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Turkey Jobs for Votes Global Don’t Underestimate External Dependency, for Now View GEF Archive

		The Global Economics Team

			Serhan Cevik
Serhan Cevik is a Vice President who covers the Middle East and North Africa.
		Read about other GEF team members

The state of the country’s labour markets is the crucial factor for voters.  There are numerous factors — ranging from ideological orientation to economic interests — that influence political preferences.  Our analysis of the Turkish case in the past suggested that both the rate of employment growth and the unemployment rate have significant effects on voting patterns (see Rock the Vote, October 31, 2002).  Therefore, over the course of the next 12 months, we will continue to scrutinise the state of the economy to uncover the links between economic and political cycles.  Let’s now start with the latest employment figures.  The unemployment rate has shown a reasonable improvement in recent years, declining from the post-crisis peak of 12.3% of the civilian workforce in 2003 to 9.2% in 2005 and 8.8% so far this year.  That also implies a sustained progress on a seasonally adjusted basis, from 11% in 2003 to 9.7% this year.  Nevertheless, the pace of employment growth is still not enough to absorb the flood of new workers.  Indeed, one important reason behind the drop in unemployment is the increase in the number of discouraged workers who have withdrawn from the labour market.  If we include these people, the unemployment rate would be 15.2% — almost twice as much as the headline reading.

The changing composition of employment is great news, but also a nightmare for politicians.  Although Turkey has not really suffered from high and persistent unemployment in the past, the structural component of unemployment increased in the 1990s and especially after the 2001 crisis.  Of course, a variety of factors contribute to this new phenomenon, which we can also see in the changing composition of employment.  The share of agriculture declined by almost ten percentage points in the last five years to below 30% of total employment, against a sustained increase in non-farm jobs.  In other words, the economy has created jobs, but the composition has shifted away from low-skilled, low-paying jobs in traditional sectors.  This is no doubt an exciting development that will accelerate income convergence vis-à-vis Europe.  Nonetheless, the adjustment phase is not painless and makes politicians vulnerable to popular anger and marginalisation.  That said, populist manoeuvres would not bring any relief on a sustainable basis at all, and the only way to ease the pain of adjustment is to move forward with consolidating macroeconomic stabilisation and introducing microeconomic reforms, in our view.

One of the main determinants of labour demand is the cost of labour.  Although the economy is going through a structural transformation that creates better jobs, the problem stems from institutional rigidities and arbitrary wages that curb the demand for labour.  In our view, the minimum wage policy is a notable example of how political manipulations distort the labour market and end up encouraging firms to undertake labour-augmenting capital spending.  With a 52.6% real increase since 2001, the minimum wage corresponds to about 87% of per capita GDP.  Of course, such a disproportionate rise has not only failed to improve living standards, but also priced unskilled and inexperienced workers out of the labour market by raising the marginal cost of labour relative to the cost of capital (see Capital-Labour Substitution and Jobless Growth, April 23, 2004).  Indeed, arbitrary wages raising unit labour costs have a fundamental role in accelerating the pace of capital deepening beyond the optimum capital/labour ratio implied by labour-market conditions.

The factor substitution process is far more powerful in labour-intensive sectors.  It has been argued that policy instruments such as the minimum wage would raise the income level among low-skilled workers.  Unfortunately, politically motivated decisions result in distortions and fail to improve the distribution of income (see The Illusion of Compassion, June 21, 2004).  Instead, as the Turkish experience shows, labour-intensive sectors of the economy struggle with lower productivity and higher unit labour costs.  And with declining profitability, firms substitute more capital for labour and/or globalise their supply chains.  The result is an unsurprising deterioration in the economy’s labour-absorption capacity, which of course hurts low-skilled and inexperienced workers more than other segments of the labour market.

Employment taxes in Turkey are the highest among OECD countries.  Decades of distortions have led to an archaic, regressive tax regime that puts a huge burden on employment.  The effective employment tax rate increased from 30.3% in 1999 to 42.7% last year, compared with 8.1% in Ireland and an average of 27.7% for OECD countries.  This is yet another factor that increases the cost of labour beyond the marginal productivity of labour and thereby encourages companies to adopt more capital-intensive production processes.  No wonder, even after a 40% increase in real GDP, the country’s employment rate stands at 44.3% of the working-age population, down from 48.5% before the crisis.  The task of improving labour-market conditions, however, is not as simple as correcting the tax regime and introducing a regional minimum wage scheme.  Turkey’s problems have deeper structural roots and require a comprehensive strategy including a programme to improve human capital.

Institutional bottlenecks lower the economy’s labour absorption capacity.  Our calculations suggest that the Turkish economy needs to create approximately 700,000 jobs per year to maintain a constant unemployment reading.  This is a challenging mission even under normal circumstances and becomes a daunting task when structural changes bring a shift in the composition of employment and demand higher productivity growth.  The very reasons — macroeconomic normalisation and greater integration with the global economy — that make us excited about Turkey’s growth prospects also reveal institutional constraints that may limit the rate of income convergence in the future.  Indeed, the economy has already started experiencing the burden of structural bottlenecks.  Take, for example, the widening mismatch between the average educational attainments and what a post-agrarian economy and global conditions demand.  Hence, even though the temptation to raise the minimum wage and public-sector compensation in an election year may be too strong to resist, we hope that the authorities will realise that maintaining macroeconomic stability and removing institutional bottlenecks is the best possible combination to ensure sustainable, welfare-enhancing growth.

