Turkey - Structural Adjustment Loan Projects

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 4015 TURKEY'S STRUCTURAL ADJUSTMENT A PROGRAM PERFORMANCE AUDIT REPORT: FIRST STRUCTURAL ADJUSTMENT LOAN (NO. 1818-TU) AND SUPPLEMENT (NO. 1915-TU) June 30, 1982 Operations Evaluation Department rIECO Y This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  ABBREVIATIONS DYB - State Investment Bank IMF - International Monetary Fund OECD - Organization for Economic Cooperation and Development PIR - (World Bank) Public Investment Review Report SAL - Structural Adjustment Loan SDR - Special Drawing Right SEE - State Economic Enterprise SPO - State Planning Organization TL - Turkish Lira CURRENCY EQUIVALENTS TL per US$ 1978 March 25.25 1979 June 47.10 1980 January 70.00 August 80.00 December 91.75 1981 April 98.20 June 107.50 September 121.10 1982 January 138.00 April 147.30 FISCAL YEARS Until February 1982, fiscal years from March 1.  FOR OFFICIAL USE ONLY A PROGRAM PERFORMANCE AUDIT REPORT TURKEY: FIRST STRUCTURAL ADJUSTMENT (LOANS 1818-TU AND 1915-TU) TABLE OF CONTENTS Page No. Preface .................... i Basic Data Sheet .iii Highlights. v PROGRAM PERFORMANCE AUDIT MEMORANDUM I. INTRODUCTION. 1 Growth and Diversification of Turkey's Economy. 1 The Pattern of Development. 1 External Shocks. 2 Required Adjustments. 3 The January 1980 Program. 3 II. THE LOANS. 3 SAL I Background. 3 Design of SAL I Loan. 5 Growth Versus Inflation. 6 Export Expansion. 8 The Balance of Payments and Capital Inflows .11 Imports and Capacity Utilization .13 Protection and Incentives Systems .14 Domestic Resource Mobilization .15 Private Credit and Mobilization of Private Savings 18 Level of Public Investment .20 Priorities and Composition of Investment .22 Incomes Policy .24 Reforming the SEEs .25 III. BROADER IMPLICATIONS .26 Follow-up and SAL II .26 Comments on Policy Dialogue .28 Bank-Fund Collaboration .29 Conclusion .30 Annex A: Schedule 5 of Loan Agreement (SAL I) .32 Annex B: Schedule 5 of Loan Agreement (SAL I, Supplement) .33 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  TABLE OF CONTLNTS (Continued) Page No. Statistical Annex Table 1: Indicators of Price Change ........... .. ............. 34 Table 2: Real Exchange Rates for Turkish Lira ........ ........ 35 Table 3: Main Outline of Turkey's Balance of Payments 1979-81 ............... .. ................. 36 Table 4: Consolidated Budget and SEE Finances ............... . 37 Table 5: Credit to Private Sector and Households ............. 38 PROJECT COMPLETION REPORT .......................................... 39 Monitoring of Policy Areas under SAL I and its Supplement 40 Progress in Areas Monitored ................................... 40 Loan Impact and Implementation ................................ 44 Summary and Conclusions ....................................... 45 Annexes: 1. Memo to EDs on Second Tranche Release ..................... 48 2. Memo to EDs on Third Tranche Release .................. .... 53 3. Supplemental Letter to SAL I Supplement on Protection Study ....... ................................. 57 4. Supplemental Letters to SAL I Supplement on External Debt Study ..................................... 66  - i - A PROGRAM PERFORMANCE AUDIT REPORT TURKEY: FIRST STRUCTURAL ADJUSTMENT (LOANS 1818-TU AND 1915-TU) PREFACE The present Performance Audit Report covers the first Structural Adjustment Loan (SAL) made to Turkey, together with its Supplement. Loans No. 1818-TU for US$200 million, signed on March 25, 1980 and No. 1915-TU for US$75 million, signed on November 24, 1980 were both made to the Government of Turkey and were fully disbursed by October 1981. Prior to these loans the Bank had advanced a Program Loan to Turkey (Loan No. 1627-TU for US$150 million in November 1978) which is the subject of a separate Performance Audit Report. A Second Structural Adjustment Loan (Loan No. 1987-TU for US$300 million) was made in May 1981 and a third SAL (for US$304.5 million) was approved by the Board on May 27, 1982. During the period covered by SAL I and its Supplement, the IMF reached a number of arrangements with Turkey which were closely related to the Bank operations under review; these are touched upon in this report where appropriate. The report comprises a Program Completion Report (PCR) prepared by the Europe, Middle East and North Africa Region and a Program Performance Audit Memorandum (PPAM) prepared by the Operations Evaluation Department (OED). In preparing the latter, extensive documentation research was under- taken and discussions held with staff members in the Bank and the Fund. A field mission to Turkey was undertaken by a staff member and an OED consultant in October 1981. Discussions were conducted with the Prime Minister's Office, the Ministry of Finance, the State Planning Organization, the Central Bank, Turkish Industrial Development Bank (TSKB), commercial banks, Chambers of Commerce and Industry, and representatives from the private sector, the academic community and others. OED is most grateful to the Government and the various institutions and individuals visited for the help given and the courtesies extended to the mission. The PCR provides a discussion of the actions taken by the government concerning those policy areas selected for special review under SAL I and its Supplement. It also reviews the implementation of these loans and their contribution to Turkey's adjustment program. The Audit Memorandum examines the design of SAL I, and reviews progress of policy actions in order to arrive at an independent evaluation of the loan effectiveness. It also considers whether the experience gained was adequately reflected in the design of SAL II.  - ii - As background to the present series of operations in support of structural adjustment, the Audit Memorandum comments on the evolution of the macro-economic policy dialogue between the Bank and the Turkish authorities. In so doing, the audit has made use of information that has become available subsequent to the initiation of SAL I and its Supplement, in particular the Bank staff draft reports on trade policy and on public investment. SAL I was initially conceived as a second program loan. The evolution of thinking in the Bank and economic conditions in Turkey, however, led to its presentation in support of structural adjustment. Inevitably, the operation had an experi- mental aspect and lacked some of the characteristics - especially the full definition of policy objectives and monitorable actions - that have come to mark subsequent operations of this type. This fact has reinforced, in this case, OED's normal practice in performance auditing to include some comment on the follow-up operation. Finally, it should be added that the SAL process is a long one, and earlier operations, by their nature, unfold into later ones with a continuity that is difficult to break. Subjecting a slice of this continuum to perfor- mance audit has obvious limitations; defining the boundaries of legitimate comment is difficult. And yet, it would be incorrect to have waited until the process of structural adjustment in Turkey is completed, given the internal and external uncertainties in reaching such an outcome. This audit is, therefore, offered in full awareness equally of the difficulties inherent in an early assessment of a process that is still incomplete, as of the need to bring such an assessment to the Executive Directors and the management without delay. Discussion of earlier drafts of this audit has coincided with the preparation of Turkey SAL III, and may have had a beneficial effect on the design of that operation. Copies of the draft report were sent to the Borrower on March 19, 1982, but no comments have been received.  - iii - PROGRAM PERFORMANCE AUDIT BASIC DATA SHEET TURKEY: FIRST STRUCTURAL ADJUSTMENT (LOANS 1818-TU) PROJECT DATA (US$ Million) As of 03/31/82 Original Disbursed Cancelled Repaid Outstanding Loan 1818-TU 200.0 200.0 0 0 - Cumulative Loan Disbursement FY80 FY81 (i) Estimated 90.0 200.0 (ii) Actual 17.0 200.0 (iii) (ii) as % of (i) 19 100 Original Dates Actual Dates Board Approval 03/25/80 03/25/80 Loan Agreement 03/26/80/a 03/26/80 Effectiveness 04/28/80- 04/01/80 Loan Closing 09/30/81 03/31/81 MISSION DATA Month, No. of No. of Man- Date of Year Weeks Persons weeks Report Identification - - - - - Preappraisal - - - - - Appraisal 07/79 - - - 02/29/80 Supervision I 06/9-27/80L.a 2 3 6 07/07/80 Supervision II 09/24/80 2 3 6 10/17/80 Supervision III 10/03/80c - - - - Supervision IV - - - - - Supervision V - - - - - Completion 06/8a/d 1 - 1 12/17/81 FOLLOW-ON PROJECTS Turkey Structural Adjustment (Supplement), Loan No. 1915-TU, approved on November 18, 1980, in the amount of US$75.00 million. /a Or earlier if conditions of effectiveness satisfied. /b First Review on progress of SAL I and appraisal of proposed SAL I (Supplement). |c Second Review on progress of SAL I. /d Necessary work for completion report done during another mission.   - iv - PROGRAM PERFORMANCE AUDIT BASIC DATA SHEET TURKEY: Structural Adjustment Supplement (LOANS 1915-TU) PROJECT DATA (US$ Million) As of 03/31/82 Original Disbursed Cancelled Repaid Outstanding Loan 1915-TU 75.0 74.98 0 0 Cumulative Loan Disbursement FY81 FY82 FY83 (i) Estimated 47.8 72.7 75.0 (ii) Actual - - - (iii) (ii) as % of (i) 154 103 100 Original Dates Actual Dates Board Approval 11/18/80 11/18/80 Loan Agreement 11/24/80 11/24/80/a Effectiveness 02/25/81 01/07/81/ Loan Closing 08/31/81 10/31/81 MISSION DATA Month, No. of No. of Man- Date of Year Weeks Persons weeks Report Identification - - - - - Preappraisal - - - - Appraisal 06/9-27/801b. 2 2 4 10/30/80 Supervision I - - - - - Supervision II - - - - Supervision III - - - - - Supervision IV - - - - - Supervision V - - - - - Completion - /c - - - 12/17/81 FOLLOW-ON PROJECTS Turkey Structural Adjustment II, Loan No. 1987-TU, approved on May 12, 1981, in the amount of US$300 million. /a Or earlier if conditions satisfied. /b Negotiating/appraisal missions. Office Memorandum of 07/07/80. /c Necessary work for completion report done during SAL II pre-appraisal mission (November 1981).   -v- A PROGRAM PERFORMANCE AUDIT REPORT TURKEY: FIRST STRUCTURAL ADJUSTMENT (LOANS 1818-TU AND 1915-TU) HIGHLIGHTS The first Structural Adjustment Loans (SAL I: Loan No. 1818-TU, signed in March 1980 and its Supplement: Loan No. 1915-TU signed in November of the same year) were made to Turkey when the economy of the country was in a state of crisis. Inflation (in terms of the implicit GNP deflator) was running at an annual rate of 73 percent in 1979; exports could only pay for less than half of the imports in 1978 and 1979 (the latter constrained to essentials for sustaining domestic activity); the current account of the balance of payments continued to be substantially in deficit (US$3.6 billion in 1977; US$1.7 billion in 1978; US$1.8 billion in 1979) and capital inflows were sharply declining. Arrears mounted on payments for imports and for debt service, and the short-term debt (before debt rescheduling) had grown from under $300 million in 1974 to $8.4 billion in 1978. In the same period gross official reserves had declined by half, and economic growth had ground to a halt, giving way to negative growth in 1979. This accentuated the economy's structural tendency toward unemployment and underemployment and fueled growing labor unrest (PPAM, paras. 2-4). ii. Amid internal political difficulties that rendered basic adjustment difficult, external relief came in the shape of a series of debt resched- ulings, beginning in 1978, stabilization arrangements worked out with the Fund, and OECD extraordinary assistance, among others (paras. 34-35). A major shift of policy was declared in January 1980: away from administrative controls and inward-looking strategies and in the direction of a better resource balance, greater use of market forces and more liberal external trade. It presaged the structural adjustment process which the Bank began to support by the lending operations under review. iii. The immediate objective of SAL I and the Supplement was to make quick disbursing funds available to Turkey in support of the program of reforms already initiated. The timing of the operation, however, did not permit the kind of thorough advance economic work which has marked a number of similar Bank operations in other countries. Quantitative objectives agreed under SAL I were few, the emphasis being on policy change which the borrower undertook to effect and to discuss intermittently with Bank staff before tranches of the loan were released. The major objectives of the program were to reduce inflation, increase foreign exchange earnings, and improve domestic resource mobilization in the public and private sectors. Priority was given to export incentives and institutional arrangements in support of exports; studying the protection and incentive system; improving external debt manage- ment; eliminating the overall public deficit in 1980; reviewing measures to encourage private savings and time deposits; harmonizing public investment and adjusting its composition to the new priorities.  - vi - iv. Progress was made in practically all the areas earmarked for reform, thus enabling the Bank to proceed with SAL II and, later, with SAL III. Significant success was achieved in reducing inflation from over 100 percent in 1980 to under 40 percent in 1981 when GNP began to expand, propelled by rapid growth in exports (paras. 20-21). The target set for export growth (of 10 percent per annum in 1979-82 in real terms) was readily realized (para. 39), though some of the institutional reforms were not carried out in the form agreed upon. The Lira was effectively devalued, and the rate of exchange made flexible. Preferential access of exporters to credit turned out to be far more effective in promoting exports than either the credit insurance scheme or the exporters' foreign exchange retention scheme, both of which received emphasis under SAL (paras. 25-29). Workers' remittances also increased. The balance of payments improved on current account, and higher imports facilitated the growth of exports, although the impact on capacity utilization in industry was mixed (paras. 38-39). Though radical reforms of the protec- tion and incentive systems were not expected under SAL I and Supplement, some progress was made, particularly after the Bank's Industrialization and Trade Strategy Mission of May 1981 (paras. 42-46). v. The objective of eliminating public deficit in 1980 was not achieved; nor was it (apparently) intended, considering that there existed no consolidated public sector accounts. It appears, however, that public savings did increase, owing partly to wage restraints, but public investment, instead of stabilizing, actually increased and its rationalization is still incomplete (paras. 76-78). Interest rates became positive (paras. 60-61), but the overall success of the domestic resource mobilization program in 1980 and 1981 was limited (para. 65). Some progress was made towards improving the recording of external debt, but the objective of improving debt management is yet to be put to the test once Turkey's ability to contract new debts is fully restored (para. 35). vi. Overall, the prospects appear bright for Turkey's ability to com- plete its structural adjustment over the medium term. Other areas of reform have been adressed by the Bank under subsequent SALs, and the results of various studies of the economy undertaken since the initiation of the program are emerging to guide policy changes. A by-product of this process has been the greatly improved dialogue between the Bank and the borrower in support of Turkey's economic development. While the cost to the Bank of increased economic work on Turkey since the adjustment process has been high the results of this work have contributed to the improved design of SAL III.  A PROGRAM PERFORMANCE AUDIT MEMORANDUM TURKEY: FIRST STRUCTURAL ADJUSTMENT (LOANS 1818-TU AND 1915-TU) I. INTRODUCTION Growth and Diversification of Turkey's Economy 1. Thirty years ago, when the Bank began operating in Turkey, the country was underdeveloped, income per capita below US$200,1/ and agriculture contributed 45 percent of GDP and industry only 12 percent. Agriculture led economic development in the fifties, but during the next two decades, under the umbrella of comprehensive economic planning (which began in 1962), indus- try became the focus of the development effort. During this period of planned development, and until the current balance of payments crisis which first became evident in 1977, economic growth was rapid, averaging 7 percent a year. In the process the economy was transformed structurally so that by 1980 agriculture contributed a quarter of GDP and industry 21 percent, and per capita income exceeded US$1,100. The Pattern of Development 2. The pattern of development adopted by Turkey in this period rested on three fundamental elements. First, active public participation in the economy through State Economic Enterprises; secondly, employment of capital- intensive methods of production in preference to labor-intensive techniques in pursuit of modernization; and thirdly inward orientation of production to substitue for imports irrespective of whether or not the country had, or was expected to develop, a comparative advantage in the activities promoted. The macro-economic policies that were pursued during this period complemented this approach, and led among other things to an overvalued exchange rate; excessive protection given to domestic industrial production through tariffs and quanti- tative controls on imports, which blunted the edge of competition and fostered inefficiency; low interest rates which discouraged savings, particularly financial savings, and, in combination with the overvaluation of the lira, kept capital cheap and militated against labor employment; and State Economic Enterprises which lacked managerial autonomy and whose production, employment and pricing practices often addressed national social and economic needs to the detriment of their own profitability and thus forced them to rely on a greatly overburdened public treasury for finance. Meanwhile the structural problem of unemployment and underemployment, which had been alleviated some- what by migration to other countries, had gradually become much more serious. 1/ Equivalent to some US$630 in 1980 prices.  -2- External Shocks 3. Turkey's economic problems were further compounded in the seventies by the energy problem, the serious deterioration of its terms of trade and the recession, inflation and rising unemployment in the industrial countries. The considerable rise of world petroleum prices in the early seventies coincided with the decline of local extraction rates. Under the impact of low domestic prices and rapid economic growth, petroleum consumption expanded, as did the petroleum import bill, which in 1977 absorbed 84 per cent of the proceeds of the stagnating exports. Inflation in Turkey's trading partners also raised the prices of other imports of goods and services as well as interest on external borrowing; and the rise of unemployment affected Western Europe's ability to continue to absorb Turkey's migrant laborers, the source of substantial foreign exchange earnings. The shock of the payments crisis which was evidenced most clearly in 1977 and 1978, and the attendant accumulation of arrears on payments for debt service and imports, and the decline of capital inflows, in addition to the slowing down in economic activity that resulted from the lack of essential imports, all helped to crystallize thinking in Turkey about the required adjustment and emphasize the inevitability of action. Such crystallization, however, was slow and difficult to accept. Turkey "took an inordinately long time, compared to almost all other develop- ing countries, to make appropriate adjustment..."l/. 