world bank document · 2016. 8. 5. · document of the world bank for official use only report no....

Document ofThe World Bank

FOR OFFICIAL USE ONLY

Report No. 22282 TU

MEMORANDUM OF THE PRESIDENT

OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

AND

THE INTERNATIONAL FINANCE CORPORATION

TO THE

EXECUTIVE DIRECTORS

ON A

COUNTRY ASSISTANCE STRATEGY

PROGRESS REPORT

OF THE

WORLD BANK GROUP

FOR THE

REPUBLIC OF TURKEY

June 7, 2001

Turkey Country DepartmentEurope and Central Asia Region

International Finance CorporationSouthern Europe and Central Asia Department

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosedwithout World Bank authorization.

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The FY01 -03 Country Assistance Strategy for Turkey was discussed by the Executive Directors onDecember 21, 2000 (Report No. 21408-TU, dated November 28, 2000).

CURRENCY AND EQUIVALENTS

Currency Unit: Turkish Lira (TL) as of June 5, 2001US$1=TL1,165,861

WEIGHTS AND MEASURES FISCAL YEAR

Metric System January 1 - December 31

ABBREVIATIONS AND ACRONYMS

APL Adaptable Program Loans MIGA Multilateral Investment Guarantee AssociationARIP Agricultural Reform Implementation Project MOH Ministry of HealthASCU Agriculture Sales Cooperative Union NBFI Non Bank Financial InstitutionBRSA Banking Regulation and Supervision Authority OECD Organization for Economic Cooperation and DevelopmentCAS Country Assistance Strategy OED Operations Evaluations DepartmentCAS PR Country Assistance Strategy Progress Report PA Privatization AuthorityCBT Central Bank of Turkey NGO Non-Govemmental OrganizationCEM Country Economic Memorandum PEIR Public Expenditure and Institutional ReviewCFAA Country Financial Accountability Assessment PFPSAL Programmatic Financial and Public Sector Adjustment

LoanCIF Cost, Inventory and Freight PFSAL Programmatic Financial Sector Adjustment LoanCPAR Country Procurement Assessment Report PPSAL Programmatic Public Sector Adjustment LoanDIS Direct Income Support PSBR Public Sector Borrowing RequirementEERL Emergency Earthquake Recovery Loan PSSP Privatization Social Support ProjectERL Economic Reform Loan SDIF Savings Deposit Insurance FundESW Economic Sector Work SDR Special Drawing RightEU European Union SECA Southem Europe and Central Asia Department (IFC)FDI Foreign Direct Investmnent SEEs State Economic EnterprisesFIAS Foreign Investment Advisory Service SME Small & Medium EnterprisesFOB Free on Board SRF Sopplemental Reserve FacilityFSAL Financial Sector Adjustment Loan SSAL Special Structural Adjustment LoanGEF Global Fnvironment Facility SSF Social Solidarity FundGDP Gross Domestic Product TDO Total Debt OutstandingGNP Gross National Product TDS Total Debt ServiceHIES Household Income and Expenditure Survey TESEV Turkish Economic and Social Studies FoundationIBRD Intemational Bank for Reconstruction and Development THY Turkish AirlinesIFC Intemational Finance Corporation TINs Tax Identification NumbersIFI Intemational Financial Institution UN United NationsIMF International Monetary Fund UJNDP United Nations Development ProgramJPPR Joint Portfolio Performance Review UNICEF United Nations Children's FundLIBOR London Interbank Offer Rate WPI Wholesale Price IndexMEER Marmara Earthquake Emergency Reconstruction Project

WB Mana2ers and Staff Responsible for this CAS

Vice President Mr. Johannes LinnCountry Director Mr. Ajay ChhibberResponsible Staff Ms. Sally Zeijlon

Mr. James Parks

IFC Mana2ers and Staff Responsible for this CAS

Vice President Mr. Assaad J. JabreDirector Mr. Khosrow ZamaniResponsible Staff Ms. Sujata Lamba

Mr. George Konda

TABLE OF CONTENTS FOR OFFICIAL USE ONLYEXECUTIVE SUMMARY ............................................. I

THE NEW ECONOMIC PROGRAM ........................................................................................................ 11

THE BANK'S ACCELERATED PROGRAM FOR TURKEY ............................................ III

TURKEY'S RECOVERY WILL HAVE REGIONAL IMPLICATIONS ............................................ v

ISSUES FOR BOARD DISCUSSION ............................................ v

I. INTRODUCTION ............................................. 1

II. RECENT DEVELOPMENTS .

A. ECONOMIC DEVELOPMENTS.I

B. POLITICAL CONTEXT AND SOCIAL DEVELOPMENTS .3

C. NEW POLIcYFRAMEWORK. 5D. OUTLOOK FOR 2001 AND THE MEDIUM TERM .12

III. THE BANK GROUP PROGRAM .14

A. IBRD PROGRAM.14B. IFC PROGRAM.25C. MIGA PROGRAM.28

IV. MANAGING THE RISKS AND IBRD) EXPOSURE.28

VJ. CONCLUSION.33

BOXES. TABLES . AND FIGURES

Box 1: Crisis IndicatorsB3ox 2: Key Actions for 2001 Under the New programBox 3: Lessons from Recent Emerging Market CrisesBox 4: Monitoring the Social Impact of the Crisis and the Reform ProgramBox 5: Revised Triggers for the High Case

T able 1: Selected Social Indicators: Country ComparisonTable 2: Key Economic IndicatorsTable 3: Proposed Revised FY01 -03 CAS Indicative Lending ProgramTable 4: Comparison of CAS High Case with Proposed Revised High Case FY01-03Table 5: Share of Bank Portfolio

Figure 1: IBRD Net Flows and Debt

ANNEXESAnnex Al Key Economic and Program IndicatorsAnnex A2 Country at a GlanceAnnex B2 Portfolio IndicatorsAnnex B3 Bank Group Program SummnaryAnnex B4 Summary of Nonlending ServicesAnnex B6 Key Economic IndicatorsAnnex B7 Key Exposure IndicatorsAnnex B8 Status of Bank Group OperationsAnnex B 11 Macroeconomic FrameworkAnnex B12 Banking Sector ReformAnnex B 13 The Legislative Agenda for 2001

|This document has a restricted distribution and mnay be used by recipients only in the performance of their|of ficial duties. Its contents may not otherwise be disclosed without World Bank authorization.

A . lRIR G A ........................................................................ 1

REPUBLIC OF TURKEYCOUNTRY ASSISTANCE STRATEGY PROGRESS REPORT

EXECUTIVE SUMMARY

i. Turkey is in a deep economic crisis and facing growing social hardships. Politicaldisputes in the Government in February 2001 triggered this sharp deterioration - but theunderlying reasons go deeper and were built up over the previous decade. The immediate threatof political instability in February, coming on top of a growing current account deficit and slow-down in policy implementation, eroded market confidence and caused a rapid exit to foreignexchange. This in turn forced Turkey to abandon the crawling peg regime, which had been a keypillar of the previous economic program designed to reduce inflation. The resulting nominaldevaluation - some 40-45 percent since February - and interest rates rising above 100 percenthave largely contributed to the onset of a sharp recession and a wider banking crisis. The socialimpact is already being felt as lay-offs, rising prices, and negative growth reduce householdincomes and place a growing risk of poverty and vulnerability on people already at the lower endof the income scale. Unemployment is rising rapidly, incomes have been reduced, and incomedisparities are widening. Inflation surged back to 6 percent in March, over 10 percent in April,and 5 percent in May. While these risks were broadly identified in the CAS discussed with theBoard in December 2000, the political disputes that triggered the crisis could not have beenforeseen.

ii. External and internal factors contributed to the collapse of Turkey's previousdisinflation program, which started in December 1999. On the external side, rising oil pricesand a weakening Euro contributed to Turkey's weakening external accounts. Internally, a sharpdrop in interest rates shortly after the start of the program had led to a surge in demand. Inflationdid not come down as quickly as was anticipated, the real exchange rate appreciated significantlybecause of the pegged exchange rate, and imports increased sharply contributing to a hugecurrent account deficit which reached 5 percent of GNP. Policy complacency slowed reformstriggering financial turmoil in November 2000. The enhanced policy package of December -which maintained the crawling peg, but strengthened the fiscal and structural program to helpTurkey recover - was, however, short-lived as political instability derailed the program inFebruary 2001. As interest rates shot up, the economy stalled, leading to a deeper financial crisis.

ill. Turkey's crawling peg was a bold but risky attempt to eliminate inflation and bringdown interest rates. With hindsight, its inherent rigidities were too demanding for Turkey'sfractured politics. A fragile banking sector with large contingent liabilities added immensely tothe structural problems. The large profits from high interest rates had allowed very weak banksto survive and take on risky positions. As interest rates came down sharply in response to therestored confidence in early 2000, banking sector profits fell, exposing the banking sector'sweaknesses. When the initial capital inflows dried up in the latter half of 2000 and liquiditytightened, the interest rates spiked, transforming the banks' weaknesses into losses. The weakestbanks collapsed, generating a systemic banking crisis. Without a fundamental restructuring of thebanking sector, the program was always vulnerable to problems in the weaker banks. The widercrisis now provides Turkey an opportunity to deal more comprehensively with weak publicfinances and a fragile banking sector to produce lasting solutions. While the new program will

not be constrained by the rigidities of a pegged exchange rate, policy credibility and fiscaldiscipline will become even more critical.

iv. Turkey's challenge going forward is to try to recover quickly from the sharprecession - but at the same time to address some of its root causes. Turkey has established anew economic team and outlined a new economic program. The new program goes much deeperthan previous attempts in trying to fix the structural causes of the crisis - weak public financesand a fragile banking system - while strengthening social programs. It will also bring Turkeycloser to its goal of EU accession. Vigorous implementation is necessary to ensure success.

The New Economic Program

v. The key structural and social elements of this new economic program are a strongfocus on public sector reform, building a sound bankingz sector and liberalization of marketsfor private sector led growth, as well as special emphasis on strengthening social assistance.The mainfeatures are:

* Large fiscal adjustment with the primary surplus exceeding 5.5 percent of GNP for 2001 and2002, and a macro-economic framework designed to bring real interest rates to around 20percent by end -2001.

- Rapid restructuring of the banking sector - especially of state banks and intervened banks -and measures to reduce connected lending..Strengthened public expenditure management and governance - including improvements inpublic procurement, accounting and auditing, and anti-corruption measures.

* Market liberalization in energ and telecommunications, and establishment of anindependent regulatory body for energy,

* Privatization and corporatisation of state-owned enterprises, including thetelecommunications company, national airline, petroleum refineries, and iron and steelcompanies.

* Continuation of agriculture sector reform to liberalize the sector, shifting from pricesubsidies to direct income payments to farmers.

* Strengthening of social assistance to help people adversely affected by the economic crisis.

vi. The new program is formulated to bring about a rapid turnaround in the economy.Rapid restructuring of the banking sector is a key factor in restoring confidence and ensuringearly recovery. Experience gained from other countries suggests that quick and decisive progresson fiscal adjustment and financial restructuring is critical for quick recovery. As a result of long-standing weaknesses in the banking sector and reinforced by the impact of financial crisis, thefiscal costs of the clean-up of the state banks and intervened private banks are expected to exceedUS$40 billion. Rapid restructuring of the banking system, necessary for early recovery, has largeup-front costs for which all the necessary financing can not be raised domestically. The macro-economic framework requires a large fiscal adjustment and an additional US$10 billion ofexternal support in 2001 to close the financing gap. This additional support is now to beprovided under the new IMF and World Bank Group programs.

ii

vii. Tourism, export and foreign investment growth will aid the initial recovery.Turkey's tourism sector is on track to produce a record year in 2001 if social tensions do not rise.The inherent rigidities of a crawling peg exchange rate arrangement, which led to a substantialappreciation of the Turkish Lira, are gone. If the large real devaluation since February of over20 percent is maintained through tight demand management, Turkey could see a substantialboost in exports. The large current account deficit of around 5 percent of GNP in 2000 is likelyto fall sharply in 2001. Turkey is also making stronger efforts to attract foreign direct investment(FDI) and there are some indications of new foreign investor interest. These positive elementscould be further strengthened by decisive actions to remove obstacles to FDI. Over all, structuralreform is being designed to strengthen the environment for private-sector led growth.

viii. But the risks going forward remain high. The political factors that contributed to thesteep market downturns in November and February remain, and may have become moreprominent. These factors imply serious implementation risks because of the need to take urgentactions without a lot of time to build consensus. There remains considerable opposition to thereform among particular interest groups such as labor unions and large farmers. Even within thecoalition opposition to aspects of the reform program has been openly expressed. These politicalfactors may encourage the markets to adopt a wait-and-see attitude. The macro-economic pictureand the debt dynamics remain uncertain because of the impact of political uncertainty.Following the latest crisis, Turkey faces much higher debt ratios than before. In 2001 publicexternal debt is around 34 percent of GNP and public domestic debt around 44 percent. The debtdynamics and recovery depend critically on the rapid reduction interest rates to around 50percent by end-2001. Even under the most favorable assumptions, the economy would contractby 3 percent in 2001, with inflation over 50 percent. The consistency of the macro-economicframework will be enhanced by the additional external financing of some US$10 billion from theIMF and IBRD. Despite additional external support by the IMF and the Bank, the markets couldremain skeptical if policy actions are delayed. Market skepticism, in turn, could prevent interestrates from coming down as projected under the program. Sustained high interest rates couldforce painful and risky debt restructuring or monetization. Turkey's new economic program isdesigned to avoid these unpalatable options, by putting into place immediate upfront measuresand a blueprint for the medium term to tackle the structural and institutional roots of currentproblems.

The Bank's Accelerated Program for Turkey

ix. In 2000 the Bank Group supported significant structural reforms. Before and evenduring the crisis, a number of important actions were taken. These included theestablishment of an independent banking authority, a new banking law, the electricity marketlaw, reform of the pension system, a constitutional amendment for international arbitration, start-up of agricultural reform, establishment of a telecommunications regulator, and acceleratedprivatization which generated over US$5 billion in revenue to date in 2000-01. However, thisimpressive set of structural reforms was insufficient to avoid a crisis. These structural actionswere supported by two adjustment loans from IBRD - the Economic Reform Loan (ERL,US$760 million) approved by the Board in May 2000 and the Financial Sector Adjustment Loan(FSAL, US$778 million) approved in December 2000. The first tranches of these loans, totaling

iii

US$777 million, were disbursed in 2000. In December 2000, the Board also discussed the CASfor FY01 -FY03 with a High Case lending envelope of US$5 billion.

x. In order to support Turkey's implementation of the accelerated New EconomicProgram, IBRD proposes to accelerate and refocus its support for Turkey - but in agraduated response to structural and social reforms. The accelerated structural reforms underthe new program deserve enhanced support from IBRD - especially in the areas of banking andpublic sector reform. In 2001 additional external financing will largely come from the IMF.IBRD will contribute US$2 billion (out of US$10 billion) towards this incremental financing, ofwhich US$0.8 billion will be provided by accelerating disbursements from the existing envelopeof US$5 billion and US$ 1.2 billion will be provided through new financing under SpecialStructural Adjustment Loan (SSAL) terms. Total disbursements from the Bank in 2001 arecurrently expected to amount to US$3.2 billion. As a result of this increased lending in 2001,total commitments for the period FYO1-03 could reach US$6.2 billion, of which US$1.2 wouldbe on SSAL terms.

xi. The Bank Group's revised CAS program increases the focus on banking and publicsector reforms and enhances assistance to Turkey for strengthening its social protection.While each of these was an important part of the program in the December 2000 CAS for FY01 -03, the revised FYOI-03 program presented in this CAS Progress Report (CAS PR) involvesaccelerating and deepening support in those three areas. In the area of banking and public sectorreform, Turkey plans to accelerate significantly the schedule of structural reforms. In support,IBRD proposes to provide two programmatic loans in 2001, totaling US$2.45 billion. Thesewould be followed in 2002 by smaller sectoral adjustment loans in the financial sector and thepublic sector. The second tranche of the FSAL (US$385 million) would be cancelled, becausethe financial sector reform program is now broader than anticipated six months ago and someaspects originally expected to be part of a later operation have been brought forward.Conceptually, the cancelled portion of FSAL I has been rolled into proposed new operations. Thesecond tranche of the ERL (US$375 million) would be maintained to continue to support reformsthat will remove remaining obstacles to private sector growth - although IBRD expects delays inmeeting tranche conditions because of the difficult market environment for privatization. IFC'sfinancing and other assistance will also focus on the financial sector and privatization, as well asfirms with good export prospects which can contribute to rapid economic recovery. IBRD is alsopreparing a Social Risk Mitigation Project (US$500 million) to bring to the Board early in thefall. At that time, an assessment of the social impact of the crisis would also be shared with theBoard. The Agriculture Reform Implementation Project (ARIP), to be presented to the Boardwith this CAS PR, supports structural reform in agriculture and implementation of a directincome support system for farmers. The triggers for the High Case program have beenstrengthened in view of Turkey's accelerated structural reforms in banking and public sectorreform as well as to ensure that social expenditures are adequately protected during a period offiscal stringency. These triggers have served well in the past in ensuring that the Bankimplements a carefully graduated response to Turkey's reforms and the same process would befollowed going forward.

xii. IBRD's long-term support to programs in education, health, community-basedwatershed management, and community development and heritage will continue alongsidesupport for Turkey's economic reforms. These programs have a very positive long-term

iv

impact and will be maintained as would the enhanced social assistance program, even if Turkeydoes not meet all of the triggers for the High Case program. On the other hand, the revisedprogram recognizes that not all agendas can be tackled at once. Therefore, operations in supportof municipal reform, seismic risk mitigation, and village and township services will take longerto prepare and will likely be in the program for FY04. The energy sector project could be readyin late FY03 or in early FY04.

xiii. IFC's medium and long-term strategy remains as in the CAS, but the short-termstrategy is changing in response to the crisis. IFC is closely collaborating with the Bank tosupport the new reform program. The focus will be on highly visible interventions with strongdemonstration effects and positive impact on market psychology. IFC will protect its portfolioby working on restructuring and, where appropriate, recapitalizing its portfolio companies.Providing swift support to enable existing export-oriented clients to generate foreign exchangewill help such firms with debt service and contribute to the vibrancy of exports, which is vital torecovery. In the current situation of credit scarcity, IFC's ability to provide long-term projectfinancing, credit lines for banks, working capital finance, and operational and financialstrengthening is a positive contribution to the private sector. During 2001-02, IFC will givepriority to: (i) the financial sector; (ii) restructuring industrial companies; and (iii) assisting theauthorities with privatization. The complementary focus of the Bank and IFC in these respectswill enhance the Bank Group's help to Turkey's implementation of the reform program.

Turkey's Recovery Will Have Wider Implications

xiii. The New Economic Program represents an opportunity for Turkey to avoid a costlydebt restructuring, run-away inflation, and a social crisis. If the program succeeds, theBank Group will have played a major role in assisting an important middle-incomecountry to deal with vital structural and social issues. While the risks are high, if the politicalwill remains intact Turkey can avert an even bigger crisis through its new program and BankGroup support. The alternatives are costly for Turkey's population (especially for the growinggroup of poor and vulnerable) and would have significant effects regionally and perhaps evenglobally. Such an alternative can be avoided with determined implementation of theGovernment's program and the right mix of financial and technical support. Turkey needs andrequests the Bank Group's support now to help its recovery and to address fundamental structuraland social problems.

Issues For Board Discussion

Executive Directors may wish to address the following issues for discussion:

* Is the Government's program appropriately structured to meet Turkey's financial, economicand social challenges during the current crisis and for long-term recovery and povertyreduction?

* Is the increase in the High Case lending under SSAL terms and the acceleration of the Bank'ssupport appropriate and adequate for the identified strategic priorities?

* Is the Bank Group's lending and non-lending support appropriately structured?* Have the risks been appropriately identified and addressed?

v

MEMORANDUM OF THE PRESIDENTOF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENTAND THE INTERNATIONAL FINANCE CORPORATION

TO THE EXECUTIVE DIRECTORS ON ACOUNTRY ASSISTANCE STRATEGY PROGRESS REPORT

OF THE WORLD BANK GROUPFOR THE REPUBLIC OF TURKEY

I. INTRODUCTION

1. On December 21, 2000, the Board discussed the Country Assistance Strategy of theWorld Bank Group for the Republic of TurkeyI for FY01-03. At that time, Turkey wasemerging from its financial turmnoil of November 2000 with renewed commitment to structuralreform and a macroeconomic stabilization plan. The CAS signaled the significant risks faced bythe program. Political, economic, financial sector, and institutional issues were flagged as likelyrisks, as well as the possibility of a large natural disaster. Unfortunately, the economic andfinancial sector risks materialized following a political dispute, which initiated the full-fledgedcrisis that hit Turkey in February 2001, resulting in the decision to abandon the pegged exchangerate and float the currency. The Government has now formulated a New Economic Programbased on a more gradual disinflation path, and a more rapid, comprehensive structural reformprogram. The Bank Group proposes, consistent with the strategic thrusts of the CAS, to supportthe new reform program of the Government, in particular focussing on its structural and socialaspects. In the structural area, the priorities for Bank Group support would be banking sectorrestructuring and reform, public sector reform, and continuation of reform in agriculture, energy,telecommunications and pensions. On the social side, IBRD will help the Government tostrengthen its social assistance programs and provide financial resources to Turkey for targetedsocial support for vulnerable groups and the poor, especially women and children. In addition tosome acceleration of disbursement within the CAS high case lending envelope of US$5 billion,this Progress Report proposes additional IBRD support over the CAS envelope on SpecialStructural Adjustment Loan (SSAL) terms of up to US$1.2 billion, for a total possible lending ofUS$6.2 billion in the period FYOI-03.

