Document of The World Bank FOR OFFICIAL USE ONLY ReportNo. 25795-TU INTERNATIONAL BANKFOR RECONSTRUCTIONAND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSEDTHIRD PROGRAMMATIC FINANCIALAND PUBLIC SECTOR ADJUSTMENT LOAN INTHEAMOUNT OFUS$1BILLION TO THE REPUBLIC OF TURKEY May 21,2004 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwisebe disclosedwithout World Bank authorization. TURKEY THIRD PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN CurrencyEauivalents (Exchange Rate Effective May 14,2004) Currency Unit = TurkishLira TurkishLira 1 = US$O.OOOOOl US$1 = 1,527,554 TurkishLira GovernmentFiscal Year January 1- December 31 Abbreviations and Acronvms ARIP Agricultural ReformImplementationProject ASCU Agriculture Sales Cooperative Union BIDP BRSA InstitutionalDevelopment Plan BOT Build-Operate-Trans fer BRSA Banking Regulation and Supervision Agency BYES Budget Management Information System CAR Capital Adequacy Ratio CAS Country Assistance Strategy CATAK EnvironmentalSet-aside Program CBT Central Bank o f Turkey C E M Country Economic Memorandum CFAA Country Financial Accountability Assessment C M B Capital Markets Board CPAR Country Procurement Assessment Review C P I M I Consumer Price IndexiWholesale Price Index DFIF Support Price Stabilization Fund DGF Directorate General o fFoundations DIS Direct Income Support EAP East Asia and Pacific EBA Execution and Bankruptcy Act EBF Extra-budgetary Funds ECA Europe and Central Asia EFIL Export Finance Intermediation Loan EMBI+ Emerging Markets Bond Index Plus EPF Vakif Bank Employee Pension Fund ERL Economic ReformLoan EU European Union FDI ForeignDirect Investment FIAS Foreign Investment Advisory Service FSAL Financial Sector Adjustment Loan FX Foreign Exchange FY FiscalYear GDF General Directorate o fFoundations GDPiGNP Gross Domestic Product'Gross National Product GDR General Directorate o f Revenues GFS Government Finance Statistics HPC High Planning Council HR HumanResources IAIS International Association o f Insurance Supervisors IAS International Accounting Standards IBRD International Bank for Reconstruction and Development IDF InstitutionalDevelopment Fund IFC International Finance Corporation IMF International Monetary Fund IOSCO International Organization o f Securities Commissions ISE Istanbul Stock Exchange L A C Latin America and the Caribbean LDP Letter o f Development Policy LIBOR LondonInterbank OfferedRate LLP Loan Loss Provisioning MARA Ministry of Agriculture and Rural Affairs M A S A K Financial Crimes Investigation Board M O F Ministry of Finance MOH Ministry of Health MONE Ministry ofNationalEducation NBFI Non-bank Financial Institutions NGO Non-Governmental Organization NPL Non-Performing Loans OECD Organization for Economic Cooperation and Development PA PrivatizationAdministration PPA Public Procurement Agency PEIR Public Expenditure and InstitutionalReview P E M Public Expenditure Management PFMC Public Financial Management and Control PFMP Public Financial Management Project PFPSAL Programmatic Financial and Public Sector Adjustment Loan PFSAL Programmatic Financial Sector Adjustment Loan PIP Public Investment Program PIR Public Investment Review P I T K I T Personal Income Tadcorporate Income Tax PPSAL Programmatic Public Sector Adjustment Loan PSSP PrivatizationSocial Support Project REER Real Effective Exchange Rate SA1 Supreme Audit Institution SCT Special Consumption Tax SDIF Savings Deposit Insurance Fund SEE State Economic Enterprise SIS State Institute o f Statistics SME Small and MediumScale Enterprise SOE State-owned Enterprise SPO State Planning Organization SRMP Social RiskMitigationProject SSAL Special Structural Adjustment Loan SSF Social Solidarity Fund SSI Social Security Institutions TCA Turkish Court ofAccounts TESEV Foundation for Economic and Social Studies TKB TurkishDevelopment Bank TL TurkishLira TIN Taxpayer Identification Number TSKB TurkishIndustryDevelopment Bank U A P Urgent Action Plan UNCITRAL UnitedNations Commissionon International Trade Law VAT Value Added Tax VB Vakif Bank WB World Bank Vice President: Shigeo Katsu Country Director: Andrew Vorkink Sector Directors: Cheryl Gray and Fernando Montes-Negret Team Leaders: Rodrigo A. Chaves - Ismail Arslan REPUBLIC OF TURKEY THIRD PROGRAMMATIC FINANCIAL AND PUBLIC SECTORADJUSTMENT LOAN LOANSUMMARY Borrower: The Republic o f Turkey Amount: U S $ l billion Terms: The terms o f the Fixed-Spread loan to Turkey for the proposed US$1 billion PFPSAL I11are 17 year final maturity including a 4 year grace period and a lending rate o f 50 basis points over USDLIBOR. Front EndFee: 1 percent o f Loan amountsFN Commitment Fee: 0.85 percent on undisbursed loan balances for first four years, standard charge o f 0.75 percent on undisbursed loan balances thereafter, beginning 60 days after signing, less any waiver. Objectives and Description: The main objective o f PFPSAL I11 is to support implementation during 2004 o f the Government's financial and public sector reform priorities while ensuring that social programs are adequately funded and increasingly better targeted. K e y reform priorities in the financial sector include: (i)strengthening theregulatoryframework forbanking(ii) building institutional capacity at the Banking Regulation and Supervision Agency (BRSA) and Saving Deposit Insurance Fund(SDIF), (iii) restructuring and privatizing state banks, and (iv) improving the corporate insolvency regime. Key reform priorities in the public sector include: (i)deepening o f structural fiscal policies in support o f sustainable fiscal adjustment, (ii) implementing public expenditure management (PEM) reforms covering budget planning and execution, financial accountability, and public liability management, and (iii)strengthening public sector governance including implementation o f the national anti-corruption strategy and preparation o f civil service reform strategy. Priorities for social spending include: (i)adequate expenditure for health, Pending approval by the Executive Directors, US$3.66 million of the fi-ont-end fee would be waived on an exceptionalbasis (see paragraph 126). education and social protection in the 2004 budget and (ii) better targeting o f social protection. Benefits: The principal benefits o f the Loan will derive from: (i) supporting the Government's efforts to create conditions for sustained growth and macroeconomic stability, (ii)ensuring adequate social expenditure and better targeted social protection, (iii)restoring confidence in the banking system and positioning the sector for accession to the European Union (EU); and (iv) establishing a better foundation for more effective government in line with EU directives and international best practice. Risks: Turkey has embarked o n an impressive financial and public sector reform agenda in the post-2001 crisis period. Although significant progress has been achieved in implementing the core reform agenda, Turkey's financial and public sector reform program still entails significant risks, but these continue to be outweighed by the benefits o f the reforms and the risks o f not proceeding. Sustained implementation o f these reforms is necessary to overcome the risks to the program. The major, domestic along with extemal, risk factors include possible (a) policy slippages that would impact public debt sustainability, (b) external vulnerability, (c) spillover from global liquidity tightening, (d) EU decision short o f expectations and (e) banking sector problems. All o f these factors pose a risk to the macroeconomic stability through weakening market confidence. Sustainability o f the public debt, which is critical to macroeconomic stability, will hinge on continued implementation o f strong macroeconomic policies and structural reform policies. High debt rollover ratios mean that a slide in the credibility attached to the government's reform implementation program will put the economy on a high interest rate-accelerating inflation-poor growth spiral, adversely affecting the vulnerable public debt dynamics. The active support o f the Bank is instrumental in providing credibility to the Government program and, thereby, mitigating these risks. Sustained implementation o f the reform program is also necessary to maintain market confidence. The Bank's assistance strategy for financial and public sector reform incorporates significant mitigation measures; however, until the reforms are fully implemented, Turkey will remain vulnerable to a range o f exogenous shocks. Schedule o f Disbursements: US$SOO million-including a 1 percent fee to be paid to the IBRD (see footnote in page 1 o f the Loan Summary)- immediately after loan effectiveness and a second tranche o f US$500 million after fulfillment o f second tranche release conditions. Poverty Category: N/A Rate o f Return: N/A Project IDNumber: PO82996 The Team for this operation consists of Rodrigo Chaves (Program Team Leader, ECSPE and ECSPF), Ismail Arslan (Joint Team Leader, ECSPE), Fernando Montes-Negret (Sector Director, ECSPF), James Parks (Lead Economist, LCC7A), Lalit Raina (Lead Financial Sector Specialist, ECSPF), Marie-Renee Bakker (Lead Financial Sector Specialist, ECSPF), Ruth Neyens (Consultant), Robert Liu (Adviser, BFR), Gordon Johnson (Lead Counsel, LEGPS), Gurhan Ozdora (Senior Operations Officer, ECSPF), Anand Rajaram (Lead Economist, PRMPS), Sergei Shatalov (Senior Country Economist, MNSED), Mathew Verghis (Senior Economist, ECSPE), Michael Engelschalk (Senior Public Sector Specialist, PRMPS), Sanjay Vani (Senior Financial Management Specialist), Brian Levy (Lead Public Sector Specialist), Mediha Agar (Economist, ECSPE), Kamer Ozdemir (Economist, ECSPE), Shaun Moss (Lead Procurement Specialist, ECSPS), Ibrahim Sirer (Senior Procurement Specialist, ECSPE), Peter Kyle (Lead Counsel, LEGPS), James Lacey (Consultant, ECSPE), Steven Weisbrod (Consultant, ECSPF), Devrim Yurdaanik (Consultant, ECSPF), Peter Dean (Financial Accountability Consultant), and Graham Glenday (Tax Policy Consultant). Dilek Barlas (Senior Counsel, LEGEC), Rohit Mehta (Senior Finance Officer, LOAG1) and Seda Aroymak (Senior FinancialManagement Specialist, ECSPS) provided legal, disbursement and financial management support respectively. Pinar Baydar and Elif Yukseker are the assistants for the project. The Bank Team worked closely together with IMF staffresponsible for the Stand-by Arrangement for Turkey. IBRD PROGRAMDOCUMENT FOR A PROPOSED THIRD PROGRAMMATIC FINANCIAL AND PUBLIC SECTORADJUSTMENT LOAN (PFPSAL 111) TO THE REPUBLIC OFTURKEY TABLE OF CONTENTS EXECUTIVE SUMMARY ......................................................................................................................................... i I INTRODUCTION . ............................................................................................................................................. 1 A. LOAN PROGRAMSUMMARY .................................................................................................................... AND 1 B. RECENT ECONOMIC DEVELOPMENTS .............................................................................................................. 2 C. MEDIUM-TERM MACROECONOMIC FRAMEWORK ............................................................................................ 5 D. THESTRUCTURAL REFORM AGENDA.............................................................................................................. 7 E. SOCIAL AND POVERTYIMPACT ............................................................................ OF THE REFORM PROGRAM 8 I1. TURKEY'SFINANCIAL SECTOR REFORM PROGRAM ..................................................................... 13 A INTRODUCTION 13 RECENTDEVELOPMENTS BANKINGSECTOR...................................................................................... .............................................................................................................................................. B.. INTHE 13 C. STRENGTHENINGTHE REGULATORYFRAMEWORK FORBANKING ................................................................ 15 D. STRENGTHENINGTHE CAPACITY OF THE B R S A AND THE SDIF.................................................................... 18 E. STATE BANKRESTRUCTURING AND PRIVATIZATION .................................................................................... 19 F. EXECUTIONANDBANKRUPTCY............................................................................................................. ACT 20 G. RESOLUTIONOF PROBLEMBANKS AND FAILEDBANKS ................................................................................ 20 H. PROGRAM CONTINUITY AND WB SUPPORT ................................................................................................... 21 I11 . TURKEY'S PUBLIC SECTOR REFORM PROGRAM ....................................................................... 23 A. INTRODUCTION.............................................................................................................................................. 23 B. STRUCTURAL FISCALPOLICIES..................................................................................................................... 25 C. PUBLIC EXPENDITURE MANAGEMENT .......................................................................................................... 30 D. PUBLIC SECTORGOVERNANCE ..................................................................................................................... 40 E. PROGRAMCONTINUITY AND WB SUPPORT................................................................................................... 43 IV. THE BANK'SASSISTANCE STRATEGY ............................................................................................. 44 A. BANKSUPPORTFORECONOMICREF0RM...................................................................................................... 44 B. THEBANK'S FINANCIALSECTORASSISTANCE STRATEGY ............................................................................ 46 C. THEBANK'SPUBLIC SECTORASSISTANCE STRATEGY ................................................................................. 49 D. PROGRAMTRIGGERS OUTCOMEINDICATORS AND ........................................................................................ 52 V. THE PROPOSEDLOAN ............................................................................................................................... 53 A B.. PFPSAL I11OBJECTIVES DESCRIPTION AND ................................................................................................. 53 LESSONSLEARNED PFPSALAND PFPSALI1.................................................................................... FROM 54 C. BENEFITS RISKS.................................................................................................................................... AND 55 D. CONDITIONS FORBOARD PRESENTATIONAND RELEASEOF THE SECONDTRANCHE ..................................... 59 E. FINANCIALMANAGEMENT ............................................................................................................................ 62 F. PROGRAMIMPLEMENTATION AND MONITORING ........................................................................................... 62 ANNEXES: Annex IA K e y Economic Indicators Annex IB K e y Exposure Indicators Annex I1 Status of Bank Group Operations and Status of IFC Annex I11 Timetable o f K e y Processing Events Annex I V Letter of Financial Sector and Public Sector Development Policy Annex V Policy Matrix for PFPSAL I11Program Annex VI Country at a Glance Annex VI1 FundRelationsNote Annex VI11 Integrated Safeguards Data Sheet MAP BRDNo. 32947 IBRD PROGRAMDOCUMENT FOR A PROPOSEDTHIRD PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN (PFPSAL 111) TO THE REPUBLIC OF TURKEY EXECUTIVE SUMMARY 1. The proposed US$1 billion Third Programmatic Financial and Public Sector Adjustment Loan (PFPSAL 111) to the Republic o f Turkey will continue the Bank's support for the Government's multi-year financial and public sector program. This program aims to ensure continued confidence in the banking system, correct the underlying structural problems in the public sector, and ensure adequate funding o f critical social programs. The PFPSAL I11will be disbursed intwo equal tranches. It follows on the U S $ l 1billion single tranche PFPSAL and the . US$1.35 billion three tranche PFPSAL I1approved in April 2002. The first US$450 million tranche of PFPSAL I1was disbursed in August 2002. However, disbursement o f the remaining tranches was delayed by a slowdown in reform implementation during the run-up to early legislative elections in November 2002 and establishment o f the new Government. The undisbursed amounts under PFPSAL I1were cancelled inJune 2003, at the authorities' request. 2. PFPSAL I11Loan Terms. While PFPSAL I1was partially on standard terms and partially on SSAL terms, the Bank has agreed to prepare PFPSAL I11on standard IBRDterms. 3. Partial Front-end Fee Waiver. The Government has requested a partial waiver o f the front-end fee on the proposed PFPSAL I11inconsideration o f the fee already paid on PFPSAL 11. A total o f US$534 million on SSAL terms (Loan No. 4657 TU) and US$366 million on IBRD terms (Loan No. 4656 TU) remained undisbursed under the second and third tranches of PFPSAL 11. As the US$366 million undisbursed under the PFPSAL II loan on standard IBRD terms (Loan No. 4656 TU) is being folded into the new programmatic operation, US$3,660,000 o f the front-end fee o f PFPSAL I11would be waived. While some new elements have been added to the financial and public sector reform program supported by PFPSAL I11 and the phasing o f other actions has changed, the continuity o f the program provides justification for the waiver request. 4. PFPSAL I11Program. The backbone o f the structural conditionality for PFPSAL I11 consists of the outstanding conditions for PFPSAL I1second and third tranche. A number o f the PFPSAL I1conditions have already been met. The remaining outstanding conditions have been incorporated into the Board presentation and second tranche conditions for PFPSAL 111. In the key areas o f the program where there have been potential problems, new conditionality has been added. These include: (i) implementation o f the direct income support (DIS) program for farmers, (ii)maintenance o f BRSA's independence and support for its institutional development, (iii)completion o f actions to prepare Vakif Bank for privatization, and (iii) elimination o f the system o f earmarked revenues and expenditures left in place after closure o f the budgetary and extra-budgetary funds. In several other areas, PFPSAL I11goes beyond the agenda set under PFPSAL 11, for example a comprehensive new banking law will be enacted under the program and new benchmarks were set under the tax strategy and public employment program. The timing o f second tranche release will depend on the actual fulfillment o f the agreed conditions. Macro-economic outcomes under PFPSAL I11 will be monitored against key indicators on a - 11- short-term basis. These indicators have been determined on the basis o f the macro-framework agreed with the IMF. 5. Linkto the CAS. PFPSALI11is inthe highcase lending scenario o fthe CAS discussed by the Executive Directors on November 6, 2003 (Report No. 26756 TU). There has been sufficient progress made inthe areas where the high case triggers apply within the current CAS (Table 12). 6. IMFProgram. The IMF's Boardo fDirectors approved inFebruary2002 a new Stand-by Arrangement for Turkey covering the 2002-04 period, bringing total IMF commitments for the program to over US$30 billion since December 1999. The Stand-by i s being implemented in close cooperation with,the Bank. The seventh IMF program review was completed in April 2004. The prior actions, performance criteria and structural benchmarks for the seventh review are fully consistent with the proposedPFPSAL 111. 7. Risks. Turkey has embarked on an impressive financial and public sector reform agenda inthe post-2001 crisis period. Although significant progress has been achieved inimplementing the core reform agenda, Turkey's financial and public sector reform program still entails significant risks, but these continue to be outweighed by the benefits o f the reforms and the risks o f not proceeding. Sustained implementation o f these reforms is necessary to overcome the risks to the program. The major, domestic along with external, risk factors include possible (a) policy slippages that would impact public debt sustainability, (b) external vulnerability, (c) spillover from global liquidity tightening, (d) EUdecision short o f expectations and the (e) banking sector problems. All o f these factors pose a risk to the macroeconomic stability through weakening market confidence. Sustainability o f the public debt, which is critical to macroeconomic stability, will hinge on continued implementation o f strong macroeconomic policies and structural reform policies. High debt rollover ratios mean that a slide in the credibility attached to the government's reform implementation program will put the economy on a high interest rate-accelerating inflation-poor growth spiral, adversely affecting the vulnerable public debt dynamics. The active support o f the Bank is instrumental in providing credibility to the Government program and, thereby, mitigating these risks. Sustained implementation o f the reform program is also necessary to maintain market confidence. The Bank's assistance strategy for financial and public sector reform incorporates significant mitigation measures; however, untilthe reforms are fully implemented, Turkey will remain vulnerable to a range o f exogenous shocks. I. INTRODUCTION A. Loan and ProgramSummary 8. This program document proposes a Third Programmatic Financial and Public Sector Adjustment Loan (PFPSAL 111) to the Republic o f Turkey for US$1 billion to continue the Bank's support for the Government's multi-year financial and public sector program. The program of structural reforms is aimed at preserving the current stability achieved after the 2001 crisis, promoting economic growth, and ensuring that social programs are adequately funded and increasingly better targeted. 9. The proposed loan (US$1 billion) will be in U S Dollar Single Currency on standard IBRDterms. The loanwill be disbursed intwo tranches. The first US$500 milliontranche will be disbursed immediately upon effectiveness and the second tranche o f US$500 million upon fulfillment of the second tranche release conditions and as long as overall progress with the program is also satisfactory. 10. The proposed PFPSAL I11is the third in a series o f programmatic loans since 2001 in support o f the Government's comprehensive reform o f the financial and public sectors. Under the PFPSAL program, the World Bank (WB) intends to disburse a total o f US$2.55 billion in adjustment lending to meet Turkey's external and budgetary financing requirements to support the Government's short and medium-term reform goals inthe financial and public sectors, and to help protect critical social spending. The PFPSAL I11follows on the first PFPSAL o f US$1.1 billion approved in July 2001 (US$700 million on standard IBRD terms and US$400 million on Special Structural Adjustment Loan-SSAI-terms) and disbursed in a single tranche in July 2001. The three-tranche Second Programmatic Financial and Public Sector Adjustment Loan (PFPSAL 11) o f US$1.35 billion (US$550 million on standard IBRD terms and US$800 million on SSAL terms) was approved in April 2002. The first US$450 million tranche o f PFPSAL I1 was disbursed upon effectiveness in August 2002. However, disbursement o f the remaining tranches o f PFPSAL I1was delayed by a slowdown in implementation of the economic reform program during the run-up to early legislative elections held in November 2002 and establishment of the new Government. Further delays resulted from external developments in the region, notably in Iraq. The undisbursed amounts under PFPSAL I1were cancelled in June 2003 at the authorities' request. 11. Bank support for sustained implementation o f reform inthe financial andpublic sectors is continuing under the high-case scenario described in the CAS (Country Assistance Strategy) for FY 04-06 discussed by the Board on November 6, 2003. The PFPSAL I11operation is included in the US$4.5 billion high-case scenario o f the new CAS for FY 04-06. Bank support for sustained implementation o f reform in the financial and public sectors is planned to continue under the high-case scenario through three follow-up operations: two programmatic public sector adjustment loans (PPSAL and PPSAL 11) and a programmatic financial sector adjustment loan (PFSAL). - 2 - B. RecentEconomicDevelopments 12. The Turkish economy continues to grow at a fast pace. Economic growth reached 5.9 percent in 2003 following 7.9 percent growth in 2002. The major contributing factor to the favourable growth outcome in 2003, because o f its weight in the national accounts, was private consumption growth. However, showing much faster rates o f growth was private sector capital formation. This augurs well for sustaining growth with capacity utilization levels reaching historic highs. Exports continued to play an important role in the recovery. The current account deficit widened to almost 3 percent o f GNP, but was easily financed by short-term capital inflows, public sector borrowing abroad and reverse currency substitution. Inflation fell to 18.4 percent in 2003, and the latest data suggest that inflation is falling towards the important single digit level for the first time since the 1970s. Table 1:Key EconomicIndicators Actual 21 Est. Prog.31 2000 2001 2002 2003 2004 MAINMACRO INDICATORS GNP Growth 6.3 -9.5 7.9 5.9 5.0 CPI Inflation (Dec-Dec) 39.0 68.5 29.7 18.4 12.0 Nominal Interest Rate 38.0 99.1 63.5 44.1 29.0 Real ex-ante Interest Rate 4/ -9.2 35.0 30.3 28.6 11.2 UnemploymentRate 6.6 8.4 10.3 10.5 UnitWage Index (1997400) 103.1 71.1 73.O PUBLIC SECTOR Primary Balance (% GNP) 2.7 5.5 4.1 6.1 6.5 Overall Deficit ("A GNP) 18.9 21.1 12.1 9.9 6.4 Net Public Debt (% GNP) 1/ 58.3 93.9 78.8 70.1 65.7 o f which net extemal debt (% GNP) 19.0 37.7 32.1 22.2 20.9 Privatization($ bn) 3.3 2.8 0.5 0.3 3.0 EXTERNALBALANCE Current account balance (% GNP) -4.9 2.4 -0.8 -2.9 -3.0 Exports (fob, $ bn) 5/ 30.7 34.4 39.8 50.8 60.4 Tourism ($ bn) 7.6 8.1 8.5 9.7 10.8 Extemal Debt (% GNP) 59.0 79.0 72.3 61.3 48.4 CBT ForeignExchange Reserves ($ bn) 23.2 19.8 28.1 35.2 32.4 Memo GNP (TL quadrillion) 125.6 176.5 275.0 356.7 415.7 1/ Includes the government securities issuedto recapitalize the SDIF and state banks. 2/ Government figures as adjusted by IMF and WB estimates. 2002 and 2003 GNP figures are as announced by SIS inApril 2004. 3/ Updated as of the 7th IMFreview. 4/ Average ofmonthly nominal interest rate dividedby 12-month ahead CPI inflation. 5/ Includes shuttle trade. Source: Government. IMF and WB estimates. 13. Employment declined in 2003 following public and private sector restructurings, which together with three years o f decline in real wages, helped preserve competitiveness in spite o f strong currency appreciation. Aggregate unemployment remained stable at around 10percent but this was helped by a temporary shrinkage in the labor force. Inurban areas unemployment rate approached 15 percent and unemployment o f educated youth rose above 30 percent at the end o f 2003. With a trend increase in the labor force at least 1.8 percent per year, further reforms are needed to strengthenjob-creation. 14. Strong fiscal performance has been the cornerstone o f the economic program. Fiscal gains were significant in 2003, and the primary surplus rose from 4 percent o f GNP in 2002 to over 6 percent o f GNP in 2003, close to the programmed 6.5 percent target. Nevertheless, the overall fiscal deficit remained considerable at 9.9 percent o f GNP. Although the 2004 budget passed inDecember was consistent with the 6.5 percent primary surplus target, a sizeable fiscal gap quickly emerged. The government announced above inflation increases in minimum wages and it also cut contribution rates for social security to reduce the additional costs to employers. In addition, the government increased pensions by 21percent, well above the inflation target. These initiatives, together with revenue shortfalls relative to the Budget, created a financing gap o f close to 1.7 percent o f GNP. The Government introduced a fiscal package inMarch to close the fiscal gap. This package has two main components: a supplementary budget and revenue measures. The supplementary budget passed in March cuts discretionary expenditures by 13 percent across all ministries. The government also introduced measures to increase tax revenues by adjusting excises o fpetroleum, alcohol, tobacco, and natural gas. While the Government has demonstrated a willingness to undertake action to meet the fiscal target, good public expenditure management and delivery o f services to citizens will require less reliance on ad hoc, short-term measures and a focus on sustainable fiscal adjustment. 15. Monetary policy followed a policy o f implicit inflation targeting, with the Central Bank (CBT) occasionally intervening in the foreign exchange market to dampen what was deemed to be excessive fluctuation in the exchange rate. The decline in inflation, which was aided by the strength o f the TL, led to a commensurate decline ininterest rates from a nominal 60 percent in the first quarter o f 2003, to about 25 percent early in2004. 16. On the external front, despite appreciation o f the Turkish Lira, rising productivity and declining labour costs helped to sustain extemal competitiveness and export growth. Exports grew sharply in 2003. Textile and vehicle exports were best performing sectors. One encouraging sign is the growing importance o f new export markets. Iraq has already become a large export market for Turkey, and there was strong growth in exports to China, Russia and Central and Eastern European countries. Imports also grew rapidly, with oil, increasedimports o f machinery and equipment, and rising demand for imported consumption goods being major contributors. Intermediate and capital goods accounted for 86 percent o f the increase in imports between 2002 and 2003. Consumption goods also rose sharply in the second half o f 2003 and continued in early 2004. Much o f the increase in consumption goods imports is driven by automobile imports which benefited from a temporary tax credit on automobile purchases introduced in August 2003. Tourism receipts were maintained in 2003 despite the Istanbul bombings and uncertainty from the Iraq war. The current account deficit increased to 3 percent o f GNP in 2003. Continued market confidence has spurred an improvement in capital inflows, - 4 - although green field investment has remained low. These inflows easily financed the current account deficit and allowed the sharp increase in intemational foreign exchange reserves to US$33 billion, equivalent to 5 months o f goods and services imports. Table 2: Exports and Imports 1999 2000 2001 2002 2003 2004 (Jan-Feb (US$million) Cxports 26,587 27,775 31,334 36,059 47,068 7,966 Agriculture 2,394 1,973 2,234 2,038 2,465 412 Fishing 38 25 30 51 80 11 MiningandQuarrying 385 400 349 387 543 71 Manufacturing 23,755 25,339 28,695 33,549 43,858 7,43 1 Other 15 38 26 34 122 41 mports 40,671 54,503 41,399 51,554 68,808 11,843 Capitalgoods 8,729 11,341 6,964 8,492 11,237 1,720 Intermediategoods 26,553 35,710 29,971 37,443 49,587 8,548 Consumptiongoods 5,062 7,220 4,084 5,008 7,5 19 1,523 o/w motor cars 1,325 2,596 588 814 2,217 423 Others 327 231 380 610 466 52 Shares Sxports 100 100 100 100 100 100 Agriculture 9.0 7.1 7.1 5.7 5.2 5.2 Fishing 0.1 0.1 0.1 0.1 0.2 0.1 MiningandQuarrying 1.4 1.4 1.1 1.1 1.2 0.9 Manufacturing 89.3 91.2 91.6 93.0 93.2 93.3 Other 0.1 0.1 0.1 0.1 0.3 0.5 mports 100 100 100 100 100 100 Capitalgoods 21.5 20.8 16.8 16.5 16.3 14.5 Intermediategoods 65.3 65.5 72.4 72.6 72.1 72.2 Consumptiongoods 12.4 13.2 9.9 9.7 10.9 12.9 o/wmotor cars 3.3 4.8 1.4 1.6 3.2 3.6 Others 0.8 0.4 0.9 1.2 0.7 0.4 17. The combination o f strong real and financial market performance had a favourable impact on the public debt burden. The net public debt to GNP ratio has fallen sharply in2002-03 from its end-2001 peak o f 93.9 percent o f GNP. Helped by declining real interest rates, strong fiscal performance, the recovery o f economic growth, and above all, by the continued appreciation o f the real exchange rate, Turkey's net public sector debt is estimated to have fallen to about 70 percent o f GNP at end-2003. The decline would have been larger without the issuance o f new debt (of TL 6.8 quadrillion) for the takeover o f failing Imar Bank in July 2003. With capital flows increasing and growing appetite for Turkish government paper, Treasury had no problem servicing the debt. Nevertheless, the highrollover rate, 88 percent in2003, indicates the continued dependence on market sentiment and thus vulnerability to extemal developments. 18. The recent deterioration in global financial indicators in early M a y 2004 combined with the higher than expected current account deficit figures have led to a sharp weakening in - 5 - domestic financial indicators. While the Turkish Lira (TL) depreciated about 14 percent takingit to a level it was inlate 2002, the stock market plunged by 18 percent albeit from an all time high level and the benchmark Treasury bond rate reached a high o f 30 percent by mid-May from 22 percent levels in early April. Turkey's Eurobond spreads widened by over 200 basis points to 525 basis points during the same period. The excess volatility in FX market was curbed in some degree by the Central Bank's intervention. It appears that some relative stability has been achieved in domestic financial markets. These recent developments have underlined Turkey's exposure to shocks from the extemal environment. While the depreciation o f the TL is an adjusting factor to the deteriorating current account balance, it is also likely to affect inflationary expectations and domestic interest rates. Higher domestic interest rates, in tum, would influence together with the impact of the TL's depreciation, the overall fiscal deficit and economic activity. Spill over from global liquidity tightening and rising spreads are likely to increase the cost o f extemal borrowing. Such developments, if persistent, could disrupt the virtuous cycle that the economy has experienced over the last year and a half. C. Medium-term Macroeconomic Framework' 19. Sustaining the momentum o f the ongoing recovery and the confidence o f markets continue to be the challenges facing policy makers. Under stable domestic and intemational conditions, Turkey would repeat, even improve on last year's macroeconomic performance in 2004. Inflation is running below projections. Carry over from last year's strong increase in industrial output and a normal harvest in agriculture sector this year should deliver the growth target. On the demand side, confidence indicators are strengthening and lower interest rates are providing stimulus to private investment and consumption. Despite strong domestic demand, the inflation target o f 12 percent remains within reach. As Turkey sustains and deepens reform beyond 2004, it will build on the recovery inboth private consumption and investment to sustain economic growth at a projected 5 percent o f GDP annually (Table 3). 