, determines the transmission and distribution access rules and tariffs and the method Natural Gas The natural gas sector in Turkey is for regulating retail prices. dominated by government-owned entities. The Competition in the electricity sector can be Petroleum Pipeline Corporation (BOTAS¸) owns achieved as long as the competition upstream is the pipeline infrastructure for oil and gas transmis- sufficiently developed and network access is open, sion, liquefied natural gas (LNG) terminals, and the but the situation is quite different in the natural gas gas distribution network. BOTAS¸ had monopoly industry, where firms are burdened with long-term rights for gas imports and exports and wholesale investments in the upstream phase (gas contracts 320 Turkey: Economic Reform and Accession to the European Union and infrastructures). They buy the gas from pro- gas sector (table 12.6). In Ireland, Luxembourg, and ducers under long-term contracts with take-or-pay Spain, the Ministry of Industry is in charge of dis- clauses. Under these obligations, gas purchasers pute resolution in this sector, but the authority must pay 70­90 percent of the contracted capacity is unspecified for France, Greece, and Portugal.3 whether they receive the natural gas or not. Thus Finally, the national liberalization plans also differ firms have to sink huge investments in extraction in the kind of regulation that is adopted on the fields and international pipelines, where they face TPA. The majority of countries have chosen ex ante huge fixed costs and almost zero marginal costs. regulation in which the regulator sets the price and In those cases, the extractor needs coverage from technical conditions in advance, rather than an the market risk. It is often claimed that vertical ex post regime in which the regulator intervenes integration is needed to cover firms' take-or-pay ex post on the tariffs communicated by firms.4 obligations. Table 12.6 describes the main features Table 12.6 shows that demand opening, the third of the natural gas industry in EU countries element to create a level playing field in the natural for three main areas of interest: access to the net- gas sector, has been treated rather differently across work, the unbundling of monopolized activities countries. Germany and the United Kingdom had from the competitive ones, and the opening of the already completed their process by 2000, and in demand side. most other countries the complete opening will be According to Polo and Scarpa (2003), three main reached by 2007 at the latest. However, in some issues must be determined for implementation of important countries--Denmark, France, Greece, the TPA principle: (1) the technical and commercial and Portugal--a final date for the process has not conditions to be set for access (access price setting), been set. In Turkey, the process of liberalization (2) how disputes about access will be solved, and began only in 2001 with the new gas law. (3) the kind of regulatory regime to be used. To weigh the overall effectiveness of the liberal- According to the authors, a key aspect of the TPA is ization plans of the EU countries for the natural gas the institution that deals with disputes and acts as an sector, Polo and Scarpa (2003) use a scoring proce- arbitrator. In most of the EU countries, the regula- dure in which higher scores correspond to a more tory authority intervenes in disputes in the natural advanced solution. The authors find that the more TABLE 12.6 EU Country Data on European Natural Gas Sectors Third Party Access Demand Opening Access Dispute Type of Percent Complete Price Setting Solution Regulation Unbundling Eligible Opening Score Austria Negotiated Regulator Ex post Accounting 49 2001 10 Belgium Regulator Regulator Ex ante Legal 59 2005 16 Denmark Regulator Regulator Ex post Legal 30 Unspecified 11 Finland Regulator Regulator Ex post Proprietary 90 2003 21 France Unspecified Unspecified Ex ante Accounting 20 Unspecified 4 Germany Negotiated Antitrust Ex post Accounting 100 2000 12 Greece Unspecified Unspecified Ex ante Unspecified Unspecified Unspecified 2 Ireland Ministry Ministry Ex ante Legal 75 2005 14 Italy Regulator Regulator Ex ante Legal 65 2003 17 Luxembourg Ministry Ministry Ex ante Accounting 51 2007 11 Netherlands Negotiated Regulator Ex ante Accounting 45 2004 10 Portugal Unspecified Unspecified Ex ante Unspecified Unspecified Unspecified 2 Spain Ministry Ministry Ex ante Legal 72 2003 15 Sweden Regulator Regulator Ex post Accounting 47 2006 11 U.K. Regulator Regulator Ex ante Proprietary 100 1998 23 Source: Polo and Scarpa 2003. Economic Implications of EU Accession for Turkey 321 advanced solutions have been adopted by Finland, evaluated at the base prices of 1996 can be Sweden, and the United Kingdom. expressed as (12.4) C = u CONS Welfare Effects where u denotes the 1 × 97 unit vector. The value This section examines the welfare effects of Turkish of the total consumption expenditure evaluated at accession to the EU by considering the 1996 input- the prices that will prevail after Turkey adopts and output table of the Turkish economy. The table has implements the EU rules and regulations in the 97 sectors. Of these, banking is sector 84; telecom- banking sector is then given by munications, sector 83; transport via railways, sector 78; land transport, sector 79; water transport, (12.5) C = CONS sector 80; air transport, sector 81; electricity pro- The effect on consumer welfare5 can now be calcu- duction, transmission, and distribution, sector 69; lated as and natural gas, sector 70. Consider the case in which Turkey adopts and (12.6) (C - C) × 100/C implements the EU rules and regulations in the By construction, the prices of all commodities in banking sector. A denotes the 97 × 97 matrix of the base year equal unity. The previous section input coefficients. Given A, the 96 × 96 input revealed that adoption of the EU rules and regula- matrix B is formed by deleting the 84th column tions by the banking sector will decrease the net and 84th row referring to the banking sector. The interest margin by 26.22 percent. If the value of the 84th row where the 84th column element has been 26.22 percent decrease is taken as the percentage deleted is denoted by e; p denotes the 1 × 96 price change in the price of banking services stemming vector of the 96 commodities, excluding the bank- from adoption of the EU rules and regulations by ing sector; and va denotes the corresponding the banking sector, it is possible to conclude that 1 × 96 unit gross value added vector. The price the welfare of society will increase by 1.36 percent equation can then be written as after adoption of the EU rules and regulations by (12.1) p = pB + pbe + va the banking sector. The change in consumer wel- fare will amount to about 2.12 billion.6 where pb denotes the price of the banking services. Assuming that with the adoption of EU rules From this equation follows and regulations by the telecommunications, trans- (12.2) p = pbe(I - B)-1 + va(I - B)-1 portation, and electricity sectors prices will decline by 33.5 percent in the telecommunications sector, Thus, given the price of banking services that 8.9 percent in transport services, and 20.7 percent will prevail in Turkey after it adopts and imple- in the electricity sectors, a study similar to that in ments the EU rules and regulations, pb, the equilib- the banking sector reveals that adoption of the EU rium prices of the other 96 commodities can be rules and regulations by the telecommunications, determined from equation 12.2, assuming that transportation, and electricity sectors will cause the there is no change in the unit gross value added welfare of society to increase in those sectors by vector va. Given the equilibrium price vector p, the 0.59 percent, 1.01 percent, and 0.53 percent, respec- 1 × 97 price vector can be formed as = (p pb). If tively. The effect of the adoption of EU rules and CON denotes the 96 × 1 consumption expenditure regulations by the telecommunications, transporta- vector obtained from the 1996 input-output table tion, and electricity sectors thus amounts, respec- by deleting the value of consumption of the bank- tively, to increases of 915 million, 1.57 billion, ing sector and if conb denotes the value of con- sumption of banking services, the 97 × 1 consump- and 822 million in the real incomes of consumers. Table 12.7 reveals that the natural gas prices in tion vector can be formed as Turkey are considerably higher than those in some CON (12.3) CONS = EU countries, which, as was determined earlier, conb have adopted more advanced regulatory solutions Initially, all base year prices equal unity. The in the sector. A weighted average of natural value of the total consumption expenditure gas prices for the industry in Finland and the 322 Turkey: Economic Reform and Accession to the European Union TABLE 12.7 Retail Prices of Natural Gas and Electricity, 2000 Natural Gas Natural Gas for Industry for Households Electricity Electricity (US$/107 kcal, (US$/107 kcal, for Industry for Households GCV basis) GCV basis) (US¢/kWh) (US¢/kWh) Austria .. 348.40 3.80 11.80 Finland 130.70 159.50 3.90 7.80 France 167.80 347.50 3.60 10.20 Germany 187.90 373.40 4.10 12.10 Greece 216.10 287.20 4.20 7.10 Ireland 145.00 345.80 4.90 10.10 Spain 175.40 491.40 4.30 11.70 U.K. 104.60 292.80 5.50 10.70 Turkey 175.20 259.60 8.00 8.50 .. Negligible. Note: GCV = gross calorific value. Source: International Energy Agency 2003. United Kingdom demonstrates that Turkish natu- and the table reveal that the price wedge implicit in ral gas prices are 48.9 percent higher than the aver- these figures is much larger than the figure of age price in those countries. Calculation then 33.5 percent used in the calculations made here.7 shows that with the adoption of EU rules and regu- Thus the estimates presented of the price wedge in lations by the natural gas sector, the welfare of soci- the telecommunications sector are rather conserva- ety will increase by 0.08 percent. This change tive, and the estimate of the effects of liberalization amounts to a 128 million increase in the real in telecommunications services gives the lower income of consumers. bound of the welfare gains derived in the sector. The findings described in this section therefore A look at the nominal prices for electricity over reveal that Turkey will benefit from adopting EU the period 1990­2000 in Turkey reveals that elec- rules and regulations in the banking, telecommuni- tricity prices for industrial customers have fluctu- cations, transportation, electricity, and natural gas ated between $.075 and $.095 per kilowatt-hour sectors, and that liberalization within the context and prices for residential customers between $.045 of EU integration in those sectors will lead to a and $.10 per kilowatt-hour. The prices for indus- 3.56 percent increase in real household incomes. trial consumers are almost exactly as high as those This increase is equivalent to a change in con- for residential consumers. Because the cost of sup- sumers' welfare of 5.56 billion. During 1996, con- plying residential consumers is much higher than sumption was 72.95 percent of GDP, and thus the that of supplying industry, there seems to be cross- percentage change in the welfare of the society is subsidization in favor of residential consumers. equivalent to a 2.6 percent increase in real GDP. According to TEAS, the state-owned generation Because the estimates of the price wedges caused and transmission company, the sales prices per by service barriers are the key parameters deter- kilowatt-hour at the end of 1999 for industrial cus- mining the welfare effects of services liberalization tomers was $.0687 for high-voltage customers, and liberalization in the calculations just presented, $.0715 for intermediate and low-voltage customers, the estimates made here of tariff equivalents are and in the range of $.04 per kilowatt-hour for dis- compared with estimates from other sources. Fig- tributors. However, the cost of producing electric- ures 12.1 and 12.2 show, respectively, the telecom- ity, as noted by OECD (2002), is much larger than munications prices for business and residential cus- is suggested by these data. The cost of purchasing tomers in selected countries. By contrast, table 12.8 additional electricity from BOT, BOO, and transfer presents the OECD basket of international tele- of operating rights (TOOR) contract generators phone charges during November 2001. The figures reaches $.11­$.12 per kilowatt-hour. Atiyas and Economic Implications of EU Accession for Turkey 323 FIGURE 12.1 OECD Composite Telecommunications Business Basket, November 2001 (US$ PPP) US$ PPP 3,500 Fixed Usage 3,000 2,500 2,000 1,500 1,000 500 0 U.K. Italy Rep. Rep. Iceland Korea Norway Sweden Finland Ireland Greece Poland Turkey Mexico Denmark Canada France Germany Belgium AustriaStatesSpainJapan Zealand average Australia of Portugal Hungary LuxembourgNetherlands Switzerland Czech Slovak United New OECD Rep. Note: VAT is excluded; calls to mobile networks and international calls are included; PPP = purchasing power parity. Source: OECD. FIGURE 12.2 OECD Composite Telecommunications Residential Basket, November 2001 (US$ PPP) US$ PPP 1,400 Fixed Usage 1,200 1,000 800 600 400 200 0 U.K. Italy Rep. Rep. Iceland JapanStatesSpain Korea Sweden Norway Ireland Finland Greece Mexico Turkey Poland Denmark Germany Canada BelgiumAustria France Australia Zealand average of Portugal Hungary LuxembourgSwitzerland Netherlands Czech Slovak United New OECDRep. Note: VAT is included; calls to mobile networks and international calls are included. Source: OECD. Dutz point out in chapter 7 of this volume that the tries and Turkey, reveals that the electricity prices in average cost of producing electricity will further Turkey are considerably higher than those in the increase over time as new BOT, BOO, and TOOR EU countries where prices are the least expensive. plants begin to produce electricity. Table 12.7, Thus the price wedge implicit in these figures is which presents the electricity prices in EU coun- much larger than the figure of 20.7 percent used 324 Turkey: Economic Reform and Accession to the European Union TABLE 12.8 OECD Basket of International Telephone Charges, November 2001 TABLE 12.8 OECD Basket ofBusiness, International Telephone Charges, November 2001 Excluding Tax Residential, Including Tax (US$) (US$ PPP) (US$) (US$ PPP) Austria 0.77 0.83 1.06 1.15 Belgium 0.49 0.56 0.57 0.66 Denmark 0.50 0.46 0.80 0.73 Finland 0.78 0.74 1.00 0.95 France 0.34 0.37 0.66 0.73 Germany 0.42 0.45 0.62 0.67 Greece 0.77 1.12 1.17 1.69 Ireland 0.51 0.55 0.70 0.76 Italy 0.90 1.16 1.32 1.69 Luxembourg 0.37 0.41 0.49 0.55 Netherlands 0.30 0.35 0.46 0.53 Portugal 0.71 1.08 0.96 1.46 Spain 0.78 1.01 1.12 1.46 Sweden 0.34 0.34 0.53 0.54 U.K. 1.18 1.16 1.61 1.58 Turkey 1.51 3.98 1.89 4.98 Note: PPP = purchasing power parity. Source: OECD 2002. TABLE 12.9 Estimated Tariff Equivalents in Traded Services and Network Industries TABLE 12.8 OECD Basket of International Telephone Charges, NovemberFrancois 2001 Hoekman (1999) Current Study (1996) and Hoekman (2000) Financial services 9.2 46.3 Banking 31.54 Telecommunications 33.53 Basic telecommunications 92.9 Value added telecommunications 42.9 Source: The author. here in calculations, and the estimate made here of second column of table 12.9. According to the fig- the price wedge in the electricity sector is thus ures, the tariff equivalent in the banking sector is rather conservative. 9.2 percent, in the basic telecommunications sector Table 12.9 shows the tariff equivalents of trade 92.9 percent, and in the value added telecommuni- barriers in traded services and network industries cations sector 42.9 percent. But these estimates estimated by different authors for Turkey. Research have, as Hoekman notes, certain drawbacks.8 First, into the measurement of services trade barriers is the method assumes that the absence of positive fairly recent, and very few studies cover Turkey. One country commitments in the GATS schedules can such study was conducted by Hoekman (1996), who be interpreted as indicating the presence of restric- used information from the country schedules of the tions. Second, the different types of restrictions are General Agreement on Trade in Services (GATS). given equal weight and are not distinguished Hoekman's estimates for Turkey are shown in the according to their economic impact. Finally, the Economic Implications of EU Accession for Turkey 325 method assumes that market access restrictions are must adopt the required EMU legislation in order the only type of barriers to trade in services. to acquire the status of "Member State with a dero- Francois (1999) fits a gravity model to bilateral gation" for adoption of the euro. In particular, trade in services between the United States and its Turkey needs to take the relevant steps to liberalize major trading partners, taking Hong Kong (China) capital movements completely, prohibit the privi- and Singapore as free trade benchmarks. The inde- leged access of financial institutions to the public pendent variables are per capita income, gross sector, and attain the political and economic domestic product, and a Western Hemisphere independence of the monetary authorities. Upon dummy variable. He interprets the differences accession, the common macroeconomic policy between actual and predicted imports as indicative framework will become more constraining, with of the size of barriers to trade. These differences strong reinforcement of fiscal discipline and the between actual and predicted imports are then integration of other economic policies. Budgetary normalized relative to the free trade benchmarks. policy and outcomes will become subject to the These quantity measures also are converted into excessive deficit procedure and the nonpunitive tariff equivalents by assuming a specific value of parts of the Stability and Growth Pact (SGP). The demand elasticity. Francois's estimate for Turkey, Maastricht Treaty specifies that the country will reported in Hoekman (2000) and shown in the have to progress toward fulfillment of the Maas- third column of table 12.9, is 46.3 percent in finan- tricht criteria, and under the conditions of the SGP cial services. Finally, a comparison of the tariff it will have to endeavor to avoid excessive deficits. equivalents for Tunisian financial services and Furthermore, exchange rate policy will become a telecommunications sectors used by Konan and matter of common interest. Finally, adoption of the Maskus (2002) with the estimates made here of tar- euro will require Turkey to become part of the sin- iff equivalents reveals that the estimates used in this gle, stability-oriented monetary policy and of the study are rather reasonable. ensuing single exchange rate policy. Furthermore, Turkey will become subject to the sanction parts of the SGP. Once Turkey adopts the euro, it will Economic Challenges replace its domestic currency with the euro at an This section considers issues related to Turkey's irrevocably fixed exchange rate, transfer the bulk of membership in the European Economic and Mon- its reserves to the European Central Bank, and etary Union (EMU), labor markets, compliance agree to be bound by the SGP. with EU environmental directives, and state aids. In addition to the legislative changes just described and thorough