Turkey - Financial Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 6095-TU STAFF APPRAISAL REPORT TURKEY FINANCIAL SECTOR ADJUSTMENT LOAN May 15, 1986 Industrial Development and Finance Division Europe, Middle East and North Africa Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit - Turkish Lira (TL) Value of US$ 1975 a/ TL 14.44 1976 TL 16.05 1977 TL 18.00 1978 TL 24.28 1979 TL 31.08 1980 January TL 70.00 1981 January TL 91.00 1982 January TL139.60 1983 January TL191.15 1984 January TL309.20 1985 January TL451.40 1986 January TL586.40 a/ Annual averages through 1979. GLOSSARY OF ABBREVIATIONS BOP Balance of Payments CD - Certificate of Deposit CMB Capital Markets Board DESIYAB Devlet Sanayi ve Isci Yatirim Bankasi DYB Devlet Yatirim Bankasi FERIS Foreign Exchange Risk Insurance Scheme GDP Gross Domestic Product GNP Gross National Product IMF International Monetary Fund LIBOR London Inter Bank Offering Rate OECD Organization for Economic Cooperation and Development SEE State Economic Enterprise SSI Small Scale Industry SYKB Sinai Yatirim ve Kredi Bankasi TCZB T.C. Ziraat Bankasi, or Agricultural Credit Bank TSKB Turkiye Sinai Kalkinma Bankasi TNO Soil Products Office tWPI Wholesale Price Index  FOR OFFICIL USE ONLY TURKEY STAFF APPRAISAL REPORT FINANCIAL SECTOR ADJUSTMENT LOAN Table of Contents Page No. LOAN SUMMARY ***....*.......**......**......***.....****....*****.. (i) I. INTRODUCTION 1...........*** .........****....***... A. Importance of Financial Sector Reform .................. I B. Objectives of Financial Sector Reform .................. 2 C. Role of the Bank Group ...................... .......... 2 II. THE MACRO-ECONOMIC SETTING ............................. ... 3 A. The Economic Adjustment Program: 1980-1986 ............. 3 B. Issues in the Macro-Economic Setting ................... 4 C. The Outlook for 1986 and Beyond ........................ III. THE FINANCIAL SECTOR .............................. ...... 10 A. Structure, Depth and Growth ... ......................... 10 B. Impact of Interest Rate Reforms ....... ................. 13 C. Issues in the Financial Sector ......................... 15 D. The Medium-Term Adjuatment Program ......# .............. 16 IV. FINANCIAL POLICIES FOR STRUCTURAL CHANGE ................... 18 A. Interest Rates ..........**................ 18 B. Determinants of High Cost of Credit ............o........ 22 C. Selective Credit Policies .......... .............. 24 D. Preferential Credit .. ... .......... 27 E. Reference Rate for Selective Credit .................... 27 V. STRENGTHENING THE BANKING SYSTEM ........ ........ 28 A. Role of the Central Bank . . .... 29 B. The Board of Sworn Bank Examiners . ...... 31 C. The Commercial Banks: Structure and Performance so..... 32 D. The Courts and Collection Procedures ................... 36 E. The Propmsed Banking Institute. .................. 38 This report is based on findings of Bank missions which visited Turkey on five occasions during 1985 and 1986. The missions included Messrs. Abhay Desh-,.na", Jeffrey Balkind, Cesare Calari, William Hayden and Alain Soulard from the Banai and IFC. Messrs. Bulent Gultekin, Hans Horch, Cengiz Israfil, Vincent Polizatto, William Pugh, Einar Sekse, Jose da Silva Lopes and Christia- Va. Zeller assisted the missions as Consultants. This document has a restricted distribution and may be used by recipients only in the performance of theit offci duties. Its contents may not othewise be disclosed without World Bank authonution.  Table of Contents .zontinued) VI. DEVELOPING THE MONEY AND CAPITAL MARKETS ................... 39 A. Money Narkets ............... 9 , , 40 B. Capital Markets: Institutional and Regulatory Framework ....* ................... 42 C. The Primary and Secondary Capital Markets ....... 45 VII. DEVELOPING THE ACCOUNTING AND AUDIT PROFESSIONS ............ 47 A. The Present Situation 47................................ - 41 B. Needs for Development of the Profession ................ 49 C. Proposed Council for Sworn Financial Advisors .......... 49 VIII. THE PROPOSED LOAN .......................................... 50 A. Rationale and Objectives ............................... 50 B. Loan Components .......... ............................ 51 C. Utilization ... ............. ..... ...................... 52 D. Procurement, Disbursement and Administration ........... 52 E. Monitoring and Tranche Release ......................... 53 F. Justification and Risks ..... ....... ...... ............ . 54 IX. RECOMMENDATIONS ..................... 55 ANNEXES Annex 1 Statement of Financial Sector Policies - 1986 Annex 2 Credit Flows by Source Annex 3 Total Credit Outstanding Annex 4 Shares of Total Credit Outstanding Annex 5 Key Financial Sector Indicators Annex 6 Linkage between Sector and Loan Objectives Annex 7 Interest Rates Weighted by Volume of Credit Outstanding Annex 8 Effective Cost of Loanable Deposit Resources (based on average cost of deposits) Annex 9 Effective Cost of Loanable Deposit Resources (based on cost of time deposits) Annex 10 Central Bank Rediscount Rates and Final Costs to Borrowers Annex 11 Blended Cost of Credit to Borrowers Annex 12 Preferential and Total Credit Outstanding Annex 13 Summarized Accounts of Public Sector Commercial Banks Annex 14 Summarized Accounts of Private Sector Commercial Banks Annex 15 Summarized Accounts of Foreign Commercial Banks Annex 16 Technical Assistance Program for the Central Bank Annex 17 Technical Assistance Program for the Board of Sworn Bank Auditors Annex 18 Technical Assistance Program for the Banking Institute Annex 19 Technical Assistance Program for the Capital Markets Board Annex 20 Technical Assistance Program for the Treasury Annex 21 Summary of Technical Assistance Component Costs Annex 22 Implementation Schedules of Technical Assistance Components  TURKEY FINANCIAL SECTOR ADJUSTMENT LOAN LOAN SUMMARY Borrower: Republic of Turkey. Beneficiaries; The Undersecretariat of the Treasury and Foreign Trade, the Central Bank, the Capital Market Board, the Board of Sworn Bank Examiners, the Board of Sworn Financial Advisors and the commercial banks. Amount: US$300 million eq-iivalent. Terms: Seventeen years including four years of grace, with interest at the standard variable rate. Description: The proposed loan would support the Government's financial sector adjustment program during the two-year period 1986-88. The principal objectives of the program are to establish an efficient and flexible system of resource mobilization and allocation, which would respond rapidly to market forces and would offer a wide variety of financial instrument to both borrowers and savers. The principal measures to be taken would include: (i) the reduction of subsidies on preferential credit and achievement of positive real interest rates on preferential credit to the productive sectors; (ii) standardization of accounts and introduction of external audit of commercial banks, along with strengthening of bank supervision; (iii) development of the capital market through reform of the regulatory framework including introduction of external audit of corporations; and (iv) development and introduction of new financial services. Simultaneously, the institutional capacities of the major agencies in the sector adjustment process would be strengthened by provision of technical assistance at a total foreign exchange cost oi $3.0 million. The loan would finance all imports with the exception of items financed by other sources, military or para-military items, luxury goods and nuclear reactors.  - iA- Benefits and Risks: The reforms agreed under the loan will help to create a more efficient financial sector and thus enhance growth, both by increasing savings and by channelling them to more productive investments. In particular, by developing a greater variety of financial instruments, the reforms would contribute to a revival of private investment. The main risks arise due to uncertainties in the control of inflation, as-the persistence of high levels of inflation is a major constraint to the reduction of the prevailing high interest rates and consequent corporate financial distress. The other main risks relate to the prospects for the rapid development of the capital markets, and the degree of resistance that might be encoutered in the introduction of external audit of banks and corporations. These risks are considered manageable in view of the progress already made and the Government's commitment to the reform program. Estimated Disbursement; The proceeds of the loan would be disbursed in two tranches$ $200 million equivalent soon after effectiveness, and $100 million after a performance review expected to be carried out in July 1987.  CHAPTER I INTRODUCTION 1.01 This report appraises a loan of $300 million to support the process of financial sector reform in Turkey. The Fifth-Five Year Development Plan (1985-89) charts a course for the economy wiich aims to consolidate the stabi- lization and adjustment program begun in the wake of the economic crisis in January 1980, and to return the economy to steady growth. Reliance on market forces and an increased outward orientation for the economy are the central themes of the Government's policy. The process of liberalization and adjust- ment in the real sectors of the economy needs to be supported by eorresponding liberalization of the financial system. 1.02 The proposed loan originated from the Bank's extensive economic and sector work program in Turkey over the last five years. One of the important tasks undertaken during 1982-83 was a survey of the financial sector of Turkey (Special Economic Report -- Policies for the Financial Sector -- Report No. 4459-TU, dated September 21, 1983). The report clearly indicated the need for reform and restructuring of the financial sector. The urgency of action is also underlined by the deteriorating portfolio quality of financial insti- tutions and by the serious distortions evident in the resource allocation pro- cess, partly caused by the lack of an efficient financial sector. A. The Importance of Financial Sector Reform 1.03 The financial system is crucial to economic development because of its key role in mobilizing and allocating resources, as well as in stabilizing the economy. Recent experience has shown that the role and performance of the financial system are intertwined with the state of the macro-economy and cor- porate financial health, that negative real interest rates reduce domestic resource mobilization and encourage excessive dependence on foreign capital, and that excessive reliance on directed credit leads to inefficient resource allocation. Buildiug a sound and efficient financial system involves much more than creating and nurturing individual institutions. It requires a balanced approach involving: development of appropriate financial sector policies; promotion, in a competitive environment, of a range of financial institutions and intermediaries capable of delivering equity and debt finance as well as various financial services at reasonable costs; and creation of an institu- tional infrastructure for financial information, regulation and supervision. Finally, recent experience has confirmed that for financial sector reform to yield its full benefits, parallel changes should be made in macro-ec3nomic and trade policies. 1.04 Development of the financial system is closely dependent on the policies followed for management of the overall ecc,-my. During the period of economic and financial instability in the early .980s, countries such as Turkey, with relatively open trade and capital markets, were especially hard hit. Some of these countries had allowed their economies to become overheated during the 1970s. High and fluctuating inflation, combined with delays in interest rate adjustments, produced highly negative real rates as interest  -2- rates remained fixed at nominal levels that were substantiaily below inflation levels. This adversely affected mobilization of domestic savings. When low cost foreign funds to finance budget deficits were no longer available, they were forced to take drastic stabilization measures. The financial systems of some of these countries actually contracted as a result and have therefore not acquired the depth necessary to perform their functions effectively. 1.05 Conversely, the existence of a well developed financial system makes the task of management of the macro economy and the achievement of sustained growth rates easier. The financial sector is a service sector which affects all productive sectors of the economy. The contribution of the finaacial sector to the econoay depends on the quality and quantity of the services it produces and the efficiency with which they are produced. The financiai sector fosters capital accumulation by providing assets which are attractive ia terms of yield, risk and maturity. It also plays an important role in improving allocation of capital by pooling the savings of surplus entities to finance large investment projects. Finally, the financial sector enables term trans- formation of maturities, by matching the preference of savers for short-term investments with the longer term needs of investors for investment finance. An efficient financial sector thus enhances growth, both by increasing the financial savings ratio and by channelling savings to financing higher yielding investments. B. The Objectives of Financial Sector Reform 1.06 The objectives of financial sector reform are: (i) to deepen the financial system by channelling an increasing proportion of capital accumu- lation through the formal financial system, in order to improve the allocation of savings in the economy; (ii) to expand the consolidation of relatively small pools of private savings into institutional hands to permit the allocation of these funds to large productive investments; and (iii) to improve term trans- formation by converting a larger proportion of short-term financial surpluses into longer-term resources needed to finance capital investments. These objec- tives can be translated, in systemic terms, as seeking the establishment, over the medium term, of an efficient and flexible system of resource mobilization and allocation, which would grow in real terms to meet the needs of Turkey's modernizing economy and which would respond rapidly to market forces, would offer a wide variety of instruments to both borrowers and savers yielding positive returns in real terms, and make resources available at positive real rates. C. Role of the Bank Group 1.07 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 discussion with the Government has been the structural adjustment lending (SAL) program, which was completed in June 1984. Significant progress has been achieved in the last five years, but the task of restructuring is by no means over. Recent economic developments have underlined the need for a continuation of the stabilization program without giving up the goals of sec- toral adjustment. Hence the emphasis of Bank lending in the post-SAL period  -3- would be on striking an appropriate balance between sectoral adjustment lending designed in part 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, industry and transport sectors. 1.08 The Bank Group has been involved in the Turkish financial sector through projects to support industrial development, agricultural credit ope- rations, and technical assistance to the Capital Market Board through IFC. Joint ventures in merchant banking and manufacturing projects have also been supported by IFC. The Bank group has had continuing dialogue with the Government regarding measures to be implemented as a part of financial sector adjustment. As a result, the Government has already given effect to many of the recommendation made in the report of the Financial Sector Survey. The proposed loan would be an outcome of the close dialogue-and help to place the sector adjustment program on a sound medium-term footing. CHAPTER II THE MACRO-ECONOMIC SETTING 2.01 Turkey's structural adjustment program has brought about major reforms in the macro-economic environment, particularly in exchange rates, the trade regime, the incentives framework, the taxation system, pricing policies, the state enterprise sector, and the planning framework. Most of the reforms were aimed at accomplishing two central medium-term objectives - opening up Turkey's economy to market forces and pressures and achieving an outward orientation. The macro-policy-framework put in place since 1980 mainly affects the real sectors of the economy, principally agriculture, industry and energy, but it also affects in a major way how the financial sector operates. The purpose of this chapter is to review the main results of the adjustment program, the issues that now appear important in the macro-economic setting, and to assess the prospects for macro-economic developments as the background for the financial sector adjustment program. A. The Economic Adjustment Program: 1980-1986 2.02 Despite the fairly tight monetary and fiscal policies followed by the Government as part of the stabilization program, Turkey's GDP has grown at an ar.nual average rate of 4.7 percent in real terms during 1980-84. The highest growith was zecorded in 1984 (5.8 percent), while in 1985 the economy grew by a more moderate 4.9 percent. The main engine of growth has been the impressive growth in exports at an average annual rate of 25 percent over the period 1981-85. Domestic demand on the other hand has been constrained throughout most of this period. Export growth has been particularly evident in the manu- facturing sector, where value-added grew by 9.3 percent in 1984 and 6.6 percent in 1985. It also benefitted the agricultural sector where output grew by positive 3.0 and 2.3 percent in 1984 and 1985 respectively, following a decline in 1983. Exports are dominated by private sector producers who nave made con- siderable strides in improving product quality and in producing and delivering goods in a timely manner. Production bottlenecks have been considerably alle- viated as a result of a substantial increase in electricity production, and better availability of other inputs due to import liberalization.  -4- 2.03 The stabilization program involves consolidation of this process, particularly in the industrial and financial sectors. Liberalizatior of the economy has been sequenced appropriately starting with the introduction of an active exchange rate policy, followed by coordinated actions relating to the public enterprise sector and the relaxation of price controls, import restric- tions and investment licensing. The financial sector is new being liberalized following the reforms in the real sectors. Already few restrictions exist regarding movements in items affecting the capital account. Turkish citizens are now able to hold foreign-exchange denominated deposits and to remit capital abroad fairly easily. This is linked to the continued application of a realistic flexible exchange rate policy based on the daily determination of the exchange rate by the Central Bank against a basket of currencies of Turkey's major trading partne"a. This key factor in Turkey's export drive aims at making the Turkish Lira fully convertible in the near future. While not an end itself, convertibility of the Lira would represent proof of the successful liberalization of the Turkish economy in general and of the financial sector in particular. Hence, it would enhance the image of Turkey in international credit markets. In the last five years Turkey's standing has already improved considerably as demonstrated by the fact that since 1983, foreign commercial borrowings exceeded loans from official sources. B. Issues in the Macro-Economic Setting 2.04 Despite the impressive results achieved under the adjustment program, there are two issues in the macro-economic setting which have substantial impact on the health of the financial sector. These are: (i) control of inflation, and (ii) sustaining the export drive, through increase in manufac- turing investment in the private sector. The prospects for the resolution of these issues are discussed below. 1. Inflation Control 2.05 Turkey's persistent, though declining, high inflation rate still remains the main problem. In 1984 the inflation rate reached 50 percent, up from 31 percent in 1983. By March 1985 it had reached 60 percent. However, since April 1985 there has been a steady decline in the inflation rate, with the year-on-year change in the Wholesale Price Index (WPI) hovering around 36 to 38 percent in most monchs. The inflation rate for the year 1985 was about 43 percent, influenced by the substantial SEE price increases in the first quarter. However, measured on a month-over-month basis, the inflation rate appears lower: the December 1985/December 1984 WPI increase was 38.3 percent. Price behaviour in the first quarter of 1986 confirms the picture that the inflation rate is declining. The March 1986/March 1985 WPI increase was 29.3 percent, and it seems reasonable to expect this trend to continue and result in an inflation rate under 30 percent by end of 1986. Four factors can be identified as being among the root causes of the high rate of inflation in 1984-85: (i) prices of imported goods and inputs pushed upwards by the creeping devaluation of the Turkish Lira; (ii) sizeable "catch-up" increases in prices of products of State Economic Enterprises (SEE), including in energy and transportation; (iii) pressures on domestic food prices in particular, due to the greater proportion of agricultural output exported; and (iv) intro- duction of the value-added-tax put some pressures on prices. Some of these  -5- inflationary pressures are not currently present to the same degree,-but even at a reduced level, an inflation rate of 30 percent poses very considerable stress on the financial system, as it results in high interest rates, leading to deterioration in loan portfolio quality and consequent reduction in profi- tability of financial institutions. The difficulties being experienced in control of inflation in Turkey can be viewed from the twin aspects of management of the budget deficit and control of growth in money supply as discussed below. 2.06 The Budget Deficit. The budget deficit rose -rom 2.1 percent of GNP in 1982 to 3.3 percent in 1983 and 5.0 percent in 1984. The Government moved in 1985 to restore fiscal balance. Originally, it hoped to reduce the deficit to TL 250 billion, as compared to TL 930 billion in 1984. However, the out- turn for 1985 was a deficit of about TL 530 billion which represents about 2.3 percent of the 1985 estimated GNP. The main measures used to achieve this improvement were the strengthening of tax collections and the implementation of some new taxes, the most important of which is the value-added-tax (VAT). In 1985, the VAT netted about TL 1,070 billion of revenues, comopared to a target of TL 760 billion. Also, Government current and capital expenditures were curtailed, including limiting wage increases to about 35 percent on average. It appears that these is still substantial capacity irt the country to increase revenues further. In fact, the ratio of budgetary revenues to GDP was about 15.4 percent in 1984, which is low for a country of Turkey's level of development. Budgetary revenues would have appeared higher if certain taxes and levies which were allocated to two new extra-budgetary funds (the Mass Housing Fund and the Public Participation Fund) had been included in budgetary revenues, which would have raised the ratio of budgetary revenues to GNP in 1984 to about 16.4 percent. 2.07 The persistent budget deficit has had a marked effect on the financial sector, felt principally through the Government's program of public borrowing to finance the deficit. In 1985, the Government issued TL 1,200 billion of Treasury bills and bonds. Most of the instruments were under one-year maturity and some of the debt instruments were for refinancing maturing debt. In May 1985, the Gciqrnment began to issue these bills by public auction, on a regular weekly basis. On an average, about TL 30 billion of bills have been auctioned every week at a market determined yield of about 50-53 percent. While this development is welcome from the point of view of requiring the Government to pay a market yield on its borrowings, it could lead to the Government's crowding-out private borrowers from the market. The interest earned on the Treasury bills is tax-free, thus the nominal yield of 50 percent represents a tax-adjusted yield of at least about 65-75 percent, depending on the tax position of the financial institution holding the bonds. It appears that financial institutions, which are the major participants in the auctions, clearly prefer to subscribe to such risk-free bonds rather than lend to corpo- rations and smaller firms, given that the return on loans to private borrowers is not much higher, on a tax-adjusted basis. The emphasis of the Governmean measures is therefore on reduction of the deficit by reduction of expenditures and revenue increases, rather than increase in debt financing. As a part of the monitoring program agreed with the Government (para 2.14), the Bank will continue to monitor progress by the Government in reducing its fiscal deficit.  6 2.08 Growth of Honey Supply. A second element hampering inflation control has been the rapid growth of money supply. In fact consistent management of the money supply has proven difficult for Turkey's policy-makers, partly because of budget deficits, partly because the inadequacy of available monetary policy instruments made it difficult to control monetary aggregates, and partly because of the build-up of foreign exchange deposits in recent years which cannot be sterilized easily. In 1984 broad money (M2) defined as cash plus demand and time deposits grew by 57 percent, while broad money defined as M2 pltis foreign exchange deposits (M2X) grew by 73 percent. These increases were well above the authorities' targets of 51 and 59 percent respectively. The Central Bank has made considerable effort3 to maintain control of the growth of monetary aggregates by setting limits on the growth of net domestic assets of the Central lank and on the growth of reserve money. In addition, the success of the effort required that the reserve money multiplier remained at about 2.3. However, during 1984 commercial banks sold large amounts of foreign exchange to the Central Bank which increased the amount of reserve money, while the reserve money multiplier rose as the public increased deposits at commercial banks. In response, the authorities took several steps during 1984-85 to tighten monetary control. They (i) lowered the Central Bank buying rate for foreign exchange, thus discouraging the sale of foreign currency by commercial banks to the Central Bank; (ii) introduced compulsory reserve requ.