Turkey - Second Programmatic Financial and Public Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P7503-TU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ONA PROPOSED SECOND PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN N THE AMOUNT OF US$1.35 BILLION TO THE REPUBLIC OF TURKEY March 22, 2002 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 SECOND PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN Currency Eanivalekts (Exchange Rate Effective March 1, 2002) Currency Unit = Turkish Lira Turkish Lira I = USSQ0000001 USSI = 1,386,305 Turkish Lira Goverment Flscal Year January I - December 31 Abbreviations and Acronyms ASCU Agriculture Sales Cooperative Union MOF Ministry of Finance BOT Build-Operate-Transfer MOH Ministry of Health BRSA Banking Regulation and Supervision Agency MONE Ministry of National Education CAS Country Assistance Strategy NBFI Non-bank Financial Institutions CBT Central Bank of Turkey NGO Non-Governmental Organization CEM Country Economnic Menorandum NPL Non-Performing Loans CFAA Country Financial Accountability Assessmtent OECD Organization for Economic Cooperation and Developnent CMB Capital Markets Board PA Privatization Admninistration CPAR Country Procurement Assessmnent Report PCT Petroleutn Consutmption Tax DFIF Support Price Stabilization Fund PEIR Public Expenditure and Institutional Review DIS Direct Inconme Support PEM Public Expenditure Maagent EBF Extra-budgetary Funds PFMFC Public Financial Managemnent and Financial Control EFIL Export Finance Intermediation Loan PFMP Public Financial Management Project EMRA Energy Markets Regulatory Agency PFPSAL Progranmmatic Financial and Public Sector Adjustnent Loan ERL Econormic Reform Loan PFSAL Public Financial Sector Adjustment Loan EU European Union PIP Public Investment Programn FIGs Financial Industrial Groups PIR Pubhc Investment Review FOB Free on Board PPSAL Progranmnatic Public Sector Adjustment Loan FSAL Financial Sector Adjustnent Loan PSBR Public Sector Borrowing Requirement FX Foreign Exchange PSI Private Sector Involvement GDP/GNP Gross Domestic Product/Gross National Product PSSP Privatization Social Support Project GFS Government Finance Statistics SDIF Savings Deposit Insurance Fund HPC High Planning Council SDR Special Drawing Rights HR Human Resources SEE State Economic Enterprise IAIS International Association of Insurance Supervisors SIS State Institute of Statistics IAS International Accounting Standards SPO State Planning Organization IFI International Financial Institution SRMP Social Risk Mitigation Project IOSCO International Organization of Securities Conmissions SSAL Special Structural Adjustment Loan IBRD International Bank for Reconstruction and Development SSF Social Solidarity Fund ISE Istanbul Stock Exchange SSI Social Security Institutions LCU Local Currency Units TCA Turidsh Court of Accounts LDP Letter of Development Policy TESEV Foundation for Economic and Social Studies LIBOR London Interbank Offered Rate TL Turkish Lira LLP Loan Loss Provisioning TIN Taxpayer Identification Number MARA Ministry of Agriculture and Rural Affairs TOOR Transfer of Operating Rights MASAK Financial Crimes Investigation Board UNCITRAL United Nations Conmmission on International Trade Law METU Middle East Technical University VAT Value Added Tax Vice President: Johannes F. Linn Country Director Ajay Chhibber Sector Directors: Paul Siegelbaum and Pradeep Mitra Team Leaders: Lalit Raina and James Parks  FOR OFFICIAL USE ONLY REPUBLIC OF TURKEY SECOND PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN LOAN SUNIMARY Borrower: The Republic of Tirjcey Amount: US$1.35 billion Terrns: US$550 million on standard IBRD terms, payable in 15 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$800 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 amounts Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days after signing, less any waiver on the US$550 million amount on standard IBRD terms. Objectives and Description: The proposed Second Programmatic Financial and Public Sector Adjustment Loan (PFPSAL II) is the second Loan in support of the Governnent's multi-year financial and public sector reform program. It follows on the first Programmatic Financial and Public Sector Adjustment Loan