II. RECENT DEVELOPMENTS

A. Economic Developments

2. External and internal factors contributed to the collapse of Turkey's previous disinflationprogram, which was adopted in December 1999. On the external side, rising oil prices and aweakening Euro added to Turkey's large current account deficit. Internally, a sharp drop ininterest rates led to a surge in demand. Inflation did not come down as quickly as was anticipatedand imports increased sharply. The exchange rate appreciated significantly. Policy complacency

'Report No. 21408 TU, dated November 28, 2000.

Turkey CAS Progress Report 2

Box 1: Crisis Indicators

CPI Inflation Exchange Rate

12.0 40\0

10.0 30.0

8.0 10.0 P.R 6.0 0.0

4.0 -10.0- - - -

2.0 C s ~ C S

0.0 4

o4~ 0 )\1 0ly ~' Monthly average exchange rate percentage change

(T L/UJS5)CPI monthly percentage change

Interest Rate Istanbul Stock Exchange

250.0 21000 -

150.0 18000

100.0 9000

50.0 3000

0.0

iSE National 100 index - 1986=1 TL.12 month norrinal interest rate on T-bdls

Unemployment Rate GNP Growth

10 1.00

Apr-99 Oct-99 01- 02- Q3- 04- 01- NCi ab b No

2000 2000 2000 2000 2001 O ;( N GN (i5O.CO

SS reported unemrpbyrrent Q1 & Q2-2001: WB forecast

Real Private Credit 83 Capacity Utlilization i- Mas.utactaring

3000 ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~.

2000 ____ __X 9 Y 2- 10000DIDX

4000 el liuiiIrnhi Z g 7 8 7 8

l I3000679 _ _ _ _ _ _ _ _ _ _ _ _

Turkev CAS Progress Report 3

slowed reforms triggering a mini-crisis in November 2000. The enhanced policy package ofDecember, which kept the crawling peg and strengthened the fiscal and structural program, wasshort-lived as political instability derailed the program in February 2001. As interest rates shotup, the economy stalled, bringing on a deeper financial crisis (see Box 1).

3. With hindsight, Turkey's crawling peg was a bold but risky attempt to eliminate inflation,and bring down interest rates and its inherent rigidities were too demanding for Turkey'sfractured politics. A fragile banking sector with large contingent liabilities-added immensely tothe problems. The large profits from high interest rates had allowed very weak banks to surviveand take on risky positions. As interest rates came down sharply in response to the restoredconfidence in early 2000, banking sector profits fell rapidly, exposing the banking sector'sweaknesses. When initial capital inflows stopped in the latter half of 2000 and liquiditytightened, the interest rates spiked and the banks' weaknesses were transformed into losses. Theweakest banks collapsed, generating a systemic banking crisis. Without a fundamentalrestructuring of the banking sector, the program was always vulnerable to problems in theweaker banks. In the end it did not succeed due to political instability. The wider crisis nowprovides Turkey with an opportunity to deal more comprehensively with weak public financesand a fragile banking sector to produce more lasting solutions. While the new program will notbe constrained by the rigidities of a pegged exchange rate, policy credibility and fiscal disciplinewill become even more important to restore and maintain the market confidence that is criticalfor the success of the program.

B. Political Context and Social Developments

4. The underlying causes of Turkey's economic crisis date back to the late 1980s. After aperiod of impressive trade reforms in the early and mid-1980s, subsequent governments did notdeal seriously with Turkey's fiscal and structural problems. Since the early 1990s, a series ofcoalition govermments (ten since 1990) took populist decisions leading to large and unsustainablefiscal deficits. The lowering of the pension age, the widespread expansion of agriculturalsubsidies, and the use of state banks for subsidized credit and the state-owned enterprises togenerate employment are examples of a system of patronage which lies at the root of Turkey'scurrent crisis. When budgetary resources were unavailable, the state banks were utilized asquasi-fiscal instruments to pay for populist policies. As a result, they built up huge andunsustainable liabilities. Connected lending also led to problems in the private banking sector.Each successive government outdid its predecessor in providing hand-outs to its supporters.Real wages in the civil service eroded.

5. The current coalition government includes three parties of different backgrounds2 , whocame together on the basis of agreement on the broad outlines of an economic program and theintention of dealing with past problems. This coalition government, under Prime MinisterEcevit, began a bold and comprehensive reform while tackling growing economic problems and

2 As of June 5, 2001 the coalition is composed of: the Democratic Left Party (DSP), headed by Prime MinisterBulent Ecevit, with 132 seats; the Nationalist Movement Party (MHP), headed by Deputy Prime Minister DevletBahceli with 126 seats; and the Motherland Party (ANAP), headed by Deputy Prime Minister Mesut Yilrnaz, with89 seats. Other parties in Parliament are the True Path Party (DYP) led by Tansu Ciller, with 83 seats and the VirtueParty (FP) led by Recai Kutan, with 102 seats. Those, plus 10 independents and 8 empty seats give the total of 550seats in Parliament

Turkey CAS Proszress Report 4

the after effects of two devastating earthquakes. Beginning in late 1999, some important refonnswere enacted, but partly due to early success in restoring confidence there was soon resistance tochange from within the coalition. As the program was being implemented in 2000, resistance toparticular aspects of the program became more pronounced. It has taken a very deep crisis inFebruary for the realization to set in that without more fundamental reform, Turkey's economicsituation would deteriorate further. The start of the new program has been noteworthy, butresistance is still present (including within the coalition) and could get stronger as the program isimplemented and actions are taken to de-politicize economic decision-making. The socialimpact of the crisis is already being felt as lay-offs, rising prices, and negative growth reducehousehold incomes and place a growing risk of poverty and vulnerability on people already atthe lower end of the income scale. The Government has thus lost considerable public supportdue to the crisis. Opinion polls show that the population is unwilling to tolerate a continuedpattern of recurrent crises, and values transparency and rules-based decision making. This iscontributing to the wider recognition among the population, civil society and the private sectorthat de-politicization of economic decision-making is an urgent task for the Government. TheTurkish political situation is in a state of flux.

6. Turkey's current crisis will exacerbate its already large inequalities and weak socialindicators (see Table 1 below) which were highlighted in the CAS presented to the Board inDecember 2000 and analyzed in greater detail in "Turkey: Economic Reforms, Living Standardsand Social Welfare Study" published in January 2000 (report no. 20029-TU). Building from thatanalysis (although it is still early to provide a comprehensive social assessment of the crisis)initial indications are worrisome. The economic data (see Box 1) shows that the crisis is deeperand more severe than in 1994. Feedback received from groups of poor people and provincialgovernment officials in May by a World Bank mission gives preliminary confirmation of theseverity of the current situation. There is growing evidence of large-scale lay-offs in thecorporate sector. During the first two months of the crisis, large firms tried to reduce hours,advance holidays, and cease using temporary workers, but further cuts in labor costs can onlycome from lay-offs. This, combined with the expected reductions of staff in state-ownedenterprises during pre-privatization restructuring and the freeze on public sector hiring, isexpected to raise unemployment in the short term. The general economic downturn from thedisruptions of the last two months will also have an effect on small businesses and therefore oninformal employment. The unemployment rate rose from 6.3 percent in the fourth quarter of2000 to 8.3 percent in the first quarter of 2001, representing a total of 1.8 million unemployed or32 percent more than three months earlier. Estimated unemployment among youths aged 15-24with high school or higher education is now 23.7 percent. The landless poor in rural areas appearto have been affected by the decline in construction and other informal job opportunities.

7. The Living Standards Study demonstrated that in the 1980s and 1990s, "non-anticipatedjumps in inflation or periods of accelerating inflation have unambiguously hurt the poor andworsened the distribution." The rate of the inflation has increased sharply to 6 percent in March,over 10 percent in April, and 5 percent in May (see Box 1). Although data is not yet available totrack the impact of the jump in inflation following the February 2001 crisis, it is safe to assumethat the poor will be especially hard-hit. There is already some evidence of the increased inputcosts in agriculture afflicting poor rural landholders.


Table 1: Selected Social Indicators - Country Comparison

Indicator Tu Chile Colombia Mexico Poland Hungary Malaysia Tunisia EUPopulation Growth (%) 1.5 1.6 2.0 2.0 0.2 -0.3 2.8 2.0 N.A

Life Expectancy at Birth 69X5 75.0 70.0 72.5 72.5 71 72.5 69.5 77.4(years) _)_

Infant Mortality Rate 39 13 30 31 15 10 I11 30 6.1(per 1,000 live births)

Maternal Mortality ISO 65 l00 120 1 9 30 34 170 N.A(per 100,00 live births) I _

Literacy Rate 84t' 95 91 90 100 99 86 67 100(% of adult population) _

Female Literacy Rate 75 95 91 88 100 99 81 56 100

GNP per Capita (US$) 2,O 4,810 2,600 3,970 3,900 4,510 3,600 2,050 N.A

1/1998 data2/1999Sources: World Development Indicators. 2000; WHO World Health Report 1999; Turkey Demographic and Health Survey, 1998 (HacettepeUniversity, Institute of Population Studies); Turkey Human Development Report, 1997 (UNDP).

8. In March 2001, a simulation of the impact of the crisis on the welfare distribution wasdone using household data from 1994, to identify the characteristics of the most vulnerablehouseholds. This simulation suggested five patterns of likely increased poverty as a result of theFebruary financial crisis: (i) families with many children3 and extended families with manychildren, as well as single-parent families, seem to be the most affected in terms of high rates andhigh increases in food poverty4 ; (ii) an increase in unemployment would disproportionatelyaffect families with many children; (iii) those with middle education seem more likely to becomevulnerable-but still above the food poverty line-while the least educated are those most likelyto become food poor; (iv) the three regions of Anatolia have the highest rates of vulnerability andfood poverty but not always the highest increases in those characteristics; and (v) the urbanpopulation seems more at risk for vulnerability but there is not much difference between urbanand rural households in terms of the risk of food poverty. It will take some weeks to fullyevaluate the impact of the crisis and ongoing reform program on the poor (see Box 4). Thiswork is underway and will be presented to the Board with the proposed Social Risk Mitigationproject.

C. New Policy Framework

9. The Government's new economic program entitled "Turkey's Proeram for Transition toa Strong Economy" was announced in mid-April (see Box 2 for the main priorities). The

program aims to minimize the short-term impact of the crisis while setting the stage for an early

resumption of disinflation and growth. It draws on the lessons of other countries in recovering

from major currency attacks, including the Asian crisis (Box 3). The program takes account of

the specifics of the Turkish economy including the much larger stock of public debt relative to

other crisis countries on the one hand and the potential of a dynamic response of exports and

tourism on the other. By moving immediately to address the fundamental structural problems

underlying the crisis, with a strong focus on restructuring the banking sector, the Government

3 In Eastern Anatolia, widows with many children are particularly vulnerable, according to provincial officials.4Food poverty occurs when a household spends less than is necessary to maintain minimum caloric consumption,expressed by a basket of food items.


hopes to engineer a quick recovery (closer to the experience of Brazil and Korea), and avoid theprolonged recession that some other cnrsis countries have experienced.

Box 2: Key Actions for 2001 under the new Program

Macro-Economic:> Implement urgent measures to address the economic crisis to reduce uncertainty in the financial markets

and introduce credible macroeconomic measures aimed at stabilizing the exchange rate, lowering interestrates and reducing inflationary expectations after the initial devaluation; maintain tight fiscal and activemonetary policies in an effort to bring inflation to under 2 percent per month and restore growth by the endof the year.

Key actions:* Announce revised macroeconomic targets and policies for 2001;* Transfer the ovemight borrowing of the state and SDIF banks to the Central Bank.* Increase target for the primary surplus of the public sector to 5.5 percent of GNP and implement required

package of fiscal measures;. Enact new Central Bank law to underpin CBT independence;* Limit CBT intervention in the foreign exchange market to smooth fluctuations only;* Engage intensive consultations on incomes policy consistent with inflation targets.

Structural:) Carry out a rapid clean-up and comprehensive restructuring of the banking sector.

Key actions:* Appoint a joint, politically independent Board of Directors for the state banks;* Eliminate overnight borrowing of state and SDIF banks and shrink their balance sheets;* Complete the financial restructuring of the state and SDIF banks;* Close Emlak Bank and transfer its liabilities and some assets to Ziraat Bank;* Implement a clear, time-bound action plan for resolving the SDIF banks;* Require all capital deficient private banks to present capital strengthening plans;* Amend Banking law to facilitate resolution process and allow for full tax deductibility of specific loan loss

provisions and enact legislation to prevent future duty losses;* Adopt connected lending regulation and align bank accounting standards with international norms.

> Continue with vital structural reforms-in telecommunications, energy, agriculture, and privatization inorder to improve the investment climate and underpin fiscal adjustment.

Key actions:* Appoint professional Board and management team for Turk Telekom and implement a corporatization plan to

fully commercialize the company;* Amend telecommunications legislation to allow for full privatization of Turk Telekom and transfer all licensing

authority to the Telecommunications Regulatory Authority;* Implement Electricity Market Law and enact Gas Market Law;* Appoint Board of Energy Regulatory Authority and launch privatization of thermal electricity generation and

electricity distribution companies which remain in state hands after June 30 deadline for transfer of operatingrights;

* Launch farmer registry to underpin Direct Income Support program and continue with reform of agriculturesupport policies including new legislation to reform the sugar and tobacco markets;

* Prepare all companies in the Privatization Administration's portfolio for privatization as soon as marketconditions permit, including THY (national airlines), TUPRAS (refinery), PETKIM (petrochemnicals),ERDEMIR (steel), TEKEL (tobacco and alcohol), and SEKER (sugar);

* Enact implementing legislation for intemational arbitration and prepare action plan to eliminate administrativebarriers to FDI as recommended by FIAS.


Box 2: (continued)

> Launch a comprehensive program of reforms to improve the transparency and efflciency of public sectormanagement andfight corruption.

Key actions:. Enact Expropriation Law;. Prepare a comprehensive program of public expenditure management reform in line with the recommendations

of the PEIR, including actions to imnprove coverage and transparency of the budget;. Enact Public Debt Management law;. Enact Public Procurement law;. Enact legislation to streamline procedures for imnproving the code of conduct of government officials;. Prepare and adopt national anti-corruption program.

Social:> Ensurepopular supportfor theprogram through extensive consultations with alt stakeholders, in particular

labor unions and representatives of civil society.

Key actions:. Enact the Econornic and Social Council law;* Enact job security law;. Design and irnplement a comprehensive communications strategy for the new reform program.

> Strengthen social protection for vulnerable groups through a combination of measures to improve Turkey'ssocial insurance system and new social assistance Initiatives.

Key actions:. Enact legislation on voluntary private pensions;. Protect public expenditure on education and increase spending on preventive care;. Introduce new targeted social assistance programs for vulnerable groups affected by the crisis.

10. The program is based on a three-pronged strategy: (i) structural policies aimed atcorrectinz the weaknesses underlving the crisis and establishing a sounder basis for disinflationand growth over the medium term; (ii) strong social policies including enhanced social dialogueto achieve price and wage policies consistent with macroeconomic stability, and increasedemphasis on the protection of the most vulnerable groups of society; and (iii) fiscal and monetarvpolicies geared towards restoring financial stability and resuming the disinflation process. As theGovernment's program puts it: "It is very well understood that a productive and strong privatesector is needed to be a strong and reputable state in the 215' century. In the same way, in orderto have a sound free market economy, it is important to have a strong state providing socialsupport to the needy and undertaking regulatory supervision. A strong economy will be createdby a functioning private sector, an effective state, and a broad social solidarity. This is ourtarget, what we are longingfor, and indeed it is what Turkey deserves. "


Box 3: Lessons from Recent Emerging Market Crises

A Bank team reviewed six other major emerging market crises over the last decade' to draw policy lessons forTurkey. The main conclusions are:

* Economic downturns in recent crises have lasted a median 2-3 quarters, with previous output being recovered ina median 4-6 quarters from the trough. Given the relatively limited role of bank credit to the private sector,quick and decisive progress on bank restructuring and fiscal adjustment can help ensure that Turkey'sexperience is similar to the median path, closer to the more limited downturn in Brazil than to the deeper andmore extended recessions in Indonesia and Thailand.

* While large, the fiscal cost of bank restructuring may be relatively less than in the harder hit countries in EastAsia. However, Turkey went into the crisis with significantly higher public indebtedness than most other crisiscountries, much of this in short term local currency debt. Establishing confidence in public sector solvency andaverting a further inflation-domestic debt spiral will require strong fiscal adjustment backed by crediblestructural fiscal reforms.

* Given large vulnerabilities on both the asset and liability side of the balance sheet, it is clear that the solvency ofthe banking system is in serious jeopardy. The fiscal cost of the bank clean up can escalate at a rapid pace ifinsolvent or weak banks are allowed to continue lending unchecked. To reestablish confidence in the bankingsystem and to limnit fiscal costs, a strong, front-loaded program to restructure banks is needed.

* Most crisis countries in the 1990s have moved towards an inflation targeting framework after the crisis, thespeed of the transition depending on macroeconomic and institutional conditions. In the volatile, high inflationenvironment of Turkey, it may be important to avoid a premature adoption of formal inflation targeting (IT)since the collapse of an inadequately prepared IT program may end by damaging policy credibility even more.

* The role of structural reform in crisis management must be carefully managed. Reforms that directly underpinfiscal reform and bank restructuring are important to address right away. Privatization and accompanyingregulatory reforms have fiscal implications and are also valuable in stimulating FDI and reestablishing foreignconfidence. Other structural reforms are good for long run growth. However, the short-term costs of specificstructural measures--in terms of provoking interest-group and political opposition, or complicating economicmanagement and creating uncertainty in the near term--must be given adequate weight in formulating policy.

* Maintaining social cohesion is especially important given the political volatility and social stresses of thecountry. Meeting the fiscal cost of programs to support social cohesion and protect vulnerable groups withinthe overall fiscal adjustment will be a challenge.

Quarterly Real GDP in Crisis Countries

1 2 0 o-Mexicoa + Brazil

O Arg entina -X_ - - -s - - Ko r ea X -X ,

IL1 - - -& -Thailand,_ii +I~~~~ndonesia _XI

4 1.00~ ~~~

08L

a. 01. ' _S

'9 8 -N., , , ._~' , .~ ., .

'5 N. . N. . N. N. N. N. N. N. e , ,' C"> l

(1) The country-crisis experiences reviewed are: Argentina and Mexico in the tequila crises at the end of 1994, Indonesia, Korea,and Thailand in the 1997 East Asian crises, and Brazil at the beginning of 1999.


11. Structural Policies. The new program gives top priority to banking reform. The bankingreform has four core objectives:

(i) The immediate objective is to clean up the bank sector which has been badly hit by thecrisis. Financial restructuring of the state banks and those under the Savings DepositInsurance Fund (SDIF) is already underway to eliminate their overnight borrowingposition and resolve their liquidity requirements. The state banks have been recapitalizedto a capital adequacy ratio of 8 percent and the SDIF banks have been recapitalized tocover their negative net worth. The Banking Regulation and Supervision Agency (BRSA)is requiring all capital deficient private banks to present detailed capital strengtheningplans and will actively monitor their implementation.

(ii) The second objective is to reform the governance structure for the state banks in order toeliminate political influence and ensure that they do not become the source of structuralweakness in the future. A joint, politically independent Board was appointed for twomain state banks (Ziraat, and Halk) in March. Emlak will be closed by June and itsliabilities and some assets transferred to Ziraat. The state banks will no longer becompelled to run duty losses. Funding has been allocated in the 2001 budget fortemporary credit subsidies for farmers and small and medium enterprises (SMEs) in lightof the extraordinarily high interest rates after the crisis. Legal changes will be made tofacilitate the privatization of Vakif Bank, the fourth state bank, as soon as marketconditions allow. Restructuring of Halk and Ziraat banks will begin immediately inpreparation for their privatization over the medium term.

(iii) The third objective is to resolve the banks taken over by the SDIF as quickly as possible.The BRSA has prepared a time-bound action plan for selling, liquidating or otherwiseresolving the 13 SDIF banks by the end of 2001. This plan includes steps to reinforce theBRSA's implementation capacity including the bad loan collection department of theSDIF and legal amendments to facilitate debt recovery. In addition, SDIF wouldintervene in any emergent insolvent banks that may not be able to recapitalizethemselves.

(iv) The fourth objective is to complete the process of upgrading the legal and regulatoryframework to international and EU norms which began in mid-1999. Amendments to thebanking law have been enacted to implement the new connected lending limits on aconsolidated basis, broaden the definition of credit exposure to include derivatives andprovide for full tax deductibility of specific loan loss provisions. International standardsfor bank accounting are also being introduced.

