Turkey - Pulp and Paper Rehabilitation Project

The Wodd Bank FOR OMCIAL USE ONLY Newllo N. P-3936-TU REPORT AND EEN OF THE PRESIDEINT OF THE INTERNATIONAL BANK FOR RECONSCTION AID DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOuNT EQUIVALENT TO US$55.1 MILLION TO THE REPUBLIC OF TURKEY FOR A PULP AND PAPER REHBILITATION PROJECT April 18, 1985 II I op1_ ba tal re_ q d _I&O =d maF _be by rpiff nyInte pewfo_c of dwk ofii ei f wmtm W rdwmb badw w Bm __ ,i=om  TURE CURREICY EQUIVALENTS Currency Unit Jan. 1980 1/ Jan. 1981 Jan. 1982 Jan. 1983 Jan. 1984 mar. 1985 US Dollar - TL 70.CO TL 91.00 TL 139.60 TL 191.15 TL 309.20 TL 490.40 IL 1 - USA$ 0.014 US$ 0.011 US$ 0.007 US$ 0.005 US$ 0.003 US$ 0.002 1/ Since January 1980, the rate is being adjusted for the differential inflation between Turkey and its major trading partners. TL 3251$1 (the exchange rate at the time of appraisal) was used for Parts III an'i 1V of this Report. FISCAL YEAR Republic of Turkey January 1 to December 31 LIST OF ABBREVIATIONS DYB Devlet Yatirim Bankasi (State Investment Bank) MIT Ministry of Industry and Trade PPF Project Preparation Facility SAL Structural Adjustment Loan SEE State Economic Enterprise SEKA Turkiye Seluloz ve Kagit Fabrikalari (Turkish Pulp and Paper Enterprise) SPO State Planning Organization TPy Tons Per Year  Fait OFFICIAL Usrl ONLY -i-s PULP AJD PAPER REEfILETh2IOE PRECT Loan and Project Suimary Borrower: Republic of Turkey Beneficiary; Turkiye Seluloz ve Kagit Fabrikalari (SEKA) (Turkish Pulp and Paper Enterprise) Awountz US$55.1 milliLon Terms; Seventeen years including four years of grace, at the standard variable interest rate. Relending Termz: The Borrower would onlend to SEKA, under a Subsidiary Financing Agreement, $54.8 million for a period of 15 Years including four years of grace, at an interest rate equal to the Bank's standard variable rate plus a nark-up of one percentage point. SEKA would bear the foreign exchange risk. Proiect The proposed project supports the Government's development Description: objectives to improve the efficiency of State Economic Enterprises (SEEs), rehabilitate existing capacity in manufacturing enterprises and explore the potential for selective privatization of SEEs. The project would provide for rehabilitation of the Aksu, Dalaman and Afyon mills, as well as imported spare parts and energy saving improveMents for all of SEKA's mills. It would furthermore strengthen SEKA's management structure and improve operation and maintenance nrocedures through the provision of technical assistance to SEKA. A review of the pulp and paper -subsector including a study of priVatization possibilities for sELA would also be undertaken. Benefits The proposed project would reduce imports of newsprint and and Risks; short-fiber bleach pulp and increase the potential for exporting selected grades. When fully operational, the project would generate net foreign exchange savings of about *29 million p.r year and reduce energy consumption. Unquantified benefits to be derived from the technical assistance component include improved sectoral policies and identification of strategies for the future development of the pulp and paper subsector encompassing both the public and private sectors; it would also strengthen SEKA's corporate structure and improve its operational procedures. Tbia doc_me bhaa esue distbuio and may be wnd by rmcpts only io t perfonnnce 1 or thl offici duuits cotnt5 may not otherwe be dickos withou WOW Bank lmOm  -ii- The estimated finacial rate of return an investmt is the Aksu, Dalmm and Afyon mills is higher than could be expected for investmnts in new pulp and paper projects. Fhe main risk is that the recimmeded iiets is SEA's unagenet and operational procedures may not be fully realized. To increase the chances for an effective technical and management assistance program and to avoid delays iu its implementation, technical assistance for SEKA would be carried out under the guidance of a committee comprised of representatives from SEKA and consultants. A second risk relates to the possibility of paper prices being lower and input prices being higher than those projected. SEEMs freedom under the law to set prices for its products in line with market forces and the arraugeaents proposed for wood supply should significantly reduce this risk. $ million Estimated Proiect Costs: Local Foreign Total Plant Rehabilitation Aksu 10.8 16.5 27.3 Dalagnman 2.0 4.7 6.7 Afyon 1.0 2.9 3.9 Sub-total 13.8 24.1 37.9 Spare Parts 1.0 4.0 5.0 Energy Saving Improvements 3.0 2.5 5.5 Technical Assistance to SEKA 1.0 2.0 3.0 Technical Assistance to the Government 0.1 0.3 0.4 Working Capital 3.4 1.5 4.9 Refinancing of the PPF - u.6 0.6 Base Cost Estimate 22.3 35.0 57.3 Physical CorAngencies 2.6 4.6 7.2 Price Contingencies 6.6 11.3 17.9 Total Project Cost 31.5 50.9 82.4 Interest During Construction 0.2 4.2 4.4 Total Financing Required 31.7 55.1 86.8 8= M==  $ -lilliom Finanucig PLan: Local Foreign Total IBD - 55.1 55.1 GoerDment Equity 31.6 - 31.6 Contribution for Study 0.1 - 0.1 Total 31.7 55.1 86.8 Estitated Disbursements: $ Million IBID Fiscal Year 1986 1987 1988 1989 1990 Annual 2.2 24.7 21.3 6.4 0.5 cumulative 2.2 26.9 48.2 54.6 55.1 Economic Rate of Return: 41 percent (for rehabilitation of the Aksu, Daluan and Afyon mills). Staff Appraisal Report: No. 5357-TU, dated April 5, 1985. Ma: No. 18435.  INTERNTIOL BANK FOR RCOMSTRUCTION AND DEVELOPHENT REPORT AND REC ION OF THE PRESID OF TIE IBRD TO THE mCUWIV DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TURKEY FOR A PULP AND PAPER BILI IO PROJECT 1. I submit the following report and reciedation a proposed loan to the Republic of Turkey for the equivalent of US$55.1 million to help finance a Pulp and Paper Rehaubilitation Project. The loan would have a tern of 17 years including 4 years of grace, with interest at the standard variable rate. The Goverment would retain t0.3 million and would onlend to SEKA, under a Subsidiary Financing Agreement, the balance of $54.8 million for a period of 15 years including 4 years of grace, at an interest rate equal to the Bank's standard variable rate plus a mark-up of one percentage point. PART I - THE ECONOIY 1/ 2. An economic mission visited Turkey in June 1982, and its report entiZled "Turkey: Country Economic Memorandum, Recent Economic Developments and Medium-Term Prospects" (No. 4287-TU) was distributed to the Executive Directors in June 1983. The report of a mission to review the financial sector, entitled: "Turkey: Special Economic Report - Policies for the Financial Sect-r" (No. 4459-TU), was distributed in September 1983. A Bank mission reviei'ed the Government's Fifth Five-Year Plan (1985-89) in August/September 1984 and its findings are reflected in this section. 3. Turkey is about as large as France and Germany combined, with a population of around 48 million and an estimated GNP per capita of $L230 in 1983. The density of population is low (78 per square kilometer of agricultural land), and about 47 percent live in urban centers. Population growth (2.2 percent per annum) is below the median for middle-income cuuntries. Despite rapid economic growth in the mid-1970s as vell as substantial emigration of workers (to Western Europe and more recently, to the Middle East), the employment situation has deteriorated steadily with an unemployment rate currently estimated at about 19 percent. There is, however, little or no absolute poverty, although income distribution is skewed. There are considerable regional differences in income and large rural-urban disparities. Recent data indicate a probable worsening in income distribution, especially of wage and salary earners, and a sharp real decline in average earnings. Educational enrollments have expanded greatly, but the level of adult literacy remains relatively low. Background 4. During the 1970s Turkey did not make the necessary adjustuents to the shocks caused by the steep rise in oil prices, stagflation in the OECD economies, and the consequent deterioration of its terms of external trade. 