of US$ 1.1 billion approved in July 2001 (US$700 million on standard I3RD terms and US$400 million on SSAL terms). The main objective of the proposed PFPSAL 11 is to support the next phase of the Government's financial and public sector reform priorities in response to the February 2001 financial crisis, while continuing to ensure that social programs are 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) a further deepening of structural fiscal policies in support of sustainable fiscal adjustment, (b) a broadening of the Governnent's public expenditure management reform program including the implementation of concrete improvements to the framework for budget planning and execution, financial accountability, and public liability 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.  management, and (c) implementation of the Government's strategy to strengthen public sector governance including adoption and implementation of a national anti-corruption strategy and initial steps towards civil service reform. Benefits: The principal benefits of the Loan will be to: (i) support the Government's macroeconomic policy framework which aims to overcome the affects of the February crisis and create the conditions for renewed growth and disinflation, (ii) restore confidence in the banking system; (iii) strengthen the foundation for an efficient and sound banking system which can be competitive in quality and performance at the international level; (iv) reduce the vulnerability of the banking system and enhance its capacity to withstand external shocks and thereby reduce systemic failure risk; (v) 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; (vi) support structural fiscal measures to underpin the sustainability and quality of the fiscal adjustment needed to achieve macroeconomic stability while ensuring that social spending is protected; (vii) lay the foundation for durable improvements to public expenditure management and fiscal transparency in line with international standards; and (viii) raise the quality of public sector governance. The PFPSAL II will provide essential budgetary support to help the Government finance the costs of recovering from the crisis while continuing to fund its critical social programs. Risks: The risks associated with the Government's financial and public sector reform program arise from macroeconomic factors, political considerations and institutional weaknesses. The key macroeconomic risk is that real interest rates will remain higher than projected which would delay the economic recovery and affect public debt sustainability. A related macroeconomic risk factor is Turkey's vulnerability to both internal and external shocks as evidenced by the impact of the September 11 events. The commercialization and privatization of the state-owned banks is a major political and organizational challenge for the Govermnent. The rapid restructuring of Halk and Ziraat also has significant fiscal and social implications. While the Government has so far been able 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), the public debt has increased sharply as a share of GNP. Continued tight fiscal discipline and further reform  actions to bolster the confidence of domestic and international investors in Turkish sovereign debt instruments will be essential. 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 may also slow down the pace of the envisaged public sector reforms. Schedule of Disbursements: US$450 million (US$184 million on standard IBRD terms and US$266 million on SSAL terms), including a 1 percent fee to be paid to the IBRD, immediately after loan effectiveness expected in April 2002, a second tranche of US$450 million (US$183 million on standard IBRD terms and US$267 million on SSAL terms) after fulfillment of second tranche release conditions, and a third tranche of US$450 million (US$183 million on standard IIBRD terms and US$267 million on SSAL terms) after fulfillment of third tranche release conditions. Poverty Category: N/A Rate of Return: N/A Project ID Number: PE-P070560  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), Robert Liu (Adviser, BFR), Emesto 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), Michael Engelschalk (Senior Public Sector