Turkey - Municipal Services Project

Documentof The World Bank FOROFFICIAL USEONLY ReportNo: 32451-TR PROJECT APPRAISAL DOCUMENT ONA PROPOSED LOAN INTHEAMOUNT OF EURO 212.9MILLION (US$275 MILLIONEQUIVALENT) TO ILLERBANKASI WITH THE GUARANTEE OF THE REPUBLIC OF TURKEY FOR THE MUNICIPAL SERVICES PROJECT May 27,2005 Turkey Country Unit Infrastructure andEnergy Sector Department Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCYEQUIVALENTS Currency Unit = TL (TurkishLira) until December 31,2004 - = YTL (YeniTurkish Lirasi)- fromJanuary 1,2005 1YTL = 1,000,000 TL 1Euro (e) = 1.29 US Dollar ($), usingexchange rate on April 30,2005 FISCALYEAR January 1 - December31 ABBREVIATIONS AND ACRONYMS EU European Union ISA International Standards onAuditing Bank World Bank JICA JapanInternational Co-operation Agency BRSA Banking Regulationand Supervision MIS Management InformationSystem Agency (BDDK inTurkish) CAS Country Assistance Strategy M o U Memorandum o f Understanding CFAA Country Financial Accountability LCS Least Cost Selection Assessment CPAR Country Procurement Assessment Review NCB National Competitive Bidding CQ Consultant Qualifications O M Operational Manual ESW Economic and Sector Work PHRD Policy and HumanResources Development Fund DebtLaw Law on Regulating Public Finance amd PMU Project Management 1Jnit Debt Management FI Financial Intermediary QCBS Quality and Cost Based Selection FMR Financial Monitoring Reports SA Special Account GDP Gross Domestic Product SBD Standard Bidding Documents I A S International Accounting Standards SEE State Economic Enterprise IB Iller BankasYIller Bank SIL Specific Investment Loan I C Individual Consultant SOE Statement o f Expenditure ICB Intemational Competitive Bidding SPO State Planning Organization IDF Institutional Development Fund TA Technical Assistance IFRS IntemationalFinancial Reporting UFW Unaccounted for Water Standards Vice President: Shigeo Katsu Country ManageriDirector: Andew N.Vorkink Sector Manager: Sumter Lee Travers Task Team Leader: Sudipto Sarkar  .... FOROFFICIAL USEONLY TURKEY MunicipalServices Project CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE ................................................................. 1 1. Country and sector issues .................................................................................................... 1 2. Rationale for Bank involvement ......................................................................................... 6 3. Higher level objectives to which the project contributes.................................................... 7 B PROJECTDESCRIPTION . ................................................................................................. 7 1. Lendinginstrument............................................................................................................. 7 2. [IfApplicable] Programobjective andPhases.................................................................... 7 3. Project development objective andkey indicators.............................................................. 7 4. Project components ............................................................................................................. 8 5. Lessons learned and reflected inthe project design.......................................................... 10 6. Alternatives considered and reasons for rejection ............................................................ 11 C . IMPLEMENTATION ........................................................................................................ 12 1. Partnership arrangements (ifapplicable) .......................................................................... 12 2. Institutional andimplementationarrangements ................................................................ 12 3. Monitoring and evaluation o f outcomes/results ................................................................ 13 4. Sustainability..................................................................................................................... 13 . . 5. Critical risks andpossible controversial aspects............................................................... 14 6. Loadcredit conditions and covenants............................................................................... 16 D APPRAISAL SUMMARY . ................................................................................................. 17 1. Economic and financial analyses...................................................................................... 17 2. Technical........................................................................................................................... 17 3. Fiduciary ........................................................................................................................... 18 4. Social................................................................................................................................. 19 5. Environment...................................................................................................................... 19 6. Safeguard policies............................................................................................................. 19 7. Policy Exceptions andReadiness...................................................................................... 20 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.  Annex 1: Country and Sector or Program Background................................................................ 22 Annex 2: Major RelatedProjects Financedby the Bank and/or other Agencies.......................... 27 Annex 3: Results Framework and Monitoring.............................................................................. 28 Annex 4: DetailedProject Description......................................................................................... 30 Annex 5: Project Costs.................................................................................................................. 34 Annex 6: ImplementationArrangements ...................................................................................... 35 Annex 7: Financial Management and DisbursementArrangements ............................................ 40 Annex 8: Procurement .................................................................................................................. 46 Annex 9: Economic and Financial Analysis ................................................................................. 52 Annex 10: Safeguard Policy Issues............................................................................................... 65 Annex 11:Project Preparation and Supervision........................................................................... 66 Annex 12: Documents inthe Project File..................................................................................... 67 Annex 13: Statement o fLoans andCredits .................................................................................. 68 Annex 14: Country at a Glance..................................................................................................... 71 MAP IBRD33685  TURKEY MUNICIPAL SERVICES PROJECT PROJECT APPRAISAL DOCUMENT EUROPE AND CENTRAL ASIA ECSIE Date: May 27,2005 Team Leader: Sudipto Sarkar Country Director: Andrew N.Vorkink Sectors: General water, sanitation and flood Sector Managermirector: Sumter Lee Travers protection sector (70%);Sub-national government administration (30%) Themes: Municipal finance (P);Other urban development (P) Project ID: PO81880 Environmental screeningcategory: Financial Intermediary Lending Instrument: Specific Investment Loan Safeguardscreeningcategory: Financial Intermediarv Project Financing Data [XI Loan [ 3 Credit [ 3 Grant [ ] Guarantee [ ] Other: For Loans/Credits/Others: Fixed Spread Commitment LinkedLoan Total Bank financing: 212,900,000 (US$275.0m equivalent) Proposedterms: (a) Term: FSLwith 17years maturity; (b) Grace: 5 years, levelrepayment ofprincipal; (c) Front-endFee: 100basis points, less existing waivers; (d) Commitment charge: 85 basis points, for the first four years; thereafter 75 basispoints, less any waivers ineffect; and (e) Interest: LIBOR plus spread. BORROWER RECONSTRUCTIONAND DEVELOPMENT (including Front-End Borrower: Iller Bank; Yeni Ziraat Mahali 14 Sokak, Diskapi; Ankara, Turkey Tel: 90-312-384-6126 Fax: 90-312-341-2071 Contact: Mr.Hidayet Atasoy, General Director  RemonsibleAgencv: Treasurv is the Guarantor o fthe loan :Y 1 6 1 7 1 8 1 9 10 I 0 0 0 0 h u a l 5 20 50 120 80 0.00 0.00 0.00 0.00 hmulative 5 25 75 195 275 0.00 0.00 0.00 0.00 Does the project depart from the CAS incontent or other significant respects? Re$ PAD A.3 [ ]Yes [XINO Does the project require any exceptions from Bankpolicies? [ ]Yes [XINO Re$ PAD D.7 Have these been approved by Bank management? [[ ]Yes [XINO ]Yes [ IN0 [s approval for any policy exception sought from the Board? Does the project include any critical risks rated "substantial" or "high"? Re$ PAD C.5 [XIYes [ ] N o Does the project meet the Regional criteria for readiness for implementation? Re$ PAD D.7 [XIYes [ ] N o Project development objective Re$ PAD B.2, TechnicalAnnex 3 Sumort sustainable environmentalservices inselected munichalities Project description [one-sentence summary of each component] Re$ PAD B.3.a, TechnicalAnnex 4 The project will have the following three components: a) MunicipalDevelopment to support investments inthe water, wastewater, and solid waste sectors; b) MunicipalTechnicalAssistance to support preparationo ffeasibility studies, urbanplanning, preparation o fbiddingdocuments, andutilityoperational improvementplans; and c) Iller Bank Institutional Strengthening to increase the financial and technical capacity, suppor. incremental operating costs, andprepare audits Which safeguard policies are triggered, ifany? Re$ PAD D.6, TechnicalAnnex 10 Environment Assessment Involuntary Resettlement (land acquisition only) Significant, non-standard conditions, if any, for: Re$ PAD C.7 Board presentation: June 23,2005 Loadcredit effectiveness: September 15,2005 Covenants applicable to project implementation: They are summarized inthe PAD  A. STRATEGICCONTEXTAND RATIONALE 1. Country and sector issues On December 17, 2004, the European Union (EU) invited Turkey to begin negotiations in October 2005 to be a member o f the EU Union. This agreement i s a significant event for the country and shows Turkey's commitment towards making sustainable economic, social, and political reforms. At the same time the country has recovered from the economic and financial crisis o f 2001. The GNP has been growing at a fast pace in recent years (2002: 7.9%; 2003: 5.9%; 2004: 9.6%) and the current positive macroeconomic situation allows the policy makers to move from crisis management to systemic solutions ina number o f areas that are relevant for EU accession. Environment investments related to EU accession will be large. Inresponse to the EUdecision to invite Turkey for accession negotiations, Turkey i s considering institutional arrangements and realignment o f laws to be in compliance with the EUdirectives. The total cost o f compliance to meet the EU environmental directive is expected to exceed US$ 40 billion between 2005 and 2020. This cost includes a cost o f over US$ 20 billion for the water, wastewater, and solid waste sectors. Rapidurbanization also leads to highinvestment costs and Turkey spends about 2% of GNP on an annual basis for capital investmentsat the local level, which represents about 50% o f the local government expenditure. Currently, 70% o f Turkish citizens live in urban areas and this urbanization rate i s expected to increase to 85% before it stabilizes. This highurbanization leads to demand for core municipal services that include water, wastewater, and solid waste management, and transportation. Given this high rate o f urbanization and the need to meet EU environmental directives, Turkey will have to sustain a high level o f investments at the local level to develop the infrastructure. Further, it i s also important for policy makers to ensure that quality services are sustained. This project will focus on water, wastewater, and solid waste investments and will contribute towards developing the infrastructure and promoting sustainable services. Some o f the issues faced inthe sector are summarized below: Watermastewater Cost coverage varies: The average water supply tariff i s US$0.70 per cubic meter in metropolitan areas and around US$ 0.42 in non-metropolitan areas. In general, most mediumsized to large municipalities (population > 100,000) are able to cover their costs. However, smaller andpoorer municipalities have difficulties infully covering the costs; Inefficient operations: The average Unaccounted for Water (UFW) i s around 50% o f production. This figure is high compared to some o f the EUcountries: Germany (10%); France (25%); England (around 25%); and Austria (10%). Thus, it i s important to focus on reducing UFW through administrative measures and rehabilitation o f pipes to prevent commercial and physical losses, respectively; and 1  e Policies on central government support for the sector are not fully inplace: The nature o f the water and wastewater business is such that it often requires public support for investments. The involvement o fthe public sector i s oftenjustified since the investments generate positive externalities such as better environment, reduction o f water borne disease, and increased tourism. All EU countries have provided support for the development o f the water and wastewater sector with a wide range o f investment subsidy (3-24% o f costs) and instruments (budget support, tax advantages to utilities, partial debt service coverage by the central government, and waiver o f fees and charges due to the central government). The countries that joined the EU in May 2004 also receive investment subsidies inthe form o fEUcohesion and structural fund grants. Turkey will need to develop policies inproviding assistance to the water and wastewater utilities, especially in the poorer areas o f the country. The assistance from the central government should be: fiscally sound, based against pre-determined criteria to make objective decisions on the eligibility for assistance, and linked to improved operating efficiency. The type o f instrumentto be used should be determined based on a review of various methods usedinthe EUcountries. Solid Waste Management e There i s a shortage o f proper sanitary landfills in the country: Most o f the wastes generated in the country are disposed o f in about 2,000 small scale and 50 large dump sites. The disposal i s not controlled and the dump sites pose an environmental and health risk. There are about 11 sanitary and controlled landfills that serve about 20% o f the population. To meet the EU directives on solid waste management, Turkey would have to construct more sanitary landfills. The issue o f not having adequate landfills should be addressed urgently as the per capita solid waste generation i s increasing: Between 1995 and 2002 there has been an annual increase o f 3.5% o f household waste generated in the country'. Currently the per capita waste generation i s around 1kg/day. However this number i s expected to increase to 1.5 to 2.5 kg/day as income level rises. The increase in waste generation is a concern for policy makers and measures to dispose o f the waste in an environmentally safe manner and reduce the volume o fwaste through recycling should be considered; and e Costs are not covered and are not linked to the service: The fees are not sufficient to meet costs, especially investments. A fee of around US$ 0.07 (fixed at 100,000 TL) per cubic meter o f water sold i s charged to water users. Linking a solid waste management fee to water consumption is not appropriate. The users should be charged separately for solid waste services and the level o f fees should reflect the cost o f service provision. TechnicalAssistance for EnvironmentalHeavy Cost InvestmentPlanning; ENVEST; September2004 2  GovernmentActions The government recognizes the importance o f providing good quality municipal services and to start preparations to meet EUdirectives. To this end, it i s pursuingactivities related to municipal reform so that municipalities and their utilities have more resources, follow prudent financial management practices, and report on performance and financial matters to the central government on a regular basis. The government has also initiated reforms in Iller Bank (B), which transfers central government taxes to the municipalities on a monthly basis and provides technical assistance, loans, and grants to municipalities. Municipal Reform There are 3,225 municipalities that have a mandate to provide the basic infrastructure services - water, wastewater, transportation, solid waste management - which account for the bulk o f their expenditures. Details o f the revenues and expenditures o f local govemments are provided in Annex 1. The sector faces the following challenges from the service delivery and investment perspectives: a Financial resources are inadequate at the local level: In aggregate, there is a chronic financing gap at the local level given the amounts o f financing and the levels o f municipal expenditure. However, the situation i s not uniform across the country. The metropolitan municipalities are financially better placed, in relative terms. On a per capita basis, the metropolitan municipalities receive more tax transfers from the central government compared to non-metropolitan municipalities; e Financial management at the local level i s limited: Municipalities often do not manage their limited resources prudently, contributing to the problem of a perpetual financing gap. Public expenditure management reforms have started in the country and the government i s taking measures to implement the reforms at the municipal level; and a The municipal debt market is not developed: Long term capital, typically needed for municipal infrastructure development, i s only available through government sources in the country, including loans from International Financial Institutions (IFIs) backed by a Treasury guarantee. This lack o f long term capital and the inadequate financial resources and management at the local level have not allowed the municipal debt market to grow, which in tum has affected municipal development. The total local government borrowings from domestic banks are very small compared to the assets o f the banking sector. At the end o f 2003, total local government domestic borrowings were 1,336 trillion TL (1,129 trillion TL with Iller Bank; and 207 trillion TL with deposit money banks), which represents about OS%* o fthe entire bankingsector assets. Inthe absence of long-term funds, municipalities use their current revenues and short- term borrowings to finance investments. Reliance on hlly financing investment costs from current