Turkey - Country assistance strategy progress report (CASP)

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 22282 TU MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT OF THE WORLD BANK GROUP FOR THE REPUBLIC OF TURKEY June 7, 2001 Turkey Country Department Europe and Central Asia Region International Finance Corporation Southern Europe and Central Asia Department 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.  The FY01 -03 Country Assistance Strategy for Turkey was discussed by the Executive Directors on December 21, 2000 (Report No. 21408-TU, dated November 28, 2000). CURRENCY AND EQUIVALENTS Currency Unit: Turkish Lira (TL) as of June 5, 2001 US$1=TL1,165,861 WEIGHTS AND MEASURES FISCAL YEAR Metric System January 1 - December 31 ABBREVIATIONS AND ACRONYMS APL Adaptable Program Loans MIGA Multilateral Investment Guarantee Association ARIP Agricultural Reform Implementation Project MOH Ministry of Health ASCU Agriculture Sales Cooperative Union NBFI Non Bank Financial Institution BRSA Banking Regulation and Supervision Authority OECD Organization for Economic Cooperation and Development CAS Country Assistance Strategy OED Operations Evaluations Department CAS PR Country Assistance Strategy Progress Report PA Privatization Authority CBT Central Bank of Turkey NGO Non-Govemmental Organization CEM Country Economic Memorandum PEIR Public Expenditure and Institutional Review CFAA Country Financial Accountability Assessment PFPSAL Programmatic Financial and Public Sector Adjustment Loan CIF Cost, Inventory and Freight PFSAL Programmatic Financial Sector Adjustment Loan CPAR Country Procurement Assessment Report PPSAL Programmatic Public Sector Adjustment Loan DIS Direct Income Support PSBR Public Sector Borrowing Requirement EERL Emergency Earthquake Recovery Loan PSSP Privatization Social Support Project ERL Economic Reform Loan SDIF Savings Deposit Insurance Fund ESW Economic Sector Work SDR Special Drawing Right EU European Union SECA Southem Europe and Central Asia Department (IFC) FDI Foreign Direct Investmnent SEEs State Economic Enterprises FIAS Foreign Investment Advisory Service SME Small & Medium Enterprises FOB Free on Board SRF Sopplemental Reserve Facility FSAL Financial Sector Adjustment Loan SSAL Special Structural Adjustment Loan GEF Global Fnvironment Facility SSF Social Solidarity Fund GDP Gross Domestic Product TDO Total Debt Outstanding GNP Gross National Product TDS Total Debt Service HIES Household Income and Expenditure Survey TESEV Turkish Economic and Social Studies Foundation IBRD Intemational Bank for Reconstruction and Development THY Turkish Airlines IFC Intemational Finance Corporation TINs Tax Identification Numbers IFI Intemational Financial Institution UN United Nations IMF International Monetary Fund UJNDP United Nations Development Program JPPR Joint Portfolio Performance Review UNICEF United Nations Children's Fund LIBOR London Interbank Offer Rate WPI Wholesale Price Index MEER Marmara Earthquake Emergency Reconstruction Project WB Mana2ers and Staff Responsible for this CAS Vice President Mr. Johannes Linn Country Director Mr. Ajay Chhibber Responsible Staff Ms. Sally Zeijlon Mr. James Parks IFC Mana2ers and Staff Responsible for this CAS Vice President Mr. Assaad J. Jabre Director Mr. Khosrow Zamani Responsible Staff Ms. Sujata Lamba Mr. George Konda  TABLE OF CONTENTS FOR OFFICIAL USE ONLY EXECUTIVE SUMMARY ............................................. I THE NEW ECONOMIC PROGRAM ........................................................................................................ 11 THE BANK'S ACCELERATED PROGRAM FOR TURKEY ............................................ III TURKEY'S RECOVERY WILL HAVE REGIONAL IMPLICATIONS ............................................ v ISSUES FOR BOARD DISCUSSION ............................................ v I. INTRODUCTION .............................................1 II. RECENT DEVELOPMENTS . A. ECONOMIC DEVELOPMENTS.I B. POLITICAL CONTEXT AND SOCIAL DEVELOPMENTS .3 C. NEW POLIcYFRAMEWORK. 5 D. OUTLOOK FOR 2001 AND THE MEDIUM TERM .12 III. THE BANK GROUP PROGRAM .14 A. IBRD PROGRAM.14 B. IFC PROGRAM.25 C. MIGA PROGRAM.28 IV. MANAGING THE RISKS AND IBRD) EXPOSURE.28 VJ. CONCLUSION.33 BOXES. TABLES . AND FIGURES Box 1: Crisis Indicators B3ox 2: Key Actions for 2001 Under the New program Box 3: Lessons from Recent Emerging Market Crises Box 4: Monitoring the Social Impact of the Crisis and the Reform Program Box 5: Revised Triggers for the High Case T able 1: Selected Social Indicators: Country Comparison Table 2: Key Economic Indicators Table 3: Proposed Revised FY01 -03 CAS Indicative Lending Program Table 4: Comparison of CAS High Case with Proposed Revised High Case FY01-03 Table 5: Share of Bank Portfolio Figure 1: IBRD Net Flows and Debt ANNEXES Annex Al Key Economic and Program Indicators Annex A2 Country at a Glance Annex B2 Portfolio Indicators Annex B3 Bank Group Program Summnary Annex B4 Summary of Nonlending Services Annex B6 Key Economic Indicators Annex B7 Key Exposure Indicators Annex B8 Status of Bank Group Operations Annex B 11 Macroeconomic Framework Annex B12 Banking Sector Reform Annex B 13 The Legislative Agenda for 2001 |This document has a restricted distribution and mnay be used by recipients only in the performance of their |of ficial duties. Its contents may not otherwise be disclosed without World Bank authorization. A . lRIR G A ........................................................................1   REPUBLIC OF TURKEY COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT EXECUTIVE SUMMARY i. Turkey is in a deep economic crisis and facing growing social hardships. Political disputes in the Government in February 2001 triggered this sharp deterioration - but the underlying reasons go deeper and were built up over the previous decade. The immediate threat of political instability in February, coming on top of a growing current account deficit and slow- down in policy implementation, eroded market confidence and caused a rapid exit to foreign exchange. This in turn forced Turkey to abandon the crawling peg regime, which had been a key pillar of the previous economic program designed to reduce inflation. The resulting nominal devaluation - some 40-45 percent since February - and interest rates rising above 100 percent have largely contributed to the onset of a sharp recession and a wider banking crisis. The social impact is already being felt as lay-offs, rising prices, and negative growth reduce household incomes and place a growing risk of poverty and vulnerability on people already at the lower end of the income scale. Unemployment is rising rapidly, incomes have been reduced, and income disparities are widening. Inflation surged back to 6 percent in March, over 10 percent in April, and 5 percent in May. While these risks were broadly identified in the CAS discussed with the Board in December 2000, the political disputes that triggered the crisis could not have been foreseen. ii. External and internal factors contributed to the collapse of Turkey's previous disinflation program, which started in December 1999. On the external side, rising oil prices and a weakening Euro contributed to Turkey's weakening external accounts. Internally, a sharp drop in interest rates shortly after the start of the program had led to a surge in demand. Inflation did not come down as quickly as was anticipated, the real exchange rate appreciated significantly because of the pegged exchange rate, and imports increased sharply contributing to a huge current account deficit which reached 5 percent of GNP. Policy complacency slowed reforms triggering financial turmoil in November 2000. The enhanced policy package of December - which maintained the crawling peg, but strengthened the fiscal and structural program to help Turkey recover - was, however, short-lived as political instability derailed the program in February 2001. As interest rates shot up, the economy stalled, leading to a deeper financial crisis. ill. Turkey's crawling peg was a bold but risky attempt to eliminate inflation and bring down interest rates. With hindsight, its inherent rigidities were too demanding for Turkey's fractured politics. A fragile banking sector with large contingent liabilities added immensely to the structural problems. The large profits from high interest rates had allowed very weak banks to survive and take on risky positions. As interest rates came down sharply in response to the restored confidence in early 2000, banking sector profits fell, exposing the banking sector's weaknesses. When the initial capital inflows dried up in the latter half of 2000 and liquidity tightened, the interest rates spiked, transforming the banks' weaknesses into losses. The weakest banks collapsed, generating a systemic banking crisis. Without a fundamental restructuring of the banking sector, the program was always vulnerable to problems in the weaker banks. The wider crisis now provides Turkey an opportunity to deal more comprehensively with weak public finances and a fragile banking sector to produce lasting solutions. While the new program will  not be constrained by the rigidities of a pegged exchange rate, policy credibility and fiscal discipline will become even more critical. iv. Turkey's challenge going forward is to try to recover quickly from the sharp recession - but at the same time to address some of its root causes. Turkey has established a new economic team and outlined a new economic program. The new program goes much deeper than previous attempts in trying to fix the structural causes of the crisis - weak public finances and a fragile banking system - while strengthening social programs. It will also bring Turkey closer to its goal of EU accession. Vigorous implementation is necessary to ensure success. The New Economic Program v. The key structural and social elements of this new economic program are a strong focus on public sector reform, building a sound bankingz sector and liberalization of markets for private sector led growth, as well as special emphasis on strengthening social assistance. The mainfeatures are: * Large fiscal adjustment with the primary surplus exceeding 5.5 percent of GNP for 2001 and 2002, and a macro-economic framework designed to bring real interest rates to around 20 percent by end -2001. - Rapid restructuring of the banking sector - especially of state banks and intervened banks - and measures to reduce connected lending. . Strengthened public expenditure management and governance - including improvements in public procurement, accounting and auditing, and anti-corruption measures. * Market liberalization in energ and telecommunications, and establishment of an independent regulatory body for energy, * Privatization and corporatisation of state-owned enterprises, including the telecommunications company, national airline, petroleum refineries, and iron and steel companies. * Continuation of agriculture sector reform to liberalize the sector, shifting from price subsidies to direct income payments to farmers. * Strengthening of social assistance to help people adversely affected by the economic crisis. vi. The new program is formulated to bring about a rapid turnaround in the economy. Rapid restructuring of the banking sector is a key factor in restoring confidence and ensuring early recovery. Experience gained from other countries suggests that quick and decisive progress on fiscal adjustment and financial restructuring is critical for quick recovery. As a result of long- standing weaknesses in the banking sector and reinforced by the impact of financial crisis, the fiscal costs of the clean-up of the state banks and intervened private banks are expected to exceed US$40 billion. Rapid restructuring of the banking system, necessary for early recovery, has large up-front costs for which all the necessary financing can not be raised domestically. The macro- economic framework requires a large fiscal adjustment and an additional US$10 billion of external support in 2001 to close the financing gap. This additional support is now to be provided under the new IMF and World Bank Group programs. ii  vii. Tourism, export and foreign investment growth will aid the initial recovery. Turkey's tourism sector is on track to produce a record year in 2001 if social tensions do not rise. The inherent rigidities of a crawling peg exchange rate arrangement, which led to a substantial appreciation of the Turkish Lira, are gone. If the large real devaluation since February of over 20 percent is maintained through tight demand management, Turkey could see a substantial boost in exports. The large current account deficit of around 5 percent of GNP in 2000 is likely to fall sharply in 2001. Turkey is also making stronger efforts to attract foreign direct investment (FDI) and there are some indications of new foreign investor interest. These positive elements could be further strengthened by decisive actions to remove obstacles to FDI. Over all, structural reform is being designed to strengthen the environment for private-sector led growth. viii. But the risks going forward remain high. The political factors that contributed to the steep market downturns in November and February remain, and may have become more prominent. These factors imply serious implementation risks because of the need to take urgent actions without a lot of time to build consensus. There remains considerable opposition to the reform among particular interest groups such as labor unions and large farmers. Even within the coalition opposition to aspects of the reform program has been openly expressed. These political factors may encourage the markets to adopt a wait-and-see attitude. The macro-economic picture and the debt dynamics remain uncertain because of the impact of political uncertainty. Following the latest crisis, Turkey faces much higher debt ratios than before. In 2001 public external debt is around 34 percent of GNP and public domestic debt around 44 percent. The debt dynamics and recovery depend critically on the rapid reduction interest rates to around 50 percent by end-2001. Even under the most favorable assumptions, the economy would contract by 3 percent in 2001, with inflation over 50 percent. The consistency of the macro-economic framework will be enhanced by the additional external financing of some US$10 billion from the IMF and IBRD. Despite additional external support by the IMF and the Bank, the markets could remain skeptical if policy actions are delayed. Market skepticism, in turn, could prevent interest rates from coming down as projected under the program. Sustained high interest rates could force painful and risky debt restructuring or monetization. Turkey's new economic program is designed to avoid these unpalatable options, by putting into place immediate upfront measures and a blueprint for the medium term to tackle the structural and institutional roots of current problems. The Bank's Accelerated Program for Turkey ix. In 2000 the Bank Group supported significant structural reforms. Before and even during the crisis, a number of important actions were taken. These included the establishment of an independent banking authority, a new banking law, the electricity market law, reform of the pension system, a constitutional amendment for international arbitration, start- up of agricultural reform, establishment of a telecommunications regulator, and accelerated privatization which generated over US$5 billion in revenue to date in 2000-01. However, this impressive set of structural reforms was insufficient to avoid a crisis. These structural actions were supported by two adjustment loans from IBRD - the Economic Reform Loan (ERL, US$760 million) approved by the Board in May 2000 and the Financial Sector Adjustment Loan (FSAL, US$778 million) approved in December 2000. The first tranches of these loans, totaling iii  US$777 million, were disbursed in 2000. In December 2000, the Board also discussed the CAS for FY01 -FY03 with a High Case lending envelope of US$5 billion. x. In order to support Turkey's implementation of the accelerated New Economic Program, IBRD proposes to accelerate and refocus its support for Turkey - but in a graduated response to structural and social reforms. The accelerated structural reforms under the new program deserve enhanced support from IBRD - especially in the areas of banking and public sector reform. In 2001 additional external financing will largely come from the IMF. IBRD will contribute US$2 billion (out of US$10 billion) towards this incremental financing, of which US$0.8 billion will be provided by accelerating disbursements from the existing envelope of US$5 billion and US$ 1.2 billion will be provided through new financing under Special Structural Adjustment Loan (SSAL) terms. Total disbursements from the Bank in 2001 are currently expected to amount to US$3.2 billion. As a result of this increased lending in 2001, total commitments for the period FYO1-03 could reach US$6.2 billion, of which US$1.2 would be on SSAL terms. xi. The Bank Group's revised CAS program increases the focus on banking and public sector reforms and enhances assistance to Turkey for strengthening its social protection. While each of these was an important part of the program in the December 2000 CAS for FY01 - 03, the revised FYOI-03 program presented in this CAS Progress Report (CAS PR) involves accelerating and deepening support in those three areas. In the area of banking and public sector reform, Turkey plans to accelerate significantly the schedule of structural reforms. In support, IBRD proposes to provide two programmatic loans in 2001, totaling US$2.45 billion. These would be followed in 2002 by smaller sectoral adjustment loans in the financial sector and the public sector. The second tranche of the FSAL (US$385 million) would be cancelled, because the financial sector reform program is now broader than anticipated six months ago and some aspects originally expected to be part of a later operation have been brought forward. Conceptually, the cancelled portion of FSAL I has been rolled into proposed new operations. The second tranche of the ERL (US$375 million) would be maintained to continue to support reforms that will remove remaining obstacles to private sector growth - although IBRD expects delays in meeting tranche conditions because of the difficult market environment for privatization. IFC's financing and other assistance will also focus on the financial sector and privatization, as well as firms with good export prospects which can contribute to rapid economic recovery. IBRD is also preparing a Social Risk Mitigation Project (US$500 million) to bring to the Board early in the fall. At that time, an assessment of the social impact of the crisis would also be shared with the Board. The Agriculture Reform Implementation Project (ARIP), to be presented to the Board with this CAS PR, supports structural reform in agriculture and implementation of a direct income support system for farmers. The triggers for the High Case program have been strengthened in view of Turkey's accelerated structural reforms in banking and public sector reform as well as to ensure that social expenditures are adequately protected during a period of fiscal stringency. These triggers have served well in the past in ensuring that the Bank implements a carefully graduated response to Turkey's reforms and the same process would be followed going forward. xii. IBRD's long-term support to programs in education, health, community-based watershed management, and community development and heritage will continue alongside support for Turkey's economic reforms. These programs have a very positive long-term iv  impact and will be maintained as would the enhanced social assistance program, even if Turkey does not meet all of the triggers for the High Case program. On the other hand, the revised program recognizes that not all agendas can be tackled at once. Therefore, operations in support of municipal reform, seismic risk mitigation, and village and