Turkey - Third Programmatic Financial and Public Sector Adjustment Loan

36456 TURKEY ThirdProgrammaticFinancialandPublicSector Adjustment Loan - (PFPSAL3) (LoanNo. 7233-TU) Releaseof the SecondTrancheandPartialWaiver of One Condition 1. This memorandum summarizes the progress made under the Programmatic Financial and Public Sector Adjustment Loan (PFPSAL 3) to Turkey. The Bank approved the $1billion PFPSAL3 to the Republic of Turkey on June 17,2004. The Loan Agreement was signed on June 18, 2004 and became effective on July 1, 2004. The first tranche of $500 million was disbursed on July 2, 2004. The second tranche i s US$500 million. PFPSAL 3 i s the third in a series of structural adjustment loans extended to Turkey following the 2001 crisis to support the Government's multiyear financial and public sector reformprogram. 2. PFPSAL3 aimed at supporting implementationof the Government's financial and public sector reform priorities while ensuring that social programs remain adequately funded and are increasingly better targeted. Key reform priorities in the financial sector supported by PFPSAL3 include: (a) strengthening the regulatory framework for banking, (b) building institutional capacity at the Banking Regulation and Supervision Agency (BRSA) and Saving Deposit Insurance Fund (SDIF), (c) restructuring and privatizing state banks, and (d) improvingthe corporate insolvency regime. 3. Key reform priorities in the public sector supported by PFPSAL 3 include: (a) deepening of structural fiscal policies in support of sustainable fiscal adjustment, (b) implementation of public expenditure management (PEM) reforms covering budget planning and execution, financial accountability, and public liability management, and (c) strengthening public sector governance including implementation of the national anti- corruption strategy and preparation of civil service reform strategy. 4. Finally, the priorities for social spending supported by PFPSAL 3 include: (a) adequate expenditure for health, education and social protection in the 2004 budget and (b)better targeting of social protection. 5. The Government's IMF and World Bank supported economic and structural reformprogram has delivered strong economic performance and stability in the last three years, with average growth rate reaching 8 percent during this period and inflation subsidingto 7.7 percent at end-2005, which representedthe lowest rate inmore than three decades. Fiscal tightening led to an average primary surplus of about 6.5 percent in the last three years and the overall deficit declined to below 2 percent of GNP in 2005. Helped also by the appreciation of the Turkish lira, the net public debt to GNP ratio declined sharply from the post-crisis peak of 91 percent in 2001 to below 56 percent in 2005. The political stability following the November 2002 elections has been instrumental inthe recently achieved economic stability.  6. Key structural reforms have taken place in the last four years in important subjects such as public expenditure management, financial sector, privatization, social security and agriculture, energy and telecommunications. Notwithstanding achievements in many issues, progress was slower than envisaged in a few areas, most notably privatization of state banks. The Government requested an extension of the closing date of the loan, originally June 30, 2005 as there were tranche disbursement conditions still pending at the time. The Bank agreed to extend the closing date to December 31, 2005. The closing date was then further extended to June 30, 2006 upon Government's request to provide additionaltime neededto finalize three pending actions supported by the Loan. 7. The Government has fully met 11out of 12 core conditions for the release of the second tranche. The one remaining condition has been partially met -- as presented in detail in section I11 below. The Government has requested a partial waiver for the condition related to privatizing state owned Ziraat Bank -- which i s the largest bank (private or public) inthe country ranked by assets. 8. The authorities have decided that it i s advisable to first observe the results of the privatization of Halk Bank prior to proceeding with the sale of the much larger Ziraat Bank. Nonetheless, the Government has assumedan active shareholder role in overseeing the functioning and restructuring of Ziraat. Its Board of Directors was re-configuredand a senior level steering committee was established to develop and implement an extensive operational restructuring plan (entitled "Strategic Road Map") to ready the bank for its envisaged privatization. The authorities and Ziraat Bank have developed a time-table to systematically un-wind the `burdens and privileges' the bank has long been obliged to fulfill including, for example, removing the `burdens' of mandatory tax collections and payment of public employee pensions, and similarly, the `privilege' that government agencies mustkeep their deposit accounts inone of three state controlled banks. 9. The following sections of this memorandum summarize the recent macroeconomic developments since 2004, the overall progress in the structural reform program supported by PFPSAL 3 and the actions taken by the Government to meet the specific conditions for release of the secondtranche. I.RecentEconomicDevelopments 10. The commitment of the government to sound economic policies since 2001 and the determined implementation of its reform program have placed the Turkish economy in a good position to embark on a sustained path of faster economic growth. Substantial progress has been achieved in reducing inflation and real rates of interest, improving public finances, restructuring the financial sector, improving the business environment, and reforming the public sector. In particular, strong fiscal discipline helped lower inflation and inflationary expectations and improve debt sustainability. Thus, stability has been restored, predictability has improved and market confidence has increased. The Stand-By arrangement with the IMF, and the ongoing process of EU accession, i s expected to provide an anchor for the continuation of the reform process in the years ahead, and contribute to increasing Turkey's growth potential and improving convergence to the EUaverage income level. 