- rements for foreign exchange deposits; (iii) raised the liquidity reserve requirement on commercial banks from 10 to 15 percent of their deposit base; (iv) absorbed part of the liquidity in the system by issue of large volumes of Treasury bonds (about TL1,200 billion) mainly to financial institutions; and (v) curtailed the rediscounts of selective credits. Despite these efforts the reserve money rmultiplier still rose to nearly 2.5 and the growth of money supply remained high, as shown below; Monetary Developments (TL billions) ________ 1982 1983 1984 1985 (Sept.) 1. Broad Money (M2) 2,306 3,018 4,754 6,908 Growth over previous year (%) 31 57 64 2. Broad Money (M2X) 2,324 3,041 5,275 7,775 Growth over previous year M%) 31 73 74 Net Domestic Assets of the Central Bank Credit to public sector 585 634 730 2,604 Credit to private sector 395 604 543 312 other items 2 87 192 64 3. Net Domestic Assets 982 1,325 1,465 2,980 4. Net Foreign Assets -39 -43 447 -186 5. Reserve Money (3+4) 943 1,282 1,912 2,794 Reserve Money Multiplier (1!5) 2.45 2.35 2.49 2.47 Source: IMF staff-estimates.  -7- 2.09 The main reason for high rates of growth in broad money appears to be the Central Bank's inability to curtail the growth of reserve money as a result of large increases in Central Dank credit to the public sector. In particular: (i) Central Bank advances to the Treasury, to refinance publicly held Treasury bonds; (ii) Central Bank credit to the Treasury to consolidate the debt of SEEs to the Central Bank; and (iii) Central Bank credit to the Soil Producte Office (TMO) to finance agricultural purchases. Another reason for the rise in the reserve money multiplier was the gradual reduction in the level of compulsory reserve deposits required from commercial banks (the reserve ratio) from 25 to 19 percent of deposits. To offset the impact of the lower reserve ratio the Central Bank steadily decreased the interest paid on reserve deposits from an annual rate of about 25 percent in early 1985 to 5 percent as of December 1985, and finally stopped payment of interest on reserve deposits from January 1, 1986, which helped to slow the injection of liquidity into the system. Inspite of all these efforts, the high growth of M2 during 1985 posed a considerable liquidity overhang as of December 1985. Considering the above, it does seem that: (i) monetary growth was higher than the dictates of inflation control warranted; and (ii) a tighter monetary program will be needed in 1986 and probably in 1987 as well. The Government's policies are taking account of these concerns, which will be monitored closely by the Bank as discussed in para 2.14. These conclusions support the assessment that the financial sector will continue to function under difficult, though improving circumstances during 1986-87. 2. The Export Drive 2.10 Export sustainability is the key to the success of Turkey's develop- ment strategy. The growth of exports projected for the period 1985-90 (8.6 percent) is consistent with the trade policies undertaken by the Government. However, other conditions will be necessary to sustain export growth, inclu- ding: (i) the continuation of favorable demand conditions for Turkey's exports, particularly in the Middle East; 1/ and (ii) the undertaking of required in- vestments in export industries that are approaching full capacity utilization. The private sector is expected to play a key role in supporting export growth and employment. The Fifth Plan calls for a significant increase in private fixed investment during the 1986-89 period (about 10 percent on average per annum), as compared to the dismal growth of -6 percent per annum recorded during the 1979-83 period. The trend has since been reversed in 1984 when private fixed investment grew by 7.1 percent, and in 1985 when it is estimated to have grown also by 7.1 percent. Nevertheless, the Fifth Plan target appears formidable and its attainment will critically depend on the reform of the financial sector and on stabilizing inflation. Sustained actions are needed in the financial sector to reduce the current high real interest rates for aon-preferential borrowing (currently 30 percent p.a.), reduce the high cost of financial intermediation, address the high level of non-performing loans, 1/ To take account of the recent decrease in oil prices, growth of Turkey's exports to the Middle East has been scaled down in the Bank's medium-term projections, described in paras 2.12-2.13, although projected growth in exports to OECD countries is likely to offset this to some extent.  -8- increase the availability of medium- and long-term industrial lending parti- cularly by the commercial baAks, and to develop new financial services and instruments to meet the needs of Turkish exporters. Under the loan, the Government has therefore agreed to introduce new financial services, such as medium- and long-term export credit and export credit insurance to sustain the export drive. 2.11 If the level of investment in the private manufacturing sector were not to pick up the slack in the demand for credit, the result would be more modest growth of the financial system. On the other hand, the financial system could benefit, at least temporarily, from a relatively slow growth in demand for long-term investment resources, as available funds could be employed in higher-yielding, short-term trade credit. Over the medium-term, however, the lack of growth if the borrower base will inevitably affect the growth of the- financial system. The lending and economic/sector work of the Bank over the next five years would focus on assisting Turkey to revitalize the investment climate and its exports. C. The Outlook for 1986 and Beyond 2.12 The Bank's medium-term projections indicate the need for a conti- nuation of the stabilization program well into 1987, implying a lower GNP growth rate than the average 6 percent planned for the initial years of the Five-Year Plan. Indeed, it may not be realistic to aim for GNP growth of above 6 percent until the second half of the Plan period. This approach is in line with Government thinking, as reflected in the revised program implemented in 1985 and in the revised 1986 program. The reviced 1985 program and the proposed 1986 program were reviewed by the Bank, and the 1986 proposals have been incorporated into the Bank's medium-term projections for Turkey which are summarized in the table below. The projections highlight the concern that Turkey's creditworthiness could be put at risk if the Government were to relax stabilization policies thus undermining the foundation for sustainable growth. 2.13 The difficulties the authorities have experienced in achieving fiscal balance, and controlling monetary expansion, suggest that no matter how suc- cessful liberalization policies are in improving the functioning of the finan- cial system, the achievement of both high economic growth and disinflation aimed at in the Plan may be overly optimistic. Thus, the Bank projections indicate a lower GDP growth than the 6 percent contained in the plan, with a target of 5.7 per annum on average, based on a low of 5.3 percent per annum during 1986-87 and a high rate of 6.0 percent per annum during 19d8-90. Inflation is assumed to decline to 30 percent in 1986, at a more slow pace than the Government predicts, unless more drastic steps are taken. However, an inflation target of 18 percent for 1990 appears feasible. The implications for the financial sector of this assessment are: (a) a slower growth in time deposits compared to 1984-85 due to the need to curb the growth of broad money (M2) and, (b) a slowing down of the Government's borrowing program as a result of the reduction of the budget deficit. The consequences of these developments could be towards lower interest rates in general. On the other hand, maintenance of a tight monetary policy and curtailment of domestic demand as part of the inflation control program could maintain an upward pressure on lending rates, though not necessarily at the current high real levels.  -9., 2.14 As a part of its ongoing economic work, the Bank will monitor the developments in the macro-economy on a regular basis, and satisfactory per- formance of the macro-economy will be a major prerequisite for the release of the second tranche of the loan. The principal indicators which will be moni- tored will be those which relate to: (i) inflation control (Budget deficit/ GNP, growth of money supply; (ii) balance of payments (BOP deficit, growth of exports and debt service ratio); (iii) public investment (ratio of public sector/private sector investment, SEE profits/GNP, public sector borrowing requirements/GNP); and (iv) the growth of private investment, especially-in the manufacturing sector. The targets against which the indicators will be monitored will be those derived from the Bank's projection in the table below. TURKEY - Selected Macro-Economic Indicators Actual Est. Projected 1984 1985 1986 1987 1988 1989 1990 Balance of Payments (In Millions of US$) Exports (Goods) 7,134 7,959 8,876 10,470 12,406 14,731 17,481 Imports (Goods) 10,757 11,613 12,408 14,049 16,046 19,001 22,466 Workers' Remittances 1,791 1,694 12,321 2,437 2,535 2,636 2,742 Current Account Balance -1,407 -1,013 -718 -416 -213 -499 -809 Debt Servicing -2,906 -3,890 -4,163 -4,275 -4,660 -8,868 -5,176 Ratios: Curr. Acct. Deficit/GDP 2.9 1.9 1.2 0.6 0.3 0.6 0.9 Debt Service/Exports GNFS & Worker's Remittances 28.0 33.0 31.4 28.1 26.5 23.9 21.9 Output (Real Growth Rates it, % GDP 5.8 5.1 5.1 5.5 5.7 6.0 6.1 (of which value-added): Agriculture 3.7 2.8 3.0 3.0 3.0 3.0 3.0 Industry 9.3 6.6 6.8 7.0 7.3 7.6 7.8 Services 5.2 4.8 5.2 5.4 5.6 6.0 6.0 Fixed Investment (Real Growth Rates in % Total Private Investment 7.1 7.1 7.4 10.3 10.4 10.6 10.9 Manufacturing Investment 4.5 -2.0 11.0 13.8 10.4 10.6 10.9 Public Finance (in %) Budget deficit/GNP -4.9 -2.2 -1.4 -0.5 -0.3 0.0 0.2 SEE profits/GNP 1.0 1.5 1.0 1.5 1.4 1.5 1.5 Public sector borrowing requirement/GNP -7.9 -5.1 -3.7 -3.9 -3.8 -3.4 -3.2 Public Investment/Total fixed investment 60.0 61.3 57.9 56.4 54.9 53.4 51.8 Memo Item: Wholesale Price Index (12 months average change in %) 50 43 30 25 20 20 18 Source: Bank staff estimates.  - 10 - CHAPTER III2 THE FINANCIAL SECTOR 3.01 The structure and performance of Turkey's financial sector has been markedly affected by two major developments during the last six years, These are: (i) the liberalization and subsequent rise in deposit rates, and (ii) the growth of Government borrowing. The rise in deposit rates to positive real levels has deepened the financial sector and also brought about major changes in the composition of money supply. These changes have in turn affected the cost and the manner in which the Government has financed the budget deficit. The Government's recourse to borrowing at market rates, as opposed to borrowing from the Central Bank to finance the budget deficit has also brought about changes in the functioning of the financial system. These developments are described in this chapter, along with the issues now requiring attention, and the manner in which they are proposed to be addressed under the reform program. A. Structure, Depth and Growth 1. Structure 3.02 The financial system of Turkey consists of (a) the Central Bank and the commercial banks; (b) the development banks; (c) the social security system; (d) insurance companies and credit cooperatives; and (e) the securities market. Although, Government incentives and the sale of Government bonds have encouraged the development of a more active securities market in the past few years, commercial banks still dominate the financial system. In the early 1980s, commercial banks accounted for about 65 percent of the total domestic resources mobilized by the financial system, the Central Bank for 20 percent, the social security system for 10 percent and other institutions for 5 percent. The social security system has become less significant, as its share in the financial system declined steeply from 23 percent in the early 1970s to less than 10 percent in 1983 as a consequence of erosion by high inflation of the real value of its outstanding assets. Domestic bonds issued by the development banks (DYB, TSKB, Desiyab, etc.) accounted for a small proportion of the total domestic assets in the Turkish financial system as shown in the following table. Structure of the Turkish Financial System (in percent of total financial assets) 1970 1981 1983 1985 (Sept.) Central Bank 16.4 21.5 18.2 16.5 Commercial Banks 52.2 64.0 66.6 69.2 Development Banks 6.3 2.4 4.0 4.0 Social Security 22.6 10.1 8.8 7.7 Others 2.5 2.0 2.4 2.6 Total 100.0 100.0 100.0 100.0 Outstanding Domestic Instruments (In billion T.L.) 75.5 2,538.0 5,168.4 13,436.3 (As percent of GDP) 54.0 40.0 47.5 48.7 Source; Mission estimates.  - 11 - 3.03 Total domestic resources of the financial system declined rapidly from 54 percent of GDP in 1970 to 40 percent in 1981 as the return on financial assets became highly negative in the late 1970s due to low deposit rates under conditions of high inflation (see Chapter IV). The liberalization of deposit interest rates in July 1980, (see below) however, restored returns to positive levels and helped to raise the value of total financial assets to 48.7 percent of GDP in 1985. The interest rate reform benefitted mainly the banking sector whose share of total resources in the financial system increased to 69.2 per- cent in 1985. 2. Death of the Financial Sector 3.04 As stated at the outset, a major objective of financial sector reform is to deepen the financial system by bringing the bulk of capital accumulation into the formal financial system, thus to improve resource allocation. The K2/GDP ratio is indicative of the absolute size of the banking system in- cluding the Central Bank, and of the stock of liquidity available. This ratio is generally between 30-35 percent in middle income countries. In the case of Turkey, frequent changes in the Government's interest rate policy have affected the ability of banks and other institutions to mobilize domestic resources. Consequently, the depth of the Turkish financial system, as measured by the M2/GDP ratio, has fluctuated widely over the past 15 years as shown in the following table. Depth of the Financial Sector (TL billion) a/ 1970 1980 1981 1982 1983 1984 1985 (Sept.) Ml 30.5 569.1 784.6 1,012.2 1,436.7 1,810.9 2,313.4 Quasi Money 7.4 117.7 428.2 995.0 1,291.8 2,390.7 4,036.2 M2 37.9 686.8 1,212.8 2,007.2 2,728.5 4,201.6 6,349.6 Ml/GDP (X) 210 13.2 12.2 11.8 12.5 9.9 8.3 M2/GDP (%) 26.1 15.8 18.9 23.4 23.8 22.9 22.9 a/ Quarterly geometric averages. Source: Mision estimates. 3.05 The substantial rise in the M2/GDP ratio in 1981-82 was due to the effective lifting of ceiling on deposit rates in July 1980. Deposit interest rates rose substantially and have remained generally at positive levels in real terms thereafter (see paras 4.02 - 4.05). In response to the interest rate reform, M2 grew on average by 58 percent per annum in the period 1981-83, while inflation averaged 33 percent per annum. The financial depth achieved as a result of the interest rate reform brought the M2/GDP ratio from 15.8 per- cent in 1980 to 22.9 percent in 1985, thought it failed to bring the M2/GDP ratio back to its 1972-73 level of 27.2 percent. It should be noted however that the M2 figures exclude holdings of Government bonds outside the banking  - 12 - sector as well as foreign currency deposits by residents. The latter have grown vety rapidly in recent months and reached nearly US$2.0 billion by the end of 1985 representing approximately 2.8 percent of GDP. Taking into account foreign currency deposits And Government bonds held outside the banking system, the size of the financial system is probably about 26-27 percent of GDP at present. This is still rather low for a country at Turkey's stage of economic development but it represents a considerable improvement over the of 1980. 3. Growth and Shares of Credit 3.06 Total credit extended by the financial sector - including the Central Bank, deposit money banks and investment and development banks -- has grown from TL 796 billion in 1979 to TL 5,851 billion in September 1985, excluding holdings of Government bonds by commercial banks (see Annexes 2, 3 & 4). This 45 percent p.a. increase in nominal terms has been characterized by very subs- tantial fluctuations in real terms. During 1980 the volume of credit out- standing fell by 19.2 percent in real terms, and has slowly increased there- after. The sharp fall in 1980 has resulted in a decline in credit in real terms from TL 796 billion in 1979 to TL 606 billion in September 1985 (in 1979 prices), a decline at a compounded annual rate of 4.6 percent. The sharpest decline has been in direct credit extended by the Central Bank to the Govern- ment, as the Government has resorted increasingly to financing the budget deficit by issue of bonds which are purchased mostly by commercial banks, rather than by borrowing from the Central Bank. Consequently, holdings of Government bonds by commercial banks increased from only Ti 32.3 billion in 1979 to Ti 1,080 billion in 1985. If commercial bank bond holdings are included in credit, total credit extended by the financial system would have declined at a smaller rate of 2.4 percent in real terms. The rising volumes of Government bond issues which have been purchased by commercial banks have been partially substituting for credits to the private sector. While fears of crowding out the private sector may be excessive, the following table shows that the share of the private sector in total domestic credit declined in 1984-85 following a steady increase since 1980. Domestic Credit Outstanding and Shares (as percent of GDP) ___________ -1979 1980 1981 1982 1983 1984 1985 (Sept.) Net Claims on Government 8.6 10.9 10.4 10.8 12.0 18.8 20.9 Claims on Public Enterprises 7.2 6.6 6.0 5.4 3.6 2.0 1.4 Claims on Private Sector 16.5 12.9 15.3 18.3 20.2 14.6 15.6 Total Domestic Credit 32.3 30.4 31.7 34.5 35.8 35.4 37.9 Share of Government in Total Domestic Credit (X) 26.6 35.9 32.8 31.3 33.5 54.9 55.1 Share of Public Enterprises in Total Domestic Credit (%) 22.3 21.7 18.9 15.7 10.1 5.5 5.3 Share of Private Sector in Total Domestic Credit (%) 51.1 42.4 48.3 53.0 56.4 42.6 39.6 Source: Mission estimates.  - 13 - B. Impact of Interest Rate Reforms 3.07 In addition to the effect on the structure, depth and growth of the financial system, the liberalization of interest rates have also produced other changes, including (i) changes in the composition of money supply, (ii) shortening of deposit maturity, (iii) changes in the financing of the budget deficits, and (iv) changes in the role of the Central Bank. These changes are discussed below. 1. Changes in the Composition of Money Supply 3.08 The composition-of money supply has changed during 1980-85 because of the large differentials in the yields offered on the various types of financial instruments. Interest bearing time and savings deposits (M2-Md)increased rapidly from 2.6 percent of GDP in 1980 to 6.7 percent in 1981 and 13.0 percent in 1984. There was also a shift within money supply from non-interest or low interest bearing instruments (i.e. currency and demand deposits) to interest bearing time and savings deposits. As a consequence, the ratio of M1 fell, as a percentage of GDP, from 17.3 percent in 1979 to 9.9 percent in 1984. Trends in the Composition of Money Supply (in percent of total) 1979 1980 1981 1982 1983 1984 1985 (Sept) Currency 28.3 26.0 35.3 18.1 15.9 16.7 15.0 Sight Deposits 56.6 56.9 44.6 32.3 36.8 26.4 21.4 Time and Savings 15.1 17.1 20.1 49.6 47.3 56.9 63.6 Broad Money (M2) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source; Mission estimates. 3.09 In aggregate, sight, time and savings deposits have increased their share of monetary assets from nearly 72 percent in 1979 to about 88 percent in 1985. On the other hand, currency issued by the Central Bank has declined from 28.3 percent to 15.0 percent. This change in the composition of money supply has increased the relative importance of commercial banks within the financial system. Until 1980, the share of non-interest (currency) or low- interest (sight deposits) bearing instruments in total money supply was more than 80 percent, an extremely high proportion for a country at Turkey's stage of development. By 1985, however, they accounted for 36 percent only, wbile time and savings deposits had risen from 15 percent to 64 percent. The reason for this dramatic change is the large differential in the comparative yields of these financial instruments. Since 1981, time and savings deposits have been yielding nominal interest rates of approximately 50 percent p.a. The rapid fall in the share of currency within money supply reflected the high oppor- tunity cost of holding zero-yielding cash balances compared to a 50 percent yield on time and savings deposits. Holdings of sight deposits have declined in relative terms for the same reason. The interest rate on sight deposits has been kept at a very low level of 5 percent which made these holdings barely more attractive than currency. As a consequence their share of money supply has been cut in half from 56.6 percent in 1979 to 21.4 percent in 1985.  - 14 - 2. Changes in Deposit Cost and Maturity 3.10 The drastic changes in the composition of financial assets have increased the average cost of bank deposits rapidly. As low cost sight deposits declined as a proportion of bank deposits, the increasing share of time deposits carrying higher interest rates has pushed up the average interest cost of bank deposits from about 30 percent in 1982 to over 40 percent in 1985. a rate close to the rate of inflation. These cost increases have put pressures on banks to improve their efficiency. Many uneconomic brancties, principally in rural areas, which were able to operate profitably because cneap sight deposits offset their high administrative costs, became unprofitable when the average interest cost of deposits increased drastically. In response to these develop- ments, commercial banks have begun to stronger efficiency measures, including closing down their least profitable branches. This is a positive development that should result in reduction of intermediation costs. The rising interest cost of bank deposits ha.s also caused a significant increase in the lending rate of banks. Similarly, the opportunity cost to the banks of the compulsory liquidity and reserve requirements imposed by the Central Bank has been rising as the cost of mobilizing deposit rose. In order to mitigate the impact of these requirements on the lending rates of commercial bataks, the Central Bank has gradually reduced the level of reserve requirements, which will decline to 15 percent of deposits by September 1986. 3.11 In the past few years, these has been a rapid shortening of the average maturity of all types of bank deposits from 8.8 months in 1979 to 3.4 months by the end of 1984. Excluding demand deposits, the average maturity of time deposits has declined from 32.6 months in 1979 to 6.1 months in 1984. This development resulted from the combination of high and volatile inflation since 1980 with a system of fixed rather than floating deposit rates. In a context of uncertainty as to the course of inflation, depositors have become extremely reluctant to commit funds for more than short periods of time. In addition, the effective compounded yield set by the Government on 12 month deposits has been less than on 3 or 6 month deposits reflecting the expectation that inflation will decline. The increasingly short maturity of bank deposits puts a serious constraint on the ability of banks to lend Turkish Lira funds on a long-term basis. This would only be possible if banks were able to adjust the rate they charge on long-term loans to reflect the average maturity of deposits, that is, if they moved to a system of floating rates indexed to the average cost of commercial bank deposits. The Government is not in a position to force the banks to do so, as banks are free to set their lending rates, except in respect of loans rediscounted with the Central Bank. Furthermore, at present, the Government is reluctant to introduce a system of fully floating or variable rates in respect of rediscounted loans as it may induce inflationary expectations. The Government has however recognized the difficulties caused in financing of investments in the absence of medium- and long-term lending and has agreed to design and introduce interest rate mecha- nisms on such loans designed to reduce the interest rate risk to both borrowers and lenders and thus to encourage medium- and long-term lending.  - 15 - 3. Changes in the Financingi of the Budget Deficit 3.12 The sources of financing of the Government's budget deficit have changed as a result of the change in the composition of monetary assets. As currency issued by the Central Bank (which earns no interest), declined as a proportion of M2 and also as a proportion of GDP from 5.8 percent in 1979 to 3.8 percent in I984, the ability of the Central Bank to expand its assets without fueling inflation declined as well. Even a partial monetization of the public sector deficit was bound to have some inflationary impact. This consideration led the Government to increase its reliance on bond issues principally to commercial banks as a means of financing the budget deficit. While the issue of such bonds could have a favorable impact on the inflation control program, as it withdraws liquidity from the system, the lags of such liquidity contraction in 1985 has meant that its impact is beginning to be felt only recently. It is expected that during the next few years, a secondary market for Government securities will be developed, with the Central Bank undertaking open iuarket operations. This development would create an instru- ment of monetary control which would improve inflation control. 