12. The Government has developed a comprehensive public sector reform program based inpart on the recommendations of the Public Expenditure and Institutional Review (PEIR) jointlyprepared by the Government and the Bank. This program is designed to ensure the long-termsustainability of the fiscal adjustment, raise the standard of public sector governance, andmodernize the role of the Turkish State. It features measures in five areas:

(i) Structural fiscal policies to strengthen aggregate fiscal management. To combat taxevasion and more evenly distribute the tax burden, the Govermment intends to expand

Turkey CAS Pro2ress Revort _J_o

broadly the use of tax identification numbers (TINs) introduced as part of the 1997 taxreform, particularly for financial transactions. The Government has frozen the totalnumber of civil servants in 2001 and intends to implement strictly a policy of replacingno more than 15 percent of retiring personnel in the state economic enterprises (SEEs).

(ii) Public expenditure management. The first priority here is the reform of the process forbudget preparation and execution, including steps to improve transparency andcomprehensiveness of the budget, capacity for policy formulation related to establishingbudget priorities, and improvements to outcomes of budget execution through aprogressive shift to performance budgeting. As part of the on-going effort to expandcoverage of the budget and improve fiscal control, legislation is expected in June to closethe remaining budgetary funds and two extra-budgetary funds and bring these resourcesand expenditures fully on budget, with the exception of the Support Price Stability Fund.The number of revolving funds - currently over 2,600 - which are used by localinstitutions to supplement budget allocations will be cut by half by the end of 2001.

(iii) Financial accountability. To upgrade public accounting, procurement and audit functionsto ensure adequate financial accountability, the Government aims to make legal changesto introduce international fiduciary standards and institutional changes to build capacityto implement the new standards and shift from excessive ex ante control to effective expost monitoring.

(iv) Public liability management. A new public debt management law, expected to besubmitted to Parliament in June, will establish clear procedures for contracting publicdebt and help the Treasury contain the growth of contingent liabilities, as well as settingup transparent reporting of public liabilities and institutional measures to build up thecapacity for fiscal risk management.

(v) Public sector governance. The new approach to public sector management encompassesstrong actions to fight corruption. An inter-ministerial steering committee is chargedwith developing an anti-corruption strategy under which the Government will collaboratewith civil society. A series of conferences on "Effective Government" are planned.Legislation to streamline procedures for improving the conduct of Government officialswill be submitted to Parliament before the summer recess. New public procurementlegislation will be submitted to Parliament by mid-October which will comply withUNCITRAL standards as a first step towards meeting the full EU directives.

13. Structural measures to improve the climate for private investment feature strongly in theprogram. The basic objective is to reduce direct state intervention in the economy and putrelations between the state and the private sector on a more sound and transparent footing. Arelated objective is to sustain the fiscal adjustment by reducing the deficits of the state enterprisesystem, easing the budgetary burden of agriculture support and containing the growth ofcontingent liabilities. Key measures include:

(i) Completion of regulatory reforms in the energy and telecommunications sectors.Legislation to open up the gas market and establish an independent regulator was adoptedin April, following on the electricity markets law passed in February. These laws set the


foundation for comprehensive structural transformation of the energy sector from thecurrent system dominated by state intervention to a regulated market model consistentwith EU norms. Major new telecommunications legislation has been enacted respondingto two failed attempts to sell a stake in Turk Telekom to a strategic investor. The newlaw will allow full privatization of Turk Telekom and transfer all licensing authority tothe newly established Telecommunications Regulatory Authority. While the actual saleof Turk Telekom depends on an upturn in the global telecommunications market, theimmediate focus will be on restructuring the company and promoting broaderdevelopment of the sector. The Government intends to appoint a professional Board ofDirectors and management team for Turk Telekom by end-June

(ii) Continued reform of agricultural support policies. The agriculture reform aims to raisefarmer incomes by reversing the downward trend in agriculture productivity. A law toreform the sugar market and clear the way for privatization of the state-owned sugarfactories was enacted in April and similar legislation for tobacco is expected in June.

(iii) Steps to eliminate obstacles to FDI as recommended by the Foreign Investment AdvisoryService (FIAS). As part of the Government's strategy to promote FDI, comprehensiveimplementing legislation for the constitutional amendment on international arbitrationwill be submitted to Parliament before the summer recess. Privatization remains a keypolicy objective, but the timing of specific transactions will depend on how quicklymarket conditions improve, both in Turkey and internationally.

14. Social Policies. Stronger social policies are a linchpin of the program to help deal withsocial hardships. There are four aspects to this:

(i) Improved social dialogue. In April, a law was adopted to formalize the role of theEconomic and Social Council. Henceforth, the Council, which brings together theGovernment, labor unions and employees under the chairmanship of the Prime Minister,will hold regular and frequent meetings. A central function of the Council is to enable anintensive dialogue on wages and prices with employers and trade unions to take place.

(ii) Incomes policy. While the purchasing power of civil servants will be protected againsterosion by inflation, real wages for public sector workers are expected to be reducedtaking into account the real increases accorded in 1999-2000. Agreement on an incomepackage was reached between the Government and the labor unions in May 2001.

(iii) Social protection. Efforts to strengthen the social insurance system will continue. Theexisting severance payment system which covers both public and private enterprisescontinues to operate. The unemployment insurance program, introduced as part of thereform of the public pension system in August 1999, will begin to make payments to theenrolled unemployed in early 2002. Structural reform of the pension system continues toprogress with the adoption in April of legislation for the third voluntary pension pillar(private pensions). The Government intends to move quickly to expand targeted socialassistance to those groups most affected by the crisis. This support could includeprograms to protect vulnerable families (such as assistance with food, medicine andsocial services). The program of Direct Income Support (DIS) to farmers will be kicked

Turkel (AS Prozress Report 12

off in 2001, as part of the agricultural reform. It will also help farmers - especially smallfarmers - deal with the crisis.

(iv) Social services. Spending on immunization/vaccination programs will be increased inreal terms within the overall budget ceiling. The Government intends to protect publicexpenditure on education, as well as increase the public health budget while reducingwaste within the overall health budget.

15. Macroeconomic Policies. The Government has reached agreement with the IMF on arevised macroeconomic framework in response to the crisis. The framework relies on tight fiscaland monetary policies to restore financial stability under the floating exchange rate. Fiscalpolicy is being tightened further in 2001 in order to help meet the costs of bank restructuring. Aprimary surplus of 5.5 percent of GNP is targeted in 2001, increasing to 6.5 percent in 2002-03.This is well above the surplus of 3 percent of GNP achieved in 2000. While the new fiscalpackage includes significant revenue measures, it strongly emphasizes expenditure reductions, animportant policy shift for Turkey. New revenue measures include: (i) an increase in thepetroleum consumption tax by 15 percent in May (after a 20 percent increase in April) andsubsequent monthly increases at least equal to WPI inflation; (ii) an increase in the standard andluxury VAT rates, by one percentage point; and (iii) an increase in the minimum contributionbase relevant for social security payments. On the expenditure side, current expenditure,transfers and investment spending will be held below the increase in inflation. Defense spendingwill also be scaled back. Savings will be generated in the state enterprise sector which isprojected to shift from a primary deficit of 1.5 percent of GNP in 2000 to broad balance in 2001.To support this, new provisions to encourage early retirement are being considered and existingmeasLures to limit replacement hiring are being strengthened. Monetary policy under the newprogram will focus first on containing the inflationary impact of the Lira depreciation and thenon bringing inflation down over the second half of the year. Under the new framework, theexchange rate will be allowed to adjust freely to ensure competitiveness.

D. Outlook for 2001 and the Medium Term

16. A key objective of the program is to bring interest rates down to more sustainable levelsthrough a combination of tight macro policies, rapid action to clean up the banking sector, andadditional external support from official creditors (see below). Nominal interest rates ongovernment securities are projected to fall to the 50 percent level by the end of 2001, comparedto the 100 percent range in April. As interest rates fall and confidence returns, the economy isexpected to recover relatively quickly from the initial shock of the crisis in line with theexperience of other crisis countries which responded with aggressive reforns. The programprojects a 3 percent contraction of GNP in 2001 based on a resumption of growth in the secondhalf of the year underpinned by expectations of strong export growth and record tourism (Table1). As financial stability takes hold, the recovery is expected to continue in 2002-03 withprojected annual growth on the order of 5 percent.

17. Incremental external financing of around US$10 billion in 2001 is needed to fill afinancing gap caused by the crisis and to ensure the consistency of the program. This gap comesfrom the need to finance the high costs of bank restructuring and roll over the existing stock ofdomestic Treasury securities, while at the same time bringing down domestic interest rates. By


the end of 2001, the Treasury will have issued an estimated TL 54 quadrillion (equivalent to US$46.3 billion at the June 5 exchange rate, or 30 percent of GNP) in transferable securities to coverthe recapitalization of the state and SDIF banks. The bulk of those securities were issued bymid-May to bring the capital adequacy ratio for the state banks to 8 percent and the SDIF baics tozero net worth. While part of the burden of financing this debt will be met through further fiscaladjustment as mentioned above, additional extemal support is also needed.

18. Raising an additional US$10 billion in the domestic market, which is already fiacingserious liquidity shortages, would keep interest rates at high levels and the debt dynamics wouldbecome unsustainable forcing Turkey into a debt restructuring. The Government's market-oriented solution to the debt problem is the best alternative and deserves support. While thestock of net public debt is projected to increase sharply in 2001, the underlying dynamics ofpublic finances would remain stable if targets for interest rates, primary surplus and economicgrowth are achieved. Under these conditions, the public debt to GNP ratio is projected to dropsharply in 2002-03 (Table 1).

Table 2: Key Economic Indicators

. _= .Actual 1/ Projected 2/1998 1999 2000 2001 2002 2003

OUTPUT, INFLATION, INTEREST RATE AND UNEMPLOYMENTGNP Growth 3.9 (6.1) 6.1 (3.0) 5.0 6.0CPI Inflation (Dec-Dec) 70 69 39 52.5 20 15Nominal Interest Rate 115.7 106.2 38 81.1 40.6 32.6Unemployment Rate 3/ 6.8 7.7 6.6 >8.5 6.0 6.0

PUBLIC SECTOR BUDGETPrimary Balance (%GNP) 1.1 (2.0) 2.8 5.5 6.5 6.5Overall Deficit (%GNP) (15) (24) (19) (17) (10) (7)Public Debt (%GNP) 4/ 44 61 58 79 71 65

of which net external debt (% of GNP) 19 20 20 34 28 23Privatization ($ bn) 2.2 0.1 3.3 3.1 3.5 3.5

EXTERNAL BALANCECurrent account balance (%GNP) 1.0 (0.7) (4.8) (0.6) (0.9) (0.6)Exports (fob, $ bn) 31 29 31 34 36 39Tourism (S bn) 7.1 5.2 7.6 8.3 8.6 9.1External Debt (%GNP) 47 55 57 66 60 57Foreign Exchange Reserves ($ bn) 21 24 23 21 22 24

1/ Government figures as adjusted by IMF and WB estimates.21 Projections for 2001-03 are based on revised IMF program figures.3/ Projections for 2001 are based on preliminary figures for the first quarter; projections for 2002-03 are from theState Institute of Statistics.4/ Includes the government securities issued to recapitalize the SDIF and state banks.Source: Govemment, IMF and WB estimates.

19. Balance of Payments and External Financing Plan. Exceptional official financingfrom the IMF and World Bank would support the balance of payments and close the financinggap in 2001. A sharp correction in the current account is projected on the basis of the exchangerate adjustment and economic slowdown. However, this will be accompanied by an expected

Turkei CAS Progress Report 14

reduction in Turkey's access to international capital markets as a result of the crisis. The currentaccount deficit is projected to fall abruptly in 2001 to about US$1 billion (0.6 percent of GNP),and to remain close to balance in 2002-03 under the floating exchange rate regime. However,portfolio flows and international private financing for banks and the corporate sector are allexpected to contract in 2001. Efforts by Turkish banks to close open foreign exchange positionswill add to pressure on the capital account. While the program incorporates steps to encourage"bail in" by private creditors, without additional multilateral support, Central Bank reserveswould most likely drop precipitously and pressure on domestic interest rates would intensify. Aproposed package of US$ 1O billion in exceptional official financing, of which US$8 billion fromthe IMF on Stand-By terms and US$2 billion from the World Bank, is proposed to support theprogram in 2001 and meet the external financing gap. This funding is over and above theamounts programmed by the IMF prior to the February crisis and the original high-case programof the CAS. As confidence returns, Turkey's access to the international capital markets isexpected to recover in 2002-03 (see Annex BI 1 for more details), and the anticipated "bail-in" ofthe private sector is realized.

III. THE BANK GROUP PROGRAM

A. IBRD Program

20. The CAS presented to the Board in December 2000 was designed to help Turkey to laythe basis for sustained long-term growth and reducing economic vulnerability. This remains thecore objective of the Bank Group strategy. Poverty and economic vulnerability, and wideningdisparities, have been worsened in Turkey by erratic growth and inflation: periods of risinginflation and slowing growth have especially hurt those at the lower end of the incomedistribution. Restoring stable and higher growth, creating employment, reducing inflation, andimproving the management of the financial and public sectors (the latter particularly with respectto well targeted delivery of social services), have again been shown to be the goals upon whichTurkey must focus. In light of the economic crisis that began in February 2001, reaching theobjective of sustained growth and reduced economic vulnerability and the latter goals requiresTurkey to undertake accelerated structural reform, while working quickly to recover from thecrisis and mitigate its worst effects. Thus, the Bank Group's strategy now is to focus on helpingTurkey recover from the crisis while dealing with its deeper causes - especially the large andinefficient public sector and fragile banking system - and address increasing social hardships.The Government of Turkey has requested intensive financial and technical help from the BankGroup and an acceleration of IBRD's assistance focussed on the structural and social issues.

21. The CAS program for FY01 -03 included US$5 billion in IBRD lending for the high case,of which US$4 billion aimed to support structural reforms (within which, US$2.4 billion was foradjustment operations in the indicative lending program), and US$1 billion was for base caselending, largely in support of social and environmental investment projects. In the discussion ofthe FYOI-03 CAS with the Board in December 2000, the Bank indicated its willingness toaccelerate the high case commensurate with the pace of reform as appropriate. In tandem withthe CAS discussion, just over US$1 billion was committed for two operations: FSAL I (US$778million) and the Privatization Social Support Project (PSSP, US$250 million). The first trancheof FSAL I (US$393 million) was disbursed on December 22, 2000. Including the Economic

Turkev CAS Prozress Report 15

Reforn Loan (ERL, US$760 million) committed under previous CAS, IIBRD has to datecommitted slightly under US$1.8 billion and disbursed US$777 million to support Turkey'seconomic reform program since its inception at the end of 1999.

22. Revised program. Given the positive features of Turkey's new strategy and economicframework, but mindful of the risks it entails, IBRD has reformulated its planned support toTurkey. The financing plan required for the Government's new economic program entails anincremental US$2 billion of disbursements from IBRD over the original CAS disbursementprofile for calendar year 2001. To provide this support, IBRD proposes to structure lendingoperations within the original CAS envelope to bring US$800 million more disbursements inCYOI than projected in the CAS and make available an additional US$1.2 billion (over theoriginal CAS envelope), on Special Structural Adjustment Loan (SSAL) terms. While IBRDfinancial support provides a relatively small part of Turkey's liquidity needs, enhanced andredirected support is vital to ensure that: Turkey's enhanced structural reforms, in particularbanking sector restructuring and public sector reforms are supported and previous reforms aremaintained; and adequate resources are also available to mitigate the socio-economic andeconomic consequences of the crisis.

23. The structural origins of crisis and its potentially large social and poverty impact, justifyexceptional Bank financing on SSAL terms to support specific policy changes and institutionalreforms and provide fast disbursing assistance to close the external financing gap. In addition,the volume of support now envisaged over the CAS period is in excess of the original programdiscussed with the Board in December 2000; IBRD exposure was already expected to increaserapidly under the CAS program; there is a need to protect IBRD's capacity to provide long-term,standard-price funding in support of the Government's medium-term structural reform program;and accelerated disbursement to Turkey will add to the existing financial pressures on IBRD.

24. IBRD will support strongly the structural reforms and social agenda, outlined in sectionII-C above. The proposed revised lending program includes up to US$3.8 billion inprogrammatic structural adjustment loan commitments, in addition to a possible quick-disbursingportion of the proposed Social Risk Mitigation Project, an adjustment component of the ARIPhybrid operation, and the outstanding second tranche of the ERL. Other operations - foreducation, health, and rural development - would remain in the FYO1-03 program, but theirpreparation would be paced to match the capacity of the Government to focus on those agendasand provide adequate counterpart funding. Table 3 presents the proposed revised program, andTable 4 compares the high case under this program to that under the original CAS. Thefollowing paragraphs explain the main revisions to the program.

25. Support for the Financial Sector and Public Sector Reforn. Turkey has adopted a newreform program that combines urgent financial and fiscal measures to restore stability with acomprehensive medium-term program that links macroeconomic sustainability with deepstructural and institutional reforms. This complex medium-term program is now being madeexplicit to signal to markets both the future expectations of reforn and the sustainability of theprogram. The need for structural reform is particularly evident in the financial sector and publicsector. Now, there are synergies between the reforms in these two sectors. A key element intheir interlinkage is the need to eliminate the contingent fiscal liabilities stemming from thefinancial system. The immediate financing needs for the recapitalization of the state and SDIF


banks (see para. 17 above) are having an impact on the budget and debt management. Reforrm ofthe financial system to disentangle it from the public sector budget will make the elimination ofcontingent liabilities permanent. Thus, for the next half year, the reforms of the financial andpublic sectors are intertwined, and should be addressed together. Sustained recovery from thecrisis and the credibility needed for supportive market reactions depend on quickly implementingreforms in both areas.

26. Over the medium and longer terns, public sector and financial sector reform willcontinue to be crucial to creating an economy characterized by steady growth, at low inflation, inan equitable pattern. Sound banking and transparent, effective government will greatly reducethe risk of crises, which in themselves have proven so damaging to economically vulnerablegroups in Turkey. By raising the overall efficiency of resource allocation and encouragingprivate capital investment, these reforms will raise productivity, another key factor for raisingincomes in Turkey. The medium-term reforms in the two sectors, beyond the actions planned forthe remainder of 2001, are not inter-linked to the same extent as the immediate actions.

27. The Bank proposes a program of programmatic lending, which would recognize both theneed to take key up-front actions to reduce short-term vulnerabilities as well as to establish andbegin the medium-term phased process required for full public and financial sector reformimplementation. The latter reform involves complex institutional changes - some of which willtake time to specify in detail and implement - in addition to policy and legislative action. Aprogrammatic approach is needed to establish very clearly the goals and objectives of theprogram - but with adaptability on timing and specific actions in 2002 and 2003. To support thestrengthening of the fiduciary framework, the Bank has recently completed a CountryProcurement Assessment Report (CPAR) and is completing a Country Financial AccountabilityAssessment (CFAA, see below). Reflecting the inter-linkage of the reforms in the financial andpublic sectors for the remainder of 2001, the indicative lending program includes two operationsaddressing the two sectors together. Then, starting in the second half of FY02, IBRD supportwould involve separate operations for the financial and public sector, since the agenda would befocused on medium-term institutional change, an area best handled in sector-specific detail.Specifically, the proposed high case program includes the following five operations:

* Two Programmatic Financial and Public Sector Reform Adjustment Loans (PFPSALs) forthe first phase of support. The first PFPSAL, totaling US$1.1 billion, and will compriseUS$700 million under standard IBRD terms and US$400 million under SSAL termns. Thisoperation is expected to be presented to the Board by the end of June 2001, but if reformnactions are delayed, could be presented slightly later, in July 2001. The second loan, to bepresented to the Board before the end of December 2001, would total US$1.35 billion, ofwhich US$550 million would be on standard IBRD terms, and US$800 million on SSALterms.5 These loans address both public and financial sector issues, although the first has ahigher proportion of financial sector actions needed quickly to reduce vulnerabilities in the

5The total of US$2.45 billion will result in US$2.0 billion over the CAS projected disbursements for CYOI becausethe second tranche of the Econormic Reform Loan (ERL) could be delayed to the beginning of CY02 anddisbursements on investment lending are now expected to be below original projections.


banking sector. The reforms supported by these two loans are clearly specified and wellunderstood by the Government and the Bank, and thus ready to be implemented.

* Subsequently, two Programmatic Financial Sector Adjustment Loans (PFSALs) of US$500million each, one in FY02 and the second in FY03; and

* the first of an anticipated series of ProZrammatic Public Sector Adiustment Loans (PPSALs).of US$375 million, in FY03.

