Turkey - Programmatic Financial and Public Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P7463-TU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS O NA PROPOSED PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN IN THE AMOUNT OF US$1.1 BILLION TO THE REPUBLIC OF TURKEY June 20, 2001 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.  TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN Currency Equivalents (Exchange Rate Effective June 1, 2001) Currency Unit = Turkish Lira Turkish Lira I = US$0.000001 USSI = 1,206,147 Turkish Lira Government Fiscal Year January I - December 31 Abbreviations and Acronvms ASCU Agriculture Sales Cooperative Union MOF Ministry of Finance B/S Balance Sheet MOH Ministry of Health BCS Budget Clarification System MONE Ministry of National Education BOT Build-Operate-Transfer NBFI Non-bank Financial Institutions BRSA Banking Regulation and Supervision Agency NGO Non-Governmental Organization CAS Country Assistance Strategy NPL Non-Performing Loans CBT Central Bank of Turkey OECD Organization for Economic Cooperation and Development CEM Country Economic Memorandum PAYG Pay-As-You-Go CFAA Country Financial Accountability Assessment PCT Petroleum Consumption Tax CIF Cost, Insurance and Freight PEIR Public Expenditure and Institutional Review COM Council of Ministers PEM Public Expenditure Management CPAR Country Procurement Assessment Report PFMP Public Financial Management Project DS Debt Service PFPSAL Programmatic Financial and Public Sector Adjustment Loar EBF Extra-budgetary Funds PFSAL Public Financial Sector Adjustment Loan EFIL Export Finance Intermediation Loan PIP Public Investment Program ERL Economic Reform Loan PPSAL Programmatic Public Sector Adjustment Loan ESW Economic Sector Work PSSP Privatization Social Support Project EU European Union SAL Structural Adjustment Loan FIG Financial Industrial Groups SDIF Savings Deposit Insurance Fund FOB Free on Board SDR Special Drawing Rights FSAL Financial Sector Adjustment Loan SEE State Economic Enterprise FX Foreign Exchange SME Small and Medium-Scale Enterprises GDP/GNP Gross Domestic Product/Gross National Product SPO State Planning Organization GFS Government Finance Statistics SRF Supplemental Reserve Facility GNFS Goods and Non-factor Services SSAL Special Structural Adjustment Loan GPL Government Procurement Law SSF Social Solidarity Fund HPC High Planning Council TCA Turkish Court of Accounts IAIS Intemational Association of Insurance Supervisors TDO Total Debt Outstanding IAS Intemational Accounting Standards TDS Total Debt Service IOSCO Intemational Organization of Securities Commissions TEAS Turkish Electricity Generation and Transmission Company IBRD Intemational Bank for Reconstruction and Development TESEV Foundation for Economic and Social Studies IMF International Monetary Fund TIN Tax Identification Number ISE Istanbul Stock Exchange UNCITRAL United Nations Commission on Intemational Trade Law LCU Local Currency Units UT Undersecretariat of Treasury LEGOP Legal Operations VAT Value Added Tax LIBOR London Interbank Offered Rate WB World Bank LLP Loan Loss Provisioning WBI World Bank Institute LPG Liquified Petroleum Gas WTO World Trade Organization M2 Broad Money Supply XGS Exports of Goods and Services MHA Mass Housing Administration Vice President: Johannes F. Linn Country Director: Ajay Chhibber Sector Directors: Paul Siegelbaum and Pradeep Mitra Team Leaders: Lalit Raina and James Parks  REPUBLIC OF TURKEY FOR OFFICL USE ONLY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN LOAN SUMMARY Borrower: The Republic of Turkey Amount: US$1.1 billion Terms: US$700 million on standard IBRD terms, payable in 17 years including 5 years of grace and level principal repayment, at six months LIBOR for US Dollars plus variable spread for Variable Single Currency Loans; and US$400 million on special structural adjustment loan (SSAL) terms, payable in 5 years including 3 years of grace and level principal repayment, at six months LIBOR for US Dollar plus 400 basis points. Front end fee: I percent of Loan amountsFN Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days after signing, less any waiver on US$700 million amount on standard IBRD terms. On the US$400 million amount on SSAL terms, there are no waivers of interest or commitment charges. Objectives and Description: The proposed Programmatic Financial and Public Sector Adjustment Loan (PFPSAL) is the first Loan in support of the Govemment's multi-year financial and public sector reform program. It is envisaged that the proposed PFPSAL will be followed by a second Programmatic Financial and Public Sector Adjustment Loan (PEPSAL II) of US$1.35 billion (US$550 million on standard IBRD terms and US$800 million on SSAL terms), tentatively planned for December 2001. The main objective of the proposed PFPSAL is to address the Government's immediate financial and public sector reform pnorities in the aftermath of the November 2000 and February 2001 financial cnrses, while ensuring that social programs continue to be adequately funded. Key priorities include, in the financial sector: (i) overhaul of the regulatory framework for banking activity, (ii) institutional development of the new Bank Regulation and Supervision Agency (BRSA), (iii) problem FN Pending approval by the Executive Directors, US$3.85 million of the front-end fee would be waived on an exceptional basis (see paragraph 98). This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.  bank/bank failure resolution, and (iv) state bank restructuring and privatization; and in the public sector: (a) structural fiscal policies, (b) public expenditure management, (c) financial accountability, (d) public liability management, and (e) public sector governance. The PFPSAL will provide budgetary support to help the Government finance the costs arising from the crisis while continuing to fund its critical social programs. Benefits: The principal benefits of the Loan will be to: (i) restore confidence in the banking system and in the Government's ability to implement and sustain the required sizeable fiscal adjustments following the November 2000 and February 2001 crises; (ii) strengthen the foundation for an efficient and sound banking system which can be competitive in quality and performance at the international level; (iii) reduce the vulnerability of the banking system and enhance its capacity to withstand external shocks and thereby reduce systemic failure risk; (iv) position Turkey's banking sector for accession to the European Union (EU) by starting the process of aligning the prudential regime for the banking system with applicable EU banking sector directives; (v) support urgent fiscal measures to respond to the crisis while ensuring that social spending is protected; (vi) lay the foundation for sustained fiscal adjustment; and (vii) modernize the public sector through actions to improve management of public expenditure and liabilities, ensure financial accountability in line with international standards, and raise the quality of public sector governance. Risks: The risks associated with the Government's financial and public sector reform program arise from macroeconomic factors, a potential loss of political consensus and institutional weaknesses. The key macroeconomic risk is that interest rates will remain higher than projected which would affect the sustainability of the public debt and create the conditions for renewed instability. Given the severity of the February 2001 crisis, Turkey will remain vulnerable to both internal and external shocks over the medium term. The comnrmercialization and privatization of the state-owned banks will be a major political and organizational challenge for the Government. The closure of Emlak and the rapid restructuring of Halk and Ziraat will also have significant fiscal and social implications. Another risk is that of possible inability to raise sufficient resources to finance the restructuring of the state banks and the resolution of the banks under the Savings Deposit Insurance Fund (SDIF). Tight fiscal discipline and the confidence of  domestic and international investors in Turkish sovereign debt instruments will be essential here. Finally, satisfactory and timely failure resolution efforts by the SDIF (for already intervened banks) and enforcement of capital restoration plans by the BRSA (for non-intervened banks) are important; the risk that such efforts will fall short of what is needed is related to the political pressure that may be put on these agencies for a slowdown of regulatory enforcement action and general regulatory forbearance. The public sector reform agenda is politically sensitive and may be jeopardized by resistance of vested interest groups that would prefer to maintain the status quo. Capacity constraints and crisis management efforts at key Government agencies, such as the Ministry of Finance and Undersecretariat of Treasury, may also slow down the pace of the envisaged public sector reforms. Schedule of Disbursements: US$1.1 billion, including a 1 percent fee (see footnote in page 1 of the Loan Summary) to be paid to the IBRD, immediately after loan effectiveness - expected July 2001. Poverty Category: N/A Rate of Return: N/A Project ID Number: PE-P070561 The Team for this operation consists of Lalit Raina (Joint Team Leader/Lead Financial Sector Specialist, ECSPF), James Parks (Joint Team Leader/Lead Economist, ECSPE), Marie-Ren6e Bakker (Lead Financial Sector Specialist, ECSPF), Margery Waxman (Director, BFR), Robert Liu (Adviser, BFR), Ernesto Aguirre (Banking Adviser, BFR), Gordon Johnson (Senior Counsel, LEGOP), Michael Gascoyne (Financial Sector/Financial Management Specialist), Anand Rajaram (Senior Economist, PRMPS), Sergei Shatalov (Senior Economist, ECSPE), Ismail Arslan (Senior Economist, ECSPE), Shaun Moss (Senior Procurement Specialist, ECSCS), Gurhan Ozdora (Senior Operations Officer, ECSPF), Kamer Ozdemir (Economist, ECSPE), Mark Carawan (Bank Resolution Consultant), James Lacey (Bank Restructuring Consultant) and Peter Dean (Financial Accountability Consultant). Dilek Barlas (Senior Legal Counsel) and Ahmed Jehani (Senior Legal Counsel) and Rohit Mehta (Senior Disbursement Officer) provided legal and disbursement support. Sophia Cox, Pinar Baydar and Meral Gokcek are the Program Assistants for the project. The Bank Team worked closely together with an IMF Monetary and Exchange Affairs Department Team, including through joint missions, as well as with IMF Area Department Staff responsible for the preparation of the IMF Stand-by Arrangement and Supplemental Reserve Facility.   REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN (PFPSAL) TO THE REPUBLIC OF TURKEY TABLE OF CONTENTS I. INTRODUCTION ........................................................1 A. RECENT ECONOMIC DEVELOPMENTS ........................................................1 B. THE GOVERNMENT'S NEW ECONOMIC PROGRAM ....................................................... 5 C. SOCIAL AND POVERTY IMPACT OF THE CRISIS AND REFORM PROGRAM ....................................................... 9 D. INITIAL MARKET RESPONSE TO THE PROGRAM ....................................................... 12 E. BANK SUPPORT FOR ECONOMIC REFORM ........................................................ 12 II. TURKEY'S FINANCIAL SECTOR REFORM PROGRAM .15 A. FINANCIAL SECTOR PROFILE/RECENT DEVELOPMENTS IN THE BANKING SECTOR .15 B. PROPOSED MULTI-YEAR FINANCIAL SECTOR REFORM PROGRAM. 1 7 C. STRENGTHENING THE REGULATORY FRAMEWORK FOR BANKING AND NBFI ACTIVITY .18 D. STRENGTHENING THE INSTITUTIONAL CAPACITY OF THE BRSA AND THE SDIF ............... .............................. 22 E. IMPLEMENTATION OF EFFICIENT PROBLEM BANK/BANK FAILURE RESOLUTION ............... ............................. 25 F. IMPLEMENTATION OF COMPREHENSIVE RESTRUCTURING AND PRIVATIZATION OF STATE-OWNED BANKS ..... 30 tII. TURKEY'S PUBLIC SECTOR REFORM PROGRAM .......................................................................... 36 A. STRUCTURAL FISCAL POLICIES ............................................................................. 37 B. PUBLIC EXPENDITURE MANAGEMENT ............................................................................. 39 C. PUBLIC SECTOR GOVERNANCE .............................................................................. 45 IV. THE PROPOSED LOAN ............................................................................. 47 A. THE BANK'S FINANCIAL SECTOR ASSISTANCE STRATEGY ............................................................................. 47 B. THE BANK'S PUBLIC SECTOR ASSISTANCE STRATEGY ............................................................................. 51 C. PFPSAL OBJECTIVES AND DESCRIPTION ............................................................................. 54 D. BENEFITS AND RISKS .55 E. BOARD CONDITIONS .58 F. EFFECTIVENESS CONDITION .62 G. TRIGGERS FOR THE FOLLOW-UP PROGRAMMATIC LOANS PFPSAL II, PFSAL I & II AND PPSAL I & II; AND PROGRAM OUTCOME INDICATORS ..62 H. FINANCIAL MANAGEMENT .63 1. PROJECT IMPLEMENTATION AND MONITORING .67 V. RECOMMENDATION .68  ANNEXES: Annex IA Key Economic Indicators Annex IB Key Exposure Indicators Annex IIA Turkey - Financial Sector at a Glance Annex IIB Turkey - List of Banks Annex III Status of Bank Group Operations and Status of IFC Annex IV Timetable of Key Processing Events Annex V Letter of Financial Sector and Public Sector Development Policy Annex VI Policy Matrix for PFPSAL Program Annex VII The Government's Strategic Framework for Public Expenditure Management Reform Annex VIII Country at a Glance Annex IX Environmental Data Sheet  - I - REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN TO THE REPUBLIC OF TURKEY 1. I submit for your approval the following Report and Recommendation on a proposed Programmatic Financial and Public Sector Adjustment Loan (PFPSAL) to the Republic of Turkey for US$1.1 billion to support the Government's multi-year financial and public sector program aimed at restoring confidence in the banking system and correcting the underlying structural problems in the public sector that created the conditions under which financial crises like those that hit Turkey in November 2000 and February 2001 could occur. The proposed loan will be in US Dollar Single Currency, partly on standard IBRD terrns (US$700 million) and partly on special structural adjustment loan terms (US$400 million). The loan will be disbursed in a single tranche immediately upon effectiveness--including fulfillment of the special effectiveness condition on the revocation of Emlak Bank's license and completion of its merger with Ziraat Bank and Halk Bank. 2. The proposed PFPSAL is the first in a series of two programmatic loans to be implemented over the remainder of 2001 in support of the Government's new economic program in response to the financial crisis. This loan is the first operation to support Turkey's program for comprehensive reformn of the financial and public sectors. The PFPSAL would be followed by a second Programmatic Financial and Public Sector Adjustment Loan (PFPSAL II) of US$1.35 billion (US$550 million on standard IBRD terms and US$800 million on SSAL termns). Under the PFPSAL program, the World Bank would disburse US$2.45 billion in adjustment lending in 2001 to meet Turkey's external and budgetary financing requirements arising from the crisis, and to support its short and medium term reform goals in the financial and public sectors. Bank support for sustained implementation of reform in the financial and public sectors would continue in 2002-03 in the high case lending scenario through a series of new programmatic loans under the restructured CAS as described in the CAS Progress Report scheduled to be discussed by the Board on June 29, 2001 (Report No. 22282-TU). Specifically, two Programmatic Financial Sector Adjustment Loans (PFSAL I and II) of US$500 million each and a Programmatic Public Sector Adjustment Loan (PPSAL) are envisaged. A second PPSAL is tentatively envisaged in late 2003 beyond the current CAS period. I. INTRODUCTION A. Recent Economic Developments 3. In late February 2001, Turkey experienced a major currency crisis which forced the Government to abandon the exchange rate based disinflation program and float the Lira. The immediate cause of the crisis is attributable to weaknesses in the financial sector, but its deeper roots lie in the structure and management of the public sector which are at the core of Turkey's chronic macroeconomic instability. The combination of an oversized public sector living beyond its means and inadequate management of existing resources has generated structural imbalances  - 2 - which have thwarted successive attempts at disinflation (Figure 1). These imbalances and the constant search for financing have become intertwined with financial sector weaknesses in a vicious circle. The state banks were traditionally used to finance Government-mandated subsidized lending to agriculture and SMEs (resulting in the so called "duty losses"- these were the annually compounded Figure 1: TURKEY: PSBR and Interest Payments interest rate subsidy related (in % of GNP) losses suffered by the banks, and reflected nominally in the balance sheet as perpetual Government paper 30.0 claims). This recourse to 25.0 quasi-fiscal financing 1.50 directly undermined financial 10I _______ _I sector stability. In parallel, 5.0 the emergence of a lucrative _ A* l_*-_l_____ *___ *___ *_I_*_l____i_l,i_I domestic market for high 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 return Government bonds indirectly contributed to PFSBR -- hiterest Payments financial sector instability as 2001 is program projection. banks became dependent on I artificially inflated profits Source: SPO, Treasury and WB. from investments in Government paper. Faced with prohibitively high interest rates, the Government traditionally relied on the inflation tax to keep the public debt under control. However, this created a deeply ingrained pattern of inflationary expectations which has blocked financial sector deepening and promoted steadily increasing currency substitution (Figure 2). 4. The disinflation program launched in late 1999 based on a nominal exchange rate anchor was a bold and risky attempt Figure 2: Turkey: CPI Inflation and M2/GNP to break the unsustainable cycle of inflation, financial 1 150 -- 30.00 sector weakness, high interest rates and ever increasing 130 --- 25.00 public indebtedness. The 110- program included ambitious 20.00 structural reforms. A major 90-o _ i _ _ reform of the public pension - - 15.00 system was undertaken in 70-l August 1999 and ambitious 50 - 10.00 reforms were launched in the * - * * 30 en an5.00 agriculture, energy and 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 telecommunications sectors. l In the financial sector, a new i CPI - year on year -4-- M2/GNP - - M2Y(includes FX deposits)/GNP commercial bank law was Source: SPO, Treasury and WB. passed in December 1999 that called for the creation of a new independent bank regulatory agency, initiated a much needed overhaul of the banking sector regulatory regime and enhanced the powers of the SDIF, the  - 3 - agency responsible for bank failure resolution and administration of the deposit insurance scheme. Immediately after passage of the new law, the SDIF intervened in 5 private banks. However, the Government had difficulty maintaining the pace of reform implementation. After some early success including a rapid decline in interest rates, there was soon resistance to change from within the governing coalition. As implementation progressed during the course of 2000, resistance to particular aspects of the program became more pronounced. The macroeconomic risks quickly built up and the program eventually collapsed at its weakest point, the financial sector. 5. Although, as mentioned above, the legal and regulatory framework for the banking sector was improved prior to the crisis, progress was slow in resolving the SDIF banks or in restructuring the state-owned banks which remained subject to political Figure 3: Duty Losses of State Banks control. The SDIF banks were kept open throughout 2000, and little headway was made in 12 restructuring the state banks. These delays allowed the losses of 1 the SDIF banks to accumulate, and z 8 forced the state banks to finance their duty losses through a mix of n high-cost deposits, money market 4 borrowing, and short-termd repurchase agreements (repos). 2 Private banks, grown accustomed p to easy profits from Government 1995 1996 1997 1998 1999 2000 securities, had difficulty adjusting * (FiguBak 3 A Bank to the rapid fall in interest rates. Source:_U_dersecretariat_of_Treasury_and_WB _estirnates Banks turned increasingly to source Uerseetarit of assr t and W iaetlmtes external borrowing to finance their en Government secun'ty purchases given the incentive structure created by the crawling peg and associated quasi-currency board rules. As a result, many banks were continuously maintaining their open FX positions at or near the maximum allowable limits or, in some instances, found ways around these limits through the use of balance sheet window dressing and structured finance products (see also paragraph 36), enhancing their vulnerability to exchange rate shocks. The open FX positions were particularly large in the SDIF banks, as they offered premium rates on foreign exchange deposits in order to fund their continuing operations. At the same time, the stock of duty losses continued to snowball (Figure 3). A first round of acute financial turmoil in November 2000 demonstrated the vulnerability of the Turkish banking sector to interest rate risks, caused among others by 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. The Government tried to accelerate financial sector reform in response to the November turmoil and new legislation for restructuring and privatization of the state banks was adopted. However, this came too late to prevent the full-fledged financial crisis of February 2001.  - 4 - Table 1: Size of General Government in the OECD (as % of GDP) 1996 1999 Revenue Expenditure Deficit/Surplus Revenue Expenditure I Deficit/Surplus Australia a! 33.1 36.3 -3.2 33.3 34.41 -11 Austria 48.2 54.11 -5.9 47.3 50.9 3.6 Belgium 47.7 53.2 -5.5 48.2 50.5 -2.3 Canada a/ 42.81 46.7 -3.9 43.4 44.4 -1.0 Denmark 55.3 58.7 -3.4 55.1 54.4 0.7 Finland 51.0 56.6 -5.6 48.7 49.2 -0.5 France 47.5 53.8 -6.3 48.1 52.1 -4.0 Germany 43.9 49.1 -5.2 44.5 47.6 -3.1 Greece 44.9 52.5 -7.6 50.2 52.0 -1.8 Italy 44.3 52.6 -8.3 45.2 48.4 -3.2 Japanal 31.7 36.5 -4.8 31.6 42.7 -11.1 Netherlands 43.8 48.3 -4.5 44.2 45.8 -1.6 Portugal 37.4 43.2 -5.8 38.9 42.8 -3.9 Spain 39.0 44.6 -5.6 n.a. n.a. n.a. Sweden 56.8 62.5 -5.7 57.2 57.7 -0.5 Switzerland a/ 33.6! 37.3 -3.7 34.4 37.7 -3.3 United Kingdom 37.31 43.0 -5.7 39.1 39.1 0 United States b/ 32.41 35.21 -2.8 32.8 34.3 -1.5 Source: OECD Historical Statistics, 1970-1999. a/ The figures in the second part of the table are for 1998. b/ The figures in the second part of the table are for 1997. 6. The underlying problems with the structure and management of the public sector have been analyzed in detail in the Country Economic Memorandum (CEM) on Structural Reforms for Sustainable Growth (Report No. 20657-TU, September 2000) and the Public Expenditure and Institutional Review (PEIR) discussed with the Government in May 2001. Table 1 shows that Turkey's public sector is large relative to OECD comparators such as Spain and Portugal, and that public spending has greatly exceeded available resources. Countries like Germany and Italy, with comparably high levels of expenditure sustain this with much greater revenue effort and therefore run much smaller deficits. Central to this problem is extensive Government intervention throughout the economy and an under performing system of public sector management. The first dimension of the problem is being addressed though the on-going structural reforms to the social security system, to modernize agriculture support policies, deregulate energy and telecommunications, and implement privatization. The second dimension arises from the long neglect of the need to modernize the procedures and institutions which govern decision-making and resource allocation in the public sector. The impact of many years of weak fiscal discipline and poor expenditure management is also reflected in the composition of public expenditure. As shown in Figure 4, the share of public spending on interest payments and wages and salaries in Turkey varies greatly from almost all of its OECD counterparts. This difference is inconsistent with the objectives of sustained economic growth and equity. 7. Turkey must tackle adjustment and reform simultaneously in the financial and public sectors in the aftermath of the crisis. The costs of cleaning up the banking sector has added over US$40 billion to the Treasury's debt although about half of this represents losses on the books of  - 5 - the state and SDIF banks before the crisis which were already included in the broader definition of the public debt. Interest rates have fallen from the levels prevailing immediately after the February crisis, but remain well above pre-crisis levels and the sustainability of the public debt is at increased risk. Restoring investor confidence depends critically on rebuilding the credibility of the reform program. This in turn requires decisive action to correct the underlying structural weaknesses in the financial sector, while at the same time undertaking urgent financial restructuring to address the impact of the crisis on the banks. In parallel, institutional and policy reforms are needed to address systemic problems in the public sector, together with stronger structural measures to underpin the fiscal adjustment. These reforms will complement on-going actions to improve the climate for private investment and promote growth. Turkey needs these comprehensive reforms to break definitively with its troubled history of public deficits, inflation and financial instability. Figure 4: Central Government Expenditure in the OECD 70 0. 40 CL 0O 30 -- . ____--_ __ ___ ~20 J- 101 clCD 2 * 1 ) 11 O~~~~~~~ .) a -E E) a) aL C , -X E~ ! w G. a =v D 0) 1 - a Wage Expenditure * Interest Expenditure Source: OECD. B. The Government's New Economic Program 8. The Government has prepared a new economic program that aims to minimize the short- term impact of the crises while setting the stage for an early resumption of disinflation and growth. The program targets a more gradual disinflation path, but a more aggressive push on structural reformns. By moving immediately to address the fundamental structural problems underlying the criss, with a strong focus on restructuring the banking sector, the Governent hopes to engineer a quick recovery closer to the experience of Brazil and Korea, and avoid the  - 6 - prolonged recession that some other crisis countries have experienced. The program is based on a three-pronged strategy: (i) macroeconomic policies geared towards restoring financial stability and resuming the disinflation process; (ii) structural policies aimed at correcting the financial sector and public sector weaknesses underlying the crisis and establishing a more sound basis for disinflation and growth; and (iii) 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. Table 2: Key Econoniic Indicators Actual 1/ Projected 2/ 1998 1 1999 1 2000 2001 1 2002 1 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 NominalInterestRate 116 106 38 81 41 33 Unemployment Rate 3/ 6.8 7.7 6.6 >8.5 6.0 6.0 PUBLIC SECTOR BUDGET Primary Balance (%of GNP) 1.1 -2.0 2.8 5.5 6.5 6.5 Overall Deficit (% of GNP) -15 -24 -19 -17 -10 -6 PublicDebt(%ofGNP)4/ 44 61 58 79 71 65 of which net external debt (% of GNP) 19 20 20 34 28 23 Pnvatization (US$ billion) 2.2 0.1 3.3 3.1 3.5 3.5 EXTERNAL BALANCE Current account balance (% of GNP) 1.0 -0.7 -4.8 -0.6 -0.9 -0.6 Exports (fob, US$ billion) 31 29 31 34 36 39 Tourism (US$ billion) 7.1 5.2 7.6 8.3 8.6 9.1 External Debt (% of GNP) 47 55 57 66 60 57 Foreign Exchange Reserves (US$ billion) 21 24 23 21 21 24 1/ Government figures as adjusted by IMF and WB estimates. 2/ Projections for 2001-03 are based on revised IMF program figures for the 6' and 7h Stand-by program review. 3/ Projections for 2001 are based on 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-owned banks. Source: Govenmment, IMF and Bank estimates. 9. The macroeconomic targets are necessarily ambitious. The principal macroeconomic objectives of the new program are: first, to contain the impact of the collapse of the crawling peg and subsequent devaluation of the TL; and second, to resume a path of progressively lower inflation and increasingly sustainable growth. * CPI inflation is targeted fall to about 2 percent per month (seasonally adjusted) by the last quarter of 2001 giving a cumulative 52.5 percent for the year (Table 2); inflation is targeted to fall to 20 percent in 2002 and 15 percent in 2003; * Interest rates on Government securities, in the 180 percent range immediately after the February 2001 crisis, are targeted to fall to 50 percent by December, resulting in average real rates of some 36 percent for the year; interest rates are expected to fall further in 2002-03;  * A primary surplus for the consolidated public sector of 5.5 percent of GNP is targeted. This compares to a surplus of 2.8 percent in 2000; the primary surplus is targeted to increase to 6.5 percent of GNP in 2002-03; * Monetary policy will focus in the short terrn on containing the inflationary impact of the cnsis. Inflation targeting will be introduced in the near future under the new Central Bank law enacted in May 2001. The exchange rate will be allowed to adjust freely to ensure external competitiveness; * Incomes policy will be a key nominal anchor. Civil service wages are expected to remain broadly constant in real terms. However, real wages for public sector workers, which increased by about 43 percent in real terms in 1999-2000, will fall. The Government's dialogue on incomes policy with its social partners will be strengthened under the Economic and Social Council law enacted in April 2001; * The economy is expected to contract sharply during the first semester before recovery begins during the second semester as confidence improves, resulting in a fall of GNP by 3 percent for the year; the economy is projected to recover strongly in 2002-03. Table 3: Fiscal Cost of Bank Restructurin as of May 2001 Government Government Cash Total Of which Of which Net Securities Securities Injection Outlay Reissuance Interest Increase Issued Issued in Capitalization in Public Before 2001 2001 Debt up to and Stock in including 2001 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ M ay 15 _ _ _ _ _ _ _ _ _ _ _ _ _ TL Trillion _______ _ _ _ _ 2DOI Ziraat 1,909 13,326 218 15,453 5,622 1,213 5,027 Halk 863 13,074 67 14,004 6,991 1,378 6,177 Emlak* 10 669 41 720 669 SDIF Banks** 3,842 15,905 - 19,747 3,458 15,905 Total 6,624 42,974 326 49,924 16,071 2,591 24,320 % of GNP Ziraat 1.0 7.3 0.1 8.5 3.1 0.7 2.8 Halk 0.5 7.2 0.0 7.7 3.8 0.8 3.4 Emlak* 0.0 0.4 0.0 0.4 0.0 0.0 0.4 SDIF Banks** 2.1 8.7 0.0 10.8 1.9 0.0 6.8 Total 3.6 23.6 0.2 27.4 8.8 1.4 13.3 * Excluding TL 900 trillion of Government securities still to be issued to replace construction related assets on Emlak's balance sheet to be transferred to the Mass Housing Administration. ** Includes FX bonds valued at the exchange rate on the date of issuance. Source: Treasury and WB estimates. 10. Success of the new program depends critically on the ability of the Government to simultaneously finance the costs of cleaning up the banking sector while achieving the targeted reduction in interest rates. This requires keeping public finances on a sustainable path despite the February crisis. To finance the bank clean up, in the period up to and including May 15, 2001, the Treasury issued TL 49.60 quadrillion in marketable Government securities and TL 326  - 8 - trillion in cash, giving a total outlay of TL 49.92 quadrillion. This amount includes TL 6.62 quadrillion issued prior to 2001, of which TL 2.78 quadrillion to the state banks (reissued as marketable securities in 2001) and TL 3.84 quadrillion to the SDIF banks. It also includes the reissuance of additional non-marketable securities given to Ziraat and Halk in early 2001 pnror to the crisis, and the replacement of low-interest securities on the books of the SDIF banks to allow these banks to meet their funding costs (see Table 3). While the total outlay for bank restructuring as of mid May was TL 49.9 quadrillion, the net increase in the public debt stock in 2001 has been only TL 24.3 quadrillion given that the state bank duty losses (TL 21.8 quadrillion) and securities issued to the SDIF banks in 2000 (TL 3.8 quadrillion) as well as the low-interest securities replaced on the books of the SDIF banks (TL 3.46 quadrillion) were already included in the public debt figures for end-2000. The program estimates that the stock of Treasury securities issued for bank restructuring will reach up to TL 54 quadrillion (30 percent of GNP) by the end of 2001, including revaluation of FX denominated securities and a contingency for possible additional costs of bank restructuring which may arise. 11. Together with the impact of higher interest rates and recession induced by the crisis, the costs of bank restructuring will push the stock of net public debt (including CBT net assets) from 58 percent of GNP at the end of Figure 5: Public Sector Net Debt and Real Interest Rates 2000 to a projected 79 percent by the end of 2001, a level at the limit 90.00 - -- - - 40 of sustainability. The projected 80.00 35 path for public sector debt under 30 the program is shown in Figure 5. 70.00 t --X ----30 The program aims to begin ' 60.00 20 reducing the public debt stock in 50.00 ------ - t* 2002-03 through a combination of 4 0.0oo 0 /0 further fiscal adjustment and a 30.00 .L -E continued decline in interest rates. 20.00 i - - _ This projection incorporates the 10.00 impact of US$18 billion in -l disbursements from the IMF and 1998 1999 2000 2001 2002 2003 the Bank in 2001 which both reduces the amount of high-cost | Total Net Debt Marketable Treasury Scurities - Ex-ante Real Interestrtes domestic borrowing given current Source: Treasury, IMF and WB estimates. interest rates that the Treasury must undertake and eases the pressure on domestic interest rates. However, even with this large package of extermal support, the stock of public debt is projected to increase sharply in 2001. Clearly, there is no room for complacency on the part of the Government. 12. Achieving the program scenario will require fundamental restructuring of the Turkish economy, most importantly a transformation of the roles of the State and the private sector. There are three core directions for structural reform. The first is a major acceleration of financial sector reform, first to respond to the crisis and then to realize the structural changes required to wean the banking sector from a dependence on high interest rates on Government paper. The second core direction is comprehensive public sector reform to address the underlying structural causes of the Government deficit and to increase the transparency and efficiency of public expenditure management. The third direction is continuation of vital reforms in the agriculture.  energy and telecommunications sectors to improve the climate for private investment in an effort to raise productivity, growth and incomes. 13. The Govermment has reached agreement with the IMF on the revised macroeconomic framework and policy package for 2001, including a detailed program of structural reforms worked out in collaboration with the Bank. This agreement cleared the way for completion of the 6th and 7th reviews of the Stand-by Arrangement which resulted in the disbursement of SDR 3 billion (US$3.9 billion) on May 15, 2001. An augmentation of the Stand-by amount with SDR 6.36 billion was also approved which brings total IMF support for the program 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. The IMF program has been prepared in close cooperation with the Bank. The prior actions, performance criteria and structural benchmarks for the Stand-by are fully consistent with the Bank's Economic Reform Loan (ERL) and Financial Sector Adjustment Loan (FSAL) approved by the Board in May and December 2000 respectively, and the program to be supported by the proposed PFPSAL. The 8th Stand-by review is scheduled to be completed by end-June. C. Social and Poverty Impact of the Crisis and Reform Program 14. 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. 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. It is still early to provide a comprehensive social assessment of the crisis, but initial indications are worrisome. The Turkey: Economic Reforms, Living Standards and Social Welfare Study published in January 2000 (report no. 20029-TU), 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." 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 are being especially hard- hit. The landless poor in rural areas have been affected by a decline in construction and other informal job opportunities. Meanwhile the poor with land are beset by increased input costs due to inflation. It will take some further weeks to fully evaluate the impact of the crisis and ongoing reform program on the poor. Data from SIS indicate an unemployment rate of 8.6 percent in the first quarter of 2001, a jump of more than two percentage points over the last quarter of 2000. Fieldwork in May for the Corporate Sector Assessment (see Part IV) indicates that: * Industry's initial perception is that the crisis is unprecedented in its severity in comparison to previous crisis due, in part, to the spillover effects of the problems caused by the Russian crisis in 1998-1999 and earthquakes in 1999 and the November 2000 crisis. * SMEs are laying off workers (some 65 percent of SMEs surveyed) according to both surveys and interviews, while larger firms are using accelerated vacation schedules, short work weeks and other methods to avoid formalized layoffs. Were the crisis to go beyond the summer, without signs of pick-up, most industrialists indicated that they would be forced into formal layoffs.  - 10- * Both banks and business owners confirm that credit is generally not available, except to the best customers and even then for 90 days or less. Interest rates are very high, in US dollar terms at 15-18 percent. Lease financing and factoring have largely dried up. 15. The financial and public sector reforms that would be supported by the PFPSAL program will have important social benefits and will support the Government's poverty reduction efforts. These structural reforms are designed to help pull the economy out of recession and restore growth as soon as possible which is the key to minimizing job loss, and the social and poverty impact of the crisis. Restored confidence in the financial sector will help reverse the on-going credit crunch and generate new resources for economic recovery and job creation. The public sector reforms will help ensure the quality of the fiscal adjustment and improve overall efficiency of social service delivery. Better public expenditure management will increase the availability of resources for social expenditure. Actions to upgrade the operational performance of line ministries and agencies, including increased emphasis on policy formulation and a progressive shift to performance budgeting, will help ensure that these additional resources are used effectively to fight poverty and vulnerability. The program features institutional and policy measures to improve the operational performnance of line ministries and agencies including those responsible for basic social services. Action under the program to improve public governance and tackle corruption are likely to benefit the poor disproportionately as shown in numerous international studies. Structural reform of the financial and public sectors is also crucial to avoid future crisis which would likely be devastating for the poor. 16. However, the financial and public sector reforms do entail some short-term social costs which must be mitigated. Resolution of SDIF banks has entailed loss of almost 10,000 jobs as of May 2001, and further layoffs are expected among the remaining 18,000 employees. These workers are eligible for severance payments under the law, but are not eligible for early retirement benefits. Bank estimates are that restructuring and privatization of the state banks will lead to a downsizing of staff by some 25,000-30,000 - or 0.25 percent of total permanent, non- agriculture employment of about 11 million - through retirement, voluntary separation or reassignment. These workers are civil servants and public sector workers who will benefit from relatively generous retirement and severance payment provisions financed by the Government'. Similar provisions will apply to those laid off or retired under programs to adjust staffing levels in the broader public sector, including public sector workers affected by privatization. Over the past six years, a total of some 16,000 workers have been laid off under the program of the Privatization Administration. A social impact assessment prepared for the ERL and the Bank supported Privatization Social Support Project (PSSP) estimated that roughly 48,000 additional employees could be laid off or take early retirement as a result of the privatization program, although this estimate is subject to change following the crisis. These employees would benefit from the social protection provisions mentioned above in addition to special compensation under the privatization law Described in the PSSP documentation. All formal sector workers will benefit from the new unemployment insurance system launched in mid 2000, once they meet the minimum contribution history requirement of 18 months. The Government has prepared draft legislation which would provide an additional lump-sum retirement bonus to civil servants in the state banks who retire before the end of 2002. Under this legislation, staff in Emlak Bank would be allowed to transfer their retirement plans to the public pension fund.  - 11 - Table 4: Social Expenditures TL billion 1998 1999 2000 est. 2001 prog.l/ Education Expenditures 2,185,156 3,608,721 5,017,843 7,736,875 Health Expenditures 1,479,673 2,567,369 4,359,145 6,379,445 of which health expenditures by SSIs 728,343 1,408,963 2,473,000 3,849,000 Social Protection 3,338,299 5,916,192 8,493,000 13,774,000 a. Social Security Institutions (non-health) 3,254,299 5,660,192 8,123,000 12,849,000 b. Social Solidarity Fund 84,000 256,000 370,000 425,000 c. Direct Income Support - - - 500,000 Total Social Expenditures 7,003,128 12,092,282 17,869,988 27,890,320 in % of GNP 1998 1999 2000 est. Average 2001 prog.2/ 98-00 Education Expenditures 3.73 4.61 3.98 4.11 4.24 Health Expenditures 2.53 3.28 3.46 3.09 3.50 of which health expenditures by SSIs 1.24 1.80 1.96 2.11 Social Protection 5.70 7.56 6.74 6.67 7.55 a. Social Security Institutions (non-health) 5.56 7.23 6.45 7.04 b. Social Solidarity Fund 0.14 0.33 0.29 0.23 c. Direct Income Support - - - 0.27 Total Social Expenditures 11.97 15.45 14.19 15.29 Source: MOF, MONE, MOH, SPO and WB. 1/ Supplementary budget allocations for 2001. 17. The Government is strengthening Turkey's social protection programs as detailed in the CAS Progress Report and is committed to protecting social spending under the PFPSAL program. Protecting expenditure on health, education and social protection from the impact of the crises is a key social objective. Otherwise, Turkey's human capital will suffer and the burden of adjustment will fall on vulnerable groups. A supplementary budget for 2001 was approved by Parliament in June which is consistent with the Govenment's macroeconomic objectives and also ensures adequate expenditure envelopes for health, education and social protection. The budget maintains aggregate spending on education slightly above the average levels of 1998- 2000 (as a share of GNP) and programs a significant increase in expenditure on social protection relative to 2000 resulting in part from the launch of the direct income support (DIS) program for farmers. Overall public spending on health is also projected to remain above the 1998-2000 average level. Savings are expected to come from efficiency gains in health expenditures for civil servants under the adininistrative reform of the social security system, but part of these savings are being channeled into increased expenditure on preventive and primary care (Table 4)2 . The preliminary outcome for spending on health, education and social protection under the 2001 budget will be monitored in October. Benchmarks for public spending on health, education and social protection as shares of GNP agreed with the Bank have been established for the program (see Table 8 in Part IV). These benchmarks have been set at a level somewhat above the averages for the 1998-2000 period, reflecting the Government's policy decision to ensure 2 The broader issues concerning the composition of public expenditure on health and education are addressed in the Public Expenditure and Institutional Review (PEIR), while equity and efficiency issues concerning the social protection system are analyzed in the Bank's Living Standards and Social Welfare Study dated January 27, 2000.  - 12 - adequate expenditure on social priorities. Significant deviations from the program benchmarks will be discussed with the Bank with the aim of determining appropnrate corrective action. The Government is committed to allocating satisfactory expenditure envelopes for social programs in the 2002 budget which will be a trigger for PFPSAL II. D. Initial Market Response to the Program 18. Economic developments since the Government's new program was announced in April have been mixed with a number of encouraging signs of response in the economy combined with some signals of concem. Interest rates have fallen from post-crisis highs of 150-200 percent which prevailed through mid-March to the 80 percent range in mid-June. However, they remain above the projected path under the program, thereby increasing pressure on the public debt. This is due in part to higher than expected inflation in April which saw an 10.3 percent increase in the CPI and 14.4 percent in the WPI as prices adjusted to the devaluation. Inflation subsequently subsided in May (5.1 percent CPI and 6.3 percent WPI) in a positive sign, but there is now a possibility that inflation will exceed the year-end projection of 52.5 percent. Another important factor has been market perceptions of differing opinions in the Cabinet over important aspects of the program based on public statements of some ministers. The coalition leaders have periodically stressed their support for the program, but the market perceptions and public airing of disagreements over certain reform actions have continued. Another factor affecting interest rates had been anticipation and uncertainty over the terms of the debt swap which was announced on June 12. Now that the swap operation has been completed, this uncertainty should dissipate3. Higher than expected increases in public sector wages and cereal support prices, while not threatening the fiscal balance, have impacted inflationary expectations. On the real side, short-term indicators have pointed to a deepening recession. Industrial output fell 10.5 percent in April over a year earlier and there are clear indications of increased unemployment. The capacity utilization rate declined to 68 percent in April compared to 71 percent in March and 77 percent in April 2000. At the same time, developments in the balance of payments are more encouraging, imports fell some 25 percent year-on-year in March in US dollar terms and exports increased by almost 10 percent leading to an improvement in the current account deficit. The current account deficit for the first quarter was some US$565 million compared to US$2.3 billion in the first quarter of 2000. These developments in the balance of payments are in line with the program projections. In the coming months, it will be essential to improve investor confidence further in order to bring down inflationary expectations and interest rates in line with the program projections. Sustained implementation of the financial and public sector reforms supported by the PFPSAL and subsequent programmatic operations will be critical to this effort. E. Bank Support for Economic Reform 19. The proposed PFPSAL is part of a broader package of Bank financing in support of the Government's economic reform efforts. The Bank's overall lending program for the next three years has been adjusted in response to the November 2000 and February 2001 macro-economic 3The Treasury has swapped TL 9.3 quadrillion of outstanding short-term TL securities (maturing in 2001-02) with a basket of longer maturity FX-indexed (3 and 5 year) and TL-denorninated (1 and 2 year) bonds. The swap terms were determined following an auction on June 15.  - 13 - and banking crises. It is described in detail in the CAS Progress Report. The revised CAS includes a high case lending program of US$5.0 billion plus US$1.2 billion on SSAL terms. The program provides for adjustment lending of up to US$4.5 billion and up to US$1.7 billion in financing for investment in support of economic reform and social priorities during the CAS period. Simultaneously with Board approval of the proposed PFPSAL, the Government will request the Bank to cancel the second tranche of the Financial Sector Adjustment Loan (FSAL) approved by the Board in December 2000. The conditionality for the second tranche of the FSAL has been overtaken by the banking crises events, and the financial sector reform agenda envisaged under the second tranche of this loan has been subsumed in the conditionality for the proposal PFPSAL and the planned PFPSAL II. The Government's program meets all of the triggers for the revised high case as presented in the CAS Progress Report. 20. The proposed loan meets all of the criteria for both programmatic and SSAL lending: Proerammatic Lendin .4 The proposed PFPSAL and follow-up programmatic loans would support a medium-termn program of second generation structural, policy and institutional reforms in the financial and public sectors. This program is designed to help prevent a future crisis by tackling the deeper roots of the chronic financial instability in Turkey. The program will help Turkey achieve sustainable poverty reduction through macroeconomic stability and growth. The program is articulated in detail in the attached LDP and policy matrix. It includes well specified triggers and monitoring indicators (see Part IV). It is grounded in the revised CAS and is closely integrated with other elements of the CAS. The program is supported by extensive ESW including analytical work on key fiduciary aspects of public expenditure management. The presentation of a medium-term strategy for financial and public sector reform will help the Government restore confidence by demonstrating how Turkey will resolve the underlying structural weaknesses which led to the February crisis. SSAL Lendinl.5 The provision of US$1.2 billion on SSAL terms (US$400 million under PFPSAL and US$800 million under the proposed PFPSAL II) over and above the US$5 billion CAS envelope is justified by the breadth and severity of the crisis, and its fundamental structural dimension. The Bank's participation, in concert with the IMF, is helping the Government articulate its program and is contributing to the restoration of market confidence, financial health and growth. The Government's structural and macroeconomic policy package is satisfactory and the Government has quickly developed a track record of implementation performance since the program was announced in April, including completion of the 6th, 7th Stand-by program reviews in May and progress towards completion of the 8th review expected by the end of June. The proposed PFPSAL program is part of a concerted international support package centered on an additional US$8 billion in exceptional financing from the IMF. An external financing plan is in place which includes efforts to strengthen private sector involvement6 and projects a return of private capital inflows in 2002-03. Under the high case lending program, IBRD debt outstanding and disbursed would increase to US$9.2 billion or around 7.2 percent of the total IBRD portfolio See Operational Memorandum Guidelines for Programmatic Adjustment Loans/Credits, February 11, 2000. See Operational Memorandum Guidelines for Special Structural Adjustment Loans, April 19, 1999. 6 On June 12, a first group of more than 40 international banks pledged to maintain their current inter-bank and trade credit lines to Turkey. Discussions with other banks are continuing.  - 14 - in 2003. Despite this rapid projected increase, IBRD exposure and IBRD debt service as a share of exports of goods and non-factor services and as a share of total public debt service are projected to remain within IBRD's guidelines. 21. The Bank's programmatic assistance in support of financial and public sector reform in Turkey is a graduated response conditioned on concrete actions taken by the Government. The programmatic approach recognizes that the complex second generation policy and institutional reforms that Turkey is undertaking must be sequenced over the medium term. It also takes into account the uncertainties inherent in the current crisis conditions that Turkey faces and allows for a reasonable degree of adaptability of the prograrn to unfolding events on the ground. The proposed Programmatic Financial and Public Sector Adjustment Loan is the first operation in support of the Government's multi-year financial and public sector reform program. It is envisaged that the proposed PFPSAL will be followed by a second PFPSAL of US$1.35 billion tentatively planned for December 2001, as well as by two Programmatic Financial Sector Adjustment Loans of US$500 million each and a Programmatic Public Sector Adjustment Loan of US$375 million, all on standard IBRD terms, during 2002-03 to support the implementation of the program. A second PPSAL is tentatively envisaged in late 2003 beyond the CAS period. The actions taken in May-June for PFPSAL I and those expected to be taken in December for PFPSAL II are specified in the attached policy matrix (Annex VI). 22. The PFPSAL program is linked with other support for the Government's reform program under the revised CAS. Further implementation of the energy and telecommunications reforms, and the privatization program, is covered under the conditionality for the second tranche of the ERL. Mitigation of the social costs of privatization is supported by the PSSP approved by the Board in December 2000. The Agricultural Reform Implementation Project expected to be presented to the Board in June 2001 will assist the Government in carrying out core aspects of the agriculture reform program originally supported by the ERL, including further reform of agriculture support policies which is an important element of the overall fiscal adjustment effort. The Social Risk Mitigation Project under preparation will bolster the Government's efforts to strengthen social assistance programs. Future support for basic and secondary education, and for health, will support realization of the objectives of the broader public sector reform in key social sectors. 23. The financial and public sector programmatic lending operations are supported by several targeted non-lending activities, including a Corporate Sector Assessment that is currently underway to determine the impact of the crises on the corporate sector, and a Non-Bank Financial Institutions (NBFI) study planned for early 2002 in support of the design of the PFSAL I and II, which in addition to the finalization of the banking system reform agenda will focus on NBFI issues. The content of the public sector reform program draws on analysis presented in the CEM and the PEIR. It also benefits from the Bank's fiduciary sector work including the Country Procurement Assessment Review (CPAR) discussed with the Govenment in early June 2001. A Country Financial Accountability Assessment (CFAA) is under preparation and the public sector component of the draft CFAA was incorporated into the PEIR.  - 15 - II. TURKEY'S FINANCIAL SECTOR REFORM PROGRAM A. Financial Sector Profile/Recent Developments in the Banking Sector 24. The Turkish financial sector consists of a predominant banking sector of 74 banks. Of these, 56 are deposit taking banks and 18 are non-deposit taking investment and development banks. Of the 56 deposit taking banks, 4 are state-owned, 8 (formally privately owned) are under the SDIF7 (now quasi state-owned), 28 are privately Turkish owned and 16 are foreign owned. The banks are complemented by 66 insurance companies, 128 securities trading companies, 216 mutual funds, 91 leasing and 100 factoring companies, and a limited number of hitherto unfunded private pension schemes run by the banks and insurance companies for their own staff. Most of the financial institutions are part of financial conglomerates, with the main group commercial bank at the center of such conglomerates, and other bank and non-bank financial institutions formed and managed as subsidiaries. Issues related to consolidated regulation and supervision, financial reporting and comprehensive risk management are increasingly gaining more relevance because of the prevalence of such group structures. However, even though the non-bank financial institutions (NBFI) sector has begun to grow in Turkey in terms of size and economic importance in recent years, and the regulatory oversight and sectoral development issues for the NBFI segment of the financial system are increasing in importance, its relative size and economic impact compared to the banking sector is still rather small (see Annex IIA). 25. Banking Sector: 1990 - November 2000. So far as the banking sector is concerned, beginning in the early 1980s the emphasis of the Government's initial reform efforts has been on the development of a basic legal and regulatory infrastructure to facilitate ease of entry, and to increase competition and growth. This triggered a rapid expansion of banking system assets in Turkey during the 1990s, and in spite of the 1994-95 banking crisis, total system assets in absolute terms tripled from US$57.9 billion in 1994 to US$156.4 billion as of end 2000, and also increased substantially as a percentage of GNP from 39.2 in 1994 to 77.3 in 2000 (Table 5). The introduction of 100 percent deposit insurance for household deposits in response to the 1994-95 crisis, coupled with the growth in demand for Government securities, permitted the banks to generate a relatively high risk free real return on a large part of their asset base during the years 1994-1999. However, as a result of the initial success of the Government's disinflation program in early/mid 2000, yields on Government paper fell sharply leaving many banks scrambling to develop more traditional lines of business. 26. The rapid growth in the size of the banking sector has also had some negative consequences. Prudential regulations and enforcement capacity have lagged behind considerably, and there has been a significant proliferation of connected and insider lending and excessive concentration of exposure and default risks. The explosive asset growth has allowed banks to hide the deteriorating quality of a major proportion of their credit portfolios; while at the same time credit risks have been significantly understated due to previous lenient loan loss provisioning rules. Excesses in foreign currency exposures and in maturity transformation 7The number of SDIF banks recently decreased from 13 to 8 when the licenses of 5 banks were revoked and these banks were merged into the transition bank Sumer (see Box I for further details).  - 16- generating significant duration mismatches have also created enhanced foreign currency and interest rate/liquidity risks in addition to the credit risks. Table 5: Consolidated Balance Sheet of the Turkish Banking System, 1990 - 2000 (US$ millions) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000* Assets Liquid 18,762 20,586 24,732 29,893 20,396 25,249 30,347 31,683 38,074 47,882 56,283 Loans 26,877 25,413 26,925 29,849 20,315 29,072 35,906 43,037 45,019 40,206 53,393 Fixed 4,574 4,917 5,065 5,139 4,133 5,183 6,109 6,312 9,237 12,490 11,163 Other 7,016 6,981 7,695 7,245 7,082 8,894 10,975 13,612 25,069 32,955 35,518 Total 57,230 57,898 64,418 72,126 51,926 68,398 83,337 94,645 117,399 133,533 156,357 Liabilities Deposits 32,173 32,615 35,526 37,506 32,795 44,431 57,165 61,273 77,097 89,361 87,677 Non-deposit 11,017 10,570 13,635 18,796 8,911 9,664 11,851 15,724 18,218 22,934 47,754 funds Other 8,243 9,166 9,715 9,086 5,863 8,196 6,886 8,719 11,595 13,398 8,302 Liabilities Shareholders 4,455 4,151 3,890 4,791 3,218 4,187 5,028 6,120 6,786 9,359 16,585 Equity Retained 1,342 1,396 1,652 1,947 1,139 1,919 2,406 2,809 3,703 (1,520) (3,961) Earnings Total 57,230 57,898 64,418 72,126 51,926 68,398 83,337 94,645 117,399 133,533 156,357 GNP (USS 150,758 150,168 158,122 178,715 132,302 170,081 183,994 194,300 203,800 187,770 202,158 million) Total Assets 37.96 38.56 40.74 40.47 39.24 40.21 45.29 48.71 57.60 71.12 77.34 (% of GNP) Total 21.34 21.72 22.47 20.99 24.79 26.12 31.07 31.54 37.83 47.59 43.37 Deposits (% of GNP) . *unaudited; at pre-devaluation exchange rates; at today's exchange rates the size of the banking system in USS terms would be much smaller (around US$ 104 billion in terms of total assets). Source: Banks' Association of Turkey and BRSA. 27. Banking sector: post November 2000. Starting in late November 2000, Turkey experienced a banking system liquidity crisis which was triggered by the need of a medium-sized private bank (Demir) to refinance an excessive stock of Government securities. Demir's liquidity needs exacerbated the already apparent strains on the interbank market resulting from the persistently high funding requirements of the large state banks (see paragraphs 58-59 below). In early December, interest rates briefly spiked to levels above 1,900 percent. The impact of this interest shock on the regulatory capital base of the banking system has been heavily concentrated in the SDIF banks. The interest rate shock wiped out over half of the US$5.6 billion (TL 3.86 quadrillion) capital injection of Government bonds into these banks just prior to the crisis, reflecting the high percentage of SDIF banks' assets in interest rate sensitive instruments, resulting in a sharp increase in short term funding costs and needs. Outside the SDIF banks, the state-owned banks (which until very recently were able to offset increased funding costs through their duty loss accounts) and the investment and development banks suffered a relatively much smaller erosion of their capital base. 28. In February 2001, there was another, much more serious crisis that was ignited by the public airing of tensions between the President and Prime Minister. This set off a new wave of  - 17 - turbulence in the financial sector as investors liquidated TL positions and fled to US$ in expectation of a full fledged political crisis. Interest rates once again spiked, this time as high as 6,200 percent, and with a rapid depletion of the Central Bank of Turkey's (CBT's) foreign currency reserves apparent, the authorities were forced to float the TL. 29. The main elements of the crisis impact consist of: (i) interest rate losses; (ii) losses arising from the TL devaluation; and (iii) loan book deterioration losses due to corporate sector distress resulting from the crises. Although the impact of these factors on each bank individually depends on its liquidity and FX open position situation during the crises, as well as on the size and composition of its loan book and its pre-crisis capital adequacy, the most recently available regulatory data and stress test results indicate that the combined effect of these factors has eroded most of the banking system's capital. Whether this insolvency is temporary and can be reversed in a number of private banks through new capital injections from existing or new owners depends upon the success of the revised macro-economic stabilization program. The strategy agreed and implemented will determnine the depth and breadth of the secular decline in the corporate and other economic sectors going forward, and hence decide the fate of the banking sector in the near term. 30. The Bank and the IMF worked closely with the Government during each of the crises and together developed a consensus on the actions necessary to restore confidence to the financial sector and to set the sector on a path of stable growth. Many of the elements of the strategy are a continuation of the reforms proposed under the FSAL, and build upon the actions taken by the Government under the FSAL program. The major elements of the new program are elaborated below. B. Proposed Multi-Year Financial Sector Reform Program 31. In the aftermath of the November 2000 and February 2001 banking crises, the Government has committed itself to a significant acceleration and widening of the scope of the financial sector reform effort already initiated as part of the FSAL. Such acceleration and widening of the scope of the financial sector reform program is clearly necessary to restore banking system confidence and put the banking system on a sustainable path towards competitiveness at the international level and towards EU accession. As part of the widened scope of its financial sector reform effort, and once the initial phase of immediate urgent post- crises banking sector reform and restructuring activity is over, the Government will also implement a comprehensive non-bank financial institutions reform program, to complement the banking sector refonn effort. Currently, NBFI activity in Turkey is still limited (see Annex IIA). However, it is anticipated that NBFI activity could grow significantly once the macro-economic situation stabilizes. As banks are the key players in NBFI activity, and as it is anticipated that in the aftermath of the banking crisis stronger, larger banks with a universal mandate will appear, a proactive approach on the part of the Government will be necessary to manage the risks and vulnerabilities of such rapid NBFI growth. 32. As the experience in other crisis countries (e.g., East Asia, Latin America) has shown, banking crises resolution efforts will take time. Therefore, the Government has structured its financial sector reforrn effort in two phases, with the first phase focused primarily on implementation of urgent banking system reform and restructuring efforts, and the second phase  - 18 - focused more on the medium term broad based financial sector development agenda. As such, this effort will stretch over multiple years. 33. The initial phase of the Government's multi-year reform program will be supported by the proposed PFPSAL and the planned PFPSAL II. The PFPSAL will support reform measures in the following four areas: (i) acceleration of the overhaul of banking system prudential regulation; (ii) institutional development of the new Bank Regulation and Supervision Agency (BRSA); (iii) accelerated resolution of problem banks and failed banks already taken over by the SDIF; and (iv) initiation of comprehensive financial and ownership restructuring of the four major state-owned banks. These reform measures are described in more detail in the paragraphs below and in the policy matrix for the PFPSAL (Annex VI). The planned PFPSAL II, for which the benchmarks are outlined in the policy matrix, will focus on: (i) finalizing the overhaul of the banking system prudential regime; (ii) continued institutional development of the BRSA and initiation of a comprehensive institutional development effort at the Savings Deposit Insurance Fund (SDIF); (iii) continuation/completion of the problem bank/failed bank resolution effort; and (iv) further restructuring and privatization of the state-owned banks. The follow-up reform efforts in the banking area (especially the completion of the state bank privatization effort) as well as the reform efforts in the NBFI segment of the financial sector will be supported by two additional programmatic financial sector adjustment loans during 2002 and early 2003. C. Strengthening the Regulatory Framework for Banking and NBFI Activity 34. Until recently, Turkey's prudential regime for banking activity was seriously out of line with Basle/EU standards and international best practice. The weakness in the prudential regime, coupled with rapid banking system growth (Table 5 above), contributed to the appearance of major vulnerabilities in the banking system to exchange rate, interest rate and credit risk shocks. These vulnerabilities were already apparent even before the latest two crises, as evidenced by the emergence of a sizeable pipeline of failed private banks under the SDIF (Box 1) and the continued financial difficulties experienced by the state banks (Box 2). The authorities initiated (from December 1999 onwards) an overhaul of the prudential regime as part of the program supported by the FSAL. Under the proposed PFPSAL, this effort is being accelerated and it is the Government's intention to complete the overhaul by late 2001/early 2002 under the planned PFPSAL II, and the following PFSALs I & II in 2002 and early 2003. Specifically, concerning the prudential regime for banks the Govermment already has undertaken and plans to undertake during 2001-02 a number of reforms in this area which are described below. 35. Loan Loss Provisioning Rule. The current loan loss provisioning rule was adopted by the Council of Ministers (the responsible authority for issuing banking regulations before the new BRSA was created) in December 1999 as a Board presentation condition for the FSAL. As such, it was a major improvement over the previous, much more lenient rule. However, the rule was still not fully in line with best practice standards. Remaining weaknesses included the exemption from both classification and provisioning for the agricultural support loans made by Ziraat bank (the state-owned agricultural bank), the use of a rigid collateral classification system, the absence of a provisioning requirement for watch loans, and a still somewhat mechanical application of the provisioning percentages. Additionally, specific provisioning requirements could still not be treated by banks as a pre-tax expense, resulting in overpayment by banks of taxes on sometimes non-existing profits. This unfavorable tax treatment discouraged banks from  - 19- making the required provisions, and also further eroded their already small capital base. To remedy these weaknesses, the BRSA will reissue in June the current loan loss provisioning rule in its own name, while lifting the exemption from classification and provisioning for Ziraat's agricultural reforrn loans. Additionally, the Parliament has enacted an amendment to the banking law that clearly nominates all specific provisions to be made by banks under the new BRSA loan loss provisioning rule as a tax deductible expense, retroactive to January 1. 2001. As a benchmark for the planned PFPSAL II, the BRSA has agreed to further strengthen the loan loss provisioning rule to address the other remaining deficiencies and to bring the rule fully in line with international best practice standards. 36. Large/Connected Exposures. As a Board presentation condition for the FSAL, the December 1999 banking law introduced a new, lower limit for connected exposures by banks. The law also introduced a phase-in period for banks to reach the new limit in a step-wise fashion by the end of 2006. The BRSA was supposed to introduce through regulation a definition of connected exposure in line with the applicable EU Directive to operationalize the new limit. Resistance from the banking sector, however, and concern about the high number of banks that would be out of compliance with the new limit on the basis of the EU definition of connected exposures, resulted in inaction in this area. The two banking crises at the same time have further highlighted the importance of accelerated reform in this area. Therefore, the Parliament has enacted a further amendment to the banking law separating connected lending & derivative exposures from equity exposures (i.e., equity ownership in non-financial entities), and introducing a new separate limit for such non-financial equity exposures. This new limit, which is consistent with the applicable EU Directive, will be phased in over a period of 8 Y2 years, to be in full compliance with EU non-financial equity exposure levels by 2009. Additionally, the latest banking law amendment also mandates the application of the exposure limits (for connected lending/derivatives and non-financial equity) on both a solo and consolidated basis (i.e.. to banks and their financial subsidiaries together). The BRSA will also issue in June the new. EU Directive based definition of connected exposures called for by the banking law, as well as the interim targets and time-table for banks to come stepwise into compliance with the new non-financial equity exposure limits. Furthermore, the BRSA will by August 31, 2001 enter into time-bound action plans with all banks out of compliance with the new limits. 37. Foreign Exchange (FX) Exposure. During 1998-99, the maximum open FX position limit for banks was reduced in a stepwise fashion from 50 percent of regulatory capital in June 1998 to 20 percent in October 1999. In December 1999, as a Board condition for the FSAL, the limit also was made applicable on both a solo and consolidated basis. A new BRSA regulation that will impose a capital charge on banks for their open FX positions was issued in February 2001. The new market risk charge regulation8 is fully in line with applicable Basle capital rules, and will become effective on January 1, 2002 on a solo basis and July 1, 2002 on a consolidated basis. While all these reform actions are steps in the right direction, the current regime still 8 This regulation was accompanied by another new BRSA regulation, also issued in February 2001, requiring banks to develop and operationalize by January 1, 2002 comprehensive risk management systems and internal audit functions to capture all banking risks on a solo and consolidated basis. The regulation allows for the possibility of a one-time extension of this deadline by six months for those banks (e.g., large state-owned banks like Ziraat) that are unlikely to be able to comply with the January 1, 2002 deadline due to the current backward state of their information technology infrastructure.  - 20 - contains several weaknesses. These include different reporting frequencies for open FX positions (solo - weekly and monthly, consolidated - quarterly) and capital adequacy (solo and consolidated - quarterly), balance sheet window dressing at reporting dates and the use of structured finance products to run up open FX positions in circumvention of the 20 percent limit. Additionally, the larger banks are lobbying the BRSA and the CBT, which has issued a liquidity based foreign currency exposure rule, to lift the existing open FX position rules in anticipation of the introduction of the market risk charge for FX risk on January 1, 2002. To address these concerns, the BRSA will issue in June 2001: (i) an amendment to the capital adequacy rule increasing the reporting frequency for both solo and consolidated capital from quarterly to monthly; and (ii) an amendment to the consolidated FX position reporting rule to change the reporting frequency from quarterly to monthly. During the next six months, the BRSA will work jointly with the Treasury's NBFI and Insurance Department and the CMB to harmonize the reporting frequency on all financial statements (i.e., financial statements of banks' financial subsidiaries. As benchmarks for the planned PFPSAL II, the BRSA has also agreed to set up a working group comprising BRSA staff, external auditors and banks to: (i) catalogue the use by banks of structured finance products to incur FX exposures not captured by existing regulations, and (ii) formulate remedial regulatory action to capture such exposures as necessary. Furthermore, the BRSA will announce its intention to undertake surprise on-site examinations, in coordination with foreign supervisors where necessary (i.e., for the foreign branches/subsidiaries of Turkish banks abroad), to verify compliance with consolidated FX open position limits between reporting dates. Finally, the BRSA and the CBT have committed not to lift the existing foreign currency exposure limits until onsite examinations have confirmed that banks' risk management systems and the market risk charge for FX risk, which becomes mandatory on January 1, 2002, are functioning satisfactorily. As a benchmark for the planned PFPSAL II, the BRSA will ensure satisfactory implementation of the action plans for banks with excess connected lending/derivatives and non-financial equity exposures to reach compliance with the new banking law limits. 38. Repurchase Transactions. Turkey is unique in having a significant retail repurchase and reverse repurchase agreement (repo/reverse repo) market. In most of the world, repos are transacted on a wholesale basis, usually only between banks, other financial institutions or large corporate treasuries for liquidity management purposes. Prior to December 2000, in order to encourage secondary market liquidity, the repo/reverse repo market enjoyed more favorable withholding tax treatment than deposit interest and made repos attractive instruments for retail customers. Following the amendment of the withholding tax rules in December 2000, commercial banks in Turkey now primarily enter into repo contracts with their retail clients to circumvent the CBT's reserve requirement on deposits. In February 2001, as repo interest rates rose to as high as 6,200 percent per annum, a large numbers of customers cancelled time deposits and moved into the highly lucrative repo market. The movement of funds from time deposits to the overnight repo market obliged some banks to borrow more heavily on the interbank market, further destabilizing the banking system. As a first step to curb repo activity, the Government in June 2001 has set up a committee comprising of representatives of the Treasury, the BRSA, the CBT, the CMB and the MOF to recommend measures (e.g., setting a minimum allowable size for repo transactions, setting a liquidity requirement for repos, adjusting withholding taxes based on the length of liability maturities, etc.) to reduce the risks caused by excessive use of retail repos/short-term liabilities in the banking sector. Additionally, to further enhance the transparency of the repo market, as benchmarks for the proposed PFPSAL II, the BRSA will  -21 - require banks to bring repos on balance sheet as collateralized finance transactions by the end of December 2001, and the Government will take the necessary measures to reduce the risks caused by excessive use of retail repos, short-term liabilities in the banking sector taking into account the recommendations of the committee. The Capital Markets Board at a later stage will also introduce a regulation restricting repos to wholesale transactions, thereby creating further incentives to investors to move their money into banking deposits or money market mutual funds. 39. Taxation and Corporate Law Reform to Encourage Merger and Consolidation in the Financial Sector and to Facilitate Separation of Financial Industrial Groups. Because of a past history of somewhat indiscriminate issue of licenses, the banking sector in Turkey is quite fragmented with a large number of small or pocket banks without the requisite size, capital, range and diversification of products and services, and the depth of technical and managerial skills necessary to develop a healthy, strong and modern banking sector. In order therefore to strengthen the capital structure, and to reverse the fragmentation of resources of the banking sector, it is necessary to encourage mergers and consolidation. At the same time, to facilitate efficient financial flows among several financial entities within a single business group, and to better manage and supervise the inherent risks on a consolidated basis for the group financial institutions (which is essentially required because of the public trust role of such institutions), it is necessary to separate the financial and industrial activities of the financial-industrial groups in Turkey into separate financial and industrial holdings. However, at this time any such merger, consolidation or separation activity faces several tax (VAT, Banking and Insurance Transaction tax, etc.) and corporate law disincentives. During 2001-02, the Government plans to review and amend corporate and tax legislation as necessary to encourage mergers and consolidation in the financial sector, and to facilitate transformation of financial-industrial groups into separate financial and corporate conglomerates. 40. Prudential Regulations for Non Banking Financial Institutions. In view of the size and scale of the banking sector and the urgency under the present crisis circumstances, the prudential reforms required for commercial banking activity have quite naturally received the greater priority, during the years 2000-01. However during 2002, the Govermment plans to also undertake a comprehensive review (with the assistance of the World Bank) of the prudential regulations' regime for the non-banking financial institutions, to reduce their vulnerability to potential macroeconomic volatility and to facilitate a more accelerated growth of non banking financial activity in Turkey including equity and fixed income securities markets, insurance, mutual funds and pension funds. Some of the focus areas identified as priority for reform are listed below: * Completion of a review of the need for new/tighter FX and large/connected exposure limits for the insurance industry and other non-bank financial institutions, and the introduction of appropriate new limits as indicated by such review; * Adoption by Parliament of a new insurance law in line with applicable EU Directives; * Adoption by Parliament of amendments to applicable legislation to equalize absolute minimum capital requirements for private pension funds and life insurance companies involved in pension funds; * Strengthening the regulatory and governance structure of all insurance companies' and other financial institutions' employee pension funds;  - 22 - * Completion of a review of all other prudential rules applicable to NBFI activity (insurance, leasing, finance, factoring, pension funds, mutual funds, asset management) and adoption of a formal plan to overhaul these rules as necessary to bring them in line with applicable IAIS/IOSCO and other international standards; and * Completion of full introduction of IAS for banks and non bank financial institutions, including IAS 29 with an appropriate phase-in period and IAS 39; activation of the new Accounting Standards Board mandated by the Capital Markets Law; revision of Istanbul Stock Exchange listing and disclosure rules for all financial institutions; overhaul of the licensing regime for auditors of banks and other financial institutions; * Initiation of a review of the overall tax regime for financial transactions and activity, and identification of all tax structures that favor or discriminate against certain types of financial sector activity; and preparation of amendments to tax legislation with a view to eliminate any biases in favor or against certain types of financial sector activity. D. Strengthening the Institutional Capacity of the BRSA and the SDIF 41. Bank Regulation and Supervision Agency (BRSA). The BRSA since its creation on September 1, 2000 has made progress towards its operationalization, but the November 2000 and February 2001 banking sector crises have diverted attention and energy away from its own institutional development agenda, which is far from finished. Therefore, the BRSA needs further improvements in the following areas: 3 consolidate staff structure; BRSA staff came from five different departments within the Undersecretariat of Treasury, the Ministry of Finance and the Central Bank and, while these staff now work within a single organization, they continue to operate on a semi-independent basis and are still being paid using their previous employers' pay scales, diminishing the potential benefits of creating a single regulatory authority for the banking sector; D development of a common database; the maintenance by each function within the BRSA (e.g., offsite monitoring, on-site monitoring, enforcement, licensing) of separate databases and the use of different analytical models to assess the condition of individual banks, resulting in sometimes conflicting analyses and policy recommendations being made by the different departments to senior BRSA management; * upgrade detailed procedures manuals for each BRSA function; while BRSA staff claim they are all fully aware of their task responsibilities and the procedures to be followed in case of regulatory/supervisory and enforcement action to be undertaken, these procedures are currently not documented or the manuals that do exist are out of date; * integrate offsite monitoring, onsite monitoring and enforcement activity; when onsite examiners (called Swom Bank Auditors) go onsite in a bank, offsite and enforcement staff are not allowed to participate in these site visits; additionally, the findings of the onsite examiners are not fed back to the offsite department for correcting the offsite information on the banks concerned; * establish a specific problem bank unit within the enforcement function; following the November 2000 and February 2001 crises, a further three banks were taken over by the SDIF and a large number of other banks were severely weakened and are not currently able to comply with all the BRSA's regulatory requirements; it is the responsibility of the BRSA's enforcement division to work with any bank which is in violation of the banking regulations;  - 23 - however, the capacity of the enforcement division is severely strained due to the large number of banks which are currently not in compliance; furthernore, many of the banks are not merely out of compliance but face the possibility of failure and hence require more 'hands on' attention and possibly the application of different skills to those available in the enforcement division; the enforcement department has already assigned specific teams to deal with capital deficient banks within the enforcement department, but they have to be strengthened with staff and procedures and specific guidelines to deal with such problem banks; * introduce an early warning system that could guide the efforts of the onsite examiners and provide input in determining the onsite examination cycle; and * develop the concept of risk-based supervision, to shift the onsite examiners from being mostly focused on compliance testing to identifying banking risks and assessing the quality of the risk management undertaken by bank managers. 42. To start addressing these weaknesses, the BRSA management will develop, and the BRSA Board will adopt in June, a time-bound strategic plan with clearly assigned implementation responsibilities for reaching the following objectives: (i) having a comprehensive human resource policy further assimilating its staff from different sources and strengthening the staff training program; (ii) integrating the existing multiple databases into a common database and a common platform for analyzing and assessing banking risks; (iii) upgrading/developing procedures manuals for all major existing BRSA units; and (iv) introducing the concept of relationship supervision with offsite examiners, enforcement staff and Sworn Bank Auditors working in teams on individual banks. As part of a revised human resource policy, the BRSA/Government will review the salaries of BRSA Board members and staff and will bring them in line with the prevailing salary scales for similar professional staff in the banking sector, in any event not less than the comparable salaries at the CBT or CMB. In addition, as benchmarks for the planned PFPSAL 11 (a) the BRSA has agreed to set up problem bank unit within the BRSA's enforcement department and to adopt a pre-failure corrective action manual for the new unit, which will define pre-failure intervention triggers (effectively defining a 'problem bank') and pre-failure corrective action procedures to be administered by the new unit, and (b) the Government/BRSA have agreed to review the salaries of BRSA Board members and staff and to bring them in line with the prevailing salary scales for similar professional staff in the banking sector, in any event not less than the comparable salaries at the CBT or CMB. The Bank will also look for satisfactory implementation of the time-bound strategic plan for the BRSA as a policy benchmark for the planned PFPSAL II. Additional institutional development efforts by the BRSA will be undertaken in the context of the planned PFSAL I and II during 2002. These additional actions include the development and operationalization of an early warning system for monitoring of banks, and the introduction of a risk-based approach to supervision. 43. Savings Deposit Insurance Fund (SDIF). When the BRSA was created the SDIF, the entity responsible for administering the deposit insurance scheme and resolving failed banks, was transferred from the CBT where it was housed before the December 1999 banking law became effective, to the new BRSA. The SDIF was already dealing with a sizeable pipeline of failed banks before this transfer, and the case load of the agency has only increased since then. Additionally, immediately after the November 2000 banking crisis, the SDIF was also given the  - 24 - responsibility by the Government to administer the blanket guarantee covering all bank depositors and creditors (except subordinated debt holders; shareholders are also not covered by the guarantee). Thus, a targeted institutional development effort is also needed at the SDIF to ensure it can effectively perform the function of bank failure resolution entity and administrator of the blanket guarantee and the deposit insurance scheme. To meet this need, and as a benchmark for the planned PFPSAL II, SDIF management has agreed to prepare, and the SDIF Board has agreed to approve a time-bound strategic plan, with clearly assigned implementation responsibilities, that will achieve the following objectives: (i) putting in place a more effective organizational structure, with clearly separated line responsibilities for bank resolution efforts, asset management efforts, administration of the blanket guarantee & the deposit insurance scheme and supporting functions such as legal, human resources and infornation technology; (ii) setting perforrnance targets for the bank resolution and asset management functions; (iii) hiring additional qualified staff to handle the high volume of non-performing loans and other problem assets to be transferred to the Collections Department for collection/workout; and (iv) building a centralized and high quality management information system that will allow SDIF senior management and the SDIF Board to monitor progress being made towards reaching agreed resolution and asset management/collection targets. The Bank will be looking for satisfactory implementation of this time-bound strategic plan as a reforrm action under the PFSAL I. 44. Deposit Insurance Reform. The institutional development of SDIF can not be successfully completed till the policy on its long term mandate is clearly articulated. In this context, during 2002, the Government plans to remove the blanket guarantee to all commercial bank depositors and creditors presently in force under crisis conditions, and replace it with a deposit insurance regime consistent with the EU standards on Deposit Insurance, including the use of risk based premiums. At the same during 2002, the effective functioning of the SDIF's present legal, governance, financing and management structure as a subsidiary of the BRSA will be reviewed, and the feasibility of the SDIF existing as a separate autonomous and institution will be considered as necessary. These further reform measures for the SDIF are envisaged under the planned PFSAL I and II during 2002/early 2003. 