implementation of this leg- islation, Turkey will face the problem of attaining Membership in the European Economic over time sustainable development while simulta- and Monetary Union neously satisfying the Maastricht criteria.The coun- Participation in the European Economic and Mon- try realizes that, in the long run, price stability and etary Union is a must for Turkey, because the acquis fiscal discipline create the best conditions for sus- is expected to be adopted in full, including EMU tained, robust economic growth. But the current sit- participation, as well as, in due time, all the requi- uation is problematic. Turkey is not satisfying the site "Maastricht criteria" for Euro Area integration. Maastricht conditions.In 2003 the inflation rate was Turkey is not expected to adopt the euro immedi- 25.3 percent compared with 2.7 percent, the refer- ately upon accession. According to Article 122 of ence value for inflation in the EU; public sector bor- the Treaty Establishing the European Community, rowing requirements as a percentage of GDP were upon accession Turkey will be treated as a "country 8.8 percent compared with 3 percent, the reference with a derogation" until it fulfills the convergence value of the budget deficit in the EU; the debt-to- criteria, which involve conditions on price stability, GDP ratio was 80.3 percent compared with 60 per- interest rate convergence, the budget deficit, the cent, the reference value of the debt-to-GDP ratio in government debt, and exchange rate stability. the EU; and the average interest rate was 28.5 per- As emphasized by the European Commission cent compared with 6.2 percent, the reference value (2003), during the preaccession period Turkey of long-term interest rates in the EU. But as of the 326 Turkey: Economic Reform and Accession to the European Union end of 2004, the annual inflation rate had been values of foreign real interest rates. Sustainabil- reduced to 9.2 percent, and the average interest rate ity of the current account requires depreciation on government debt during December 2004 to of the real exchange rate over time to its long- 19.8 percent. During 2004, the growth rate of GDP run equilibrium value. is expected to be more than 8 percent, and the unemployment rate as of the second quarter of 2004 Labor Markets had been reduced to 9.3 percent. Although these are all positive developments, the annual current In chapter 9 of this volume, Taymaz and Özler account deficit during 2004 amounted to $15.6 bil- describe the flexibility of the Turkish labor market, lion,and the annual current account deficit-to-GDP which stems primarily from the fact that the labor ratio for 2004 is expected to exceed 5 percent. market is not homogeneous. It has different wage- The challenge facing Turkey is how to move setting mechanisms in its formal and informal sec- from the current state of affairs to a state in which tors. The informal sector is largely free from most the Maastricht criteria are satisfied. According to types of labor regulation and pays few taxes and Togan and Ersel in chapter 1 of this volume, the fol- related charges. Activities in this sector rely mostly lowing issues are facing Turkey: on the provision of labor services without formal employment contracts. Job insecurity is pervasive, · Although the country has reduced the inflation and workers receive very few benefits from their rate considerably through strict implementation employers. By contrast, the formal sector observes of the International Monetary Fund (IMF) eco- labor regulations and pays all taxes and related nomic program, the reduction was achieved charges such as social security contributions and partially through decreases in the cost of payments to various funds. According to various imported goods stemming from real apprecia- studies, the share of the informal sector of total tion of the Turkish lira. But reducing the infla- employment is about 60 percent.9 The reasons for tion rate through real appreciation of the cur- the relatively high share of the informal sector in rency is not sustainable in the long run, because total employment are (1) the very high tax rates on such a measure will lead to problems of sustain- wage income, the high tax-related charges, and the ability of the current account. substantial payments to various funds that must be · Although the country has reduced the debt-to- paid by those working in the formal sector to com- GDP ratio substantially during the last few years ply with the social security law and the laws regulat- by running primary surpluses amounting to ing the taxation of personal incomes; (2) the rela- 6.3 percent, such as during 2003, the reduction tively high firing costs imposed by the labor law was achieved partially through real appreciation and the stringency of the various clauses of the of the currency. However, reducing the debt-to- labor law; and (3) the lack of enforcement mecha- GDP ratio by this means is not sustainable in the nisms for the respective laws in the economy. long run. The population of Turkey increases on average · Because the debt-to-GDP ratio can be reduced at a rate of 1 million persons per year, and thus the over time by achieving surpluses of govern- country must continually create new jobs to ment revenues over noninterest expenditures accommodate this growth. In addition, Turkey amounting to at least 6.5 percent of GDP, the must create jobs for those unemployed and must government will be constrained in its use of fis- increase the labor force participation rate from its cal policy to decrease the unemployment rate in low level of 48.3 percent. In the past, Turkey suc- the economy, which in 2004 was still 9.3 percent. cessfully managed the unemployment problem The constraint may have political implications. through its large, flexible informal sector where · A close look at the issues related to the sustain- wages are free to equilibrate demand and supply ability of the current account reveals that the and through labor migration from Turkey. choice of exchange rate policy during the preac- With its accession to the EU, Turkey will have to cession period will be of prime importance for enforce the rule of law uniformly in the country. It Turkey. The policy of real exchange rate appreci- can no longer tolerate the lack of enforcement ation pursued during the last two years is not mechanisms for different laws and regulations in sustainable in the long run under rather realistic the economy. Yet such a shift will have to occur Economic Implications of EU Accession for Turkey 327 without increasing Turkey's unemployment rate. with more than 10,000. In 1997 there were 2,835 Taymaz and Özler estimate that when all manufac- municipalities with a total population of 48.2 mil- turing firms in the informal sector begin to pay lion; 7.3 million people were living in rural taxes and social security contributions at the same municipalities. According to the State Planning rates as in the formal sector and when informal Organization, 72 percent of the people living in sector firms lose half of their market shares municipalities were not connected to sewage treat- because of the change, employment in the manu- ment. For an additional 23 percent of population, facturing sector will decline by 8.9 percent. Thus sewer systems were under construction. Upon the about 300,000 jobs will be lost. But the effect of the completion of these systems, 51 percent of the pop- policy change on employment--when all informal ulation living in municipalities (24.5 million out of sector firms in all sectors of the economy begin to 48.2 million) will be connected to sewer systems, pay taxes and social security contributions at the leaving 23.7 million with no connection. Two per- same rates as in the formal sector--will actually be cent of municipalities have wastewater treatment much more drastic, because the effects on employ- facilities and 14 percent of people living in villages ment in the agricultural and services sectors must have a sewer connection with septic tanks, but be considered as well. In the end, the number of 11.8 million people have no sewer connection. jobs lost will far exceed the 300,000 estimated by The costs of meeting sewer needs will depend on Taymaz and Özler. Thus to avoid an increase in three parameters: (1) the proportion of the rural unemployment the country must introduce com- population living in towns that would be classified prehensive labor market reform. Such a reform will as agglomerations with a population of more than probably entail substantial decreases in the tax 2,000 population equivalent; (2) the proportion of rates on wage income, tax-related charges and pay- towns with between 2,000 and 10,000 population ments to various funds, decreases in the firing that will be exempted from constructing sewer sys- costs, and changes in various clauses of the labor tems on the grounds of no environmental benefit law so they are less stringent. or excessive costs; and (3) the proportion of rural population that must have sewers. Once the European Commission and Turkey agree on these Complying with EU Environmental Legislation parameters during the negotiations, the cost of To join the EU, Turkey must adopt and implement compliance with the EU directive would be deter- the entire body of EU legislation and standards on mined. The investment cost of complying with the environmental protection. Bringing its environ- directive has been roughly estimated at more than mental protection system, infrastructure, and stan- $10 billion. Adding the additional operations, dards up to Western European levels will require, in maintenance, and replacement costs would turn, substantial investments by the public and pri- increase this cost even further. vate sectors as well as changes in regulations and Environmental protection will therefore present supporting institutions. challenges for Turkey. The costs will be substantial Within the EU regulations on wastewater collec- when, in addition to the costs of complying with tion and treatment, the urban wastewater directive EU regulations on wastewater collection and (91/271/EEC) requires all urban areas with a total treatment, the costs of complying with those on wastewater discharge of 2,000 population equiva- drinking water, industrial pollution, dangerous lent to be connected to the sewer system, and the chemicals, fuel standards, air quality, and waste discharges of sewers must receive at least secondary management are considered. In chapter 11 of this treatment. The directive allows exceptions for volume, Markandya estimates that the total cost towns with a population of less than 10,000 when would be between 28 billion and 49 billion. sewers would produce no environmental benefit or But he notes that because the outlay will be over a would involve excessive cost. long period (about 17 years), the annual amount In 1997 the population of Turkey was 62.87 mil- will be more manageable. Furthermore, he finds lion. Of this number, 13.75 million were living in that annual investments would amount to around areas with a population of 2,000 or less, 49.12 mil- 2 billion to 3 billion in the "fast reform" lion in areas with more than 2,000, 22.57 million in (low-cost) case and 3 billion to 5 billion in the areas with 10,000 and less, and 40.3 million in areas slow reform (high-cost) case. In the initial years, 328 Turkey: Economic Reform and Accession to the European Union this investment would amount to 1­1.5 percent of ment activities and environmental projects and to GDP in the low-cost case and 1.5­2.5 percent of GDP export promotion activities. Although considerable in the high-cost case. The extra annual operating progress has been achieved in the fields of invest- costs also incurred would range from 5 to 8 bil- ment and export incentives, similar progress has lion. Markandya reports that OECD has estimated not been possible for public enterprises. Privatiza- Turkey's capital spending on the environment at tion has become a prominent part of the Turkish about 0.5 percent of GDP. Thus with accession, this structural adjustment program since 1983, but it spending would have to double, or more likely did not gain momentum until very recently. Turkey increase by a factor of three or four. In addition, a recognizes that it will have to stop subsidizing its much higher level of current spending would be public enterprises at the prevailing rates and that it required. These costs, although substantial by any will have to take steps to align its state aid policies standards, could be considered the price for joining with those of the EU, to apply the same competi- the EU. One could also argue that these investments tion policies to all firms whether private or public, would have been made in any case by Turkey. Only and to privatize public enterprises.10 the timing of the investments would be different, Growth Effects because EU directives may not correspond to Turkey's priorities at this stage of its development. The preceding discussion of the welfare effects of accession reveals that Turkey's integration within the EU will remove the distortions in the country's State Aid price system, which, in turn, will boost allocative During the 1980s, Turkey used three tools of indus- efficiency within the economy. The heightened effi- trial policy intensively: investment incentives, ciency also will make the country a better place in export incentives, and policy on state-owned enter- which to invest. Investment will therefore increase, prises. In each case, the government tried to obtain as will foreign direct investment. Thus the allo- a preferred allocation of resources through the use cative efficiency gains from integration will be of subsidies. The investment incentives, regulated boosted by induced capital formation. When by laws and decrees, have been directed toward investment rises above its normal level, the Turkish reducing the cost of investment, reducing the need economy will experience a growth effect. All this for external financing, and increasing profitability. means improved material well-being for the On the export side, the government's use of various Turkish people in the long term. types of export incentives during the 1980s in- The growth effects of accession will be studied creased the profitability of export activities. As for here by first forecasting the volume of trade the policy on state-owned enterprises in Turkey, the between Turkey and the EU15, under the assump- Turkish public enterprise sector has been and still is tion that it will reach the same level of intensity as very large. The state-owned enterprises have in the present trade between the EU member states. general exhibited poor economic performance The forecast is then used to study the growth effects because of the soft-budget constraints they have of accession. faced. Public enterprises are not subject to com- The forecast of the volume of trade between mercial code and, as such, they escape bankruptcy Turkey and the EU is based on estimation of a grav- laws. Moreover, they receive subsidies from the gov- ity function for trade within the EU15. The gravity ernment in the form of direct transfers, equity function, which has been used to explain the vol- injections, and debt consolidation. ume of bilateral international trade since the 1960s, Recently, Turkey eliminated most of the invest- has proved remarkably successful. It postulates that ment and export incentives. Within this context, the volume of trade between a pair of countries is a General Agreement on Tariffs and Trade (GATT) function of (1) the size of the trading partners, legal subsidies (e.g., research and development measured by GDP, population, or geographic area; subsidies and subsidies to facilitate the adaptation (2) their income level or capital abundance, of plants to new environmental regulations) have measured by GDP per capita; and (3) trade costs, been introduced. Export subsidies in Turkey are measured by a variety of factors such as tariffs restricted to those given to research and develop- and other administratively imposed trade barriers, Economic Implications of EU Accession for Turkey 329 TABLE 12.10 Gravity Estimates for also of the costs of cultural differences, which tend Intra-EU15 Trade to increase with geographic distance. The estimates of the gravity equation are pre- Estimate sented in table 12.10. The equation explains more Constant -3.884133 than 90 percent of the variation in the data.All coef- (-3.193833) ficients are estimated with a very high level of statis- tical significance (less than 1 percent) and have the ln real product GDP 0.815026 expected sign, with one exception. The product of 52.1816 real per capita GDP is found to have an unexpected ln real product GDP per capita -0.145238 negative effect on the volume of trade. The estimate (-2.705978) of the gravity equation is then used to make fore- ln distance -0.901144 casts of bilateral trade for Turkey with the EU15. (-21.50092) The forecasted value of Turkish­EU15 trade for 2000 is $25.75 billion, which is almost 25.2 percent R-squared 0.622767 higher than the actual average value of $18.55 bil- lion for the period 1999­2001. For that period, the Source: The author. average of Turkish exports to the EU was $14.99 bil- lion and of imports from the EU $22.1 billion. geographic distance, common borders, common Next, it is assumed that Turkey eventually will language, or common legal systems. The follow- have a share of EU trade to total trade that is equal ing standard version of the gravity function was to that of the four largest EU countries--58 per- estimated: cent. Then, the total trade of Turkey will increase to $44.4 billion. When this value is divided by the (12.7) ln [(exports from country i to country j average value of GDP for the period 1999­2001, it +exportsfromcountryjtocountryi)/2] produces a ratio between the average of exports and = constant + 1ln (GDP of country i imports to GDP of 25.2 percent. The actual value of × GDP of country j) + 2 ln (GDP per total trade to GDP over the 1999­2001 period is, by capita of country i × GDP per capita contrast, 20.67 percent. Noting the assertion by of country j) + 3 ln (geographic Frankel and Rose (2002) that every percent increase distance) + error term. in the country's overall trade relative to GDP raises The dependent variable in the gravity equation income per capita by at least one-third of a percent, is the logarithmic average of bilateral exports. It is one then finds that, with EU accession, per capita explained by the logarithmic product of GDP; the income in Turkey will increase by about 1.5 percent. volume of trade is simply assumed to rise in pro- portion to the combined economic size of the trade Conclusion partners. GDP per capita can be thought of as a measure of product differentiation and specializa- To join the EU, Turkey must attain macroeconomic tion. The higher the per capita income, the more stability, adopt the EU's Common Agricultural Pol- differentiated are taste and production and the icy, and liberalize its services and also its network larger is the volume of trade based on product dif- industries. Integration will be beneficial for Turkey, ferentiation and increasing returns to scale. A high because it will remove the distortions in the price per capita income is also an indication of abundant system, thereby boosting allocative efficiency within physical and human capital relative to manual the economy,which,in turn,will make the country a labor. Thus the per capita variable should serve to better place to invest. Furthermore, with accession capture both the intraindustry trade produced by Turkey will be eligible for EU structural funds. The product differentiation and the increasing returns increase in infrastructural investments will con- to scale and interindustry trade produced by differ- tribute to economic growth in Turkey. Turkey will ences in factor endowments. Trade costs are also reap benefits from monetary integration. controlled by the inclusion of geographic distance, The welfare gains derived by Turkey from inte- which is an indicator of transportation costs, but gration will, however, have a price. The price will be 330 Turkey: Economic Reform and Accession to the European Union the adjustment costs associated with the attainment European Commission. 