Proposed Time Line of Bank Support for Public Sectorand Financial Sector Reform Program

Public Sector

(USS375 Million) beyond this CASperiod

Combined Public Sector andFinancial Sector

PFPSALI PFPSAL11(USSI.I Billion (US$1.35 Billion)

Financial Sector

A &

(US$500 million) (US5500 Million)

I~~~~~~~~~~ i

June Dec. June Dec June

2001 2001 2002 2002 2003

28. For 2002 and 2003 the Bank and the Government have reached agreement on keystructural triggers but the precise conditionality needs further formnulation. The programmaticapproach does not exclude investment lending and covers the public and financial sectors. Thediagram above shows the timeline of this and subsequent proposed programmatic support.

29. In moving to the programmatic approach, the Bank has taken into account progress madeon the financial sector reform agenda already, and the impact of the crisis on the next stages ofthat agenda, and concluded that the previously planned operations in this sector do not suit thephasing of the Government's new program. A banking sector assessment prepared by the Bank'sfinancial sector team in March 2001 showed the extent of the crisis and proposed a revisedpolicy agenda. The agenda for further restructuring in the private banks, and governance issuesin the non-bank financial sector, also presents new and still evolving challenges as a result of theFebruary crisis. Overall, the financial sector reform program is now broader than envisaged atthe time FSAL I was prepared, and some elements originally expected to be part of a lateroperation have been brought forward. Thus, the revised program involves canceling the second


tranche of the FSAL I (US$385 million) and combining it conceptually with the previouslyplanned State Bank Restructuring Project (US$500 million) and FSAL II (US$800 million) intoa programmatic approach. The first urgent stages of the banking reform will be implemented atthe same time as an array of other pressing institutional and regulatory changes, particularlythose with important implications for public finance. Hence, the most efficient approach todesigning support to the financial sector reforms in CYOI would be within the PFPSALsoperations. Subsequently, the financial sector reform agenda would be supported through thetwo PFSALs.

30. Overall, with respect to the financial sector, the proposed IBRD operations wouldsupport the phased implementation of a comprehensive financial sector reform program,especially issues related to:

* the legal and regulatory framework for banking;

* resolution of the SDIF banks;

* the privatization of the state-owned banks; and

* regulatory issues related to capital markets, insurance and other non-bank financialinstitutions like leasing, factoring, mutual funds and private pension funds.

31. An important benefit of these operations would be to restore confidence in the bankingsector following the November 2000 and February 2001 banking crises by exhibiting clearinternational support for the Government's reform program. Further, the reform programsupported by the loans would: strengthen the foundation for an efficient, sound and healthybanking system which could be competitive in quality and performance at the international level,as well as offering improved financial intermediation to the benefit of the real economy; reducethe vulnerability of the banking system and enhance its capacity to withstand external shocks andthereby reduce systemic failure risk; and position Turkey's banking system for EU accession, inparticular by aligning the prudential regime for the banking system with applicable EU bankingsector directives. (See Annex B12 for further details). IFC's strategic approach to the financialsector, focusing on assisting the authorities with the intervened banks, while helping to buildinstitutions and support new financial product development, further buttresses Bank Group workin the sector.

32. Increase support for public sector reform. The Bank has just completed a comprehensivePEIR, and a CPAR, while a CFAA is underway; together these form the basis of a public sectorreforrn program. The Government and the Bank are working closely on this agenda, given itsimportance for sustained improvement in macro management, effective public investment, bettergovernance, and public trust. The EU is an active partner in this area, particularly with respect toprocurement law. This agenda would be supported by the Bank in the two PFPSALs andsubsequently the PSALs. In addition, an anticorruption conference is being scheduled for earlyin June 2001. The PFPSALs would encompass support to the full public sector reform agendaoutlined in paragraph 14 above.


Table 3: Proposed Revised FYO1-03 CAS Indicative Lending Program (US$ million)*

Year New High Case New Base Case

FYOI FSAL I** 393Privatization Social Support *** 250ARIP (hybrid) 600PFPSAL I *** 1,100

Sub-total 2,343 Sub-total 0

FY02 Basic Education (APL II) 300 Basic Education (APL II) 300Social Risk Mitigation 500 Social Risk Mitigation 368PFPSAL II**** 1,350 Community Dev't and Heritage 25Prog. FSAL I 500Community Dev't and Heritage 25


FY03 Prog. FSAL II 500Health***** 100 Health 100Micro Watershed 32 Micro Watershed 32PSAL Prog. Loan 1 375Secondary Education 175 Secondary Education 175


FYOI-03 Total 6,200 Total 1,000

of which on SSAL terms 1,200

* Plus US$500 million for emergency lending, in the event of a large natural disaster.** FSAL I was approved December 21, 2000, with a loan amount of US$778 million. Of this, US$393 million

was disbursed on December 22, 2000, and US$385 million is proposed for cancellation under the newprogram (to be folded into the new larger financial sector reform programmatic operation).

*** Actual (approved December 21, 2000).**** The PFPSALs are sets of structural adjustment loans in support of the accelerated reform program.

PFPSAL I consists of US$400 million on SSAL terms, and US$700 million on standard IBRD loan terms;PFPSAL II consists of $US800 million on SSAL terms and US$550 on standard IBRD loan termns.

***** Depending on sector reform progress either this or an energy project with the same loan amount couldbe proposed for FY03 approval, with the other coming in early FY04.


Table 4: Comparison of CAS High Case with Proposed Revised High Case FY01 -03

Year Original CAS High Case New High Case*

FY01 FSAL I ** 778 FSAL I** 393

Privatization Social Support *** 250 Privatization Social Support *** 250

ARIP (APL 1) 400 ARIP (hybrid) 600Basic Education (APL 11) 300 PFPSAL I * 1.100

Sub-total 1728 Sub-total 2,343

FY02 Local Initiatives and Soc. Assist. 112 Basic Education (APL 11) 300State Bank Restructuring 500 Social Risk Mitigation 500PSAL 820 PFPSAL II**** 1,350Natural and Cultural Heritage 50 Prog. FSAL 1 500Secondary Education 175 Community Dev't and Heritage 25Village/Township Services 100


FY03 FSAL 11 800 Prog. FSAL 11 500Health loo Health***** 100Micro Watershed 35 Micro Watershed 32Energy 200 PSAL Prog. Loan 1 375Municipal (APL 1) 300 Secondary Education 175Seismic Risk Mitigation 80


FYOI-03 Total 5000 Total 6,200of which on SSAL terms 1,200

* Plus US$500 million for emergency lending, in the event of a large natural disaster.** FSAL I was approved December 21, 2000, with a loan amount of USS778 million. Of this, USS393 million

was disbursed on December 22, 2000, and US$385 million is proposed for cancellation under the proposedrevised program (to be folded into the new larger financial sector reform programmatic operation).

*** Actual (approved December 21, 2000).**** The PFPSALs are sets of structural adjustment loans in support of the accelerated reform program.

PFPSAL I consists of US$400 million on SSAL terms, and US$700 million on standard IBRD loan tenns;PFPSAL 11 consists of $US800 million on SSAL terms and US$550 on standard IBRD loan terms.Depending on sector reform progress either this or an energy project with the same loan amount could beproposed for FY03 approval, with the other coming in early FY04.

33. Support accelerated social assistance to poor households and permanent institutionalstrengthening for better social protection. A proposed loan for a Social Risk Mitigation Project(US$500 million) would provide help to poor families affected by the crisis to receive someincome or basic necessities, continue to invest in their human capital, and build the institutionalbasis for better targeted, sustained social protection. This loan could support immediate actionsto get assistance to the most needy through existing programs with strengthened monitoring, andsubsequent actions to invest in human capital, support and better target the income-generating


programs for poor communities through the Social Solidarity Fund (SSF), and design andimplementation of institutional strengthening of SSF. Preparation of this proposed project isdrawing both on recent experience in similar projects in Colombia, Jamaica, Indonesia and othercountries, and successful experience in Turkey under the Emergency Earthquake Recovery Loan(EERL) with the delivery of rapid payments to needy families by the SSF after the Marmaraearthquake. The SSF has experience in delivering a variety of social assistance targeted at needywomen and children, some of it linked to education, and a decentralized administrative apparatusthat allows it to act quickly. The Bank team will coordinate with UNICEF in this work as well.The studies soon to be undertaken within the ongoing Privatization Social Support Project(PSSP) and the Agricultural Reform and Investment Project (ARIP) will provide information onspecific affected groups (laid off workers and agricultural workers), complementing the resultsof the Rapid Assessment Survey underway in preparation for the Social Risk Mitigation Project.Tight monitoring of the impact of the crisis and mitigating measures will be carried out, asexplained in Box 4 below.

34. Increase the proposed size of the Agricultural Reform Implementation Loan (ARIP) fromUS$400 million to US$600 million by adding to it an adjustment component of US$200 million,disbursement of which would be based on progress in introducing the direct income support(DIS) payment system. This latter support is an important element in cushioning potentialadverse impacts of the reform in that it provides support to farmers who will no longer receiveprice supports and other distortionary subsides. The DIS is designed to give proportionately morecash to farmers with smaller land holdings, thus improving the targeting of assistance in thesector. The ARIP Loan would also help with the cost to farmers of shifting from uneconomic tomore competitive crops in the newly market-oriented environment, and fund some of theseverance to employees of the Agricultural Sales Cooperative Unions (ASCUs) who would belaid off as part of the restructuring of those activities (a process already underway). ARIP6 willbe presented to the Board on the same day as discussion of this CAS PR.

35. Maintain the ERL program to support private sector development. This will include asoriginally agreed, further progress on energy reform, agricultural reform, and privatization. Onenergy reform, key actions to implement the new electricity and gas market law are expected inthe coming months, and a prequalification tender for privatization of electricity distributioncould be launched within CY01. Furthermore, the ongoing loan in support of the NationalTransmission Grid project will be restructured to introduce a technical assistance component tohelp the Government to implement the energy sector reform program. In agriculture continuedprogress in reforming support policies and introducing the direct income support program willassist the Govermnent to implement the remaining ERL conditions. On the privatizationconditions, though, some delays are likely. It would be possible to sell two more large publicenterprises, as required by ERL conditionality, but under current weakened local and worldmarket conditions, the prices could be unfavorable and generate a political backlash overperceived depletion of public asset value. In telecoms, the Government was unable to sell aminority stake in Turk Telekom to a strategic investor. Under the new program, legislation hasbeen enacted to allow up to 100 percent of the company to be privatized (with the exception of a"golden share") and to strengthen the regulatory framework, thereby going beyond the scope ofthe ERL conditionality. IBRD is working closely with the authorities on an appropriate approach

6Project Appraisal Document, Report No.21 177-TU, June 2001


to this matter. IFC's activities strongly complement the Bank's work in the area of reform tosupport private sector development.

36. IBRD would postpone or alter some proposed operations to reflect changes in theGovernment's priorities in light of the urgency of the reform areas mentioned above. TheMunicipal APL (US$300 million) would shift into FY04, as this reform dialogue is unlikely togain accelerated momentum for another year. A study of municipal reform will be done jointlywith Germany (KfW) starting in FY02. The new timing would have the advantage of coincidingwith the entry of newly elected leaders following 2003 municipal elections. Given the delays inimplementation of the institutional component of the MEER earthquake project, the follow-upSeismic Risk Mitigation project (US$80 million) would also shift to FY04. Both the Energyproject and the Health project previously planned for FY03 are the subject of continued dialogueand study; depending on reform progress in the sectors, one would be brought to the Board inFY03 and the other in early FY04. Due to delays on implementation triggers under the firstBasic Education APL, the second will be brought to the Board in the autumn of 2001. Workwith the counterpart agencies on the earlier concept of a Natural and Cultural Heritage projecthas led to a different formulation, focused on using heritage as a basis for communitydevelopment and income generation, and basing one component on a process of participatorycommunity decision-making underway with UNDP support. The new project concept has beennamed Community Development and Heritage in light of this positive development. The Villageand Township Services project would be dropped from the FY01-03 program, although such aconcept could be reconsidered for inclusion in a later year, when appropriate participatorymechanisms have taken root.

Box 4: Monitoring the Social Impact of the Crisis and the Reform Program

A series of activities are being undertaken to monitor and evaluate the impact of the crisis on household welfare.These build on earlier work in place to monitor the impact of the reform prograrn, and together allow comprehensivesocial monitoring program over the CAS period. The simulation performed in March 2001 indicated the likely areasof increased vulnerability. Next, a rapid social and economic survey was fielded, with preliminary results expectedin late July 2001. This survey is designed to provide early data on the impact of the crisis on different groups ofpoor and vulnerable households by asking them about changes in their consumption/expenditure patterns before andafter the crisis. Its purpose is to confirm the simulation results and develop a targeting mechanism for the immediatechanneling of assistance to the poor and vulnerable. The third is an agricultural household survey planned as part ofthe social monitoring and evaluation of the Agricultural Reform Implementation Project. This survey, whichincludes selected qualitative follow-up, will follow a panel of 5,000 rural and 500 urban households for a four-yearperiod starting in the summer of 2001. It will be used to provide ongoing monitoring and evaluation of the impactof the crisis and the government's response in the agricultural sector. A fourth activity consists of a series of studiesto be undertaken as part of the PSSP, including a community and sectoral study, a quantitative survey for impactevaluation (3,000 workers surveyed five times), a qualitative survey of displaced workers (200 studied five times) astudy of the national social assistance system, and a quasi-experimental study of the net impact of labor deploymentservices. In addition to these surveys, a program of regular household surveys is proposed; the Bank will workclosely with the authorities to encourage more frequent, but also affordable, surveys, including both a HouseholdIncome and Expenditure Survey every two or three years, and interim rapid surveys.

37. Revise the economic and sector work program to be responsive to new needs. The Bankhas recently completed a CEM, PEIR, and a Country Procurement Assessment Report (CPAR); aCountry Financial Accountability Assessment (CFAA) is nearing completion. Two new studiesnot anticipated at the time of the CAS are underway: the first will assess the social impact (this


will be shared with the Board at the time of presentation of the proposed Social Risk MitigationProject) and the second - a joint IBRD-IFC undertaking - is reviewing effects on the corporatesector. Future ESW will continue as planned including a Health Study and a Non-BankFinancial Institutions Study in FY02, and a CEM with a focus on EU accession in FY03. Box 4outlines the activities that will contribute to sound monitoring of the social impact of the crisisand the reform program.

38. Portfolio Management. The Bank will need to work closely with Government to ensurethat new operations can be provided with adequate counterpart funds before going ahead and thatthe ongoing portfolio can continue effectively despite the likely impacts of the crisis. At the endof March, the Bank portfolio in Turkey was healthy, with no projects showing unsatisfactoryratings on development objectives and only 1 out of 24 rated unsatisfactory on implementationprogress. There is no doubt, though, that the consequences of the economic crisis will be felt inthe portfolio. Two key areas of strain are likely to be the effects of the devaluation on theautonomous borrowers (especially municipalities) who have debt denominated in foreigncurrency and revenues in Turkish Lira, and restrictions on counterpart funding stemming fromreallocation of budgetary fund towards more pressing needs. Therefore, instead of a traditionalJoint Portfolio Performance Review (JPPR), the Bank has begun a rapid forward-lookingassessment of the portfolio, with the Treasury, State Planning Office, and Ministry of Finance,with a view to identifying and resolving issues likely to face ongoing projects in light of changedeconomic conditions, the revised Government budget, and other factors.

39. Lending Scenarios and Triggers. Bank lending to support structural reforms in Turkey,as was the case over the past two years, will continue to be strongly linked to upfront actions.The triggers for the high case have been strengthened in the financial and public sectors, andsocial protection and services, to match the new high case lending program (see Box 5). Thetrigger for the fiscal adjustment has been tightened to 5.5 percent of GNP given the need forstrong fiscal adjustment in the macro-economic program. This trigger is consistent with theGovernment's IMF-supported macro-economic program for 2001 and will be adjusted on anongoing basis in light of developments in the Government's IMF-supported macro-economicprogram. The trigger for the current account deficit has been removed because it was relevantunder a crawling peg exchange rate mechanism but is no longer so. All the triggers outlined inBox 5 must be met to keep the program in the high case. These imply implementation of theGovernment's new program, and continued delivery on commitments under ERL and theproposed programmatic lending for the public and financial sector reform agendas. High caselending would total US$5.0 billion for FYO1-03 with an additional US$1.2 billion provided onSSAL terms, and base case of US$1.0 billion for FY02-03. The Bank expects, even in a basescenario, to continue support to education and other aspects of the human and sustainabledevelopment agendas as long as institutional conditions, sectoral policies, and counterpartfunding availability allow such projects to have a strong positive effect on the poor andvulnerable.

40. The external financing plan assumes that the IMF provides large upfront financing in2001, of around US$13.5 billion (net), but is then re-paid US$5.7 billion in 2002 and 2003 on anet basis (see Annex B 1l, Table B, Page 9). The private sector on the other hand is repaid in2001, but as confidence is restored, and Turkey's access to international credit is re-activated,private inflows and sovereign borrowing increase in 2002 and 2003. Successful realization of


such financing and "bail-in" strategy would be a tnrgger for continued high-case lending fromIBRD. Without a successful "bail-in" strategy, the financing plan would be inadequate and IBRDlending would not be productive. Ongoing reforns defined very clearly in the ARIP (foragricultural reform), the ERL (for pnrvatization and establishment of the regulatory frameworkfor energy and telecommunications), and in the PFPSAL (for banking and public sector reforms)will be used to the determine the continuation of the high-case lending program for Turkey onthe structural side. These reforms are all inter-linked and, as stated in the government's reformstrategy, delays in any one area affect the entire program.

41. Partnership. The Bank would lead external support to Turkey in the structural and socialprograms. The IMF will continue to lead on the macro-economic framework, and the Bank willremain in close coordination with the IMF on macro-economic and broad structural issues, withthe banking sector taking particular prominence among the latter. The Bank and the EU areworking closely on a number of regulatory and governance issues. OECD is also a close partnerin these areas. Other partners continue to support Turkey as indicated in the CAS. Close on-going relationships are developing with KfW on municipal reforn, JBIC on banking sectorissues, UNICEF on social services and social protection, UNDP on community development, theTurkish Economic and Social Studies Foundation (TESEV) on anti-corruption, severalgrassroots NGOs who have recently received funding through the Small Grant Program, andother NGOs that work with the Bank on selected projects.

Box 5: Revised Triggers for the High Case

The core policies underpinning the New Economic Program and the triggers for maintaining the high case are:

Macroeconomic* Sustained fiscal adjustment yielding a primary surplus for the consolidated public sector of at least 5.5 percent

of GNP; appropriate exchange rate policies to maintain competitiveness over the medium term; and an externalfinancing plan based on adequate burden sharing with the IMF and private inflows satisfactory to the Bank.

Structural* Rigorous implementation of structural reform programs in social security and agriculture sector as outlined in

the ERL and the ARIP; and* Sustained and transparent privatization effort in line with the Government's announced targets for 2001 and

2002; and establishment of credible legal and regulatory frameworks to promote private investment in theenergy and telecommunications sectors; and

* Sustained strong implementation of banking sector reform including: restructuring privatization of all statebanks by June 2003, resolution of SDIF banks by December 2001, effective functioning of BRSA, andimplementation of banking law and regulations, as outlined in the PFPSAL 1.

* Introduction of reform in public sector management and public accountability, including procurement, anddevelopment and announcement of a clear anti-corruption strategy, as outlined in the PFPSAL I.

Social* Strengthened social assistance program to deal with social impact of the crisis - especially focused on women

and children, and maintenance of adequate expenditure allocations for public health and, education; and* Implementation of unemployment insurance as well as establishment of institutionalized mechanisms for social

dialogue such as the Economic and Social Council.


B. IFC Program

Crisis impact

42. The year 2001 will be pivotal for Turkey and IFC expects to provide it with a great dealof support in FY02. Targeted interventions designed to help the sustainability of reform willremain the basis for the Corporation's activities in Turkey. IFC support for financial sectorreform and corporate restructuring are expected to have a beneficial development and catalyticimpact as Turkey works to re-establish a reform program which is viable and which will inspireinvestor confidence.

43. As a result of the financial crises there is little lending to the domestic private sector andthis is at very short maturities and very high real interest rates. The depreciating Turkish Lira,lack of liquidity and steep rises in interest rates, combined with lower domestic demand isleading to widespread distress in the corporate sector. There is also an acute working capitalshortage, paralyzing otherwise viable companies. Exports, which are very important for therevival of the economy, are being constrained by lack of finance for imported inputs.

44. Turkey is an important country for IFC, the fourth largest exposure after Argentina,Brazil and Mexico, accounting for 4.6 percent of the total IFC portfolio. The total IFC own-account held portfolio in Turkey is US$614 million. In addition, the outstanding balance of Bloans that IFC has mobilized is US$370 million. IFC also has invested over US$150 million inTurkish companies outside of Turkey. While it is still too early to assess the impact of the crisison IFC's portfolio, its diversification across sectors and export-orientation should help tomitigate the impact. Most of IFC's corporate clients are conservatively leveraged and exportoriented (export range from 20-40% of their sales), and devaluation should enhance theircompetitiveness. However, it is certain that there has been an impact on IFC's portfoliocompanies due to: depressed domestic sales, lengthened collection time of accounts receivables,higher interest rates, impact of devaluation on debts in foreign currencies and possible problemswith debt rollover. Companies with un-hedged foreign exchange exposure and maturitymismatches will be particularly vulnerable.

