Turkey - Second Railway Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No.- P-4223-TU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US6197 MILLION TO THE REPUBLIC OF TURKEY FOR A SECOND RAILWAY PROJECT June 11, 1986 This document has a restricted distribution and may be used by recipients only in the performancel eof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.|  TURKEY CURRENCY EqUIVALENTS Currency Unit Jan.1980 I/ Jan. 1982 Jan. 1983 Jan. 1984 July 1985 Mar. 1986 USDollar TL 70.00 TL 139.60 TL 191.15 TL 309.20 TL 540.00 TL 658.25 TL 1 US$0.014 US$U.007 US$0.005 US$0.003 US$0.002 US$0.0015 1/ Since January 1980, the rate is being adjusted for the differential inflation between Turkey and its major trading partners. In this report it is assumed that this policy will continue. FlSCAL YEAR January 1 to December 31 LIST OF ABBREVIATIONS DLH - General Directorate of Construction of Harbours, Ports, Airports and Railways, Ministry of Public Works and Settlement MPW - Ministry of Public Works and Settlement IIrKM - Net Ton Kilometer NTMP - National Transport Master Plan SEE - State Economic Enterprise SPO - State Planning Organization TCDD - Turkish State Railways TCL - Turkish Cargo Lines TDT - Turkish Maritime Organization THY - Turki-h Airlines  FOR OFCIAL USE ONLY REPUBLIC OF TURKEY SECOND RAILWAY PROJECT Loan and Project Summary Borrower: Republic of Turkey Beneficiaries: Turkish State Railways (TCDD) and General Directorate of Construction of Harbours, Ports, Airports and Railways (DLH). Amount: $197 million equivalent. Terms; 17 years including four years of grace, at the standard variable interest rate. Relending Terms: $188 million would be onlent by the Borrower to TCDD for a period of 17 years on the same terms and conditions as the Bank loan, with TCDD bearing the foreign exchange risk. Project Description: The proposed project is designed to support the Government's effort to increase the operational efficiency of its railways and to assist the railways in their financial recovery. The project consists of: 5i) a comprehensive program for improving the maintenance and management of the locomotive fleet; (ii) overhaul of about 740 km of m"in line track, and provision of track overhaul equipment; (iii) modernization of about 700 km of main line signalling, (iv) construccion of about 65 km of track; and (v) technical assistance and training. The project is also designed to assist in institutional development through an agreed Action Plan covering organizational, planning, marketing and financial objectives as well as measures for improving technical and operational performance. Benefits and Risks: The railways' limited carrying capacity and poor quality of service is a significant economic bottleneck, particularly for bulk commodity traffic for which railways are inherently the most economic mode. The proposed project would increase railway carrying capacity, reduce transport costs and help make Turkish goods more competitive on the world market. It would also upgrade the quality and safety This document hbs a rsntfted distibudon o may be and by reopients ony in the - |of tWeir olci duties. Its contents may not otherwise be dislosod wbout Wodd Beni s u tfoat  -ii- of railway services and reduce the burden on the budget of Government payments for railway operating expenses. Project technical risks and risks of inadequate traffic are considered small as the technical solutions envisaged are based on proven technology and a substantial portion of the forecast additional bulk traffic is already available and could be carried more cheaply by the railways, but is moving by road due to inadequate railway capacity. Furthermore, the annual plan mechanism to be followed by the railways in their investment planning will allow flexibility in progressive adjustment of investments to correspond with changes in traffic levels so as to reduce the risk of over-investment. The most serious risks concern institutional and policy improvements. Long-standing traditions in railway practices might impede introduction of more modern methods and tariff adjustments could be delayed. The emphasis of the Government on improving the accountability and efficiency of public enterprise management makes this risk manageable. Actions taken recently freeing tariffs from Government control and the tariff adjustments introduced in January 1986 support this assessment. Estimated Costs: Local Foreign Total ---4 imiLlion- 1. Improvement of Diesel Locomotives 82.4 62.7 145.1 2. Track Overhaul 73.1 45.2 118.3 3. Track Overhaul Machinery 5.7 13.5 19.2 4. Signalling and Tele- communications 28.6 30.6 59.2 5. Line Capacity Works 75.6 18.9 94.5 b. Technical Assistance and Training 1.7 3.1 4.8 Total Base Cost 267.1 174.0 441.1 Physical Contingencies 26.0 15.8 41.8 Price Contingencies 64.6 34.7 99.3 Total Project Cost 357.7 11 224.5 582.2 1/ I/ Includes about $150 million of taxes and duties.  -iii- Financing Plan: Local Foreignt Total ~~~f - million - - World Bank - 197.0 197.0 Government/TCDV 357.7 18.5 376.2 Suppliers' Credits or Cofinancing 1/ 9.0 9.0 357.7 224.5 582.2 1/ The Government would retain responsibility for these costs if the expected external financing does not materialize. Estimated Disbursements; lIBD FY 1987 1988 1989 1990 1991 1992 1993 Annual 22.0 42.0 45.0 37.0 30.0 17.0 4.0 Cumulative 22.0 64.0 109.0 146.0 176.0 193.0 197.0 Economic Rate of Return: About 22 percent. Appraisal Report: No.5898-TU, dated June 2, 1986. map: IBRD 19221  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TURKEY FOR A SECOND RAILWAY PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Turkey for the equivalent of US$197 million to help finance the foreign exchange cost of a Second Railway Project. The loan would have a term of 17 years including 4 years of grace, with interest at the standard variable rate. About $188 million equivalent would be onlent to the Turkish State Railways (TCDD) on the same terms and conditions as the Bank loan, with TCDD bearing the foreign exchange risk. PART I - THE ECONOMY 1/ 2. An economic mission visited Turkey in June 1982, and its report entitled "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 Sector" (No. 4459-TU), was distributed in September 1983. A Bank mission reviewed the Government's Fifth Five-Year Development Plan (1985-89) in September 1984 and its report: "Turkey: The Vth Five-Year Plan in the Context of Structural Adjustment" (No. 5418-TU) was distributed in July 1985. 3. Turkey's area is about 780,000 square kilometers (i.e. about equal to the area of France and West Germany combined) with a population of around 50 million and GNP per capita of $1200 in 1984. 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 countries. Despite rapid economic growth in the mid-1970s as well as emigration of workers (to Western Europe and more recently, to the Middle East), there is still substantial unemployment which, including disguised unemployment in agriculture, is estimated at about 19 percent of the civilian labor force. 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 increase in income inequality since the 1970s, especially a relative deterioration of the position of wage and salary earners and an improvement in the position of the trading and commercial classes, and, more generally, of capital-owners. Educational enrollment has expanded greatly, but the level of adult literacy remains relatively low compared to the European average for middle income countries. 1/ Parts I and II are substantially the same as Parts I and V of the President's Report for the Financial Sector Adjustment Loan (P-4258-TU) dated May 15, 1986.  -2- Background 4. During the 1970s Turkey did not make the necessary adjustments 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. Until 1977 Turkey maintained high rates of economic growth by increasing public investment. The foreign exchange requirements were financed initially by workers' remittances and then increasingly by borrowing, a large part of it short-term. 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, disruptions in industrial production and a rise in unemployment. By the end of 1979, domestic inflation had also become an issue of critical importance. 5. In response to the crisis of the late 1970s, the Turkish authorities made a major shift in development strategy in 1980, moving towards outward orientation and giving an increased role to market forces. To alleviate the balance of payments constraint and import shortages, policies were adopted to expand exports, increase workers' remittances, liberalize imports, encourage foreign investment and improve external debt management. On the domestic frout, 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 and an Agricultural Sector Adjustment Loan, involves far-reaching changes in attitudes, institutions, and the legal and policy framework, all of which require time to be put in place. M4ajor 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 started in January 1980, continued under a military regime during the period September 1980 - November 1983, and has since been carried out by an elected government. The Structural Adjustment Program, 1980-85 7. The Turkish ecunomy has shown an impressive response to the structural adjustment program and the outcome met or exceeded the Government's own targets through 1982. The overall performance deteriorated in 1983 due to a corabination of factors (slowdown of export growth, slippages in the monetary program, shortfall in Government revenues), but improved again, except in the area of inflation and the budget deficit, in 1984. The improvement was maintained in l985, this time including a slowdown in inflation and a reduction in the budget deficit. 8. After expanding by 4.1 percent in 1981 and 4.6 percent in 1982, real GNP growth slowed down to 3.2 percent in 1983, due to the effects of a bad harvest, stagnant exports and lower workers' remittances. The growth rate rebounded in 1984 to 5.9 percent, mostly on account of favorable performance in agriculture (3.7 percent growth) and industry (9.3 percent growth).  -3- Merchandise exports also expanded strongly, by more than 25 percent in dollar terms. In 1985, according to the latest estimates, the economy grew by about 4.9 percent, as against the program target of 5.5 percent. The slowdown in growth was most significant in agriculture (2.2 percent growth) and manufacturing (5.5 percent), due respectively to less favorable climatic conditions and slackening domestic demand. On the expenditure side, the average annual real rate of growth of public fixed investment over the period 1980-84 was 3.8 percent. Provisional estimates for 1985 indicate that public fixed investment totalled TL 3,289 billion, implying a much higher real growth (12.8 percent) over 1984 than programmed (5.8 percent). However, the size of public investment is overestimated for two reasons: (i) the increase in local currency cost of outstanding foreign debt due to devaluation is included in the investment figures for ongoing projects; and (ii) interest costs incurred by ongoing projecrs are also added to public investment. Rough calculations indicate that these could add up to as much as 30 percent of the total investment figure for 1985 cited above. The growth rate of private investment has fluctuated more severely, falling by 17 percent in 1980, recovering slowly, and then rising by 7.1 percent in both 1984 and 1985. Private consumption, after declining by 5 percent in real terms in 1980, grew by 5 percent in 1983 and 1984 before slowing down to an estimated 3.8 percent in 1985. Strict budgetary discipline contributed to a steady decline in the real rate of growth of public consumption frow 8.4 percent in 1980 to 1.8 percent in 1983; however, it increased to 3.2 percent in 1984 and an estimated 3.3 percent in 1985. 