Specialist), James Moose (Public Investment Program - Energy), Sudipto Sarkar (Public Investment Program - Urban Infrastructure), Olivier Le Ber (Public Investmnent Program - Transportation), Martin Ramna (Public Employment Program), Gurhan Ozdora (Senior Operations Officer, ECSPF), Kamer Ozdemir (Economist, ECSPE), Mediha Agar (Research Analyst, ECSPE), Elmas Arisoy (Procurement Specialist, ECC06), Anders Zeijlon (Public Investment Program Consultant - Urban Infrastructure), Mark Carawan (Bank Resolution Consultant), James Lacey (Bank Restructuring Consultant), Peter Dean (Financial Accountability Consultant), Trevor Robinson (Public Employment and Civil Service Reform Consultant), Jean- Luc Steylaers (Public Liability Management Consultant), Graham Glenday (Tax Policy Consultant), and Daniel Tommasi (Public Investment Policy Consultant). Hans Gruss (Chief Counsel) and Rohit Mehta (Senior Disbursement Officer) provided legal and disbursement support. Manuel Santiago, 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 INF EUI staff responsible for Turkey.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN (PFPSAL II) TO THE REPUBLIC OF TURKEY TABLE OF CONTENTS I. INTRODUCTION ................................................................................1 A. RECENT ECONOMIC DEVELOPMENTS ................................................................................ 1 B. TURKEY'S MEDIUM-TERM MACROECONOMIC FRAMEWORK ...........................................................................4 C. THE STRUCTURAL REFORM AGENDA ................................................................................6 D. SOCIAL AND POVERTY IMPACT OF THE CRISIS AND REFORM PROGRAM ........................ ..................................7 E. BANK SUPPORT FOR ECONOMIC REFORM ............................................................................... 10 Il. TURKEY'S FINANCIAL SECTOR REFORM PROGRAM ................................................... 14 A. INTRODUJCTION ...... . . . . . . . . . . . . . . . . . . .. . . 14 B. FINANCIAL SECTOR PROFILE/RECENT DEVELOPMENTS IN THE BANKING SECTOR .14 C. STRENGTHENING THE REGULATORY FRAMEWORK FOR BANKING.................................................................. 17 D. STRENGTHENING THE INSTITUTIONAL CAPACITY OF THE BRSA AND THE SDIF .21 E. IMPLEMENTATION OF EFFICIENT PROBLEM BANK/BANK FAILURE RESOLUTION .23 F. LEGAL FRAMEWORK FOR CREDITOR RIGHTS, BANKRUPTCY AND DEBT WORKOUT .27 G. IMPLEMENTATION OF COMPREHENSIVE RESTRUCTURING AND PRIVATIZATION OF STATE-OWNED BANKS 27 III. TURKEY'S PUBLIC SECTOR REFORM PROGRAM......................................................................... 31 A. INTRODUCTION.............................................................................. 1 B. RE CEN T D EVELOPMENTS IN PUBLIC SECTOR REFORM .32 C. STRUCTURAL FISCAL POLICIES.............................................................................. 34 D PuBLic EXPENDITURE MANAGEMENT ...............................................................................40 E. PUBLIC SECTOR G OVERNANCE .50 IV. THE PROPOSED LOAN...............................................................................53 A. THE BANK' S FINANCIAL SECTOR ASSISTANCE STRATEGY .53 B. THE BANK' S PUBLIC SECTOR ASSISTANCE STRATEGY .56 C. PFPSAL OBJECTIVES AND DESCRIPTION......................................................5......................... 58 D. LESSON S LEARNED FROM PFPSAL I .59 E. BENEFITS AND R ISKS .59 F. CONDITIONS FOR BOARD PRESENTATION AND RELEASE OF THE SECOND AND THiRD TRANCHES .65 G. TRIGGERS FOR THE PFPSAL II, AND FOLLOW-UP PFSAL I & II AND PPSAL I & II; AND PROGRAM OUTCOME INDICATORS ..70 H. FINANCIAL MANAGEMENT .70 I. PROJECT IMPLEMENTATION AND MONITORING .74 V. RECOMMENDATION .75  ANNEXES: Annex IA Key Economic Indicators Annex IB Key Exposure Indicators Annex HA Turkey - Financial Sector at a Glance Annex UB Turkey - List of Banks Annex HI 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 II Program Annex VII Enhancing Transparency and Good Governance in Turkey's Public Sector Annex VIII Country at a Glance Annex IX Integrated Safeguards Data Sheet  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND 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 second Programmatic Financial