New Lending Trend Could Improve Tax Collection in Turkey

Speaking at the World Economic Forum in Istanbul late last year, Turkish Finance Minister Ali Babacan described his government's lack of progress in curtailing the country's informal economy as its greatest failing.

It's easy enough to see why. He was referring to a sector estimated to be worth between one-fifth and two-fifths of the country's GDP. So bad are Turkish authorities at collecting taxes from individuals and companies that they are obliged to obtain the bulk of their revenues through indirect taxation. Turkish drivers, for example, pay some of the highest prices in the world for gasoline, due to the high taxes on fuel.

Many measures specifically aimed at encouraging individual and business compliance with the country's tax code, such as reducing corporate tax from 30 percent to 20 percent, have yet to have an a noticeable impact on improving revenue collection. However, recent changes in the banking sector lending practices seem to be having the unintended benefit of curtailing Turkey's grey market.

Taking advantage of high interest rates, Turkey's banks used to generate large profits by funding the government's massive borrowing needs. But the 2001 economic crisis prompted banks to reorient their lending practices. Now, financial institutions are receiving a larger share of profit through private borrowing. Retail lending has grown by an annual rate of roughly 80 percent over the past three years.

Turkey's nearly 2 million small and medium-sized enterprises (SMEs) have benefited the most from the banks' change of direction. They may employ about seven out of every 10 Turkish workers, but until recently SMEs received barely 5 percent of bank credits. Now analysts reckon they receive around a one-third of the total. "It's the most profitable part of the banking business today," says Murat Sari, head of the small business credits department in Akbank, whose SME loans topped $4 billion during first nine months of 2006, up from $700 million in 2003.

Melsa Ararat, an economist at Sabanci University in Istanbul, thinks this boom in SME loans has a vital part to play in the modernization of Turkey's economy. Like many developing countries, she says, Turkey has traditionally had a two-tiered economy. While the big companies have long based their competitiveness on innovation, SMEs have been caught in a cycle of low investment and low productivity. Not paying taxes has been their traditional way of competing.

"The existence of banks willing to lend changes all that," she says. "If SMEs want credits, they need good financial statements."

The heart of the ongoing transformation is the Revised International Capital Framework, or Basel II, which Turkey has pledged to implement by the end of 2008. As part of its brave new world of improved risk management, Basel requires banks to give credit ratings to all corporate clients, large and small.

Selim Seval -- managing director of Finar D&B, the Turkish representative of the international corporate rating agency Dun & Bradstreet -- has rated 40,000 Turkish companies since he set up shop in 1989. He is convinced Basel II will help foster the spread of a registered economy in Turkey. "When you rate a company for credit-worthiness, you're not too concerned at what's declared and undeclared," he explains. "But the amount of credit a company receives depends on its declared income. If you only declare half, you only get half."

While Turkey's banks are well prepared for Basel, that's less true of the smaller boardrooms of Turkey's corporate sector, bankers and analysts say. "Most SME owners are not aware of what Basel will bring," says Levent Topcu, a banking expert with the Istanbul-based brokerage HSBC Securities. An assistant manager in Akbank's small business marketing department, Osman Ozel jokes that "there's a long tradition of leaving things until the last moment in this country."

The government and local business organizations are doing their best to make sure the message gets through. Banks have been very active too, handing out to their clients brochures on Basel II and accounting software. Some have gone as far as to organize seminars on small-business practices. "This is a period of transition, so I suppose it's natural people should be afraid," said Sari, the Akbank lending officer.

He thinks such fears are largely ungrounded. "The banking sector is the most developed part of Turkey's economy," he says. "It is in our interest to pull the rest of the country along with us."