2003. 2003 Regular Report on Turkey's of macroeconomic stability, adoption of the CAP, Progress towards Accession. Brussels: EC. Francois, J. 1999. "Estimates to Barriers to Trade in Services." adoption of the EU's labor market rules and regula- Erasmus University, Rotterdam. tions, and compliance with EU environmental Frankel, J., and A. Rose. 2002."An Estimate of the Effect of Com- directives. mon Currencies on Trade and Income." Quarterly Journal of Economics 117: 437­66. Harrison, G. W., T. F. Rutherford, and D. G. Tarr. 1997. "Eco- nomic Implications for Turkey of a Customs Union with the Notes European Union." European Economic Review 41: 861­70. Hoekman, B. 1996. "Assessing the General Agreement on Trade 1. All dollar amounts are U.S. dollars unless otherwise in Services." In The Uruguay Round and the Developing indicated. Economies, ed. W. Martin and L. A. Winters. Cambridge: 2. Cabotage refers to the carriage of freight within a country Cambridge University Press. or between two countries by a carrier that is from neither --------. 2000. "The Next Round of Services Negotiations: country. Identifying Priorities and Options." Federal Reserve Bank of 3. Polo and Scarpa (2003) consider it more appropriate that St. Louis Review 82: 31­47. an independent regulatory authority devoted to the liberaliza- International Energy Agency. 2003. Energy Prices & Taxes: Quar- tion of the industry fill the delicate role of arbitrator rather than terly Statistics Fourth Quarter 2002. Paris: IEA. a ministry, which is typically responsible for a broader range of International Telecommunications Union. 1998. Telecommuni- political objectives. cations Reform. Geneva: ITU. 4. Although in both cases the regulator has the final word on Kalirajan, K., G. McGuire, D. Nguyen-Hong, and M. Schuele. the access conditions, Polo and Scarpa (2003) argue that the ex 2000. "The Price Impact of Restrictions on Banking Ser- ante regime, requiring the regulator to act as a first mover, forces vices." In Impediments to Trade in Services: Measurement and it to reach a better solution. Policy Implications, ed. C. Findlay and T. Warren. London: 5. This approach determines the equivalent variation in con- Routledge. sumer income. Konan, D. E., and K. E. Maskus. 2004. "Quantifying the Impact 6. When considering the welfare effects of integration, I of Services Liberalization in a Developing Country." Work- abstract from explicit consideration of problems of implemen- ing Paper No. 3193, World Bank, Washington, DC. tation and assume that once the acquis is adopted liberalization McGuire, G. 1998."Australia's Restrictions on Trade in Financial of the sector will be achieved. This is a simplification introduced Services." Productivity Commission Staff Research Paper, in the analysis. 7. The implicit price wedge is derived from the relation p = Australian Productivity Commission, Melbourne. p (1 + t), where p refers to the Turkish price p, the best prac- McGuire, G., and M. Schuele. 2000. "Restrictiveness of Interna- tional Trade in Banking Services." In Impediments to Trade in tice price in the EU, and t is the price wedge parameter. Services: Measurement and Policy Implications, ed. C. Findlay 8. See Stern (2002) and Whalley (2004) for further discus- and T. Warren. London: Routledge. sion of the state of knowledge on barriers to trade in services OECD (Organisation for Economic Co-operation and Develop- and the robustness of existing empirical research in this area. ment). 2002. Turkey: Crucial Support for Economic Recovery. 9. Taymaz and Özler report that the share of the informal OECD Reviews of Regulatory Reform. Paris: OECD. sector in manufacturing is 40 percent. Its share is much higher, Polo, M., and C. Scarpa. 2003. "The Liberalization of Energy however, in the agricultural and services sectors. Markets in Europe and Italy." Paper presented at the 4th 10. Turkish competition law is silent on the subject of public Mediterranean Social and Political Research Meeting, undertakings. It does not contain a clause like Article 86 (ex Florence, March 19­23. Article 90) of the Treaty Establishing the European Community, Steiner, F. 2000. "Regulation, Industry Structure and Perfor- which explicitly brings public undertakings within the scope of mance in the Electricity Supply Industry." Economics competition policy. Recently, state aid in Turkey has taken the Department Working Paper No. 238, Organisation for Eco- form of injections to private banks under the management of nomic Co-operation and Development, Paris. Savings Deposit Insurance Fund (SDIF). These banks are largely Stern, Robert. 2002. "Quantifying Barriers to Trade in Services." those hit by capital losses during the November 2000 and Febru- In Development, Trade and the WTO: A Handbook, ed. B. ary 2001 crises. The capital losses stemmed from the sharp Hoekman, A. Mattoo, and P. English. Washington, DC: decline in the market value of government securities holdings World Bank. and the sharp increase in the foreign exchange rate. According to Warren, T. 2000a. "The Identification of Impediments to Trade EU regulations, state aid to the banking sector is subject to the and Investment in Telecommunications Services." In same conditions as any other state aid and as such it should be Impediments to Trade in Services: Measurement and Policy avoided. Implications, ed. C. Findlay and T. Warren. London: Routledge. --------. 2000b. "The Impact on Output of Impediments References to Trade and Investment in Telecommunications Services." In Impediments to Trade in Services: Measurement and Doove, S., O. Gabbitas, D. Nguyen-Hong, and J. Owen. 2001. Policy Implications, ed. C. Findlay and T. Warren. London: "Price Effects of Regulation: International Air Passenger Routledge. Transport, Telecommunications and Electricity Supply." Whalley, John. 2004. "Assessing the Benefits to Developing Productivity Commission Staff Research Paper, Productivity Countries of Liberalisation in Services Trade." World Econ- Commission, Canberra. omy 27: 1223­53. 13 The Impact of Turkey's Membership on EU Voting Richard Baldwin and Mika Widgrén The Treaty of Nice in 2001 and the Constitutional Up to October 31, 2004, the pre­Treaty of Nice Treaty in 2004 radically reformed the voting rules rules apply--that is, qualified majority voting with of the Council of the European Union (also known weighted votes and the old majority threshold of as the Council of Ministers).1 The Constitutional 71 percent to win. The number of votes for the Treaty rules were accepted politically at the Brussels incumbent 15 are unchanged; those for the 10 new- summit in June 2004. The Nice rules went into comers are a simple interpolation of EU153 votes as effect in November 2004. Implementation of the specified in the Accession Treaty. changes was postponed by five years and made con- From November 1, 2004, to October 31, 2009, the ditional on ratification of the constitution by all 25 Nice Treaty rules apply (as per the "Draft Council member states of the European Union (EU). The Decision relating to the implementation of Article next EU enlargement (Bulgaria and Romania) is I-24"). The Nice Treaty rules maintain the basic tentatively scheduled for 2007. Thus Bulgaria and "qualified majority voting" framework, but add two Romania will enter under the current Nice Treaty extra criteria for the number of yes voters and the rules, but future new members are likely to join population they represent. Specifically, the vote under the rules of the Constitutional Treaty. threshold is 72.2 percent of Council votes (232 of This chapter evaluates the impact of Turkey's 321 votes); the member threshold is 50 percent of membership on EU voting--specifically, decision- members (13 members); and the population making efficiency and the distribution of power in threshold is 62 percent of the EU population.4 the EU's leading decision-making body, the Council As of November 1, 2009, the Constitutional of Ministers. The chapter compares two alternative Treaty rules apply, and thus weighted voting is out Council voting rules: those accepted in the Treaty of and a double majority is in. A winning coalition Nice and implemented by the Accession Treaty for must represent at least 55 percent of EU members the 10 entrants in 2004 and the rules laid down in and 65 percent of the EU population. A last-minute the Constitutional Treaty.2 summit compromise inserted the requirement that at least 15 members vote yes, but this compromise was irrelevant; 15 of 25 members is 60 percent and Council of Ministers Voting thus greater than 55 percent. By the time these rules Reforms take effect, however, the EU should have 27 The Constitutional Treaty explicitly sets out two members, and 55 percent of 27 is 15 (Bulgaria sets of voting procedures for the Council of Minis- and Romania are tentatively slated for membership ters and implicitly recognizes the current system in 2007). The 15-member rule will therefore implemented by the Accession Treaty (Article 24). be redundant when it takes effect. Turkey's and 331 332 Turkey: Economic Reform and Accession to the European Union Croatia's membership will, in any case, materialize FIGURE 13.1 Passage Probabilities: after that date. European Council, 1957­2004, To enter into force, the Constitutional Treaty and after Entry of Bulgaria, Romania, Croatia, and Turkey rules must be ratified by all member states. The fall- back position is the Nice Treaty rules, which means Passage probability that Turkey and Croatia may enter the EU under 25 Historical those rules. Therefore, what follows is an evaluation Status quo: May 04 to Nov. 04 of these two rules for the EU25 and EU29. It com- 20 Nice rules: Nov. 04 to Nov. 09 pares especially the impact of Turkey's membership CT rules: Nov. 09 onward on the countries of the EU25 that have the most 15 substantial say in the ratification process of the constitution. 10 Tools of Assessment 5 "Capacity to act" and "decision-making efficiency" are slippery concepts. However, one quantitative 0 tool in voting game theory will help to achieve pre- EU6 EU9 EU10 EU12 EU15 EU25 EU27 EU29 cision. Passage probability gauges how likely it is Note: Passage probability measures the likelihood that that the Council would approve a randomly a randomly selected issue would pass in the Council selected issue--random in the sense that each EU of Ministers. Source: Authors' calculations. member would be equally likely to vote for or against it. The best way to describe this measure is to explain how it is calculated. members without any reforms would cut the First, the researcher, with the help of a com- passage probability to 2.5 percent--a third of its puter, calculates all possible coalitions among EU already low level. With the Nice Treaty reforms, the members--that is, every possible combination of figure drops even further, to 2.1 percent. The main yes and no votes by EU members (134 million source of the lower efficiency is the high threshold coalitions are possible in the EU27). Second, each of the Nice Treaty rules for Council votes. An even coalition is evaluated to determine whether it is a cruder but more transparent efficiency-measuring winning coalition under the Nice Treaty voting tool--blocking-minority analysis--confirms these system. This process is carried out using each efficiency findings. member's actual weight for three criteria (votes, No perfect measure of power exists, but even members, and population) and the three thresh- imperfect measures are useful when considering olds. Passage probability is, then, the likelihood that complex voting rules, because a voting scheme's a random proposal would attract a winning political acceptability turns almost completely on coalition, assuming all coalitions are equally likely its power implications. The measures used here-- (random in the sense that member states do not the normalized Banzhaf index (NBI) and the know what their stance would be). Admittedly, Shapley-Shubik index (SSI)--gauge how likely it is passage probability is a crude measure, but it is that a nation finds itself in a position to "break" a objective and precise, and its strengths and short- winning coalition on a randomly selected issue.5 comings are clear. The NBI assumes that each possible coalition has Even if the exact passage probability is meaning- the same probability of occurrence. Thus all coali- less (the European Commission does not put forth tions are equally likely to be winning ones, and random proposals), figure 13.1 reveals that the Nice power is measured simply by calculating the score Treaty fails on efficiency grounds, because it of breaking positions for each player. A relative implies a level of efficiency that is far, far below that measure of power is then obtained by dividing this of the EU15. Indeed, the Nice Treaty reforms score by the total of all of scores. On particular actually make matters worse. Admitting 12 new issues, some countries may be much more powerful The Impact of Turkey's Membership on EU Voting 333 or much less powerful than others, especially if they A is not critical. Should voter A try to break the are part of a like-minded group (see Baldwin and winning coalition AB by voting against spending, others 2001 for details and simple numerical exam- voter B would have already broken that coalition ples), but the NBI has recently proved its worth, because B is less eagerly in favor of spending. In the especially as an unbribable tool in assessing and example, voter A has four pivotal positions, designing voting rules. and voters B and C have one each. In relative What follows is a simple example of how the terms, winning probabilities ("power") of 2/3 are NBI works. Consider a three-person voting body, obtained for A and 1/6 for both B and C. If SSI is a such as the Council of Ministers, in which the vot- meaningful estimate of power and if power politics ers are labeled A, B, and C. Suppose that A has four is able to explain EU budget, then these fractions votes, B has two votes, and C has one vote, for a should represent the budget shares of A, B, and C, total of seven votes. It is assumed that five votes are respectively. needed to pass proposals. The three winning coali- Clearly, these measures of power do not provide tions are then a detailed description of real-world voting proce- dures. For example, they lack all the strategic AB AC ABC aspects, such as who makes the proposal to be voted on or the sequence of moves. They both contain, where underlining indicates the actors able to however, some information on voters' preferences, "break" a winning coalition. In this situation, A has understood as the intensities of holding a favorable three breaking positions, B has two, and C only one, position. The measures also consider all possible for a total of six breaking positions. Thus the NBI orderings of intensities (SSI) or presume the equal of A is 1/2, whereas the NBIs of B and C are 1/3 and likelihood of all coalitions (NBI), and so they repre- 1/6, respectively. sent a very long-term concept. For a general evalua- The SSI tries to capture a different abstract tion of voting rules, this is a desirable property. voting model. It assumes that voters have different The example just described demonstrates that intensities in terms of accepting or rejecting a the NBI and SSI can have very different values. proposal. Suppose that these intensities can be Which one should then be chosen to assess expressed as a continuum that extends between the decision-making power? The answer is not clear, extremes of more spending and less spending. For but a rough distinction can be made between the example, when the issue is the support for hillside two measures. If one is interested in voting rules as farmers, A may be the most reluctant to increase such, the NBI is more advantageous. If one is more spending, and B may be the second most reluctant, interested in decision making and bargaining leaving C as the most favorably disposed toward under certain rules, knowing that actors communi- increasing support for this purpose. On another cate, then the SSI is a far more suitable tool.6 day, the issue might be the inclusion of reindeer meat in the price support mechanism of the Common Agricultural Policy (CAP). This time, a Impact of Turkey's Membership different order of preferences might emerge. on EU Voting In general, given a large enough number of Turkey's accession to the EU would have issues, all preference orders of A, B, and C are equally implications for EU decision making. As a large likely. In the example used earlier, six orderings are country, Turkey would play a relatively bigger role possible: in the EU than many other entrants. To what extent ABC ACB BAC BCA CAB CBA will accession change the balance of power? where the critical voter is underlined. A critical Implications of Turkey's Membership for EU's voter exerts the power of being able to break a win- Capacity to Act ning coalition. In the first order of ABC, B can break the winning coalition AB. Voter A favors Turkey's membership would have only moderate spending more on this issue than does B. Therefore, implications for the passage probabilities--see 334 Turkey: Economic Reform and Accession to the European Union figure 13.1. This finding is not surprising, because criteria--at least 14 member states and 62 percent moving from 27 members to 29 members does of population. not change much. Although the addition of The Nice Treaty rules--which are essentially Croatia increases the number of small nations in unworkable in an EU27--become even less viable the EU, Turkey's large population means that effi- in an EU29. The same does not hold for the ciency suffers little. (Efficiency, if not legitimacy, Constitutional Treaty voting rules. The passage tends to be higher when a large share of power is probability jumps drastically from the low levels of in the hands of just a few nations.) The vote the Nice Treaty rules up to the level of the EU12 thresholds used in calculations of passage proba- and even higher. Surprisingly, under the Constitu- bilities are extrapolations of the current Nice tional Treaty rules the EU's ability to act improves Treaty/Accession Treaty threshold. In EU29, it is when its membership expands from 25 to 27 or 29. 