1/ Parts I and II are substantially the same as Parts I and II of the President's Report on the Industrial Schools Project (P-3956-TU), dated April 18, 1985.  Until 1977 Turkey maintained high rates of economic growth by raising the share of public investment in GDP. This was financed initially by workers' remittances and, following the quadrupling of oil prices, increasingly by short-term borrowings. The rapid GNP growth came to an abrupt halt in 1977 as the massive external debt burden led to a sharp deterioration in creditworthiness severe shortages of imports, and disruptions in industrial production with a rise in unemployment. By the end of 1979, domestic inflation had also become an issue of critical importance. 5. The Turkish authorities' response to the crisis of the late 1970s was a major shift in development strategy in 1980, moving towards outward orientation and giving an increas_d role to market forces. Policies were adopted to expand exports and increase workers' remittances which, together with liberalization of imports, encouragement of foreign investment and prudent external debt management, were aimed at alleviating the balance of payments constraint and import shortages. On the domestic front, the objectives were a reduction in the inflation rate, reform of the State Economic Enterprises (SEEs), a more efficient financial sector, improved resource mobilization and better selection of investments, especially in the public sector. 6. The adjustment program, which has been supported by the Bank through five structural adjustment loans, involves far-reaching changes in attitudes, institutions, and the legal and policy framework, all of which require time to put in place. Major structural changes have been made in the exchange rate system, the export and import regimes, the tax system, interest rate and selective credit policies and the public investment program. Implementation of the adjustment program was carried out under a military regime during September 1980 - November 1983 and since then by an elected government. The Structural Adjustment Program - 1980-84 7. The Turkish economy has show-n an impressive response to the structural adjustment program and actual performance met or exceeded the Government's own targets through 1982. By contrast, results in 1983 and 1984 proved to be mixed, due in part to adverse economic developments on the external front, slippages in the monetary program, a persistent shortfall in Government revenues and the renewal of inflationary pressures. 8. Real GNP expanded by 4.1 percent in 1981 and 4.6 percent in 1982. In 1983, GNP growth slowed down to 3.Z percent, due in large part to the effects of a bad harvest and a decline in the contribution of the foreign balance. The growth rate rebounded in 1984 to an estimated 5.7 percent, supported by favorable performance in the productive sectors with agricultural value added growing at 3.6 percent and industrial value added at 9.6 per.ent. Capacity utilization rates in private industry in 1984 are estimated to have risen by about 5 percent to an average rate of 72 percent. On the expenditure side, the average annual real rate of growth of Dublic fixed investment has been contained to 3.1 percent over the 1980-84 period while the growth rate of private investment has improved systematically from -17.3 percent in 1980 to 4.8 percent in 1983 and an estimated 5.4 percent in 1984. Private consumption, which had actually fallen by 5 percent in 1980, grew at 4.9 percent in 1983 and an estimated 5.0 percent in 1984. On the other hand, helped by strict budgetary discipline, the rate of growth of public consumption declined from 8.4 percent in 1980 to 1.8 percent in 1983. Estimates for 1984 suggest a modest growth of 2.4 percent.  - 3 - 9. Through 1982, the Government met with considerable success in reducing the rate of inflation through a combination of fiscal, monetary and incoMes policies. After peaking at 107 percent in 1980, the annual average rate of increase in the wholesale price index declined to 37 percent in 1981 and 27 percent in 1982. In 1983 the downward trend was reversed and the inflation rate rose to 30 percent. This rise was fueled by an expansion of Central Bank credits to firms and commercial banks in difficulty during the second half of 1983 as well as an unexpected increase in the budget deficit. The resulting liquidity expaDsion, in conjunction vith a lowering of nominal deposit interest rates, encouraged consumption at the expense of savings. 10. Inflation accelerated further in the first half of 1984, although it moderated in the second half. The average inflation for 1984 is estinated at a little over 50 percent. The major factors that contributed to the worsening of the inflationary situation were the lagged impact of the expansionary monetary policy pursued during the second half of 1983, and a significant increase in agriculture product prices, especially of fresh fruits and vegetables, as a consequence of export liberalization and higher export market prices. Other important inflationary factors included substantial "catch up" increases of SEE prices and higher import prices resulting from the noninal depreciation of the Turkish lira. In addition, inflationary pressures etemmed from a larger than anticipated budget deficit in 1984 as a result of a slowdown in the growth of revenues. Given the tight monetary and fiscal programs likely to be agreed upon with the IMF as part of a new standby agreement (para. 25), the expectations are that inflation will decline this year. 11. Commercial bank interest rates, which were deregulated in July 1980, have increased substantially and are now positive in real terms. As a result, total bank deposits increased by 72 percent in 1980 over 1979, and in 1981 this trend accelerated, with total deposits growing by 103 percent and time deposits by 274 percent. Growth in total deposits slowed after 1982, and in 1983 and 1984 they grew at 53 percent and 42 percent respectively. The bankruptcy in late June 1982 of a major non-bank financial institution shook depositor confidence and was followed by a shift of funds into the larger banks. The Government averted an immediate crisis in the banking sector and undertook actions to reform and strengthen the financial sector as a whole. A new banking law was enacted in June 1983 which covered many of the recommendations made in the Bank's report on the Financial Sector (No. 4459-TU). These in-luded measures to reduce the undercapitalization of banks, place limits on the real assets and investments of banks, link the establishment of branches to the level of a bank's equity, reduce the interlocking between banks and corporations, introduce a deposit insurance scheme, and increase the role of the Central Bank in the supervision of the banking sector. A new law is currently before Parliament which will further the banking reform process by introducing standardized accounting for banks and improved procedures for handling non-performing loans. The Government also took a major step towards reducing the cost of intermediation by reducing the financial transactions tax from 15 percent to 3 percent. Separately, the Government has reduced the level of withholding tax applicable to interest payments on deposits and bonds from 20 percent to 10 percent. Other important developments in the financial sector include measures undertaken to revitalize the capital markets, for which IFC has provided technical assistance, and the sale of revenue-sharing certificates linked to the income from selected public facilities (e.g. the Bosphorus bridge).  