revenues i s sub-optimal because it makes the current generation pay for the *`Borrowings inLocal Governments'; Messrs. Ferhat EmilandH.HakanYilmaz, September 2004 3  hllinvestmentcomparedtoascenariowhereinvestmentcostscouldbefinancedthrough loans repaidthrough imposition o fuser fees and taxes over the life o fthe assets financed. In2004, the government submitted anumber oflawsto the Parliamentrelatedto public andlocal administration. These laws support proper allocation o f responsibilities between the central and local administrations, elimination o f unfunded mandates, an increase in accountability at the local level, anddelivery o f quality service. e inJuly 2004, the Parliament approved the Public Administration Framework Law which i s the basic law that governs responsibilities o f central and local authorities. This law, however, i s not yet ineffect; e inJuly 2004, the Metropolitan Municipal Law was approved by the Parliament and the law is now effective. The law increases the physical areas to be covered by these municipalities by including the adjacent settlements under the jurisdiction of the metropolitan administration. This will increase the infrastructure development requirements of the metropolitan municipalities since the adjacent settlements often do not have the same level of infrastructure compared to the metropolitan area. The project includesthree metropolitan municipalities; and e inDecember 2004, the Parliamentapprovedthe MunicipalLaw (the law is ineffectbutis currently being examined by the Constitutional Court). The essence o f this law is to enhance municipal financial management, strengthen the local institutional capacity, and increase local revenues. Also, the law emphasizes the need to provide quality service and the financial and service quality will be monitored on a regular basis. The Municipal Law outlines borrowing principles that will bring about financial discipline in the municipalities. The law also requires municipalities to submit their financial position on a quarterly basis to the Ministry o f Interior, Ministry o f Finance, State Planning Organization, and Treasury. Failure to comply with the law will lead to the applicationofthe Turkish penal code onthe responsible municipal officials. The government i s now considering the revision of the Municipal Revenue Law that will increase the taxes and tariffs that were not updated since 1992. The Municipal Revenue Law also proposes to simplify the local revenue system by eliminating local taxes where administrative costs are higher than the collection. Furthermore, the law proposes to introduce a hotel tax that will help finance the infrastructure inareas that attract tourists. Iller Bank Reform In 1933, Iller Bank (IB) was established as a municipal bank with a purpose of providing financial resources to the municipalities and it carries out two essential hnctions: transfer central tax revenues to the local authorities on a monthly basis, and support infrastructure development at the local level through technical assistance, loans, and grants. Some key features o f IB relative to municipal sector development are summarized below and details are provided in Annex 9. 4  0 IB has about 3,500 staff with expertise on technical, financial, accounting, and legal matters. About 55% o f its staff are based inthe eighteen regional offices throughout the country; 0 By law, all municipalities contribute towards the equity o fthe bank. Through a decision o f the government inMay 2004, the capital o f IBwas increased to 3 quadrillion T L to be gradually paid by municipalities before 2009. This capital can be increased further through a decision o f the government. IB uses this equity as a primary source o f capital for investments. It i s not a deposit taking bank andhas not raised funds from the market; 0 Traditionally, IB's total loans to municipalities have been in the range o f US$ 250-300 million annually. These loans have been for equipment, infrastructure development, and working capital. Interms o f the entire banking sector, IB is not a significant player and its assets represent about 0.9% o f the entire banking sector assets3. IB's share o f financing the municipal sector i s low, compared to the total capital investments at the local level which have been around US$ 4-5 billion per year inrecent times. Most o f the financing at the municipal level has come from the revenues rather than borrowings and there are no restrictions for private banks to lend to municipalities. The central government, however, would like IBto provide more loans in the future and to this end, reforms inthe institution are beingplanned; 0 About 6% o f national taxes are transferred back to all the municipalities through IB.This transfer represents the central government's share o f financing municipal expenditures. By law, IB is able to intercept the transfers in lieu of debt service for an IB loan to a municipality, incase o f debt service default by a municipality; 0 IBalso transfers grants to municipalities for investments. Traditionally, about 10% ofthe investments supported by IBhave beenfunded through grants; and 0 IBprovides Technical Assistance to municipalities, especially the ones that are small and have limited institutional capacity. The T A includes preparation o f surveys and construction supervision. Reforms inIller Bank were identified inthe EighthFive Year Development Plan (covering 2001 to 2005), given the mandate o f the institution to develop municipal infrastructure. Recently, the reforms in IB have taken on special significance as the institution will play an important role in implementing upcoming EU grant programs. To this end, the government i s carrying out the following tasks: e it initiated the development o f the Iller Bank Strategy under the leadership o f State Planning Organization (SPO). The strategy has been drafted and i s expected to be finalized by October 2005. The strategy includes the following objectives: (a) provide service to municipalities in a timely manner; (b) strengthen the banking function o f IB; September 30, 2004 - total banking assets: US$ 196.50 billion; IB assets: US$ 1.81 billion. Source: Banks Association o fTurkey (http://www.tbb.orn.tr/enrzlishlbulten/3%2OavliWTopluMaliTablolar/200409/tables-usd/default.htm) 5  (c) complete projects to meet the needs o f municipalities; (d) ensure that proper technology is used; (e) improve the quality o f staff in IB; and (f) ensure efficient use o f public resources so that loans are repaid in a timely manner, the capital o f the bank i s utilized more economically, and the financial management o f the bank improves. Among other things, the strategy specifically notes that IBhas an ideal opportunity to be involved in helping municipalities meet EU directives; and that IB will play a key role in implementing environmentalactivities; and e it has drafted amendments to the Iller Bank Law. The main features of the law are to strengthen the financial and technical function o f IB, and create an internal audit and a risk management unit as per the requirements o f the Turkish banking legislation (Annex 9). The proposed amendments to the law are expected to be sent to the Parliament after the Iller Bank Strategy is finalized. 2. Rationale for Bank involvement The Country Assistance Strategy (CAS), dated October 2, 2003, aims at reducing the risk o f re- emergence o f crisis inTurkey and helping the country address economic challenges of preparing for EU membership. The CAS presents four development themes: (a) sound macroeconomics and governance; (b) equitable humanand social development; (c) attractivebusiness climate and knowledge; and (d) strong environmental management and disaster prevention. At a policy level, the government and the EU expect that the Bank will assist Turkey in its EU accession process. Collaboration among the government, EU, and the Bank on this project i s an example o f this understanding. The project will support the government's plans to provide basic urban services and comply with EU environmental directives. Further, as an implementing agency o f the project, IB's capacity to appraise and supervise Sub-projects will increase. This i s relevant since the government i s considering to use IB as an agency that will help in the implementation o f the upcoming EUprograms. The project i s aligned with the fourth development theme since it will support environmental improvements at the municipal level. Specifically, the CAS mentions that the project will help to improve services. This will be achieved through the proposed investments and institutional strengthening components ofthe project. The Bank has been involved in the municipal sector in Turkey through a number o f water and wastewater projects and through economic and sector work (ESW). The involvement of the Bank will be a continuation of the ongoing dialog between the Bank and the key stakeholders. Lessons learned from past activities have been incorporated inthe project design. 6  3. Higher level objectivesto which the projectcontributes The project contributes to the overallmunicipal sector development inthe followingways: 0 Support Turkey's intent to meet EU's environmental directive: The investments will contribute towards meetingEU's directives on water, urbanwastewater, and solid waste management. Further, through the project, IBwill be strengthenedand this i s inline with the government's plan to use the institution as an implementing agency for upcoming EU programs; 0 Promote efficiency o f investments: At the feasibility study stage, analysis will be carried out to ensure that viable investments are being supported and the procedures followed under this project could be replicated in other municipal investments. A debt-service coverage ratio (at least 1.2) will be used to test the affordability o f investments; and 0 Promote efficiency o f operations: Every Sub-project will have an institutional component at the municipal level to promote operational efficiency and to increase the financial strength o f utilities. The procedures followed under this project could be replicated in other municipal investments inTurkey. B. PROJECTDESCRIPTION 1. Lendinginstrument This project will beprocessed as a Specific Investment Loan (SIL). 2. [IfApplicable]ProgramobjectiveandPhases Programobjective and Phases are not applicable for a SIL. 3. Projectdevelopmentobjectiveand key indicators The objective o f the project is to support sustainable environmental services in selected municipalities. To meet this objective the project will: 0 support the development o f municipal infrastructure to improve the environment and quality o f water, wastewater, and solid waste management services. This development will bemeasured by the following indicators: reduction inwater losses, increased volume o fwastewater treated, increased number o f water and sewerage connections, and use o f a sanitary landfill. Satisfactory output indicators will be a Sub-project financing eligibility criterion; 0 support the utilities to strengthen their financial position, improve operational efficiency, and prepare and implement projects. This would be measured by the following 7  indicators: improvement in working ratio, reduction o f unaccounted for water, and successful completion o f projects. An Operational Improvement Plan will outline the plans o f municipalities and their utilities to improve their institutional and financial position and will be a Sub-project financing eligibility criterion; and a support the institutional strengthening o f IB so that it i s able to implement the project ina satisfactory manner. The above mentioned key indicators at the Sub-project level will be monitored through the Sub- loans and IB will report the performance o f each Sub-project through the Project Progress Report. The overall project progress would be measured by the aggregated performance o f individual Sub-projects. 4. Projectcomponents The project will have three components. The Bank loan will be denominated in Euros and will be equivalent to US$ 275 million. Incomponents 1and 3, the counterpart funds will beprovided bythe municipalities and IB,respectively. The front end fee will beborne by IBwhich will pass the cost to the municipalities. Preparation work has started through a PHRD grant o f US$ 500,000 which was signed on May 4,2004. 0 Component 1: Municipal Development Eligible expenditures under this category - would be for the water, wastewater, and solid waste sectors. Investments have been proposed by IB and the PHRD grant is financing feasibility studies in a number o f municipalities to confirm the viability o f the investments. Indicative investments are shown in Table 2. The project implementation arrangements outline Sub-borrower and Sub-project eligibility criteria (Annex 6). IB will carry out the due diligence on appraising each Sub-project and will also be responsible for supervision. Without prior approval o f the Bank, no other municipality will join the project and it would have to meet the Sub-borrower eligibility criteria. The municipalities that have been included in the project were short listed from the demand survey conducted by IB. In the survey, about ninety municipalities showed interest to participate in the project from which the fourteen municipalities shown below were chosen based on their current financial standing (no overdue payments to IB). These municipalities have all signed a Memorandum o f Understanding (MoU) with IB through which an agreement has been reached that the PHRD grant will finance the feasibility studies that will help define the investments. 8  e Component 2: Municipal Technical Assistance -Eligible expenditures under this category will be for municipalities for the following purposes: (a) feasibility studies; (b) urban planning; (c) preparation of design and bidding documents; (d) Operational Improvement Planrelatedto institutional, technical, financial, and environmental matters. All Sub-projects will have an Operational Improvement Plan; and (e) construction supervision. The expenditures will be financedthrough Sub-loan proceeds from IB. e Component 3: Iller Bank Institutional Strengthening Eligible expenditures under - this category will include technical assistance to Iller Bank so that it is able to implement the project and the Action Plan (below) in a satisfactory manner. The expenditures will be financed fiom IB's own resources and the Bank loan. Eligibleexpenditures under this category will be: (a) increasing financial and banking capacity; (b) increasing technical capacity; (c) incremental operating costs; and (d) audits. 9  The project's Action Plan includes key items that increase transparency inoperations and supports the needs o f the municipalities. Satisfactory implementation o f this Action Plan by IBis a covenant inthe Loan Agreement. The institutional strengthening of IBwill be inline withthe ongoing government reforms ofthe agency. Inthis context, IBwill share the Iller Bank Strategy and the proposed amendments to the Iller Bank Law with the Bankto allow exchange o fviewsonthese documents. Table3 ACTION PLAN June 30,2005: Report loans and grants separately. They are currently accounted separately butreported jointly. Separation o fthe grants will also help with the upcoming EUprograms June 30, 2005: Post IB's quarterly financial statements on the internet, updating it quarterly and explicitly showing overdue payments January 1,2006: Working with the SPO, develop explicit policies to provide assistanceto small and poor municipalities and for water and wastewater investments with positive environmental externalities January 1,2006: Allow municipalities to access the following informationvia the internet: Debt service payments, tax transfers, andthe level o f intercepts January 1,2006: Complete the E-transformationprocess to provide better financial andtechnical information within IB January 1, 2006: IBwill hire: a) financiabanking consultants for riskmanagement, internal auditing, and training; andb) technical consultants for project appraisal from a technical and financial standpoint. 6 months after passage o fnew Iller Bank Law, IB will establish: a) an Internal AuditUnit;andb) a Risk Management Unit. 5. Lessonslearnedandreflectedin the projectdesign The Bank has been involved in the Turkish municipal sector for a number o f years and the lessons learned from the various Implementation Completion Reports, audit reports, and sector reports are summarized below. Investment pipeline for projects should be strong: Very often in projects where the Bank's loan is administered by an implementingagency which provides Sub-loans to the final beneficiaries, the emphasis i s on developing the procedures on the use o f the Bank loan funds. This reduces the emphasis on the investment pipeline creating a risk o f insufficient demand o f the Bank loan funds. In this project, the Bank loan amount i s basedon preliminary assessment o fthe feasibility studies inpre-identified municipalities. Inaddition, IBhas apipeline ofinvestments with other municipalities andwill be able to rapidly prepare Sub-projects, ifneeded. Thus, the risk o f a low demand for the Bank loan fundis modest; 0 Focus on improving the efficiency of operations and investments: While investments are necessary, there i s a need to focus on operating efficiency. Thus, a satisfactory Operational Improvement Plan i s a Sub-project eligibility criterion through which efficiency gains will materialize - reduction o f water losses, increase in bill collection etc. In addition, investment decisions have not always been economic in the past. The feasibility studies and subsequent Sub-project appraisal by IB and review by the Bank will ensure that the investments are economicallyjustified; 10  0 Focus on institutional aspects of Sub-projects: The past Bank projects were successful in completing the physical infrastructure but there were difficulties in meeting the institutional and financial objectives. Underthe past projects, the LoanAgreements were betweenthe municipalities and the Bank with the Treasury as the Guarantor. Under this project, the Borrower will be Iller Bank, a public agency that will on-lend the Bank loan proceeds to the municipalities. By having a public agency with considerable municipal expertise and experience as a Borrower, the government will be able to better implement its institutional and financial policies at the local level; and 0 Focus on institutional aspectsfor usingEUfunds: The absorption rate o f EUgrant funds for environmental investmentshas been low incountries that have recently joined the EU or are inthe accession process. The main reason for delays inutilizing EUgrant funds is inadequate institutional arrangement to prepare, appraise, and implement projects. To overcome this problem, the government is already making plans to strengthen IB so that it is able to implement the EU environmental programs. The project will support the plans o fthe government through the Iller Bank's Institutional Strengthening component. 