and Public Sector Adjustment Loan (PFPSAL II) to the Republic of Turkey for US$1.35 billion to continue the Bank's support for the Government's multi-year financial and public sector program. This program aims to restore confidence in the banking system and correct the underlying structural problems in the public sector that created the conditions under which financial crises like those which hit Turkey in November 2000 and February 2001 could occur. The proposed loan will be in US Dollar Single Currency, partly on standard IBRD terms (US$550 million) and partly on special structural adjustment loan terms (US$800 million). The loan will be disbursed in three tranches. The first US$450 million tranche (US$184 million on standard IBRD terms and US$266 million on SSAL terms) will be disbursed immediately upon effectiveness, and the second and third tranches of US$450 million each (US$183 million on standard IBRD terms and US$267 million on SSAL terms) upon fulfillment of the second and third tranche release conditions as long as overall progress with the program is also satisfactory. 2. The proposed PFPSAL II is the second in a series of programmatic loans to be implemented over the 2001-03 period in support of the Government's comprehensive reform of the financial and public sectors. Under the PFPSAL program, the World Bank intends to disburse a total of US$2.45 billion in adjustment lending 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. The PFPSAL II follows on the first Programmatic Financial and Public Sector Adjustment Loan (PFPSAL) of US$1.1 billion (US$700 million on standard IBRD terms and US$400 million on SSAL terms) disbursed in a single tranche in July 2001. Bank support for sustained implementation of reform in the financial and public sectors would continue in the high case lending scenario through a series of further programmatic loans as described in the CAS Progress Report (Report No. 22282-TU) discussed by the Board together with the first PFPSAL in July 2001. Specifically, two Programmatic Financial Sector Adjustment Loans (PFSAL I and II) of US$500 million each and a Programmatic Public Sector Adjustment Loan (PPSAL) of US$375 million are envisaged. A second PPSAL is tentatively envisaged beyond the current CAS period. I. INTRODUCTION A. Recent Economic Developments 3. Macroeconomic outcomes have been mixed since the first PFPSAL was approved in July. The program put in place in May 2001 in response to the currency crisis of February 2001 was designed to help Turkey rebound from the February shock and quickly resume economic  - 2 - Table 1: Key Economic Indicators - . - Actual ll -.- Original Program 41 Estimated 5/ . Nzew Prograin 61--r' 2000 -2001 2002 2003 2001 2002 -2003 2004 HEADLINE INDICATORS GNP Growth 6.3 -3.0 5 0 6.0 -8.5 3.0 5.0 5.0 CPI Inflation (Dec-Dec) 39 52.5 20 i5 68.5 35 20 12 Nominal Interest Rate 38 SI 41 33 99 69 46 32 Unemployment Rate 2/ 6.6 >8.5 6.0 6.0 8.5 7.0 6.0 6.0 PUBLIC SECTOR BUDGET Primary Balance (% GNP) 2.3 5 5 , ' 5.7 6.5 6.5 6.5 Overall Deficit (% GNP) -20 * -17 -i( -7 -17 -12 -9 -7 Public Debt (% GNP) 3/ 57 79 . 71- 65 91 81 73 69 of which net extemal debt (% GNP) 18 .4 '28 23 36 35 31 28 Privatization ($ bn) 3.3 3i; 3.5 3.5 2.8 1.5 2.5 1.0 EXTERNAL BALANCE Current account balance (% GNP) -4.9 -0.6 '-;0.9 -0.6 2.2 -1.2 -1.2 -1.2 Exports (fob, $ bn) 32 34 - 36 39 35 37 40 43 Tourism ($ bn) 7.6 8.3 8.6 9.1 8.1 6.0 8.2 8.7 External Debt (% GNP) 7/ 59 66 60 57 78 74 69 65 CBT Foreign Exchange Reserves ($ bn) 23 2 1; * 22 24 20 22 24 28 Memo GNP (TL quadrillion) 125.6 182.4 245.8 303:6 184.7 283.2 371.6 441.3 GNP (USD billion) 201.3 170.7 i88.5 203.3 150.7 165.6 183.0 201.3 1/ Government figures as adjusted by IMF and WB estimates. 2/ Projection for 2001 is based on quarterly unemployment figures from the State Institute of Statistics. 3/ Includes the government securities issued to recapitalize the SDIF and state banks. 4/ As presented in the CAS Progress Report based on the 6th and 7th IMF program reviews in May 2001. 5/2001 estimates as of the Ist IMF review under the new SBA in March 2002. 6/ Baseline projections for the new IMF SBA program, February 2002. 