Turkey - Erdemir Steel Plant Expansion Project

CIRCULATING CoPY RESTRICTED TO BE RETURNED TO REPORTS DESK Report No. P-1038 FILE C'Mmtaf This report is for official use only by the Bank Group and spccifically authorized organizations or persons. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TURKEY FOR THE ERDEMIR STEEL PLANT EXPANSION PROJECT March 1, 1972  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOtENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TURKEY FOR THE ERDEMIR STEEL PLANT EXPANSION PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Turkey for the equivalent of US $76 million to help finance the expansion of the Erdemir Iron and Steel Company (Erdemir) from an annual capacity of 0.9 million ingot tons to 1.3 million ingot tons. The loan would have a term of 15-1/2 years, including 5 years of grace and would be relent by the Government to Erdemir on substantially the same terms plus a guarantee fee of 1.5 percent payable to the Government. The loan would be made jointly with a $40 million loan from the U.S. Agency for Inter- national Development (USAID) and a $70 million loan from the Export-Import Bank of the United States (Eximbank), both made also to the Government for relending to Erdemir. PART I - INTRODUCTION 2. The level of Bank Group operations in Turkey in past years has been largely influenced by the almost chronic balance of payments difficulties and the heavy external debt-service burden, the limited IDA resources which could be made available to Turkey and to some extent difficulties in project preparation. Since 1968 the Bank and the Turkish authorities have discusaed the basis for a major increase in the level of lending. This was regarded as mainly dependent on improvements in Turkey's capacity to borrow a sub- stantial part of its needs on Bank terms which could primarily be achieved by an intensification of measures to improve foreign exchange earnings and particularly encourage exports by giving high priority to the allocation pf resources and incentives for export-oriented projects and introducing a num- ber of reforms in the system of trade and payments. Another important factor was a significant expansion in Turkey's capacity to select and prepare pro- jects in priority areas. By the end of 1970, marked progress was made in these fields culminating in the devaluation of the Turkish lira in August 1970 and the introduction of a stabilization program. The Government recog- nized the need for Turkey to reach external viability, within a reasonable time period, and gave high priority to the expansion of exports as the prin- cipal means to achieve this. Parallel with these developments, the Bank Group stepped up its level of assistance in project preparation with special attention being given to selection criteria, institution building and pro- vision for management and technical assistance. As a result, the volume of Bank/IDA lending reached $114 million in FY 1971, thus exceeding the level achieved in the five preceding years.  3. Bank Group lending to Turkey aims at assisting three major objec- tives: (a) improving the foreign exchange position particularly through ex- port promotion; (b) institution building in key sectors including improved financial viability of the major State Economic Enterprises; and (c) a simul- taneous effort to check rural migration through agricultural development and the decentralization of industry and to rationalize urban development. Several projects financed by the Bank Group in recent years or presently under dis- cussion focus on the first objective. For instance, emphasis was placed on export-oriented projects in the last loan (713-TU) made to the Industrial Development Bank of Turkey (TSKB) and in the Loan/Credit (762/257-TU) for the Fruit and Vegetable Export Project. Other projects for which lending is con- templated in coming years, especially for livestock, forestry and irrigation, are expected to enhance Turkey's ability to export but attempts to assist the expansion of tourism have not borne fruit so far for lack of a firm Government policy and of suitable projects. The second objective of insti- tution building has been pursued chiefly in the agriculture (including agri- cultural credit), power and transportation sectors. The Ba8lk has been in- strumental in bringing about a comprehensive reorganization of the power sector culminating in the establishment of the Turlcish power authority (TEK) to which a loan (763-TU) was made in 1971. It has also acted as executing agency for UNDP technical assistance studies on transport coordination and a program for railway rehabilitation, and a first railway project will be appraisec in 1972. Fina;.ly, the t-o-proinged approach to agricultural and industrial development of the poorest parts of Central and Eastern Turkey and to urban development has been started with the second livestock project recently nego- tiated and with an urban develcpment and water supply project for the Greater Istanbul area, which is the most rapidly growing urban center. 