9. During 1981-82, 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 average annual rate of increase in the wholesale price index (WPI) decelerated 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. Inflation accelerated further in 1984, and reached 50 percent, due to the lagged impact of the expansionary monetary policy pursued during the second half of 1983, and a significant increase in agricultural product prices, especially of fresh fruits and vegetables, as a consequence of export liberalization and higher export market prices. Other coutributory factors included substantial "catch up" increases of SEE prices - since January 1984 most SEEs have effectively been allowed to set their prices freely - and higher import prices resulting from the nominal depreciation of the Turkish lira. In addition, inflationary pressures stemmed from a larger than anticipated budget deficit in 1984 as a result of a slowdown in the growth of revenues. 10. In 1985 inflation declined considerably -- the average annual rate of increase in the WPI fell to 43.2 percent, after reaching a very high level in the first quarter of 1985 (about 60 percent as of March 1985). By December 1985, the month-over-month change in the WPI (i.e. December 1985 over December 1984) had correspondingly declined to 38.3 percent and by March 1986 it had dipped even further, dropping to below 30 percent for the first time in two and half years. Factors causing the high inflation rate in the first quarter of 1985 were the introduction of a value added tax (VAT) in January 1985 and continued substantial increases in the. prices of several key  -4- intermediate goods and inputs. Thereafter, several factors combined to lower inflationary pressures: Ci) monetary growth slowed, particularly in the fourth quarter, with M2 growth declining from an annual rate of 64 percent as of September 1985 to 53 percent at year-end; (ii) by April 1985 most of the catch-up increases in the prices of SEE products appeared to have been completed and the rate of price adjustment abated considerably; (iii) the significant slide of the dollar, which started after March 1985, resulted in a slowing down of the nominal depreciation of the Turkish lira against the dollar and therefore in smaller increases in prices of imported products than were witnessed in 1983-84; (iv) the persistence of high real interest rates (which increased as inflation declined) helped to channel liquidity towards savings rather than consumption and thus lowered aggregate demand; and (v) lower exports of certain agricultural products (cereals and pulses) meant that the domestic market was well supplied, thus easing inflationary pressures on food prices. The steady deceleration in the inflation rate, which has now continued for over 12 months, reinforces the expectation that the Government's target rate of 25 percent for 1986 could be achieved, particularly considering the large decline in world oil prices since January 1986, the continued weakening of the dollar relative to other international currencies, and the Government's maintenanca of a tight monetary and fiscal program. 11. In the fiscal area, progress has been uneven. During 1980-82 the budget deficit declined from 5.3 to 2.i percent of GNP, but increased to almost 5 percent of GNP in 1984, due mainly to a disappointing performance in raising tax revenues. In 1985, however, the budget deficit is estimated to have been TL 621 billion or 2.3 percent of GNP, a significant improvement over 1984. This is largely because the Government took several measures in 1985 to increase revenues, the most important of which was the introduction of VAT. In its first year, VAT collections amounted to about TL 1 trillion, significantly above the target. Other tax measures which were adopted included substantial increases in various fixed charges and duties and large increases in penalties for overdue tax payments. As a result of these measures, budget revenues rose from 15.4 percent of GNP in 1984 to 17 percent in 1985, reversing the downward trend in revenues over the previous three yea-s. Government expenditures decreased from 20.3 percent of GNP in 1984 to an estimated 19.3 percent in 1985. 12. Progress has also been made in rationalizing interest rates and reforming the banking system. Since 1981, interest rates on time deposits at commercial bauks have been positive in real terms. Time deposits have been yielding a positive real return since early 1984. Positive deposit interest rates have resulted in a steady growth in deposits, about 10 percent per annum in real terms in 1984 and 1985. Improvements in incentives for savings were accompanied by administrative reforms of the banking system, the enactment of a new banking law, and measures to revitalize the capital market. 