20. The interest rate path will be critical to the success o f the program. Interest rates affect the growth prospects, increase the debt burden and also make fiscal adjustment more difficult and hence less credible. The authorities are deploying fiscal and monetary policies aimed at bringing interest rates down. The disinflation process that supports real interest reduction has continued through the first quarter o f 2004. Further declines will have to be underpinned by growing market credibility. As confidence consolidates and government crowding out is reduced, real interest rates are projected to decline in2004-06 period. The favorable effect on the macroeconomic outlook will work through several channels. First, it would directly stimulate consumption and investment. Second, it would improve the debt sustainability picture, thereby facilitating fiscal adjustment while increasing the credibility o f the reform program. Third, as confidence in the policy framework grows, risk margins would decrease and foreign and domestic investment would rise. * The projections presentedinthis section are made by the World Bank and are based on policy assumptions that are yet to be confimedby the authorities. - 6 - 21. The Government has reiterated its determination to adhere to the primary surplus target o f 6.5 percent o f GNP in 2004. A set o f fiscal measures including an across-the-board cut in discretionary expenditure was introduced inearly 2004 to close the fiscal gap and to ensure fiscal sustainability (see para. 14). This across-the-board cut has a negative impact on the public investment program. The sizeable cut in govemment investment in 2004 follows a decline in public investment in 2003 and i s not conducive to sustainable growth. In addition to a focus on reaching the primary surplus target the quality o f fiscal adjustment is also important. A centerpiece o f the reform program will be continued fiscal consolidation accompanied by better targeting o f Government spending towards investment and targeted social protection and away from the wage bill, subsidies and untargeted social interventions (see section I11 for further discussion o ffiscal reforms). 22. There has been progress in reducing the net public debt to GNP ratio in 2002 and 2003. The ratio is projected to fall to 66 percent at the end of 2004. The projections for the key macroeconomic parameters, including growth, interest rates, exchange rates and the primary surplus, imply a further steady decline in the public debt to GNP ratio, falling below 60 percent in2006. 23. The extemal position will strengthen markedly with the overall balance improving from virtual equilibrium in 2004 to a surplus o f US$4.6 billion in 2006, notwithstanding the end of IMF financial support and Turkey making significant IMF repurchases, rising from US$1.7 billion in2003 to US$11.6 billionin2006. The current account deficit will decline from US$9.1 billion in 2004 to 7.5 billion in 2005 and 2006 while the capital account will improve from net inflows o f US$9.2 billion in 2004 to US$12.1 billion in 2006. As the real exchange rate i s projected to depreciate gradually and foreign demand to recover, exports are projected to surge from US$60.4 billion in 2004 to US$73.1 billion in 2006. Strong consumption and investment recovery shouId boost imports by a similar amount from US$77.2 billionto US$90.4 billion over the same period. FDIis conservatively projected to increase from an average o f US$0.9 billion over 2002 to 2004 to US$2.2 billionin2006. 24. Medium-termprojections suggest that sustained implementation o f economic reform is necessary for Turkey to attain macroeconomic stability and growth. Under these projections, the economy i s expected to grow about 5 percent annually in the 2005-06 period. Specific factors underlying stability and sustained growth include: (a) greater confidence in the policy framework, (b) improved macroeconomic stability and declining real interest rates-which would stimulate private investment and consumption demand, (c) stronger exports performance-which would permit faster import and output growth, and (d) higher extemal inflows, including larger FDI. Under this scenario, fiscal adjustment would yield a permanent reduction inthe public sector borrowing requirement from about 10percent o f GNP in2003 to 5 percent o f GNP in 2006. This will underpin the projected stabilization o f the net public debt stock to GNP ratio below 60 percent o f GNP by 2006. The programmed fiscal adjustment would also support the projected decline ininflation to single digitsby 2005. - 7 - Table 3: Selected Medium-term Macroeconomic Indicators 2001 2002 2003 2004 2005 2006 GDP Growth -7.5 7.9 5.8 5.0 5.O 5.c Investment (% of GDP) 18.2 16.6 18.8 19.4 20.0 20.2 Public 5.6 5.3 2.9 2.7 2.7 2.6 Private 12.6 11.3 15.9 16.6 17.3 17.6 CPI Idlation 68.5 29.7 18.4 12.0 8.0 5.c Current Account (billion $) 3.4 -1.5 -6.8 -9.1 -7.6 -7.5 Exports (f.0.b.) 34.4 39.8 50.8 60.4 66.6 73.1 Imports(f.0.b.) -38.9 -48.1 -64.8 -77.2 -82.8 -90.4 CapitalAccount (billion$) -14.6 1.4 5.7 9.2 10.0 12.1 FDI 2.8 0.9 0.1 1.6 1.8 2.2 OverallBalance (billion S) -12.9 -0.2 4.1 0.1 2.4 4.6 Source: Government,IMF andWB estimates. D. The StructuralReformAgenda 25. The Government's program emphasizes the critical role o f structural reforms. Policy continuity i s essential to maintain the stability achieved after the 2001 crisis and to preserve the growth and macroeconomic performance o f the last three years. The first reform priority is to accelerate banking reform-to consolidate the renewed trust in the sector and to preclude the possibility o f a systemic crisis. The program emphasis has now moved from crisis management to broad base financial sector development. The second priority area i s the comprehensive reform o f the public sector to address the underlying structural causes o f Turkey's macroeconomic instability, ensure medium-term fiscal sustainability, and increase the transparency and efficiency o f public expenditure management. The third priority area i s continuation o f vital reforms in the agriculture, energy and telecommunications sectors to improve the climate for private investment inan effort to raise productivity, growth and incomes. Many o fthe latter reforms also have a structural fiscal dimension. 26. Turkey needs comprehensive financial and public sector reforms to break definitively with its history o f inadequate transparency, public deficits, inflation and financial instability. A quick retrospective highlights the structural weaknesses in both the public and financial sectors which contributed to macroeconomic instability and created the pre-conditions for the 2001 crisis. Chronic public sector deficits led to the buildup o f debt and rapid expansion o f the banking sector, which greatly outpaced the capacity o f the regulatory framework. Macroeconomic distortions arising from fiscal imbalance created incentives for the banksto take on excessive risk which was not curtailed by adequate regulation and enforcement. The absence o f ample, accurate and timely fiscal information-particularly the reliance on off-budget funds and quasi-fiscal obligations including the so-called "duty losses" o f the state banks- reinforced political and institutional obstacles to structural change and sustainable fiscal adjustment. Unhealthy interactions between inadequate fiscal and financial transparency compounded the risks to the economy and helped ensure the buildup o f a major systemic crisis following earlier cycles o f crisis and aborted stabilization efforts throughout the 1990s. After undertaking urgent financial restructuring to address the impact o f the November 2000 and February 2001 crises on the banks, the authorities are making progress in correcting the underlyingweaknesses in the financial sector. In parallel, institutional and policy reforms are - 8 - being deepened to address systemic problems inthe public sector, together with further structural measures to gradually underpin the fiscal adjustment. These reforms complement on-going actions to improve the climate for private investment and promote growth. Rebuildinginvestor confidence and sustaining economic growth depend critically on the Government's ability to maintain the momentum o f reforms to address the structural roots o f Turkey's chronic financial instability. E. Social and Poverty Impact of the Reform Program 27. The recovery has yet to translate into welfare gains for the average citizen. The Bank prepared an interim Poverty Update in 2002 based on a household survey during the summer o f 2001 which confirmed an increased risk o f poverty and vulnerability following the 2001 financial crisis. The survey questionnaire on consumption and income was applied to 4,200 households. There were 120 in depth case studies o f survey respondents. The Study (Report No. 24185-TU) built on the analysis o f the Poverty Assessment completed in 2000 (Turkey: Economic Reforms, Living Standards and Social Welfare Study - Report No. 20029-TU) and compared the results with the last nationwide household survey in 1994, taking due account o f the problems comparing data taken from two very different surveys. The major effect has been an increase in poverty in the urban areas o f Turkey. Extreme poverty in all o f Turkey has not changed, and remains at low levels, but inequality remains unchanged at quite high levels. A relatively large share (nearly one-fifth) o f the urban population had consumption below nutrition standards, and qualitative evidence indicates that poverty has worsened in rural areas as well. The poor include: (i) families with children, particularly families with many children, (ii) single elderly females living alone, (iii) widoweddivorced mothers with children (small group), (iv) families with children in disadvantaged regions: Southem and Eastern Anatolia reflect high levels o f poverty incidence and severity, and (v) families with children in gecekondu housing. The poor have been particularly impacted by a reduction in seasonal and informal employment opportunities inthe urbanized areas, and some men are returning to their rural villages because they cannot earn enough inthe cities to cover their subsistence. The primary coping strategy o f the poor has beento reduce consumption, particularly the quantity and quality o f food consumed, but there are also indications that the poor may have to cut back on education expenses and withdraw children from school. The poor rely strongly on networks o f extended family, friends, neighbors, and hemgeri (people o f same place o f origin), but these networks are strained by the macroeconomic shocks experienced in 1999 (recession and earthquake) and 2001 (economic crisis). 28. A new nationwide representative household survey was completed in2002 and the data are being used by the State Institute o f Statistics (SIS) and WB to prepare a Joint Poverty Assessment Report (JPAR), expected to be completed in December 2004. Using a revised methodology, the JPAR determined that less than one percent o f the Turkish population was extremely poor in 2002 (with consumption below a 2,100 calorie per person average food basket), but many more are poor (below a poverty line including both food and necessary non- food spending); some 27 percent o f the population. The difference between the very low extreme poverty rate and the relatively highoverall poverty rate reflect two factors inTurkey: (i) social solidarity; and (ii)the high levels o f inequality. Social solidarity mechanisms were described in the Poverty Update (World Bank 2002) whereby households help each other to - 9 - ensure that the poorest families have enough food, but this inter-household assistance i s not enough to lift families out o f poverty. Overall poverty is relatively high for a middle-income country, reflectingthe highlevel o f inequality inconsumption and income inTurkey. 29. Comparisons over time require caution since the sources o f data and the methodologyhas changed. Using a consistent methodology and poverty line suggests that poverty has declined only slightly since 1987, reflecting the impact o f financial crises in 1994 and 2001 and the 1999 earthquake, and the persistent inequality which has kept Turkey from "growing" its way out o f poverty. I t does appear that urban poverty lessened between 2001 and 2002 as the economy recovered from the 2001 crisis, but the 2001 data are not fully comparable to the 2002 data. 30. The PFPSAL program will produce important social benefits interms o f restored growth, job creation and reduced economic vulnerability. Nonetheless, structural reforms entail short- term social costs which the Government i s working to mitigate. Employment reduction in the public sector is aparticularly sensitive area. A key element o f the public employment program is to address the over-employment in the state economic enterprises. At end 2001/early 2002, approximately 15,000 workers were retired, notified o f their retirement, laid off or converted to private contract status. Inaddition most o f the unfilledpositions in State Economic Enterprises (SEEs) were eliminated. An assessment of SEE redundancies was conducted. It indicated that there were about 46,000 redundant positions in the SEE system as o f January 2002. A majority of these redundancies were eliminated as o f mid-March 2004 and many o f the SEEswere infact able to reduce the number o f their workers by more than the figure determined through the redundancy assessment carried out in 2002. The overall attrition from SEEs between February 2002 and mid-March 2004 reached over 59,000. These workers are eligible for pensions and other social insurance benefits. In addition to these standard benefits, workers laid off from SEEs inthe portfolio o fthe Privatization Administration (PA) benefit from special compensation under the privatization law. All formal sector workers can benefit from the new unemployment insurance system launched in mid-2000, once they meet the minimum contribution history requirement o f 18 months. 31. The Government has acknowledged some problems with targeted social spending outcomes in2002 and 2003 and it is determined to address these problems inthe 2004 budget in order to ensure strengthened social protection for all o f Turkey's citizens, inparticular poor and vulnerable groups. Benchmarks for public spending on health, education and social protection, as shares o f GNP were agreed with the Bank under the first PFPSAL (Table 4). These benchmarks have been set at a level above the averages for the 1998-2000 period, reflecting the policy decision to ensure adequate expenditure on social priorities. The estimated outcome for total social spending as a share o f GNP is in the range o f 18.2 percent o f GNP,well above the PFPSAL benchmark o f 14.5 percent, in large part due to the unplanned increase in social security expenditure. Under the 2004 revisedbudget, the overall social spending as a percent o f GNP is expected to be even higher than in2003, at about 19.3 percent. However, the education spendingis likely to fall slightlybelow the PFPSALbenchmark o f4.25 percent, due to the fiscal measures requiringexpenditure cuts to attain the end-year primary surplus target. - 10- Table 4: SocialExpenditures PFPSAL I I prog TL trillion 2000 Benchmark I200431 EducationExpenditures 5018 17,07: o/w education expenditures by SSF 69 22E 50 Health Expenditures 4,359 17,316 23,171 olw health expenditures by SSIs 2,514 7,246 10,025 13,63( o/w health expenditures by SSF 43 252 57: SocialProtection 8,245 21,800 32,218 38,83( a. Social Security Institutions(non-health) 7,981 20,118 29,804 35,78! b. Social Solidarity Fund(non health and e-ication) 258 163 451 c. Direct Income Support 1,469 2,252 2,591 Total Social Expenditures(PFPSAL) 17,622 47,226 64,448 79,07! Other social programs 21 67 385 48t Grand Total 17,689 47,468 -64,833 79,561 PFPSAL I I Yo of GNP 2000 Benchmai 2001 2002 2003 est. 2004 prog EducationExpenditures 4.00 4.25 4.27 4.50 4.11 olw education expenditures by SSF 0.06 0.11 0.09 0.12 HealthExpenditures 3.47 3.25 4.31 4.80 4.86 5.66 o/w health expenditures by SSIs 2.00 2.25 2.65 2.81 3.32 olw health expenditures by SSF 0.03 0.06 0.06 0.07 0.14 Social Protection 6.56 7.00 7.73 7.97 9.03 9.45 a. Social Security Institutions(non-health) 6.36 7.35 7.36 8.36 8.70 b. Social Solidarity Fund(non health and education) 0.21 0.10 0.08 0.05 0.11 c. Direct Income Support 0.00 0.28 0.54 0.63 0.63 TotalSocialExpenditures(PFPSAL) 14.03 16.31 17.27 18.04 19.22 Other social programs 21 0.05 0.06 0.09 0.11 0.12 Grand Total I 14.08 16.37 17.36 18.15 19.34 1/ Supplementarybudget allocations for 2001. 2/ Includes spending by General Directorate of Social Services and Child Protection, Institution for DisabledPersons and Unemployment Insurance Fund 31 Revised budget figures. Source: MOF, MONE, MOH, SPO and WB. 32. Expenditure o n targeted social assistance in GNP terms is budgeted to increase in 2004. The Government intends to increase the spending for the SSF to over 0.3 percent o f GNP (0.37 percent o f GNP or TL 1.527 quadrillion) inclusive o f the transfer from the budget carried over from 2003. The D I S payments increased to 0.64 percent of GNP (TL 2.25 quadrillion) in2003. In2004budget, an allocation ofTL 2.6 quadrillion will cover the remaining 2003 DIS liabilities and the second installment o f D I S compensation payments for diesel h e l . The Government is targeting to disburse at least TL 275 trillion this year under the 2004 D I S program and will make efforts to increase disbursement at least to TL 400 trillion. Additional resources will be transferred to the D I S program by the Ministry o f Finance and Treasury to achieve this target. The authorities finalized the agricultural policy paper which includes adequate provisions for D I S as well as other agriculture support instruments. This policy paper will form the basis for the new agricultural framework law which will be enacted before the end of 2004. 33. The Bank and the Government reached agreement on the content of the Agriculture Framework Law. This was achieved following substantial discussions o f the agricultural policy - 11- paper by the Ministry o f Agriculture and Rural Affairs (MARA),SPO, and Treasury. Key issues include: 0 H o w DIS will be phased down - beginning in 2006, DIS will not be granted to high value crop areas (under greenhouses, fruits and other perennial crops, and vegetables) and to farmers who participate in the agricultural conservation program (known as CATAK). Combined, these exclusions are expected to cover about 20 percent o f the cultivated area. The DIS payment rate will be held constant at 160 million TL/ ha (the current level). With projected registered area inthe National Registry of Farmers rising from the current level o f 17.0 million ha to a maximum o f about 18.5 million ha (a final maximum 85 percent registration rate for all cultivated area), DIS payments would be made on roughly 14.5 million ha and total 2.3 quadrillion TL annually in2006-2010. Depending on the growth o f GDP and whether the agricultural transfer budget reaches its targeted level o f 1.0 percent o f GDP (currently the level is at 0.85 percent o f GDP), the DIS share inagricultural transfers would range between 44 percent and 52 percent. So it was agreed by the Bank and the Government representatives that a 45 percent share o f DIS in agricultural transfers is a prudent and reasonable target. 0 Justification for an increased share for premium payments - given structural problems in the maize sector related to fanners' inability to dry and store maize (grown currently on 500,000 hectares), the Bank and the government representatives agreed that rural development grants targeted at this problem during the 2006-2010 period will be the most effective policy in improving the efficiency o f the maize market and reducing the very sharp price reductions for maize at harvest time. However, since improvements to the maize market is expected to take some years, a maize deficiency payment would be introduced to boost the incomes o f producers o f maize. It was also agreed that irrigation water metering and increased water tariffs could boost maize production in South Eastern Anatolia (where maize competes with cotton), and that in the Western Black Sea area, current hazelnut policy and the alternative crops program could achieve substantial shifts out o f hazelnut into maize production. These medium term measures are expected to be the greatest contributing factors to the expansion o f maize area. With the addition o f a deficiency payment for maize, the expected share o f deficiency payments in the agricultural transfer budget would rise to 12-14percent. 0 Why and how livestock support is supposed to increase. Animal husbandry (particularly cattle and sheep raising) has been a declining sector, particularly in the eastern half o f the country. A number o f problems persist such as low quality but expensive breeding stock, small herds, poor feed, difficult commercialization of live animals, and poorly arranged logistics for transportation o f slaughtered carcasses and butchered meat to the main demand centers within the country. Thus, the Government is focused on increasing support to the livestock sector - 12- through existing measures and introducing a number o f new measures to address these problems. Some are price-based, while others take the form o f increased investment subsidies. These measures were explained convincingly to the Bank by the Government and are expected to reach a share o f 11-14 percent of agricultural transfers over 2006-2010. Thus, a target share for the instrument "Livestock Support" o f 12 percent o f agricultural transfers was agreed by the Bank, noting that additional funds for promoting investment in the livestock sector are available under the "Rural Development Grants" instrument. This would assure that enough investment support would be available to the livestock sector to reach the goals set out inthe Agricultural PolicyPaper. 34. The Agriculture Framework Law also covering the DIS i s expected to be enacted by December 2004. One o f the objectives o f the Law i s to institutionalize the DIS program and fix the key principles (non-distortionary, per-hectare payment) and milestones (issuance o f annual decree, farmer registrationperiod, payment period, etc.) for the annual program cycle. Equally important, the Law will signal to farmers the Government's intention to maintain the DIS and other tools to be available for the period 2006-2010 as the key farmer support mechanisms. An important goal i s to prevent hrther slippage in funding which would hurt the safety net for farmers andpotentiallyundermine support for the agriculture reform program. 35. Additional institutional and structural reforms to address the chronic overruns in the social security system are slated to be prepared in 2004. Correcting fiscal imbalances will be part o f a broader reform o f the social protection system that includes pensions, health insurance, social assistance, unemployment insurance and labor markets. The institutional reforms are expected to include merging the three existing pension institutions into one organization and transfer the health insurance and social assistance programs to separate institutions. The objectives o f the structural reforms will be: (i)ensuring the medium-termsolvency o f the social security system while extending the formal social protection system so that it eventually covers the entire population and (ii) improving the functioning o f the labor market to encourage formal job creation. In2004, the authorities planto submit draft laws to Parliament to reform the social protection system in a manner consistent with these objectives. The Bank will support these reforms through the proposed PPSAL Iinthe CAS. 36. The measures taken and planned by the Government would be sufficient to address past slippages and would provide adequate social spendingin2004. However, satisfactory outcomes will depend on sustained political will to implement the commitments made, including the Agriculture Framework Law. Actual social spending in 2004 will be monitored during the supervision o f PFPSAL 111. The Government has stated its willingness to take further measures should actual social spending fall short of the budgeted targets during the course o f 2004. Significant deviations from the program benchmarks will be discussed and appropriate corrective actions will be taken as neededprior to release o f the second tranche o f the Loan. Furthermore, the reforms being considered under the PPSAL are critical for consolidating Turkey's ongoing fiscal adjustment in a sustainable manner, while also improving the coverage and quality o f Turkey's social protection system. - 13- 11. TURKEY'S FINANCIAL SECTORREFORMPROGRAM A. Introduction 37. In the aftermath of the November 2000 and February 2001 banking crises, the Government is committed to accelerating and widening the scope o f its financial sector reform efforts to consolidate confidence inthe banking system andplace it on a sustainable path towards competitiveness at the international level and EU accession. The experience in other crisis countries has shown that banking crises resolution takes time. Accordingly, the Government structured its financial sector reform program in two phases, with the first focussing primarily on implementation of urgent banking system reform and restructuring efforts, and the second phase on the medium term broad based financial sector development agenda. The first phase was virtually completed with World Bank support under PFPSAL and PFPSAL 11. Implementation o f the second phase has now began with support o f PFPSAL 111. 38. The current phase o f the program will (i) Turkey's legal and regulatory fiamework bring for banking up to Basel/EU and intemational best practice standards and ensure effective enforcement o f all regulations, (ii)restructure the state banks inorder to privatize them, and (iii) improve creditor rights and the regime for corporate insolvency. The program will include reforming non-bank financial intermediaries and capital markets at a later stage. B. RecentDevelopmentsin the Banking Sector 39. The Turkish banking sector consists o f 51 banks (Table 5). Of these, 37 are deposit taking banks and the remaining 14 are investment and development banks which do not take deposits. Of the deposit taking banks, three belong to the state, two (formerly privately owned) are under the SDIF, 18 are privately Turkish-owned and 14 are foreign owned. 40. The country's banks co-exist with approximately 68 insurance companies, 130 securities trading companies, 306 investment funds, and 210 factoring and leasing companies (several deposit taking and investment and development banks also hold leasing licenses). There are also several hitherto unregulated private pension schemes, including schemes run by the banks and insurance companies for their own staff. The majority of financial institutions are part o f financial conglomerates which inmost cases have a main commercial bank and other subsidiary NBFIs. 41. Even though the NBFI sector is growing, its size and economic significance are still rather small in comparison to the banking sector which accounts for over 85 percent o f the financial system assets. Consequently, the government's policy program still focuses on the banking system. - 14- Deposit Taking Non-Deposit Taking 4 Largest Private September2003 State Private Turkish SDIF Foreign State Investment Percent, unlessotherwisenoted Total Banks Banks Banks Banks Banks Banks Banks Structural Indicators Number ofbanks (in numbers) 51 3 4 18 2 14 3 11 Share o fassets 100 33.8 41.2 15.6 3.1 3.0 3.2 0.1 Shareof deposits 100 37.7 41.4 15.6 3.2 2.1 0.0 0.0 Shareofnet loans 100 17.3 46.3 22.3 1.7 4.0 8.4 0.1 Loanddeposits 43.4 19.3 48.9 63.8 24.9 86.9 Total Gov. debt securitiedassets 31.1 52.2 21.2 22.2 24.7 14.1 3.3 6.9 Source: Banks Association of Turkey. 42. The banking industry is comparatively concentrated and the state banks represent an important share of the sector (Table 5). The four largest domestic private banks account for 41 percent of total assets and the three deposit taking state banks account for 33 percent of Figure 1: Lower Middle Income Countries: DepositMoney Bank total assets. Market participation of foreign AssetslGDP banks is limited at about 3 percent of assets. 100 1 - __ _ _ - - II I 111 ._- 43. Incomparison to countries o f similar per capita income, Turkey's banking system is large as a percentage o f GDP (68 percent), AOther but it is exceptionally small when measured by the ratio of claims on the private sector to GDP, which i s only 16 percent (Figure 1). One factor contributing to the comparatively l o w amounts of credit to the private sector is 0 25 50 75 100 that about 30 percent o f banking assets are Chhrs on Govemmnt/GDP held ingovernment securities. Figure 2: Total Assets andclaim on Primte Sector 44. In real terms, the banking system 350 ~ - _ _ _ -- - ~ -" grew quite rapidly in the mid-l990s, but II -Total assets credit to the private sector showed almost no -Credit to the private sector real growth (Figure 2). One reason for the slow growth is that government securities have been increasingly held directly by the 1 public, including about TL 15 quadrillion in money market mutual funds2. 45. After a decade o f high inflation, volatile interest rates, and high ex post real interest rates, the market i s stabilizing as inflation and real interest rates have declined rapidly. While this bodes well for the economic future o f Turkey, it creates some immediate adjustment challenges for its banking system. Inthe Banks offer automatic transfer between money market hnds and demand deposits, so that retail customers can maintain a current account with almost zero value. - 1 5 - previous economic environment banks were able to earn highspreads between Treasury billrates and deposits, reducing the need to focus on core banking services. As the market has stabilized, the spread between Treasury bills and deposits has declined dramatically. Until recently banks were able to offset declining spreads by increasing trading activity, but the flattening yield curve makes it unlikelythat this can continue. 46. To compete in the new environment, both private and state banks must learn to make money the "old fashioned way" by developing strong deposit andor lending franchises. Banks will need to improve their networks to facilitate convenient access for consumers to their deposit funds through technology and strategically placed branches. They will need to develop consumer lending products such as credit cards and overdraft facilities through buildingeffective payments networks. They will originate loans for consumer durables and mortgages by developing business relationships with retailers and real estate agents. The strategy for business customers is likely to be similar. Banks will need to develop hrther deposit relations with customers in order to evaluate their financial viability as loan customers. This will require a full range o f payments services for businesses as well as payroll services for the employees of these businesses. Providingthese services will require state o f the art technology platforms. C. Strengtheningthe Regulatory Framework for Banking 47. The emphasis o f the Government's banking sector reform during the 1990s was developing a basic legal and regulatory infrastructure to facilitate entry to increase competition and sector growth. This policy caused a rapid expansion o f banking system assets (see figure 1). Notwithstanding the 1994-95 banking crisis, total system assets tripled from US$51.9 billion in 1994 to US$155.2 billion in 2000. The rapid growth o f the sector outpaced the regulations, enforcement capacity, and the sector's risk management capabilities in place at the time. One result was the proliferation o f connected lending and concentration o f exposures inrelated risks. Lenient loan loss provisioning (LLP) rules and enforcement allowed banks to understate credit risks. Large foreign exchange (FX) open positions and asset/liability mismatches also created foreign currency and interest ratehiquidity risks inaddition to credit risks. 48. Excessive banking risks, an unstable macroeconomic environment, and political uncertainty combined to cause banking crises in November 2000 and February 2001. Investors liquidated TL positions and fled to the U S Dollar, interest rates peaked at 6,200 percent, and with a rapid depletion of the CBT's foreign currency reserves, the authorities were forced to float the Lira leading to a sharp depreciation. The system's capital position was eroded by the combination o f losses from (i) interest rate fluctuations, (ii)devaluation, and (iii)loan defaults due to corporate sector distress. 49. Inresponse to the crisis, the authorities undertook urgent reforms, including(i) amending prudential regulations for loan loss provisions, connected lending and FX exposures, (ii) strengthening o f the, at the time, new bank supervision entity BRSA; (iii) restructuring the private banking sector by intervening insolvent private banks and undertaking their resolution through sales, mergers and closures; and (iv) initiating the reform of the state banks by closing down the insolvent Emlak Bank, and implementing financial and governance restructuring o f Ziraat and Halk banks, as well as attempting to sell Vakif Bank (VB). - 16- Box 1: Elementsin the Draft New Credit InstitutionsAct GeneralRequirements Comply with Basle Core Principles, EUbanlung law requirements and intemational best practice. Ensure the legal separation, autonomy, and independence o f the BRSA and the SDIF . Scope of Legislation 0 Provide that a banking license i s required for all entities that fund their operations with deposits (or other repayable funds) received from the general public. 0 Define the permissible scope o f banking activities and authorize the BRSA to impose conditions for the operation o f such activities. "Fit and Proper" Criteria 0 Strengthen existing fit and proper criteria by including criteria on personal integrity for general managers and assistant general managers o f banks, members o f boards o fbanks, and members o f the BRSA board. Criteria for Approval of LicenseApplication Specify clear and objective criteria to be usedby the BRSA indetermining whether to approve or disapprove a license application. Approval Requirementfor Bank Subsidiaries 0 Provide that no bank may have a qualifying holding the amount o f which exceeds 15% o f its own funds inan undertalung that is neither a credit institution nor a financial institution or an undertaking specified by BRSA. All banks shall be required to bringtheir subsidiary interests into conformity with this provision in2009. ExposureLimits 0 Provide that the limit on exposures set out inArticle 11- 2(a) o f Law 4389 as amended by ProvisionalArticle 1 of Act 4491 shall be applicable not beyond January 2006. Lendingto RelatedParties 0 Strengthen the prudentialrequirements on lending to related parties by 9 Broadening the scope o f coverage to deal with lending to substantial shareholders, P Eliminating the explicit exemption for board members who are also substantial shareholders, 9 Incorporating additional safeguards ifthe authorities wishto establish limits on lending to parties who are brought within the coverage o f this provision, 9 Requiring banks to maintain detailed records on lending to related parties, if any, and to provide regular reports on such lending to the BRSA, 9 Inthose cases inwhchthe BRSA hasreasonto believethat such loans may endanger the financial situation o f a bank, the BRSA shall have the authority to restrict or prohibit such lending to related parties, and to require a bank to deduct credits to relatedparties from capital for the purpose o f determining capital adequacy or to require collateralization. 