Global
Don’t Underestimate External Dependency, for Now
November 15, 2006

By Denise Yam, CFA | Hong Kong

China as an independent source of growth?

A popular view is that Asia, especially China, is decoupling from the US, and will show resilience against a US slowdown.  We are sceptical of such confidence in domestic demand in Asia, and China in particular.  We believe that China’s growth remains external-oriented, underpinned by the ongoing strength in global demand and sustained risk appetite that has continued to feed the region with liquidity.

Exports to the US have seen their share decline as a percentage of non-Japan Asia’s total exports, from 22% in 1999 to 16.7% in 1H06.  However, their share in GDP has remained stable at around 7.5% for both the region as a whole as well as for China, suggesting no loss in their significance.  The growth in intraregional trade (now 40% of the total) over the past few years has been driven not so much by domestic demand, but rather on the back of increasing specialisation in the production chain.  Many of the intraregional shipments comprise components that are assembled for OECD markets, or machinery that is geared towards export production.  We believe that about half of China’s imports are such equipment and components.  Moreover, demand from other developed markets is also likely to be hurt by a US downturn, not to mention the multiplier effect on domestic demand from the loss in export income.  Therefore, we remain wary that a slowdown in global demand and reduction in investment risk appetite that withdraws liquidity from the region would have a negative impact on China’s growth.

Growth still underpinned by favourable external conditions

There are many indicators that serve as useful measurements of an economy’s openness and external dependency.  For example, exports’ share in GDP, trade surplus’ share in GDP, and balance of payments trends are commonly used indicators.  We, on the other hand, often look into the marginal contribution of these external exchanges to the economy, by following the ratio in incremental changes of the available indicators.

The export-to-GDP ratio has trended upwards continuously, climbing above 40% of GDP in 3Q06.  If we look at the incremental export-to-GDP ratio, which is the ratio of the incremental year-on-year increase in exports over that in GDP, it has risen from an average of below 25% over the late 1990s to 2002, to 50-60% since 2003, and averaged 58% in the first three quarters of 2006.  Even though exports are reported in gross terms versus GDP in a value-added concept, the steady increase in the ratio still helps to illustrate the dominance of exports as a driver of growth.

Next, we look at how the labour market has also become more externally-dependent.  Although foreign-invested enterprises account for less than 5% of China’s total urban employment, their contribution to new job creation surged to 25% of the 8.6 million increase in jobs in 2005, up from just 4% in 2000.

Meanwhile, fixed asset investment has been labelled the powerhouse of China’s growth, but its funding is driven by export income and foreign capital inflows that relentlessly liquefy the banking system.  In other words, we believe that strong global demand, below-neutral global interest rates and high risk appetite have made an immense contribution to China’s growth.  The surge in China’s balance of payments surplus has pumped up liquidity in China’s banking system and subsequently loan growth, amid incomplete sterilisation.  The increase in outstanding central bank bonds and financial institutions’ reserve deposits with the PBoC amounted to Rmb1.2 trillion (US$146 billion) in 2005 and Rmb471 billion (US$59 billion) in 1H06, compared with a balance of payments surplus of US$207 billion and US$122.1 billion in the respective periods.  Such foreign funding, especially in a low interest rate environment, has in turn helped drive the surge in fixed investment.  The recent correction in commodity prices and the pause in rate hikes by the Fed have further lifted expectations for sustained asset market performance, and could well prolong the liquidity-supported boom.

Exogenous boosts to demand in the making nonetheless

Private consumption expenditure in China totalled Rmb7.1 trillion in 2005, or US$865 billion, which is only 10% of the size of the US consumer market.  Even in terms of incremental increases, China (US$94 billion) compared poorly with the US (US$531 billion) in 2005, at 18%, offering little to offset a potential marked slowdown in US consumer spending in the short term.  Nevertheless, we do believe in a structural uplift in China’s domestic consumption over the longer term. 

China’s government policy focus has shifted from growth to rebalancing and redistribution towards social harmony.  Fiscal support in housing, education and healthcare should help unleash households’ purchasing power and lower the savings rate.  We have been excited about the hike in wages as announced in several industrial cities, which we believe is the beginning of a trend that will help recover the share of household income in GDP, and is crucial to rebalancing the economy from investment to consumption.  We believe that the possible slip in manufacturing labour demand due to the loss in export competitiveness could be more than offset by the increase in consumption-oriented service-sector jobs.  Moreover, increased remittance by migrant workers to their families in rural areas could give a meaningful boost to rural consumption.  Further gradual privatisation of government assets will also play an instrumental role in driving household wealth accumulation.

Be patient — domestic demand is a long-term story

While we are sceptical of the bullish view on China being an independent source of demand that will take up the slack from a slowdown in developed markets in the short term, we believe that China is securing a structural uplift in consumer demand.  Nevertheless, patience is called for — structural rebalancing towards consumption involves reforms that promote more equality in income and wealth distribution.  It could be several years before such reforms transform China into a promising consumer market.  And before that, don’t underestimate China’s external dependency for growth.

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