township services will take longer to prepare and will likely be in the program for FY04. The energy sector project could be ready in late FY03 or in early FY04. xiii. IFC's medium and long-term strategy remains as in the CAS, but the short-term strategy is changing in response to the crisis. IFC is closely collaborating with the Bank to support the new reform program. The focus will be on highly visible interventions with strong demonstration effects and positive impact on market psychology. IFC will protect its portfolio by working on restructuring and, where appropriate, recapitalizing its portfolio companies. Providing swift support to enable existing export-oriented clients to generate foreign exchange will help such firms with debt service and contribute to the vibrancy of exports, which is vital to recovery. In the current situation of credit scarcity, IFC's ability to provide long-term project financing, credit lines for banks, working capital finance, and operational and financial strengthening is a positive contribution to the private sector. During 2001-02, IFC will give priority to: (i) the financial sector; (ii) restructuring industrial companies; and (iii) assisting the authorities with privatization. The complementary focus of the Bank and IFC in these respects will enhance the Bank Group's help to Turkey's implementation of the reform program. Turkey's Recovery Will Have Wider Implications xiii. The New Economic Program represents an opportunity for Turkey to avoid a costly debt restructuring, run-away inflation, and a social crisis. If the program succeeds, the Bank Group will have played a major role in assisting an important middle-income country to deal with vital structural and social issues. While the risks are high, if the political will remains intact Turkey can avert an even bigger crisis through its new program and Bank Group support. The alternatives are costly for Turkey's population (especially for the growing group of poor and vulnerable) and would have significant effects regionally and perhaps even globally. Such an alternative can be avoided with determined implementation of the Government's program and the right mix of financial and technical support. Turkey needs and requests the Bank Group's support now to help its recovery and to address fundamental structural and social problems. Issues For Board Discussion Executive Directors may wish to address the following issues for discussion: * Is the Government's program appropriately structured to meet Turkey's financial, economic and social challenges during the current crisis and for long-term recovery and poverty reduction? * Is the increase in the High Case lending under SSAL terms and the acceleration of the Bank's support appropriate and adequate for the identified strategic priorities? * Is the Bank Group's lending and non-lending support appropriately structured? * Have the risks been appropriately identified and addressed? v   MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT OF THE WORLD BANK GROUP FOR THE REPUBLIC OF TURKEY I. INTRODUCTION 1. On December 21, 2000, the Board discussed the Country Assistance Strategy of the World Bank Group for the Republic of TurkeyI for FY01-03. At that time, Turkey was emerging from its financial turmnoil of November 2000 with renewed commitment to structural reform and a macroeconomic stabilization plan. The CAS signaled the significant risks faced by the program. Political, economic, financial sector, and institutional issues were flagged as likely risks, as well as the possibility of a large natural disaster. Unfortunately, the economic and financial sector risks materialized following a political dispute, which initiated the full-fledged crisis that hit Turkey in February 2001, resulting in the decision to abandon the pegged exchange rate and float the currency. The Government has now formulated a New Economic Program based on a more gradual disinflation path, and a more rapid, comprehensive structural reform program. The Bank Group proposes, consistent with the strategic thrusts of the CAS, to support the new reform program of the Government, in particular focussing on its structural and social aspects. In the structural area, the priorities for Bank Group support would be banking sector restructuring and reform, public sector reform, and continuation of reform in agriculture, energy, telecommunications and pensions. On the social side, IBRD will help the Government to strengthen its social assistance programs and provide financial resources to Turkey for targeted social support for vulnerable groups and the poor, especially women and children. In addition to some acceleration of disbursement within the CAS high case lending envelope of US$5 billion, this Progress Report proposes additional IBRD support over the CAS envelope on Special Structural Adjustment Loan (SSAL) terms of up to US$1.2 billion, for a total possible lending of US$6.2 billion in the period FYOI-03. II. RECENT DEVELOPMENTS A. Economic Developments 2. External and internal factors contributed to the collapse of Turkey's previous disinflation program, which was adopted in December 1999. On the external side, rising oil prices and a weakening Euro added to Turkey's large current account deficit. Internally, a sharp drop in interest rates led to a surge in demand. Inflation did not come down as quickly as was anticipated and imports increased sharply. The exchange rate appreciated significantly. Policy complacency 'Report No. 21408 TU, dated November 28, 2000.  Turkey CAS Progress Report 2 Box 1: Crisis Indicators CPI Inflation Exchange Rate 12.0 40\0 10.0 30.0 8.0 10.0 P .R 6.0 0.0 4.0 -10.0- - - - 2.0 C s ~ C S 0.0 4 o4~ 0 )\1 0ly ~' Monthly average exchange rate percentage change (T L/UJS5) CPI monthly percentage change Interest Rate Istanbul Stock Exchange 250.0 21000 - 150.0 18000 100.0 9000 50.0 3000 0.0 iSE National 100 index - 1986=1 TL. 12 month norrinal interest rate on T-bdls Unemployment Rate GNP Growth 10 1.00 Apr-99 Oct-99 01- 02- Q3- 04- 01- NCi ab b No 2000 2000 2000 2000 2001 O ;( N GN (i5O.CO SS reported unemrpbyrrent Q1 & Q2-2001: WB forecast Real Private Credit 83 Capacity Utlilization i- Mas.utactaring 3000 ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~. 2000 ____ __X 9 Y 2- 10000DIDX 4000 el liuiiIrnhi Z g 7 8 7 8 l I3000679 _ _ _ _ _ _ _ _ _ _ _ _  Turkev CAS Progress Report 3 slowed reforms triggering a mini-crisis in November 2000. The enhanced policy package of December, which kept the crawling peg and strengthened the fiscal and structural program, was short-lived as political instability derailed the program in February 2001. As interest rates shot up, the economy stalled, bringing on a deeper financial crisis (see Box 1). 3. With hindsight, Turkey's crawling peg was a bold but risky attempt to eliminate inflation, and bring down interest rates and its inherent rigidities were too demanding for Turkey's fractured politics. A fragile banking sector with large contingent liabilities-added immensely to the problems. The large profits from high interest rates had allowed very weak banks to survive and take on risky positions. As interest rates came down sharply in response to the restored confidence in early 2000, banking sector profits fell rapidly, exposing the banking sector's weaknesses. When initial capital inflows stopped in the latter half of 2000 and liquidity tightened, the interest rates spiked and the banks' weaknesses were transformed into losses. The weakest banks collapsed, generating a systemic banking crisis. Without a fundamental restructuring of the banking sector, the program was always vulnerable to problems in the weaker banks. In the end it did not succeed due to political instability. The wider crisis now provides Turkey with an opportunity to deal more comprehensively with weak public finances and a fragile banking sector to produce more lasting solutions. While the new program will not be constrained by the rigidities of a pegged exchange rate, policy credibility and fiscal discipline will become even more important to restore and maintain the market confidence that is critical for the success of the program. B. Political Context and Social Developments 4. The underlying causes of Turkey's economic crisis date back to the late 1980s. After a period of impressive trade reforms in the early and mid-1980s, subsequent governments did not deal seriously with Turkey's fiscal and structural problems. Since the early 1990s, a series of coalition govermments (ten since 1990) took populist decisions leading to large and unsustainable fiscal deficits. The lowering of the pension age, the widespread expansion of agricultural subsidies, and the use of state banks for subsidized credit and the state-owned enterprises to generate employment are examples of a system of patronage which lies at the root of Turkey's current crisis. When budgetary resources were unavailable, the state banks were utilized as quasi-fiscal instruments to pay for populist policies. As a result, they built up huge and unsustainable liabilities. Connected lending also led to problems in the private banking sector. Each successive government outdid its predecessor in providing hand-outs to its supporters. Real wages in the civil service eroded. 5. The current coalition government includes three parties of different backgrounds2, who came together on the basis of agreement on the broad outlines of an economic program and the intention of dealing with past problems. This coalition government, under Prime Minister Ecevit, began a bold and comprehensive reform while tackling growing economic problems and 2 As of June 5, 2001 the coalition is composed of: the Democratic Left Party (DSP), headed by Prime Minister Bulent Ecevit, with 132 seats; the Nationalist Movement Party (MHP), headed by Deputy Prime Minister Devlet Bahceli with 126 seats; and the Motherland Party (ANAP), headed by Deputy Prime Minister Mesut Yilrnaz, with 89 seats. Other parties in Parliament are the True Path Party (DYP) led by Tansu Ciller, with 83 seats and the Virtue Party (FP) led by Recai Kutan, with 102 seats. Those, plus 10 independents and 8 empty seats give the total of 550 seats in Parliament  Turkey CAS Proszress Report 4 the after effects of two devastating earthquakes. Beginning in late 1999, some important refonns were enacted, but partly due to early success in restoring confidence there was soon resistance to change from within the coalition. As the program was being implemented in 2000, resistance to particular aspects of the program became more pronounced. It has taken a very deep crisis in February for the realization to set in that without more fundamental reform, Turkey's economic situation would deteriorate further. The start of the new program has been noteworthy, but resistance is still present (including within the coalition) and could get stronger as the program is implemented and actions are taken to de-politicize economic decision-making. The social impact of the crisis is already being felt as lay-offs, rising prices, and negative growth reduce household incomes and place a growing risk of poverty and vulnerability on people already at the lower end of the income scale. The Government has thus lost considerable public support due to the crisis. Opinion polls show that the population is unwilling to tolerate a continued pattern of recurrent crises, and values transparency and rules-based decision making. This is contributing to the wider recognition among the population, civil society and the private sector that de-politicization of economic decision-making is an urgent task for the Government. The Turkish political situation is in a state of flux. 6. Turkey's current crisis will exacerbate its already large inequalities and weak social indicators (see Table 1 below) which were highlighted in the CAS presented to the Board in December 2000 and analyzed in greater detail in "Turkey: Economic Reforms, Living Standards and Social Welfare Study" published in January 2000 (report no. 20029-TU). Building from that analysis (although it is still early to provide a comprehensive social assessment of the crisis) initial indications are worrisome. The economic data (see Box 1) shows that the crisis is deeper and more severe than in 1994. Feedback received from groups of poor people and provincial government officials in May by a World Bank mission gives preliminary confirmation of the severity of the current situation. There is growing evidence of large-scale lay-offs in the corporate sector. During the first two months of the crisis, large firms tried to reduce hours, advance holidays, and cease using temporary workers, but further cuts in labor costs can only come from lay-offs. This, combined with the expected reductions of staff in state-owned enterprises during pre-privatization restructuring and the freeze on public sector hiring, is expected to raise unemployment in the short term. The general economic downturn from the disruptions of the last two months will also have an effect on small businesses and therefore on informal employment. The unemployment rate rose from 6.3 percent in the fourth quarter of 2000 to 8.3 percent in the first quarter of 2001, representing a total of 1.8 million unemployed or 32 percent more than three months earlier. Estimated unemployment among youths aged 15-24 with high school or higher education is now 23.7 percent. The landless poor in rural areas appear to have been affected by the decline in construction and other informal job opportunities. 7. The Living Standards Study demonstrated that in the 1980s and 1990s, "non-anticipated jumps in inflation or periods of accelerating inflation have unambiguously hurt the poor and worsened the distribution." The rate of the inflation has increased sharply to 6 percent in March, over 10 percent in April, and 5 percent in May (see Box 1). Although data is not yet available to track the impact of the jump in inflation following the February 2001 crisis, it is safe to assume that the poor will be especially hard-hit. There is already some evidence of the increased input costs in agriculture afflicting poor rural landholders.  Turkey CAS Progress Report 5 Table 1: Selected Social Indicators - Country Comparison Indicator Tu Chile Colombia Mexico Poland Hungary Malaysia Tunisia EU Population Growth (%) 1.5 1.6 2.0 2.0 0.2 -0.3 2.8 2.0 N.A Life Expectancy at Birth 69X5 75.0 70.0 72.5 72.5 71 72.5 69.5 77.4 (years) _)_ Infant Mortality Rate 39 13 30 31 15 10 I11 30 6.1 (per 1,000 live births) Maternal Mortality ISO 65 l00 120 1 9 30 34 170 N.A (per 100,00 live births) I _ Literacy Rate 84t' 95 91 90 100 99 86 67 100 (% of adult population) _ Female Literacy Rate 75 95 91 88 100 99 81 56 100 GNP per Capita (US$) 2,O 4,810 2,600 3,970 3,900 4,510 3,600 2,050 N.A 1/1998 data 2/1999 Sources: World Development Indicators. 2000; WHO World Health Report 1999; Turkey Demographic and Health Survey, 1998 (Hacettepe University, Institute of Population Studies); Turkey Human Development Report, 1997 (UNDP). 8. In March 2001, a simulation of the impact of the crisis on the welfare distribution was done using household data from 1994, to identify the characteristics of the most vulnerable households. This simulation suggested five patterns of likely increased poverty as a result of the February financial crisis: (i) families with many children3 and extended families with many children, as well as single-parent families, seem to be the most affected in terms of high rates and high increases in food poverty4; (ii) an increase in unemployment would disproportionately affect families with many children; (iii) those with middle education seem more likely to become vulnerable-but still above the food poverty line-while the least educated are those most likely to become food poor; (iv) the three regions of Anatolia have the highest rates of vulnerability and food poverty but not always the highest increases in those characteristics; and (v) the urban population seems more at risk for vulnerability but there is not much difference between urban and rural households in terms of the risk of food poverty. It will take some weeks to fully evaluate the impact of the crisis and ongoing reform program on the poor (see Box 4). This work is underway and will be presented to the Board with the proposed Social Risk Mitigation project. C. New Policy Framework 9. The Government's new economic program entitled "Turkey's Proeram for Transition to a Strong Economy" was announced in mid-April (see Box 2 for the main priorities). The program aims to minimize the short-term impact of the crisis while setting the stage for an early resumption of disinflation and growth. It draws on the lessons of other countries in recovering from major currency attacks, including the Asian crisis (Box 3). The program takes account of the specifics of the Turkish economy including the much larger stock of public debt relative to other crisis countries on the one hand and the potential of a dynamic response of exports and tourism on the other. By moving immediately to address the fundamental structural problems underlying the crisis, with a strong focus on restructuring the banking sector, the Government 3 In Eastern Anatolia, widows with many children are particularly vulnerable, according to provincial officials. 4Food poverty occurs when a household spends less than is necessary to maintain minimum caloric consumption, expressed by a basket of food items.  Turkey CAS Progress Report 6 hopes to engineer a quick recovery (closer to the experience of Brazil and Korea), and avoid the prolonged recession that some other cnrsis countries have experienced. Box 2: Key Actions for 2001 under the new Program Macro-Economic: > Implement urgent measures to address the economic crisis to reduce uncertainty in the financial markets and introduce credible macroeconomic measures aimed at stabilizing the exchange rate, lowering interest rates and reducing inflationary expectations after the initial devaluation; maintain tight fiscal and active monetary policies in an effort to bring inflation to under 2 percent per month and restore growth by the end of the year. Key actions: * Announce revised macroeconomic targets and policies for 2001; * Transfer the ovemight borrowing of the state and SDIF banks to the Central Bank. * Increase target for the primary surplus of the public sector to 5.5 percent of GNP and implement required package of fiscal measures; . Enact new Central Bank law to underpin CBT independence; * Limit CBT intervention in the foreign exchange market to smooth fluctuations only; * Engage intensive consultations on incomes policy consistent with inflation targets. Structural: ) Carry out a rapid clean-up and comprehensive restructuring of the banking sector. Key actions: * Appoint a joint, politically independent Board of Directors for the state banks; * Eliminate overnight borrowing of state and SDIF banks and shrink their balance sheets; * Complete the financial restructuring of the state and SDIF banks; * Close Emlak Bank and transfer its liabilities and some assets to Ziraat Bank; * Implement a clear, time-bound action plan for resolving the SDIF banks; * Require all capital deficient private banks to present capital strengthening plans; * Amend Banking law to facilitate resolution process and allow for full tax deductibility of specific loan loss provisions and enact legislation to prevent future duty losses; * Adopt connected lending regulation and align bank accounting standards with international norms. > Continue with vital structural reforms-in telecommunications, energy, agriculture, and privatization in order to improve the investment climate and underpin fiscal adjustment. Key actions: * Appoint professional Board and management team for Turk Telekom and implement a corporatization plan to fully commercialize the company; * Amend telecommunications legislation to allow for full privatization of Turk Telekom and transfer all licensing authority to the Telecommunications Regulatory Authority; * Implement Electricity Market Law and enact Gas Market Law; * Appoint Board of Energy Regulatory Authority and launch privatization of thermal electricity generation and electricity distribution companies which remain in state hands after June 30 deadline for transfer of operating rights; * Launch farmer registry to underpin Direct Income Support program and continue with reform of agriculture support policies including new legislation to reform the sugar and tobacco markets; * Prepare all companies in the Privatization Administration's portfolio for privatization as soon as market conditions permit, including THY (national airlines), TUPRAS (refinery), PETKIM (petrochemnicals), ERDEMIR (steel), TEKEL (tobacco and alcohol), and SEKER (sugar); * Enact implementing legislation for intemational arbitration and prepare action plan to eliminate administrative barriers to FDI as recommended by FIAS.  