45. Creation of Consolidated Regulatory Infrastructure. While the above outlined reform efforts are expected to contribute to the emergence of the BRSA as a more effective bank regulatory agency, the current financial sector regulatory infrastructure in Turkey remains fragmented, while the banks, through majority ownership of numerous financial subsidiaries, de facto operate as universal banks across all fields of financial sector activity (i.e., in areas such as insurance, portfolio management, securities trading and underwriting, mutual and pension fund management the banks' subsidiaries are the key players). There are currently separate regulatory agencies for insurance (the General Directorate of Insurance in the Undersecretariat of Treasury), leasing, finance & factoring (the General Directorate of Non-Bank Financial Institutions in the Undersecretariat of Treasury), portfolio management, securities trading and underwriting and mutual funds (the Capital Markets Board) and private pension funds (a new Private Pension Fund Regulator operating under a Coordinating Committee comprising the Ministry of Labor, the General Directorate of Insurance and the Capital Markets Board). Such an atomized regulatory infrastructure, coupled with a potential lack of smooth inter-agency cooperation, adds to the risks of an already fragile financial sector. Therefore, the Government intends to further deepen the consolidated supervision of financial conglomerates during 2002 and early 2003 in the context of the planned PFSAL I and II by: (i) extending the coverage of the BRSA's  - 25 - consolidated reporting requirement for banks to horizontal conglomerates; and (ii) further amendments to prudential regulations for banks and NBFI/capital markets activity as necessary to introduce a consolidated regulatory infrastructure. In addition, during 2002 the Government will evaluate the feasibility of the creation of an integrated financial sector regulatory infrastructure umbrella (if necessary through merger/coordination of the BRSA with the Capital Markets Board and the Treasury's Insurance and NBFI Directorates) for comprehensive regulation and supervision of banking, non-bank financial institutions & capital markets activity. E. Implementation of Efficient Problem Bank/Bank Failure Resolution 46. Private Banks (Monitoring and Addressing Current and Future Capital Adequacy). Due to the November 2000 and February 2001 crises, the capital base of nearly all of the private, domestically owned deposit taking banks (28 banks in total as of end May, 2001 excluding SDIF banks) has been weakened substantially. Stress testing has confirmed that as a result of the combined impact of interest rate, exchange rate and credit risk shocks, many of the banks concerned either already have suffered, or are likely to suffer, from capital inadequacy in the near future. These capital deficits among such private banks range from temporary non- compliance with the 8 percent minimum capital adequacy ratio requirement, to permanent insolvency and inability of some of the banks concerned to survive on their own. In order to remedy this potentially systemic capital shortfall, during the period March-May, 2001 the BRSA has undertaken the following actions: * The BRSA has, in the aftermath of the February crisis, instructed all private commercial banks except well-capitalized banks not to pay dividends and to retain all year 2000 earnings; * Through a combination of offsite analysis and on-site examinations, the BRSA has identified all capital deficient banks, and the likely size of the already apparent, or soon to be apparent capital shortfall in each bank concerned; * The BRSA has held in-depth discussions with each bank concerned on the need to prepare time-bound capital restoration plans, including in some instances the need for the merger of multiple weaker banks that belong to the same financial-industrial group into one larger, stronger bank; and * The BRSA has also publicly announced that it is seeking credible capital restoration plans on a system-wide basis. By end June 2001, the BRSA will enter into capital restoration plans with all banks concerned. 47. The BRSA's existing Enforcement Department is responsible for monitoring the timely implementation of these capital restoration plans. Those banks that will not be able to satisfactorily implement their capital restoration plan will be intervened by the SDIF and resolved. To assist the Department's staff in doing so, and to strengthen the ability of the BRSA's Offsite Monitoring Department to timely detect new problem bank cases on an ongoing basis, the BRSA as part of its overall institutional development effort, will create a sophisticated early warning system. Based on earlier indications, a significant number of banks will be able to recapitalize themselves from internal sources or through mergers or acquisition by domestic or foreign banks. The fiscal costs for undertaking the intervention and resolution of any remaining insolvent banks by the SDIF are therefore expected to be relatively less compared to the total re-  - 26 - capitalization outlays required for all the remaining private banks in the sector, and based on current estimates is unlikely to impose a major additional fiscal burden. 48. Complementing the BRSA's efforts in this respect, the CBT has also put in place a new mechanism allowing it to monitor deposit interest rate movements for different maturities and currencies of all banks on a weekly basis. In this manner, the CBT will be able to identify very early on any undue liquidity pressures that may arise in individual banks, signaling possible new capital shortfalls. The already agreed Memorandum of Understanding between the CBT, the BRSA and the Treasury allows for the full and confidential exchange of information relevant to the early detection of new 'problem' bank cases between the three agencies, providing an additional safeguard against the risk of renewed and unexpected systemic crisis. Additionally, the Government has identified obstacles in tax legislation to bank mergers, and has submitted amendments to Parliament to remove these obstacles. Parliament is expected to enact these amendments by end-June. 49. Resolution of Failed SDIF Banks. The reform effort to accelerate the resolution of failed banks by the SDIF was initiated in December 1999 with the passage of the new banking law that provided the SDIF with an extended range of resolution options9. However, the resolution effort remained on the back burner and got under way in earnest only after September 2000 for several reasons: (i) absence of clear financing arrangements between the SDIF and the Treasury for the cash and Government securities needed for expeditious bank failure resolution efforts; (ii) inertia and uncertainty at the Treasury (previously responsible for bank supervision) and the SDIF, managed by the CBT, in anticipation of their transfer to the new BRSA, which was created and became operational only on September 1, 2000; and (iii) lack of a coordinated policy for the provision of lender of last resort financing by the CBT in a manner consistent with the Net Domestic Asset ceiling under the IMF Stand-by Agreement; fear of unavailability of such financing probably has contributed to regulatory forbearance. 50. Post September 2000, the SDIF stepped-up efforts to sell banks under its control as going concerns but, due in part to the two banking crises that occurred in November 2000 and February 2001, these efforts were not successful. To date, the SDIF has not yet sold any bank, and the post crises environment is not very conducive to sales. Therefore, more recently the SDIF has initiated a strategy of merging some of the banks under its control into a transition bank and revoking the licenses of the banks so merged. This strategy, while much slower than the 9 The available failure resolution techniques include: Deposit Transfer. When good assets are sufficient to cover insured depositors. Insured deposits and good assets are simply transferred to another bank, and the remaining shell is liquidated by the SDIF. Purchase and Assumption. When good assets are not sufficient to cover insured depositors or protected liabilities. Bonds and/or cash are used to carve out bad assets to balance good assets and protected liabilities. The good assets (along with bonds and/or cash) are purchased by another bank that also assumes the liabilities. Ideally, the "purchase and assumption" transactions would occur over a weekend or a very short span of time. However, if a buyer cannot be found, the good assets and protected liabilities are moved into a newly licensed bank (a "bridge" bank) until a buyer can be found. Importantly, the split of assets (i.e., "good" and "bad" banks) will occur immediately whether or not a buyer is found. The actions are taken secretly in order to avoid further depletion/depreciation of assets by shareholders/borrowers. The remaining shell of the original bank with the bad assets and remaining liabilities is liquidated by the SDIF. Depositor Payoff. There are so few good assets that the simplest and quickest means of resolving the failure is for the SDIF to pay insured depositors and liquidate the failed bank's assets.  - 27 - expeditious resolution efforts envisaged under the December 1999 banking law, has so far resulted in the 'exit' of 5 banks (see Box 1 below). The branches of these banks are being closed and their staff is being laid off over a 5-6 months period. Thus, a slower process of consolidation is being implemented in the short term, while a medium term decision on sale/merger/closure is being evaluated. 51. Keeping the SDIF intervened banks open for a long period with inadequate liquidity and solvency support, rather than using expeditious 'least cost' resolution efforts such as those envisaged by the December 1999 banking law (including Igaying off depositors and closing the non-viable banks) has continued to cause major losses to these banks; and has therefore ultimately proved to be much more costly to the Government. In fact, the slow pace of resolution of SDIF banks has in itself been a major contributing factor to the November 2000 and February 2001 banking crises, as the SDIF banks' unaddressed large capital and liquidity shortages have forced them to continuously borrow in the interbank market at very high interest rates. These high rates, also fuelled by unresolved problems at the large state-owned banks Ziraat and Halk (see paragraph 58-59 below), in turn have eroded the profit margins of other private banks, thereby contributing to a further weakening of the banking system's capital base. 10 Cumulative restructuring outlays for SDIF banks are estimated to be TL 19.8 quadrillion (US$17.2 billion at post- crisis exchange rates) as of May 15, 2001 (this number includes TL 3.46 quadrillion replacement of earlier issued low-interest rate securities to allow the SDIF banks to cover their funding costs). The TL 3.84 quadrillion (US$5.6 billion at pre-crisis exchange rates) injection of Govermnent securities in December 2000 intended to recapitalize the SDIF banks up to 8 percent was nearly completely wiped out as a result of the late November/early December 2000 interest rate spike alone. The SDIF banks' large FX open positions also have proven to be a very costly proposition in the face of the February 2001 exchange rate devaluation. Earlier estimates of the cost of resolution of SDIF banks (based on a caseload of 8 banks as of end December 1999) using least cost resolution methods were in the range of US$5-6 billion only.  - 28 - Box 1: SDIF BANKS During the period 1997-early 1999 only 3 banks were intervened by the SDIF. In September 1999, recognizing that problems were mounting in the banking sector, the Government approached the Bank for assistance with a planned SDIF intervention in an additional 5 banks. An intensive dialogue between the Govermnent and the Bank resulted in the enactment of a new banking law in December 1999 with strong resolution powers for the SDIF. Immediately upon the passage of the new law, the SDIF intervened in the aforementioned 5 banks. This rapid phase of initial action was followed by a 9 month period of relative inaction, as the CBT and the Undersecretariat of Treasury were waiting for the formation of the new BRSA. Unresolved questions about how the SDIF was to finance the injection of cash and Government securities required for resolution of the banks under its control also contributed to the inaction. Turk Ticaret 26.05.1997 661 Ekspres 25.10.1998 329 Sale negotiations ongoing Interbank 27.01.1999 1,606 _ __ Egebank 22.12.1999 Merged into Sumer Bank (on February 18, 2001) Eskisehir 22.12.1999 863 Sumerbank 22.12.1999 3,066 Transition Bank Yurtbank 22.12.1999 Merged into Sumer Bank (on February 18, 2001) Yasarbank 22.12.1999 Merged into Sumer Bank (on February 18, 2001) Bank Kapital 27.10.2000 Merged into Sumer Bank (on February 18, 2001) Eti Bank 27.10.2000 766 Demir Bank 06.12.2000 2,994 Sale negotiations ongoing Ulusal Bank 28.02.2001 Merged into Sumer Bank (on May 8, 2001) Iktisat Bank 15.03.2001 1,072 B/S review ongoing Source: BRSA and SDIF. With the operationalization of the BRSA on September 1, 2000 the pace of resolution picked up. In October 2000, an additional 2 banks were intervened. In November 2000, the SDIF signed a protocol with the Undersecretariat of Treasury that allowed it to increase, during December 2000, the share capital of the banks under its control through the injection of US$ 5.6 billion of Government securities (TL 3.86 quadrillion). Immediately afterwards the SDIF announced the sale of the banks. Though there was some initial interest from both domestic and international groups, no banks were sold. The November 2000 banking crisis was triggered by the excessive liquidity demands of Demir, which needed funds to support a highly speculative position in Government securities. Unable to meet its liabilities as they fell due, Demir was taken over by the SDIF. To prevent a system-wide deposit run, the Government issued a blanket guarantee, to be administered by the SDIF and exercisable upon SDIF intervention, covering all banking system liabilities (except subordinated debt). Following the February 2001 banking/economic crisis the SDIF intervened in an additional 2 banks, bringing the total number of intervened banks to 13, and the number of banks that have failed during the past 18 months to 10. The principal features of most of these bank failures have been acute shortages of liquidity and a high incidence of fraudulent/crirninal activity on the part of shareholders and management. Unable to dispose of the banks as going concerns, the SDIF has recently revoked the licenses of 5 banks and merged them into a transition bank (Sumer). As a result, the number of SDIF banks was reduced from 13 to 8. After financial and operational restructuring Sumer bank has been offered for sale in early June. If the bank cannot be sold by year end 2001, its license will be revoked and its remaining assets will be sold off, its creditors will be paid down and the remaining shell will be liquidated. A second transition bank will be formed by merging Inter, Es and Eti into Turk Ticaret and the licenses of the banks concerned will be revoked by end-June 2001 if these banks cannot be sold. In case any of these banks will not be merged into a transition bank, its license will be revoked and liquidation initiated. Again, the merged entity will be restructured and offered for sale. If the bank cannot be sold by end 2001, its license will be revoked, its assets sold off, its creditors paid and the remaining shell will be liquidated.  - 29 - 52. To address these urgent resolution priorities and to set this disappointing resolution record straight, a set of comprehensive new problem bank and bank failure resolution measures need to be undertaken. These must be implemented in a coordinated fashion by the BRSA and the SDIF on the one hand, and the Treasury and the CBT on the other hand. As a first step, and as a condition for the proposed PFPSAL, the following measures have already been taken: * The Undersecretariat of Treasury in cooperation with the CBT has injected into the SDIF banks enough (i) marketable Government securities (in TL and FX) in a mix of maturities and currency denominations carrying quarterly market-based floating rate coupon interest to ensure that the banks have sufficient liquidity to operate and honor any deposit withdrawals, and to recapitalize them up to 0 percent capital adequacy; and (ii) cash (in lieu of the Government securities above) to retire at least two thirds of all on and off balance sheet overnight high cost liability funding of the SDIF banks outstanding as of March 16, 2001 (excluding liabilities to the CBT); the CBT has subsequently mopped up excess liquidity through open market operations within an overall ceiling on the stock of repurchase agreements of the SDIF and state-owned banks with the CBT as of end May of TL 7 quadrillion. By the end of June 2001, the following further steps will be completed: * The SDIF will: (i) hire additionally required staff for its Collection Department; (ii) receive approval from its Board to allow the transfer of 1,166 problem loan files above TL 75 billion of Sumer to the Collections Department; (iii) transfer 150 problem loan files above TL 75 billion from Sumer to the Collection Department. In addition, the SDIF regulation will be amended before August 31, 2001 to reflect the recent amendment of the Banking Law and to adopt the necessary organizational structure and detailed operating procedures for the Collection Department; and * The SDIF Board will select a second 'transition bank' to avoid overload at Sumer, and will revoke the licenses and initiated the merger of Turk Ticaret, Ekspres, Es, Inter and Eti with either one of the transition banks in the absence of successful sales; even in case any of these banks will not be merged into a transition bank, its license will be revoked and liquidation initiated. 53. Additional measures are foreseen as benchmarks for the planned PFPSAL 11. Specifically, the SDIF has agreed to undertake the following additional steps: * To sell Ekspres, Demir and Iktisat, or revoke their licenses and merge them with the transition bank(s); * To resolve Sumer and the second transition bank through sale or license revocation/liquidation; and * To complete the transfer of all problem loan files above TL 75 billion to the Collection Department and the Collection Department to either reach negotiated settlement with the loan defaults or initiate legal action for all problem loan files;  - 30 - * The SDIF to amend its regulations to reflect the recent amendments in the banking law, and to adopt the necessary organizational structure and operating procedures for the Collection Departnent by August 31, 2001. These measures will result in the complete resolution of the existing pipeline of 8 SDIF banks by year end 2001. 54. Bankruptcy, Foreclosure and Collateral Legislation and Infrastructure Reform. The banking crisis and its aftermath in the corporate sector is likely to cause a significant amount of downstream corporate restructuring/workout activity as a result of foreclosure and bankruptcy procedures by banks. Though some work has been initiated in this area by the Bank's financial sector team, a coordinated review by the Government of the improvements required in the legal framework for debt restructuring and workout will be undertaken and refonn recommendations developed as part of the PFPSAL II, and the PFSALs I & II. These will also include a review of the need to set up a movable goods collateral register. F. Implementation of Comprehensive Restructuring and Privatization of State-owned Banks 55. Overview. Over a third of banking system assets and deposits are accounted for by four large state-owned banks, Ziraat, Halk, Emlak and Vakif (Table 6 below). Ziraat has traditionally focused on agricultural finance'" and Halk on lending to small businesses and artisans. Emlak has been engaged in such disparate activities such as public housing construction, trade finance and shipbuilding as a result of a previous Government policy of merging failed banks operating in different economic sectors, and as such has no clear mandate. Vakif is a retail and general corporate sector focused bank, and has an ownership structure dating from Ottoman times, with A and B shares (55 and 20 percent of capital respectively) historically belonging to so-called 'vakifs' (foundations) and now represented by the Ministry of State's General Directorate of Foundations, and the remaining C shares (25 percent of total) belonging to the bank's pension fund and employees. Table 6: Assets and Deposits of State-Owned Banks as of end March, 2001 Total Assets Percent of Deposits Percent of (TL trillion*) Total** (TL trillion*) Total** Ziraat 17,786 16 13,502 19 Halk 9,016 10 7,267 11 Emlak 4,488 4 3,395 4 Vakif 6,110 5 4,448 6 Total 37,400 35 28,612 40 * 1 TL trillion = US$0.87 million at current exchange rates. ** Based on end December 2000 data. Source: Undersecretariat of Treasury and BRSA Ziraat actually combines three separate activities into one entity: (i) agricultural finance; (ii) general commercial banking; and (iii) payrnent and collection services for the Government. Because of the latter, and as the bank is the only bank serving small rural communities, its restructuring and privatization will be more complex than that of the other three state banks. In preparation for its eventual privatization, Ziraat prepared its first set of IAS financial statements for the year ended December 1999.  -31 - 56. Halk, Ziraat and Emlak. Longstanding Government governance and ownership has steadily eroded the financial condition of Ziraat, Halk and Emlak. For Ziraat and Halk, enormous losses have been hidden under the umbrella of illiquid Government "duty losses" (paper claims on the Government carried on the banks' books) for the last five years as a by-product of subsidized, directed lending for agriculture and small business development. Emlak has accumulated significant losses through its construction related activities and non-performing loans, and the bank was already insolvent even before the November 2000 crisis. 57. The total duty losses in the books of Ziraat and Halk for the period 1995 - April 2001 are presented in Table 7 below. The losses increased from US$2.8 billion at the end of 1995 to US$22.6 billion at the end of 2000 (at pre-crisis exchange rates). During the first four months of 2001, due to the enormous losses incurred by these banks as a result of the crisis and despite large injections of Government securities in lieu of part of the outstanding stock (see paragraph 59 below), in TL terms the duty losses further increased by more than 50 percent, even though in US$ terms the total amount declined due to the February devaluation of the TL. The distortion in the money markets caused by the large liquidity shortfalls experienced by the two banks as a result of the rapid build-up of the duty loss claims was one of the principal propagators of the November 2000 and February 2001 banking crises. 58. During the November 2000 and February 2001 crises, both Ziraat and Halk suffered a rapid and dramatic transformation of the maturity structure of their liabilities (much more so in Halk), resulting in a sharp increase in their liability funding costs. Additionally, as both banks were already heavily dependent on overnight interbank and central bank funding, on this portion of their funding the costs also shot up immediately. To compensate for these funding losses, Ziraat and Halk continued to accrue duty loss receivables. During the first quarter of 2001, the Treasury gave the banks12 a total of TL 7.8 quadrillion (nearly US$6.8 billion at today's exchange rates) worth of Government bonds, in a combination of a marketable and non- marketable securities, primarily to use as collateral to raise funding on the repo market. Due to the large incremental losses run up by these two banks during and in the aftermath of the November 2000 and February 2001 crises, however, the outstanding stock of duty losses continued to increase (in TL terms; as noted above, in US$ terms the amount actually declined slightly due to the TL devaluation that occurred in February). 59. As neither Ziraat nor Halk ran large open foreign currency positions, the devaluation of the Lira during the February crisis had little direct impact on these two banks. At the same time, it is expected that the secular increase in borrowing costs for the banks' customers will be reflected in a decrease in the quality of the banks' loan portfolios and an increase in the amount of funds to be set aside to account for non-perforning loans. 12 TL 2,883.4 trillion for Ziraat and TL 4,916.7 trillion for Halk.  - 32 - Table 7: Duty Losses of State-Owned Banks 1995 1996 1997 1998 1999 2000 April, 2001* TL billion Ziraat 92,678 409,550 945,562 2,395,610 6,123,841 8,212,453 12,118,895 Halk 76,484 221,844 570,471 1,586,645 4,232,839 6,897,172 10,803,124 Total 169,162 631,394 1,516,033 3,982,255 10,356,680 15,109,625 22,922,019 US$ million Ziraat 1,519 3,792 4,618 7,660 11,338 12,261 10,918 Halk 1,254 2,054 2,786 5,074 7,837 10,297 9,733 Total 2,773 5,846 7,404 12,734 19,176 22,558 20,651 As percent of 2.15 4.22 5.16 7.51 13.23 11.50 GNP . * Lower in USS terms because of the TL devaluation in February 2001. Source: Undersecretariat of Treasury 60. Pre-crises, the Government had already initiated the financial and ownership restructuring of the state banks. In November 2000, Parliament enacted an amendment to the law on Vakif allowing the sequential sale of the B shares and A shares held by the Ministry of State's General Directorate of Foundations. In August of that same year, Vakif engaged an investment banks for the sale of B shares through an initial public offering. The Government also initiated the commercialization and financial restructuring of Emlak during late 1999 and early 2000 by removing the stock of housing from its books. In December 2000, at the initiative of the Undersecretariat of Treasury, new legislation was submitted to, and enacted by Parliament that: (i) allowed Ziraat, Halk and Emlak to be completely privatized; (ii) selectively removed the application of state economic enterprise legislation (Decree Law No. 233 and related laws) to the banks in preparation for their privatization; and (iii) allowed the Government to undertake any restructuring actions necessary to prepare these banks for privatization. Restructuring Boards had been created for the banks and management had begun to formulate operational restructuring plans. The Government had envisaged a 2-3 year timeframe for the privatization of Halk and up to 4 !/2 years for Ziraat. However, the destabilizing effect of the state banks on the whole banking system has made it clear that the process of state bank restructuring and privatization must be significantly accelerated to restore banking system stability and confidence. 61. Financial and Governance Restructuring. The objective of restructuring the three state banks Ziraat, Halk and Emlak is: (i) to reduce the excessive liquidity pressure on the banking system caused by the overnight refinancing needs of Ziraat and Halk; and (ii) to ensure that these banks are effectively and professionally managed on an arms length basis and transformed into profitable commercial banks that can be rapidly privatized. To achieve these objectives, as conditions for the proposed PFPSAL the Government, in cooperation with the CBT and the BRSA, has undertaken the following actions: * Injection into Ziraat and Halk of enough (i) marketable Government securities at market terms in a mix of maturities and currency denominations with floating coupon interest paid quarterly to ensure that the banks have sufficient liquidity to operate and honor any deposit withdrawals, allow the write-off of all duty loss claims as of mid May 2001 and the  - 33 - recapitalization of the two banks to 8 percent capital adequacy 3; in addition, non-standard below market interest rate Government securities in the books of these two banks issued earlier in lieu of duty loss claims have been reissued in uniformity with the new set of securities 14; and (ii) cash (in lieu of the Government securities above) to allow the banks to retire at least two thirds of their on and off balance sheet overnight high cost liability funding outstanding as of March 16, 2001, with the CBT subsequently mopping up excess liquidity through open market operations within an overall maximum ceiling of TL 7 quadrillion as of end May, 2001 on the stock of repurchase agreements of the state-owned and SDIF banks with the CBT (see also Box 2 below); and * Appointment of a new independent professional Governing Board for the two banks with the mandate to manage these banks in accordance with commercial principles and all prudential guidelines under the banking law/issued by the BRSA; the Governing Board has initiated the operational restructuring of the two banks, including the closure of unprofitable branches and the reduction of redundant staff. By the end of June 2001, the following additional action will be taken: * Appointment by the Governing Board of a Restructuring Adviser for Ziraat and a Restructuring and Privatization Adviser for Halk. Given the Government's view that legislation is needed to authorize the close of Emlak Bank, the following further actions will be completed by July 15, 2001: - The transfer of construction related assets on the books of Emlak to the Mass Housing Administration, the completion of the merger of all banking liabilities and all the performing banking assets of Emlak with Ziraat and Halk, the revocation of Emlak's banking license; the provision of sufficient capital to Ziraat and Halk in the form of marketable Government securities carrying quarterly floating rate coupon interest to allow them to absorb all losses related to Emlak's merger, including the issuance of Mass Housing Fund securities to Emlak in lieu of the construction related assets transferred to the MHA on a short-term basis to be exchanged with Treasury securities within 2001. 62. Operational Restructuring. Soon after the financial and governance restructuring is implemented by mid 2001, the Government intends to initiate the operational restructuring of Halk and Ziraat. Under the oversight of the new independent Governing Board, Ziraat is expected to make substantial progress towards the closure of unprofitable branches and will also be able to reduce a large part of its excess staff through early retirement packages and alternative placements. In the latter area, the Governing Board expects to achieve substantial progress in 13 During April and the first two weeks of May, 2001 the Government issued an additional TL 9.23 quadrillion in securities to Ziraat, and TL 5.88 quadrillion to Halk, bringing the total injection of securities (including securities issued during the first quarter of 20010 during 2001 to TL13.33 quadrillion for Ziraat and TL 13.07 quadrillion for Halk. 14 The re-issuance occurred on May 14, 2001 in an amount of TL 5.62 quadrillion for Ziraat and TL 6.99 quadrillion for Halk.  -34 - this area by end 2001, and plans to complete the process of unprofitable branch closures and excess staff relocation or early retirement during 2002. 63. In case of Ziraat specifically, the new Governing Board will undertake a review of its products, services and operating structure to be able to develop a strategic model for delivering agricultural services on a commercial basis. For this purpose, a review of similar successful models in other parts of the world including Europe will be carried out, and technical assistance sought as necessary. Additionally, all public service functions of Ziraat will be identified, all the options to determine how such services can be provided on a cost neutral or profitable basis in future will be reviewed (whether by Ziraat or transferred to other entities, or even offered through other banks, or a network of the postal service being several of the potential options), and a transfer plan based on the most suitable option will be adopted through issuance of necessary decrees/legislation. This is expected to be achieved during 2002. Box 2: Costs of State Bank Restructuring The financial restructuring of the three state-owned banks Ziraat, Halk and Emlak is based on a three step process. The first step entails retiring all of the high cost ovemight liabilities of the banks (both on and off balance sheet) and replacing them with liabilities to the Central Bank of Turkey (CBT). The second step entails the recapitalization of the banks to 8 percent capital adequacy with marketable Government securities carrying quarterly floating rate coupon interest. This step includes the replacement of earlier issued non-marketable paper with marketable paper carrying quarterly floating rate coupon interest. The final step entails the purchase of these securities from the banks by the CBT, and the use of the cash so received to retire the banks' liabilities to the CBT. The restructuring has been carried out gradually over a 2-3 months period, so as to allow any monetary leakage to be absorbed through accompanying open market operations. The total cost of restructuring the three banks, based on a cut-off as of mid May 2001 of the duty loss connection with the Treasury is given below. Cost of Restructurin the State-Owned Banks Ziraat 1,909 13,326 218 15,453 5,622 Halk 863 13,074 67 14,004 6,991 Emilak 10 669 41 720 Total 2,782 27,069 326 30,177 12,613 Source: Undersecretariat of Treasury. 64. Privatization of Halk and Ziraat. With the financial and governance restructuring completed by June 2001, and operational restructuring underway in the coming months, the structural reform in this area will be sustained by shifting the focus to ownership change through effective privatization of Halk and Ziraat. In this area, the Government: (i) will appoint a Restructuring and Privatization Adviser for Halk in June, and intends to complete the full resolution of Halk, resulting in either 100 percent private ownership of the bank or merger with an acquisition of Halk by another bank in 2002; and (ii) will appoint a Restructuring Adviser for Ziraat, and intends to carry out the sale of shares in Ziraat to private sector entities resulting in majority private ownership and control (more than 51 percent) by late 2002/early 2003. 65. Vakif Privatization. Furthermore, the Government has submitted, and Parliament is expected to adopt in June, an amendment to the legislation conceming the privatization of Vakif  -35 - to allow the simultaneous sale of A and B shares. The Government also has agreed to authorize the simultaneous sale of the A and B shares. By December 2001 the Government intends to complete the privatization of all remaining Government ownership (75 percent) in Vakif, resulting in this bank becoming fully privately owned and controlled.  -36- III. TURKEY'S PUBLIC SECTOR REFORM PROGRAM 66. The Government's public sector reform program aims to underpin sustained fiscal adjustment and create the conditions for transparent and effective government. In combination with the financial sector reform program described in Section II, the public sector reform program addresses the underlying structural factors that led to the crisis, thereby trying to ensure that these conditions do not recur in the future. In particular, the program aims to break the vicious circle of inadequate public sector management leading to ever increasing public indebtedness that fuels financial sector weakness through dependency on high return government securities which in turn inflates the public debt burden. The reform aims to achieve pernanent fiscal adjustment; as well as radical improvements in public policy formulation, the framework for resource mobilization and allocation, the system of public oversight and accountability, and public sector governance. This is an agenda for modernizing the Turkish state to meet the challenges of the new century. 67. The program focuses on three critical areas, each of which has a medium-term dimension: * Implement structural fiscal policies to ensure permanent fiscal adjustment; * Launch a medium-term program of policy and institutional reforms to improve the transparency and efficiency of public expenditure management (PEM) including action to: * Improve budget preparation and execution, policy formulation, and the operational performance of public agencies, * Upgrade public accounting, procurement and audit standards to ensure financial accountability, and * Ensure prudent public liability management; and * Initiate broad based institutional reforms to improve the quality of public sector governance. 68. In each of the these areas, the Government has developed or is preparing a strategic approach to guide its actions over the next three years. * In the area of structural fiscal policies, the approach will be based on (i) a medium-term strategy for improving the tax system and (ii) a comprehensive program to adjust staffing levels in the central government and SEEs, both of which are to be prepared and adopted during the remainder of 2001. * With regard to public expenditure management, the Government has prepared a three year Strategic Framework for Public Expenditure Management Reform (Annex VII) which is annexed to the Letter of Development Policy. * In the area of public sector governance, the Government is preparing a national strategy for improving governance and combating corruption which it intends to finalize by late September and adopt and publish before the end of the year. 69. Bank support for public sector reform in Turkey is designed to take into account the complex requirements of the institutional changes that lie at the heart of this reform. The first phase focused on sustaining the fiscal adjustment and setting into motion the key change processes for institutional reform will be supported by the proposed PFPSAL and PFPSAL II.  - 37 - The PFPSAL will support measures in the following four areas: (i) implementation of structural fiscal polices to support the primary surplus targets for 2001 and beyond; (ii) initiation of the PEM reform process including preparation of key legislation to underpin improvements in financial accountability (procurement) and public liability management; and (iii) initiation of work on a national strategy to improve governance and fight corruption. These reform measures are described in more detail in the paragraphs below and in the policy matrix for the PFPSAL (Annex VI). The planned PFPSAL II, for which the benchmarks for public sector reform are given in the policy matrix, will focus on: (a) deepening structural fiscal policies paving the way for permanent fiscal adjustment; (b) implementation of the first phase of the PEM reform on a pilot basis in the 2002 budget and rationalization of the public investment program (PIP); (c) enactment of legislation on public procurement and public debt management; and (d) adoption and publication of the national anti-corruption strategy. Subsequent reform efforts, including rollout of the PEM reform, steps to adjust staffing in the government and state economic enterprises (SEEs), and deeper institutional changes in the areas of tax administration, financial accountability and public sector governance--including civil service reform--will be supported by the programmatic public sector adjustment loan (PPSAL) planned for late 2002 and possible subsequent operations beyond the timeframe of the CAS. A. Structural Fiscal Policies 70. The Government is implementing tough fiscal measures to support the revised budget for 2001. These measures supplement the original fiscal package for the 2001 budget approved in December 2000. The original package included important revenue measures including extension through 2002 of several temporary taxes, renewal of quarterly advance income tax payments, increases in motor vehicle taxes, and the re-introduction of presumptive income taxation based on living standards. The supplementary fiscal package includes significant additional revenue measures, but the main emphasis is on expenditure cuts, a major policy shift for Turkey (Box 3). The additional revenue measures including increases in the petroleum consumption tax, the VAT rates, and the contribution base and ceiling for social security contributions, were implemented in May as prior actions for the 6th and 7th Stand-by reviews. The supplementary budget for 2001 was approved by Parliament on June 15 as a condition for Board presentation of the PFPSAL and completion of the 8th Stand-by review15. 71. Looking past the immediate crisis, further effort will be needed to shift from temporary to more permanent measures in order to sustain the fiscal adjustment over the medium term. The 2001 fiscal package continues to rely heavily on temporary and ad hoc measures notably taxes introduced in the aftermath of the 1999 earthquakes, slowdowns in expenditure and across-the- board expenditure cuts. Together with increases in the VAT (3 percentage points since late 1999) and in specific commodity taxes (e.g., gasoline, vehicles and cellular phones), this may be sufficient to achieve the 5.5 percent of GNP primary surplus targeted for 2001. However, more fundamental measures will be required to reach the 6.5 percent of GNP surplus targeted for 2002 15 Further fiscal measures are being taken in the context of the 81h Stand-by review to compensate for the higher than expected increases in public sector wages and cereal support prices. These measures include: (i) additional increases in the PCT in May and June, (ii) additional increases in electricity and gas prices, (iii) increases in cigarette prices by the state tobacco company, and (iv) increase in the margin between the purchase and sales prices of the state grain company.  - 38 - and to sustain this adjustment over the medium term. These structural fiscal measures will complete and build on the results achieved under the ERL program particularly in the areas of social security reform, energy reform, and reform of agriculture support policies. Box 3: Fiscal Measures for 2001 * Increase petroleum consumption tax by 20 percent in April and 15 percent in May; thereafter tax will be increased at a rate at least equal to WPI inflation; * Increase standard and luxury VAT rates by one percentage point; * Increase, as of April, the minimum base for social security contributions by 40 percent and increase the ceiling on contributions from 4 to 5 times the niinimum base; * Maintain civil service salaries constant in real tenrns according to the current indexation system and freeze the total number of civil servants in 2001; * Negotiate two year contracts with public workers which are in line with disinflation objectives; * Adjust current expenditure, transfers and investment by less than the inflation rate in order to save 1.5 percentage points of GNP; * Cut "other current expenditure", including defense outlays, covered by article 53 of the budget law to save 0.3 percent of GNP; * Include costs of temporary credit subsidies in 2001 (0.2 percent of GNP) in the budget to avoid duty losses; * Improve prinmary position of the state enterprise sector by 1.5 percent of GNP compared to 2000 level based on the following measures: (i) increase SEEs' tariffs and prices in line with their increased costs; (ii) reduce SEEs' operating expenses in real terms; (iii) cut sugar beet quotas from 12 V2 to 11 Y2 million tons; (iv) limit the volume of support purchases of cereals and offload additional grain stocks; (v) keep agriculture support price increases in 2001 to at most targeted inflation; (vi) maintain the average price of electricity sold by TEAS at US$4.5 cents/kwh; (vii) discontinue LPG subsidies; and (viii) eliminate all discounts and exemptions on SEE products and services. In addition, the Government will continue to implement the policy of replacing up to a maximum of 15 percent of retiring personnel in the SEEs; * Slow down spending by extra-budgetary funds to save 0.25 percent of GNP relative to 2000; and * Implement measures approved in original 2001 budget as planned. 72. The Government is preparing a medium-term strategy for improving the tax system in Turkey based on a review to be carried out jointly with the World Bank. Building on the 1998 tax reform, the strategy will cover: tax administration, personal income tax, corporate income tax and the indirect tax system. The overall objective is to improve the stability, transparency and equity of the tax system. Given that the tax burden in Turkey is already in line with OECD averages, there is limited scope for increasing revenues in aggregate, but there is a pressing need to stabilize tax revenues by broadening the tax base and to improve equity by reducing the heavy reliance on commodity taxes and the VAT. Improving tax administration is a priority including automation, transparency, compliance, taxpayer services and tax audit. In an important up-front action, the Government will enact in June 2001 a tax regulation expanding the use of Tax Identification Numbers (TINs) to owners of bank accounts, users of banking services and participants in financial transactions. As part of the medium-term strategy, the MOF is preparing provisions to facilitate mergers and acquisitions in the corporate sector as the economy recovers from the crisis, as well as a special consumption tax to replace the existing system of specific excise taxes. Most of these initiatives involve complex institutional and policy changes which will take time to carry out and it is important that the changes be carefully prepared and sequenced. Adoption of the medium-term strategy will be a benchmark for PFPSAL II and its implementation will be supported by the subsequent PPSAL.  - 39 - 73. Deeper structural measures will be needed on the expenditure side as well. Credible actions will be required to adjust staffing levels throughout the central government and SEEs to a level consistent with medium-term resource constraints and the announced fiscal targets. The Government has decided that the total number of civil servants will not increase in 2001, although replacement hinrng is allowed and recruitment will continue to meet needs in the social sectors, notably education. The Government also implementing strictly the existing policy of replacing up to a maximum of 15 percent of retiring personnel in the SEEs including Turk Telekom and the enterprises in the portfolio of the Privatization Administration. Going forward, a more comprehensive approach to right sizing the public sector is urgently needed, including sustained implementation of the privatization program and wider use of early retirement incentives such as those in the telecommunications legislation adopted in May. Initiation of this program would be a benchmark for PFPSAL II and its further implementation would be supported by the PPSAL in 2002. Preparation and implementation of the program will be coordinated with the work of the ministerial committee on civil service reform (paragraph 91). B. Public Expenditure Management 74. A well functioning, transparent public expenditure management system is at the heart of effective government. On all counts the Turkish system of public expenditure management performs poorly not only in comparison to standards achieved by most industrial countries but also by the standards achieved by many developing countries. In countries as diverse as France, Australia, the United Kingdom, Sweden and New Zealand, broadly similar problems have: (i) provoked reforms to national administration that strengthen aggregate fiscal discipline, (ii) linked policies to budgets more effectively through multi-year budget frameworks and efforts to build capacity for policy formulation, and (iii) initiated longer term changes in managerial behavior and organizational culture to improve the performance of public agencies. Institutions and budget processes have been strengthened to ensure that individual agency decisions are consistent with the aggregate fiscal framework and priorities are effectively funded. Most dramatic has been the clear shift away from strong central controls over details of budget implementation. France, with a strong tradition of detailed supervision by financial controllers similar to Turkey, has introduced "responsibility centers" that provide civil servants with incentives and accountability mechanisms to improve quality of public services. 75. The key elements of the Government's multi-year strategy for public expenditure management reform are laid out in its Strategic Framework for Public Expenditure Management Reform (Annex VII) which is the basis for the agreed actions in this area under the PFPSAL and subsequent operations. The Government's strategy for reforming public expenditure management is structured around the same three objectives as pursued in other countries (commonly referred to as levels 1-3), i.e., strengthening aggregate discipline (level 1), building capacity for policy forrnulation (level 2), and improving the performance of public agencies (level 3). It is consistent with the recommendations of the PEIR. The strategy is the result of many years of internal discussion in Turkey about the need to modernize public expenditure management, particularly at the higher levels of the government bureaucracy. It also incorporates recommendations from the Fiscal Transparency Review carried out by the IMF in 2000. The strategy took final shape during two weeks of participatory discussions on the draft PEIR in Ankara. Implementing this broad PEM reform program will take several years of  - 40 - determined effort and results will not be immediate. The Government has established a high- level Steering Committee to coordinate implementation of the PEM reform including representatives of MOF, Treasury, SPO, and TCA. The Steering Committee will be expanded to include selected line ministries and agencies as needed. The reforrn focuses on three core priority areas to support the objectives mentioned above. * The first priority is to reform the processes for budget preparation and execution. This involves steps to: (i) improve the transparency and comprehensiveness of the budget in line with international standards in order to provide the informnation required for proper policy formulation and performance evaluation, (ii) strengthen the credibility of the budget preparation process, (iii) build capacity for policy formulation at all levels of government which can provide a rational orientation for the budget process and ensure that resources are allocated to policy priorities, and (iv) realize concrete improvements in the operational performance of line ministries and agencies through a progressive shift to perforrnance budgeting. * The second priority is to upgrade public accounting, procurement and audit functions to ensure adequate financial accountability. This encompasses legal changes to introduce international fiduciary standards, as well as institutional changes to build capacity to implement the new standards and shift from excessive ex ante control to effective ex post monitoring. * The third priority is to ensure prudent public liability management. This involves legal measures to establish clear lines of borrowing authority and transparent reporting of public liabilities, as well as institutional measures to build up the capacity for modern fiscal risk management. 76. Budget Reform. The Government is making good progress in improving the transparency and scope of the budget. Under the ERL program, the number of budgetary and extra-budgetary funds has been greatly reduced. As of March 2001, 46 budgetary funds and 6 EBFs had been closed. In June 2001, the Parliament is expected to adopt legislation to close 15 more budgetary funds and two EBFs. As a result, all budgetary funds, with the exception of the Support Price Stabilization Fund linked to the reform of the agriculture sales cooperative unions (ASCUs) under the ERL, and all but five EBFs will be eliminated in the 2002 budget. The Government has committed not to create new budgetary or extra-budgetary funds. 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 as a prelude to a comprehensive review of these funds during the first semester of 2002. In June 2001, the Government completed a new budget classification for consolidated budget agencies in line with new GFS standards (including full functional classification) for implementation on a pilot basis in the 2002 budget. 77. The Government is also moving to improve the credibility of the budget preparation process, including a rationalization of the public investment program (PIP). The budget preparation process is largely a formality as the central agencies essentially determine the budget allocations for the line agencies at the last minute with limited meaningful dialogue. Reflecting problems with the budget preparation process, the PIP has more projects than can be funded within a reasonable timeframe. While public investment in Turkey is not excessive at about 6- 6.5 percent of GNP, the size of the investment program is out of proportion with the available resources. At the end of 1999, the PIP consisted of 5,321 projects with an estimated cost of  -41 - US$150 billion and an unfinished balance of US$105 billion (equal to 70 percent of the estimated total cost of projects in the public investment portfolio). The SPO estimated that the 1999 portfolio would take over 10 years to complete on average, compared to 6 years in 1994. In the 2001 budget, the number of projects was reduced to 5,047 and the estimated average completion time was lowered to 9 1/3 years according to SPO. However, the over-programming problem remains senrous. This problem arises from institutional weaknesses in the budget preparation process. including initiating an excessive number of projects relative to financial resource availability, inadequate prioritization relative to plan objectives, inefficiencies due to the lack of integration between investment and recurrent budgets as well as the fragmentation of investment budgets due to earmarking revenues for specific purposes. The Government now plans to begin to tackle the problems with the budget preparation process and PIP more systematically. The High Planning Council will issue in June a decision for the 2002 budget preparation process to accompany the Prime Minister's Budget Call. The decision will: (i) provide a macro-fiscal framework for 2002 budget preparation including overall levels for the recurrent and investment budget, (ii) establish indicative ceilings for both the recurrent and investment budgets for ministries and line agencies, (iii) freeze the introduction of new multi- year projects into the PIP, except for possible emergency projects, and (iv) call for a rationalization of the PIP in the 2002 budget. The decision will include: * timetable for rationalization process, * objective of reducing expected average time to completion of the overall PIP by 20 percent in 2002 compared to the 2001 PIP along with sector-specific reductions consistent with this overall objective, * global criteria for prioritizing projects, and * instruction to ministries and line agencies to prioritize their investment programs in line with the ceilings, objectives and criteria. 78. Strengthening the budget preparation process will be a graduated action. For the 2002 budget cycle, the indicative ceilings will be based on an indexation formula applied to the actual budget allocations that each ministry and line agency received in 2001. For the 2003 budget preparation process, the Government intends to set individual indicative ceilings for each ministry and line agency based on the experience with the 2002 preparation process. As part of the PIP rationalization, the Government intends to carry out a Public Investment Review on an urgent basis and has requested support for this review from the Bank. 79. Sustained implementation of the budget reform would be supported by PFPSAL II and the follow-up PPSAL operation linked to the annual budget cycle for 2003. As benchmarks for PFPSAL II, the Government plans to do the following: * Take the remaining preparatory actions, including legal changes, required to implement the new budget classification and coding on a pilot basis in the 2002 budget; and expansion of the budget classification to cover all of general government as defined by GFS. The general government definition will include: consolidated budget agencies, local government, social security institutions, EBFs, revolving funds and autonomous agencies.  - 42 - * Adopt a satisfactory PIP for 2002, including a 20 percent reduction in the time to completion of on-going projects in the program, would be a further benchmark for PFPSAL II, together with an action plan for sustaining a rational PIP beyond 2002. * Build up the role of policy formulation in guiding resource allocation. The objective is to enhance the 5 year Plan prepared by SPO with input and action by line ministries and policy reviews by the Cabinet. As an additional benchmark for PFPSAL II, SPO will prepare guidelines for strategic planning by key line ministries and departments including guidelines for costing policies. The Government will also initiate policy reviews by line ministries and agencies to derive clear statement of objectives and expenditure priorities in preparation of 2002 budget. This will be complemented by action to revive the role of ministerial departments responsible for policy reviews with support from SPO. * Adopt a pilot program for a group of line ministries and agencies willing to volunteer for reforrns that will provide them with greater discretionary control over inputs linked to adoption of effective internal controls and commitment to improved performance. 80. Rollout of the new budget classification, based on the experience with the pilot exercise in 2001, and an enhanced preparation process for the 2003 budget--including introduction of a rolling two-year expenditure framework, would be supported by the PPSAL in late 2002. This operation would also support further efforts to build the capacity for policy formulation and implementation of the pilot program to improve operational performance. By late 2003, the core priorities of the budget reform would be well established. Together with the projected decline in inflation under the program, the stage would be set for a progressive shift to a full medium-term expenditure framework. 81. Financial Accountability. Turkey's system of public financial accountability is in need of improvement. Some of the basic building blocks appear to be in place: an established legal framework; reliable, albeit fragmented, budgeting and accounting processes; regular reporting of financial results; an apparently independent Supreme Audit Institution, the Turkish Court of Accounts (TCA), which reports to Parliament; a relatively open system of accountability and plenty of skilled personnel. But deeper analysis reveals significant problems and lack of systemic coherence. Complex institutional relationships, multiple sources of public funds, heavy emphasis on pre-spending controls and inadequate reporting to the legislature reduce transparency and weaken financial management. The accounting law which governs public sector accounting dates from 1927, and the procurement legislation has not kept up with evolving international standards. Similar to the budget, the audit system is fragmented with many bodies besides the TCA carrying out activities analogous to external inspection and audit, and the reporting relationships among these bodies are ambiguous. 82. Accounting. Action to upgrade the public accounting system is already underway with the introduction of the say2000i automated system under the Public Financial Management Project (PFMP) supported by the Bank. Under this internet based system, the Government's accounting data base will be held centrally and will contain data on all individual transactions wherever they occur in the system. Accountancies, which include some 1,500 field offices across Turkey, will access the central system for applications software and will be able to carry out their transactions on-line. Field installations for the say2000i system will be substantially completed by end-June with the objective of starting full automation for consolidated budget agencies by end-2001.  - 43 - 83. Over the next several years, reforms to the public accounting system will proceed under the PEM reform strategy. The Government will take necessary actions to revise the accounting system to incorporate the new GFS classification for the budget and to introduce accrual accounting. A phased approach is planned with the following benchmarks for PFPSAL II: * Start full automation under say2000i system for the consolidated budget agencies. * Revise Accounting Law (No. 1050) to incorporate new definition of general government and allow MOF to issue accounting standards for all general government agencies in line with new GFS classification. * Issue new modified accrual based chart of accounts consistent with GFS for general government. * Develop strategy for phased introduction of accrual accounting across general government 1 6 agencies 84. The PPSAL would support further implementation of these reforms, in particular implementation of the revisions to the accounting law--which will inter alia allow for the budget definition to be expanded to cover the full general government--and the phased introduction of accrual accounting. 85. Procurement. The Government intends to upgrade Turkey's public procurement legislation and procedures in line with international standards, and a new procurement law is under preparation. The Government has announced that the new public procurement law will be consistent with the UN's UNCITRAL standards as part of a medium-term strategy to meet full compliance with EU directives. This graduated approach is consistent with the recommendations of the Bank's CPAR. Enactment of the new procurement law in a form satisfactory to the Bank will be a benchmark for PFPSAL II, together with steps to initiate preparation of a system to define qualified contractors in line with new law. The law is expected to: (i) cover all goods, works, and services, (ii) be applicable to all central and local government agencies; and (iii) encompass both budgetary and non-budgetary procurement. The law should also cover non-commercialized SEEs. Implementation of the new legislation and related efforts to strengthen institutional capacity would be supported by the PPSAL operation, together with steps to prepare for the introduction of periodic procurement audits by TCA and publication of the results. 86. Auditing. The Government established in June a task force to develop a reform program for the public audit system. The objectives of the program are two fold. First, develop a plan of action, including necessary legal amendments, to expand scope of TCA audits to cover the entire general government including autonomous agencies, social security institutions, remaining EBFs, and revolving funds. Second, prepare a new law on internal financial control and audit in line with international standards based on a review of current control, inspection and audit processes. This new legislation will promote improvements in audit quality in line with international standards and support the shift from ex ante controls to ex post monitoring in harmony with the efforts to improve operational performance of budget agencies. The TCA will 16 Full accrual accounting is the version of accounting in which fixed assets are capitalized. Governments may adopt different bases of accounting (See International Public Sector Accounting Standards, International Federation of Accountants, New York, 2000).  -. 44 - discontinue involvement in budget execution in line with new law on internal financial control and audit. The following benchmarks for the audit reform under PFPSAL II have been established: * TCA will include all consolidated budget agencies under its annual audit as required by the Constitution, including the Presidency, Parliament and TCA. * TCA's own accounts will be subject to audit with reports submitted to the Parliament. * Government will adopt a plan of action to expand scope of TCA audits to cover the entire general government and MOF will circulate to ministries and line agencies a discussion draft of the new law on internal financial control and audit. Implementation of the law on internal financial control and the shift to performance audits would be supported by PPSAL in late 2002 and possible follow up programmatic operations in 2003. 87. Public Liability Management. The role of the buildup of quasi-fiscal and contingent liabilities in the state banks in triggering the November and February crises highlights the importance of strengthening public liability management in Turkey. In 1999, as much as 10 percent of GNP was spent on quasi-fiscal programs which were not considered or included in the budget. A growing amount of resources are committed under guarantees and other contingent commitments without going through a formal budget framework process or evaluation of risk to the budget. Action is needed to strengthen debt management and contain the spread of contingent liabilities. Regulatory reforms in the electricity sector supported by the ERL are addressing one of the main sources of contingent liabilities in the form of government guaranteed BOT contracts. State bank reform and other actions under the financial sector reform program are addressing another major source of contingent liabilities. In May, a Government decree was published and legislation is expected to be adopted in June which together will eliminate all existing legal provisions authorizing creation of duty losses in the state banks. This action will align the legal framework with the state banks restructuring law approved in December 2000. However, other important sources of contingent liabilities and quasi-fiscal losses persist, including those arising from banking sector guarantees, take-or-pay contracts for natural gas imports, non-energy BOT projects, and guarantees to municipal and local governments. 88. Future action to improve public liability management centers around the development of a comprehensive risk management framework. The Government intends to submit to Parliament in June a law on public finance and debt management satisfactory to the Bank that establishes the Treasury as the single borrowing authority for the central government. The Govermment will also initiate in June development of a comprehensive fiscal risk management framework for the general government which will be underpinned by the new law. Enactment of the public debt management law will be a benchmark for PFPSAL II. In addition, the Government will conduct a review of its guarantee portfolio and prepare a debt sustainability analysis including all identifiable contingent liabilities of the central government. Over the course of 2002, as elements of the risk management framework, the Government intends to: (i) develop guidelines for the issuance of government guarantees and for borrowing by state enterprises, (ii) implement mechanisms for monitoring government project guarantees and on-lending operations, and develop a centralized fiscal risk analysis capability; and (iii) prepare and disclose a Government Fiscal Risk Statement. These actions would be supported by the first PPSAL. The full institutional structure for the new public liability management system, including all necessary  - 45 - legal changes, should be in place by 2003, and the Government should then be in a position to issue its public liability strategy as an annex to the future medium-term expenditure framework. C. Public Sector Governance 89. Actions to improve public sector governance and reduce political influence over economic management complement and are integrated with implementation of structural fiscal policies and PEM reforrm. The Government has made major progress in improving the quality of the regulatory environment in Turkey under the ERL in energy and telecommunications, and the FSAL in the financial sector. These actions anchor the Government's efforts to depoliticize management of the Turkish economy. Recently enacted legislation for electricity (February 2001) and gas (May 2001) has established a unified independent regulator for the energy sector. In telecommunications, legislation enacted in January 2000 created an independent regulatory authority and amendments enacted in May 2001 transferred all licensing authority to this authority. On the basis of the new legislation, the Government plans to appoint a professional Board of Directors and management team for Turk Telekom in June. Successive amendments to the banking law have strengthened the Banking Regulatory and Supervision Agency established in mid 1999. These new regulatory agencies form the first pillar of the Government's program for improving public sector governance. 90. The Government has initiated preparation of a national strategy to improve governance and combat corruption which will encompass the on-going regulatory reforms and other measures which are enhancing governance including legislation under preparation to improve the code of conduct for public officials. A steering committee has been formed consisting of representatives from the Treasury, the Prime Minister's Inspection Board, the Anti-Money Laundering Unit of the Ministry of Finance, the Ministry of Justice and the Ministry of Interior. The objective is to develop a comprehensive approach to the issue which establishes clear priorities and benchmarks, and empowers and energizes public opinion to fight corruption. The strategy is viewed as integrating many on-going actions by the Government-including elements of the PEM reform--into a more systemic framework for improving governance and reducing political influence over the economy. The Government is also counting on the active involvement of national NGOs. A household diagnostic survey on corruption based on a World Bank questionnaire has been completed by TESEV and work is now beginning on a business diagnostic survey funded in part by the Bank. To help formulate the strategy, the Government plans to host two international conferences on Effective Government in collaboration with the Bank. The first, scheduled for September, will focus on anti-corruption. It will be preceeded by a workshop with key government officials on the elements of an effective anti-corruption strategy to be held in July with the participation of WBI. The second conference, scheduled for November, will focus on public management reforms linked to the PEM agenda. The steering committee expects to complete preparation of the anti-corruption strategy by end-September and its adoption and publication would be benchmarks for PFPSAL II. Implementation of the strategy would be supported by the subsequent PPSAL operation. 91. The medium-term agenda for improving public governance necessarily encompasses civil service reform. Civil service reform is vital to raising the quality of public services while adjusting aggregate government expenditure in line with medium-term resource constraints. The Government has already initiated work on a norn cadre (staffing norms) system to establish  - 46 - benchmarks for staffing in public agencies. This system is operational within the Ministry of Education. As a benchmark for PFPSAL II, the Government plans to establish a ministerial committee to carry out a full functional review of government in preparation for the civil service reform. On the basis of this review, the Government expects to present its strategy for civil service reform to the Parliament as part of the program for PPSAL in late 2002. Continued implementation of the civil service reform program could be supported by subsequent programmatic operations in the next CAS period.  - 47 - IV. THE PROPOSED LOAN A. The Bank's Financial Sector Assistance Strategy 92. Background. Turkey and the Bank have had a long relationship in the financial sector since the early 1980s through a series of SALs (I-V) during the 1980-85 period and two FSALs during the late 1980s. A number of policy and institutional reforms were undertaken during this period. The focus of both the FSALs was on financial policies, financial institutions and regulations, and money and capital markets. The FSAL programs were, however, only partially completed, as Turkey's political and economic arena remained caught up in ad hoc short term choices during most of the 1990s, making it difficult to engage in long term policy and institutional development decisions. Thus, actions on better banking regulations and supervision and on bank privatization still remained on the agenda in the late 1990s. 93. Assistance strategy. After some years of lower intensity interaction during the early and mid 1990s, the level, nature and quality of the dialogue on the financial sector policy and institutional issues between the Bank and the Government has recently substantially increased, and has been quite high during the past three years. The Asian crisis followed by the August 1998 crisis in Russia, necessitated a further review and analysis of the policy and regulatory framework and a vulnerability assessment of the banking sector. Such a review was undertaken by a Bank mission in November 1998, and based on the assessment of this mission, a financial sector reform agenda and the Bank's financial sector assistance strategy for Turkey was developed. This assistance strategy was further reviewed and updated during 1999 and early 2000 as part of ongoing sector dialogue and the new Country Assistance Strategy. Following the two recent financial crises, the sequencing of the Government's financial sector reform efforts and of the Bank's support has been amended to reflect the sector's more pressing needs, but the core assistance strategy remains unchanged.  -48 - Figure 6 - Financial Sector Assistance Program Comprehensive Banking Risk Management Non Bank Financial ankIng Workshop Corporate Sector Institutions Sector Assessment Review Review Nov. 1998 Feb. 2000 Sept. 2001 May 2002 Aug. 1999 Dec. 2000 July 2001 Dec. 2001 June 2002 June 2003 EFIL ~ FSA C FSA ,FSA !1 .PF, DSALz { FSA XI ) / F Initroduce LLP tax Implement BRSA Insti - Implement SOIF Deposit Insurance Establishing Banking Law; deductibility, Consol. tutional Dev; remove Institutional Dev.; Reform; SDIF dialogue with the creation of an connected and forex tax & legal hurdles for Resolve remaining autonomy; banking sector, independent exposure; Institutional bank m ergers; Resolve insolvent private Consomdated introducing BRSA, Strengthening of BRSA;hakmresRsovinletpiaeConodtd comprehensive risk Intervention in eliminate ovemight repos all 13 SDIF banks, Re - banks; privatizeHalk; Supervision; mateagement to 5 of Irailed banks, and re -capitalize SDIF and capitalization of pnvate new insurance law, Privatization of the largest/strongest enabingled b nSatanks,;n re-aitlie EmlFand banks by owners; Vakif Full IAS for banks, Ziraat; regulatory private banks, enabing law on State Banks; revoke Emiak Privatized, Operational listing & disclosure reform for NBFI prvso .of exot Privatization of license &merge with Ziraat; R-tuurnofiat rermor1; provisionanc e xport State banks Initiate recapitalization of & Balk 50% cornpieted reform for ISE; finance, remaining capital deficient private banks  - 49 - 94. The strategy to date has consisted of carrying out: (i) a banking sector review to determine the vulnerabilities and policy and institutional reforrns required in the sector; (ii) a bottom up financial intermediary operation, the Export Finance Intermediation Loan (EFIL), approved by the Board in July 1999, to build up dialogue and consensus for reform directly with a core group of healthy commercial banks; (iii) a comprehensive risk management workshop and Pilot Risk Management Audits of selected banks to enhance awareness in the sector of the latest developments and tools and techniques in the area of bank risk management; and (iv) a top down financial sector policy-based FSAL, approved by the Board in December 2000, to address the most pressing banking sector reform priorities. In response to the two recent crises, the proposed financial sector reform strategy going forward comprises: (a) a corporate sector assessment, currently ongoing, to determine the impact of the banking and macro-economic crises on the corporate sector; (b) the proposed PFPSAL; (c) the planned PFPSAL II; (d) a Non Bank Financial Institutions (NBFI) Review to determine the risks and vulnerabilities, as well as development priorities of the NBFI sector; and (e) two Programmable Financial Sector Adjustment Loans (PFSAL I-II) to address the remaining reform agenda in the banking sector and urgent reform priorities for the NBFI sector. Elements of the Bank's strategy of lending and non-lending assistance in the financial sector as the context for the proposed PFPSAL are presented in Figure 6 and described below: D Banking Sector Review (November 1998). The November 1998 Banking Sector Review assessed the legislative, regulatory and banking supervision infrastructure, problem bank and bank failure resolution issues, the regulations related to management of interest rate, foreign exchange, liquidity, credit, market and operational risks in the banking sector, and the restructuring requirements of the state-owned banking sector. The policy and sectoral reform recommendations of the Bank were well received by the Treasury and the Central Bank, and succeeded in laying a consensus foundation for the Government's reform effort in the sector. The sectoral review also helped in preparing a draft FSAL policy matrix, which formed the basis for FSAL preparation. * Export Finance Intermediation Loan (US$252 million, EFIL - July 1999). The EFIL was undertaken in response to the liquidity squeeze in the export sector post Russia crisis. The EFIL structure enables a strategic dialogue and close interaction with the major private commercial banks and the Bankers Association in Turkey, through setting up of stricter and upgraded prudential eligibility criteria and banking standards for capital adequacy, foreign exchange exposure, large/connected exposures and risk management systems. Besides the prudential criteria, a comprehensive review of the existing risk management systems and practices at a pilot group of five banks, intended to enhance awareness and the application of best practice standards and techniques in the management of banking risks, was carried out for the participating banks under EFIL. The EFIL therefore continues, through a bottom up sectoral consensus building approach, to complement the top down policy dialogue undertaken in the context of the FSAL and the proposed PFPSAL and follow-up financial sector loans. * Comprehensive Banking Risk Management Workshop (February 2000). This workshop was held in Istanbul under the joint sponsorship of the Bank and the Basle Financial Stability Institute, and locally hosted by the Bankers Association to discuss the latest issues related to comprehensive and dynamic risk management in the banking sector, and the regulatory  - 50 - approaches towards risk management in different countries. The workshop raised the awareness of the banking community to the critical need for a comprehensive and dynamic approach to risk management in their institutions, and facilitated the drafting of new BRSA regulations on risk management and market risk charges for capital adequacy purposes (see paragraph 36). * Financial Sector Adjustment Loan (US$778 million, FSAL - December 2000). The FSAL focused on strengthening the legislative, regulatory and supervision infrastructure for banks, updating bank prudential regulations to EU/Basle standards, strengthening problem bank and bank failure resolution capacity, and initiating the restructuring! privatization of state-owned banks. Following the November 2000 and February 2001 banking crises, part of the conditionality for the second tranche of the FSAL was overtaken by events, especially the conditionality for the sale of one of the state banks (Vakif). Other FSAL second tranche conditions remain highly relevant, however, and have been incorporated in the policy matrices for the proposed PFPSAL and the planned PFPSAL II. Simultaneously with Board approval of the proposed PFPSAL, the Government will request cancellation of the second tranche of the FSAL. * Corporate Sector Assessment (May-September 2001). In response to the November 2000 and February 2001 banking and macro-economic crises, the Bank is undertaking a corporate sector assessment to determine the impact of the crises on private sector enterprises. The findings of this assessment and relevant policy recommendations, if any, will be incorporated in the design of the planned PFPSAL II and the PFSAL I and II. D Programmatic Financial and Public Sector Adjustment Loan (US$1.1 billion, PFPSAL - July 2001). As part of the Bank's immediate crisis response effort, the proposed one tranche PFPSAL, covering the most urgent banking system reform and restructuring actions, is presented to the Board for approval. * Second Programmatic Financial and Public Sector Adjustment Loan (US$1.35 billion, PFPSAL II - December 2001). Following the proposed PFPSAL, the PFPSAL II will support the further deepening of the Government's banking system reform and public sector restructuring efforts. * Non Bank Financial Institutions (NBFI) Review (Fiscal 2002). A fornal non bank financial institutions review will be undertaken during fiscal year 2002, to analyze the existing development issues and future reform priorities related to: (i) financial markets-- Government securities, money markets, bond markets, equities, commodities and derivatives; and (ii) non bank financial intermediaries like securities firms, investment companies, contractual savings institutions such as insurance companies, mutual funds and pension funds, and the near-banks like leasing, factoring and consumer finance companies. The review will also assess the cross linkages between the banking system and the capital markets and NBFI segments of the financial sector, and identify key reform measures necessary to mitigate the risks arising from such cross linkages and eventual rapid capital markets/NBFI growth in response to the lasting macro-economic stability. The findings of this review will serve as inputs into the design of the planned PFSAL I and II. * First and Second Programmatic Financial Sector Adjustment Loan (US$500 million each, PFSAL I and II - Fiscal 2002-2003). The planned PFSAL I and PFSAL II will build up on the proposed PFPSAL and the planned PFPSAL II. The two PFSALs will address the remaining reform agenda in the financial sector, especially issues related to: (i) the completion of the state bank privatization agenda, (ii) deposit insurance reform; (iii) the  - 51 - development of consolidated financial sector regulatory and supervisory infrastructure; and (iv) regulatory issues related to capital markets, insurance and other non-bank financial institutions like leasing, factoring, mutual funds and private pension funds. B. The Bank's Public Sector Assistance Strategy 95. Background. The current assistance program for public sector reform draws on earlier efforts. In particular, the PFMP project approved in 1995 supported an ambitious agenda to improve the quality of public financial management in Turkey. This project has achieved considerable results in modernizing Turkey's customs service and improving the debt and cash management functions in the Treasury. It also supported design and development of the say2000i automated accounting system. However, the PFMP has been less successful in catalyzing improvements in tax administration and public expenditure management as had been originally envisaged. Political support for these objectives was not adequately secured and bureaucratic inertia eventually set in. The tax and PEM measures supported by the project were seen by many in the government as technical fixes of limited significance in the absence of a broader reform vision for the public sector. Drawing a lesson from this experience, the current assistance strategy aims to support a comprehensive medium-term program to modernize the public sector for which political support has been obtained in advance from the highest levels of government. In addition, the motivation for the reform has been made crystal clear by the crisis: without deep structural changes to the way the public sector operates in Turkey, financial stability and sustained growth will remain elusive goals. 96. The public sector assistance strategy is multi-faceted. Work to date has comprised preparatory economic and sector work, and implementation of a first phase of measures to support public sector reform under the ERL. The ESW includes: (i) the CEM which confirmed the public sector deficit as the core source of macroeconomic instability in Turkey and detailed reforms in support of fiscal adjustment and growth, (ii) the PEIR which presents an in-depth diagnosis of the operational and institutional problems confronting public sector management and outlines a strategic framework for reform, and (iii) the CPAR and CFAA which review the current legal framework and procedures for financial accountability in Turkey and develop recommendations for reform. The ERL program has supported implementation of the reform agenda for social security, energy, agriculture and telecommunications which help underpin the fiscal adjustment and contain the growth of quasi-fiscal and contingent liabilities. The ERL also supported a first set of budget reform measures including legislation to close the first two groups of budgetary and extra-budgetary funds in December 1999 and March 2001. The proposed assistance strategy going forward comprises: (a) a first international conference on Effective Government focused on anti-corruption scheduled for September and a second conference focused on public sector management scheduled for November; (b) the proposed PFPSAL; (c) the planned PFPSAL II; and (d) a Programmatic Public Sector Adjustment Loan (PPSAL) to support continued implementation of the reform agenda. A second PPSAL is tentatively envisaged in late 2003 beyond the current CAS period. Elements of the Bank's strategy of lending and non-lending assistance in the public sector as the context for the proposed PFPSAL is presented in Figure 7 and described below:  - 52 - Figure 7: Public Sector Assistance Program Publc Expendiure and CEM: Structural Institutional Review rence on on n Reforms for Effective Effective Country Financial Sustainable Growth Country Procurement Govemment Govemment Accountability Assessmen Report I ssessment September 2000 June 2001 September 2001 November 2001 May 2000 July 2001 December 2001 December 2002 December 2003 P AL +ossi b ERL PFPSAL PFPSAL 11 PPSAL I ~~~~~~~~~~~~~PPSAL II Fiscal packages for Urgent supplementary Fiscal package to underpin Implement strategy to Implement program to 2000-01; public fiscal package for 2001; 2002 budget; Complete improve tax system; adjust staffing levels in pension reform Adopt medium-term first phase of PEM reform Deepen PEM reform central government and implemented; strategy for PEM reform including steps to: expand agenda including measures SEEs; Further deepening regulatory agencies and take action to: close 15 GFS classification to to: implement new GFS of PEM reform including for remaining budgetary funds general govemment and classification on a pilot steps to: rollout new GFS telecommunications and 2 more EBFs, initiate intToduce new chart of basis, launch pilot program budget classification to all and energy new GFS budget accounts, adopt to improve operational consolidated budget established; 46 classification, launch PIP rationalized PIP for 2002 performance, and develop agencies, continue budgetary funds rationalization, submit new budget, and enact new comprehensive risk program to improve and 6 EBFs closed. public debt management public procuremcnt and management framework; operational performance, law to Parliament; Prepare debt management laws; Prepare civil service and enact new law on national anti-corruption Adopt and publish national reform strategy. internal control and audit; strategy. anti-corruption strategy. Initiate civil service reform.  - 53 - * Economic Reform Loan (US$760 million, May 2000). The following public sector reform actions have been carried out under the ERL program: * fiscal packages introduced to underpin the 2000 and original 2001 budgets, * major reform to the public pension system carried out, voluntary pension pillar introduced, and reform of agriculture support policies started; * regulatory agencies for telecommunications and energy established; and * a first set of budget reform measures taken including: (a) closure of 46 budgetary funds and 6 EBFs, (b) limits established on the introduction of new projects into the public investment program, and (c) a public registry of government guarantees and limits on the issuance of new guarantees established. * Country Economic Memorandum (September 2000). The CEM analyzed the structural sources of the public deficits including the build-up of quasi-fiscal and contingent liabilities in the energy, banking and other sectors. The report presented in detail the Government's program of structural reform covering social security, energy, agriculture, banking and telecommunication, and outlined the agenda for further reform in a number of key areas. It demonstrated how these reforms would support sustained fiscal adjustment. * Public Expenditure and Institutional Review (expected June 2001). The PEIR, prepared under the ERL program, presents the findings of a detailed analysis of the budget and institutions of public expenditure management and public accountability which are fundamental to policy decisions and economic management in Turkey. The review suggests that the current economic crisis has deep roots in the institutions of collective decision making in government. It shows that radical improvements to the manner in which public policy is determined are needed, that the processes which govern the decisions regarding resource allocation and budget implementation must be improved, and the transparency and Parliamentary oversight over the whole process must be increased. The PEIR is a joint collaboration with the Government. A series of participatory workshops on the report held with the Government in May 2001 were instrumental in shaping the Government's medium- term strategy for PEM reform. * Country Procurement Assessment Review (expected June 2001) and Country Financial Accountability Assessment (under preparation). These reports analyze the current legal and institutional framework in Turkey for financial accountability and develop recommendations for reform in line with international standards. They form the backbone of the Bank's due diligence work on fiduciary issues in Turkey. * First International Conference on Effective Government (September 2001). The first conference on effective government will be co-hosted in September by the Government and World Bank with support from WBI. The theme was good governance and fighting corruption. It provided an opportunity to present and discuss international experience with developing anti-corruption strategies, and provided the Government with a forum to express its commitment to combating corruption in Turkey. It also involved local NGOs including TESEV which presented the results of its household survey on corruption issues. The results of the conference will help the Government to formulate its national strategy. * Programmatic Financial and Public Sector Adjustment Loan (US$1.1 billion, PFPSAL - July 2001). The proposed one tranche PFPSAL will cover: * implementation of urgent additional fiscal measures to meet the post-crisis macro targets for 2001, * launch of a medium-term reform program to improve public management,  - 54 - * preparation of a national strategy to improve governance and tackle corruption. * Second International Conference on Effective Government (November 2001). The second international conference will serve as a venue to disseminate the PEIR findings and strategic framework for PEM reform to both national and international audiences. It will also help expose government officials to broader international experience with public sector management reforms. The results of the conference will help the Government to fine tune its program to be supported by the planned PFPSAL II and subsequent PPSALs. * Second Programmatic Financial and Public Sector Adjustment Loan (US$1.35 billion, PFPSAL II - December 2001). Following the proposed PFPSAL, the PFPSAL II will support continuation of Turkey's public sector adjustment and reform effort. Key benchmarks include: * implementation of a fiscal package to underpin the 2002 budget; * completion of first phase of PEM reform including further action to improve budget consolidation, rationalization of public investment program, and enactment of legislation to introduce international procurement standards and strengthen public liability management; and * adoption and publication of national strategy to improve governance and combat corruption. * Programmatic Public Sector Adjustment Loan (US$375 million, PPSAL - Fiscal 2003). The planned PPSAL will build on the progress on public sector reform achieved under PFPSAL and PFPSAL II. Benchmarks for the PPSAL include: * implementation of a comprehensive strategy to improve tax system as part of the effort to consolidate the fiscal adjustment; * steps to deepen the PEM reform agenda including implementation of the new GFS budget classification on a pilot basis for consolidated budget agencies, implementation of the pilot program to improve operational performance, and development of a comprehensive risk management framework; and * continuing efforts to improve public sector governance including preparation of a strategy for civil service reform. * Possible second Programmatic Public Sector Adjustment Loan (PPSAL II Fiscal 2004). A possible PPSAL II in the next CAS period would support further deepening of the public sector reform agenda including: (i) implementation of a program to adjust staffing levels in central government and SEEs, (ii) rollout of the new GFS budget classification to all consolidated budget agencies and further implementation of the program to improve operational performance, (iii) implementation of the new law on internal financial control and audit, and (iv) initiation of civil service reform. C. PFPSAL Objectives and Description 97. The main objective of the proposed PFPSAL is to address the Government's immediate financial and public sector reformn priorities in the aftermath of the November 2000 and February 2001 banking system and macro-economic crises, including, in the financial sector: (i) overhaul of the regulatory framework for banking activity; (ii) institutional development of the new Bank Regulation and Supervision Agency (BRSA); (iii) problem bank/bank failure resolution; and (iv) state bank restructuring and privatization; and in the public sector: (i) structural fiscal policies;  - 55 - (ii) public expenditure management; and (iii) public sector governance. The PFPSAL will provide budgetary support to help the Government finance the costs arising from the crisis while continuing to fund its critical social programs. The subsequent PFPSAL II and follow-up programmatic operations in the financial and public sectors will support a sustained effort by the Government to carry out this complex reform agenda. 