4. Changes in the Role of the Central Bank 3.13 The interest rate reform of the early 1980s has also had consequences which went far beyond the change in the composition of financial assets. The changing composition of financial assets in Turkey has caused structural changes in the role of the Central Bank relative to commercial banks within the financial system. In order to curtail its intervertion in the economy, the Central Bank has drastically cut its credits to public sector enterprises and to other financial institutions, mainly the commercial banks through its redis- counting schemes (see Chapter IV). The net increase in Central Bank claims over the 1984-85 period has been largely due to increase in claims on the Government for financing the budget deficit. In response to the decline in the ratio of currency to GDP and the reduction in compulsory reserve requirements, the Central Bank has cut the volume of its credit to public sector enterprises also, along with reduction in rediscounting of credits by commercial banks. In practice, the net flow of resources from the Central Bank to commercial banks has become negative as repayments of Central Bank advances exceeded the level of new rediscounts. Outstanding Central Bank rediscounts to banks were cut in half in nominal terms between 1983 and 1984. This reduction in Central Bank credit to the commercial banks has been highly beneficial as the reduction in the proportion of such credit, generally consisting of preferential credit at subsidized interest rates has meant an increase in noni-preferential credit at market rates. The reduction in the volume of Central Bank credit and reserve requirements will allow the banks to reduce the high seal interest rates on non-preferential credit. C. Issues in the Financial Sector 3.14 The issues in the financial sector which are being addressed in connection with the proposed project relate to the twin objectives of financial sector reform: improved resource mobilization and, improved resource allocation. Progress in meeting these objectives requires that measures be taken to address issues in the areas of (a) financial policies, (b) financial instruments, and (c) financial institutions.  - 16 - (a) Financial Policies 3.15 The major policy issues that appear to require resolution are: (i) fiscal policy (reduction of fiscal deficit, inflation and crowding out of the private sector); (ii) monetary policy (reserve and liquidity requirements resulting in high lending rates); (iii) lending interest rates (high inter- mediation margins and high cost of credit); and (iv) selective credit policies (reduction of selective credits and subsidies on credit to improve resource allocation). (b) Financial Instruments 3.16 The major objective of future reforms should be to develop availabi- lity of instruments for both short-term working capital and for long-term investment resources. This requires adoption of measures to msrge growth of (i) treasury bills, and (ii) commercial paper at the short end of the maturity structure and (i) corporate bonds, (ii) corporate equities, and (iii) treasury bonds at the longer end of maturity. Cc) Financial Institutions 3.17 Considerable strengthening of financial institutions is required, and there is also a need for new institutions and services. These objectives require strengthening the banking system by: (i) improving supervision; (ii) standardizing accounting and audit; and (iii) staff training. Secondly, the money and capital markets have to be developed by: (i) improving the regu- latory framework; (ii) improving financial disclosure requirements; and (iii) deepening the interbank market. 3.18 The relationship of these issues with the overall objective of financial sector adjustment and finally with the role of the financial sector in the macro-economy is complex and very close. The chart opposite depicts these issues within the overall framework of financial sector adjustment. D. The Medium-Term Adjustment Program 3.19 These overall objectives listed above are necessarily ambitious, and can only be reached over the medium-term. The Government has committed itself to implement the reform program within a medium term framework described in its Statement of Financial Sector Policies-1986, which is annexed to this report (Annex 1). While the expected results of the mediumrterm reform program can only be delineated in indicative terms, Turkey's financial system is expected to exhibit characteristics increasingly similar to those of the financial sys- tems in other middle income modernizing economies, and to develop in the fol- lowing directions: (a) financial depth, measured by the percentage of M2 to GDP, would increase from the present 20-25 percent to 30-35 percent; (b) the intermediation margins of commercial banks would decline to about 3-5 percent of assets from the present level of 7-10 percent; (c) the share of long-term instruments in financing of investments would increase to about 7-10 percent from the present level of 3-4 percent; and (d) the issues of corporate bonds would increase by about 50 percent (because of the low base level of such issues at present), equity issues by about 15 percent and the volume of trading in the interbank market by about 30 percent, all in real terms. Progress in these directions-would be monitored with the help of key financial sector indi- cators listed in Annex 5.  - 17 - FINANCIAL SECTOR ADJUSTMENT RELATIONSHIPS AND MEASURES Fiscal Policy: Reduce inflation and crowding out of private sector. Monetary Policy: Reduce reserve and liquidity requirements, to reduce Financial high cost of lending. Policies Interest rates: Positive deposit rates to increase depth of financial sector. Selective credits: Reduce subsidies on Resource credit to improve resource allocation. Mobilization Short-term Instruments: encourage secondary markets for Treasury bills and commercial paper. FINANCIAL Financial SECTOR -- Instruments Mediumr-term Instruments: Develop ADJUSTMENT Treasury bond market, corporate bond market and equity market. iCentral Bank: Strengthen bank surveillance capacity. Resource Allocation Bank Examiners' Board: Reorient examination procedure. Commercial Banks: Standardize accounting, introduce external audit, and train staff. Financial ,- Institutions Capital Markets: Improve regulatory framework and functioning of Capital Markets Board. Money Markets: Deepen interbank market. Equities Markets: Improve financial disclosure requirements.  - 18 - 3.20 The proposed loan would achieve major progress towards the needed reform objectives by supportins; critical actions which lie in the core area of interest rates, selective credit policies, accounting and audit of commercial banks, and audit of corporat ons with publicly issued securities. Under the loan, the institutional capacities of the Treasury, the Central Bank, the Capital Markets Board, the Commercial Banks and supervisory agencies would be upgraded by provision of technical assist..nce. Finally, the proposed loan would support actions to introduce new financial services such as medium-term export credit and export cretdit insurance which would increase in importance over the medium-term. The loan would thus touch upon and address issues covering the major elements of the financial systems. The linkage between sector reform objectives, sector issues and reform measures to be implemented under the loan is shown in Annen 6. 3.21- In sum, in the proposed loan is in support of a systematic reform program which, when implemented, would accelerate the transformation of the Turkish financial system from a tightly regulated, fragmented and generally non-competitive system into a market oriented and flexible system. A wide ranging set of measures, which the Government is committed to implement, have been designed to ensure that the reform process is comprehensive and self- sustaining. The full listing of the reform measures agreed with the Govern- ment is shown in the Attachment to the Statement of Financial Sector Policies (Annex 1, Attachment II). CHAPTER IV FINANCIAL POLICIES FOR STRUCTURAL CHANGE 4.01 Apart from causing changes in the structure of the assets of the financial sector, the liberalization of the deposit rates have also affected lending rates and the effective cost of credit. In an environment of high and fluctuating inflation, the maintenance of positive deposit rates in real terms, together with fairly high reserve and liquidity requirements has produced an effective cost of borrowed funds which is perhaps unsustainably high. The impact of these high costs on the corporate sector and on the portfolios of financial institution is dealt with in a subsequent chapter. The purpose of this chapter is to set the framework within which sector policies -- i.e. those dealing with: (i) deposit rates; (ii) lending rates; (iii) selective credit; and (iv) preferential credit -- are formulated. The changes that have occurred in this policy area, and the policy changes envisaged under the sector adjust- ment program supported by the proposed loan, are then set out. A. Interest Rates 1. Deposit Rates 4.02 Until 1980, Turkey followed a policy of fully-managed interest rates. Deposit and lending rates were determined by the Government. Effective July 1, 1980, interest rate ceilings on bank deposits and loans were abolished, except for a ceiling of 5 percent on sight deposits. Subsequently, deposit rates reached highly positive levels in real terms as competition for deposits in-  - 19 - creased among banks and money brokers. In response to excessive competition and the collapse of a major non-bank financial intermediary (see Chapter VI), the Government reinstated deposit interest rate ceilings in January 1983, but these ceilings were set at positive real levels. In December 1983, lending rates changed by financial institutions on non-preferential credits were freed. The Central Bank was empowered to review and adjust if necessary, the ceiling on deposit rates at least quarterly. Since then, deposit rates have been maintained at positive real levels except on sight deposits. 4.03 The Government's decision to maintain ceilings over deposit rates was motivated by a lack of confidence in the ability of banks to operate in a free market environment. The financial crisis of 1982 was largely a resulL of sys- temic inefficiencies. Since then, measures have been adopted to improve the efficiency and to increase competition within the commercial banking sector. The Government has encouraged the establishment of. new financial institutions and the creation of new financial instruments. The Government's ultimate objective is to liberalize all deposit rates fully, once the financial system has improved its efficiency and robustness. At the present time however, the effective cost of deposit resources is largely determined by Government deci- sions on maximum permissible deposits yields and other regulatory requirements such as compulsory reserves and liquidity requirements. With respect to foreign currency deposits by Turkish residents, banks have been authorized to determine yields freely. 4.04 Since 1983, interest rates on 3, 6 and 12-month deposits have ranged between 45 percent and 53 percent. At times, shorter maturities paid higher yields, but since July 1985 the 6 and 12-month deposits have the highest yields. The yield structure on bank deposits has been kept unchanged since August 1, 1985. 1/ The following table shows the nominal yield on the various maturities and the net of tax yield to depositors taking into account the 10 percent withholding tax on interest income. Comparison with the December 1984 - December 1985 rate of inflation (WPI) of 38 percent shows that real after tax yields were significantly negative on sight deposits (-24.2 percent) but generally positive for time deposits with real yields reaching 12.1 percent for 6 month maturities. l/ With effect from March 1, 1986, the nominal interest rate ceilings on 3-month and 6-month deposits were reduced by 1 and 2 percentage points respectively. More recently, from May 1, 1986 nominal interest rate ceilings on 3, 6 and 12-month deposits have all been reduced by 3 percentage points. In addition, the interest rate ceiling on sight deposit has been raised to about 12 percent and with a further rise to about 24 percent to take effect on August 1, 1986. These changes are designed to establish a more appropriate yield-curve and deposit structure, thus improving deposit mobilization.  20 - Deposit Yields (As of January 1, 1986) Effective Annualized Effective Annualized Nominal yield before yield after Yield Withholding Tax Withholdin] tax Sight Deposits 5 % 5.11% 4.60% i-Month Time Deposits 35% 40.52% 36.47% 3-Morth Time Deposits 45% 52.31% 47.08% 6-Month Time Deposits 50% 55.62% 50.06% 1-Year Time Deposits 55% 55.00% 49.50% Source; Central Bank. 4.05 While real net-of-tax yield of 12 percent may seem excessive, it is very difficult for the banks to offer lower net-of-tax yields on Turkish Lira time deposits below 9 percent real since foreign cur:ency deposits effectively yield that return, if not more. At lower deposit rates, the banking system may not be able to mobilize the domestic resources needed to maintain the growth of the economy while financing the current levels of Government deficits. Nominal yields on deposits of comparable maturity in US dollars and Deutsche- marks were about 7 percent and 4 percent respectively in 1985. Taking into account the depreciation of the Turkish Lira, against the US dollar and the Deutschemark, effective yields including foreign exchange gains on dollar and DM deposits reached 39 percent and 72 percent respectively. Thus, it was most profitable for Turkish depositors to invest in DM deposits in 1985. Overall, it seems that the 50 percent nominal yield on 6-12 months TL deposits fits midway between effective yields on DM and US dollar deposits, and is at an appropriate level in terms of domestic resource mobilization concerns and alternative opportunities available to savers. 2. Lending Rates 4.06 When lending rates were regulated by the Government, it was common practice for the banks to require eompensating deposit balances as a means of raising effective lending rates. By and large, this practice has been discontinued due in part to greater competition and, more importantly, to the deregulation of lending rates. At present, lending rates charged by commercial banks on short-term credit range between 53 and 64 percent. A nominal rate of 60 percent represents an effective rate of about 75 percent after quarterly compounding of interest payments. Lending rates for medium-term investnent credit differ considerably according to purpose and source. Key lending rates by sector are shown in the following table. 4.07 These lending rates do not represent the final cost to the borrower in all cases. The financial transactions tax, bank commisions and contri- butions to the Resource Utilization Support Fund (see para 4.16) which are added to the base interest rate in several of the above categories of credit raise the effective costs by about 6 percentage points. Most of the rates applicable to medium- and long-term loans are fixed for the life of the loans. The rates applicable to long-term housing loans (usually 15 years) are  - 21 - varied according to the size of the housing unit. The smaller units (below 80 sq. m) being financed at interest rates nearer the lower end of the 15-40 percent interest rate range. The Government is reluctant to raise housing credit interest rate at present because it regards provision of mass housing at affordable costs as an important part of its effort to alleviate the social costs of its adjustment program. As part of the Bank's economic and sector work, a study has been undertaken of housing finance, which is expected to be discussed with the Government later this year. 4.08 An analysis of interest rates weighted by the volume of credit out- standing in the relevant category of credit is provided in Annex 7. The volume weighted interest rate has risen from 36 percent as of December 31, 1982 to 42 percent by end of 1983 and further to over 51 percent by September 1985. An analysis of the variance of the interest rates from the average of 51 percent shows that the coefficient of variance has slowly declined, indicating that interest rates are clustering around this level. Based on the annual average inflation rate of 47 percent up to Sept. 1985, the average interest rate in Turkey was 4 percent in real terms. As inflation declined to an annual average rate of 43 percent by end of 1985, the real interest rate on credit rose to a substantially positive level of 8 percent. Key Lending Rates for Investment Credits (in percentage points, TL denominated loans) 1983 1984 1985 1986 Type of Credit (June) (june) (August) (January) I. Manufacturing Investment Credit - Central Bank Rediscounted Loans 26 30 35 35 - FERIS a/ Loans - 26 35 35 1I. Agriculture Investment Credits - Investment Loans from TCZB 22 28 30-34 30-34 - Agro-industry Loans from TCZB 20-22 28 45 45 III. SSI - Artisans, Entreprenuers, etc. 22 24 26 30 IV. Tourism 15-30 15-30 15-30 35 V. Housing - Mortgage Loans from Emlak Bankasi and Mass Housing Fund 15 15 15-40 15-40 VI. SEEs - Investment Credits from DYB 21.5 21.5 35 35 VII. General - Commercial bank credit b/ 36 33-62 53-62 53-64 a/ Foreign Exchange Risk Insurance Scheme (see aras 4.18-4.20). b/ These are usually short-term, but frequently rolled-over. Source: Central Bank and Mission estimates.  - 22 - 4.09 As of the end of September 1985, two-thirds of the credit outstanding was at the highest interest rate of 61 percent. In addition, interest is generally charged at quarterly intervals. The effect of quarterly compounding raises the effective cost to about 75 percent, i.e. a real interest rate of over 40 percent. However, the real rate of 40 percent p.a. charged on short-term credits does not represent the average cost of borrowed funds in the corporate sector. The average cost of borrowed funds has indeed been rising in the past few years but is mitigated by some lower rates on preferential credits, as well as by the lower cost of short-term foreign currency borrowings. In 1985, the effective cost of a LIBOR based dollar borrowing was approximately 50 percent, which was significantly less than the 80 percent to 90 percent cost-of TL loans. The very high cost of Turkish Lira borrowings has significantly reduced demand for domestic credit. Banks have responded to this by investing liquid Ttrkish Lira assets in Government bonds. The proportion of foreign cur' cy denominated loans extended by domestic banks has also been rising as foreign currency deposits were growing. The resort to short-term foreign currency denominated borrowing poses considerable risks that short-term foreign currency debt might increase unmanageably. The Government has therefore imposed a 3 percent surcharge on non-export related foreign currency borrowing to curb this tendency. B. Determinants of High Cost of Credit 4.10 There are two main reasons for the extremely high level of non- preferential commercial banks lending rates. First, banks can only lend 66 percent of the deposit resources they mobilize due to compulsory liquidity and reserve requirements of 15 percent and 19 percent of the deposit base res- pectively. As a consequence the effective cost of the net loanable resources of banks is about 1.5 times the cost of deposits, with earnings on the liqui- dity deposits offsetting only part of this added cost. The second reason behind high lending rates is that banks, instead of lending, have the option of investing their loanable funds in virtually tax-free Government bonds whose net yield is equivalent to a before tax yield of about 70 percent p.a. 4.11 In February 1986, the weighted average cost of bank deposits (sight and time) was about 47 percent including mobilization coste. Net of yield on reserve and liquidity requirements, the cost of loanable resources (deposits minus reserve and liquidity deposits held in the Central Bank) was approxima- tely 57 percent p.a. as shown in the following table (see Annex 8 for details). The yield on reserve deposits has been sharply reduced by the Central Bank as apart of its monetary program, and payment of interest on reserve deposits has been stopped from January 1986. The planned reduction in the level of reserve deposits from 19 percent to 15 percent by September 1986 will result in some reduction of the cost of loanable funds in the next few months as shown below.  - 23 - Effective Cost of L.oanable Deposit Resources (in percent) As of 9/85 10/85 11/85 1186 2/86 4/86 6/86 9/86 Yield to depositors 37.1 37.1 37.1 37.1 37.1 37.1 37.1 37.1 Withholding tax 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 Admin. costs 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.0 Total cost 47.3 47.3 47.3 47.3 47.3 47.3 47.3 47.3 Less: Yield on liquidity deposits 9.0 9.0 9.0 9.0 9.0 9.0 9.0 9.0 Less: Yield on reserve deposits 3.5 3.2 1.0 - - - - - Net cost of Funds 34.9 35.1 38.4 38.4 38.4 38.4 38.4 38.4 Cost of loanable funds a/ 53.6 54.1 56.6 58.2 57.3 56.4 55.6 54.9 A/ See footnote (e), Annexes 8 and 9 for method of computation. Source: Mission estimates. 4.12 The cost effect of reserve and liquidity requirements is even more dramatic when considering time deposits alone. In this case, the "all-in" cost of deposits would be about 62 percent p.a.. Net of yield on liquidity deposits (9.0 percent), the net cost of loanable deposits is estimated at 80 percent p.a (see Annex 9). In other words, banks need to charge a lending rate of at least 56 percent to break even on a weighted average basis (combining sight and time deposits). Based on the marginal cost of time deposits, the marginal lending rate must be at least 80 percent p.a. to ensure break even. 4.13 The Government is aware of the cost pressures discussed above, which keep non-preferential lending rates at a high level. Three types of measures have been agreed to create downward pressure on lending rates. First, reserve requirements will be gradually reduced from 20 percent in late 1985 to 15 per- cent in September 1986. The constraint in this area is that a tight monetary policy implies that the Central Bank cannot afford to lower the reserve requirements any further, since this affects the money multiplier and there- fore the liquidity injected into the economy. The second measure is to in- crease the attractiveness of lending to the private sector by increasing the taxation on income of corporations (including banks) arising from Government bond holdings. The Government obtained the authority to levy a withholding tax of up to 10 percent of interest income, It introduced a 3 percent withholding tax on interest income from holdings of Government bonds, but discontinued the tax temporarily due to some technical difficulties. The Government intends to reintroduce the tax as soon as the technical issues have been resolved. Higher taxes on income from holdings of Government bonds would make it comparatively more attractive for banks to make loans to the private sector rather than invest their liquidity in Government bonds. Thirdly, the Government has reduced the flow of rediscounted preferential credit (see below) from the Central Bank, with the notable exception of medium-term investment credits. This exception is designed to help maintain investment in  - 24 - the productive sectors which would otherwise be completely stifled by real lending rates of 35 percent or more. On medium-term rediscountable credits, the effective uominal cost is approximately 40 percent per annum at the present time. This level is appropriate given the need to maintain positive real-lending rates while keeping borrowing costs significantly below market rates on short-term commercial credits. C. Selective Credit Policies 1. Rediscounting of Credit 4.14 Turkey, in common with many developing countries, maintains a formal system of selective credits to encourage the development of higher priority sectors, such as agriculture, small scale industry and exports. However, in Turkey there are now no mandatory controls instructing banks to lend any given amount or proportion of their deposits to priority sectors. Rather, Turkey has relied on the Central Bank's rediscount facility to support the selective credit system, and to influence lending. The Government's policy regarding interest rates, as reaffirmed under the proposed loan, is to achieve positive interest rates for all selective credit to the productive sectors before the end of 1986. This has been reconfirmed during negotiations. 4.15 The current structure of rediscount rates are detailed in Annex 8, which range from 28 percent for small scale industries, 28 percent for agri- culture and 52 percent for the "general rate". The list appears to be very extensive, but in reality, after substantial rationalization of the scheme by the Central Bank in the past two years, there exist only five categories com- pared to more than 30 categories three years ago. Central Bank Rediscount Rates on Loans (As of January 1, 1986) Rediscount Rate Credit Category (in percent) (i) General Rate 52.0 (ii) Agricultural Sales Cooperatives 46.5 (iii) Industrial investment credit 33.0 (iv) Agricultural Credit Cooperatives 28.0 (v) Small Scale Industry and Artisans 28.0 Source: Central Bank. 4.16 The actual cost to the borrowers is higher than the rediscount rates listed above. The lending bank's commissions (1 to 2 percentage points), the  - 25 - contributions to the Resource Utilization Support Fund (RUSF), 1/ and in some cases, the 3 percent financial transactions tax are added to the rediscount rate. These "add-ons" result in a final cost of a rediscounted loan which ranges between 30 percent for agricultural credit coops. and 61 percent for general credit (see Annex 10). Even then the rates on agriculture credit rediscounts cannot be said to constitute lending at negative real rates, since the Central Bank only rediscounts a part of the loan amount, typically between 50 and 70 percent. The lending institution (commercial or development bank) is free to charge its own interest rate on the non-rediscounted part of the loan, which is typically around 65 percent. Thus the blended cost of a loan package can vary between 37 and 63 percent, depending upon the terms of the lending bank (see Annex 11 for details). 