Turkey CAS Progress Report 7 Box 2: (continued) > Launch a comprehensive program of reforms to improve the transparency and efflciency of public sector management andfight corruption. Key actions: . Enact Expropriation Law; . Prepare a comprehensive program of public expenditure management reform in line with the recommendations of the PEIR, including actions to imnprove coverage and transparency of the budget; . Enact Public Debt Management law; . Enact Public Procurement law; . Enact legislation to streamline procedures for imnproving the code of conduct of government officials; . Prepare and adopt national anti-corruption program. Social: > Ensurepopular supportfor theprogram through extensive consultations with alt stakeholders, in particular labor unions and representatives of civil society. Key actions: . Enact the Econornic and Social Council law; * Enact job security law; . Design and irnplement a comprehensive communications strategy for the new reform program. > Strengthen social protection for vulnerable groups through a combination of measures to improve Turkey's social insurance system and new social assistance Initiatives. Key actions: . Enact legislation on voluntary private pensions; . Protect public expenditure on education and increase spending on preventive care; . Introduce new targeted social assistance programs for vulnerable groups affected by the crisis. 10. The program is based on a three-pronged strategy: (i) structural policies aimed at correctinz the weaknesses underlving the crisis and establishing a sounder basis for disinflation and growth over the medium term; (ii) strong social policies including enhanced social dialogue to achieve price and wage policies consistent with macroeconomic stability, and increased emphasis on the protection of the most vulnerable groups of society; and (iii) fiscal and monetarv policies geared towards restoring financial stability and resuming the disinflation process. As the Government's program puts it: "It is very well understood that a productive and strong private sector is needed to be a strong and reputable state in the 215' century. In the same way, in order to have a sound free market economy, it is important to have a strong state providing social support to the needy and undertaking regulatory supervision. A strong economy will be created by a functioning private sector, an effective state, and a broad social solidarity. This is our target, what we are longingfor, and indeed it is what Turkey deserves. "  Turkev CAS Progress Report 8 Box 3: Lessons from Recent Emerging Market Crises A Bank team reviewed six other major emerging market crises over the last decade' to draw policy lessons for Turkey. The main conclusions are: * Economic downturns in recent crises have lasted a median 2-3 quarters, with previous output being recovered in a median 4-6 quarters from the trough. Given the relatively limited role of bank credit to the private sector, quick and decisive progress on bank restructuring and fiscal adjustment can help ensure that Turkey's experience is similar to the median path, closer to the more limited downturn in Brazil than to the deeper and more extended recessions in Indonesia and Thailand. * While large, the fiscal cost of bank restructuring may be relatively less than in the harder hit countries in East Asia. However, Turkey went into the crisis with significantly higher public indebtedness than most other crisis countries, much of this in short term local currency debt. Establishing confidence in public sector solvency and averting a further inflation-domestic debt spiral will require strong fiscal adjustment backed by credible structural fiscal reforms. * Given large vulnerabilities on both the asset and liability side of the balance sheet, it is clear that the solvency of the banking system is in serious jeopardy. The fiscal cost of the bank clean up can escalate at a rapid pace if insolvent or weak banks are allowed to continue lending unchecked. To reestablish confidence in the banking system and to limnit fiscal costs, a strong, front-loaded program to restructure banks is needed. * Most crisis countries in the 1990s have moved towards an inflation targeting framework after the crisis, the speed of the transition depending on macroeconomic and institutional conditions. In the volatile, high inflation environment of Turkey, it may be important to avoid a premature adoption of formal inflation targeting (IT) since the collapse of an inadequately prepared IT program may end by damaging policy credibility even more. * The role of structural reform in crisis management must be carefully managed. Reforms that directly underpin fiscal reform and bank restructuring are important to address right away. Privatization and accompanying regulatory reforms have fiscal implications and are also valuable in stimulating FDI and reestablishing foreign confidence. Other structural reforms are good for long run growth. However, the short-term costs of specific structural measures--in terms of provoking interest-group and political opposition, or complicating economic management and creating uncertainty in the near term--must be given adequate weight in formulating policy. * Maintaining social cohesion is especially important given the political volatility and social stresses of the country. Meeting the fiscal cost of programs to support social cohesion and protect vulnerable groups within the overall fiscal adjustment will be a challenge. Quarterly Real GDP in Crisis Countries 1 2 0 o-Mexico a + Brazil O Arg entina -X _ - - -s - - Ko r ea X -X , IL1 - - -& -Thailand,_ ii +I~~~~ndonesia _XI 4 1.0 0~ ~~~ 08L a. 01. ' _S '9 8 -N., , , ._~' , .~ ., . '5 N. . N. . N. N. N. N. N. N. e , ,' C"> l (1) The country-crisis experiences reviewed are: Argentina and Mexico in the tequila crises at the end of 1994, Indonesia, Korea, and Thailand in the 1997 East Asian crises, and Brazil at the beginning of 1999.  Turkey CAS Progress Report 9 11. Structural Policies. The new program gives top priority to banking reform. The banking reform has four core objectives: (i) The immediate objective is to clean up the bank sector which has been badly hit by the crisis. Financial restructuring of the state banks and those under the Savings Deposit Insurance Fund (SDIF) is already underway to eliminate their overnight borrowing position and resolve their liquidity requirements. The state banks have been recapitalized to a capital adequacy ratio of 8 percent and the SDIF banks have been recapitalized to cover their negative net worth. The Banking Regulation and Supervision Agency (BRSA) is requiring all capital deficient private banks to present detailed capital strengthening plans and will actively monitor their implementation. (ii) The second objective is to reform the governance structure for the state banks in order to eliminate political influence and ensure that they do not become the source of structural weakness in the future. A joint, politically independent Board was appointed for two main state banks (Ziraat, and Halk) in March. Emlak will be closed by June and its liabilities and some assets transferred to Ziraat. The state banks will no longer be compelled to run duty losses. Funding has been allocated in the 2001 budget for temporary credit subsidies for farmers and small and medium enterprises (SMEs) in light of the extraordinarily high interest rates after the crisis. Legal changes will be made to facilitate the privatization of Vakif Bank, the fourth state bank, as soon as market conditions allow. Restructuring of Halk and Ziraat banks will begin immediately in preparation for their privatization over the medium term. (iii) The third objective is to resolve the banks taken over by the SDIF as quickly as possible. The BRSA has prepared a time-bound action plan for selling, liquidating or otherwise resolving the 13 SDIF banks by the end of 2001. This plan includes steps to reinforce the BRSA's implementation capacity including the bad loan collection department of the SDIF and legal amendments to facilitate debt recovery. In addition, SDIF would intervene in any emergent insolvent banks that may not be able to recapitalize themselves. (iv) The fourth objective is to complete the process of upgrading the legal and regulatory framework to international and EU norms which began in mid-1999. Amendments to the banking law have been enacted to implement the new connected lending limits on a consolidated basis, broaden the definition of credit exposure to include derivatives and provide for full tax deductibility of specific loan loss provisions. International standards for bank accounting are also being introduced. 12. The Government has developed a comprehensive public sector reform program based in part on the recommendations of the Public Expenditure and Institutional Review (PEIR) jointly prepared by the Government and the Bank. This program is designed to ensure the long-term sustainability of the fiscal adjustment, raise the standard of public sector governance, and modernize the role of the Turkish State. It features measures in five areas: (i) Structural fiscal policies to strengthen aggregate fiscal management. To combat tax evasion and more evenly distribute the tax burden, the Govermment intends to expand  Turkey CAS Pro2ress Revort _J_o broadly the use of tax identification numbers (TINs) introduced as part of the 1997 tax reform, particularly for financial transactions. The Government has frozen the total number of civil servants in 2001 and intends to implement strictly a policy of replacing no more than 15 percent of retiring personnel in the state economic enterprises (SEEs). (ii) Public expenditure management. The first priority here is the reform of the process for budget preparation and execution, including steps to improve transparency and comprehensiveness of the budget, capacity for policy formulation related to establishing budget priorities, and improvements to outcomes of budget execution through a progressive shift to performance budgeting. As part of the on-going effort to expand coverage of the budget and improve fiscal control, legislation is expected in June to close the remaining budgetary funds and two extra-budgetary funds and bring these resources and expenditures fully on budget, with the exception of the Support Price Stability Fund. The number of revolving funds - currently over 2,600 - which are used by local institutions to supplement budget allocations will be cut by half by the end of 2001. (iii) Financial accountability. To upgrade public accounting, procurement and audit functions to ensure adequate financial accountability, the Government aims to make legal changes to introduce international fiduciary standards and institutional changes to build capacity to implement the new standards and shift from excessive ex ante control to effective ex post monitoring. (iv) Public liability management. A new public debt management law, expected to be submitted to Parliament in June, will establish clear procedures for contracting public debt and help the Treasury contain the growth of contingent liabilities, as well as setting up transparent reporting of public liabilities and institutional measures to build up the capacity for fiscal risk management. (v) Public sector governance. The new approach to public sector management encompasses strong actions to fight corruption. An inter-ministerial steering committee is charged with developing an anti-corruption strategy under which the Government will collaborate with civil society. A series of conferences on "Effective Government" are planned. Legislation to streamline procedures for improving the conduct of Government officials will be submitted to Parliament before the summer recess. New public procurement legislation will be submitted to Parliament by mid-October which will comply with UNCITRAL standards as a first step towards meeting the full EU directives. 13. Structural measures to improve the climate for private investment feature strongly in the program. The basic objective is to reduce direct state intervention in the economy and put relations between the state and the private sector on a more sound and transparent footing. A related objective is to sustain the fiscal adjustment by reducing the deficits of the state enterprise system, easing the budgetary burden of agriculture support and containing the growth of contingent liabilities. Key measures include: (i) Completion of regulatory reforms in the energy and telecommunications sectors. Legislation to open up the gas market and establish an independent regulator was adopted in April, following on the electricity markets law passed in February. These laws set the  Turkev CAS Progress Report 11 foundation for comprehensive structural transformation of the energy sector from the current system dominated by state intervention to a regulated market model consistent with EU norms. Major new telecommunications legislation has been enacted responding to two failed attempts to sell a stake in Turk Telekom to a strategic investor. The new law will allow full privatization of Turk Telekom and transfer all licensing authority to the newly established Telecommunications Regulatory Authority. While the actual sale of Turk Telekom depends on an upturn in the global telecommunications market, the immediate focus will be on restructuring the company and promoting broader development of the sector. The Government intends to appoint a professional Board of Directors and management team for Turk Telekom by end-June (ii) Continued reform of agricultural support policies. The agriculture reform aims to raise farmer incomes by reversing the downward trend in agriculture productivity. A law to reform the sugar market and clear the way for privatization of the state-owned sugar factories was enacted in April and similar legislation for tobacco is expected in June. (iii) Steps to eliminate obstacles to FDI as recommended by the Foreign Investment Advisory Service (FIAS). As part of the Government's strategy to promote FDI, comprehensive implementing legislation for the constitutional amendment on international arbitration will be submitted to Parliament before the summer recess. Privatization remains a key policy objective, but the timing of specific transactions will depend on how quickly market conditions improve, both in Turkey and internationally. 14. Social Policies. Stronger social policies are a linchpin of the program to help deal with social hardships. There are four aspects to this: (i) Improved social dialogue. In April, a law was adopted to formalize the role of the Economic and Social Council. Henceforth, the Council, which brings together the Government, labor unions and employees under the chairmanship of the Prime Minister, will hold regular and frequent meetings. A central function of the Council is to enable an intensive dialogue on wages and prices with employers and trade unions to take place. (ii) Incomes policy. While the purchasing power of civil servants will be protected against erosion by inflation, real wages for public sector workers are expected to be reduced taking into account the real increases accorded in 1999-2000. Agreement on an income package was reached between the Government and the labor unions in May 2001. (iii) Social protection. Efforts to strengthen the social insurance system will continue. The existing severance payment system which covers both public and private enterprises continues to operate. The unemployment insurance program, introduced as part of the reform of the public pension system in August 1999, will begin to make payments to the enrolled unemployed in early 2002. Structural reform of the pension system continues to progress with the adoption in April of legislation for the third voluntary pension pillar (private pensions). The Government intends to move quickly to expand targeted social assistance to those groups most affected by the crisis. This support could include programs to protect vulnerable families (such as assistance with food, medicine and social services). The program of Direct Income Support (DIS) to farmers will be kicked  Turkel (AS Prozress Report 12 off in 2001, as part of the agricultural reform. It will also help farmers - especially small farmers - deal with the crisis. (iv) Social services. Spending on immunization/vaccination programs will be increased in real terms within the overall budget ceiling. The Government intends to protect public expenditure on education, as well as increase the public health budget while reducing waste within the overall health budget. 15. Macroeconomic Policies. The Government has reached agreement with the IMF on a revised macroeconomic framework in response to the crisis. The framework relies on tight fiscal and monetary policies to restore financial stability under the floating exchange rate. Fiscal policy is being tightened further in 2001 in order to help meet the costs of bank restructuring. A primary surplus of 5.5 percent of GNP is targeted in 2001, increasing to 6.5 percent in 2002-03. This is well above the surplus of 3 percent of GNP achieved in 2000. While the new fiscal package includes significant revenue measures, it strongly emphasizes expenditure reductions, an important policy shift for Turkey. New revenue measures include: (i) an increase in the petroleum consumption tax by 15 percent in May (after a 20 percent increase in April) and subsequent monthly increases at least equal to WPI inflation; (ii) an increase in the standard and luxury VAT rates, by one percentage point; and (iii) an increase in the minimum contribution base relevant for social security payments. On the expenditure side, current expenditure, transfers and investment spending will be held below the increase in inflation. Defense spending will also be scaled back. Savings will be generated in the state enterprise sector which is projected to shift from a primary deficit of 1.5 percent of GNP in 2000 to broad balance in 2001. To support this, new provisions to encourage early retirement are being considered and existing measLures to limit replacement hiring are being strengthened. Monetary policy under the new program will focus first on containing the inflationary impact of the Lira depreciation and then on bringing inflation down over the second half of the year. Under the new framework, the exchange rate will be allowed to adjust freely to ensure competitiveness. D. Outlook for 2001 and the Medium Term 16. A key objective of the program is to bring interest rates down to more sustainable levels through a combination of tight macro policies, rapid action to clean up the banking sector, and additional external support from official creditors (see below). Nominal interest rates on government securities are projected to fall to the 50 percent level by the end of 2001, compared to the 100 percent range in April. As interest rates fall and confidence returns, the economy is expected to recover relatively quickly from the initial shock of the crisis in line with the experience of other crisis countries which responded with aggressive reforns. The program projects a 3 percent contraction of GNP in 2001 based on a resumption of growth in the second half of the year underpinned by expectations of strong export growth and record tourism (Table 1). As financial stability takes hold, the recovery is expected to continue in 2002-03 with projected annual growth on the order of 5 percent. 