98. Partial Front-end Fee Waiver. The Government of Turkey has requested a waiver of part of the front-end fee on the proposed PFPSAL in consideration of the fee already paid on the FSAL, the second tranche of which is to be cancelled and folded into the PFPSAL. The standard front-end fee for FSAL amounted to US$7,777,800 which was capitalized into the loan amount of US$777.78 million and paid to the Bank by Turkey from the first tranche disbursement of US$392,778,900 on December 22, 2000. Following the February crisis, the financial sector reform program is now broader than envisaged at the time FSAL was prepared, and some elements originally expected to be part of a later operation have been brought forward, while the phasing of some other actions has changed. As the second tranche amount of the FSAL is being folded into the new larger financial sector reform programmatic operation, US$3.85 million of the front-end fee of PFPSAL would be waived. This amountFN is equivalent to the front-end fee paid for the second tranche of FSAL which will be cancelled. The request for this waiver is justified on the basis that the second tranche of FSAL will be cancelled as a result of a revision of the Bank's assistance strategy and lending program for Turkey to which the Bank and Turkey agreed on the basis that the remaining substantive implementation of FSAL would take place within the context of the programmatic approach to financial sector reform. D. Benefits and Risks 99. Benefits. The principal benefits of the Loan will be to: (i) restore confidence in the banking system and in the Government's ability to implement and sustain the required sizeable fiscal adjustments following the November 2000 and February 2001 crises; (ii) strengthen the foundation for an efficient and sound banking system which can be competitive in quality and performance at the international level; (iii) reduce the vulnerability of the banking system and enhance its capacity to withstand external shocks and thereby reduce systemic failure risk; (iv) position Turkey's banking sector for EU accession by starting the process of aligning the prudential regime for the banking system with applicable EU banking sector directives; (v) support urgent fiscal measures to respond to the crisis while ensuring that social spending is protected; (vi) lay the foundation for permanent fiscal adjustment which ensures a sustainable path for the public sector debt and prevents a recurrence of the conditions which led to the current crisis; and (vii) modernize the public sector through action to improve management of public expenditure and liabilities, ensure financial accountability in line with international standards, and raise the quality of public sector governance. 100. Risks. The risks associated with the financial and public sector reform program are extensive, but are outweighed by the benefits of the reforms and the risks of not proceeding. Were the Bank not present, it is likely that the Government would have great difficulty FN Pending approval by the Executive Directors, US$3.85 million of the front-end fee would be waived on an exceptional basis (see paragraph 98).  - 56 - sustaining implementation of such a complex and difficult reform program. The program incorporates significant mitigation measures. However, given the severity of the crisis and extent of the structural and institutional reforms required, the risks cannot be fully offset in advance and the program will be subject to continued uncertainty as events unfold on the ground. The three main risk factors are: * unstable macroeconomic conditions arising from the crisis, * a potential loss of consensus for political or social reasons, and * institutional challenges in implementing the program, including the risk of regulatory forbearance. 101. Macroeconomic risks. The crisis has generated a massive internal shock and it will take time to restore stability to the financial markets under even the most optimistic scenario. The key macroeconomic risk is that actual real interest rates will remain higher than programmed which would affect the sustainability of the public debt and create the conditions for renewed instability. A critical factor in achieving the projected sustained decline interest rates from the levels immediately following the February crisis is the ability of the Government to restore investor confidence and contain inflationary expectations. This will have to be achieved first and foremost by maintaining the overall credibility of the program and its political leadership, and effectively tackling the core structural weaknesses in the banking and public sectors. Given the large increase in public debt arising from the crisis, an important near-termn risk is that of possible shortfalls in raising resources to finance the restructuring of the state banks and the resolution of the SDIF banks. The Government's market friendly reform strategy and the large package of exceptional external financing from the IFIs are designed to mitigate this risk by rebuilding confidence. Confidence will also be helped by the fact that the Government has now outlined a detailed medium-term program for addressing the structural weaknesses in the financial and public sectors which have built up over many years. However, the Treasury will still have to roll over an estimated US$ 35 billion in the domestic bond market during the remainder of 2001 and the risks involved in this roll-over remain very high. Fiscal discipline and efforts to rebuild the confidence of domestic and international investors in Turkish sovereign debt instruments will be essential to mitigating this risk. One measure that the Government has undertaken is a swap of existing short-term TL securities for longer-term FX-indexed bonds. However, the scope for this type of operation is limited given the need to avoid the assumption of excessive foreign exchange risk by the Treasury. Acceleration of the privatization program supported by the ERL will be important to generate resources to reduce the public debt. Economic activity has slowed sharply since the crisis and a deeper-than-expected recession in 2001 is a distinct possibility. The actual pace of recovery of the economy will depend heavily on the Government's ability to sustain an aggressive pace of reform. The fragility of Turkey's banking sector and public finances will take years to correct even under the most optimistic scenario, and the country will remain vulnerable to internal and external shocks over the medium term. 102. Political and social risks. The financial and public sector reforms pose major political challenges to the Government and there are certain social risks as well. 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 timely delivery of the reform program and awareness of this is  - 57 - keeping the Government focussed on rapid implementation. At the same time, sustained implementation of the reforms will continue to test the coalition. The commercialization and privatization of the state-owned banks will be a major political hurdle for the Government. The closure of Emlak and the privatization of Halk and Ziraat will have social implications as their workforces are downsized, although this is mitigated to a significant extent by the relatively extensive social protection programs for civil servants and public sector workers. The reform agenda for the public sector is also politically sensitive. Institutional change may be jeopardized by resistance of vested interest groups that would prefer to maintain the status quo. To mitigate this risk, the program relies on strong consensus and up-front ownership of the strategy by the Government and in particular key ministries. Sustained fiscal adjustment will have social costs and incomes policy and action to adjust staffing levels in the public sector will be particularly sensitive. The Government is trying to mitigate this risk by strengthening its social protection programs and dialogue with key social partners including under the newly formalized Economic and Social Council. Of course, the social risks of the Government's broader economic reform program are substantial and cannot be fully mitigated despite efforts to protect social spending and improve targeted social assistance. One further initiative that the Government has taken is to reintroduce credit subsidies on a temporary basis for 2001 only, fully funded in the supplementary budget under the ceilings agreed with the IMF, to ease the burden of the crisis on farmers and small businessmen. Analytical work undertaken by the Bank points to families with multiple children who are dependent on informal employment as particularly likely to fall through the cracks. However, this group will also be among the first to benefit from the economic recovery targeted by the reform program. To help build and sustain social consensus for the program during the tough initial austerity phase, the Treasury and CBT are strengthening their public information and outreach efforts. 103. Implementation risks. The complex reforms which make up the program will challenge the institutional capacity of the administration. In the financial sector, the BRSA has made impressive strides as explained in Part II, but must continue to build up its implementation capacity. The program includes support to the BRSA and SDIF, but their learning curves will continue to be steep and tested by the crisis. Crisis management efforts at key Government agencies such as the MOF, SPO and Treasury may deflect attention from slower moving public sector reforms. Institutional capacity constraints are likely to be a serious obstacle to public sector reform implementation at all levels of government. The need for extensive institution building and training to move ahead with public sector reform is one of the major rationales for the programmatic approach proposed by the Bank. The Bank will continue to provide intensive technical support for key public sector reform measures: for the remainder of 2001 this will include support for the development of the strategy for improving the tax system and for the Public Investment Review. Further technical support will be provided in 2001 and the Bank stands ready to consider financial support for selected institution-building initiatives linked to the program. 104. Regulatory forbearance. Satisfactory and timely failure resolution efforts by the SDIF (for already intervened banks) and enforcement of capital restoration plans by the new Bank Regulation and Supervision Agency for non-intervened banks are important. There is a risk that such efforts will fall short of what is needed due to political pressure that may be put on these agencies for a slow-down of regulatory enforcement action and general regulatory forbearance. To mitigate these risks, the proposed program has specifically focused on strengthening both the  - 58 - monitoring and enforcement functions of the BRSA. The monitoring of capital adequacy and foreign exchange exposure of banks will become more frequent: on a monthly basis rather than quarterly basis. An early risk warning system will be upgraded as part of the institutional development program and the BRSA. The Bank is providing direct technical assistance with its own bank specialists in this area. On the enforcement side for private banks, the BRSA will have identified and entered into closely monitored capital restoration plans of capital deficient banks prior to the Board presentation of this loan. This will significantly reduce the risk of regulatory forbearance. E. Board Conditions 105. The PFPSAL is a single tranche loan. All of the actions listed below will have been completed prior to Board presentation. For further details see the policy matrix (Annex VI). I. Macroeconomic Environment * Satisfactory macroeconomic framework consistent with the core objectives for 2001 including positive GNP growth during the second semester, inflation of 2 percent per month and nominal interest rates of 50-55 percent by the end of the year, and a primary surplus for the consolidated public sector of 5.5 percent of GNP. * Approval of a satisfactory supplementary budget for 2001 consistent with the Government's macroeconomic objectives which also ensures satisfactory expenditure envelopes for health, education and social protection. II. Banking Reform A. Regulatory Framework for Banking Activity: - The Parliament to enact a banking law amendment: (i) allowing full tax deductibility of all specific loan loss provisions required by the BRSA effective for the year beginning January 1, 2001, and (ii) allowing application of connected exposure limits on a consolidated basis while retaining the existing phase-in period in the law for connected exposures to reach EU limits, and introducing separate exposure limits for equity investments in non-financial subsidiaries in line with the applicable EU Directive, with a phase-in period satisfactory to the Bank. * The BRSA to: (i) reissue the existing loan loss provisioning rule issued by the Council of Ministers as a BRSA regulation, and to apply the loan loss provisioning regime uniformly to Ziraat also, thereby de facto lifting the exemption from specific provisioning for Ziraat's agricultural support loans; (ii) issue a definition of connected exposure in line with the applicable EU directive and to apply this definition and maximum exposure limits on a solo and consolidated basis; and the interim targets and time-table for banks to reach compliance with the new banking law limits on non-financial equity exposures; (iii) amend the solo and consolidated capital adequacy regulations to change the reporting frequency for the capital base constituting the denominator of the FX exposure limit from quarterly to monthly; and the consolidated FX position reporting rule to change the reporting frequency from quarterly to monthly, both with effect as of January 1, 2002.  - 59 - * The BRSA and any banks out of compliance with the new connected lending and non- financial equity exposure limits has agreed to finalize by August 31, 2001 on time-bound action plans to reach compliance. * The Government to set up a committee comprising representatives of the Treasury, the BRSA, the CBT, the CMB and the MOF to recommend measures (for example, setting a minimum allowable size for repo transactions, setting a liquidity requirement for repos, adjusting withholding taxes based on the length of liability maturities, etc.) to reduce the risks caused by excessive use of retail repos/short-term liabilities in the banking sector. B. Institutional Development of the BRSA: * The BRSA to develop, and the BRSA Board to approve, a time-bound strategic plan with clearly assigned implementation responsibilities with the objective of (i) having a comprehensive human resource policy further assimilating its staff from different sources and strengthening the staff training program; (ii) integrating the existing multiple databases into a common database and a common platform for analyzing and assessing banking risks; (iii) upgrading/developing procedures manuals for all major existing BRSA units; and (iv) introducing the concept of relationship supervision with offsite examiners, enforcement staff and Sworn Bank Auditors working in teams on individual banks. C. Problem Bank/Bank Failure Resolution: * The BRSA to identify all capital deficient banks in the system, and to agree capital restoration plans with these banks, or to initiate appropriate resolution action. * Treasury in co-operation with the CBT to inject into the SDIF banks enough: (i) marketable Government securities (in TL and FX) in a mix of maturities and currency denominations carrying quarterly floating rate market-based coupon interest to ensure that the banks have sufficient liquidity to operate and honor any deposit withdrawals, and to recapitalize the SDIF banks up to 0 percent capital adequacy; and (ii) cash (in lieu of the Government securities above) to retire at least two thirds of all on and off balance sheet overnight high cost liability funding of the SDIF banks outstanding on March 16, 2001 (excluding liabilities to the CBT); and the CBT to subsequently mop up excess liquidity through open market operations within an overall ceiling on the stock of repurchase agreements of the SDIF and state-owned banks with the CBT by end May of TL 7 quadrillion. * The SDIF to: (i) hire additionally required staff for its Collection Department; (ii) receive approval from its Board to allow the transfer of 1,166 problem loan files above TL 75 billion of Sumer to the Collection Department; (iii) transfer 150 problem loan files above TL 75 billion of Sumer to the Collection Department. * The SDIF to select a second 'transition bank' if necessary due to overload at Sumer, and in the absence of a sale, to arrange for the revocation of these banks' licenses by the BRSA, and to initiate the merger of Turk Ticaret, Es, Inter and Eti with either one of the transition banks; even if any of these banks are not merged with a transition bank, their licenses will be revoked and liquidation initiated.  - 60 - D. State Bank Restructuring and Privatization: * Treasury in co-operation with CBT to inject into Ziraat and Halk enough: (i) marketable Government securities in a mix of maturities and currency denominations carryirg quarterly floating rate market-based coupon interest to ensure that the banks have sufficient liquidity to operate and honor any deposit withdrawals, and to write off all remaining duty loss claims and recapitalize the two banks up to at least 8 percent capital adequacy; in addition, all already existing Government securities in the books of these two banks to be reissued in uniformity with the new set of securities as necessary; and (ii) cash (in lieu of the Government securities above) to retire at least two thirds of all on and off balance sheet overnight high cost liability funding of the two state banks outstanding as of March 16, 2001 (excluding liabilities to the CBT), and the CBT to subsequently mop up excess liquidity through open market operations within an overall ceiling on the stock of repurchase agreements of the SDIF and state-owned banks with the CBT of TL 7 quadrillion as of end May 2001. * The Govemrnent to appoint a new independent professional Governing Board for Halk Bank and Ziraat Bank with the mandate to manage these banks in accordance with commercial principles and all prudential guidelines under the banking law/issued by the BRSA; and the Governing Board to initiate operational restructuring of the two banks, including the closure of unprofitable branches and the reduction of redundant staff. * The Governing Board to appoint a Restructuring Adviser for Ziraat Bank and a Restructuring and Privatization Adviser for Halk Bank. * The Parliament to adopt amendments to law 6219 concerning the privatization of Vakif to allow the simultaneous sale of A and B shares, and the Govermment to agree to authorize the simultaneous sale of the A and B shares. III. Public Sector Reform A. Structural Fiscal Policies: * Introduce a supplementary fiscal package consistent with the revised fiscal targets for 2001 including: > Increase in the petroleum consumption tax (PCT) by at least 15 percent in May, following a 20 percent increase in April, and subsequent full implementation of the indexation regulation for the PCT adopted in 2000; > Increase in standard VAT rate from 17 to 18 percent and in luxury rate from 25 to 26 percent; > Increase in the minimum base for social security contributions by 40 percent and increase in the contribution ceiling from 4 to 5 times the minimum base in line with existing regulations; Full pass through by SEEs of cost increases due to exchange rate adjustments and the revised inflation targets; and f Adjustment of agriculture support prices in line with the agriculture reform program supported by the ERL. * Enact tax regulation to expand the use of Tax Identification Numbers (TIN) to owners of bank accounts, users of banking services and participants in financial transactions.  - 61 - * Announce that the total number of civil servants will not increase in 2001 and commit to implement strict policy of replacing up to a maximum of 15 percent of retiring personnel in the SEEs including public banks, Turk Telekom and enterprises in the portfolio of the Privatization Administration. B. Public Expenditure Management: * Establish high-level Steering Committee to coordinate implementation of the PEM reform including representatives of MOF, Treasury, SPO and TCA, and selected line ministries and agencies as needed. * Adopt legislation to close the remaining 15 budgetary funds and two extra-budgetary funds (EBFs); as a result, all budgetary funds (with the exception of the Support Price Stabilization Fund linked to the ASCU reform) and all but five EBFs (SSF, Defense Fund, Promotion and Publicity Fund, SDIF, and the Privatization Fund) will be eliminated in the 2002 budget; no new budgetary or extra-budgetary funds will be created. * Complete new budget classification for consolidated budget agencies in line with new GFS standards (including full functional classification) for implementation on a pilot basis in the 2002 budget. - Issue a High Planning Council Decision for the 2002 budget preparation process to accompany the Prime Minister's Budget Call. The decree will: (i) provide a macro-fiscal framework for 2002 budget preparation including overall levels for the recurrent and investment budget, (ii) establish indicative ceilings for both the recurrent and investment budgets for ministries and line agencies, (iii) freeze the introduction of new multi-year projects into the PIP, except for possible emergency projects, and (iv) call for a rationalization of the PIP in the 2002 budget. The decision will include: f timetable for rationalization process, > objective of reducing expected average time to completion of the overall PIP by 20% in 2002 compared to the 2001 PIP along with sector-specific reductions consistent with this overall objective, > global criteria for prioritizing projects, and F instruction to ministries and line agencies to prioritize their investment programs in line with the ceilings, objectives and criteria. C. Financial Accountability: * Substantially complete field installations for the say2000i computerized accounting system with the objective of starting full automation for consolidated budget agencies by end-2001. * Announce that new public procurement law to be submitted to Parliament by mid- October will be fully compatible with UNCITRAL standards as a first step towards full compliance with EU directives. * Establish task force in coordination with Steering Committee to develop an audit reformn program encompassing: (i) a plan of action, including necessary legal amendments, to expand scope of TCA audits to cover the entire general govemment including autonomous agencies, social security institutions, remaining EBFs, and revolving funds,  - 62 - and (ii) preparation of a new law on internal financial control and audit in line with international and EU standards based on a review of current control, inspection and audit processes. D. Public Liability Management: * Enact COM decree and adopt legislation to eliminate all existing legal provisions authorizing creation of duty losses in the state banks. * Submit to Parliament a satisfactory law on public finance and debt management that establishes the Treasury as the single borrowing authority for the central government, and initiate development of a comprehensive fiscal risk management framework for the general government. E. Public Sector Governance: * Initiate preparation of a national strategy to improve governance and combat corruption. F. Effectiveness Condition 106. The PFPSAL has one special condition of effectiveness which the Government is committed to meet by July 15, 2001. The condition is in the area of state bank restructuring and relates to the closure of Emlak Bank which the Government has determined will require the prior passage of legislation. The effectiveness condition is related to the item in sub-section D of Section II on Banking Reform as follows: "UI. Banking Reform D. State Bank Restructuring and Privatization: * The Government to complete the transfer of all construction-related assets on the books of Emlak to the Mass Housing Administration, and to complete the merger of all banking liabilities and all performing banking assets of Emlak with Ziraat and Halk, Emlak's banking license to be revoked and the Government to provide sufficient capital to Ziraat and Halk in the form of marketable Government securities carrying quarterly market- based floating rate coupon interest to allow them to absorb all losses related to Emlak's merger, including the issuance of Mass Housing Fund securities to Emlak in lieu of the construction related assets transferred to the MHA on a short-term basis to be exchanged with Treasury securities within 2001." G. Triggers for the Follow-up Programmatic Loans PFPSAL II, PFSAL I & II and PPSAL I & II; and Program Outcome Indicators. 107. In view of the fact that the planned financial and public sector reform program would be supported by the Bank through a series of Programmatic Adjustment Loans, there is a certain flexibility in the final conditionally for each loan based on actual developments in the relevant sectors. However, while retaining this flexibility, there are some critical necessary conditions  - 63 - (program triggers) to be implemented in any event to ensure that the reform program is implemented in line with the agreed program. These necessary conditions or triggers for the follow up programmatic loans have been presented in Table 8 below along with the reform outcome indicators. For the public sector reform component, the triggers will be refined as the program moves forward and the set of specific outcome indicators will be expanded in collaboration with the Government. The Government is committed to meeting all of the benchmarks for PFPSAL 11 in the policy matrix in Annex (VI). H. Financial Management 108. The Undersecretariat of Treasury will have in place adequate accounting and financial management reporting systems for the Deposit Account. The Treasury will maintain records of all transactions under the loan in accordance with sound accounting practices. The Government will submit to the Bank a monthly receipts and payments account showing the transactions on the Deposit Account, starting with the receipt of Bank funds and ending when the balance on the Deposit Account has been reduced to nil. The Borrower shall: (a) have the Deposit Account audited in accordance with appropriate auditing principles consistently applied by independent auditors acceptable to the Bank; (b) furnish to the Bank as soon as available but in any case not later than four months after the date of the Bank's request for such audit, a certified copy of the report of such audit by said auditors of such scope and in such detail as the Bank shall have reasonable required; and (c) furish to the Bank such other information concerning the Deposit Account and the audit thereof as the Bank shall have reasonably requested. The audit will be carried out at quarterly intervals as agreed with the Bank, calculated from the date funds are paid into the Deposit Account, with suitable adjustments of timing depending on the funds left in the Deposit Account at any point in time. The terms of reference for the audit will be agreed between the Bank and the Borrower. Audits would end once all funds have been transferred from the Deposit Account. In addition to the above, the Bank may request that its own staff (or a specialist contractor working on its behalf) carry out special reviews of the Deposit Account. If, after deposit into the Deposit Account, the proceeds of this loan are used for ineligible purposes, the Bank will require the Borrower to either: (i) return that amount to the account for use for eligible purposes; or (ii) refund the amount directly to the Bank.  - 64 - Table 8: Program Triggers and Outcome Indicators Area Triggers Outcome Indicators PFPSAL II (end 2001) PFSAL I & PPSAL 1(2002) PFSAL 11 & Possible PPSAL II (2003) Macro- Satisfactory budget for 2002 is adopted Satisfactory budget for 2003 is Satisfactory budget for 2004 is Actual public expenditure on health, framework which is consistent with the Government's adopted which is consistent with the adopted which is consistent with the education and social protection is macroeconomic objectives and ensures Government's macroeconomic Government's macroeconomic sustained at pre-crisis levels. The satisfactory expenditure envelopes for objectives and continues to allocate objectives and continues to ensure benchmarks, as shares of GNP, are health, education and social protection. satisfactory expenditure envelopes for satisfactory expenditure envelopes * education: 4.25%, health, education and social for health, education and social * health: 3.25% protection. protection. * social protection: 7.0%. Financial BRSA Institutional Development Plan New FX & connected exposure limits Consolidated Supervision introduced. Effective Independent Banking Sector Implemented. New FX & connected applicable during 2003 effectively Regulation and Supervision Capacity exposure limits applicable during 2002 enforced, with non-compliant banks created. FX and connected exposure effectively enforced by BRSA, with non- under explicit enhanced supervision. regulations are aligned with compliant banks under explicit enhanced international norms (best practice). supervision. Banks in general compliance with applicable FX and connected exposure regulations. Consolidated Supervision achieved All capital deficient banks identified, and All banks unable to implement their All the non intervened banks have a capital restoration plans for these banks capital restoration plans satisfactorily minimum risk weighted Capital enforced by BRSA or banks unable to intervened and resolved. Adequacy Ratio of at least 8%. implement these plans intervened by the SDIF. SDIF to sell, merge or close the five SDIF to sell, merge or close any Deposit Insurance Reform, SDIF Restructuring of troubled private remaining banks (Sumer, Demir, Iktisat, remaining identified capital deficient Financial Viability ensured. sector banks mostly completed. Fkspres and the second transition bank) banks. Effective Bank Failure Resolution under its control as of June 2001, by the end Capacity Created. of December 2001. Vakif completely privatized, continued Operational Restructuring of Halk Operational Restructuring of Ziraat Restructuring of state banks compliance by Halk and Ziraat with BRSA satisfactorily completed and Halk satisfactorily completed and Ziraat completed. The benchmarks are: capital adequacy rules, satisfactory progress resolved resulting in full privatization privatized. Emlak closed, Vakif 100% privatized, towards the operational restructuring of or merger with/acquisition by another Halk fully resolved either through Halk and Ziraat. bank. 100% privatization or merger with/acquisition by another bank, Ziraat at least 51% privatized. Satisfactory progress towards Full implementation of IOSCO implementation of listing and standards for all securities activities  - 65 - Area Triggers Outcome Indicators PFPSAL II (end 2001) PFSAL I & PPSAL I (2002) PFSAL II & Possible PPSAL II (2003) disclosure requirements at ISE in line and IAS for all financial institutions. with international norms. Satisfactory progress towards Regulations for the insurance industry adoption of laws and regulations for in line with international IAIS norms. the insurance industry in line with international norms, Public Strategy to improve tax system is Program to adjust staffing levels in Conditions for sustained fiscal Sector successfully implemented. central government agencies and adjustment are solidly in place. ____________ _________________________________________ SEEs is successfully implemented. Satisfactory progress on consolidating Pilot program for GFS budget Rollout of GFS budget classification New GFS budget classification is budget including: classification is successfully and new chart of accounts to all operational for the entire general [ [Complete all preparations for implemented. consolidated budget agencies is government in the 2004 budget. implementing new GFS budget substantially underway. classification and coding on a pilot basis in 2002 budget. [ Expand definition of new budget classification to cover all of general government as defined by GFS. > [Revise accounting law to incorporate new definition of general government and allow MOF to issue accounting standards for all general government agencies in line with GFS. f [Issue new modified accrual based chart of accounts consistent with GFS for general government. Government to adopt satisfactory Action plan for sustaining a Program to improve operational Budget preparation process has rationalized public investment program for rationalized public investment performance of line ministries and gained real credibility and shift to 2002. program is implemented and pilot agencies is fully operational. performance budgeting is underway. program to improve operational performance is initiated. Satisfactory new public procurement law is Public procurement practices for all Ministries and line agencies adopt Financial accountability practices in enacted which meets UNCITRAL goods, works and services are adapted effective internal controls in line with the consolidated budget agencies are standards. to conform with new law. new law on internal financial control aligned with international norms. and audit is implemented. Satisfactory public debt management law is Comprehensive risk management Comprehensive risk management The Government is able to manage enacted. framework is introduced in line with framework is fully functional. prudently all public sector liabilities.  - 66 - Area Triggers Outcome Indicators PFPSAL II (end 2001) PFSAL I & PPSAL I (2002) PFSAL II & Possible PPSAL II (20031 public debt management law. National strategy to imnprove Implementation of national strategy Turkey demonstrably improves in governance and combat corruption is to improve governance and combat ternis of perceived corruption as successfully implemented; public corruption is continued; training for measured by diagnostic and business awareness programs launched. civil servants underway. surveys. Civil service reform is underway. Government has launched a medium- term strategy for civil service reform.  -67 - 1. Project Implementation and Monitoring 109. The PFPSAL will be implemented in accordance with the procedures for adjustment loans in Turkey established under the ERL and FSAL. The financial and public sector program will be implemented by the Undersecretariat of Treasury, in cooperation with the Central Bank of Turkey, the BRSA, the SDIF, the Ministry of Finance, the State Planning Organization, and the Turkish Court of Accounts. The Bank will conduct regular supervision of the PFPSAL in close collaboration with the IMF. To help ensure timely implementation of the program, the Bank team has confirmed with the Government that each benchmark for PFPSAL II in the policy matrix has been clearly assigned and is owned by a particular government agency. The high- level Steering Committee established for the public expenditure management component of the public sector reform will ensure effective cooperation among the numerous ministries and line agencies involved in this component of the public sector reform program. Disbursement arrangements will be fully consistent with Bank practice for adjustment loans. Upon notification by the Bank of loan effectiveness (immediately following Board approval), the proceeds of the loan will be deposited by the Bank into the designated Deposit Account at the request of the Borrower. In accordance with the Operational Directive on the Simplification of Disbursement Rules under Structural Adjustment and Sector Adjustment Loans (February 8, 1996), disbursements will not be linked to specific purchases. The closing date for the Loan is December 31, 2001. 110. Monitoring. Progress will be monitored against agreed benchmarks in all areas of the PFPSAL program. A daily monitoring system is in place with support from the IMF for key macroeconomic indicators such as interest rates, the exchange rate, and CBT net domestic assets and reserves. Monthly monitoring is in place for inflation, the fiscal balance and the external accounts. In the financial sector, an upgraded monitoring framework for the banks is being established as described in the risks section above. Quantitative benchmarks have been established for the social expenditure envelopes under the supplementary 2001 budget. Progress towards these benchmarks will be evaluated in October. Benchtnarks have also bee set for the commitments on staffing levels in the civil service and SEEs, and these will be monitored on a continuous basis, including the extent of layoffs in the state and SDIF banks. Additional quantitative benchmarks will be established for the public sector reform program under PFPSAL II and subsequent operations as events unfold on the ground. An extensive monitoring of the broader social impact of the overall reforrn program is being carried out through a combination of activities under the PSSP, ARIP and Social Risk Mitigation Project.  - 68 - V. RECOMMENDATION 111. I am satisfied that the proposed loan complies with the Articles of Agreement of the Bank and I recommend that the Executive Directors approve the loan. I also recommend that the Executive Directors approve the proposed partial waiver of the front-end fee. James D. Wolfensohn President By Sven Sandstr6m Washington D.C. June 20, 2001  Annex IA Page I of 2 Turkey - Key Economic Indicators National accounts (as % of InP) 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 61 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 15 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$. Atlas method) 3170 2910 3270 2830 2800 2880 Real annual growth rates (%, calculated from 1994 prices) Gross domestic product at market prices 3.1 -4.7 7.2 -3.0 5.0 6.0 Gross Domestic Income 2.5 -4.0 9.8 -3.7 3.9 5.3 Real annual per capita growth rates (%, calculated from 1994 prices) Gross domestic product at market prices 1.5 -6.1 5.6 -4.5 3.6 4.6 Total consumption -0.3 -3.2 12.1 -12.6 0.7 2.9 Private consumption -1.4 -4.7 12.3 -13.0 1.0 2.7 Balance of Payments (US$ niillions) 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 51 75 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 capital (net, incl. errors & ommissions -6095 6087 -2877 -10160 2204 4522 Change in reservesd -447 -5206 2549 14638 -5886 -5413 Memorandum items Resourcebalance(%of GDP) -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 IA 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 Private sector credit growth / 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$/LCU)f 120.6 124.2 128.2 107.9 109.5 108.3 Real interest rates Consumer price index (% change) 83.7 63.5 50.6 49.4 28.3 16.5 GDP deflator (% change) 75.7 55.6 50.6 49.4 28.3 16.5 a. GDP at factor cost b. "GNFS" denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use of IMF resources. e. Consolidated central govermment. f. "LCU" denotes "local currency units." An inicrease in US$/LCU denotes appreciation. g. Includes government guaranteed loans to SP.Es.  Annex 1B Page 1 of 1 Turkey - Key Exposure Indicators Total debt outstanding and 97,211 101,795 114,260 116,327 116,767 117,426 disbursed (TDO) (USSm)a Netdisbursements(US$m)a 2,429 5,155 17,717 7,907 1,940 661 Total debt service (TDS) 14,900 18,286 20,510 23,626 26,492 23,938 (USSrm)a Debt and debt service indicators TDO/XGSb 155.8 193.5 201.3 197.2 188.7 176.7 TDO/GDP 48.3 54.8 57.0 68.6 62.4 58.2 TDS!XGS 23.9 34.8 36.1 40.0 42.8 36.0 Concessional"TDO 6.0 5.6 5.0 4.9 4.9 4.9 IBRD exposure indicators (%) IBRD DS/public DS 8.2 7.7 4.4 3.6 3.7 4.6 Preferred creditor DS/public 15.9 14.2 11.4 17.9 32.2 19.9 DS (%)c [BRD DS/X(,S 1.4 1.8 1.3 1.4 1.6 1.7 IBRD TDO (US$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 (USSm)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 IIA Page 1 of 2 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN FINANCIAL SECTOR AT A GLANCE BANKING INSURANCE EQUITY INVESTMENT MUTUAL FUNDS/ LEASING/ PENSION MARKET COMPANIES/ INVESTMENT FACTORING _________ BROKERAGES TRUSTS Number of * 54 deposit * 4 re-insurers * Istanbul Stock * 128 intermediaries * 216 mutual funds * 91 leasing * 3 State Institutions taking banks (4 * 62 insurance Exchange authorized to trade (1999), including: companies controlled state-owned, 8 companies (ISE) has about on ISE * 105 Type A funds * 100 social intervened by (22 life, 17 280 listed * 102 brokerages, 53 (25 percent of factoring security the SDIF, 31 composite companies commercial banks, assets invested in companies funds privately and 23 non- and 15 investment Turkish equity (1999) (PAYG) Turkish owned, life) of which: banks authorized with some tax * Unregulated and II foreign * 48 to trade in the advantages) private owned) private bonds and bills * 1l type B funds pension 20 non-deposit * 8 foreign market (3/2001) (less restrictive funds for taking * 6 state and 80 percent of staff of investment and owned total market net banks and development asset value) insurance banks (3 state- * 21 investment companies owned, 14 trusts (all Type privately A) Turkish owned * 8 Reties (real and 3 foreign estate) owned) Total Assets 104.8 quadrillion TL * Total Market Cap of Daily trading volume Total net asset value of: * Volume of (US$104 billion) premiums in US$37 billion ranges from US$300 * mutual funds is US$ leasing 1999 - (3/2001); free float man to US$1 billion. 2.9bn transactions US$2.3 is about 28 percent * Investment trusts is is US$1.4 billion of market cap US$ 202m billion . Total assets of * Real estate trusts is * Factoring insurance US$ 501m turnover companies - was US$3.5 US$3.3 billion billion (1999) Major Ziraat, Halk, Is, Yapi Millie Reassurance Foreign portfolio Ata Invest Not applicable Players Kredi, Garanti, Ak (all insurers investment accounts and Pamuk obliged to reinsure for approximately a fixed percentage 38 percent of the with them) free float in the equity market. .  