SMALL AND MEDIUM SIZED ENTERPRISES IN TURKEY: OPPORTUNITIES AND CHALLENGES

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1 SMALL AND MEDIUM SIZED ENTERPRISES IN TURKEY: OPPORTUNITIES AND CHALLENGES ALOVSAT MUSLUMOV Department of Management, Dogus University. Acibadem 81010, Istanbul, TURKEY Tel: (90216) (Ext: 294) Mobile: (90532) Fax: (90216) I. INTRODUCTION Small and medium sized enterprises (SMEs) are the subject of major concern in emerging countries. The governments are trying to develop economic policies that will assist the development of SMEs. However, the macroeconomic instabilities adversely affect SMEs as in the case of Turkey. Turkish SMEs account for 99% of established enterprises, 55% of the labor force, 30% of investments and 27.3% of total value-added in Turkey, becoming a key player in the economic activities. Turkish SMEs usually undertakes subcontractor role in the economy. The downturn of the Turkish economy in the recent decade has deteriorated the financial and operating performance of industrial firms, including SMEs. This paper tries to examine broad array of the issues related with the SME s in the economy. The remainder of the paper is organized as follows. Section II analyzes Turkish economy and place of SMEs within the economy. Section III provides the trend of financial performance variables of SMEs and larger firms in recent period. Section IV examines the effects of macroeconomic forces on Turkish SMEs. Section V studies the financial problem of SMEs. Section VI gives a brief conclusion. II. TURKISH ECONOMY AND SME S Turkish economy followed inward-oriented economic development strategy which is based on protectionism and import-substituting industrialization policies until The globalization process in the world has managed Turkey to integrate its economy to the international markets and to follow export-oriented development strategy. Many economic reforms have been implemented for transforming Turkish economy since 24 January However, economic stabilization couldn t be sustained in this transformation process and Turkey has faced the adverse effects of the three serious economic crises within last ten years. One of the main causes of the economic crises in Turkey is the weak competitiveness of Turkish manufacturing industries. The analysis of the distribution of Turkish foreign trade according to product categories shows that Turkey is the exporter of labor-intensive, low value-added products such as textile and clothing materials, whereas it is the importer of technology-intensive, high value-added products such as machinery and chemical materials. 1

2 The overwhelming majority of the firms operating in textile and clothing industries are SMEs, whereas most of the SMEs undertake subcontractor role. The specialization of Turkish firms, especially SMEs on low value-added, labor intensive products make them more vulnerable to international contagion effects through foreign trade channels. Since competition power of Turkish companies mostly relies on the cost advantage, the instabilities in real exchange rates cause to periodic contractions in the foreign trade. Muslumov and Aras (2002) shows that profitability of Turkish SMEs is favorably affected by devaluations in the real exchange rates, whereas the appreciation of the real exchange rates cause to the loss of the profitability. However, devaluation policies have adverse effects on the inflation and increase the vulnerability of short-term capital inflows. Therefore, when Turkish government authorities set an economic stabilization plan to fight with the inflation, its local currency becomes overvalued which leads to the increasing current account deficits and eventually to financial and economic crisis. We witness this scenario in the case of the economic crisis occurred in November 2000 and February 2001 in Turkey. Due to the low competitiveness of Turkish economy, the foreign trade deficit started to increase in the beginning of 1990s. The magnitude of the foreign trade deficit was about 3 billion U.S. dollars between , whereas it increased to 9.3 billions dollars in 1990, and to 14 billion in These current account deficits were financed by short-term capital inflows benefiting from high real interest rates. Asian countries are competitors to Turkish products in many markets. During the East Asian crisis, East Asian countries devalued their currencies significantly. Turkey on the other hand kept its currency pegged to the USD and DM basket. This reduced the competitive position of Turkish goods in external and internal markets. By the end of 1997, the foreign trade deficit of Turkey increased to 22.5 billion USD. Due to high public sector borrowing requirements (PSBR) internal interest rates adjusted for inflation remained at very high levels, at about 25%. The short-term capital inflow to Turkey was able to finance the current account deficits. At that time Russia was a good trade partner for Turkey. The Russian crisis of 1998 increased the vulnerability of the Turkish economy. In spite of these developments, in January 2000, Turkey launched an IMF supported stabilization program based on using exchange rates as a nominal anchor. Although some degree of success was recorded, the value of the TL was further appreciated about 15% against the European currencies until November At that time, Europe accounted to about one half of the Turkish foreign trade. In the months leading up to November, Turkey s foreign trade deficit increased to 22 billion USD, almost 50 percent of its imports. The current account deficit increased to record levels of 10 billion USD. Naturally these developments resulted in the flight of short-term foreign capital, causing a currency crisis and interest rate hikes. Since the government attempted to stick to the pegged exchange rate policy, Turkey faced a very severe financial crisis by February Turkey had to abandon the pegged exchange rate regime leaving the exchange rates free to be determined by the market. At that time Turkey could have managed the crisis by devaluing its currency by, perhaps 30%. The market overreacted and exchange rates more than doubled within a month. The February crisis had a devastating impact on the Turkish economy: one and a half million workers lost their employment, national income dropped by 8.5 percent, income distribution worsened (Ertuna, 2002). The study of the recent crises suggests that the starting point of the crises is most probably low-level of the productivity of Turkish manufacturing industries. Therefore, rehabilitation process of the economy should first start with the rehabilitation of the manufacturing sector of the economy. For this purpose, Turkish economy should try to allocate its limited sources to the companies in competitive and high value-added industries in 2