9 Incorporating a provision that would hold boardmembers and senior managers liable, jointly and severally, for the repayment o f credits extended inviolation o fthe Banks Act with their knowledge and without their objection, 9 Article 11-10 o f Law 4389 shall be amended so as to require immediate liquidation or such other period, not exceeding 6 months, as the BRSA shall determine. On-site Inspections Authorize the BRSA to use members o f its staff or independent audit fm to perform on-site inspections whenever BRSA believes that the supervisory process would benefit thereby. Such audit firms shall have access to such information as may be necessary to enable them to carry out such inspections and shall be subject to the same ethical requirements, obligations and liabilities regarding the preservation o f confidential information as the BRSA staff. LegalProtectionof Staffof Supervisory Agencies - 17- 1 Provide that no civil proceedings may be brought against board members or staff o f the BRSA, the SDIF or their agents for actions taken by any such members, staff, or agents ingood faith inthe normal course of their duties. Where cases are re-coursed against the persons referred to inArticle 24-6, such persons shall have the right to have a court proceeding to establish their liability. B Provide that board members, staff, and agents o f the BRSA and SDIF shall be indemnified, to the extent that they are ultimately exonerated, for expenses o f legalrepresentation and any other costs relatedto the defence of (1) claims brought against themfor civil damages, and (2) the investigation and prosecution o f criminal charges brought against them.The law should be amended to give individuals the right to choose their own lawyer. 1 Undertake a review to ensure that actions taken in good faith by board members, staff, and agents o f the BRSA and the SDIF in the normal course o f their duties do not fall under the scope o f the criminal law. Where the Minister decides to refer any such member,staff or agent to the public prosecutor for possible prosecution, such persons shall have the Minister's decision reviewedby a court. ludicial Review b Seek to limit the scope o f judicial review, consistent with Turkey's constitutional and adrmnistrative law framework, so as to ensure that the responsibilities imposed by the law on the BRSA and SDIF can be carried out. )elineation of Responsibilities between the BRSA and the SDIF 1 Clarify the respective roles and responsibilities o f the BRSA and SDIF by 9 Amending Article 15-1 o f Law 4389 so as to provide for the independence o f SDIF using language similar to that set out inArticle 3-1 o f Law 4389 inrelation to the BRSA, 9 Adding "fit andproper" criteria for SDIF Boardmembers using language similar to that set out in Article 3-3 butbroadened to include criteria on personal integrity, 9 Empowering the SDIF to issue regulations on matters necessary to enable it to carry out its responsibilities under Article 15 o f the Act provided always that any such regulations shall not contravene any other provisions o f the act, 9 Requiring the publication o f audited annual reports for both the BRSA and the SDIF, 9 Requiring the BRSA to provide the SDIF with reasonable advance notification before declaring a bank to be insolvent and to solicit the views o f the SDIF before the choice between restructuring or liquidation o f the insolvent bank is made, 9 Facilitating information sharing between the BRSA and the SDIF and ensuring that they operate on the basis o fthe same data, 9 Requiring the BRSA to provide the SDIF with timely access to accurate data conceming the overall financial condition o fbanks and o f eachbank's deposit base as well as specifics on the amount o f insured deposits, the number o f accounts, and total deposits so as to allow the SDIF to estimate deposit insurance assessmentsand, inthe case o f a pending insolvency, to plan for possible payouts. 9 Enabling the SDIF to obtain through the BRSA any additional information necessary to enable the SDIF to carry out its responsibilities under the law, 9 Uponthe invitationo f the SDIF Board, permittingthe participation, but not the right to vote, o f a BRSA representative inmeetings o fthe SDIF Board, and vice versa, 9 Permittingrepresentatives o f the CBT or the Treasury to attend relevant SDIF Boardmeetings on issues that may affect their interests, 9 Authorizing the SDIF, when needed and subject to appropriate conditions, to access the funding necessary to enable it to meet its financial responsibilities under the law, 9 Involvingthe SDIF, rather than the BRSA, inthe process o f determination o f the terms and conditions o f advances to be made pursuant to Article 15-2(f), 9 Requiring that requests for funding pursuant to Article 15-5(b) shall originate from the SDIF (and not the BRSA), 9 Amending Article 15-5(a) to provide that the rate o finterest applicable to advances made by banks to the SDIF shall be determined by the SDIF Board rather than the BRSA Board. - 18 - 50. Under PFPSAL 11, the authorities enacted appropriate, yet mostly ad hoc, regulatory measures. They also focused on enforcing compliance which has been proceeding adequately. Measures introduced then and enforced since include connected exposure regulatory limits, which began to come down inJanuary 2003 and will decline stepwise every year untilthey reach full compliance with the applicable EU Directive in 2006. In addition, enforcement of FX exposure regulations has been stepped up, REP0 transactions have been brought on balance sheet, and most obstacles to transformation o f financial-industrial groups into separate financial and corporate conglomerates have been removed. The authorities are committed to continued implementation o f these policies. 51. The authorities are now consolidating the current stability o f the sector by drafting a new banking law fully consistent with European Union principles which will be enacted in early 2005. By moving away from promulgating ad hoc rules and taking a comprehensive approach, Turkey will finally bring its banking regulation in line with international best practice. Box 1 presents the main elements o f this major structural reform. D. Strengtheningthe Capacity of the BRSA and the SDIF 52. Better banking supervision and regulatory enforcement were core elements o f the program supported by PFPSAL I1and will continue to be supported under PFPSAL 111. Progress instrengthening the operational capacity ofBRSA began inJune 2001when the BRSA's Board adopted an Institutional Development Plan (BIDP) covering a wide range o f institutional priorities. The BRSA has achieved substantial progress in implementing the BIDP. On March 16, 2004, the BRSA's Board changed the organizational structure o f the agency with the objective o f better adapting to emerging challenges and changing priorities. A second Institutional Development Plan was adopted by the Board. This second plan requires, among other things, the preparation of a strategy based on each department's operational plans and work flows. 53. Key SDIF strategic issues have been solved or are inthe process o f being solved through the draft new banking act, includingthe (i) governance o f the SDIF and (ii) clarifying further the responsibilities and attributions o f the BRSA and the SDIF. Regarding the first issue, new legislation (Law No. 5020) was enacted on December 26,2003 which stipulates the separation o f BRSA (regulation and supervision) and SDIF (deposit insurance, bank resolution, and asset management) in order to enhance the asset recovery process. The new banking act will provide for more coordination and better exchange o f information between the two entities as well as empowering the SDIF to issue regulations on matters necessary to enable it to carry out its responsibilities. 54. The Board of the SDIF adopted an institutional development plan in August 2003. Implementation o f this plan has led to a more effective organizational structure with clearly separated line o f responsibilities for bank resolution, liquidation, asset disposition, administration of deposit insurance scheme, and supporting functions such as legal, human resources and information technology (meeting a second tranche condition for PFPSAL 11). - 1 9 - E. State Bank Restructuring and Privatization 55. The program supported by PFPSAL 111will ensure that the state banks will not undertake quasi-fiscal activities again, that these banks will continue to operate under commercial principles, and that they will be promptly and sufficiently restructuredinorder to be privatized as soon as possible, taking market conditions into account. 56. Turkey entered the crisis with four state banks: Emlak (public housing construction), Halk (lending to small businesses and artisans), Ziraat (agricultural finance) and Vakif. Emlak's banking license was revoked after all its banking liabilities and performing bank assets were mergedwith Ziraat. The large duty losses accumulated on the balance sheets o f both Ziraat and Halk have beenreplaced with non-marketable government securities. Their governance has been strengthened with the appointment o f a new independent professional Joint Board for the two banks with a mandate to manage these banks in accordance with commercial principles and all prudential guidelines under the banking lawh-egulations issued by the BRSA. Senior management has been changed; credit systems strengthened; and significant operational restructuring undertaken which resulted in the closure o f 820 branches, staff reduction o f more than 30,000 as o f end 2003, and a change in status o f bank staff to that o f private sector employees. At present both banks are operating under legislation (Law. No. 4603) which provides them with their own financial and administrative authority and which prevents them from being assigned duties without advance payment by the general budget. As o f 2003, sworn bank auditors began certifying every six months that their lending procedures inthe state banks are based on commercial principles. The overall result is that both banks are profitable, albeit from trading in government securities rather than lending activities and from a large amount o f equity intheir balance sheet. 57. The authorities are ready to move to the second phase o f the reform on state banks; namely, the development o f a market based strategic direction for each o f the banks that will lead to their privatization. The challenges, however, are many. Ziraat and Halk together hold a 32 percent market share o f the deposit market but only an 8 percent share o f the loan market. Both banks have a large portfolio o f non-marketable securities that must be reduced prior to privatization in a manner that ensures stability in the market for government. And the Turkish bankingmarket is inthe process o fundergoing a dramatic change as detailed above. 58. In order to meet this challenge the authorities have engaged a strategic advisor to formulate a restructuring strategy to allow the privatization o f these state banks. The advisor has already begun working. Its work will entail three steps. The first, pre-privatization, will involve a significant amount o f benchmarking and analysis designed to develop and implement a viable market based business strategy for each institution. Recommendations will include all necessary balance sheet and operational restructuring. The second step will consist of developing an appropriate privatization strategy that is accepted by the Government, and the third and final phase will consist of all actions required to accomplish the privatization itself. The Council o f Ministers will adopt a privatization strategy for both banks in 2004. Inaddition, their Board will implement the restructuring actions recommended by the strategic advisor in 2004 and the restructured two banks will be offered for sale to the private sector as soon as the market conditions are appropriate per the advise o f privatization advisors that will be engaged at a later stage for this purpose. - 20 - 59. Finally, VB was offered for sale inJune 2002 but the tender offer did not result inviable bids. This bank is controlled by the State through the Directorate General o f Foundations (DGF) because 75 percent o f shares belong to thousands o f foundations, a majority o f which have ceased to function and have no identifiable authorized representatives. It was necessary, therefore, to pass legislation to give the government's DGF the authority to exercise shareholder voting rights on behalf o f the foundations. Consequently, the DGF represents 75 percent o f shares and is, therefore, able to appoint VB management. The remaining 25 percent o f VB shares belong to the VB employee pension fund (EPF). This ownership structure may have contributed to the outcome o f the 2002 tender offer. 60. In order to pursue the program's state bank agenda with respect to VB, the authorities have hired consultants with adequate experience and qualifications to carry out a due diligence of VB to confirm that the bank has been managed appropriately. Further, the Council o fMinisters will adopt in2004 a strategy to bring about private sector control o f VB and this strategy will be implemented expeditiously. F. ExecutionandBankruptcyAct 61. The program appreciates that a better functioning banking sector requires a legal framework that addresses creditor rights, formalhformal corporate insolvency and restructuring systems to allow for improved credit risk management practices. An Execution and Bankruptcy Act (EBA) that conforms with international best practice would assist in increasing private sector's access to credit and facilitating that productive assets in the economy be allocated to their most efficient uses. 62. In December 2003, amendments to the Execution and Bankruptcy Act (EBA) were enacted to introduce pre-packaged options and to complement earlier amendments enacted in July 2003 (meeting a second tranche condition for PFPSAL 11). The regulations for the amended EBAwere publishedinApril 2004 andwill be implemented effectiveIy. G. Resolutionof ProblemBanks andFailedBanks 63. In the.aftermath of the November 2000 and February 2001 crises, the capital base of nearly all o f the domestic private banks weakened substantially. Banks' capital deficits ranged from temporary non-compliance with the 8 percent minimum capital adequacy ratio (CAR) requirement to deep insolvency. The deep recession in the second half o f 2001, coupled with high interest rates and exchange rate depreciation, caused widespread corporate and financial sector distress, causing a steep increase in the level o f Non-Performing Loans (NpLs) to risky levels. 64. The authorities approached the crisis with the following sequence: (i) full recognition o f NPLs and capital losses as the first step, (ii) restructuring and ownership/management capital changedadjustments as a result o f new capital holdings as a second step, and (iii)corporate debt restructuring to be undertaken by healthy banks as a third step. A public solvency support scheme to assist in the re-capitalization o f private banks was implemented through a "private bank re-capitalization law" which became effective on January 31, 2002. Subsequent to this law, further regulations were issued by the BRSA regarding (i)the norms for portfolio audits to be -21 - carried out inthe private banks by the external auditors to determine the correct levels o f NPLs, and (ii) procedures for implementation of the re-capitalization program. the 65. In May 2002, the BRSA completed a three-stage audit process for all banks and corrective actions were completed by August 2002 (meeting a second tranche condition for PFPSAL 11) with the objective o f solving the situation o f problem and failed banks (meeting a second tranche condition for PFPSAL 11). A number o f banks that had fallen below the minimumCAR level were re-capitalized from private sources. VB received a subordinated loan from the SDIF to meet the minimum CAR requirement. Presently only two banks remain with SDIF (Bayindir and Pamuk). Liquidationproceedings for Imar have been initiated. Liquidation proceedings for Ticaret are continuing, although these have been interrupted from time to time by legal actions. Pamuk bankwas re-offered for sale inApril 2003 but the authorities have now decided to integrate it with Halk Bank. Bayindir's status as a "bridge bank" to place the permanent assets of failed banks. Its eventual liquidation will be decided in the future once its mission is completed. 66. The failure o f Imar Bank in mid-2003 was a serious setback. The bank, owned by the Uzan Group, saw its license revoked by the BRSA in July 2003. A subsequent investigation found that the bank: (i) vastly understated its deposits-a true total o f US$5.5 billion in contrast to the balance sheet figure o f US$550 million; (ii) hadpaid only a fraction o f its withholding tax obligations; and (iii) had sold some US$500 million in T-bills that it had never owned and was not licensed to sell. The Government announced a payment plan for individual depositors in November 2003 which will create a burden on the Treasury totalling some 2.2 percent o f GNP. H. ProgramContinuityand WB Support 67. PFPSAL I11will provide continued support to the government's financial sector reform program. It supports the outstanding objectives sought under the second and third tranches o f PFPSAL I1as well as new important policy actions. On the subject o f banking regulation where new issues have appeared, relevant conditionality was added to ensure that a banking law fully consistent with European Union principles is enacted. The authorities are committed to fully enforce the regulations under the new banking act. The capacity and independence o f the BRSA andthe SDIF will continue to be strengthened. The effective resolution o f probledfailed banks and the completion o f all related PFPSAL I1conditions, after the Loan had been cancelled, attest to the authorities commitment to enforcing banking regulations and strengthening the regulatory agencies. 68. In the one area where implementation o f the program had been delayed, namely the privatization o f Vakif Bank, corrective actions have been introduced in order to ascertain the situation o f the bank, resolve its ownership issues, and adopt a privatization strategy to be implemented expeditiously The program to be supported under PFPSAL I11goes beyond the state bank agenda o f PFPSAL 11. New and more ambitious benchmarks aimed at the privatization o f the two larger state banks Ziraat and Halk have been introduced. 69. Box 2 illustrates that PFPSAL I11supports to a more robust overall bankingsector reform program than the one left pending with the cancellation o f the second and third tranches o f PFPSAL 11. - 22 - Box 2: FinancialSector ReformProgramSupportedby PFPSALI1and PFPSALI11 0 Regulatory Framework 9 PFPSAL11: Program supported urgent enactment o f suitable ad-hoc regulations andbeganto put emphasis on enforcement compliance. P PFPSAL111:Program will go beyond PFPSAL I1second and thirdtranche conditions, which have beenmet, by supporting an additional set o f amendments to the banking law beyondPFPSAL I1to make it fully consistent with EUprinciples and requiring continued effective enforcement 0 InstitutionalDevelopment 9 PFPSAL11: Firstphase o fBRSA institutionaldevelopment was achieved, butsecond generation issues related to independence, governance, staffing and budgets have emerged. First phase institutional development o f SDIF was also successful ininterventionand resolution o fbanks, but progress has been slow insales o fnon-performing assets, governance, and development o f a long- term financially viable structure. 9 PFPSAL111: The new bankinglaw is expectedto enshrine full independence o fBRSA on the issues above, provide for appropriate coordination and separation o f functions between BRSA and SDIF, and enhance SDIF's collection powers. There has beenprograms already under the PFMC which states that the budgetso f BRSA and SDIF will be approved by Parliament without consultation with the execution. 0 ProblemBankResolution 9 PFPSAL11: Identificationo fthe correct capital positiono f all private banks was completed and capital restorationplans for all capital deficient banks were implemented and all SDIF banks intervened as o f 2002 were sold, liquidated or merged with the exception o f Bayindir, and Pamuk. P PFPSAL111: Following a failed sales effort in2003, Pamuk Bank will be integrated with Halk Bank. Bayindir Bank will be used as bridge bank for the resolution o f assets inintervened banks. Imar Bank i s under liquidation. 0 StateBankRestructuringandPrivatization 9 PFPSAL11: All plannedbranch closures andreductiono fexcess personnel for both Ziraat and Halk banks were completed. Public tender for VB inJune 2002 didnot result inviable bids. P PFPSAL111: State banks willnot undertake quasi-fiscal activities and will continue to operate under commercial principles while a restructuring planis implemented in2004 and early 2005 to offer these banks for sale. Specialized strategic advisor has began work inrestructuring Ziraat and Halk and developing privatization strategies for each o f these two banks which will be adopted in 2004 and implemented as soon as market conditions permit. A due diligence for VB will be undertaken and a strategy to bring about private sector control o fthis bank will also be adopted in 2004 and implemented as soon as market conditions permit. 0 Execution and Bankruptcy Act 9 PFPSAL11: Review was completed o fimprovements requiredinthe legal framework for bankruptcy and collateral foreclosure and acceleratedmore efficient NPL resolution, and amendments to the EBAprepared. P PFPSAL111: InDecember 2003, amendments to the EBA were enacted to introduce pre-packaged options and to complement earlier amendments enacted inJuly 2003. The regulations for the amended EBA were published inApril 2004 and will be implementedeffectively. - 23 - 111. TURKEY'S PUBLIC SECTOR REFORMPROGRAM A. Introduction 70. Turkey's ongoing public sector reform program aims to underpin sustained fiscal adjustment and create the conditions for transparent and effective govemment. In combination with the financial sector reform program described in Section 11, the public sector reform program addresses the underlying structural factors that led to the 2001 crisis, thereby trying to ensure that these conditions do not recur in the future. Inparticular, the program aims to break the vicious circle o f inadequate public sector financial management leading to ever increasing public indebtedness that fuels financial sector weakness through dependency on high retum govemment securities which intum inflates the public debt burden. 71. The program focuses on three critical areas, each o f which has a medium-term dimension: 0 Implement structural fiscal policies to ensure permanent fiscal adjustment; 0 Launch a medium-term program o f policy and institutional reforms to improve the transparency and efficiency o fPEMincludingaction to: 0 Improve budget preparation and execution, policy formulation, and the operational performance o f public agencies, 0 Upgrade public accounting, procurement and audit standards to ensure financial accountability, and 0 Ensure prudent public liability management; and 0 Initiate broad based institutional reforms to improve the quality o f public sector governance. 72. The underlying problems with the structure and management of the public sector have been analyzed in detail in the 2000 and 2003 Country Economic Memorandums (CEMs), and 2001 Public Expenditure and Institutional Review (PER). Table 6 shows that Turkey's public sector is large relative to Organization for Economic Cooperation and Development (OECD) comparators such as Spain and Portugal, and that public spending has greatly exceeded available resource^.^ Countries like Germany and Italy, with comparably high levels o f expenditure, sustain this with much greater revenue effort and therefore runmuch smaller deficits. Central to this problem is extensive govemment intervention throughout the economy and an under performing system o f public sector management. The first dimension o f the problem is being addressed through the on-going structural reforms to the social security system, to modemize agriculture support policies, deregulate energy and telecommunications sectors and implement privatization. The second dimension arises from the long neglect o f the need to modernize the procedures and institutions which govem decision-making and resource allocation in the public Including a monetary correction for nominal interest payments would reduce the general govemment deficit for Turkey inTable 6 to about 3 percent of GDP in 1999. However, this does not include duty losses o fthe state banks (estimated at about 6 percent o f GDP in 1999 after monetary correction) or the losses o f the SEE sector. The operational deficit for the public sector as a whole is estimated to have exceeded 12 percent o f GDP in 1999. - 24 - sector. The impact o f many years o f weak fiscal discipline and poor expenditure management is also reflected in the composition o f public expenditure. The share o f public spendingon interest payments and wages and salaries in Turkey varies greatly from almost all o f its OECD counterparts. This difference i s inconsistent with the objectives o f sustained economic growth andequity. Table 6: Size of General Government in the OECD (as YOof GDP) 2000 ~ Revenue " Expenditure */ Deficit/Surplus Revenue '/ Expenditure Deficit/Surplus Australia 33.3 34.4 -1.1 32.9 33.7 -0.8 Austria 48.1 52.0 -3.9 46.8 48.0 -1.2 Belgium 47.5 51.2 -3.7 47.8 47.7 0.1 Canada " 42.5 44.4 -1.9 42.7 41.8 0.9 Denmark 55.3 56.3 -1.o 53.1 50.6 2.5 Finland 51.0 54.1 -3.1 51.1 44.2 6.9 France 47.5 51.6 -4.1 47.5 48.9 -1.4 Germany 43.9 47.3 -3.4 44.4 43.3 1.1 Greece 44.9 52.4 -7.5 51.2 52.3 -1.1 Italy 44.3 51.4 -7.1 44.3 44.6 -0.3 Japan 30.0 34.9 -4.9 29.4 36.8 -7.4 Netherlands 43.8 45.6 -1.8 43.8 41.6 2.2 Portugal 37.4 41.3 -3.9 38.2 39.7 -1.5 Spain 36.3 41.2 -4.9 37.3 37.7 -0.4 Sweden 56.8 59.9 -3.1 56.9 52.5 4.4 Switzerland31 33.6 35.3 -1.7 34.3 34.1 0.2 TURKEY 4/ 28.5 33.9 -5.4 36.0 46.5 -10.5 UnitedKingdom 37.0 41.3 -4.3 39.6 37.6 2.0 UnitedStates5/ 32.4 34.3 -1.9 32.8 33.3 -0.5 Source: OECD Historical Statistics, 1970-2000. '/OECDdefinition o ftotalrevenues is taxes onproductionandimports, propertyincomereceivable, currenttaxes on incomeandwealth 'receivable,definition social contributions andother current transfers. OECD oftotal expendituresis the current disbursementsplusgross capital formation, acquisitions less disposalsofnon- producednon-financialassets andnet capitaltransfers. 3'The figures inthe secondpart ofthe table are for 1998 for Canadaand for 1999for Switzerland. 41Datafor Turkeyare from PEIR estimatesandsecondpartofthe tablereflect 1999 figures. The figures in the secondpart ofthe table are for 1997. 73. The need for structural and institutional reforms is now widely acknowledged by the government and civil society institutions. In response, the new Government has articulated a second stream o f public sector reform which proposes both a major restructuring of central government public administration and far reaching reassignment o f responsibilities across levels o f government to achieve greater decentralization and stronger accountability for public sector performance. These reforms are now articulated inthe form o f draft legislation before Parliament which are likely to be enacted later in 2004. The new Government has also deepened the scope o f public sector reforms through passage o f the Public Financial Management and Control (PFMC) Law that was approved by Parliament inDecember 2003. This government has used the opportunity to revise the core public finance legislation to establish a modern and more ambitious framework and institutions for public finance management inTurkey. 74. Coordinating the public sector reform agenda is a significant challenge, particularly inthe context o f the wider scope o f reform under the two streams, namely public finance management - 25 - and public administration, and the need to ensure effective sequencing o f the two groups. Under the previous coalition government, the attempt to ensure coordination through the use o f steering committees were not particularly effective. Under the current government, there is stronger high level political commitment to public sector reform as well as more effective intra-governmental coordination. Therefore the prospects for effective implementation and monitoring o f the public sector reforms, including the PFPSAL I11agenda, are much better. More detailed information on the status o f the public sector reform program and expected follow-up actions is presented in the paragraphs below. B. Structural Fiscal Policies 75. Fiscal adiustment. Strong fiscal performance has been the comerstone o f the economic program inthe last few years. Fiscal gains were significant in2003, and the primary surplus rose from 4 percent o f GNP in 2002 to over 6 percent o f GNP in 2003, close to the programmed 6.5 percent target. Although the 2004 budgetpassed inDecember was consistent with the 6.5 percent primary surplus target, a sizeable gap quickly emerged. The government announced above inflation increase in minimum wages and it also cut contribution rates for social security to reduce the additional costs to employers. Inaddition, the government increased pensions by 21 percent, well above the inflation target. These initiatives together with revenue shortfalls relative to the budget, created a financing gap o f close to 1.7 percent o f GNP. The government introduced a fiscal package in March 2004 to close the fiscal gap. The Government is implementing additional measures to meet the primary surplus target o f 6.5 percent o f GNP for the consolidated public sector-of which 5 percent o f GNP for the central government-set in the revisedbudget for 2004 (Table 7). Table 7: Public Sector Balances Actual Program Estimate Program 2000 2001 2002 2003 2003 2004 Central Government Budget(in percent of GNP) Primarybalance I/ 4.3 4.8 2.4 5.0 5.0 5.0 Net interestpayments2/ 15.8 24.7 17.6 15.5 16.3 13.1 Budgetbalance -11.5 -19.9 -15.2 -10.5 -11.3 -8.1 ConsolidatedPublic Sector (in percentof GNP) Primarybalance ofpublicsector 2.7 5.5 4.1 6.5 6.1 6.5 o/w SEE sector -1.5 0.1 1.1 1.1 Net interestpayments 3/ 21.9 26.6 16.2 15.4 16.2 13.1 PSBR(incl. CBT profits) 19.2 21.1 12.2 8.9 9.9 6.6 Operationalbalance41 -6.9 -4.8 -4.7 -3.5 -4.9 -2.5 Financing (in percent of GNP) 19.2 21.1 12.2 8.9 9.9 6.6 Domesticfinancing 13.9 13.6 9.2 8.6 10.4 6.6 Externalfinancing(including IMF andprivatizalion) 5.3 7.5 3.0 0.3 -0.5 0.0 I/Onacommitmentbasis,excludingprofittransfersfromtheCBT,interestreceipts,andprivatizationproceeds. -. 2/ Interestpaymentsminusinterest receiptsplusprofit transfers from the centralbank. 3/ InterestpaymentsminusinterestreceiptsplusCBT profitsbeforetransfers to thegovernment. 41Overall balancenettedout ofthe differencebetweennominal interestpayments andreal interestpayments. Source: Govemment,IMF and WB estimates. 76. The 2004 fiscal package has two main components: original budget measures and supplementary budget measures (Box 3). To meet the 2004 primary surplus target, the authorities took a set o f measures inDecember 2003 within the context o f original 2004 budget. The special communication and transaction taxes as well as surcharge on income taxes have been - 26 - extended for one more year. Motor vehicle taxes were adjusted upward to compensate the reimbursement of 2003 payments for additional car tax (ruled unconstitutional). In addition, savings also came from cuts in investment programs, lower value-added tax (VAT) rebates for pensioners, and by eliminating vacancies when public sector workers leave their positions. The special appropriation4 has been eliminated. The second set o f measures were introduced with the supplementary budget in March. The supplementary budget law cuts discretionary spending by 13 percent across all ministries. The govemment also introduced measures to increase tax revenues by adjusting excises ofpetroleum products, alcohol and tobacco. Box 3: FiscalPackage for 2004 RevenueMeasures (2.3 percentof GNP) 0 Writing over special revenues to the budget. Extending 10% hndlevy (PIT and CIT). 0 Extending special communication and special transaction taxes for an additional year. 0 Increase incar excises (list 11, approximately 14%). Increase inmotor vehicles tax. 0 Increase inpetroleum and gas excises. 0 Increase intobacco revenues (combination o f a specific excise tax and TEKELprice hike) Increase inalcohol excises. 0 Increase inVAT (effect from excise taxes). ExpenditureMeasures(1.2 percentof GNP) 2% cut ininvestment budget through the budget law. 0 13% cut indiscretionary spendingthroughthe supplementary budget law. 0 Blockage o f investment incentives. 0 Cancellation o fpositions from workers attrition (10,000). 0 Cut inVAT rebate to pensioners (5% to 4%). SEE Balances(0.3 percentof GNP) 0 Revision o f Telecom tariff regulation (7.5% to 2.5%). 0 Eliminating gas subsidy to auto producers. 0 Reductioninmembership fees. 77. The 2004 fiscal package, total fiscal measures inthe range o f 3.8 percent o f GNP,relies again heavily o n revenue measures (Box 3). This is of concem given that revenue increases since the fiscal adjustment began in 2000 have tended to be offset by increases in non-interest expenditures in subsequent years. Of particular concem i s the sizeable cut in public investment (3.5 percent of GNP planned compared to 4.3 percent spent o n average over the 2000-02 period). The development needs of Turkey's young and growing population are such that a larger share o f public resources will need to be devoted to public investment over the medium term. Another concem relates to the very large number o f relatively small expenditure measures in the package which will require rigorous implementation to avoid shortfalls. Efforts to tighten wage policy- including moderate civil service salary increases, no backward indexation, and limits on the growth o f the overall public worker wage bill-are a key element of the fiscal package. Here, the outcome will hinge o n agreement with the trade unions. Overall, it remains clear that deeper Special appropriation is a mechanism o f converting earmarked revenues into appropriation duringthe year. - 27 - and more permanent structural fiscal measures will be needed in order to sustain a high quality fiscal adjustment including continued implementation o f the tax strategy and public employment program discussed below. These structural measures will complete and build on the results achieved so far, including in the areas o f social security reform, energy reform, and reform o f agriculture support policies under the ERL program. Most o f the elements o f the 2004 fiscal package have been introduced by the Government in the context o f the 7thReview o f the IMF Stand-by Arrangement. The Government i s committed to take additional action, if needed to meet the primary surplus target. Box 4: Tax Strategy Priorities Tax Policy Simplify and consolidate the indirect tax structure with a VAT with a standard rate and two low rates (1 percent for agriculture and 8 percent for other basic consumption goods). Introduce a unifiedspecial consumption tax (SCT) that will consolidate the current range o f excise and specific taxes into a single tax charged on a limited range of luxury goods. A threshold will be established for obligatory filing o f VAT returns. Earmarking o f revenues will be abolished and all revenues from earmarked taxes will be brought into the budget. Simplify and consolidate the direct tax regime in line with OECD standards and international best practice. Convert tax rebate for wage earners into a tax credit to simplify administration and reduce tax burden on low income wage earners. Minimize tax exemptions and exceptions. 