17. Incremental external financing of around US$10 billion in 2001 is needed to fill a financing gap caused by the crisis and to ensure the consistency of the program. This gap comes from the need to finance the high costs of bank restructuring and roll over the existing stock of domestic Treasury securities, while at the same time bringing down domestic interest rates. By  Turkev CAS Progress Report 13 the end of 2001, the Treasury will have issued an estimated TL 54 quadrillion (equivalent to US$ 46.3 billion at the June 5 exchange rate, or 30 percent of GNP) in transferable securities to cover the recapitalization of the state and SDIF banks. The bulk of those securities were issued bymid- May to bring the capital adequacy ratio for the state banks to 8 percent and the SDIF baics to zero net worth. While part of the burden of financing this debt will be met through further fiscal adjustment as mentioned above, additional extemal support is also needed. 18. Raising an additional US$10 billion in the domestic market, which is already fiacing serious liquidity shortages, would keep interest rates at high levels and the debt dynamics would become unsustainable forcing Turkey into a debt restructuring. The Government's market- oriented solution to the debt problem is the best alternative and deserves support. While the stock of net public debt is projected to increase sharply in 2001, the underlying dynamics of public finances would remain stable if targets for interest rates, primary surplus and economic growth are achieved. Under these conditions, the public debt to GNP ratio is projected to drop sharply in 2002-03 (Table 1). Table 2: Key Economic Indicators . _= .Actual 1/ Projected 2/ 1998 1999 2000 2001 2002 2003 OUTPUT, INFLATION, INTEREST RATE AND UNEMPLOYMENT GNP Growth 3.9 (6.1) 6.1 (3.0) 5.0 6.0 CPI Inflation (Dec-Dec) 70 69 39 52.5 20 15 Nominal Interest Rate 115.7 106.2 38 81.1 40.6 32.6 Unemployment Rate 3/ 6.8 7.7 6.6 >8.5 6.0 6.0 PUBLIC SECTOR BUDGET Primary Balance (%GNP) 1.1 (2.0) 2.8 5.5 6.5 6.5 Overall Deficit (%GNP) (15) (24) (19) (17) (10) (7) Public Debt (%GNP) 4/ 44 61 58 79 71 65 of which net external debt (% of GNP) 19 20 20 34 28 23 Privatization ($ bn) 2.2 0.1 3.3 3.1 3.5 3.5 EXTERNAL BALANCE Current account balance (%GNP) 1.0 (0.7) (4.8) (0.6) (0.9) (0.6) Exports (fob, $ bn) 31 29 31 34 36 39 Tourism (S bn) 7.1 5.2 7.6 8.3 8.6 9.1 External Debt (%GNP) 47 55 57 66 60 57 Foreign Exchange Reserves ($ bn) 21 24 23 21 22 24 1/ Government figures as adjusted by IMF and WB estimates. 21 Projections for 2001-03 are based on revised IMF program figures. 3/ Projections for 2001 are based on preliminary figures for the first quarter; projections for 2002-03 are from the State Institute of Statistics. 4/ Includes the government securities issued to recapitalize the SDIF and state banks. Source: Govemment, IMF and WB estimates. 19. Balance of Payments and External Financing Plan. Exceptional official financing from the IMF and World Bank would support the balance of payments and close the financing gap in 2001. A sharp correction in the current account is projected on the basis of the exchange rate adjustment and economic slowdown. However, this will be accompanied by an expected  Turkei CAS Progress Report 14 reduction in Turkey's access to international capital markets as a result of the crisis. The current account deficit is projected to fall abruptly in 2001 to about US$1 billion (0.6 percent of GNP), and to remain close to balance in 2002-03 under the floating exchange rate regime. However, portfolio flows and international private financing for banks and the corporate sector are all expected to contract in 2001. Efforts by Turkish banks to close open foreign exchange positions will add to pressure on the capital account. While the program incorporates steps to encourage "bail in" by private creditors, without additional multilateral support, Central Bank reserves would most likely drop precipitously and pressure on domestic interest rates would intensify. A proposed package of US$ 1O billion in exceptional official financing, of which US$8 billion from the IMF on Stand-By terms and US$2 billion from the World Bank, is proposed to support the program in 2001 and meet the external financing gap. This funding is over and above the amounts programmed by the IMF prior to the February crisis and the original high-case program of the CAS. As confidence returns, Turkey's access to the international capital markets is expected to recover in 2002-03 (see Annex BI 1 for more details), and the anticipated "bail-in" of the private sector is realized. III. THE BANK GROUP PROGRAM A. IBRD Program 20. The CAS presented to the Board in December 2000 was designed to help Turkey to lay the basis for sustained long-term growth and reducing economic vulnerability. This remains the core objective of the Bank Group strategy. Poverty and economic vulnerability, and widening disparities, have been worsened in Turkey by erratic growth and inflation: periods of rising inflation and slowing growth have especially hurt those at the lower end of the income distribution. Restoring stable and higher growth, creating employment, reducing inflation, and improving the management of the financial and public sectors (the latter particularly with respect to well targeted delivery of social services), have again been shown to be the goals upon which Turkey must focus. In light of the economic crisis that began in February 2001, reaching the objective of sustained growth and reduced economic vulnerability and the latter goals requires Turkey to undertake accelerated structural reform, while working quickly to recover from the crisis and mitigate its worst effects. Thus, the Bank Group's strategy now is to focus on helping Turkey recover from the crisis while dealing with its deeper causes - especially the large and inefficient public sector and fragile banking system - and address increasing social hardships. The Government of Turkey has requested intensive financial and technical help from the Bank Group and an acceleration of IBRD's assistance focussed on the structural and social issues. 21. The CAS program for FY01 -03 included US$5 billion in IBRD lending for the high case, of which US$4 billion aimed to support structural reforms (within which, US$2.4 billion was for adjustment operations in the indicative lending program), and US$1 billion was for base case lending, largely in support of social and environmental investment projects. In the discussion of the FYOI-03 CAS with the Board in December 2000, the Bank indicated its willingness to accelerate the high case commensurate with the pace of reform as appropriate. In tandem with the CAS discussion, just over US$1 billion was committed for two operations: FSAL I (US$778 million) and the Privatization Social Support Project (PSSP, US$250 million). The first tranche of FSAL I (US$393 million) was disbursed on December 22, 2000. Including the Economic  Turkev CAS Prozress Report 15 Reforn Loan (ERL, US$760 million) committed under previous CAS, IIBRD has to date committed slightly under US$1.8 billion and disbursed US$777 million to support Turkey's economic reform program since its inception at the end of 1999. 22. Revised program. Given the positive features of Turkey's new strategy and economic framework, but mindful of the risks it entails, IBRD has reformulated its planned support to Turkey. The financing plan required for the Government's new economic program entails an incremental US$2 billion of disbursements from IBRD over the original CAS disbursement profile for calendar year 2001. To provide this support, IBRD proposes to structure lending operations within the original CAS envelope to bring US$800 million more disbursements in CYOI than projected in the CAS and make available an additional US$1.2 billion (over the original CAS envelope), on Special Structural Adjustment Loan (SSAL) terms. While IBRD financial support provides a relatively small part of Turkey's liquidity needs, enhanced and redirected support is vital to ensure that: Turkey's enhanced structural reforms, in particular banking sector restructuring and public sector reforms are supported and previous reforms are maintained; and adequate resources are also available to mitigate the socio-economic and economic consequences of the crisis. 23. The structural origins of crisis and its potentially large social and poverty impact, justify exceptional Bank financing on SSAL terms to support specific policy changes and institutional reforms and provide fast disbursing assistance to close the external financing gap. In addition, the volume of support now envisaged over the CAS period is in excess of the original program discussed with the Board in December 2000; IBRD exposure was already expected to increase rapidly under the CAS program; there is a need to protect IBRD's capacity to provide long-term, standard-price funding in support of the Government's medium-term structural reform program; and accelerated disbursement to Turkey will add to the existing financial pressures on IBRD. 24. IBRD will support strongly the structural reforms and social agenda, outlined in section II-C above. The proposed revised lending program includes up to US$3.8 billion in programmatic structural adjustment loan commitments, in addition to a possible quick-disbursing portion of the proposed Social Risk Mitigation Project, an adjustment component of the ARIP hybrid operation, and the outstanding second tranche of the ERL. Other operations - for education, health, and rural development - would remain in the FYO1-03 program, but their preparation would be paced to match the capacity of the Government to focus on those agendas and provide adequate counterpart funding. Table 3 presents the proposed revised program, and Table 4 compares the high case under this program to that under the original CAS. The following paragraphs explain the main revisions to the program. 25. Support for the Financial Sector and Public Sector Reforn. Turkey has adopted a new reform program that combines urgent financial and fiscal measures to restore stability with a comprehensive medium-term program that links macroeconomic sustainability with deep structural and institutional reforms. This complex medium-term program is now being made explicit to signal to markets both the future expectations of reforn and the sustainability of the program. The need for structural reform is particularly evident in the financial sector and public sector. Now, there are synergies between the reforms in these two sectors. A key element in their interlinkage is the need to eliminate the contingent fiscal liabilities stemming from the financial system. The immediate financing needs for the recapitalization of the state and SDIF  Turkey CAS Progress Report 16 banks (see para. 17 above) are having an impact on the budget and debt management. Reforrm of the financial system to disentangle it from the public sector budget will make the elimination of contingent liabilities permanent. Thus, for the next half year, the reforms of the financial and public sectors are intertwined, and should be addressed together. Sustained recovery from the crisis and the credibility needed for supportive market reactions depend on quickly implementing reforms in both areas. 26. Over the medium and longer terns, public sector and financial sector reform will continue to be crucial to creating an economy characterized by steady growth, at low inflation, in an equitable pattern. Sound banking and transparent, effective government will greatly reduce the risk of crises, which in themselves have proven so damaging to economically vulnerable groups in Turkey. By raising the overall efficiency of resource allocation and encouraging private capital investment, these reforms will raise productivity, another key factor for raising incomes in Turkey. The medium-term reforms in the two sectors, beyond the actions planned for the remainder of 2001, are not inter-linked to the same extent as the immediate actions. 27. The Bank proposes a program of programmatic lending, which would recognize both the need to take key up-front actions to reduce short-term vulnerabilities as well as to establish and begin the medium-term phased process required for full public and financial sector reform implementation. The latter reform involves complex institutional changes - some of which will take time to specify in detail and implement - in addition to policy and legislative action. A programmatic approach is needed to establish very clearly the goals and objectives of the program - but with adaptability on timing and specific actions in 2002 and 2003. To support the strengthening of the fiduciary framework, the Bank has recently completed a Country Procurement Assessment Report (CPAR) and is completing a Country Financial Accountability Assessment (CFAA, see below). Reflecting the inter-linkage of the reforms in the financial and public sectors for the remainder of 2001, the indicative lending program includes two operations addressing the two sectors together. Then, starting in the second half of FY02, IBRD support would involve separate operations for the financial and public sector, since the agenda would be focused on medium-term institutional change, an area best handled in sector-specific detail. Specifically, the proposed high case program includes the following five operations: * Two Programmatic Financial and Public Sector Reform Adjustment Loans (PFPSALs) for the first phase of support. The first PFPSAL, totaling US$1.1 billion, and will comprise US$700 million under standard IBRD terms and US$400 million under SSAL termns. This operation is expected to be presented to the Board by the end of June 2001, but if reformn actions are delayed, could be presented slightly later, in July 2001. The second loan, to be presented to the Board before the end of December 2001, would total US$1.35 billion, of which US$550 million would be on standard IBRD terms, and US$800 million on SSAL terms.5 These loans address both public and financial sector issues, although the first has a higher proportion of financial sector actions needed quickly to reduce vulnerabilities in the 5The total of US$2.45 billion will result in US$2.0 billion over the CAS projected disbursements for CYOI because the second tranche of the Econormic Reform Loan (ERL) could be delayed to the beginning of CY02 and disbursements on investment lending are now expected to be below original projections.  Turkey CAS Progress Report 17 banking sector. The reforms supported by these two loans are clearly specified and well understood by the Government and the Bank, and thus ready to be implemented. * Subsequently, two Programmatic Financial Sector Adjustment Loans (PFSALs) of US$500 million each, one in FY02 and the second in FY03; and * the first of an anticipated series of ProZrammatic Public Sector Adiustment Loans (PPSALs). of US$375 million, in FY03. Proposed Time Line of Bank Support for Public Sector and Financial Sector Reform Program Public Sector (USS375 Million) beyond this CAS period Combined Public Sector and Financial Sector PFPSALI PFPSAL11 (USSI.I Billion (US$1.35 Billion) Financial Sector A & (US$500 million) (US5500 Million) I~~~~~~~~~~ i June Dec. June Dec June 2001 2001 2002 2002 2003 28. For 2002 and 2003 the Bank and the Government have reached agreement on key structural triggers but the precise conditionality needs further formnulation. The programmatic approach does not exclude investment lending and covers the public and financial sectors. The diagram above shows the timeline of this and subsequent proposed programmatic support. 29. In moving to the programmatic approach, the Bank has taken into account progress made on the financial sector reform agenda already, and the impact of the crisis on the next stages of that agenda, and concluded that the previously planned operations in this sector do not suit the phasing of the Government's new program. A banking sector assessment prepared by the Bank's financial sector team in March 2001 showed the extent of the crisis and proposed a revised policy agenda. The agenda for further restructuring in the private banks, and governance issues in the non-bank financial sector, also presents new and still evolving challenges as a result of the February crisis. Overall, the financial sector reform program is now broader than envisaged at the time FSAL I was prepared, and some elements originally expected to be part of a later operation have been brought forward. Thus, the revised program involves canceling the second  Turkev CAS Progress Report 18 tranche of the FSAL I (US$385 million) and combining it conceptually with the previously planned State Bank Restructuring Project (US$500 million) and FSAL II (US$800 million) into a programmatic approach. The first urgent stages of the banking reform will be implemented at the same time as an array of other pressing institutional and regulatory changes, particularly those with important implications for public finance. Hence, the most efficient approach to designing support to the financial sector reforms in CYOI would be within the PFPSALs operations. Subsequently, the financial sector reform agenda would be supported through the two PFSALs. 30. Overall, with respect to the financial sector, the proposed IBRD operations would support the phased implementation of a comprehensive financial sector reform program, especially issues related to: * the legal and regulatory framework for banking; * resolution of the SDIF banks; * the privatization of the state-owned banks; and * regulatory issues related to capital markets, insurance and other non-bank financial institutions like leasing, factoring, mutual funds and private pension funds. 31. An important benefit of these operations would be to restore confidence in the banking sector following the November 2000 and February 2001 banking crises by exhibiting clear international support for the Government's reform program. Further, the reform program supported by the loans would: strengthen the foundation for an efficient, sound and healthy banking system which could be competitive in quality and performance at the international level, as well as offering improved financial intermediation to the benefit of the real economy; reduce the vulnerability of the banking system and enhance its capacity to withstand external shocks and thereby reduce systemic failure risk; and position Turkey's banking system for EU accession, in particular by aligning the prudential regime for the banking system with applicable EU banking sector directives. (See Annex B12 for further details). IFC's strategic approach to the financial sector, focusing on assisting the authorities with the intervened banks, while helping to build institutions and support new financial product development, further buttresses Bank Group work in the sector. 32. Increase support for public sector reform. The Bank has just completed a comprehensive PEIR, and a CPAR, while a CFAA is underway; together these form the basis of a public sector reforrn program. The Government and the Bank are working closely on this agenda, given its importance for sustained improvement in macro management, effective public investment, better governance, and public trust. The EU is an active partner in this area, particularly with respect to procurement law. This agenda would be supported by the Bank in the two PFPSALs and subsequently the PSALs. In addition, an anticorruption conference is being scheduled for early in June 2001. The PFPSALs would encompass support to the full public sector reform agenda outlined in paragraph 14 above.  