4. Political instability during the latter part of the seventies did not advance the chances of implementing the required change which meant short-and medium-term sacrifices during a period of structural adjustment, in production and employment, reduced overall growth and decline in certain activities, and perhaps also changes in the distribution of income which could be destabilizing. The economic problem was further complicated by a raging inflation which was fueled also by reduced imports. Required Adjustments 5. The ability of Turkey to continue with past economic policies had come gradually to be doubted with the periodic recurrence of balance of pay- ments crises. Both from within Turkey and from outside (particularly Bank missions and the IMF) alternative approaches to development were intermit- tently discussed with the authorities, but the dialogue on these matters was never easy. 6. Within Turkey there developed a conflict between those who advocated a new approach based on an outward-looking development strategy giving more rein to market forces, and those who, while conceding the need for a more 1/ World Bank, Turkey: Policies and Prospects for Growth, (Report No. 2657a-TU), December 12, 1979, Volume I, page ix, para. 31.  - 3 - outward-oriented strategy, wanted to conserve as much as possible of the old system, characterized by public sector dominance and administrative controls, claiming that more efficient planning and administration would restore the economy to its previous health. Although the private sector had grown con- siderably in the sixties and early seventies, contributing much to Turkey's rapid growth on a wide front of activities that spanned industry, trade and agriculture, there were claims that it was unduly favored by protectionist policies and government incentives; and that the private sector entrepreneurs of Turkey have been mainly rentiers in a system of public controls which they had learnt to manipulate. 7. The successive governments that began to grapple with Turkey's economic difficulties in the late seventies were gradually moving toward recognizing the necessity of turning the economy outward. But controversy over the part to be played by the private sector and market forces seemed to freeze action on reform. The Fourth Plan itself (1979-83), with its high target growth rates for output and exports, while avoiding fundamental policy adjustments, reflected this ambivalence. This program was critically examined by the Bank mission report cited above. The January 1980 Program 8. By the end of 1979, however, a new government, spurred by the crisis, formulated a new economic program much more responsive to the concerns expressed by the Bank, the Fund, and Turkey's other creditors; this program was later supported by the regime that assumed power in September 1980. The role to be undertaken by the private sector and the mix between market forces and administrative controls remain, as in most countries, questions to be addressed on a continuing basis. II. THE LOANS SAL I Background 9. SAL I and its supplement were extended in support of Turkey's commitment to the policies stated in the January 1980 program and communicated to the Bank in a letter dated February 7, 1980. These policies were sum- marized in that letter as follows: '(a) Reliance on economic planning down to micro levels and administra- tive controls to realise planned targets and objectives needs to be shed, and replaced by greater reliance on market mechanisms and forces; (b) Curbing of inflation has more importance and greater priority than the attainment of higher growth rates in the current situation; (c) Import substitution and protection oriented policies, which resulted in bias against exports in favor of the domestic market, must give way to those which encourage both our public and private sectors to improve produc- tivity and, to the extent feasible, be internationally competitive;  - 4 - (d) The fulcrum of our development policy should be to correctly set the rate of exchange and operate an effective exchange rate policy to ensure that our foreign trade orientation changes to one where Turkey should rely heavily in future on export earnings and other foreign currency earning activities, including workers remittances, private foreign investment, tourism and transfer of savings from abroad; (e) Reform of the State Economic Enterprise (SEE) sector is needed so that it no longer constitutes a drain on the Government's budget, nor its investment programs continue to be one of the basic causes of inflationary pressures; (f) Since one of the most alarming features of our economy is the decrease in domestic savings as a percent of GDP, domestic resource mobiliza- tion efforts stressing reliance on taxes, augmentation of public and household savings and greater reliance on the banking system and financial markets, needs to be substantially increased; (g) Utilization of existing productive capacity and essential new investments stressing exports and employment or those removing critical infrastructure bottlenecks must be made, with due consideration to the scar- city of resources." 10. The Bank was convinced that the new policy direction enunciated by the Government was truly responsive to Turkey's needs. Further, some impor- tant actions had already been taken towards implementing a 1979 stabilization program which formed the basis for a standby with the 1MF. Most important among these actions was a more rational exchange rate policy, considered by both the Bank and the Fund as a sine qua non for a fundamental structural change. Already, it appeared that during the course of 1979 some success had been achieved in producing an effective devaluation of the Turkish Lira in real terms, which it was believed would be further consolidated by actions under the 1980 program. The Bank, moreover, was encouraged by the continuing discussions between the Fund and Turkish officials, which led to further releases under the 1979 Standby after the January 1980 program was adopted and before the SAL was brought before the Bank's Executive Directors. Finally, it was decided to go ahead with the loan, even in the absence of a time bound medium-term framework for structural adjustment and despite a lack of specifi- city in many policy areas. Turkey's need was urgent for non-project assis- tance from the Bank as well as from other sources. Without such assistance, and given its foreign debt service obligations, Turkey would not have had sufficient room for maneuver in 1980 and 1981 on the external side to recon- cile the potentially conflicting policy objectives which it had adopted. It was envisaged that a comprehensive and more specific actiOil plan would be progressively developed pari passu with the implementation of the existing program, and that future SALs would be contingent on such progress. Discus- sions between the Bank and the Turkish authorities during --he course of loan disbursement and prior to new loans were supposed to contribute, along with discussions between the IMF and Turkey, to continuing improvement in policy formulation and implementation. The audit finds this approach to have been appropriate and justified in the circumstances.  -5- Design of SAL I Loan 11. The key features of SAL I Loan Documents relating to Turkey's economic program are the following: (a) The Economic Program and Medium-Term Economic Policies are formally described in the letter cited above dated February 7, 1980, from the Under- secretary of the Prime Ministry to the President of the World Bank, and are further articulated in the President's Report. (b) Performance in carrying out this program is to be appraised by the Bank during the disbursement of the Loan and at stated intervals leading to an exchange of views, particularly on the measures described in Schedule 5 of the Loan Agreement. (See Annexes A and B) (c) The Bank shall not permit commitments or withdrawals under the loan beyond specified amounts (or tranches) of the Loan (the equivalent of 40 percent and 75 percent) unless the Bank is satisfied with the progress of the borrower in carrying out the program, particularly on those aspects covered in Schedule 5 of the SAL Agreement. Quantitative objectives were cited in Schedule 5 in a couple of fields. The emphasis, however, was on policies to achieve objectives, whether stated in quantitative or qualitative terms. If during the course of implementation of the policies, it appeared that objectives were either not being pursued, or were not going to be achieved, the reasons would have to be examined. If policies were implemented unsatisfactorily and the Government was unresponsive, the implication was that the Bank could refuse to permit further commitments and withdrawals of the loan proceeds. (d) Subsequent SAL loans would also be conditional upon findings of satisfactory progress on the economic program, with specific items to be selected for special monitoring in subsequent loans on the basis of a new evaluation of critical policy areas. 12. The specific policy areas to be monitored explicitly under Sched- ule 5 covered: (a) the export expansion program; (b) adjusting the composition of public investment to new priorities; (c) regulating the level of public investment; (d) initiating a rationalization of the protective and incentive system by carrying out studies (which were later elaborated under the SAL I Supple- ment; (e) domestic resource mobilization measures, including interest rate policies, which would presumably lead to actions affecting the mobilization of private savings and their more effective deployment;  (f) the size of the public sector deficit; and (g) external debt management. 