0 Harmonize real effective tax rates across all types o f financial instruments and maturities. Phase in the full indexation o f the corporate and business income taxes (real interest deduction to replace nominal interest deduction). Reduce the scope o f investment incentives, consolidate into a single investment allowance rate across sectors and geographic regions, and gradually eliminate withholding tax on these allowances. Make the incentive system more transparent and automatic. 0 Overhaul the tax regime for free trade zones. Terminate the corporate tax and payroll tax exemptions. Provide reduced corporate tax rate only on condition that separate subsidiaries are established and inward trading i s below 15 percent o f sales. Adjust taxation offinancial leasing inline with internationally generally accepted accounting practices. Tax Administration Reorganize the General Directorate o f Revenues (GDR) to introduce functional structure in line with OECD practice. Revise payment scheme for managers and key technical staff and design a bonus and incentive system which allows more competitive total remuneration for these positions. Upgrade the tax policy department within the MOF. Strengthen tax audit management capacity within the MOF by establishing an audit coordination unit and upgrade the role o f the audit department in the GDR. Prepare a coordinated annual auditing plan. Develop databases for tax audit planning and the use o f information from the taxpayer identification number (TIN) system for effective auditing. Design a more comprehensive audit strategy for large taxpayer and improve knowledge and database on large taxpayers and their business transactions. Develop a strategy for taxpayer services and improvements inrelations between taxpayers and the GDR. Upgrade internal audit function for the tax administration reporting directly to the head o f GDR. Design and implement program to reduce tax arrears. Upgrade the management information systems throughout the GDR. 78. Tax strategy. A medium-term strategy for improvingthe tax system inTurkey i s inplace based on a review carried out jointly with the Government (Box 4). The overarching objective o f the strategy is to improve the stability, transparency and equity o f the tax system through measures to minimize tax distortions, broaden the tax base and improve the efficiency of tax administration. This will allow an equivalent amount o f revenue to be raised at lower marginal - 28 - tax rates thereby promoting economic growth. The strategy builds on the 1998 tax reform and draws on earlier analysis o f the tax system including work carried out under the Bank's Public Financial Management Project (PFMP). Earlier studies o f the tax system by the IMF and WB and o f the investment environment by FIAS (Foreign Investment Advisory Service) signaled concems about the complexity and lack o f transparency o f Turkey's tax system which has been exacerbated by tax policy instability coupled with high and unstable inflation rates. The proliferation o f special and additional taxes and surcharges as a result o f urgent pressures to reduce the fiscal deficit contributed to the complexity and instability. Partial inflation indexation in combination with differential nominal tax rates and investment incentives across financial instruments distorted real effective tax rates across financial instruments and real business investments. Investors have identified bureaucratic red tape, delays in processing applications for licenses or investment allowances and VAT refund claims, and corruption as additional negative factors affecting investment andbusiness operations. 79. Implementation o f the tax strategy is progressing reasonably well. Onthe tax policy side, a unified SCT to consolidate a range o f excise and specific taxes into a single tax charged on a limited range o f luxury goods was enacted in June 2002. Implementing circulars for the SCT law were published in July and the tax came into effect in August 2002. Earmarking o f SCT revenues was eliminated, with effect from the 2003 budget, through a government decree issued inJanuary 2003. In April 2003, the Parliament enacted the first legislative package under the direct tax reform designed to simplify and consolidate the direct tax regime in line with OECD standards and intemational best practice. This legislation: (i) harmonizes tax rates on income from financial investments at the declaration stage, (ii) simplifies and harmonizes the system o f investment incentives, (iii) reforms the system of income tax credits, and (iv) simplifies taxation o f corporate earnings and dividends. K e y provisions o f the legislation became effective immediately and the remaining articles became effective inJanuary 2004. 80. Subsequently, a second package o f direct tax reform legislation was enacted in January 2004 to minimize geographical, sectoral, and other investment incentives-including rationalizing the benefits in Free Trade Zones. The Government is strongly committed to address the problem of taxation o f unrecorded income and has prepared secondary legislation to require that all large financial transactions take place through the banking system. 81. The strategy also tackles tax administration issues encompassing institutional improvements, automation, transparency, compliance, taxpayer services and tax audit. It is designed to align Turkey progressively with best practice in other OECD countries. Implementation o f the tax administration reforms has proceeded somewhat more slowly than originally envisaged, in large part due to the elections. In a positive step, the audit coordination committee has been established and a coordinated audit plan for 2003 has been prepared and implemented. Resources have been included inthe 2004 budget to enhance the audit capacity o f the GDR. Effective implementation o fthe audit planwill help discourage future tax evasion, but broader efforts and organizational changes will be required to bring tax administration up to intemational norms. The functional reorganization o f GDR will be completed by end-2004 as agreed with the Bank and this structure will be extended to local level. The GDR will be transformed into a semi-autonomous body within the Ministry o f Finance its Head directly reporting to the Minister. Tax policy unit will be transferred to the Ministry o f Finance. The functional reorganization will reorient the GDR from a structure based on administration o f - 29 - individual taxes to one based on the core functions o f tax administration including taxpayer registration, taxpayer services, collections, audit, legal, information technology, and human resources (HR). 82. Public employment. The comprehensive public employment program initiated under PFPSAL i s beginning to generate results. The program i s part o f the longer-term strategy to modernize the public sector, ensure medium-term fiscal sustainability, and free up resources for private investmentandjob creation. This strategy includes action to: (i) withdraw the state from direct involvement in productive activities through the restructuring and privatization of SEEs and reform of agriculture support policies, (ii) contain and then gradually eliminate the deficits o f the SSIs, (iii)curtail the scope o f the government's contingent liabilities through the introduction o f an energy market and transparent guidelines for financial and project guarantees under the new public debt management law, (iv) restructure central govemment agencies and decentralize additional functions to provincial and local governments incoordination with efforts to improve governance and financial accountability at the local level, and (v) implement a comprehensive public employment program, including retrenchment o f SEE employment. While reducing SEE employment is always difficult and entails social costs, the fiscal adjustment it supports will reduce crowding out and promote the strategically important objective of private sector investment and job creation, particularly for Turkey's youth. Rationalizing SEE employment will also ease the chronic pressure for public sector price increasesand help pave the way for acceleratedprivatization. 83. As part o f a broader programof structural measuresbeingundertaken on the expenditure side, the public sector employment policy has become more comprehensive in 2002 and 2003 and was maintained and strengthened in 2004. The policies for 2004 include: (i) a cap on the total number o f civil servants in the central and local government-the ceiling on new hiring in the consolidated budget has been set at 40,000; and (ii)limit on replacement hiringinthe SEEs a equal to 10 percent o f attrition and no replacement hiringfor budget-financed SEEs. A quarterly monitoring system has been established in 2002 which provides a clear picture o f public employment across the general government for the first time in Turkey (Table 8). The employment figures o fthe consolidated budget agencies, SEEs, local administrations, state banks and social security institutions are being monitored by a committee chaired by Ministry of Finance. The employment monitoring mechanism has been extended to all municipalities and special provincial administrations through circulars published in February and July 2002, and data has been collected to establish a baseline for end-2001. The quarterly public employment reports will continue to beprepared andprovided to the Bank in2004. 84. A key element of the public employment program is to address the over-employment in the state economic enterprises. At end 2001/early 2002, approximately 15,000 workers were retired, notified o f their retirement, laid off or converted to private contract status, following the lifting o f restrictions on the ability o f managers to require public sector workers over 50 years of age to retire. In addition, most of the unfilled positions in SEEs were eliminated. The Government conducted an assessment o f SEE redundancies which indicated 45,800 redundant positions in the SEE system as of January 2002. A majority of these redundancies were eliminated as o f mid-March 2004 and many o f the SEEs were in fact able to reduce the number o f their workers by more than the figure determined through the redundancy assessment carried - 30 - out in 2002. The overall attrition from SEESbetweenFebruary 2002 and mid-March 2004 has reachedto over 59,000. Table 8: Employment in the Public Sector I/ 2003 End-2000 End-2001 End-2002 Attrition Entries Net increase End-2003 I EonsolidatedBudget 1,914,234 1,903,473 1,897,067 1,857,180 Civil Servants 1,700,000 1,700,000 1,69 1,458 69,791 33,211 -36,580 1,654,878 Contracted 21 13,207 13,571 15,040 n.a n.a n.a 14,620 Workers 21 201,027 189,902 190,569 n.a n.a n.a 187,682 SEES 440,110 415,332 382,698 52,296 19,501 -32,795 349,903 DL 233 379,508 303,727 280,666 30,583 15,240 -15,343 265,323 Civil Servants 9,588 8,293 7,996 1,266 785 -481 7,5 15 Contracted 135,242 119,434 112,153 8,755 3,407 -5,348 106,805 Workers 234,678 176,000 160,517 20,562 11,048 -9,514 151,003 PA 3/ 60,602 111,605 102,032 21,713 4,261 -17,452 84,580 Civil Servants 879 1,786 1,717 465 160 -305 1,412 Contracted 4,609 14,553 13,277 1,807 334 -1,473 11,804 Workers 55,114 95,266 87,038 19,441 3,767 -15,674 71,364 State Banks 4/ 61,721 47,979 32,558 2,443 538 -1,905 30,65: Civil Servants 7,978 3,250 307 152 93 -59 241 Contracted 53,512 41,391 1,927 1,231 115 -1,116 81 Workers 23 1 66 11 6 0 -6 Workers Converted 51 3,272 30,313 1,054 330 -724 29,58! ,oca1 Administrations 213,428 211,702 -3,810 207,89; Municipalities 208,356 206,671 203,04! Civil Servants 100,330 98,75 1 95,24: Contracted 61 1,326 1,249 1,10: Workers 61 106,700 106,700 106,70( Special Provincial Adm. 5,072 5,031 4,84: Civil Servants 4,257 4,190 4,04 1 Contracted 61 53 50 4f Workers 6/ 762 762 76; locialSecurity Institutions 77,854 78,937 2,109 81,04f Civil Servants 70,341 71,417 72,72; Contracted 3,32 1 3,328 4,12; Workers 4,192 4,192 4,192 ;RAND TOTAL 2,658,066 2,602,962 -76,288 2,526,674 . Numbersbasedon "filled positions"unless statedotherwise. . Total number ofauthorizedpositions, obtainedannually from "Butce Gerekcesi" publishedby MoF. .The list ofcompaniesinthePA portfoliochangesovertheyears. . Includesemploymentin Ziraat, Halk and Emlakbanks(which was mergedinto Ziraat in2001). .Employeeshavingworked as officials or as contractedpersonnelunderthe Cabinet DecreeNo. 399 who opt for working on ontractwithin the framework o fthe Law No. 1475 are definedas workers-converted. .Totalnumberofauthorizedpositions. ource: Ministry of Financechaired Public EmploymentCommitteeandWorld Bank. C. PublicExpenditureManagement 85. The key elements of Turkey's multi-year strategy for PEM reform were laid out in the Strategic Framework for Public Expenditure Management Reform in 2001. The strategic - 3 1 - framework was annexed to the Letter o f Development Policy (LDP) for the first PFPSAL and remains the basis for the PEM reforms under the PFPSALprogram. The framework i s structured into three priority areas in support o f core objectives for better PEM, commonly referred to in international practice as levels 1-3: strengthening aggregate discipline (level l), building capacity for policy formulation (level 2), and improving the performance of public agencies (level 3). The three priorities for PEMreform are to: 0 Reform the processes for budget preparation and execution. This involves steps to: (i) improve the transparency and comprehensiveness o f the budget in line with international standards, (ii)strengthen the credibility o f the budget preparation process, (iii) capacity build for policy formulation at all levels o f government, and (iv) realize concrete improvements in the operational performance o f line ministries and agencies through a progressive shift to performance-oriented budgeting. 0 Upgrade public accounting, procurement and audit hnctions to ensure adequate financial accountability. This encompasses legal changes to introduce international fiduciary standards, as well as institutional changes to build capacity to implement the new standards and shift from formalistic ex ante controlto effective ex post monitoring. 0 Ensure prudent public liability management. This involves legal measures to establish clear lines o f borrowing authority and transparent reporting o f public liabilities, as well as institutionalmeasures to buildup the capacity for modem fiscal risk management. 86. The Public Financial Management and Control (PFMC) Law. The PFMC Law, enacted by the Parliament inDecember 2003, forms the cornerstone of the legal framework for modem PEMinTurkey. The PFMC law replaces the Public Accounting Law of 1927 (Law No. 1050). It introduces modern public management principles by clarifying accountability of public officials, by delegating managerial responsibility and by putting inplace an internal control and audit framework that i s compatible with EU and international practice. The new PFMC law, which addresses a number o f weaknesses o f the existing system: (i)incorporates a comprehensive definition o f public revenue and expenditure encompassing the general government, (ii) provides the MOF with clear legal authority to issue budget classification, accounting and reporting standards for all government agencies, (iii) introduces a medium term approach to strategic planning and budget preparation that will apply to all parts o f the central government, (iv) provides a clear definition o f accountability of ministers and heads o f public administrations as well as key officials for financial management and performance relative to policy goals, (v) delegates financial control and internal audit responsibilities to spending agencies inline with EU standards, (vi) strengthens government accountabilityby extending the scope and mandate o f external audit by the Turkish Courts of Accounts (TCA) to the entire general government. The government i s currently preparing secondary legislation and regulations necessary for implementation o f the provisions of the law. While many aspects o f this law are expected to be implemented from January 2005, others will be implemented gradually over the period 2005-07. BudgetReform 87. Inline with the government's strategy to achieve comprehensive budget framework, that supports sound fiscal management, a number o f steps have been taken to improve the - 32 - classification and reporting o f fiscal activity o f the general government and to integrate extra- budgetary items into the budget. 88. Budget classification. Until recently, Turkey lacked the functional classification of government expenditure that is recommended by the IMF's Manual on Government Financial Statistics (GFS) and which i s essential for policy analysis o f expenditure. Introduction o f the new GFS has improved budget transparency by allowing for a comprehensive and consistent presentation o f the budget across all general government agencies with a complete functional breakdown of expenditure. The GFS classification, including the ten sector functional classification has been applied in the 2004 Budget for consolidated budget agencies. The expansion o f the GFS to the rest o f central government will be implementedinthe 2006 budget. Current plans are also to expand the GFS to the rest o f general government, i.e.socia1 security institutions and the local administrations, by the 2006 budget. Turkey now has the full complement o f internationally standard budget classification. 89. Budgetary and EBFs. All budgetary funds, with the exception o f the Support Price Stabilization Fund (DFIF) linked to the reform o f the agriculture sales cooperative unions (ASCUS), and all but five extra budgetary funds (EBFs) (Social Solidarity Fund, Defense Fund, Promotion and Publicity Fund, SDIF, and Privatization Fund) were eliminated by legislation in 2000 and 2001. Despite formal closure o f the funds, the system o f earmarked revenues and expenditures associatedwith them has remained largely inplace. This has been done by keeping open the accounts o f the closed funds and using the mechanism o f special appropriations whereby earmarked revenues to these accounts are written as special appropriations for the spending agencies concerned during the course o f the year. To meet the initial objectives o f improved fiscal control, transparency, accountability and comprehensiveness o f the budget, the Government intends to terminate the use o f the special appropriations mechanism, close the accounts linked to the closed funds and incorporate their earmarked revenues into the general revenuebase. This will be accomplished through legislationwhich is expected to be enacted by end-June 2004. For the remaining EBFs (excluding the SDIF for which measures are being taken under the financial sector reform program), the following measures have been incorporated into the PFMC law: (i) incorporation o f EBF budgets inthe budget o f the related administration submitted to Parliament for approval; (ii) inclusion o f the remaining EBFs under the internal control and audit regime as well as extemal audit by the TCA; and (iii) monthly reporting o f EBFoperations on aconsolidated basis with the central government. 90. Rationalization and reform o f revolving funds which represent another form o f off- budget activity, is progressing. Through consolidation by agency, the numbero f revolving funds was reduced from about 2,650 inmid-2001 to about 1,400 by end-March 2002. The PFMC Law confirms the government's intention to eliminate all revolving fund revenues within general government by end-2007. Untiltheir elimination, revolving fund revenues and expenditures will be incorporated into the budget o f each government agency and reported in the budget submission to Parliament. 91. Budget preparation. Relative to the situation prior to 2001, the government has made steady improvements in the budget preparation process over the past few years with better central guidance to budget preparation by line ministries. The framework for these actions was established under the PFPSAL by a HighPlanning Council (HPC) decision issued in June 2001 - 33 - to accompany the Prime Minister's Budget Call. The HPC decision provided a macro-fiscal framework for 2002 budget preparation and established indicative ceilings for both the recurrent and investment budgets for ministries and line agencies based on an indexation formula applied to the actual budget allocations that each ministry and line agency received in2001. As a further step, the Prime Minister's Budget Call for the 2003 and 2004 budgets included individually specified indicative ceilings for each ministry and line agency, based on the experience with the 2002 budget preparation process. The PFMC law now proposes a significant upgrading o f budget preparation through the adoption o f a formal medium term approach to budgeting which is widely followed in other OECD countries. Under this approach, budget preparation will be based on a medium term economic program to be endorsed by the Council o f Ministers and a medium term fiscal strategy that will be reviewed and ratified by the High Planning Council. The political commitment to a medium term fiscal strategy is expected to reinforce fiscal discipline and management and provide the basis for improved strategic allocation o f budgetary resources to priorities. This approach is expected to be introduced in the 2006 budget preparation cycle which will commence in mid-2005. The government expects to receive technical guidance and support for this new approach from the Ministry o f Finance o f the Netherlands and is currently negotiatingthe project agreement for this support. Table 9: Public Sector Investment,1996-2004 1/ (currentprices,trillion TL) Total Vumber o TotalValue Expenditureby Initial Actual nvestment(in New Projects Projects o f Projects the end of Allocation Investment21 percentof of Completion previousyear Total Multiyear 5221 8,155 2,629 467 545 3.6 10.8 1449 459 5332 16,597 4,788 1,008 1,298 4.4 10.7 1428 577 5556 34,084 9,657 2,135 2,378 4.4 10.4 1,574 714 5458 57,126 17,380 3,560 3,649 4.7 10.2 1,186 305 2000 5321 86,219 26,125 5,905 6,183 4.9 9.2 1,176 249 2001 4/51 5047 142,919 45,885 7,167 7,570 4.3 12.5 1,234 286 2002 61 4414 166,797 66,021 10,590 12,222 4.4 8.5 1,066 128 3851 187,110 80,372 12,464 9,981 2.8 7.6 1,032 134 2004 I/8/ 3555 196,113 86,766 11,426 1,079 149 I/ExcludesIC 1administl ions. 212003 figure is provisional. 2004 figure is programprojection. 31Average time ofcompletionis calculatedas the amount of time requiredto finish upthe remainingstock completely, assumingthat no other projects are taken intothe investmentprogramin the following years andan appropriationandexpenditureis madeof the magnitudeo f the current year level. 41Total Value andTotal Expenditurefigures for 2001 are deflatedby a factor of 1,3584 (1,603/1.18) to adjust for crisis impact. 51Includessupplementarybudget allocation ofTL 280 trillion. 61Annualallocation includesTL 555 trillion from Law 3418 revenues. 71Includesacut o f 14.74% on the consolidatedbudget investments. 81TL 450 trillion budget project specific investmentallocation from GSM revenueshare andTL 100trillion from the Ministry ofFinance(reserve for acceleratinginvestments) included. 92. Public Investment Program (PIP). Inline with commitments under the program, the 2002 PIP cut the average completion time to 8.5 years, a 32 percent reduction from the 12.5 year average completion time in 2001 (adjusted for the higher than expected devaluation and inflation). Overall, 353 individual projects and 649 subprojects were dropped from the PIP and the rationalization reduced the total cost o f the PIP by TL 36.9 quadrillion. This rationalization was based on a Public Investment Review (PR) carried out by SPO in 2001 with support from the Bank. An action plan for further rationalization o f the PIP in 2003-04 prepared by SPO was adopted by the HPC in October 2002. The plan includes quantitative targets for further - 34 - reductions in average project completion time o f at least 3 percent per year starting from the 8.5 year baseline established in 2002. It also outlines steps to strengthen the role o f formal costhenefit analysis in the project approval process and establish a framework for project monitoring and evaluation. An assessment prepared by SPO in May 2003 confirmed the reduction in the average project completion time in the 2002 PIP and indicated a hrther reduction inthe average completion time to an estimated 7.6 years in the 2003 PIP along with a continued reduction in the number o f projects (Table 9)5. Following the budgetary cut in the context o f fiscal measures required to meet the end-year primary surplus target, the Government expects a transitory increase in the average completion time to 8.6 years in 2004 due to reduced investment program allocation. In order to contain this increase and reduce the average project completion time further, the Government plans to revise the action plan prepared in 2002 and strengthenthe implementation o f the new plan. 93. Policy formulation. The 2001 PER noted that the institutional processes for policy formulation and management, both in ministries and at the level o f the Council o f Ministers, were weak and had been neglected due to the highturnover o f governments. It is important both to ensure that the capacity o f ministries and departments to propose policy in line with strategic objectives is strengthened and also to establish a more disciplined process for policy decision making by the Council o f Ministers. The PFMC law underlines the need for such institutional and capacity strengthening by requiring the fiscal implications o f new policies to be estimated and for decisions to be made consistent with the medium term fiscal strategy. INSTITUTION 1 Ministry o fAgriculture and Rural Affairs 2 State Institute o f Statistics 3 General Directorate of Health for Borders and Coasts 4 General Directorate of Highways 5 Hacettepe University 6 Denizli Special Provincial Administration 7 Iller Bank 8 Kayseri Metropolitan Municipality 94. The Government has made progress with regard to building the capacity for strategic planning and policy formulation in public agencies. The PFMC law requires ministries to undertake a strategic planning exercise in order to clarify policy goals and performance objectives and to prepare budget requests. The draft Public Administration Framework law which is before Parliament proposes the administrative restructuring and processes to support such functions. The SPO has issued guidelines for strategic planning by key line ministries and departments including guidelines for costing policies. In July 2003, the High Planning Council issued a decision announcing the launch o f the strategic planning initiative on a pilot basis in eight agencies representing various parts o f general government (Table 10). With guidance and support from SPO, the eight agencies are expected to finalize their strategic plans during 2004 with a view to reflecting these plans in the 2005 Budget. Based on the experiences o f these The number o fnew projects were reduced to 1032 in2003 from 1234 in2001. - 35 - pilots a phased program to expand strategic planning to the rest o f govemment will be prepared and implemented. 95. Until recently there has not been adequate attention given to the need to strengthen the capacity for policy management at the center o f government. This will be critical to the success o f the medium term approach to budget management. Good practice examples can be studied from across the OECD and other well functioning governments to derive a design that i s appropriate for the Turkish institutional context. The restructuring o f government required under the PAF law will provide a good opportunity to implement the necessary arrangements to support effective decision makingby the Council o f Ministers and the HighPlanning Council. 96. Operational performance. Under the original PEM strategy, the government introduced in 2002 a pilot program on improving operational performance in specific projects in six agencies that was designed to draw lessons for understanding the reIationship between strategic planning and goal setting, budgetary predictability, financial management and operational performance. The Ministry o f Finance is evaluating the experience o f this pilot to date and will prepare an interim report inthis regard. Since performance improvements require time to bear fruit, it will be necessary to continue this initiative over some more years in order to draw real lessons regardingthe conditions necessary for better public sector performance. 97. A number o f reasons, includingthe desire o f the new government to initiate performance improvements in government, prompted a broader effort to institute performance oriented management starting from 2005. As noted earlier, the new PFMC law proposes a fundamentally new framework for public management that includes strategic agency level planning and performance related budgeting in government. By clarifying accountability of heads o f public administrations, requiring spending agencies to define their performance goals and requiring the submission o f accountability reports for performance, the new framework highlights the focus on performance. In order to enable achievement o f goals the framework proposes delegating managerial and financial authority while ensuring that it is backstoppedby an adequate system o f internal control and audit. In this respect, the law proposes an ambitious expansion of the original reform program. The government has been advised by the Bank and other agencies to consider a phased approach to these reforms since they are complex and management intensive. Its implementation is a long term challenge but the government is currently considering the introduction o f key enabling steps. 98. InJuly 2003, the HighPlanning Council selected eight general govemment agencies, including a provincial and a municipal administration, to be part o f a pilot initiative to introduce strategic planning and performance related budgeting and management in government (Table 10). The SPO and the MOF have been providing guidance to the eight agencies with a view to completing their strategic plans by June 2004 and to prepare their 2005 budgets on that basis. Carehl design, pragmatic adjustments and managerial follow-through will be important for the successfil implementation o f these reforms. 99. Future budget reforms. The core priorities o f the budget reform-particularly the level 1 reforms in support o f greater comprehensiveness and transparency-will be accomplished by 2006 based on ongoing reforms. The emphasis, as indicated by the discussion above on medium term budgeting and performance oriented management, is now shifting to level 2 and level 3 - 36 - issues in support o f improved public service delivery. The new public finance framework established by the PFMC law defines an ambitious and comprehensive agenda for reform implementation over the next 3-5 years. Commencing in 2005, the government will be engaged in implementation o f the new decentralized internal financial control system with the appointment o f financial controllers and internal auditors in line ministries. Preparations to develop the necessary secondary legislation and guidelines are underway during 2004 with technical assistance from the French Ministry o f Finance under an EU-supported "twinning" project. Similarly, the government has sought technical assistance from the Netherlands Ministry o f Finance with regard to preparations for the introduction o f a medium term approach to budgeting and performance basedmanagement. FinancialAccountabilitv 100. Modernization o f Turkey's system o f public financial accountability in line with international standards is an urgent PEM priority. As detailed in the August 2001 Country Financial Accountability Assessment (CFAA), some o f the basic buildingblocks appear to be in place: an established legal framework; reliable, albeit fragmented, accounting processes; regular reporting o f financial results; an apparently independent Supreme Audit Institution (SAI), the TCA, which reports to Parliament; a relatively open system o f accountability and plenty o f skilled personnel. However, deeper analysis reveals significant problems and lack o f systemic coherence. Complex institutional relationships, multiple sources o f public funds, heavy emphasis on ex ante controls and inadequate reporting to the legislature reduce transparency and weaken financial management. The accounting law which governs public sector accounting dates from 1927, and procurement legislation has not kept up with evolving international standards. Similar to the budget, the audit system is fragmented with many bodies besides the T C A carrying out activities analogous to external inspection and audit. 101. Accounting. Inthe last few years, Turkey has made systematic and conscious efforts to reform the public accounting system. This began with the introduction of an automated on-line accounting system, called Say2000i,in more than 1500 accountancies spread across the country. A commendable aspect o f the automated accounting system is that it was developed completely by MOF in-house IT department without outside technical and financial assistance. Under this internet based system, the MOF's central accounting database contains data on all individual transactions wherever they occur in the system. Recording o f every transaction in a secure information system, automated internal controls, and real time recording capacity are among the main benefits derived from the automated system. The system is capable o f producing periodic financial statements without any delay and thus provide the decision makers with up-to-date financial information. 102. The initiative to introduce modified accrual accounting in line with the new GFS (2001) requirements is makingprogress. However, this exercise has turned out to be quite complex and will take more time to complete than initially envisaged under the PFPSAL program. A policy paper on accrual accounting prepared by MOF was published inNovember 2002. The MOF has also prepared a regulation referring to accounting policies and principles, and containing framework accounting standards and a framework chart o f accounts. Beginning 2004, the accounting system has begun capturing acquisition o f new assets and creation o f liabilities. However, valuation o f existing assets (including heritage assets) andthe depreciation policies are - 37 - yet to be worked out. Based in part on the experiences from the pilots, the timetable for the rolling out modified accrual system has been revised and is now as follows: .