7/ External Debt projections under the new SBA are revised in line with the latest 2001 estimates. Source: Government, IMF and WB estimates. growth and disinflation. It combined tight demand management-centered on a large primary surplus-with a market-based approach to managing the growing public debt burden, accelerated financial sector restructuring and a large inflow of external official financing. However, outcomes deviated significantly from program targets and Turkey was hit by another external shock following the events of September 11. The financial turmoil which followed the decision in February to abandon the crawling peg exchange rate and float the Lira has been contained, but this relative stability remains fragile. While the price spike following the initial devaluation in February was fairly quickly absorbed, inflationary pressures remain significant. Interest rates were brought down from crisis peaks, but remained above the original May program path through the end of 2001, due in part to the higher-than-expected inflation. After falling below 1.6 million TL/USD in October 2001, the exchange rate stabilized by the end of the year, albeit at a more depreciated level than originally projected. The external current account improved sharply registering a surplus of about US$3.3 billion (2.2 percent of GNP) compared to the deficit of US$7.6 billion (4.9 percent of GNP) in 2000 (Table 1). Preliminary data indicate that the fiscal program met the 5.5 percent of GNP primary surplus target for the consolidated public sector for 2001, but the fiscal cost of bank restructuring contributed to a sharp increase in the public debt.  -3 - 4. The most immediate problem is that the economic recession has been much deeper than projected and recovery has been delayed. A serious drought exacerbated the recession with agricultural output contracting by some 3.2 percent through the first nine months of 2001. Real credit to the economy contracted by about 30 percent during the year as banks cut back on lending and enterprises reduced borrowing in the face of high real interest rates. Output contracted by 8.5 percent in the 3rd quarter of 2001, compared to 11.4 percent in the 2nd quarter, bringing the fall for the first nine months of the year to 8.3 percent. The combination of high interest rates, large devaluation and deep recession caused the stock of public debt as a share of GNP to rise significantly more than projected under the May program. This occurred despite the disbursement of US$10.9 billion in combined IMF support (US$9.8 billion) and World Bank adjustment lending (US$ 1.1 billion) between May and December. The ratio of public debt (net of the net assets of the central bank) to GNP is now estimated to have increased from 57.4 percent of GNP at the end of 2000 to about 91 percent by the end of 2001, 12 percentage points higher than originally projected in May. 5. The costs of cleaning up the banking sector has added over US$40 billion to the Treasury's debt in 2001, although about half of this represents losses on the books of the state and SDIF banks before the crisis which were already included in the broader definition of the public debt. The stock of Treasury securities issued for bank restructuring (including revaluation of FX denominated securities) is estimated to have reached TL 60 quadrillion (33 percent of GNP) by the end of 2001 (Table 2). While the Treasury has restructured recapitalization securities held by the central bank and the state banks in order to lengthen maturities and reduce interest payments, the risks to public debt sustainability will remain significant through the medium term. Table 2: FRsacs - c- Bank Resrtu ring -,:: -- RecwalizaZion . PRecap Securites i> To Out7ay Of vwich:h Value of Petncr In i.- Scud*esv- - selssd in 200 JnctSn Po R ec urities Public Dub, ck- isse 6efoZ)f --.--u lymy i5. -m - a- at the ed of 200 I/l ii 2M 7L Trillion raat 2,034 13,202 218 15,454 - 14,262 3,711 Halk 863 13,075 67 14,005 - 8,301 474 Emlak 12 668 41 721 - 157 104 SDIF Banks 3,862 15,871 - 19,733 3,443 18,739 11,434 CBT 2/ 18,778 18,778 Total 6,771 42,816 326 49,912 3,443 60,237 34,501 % of 2001 GNP Ziraat 1.1% 7.1% 0.1% 8.4% 0.0% 7.7% 2.00/ Halk 0.5% 7.1% 0.0% 7.60/o 0.0% 4.5% 0.3% Erlak 0.0% 0.4% 0.0% 0.4% 0.0% 0.1% 0.1I SDIF Banks 2.1% 8.6% 0.0% 10.7% 1.9% 10.1% 6.2