Annex IIA Page 2 of 2 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN FINANCIAL SECTOR AT A GLANCE BANKING INSURANCE EQUITY INVESTMENT MUTUAL FUNDS/ LEASING/ PENSION MARKET COMPANIES/ INVESTMENT FACTORING BROKERAGES TRUSTS Regulator Banking Regulation Insurance Capital Markets Capital Markets Board Capital Markets Board Ministry of Ministry of and Supervision Supervisory Office Board Treasury Employment and Agency (BRSA) (Ministry of Social Treasury) Security/Capital ____ ___ ___ _ __ ___ ___ ____ ___ _ _ ____ ___ ___ ____ ___ ___ ____ ___ ___ ____ ___ ___ ____ ___ _ _ ____ ___ ___ ____ ___ __ ____ _M ark ets_ ark ts ao ar  Annex IIB Page 1 of 1 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN LIST OF BANKS Deposit Taking Banks (56) Deposit Taking Banks (continued) State Owned (4) Turkish Private (continued) Ziraat Fiba Halk Turkish Emlak Foreign Private (16) Vakif HSBC SDIF (Intervened) Banks (8) Morgan Guarantee Iktisat Chase Manhattan Ticaret Citibank Demir ABN-AMRO Inter Arap-Turk Sumer (including the former SDIF banks Yasar, WDLB Yurt, Ege, Kapital and Ulusal) ING Ekspres Credit Lyonnais Eti Societe General Eskisehir Rabo Turkish Private (28) Banca Di Roma Is Mellat Yapi Kredi Habib Ak CSFB Garanti BNP-Ak Dresdner Pamuk Investment and Development Banks (18) Finans State Owned (3) Osrnanli Kalkinma Koc Exim Tekstil Iller Toprak Turkish Private (12) Dis Takasbank Ekonomi SYB Korfez TSKB Kent Tekfen Imar Tat Alternatif Okan Seker Diler Deniz GSD EGS Nurol Anadolu Toprak Bayindir Calik Oyak Atlas Taris Foreign Private (3) Site Deutsche Bank MNG Taib Ada Credit Agricole Indosuez Turk  Annex III Page 1 of 2 Status of Bank Group Operations (Operations Portfolio) As Of Date 94711Qi001 Closed Projects 122 IBRD4DA' Total Disbursed (Active) 1 ,755.30 of which has been repaid 6811 Total Disbursed (Closed) 10,501 40 of which has been repaid 10,233.80 Total Disbursed (Active + Closed) 12,256 72 of which has been repaid 10,301.90 Total Undisbursed (Active) 2,618 61 Total Undisbursed (Closed) 24.19 Tota Undisbursed (Active Closed) 2,642.80 Actie Projects Difference Between Last PSR Expected and Actual SupernAsion Rating Original Amount in USS Millions Disbursemrnts " ProjectID ProjedNarne DObiedive Implementation Fiscal Year IBRD IDA GRANT Cancel. Undisb. Orig. FrmF RVtd project ID Project ~~~~~~~~~ Obieclivws Prooress P009044 AGRIC RES s s 1992 65 0 0 6 4.4 10.4 4.4 P009093 ANTALYA WATER SUPPL S S 1996 100 0 0 14.9 44 8 34 0 P009089 BASIC ED I HS S 1998 300 0 0 0 1501 148.2 0 P044175 BIODIVERSITY/NR MGT S S 2000 0 0 8.2 0 7.5 0.3 0 P09065 BURSA WATER & SANITA S S 1993 129 5 0 0 20 4 9 23.7 2 2 P0089865 CESMEW.S. &SEWER. S S 1996 131 0 0 0 11.4 6.3 0 P048861 COMMODITIES MKT.DEV S S 1999 4 0 0 0 3.3 3 0 P009023 E ANATOLIA WATERSHEI S S 1993 77 0 0 0 20.8 29.5 1.9 P065188 EFIL S S 2000 252.5 0 0 0 185 2 -67.2 0 P0568877 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 0 375 376 0 P066611 FSAL S S 2001 777 8 0 0 0 385 0 0 P009076 HEALTH II S S 1995 160 0 0 0 76.2 98.2 17.5 P009073 INDUSTRIALTECH S S 1999 156 0 0 0 136.5 -3.5 0 P068368 MARMARA EARTHQUAKE S S 2000 605 0 0 0 374 6 254.6 0 P048862 NAT'L TRNSM GRID S S 1998 270 0 0 0 268 196 0 P036404 ODS PHASEOUT2 S S 1996 0 0 14 0 6.9 6.9 0 P009095 PRIM HEALTH CARE SER S U 1997 14.5 0 0 0 139 13.9 8.9 P089894 PRIVSOC SUPPRT S S 2001 250 0 0 0 247 5 9.6 0 P009072 PRIV. 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 18.6 P038091 ROAD IMPR &SAFETY S S 1998 260 0 0 0 81.9 85.5 0 Overall result Result 4514 0 22.2 45.9 26331 1031 144.9  Annex III Page 2 of 2 Turkey Statement of IFC's Held and Disbursed Portfolio As of 12131/2000 (In US Dollars Millions) Hed Disbursed FY Appsovdl CoTspcy Loss E.quty Qusit Pntis Loss Equivt Quasi PFesc 1990/93 Corad 0 0 0 0 0 0 0 0 1997/98 Dernit Le.sing 3 89 0 0 0 3.89 0 0 0 0/94096 Deseirbalnk 7 5 0 0 7.5 7.5 0 0 75 1989 Edimc 1 13 0 0 0 1 13 0 0 0 1993596 Fld4 3 0 0 0 3 0 0 0 1988393/96 Elgisk1n 8 49 0 0 0.32 849 0 0 0.52 1995 Entek 24 0 0 23.19 24 0 0 23.19 1997/9S Finens Leasing 3.89 0 0 0 3.89 0 0 0 1992199 Finab-sclk 10 0 0 33 10 0 0 35 1994198190 GesmiLeasing 2.35 0 0 16.19 2.55 0 0 1619 1994195f96 Olobd Se-uity 0 0 0 0 0 0 0 0 1999 O3ueussuyuKap 4 0 264 0 4 0 2.64 0 199% Ind-rasalplik 10 0.66 0 0 10 0.66 0 0 1998/O0 IpekPsper 0 0 0 15 0 0 0 15 2000 IaildusAsbalj 0 0 10 0 0 0 95 0 1990 Kepeszlelktik 1134 0 0 0 11.34 0 0 0 [9%8S90 Kids 826 0 0 0 8.26 0 0 0 1996 dKcba-k 5.71 0 0 0 571 0 0 0 1996 Keioease 6.43 0 0 0 6.43 0 0 0 1992197 Korfeeb nls 9 0 0 13 9 0 0 13 1990092 Koy-Tu 0 0 0 0 0 0 0 0 1991 Kwa 433 0 0 0 4.33 0 0 0 1993196 MLedya 0 0 4.99 0 0 0 499 0 1998 ModsmKett-s 20 0 0 10 20 0 0 10 1991 NASCO 10.18 0 0 3355 t 18 0 0 3 55 1998 Ottosman IS.18 0 0 72.73 18.18 0 0 72 73 1997 Oy kB.nk 8.33 0 0 5 833 0 0 5 1998 P.s.beh-c-Schott 11.83 0 0 11.83 11.83 0 0 11.83 1983/94/98 Pi.e.ET 10.21 0 0 0 10.21 0 0 0 199440O PinesSUT 1447 0 0 0 0 0 0 0 0197 R-ntLeassng 1 78 0 0 0 1 78 0 0 0 1999 SAK.Sa 21.9 0 0 2142 219 0 0 21.42 1986190 Silas. Tui=m 3 34 0 0 3 8 3 34 0 0 3 8 1993/96 Sise Ve.s c 6.3 0 0 8 4 63 0 0 8 4 199S Soktas 10.85 0 0 0 10 85 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 1999 TEB Fi,ensla 5 0 0 0 5 0 0 0 1997 ToprakLessing 137 0 0 0 1.78 0 0 0 1979/32/83/89/91/6/99 TrecysCsec 0 1.18 0 0 0 1 18 0 0 1995t99 TwkEkonBenk 13 0 0 20 15 0 0 20 1993/98 Tu-lyeOssGnti 1435 0 0 69.09 1455 0 0 6909 1999 Unye Cement 19.74 0 0 0 19 74 0 0 0 1999lUe- 20 0 0 15 1137 0 0 853 1970/71/82193/98 Viking 1108 0 0 0 1108 0 0 0 1995 Y.1ove Acryli 2.5 0 0 133 235 0 0 1.33 1997/98 YspiK-ediLeses 2.73 0 0 0 2.73 0 0 0 0 ALe-s 3.89 0 0 0 389 0 0 0 1994 AYTAC 4 0 0 5 4 0 0 5 1998 AdeneCespent 15 0 0 8 15 0 0 8 0/98 AltemstifBenlk 8.89 0 0 9 8 89 0 0 9 1995J96 Arcehk 375 0 0 11 5 375 0 0 11 5 2000 A-rsliGL Klis- 1343 0 0 8.94 13.43 0 0 8.94 1994/97 Ass- 566 0 4 3.75 566 0 4 3.75 2000 Bmvit 20 5 0 0 10 5 0 0 1994/96/97 Borreluk 0 0 0 0 0 0 0 0 199556 CBS BsyaKisyc 0 0.65 0 0 0 0.65 0 0 1994 CBS Hclding 4 0 0 0 4 0 0 0 1996101 CBS Printes 0 0.01 0 0 0 0401 0 0 1992 CayeliBekic 14.7 0 0 0 147 0 0 0 1994 Ces-ehegullai 0 61 0 0 0 0 61 0 0 0 Total Portfolio: 481 75 7 6 21.63 398.74 44865 7 35 21 13 39227 Approvals Pending Corneitmetnt Loes Esuity Quasi Pstic 2000 Pi,erSe. 4009 0 0 0 2001 Akbbsk 20000 0 0 80000 2001 Ar.eliklll 20000 0 0 100000 2000 BICT 20000 0 5000 0 1999 CBS c-up Rests 5S00 0 0 0 1999 Ege Sermik 18000 5000 0 0 2000 Esblde 5000 0 5000 0 TOtlIPendingCo..ait-snt. 92000 5000 10000180000  Annex IV Page I of I TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN TIMETABLE OF KEY PROCESSING EVENTS 1. Time Taken to Prepare and Process this Loan 3 months 2. Loan Prepared By Government of Turkey with IBRD assistance 3. Pre-appraisal Mission April 9, 2001 4. Technical Discussions/Appraisal May 2001 5. Negotiations June 5, 2001 6. Planned Board Presentation July 5, 2001 7. Planned Date of Effectiveness July 2001 8. PFPSAL II - Planned Board Presentation December 2001 9. PFSAL I- Planned Board Presentation June 2002 10. PPSAL Planned Board Presentation December 2002 11. PFSAL II Planned Board Presentation June 2003   Annex V REPUBLIC OF TURKEY PRIME MINISTRY THE UNDERSECRETARIAT OF TREASURY Ref: BI02.1`.HIVl0.DE.01.05.PFPSAL 150691 Ankara, June 18, 2001 Mr. James D. Wolfensohn President The World Bank Washington DC 20433 U.S.A. Dear Mr. Wolfensohn, 1. In February 2001, Turkey experienced a serious financial crisis. Since then, we have been working intensively with the IMF and the Bank to put in place a new and stronger multiyear macroeconomic and structural reform program with increased emphasis on banking and public sector reforms. Our new program in response to the crisis was announced in April. It not only seeks to preserve the progress already achieved to date in carrying out structural reform, but also to resume disinflation and revive growth as soon as possible. The new program aims to restore banking sector confidence and lay the basis for a wide ranging modemization of the public sector which will ensure sustained fiscal adjustment and more effective govemment. It addresses the underlying problems in the financial and public sectors that created the conditions in which the financial crisis took place, thereby seeking to ensure that these conditions do not recur in the future. 2. To support implementatlon of the new program, we have requested additional support from the World Bank and the IMF. A linchpin of the program is a dramatically stepped up effort to address a series of longstanding banking and public sector reform issues, in addition to continued implementation of structural reforms to support private sector development We had already initiated efforts to address these issues under the financial sector reform program supported by the Bank's Financial Sector Adjustment Loan (FSAL) and the program supported by the Economic Reform Loan (ERL). The February 2001 crisis has made clear,  however, that a much more aggressive and accelerated effort is necessary to restore banking system safety and to instill confidence in the sustainability of our fiscal policy and public sector management. Therefore, we are requesting the Bank to provide Turkey with a seres of new quick-disbursing loans under the current CAS starting with two single tranche Programmatic Financial and Public Sector Adjustment Loans (PFPSAL and PFPSAL II), and to cancel the second tranche of FSAL. Below, we present our multi-year reform effort in the financial and public sectors in more detail. 3. Our new program places great emphasis on protecting the social welfare and human capital of Turkey's citizens. The supplementary budget for 2001 approved by Parliament on June 14 maintains adequate expenditure envelopes for health, education and social protection even as overall spending is reduced as a share of GNP in line with the new macroeconomic targets. The budget will allow the Govemment to maintain aggregate spending on educabon slightly above the average levels of 1998-2000 (as a share of GNP) and actually increase expenditure on social protection. Overall public spending on health is also projected to remain above the 1998-2000 average level. Savings are expected to come from efficiency gains in health expenditures for civil servants under the administrative reform of the social security system supported by the ERL program. Part of these savings are being channeled into increased expenditure on preventive and primary care. In addition to protecting social spending in the budget, we intend to strengthen our social protection programs, with the support of the World Bank, including through a proposed Social Risk Mitigation project. We also intend to complete the actions agreed to under the Economic Reform Loan (ERL). 1. Turkey's Medium-term Financial Sector Reform Program 4. We have already put in place several measures to address the most urgent banking system issues post March 2001 crisis, especially as they relate to regulatory reform, initiation of capacity building at the BRSA, stepped-up resolution of the growing number of failed SDIF banks and the urgent financial and govemance restructuring of the state-owned banks. In order to fully restore and strengthen banking system safety and productivity on a sustainable basis, and to develop the non-bank segments of our financial system in support of private sector growth, we plan to implement the financial sector reform and seek the Bank's support for these reform measures in two phases. The first phase will consist of (i) all urgent legal, regulatory, and structural reforms necessary to begin the restructuring of the banking sector as mentioned above in the first PFPSAL in June 2001; and (ii) the remaining urgent reforms that we expect to implement by December 2001. These measures comprise of additonal banking regulatory reform, further institutional strengthening of the BRSA, finalizing the 2  resolution of the current group of SDIF banks and initiating the privatization and operational restructuring of the state-owned banks. We request the Bank's support for these measures under PFPSAL It. 5. The second phase of the financial sector reform program will be undertaken during the calendar year 2002/2003. During this period, we intend to complete the overhaul of the banking system regulatory regime and implement non-bank financial institutions (N8Flycapital markets regulatory reform, further deepen the institutional development effort at the BRSA and initate such efforts at the SDIF, continue the bank failure resolution as necessary and overhaul the NBFI failure resolution regime, and complete state bank privatization. 6. The details of the proposed financial sector reforms are presented below under four major headings; namely (i) Regulatory Framework for Banking and Non-Bank Financial Institutions; (ii) Institutional Development of BRSA and SDIF; (iii) Problem Bank/Bank Failure Resolution, and (iv) State Bank Restructuring and Privatization. Recgulatory Framework for Banking and Non Bank Financial Institutions 7. Loan Loss Provisioning. The current loan loss provisioning rule was adopted by the Council of Ministers (the responsible authority for issuing banking regulations before the new 8RSA was created) in December 1999. While the new rule was a major improvement over the previous, much more lenient rule, it was still not fully in line with best practice standards. Remaining weaknesses included Ziraat Bank being exempted from classifying and provisioning agicultural support loans, the use of mechanistic provisioning percentages and collateral classification & valuation rules and unfavorable tax treatment of specific provisions. To remedy these weaknesses, the BRSA will reissue in June 2001 the current loan loss provisioning rule in its own name, while lifting the exemption from classification and provisioning for Ziraat's agricultural support loans. Additionally, Parliament has enacted an amendment to the banking law allowing specific provisions to be treated as a tax deductible expense effective in the year beginning January 1, 2001. We intend to further strengthen the loan loss provisioning rule to address the above referenced remaining deficiencies and to bring the rule fully in line with international best practice standards. 8. Large/Connected Exposures. The December 1999 banking law introduced new, lower limits for banks' connected exposures, phased-in in a step-wise fashion to reach compliance with EU Directive levels by the end of 2006. The BRSA was to issue an EU Directive compliant definition of connected exposure to operationalize the new limits. The issuance of this definition got delayed because of protracted discussions with the banking sector. The recent 3  banking crises have highlighted the importance of accelerated reform in this area. Therefore, Parliament has enacted further amendments to the banking law introducing new separate limits for equity ownership in non-financial entities. These new limits will be phased in over a period of 8 Y2 years, for banks to be in full compliance with EU non-financial equity ownership standards by 2009. Additionally, the amendment also mandates the application of exposure limits on both a solo and consolidated basis. The BRSA also will issue in June the new, EU Directive based definition of connected exposures, as well as a regulation setting the interim targets and time-table for banks to reach compliance with the new equity ownership limits. Furthermore, the BRSA will by August 31, 2001 enter into time-bound action plans with all banks out of compliance with the new limits. Additionally, during all of 2002 the BRSA will continue to proactively monitor and enforce the impfementation of the action plans for banks with excess connected lending and equity exposures to reach compliance with the new banking raw limits. 9. FX Exposure. During 1998-99, the maximum open FX position'limit for banks was reduced in a stepwise fashion from 50 percent of regulatory capital in June 1998 to 20 percent in September 1999. In December 1999 the limit also became applicable on a consolidated basis. A new Basle compliant BRSA regulation imposing a capital charge on banks for their open FX positions was issued in February 2001 and will become effective on January 1, 2002 on a solo basis and July 1, 2002 on a consolidated basis. While these actiQns are steps in the right direction, the current regime still contains several weaknesses, including different reporting frequencies for open FX positions and capital adequacy, opportunities for balance sheet wvindow dressing and the use of structured finance products to run up open FX positions in circumvention of the 20 percent limit. Additionally, the larger banks are lobbying the BRSA and the Central Bank of Turkey (CBT), which monitors compliance with a separate liquidity based FX exposure rule, to abolish the existing rules in anticipation of the introduction of the market risk charge. To address these concerns, the BRSA will issue in June: (i) an amendment to the capital adequacy rules increasing the reporting frequency for both solo and consolidated capital from quarterly to monthly; and (ii) an amendment to the consolidated FX position reporting rule to change the reportng frequency from quarterly to monthly, both to be effective from January 1, 2002. During the next six months, in order to facilitate preparation of the above consolidated financial reports from the banks and non-bank financial subsidiaries within the same group, the BRSA will work jointly with the Treasury's NBFI & Insurance Departments and the 'CMB to harmonize the reporting frequency of all financial statements (i.e. of banks' financial subsidiaries). To further reduce the FX exposure risks of the banking system, we intend to create a working group comprising BRSA and CBT staff, extemal auditors and banks to catalogue the use by banks of structured finance products to incur FX exposures 4  not captured by existing regulation. This working group will formulate remedial regulatory action to capture such exposures. The recommendations of the working group will be implemented by the BRSA during 2002. Additionally, the BRSA will announce its intention to undertake surprise on-site examinations, in coordination with foreign supervisors where necessary, to verify compliance with consolidated FX open position limits between reporting dates. Finally, the BRSA and the CBT - being keenly aware of the risks involved in a preliminary lifting of FX exposure limits in advance of full operationalization of the BRSA's new market rsk charge regulation on January 1, 2002 - have committed not to abolish these limits until onsite examinations have confirmed that banks' risk management systems and the market risk charge regulation are functioning satisfactorly. 10. Repurchase (Repo) Transactions. Turkey has a significant retail repurchase and reverse repurchase agreement (repo/reverse repo) market. Prior to December 2000, in order to encourage secondary market liquidity, the repo/reverse repo market enjoyed more favorable withholding tax rates than bank deposits. Followng the equalization of the withholding tax regime in December 2000, commercial banks primarily sold repos to their retail customers to circumvent the C8T's reserve requirement on deposits. In February 2001, as repo rates rose to 6,200 percent per annum, many customers cancelled their time deposits and moved into repos, forcing some banks into heavy interbank borrowing. As a first step to curb such destabilizing activities in future, we have set up a working group comprising of representatives from the Treasury, the BRSA, the CBT, the CMB and the MOF, to recommend measures (e.g. setting the minimum allowable size of repo transactions, setfing liquidity requirements for repos, adjusting withholding taxes based on length of liability maturities, etc.) to reduce the risks caused by excessive use of retail reposlshort-term liabilities in the banking sector. Taking into account the recommendations of this working group, we shall implement measures as necessary to reduce such risks by the end of December 2001. To further enhance the transparency of the repo market, the BRSA will also require banks to bring repos on balance sheet as collateralized finance transactions as of the beginning of January 2002. 11. Taxation and Corporate Law Reform to Encourage Merger and Consolidation in the Financial Sector and to Facilitate Separation of Financial Industrial Groups. We believe that, in order to strengthen the capital structure, and to reverse the fragmentation of resources of the banking sector, it is necessary to encourage mergers and consolidation in the banking sector in Turkey. At the same time in order to facilitate efficient financial flows among several financial entities within a single business group, and to better manage and supervise the inherent risks on a consolidated basis for the group financial insttutons (which is essentially required because of the public trust role of such 5  institutions), 't is necessary to separate the financial and industrial activities of the financial industrial groups (FlGs) in Turkey into separate financial and industrial holdings. However, at this time any such mergers, consolidation or separatCon activity has several taxation (e.g. VAT, banking and insurance transaction tax) and corporate law disincentives. As part of our reform effort we will review and amend as necessary corporate and tax legislahon to encourage mergers and consolidation in the financial sector, and to facilitate transformation of financial- industrial groups into separate financial and corporate conglomerates- 12. Prudential Regulations for Non Banking Financial Institutions. During 2002, we also wish to undertake a review of the prudential regulations regime for the non-banking financial institutions, to reduce their vulnerability against potential macroeconomic volatility and to facilitate a more accelerated growth of non banking financial activity in Turkey including equity and fixed income securities markets, insurance, mutual funds and pension funds. Though we plan to undertake a more comprehensive assessment of the NBSFI sector needs with the help of the Bank during 2002, some of the focus areas we have identified as priority for reform are: (i) To review of the need for, and introduce if necessary, newltighter FX and large/connected exposure limits for insurance industry and other non-bank financial institutions; (ii) Adopton by Parliament of a new insurance law in line with applicable EU Directives; (iii) Adoption by Parliament of amendments to applicable legislation to equalize absolute minimum capital requirements for private pension funds and life insurance companies involved in pension funds; (iv) Strengthening the regulatory and governance structure of all insurance companies' and other financial institutions' employee pension funds; (v) Completion of a review of all other prudential rules applicable to NBFI activity (insurance, leasing, finance, factoring, pension funds, mutual funds, asset management) and adoption of a formal plan to overhaul these rules as necessary to bring them in line with applicable IAIS/IOSCO and other international standards; (vi) Completion of full introducton of IAS for banks and non bank financial institutions, including IAS 29 with an appropriate phase-in period and LAS 39; Activation of the new Accounting Standards Board mandated by the Capital Markets Law; Revision of Istanbul Stock Exchange listing and disclosure rules for all financial institutions; Overhaul of the licensing regime for auditors of banks and other financial insbtutons; and (vii) Initiation of a review of the overall tax regime for financial transactions & activity and identification of all tax structures that favor or discriminate against certain types of financial sector activity; and preparation of amendments to tax legislation with a view to eliminate any biases in favor or against certain types of financial sector activity (with the possible exception of individual retirement products). Institutional Development of the BRSANSDIF 6  13. BRSA (Banking Regulation and Supervision Agency). The BRSA since its creation on August 31, 2000 has made remarkable progress towards its operationalizatfon, but the November 2000 and February 2001 banking sector crises have diverted attention and energy away from its own institutional development agenda, which remains unfinished. Therefore, the BRSA today needs further strengthening and improvement in several areas. These include: (i) harmoniting staff structure; BRSA staff came from five different departments within the Undersecretarat of Treasury, the Ministry of Finance and the Central Bank and, while these staff now work within a single organization, they continued to operate on a semi-independent basis and till recently were still being paid using their previous employers' pay scales, diminishing the potential benefits of creating a single regulatory authority for the banking sector; (ii) the maintenance by each function within the BRSA (e.g., offsite monitoring, on-site monitoring, enforcement, licensing) of separate databases and the use of different analytical rnodels to assess the condition of individual banks, resulting in sometimes conflicting analyses and policy recommendations being made by the different departments to senior BRSA management; (iii) the need for upgraded detailed oroedures manuals for each BRSA function; while BRSA staff are aware of their task responsibilities and the procedures to be followed in case of regulatory/supervisory and enforcement action to be undertaken, these procedures are currently not documented or the manuals that do exist are out of date; (iv) need for integration of offsite monitoring, onsite monitonng and enforcement activit y, for example, when onsite examiners (called Swom Bank Auditors) go onsite in a bank, offsite and enforcement staff are not allowed to participate in these site visits; additionally, till recently the findings of the onsite examiners were not fed back to the offsite department for correcting the offsite information on the banks concemed; (v) the need for a specific problem bank unit within the enforcement function; it is the responsibility of the BRSA's enforcement division to work with any bank which is in violation of the banking regulations; however, the division's capacity is stretched due to the need to focus on both large numbers of such non-compliant banks as well as financially distressed banks requiring more 'hands on' attention and possibly the application of different skills to those available in the enforcement division; (vi) the need for an earlv waming system that could guide the efforts of the onsite examiners and provide input in determining the onsite examination cycle; and (vii) need for developing the concept of isk-based supervision, with the onsite examiners being mostly focused on compliance testing rather than on identifying banking isks and assessing the quality of the rsk management undertaken by bank managers. 14. To start strengthening the institution, BRSA management will develop, and the BRSA Board will adopt in June a time-bound strategic plan with clearly assigned implementation responsibilities to: (i) put in place a comprehensive 7  numan resource policy to assimilate staff from different sources and to strengthen staff training; (ii) integrate the existing multiple databases into a common database and a common plafform for analyzing and assessing banking risks; (iii) upgradeldevelop procedures manuals for all major existing BRSA units; and (iv) introduce the concept of relationship supervision with offsite examiners, enforcement staff and Sworn Bank Auditors working in teams on individual banks. By December 2001 we expect the BRSA to have made significant progress towards implementing the Institutional development activities outlined in its June 2001 strategic plan. The BRSA will also at that time set up a new problem bank unit within its enforcement function, to allow a more targeted monitoring and follow-up of problem banks. The new unit will operate on the basis of a pre-failure corrective action manual that Mil define pre-failure intervention triggers (effectively defining a 'problem bank') and pre-failure corrective action procedures to be administered by the new unit. Additionally, the GovernmentBRSA will review the salaries of BRSA Board members and staff and will bring them in line with the prevailing salary scales for similar professional staff in the banking sector, in any event not less than the comparable salaries at the CBT or CMB. 15. Institutional Development of the SDIF (Savings Deposit Insurance Fund). The SDIF at this stage will also initiate a comprehensive institutional development effort, through preparation of a time-bound strategic plan, with clearly assigned implementation responsibilities, that (i) puts in place a more effective organizational structure, with clearly separated line responsibilities for bank resolution effort, asset management efforts, administration of the blanket guarantee & the deposit insurance scheme and supporting functions such as legal, human resources and information technology; (ii) sets performance targets for the bank resolution and asset management functions; (iii) envisages the hiring of additional qualified staff to handle the high volume of non-performing loans and other problem assets to be transferred to the Collections Department for collectiontworkout; and (iv) builds a centralized and high quality management information system that will allow SDIF senior management and the SDIF Board to monitor progress being made towards reaching agreed resolution and asset management/collection targets. The plan will be formally submitted for approval to the SDIF Board by late 2001, and will be implemented during 2002. In additon, during 2002 (or even earlier if feasible), we plan to ensure the future functioning of the SDIF on a sound financial foobng, and plan to cancel all outstanding SDIF debts to the Treasury arsing from the receipt of Treasury securities needed for the resolution of the pipeline of failed banks. 16. Deposit Insurance Reform (Removal of Blanket Guarantee, Autonomy for SDIF, Bring Deposit Insurance to EU Standards). The institutional 8  development of SDIF can not be successfully completed till the policy on the long term mandate of SDIF is clearly articulated. In this context, during 2002, we plan to remove the blanket guarantee to all commercial bank depositors and creditors presently in force under crsis conditions, and replace it with a deposit insurance regime consistent with the EU standards on Deposit Insurance. At the same during 2002, we shall review the effective functioning of the SDIF's present govemance and management structure as a subsidiary of the BRSA, and revise as necessary. 17. Consolidated Regulation and Supervision of Financial Activities of Conglomerates. The Turkish financial sector consists of financial-industrial conglomerates with commercial banks in the center of such groups, surrounded by a number of financial subsidiaries in the areas of insurance, leasing and factoing, capital markets, and mutual funds. Many of these financial subsidiaries as well as the parent bank have both loan and equity exposures to the same groups of clients. Until very recently, the prudential lending limits applicable to a commercial bank's exposure to its clients also applied to its exposure to its financial subsidiaries, but capital adequacy and foreign exchange exposure rules did not apply to banks on a consolidated basis. We have now rectified these shortcomings in the prudential framework for banks through the introducton of consolidated large and connectedAnsider lending limits, and capital adequacy and foreign exchange exposure rule requirements, and plan to monitor the implementation of these new rules on a consolidated basis for such financial conglomerates. .18. However, the overall process af consolidated regulation and supervision is quite complex because of the current existence in Turkey of a number of different regulatory and supervisory bodies; e.g., the banks are regulated by the new BRSA; the insurance sector is regulated by the Treasury's General Directorate of Insurance and Board of Insurance Auditors the Insurance Supervisory Office of the Treasury; leasing and factoring activities are supervised by the Treasury's Banking and Exchange Department, investment and brokerage companies, mutual funds and investment trusts are regulated by the Capital Markets Board; private pension funds will be regulated jointly by the Treasury's General Directorate of Insurance and Board of Insurance Auditors and the Capital Markets Board: and bank and insurance company pension funds are regulated by the Ministry of Labor and Social Security and the General Directorate of Foundations. This dispersion of regulatory and supervisory responsibility across muliple Government agencies carres the risk of creating insufficient, overlapping or even conflicting regulatons and operating standards, thereby reducing regulatory efficiency and imposing an unnecessary burden on the financial institutions concemed. In order to further improve the consolidated supervision infrastructure, we plan to undertake a non-bank financial institutions sector 9  review with the assistance of the World Bank in late 2001/early 2002, and incorporate applicable recommendations and conclusions from this review in the latter part of our mult-year financial sector reform program. Problem Bank/Bank Failure Resolution 19. Private Banks (Monitoring and Addressing Current and Future Capital Adequacy). Due to the November 2000 and February 2001 crises, the capital base of nearly all of the private, domestically owned deposit taking banks (28 banks in total as of end May, 2001 excluding SDIF banks) has been weakened substantially. Stress tesfing has confirmed that as a result of the combined impact of interest rate, exchange rate and credit risk shocks, many of the banks concemed either already have suffered, or are likely to suffer, from capital inadequacy in the near future. These capital deficits among such private banks range from temporary non-compliance with the 8 percent minimum capital adequacy ratio requirement, to permanent insolvency and inability of some of the banks concerned to survive on their own. In order to remedy this potenfially systemic capital shortfall, during the perod March-May, 2001 the BRSA has undertaken the following actions: The BRSA has, in the aftermath of the February crisis, instructed all private commercial banks, except well-capitalized banks, not to pay dividends and to retain all year 2000 earnings; * Through a combination of offsite analysis and on-site examinations, the BRSA has identified all capital deficient banks, and the likely size of the already apparent, or soon to be apparent capital shortfall in each bank concerned: * The BRSA has held in-depth discussions with each bank concerned on the need to prepare time-bound capital restoration plans, including in some instances the need for the merger of multiple weaker banks that belong to the same financial-industrial group into one larger, stronger bank; and * The BRSA has also publicly announced that it is seeking credible capital restoration plans on a system-wide basis. By end June 200i, the BRSA will enter into capital restoration plans with all banks concerned. With the help of close proactve supervision and enforcement, BRSA will ensure that the capital restoraton plans for capital deficient banks are implemented in a satisfactory manner or, altematively, arrange for SDIF intervention, and the SDIF stands ready to intervene in these banks in case these plans fail. 20. Bank Failure Resolution. We initiated our effort to acoelerate the resolution of problem banks by the BRSA and failed banks by the SDIF with the 10  passage of the December 1999 banking law that gave the BRSA more powers to impose correctve actions on problem banks, and provided the SDIF with an extended range of resolution options to deal with problem banks. Pre-crises, the BRSA was already using its enhanced powers under Article 14 with a view to rectify problems at a growing number of privately owned problem banks. The resolution effort at the SDIF, on the other hand, got under way in earnest only after September 2000 for several reasons: (i) lack of a mechanism to finance the SDIF's resolution outays; (ii) inertia and uncertainty at the Treasury (previously responsible for bank supervision) and the SDJF in anticipation of their transfer to the new BRSA on August 31, 2000; and (iii) lack of a coordinated policy for the provision of lender of last resort financing by the CBT in manner consistent with the Net Domestc Asset ceiling under the IMF Stand-by Agreement. The stepped- up efforts by the SDIF to sell banks under its control as going concerns were not successful, however, especially in the wake of the November 2000 and February 2001 crises. To date, the SDIF has not yet sold any bank, and the post cnses environment is not very conducive to sales. 21. To accelerate failure resolution, we have already undertaken the following steps: T he SDIF has arranged for the revocation of the licenses of five banks (Ege, Yurt, Yasar, Kapital and Ulusal) and merged them into Sumer Bank as a transition bank. The branches of these banks are being closed and their staff is being laid off; and - The Undersecretariat of Treasury in cooperation with the CBT has injected into the SDIF banks enough (i) marketable Govemment securibies (in TL and FX) in a mix of maturities and currency denominations carrying market-based floating rate coupon interest to ensure that the banks have sufficient liquidity to operate and honor any deposit withdrawals, and to recapitalize the SDIF banks up to 0 percent capital adequacy; and (ii) cash (in lieu of the Govemment securities above) to retire at least two thirds of all on and off balance sheet ovemight high cost liability funding of the SDIF banks; the CBT has subsequently mopped up excess liquidity through open market operations within an overall maximum limit of TL 7 quadrillion of stock of repurchase agreements of the SDIF and state-owned banks with the CBT. By the end of June, we will complete the following further steps: a The SDIF will: (i) hire additionally required staff for its Collection Department; (ii) receive approval from its Board enabling the transfer of 1,166 problem loan files (each above TL 75 billion) from Sumer bank to the Collection Department; and (iii) complete the transfer of 150 of the above files. In addition, the SDIF will amend its regulations to reflect the recent amendments II  in the banking law, and adopt the necessary organizational structure and operating procedures for the Collection Department by August 31, 2001 ;and * The SDIF Board will select a second 'transition bank' to avoid overload at Sumer, and will revoke ,the license and initiated the mergerAiquidation 'of Turk Ticaret, Es, Inter and Eti with either one of the transition banks. 22. In addition, before the end of December 2001, the SDIF will undertake the following additional steps: (i) sell Ekspres, Demir and lktisat, or revoke their licenses and merge them with the transition bank(s); (ii) resolve Sumer and the second transiUon bank through sale or license revocation/liquidation; and (iii) complete transfer of all problem loan files (above TL 75 billion) to the Collection Department, and either reach a negotiated settlement with the loan defaulters or initiate legal action for collection on all these files. These measures will result in the complete resoluton of the existing pipeline of 8 SDIF banks by year end 2001. 23. Besides the resolution of the existing pipeline of 8 SDIF banks, SDIF will by the end of December 2001, intervene in all those banks that are unable to raise the necessary capital as per the capital restoration plans, and begin the implementation of satisfactory SOIF resolufion acton for such banks. All such remaining resolution of new SDIF banks will be completed during 2002. 24. Bankruptcy, Collateral Legislation and Infrastructure. To facilitate resolution of non-performing loans (NPLs) by both the Collections Departnent of the SDIF and banks or third parties that might acquire such NPLs, we intend to undertake a coordinated review of the improvements required in the legal framework for bankruptcy and collateral foreclosure, and to seek Parliamentary enactment of the changes required to allow accelerated/more efficient NPL resolution. We will also prepare a plan for the creation of a new central register for the registration of movable collateral. Restructurina and Privatization of the State-Owned Banks 25, Ziraat, Halk & Emlak. Over a third of banking system assets and deposits are accounted for by 4 large state-owned banks (Ziraat, Halk Emiak and Vakif). Longstanding public service related socially subsidized lending activities under the Govemments govemance and ownership of these banks has steadily eroded the financial condition of these banks. For Ziraat and Halk, enormnous subsidy related losses have been incurred under the umbrella of illiquid Govemment "duty losses" (paper claims on the Government carried on the bankse books) for the last five years as a by-product of subsidized, directed lending for agricuiture and small business development. These losses increased from US$2.8 billion at the end of 1995 to almost US$23 billion at the end of April 2001 (the number 12  would have been even higher at pre-crisis exchange rates). The distortion in the money markets caused by the liquidity shortfalls experienced by the two banks as a result of the rapid build-up of the duty loss claims was one of the principal propagators of the November 2000 and February 2001 banking crises Emiak has also accumulated significant losses through its construction related activities and non-performing loans, and the bank was already insolvent even before the November 2000 crisis. 26. Pre-crises, we had already initiated the financial and ownership restructuring of the state banks. In November 2000, Parliament enacted an amendment to the law on Vakif allowing the sequential sale of the 8 shares and A shares held by the General Oirectorate of Foundatfons. In August of that same year, Vakif engaged an investment banks fwr the sale of B shares through an initial public offerng. The Govemment also initiated the commercialization and financial restructuring of Emlak during late 1999 and early 2000 by removing the stock of housing from its books. In December 2000, at the initiative of the Undersecretariat of Treasury, new legislation was submitted to, and enacted by Parliament that: (i) allowed Ziraat, Jlalk and Emiak to be completely privatized; (ii) selectively removed the application of state economic enterprise legislation (Decree Law No. 233 and related laws) to the banks in preparation for their privatization; and (iii) allowed the Government to undertake any restructuring actions necessary to prepare these banks for privatization. Restructuring Boards had been created for the banks and management had begun to formulate operational restructuring plans. We had envisaged a 2-3 year timeframe for the privatization of Halk and up to 4 Y/z years for Ziraat. However, the destabilizing effect of the state banks on the whole banking system has made it clear that the process of state bank restructuring and privtization must be significantly accelerated to restore banking system stability and confidence. 27. Financial and Governance Restructuring of the State-Owned Banks. Therefore, we have taken the following actions in cooperabon with the CBT and the BRSA: * Injection into Ziraat and Halk of enough (i) marketable Government securties at market terms in a mix of maturities and currency denominations with interest paid quarterly to ensure that the banks have sufficient liquidity to operate and honor any deposit withdrawals, allow the write-off of all remaining duty loss claims and the recapitalizaton of the two banks to 8 percent capital adequacy; in addition, we have reissued all already existing Government securities in the books of these two banks carying non-market terms with similar marketable Government securities; and (ii) cash (in lieu of the Government secuities above) to allow the two banks to retire their on and off balance sheet overnight high cost liability funding; the CBT is currently in the 13  process of mopping up the excess liquidity injected into the system as a result through open market operations within an overall ceiling on the stock of repurchase agreements of the SDIF and state-owned banks as of end May 2001 of TL 7 quadrillion; and Appointment of a new independent professional Goveming Board for the two banks with the mandate to manage these banks in accordance with commercial principles and all prudential guidelines under the banking law/issued by the BRSA. the Goveming Board has initiated the operational restructuring of the two banks, including the closure of unprofitable branches and the reducbon of redundant staff; By the end of June, we will have completed the following additional action: * Appointment by the Governing Board of a Restructuring Adviser for Ziraat and a Restructunng and Pnvatization Adviser for Halk. By July 15, 2001 we will complete the following further actions: * The merger of all banking liabilities and all performing banking assets of Emlak with Ziraat and Halk, the revocation of Emlak's banking license, and provision of sufficient capital in the form of marketable Govemment securities carrying quarterly market based floating rate coupon interest to Ziraat and H alk to allow them to absorb all losses related to Emlak's merger, including the issuance of Mass Housing Fund securities to Emiak in lieu of the construction related assets transferred to the MHA on a short-term basis to be exchanged with Treasury securities within 2001. 28. Operational Restructuring. At this time, we also intend to initiate the operational restructuring of Halk and Ziraat. We expect that under the oversight of the new independent Govemance Board, Ziraat will make substantial progress towards the closure of unprofitable branches and will also be able to reduce a large part of its excess staff through early retirement packages and altemative placements. In the latter area, we are targeting substantial progress in this area by end 2001 and expect to complete the process of unprofitable branch closures and excess staff lay-offs during 2002. 29. In case of Ziraat specifically, we will undertake a review of its products, services and operating structure to be able to develop a strategic model for delivering agricultural services on a commercial basis. For this purpose, we will review such successful models in other parts of the World including Europe, and seek technical assistance as necessary. Additionally, we will identify all public service functons of Ziraat, and review all the options to determine how such services should be provided on a cost neutral basis in future (whether by Ziraat 14  or transferred to other entities, or even offered through other banks, or a network of the postal service being several of the potential options), and formally adopt a transfer plan through issuance of necessary decrees/legislation. We expect to achieve this in 2002. 