Crisis Response

45. This year poses a particular challenge for IFC in Turkey. While the underlying mediumand long term strategy remains the same as presented in the CAS document, IFC is adjusting itsshort-term strategy to respond to the crisis. IFC strategy will complement the Bank'sconsolidated and strengthened support to the financial sector and private sector development.IFC has a strong role to play by taking risks and making selective counter-cyclical investments,but at the same time it must maintain its reputation as an internationally credible investor with atriple A rating. Given the size of the problem and IFC's limited resources, the focus will be on afew key, visible interventions, with strong demonstration effects and positive impact on marketpsychology in view of the volatile shifts in market sentiments.

46. IFC will protect its portfolio by working on restructuring and, where appropriate, re-capitalizing its portfolio companies. IFC aims to provide a swift response to enable its existing

Turkey CAS Prozress Report 26

export-oriented clients to generate foreign exchange cash flows to service their debt, therebyavoiding insolvency. IFC will also be active in the following areas: the traditional long-termproject financing and credit lines for financial institutions which will be very scarce; workingcapital finance; and operational and financial restructuring.

47. Thus, during next fiscal year IFC will give priority to: (i) the financial sector; (ii)restructuring industrial companies; and (iii) assisting the authorities with privatization. IFCexpects to play an active role in each of these areas during 2001-02.

48. Financial Sector. IFC's strategy in the financial markets will be to focus on: (i) assistingthe authorities with the sale of intervened banks, as appropriate, and of the non-performing loansof these banks; (ii) working with a mid-sized bank to strengthen capital and to use it as aplatform for helping the consolidation process; (iii) developing a possible trade finance facility toassist viable companies hampered by lack of liquidity; and (iv) continuing with efforts aimed atinstitution building and introduction of new products-including the development of theinsurance sector, mortgage finance and contractual savings institutions, and development of theprivate equity market.

(i) IFC has met with the Banking Regulatory and Supervisory Agency (BRSA), to discusshow IFC might assist with the task of selling of intervened banks7. In the case ofDemirbank, an existing client, IFC is prepared to take an equity stake alongside anacceptable investor, should there be a role for IFC. IFC has also been asked by theBRSA for assistance on the resolution of non-performing loan issues of the banks underthe SDIF. In this regard, working jointly with the Bank, IFC can draw on its experienceon similar work done on recent projects in Eastern Europe.

(ii) A consolidation of the banking sector is inevitable and, in the short term, we believe thefocus needs to be on strengthening viable financial institutions hit by the downturn. Inthis regard, complementing the Bank's support to banking sector reform, IFC is planningto work with a mid-size bank to strengthen its capital base and to use it as a platform topromote the consolidation of the banking system, by acquiring weak or intervenedbanks, assets, and/or through management contracts. This could also provide a channelfor extending credit to the SME and corporate sectors, both of which are facing aliquidity squeeze.

(iii) In addition, IFC is working to structure innovative mechanisms to enhance banks'capacity to provide trade finance to viable companies so as to help promote exports.

(iv) As calm returns to the markets, in accordance with its medium term strategy, IFC willcontinue with its institution building efforts, to develop domestic long-term contractualsavings institutions via projects in housing/mortgage finance, pension reform, and

7 Thirteen private banks have been taken over by the Savings Deposits Insurance Fund (SDIF) since 1998. SDIFplans to consolidate and sell off the banks to investors, but little interest has been shown by domestic or foreigninvestors. Only Demirbank has attracted foreign interest, but even there, the difficult economic environment isdelaying the receipt of firm bids.


development of a local currency debt market. In addition, IFC is working on a privateequity fund, a re-insurance company and an online brokerage project.

49. Restructurin' Industrial Companies. IFC and the Bank are working to: (i) prepare adiagnostic analysis of the degree of corporate distress by sector/corporate segment; (ii) examinethe incidence of formal bankruptcy and insolvency; (iii) deternine the workout capacity of thebanks and how the banks are addressing their own portfolio problems; and (iv) developinstruments to address the problems identified in the corporate sector.

50. IFC is focusing on enabling its existing clients to survive the crisis by providing themmedium-term financing, if necessary, to restructure their balance sheet, bring in potentialstrategic investors, save on the high cost of short term financing, and undertake necessary capitalexpenditure to reach optimum capacities. Companies suffering from liquidity difficulties areseeking support from IFC in the form of equity investment or bridge financing, which wouldpotentially enhance their profitability or financial structure in anticipation of an eventual sale.IFC's response is to work with them on corporate restructuring, offering assistance to restructuretheir liabilities and, where appropriate, providing additional financing. IFC has therefore givenpriority to restructuring such companies which have good fundamental business prospects, butwhich were constrained by inadequate equity and/or liquidity problems. IFC will develop modeltransactions that serve to demonstrate how such companies can de-leverage their balance sheets,increase their equity base, meet increased working capital requirements and improve theircorporate governance. IFC would also endeavor to convince the B lenders to do the same. The Bloan management unit has been actively involved in working with B loan participants to insurethat they are fully informned of5project developments and their views are adequately considered indeveloping restructuring plans .

51. Given the problem of tight local financial markets and export financing, IFC is exploringmechanisms to alleviate working capital shortages to enable its existing export-oriented clients togenerate foreign exchange cash flows to service their debt, thereby avoiding insolvency. Inaddition to assisting individual export-oriented clients, IFC is considering a Trade CreditFacility, to help restore intermediation in the banking system disrupted as a result of the crisis.

52. Beyond the crisis response and despite the difficult environment, IFC will continue topursue new investments where appropriate. Financing new projects with strong cash flows andpositive fundamentals, through corporate loans of sizeable arnounts, IFC will provide appropriatesignals in the market and send a strong message of confidence to the Turkish private sector andto international banks.

53. Privatization and FDI. It has become critical for Turkey to accelerate restructuring andprivatization of state owned companies. IFC strategy is to support flagship privatization to

8Recently, IFC stepped in expeditiously with additional financing to close an international syndication of US$80million aggregated funding for a large Turkish corporate (Arcelik). This loan, the first post-crisis internationalsyndication for the private sector for long-term funds, was signed in London on April 20. This message ofconfidence in the private sector, at an opportune time, signals strong support for viable enterprises by internationalcommnercial and financial institutions. It will encourage domestic banks to lend more on longer termis tocorporations with strong business foundations.

Turkey CAS Proress Report 28

achieve its catalytic or leveraging impact in Turkey, to help restore investor confidence, attractforeign interest and stimulate the flow of foreign direct investment (FDI) in privatization deals.To achieve this goal, IFC will support privatization of powerful demonstration projects such astelecoms and the national airline. The Information and Communication Technologies Group, ajoint Bank/IFC unit, could play an advisory role in the privatization of Turk Telekom.

54. IFC is leading a Bank Group initiative to enhance the quantity and quality of FDIinflows. FIAS carried out a diagnostic study (50 percent financed by IFC), which was discussedat a workshop with the government and leading members of the business community at the endof March. An analysis of administrative and regulatory barriers and a work plan for theirremoval is now underway and should be completed by end June. These measures are central toimproving the investment climate and they address some of the issues underlying the currentcrisis. A FDI investor conference is planned for spring 2002.

55. Istanbul Hub. Recognizing the importance of Turkey in the region, IFC has established ahub in Istanbul for its operations in Turkey, the Balkans and Central Asia. This will help IFC toreact swiftly to the crisis, promote private sector investment, encourage FDI and support Turkishinvestments in the region at large. The Director of the Southern Europe and Central Asia(SECA) Department will be in Istanbul.

56. SMEs. For several years IFC has been assisting SMEs in Turkey's hihg inflationenvironment via loans to banks and leasing companies. Anticipating a lower-inflation economy,IFC's medium-term strategy is to focus increasingly on development of domestic long-termcontractual saving institutions. However, as a consequence of the current economic crisis, IFC'sshort-term strategy is to continue to provide term funding to SMEs through loans or creditenhancements to leasing companies and banks. Also, IFC has commissioned a feasibility study toestablish a joint venture micro-finance institution focused on South-East Anatolia to helpeconomic development in that region.

C. MIGA Program

57. Turkey's share of MIGA's portfolio is US$165 million (gross), representingapproximately 4 percent of the total portfolio. MIGA has not experienced any difficulties withits guarantees in Turkey during the recent financial crisis. The Agency continues to see a strongdemand for its guarantee activities, both from foreign investors into Turkey and from Turkishinvestments into Russia and Central Asia.

IV. MANAGING THE RISKS AND IBRD EXPOSURE

58. The CAS identified four main areas of risk at the end of 2000: political pressures.economic considerations, administrative constraints, and the possibility of another large naturaldisaster. Risks continue to exist in each of these areas, but for all but the last area their naturehas changed. The dynamics of February 2001 crisis has highlighted the importance of politicalfragility and institutional risks, including the need for transparency in public management.


59. The political risk has now heightened with increased pressures under the crisis. Theresilience of the coalition has faced new tests daily since February 2001, including calls from theprivate sector and society at large for changes ranging from Cabinet reshuffles to elections. Theability of the coalition to survive depends upon the rapid delivery of the New EconomicProgram. A spate of further disputes in the coalition on agreed actions once again panicked themarkets late in May 2001 and included disagreement over telecommunications privatization andwheat prices. Ultimately the Privatization Minister, who opposed the Tobacco Law, was askedto resign, which sent a signal to the markets and to coalition members that the three party leadersremain committed to the program. Such disputes may arise again, and could weaken the coalitionand prove disruptive, even as there are signs of increasing support in the country for the broaderdirection of the reform of a discredited system.

60. A second type of risk is the possibility of a greater social backlash from both theeconomic downturn and tough reform measures. This risk, identified in the CAS, has also beenmagnified by the crisis. A sharp contraction in output has occurred with serious socialconsequences. While the Government's program anticipates a V-shaped recovery, this is not aforegone conclusion. Some politically vocal groups (including organized labor and thecommercial sector) and some economically vulnerable groups could fail to regain rapidly theirstandards of living. Nevertheless, if the Government is unable to protect social sector spendingand bolster safety nets, a growing risk of social disenchantment could emerge. In this regard,several projects supported by IBRD will help the Government to deliver better social protection.The ongoing PSSP finances severance and related payments to workers displaced by job loss dueto the privatization of state-owned enterprises, and labor redeployment services to those workers.The proposed ARIP, as explained above, would assist farmers affected by the reform programand help to finance severance to laid off employees of restructured ASCUs. The proposed SocialRisk Mitigation Project would support social assistance schemes targeted at the poor and mostvulnerable. The Government has committed itself to maintaining the budgets for education andessential public health, and increasing support for immunization. Together, these actions willhelp to reduce the risk of severe social reactions.

61. The CAS pointed out that, with respect to the key economic risks confronting Turkey, thedownside scenario would be worse than the pre-reform starting point, in part because the loss ofcredibility would have enduring effects. This is what has occurred9 . The New EconomicProgram is the appropriate means to gain a stable growth path; nevertheless, the macroeconomicframework and targets are ambitious given the extent of the current crisis. There is a substantialdownside risk that real interest rates will be higher than programmed which would affect thesustainability of the public debt. The actual path of real interest rates will depend critically onthe effectiveness of macro-economic policies, rigorous implementation of the economicprogram, and the Government's domestic borrowing requirements. Growth will dependsensitive!y on how tight monetary policy must be to control inflationary expectations, and on

9 One indicator of the loss of credibility is the downgrading of Turkey by the rating agencies. In April, Fitch IBCAdowngraded Turkey's long-term domestic currency rating from B+ to B, and its long-term foreign currency ratingfrom B+ to B-. Moody's downgraded Turkey's foreign exchange deposits ceiling from B2 to B3. Standard and Poordropped Turkey's long-term credit rating from B to B-. The agencies noted the importance of implementation of thereform program within a coherent macroeconomic framework (including plausible public borrowing plans) toeasing market worries.


interest rates. A deeper recession in 2001 is a distinct possibility. The extent of recovery in2002-03 will play an important role in public debt dynamics.

62. Turkey's vulnerability to adverse external developments and shocks remains high. Theviability of the medium-term external financing plan hinges on the government's ability to regainaccess to international capital markets at affordable cost, to secure large foreign investmentinflows including realization of the privatization program, and to discourage capital flight.Annual gross financing requirements over 2001-03 average $22.2 billion per annum. Of this, thecurrent account deficit accounts for roughly S1.6 billion, refinancing of medium and long-termdebt $20.3 billion, and increases in reserves $0.3 billion. External financing over 2001-03depends heavily on the private sector. Net foreign direct investment is projected to average $1.3billion per annum - a sharp increase from $0.3 billion per annum in the preceding three years.Portfolio inflows account for $ 4.1 billion per annum, up from a three-year average of $1.6billion per annum. Debt financing accounts for $16.5 billion per annum, of which $7.6 billion isthe average level of gross official assistance from the Bank and IMF. Access to private capitalmarkets depends heavily on the credibility of the reform program. Failure to maintain the paceof reforms or political infighting could adversely affect market sentiment and lead to restrictedmarket access, capital flight, a depletion of foreign reserves and a sharp fall in the exchange rate.Market access may also be adversely influenced by a slowdown in global growth or contagionfrom other emerging market crises.

63. Managing the vulnerabilities of the financial system has to be an integral part of Turkey'sreform. Significant accomplishments had been made as detailed in the FSAL documentspresented to the Board in December 2000. Political resistance to serious banking reform remainsa serious risk to the reform of the financial sector as does the fragility of the banking system. Thecommercialization and privatization of the state-owned banks will be a major political andorganizational challenge for the Governrnent. The rapid privatization of Halk and Ziraat and thesubsuming of Emlak into Ziraat will have also significant fiscal costs. There could be somesocial fall-out because of lay-offs, but given the required down-sizing of the banking sector andsubstantial severance payments under Turkish Law, these issues are manageable. Significanttechnical expertise will be needed to develop the restructuring and privatization plans. Anotherrisk is that of possible inability to raise sufficient resources to finance the restructuring of thestate banks and the resolution of the SDIF banks. Tight fiscal discipline and the renewedconfidence of domestic and international investors in Turkish sovereign debt instruments will beessential. Finally, satisfactory and timely failure resolution efforts by the SDIF are important; therisk that such efforts might not be made is related to the large burden of work on both SDIF andBRSA.

64. Leaming from the past, the Government has explicitly recognized the need forinstitutional change to reduce political interference in the economy as part of its overall reformprogram. Institutionalizing the reforms is also critical in ensuring their irreversibility. Importantmeasures in this respect are the new law granting independence to the Central Bank, theestablishment of an energy board and the BRSA, the corporatization of the telecommunicationscompany and greater independence for the telecommunications board. Strengthening publicexpenditure management and investment planning, and improving financial accountability andoversight (including bringing procurement legislation to intemationally accepted standards) - allareas in which the Bank's recent joint work with the Government is contributing to the change


process - will also assist sound program implementation, and reduce risk of backtracking. Aslong as the structural and social changes are institutionalized, the risks to IBRD are reduced andIBRD's support will bear results.

65. The risk of a large natural disaster, which could bring about extensive human loss anddisrupt the economic recovery, still remains. Progress has been made in disaster preparednessand mitigation under ongoing emergency projects. Particular accomplishments supported by theongoing Marmara Earthquake Emergency Reconstruction (MEER) project include the expectedcompletion in June 2001 of over 12,000 earthquake resilient housing units, and the sale of 1.7million housing insurance policies. If needed, additional financial support could be providedthrough reallocations and potential new lending in the event of a major natural disaster.

66. Under the previous program, and prior to the recent crises, Turkey's creditworthiness forIBRD borrowing was already weak due to persistent macroeconomic imbalances and significantstructural deficiencies. By end-2000, annual inflation was 39 percent, the real exchange rate hadappreciated significantly, and the current account deficit had widened to 5 percent of GNP.Government finances continued to be undermined by unsustainable fiscal policies, includingextensive budgetary subsidies and subsidized credit extended through the state banks. As aresult, large contingent liabilities continued to accumulate in the banking system. Structuralreforms had slowed in the face of political resistance, delaying restructuring of the bankingsector, retarding the privatization program, and jeopardizing medium-term growth targets. Theseweaknesses and vulnerabilities were exposed in the November and February crises.Notwithstanding the subsequent move to a floating exchange rate, the crises have done furtherdamage to the macroeconomy, leaving Turkey in a much weaker position from which to embarkon the revised program. Foreign currency reserves fell $6.5 billion in November, and a further$7.6 billion in February. Short-term interest rates soared and have only recently fallen to levelsthat could be serviceable over the medium term. The stock of public debt jumped from 59percent of GNP at end-2000 to 78 percent. The economic adjustment precipitated by the crisesis projected to lead to a contraction in GDP of 3 percent this year, with inflation over 50 percent.

67. Creditworthiness is only expected to improve over time as debt indicators are reduced tomore manageable levels and the conditions for sustainable economic growth are put in place.This will require the government to implement an ambitious reform program in a difficultpolitical environment. A crucial element of the program is to lower inflationary expectationsand the trajectory for domestic interest rates in order to put public finances on a sustainablefooting. Moreover, maintaining investor confidence is essential to enable the rollover of existingdomestic and extemal debt as it falls due over the short term. Investor confidence in tum hingeson credibility of the program which depends to a large extent on political commitment. Over thelonger term, sustained progress on structural reforms will be required for Turkey to achieve thegrowth rates that will facilitate an improvement in debt service capacity and a reduction in theextemal debt burden. At present, however, the risks to the program are considerable andintemational capital markets remain cautious. Turkey's long-term sovereign debt ratings, whichwere already well below investment grade, were further downgraded by the rating agencies afterthe February crisis. Eurobond spreads have more than doubled since January 2000 and reflect arisk premium attached to Turkish bond issues of 7 to 8 percent above comparable US treasuries.

Turkey GAS Progress Report 32

68. As of December 2000, total IBRD debtoutstanding and disbursed was US$3.6 billion, Figure 1: IBRD Net Flows and Debtequivalent to 3.0 percent of the total IBRD portfolio. .0000t - 2700

-I - -- k 2300The proposed revised lending program would add sooo --- X 200

US$1.2 billion under SSAL terns to the approved 6000. 500

CAS envelope of US$5 billion. IBRD disbursements 4000 700100 00and exposure would increase faster than originally 3000 lI 300

projected in the CAS because the amount of quick- 2000 l-l0

disbursing loans during the CAS period would be ' :900higher than originally proposed. Under the high case 1990 1992 1994 1996 1998 2000 2002

lending program with the SSALs, IBRD debt DOD(JeRscale)NetFlows(rghtscale)

outstanding and disbursed would increase to US$9.2billion or around 7.2 percent of the total IBRD portfolio in 2003 (Table 5). The program, nodoubt, involves high risks for IBRD. While projected exposure to Turkey at the end of the CASperiod is high, increases in exposure are carefully linked to progress on reform. The largeincrease in upfront lending in 2001 is necessary to ensure that the key upfront actions whichensure that political interference in economic decision-making is reduced are taken upfront. Inparallel IBRD's upfront support, ensures that these actions are taken and that the program hasadequate financing in order to succeed.

Table 5: Summary of Key Exposure Indicators in the High Case

Actual Projected1999 2000 2001 2002 2003

IBRD DOD 2,902 3,634 6,335 8,333 9,170Share of IBRD Portfolio 2.4 3.0 5.0 6.4 7.2IBRD Debt Service XGNFS 1.8 1.4 1.4 1.7 1.9IBRD Debt Service / Total Public Debt Service 7.7 4.8 3.9 4.9 5.3Preferred Creditor DS/ Total Public Debt Service 14.2 11.0 13.5 13.0 15.5Memo Items

IBRD Interest payment 235 237 359 531 600IBRD principal repayments 610 486 434 433 475


V. CONCLUSION

69. Despite the formidable challenges facing Turkey as a result of the current severe crisis,the country retains fundamental strengths and potential. There is still a national will to breakfrom an inflationary past, achieve stable growth, and reduce inequality and social and economicvulnerability. A competently led economic team with strong domestic support and internationalcredibility is now in place. Large but judicious international support remains crucial for success- despite the high risks going forward. In this context, the Bank Group's program, carefullytimed, can make a substantial and positive difference.