4.17 Due to the need to meet the limits to growth of net domestic assets of the Central Bank, in accordance with the targets of the Government's monetary program, the rediscount windows have been closed at various times, thus reducing the stock of rediscounted credit outstanding gradually. Substantial decreases in the flow of such credit over several quarters of 1984 and 1985 has now resulted in significant decline in the proportion of the stock of rediscounted credit in total credit, as shown below. The fact that redis- counted credit, which accounts for the bulk of preferential credit, amounts to only 5.2 percent of total credit outstanding as of September 1985 demonstrates the change that has occurred in selective credit policy over the last four years. Decline in Rediscounted Credit Outstanding (TL billion) As of the end of 1982 1983 1984 1985 (Sept) Total credit 2,668.5 3,426.5 4,231.8 5,851.3 Rediscounted credit 387.9 645.0 314.8 305.8 Redicounted/Total cre~dit 14.5% 18.8X 7.4% 5.2% Source: Mission estimates 17 The Resource Utilization Support Fund (RUSF) was introduced in December 1984 as a scheme to finance capital grants to investors as an incentive for investment. Grants ranging from 7 to 20 percent of the capital costs of a project considered to be of high priority are paid. The RUSF replaced the Interest Rate Rebate Fund (IRRF) which was a cross subsidization scheme used to lower the interest cost on certain types of credit. Under the IRRF, borrowers had to pay contributions at a rate of 10 percent of the base interest rate. Thus, a 50 percent interest rate would become 55 per- cent. The proceeds of the IRRF were allocated to subsidizing certain credits -- agriculture, small industry, and FERIS loans in 1984. During 1981-84 the IRRF was in balance, i.e. contributions matched subsidies. In 1984 the Government allocated TL 35 billion to the IRRF for future ope- rations which was transferred to the RUSF.  - 26 - 2. Foreign Exchange Risk 4.18 During the last five years, borrowers of loans denominated in foreign currencies and who carried the foreign currency risk in respect of the loans have suffered large losses due to the devaluations of the Lira. As a result, they became reluctant to borrow foreign currency loans, especially those with medium and long maturities. This naturally affected the investment climate. In response. the Government introduced a Foreign Exchange Risk Insurance Scheme (FERIS) in 1984. Under this scheme, the foreign currency liability of a bor- rower, who takes a mediumr- or long-term loan with a maturity of eight years or longer for investment purposes, is converted into a TL liability at the exchange rate prevailing on the date the loan is signed. The borrower then repays the loan in TL and pays interest at a fixed rate, currently 35 percent, (representing an effective rate of 42 percent after adding other changes), which is substantially higher than the interest rate applicable to foreign currency loans in nominal terms. The extra interest income is placed in the FERIS fund, which repays the foreign lender in -foreign currency. Thus, the foreign currency risk is transferred from the borrower to the FERIS fund in exchange for the borrower paying a higher nominal interest rate on the TL denominated liability. Any profit or loss resulting from the operation of FERIS accrues to the FERIS fund, which is in effect guaranteed by the Govern- ment. The FERIS interest rate, which is adjusted every six months is fixed so as to keep the FERIS fund in approximate balance over the life of the loans. 4.19 The Bank has generally discouraged the continued resort to a fixed rate foreign exchange risk coverage scheme, as this runs counter to the principles of economic liberalization which drive the Governments' program. Given the very limited prospect for private investment without such a scheme, the Government has indicated that it would not be prepared to eliminate the scheme until investor confidence, and a more stable inflation environment, was restored. In the circumstances, the Bank recommended and the Government has agreed, that the scheme should be designed to be self-financing, non- discriminatory, and catalytic. 4.20 The climate tor private sector investment in Turkey is still not very favorable. Private manufacturing investment is estimated to have declined by about 5 percent in real terms during 1985. The level of applications for investment approvals received by S0 remains very sluggish. The Government believes that FERIS should be continued during 1986. The framework under which the scheme now operates is largely similar to the original 1984 framework, but the need to make the scheme self-financing has been recognized by raising the interest rate from 26 percent to 35 percent, which results in an effective cost of 38-42 percent, and by extending the application of the current higher interest rate to undisbursed balances of loans signed in 1984-85. The Govern- ment has also confirmed that -the scheme would'be discontinued as soon as the private investment climate has revived, and has agreed to review the need for its continuance before the end of 1986. This review will take into account the prevailing rate of inflation, the cost of foreign currency borrowing from other sources available to prospective investors, and the level of private sector investment. The possibility of i-stroducing a floating rate option under the scheme to reduce the interest rate risk inherent in a fixed rate long term loan scheme, will be explored.  - 27 - D. Preferential Credit 4.21 Preferential credit is defined as credit carrying interest rates below the prevailing inflation rates. An estimate of the flow of preferential credit extended to the productive sectors of the economy can be used to throw light on the level of subsidy (financial and economic) in the system, and the trend in the volume of such credit can indicate the movement of the financial system towards market orientation. In order to measure the extent of preferential credit in the financial system, the inflation index most relevant to use is the change in the Wholesale Price Index over a 12 month period, i.e. the month- over-month index. The WPI change December 1985/December 1984 was 38.3 percent, which is used as the threshold level. All credit outstanding as of September 1985 extended at interest rates below this level is considered to be preferen- tial. For comparison of the cost of a particular category of credit with the -threshold level of 38.3 percent for 1985, the-final Coat -- not the rediscount interest rate -- is used, as that represents the cost to the borrower. Fol- lowing this methodology, the proportion of preferential credit outstanding to the productive sectors of the economy (i.e. agriculture industry, mining, tourism and trade) is estimated to have declined from 41.6 percent to 13.5 per- cent during the last two years, as seen from the table below (see Annex 12). This represents a very substantial shift to a less subsidized and therefore more market determined credit system. Proportion of Preferential Credit (TL billion) As of Dec. 1983 Dec. 1984 Sept. 1985 Total credit outstanding 3,426.5 4,321.8 5.851.3 of which: Credit to prod. sectors 2,768.6 3,512.3 4,640.5 Preferential credit 1,810.8 1,642.3 1,837.6 of which: Pref. Credit to produc. sectors 1,152.9 922.8 626.8 P-ef. cred./total cred. 52.8% 38.8% 31.4% Pref. cred./total cred. to productive sectors 41.6% 26.3X 13.5X Source: Mission estimates E. Reference Rate for Selective Credit 4.22 While the movement towards adjusting rediscount rates and reducing the level of preferential credit to the productive sectors of the economy is very substantial, the practice of adjusting rediscount rates for selective credit on an ad-hoc basis implies that adjustments would normally lag behind changes in the inflation rate, resulting in fluctuating real rates. Whenever the inflation rate rises, the implied subsidy increases, unless adjustments in the rediscount rates and other preferential credit rates (such as the interest rate on agricultural credit extended directly by the Agriculture Bank-T.C.Z.B.) are made, which has proved to be a cumbersome administrative process. To address  - 28 - this problem, an appropriately formulated reference rate would help provide the -basis for adjustments of selective credit rates.- Under such a system, the structure of selective credit rates would be adjusted regularly on the basis of market signals. The development of such a system requires, as a precondition, the existence of an interbank money market with adequate depth for determi- nation of the cost of money at a given time. Using this rate as a basis, a program to converge selective credit rates towards the market-determined rate can be formulated. An important consideration in the introduction of such a system is the need to preserve the degree of flexibility necessary to the authorities in management of the monetary program under conditions of fluctuating inflation. Discussions on this proposals are on-going with the Government. Under the loan, a reference rate will be developed in order to help the Government to monitor and adjust preferential interest rates. CHAPTER V STRENGTHENING THE BANKING SYSTEM 5.01 As noted earlier, the Turkish financial sector is dominated by the banking system. A major element of the financial sector reform should there- fore be to improve the efficiency of the banking system. The environment in which the banks traditionally operated in Turkey was protected, non-competitive and generally designed to ensure profitable operations of banks by restricting the opening of branches of foreign banks and by keeping deposits rates low. In the last six years, the environment has changed markedly. There are now 19 foreign banks which provide vigorous competition to local banks in providing trade finance and other services. Increase in cost of deposits has reduced the profitability and increased pressures to improve efficiency of the large retail banks with a wide branch network. At the same time, the regulatory framework in which the banks operate is changing in order to provide adequate protection to depositors, which is necessary to maintain confidence and ensure deepening of the financial system. Standardization of bank accounting and reporting requirements have been introduced from January 1, 1986. Bank financial state- ments will have to be externally audited commencing from the financial year 1987. Major changes are being made in the role of the Central Bank in surveillance of banks, and the antiquated methods followed by the Board of Sworn Bank Examiners are to be revised. 5.02 At the same time, the strain of the economic adjustment program on the corporate sector has had an effect on the portfolio quality of commercial banks. As overdue debt payments have mounted, the overburdened system of collection through the courts has slowed down further, causing long delays in loan collection. Commercial banks are passing through a very critical period, simultaneously facing increased competitive pressures, closer scrutiny and portfolio problems. The proposed adjustment program contains a number of measures to improve the efficiency of Turkish banks by encouraging competition, strengthening the supervisory system and by assisting the establishment of a training institute to train bank staff in modern banking techniques. This chapter reviews the roles of the Central Bank in the financial system, and that of the Board of Sworn Bank Auditors which shares the responsibility for super- vision of Banks with the Central Bank. The changes occurring within the com- mercial Banks and the problems of portfolio quality and collection are also analyzed.  - 29 - A. Role of the Central Bank 5.03 A central feature of the Government's policies vis-a-vis the financial sector is that the Central Bank should concentrate on implementing the traditional role of a Central Bank and not that of a development bank, as has been the tendency in the past. The Government now wishes to reduce Central Bank intervention in credit allocation through the array of selective credit schemes used very extensively in Turkey in the past. The intention is to have the Central Bank (which was given the role of implementing such schemes) cease to be the refinancier of special credit schemes, and to concentrate on: (i) the formulation and implementation of appropri-ate monetary policies; and (ii) the supervision of the banking sector. 1. Conduct of Monetary Policy 5.04 The conduct of monetary policy requires a clear program regarding the goals of monetary control, as well as the use of appropriate monetary instru- ments to implement this policy, including such classical instruments as the setting and enforcement of liquidity and reserve requirements, overall direction of interest rates through such means as the discount rate and the interbank deposit rate, and influencing growth (or contraction) of money supply through open market transactions. In Turkey at present, goals of the economic stabilization program call for a tight monetary policy to combat inflation and consistent, steady growth rates in money supply to restore economic growth on a stable path. During the last twelve months in particular, the Central Bank has moved energetically to gain effective control over monetary developments. Thus, reserve requirements for commercial banks are now being monitored at shorter intervals (weekly instead of the previous monthly interval). As noted in Chapter IV, the interest rate on reserve deposits maintained by commercial banks with the Central Bank has been gradually reduced. From January 1, 1986, interest is no longer paid on reserve deposits. As the payment of such interest by the Central Bank to the commercial banks constituted a substantial injection of liquidity into the system, this action will lead to a tighter monetary policy. During 1986 t-he Central Bank will be monitoring the growth of reserve money, the movement of the money multiplier, as well as the broader monetary aggregates (M2 and M2X) more closely. 5.05 The Central Bank's role in interest rate policy is exercised princi- pally through its membership on the Money and Credit Council of which it also acts as the secretariat. The composition of the Council consists, inter alia, of the Deputy Prime Minister (Chairman), the Undersecretaries of the Treasury and Foreign Trade and the State Planning Organization, and the Governor of the Central Bank. As the economy moves towards freely determined market interest rates for deposits, the role of the Money and Credit Council will diminish in importance. The Council also exercises a direct role in setting lending rates for preferential credit, principally by setting the rediscount interest rates and the rediscount proportions applicable to the various credit schemes. 5.06 The Central Bank also plans in the near future to start open market operations, though in order to engage in buying or sel ng of Government securities in significant amounts, the Central Bank's ued capital will have to be substantially expanded from its present level of ii. 25.0 billion. Finally the Central Bank has started acting as an intermediary in the interbank market from March 1986, which would provide it another instrument for influencing the liquidity level in the banking system.  - 30 - 2. Supervision of Banks 5.07 Historically, the Central Bank had played a minor role in the super- vision of banks. Its primary responsibilities included monitoring liquidity and reserve requirements and gathering information from the banks through its modest reporting mechanisms. This information included a statement of con- dition, a profit and loss statement, and selected memoranda items from which a handful of ratios were calculated. When concerns were identified, the Board of Sworn Bank Examiners and the Banking Directorate within the Under-secretariat of Treasury and Foreign Trade were notified so that they might undertake appro- priate action. The Central Bank effort included not more than five individuals who were-responsible for data collection, data processing, analysis, and other related duties. In keeping with the Government's intention of redefining the Central Bank's responsibilities, the Banking Law of April 25, 1985 envisages a greater role for the Central Bank in the off-site surveillance of banks. This is a necessary measure to induce public confidence in the banking system. Unlike in the case of other industries, a bank failure imposes costs not only on the owners, but also on the depositors, and also disrupts the payments mechanism, which is the direct responsibility of the Central Bank. Therefore, in order to strengthen the ability of the Central Bank to supervise the banking system, important changes have been agreed to be introduced. These are (i) standardization of accounts of banks, (ii) changes in treatment of non- performing loans, and (iii) introduction of external audit. 5.08 Standardization of Accounts. As part of the changes enacted by this law, banks are required to maintain their accounts, annual balance sheets, and profit and loss statements according to a uniform chart of accounts. The Central Bank played a pivotal role in establishing this standardized system of accounts.- The Uniform Chart of Accounts, as it is known, has been introduced from January 1, 1986. The chart of accounts when fully implemented will address several major deficiencies in the existing system of bank supervision. The Uniform Chart of Accounts, for the first time, establishes a body of defi- nitions and rules for the classification of accounts. This will ensure a reasonable basis for the presentation and comparison of financial results. 5.09 Treatment of Non-Performing Loans. A critical adjunct to the Uniform Chart of Accounts is the Decree Law on Non-Performing Assets dated December 11, 1985. Under the earlier system, non-performing assets, other than those in litigation, were determined subjectively by banks without regard to delinquency status or other criteria. Further, banks could continue to accrue interest into income for such non-performing assets. Provisions were made to loss reserves on the basis of the bank's profitability, and bad debts were written- off at the sole discretion of management. Now, with the passage of the Decree Law, non-performing status for loans other than current accounts is to be determined on the basis of delinquency. Upon reaching non-performing status, the accrual of interest must be discontinued and mandatory minimum provision6s are to be made to loan loss reserves, thus establishing a linkage between port- folio quality and the reserve for loan losses which does not exist under the present system. In Turkey, the current account (or overdraft limit) is widely used as a vehicle for medium-term financing and for other forms of short-term credit better suited to other lending instruments. Current account lending contains an inherent weakness in that the lender is unable to control the  - 31 - timing and use of drawings against the account. A problem borrower can main- tain the appearance of performing on his current account by additional drawings to pay interest and this conceal the true nature of his finances. For current accounts, the Decree Law on Non-Performing Assets is less specific concerning the criteria triggering default. Essentially, a declaration of default remains at the discretion of management. 5.10 External Audit of Banks. Closely linked to the Uniform Chart of Accounts is the requirement contained in the Banking Law that annual balance sheets and profit and loss statements be certified by external auditors. It has been agreed that the Central Bank will define the criteria by which the acceptability of auditors will be determined. These criteria are expected to include certain minimum qualifications related to education, work experience, and professional reputation. The audits to certify banks' financial statements are to commence from 1987. 5.11 Off-site Surveillance. Clearly, the Central Bank's objective in stan- dardizing accounts and accounting procedures and introducing external audit is to strengthen the quality of financial reporting by banks and to enable effective off-site surveillance. To this end, the Central Bank will require the submission of nearly 50 periodic reports, most quarterly, for the purpose of supervising each bank's activities. These reports will provide a substan- tive base of detailed information for analysis and will be used to generate a standard package of analytical information for each bank. Ratios will be cal- culated for four primary areas: capital adequacy, asset quality, profitability and efficiency, and liquidity. Where banks of similar size, lines of business, and characteristics exist, peer groups and percentile rankings will be esta- blished for comparative purposes. Transactions involving related entities, insiders, large borrowers, major firms and large depositors will be monitored. Based on an analysis of all information, each bank will be assigned a rating as part of a uniform rating system. The performance of off-site surveillance and early warning analysis is a critical part of the Central Bank's emerging role in the system of bank supervision in Turkey. The Central Bank is therefore committing additional resources for bank supervision including staff and micro- computers, and the setting up a Division of Bank Surveillance. This division is to be staffed with approximately ten analysts at inception but may increase in number as does the Central Bank's role in the supervisory process. The Central Bank will require technical assistance in bank supervision, and in upgrading its internal training effort. A technical assistance program with a total foreign exchange cost of $484,000 has been formulated for this purpose to be implemented with funding out of the proceed of the proposed loan (see Annex 16 for details). B. The Board of Sworn Bank Examiners 5.12 The Board of Sworn Bank Examiners was established by a separate law in 1958 and is the principal bank supervisory body charged with implementing the provisions of the Banking Law and other laws concerning banking operations. This responsibility has been carried out through onsite examinations as dis- tinguished from off-site surveillance, which is the responsibility of the Central Bank. Examinations are required once during a two-year period although problem banks and branches are examined more often. The examination process is  - 32 - designed to determine compliance with law and the financial condition of the bank. To accomplish this, the Sworn Bank Examiners perform a detailed analysis of financial transactions and reconstruct a balance sheet which emphasizes the bank's liquidity. Results are compiled in an examination report which is formally communicated to the bank. Summary findings are divided into several categories: general comments, analyais of balance sheet accounts, analysis of revenues and expenses, financial statistics anid ratios, and violations of law, accounting principles, and other banking practices. 5.13 The current examination process provides a snapshot of a bank's condition at a particular moment in time. It is however more important to anticipate and prevent problems in a dynamic environment and contain risks within certain optimal parameters. This can be accomplished by focusing on a "stop down' approach which encourages bank management to adopt the systems, policies, procedures, and controls which are necessary to appropriately admi- nister the affairs of the bank on an informed and controlled basis, i.e., with the help of management information systems. Management information systems in- clude written policies, procedures, internal controls, audit activities, and quality control systems, such as an effective program of loan review. By encouragiug the development of such systems, the bank examiner's role becomes one of (i) determining that the policy element of the system provides adequate guidance to management concerning the optimal level of risk and the future direction of the bank; and, (ii) testing the other elements of the system which are designed to ensure compliance with policies and procedures and minimize risk. If any part of the system is determined to be inadequate, the examiner is obliged to perform more detailed analysis. However, if the system is determined to be functioning properly, the examiner may forgo detailed analysis and devote more time to other aspects of the examination. With the establishment of foreign banks in Turkey many foreign and large local banks are establishing management information systems along these lines. The current examination procedures and capabilities of the examiners, however do not enable the implementation of on site examinations in this manner. 