30. Privatization of Halk and Ziraat. With the financial and governance restructuring anticipated to be completed by mid 2001. and operational restructuring underway in the coming months, the sustainability of the structural reform in this area will be sustained by shifting the focus to ownership change through effective privatization of Halk and Ziraat In this area, we expect to (i) complete the full resolution of Halk, resulting in either 100 percent private ownership of the bank or the merger with/acquisition of the bank with another bank: (ii) appoint a Pivatization Adviser for Ziraat; and (iii) carry out the sale of shares in Ziraat to private sector entities resulting in majority private ownership and control (more than 51 percent). 31. Vakif Privatization. Furthermore, we have submitted and Padiament is expected to adopt in June an amendment to the legislation concerning the privatization of Vakif to allow the simultaneous sale of A and B shares. We have also decided to authorize the simultaneous sale of the A and B shares. By December 2001 we intend to complete the prvatizaton of all remaining Government ownership (75 percent) in Vakif, resulting in this bank becoming fully privately owned and controlled. It. Turkey's Public Sector Reform Program 32. The Government has moved decisively to strengthen the fiscal adjustment in response to the crisis and to initiate a broader based program of reforms in the public sector that addresses the underlying structural factors that contributed to the crisis A supplementary budget and fiscal package for 2001 have been introduced. We have also taken important steps to increase fiscal transparency and intend to launch a comprehensive program of reforms to improve public sector management. The public sector reform program aims to achieve permanent fiscal adjustment and establish the foundation for transparent and effective govemment. This will entail radical improvements in public policy formulation, the framework for resource mobilization and altocation, the system of public oversight and accountability, and public sector governance. This is an agenda for modernizing the Turkish public sector to meet the challenges of the new century. 33. The Govemment's public sector reform program has three pillars. The first involves structural fiscal policies to underpin the near-term fiscal adjustment and then to ensure that this adjustment becomes permanent The Government intends to adopt a mediumterm strategy for improving the tax system by 15  December 2001 and a comprehensive program to adjust staffing levels in the central government and SEEs is envisaged. The second pillar comprises institutional and policy reforms to improve public expenditure management (PEM). The Government has prepared a multi-year Strategic Framework for Public Expenditure Management Reform which is in line with the recommendations of the Public Expenditure and Institutional Review (PEIR) carried out jointly with the World Bank. The strategic framework is annexed to this letter. The third pillar involves broad based institutional reforms to improve the quality of public sector goveemance. This includes on-going regulatory reforms in the banking, energy and telecommunications sectors, a systematic approach to combating corruption and - over medium term - civil service reform. The Government is preparmng a natonal strategy for improving govemance and combating corruption which it expects to adopt by December 2001. To help further develop its public sector reform program, the Govemment plans to host two international conferences on Effective Govemment in collaboration with the Bank. The first, scheduled for September, will focus on anti-corruption. The second conference, scheduled for November 2001, will focus on public management reforms linked to the PEM agenda. 34. We request the support of the World Bank in carrying out our public sector reform program. The agenda for the remainder of 2001 would be supported by the PFPSAL program. The public sector reform actions to be taken prior to Board presentation of the first PFPSAL operation are detailed below together with the implementation benchmarks expected to be completed by December 2001 for the second PFPSAL operation. These prior actions and implementation -benchmarks will ensure that the core framework for the public sector reform program is in place by the end of 2001, together with the urgent measures required to achieve the revised 2001 fiscal targets agreed with the IMF. The second phase of the public sector reform program will be undertaken during 2002-03 in synchronization with the annual budget cycle. During this period, we intend to complete the main policy and legal reforms underpinning the program and set in motion the key longer-term institutional reforrns required to ensure its sustainability and to realize the full benefits. We would request the Bank to support these conUinued efforts through the first programmatic public sector adjustment loan (PPSAL) envisaged for late 2002 in the revised CAS high case- 35. The specifics of the Govemments proposed public sector reforms are presented below under three major headings; namely (i) Structural Fiscal Policies, (ii) Public Expenditure Management Reform, and (iii) Public Sector Govemance. Structural Fiscal Policies 16  36. The Government is implementing tough fiscal measures to support the supplementary budget for 2001. These measures supplement the orginal fiscal package for the 2001 budget approved in December 2000. The original package included important revenue measures including extension through 2002 of several temporary taxes, renewal of quarterly advance income tax payments, increases in motor vehicle taxes, and the re-introduction of presumptive income taxation based on living standards. The supplementary fiscal package incorporates the following measures: . Increase in the petroleum consumption tax (PCT) by at least 15 percent in May, following a 20 percent increase in April, and subsequent full implementation of the indexation regulation for the PCT adopted in 2000; * Increase in the standard VAT rate from 17 to 18 percent and the luxury rate from 25 to 26 percent; * Increase in the minimum base for social security contrbutions of 40 percent and increase in the ceiling from 4 to 5 times the minimum base in line with existing regulations; . Full pass through by SEEs of cost increases due to exchange rate adjustments and the revised inflation targets; and 3 Adjustment of agriculture support prices in line with the agriculture reform program supported by the ERL. 37. Looking past the immediate crisis, further fundamental fiscal reforms will be required on both the revenue and expenditure sides to reach the 6.5 percent of GNP primary surplus for the consolidated public sector targeted for 2002 and to sustain this adjustment over the medium term. These reforms will complete and build on the results achieved under the ERL program in the areas of social security reform, energy reform, and reform of agriculture support policies. 38. The Government's medium-term strategy for improving the tax system in Turkey will cover tax administration, personal income tax, corporate income tax and the indirect tax system. The overall objective is to improve the stability, transparency and equity of the tax system, but without a major increase in the overall tax burden for existing taxpayers who comply with the system, Improving tax administration is a priority including automaion, transparency, compliance, taxpayer services and tax audit. In June 2001, the Government will enact a tax regulation expanding the use of Tax tdentification Numbers (TINs) to owners of bank accounts, users of banking services and participants in financial transacfions. As part of the medium-term strategy, the MOF is preparing provisions to facilitate mergers and acquisitions in the corporate sector as the economy recovers from the crisis, as well as a special consumption tax to replace the existing system of specific excise taxes. The Government intends to 17  adopt the medium-term strategy for improving the tax system by December 2001. The strategy will be implemented during 2002-03, 39. On the expenditure side, the Government recognizes that strong action is needed to adjust staffing levels throughout the central government and SEEs to a level consistent with medium-term resource constraints and fiscal targets. The Government has decided that the number of civil servants will not increase in 2001 and that it will strictly implement the existing policy of replacing up to a maximum of 15 percent of retiring personnel in the SEEs including Turk Telekom and the enterprises in the portfolio of the Privatization Administration. By December 2001, the Government intends to initiate a comprehensive program to right size the public sector based in part on extension of the norm cadre system and a functional review of govemment. The program will include sustained implementation of the privatization program and specific targets for staffing in the central government for end-2002 and end-2003. As part of the program, the Govemment will consider expanding the use of early retirement incentives such as those included in the telecommunications amendments enacted in May. This program will be prepared and implemented in coordination with the ministerial committee for civil service reform which the Government plans to establish. Public Expenditure Manatement 40. The Government has adopted a multi-year strategy for reforming public expenditure management and has established a high-level Steering Committee to coordinate implementation including representatives of MOF, Treasury, SPO, and TCA. The Steering Committee will be expanded to include line ministres and agencies. The strategy encompasses: (i) reform of the processes for budget preparation and execution to ensure transparency and aggregate fiscal discipline, institutional measures to build capacity for policy formulation to guide resource allocation, and concrete steps to improve operational performance of line ministries and agencies; (ii) upgrade of public accounting, procurement and audit functions to ensure adequate financial accountability in line with internatonal standards; and (iii) legal measures and institution building to ensure prudent public liability management. 41. Budget Reform. The Govemment is taking steps to improve budget management which will serve as the basis for a broader effort over the medium term. For the 2002 budget, the following actions are being taken: * Budgetary and Extra-budgetary Funds. Progress has been made under the ERL program to expand the scope of the budget by reducing the number of budgetary and extra-budgetary funds. In June 2001, the Parliament is expected to adopt legislation to close 15 more budgetary funds and two EBFs. 18  As a resuKt, all budgetary funds, with the exception of the Support Price Stabilization Fund linked to the reform of the agriculture sales cooperative unions (ASCUs) under the ERL, and alt but five EBFs wlll be eliminated in the 2002 budget. The Government is committed not to create new budgetary or extra-budgetary funds. Revolving Funds. The Government plans to consolidate the revolving funds by agency which is expected to result in a reduction in the number of revolving funds by half by the end of 2001. These funds include about 2,650 special accounts or institutions recording expenditures against revenues from the sale of public services amounting to some one percent of GNP. Subsequendy, a comprehensive financial and economic review of the operations of the revolving funds will be carried out and further steps will be identified by mid 2002 to facilitate their incorporation into the general government budget presentation. In carrying out this exercise, the Government will pay close attention to the importance of maintaining the access of institutions at the local level to revolving fund revenues. Revolving fund revenues will be reported as "own source revenues of general govemment agencies in an annex to the 2002 budget presented to Parliament. * Foundations. A task force from the relevant govemment units will be established in 2001 to review the role and appropriate treatment of foundations and associations within the overall public sector. V Budget Classification. A budget classification for consolidated budget agencies in line with the new GFS standards (including full functional classification) has been completed and will be implemented on a pilot basis in 2002. The draft budget submitted to Parliament for 2002 will be accompanied by the accounts and financial outlook for: (i) contingent liabilities of the Treasury, (ii) other general govremment agencies including EBFs, social security institutions, revolving funds, autonomous agencies, and local authorities; and (iii) the SEEs. * Public Investment Proqram. The Govemment intends to rationalize the public investment program (PIP) in the 2002 budget. As part of the PIP rationalization, the Government intends to carry out a Public Investment Review on an urgent basis and has requested support for this review from the Bank. 42. The High Planning Council will issue in June a decision for the 2002 budget preparation process to accompany the Prime Minister's Budget Call. The decision will: (i) provide a macro-fiscal framework for 2002 budget preparation including overall levels for the recurrent and investment budget, (ii) establish indicative ceilings for both the recurrent and investment budgets for ministries and line agencies, (iii) freeze the introduction of new multi-year projects into the 19  PIP, except for possible emergency projects, and (iv) call for a rationalization of the PIP in the 2002 budget. The decision will include: * timetable for rationalization process, * objective of reducing expected average time to completion of the overall PIP by 20% in 2002 compared to the 2001 PIP along with sector-specific reductions consistent with this overall objective, * global criteria for prioritizing projects, and * instruction to ministries and line agencies to prioritize their investment programs in line with the ceilings, objectives and criteria. 43. Sustained implementation of the budget reform wnill be linked to the annual budget cycles for 2002-03. The following actons are planned: * Budget Classification. The remaining preparatory actions, including legal changes, required to implement the new budget classification and coding on a pilot basis in the 2002 budget will be completed by December 2001, and the budget classification will be extended to cover all of general govemment as defined by the new GFS. Rollout of the new budget classification for the consolidated budget agencies will begin with the 2003 budget cycle. The new GFS budget classification is expected to be fully operafional for the entre general government in the 2004 budget. * Bud-et Pre2aration. The Govemment will ensure effective implementation of the 2002 budget preparation process in line with the Prme Minister's Budget Call. An enhanced preparation process will be implemented for the 2003 budget-including introduction of a rolling two-year expenditure framework. The Government intends that the Prime Ministers Budget Call for in the 2003 budget will include individually specified indicative ceilings for each ministry and line agency based on the experience with the 2002 budget preparation process. a Public Investment Program. The Govemment will adopt a PIP for 2002 which is consistent with the rationalization objectives set out in the High Planning Council Decision, together with an action plan for sustaining a rational PIP beyond 2002. . Building Ca2acitv for Policy Formulation. The Govemment will undertake actions by December 2001 to introduce new elements of policy formulation into the budget process. The SPO will prepare by December 2001 guidelines for strategic planning by key line ministries and departments including guidelines for costng policies. Policy reviews will be initiated by line ministries and agencies to derive clear statement of objectives and expenditure priorities in preparation of 2002 budget. The role of ministerial departments responsible for policy reviews will be revived with support of SPO. Dunng 2002, the Govemment will undertake further efforts to build 20  capacity for policy formulation in the line ministries and agencies with support from SPO. rmprovinp Ooerational Performance. The Government intends to identify by December 2001 a group of line ministries and agencies willing to volunteer for a pilot reform program that wilt provide them with greater discretionary control over inputs linked to implementation of effective internal controls and commitment to improved performance. For agencies in the pilot program that satisfy the requirements of satisfactory intemal control systems, the 2002 budget will provide appropriate levels of appropriations linked to areas of agreed performance in 'block' form, allowing agency discretonary authority for management of resources. During 2002, the pilot program to improve operational performance will be implemented. Expansion of the prograrn to improve operational performance will begin with the 2003 budget cycle. 44. FInancial Accountability. Accounting. Action to upgrade the public accounting system is already underway. Field installations for the say2000i system will be substantially completed by the end of June with the objective of starting full automation for consolidated budget agencies by end-2001. Full automation under the say2000i system will start in December 2001. Going forward, the Government will take necessary actions to adapt the accounting system to the new GFS classification for the budget and to introduce accrual accounting. By December 2001, the Govemment intends to: (i) revise the Accounting Law (No- 1050) to incorporate the new definition of general govremment and atlow MOF to issue accounting standards for all general government agencies in line with the new GFS classification, (ii) issue new modified accrual based chart of accounts consistent with GFS for general government, and (iii) develop a strategy for phased introduction of accrual accounting across general govemment agencies. 45. Procurement. The Govemment intends to upgrade Turkey's public procurement legislation and procedures in line with intemational standards. A new public procurement law is under preparation that vill be consistent with UNCITRAL standards as part of a medium-term strategy to meet full compliance with EU directives. The Govemment expects the new public procurement law to be enacted before the end of 2001. The law is expected to: (i) cover all goods, works, and services, (ii) be applicable to all central and local govemment agencies; and (iii) encompass both budgetary and non-budgetary procurement. The law will also cover non-commercialized SEEs. The Government will initiate preparation of a system by December 2001 to define quatified contractors in line with new law. During 2002, the Government will implement the new legislation and undertake efforts to strengthen institutional capacity. Steps will also be taken to prepare for the introduction of perfodic procurement audits by TCA and publication of the results. 21  46. Auditing, The Govemment has established a task force to develop a reform program for the public audit system. The objectives of the program are two fold. First, develop a plan of action, including necessary legal amendments, to expand scope of TCA audits to cover the entire general government including autonomous agencies, social security institutions, remaining EBFs, and revolving funds. Second, prepare a new law on internal financial control and audit in line with international standards based on a review of current control, inspection and audit processes. This new legislation will promote improvements in control and audit quality in line with international standards and support the shift from ex ante controls to ex post monitoring in harmony with the efforts to improve operational performance of budget agencies. By December 2001, the Government intends to adopt a plan of action to expand scope of TCA audits and MOF will circulate to ministries and line agencies a discussion draft of the new law on intemal financial control and audit with objective of submitting it to Parliament by mid 2002. In addition, by December, TCA will include all consolidated budget agencies under its annual audit as required by the Constfitution, including the Presidency, Parliament and TCA. TCA's own accounts will be subject to audit with reports submitted to the Parliament. In line with new law on internal financial control, TCA's involvement in budget execution under the pre-audit system will be discontinued, starting in 2002, and TCA will initiate a shift to ,erformance audits. 47. Public Liability Management The Government recognizes that role of the buildup of quasi-fiscal and contingent liabilities in the state banks in triggering the November and February crises highlights the importance of strengthening public liability management in Turkey- Regulatory reforms in the electricity sector supported by the ERL are addressing one of the main sources of contingent liabilities in the form of government guaranteed BOT contracts. State bank reform and other actions under the financial sector reform program are addressing another major source of contingent liabilities. In May, a Govemment decree was published and the Parliament is expected to adopt legislation in June which together will eliminate all existing legal provisions authornzing creation of duty losses in the state banks. This action aligns the legal framework with the state banks restructuring law approved in December 2000. 48. The Govemment intends to establish a comprehensive risk management framework as the foundation for future management of public liabilities. The Govemment will submit to Padiament in June a law on public debt management that establishes Treasury as the single borrowing authority for the central govemment. This law, which the Government expects to be enacted before the end of 2001, will serve as the legal basis forthe risk management framework on which work has been initiated. By December 2001, the Govemment will conduct a review of its guarantee portfolio and prepare a debt sustainability analysis including all identifiable contingent liabilities of the central government. Over the 22  course of 2002, as eiements of the risk management framework, the Govemment intends to: (i) develop guidelines for the issuance of government guarantees and for borrowing by state enterprises, (ii) implement mechanisms for monitoring government project guarantees and on-lending operations, and develop a centralized fiscal risk analysis capability; and (iii) prepare and disclose a Government Fiscal Risk Statement. The full institutional structure for the new public liability management system, including all necessary legal changes, should be in place by 2003, and the Govemment will then be in a position to issue its public liability strategy as an annex to the future medium-term expenditure framework. Public Sector Governance 49. Regulatory reforms are a key element of the Government's program for improving public sector governance. Major progress has been made in improving the quality of the regulatory environment in Turkey, under the ERL program in energy and telecommunications and the FSAL program in the financial sector. Recently enacted legislation for electricty (February 2001) and gas (May 2001) has established a unified independent regulator for the energy sector. In telecommunications, legislation enacted in January 2000 created an independent regulatory authority and amendments enacted in May 2001 transferred all licensing authority to this authority. Successive amendments to the banking law have strengthened the Banking Regulatory and Supervision Agency as described earlier. 50. The Govemment has initiated preparation of a national strategy to improve govemance and combat corruption which will extend beyond the on-going regulatory reforms. A steering committee has been formed consisting of representatives from the Treasury, the Prime Ministers Inspection Board, the Anti-Money Launderng Unit of the Ministry of Finance, the Ministry of Justice and the Ministry of Interior. The objective is to develop a comprehensive approach to the issue which establishes clear priorites and benchmarks, and empowers and energizes public opinion to fight corruption. The Government is counting on the active involvement of national NGOs. To help formulate the strategy, the Government plans to host an intemational conference on good governance and anti-corruption in collaboration with the Bank in September 2001. The steering committee expects to complete preparation of the strategy by end-September and its adoption and publicaion by the Government is planned before the end of 2001. The strategy will encompass specific actions reJated to improving the transparency of the tax system and public expenditure management. It is expected to include concrete performance benchmarks for the ministries and line agencies. In a related action, the Government submitted to Parliament in early June legislation to improve the code of conduct of public officials. 23  bZ d fliiOi 51. The medium-term govemance agenda encompasses civil service reform which is vital to ensuring the quality of public services. The Government plans to establish a ministerial committee in 2001 to carry out a functonal review of government in preparation for the civil service reform. On the basis of this review, the Government will present its strategy for civil service reform to the public in 2002. 52. The Government of Turkey believes that the policies and measures described above are adequate to achieve the objectives of our financial and public sector reform prram for which support from the World Bank is requested. The Govremment is committed to meeting all of the benchmarks and triggers agreed with the Bank for the PFPSAL If and for follow up programmatic loans in the financial and public sectors. The Govemment also stands ready to take additional measures, if necessary to achieve the success of our program, in regular consultation with the World Bank. Sincerely yours, Kema) DERVI$ Smmer ORAL Minister of State Minister of Finance 24  Annex VI Page 1 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL II Program Benchmarks Area _ 1. Macroeconomic Framework Minimize the short-term In February 2001 Turkey * Satisfactory macroeconomic framework * Continued satisfactory macroeconomic impact of the crisis and set experienced a severe financial consistent with the core objectives for framework. Adopt a satisfactory budget the stage for an early crisis. The Government was 2001 including positive GNP growth for 2002 which continues to allocate resumption of disinflation compelled to abandon the crawling during the second semester, inflation of 2 satisfactory expenditure envelopes for and growth. peg exchange rate regime and float percent per month and nominal interest health, education and social protection. the Lira which has subsequently rates of 50-55 percent by the end of the depreciated by over 40 percent. year, and a primary surplus for the Interest rates, which skyrocketed to consolidated public sector of 5.5 percent of 6,200 percent (overnight) at the GNP. peak of the crisis, have fallen but * Approval of a satisfactory supplementary remain well above pre-crisis levels budget for 2001 consistent with the and unsustainably high in real Government's macroeconomic objectives terms, adding to both sovereign which also ensures satisfactory and corporate sector debt service expenditure envelopes for health, burdens. education and social protection. II. Banking Reform A. Re ulatory Framework for Banking Activity Further strengthen the As a condition for the December * The Parliament to enact a banking law * The BRSA to bring the LLP fully in line legal, regulatory and 2000 FSAL, a new loan loss amendment: (i) allowing full tax with international best practice standards. enforcement regime for provisioning rule (LLP) was deductibility of all specific loan loss * Satisfactory implementation of the action banking (loan loss introduced. While this rule was a provisions required by the BRSA effective plans for banks with excess connected provisioning and tax major improvement over the earlier for the year beginning January 1, 2001; exposures to reach compliance with the deductibility, connected version, it still was not fully up to and (ii) allowing application of connected new banking law limits. and FX exposure best practice standards. Some exposure limits on a consolidated basis * The BRSA to set up a working group monitoring and further changes were agreed as while retaining the existing phase-in period comprising BRSA and CBT staff, enforcement). conditionality for the release of the in the Banking Law for connected external auditors and banks to: (i) second tranche of the FSAL. exposures to reach EU limits, and catalogue the use by banks of structured These changes remain to be introducing separate exposure lirnits for finance products to incur FX exposures implemented. Connected exposure equity investments in non-financial not captured by existing regulation, and limits on a solo and consolidated subsidiaries in line with the applicable EU (ii) formulate remedial regulatory action basis were to be brought in line Directive, with a phase-in period. to capture such exposures as necessary. with EU standards as a condition * The BRSA to: (i) reissue the existing LLP * The BRSA to announce its intention to for second tranche release of issued by the COM as a BRSA regulation, undertake surprise on-site examinations, FSAL. This reform to date has not and to apply the LLP regime uniformly to in coordination with foreign supervisors yet been implemented. While FX Ziraat also, thereby de facto lifting the where necessary (i.e., for the foreign  Annex VI Page 2 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL II Program Benchmarks Area exposure limits had already been exemption from specific provisioning for branches/subsidiaries of Turkish banks reduced from 50 to 20 percent of Ziraat's agricultural support loans; (ii) abroad), to verify compliance with regulatory capital before the issue a definition of connected exposure in consolidated FX open position limits November 2000 crisis, and were line with the applicable EU directive and between reporting dates. also already applicable both on a to apply this definition and maximum * The BRSA and the CBT to commit not to solo and a consolidated basis, the exposure limits on a solo and consolidated lift the existing FX exposure limits until November 2000 and February basis; and the interim targets and timetable onsite examinations have confirmed that 2001 crises have focused attention for banks to reach compliance with the banks' risk management systems and the on the sometimes excessively high new banking law limits on equity holdings market risk charge for FX risk becoming short positions of banks, which are in non-financial subsidiaries, satisfactory mandatory on January 1, 2002 are often closed through non- to the Bank; and (iii) amend the solo and functioning satisfactorily. transparent off balance sheet consolidated capital adequacy regulations forward FX purchases. to change the reporting frequency for the capital base constituting the denominator of the FX exposure limit from quarterly to monthly; and the consolidated FX position reporting rule to change the reporting frequency from quarterly to monthly, both with effect as of January 1, 2002. * The BRSA and any banks out of compliance with the new connected exposure limits to agree to finalize by August 31, 2001 time-bound action plans to reach compliance. Enhance transparency and Turkish banks are routinely * The Government to set up a committee * The Government to take the necessary reduce risks inherent in engaged in unusually large comprising of representatives of the measures to reduce such risks taking into repo/reverse repo activity amounts of off balance sheet repo Treasury, the BRSA, the CBT, the CMB account the recommnendations of the of banks. and reverse repo transactions using and the MOF to recommend measures (e.g. committee. Government securities, not only setting a minimum allowable size for repo * The BRSA to require banks to bring repos with wholesale clients but also transactions, setting a liquidity requirement on balance sheet as collateralized finance with retail clients. Historically, in for repos, adjusting withholding taxes transactions. order to encourage secondary based on the length of liability maturities, market liquidity, the repo/reverse etc.) to reduce the risks caused by repo market has enjoyed a excessive use of retail repos/short-term favorable withholding tax regime liabilities in the banking sector. (as compared with the regime for regular deposits). The discrepancy  Annex VI Page 3 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL II Program Benchmarks Area in withholding tax rates was corrected only in December 2000. However, repos remain exempt from (unremunerated) reserve requirements, Create legal basis for * The Government to review and amend as formation of financial necessary corporate and tax legislation to conglomerates. facilitate transformation of financial- industrial groups into separate financial and corporate conglomerates. B. Institutional Development of the Bank Regulatory and Supervisory Agency Further strengthen the The BRSA since its creation on * The BRSA to develop, and the BRSA * The GovernmentlBRSA to review the institutional capacity of the September 1, 2000 has made Board to approve, a time-bound strategic salaries of BRSA Board members and BRSA. remarkable progress towards its plan with clearly assigned implementation staff and to bring them in line with the operationalization. However, the responsibilities with the objective of (i) prevailing salary scales for similar November 2000 and February having a comprehensive human resource professional staff in the banking sector, in 2001 banking sector crises, also policy further assimilating its staff from any event not less than the comparable taking into account that the different sources and strengthening the salaries at the CBT or CMB. SDIF-the entity responsible for staff training program; (ii) integrating the * Satisfactory implementation of the time- bank failure resolution--is existing multiple databases into a common bound strategic plan for the BRSA. currently part of the BRSA, have database and developing a common * The BRSA to set up a problem bank unit diverted attention and energy away platform for analyzing and assessing within the BRSA's enforcement from its own still unfinished banking risks; (iii) upgrading/developing department and to adopt a prefailure institutional development agenda. procedures manuals for all major existing corrective action manual for the new unit, BRSA units; and (iv) introducing the which predefines mandatory prefailure concept of relationship supervision with intervention triggers. offsite examiners, enforcement staff and Sworn Bank Auditors working in teams on individual banks. Further strengthen the * The SDIF staff to prepare, and the SDIF institutional capacity of the Board to approve a time-bound strategic SDIF. plan, with clearly assigned implementation responsibilities that (i) puts in place a more effective organizational structure, with clearly  Annex VI Page 4 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL HI Program Benchmarks Area separated line responsibilities for bank resolution effort, asset management efforts, administration of the blanket guarantee & the deposit insurance scheme and supporting functions such as legal, human resources and information technology; (ii) sets performance targets for the bank resolution and asset management functions; (iii) envisages the hiring of additional qualified staff to handle the high volume of non- performing loans and other problem assets to be transferred to the Collections Department for collection/workout; and (iv) builds a centralized and high quality management information system that will allow SDIF senior management and the SDIF Board to monitor progress being made towards reaching agreed resolution . _ . ~~~~~~~~~~~~~~~~~~~~~~~~~~~and asset management/collection targets. C. Problem Bank/Bank Failure Resolution Enforce capital restoration In addition to the 13 banks already * The BRSA to identify all capital deficient * Satisfactory implementation of capital plans for all capital intervened by the SDIF so far, banks in the system, and to agree capital restoration plans with capital deficient deficient deposit taking several additional banks are restoration plans with these banks, or to banks, or implementation of satisfactory banks. estimated to be capital deficient as initiate appropriate resolution action. SDIF resolution action for such banks. a result of the February banking crisis. It is therefore necessary for the enforcement department of the BRSA to assess the capital deficiency and enter into capital restoration agreements with each of such capital deficient banks. Retire the high cost The increasing high cost overnight * Treasury in co-operation with CBT to overnight liabilities of liability position of Demir and inject into the SDfF banks enough (i) SDIF banks, other SDIF banks has created marketable Government securities (in TL pressure on interest rates and has and FX) in a mix of maturities and  Annex VI Page 5 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL 11 Program Benchmarks Area increased the compounding rate of currency denominations carrying quarterly these overnight liabilities on the market-based floating rate coupon interest books of these banks. It is to ensure that the banks have sufficient therefore necessary to urgently liquidity to operate and honor any deposit retire the overnight liabilities by withdrawals, and to recapitalize the SDIF repaying them and/or where banks up to 0 percent capital adequacy; possible to restructure them into and (ii) cash (in lieu of the Government term liabilities. securities above) to retire at least two thirds of all on and off balance sheet overnight high cost liability funding of the SDIF banks outstanding as of March 16, 2001 (excluding liabilities to the CBT), and the CBT to subsequently mop up excess liquidity through open market operations within an overall ceiling on the stock of repurchase agreements of the SDIF and state-owned banks with the CBT as of end May 2001 of TL 7 quadrillion. Resolve existing 8 SDIF The number of banks intervened * The SDIF to: (i)hire additionally required * Sell Ekspres, Demir and Iktisat, or revoke banks by the SDIF has steadily increased staff for the Collection Department; (ii) their licenses and merge them with the from 3 in November 1999 to 13 in receive approval from its Board for the transition bank(s). June 2001. No banks have as of yet transfer of 1,166 problem loan files (each * Resolve Sumer and the second transition been sold, and selling SDIF banks above TL 75 billion) from Sumer bank to bank through sale or license in the current circumstances is the Collection Department; and (iii) revocation/liquidation. difficult at best. In order to reduce complete the transfer of 150 of the above * SDIF to complete transfer of all problem losses, non saleable banks in SDIF files to the Collection Department. loan files above TL 75 billion to the are being merged internally and * Select a second 'transition bank' if Collection Department and the Collection operations are shrunk to reduce necessary due to overload at Sumer, and in Department to either have reached a losses. As a first step in this the absence of a sale, revoke the licenses negotiated settlement with the loan direction, the licenses of 5 SDIF and initiate the mergerfliquidation of Turk defaulters, or to have initiated legal action banks (Ege, Kapital, Yurt, Yasar Ticaret, Es, Inter and Eti with either one of for all its problem loan files; and and Ulusal) have already been the transition banks. * The SDIF to amend its regulations to revoked and their merger with reflect the recent amendments in the Sumer, which has been designated banking law, and to adopt the necessary as a 'transition' bank, has been organizational structure and operating completed, reducing the number of procedures for the Collection Department banks under SDIF to 8. By the end by August 31, 2001.  Annex VI Page 6 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL II Program Benchmarks Area of June, it is anticipated that only 5 banks out of the original 13 will remain;--these will be Sumer, Iktisat, Demir and Bank Express (if not sold); and a second transition bank (most likely Turk Ticaret). The remaining 5 banks will be resolved by the year end 2001. Upgrade bankruptcy and * The Government to undertake a co- collateral legislation and coordinated review of the improvements supporting infrastructure as required in the legal framework for necessary to facilitate NPL bankruptcy and collateral foreclosure, and resolution. to seek Parliamentary enactment of the changes required to allow accelerated/more efficient NPL resolution. * The Government as part of the follow up to the above review to prepare a plan to set up a movable goods register. D. State Bank Restructuring and Privatization Restructuring of Halk and Both as a result of many years of * Treasury in co-operation with the CBT to * Substantial progress towards unprofitable Ziraat. political interference and the inject into Ziraat and Halk enough (i). branch closures and excess staff layoffs November 2000 and February marketable Goverrinent securities in a mix by Halk and Ziraat. 2001 crises, Halk and Ziraat are of maturities and currency denominations * Identify all public service functions of insolvent as well as illiquid and carrying quarterly market-based Ziraat that should be transferred to other because of large unpaid floating rate coupon interest to ensure that entities as well as the recipient entities for Government 'duty losses', and the the banks have sufficient liquidity to these functions and formally adopt a excessive interbank borrowing to operate and honor any deposit transfer plan through issuance of finance these losses has become a withdrawals, write off all remaining duty necessary decrees/legislation. major distortive factor for loss claims and recapitalize the two banks monetary policy. The banks do up to at least 8 percent capital adequacy; in have, however, a natural niche addition, all already existing Government market in SME and agricultural securities in the books of these two banks lending respectively, and with to be reissued in uniformity with the new expeditious financial, governance set of securities as necessary; and (ii) cash and operational restructuring could (in lieu of the Government securities  Annex VI Page 7 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL 11 Program Benchmarks Area be privatized quickly. above) to retire at least two thirds of all on and off balance sheet overnight high cost liability funding of the two state banks outstanding as of March 16, 2001 (excluding liabilities to the CBT), and the CBT to subsequently mop up excess liquidity through open market operations within an overall ceiling on the stock of repurchase agreements of the SDIF and state-owned banks with the CBT as of end May of TL 7 quadrillion. * Government to appoint a new independent professional Governing Board for the two banks with the mandate to manage these banks in accordance with commercial principles and all prudential guidelines under the banking law/issued by the BRSA; and the Governing Board to initiate operational restructuring of the two banks, including the closure of unprofitable branches and the reduction of redundant staff. * The Governing Board to appoint a Restructuring Adviser for Ziraat and a Restructuring and Privatization Adviser for Halk. Emlak Emlak was already insolvent * The Government to (i) complete the before the crises, due to a transfer of all construction-related assets problematic loan portfolio and on Emlak's balance sheet to the Mass construction activity related losses. Housing Administration (MHA); (ii) The crises have further deepened complete the merger of all banking the bank's insolvency. Emlak has liabilities and all performing banking little franchise value as it is assets of Emlak with Ziraat Halk, (iii) engaged in a disparate range of revoke Emlak's banking license: and (iv) activities (maritime finance, trade provide sufficient capital to Ziraat and finance and construction) due to Halk in the form of rnarketable  Annex VI Page 8 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL II Program Benchmarks Area previous Government policy of Government securities carrying quarterly merging other failed state banks market based floating rate coupon interest into Enlak. to allow them to absorb all losses related to Emlak's merger, including the issuance of Mass Housing Fund securities to Emlak in lieu of the construction related assets transferred to the MHA on a short-term basis to be exchanged with Treasury securities within 200117. Vakif Vakif traditionally has been run on * The Parliament to adopt amendments to * Complete the privatization (100 percent) a more commercial basis than the existing legislation concerning the of Vakif. other three state banks, and was privatization of Vakif to allow the solvent before the crises. Like simultaneous sale of A and B shares, and other banks, however, it also has the Government to agree to authorize the suffered a capital erosion as a simultaneous sale of the A and B shares. result of the crises. 7 This action on revocation of Emlak Bank's license and completion of its merger with Ziraat Bank and Halk Bank is a condition of effectiveness of the loan.  