6. Alternatives consideredandreasonsfor rejection 0 Use commercial banks to on-lend to municipalities: The use o f commercial banks, rather than IB, was considered. However, this option was not pursued for the following reasons: (a) the government requested the Bank to work with IB as the Borrower so that the institution gains experience inproject appraisal and supervision. IB is a specialized public institution for local infrastructure development and the government plans to promote the role o f the institution to address basic service needs at the local level in line with EU environmental directives; and (b) IB has a long standing relationship with all municipalities, which are its shareholders, and is well placed to implement the project. The institutionhas a core competency inthe water and wastewater business, representing about 95% o f its loan assets, that will simplify project arrangements since IBwill be able to handlebothtechnical and financial issues; 0 Completely restructure IB, prior to making the Bank loan: Completely restructuring IB - change in governance structure, separation o f technical and financial functions, capitalizing the bank through the market, amending the Iller Bank Law - prior to making the Bank loan was considered. However, it was felt that these reforms would be medium term innature and critical investments related to the environment should not be delayed if they can bejustified. The government also wanted to follow a well thought out reform in the bank. To this end, it is now drafting a Iller Bank Strategy which will be the basis for the amendments to the IllerBank Law; 0 Direct lending by Bank to municipalities: Direct lending by the Bank to municipalities was considered. However, reviewing the wide range o f municipal demands, spread across the country, it was felt that it would be difficult for the Bank to directly prepare and supervise multipleactivities. IBwas chosen as the implementingagency as it has the 11  mandate and the capacity to develop municipal infrastructure and i s fully supported by the central government; and Limiting sector focus: Municipalities are responsible for the provision o f multiple infrastructure services but the project focuses on water, wastewater, and solid waste management. This decision was taken since these sectors represent the largest cost to meet EU's environmental directives. Further, these sectors are financed through tariffs that are under the control o f municipalities and not backed by taxes that have competing demands and are not under the control o f the municipalities. Under the Sub-projects, municipalities will be requiredto adjust tariffs to meet costs. C. IMPLEMENTATION 1. Partnershiparrangements(if applicable) The government i s planning to direct EU assistance towards IB, starting in 2006, so that the institution i s well placedto implement EUprograms inthe future. To this end, the Bank will co- ordinate both with the government andEUto ensure that any assistance to IB is complementary innature. 2. Institutionaland implementationarrangements This operation supports public sector infrastructure development and IB, as an agent for the central government to serve local administration, will implement the project and use the Bank loan proceeds to lend to municipalities. The operation is not characterized as financial intermediary lending, where the Bank's Operational Policy 8.30 would apply, for the following reasons: IB's loans are effectively guaranteed by the central government by virtue o fthe ability o f the institution to withhold central government tax transfers to municipalities in lieu o f debt service. Municipal revenues, the source o f the debt service for the loans made by IB, are heavily dependent on central government transfers. Currently, about 45% o f municipalrevenues originate from the central government; I B ' s capital mainly comes from legally mandated equity contributions from municipalities, which are its shareholders and borrowers. IB has not raised funds from the market and as a result it has no outstanding financial liabilities; and @ The Sub-borrowers in the project have already been pre-identified and individual Sub- loans are subject to explicit approval o f the Bank, based on Sub-project eligibility criteria. IB has the capacity to implement the project and due to its central tax transfer function, the institution i s in regular contact with all municipalities. It has specialized water and wastewater departments that currently appraise and finance projects. The institution also has eighteen 12  regional offices that will help to prepare and supervise projects. A Project Management Unit (PMU) within IB was established in April 2005 and will be responsible for co-ordinating activities andbe the primary contact point for the Bank. The PMUcomprises a Director and four staff members with technical and bankingqualifications. The PMU Director and the staff are all employed by IB. The PMU will draw upon other staff within the bank, as needed. Apart from the PMU, IB's Project Appraisal Unit will help to prepare the project. Project supervision will be carried out by IB's Water Supply Department and Sewerage and Wastewater Department, botho f which have staff based inAnkara and the regional offices. Municipalities that have beenselected will have to meet the Sub-borrower eligibility criteria. IB will have to ensure that Sub-project eligibility criteria are met. The details o f the on-lending conditions are presented inAnnex 6. The Mid Term Review o f the project will be carried out by September 30,2007. 3. Monitoring and evaluation of outcomes/results The parameters to measure outcomes on quality local service delivery will be outlined in the feasibility studies and included as benefits o f the project. The Project Progress Report will provide information on: 0 success in meeting the environmental objective o f the project measured through wastewater treated, water loss reduced, sewerage connections increased, and disposal o f waste inan environmentally safe manner; e improvements in the financial position and operational efficiency through indicators like improvement inworking ratio, andreduction o f unaccounted for water; and 0 status o f the technical assistanceprogram in Iller Bank, including the status o f the Action Plan. The Project Progress report will be submitted to the Bank on a semi-annual basis. On an annual basis, an independent auditor will audit IB as per international standards and the audit report will bemade available to the Bank. 4. Sustainability The government i s emphasizing the delivery o f local services as seen through the passage and discussions o f various laws related to municipalities and their services. The intent o f Turkey to meetEUdirectives on environment has also created the needto look into municipal development inamore holistic manner. Thus, the assets created by the project are expected to bemaintained for the provision o f services. The project supports basic services such as provision o f potable water and wastewater treatment. The risk o f these services being discontinued is negligible. The financial analysis carried out as part o f project preparation will ensure that tariffs are adequate to cover investment and operational costs. The technology used for the proposed investments is well tested and the risk 13  o f operational failure i s low. Further, the technology usedwill have to bejustified as part o fthe Sub-project approval process. These factors will ensure the sustainability o f investments. 5. Critical risks andpossiblecontroversialaspects Full development o f the municipal sector will take time as it is related to efficient implementation o f the public administration and municipal laws, some o f which are still not effective. Further, changes would have to take place in the financial sector so that long term capital i s available to support a municipal debt market. However, important environmental investments should not be delayed and should be completed ifthey can be justified on a case by case basis. The project takes this approach by selecting municipalities with relatively good financial standing and environmental needs. Prior review o f investments by IB and the Bank will ensure that the investments arejustified. All municipalities andinvestments will have to meet the Sub-borrower and Sub-project eligibility criteria. The risk o f not meeting the project development objective is substantial since the overall governance structure of IB makes it subject to political interference. IB may be asked to grant favors to municipalities (debt forgiveness, collect less than what i s due from municipalities, provide free services) that would affect the project. To mitigate this risk, the project design includes: e A ring fenced approach where the project activities are separated from the rest of the operation o f IB through technical and financial covenants inthe Bank's LoanAgreement, some o f which will also be reflected in the Sub-loan Agreement. Failure to implement the covenants in a satisfactory manner would lead to remedial actions, including suspension o fthe loan; and e Assurance from the government that it would facilitate project implementation. This assurance will be sought through the Guarantee Agreement since the government has full administrative and financial control over IB. 14  Risk MitigationMeasure - RiskRating v To Project DevelopmentObjectives IBmaybe asked to grant favors The project will be ring fenced - S to municipalities. This may affect key technical, financial, and the project reporting requirements will be same for IBand the municipalities The Guarantor will provide assurances that IBwill be able to implement the project ina delayed due to lack o f Sub-projects will ensure that the counterpart funds and political projects are viable, affordable, commitment; construction and simple. These factors are delays; and non-familiarity with included as Sub-project financing Bankprocurement procedures criteria. The signing o f Sub- loans by municipalities will indicate the commitment on the part o f municipalities IBmaynotbe able to effectively The P M U i s authorized to co- M supervise the project due to lack ordinate activities among various o f co-ordination among the departments. Further, the PMU involved departments i s adequately staffed and can draw on consultants as required Municipalities may want to Adequate planned expenditure on M minimize expenditure on technical assistance and an Technical Assistance which Operational Improvement Plan would prevent plannedand willbe a Sub-project financing sustained development criteria Implementationo f the IB's IntheGuaranteeAgreement, M Technical Assistance delayed assurances will be providedby the government that it will facilitate satisfactory implementation o fthe project and implementation o f the Action Plan RiskRating: H=High; S = Substantial; M=Modest; N=Negligible or Low 15  6. Loadcredit conditions and covenants Effectiveness Condition a at least two Sub-loan Agreements signed; and a satisfactory legal opinions on the Loan Agreement, Guarantee Agreement, and Sub-loan Agreement provided to the Bank. Loan Agreement Covenants IBwill: hire an auditor in accordance with terms and conditions agreed with the Bank by November 30, 2005. International Financial Reporting Standards (IFRS) will be applicable for the financial statements of IB and the project. These statements will be audited annually as per international auditing standards; submit aProcurement Planby October 1,2005; share the Iller Bank Strategy and the proposed amendments to the Iller Bank Law with the Bank to allow exchange o fviews on these documents; ensure that qualified and adequate staff are assigned to implementthe project; select municipalities andmunicipal utilities based on the Sub-borrower eligibility criteria; appraise projects based on the Sub-project eligibility criteria; implementthe Action Planina satisfactory manner; submit a Project Progress Report to the Bank semi-annually; submit aFinancial Monitoring Report to the Bank on aquarterly basis; submit an updated Procurement Planto the Bank on a semi-annual basis; open an escrow account where the debt service requirements for the Bank loan will be set aside; maintain a debt service coverage o f at least 1.2 throughout the duration o fthe project; enter into Sub-loan Agreements satisfactory to the Bank and maintain such subsidiary agreements throughout the duration o fthe project; and 16  e use the Operational Manual o fthe project for guidance on the use o f the Bank loan funds. The Financial Management Manual will be part o f the Operational Manual. D. APPRAISAL SUMMARY 1. Economic andfinancial analyses The economic analysis of the investments will be conducted as part o f the feasibility assessment o f each Sub-project. The benefits o f the investments will be compared against the costs. The financial analysis o f the investments will also be conducted as part o f the feasibility studies. The affordability o f tariffs will be taken into account as part o f the analysis. The feasibility studies are being conducted by consultants, financed by the PHRD grant, under the supervision o f IB. The Bank's approval to the investments would be based on Sub-borrower and Sub-project eligibility criteria. Overall, the financial situation in IB is stable due to capital contributions by municipalities. At the same time, IBdoes not have financial liabilities since it has not raised hnds fi-om the market and it is not a deposit taking institution. Loans made by IBhave a cash collateral as by law the institution can intercept the tax transfers in lieu o f debt service payments. However, the interception i s not always used uniformly which resulted in overdue payments to the institution (principal, interest, and penalties) at the end o f 2004. In 2005, these overdue payments- representing about 28% o f the equity o f the institution - were restructured into 3 years loans. For purposes o f the project, the ability o f IB to service the Bank loan is assured through the use o f an escrow account where the municipalities will deposit their debt service and through the liquidityo f IB due to the capital contributions o fmunicipalities. Key financial covenants for the Loan Agreement are: e Creation o f an escrow account in IBwhere municipalities will deposit their debt service payments. Funds inthis escrow account will be utilized to repay the Bank; and e The debt service coverage for IB and the municipalities will be at least 1.2. 2. Technical The techndlogy to be used under the project i s standard and well tested. As part of the feasibility studies, the consultant will suggest technical solutions that are viable, cost efficient, and have minimal operating costs. IB has the capacity to review the work of the consultants carrying out the feasibility studies and also will be supported by an independent consultant - financed by the PHRD grant -duringthe review. The investments have to be technically viable as a Sub-project eligibility criterion. 17  3. Fiduciary Procurement The overall procurement risk is rated high since IB and the municipalities are not familiar with the Bank's procurement procedures. However, this rating can be revised inthe future as IB and the municipalities get more familiar with Bank's procurement processes. IB has significant procurement capacity on Turkish procedures and it i s expected that it would be able to quickly and satisfactorily follow Bank procedures. The IB Institutional Strengthening o f the project allows for procurement training o f IBstaff on this matter. Over the years, IB has developed substantial capacity in preparation o f bidding documents, launching o f contracts, record keeping, and supervising contracts as the bank carried out procurement activities on behalf o f municipalities. This experience will be useful for IB to supervise procurement activities and assist municipalities, if needed, under this project. For works contracts less than US$ 5 million, IB will have the option to use the Bank's sample bidding document for National Competitive Bidding (NCB) with the Bank's procurement procedures. IB will also be given an option to use local N C B documents and procedures stipulated in the Public Procurement Laws (Law No: 4734 & 4735) under certain provisions required by the Bank (Annex 8). Based on the performance o f the PMU, the threshold for N C B may be increasedone year after the loan is effective. FinancialManagement The financial management assessment o f IB has been completed and the overall rating is satisfactory (Annex 7). The assessment o f the implementing entity, fund flow arrangements, staffing, accounting policies and procedures, reporting and monitoring, and information system was satisfactory. IB does not perform internal audits and amendments to the Iller Bank Law propose to create an internal audit department along with a risk management department. On external audits, IB i s audited by auditors acceptable to Banking Regulation and Supervision Agency (BRSA) in accordance with Accounting and Auditing standards also published by BRSA. IBis also audited by the Higher Audit Board andthe report is sent to the Parliament. IB has agreed that it will hire an external auditor to carry out the annual audits of the institution and the project as per International Financial Reporting Standards (IFRS). The Terms o f Reference o fthe audit have to be acceptable to the Bank. IBwill prepare financial statements and maintainrecords to ensure appropriate accountingo fthe loan funds. The Financial Monitoring Reports (FMR) will be prepared quarterly and will be submitted to the Bank no later than 45 days after the end o f the quarter. The format and the content o fthe FMRs are outlined inthe OperationalManual. 18  4. Social The public will be consulted on the investments as per the Environmental Framework and information on the project will be disclosed. In case o f land acquisition, a Land Acquisition Framework has been developed for the project which will ensure that the property and inheritance rights o f the public will be respected, the public will be fully informed, the land acquisition process will be transparent, and the expropriation price will be fair. Further, the Bank financing will take place only after the landacquisition process is completed satisfactorily and the municipality has ownership o f the land, inline with the framework. The Bank loan will not finance investments that require resettlement. Affordability o f tariffs is a Sub-project eligibility criterion and will be considered as a key element in determining the size o f the investments. This will help mitigate any social risks associated with hightariffs. 