5.14 As a part of the program supported by the loan, the Board of Sworn Bank Examiners will undertake two actions to implement this concept of onsite examination. Firstly, the examination manual presently in use will be revised with the assistance of consultants financed under the loan. Second, a tech- nical assistance program will be implemented in cooperation with the Office of The Comptroller of the Currency in the United States for training of bank examiners, and essential office equipment including computers and related software will be acquired. The cost of the program as described in Annex 17 is estimated to be $255,000 in foreign currency, which is proposed to be funded out of the proposed loan. C. The Commercial Banks: Structure and Performance 5.15 The impact of the reform of the Turkish financial system has been particularly strong on commercial banks. Entry of new banks has increased competition, assets have grown rapidly, new financial instruments (e.g. repurchase agreements and interbank credits), have been introduced and, more generally, efficiency of intermediation has improved. At the end of 1985, there were 50 commercial banks operating in Turkey. The twelve public sector banks accounted for 52 percent of total assets as against 44 percent for the 19  - 33 - private banks and 4 percent for the group of foreign banks. The number of foreign banks licensed to operate in Turkey has grown considerably in recent years as the Government sought to encourage greater competition and the intro- duction of modern techniques in banking. In practice, however, the foreign banks concentrate their efforts on a relatively limited clientele of two to three hundred of the better firms operating in Turkey, and they specialize in trade finance rather than working capital or project finance. Annexes 13, 14 and 15, provide summarized financial statements of public sector, private sector and foreign commercial banks in Turkey, which are used in the following analysis. Some of the main issues facing commercial banks are discussed below. 1. Interlocking Ownerships - 5.16 Interlocking ownerships between commercial banks and major industrial conglomerates hlas been commonly recognized as a factor inhibiting competition among banks in providing services to the corporate sector in Turkey. The Turkish banks have also been slow in responding to foreign competition. Few of them have set up the kind of corporate finance services oftered by foreign banks. Banks affiliated with industrial conglomerates have tried to reduce competitive pressures by lending to firms within the group. However, the increasing export orientation of large industrial groups is giving them access to relatively inexpensive sources of credit from foreign and, increasingly, from domestic banks specializing in foreign trade finance. Affiliated banks have therefore had to reduce their margins to their own firms in order to remain competitive. As a consequence of these competitive forces, as far as allocation of credit is concerned, the problems caused by the interlocking ownership of banks and firms are becoming less severe. Furthermore, the drastic reduction in the share of preferential credit to total credit makes it less imperative to secure control of banks in order to ensure access to cheap credit. However, allocation of credit is a relatively minor issue relating to the interlocking ownership of Turkish banks and corporations. The major pro- blem is the reluctance of banks to stop extending credit to associated cor- porations that are no longer creditworthy, or to enforce repayment of existing loans. The new Banking Law has introduced important safeguards to ensure that this problem is not further worsened. It has imposed restrictions on the ope- rations of banks including inter alia, a 20:1 debt/equity ratio limit, a limit on the maximum exposure to any single customer equal to 10 percent of the bank's net worth, a limit on the bank's exposure to officials of the bank and their relatives, and to companies in which the bank has an equity investment. The next major step would be to introduce limits on the proportion of shares of a oompany, except of a related financial operation such as a leasing company, that can be held by banks. The Government has agreed to explore this course under the loan, though its timing is uncertain as it might have to be preceded by adequate growth of the equities market. 2. Capital Adequacy 5.17 More stringent capitalization requirements are contained in the new Banking Law to improve the soundness of the banks and their ability to weather unexpected loan losses. The deterioration of the equity position of banks was particularly visible in the late 1970s with paid in capital declining from 3 percent of total assets to 2.5 percent in 1980. Thereafter, the debt/equity ratios of banks improved substantially from 38.9:1 in 1980 to 15.2:1 in 1984. This was an-improvement achieved in spite of a six-fold increase in banks' deposits during that period.  - 34 - 5.18 Despite the increasing capitalization of Turkish banks, paid-in capital was little more than 6 percent of total assets in 1984. Overdues are officially estimated at 2.8 percent of assets but are probably higher given the inconsistency of classification crite::ia among the various institutions. It seems, however, that the portfolio quality of banks has somewhat improved in recent years and that banks are increasingly able and willing to set aside provisions for bad debts subject to adequacy of profits. Provisions have been raised from 0.3 percent of assets in the late 1970s to an average of 0.6 per- cent in the period 1981-84 by the private banks. At the same time, the profi- tability of batiks increased significantly from 1.2 percent of assets in 1983 to 2.3 percent in 1984. Nevertheless, the financial situation of the banks will continue to be closely monitored by the Central Bank and the Government to minimize the risk of a major banking crisis, which could jeopardize the liberalization of the financial system. The systems and technical assistance provided under the proposed loan will assist in this regard. 3. Large Retail versus Small Urban Banks 5.19 While the overall profitability and soundness of the commercial banks have improved, performance has been uneven at the individual bank level. Major banks with a national network of branches have tended to perform less well than some of the fast growing small urban-based banks. The primary reason for the differing performance levels of these two groups of banks is the rising costs of branch banking. The two largest commercial banks accounted for about 45 percent of total bank assets in 1984. They operated one third of the 6,250 bank branches and their staff accounted for 44 percent of total bank employees. Their profits, however, were only 21 percent of total bank profits while their overdues represented 62 percent of total overdues. 5.20 Branch banking has become less profitable as depositors shifted from low yielding sight deposits to higher yielding time deposits. It had been profitable for banks to operate branches for which the ratio of administrative and personnel expenses to deposits mobilized was high so long as the proportion of low-cost household sight deposits was high. However, the shift to time deposits (see para. 3.08) has raised the average cost of bank deposits drama- tically without a corresponding increase in average interest income from loans. The interest spread of banks ' v thus declined by 5 percentage points from 1980 to 1984. Some of the medium sized banks are now responding to these develop- ments by closing down unprofitable branches. The largest banks, however, are still reluctant to do so. It would be appropriate for the Government to encourage an orderly program of closing uneconomic bank branches to reduce the phenomenon of overbranching which characterizes the Turkish banking system. With an average population of 7,300 per branch, Turkey has bank branches far in excess of countries with similar per capita incce'es, which typically have one bank branch per 20,000 persons. 5.21 The increasing cost of branch banking favors the emergence of smaller, urban based commercial banks which concentrate their activities on providing services to the corporate sector. Among the 19 private banks (excluding foreign bank branches), it is possible to differentiate between a group of six large retail banks with total assets exceeding TL 200 billion, each and 13 smaller banks. While deposits accounted for 72 percent of the assets of large  - 35 - banks in 1984, the proportion was only 42 percent for smaller banks which re- lied more heavily on borrowed funds. In larger banks corporate deposits, which are cheaper on average than household deposits, represented only about 25 per- cent of total deposits, with households contributing as much as 65 percent. In the smaller banks, corporate deposits were relatively more important (45 per- cent of total deposits) with household deposits representing less than 41 per- cent of total deposits. While lending activities provided about 81 percent of the total gross income of large banks, it accounted for 69 percent of income in smaller banks. Small banks rely more heavily on fees and commissions derived primarily from financing foreign trade activities. Theo- activities helped raise the net profits of smaller banks to 4.8 percent of assets in 1984 comr pared to 1.4 percent for large banks. 4. Intermediation Costs and Margins 5.22 The margin of intermediation needed to cover the operating costs and profits of Turkish banks has decreased in recent years but remains very high. Expressed as a percentage of total assets, the margin of private banks in- creased steadily from 6.2 percent in 1977 to 10.5 percent in 1980 mainly on account of increased administrative costs (inclusive of personnel expenses) which rose from 4.4 percent of assets to 7.6 percent during that period. During the next three years, administrative costs declined steadily to 4.7 per- cent of assets in 1983. The gross margin of intermediation of private banks therefore declined from 10.5 percent in 1980 to 6.9 percent in 1983. In 1984, it increased significantly to 8.8 percent of assets due in part to adminis- trative expenses reaching 5.3 percent of assets, but more importantly due to an increase of net profits from 1.2 percent of assets in 1983 to 2.3 percent in 1984. 5.23 The ratio of administrative expenses to total bank assets n Turkey is high by comparison with banks in other countries. Variation in that ratio over time reflect more than the relative inefficiency of commercial banks in Turkey. During the 1977-84 period, the administrative costs of banks grew at approximately the same rate as the domestic inflation rate. On the other hand, the assets and deposits of banks grew less rapidly than the inflation rate until 1980, thus causing a deterioration in the ratio of administrative costs to total assets. From 1981, however, assets and deposits have grown much more rapidly than inflation and this led to a significant improvement in the ratio of administrative costs to total assets. Growth of Costs, Deposits and Assets (in percent) 1978-80 1981-83 1984-85 Cumulative inflation (CPI) 420.5 135.2 45.6 Growth in administrative costs 428.9 158.5= 59.0 Average assets growth 203.7 315.4 40.5 Average deposit growth 194.1 326.1 43.8 Source: Mission estimates.  - 36 - 5.24 The decline in the inflation adjusted value of bank assets and- deposits in the late 1970s was the result of increasingly negative real deposit rates as discussed earlier. Conversely, the rapid expansion of bank assets and deposits in the early 1980s reflects the change in the Government's interest rate policy with the introduction of significantly positive real rates of interest on time and savings deposits. The rising administrative costs ratio up to 1980, followed by a rapid decline therefore reflects variations in the real value of Bank assets rather than gains or losses in administrative effi- ciency. As noted in paras 5.32 - 5.38, under the loan, technical assistance will be provided to help commercial banks to train their staff to improve the efficiency of the banking system. The high intermediation margin of banks is striking, since the average interest cost of bank deposits was slightly below 30 percent in 1984, while the average interest earnings of banks on their loans portfolio was 58 percent-and fees and commissions raised total bank income on the loan portfolio to 73 percent. However, due to liquidity and reserve requirements, loans represented only 57 percent of total bank deposits ia 1984. Based an average deposit cost of 37 percent, the effective interest cost of loans was over 53 percent (see Annex 7), leaving banks with an interest margin between the interest earnings and interest costs of loans of only about 5 per- cent. In fact, this margin was insufficient to cover administrative costs which, expressed as a percentage of loans were 12.9 percent. However, fees and commissions allowed banks to show adequate profits. Apart from administrative costs and reserve and liquidity requirements, another factor pushing up inter- mediation costs is the relatively large proportion of non-performing loans. Non-performing loans could be estimated at 10 to 20 percent of the total bank portfolio based on recorded arrears of 7.4 percent of total loans at end-1984. 5.25 The intermediation costs of Turkish banks are still abnormally high and ought to be reduced by half to match the efficiency of banks in other developing countries. As indicated above, banks may have few alternatives but to close some of their most inefficient branches to reduce their administrative costs ratios, but progress in this area is likely to be very slow as it involves significant social costs. Computerization of bank operations is also likely to help reduce the burden of administrative expenses. 5. Deposit Insurance 5.26 A critical measure necessary to foster confidence in the banking system, and to deepen the financial sector, is the improvement in the deposit insurance scheme which was introduced in 1983. The scheme at present provides coverage of principal amounts upto TL 3.0 million. It has been agreed that the ceiling will be raised periodically to maintain the level of coverage in real terms. D. The Courts and Collection Procedures 5.27 In the protected environment for the industrial sector which existed prior to 1980, the banks' losses from bad debts were insignificant. The gradual removal of the tariff barriers since 1980 caused a dramatic change in the industrial climate. These changes, combined with real interest rates of up to 35 percent, devaluation, and reduced demand in the domestic market, decreased profitability in the industrial sector. The financial problems of the industrial sector inevitably had their effect on the banking sector in the form of non-performing loans.  - 37 - 5.28 Confronted by the choice of whether to declare a borrower in default or to roll-over the loan, banks at the beginning opted for the latter in a large number of cases. The fiscal and financial regulations did not encourage banks to declare loans in default as investment incentives on such loans were cancelled and loans discounted with the Central Bank had to be called and repaid immediately. Furthermore, banks were not allowed to deduct provisions for bad debts for tax purposes unless strict conditions were met. Loans were therefore rescheduled and interest accrued was capitalized. But with the prevailing high level of real interest rates, this position was not sustainable for long. As their portfolios problems grew and their liquidity position deteriorated, the banks had to resort to the courts to recover their overdue accounts. 5.29 In Turkey, as in most countries, the recovery of overdue debts through the courts is a-time consuming-affair. To realize the security in the case of overdue accounts, it was necessary to secure a court order from the commercial court and have this order implemented by the court's execution officer. These procedures usually required numerous court appearances. With the economic dif- ficulties of the last five years, the number of cases before the court for recovery of debts increased dramatically. There was a delay of three to four months between each court hearing on a case which resulted in delays of three to five years before cases were finally resolved and the property sold to meet overdue debts. Problems were also being experienced with the operation of the bankruptcy law. Under the law, a Bankruptcy Administration Committee, respon- sible for the administration of the bankrupt estate, was elected by a poll of creditors atteuding the bankruptcy meeting without regard to the amount owed. At times these meetings were packed with fictitious creditors who elected admi- nistrators sympathetic to the bankrupt. In many cases the banks were not represented at creditors meeting as the debtors did not list the banks as creditors in their report to the court. The elected Administration Committee refused to take appropriate action to wind up the estate and acted as a facade behind which the debtor continued to control the estate. The total effect of these problems with court procedures and bankruptcy administration was that the collection of overdue debts was virtually unenforceable. 5.30 The Bankers' Association established a commission to review the situation. The commission submitted a draft bill to the Government in 1984 to amend the Law of Procedure and the Execution and Bankruptcy Law. The Government accepted the need for action and revisions to the Banking Law,the Law of Procedure, and Execution and Bankruptcy Law were enacted in February and May 1985 respectively. A summary of the major amendments is as follows: (i) statements submitted by the banks to clients will be deemed prima facie evidence of debt unless debtors submit a notarized objection within 30 days of receipt; (ii) foreclosure on mortgaged property taken as security for overdraft facilities will be authorized and certain procedural grounds used by debtors to delay this process will be removed; (iii) a debtor applying for bankruptcy must present a declaration of assets to the court together with a notarized statement that he has notified his bank-of his bankruptcy application if the bank is a creditor; and  - 38 - (iv) two of the three members of the bankruptcy administration committee will be appointed based on amounts of receivables and appointment of the third member will be on the basis of a poll of creditors. 5.31 It will take some time yet to enable the appeals against some of the legal changes to be completed to permit 8 final evaluation of the effects of the amendments. Problems in collecting overdue accounts through legal action will continue to be experienced, however, due to the major increase in the number of cases before the courts, inadequate staffing of the courts and court offices, and the many procedural requirements under Turkish Law. This is a matter which will require continuous review. E. The Proposed Banking Institute 5.32 The improvements desired in the commercial banking system necessitate the introduction of modern banking methods and technology, upgrading and internationalizing the skills of the existing personnel, and recruitment and training of new talent. These needs are of such a magnitude that they can be best addressed by establishing a central training institute which would serve the entire banking industry. A central training institute would have two very important advantages. Firstly, it would offer substantial economies of scale. Secondly and most importantly, the magnitude of the training staff needs will be reduced to a manageable scale. Accordingly, the Central Bank has taken the initiative through the Turkish Banks Association, to set up a banking institute or training school as described below (see Annex 18 for details). 5.33 The proposed banker's training school will have the following objectives: -i) upgrade and internationalize skills in the core banking functions of credit/marketing, operations/technology, and treasury. (ii) introduce the most recent techniques and technologies in banking and financial markets. (iii) upgrade English language skills in the banking system. (iv) upgrade training materials and instruction within the Turkish banks. 5.34 The proposed banking school is modelled after the Citibank Training Center in Athens. The curriculum will be designed by Citibank and some minor changes will be made to meet the specific needs of the Turkish banking sector. The official language of the school is to be English. The school will be resi- dential and it will own its facilities. Citibank will manage the school during the first five years under a management contract. Citibank's costs will be fully reimbursed by the bank's association. Citibank will not change any separate management fees. Although the legal framework has not been worked out completely yet, the school will be technically owned by the Turkish Banks' Association through a subsidiary.  - 39 - 5.35 The initial capital expenditures for buildings and grounds will be provided by the Turkish Banks Association. The Banks' Association will use its accumulated funds which-are earmarked for educational purposes. In the event that these funds are insufficient, the Banks' Association will levy fees on its members to make up the difference. The recurrent costs will be met from tuition fees from the core programs and seminar participation fees. 5.36 Surveys were undertaken to determine the types of courseb for which there was the most urgent need in Turkey. Bank consultants were involved in the conduct of these surveys. The most urgent needs established by the Surveys are for three core programs which are being offered at the Citibank Training Center at present: (i) the Core Credit Program, (ii) The Core Bank Operations Program, and (iii) the Core Treasury Program. In addition, seminars on topics of interest to senior officers of banks will be offered on subjects such as international funding, market and industry analysis, technology management, country risk analysis etc. 5.37 Under the terms of the proposed management contract, Citibank will provide the director of the school, as well as the teaching staff and coordi- nators for the core programs, provide teaching materials used in similar Citibank training programs without copyright charges, and generally manage the school. The execution of the management contract will be required before the funds earmarked for this component can be disbursed from the loan. 5.38 Under the proposed loan, an amount of $882,000 will be provide to finance the foreign exchange component of the capital cost of setting up the school. The amount will cover the cost of teaching equipment including per- sonal computers and audio visual equipment, copying and printing equipment, computer software etc. These goods will be procured by the Government and leased to the institute on a rent-free basis. The goods will remain the property of the Government. The establishment of the school will be a condition for disbursement of this component of the technical assistance program. Detailed budget estimates for the capital costs and the recurrent costs of the school are shown in Annex 18, Attachment 3. CHAPTER VI DEVELOPING THE MONEY AND CAPITAL MARKETS 6.01 Money and capital markets have traditionally been a weak link in the Turkish financial sector. Their growth has been hampered by an inadequate institutional and regulatory environment and, more recently, by high inflation. Under these circumstances these markets have been characterized by low activity level, segmentation, high intermediation costs and occasional speculative bursts. Recently, however there has been increasing appreciation of the potential benefits of well organized financial markets. Consequently, their development has been accorded high priority by the Government, as witnessed by the institutional and regulatory improvements that are taking place. This chapter deals with this relatively undeveloped component of the financial sys- tem by analyzing its segments accordinz to maturity of principal instruments, as defined in Turkey. Therefore, money markets, which deal with instruments with maturities of less than two years are distinguished from capital markets,  - 40 - defined in Turkey to mean markets dealing in instruments with a maturity of more than two years. Efforts of the main regulatory agency -- the Capital Market Board to restore confidence after a major collapse in 1982, and changes in its approach which now appear necessary are discussed in the context of the sector adjustment program. A. Money Markets 6.02 Money markets in Turkey encompass instruments as varied as interbank deposits, CDs, Treasury Bills, commercial paper and bankers' acceptances. These instruments require a common approach due to their common characteris- tics, such as their liquidity and their implications for the operation of the banking system and the conduct of monetary policy. 6.03 A large but completely unregulated market for a variety of private paper had emerged in Turkey in the late 1970s as a result of the regulated deposit interest rate structure which produced highly negative real rates in the high inflation period of the late 1970s. As savings consequently moved out of bank deposits, smaller banks experiencing liquidity problems devised ways to circumvent deposit rate ceilings by issuing CDs through brokers at discounts. These brokers would resell the CDs to the public at par, adding to the interest by issuing parallel promissory notes in their own names. The difference between the brokers' buying and selling prices was lent, usually at very high interest rates, to marginal businesses desperate for cash. The brokers thus acted as bankers, borrowing and lending money in their own names, but without being subject to reserve or liquidity requirements or controls. In the absence of an organized secondary market, liquidity for all the CDs and other instruments (corporate bonds, stripped bond coupons, IOUs etc.) was provided only by the brokers' own sight repurchase guarantees. Initially this line of business proved highly profitable and hundreds of brokerage houses sprang up, while negotiable CDs, first issued in 1980, reached 10 percent of bank deposits in 1981. The system collapsed in 1981-82 as brokers could not collect the loans they had made, and in the absence of a lender of last resort, could not honor repurchase guarantees. These events have profoundly affected the attitudes of the authorities towards the money markets and influence the regulatory framework set up in response to the crisis. 