2  11. The recovery following the 2001 crisis has been remarkable. The Turkish economy rebounded very strongly and has been one of the fastest growing economies in the world over the last four years. Annual growth averaged 7.8 percent during 2002- 2005. The rapid increase in real per capita income helped Turkey achieve faster convergence with higher income countries. Inflation came down to single digits in 2004 for the first time in 35 years and further decelerated to 7.7 percent in 2005, greatly facilitating the reduction in interest rates. However, two key challenges remain, namely that (a) high unemployment continues to persist, at 10.3 percent in 2005 despite strong growth for four consecutive years and (b) the current account deficit reached 5.2 percent of the GNP in 2004 and widened further to 6.4 percent of GNP in 2005, inpart caused by higher imported energy bill due to increases in the price of oil derivatives. The 2006 current account deficit as a percentage of GNP i s expected to be close to 7 percent. 12. Resolute fiscal consolidation has been the cornerstone of the economic program. The public sector primary balance moved to a surplus of 7.1 percent of GNP by 2004, and to about 6.5 percent in 2005, from a deficit of 1.6 percent in 1999. The overall deficit has declined to below 2 percent of GNP. The fiscal performance showed no deterioration in the first three months of 2006 as the primary surplus of the consolidated budget amounted to 32 percent of the annual target for 2006. The net debt to GNP ratio, which reached a peak of 91 percent in 2001, came down to 56 percent in 2005, due to declining real interest rates, strong fiscal performance, the robust economic growth and continued appreciation of the real exchange rate. 13. The GNP growth rate in 2005 reached 7.6 percent exceeding expectations for the fourth straight year. The major contributing factors were private consumption, private investment, and export growth. A noticeable change from the past rapid growth episodes was that growth mainly came from the private sector, while public sector consumption and investment expenditures were heavily constrained by tight fiscal policies. GDP per capita at current dollars exceeded US$ 5,000 for the first time in Turkey's history, and total GDP reached US$361.5 billion in 2005. The early signs in2006 are mixed, but the strong investment demand bodes well for the sustainability of growth. Preliminary data indicatethat the economy continues to grow in 2006, albeit at a slower pace. The official estimate of 5 percent growth for the whole year seems within reach. 14. With increasing capital inflows and growing appetite for the Turkish government paper, the Treasury had no problem in servicing the debt. The average maturity of new debt increased from 15 months in 2004 and to over 27 months in 2005. More encouragingly, Treasury was able to issue YTL 27.7 billion of 5-year floating rate bonds (FRNs) in2005. 15. Strong growth in 2005 has been associated with increasing imports of capital and intermediate goods. As the trade deficit further widened in 2005 (despite the moderation inthe automobile imports) to about US$43 billion, the current account deficit hit US$23 billion, or 6.4 percent of GNP, up from 5.2 percent in 2004. The increase came as a result of imports growth outpacing exports. On a more positive note, the contribution of consumption goods imports declined and the increase in the capital and intermediate 3  goods (of about US$17billion) was the main factor behindthe growing trade deficit. The hike inthe energy imports alone was a striking US$7 billion, due to surging oil prices. 16. The financing of the current account deficit has not been a problem partly because the share of long-termcapital and non-debt creating flows continues to increase. In2004, about 53 percent of total net inflows (excluding IMFcredits and official reserves) were in the form of short-term flows. This share dropped to 41 percent in 2005, which i s a healthy sign. Non-debt creating flows such as foreign direct investment (FDI), equity flows, and net errors and omissions covered some 75 percent of the current account deficit in 2005. Inparticular the FDIinflows (on a cash basis) reached a historical high of US$9.7 billion (2.7 percent of GNP) in2005. 17. Even though the level and the structure of Turkey's public debt has improved, Turkey remains exposed to risks. The comparatively high level of private and public external debt underscores the important risk of a significant depreciation in the currency. However, there are some mitigating factors that make the economy more resilient to such shocks. In contrast to the pre-2001 crisis period, a flexible exchange rate regime i s in place and an independent Central Bank has established strong credibility over the past few years, as evidenced by the shift to an explicit inflation targeting regime in January 2006. The official reserves of the CBT rose from around US$19 billion in 2001 to US$52.4 billion in2005. 18. Inthe longterm, sustainability of the current account i s going to be helpedby the following: (a) increased confidence level, mostly due to continued macroeconomic stability and positive developments on the EU relations front, i s likely to improve the structure of capital flows, towards more long-term financing including FDI; and (b) continued fiscal discipline through a high primary budget surplus to ensure needed mobilization of domestic savings for the financing of investment. 19. The year 2005 represents a milestone in the history of privatization in Turkey. The Privatization Administration completed the ever biggest privatization, Turk Telekom, in July 2005, raising US$ 6.6 billion for a sale of 55 percent shares of the company. The total amount of privatization deals in 2005 i s expected to yield close to US$ 26 billion (not including sales by the SDIF), although some of the sales are still in the legal process. By comparison, only US$ 9.4 billion of privatization deals was realized in the whole period 1986-2004. All these developments signal a strong confidence in the Turkish economy and confirm the government's commitment to the privatization program. Continuing efforts of privatization will help reduce public debt and, combined with greater green-field FDI, will be particularly helpful in financing the widening current account deficit-especially in a context where short-term capital flows to emerging market economies may dry up with increasing interest rates in international capital markets. The year 2006 also looks quite promising in terms of privatization as well. As of March 31, 2006; Turkey had implementedprivatizationtransactions for US$ 7.3 billion. 