5. Environment The project i s expected to bring about environmental benefits through the treatment o f wastewater, reduction o f water losses, collection o f wastewater, and improving solid waste management practices. The benefits o f the investments will be analyzed during the feasibility studies andbaseline information on the environment will be collected. To measure the progress o f the project, environmental parameters - such as number of sewerage connections or volume o f wastewater treated -will be used. As perthe Bank's OperationalPolicy 4.01, the environmental category o f Financial Intermediary (FI) will be applicable for this project. An Environmental Framework has been developed for the project that will be implementedby IBwhich will be responsible for screening projectsbased on the Bank's environmental categories o f A, B, and C. The municipalities will carry out the environmental assessments and IB will submit the necessary information to the Bank seeking financing for the investments. The framework also outlines the procedures for public consultation and information disclosure on environmental matters. 6. Safeguard policies Duringproject implementation, IBwill supervise municipalities to ensure that the Environmental Framework and LandAcquisition Framework are beingfollowed. These frameworks have been discussed in Turkey and have been posted on IB's internet site. The Environmental Framework and the LandAcquisition Framework have been sent to the Bank's Infoshop on January 24,2005 and March22,2005, respectively. The selected Sub-project sites are either located adjacent to the Mediterranean Sea, Black Sea, and Aegean Sea or on national rivers that discharge to these seas. For these sites, a Sub-project eligibility criterion is that the activities o f the project will not adversely affect the quality and quantity o f water flow and will be in compliance with Turkey's commitments under the 19  Bucharest and Barcelona Conventions. Each Sub-project will require the Bank's review and approval for financing underthe Bank loan. A Sub-project criterion will be used for Sub-projects located on trans-boundary waters. The criterion requires that for such sites, investments should only be for ongoing schemes, involving additions or alterations that require rehabilitation, construction, or other changes that (i) not will adversely change the quality or quantity o f water flows to the other riparians; and (ii) will not be adversely affectedby the other riparians' possible water use. Inaccordance with this criterion, it is required that investments will only involve minor additions or alterations to the ongoing scheme which will not cover works and activities that would exceed the original scheme, change its nature, or so alter or expand its scope and extent as to make it appear a new or different scheme. Safeguard Policies Triggered by the Project Yes ' N o Environmental Assessment (OP/BP/GP 4.01) [XI [I Natural Habitats (OP/BP 4.04) [I [I Pest Management (OP 4.09) [I [I Cultural Property (OPN 11.03, beingrevised as OP 4.11) [I [I Involuntary Resettlement (OP/BP 4.12) [XI [I Indigenous Peoples (OD 4.20, being revised as OP 4.10) [I [I Forests (OP/BP 4.36) [I [I Safety o f Dams (OP/BP 4.37) [I [I Projects inDisputedAreas (OP/BP/GP 7.60)* [I [I Projects on International Waterways (OP/BP/GP 7.50) [I [I 7. Policy Exceptions and Readiness The project does not require any exceptions to Bank policies. The project is ready for implementationas indicatedthrough the following: e Fiduciary arrangements - financial management and procurement - are satisfactory and inplace; e The PMU in IB is fully operational and it has been successful in carrying out project preparation, drawing on help o f consultants and the rest o f the bank as needed. The effectiveness o f the P M U i s expected to continue during project implementation where consultants and relevant departments o f IB will continue to provide support to the unit; e The bulk o f the counterpart funds required for the project will come from the municipalities and they have indicated their willingness to contribute towards the project by signingthe M o Uwith the IB to initiate the feasibility studies. The project is included 'Bysupportingtheproposedproject,theBankdoesnotintendtoprejudicethejkaldeterminationof theparties'claimsonthe disputed areas 20  inthe government's public investmentprogramandthe process to finalize the investment amount, through a review o fthe feasibility studies by SPO, i s underway; e Feasibility studies for the participating municipalities started on December 1, 2004 and the detailed investment program will be defined by June 2005, allowing for a timely implementationo fthe project; and a As per the Bank's policies, environmental and land acquisition frameworks have been prepared and are satisfactory to IB and the Bank. 21  Annex 1: CountryandSector or ProgramBackground TURKEY: MunicipalServices Project MunicipalSector Background Turkey has 81 provinces covering the territory o f the whole country. Governors head each province which are sub-divided into sub-provinces headed by a sub-Governor. Within a province, there are four types o f local authorities: Municipalities.There are 3,225 municipalities that have beenestablished inareas which have more than 2,000 inhabitants. They cover about 75% o f the country's landmass and the average municipality has a population o f 15,000. Each municipality i s headed by a directly elected mayor and governed by an elected municipal council. Metropolitan Municipalities. In 16 o f the main urban areas in Turkey, the municipalities are organized under umbrella organizations referred to as a metropolitan municipality that i s responsible for the provision o f services for all its constituent district municipalities. All metropolitan municipalities have a separate water and wastewater utility. In September 2004, the Metropolitan Municipality Law was amended which increased their area o fcoverage. Villages. Turkey has about 35,000 villages that are governed by a Muhtar (head man). The average village has a population o f about 500. SpecialProvincialAdministrations (SPAs). There are 81 SPAs, one in each province, covering urban areas and villages. The local authority functions within an SPA are carried out by the provincial administration under the province Governor. Budget An overview o f the local government budget is shown below inthe table. The budget deficit in the local government sector has been financed by the central government through loans or allowing central government receivables from the local government to grow. Municipalities account for more than 80% o f the local government budget. While overall there i s a budget deficit, typically the revenues and expenditures balance inthe larger municipalities. The figures mentioned below are derived from the paper entitled `Assignment o f Local Functions and Expenditures inTurkey' (preparedbyMessrs. Baki Kerimoglu and H.HakanYilmaz, September 2004). 22  LOCALGOVERNMENTBUDGET (YOshare of GNP) I 1999 I2000 2001 I I2002 2003 I REVENUES 4.19 4.33 4.90 3.74 3.78 1.Tax revenues 2.70 2.88 3.12 2.07 2.13 2. Non-tax revenues 0.68 0.61 0.74 0.72 0.73 Ofwhich domestic borrowine 0.06 0.03 0.04 0.04 0.07 Y Ofwhich external bonowing 0.15 0.19 0.16 0.04 0.18 3. Factor Incomes 0.82 0.85 1.05 0.95 0.92 I I I I I I I I I EXPENDITURES 14.60 4.69 5.17 3.80 3.89 Note: 2003 figures are estimates Revenues: Municipalities have three sources o f financing: Tax revenues: Taxes represent about 60% o f the revenues o f the local government. Central novernment sources: On average, about 75% o f the tax revenues are from central government sources with the smaller municipalities being more dependent on central government resources. 6% o f general taxes collected by the central government are distributed to the municipalities based on population. In addition, the metropolitan municipalities receive 3-6% o f the central taxes collected within the region with the percentage being decided by the Council o f Ministers. The transfer mechanism is not complicated and brings about certain level o f predictability on the level o f local government income. However, the large share o f central transfers de-links taxation and spending at the local level. Further, transfers are not linked to actual service levels and extra transfers to metropolitan municipalities generally allow them to have additional resources inrelative terms; and Local taxes: About 25% o f the taxes are generated from local taxes and duties. The main local tax is the real estate tax. Locally raised revenues are centrally controlled and while there are many taxes, the collection rates are low and the proliferation o f local taxes and fees makes them costly to administer. Non-tax revenues: About 18% of local government revenues are generated from non-tax revenues that include duties, contribution to investments (represents less than 2% o f municipal revenues), fees based on revenues generated from mineral enterprises within a municipality or museum entrance fees. Further, municipalities are allowed to establish 23  commercial enterprises such as shops and 5 4 % o f the profits o f these enterprises are a source o f local government revenue; and Borrowings (short and longterm) are included inthe non-tax revenues but they constitute a small portion (5%) o f the cash inflow to the municipalities. About 3.5% and 1.5% o f the cash inflow to municipalities are from foreign and domestic sources, respectively. The low borrowings are largely due to lack o f creditworthiness o f municipalities and unavailability of long term funds inthe country. Factor incomes: About 22% o f the local revenues are generated from commercial enterprises and utility services such as water, sewerage, and transportation. These incomes are based on tariffs that are decided by the local authorities. In metropolitan municipalities the waterhewerage services and transportation services are provided through municipal companies. Inother municipalities, the accounts o f these services are merged with the rest o f the municipal operations. Generally speaking, the water and wastewater services result in operating surplus and they often subsidize other municipal operations. Expenditures: Municipalities have the following expenditures: a) Current expenditures: About 40% o f municipal expenditures correspond to current expenditures. This cost i s mainlyrelated to personnel expenditures that constitute about 75% o fthe current expenditures. b) Investment expenditures: This corresponds to about 35% o f municipal expenditures and includes machinery, equipment, and construction costs. The municipalities would like to increase their investment expenditures but are constrained by limited resources and inability to reduce current expenditures. c) Current transfers: About 20% o f the expenditures correspond to transfers from the municipalities to the central government for taxes, social security payments, and debt service. Inpercentage of GNP terms, there has beena decline inthe payments since 1999 and this is due to the fact that less than 20% o f the social security payments are made by the municipalities. Further, municipalities have overdue payments to the tax office and other public institutions. d) Expenditureon assets: About 3% o fthe expenditures are due to debt service on various investments. A large portion o f the domestic municipal debt is held by Iller Bank. Municipalities - especially the large ones - may also have debt to InternationalFinancial Institutions, backedby Treasury guarantees. e) Capitaltransfers: All municipalities are shareholders o f IB andby law they are required to contribute towards the equity of the bank. Transfer payments, corresponding to about 2% o f the municipal expenditures, are made to IB on a regular basis. The municipalities are current on this payment to IB. 24  MunicipalDebt There are two fimdamental constraints inthe municipal debt market. Long term financing - needed for municipal infrastructure development - is not currently available. The situation i s however getting better with the declining interest rates as described earlier. However, inthe short term, it is unlikely that municipalities will have access to long-term credit that i s necessary to finance local public infrastructure that requires a longpayback period; and Municipalities have limitations on the resources that they can mobilize from taxes and have limited flexibility inreducing expenditures. However, they do have some flexibility inraisingwater andwastewater tariffs. Municipalities rely heavily on the central government to finance their operations. This i s done through maintaining high levels o f payables and debt to the central government. At the end o f 2003, the local government debt heldby the central government was around 18.3 quadrillion TL or around 5.6% of the GNp4(shown below inthe table). This highlevel o f debt is a concern for the central government that is inthe process o freforming the municipal sector (next section). The debt due to Treasury is for guarantees that have been called and paid by Treasury. The amounts paidby Treasury, on behalf o f municipalities, become municipal debt and accounts for about 56% o f the municipaldebt heldby Treasury. The remaining Treasury debt stock i s due to contingent liabilities o f BuildOperate and Transfer projects (24%) and loans (20%). These loans have been mainly made by Intemational Financial Institutions. The liabilities to the public institutions are mainly the local government payables to the Social Security Administration and the Tax Office. Iller Bank debt i s also included in the entire municipal debt stock. Under Turkishregulations, the loans madebyIller Bank are backedby cashcollateral since, by law, the institutioni s able to intercept tax transfers inlieu o f debt service payments. Local government borrowings from domestic banks are very small compared to the assets o f the banking sector. At the end o f 2003, total local government domestic borrowings were 1,336 4BorrowingsinLocal Government; Messrs. Ferhat Emil andH.Hakan Yilmaz; September 2004 `BorrowingsinLocalGovernments'; Messrs. FerhatEmilandH.HakanYilmaz, September2004 25  trillion TL (1,129 trillion TL with Iller Bank; and 207 trillion with deposit money banks), which represents about 0.5% of the entire banking sector assets. This low utilization o f local commercial banks illustrates the above-mentioned issues of lack of long-term hnds and municipal creditworthiness. 26  Annex 2: Major RelatedProjectsFinancedby the Bank and/or other Agencies TURKEY: MunicipalServices Project A list o f recent Bank projects in the sector is shown below. The lessons learned from these projects have beenincorporatedinthe design o fthis project. Name I ClosingDate 1 OED Rating The Bank has been involved in the municipal sector in Turkey through a number o f water and wastewater projects andthrough economic and sector work (ESW). Through these activities the Bank has assisted in the development o f the infrastructure and provided policy advice. The involvement o f the Bank will be a continuation of the ongoing dialog betweenthe Bank and the key stakeholders. Lessons learned from past activities have been incorporated in the project design. Some ofthe recent activities are: a In the last twenty years, the Bank financed water and wastewater projects in the municipalities o f Istanbul, Ankara, Bursa, Izmir, Antalya, and Cesme-Alacati. In the Bursa project, there was a solid waste component which assisted the city to construct a landfill and promote recycling o f wastes. The Bank also financed the Cukurova Urban Development Project where IBwas involved; a Inthe last three years, the Bankprepareda MunicipalSector Review and anUrbanWater and Wastewater Sector Review. These ESW outline the issues in the sectors and make recommendations which have beenconsidered underthe project; and a The Bank's Institutional Development Fundsupported the development o f a Performance Monitoring System. Through the system, the operational and financial performance o f 129 pilot municipalities (including all of the 122 municipalities that have a population more than 100,000) are made public through the internet. The government plans to expand this performance monitoring to other municipalities as it i s beingpromoted under the current decentralizationefforts. The Project Status Report at project closure rates both the IP and DO as satisfactory. 27  Annex 3: ResultsFrameworkandMonitoring TURKEY: MunicipalServices Project ResultsFramework PDO OutcomeIndicators Useof OutcomeInformation Support sustainable environmental Quality local services provided in Determine the progress made in services in selected municipalities participating municipalities supporting the urbanization trend in Turkey ResultsIndicatorsfor Each Use of ResultsMonitoring OneDer ComDonent Component Component One: Component One: Component One: Municipal Development These results will be Sub-project Establish and implement policies on specific and will include: providing quality service ----Wastewater treated Water loss reduced Sewerage connection increased Solid waste disposed insanitary landfill Component Two: ComponentTwo : ComponentTwo : MunicipalTechnical Assistance - Feasibility studies, design, Allow for planned and sustained and construction supervision municipal development I carried out efficiently - Operational Improvement Plan implemented Component Three: Component Three: ComponentThree: Iller Bank Institutional Project implemented satisfactorily A strengthenedIB will help the Strengthening development o f the municipal sector 28   Annex 4: DetailedProjectDescription TURKEY: MunicipalServices Project Descriptionof ProposedInvestments The proposed investment projects that have beenidentified are listedbelow. PHRD grant financed consultants are currently concluding feasibility studies that analyze the projects from an economic, financial, technical, and environmental perspective. In order to qualify for Bank financing the proposed Sub-borrowers must meet all Sub-project eligibility criteria. a Antalya MetropolitanMunicipality:(2000 census population is 675,000 inthe winter and double that level in the summer.) The project comprises the construction o f a sewerage system in the eastern part o f the city and in 11 municipalities that have been attached to the Antalya Metropolitan Municipality. The project also includes building a wastewater treatment plant for the additional flow andto a marine outfall to protect the environment inthis city that depends on its large tourism industry. Implementation could be expected to start early since the proposed Sub-borrower, ASAT, i s experienced with Bank projects after executing a large Bank-financed water supply and sewerage project in the year 2003. a Bergama: (Population of 52,000). The project consist o f the constructing a sanitary landfill that would replace the present practice o f dumping garbage in an unsanitary and temporary site. The tourism industry is important and continuing the present improvised disposal system would risk perpetuating the associated health and environmentalhazards. a Cankiri (Population of 63,000). The municipality seeks financing to build a water transmission line from the existing Giildiircek dam and to construct a potable water treatment plant in order to alleviate the supply problems with insufficient water and low service pressure. These investments should be complemented with a plan to improve operations and reduce unaccounted water, possibly be replacing old and leaking segments of the existing water supply network and introducing demand management programs. 