(i) introduce modified accrual accounting in consolidated budget entities in 2004, (ii) begin introduction of modified-accrual basis in entities outside the consolidated budget in 2005. The government accounting standards board to be established, as required under the PFMC law, will be responsible for transforming the framework standards included in the accounting regulation into full-fledged accounting standards over time. 103. Procurement. Turkey has moved decisively to upgrade its public procurement legislation and practices in line with international standards. The new public procurement law was enacted in January 2002 and subsequently amended inJune 2002. The new law is based on the United Nations Commission on International Trade Law (UNCITRAL) model and moves Turkey inthe direction o f compliance with EU standards. The law covers all goods, works, and services- with the exception o f military contracts-and encompasses both budgetary and non-budgetary procurement. It is applicable to central and local government agencies, as well as SEEs. The law establishes thresholds above which foreign bidders cannot be restricted and a domestic preference o f 15 percent can be applied. The new law also stipulates the qualification requirements (including technical and financial criteria) for contractors which will supersede the existing contractor certificate system. The independent Public Procurement Board and Agency (PPA) established under the law to oversee public procurement and ensure enforcement o f the new procurement standards is fully operational. The Bank is providing technical assistance to the PPA under an Institutional Development Fund(IDF) grant and the EUis also providing grant assistance. The secondary legislation required under the Law has been issued by the PPA. Although the new Government initially considered delaying implementation of the law or amending key provisions, inthe end, the new procurement standards came into force on January 1, 2003 as scheduled. InJuly 2003, a set o f further amendments was enacted which authorized limitedprocurement by SEEs under commercial practices. InApril 2004, further amendment was made to exempt from the law certain categories o f procurement transactions conduced by the Privatization Administration (PA), resolve difficulties experienced bythe PA inconducting those transactions; procurement transactions o f a commercial nature undertaken by Turkish Airlines were also exempted by the same amendment. New procurement legislation for SEEs in the public utilities sectors consistent with the relevant EU directive is now being prepared. These initiatives are being closely coordinated with the Bank. 104. Auditing. Effective financial accountability requires extensive modernization o f Turkey's public audit system. The objectives o f reforms in the external audit are: (a) to extend the mandate o f Turkish Court o f Accounts (TCA) to the entire general government; (b) to end TCA's involvement in budget execution; and (c) to transform T C A into an effective supreme audit institution operating in accordance with recognized international standards. These objectives have been facilitated by enactment of the PFMC law. With regard to external audit, the PFMC law clarifies the roles and responsibilities o f the line agencies, the MOF and the TCA, and establishes a principle o f accountability which extends to the heads o f public administrations. It also requires T C A to focus on ex-post financial and performance audit. With regard to the transformation o f TCA, the law: (a) includes all consolidated budget agencies under TCA's annual audit as required by the Constitution, includingthe Presidency and Parliament; (b) subjects TCA's own accounts to external audit with reports submitted to the Parliament; and (c) - 38 - expands the scope o f TCA audits to cover the entire general government agencies and institutionswith a transition period. 105. As with any major institutional reform, the transformation o f TCA into a modem Supreme Audit Institution (SAI) must be carefully designed to build consensus with the public administration. A key objective o f the transition period in the PFMC law i s to provide time for this consensus to be established and for the TCA to reform itself. The TCA will use this transition period to undertake internal reforms to align its institutional structure with international standards for SAIs, to upgrade its audit capabilities, and to reach consensuswith the other government audit bodies on implementation o f the reform. A draft action plan for the TCA's internal reform has been prepared and will be improved, including through a peer review byauditors from other European SAIs. The actionplanwill encompassthe definition of an audit regime for entities such as autonomous bodies which precludes the application of TCA's judicial process to the officials concerned. I t will also address the role o f other existing audit institutions in the transformation of TCA into a full SAI. Among these institutions the Prime Ministry's HighAudit Boardwhich currently audits the social security institutions andthe SEES. 106. The Government is also drafting a new TCA law inline with the external audit structure underthe PFMC Law. The proposedamendments will significantly alter the existing TCA law in several respects. First, the amendments envisage a further extension o f TCA's mandate to cover the general government institutions and also the State Owned Enterprises and to certain other bodies which use public funds or provide public services. Second, the draft law defines performance and financial audit together with compliance audit as the types o f audit to be performedby the TCA. The proposed amendments will have a profound impact on the working of the TCA by enhancing the emphasis on audit work from the current focus on compliance audits andjudicial work. The new legislationwill be submittedto Parliament by December 2004. PublicLiabilitVManagement 107. Efforts to improve public liability management under the PEM reform strategy focus on strengthening debt management and containing the spread of contingent liabilities. These actions complement the energy reforms supported by the ERL that are tackling a key source o f contingent liabilities in the form o f government guaranteed Build-Operate-Transfer (BOT) contracts, as well as the banking reforms under the PFPSAL program that address the buildup o f quasi-fiscal and contingent liabilities inthe banking system which triggered the February crisis. Measures to strengthen public liability management will address other important sources o f contingent liabilities and quasi-fiscal losses, including those arising from take-or-pay contracts for natural gas imports, non-energy BOT projects, and guarantees to municipal and local governments. Table 11presents information on the guaranteeportfolio o fthe Treasury. - 39 - Table 11 :Treasury GuaranteePortfolio (MillionUSD) 2000 2001 2002 2003 ?roiect Guarantees (# of contracts) BOT TEAS 10 10 10 10 BOTAS 1/ 3 3 3 3 Municipality o f Izmit Greater City 1 1 1 1 BO TEAS 5 5 5 5 TOTAL 19 19 19 19 Zredit Guarantees (million $1 2000 2001 2002 2003 Beneficiaries Bv Budget Tvue SOEs 3,485 3,378 3,500 3,178 Financial SOE's 0 0 0 0 N o nFinancial SOE's 3,485 3,378 3,500 3,178 LOCALADMINISTRATIONS 2,112 1,709 1,470 1,290 Metropolitan Municipalities 1,027 848 685 641 Economic Enterprices o f Municipalities 749 548 520 449 Urban Municipalities 74 68 64 51 SubprovincialMunicipalities 116 82 69 58 Local Administration Unions 80 70 47 24 Private Admiministration o fUrban 66 94 85 67 FUNDS 591 560 655 628 Extra Budgetary Funds 591 560 655 628 BANKS 474 399 551 716 Public 410 344 439 414 Investment & Development (T.EXIMBANK, TKB) 410 344 439 414 Private (TSKB) 64 55 112 302 rOTAL 6,662 6,046 6,177 5,812 / TEAS and BOTAShave separate contracts for three natural gas projects and the contracts for these lrojects are included inthe TEAS BOT contracts total above. iource: Treasury. 108. The new Law on Public Finance and Debt Management, enacted in March 2002, has established the foundation for a comprehensive risk management framework in Turkey. The new Law: (i)confirmed that the Treasury is the single borrowing authority for the central government; (ii)created a more prudent and transparent framework for the management of government guarantees; and (iii) established a risk account in the budget, starting with the 2003 Budget, to cover the expected fiscal cost o f called guarantees and unexpected losses from other fiscal risks. In accordance with the law, more .stringent regulations for the issuance of government guarantees and for borrowing by SEESwere issued inApril 2002. The Treasury has established a new "Middle Office" for public liability and risk management. The circular on establishment o f the middle office and a Public Debt Committee to set policy within the Treasury, originally published in September 2002, was reissued in January 2003 with a strong emphasis on the risk control function o f the middle office. The new institutional structure for - 40 - public liability management i s now in place and fully operational. Furthermore, the Middle Office has launched monthly fiscal risk monitoring notes for the Treasury Management, and since April 2003 publishes quarterly Public Debt Management Reports covering risks coming from both its direct debt and contingent liabilities. A review o f the government guarantee portfolio was completed in June 2003, providing a preliminary valuation o f the guarantee portfolio. The Middle Office updates this valuation on a quarterly basis. Starting from January 2004 it has also been implementing strategic risk benchmarks and medium-term borrowing scenarios to manage the portfolio o f direct govemment debt. 109. The Government aims to continue strengthening its capacity in public liability management. To this end, the Government formulated a two-year capacity-building program supported by a grant from the WB's IDF in the amount o f US$320,000. Within the context o f this IDF program, consultants are being identified to assist the Treasury's Middle Office in examining the best international practices in debt and risk management, in strengthening its financial and fiscal risk management practices, and in formulating optimal institutional arrangements for managing the govemment liability portfolios. D. PublicSector Governance 110. Actions to improve public sector govemance aim to reduce political influence over economic management and upgrade the quality and effectiveness o f Turkey's public sector. This agenda includes the preparation and implementation o f a national anti-comption strategy as well as the launch o f a comprehensive civil service reform. These actions complement and are integratedwith the structural fiscal reforms andPEMreforms discussed earlier. Box 5: Priorities under the National Strategy to Enhance Transparency and Good Governance inTurkey's Public Sector Accelerating the completion o f ongoing work, w i t h the framework o f public administration reform, for institutional improvement and financial management. Implementing amendments to the Law on the Contents o f a Declarationo f Wealth, Briberyand Anti-Corruption (No. 3628) inorder to make these declarations public and to require mandatory audits and public access to the declarations for all elected officials. Enacting regulations to ensure that inspections o f campaign financing, income and expenses o f political parties and election candidates are made available to the public. Amending the existing Law on Political Parties to require that political parties and candidates make a public declaration o f contributions from individuals and legal persons above a fixed amount. The HighElections Board will be responsible for publishing and auditing this information. Implementing amendments to the Law on the Prevention o f Money Laundering (No. 4208) to expand the list o f criminal activities giving rise to illegitimate profits and to restructure Financial Crimes Inspection Board (MASAK) inorder to provide investigative powers to M A S A K experts inspecific areas. Creation o f an Inspection and Audit Services Class and passage o f an Inspection Law to put into effect inspection standards, to allow for a complete restructuring o f all inspection and auditing units, and to implement changes to appointment procedures to allow for fixed-term appointment o f presidents. Amending the Civil Service Law (No. 657) to include a specific employment category for inspection and auditing services. Establishing specialised courts to facilitate quick resolution o f corruption cases. Founding specialised units within the security forces and under the supervision and inspection o f the Chief State Prosecutor to investigate corruption cases. Implementingethic agreements inTurkey. -41 - 111. Anti-corruption strategy. A national strategy to enhance transparency and good governance in the public sector was published in March 2002 under the slogan "A Transparent and Clean Turkey: Together Hand in Hand". The objective o f the strategy is to provide a comprehensive framework for improving governance and reducing political influence over the economy which establishes clear priorities and benchmarks, and empowers and energizes public opinion to fight corruption. Priorities under the national anti-comption strategy are summarized inBox 5. The new Government is strongly committed to improve public sector governance in Turkey. The basic structure and actions o f this strategy has been reflected in the recent Urgent Action Plan (UAP) o f the Government. The Government is undertaking efforts to improve public awareness about good governance and is counting on the active contribution o f national non-governmental organizations (NGOs). The Government is committed to implementation o f the UAP which is in line with the framework set out in the national strategy. The ministerial committee for enhancing transparency and improving good governance was established inMarch 2003. The committee will steer relevant actions o f both the UAP and national strategy in this reform area. The responsibility for implementation o f each action is clearly specified in the UAP. The ministerial committee will prepare regular implementation reports for the national strategy within the context o f the UAP. Among a comprehensive set of substantive actions was the enactment o f the L a w on "Freedom o f Information for Citizens" in October 2003. The Government recognizes that this law provides an important new basis for enabling citizens to monitor the performance of public sector. Legislation establishing a code o f conduct for civil servants i s expected to be passed by end-July. The Government is counting on the active involvement o f national NGOs to improve public awareness about good governance. One o f the major national NGOs, Foundation for Economic and Social Studies (TESEV), has completed two diagnostic surveys co-sponsored by the Bank on corruption covering households and the business community respectively. Work on a third survey covering civil servants was delayed bythe local elections. 112. Civil service reform. Sustained improvements in public governance will hinge in large part on effective reform o f the civil service. Indeed, civil service reform features prominently in the national anti-corruption strategy and features in the UAP. Civil service reform is vital to raising the quality o f public services and ensuring the quality o f the fiscal adjustment. The Government has already initiated work on a norm cadre system to establish benchmarks for staffing in public agencies which is now operational within the MONE. There is widespread acknowledgement that a more complete, medium-term approach is needed in order to adapt the civil service to the changing role o f government in Turkey and to internalize the on-going reforms to PEM. Inaddition to questions about the size and composition o f the civil service in a changing Turkey, the reform will need to address issues such as distorted salary incentives, career development requirements and inadequate operational budgets in most agencies. Preparations for the functional review were initiated inmid-2002, but then delayed by the run-up to elections. The functional review has now been re-launched under the responsibility o f SPO and the report will be submitted to the Government in July 2004. The Government is cognizant o f the potential impact o f the measures in the Public Administration Framework Law on the implementation o fboth civil service reform and the results o f the functional reviews. It intends to examine carefully how these processes can effectively be aligned with one another, without slowing down the process o f implementation. - 42 - Box 6: PublicSector ReformProgramSupportedby PFPSALI1and PFPSAL I11 0StructuralFiscalPolicies 9 PFPSAL 11: Under the tax strategy, Special Consumption Tax was introduced and the first direct tax reform package was enacted to harmonize personal and corporate income tax regimes. Public employment monitoring system became fully functional. Under the SEE redundancy program, 28,000 redundancies out o f the 45,800 identified had been eliminated. 9 PFPSAL 111:Functional reorganization of the GeneralDirectorate of Revenues will be completed by end-2004 and this structure will start to be extended to the local level. A majority of the SEE redundancies were eliminated as o f mid-March 2004 and many o f the SEEs were in fact able to reduce the number o f their workers by more than the determined redundancy figure. The overall attrition from SEEs betweenFebruary 2002 and mid-March 2004 has reachedto over 59,000. 0PublicExpenditureManagement 9 PFPSAL11:Thepilotprogramfor the GFSbasedbudgetclassification was underway. Inthe 2002 budget, most extra-budgetary funds and all but one budgetary funds were closed, although the special accounts linked to many o f these funds remained inplace. The Government rationalized the Public Investment Program significantly, cutting the average completion time by 32 percent in2002 to 8.5 years. The average completion time was further reduced in 2003 to an estimated 7.6 years. The say2000i automated accounting system for consolidated budget agencies went on-line in January 2002. The new modified accrual chart o f accounts was being piloted within consolidated budget agencies. The new public procurement agency became operational and the new public procurement law went into effect in January 2003 as planned. Law on Public Finance and Debt Management was enacted followed by secondary legislationto tight government guarantees. A new Debt Management office was established. 9 PFPSAL 111: The PFMC Law was enacted in December 2003, which incorporates modern principles o f public management and addresses a number o f weaknesses inthe current system (see para. 86). The government is currently preparing secondary legislation and regulations necessary for implementation o f the provisions o f the law. Legislation to terminate the special appropriations mechanism close the accounts linked to the closed funds and incorporate their earmarked revenues into the general revenue base has been submittedto the Council o f Ministers inM a y 2004. The PIP rationalization action plan will be revised and strengthened in 2004 to reduce the average project completion time. The new accounting regulation for general government in compliance with GFS requirements was published inthe official gazette o n November 19, 2003. Government Accounting Standards Board will be established by December 2004. A satisfactory new TCA law clearly defining the scope and types o f audits, in conformity with the PFMC law, will be submitted to Parliament. 0PublicSector Governance > PFPSAL 11: A national strategy to enhance transparency and good governance in the public sector was published in March 2002 whose main elements are reflected in the Urgent Action Plan (UAP) o f the new Government. The ministerial committee for enhancing transparency and improving good governance was established in March 2003. Work on civil service reform was revitalized under the UAP. The draft functional review was preparedby SPO. 9 PFPSAL 111: The Law on "Freedom of Information for Citizens" was enacted in October 2003. Legislation establishng a code o f conduct for civil servants will be passed by end-July 2004. The final functional review report will be submitted to the government inJuly 2004. - 43 - E. ProgramContinuity andWB Support 113. PFPSAL I11will provide continued support to the government's program. Under the proposed PFPSAL 111, implementation o f the public sector reform program will be deepened considerably, completing and going beyond the agenda set under PFPSAL 11. The PFMC Law, enacted by the Parliament in December 2003, forms the cornerstone o f the legal framework for modern public expenditure management in Turkey. With the legal framework in place, reform implementation is expected to accelerate prior to release o f the second tranche o f PFPSAL 111. Inthe structural fiscal reform area, functional reorganizationofthe GDR, implementation ofthe comprehensive public employment program, enactment o f satisfactory EBF law are all expected to be completed by the end o f 2004. In parallel, the Ministry o f Finance will prepare the performance budgeting guidelines and the Government Accounting Standards Board will be established. A new T C A law clearly defining the scope and types o f audits, in conformity with the PFMC law will be submitted to the Parliament. Finally, an initial set o f legislation is expected to be adopted in line with the national anti-comption strategy and preparation of the civil service reform strategy is scheduled to be completed by the end o f the year. Box 6 illustrates the key actions completed under PFPSAL I1prior to cancellation o f the second and thirdtranches, as well as the actions foreseen under PFPSAL 111. - 44 - IV. THE BANK'S ASSISTANCE STRATEGY A. Bank Supportfor EconomicReform Trigger Comments I Macroeconomic e Implementationo f a satisfactory macroeconomic Macroeconomic management has been framework consistent with the Country Performance successful with an impressive performance. Indicators included inthe Country Assistance Strategy Most targets were met in 2003. The same Matrix. performance i s expected in 2004. The IMF SBA i s on track and its seventh review was completed on April 16,2004. Structural Sustained sacfactory implementation o f public sector Public sector structural reforms are being reforms, including: satisfactorily implemented including the 9 budget reforms to improve transparency and completion o f the Board conditions under the effectiveness o fpublic expenditure; public sector reform component o fPFPSAL 111, 9 tax reforms to improve efficiency and equity, covering: and promote growth; and 9 enactment of the Public Financial 9 public liabilitymanagement reforms to manage Management and Control Law to financial and fiscal risks. establish the legal framework for harmonizing and modernizing budgetary practice across all o f general governinent. k enactment o f direct tax reform legislation to improve efficiency and equity o f tax system 9 establishment of a debt office and a Public Debt Management Committee in the Treasury to improve liability management. Sustained satisfactory implementation o f regulatory reforms, privatization and liberalization o f the energy The release o f the second tranche o f ERL and telecommunications sectors; and o f the agriculture c o n f m that the triggers related to the reform program designed to replace indirect subsidies sustained implementation o f regulatory with direct income support and promote the reforms, privatization and liberalization o f the development o f agriculture markets. energy and telecommunications sectors and agricultural reformprogram have beenmet. Sustained satisfactory implementation o f financial and private sector reforms, including: 9 continued independence and further PFPSAL I11 i s the main Bank instrument strengthening o f financial markets regulatory supporting these reforms, including: agencies; 9 Drafting and enacting a new banks act 9 completion ofprivatizationofstatebanks; I will provide the banking regulation - 45 - b passage ofan amendedBankruptcy Law; agency with independence and legal protection for banking supervisors when discharging their functions; P adopting and implementing a Road Map to privatize state banks; b enacting amendments to Execution Design and implementation o f the next phase o f a and Bankruptcy Act and issuing comprehensive social security reform. implementation rules. 0 Government is working closely with the Bank on the design o f a comprehensive reform o f the social protection system encompassing social security, health insurance, unemployment insurance, labor market reform and social assistance. Bank support is expected through the PPSAL Ischeduled to be presented to the Board inDecember 2004. Social Maintenance o f public expenditure targets for health, 0 The Government has made progress in education and social protection. strengthening o f Turkey's social protection system and has successfully maintained public spending on health, education and social protection. 115. The CAS envisions a high-case lending program of US$4.5 billion and a low case lending of US$1.3 billion. Under the high case lending program, IBRD debt outstanding and disbursed(DOD) would increase to about US$8 billionin2006. This would represent about 7.4 percent o f the IBRD portfolio, up fkom 3.0 percent in 2000. Financial markets perceive Turkey as a risky country, as seen in the premium on Turkish dollar Eurobonds over LIBOR. Additionally, Turkey has a high external debt burden, with a debt service ratio inthe 40 percent range. Debt service to preferred creditors as a share o f external public debt service i s expected to reach about 40 percent, while IBRD debt service as a percentage o f exports o f goods and services will remainmodest, at 1.2 percent in2006. 116. Turkey's financial and public sector reform program meets all criteria for programmatic lending.6 The proposed PFPSAL I11 and follow-up programmatic loans would continue to support the Government's medium-term reform program which emphasizes structural, policy and institutionalreforms inthe financial and public sectors. 117. Building on the progress achieved under PFPSAL and PFPSAL 11, the PFPSAL 111 program will help Turkey achieve sustainable poverty reduction through macroeconomic stability and growth. The program is articulated in detail in the attached Letter of Development Policy (LDP) (Annex IV). The actions taken prior to Board presentation o f PFPSAL 111and those expected to be taken prior to release o f the second tranche o f the loan are specified in the policy matrix (Annex V). The program i s supported by extensive economic sector work. See Guidelines for Programmatic Adjustment Loansicredits, OPS, February 11,2000. - 46 - Reforms implemented under the program are helping to maintain the confidence earned by the new government which has demonstrated its determination to resolve the pending structural weaknesses which caused significant instability inthe past. B. The Bank'sFinancialSector AssistanceStrategy 118. The Bank's assistance to Turkey in the financial sector i s aimed at assisting the authorities incontinuing the reform of the sector. The ultimate result beingpursued is a safe and sound financial sector that will not constitute a source o f macroeconomic risk and which will increasingly finance the investments required for the economy to grow. 119. The first phase o f financial sector reform following the 2001 banking crisis focused on urgent priorities including bringing the regulatory and institutional framework o f the banking sector closer to international best practice, restructuring and cleaning up the private banks, and the financial and operational restructuring o fthe state banks. 120. A degree o f stability has been achieved inthe banking sector, and the emphasis is now on consolidation and sustainability of the remaining reforms required to develop the sector. The next phase o f reform, supported under PFPSAL 111, focuses primarily on making the banking act fully consistent with EU principles and strengthening and increasing the independence o f the Banking Regulation and Supervision Agency (BRSA) and the Savings Deposit Insurance Fund (SDIF), privatization o f the state banks, sales o f non performing assets held by the SDIF, and improving the EBA. 121. The Bank's strategy is based on the notion that development o f a broader and deeper financial sector i s essential for sustained financial stability and economic growth. This will be essential to improve real sector access to a wider range o f modem financial products and services; to improve access to finance for a broad range o f economic agents, including SMEs, micro-enterprises and low income earners; andto reduce the systemic risks inthe financial sector through diversification. Completion o f the reform agenda in the banking sector is key for the ongoing process o f economic recovery. 122. This Bank's support for financial sector reform started under the F S A L and continued with the PFPSAL Iand I1 and the proposed PFPSAL 111. Two subsequent Programmatic Financial Sector Adjustment Loans (PFSAL Iand 11) are planned, the first falling in the current CAS period. The reform program supported by this sequence o f loans have and will strengthen the foundation for an efficient and healthy banking system that could be competitive in quality and performance at the international level; reduce its vulnerability to external shocks; and position Turkey's banking system for EU accession. PFPSAL 111, as the two previous Loans, focuses on: (i) the legal and regulatory framework for banking; (ii) privatization o f state- the owned banks; and (iii)creditor rights and corporate restructuring. PFSAL Iwill assist in completing this agenda and in regulatory issues related to capital markets, insurance and other non-bank financial institutions. During this CAS period, the Bank will also prepare a SME Finance Loan which will provide financing for investments required for increasing access to investment capital by SMEs. These investments will trigger rapid harvesting o f the benefits that will follow the policyreforms supported under PFPSAL I11andPFSAL. - 4 1- 123. The Bank's assistance has been and will continue to be closely coordinated with International Finance Corporation (IFC) and the International Monetary Fund (IMF). The Bank has taken the lead with respect to the reform o f the legal framework and regulations for bank supervision, the institutional development o f the regulatory bodies, and the reforms required to restructure and improve the governance o f the state banks leading to their ultimate privatization as well as the sector work on non-bank financial institutions. The IFC strategy focuses on: (i) assisting the authorities with the sale o f intervened banks, as appropriate, and o f the non- perfonning loans o f these banks; (ii) working with mid-sized banks to strengthen their balance sheets and to use them as a platform in the consolidation process; (iii) continuing with efforts aimed at institution building and the introduction o f new products. The IMF has taken the lead inassessing the soundness ofthe banking system andwhere there has beenan immediate macro- fiscal impact such as the re-capitalization of the state banks, the closing o f insolvent banks, and the private bank re-capitalization scheme. -N 0 0 -N $- m C Y - 49 - C. The Bank's Public Sector Assistance Strategy 124. The Bank's public sector assistance strategy is based on a carefully sequenced series of lending operations backed by extensive economic and sector work and other non-lending services, Drawing a lesson from experience, the current assistance strategy exploits the advantages o f the programmatic approach to support a comprehensive medium-term program to modernize the public sector for which political support has been obtained in advance from the highest levels o f government. The emphasis inthe early stages of the program has beenon the preparation o f medium-term strategies underpinned by economic sector work in the critical reform areas (including PEM, taxation, public employment, and anti-corruption). The articulation o f these strategies and the involvement o f high-level steering committees in their formulation and implementationhas helpedbuildboth intemal consensus as well as the political and bureaucratic muscle needed to ensure effective implementation. Elements of the Bank's strategy o f lending andnon-lending assistanceinthe public sector are presented inFigure 4. 125. ERL - 2000. The first phase of the reform was supported by the ERL. It involved measures to underpin the initial fiscal adjustment in 1999-2000, and a first round o f budget reforms including closure of two groups o f budgetary EBFs inDecember 1999 and March 2001. The ERL program also encompasses implementation o f the structural reform agenda for social security, energy, agriculture and telecommunications which helps underpinthe fiscal adjustment and contain the growth o f quasi-fiscal and contingent liabilities. The analyticalbasis for the ERL program was provided in large part by the CEM on Structural Reforms for Sustainable Growth (September 2000) which confirmed the public deficit as the core source o f macroeconomic instability inTurkey and detailed reforms insupport o f fiscal adjustment and growth. 126. PFPSAL - 2001. The second phase o f the public sector reform was initiated by work on the PER which provided an in-depth diagnosis o f the operational and institutional problems confrontingpublic sector management and outlined a strategic framework for PEM reform. The PEIRwas complemented by due diligence economic and sector work inthe form o f the Country Procurement Assessment Review (CPAR) and Country Financial Accountability Assessment (CFAA) which reviewed the status of financial accountability in Turkey and developed recommendations for reform. This analytical work provided much o f the analytical framework for the first PFPSAL approved in July 2001. The first PFPSAL focused on establishing the strategy for a full-scale public sector reform program including the strategic framework for PEM reform developed inthe PEIR, a strategy for deeper structural fiscal reforms centered on tax and public employment policy, and the preparation o f a national anti-comption strategy. Inaddition to economic and sector work, the Bank supported this effort through two international conferences designed to increase public awareness and expose Turkey to international experience andbest practice. 