20. The impressive economic growth did not reduce the overall unemployment rate. Despite the strong growth performance for the four consecutive years in a row, 4  unemployment remained high at 10.3 percent in 2005. In urban areas however, the unemployment rate declined to 12.7 percent, close to one percentage point, while the unemployment of youth declined by more than 2 percentage points to 22.8 percent. Although the rate of increase in employment in services, industry and construction sectors was significant, employment in the agriculture sector declined by 907,000 over this period. The drop in agricultural employment, which reflects a shift away from the agricultural sector towards finding employment in more productive sectors, was the main reason for the low overall net employment gain. 21. Turkey's economic program i s supported by an International Monetary Fund (IMF)Stand-By Arrangement (SBA). InMay2005, the IMFapproved athree-year, SDR 6.66 billion (about US$ 10 billion) SBA to support Turkey's economic and financial program through May 2008. The overriding goals of the new program are to create conditions for sustained growth that will raise living standards and reduce unemployment; facilitate convergence towards the EU economies; and bring about an orderly exit from IMF support. A combined first and second review and an amount of SDR 1.1billion (about US$ 1.6 billion) credit disbursement have been completed under the new SBA. The discussions on the 3rd and 4th reviews were concluded in May 2006 with a targeted Board discussion date of July 2006. 22. Global volatility in the prices of equities, bonds, FOREX, and commodities since 2006 has affected all emerging markets including Turkey, where the lira depreciated by about 17 percent with respect to the US dollar. While Turkey has not been disproportionately affected compared to other countries, domestic developments that occurred prior to this episode of global volatility probably magnified the effects of these global events into local markets. 23. The nature and magnitude of the macroeconomic risksresulting from these recent events will ultimately depend on the depreciation of YTL with respect to the Euro and the U S dollar following the reestablishment of normalcy in global markets. If the current level of depreciation in YTL sustained, it would have a negative impact on the pace of disinflation and on public debt. However, a positive impact on price competitiveness and exports and therefore on the current account balance would also be expected. 24. A comprehensive analysis of the possible effect of this recent FX volatility on key economic variables could not be yet completed as it i s not obvious at this stage whether the current move i s permanent or would be partially or totally reversed. However, early estimations indicate that such effects are unlikely to be large in magnitude. Due to the flexible exchange rate regime and a decline in currency substitution, the pass through of YTL depreciation to inflation has declined in recent years. World Bank staff carried out a public debt sensitivity analysis which indicates that a 10 percent permanent depreciation in YTL would not have a major impact on the public debt stock. 25. A recent positive development i s that on June 7, 2006 the Monetary Policy Committee of the Central Bank increased its key policy rate by 175 bps to 15 percent from 13.25 percent. This action i s seen as a reaffirmation of the independence of the Central Bank and a signal of its continuing commitment to the disinflation process. The 5  sharp tightening in monetary policy will dampen domestic demand and should limit the depreciation of the currency which means a likely easing of inflationary pressures. In addition, slower consumer loans and private consumption are likely to be positive for the current account. 11.The StructuralAdjustmentProgram 26. The main objective of PFPSAL 3 was to support implementation of the Government's financial and public sector reform priorities while ensuring that social programs were adequately funded and increasingly better targeted. These objectives were met, as follows. 27. The key reform priorities in the financial sector supported by PFPSAL 3 include: (a) strengthening the regulatory framework for banking, (b) building institutional capacity at the Banking Regulation and Supervision Agency (BRSA) and Saving Deposit Insurance Fund (SDIF), (c) restructuring and privatizing state banks, and (d) improving the corporate insolvency regime. The key reform priorities in the public sector supported by PFPSAL 3 included: (a) deepening of structural fiscal policies in support of sustainable fiscal adjustment, (b) implementation of public expenditure management (PEM) reforms covering budget planning and execution, financial accountability, and public liability management, and (c) strengthening public sector governance including implementation of the national anti-corruption strategy and preparation of civil service reform strategy. The priorities for social spending supported by PFPSAL 3 included: (a) adequate expenditures for health, education and social protection in the 2004 budget and (b) better targeting of social protection. 28. The overall implementation of the PFPSAL 3 structural reform program has been successful. The Government fully met 11 of the 12 core conditions for disbursing the second tranche and partially met the remaining condition, as explained indetail in section I11below. The structural reform program supported by the PFPSAL 3 has been well implementedwith important progress inboth the banking sector and public sector reform components. In the banking sector, several actions have been taken with the aim of further developing the financial sector in a way that will not constitute a source of macroeconomic risk. The main policy actions include: enactment of amendments to the Banking Act, implementation of the BRSA Strategic Plan and SDIF Institutional Development Plan, amendments to the Execution and Bankruptcy Act including enactment of its implementing regulations, substantial progress towards the privatization of Halk Bank as well as a successful Initial Public Offering for Vakif Bank. 29. In the public sector, implementation of the comprehensive reform agenda continued, through the establishment of a semi-autonomous Revenue Administration (RA), enactment of a law that eliminated earmarked revenues of the now closed extra budgetary funds and the special appropriation mechanism, submission of a new Turkish Court of Accounts law to the Parliament and the enactment of a Code of Conduct for civil servants. 