12. The Government is comnitted to maintaining an interest rate structure for deposits which is positive in real terms. Time deposits have been yielding more or less positive real returns since end-1983, with interest rates ranging from 45 to 53 percent depending upon the term of the deposit. While positive real interest rates have provided an incentive to save, they have also meant high borrowing costs. Nominal interest rates range from 60 to 80 percent on non-preferential credits, in part because of the high intermediation costs of the commercial banks and their widely prevalent practice of requiring compensating balances. The interest rate differentials between preferential and non-preferential credits and among preferential credits are large and need to be reduced. The Government has reaffirmed its determination to achieve positive real rates on all lending by a combination of bringing down inflation and phasing out interest rate subsidies on preferential credits. In January 1985, it eliminated preferential interest rates on short-term export credits. High market interest rates, together with the limited availability of credit, have led to considerable liquidity problem for the private business sector, particularly for businesses supplying the domestic market. Measures are also needed to lower the operating costs of banks, which are well above prevailing levels in comparable countries. 13. In the fiscal area, progress was evident from 1980 to 1982 but there have been slippages in 1983 and 1984. The budget deficit to GNP ratio was reduced from 5.3 percent in 1980 to 2.1 percent in 1982, and the Public Sector Borrowing Requirement (PSBR) dropped sharply from 12.6 percent of GNP to 6.9 percent over the same period. However, the revenue to GNP ratio has been declining over the past three years. From a high of 20.3 percent in 1981, it has fallen sharply to an estimated 15.6 percent in 1984. Largely because of this significant shortfall in revenues, overall fiscal performance has worsened since 1983 even though government expenditures have been considerably curtailed (from 24.2 percent of GNP in 1980 to an estimated 20.8 percent in 1984) and budgetary transfers to SEEs as a percentage of GNP have fallen steadily (from 4.8 percent in 1980 to an estimated 1.6 percent in 1984). The budget deficit is estimated at 5.2 percent of GNP in 1984 and the PSBR at 8.8 percent. The downward trend in the Government revenue to GNP ratio highlights the urgency of mobilizing additional public resources. As a step in this direction, the Government introduced a Value Added Tax (VAT) in January 1985. 14. Improvements in the balance of payments were systematic through 1982 with the current account deficit decreasing from $3.3 billion (5.7 percent of GNP) in 1980 to $1.2 billion (2.2 percent of GNP) in 1982. However, in 1983 the current account deficit widened to about $2.1 billion (4.2 percent of GNP) as merchandise exports and workers' remittances fell short of targets. Exports rebounded strongly-in 1984, growing by 25 percent in dollar terms to $7.1 billion. Remittances, too, registered a higher than expected increase, reaching $1.9 billion (up by 24 percent). Concurrently, there was a continued large inflow of deposits through the Dresdner scheme ($550 million in 1984). Under this scheme the Dresdner Bank collects deposits from Turkish workers in Germany and automatically places these funds at the disposition of the Central Bank of Turkey, which guarantees the deposits and pays an interest rate commensurate with the Euro-market rate. However, these increases were offset by a sharp rise in merchandise imports to $10.8 billion (up by 16 percent in dollar terms). As a result, the current account deficit in 1984 was considerably higher than projected, reaching $2.1 billion (4.3 percent of GNP), or about the same level as in 1983.  15. On balance, merchandise export performance has been impressive over the 1980-84 period, growing at an average annual rate of about 26 percent in dollar terms. This growth has been led by the manufacturing sector and has involved a rise in the share of exports to the Middle Eastern countries. Industrial exports, comprised primarily of processed foods and textiles, have risen from 36 percent of total exports in 1980 to 72 percent in 1984. These results were achieved by a combination of indirect (flexible exchange rate policy and import liberalization) and direct (tax rebate., preferential credits) measures to enhance the relative profitability of exports and offset the traditional bias towards producing for the domestic market. The flexible exchange rate policy was one of the most important factors contributing to the growth of exports, together with the penetration of Turkish products in Middle East markets. 16. On the import side, the 1982-83 period was marked by a relative stability in the growth of merchandise imports, mostly due to exogenous factors. Imports fell by 1.0 percent in dollar terms in 1982 and rose by only 4.4 percent in 1983. This reflected price decrease3 in both oil and non-oil imports. Merchandise imports, however, increased substantially in value in 1984. The increase has been most significant in some of the groups (e.g. raw materials and consumer goods) that have been subjected to major liberalization in terms of both a lowering of tariff rates and a significant removal of quantitative restrictions. Mediumr-Term Prospects 17. The Governument's Fifth Five Year Plan (1985-89) was approved by the Grand National Assembly in July 1984. The Plan reaffirms the Government's determination to pursue an outward-oriented development strategy and to liberalize the economy by relying increasingly on market forces for allocation decisions. The public sector is targeted to play a supportive role by concentrating its investments in infrastructuxe rather than manufacturing, while the private sector is to be encouraged to play a leading role in the growth of manufacturing and exports. Some of the key targets are: {i) an average annual GNP growth rate of 6.3 percent; (ii) an average annual real rate of growth of merchandise exports of 10.6 percent; (iii) an average annual real rate of growth of merchandise imports of 8.2 percent; (iv) an average annual real rate of growth of 10.9 percent in private investment and 6.8 percent in public investment; and (v) a declining external debt service ratio, from 26 percent in 1984 to around 18 percent in 1989.  -6- 18. While the overall thrust of the Plan is in accord with the goals of the structural adjustment program, certain targets seem optimistic in view of both past performance and the iuzediate prospects for the economy. The Bank's projections indicate the need for a continuation of the stabilization program well into 1987, implying a lower growth rate in GDP for the early years of the Plan and a return to a higher growth path only in 1988. Key economic variables in the Bank's latest projections for the period 1985-89 are presented in Table 1: Table 1; TUREY - SELECTED ECONOMIC INDICaTORS, 1983-89 1953 195 1955 1989 1 Cr Nat.e AReralG Anual Units Actual got. Projected 102 1953 18 19859 (2) (2) CDP /b 1983 M. b 11468 12122 12700 15899 5.0 3.7 5.7 5.6 Agriculture 2058 2132 2202 2481 6.4 -0.3 3.6 3.0 liduetry 3096 3393 358 4732 5.0 7.6 9.6 7.0 Services 5631 5929 0179 7771 4.1 4.0 5.3 547 Conuiaptimn - 584 100"4 10539 12500 3.9 4.5 4.8 5.1 Fixd inveumnt n2181 2220 240e 3180 3.5 3.0 1.8 7.5 Exports of moods Current * a 5728 7100 8541 17574 24.0 13.9 23.1 9.4 lIporct of goods 9235 1O7Sb 115io 21307 -0.1 12.0 15.8 7.2 Trade balanee -3507 -3656 -2959 -3733 Current account balemca Current $ I -2122 -2135 -1750 -2003 Ratios Invetment/Cup 2 19.0 18.3 15.9 20.0 SavingslGOP 2 16.5 17.1 17.4 19.5 Exports of gooda/GDP 2 11.3 14.6 13.9 15.9 Current account deficit/GD? /b 2 4.2 -4.3 -2.8 -1.8 Debt svice ratio /c 2 28.0 25.0 23.7 19.8 Public fizad invemtmt/ 2 60W3 58.9 57.6 52.6 Total fimed invstment .3 itet Grose capital required Id Current S u 3657 4290 354 5905 /a At market prices; components are expressed at factor cost and will not add up due to exclusion of indirect taxes and subsidies. /b Based on constant TL. /c Total Debt Service (excluding short-term) /Exports of Goods and NFS plus Workers' Remittances. _d Includes net IMF. Source: State Planning Organization for actuals and IBRD projections.  - 7 - 19. Bank projections indicate a GDP growth of 5.6 percent per annum on average for the Plan period, with a low of 4.9 percent in the initial year of the Plan (stabilization period) and a high of 6.3 percent for the final year (growth period). Achievement of these growth rates will depend on the performance of the productive sectors, namely agriculture and manufacturing. This in turn will depend to a large extent on the Government's determination to constrain the growth of the public sector in line with public resources and to create a more favorable investment climate for the private sector. This translates itself into a projected real growth per annum in public fixed investment of about 5.0 percent on average for the Plan period, starting with a modest increase in the early years. The comnarable figure for private fixed investment is 10.6 percent or a ;ittle more than twice the growth rate for public fixed investment. These figures are consistent with the need to meet the infrastructure requirements of the economy through the public investment program, while providing for the capacity expansion of the private sector necessary to meet the export and growth targets. 20. Merchandise exports are projected to grow at an average 9.4 percent per annum in real terms. Merchandise imports, on the other hand, are projected to grow more slowly in real terms through 1986 and then pick up to an average 7.5 percent per annum in the terminal years of the Plan. On these assumptions, the current account deficit is projected to decrease through 1986 as stabilization policies act to contain import growth while encouraging exports. As higher growth rates set in during the middle of the Plan period, the trend would reverse and the current account deficit would rise moderately through the end of the Plan. The terminal year 1989 would show a deficit of approximately $2.0 billion as compared to a 1985 figure of $1.7 billion. The projected capital account is seen to remain manageable throughout the period even in the face of some sharp increases in the amortization payments in 1985-87 arising fron. the debts rescheduled during the 1978-80 period and an imposed constraint on foreign exchange reserves equivalent to at least two monchs' imports. Consistent with the above is an average debt service ratio for medium and long-term credits for the Plan period of 21.7 percent. Including short-term debt the average debt service ratio for the Plan period is 23.7 percent. Gross capital inflows required in 1989, on these assumptions, would be about $5.9 billion, or about 38 percent higher than the amount in 1984. Such an inflow is consistent with a decreasing debt service ratio from 1986 onwards. 21. The medium-term scenario presented above is, of course, only one of many possibilities and is used specifically to illustrate Turkey's potential in the light of the Government's own development strategy. Given Turkey's progress in the structural adjustment program, rae favorable response which this has evoked from the international financial coummunity and the present view of future resources and export market possibilities, the Government's somewhat more ambitious Plan targets would be feasible provided they are supported by slightly higher export growth rates and greater success in the mobilization of public resources. This may be more difficult to achieve in the early (stabilization) pt-Ie of the Plan. 22. In view of the sensitivity of the projections to the assumptions of export and import growth ra -, a downside risk case has also been developed. With Turkey's export performance heavily dependent on exogenous factors such  as the world economic outlook and moveaents in international prices, a slover growth of merchandise exports (an average of 6.9 percent over the Plan period) would lead to a more difficult but still manageable balance of payments situation, more external borrowing, a lover GDP growth (averaging about 4_8 percent per annum) and a higher debt service ratio (22-24 percent per annum). In such a situation the Government would have little chance of absorbing the umemployed and improving tangibly the average standard of living. However, given the Government's emphasis on export promotion and the determined efforts to counter the bias towards producing for the domestic market, there is good reason to support the perspective set out in the mediumrterm scenario presented in paragraphs 18 to 21. External Debt and Creditworthiness 23. At the end of 1978, Turkey had $7.2 billion in short-term debt and $7-0 billion in medium and long-term debt. Between 1978 and 1980, Turkey rescheduled some $9.2 willion of outstanding obligations through a series of rescheduling arrangements concluded with official and commercial creditors. Approxaimately $6.0 billion of short-term debt, including $2.6 billion in cowertible Turkish lira deposits and bankers' credits and $1.2 billion of non-guaranteed suppliers' credits, were consolidated into medium-tern loans or partially converted into Turkish lira obligations. Following the resolution of the debt crisis, inflows were mostly from official sources - major creditors being the OECD countries, the World Bank and the IMF. Of the estimated total debt outstanding of $22.7 billion at end-1984, 81 percenr constituted medium and long-term debt (including IF). Short-term debt as a percentage of total debt outstanding fell from 51 percent in 1978 to about 11 percent in 1982, then increased to 14 percent in 1983 and to an estimated 18 percent in 1984. Much of this growth in the stock of short-term debt is due to the inflows associated with the Dresdner Bank scheme (para. 14). At end-1984 the outstanding liabilities associated with the Dresdner scheme are estimated to amount to $1.8 billion, which would represent about 45 percent of Turkey's short-term external obligations and 8 percent of its total outstanding debt. Based on the growth scenario outlined earlie., debt outstanding and disbursed as a percentage of GDP is projected to fall from an estimated 41 percent in 1984 to 32 percent in 1989. This translates into a total debt outstandiug forecast for 1989 of $30.6 billion, with short-term debt constituting about 23 percent of that total. Dresdner scheme inflows are projected to be around $600 milliou per annmu throughout this period and to account for a large part of the rise in the ratio of short-term debt to total debt outstanding. 