127. PFPSAL I1 2002. The PFPSAL I1initiated the shift from design o f the public sector - reform strategy to reform implementation, particularly improvements to the legal framework and a first phase o f institution building. Milestones under the PFPSAL I1program included: (i) rationalization o f the PIP, (ii) enactment o fthe new public procurement law and establishment o f the PPA, (iii) enactment o f the public debt management law and creation o f the middle office for debt and risk management inthe Treasury, and (iv) preparation of the PFMC Law which is the cornerstone for modernizationo f fiscal management inTurkey. - 50 - 128. PFPSAL I11 - 2004. Under the proposed PFPSAL 111, implementation o f the public sector reform program will be deepened considerably, completing and going beyond the agenda set under PFPSAL 11. The PFMC Law, enacted by the Parliament inDecember 2003, forms the comerstone o f the legal framework for modem public expenditure management inTurkey. With the legal framework inplace, reform implementation i s expected to accelerate prior to release o f the second tranche of PFPSAL 111. Inthe structural fiscal reform area, functional reorganization o f the GDR, implementation o f the comprehensive public employment program, enactment o f satisfactory EBF law are all expected to be completed by the end o f 2004. In parallel, the Ministry of Finance will prepare the performance budgeting guidelines and the Government Accounting Standards Board will be established. A new T C A law clearly defining the scope and types o f audits, in conformity with the PFMC law is submitted to the Parliament. Finally, an initial set o f legislation i s expectedto be adopted inline with the national anti-corruption strategy and preparation o f the civil service reform is scheduled to be completed by the end of the year. 129. PPSAL Iand I1- 2004-06. The assistance strategy going forward envisages two PPSALs under the CAS to support continued implementation o f the public sector reform agenda. The PPSAL Ienvisages to support a " four pillar'' comprehensive, efficient, inclusive and modem social security system. The four pillars are: (a) unified pension system, (b) universal health insurance, (c) modem labor market and employment services system, and (d) efficient social assistance and social services system. The PPSAL Imay also include support for the completion o f PFPSAL reforms. Buildingupon the seminal Public Administration Law, the PPSAL I1will support the recently initiated public administration reform. Reforms to local government will be another area for consideration drawing on the analysis and recommendations o f the Municipal Sector Review completed in 2002. The PPSALs will also be grounded on the analysis in the C E M focused on economic recovery and medium-term growth completed in2003. W 0 . N 0 0, 0 P 3 CI m d 0 0 N e, L .I)E a a" d 0 " 0 e, a c1 1 v) 4w f c - 0 N 0 x -r f 0 0 0 N L e, I) * eg VI - 52 - D. Program Triggers and Outcome Indicators 130. The Bank is supporting Turkey's financial and public sector reform program through a series o f Programmatic Adjustment Loans. The triggers for the proposed PPSAL and PFSAL operations to follow on PFPSAL 3 are presented in Table 13 together with indicative benchmarks for PPSAL I1and PFSAL I1and the outcome indicators for the program as a whole. The indicative benchmarks for PPSAL I1and PFSAL I1will be transformed into triggers at the time of Board presentation of PPSAL and PFSAL, respectively, taking into account actual developments on the ground. Establishing triggers helps in evaluating implementationprogress andthe appropriate timing for eachfuture programmatic loan inthe series. Table 13: Progi n Triggers and Outcome Ind :atom Area PFSAL I& PPSAL I PFSAL I1& PPSAL I1 Outcome Indicators Triggers Indicative Benchmarks Macro- Satisfactory Satisfactory Macro and financial framework macroeconomic program macroeconomic program stability conducive to including track record for at including track record for at investment, growth, and least 2004 (43) to be least 2005 (43) to be employment generation. evaluated on the basis o f the evaluated on the basis o f the overall program and with overall program and with respect to key economic respect to key economic variables. variables. Actual public expenditure Satisfactory budget for Satisfactory budget for on health, education and social 2005 is adopted which is 2006 is adopted which is protection is sustained at pre- consistent with the consistent with the crisis levels. The benchmarks, Government's Government's as shares o f GNP, are macroeconomic objectives macroeconomic objectives education: 4.25% and continues to allocate and continues to ensure health: 3.25% satisfactory expenditure satisfactory expenditure social protection: 7.0%. envelopes for health, envelopes for health, education and social education and social protection. protection. Financial A new banking act has An improved regulatory Turkey has a financial Sector been enacted and draft framework for NBIs has been sector o f which the large improvements to the submitted to Parliament for majority i s controlled by the regulatory and supervisory approval. private sector and that i s framework for NBIs have financing increasing portions o f beenprepared. The existing regulations the investments required by the The state banks have for all types o f financial productive sector to grow and been restructured and intermediaries are effectively compete effectively in offered for sale to the enforced. international markets. private sector. Public Agreement on draft * A Government's Turkey has a public Sector legislation on: comprehensive public admmistration that provides Unified social a m s t r a t i o n reform enhanced public services, security system. programhas been elaborated. including social protection, to its Universal health population by an effective public insurance. sector. Social assistance. - 53 - V. THE PROPOSEDLOAN A. PFPSALI11Objectives and Description 131. The main objective o f PFPSAL I11 i s to support implementation during 2004 o f the Government's financial and public sector reform priorities and ensuring that social programs are adequately funded and increasingly better targeted. K e y reform priorities in the financial sector include: (i)strengthening the regulatory framework for banking; (ii)building institutional capacity at the Banking Regulation and Supervision Agency (BRSA) and Saving Deposits Insurance Fund (SDIF), (iii)resolving problem and failed banks, (iv) restructuring and privatizing state banks, and (v) improving the corporate insolvency regime. Key reform priorities in the public sector include: (i)deepening o f structural fiscal policies in support o f sustainable fiscal adjustment, (ii) implementing public expenditure management (PEM) reforms covering budget planning and execution, financial accountability, and public liability management, and (iii) strengthening public sector governance including implementation o f the national anti-corruption strategy and preparation o f civil service reform. Priorities for social spending include: (i) adequate expenditure for health, education and social protection inthe 2004 budget and (ii) better targeting o f social protection. 132. The proposed PFPSAL I11o f US$1 billion on standard IBRD terms is the third loan in support o f the Government's multi-year financial and public sector reform program. It follows on the first PFPSAL o f US$1.1 billion approved in July 2001 (US$700 million on standard IBRD terms and US$400 million on SSAL terms) and the PFPSAL I1 o f US$1.35 billion approved inApril 2002 (US$550 million on standardIBRD terms and US$SOOmillion on SSAL terms). As with the first PFPSAL and PFPSAL 11, the PFPSAL I11 operation will provide budgetary support to help the Government defray the costs o f implementing its reform agenda while continuing to fund critical social programs. The subsequent programmatic operations in the financial and public sectors planned under the CAS will support the sustained effort by the Government inthe next few years. 133. The Bank agreed with the authorities to prepare PFPSAL I11on standard IBRD terms, while PFPSAL I1was partially on standard terms and partially on SSAL terms. The early elections and subsequent establishment o f the new Government, coupled with external developments including the war in Iraq, led to delays in the realization o f the Bank's high-case assistance program. The second and third tranches o f PFPSAL I1were cancelled at the request of the authorities. The preparation o f PFPSAL I11 supported the new Government's determination to take full ownership o f the financial and public sector reform program and make a strong public commitment to the program's objectives. It also facilitated the fine-tuning o f the program in line with the Government's policy priorities and the required adjustment o f the timetable for particular program benchmarks in accordance with actual developments over the past year. 134. Partial front-end fee waiver. The Government has requested a partial waiver o f the front- end fee on the proposed PFPSAL I11in consideration o f the fee already paid on PFPSAL 11. The front-end fee for PFPSAL I1amounted to US$13,500,000 paid to the Bank by Turkey from the first tranche disbursement o f US$450,000,000 on August 15, 2002. A total o f US$534 million - 54 - on SSAL terms (Loan No. 4657 TU) and US$366 million on IBRD terms (Loan No. 4656 TU) remained undisbursed under the second and third tranches o f PFPSAL 11. As the US$366 million undisbursed under the PFPSAL I1loan on standard IBpDterms (Loan No. 4656 TU) is being folded into the new programmatic operation, US$3,660,000 o f the front-end fee o f PFPSAL 111would be waived. This amount is equivalent to the front-end fee already paid for the second and third tranches o f the loan on IBRD terms under PFPSAL I1which were cancelled (Loan No. 4656 TU). While new elements have been added to the financial and public sector reform program supported by PFPSAL I11and the phasing o f some actions was modified, the continuity o f the program has been maintained, providing justification for the Government's waiver request. B. LessonsLearnedfromPFPSAL andPFPSALI1 135. The combination o f financial and public sector reforms under the PFPSAL operations proved useful in supporting Turkey's program to respond to the 2001 crisis. This combination provided important synergies, most importantly ensuring consistency between fiscal adjustment and the financing requirements o f the front-loaded bank restructuring program. The results in terms o f economic recovery, disinflation and debt sustainability have been impressive. 136. The programmatic approach allowed for a reasonable degree o f adaptability to unfolding events on the ground while maintaining overall coherence and direction o f the reforms. The single tranche PFPSAL provided substantial up-front support in the critical period immediately following the February 2001 crisis, while the multi-tranche structure of PFPSAL I1provided the necessary flexibility for the Bank to calibrate its financial support in accordance with actual implementation o f specific reform measures. As the emphasis o f the Government's program is shifting from crisis recovery to sustaining growth over the medium term, the Bank is planning to shift to separate programmatic public sector adjustment loans (PPSALs) and programmatic financial sector adjustment loans (PFSALs) under the current CAS. This shift will allow the Bank's assistance program to take account o f the differing implementation requirements for the public and financial sector reform programs, including supplementary technical assistance and related investment financing. 137. Events inTurkey and elsewhere have shown that the programmatic approach is subject to political change, and that flexibility is needed to adjust to the priorities and timetable o f a new government. While the run-up to the November 2002 elections resulted in implementation delays, the PFPSAL I1program provided the new Government with an established framework for core financial and public sector reforms. The new Government demonstrated its commitment to the program by adopting the April 2003 roadmap. However, the Iraq war and other internal and external developments led to further implementation delays which required adjustments in the timing and design o f key conditionality under the program. Upon the Government's request, the remaining tranches o f PFPSAL I1(a mix o f SSAL and IBRD terms) were cancelled in June 2003 and work began o n PFPSAL I11 (fully on IBRD terms). As PFPSAL I11preparation progressed, the Government continued to articulate its reform strategy, particularly with regard to the DIS and financial sector reform. This resulted inextended negotiations o f PFPSAL I11and led to improvements in the conditionality that reflect stronger ownership and conditions better calibrated to recent events. - 55 - 138. Nonetheless, this flexibility indeed allowed continuity o f the program as PFPSAL I11 encompasses the key outstanding objectives foreseen under the second and third tranches of PFPSAL 11, including further progress o n the state bank agenda, as well as additional conditionality in areas where implementation under PFPSAL I1ran into delays. The renewed Government commitment to program implementation was highlighted by passage o f the PFMC law in mid-December. Sustained implementation of the public and financial sector reforms over the medium term is a priority for the new C A S under the planned PPSALs and PFSAL. C. BenefitsandRisks 139. Benefits. The principal benefits of the PFPSAL I11 Loan will be to: (i)support the Government's efforts to create the conditions for sustained growth and macroeconomic stability, (ii)ensure adequate social expenditure and better targeted social protection, (iii)restore confidence in the banking system, (iv) strengthen the foundation for an efficient and sound bankingsystem which can be competitive inquality and performance at the international level, (v) reduce the vulnerability o f the bankingsystem and enhance its capacity to withstand external shocks and thereby reduce systemic failure risk, (vi) position Turkey's banking sector for accession to the EU by aligning the prudential regime with applicable EU banking sector directives, (vii) improve the sustainability and quality of the fiscal adjustment needed to achieve macroeconomic stability, (viii) lay the foundation for durable improvements to PEM and fiscal transparency in line with international standards, and (ix) raise the quality of public sector governance. 140. Risks and mitigating measures. Turkey has embarked on an impressive financial and public sector reform agenda in the post-2001 crisis period. Although significant progress has been achieved in implementing the core reform agenda, Turkey's financial and public sector reform programstill entails significant risks, but these continue to be outweighed by the benefits of the reforms and the risks of not proceeding. Sustained implementation o f these reforms is necessary to overcome the risks to the program. The major, domestic along with external, risk factors include: policy slippages that would impact public debt sustainability, 0 external vulnerability, 0 spillover from global liquiditytightening, EUdecision short ofexpectations, 0 banking sector weaknesses. 141. All ofthese factors pose a risk to the macroeconomic stability throughweakening market confidence. Sustainability of the public debt, which is critical to macroeconomic stability, will hinge on continued implementation of strong macroeconomic policies and structural reform policies. High debt rollover ratios mean that a slide in the credibility attached to the government's reform implementation program will put the economy on a high interest rate- accelerating inflation-poor growth spiral, adversely affecting the vulnerable public debt dynamics. The active support of the Bank is instrumental in providing credibility to the Govemment program and, thereby, mitigating these risks. Sustained implementation o f the - 5 6 - reform program is also necessary to maintain market confidence. The Bank's assistance strategy for financial and public sector reform incorporates significant mitigation measures; however, untilthe reforms are fully implemented, Turkey will remain vulnerable to a range o f exogenous shocks. 142. Reformprogress has mitigated a number o fmacroeconomic risk factors, but the economy remains vulnerable. The floating exchange rate regime introduced in 2001 has increased the economy's ability to absorb shocks. Systemic risks in the banking sector are being addressed, the state banks have been re-capitalized, and the open foreign exchange position o f the banking sector has moved close to balance. Central bank independence and the newly established regulatory bodies for banking, energy, telecommunications and public procurement are helping to de-politicize economic management in line with intemational and EU norms. Structural reforms since 1999 have helped shift the primary fiscal balance from deficit to surplus and the legal framework for better fiscal management is being gradually put inplace. Stronger economic and fiscal management, coupled with steadily improving financial accountability and oversight, will assist sound program implementation and reduce the risk o fbacktracking. Nevertheless, the problems o f Turkey's banking sector and public finances will take time to resolve, and the country will remain vulnerable to intemal and extemal shocks over the medium term. The effectiveness o f the floating exchange rate as an adjustor will be limited for some time to come bythe large public debt a substantial share o fwhich is inforeign currency. 2000 2001 2002 2003 2004 2005 2006 Net Public Debt 58.3 93.9 78.8 70.1 65.7 62.3 58.8 Domestic Debt Stock 39.3 56.2 46.7 48.0 44.9 43.4 44.7 Domestic Interest Payments I/ 14.9 14.9 14.7 12.7 12.2 10.0 9.8 Dom.Debt Amortization 12.9 23.2 24.6 24.1 27.5 32.0 32.5 PSBR 21 18.9 21.1 12.1 9.9 6.4 5.1 4.6 i Macroeconomic Indicators 2000 2001 2002 2003 2004 2005 2006 ~ , CPI Inflation 39.0 68.5 29.7 18.4 12.0 8.0 5.0 Depreciation (DeciDec) 24.8 115.3 13.3 -15.0 4.2 8.0 5.0 REER@ec/Dec) 13.7 -24.0 11.1 35.2 4.4 -2.9 -2.9 GNP growth rate (%) 6.3 -9.5 7.9 5.9 5.0 5.0 5.0 Primary Balance (%o fGNP) 2.7 5.5 4.1 6.1 6.5 6.5 6.5 143. Public debt sustainabilitv. Under the program baseline, the net public debt to GNP ratio, which has fallen from a high o f 94 percent in 2001 to 79 percent in 2002 and to 70 percent in 2003, is projected to fall further to 66 percent at the end o f 2004 (see Table 14). Extendingthe programmed trends for the key macroeconomic parameters, including growth, interest rates, exchange rate and the primary surplus, results in a further steady decline in the public debt to GNP ratio, reaching below 60 percent levels in 2006. Realizing this outcome hinges on sustained growth, continuous fiscal adjustment (a primary surplus o f 6.5 percent o f GNP) and stable exchange rates. While the strong Lira has underpinned the fall in inflation and decline in - 57 - the public debt to GNP ratio, the extent o f the exchange rate appreciation and current account deficit that have accompanied growth in economic activity, has generated additional sources o f macroeconomic risk. 144. A sensitivity analysis o f the public debt dynamics demonstrates the central role o f credible policies to build confidence and deepen the fiscal adjustment. The level and structure o f Turkey's public debt leave the Treasury's borrowing program vulnerable to a potential loss o f market confidence. The short average maturity o f the domestic debt leads to high monthly rollover requirements. Foreign exchange exposure is another important determinant. Turkey's crisis response program has featured debt swaps by the Treasury to eliminate the excess open FX position of the banks, together with increased FX and FX-linked borrowing. As a result, the share o f FX andFX-linked debt inthe total public debt stock has risen sharply. Moreover, a high proportion o f the domestic debt is in floating rate notes which increases exposure to interest rate movements. Finally, a very substantial share o f Turkey's public debt is to preferred creditors. 145. To illustrate the risks, a low-case scenario can be formulated where the political will to strengthen the fiscal program falters and the primary surplus does not exceed 4 percent o f GNP. As a result, real interest rates could be in the 20 percent range, i.e., well above the projected program path. The recovery would be expected to falter under the burden o f sustained highreal interest rates with growth falling to 2 percent per year. A slowdown in the recovery and deterioration in the public debt dynamics could lead to renewed capital account outflows and exchange rate instability which would exacerbate the impact on the debt burden. Under these conditions, the public debt burdencould begin to rise and debt to GNP increases to unsustainable levels. This analysis underscores the critical need for the Government to strengthen its commitment to its reform implementation, by means necessary for the international (and domestic) investors to have renewed confidence inthe program. 146. External financing. Turkey faces a serious external financing challenge over the medium- term which relates to both the magnitude and the composition o f this financing. Annual gross financing requirements although declining from US$26 billion in 2004 will remain large at US$19 billion by 2006 (Table 15). Moreover, a change in the composition o f financing from public sector to private sector and from short to longer term would be beneficial. Turkey needs to generate enough capital inflows to: (a) finance a moderate current account deficit o f between US$8 billion to US$9.5 billion linked to sustained recovery, (b) service sizeable long term loan repayments including net repurchases from the IMF set to increase from US$2.9 billion in 2004 to US$11.6 billion in2006, and (d) keep short-term debt inflows at supportable levels. Increased FDI is, therefore, key to successfully meeting this challenge without adding to the already considerable external debt burden. Given its location, size, and expected EU accession, Turkey could attract a multiple o f the US$1.6 billion projected for 2004. Recent history, including the 2001 crisis aftermath, indicates the responsiveness o f Turkey's current account to shocks, although at a significant cost to growth. Moreover, the improving level o f Central Bank gross reserves (nearly US$33.6 billion as of early May) could provide some additional cushion in case of a severe external shock. Naturally, the scope for a reserve draw-down is limited and could raise investor concerns about the longer-term external payments picture. The stock o f external debt reached US$143 billion by the end o f 2003, equal to about 61 percent o f GNP, o f which about US$23.5 billion in IMF credit. Looking ahead, the extent to which Turkish banks and enterprises will be able to roll over their external obligations and attract new financing on - 58 - favourable terms will remain an important determinant for the program. The reliance on private capital inflows will increase in 2005-06 when Turkey will face annual repayments to the IMF averaging US$9.6 billion. Table 15: External FinancingRequirements and Sources, 2000-2006 (in billions of US dollars) Actual Estimate Program 5/ Projection 61 2000 2001 2002 2003 2004 2005 2006 lross financing requirements 25.9 10.5 24.2 30.1 25.8 21.2 18.6 Currentaccountdeficit (excl. official transfers) 10.0 -3.2 2.0 7.1 9.5 8.0 8.2 Amortization on debt securities, olw: 1.7 2.1 2.7 3.9 3.5 3.2 2.6 Public sector 1.4 2.0 2.3 3.8 3.5 2.8 2.5 Depositmoneybanks 0.4 0.0 0.4 0.2 0.0 0.4 0.1 Mediumand long-termdebt amortization,o/w: 13.8 14.3 13.4 15.0 15.6 14.6 14.8 Public sector I/ 3.6 3.6 3.0 3.2 3.5 3.3 3.1 Private sector 7.9 8.9 8.8 10.4 11.0 9.9 10.2 Deposit moneybanks 2.3 1.9 1.6 1.4 1.1 1.4 1.5 Accumulationofgross reserves 0.4 -2.7 6.2 4.0 -2.8 -4.5 -7.0 vailable financing 25.9 10.5 24.2 30.1 25.8 21.2 18.6 Foreign direct investment(net) 0.1 2.8 0.9 0.1 1.6 1.8 2.2 Portfolio flows 3.4 -1.7 4.2 7.9 8.1 8.5 8.7 Public sector 7.5 2. I 3.3 5.3 5. I 5.6 5.8 Depositmoneybanks 0.5 0.0 0.0 0.0 0.1 0.2 0.2 Privatesector (net) -4.6 -3.8 0.9 2.6 2.9 2.7 2.7 Mediumandlong-termdebt financing, o/w: 18.1 13.2 15.7 14.1 16.8 14.8 15.4 Public sector I/ 3.4 3.2 2.9 0.7 2.8 2.2 2.2 Privatesector 12.8 9.2 11.5 11.9 12.1 10.9 11.2 Depositmoneybanks 1.9 0.9 1.3 1.4 1.9 1.8 2.0 Short-termdebt financing(net) 3.6 -12.6 -3.3 2.6 1.9 2.5 3.2 Official transfers 0.2 0.2 0.5 0.3 0.4 0.5 0.7 Other 21 -2.8 -1.7 -0.1 5.2 0.0 0.0 0.0 IMF (net) 3.4 10.2 6.4 -0.1 -2.9 -7.0 -11.6 Purchases 3.4 11.3 12.5 1.7 1.9 0.7 0.0 Repurchases -0.1 -1.1 -6.1 -1.7 -4.7 -7.6 -11.6 emo :t official inflows 4.2 11.3 7.0 0.5 -1.8 -6.0 -11.4 I/WWorld Bank (updated09/03) 0.8 1.1 0.6 0.6 1.0 1.o 0.2 )tal ExternalDebt 118.7 113.8 131.3 142.9 145.3 143.7 137.9 `w Short-termDebt 28.3 16.2 15.2 18.7 20.8 23.0 25.3 )tal ExternalDebUGNP 59.0% 79.0% 72.3% 60.6% 48.4% 45.1% 40.4% :bt Service Ratio 3141 35.4% 43.8% 37.8% 37.8% 37.0% 36.0% 36.8% GeneralgovemmentandCentralBankof Turkey. Errors and omissions. Interestplus medium-and long-termdebt repayments including IMF repurchasesas percent ofexports ofgoods andservices. 2002 figure doesnot includethe SRF repaymentso f $6.1 billion. IMF 7th review figures. World Bank estimates. 147. External factors. In early 2004, the fears o f overheating in the U S economy and expectations o f an interest rate increase by the U S Federal Reserve earlier than originally envisaged has started to put pressure on the emerging market economies including Turkey. As o f early May, the EMBIspread for Turkey haswidened to above 500 basis points from 200 basis points in early April. Inaddition, the market participants are increasingly looking for an anchor for the economic program beyond 2004. The lack o f clear prospects for receiving a date from EU in December 2004 to start accession negotiations is also a risk to the fragile market sentiment. Prospects o f EU accession can serve as a powerfbl anchor for the program. A - 59 - negative decision by the EU in December can be expected to cause some reactions in financial markets. A mitigating factor will be ifthe authorities move forcefully on a program o f structural reforms in 2004 that will substitute for the EU anchor. In any event, geo-political events since September 11, 2001 have provided markets with some comfort that Turkey will have support from the international community regardless o f the EUdecision. 148. Bankina Sector. A stress test was conducted to assess the impact on the banking sector o f a purely hypothetical and, at this point, unlikely macroeconomic shock. The stress test simulated the impact o f a simultaneous increase in interest rates o f 30 percentage points, an increase in NPLs o f 20 percent, and 15 percent depreciation o f the Lira. The simulation measured the losses or gains incurred directly as a result o f the banks' on and o f f balance sheet positions. 149. The main result o f the analysis is that the solvency o f the system i s robust and only somewhat sensitive to such scenario as the resulting aggregate capital adequacy ratio (CAR) would remain at 15 percent which is about twice the regulatory requirements. Interest risk and credit risk are the main contributors to the hypothetical reduction inbanking sector capital. Net open foreign positions are very small for all banks outside SDIF, so the system i s not directly exposed to exchange rate shocks. 150. While there could be some individual bank failures under this scenario, such failures are unlikely to cause a systemic crisis because the inter-bank credit market in Turkey is small at about 3.5 percent o f total banking sector assets. Also, Turkish banks are highly liquid due to their large holdings o f Government debt securities, andunless the individualbank failure leads to a disruption o f that market, which is unlikely, the system will not experience liquidityproblems. D. Conditions for Board Presentation and Release of the Second Tranche' 151. The proposed PFPSAL I11will be disbursed in two equal tranches. The actions listed below are conditions for Board presentation and second tranche release as noted. The backbone of the structural conditionality for PFPSAL I11 consists of the outstanding conditions for PFPSAL I1second and third tranches. A number o f the conditions for release of the second and thirdtranches o fPFPSAL I1have already beenmet. The remaining outstanding conditions have been incorporated into the Board presentation and second tranche conditions for PFPSAL 111. In the key areas o f the program where there have been problems, new conditionality has been added. These areas include: (i) implementation o f the DISprogram for farmers, (ii) maintenance o f BRSA's independence and support for its institutional development, (iii) completion o f all necessary actions to prepare VB for privatization, and (iii)elimination o f the system o f earmarked revenues and expenditures left in place after closure o f most budgetary funds and EBFs. In several other areas, PFPSAL I11goes beyond the agenda set under PFPSAL 11, for example, new benchmarks for 2004 are being set under the tax strategy and public employment program. operational and financial autonomy o f BRSA, and privatization o f VB-new Paragraph numbers next to the Board and second tranche conditions refer to the relevant paragraph inthe attached Letter o fDevelopment Policy. - 60 - conditionality has been added. For the second tranche of PFPSAL 111, the core conditions are included in the legal agreement. The timing o f tranche release will depend on the actual fulfillment o f the agreed core conditions. For further details see the policy matrix (Annex V). BoardPresentation I. MacroeconomicEnvironment 0 Satisfactory macroeconomic program including track record for at least 2004 (Ql) to be evaluated on the basis o f the overall program and with respect to inflation, consolidated government sector budget, new external public debt and current account balance (para. 5). 0 Agreement is reached on medium-term agriculture policy paper including satisfactory provisions for DIS (para. 7). 11. BankingReform B. Institutional Development o f BRSNSDIF 0 Agreement has been reached on the principles, scope, and contents o f satisfactory and comprehensive set o f draft amendments to the Banking Act that will be submitted to the Council o f Ministers (para. 16). B. State Bank Restructuring; and Privatization: 0 The Government has made the decision to hire consultants with adequate experience and qualifications under satisfactory TORs to carry out a due diligence o f VB. The process o f selecting consultants with adequate qualifications and experience to carry out the due diligence activities has been launched (para. 19). 0 The Government in collaboration with Ziraat and Halk have prepared satisfactory TORs to engage strategic advisors to formulate a privatization strategy which includes required prior restructuring actions (para. 21). 111. Public Sector Reform B. Public Expenditure Management: Satisfactory EBF law is submitted by the Council o f Ministers to Parliament (para. 35). - 61 - SecondTranche I. MacroeconomicEnvironment 0 Satisfactory macroeconomic program including track record for at least 2004 (43) to be evaluated on the basis o f the overall program and respect to inflation, consolidated government sector budget, new external public debt and current account balance (para. 5). 0 Agriculture framework law i s enactedincluding satisfactory provisions for DIS (para. 7). 11. BankingReform A. Regulatory Framework for BankingActivity: 0 Satisfactory amendments to the Banking Act have been enacted and are being implemented (para 16). 0 Implementation o f BRSA strategic plan and SDIF institutional development strategy is satisfactory (para. 16). B. StateBank Restructuring and Privatization: 0 The Government has reviewed the due diligence report and the Council o f Ministers has adopted a satisfactory strategy to bring about private sector control o f VB and such strategy i s being satisfactorily implemented(para. 18). 0 The Council o f Ministers has adopted a satisfactory restructuring and privatization strategy for Halk and Ziraat and such strategy i s beingsatisfactorily implemented(para. 21). C. Executionand Bankruptcy Act: 0 Theregulations for the amended EBAhave been satisfactorily implemented(para. 23). 111. PublicSector Reform A, Structural Fiscal Policies: 0 Implementationo f the medium-termstrategy to improve the tax system is satisfactory (para. 27). 0 Implementationo fthe comprehensive public employment programi s satisfactory (para. 28). 