276 out of a total of 381 votes, plus the two addi- There is only a slight drop from EU27 to EU29 tional criteria: at least 15 member states and from 12.9 to 12.2 percent.7 62 percent of population. In EU27, it is 250 out of In summary, the passage probability calcula- a total of 345 votes, plus the two additional tions demonstrate that Turkey's membership in the FIGURE 13.2 Change in Power for EU25, Nice Treaty to Constitutional Treaty Rules (percentage points) Malta NBI SSI Luxembourg Cyprus Estonia Slovenia Latvia Lithuania Ireland Croatia Finland Denmark Slovakia Austria Bulgaria Sweden Portugal Hungary Belgium Czech Rep. Greece Netherlands Romania Poland Spain Italy France U.K. Turkey Germany 0.04 0.03 0.02 0.01 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 Source: Authors' calculations. The Impact of Turkey's Membership on EU Voting 335 EU does not erode the EU's ability to act. Under the and figure 13.3 reveals the same numbers for the Constitutional Treaty rules, the effect of Croatia EU29. The difference is measured in percentage and Turkey together is significantly smaller--one points. percentage point--than Turkey's alone. The most According to figure 13.2, before Turkey's entry important impact on the EU's capacity to act stems the Constitutional Treaty rules favor the four from the switch from the Nice Treaty rules to the biggest nations and the six smallest--that is, Constitutional Treaty rules. Latvia and smaller--if the comparison is made using the SSI. Based on the NBI, the conclusion is somewhat different: Germany and Slovakia and Impact of Turkey's Membership on the Distribution smaller countries would gain from the Constitu- of Power tional Treaty rules compared with the Nice Treaty The Constitutional Treaty and the Nice Treaty rules. This result differs from that obtained by rules also differ substantially in power evaluation. Baldwin and Widgrén (2004b) for EU27, in which Figure 13.2 shows the difference between these the NBI produced exactly the same pattern as the rules in terms of the NBI and SSI for the EU25, SSI here. FIGURE 13.3 Power Difference between Nice Treaty and Constitutional Treaty Rules for EU29 (percentage points) Malta NBI SSI Luxembourg Cyprus Estonia Slovenia Latvia Lithuania Ireland Croatia Finland Denmark Slovakia Austria Bulgaria Sweden Portugal Hungary Belgium Czech Rep. Greece Netherlands Romania Poland Spain Italy France U.K. Turkey Germany 0.02 0.01 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 Source: Authors' calculations. 336 Turkey: Economic Reform and Accession to the European Union FIGURE 13.4 NBI Values under Nice Treaty and Constitutional Treaty Voting Rules for EU29 NBI 0.12 CT Nice 0.10 0.08 0.06 0.04 0.02 0.00 U.K. Rep. Malta Turkey FranceItalySpain Poland Latvia Greece CroatiaIreland EstoniaCyprus Germany Romania Belgium Hungary Portugal Sweden BulgariaAustria Slovakia DenmarkFinland Lithuania Slovenia NetherlandsCzech Luxembourg Source: Authors' calculations. After Turkey's entry into the EU, the biggest most power, while the smaller nations lose less. The nations gain more from the Constitutional Treaty relative losses are of the same magnitude. This find- rules than was the case for the EU25. This finding ing reflects the fact that in weighted voting power, holds true for both power measures. For the small- the indices tend to converge to voting weights if the est countries, the effect is ambiguous: the NBI number of actors increases and if the voting shows gains for Latvia and smaller nations, whereas weights have relatively small variance. the SSI shows small losses. Otherwise, both indices In figure 13.6, the result is more interesting. show consistent results. When evaluated by the NBI, the enlargement from Figure 13.4 explicitly compares the Nice Treaty EU25 to EU29 benefits France and the United and Constitutional Treaty rules by showing the NBI Kingdom.8 The losses of the other large countries values under both rules. The message of the figure is (the Netherlands and larger nations) are very small. very clear. The countries that gain the most from the For the countries smaller than Romania, the losses Constitutional Treaty rules are the biggest nations, increase slightly as the nations become smaller. The Germany and Turkey. The biggest losers are Spain SSI, however, gives a somewhat different picture. and Poland, as well as the medium-size countries, The most notable exceptions are the biggest from the Netherlands to Austria. This finding could countries, especially Germany. The power loss of affect these countries' attitudes toward either the the Netherlands remains small. ratification of the Constitutional Treaty or Turkey's membership. (The index values for both the EU25 and EU29 are found in the annex to this chapter.) Conclusions This chapter investigates the decision-making Impact of EU Enlargement on Incumbent's impact of expanding the EU from 25 members to Power Figures 13.5 and 13.6 evaluate the impact 29 members with the addition of Bulgaria, of the EU25 to EU29 enlargement in terms of both Romania, Turkey, and Croatia. The chapter focuses power indices. Under the Nice Treaty rules, the on a measure of the EU's capacity to act--passage countries' power losses are proportional to their probability--and the power distribution among sizes. Thus Germany, the biggest country, loses the members. The Impact of Turkey's Membership on EU Voting 337 FIGURE 13.5 Impact of Enlargement on EU25 Power, Nice Treaty Rules (percentage points) Malta NBI SSI Luxembourg Cyprus Estonia Slovenia Latvia Lithuania Ireland Croatia Finland Denmark Slovakia Austria Bulgaria Sweden Portugal Hungary Belgium Czech Rep. Greece Netherlands Romania Poland Spain Italy France U.K. Turkey Germany 0.016 0.014 0.012 0.010 0.008 0.006 0.004 0.002 0.000 Source: Authors' calculations. As for the capacity to act, the enlargement is As for power, Turkey's membership in the EU projected to have relatively little impact if the will have a big impact. Under either the Nice Constitutional Treaty voting rules take effect. In Treaty or Constitutional Treaty rules, Turkey particular, Turkey's membership would have only would be the second most powerful member of a negligible effect on the EU's capacity to act. The the EU29. Under the Constitutional Treaty rules, answer is quite different, however, if the Constitu- Turkey would be substantially more powerful than tional Treaty is rejected and the Nice Treaty rules France, Italy, and Britain, while under the Nice remain in place. Under the Nice Treaty voting Treaty rules the power differences among the rules, the EU25 to EU29 enlargement would members with more than 50 million population substantially lower the ability of the EU25 to act. would be small. Plainly, this situation might Thus our findings confirm that the enlarged EU decrease the acceptability of the Constitutional cannot function well under the Nice Treaty rules. Treaty or Turkey's membership. It also suggests that if the Constitutional Treaty is The impact of the enlargement from EU25 to rejected, the Nice Treaty voting rules must be EU29 on the voting power of EU incumbents reformed before further enlargement. depends heavily on the rules. Under the 338 Turkey: Economic Reform and Accession to the European Union FIGURE 13.6 Impact of Enlargement on EU25 Power, Constitutional Treaty Rules (percentage points) Malta NBI SSI Luxembourg Cyprus Estonia Slovenia Latvia Lithuania Ireland Croatia Finland Denmark Slovakia Austria Bulgaria Sweden Portugal Hungary Belgium Czech Rep. Greece Netherlands Romania Poland Spain Italy France U.K. Turkey Germany 0.025 0.020 0.015 0.010 0.005 0.000 0.005 Source: Authors' calculations. Constitutional Treaty rules, the enlargement lowers bents. Again, all incumbents are projected to lose the power of all incumbents on a fairly even basis, power, but the power loss increases progressively with the marked exception of Germany; Germany with member size. For example, the power loss to loses more than twice as much power as any other France under the Nice Treaty rules is about seven member. Under the Nice Treaty rules, the power times larger than the power loss to Malta. loss is more heavily skewed toward the big incum- The Impact of Turkey's Membership on EU Voting 339 Annex: Power Indices under the Constitutional Treaty Rules and Nice Treaty Rules TABLE 13.1 Power Indices under Constitutional Treaty Rules Member State NBI_EU29 NBI_EU25 SSI_EU29 SSI_EU25 Germany 0.10203 0.10407 0.13556 0.15816 Turkey 0.09960 n.a. 0.13152 n.a. U.K. 0.07644 0.07614 0.09389 0.10332 France 0.07611 0.07587 0.09339 0.10278 Italy 0.07469 0.07475 0.09121 0.10041 Spain 0.05491 0.05670 0.06313 0.06798 Poland 0.05429 0.05602 0.06203 0.06694 Romania 0.03786 n.a. 0.03664 n.a. Netherlands 0.03052 0.03715 0.02701 0.03440 Greece 0.02495 0.03304 0.01991 0.02721 Czech Rep. 0.02474 0.03287 0.01964 0.02693 Belgium 0.02463 0.03279 0.01950 0.02680 Hungary 0.02453 0.03271 0.01936 0.02666 Portugal 0.02442 0.03262 0.01922 0.02651 Sweden 0.02314 0.03162 0.01758 0.02489 Bulgaria 0.02250 n.a. 0.01676 n.a. Austria 0.02239 0.03103 0.01663 0.02403 Slovakia 0.01940 0.02870 0.01288 0.02000 Denmark 0.01940 0.02870 0.01288 0.02000 Finland 0.01918 0.02854 0.01261 0.01975 Croatia 0.01886 n.a. 0.01221 n.a. Ireland 0.01768 0.02737 0.01077 0.01785 Lithuania 0.01768 0.02737 0.01077 0.01785 Latvia 0.01628 0.02630 0.00905 0.01631 Slovenia 0.01585 0.02598 0.00853 0.01568 Estonia 0.01521 0.02547 0.00774 0.01487 Cyprus 0.01445 0.02490 0.00680 0.01384 Luxembourg 0.01413 0.02465 0.00641 0.01342 Malta 0.01413 0.02465 0.00641 0.01342 n.a. Not applicable. Source: Authors' calculations. TABLE 13.2 Power Indices under Nice Treaty Rules Member State NBI_EU29 NBI_EU25 SSI_EU29 SSI_EU25 Germany 0.07189 0.08630 0.07814 0.09292 Turkey 0.07189 n.a. 0.07814 n.a. U.K. 0.07189 0.08630 0.07814 0.09292 France 0.07189 0.08630 0.07814 0.09292 Italy 0.07189 0.08630 0.07814 0.09292 Spain 0.06821 0.08159 0.07237 0.08613 Poland 0.06821 0.08159 0.07237 0.08613 Romania 0.03832 n.a. 0.03615 n.a. Netherlands 0.03565 0.04195 0.03340 0.03983 Greece 0.03305 0.03881 0.03082 0.03648 Czech Rep. 0.03305 0.03881 0.03082 0.03648 340 Turkey: Economic Reform and Accession to the European Union TABLE 13.2 (Continued) Member State NBI_EU29 NBI_EU25 SSI_EU29 SSI_EU25 Belgium 0.03305 0.03881 0.03082 0.03648 Hungary 0.03305 0.03881 0.03082 0.03648 Portugal 0.03305 0.03881 0.03082 0.03648 Sweden 0.02771 0.03246 0.02560 0.03024 Bulgaria 0.02771 n.a. 0.02560 n.a. Austria 0.02771 0.03246 0.02560 0.03024 Slovakia 0.01954 0.02291 0.01777 0.02099 Denmark 0.01954 0.02291 0.01777 0.02099 Finland 0.01954 0.02291 0.01777 0.02099 Croatia 0.01954 n.a. 0.01777 n.a. Ireland 0.01954 0.02291 0.01777 0.02099 Lithuania 0.01954 0.02291 0.01777 0.02099 Latvia 0.01124 0.01324 0.00999 0.01190 Slovenia 0.01124 0.01324 0.00999 0.01190 Estonia 0.01124 0.01324 0.00999 0.01190 Cyprus 0.01124 0.01324 0.00999 0.01190 Luxembourg 0.01124 0.01324 0.00999 0.01190 Malta 0.00841 0.00998 0.00755 0.00895 n.a. Not applicable. Source: Authors' calculations. Notes References 1. Legally, the Accession Treaty for the 10 new member states Baldwin, R., and M. Widgrén. 2003a. "Decision-Making and the in 2004 implemented the voting system agreed on politically in Constitutional Treaty: Will the IGC Discard Giscard?" CEPS the Treaty of Nice. The voting rules of the Constitutional Treaty Policy Brief No. 37, Center for European Policy Studies, will come into force on November 1, 2009, if it is ratified by all Brussels. member states. --------. 2003b. "The Draft Constitutional Treaty's Voting 2. This chapter draws on the methodology and results Reform Dilemma?" CEPS Policy Brief No. 44, Center for described in Baldwin and Widgrén (2003a, 2004a, 2004b). European Policy Studies, Brussels. 3. EU15 refers to the 15 members of the EU prior to the 2004 --------. 2004a. "Winners and Losers under Various Dual enlargement in which 10 more countries joined the EU. The Majority Rules for the EU Council of Ministers." In Reasoned 15 countries are Austria, Belgium, Denmark, Finland, France, Choices--Essays in Honor of Academy Professor Hannu Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Nurmi on the Occasion of His 60th Birthday, ed. M. Wiberg. Portugal, Spain, Sweden, and the United Kingdom. Helsinki: Finnish Political Science Association. 4. The rules that took effect in November 2004 were not those --------. 2004b. "Council Voting in the Constitutional Treaty: agreed on at the Nice summit in December 2000. The deal struck Devil in the Details." CEPS Policy Brief No. 53, Center for at4a.m.attheendof thelongestEUsummitinhistorywasapolit- European Policy Studies, Brussels. ical commitment. The legally binding changes are in the Acces- Baldwin, Richard, Erik Berglöf, Francesco Giavazzi, and Mika sionTreaty.BecauseEUleaderseventuallyrealizedhowinefficient Widgrén. 2001. "Nice Try: Should the Treaty of Nice Be the Nice rules were,they improved efficiency by lowering the vote Ratified?" Monitoring European Integration 11. London: threshold from the 74 percent mentioned in the Nice Treaty. Centre for Economic Policy Research. 5. In the literature, the term swing is quite often used instead Kauppi, H., and M. Widgrén. 2004. "What Determines EU of break. Decision-Making: Needs, Power or Both. Economic Policy 39: 6. See, for example, Widgrén (1994), Laruelle and Widgrén 221­66. (1998), and Laruelle and Valenciano (2004). A recent empirical Laruelle, A., and F. Valenciano. 2004."Bargaining in Committees application of the SSI can be found in Kauppi and Widgrén of Representatives: The Optimal Voting Rule." Discussion (2004). Paper 45/2004, Departamento de Economía Aplicada IV, 7. Note that in EU28 (EU27 Turkey), the passage probabil- Basque Country University, Bilbao, Spain. ity is 11.2 percent, which is lower than it is in EU29 (see Baldwin Laruelle, A., and M. Widgrén. 1998. "Is the Allocation of Voting and Widgrén 2003b). The reason is that the membership Power among EU States Fair?" Public Choice 94: 3­4, 317­39. quota--55 percent of membership--is 16 in both EU28 and Widgrén, M. 1994. "Voting Power in the EU and the Conse- EU29. It is thus closer to 55 percent in EU29 than in EU28--the quences of Two Different Enlargements." European Economic exact numbers are 55.2 percent and 57.1 percent, respectively. Review 38: 1153­70. 8. This phenomenon is often referred to as the paradox of new members. 14 Economic Effects of Turkey's Membership on the European Union Harry Flam From the perspective of the European Union (EU), recipient of transfers from the EU budget, at least which is considering the economic consequences of under the present rules and policies. accepting Turkey as a member, the most important As for trade, Turkey's accession is not likely to facts about Turkey are its size and its low per capita have any significant trade effects, and consequently income.1 any significant effects for EU industry, for two With a population of almost 70 million, Turkey reasons. First, Turkey is not an important trading would, in terms of today's population figures, partner of the EU countries, with the exception of become the second largest member of the EU. Greece. (The EU is, however, Turkey's most impor- However, the population of Turkey is relatively tant trading partner.) Second, Turkey has free com- young, and it is likely to exceed Germany's 82 mil- modity trade with the EU under a customs union, lion by 2020, if not earlier. except for agricultural commodities. By the time By comparison with the European countries, Turkey becomes a member of the EU, the customs Turkey is poor. It has a PPP (purchasing power union will have been in effect for more than a parity)-adjusted per capita income of roughly decade. US$7,000,2 which is equal to those of Bulgaria and Romania, countries slated to join the EU in 2007. Migration The income disparities across Turkey are great; the population in the southeast has less than half the The PPP-adjusted per capita income of the EU153 is national average income, and the large rural popu- four times higher than that of Turkey. Because lation is generally much poorer than the urban Turkey has had about the same per capita growth population. Turkey's relatively low level of develop- rate as the EU15 since 1990, the probability that ment is evident in the share of the labor force in Turkey will catch up in the foreseeable future seems agriculture and in the sector's share in value added. very low. The income differential will therefore con- Only Bulgaria and Romania have a similar depend- tinue to be a strong incentive for migration from ence on agriculture. Turkey to the EU. Turkish migration to Western The descriptive statistics suggest that the impor- Europe was particularly high in the 1960s, but it tant economic effects of Turkey's accession to the continues to be steady flow, particularly to Germany EU should be related to its size, per capita income, and, to a lesser extent, the Netherlands. In the 1950s and dependence on agriculture. For the EU, these and 1960s, many of the present EU countries three factors combine to create a huge immigration actively recruited foreign labor,but that recruitment potential if migration is let free. Moreover, these ended after the first oil crisis in 1973­74. Since then, factors indicate that Turkey may become the largest immigration policies have become successively 341 342 Turkey: Economic Reform and Accession to the European Union more restrictive, and immigrants have mostly con- differentiated by education, training and experi- sisted of relatives of former immigrants, refugees, ence. The demand for labor by employers in Turkey and asylum seekers. Most migrants from Turkey is shown by the demand curve DT. Likewise, the have ended up in Germany, which has a population demand for labor in Germany is shown by the of Turkish origin of 2.1 million. The second largest demand curve DG. The total supply of labor in recipient has been the Netherlands, which has Germany and Turkey is assumed to be fixed. Ini- 250,000 immigrants and their descendants from tially, the total supply is divided so that the supply Turkey. of labor in Turkey is measured by the length of the The prospect of large-scale immigration from line segment LTL0 and the supply of labor in Turkey is a source of considerable concern among Germany by the length of the line segment LGL0. the EU15; they fear immigrants will depress wages, The supply of labor in each country is assumed to boost unemployment, and cause social frictions be inelastic. Before migration is allowed, the equi- and political upheavals. Free migration will surely librium wage in Germany is wG, which is much not be allowed immediately upon full membership. higher than the equilibrium wage in Turkey, wT. After the enlargement in the 1980s and the latest When free migration is allowed, labor will move enlargement in 2004, old member countries were from Turkey to Germany to earn the higher wage. allowed to restrict immigration from new member Migration stops when the wage is equalized countries for a period of seven years. It can there- between the two countries, at w, and when L1L0 of fore be safely assumed that immigration from the labor force has moved from Turkey to Germany. Turkey will be subject to restrictions for several Thus one effect of migration is that it raises the years. wage in the sending country and reduces the wage in the receiving country. Migrants as well as those Migration Theory remaining in Turkey gain, while German workers lose. The effects for capital owners are the opposite; The effects of migration from Turkey to any of the Turkish