Turkey CAS Progress Report 19 Table 3: Proposed Revised FYO1-03 CAS Indicative Lending Program (US$ million)* Year New High Case New Base Case FYOI FSAL I** 393 Privatization Social Support *** 250 ARIP (hybrid) 600 PFPSAL I *** 1,100 Sub-total 2,343 Sub-total 0 FY02 Basic Education (APL II) 300 Basic Education (APL II) 300 Social Risk Mitigation 500 Social Risk Mitigation 368 PFPSAL II**** 1,350 Community Dev't and Heritage 25 Prog. FSAL I 500 Community Dev't and Heritage 25 Sub-total 2,675 Sub-total 693 FY03 Prog. FSAL II 500 Health***** 100 Health 100 Micro Watershed 32 Micro Watershed 32 PSAL Prog. Loan 1 375 Secondary Education 175 Secondary Education 175 Sub-total 1,182 Sub-total 307 FYOI-03 Total 6,200 Total 1,000 of which on SSAL terms 1,200 * Plus US$500 million for emergency lending, in the event of a large natural disaster. ** FSAL I was approved December 21, 2000, with a loan amount of US$778 million. Of this, US$393 million was disbursed on December 22, 2000, and US$385 million is proposed for cancellation under the new program (to be folded into the new larger financial sector reform programmatic operation). *** Actual (approved December 21, 2000). **** The PFPSALs are sets of structural adjustment loans in support of the accelerated reform program. PFPSAL I consists of US$400 million on SSAL terms, and US$700 million on standard IBRD loan terms; PFPSAL II consists of $US800 million on SSAL terms and US$550 on standard IBRD loan termns. ***** Depending on sector reform progress either this or an energy project with the same loan amount could be proposed for FY03 approval, with the other coming in early FY04.  Turkey CAS Progress Report 20 Table 4: Comparison of CAS High Case with Proposed Revised High Case FY01 -03 Year Original CAS High Case New High Case* FY01 FSAL I ** 778 FSAL I** 393 Privatization Social Support *** 250 Privatization Social Support *** 250 ARIP (APL 1) 400 ARIP (hybrid) 600 Basic Education (APL 11) 300 PFPSAL I * 1.100 Sub-total 1728 Sub-total 2,343 FY02 Local Initiatives and Soc. Assist. 112 Basic Education (APL 11) 300 State Bank Restructuring 500 Social Risk Mitigation 500 PSAL 820 PFPSAL II**** 1,350 Natural and Cultural Heritage 50 Prog. FSAL 1 500 Secondary Education 175 Community Dev't and Heritage 25 Village/Township Services 100 Sub-total 1757 Sub-total 2,675 FY03 FSAL 11 800 Prog. FSAL 11 500 Health loo Health***** 100 Micro Watershed 35 Micro Watershed 32 Energy 200 PSAL Prog. Loan 1 375 Municipal (APL 1) 300 Secondary Education 175 Seismic Risk Mitigation 80 Sub-total 1515 Sub-total 1,182 FYOI-03 Total 5000 Total 6,200 of which on SSAL terms 1,200 * Plus US$500 million for emergency lending, in the event of a large natural disaster. ** FSAL I was approved December 21, 2000, with a loan amount of USS778 million. Of this, USS393 million was disbursed on December 22, 2000, and US$385 million is proposed for cancellation under the proposed revised program (to be folded into the new larger financial sector reform programmatic operation). *** Actual (approved December 21, 2000). **** The PFPSALs are sets of structural adjustment loans in support of the accelerated reform program. PFPSAL I consists of US$400 million on SSAL terms, and US$700 million on standard IBRD loan tenns; PFPSAL 11 consists of $US800 million on SSAL terms and US$550 on standard IBRD loan terms. Depending on sector reform progress either this or an energy project with the same loan amount could be proposed for FY03 approval, with the other coming in early FY04. 33. Support accelerated social assistance to poor households and permanent institutional strengthening for better social protection. A proposed loan for a Social Risk Mitigation Project (US$500 million) would provide help to poor families affected by the crisis to receive some income or basic necessities, continue to invest in their human capital, and build the institutional basis for better targeted, sustained social protection. This loan could support immediate actions to get assistance to the most needy through existing programs with strengthened monitoring, and subsequent actions to invest in human capital, support and better target the income-generating  Turkev CAS Progress Report 2 programs for poor communities through the Social Solidarity Fund (SSF), and design and implementation of institutional strengthening of SSF. Preparation of this proposed project is drawing both on recent experience in similar projects in Colombia, Jamaica, Indonesia and other countries, and successful experience in Turkey under the Emergency Earthquake Recovery Loan (EERL) with the delivery of rapid payments to needy families by the SSF after the Marmara earthquake. The SSF has experience in delivering a variety of social assistance targeted at needy women and children, some of it linked to education, and a decentralized administrative apparatus that allows it to act quickly. The Bank team will coordinate with UNICEF in this work as well. The studies soon to be undertaken within the ongoing Privatization Social Support Project (PSSP) and the Agricultural Reform and Investment Project (ARIP) will provide information on specific affected groups (laid off workers and agricultural workers), complementing the results of the Rapid Assessment Survey underway in preparation for the Social Risk Mitigation Project. Tight monitoring of the impact of the crisis and mitigating measures will be carried out, as explained in Box 4 below. 34. Increase the proposed size of the Agricultural Reform Implementation Loan (ARIP) from US$400 million to US$600 million by adding to it an adjustment component of US$200 million, disbursement of which would be based on progress in introducing the direct income support (DIS) payment system. This latter support is an important element in cushioning potential adverse impacts of the reform in that it provides support to farmers who will no longer receive price supports and other distortionary subsides. The DIS is designed to give proportionately more cash to farmers with smaller land holdings, thus improving the targeting of assistance in the sector. The ARIP Loan would also help with the cost to farmers of shifting from uneconomic to more competitive crops in the newly market-oriented environment, and fund some of the severance to employees of the Agricultural Sales Cooperative Unions (ASCUs) who would be laid off as part of the restructuring of those activities (a process already underway). ARIP6 will be presented to the Board on the same day as discussion of this CAS PR. 35. Maintain the ERL program to support private sector development. This will include as originally agreed, further progress on energy reform, agricultural reform, and privatization. On energy reform, key actions to implement the new electricity and gas market law are expected in the coming months, and a prequalification tender for privatization of electricity distribution could be launched within CY01. Furthermore, the ongoing loan in support of the National Transmission Grid project will be restructured to introduce a technical assistance component to help the Government to implement the energy sector reform program. In agriculture continued progress in reforming support policies and introducing the direct income support program will assist the Govermnent to implement the remaining ERL conditions. On the privatization conditions, though, some delays are likely. It would be possible to sell two more large public enterprises, as required by ERL conditionality, but under current weakened local and world market conditions, the prices could be unfavorable and generate a political backlash over perceived depletion of public asset value. In telecoms, the Government was unable to sell a minority stake in Turk Telekom to a strategic investor. Under the new program, legislation has been enacted to allow up to 100 percent of the company to be privatized (with the exception of a "golden share") and to strengthen the regulatory framework, thereby going beyond the scope of the ERL conditionality. IBRD is working closely with the authorities on an appropriate approach 6Project Appraisal Document, Report No.21 177-TU, June 2001  Turkey CAS Progress Report 22 to this matter. IFC's activities strongly complement the Bank's work in the area of reform to support private sector development. 36. IBRD would postpone or alter some proposed operations to reflect changes in the Government's priorities in light of the urgency of the reform areas mentioned above. The Municipal APL (US$300 million) would shift into FY04, as this reform dialogue is unlikely to gain accelerated momentum for another year. A study of municipal reform will be done jointly with Germany (KfW) starting in FY02. The new timing would have the advantage of coinciding with the entry of newly elected leaders following 2003 municipal elections. Given the delays in implementation of the institutional component of the MEER earthquake project, the follow-up Seismic Risk Mitigation project (US$80 million) would also shift to FY04. Both the Energy project and the Health project previously planned for FY03 are the subject of continued dialogue and study; depending on reform progress in the sectors, one would be brought to the Board in FY03 and the other in early FY04. Due to delays on implementation triggers under the first Basic Education APL, the second will be brought to the Board in the autumn of 2001. Work with the counterpart agencies on the earlier concept of a Natural and Cultural Heritage project has led to a different formulation, focused on using heritage as a basis for community development and income generation, and basing one component on a process of participatory community decision-making underway with UNDP support. The new project concept has been named Community Development and Heritage in light of this positive development. The Village and Township Services project would be dropped from the FY01-03 program, although such a concept could be reconsidered for inclusion in a later year, when appropriate participatory mechanisms have taken root. Box 4: Monitoring the Social Impact of the Crisis and the Reform Program A series of activities are being undertaken to monitor and evaluate the impact of the crisis on household welfare. These build on earlier work in place to monitor the impact of the reform prograrn, and together allow comprehensive social monitoring program over the CAS period. The simulation performed in March 2001 indicated the likely areas of increased vulnerability. Next, a rapid social and economic survey was fielded, with preliminary results expected in late July 2001. This survey is designed to provide early data on the impact of the crisis on different groups of poor and vulnerable households by asking them about changes in their consumption/expenditure patterns before and after the crisis. Its purpose is to confirm the simulation results and develop a targeting mechanism for the immediate channeling of assistance to the poor and vulnerable. The third is an agricultural household survey planned as part of the social monitoring and evaluation of the Agricultural Reform Implementation Project. This survey, which includes selected qualitative follow-up, will follow a panel of 5,000 rural and 500 urban households for a four-year period starting in the summer of 2001. It will be used to provide ongoing monitoring and evaluation of the impact of the crisis and the government's response in the agricultural sector. A fourth activity consists of a series of studies to be undertaken as part of the PSSP, including a community and sectoral study, a quantitative survey for impact evaluation (3,000 workers surveyed five times), a qualitative survey of displaced workers (200 studied five times) a study of the national social assistance system, and a quasi-experimental study of the net impact of labor deployment services. In addition to these surveys, a program of regular household surveys is proposed; the Bank will work closely with the authorities to encourage more frequent, but also affordable, surveys, including both a Household Income and Expenditure Survey every two or three years, and interim rapid surveys. 37. Revise the economic and sector work program to be responsive to new needs. The Bank has recently completed a CEM, PEIR, and a Country Procurement Assessment Report (CPAR); a Country Financial Accountability Assessment (CFAA) is nearing completion. Two new studies not anticipated at the time of the CAS are underway: the first will assess the social impact (this  Turkey CAS Progress Report 23 will be shared with the Board at the time of presentation of the proposed Social Risk Mitigation Project) and the second - a joint IBRD-IFC undertaking - is reviewing effects on the corporate sector. Future ESW will continue as planned including a Health Study and a Non-Bank Financial Institutions Study in FY02, and a CEM with a focus on EU accession in FY03. Box 4 outlines the activities that will contribute to sound monitoring of the social impact of the crisis and the reform program. 38. Portfolio Management. The Bank will need to work closely with Government to ensure that new operations can be provided with adequate counterpart funds before going ahead and that the ongoing portfolio can continue effectively despite the likely impacts of the crisis. At the end of March, the Bank portfolio in Turkey was healthy, with no projects showing unsatisfactory ratings on development objectives and only 1 out of 24 rated unsatisfactory on implementation progress. There is no doubt, though, that the consequences of the economic crisis will be felt in the portfolio. Two key areas of strain are likely to be the effects of the devaluation on the autonomous borrowers (especially municipalities) who have debt denominated in foreign currency and revenues in Turkish Lira, and restrictions on counterpart funding stemming from reallocation of budgetary fund towards more pressing needs. Therefore, instead of a traditional Joint Portfolio Performance Review (JPPR), the Bank has begun a rapid forward-looking assessment of the portfolio, with the Treasury, State Planning Office, and Ministry of Finance, with a view to identifying and resolving issues likely to face ongoing projects in light of changed economic conditions, the revised Government budget, and other factors. 39. Lending Scenarios and Triggers. Bank lending to support structural reforms in Turkey, as was the case over the past two years, will continue to be strongly linked to upfront actions. The triggers for the high case have been strengthened in the financial and public sectors, and social protection and services, to match the new high case lending program (see Box 5). The trigger for the fiscal adjustment has been tightened to 5.5 percent of GNP given the need for strong fiscal adjustment in the macro-economic program. This trigger is consistent with the Government's IMF-supported macro-economic program for 2001 and will be adjusted on an ongoing basis in light of developments in the Government's IMF-supported macro-economic program. The trigger for the current account deficit has been removed because it was relevant under a crawling peg exchange rate mechanism but is no longer so. All the triggers outlined in Box 5 must be met to keep the program in the high case. These imply implementation of the Government's new program, and continued delivery on commitments under ERL and the proposed programmatic lending for the public and financial sector reform agendas. High case lending would total US$5.0 billion for FYO1-03 with an additional US$1.2 billion provided on SSAL terms, and base case of US$1.0 billion for FY02-03. The Bank expects, even in a base scenario, to continue support to education and other aspects of the human and sustainable development agendas as long as institutional conditions, sectoral policies, and counterpart funding availability allow such projects to have a strong positive effect on the poor and vulnerable. 40. The external financing plan assumes that the IMF provides large upfront financing in 2001, of around US$13.5 billion (net), but is then re-paid US$5.7 billion in 2002 and 2003 on a net basis (see Annex B 1l, Table B, Page 9). The private sector on the other hand is repaid in 2001, but as confidence is restored, and Turkey's access to international credit is re-activated, private inflows and sovereign borrowing increase in 2002 and 2003. Successful realization of  Turkey CAS Progress Report 24 such financing and "bail-in" strategy would be a tnrgger for continued high-case lending from IBRD. Without a successful "bail-in" strategy, the financing plan would be inadequate and IBRD lending would not be productive. Ongoing reforns defined very clearly in the ARIP (for agricultural reform), the ERL (for pnrvatization and establishment of the regulatory framework for energy and telecommunications), and in the PFPSAL (for banking and public sector reforms) will be used to the determine the continuation of the high-case lending program for Turkey on the structural side. These reforms are all inter-linked and, as stated in the government's reform strategy, delays in any one area affect the entire program. 41. Partnership. The Bank would lead external support to Turkey in the structural and social programs. The IMF will continue to lead on the macro-economic framework, and the Bank will remain in close coordination with the IMF on macro-economic and broad structural issues, with the banking sector taking particular prominence among the latter. The Bank and the EU are working closely on a number of regulatory and governance issues. OECD is also a close partner in these areas. Other partners continue to support Turkey as indicated in the CAS. Close on- going relationships are developing with KfW on municipal reforn, JBIC on banking sector issues, UNICEF on social services and social protection, UNDP on community development, the Turkish Economic and Social Studies Foundation (TESEV) on anti-corruption, several grassroots NGOs who have recently received funding through the Small Grant Program, and other NGOs that work with the Bank on selected projects. Box 5: Revised Triggers for the High Case The core policies underpinning the New Economic Program and the triggers for maintaining the high case are: Macroeconomic * Sustained fiscal adjustment yielding a primary surplus for the consolidated public sector of at least 5.5 percent of GNP; appropriate exchange rate policies to maintain competitiveness over the medium term; and an external financing plan based on adequate burden sharing with the IMF and private inflows satisfactory to the Bank. Structural * Rigorous implementation of structural reform programs in social security and agriculture sector as outlined in the ERL and the ARIP; and * Sustained and transparent privatization effort in line with the Government's announced targets for 2001 and 2002; and establishment of credible legal and regulatory frameworks to promote private investment in the energy and telecommunications sectors; and * Sustained strong implementation of banking sector reform including: restructuring privatization of all state banks by June 2003, resolution of SDIF banks by December 2001, effective functioning of BRSA, and implementation of banking law and regulations, as outlined in the PFPSAL 1. * Introduction of reform in public sector management and public accountability, including procurement, and development and announcement of a clear anti-corruption strategy, as outlined in the PFPSAL I. Social * Strengthened social assistance program to deal with social impact of the crisis - especially focused on women and children, and maintenance of adequate expenditure allocations for public health and, education; and * Implementation of unemployment insurance as well as establishment of institutionalized mechanisms for social dialogue such as the Economic and Social Council.  