24. The debt service ratio for medium and long-term credits (in relation to exports of goods and non-factor services and workers' remittances) increased from about 14.6 percent in 1981 to a peak of 28 percent in 1983 as a result of a large repayment of previously rescheduled debt under the earlier OECD agreements. Debt service obligations are likely to be high over the coming years and would average about $3.8 billion per year in 1985-89. However, the debt service ratio is seen to decrease from an estimated 25 percent in 1984 to 19.8 percent in 1989. The debt burden should remain manageable provided current policies are successfully implemented, the export drive is sustained, and Turkey continues to receive further support from international commercial and official sources. There have been encouraging  -9- signs of Turkey's ability to enter the market for comerial borrowings. From December 1983 to November 1984, Turkey had secured a little over $500 million from coaercial credits, contituting about 23 percent of the total external credits received during this period. The Central Bank of Turkey recently completed the syndication of a $500 million uulti-component medium-term (seven years) facility iuvolving a large number of U.S., European, Japanese and Middle Eastern commercial banks as lead managers. 25. Turkey's economic program has been supported by the IF through a series of standby arraugmients. A three-year standby arranmet in an amount equivalent to SDR 1250 million ma approved by the IMF's Board and became effective on June 18, 1980. The Government purchased the full amount authorized under the arra ent. The Government also purchased three-quarters of a SDL 225 million one-year standby arrangement Which was approved by the WT in April 1984 and replaced an earlier one-year arrangement terminated at the request of the Government. Discussions are presently under way on a further one-year st.ndby arrangevent. PART II - BANK GROUP OPERATIONS IN TUnEY 26. Through March 31, 1985 the Bank and IDA have lent $5383.5 million 1/ to Turkey, through 81 projects. Agriculture accounts for 19 percent of funds lent, industry and DFCs for 24 percent, pover for 13 percent, structural adjustment and program loans for 32 percent, and urban development, transportation, education, touri-m and technical assistance for the remaining 12 percent. Disbursements f. all sectors combined (excluding structural adjustment loans) average 49 percent of appraisal estimtes, as compared to 50 percent for Tunisia and 49 percent for Morocco. As of March 31, 1985, IFC couitments to Turkey totalled about $239 million, of which .aout $64 million were still held by IFC. Annex II provides a suumary statement of Bank loanr, IDA cre4its and IrC investments as of March 31, 1985. 27. Bank lending is aimed at supporting Turkey's medium-term objectives of restructuring the Turkish economy by placing more reliance on market forces and adopting a more outward-oriented strategy. The main vehicle for the Bank's operational discussions with the Government has been the structural adjustment lending (SAL) program. SAL V, which was approved in June 1984, completed the series of five loans which the Bank had indicated would be the maximum to a country. Significant progress has been achieved in the past five years, but the task of restructuring is by no means over. The next phase will involve the broadening and deepening of the adjustment process at the sectoral level. Recent economic developments have underlined the need for a continuation of the stabilization program without giving up the goals of 1/ Net of cancellations.  - 10 - sectoral adjustment. Hence the emphasis of Bank lending in the post-SAL period would be on striking an appropriate balance between sectoral adjustment leading designed to be quick disbursing and supportive of policy reforms in the major sectors, and carefully formulated project lending focussing on high priority projects principally in the agriculture, energy and transport sectors. 28. Efforts have already been initiated to develop a series of sectoral adjustment loans for the major sectors over the next few years, starting with agriculture. The loans for the agriculture sector would help to support a wedium-term action program aimed at increasing the growth of primary production and exports, rationalizing public investment and strengthening sectoral institutions. Sectoral adjustment lending would also support measures to address the structural problems of the financial sector and enhance the utilization of industrial capacity in the public and private sectors, keeping in view the scope for the "privarization" of publie!ly-held assets in the manufacturing subsectors. Other sectors Where sectoral adjustment leans could be developed include energy and transport. 29. Project lending, which will continue to make up the majority of the lending operations, will be designed to support and strengthen the adjustmet process. A portion of project leading would be earmarked for the construction or rehabilitation of key projects in the energy sector. Other projects would be guided by the major policy objectives of the Government, which include generation of foreign exchange (including improving productivity in export industries and providing essential infrastructure for exports), improvement of institutional efficiency, non-inflationary output growtY. and amelioration of the social costs of adjustment (including provision of social infrastructure and employment generation, with some emphasis on the least developed provinces in Eastern Turkey). 30. The close macroeconomic and sector dialogue established with the Government in recent years is expected to be pursued. The economic and sector work currently being undertaken includes a review of the five-year development plan and studies of housing finance, teleconnunications and electronics. Topics to be covered in the future include a review of the public investment program, a study focussing on the impact of structural adjustment, a review of transport investments and studies of engineering and agro-industries. 31. In addition to this loan to Turkey, other projects being presented to the Executive Directors this fiscal year include an -.ngineering loan for urban development, an agricultural sector adjustment loan, and loans for a fourth power transmission project, a power system operations assistance project, industrial schools project and a ports project. 32. Turkey's debt burden is projected to remain manageable throughout 1985-89 (paras. 23 and 24). The Bank Group's share of Turkey's total external debt was 12.4 perceut in 1983, is estimated at 13 percent in 1984, and is expected to grow to about 17 percent by 1989. Official debt outstanding is projected to increase from $11.4 billion in 1984 to $14.4 billion in 1989 and private medium and long-term debt outstanding is projected to increase from $5.7 billion in 1984 to $8.8 billion in 1989. The Bank group's share of total debt service payments is projected to increase from about 12 percent in 1983 to an estimated 13 percent in 1984, and to about 17 percent in 1989.  - 11 - 33. IFC has invested in synthetic yarns, textiles, pulp and paper, glass, aluminum, cement, iron and steel products, heavy diesel engines, motor bicycle engines, piston rings, food processing and tourism. It has also invested in the Industrial Development Bank of Turkey (TSKB) and provided guarantees for overseas contracting firms. In addition, IFC is currently providing technical assistanrce to the Government with respect to the development of the capital market and a regulatory frameork for leasing. PART II - THE SECTORAL FRMWiORK The Industrial Sector 34. The central objective of Thrsey's developmnt strategy till the late 1970s was rapid growth through industrialization and modernization of agriculture, with special emphasis on import-substitution and capital-intensive technology. While the private sector was provided with considerable protection and generous incentives, a major role was assumed by the public sector. Through the State Economic Enterprises (SEKs), the public sector provided the necessary infrastructure and basic industries as a pre-condition for growth. 35. This str-.tegy produced significant modernization of the industrial sector. The pattern of growth, however, was inappropriate for Turkey's resource base and its interaational comparative advantage. The new development strategy adopted in 1980 entailed moving industry towards outward orientatioa and giving an increased role to market forces, with greater emphasis on the private sector to stimulate growth, exports and employment. The main industrial policy objectives of the Government's program are to improve public and private sector efficiency, focus public investment in manufacturing on rehabilitation of existing capacity, promote exports by developing industries in which Turkey possesses a comparative advantage, and explore possibilities for the selective "privatization" of SEEs. 36. The share of industry in Turkey's economy has grown rapidly and in 1983 accounted for 32 perceat of GDP, 30) percent of fixed investment, 10 percent of aggregate employment and 65 percent of total merchandise exports, which were mainly from the private sector. heavy industries (i-luding petroleum refining and basic metals, steel, fertilizers, pulp and p,a -r, cement, coal, sugar, machinery and chemicals) are concentrated in about twenty manufacturing SEEs in the public sector. The Pulp and Paper Subsector 37. Over the last 25 years, the public and private sectors of the pulp and paper industry have evolved with differences in grade mix, raw material requirements and the degree of vertical integration. Turkey's first paper mill was established in 1934 in the public sector by the SEE, Sumerbank. Responsibility for this plant and all public sector participation in the pulp and paper industry was later transferred to Turkiye Seluloz ye Kagit Fabrikalari (SEKA) which was formed in 1955. Since Turkey remined a substantial importer of paper products, particularly newsprint, the Government undertook a series of integrated pulp and paper mill investments starting in  - 12 - the early 1970s. At the end of 1984, SEKA had eight pulp and paper mills in operation, seven of which have an average installed capacity of close to 90,000 tpy, and which account for some two thirds of the country's total output of paper and paperboard. SEKA is the sole domestic producer of newsprint and sack paper. Since 1970, the private sector has expanded its operations and now accounts for about one third of the country's production. There are 36 mills in the private sector with an average capacity of 5,000 tpy, although five mills are of moderate size (20,000 tpy). The private pulp and paper sector is based primarily on waste paper, straw and some imported pulp, and mainly produces hygienic paper, wrapping paper and paperboard. 38. In 1983, the pulp and paper industry's share of industrial output was around 2.5 percent of the total, with its 16,000 workers accounting for two d percent of total industrial employment. Over the last decade, the industry has made significant progress towards attaining a high degree of self-sufficiency for Turkey in the production of paper and paperboard. By 1983, domestic production of 568,000 tons accounted for more than 90 percent of consumption. Altbough newsprint and sack kraft have been imported in varying quantities over the past few years, such imports are expected to diminish as production in the recently commissioned Akdeniz and Balikesir mills increases. There has recently been some measure of success in exporting hygienic paper and coated boards to neighboring countries, amounting to about five percent of total domestic paper production in 1983. 39. Wood is the most important fibrous raw material utilized by the public sector, supporting about 80 percent of SEKA's pulp production. In 1983 about 53 percent of Turkey's paper production came from wood, 28 percent from waste paper, 10 percent from straw and reeds, and the balance of 9 percent from imported pulp. Turkey has extensive natural forests in the mountainous areas of the Black Sea, Marmara, Aegean and Mediterranean regions, virtually all vested in the state. Total roundwood production over the past five years has averaged 7.5 million u3/year or about 0.4 m3/hectare. By comparison, wood production in Scandinavia is about 1.5 m3/hectare. Efforts to increase industrial roundwood production and improve forestry management practices are being addressed under the Northern Forestry Project (Loan 1585-TU). 40. SEKA's wood purchases over the past four years have varied from 1.0 to 1.5 million m3/year, or the equivalent of between 12 to 21 percent of total industrial roundwood production. The additional volume of coniferous wood required for the Aksu mill as a result of the proposed project can easily be met within the current level of wood production. The availability of logs for SEKA is therefore reasonably secure. However, a number of related problems have been identified, including delays in wood delivery due to bottlenecks in log harvesting and delivery arrangements. The technical assist rce program under the proposed project would examine these issues and make recommendations on institutional and technical measures to improve wood utilization, including the possibility of SEKA and other wood-using entities directly undertaking forest management and wood production. 4L. Domestic consumption of paper and paperboard products grew at a relatively steady rate of 6.6 percent per year between 1970 and 1982. About one quarter of all paper and paperboard currently consumed in Turkey is newsprint. With the completion of two new mills in 1981 and 1984, imports  - 13 - (mainly newsprint and specialty papers) have dropped to previous levesa. The Fifth Five-Year Development Plan (1985-89) estisates that domestic demand for paper and paperboard products would grow by an average of 5.3 percent per annum. The demand for packaging paper and paperboard products, which are critically needed for the export drive, is projected to grow by 10.1 percent per year over the Plan period. Even with the increase in newsprint production which would result from the proposed project, only 80 percent of domestic demand for newsprint is expected to be met by 1990. In contrast, there is potential to increase exports of sack kraft and linerboard through efficiency improvements in SEKA's operations. 