3 order to feed sustainable development. A priority may be given to the competitive SMEs in this rehabilitation process. III. THE FINANCIAL DISCRIMINATION OF SMES FROM LARGE SCALED ENTERPRISES In this section, I analyze how the downturn of the economy has deteriorated the financial and operating performance of manufacturing industries, including SME s. For this purpose, we have conducted trend analysis of financial variables within which compare the financial ratios of small, middle and large scaled manufacturing firms The data is drawn from the Corporate Accounts Database of the Central Bank of Turkey (CBT). The corporate accounts database of the CBT includes consolidated financial accounts of 7537 companies. CBT classification of the company size utilize the net sales criterion of BACH (The Bank of Harmonized Data on Company Accounts), which groups the firms with net sales less than or equal to EURO 7 millions in small firm category, while the firms with net sales between EURO 7-40 millions is grouped within medium firm category, and the firms with net sales higher than EURO 40 millions is grouped within large firms category Return Indicators Total asset operating profitability of firms in manufacturing industries has continuously fallen in all firm scales between (Figure 1). Total asset operating profitability was 4% in small sized firms, 7% in medium sized firms, and 14% in large sized firms. This evidence shows that SMEs were the most badly affected firms from economic contraction. Figure 1: Total Asset Operating Profitability Total asset operating profitability ratio is defined as the ratio of income before interest and tax to total assets

4 The decline in total asset operating profitability can arise from two sources. These include declines in cash flow margins and total asset productivity. Cash flow margin on sales measures the operating income generated per sales dollar. Asset turnover measures the sales dollars generated from each dollar of investment in assets. The variables are defined so that their product equals to the operating cash flow return on total assets. Figures 2 and 3 indicate that the decrease in total asset operating profitability arise from both sources. Operating income margin has continuously fallen across all scale categories in This situation may be best explained by contracting domestic demand and declining competitiveness in front of foreign competitors. It is obvious that SMEs own much lower operating income margin than larger firms. SMEs are supposed to maintain greater total asset productivity than their larger counterparts because of their dynamic structures. Figure 3 shows that economic instabilities in recent years have adversely affected total asset turnover ratio of manufacturing industries, whereas SMEs were the worst affected. Small sized firms owned higher total asset turnover ratios in 1996 and 1997 years. However, in subsequent years total asset turnover ratio of large sized firms exceeded the ratio values for small-sized firms. This finding provide evidence that macroeconomic instabilities has much adverse effects on the financial performance of SMEs Figure 2: Operating Profitability Margin Operating profitability margin ratio is defined as the ratio of operating income to net sales

5 Figure 3: Total Asset Turnover Total asset turnover ratio is defined as the ratio of net sales to total assets Risk Indicators Financial leverage is defined as two-edged sword in the financial literature. It produces highly favorable results when things go well, and quite the opposite under negative conditions. In the other words, financial leverage not only magnifies returns as volume increases, but also magnifies losses as volume increases. Figure 4: Financial Leverage Ratio Financial leverage ratio is defined as the ratio of total liabilities to total assets