4. The industrial development that the Bank is seeking to encourage in Turkey aims primarily at improving the competitiveness of both the private and state enterprises which had for a long time been accustomed to a rapid but inward-oriented growth behind a barrier of high tariffs and quantitative restrictions. Given Turkey's natural resources and the emergence during the 1960's of a new class of industrial entrepreneurs, increasingly capable and outward looking, there appears now to be considerable scope for further growth both in export-oriented industries using domestic raw materials (mining, food processing, forest products, textiles and boron products) and in import re- placement (particularly fertilizers and heavy engineering). Past Bank in- dustrial lending has been channeled through TSKB whlich has received since 1950 eight loans totaling $126 million to assist private enterprises, cover- ing the whole spectrum of industrial activities, but mostly for relatively small projects. The private sector has so far been unable to mobilize capital re- sources on the scale required for large scale industrial operations which, as a result, have been left mostly to the Government. The establishment of Erdemir as a company which,despite a majority Government ownership,is operated as a private enterprise and eventually to be transferred to private ownership, represents an effort to resolve this problem,although a long-run solution has to be sought mainly through the development of the capital market. The pro- posed loan would finance steel production, and be the first direct lending operation to industry. Two other loans are currently contemplated for a  -3- fertilizer plant and a combined forestry and paper mill project respectively. The Bank is also encouraging the Government to spur industrial development, which has so far been largely concentrated in Istanbul and the coastal areas, in the much less developed Eastern part of Turkey on the basis of the exist- ing natural resources and labor, and to foster labor intensive projects which would take advantage of Turkey's competitive wage structure. 5. The execution of most projects has been satisfactory, although lately a number of projects have experienced prolonged delays before becoming effective (for details see my Report on the Irrigation Rehabilitation and Completion Project No. P-1011, dated January 6, 1972). 6. Five Bank and IDA operations are planned for FY 1972. A $18 mil- lion credit for an Irrigation Rehabilitation and Completion project was approved by the Executive Directors on January 18, 1972. Negotiations for a second livestock development project and for the IGSAS urea and ammonia plant project have been substantially completed, and the proposed credit and loan will be presented to the Executive Directors in late March and April, respectively. A further loan or credit is contemplated for the Istanbul urban development and water supply project which has been appraised and is expected to be negotiated in the first half of 1972. 7. IFC has been active in Turkey in the past, having participated in industrial investments for nylon yarn, pulp and paper, glass and aluminum. Total commitments so far amount to $23.9 million. IFC is currently investi- gating a number of new investment opportunities in various sectors including mining, special steel, and cement. 8. The project was appraised by Bank missions in April and September 1971. The conclusions contained in the appraisal report have also served as a basis for USAID and Eximbank lending. During negotiations in Washington in November and December 1971 the Borrower wJas represented by Wr. Ahmet Tufan Gull, Chief Commercial and Economic Counselor and Mr. Teoman Koprululer, Counselor, both at the Turkish Embassy, Washington, D.C., and Erdemir by 1Mr. Orhan Goncuoglu, Vice Chairman of the Board, Mr. I4etin Iplikci, President, and Mr. Kenan Okan, Senior Vice President.  PART II - THE ECONOMY 9. A report "The Development Prospects of Turkey" (EMA-30a) was dis- tributed to the Executive Directors on February 4, 1971. This was updated by a memorandum entitled "Current Economic Position and Prospects of Turkey" (EMA- 40a) dated July 19, 1971, which was distributed on July 26, 1971. The next economic mission is scheduled for spring 1972. A country data sheet is attached as Annex II. 10. Following the 1969 elections, which confirmed the Justice Party in power, the Government under Prime Minister Demirel faced a constant erosion of its majority in the National Assembly. At the same time, there was growing violence by extremist groups of students and unrest among workers, which con- tinued through 1970 to the early months of 1971. In March 1971, a new "above- party and reformist" government iwas formed under Prime linister Erim following the intervention of the Armed Forces and the resignation of the former govern- ment. The new government's program called for the restoration of law and in- ternal security, the reorganization of the state administration, more rational management of the economy and long overdue structural reforms. Growing opposi- tion from Parliament and the private sector to the reform proposals brought about the resignation of a large group of technocratic iinisters in December 1971. A new coalition Government headed again by Prime Iiinister Erim, comprises a large number of representatives of the political parties and fewer technocrats. Its new program contains substantial parts of the Prime Minister's first policy declaration in April 1971. It reiterates the national urgency of executing major structwurl reforms, emphasizes the importance of the survival of democratic pro- cedures in Turkey and appears to be conciliatory both in tone and in the choice of key Ministers towards Parliament and the private sector. 11. The report "The Development Prospects of Turkey" identified the principal obstacles to development and noted that devaluation and the stabili- zation program introduced in August 1970 reflected the Government's aim to in- troduce a new external orientation of the economy and an effort to develop ex- ports and accelerate progress towards external viability. The report pointed to the need to improve the situation of public finance and to make more effective use of the budget as a fiscal instrument in controlling the level of aggregate demand; to slow down the planned rate of growth of public investment and improve its composition; to liberalize the external trade regime and promote inter- national competitiveness; and to embark on an urgent program of rehabilitation of the principal deficitary State Economic Enterprises (SEEs). These issues are not new; they have been the central issues in Turkey's economic development for many years but are of special importance at a time when Turkey aims at further rapid growth and progress towards external viability.  -5- J2. The memorandum on "the Current Economic Position and Prospects of Turkey" reviewed economic developments since devaluation and described the M4arch 1971 Government program. The main thrust of the program was towards long-term structural reforms which were unlikely to bear fruit in less than 2-3 years. The wide-ranging reforms were to include: land and educational reforms; far-reaching reorganization of the Government administration, in- cluding SEEs and control of external trade; reform of tax administration and extension of tax coverage to agricultural incomes; nationalization of private enterprise in mining, petroleum and forestry industries; and stricter enforcement of the conditions for foreign capital investment, including in- sistence on Turkish majority participation. 13. While law and order were restored rapidly, the first Erim Government was able, in its eight months of office, to translate few of its long-range policies into detailed measures and decrees, although it was possible to in- crease substantially the prices of various SEEs to make them financially viable. The Government was unable to bring under control a number of criti- cal short-term difficulties, such as a serious fiscal imbalance and a rapid price increase, both of which were adversely affected by the financiai im- plications of the ambitious Personnel Reform introduced by its predecessor. The private sector's attitude was affected by what were believed to be anti- business trends in the Government's policies and, consequently, economic activity did not pick up as rapidly as expected. In the Prime Minister's December 1971 statement more emphasis is placed on the role of the private sector which is to enjoy the same importance as the State sector. Many of the features of the original program of April 1971 affecting the private sector have been modified and should help allay the fears of both domestic and foreign private investors. 14. Economic growth in 1970 was influenced by factors associated with civil unrest, growing balance of payments difficulty and devaluation as well as by unfavorable weather for agriculture. GNP grew by 5.6 percent at con- stant prices, compared with an average of 6.6 percent in earlier years. In- dustrial growth slowed down to 3 percent, compared to 10 percent in 1969, and agricultural output rose by only 1 percent. However, other sectors grew in the aggregate at 7 percent. In 1971 the economic situation has been favored by a remarkable improvement in the overall balance of payments position following the devaluation and by the record agricultural output for the 1970/71 crop year. Despite these favorable factors, which will probably re- sult in a record growth rate of about 8 percent for the year as a whole, in- vestment and industrial growrth have only grown slowly from the lowr point reached at the time of devaluation. 15. The trade deficit for 1971 has increased but this has been partly offset, following devaluation, by the increase in workers' remittances to a record level of $273 million in 1970 and $485 million for 1971. The current account deficit was also Linanced by increased public capital inflow and some private foreign investment. As a result, net foreign assets rose to about $411 million at the end of 1971 compared with about $10 million at the end of 1970 and a net liability at the end of 1968. Following the changes intro-  - 6 - dnced in tha relationship between the major world currencies in December 1971, Turkey established a central rate of 14 Turkish lira to the US dollar (instead of the previous parity of TL 15 to the dollar). 16. The growth in domAstic savings, which had been improving during earlier years, slowed down in 1969 and more noticeably in 1970, the rate of increase dropping to 2.5 percent in 1970 compared to 14 percent in 1968. Budgetary resources in particular have been severely strained, mainly because of the rise in civil servants' salaries under the 1970 Personnel Reform Law. The public investment target for 1971 (10 percent above 1970) has probably not been achieved. In the private sector investment has also continued to lag. and deposits in the banking sector have grown faster than credits. Finally, there have been substantial price increases in Turkey during the last eighteen months. A 66 percent devaluation in 1970 increased import prices substantially. The change in govermnent salaries and a pattern of high wage settlements have contributed to inflation. In addition, the State Economic Enterprises have implemented long overdue price increases in their products. As a result, the wholesale price index increased by 21 percent between August 1970 and August 1971. 17. T'hie economic situation in 1971 can be regarded as a transitional one, reflecting the first effects of major adjustments in exchange rate, domestic prices and salaries. Other major factors not likely to be repeated are probably once-for-all changes, such as clearing of the backlog of imports and changes in the Personnel Reform Law, which have led to a jump to a new plateau. However, the basic economic problems restricting growth remain unchanged and the need for structural reform is as strong as ever. Moreover, the immediate economic situation is severely strained by the heavy budgetary cost of the Personnel Reform Law, by a possible continued drain on resources arising from the financial situation of some of the SEEs and by the need to step up investment expenditures. At the same time, substantial inflationary pressures exist from the side of wages and output prices. In view of these inflationary pressures and budgetary difficulties, the Government will need to take energetic but delicately balanced measures to contain aggregate demand whilst at the same time mobilizing and injecting additional resources into the economy through efforts to step up investment activity in both the public and private sectors. The Government program attaches special importance to the allocation of resources required for efficient utilization of existing capacities, investment in quick yielding projects and concentration on completing on-going ones. It reiterates the necessity for renewed efforts to promote exports and calls for a major increase in taxation to balance the 1972 budget and finance an increase of 30 percent in the level of public investment expenditures in 1972. These measures, which will put the strength of the new Government to a major test, should be supplemented by an overall income policy and effective machinery for consultation between the Government, employers and labor to exercise some control over wage and price increases. 