0 Elbistan: (Population 77,000). The project aims at upgrading the existing water transmission lines, storage tanks and water distribution network. The construction o f a wastewater treatment plant is also included. Currently untreated wastewater i s being discharged in the Ceyhan river, creating a threat to public health and the environment. 30  e Gelibolu: (Population 22,000). The project comprises construction o f a sanitary landfill to discontinue the present unplanned and unsanitary disposal o f solid waste. The proposed new landfill site i s about 6 kilometers inland and only domestic waste (not hazardous) will be disposed in the site. Any generated leachate will be sufficiently treated - as per Bank guidelines and applicable national standards - and discharged on land. e Giimiigova (Duzce) (Population 12.000). The project proposes to construct a water treatment plant to eliminate the turbidity in the water. Water i s presently supplied from karstic springs and the turbidity inthe water rises above acceptable levels whenever it rains. The exact causes and suggested corrective measures would be determined underthe project. e Ilica: (Winter population 17,000; summer population70,000). The municipality is located in the tourism growth pole between Antalya and Manavagat. At present, the town relies on septic tanks to accept the wastewater. Due to the local impervious clays the individual tanks cannot absorb the wastewater that rises to the surface and constitutes a pubic health danger. The project would construct a sewerage network. Kutahya: (Population 170,000). The project objectives are (i) rehabilitate the to major share o f the existing water supply network that i s approaching the end o f its usehl life; (ii) begin building a stormwater drainage system; (iii) build a to to sanitary landfill; and (iv) to rehabilitate the existing wastewater treatment plant. Giventhat the city has proposed multipleinvestments there is a need to prioritize them to ensure that the activities supported under this project are affordable. The project would improve environmental and health conditions within the city and improve the quality o f water discharged from the city. e Mersin Metropolitan Municipality: (Population 545,000). The application o f the new Metropolitan Municipal Law has expanded the jurisdiction of the metropolitan municipality. Present service i s inefficient with unaccounted water approaching 55% o f water produced. The project proposes to rehabilitate the water network by replacing leaky distribution network segments with high- densitypolyethylene pipe. e Mugla: (Population 44,000). The project proposes to develop sewerage network and construct a wastewater treatment plant. Currently untreated wastewater i s discharged undergroundwhich creates the potential o f groundwater contamination and seepage o fwastewater to the nearby Aegean Sea. e Odemig (Population 62,000). The project proposes to construct a wastewater treatment plant. Currently, untreated wastewater i s discharged to a nearby stream which eventually reaches the Aegean Sea. 31  e Polatli: (Population 80,000). The town suffers from excessive hardness in its present water supply. The project proposes to build a water treatment plant to soften the hardness o fthe water. e Samsun Metropolitan Municipality: (Population 363,000). Due to the application o f the new Metropolitan Municipal Law, the jurisdiction o f the metropolitan municipality has increased. The municipality proposes to rehabilitate the water network. Although the present water supply will be sufficient for the city's projected needs for the foreseeable future the high levels o f unaccounted water o f 50% justifies a program o f demand management and selective upgrading o f the present water distribution network. The project would need to create an information system o fthe existing water supply system, possibly on the basis o f a Geographic Information System (GIs). e Serik Tourism Infrastructure and Environment Union: (Population 170,000 residing inthe Union of Serik, Kadriye, Belek, Karadayi, Belkis, Yeni Kocayatak, Candir, Bogazkent, Tasagil municipalities). The union i s located between Antalya and Manavgat in a region that relies on agriculture and tourism. Insufficient and inadequate water service has prompted the union to request the rehabilitation and expansion o f its water distribution network. The project may well include a program of demand management and measures to reduce unaccounted for water. 32  Iller BankInstitutionalStrengthening Under Component 3 o f the project, there will be Technical Assistance (TA) for IB. The objective o f the TA will be to strengthen the institutional capacity o f Iller Bank. The TA will cover: strengthening o f financial and banking capacity; and strengthening o f technical capacity, audit, and incremental operating costs. The TA for Iller Bankwill include the following: Increasing financiavbanking capacity: By January 1, 2006, IB will hire three financialbanking consultants who will provide advice and report to the PMU. The TA will strengthen IB's capacity o f risk management and internal auditing and also strengthen IB's capacity to implement the upcoming EUprograms. The Terms ofReference for the consultants are included inthe Operational Manual; Increasingtechnical capacity: By January 1, 2006, IB will hire three technical consultants (financial specialist, engineer, procurement specialist) who will provide advice and report to the PMU. The TA will enable IB staff to provide efficient technical and utility management solutions to the municipalities. It will also strengthen IB's capacity to implement the upcoming EU programs. The Terms o fReference for the consultants are included inthe OperationalManual; Audit: On an annual basis, IB will complete an audit as per international accounting standards (Annex 7); and IncrementalOperating Costs: The incremental operating costs include salaries o f consultants working in the PMU, staff per diems, lodging and travel costs for field trips related to the implementation o f the project, seminars and workshops, and equipment - hardware and software. 33  Annex 5: Project Costs TURKEY: MunicipalServices Project ProjectCost By Componentand/or Activity Local Foreign Total US $million U S $million US $million 1. MunicipalDevelopment 250.7 30.0 280.7 2. Municipal Technical Assistance 15.0 5.0 20.0 3. Iller Bank Institutional Strengthening 4.0 2.0 6.0 TotalProject Costs(withcontingencies) 269.7 37.0 306.7 Front-end Fee 0.0 1.4 1.4 TotalFinancingRequired 269.7 38.4 308.1 34  Annex 6: ImplementationArrangements TURKEY: MunicipalServices Project The implementation arrangement o f the project is schematically shown below. There will be the following legal agreements for the project (i)Loan Agreement between the a Bank and IB; (ii)Guarantee Agreement betweenTreasury and the Bank; and (iii) a Sub- loan Agreements between IB and the participating municipalities. The Operational Manual o f the project will provide guidance to IB on the use o f loan funds and reporting arrangements. PROJECT SCHEME SUB-LOAN AGREEMENT /" VK/ Account Loan Conditions: The loan to IBwill be made inEuroswith the following conditions: (a) Term: Fixed Spread Loan with 17 years maturity; (b) Grace: 5 years, with level repayment o f principal; (c) Front-end Fee: 100 basis points, less existing waivers; (d) Commitment charge: 85 basis points, for the first four years; thereafter, 75 basis points, less any waivers ineffect; and (e) Interest: LIBOR plus fixed spread. On-lendingterms: The Sub-loans will be made in Euros and the exchange risk will be borne by the municipalities. This has been a policy o f the government for all foreign loans directed towards municipalities. Guidelines for on-lending arrangements from IB to the municipalities will be as follows: (a) The term will be 17 years and the grace period for Sub-loans will end on the day the grace period for the loan to IB from the Bank ends; (b) Front end Fee: same charge to IB due to the Bank loan; (c) Commitment charge: same as the charge to IB due to the Bank loan; (d) Interest rate: interest rate due to the Bank loan plus a spread o f 100basis points to cover IB's cost; and (e) Guarantee Fee: 25 basis points that will be charged by Treasury and passed to the municipalities by IB. 35  Escrow account: To secure debt service, IB will require municipalities to deposit the interest and principal repayments in an escrow account. IB will use the funds in the escrow account to service the Bank loan. The municipalities will deposit the funds inthe escrow account 15 days prior to the repayments due from IBto the Bank. As per the law, IB is authorizedto usethe tax intercept also as collateral for a Sub-loan. Project Management:In April 2005, a Project Management Unit (PMU) was created which is authorized to carry out project preparation and supervise implementation. Preparation and supervision will be carried out by other relevant units in IB with the PMU playing a co-ordinating role. The PMU comprises a Director and four staff members with technical and banking qualifications. The PMU Director and the staff are all employed by IB. The P M U will draw upon other staff within the bank - financial, technical, procurement, environmental, legal etc. - on an as neededbasis. The PMUwill be the primary contact point for the Bank. Currently, the PMU is also supervising three consultants (financial, technical, and procurement) that are financed by the Policy and Human Resources Development Fund (PHRD) grant. These consultants are providing training to the IB staff (inthe PMU and in other departments) and assisting with project preparation. Project Appraisal: Within the Planning Department, comprising 110 staff, a Project Appraisal Unit, comprising 8 staff, has been formed. This unit will be responsible for appraising the projects in consultation with the PMU. Out o f the 8 staff, 7 o f them are technical and 1o f them i s a financial specialist. The financial capacity o f this unit needs to be strengthened and IB will support the Project Appraisal Unit in the following manner: a) utilize the financial consultant, funded by the PHRD grant; b) draw on other financial specialists in the bank; and c) hire additional financial staff for the project. Under the proposed amendment to the Iller Bank Law, the PlanningDepartmentwill be converted to a Project Development Department and the Project Appraisal Unit will be converted to a Project Appraisal Department. The experience gained under the project will bebeneficial for other appraisal work to be carried out byIB. Project Supervision: IBwill carry out project supervision of the Sub-loan Agreements. The water projects will be supervised by the Iller Bank's Water Supply Department, which has about 90 staff. The wastewater and solid wastewater management will be supervised by the Sewerage and Wastewater Department, which has about 70 staff. These units are based inAnkara and the units will draw upon the capacity o f the regional offices for the supervision. Project Design and Construction Supervision: All design work and construction supervision will be conducted by consultants. These consultants would be employed either by the municipalities or by Iller Bank on behalf o f the municipalities ifthe capacity o f a municipality is inadequate. Role of Regional Offices: IB has an extensive regional representation through its 18 Regional Directorates where 55% o f the staff are located. These regional offices will play an important role inpreparing and supervising the projects. Duringpreparation, the 36  regional offices will support the PMU and the Project Appraisal Unit in providing relevant information ina timely manner and co-ordinating with the municipalities andthe municipal utilities. Duringimplementation the regional offices will supervise the project jointly with the Water Supply and Sewerage and Wastewater Department. Supervision reports will beprovided to the PMU. DuringPreparation IBwill beresponsible for identifying eligible Sub-borrowers and ensuring that the Sub- project eligibility criteria are met. Sub-borrower Eligibility: Municipalities or municipal utilities eligible to receive the Bank loan for investments and technical assistancewill have met the following criteria. e No overdue payments to the Treasury or IB; e Debt service coverage throughout the duration o f the project should be at least 1.2; and 0 Satisfactory institutional arrangements for a Sub-project to be carried out effectively. For the project, the municipalities have been pre-identified. Preliminary assessment indicates that these municipalities will be able to meet the above criteria and this will be verified through the ongoing feasibility studies. Sub-project Eligibility. IBwill ensure that the following Sub-project eligibility criteria are met. IB will work with the municipalities to appraise a Sub-project that will be based on feasibility studies. IB will submit viable Sub-projects to the Bank for proposed financing. A Sub-project will be eligible to receive loan fimds if the following criteria are met satisfactorily: e Environmental Benefits: There should be an environmental benefit to justify the investments; e Economics; The Sub-project should be justified on economic grounds through a cost benefit analysis. Wherever possible, the cost benefit analysis will be quantified; e Technical: The Sub-proj ect should be technically feasible and cost effective; e Financial: (i) projected tariffs should cover all costs related to operations and the investments; and (ii) projectedhouseholdbills should be at socially affordable the levels for the services provided under the Sub-project; 37  e Operational Improvement Plan: There should be a satisfactory Operational Improvement Plan at the municipal or utility level. The success o f the plan would be measured through financial improvements (e.g. decrease in working ratio) or efficiency gains (e.g. reduction o fwater losses); e Water Quality/Quantity Issues: IB will confirm the following and their judgment will be substantiated with analysis for the review o f the Bank: (a) For Sub- projects on trans-boundary waters, investments should be for ongoing schemes, involving additions or alterations that require rehabilitation, construction, or other changes that (i) will not adversely change the quality or quantity o fwater flows to the other riparians; and (ii) will not be adversely affected by the other riparians' possible water use. This applies only to minor additions or alterations to the ongoing scheme and it does not cover works and activities that would exceed the original scheme, change its nature, or so alter or expand its scope and extent as to make it appear a new or different scheme; and (b) For projects located adjacent to the Mediterranean Sea, Black Sea, or the Aegean Sea or on national rivers that discharge to the seas, investments should not adversely affect the quality and quantity o f water flow and should in line with Turkey's commitment under the Bucharest and Barcelona Conventions; and e Social: (a) no physical resettlement of people should be needed due to the project; and (b) the land expropriation process, if required, should be completed prior to signature o f a Sub-loan in a satisfactory manner in line with the Land Acquisition Framework and the municipality shouldbe the owner o f the land. DuringImplementation Through the Sub-loan Agreement the municipalities will agree with IB to carry out the following: e implement the project ina sound technical and financial manner; e adjust tariffs to meet operating andinvestmentcosts; e implement the Operational Improvement Plan satisfactorily ineach municipality; e set up an escrow account in which amounts that correspond to 6 months o f debt service will be deposited 15 days prior to their due date to repay IB which will also have the right to intercept tax transfers in lieu o f debt service by the municipalities; e implement the Environmental Framework Agreement in a satisfactory manner. This will include environmental activities during project preparation and implementation involving appropriate level o fpublic consultation and information disclosure; 38  e implement the Land Acquisition Framework Agreement in a satisfactory manner, ifrequired; and e provide necessary technical and financial information to IBina timely manner. Reporting Every six months, IB will provide a status report to the Bank through Project Progress Report that will include the following. e Project Summary: (a) status o f individual Sub-project on physical investments; (b) status o f improvements in service quality and institutional arrangements in each Sub-project; (c) status o f Operational Improvement Plan o f each Sub-project; (d) status o f reforms in IB, including the implementation o f the Action Plan; (e) reporting o fthe Outcome andResults Indicators as per the project; e Fiduciary/Safeguard: Summary information on (a) procurement progress, including an updated procurementplan; (b) disbursements whichwill include loan committed amounts, actual disbursements, and upcoming disbursements for a year; (c) financial management, including the submission o f audits, once a year; (d) status o f implementing the Environmental Framework; and (e) status of implementingthe LandAcquisition Framework; and e Comments: Any special concerns or suggestions to streamline project implementation should also be provided. Apart from the Project Progress Report, IB will submit to the Bank a Financial Monitoring Report on a quarterlybasis and a Procurement Planon a semi-annual basis. 