42. Under the import liberalization program, significant changes were made in the trade regime for pulp and paper in January 1984 including, for example, the relaxation of controls over the importation of paper and paper products and a substantial reduction in nominal tariff rates. Furthermore, since the passage of the SEE Reform Law in October 1983, the Government has encouraged SEEs, including SEKA, to exercise their freedom to set prices accordiug to market conditions. As a result, in 1984, SEKA's selling prices for printing and writing paper, newsprint and sack kraft have been increased substantially and are in line with import parity prices but below the general landed cost after applicable duty and levies. The Borrower 43. SEKA was established in 1955 as the SEE responsible for public sector operations in pulp and paper. Each of SEKA's eight mills and the Bolu fiberboard plant are separate legal entities incorporated as companies under Turkish law. However, autonomy is limited to general and routine operational matters, and in practice, they operate as divisions of SEKA. SEKA's authorized capital is fully held by the Government. Under the SEE Decree of June 1984, SEKA reports directly to a State Minister in the Office of the Prime Ministry responsible for the manufacturing SEEs. SEKA's Board of Directors is appointed by the Government for three-year terms and concentrates on policy issues leaving executive powers to the Chairman, who is also General Director. Each mill has a management committee to take decisions regarding mill management in accordance with operating targets, plans and budgets. SEKA has benefitted from less frequent changes in senior management as compared to the past. There has also been a trend towards decentralization of decision making with mill managers being held more accountable for operational performance. Overstaffing has been a major problem confronting SEKA's management. SEKA has taken specific measures to address this issue, including freezing the number of job positions at the November 1980 level, cancelling 50 percent of job positions becoming vacant through resignation, retirement or death, and allocating priority to staffing new mills from existing manpower. As a result, between 1980 and 1983 some 1,382 positions or 10 percent of total job positions in SEKA were eliminated. In spite of these significant improvements, SEKA's manpower efficiency is low in comparison to major pulp and paper producing countries. Further improvements in labor productivity are expected to follow from the proposed project. 44. SEKA's capacity utilization of about 75 percent in 1983 is low in comparison with similar mills in North America and Scandinavia where capacity utilization of at least 90 percent is normal. The major factors which  - 14 - affected SEKA's performance in the past include price controls, low operational efficiency, frequent changes in management and difficulties in attracting and retaining high caliber staff. 1., addition to liberalization of prices, the SEE Reform Law provides for greater delegation of powers to Boards of Directors, including the power to appoint Assistant Director Generals and other high level managers (appointments of Assistant General Managers were pi-.viously made by the Council of Ministers on the proposal of the Minister concerned). Employees of SEEs are also to be governed by a new personnel regime to be announced in the near future, whicE. is expected to give greater flexibility to SEE managements in determining wages and salaries. Improvements in SEKA's operational procedures and strengthening of its management structure would be a major aim of the technical assistance program to SEKA under the proposed project. 45. SEKA's financial performance deteriorated fros 1977 to 1983 primarily because of inadequate pricing policies. By the end of 1983, SEKA had accumilated losses in excess of IL 30,000 miLlion and had a current ratio of 0.58. As part of its SEE reform efforts, the Government drew up a financial assistance plan in 1983 for SEKA which provided for TL 12,000 million of new equity through various measures, along with provision for revaluation of assets. In addition, in 1984 approximately TL 39,000 million (about $121 million equivalent) of SEKA's debts were consolidated and converted to equity capital. Following the reaffirmation of the Government's policy of allowing SEEs to set prices for all their products in the light of market conditions, SEKA increased its prices by about 40 percent across the board in two steps during the first four months of 1984. It is SEKA`s intention to continue to set prices at levels which do not depend on protection measures and are not increased unduly to cover high costs caused by inefficient operations. Approach to Privatization 46. As part of its development strategy, the Government is exploring opport:inities for the selective privatization of SEEs and is considering various alternatives including divestiture, sale of shares to the public, leasing and management contracts. The Government has identified the pulp and paper subsector as a possible candidate for privatization. A component of the technical assistance program under the proposed project would review the possibilities for privatization of some of SEKA's facilities. The Government has indicated that selective privatization could be pursued even in advance of completion of the proposed subsector study. SEKA has thus recommended to the High Economic Council that, as a first step, the Bolu fiberboard plant be considered as a suitable candidate for privatization. Bank Participation in the Subsector 47. Bank participation in the subsector began in 1974 with a loan to the Government of $40 million for the Antalya Forest Utilization Project (Loan 95.-TU), of which g35.5 million was onlent to SEKA for the Akdeniz integrated pulp and paper and saw mills and the remaining $4.5 million was for modernization of forestry operations. The loan was closed in 1982. There were delays in the implementation of the Akdeniz component, primarily due to initial changes in the site location. The mill was commissioned in early 1984 and is now exceeding the production rates estimated at the time of appraisal.  - 15 - The Bank also provided a loan of $70 million to SEKA for the Balikesir Newsprint Project (Loan 1258-TU), which was signed in 1976 and closed in 1982. The Project Completion Report dated June 1984 noted that implementation was delayed on account of a shortage of materials and domestic financing during a period of general economic crisis in Turkey. The facilities were commissioned in 1981, and after initial technical difficulties, production performance is currently at 80 percent of design capacity which is close to appraisal estimates. The experience gained from these projects has been taken into account in the design of the proposed project, which includes a comprehensive technical assistance program aimed at strengthening SEKA's management structure and improving its operational procedures. The Bank also made an $86 million loan for the Northern Forestry Project (Loan 1585-TU) signed in 1978 and still under implementation. The project seeks to increase industrial roundwood production and improve the Government's forest management planning and operations. 