6  30. The following table presents an overview of the progress of the PFPSAL 3 in terms of the main program areas to be monitoredfor the releaseof the second tranche. Table 1. Progress in Loan Conditions Main Program Areas Summaryof Progress Satisfactorymacroeconomic program Achieved Agricultureframework law Achieved Bankingsector reform 1. Regulatoryframework and institutionaldevelopmentof the BRSNSDIF Achieved 2. State Bank restructuringand privatization Partiallyachieved 3. Executionand BankruptcyAct Achieved PublicSector Reform 1. Structuralfiscal policies Achieved 2. Budget reform Achieved 3. Financialaccountability Achieved 4. Public liabilitymanagement Achieved 5. Public sector governance Achieved 31. CAS Linkage. The PFPSAL 3 i s part of a broad program of World Bank financing in support of the Government's comprehensive reform efforts. The Bank's overall lending program for the FY 2004-06 was approved by the Board in November 2003. In November 2005, the Board approved the extension of the CAS period by another fiscal year under a largely unchanged strategic framework. The enhanced high case presented in the CAS Progress Report i s in the amount of US$6.6 billion for FY 2004-07, of which US$2.6 i s inprogram lending. 32. The progress in meeting the conditions for release of the PFPSAL 3 second tranche indicates that the CAS high case triggers (particularly triggers related to a satisfactory macroeconomic framework, social expenditures and reforms in the public sector and financial sector) are on track. The release of the second tranche of the Economic Reform Loan in April 2004 confirms that triggers related to the sustained implementation of regulatory reforms, privatization and liberalization of the energy and telecommunications sectors and the agriculturalreform programhave been met. The CAS trigger on social security reform has also been met as evidenced by the adoption of the Social Security Administrative Law (No.5502 dated May 16, 2006) and the Social Security and UniversalHealth Insurance Law (No. 5510dated May 31,2006). 111.Conditions for Releaseof the SecondTranche 33. For release of the second tranche, the Loan Agreement requires that: The Borrower has made satisfactorv progress in carrving out the Third Phase of the Program as set forth in the Government's Letter of Development Policy dated May 20, 2004. This progress i s evidenced by the general progress in all substantive areas of the Program, as well as by a review of the specific actions described in Schedule 3 of the Loan Agreement. The macro-economic policy framework of the Borrower i s satisfactorv. The existence of an adequate macroeconomic policy framework i s evidenced by the recent economic, - 7  fiscal, monetary and external aspects of the Turkish economy that were described in Part Iofthismemorandumandasmeasuredonthebasisofindicatorsagreedbetweenthe Borrower and the Bank. The country's macroeconomic framework and policies are supportedby an active IMFprogramthat remains on track. The actions described in Schedule 3 of the Loan Agreement have been taken in form and substance satisfactory to Bank management. That these actions have been completed i s evidenced by the fact that 11 out of 12 conditions have been fully met and that one condition has been partially met in a manner satisfactory to Bank management. The compliance with each of these conditions i s discussed inthe following paragraphs. I.MacroeconomicFramework 1.TheBorrower has implementeda satisfactory macro-economicframework up to the time of the exchange of views referred to in Section 3.01 of the Loan Agreement, including at least through the second quarter of calendar year 2004, such macro-economic framework to be evaluated on the basis of the overall ThirdPhase of the Program and with respect to key economic variables. 34. This condition has been met. The Government has implemented a strong macroeconomic framework as evidenced in the track record of key macroeconomic outcomes and the existence of an IMFprogram. Following the successful completion of the previous stand-by arrangement in February 2005, the Government embarked on a new US$ 10 billion stand-by arrangement with the Fund in May 2005. The first and second reviews under the current arrangement have been completed in December 2005. The discussions on the third and fourth reviews were concluded in May 2006 with a targeted IMFBoard discussion inJuly 2006. 35. Macroeconomic outcomes for 2004 and 2005 generally surpassed the targets and indicators set by the program, although the current account emerged as the main source of potential risk. Substantial progress has been achieved in reducing inflation and real rates of interest and improving public finances. Thus, stability has been restored, predictability has improved and market confidence has increased. 36. Average growth for 2002-2005 reached about 8 percent while inflation rates declined to single digit rates (9.3 percent) in 2004 for the first time in more than 30 years and further to 7.7 percent in 2005. Strong fiscal discipline helped lower inflation and inflationary expectations and improve debt sustainability. The public sector primary balance exceeded the target of 6.5 percent of GNP in 2004 and the preliminary estimates indicate that the 2005 primary surplus was over 6 percent. The overall deficit has declined to below 2 percent of GNP in 2005 helping Turkey meet one of the Maastricht criteria of the EU. The net debt to GNP ratio, which reached a peak of 90 percent in 2001, came down to below 60 percent in2005. While the current account deficit widened to 6.4 percent of GNP in 2005, from 5.2 percent in 2004, the financing of the deficit has not been a problem partly because the share of long-term capital and non-debt creating flows continues to increase. Non-debt creating flows such as foreign direct investment (FDI),equity flows, and net errors and omissions covered some 75 percent of the current 8  account deficit in 2005. In particular the FDI inflows (on a cash basis) reached a historicalhigh of US$9.7 billion (2.7 percent of GNP) in 2005. 37. As of early 2006, economic fundamentals continue to be strong as evidenced by the resilience exhibited by the economy to an adverse shock in mid-May 2006 caused by global financial volatility. 