13. Some of the policy areas listed above may be regarded primarily as supply side, and others as demand side measures; both are viewed as means of restoring growth on a sustainable basis, limiting the size of the balance of payments deficit and controlling inflation. In fact, interaction among the effects of the measures falling under most of these policy areas is so broad that the distinction between demand-management and supply-oriented measures soon breaks down. 14. The agreement under the SAL I and the agreements under IMF standby arrangements with Turkey are in most respects complementary, but are sometimes overlapping. It is illusory to expect exclusive areas of interest. The practical arrangements are, however, for one institution to be primarily responsible for monitoring and for discussing with the Turkish Government certain specific policy actions (such as the exchange rate [IMF] or the size and composition of the public investment program [IBRDI). 15. SAL I was approved in March of 1980. Only three months later a three year standby arrangement was concluded with the IMF. This standby covered with much greater specificity many of the same areas as the SAL, and in some respects incorporated revisions in the Government's program for 1980-81. During the course of 1980, major political changes took place in Turkey, culminating in military intervention in September. While the new Government confirmed its intentions to carry out the program and promoted its architect to a deputy premiership, important changes were made in emphasis. Prospects for implementation, particularly in the field of taxation, interest rates and incomes policy, were greatly improved. Growth versus Inflation 16. Turkey's January 1980 program was based on a realization that the difficulties of 1977-79 arose in large part from an attempt to maintain an unrealistically high rate of growth under adverse external conditions. It will be recalled that the list of major policy objectives contained in the February 7, 1980 letter cited above included the statement: "Curbing of inflation has more importance and greater priority than the attainment of higher growth rates in the current situation." The way in which these two objectives, inflation control and growth, would be balanced was not, however, made explicit in any medium-term program at the time of the SAL. The short- run aspects of this trade-off only became clear as the new agreement with the Fund emerged in mid-year. 17. With respect to the medium-term, the Turkish authorities, in view of many prevailing uncertainties, did not and had not formulated an up-to-date set of growth objectives at the time of audit. The Bank itself at the time of SAL I spoke of a 4.2 percent average rate of growth between 1978 and 1985  instead of the 6.1 percent projected in the December 1979 Economic Report.l/ This reduced rate was found by the Bank to be consistent with balance of payments constraints if substantial capital inflows and debt rescheduling could be obtained. 18. With respect to the short run, a gradualist approach to the control of inflation was already in process in early 1980. The July 1979 letter to the Fund had envisaged "a slowing down of the rate of inflation but this can only be achieved gradually." This gradualist approach was confirmed by the Turkish Government in the June 2, 1980 Memorandum given to the IMF on its economic and financial policies. The Government stated its objective for 1980 to be a 2-3 percent rate of growth, with inflation to be brought down from an average annual rate of 65 percent in 1979 to a rate of 30-40 percent per annum by the end of 1980. 19. The President's Report on the SAL (Supplement) of October 30, 1980, perhaps recognizing that positive growth was unlikely to be achieved in 1980, mentioned a range of 0 and 2 percent, but continued to be optimistic about growth in 1981, projecting it at 3 percent. 20. The actual results in 1980 differed somewhat but not in a basic way from these projections. On the general price level, success was achieved in bringing down the rate of inflation in the latter part of 1980, but the intended reduction was not realized until 1981 when the annual rate dropped to about 35 percent in tfhe course of the year (see Table 1). For 1980, however, the year as a whole had an average rate of over 100 percent which was consid- erably higher than the rate envisaged under the IMF-supported monetary pro- gram. Growth in 1980 was below the original expectations of the Turkish Government, and GNP actually declined. As foreseen in 1980, GNP began to expand in 1981, and the reduction in the rate of inflation accomplished in late 1980 appears to have been consolidated in 1981 and will probably prove to be the lowest rate of inflation in the past four years.2/ 21. Cutting the rate of inflation by two-thirds from its peak while suffering only a one year interruption in growth, must be considered a sub- stantial achievementJ/ As noted below, credit must be given not only to 1/ See "Turkey: Postscript Special Economic Report" (Report No. 2918-TU, dated March 20, 1980). 2/ The latest estimates of output show a reduction in GNP at constant prices by 0.5 percent in 1979 and 0.7 percent in 1980. A 4.4 percent growth is projected for 1981 (see Turkish Government, Prime Ministry, Institute of Statistics, "The Second Estimation of Gross National Product According to Six Months Figures", September 15, 1981). 3/ In fact, growth was also interrupted in the year preceding adoption of the January 1980 program.  -8- the effectiveness of the Government's anti-inflation program, but also to the success achieved in mobilizing foreign capital inflow and in devising measures which had a fairly rapid response in terms of expanded exports and workers' remittances. 22. We must recognize that there probably remained in 1981 imbalances within the Turkish economy which could generate a return to higher rates of inflation, or a more difficult trade-off between inflation and growth. The long-term tendency of the economy toward unemployment and under-employment was aggravated by the slow-down of economic growth, and there was little evidence that the resumption of growth had yet been accompanied by a reduction in Turkey's high rate of unemployment. The readjustment in income shares which occurred in the period 1977-80 may also make it difficult, as noted below, to reconcile the objectives of growth, balancing external payments and inflation control. Until a medium-term program has been formulated by the Turkish Government it will be difficult to judge how good the prospects are for maintaining a reasonable balance among program objectives. 23. Rather disturbing is the conclusion which appears to be emerging in recent Bank staff appraisals of the Turkish economy that medium-and longer- term prospects for a significant reduction in the rate of unemployment are not bright. The Bank was perhaps justified in not pressing the Turkish authori- ties in the context of the present operation for a more precise time bound medium term action program placed within a comprehensive economic framework. The agreement under SAL II also does not envisage the early formulation of such a program, and the Turkish authorities themselves are unlikely to address this problem before a new five-year plan is drawn, perhaps to apply from 1984. 24. Each of the major policy areas subject to review under SAI. I is discussed below in order to see what light this experience sheds on the design of SAL I and its contribution to Turkey's policy formulation and implementa- tion. Progress in each of these areas, as noted above, was considered to be particularly important in determining tranche releases. Export Expansion 25. As explained in the Audit Report on Turkey's First Program Loan, that 1978 loan was geared to initiating a shift to export expansion._ During 1979 a more active policy of exchange rate changes was initiated and other measures were taken. These measures were supported by an IME standby arrange- ment under which greater monetary discipline was followed. It was believed at the time that the net result was to accomplish during 1979 a significant real devaluation of the Turkish lira, thus establishing a price-cost framework conducive to export expansion. 1/ OED, Program Performance Audit Report, Loan No. 1627-TU (1978).  - 9 - 26. A key objective of the January 1980 program was to introduce further policy changes and consolidate the real effective devaluation of the lira. As the Turkish authorities letter to the Bank stated, "The fulcrum of our devel- opment policy should be to correctly set the rate of exchange and to operate an effective exchange rate policy....''_1 By a real devaluation is meant an increase in the Turkish lira equivalent of a unit of foreign exchange earnings substantially in excess of the rate by which costs (and prices) increased in Turkey compared with Turkey's trading partners. While the test was by no means explicit in the agreement with the IMF, the real value of the Turkish lira in late 1970 and early 1971 seems to have been the historical standard selected for comparison. Successive devaluations taken during 1979 and 1980 reversed the real appreciation in the Turkish Lira which had occurred between 1971 and 1979 and re-established in real terms the 1970-71 value.1! In late 1980 and early 1981 there appears to have occurred some backsliding in the real results achieved, but with continuing concern being expressed on the part of the Fund and Bank, exchange rate policy became even more flexible after May 1981 with competitiveness of exports being maintained roughly at the 1970-71 real value. Moreover, other evidence accumulated that the private sector was becoming more optimistic concerning the maintenance of a price cost structure conducive to export expansion. 