48. In addition to these direct loans, about $7 million in proceeds from the State Investment Bank (DYB) I and DYB II Projects (Loans 1024-TU and 1379-TU) were utilized to finance investments designed to balance production facilities at the Dalaman and Caycuma mills, and $20 million for construction of the Akdeniz mill. The Project Completion Report of February 10, 1984 for DYB I (Loan 1024-TU) and the Bank report entitled, "Sector Operations Rewiew: The Industries and DFCs Program in Turkey"' (No. 3077), dated July 18, 1980 concluded that a major lesson from the Bank's experience with DYB is that improvements in SEE performance can be better achieved through direct loans and industrial sector policy dialogue. Both of these recommendations have been taken into account in designing the proposed project. Through the Export-Oriented Industries Project (Loan 2093-TU). the Bank is also indirectly involved in the expansion of Kartonsan, a private sector company which produces coated board. IFC has been actively involved in the private sector and currently holds equity in Viking Pulp & Paper Company, one of the largest private sector mills producing about 12,000 tpy of wrapping paper. PART IV - THE PROJECT 49. The proposed project was identified during a June 1980 mission and preparation was financed under a $560,000 advance from the Project Preparation Facility (PPF). Project appraisal was complered in May 1984. Loan negotiations took place in Washington, D.C. from March 12 to March 18, 1985 with a Turkish delegation headed by Mr. Tunc Bilget, Chief Financial and Economic Counselor, Embassy of the Republic of Turkey, and including representatives from SEKA, the State Planning Organization (SPO) and the Uadersecretariat for the Treasury and Foreign Trade. A report entitled "Staff Appraisal Report - Turkey: Pulp and Paper Rehabilitation Project" (No. 5357-TU) dated April 5, 1985 is being circulated separately to the Executive Directors. A sumnary of the proposed project is provided at the beginning of this report and Annex III contains supplementary project data.  - 16 - Project Objectives 50. The proposed project supports the Government's objectives to improve the efficiency of SEEs, rehabilitate existing capacity in manufacturing enterprises and explore the potential for selective privatization of SEEs. In line with Turkey's strategy of export promotion and efficient import substitution, the project also aims at reducing imports of newsprint and short-fiber bleach pulp, and increasing SEKA's export potential in selected grades. The project would furtherucre strengthen SEKA's management and operations. Project Description 51. The project consists of the following main components: (i) rehabilitation of the Aksu, Dalaman and Afyon mills; (ii) purchase of critical spare parts for all of SEKA's mills; (iii) identification and implementation of various energy saving improvements for all of SEKA's mills; (iv) technical assistance (a) to the Government to undertake a reviev of the pulp and paper subsector as well as a study of privatization possibilities for SEKA; and (b) to SEKA for improving operational procedures and strengthening its management structure. These components are described below. Rehabilitation of Aksu, Dalaman and Afyon Mills 52. Aksu Mill. The existing mill became operational in 1971 with a design capacity of 82,500 tpy of standard newsprint. However, production over the past nine years has averaged only 65,000 tpy, and since 1981, has been lower than this level and is on a declining trend. In order to reduce operational costs and increase newsprint production to 100,000 tpy, the project would provide for debottlenecking of machinery and equipment including two new pulp grinders, modernization of the paper machine and a package boiler. The projected increase in newsprint production would require an additional volume of coniferous wood amounting to about four percent of SEKA's present annual wood requirements. The Government has confirmed that SEKA would be provided with wood supplies sufficient to ensure that SEKA is at all times able to operate at full capacity, and in this respect, would furnish to the Bank not later than October 31 of each year a report covering all relevant information on the suceeding year's provision of wood supplies, and would take into account the Bank's comments prior to finalizing the protocol with wood suppliers (Loan Agreement, Section 4.03). 53. Dalaman Mill. The Dalaman mill was completed in 1970 with a design capacity of about 75,000 tpy of bleached kraft pulp; one paper machine currently produces printing and writing paper (38,000 tpy) and the second produces a variety of paperboard (37,000 tpy), of which unbleached kraft linerboard is a major component. SEKA's new mill at Akdeniz began comercial production of unbleached linerboard in 1984, and this grade will nov be displaced from the Dalaman mill. Under the proposed project, the board machine at Dalaman would be rebuilt to allow production of a high quality  - 17 - paperboard which would be coated in an existing but underutilized off-machine coater. These changes vould allow for production of about 40,000 tpy of high quality coated and uncoated bristol and chromo boards. 54. Afyon Mill. This mill uses straw and reeds to produce bleached short-fiber kraft pulp which is consumed by both SEKA and the private sector. The mill is currently producing at 60 percent of design capacity. The proposed project would include partial replacement and rebuilding of the straw-handling, preparation and feeding systems. These improvements would allow production to increase to the mill's design level of 50,000 tpy. Spare Parts 55. The proposed project would include purchase of critical imported spare parts for all of SEKA's mills to make up for past shortages. The project would also provide support for improving maintenance procedures including adoption of monitoring systems for spare parts' inventory planning and control. Energy Saving Improvements 56. Several of the proposed rehabilitation components undertaken to increase production or for quality improvement would result in energy conservation. In addition, the project would provide funds to identify and implement low-cost energy saving improvements in all of SEKA's mills, including increasing recirculation and reuse of process water. SEKA would select, on the basis of criteria acceptable to the Bank, a program of energy-saving projects for review and approval by the Bank (Project Agreement, Section 2.04). Technical Assistance 57. Through the Bank's previous involvement and continuing dialogue with the Government, considerable knowledge of the pulp and paper subsector is now available. About 30 man-months of expert services would be provided under the project to undertake a study to assist the Government in identifying a strategy for the future development of the subsector including possibilities for privatization of SEKA. This study would examine such aspects of the pulp and paper subsector as the appropriate industrial structure and policy environment, the key resources required by the industry and the institutional relationship between SEKA and the Government. The study would be carried out by the SPO in collaboration with SEKA and other government agencies. The Government would make arrangements, satisfactory to the Bank, by December 31, 1985 for carrying out the study and would furnish to the Bank, by September 30, 1986, the