18. Following successive debt rescheduling and arrangements for debt re- lief, and the record level of workers' remittances in 1970, the debt service ratio was lower than expected, amounting to 16 percent of total foreign ex-  -7- change earnings. In the longer term, if the country enjoys political stabil- ity and if the Government intensifies its efforts to promote exports and can push through at least a modified reform program, the economic prospects remain promising. Turkey, however, will continue to need substantial external assis- tance. But even with a projected gross inflow of external assistance in ex- cess of $400 million per year and gradually hardening terms, the debt service burden is unlikely to be much above 15 percent of exports of goods and ser- vices, including workers' remittances, provided exports and workers' remit- tances continue to grow as projected. PART II; - TIE STEEL SECTOR 19. Detailed reports on the Turkish industrial sector were distributed to the Executive Directors as Annexes of the main economic report on Turkey entitled "The Development Prospects of Turkey" (ENk-30a) dated February 1, 1971. They are respectively "The Mining Sector" (Volume IV, Annex II, dated September 20, 1971), "The Manufacturing Industries" (Volume V, Annex III, dated December 10 1971), "The Forest Industries" (Volume VI, Annex IV, dated December 10, 19715, and "The Engineering Industries" (Volume VII, Annex V, dated December 10, 1971). 20. The rate of industrial growth in recent years has averaged about 10 percent and has permitted the broadening of the industrial structure, which now covers a wide variety of heavy engineering goods including metal process- ing, as well as durable consumer goods, phosphate and nitrogen fertilizer, synthetic fibers, newsprint, kraft paper, etc. Plants presently under con- struction will make aluminum, motor vehicles, and major chemical intermediates. Although the emphasis given to industrialization has permitted the Turkish in- dustrial sector to reach 20 percent of GNP in 1969, growth has been largely based on import substitution with too often little regard for cost competitive- ness. 21. The growfth in Turkish manufacturing output during the 1960's was spurred by the industrial materials and equipment industries among wrhich steel, next to machinery, showed the highest increase. Steel consumption in Turkey grew 12.3 percent per year during the 1960's reaching a level of 1.4 million tons of finished steel in 1970. Flat steel constitutes slightly less than one third of the entire steel market, and is expected to continue its growth at rates exceeding 10 percent per year. On this basis demand for Erdemir's output of flat steel is expected to be about 800,000 tons per year in 1975 and about 1,300,000 tons per year in 1930. 22. Erdemir is the only significant flat steel producer in Turkey, manufacturing 486,000 of the 525,000 tons of finished steel consumed in 1970. The remainder was provided by imports and some minor production of sheet at Karabiik, a state-owned enterprise, which hold' 29 percent of Erdemir's shares and is the major producer of shapes, rounds, and construction steel. Total consumption in 1971 was 551,000 tons but supply was restrained in that year by a blast furnace breakdown at Erdemir. The Erdemir expansion is scheduled in two stages (the first of which constitutes the present project) and will increase Erdemir's flat steel capacity to 1.2 million tons with a view to meetting domestic flat steel demand through 1980 for all except a small volume  -8 - of specialty flat steel products which will be imported. If Stage II is not implemented in the middle to late 1970's, the expected shortfall by 1980 in domestic flat steel production would be about 355,000 tons. 23. KarabEfi has a capacity of 600,000 tons of ingot steel which are processed mainly into non-flat products (billets, bars, rods). Total 1971 production in the non-flat sector was about 830,000 tons with a number of small firms responsible for over 200,000 tons. The increase in demand for these products is expected to be met by a new 900,000 ton USSR-financed plant now under construction at Iskenderun which is scheduled to begin production around 1976. Karabik is a major shareholder of this state-owned company and will be responsible for its management. Immediately before the completion of the Iskenderun Plant and the Erdemir Stage I expansion, flat, non-flat and scrap steel imports may reach about 1 million tons by 1974-75. If steel de- mand continues to grow at the projected rate of 10 percent throughout the seventies, construction of further capacity in the steel sector will have to be initiated before 1980. 