Turkey CAS Progress Report 25 B. IFC Program Crisis impact 42. The year 2001 will be pivotal for Turkey and IFC expects to provide it with a great deal of support in FY02. Targeted interventions designed to help the sustainability of reform will remain the basis for the Corporation's activities in Turkey. IFC support for financial sector reform and corporate restructuring are expected to have a beneficial development and catalytic impact as Turkey works to re-establish a reform program which is viable and which will inspire investor confidence. 43. As a result of the financial crises there is little lending to the domestic private sector and this is at very short maturities and very high real interest rates. The depreciating Turkish Lira, lack of liquidity and steep rises in interest rates, combined with lower domestic demand is leading to widespread distress in the corporate sector. There is also an acute working capital shortage, paralyzing otherwise viable companies. Exports, which are very important for the revival of the economy, are being constrained by lack of finance for imported inputs. 44. Turkey is an important country for IFC, the fourth largest exposure after Argentina, Brazil and Mexico, accounting for 4.6 percent of the total IFC portfolio. The total IFC own- account held portfolio in Turkey is US$614 million. In addition, the outstanding balance of B loans that IFC has mobilized is US$370 million. IFC also has invested over US$150 million in Turkish companies outside of Turkey. While it is still too early to assess the impact of the crisis on IFC's portfolio, its diversification across sectors and export-orientation should help to mitigate the impact. Most of IFC's corporate clients are conservatively leveraged and export oriented (export range from 20-40% of their sales), and devaluation should enhance their competitiveness. However, it is certain that there has been an impact on IFC's portfolio companies due to: depressed domestic sales, lengthened collection time of accounts receivables, higher interest rates, impact of devaluation on debts in foreign currencies and possible problems with debt rollover. Companies with un-hedged foreign exchange exposure and maturity mismatches will be particularly vulnerable. Crisis Response 45. This year poses a particular challenge for IFC in Turkey. While the underlying medium and long term strategy remains the same as presented in the CAS document, IFC is adjusting its short-term strategy to respond to the crisis. IFC strategy will complement the Bank's consolidated and strengthened support to the financial sector and private sector development. IFC has a strong role to play by taking risks and making selective counter-cyclical investments, but at the same time it must maintain its reputation as an internationally credible investor with a triple A rating. Given the size of the problem and IFC's limited resources, the focus will be on a few key, visible interventions, with strong demonstration effects and positive impact on market psychology in view of the volatile shifts in market sentiments. 46. IFC will protect its portfolio by working on restructuring and, where appropriate, re- capitalizing its portfolio companies. IFC aims to provide a swift response to enable its existing  Turkey CAS Prozress Report 26 export-oriented clients to generate foreign exchange cash flows to service their debt, thereby avoiding insolvency. IFC will also be active in the following areas: the traditional long-term project financing and credit lines for financial institutions which will be very scarce; working capital finance; and operational and financial restructuring. 47. Thus, during next fiscal year IFC will give priority to: (i) the financial sector; (ii) restructuring industrial companies; and (iii) assisting the authorities with privatization. IFC expects to play an active role in each of these areas during 2001-02. 48. Financial Sector. IFC's strategy in the financial markets will be to focus on: (i) assisting the authorities with the sale of intervened banks, as appropriate, and of the non-performing loans of these banks; (ii) working with a mid-sized bank to strengthen capital and to use it as a platform for helping the consolidation process; (iii) developing a possible trade finance facility to assist viable companies hampered by lack of liquidity; and (iv) continuing with efforts aimed at institution building and introduction of new products-including the development of the insurance sector, mortgage finance and contractual savings institutions, and development of the private equity market. (i) IFC has met with the Banking Regulatory and Supervisory Agency (BRSA), to discuss how IFC might assist with the task of selling of intervened banks7. In the case of Demirbank, an existing client, IFC is prepared to take an equity stake alongside an acceptable investor, should there be a role for IFC. IFC has also been asked by the BRSA for assistance on the resolution of non-performing loan issues of the banks under the SDIF. In this regard, working jointly with the Bank, IFC can draw on its experience on similar work done on recent projects in Eastern Europe. (ii) A consolidation of the banking sector is inevitable and, in the short term, we believe the focus needs to be on strengthening viable financial institutions hit by the downturn. In this regard, complementing the Bank's support to banking sector reform, IFC is planning to work with a mid-size bank to strengthen its capital base and to use it as a platform to promote the consolidation of the banking system, by acquiring weak or intervened banks, assets, and/or through management contracts. This could also provide a channel for extending credit to the SME and corporate sectors, both of which are facing a liquidity squeeze. (iii) In addition, IFC is working to structure innovative mechanisms to enhance banks' capacity to provide trade finance to viable companies so as to help promote exports. (iv) As calm returns to the markets, in accordance with its medium term strategy, IFC will continue with its institution building efforts, to develop domestic long-term contractual savings institutions via projects in housing/mortgage finance, pension reform, and 7 Thirteen private banks have been taken over by the Savings Deposits Insurance Fund (SDIF) since 1998. SDIF plans to consolidate and sell off the banks to investors, but little interest has been shown by domestic or foreign investors. Only Demirbank has attracted foreign interest, but even there, the difficult economic environment is delaying the receipt of firm bids.  Turkev CAS Progress Report 27 development of a local currency debt market. In addition, IFC is working on a private equity fund, a re-insurance company and an online brokerage project. 49. Restructurin' Industrial Companies. IFC and the Bank are working to: (i) prepare a diagnostic analysis of the degree of corporate distress by sector/corporate segment; (ii) examine the incidence of formal bankruptcy and insolvency; (iii) deternine the workout capacity of the banks and how the banks are addressing their own portfolio problems; and (iv) develop instruments to address the problems identified in the corporate sector. 50. IFC is focusing on enabling its existing clients to survive the crisis by providing them medium-term financing, if necessary, to restructure their balance sheet, bring in potential strategic investors, save on the high cost of short term financing, and undertake necessary capital expenditure to reach optimum capacities. Companies suffering from liquidity difficulties are seeking support from IFC in the form of equity investment or bridge financing, which would potentially enhance their profitability or financial structure in anticipation of an eventual sale. IFC's response is to work with them on corporate restructuring, offering assistance to restructure their liabilities and, where appropriate, providing additional financing. IFC has therefore given priority to restructuring such companies which have good fundamental business prospects, but which were constrained by inadequate equity and/or liquidity problems. IFC will develop model transactions that serve to demonstrate how such companies can de-leverage their balance sheets, increase their equity base, meet increased working capital requirements and improve their corporate governance. IFC would also endeavor to convince the B lenders to do the same. The B loan management unit has been actively involved in working with B loan participants to insure that they are fully informned of5project developments and their views are adequately considered in developing restructuring plans . 51. Given the problem of tight local financial markets and export financing, IFC is exploring mechanisms to alleviate working capital shortages to enable its existing export-oriented clients to generate foreign exchange cash flows to service their debt, thereby avoiding insolvency. In addition to assisting individual export-oriented clients, IFC is considering a Trade Credit Facility, to help restore intermediation in the banking system disrupted as a result of the crisis. 52. Beyond the crisis response and despite the difficult environment, IFC will continue to pursue new investments where appropriate. Financing new projects with strong cash flows and positive fundamentals, through corporate loans of sizeable arnounts, IFC will provide appropriate signals in the market and send a strong message of confidence to the Turkish private sector and to international banks. 53. Privatization and FDI. It has become critical for Turkey to accelerate restructuring and privatization of state owned companies. IFC strategy is to support flagship privatization to 8Recently, IFC stepped in expeditiously with additional financing to close an international syndication of US$80 million aggregated funding for a large Turkish corporate (Arcelik). This loan, the first post-crisis international syndication for the private sector for long-term funds, was signed in London on April 20. This message of confidence in the private sector, at an opportune time, signals strong support for viable enterprises by international commnercial and financial institutions. It will encourage domestic banks to lend more on longer termis to corporations with strong business foundations.  Turkey CAS Proress Report 28 achieve its catalytic or leveraging impact in Turkey, to help restore investor confidence, attract foreign interest and stimulate the flow of foreign direct investment (FDI) in privatization deals. To achieve this goal, IFC will support privatization of powerful demonstration projects such as telecoms and the national airline. The Information and Communication Technologies Group, a joint Bank/IFC unit, could play an advisory role in the privatization of Turk Telekom. 54. IFC is leading a Bank Group initiative to enhance the quantity and quality of FDI inflows. FIAS carried out a diagnostic study (50 percent financed by IFC), which was discussed at a workshop with the government and leading members of the business community at the end of March. An analysis of administrative and regulatory barriers and a work plan for their removal is now underway and should be completed by end June. These measures are central to improving the investment climate and they address some of the issues underlying the current crisis. A FDI investor conference is planned for spring 2002. 55. Istanbul Hub. Recognizing the importance of Turkey in the region, IFC has established a hub in Istanbul for its operations in Turkey, the Balkans and Central Asia. This will help IFC to react swiftly to the crisis, promote private sector investment, encourage FDI and support Turkish investments in the region at large. The Director of the Southern Europe and Central Asia (SECA) Department will be in Istanbul. 56. SMEs. For several years IFC has been assisting SMEs in Turkey's hihg inflation environment via loans to banks and leasing companies. Anticipating a lower-inflation economy, IFC's medium-term strategy is to focus increasingly on development of domestic long-term contractual saving institutions. However, as a consequence of the current economic crisis, IFC's short-term strategy is to continue to provide term funding to SMEs through loans or credit enhancements to leasing companies and banks. Also, IFC has commissioned a feasibility study to establish a joint venture micro-finance institution focused on South-East Anatolia to help economic development in that region. C. MIGA Program 57. Turkey's share of MIGA's portfolio is US$165 million (gross), representing approximately 4 percent of the total portfolio. MIGA has not experienced any difficulties with its guarantees in Turkey during the recent financial crisis. The Agency continues to see a strong demand for its guarantee activities, both from foreign investors into Turkey and from Turkish investments into Russia and Central Asia. IV. MANAGING THE RISKS AND IBRD EXPOSURE 58. The CAS identified four main areas of risk at the end of 2000: political pressures. economic considerations, administrative constraints, and the possibility of another large natural disaster. Risks continue to exist in each of these areas, but for all but the last area their nature has changed. The dynamics of February 2001 crisis has highlighted the importance of political fragility and institutional risks, including the need for transparency in public management.  Turkev CAS Progress Report 29 59. The political risk has now heightened with increased pressures under the crisis. The resilience of the coalition has faced new tests daily since February 2001, including calls from the private sector and society at large for changes ranging from Cabinet reshuffles to elections. The ability of the coalition to survive depends upon the rapid delivery of the New Economic Program. A spate of further disputes in the coalition on agreed actions once again panicked the markets late in May 2001 and included disagreement over telecommunications privatization and wheat prices. Ultimately the Privatization Minister, who opposed the Tobacco Law, was asked to resign, which sent a signal to the markets and to coalition members that the three party leaders remain committed to the program. Such disputes may arise again, and could weaken the coalition and prove disruptive, even as there are signs of increasing support in the country for the broader direction of the reform of a discredited system. 60. A second type of risk is the possibility of a greater social backlash from both the economic downturn and tough reform measures. This risk, identified in the CAS, has also been magnified by the crisis. A sharp contraction in output has occurred with serious social consequences. While the Government's program anticipates a V-shaped recovery, this is not a foregone conclusion. Some politically vocal groups (including organized labor and the commercial sector) and some economically vulnerable groups could fail to regain rapidly their standards of living. Nevertheless, if the Government is unable to protect social sector spending and bolster safety nets, a growing risk of social disenchantment could emerge. In this regard, several projects supported by IBRD will help the Government to deliver better social protection. The ongoing PSSP finances severance and related payments to workers displaced by job loss due to the privatization of state-owned enterprises, and labor redeployment services to those workers. The proposed ARIP, as explained above, would assist farmers affected by the reform program and help to finance severance to laid off employees of restructured ASCUs. The proposed Social Risk Mitigation Project would support social assistance schemes targeted at the poor and most vulnerable. The Government has committed itself to maintaining the budgets for education and essential public health, and increasing support for immunization. Together, these actions will help to reduce the risk of severe social reactions. 61. The CAS pointed out that, with respect to the key economic risks confronting Turkey, the downside scenario would be worse than the pre-reform starting point, in part because the loss of credibility would have enduring effects. This is what has occurred9. The New Economic Program is the appropriate means to gain a stable growth path; nevertheless, the macroeconomic framework and targets are ambitious given the extent of the current crisis. There is a substantial downside risk that real interest rates will be higher than programmed which would affect the sustainability of the public debt. The actual path of real interest rates will depend critically on the effectiveness of macro-economic policies, rigorous implementation of the economic program, and the Government's domestic borrowing requirements. Growth will depend sensitive!y on how tight monetary policy must be to control inflationary expectations, and on 9 One indicator of the loss of credibility is the downgrading of Turkey by the rating agencies. In April, Fitch IBCA downgraded Turkey's long-term domestic currency rating from B+ to B, and its long-term foreign currency rating from B+ to B-. Moody's downgraded Turkey's foreign exchange deposits ceiling from B2 to B3. Standard and Poor dropped Turkey's long-term credit rating from B to B-. The agencies noted the importance of implementation of the reform program within a coherent macroeconomic framework (including plausible public borrowing plans) to easing market worries.  Turkey CAS Progress Report 30 interest rates. A deeper recession in 2001 is a distinct possibility. The extent of recovery in 2002-03 will play an important role in public debt dynamics. 62. Turkey's vulnerability to adverse external developments and shocks remains high. The viability of the medium-term external financing plan hinges on the government's ability to regain access to international capital markets at affordable cost, to secure large foreign investment inflows including realization of the privatization program, and to discourage capital flight. Annual gross financing requirements over 2001-03 average $22.2 billion per annum. Of this, the current account deficit accounts for roughly S1.6 billion, refinancing of medium and long-term debt $20.3 billion, and increases in reserves $0.3 billion. External financing over 2001-03 depends heavily on the private sector. Net foreign direct investment is projected to average $1.3 billion per annum - a sharp increase from $0.3 billion per annum in the preceding three years. Portfolio inflows account for $ 4.1 billion per annum, up from a three-year average of $1.6 billion per annum. Debt financing accounts for $16.5 billion per annum, of which $7.6 billion is the average level of gross official assistance from the Bank and IMF. Access to private capital markets depends heavily on the credibility of the reform program. Failure to maintain the pace of reforms or political infighting could adversely affect market sentiment and lead to restricted market access, capital flight, a depletion of foreign reserves and a sharp fall in the exchange rate. Market access may also be adversely influenced by a slowdown in global growth or contagion from other emerging market crises. 