27. Additional measures were taken under the January 1980 export expan- sion program, some of which were monitored under SAL I. These measures are described in the PCR (page 3). Among these measures, the Turkish authorities themselves attached most importance to the right given to exporters to import materials and intermediate inputs without restraint and duty free under the foreign exchange allocation scheme. The actual administration of this measure was not monitored explicitly under SAL I. Judging from discussions of the Audit Review Mission with the private sector this measure, aided greatly by increasing availability of foreign exchange, appeared to be working. Major attention under SAL I was given to arrangements for establishing export credit insurance, priority access to credit for exporters, and institutional arrange- ments to promote exports. With respect to export credit insurance it appears that the revised interim arrangements which the PCR asserts were instituted in May 1981, were not functioning. The PCR seems to attach undue weight to the foreign exchange retention scheme, the relative importance of which has in 1/ This emphasis given to exchange rate policy in this quotation from the February 1980 letter to the Bank was further confirmed by discussions with the Turkish authorities during the Audit Mission. 2/ This kind of standard has several weaknesses, particularly when the base period extends back 10 years, a period during which structural changes of considerable importance had occurred. It is not possible to quantify in Turkey (as in most other countries) the impact of changes in productivity in the major sectors on the competitiveness of domestic industry, agri- culture, and other tradeables, mainly because of the weak data base.  - 10 - fact declined because of the narrowing of spreads between the formal and informal markets for foreign exchange. On the other hand, preferential access of exporters to domestic credit, which was one of the items to be monitored under SAI. I has been of considerable importance. This is discussed below. 28. A recent Bank mission on Industralization and Trade Strategy re- viewed the various incentives to industrial exports and attempted to quantify their impact. It concluded that between 1979 and the first quarter of 1981, the real export exchange rate (combining the nominal exchange rate with the export subsidy rate, with adjustment made for relative price changes at home and abroad), depreciated by 18 percent if foreign exchange premia were included, and by 30 percent if these premia were excluded. These results reflect the increased incentives industrial exports received after January 1980. 29, As noted in the PCR, exports (and workers' remittances), after a not unexpected lag, have been increasing at a rapid pace. This tends to confirm the Fund's findings that price-cost relationships have moved in favor of tradeable goods and services, as suggested by estimates of movements in the real exchange rate. 30. Under SAL I the adequacy of export expansion measures was to be judged to be positive if real export growth averaged not less than 10 percent per annum between 1979 and 1983.!/ In the event, according to the Region, the volume of exports increased by 42 percent between 1979 and 1981, and the four-year target was reached in two years. It should be noted that a quanti- tative test of export performance was not incorporated in the SAL II Loan. 31. It may, however, be useful in this Report to consider the durability of some of the factors accounting for the rapid expansion of exports. (a) A key factor in stimulating interest in exports was the reduction in real domestic demand in 1980 and the modest growth in 1981, at the same time that substantial excess capacity existed. As GNP growth accelerates, even if fiscal and monetary policies succeed in containing aggregate demand, the incentive to export may be reduced. On the other hand, increasing famil- iarity with foreign markets, particularly in the Middle East and the estab- lishment of better marketing channels will help to maintain some momentum. (b) Regarding the permanence of the interest in exports, a more serious question perhaps arises from the employment policy which has been applied by the Turkish Government since September 1981. Private employers, as well as Government enterprises, are not permitted to lay off large numbers of workers 1/ This is the period specified in the Loan Agreement (Schedule 5, Article 1). However, the letter on the economic program dated February 7, 1980 (para. 6) refers to the period 1980-83, when the 1980 level of exports could not have been known.  - 11 - without approval from the Government. In a period of declining domestic demand for industrial products, this is a powerful factor forcing producers to compete actively for export business. This approach may well have to be substantially modified as policies are addressed more and more to increasing productivity in the industrial sector, both private and public. Thus, unless price cost relationships move even more in favor of exports and import substi- tutes, i.e., in favor of tradeables against non-tradeables, it may become increasingly difficult to reconcile policies designed to raise productivity in the manufacturing sector with short-run employment objectives. 32. In the final analysis, the excellent record of export growth realized in 1981 can only be expected to be consolidated if it derived from lines of activity that conformed with Turkey's comparative advantage, the latter being defined in a dynamic sense. Too many controls and specific incentives have been at work for such comparative advantage to emerge without ambiguity. While certain lines of exports may still be handicapped by the present set-up of controls, others may be enjoying excessive subsidization, and it is possible that some of the recently expanded exports generate little or even negative value added.l/ 33. At the same time, the increase in workers remittances during 1980 and 1981 may also be unsustainable. Analysis of monthly data shows a peak in February 1980 following the enunciation of the January program and a much higher peak in mid-year on the deregulation and rise of interest rates and the further depreciation of the lira. More recent figures have been considerably below this latter peak which may have reflected in part a one-time transfer of accumulated savings in response to the higher interest rates, the more advan- tageous exchange rates and the introduction of the new savings scheme men- tioned in para. 13 of the PCR. On the other hand the opening up of fresh sources of workers' remittances in neighboring petroleum countries is likely to be an element of potential growth, but it is too early to reach firm conclusions on how these remittances will develop. The Balance of Payments and Capital Inflows 34. An important aspect of Bank involvement in the structural adjustment of the Turkish economy was the attempt by the Bank to contribute by its presence, and to a lesser extent also by its lending, t6 the improvement of capital inflows into Turkey. Net capital inflows had sharply declined: by 34 percent in 1978 and again by 33 percent in 1979, precipitated partly by an 1/ The Region disagrees with this assessment, holding to the view that the emerging export pattern conforms broadly with Turkey's comparative advantage.  - 12 - adverse swing in credits supplied by foreign commercial banks.l/ Simul- taneously arrears accumulated on foreign debt service and on payments for iMports which had to be drastically curtailed. Shortages in essential imports resulted in further reductions in production and exports. The Bank and the Fund moved to increase their own disbursements to Turkey and, under the aegis of the OECD, three successive rescheduling of debt obligations were worked out both with official and commercial creditors, in May 1978, July 1979 and July 1980. This resulted in relief for the balance of payments of US$295 million in 1978, US$924 million in 1979 (and about US$1.5 billion in 1980), but deferred much of the service burden to the later 1980s. Bilaterally Turkey's other creditors rallied also to help by pledges of extraordinary assistance in the form of quick-disbursing program loans both under the auspices of the Aid-to-Turkey OECD Consortium and outside the OECD framework. 35. There were initial delays in the mobilization of capital assistance to Turkey. Less than half of the US$900 million pledged in 1979 under the OECD special assistance program was committed by end-1979, and only part of this could be disbursed. Things began markedly to improve in the latter part of 1980, and total disbursements under program aid from all sources rose from US$0.5 billion in 1979 to US$1.6 billion in 1980, and debt relief from US$0.9 billion to US$1.5 billion. In all, capital inflows in 1980 (including debt relief) aggregated US$3.4 billion or 5.75 percent of GNP as compared with US$1.7 billion and 2.5 percent of GNP in 1979.1/ The level of caDital in- flows in 1981 was being estimated at a lower level than in 1980, but remained quite high. It should be noted, however, that there is no indication that the foreign commercial banks increased their net contribution in Turkey.3' 36. The growth of exports and workers' remittances together with the revival and expansion of foreign capital inflows gave Turkey the means to expand its imports which had fallen in real terms by 30 percent in 1978, and by another 7 percent in 1979. Since petroleum imports could not be much squeezed, the reduction in non-petroleum imports was even more severe, amounting to some 40 percent in real teras in 1978 and an additional 5 percent in 1979. 1/ See IMF, Turkey - Recent Economic Developments, August 27, 1981, (SM/81/180) page 70. 2/ IMF, Turkey - Review of Standby Arrangement, August 24, 1981 (EBS/ 81/180). 3/ SAL I had made improvement in external debt management a focus for periodic review (Schedule 5, Article 2). The PCR describes (para. 11) the disappointing progress made toward improving the recording of the debt data. In recent years external debt management has been exercised largely by Turkey's creditors without Turkey having to formulate a policy in this respect. As Turkey's creditworthiness improves, the importance of an external debt management policy will increase.  - 13 - 37. The improvement in the foreign exchange earnings and in capital inflows that took place in 1980 made it possible to finance US$7.7 billion of imports (or 13 percent of GNP) as compared with US$5.1 billion (or 7 percent in GNP) in 1979, but the import volume was some 27 percent below the unsus- tainable level of 1977. Imports in 1981 are expected to climb further to US$8.5-9.0 billion, thanks to the greatly improved earnings from exports and workers' remittances as described above, though the level of capital inflows is likely to be lower than in 1980. The broad outlines of Turkey's balance of payments during the past three years are shown in Table 3. Imports and Capacity Utilization 38. A key objective of SAL I and its Supplement was the provision of foreign exchange required for the importation of raw materials and intermedi- ate goods in order to increase the utilization of Turkey's productive capacity in industry and agriculture.l/ The proceeds of the loan were earmarked for the financing of materials for the production of fertilizers, plant protection chemicals, steel, and steel products, copper products, aluminum products, petrochemicals and chemical products. 39. No system was established under the loan for monitoring the utiliza- tion of capacity in the specified industries, or in industry (including industry supplying agriculture) at large. In the absence of information about completed investments in this period, the following interpretations may be valid. Production of fertilizers increased greatly in 1980 and even more in the first part of 1981, suggesting increased capacity utilization. Statis- tical indicators of iron and steel production in 1980 point to reduced capa- city utilization. No index of production is available which covers steel products, aluminum products, petrochemicals and chemical products. Scattered data on chemicals suggest some improvement. However, given the widespread outbreak of work stoppages in 1980 the significance of production or capacity utilization changes would not be very clear, and interpreting these in terms of imports availability could not be conclusive. 40. With the overall increase in industrial output in 1981, now esti- mated to be 7 percent,2/ utilization probably increased. Data on capacity utilization collected by the Istanbul Chamber of Commerce do not go beyond the first quarter of 1981 and do not permit comparisons with 1979 or earlier 1/ This formulation is based on the wording of Item (c) of the Preamble of the Loan Agreement. Schedule 2 of the Loan Agreement refers to improving the Borrower's "productive capacity in agriculture and indus- try" rather than increasing utilization. 2/ See "The Second Estimation of Gross National Product According to Six Months Figures", Prime Ministry, Irstitute of Statistics, September 15, 1981, already cited.  - 14 - years. Answers to questionnaires reveal that raw materials were considered as limits to capacity utilization during late 1980 and early 1981, after the end of massive work stoppages, in chemicals and metal products but not in basic metals. It can probably be assumed that as the implementation of the 1980 import policies proceeded, increased availability of raw materials and inter- mediate products facilitated increased capacity utilization overall. Whether the industries selected for special treatment under SAL I achieved this result could not be determined on the basis of the available data. 41. The private sector got more than the share allocated to it of the proceeds of the loan under SAL I (a third of the total). However, the condition that the government allocate out of its own resources US$30 million for imports of spare parts could not be adequately monitored, and inclusion of such a condition in the loan documents was therefore of doubtful value. 42. Thus, SAL I was successful in contributing to the expanded flow of imports in 1980 and 1981, and to the increased utilization of capacity in 1981. Moreover, as a result of the favorable developments of exports and workers' remittances in 1981 the Turkish authorities were able to reduce the current account deficit, taking in stride the reduced foreign capital inflow. 43. The Audit Mission was unable to obtain from the Turkish authorities an analysis of the significance of these developments for the medium-term. Bank staff projections made at the time of the SAL I supplement showed a current account deficit being reduced relative to GNP but at a very slow pace. The PCR does not include an assessment of the significance of 1980-81 develop- ments for the balance of payments outlook over the medium term. 44. The Audit is, however, disposed on balance to agree with the PCR that the growth of foreign exchange earnings in 1981 is a very positive development. If the final estimates of the balance of payments for 1981 confirm the reduction of the current account deficit at the same time that growth has been resumed, SAL I and its Supplement must be regarded as having contributed to an adjustment process which shows promise even if there are many policy areas in which weaknesses persist. Protection and Incentives Systems 45. As indicated in the PCR, major changes in the protection and incen- tives systems were not expected during 1980-81. In fact, some actions were taken to liberalize imports but it has not yet been possible to appraise how the reallocation of items to the various lists has precisely influenced the protective system. Moreover it should be noted that the importation is prohibited of many items not included in any of the lists. No estimates, however, are available to enable an assessment of the importance of these items to domestic production. 46. In the letter to the Bank dated February 7, 1980, it was stated that the Turkish authorities "would envisage that the rationalized protection system will be in place by 1984." There were of course serious practical  - 15 - obstacles to an earlier and more radical changes in the protection system, not the least of which was considerable uncertainty concerning the availability of foreign exchange. With this uncertainty, drastic changes in the administra- tive controls could only be embarked upon after a tariff reform had already taken shape and if the authorities were prepared to accept a much larger devaluation of the Lira, or even a market determined exchange rate. Some consideration was apparently given later in 1980, during discussions with the IMF and the Bank, to earlier action in the field of tariff reform, but the arguments of the Turkish authorities seemed persuasive at that time. The Bank's Industrialization and Trade Strategy Mission of May, 1981 had further discussions with the Turkish authorities on these issues, having formulated a series of proposals for early action with respect to the protective system.l/ Domestic Resource Mobilization 47. A critical area in domestic resource mobilization and aggregate demand management is the change in the balance between public sector receipts and expenditures covering both the consolidated budget and state enterprises. In Schedule 5 of the Loan Agreement it was agreed that one of the criteria for judging progress achieved in carrying out the economic program would be an assessment of the "adequacy of measures to increase domestic resource mobili- zation including (i) the objective of eliminating overall deficit financing in the public sector in 1980..." (para. 3). Discussions between the Audit Mission and the parties concerned revealed that this objective of eliminating the deficit which was not precisely defined in the Loan Documents, was prob- ably impracticable even on the basis of optimistic assumptions about tax reforms and expenditure controls as conceived at the time and was probably not consistent with the gradualist approach to inflation control incorporated in the 1979 agreement with the IMF. Many of the measures taken during 1980, including the devaluation and loosening of controls over prices, involved ''corrective inflation." A fairly substantial increase in the price level was necessary to improve price relationships within the economy and between Turkey and the outside world, taking into account pressures for increases in money wages which could not be resisted during most of 1980. Complete elimination of the public sector deficit, or even reducing public sector domestic borrow- ing to zero, could probably have been accomplished only by accepting much lower levels of output and employment. By the time the June 1980 agreement with the Fund was signed, the Government's program for 1980 involved a limit on Central Bank lending to the public sector, including State Economic Enter- prises, a figure which implied a very substantial public sector deficit. Since, however, no consolidated public sector accounts existed for 1980, reference to any target for public sector deficit in the Loan Agreement was premature. To this day the Government of Turkey does not construct consoli- dated public sector accounts on a regular basis. Such a consolidation is necessary if public sector resource mobilization were to be defined in terms 1/ The report of this mission was published on February 18, 1982 (Report No. 3641-TU).  - 16 - of public savings. While an increase in public sector savings is an objective of Government policy, the Government has no quantitative targets for public savings. Moreover, monitoring of results in this field requires substantial changes in the way in which actual receipts and expenditures are reported. 48. Included in the Government's February 7, 1980 letter is a statement dealing with public investment, which is also relevant for domestic resource mobilization: Public investment is to be contained "in 1980 and future years to available fiscal resources." The same statement is echoed in paragraph 4 of Schedule 5 of the SAL I Loan Agreement. Performance reviews have failed to give a precise definition to this objective. 