39  Annex 7: FinancialManagementandDisbursementArrangements TURKEY: MunicipalServices Project FINANCIAL MANAGEMENT 1.Summary oftheFinancialManagementAssessment An assessment o f the adequacy o f the project financial management system at IB was undertaken in February 2005. The current financial management arrangements for the project are satisfactory to the Bank. The detailed financial management assessment questionnaire i s included in the project files.A summary o f financial management assessment andconclusions follows: FINANCIALMANAGEMENT ASSESSMENT ' COMMENTS Iller Bank Law an Internal Audit unit CountryIssues A Country Financial Accountability Assessment (CFAA) for Turkey was carried out in 2001. The CFAA report identified some weaknesses in the Turkish financial accountability, in both the public and the private sector. However, since then, the financial management environment inTurkey has improved. The 1999 Banks Law established the Banking Regulation and Supervision Agency (BRSA) which has the authority to determine the accounting and auditing requirements applicable to the banks under its supervision. Banks must submit non-audited monthly prudential returns to the BRSA, and publish audited annual financial statements. Only auditors approved by the BRSA may carry out such audits. All changes in auditor must also be approved, and a change can be imposed by BRSA if the performance o f an auditor i s not satisfactory. The external auditor is required to report to the BRSA on banks' internal control and risk management systems and on issues which may negatively affect the operation o f a bank. 40  The BRSA issued a new comprehensive regulation on accounting standards for banks in July 2002, which brings these standards in line with IFRS. However, the BRSA regulation does not require full application o f International Accounting Standards (IAS) 27 (consolidation o f subsidiaries), as banks are required to consolidate the statements o f only their financial subsidiaries. For non-financial subsidiaries, separate financial statement disclosure i s mandated. The statements o f such non-financial subsidiaries are not IAS-based, however, and thus their disclosure will not allow the user to consolidate the statements with the IAS-based consolidated statements o f the parent bank and its financial subsidiaries. The BRSA also regulates external audit o fbank financial statements and auditors have to be approved by the BRSA. The Regulation on Principles for Independent Auditing and the Regulation on Authorization o f the Auditing Institutions and Permanent or Temporary Withdrawal o f their Authorities are the applicable regulations for the external audits and they are broadly inline with International Standards on Auditing(ISA). IBis governed bythe IllerBank Law andthe BRSAregulations. BRSA recognizes that IBis not fully incompliance withtheprudential regulations due to the absence of a) an Internal Audit unit; and b) a Risk Management unit. The BRSA has not considered this to be a serious breach and not issued any warnings to IB. Remedial actions are being taken by the government and the proposed amendments to the Iller Bank Law include the creation of an InternalAudit and a Risk Management unit. FinancialManagementAssessment Implementing Entity: The project will be implemented by IB which has two core functions: a) support infrastructure development at the local level through technical assistance, loans, and grants; and b) transfer central tax revenues to the local authorities. Through these function, IB i s in regular contact with all municipalities and has the capacity to implement the project. To manage the project, a Project Management Unit (PMU) has been established at IB. The PMU is staffed with experienced management and staff and it will co-ordinate project activities and will be the primary counterpart for the Bank. The risk associated with the implementing entity i s assessed as negligible. Funds Flow: There will be a Special Account in a bank, acceptable to the World Bank. Funds from the loan will be made available to municipalities following submission o f payment documents (invoices for the goods purchased and completion reports for construction activities) to IB. This information will be collected and controlled by IB to ensure compliance with the Sub-loan conditions. The risk associated with funds flow i s considered as negligible. 41  Staffing: Staff currently working in the PMU will continue to work during project implementation. The qualifications and experience o f these staff are satisfactory to the Bank. Since IBwill be responsible for controlling the documents that will form the basis for payments, additional staff from relevant departments will support the PMU during project implementation. The risk associatedwith staffingis considered as negligible. Accounting Policies and Procedures: The financial management capacity at IB is satisfactory. The Bank has qualified personnel and adequate manuals and guidelines to conduct efficient financial management. The accounting and reporting systems at IB are geared toward producing statements and information as required by Turkish laws and regulations. Currently, the Iller Bankasi Bilgi Islem Sistemi (IL BIS) i s being implemented which is a web based management information system linking all the departments o f the institution. Considering that IB has adequate accounting and reporting systems all project related activities will be integrated into the existing system o f the institution. Financial Monitoring Reports (FMR) will also be produced by the system. All accounting policies and procedures for the loan will be documented in the Financial Management Manual, which is a part o f the Operational Manual for the project. The risk associated with accounting policies andprocedures is assessedas negligible. Reporting and Monitoring: IB will maintain records and will ensure appropriate accounting for the loan funds. Financial statements for the project will be prepared by IB.The new information systemof IBinstalledwithin the ILBISis capable o fproducing the Financial Monitoring Reports (FMR) which will be prepared quarterly and will be submitted to the Bank no later than 45 days after the end o f the quarterly period. The Bank and IB have agreed on the formats o f the FMRs and they include the following reports: Project Sources and Uses o f Funds, Use o f Funds by Loan Term, Uses o f Funds by Sub-loan, Special Account Statement, Project Balance Sheet, Investment Monitoring Report, Uses o f Funds by Procurement Category, Sub-loan Distribution According to Regions, Sub-loan Distribution According to Investment Type, Sub-loan Drawdown Status, Quarterly Financial Reports (covering interest received and terms o f Sub-loans). The risk associated with reporting and monitoring is assessedas negligible. Information Systems: IB is currently implementing the IL BIS project which is a web based secure application that will link all departments o f the institution allowing it to execute, monitor, and report using the same data source. By June 2005, it is expected that the system will be fully fbnctional and the regional offices will also be connected to the system. The project's accounting and monitoringwill be carried out by the ILBIS. The risk associated with information systems i s assessedas negligible. SupervisionPlan: Duringproject implementation, the Bank will supervise the project's financial management arrangements intwo ways: (i) review the project's quarterly FMR, 42  and the annual audited financial statements and auditor's management letter; and (ii) during the Bank's supervision missions, review the project's financial management and disbursement arrangements to ensure compliance with the Bank's requirements. As required, a Bank-accredited Financial Management Specialist will assist in the supervisionprocess. 2. Audit Arrangements InternalAudit. Iller Bank does not have an intemal audit department as explained inthe Country Issues section. The amendments to the Iller Bank Law propose to create the Intemal Audit unit. ExternalAudit. Currently IB has its accounts audited in accordance with Accounting andAuditing standards publishedby BRSAbyindependent auditors acceptable to BRSA. The current auditors o f IB have issued unqualified audit opinion on the financial statements o f IB for the year ended December 31, 2003. Duringproject implementation, the annual audit of IB will be completedby an independentauditor, approved by BRSA and acceptable to the Bank, as per IFRS and ISA. The TOR o f the audit firm will cover the audit of the project accounts and the Special Account in addition to the audit o f IB's IFRS financial statements. The audited project financial statements will include: project balance sheet, sources and uses of funds and the Special Account statement. The auditor's TOR will also address the issue o f whether the State of Expenses (SOEs) submitted during the fiscal year, together with the procedures and intemal controls involved in their preparation, can be relied upon to support the related withdrawal applications. IBis also auditedbythe Higher Audit Board on an annual basis. The 2002 Higher Audit Report was reviewed by the Bank and there are no recommendations relating to financial management. The risk associated with external audit i s assessed as substantial since the audit firm is not yet engaged. However, this risk will be addressed through the hiring o f an external audit firmbyNovember 30,2005. 3. Financial RiskAnalysis From a financial management perspective, the overall rating risk rating of the project i s moderate. A summary of the risk assessment for the project follows: 43  INHERENTRISK RATING COMMENTS 1. Country FinancialManagement Risk High Based on CFAA report 2. Project Financial Management Issues Moderate Overall Inherent Risk High CONTROLRISK RATING COMMENTS BRSA regulations. IFRS financial statements for IB are currently not available. However, the audit report o f the 2005 financial statements will Country financial management risk. The CFAA identified some weaknesses in the Turkish financial accountability, inthe public, private and the banking sectors. However, IBis incompliance with the BRSAprudentialregulationswith the following exceptions - it needs to create an Intemal Audit unit and a Risk Management unit. These units are expected to be created through an amendment to the Iller Bank Law. Although IB currently does not use IFRS, under the project IB will submit its IFRS based audited financial statements to the Bank inaddition to its audited financial statements prepared in accordance with the BRSA accounting standards. DISBURSEMENTARRANGEMENTS The loan hnds will be disbursed through Bank procedures on direct payments and Statement o f Expenditures (SOEs). Supporting documentation for SOEs, including completion reports and certificates, will be retained by IB and made available to the Bank during project supervision. Disbursements for expenditures above the SOE thresholds will be made against presentationo f full documentationrelating to the expenditures. The following shows the allocation of loanproceeds. 44  Expenditure Total Cost Financing BankFinancing Category (US$ million) (US$ million) Bank ICounterpart Works 269.6 242.6 27.0 90% oftotal cost Goods 11.1 10.0 1.1 90% oftotal cost Consultant 24.0 20.0 4.0 100%of the total cost Services and Training Incremental 2.0 1.o 1.o 100%ofthe portionto be Operating Cost financedby the Bank Project Cost 306.7 273.6 33.1 Front EndFee 1.4 1.4 0 NIA TOTAL 308.1 275.0 33.1 90% ofthe total cost The Bank financing in Euros as mentioned in the Loan Agreement for the above categories i s as follows: (a) Works - 188,000,000; (b) Goods - 7,540,000; 775,000; and (e) Front End Fee - 1,085,000. Retroactive financing o f 10,000,000 is Consultant Services and Training - 15,500,000; (d) Incremental Operating Cost -(c) made available for Works, Goods, and Consultant Services and Training. The above financing percentage i s based on the note entitled `Turkey: Country Financing Parameters' that was sent to the Bank's Board on January 27,2005 by Bank management (SecM2005-0031). The note mentions that ingeneral, the cost sharing i s expected to not exceed 87%. However, the note also mentions that the Bank may finance up to 100% o f the costs o f individual projects, but will only do so after considering the context o f the operation, availability o f counterpart funds, and implications for the overall portfolio. In this particular project, the overall financing of the Bank is around 90% which is reasonable given that counterpart funds are not readily available at the local level. Further,the investments to be supported underthe project have highpositive externalities due to the environmental, health, and social benefits but the cost recovery period is long. Thus, a high percentage o f Bank financing will help with the cash flow o f the utilities, reducingthe pressures to increase tariffs beyondunaffordable levels. Use of Statements of Expenditures(SOEs): The reimbursement o f expenditures made following items: (a) contracts for goods valued at less than Euro (e) 400,000; (b) from the Special Accounts (SA) may be made on the basis o f certified SOEs, for the contracts for works less than 4,000,000; (c) consulting contracts with firms valued less than 200,000 and with individuals valued less than 50,000; (d) incremental operating costs; and (e) training. Expenditures above these thresholds will be fully documented. Special Account (SA): IB will establish, maintain, and operate a Special Account in a bank, acceptable to the World Bank. The account will be denominated in Euros. The maximum Authorized Allocation for the SA will be 20 million. During the initial stages o f the project, the deposits will be limitedto 10 million. When more than 35 million o f the loan is disbursed, the deposits will be increased to the maximum Authorized Allocation. 45  Annex 8: Procurement TURKEY: MunicipalServices Project This section covers the procurement assessment andprocurement arrangements for the project. PROCUREMENTASSESSMENT InOctober 2004, the Bank carried out a procurement assessment of IB. Meetings were held with (a) department dead o f IB responsible for procurement and operations (b) division manager o f IBresponsible for procurement (c) head o f the PMU for the project and his procurement staff and consultant financed by the PHRD grant. The findings o f the Country Procurement Assessment Report (CPAR) and the experience gained in the use o f the PHRD grant for this project have been taken into account while completing this assessment. The overall procurement risk is ratedhighsince IB and the municipalities are not familiar with Bank's procurement procedures. However, this rating canberevised inthe future as IBandthe municipalitiesbecome more familiar with Bank's procurement processes. It should be noted that IB has significant procurement capacity and it is expected that it would be able to quickly and satisfactorily follow Bankprocedures. ProjectManagement IBwill be the Borrower for the project and on-lend to municipalities. IBhas created a Project Management Unit (PMU) in April 2005. The PMU is authorized to carry out project preparation and supervise the implementation o f the municipalities on behalf o f IB. The PMU is staffed by a Director and four staff with technical and banking qualifications. The Director o f the PMU and the staff are employed by IB. Inaddition, a procurement consultant i s providing support to the PMU. IBhas significant procurement capacity and i s knowledgeable on Turkish procurement procedures since it carried out this function for municipalities over a number o f years. The PMUwill draw upon other staff in IB for procurement assistance, ifneeded. IB has an extensive regional coverage through its 18 Regional Directorates. These regional offices will also play an important role insupervising the project which will have three components: e Component 1:MunicipalDevelopment; 0 Component 2: MunicipalTechnical Assistance; and e Component 3:Iller Bank Institutional Strengthening. For components 1 and 2, procurement will be implemented and contracts will be signed by the municipalities. Contracts will be signed by IB for component 3. The role o f the PMUonprocurement matters will be to: 46  assist the municipalities inpreparingbiddingdocuments and Terms of References for consulting assignment; supervise municipalities to ensure that procurement arrangements, as agreed under the project, are being followed. The PMU will also ensure that IB i s following the agreed procurement procedures o fthe project; prepare a Procurement Plan for each Sub-loan in co-ordination with the project municipalities. The Procurement Plan for all Sub-loans and activities to be undertaken in IB will be aggregated by the PMU. This overall Procurement Plan will be updated on a regular basis; facilitate the implementation o f the project at the municipal level and provide technical assistance, as required; prepare Project Summary Report that will include the overall status in project implementation, updatedprocurement plans, andperformance o f municipalities to meet the progress benchmarks; make payments to the contractors and consultants employed by the municipalities against completedworks or delivered goods; and maintain procurement records for review and audit by Turkish authorities. This record keeping will also help with the procurement supervision o f the Bank, including the post review o fprocurement procedures. IBfollows Public Procurement Law No.4734 andPublic ProcurementDocuments lawNo 4735. The new Public Procurement Law became effective in January 1, 2003 and incorporates comments provided by the Bank and the EU. This law aims to provide a more competitive and transparent environment on procurement matters. The Bank is also providing assistance - through a grant - where Turkish officials are receiving technical assistance to implement the new law. The Bank has reviewed the Turkish procurement processes indetail andwherever possible local procedures will be used. Recommendations IB has been supporting municipalities on procurement matters over a number o f years. The institution is familiar with Turkish procurement procedures and the procurement capacity within the institution i s high. The bank also has its own legal department that can provide advice on procurement matters and can draw on consulting help ifnecessary. However, IB's experience with World Bank procurement procedures i s limited and to this end, the following recommendationswill beimplementedduringproject preparation: a the PMUwill seek the assistance o fprocurement and legal experts within IB, on a as neededbasis. Ifrequired, the PMUwill hire consultants; 47  e record keeping and filing will be conducted with due diligence and be systematic to facilitate rapid document retrieval; and e the PMU and project municipalities' procurement staff will receive training on Bank procurement procedures. The training o f the procurement staff inthe PMU shouldbe continued throughout the duration o fthe project. PROCUREMENT ARRANGEMENTS A. General Procurement for the proposed project would be carried out in accordance with the World Bank's `Guidelines: Procurement Under IBRD Loans and IDA Credits' dated May 2004, `Guidelines: Selection and Employment o f Consultants by World Bank Borrowers' dated May 2004, and the provisions stipulated in the Loan Agreement. During project implementation, IB will develop the specific investmentplan in each municipality. The processes to be followed to develop a Procurement Plan based on the investments are outlined below. Procurement of Works: Eligible investments under this category would be for water, wastewater, and solid waste sectors. For