2. The Borrower has enacted an agriculture framework law including satisfactory provisionsfor direct income support. 38. This condition has been met. The agricultural framework law (No.5488) was enacted on April 25, 2006. The law and its implementing regulations are fully consistent with the Agriculture Strategy Paper which was approved by the HighPlanning Council in November 2004. The Bank has supported the adoption of the Agriculture Strategy Paper which sets out the various agriculture subsidy schemes (including Direct Income Support to farmers) and their shares in the total amount of subsidies granted in the period 2006- 2010. While the law contains most of the substance in the Strategy, the shares of each agriculture subsidy scheme in total subsidies were removed from the law during Parliamentary discussions. To confirm its commitment to the allocation of the agriculture subsidies as set out in the Strategy Paper, the Steering Committee established under the new Law, issued implementing regulations towards this end. As a result, the subsidy program during 2006-2010 i s in conformity with the shares determined in the Strategy Paper, including a 45 percent share for DIS. The 2006 budget has been allocated consistently with the Strategy. 39. Through the Agricultural Strategy Paper Government took the initial steps of recasting the shape of the agricultural transfer budget to address a number of key agricultural sector challenges and initiate programs more broadly targeted to rural development. There are two key factors motivating this approach. First, there i s a widely held view in the Government that the DIS Program, although serving the useful purpose of income support for farmers (in the transition after subsidy reduction), should be better targeted to exclude wealthier farmers. Second, there i s the view that the DIS Program needs to be accompanied by transfer policies which aim to promote productivity and market development more directly. 40. The other encouraging aspect of planned adjustments i s that 30 percent of the transfer budget i s to be allocated to productivity enhancing measures, including (a) grants to farmers for stimulating environmentally sustainable agricultural practices and alternative crops to tobacco, hazelnut, and sugar; (b) investment grants awarded on a competitive basis for agribusiness and other rural SMEs, as well as for public providers of infrastructure and services; and (c) agricultural sector risk mitigation through partial coverage of crop insurance premia for farmers. These areas are the main source of the planned reduction in the share of the DIS program (from about 80 percent of total agriculture subsidies to 45 percent, as institutionalized through the Agriculture Framework Law and the Agriculture Strategy Paper). 9  11.FinancialSector Reform A. InstitutionalDevelopmentof BRSA andSDIF 3. The Borrower satisfactorily has enacted amendments to the Banking Act and has implemented such amendments as well as the BRSA strategicplan and the SDIF institutionaldevelopmentstrategyplan. 41. This three-part condition has been met. The Parliament passed a set of comprehensive amendments to the Banking Act in July 2005, which substantially broadened and clarified BRSA's scope of responsibilities including various of its core competencies, such as: (a) licensing banks; (b) defining related parties; (c) establishing new limits on the credit exposure of related parties; (d) specifying corrective measures to be taken against bank directors; (e) establishing explicit legal protection for BRSA staff in the performance of their duties; and (f) expanding the legal basis of BRSA staff to examine banks. The World Bank and other international financial institutions, most notably the IMF, provided significant comments and technical assistance throughout the drafting of the Banking Act. Implementation of the new Banking Act i s to be supported by more than fifty new or amended regulations, which once fully in place later in 2006, will enable to the BRSA to better fulfill its responsibilities as a modern financial supervisory authority. 42. The World Bank offered several rounds of comments on various working drafts of the Strategic Plan prepared by BRSA as the agency has adapted its strategies in response to the rapidly changing environment since 2001 - including the major changes in the agency and in the industry resulting from the enactment of the 2005 Banking Act. The World Bank has been supportive of the aims contained inthe various versions of the plan, which by definition must be a living document. 43. The current version of the plan outlines the Agency's eight main values and i s supported by a detailed matrix of five strategic goals and a large number of underlying separate activities and measures used to determine progress in achieving the agreed strategic goals. Progress in implementing the plan includes the following actions among others: the completion of implementing the organizational changes introduced by the Banking Law and progress in preparation of supporting regulations to bring them in line with the EUdirectives and Basle core principles (expected to be completed in November 2006). BRSA considers 2006 to be a transition year for risk based supervision and has prepared supervisory guidelines for this purpose. The year 2006 i s also intended for strengthening the regulatory framework for non bank financial institutions. Implementation of the Strategic Plan i s one of the key guiding principles for BRSA. The BRSA senior management will update the strategic plan by taking into consideration BRSA Board views, World Bank comments, the recently launched Financial Sector Assessment Program(FSAP) and EUaccession negotiations. 44. As to the SDIF's Institutional Development Plan (IDP), the SDIF Board of Directors approved in September 2005 an IDP for 2005 through 2007 which spells out the Agency's vision, four strategic goals and a set of underlying strategic objectives 10  supporting the respective goals. The World Bank provided the SDIF a number of inputs in the development of its draft IDP. Moreover, the Agency established and resourced a new `Strategic Development Department' to oversee implementationof the multi-faceted IDP. B. ExecutionandBankruptcyAct 4. The Borrower has satisfactorily implemented regulations to the Execution and BankruptcyAct. 