49. As noted above, it is by no means easy to quantify under present circumstances targets for public sector resource mobilization. The Fund's approach incorporated in the standby agreements with Turkey is indirect: limiting the increase in Central Bank lending to the public sector, and thus encourage the authorities to take measures to raise public savings, and to increase financial resources in the banking system and in the hands of the public, which can be tapped for public sector borrowing. Such targets, which if violated, may lead to suspension of drawing rights, are arrived at in a broad monetary framework and are constructed in the light of the outlook for the "consolidated budget" and the accounts of the State Enterprises. The monetary framework in which the ceiling on public sector borrowing from the Central Bank is set, involved projecting a reasonable rate of growth for money (including broad money M2) in relation to projected increases in prices and GNP, and the limit on net domestic assets involved also a forecast of absorp- tion through the balance of payments. In a period when inflationary expecta- tions are themselves to be influenced by the anti-inflation program and when substantial interest rate changes are being made, changes in demand for money become very difficult to predict. This has posed special difficulties for the application of the monetary benchmarks adopted by the Turkish Government, with Fund (and Bank) support. 50. Partly to overcome this problem the understandings on Central Bank asset limits contained in the 1980 agreement in the framework of the 3-year standby of June 1980 were set only six months ahead. The limits on the increase in net domestic assets and in credit to the public sector must be reconciled with the outlook projected only on an annual basis for the con- solidated budget and the accounts of the State Economic Enterprises, taking into account the measures underway to restrain the size of their deficits, and the availability of credit from external and other domestic sources. Bank and IMF reports on Turkey have not dealt explicitly with the implications of the limit on Central Bank financing for the availability of total bank credit to the private sector. 51. In this respect, neither the Fund nor Bank reports on Turkey have tried to pierce the monetary veil and examine in depth the impact of monetary policy in those parts of the private sector of the economy most sensitive to credit conditions, including impacts via credit availability and interest rates. We shall return to this subject below.  - 17 - 52. During 1980 credit limits to the public sector were observed but only after limits for the end of the year were adjusted upward in the fall of 1980. This readjustment which applied also to overall credit limits, rose in part from the unexpected high cash deficit of the consolidated budget, which increased from 2.1 per cent of GNP in 1979 to 4.3 percent in fiscal 1980-81 (ending February), and even more from the financing requirements of the State Economic Enterprises, which increased from 7.2 percent of GNP in calendar 1979 to 7.7 percent of GNP in 1980. If progress in resource mobilization is defined in terms of reducing total financing requirements relative to GNP there was no progress in 1980. 53. There were extenuating circumstances, however. Financial require- ments of the SEEs were greatly increased by inventory accumulation. It appears that the 1980 budget program did not foresee adequately the need to rebuild stocks of petroleum products, which had been reduced to very low levels during the 1979 exchange shortage. Moreover, with the unanticipated decline in GNP and domestic demand, stocks of other products, particularly building materials, increased. Even if these factors had been foreseen it is difficult to see how they could have been countered by effective action in the circumstances prevailing. It proved impossible during 1980 for the Government to obtain the enactment of any major tax measures. In fact, government revenues as a percentage of GNP declined by almost 4 percentage points from 1979 to 1980, partly because of the (unexpectedly) negative effects of accel- erated inflation on tax revenues. 54. If progress in domestic resource mobilization is defined in terms of the movement of public savings, the picture in 1980 was better.L/ The primary factor in this was the reduction in the operating losses of SEEs, following upon the long postponed price increases which the SEEs were authorized to make. While tax receipts lagged, as noted above, some success was achieved in holding down wage increases and in reducing the volume of a wide variety of miscellaneous transfers. Thus, the decline in tax receipts as a percent of GNP was probably associated with a similar, if not greater decline in current expenditures included in the consolidated budget. SEEs' current account deficits were reduced also by the wage policy in effect during 1980. 55. Thus, there was a mixed picture in 1980 with respect to progress on domestic resource mobilization via improvement in public sector finance. 56. Actions in connection with the 1980-81 budget, formulated in late 1980, and actions since taken, may provide a basis for a more positive judg- ment, but this is by no means assured. The 1981 Government program for SEEs shows some but not significant improvement in reducing losses. (See Table 4). 1/ According to unofficial estimates by SPO, public savings increased from 3 percent of GNP in 1979 to over 5 percent in 1980. See table on page 20, November 1981 draft of the PSIR Mission. It is difficult to place much confidence in these estimates because their basis is not known.  - 18 - While sales proceeds in 1981 may be increasing, the planned pace of further price adjustments in those sectors still subject to control is scheduled to be slow, and in the decontrolled sectors appears to be lagging. Managers of SEEs are on the whole still reluctant to take independent decisions. Not all of the related Ministries are encouraging rapid action. As for the consolidated budget, the picture is more favorable: control over wage increases and the tax changes cited in the PCR are likely to produce a significant increase during 1981 in public savings from this source. 57. The outlook for a reduction in the overall public sector deficit in 1981 was favorable. A further increase in stocks of petroleum products was not foreseen. However, at the time of the audit mission, public sector fixed investment expenditures were expected to increase in constant prices by about 9 percent instead of stabilizing, and would represent an even greater increase than was implied in mid-1981 in the Government's letter to the IMF.l/ On this basis, and barring the possibility of foreign project financing, the limits during 1981 on Central Bank lending to the public sector will probably only be fulfilled if there is a further build-up in arrears to the private sector, or by otherwise borrowing more within Turkey. Private Credit and Mobilization of Private Savings 58. The implications of the 1980 and 1981 fiscal program for the avail- ability and cost of credit to the private sector are not fully discussed in the PCR. 59. The agreements under SAL I did include a joint review of adequacy of measures to increase household savings and time deposits and a review of a financial sector study. No action program in this area was defined, but rapid progress was not expected. The PCR is correct in stating that the actions described exceeded expectations. 60. The establishment of positive interest rates on the deposit side initiated in June 1980, was a forward step and has led to a rapid expansion of savings in the hands of financial intermediaries, as noted in the PCR. It is not at all clear to what extent have these positive deposit interest rates affected private savings. There is little hope of reaching conclusions on the impact of these and other measures on household consumption and savings, as contemplated in SAL I President's Report (page 4), because of the lack of reliable estimates. 61. In 1979 and to a lesser extent in 1980 the volume of credit to the private sector declined. (See Table 5). The growth of financial savings in the hands of financial intermediaries in response to the establishment of 1/ The 9 percent figure is taken from the PSIR mission report of November 1981. However, the President's Report on SAL III (Report No. P-3273-TU), dated May 7, 1982, p. 28) shows an estimated increase of 5.7 percent only. See also footnote 1 to paragraph 68 below.  - 19 - positive deposit rates made it possible to reverse this decline. In the year ending May 1981, the latest month for which data were available to the Audit Mission, the volume of credit to the private sector expanded at a rapid rate. Thus the Government during the latter part of 1980 and the first part of 1981 was able to draw increasing financial resources from the banking system without unduly depressing private investment, insofar as the availability of credit is concerned. 62. There was still apparently a squeeze on private investment, result- ing probably from declining profits and other factors reducing internal cash flow generation and increasing non-investment uses for funds. One of these factors is the increasing public sector arrears to the private sector. No data are yet available to confirm these impressions which are based on dis- cussions with the private sector, including bankers and borrowers. 