6 Figure 5: Current Ratio Current ratio is defined as the ratio of current assets to current liabilities Since Turkish economy experienced economic instabilities in years, we may predict that higher financial leverage would on average lead to deteriorating returns. The trend analysis of the financial leverage ratios of Turkish firms across scale categories (Figure 4) shows that financial leverage of small and medium sized firms was higher in 2000 year compared with 1996 year. The maximum financial leverage level of small sized firms was 74% in 2000 year, whereas it was %62 for large sized firms. These results should be interpreted as increasing financial risk of SMEs in Turkey. Current ratio shows whether the firm is capable to meet maturing obligation as it comes due. The current ratio of small sized firms has been in gradual decline and reached to the very critical limit of 1.0 in 2000 year, whereas the current ratio of medium and large sized firms experienced a slight increase (Figure 5). Higher financial leverage ratio of SMEs combined with lower current ratio indicates higher financial risk for SMEs which is significant finding. IV. THE EFFECTS OF THE MACROECONOMIC FORCES ON THE PERFORMANCE OF SMEs IN TURKEY The trend analysis conducted in the previous section shows that Turkish SMEs experienced sharp decrease in profitability and sharp increase in risk measures. Average profitability of SMEs over the period of was below than real interest rates in the economy and showed downward trend. In the other hand, the business risk of SMEs has increased in recent years. These results imply that SMEs in Turkey are standing in very difficult position and the situation may become worse if a serious rehabilitation process will not be implemented. 6

7 The comovement of financial variables suggests the presence of underlying exogenous influences. Since macroeconomic variables represent systematic risk, it may systematically affect the risk and return measures of the industrial firms. Müslümov and Aras (2002) has conducted the multiple regression analysis on the sample of 32 publicly-held SMEs operating in manufacturing industries over the period of to analyze the relationship between macroeconomic and financial variables of SMEs. The independent macroeconomic variables analyzed in this study were real exchange rates, real interest rates, expected inflation rates, real per capita GDP growth, production index and crude oil prices. The dependent financial variables were return on assets, current ratio and financial leverage ratios. The results of the multiple regression study shows that real exchange rates affect the profitability of Turkish SMEs. The analysis results show that profitability of SMEs in Turkey has been significantly affected by the changes in the real exchange rates. Currency devaluations increase, whereas currency overvaluations decrease profitability of Turkish SMEs. This is most probably due to the fact that currency devaluations increase the competitiveness power of SMEs over its foreign competitors in domestic and foreign markets. The effects of the remaining macroeconomic variables on the profitability of SMEs are not found statistically significant. The business risk variables of Turkish SMEs are found to be significantly affected by the expected inflation, crude oil prices, real per capita GDP growth and real exchange rates. An increase in the expected inflation and crude oil prices, a decrease in real per capita GDP growth and currency overvaluations have been perceived as the potential risk sources by SMEs. The research results are very instrumental in explaining the nature of the economic crises in Turkey. It clearly shows that stabilization programs based on using exchange rates as a nominal anchor leads to the currency overvaluations which results in the loss of the competitiveness of real side of the economy and leads to the increasing current deficits which is the main reason of the recent economic crises. These results suggest in the case of emerging country that macroeconomic dynamics actively affect the financial performance of the SMEs. Governments should pay attention to the effects of the macroeconomic forces on the performance of the real side of the economy in order to support the balanced growth of the SMEs. V. THE FINANCIAL PROBLEM OF SMEs IN TURKEY In spite of some dissimilarities across countries, financial problem remains to be most important problem of SMEs. The financial problems of Turkish SMEs can be classified to following categories. Working capital problems Inadequate capital Difficulties in obtaining bank credit Higher borrowing costs Inefficiency in the collection of receivables 7

