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 wi