capital owners now earn the surplus TwE EU15 member states are illustrated in figure 14.1. instead of TwTC, and German capital owners The horizontal axis measures the total supply of earn GwE instead of GwGA. (It is assumed that labor in Turkey and, say, Germany. The simplified capital does not migrate in response to earnings approach used here first assumes that labor is a differences.) The fact that part of the labor force has homogeneous factor of production. Later, labor is moved from Turkey to Germany also means a decline in the Turkish gross domestic product FIGURE 14.1 Effects of Migration (GDP) and a rise in the German GDP. All these changes amount to an increase in the combined Wage Wage social surplus or welfare. The increase is given by the area ACE, and it is captured by German capital T G owners and Turkish migrants. The welfare increase stems from a more efficient allocation of labor; DT DG Turkish laborers become more efficient when moved to Germany, and the optimal allocation is achieved when the marginal productivity of labor in Germany A wG and that in Turkey are equalized. Figure 14.1 provides a simplistic but powerful E B analysis of the income, redistribution, output, and w w welfare effects of migration. It builds on the assumption that migration is entirely driven by a wT D C wage differential and that no unemployment exists. Unemployment can be easily added to the model. LT LG Assume that before migration is allowed, L1L0 of L1 L0 the Turkish labor force is unemployed. Those Source: The author. employed now earn a higher wage--w instead of wT. Economic Effects of Turkey's Membership on the European Union 343 Assume also that employment is decided periodi- from migration tends to rise the more comple- cally by a lottery. Thus the expected wage (the mentary migrants and native workers are. In terms actual wage w times the probability of winning of figure 14.1, a smaller substitutability between employment) is lower than the actual wage and lies labor and capital means that the demand curves somewhere between w and wT. The expected wage become steeper and the size of the surplus triangles in Turkey is still below the certain wage wG in becomes greater (up to a point). Germany. Consequently, labor will migrate to The decision to migrate depends not only on Germany once migration is allowed. Assume that relative wages and unemployment, but also on all the unemployed in Turkey migrate to Germany, many other factors. The early theoretical research that those who remain are employed, and that some (e.g., Berry and Soligo 1969) focused on income fraction of the larger labor force in Germany can- differentials and individual decisions. Recent not be employed because of a lack of new invest- research stresses that migration is a household ment. Employment in Germany is also decided decision and that social networks, culture, lan- periodically by a lottery, in which German and guage, geographical distance, and other factors are Turkish workers have equal probabilities of win- also important. For example, the adjustment cost ning. The expected wage therefore falls below wG, for a migrant depends on the size of the migrant but not all the way to w. Thus in the new equilib- population from the same source country in the rium, both the actual and the expected wage are receiving country and on language and cultural dif- higher in Germany than the actual wage in Turkey. ferences. Turks are attracted to Germany in part The expected wage can be higher in Germany because of the large Turkish immigrant population because workers attach a negative value to the risk there, and Algerians are attracted to France partly of becoming unemployed and demand a higher because of their knowledge of French and familiar- expected wage to compensate for the risk. The ity with French culture (for a survey, see Ghatak, analysis here captures an idea first expressed in a Levine, and Wheatley Price 1996). model by Harris and Todaro (1970) of rural to urban migration in a developing country. Empirical Research Findings Turkish migration can, then, serve both to depress wages in the receiving country and to raise Empirical research on immigration has focused unemployment. Changes in the assumptions made, largely on two questions (Borjas 1994). First, how such as allowing employment to increase in do immigrants perform in the host country? Sec- Germany or letting immigrant Turkish workers ond, what is the impact of immigration on the have a higher risk of becoming unemployed than wages and employment of natives? Most of the native German workers, would not change the basic research has been carried out on the United States, conclusions. One assumption in the analysis is and it is therefore not fully relevant for Europe. In questionable, however--that labor is homoge- the past, immigration to the United States has been neous. In reality, labor is highly differentiated by more permanent in nature than immigration in education, training, experience, and many other Europe, and permanence has an impact on the per- characteristics. Thus there are not just two factors formance of immigrants. Furthermore, European of production--labor and capital; there are many labor markets are generally considered to be more types of labor and many types of capital. As soon as rigid than those in the United States because of three factors or more are allowed for, the effects of their stronger labor unions, more regulation, and migration on income distribution and social wel- immigration policies. fare become less clear-cut (see Borjas 1995). In gen- The recent wave of immigration in the United eral, its effects on native labor and capital become States differs from past waves by the markedly more favorable when immigrants are complements lower level of education of immigrants compared to rather than substitutes for the native factors. For with that of natives. Whereas earlier immigrants example, if German workers are skilled and Turkish reachedtheincomeandemploymentlevelsof natives immigrants are unskilled, then immigrants tend to fairly soon, later immigrants do not. Moreover, increase the productivity and wages of German there is a high correlation between first- and second- workers. Likewise, the increase in social surplus generation immigrants in terms of educational 344 Turkey: Economic Reform and Accession to the European Union attainment, and therefore a high probability that grants by far, seems to indicate fairly small and the second generation, too, will fall behind (Borjas mixed effects: employment opportunities are not 1994). These findings for the United States may be much affected; the wage of low-skilled labor is applicable to Europe and, in particular, to immigra- somewhat depressed but that of skilled labor is tion from Turkey, which mostly consists of people raised; and the net present value of public transfers from rural areas with low levels of education. is positive. It is more difficult to evaluate the social There is little evidence that immigration has a costs and benefits of immigration. Immigrant ghet- significant negative effect on the employment tos with high unemployment, crime rates, and opportunities of natives, either in the United States social problems loom large in the minds of the or in Europe. There is, however, some evidence of native population in many countries, although the small negative effects on the wage of unskilled labor immediate costs are mostly borne by the immi- in both. A positive effect on the wage of skilled grants themselves. labor has been found in Germany, which can be expected when unskilled immigrants are comple- ments to skilled native workers.4 Estimated Model of Migration to Germany from Southern Europe A third question that has been the subject of some research and has received much attention The forecast of free Turkish migration to Germany from policymakers and the general public is presented in this section is based on an estimated whether immigrants are net recipients of or net model of immigration to Germany from the EU15, contributors to the public coffer. The problem with Norway, Turkey, the United States, and former earlier studies is that they focus on a single year, Yugoslavia by Boeri and Brücker (2000) in a report neglecting the cost and expenditures for an immi- to the European Commission. The choice of grant later in life, such as pensions, and they do not Germany is dictated by the facts: first, Germany is consider some general equilibrium interactions, home to the largest population of Turkish immi- such as that between immigrants and an aging pop- grants among the EU15 countries by far, and it can ulation. The studies by Auerbach and Oreopoulos therefore be expected to attract the largest numbers (1999) and Storesletten (2000) for the United States of future immigrants; and second, there is a paucity take a dynamic, life-cycle approach with partial or of data on migration flows and stocks before the general equilibrium interactions. They find nega- 1990s for most of the EU15 countries. tive, but relatively small, fiscal effects for low-skilled Boeri and Brücker estimated how the flow of immigration. Storesletten estimates the average net migration depends on the wage differential, employ- present value of a representative low-skilled legal ment rates in the home and host countries, the immigrant to be -$36,000. A high-skilled immi- stock of migrants from the home country, restric- grant, by contrast, contributes $96,000 over his or tions on migration, and country specifics, such as her lifetime. A study of Germany by Bonin (2001) language differences, distance, and institutions. The finds a significant positive effect for the average migration decision is assumed to be dependent on immigrant over his or her life cycle; net immigra- expectations about the following factors: the future tion of 200,000 persons to Germany is estimated to wage differential, based on present and past values yield natives 200 per capita per year. The positive of the differential, conditioned by the individual effect stems from the fact that the average immi- probability of finding employment in the host grant has a younger working age and thus is obliged country relative to the home country, which is to participate in the repayment of the existing assumed to be based on present and past average government debt. The fiscal impact of immigration employment rates; the ease of adjustment, proxied is bound to differ among European countries, by the number of migrants in the host country; the depending on the structure and level of taxes and difference in development between the home and benefits. host country and language differences; and the The relatively scant empirical research on the agreements regulating migration, such as guest economic effects of immigration to Germany, host worker agreements. Migration flows are viewed as to the largest immigrant population among the short-run adjustments to a long-run equilibrium EU15 and the largest population of Turkish immi- in which migration has ceased and the migrant Economic Effects of Turkey's Membership on the European Union 345 population relative to the source country popula- FIGURE 14.2 Forecast of Turkish Immigrant tion has attained an equilibrium level dependent Population in Germany, on the wage differential, the employment rate dif- 2000­30 ferential, restrictions on migration, and country- Million specific factors. The long-run equilibrium is also 4 estimated, thereby producing long-run relations 1% between the ratio of migrants to the source country 2% 3.5 population and the explanatory variables.5 The 3% existence of a long-run equilibrium builds on the 3 assumption that the propensity to migrate has a certain distribution over individuals in the home country; the equilibrium is reached when those 2.5 with the highest propensity have emigrated for the given long-run values of the explanatory variables 2 and those remaining do not find emigration 2000 2010 2020 2030 worthwhile.6 Note: Figure shows forecasts for a 1, 2, and 3 percent As expected, the migrant population as a pro- convergence rate of per capita income between portion of the source country population is in the Germany and Turkey. long run positively related to the income differen- Source: Author's calculations based on Boeri and Brücker 2000. tial between the receiving and the source country, the employment rate in the receiving country, and free migration and guest worker agreements, and is negatively related to the employment rate in the This rate can be compared with the average GDP source country. per capita growth rate of about 3 percent over the last five decades. The results of the forecast are shown in fig- Forecast of Migration from Turkey to Germany ure 14.2. In the figure, the Turkish immigrant pop- Boeri and Brücker's estimates are used here to fore- ulation starts out at about 2.2 million in 2000 and cast free migration from Turkey to Germany from reaches about 3.5 million in 2030 under the 2000 to 2030. Making such a forecast requires assumption that no restrictions are placed on assumptions about population and GDP growth migration. This forecast, however, is highly uncer- rates and employment rates for the whole period. tain. It depends on the specification of the migra- Population growth is based on forecasts by the tion model, the precision of the estimates, and World Bank in its World Development Indicators heroic assumptions about GDP and population database. It is assumed that the employment rates growth rates. Furthermore, it is assumed that esti- in 2000 remain constant during the period under mates made for a group of countries can be applied consideration. German GDP growth is assumed to to a different country pair and a different time be the average for 1990­2000. The GDP and popu- period. If anything, the assumed rates of conver- lation growth rates yield a GDP per capita growth gence may be overly optimistic, considering the fact rate of 1.7 percent. For Turkey, a higher GDP that no convergence has taken place since 1990. growth rate is assumed. The forecasts are based on The rate of migration is about 80,000 per year in the admittedly optimistic assumption that, alterna- the beginning of the forecast period, when little tively, 1, 2, or 3 percent of the per capita income gap convergence has taken place. This finding implies is closed every year. This assumption means, in that in the extreme case of no convergence, about turn, that GDP per capita in Turkey is assumed to 2.5 million Turks would migrate to Germany over grow at (a very high) 9, 12, or 15 percent at the a 30-year period compared with about 1.3 million beginning of the period and at about 3 percent at in the case in which 2 percent of the income gap is the end. The assumption of a 2 percent yearly closed every year. reduction of the per capita income gap implies an Although forecasts of Turkish migration to all average GDP per capita growth rate of 5.5 percent. EU15 countries are desirable, lack of data makes it 346 Turkey: Economic Reform and Accession to the European Union impossible to estimate the flow of migration along The total contribution by a member state to the EU the lines of Boeri and Brücker for more than one budget is, by decision, capped at an annual amount or two countries. However, Germany is by far the equal to 1.27 percent of GNP until 2006, when the most important target country of migration from present budget ends. Turkey, and it would dominate any estimate of Expenditures have two main destinations: the immigration to the whole of the EU. Common Agricultural Policy (CAP) and Structural Operations, aimed at disadvantaged countries and regions. Until recently, the CAP focused on price The EU Budgetary Effects of supports. The prices of many agricultural products Turkey's Membership were kept above world market prices by purchasing The structure of the present system of EU revenue excess supplies at administratively determined and expenditure is such that rich member states minimum prices and by protecting EU markets transfer resources to poor members, but the rela- from low world market prices by imposing duties tion between income per capita and net transfer is on imports. Excess supplies were disposed of at a far from straightforward.7 Some rich countries give loss in the EU and on the world market. Since 1993, proportionately more than others, and some poor the CAP has gradually shifted away from price countries receive a disproportionate share of the support to income support. Prices in the EU have transfer. The countries that joined the EU in 2004 been reduced so that they are more in line with and Turkey are all poor relative to the EU15. Much world market prices, and farmers are increasingly attention has therefore been given to the effects of receiving support payments based on their hold- EU enlargement on the EU budget, assuming that ings of land and animals. The CAP favors farmers enlargement will be very costly for the EU15. The and the main agricultural products--grains, sugar present net recipients from the EU budget fear that beet, dairy products, and beef--of the original EU6 they will be the ones to bear a disproportionate (Belgium, Federal Republic of Germany, France, share of the cost, and the net contributors fear that Italy, Luxembourg, and the Netherlands). Fruits, they will be required to raise their contributions. vegetables, poultry, and pork, important products The major items on the revenue and expenditure of the newer, southern members, receive less or no sides of the budget in 2002 are shown in table 14.1. support. Revenues are collected from three sources: member Structural Operations are based on criteria of states' valued added tax (VAT) revenues, customs underdevelopment and the structural disadvan- duties collected by member states, and a tax related tages of particular regions and countries. Regional to member states' gross national product (GNP). support is furnished through the EU's Structural TABLE 14.1 EU Budget, 2002 Revenues Expenditures Amount Share Amount Share ( millions) (%) ( millions) (%) Duties and levies 15,267 17.3 Agriculture 40,506 48.6 Value added tax 35,193 40.0 Structural operations 27,591 33.1 GNP 37,580 42.7 Internal policies 5,361 6.4 Correctiona -71 External expenditure 5,231 6.3 Total 87,969 100.0 Administrative Other revenueb 4,755 expenditure 4,643 5.6 Total 92,724 Total 83,331 100.0 a. Does not add up to zero because of exchange rate differences. b. Consists of interest, surplus from previous years, fines, taxes on salaries of employees of European institutions, and so forth. Source: European Commission 2001. Economic Effects of Turkey's Membership on the European Union 347 Funds. For example, to be eligible for support under as a form of compensation to Greece, Ireland, the classification of Objective 1, a region must have Portugal, and Spain. Austria, Finland, and Sweden a per capita income that is less than 75 percent of do not have poor regions eligible for much support the EU average. About 55 percent of the Structural from the Structural Funds. Objective 6 of those Operations expenditure falls under this classifica- funds (later included in Objective 1) was tailored tion. By construction, the Cohesion Fund is exclu- for support to the northernmost parts of Finland sively directed at Greece, Ireland, Portugal, and and Sweden and the mountainous areas of Austria