24. Turkey's present steel import policy relies chiefly on quantita- tive restrictions rather than on duties which average only about 15 percent for steel products. Wqhen domestic production is available, import licenses are normally not granted. Future policy will be guided by agreements with the European Iron and Steel Community (EISC), after Turkey's transitional affili- ation with the European Economic Community (EEC) is ratified by Turkey and the EEC member countries. No specific commitments have so far been made to reduce tariff or quantitative restrictions for items included in the EISC product lists, but it has been agreed that negotiations on a program of grad- ual reduction will start after 1975. A few steel products, such as billets, are treated separately from those in the EISC lists, and it has already been agreed that these products will be freed gradually from import restrictions over a 22-year period. Turkey's affiliation with the EEC will also relax re- strictions on products which use steel as a raw material and, thereby, will also provide competition indirectly for Erdemir. 25. The justification for an expanded Turkish steel industry is based primarily on its ability to operate on an economic scale at competitive prices and on Turkey's virtual self-sufficiency in coal and iron ore. The relatively sophisticated industrial sector includes major steel consumers for whom a com- petitive steel price is essential, such as machinery and metal fabrication, appliances, automotive and tractor manufacture, and all types of pipe for water, gas and electricity. Much of the production is for domestic consump- tion but Turkey's increasing links with the Common M4arket may provide export potential, and the favorable wage rates of Turkish labor offer sub-contract- ing opportunities to Common Market firms in the metals fabrication sector. Competitive prices for steel supplies may also enable Turkish tractor and appliance manufacturers to compete in regional export markets. It is in this context of achieving an input at reasonable prices for the Turkish steel con- suming industry, that the Erdemir expansion project has its main significance.  - 9 - PART IV - THE PROJECT 26. A report entitled "Appraisal of the Erdemir Steel Plant Expansion Project" (PI-13a, dated February 4, 1972) is attached. A Loan and Project Summary is attached as Annex III. The Company 27. The Erdemir Iron and Steel Company is operated as a private enterprise as provided for in its Articles of Association although the Government owns the majority of the shares. The Company was formed in May 1960 with loans from USAID and the Turkish Government, and equity from the Turkish Government (represented by Karabuk and Sumerbank), Koppers Associates (USA), and the Turkish private sector. It had an initial capacity of 470,000 ingot tons per year. Equipment for the mill was provided by Koppers Associates and a consortium of US suppliers, and operations started in late 1965. Present capacity in place or under construction is 900,000 ingot tons per year. Over the past few years Erdemir has been able to produce close to capacity. Erdemir's management is efficient and results oriented, and the plant has excellent operational and budgetary control systems. Its workforce of Turkish nationals has quickly learned the required skills and the plant has shown a steady improvement in manhours spent per ton of steel produced. 28. Despite efficient management, the inadequate scale of Erdemir operations has meant high cost steel. The larger European flat steel mills have a capacity in excess of two million tons and operate at investments per ton considerably below Erdemir's present investment level of $415/ton. This difference is significant since capital costs comprise about one-fourth of total production cost. The project now proposed will reduce investment per ton on the entire plant from $415 to $340. Labor costs are also affected by economies of scale and will be reduced from 194 TL/ton to 115 TL/ton by the project as the labor force will increase by only one-third while saleable output increases 2.5 times. Turkey's lower wage rates will substantially counter-balance an investment cost disadvantage which will still remain even after the completion of the project. In addition, the Company which was heavily geared towards debt since its inception will, as a result of the financial reconstruction agreed upon during negotiations and despite the new debt contracted for the project, see the interest payments reduced from 20 percent of cost of goods sold in 1970 to 15 percent in 1977. The Project 29. The project, known as the Stage I expansion, is designed to double Erdemir's major facilities, and includes a second blast furnace, a third oxygen vessel, a billet caster, a semi-continuous hot strip mill, an expanded cold reduction mill, and additional auxiliary equipment. At the end of the project in 1976, Erdemir's manufacturing facilities will produce over 900,000 tons of flat products, 300,000 tons of billets, 60,000 tons of ingot and 180,000 tons of pig iron. The Stage II expansion of rolling facilities,  - 10 - not financed by this project, is expected to begin in 1976-77 to utilize the spare capacity of the second blast furnace and increase flat steel output to meet the expected demand of 1980. Ultimately, Erdemir could be expanded to a capacity of 4-5 million tons. 30. United States Steel Engineers and Consultants, Inc.(UEC) prepared the feasibility report on the project which was completed in September 1970. Turkey's demand for steel produacts through 1980 is projected by the Bank-at somewhat higher than that forecast by UEO, implying a margin of safety for the project. Should a higher demand in fact materialize, the Company could advance the additional rolling capacity planned for Stage II and also the installation of continuous slab casting. Cost and Financing 31. The cost of the project, including incremental working capital and $35 million of physical and escalation contingencies, is estimated at $290 million equivalent, of which the foreign exchange component is $181 million. After the negotiations for the Bank loan were completed, these estimates were increased by $5 million to allow for possible additional foreign exchange costs and the amount of the proposed Eximbank loan increased correspondingly. Financing for the project is