8 The limited opportunities for obtaining funds from capital markets. The most cited financial problems of Turkish SMEs are inadequate finance sources and higher borrowing costs. SMEs usually operate with internally generated funds. SMEs usually look for outside financing, especially bank credits and public offerings through capital markets in their growth stages. Since funding costs from capital markets are subject to the scale economies, in other terms since high fixed costs makes low volume fund demands infeasible, SMEs do not much prefer initial public offerings through capital markets. Muslumov (2002) shows that there are 8 publicly held SMEs in the Istanbul Stock Exchange out of the total 180 manufacturing publicly held companies whose data is available. This situation is the indicator of the fact that SMEs in Turkey do not fully exploit capital market facilities Similar problem is observed in the bank credits. Yazman and Akpinar (2001) estimate that SMEs benefit from only 10-15% of total bank credits. Considering the key position of SMEs in Turkish economy, this portion remains to be trivial. However, it shouldn t be neglected that the main financial problem of Turkish SMEs is higher borrowing costs. The scale disadvantages of SMEs heighten their bankruptcy risk and eventually, capital cost. In the other hand, since capital cost is the decreasing function of required funds, the capital cost of SMEs remains higher because of fixed costs. Muslumov and Aras (2002), shows that publicly-held Turkish SMEs retain higher capital costs than larger firms. Because of abnormally higher real interest rates in the Turkish economy ( period average is equal to 32%), the capital cost of Turkish SMEs escalated to very high levels which damaged their economic activities. Another important problem that SMEs face in the credit markets is the credit rationing problem that is the result of asymmetric information. Credit rationing is a common feature of most developing economies. In case of the existence of asymmetric information in credit markets, banks ask for collateral in order to differentiate between good and bad customers. However, SMEs have many difficulties in presenting collaterals to banks. In addition, their financial statements are far from meeting the expectations of banks. Therefore, banks prefer working with larger firms instead of SMEs which intensify the financial problem of SMEs. The financial problem of the SMEs calls for the government intervention to the market in order to alleviate the problem. However, it should be denoted that the financial problem of SME s in Turkey is just the reflection of their all remaining marketing, management, production and technological problems. Therefore, government intervention is only necessary for creating equal conditions for smaller and larger firms, whereas other types of the intervention that will create exclusive parts in the economy will be harmful for the health of the whole. VI. CONCLUSION In this paper, I am investigating the problems of Turkish SME s in the recent years. I show that Turkish economy has been specialized in the production of labor-intensive and low value-added products, whereas Turkish SME s mainly undertakes subcontractor role. I indicate that this role attributed to the Turkish economy and SME s contribute to the collapse of the economy when government ceases to support manufacturing industries through devaluations. It is concluded that Turkish economy should try to allocate its limited sources to 8

9 the SME s in competitive and high value-added industries in order to feed sustainable development. Second, I analyze how the downturn of the economy has deteriorated the financial and operating performance of manufacturing industries, including SME s. The trend analysis conducted in this study shows that manufacturing industries experienced sharp decrease in return and increase in risk measures. Average return on assets of SME s showed continuously decreasing trend. The financial leverage ratio and the ratio of short-term debts to total debts have increased sharply, where the liquidity of SME s declined drastically. These results imply that SME s of manufacturing industries in Turkey is standing in a very difficult position and the situation may become worse if a serious rehabilitation process will not be implemented. Third, I examine the effects of macroeconomic factors on the financial performance of SMEs. The results suggest in the case of emerging country that macroeconomic dynamics actively affect the financial performance of the SMEs. Governments should pay attention to the effects of the macroeconomic forces on the performance of the real side of the economy in order to support the balanced growth of the SMEs. Fourth, I focus on the financial problem of SME s in the globalization process and argue that this problem is the reflection of all remaining problems of SME s such as marketing, management, production and technological. However, SME s suffer from credit rationing and high capital cost problems due to their scales, which require government s intervention in the market for creating equal conditions for smaller and larger firms, whereas other types of the intervention that will create exclusive parts in the economy will be harmful for the health of the whole. REFERENCES Ertuna, O. (2002), Short Term Capital Mobility and Crises: Asymmetric Risk and Return, Bogazici University Working Paper. Muslumov, A. (2002). Turkish SMEs in the 21st Century: Problems, Opportunities, and Solutions, Literatur Publications, Istanbul. Muslumov, A. and G. Aras (2002), The Effects of the Macroeconomic Forces on the Performance of SMEs in Turkey, SMEs in a Global Economy International Conference, Wollongong, Australia. Yazman, I. and A. Akpinar, (2001). Financing SMEs. TESKOMB Publications, Ankara, Turkey Yılmaz, E. (2000). The Impact of Persistent Devaluation on Growth: The Case of Turkey During the Post-1980 Period. Yapı Kredi Economic Review 11. pp