45. This condition has been met. The Government recognizes that a better functioning banking sector requires a legal framework that addresses creditor rights, formalhnformal corporate insolvency and restructuring systems to allow for improved credit risk management practices. In this context, amendments to the Execution and Bankruptcy Act (EBA) were enacted in December 2003 to introduce pre-packaged options and to complement earlier amendments enacted in July 2003. The implementing regulations of the law were issued by the Ministry of Justice in April 2004. The Government continues to effectively implement secondary regulations of the EBA law. C. StateBankRestructuringandPrivatization 5. The Borrower, through its Council of Ministers, has adopted a satisfactory restructuringandprivatizationstrategyfor Halk and Ziraat and such strategy is beingsatisfactorily implemented. 46. This two-part condition has been partially met. (Waiver requested for the second part related to Ziraat Bank). Halk Bank is the sixth largest Turkish bank by assets. At the end of 2005, the authorities launched through a November 2005 decision of the High Privatization Council,' an international tender to engage a financial advisor for the sale of Halk Bank. An advisory and sale mandate was awarded to an international consortium lead by the investment bank Goldman Sachs in April 2006. In accordance with the contract terms, the advisor i s to outline for the shareholder in June 2006 the different strategic options for selling Halk Bank to the private sectcr. Subsequently, the Government i s expected to announce the decision of which specific option to be pursued. Investor interest in Halk Bank has been high, which bodes well for the privatization process. 47. With regards the waiver sought for the divestment of Ziraat Bank, the Government's interest i s to first benefit from the lessons learned through the Halk Bank offering before proceeding with the sale of Ziraat Bank, the largest (state or private) bank in Turkey. In addition, the authorities are concerned about potential "cannibalizing" in `The HighPrivatizationCouncil was established throughthe PrivatizationLaw No.4046.The Council i s chaired by the Prime Minister and consists of the Ministers that are relevant to economic policy and privatization, namely the Minister of State incharge o f the Economy, the Minister of Finance, the Minister of Transportation and the Minister of Industry and Trade. The PrivatizationAdministration acts as the secretariat of the Council. 11  the sale of both state banks by attempting to sell two of the largest banks in the country simultaneously while also issuingshares of Vakif Bank - another state controlled bank. 48. In the interim the Government has assumed a very active shareholder role in overseeing Ziraat Bank. Its Board of Directors was re-configured and a senior level steering committee established to develop and put in place an extensive operational restructuring plan (entitled "Strategic Road Map") to ready the bank for its envisaged privatization. Further to which, Government in collaboration with Ziraat Bank has developed a time-table to systematically un-wind the historical `burdens and privileges' the bank has long been obliged to fulfill (for example, removing the `burdens' of mandatory tax collections and payment of public employee salaries and pensions, and similarly, the `privileges' such as mandatory state-enterprisedeposit requirements, etc). 6. TheBorrower has reviewedthe due diligencereport and, through its Council of Ministers, has adopted a satisfactory private sector strategy for Vakif and such strategy is being satisfactorily implemented. 49. This condition has been met. The authorities reviewed Vakif Bank's due diligence report titled "Strategic Roadmap for Vakif Bank's Privatization" dated October 2004. The recently enacted Banking Law gave Vakif Bank legal authority to issue a new "D" series of shares which is the only legally viable instrument to bring about private sector control of Vakif Bank in view of its intricate ownership structure. An Initial Public Offering of about 22 percent stake in Vakif Bank was successfully floated in the autumn of 2005, which brought the first private sector participation into the bank's ownership structure through a single seat on Vakif`s Board of Directors. 50. The Government has confirmed its private sector strategy for Vakif Bank and highlighted the progress in implementing this strategy. A key element of the strategy i s to increase the value of the Bank by continued restructuring, product development and profitability enhancement, which resulted in a recent upgrade in the ratings of Vakif Bank by key rating agencies. The Government envisions a series of subsequent IPOs leadingto majority private control or depending on expert advice and market conditions, a block sale of shares to strategic investors, and i s prepared to undertake any needed legislative changes or amendments to the Bank's articles of incorporation towards this goal. The Government expects to fully implement the strategy within one or two years, depending on expert advice and market conditions. 111.PublicSectorReform D.StructuralFiscalPolicies 7. The Borrower has made satisfactory progress in the implementation of its medium-term strategy to improve the tax system. 51. This conditionhas beenmet. The Government adopted in May 2005, a law on the establishment of the Presidency of Revenue Administration (RA). This law restructured the General Directorate of Revenues into the Presidency of Revenue 12  Administration which has been established as a semiautonomous entity under the Ministry of Finance. RA is structured functionally, with local tax offices directly under its control. The function of collecting revenues performed by the fiscal offices in the provinces was transferred directly to the RA. Tax Office Presidencies were established in 29 provinces thus providing a direct linkbetween the RA's central and field units.Within the principle of separating the stages of determining revenue policies and implementation of such policies, a separate unit to determine revenue policies was created within the Ministry of Finance. However, the progress has been slow in setting up a large taxpayer unit,reorganizing the new RA along functional lines and increasing control over regional offices. Continuation of the tax administration reform, including for example the establishment of a large tax-payer unit, i s also supported by the IMFprogram. 