thus now provided for a total of $295 million and will come from the following sources: Foreign Exchange Financing (in $ million) IBRD 76 USAID 4 Eximbank 70 Sub-total 186 Local Currency Financing Company generated funds 109 Total 295 The AID loan will bear a 3 percent interest rate to the Government and will be relent to the Company at 7 percent. Repayment is scheduled over a period of 15-1/2 years including a grace period of five years. The Eximbank loan will have an average interest rate of 6.5 percent to the Company and will be repaid in 16 years with 4-1/2 years of grace 32. Contingency and escalation allowances in the project cost estimates and a capital cost overrun guarantee by the Government provide the safeguards needed to protect a project of this magnitude. However, in view of the possibility that contingencies may not be used in their entirety, the Bank has provided for additional flexibility in the financing plan by agreeing to finance interest and other charges on its loan during construction to a maximum of $7 million. Interest payments will be charged to the Bank loan  - l1 - from the beginning but this arrangement will be suspended if it becomes apparent that the remaining balance is required for equipment. 33. In view of the Company's high existing debt equity ratio, equity for the expansion would have been particularly desirable but private equity capital in Turkey is not presently available on the scale needed for this project and an increase in the Government's share in the equity could probably not have been made without altering the private character of Erdemir. Instead, a reorganization of existing loans from the Government and AID has been negotiated to assure adequate debt service for the new loans and a sound financial basis for the Company. The Turkish Government has agreed to defer repayments and servicing of its original Main Construction Loan of TL 469 million, made in 1960, until all new foreign exchange loans have been repaid. Also, payments on Turkey's other loans to the Company have been deferred until 1976 i.e. after the Stage I construction period. USAID has deferred some of the repayments due during the construction period on its three earlier loans of 1960, 1961 and 1964. Subject to a current ratio test agreed upon during negotiations, the servicing of certain of these loans could be further deferred, thus providing an additional safeguard for the new foreign exchange debts. 34. Erdemir has been profitable in every year of its operation except the first, reaching a profit before tax of over TL 130 million in 1969 and 1970. This performance was not matched in 1971 because of a blast furnace breakdown but, with normal operations and the recent increase in selling prices which primarily compensate for cost increases in inputs, profits in excess of the 1970 levels are expected during the construction period. The reorganization of past debts and improved operating results assure adequate debt service coverage which reaches its lowest level of 1.5 in 1977 and improves rapidly thereafter. Payment of dividends, cash distributions, and other borrowings by the Company will also be restricted. Nevertheless, Erdemir should be able, in the long run, to distribute dividends at a sufficiently high level to attract private Turkish investors and thus to enable the Company to widen its equity base and the Government to divest itself of its shares as provided for in the Company's Articles of Association. Procurement 35. Procurement for the project under the Eximbank, USAID and Bank loans has been designed, after assessment of the relative competitiveness of the various sources of supply, so as to impose the least cost penalty to the Company from tied procurement. Erdemir has pre-allocated to Eximbank the financing of consulting services by US firms as well as that part of the equipment which could be competitively procured from US sources. Procurement under the Eximbank loan will be carried out under their usual procedures limiting bidding to US suppliers only. The rest of the equip- ment to be financed under the USAID and Bank loans will be procured against the lowest evaluated bids emerging from international competitive bidding. All awards to US suppliers meeting USAID criteria will be first set off against the USAID loan but should this loan be exhausted before the Bank loan, further lowest US awards will be paid out of the Bank loan. Should the Bank loan be exhausted first, the remaining equipment will be procured under USAID procedures limiting the bidding to US suppliers.  - 12 - 36. The Bank loan would be disbursed against the delivered cost of equipment purchased under international competitive bidding. All equipment for the project will continue to be exempted from import duties as was the case for the original plant. Because of the joint procurement arrangements with USAID, the specific items to be financed by the Bank will depend on the outcome of the bidding. 37. Contracts for civil works which will be financed by Erdemir will be submitted to competitive bidding in Turkey. Should it appear that domestic construction industry constraints would result in delays and undue cost in- creases, the Bank and Erdemir have agreed that international competitive bidding would be used for part of the civil works. 38. The Koppers Company which headed the consortium of U.S. suppliers which designed and built the original Erdemir facility and is a shareholder in Erdemir, has been the successful bidder for the general engineering con- tract for the project for which Erdemir obtained bids from several qualified firms; this contract will be financed by Eximbank. While Koppers will have responsibility for the design and supervision of the expansion project, Erdemir will, in addition, enter into a long term technical assistance con- tract with an international steel producer in order to have access to new technical developments and operating techniques in the steel industry. The Bank would finance up to $1.0 million of the cost of the technical assistance contract. 