63. Managing the vulnerabilities of the financial system has to be an integral part of Turkey's reform. Significant accomplishments had been made as detailed in the FSAL documents presented to the Board in December 2000. Political resistance to serious banking reform remains a serious risk to the reform of the financial sector as does the fragility of the banking system. The commercialization and privatization of the state-owned banks will be a major political and organizational challenge for the Governrnent. The rapid privatization of Halk and Ziraat and the subsuming of Emlak into Ziraat will have also significant fiscal costs. There could be some social fall-out because of lay-offs, but given the required down-sizing of the banking sector and substantial severance payments under Turkish Law, these issues are manageable. Significant technical expertise will be needed to develop the restructuring and privatization plans. Another risk is that of possible inability to raise sufficient resources to finance the restructuring of the state banks and the resolution of the SDIF banks. Tight fiscal discipline and the renewed confidence of domestic and international investors in Turkish sovereign debt instruments will be essential. Finally, satisfactory and timely failure resolution efforts by the SDIF are important; the risk that such efforts might not be made is related to the large burden of work on both SDIF and BRSA. 64. Leaming from the past, the Government has explicitly recognized the need for institutional change to reduce political interference in the economy as part of its overall reform program. Institutionalizing the reforms is also critical in ensuring their irreversibility. Important measures in this respect are the new law granting independence to the Central Bank, the establishment of an energy board and the BRSA, the corporatization of the telecommunications company and greater independence for the telecommunications board. Strengthening public expenditure management and investment planning, and improving financial accountability and oversight (including bringing procurement legislation to intemationally accepted standards) - all areas in which the Bank's recent joint work with the Government is contributing to the change  Turkey CAS Progress Report 31 process - will also assist sound program implementation, and reduce risk of backtracking. As long as the structural and social changes are institutionalized, the risks to IBRD are reduced and IBRD's support will bear results. 65. The risk of a large natural disaster, which could bring about extensive human loss and disrupt the economic recovery, still remains. Progress has been made in disaster preparedness and mitigation under ongoing emergency projects. Particular accomplishments supported by the ongoing Marmara Earthquake Emergency Reconstruction (MEER) project include the expected completion in June 2001 of over 12,000 earthquake resilient housing units, and the sale of 1.7 million housing insurance policies. If needed, additional financial support could be provided through reallocations and potential new lending in the event of a major natural disaster. 66. Under the previous program, and prior to the recent crises, Turkey's creditworthiness for IBRD borrowing was already weak due to persistent macroeconomic imbalances and significant structural deficiencies. By end-2000, annual inflation was 39 percent, the real exchange rate had appreciated significantly, and the current account deficit had widened to 5 percent of GNP. Government finances continued to be undermined by unsustainable fiscal policies, including extensive budgetary subsidies and subsidized credit extended through the state banks. As a result, large contingent liabilities continued to accumulate in the banking system. Structural reforms had slowed in the face of political resistance, delaying restructuring of the banking sector, retarding the privatization program, and jeopardizing medium-term growth targets. These weaknesses and vulnerabilities were exposed in the November and February crises. Notwithstanding the subsequent move to a floating exchange rate, the crises have done further damage to the macroeconomy, leaving Turkey in a much weaker position from which to embark on the revised program. Foreign currency reserves fell $6.5 billion in November, and a further $7.6 billion in February. Short-term interest rates soared and have only recently fallen to levels that could be serviceable over the medium term. The stock of public debt jumped from 59 percent of GNP at end-2000 to 78 percent. The economic adjustment precipitated by the crises is projected to lead to a contraction in GDP of 3 percent this year, with inflation over 50 percent. 67. Creditworthiness is only expected to improve over time as debt indicators are reduced to more manageable levels and the conditions for sustainable economic growth are put in place. This will require the government to implement an ambitious reform program in a difficult political environment. A crucial element of the program is to lower inflationary expectations and the trajectory for domestic interest rates in order to put public finances on a sustainable footing. Moreover, maintaining investor confidence is essential to enable the rollover of existing domestic and extemal debt as it falls due over the short term. Investor confidence in tum hinges on credibility of the program which depends to a large extent on political commitment. Over the longer term, sustained progress on structural reforms will be required for Turkey to achieve the growth rates that will facilitate an improvement in debt service capacity and a reduction in the extemal debt burden. At present, however, the risks to the program are considerable and intemational capital markets remain cautious. Turkey's long-term sovereign debt ratings, which were already well below investment grade, were further downgraded by the rating agencies after the February crisis. Eurobond spreads have more than doubled since January 2000 and reflect a risk premium attached to Turkish bond issues of 7 to 8 percent above comparable US treasuries.  Turkey GAS Progress Report 32 68. As of December 2000, total IBRD debt outstanding and disbursed was US$3.6 billion, Figure 1: IBRD Net Flows and Debt equivalent to 3.0 percent of the total IBRD portfolio. .0000t - 2700 -I - -- k 2300 The proposed revised lending program would add sooo --- X 200 US$1.2 billion under SSAL terns to the approved 6000. 500 CAS envelope of US$5 billion. IBRD disbursements 4000 700 100 00 and exposure would increase faster than originally 3000 lI 300 projected in the CAS because the amount of quick- 2000 l-l0 disbursing loans during the CAS period would be ' :900 higher than originally proposed. Under the high case 1990 1992 1994 1996 1998 2000 2002 lending program with the SSALs, IBRD debt DOD(JeRscale)NetFlows(rghtscale) outstanding and disbursed would increase to US$9.2 billion or around 7.2 percent of the total IBRD portfolio in 2003 (Table 5). The program, no doubt, involves high risks for IBRD. While projected exposure to Turkey at the end of the CAS period is high, increases in exposure are carefully linked to progress on reform. The large increase in upfront lending in 2001 is necessary to ensure that the key upfront actions which ensure that political interference in economic decision-making is reduced are taken upfront. In parallel IBRD's upfront support, ensures that these actions are taken and that the program has adequate financing in order to succeed. Table 5: Summary of Key Exposure Indicators in the High Case Actual Projected 1999 2000 2001 2002 2003 IBRD DOD 2,902 3,634 6,335 8,333 9,170 Share of IBRD Portfolio 2.4 3.0 5.0 6.4 7.2 IBRD Debt Service XGNFS 1.8 1.4 1.4 1.7 1.9 IBRD Debt Service / Total Public Debt Service 7.7 4.8 3.9 4.9 5.3 Preferred Creditor DS/ Total Public Debt Service 14.2 11.0 13.5 13.0 15.5 Memo Items IBRD Interest payment 235 237 359 531 600 IBRD principal repayments 610 486 434 433 475  Turkev CAS Progress Report 33 V. CONCLUSION 69. Despite the formidable challenges facing Turkey as a result of the current severe crisis, the country retains fundamental strengths and potential. There is still a national will to break from an inflationary past, achieve stable growth, and reduce inequality and social and economic vulnerability. A competently led economic team with strong domestic support and international credibility is now in place. Large but judicious international support remains crucial for success - despite the high risks going forward. In this context, the Bank Group's program, carefully timed, can make a substantial and positive difference. James D. Wolfensohn President By: Sven Sandstrom Peter Woicke Washington D.C. June 7, 2001  Annex Al Page I of I Annex Al-Turkey Key Economic & Program Indicators - Change from Last CAS As of 05/10/2001 Forecast in Last CAS Actual Current CAS Forecast Economy 2006 200/ 200!' 20036 2006 200f 200! 20036 Growth rates GDP 5.5 5.2 5.8 5. 7. -3.0 5.0 6.0 Exports 8.8 5.6 5.6 4. 8. 8.4 8.1 3.4 Imports 5.9 5.7 7.9 8.1 47. -16.2 2 2.5 Inflation 49.0 14.0 8.0 7. 39 52.5 20 15 National accounts (% Current account -4.0 -3.0 -2.5 -2. -4. -0.6 -0.9 -0.7 Gross 23.8 24.1 24.5 24. 23. 21.5 22.8 23.5 Public finance (% Fiscal -18.1 -7.8 -3.6 -3. -18. -18.4 -10.1 -9.1 Foreign 3.0 2.8 2.0 0. 5.2 9.6 0.5 1.2 International reserves (as months of imports) 5.1 6.0 7.0 7.4 4. 4.5 4.4 4.7 Progaram (Bank's FY) FY0 FYOf FY0 FY0O FY06 FY01 FY02 FY0O Commitment ($ million) 1,770 1,640 1,770 1,590 177 2728 2650 1207 Gross disbursements 992 1,897 1,871 1,436 95 1960 3152 175C ($ million) a. Estimated b. Projected c. Actual 1/ December 2000 2/ May 2001 CAS  Annex A2 Page I of 2 Turkey at a glance 8/31/00 Europe & Lower- POVERTY and SOCIAL Central middle- Turkey Asia income Development dlamond* 1999 Population, mid-year (millions) 64.3 475 2,094 Life expectancy GNP per capita (Atlas ntethod, USS) 2,900 2,150 1,200 GNP (Atlas method, US$ bllionsi 186.6 1,022 2.513 Average annual growth, 199309 9 Population (%) 1t5 0,1 1 1 Labor force (I%) 2.6 0 6 1.2 GNP , Gross per primary Most recent estimate (latest year available, 199349) capita ' enrollment Poverty (% of population below national Poverty line) Urban population (% of total population) 74 67 43 Life expectancy at birth (years) 69 69 69 Infant mortality (per 1,000 live births) 38 22 33 Child malnutrition (% of chilkren under 5) 10 8 15 Access to safe water Access to improved water source (% o,f popu/ation) .. 86 Illiteracy (% ofpopulation age 15+) 15 3 16 1 Grossipimaryenrollment (%of'school-agopopulation) 107 100 114 _ Turkey Male 111 101 114 - Lower-middle-income group Female 104 99 116 KEY ECONOMIC RATIOS ard LONG-TERM TRENDS 1979 1989 1998 1999 - - Economic ratios GDP (US$ billions) 91.7 1071 201.2 1857 Gross domestic investmentGOP 14 1 23 5 24.2 23.3 Exports of goods and services/GDP 3 1 16.2 24.3 23.2 Trade Gross domestc savings/GDP 11 5 21.9 20.6 19.6 Gross national savinqs/GDP 14.4 26.6 25 9 23.5 { Current account balance/GDP -1.5 0.9 1.0 7 Domestic Interest payments/GDP 0 3 2.5 1 7 2.4 Investment Total debtGDP 17.4 38.8 48.2 54.8 Savings Ie n Total debt service/exports 26.7 32.4 26.5 34.8 Present value of debt/GDP . 49.9 Present value of debtlexports 160 9 Indebtedness 19794S9 1989.99 1998 1999 1999-03 (average annual growth) GOP 5.0 4.0 31 -5.t1 .5 - Turkey GNP Per capita 2.4 2.5 2 3 -7 8 4.1 Lower-middle-income group Exvort of goods and services .. 11.0 12 0 -7 0 5 9 STRUCTURE of the ECONOMY 1979 1989 1998 1999 Growth of Investment and GDP (%) (%6 of GDP) Agriculture 27.9 17.4 18.5 15.8 40T Industry 23.8 32.8 25.0 24.3 20 Manufactunng 16.0 21.4 15.5 14.6 Services 48.3 49.8 56.5 60.0 -20 96 97 98 Prvate consumption 77.0 68.8 66.7 65.2 -40 General govemmentconsumption 11.5 9.3 12.7 15.2 "-GDI O-GDP Imports of goods and services 5.7 17.8 27.9 26.9 (average annuat growth) 1979-89 1989-99 1998 1999 Growth of exports and imports (%) Avrculture 1.1 1.6 9.3 -5.2 40 Industry 7.3 4.5 1.8 -6.7 20 Manufacturng 7.5 5.4 1.0 -6.0 Services 4.0 4.0 3.1 -3.9 Private consumption . 4.0 0.1 -3.9 .sr General govemment consumption .. 4.0 7.8 6.5 Gross domestic investment .. 4 6 -1.4 -9.5 Exp Importsof goods and services .. 11.1 2.3 -3.7 -Exports .Imports Gross national product 4.9 4.1 3.9 -6.4 Note: 1999 data are preliminary estimates. The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete.  Annex A2 Page 2 of 2 Turkey PRICES and GOVERNMENT FINANCE 1979 1989 1998 1999 Inflation (%) Domestic prices (% change) Consumer prices 63.0 83.7 63.5 100 Implicit GDP deflator 75.8 75.7 75.7 56.2 Government finance l (% of GDP, includes current grants) o Current revenue .. 21.5 24.6 25.4 94 95 96 97 99 8 9 Current budget balance .. 4.2 -5.7 -14.4 -GDP rceflator _ CPI Overall surplus/deficit . -5.2 -13.4 -23.4 TRADE 1979 1989 1998 1999 Export and import levels (USS mill.) (USS millions) Total exports (fob) 2,261 11,780 31,221 29,326 60,000 Textiles 428 3,911 10,510 9,830 Processed agncultural products 1,081 1,971 2,141 1,840 400 Manufactures 1,732 10,437 23,873 23,755 Total imports (cif) 5,069 15,792 45,921 40,693 J Food 85 890 510 444 .001) Fuel and energy 1,817 3,406 4,501 5,376 Capital goods 1,403 3,953 11,033 9,062 o Export price index (1995=100) .. 5 87 82 9 4 9 6 9 e 2 Import price index (1995=100) . 90 86 84 | Exports U Imports Temms of trade (1995=100) .. 94 101 98 BALANCE of PAYMENTS 1979 1989 1998 1999 Current account balance to GDP (%) (USS mllllons) Exports of goods and services 2,969 17,612 52,037 44,548 2 Imports of goods and services 5,182 18,464 55,299 48,726 Resource balance -2,213 -852 -3,262 -4,178 o 3 Net income -1,009 -1,745 -481 -2,361 .9 Net current transfers 1,810 3,558 5,727 5,175 i ' _ Current account balance -1,412 961 1,984 -1,364 -2 1 Financing items (net) 1,300 1,801 -1,537 6,570 Changes in net reserves 112 -2,762 -447 -5,206 .41 Memo: Reserves including gold (US$ millions) .. 9,283 29,499 34,128 Conversion rate (DEC, local/US$) 31.1 2,122 259,627 416,686 EXTERNAL DEBT and RESOURCE FLOWS 1979 1989 1998 1999 (US$ mi/lions) Composition of 1999 debt (US$ mill.) Total debt outstanding and disbursed 15,929 41,577 96,906 101,781 IBRO 890 5,869 3,304 2,902 107 890 IDA 190 162 112 107 2902 37a3 Total debt service 1,340 7,092 16,513 18,316 23472 37 IBRD 105 1,010 924 845 IDA 3 6 7 7 _j237 Composition of net resource flows Official grants 52 95 37 80 Official creditors 964 -555 -118 -760 Private creditors 3,068 1,631 -153 -3,269 Foreign direct investment 75 663 573 138 Portfolio eguity 0 56 2,888 -1,727 62390 World Bank program Commitments 306 604 956 1,165 A - IBRO E - Bilateral Disbursements 280 419 271 384 B - IDA D- Other multilateral F - Private Principal repayments 36 506 684 616 C - IMF G - Short-term Net flows 244 -87 -414 -232 Interest payments 72 510 246 236 Net transfers 172 -597 -660 -468 Development Economics 8/31/00  Annex B2 Page I of 1 CAS Annex B2 - Turkey Selected Indicators* of Bank Portfolio Performance and Management As Of Date 04111/2001 Indicator 1998 1999 2000 2001 Portfolio Assessment Number of Projects Under Implementation a 22 20 23 22 Average Implementation Period (years) b 4.3 3.9 3.8 3.7 Percent of Problem Projects by Number a, c 4.5 20 17.4 4.5 Percent of Problem Projects by Amount a, c 2.9 8.3 13.2 0.3 Percent of Projects at Risk by Number a, d 9.1 20 17.4 9.1 Percent of Projects at Risk by Amount a, d 7.2 8.3 13.2 6.3 Disbursement Ratio (%) e 20.9 16.6 20.0 17.6 Portfolio Management CPPR during the year (yes/no) yes yes yes yes f Supervision Resources (total US$ million) 1.3 1.5 2.5** 2.2 g Average Supervision (thousand US$/project) 51 61 90.9** 93.3 g Memorandum Item Since FY 80 Last Five FYs Proj Eval by OED by Number 84 13 Proj Eval by OED by Amt (US$ millions) 7915.7 1550.7 % of OED Projects Rated U or HU by Number 34.9 23.1 % of OED Projects Rated U or HU by Amt 42.6 27.7 a. As shown in the Annual Report on Portfolio Performance (except for FY00, FY01). b. Average age of projects in the Bank's country portfolio. c. Percent of projects rated U or HU on development objectives (DO) and/or implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the beginning of the year: Investment projects only. f. JPPR, focussing on effect of economic crisis on project implementation is ongoing. g. Planned budget for FY01 * All indicators are for projects active in the Portfolio, with the exception of Disbursement Ratio, which includes all active projects as well as projects which exited during the fiscal year. * FY00 and FY01 are in full costs (Salaries, Benefits, HQ and Field Activity Costs)  Annex B3 Page I of 2 Bank Group Program Summary Turkey As of Date 04/11/2001 Proposed IBRD/IDA High-Case Lending Program i Strategic Rewards b Implementation b Fiscal year Proj ID US$(MX) (H/M/L) Risks (H/IM/L) 2001 FSAL I (b), (c) 393.0 H H Pnvatization Social Support (b) 250.0 H M Agricultural Reformn and Investment (hybrid) 600.0 H H PFPSAL 1,100.0 H H Result 2,343.0 2002 Basic Education (APL 11) 300.0 H M Social Risk.Mitigation 500.0 H H PFPSAL 11 1,350.0 H H Community Development and Heritage 25.0 M M Financial Sector Reform Program Loan I 500.0 H H Result 2,675.0 2003 Financial Sector Reformn Program Loan 11 500.0 H H Health 100.0 H M Micro Watershed 32.0 M L PSAL Program Loan 1 375.0 H H Secondary Education 175.0 M L Result 1,182.0 Overall result 6,200.0 Notes: (a) We are currently in the High Case Lending Scenario. The Base Case would amount to lending of USS I billion only. (b) Actual, approved on Dcember 21, 2000 (c ) FSAL was approved in the amount of US5 778 million. Of this, USS 393 million was disbursed in December 2000, and US$ 393 million is proposed for cancellation (to be folded into the new larger financial sector reforrn program)  Annex B3 Page 2 of 2 CAS Annex B3 (IFC & MIGA) for Turkey Turkey - IFC and MIGA Program, FY 1998-2001 1998 1999 2000 2001 IFC approvals (US$m) 251.40 125.60 181.18 65.01 Sector (%) CEMENT & CONSTRUCTION 6 18 CHEMICALS & PETROCHEMS 5 FINANCIAL SERVICES 33 32 32 FOOD & AGRO-BUSINESS 4 24 HOTELS & TOURISM 31 INFRASTRUCTURE 14 MANUFACTURING 7 5 14 MOTOR VEHICLES & PARTS 16 OTHER 69 SOCIAL SERVICES 10 TEXTILES 9 29 11 TIMBER, PULP & PAPER 26 6 Total 100 100 101 100 Investment instrument(%) Loans 95 86 83 62 Equity 0 4 3 0 Quasi-Equity 2 10 14 Other 3 0 0 38 Total 100 100 100 100 MIGA guarantees (US$m) 141.98 250.56 246.92 0.00  Annex B4 Page I of I Turkey - Sumrary of Nonlending Services Product Completion FY Cost (US$000) Audience " Objective b Recent completions CEM FY00 500 GDPB KG, PS Living Standards Study FY00 400 G D P B KG, PS, PD Livestock Sector Study FYOI 300 G D P B KG, PS PEIR FY01 345 GDB KG, PD, PS CPAR FYOI 100 G B KG, PS Forestry Review FYOI 300 GDBP KG, PD, PS Underway Energy and Env. Review FY01 25 G D B P KG, PD Caspian oil and gas dialogue FY03 60 G B KG CFAA FY02 100 G B KG, PS Conference on Effective Government FY01 100 GDBP KG,PD Assessment of Crisis Effect on Corporate Sector FY02 100 GBP KG,PD Assessment of Social Impact of Crisis FY02 150 GDBP KG,PD Planned Non-Bank Financial Institutions Study FY02 150 G D B KG, PS Health Sector Study FY02 320 GDBP KG, PD, PS Technology Assessment FY02 300 GD B P KG, PD, PS Gas Sector Note FY02 215 GDB KG, PS Governance Workshop FY02 120 G D B P KG, PD, PS NEAP/Clean Air FY02 145 GDBP PD, PS Global Development Gateway FY03 175 G B P KG, PS CEM (EU Accession) FY03 400 G D P B KG, PD, PS a. Government, donor, Bank, public dissemination b. Knowledge generation, public debate, problem-solving  Annex B6 Page I of 2 Turkev - Key Economic Indicators National accounts (as % of GDP) Gross domestic producta 100 100 100 100 100 100 Agriculture 19 16 16 17 17 15 Industry 25 25 25 26 26 24 Services 56 59 58 57 56 6] Total Consumption 79 80 82 77 76 75 Gross domestic fixed investment 25 22 22 20 21 22 Govemment investment 4 4 7 7 7 7 Private investment 20 18 1 5 13 15 15 Exports (GNFS)b 24 23 24 31 30 30 Imports (GNFS) 28 27 30 30 29 29 Gross domestic savings 21 20 18 23 24 25 Gross national savingsc 26 23 21 23 24 25 Memorandum items Gross domestic product 201154 185788 200316 169466 187127 201820 (US$ million at current prices) GNP per capita (US$, Atlas method) 3170 2910 3270 2830 2800 2880 Real annual growth rates (%, calculated from 1994 prices) Gross domestic product at market prices 3.1 -4.7 7.2 -3.0 5.0 6.0 Gross Domestic Income 2.5 -4.0 9.8 -3.7 3.9 5.3 Real annual per capita growth rates (%, calculated from 1994 pnces) Gross domestic product at market ptices 1.5 -6.1 5.6 -4.5 3.6 4.6 Total consumption -0.3 -3.2 12.1 -12.6 0.7 2.9 Private consumption -1.4 -4.7 12.3 -13.0 1.0 2.7 Balance of Payments (US$ millions) Exports (GNFS)b 52037 44548 49066 53322 56132 59825 Merchandise FOB 31220 29326 31180 33707 36229 39264 Imports (GNFS)b 55299 48726 59715 50837 53956 57567 Merchandise FOB 45440 39773 53613 47151 50055 53420 Resource balance -3262 -4178 -10649 2485 2176 2257 Net current transfers 5727 5175 5012 4411 4540 4945 Current account balance 1984 -1364 -9755 -1035 -1647 -1347 Net private foreign direct investment 573 138 112 800 1570 1588 Long-term loans (net) 3985 345 9971 -4243 3759 650 Official g/ -72 -642 1015 3261 3347 1881 Private 4057 987 8956 -7504 412 -1231 Other capita] (net, incl. errors & ommissions -6095 6087 -2877 -10160 2204 4522 Change in reservesd -447 -5206 2549 14638 -5886 -5413 Memorandum items Resource balance (% ofGDP) -1.6 -2.2 -5.3 1.5 1.2 1.1 Real annual growth rates ( YR94 prices) Merchandise exports (FOB) 9.2 -2.4 8.3 8.4 8.3 4.6 Primary 10.4 .. .. .. .. Manufactures 3.2 .. .. .. .. Merchandise imports (CIF) 0.8 -8.1 47.2 -16.3 1.7 3.3  Annex B6 Page 2 of 2 Turkey - Key Economic Indicators (Continued) Public finance (as % of GDP at market prices)e Current revenues 23.8 25.0 29.1 30.4 29.2 27.8 Current expenditures 29.6 41.0 39.1 39.6 30.5 28.3 Current account surplus (+) or deficit (-) -5.8 -16.0 -10.0 -9.2 -1.3 -0.6 Capital expenditure 7.9 7.7 8.9 8.8 8.6 8.3 Foreign financing -1.2 1.8 5.2 9.6 0.5 1.2 Monetary indicators M2/GDP 39.2 52.4 40.0 41.7 41.7 41.7 Growth of M2 (%) 89.7 98.3 23.1 51.0 34.7 23.5 Privatesectorcreditgrowth/ 47.5 32.5 -116.7 22.9 69.7 66.3 total credit growth (%) Price indices( YR94 =100) Merchandise export price index 95.6 92.0 90.3 90.1 89.4 92.6 Merchandise import price index 99.6 96.0 91.1 95.8 100.0 103.3 Merchandise terms of trade index 95.9 95.8 99.1 94.0 89.4 89.6 Real exchange rate (US$/LCU)f 120.6 124.2 128.2 107.9 109.5 108.3 Real interest rates Consumer price index (% change) 83.7 63.5 50.6 49.4 28.3 16.5 GDP deflator (% change) 75.7 55.6 50.6 49.4 28.3 16.5 a. GDP at factor cost b. "GNFS" denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use of IMF resources. e. Consolidated central government. f. "LCU" denotes "local currency units." An increase in US$/LCU denotes appreciation. g. Includes government guaranteed loans to SEEs.  