Spain. The Cohesion Fund expenditure is modest, as compensation. or about 2 percent of the total budget, but it is The present rules for contributions to and important for the recipient countries. receipts from the EU budget favor poor countries, Turkey's contributions to and receipts from the because contributions are more or less propor- EU budget can be calculated by estimating the "tax tional to income per capita. Meanwhile, Structural base"--that is, VAT and tariff revenue and GNP-- Operations are targeted at poor countries and and the extent to which Turkish agriculture and regions to raise their incomes relative to those of regions are eligible for support from the CAP, the richer countries and regions. The CAP has a Structural Funds, and Cohesion Fund. Such a bias toward temperate climates and therefore the calculation is likely to produce a large net transfer richer members, but not enough to overturn the to Turkey, both because of the size of the agricul- redistributive effects of Structural Operations. In tural sector and because Turkey is relatively poor. It the final instance, the rules in a future EU29 (i.e., an is unlikely that the EU will accept Turkey as a mem- EU that includes Bulgaria, Croatia, Romania, and ber if this transfer proves to be very costly. More- Turkey) will depend on whether the decision rules over, the enlargement in 2004 included countries under the new Constitutional Treaty will come into with relatively large agricultural sectors that will force in 2009 and what strategy the countries that put a heavy demand on the EU budget once the entered in 2004 and the four candidate countries present transition period has come to an end. are going to follow. Negotiations are presently under way on the EU The old pre­Nice Treaty rules gave small coun- budget for 2007­13. It is expected that the EU15, tries much more voting power per capita than large which is a large net contributor to the budget, will countries (see chapter 13). This situation produced try to modify the rules for contributions to and these extremes: Germany, with a population of receipts from the budget in order to reduce the 82 million, had 10 votes in the Council of Ministers, amount of redistribution from rich to poor mem- while Luxembourg, with a population of 400,000, ber states. had two, giving voters in Luxembourg 42 times the Under past enlargements, rules were changed if voting power of voters in Germany. The Nice Treaty an acceding country became a disproportionately rules modified the inequality, giving Luxembourg large net contributor or was a disadvantaged recip- voters 22 times more weight than German voters. ient of CAP or Structural Funds support under the The Constitutional Treaty rules, which are sup- existing rules. For example, the United Kingdom posed to take effect in 2009, do away with weighted has a relatively small agricultural sector and voting and introduce a double majority rule: for a receives modest CAP support. After a long struggle, decision to pass, it has to be supported by 55 per- it won a permanent rebate--a "correction of budg- cent of EU members and 65 percent of the EU pop- etary imbalances"--on its contribution. Portugal ulation. A coalition of the 14 countries that entered and Spain also receive modest CAP funding, the EU in 2004 or will enter later would comprise because their agriculture produces relatively little 48 percent of EU members and 28 percent of the grain. After Portugal and Spain acceded to the EU, population. Thus such a coalition could be power- the member states decided to limit the aggregate ful and even decisive in a future EU that includes CAP spending in favor of Structural Funds spend- Turkey.8 ing, which benefited both countries. The Cohesion The present redistribution of funds between Fund, established in 1993 ostensibly to help the member countries through the EU budget reflects poor members cope with the European Economic the pre­Nice Treaty distribution of votes in the and Monetary Union (EMU), can be viewed as well Council of Ministers. Calculation of the transfers to 348 Turkey: Economic Reform and Accession to the European Union the countries that entered the EU in 2004 and to that each country will have is, of course, somewhat Turkey if these rules were unchanged would indi- uncertain, but it is known that each country will cate what incentive the EU15 has to alter the rules receive a number of votes equal to that of an EU15 in order to reduce the transfer of funds to the new country with a population of similar size. Whether members. a country will have Cohesion Fund status is also The contribution per capita to the EU budget is uncertain. The assumption is that all countries explained by regressing contribution per capita on except Cyprus have such status. GDP per capita, and the receipts per capita are explained by regressing receipts per capita on the number of Council votes per capita plus the level of TABLE 14.2 Estimates of EU Budget development as defined by eligibility for Cohesion Contributions/Receipts Fund status.9 The results are shown in table 14.2. Equations The table reveals that GDP per capita alone can explain 78 percent of the variation in contributions Receipts Contributions per capita among the EU15. The estimated coeffi- per Capita per Capita cient is highly significant. As for receipts per capita, GNP per capita 0.008 the number of votes per capita and Cohesion Fund (0.00) status can explain as much as 86 percent of the Votes per capita 19.3 variation in the data. The effect of voting power is (0.067) borderline significant (it is significant at the 10 per- Cohesion dummya 629.9 cent confidence level, but not at the 5 percent confi- (0.00) dence level), whereas the effect of Cohesion Fund Adjusted R2 0.86 0.78 status is highly significant. No. of observations 30 15 The estimates in table 14.2 were then used to estimate the contributions and receipts of each new Note: P values appear in parentheses. Receipts member country, plus Bulgaria, Romania, and per capita are based on for 1999 and 2000 data, and contributions per capita are based on 2000 Turkey, on the assumption that each country would data. receive a number of votes consistent with pre­Nice a. Interacted with votes per capita. Treaty rules (table 14.3). The exact number of votes Source: European Commission 2001. TABLE 14.3 Estimated EU Budget Contributions and Receipts GDP Assumed Cohesion Contribution Total Receipts Total Population ( Number Fund per Capita Contribution per Capita Receipts (millions) billions) of Votes Status (euros) ( millions) (euros) ( millions) Poland 38.7 174 8 1 90 3,472 297 11,505 Romania 22.4 39 6 1 67 1,499 337 7,544 Czech Rep. 10.3 55 5 1 96 992 477 4,917 Hungary 10.0 49 5 1 93 930 487 4,868 Bulgaria 8.2 13 4 1 65 536 479 3,927 Slovak Rep. 5.4 21 3 1 84 453 523 2,823 Lithuania 3.7 12 3 1 79 293 688 2,544 Latvia 2.4 8 3 1 79 190 971 2,331 Slovenia 2.0 19 3 1 133 266 1,133 2,266 Estonia 1.4 5 3 1 84 118 1,548 2,168 Cyprus 0.8 10 2 0 159 128 212 170 Malta 0.4 4 2 1 133 53 3,394 1,358 Turkey 65.3 215 10 1 80 5,200 263 17,152 Total 14,130 63,572 Source: World Bank 2001 and author's estimates. Economic Effects of Turkey's Membership on the European Union 349 The total net transfer to the 13 countries is quite that trade will reach the same level of intensity as large, 49 billion, which is more than half of the trade between the EU member states at present. present budget of the EU15. Turkey would receive a The forecast is based on estimation of a gravity net transfer of about 12 billion and Poland a net of equation for trade within the EU15.10 In the gravity about 8 billion. The smaller countries receive net equation, the trade between a pair of countries is transfers that are much larger per capita than those explained by the size of their GDP and their GDP of the larger countries because of their greater vot- per capita, as well as the geographical distance ing power. The extreme cases are Malta and Turkey, between them and whether they share a common with net transfers of 3,400 and 263 per capita, land border. GDP captures the effect of country respectively. size; a large country typically has more trade than It is clear that balancing the EU budget will a smaller country. GDP per capita is a measure require changes in the EU budget rules and in the of product differentiation and specialization. The CAP. The calculations in table 14.3 assume full CAP higher the per capita income, the more differenti- subsidies to the new members, but, at present, the ated are taste and production, and the larger is the countries that entered in 2004 receive 25 percent of volume of trade based on product differentiation CAP subsidies. Such changes must take effect and increasing returns to scale. A high per capita before the new members are eligible for full CAP income is also an indication of abundance of phys- and Structural Operations support. (The latter are ical and human capital relative to manual labor. more redistributive than the CAP.) Thus the per capita variable should serve to capture both intraindustry trade caused by product differ- entiation and increasing returns to scale and Trade interindustry trade caused by differences in factor Commodity trade between Turkey and the EU has endowments. Trade costs are controlled for by the been practically free since the late 1990s, except for inclusion of geographical distance and a common agricultural commodities. The pattern of trade is land border. Geographical distance is an indicator not expected to change substantially as a result of of transportation costs, but also of the costs of full EU membership for Turkey, but the volume cultural differences, which tend to increase with of trade could increase considerably. The 2004 geographical distance. Finally, a common land entrants have experienced substantial increases in border is considered to have a level effect on the trade volumes as a result of large investments by volume of trade. The ordinary least squares (OLS) firms from Western Europe and elsewhere, which estimates of the gravity equation are presented in combine their technical, managerial, and marketing table 14.4. assets with a generally well-educated and skilled In the column OLS (1), the estimated coefficient labor force at low wages. Turkey has a long way to go on GDP per capita has an unexpected negative sign. before it can hope to attract the same level of foreign Leaving out distance as an explanatory variable direct investment (FDI) as some of the more suc- in the specification OLS (2) yields the expected cessful countries in Central and Eastern Europe. For positive sign. Apparently, the effects of GDP per example, Turkey attracted $15 in foreign direct capita and distance are confounded in the original investment per capita in 2000 compared with specification because of a high positive correlation Poland's $256 per capita. FDI in Turkey is hampered between distance and differences in GDP per by political and economic uncertainty, bureaucracy, capita; the poorest countries are on the periphery detailed regulation, and--by rumor--corruption. of Europe. (The correlation between distance and Indeed, according to UNCTAD (2002), Turkey has the log of the product of GDP per capita is ­0.51.) one of the lowest rankings in terms of FDI potential The OLS (1) estimates were then used to forecast and performance. EU membership and adoption of the bilateral trade of each of the 2004 entrants and the acquis communautaire will go some way toward Turkey with the EU15, notwithstanding the negative establishing a better investment climate, which, in sign on GDP per capita. For one thing, distance is a turn, should lead to higher volumes of trade. more important factor between the candidate coun- What follows is a forecast of the volume of trade tries and the EU15 than between the EU15 coun- between Turkey and the EU15 under the assumption tries and should therefore be included. Second, both 350 Turkey: Economic Reform and Accession to the European Union TABLE 14.4 Pooled Panel Gravity Estimates entrants are also projected to increase their trade for Intra-EU15 Trade with the EU15, some of them considerably more than Turkey, and two countries--Estonia and OLS (1) OLS (2) Hungary--actually have higher actual trade than projected trade. However, the point estimates Log real product GDP 0.8577 0.8818 (0.0098) (0.0120) obtained with this forecast method are highly Log real product GDP -0.2802 0.2439 uncertain, as shown by the 95 percent confidence per capita (0.0362) (0.0384) intervals for the point estimates. Log distance -0.8819 (0.0326) Conclusion Common border 0.4000 1.2557 (0.0516) (0.0673) Turkey's membership in the EU is not expected to have significant economic effects on the present R2-adjusted 0.9249 0.8797 EU members, with the possible exception of immi- gration and EU budget transfers. Turkey has a Note: Estimates are based on 1,155 observations, large population, a low level of income, and a large annual data for 15 countries, 1990­2000. Intercept and year controls are not recorded. agricultural sector. These facts could stimulate Standard errors are in parentheses. All estimates substantial migration from Turkey to Germany are significant at less than 1 percent. and other West European countries and make Sources: GDP and population: OECD 2001; trade: Turkey a recipient of large transfers from the richer OECD Monthly Statistics of International Trade, CD-ROM, June 2001; great circle distances EU members. between capitals: U.S. Department of Provided that migration from Turkey to the EU Agriculture, http://www.wcrl.ars.usda.gov/cec/ is free, it is estimated that about 1.3 million people java/lat-long.htm. would migrate to Germany--the country with the largest Turkish immigrant population--over a specifications have about the same explanatory 30-year period and thus increase its population by power. The results are presented in table 14.5. In the 1.5 percent. However, this estimate is highly uncer- table, the forecast value of Turkish­EU15 trade is tain; it rests on heroic assumptions about relative $26.3 billion in 2000, which is much higher than the growth rates and parameters in the estimating actual value of $18 billion. Most of the 2004 equation, among other things. TABLE 14.5 Forecast of Trade with EU15 95% Confidence Interval Forecast, 2000 Lower Upper Forecast/Actual Country ( billions) Bound Bound Trade, 2000 Bulgaria 4.4 1.6 12.3 1.82 Czech Rep. 24.4 9.0 65.3 1.29 Estonia 1.8 0.7 5.1 0.69 Hungary 15.0 5.5 40.4 0.80 Lithuania 3.5 1.3 9.4 1.82 Latvia 2.5 1.0 6.7 1.59 Poland 42.0 15.6 112.8 1.75 Romania 10.4 3.9 28.4 1.63 Slovak Rep. 11.1 4.1 30.4 2.02 Slovenia 7.3 2.7 19.5 1.26 Turkey 26.3 10.5 76.3 1.46 Sources: GDP and population data: World Bank, World Development Indicators; trade: OECD Monthly Statistics of International Trade, CD-ROM, June 2001; great circle distances between capitals: U.S. Department of Agriculture, http://www.wcrl.ars.usda.gov/cec/java/lat-long.htm. Economic Effects of Turkey's Membership on the European Union 351 If present rules for contributions to and receipts of migration between Germany as the host country and Greece, from the EU budget were unchanged--including Portugal, and Spain as the home countries with disappointing results--most of the coefficients were insignificant or very the Common Agricultural Policy--it is estimated small. An examination of the time-series data makes it clear that that Turkey would receive a net transfer of 12 bil- other factors not accounted for, such as political developments, lion, which corresponds to about 14 percent of the played a major role. 7. This section draws on the corresponding discussion in present EU budget. The overall net contribution to Baldwin, Francois, and Portes (1997). the 2004 entrants and Turkey was projected to cor- 8. In chapter 13 of this volume, Baldwin and Widgrén ana- respond to about 60 percent of the present budget. lyze various aspects of the different sets of rules for decision making in the EU. The EU budget for 2006­13 is now under negotia- 9. This approach was taken in Baldwin, Francois, and Portes tion. It is unlikely that present rules will not change (1997). in the face of such large increases in net transfers 10. A fixed-effects estimation is preferable, but it cannot be from richer to poorer countries. used to make out of sample forecasts. Standard versions of the gravity equation can be derived from all three basic trade Turkey has had free trade with the EU since the models--that is, the Ricardian, Heckscher-Ohlin, and increas- late 1990s, except in agricultural products. The pat- ing returns to scale models, as well as from other models, tern of trade should therefore not change as a result as demonstrated by Anderson (1979), Bergstrand (1990), Deardorff (1998), and Helpman (1998). Recent research has of membership, but there is the potential for a sought to ascertain to what extent the various models con- higher volume of trade should Turkey become tribute to the empirical success of the gravity equation and more attractive for foreign direct investment. If thereby to evaluate their empirical relevance--see Feenstra, Markusen, and Rose (2001) and Evenett and Keller (2002). A the volume of trade between Turkey and the EU tentative conclusion is that models based on increasing returns were to reach the same level as that of trade among and product differentiation are more successful in explaining the EU15--controlling for differences in income intraindustry trade, whereas trade in homogeneous goods is levels, geographical distance, and the absence of better explained by differences in factor endowment or differentiation of goods by country of origin (Armington common land borders--it would be about 50 per- assumption). cent higher than at present, according to the estimates presented in this chapter. References Anderson, J. 1979. "A Theoretical Foundation for the Gravity Notes Equation." American Economic Review 69: 106­16. Auerbach, A., and P. Oreopoulos. 1999. "Analyzing the Fiscal 1. The author is grateful for comments on earlier versions of Impact of U.S. Immigration." AER Papers and Proceedings this chapter by Refik Erzan and Sübidey Togan, for research 89: 176­80. assistance by José Mauricio Prado Jr., and for editorial work by Baldwin, R., J. Francois, and R. Portes. 1997. "The Costs and Christina Lönnblad. Benefits of Eastern Enlargement: The Impact on the EU and 2. All dollar amounts are U.S. dollars unless otherwise Central Europe." Economic Policy 24: 127­76. indicated. Bergstrand, J. 1990. "The Heckscher-Ohlin-Samuelson Model, 3. EU15 refers to the 15 members of the EU prior to the 2004 the Linder Hypothesis and the Determinants of Bilateral enlargement in which 10 more countries joined the EU. The Intra-industry Trade." Economic Journal 100: 1216­29. 15 countries are Austria, Belgium, Denmark, Finland, France, Berry, R. A., and R. Soligo. 1969. "Some Welfare Effects of Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, International Migration." Journal of Political Economy 77: Portugal, Spain, Sweden, and the United Kingdom. 778­94. 4. For the United States, see Friedberg and Hunt (1995); for Boeri, T., and H. Brücker. 2000. "The Impact of Eastern Europe, see Zimmerman (1995); for Germany, see Haisken-De Enlargement on Employment and Labour Markets in the New and Zimmerman (1996); and for Germany and Austria, see EU Member States." European Integration Consortium Winter-Ebner and Zimmerman (1998). 