39. TWo ecologists engaged by the Bank have studied in detail the present and future situation of the Company's plant at Eregli, on the Black Sea Coast with regard to air and water pollution. Their preliminary findings confirm that environmental damage due to present plant operations are minor, although as the plant expands attention must be given to disposal and treatment of liquid and gaseous wastes. Erdemir has agreed to undertake ecological im- provements and a provision of $5.0 million has been included in the project cost estimate for this purpose. Benefits 4o. The economic benefits of the project derive from savings of foreign exchange by manufacturing rather than importing finished flat steel. The project will operate largely on domestic iron ore and coal, and will save Turkey about $60 million in foreign exchange per year. At the completion of the project Erdemir's production costs will become reasonably competitive with those of its European competitors. For the moment, Turkey will have to continue to use quantitative restrictions for steel and steel-using imports but over the longer term the project will enable Turkey to meet the obliga- tions which will arise in this respect from its Association Agreement with the EEC.  - 13 - 41. Before the currency revaluations of December 1971, Erdemir's domes- tic selling prices based on the 1976 product mix were calculated to be 11.7 percent higher in the average than import prices net of duties as shown in the following table: Expressed in US $ per ton Erdemir's domestic Import prices Excess of selling prices excluding im- domestic over __________________ port duty iport price (percent) Pig Iron/Ingots 107.53 92.03 16.8 Billets 119.47 110.00 8.6 Flat Products 188.89 167.51 12.7 Weighted Average 161.16 144.25 11.7 The currencies of the major European steel producing countries and Japan have risen between 2 and 10 percent against the Turkish lira. The most recent (January 1972) export prices in US $ terms of European Common Market countries have been increased by between US $5 and US $10/ton, equivalent to 2 to 8 per- cent of the FOB Europe prices and this will have the effect of reducing the margin between prices of domestic and imported steel. With regard to future prices, the Company has agreed to consult the Bank before implementing changes from present prices. 42. Periodically a wJorld wide surplus of steel products has depressed prices a-d motivated "dumping" of steel exports. Erdemir, as most steel pro- ducers, would not be able to withstand such competition without protection. But Erdemir's prices are more competitive when buyers take into account the advantages of a secure domestic steel supply during periods of worldwide steel shortages. For example inflated prices and long delivery times in 1969 in- curred cost penalties to steel importing countries. Over the long term world steel prices are expected to drop in real terms as a result of new technology and the construction of even larger plants. But future expansion of Erdemir as Turkey develops should permit the Company to operate with acceptable levels of protection. 43. To ensure Erdemir's, and Turkey's, continuing ability to improve its international cost competitiveness, the Government has agreed to give priority to the Stage II Erdemir expansion before considering the construction of any new flat steel mills. In addition, a study will be undertaken to determine means for improving the production and transport of domestic iron ore. The iron con- tent of domestic ore is presently 10 percent more expensive than top grade foreign ore. Its use also reduces blast furnace capacity by 15 percent which, during periods of capacity constraints, leads to large losses in potential pro- fits and foreign exchange savings. The study should lead to steps to correct these problems and, until the recommendations of the study are implemented, the Company will be allowed to obtain at least 20 percent of its ore re- quirements from abroad. This level of imports represents an attempt at a balance between the long term need to develop domestic ore mines and the short term benefits of using higher quality imported ore.  - 14 - 44. The internal economic and financial rates of return of the project are estimated at 18 and 21.2 percent, respectively. Employment 45. While the project aims primarily at making more competitive the largest industrial enterprise in Turkey, it will nevertheless have significant employment effects. The Company's labor force is expected to add approximately 1,200 men. The jobs created indirectly in both the supplier and user industries of Erdemir will be even more numerous. As regards Erdemir's supplier industries, Turkey has some possibility of exporting coking coal not used domestically, but Erdemir's expansion will require the prod- uction of an additional one million tons of iron ore each year - a 50 percent increase in ore production - which otherwise would not take place since Turkish iron ore is not of an exportable quality. Erdemir's expansion should provide the impetus for the necessary additional investment to take place in the supplier industries employing about 12,000 additional workers. PART V - LEGAL INSTRUMENTS AND AUTHORITY 46. The draft Loan Agreement between the Republic of Turkey and the Bank, the draft Project Agreement between the Bank and Erdemir, the Report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement and the text of the Resolution concerning the proposed loan are being distributed to the Executive Directors separately. 