International Competitive Bidding (ICB), the Bank's Standard Bidding Documents (SBD) will be followed. N C B procedures will be followed for works contracts to cost less than Euros () 4,000,000. Any ambiguity regarding documentation on NCBs will be overcome by using the Bank's sample N C B documents for ECA Region for Works and Goods. IBwill also be given the option to use local N C B documents and procedures stipulated in the Public Procurement Law (Law No: 4734 & 4735) with certain modifications (Attachment 1to this annex). Based on the implementation o f the contracts, the Bank may increase the N C B thresholds to 5,000,000 one year after the effectiveness of the project. Procurement of Goods: Goods procured under this project would include equipment and materials needed for the eligible investments for the water, wastewater, and solid waste sectors. For ICB, Bank's SBD will be followed. N C B procedures will be followed for goods manufactured in the country, readily available inthe local market, and costing less than 400,000. Any ambiguityregarding documentation on NCBs will be overcome by usingthe Bank's sample NCB documents for ECA Region for Works and Goods. IB will also be given the option to use local NCB documents and procedures stipulated in the Public Procurement Law (Law No: 4734 & 4735) with certain modifications (Attachment 1to this annex). Shopping procedures will be followed for goods and small works that cost less than 80,000. Selection of Consultants: Consultants maybe hiredby IB or the municipalities for: (a) preparation o f bidding documents including the detailed design drawings, technical specifications and bills o f quantities and for the construction supervision o f the eligible municipal infrastructure works; (b) feasibility studies; (c) urban planning; (d) 48  improvements in the municipality or municipal utility. These improvements relate to institutional, technical and financial matters including the water leak detection and reduction techniques andother efficiency improvement programs; (e) technical assistance to IB to implement the Iller Bank Strategy, the Action Plan, and the project - training; seminars; consultants on technical, financial, procurement matters; and audits. The consultant procedures to be followed are: Quality and Cost Based Selection (QCBS), Consultant Qualifications (CQ), Least Cost Selection (LCS), and Individual Consultants (IC). Short lists o f consultants for services estimated to cost less than 200,000 equivalent per contract, may be composed entirely o f national consultants in accordance with the provisions ofparagraph 2.7 o fthe Consultant Guidelines. Prior Review Thresholds: The following prior review thresholds will apply for the project: (a) all ICB for goods and works; (b) first two N C B works and Goods and Shopping (Minor Works, International Shopping and National Shopping) contracts; (c) all consultant contracts with firms that are valued at 200,000 or more; (d) all individual consultant contracts valued at 50,000 or more; and (e) all single source contracts for services and direct contracts for goods. Post review ratio: Contracts not subject to Bank's prior review will be post reviewedby Bank's supervision missions and procurement specialists. At a minimum, 1 out of 5 contracts will be chosen for post review. The frequency o f procurement supervision will be every six months. B. Procurement Plan As the investment plan under each Sub-project i s not yet defined, a Procurement Plan, which outlines the procurement methods, has not been prepared. However, by October 1, 2005 IB will submit a Procurement Plan to the Bank since the investments under the project will be definedby then. The Procurement Plan will include the procurement to be conducted by the municipalities and IB. The Procurement Plan, satisfactory to the Bank, will be available at the P M U and at the Bank's external database and website. IB will revise the Procurement Plan on a semi-annually basis to reflect the updated implementation status o fthe project. 49  Attachment 1 LocalN C B documents andprocedures can be usedwith the following modifications: Eligibility: Bidding should not be restricted to domestic bidders. N o restriction shall be applied to foreign bidders who wish to submit a bid. Procedures: The Open Procedure, as defined in the Public Procurement Law, shall be followed in all cases. Invitations to bid shall be advertised inthe Official Gazette and in at least one widely circulated national daily newspaper or at the web site o f the public procurement agency allowing a minimumo f 30 days for the preparation and submission o fbids. Assessment of the bidder's qualifications: In the procurement o f goods and works, where pre-qualification i s not used, the qualifications o f the bidder, recommended for award o f contract, shall be assessedby post-qualification using the following: minimum experience; and technical and financial requirements. These criteria will be explicitly stated in the biddingdocuments and a `pass/fail' method (not a merit point system) will be used. Participation by government-owned enterprises: Government-owned enterprises inthe Republic o f Turkey are eligible to participate inbidding only if they can establish that they are legally and financially autonomous, operate under commercial law, and are not a dependent agency of the government.Further, they will be subject to the same bid and performance security requirements as other bidders. Participation by joint ventures: Participation shall be allowed from joint ventures on the condition that suchjoint venture partners arejointly and severally liable under a Contract. Biddingdocuments: Procuring entities shall use the appropriate standardbidding documents for the procurement o f goods, works or services, and shall contain draft contract conditions, acceptable to the Bank. Bid evaluation: Evaluation of bids shall be made in strict adherence to the monetarily quantifiable criteria declared in the bidding documents. A merit point system will not be used. Extension o f bid validity will be allowed once only for not more than 30 days. The Bank has to provide prior approval o f extensions beyond the first one. Contracts shall be awarded to the qualified bidder that submits the lowest evaluated and responsive bid. N o domestic preference will apply under N C B procedures. Price adjustment: Civil works contracts o f long duration (e.g. more than eighteen (18) months) will contain an appropriate price adjustment clause. 50  e Rejection of all bids: All bidswill not be rejected andnew bids solicited without prior approval ofthe Bank. e Contracts: All contracts will be in writing and they should be signed and stamped by authorized signatories of the Purchaser and the Supplier and contain identical terms and conditions o f contract to those included in the tender documents. e Securities: Bid Securities should not exceed 3% (three percent) of the estimated cost o f the contract. Performance Securities should not exceed more than 10% (ten percent) o f the value o f the contract. No advance payments will be made to Contractors without a suitable Advance Payment security. The wording o f all securities will be included in the bidding documents and has to be approved by the Bank. 51  Annex 9: Economic and FinancialAnalysis TURKEY: MunicipalServices Project The economic and financial appraisal o f Sub-projects will be carried out as part to the feasibility analysis. They have to be satisfactory for the Bank to provide the no objection to the financing o f investments. The discussions below provide the following: a) background information on Iller Bank (IB);b) government actions regarding IB; and c) financial projections o f IB. 1. BACKGROUND InJune 1933, IBwas established as the Municipalities' Bank pursuant to the Law No. 2301 with the purpose o f providing financial resources to the municipalities. In June 1945, pursuant to the Law No. 4759, the Bank changed its name to Iller Bank with expanded tasks and organization as a development and investment bank for the local authorities. Its capital has been increased periodically, and through a law dated May 18, 2004 the bank received an authorization to increase its capital to 3 quadrillion TL. Although IB i s classified as a bank and is regulated by BRSA, it functions as a central government agent providing assistance to municipalities. It i s not a deposit taking bank but functions as apublic sector institutionwith amandate to develop localinfrastructure. Institutional Structure The institutional structure o f IB is as follows: 0 General Assemblv: IB's shareholders are classified into three groups: provincial administration, municipalities, and village administration. These three groups are represented in the General Assembly. In addition, there is representation from Treasury, and the ministries o f Finance, Interior, Public Works and Settlement, Education, Agriculture, Forest and RuralAffairs, Health, and Industry and Trade. The General Assembly meets inApril each year. 0 Board o f Directors: The highest executive unit in IB is the Board o f Directors that comprises five people: a chairman and four members. The General Manager o f IB i s also the chairman o f the Board. Three members are nominated by the Ministry o f Public Works and Settlement while the fourth i s nominated by the Ministryo fFinance. 0 Management: The highest level o f management i s the General Manager and four Deputy General Managers who are based inAnkara, which is the headquarters o f IB. This management team is supported by other managers in Ankara and eighteen regional offices. The Council o f Ministers nominates the General Manager and the President o f the Republic approves the nomination. There are 52  laws that provide guidelines on the required qualification for the management and the current management team meets the requirement o f the law. At the end o f 2003, IB had a total of 3,552 personnel who are based in Ankara and the eighteen regional offices. The decentralization o f staff is high and about 56% o f the personnel are based in the regional offices. Compared to 2002, there has been a slight decline in staff. The administrative staff includes the ones that carry out non-technical activities and includes accounting professionals. The technical staff are primarily the engineering experts that have supported municipalities in the past on surveys, feasibility studies, detailed design, andprocurement. Staff Classification As of Dec. 31,2003 As of Dec. 31,2002 Administrative 1,513 1,685 Technical 1,251 1,319 support 788 811 TOTAL 3,552 3,815 Operations As per the 1945 Law No. 4759, IB has two core functions: a) support infrastructure development at the local level through technical assistance, grants, and loans; and b) transfer central tax revenues to the local authorities. InfrastructureDevelopment The bank carries out the following hnctions: 0 provide investment loans to local administration for public improvements in cities, towns, andvillages; 0 provideshort term loans to local administration; 0 prepare maps and surveys and conduct studies - such as urban planning - to support development at the local level; 0 supervise construction, on behalf o fmunicipalities; 0 sell or lease local assets, on behalf o f local administration; 0 arrange insurance for local assets, on behalfo f local administration; and 0 provide equipment that i s necessary for construction at the local level. While IB has multiple functions, its core business has been in the provision o f loans for the water and wastewater sector (shown below inthe table). To help the country meet 53  EUenvironmental directives, the institution intends to strengthen this core business and also assist municipalities with their solid waste management needs. IB also channels central government grants to municipalities and about 10% o f the investments supported byIBhavebeengrant funded. No. of activities Other civil works Geotechnical studies Tax Transfers In addition to infrastructure development function, IB also has a core function to act as the agent for the central government to transfer taxes to the local authorities on a monthly basis. About 6% o fnational taxes collected inthe country are directed to local authorities based on population. IB has the infrastructure to carry out this activity for the 3,225 municipalities on a monthly basis. In 2003, the total transfers amounted to TRL 2.9 quadrillion. Investmentsand Financing In2004, IB investedaround 458 trillion TL (around US$ 300 million) inthe municipal sector. The proposed investment and financing o f IB are shown as Attachment 1 of this Annex. Traditionally, IB has been able raise its capital from the equity contribution from municipalities. As per the Iller Bank Law, 5% o f actual municipal net income o f the previous year i s transferred bythe municipalities to IB as an equity contribution to the IB. The institution does not take deposits and has not raised funds from the market and as a result, there are no financial liabilities. The capital infusion through equity contribution from municipalities will continue due to the requirements o f the Iller Bank Law and IB plans to use this capital and the Bank loan to support municipal infrastructure development in the medium term. In lieu of debt service on loans made by IB to municipalities, IB is authorized to deduct 100%o f the tax transfers to the municipalities. However, the method o f loan recovery through interception o f tax transfers as a last resort enforcement measure has not been uniformly applied. Sometimes, there is political pressure on IB to intercept lower than the maximum amount to not hamper the tax revenue flows to financially-constrained municipalities. 54  2. GOVERNMENT ACTIONS IBwas created in 1933 andthe conditions thenwere different from the challenges faced today by the municipalities. Recognizing that IB can play an important role in developing municipal infrastructure, the government intends to strengthen the technical and financial function o f the institution. To this end, the government has started two key activities: 0 Preparingthe Iller Bank Strategy, under the leadership o f SPO. This strategy is expected to be completed by October 2005; and 0 Amending Iller Bank Law taking into account the key recommendations o f the Iller Bank Strategy. The amendments to the Iller Bank Law are expected to be sent to the Parliament after the strategy i s finalized. Iller Bank Strategy On July 7, 2003 a governmental decision was taken to prepare the Iller Bank Strategy under the leadership o f the State Planning Organization (SPO). A draft strategy was prepared in November 2004 which recognizes that IB has been providing key local government services since 1933 and that the bank has an important role to play in the future, especially taking into account the rapid urbanization in Turkey. The strategy defines the mission o f IB as `contribute to sustainable urbanization through the development o f projects at international standards, providing loans, consultancy, and technical assistance to meet the needs o f the local administration.' To meet this mission, IB has defined the following seven specific actions, along with benchmarks: (a) provide service to municipalities in a timely manner; (b) strengthen the banking function o f IB; (c) complete projects to meet the needs o f municipalities; (d) ensure that proper technology i s used; (e) improve the quality o f staff in IB; (f) support development o f projects in other countries; and (g) ensure efficient use o f public resources so that loans are repaid in a timely manner, the capital o f the bank i s utilized more economically, and the financial management o f the bank improves. The strategynotes that special assistance will be requiredfor the medium and small sized municipalities. Out of the 3,225 municipalities inthe country, 2,838 municipalities have a population less than 20,000 andthere are 182 municipalities with a population between 20,000 and 50,000. The strategy outlines some o f the recent steps taken within IB: 0 As o f January 1, 2004 IB is no longer involved inprocurement o f works, goods and services on behalf o f municipalities. This decision was taken through `Regulation on Amendment to the application regulation o f Iller Bank Law' (Official Gazette No. 25245); 0 On March 18, 2004 a decision was taken by Ministry o f Public Works and Settlement to adopt the `Regulation on Construction Supervision Services o f Iller 55  Bank'(Offcia1 Gazette No. 25406) on the role o f IB in supervision of contracts. Through this decision Iller Bank will be able to provide technical assistance to municipalities, ifrequested; and a In December 2003, the Department of Project Development and Appraisal was created and guidelines for project appraisal were established. The strategy also notes the following priorities o fIBinthe coming years: a Protect seas, lakes, rivers, and fresh water sources. IBwill receive funds for the protection o fwater sources, giventhe national importance o f such activities; 0 Be more responsive to the needs o fmunicipalities. The transfer o fprocurement to the municipalities i s an important step inthis regard; a Provide supervision o f contracts as support to municipalities, ifrequested; 0 B e an implementing agency for the upcoming EUprograms, as Turkey gets ready to upgrade its water and wastewater systems in line with the EU environmental directive; a E-transformation o f IB through which the decisions will be well documented and available to relevant parties, including the regional offices. The E-transformation process was launched inthe bank on April 29,2004 and the process i s expected to be completed by end December2005; and 0 Create a database on the service needs o f all municipalities so that future investment programs can be developed. The data collection process has been completed and the information now needs to be stored in a database that will be regularly updated. Iller Bank Law Draft amendments to the law have been prepared and circulated among related ministries for comments. It i s expected that the key recommendations o f the strategy will also be incorporated in the amendments which will be sent to the Parliament after the Iller Bank Strategy i s finalized. A major feature o f the proposed amendment (November 2004 version) is the institutional restructuring o f IB through the separation o f the following functions: service, consulting, supervisory, and ancillary units. 0 Service units - departments o f Loan, Banking Services and Fund Management, Urbanization, Project Development, Project Assessment, Infrastructure Implementation, Superstructure Implementation, and Accountancy. These service unitswill helpto bringmore focus onbanking andtechnical functions; 56  0 Consulting units - departments o f Legal Consultancy, and Press and Public Relations Consultancy. The consultancy is expected to be fee based and as a result they have to be competitive with the private sector; 0 Supervisory units - Internal Audit unit and Risk Management unit to be in compliance with BRSA regulations; and 0 Ancillary units - departments o fHuman Resources and Back-up Services. 