0 Satisfactory EBF law i s enacted (para. 35). C. FinancialAccountability: 0 A satisfactory new TCA law clearly definingthe scope and types o f audits, in conformity with the PFMC law, is submittedto the Parliament (para. 46). lj.c Public Sector Governance: - 62 - Legislation establishing a satisfactory code o f conduct for civil servants is enacted (para. 49). Progress inpreparation o f civil service reform strategy is satisfactory (para. 50). E. FinancialManagement 152. The Undersecretariat o f Treasury has in place adequate accounting and financial management reporting systems for the Deposit Account under the loan. The Treasury will maintain records o f all transactions under the loan in accordance with sound accounting practices. The Government will submit to the Bank a monthly receipts and payments account showing the transactions on the Deposit Account, starting with the receipt o f the first tranche o f Bank funds and ending when the final tranche o f loan funds has been received and the balance on the Deposit Account has been reduced to nil. The Borrower shall: (a) have the Deposit Account audited in accordance with appropriate auditing principles consistently applied by independent auditors acceptable to the Bank, (b) furnish to the Bank as soon as available but in any case not later thanfour months after the date o fthe Bank's request for such audit, a certified copy o f the report o f such audit by said auditors o f such scope and in such detail as the Bank shall have required, and (c) furnish to the Bank such other information concerning the Deposit Account and the audit thereof as the Bank shall have reasonably requested. The audit will be camed out at intervals agreed with the Bank, calculated from the date the first tranche o f loan funds is paid into the Deposit Account, with suitable adjustments o f timing depending on the funds left inthe Deposit Account at any point in time. The terms of reference for the audit will be agreed between the Bank and the Borrower. Audits would end once the final tranche o f loan funds has been received and all funds have been transferred from the Deposit Account. In addition to the above, the Bank may request that its own staff (or a specialist contractor working on its behalf) carry out special reviews o f the Deposit Account. If, after deposit into the Deposit Account, the proceeds o f this loan are used for ineligible purposes, the Bank will require the Borrower to either: (i) return that amount to the account for use for eligible purposes, or (ii) refimdthe amount directly to the Bank. F. ProgramImplementationand Monitoring 153. The implementing agency for PFPSAL 111will be the Undersecretariat o f Treasury which is cooperating closely with the CBT, the BRSA, the SDIF, the MOF, the SPO, and the TCA. To ensure timely implementation o f the program, the Bank team has confirmed with the Government that each condition for release o f the second tranche o f PFPSAL I11as presented in the policy matrix has been clearly assigned to a particular government agency. A ministerial committee has been established to ensure effective implementation o f the national anti- corruption strategy in the context o f the UAP. Disbursement arrangements for PFPSAL I11will follow Bank practice for adjustment loans. Upon notification by the Bank o f loan effectiveness, theproceeds o fthe first tranche o fthe loan (excluding the front-end fee) will be depositedbythe Bank into the designated Deposit Account at the request o f the Borrower. Inaccordance with the Operational Directive on the Simplification o f Disbursement Rules under Structural Adjustment and Sector Adjustment Loans (February 8, 1996), disbursements will not be linked to specific purchases. The closing date for the Loan will be June 30,2005. - 63 - 154. Monitoring. The Bank will carry out regular supervision o f the PFPSAL I11program. Progress will be monitored against implementation of the conditions for release o f the second tranche o f the loan. Macro-economic outcomes under PFPSAL I11will be monitored against key indicators on a short-term basis. Implementation o f the 2004 fiscal package will be monitored during PFPSAL I11supervision in close collaboration with the IMF. Quantitative benchmarks have been established for the social expenditure envelopes under the 2004 budget. An extensive monitoring o f the broader social impact o f the overall reform program i s being camed out through a combination of activities underthe Bank-supported PSSP, ARIP and SRMP projects. Annex 1A Page 1of 2 Turkey -Key Economic Indicators Estimate Projected Indicator 2001 2002 2003 2004 2005 2006 Nationalaccounts (as YOof GDP) Gross domestic producta 100 100 100 100 100 100 Agriculture 13 13 12 11 11 10 Industry 26 24 22 22 22 22 Services 61 63 66 66 67 67 Total Consumption 81 80 79 78 77 76 Gross domestic fixed investment 18 17 19 19 20 20 Government investment 6 5 3 3 3 3 Privateinvestment 13 11 16 17 17 18 EXPOITS (GNFS)~ 34 29 28 26 27 27 Imports(GNFS) 31 31 30 29 29 29 Gross domestic savings 19 20 21 22 23 24 Gross nationalsavings' 21 21 21 23 24 24 Memorandum items Gross domesticproduct 145,244 183,888 240,502 305,520 324,389 353,847 (US$million at current prices) GNPper capita (US$, Atlas method) 2,410 2,500 2,790 3,460 4,070 4,640 Real annualgrowthrates (%, calculatedfrom 1994prices) Gross domestic product at marketprices -7.5 7.9 5.8 5.0 5.0 5.0 GrossDomesticIncome 18.3 4.7 7.6 6.8 5.5 5.4 Real annualper capitagrowthrates(%, calculatedfrom 1994prices) Grossdomestic product at market prices -9.0 6.2 4.2 3.4 3.5 3.5 Total consumption -10.6 1.o 4.7 4.4 2.4 3.3 Privateconsumption -10.7 0.6 6.1 4.7 2.6 3.6 Balance of Payments(US$ millions) E X P O ~ ~(GNFS)~ S 50,403 54,907 68,267 80,218 87,864 95,817 Merchandise FOB 34,373 40,124 50,83 1 60,404 66,605 73,076 Imports(GNFS)~ 45,816 55,365 73,265 87,536 93,786 102,102 MerchandiseFOB 38,916 48,461 64,765 77,186 82,s 13 90,426 Resourcebalance 4,587 (458) (4,998) (793 18) (5,922) (6,285) Net current transfers 3,803 3,490 3,618 4,068 4,340 4,722 Currentaccountbalance 3,390 (1,522) (6,808) (9,149) (7,547) (7,502) Net privateforeigndirect investment 2,769 863 79 1,552 1,811 2,156 Long-termloans(net) 7,012 6,867 2,09 1 45 (3,808) (5,878) Official 180 224 (283) 1,719 (154) (357) Private 6,832 6,643 2,374 (1,674) (3,653) (5,521) Other capital(net, inct.errors & ommissions) (15,865) (55) 8,685 4,764 5,003 4,244 Change in reservesd 2,694 (6,153) (4,046) 2,788 4,541 6,980 Memorandum items Resourcebalance (% ofGDP) 3.2 -0.2 -2.1 -2.4 -1.8 -1.8 Real annualgrowthrates( YR94 prices) Merchandiseexports (FOB) 16.6 11.8 16.5 13.2 9.6 9.4 Merchandiseimports (CIF) -16.9 20.9 18.2 13.0 7.2 8.9 Annex 1A Page 2 of 2 Turkey-KeyEconomicIndicators (continued) Estimate Projected Indicator 2001 2002 2003 2004 2005 2006 Publicfinance (as % of GDP at market prices)e Current revenues 31.6 31.8 32.0 31.8 31.4 30.7 Current expenditures 44.3 37.1 35.7 32.2 30.2 29.2 Current account surplus(+) or deficit (-) -12.7 -5.3 -3.6 -0.5 1.2 1.5 Capital expenditure 6.9 6.9 6.2 6.0 6.2 6.1 Foreignfinancing 0.7 6.5 1.6 1.5 0.7 0.5 Monetary indicators M2/GDP 26.8 22.6 22.8 23.0 22.0 24.0 Growth o f M 2 (%) 48.0 31.0 29.9 23.6 18.7 11.2 Priceindices(YR94 =loo) Merchandise export price index 85.4 87.1 98.1 104.3 105.6 106.4 Merchandise import price index 88.0 89.8 102.0 107.7 107.9 108.1 Merchandise terms o f trade index 97.0 97.0 96.2 96.8 97.9 98.4 Consumer price index (%change, yoy) 68.5 29.7 18.4 12.0 8.0 5.0 GDP deflator (% change) 54.8 44.1 22.5 11.0 9.9 8.0 a. GDP at factor cost b. "GNFS" denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use of IMFresources. e. Consolidated central govemment. f. "LCU" denotes "local currency units." Anincrease inUS$/LCU denotes appreciation. Annex 1B Page 1of 1 Turkey - Key Exposure Indicators Estimate Projected Indicator 2001 2002 2003 2004 2005 2006 Total debt outstandingand 113,437 131,556 142,947 145,332 143,735 137,872 disbursed(TDO) (US$m)" Net disbursements(US$m)a -2359.0 8284.0 4502 2316 -1582 -6093 Total debt service (TDS) 24515 22430 27533 31680 33904 37769 (US$m)" Debt and debt service indicators ("/.I TDOIXGS~ 202.8 221.7 196.3 169.6 152.7 134.4 TDOIGDP 78.1 71.5 59.4 47.6 44.3 39.0 . TDSiXGS 43.8 37.8 37.8 37.0 36.0 36.8 ConcessionaVTDO 3.6 3.2 3.2 3.0 2.9 2.8 IBRD exposureindicators(%) IBRD DS/publicDS 4.4 4.0 3.7 3.4 3.9 3.6 Preferredcreditor DSIpublic 24.8 14.6 19.2 27.3 34.0 40.7 IBRDDS/XGS 1.3 1.2 1.0 1.o 1.2 1.2 IBRD TDO (US$m)d 4707 5367 5223 7386 7837 8046 Share o fIBRDportfolio ("h) 3.9 4.4 4.5 6.5 7.1 7.4 IDA TDO KJS$mjd 95 89 84 78 77 a. Includespublic and publicly guaranteed debt, privatenonguaranteed,use of IMF credits andnet short- termcapital. Year 2002 figure does not includethe SRF paymento f$6.1 billion b. "XGS" denotes exports o fgoods and services, includingworkers' remittances. c. Preferredcreditorsare defined as IBRD,IDA, the regionalmultilateraldevelopment banks, the IMF, andthe Bank for IntemationalSettlements. d. Includespresentvalue ofguarantees. e. Includesequity and quasi-equitytypes o fbothloan and equity instruments. E T 7 E m ri N Annex I1 Page 2 of 2 CASAnnex 68 (IFC)for Turkey Statement of IFC's Held and Disbursed Portfoliofor Turkey As of04l30104 (In U5 Dollar Millions) ~ A p p r d Company Held Disbursed Loan Equity Quasi Partic Loan Equity Quasi Partic 2000 ALease 0.6 0 0 0.0 0.6 0 0 0.0 200112003 Akbank 55 0 0 0 1000 55 0 0 0 1000 199812000 Altematif Bank 4 6 0 5 0 0 0 1 6 0 5.0 0 0 1995119961200112003 Arcelik 72 9 0 0 34 2 72 E 0 0 34 2 2000 ArcelikLG Klima 11 4 0 0 1 6 11 4 0 0 1 6 19941199712002 Assan 26 0 0 1 0 0 0 26 0 0 1.o 0 0 2002 Atlllm 6 5 0 0 0 0 5 5 0 0 0 0 2000 Banvit 11 7 5 0 0 0 0 11 7 5 0 0 0 0 19941199612000 BayindirbankA S 4 5 0 0 0 0 4 5 0 0 0 0 2002 Beko 30 1 0 0 30 1 30 1 0 0 30 1 2001 Bilgi 10 0 0 0 0 0 1 0 0 0 0 0 0 1994119951199611997 Borcelik 10 0 9 7 0 0 0 1 0 0 9 7 0 D O 2004 Borusan Holding 30 0 0 100 0 0 30 0 0 10.0 0 0 1994 CES Holding 4 0 0 0 0 0 4 0 0 0 0 0 199612001 CBS Printas 0 0 3 0 0 0 0 0 3 0 0 0 19901199312002 Conrad 9 8 0 0 0 0 9 9 0 0 0 0 2002 EKS 126 0 0 0 0 1 2 6 0 0 0 0 1995 Entek 20 5 0 0 13 3 20 5 0 0 133 199211999 Finansbank 4 4 0 0 0 0 4 4 0 0 0 0 1994119981200012004 Geranti Leasing 1 0 0 0 0 0 0 0 0 0 0 0 0 1999 Gumussuyu Kap 4 0 0 3 4 0 0 4 0 0 3.4 D O 1001 Gunkol 6 2 0 6 2 0 0 6 2 0 6.2 0 0 1998 lndorama Iplik 5 6 0 0 0 0 5 6 0 0 D O 19901200012002 IpekPaper 29 5 0 5 0 6 4 20 5 0 5.0 6 4 1990 Kepez EleMrik 4 0 0 0 0 0 4 0 0 0 0 0 19801199011996 Kiris 25 8 0 0 0 0 25 E 0 0 0 0 1996 Koclease 30 0 0 0 0 0 0 0 0 0 0 0 1991 Kula 5 0 0 0 0 0 5 0 0 0 0 0 2003 MESA Group 11 0 0 0 0 0 5 5 0 0 0 0 199311996 Medya 0 0 0 0 0 0 0 0 0 0 2002 Mill Re 50 0 0 0 0 0 0 0 0 0 0 0 199812002 Modern Karton 19 1 0 0 0 0 19 1 0 0 0 0 1991 NASCO 10 2 0 0 3 5 10 2 0 0 3 5 2004 OPET 25 0 0 0 0 0 0 0 0 0 0 0 199712004 OyakBank 50 0 0 0 0 0 50 0 0 0 0 0 199812002 Pasabahce 7 5 0 0 0 0 7 5 0 0 D O 19831199411998 Pinar ET 4 7 0 0 0 0 4 7 0 0 0 0 199412000 Plnar SUT 137 0 0 0 0 1 0 3 0 0 0 0 1999 SAKoSa 1 0 8 0 0 120 1 8 8 0 0 120 198611990H 990 Silkar Turizm 2 4 0 0 2 7 2 4 0 0 2 7 1993119961200212003 SISB ve cam 93 6 0 0 40 3 93 6 0 0 40 3 199#2002 SoMas 7 6 0 0 0 0 7 6 0 0 0 0 1999 TEB Finansal 1 1 0 0 0 0 1 1 0 0 0 0 1979119021190311g89119911199611999 Traba Cam 0 1 8 0 0 0 0 1 0 0 0 0 19951199412002 TurkEkon Bank 1 8 9 0 150 0 0 189 0 15.0 0 0 2001 Turhsh PEF 0 100 0 0 0 0 1 4 0 0 0 1999 Unye Cement 12 6 0 0 0 0 1 2 6 0 0 0 0 1999 Uzel 9 5 0 0 5 7 9 5 0 0 5 7 197011971119821190311998 Viking 8 3 0 0 0 0 9 3 0 0 0 0 1995 YalovaAcrylic 2.5 0 0 1.3 2.5 0 0 1 3 TotalPortfolio: 811.4 26.7 45.6 251.2 683.5 18.2 45.6 251.2 Approvals PendingCommitmentfor Turkey As of 05112104 (In US Dollar Millions) MAppfOMI Company Approved IFC - TOTAL Loan Eauih, . _ Quasi GT RM 1 IFC Partic Akbank 0 0 0 0 0 0 250 0 0 250 0 0 Akbank BLoan Inc 0 0 0 0 0 0 0 0 0 0 0 0 200 Cayeli Expan 2 200 0 0 0 0 0 0 0 0 200 0 0 Kusadasl Pori 1 0 0 0 0 0 0 0 0 0 0 100 EO Meteksan sistem 1 0 0 0 0 0 0 0 0 0 0 100 0 0 MIIII Reasurans 0 0 100 0 0 0 0 0 0 100 0 0 OPET Petrolculuk 0 0 0 0 0 0 0 0 0 0 0 0 500 Sisecam Exp 0 0 0 0 0 0 0 0 0 0 0 0 7 5 2002 TEE 111 1 0 0 0 0 0 0 0 0 0 0 0 0 500 TotalPending: j 40.0 10.0 0.0 25.0 ao 11 75.0 135.5 Annex I11 Page 1of 1 TURKEY THIRD PROGRAMMATICFINANCIAL AND PUBLICSECTORADJUSTMENT LOAN TIMETABLE OF KEY PROCESSINGEVENTS 1. Time Taken to Prepareand Processthis Loan 15 months 2. Loan PreparedBy Government o f Turkey with IBRDassistance 3. Preparation March-April2003 4. Appraisal April 2003 5. Negotiations May 2004 6. Planned BoardPresentation June 2004 7. Planned Date o f Effectiveness June 2004 8. PPSAL PlannedBoardPresentation December 2004 9. PFSAL I PlannedBoardPresentation September 2005 Annex IV Page 1of 14 REPUBLIC OF TURKEY PRIME MINISTRY THE UNDERSECRETARIAT OFTREASURY Ref: B.02.1.HM.O.DEI.01.05.197-29961 Ankara, M a y 20,2004 Mr.JamesD.Wolfensohn President The World Bank Washington D C 20433 U.S.A. Dear Mr.Wolfensohn: 1. Our Government is determined to continue implementing its program o f economic reform. Following our successful efforts to stabilize the economy, we are implementing structural reforms to preserve the current stability, promote economic growth, and create employment. Our structural reform priorities are contained inthe Urgent Action Plan adopted by the Council o f Ministers in December 2002. These priorities largely coincide with the actions we are undertaking under our Financial and Public Sector Reform Program, implementation o f which suffered some delays during the run up to the early elections o f November 2002 and the formation o f the new Government. 2. We have now implemented some o f the previously pending actions and are ready to move ahead with the rest o f the Program. On this basis, we request World Bank support for our Program by approving a Third Programmatic Financial and Public Sector Adjustment Loan (PFPSAL 111) for an amount o f US$1 billion on standard IBRD terms for Turkey and to be disbursed in two equal tranches. We firmly believe that the reforms detailed in this Letter o f Development Policy merit full support from the World Bank and the international community. 3. We also request a waiver o f the 1percent front-end fee on the part o f the front-end fee for PFPSAL 3 corresponding to the US$366,000,000 amount on standard IBRD terms which was cancelled under PFPSAL I1(Loan No. 4656-TU). The rationale for this partial waiver request is that: (a) the US$366 million un-disbursed under the PFPSAL I1loan on standard IBRD terms (Loan No. 4656 TU) would be folded into the proposed PFPSAL I11and (b) the continuity o f the financial and public sector reform program is and will be maintained as we are hlly committed to meeting the objectives o f the Financial and Public Sector Reform Program in accordance with the timetable presented below. I. MacroeconomicFrameworkandSocialExpenditure 4. Macroeconomic outcomes for 2003 show continued recovery from the crisis o f 2001. Growth was stronger than expected, 5.9 percent for 2003, above the target o f 5 percent and Annex I V Page2 of 14 following 7.9 percent growth in 2002. Inflation (CPI) fell to 18.4 percent in 2003, below target for the second year running. The floating exchange rate regime was successfully maintained and an important degree o f exchange rate stability was achieved. The current account registered a deficit o f US$6.6 billion (2.9 percent o f GNP) below the expected level for 2003, with surging imports overshadowing strong export performance. By the end o f 2003, interest rates on government securities had fallen to the low 20s compared with peaks during 2001 crisis o f well over 100 percent. Gross international reserves o f the Central Bank were about US$35 billion at the end o f the year, above programmed levels. The positive impacts o f exchange rate stability, lower interest rates and higher growth improved the public debt dynamics with the stock o f net public debt estimated to have fallen from 91 percent o f GNP at the end o f 2001 to about 71 percent at the end of 2003, below projections at the beginning of the year. The primary surplus for 2003 was above 6.0 percent, the highest ever, andjust short ofthe target o f 6.5 percent. 5. In order to sustain the economic recovery, deepen the disinflation process and further improve debt sustainability, we will continue strong macroeconomic policies in 2004. We are confident that we will meet our end-year target o f 5 percent real GNP growth. Based on the low base for private consumption and steadily increasing capacity utilization rates inprivate industry, we expect the growth to be driven by private fixed investment and consumpti.on. Maintaining consumer and investor confidence will be the most crucial factor in fostering final domestic demand. W e believe the strong disinflationary trend in 2003 will continue in 2004 and we will meet the 12 percent end-year inflation target On the fiscal front, buildingup on the 2003 fiscal performance, we aim to achieve a public sector primary surplus of 6.5 percent o f GNP. Iffuture developments point to significant changes in the macroeconomic framework or in financing prospects, w e stand ready to (a) revise the program's macroeconomic projections and (b) adopt, on a timely basis, additional measures necessary to safeguard our program objectives. 6. We are determined to ensure strengthened social protection for all o f our citizens, in particular poor and vulnerable groups. The estimated outcome for total social spending in 2003 as a share of GNP is inthe range o f 18.2 percent o f GNP, well above the PFPSAL benchmark of 14.5 percent, in large part due to the unplanned increase in social security expenditure. In2004, the overall social spending as a percent o f GNP is expected to be even higher than in 2003, at about 19.3 percent. However, the education spending is likely to fall slightly below the PFPSAL benchmark o f 4.25 percent, due to the fiscal measures requiring expenditure cuts to attain the end-year primary surplus target. 7. Expenditure on targeted social assistance in GNP terms is budgeted to increase in 2004. We intend to increase the spending for the Social Solidarity Fund to over 0.3 percent o f GNP inclusive o f the transfer from the budget carried over from 2003. The Direct Income Support (DIS) payments to farmers increased to 0.64 percent o f GNP (TL 2.25 quadrillion) in 2003. In 2004 budget, an allocation o f TL 2.6 quadrillion will cover the remaining 2003 DIS liabilities and the second installment o f DIS compensation payments for diesel fuel. Our Government intends to disburse at least TL 275 trillion this year under the 2004 DIS program and will make every effort to increase disbursement at least to TL 400 trillion. Additional resources will be transferred to the DIS program by the Ministry o f Finance (MOF) and Treasury to achieve this target. We have completed an agricultural policy paper which includes adequate provisions for Annex I V Page 3 of 14 DIS as well as other agriculture support instruments. This policy paper will form the basis for the new agricultural fiamework law which will be enacted before end-2004. 11. Banking Sector Reform Program 8. The banking sector has been one o f the sources o f economic instability in repeated occasions. Most recently, banking sector imbalances contributed significantly to the macroeconomic crisis o f February 2001. We are determined to prevent the repetition of systemic crises and aim at having a safe and sound private banking sector operating under appropriate regulations and market principles. 9. Meeting these goals requires our decisive intervention in areas that include refining our regulation and supervision o f banks, privatizing state banks, and improving the legal and institutional environment for financial transactions. Inview o f the complexity o f these issues we have established a realistic policy program. Our immediate policy targets are to (a) consolidate the current stability o f the sector by ensuring that a banking law fully consistent with European Union principles is in place and its regulations are fully enforced by regulatory bodies with sufficient capacity and independence, (b) ensure that state banks will not undertake quasi-fiscal activities again by requiring these banks to operate on commercial principles while undertaking a rapid restructuring process aimed at privatizing them as soon as feasible, and (c) assist banking sector development by improving its legal framework on areas related to creditor rights, formalhnformal corporate insolvency and restructuring systems in order to facilitate credit risk management practices. 10. To put our policy priorities in perspective, it is necessary to recount the measures we implemented following the crisis o f February 2001. Our efforts have been successful inrestoring confidence in the banking system and preventing the state banks from accumulating hrther operational and duty losses. Regulatory and Supervisory Framework 11. We are enforcing and will continue to enforce key regulations in line with international standards. Inorder to reduce the high degree o f connected lending and equity exposures within financial and industrial groups, the Banking Regulation and Supervision Agency (BRSA) introduced time-bound exposure reduction targets for non-compliant banks, and will continue to actively monitor compliance with these targets. Enforcement actions include restructuring o f financial-industrial groups into separate financial and industrial holding companies where prudent and necessary. Inorder to achieve full compliance with the applicable EUDirectives by January 2006, lower limits have been in force since December 1999 and are being decreased yearly thereafter. At the moment, there are no banks that violate the BRSA's excess connected exposure limits. The BRSA will continue to closely monitor continued compliance with the lower limits. 12. BRSA amended the Loan Loss Provisioning (LLP) rules to require up-to-date loan loss classification and provisioning by banks. The LLP include the concept o f fair value o f collateral to facilitate restructuring o f loans. The new LLP will continue to be rigorously enforced in order to maintain robust Capital Adequacy Ratios (CAR) in the banking sector. BRSA is also strictly Annex IV Page 4 of 14 enforcing regulations on Foreign Exchange (FX) exposures o fbanks (including indirect exposure through structured finance products) in coordination with the Central Bank o f Turkey and through onsite examination o f Turkish banks' subsidiaries and branches abroad. In addition, BRSA required banks to bring REPOs on to their balance sheet as collateralized finance transactions. Furthermore, a number o f regulations have been put into force on issues like capital adequacy, risk management, accounting standards, independent auditing, mergers and acquisitions, and cooperation agreements with foreign supervisory authorities. 13. On March 16, 2004, BRSA Board changed the organizational structure o f the Agency with the objective o f strengthening BRSA and ensuring its operational effectiveness. To address several priority areas, a time-bound Institutional Development Plan was adopted by the Board. This plan requires, among other things, the preparation o f a strategy based on each department's own operational plans and work flows. Actions to strengthen the Saving Deposits Insurance Fund (SDIF), another pillar o f our prudential system, have also been undertaken. Its Board approved a strategic plan with clearly assigned implementation responsibilities to: (a) put in place a more effective organizational structure, with clearly separated line responsibilities for bank resolution, asset management, administration o f deposit guarantees, and supporting functions such as legal advise and information technology; (b) set performance targets for the bank resolution and asset management functions; (c) envisage the sufficient quantities of qualified staff and (d) build a centralized and highquality management information system. 14. Several key strategic SDIF issues are being solved including (a) governance o f SDIF; (b) transition to a limited deposit guarantee scheme and removal o f the current blanket guarantee as o f July 5, 2004; and (c) development o f a long term financial sustainability strategy for the deposit insurance fund that takes into account operating budget and performance plans. 15. The re-capitalization process of the banking sector has been completed. Banks that were not in compliance with the minimum CAR levels were able to comply with this requirement by capital injections from private sources and subordinated loans from SDIF. W e have either sold, revoked the licenses, or liquidated Ekspress, Demir, Sumer, Site, Taris, Eti, Iktisat, Kent, Toprak, EGS, and Imar banks. Pamuk Bank was intervened and taken over by SDIF and, following a failed sales effort in 2003, it will be integrated with Halk Bank. The resolution o f SDIF banks involved a carve-outs o f selected assets and deposits, leaving parts o f their balance sheet with the SDIF. The SDIF auctioned o f f US$2.9 billion o f SDIF bank liabilities and matching assets to private banks and transferred the residual assets and liabilities to Ziraat and Halk (US$2.4 billion o f FX liabilities and assets) and Bayindirbank, the bank used as bridge for the resolution o f assets in intervened banks. All remaining non performing assets were transferred to the Collections Department o f the SDIF. 16. There is still room for improving our regulatory framework and supervisory capacity. Thus, we are working in drafting a new set o f comprehensive amendments to the banking law. We will submit to the Council o fMinisters these amendments inJune 2004. They will, inter alia: (a) delineate the functions o f and regulate the collaboration between BRSA and SDIF as well as secure the institutional independence o f each o f these institutions and (b) enhance SDIF's collection and enforcement powers. Our commitment is that by the end o f 2004, we will have in place an improved Banking Act consistent with all EU principles and that will secure and Annex IV Page 5 of 14 strengthen the institutional, financial, operational, and regulatory independence o f BRSA and SDIF. By then all the regulations under the Act will be fully enforced by regulatory bodies with sufficient capacity and independence. To complement this new regulatory and supervisory framework we will continue implementing strategic and institutional development plans for BRSA and SDIF. StateBank Reform 17. We are determined to ensure the state banks will not undertake quasi-fiscal activities again. These banks are operating under commercial principles and will continue to do so. We are developing and will implement in 2004 and early 2005 an ambitious restructuring plan in order to ultimately privatize the state banks as soon as feasible but taking market conditions into account. 18. Vakif Bank (VB) i s controlled by the State through the Directorate General o f Foundations (DGF). This situation resulted from the fact that 75 percent o f shares belong to thousands o f foundations. Since the majority o f these foundations have ceased to function and have no identifiable authorized representatives, a law was passedto give the government's DGF the authority to exercise shareholder voting rights on behalf o f the foundations. Consequently, the DGF represents 75 percent o f shares and is, therefore, able to appoint VB management. The remaining 25 percent o f VB shares belong to the VB employee pensionf h d (EPF). 19. We are resolute in our objective that banks should not be controlled by the state. To pursue our agenda, we have made the decision to hire consultants with adequate experience and qualifications to carry out a due diligence o f VB to confirm that the bank has been managed appropriately. The process o f selecting consultants to carry out the due diligence will be completed inMay 2004. By the end o f 2004, the Council o f Ministers will adopt a strategy to bring about private sector control of VB as soon as market conditions permit. We will implement expeditiously the strategy adopted bythe Council o fMinisters. 20. Ziraat and Halk banks. We are committed to privatize these banks and have restructured them substantially. We have closed more than 800 branches and reduced staff numbers by more than 30,000 inbothbanks. They are now lendingon creditworthiness criteria and on commercial terms and this will remain the case in the future. The Government will continue to refrain from interfering inthe management and decisions o f these banks. A strategic advisor to formulate a restructuring strategy to allow the privatizationo f these state banks has already begunworking. 21. The Council o f Ministers will adopt by the end o f 2004 a privatization strategy for both banks that will be implemented as soon as feasible in terms o f market conditions. Inaddition, their Board will implement the restructuring actions recommended by the strategic advisor in 2004. We will offer the restructured two banks for sale thereafter to the private sector as soon as the market conditions are appropriate as per the advise ofprivatization advisors. ExecutionandBankruptcyAct 22. A better functioning banking sector requires a legal framework that address creditor rights, formalhformal corporate insolvency and restructuring systems to allow for improved Annex I V Page 6 of 14 credit risk management practices. An Execution and Bankruptcy Act (EBA) that conforms with international best practice is a pre-condition for increasing private sector's access to credit and for the productive assets inthe economy to be allocated to their most efficient uses. 23. In December 2003, amendments to the Execution and Bankruptcy Act (EBA) were enacted to introduce pre-packaged options and to complement earlier amendments enacted in July 2003. The regulations for the amended EBA were published in April 2004 and will be implemented effectively. 111. Public Sector Reform Program 24. Our public sector reform program aims to achieve permanent fiscal adjustment and establish the foundation for more transparent and effective government. The program comprises three core pillars each o f which has a medium-term dimension. The first pillar involves structural fiscal policy reforms to underpin the fiscal adjustment required for overcoming the crisis and to ensure that this adjustment is sustainable over the medium term. The second pillar of the public sector reform program comprises institutional and policy reforms to improve public expenditure management (PEM) based on the multi-year Strategic Framework prepared in line with the recommendations of the Public Expenditure and Institutional Review (PEIR) carried out jointly with the World Bank. The thirdpillar of the public sector reform program involves broad based institutional reforms to improve the quality of public sector governance. This includes a systematic approach to combating corruption as well as civil service reform. Structural Fiscal Policies 25. Structural fiscal policies encompass the package of fiscal measures to underpin the fiscal program, a medium-term strategy to improve the tax system, andstructural expenditure measures including more comprehensive public employment policies. Fiscal gains were significant in 2003, and the primary surplus rose from 4 percent of GNP in 2002 to over 6 percent of GNP in 2003. The 6.5 percent of GNP public sector primary surplus target for 2004 remains a corner- stone of our program. The recent minimum wage and pension increases-motivated by our concerns for the most vulnerable segments of the society-created challenges for this year's target, as have weaker-than-anticipated revenues. To address this slippage and underpin the 2004 budget, we have announced a new fiscal package for 2004 totaling 1.7 percent of GNP. While the 2004 fiscal package increases the emphasis o n expenditure reductions, the Government has been obliged to resort to additional revenue measures as well. W e acknowledge that deeper structural measures on both the revenue and expenditure sides will be needed to underpin the fiscal program over the medium term. 26. Tax Strategy. Our Government i s moving forward with the medium-term tax strategy adopted in January 2002. A unified Special Consumption Tax (SCT) to consolidate a range o f excise and specific taxes into a single tax charged on a limited range of luxury goods was enacted in June 2002. Implementing circulars for the SCT law were published in July and the tax came into effect in August 2002. Earmarking of SCT revenues was eliminated, with effect from the 2003 budget, through a government decree issued in January 2003. InApril 2003, the Parliament approved the first legislative package under the direct tax reform designed to simplify Annex IV Page 7 of 14 and consolidate the direct tax regime in line with OECD standards and international best practice. This legislation: (a) harmonizes tax rates on income from financial investments at the declaration stage; (b) simplifies and harmonizes the system o f investment incentives; (c) reforms the system o f income tax credits, and (d) simplifies taxation o f corporate earnings and dividends. Key provisions o f the legislation became effective immediately and the remaining articles became effective in January 2004. Subsequently, we further rationalized direct taxation by enacting a second package o f direct tax reform legislation in January 2004, which progressively transforms free trade zones into export processing zones in line with international best practice, and targets regional incentives at employment generation inlower income regions. 27. Onthe tax administration side, steps have beentaken to strengthen tax audit management capacity within the MOF by establishing an audit coordination unit. A coordinated audit plan for 2003 was prepared and implemented. We will complete the functional reorganization of the General Directorate o f Revenues (GDR) by end-2004 and will start to extend this structure to the local level. Drawing on OECD experience, and maintaining the accountability o f the GDR to the Ministero fFinance, we will transform the GDR into a semi-autonomous body within the MOF, its Head directly reporting to the Minister. Tax policy unit will be transferred to the MOF. 28. Public Employment. As part o f a broader program o f structural measures being undertaken on the expenditure side, the public sector employment policy has become more comprehensive in2002 and 2003 and was maintained and strengthened in2004. The policies for 2004 include: (a) a cap on the total number o f civil servants in the central and local govemment-the ceiling on new hiringinthe consolidated budget has been set at 40,000; and (b) a limit on replacement hiring in the SEEs equal to 10 percent o f attrition and no replacement hiring for budget-financed SEEs. A system o f quarterly monitoring for public employment across the general government has been established in 2002. The employment figures o f the consolidated budget agencies, SEEs, local administrations, state banks and social security institutions are being monitored by a committee chaired by MOF. The quarterly public employment reports will continue to be prepared. 29. A key element o f the public employment program is to address the over-employment in the state economic enterprises. At end 2001/early 2002, approximately 15,000 workers were retired, notified o f their retirement, laid o f f or converted to private contract status, following the liftingo frestrictions on the ability o fmanagers to require public sector workers over 50 years of age to retire. Inaddition most o f the unfilled positions in SEEs were eliminated. We conducted an assessment o f SEE redundancies which indicated 45,800 redundant positions in the SEE system as of January 2002. A majority o f these redundancies were eliminated as o f mid-March 2004 and many o f the SEEs were in fact able to reduce the number o f their workers by more than the figure determined through the redundancy assessment carried out in 2002. The overall attrition from SEEs between February 2002 and mid-March 2004 has reached to over 59,000. PublicExpenditureManagement 30. The multi-year strategy for reforming public expenditure management envisages: (a) putting in place a comprehensive revenue and expenditure framework to guide fiscal management, (b) reforming the processes and institutional arrangements for budget preparation Annex IV Page 8 of 14 and execution to ensure that strategic planning and policy priorities would guide resource allocation, (c) upgrading public accounting, reporting, procurement and external audit functions to strengthen financial accountability in government inline with international standards; and (d) legal measures and institution building to ensure prudent public liability management. In undertaking these reforms and in revising the legislation, our government has launched a far- reaching reform which goes well beyond the initial strategy in a number of key respects. In particular, the drafting o f the PFMC law was seen as an opportunity to introduce modem public management principles by clarifying accountability o f public officials, by delegating managerial responsibility and by putting inplace an intemal control and audit framework that i s compatible with EUandinternationalpractice. 31. The PFMC Law. The PFMC Law enacted in December 2003 undertook a long due overhaul o f public finance legislation in Turkey and replaces the Public Accounting Law o f 1927. The new PFMC law incorporates modem principles o f public management and addresses a number o fweaknesses o f the existing system: (a) it incorporates a comprehensive definition o f public revenue and expenditure encompassing the general government sector (b) it provides the MOF with clear legal authority to issue budget classification, accounting and reporting standards for all general government agencies, (c) it proposes a medium term approach to strategic planning and budget preparation that will apply to all parts o f the central government, (d) it provides a clear definition o f accountability o f ministers and heads o f public administrations as well as key officials for financial management and performance relative to policy goals, (e) it delegates financial control and internal audit responsibilities to spending agencies, in line with EUstandards, (f) it strengthens government accountability by extending the scope and mandate o f external audit by the Turkish Court o fAccounts to the whole o f general govemment. 32. Our government is currently preparing secondary legislation and regulations necessary for implementationo f the provisions o f the PFMC law. Many aspects o f this law are expected to be implementedfrom January 2005 while others will be implementedover the period2005-07. BudgetReform 33. In line with our strategy to achieve a comprehensive budget framework that supports sound fiscal management, a number o f steps have been taken to improve the classification and reporting o f fiscal activity o f the general government and to integrate extra- budgetaryitems into the budget. 