52. A medium-term strategy for improving the tax system inTurkey has been inplace since 2000, based on a review carried out jointly with the World Bank. The overarching objective of the strategy i s to improve the stability, transparency and equity of the tax system through measures to minimize tax distortions, broaden the tax base and improve the efficiency of tax administration. 53, Implementation of the tax strategy has progressed reasonably well. On the tax policy side, a unified special consumption tax to consolidate a range of excise and specific taxes into a single tax charged on a limited range of luxury goods was enacted in June 2002. The first legislative package under the direct tax reform was submitted to Parliament in March 2003 and enacted in April. This legislation harmonized tax rates on income from financial investments at the declaration stage, simplified and harmonized the system of investment incentives, reformed the system of income tax credits and simplified taxation of corporate earnings and dividends. 54. The first stage of personal income tax (PIT) reform has been implemented by the enactment of the Law reducing the number of brackets and unifying the wage schedules in March 2006. The new PIT schedule consists of four tax brackets instead of five brackets and the tax rates are 15, 20, 27 and 35 percent, respectively and it unifies the wage and non-wage income. The second stage reforms will aim at broadening the tax base and replacing the existing system of expenditure credits with a system of standard credits. Turkey has also initiated reforms for simplifying the corporate income tax (CIT) as well as reducing its rates. The CIT rate was reduced from 33 percent to 30 percent for corporate income earned in 2005 and the government has announced that the rate will be further reduced to 20 percent in 2006 with a competitiveness consideration consistent with the developments and the trends in the European Union and OECD countries. The related law reducing the CIT rate to 20 percent and bringing about simplifications in the schedule has been submitted to parliament and i s expected to be enacted soon. With the enactment of this law, the content of the exemptions and allowances in CIT will be narrowed and investment tax allowances will be gradually phased out. In addition, starting January 1, 2006, interest and capital gains - including on previously exempt government securities-have been made subject to a flat 15 percent final withholding tax, helpingto further harmonize, simplify, and broaden the base of the income tax system. 13  8. The Borrower has made satisfactory progress in the implementation of its comprehensivepublic employmentprogram. 55. This condition has been met. The comprehensive public employment program initiated under PFPSAL program i s part of the longer-term strategy to modernize the public sector, ensure medium-term fiscal sustainability and free up resources for the private sector and job creation. In this context, the Government continues to implement its quarterly public employment monitoring program. Quarterly public employment figures for consolidated budget agencies, SOEs, local administrations, state banks and social security institutions are being monitoredby a committee chaired by the Ministry of Finance and quarterly employment tables have been provided to the Bank since the initiation of the system in 2002. The latest available data for end-2005 have been submitted to the Bank at end-March 2006. The quality of the data reported i s being improved over time as indicated for example in the shift from reporting only the number of cadres for the permanent workers in central government agencies to reporting occupied cadres, starting from the secondquarter of 2005. 56. Notwithstanding one-off policies for hiring new staff in selected sectors when required on public policy grounds -- as, for example, in the case of granting 22,000 temporary personnel in the health sector; employment policies have been consistently implemented in 2004 and 2005. The cap on the number of civil servants in the consolidated budget agencies has been maintained at 1.7 million. Employment in SOEs continued to decline in 2005 in line with the policy of limiting replacement hiring and as a result of privatization, especially of big SOEs like Turk Telekom. The total employment in SOEs declined from around 320,000 at end-2004 to slightly above 246,000 at end-2005, representing a 23 percent decline. This i s consistent with the policy of addressing the over-employment in SOEs. A government assessment of redundancies in SOEs as of January 2002 had resulted in an overall attrition of over 59,000 between February 2002 and mid-March 2004. E.PublicExpenditureManagementandFinancialAccountability 9. TheBorrower has enacted a satisfactory extra budgetaryfund law. 57. This condition has been met. As part of the economic stabilization program initiated by the Government in 1999, and the commitment given to the Bank under the Economic Reform Loan (ERL) and the Programmatic Financial and Public Sector Adjustment Loan I(PFPSAL), a total of 69 budgetary and extra-budgetary funds (EBFs) have been abolished. As a first step, a total of 27 budgetary and extra-budgetary funds were abolished in 2000. The funds were either not operational or had lost their functions through time and did not have any appropriation allocated since 1993. Additionally 42 other funds were abolished with legislationthat became effective inJanuary 2002. 58. Despite the formal closure of the funds to meet the initial objective of improved fiscal control, transparency, accountability and comprehensiveness of the budget, the above mentioned legislations also allowed the Government to continue collecting the special revenues of these funds and to transfer them to the accounts of the corresponding 14  agencies as special appropriations. Therefore, even though the legislation for closure had been enacted, in practice the ear-making system continued to be in operation for 24 funds out of the 69 funds closed since the beginning of 2000. 