47. The Executive Directors' attention is drawn to the covenants in the draft Loan Agreement related to: changes in the Company's Articles of Association which require the Bank's consent (Section 4.03); the study of domestic iron ore to be carried out by the Government (Section 4.04); the importation of foreign iron ore by the Company (Section 4.06); the coordination of expansion of steel producing facilities in Turkey (Section 4.08); and the fnformation to be provided to the Bank regarding the system of import quotas and duties for steel products in Turkey (Section 5.0) The covenant related to steel prices in the draft Project Agreement (Section 3.10) as well as Schedule 1 thereto on procurement procedures are also of special interest. 48. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 49. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments March 1, 1972  ANNEX I Page 2 STATEMENT OF BANK LOANS AND IDA CREDITS TO TURKEY AT JANUARY 3J, 1972 loan or (US $ mill.) Credit Amount Undis- Number Year Borrower Purpose Bank IDA bursei Seven loans and six credits fully disbursed 70.7 56.3 _ 59 TU 196h Republic of Turkey Second Cukurova Power - 24.0 - 568 TUi 1968 - - Keban Transmission Lines 25.0 - 7.0 587 TU 1969 - - Seyhan Irrigation Stage II 12.0 - 11.8 113 TU 1969 _ " Seyhan Irrigation Stage II 12.0 3.6 589 TU 1969 T.S.K.B, Industry 25.0 2.h 623 TU 1969 Republic of Turkey Third Cukurova Power 11.5 - 5.0 713 TU 1970 T.S.K.B. Industry 40.0 - 34.9 236 TU 1971 Republic of Turkey Intensive Dairy - 4.5 4.5 7M8 TU 1971 - " Education 13.5 - 13.5 257 TU* 1971 - - Fruit and Vegetable - 15.0 15.0 762 TU 1971 _ n Fruit and Vegetable 10.0 - 10.0 763 TU 197J TIE.K. Power Transmission 2k.0 - 2h.0 775 TU 1971 Republic of Turkey Fourth Cukurova Power 7.0 - 7.0 281 TU* 1972 _ n Irrigation Rebabilitation - 38.0 18.0 Total (less cancellations) 238.7 129.8 of wbich has been repaid 19.0 Total now outstanding 189.7 Amount sold 1.2 of which has been repaid 0.7 0.5 Total now held by Bank & IDA 189.2 129.8 Total undisbursed 115.6 41.1 156.7 * Not yet effective  ANNEX I Page 2 STAT&EMNT CF IFC INVESTMENTS IN TJRIET AT JANUARY 31, 1972 Coumitments (Net of Exchange AdJustments) Calendar (US$ millions) Year Company Loan Eqity Total 1963 Industrial Development Bank of Turkey - 0.92 0.92 (TSKB) 1966 SIFAS I (Nylon yarn) 0.90 0.47 1.37 1967 Industrial Development Bank of Turkey - 0.34 0.34 (TSKB) 1969 Industrial Development Bank of Turkey - 0.41 0.41 (TSKB) 1969 SIFAS II (Nylon yarn) 1.50 o.43 1.93 1969 Viking I (Pulp and paper) 2.50 0.62 3.12 1970 A.C.S. (Glass) 10.00 1.58 11.58 1970 NASAS (Aluminum Sheet and Foil) 7.00 1.37 8.37 1970 SIFAS III (Nylon yarn) 0.75 - 0.75 1971 Viking II (Pulp and Paper) - 0.05 0.05 1971 SIFAS IV (Nylon yarn) - 0.52 0.52 Total commitments 22.65 6.71 29.36 Less cancellations, sales,and repayments 5.06 0.37 5.43 Total held 17.59 6.34 23.93 Undisbursed balance 12.39  ANNEX II page 1 TURKEY - COUNTRY DATA Area 780,000 sq. km. Population 35.5 million Rate of growth 2.6 percent per annum Density 46 per sq.km. Gross National Product 1970 (current markec prices) TL 144.5 billion Annual Rate of growth (constant prices) 1963-67 = 6.95 1969 = 6.4% 1970= 5.6 GNP at factor cost (1970 current prices) TL 127.7 billion GNP per capita at factor cost (1970) TL 3,597 / Industrial Origin of ND? (% of NDP at constant prices) 1962 1970 Agriculture and forestry 39.7 29.6 1ianufacturing, mining and power 16.2 19.5 Construction 6.3 7.4 Transport and Communications 7.2 8.0 Trade 8.1 9.0 Housing h.8 5.5 Government services 9.7 11.1 Financial institutions and other services 8.1 9.9 Expenditure of GNP (% of GNP at constant prices) Private Consumption 7L.1 70.7 Public Consumption 15.4 12.7 Gross fixed irvestment 14.8 19.5 Net imports of goods and services 3.6 3.8 Net factor income from abroad -0.6 0.9 Gross National Saving 10.5 16.6 1969/1970 Public Finance (Billion TL) 1969 1970 Growth Rate e Current Receipts 21.6 28.6 32.)4 Current expenditures 15.6 20.3 30.1 Capital transfer 3.4 4.8 41.2 Surplus, net of transfer 2.6 3.5 34.6 Investment expenditures 6.9 7.0 1.4 g/ $257 at the new central rate of TL 1h = US$1.  ANNEX II page 2 1969/1970 Money, Credit and Prices (Billion TL) 1969 1970 Growth Rate % Total money supply, including sight and saving deposits 30.1 35.1 16.6 Total central credits and advances 12.9 14.6 13.2 Total commercial bank credits 33.2 37.2 12.0 Change of wholesale price index 6.0% 5.8% Change of consumer price index (Istanbul) 4.3% 7.6% Balance of Payments (l'illion US$) 1962 1969 1970 Imports of goods 622 801 948 Exports of goods 381 537 588 Net invisibles (including NATO receipts) - 1 43 188 Current Account Deficit -242 -221 -172 Commodity Concentration of Exports (%) 1962 1970 Cotton 17 29 Tobacco 25 13 Hazelnuts 17 15 Fruits and vegetables 7 9 External Public Debt (million US$) 1969 1970 Total outstanding debt (end of calendar 2,196.7 2,442.9 Debt service year) 134.1 160.4 Debt service ratio (% of exports of goods) 25 27 (% of exports of goods & services, gross) 20 22 (% of goods & ser- vices, incl. workers' remittances) 16.7 15.6 IB,ID/IDA Operations (Diillion US$) 1968 1969 1970 Nov. 1971 (Cumulative - end of Calendar year) Total loans - IBPJ 98.4 1h6.9 186.9 241.4 - IDA 80.7 92.7 92.7 112.2 Repayments - IBRD 39.9 42.2 45.1 49.0 Total loans outstanding - IBMD 55.8 102.0 139.1 189.7 - IDA 80.5 92.5 92.3 111.8  ANNEX II page 3 B-; Position (Hlillion US$) 1968 1969 1970 1971 Quota 108 108 151 152 Net flD' position 27 - 1.2 48 - 12 SDR drawings - - 18 16 Foreign Exchange Reserves (ItIillion US$) Gold and convertible foreign exchange, gross 123 245 431 773 Net foreign assets - 6 13 10 411 Inconvertible currencies 92 125 151 159 Exchange Rate December 1971: Turkey established a central rate of US $ 1 = TL 14.00 August 9, 1970 to December 1971 US $ 1 = TL 15.00 Prior to August 9, 1970: US $ 1 = TL 9.00 Social Indicators Unit 1950 1960 1965 1970 Population Growth rate % 2.7 2.9 2.5 2.6 Urban Population growth rate % 6.2 5.4 School enrollment: school 33.0 47.0 54.0 56.0 2/ Primary and age Secondary adjusted popln Literacy rate . adu].t 32.0 38.0 popln Unemployment rate % labor force 9.0