2000, Berlin. 5. Boeri and Brücker estimate an error-correction model. Bonin, H. 2001. "Fiskalische Effekte der Zuwanderung nach The assumptions and the model are described in detail in Boeri Deutschland: Eine Generationenbilanz." IZA Discussion and Brücker (2000). Paper No. 305, Institute for the Study of Labor, Bonn. 6. A common approach to explaining migration is to esti- Borjas, G. 1994. "The Economics of Immigration." Journal of mate a gravity equation. Yearly migration is explained by wage Economic Literature 32: 1667­17. and employment rate differentials, distance, language, regula- --------. 1995. "The Economic Benefits from Immigration." tion, and the stock of earlier migrants in the host country--that Journal of Economic Perspectives 9: 3­22. is, much the same variables as in the present error-correction Deardorff, A. 1998. "Determinants of Bilateral Trade: Does model. A problem with this approach is the long-run implica- Gravity Work in a Neoclassical World?" In The Regionaliza- tion that the entire population will leave for a sufficiently large tion of the World Economy, ed. J. A. Frankel. Chicago: Univer- income differential. The error-correction model tests for the sity of Chicago Press. existence of a long-run equilibrium in which only a (small) part European Commission. 2001. "Allocation of 2000 EU Operating of the population has emigrated. Technically, it tests for co- Expenditure by Member State." European Commission, integration between the variables. I estimated a gravity equation Brussels. 352 Turkey: Economic Reform and Accession to the European Union Evenett, S. J., and W. Keller. 2002. "On Theories Explaining the Helpman, E. 1998. "The Structure of Foreign Trade." NBER Success of the Gravity Equation." Journal of Political Econ- Working Paper No. 6752, National Bureau of Economic omy 110: 281­316. Research, Cambridge, MA. Feenstra, R. C., J. A. Markusen, and A. K. Rose. 2001. "Using OECD (Organisation for Economic Co-operation and Develop- the Gravity Equation to Differentiate among Alternative ment). 2001. Economic Outlook No. 70. Paris: OECD, Theories of Trade." Canadian Journal of Economics 34: December. 430­47. Storesletten, K. 2000. "Sustaining Fiscal Policy through Immi- Friedberg, R. M., and J. Hunt. 1995. "The Impact of Immigrants gration." Journal of Political Economy 108: 300­23. on Host Country Wages, Employment and Growth." Journal UNCTAD (United Nations Conference on Trade and Develop- of Economic Perspectives 9: 23­44. ment). 2002. World Investment Report 2002. Geneva: Ghatak, S., P. Levine, and S. Wheatley Price. 1996. "Migration UNCTAD. Theories and Evidence: An Assessment." Journal of Economic Winter-Ebner, R., and K. F. Zimmerman. 1998."East-West Trade Surveys 10: 159­98. and Migration: The Austro-German Case." IZA Discussion Haisken-De New, J., and K. F. Zimmerman. 1996. "Wage and Paper No. 2, Institute for the Study of Labor, Bonn. Mobility Effects of Trade and Migration." CEPR Discussion World Bank. 2001. World Development Report 2000/2001: Paper No. 1318, Centre for Economic Policy Research, Attacking Poverty. Washington, DC: Oxford University London. Press. Harris, J., and M. Todaro. 1970."Migration, Unemployment and Zimmerman, Klaus. 1995. "Tackling the European Migration Development: A Two-Sector Analysis." American Economic Problem." Journal of Economic Perspectives 9: 45­62. Review 60: 126­77. Index References to boxes, figures, tables, and notes are denoted respectively by b, f, n, and t. access directive for electronic communications, 155­56 farmer registry, 73 accession countries farmer's income, 70 Central and Eastern European countries, 19 food safety and quality standards, 73­74 environmental acquis, estimated cost of, 296­98, 297t IACS of payments, 72­73, 75 euro, adoption of single currency, 18­19, 29­30, 325 institutional development and EU accession, 70­75 macroeconomic framework for, 17­19 market-oriented sustainable agriculture, 55 preaccession phase, 17­18 output price supports, input subsidies, and supply Accession Partnership (AP), xvii, 223, 283 control measures, 44­45 ACCs (agricultural credit cooperatives), 71 policies, 41, 44­49, 71­72 acquis communautaire preferential trade regime for, 128­29, 128­29t See also specific subject of legislation state budget effects of EU integration, 67­69, adoption of, xvii, 17­19, 127, 223, 230, 261, 295, 349 68­69t, 70 composition of, 230 trade policy and border control, 45­48, 46­47t, costs of accession, 23 74­75, 76­80t macroeconomic policy framework for accession welfare effects of EU integration, 69­70, 70t, countries, 17­19 311­12, 312t manufacturing, 109 Agricultural Reform Implementation Project (ARIP), monetary policy, 14­15 48­49, 49t, 71, 72, 73, 75 administrative procedures, reform of, 284 agricultural sales cooperative unions (ASCUs), 44, 48, age demographics, 226, 273­74, 341 71, 72 Agenda 2000 reform of CAP. See Common Agricultural agriculture acquis, status of implementation, 72­75 Policy (CAP) of European Union (EU) Algeria's natural gas sector, 212, 219 agricultural credit cooperatives (ACCs), 71 Amsterdam, Treaty of, 230­31 agricultural markets and incomes, xxi­xxii, 39­85 Ankara, Treaty of, 124 acquis in agriculture, status of implementation, 72­75 antidumping measures, 103, 104t, 114 adoption of Common Market Organization, 72 antisubsidy measures, 103, 114 alternative policy options for Turkey, 58­59, AP. See Accession Partnership 60­62t, 64t approximation process, 295 ARIP and, 48­49, 49t, 71, 72, 73, 75 ARIP. See Agricultural Reform Implementation Project background, 39­41, 40­43t Article 122 of Treaty Establishing European Community, COM, adoption of, 72 14, 325 common agricultural policy of EU, 49­70, 127, 129 Article 125 of Treaty Establishing the European See also Common Agricultural Policy (CAP) of Community, 223, 224­25, 230, 257 European Union (EU) ASCUs. See agricultural sales cooperative unions common organization of market (COM), 50­54 Australia's energy sector, 204, 212 impact of introducing in Turkey, xxi, 56­70, 57t, Austria 60­62t, 64­66t, 68­70t natural gas sector, 211, 218 producers, impact on, 46­47t, 57t, 58, 59, 62­63, tax wedge, 229, 229t 64t, 70 authorization directive for electronic communication consumers, impact of EU integration on, 63, 65­66t, networks, 54­155 65­67, 81­82t automotive industry and FDI, 275 costs of accession, 23 Azerbaijan's natural gas industry, 212, 213 customs union agreements and, 127, 128, 129 dependence on, 341 Baltic states' water utilities, 299b, 300 employment, 12, 13t, 226­27 Banking Regulation and Supervision Agency (BRSA), estimates of support in agriculture, 49, 49t xxv, 161, 162, 166, 170, 171, 284 353 354 Index banking sector, xxiv­xxvi, 161­85 agriculture in Turkey compared, 75, 83nn8­10 asset, deposit, and loan indicators, 166­67, 167f CAP and, xxi­xxii, 55 asset quality, 168­69, 169f convergence criteria, fulfilling, 14 average bank size, 166, 166f environmental acquis, estimated cost of, 297t, BRSA. See Banking Regulation and Supervision 298, 299 Agency exchange rate policy, 20t, 29­30 Capital Adequacy Directive, adoption of, 170­72, 171t FDI in, xxxiv, 261, 264f, 264­71, 265­66t, 267f, comparison of EU and Turkish structural indicators, 268­71t, 275­76, 289, 349 164­70, 165­70f foreign bank entry, 169 compliance with EU banking regulations, 170­73, privatization, 267f, 267­68 181­85 trade issues, xxxiii­xxxiv concentration ratio, entry to sector, public share, and water utilities in Baltic states, 299b, 300 capital adequacy, 164­66, 165f child labor, 223, 235 deposit insurance, 166, 166f Chile's labor market, 248 economic implications of EU accession, 313t, 321­22 collective redundancies, 234­35 EU banking regulations, compliance with, 181­85 Colombia's labor market, 248 financial strength ratings, 169, 170f COM (Common Organization of Market). foreign bank entry, 169­70 See Common Agricultural Policy (CAP) of government debt securities and, 169, 169f European Union (EU) income, expenditure, and cost structure, 167­68, 168f Common Agricultural Policy (CAP) of European Union "Member State with a derogation" status and, 17 (EU), 39, 49­56 microeconomic policy framework for EMU members adoption of, xxi, 311­12, 329 and, 14­17 alternative options for Turkey, 58­59, 60­62t, 64t number of banks, average size, and staff employed, Common Organization of Market (COM), 50­54, 72 166­67f, 174­80t for beef and veal, 53­54 profitability, 167, 168f, 174­80t for cereals, 50­51 restructuring in Turkey, 162­64, 163f, 163t, 284 for fruits and vegetables, 52 welfare effects of integration, 312­13 for milk and dairy products, 52­53 Basel II, 170­72 for oilseeds, 51 BEPG (Broad Economic Policy Guidelines), 18 for ovine meat, 54 BIPS (border inspection points), 74­75 for sugar beets, 51­52 birthrate, 226 for wine-growing sector, 52 border control. See trade and border control consumers, impact of EU integration on, 63, 65­66t, border inspection points (BIPs), 74­75 65­67, 81­82t BOTAS¸, xxviii, 210­14, 217­19, 319 costs of, xxxv, 346, 347, 348 See also natural gas sector food safety and quality standards, 73­74 Broad Economic Policy Guidelines (BEPG), 18 free trade agreements (FTAs), 124 BRSA. See Banking Regulation and Supervision Agency future evolution of, 54­56 Bulgaria impact of introducing CAP in Turkey, 56­70, 57t, agriculture, 341 60­62t, 64­66t, 68­70t budgetary effects of EU membership, 348 institutional development and EU accession, 70­75 electricity industry, 203 mid-term review and future directions, 54­56 exchange rate policy, 20t, 30 producers, 46­47t, 57t, 58, 59, 62­63, 64t, 70 natural gas sector, 211 state budget effects of EU integration, 67­69, unemployment, 227, 227t 68­69t, 70 status of implementation of acquis in agriculture, California electricity crisis, 204, 205b 72­75 Capital Adequacy Directive (CAD), 170­72, 171t trade and border control, 74­75 Cassis de Dijon judgment (1979), 105 Common Customs Tariffs (CCTs), xvii, 87, 124 CCT. See Common Customs Tariff Common Organization of Market (COM). See CE (Conformité Européne) conformity marking, Common Agricultural Policy (CAP) of European 107, 109 Union (EU) CEN (Comité Européen de Normalisation), xxiii, 106­7 Competition Act, 287­88 CENELEC (Comité Européen de Normalisation Competition Authority, 114 Electrotechnique), xxiii, 106­7 Competition Board, xvii, 287­88 Central and Eastern European (CEE) countries Constitutional Treaty voting rules, xxxii, 331­32, accession prospects for, 19, 20t 334­36, 334­36t, 347 Index 355 consumers Directive 2002/14, 235­36 See also households Directive 2002/74, 235 agriculture and impact of EU integration on, 63, Directorate General for the Tobacco Products, Salt and 65­66t, 65­67, 81­82t Alcohol Industry (TEKEL), 72 electricity industry and, 198­99 direct payments as agricultural support, 44, 62 contingent protectionism, 102­3, 104t See also agricultural markets and incomes convergence criteria for Turkey, 19, 20t direct technology transfers, 263 Coordination Council for the Investment Climate DIS. See direct income support for farmers (YOIKK), 284­86, 285t, 289 disinflation programs. See inflation Copenhagen criteria for membership, 17, 230, 253 Doha Round Agreement, 55 costs dumping, 103, 104t, 114 of accession, 23, 67 bank sector restructuring, 162­63, 163t EAGGF (European Agricultural Guidance and CAP, 346, 347, 348 Guarantee Fund), 50 of environmental acquis. See environmental acquis earthquakes, effect of, 3, 6, 162 Council Directive 93/104, 234 Eastern Europe. See Central and Eastern European Council Directive 98/59, 234­35 (CEE) countries Council for Economic and Financial Affairs ECB. See European Central Bank (ECOFIN), 16 ECOFIN (Council for Economic and Financial Council of Ministers voting reforms, 331­32 Affairs), 16 crawling peg regime, abandonment of, xix, 3, 6, 34n48 economic effects of EU accession for Turkey, xxx­xxxi, Croatia and EU voting rules, 332 311­30 CUD. See Customs Union Decision agriculture, 311­12 current account banking sector, 312­13, 313t, 321­22 real exchange rate and, 6­7, 7t challenges of, 325­28 sustainability of, 23­28, 25­26t, 326 electricity, 316­19, 318­19t, 321­23, 322t customs union, 123­27, 125­27t EMU membership and, 325­26 creation of, 87 environmental compliance, 327­28 effect of, 94, 103, 230, 341 growth effects, 328­29, 329t quantitative assessment of, 127­32, 128­30t labor markets, 326­27 Customs Union Decision (CUD), 87, 102­3 natural gas, 319­22, 320t, 322t Czech Republic service and network industries, 312­21, 324t, 324­25 exchange rate policy, 20t, 30 state aid, 328 FDI in, 27, 264f, 264­65, 265t, 267, 267f, 268, 270t, telecommunications sector, 313­14, 315t, 271, 273­74t 322­25, 324t privatization, 268 transportation, 314, 316 welfare effects, 311­25, 312­13t, 315t, 318­20t, 322t, Decision No. 2/97 of EC-Turkey Association Council, 323f, 324t, 329 108, 120 economic effects of Turkey's membership on EU, 341­52 Decision Nos. 1/72, 1/80, and 1/98 of EC-Turkey budgetary effects, 346­49, 346t, 348t Association Council, 45 migration, xxxii­xxxiii, 341­46 "Delors' White Book" on Growth, Competitiveness and trade, 349­50, 350t Employment (EU), 236 Economic Partnership Agreements, 56 Denmark ECSC. See European Coal and Steel Community natural gas sector, 320, 320t education, 28, 343­44 tax wedge, 229, 229t EES. See European Employment Strategy deposit insurance, 166, 166f eEurope+2003 Action Plan, xxiv, 147, 150, 151, 154 developing countries, implications for, xxxiii­xxxv EFTA (European Free Trade Association), 106 direct income support (DIS) for farmers, 48, 68, 70, Egypt's natural gas industry, 212 73, 75 83/189 procedures, 105 See also agricultural markets and incomes Electricity Directive of 1996, 189­90 Directive 80/987, 235 electricity industry, xxvi­xxviii, 187­208 Directive 91/533, 235 background of current structure, 191­92 Directive 94/33, 235 California electricity crisis, 204, 205b Directive 97/81, 234 challenges for, 196t, 196­200, 198f, 199t, 205b Directive 99/70, 234 characteristics and evolution of industry, 187­88 Directive 2001/23, 235 competition-enhancing solutions, 200­07 356 Index electricity industry (continued) medium reform scenario for EU accession, 303­6, cross-border trade and benefits of EU accession, 304­5t 202­3 pollution reduction investment, 306 current model, 193­96 public sector's costs, 299­300, 299b developing competition, 204 reducing total investment costs, 298­99, 299b Electricity Directive of 1996, 189­90 water utilities in Baltic states, 299b, 300 facilitating effective regulation, 204, 206­7 wetlands regulation, 71­72 implementation and proposed amendment to EONIA (European Over-Night Index Average), 15 directive, 190­92 ESBC. See European System of Central Banks Independent Regulatory Authority, 196 Estonia interinstitutional coordination and national exchange rate policy, 20t, 30 electricity policy, 200 trade, 350 market design, 194f, 194­95 EU. See European Union market opening, 189, 190, 193 EUAS. See Turkish Electricity Generation Company mitigating wholesale price risk, 204 euro, adoption of, 18­19, 29­30, 325 privatization and entry promotion strategies for Eurogold investment, 276­78, 277t generation and distribution assets, 192, 195, Europe Agreements on Conformity Assessment and 203­4, 206­7 Acceptance of Industrial Products (PECAs), 106 public service obligations (PSOs), 189­90, 191, 195 European Agricultural Guidance and Guarantee Fund regulatory reform in EU, 188­91 (EAGGF), 50 revenue deficits, technical loans, and private European Central Bank (ECB), 14, 15 participation in distribution, 198, 198f, 199t European Coal and Steel Community (ECSC), 87, 94 stranded costs and competition in generation European Commission, 105, 107 markets, 196t, 196­98, 200­02 European Council Summits, 16, 236­37 structure of, 191­96, 194t European Economic and Monetary Union (EMU), 347 tariff rebalancing, social protection, and industrial convergence criteria, 14, 18, 19­21, 20t competitiveness, 198­99 economic challenges of, 325­26 third party access, 189, 194, 200, 317, 319 exchange rate policy, 17, 31 transitional regimes for stranded costs, 200­02 fiscal policy, 15­17 unbundling regulations, 189, 190, 191, 193­94, macroeconomic policy framework for EMU 200, 204 members, 14­17, 31 universal service and tariffs, 202 monetary policy, 14­15, 30 vesting contracts, 195 participation in, xx, 261 welfare effects of integration, 316­19, 318­19t, European Economic Area (EEA) Agreement, 106 321­23 European Employment Strategy (EES), 223, 236­40 wholesale market concentration and role of TETAs, European Free Trade Association (EFTA), 106 199­200 European Neighborhood Policy, xxxiv El Salvador, electricity industry, 204 European System of Central Banks (ESCB), 14, 18 employment European Union (EU) See also labor market policies access directive, 155­56 acquis, 223, 252­53 authorization directive, 154­55 growth and, 12­14, 13t, 28­29 budget for, 15 immigration and. See migration case law, 231 protection. See labor market policies Central and Eastern European (CEEC) countries, rate, 226, 227t prospects for, 19, 20t EMRA. See Energy Market Regulatory Authority Common Agricultural Policy. See Common EMU. See European Economic and Monetary Union Agricultural Policy (CAP) of European energy, xxvi­xxviii Union (EU) See also electricity industry; natural gas sector costs of accession, 23, 67 Energy Market Regulatory Authority (EMRA), 192, 193, Council of Ministers voting reforms, 331­32 217­18, 319 coverage of EC technical regulations, 107, 108t England. See United Kingdom customs union between Turkey and, 87, 94, 103, environmental acquis, xxix­xxx, 295­307 123­27, 125­27t, 128f, 128­30, 129­30t, breakdown by share of investment by sector, 300, 301t 230, 341 cost-benefit analysis of environmental directives, distribution of power, 334­35f, 335­36, 339­40t 300­03, 302­3t EC technical regulation, coverage of, 107, 108t costs of complying with, 295, 296­98, 297t, 327­28 Electricity Directive of 1996, 189­90 Index 357 employment and Turkish labor law. See labor economic growth and, 262 market policies electricity industry, 201 enlargement's impact on incumbents' power, 336 EU requirements, 283 euro area phase, 19 Eurogold investment, 276­78, 277t European Council Summits, 236­37 full EU accession's effect on, 288­89 European Employment Strategy, 223, 236­40 governance and institution related-constraints, harmonization of national regulations and standards, 275­82, 277f 106­7, 109, 120 infrastructure-related factors, 27, 273­75, 273­74t impact of EU enlargement on incumbent's power, investment climate, 271­72 337­38f investment promotion agency, 289, 291­92 labor market policies. See labor market policies is¸-TIM Mobile Telecom Investment, 277t, 280­81 migration. See migration legal and judicial reforms, 286­87 mutual recognition principle, 105­6 macroeconomic and trade policies, 272­73, 272t preaccession phases, 17­18, 20t, 29­30 policies and institution and EU accession, 273­74t, primary legislation of, 230­31 282­90 secondary legislation of, 231 priorities in future reforms, 286­90 status upon accession, 14 proactive investment promotion policies, role of, taxes, structure of, 11­12, 11­13t 289­90 technical barriers to trade, 103, 105­12, 111t, 113t raising productivity and stimulating spillovers, role in, telecommunications sector, 153­57 262­64 tools of assessment, 332f, 332­33 