34. Budget Classification. Until recently, the budget system lacked the functional classification o f government expenditures that i s recommended by the IMF's Manual on Government Financial Statistics (GFS) and which i s essential for policy analysis o f expenditure. This situation has been addressed by the government's adoption o f functional budget classification in line with the GFS 2001 and by the parallel amendment o f the chart o f accounts for all entities forming part o f the general government. The GFS classification, including the 10 sector hnctional classification, has been applied in the 2004 budget for general and annexed budgets. The expansion o f the GFS to the rest o f central government (regulatory, supervisory and other public agencies) will be implementedinthe 2006 budget. Current plans are to also expand the GFS to the rest o f general government, i.e. social security institutions and the local Annex I V Page 9 of 14 administrations, by the 2006 budget. Turkey now has the full complement o f intemationally standard budget classification (functional, administrative and economic classification) while program level information on the budget is also available. 35. Integrating Off-Budget Activities into the Budget. All budgetary funds, with the exception o f the Support Price Stabilization Fund(DFIF) linked to the reform o f the agriculture sales cooperative unions (ASCUS), and all but five EBFs (Social Solidarity Fund, Defense Fund, Promotion and Publicity Fund, SDIF, and Privatization Fund) were eliminated by legislation in 2000 and 2001. Despite formal closure o f the funds, the system o f earmarked revenues and expenditures associated with them has remained largely inplace. This has been done by keeping open the accounts o f the closed funds and using the mechanism o f special appropriations whereby earmarked revenues to these accounts are written as special appropriations for the spending agencies concerned during the course o f the year. To meet the initial objectives o f improved fiscal control, transparency, accountability and comprehensiveness o f the budget, our Government intends to terminate the use o f the special appropriations mechanism, close the accounts linked to the closed funds and incorporate their earmarked revenues into the general revenue base. This will be accomplished through legislation which i s expected to be enacted by end-June 2004. For the remaining EBFs (excluding the SDIF for which measures are being taken under the financial sector reform program), the following measures have been incorporated into the PFMC law: (a) incorporation o f EBF budgets in the budget o f the related administration submitted to Parliament for approval; (b) inclusion o f the remaining EBFs under the intemal control and audit regime as well as external audit by the TCA; and (c) monthly reporting o f EBF operations on a consolidated basis with the central government. 36. Other Budget Reforms. Rationalization and reform o f the revolving funds is progressing. Through consolidation by agency, the number of revolving funds was reduced from about 2,650 in mid-2001 to about 1,400 by M a y 2004. The PFMC law indicates the government's intention to eliminate all revolving funds within general government by end-2007. Untiltheir elimination, revolving fund revenues and expenditures will be incorporated into the budget o feach general government agency and reported inthe budget submission to Parliament. 37. Other actions to improve the scope o f relevant information conveyed to Parliament are ongoing. As was done for the 2004 budget, presentation o f the 2005 budget to the Parliament will be supplemented with the submission o f the accounts and financial outlook for the contingent liabilities o f the Treasury, the remaining extra budgetary funds, the social security institutions, autonomous agencies, local authorities, and SEES. Further steps have also been taken to improve the credibility o f the budget preparation process. The macro framework decision o f HighPlanning Council for the 2004 budget included individually specified indicative ceilings for each ministry and line agency based on the experience with the 2002 budget preparationprocess. 38. Rationalizingthe PublicInvestmentProgram. Onthe basis o f HighPlanning Council decisions, the 2002 public investment program (PIP) cut the projected average completion time to 8.5 years, a 32 percent reduction from the 12.5 year average completion time in 2001 (adjusted for the higher than expected devaluation and inflation). An action plan for further rationalization o f the public investment program (PIP) in2003-04 has been prepared by SPO and Annex IV Page 10 of 14 was adopted by the High Planning Council in October 2002. The plan includes quantitative targets for further reductions in average project completion time o f at least 3 percent per year starting from the 8.5 year baseline established in 2002. An assessment prepared by SPO inM a y 2003 confirmed the reduction in the average project completion time in the 2002 PIP and indicated a further reduction inthe average completion time, based on the initial allocations, to an estimated 7.6 years in the 2003 PIP along with a continued reduction in the number o f projects. Following the budgetary cut inthe context o f fiscal measures required to meet the end- year primary surplus target, we expect a transitory increase in the average completion time to 8.6 years in 2004 due to reduced investment program allocation, however we will try to contain this increase through structural measures. Towards this end, we plan to revise the action plan prepared in2002 and strengthen the implementation o f the new plan. 39. Policy Formulation. Actions are also underway to buildcapacity for policy formulation and strategic planning, both at the central government and within public administrations to complement the budgetary initiatives in improving the performance o f public agencies. The strategic planning guidelines have been issued by State Planning Organization (SPO) following consultations with public administrations. In July 2003, the High Planning Council issued a decision announcing the launch o f the strategic planning initiative on a pilot basis in eight agencies representing various parts o f general government. With guidance and support from SPO, the eight agencies are expected to make satisfactory progress in their pilot strategic planning studies. Based on the experiences o f these pilots a phased program to expand strategic planning to the rest o f government will be prepared and implemented. 40. Operational Performance.Under the original PEMstrategy, the government introduced in2002 apilotprogram on improvingoperational performance insix agencies that was designed to draw lessons for understanding the relationship between strategic planning and goal setting, budgetary predictability, financial management and operational performance. As noted earlier, the new PFMC law proposes a fundamentally new framework for public management that seeks to improve performance orientation in government. By clarifying accountability o f heads of public administrations, requiring spending agencies to define their performance goals and requiring the submission o f accountability reports for performance, the new framework highlights the focus on performance. In order to enable achievement o f goals the framework proposes delegating managerial and financial authority while ensuring that it is backstopped by an adequate system o f internal control and audit. Inthis respect, the law proposes an ambitious expansion o f the original reform program. Its implementation is a long term challenge but key enabling steps are being introduced. The performance based budgeting guidance is being prepared by the MOF and it will be completed by end-December 2004. FinancialAccountabilitV 41. The PFMC Law clarifies accountability arrangements within the public administration, o f the executive to Parliament, and the role o f TCA to provide assurance to Parliament as regards financial statements prepared by the government. In addition, our government has undertaken several reforms strengthening the public financial management systems. Annex IV Page 11of 14 42. Accounting Reform. Reform of the public accounting system is well underway. The say2000i automated accounting system is now fully operational in all MOF accountancies. As a result, it is now possible to prepare periodic financial statements within a reasonable period o f time. Interfaces of the say2000i system have been completed with the automated revenue systems o f the General Directorate of Revenues. Additional interfaces are being established: (a) to the budget system (BYES) o f the General Directorate o f Budget and Fiscal Control o f the MOF and (b) to the accountancies o f the Treasury. These remaining interfaces would provide a fully integrated, automated system for tracking central government revenue and expenditure in Turkey. 43. The initiative to introduce modified accrual accounting in compliance with GFS requirements is making progress but will take longer to complete than originally envisaged. MOF has prepared a policy paper on accrual accounting which was published in November 2002. MOF has also prepared a regulation referring to accounting policies and principles, and containing framework accounting standards and a framework chart o f accounts consistent with GFS. This framework chart o f accounts will be adapted to meet the specific requirements o f individual agencies while maintaining full compliance with GFS standards. The new chart o f accounts is being piloted within consolidated budget agencies including several joint pilots with the GFS budget classification. Based inpart on the experiences from the pilots, the timetable for the accounting reform has been revised and is now as follows: (a) introduce modified accrual accounting in consolidated budget entities in 2004; and (b) begin introduction o f the modified accrual accounting in entities outside the consolidated budget in 2005. The long term objective is to introduce full accrual accounting in general government. The government accounting standards board to be established through the PFMC law will be responsible for transforming the framework standards included inthe accounting regulation into full-fledged accounting standards over time. 44. Procurement. We have moved decisively to upgradepublic procurement legislation and practices in line with international standards. The new public procurement law was enacted in January 2002 and subsequently amended inJune 2002. The new law is based on the UNCITRAL model and moves Turkey inthe direction of compliance with EU standards. The law covers all goods, works, and services-with the exception o f military contracts-and encompasses both budgetary and non-budgetary procurement. It i s applicable to central and local government agencies, as well as SEEs. The law establishes thresholds (in TL) above which foreign bidders cannot be restricted and a domestic preference o f 15 percent can be applied. The new law also stipulates the qualification requirements (including technical and financial criteria) for contractors which will supercede the existing contractor certificate system. The independent Public Procurement Board and Agency established under the law to oversee public procurement and ensure enforcement of the new procurement standards are fully operational. The secondary legislation required under the law has been issued and the new procurement standards came into force on January 1, 2003 as scheduled. In July 2003, a set o f further amendments was enacted which authorized limited procurement by SEEs under commercial practice. New procurement legislation for SEEs inthe public utilities sectors consistent with the relevant EUdirective is now being prepared. W e are monitoring the implementation o f the new procurement system. If improvements are deemed necessary, we will ensure that they are consistent with international best practice. Annex IV Page 12 of 14 45. Auditing. The modernization o f Turkey's public audit system has three main objectives: (a) to extend the mandate o f Turkish Court o f Accounts (TCA) to the whole o f General Government (b) to end TCA's involvement inbudget execution (c) and to transform T C A into an effective supreme audit institution operating in accordance with recognized international standards. These objectives have been facilitated by enactment o f the PFMC law. With regard to extemal audit , the law clarifies the roles and responsibilities o f the line agencies, the MOF and the TCA, and establishes a principle o f accountability which extends to the heads o f public administrations. It also requires T C A to focus on ex-post financial and performance audits. With regard to the transformation ofTCA, the law :(a) includes all consolidatedbudget agencies including the Presidency and Parliament within TCA's audit mandate as required by the Constitution; (b) subjects T C A to extemal audit, the reports o f which are submitted to the Parliament; and (c) after a transition period expands the scope o f TCA audits to cover the entire general government. 46. The transition period provides time for T C A to undertake intemal reforms to align its working methods with international standards for supreme audit institutions and to upgrade its audit capabilities. A draft action plan for the TCA's internal reform has beenprepared andwill be improved. Peer review o f the TCA and its action plan by auditors from another European Supreme Audit Institution is envisaged. We are drafting a new legislation on Turkish Courts o f Accounts to clarify the types o f audit (compliance, financial and performance) to be performed by TCA. We believe that the new legislation will have a profound impact inthe public interest by developing TCA's role in financial and performance audit. The new legislation will be submitted to Parliament by December 2004. Public Liability Management 47. Our Government recognizes the importance o f strengthening public liability management. The new Law on Public Finance and Debt Management, enacted in March 2002, has established the foundation for a comprehensive risk management framework. The new Law: (a) confirmed that the Treasury is the single borrowing authority for the central government; (b) created a more prudent and transparent framework for the management o f government guarantees; and (c) established a risk account in the budget, starting with the 2003 Budget, to cover the expected fiscal cost o f called guarantees and unexpected losses from other fiscal risks. The Treasury has established a new "Middle Office" for public liability and risk management. The circular on establishment o f the Middle Office and a Public Debt Management Committee to set the borrowing and liability management policy within the Treasury, was re-issued inJanuary 2003 with a strong emphasis on the risk control fimction o f the Middle Office. The new institutional structure for public liability management is now in place and fully operational. Furthermore, the Middle Office has launched monthly fiscal risk monitoring notes for the Treasury Management, and since April 2003 publishes quarterly Public Debt Management Reports covering risks coming from both its direct debts and contingent liabilities. A review o f the government guarantee portfolio was completed in June 2003, providing a preliminary valuation o f the guarantee portfolio. The Middle Office updates this valuation on a quarterly basis. Starting from January 2004 it had also implemented strategic risk benchmarks and medium-term borrowing scenarios to manage the portfolio o f direct govemment debt. Annex IV Page 13 of 14 48. Our Government aims to continue strengthening its capacity in public liability management. To this end, a two-year capacity-building program supported by a grant from the World Bank's Institutional Development Fund (IDF) in the amount o f US$320,000 was formulated. Within the context o f this IDF program, consultants are being identified to assist the Treasury's Middle Office in examining the best intemational practices in debt and risk management, in strengthening its financial and fiscal risk management practices, and in formulating optimal institutional arrangements for managing the government liability portfolios. Public Sector Governance 49. The Government is strongly committed to improve public sector govemance. A national strategy to enhance transparency and good govemance in the public sector was adopted in January 2002. The basic structure and actions o f this strategy has been reflected in the recent Urgent Action Plan (UAP) o f our Government. We are undertaking efforts to improve public awareness about good governance and is counting on the active contribution o f national NGOs. Our Government is committed to implementation o f the UAP which is in line with the framework set out in the national strategy. The ministerial committee for enhancing transparency and improving good govemance was established in March 2003. The committee will steer relevant actions o f both the UAP and national strategy in this reform area. The responsibility for implementation o f each action is clearly specified inthe UAP. The ministerial committee will prepare regular implementation reports for the national strategy within the context o fthe UAP. Among a comprehensive set o f substantive actions was the enactment o f the Law on "Freedom o f Information for Citizens" in October 2003. Our Government recognizes that this law provides an important new basis for enabling citizens to monitor the performance of public sector. Legislation establishing a code of conduct for civil servants is expected to be passed by end-July 2004. 50. We realize that sustained improvements inpublic governance will hinge in large part on effective reform of the civil service. Civil service reform is vital to raising the quality o f public services and ensuring the quality o f the fiscal adjustment. Preparations for a functional review o f government were initiated in mid-2002, but then delayed by the run up to elections. The functional review has now been re-launched under the responsibility o f SPO and the report will be submitted to the Government in July 2004. Our Government is cognizant o f the potential impact o f the measures in the Public Administration Framework Law on the implementation o f both civil service reform and the results o f the functional reviews. It intends to examine carehlly how these processes can effectively be aligned with one another, without slowing down the process o f implementation. Annex I V Page 14 of 14 5 1 . \VC bclicve that the policies and measures described above are adequate to achieve the objectives of the i;inancral arid Public Sector Reform Program. Our Govemmcnt is committedto meeting all of' the conditions agreccl with the Bonk [or Board presentation and release of the tranche of' Pb`PSAL, 111. The Government also stands ready to take additional ineasures, if ticcessary to actiieve the success of our program. In this rcgard. wc ntay consult with the Bank 3s the kxq" urrtblcts. Siirccrdy yours, c r .i Ali Babacan MinisterofState 4 Annex VI Page.1of 2 TURKEY THIRD PROGRAMMATIC FINANCIAL AND PUBLIC SECTORADJUSTMENT LOAN Turkey at a glance 5/14/04 Europe 8 Lower- POVERTY and SOCIAL Central middle- Turkey Asia income Development diamond' 2002 Population. mid-year (millions) 69.6 476 2,411 Life expectancy GNI per capita (Atlas mefhod, US$) 2,510 2,160 1,390 GNI (Atlas method, US$ billions) 174.5 1,030 3,352 T Average annual growth, 1996-02 I Population (%) 1.7 0.1 1.o Labor force (%) 2.2 0.4 1.2 GNI Gross per 1 primary Most recent estimate (latest year available, 1996-02) capita enrollment Poverty (% ofpopulation below national poverty line) I Urban population (% of fofalpopulation) 67 63 49 Life expectancy at birth (years) 70 69 69 - Infant mortality (per 7,000 live births) 36 25 30 Child malnutrition (% ofchildren under 5) 8 11 Access to improved water source Access to an improved water source (% ofpopulation) 82 91 81 Illiteracy (% ofpopulation age 15+) 14 3 13 Gross primary enrollment (% of school-age population) 101 102 111 -Turkey Male 105 103 111 ___ Lower-middle-incomegroup Female 96 101 110 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1982 1992 2001 2002 Economic ratios' GDP (US$ billions) 64.4 158.9 145.2 183.9 Gross domestic investment/GDP 17.0 23.9 16.8 21.3 Exports of goods and services/GDP 11.9 14.4 33.7 29.2 Trade Gross domestic savings/GDP 13.8 20.9 19.2 19.8 Gross national savings/GDP 18.5 24.4 20.7 20.8 Current account balance/GDP -1.5 -0.6 2.3 -0.8 Interest payments/GDP 1.8 2.0 3.6 2.3 savings Domestic - Investment Total external debt/GDP 30.6 35.6 78.1 71.5 Total debt service/exports 29.4 32.1 40.0 46.5 Present value of debtlGDP 1 Present value of debtlexports Indebtedness 1982-92 1992-02 2001 2002 200266 (average annualgrowth) GDP 5.1 2.8 -7.5 7.9 5.2 Turkey ~ GDP per capita 2.7 1.o -9.0 6.2 3.6 __ Lower-middle-incomeWOUD Exports of goods and services 5.5 11.4 7.4 11.1 5.5 ~~ ~ STRUCTURE of the ECONOMY 1982 1992 2001 2002 1 Growth of investment and GDP (Oh) (% of GDP) I Agriculture 22.7 15 3 12.8 1 3 0 :: Industry 25.1 29.9 26.1 23.7 Manufacturing 17.7 18.9 15.8 14.0 Services 52.2 54.7 61.1 63.3 ::: Private consumption 76.3 66.2 66.6 66.2 -60 1 General government consumption 9.9 12.9 14.2 14.0 Imports of goods and services -GDI - O - G D P 1 (average annualgrowth) 1982-92 1992-02 2o02 Growth of exports and imports (Oh) 1 Agriculture 1.4 1.1 -6.0 Industry 7.2 2.6 -7.2 Manufacturing 7.2 3.3 -8.0 Services 4.2 3.1 -6.2 Private consumption 4.3 2.2 -9.2 2.1 ' !-2O- General government consumption 3.4 4.4 -8.5 5.4 I-30 - V Gross domestic investment 5.0 1.1 -42.0 35.9 ~ -Exports - 0 l l m p O r t s Imports of goods and services 8.8 8.3 -24.8 15.8 ~ ~ __ Note 2002 data are preliminary estimates *The diamonds show four key indicators in the country (in bold) compared with its income-group average If data are mlssing, the diamond will be incomDlete Annex VI Page 2 of 2 PRICES and GOVERNMENT FINANCE 1982 1992 2001 2002 __ II ~ I Domesticprices Inflation (%) (% change) I100 - Consumer prices (1987=100) .. 70.1 53.9 44.8 implicit GDP deflator 28.2 63.7 54.8 44.1 1 40 - Government finance (% of GDP, includes current grants) Current revenue 19.0 32.0 32.3 Current budget balance .... -1.3 -12.3 -4.5 , Overall surplus/deficit .. -10.7 -19.2 -11.4 -GDP deflator -0-CPI TRADE 1982 1992 2001 2002 (US$ mi//ions) Export and import levels (US$ mill.) I Total exports (fob) 5,890 14,715 34,373 40,124 60,000 - Textiles 1,145 5,603 10,344 12,148 Processed agricultural products 1,571 2,293 1,876 1,743 Manufactures 4,655 13,264 28,695 33,549 Total imports (cif) 8,843 22.871 41,399 51,555 Food 123 1,398 1,072 1,449 Fuel and energy 3,943 3,903 8,339 9,204 "I Capital goods 2,214 7,970 6,964 8,492 Export price index (1995=100) 95 76 75 96 97 98 99 00 01 Import price index (1995=100) 90 81 76 FaExports Imports Terms of trade (1995=100) .. 105 94 98 BALANCE of PAYMENTS 1982 1992 2001 2002 (US$ millions) Current account balance to GDP (%) Exports of goods and services 7,818 24,279 50,403 54,907 3 - Imports of goods and services 9,592 26,687 45,816 55,365 2 Resource balance -1,774 -2,408 4,587 -458 Net income -1,455 -2,625 -5,000 -4.554 Net current transfers 2,277 4,059 3,803 3,490 Current account balance -952 -974 3,390 -1,522 - 4 1 Financing items (net) 1,120 2,458 -6,084 7,675 -5 1 Changes in net reserves -168 -1,484 2,694 -6,153 Memo: Reserves including gold (US$ millions) 2,027 15,254 30,212 36,344 Conversion rate (DEC, local/US$) 162.9 6,881.3 1,228,367 1,509,471 EXTERNAL DEBT and RESOURCE FLOWS 1982 1992 2001 2002 (US$ millions) 1 Composition of 2002 debt (US$ mill.) Total debt outstanding and disbursed 19,716 56,554 113,437 131,556 IBRD 1,962 5,564 4,707 5,367 IDA 187 148 95 89 I G: 15.192 A: 5.367 Total debt service 2,968 9,086 22,369 27,604 IBRD 209 1,207 723 708 IDA 3 6 7 7 Composition of net resource flows Official grants 307 506 Official creditors 762 -737 180 224 Private creditors 146 6,104 -2,293 6,562 Foreign direct investment 55 779 2,769 863 Portfolio equity 0 -394 -4,611 -1,183 F:80.451 World Bank program Commitments 648 686 2,200 1,650 A IBRD - E Bilateral Disbursements 500 286 1,537 1,031 B- IDA D Other multilateral - F Private -- Principal repayments 86 733 438 443 C iMF - G- Short-term Net flows 415 -447 1,099 588 Interest payments 127 480 292 272 Net transfers 288 -927 807 316 Development Economics 5/14/04 Annex VI1 Page 1of 2 FundRelationsNote Press Release No. 04/76 InternationalMonetary Fund April 16,2004 700 19thStreet, NW Washington, D.C. 20431USA IMFCompletesSeventhReview andApproves US$495MillionDisbursementUnder Stand-ByArrangement with Turkey The Executive Board o f the InternationalMonetary Fund(IMF) today completed the seventh review o f Turkey's economic performance under the Stand-By Arrangement and approved the disbursement of an amount equivalent to SDR 340 million (about US$495 million). Incompleting the review, the ExecutiveBoardalso grantedTurkey's request for waivers, and approved the rephasing o f the remaining program reviews and an extension o fthe Arrangement through February 3,2005 to allow time for the final disbursement under the program. Turkey's Stand-By Arrangement was approved on February 4,2002 (see Press Release No.02/7) ina total amount o f SDR 12.8 billion (about US$18.6 billion). So far, Turkey has drawn SDR 11.1 billion (about US$16.2 billion) under the Arrangement. Following the Executive Boarddiscussion, Anne Krueger, Acting ManagingDirector and Chair, said: "Turkey's economic program has continued to deliver impressive results. Economic growth has exceeded program targets for the second year running, interest rates have fallen sharply, helping Turkey's debt dynamics, inflation has declined to its lowest rate ina generation, andconfidence inthe Turkish lirahasbeenrestored. "The government's commitment to meeting its primary surplus target o f 6% percent o f GNP in2004 has playedan important role inthis success. The government's recent corrective measures, includingcutting discretionary spending by 13 percent andraising excises, demonstrate its commitment to meeting the 2004 program target, and the government should remain vigilant to avoid slippages. "The adoption o f a comprehensive structural fiscal reform strategy in2004 should help sustain this fiscal adjustment inthe mediumterm and lead to a better composition o f the budget. Stronger tax administration will aid incombating tax evasion, planned social security reforms will help underpin medium-term fiscal stability, and the forthcoming public expenditure review should provide guidance on reducing rigidities inthe budget structure. Timely implementation o f this ambitious reform agenda is needed to help boost policy credibility. "The Central Bank o f Turkey's handling o f monetary policy has continued to be impressive, with inflation rates falling sharply. The government's continued fiscal discipline has played a key role inthis accomplishment. Annex VI1 Page2 of 2 "The current policy response to capital inflows-reintroducing foreign exchange purchase auctions, allowing modest real appreciation o f the exchange rate, and cutting interest rates gradually-is appropriate. Closer coordination between the Central Bank and the Treasury insharingthe cost ofaccumulating reserves shouldhelp strengthen monetary anddebt management. "The authorities' intention to reinvigorate banking reform is welcome. The BankingAct is being brought more closely inline with EuropeanUnionpractice, while the inquiryinto Imar bank should help strengthen banlung supervision. Needed further steps include accelerating asset recovery by the Savings Deposit and Insurance Fund(SDIF) and reform o f state banks. Firm support o fthe Banking Regulation and Supervision Agency (BRSA) will continue to be important. "The Turkish authorities have continued to make strong efforts to adhere to their ambitious program, includingby implementation o f fiscal measures ahead o f the Marchelections to help meet the primary surplus targets. They have also adopted an ambitious structural reform agenda for the remainder o f the program. The result has been a marked improvement inmarket confidence and economic performance. These strong efforts deserve the continued support o f the international community," Ms.Krueger said. Annex VI11 Page 1of 4 TURKEY THIRD PROGRAMMATIC FINANCIAL AND PUBLIC SECTORADJUSTMENT LOAN INTEGRATED SAFEGUARDSDATA SHEET (as originally approved) I.A.1. Project Statistics COUNTRY: Turkey PROJECT ID:TU-PE-PO82996 PROJECT: PFPSAL I11 TTL: James ParksiLalit Raina APPRAISAL DATE: Mav 2003 IBRDAMOUNT ($mk 900 BOARD DATE: June 19,2003 IDA AMOUNT ($m): - MANAGINGUNIT: ECSPE/ECSPF SECTOR: EP-Economic Policy LENDINGINSTRUMENTS: PSL STATUS: Preparation completed. I.A.2. Project Objectives (From PDS) The mainobjective o fthe proposedPFPSAL I11is to support implementationduring2003 o fthe Government's financial and public sector reform priorities inresponse to the 2001 economic crisis, while I.A.3. Project Description (From PDS) The proposed Third Programmatic Financial and Public Sector Adjustment Loan (PFPSAL 111) is the third Loan insupport o f the Government's multi-year financial and public sector reformprogram. It follows on the first Programmatic Financialand Public Sector Adjustment Loano fUS$l.1billionapproved inJuly 2001 (US$700 million on standard IBRD terms and US$400millionon SSAL terms) and the second Programmatic Financial and Public Sector Adjustment Loan o fUS$1.35 billionapproved inApril 2002 (USSSSO million on standard IBRDterms and US$800 million on SSAL terms). Key reformpriorities in the financial sector include: (i) o f the regulatory framework for banking activity, (ii) overhaul institutional development o f the new Bank Regulation and Supervision Agency (BRSA), (iii) problembankhank failure resolution, and (iv) state bank restructuring and privatization. Key reform priorities inthe public sector include: (a) a hrther deepening o f structural fiscal policies insupport of sustainable fiscal adjustment, (b) implementation o f the Government's public expenditure management reform program including concrete improvements inbudgetplanning and execution, completion o f the new legal and institutional framework for financial management and accountability, and consolidation of the new system o f public liability management, and (c) implementation o fthe Government's strategy to strengthen public sector governance including implementation o f the national anti-corruption strategy and preparation o f civil service reform. Priorities for social spending include: (i)adequate expenditure allocations for health, education and social protection inthe 2003 budget inline with benchmarks agreedunder the PFPSAL program and (ii) better targeting o f social protectionto vulnerable groups including framework legislation to institutionalize the direct income support (DIS) programfor farmers. conservation and the shft awayfiom indirect agricultural subsidies to DIS may reduce the use of environmentally harmful fertilizers. Improvements in Public ExpenditureManagement should permit line 11 ; ministries, including TheMinistry of Environment, to be morefocused in their use of resources. Clickon Policy name for brief summary o f objectives, triggers and requirements Click on Policy reference number for full policy LC1. Table on applicability Yes No TBD Annex VI11 Page 2 of 4 Environmental Assessment (OPIBPIGP 4.0 1) [I [ X I [I Forestry (OPIGP 4.36) E[I 1x1 l [I NaturalHabitats (OPIBP 4.04) [ X I [I Safety of Dams (OPIBP 4.37) [I [ X I [I Pest Management (OP 4.09) [I [ X I [I Involuntary Resettlement(OD 4.30) [I [ X I [I Indigenous Peoples(OD 4.20) [I [ X I [I Cultural Property (OPN 11.03) [I [ X I [I Projects inDisputedAreas (OPIBPIGP 7.60)* [I [ X I [I Projects on International Waterways (OP/BP/GP 7.50) [I [ X I [I * By supporting the proposed project, the Bank does not intend to prejudice thefinal determination of the parties' claims on the disputed areas Annex VI11 Page 3 of 4 Section I1-Key Safeguard Issues and Their Management ILD. Summary of Key Safeguard Issues. Pleasefillinall relevant questions. Ifinformation is not available, describe steps to be taken to obtain necessary data. 1I.D.la. Describe any safeguard issues and impacts associated with the proposed project. Identify and describe any potential large scale, significant andor irreversible impacts. The project will not directly finance physical investments; it will provide foreign exchange and general budgetary support. 1I.D.lb. Describe any potentialcumulative impacts due to application ofmore thanone safeguardpolicy or due to multiple project component. NIA 1I.D.IC any potentiallongterm impacts due to anticipated future activities inthe project area. Describe NIA II.D.2. Inlight o f 1, describe the proposed treatment o f alternatives (ifrequired) NIA II.D.3. Describe arrangement for the borrower to address safeguard issues NIA II.D.4. Identify the key stakeholders and describe the mechanisms for consultation and disclosure on safeguard policies, with an emphasis on potentially affected people. NIA E. Safeguards Classifcation (select one). Category is determinedbythe highest impact inany policy. Or onbasis o f cumulative impacts from multiple safeguards. Whenever an individual safeguardpolicy i s triggered the provisions o f that policy apply. [] S,. -Significant, cumulative andor irreversible impacts; or significant techcal and institutionalrisks inmanagement o fone or more safeguardareas [ ] Sz. -One or more safeguardpolicies are triggered, but effects are limitedintheir impact and are technically and institutionally manageable [x] S3. -No safeguard issues [3 SF-Financialintermediary projects, social development funds, community drivendevelopment or similar projects which require a safeguard framework or programmatic approach to address safeguard issues. I;. DisclosureRequirements ExpectedDate Actual Date Environmental Assessment/Analysis/Management Plan: Date o f receipt by the Bank NIA Date o f "in-country'' disclosure NIA Date o f submission to InfoShop NIA For category A projects, date o f distributingthe Executive Summary o f the EA to the Executive Directors NIA ResettlementAction Plan/Framework: Date o f receipt by the Bank NIA Date o f "in-country" disclosure NIA Date o f submission to InfoShop NIA Indigenous Peoples Development Plan/Framework: Date o f receipt by the Bank NIA Date o f "in-country" disclosure NIA Date o f submission to InfoShop NIA Pest Management Plan: Date o freceipt by the Bank NIA Date o f "in-country" disclosure NIA Date o f submission to InfoShop NIA Dam Safety Management Plan: Date o f receipt by the Bank NIA Date o f "in-country'' disclosure NIA Date o f submission to InfoShop NIA Annex VI11 Page 4 of 4 Ifin-countrydisclosureofanyoftheabovedocumentsisnotexpected,pleaseexplainwhy. N/A Signed and submittedby: Task TeamLeader: James Parks Date: April29,2003 ProjectSafeguards Specialist 1: Name Date: ProjectSafeguards Specialist2: Name Date: ProjectSafeguards Specialist3: Name Date: Approvedby: Regional SafeguardsCoordinator Jane Holt Date: April29,2003 Comments Sector Manager L(4ulkbk SamuelOtoo B m :April29,2003 Comments