59. Nonetheless, with the enactment of law no.5217 dated July 14, 2004, the Government eliminated the earmarked revenue and special appropriations mechanism system. The only exceptions to these are Ministry of Education's revenues left from the closed Apprenticeship and Vocational Training Fund and Universities Research Funds. For Universities Research Funds, special appropriation mechanisms were discontinued with the effectiveness of the PFMC law, as Universities became special budget institutions, and their special revenues became part of their budget. The Government will, in agreement with the Bank, undertake the special appropriation allocation for Ministry of Education inline with the Public FinancialManagement and Control Law. 10. The Borrower has submitted a satisfactory new Turkish Court of Accounts Law clearly defining the scope and types of audits, in conformity with the Public Financial Management and ControlLaw, to Parliament. 60. This condition has been met. Enactment of the Public Financial Management and Control (PFMC) law enabled TCA to carry out audits of all budget executing institutions including Presidency, and removed the requirement of TCA's ex-ante involvement inthe budget execution, which could hinder independence and objectivity of an audit institution. The PFMC Law also requires TCA audit of accountability reports prepared by line ministries. Inorder to ensure consistency with the PFMC law and to reform TCA inline with international best practice, a draft TCA law was submitted to the Parliament on February 25, 2005. The draft law aims to significantly alter the existing TCA law in several respects - it envisages extension of TCA's mandate to cover the general government institutions (in line with the PFMC law) and the State-owned Economic Enterprises, and to certain other bodies which use public funds. Second, the draft law clearly defines the types of audits that TCA can carry out including financial audits and performance audits, in addition to compliance/regularity audit. The new law, which i s expected to be enacted as part of the Programmatic Public Sector Development Policy Loan (PPDPL) program supported by the Bank, will have a profound impact on the working of the TCA by enhancing the emphasis on financial and performance audit from the current focus on compliance audits andjudicial work. 61. An effective supreme audit institution is an essential element for public sector accountability. These reforms would enable TCA to become an effective supreme audit institution and strengthen public sector accountability. The PFPSAL program has supported external audit reforms including drafting of a new legal framework. The proposed PPDPL program i s expected to support the full implementation of these reforms. The TCA will continue to receive technical advice from the Bank and support from EUa twinning project with the National Audit Office of the United Kingdom. The twinning project i s assisting TCA in developing audit standards consistent with EU guidelines, revamping the organization structure, and training its staff in financial and performance audits. As part of this project, TCA will also undergo a peer review process to be conducted by the Spanish Supreme Audit Institution. 15  62. While awaiting the enactment of the new law, the TCA and its twining partner have begun working on the implementation plan for successfully implementing the new law. The Bank will play an important role in this exercise by providing technical assistanceand advice in preparing secondary legislation. F.PublicSector Governance 11.TheBorrower has enacteda satisfactory code of conductfor civilservants. 63. This condition has been met. The Law No. 5176 on the establishment of an Ethics Board for civil servants was enacted in June 2004. The law established the principles and procedures of the establishment of the Civil Servants Ethics Board and set out the duties of the Board as follows: (a) to determine the code of conduct for civil servants through regulations, (b) to investigate claims of violation of code of conduct and report the findings of such investigations to the relevant authorities and (c>to carry out, commission or support studies with the aim of establishing ethical culture in the civil service. The members of the Board were appointed and met for the first time in September 2004 and the Boardhadits first meeting at the end of September 2004. 64. The regulation on the Code of Conduct for civil servants was issued in April 2005. The regulation required that, within three months after issuance, all civil servants covered by the law need to sign an ethics contract which i s an annex to the regulation. All civil servants covered by the law have signed the contract and new staff i s required to sign it before they start their job. The Ethics Board i s engaged in an extensive communications program aimed at promoting the Code of Conduct and providing training to civil servants. In this context, the Board has been holding meetings with media and organizing seminars and conferences in addition to publishing and distributing widely, information on the Code of Conduct. Training i s being providedto civil servants, and studies are underway to incorporate this training in the in-service training programs of agencies. In addition, there i s ongoing collaboration with universities for designing a programfor Ethics Certification, which would be aimed at certifying trainers. The Ethics Board has received close to 80 complaints in 2005, which were investigated and forwarded to the relevant agencies. 12. The Borrower has made satisfactory progress in thepreparation of a civil service reform strategy. 65. This condition has been met. The State Planning Organization finalized the functional review of the government which was transmitted to the Bank in early June 2006. The draft functional review was prepared in 2004 and shared with the Bank in September 2004. The study aimed at clarifying the duties and authorities of public institutions and identifying overlaps and conflicts among them. The government recognizes that such conflicts among public institutions represent a major obstacle for the efficiency and effectives of the functioning of the state. As part of the implementation process of the recommendations of the study, the Government abolished some institutions including for example, the General Directorate of Rural Services and the Undersecretariat of Housing. 16  66. Implementation of the Government's comprehensive agenda on public sector reform has continued with other important actions most notably the drafting of a new law on Public Personnel. The draft law aims at: (a) improving efficiency; (b) eliminating discrepancies in remuneration across similar positions within the public sector; (c) making it easier to ensure a fiscally sound wage bill; and (d) providing competitive opportunities for entry into the public administration. 17