reform efforts, 283­86, 285f treaties, 230­31 sustainability of current account, 23­28, Turkey's membership's impact on, 332f, 334­35f, 25­26t, 326 339­40t France budgetary effects, xxxii­xxxiii, 346t, 346­49, 348t electrical industry, 188, 190 decision making and, 333­36 excessive deficit proceedings, 33n31 economic effects, xxxi­xxxiii, 341­52 natural gas sector, 320, 320t migration and, xxxii­xxxiii, 341­46 free-floating exchange rate, 30­31 trade effects, 349­50, 350t free trade agreements (FTAs), 87, 124, 125­27t voting effects, 331­40 Eurosystem's monetary policy, 14­15, 30 GATT "Everything But Arms," 56 Article XXIV, 124, 129 Exchange Rate Mechanism (ERM II), xx free trade, 124 exchange rate policy legal subsidies, 87, 328 debt-GDP ratio and, 22­23 Geographic Information System (GIS), 73, 75 for EMU members, 17 Germany macroeconomic challenges facing Turkey, 20t, electricity industry, 190, 191, 317, 319 29­31 excessive deficit proceedings, 33n31 real exchange rate (RER) and current account, 6­7, 7f, FDI in, 290 26t, 26­28, 31, 326 migration and, xxxiii, 341­46, 345f natural gas sector, 218, 320, 320t FDI. See foreign direct investment tax structure, 11­13t, 12 Finland's energy sector, 317, 320t, 321 "Good Agricultural Practices," 74 flat tax, 23, 28, 34n35 Greece See also taxation electricity industry, 203 food prices, 63, 65­66t, 65­67, 70 labor market flexibility, 247 food safety and quality standards, 73­74 natural gas sector, 211, 214­15, 320, 320t foreign direct investment (FDI), xxix, 27, 261­93 tax wedge, 228­29, 229t automotive industry, 275 trade with, 341 benefits of, xxviii, 262­64 growth effects of accession, 328­29, 329t Cargill starch-based sugar investment, 277t, 278­80 GSM. See mobile phone (GSM) service case studies, 275­82 Guatemala's electricity industry, 204 comparison between Turkey and Eastern Europe, 264­71, 264f, 265­66t, 267f, 268­71t Harmonised Index of Consumer Prices (HICP), competition-related reforms, 287­88 14­15 current state of, xx, xxxiv, 264­82, 349 harmonization of national regulations and standards, determinants of, 271­72 106­7, 109, 120 358 Index Hazard Analysis and Critical Control Point labor cost for employers, 228­29, 228­29t (HACCP), 74 labor market policies, xxviii­xxix, 223­60 Helsinki Council and recognition of Turkey as EU child labor, 223, 235 candidate, xvii, 127, 223, 261 collective redundancies, 234­35 households coordinating employment policies, impact of, 253 See also consumers disinflation and, 22 electricity costs, 198­99, 199t, 202 employment acquis, impact of adopting and expenditures, 63, 64, 65­66, 65­66t, 70, 81­82t implementing, 223, 252­53 human capital formation, investment in, 28, 29 employment and growth, 12­14, 13t, 128­29 Hungary employment protection, 224, 225, 240­46, 241­44t, exchange rate policy, 20t, 30 245­46f, 252 FDI in, 27, 264f, 264­65, 265t, 267, 267f, 268, 270­71t, EU labor market policies, 230­40 273­74t European Council directives on employment and labor cost for employers, 228 Turkish labor law, 231­36, 232­33t labor market flexibility, 247 European Employment Strategy (EES), 223, 236­40 natural gas industry, 211 flexibility of market, 224­25, 226, 240, 246­51, trade, 350 247­50f, 326 unemployment, 227, 227t immigration and. See migration implications of EU accession, 256­57, 326­27 IMF. See International Monetary Fund assistance informal employment, 32n14 to Turkey labor market indicators, 226­30, 227­29t immigration. See migration new labor law, impact of, 251­52 independent floating, 34n48 problems and prospects, 251­56 Independent Regulatory Authority, 196 safety and health requirements, 234, 251 inflation simulation analysis, 253­56, 254t, 254­55f, 256t FDI and, 27 unemployment, 12, 14, 23, 28, 224, 225, 227, 227t, IMF program to reduce, xix­xx, 161 327, 342, 343 macroeconomic challenges facing Turkey and, working conditions, 234, 251 21­22, 21t land database, 73 monetary developments and, 3­6, 4f, 5t Latin America's electricity industry, 204 reducing and disinflation, 21­22, 21t, 161, 162, layoffs, 251 224, 326 licensing, 28, 147, 154­55 informal employment, 32n14 Lithuania's exchange rate policy, 20t, 30 infrastructure Luxembourg's tax structure, 11­13t, 12 See also specific type of energy FDI and, 27, 273­75, 273­74t Maastricht Treaty criteria, xx­xxi, 15­16, 18, 29, quality, 108­9 325­26 insolvency of employers, 235 macroeconomic policies, xix­xxi, 3­35 Integrated Administration and Control System (IACS) accession countries, macroeconomic framework for, of payments, 72­73, 75 17­19 intellectual property rights, 28, 285, 285f challenges, 19­31, 20­21t, 25­26t interconnection and roaming, 156 developments, 3­14, 4f, 5t, 7f, 8t, 9f, 10­13t International Monetary Fund (IMF) assistance to employment and, 12­14, 13t, 28­29 Turkey, xix­xx, 3, 7, 21, 48, 161, 216 EMU members, macroeconomic policy framework Internet service and facilities, 150­51, 150­51f, 313 for, 14­19 investment climate, 271­72 exchange rate policy, 20t, 29­31 investment incentives, 112, 114 fiscal developments, 7­12, 8t, 9f, 10t, 11, 12t, 22­23 investment promotion agency (IPA), 289, 291­92 inflation, 3­6, 4f, 5t, 21­22, 21t investment ratio, 28, 29 public sector borrowing and, 9­11, 9f, 10­11t Investment Service Directive (ISD), 170 real exchange rate and current account, 6­7, 7f Iran's natural gas sector, 210, 212­13 sustainability of current account, 23­28, 25­26t Ireland's tax structure, 11­13t, 12 taxes, structure of, 11­12, 11­13t irrigation projects, 44, 72 Malaysia, electricity industry, 204 is¸-TIM Mobile Telecom Investment, 277t, 280­81 manufacturing industry, xxii­xxiii, 87­121 Italy's energy sector, 190, 215­16, 218, 219 applied tariff structure, 99­102, 100­02t conditions of competition, 112­20, 115t, 116f, judicial system reforms, 286­87 117­19t Index 359 conformity assessment and market surveillance, 107, NACE (Nomenclature Générale des Activités 109­10 Économiques dans les Communautés contingent protectionism, 102­3, 104t Européennes), 110 development in Turkey's trade regime, 87­98, 88­89t, NAFTA (North American Free Trade Agreement), 132 91­93t, 95­98t national central banks (NCBs), 14, 15 EC technical regulations and, 107, 108t national regulatory agency (NRA), 155, 156 harmonization of national regulations and standards, natural gas sector, xxvi­xxviii, 209­20 106­7, 109, 120 comparative analysis of Turkey's gas legislation, markups in, 116, 116f, 117, 117t, 120 218­19 mutual recognition principle, 105­6 emerging gas markets in EU, 214­15 structure of protection, 99­102, 100­02t import and export infrastructure and future technical barriers to trade, 103, 105­12, 111t, 113t developments, 210­11 map of Turkey, 1 long-term purchase contracts, 211­13 MARA. See Ministry of Agricultural and Rural Affairs mature gas markets in EU, 215 market access and regulatory issues, xxiii­xxiv, national networks and future development, 213­14 123­45 ownership and industry structure, 214­16 See also trade and border control present Turkish gas market, 209­14 customs union, 87, 94, 103, 123­30, 125­30t, 132, regulatory reform, 216­19 230, 341 third party access, 320 developing countries, implications for, xxxiii­xxxv welfare effects of integration on, 319­22, 320t, 322t factor analysis of regulatory structures, 132­39, Netherlands and migration, 342 133­38t, 138f, 139f New Basel Accord (Basel II), 170­72 global general equilibrium, application of, 127­32, Nice Treaty voting rules, xxxii, 331­32, 332f, 334­36, 128­31t, 140­44, 141t, 142­43f 334­35t, 336f, 339­40t, 347 model of study, 140­44, 143f nominal exchange rate (NER), 31 quantitative assessment, 127­32, 128­31t tariff equivalents for transport services, On the Prevention of Unfair Competition in 139­40, 140t Importation (Turkey 1989), 114 "Member State with a derogation" status, 14, 17, 18, Organisation for Economic Co-operation and 19, 325 Development (OECD) mergers and acquisitions (M&As), 267, 267f agriculture, estimates of support, 49 MFN. See most-favored nation tariff rates on CAP program, 50 Middle Eastern countries and trade policy, xxxiv competition policy, 114 migration, xxxii­xxxiii, 341­46 electricity industry and, 198, 200 effects of, 342f, 342­43 factor analysis of regulatory structures, 132­39, empirical research findings, 343­44 133­38t, 138­39f EU budget, xxxii­xxxiii FDI and, 265, 266t fiscal impact of, 344 inflation and unemployment, 224 forecast of migration from Turkey to Germany, 345f, labor market data of, 240 345­46 on telecommunications sector, 148 model of migration to Germany from Southern Europe, 344­45 part-time and fixed term employment, 226, 227t, restrictions from new member countries, 342 234, 251 theory, 342­43, 342f PECAs (Europe Agreements on Conformity Assessment Ministry of Agricultural and Rural Affairs (MARA), and Acceptance of Industrial Products), 106 71, 72 PEP (Preaccession Economic Programme), 17­18 mobile phone (GSM) service, 147, 149­50, 150f, 153, personal computer (PC) usage, 150­51, 151f 157, 313 Poland monetary developments and inflation, 3­6, budgetary effects of EU membership, 349 4f, 5t environmental acquis, estimated cost of, 296, monetary policy for EMU members, 14­15 297t, 298 monetary union, 14 exchange rate policy, 20t, 30 most-favored nation (MFN) tariff rates, xxxiii, 45, FDI in, 264f, 264­65, 265t, 267, 267f, 269t, 271t, 46­47t 273­74t motor vehicle sector, 131­32, 275 labor issues, 228, 247 See also transportation sector privatization, 267­68 mutual recognition principle, 105­6 unemployment, 227, 227t 360 Index Portugal Savings Deposit Insurance Fund (SDIF), xxv, electrical industry, 190 163­64, 330n10 excessive deficit proceedings, 33n31 savings rate, domestic, xx, 28, 29 natural gas sector, 215, 320, 320t SDIF. See Savings Deposit Insurance Fund Preaccession Economic Programme (PEP), 17­18 sectoral reform challenges, xxi­xxiii price self-employment rates, 226, 227t agriculture supports, 44­45 service and network industries, 312­21, 324t, 324­25 electricity and wholesale price risk, 204 See also specific industries food. See food prices SGP. See Stability and Growth Pact Harmonised Index of Consumer Prices, 14­15 short-term interest rates, 15 stability in Eurosystem, 15 Slovakia's exchange rate policy, 20t, 30 telecommunications regulation, 156­57 Slovak Republic's labor costs, 228 privatization Slovenia's exchange rate policy, 20t, 30 agriculture, 72 SMP (significant market power), 156 banking sector, xxv­xxvi, 162, 164, 165 social security taxes, 11­12, 12­13t, 227­28, 228t CEE countries, 267, 267t SOEs (state-owned enterprises), 44 competition-related reforms, 287­89 Spain electricity industry, xxvi, 192, 195, 200, 203­4, 206­7 labor market flexibility, 247 environmental acquis and, 299­300 natural gas sector, 218, 219 manufacturing, 114, 120 tax structure, 11­13t, 12 telecommunications sector, 147, 148 Special Accession Programme for Agriculture and Rural Privatization Agency, 72 Development (SAPARD), 299, 303­4, 306 public sector spillovers, 263­64 borrowing requirements and public debt, 9­11, Stability and Growth Pact (SGP), 15­16, 18, 19, 325 9f, 10­11t Structural and Cohesion Fund (EU), xxxv, 67, 68­69, deficits, 4­5 247, 347, 348 environmental acquis, costs of, 299­300, 299b subsidies, 44­45, 67­69, 328 public debt and fiscal policy, 22­23 See also GATT reforms, 284 antisubsidy measures, 103, 114 revenues and expenditures, 7, 8t, 9 Sweden's natural gas sector, 320t, 321 state aid, 328 public service obligations (PSOs), 189­90, 191, 195 tariffs. See trade and border control taxation railways, xxiii, 123, 132, 134­35t, 137, 137t, 138f costs of accession, 23 See also market access and regulatory issues; EU budget and, 347 transportation sector flat tax, 23, 28, 34n35 real exchange rate (RER) and current account, xx, 6­7, labor market policies and, 327 7t, 26t, 26­28, 31, 326 labor taxes, 28 Resolution No. 1466/97, 16 reforms, 28, 285, 285f Resolution No. 1467/97, 16­17 structure of taxes, 11­12, 11­13t Restructuring Law of 1996 (U.S.), 205b tax wedge, 228­29, 228­29t Romania value added tax (VAT) systems, 11, 12, 13t, 67­68, 69t, agriculture, 341 285, 346, 347 budgetary effects of EU membership, 348 TEAS. See Turkish Electricity and Transmission exchange rate policy, 20t, 30 Company natural gas sector, 211 technology, 28, 262­63 unemployment, 227, 227t TEDAS. See Turkish Electricity Distribution Company Rome, Treaty of, 105, 287 TEKEL (Directorate General for the Tobacco Products, rural communities, 55, 148 Salt and Alcohol Industry), 72 See also agricultural markets and incomes telecommunication acquis, 147, 153, 156 Russia telecommunications sector, xxiv, 147­59 flat tax, 34n35 access directive, 155­56 natural gas sector, 210, 212 authorization directive, 154­55 competition policy and regulation, 152­53 safety and health requirements for labor, 234, 251 framework of EU legislation, 153­54 SAPARD. See Special Accession Programme for legal and institutional comparison with EU, 153­57 Agriculture and Rural Development price regulation, 156­57 Index 361 privatization, 153 regulatory structures, 123, 134, 135­38t, 137, quantitative comparison, 148­52, 148­52f, 158t 138­39f recommendations, 157, 157f tariff equivalents for, 139­40, 140f unbundling regulation, 155­56 welfare effects of integration on, 316 universal service, 156 Treaty of. See specific name welfare effects of integration on, 313­14, 315t TSE. See Turkish Standards Institute TETAS. See Turkish Electricity Wholesale Company TURKAK. See Turkish National Accreditation Body third party access (TPA) in energy industry, 189, 194, Turkish Bank of Agriculture, 44, 71 200, 317, 319, 320 Turkish Electricity and Transmission Company (TEAS), TMO. See Turkish Grain Board 191, 193­94, 316 Tokyo Round Agreement, 87 Turkish Electricity Distribution Company (TEDAS), total factor productivity (TFP) growth, 28­29 191, 194, 198, 199, 200, 316 TPRB (Trade Policy Review Board), 129 Turkish Electricity Wholesale Company (TETAS), trade and border control 193­95, 197, 198, 199­200, 201, 207 agricultural commodities, 40­41, 42­43t, See also electricity industry 45­48, 46­47t Turkish Grain Board (TMO), 71, 72 agriculture acquis, status of implementation, Turkish National Accreditation Body (TURKAK), 74­75 xxiii, 109 applied tariff structure, 99­102, 100­02t Turkish "National Program," 161 beef and veal, 54 Turkish Standards Institute (TSE) certification, cereals, 51 xxii­xxiii, 109, 110 conditions of competition, 112­20, 115t, 116f, Turkish State Railways (TCDD), xxiii 117­19t Turkmenistan's natural gas sector, 210­11, 212, 213 conformity assessment and market surveillance, Türk Telecom, xxiv, 148­49, 151, 153, 156­57, 313 107, 109­10 See also telecommunications sector contingent protectionism, 102­3, 104t coverage of EC technical regulations, 108t UCPTE (Union for the Coordination of Production and customs union between Turkey and EU, 87, 94, 103, Transmission of Electricity), 203 123­29, 125­30t, 132 unbundling regulations developing countries, implications for, xxxiii­xxxv electricity industry, 189, 190, 191, 193­94, development in Turkey's trade regime, 87­98, 88­89t, 200, 204 91­93t, 95­98t natural gas sector, 214, 217, 218 economic effects of Turkey's membership on EU, telecommunications sector, 155, 193­94 349­50, 350t unemployment. See labor market policies EC technical regulations and, 107 United Kingdom electricity industry, 202­3 electricity industry, 204, 317, 319 growth effects of accession, 328­29, 329t natural gas sector, 204, 219, 320, 320t, 321, 322, 322t harmonization of regulations and standards, 106­7, tax structure, 11­13t, 12 109, 120 United States liberalization, effect of, 28, 285, 285t immigration, 343­44 macroeconomic and trade policies, 272­73, 272t labor market flexibility, 247, 248 most-favored nation (MFN) tariff rates, 45, universal service 46­47t electricity industry, 202 mutual recognition principle, 105­6 telecommunications sector, 156 protectionism, 99­102, 100­02t Uruguay Round commitments, 124 service and network industries, 324t, 324­25 sugar beets, 52 value added tax (VAT) systems, 11, 12, 13t, 67­68, 69t, tariff binding commitments under WTO, 83n5 285, 346, 347 technical barriers to trade, 103, 105­12, 111t, 113t veterinary border inspections, 74­75 wines, 52 voting, impact of Turkey's membership on EU, Trade Policy Review Board (TPRB), 129 xxxi­xxxii, xxxv, 331­40 transportation sector Council of Ministers voting reforms, xxxii, 331­32 See also market access and regulatory issues decision making, impact on, xxxii, 333­36 customs union and, 132 enlargement's effect on incumbents' power, xxxii, 336, direct trade in, 132 337­38f, 347 economic implications of EU accession, 314 passage probabilities of various voting scenarios, motor vehicle sector, 131­32, 275 332­33, 332f 362 Index Wales' electricity industry, 204 wetlands regulation, 71­72 welfare effects working conditions, 234, 251 agricultural markets and incomes, 69­70, 70t, World Trade Organization (WTO), 83n5, 87, 124, 311­12, 312t 152, 289 banking sector, 312­13 CAP, impact of introducing, 69­70, 70t YOIKK. See Coordination Council for the of integration, 311­25, 329 Investment Climate natural gas sector, 319­22, 320t, 322t telecommunications sector, 313­14, 315t, 322­25, 323­24t transportation sector, 316 T R A D E A N D D E V E L O P M E N T S E R I E S W hat requirements must Turkey--the largest country among the candidate and accession countries--meet to join the European Union? What progress has been made toward meeting them? This timely volume analyzes the economic challenges confronting Turkey in its quest to accede to the European Union (EU). It focuses on the extent to which Turkey is ready to join the Single Market; comply with the EU's body of economic regulations and directives, the Acquis Communautaire; and meet the Maastricht criteria for fiscal, monetary, and exchange rate policies. This book also provides an assessment of Turkey's national program to meet the accession requirements. It describes briefly what Turkey needs to achieve on the economic policy front to satisfy the conditions for accession, the progress to date, and the likely consequences of implementing the full body of EU requirements. The book is divided into four parts: a An analysis of the macroeconomic policies for EU accession a An analysis of the effects of integration on key sectors: agriculture; manufacturing; services industries, including banking, telecommunications, transportation, and natural gas; and network industries a An exploration of key economic policy challenges, including labor market regulation, foreign direct investment challenges, and the costs and benefits of meeting the EU environmental Acquis a The quantification of the impact of EU accession and consideration of the welfare effects of integration Although the focus is on the specific situation of Turkey, the subject will be of value to all researchers with an interest in the challenges of deeper integration through regional agreements. The Centre for Economic Policy Research (CEPR), established in 1983, is a network of over 600 Research Fellows and Affiliates, based primarily in European universities. The Centre coordinates the research activities of its Fellows and Affiliates and communicates the results to the public and private sectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers, and sponsors of research. CENTRE FOR ECONOMIC POLICY RESEARCH THE WORLD BANK TMxHSKIMBy359327zv":;:*:$:- 0-8213-5932-0