James D. WolfensohnPresident

By:Sven Sandstrom Peter Woicke

Washington D.C.June 7, 2001

Annex AlPage I of I

Annex Al-TurkeyKey Economic & Program Indicators - Change from Last CAS

As of 05/10/2001

Forecast in Last CAS Actual Current CAS Forecast

Economy 2006 200/ 200!' 20036 2006 200f 200! 20036

Growth ratesGDP 5.5 5.2 5.8 5. 7. -3.0 5.0 6.0Exports 8.8 5.6 5.6 4. 8. 8.4 8.1 3.4Imports 5.9 5.7 7.9 8.1 47. -16.2 2 2.5

Inflation 49.0 14.0 8.0 7. 39 52.5 20 15

National accounts (%Current account -4.0 -3.0 -2.5 -2. -4. -0.6 -0.9 -0.7Gross 23.8 24.1 24.5 24. 23. 21.5 22.8 23.5

Public finance (%Fiscal -18.1 -7.8 -3.6 -3. -18. -18.4 -10.1 -9.1Foreign 3.0 2.8 2.0 0. 5.2 9.6 0.5 1.2

International reserves

(as months of imports) 5.1 6.0 7.0 7.4 4. 4.5 4.4 4.7

Progaram (Bank's FY) FY0 FYOf FY0 FY0O FY06 FY01 FY02 FY0OCommitment ($ million) 1,770 1,640 1,770 1,590 177 2728 2650 1207Gross disbursements 992 1,897 1,871 1,436 95 1960 3152 175C($ million)

a. Estimatedb. Projectedc. Actual1/ December 20002/ May 2001 CAS

Annex A2Page I of 2

Turkey at a glance 8/31/00

Europe & Lower-POVERTY and SOCIAL Central middle-

Turkey Asia income Development dlamond*1999Population, mid-year (millions) 64.3 475 2,094 Life expectancyGNP per capita (Atlas ntethod, USS) 2,900 2,150 1,200GNP (Atlas method, US$ bllionsi 186.6 1,022 2.513

Average annual growth, 199309 9

Population (%) 1t5 0,1 1 1Labor force (I%) 2.6 0 6 1.2 GNP , Gross

per primaryMost recent estimate (latest year available, 199349) capita ' enrollmentPoverty (% of population below national Poverty line)Urban population (% of total population) 74 67 43Life expectancy at birth (years) 69 69 69Infant mortality (per 1,000 live births) 38 22 33Child malnutrition (% of chilkren under 5) 10 8 15 Access to safe waterAccess to improved water source (% o,f popu/ation) .. 86Illiteracy (% ofpopulation age 15+) 15 3 16 1Grossipimaryenrollment (%of'school-agopopulation) 107 100 114 _ Turkey

Male 111 101 114 - Lower-middle-income groupFemale 104 99 116

KEY ECONOMIC RATIOS ard LONG-TERM TRENDS

1979 1989 1998 1999 - -Economic ratios

GDP (US$ billions) 91.7 1071 201.2 1857Gross domestic investmentGOP 14 1 23 5 24.2 23.3Exports of goods and services/GDP 3 1 16.2 24.3 23.2 TradeGross domestc savings/GDP 11 5 21.9 20.6 19.6Gross national savinqs/GDP 14.4 26.6 25 9 23.5 {Current account balance/GDP -1.5 0.9 1.0 7 Domestic Interest payments/GDP 0 3 2.5 1 7 2.4 InvestmentTotal debtGDP 17.4 38.8 48.2 54.8 Savings Ie nTotal debt service/exports 26.7 32.4 26.5 34.8Present value of debt/GDP . 49.9 Present value of debtlexports 160 9

Indebtedness19794S9 1989.99 1998 1999 1999-03

(average annual growth)GOP 5.0 4.0 31 -5.t1 .5 - TurkeyGNP Per capita 2.4 2.5 2 3 -7 8 4.1 Lower-middle-income groupExvort of goods and services .. 11.0 12 0 -7 0 5 9

STRUCTURE of the ECONOMY1979 1989 1998 1999 Growth of Investment and GDP (%)

(%6 of GDP)Agriculture 27.9 17.4 18.5 15.8 40TIndustry 23.8 32.8 25.0 24.3 20

Manufactunng 16.0 21.4 15.5 14.6Services 48.3 49.8 56.5 60.0 -20 96 97 98

Prvate consumption 77.0 68.8 66.7 65.2 -40General govemmentconsumption 11.5 9.3 12.7 15.2 "-GDI O-GDPImports of goods and services 5.7 17.8 27.9 26.9

(average annuat growth) 1979-89 1989-99 1998 1999 Growth of exports and imports (%)

Avrculture 1.1 1.6 9.3 -5.2 40Industry 7.3 4.5 1.8 -6.7 20

Manufacturng 7.5 5.4 1.0 -6.0Services 4.0 4.0 3.1 -3.9

Private consumption . 4.0 0.1 -3.9 .srGeneral govemment consumption .. 4.0 7.8 6.5Gross domestic investment .. 4 6 -1.4 -9.5 ExpImportsof goods and services .. 11.1 2.3 -3.7 -Exports .ImportsGross national product 4.9 4.1 3.9 -6.4

Note: 1999 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond willbe incomplete.

Annex A2Page 2 of 2

Turkey

PRICES and GOVERNMENT FINANCE1979 1989 1998 1999 Inflation (%)

Domestic prices(% change)Consumer prices 63.0 83.7 63.5 100Implicit GDP deflator 75.8 75.7 75.7 56.2

Government finance l(% of GDP, includes current grants) oCurrent revenue .. 21.5 24.6 25.4 94 95 96 97 99 8 9

Current budget balance .. 4.2 -5.7 -14.4 -GDP rceflator _ CPIOverall surplus/deficit . -5.2 -13.4 -23.4

TRADE1979 1989 1998 1999 Export and import levels (USS mill.)

(USS millions)Total exports (fob) 2,261 11,780 31,221 29,326 60,000

Textiles 428 3,911 10,510 9,830Processed agncultural products 1,081 1,971 2,141 1,840 400Manufactures 1,732 10,437 23,873 23,755

Total imports (cif) 5,069 15,792 45,921 40,693 JFood 85 890 510 444 .001)Fuel and energy 1,817 3,406 4,501 5,376Capital goods 1,403 3,953 11,033 9,062 o

Export price index (1995=100) .. 5 87 82 9 4 9 6 9 e 2Import price index (1995=100) . 90 86 84 | Exports U ImportsTemms of trade (1995=100) .. 94 101 98

BALANCE of PAYMENTS1979 1989 1998 1999 Current account balance to GDP (%)

(USS mllllons)Exports of goods and services 2,969 17,612 52,037 44,548 2Imports of goods and services 5,182 18,464 55,299 48,726Resource balance -2,213 -852 -3,262 -4,178 o 3Net income -1,009 -1,745 -481 -2,361 .9Net current transfers 1,810 3,558 5,727 5,175 i ' _

Current account balance -1,412 961 1,984 -1,364 -2 1

Financing items (net) 1,300 1,801 -1,537 6,570Changes in net reserves 112 -2,762 -447 -5,206 .41

Memo:Reserves including gold (US$ millions) .. 9,283 29,499 34,128Conversion rate (DEC, local/US$) 31.1 2,122 259,627 416,686

EXTERNAL DEBT and RESOURCE FLOWS1979 1989 1998 1999

(US$ mi/lions) Composition of 1999 debt (US$ mill.)Total debt outstanding and disbursed 15,929 41,577 96,906 101,781

IBRO 890 5,869 3,304 2,902 107 890IDA 190 162 112 107 2902 37a3

Total debt service 1,340 7,092 16,513 18,316 23472 37IBRD 105 1,010 924 845IDA 3 6 7 7 _j 2 3 7

Composition of net resource flowsOfficial grants 52 95 37 80Official creditors 964 -555 -118 -760Private creditors 3,068 1,631 -153 -3,269Foreign direct investment 75 663 573 138Portfolio eguity 0 56 2,888 -1,727 62390

World Bank programCommitments 306 604 956 1,165 A - IBRO E - BilateralDisbursements 280 419 271 384 B - IDA D- Other multilateral F - PrivatePrincipal repayments 36 506 684 616 C - IMF G -Short-termNet flows 244 -87 -414 -232Interest payments 72 510 246 236Net transfers 172 -597 -660 -468

Development Economics 8/31/00

Annex B2Page I of 1

CAS Annex B2 - TurkeySelected Indicators* of Bank Portfolio Performance and Management

As Of Date 04111/2001

Indicator 1998 1999 2000 2001Portfolio AssessmentNumber of Projects Under Implementation a 22 20 23 22Average Implementation Period (years) b 4.3 3.9 3.8 3.7Percent of Problem Projects by Number a, c 4.5 20 17.4 4.5Percent of Problem Projects by Amount a, c 2.9 8.3 13.2 0.3Percent of Projects at Risk by Number a, d 9.1 20 17.4 9.1Percent of Projects at Risk by Amount a, d 7.2 8.3 13.2 6.3Disbursement Ratio (%) e 20.9 16.6 20.0 17.6Portfolio ManagementCPPR during the year (yes/no) yes yes yes yes fSupervision Resources (total US$ million) 1.3 1.5 2.5** 2.2 gAverage Supervision (thousand US$/project) 51 61 90.9** 93.3 g

Memorandum Item Since FY 80 Last Five FYsProj Eval by OED by Number 84 13Proj Eval by OED by Amt (US$ millions) 7915.7 1550.7% of OED Projects Rated U or HU by Number 34.9 23.1% of OED Projects Rated U or HU by Amt 42.6 27.7

a. As shown in the Annual Report on Portfolio Performance (except for FY00, FY01).b. Average age of projects in the Bank's country portfolio.c. Percent of projects rated U or HU on development objectives (DO) and/or implementation progress (IP).d. As defined under the Portfolio Improvement Program.e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the

beginning of the year: Investment projects only.

f. JPPR, focussing on effect of economic crisis on project implementation is ongoing.

g. Planned budget for FY01* All indicators are for projects active in the Portfolio, with the exception of Disbursement Ratio,

which includes all active projects as well as projects which exited during the fiscal year.* FY00 and FY01 are in full costs (Salaries, Benefits, HQ and Field Activity Costs)

Annex B3Page I of 2

Bank Group Program Summary Turkey

As of Date 04/11/2001

Proposed IBRD/IDA High-Case Lending Program i

Strategic Rewards b Implementation bFiscal year Proj ID US$(MX) (H/M/L) Risks (H/IM/L)

2001 FSAL I (b), (c) 393.0 H H

Pnvatization Social Support (b) 250.0 H MAgricultural Reformn and Investment (hybrid) 600.0 H H

PFPSAL 1,100.0 H H

Result 2,343.0

2002 Basic Education (APL 11) 300.0 H MSocial Risk.Mitigation 500.0 H H

PFPSAL 11 1,350.0 H H

Community Development and Heritage 25.0 M M

Financial Sector Reform Program Loan I 500.0 H H

Result 2,675.0

2003 Financial Sector Reformn Program Loan 11 500.0 H H

Health 100.0 H MMicro Watershed 32.0 M L

PSAL Program Loan 1 375.0 H H

Secondary Education 175.0 M LResult 1,182.0

Overall result 6,200.0

Notes: (a) We are currently in the High Case Lending Scenario. The Base Case would amount to lending of USS I billion only.

(b) Actual, approved on Dcember 21, 2000

(c ) FSAL was approved in the amount of US5 778 million. Of this, USS 393 million was disbursed in December 2000, and

US$ 393 million is proposed for cancellation (to be folded into the new larger financial sector reforrn program)

Annex B3Page 2 of 2

CAS Annex B3 (IFC & MIGA) for TurkeyTurkey - IFC and MIGA Program, FY 1998-2001

1998 1999 2000 2001

IFC approvals (US$m) 251.40 125.60 181.18 65.01

Sector (%)CEMENT & CONSTRUCTION 6 18CHEMICALS & PETROCHEMS 5FINANCIAL SERVICES 33 32 32FOOD & AGRO-BUSINESS 4 24HOTELS & TOURISM 31INFRASTRUCTURE 14MANUFACTURING 7 5 14MOTOR VEHICLES & PARTS 16OTHER 69SOCIAL SERVICES 10TEXTILES 9 29 11TIMBER, PULP & PAPER 26 6Total 100 100 101 100

Investment instrument(%)Loans 95 86 83 62Equity 0 4 3 0Quasi-Equity 2 10 14Other 3 0 0 38Total 100 100 100 100

MIGA guarantees (US$m) 141.98 250.56 246.92 0.00

Annex B4Page I of I

Turkey - Sumrary of Nonlending Services

Product Completion FY Cost (US$000) Audience " Objective b

Recent completionsCEM FY00 500 GDPB KG, PSLiving Standards Study FY00 400 G D P B KG, PS, PDLivestock Sector Study FYOI 300 G D P B KG, PSPEIR FY01 345 GDB KG, PD, PSCPAR FYOI 100 G B KG, PSForestry Review FYOI 300 GDBP KG, PD, PS

Underway

Energy and Env. Review FY01 25 G D B P KG, PDCaspian oil and gas dialogue FY03 60 G B KGCFAA FY02 100 G B KG, PSConference on Effective Government FY01 100 GDBP KG,PDAssessment of Crisis Effect on Corporate Sector FY02 100 GBP KG,PDAssessment of Social Impact of Crisis FY02 150 GDBP KG,PD

Planned

Non-Bank Financial Institutions Study FY02 150 G D B KG, PSHealth Sector Study FY02 320 GDBP KG, PD, PSTechnology Assessment FY02 300 GD B P KG, PD, PSGas Sector Note FY02 215 GDB KG, PSGovernance Workshop FY02 120 G D B P KG, PD, PSNEAP/Clean Air FY02 145 GDBP PD, PSGlobal Development Gateway FY03 175 G B P KG, PSCEM (EU Accession) FY03 400 G D P B KG, PD, PS

a. Government, donor, Bank, public disseminationb. Knowledge generation, public debate, problem-solving

Annex B6Page I of 2

Turkev - Key Economic Indicators

National accounts (as % of GDP)Gross domestic producta 100 100 100 100 100 100

Agriculture 19 16 16 17 17 15

Industry 25 25 25 26 26 24

Services 56 59 58 57 56 6]

Total Consumption 79 80 82 77 76 75Gross domestic fixed investment 25 22 22 20 21 22

Govemment investment 4 4 7 7 7 7Private investment 20 18 1 5 13 15 15

Exports (GNFS)b 24 23 24 31 30 30Imports (GNFS) 28 27 30 30 29 29

Gross domestic savings 21 20 18 23 24 25Gross national savingsc 26 23 21 23 24 25

Memorandum itemsGross domestic product 201154 185788 200316 169466 187127 201820(US$ million at current prices)GNP per capita (US$, Atlas method) 3170 2910 3270 2830 2800 2880

Real annual growth rates (%, calculated from 1994 prices)Gross domestic product at market prices 3.1 -4.7 7.2 -3.0 5.0 6.0Gross Domestic Income 2.5 -4.0 9.8 -3.7 3.9 5.3

Real annual per capita growth rates (%, calculated from 1994 pnces)Gross domestic product at market ptices 1.5 -6.1 5.6 -4.5 3.6 4.6Total consumption -0.3 -3.2 12.1 -12.6 0.7 2.9Private consumption -1.4 -4.7 12.3 -13.0 1.0 2.7

Balance of Payments (US$ millions)Exports (GNFS)b 52037 44548 49066 53322 56132 59825

Merchandise FOB 31220 29326 31180 33707 36229 39264Imports (GNFS)b 55299 48726 59715 50837 53956 57567

Merchandise FOB 45440 39773 53613 47151 50055 53420Resource balance -3262 -4178 -10649 2485 2176 2257Net current transfers 5727 5175 5012 4411 4540 4945Current account balance 1984 -1364 -9755 -1035 -1647 -1347

Net private foreign direct investment 573 138 112 800 1570 1588Long-term loans (net) 3985 345 9971 -4243 3759 650

Official g/ -72 -642 1015 3261 3347 1881Private 4057 987 8956 -7504 412 -1231

Other capita] (net, incl. errors & ommissions -6095 6087 -2877 -10160 2204 4522Change in reservesd -447 -5206 2549 14638 -5886 -5413

Memorandum itemsResource balance (% ofGDP) -1.6 -2.2 -5.3 1.5 1.2 1.1Real annual growth rates ( YR94 prices)

Merchandise exports (FOB) 9.2 -2.4 8.3 8.4 8.3 4.6Primary 10.4 .. .. .. ..

Manufactures 3.2 .. .. .. ..

Merchandise imports (CIF) 0.8 -8.1 47.2 -16.3 1.7 3.3

Annex B6Page 2 of 2

Turkey - Key Economic Indicators(Continued)

Public finance (as % of GDP at market prices)eCurrent revenues 23.8 25.0 29.1 30.4 29.2 27.8Current expenditures 29.6 41.0 39.1 39.6 30.5 28.3Current account surplus (+) or deficit (-) -5.8 -16.0 -10.0 -9.2 -1.3 -0.6Capital expenditure 7.9 7.7 8.9 8.8 8.6 8.3Foreign financing -1.2 1.8 5.2 9.6 0.5 1.2

Monetary indicatorsM2/GDP 39.2 52.4 40.0 41.7 41.7 41.7Growth of M2 (%) 89.7 98.3 23.1 51.0 34.7 23.5Privatesectorcreditgrowth/ 47.5 32.5 -116.7 22.9 69.7 66.3total credit growth (%)

Price indices( YR94 =100)Merchandise export price index 95.6 92.0 90.3 90.1 89.4 92.6Merchandise import price index 99.6 96.0 91.1 95.8 100.0 103.3Merchandise terms of trade index 95.9 95.8 99.1 94.0 89.4 89.6Real exchange rate (US$/LCU)f 120.6 124.2 128.2 107.9 109.5 108.3

Real interest ratesConsumer price index (% change) 83.7 63.5 50.6 49.4 28.3 16.5GDP deflator (% change) 75.7 55.6 50.6 49.4 28.3 16.5

a. GDP at factor costb. "GNFS" denotes "goods and nonfactor services."c. Includes net unrequited transfers excluding official capital grants.d. Includes use of IMF resources.e. Consolidated central government.f. "LCU" denotes "local currency units." An increase in US$/LCU denotes appreciation.g. Includes government guaranteed loans to SEEs.

Annex B7Page I of ]

Turkey - Key Exposure Indicators

Total debt outstanding and 97,211 101,795 114,260 116,327 116,767 117,426

disbursed (TDO) (US$m)a

Net disbursements (US$m)a 2,429 5,155 17,717 7,907 1,940 661

Total debt service (TDS) 14,900 18,286 20,510 23,626 26,492 23,938

(US$m)a

Debt and debt service indicators

(%)TDO/XGSb 155.8 193.5 201.3 197.2 188.7 176.7

TDO/GDP 48.3 54.8 57.0 68.6 62.4 58.2

TDS/XGS 23.9 34.8 36.1 40.0 42.8 36.0

Concessional/TDO 6.0 5.6 5.0 4.9 4.9 4.9

IBRD exposure indicators (%)

IBRD DS/public DS 8.2 7.7 4.4 3.6 3.7 4.6

Preferred creditor DS/public 15.9 14.2 11.4 17.9 32.2 19.9

DS (%)c

IBRD DS/XGS 1.4 1.8 1.3 1.4 1.6 1.7

IBRD TDO (US$m)d 3,446 2,902 3,634 6,335 8,333 9,170

Share of IBRD portfolio(%) 3.1 2.4 3.0 5.0 6.4 7.2

IDA TDO (US$m)d 112 107 101 96 91 85

a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short-

term capital.

b. "XGS" denotes exports of goods and services, including workers' remittances.

c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the

Bank for International Settlements.

d. Includes present value of guarantees.