13. While positive real interest rates have provided an incentive to save, they have also meant high borrowing costs. Effective nominal interest rates range from 6U to 8U percent on non-preferential credits, in part because of the impact of high liquidity and reserve requirements, the option which  -5- commercial banks have to invest in high-yielding government bonds, and high intermediation costs. The Government took a number of steps in 1985 to reduce the interest rate differentials between preferential and non-preferential credits: in particular, the preferential interest rate for export credits was discontinued in January 1985, while, during the year, interest rates for larger agricultural loans and for loans to SEEs were increased from 28 and 22 percent to 34 and 35 percent respectively. The narrowing of cte gap between interest rates on preferential and non-preferential credits, together with the decrease effected in the amount of preferential credits, is expected to increase the general availability of credit and exert a downward pressure on non-preferential interest rates. 14. Improvements in the balance of payments were substantial between 1980 and 1982, with the current account deficit decreasing from $3.3 billion (5.7 percent of GNP) in 1980 to $1.2 billion (1.6 percent of GNP) in 1982. In 1983 the current account deficit increased to $1.8 billion, as merchandise exports stagnated and workers' remittances fell by one-third. These developments were reversed in 1984 as exports increased by over 25 percent in dollar terms to reach $7.4 billion. Remittances, too, registered a higher than expected increase, reaching $1.8 billion (up by 20 percent over 1983). Merchandise imports grew by more than 16 percent to reach $10.8 billion. As a result of these developments, both the trade and the current account deficics declined as compared to 1983. Latest estimates for 1985 indicate a further strong improvement of the balance of payments situation. Merchandise exports grew by 11.6 percent (in dollar terms) in 1985, while merchandise imports increased by 8 percent. Among the invisibles, tourism revenues and investment income from abroad increased significantly compared to 1984 and previous years. Workers' remittances, on the other hand, declined by 5 percent. The current account deficit in 1985 is now estimated at about $1.0 billion, or about 1.9 percent of GNP. 15. Merchandise export performance has been impressive throughout the 1980-85 period, during which exports registered an average annual rate of increase of about 23 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, composed primarily of processed foods ar-i textiles, have risen from 32 percent cf total exports in 1980 to more than 72 percent in 1985. These results were achieved by a combination of indirect measures (flexible exchange rate policy, import liberalization) as well as direct measures (tax rebates, preferential credits) to enhance the relative profitability of exports and offset the traditional bias towards production for the domestic market. Successful penetration of the Middle Eastern markets has brought their share in total Turkish exports from 17 percent in 1980 to around 40 percent in the 1983-85 period. 16. On the import side, the 1982-83 period was marked by a relative stability in the growth of merchandise imports, as prices of both oil and non-oil imports declined, and the volume rate of growth remained moderate. In 1984, however, merchandise imports increased substantially. The increase was most pronounced in some of the groups (e.g. raw materials and consumer goods) that have been subjected to major liberalization through a lowering of tariff rates and a significant removal of quantitative restrictions. In 1985, as  -6- domestic demand eased, and the initial effects of pent-up demand for importables released by import liberalization weakened, the rate of import growth decreased to about one-half of the level recorded in 1984. MediumrTerm Prospects 17. The Fifth Five-Year Development Plan (1985-89), which was approved by the Grand Natioaal Assembly in June 1984, reaffirms the Government's determination to pursate an outward-oriented development strategy and to liberalize the economy by relying increasingly on market forces. The public sector is targeted to play a supportive role by concentrating its investments in infrastructure 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 10.9 percent in private investment and 6.8 percent in public investment; (iv) a declining external debt service ratio, from 26 percent in 1984 to around 18 percent in 1989; and (v) a decreasing rate of inflation reaching 10 percent p.a. in 1989. 18. While the overall thrust of the Plan is in accord with the goals of the structural adjustment program, the Plan targets, if viewed collectively and in the light of the developments in 1984 and 1985, appear somewhat ambitious and likely to strain domestic resources (especially in the public sector) as well as have an adverse impact on the external balance. Accordingly, the Government is adjusting the annual programs to ensure that they remain compatible with the fight against inflation and with a growth strategy commensurate with the Government's ability to generate resources. 19. The recent decline in international oil prices is likely to have a favorable impact on Turkey's balance of payments. The Bank's projections presented below take into account the most recent decline in oil prices. The analysis shows that the savings from direct petroleum imports alone could be about $1.3 billion in 1986. The favorable direct impact would be offset to some extent by lower export growth to oil-exporting countries (which account presently for about 4U percent of Turkey's exports) as well as lower profit and workers' remittances from construction activities in these countries. However, a compensating increase in Turkish exports to, and workers' remittances from, OECI) countries on account of a more favorable OECD growth outlook is likely in the medium term. Our estimate puts the net positive impact of the oil price decline on Turkey's balance of payments at about