1. Interbank Markets 6.04 The drying up of the market for negotiable CDs in the wake of the collapse left smaller commercial banks with no alternative but to borrow from larger and more liquid banks. The interbank market has therefore begun to develop slowing during the last three years. The growth of the market has been characterized by considerable fluctuations. Annual turnover in the interbank market is reported to be still quite low, not exceeding US$2.0 billion. The market is also highly fragmented, transaction costs are as high as 4-5 percent and yields vary greatly even for deposits of comparable risk and maturity. 6.05 The most active participants in the interbank market are the foreign banks operating in Turkey. Some banks are on both sides of the market, being borrowers or lenders according to their liquidity situation; however there seems to be a general unidirectional pattern to the interbank market, with  - 41 - funds flowing from the larger banks with extensive branch networks to foreign or smaller banks in need of funds. Transactions in the interbank market are often arranged directly by senior officers of banks as many banks do not have a specialized treasury function. However, this is gradually changing as the local banks emulate the treasury techniques of the foreign banks. 6.06 In order to develop the potential of the interbank market fully, the Government is taking a number of actions. These include the reduction of the financial transactions tax from its level of 3 percent to 1 percent, which is helpful, though a complete repeal of the financial transactions tax on inter- bank deposits-ought to be enacted as soon as possible. The enforcement of the reserve and liquidity requirements on commercial banks on a weekly basis by the Central Bank should also provide an impetus to the interbank market. The Government is also reviewing Article 11 of the Corporate Tax Law, which has been interpreted by the tax authorities as subjecting the foreign banks to a withholding tax of 25 percent of the income from interbank deposits thus creating an impediment to their active participation in the interbank market. Further, the Central Bank is considering monitoring of reserve and liquidity requirements of banks on a weekly average basis instead of at the end of the week, which would give banks greater flexibility to operate in the interbank market. More importantly, the Central bank has recently entered the inter- bank market itself, to overcome the traditional reluctance of Turkish banks to deal directly with each other and as a tool for control of liquidity in the system. 2. Treasury Securities 6.07 After years of reliance on inflationary financing of deficits by recourse to the Central Bank, the Government began to issue securities priced at competitive rates in 1984. Initially these securities were sold "on tap" through the Central Bank and T.C.Z.B. Due to the attractive yields offered, it has been possible to place these securities increasingly with non-captive investors, as shown by the decreasing share of purchases by banks, from 81.4 percent of total issues in 1983 to 45.1 percent in 1984, and by the increasing share of households from 9.8 percent in 1983 to 21.0 percent in 1984. In May 1985, a market pricing mechanism was introduced through weekly auctions of six-month, one-year, and two-year securities. Volume of Government bonds out- standing has thereafter increased rapidly from TL 886 billion as of December 1984, to TL 1,526 billion as of December 1985. 6.08 The introduction of regular weekly auctions of Government securities is one of the most significant developments in the securities market in recent years in Turkey, as it provides a market pricing mechanism for a highly standardized and risk free instrument. The efficiency of the system can be increased further by (i) allowing settlement at least two days after the auction, instead of on the same day as at present, to enable distribution by underwriters; (ii) by offering a range of maturities, three, six, twelve and twenty four months to suit investor preference. 6.09 The secondary market for Government securities has grown in volume from TL 35 billion in 1984, wnien trading of any consequence started, to TL 410 billion in 1985. Commercial banks account for 85 percent of the trading, and  - 42 - ten licensed firms for the rest. Trading is largely on a retail basis, between financial institutions and their clients, rather than between financial insti- tutions on a wholesale basis. Trading spreads are reported to be extremely high, and liquidity limited. Some banks are reported to sell securities to customers with a repurchase guarantee at spreads of up to 25 percent. This imperfect but growing secondary market should offer opportunities for intro- ducing open market operations by the Central Bank as an effective tooL for monetary policy purposes also. 6.10 Technological. improvements, particularly in telecommunications and in clearing and settlement of transactions, are essential for the development of a money market. One factor which restricts the payments system's ability to handle large volumes of transactions is the present lack of daylight overdraft privileges. If banks were granted daylight overdraft privileges by the Central Bank within limits related to a multiple of each bank's capital, depending on its financial conditions, this constraint could be removed. As a longer term goal, the introduction of a state-of-the-art electronic clearing and transfer system could be considered. B. Capital Markets: Institutional and Regulatory Framework 6.11 Development of sound markets for equities and longer term debt instruments is essential for improving the efficiency of the Turkish financial system. It should be recognized that, despite recent improvements, the insti- tutional framework--particularly the scarcity of reliable corporate financial information--and the current inflationary environment, are not conducive to rapid development of the Turkish capital markets. Priority should be given to improving the institutional framework and the quality of financial information. After this is achieved to a satisfactory degree, a range of measures to improve supply of, and demand for, securities can be adopted. Pending these improve- ments, and stabilization of macro-economic conditions, it is envisaged that markets for longer term securities will develop more slowly than markets for short-term Government and bank instruments. 1. The Capital Market Board 6,12 The Capital Market Board (CMB) has main responsibility for the regulation and supervision of the primary and secondary markets for securities. Its main duties include: (a) Supervision of corporations which have made public offerings of securities or have at least 100 shareholders. (b) Supervision and regulation of investment companies, mutual funds and securities market intermediaries, including securities firms and--limited to their securities operations-banks. (c) Review and approval of all public offering of corporate securities and negotiable instruments, with the exception of bank instruments.  - 43 ' 6.13 CMB has adopted the view that only instruments previously typified in the Law or in official regulations qualify for approval. Accordingly, the Board interprets its role as including the design and development of new finan- cial papers, a role which could more appropriately be fulfilled by the market. The Board "approves" public offerings, depending not just on the applicant's compliance with financial disclosure and other legal requirements, but also on a judgment on the investment merits of securities. This approach of the Board is risky, because: (i) it creates an indirect CMB responsibility -- at least a moral one -- for losses suffered by investors who bought "approved" issues; (ii) by encouraging investors to rely on the Board's judgment on the merits and safety of securities, it may hamper the development of an independent market capability to appraise and price securities; (iii) from a practical point of view, a thorough screening of all new issues would require a huge CMB staff. The fact that CMB's review is currently based on unaudited data adds to the above reasons for concern. 6.14 Considering its short existence, CMB does have a creditable record of restoring some order and confidence to the securities markets. These positive results, however, have often been achieved by imposing restrictions on permis- sible instruments and on the operations of intermediaries which, while suitable to the emergency situation in which CMB began its activity, might constrain the future development of the market. The Government intends to reduce CMB inter- ference with market forces in such areas as detailed regulation and specifi- cation of permissible securities and related activities -- including minimum and maximum maturities, underwriting fees, and pricing. The Board would in future concentrate on enforcing disclosure and audit requirements for secu- rities issuers, with a view to ultimately permitting investors and interme- diaries to assess the quality of securities on the basis of reliable information. Under the loan it has been agreed that independent auditing of companies registering for public offerings or seeking listing in the new Stock Exchange will be introduced from 1987, in accordance with the same time frame as introduced for banks. 6.15 The need for training is substantial for both private aud public sector entities operating in the capital markets. GMB has a well established training program for its entry and mid-level personnel, which is funded by OECD and implemented at the Wharton School of the University of Pennsylvania. Under the proposed loan, it is proposed to supplement the OECD program by funding the acquisition of teaching equipment for a training center at CMB, and to provide training fellowships for CMB staff, and for advisory services of consultants at a foreign exchange cost of $275,000 (see Annex 19 for details). Beneficiaries of the training facilities will also include personnel of the securities trading firms. 2. Intermediaries and Institutional Investors 6.16 Intermediation in the primary and secondary markets for longer term securities is carried out by ten licensed securities firms and a limited number of commercial banks. There is some specialization by instruments, with securities firms dominating corporate bond underwriting and trading, and commercial banks being more active in public sector securities. The small equity market is about evenly split between securities firms and banks.  - 44 - 6.17 Securities firms have the advantage of more specialized expertise, but their contribution to the financial markets is limited by (a) their being often related to large business groups, in whose securities they se- ialize; (b) legal limitations prohibiting them from entering repurchase agreements, trading bank instruments and managing mutual funds; (c) scarcity of capital and lack of a liquidity mechanism. The CMB has appropriately encouraged the establishment of independent firms, four of which have been recently licensed. The next step should be to establish strict solvency and liquidity ratios, as well as disclosure and reporting standards, and audit requirements. A flexible mechanism to accommodate the daily liquidity needs of securities firms should be established through a reform of the Central Bank's Securities Fund, whose financing is currently available only in distress situations. 6.18 Commercial and development banks are currently allowed a broader range of capital market activities than securities firms, broad enough to classify them as potential universal banks. In practice, most Turkish banks hold equity investments in affiliate companies, but have not been active in turning over these holdings and in promoting securities markets. Recently, however, more commercial banks have started securities departments, and a few are now invol- ved in limited underwriting and trading of corporate equities and bonds, in addition to a relatively large activity in public sector securities. Encou- raging banks to progressively divest their relatively large portfolios of equities of nou-financial firms, which amount to about 1/3 of the net worth of the banking system, would considerably contribute to increasing the supply of equities in the open markets. 6.19 The Turkish insurance industry has suffered from years of high in- flation which have undermined demand for insurance products. Life insurance in force in 1983 was only about 0.7 percent of GNP in Turkey, as compared to 7 percent in Thailand, 36 percent in Korea, 156 percent in the USA, 300 percent in Japan. Total assets of the Turkish insurance industry amounted to only TL 114 billion in 1983. Of these, securities accounted for 31.6 percent (6.8 percent equities and 24.8 percent bonds, mostly government bonds). Further- more, portfolio management by insurance firms has often been oriented towards investment in affiliated or otherwise related companies, which probably accounts for an overall unsatisfactory return on earning assets. However, the introduction in 1985 of tax deductibility of insurance premia has led to subs- tantial increases in the assets managed by insurance companies, with corres- ponding increases in their securities investments. A new insurance law under preparation, providing for higher capital requirements for insurance companies and a more marked separation of their activities from those of other financial institutions, should also contribute to the development of the industry. 6.20 Social Security entities include four public sector and about sixty (mostly bank-related) private pension funds. Their total assets exceeded TL 900 billion at end of 1984, with only 14 percent of assets invested in secu- rities, mostly low-yield bonds of the State Investment Bank, which the Social Security System is required to purchase. Equity holdings of private pension funds are mostly in related companies, and control-oriented. Under the loan, a review of the investment guidelines of the Social Security System to orient them increasingly towards suitable, long-term corporate bonds and equities -- but limited to those on which adequate financial information exists -- will be carried out.  - 45 - C. The Primary and Secondary Capital U4rkets 1. Primary Markets 6.21 Public offerings of the main types of capital market instruments in the past three years are shown below: Public Issues of Securities (amounts in TL billions) 1983 1984 1985 No. Amt. No. Amt. No. Amt. Corp. Equities 130 35 121 64 175 76 Corp. Bonds 54 16 26 11 43 32 Govt. Revenue Bonds - - 1 10 2 140 Source: Capital Markets Board 6.22 Corporate Equities. In the past three years, public offerings of equities have substantially exceeded, in real terms, the levels achieved in the late 1970s and early 1980s. This was partly due to a more favorable market environment, stimulated by a 1983 Asset Revaluation Law which, causing expec- tations of stock dividends, contributed to higher share prices. Other factors believed to have encouraged new share issues are the decline, after 1982, of the corporate bond market which, although partly reversed in 1985, has deprived corporations of an attractive financing tool; and the dividend payout require- ments introduced by the CMB which, limiting the ability of corporations to retain earnings, have forced them to resort increasingly to new offerings of equities in 1985. The Government took a number of steps to favor the develop- ment of the equity market. These include: (a) complete repeal of taxation of dividends; (b) repeal of taxation of the premium of newly issued shares over par value; and (c) opening of a new Istanbul Stock Exchange. These measures should contribute to creating an environment more conducive to the development of equity markets. However, this is likely to be a slow process, as several constraints remain, which affect both the supply of, and the demand for securities in the open markets. 6.23 On the supply side, the main constraints relate to the relative cost of equity versus debt financing, and to concentration of equity ownership. Despite extremely high interest rates in both nominal and real terms, the tax deductibility of interest costs contributes to making the after-tax cost of debt financing substantially lower than the cost of equity. This is particu- larly evident in the periods of high inflation, when the deduction of the nominal -- as opposed to real -- interest paid results in a tax deduction of a part of the principal as well. The reduction of inflation should therefore reduce the disparity between the costs of borrowing and of equity financing, thus boosting equity issues. Another potentially major development which might increase the supply of securities to the open market is the Government's plan for selective privatization of SEEs. While the privatization program has not yet begun, the size of the SEEs capital base suggests that even a partial  - 46 - privatization could increase supply significantly. A wider distribution of equity ownership could be achieved by placing limits on the proportion of shares of a company that can be held by a bank and encouraging the opening up of larger closely held companies. To this end, the tax exemptions for divi- dends and capital gains should, in the future, be limited to equities of "open" corporations. 6.24 On the demand side, the gradual decline in the inflation rate would improve the attractiveness of equity holding from the saver's point of view also. After the favorable tax reforms introduced in 1985, there should be no need for further tax incentives for investment in equities. The main inter- ventions should be to introduce compulsory external audit of widely held corpo- rations, since lack of transparency in corporate accounts and of consolidated group financial statements have reportedly facilitated practices such as shifting of profits, which have discouraged the public from investing in shares. 6.25 Corporate Bonds. The corporate bond market grew very fast in the late 1970s, as a tool for both borrowers and investors to bypass the high interme- diation costs of the banking system. Bond issues have however declined after 1980, partly because of the collapse in 1981-82 of many bond dealers and partly because of increasing competition from time deposits and Government paper, now carrying mote attractive yields than in the past. This trend has been partly reversed in 1985, due to the relaxation of restrictions on the coupon rates that could be offered, which previously limited the competitiveness of bonds. Consequently, new issues increased from TL 16.0 billion in 1983 to TL 32.0 bil- lion in 1985. All bonds issued thus far have either been straight unsecured debentures or, more rarely, guaranteed by banks. Mortgage instruments, colla- teralized by real estate. equipment or other real assets, have not been issued in Turkey, though they should be suitable to a market in which inadequate financial information adds to the riskiness of unsecured instruments. 6.26 By CMB regulation, minimum and maximum maturities of corporate bonds are set at two and seven years. In practice, most recent issues have had 2-3 year maturities, with the two year minimum maturity being a serious constraint, especially in the absence of a sufficiently liquid secondary market. Issuing prices and coupon yields are set by the Central Bank according to a formula which determines a minimum and maximum yield to maturity. This formula had seriously restricted the competitiveness of bonds in 1983-84 but its relaxation in 1985 has permitted a better adaptation of bond yields to market conditions. All-in cost to issuers of bonds have recently averaged 66-68 percent, well below the cost of bank loans, while net yields to individual investors have been 56-58 percent. If allowed to better adapt to market conditions, particu- larly through repeal of maturity restrictions, bonds could be an attractive instruments to borrowers and investors alike. Under the proposed loan, it has been agreed that the detailed controls exercised by CMB in review and approval of corporate bond issues will be relaxed. 6.27 Government revenue sharing instruments, essentially tax free and with maturities of 3-5 years, have been first issued in 1984-85 to finance major infrastructural projects. This sharing in a project's revenues, rather than  - 47 - paying interest, makes them particularly attractive to orthodox Islamic inves- tors. CMB is studying the introduction of similar instruments for the private sector. These instruments would be particularly useful to meet funding needs of leasing companies, some of which are being established in a regulatory environment which has been improved by the enactment of leasing legislation in 1985. 2. Secondary Markets 6.28 In the past, the lack of efficient secondary capital markets and thus of liquidity has limited the potential for developing longer term financial instruments in TurKey. Trading in corporate equities and bonds has mostly occurred over-the-counter, with the old and obsolete Istanbul Stock Exchange being practically inactive. Even in the over-the-counter market, however, transaction volume has been extremely low, amounting in January-November 1985- to TL 2.5 billion for shares, TL 46.1 billion for corporate bonds and TlI 74.5 billion for revenue sharing bonds. Furthermore, the market has been charac- terized by fragmentation, lack of transparency and high intermediation costs, with trading spreads as high as 10-20 percent for equities. In the bond markets, dealers have mostly confined themselves to making markets in the secu- rities they had underwritten, trading only with their own clients and never with other dealers. 6.29 The opening of the new Istanbul Stock Exchange, at the beginning of 1985, should contribute to improved transparency and efficiency of both the equity and bond markets. The system of dealers/market-makers adopted by the new exchange as opposed to the old one based on agents - should provide listed securities with a certain degree of liquidity through market-making services. CHAPTER VII DEVELOPING THE ACCOUNTING AND AUDIT PROFESSIONS 7.01. The existence of a well developed accounting and audit profession, applying internationally accepted accounting standards is practically a pre- condition for the development of a modern financial system. However, there is as yet no professional organization for accountants in Turkey. The accounting function in the central and local Governments, State Economic Enterprises (SEE) and medium and large-scale private industrial and commercial firms is usually controlled by university graduates from the business, economic and law facul- ties. Numerous attempts have been made in the past to establish standards for the accounting profession in Turkey, but were blocked by interests now active in accounting and auditing professions. This chapter reviews the situation of the accounting and audit professions, the effect of poor accounting standards and the development of the profession under the proposed adjustment program, now that a legal enactment to establish a body for the development of the accounting profession has been finally enacted in December 1985. A. The Present Situation 7.02 Accounting. The Government accounting systems are in need of improve- ments. Following a study by the IMF in 1978, a comprehensive Government ac- counting scheme was proposed for the modernization of the system. The scheme  - 48 - has not been implemented as successive Governments have been too busy coping with more pressing financial and economic matters. The local Government accounting systems also have major deficiencies and are urgently in need of modernization. Similarly, most SEEs have financial accounting systems designed to produce financial reports required by Government budgeting regulations, rather than to provide financial information to analyze the operations of the enterprise meaningfully. Costing and management accounting in SEEs is practi- cally nonexistent at present. In some of the private Turkish holding companies and larger manufacturing companies, modern financial and management accounting systems have been developed and are operating satisfactorily. These cases, however, are the exception. In private industry in general, accounting is limited to control of assets and liabilities and to the production of annual income statements and balance sheets, mainly to meet the requirement of the tax laws. The accounting standards used in these accounts are those required by the tax code aud not in accordance with generally accepted accounting princi- ples. The accounts are usually finalized well after the end of the fiscal year. Management accounting is generally limited to ad-hoc costing for pricing purposes. 7.03 Auditing. Within the Ministry of Finance, there are three groups of auditors with about 400 staff consisting of Finance Inspectors, Tax Auditors and Sworn Bank Examiners. The Finance Inspectors are mainly responsible for auditing the accounts of Government departments; Tax Auditors are responsible for auditing tax returns; and Sworn Bank Examiners undertake on-site audit of state, commercial and development banks to ensure compliance with Government and Central Bank regulations. In addition, the High Control Board attached to the Prime Minister's Office, with a staff of about 180 auditors, is responsible for auditing SEEs. The public sector auditors are competent, but their number is limited; the result is that audits are not completed within a reasonable time-frame and that their examination is often, by necessity, cursory. Empha- sis is largely on compliance with Government regulations, and there is not much analysis of the financial management and performance of the entity being audited. 