Annex B8Page I of 2

CAS Annex O - Turkey

Status of Barnk GrouP Operations (Operations Portfolio)

As o0rl 6ie4r11nt

Closed Projects 122

Tot Distursed (Adet) 1J75S.30

of which has been repaid 68.11

Tota DsbLrsed (Closed) 1 0,501.40of which has been repaid 10,233.80

Total Disbrsed (Actrve t Cbsed) 1 2256.72of which has benrepaid 10,301.Y0

Total lidsb.rsed (Actve) 2,61861

Total thdsbursed (Cosed) 24.19

Total Unfsbwgsed (Active + Closed) 2,642.80

Actie Proiscs Derarence BtweenExpected and ActI

S9t4slon Ratmin Oridnal Amourtt In tJSS M Dksburesmes

ProecID Proect Name Dect.-s hwr ttallion Flscal Year IIAD DA GRANT Cancel. tinls. Orf. Frm rFWd

P00944 AGRIC RES S S 1992 55 0 0 6 4.4 10.i 4.4P009093 ANTALYA WATER SUPPL S S 1995 100 0 0 14.9 44.8 34 0P009089 BASIC ED I HS S 1998 3Q0 0 0 0 150.1 148.2 aP044175 8I1DIVERSITYWNR MGT S S 2000 0 0 8.2 0 7.5 0.3 0P009065 BURSAWATER&SANITrA S S 1993 1295 0 0 20 4.9 23.7 22PF1B965 CESME W.S. & SEWER. S S 1998 13.1 0 0 0 11.4 6.3 0P048851 COMMODmES.MKT.DEV. S S 1999 4 0 0 0 3.3 3 0P009023 E ANATOLLA WATERSHEI S S 1993 77 0 0 0 20.6 29.5 1.9P065188 EFIL S S 2000 252.5 0 0 0 185.2 -67.2 0P058877 EMGY FLOOD RECOVER S S 1999 369 0 0 0 189.3 149.3 89.3P068792 ERL S S 2000 759.6 0 0 0 375 375 0P066511 FSAL S S 2001 777.8 0 0 0 385 0 0P009076 HEALTH 11 S S 1995 150 0 0 0 76.2 98.2 17.5P009073 INDUSTRIAL TECH S S 1999 155 0 0 0 136.5 -3.5 0P06368 MARMARA EARTHQUAKE S S 2000 505 0 0 0 374.6 254.6 0P048852 NATL TRNSM GRID S S 1998 270 0 0 0 268 196 0P038404 ODS PFIASEOUT 2 S S 1996 0 0 14 0 6.9 6.9 0P009095 PRIM HEALTH CARE SER S U 1997 14.5 0 0 0 13.9 13.9 869Pt69894 PRIVSOC SUPPRT S S 2001 250 0 0 0 247.5 9.5 0P009072 PRP. OF IRRIGATION S S 1998 20 0 0 0 11 9 2,2P035759 PUBLIC FINAN. MGT. S S 1996 62 0 0 5 361 41.1 188P038G91 ROAD IMPR. & SAFETY S S 1996 250 0 0 0 81.9 85.5 0Overall result Resuh 4514 0 22.2 45.9 2633.1 1031 144.9

AnnexR B8Page 2 of 2

CAS Annex BS (IFC) for Turkey

TurkeyStatement of IFC's

Held and Disbursed PorffolioAs of 12/31(2000

(In US Dollars Millions)

Held Disbursed

FY Aporovul Compan Loan Equity Quasi Panic Loan Equity Qua,si Pantic1990S93 Conrad 0 0 0 0 0 0 0 01997/98 Do esLe.aiog 339 0 0 0 339 0 0 00194f96 Demirbank 7.5 0 0 7.5 7.5 0 0 7 5

1929 Edame 113 0 0 0 113 0 0 01993196 Eldor 3 0 0 0 3 0 0 01933193196 Elgnkon 8.49 0 0 0.52 8.49 0 0 0.52

1995 Entek 24 0 0 23.19 24 0 0 23191997/98 Finens Leasing 3.89 0 0 0 3.S9 0 0 0199299 Fimansbanu 10 0 0 35 10 0 0 351994i9StU 0aranteLeas-g 255 0 0 1619 255 0 0 16191994t95f96 GlobalSecurity 0 0 0 0 0 0 0 0

1999 GumuayuKap 4 0 264 0 4 0 264 01998 Indoremalplik 10 0.66 0 0 10 0.66 0 0

199810 IpekPaper 0 0 0 15 0 0 0 152000 lsslarAwbalaj 0 0 10 0 0 0 9.5 01990 KepezElektklc 1134 0 0 0 1134 0 0 0

19S8190 Kiris 8.26 0 0 0 3 26 0 0 01996 Kosbeank 5.71 0 0 0 5.71 0 0 01996 Koclease 6 43 0 0 0 6.43 0 0 0

1992197 Korfezbonk 9 0 0 13 9 0 0 131990192 Koy-Tut 0 0 0 0 0 0 0 0

1991 Kula 4.53 0 0 0 4 53 0 0 01993/96 Medya 0 0 499 0 0 0 499 0

1993 Modem Kaeton 20 0 0 10 20 0 0 101991 NASCO 10.18 0 0 3.55 10.18 0 0 3.551993 Ottoman 18 1S 0 0 72.73 13.13 0 0 72.731997 OyakBank 8.33 0 0 5 8.33 0 0 51993 Pasabehe.-Schott 11 23 0 0 11.3 11 33 0 0 1183

19S3394t93 PnerET 10.21 0 0 0 1021 0 0 01994C0 PinerSIJT 14.47 0 0 0 0 0 0 00t97 RantLeasing 1 78 0 0 0 1 73 0 0 0

1999 SAKoSa 219 0 0 21.42 21.9 0 0 21.4219S6190 Silkar Tufino 3 34 0 0 3.8 3.34 0 0 3.31993f96 Sse Ve Cae 6.3 0 0 3 4 6 3 0 0 3 4

1993 Soktas 10.35 0 0 0 1035 0 0 01996 TCRA 0 0 1 0 0 0 0.05 0 01995 TDD 0.6 0 0 0 0.6 0 0 0l9 9

9 TEB Finanjal 5 0 0 0 5 0 0 01997 Toprak L-asmg 1.78 0 0 0 1.78 0 0 0

19791S21932/9/91/96"99 Toaky.Cam 0 1.18 0 0 0 118 0 01995199 TurkEkonBenk 15 0 0 20 15 0 0 201993t98 Turkiye Garanti 14.55 0 0 69.09 1455 0 0 69 09

1999 Unyc Cement 19.74 0 0 0 19.74 0 0 01999 Uzel 20 0 0 15 11.37 0 0 3.53

1970/7192/13/N9 Vblng 11.0S 0 0 0 1108 0 0 01995 YlovaAc-ylbc 25 0 0 133 2.5 0 0 1 33

1997/93 YapiKred,Lease 273 0 0 0 273 0 0 00 AL.aJe 389 0 0 0 339 0 0 0

1994 AYTAC 4 0 0 5 4 0 0 51993 AdanaCement 15 0 0 8 15 0 0 8

09m AltemeafBank 8.89 0 0 9 889 0 0 91995t96 A".alik 37.5 0 0 115 37.5 0 0 11.5

2000 AroclikltGfKlima 1343 0 0 8.94 1343 0 0 8.941994/97 Assen 5.66 0 4 3.75 566 0 4 3.75

2000 Banvit 20 5 0 0 10 5 0 01994/96/97 Borcelik 0 0 0 0 0 0 0 0

1995196 CBS Buya KiAmy 0 0.65 0 0 0 0.65 0 01994 CBS Holding 4 0 0 0 4 0 0 0

1996t01 CBSPnntas 0 0.01 0 0 0 001 0 01

9 92 CayeliBakir 147 0 0 0 14.7 0 0 0

1994 CereohoguUllei 0.61 0 0 0 0.61 0 0 0

ToteIPortfolio: 481.75 76 21.63 398.74 448.65 7.55 21.13 39227

Approvals Pending Comuiniment

Loan Equity Quai Pantic2000 PinoSea. 4000 0 0 02001 Akbnik 20000 0 0 800002001 Arceikljj 20000 0 0 130002000 BICT 20000 0 5000 01999 CBS Coup Reat 5300 0 0 01999 EgeSeoasoik S1000 5000 0 02000 Erbekir 5000 0 5000 0

TotalPendingCommitmoent: 92300 50O 10000 180000

Annex BlIPage I of 9

TURKEY: Macroeconomic Framework

Introduction

1. The Government has reached agreement with the IMF on a revised macro-economicframework and policy package, including a detailed program of structural reforms worked out incollaboration with the Bank. This agreement cleared the way for completion of the 6'h and 7th

reviews of the Stand-by arrangement on May 15, 2001. Completion of the reviews resulted inthe disbursement of SDR 3 billion (US$3.9 billion) from the Fund. An augmentation of theStandby amount by SDR 6.36 billion was also approved. This brings total IMF commitmentsfor the program since the Stand-by was approved in December 1999 to SDR 15 billion (overUS$19 billion), including the SDR 5.8 billion (US$7.5 billion) Supplemental Reserve Facility(SRF) approved in December 2000. Bank teams have worked closely with the Turkishauthorities and the IMF to assess the macroeconomic impact of the crisis and help prepare thenew program. A specific focus has been the banking sector, for which the Bank prepared anassessment and recommendations on further reform. The Bank is also taking the lead in assistingthe Government with other structural issues including actions to improve the private investmentclimate and public sector management; as well as on social protection issues. Bank support todate has included the US$760 million Economic Reform Loan approved in May 2000 and theUS$778 million Financial Sector Adjustment Loan approved in December 2000.

Recent Economic Developments

2. Original Program. The Government launched its three-year economic reform programunder near crisis conditions in mid-1999. The program aimed to bring inflation to single digitsand set the economy on a stable path of high growth. There were three core pillars: (i) strongfiscal adjustment, including large privatization revenues, designed to put public finances on asustainable path; (ii) a crawling peg exchange rate anchor designed to lower inflationaryexpectations and bring down interest rates; and (iii) deep structural reforms aimed at sustainingfiscal adjustment and promoting productivity and growth. Structural reforms were focussed onmeasures to: (a) support privatization, particularly in the telecommunications and energy sectors;(b) address fundamental fiscal weaknesses, notably through pension reform, modernization ofagriculture support policies, and reform of public expenditure management including measuresto contain the rapid growth of contingent liabilities; and (c) strengthen the financial sector. Theinitial results were encouraging. Domestic interest rates fell more sharply than expected.Annualized rates on government securities auctioned in early 2000 were in the 40 percent range,the lowest level in a decade. Lower rates and increased confidence generated a stock marketboom: the main market index doubled within months. Growth also picked up and was soonrunning above the 2000 target. The pick up in economic activity fueled tax revenues and by midyear the primary surplus was on track to exceed the program target by some I percent of GNP.

3. However, signs of problems soon appeared which pointed to the underlying macro risks.The current account deficit began to widen rapidly. By mid 2000 the current account deficit wason track to reach 6 percent of GNP compared to the 1.8 percent originally programmed. Thegrowing external imbalance was due to a combination of strong internal demand (fueled by thefall in interest rates), high oil prices and the decline in the value of the Euro vs. the USD.

Annex BJJPage 2 of 9

Throughout the year, inflation outpaced the rate of crawl under the peg. Although CPI inflationfell to a 15-year low of 39 percent by the end of 2000, this exceeded the 25 percent target,leading to real exchange rate appreciation of about 14 percent. Export volumes expanded nearly12 percent for the year, but import volumes rose 35 percent, leading to a record trade deficit. TheGovernment did not respond quickly to the widening macro imbalances and clear signs that theeconomy was overheating. Under the quasi-currency board rules, the Central Bank (CBT)refrained from sterilizing the capital inflows which were driving down interest rates below thetargeted path. There was little political support for additional fiscal measures when the primarysurplus was exceeding the program target. Structural reform implementation slowed perceptiblyafter mid year.

4. The Government was particularly slow in resolving problem private banks andrestructuring the state banks. Five private banks were taken over in December 1999, bringing toeight the number of banks under the Savings Deposit Insurance Fund (SDIF), but these bankswere kept open throughout 2000. Little progress was made in restructuring the state banksincluding securitization of the large stock of losses due to government-mandated subsidizedlending in the past (the so called "duty losses"). These delays allowed the losses of the SDIFbanks to accumulate and forced the state banks to finance their duty losses through a mix ofhigh-cost deposits, money market borrowing, and short-term repurchase agreements (repos). Inaddition, private banks turned increasingly to external borrowing given the incentive structurecreated by the crawling peg and the need to meet liquidity requirements by selling FX to theCBT under the quasi-currency board rules. As of September 2000, the hedged open FX positionof the banking system was US$6 billion. The un-hedged open position was much higher atUS$18 billion (over 300 percent of capital) and had increased from US$11 billion in December1999. The SDIF banks accounted for a large share of this exposure as they offered premiumrates on FX deposits in order to fund their continuing operations. While the forward FXcontracts used as hedges appeared to be valid from a prudential supervision standard, theunderlying counter party risk was not known. The structural problems in the banking sector,highlighted in the in the Country Economic Memorandum circulated to the Board in September2000, were to play a central role in the coming financial turmoil.

5. Financial Turmoil in November 2000. Turkey was hit by a first round of financialturmoil in November 2000 brought on by the withdrawal of credit lines to Demir Bank, a keyprimary dealer of government securities. The November crisis demonstrated the vulnerability ofthe Turkish banking sector to exchange and interest rate risks, as well as the mismatch betweenthe maturity of assets and liabilities which had built up as a result of past macroeconomicdistortions and inadequate banking supervision and enforcement. It also highlighted theimportance of growing macroeconomic risks as a relatively isolated incident involving DemirBank quickly escalated to a systemic problem. As confidence fell, foreign portfolio investorswithdrew funds, banking sector liquidity tightened, and short-term interest rates shot up to over1,000 percent. Large liquidity injections from the CBT did not calm the markets and resulted ina loss of about US$6.5 billion in reserves. This situation put the banking sector under severestress particularly the state banks which faced steep increases in the costs of financing theirchronic liquidity needs. Overall, the balance of risk shifted abruptly from overheating andextemal imbalance to recession and financial sector crisis.

Annex BllPage 3 of 9

6. Government Response. The Government responded to the November turmnoil with aneffort to strengthen its reform program through tighter macroeconomic policies and accelerationof structural reform. The objective was to support continuation of the crawling peg. The SDIFtook over Demir Bank, which was no longer able to finance its huge portfolio of governmentsecurities, and the Government issued a blanket guarantee of all liabilities (excluding capital) ofany bank taken over by the SDIF1. Key structural measures included enactment of a legalframework for state bank restructuring and renewed privatization efforts. The Government'sstrengthened program calmed the financial turmoil with renewed support from the IMF and fromWorld Bank under the new CAS discussed by the Board in December 2000. However, thebroader macroeconomic risks remained in place. While longer-term interest rates dropped inJanuary, they remained well above pre-November levels, signaling investor perceptions thatoverall macroeconomic risks had increased. Mirroring this, Turkish depositors shiftedincreasingly to shorter term maturities and repos which increased the liquidity pressure on theSDIF and state banks. Monthly figures for January showed that inflation continued to outpacethe rate of crawl, signaling further exchange rate appreciation in 2001. Leading economicindicators pointed to a sharp slowdown in the economy. Signs of new delays in structural reformimplementation appeared as well.

7. February 2001 Crisis. In late February, Turkey was hit by a second wave of financialturmoil which quickly grew into a full-fledged economic crisis. The fresh turmnoil was ignited bythe public airing of political tensions on February 19. This set off a new wave of turbulence inthe financial sector as investors liquidated TL positions and fled to dollars in expectation of agovernment crisis. By the end of the day, the CBT faced US$7.6 billion in FX purchase ordersand overnight interest rates spiked to over 300 percent due in large part to the inelastic liquidityrequirements of the state banks and now the SDIF banks as well led by Demir Bank. The CBTthen froze liquidity which limited the actual loss of reserves to about USS3 billion. However, byFebruary 21, overnight rates were over 2,000 percent with minimal transaction volumes. Thenext day, the Government announced the flotation of the Lira and the currency depreciated bysome 36 percent by the end of the month. As of end-April, CBT reserves had fallen to US$18billion, compared to US$27 billion in mid-November 2000 before the first crisis began, despiteover US$4 billion in disbursements from the IMF during this period.

Revised Macroframework

8. Key Macroeconomic Targets. The principal macroeconomic objectives of the newprogram are: first, to contain the impact of the collapse of the crawling peg and subsequentdevaluation; and second, to resume a path of progressively lower inflation and increasinglysustainable growth.

* After high inflation following the initial devaluation of the Lira, inflation is targeted to fall tounder 2 percent per month by the last quarter of 2001 giving an average of 52.5 percent (Dec-Dec) for the year;

The objective of this guarantee was to reassure investors and prevent a bank run, but it also highlighted thepotential for large fiscal costs in case of a systemic failure of the banking system. For an analysis of the linksbetween unfunded contingent liabilities and currency crises, see "Understanding the Korean and Thai currencycrises", Bumside, Eichenbaum and Rebelo in Economic Perspectives, Federal Reserve Bank of Chicago, 2000.

Annex B11Page 4 of 9

* Interest rates on government securities, in the 180 percent range in the weeks immediatelyafter the crisis, are targeted to fall to 80 percent by May and to 50 percent by December,resulting in average real rates of some 36 percent for the year;

* The economy is projected to contract sharply during the first semester before recoveringduring the second semester as confidence improves, resulting in a projected fall of 3 percentfor the year;

* Inflation is projected to fall further in 2002-03 and the economy is projected to recoverstrongly (Table A).

Table A Turkey: Selected Program Endicators

5il6101 14:39 1999 2000 2001 2002 2003Prel. Proj. Proj. Proj.

Real SectorGNP growth rate -6.1 6.1 -3.0 5.0 6.0CPI (12-month, end-of period) 68.8 39.0 52.5 20.0 15.0Average nominal T-bill interest rate 106.2 38.0 81.1 40.6 32.6Average real interest rate 1/ 32.0 -6.5 36.4 20.0 18.0

Central Government Budget (percent of GNP)

Budget bahm e m:t -l1i6 -11.5 -,1 S -3.6 -10.5

Consolidated Public Sector (percent ofGNP)Primary balance of public sector -2.0 2.8 5.5 6.5 6.5Net interest payments 22.1 21.9 22.6 16.2 13.5PSBR (incl. CBT profits) 24.2 19.1 17.1 9.7 6.9Operational balance 4/ -12.4 -6.6 -3.2 -2.3 -0.1

ttDsSteble ritft ...............-. 6t1 ... SX* - 58.4 - --. :, - .8- 8.-.- 674*46. 9

Net ''"-4's;-"-' p ', - -cx 4$ -' .2 .' --,' -4;3Neidb~2* 2i. ,3-,428$ 341.

fbrbatk rI ix 16.7 1. -74: 29.9 : :2Z.§- 19.0

Net External Financing of Public Sector (excluding CBT) 1,417 4,134 -291 1,773 -938Amortization (million US$) 5,971 6,199 8,535 6,927 8,438Gross borrowing (million USS) 7,388 10,333 8,244 8.700 7,500

Privatization Proceeds (million US$) 139 3,273 3,109 3,500 3,500

External Sector (billion 1TS$)

A ......- ;..,s ;;----a2 t;- ;3& --. 3.: 391-.TwiuismXc_-: ... .... -:'''5- .. '' '''' 'f ' :' 2 ' ¢'5- " 7.6 - 8--&>w 8.6, 9.1:-Capita .-a--............, c,.,: -su -.-- ".. ~- 4 g',,rvi'-iv *

Change itist r0cves 5.2 -3* -*5.4 :* 3.4

Gross International Reserves (billion US$) 24.3 23.2 21.2 21.8 24.2IMF Net Purchases (billion US$) 0.7 3.3 13.5 -4.5 -1.2Gross external debt (billion US$) 103.0 114.3 117.0 116.7 117.8

in percent of GNP 55.0 56.6 66.3 59.7 56.8Debt service ratio 5/ 34 37 45 38 37

GNP (TL trillion) 78,283 125,971 182,439 245,814 303,626

I/ Average of monthly nominal interest rate divided by 12-month ahead CPI inflation.2/ On a commitment basis, excluding profit transfers from the CBT. interest receipts, and privitization proceeds.3/ Interest payments minus interest receipts plus profit transfers from the central bank.4/ Overall balance netted out of the difference between nominal interest payments and real interest payments.5/ Interest plus medium- and long-term debt repayments as percent of current account receipts (excluding official transfers).Source: IMF.


9. Overnight Clearing Operation. A key action under the new macro framework is toeliminate the structural liquidity needs of the SDIF and state banks and to clear the enormousovernight position of these banks which built up during the November and February turmoil. Asof mid-March, the combined overnight exposure of the state and SDIF banks was about TL 21quadrillion (about 450 percent of base money). The purpose of the overnight clearing operationis to: (i) stabilize the rollover of this short-term debt, (ii) reduce short-term interest rates, ifpossible, by replacing state/SDIF bank credit risk with CBT/Treasury risk, and (iii) ensure thatthe CBT has full control over monetary policy by eliminating the SDIF and state banks as majorplayers in the money market. In practice, the clearing operation is being implemented asfollows. The Treasury is issuing new securities to the SDIF and state banks for theirrecapitalization. The banks are repo'ing these securities with the CBT, thereby reducing theirovernight positions with other creditors and depositors. The Central Bank is mopping up theliquidity created by the clearing operation through its own reverse repo operations in the market.Over time, the CBT is purchasing the securities from the banks as monetary conditions permit,and the banks will use the cash to pay off their remaining overnight loans and deposits. Throughthis operation, the balance sheets of the SDIF and state banks will shrink substantially.

Box 1: Fiscal Measures for 2001

* Increase petroleum consumption tax by 20 percent in April and 15 percent in May; thereafter tax will beincreased at a rate at least equal to WPI inflation;

* Increase standard and luxury VAT rates by one percentage point;

* Increase the minimum base for social security contributions by 40 percent and increase the contribution ceilingfrom 4 to 5 times the minimum base;

* Maintain civil service salaries constant in real terms according to the current indexation system and freeze thenumber of civil servants in 2001;

* Negotiate new contracts with public sector workers which are supportive of disinflation objectives;

* Adjust current expenditure, transfers and investment by less than the inflation rate in order to save 1.5percentage points of GNP;

. Cut "other current expenditure", including defense outlays, covered by article 53 of the budget law to save 0.3percent of GNP;

* Include costs of temporary credit subsidies in 2001 (0.2 percent of GNP) in the budget to avoid duty losses;

* Improve primary position of the state enterprise sector by 1.5 percent of GNP compared to 2000 level based onthe following measures: (i) increase SEEs' tariffs and prices in line with their increased costs; (ii) reduce SEEs'operating expenses in real terms; (iii) cut sugar beet quotas from 12½1/ to II I/2 million tons; (iv) limit the volume ofsupport purchases of cereals and offload additional grain stocks; (v) keep agriculture support price increases in 2001to at most targeted inflation; (vi) maintain the average price of electricity sold by TEAS at US$4.5 cents/kwh; (vii)discontinue LPG subsidies; and (viii) eliminate all discounts and exemptions on SEE products and services. Inaddition, the Government will continue to implement the policy of replacing up to a maximum of 15 percent ofretiring personnel in the SEEs and, Turk Telekom.