Annex B7 Page I of ] Turkey - Key Exposure Indicators Total debt outstanding and 97,211 101,795 114,260 116,327 116,767 117,426 disbursed (TDO) (US$m)a Net disbursements (US$m)a 2,429 5,155 17,717 7,907 1,940 661 Total debt service (TDS) 14,900 18,286 20,510 23,626 26,492 23,938 (US$m)a Debt and debt service indicators (%) TDO/XGSb 155.8 193.5 201.3 197.2 188.7 176.7 TDO/GDP 48.3 54.8 57.0 68.6 62.4 58.2 TDS/XGS 23.9 34.8 36.1 40.0 42.8 36.0 Concessional/TDO 6.0 5.6 5.0 4.9 4.9 4.9 IBRD exposure indicators (%) IBRD DS/public DS 8.2 7.7 4.4 3.6 3.7 4.6 Preferred creditor DS/public 15.9 14.2 11.4 17.9 32.2 19.9 DS (%)c IBRD DS/XGS 1.4 1.8 1.3 1.4 1.6 1.7 IBRD TDO (US$m)d 3,446 2,902 3,634 6,335 8,333 9,170 Share of IBRD portfolio(%) 3.1 2.4 3.0 5.0 6.4 7.2 IDA TDO (US$m)d 112 107 101 96 91 85 a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short- term capital. b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for International Settlements. d. Includes present value of guarantees.  Annex B8 Page I of 2 CAS Annex O - Turkey Status of Barnk GrouP Operations (Operations Portfolio) As o0rl 6ie4r11nt Closed Projects 122 Tot Distursed (Adet) 1J75S.30 of which has been repaid 68.11 Tota DsbLrsed (Closed) 1 0,501.40 of which has been repaid 10,233.80 Total Disbrsed (Actrve t Cbsed) 1 2256.72 of which has benrepaid 10,301.Y0 Total lidsb.rsed (Actve) 2,61861 Total thdsbursed (Cosed) 24.19 Total Unfsbwgsed (Active + Closed) 2,642.80 Actie Proiscs Derarence Btween Expected and ActI S9t4slon Ratmin Oridnal Amourtt In tJSS M Dksburesmes ProecID Proect Name Dect.-s hwr ttallion Flscal Year IIAD DA GRANT Cancel. tinls. Orf. Frm rFWd P00944 AGRIC RES S S 1992 55 0 0 6 4.4 10.i 4.4 P009093 ANTALYA WATER SUPPL S S 1995 100 0 0 14.9 44.8 34 0 P009089 BASIC ED I HS S 1998 3Q0 0 0 0 150.1 148.2 a P044175 8I1DIVERSITYWNR MGT S S 2000 0 0 8.2 0 7.5 0.3 0 P009065 BURSAWATER&SANITrA S S 1993 1295 0 0 20 4.9 23.7 22 PF1B965 CESME W.S. & SEWER. S S 1998 13.1 0 0 0 11.4 6.3 0 P048851 COMMODmES.MKT.DEV. S S 1999 4 0 0 0 3.3 3 0 P009023 E ANATOLLA WATERSHEI S S 1993 77 0 0 0 20.6 29.5 1.9 P065188 EFIL S S 2000 252.5 0 0 0 185.2 -67.2 0 P058877 EMGY FLOOD RECOVER S S 1999 369 0 0 0 189.3 149.3 89.3 P068792 ERL S S 2000 759.6 0 0 0 375 375 0 P066511 FSAL S S 2001 777.8 0 0 0 385 0 0 P009076 HEALTH 11 S S 1995 150 0 0 0 76.2 98.2 17.5 P009073 INDUSTRIAL TECH S S 1999 155 0 0 0 136.5 -3.5 0 P06368 MARMARA EARTHQUAKE S S 2000 505 0 0 0 374.6 254.6 0 P048852 NATL TRNSM GRID S S 1998 270 0 0 0 268 196 0 P038404 ODS PFIASEOUT 2 S S 1996 0 0 14 0 6.9 6.9 0 P009095 PRIM HEALTH CARE SER S U 1997 14.5 0 0 0 13.9 13.9 869 Pt69894 PRIVSOC SUPPRT S S 2001 250 0 0 0 247.5 9.5 0 P009072 PRP. OF IRRIGATION S S 1998 20 0 0 0 11 9 2,2 P035759 PUBLIC FINAN. MGT. S S 1996 62 0 0 5 361 41.1 188 P038G91 ROAD IMPR. & SAFETY S S 1996 250 0 0 0 81.9 85.5 0 Overall result Resuh 4514 0 22.2 45.9 2633.1 1031 144.9  AnnexR B8 Page 2 of 2 CAS Annex BS (IFC) for Turkey Turkey Statement of IFC's Held and Disbursed Porffolio As of 12/31(2000 (In US Dollars Millions) Held Disbursed FY Aporovul Compan Loan Equity Quasi Panic Loan Equity Qua,si Pantic 1990S93 Conrad 0 0 0 0 0 0 0 0 1997/98 Do esLe.aiog 339 0 0 0 339 0 0 0 0194f96 Demirbank 7.5 0 0 7.5 7.5 0 0 7 5 1929 Edame 113 0 0 0 113 0 0 0 1993196 Eldor 3 0 0 0 3 0 0 0 1933193196 Elgnkon 8.49 0 0 0.52 8.49 0 0 0.52 1995 Entek 24 0 0 23.19 24 0 0 2319 1997/98 Finens Leasing 3.89 0 0 0 3.S9 0 0 0 199299 Fimansbanu 10 0 0 35 10 0 0 35 1994i9StU 0aranteLeas-g 255 0 0 1619 255 0 0 1619 1994t95f96 GlobalSecurity 0 0 0 0 0 0 0 0 1999 GumuayuKap 4 0 264 0 4 0 264 0 1998 Indoremalplik 10 0.66 0 0 10 0.66 0 0 199810 IpekPaper 0 0 0 15 0 0 0 15 2000 lsslarAwbalaj 0 0 10 0 0 0 9.5 0 1990 KepezElektklc 1134 0 0 0 1134 0 0 0 19S8190 Kiris 8.26 0 0 0 3 26 0 0 0 1996 Kosbeank 5.71 0 0 0 5.71 0 0 0 1996 Koclease 6 43 0 0 0 6.43 0 0 0 1992197 Korfezbonk 9 0 0 13 9 0 0 13 1990192 Koy-Tut 0 0 0 0 0 0 0 0 1991 Kula 4.53 0 0 0 4 53 0 0 0 1993/96 Medya 0 0 499 0 0 0 499 0 1993 Modem Kaeton 20 0 0 10 20 0 0 10 1991 NASCO 10.18 0 0 3.55 10.18 0 0 3.55 1993 Ottoman 18 1S 0 0 72.73 13.13 0 0 72.73 1997 OyakBank 8.33 0 0 5 8.33 0 0 5 1993 Pasabehe.-Schott 11 23 0 0 11.3 11 33 0 0 1183 19S3394t93 PnerET 10.21 0 0 0 1021 0 0 0 1994C0 PinerSIJT 14.47 0 0 0 0 0 0 0 0t97 RantLeasing 1 78 0 0 0 1 73 0 0 0 1999 SAKoSa 219 0 0 21.42 21.9 0 0 21.42 19S6190 Silkar Tufino 3 34 0 0 3.8 3.34 0 0 3.3 1993f96 Sse Ve Cae 6.3 0 0 3 4 6 3 0 0 3 4 1993 Soktas 10.35 0 0 0 1035 0 0 0 1996 TCRA 0 0 1 0 0 0 0.05 0 0 1995 TDD 0.6 0 0 0 0.6 0 0 0 l999 TEB Finanjal 5 0 0 0 5 0 0 0 1997 Toprak L-asmg 1.78 0 0 0 1.78 0 0 0 19791S21932/9/91/96"99 Toaky.Cam 0 1.18 0 0 0 118 0 0 1995199 TurkEkonBenk 15 0 0 20 15 0 0 20 1993t98 Turkiye Garanti 14.55 0 0 69.09 1455 0 0 69 09 1999 Unyc Cement 19.74 0 0 0 19.74 0 0 0 1999 Uzel 20 0 0 15 11.37 0 0 3.53 1970/7192/13/N9 Vblng 11.0S 0 0 0 1108 0 0 0 1995 YlovaAc-ylbc 25 0 0 133 2.5 0 0 1 33 1997/93 YapiKred,Lease 273 0 0 0 273 0 0 0 0 AL.aJe 389 0 0 0 339 0 0 0 1994 AYTAC 4 0 0 5 4 0 0 5 1993 AdanaCement 15 0 0 8 15 0 0 8 09m AltemeafBank 8.89 0 0 9 889 0 0 9 1995t96 A".alik 37.5 0 0 115 37.5 0 0 11.5 2000 AroclikltGfKlima 1343 0 0 8.94 1343 0 0 8.94 1994/97 Assen 5.66 0 4 3.75 566 0 4 3.75 2000 Banvit 20 5 0 0 10 5 0 0 1994/96/97 Borcelik 0 0 0 0 0 0 0 0 1995196 CBS Buya KiAmy 0 0.65 0 0 0 0.65 0 0 1994 CBS Holding 4 0 0 0 4 0 0 0 1996t01 CBSPnntas 0 0.01 0 0 0 001 0 0 1992 CayeliBakir 147 0 0 0 14.7 0 0 0 1994 CereohoguUllei 0.61 0 0 0 0.61 0 0 0 ToteIPortfolio: 481.75 76 21.63 398.74 448.65 7.55 21.13 39227 Approvals Pending Comuiniment Loan Equity Quai Pantic 2000 PinoSea. 4000 0 0 0 2001 Akbnik 20000 0 0 80000 2001 Arceikljj 20000 0 0 13000 2000 BICT 20000 0 5000 0 1999 CBS Coup Reat 5300 0 0 0 1999 EgeSeoasoik S1000 5000 0 0 2000 Erbekir 5000 0 5000 0 TotalPendingCommitmoent: 92300 50O 10000 180000  Annex BlI Page I of 9 TURKEY: Macroeconomic Framework Introduction 1. The Government has reached agreement with the IMF on a revised macro-economic framework and policy package, including a detailed program of structural reforms worked out in collaboration with the Bank. This agreement cleared the way for completion of the 6'h and 7th reviews of the Stand-by arrangement on May 15, 2001. Completion of the reviews resulted in the disbursement of SDR 3 billion (US$3.9 billion) from the Fund. An augmentation of the Standby amount by SDR 6.36 billion was also approved. This brings total IMF commitments for the program since the Stand-by was approved in December 1999 to SDR 15 billion (over US$19 billion), including the SDR 5.8 billion (US$7.5 billion) Supplemental Reserve Facility (SRF) approved in December 2000. Bank teams have worked closely with the Turkish authorities and the IMF to assess the macroeconomic impact of the crisis and help prepare the new program. A specific focus has been the banking sector, for which the Bank prepared an assessment and recommendations on further reform. The Bank is also taking the lead in assisting the Government with other structural issues including actions to improve the private investment climate and public sector management; as well as on social protection issues. Bank support to date has included the US$760 million Economic Reform Loan approved in May 2000 and the US$778 million Financial Sector Adjustment Loan approved in December 2000. Recent Economic Developments 2. Original Program. The Government launched its three-year economic reform program under near crisis conditions in mid-1999. The program aimed to bring inflation to single digits and set the economy on a stable path of high growth. There were three core pillars: (i) strong fiscal adjustment, including large privatization revenues, designed to put public finances on a sustainable path; (ii) a crawling peg exchange rate anchor designed to lower inflationary expectations and bring down interest rates; and (iii) deep structural reforms aimed at sustaining fiscal adjustment and promoting productivity and growth. Structural reforms were focussed on measures to: (a) support privatization, particularly in the telecommunications and energy sectors; (b) address fundamental fiscal weaknesses, notably through pension reform, modernization of agriculture support policies, and reform of public expenditure management including measures to contain the rapid growth of contingent liabilities; and (c) strengthen the financial sector. The initial results were encouraging. Domestic interest rates fell more sharply than expected. Annualized rates on government securities auctioned in early 2000 were in the 40 percent range, the lowest level in a decade. Lower rates and increased confidence generated a stock market boom: the main market index doubled within months. Growth also picked up and was soon running above the 2000 target. The pick up in economic activity fueled tax revenues and by mid year the primary surplus was on track to exceed the program target by some I percent of GNP. 3. However, signs of problems soon appeared which pointed to the underlying macro risks. The current account deficit began to widen rapidly. By mid 2000 the current account deficit was on track to reach 6 percent of GNP compared to the 1.8 percent originally programmed. The growing external imbalance was due to a combination of strong internal demand (fueled by the fall in interest rates), high oil prices and the decline in the value of the Euro vs. the USD.  Annex BJJ Page 2 of 9 Throughout the year, inflation outpaced the rate of crawl under the peg. Although CPI inflation fell to a 15-year low of 39 percent by the end of 2000, this exceeded the 25 percent target, leading to real exchange rate appreciation of about 14 percent. Export volumes expanded nearly 12 percent for the year, but import volumes rose 35 percent, leading to a record trade deficit. The Government did not respond quickly to the widening macro imbalances and clear signs that the economy was overheating. Under the quasi-currency board rules, the Central Bank (CBT) refrained from sterilizing the capital inflows which were driving down interest rates below the targeted path. There was little political support for additional fiscal measures when the primary surplus was exceeding the program target. Structural reform implementation slowed perceptibly after mid year. 4. The Government was particularly slow in resolving problem private banks and restructuring the state banks. Five private banks were taken over in December 1999, bringing to eight the number of banks under the Savings Deposit Insurance Fund (SDIF), but these banks were kept open throughout 2000. Little progress was made in restructuring the state banks including securitization of the large stock of losses due to government-mandated subsidized lending in the past (the so called "duty losses"). These delays allowed the losses of the SDIF banks to accumulate and forced the state banks to finance their duty losses through a mix of high-cost deposits, money market borrowing, and short-term repurchase agreements (repos). In addition, private banks turned increasingly to external borrowing given the incentive structure created by the crawling peg and the need to meet liquidity requirements by selling FX to the CBT under the quasi-currency board rules. As of September 2000, the hedged open FX position of the banking system was US$6 billion. The un-hedged open position was much higher at US$18 billion (over 300 percent of capital) and had increased from US$11 billion in December 1999. The SDIF banks accounted for a large share of this exposure as they offered premium rates on FX deposits in order to fund their continuing operations. While the forward FX contracts used as hedges appeared to be valid from a prudential supervision standard, the underlying counter party risk was not known. The structural problems in the banking sector, highlighted in the in the Country Economic Memorandum circulated to the Board in September 2000, were to play a central role in the coming financial turmoil. 5. Financial Turmoil in November 2000. Turkey was hit by a first round of financial turmoil in November 2000 brought on by the withdrawal of credit lines to Demir Bank, a key primary dealer of government securities. The November crisis demonstrated the vulnerability of the Turkish banking sector to exchange and interest rate risks, as well as the mismatch between the maturity of assets and liabilities which had built up as a result of past macroeconomic distortions and inadequate banking supervision and enforcement. It also highlighted the importance of growing macroeconomic risks as a relatively isolated incident involving Demir Bank quickly escalated to a systemic problem. As confidence fell, foreign portfolio investors withdrew funds, banking sector liquidity tightened, and short-term interest rates shot up to over 1,000 percent. Large liquidity injections from the CBT did not calm the markets and resulted in a loss of about US$6.5 billion in reserves. This situation put the banking sector under severe stress particularly the state banks which faced steep increases in the costs of financing their chronic liquidity needs. Overall, the balance of risk shifted abruptly from overheating and extemal imbalance to recession and financial sector crisis.  Annex Bll Page 3 of 9 6. Government Response. The Government responded to the November turmnoil with an effort to strengthen its reform program through tighter macroeconomic policies and acceleration of structural reform. The objective was to support continuation of the crawling peg. The SDIF took over Demir Bank, which was no longer able to finance its huge portfolio of government securities, and the Government issued a blanket guarantee of all liabilities (excluding capital) of any bank taken over by the SDIF1. Key structural measures included enactment of a legal framework for state bank restructuring and renewed privatization efforts. The Government's strengthened program calmed the financial turmoil with renewed support from the IMF and from World Bank under the new CAS discussed by the Board in December 2000. However, the broader macroeconomic risks remained in place. While longer-term interest rates dropped in January, they remained well above pre-November levels, signaling investor perceptions that overall macroeconomic risks had increased. Mirroring this, Turkish depositors shifted increasingly to shorter term maturities and repos which increased the liquidity pressure on the SDIF and state banks. Monthly figures for January showed that inflation continued to outpace the rate of crawl, signaling further exchange rate appreciation in 2001. Leading economic indicators pointed to a sharp slowdown in the economy. Signs of new delays in structural reform implementation appeared as well. 7. February 2001 Crisis. In late February, Turkey was hit by a second wave of financial turmoil which quickly grew into a full-fledged economic crisis. The fresh turmnoil was ignited by the public airing of political tensions on February 19. This set off a new wave of turbulence in the financial sector as investors liquidated TL positions and fled to dollars in expectation of a government crisis. By the end of the day, the CBT faced US$7.6 billion in FX purchase orders and overnight interest rates spiked to over 300 percent due in large part to the inelastic liquidity requirements of the state banks and now the SDIF banks as well led by Demir Bank. The CBT then froze liquidity which limited the actual loss of reserves to about USS3 billion. However, by February 21, overnight rates were over 2,000 percent with minimal transaction volumes. The next day, the Government announced the flotation of the Lira and the currency depreciated by some 36 percent by the end of the month. As of end-April, CBT reserves had fallen to US$18 billion, compared to US$27 billion in mid-November 2000 before the first crisis began, despite over US$4 billion in disbursements from the IMF during this period. Revised Macroframework 8. Key Macroeconomic Targets. The principal macroeconomic objectives of the new program are: first, to contain the impact of the collapse of the crawling peg and subsequent devaluation; and second, to resume a path of progressively lower inflation and increasingly sustainable growth. * After high inflation following the initial devaluation of the Lira, inflation is targeted to fall to under 2 percent per month by the last quarter of 2001 giving an average of 52.5 percent (Dec- Dec) for the year; The objective of this guarantee was to reassure investors and prevent a bank run, but it also highlighted the potential for large fiscal costs in case of a systemic failure of the banking system. For an analysis of the links between unfunded contingent liabilities and currency crises, see "Understanding the Korean and Thai currency crises", Bumside, Eichenbaum and Rebelo in Economic Perspectives, Federal Reserve Bank of Chicago, 2000.  Annex B11 Page 4 of 9 * Interest rates on government securities, in the 180 percent range in the weeks immediately after the crisis, are targeted to fall to 80 percent by May and to 50 percent by December, resulting in average real rates of some 36 percent for the year; * The economy is projected to contract sharply during the first semester before recovering during the second semester as confidence improves, resulting in a projected fall of 3 percent for the year; * Inflation is projected to fall further in 2002-03 and the economy is projected to recover strongly (Table A). Table A Turkey: Selected Program Endicators 5il6101 14:39 1999 2000 2001 2002 2003 Prel. Proj. Proj. Proj. Real Sector GNP growth rate -6.1 6.1 -3.0 5.0 6.0 CPI (12-month, end-of period) 68.8 39.0 52.5 20.0 15.0 Average nominal T-bill interest rate 106.2 38.0 81.1 40.6 32.6 Average real interest rate 1/ 32.0 -6.5 36.4 20.0 18.0 Central Government Budget (percent of GNP) Budget bahm e m:t -l1i6 -11.5 -,1 S -3.6 -10.5 Consolidated Public Sector (percent ofGNP) Primary balance of public sector -2.0 2.8 5.5 6.5 6.5 Net interest payments 22.1 21.9 22.6 16.2 13.5 PSBR (incl. CBT profits) 24.2 19.1 17.1 9.7 6.9 Operational balance 4/ -12.4 -6.6 -3.2 -2.3 -0.1 ttDsSteble ritft ...............-. 6t1 ... SX* - 58.4 - --. :, - .8- 8.-.- 674*46. 9 Net ''"-4's;-"-' p ', - -cx 4$ -' .2 .' --,' -4;3 Neidb~2* 2i. ,3-,428$ 341. fbrbatk rI ix 16.7 1. -74: 29.9 : :2Z.