7.04 Private companies with a wide shareholder base are required under the Commercial Code to appoint auditors to inspect their books of accounts, report any irregularity to management and certify the company's accounts. No profes- sional qtralification is required for persons appointed as auditors. A number of the international accounting firms have associated firms operating in Turkey. These firms have two or three partners who have qualified abroad but the major part of their staff consist of recent university graduates without auditing experience. A substantial part of these firms' audit practice con- sists of auditing subsidiaries or associated companies of international firms. In recent years there has been an increase in demand for their audit services from Turkish industrialists and banks which wish to borrow abroad. There are also a number of Turkish accountants providing services to industry, but the major emphasis of their work is related to the completion of accounts for tax purposes.  ^ 49 - B. Needs for Development of the Profession 7.05 Modernization of the central and local Government accounting systems is urgently required to improve Government's budgetary control. Improvements in SEE accounting systems, particularly in the field of management accounting and costing, are an essential requirement of the Government's SEE reform stra- tegy. A modern costing system is also important for establishing pricing structures for SEEs' products, deciding on product mix and in reaching "make or buy" decisions, etc. A competent audit of SEEs covering financial management and performance in addition to the audit of accounts is important to provide an independent evaluation to the Government on the operational efficiency of these enterprises. 7.06 Major improvement in the accounting systems, with particular emphasis on management accounting, costing and auditing, are also required in the pri- vate industrial and commercial sectors. Turkish industry, which up to 1980 was heavily protected, has been gradually undergoing restructuring. A rapid in- crease in industrial productivity is essential to enable these firms to be com- petitive in the new economic environment. A reliable management accounting system is an important factor in achieving this objective. In addition, given the current high intermediation costs of the banking system, there is an urgent need to develop the securities markets in Turkey. The lack of adequate accounting standards, independent qualified auditors and disclosure require- ments has been one of the major factors in severely limiting the development of an equity and bond market for financing industrial development. 7.07 Better accounting standards are also essential to enable the Govern- ment to levy and collect tax. Public auditing would reduce the burden on tax inspectors in reviewing the tax returns of well organized industries as the inspectors could rely on a sample check of each accounting firms' returns to evaluate their work. This reduction in work load would enable inspectors to direct their attention to other areas particularly the commercial and profes- sional sectors where tax evasion is endemic. With the recent introduction of a value-added tax, the upgrading of accounting and audit procedures has become urgent to ensure adequate collection of this tax. C. Proposed Council for Sworn Financial Advisors 7.08 The Government of Turkey has made numerous efforts during the past three decades to enact a law for the control and development of the accounting profession to improve accounting and auditing practices in Turkey. Legislation has been submitted to Parliament several times but failed to secure approval due to opposition from various groups protecting their own parochial interests. In December 1985, however, an act was passed setting up the legal framework for an Council for " Sworn Financial Advisors" (SFA). The term "Sworn Financial Advisor" was used in the law as the Turkish term for accountant is now gene- rally used to refer to bookkeepers. Under the law, the Government is authorized to appoint an initial 20-member council for a 3-year period to be responsible for the development and control of the accounting profession. Under the loan, it has been agreed that the council would be appointed at the earliest, in any event prior to tranche release review, with appropriate com- position. The primary objective of the law is to increase the collection of  - 50 - tax by improving the standard of accounting. The mandate of the council, how- ever, is broad enough to enable it to undertake a general development of the accounting and audit profession. The law, (i) sets forth in general terms the scope of work of SFAs; (ii) authorizes the tax authorities to accept as audited, tax returns certified by SFAs while reserving the tax authorities right to reexamine these returns; and (iii) empowers the Council of Ministers to issue decrees setting forth regulations for the organization, adminis- tration and control of Chambers of Sworn Financial Advisors. 7.09 To enable the council to develop proposals for the establishment of a professional organization and for the development of the professional, tech- nical assistance will be funded under the proposed loan in the following fields: (i) design of the organiiation's legal charter, by-laws and establishment of an appropriate administration; (ii) assessment of the potential number of accountants required during the next ten years and appropriate accounting streams (e.g. public auditors, financial accountants, management accountants and public service accountants); (iii) establishment of educational standards for admisaions of student members, selection of appropriate professional subjects for each stream of accounting, establishment of appropriate curriculums; (iv) organization of professional examinations, establishment of practical experience requirements for admission of mature and student candidates to full membership. (v) preparation of generally accepted accounting and auditing standards for Turkey; and (vi) organization of seminars to promote the accounting profession in Turkey. 7.10 In addition, finance will be provided under the loan to cover the foreign exchange cost of the council's office equipment, travel and subsis- tence allowances for members of the council and the establishment of a library. Annex 20 summarizes the technical assistance program for the council. CHAPTER VIII THE PROPOSED LOAN A. Rationale and Objectives 8.01 The proposed loan has originated from the Bank's economic and sector work in Turkey during the last five years particularly concerning issues in the financial sector. The role of the financial sector in Turkey's develop- ment, its performance and prospects, and the policy and institutional con- straints which inhibit its development have been under continuous discussion  - 51 - between the Bank and the Government since 1983. As a result of this close dia- logue, the Government has already undertaken several important reform measures. These includes: (i) liberalization of deposit rates; (ii) reduction in the extent of selective credit; (iii) a gradual rise in selective credit interest rates; (iv) reduction in financial transactions tax; (v) reduction in reserve and liquidity requirements; (vi) substantial overhaul of banking legislation; and (vii) establishment of the Capital Market Board. These measures, while important, will not complete the process of financial sector reform. It has always been recognized that the process of financial sector reform would have to continue for several years for the impact of the reform measures to be evident at the institutional level. The proposed loan would be in support of a multi-year program of further policy and institutional measures as set out in the Letter of Financial Sector Policies. B. Loan Components 8.02 The proposed loan of $300 million will be made to the Government at the Bank's normal variable interest rate. The loan has two components: (a) the sector policies reform component, and (b) the technical assistance component. (a) Sector Policies Reform Components: This component of $297.0 million is in support of the new policy actions envisaged in the financial sector during 1986 and during the medium-term, as committed by the Government in the Statement of Financial Sector Policies. The major objectives of the sector policies reform program are to: Ci) improve the efficiency of the resource mobilization and allocation process through support for creating an appropriate interest rate structure and adjustment mechanisms; (ii) reduce the extent of implied subsidies on selective credit to productive sectors; (iii) rationalize the tax treatment of financial instruments; (iv) strengthen the capacity of the Central Bank to monitor the operation of banks; (v) support the introduction of standardized accounting and external audit of banks; (vi) encourage measures to reduce the intermediation costs of commercial banks; (vii) strengthen the institutional framework for the development, supervision and regulation of primary and secondary securities markets; (viii) assist the development and functioning of interbank and money markets; (ix) stimulate the development of the equity markets;  - 52 - (x) support the development of the accounting and audit professions; and (xi) initiate the introduction of new financial services. (b) Technical Assistance Component: 8.03 This component of $3.0 million, will benefit six agencies involved in the implementation of financial sector reforms -- the Treasury, the Central Bank, the Board of Sworn Bank Examiners, the Capital Market Board, the Proposed Council for Sworn Financial Advisors, and the commercial banks. The overall program includes the provision of about 55 staff months of consultancy services. Recruitment of consultants will be as per Bank guidelines. In addition, office equipment and training of selected staff of the beneficiary institutions at suitable institutions abroad will be financed. The technical assistance programs for the beneficiary agencies are detailed in Annexes 16-20. An overview of the costs is provided in Annex 21. Implementation schedules are shown in Annex 22. About 65 percent of the foreign exchange costs will be funded under this loan component. The local currency costs as well as the remaining foreign exchange costs will be borne by the beneficiary agencies. A summary of the foreign exchange costs which will be funded out of proposed loan is shown below: Foreign Exchange Costs of Technical Assistance Program (September 1986 - December 1987) ($'000) Consultancy Beneficiary Agency Training Services Equipmuent Total Central Bank 169.2 85.0 108.0 362.2 Board of Sworn Bank Examiners 204.0 - 51.0 255.0 Banking Institute - - 882.0 882.0 Capital Market Board 95.7 36.0 144.0 275.7 Board of Sworn Financial Advisers 180.0 218.0 114.0 512.0 Treasury 200.9 147.2 365.0 713.1 Total 849.8 486.2 1,664.0 3,000.0 C. Utilization 8.04 The proposed loan would finance about 1.3 percent of Turkey's total merchandise imports over the disbursement period (Sept-1986 to Sept-1988). The proposed loan would finance all goods to be imported into Turkey except for goods financed by other sources and a specific list of excluded items such as military or para-military items and luxury goods such as tobacco, precious stones and jewelry, gold, and nuclear reactors and parts. D. Procurement, Disbursement and Administration 8.05 The Undersecretariat for Treasury and Foreign Trade and the Central Bank will have primary responsibility for administering the proposed loan.  - 53 - Procurement of goods costing $10 million or more will be through international competitive bidding in accordance with the Bank's Guidelines for Procurement. Certain commonly traded commodities may be purchased through price quotations from organized international commodity markets. All contracts of lesser value would be awarded through normal trade channels on the basis of normal procure- ment procedures of the public and private sector firms concerned. Procurement of computer hardware/software will be on the basis of obtaining at least three price quotations from eligible suppliers as per Bank guidelines or through direct negotiations with the original manufacturer where compatibility with existing equipment is necessary. Firms in Turkey have adequate choice of international suppliers to ensure reasonable availability and price. 8.06 Consultancy services to be obtained for the various technical assist- ance components will be obtained as per the Bank's Guidelines for Recruitment of CQnsultants, except in the case of the Bankers' Training Institute, for which a management contract (which is not being financed by the Bank) with Citibank is expected to be concluded shortly. Procurement of other items such as office equipment will be as per the procurement procedure above. 8.07 To simplify disbursement, only invoices with a minimum value of $50,000 equivalent would be eligible for disbursement. The loan would be disbursed against only foreign expenditures. In order to permit a smooth flow of imports, retroactive financing of upto $30 million has been provided for. In order to ensure that Turkey will have ready access to foreign exchange, a special account would be established in the Central Bank of Turkey to which the World Bank would make an initial deposit of up to $45 million. Payment requests would be made against full documentation except for those against contracts valued up to $100,000 equivalent relating to the technical assistance of the project, and contracts valued up to $3,000,000 equivalent for the policy component, where statements of expenditure (SOEs) would be authorized. The special account would be replenished against withdrawal applications at monthly intervals or as appropriate when the undisbursed balance of the account falls below $25 million. The closing date for disbursement will be September 30, 1989. It is expected that the entire amount of Bank financing for the technical assistance component will be disbursed by this date. E. Monitoring and Tranche Release 8.08 Monitoring of performance involves essentially three complementary and inter-related activities. Monitoring of the implementation of the Government's macro-economic program which is an ongoing activity as a part of the Bank's economic dialogue and reporting arrangements; monitoring the implementation of the financial sector adjustment program as a whole; and the monitoring of progress on specific agreed reform actions as a condition of tranche release. The spzcific conditions proposed for release of the second tranche of $100 million will be achievement of satisf.. tory progress on the following: (a) Actions to ensure adequate progress in implementing the 1986 economic program including inflation control and adoption of a 1987 economic program, compatible in terms of its strategy and its targets, with the Government's adjustment program (para 2.14);  - 54 - (b) Achievement of positive real. interest rates, determined according to a methodology satisfactory to the Bank, on preferential credit to the productive sectors i.e. agriculture, industry, mining, trade, transport and tourism (para 4.14); (c) -Satisfactory completion of the review to determine the need for continuation of and form of FERIS (para 4.20); (d) Introduction of compulsGry external audit of the annual financial statements of commercial banks commencing from the fiscal year 1987 (para 5.10); (e) Introduction of compulsory external audit of annual financial statements of corporations issuing securities by public issue, or seeking listing of their securities on the Istanbul Stock Exchange commencing from the fiscal year 1987 (para 6.14); (f) Appointment of Council for Sworn Financial Advisors with appropriate composition and conclusion of satisfactory arrangements for technical assistance for the council (para 7.08); (g) Actions to revise the examination manual used by the Board of the Sworn Bank Auditors (para 5.14); (h) Actions to carry out a study and to prepare an implementation program for setting up a system of export credit and insurance (para 2.10). Disbursement for the technical assistance component would not be subject to the tranche release conditions. F. Justification and Risks 1. Justification 8.09 A more efficient financial sector will increase the Governments' ability to manage the economy and further the success of the economic adjust- ment program by increasing resource mobilization and improving resource allocation mechanisms. Increased efficiency of the financial sector will thus enhance growth, both by increasing savings and by channelling them to higher yielding investments. In particular, by developing a greater variety of finan- cial instruments, financial sector reform will enable financing of investments more economically, thus contributing to a revival of private investment. The improvement in the supervision and surveillance of the banking system by the Central Bank and the Board of Sworn Bank Examiners will increase confidence in the Banking system, which should induce its further growth. 8.10 The loan will also address the development of the accounting and audit professions, which is one of the most glaring gaps in the financial system in Turkey. The development of the profession and improved accounting systems will in the long-run improve the Government's budgetary control, improve monitoring of SEE performance and tax collection. In the private sector, efforts at productivity improvement and restructuring will be facilitated. Finally, the development of the money and capital markets, which is a major objective in the sector reform programs, will be helped.  - 55 - 2. Risks 8.11 The reforms sought in the sector policies related to interest rates and selective credit policies could be rendered more difficult by failure in attaining macro-economic policy objectives; most critical among which is the reduction of inflation. The outlook for inflation, which acts as a major impediment to stable growth in the financial sector, is more positive than at any time in the last two years. Since the reemergence of high inflation in 1984, policies have been followed to curtail inflationary pressures, and they appear to be working. During the course of 1986 and 1987 it will become clear whether stabilization has finally taken a firm hold and inflationary expecta- tions are defeated. Until then, uncertaircy about the impact of inflation on the financial sector will, by necessityv continue to prevail. 8.12 Improvements in the functioning of the banking system have a higher probability of being realized, as the pressure of competition from new banks will provide a considerable impetus. The progress made in setting up the Central Bank's surveillance department, the thoroughness of the consultants' study in setting out the procedures, and the positive response of the banks' to the new procedures and mechanisms, indicate a low risk in this area. However, the financial health of the corporate sector is critical to improvements in the banking systems. This aspect is also linked to progress in control of inflation) as corporation distress will be further worsened by high real interest rates, and in turn affect the viability of banks. 8.13 Risks in regard to the capital market program relates to the limited impact which the development program can achieve while inflation is high and the return which equity holders can obtain is unlikely to match the interest rates on fixed-term deposits. However, progress to date is encouraging in that there a strong, though somewhat thin demand for equities and the corporate bond market is growing rapidly. While the resistance to the introduction of compulsory external audit is to be expected, there is a growing awareness of the necessity of properly audited accounts as Turkish firms are entering into joint ventures with foreign companies. The above risks, though considerable, do not appear to be of a magnitude which could jeopardize the continuation of the financial sector adjustment program undertaken by the Government. CHAPTER IX RECOMMENDATIONS 9.01 The Government has committed itself to carrying out the following actions as recorded in the Statement of Financial Sector Policies: (i) Positive rates on preferential credits to productive sectors would be achieved by end of 1986 as already stated under SAL IV, and would be maintained thereafter (para 4.14). (ii) A reference rate mechanism would be developed in order to help the Government to monitor and adjust preferential credit interest rates, thereby reducing and eliminating the implied subsidies on preferential credit (para 4.22).  - 56 - (iii) Interest rates mechanisms especially for medium and long term rediscounted loans designed to reduce interest rate risk to both borrowers and lenders would be introduced (para 3.11). (iv) Need for continuation of, and form of FERIS would be reviewed prior to the end of 1986 (para 4.20). (v) Reserve requirements for banks would be progressively reduced to 15. percent, thus decreasing the marginal cost of loanable funds in the banking system (para 4.11). (vi) Taxation of income from holdings of Government bonds would be introduced to decrease the after-tax return to banks and other financial institutional holders, thus inducing the use of funds for lending (para 4.13). (vii) Surcharge on non-export related borrowing in foreign currency would be introduced to control undue increase in short-term foreign liabilities of the private sector and to bring foreign currency borrowing costs more in line with local costs (para 4.09). (viii) Standardization of accounts of commercial banks would be enforced from 1986 (para 5.08). (ix) Legal enactment to set up the Board of Sworn Financial Advisors would be completed and Audit Commission with appropriate composition to be set up (para 7.08). (x) Independent external audit of banks would be enforced from 1987. List of acceptable auditors to be prepared and issued by June 1987 (para 5.10). (xi) The capability of the Central Bank to monitor the operations of commercial banks on an off-site basis would be strengthened by setting up an adequately staffed surveillance department (para 5.11). (xii) Commercial banks would be permitted to deduct provisions for doubtful debts, subject to limits to be set by the Government (para 5.09). (xiii) The examination manual used by the Board of SBEs would be revised to shift the focus of examination from ensuring compliance with law to encouraging the setting up of management control systems in the banks (pars 5.14). (xiv) Compulsory external audit would be required of corporations issuing securities in the capital market simultaneously with the introduction of external audit of banks (para 6.14). (xv) The detailed controls exercised by the Capital Market Board while processing applications for issue of corporate bonds i.e. prior fixing of issue price, rates of brokerage and underwriting commissions, maximum and minimum maturities etc. would be relaxed in the case of corporations with audited accounts (pars 6.14).  - 57 - (xvi) issue of commercial paper and short term promissory notes would be encouraged to provide an alternative means of raising resources for corporation. Supply of equities in the market would be stimulated by providing tax incentives to corporations to offer equities to the public subject to their accounts being audited (paras 6.22, 6.26). (xvii) Demand for equities would be stimulated by reviewing the investment policies of institutional investors (para 6.20). (xviii) Demand for equity holding by individuals would be stimulated by exempting dividend income and capital gains from personal taxation (para 6.22). (xix) Financial transactions tax on interbank transactions would be reduced or abolished (para 6.06). (xx) Withholding tax on interbank deposits held by foreign banks would be reviewed with a view to its being reduced or eliminated (para 6.06). (xxi) Limits would be introduced on the proportion of shares of a company, except related financial operations such as leasing companies, that can be held by banks (para 5.16). (xxii) A system of medium and long term export credits designed to support the export of capital goods and engineering services would be set up (para 2.10). (xxiii) A system of export credit insurance would be set up-(para 2.10). (xiv) The scope of deposit insurance would be reviewed perio6 cally to maintain coverage levels in real terms (para 5.26). 9.02 On the basis of (i) the above; and (ii) agreements reached on conditions for tranche release and on the implementation of the technical assistance component, the approval of a loan of $300 million is recommended.  - 58 Annex I Page 1 of 10 May 13, 1986 Mr. A. W. Clausen President International Bank for Reconstruction and Developmeat 1818 H Street, N.W. Washington, D.C. U.S.A. Dear Mr. Clausen: The Turkish Government has now completed the sixth year of the Government's program for restructuring the economy. The adjustment program has helped Turkey to expand exports and to improve its external balance. Under the Fifth Five-Year Development Plan, the Government will continue to encourage liberalization of the economy, develop industry along lines of comparative advantage and promote growth of exports. We have also beguu to widen the adjustment process by emphasizing policy and institutional reforms at the sectoral level. The Government has given a high priority to reforms in the financial sector, within a medium-term framework covering the next five years. The attached Statement of Financial Sector Policies describes the main elements in the Government's program for financial sector reform relating to sector policies, the banking system and the development of capital markets. It encompasses policy and institutional measures either under way or those to be undertaken in 1986 and 1987. The Government is committed to carry out the financial sector reform program as described in the attachments. As always, the Government would welcome the opportunity to discuss these matters with the World Bank. I am writing to you at this time to request a Finaucial Sector Adjustment Loan in the amount of $300 million to assist in the financing of the Government's program of financial sector reform. Yours sincerely, /s/ Kaya Erdem Deputy Prime Minister and Minister of State  - 59 - Annex 1 Page V of 10 Attachment I STATEMENT OF FINANCIAL SECTOR POLICIES - 1986 Introduction 1. The Government recognizes that an important determinant of the success of the economic reform program begun in January 1980 will be the effectiveness of changes being introduced in the financial system under the reform program, and especially during the last two years. Efficient functioning of the financial system is very closely linked with macro-economic policies followed by the Government to address the major issues in the readjustment program. The overall objective of the Government is to establish over the medium term an efficient and flexible system of resource mobilization and allocation, which would respond rapidly to market forces and would offer a wide variety of instruments to both savers and borrowers, make resources available efficiently at positive real rates, and continue to grow in real terms. Macro-Economic Perspective 2. The Government will pursue an economic system in which market forces operate freely. The main function of the state in economic development should be regulatory, helping to remove obstacles to the growth of productivity. The direct activities of the state should be confined to the development of infrastructure that serves the nation as a whole. 