3. FINANCIAL PROJECTIONS The financial projections o f Iller Bank are shown below which indicate that the institution will be able to maintain profitable operations and satisfactorily carry out the project. The projections take into account the proposed changes in IB, indicated in the draft Iller Bank Strategy and amendments to the Iller Bank Law. These projections were reviewed by Treasury as part o f its due diligence process to provide the sovereign guarantee under this project. Assumptions 0 The results from the third quarter 2004 financial data (as of September 2004) were extrapolated to estimate the projections; 0 The projections are in nominal terms, based on inflation and exchange rate expectations indicated below. These assumptions were provided by Treasury to B; 2005 2006 2007 2008 Onward Inflation 8% 5YO 4% 4% YTLNS$ 1.611 1.681 1.716 Annual YTL devaluation of 4% US$/Euro 1.345 1.345 1.345 1.345 0 As of January 1,2005, Turkey has re-denominatedits currency. The new currency unit is Yeni Turk Lira (YTL). TL 1,000,000 is equal to YTL 1. The financial statements and tables have been adjusted accordingly; 0 From 2006, IB will apply the following real interest rates for its local currency loans: 4% for 3 year maturity (equipment loans); 3% for 5 year maturity (construction loans for investments that are inthe program o f SPO or IB); and 5% for short-tenn loans (working capital loans); 57  0 Annual investments were forecasted according to the demand survey conducted by IBin2004; 0 Fees associated with the Bank loan will be passed on to the borrowing municipalities. The interest rate for municipalities will be the Bank's interest rate plus a 1%marginto becharged by IB;and 0 Table o f selected financial indicators are shownbelow. Income Statement In 2003, after taxes, IB registered a net profit o f 158,946 billion TL which represents a net margin o f 32%. As IBwill start to charge a positive real interest rate from 2006, the net margini s expected to rise to 37 -41% level; The decrease inrevenue in2003, compared to 2002, is primarily due to the loss o f other revenue, which originated from the procurement and final design services provided by IB that were discontinued from 2004. However, it is planned that IB will provide technical consulting services on a fee basis to municipalities, especially the smaller ones. A steady increase in technical services is assumed between 2004 and 2009 where the fees are expected to grow from 3% o f total revenue in2003 to 8% o f total revenue in2015; Interest revenues represented about 90% o f the total revenues in 2003. Lending will remain as the main revenue source and the percentage o f interest revenue to total revenuei s expected to be around 85% duringthe projection period; On the expenses side, the main cost i s the personnel. IB plans to check this cost by not increasing the total number o f staff after 2006. The total personnel cost is assumedto increase by 2% annually inreal terms, caused by the change inmix o f technical, financial and banking staff. The financial and banking staff are paid at a higher pay scale compared to other technical staff as stipulated in the Civil Servant Law; The cost o f inflation corrections, associated with introduction of inflation adjusted accounting, was about the same amount as other expenses in 2003. This high 58  level of corrections in2003 was due to the fact that IBdid not adjust the value o f its assets with inflation ina timelymanner; and a Debt Service Coverage Ratio (net income/debt service) will be maintained at high levels since IB has low debt service requirements compared to its net income. The primary sources o f finds for investments will be: collection on loans outstanding, net income, and the Bank loan (shown inthe FundsFlow Chart). The projectedresources inliquidassets will be adequate to service the Bank loan. Balance Sheet 0 In the past, political interference hindered IB in filly collecting its loan assets from the municipalities, which led overdue payments. Total overdue loans at the end o f 2004, including accrued interest and penalties, accounted for 28% o f IB's total equity. However, as o f January 1, 2005, all overdue loan assets have been restructured into three year loans with monthly repayments and they are being closely monitored. The current regulations prevent IB from provisioning overdue loans which results in over-reporting o f income and consequently a higher tax liability, compared to a situation of adequate loan provisioning; a Paid-in capital is expected to grow from TRL 749 trillion in 2003 to YTL 3 billion by mid-2010. This i s due to the M a y 2004 decision o f IB's Board to increase the capital o f IB through equity contributions by municipalities; a 18% of the total assets were held in short term money market accounts in 2003. These are typically the tax resources held by IB over a short period (around 10 days), prior to the transfer to the municipalities. In 2003, the total amount that was transferred to the local authorities was TL 2.9 quadrillion. The money market and securities accounts are expected to stay consistent over the project period; a IB will follow a conservative financial policy that maintains its repayment capacity. Current Ratio (current assetdcurrent liability) will be maintained above 1.5 throughout the projection period; 0 The short and long-term loans constitute about 65% o f the assets during 2003. Short-term loans were mainlyshort term advances which are not inthe investment program. In line with the increasing emphasis to support infrastructure investments in municipalities, the short-term loans are projected to gradually decrease. Correspondingly, the long-term loans will increase and the total loan assets are expected to be around 75% o f total assets duringthe project period; and a The main liability arises from the tax transfers to be made to municipalities, which constitute about 60% o f all liabilities in 2003 (miscellaneous short term liabilities). Currently, there are no credit liabilities. Even as the credit liability will increase due to the Bank loan, the Gearing Ratio (liabilitiedequity) will be decreasing from around 44% in2003 to 16% in2015 due to the projected increase 59  inequity. The lowering GearingRatio and Debt Service Coverage Ratio above 2 suggest that IBhas the capacity to take on more debt, ifrequired. 60     d \o 0 0 0 0 0 0  Annex 10: Safeguard Policy Issues TURKEY: MunicipalServices Project An Environmental Framework and a LandAcquisition Frameworkhavebeen developed. IBhas conducted a public consultation on these two frameworks and has made them available on the I B ' s internet site. These two frameworks have also been sent to the Bank's Infoshop and are included inthe OperationalManual o fthe project. 65  Annex 11: ProjectPreparationand Supervision TURKEY: MunicipalServicesProject Planned Actual PCNreview 712812003 712812003 InitialPID to PIC 12/11/2003 1211112003 InitialISDS to PIC 11/03/2004 11/03/2004 Appraisal 4/29/2005 4/15/2005 Negotiations 5/16/2005 511612005 BoardiRVP approval 612312005 Planneddate o f effectiveness 911512005 Planneddate o f mid-termreview 10/1/2007 Plannedclosing date 6/30/2010 Key institutions responsible for preparation of the project: Treasury, State Planning Organization, andIller Bank Bank staffand consultants who worked onthe project included: Name Title Unit Sudipto Sarkar Lead Specialist ECSIE Kyoichi Shimazaki Lead Financial Officer IEF AlptekinOrhon Senior Financial Analyst ECSIE Shinya Nishimura Consultant (Financial) ECSIE Takao Ikegami Senior Sanitary Engineer ECSIE Ibrahim Sirer Senior Procurement Specialist ECSPS Ayse Seda Aroymak Senior Financial Management Specialist ECSPS Dilek Barlas Senior Counsel LEGEC Andrina Ambrose Senior Finance Officer LOAGl Stan Peabody Lead Social Scientist ECSSD RuxandraFloroiu Consultant (Environmental) ECSSD Hulya Bayramoglu Procurement Assistant ECCU6 UlkerKaramullaoglu Program Assistant ECCU6 ElifYukseker Team Assistant ECCU6 PoonamRohatgi Program Assistant ECSIE Bank funds expended to date on project preparation: 1. Bank resources: US$434,685 2. Trust funds: US$32,790 3. Total: US$467,475 Estimated Approval and Supervision costs: 1. Remainingcosts to approval: $ 5,000 2. Estimatedannual supervision cost: $ 120,000 66  Annex 12: Documents inthe Project File TURKEY: Municipal Services Project 1. PHRD GrantAgreement, signedMay 4,2004; 2. Bank's Financial Management Assessment of Iller Bank, October 2004; 3. Bank's Procurement Capacity Assessment of Iller Bank, October 2004; 4. Mission Documents -Aide Memoires, letters, Back To Office Reports; 5. Relevant E-mails exchanged between the Bank and Iller Bank during project preparation. 67  Annex 13: Statementof LoansandCredits TURKEY: MunicipalServicesProject Difference between expected and actual Original Amount inUS$Millions disbursements ProjectID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev'd PO94176 2005 ECSEEAPL #2 (TURKEY) (CRL) 66.00 0.00 0.00 0.00 0.00 65.29 0.00 0.00 PO93568 2005 EFIL 3 (CRL) 305.00 0.00 0.00 0.00 0.00 302.60 0.00 0.00 PO66149 2005 SEC EDUC 104.00 0.00 0.00 0.00 0.00 107.30 0.00 0.00 PO70950 2004 ANATOLIA WATERSHED REHAB 20.00 0.00 0.00 0.00 0.10 19.55 -0.05 0.00 PO72480 2004 RENEW ENERGY 202.03 0.00 0.00 0.00 1.01 197.03 0.01 0.00 PO74053 2004 HEALTHTRANSIT (APL#1) 60.61 0.00 0.00 0.00 0.30 60.53 3.89 0.00 PO75094 2004 WATERSHED REHAB (GEF) 0.00 0.00 0.00 7.00 0.00 6.75 0.15 0.00 PO82801 2004 EFIL 2 303.10 0.00 0.00 0.00 0.00 92.61 -147.49 0.00 PO82996 2004 PFPSAL 3 1,000.00 0.00 0.00 0.00 0.00 500.00 -333.33 0.00 PO59872 2003 BASIC ED2 (APL #2) 300.00 0.00 0.00 0.00 0.00 291.46 271.03 52.79 PO74408 2002 SRMP 500.00 0.00 0.00 0.00 0.00 242.25 206.89 -21.62 PO70286 2002 ARIP 600.00 0.00 0.00 0.00 0.00 273.71 267.04 50.48 PO69894 2001 PRIV SOC SUPPRT 250.00 0.00 0.00 0.00 0.00 7.21 7.21 -40.79 PO68368 2000 MARMARA EARTHQUAKE EMG 505.00 0.00 0.00 0.00 0.00 284.36 284.36 26.81 RECON PO44175 2000 BIODIVDJTRLRES MGMT (GEF) 0.00 0.00 0.00 8.19 0.00 4.12 3.39 -0.02 PO09073 1999 INDUSTRIALTECH 155.00 0.00 0.00 0.00 0.00 18.59 18.59 0.00 PO48852 1998 NAT'L TRNSM GRID 270.00 0.00 0.00 0.00 27.79 123.29 151.08 55.42 Total: 4,640.74 0.00 0.00 15.19 29.20 2,596.65 732.77 123.07 68  TURKEY STATEMENTOF IFC's HeldandDisbursedPortfolio InMillions ofUSDollars Committed Disbursed IFC IFC FYApproval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic. 2005 Acibadem 20.00 0.00 0.00 0.00 10.00 0.00 0.00 0.00 AlternatifBank 0.50 0.00 0.00 0.00 0.50 0.00 0.00 0.00 1996/01/03/05 Arcelik 103.36 0.00 0.00 103.36 103.36 0.00 0.00 103.36 2000 Arcelik LGKlima 8.29 0.00 0.00 0.00 8.29 0.00 0.00 0.00 2002 Assan 22.50 0.00 0.00 0.00 22.50 0.00 0.00 0.00 2002 Atilim 6.50 0.00 0.00 0.00 6.50 0.00 0.00 0.00 2000 Banvit 8.33 5.00 0.00 0.00 8.33 5.00 0.00 0.00 BayindirbankAS 1.50 0.00 0.00 0.00 1.50 0.00 0.00 0.00 2002 Beko 32.75 0.00 0.00 28.07 32.75 0.00 0.00 28.07 2001 Bilgi 8.00 0.00 0.00 0.00 8.00 0.00 0.00 0.00 1994196197 Borcelik 8.18 3.21 0.00 0.00 8.18 3.21 0.00 0.00 2004 BorusanHolding 30.00 0.00 10.00 0.00 30.00 0.00 10.00 0.00 1994 CBS Holding 3.50 0.00 0.00 0.00 3.50 0.00 0.00 0.00 1990102 Conrad 3.15 0.00 0.00 0.00 3.15 0.00 0.00 0.00 2002 EKS 10.96 0.00 0.00 0.00 10.96 0.00 0.00 0.00 2004 Ege 10.00 0.00 0.00 8.00 10.00 0.00 0.00 8.00 1995 Entek 19.00 0.00 0.00 9.94 19.00 0.00 0.00 9.94 1999 Finansbank 2.22 0.00 0.00 0.00 2.22 0.00 0.00 0.00 2004 GarantiLeasing 10.00 0.00 0.00 0.00 10.00 0.00 0.00 0.00 1999 GumussuyuKap 4.00 0.00 3.66 0.00 4.00 0.00 3.66 0.00 2001 Gunkol 4.53 0.00 0.31 0.00 4.53 0.00 0.3 1 0.00 1998 IndoramaIplik 4.38 0.00 0.00 0.00 4.38 0.00 0.00 0.00 2005 Intercity 15.00 5.00 0.00 27.75 4.44 5.00 0.00 8.21 1998100102 IpekPaper 10.85 0.00 0.00 0.00 10.85 0.00 0.00 0.00 1990 Kepez Elektrik 2.43 0.00 0.00 0.00 2.43 0.00 0.00 0.00 1988190 Kiris 11.33 0.00 0.00 0.00 11.33 0.00 0.00 0.00 2004 Koclease 30.00 0.00 0.00 0.00 30.00 0.00 0.00 0.00 1991 Kula 5.20 0.00 0.00 0.00 5.20 0.00 0.00 0.00 2003 MESA Group 11.00 0.00 0.00 0.00 11.00 0.00 0.00 0.00 2004 MeteksanSistem 0.00 0.00 8.50 0.00 0.00 0.00 8.50 0.00 2002 Milli Re 50.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1998102 Modem Karton 8.33 0.00 0.00 0.00 8.33 0.00 0.00 0.00 1991 NASCO 10.18 0.00 0.00 3.55 10.18 0.00 0.00 3.55 2004 OPET 25.00 0.00 0.00 40.00 8.33 0.00 0.00 25.00 2004 Oyak Bank 50.00 0.00 0.00 0.00 50.00 0.00 0.00 0.00 2002 Pasabahce 3.75 0.00 0.00 0.00 3.75 0.00 0.00 0.00 1998 PinarET 3.14 0.00 0.00 0.00 3.14 0.00 0.00 0.00 2000 Pinar SUT 11.45 0.00 0.00 0.00 7.77 0.00 0.00 0.00 1999 SAKoSa 9.91 0.00 6.61 6.64 9.91 0.00 6.61 6.64 1990 Silkar Turizm 1.89 0.00 0.00 2.15 1.89 0.00 0.00 2.15 69  2002103 Sise ve Cam 43.93 0.00 18.18 36.56 43.93 0.00 18.18 36.56 2002 Soktas 2.00 0.00 0.00 0.00 2.00 0.00 0.00 0.00 2005 TSKB 0.00 0.00 50.00 0.00 0.00 0.00 50.00 0.00 1982/83/89/91/96199 Trakya Cam 0.00 0.36 0.00 0.00 0.00 0.36 0.00 0.00 2002 Turk Ekon Bank 11.11 0.00 15.00 0.00 11.11 0.00 15.00 0.00 2001 Turkish PEF 0.00 9.59 0.00 0.00 0.00 2.17 0.00 0.00 1999 Unye Cement 8.22 0.00 0.00 0.00 8.22 0.00 0.00 0.00 1999 Uzel 8.40 0.00 0.00 4.95 8.40 0.00 0.00 4.95 1998 Viking 7.62 0.00 0.00 0.00 7.62 0.00 0.00 0.00 Total portfolio: 662.39 23.16 112.26 270.97 571.48 15.74 112.26 236.43 Approvals PendingCommitment FY Approval Company Loan Equity Quasi Partic. 2001 Akbank 0.03 0.00 0.00 0.00 2004 Akbank BLoan Inc 0.00 0.00 0.00 0.02 2005 Avea 0.12 0.00 0.00 0.30 2005 Bandirma Dogalga 0.00 0.00 0.00 0.00 2005 Gemlik Dogalgaz 0.00 0.00 0.00 0.00 2002 MilliReasurans 0.00 0.01 0.00 0.00 2005 PALEN 0.00 0.00 0.00 0.00 2005 Palgaz 0.01 0.00 0.00 0.00 2005 Sivas Dogalgaz 0.00 0.00 0.00 0.00 2002 TEB 111 0.00 0.00 0.00 0.05 2005 YUCE 0.00 0.00 0.00 0.00 Total pending commitment: 0.16 0.01 0.00 0.37 70  Annex 14: Country at a Glance TURKEY: MunicipalServices Project Europe & Lower- POVERTYand SOCIAL Central middle- Turkey Asia income Developmentdiamond' 2003 Population, mid-year(millions) 70.7 473 2,655 Life expectancy GNI percapita (Arias method, US$) 2,800 2,570 1,460 GNI (Atlas method, US$billions) 197.8 1,217 3,934 -I Average annual growth, 1997-03 Population(%) 1.7 0.0 0.9 Laborforce (%) 2.3 0.2 1.2 Most recent estimate (latestyear available, 199743) Poverty(% ofpopulationbelownationalpovefiy line) Urban population (% of totalpopulation) 66 63 50 Life expectancyat birth (years) 70 69 69 1 Infant mortality(per 1,000live births) 35 31 32 Childmalnutrition(% of childrenunder5) 8 11 1 Access to improvedwater source Access to an improvedwater source (% ofpopulation) 62 91 81 Illiteracy(% ofpopulation age 15+) 14 3 10 - Gross primaryenrollment (% ofschool-agepopulation) 94 103 112 Turkey Male 98 104 113 1 Lower-middle-incomegroup ~ Female 91 102 111 KEY ECONOMICRATIOSand LONG-TERMTRENDS 1983 1993 2002 2003 Economlcratis' GDP (US$ billions) 61.5 179.4 183.9 240.4 Gross domestic investmenffGDP 16.3 27.6 21.3 22.8 Exports of goods and ServicesIGDP 12.5 13.7 29.2 27.4 Trade Gross domestic savings1GDP 12.2 21.9 19.8 19.5 I - Gross nationalsavings1GDP 15.3 24.8 20.8 19.5 Currentaccountbaiance1GDP -3.1 -3.6 -0.8 -2.8 Interest payments1GDP 2.9 2.2 3.8 3.2 Total debtlGDP 33.0 38.2 71.3 61.2 Total debt servicelexports 39.2 31.6 50.7 40.3 Presentvalue of debffGDP 73.1 Presentvalue of debffexports 234.2 Indebtedness 1983-93 1993-03 2002 2003 2003-07 (averageannualgrowth) GDP 5.0 2.7 7.9 5.8 5.6 1 -Turkey GDP per capita 2.8 0.9 6.2 4.2 4.1 Lower-middle-incomegroup ~ Exportsof goods and services 5.9 11.4 11.1 16.0 5.4 STRUCTUREof the ECONOMY (% of GDP) Agriculture 21 4 162 130 134 ' O Industry 250 298 237 21 9 Manufacturing 168 183 140 133 0 Services 536 540 633 647 1 Privateconsumption 78.4 65.0 66.2 66.9 General government consumption 9.4 13.0 14.0 13.6 -50- Importsof goodsand services 16.6 19.3 30.7 30.7 ' ---GDI -O-GDP I I 1983-93 1993.03 2o02 II (average annualgrowth) Growthof exports and imports (%) Agriculture 1 5 1 0 industry 6 7 2 2 5 6 5 0 ~ 2 0 Manufacturing 6 9 3 0 8 2 8 4 Services 4 3 3 0 7 3 6 4 l o Privateconsumption 4 7 1 9 2 2 6 7 2o General governmentconsumption 4 0 3 9 5 4 -24 .40! Gross domestic investment 7 7 1 0 359 204 -Exports -O-lmports Importsof goods and services 114 7 8 158 27 1 Note: 2003 data are preliminaryestimates. * The diamondsshow four key indicatorsin the country (in bold)comparedwith its income-groupaverage. If data are missing,the diamondwill be incomplete. 71  Turkev PRICES and GOVERNMENT FINANCE i 1983 I993 2002 2003 Domesticprices (% change) Consumer prices 31.4 66.4 44.8 25.2 ImplicitGDP deflator 26.3 67.8 44.1 22.5 Government finance (% of GDP, includes cunent grants) Current revenue .. 19.0 31.2 30.4 Current budget balance -3.1 -5.1 -5.3 Overallsurplus/deficit .... -12.0 -11.9 -10.1 -GDP deflator *CPI 1 TRADE 1983 1993 2002 2003 i (US$ millions) Export and import levels (US$ mill.) Total exports (fob) 5,905 15,345 40,124 51,206 Agriculturaland livestock 1,032 1,044 2.089 2,545 Mining and quarryproducts 188 233 307 543 Manufactures 4,685 14,068 33,565 43,912 Total imports(ci9 9,235 29.428 51,554 69,340 Food 123 969 1,245 2,006 Fueland energy 3.851 3,903 9,192 11,568 Capitalgoods 2,311 7,499 9,103 11,792 Export price index (1995=100) 89 92 75 82 97 98 99 00 01 02 03 lmpolt price index (1995=100) 100 85 73 83 BExports .Imports Terms of trade (1995=100) 89 109 102 99 BALANCEof PAYMENTS 1 1983 1993 2002 2003 (US$ millions) Current account balance to GDP (%) 1 Exports of goods and services 7,865 26,264 54,907 70,231 14t importsof goods and services 10,118 33,721 55,365 73,760 Resourcebalance -2,253 -7,457 -458 -3,529 Net income -1,430 -2.744 -4,554 -5,427 Net current transfers 1,760 3.768 3,490 2,106 Current account balance -1,923 -6,433 -1,522 -6,850 - Financingitems (net) 2,075 6,741 7,675 10,897 -4 Changes in net reserves -152 -308 -6,153 -4,047 -6- Memo: Reservesincludinggoid (US$ milliOrIS) 2,253 17,762 38,051 44,957 Conversionrate (DEC, local/US$I 226.0 11.046.7 1,509,471 1,496,668 EXTERNALDEBT and RESOURCE FLOWS 1983 1993 2002 2003 (US$ millions) Composition of 2003 debt (US$ mlll.) Total debt outstandingand disbursed 20,324 68.605 131,058 147,035 IBRD 2,336 5,285 5,367 5,214 A 5,214 IDA 184 142 89 83 G 23,013 B 83 Total debt service 3,138 8.664 29,092 29,172 24,092 IBRD 274 1,183 708 726 IDA 4 7 7 7 D 1.199 , E 6,810 Compositionof net resourceflows Omcialgrants 98 403 Officialcreditors 327 -740 224 -1,217 Privatecreditors 139 6,104 6,901 -511 1 Foreigndirect investment 46 622 863 1,063 Portfolioequity 0 189 -1,183 2,250 F 86,624 World Bank program Commitments 675 207 1,650 0 A IBRD E Bilateral Disbursements 486 354 1,031 276 B IDA D Other multilateral - F Pnvate Principalrepayments 115 753 443 502 C IMF --- G Short-term --- Net flows 371 -399 588 -226 interestpayments 163 437 272 233 Nettransfers 208 -836 316 -459 9/20/04 72