Annex VI Page 9 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditioets PFPSAL II Program Benchmarks Area I III. Public Sector Reform A. Structural Fiscal Policies Create the structural The fiscal adjustment effort begun * Introduce a supplementary fiscal package * Adopt a satisfactory fiscal package for foundation for permanent in 1999 has made good progress. consistent with the revised fiscal targets 2002 which continues the shift from fiscal adjustment. The consolidated public sector for 2001 including: temporary to permanent measures. Sustaining the adjustment achieved a primary surplus of 2.8 [ Ilncrease in the petroleum consumption tax will require progressive percent of GNP in 2000 and the (PCT) by at least 15 percent in May, introduction of more target for 2001 has been increased following a 20 percent increase in April, permanent structural to 5.5 percent in response to the and subsequent full implementation of the measures on both the crisis. This will require significant indexation regulation for the PCT adopted revenue and expenditure additional revenue and expenditure in 2000; sides. measures to supplement the [ [Increase in the standard VAT rate from 17 original fiscal package for the 2001 to 18 percent and the luxury rate from 25 budget The original package to 26 percent; included important revenue E Increase in the minimum base for social measures including extension security contributions of 40 percent and through 2002 of several temporary increase in the ceiling from 4 to 5 times the taxes, renewal of quarterly advance minimum base in line with existing income tax payments, increases in regulations; motor vehicle taxes and the re- 0 [Full pass through by SEEs of cost introduction of presumptive increases due to exchange rate adjustments income taxation based on living and the revised inflation targets; and standards. > [Adjustment of agriculture support prices in line with the agriculture reform program _____________________ . _______________________ _ supported by the ERL. Structural revenue A major tax reform was * Enact tax regulation to expand the use of * Adopt a medium-term strategy for measures. implemented in 1998, but still Tax Identification Numbers (TIN) to improving the tax system in Turkey based much remains to be done to owners of bank accounts, users of banking on a review to be carried out jointly with strengthen the tax base and achieve services and participants in financial the World Bank. The overall objective a more equitable distribution of the transactions. will be to improve the stability, tax burden over the medium term,. transparency and equity of the tax system Tax administration must be further without major increases in the overall tax improved. burden of existing taxpayers who comply _________________________ ~~~~~~~~~~~~~~~~ ~~with the system. Structural expenditure Under the new program, the * The number of civil servants will not * Initiate comprehensive program to adjust measures. Government has emphasized increase in 2001 and the Government will staffing levels in the central government  Annex VI Page 10 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL II Program Benchmarks Area expenditure measures, an implement strict policy of replacing up to a agencies and the SEEs to ensure important policy shift for Turkey. maximum of 15 percent of retiring consistency with medium-term resource Cost cutting measures are being personnel in the SEEs including Turk constraints and fiscal targets. This introduced along with tight Telekom and enterprises in the portfolio of program will be prepared and incomes policies in the public the Privatization Administration. implemented in coordination with the sector. However, sustaining this ministerial commnittee for civil service expenditure adjustment over the reform. medium term without a major reduction in service quality will require a new effort to "right size" government to complement civil service reform and the other components of the public sector reform program. B. Public Expenditure Management (PEM): Budget Reform Implement a The Government has prepared a * Establish high-level Steering Conrmittee to comprehensive strategy for multi-year strategy for PEM coordinate implementation of the PEM improving Public reform which builds on the reform including representatives of MOF, Expenditure Management diagnosis and recommendations of Treasury, SPO and TCA, and selected line (PEM) in Turkey. the Public Expenditure and ministries and agencies as needed. Institutional Review (PEIR) carried out jointly with the World Bank. Expand the scope and In Turkey, the budget is highly * Adopt legislation to close the remaining 15 * Complete all preparations for transparency of the budget fragmented and excludes budgetary funds and two extra-budgetary implementing new GFS budget in order to provide the significant proportions of funds (EBFs); as a result, all budgetary classification and coding on a pilot basis information required for government revenue and funds (with the exception of the Support in 2002 budget. Expand definition of proper policy formulation expenditure. The lack of Price Stabilization Fund linked to the new budget classification to cover all of and performance comprehensive coverage of ASCU reform) and all but five EBFs (SSF, general government as defined by GFS. evaluation. government operations is a serious Defense Fund, Promotion and Publicity * Supplement the draft 2002 budget handicap to effective fiscal Fund, SDIF, and the Privatization Fund) submitted to Parliament with: accounts planning and management. The will be eliminated in the 2002 budget; no and financial outlook for (i) contingent budget classification is inadequate new budgetary or extra-budgetary funds liabilities of the Treasury, (ii) other Since there is no functional will be created. general governmnent agencies including classification of expenditure, * Complete new budget classification for EBFs, social security institutions, policymakers lack the informnation consolidated budget agencies in line with revolving funds, autonomous agencies,  Annex VI Page II of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL II Program Benchmarks Area required to establish and evaluate new GFS standards (including full and local authorities; and (iii) the SEEs. policies. functional classification) for implementation on a pilot basis in 2002 budget. Strengthen credibility of The budget preparation process is * Issue a High Planning Council Decision * Ensure effective implementation of the budget preparation process largely a fonnality as the central for the 2002 budget preparation process to 2002 budget preparation process in line and rationalize public agencies essentially determine the accompany the Prime Minister's Budget with the Prime Minister's Budget Call. investment program. budget allocations for the line Call. The decision will: (i) provide a * The SPO to carry out Public Investment agencies at the last minute with macro-fiscal framework for 2002 budget Review (PIR) in collaboration with the limited meaningful dialogue. preparation including overall levels for the line ministries and agencies, and with Reflecting problems with the recurrent and investment budget, (ii) support from the World Bank. budget preparation process, the establish indicative ceilings for both the Government to adopt: (i) satisfactory public investment program (PIP) recurrent and investment budgets for rationalized investment program for 2002 has more projects than can be ministries and line agencies, (iii) freeze the which meets the objective of the High funded within a reasonable introduction of new multi-year projects Planning Council's decision, and (ii) an timeframe given available into the PIP, except for possible action plan for sustaining a rationalized resources. Projects are not emergency projects, and (iv) call for a investment program beyond 2002. effectively prioritized and rationalization of the PIP in the 2002 completion rates are very low. The budget. The decision will include: SPO requires more authority in limetable for rationalization process, order to act as an effective 0 bbbjective of reducing expected average gatekeeper. time to completion of the overall PIP by 20% in 2002 compared to the 2001 PIP along with sector-specific reductions consistent with this overall objective, 0 Eglobal criteria for prioritizing projects, and 0 [instruction to ministries and line agencies to prioritize their investment programs in line with the ceilings, objectives and criteria. Build capacity for policy Policy formulation, both at the * The SPO to prepare guidelines for formulation. center and in line ministries, needs strategic planning by key line ministries to be strengthened. Because and departments including guidelines for budgetary processes are not costing policies. lnitiate policy reviews responsive to plan priorities, the by line ministries and agencies to derive I plan which is formulated every . clear statement of objectives and  Annex VI Page 12 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL II Program Benchmarks Area five years is not effective in expenditure priorities in preparation of determining real shifts in resource 2002 budget. Revive role of ministerial allocation. There is a need for departments responsible for policy strategic policy guidance to budget reviews with support of SPO. preparation. Improve operational Line ministries and agencies have * Identify a set (3-6) departments or performance. limited authority and capacity to agencies willing to volunteer for reforms respond effectively to changing that will provide them with greater service requirements. The discretionary control over inputs linked to challenge is to gradually replace adoption of effective intemal controls and overbearing central controls with commitments to improved performance. effective internal controls while Ensure that volunteer agencies have increasing the discretionary effective leadership to manage internal authority of line agencies to reforms. For agencies that satisfy the achieve better service performance. requirements of satisfactory intemal control systems, 2002 budget should provide appropriate levels of appropriations linked to areas of agreed performance/outputs in "block" form, allowing agency discretionary authority for management of resources. C. PEM: Financial Accountability Accounting reform. Turkey's public accounting system * Substantially complete field installations * Start full automation under say2000i is antiquated. Mirroring the for the say2000i computerized accounting system for consolidated budget agencies. budget, it suffers from excessive system with the objective of starting full Revise Accounting Law (No. 1050) in fragmentation and the inability to automation for consolidated budget order to incorporate new definition of provide comprehensive agencies by end-200 1. general govemment and allow MOF to information on a timely basis. issue accounting standards for all general government agencies in line with GFS. Issue new modified accrual based chart of accounts consistent with GFS for general govermment. Develop strategy for phased introduction of accrual accounting across general govermnent agencies. Procurement. Current public procurement * Announce that new public procurement * Enact satisfactory new public legislation and procedures do not law to be submitted to Parliament by mid procurement law which meets  Annex VI Page 13 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL HI Program Benchmarks Area . meet intemational standards. October will be fully compatible with UTNCITRAI. standards. The law will Turkey has not kept pace with the UNCITRAL standards as a first step cover all goods, works, and services; is development of internationally towards full compliance with EU applicable to all central and local recognized standards for directives. government agencies; and covers both procurement, such as those of budgetary and non-budgetary United Nations Commission on procurement. The law should also cover International Trade Law non-commercialized SEEs. Initiate (UNCITRAL), the European preparation of a system to define Union (EU) and the World Trade qualified contractors in line with new Organization (WTO). procurement law. Auditing. The quality of government audits * Establish task force in coordination with * TCA to include all consolidated budget falls short of international Steering Committee to develop an audit agencies under its annual audit as standards. The emphasis is on reform program encompassing: (i) a plan required by the Constitution, including administrative audits with little or of action, including necessary legal the Presidency, Parliament and TCA. no attention paid to performance amendments, to expand scope of TCA TCA's own accounts to be subject to auditing. Audit functions are audits to cover the entire general external audit with reports submitted to fragmented and there are government including autonomous the Parliament. Government to adopt plan significant gaps in coverage. agencies, social security institutions, of action to expand scope of TCA audits remaining EBFs, and revolving funds, and to cover the entire general government. (ii) preparation of a new law on internal MOF to circulate to ministries and line financial control and audit in line with agencies discussion draft of new law on international and EU standards based on a internal financial control and audit with review of current control, inspection and objective of submitting it to Parliament audit processes. by mid 2002. TCA will discontinue involvement in budget execution in line with new law on internal financial control and audit. D. PEM: Public Liability Management Establish a stronger The rapid growth of the public debt * Enact COM decree and adopt legislation to * Enact satisfactory public debt institutional framework for over the past decade highlights the eliminate all existing legal provisions management law. Conduct a review of public debt management critical importance of action to authorizing creation of duty losses in the the government guarantee portfolio and and address the remaining strengthen debt management and state banks. prepare a debt sustainability analysis structural sources of contain the proliferation of * Submit to Parliament a satisfactory law on including identifiable contingent growth in contingent contingent liabilities. Regulatory public finance and debt management that liabilities of the central government. liabilities. reforms in the electricity sector establishes the Treasury as the single Adopt guidelines for the issuance of have addressed a key source of borrowing authority for the central government guarantees in accordance  Annex VI Page 14 of 14 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN POLICY MATRIX FOR PFPSAL PROGRAM Objective/Policy Reform Current Status PFPSAL I Board Conditions PFPSAL HI Program Benchmarks Area contingent liabilities, but many government, and initiate development of a with the public debt management law and others persist including those comprehensive fiscal risk management for borrowing by SEEs. Incorporate arising from take or pay contracts framework for the general government. contingent liabilities into the government for natural gas, non-energy BOT Build capacity in Treasury to manage debt reports to be regularly disclosed. projects, and guarantees to local fiscal risks. and municipal governments. E. Public Sector Governance Adopt a systematic A steering committee has been * Initiate preparation of a national strategy to * Adopt and publish national strategy to approach to combating formed consisting of improve governance and combat improve governance and combat corruption and improving representatives from the Treasury, corruption. corruption which establishes clear governance throughout the the Prime Minister's Inspection priorities and benchmarks, and empowers public sector. Board, the Anti-Money Laundering and energizes public opinion to fight Unit of the Ministry of Finance, corruption. the Ministry of Justice, and the Ministry of Interior. A household diagnostic survey on corruption based on World Bank methodology has been completed by TESEV and work is now beginning on a business diagnostic survey. Initiate civil service The structure and function of the * Establish ministerial commnittee to carry reform, civil service in Turkey has not kept out a functional review of governunent as up with the pace of development of background to civil service reform. the economy. Civil service wages are not competitive and training opportunities are limited. Over the medium term, reform of the civil service will be a key step to modernizing the public sector and ensuring the quality of the fiscal adjustment. ___ _  Annex VII Page 1 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level One Strengthen Aggregate Fiscal Management Objective: To enable government to prepare macro-economically sustainable fiscal programs that are based on realistic assessments of revenues from all sources and expenditure plans that are consistent with deficit financing strategy Objective 2001 2002 2003 Expand scope of budget to provide Review and clarify the organization Introduce new chart of accounts for all Full implementation of new chart of information on the entire public chart of General Government and general budget and annexed budget accounts for all central government sector (SAHC Report) and, in identify changes needed for entities. entities including revolving funds. particular, on the general consistency with budgetary government sector classification. Initiate implementation of chart of accounts for local government entities. Adopt clear and common definitions of revolving funds, autonomous Initiate necessary studies for merging Improve the Comprehensiveness, institutions non-budgetary funds and presentation of II general directorates Transparency and the Quality of budgetary funds. information and oversight over currently under annexed budget with General Government (comprising all Close all remaining budgetary funds general budget and annexed budget with the exception of the Pnce Initiate necessary studies for agencles, non-budgetary funds, Stabilization Fund and record revenues presentation appropriations for revolvng funds, social security collected by closed funds as budget universities and the Higher Education institutions, autonomous institutions and local administrations) and other revenue. Council as part of General Budget public sector activities (state economic Modify budget presentation to reflect identified as appropriations for publpicsect activite pstate secton Phase out non-budgetary funds and transfer payments intended for line Autonomous Institutions. enterprises and financial public sector entities). merge earmarked revenues collected agencies under their own budget entities). by funds with general budget revenues. appropriations. Shift responsibility for transfer -only 5 funds to be left. payments other than those related to Treasury and MOF direct Report revolving fund revenues as responsibilities to respective line "own source" revenues of general ministries. government agencies in annex to 2002 Report revolving fund revenues as budget presented to Parliament. "own source" revenues of general government agencies in 2003 budget. Effect necessary regulatory arrangements to introduce cornmon _______________________________________:_1_ ..+ L_ .....2~1,.____________*_________.:-^_  Annex VII Page 2 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level One Strengthen Aggregate Fiscal Management Objective: To enable government to prepare macro-economically sustainable fiscal programs that are based on realistic assessments of revenues from all sources and expenditure plans that are consistent with deficit financing strategy Objective 2001 2002 2003 principles to be applied to revolving fund expenditures. Discontinue clawback taxation of revolving fund revenue and replace with appropriate regulation of user charges/fees where monopoly pricing may exist. Establish a task force from the relevant government units to review role and Withdraw authority for foundations appropriate treatment of "foundations" and associations to collect revenue as and "associations" within overall public agencies. public sector. Phased elimination of practice of earmarked taxes including Law 3418 and Law 4306. Replace with budget appropriations as appropriate. Improve transparency of fiscal Expand the coverage of the budget to Report amounts paid as a result of operations report on quasi-fiscal operations as an calls on guarantees issued by adjustment to revenue (as an offset) or government as an expenditure item expenditure (as a subsidy). "above the line", not as a financing item below the line. Transparently reflect the actual and potential costs of guarantees and other Report the value of contingent contingent liabilities. liabilities (existing stock and new guarantees and other commitments) as a memo item in the budget presentation.  Annex VII Page 3 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level One Strengthen Aggregate Fiscal Management Objective: To enable government to prepare macro-economically sustainable fiscal programs that are based on realistic assessments of revenues from all sources and expenditure plans that are consistent with deficit financing strategy Objective 2001 2002 2003 Prepare reports on contingent Prepare and present report on tax liabilities and undertake financial risk expenditure estimates as memo item in analysis budget for 2004. Ensure appropriate accounting and Revise Accounting Law 1050 to allow Ensure revolving fund revenues are consistency of fiscal data MOF to issue accounting standards for reported by all agencies with such all General Government agencies in funds, using a consistent accounting order to prepare appropriate accounts format. for review and budget analysis. Pilot implementation of modified Full implementation of accrual accrual accounting in selected accounting across central government agencies. agencies. Improve Coverage and Effectiveness TCA to include all consolidated Undertake legal amendments to ensure TCA to prepare audits on all general of Audit and Control Instruments budget agencies under its annual audit, that all public funds are under purview government agencies for Parliament. as required by constitution, including of Parliament in line with Articles 160 the Presidency and Parliament. and 165 of Constitution. TCA to present audit report on revolving funds to Parliament as part TCA's own accounts to be subject to Present legislation to expand TCA of general government audit. audit with reports submitted to mandate for external audits on all Parliament. general government agencies to Parliament. Government to prepare a plan of In line with reforms to increase action, including necessary legal Establish a subcommittee of the Plan performance orientation in public amendments, to expand scope of TCA and Budget committee of Parliament agencies, develop capacity of TCA audits to cover the rest of general or a standing conmiittee of Parliament and other audit bodies for performance government, including autonomous to review and follow-up on TCA Audit audits agencies, social security agencies, reports remaining non-budgetary funds, Ensure audit results are made public.  Annex VII Page 4 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level One Strengthen Aggregate Fiscal Management Objective: To enable government to prepare macro-economically sustainable fiscal programs that are based on realistic assessments of revenues from all sources and expenditure plans that are consistent with deficit financing strategy Objective 2001 2002 2003 revolving funds and any other general Increase analytical content of TCA government agency. reports Establish internal audit units in major government ministries and agencies. Launch a review of current control, Ensure clear government wide role for inspection, and audit processes and TCA as the Supreme Audit Institution prepare a new law on internal financial control and audit in line with Submit new law on internal financial international standards. control and audit to Parliament. Issue new internal control standards. Discontinue TCA involvement in budget execution in line with the new law on internal financial control and audit. Upgrade Budget Classification and Begin pilot testing of new budget Continue pilot testing and preparation Implement new BCS across all central Reporting to provide better inputs classification system in selected for roll out of new BCS to all government agencies. for policy and budget analysis consolidated budget agencies consolidated budget agencies Initiate efforts to introduce BCS to other general government units. Implement Say2000i system across Continue rollout of new IT systems to consolidated budget agencies to all entities - fine tune interfaces with provide timely on-line accounting and related systems in Treasury, Central reporting of budget implementation Bank and SPO. and information on unit costs. Publish monthly reports for both Publish quarterly reports for central and general government. consolidated central government including revolving funds, social  Annex VII Page 5 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level One Strengthen Aggregate Fiscal Management Objective: To enable government to prepare macro-economically sustainable fiscal programs that are based on realistic assessments of revenues from all sources and expenditure plans that are consistent with deficit financing strategy Objective 2001 2002 2003 security institutions, non-budgetary funds and autonomous institutions. Ensure that macroeconomic SPO to take the lead in preparation of Consider institutionalizing a Fiscal framework is robust and can be a more comprehensive macroeconomic Responsibility and Accountability Act effectively implemented framework in consultation with MOF, which aims at strengthening UT, central bank, other relevant accountability and promoting good agencies and private sector. quality fiscal management. Submit to Parliament new Public Finance and Debt Management law to provide an appropriate and explicit Build capacity in Treasury to manage framework for sustainable fiscal risks from guarantees and other management of domestic and extemal contingent liabilities. debt as well as guarantees and other contingent commitments of general government. Initiate efforts to establish capacity for fiscal risk analysis and effective management of contingent liabilities.  Annex VII Page 6 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level Two Build Capacity for Policy Decisions Objective: Improve the quality of government decisions on policies and budgets by: (a) strengthening the budget preparation process to get credible political commitment to a medium term fiscal framework (b) re-invigorating the capacity for policy formulation in sector ministries (c ) establishing capacity for Cabinet to decide on policy priorities in light of (a) and (b) Objective 2001 2002 2003 Strengthen credibility of budget Strengthen budget preparation process by Initiate an explicit medium term Review experience and evolve budget preparation process determining macro-fiscal framework for perspectivc to budget formulation: preparation processes with primary focus the 2002 budget earlier in the year and on improving credibility of the budget. launching Calls for the Budget with an > Introduce a rolling two year macro- > More comprehensive indication of Cabinet endorsed ministry fiscal framework in line with the 5 > Less fragmented and agency ceilings year plans. > Better quality macro-framework > Require line ministries and agencies Over longer term gradually expand the > Timely information on budget Improve coordination arrangements among of central govemment to submit medium term expenditure framework to envelopes for line ministries MOF, SPO and UT to achieve more budget requests for budget year cover more forward years in line with the 5 > Allocations linked to policies and integrated and comprehensivc budget (2003) plus a forward year. year plans. priorities preparation process - covering general > Use constant prices for budget year to > Better technical coordination among government and integrating discussions on estimate forward year. central agencies current and investment budgets (Special Gradually expand medium term budget Ad-hoc Committee report) processes to local government entities and Ensure that budget discussions focus on agencies. links between policy priorities and Provide SPO with authority as gate-keeper requested budget allocations. for Public Investment program to limit new project starts and effective prioritization of Consolidate and improve on innovations to project expenditure. budget preparation process introduced in 2001. SPO to lead and coordinate a rationalization of public investment program during preparations for 2002 budget to ensure full funding for priority projects. Re-invigorate the capacity for policy SPO to prepare guidelines for strategic Line ministries and agencies to preparc formulation in sector ministries and planning by line ministries and strategic plans and medium term budgets in central ministries departments including guidelines for which will be consolidated by SPO.  Annex VII Page 7 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level Two Build Capacity for Policy Decisions Objective: Improve the quality of government decisions on policies and budgets by: (a) strengthening the budget preparation process to get credible political commitment to a medium term fiscal framework (b) re-invigorating the capacity for policy formulation in sector ministries (c) establishing capacity for Cabinet to decide on policy priorities in light of (a) and (b) Objective 2001 2002 2003 costing policies. Medium term budgets to distinguish the Initiate Policy Reviews by line ministries costs of ongoing policies from the costs of and agencies to derive clear statement of new policy initiatives over next budget objectives and expenditure priorities in year and one forward year. preparation of 2002 budget. In the specific cases of Health and Revive role of ministerial departments Education, provide commitment to responsible for policy reviews with support allocate specified percentage of GNP over from SPO. a multi-year period tied to financing of priorities. Where inconsistencies between policies and plans and budgets are revealed, Initiate implementation of policy reforms develop sector action plans for policy reform. Establish capacity for Cabinet to Review and strengthen the capacity of the Cabinet deliberations to be informed and decide on policy priorities within SPO to provide necessary Secretariat constrained by medium term framework medium term fiscal framework functions to the HPC to enable it to play a and running costs of ongoing policies. more effective role in defining strategic priorities and ensuring appropriate funding. As above initiatives begin to gradually improve the quality of policy decisions, Program and Budget Policy Statements could be issued with the draft budget sent to Parliament to provide a clear and credible statement of government policy priorities and its fiscal stance.  Annex VII Page 8 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level Three Improving Operational Performance Objective: To introduce principles of modern budget management by providing agencies greater flexibility in the use of budget resources while holding them accountable for achievement of key performance objectives. Objective 2001 2002 2003 Provide line agencies with more Identify a set (3-6) departments or agencies Initiate implementation of reforms in Evaluate performance of agencies and discretionary authority for budget willing to volunteer for reforms that will volunteer ministries/agencies that have identify problems in performance implementation as a means to improving provide them with greater discretionary established adequate intemal controls and management system for resolution. performance (SAHC Report). control over inputs linked to adoption of transparency of costs. effective internal controls and Eliminate strong incentives for budget commitments to improved performance. Develop capacity to manage reforms in Identify general principles that could be fragmentation due to excessive central Ensure that volunteer has effective selected agencies. applied more widely to budget control over budget. leadership to manage internal reforms. management. Reforms to be guided by: Include a representative sample of agency For agencies that satisfy the requirements types - service delivery agencies as well as of satisfactory intemal control systems, > Generalization of principles investment agencies where public support 2002 budget should provide appropriate underlying Law 4306 for improved performance is strong. levels of appropriations linked to areas of > OECD, esp. French, experience agreed performance/outputs in "block" > Thailand "hurdles" approach Undertake surveys of volunteer agencies to form, allowing agency discretionary identify controls that limit required authority for management of resources. budgetary flexibility and establish baseline performance levels. Establish a technical task force to study and draw lessons from French and other relevant country reforms. Continue working with initial group of Draw on principles from Law 4306, French volunteer agencies to develop more reforms and Thai 'hurdles" approach to comprehensive design of reform develop framework for internal controls adapted to various types of agencies. covering budget planning, output costing, procurement management, funds control and reporting, and intemal audit. Organize discussions between central Develop capacity in SPO and MOF to Expand block budget allocation to other control agencies (MOF and TCA) and line monitor volunteer agency outputs and volunteers who meet internal control agencies to develop the framework design evaluate effectiveness of resource use by hurdles and establish objective measures of I for budget reform and reflect this in a agencies. Gradual shift from central input performance in agreement with central  Annex VII Page 9 of 9 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN THE GOVERNMENT'S STRATEGIC FRAMEWORK FOR PUBLIC EXPENDITURE MANAGEMENT REFORM Level Three Improving Operational Performance Objective: To introduce principles of modern budget management by providing agencies greater flexibility in the use of budget resources while holding them accountable for achievement of key performance objectives. Objective 2001 2002 2003 memorandum of understanding (MOU). control to monitoring of output or agencies. performance. Include user groups and associations in design and monitoring of performance reforms Provide central support to volunteer If appropriate undertake pilot performance agencies to establish internal control audits in volunteer agencies. capabilities in identified areas. Strengthen the "value for money" Revise Govemment Procurement Law Ensure budget execution supports efficient Enable TCA to undertake periodic orientation in public procurement (GPL) to ensure conformity with procurement and timely project procurement audits and publish results for UNCITRAL standards as a first step completion. broad public scrutiny. towards full compliance with E.U. directives. Enforce restrictions on procurement for projects with incomplete design elements. Ensure revision to GPL covers goods, works and services. Provide training in new procurement requirements. Make GPL applicable to all agencies at central and local government level Strengthen capacity to enforce new covering both budgetary and non- legislation. budgetary procurement. GPL should be extended to cover non-commercialized Discontinue practice of disclosing SEEs. "estimated price" and evaluating bids on basis of discounts to estimated price. Restrict negotiated procurement practices. Eliminate Contractor Certificate (carnet) system and establish system to define qualified contractors in line with new GPL.  Annex VIII Page 1 of 2 TURKEY PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN Turkey at a glance Europe & Lower- POVERTY and SOCIAL Central mirJdde. Turkey Asia Income O.velopment diamond' 1S999 Population mid-year (m/llions) 84.3 475 2.094 Life expectancy GNP per caoita (Aflas method, US$) 2,900 2 150 1'200 GNP (Atlas method. USS tfiions) 18686 1.022 2513- Average annual growth, 1993-99 Popuiation I%) 15 0.1 1/1 Labor force (%} 2,6 0.6 12 GNP Gross Most recent estimate (latest yer yalabte, 1per 399. primary Icapita *T,, enrollment Poverty (% otDoPpultion be/ow notionaipovefly //ne) Urban populatton J% oftotal population) 74 67 43 Life expectancy at birth (yearS) 69 89 89 Infant mortality (per 1t000 ive births) 38 22 33 Child malnutrition (i% of children under 5) 10 a 1 5 Access to safe water Access to improved water source (% of 0op/ation) . .. 86 Illiteracv(% of population age /5+) 18 3 16 Gross primary enrollment ( of school-oae Popu/fttion) 107 100 114 Turkey Male 11t 101 114 Lower-middle-incomegroup Femate 104 99 116 KEY ECONOMIC RATIOS And LONG-TERM TRENDS 1979 1939 199S 19- o r F E'on'ornic ratios' GDP (USS billions) 91.7 107.1 201 2 185,7 Grossdomestic investment/GDP 14.1 23.5 24.2 23,3 Trade Exports of goods and services/GDP 31 16.2 24.3 23.2 T Gross domestic savingslGDP 11.5 21 9 20.6 19.6 Gross national savings/GDP 14.4 26.6 25.9 23.5 Currentaccountbalance/GDP -1.5 0.9 1.0 -0.7 oomestic Interest Payments/GOP 0.3 2.5 1,7 2A . S Investment Total debt/GDP 17.4 38.8 48.2 54,8 Total debt serviceexports 28.7 32.4 28.5 34,8 Present value of debUGOP - 49.9 Present value of debt/exports 180.9 Indebtedness 1979469 199-99 1998 1999 199943 (average annusal gnwt/>) _ Tuk GOP n50 4.0 31 -5 1 5.5 Turkey GNP per capita 2.4 25 2.3 ?,8 4.1 Lower-middle-income group Exports 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 I%) (% of GDP) 40 Agriculture 27.9 17.4 18.5 15.8 Industry 23.8 32.8 25.0 24.3 20 Manufacturing 16.0 21.4 15.5 14.6 Services 48.3 49.8 56.5 60.0 -20 - 97 98 Private consumption 77.0 68.8 66.7 65.2 401 General government consumption 11.5 9.3 12.7 15.2 -G oI -OGDPI Imports of goods and services 5.7 17.8 27.9 26.9 1979-89 198999 1998 1999 Growth ofexports and Imports (%) (average annua/ growrth) 4 Agriculture 1.1 1.6 9.3 -5.2 40 Industry 7.3 4.5 1.8 -8.7 20 Manufacturing 7.5 5.4 1.0 -6.0 Services 4.0 4.0 3.1 -3. 94J 95 vs, 97 P85 P Private consumption - 4.0 0.1 -3.9 .20 General govemment consumption 4.0 7.8 6.5 Gross domestic investment 4.6 -1.4 -9.5 40 Imports of goods and services 11.1 2.3 -3.7 -Exports e importrs 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 VIII Page 2 of 2 Turkey PRICES and GOVERNMENT FINANCE Domestic prices 1979 1989 1998 1999 Inflation(%) (% change) 10T Consumer prices .. 63.0 83.7 63.5 1N_ Implicit GDP deflator 75.8 75.7 75 7 56.2 00 Government finance (% of GDP, includes current grants) 0 - _ Current revenue .. 21.5 24.6 25.4 94 95 96 97 98 99 Current budget balance .. 4.2 -5.7 -14.4 [GDP deflator e0CPI Overall surplus/deficit .. -5.2 -13.4 -23.4 TRADE 1979 1989 1998 1999 Export and import levels (USS mill.) (US$ millions) Total exports (fob) 2,261 11,780 31,221 29,326 60,000 Textiles 428 3,911 10,510 9,830 Processed agrcultural products 1,081 1,971 2,141 1,840 40,000 Manufactures 1,732 10,437 23,873 23,755 Total imports (cifd 5,069 15,792 45,921 40,693 * 7rn Food 85 890 510 444 2o,00000U !dlii0 1 Fuel and energy 1,817 3,406 4,501 5,376 Capital goods 1,403 3,953 11,033 9,062 0 Export price index (1995=100) .. 85 87 82 | Import price index (1995=100) .. 90 86 84 a Exports *Imponrs Terms of trade (1995=100) .. 94 101 98 BALANCE of PAYMENTS (USS millions) 1979 1989 1998 1999 Current account balance to GDP (%) 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 E U Resource balance -2,213 -852 -3,262 -4,178 I Net income -1,009 -1,745 -481 -2,361 94 _ Net current transfers 1,810 3,558 5,727 5,175 Current account balance -1,412 961 1,984 -1,364 -2 f Financing items (net) 1,300 1,801 -1,537 6,570 ] fli Changes in net reserves 112 -2,762 -447 -5,206 | 4 Memo: Reserves including gold (US$ millions) .. 9,283 29,499 34,128 Conversion rate (DEC, local/US$) 31.1 2,122 259,627 416,686 EXTERNAL DEBT and RESOURCE FLOWS 1979 1989 1998 1999 (US$ millions) Composition of 1999 debt (USS mill.) Total debt outstanding and disbursed 15,929 41,577 96,906 101,781 IBRD 890 5,869 3,304 2,902 107 890 IDA 190 162 112 107 2902 3783 Totaldebtservice 1,340 7,092 16,513 18,316 23472 8237 IBRD 105 1,010 924 845 IDA 3 6 7 7 Composition of net resource flows Official grants 52 95 37 80 Official creditors 964 -555 -118 -760 Prvate creditors 3,068 1,631 -153 -3,269 Foreign direct investment 75 663 573 138 Portfolio equity 0 56 2,888 -1,727 62390 Word Bank program Commitments 306 604 956 1,165 |A-IBRD E-Bilatera I Disbursements 280 419 271 384 8|-IDA D-Othermultilateral F-Pnvate Prncipal repayments 36 506 684 616 C-IMF G-Short-termm Net flows 244 -87 -414 -232 - -- Interest payments 72 510 246 236 Net transfers 172 -597 -6e0 -468 Development Economics 8/31/00  Annex IX Page 1 of 4 During the pilot, use this page to review /SOS data and then press "PRINT" on the Browser. Use 'BACK' to Continue. The (SDS Pilot is conducted by the Safeguards Policy Team (x32001) of ESSD Integrated Safeguards Data Sheet Pilot June 15, 2001, Print-ready *By supporting the proposed project, the Bank does not intend to prejudice the final determination of the parties' claims on the disputed areas Section I - Basic Information ISDS preparediupdated on 1 P-Jui-O1 A. Basic Project Data Region: ECAVP Country: Turkey FY: 2001 Project Name: PFPSAL I Project ID: 70561 Status: LEND Task Nlgr.: Raina, Lalit Lend Instr: SSL Type: PE .Maj Sector: FF-Financial Adjustment EA Category C Unit: ECSPF Appraisal Date IBRD Amt (S.M): 1100.0 Board Date: 06-29-2001 IDA Amt (SM): t.oanAmt (SM): I l00 Project Objectives The main objective of the proposed PFPSAL is to address the Government's immediate financial and public sector reform priorities in the aftermath of the November 2000 and February 2001 financial crises, while ensuring that social programs continue to be adequately funded. Key priorities include, in the financial sector: (i) overhaul of the regulatory framework for banking activity, (ii) institutional development of the new Bank Regulation and Supervision Agency (BRSA), (iii) problem bank/bank failure resolution, and (iv) state bank restructuring and privatization; and in the public sector: (a) structural fiscal policies, (b) public expenditure management, (c) financial accountability, (d) public liability management, and (e) public sector governance. The PFPSAL will provide budgetary support to help the Government finance the costs arising from the crisis while continuing to fund its critical social programs. Project Description The proposed Programmatic Financial and Public Sector Adjustment Loan (PFPSAL) is the first Loan in support of the Government's multi-year financial and public sector reform program. It is envisaged that the proposed PFPSAL will be followed by a second Programmatic Financial and Public Sector Adjustment Loan (PFPSAL II) of US$1.35 billion (US$550 million on standard IBRD terms and US$800 million on SSAL terms-tentatively planned for December 2001), as well as by (i) two Programmatic Financial Sector Adjustment Loans (PFSAL I and 11) of US$500 million each, and (ii) a Programmatic Public Sector Adjustment Loan (PPSAL) of US$375 million. The latter two sets of adjustment loans will all on standard IBRD terms and are tentatively planned for June 2002 (PFSAL I), December 2002 (PPSAL) and June 2003 (PFSAL II), to support the implementation of the program. The main objective of the proposed PFPSAL is to address the Government's immediate financial and public sector reform priorities in the aftermath of the November 2000 and February 2001 banking system and macro- economic crises, including, in the financial sector: (i) overhaul of the regulatory framework for banking activity; (ii) institutional development of the new Bank Regulation and Supervision Agency (BRSA); (iii) problem bank/bank failure resolution; and (iv) state bank restructuring and privatization; and in the public sector: (i) structural fiscal policies; (ii) public expenditure management; (iii) financial accountability; (iv) public liability management; and (v) public sector governance. Project Location N/A B. Environmental Classification Environmental Classification Approved by C Environmental Assessment Team http://esd.worldbanik.org/isds/dm/is/lsdsprint.cfrn?id=70561&s=lSDS 6/1 8/2001  Annex IX Page 2 of 4 Environmental Classification Comments The project will not directly finance physical investments; it will provide foreign exchange and general budgetary support. C. Applicability of Safeguard Policies Environment Assessment (OPlBP/GP 4.01) C YES C NO r TBD Natural Habitats (OP/GP 4.04) r YES NO TBD Forestry (OP/GP 4.36) r YES NO TBD Pest Management (OP 4.09) CYES NO TBD Cultural Property (OPN 11.03) YES NO TBD Indigenous Peoples (OD 4.20) YES NO TBD Involuntary Resettlement (OD 4.30) r YES NO r TBD Safety of Dams (OPIBP 4.37) C YES NO TBD Projects in Disputed Territories (OP/BP/GP rYES NO TB 7.60)* E N B Projects in International Waterways (OP/BP/GP r YE N 7.50) YES NO TBD Section il. Key Safeguard Issues and Their Management D. Summary of Key Safeguard Issues 1. Describe any safeguard issues associated with the proposed project. Identify and describe any potential large scale, significant and/or irreversible impacts. Describe any potential cumulative or long term impacts. The project will not directly finance physical investments; it will provide foreign exchange and general budgetary support. 2. In light of 1, describe the proposed treatement of alternatives N/A 3. Describe specific implementation measures for borrower to address safeguard issues N/A 4. Identify the key stakeholders and describe the mechanisms for consultation and disclosure on safeguard policies, with an emphasis on potentially affected people. N/A E. Safeguards Classifications r SI-Significant, large scale, cumulative and/or irreversible impacts; or significant technical and institutional risks in one or more safeguard areas C S2-Safeguard policies are triggered, but effects are technically and institutionally manageable Safeguards Classifications