* Slow down spending by extra-budgetary funds to save 0.25 percent of GNP relative to 2000;

* Implement measures approved in original 2001 budget as planned.

10. New Monetary Program. Monetary policy faces major challenges under the newprogram in the absence of a visible nominal anchor. The immediate priorities for monetarypolicy are to support the overnight clearing operation and contain the inflationary impact of the


crisis. The subsequent priority is to bring down inflation over the remainder of 2001. In the nearterm, monetary policy signals will be transmitted through control on monetary aggregates basedon ceilings for net domestic assets of the CBT agreed with the IMF. Over the medium term,monetary policy will shift to inflation targeting under the new central bank law grantingindependence to the CBT. The CBT does not intend to intervene systematically in the foreignexchange market to support any particular level of the exchange rate which will be allowed toadjust freely to ensure external competitiveness. The effectiveness of monetary policy will beconstrained by the huge costs of cleaning up the banking including possibility of additionalcontingent liabilities under the blanket guarantee.

11. Revised Fiscal Framework. The biggest problem confronting fiscal policy is to financethe burden of cleaning up the banking sector. To clean up the banks, the Treasury will haveissued by end-2001 an estimated total of TL 54 quadrillion (29.9 percent of GNP) in transferablegovernnent securities. The bulk of these securities were issued by mid-May to bring the capitaladequacy ratio for the state banks to 8 percent and the SDIF banks to zero net worth. This totalincludes some TL 22 quadrillion in losses already on the books of the SDIF and state banks atthe end of 2000 which were included in the stock of public debt but not covered by transferablegovernment securities. The remaining TL 32 quadrillion represents: (i) additional losses arisingfrom the crisis including a reserve contingency against possible future costs of bankrestructuring, (ii) a swap of transferable securities for auction debt held by the SDIF banks, and(iii) capitalization of interest on CPI indexed securities issued to the state banks before theFebruary crisis to partially cover their duty losses. Looking ahead, interest payments on thesecurities issued to cover the banks' losses will add substantially to the Central Government'sborrowing requirement. For the public sector as a whole, the incremental interest burden will besomewhat less as the SDIF and state banks were already financing their pre-crisis losses in theovernight market.

12. Faced with the high cost of bank clean up, the Government has decided to tighten fiscalpolicy further in 2001. A primary surplus for the consolidated public sector of 5.5 percent ofGNP is targeted. This compares to a surplus of 2.8 percent in 2000. Most of the additionalrevenue and expenditure measures which underpin the projected primary surplus have beenintroduced (Box 1). Given the projected level of the interest payments (23 percent of GNP) willremain the same as in 2000, the higher primary surplus implies that the total public sectorborrowing requirement will to actually fall from 20 percent of GNP in 2000 to 17 percent in2001. However, in the absence of exceptional financing this level of borrowing would beinconsistent with the steep fall in interest rates targeted under the program. If interest rates wereto remain at current levels, the sustainability of the public debt would be in question. Key tofunding the borrowing requirement is a US$ 10 billion package of exceptional financing from theIMF and World Bank in 2001. With this package in place, the borrowing requirement will befunded through a combination of privatization proceeds, domestic bond issues and use of CBTreserves. The stock of public debt (net of CBT net foreign assets) is projected to increase sharplyfrom 59 percent of GNP in 2000 to over 79 percent in 2001 reflecting the securities issued tocover the bank clean up, as well as the higher interest rates and temporary contraction in GNP.In order to reverse this debt buildup, the primary surplus is targeted to increase to 6.5 percent ofGNP in 2002-03.

Annex BilPage 7 of9

13. Incomes Policy. Incomes policy will have to be a key nominal anchor under the newmacroframework. For civil servants, the previous policy of ex-ante increases in line withtargeted inflation, together with ex-post adjustments for any inflation above the target willcontinue. This will keep civil service wages constant in real terms. However, a significantpolicy shift on wages of public sector workers is intended. Wages for these workers wereincreased by about 43 percent in real terms in 1999-2000, and are currently some 2.6 times thecivil service wage on average. The two year public sector wage contract agreed among theGovernment and trade unions in May implies a slight decrease in this ratio in 2001 followed by aslight increase in 2002. The Government is also intensifying dialogue with key social partners onwages and prices as part of its incomes policy in an effort to ensure that the private sectorparticipates more actively in the stabilization program.

14. External Balances. The current account is expected to undergo a sharp correction in2001 as a result of the devaluation. The current account deficit of almost US$10 billion (4.8percent of GNP) in 2000 was the largest in the recent past. The current account is projected torecord a small deficit of about US$1 billion in 2001, and then remain close to balance in 2002-03. The key factors behind the strong correction in the current account are the depreciation ofthe Lira, the economic slowdown, and negative wealth effect of the crisis. Export response isexpected to be rapid and strong, in contrast to the Asian crisis, given Turkey's specificcircumstances (free trade agreement combined with good growth prospects in the EU) and thelimited contagion impact of the crisis. A significant improvement in the invisible balances canalso be expected from tourism (Table A).

15. The capital account will be fragile despite the positive picture in the currentaccount. The extent to which banks and enterprises will be able to rollover their externalobligations is an important risk factor. The program scenario conservatively projects an overallexternal deficit of some US$151/2 billion in 2001 (Table A) essentially driven by private capitaloutflows. Despite the Government's diminished access to the international capital market, publicsector inflows are projected to roughly balance outflows largely on the basis of US$2.45 billionin adjustment lending disbursements from World Bank. Therefore, the private capital outflow iscounterbalanced by a broadly equivalent draw down in net CBT reserves (Table B). This is inturn compensated by over US$13 billion in net disbursements from the IMF. While gross CBTreserves would fall by about US$2 billion over 2001 as a whole, this is US$3 billion higher thanpresent levels. The exceptional level of financing from the IFIs in 2001 will help Turkey tostabilize its domestic financial markets by closing the financing gap created by the crisis and tofinance the large projected balance of payments deficit. In some sense, this scenario represents aconservative, worst case outcome. The program includes efforts to encourage private sectorinvolvement (PSI)2 , i.e., "bail in" by private creditors. It is also possible that confidence will berestored more quickly than expected. Were this to occur, the Government would be expected touse the exceptional external financing for reserve accumulation or not to draw on the remainingamounts. The capital account is projected to shift back to surplus in 2002-03 as private capitalinflows return, allowing a build up of reserves and providing the resources to repay the IMF3.

2 Voluntary commitments are being sought from foreign banks to restore and maintain their exposure to Turkishcomrnmercial banks at the December 2000 level.3 The Government retains the option of requesting the IMF to extend the maturity of the SRF resources for anadditional year if private capital flows were to recover more slowly than projected under the external financing plan.

Annex Bl IPage 8 of 9

The extent of Turkey's external vulnerability is highlighted by the large gross financingrequirements of some US$18-21 billion projected over 2002-03 which now represent a greaterproportion of GNP after the devaluation. The external debt stock at the end of 2000 is estimatedas US$114 billion (57 percent of GNP) of which about US$29 billion was short-term. The stockof debt is projected to rise slightly to US$117 billion in 2001, but as a result of the devaluation,this will equal 66 percent of GNP. The debt service ratio is projected to peak at 45 percent ofGNP in 2001 and remain above 35 percent through 2003.

16. Risks. The macroeconomic framework and targets are ambitious given the extent of thecurrent crisis. There is a substantial downside risk that actual real interest rates will be higherthan programmed which would affect the sustainability of the public debt. The actual path ofreal interest rates will depend critically on the effectiveness of macro-economic policies and theGovernment's domestic borrowing requirements. A critical factor in achieving the projectedlevels of nominal and real interest rates is control over inflationary expectations. This will haveto be achieved through a combination of: (i) overall credibility of the program and its politicalleadership; (ii) a well coordinated incomes policy to limit inflationary wage adjustments; (iii)tight monetary policy, (iv) strong fiscal adjustment to contain the public deficit; and (v) the largepackage of exceptional financing from the IFIs to help finance the costs of the bank crisis andlimit public sector borrowing in the domestic bond market. Actual growth will dependsensitively on how tight monetary policy must be in order to control inflationary expectations. Adeeper recession in 2001 is a distinct possibility. The extent of recovery in 2002-03 will play animportant role in the public debt dynamics as will the actual amount of fiscal adjustment.Reaching the 5.5 percent primary surplus target for 2001 will be difficult. Tightening further to6.5 percent of GNP in 2002-03 will require fundamental structural changes in the public sector.

Annex BllPage 9 of 9

Table B: Turkey: External Financing Requirements and Sources, 1998-2003(In millions of U.S. dollars)

1998 1999 2000 2001 2002 2003

Gross financing requirements 9,847 20,235 25,837 18,820 18,547 21,413

Current account deficit (excl. official transfers) -1,825 1,726 9,982 1,338 1,974 1,548Amortization on debt securities, o/w: 3,285 2,020 1,747 2,174 2,513 4,069

Public sector 2,967 1,878 1,397 2,177 2,370 3,881Deposit money banks 318 142 350 -3 143 188

Medium and long-term debt amortization, o/w: 8,171 10,558 13,800 17,273 13,533 13,406Public sector 1/ 2,834 2,943 3,616 5,495 3,762 3,727Private sector 3,040 5,169 7,919 10,000 8,000 8,000Deposit money banks 2,297 2,446 2,265 1,778 1,771 1,679

Acumulation of gross reserves 216 5,931 308 -1,965 527 2,390

Available financing 9,847 20,235 25,837 18,820 18,547 21,413

Foreign direct investment (net) 573 138 112 800 1,570 1,588Portfolio flows -3,426 5,449 2,769 -820 6,650 6,451

Public sector 2,706 5,015 7,507 2,500 4,700 4,501Deposit money banks 0 225 492 0 450 450Private sector (net) -6,132 209 -5,230 -3,320 1,500 1,500

Medium and long-term debt financing, o/w: 12,156 10,903 19,079 11,843 13,650 13,096Public sector 1/ 1,830 878 4,353 4,443 4,800 3,896Private sector 7,200 7,462 12,824 6,700 7,250 7,500Deposit money banks 3,126 2,563 1,902 700 1,600 1,700

Short-term debt (net), o/w: 2,601 759 3,035 -6,772 819 1,194Public sector 14 -125 90 0 50 50Private sector 1,163 558 645 -2,022 795 969Deposit money banks 1,424 326 2,300 -4,750 -26 175

Official transfers 159 362 214 302 311 319Other 2/ -1,985 1,899 -2,677 0 0 0IMF (net) -231 725 3,305 13,467 -4,453 -1,235

Purchases 0 806 3,398 14,588 1,160 0Repurchases -231 -81 -93 -1,121 -5,613 -1,235

1/ General government.2/ Errors and omissions.Source: Central Bank ,IMF and WB estimates.

Annex 112Page I of 4

Banking Sector Reform Program

1. Objective. The objectives of the Banking Sector Reform Program are to upgrade thebanking sector legal and regulatory framework in order to bring it in line with intemational Basleand EU standards; and to enhance the operating efficiency, governance quality, and financialstrength of the Turkish banking sector by carrying out the necessary financial and operationalrestructuring of both the state owned and privately owned banks in the system.

2. Background. Historically the Turkish banking sector has suffered from a weak legal andregulatory framework, and considerable regulatory forbearance, especially in the areas of loanloss provisioning, and connected and insider lending. Indiscriminate and liberal licensing ofbanks without enforcement of proper ownership and governance standards has led to aproliferation of "pocket banks" in Turkey with limited real capacity or commitment todevelopment of a responsible banking culture.

3. In the absence of effective regulatory enforcement, or a clear mechanism for weeding outinsolvent banks and irresponsible bank owners, such pocket banks, backed by a 100% depositinsurance regime, thrived in an environment of large public sector borrowing requirements. Theymade huge risk-free profits acting as funnels for collecting both foreign exchange and TLdeposits, and channeling them into government securities. There was very little incentive forbanks to worry about developing a creditworthiness assessment culture and incorporating riskmanagement best practices, the lack of which left them fully vulnerable against any of thepotential force, interest rate, liquidity or credit risks. The one-two high interest rate and foreignexchange devaluation punches of November 2000, and February 2001, due to the collapse ofmacroeconomic reform programs, have now left a large number of these banks effectivelyinsolvent, creating a systemic banking crisis.

4. The state-owned banks have not proven to be better run. Over the years, the Governmentnot only used the state-owned banks as vehicles for collecting public deposits to financegovernment debt, but also used them to make subsidized loans to the agricultural sector, smallenterprise and housing sectors. The large balance sheet losses of the three state owned banksZiraat, Halk and Emlak, caused by such large amounts of subsidized lending, were hidden in thebalance sheets of these banks under the heading of risk-free government debt (or duty losses) tothese banks. Since these duty losses were not actually paid by the government to the banks, theyhave compounded over the years into gigantic sums (US$25-30 billion) in a very high realinterest rate environment. Before their recapitalization in May, the three state owned banks weredeeply insolvent, and were threatening monetary stability and the viability of sovereigncreditworthiness.

5. The Proposed Reform Program. In the aftermath of the February 2001 crisis, theGovernment is keen on rapidly addressing the structural weaknesses in the banking system. Keymeasures are: closing down the deeply insolvent banks through the resolution entity SDIF,restructuring of the remaining potentially viable private and state banks, and setting properregulatory policies and supervision standards in place. In order to implement these actions, thegovernment has put together a financial sector reform program as its top priority in the neweconomic program. The reform has five main elements:


(i) further acceleration and improvement in the legal, and regulatory framework for thefinancial sector;

(ii) further institutional strengthening of the new Bank Regulation and Supervision Agency(BRSA) and the failed bank resolution entity, the Savings Deposit Insurance Fund(SDIF), in terms of organizational structure, surveillance and monitoring systems,operating manuals, additional staffing and specialized training;

(iii) quick resolution of intervened private banks;

(iv) enhanced supervision of temporarily undercapitalized banks, and prompt intervention andresolution of any permanently impaired banks; and

(v) for the remaining state owned banks strengthening the governance, and carrying outnecessary financial and operational restructuring, followed by privatization.

Some details are given below.

6. Regulatory Agenda. Further amendments to the Banking Law will be made to:accelerate the resolution process and strengthen the bad debts collection authority of SDIFbanks using the Public Collectibles Act provision; strengthen the loan loss provisioning rule andallow for full tax deductibility of specific loan loss provisions; and introduce single large/connected exposure limits in line with EU/Basle standards. In addition, the effectiveness ofmonitoring the foreign exchange exposures will be increased, and the incentives and transactioncosts on repos will be made uniform with deposits to discourage retail repo activity. Furtherlegal and regulatory measures to bring accounting and disclosure standards in line withinternational normns, and to facilitate separate of financial and industrial groups into separateholdings for better risk management purposes, will be introduced.

7. Institutional Strengthening of BRSA and SDIF. The BRSA since its creation onSeptember 1, 2000 has made remarkable progress towards its operationalization. However, theNovember 2000 and February 2001 banking sector crises, especially taking into account that theSDIF--the entity responsible for bank failure resolution--is currently part of the BRSA, havediverted attention and energy away from its own still unfinished institutional developmentagenda. In order to concentrate on that agenda, the BRSA will develop and implement a time-bound strategic plan to (i) strengthen its human resource development capacity; (ii) integrate theexisting multiple databases into a common database and a common platform for analyzing andassessing banking risks; (iii) upgrade/develop procedures manuals for all major existing BRSAunits; and (iv) introduce the concept of relationship supervision with offsite examiners,enforcement staff and Sworn Bank Auditors working in teams on individual banks. Similarly, thelegal, governance and financing arrangements for the SDIF will be reviewed to enhance itsautonomy and financial independence. In the latter part of the reform program, the depositinsurance scheme guaranteed by SDIF will need to be reviewed and brought in line withapplicable EU Directives, including the use of risk-based premiums.


8. Accelerated Resolution of Failed SDIF Banks. The resolution program for theinsolvent private banks taken over by the SDIF will be accelerated in accordance with a time-bound action plan. Non-performing loans will be transferred to the Collection Department of theSDIF. All insolvent banks which cannot be sold will be liquidated or otherwise resolved. Out ofthe original 13 SDIF banks (already merged into nine banks as of April 2001), there will remainat a maximum. five - Sumer, Turk Ticaret, Demir, Ekspres, and Iktisat - at the end of May2001. The Government is recapitalizing all SDIF banks to bring their net worth to zero. Thesebanks will be closed, sold or merged with other banks by the end of 2001.

9. Other Private Banks. Stress tests carried out by the Bank Mission on the remaining 27deposit taking private bank show that most of them are capital deficient. Most of the banks aretrying to recapitalize from their group resources and some have done so. The rest are beingclosely monitored by BRSA under enhanced supervision, and will be intervened by BRSA assoon as any of them are illiquid and unable to pay their obligations.

10. State Banks Reform including Retirement of Overnight Liabilities of State andSDIF Banks. In order to reduce the speculative interest rate stress in the state banks because ofovernight repos, the gradual retirement of these overnight transaction will be given the firstpriority. As a first step, all overnight repos of state and SDIF banks with the secondary marketare being taken over by the Central Bank of Turkey as the counterparty. Then, during the secondstage, these repos will be gradually retired by the CBT. The plan is to leave not more than astock of TL 7.0 quadrillion (approximately US$6.1 billion) as overnight repos of the state andSDIF banks with the CBT thereby retiring nearly US$14.0 billion of overnight repos by end-May. Some of these are likely to come back as desirable longer term, lower cost liabilities. TheTreasury has issued all necessary transferable securities to eliminate the overnight exposure ofthe state banks and recapitalize them to an 8 percent capital adequacy ratio. This financialrestructuring will result in a reduction in the balance sheets of the banks. Additional structuralmeasures are being introduced to ensure the future viability of the state banks and prepare themfor privatization. Specifically: (i) a joint board of directors, consisting of professional bankers,has been appointed for the two largest public banks (Ziraat and Halk) banks; (ii) politicalintervention will be eliminated and independent auditors will be appointed; (iii) Ziraat and Halkwill be restructured by the joint board in preparation for privatization; (iv) Emlak Bank's licensewill be revoked by end-June and some of its assets and liabilities will be merged with ZiraatBank; and (v) state banks will not be assigned any tasks which lead to duty losses. The statebanks will function from now on based on market rules and profitability. All excess brancheswill be closed and staffing will be reduced.

11. As part of permanent structural and governance change in the state owned banks, theywill be gradually privatized beginning with the Vakif Bank. In order to facilitate the privatizationof Vakif Bank, the Vakif privatization law will be amended by end-June 2001, to allow for thesale of both B--20% and A 55% shares in any combination as necessary. The Halk bank will beprivatized or merged in 2002, and Ziraat's privatization will be undertaken in 2003. It isanticipated that by the end of the reform program, all the state owned banks will be privatized.

12. NBFI Development Issues. It is also expected that as the Govermnent's renewedmacroeconomic stabilization and structural reform efforts across all sectors of the economy takes


hold, there will be a need to encourage and lay the foundations for significant development ofnon-bank financial institutions (NBFIs) and capital market activity in Turkey in coming years.These activities have remained artificially repressed during many years of high inflation. In orderto facilitate the growth and expansion of NBFIs and capital markets activity, it will be necessaryto satisfactorily manage the inherent risks, particularly in a situation where the banking systemmay still be fragile and not yet robustly capitalized. Therefore, in the later stages of theGovernment's multi-year financial sector reform program, additional focus will be required onputting in place a stronger legal and regulatory regime for NBFIs and capital markets, as well asmake appropriate adjustments to the regulatory and supervisory infrastructure for the banks, whoare likely to be key players in these new activities.

13. Expected Benefits. The principal benefits of the banking reform program will be to:

(i) restore confidence in the banking sector following the November 2000 and February2001 financial crises;

(ii) strengthen the foundation for an efficient, sound and healthy banking system which canbe competitive in quality and performance at the international level;

(iii) reduce the vulnerability of the banking system and enhance its capacity to withstandexternal shocks and thereby reduce systemic failure risk; and

(iv) position Turkey's banking sector for EU accession by starting the process of aligning theprudential regime for the banking system with applicable EU banking sector directives.

Annex B13Page I of I

TheLgstvoAu4fo00

Le2islation Status Timetable for Enactment

Macro2001 Budget law amendments enacted AprilCentral Bank law enacted May

BankingBanking law amendments adopted by Parliament MayState Bank Duty Loss law and decree decree published, law is under preparation May

Investment EnvironmentElectricity Market law enacted FebruarySugar law enacted AprilCivil Aviation law enacted AprilNatural Gas law enacted MayTelecommnunications law amendments enacted MayTobacco law under preparation JuneImplementing law for International Arbitration under preparation July/August

Public Sector ManagementExpropriation law adopted by Parliament MayPublic Debt Management law under preparation Submission to Parliament in June

Budgetary/Extra-budgetary Funds Closure law under preparation JunePublic Procurement law under preparation Submission to Parliament by October 15

Law to Streamline Prosecution Procedures under preparation Submission to Parliament by July/August

Social SectorPrivate Pension law enacted MayEconomic and Social Council law enacted AprilJob Security law under preparation To be determined

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