3. Financial sector reform can only be carried forward within a framework of sound fiscal and monetary policies. In the context of the economic reform program, the Government has pursued monetary and fiscal policies aimed at curbing the budget deficit, controlling inflation and maintaining export growth. These policies have produced substantial results, notwithstanding the setback that occurred in 1983. In 1984, GDP growth was 5.9 percent; it is estimated to have been 4.9 percent in 1985 and is projected at 5.0 percent in the 1986 Annual Program. Inflation is likely to be lower, at 38.2 percent in 1985 as compared to 53.5 percent in 1984 (both measured on a December/December basis), and is projected to decline to 25 percent in 1986; the budget deficit has been reduced substantially from 4.9 percent of GDP in 1984 to 2.3 percent in 1985, and is targeted to decline to 1.4 percent in 1986. The Government is fully committed to continue these policies. Scope of Financial Sector Adjustment 4. The Government proposes to address a wide range of issues in the financial sector as actions in various areas are closely interlinked. The principal issues lie in the areas of interest rates and selective credit policies, the functioning of the commercial banking system, the development of capital markets, and introduction of new financial services such as export credit and insurance. The progress that has been achieved in the principal areas during the last few years, and the steps the Government proposes to take, are described more fully in the following paragraphs.  - 60 - Annex 1 Page 3 of 10 Interest Rates and Credit Flows 5. The Government's long-term objective, in keeping with the objective of reducing the role of the state in the economy, is to allow market forces to determine the level and structure of interest rates. HIowever, there are a number of constraints which make it difficult to move immediately to full liberalization of interest rates, including the volatility of international interest rates, the lack of sufficient depth in the inter-bank money market and the heavy indebtedness of the corporate sector. The Government has already taken an important step toward liberalization of interest rates by starting a system of weekly auctions of treasury bonds since the middle of 1985, in which the yields are determined freely according to availability of funds ir -he banking system. The Government's next objective would be to encourage the development of a secondary market in Government securities which would offer opportunities for shorter-term placement of funds. 6. The Government is committed to maintain, and has maintained, positive real rates on term deposits since the beginning of 1984. In setting deposit rates, the Central Bank has also progressively provided higher yields on longer maturity deposits to lengthen the average maturity of the deposit resources in the banking system. The Central Bank will continue to review trends in domestic as well as international credit markets, in conjunction with the Government's inflation control program. Once inflationary expectatic ts have been lowered sufficiently, it is the Government's intention to liberalize deposit rates so that they are determined by market forces. 7. In the area of lending, the Government recognizes that interest rates remain high in real terms and tend to hinder investments. The Government's objectives are to (i) reduce the difference between the interest rates on preferential and non-preferential credits, (ii) reduce the flow of preferential credit, and (iii) encourage the availability of medium and long term credit for the productive sectors of economy. Substantial progress has already been achieved in reducing the difference between the interest rates on preferential and non-preferential credits during the past two years. Interest rates on preferential credits available through the Central Bank's rediscount facility have been raised by an average of about 17 percentage points since the end of 1983, and banks are permitted to charge their normal interest rate on the non-rediscounted part of a loan, thus raising the total cost to the borrower of a typical blended loan package to real positive rates for most categories of preferential credits. As a result of the substantial rationalization of the rediscount facility in the past two years, there exist basically only five categ ries of rediscount rates at present, as compared to more than 30 categories three years ago. The total flow of credit through the various rediscount windows has also been reduced sharply. The combination of reduced flows and higher interest rates has resulted in a decline in the proportion of preferential credit to the productive sectors of the economy to only about 13 percent of total credit as of September 30, 1985. The Government's intention is to maintain the progress in rationalization of rediscount rates, with the objective of providing uniform treatment for all investment credits supported by the facility.  - 61 - Annex 1 Page 4 of 10 8. The Government remains committed to achieving positive real levels on preferential credits to the productive sectors of the economy by the end of 1986. The Government proposes to ensure that these interest rates remain at positive levels thereafter by periodically reviewing and adjusting the rates. As a result of periodic adjustment, the Government plans to reduce and eliminate the implied subsidies on preferential credits to the productive sectors. 9. In order to stimulate private investment, the Government intends to encourage the development of a resilient system of medium and long term lending. This will require the strengthening of the capability of the commercial banks to appraise investment projects, and placing the resource availability to the development banks on a sound footing. Commercial banks already have the freedom to set and adjust their lending rates in the light of market conditions. The Government also intends to pursue the introduction of interest rate mechanisms on medium and long term rediscounted loans designed to reduce the interest rate risk to both borrowers and lenders in an environment of fluctuating inflation. 10. In 1984, the Government introduced a scheme to protect borrowers of long term foreign currency loans for investment purposes from foreign currency risk, and thus to encourage investment. This scheme, which is intended to be a temporary expedient until the investment climate improves, is under the Government's constant review. An examination of the need for the continuation of the scheme will be carried out before the end of 1986, taking into account the prevailing rate of inflation, the cost of financing from other sources and the level of private sector investment. 11. As a further measure to encourage the flow of credit from the banking system to the private sector, the Government is introducing a withholding tax on the income from holdings of Government bonds. This is expected to bring the return, on an after-tax basis, of bond holdings closer to the return on loans to the private sector, and thus encourage the use of the commercial banks' loanable funds for lending to the private sector. The Banking System 12. The Government's long-term objective is to enhance Turkey's growth prospects by improving the efficiency and competitiveness of the financial sector, and particularly of its most important component, the commercial banking system. These objectives are proposed to be achieved by fostering increased competition to reduce intermediation margins, strengthening the role of the Central Bank in offsite monitoring of commercial banks, improving transparency in the functioning of banks by the introduction of standardized accounting and by the introduction of independent external audit of banks. The banking law which was introduced in 1983 has already brought about improvements in the functioning of the banks. The law was further revised in 1985. The Government has licensed more foreign banks to open branches in Turkey. The number of foreign banks has grown from six in 1980 to 16 in mid-1985, thus encouraging competition among banks. The number of foreign banks is expected to increase further.  62 - Annex 1 Page 5 of 10 13. The accounting system required in the banks has been completely standardized following a major study carried out with the assistance of consultants. Extensive discussions have been held with the banks, and the new system is to be followed from January 1, 1986. Under the new system of accounts, banks will be required to provide regular reports to the Banking General Directorate of the Treasury, the Central Bank, and the Board of Sworn Bank Examiners. These reports are designed to render the accounts of the banks much more transparent and will enable the Government to monitor the banks' performance more effectively and in a timely fashion. 14. The introduction of the new accounting system and the Government's objective of improving the efficiency of the banks has brought with it the need to revise the system of bank supervision. The Government has decided that the responsibility for the offsite monitoring of commercial banks would be with the Central Bank. For this purpose, a monitoring and surveillance department is being set up in the Central Bank. The Board of Sworn Bank Examiners, which is responsible for the audit of banks, is also in the process of revising its audit methods to give greater emphasis to the setting up of management control systems in the banks rather than the detailed scrutiny of individual transactions. The Government would welcome technical assistance to train staff of these agencies to fulfill their increased responsibilities. 15. Simultaneously with the introduction of standardized accounting in the banks, the Government has announced that bank financial statements will be required to be audited by independent external auditors commencing from 1987. Tne Government is in the process of formulating criteria for the appointment of auditors in time for implementation of this requirement. 16. The capital adequacy of banks is being addressed by the Government through provisions requiring higher minimum capitalization under the new banking law. The capital structure of banks has been affected in recent years by low profitability and by the bad and doubtful loans carried on their books. With the liberalization of lending rates, banks have been able, in 1984-85, to increase their profits and to build up reserves. The standardized accounting system will also enable an accurate assessment to be made of the extent of non-performing loans in the portfolios of banks. In the near future, the Government intends to take additional measures to enable banks to set aside adequate provisions, such as permitting them to deduct provisions for non-performing loans from their taxable profits. Capital Market Development 17. The development of the manrfacturing and non-financial services sector in Turkey has in most cases been more dynamic than the development of its financial instruments. The term-to-maturity of credit available in the capital markets and the type of access to financial services available to many firms are new seen to be a constraint to healthy growth of the corporate sector. The part of the financial sector through which these problems are to be addressed is the capital market. Anl enhanced role for this market would help to make risk-reward relationships more transparent. It would also permit firms to adjust their financial structure to lessen some of their debt burden, assist entrepreneurs seeking to raise funds and permit greater private participation in capital gains produced by economic growth.  - 63 - Annex 1 Page 6 of 10 18. The Government has introduced measures to improve the regulatory framework within which the capital market functions in the capital market law which was issued in 1982. Further measures the Government intends to introduce will be aimed at improving the quality and quantity of the information regarding corporate finances available to prospective investors in the market. In approximately the same time-frame as that intended for the introduction of external audit in the banking system, external audit of corporations issuing securities in the market will be introduced. In parallel with the introduction of audit, the issue of commercial paper will be liberalized to enable corporations to meet their short-term requirements directly from savers through the capital market. 19. The Government is committed to the use of financial incentives to promote the widening of shareholding in Turkey, in recognition of the social benefits that result from increased shareholding by the public. Steps already taken in this direction include removal of the ceiling of TL 3.0 million on tax exempt income on equity holdings of individuals. Encouragement is also being provided to corporations to issue additional capital to widen their equity base by exempting premiums on issue of fresh shares from taxation. 20. Tax concessions which would provide an incentive to corporations to issue shares to the public are also under the consideration of the Government, although this step will have to be taken concurrently with the introduction of external audit of the corporations issuing the shares and also keeping in view the likely impact on Government revenues. 21. The inter-bank money market has grown rapidly in Turkey in response to the reduction in the financial transactions tax from 15 percent in 1982 to 3 percent in 1984. The Government intends to support the growth of the inter-bank market, which would enable banks to employ their short term liquidity and improve efficiency in resource utilization. To this end, the Government is seeking legislative approval to further reduce the financiaa. transactions tax. Development of the Accounting Profession 22. As the liberalization of the banking system and the development of the capital market on a healthy basis will require provision of reliable financial information to the public as well as the Government, the Government has introduced legislation to set up . Board of Sworn Financial Advisers which would set standards for auditors, educational and training requirements, and criteria for admission to the accounting and audit profession. The Board is expected to be set up, subject to passage of the legislation in the Grand National Assembly, by mid-1986. Medium-Term Measures 23. In addition to the above measures which the Government is already in the process of implementing, it is also intended that additional measures to diversify the range of services offered by the financial sector will be  - 64 - Annex 1 Page 7 of 10 studied by the Government. These relate among others to tk.e setting up ot an export credit insurance scheme, as well as the provision of medium and long term credit to promote exports of capital goods. As the r4pital market develops, the Government also intends to take up the question of enco.raging the banks to sell off most of their equity holdings in corporations, and thus widen corporate ownerships further. The Government would welcome technical assistance from the World Bank in these areas. Conclusion 24. The Government would welcome an opportunity to discuss the above adjustment measures and progress in their implementation with the Worl' Bank before the release of the second tranche of the loan. In the attachment to this Statement, the specific policy measures the Government intends to carry out in support of its program for financial sector reform are identified.  - 65 - Annex I Page 8 of 10 Attachment II FINANCIAL SECTOR MEDIUM-TERM ADJUSTMENT FRAMEWORK Policy Area Issue Measures to be Implemented A. Sector Policy Interest rates 1. Positive rates on preferential credits to productive sectors to be achieved by end of 1986 as already agreed under SAL, and to be maintained thereafter. Reference rate to be developed in order to help the Government to monitor and adjust preferential credit interest rates, thereby reducing and eliminating the implied subsidies on preferential credit. 2. Interest rate mechanisms, especially for medium and long term rediscounted loans, designed to reduce interest rate risk to both borrowers and lenders to be introduced. 3. Need for continuation of FERIS to be reviewed prior to the end of 1986. 4. Reserve requirements for banks to to be progressively reduced to 15 X, thus decreasing the marginal cost of loanable funds in the banking system. Tax treatment of 5. Withholding tax on Government bonds financial to be introduced to decrease the after- instruments tax return to banks and other holders, thus inducing use of funds for lending. 6. Surcharge on non-export related borrowing in foreign currency to be introduced to control undue increase in short-term foreign liability of the private sector and to bring foreign currency borrowing costs more in line with local costs. B. Banking System Supervision of 1. Standardization of accounts of commercial banks commercial banks to be introduced from 1986.  - 66 - Annex 1 Page 9 of 10 Banking System Supervision of 2. Board of Sworn Financial Advisers (contd.) commercial banks with appropriate composition to be set (contd.) up. 3. Independent external audit of banks to be required from 1987. List of acceptable auditors to be prepared and issued by June 1987. 4. Commercial banks to be permitted to deduct provisions for doubtful debts from their taxable profits, subject to limits to be set by the Government. 5. The examination manual used by the Board of Sworn Bank Examiners to be revised to shift focus of examination from ensuring compliance with the law to encouraging the development of management control systems in the banks. 6. The capability of the Central Bank to monitor the operations of banks on an offaite basis to be strengthened by setting up -of an adequately staffed monitoring department. C. Capital Market Regulatory 1. Compulsory external audit to be Framework required of corporations issuing securities in the capital market, in parallel to the introduction of external audit of banks. 2. The detailed controls exercised by the Capital Market Board while processing applications for issue of corporate bonds, i.e. prior fixing of issue price, rates of brokerage and underwriting commissions, maximum and minimum maturities, etc. to be relaxed in the case of corporations with audited accounts. 3. Issue of commercial paper and short term promissory notes to be encouraged to provide an alternative means of raising resources to corporations. Responsibility of regulating the issue of such short term instruments to be determined taking into account that they are essentially money market instruments.  - 67 - Annex 1 Page 10 of 10 Attachment II Capital Market Equity Markets 4. Supply of equities in the market to (contd.) be stimulated by providing tax incentives to corporations to offer equities to the public subject to audit requirements being introduced. 5. Demand for equities to be stimulated by reviewing the regulations regarding investment policies of institutional investors. 6. Demand for equity holding by individuals to be stimulated by exempting dividend income and capital gains from personal taxation. Interlocking of 7. Limits to be introduced on ownerships of proportion of shares of a company, banks and except in related financial operations companies such as leasing companies, that can be held by banks. Inter-bank Market 8. Financial Transactions Tax to be reduced to enable growth of inter-bank transactions. 9. Witholding tax charged on interest from inter-bank deposits to be reviewed with a view to its being reduced or eliminated. D. New Financial Financing of 1. A system of medium and long term Services exports credits to support the exports of capital goods and engineering services to be introduced. 2. A system of export credit insurance to be introduced. Deposit insurance 3. Scope of deposit insurance to be reviewed to raise coverage period- ically to maintain level of coverage in real terms.  TURKEY Rnanciol Sector Adjusmnent Loan Credt Rows by Source (As of September 1985) I 5,861.3 bWbn Total credit in ___ So~~~~~~~~~~enking setorf_I Other Rnancalalf"ufons Central Bank Deposit Money t& D o CredIt Ban*s (DM8s) arks (ID8s) .L _ .-- L4,362 5 bbon . 1172.7bll9on 7IIE~ IT. 164biIon -o fro DMs m dmm te | + d | < ~~r-~ ;;;X r- ~~, ;v Credh (Reicone) OwnI ~ P4mucs Credit Own Resources Credit I I I I IL916. bilion 1L 305,8bIlkn IL263.7 blIlIo lL4I15.2billion TLl421 blo IL5142 blUon Source: Central Sank d Tuxkey Wod 8*-30356c  69 bsm 3 T1ME - Financial Sctv AdiJutunt Loan Total Cr"it Oststandin,, 19745 (. Tn billions) larch June Sept Growth Rate 1979 tN 1 1991 192 1983 1994 19M5 13 19 1-85 I.U"L To Cetral Bak Direct Credits,: krt-twe 214.5 367.0 495.2 522.7 599.1 5452 751.5 773.2 916.1 23.7 Advuc to nwrent Depost Nomy anks (bi) Rudi Kcoted Credits 120.9 239. 376.9 321.3 569.5 273.3 237.4 311.9 26W on _1sources 325.3 549.6 941.8 104.3 184.0 2071.0 30.5 3593.2 4115.2 Sub-total 446.2 709.5 1310.7 1t05.6 2417.5 3149.3 3235.9 3910.1 4373.9 Lss loans lent to 18Bs 5.2 8.3 17.7 22.7 18.8 16.4 Skb-total 446.2 789.5 1318.7 1300.4 2409.2 3131.4 3263.2 3891.3 4362.5 48.7 Invnt. & Ins. Banks (Ilk) Rediscountsd Credits 44.7 48.3 53L5 66.6 75.5 3.5 36.7 40.2 42.1 On Reource 91.7 128.7 191.7 273.6 344.4 480.8 406.3 493.9 514.2 kb-total 145.4 177.0 245.2 340.2 419.9 517.3 523.5 539.1 556.3 Plus loans lInt from _ID 5.2 0.3 17.7 22.7 18.8 14.4 L=s mots Int to Nlis 10.0 7.1 Sub-total 135.4 169.9 245.2 345.4 420.2 535.0 54.2 557.9 572.7 20.5 Total Credit Stock 79t.1 1326.4 2059.1 26h8.5 3426.5 4231.8 450.9 52=2.4 5915.3 41.5 Icrease (TL bil.) - 530.3 732.7 609.4 758.0 805.3 329.1 661.5 428.9 Irosth rate Ii) 64.6 55.2 29.6 29.4 23.5 7.8 14.5 12.0 Go., BAnd Holdings 32.3 59.5 111.3 192.2 212.3 686.0 856.6 M.8 1080.0 04.1 Totbl Credit ad 6Wt.Buds 820.4 1385.9 2170.4 2840.7 308.8 4917.3 5417.5 215.2 6931.3 44.7 Increas ITL bil.) 557.5 734.5 690.3 773.1 I29.0 499.7 7.7 714.1 Growth rat 40.2 34.1 24.1 21.4 26.0 9.2 12.8 10.3 I.REAL TUM Inflation Rts (It 63.9 107.2 36.8 27.0 30.5 50.3 36.4 WI(1979a1Q0) 100.0 207.2 233.4 340.0 469.8 706.1 704.1 706.1 964.5 Cintral Balk Credit 214.5 177.1 174.7 145.2 125.4 80.0 106.4 109.5 95.0 -13.2 Total DlIh Credit 446.2 381.0 465.2 500.1 512.8 443.5 462.1 551.1 452.3 0.2 Total IgIs credit - 135.4 82.0 86.5 95.9 91.1 75.8 77.4 79.0 59.4 -13.4 Total Credit Stock 796.1 640.2 726.4 741.3 729.4 599.3 645.9 739.6 60.6 -4.6 Total Credit and Bout. Bonds 928.4 666.9 765.7 794.7 774.6 696.5 767.2 890.2 718.6 -2.4 Sourcet Central ank of Turkey, uarterly 8ulultin, 1985 111. v  Annex 4 -70- TURKEY - Financial Sector Adjustennt Loan Shares of Total Credit Outstandin;, 1979-85 11 Sept. 1979 1980 1981 1982 1983 1984 1985 Central Bank Short-Term advances 26.9 27.7 24.1 19.6 17.2 13.3 15.7 (to Treasury & SEEs) Deposit llney Banks (ORBs) Rediscounted Credits 15.2 18.1 18.3 12.0 16.6 6.6 4.5 Dun Resources 40.9 41.4 45.7 55.6 53.9 67.8 70.3 Sub-total 56.1 59.5 64.0 67.6 70.5 74.4 74.8 Less loans lent to ID8s 0.2 0.2 0.4 0.3 Sub-total 56.1 59.5 64.0 67.4 10.3 74.0 74.5 Invest. & Dev. Banks (lO8s) Rediscounted Credits 5.9 3.6 2.6 2.5 2.2 0.9 0.9 Dun Resources 12.4 9.7 9.3 10.3 10.0 11.4 8.8 Sub-total 18.3 13.3 11.9 12.8 12.2 12.3 9.5 Plus loans lnt from ODBs 0.2 0.3 0.4 0.3 Less amnunts lent to DOBs 1.3 0.5 Sub-total 17.0 12.8 11.9 13.0 12.5. 12.7 9.9 Total Credit Stotk 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Surce: Central Bank of Turkey, Quarterly Bulletin, 1985111.  -71 - nnex 5 Turkey - Financial Sector Adjustment Loan Page 1 of 3 Key Financial Sector Indicators Target Range Indicators -t190-9l) A. Relating to Financial Policies I. N216(D 30P-35X 2. Rate of growth of deposits 6reater than Inflation rate 3. Deposit rates Positive in real terns aJ 4. Lending rates ( Ron-preferential) International levels 5. Lending rates ( Preferential I Positive in real terms bh 6. Ratio of total preferential creditl Total credit cl 6radual Decline 7. Ratio of preferential credit to Decline to zero productive sectors/ Total credit dJ f. Relating to the banking system _ _ _ _ _ _ ___ _ ___ ____ _ _ 1. Intermediation margins ( in percent of assets 1 32 - 5Z 2. Cost of reserve & liquidity requirements (as percent of deposit base) 5% -6% 3. Average level of non-performing loans (as percent of assets) Under 5Z 4. Ratio of provisions for non-performing loans as percent of portfolio 2 AX C. Relating to capital markets 1. Level of corporate bond issues 50% increase annually in real terms 2. Trade volume in the stock exchange Double each year in real terms 3. Average return an equity holding Equal to return on time deposits 4. Volume of interbank transactions 30% increase eath year in real terms 5. Volume of transactions in the Double each year secondary market for Govt. securities in real terms