63. An additional cause for declining profit margins on existing invest- ments, which also reduces the profitability of new investment, are the high interest rates on the lending side, resulting from the new policies. These rates were adjusted on July 1, 1980 and again in February 1981.1/ Short-term general credits thus carry in 1981 a rate of 36 percent, compared with 21 percent before July 1, 1980, medium-term general credits 38 percent (22 percent) and long-term credits 41 percent. To these rates must be added a 15 percent levy accruing to the Differential Interest Rate Rebate Fund and a 15 percent financial transactions tax. When these taxes and bank commissions are taken into account, and with some allowance for compensatory balances which borrowers are required by lenders to deposit, effective lending rates to the borrower even on short-term approach 60 percent during most of 1981.2/ As inflationary expectations came down during the course of the year and assuming the inflation rate for a year ahead to be 35-40 percent, this implies for the second half of 1981 real interest rates of 12 to 17 percent. Borrowers, needless to say, are greatly concerned with the high cost of borrowing, accustomed as they were to negative interest rates. There is, however, no question that rising interest rates have produced declining profits and are deterring private investment. New fixed capital investment in industry is in any case limited because of excess capacity. The high interest rates affect the cost of working capital and the profitability of investment in 1/ Interest rates on the deposit side in Turkey though "deregulated" or theoretically free, are in fact determined by a gentleman's agreement among the banks, subject to direct and indirect influence of the Govern- ment. On the lending side, the influence is not only in the form of "imoral suasion". There is a complicated system of special rediscount rates as well as taxes and levies which are quantitatively important in determining the final rate. 2/ Calculation of real interest rates on longer-term loans is more difficult because expectations of inflation on the part of borrowers (and lenders) are less firm. As for the short term (1 year or less) borrowers seem to extrapolate recently prevailing rates of inflation.  - 20 - residential buildings and other construction. Some restraint on investment in buildings is probably desirable, but the present high real rates of interest might, if continued, unduly depress construction activity. Since market forces are operating only to a limited extent in setting interest rates, self- correcting forces cannot be depended upon to adjust money rates of interest. 64. The situation is complicated, however, by the complex system of preferential interest rates, both short- and medium-term available to a wide array of borrowers. Preferential borrowers, particularly those eligible for export credits, continue to enjoy negative interest rates; these implicit subsidies are financed in part by levies imposed on the general borrowers.l/ There is thus a problem of avoiding unduly high real interest rates for the general borrower while providing adequate implicit subsidies to favored borrowers, such as exporters. This is a new problem for Turkey. In the process of liberalizing the interest rate system, increasing borrowing by the public sector, whether from the central bank, commercial banks, general public, or suppliers has led to a squeeze on private sector borrowers. This squeeze is perhaps temporary, but the outlook for public sector financing in 1981 does not guarantee it and the squeeze could become an even greater problem for the future. 65. Taking into account the size of public sector deficits in 1980 and 1981 and other policies influencing the cost and availability of credit to the private sector, it must be concluded that while the results for 1981 are still not in, the measures taken during the period of disbursement of SAL I and its Supplement to increase domestic resource mobilization were not fully adequate in that they had some serious side effects on private investment, though the inflation was certainly reduced. 66. Under SAL II, the Loan Agreement (Schedule 4) provides for a con- tinuing review of actions in the field of domestic resource mobilization, with special attention to tax policy (value added tax) and tax administration, both of which are important for resource mobilization through the public sector. No quantitative framework is established for this review, however. Explicit attention is not given to the possible crowding out effect on private invest- ment, nor is there any mention of the new danger of excessive positive real rates of interest. Level of Public Investment 67. Harmonizing public investment in 1980 and 1981 with available financial resources, as called for under Schedule 5, Article 4 of the Loan Agreement, has two sides: resources, discussed above, and the investment level. The PCR concludes (para. 15) that "overall the level of public investment had been tailored to available resources, with a substantial real decline over the 1979 level." 1/ During much of 1981, the interest cost to borrowers of export credits was 19 percent, taking into account their special status under the financial transactions tax, interest equalization levy, and interest rebate system.  - 21 - 68. It is not clear that the substantial real decline in the level of public investment in the last two years, has in fact occurred. Public fixed capital investment is estimated by the SPO to have declined by 2.2 percent in 1980, but stock increases in public enterprises were very large.!/ In 1981, there were indications that fixed capital investment in the public sector was increasing by much more than the decline which occurred in 1980.2/ Thus, fixed capital investment may well have increased significantly since 1979. Moreover, it appears to be on a rising trend, threatening to jeopardize the Government's program objectives. This is the lesson which can be drawn from the report of the Public Sector Investment Review Mission. 69. The central authorities in the Turkish Government have attempted in their annual programs to put a lid on fixed public investment, but the results are ambiguous. The small decline in fixed public investment in 1980 may have resulted less from a conscious process of tailoring investment to available resources, and more from the unexpected effects of a higher rate of inflation. Such an interpretation is consistent with the finding that "budgetary cuts have tended to be made across the board, rather than by selecting the high priority projects and more fully funding them."13 In 1981, evidence was supplied of projects of doubtful economic merit being dropped or receiving only nominal allocations. The 1981 annual program reduced the total number of projects from 9,000 to 8,000, and several very large projects were explicitly deferred. The fact that fixed investment was nevertheless rising at a rapid rate in 1981, is cause for concern. Moreover, according to the PSIR mission report, the projects currently in agency pipelines which were sanctioned by being given some recognition in the 1981 annual program, if actually imple- mented according to a reasonable schedule, would require over the next three years, resources which are almost twice as large as those utilized in 1980. 70. The State Planning Organization has not laid down meaningful guide- lines for the preparation of agency plans. As described by the PSIR Mission many investing agencies are still planning their multi-year programs on the basis of GNP growth rates which the central authorities recognize to be 1/ As late as October 1980 at the time of presenting to the Executive Directors the SAL I Supplement, the Government's figures for 1980 implied a fall in public investment of around 14 percent (P-2888TU, p. 15). There, it was further observed: "The effective constraint on total public investment continues to be IMF Standby's limit on the increase in Central Bank credit to the public sector." 2/ As mentioned earlier (para. 57), the PSIR mission reports a 9 percent increase in 1981, based on provisional data. Later, the President's Report on SAL III (May 1982) showed an increase of estimated public fixed investment of 5.7 percent in real terms in 1981 after a decline of 2.4 percent in 1980. 3/ Turkey: Public Sector Investment Review, (dated December 7, 1981), Report No. 3472-TU, Volume I, para. 6, page iii.  - 22 - unrealistically high - over 8 percent. Until the investing agencies them- selves scale down their investment programs the pressures for increasing public investment are difficult to resist. 71. An official consolidated public sector investment program with a financing plan was not insisted upon as a precondition for SAL I. No under- taking to prepare such a program was included in SAL II either. However, in early 1980, the Turkish Government did request the Bank to review the coun- try's public investment program in the context of its new economic policies and long-term growth potential. Discussions with the Turkish Government on the mission's draft report were held in October 1981. 72. The above comments draw heavily on the draft report which takes these discussions into account. It is still not clear whether the Turkish authorities will accept one of the major conclusions of this report, namely that public investment in the period 1982-85 should not on average much exceed in real terms the level recorded for 1980.1/ 73. The Audit Mission discussed with the Turkish authorities the obsta- cles to preparation of a multi-year program. The obstacles cited were these. Such a program cannot be kept secret. Such a program, which would have to be restrictive rather than expansive under present circumstances, would trigger strong public pressures from regions and groups, and thus by its very compre- hensiveness would encourage the consolidation of the opposition to the Government's program from many different quarters. 74. There is some merit in this argument. But this also applies to the annual investment programs, which, however, have been found useful and neces- sary. The political advantages of keeping low priority projects on the books, with small annual appropriations assigned to them, are likely to be soon lost as their advocates come to realize what is happening. 75. The fact remains that in the absence of a multi-year investment program and financing plan, it is going to be extremely difficult for the authorities to tailor investment to available resources, for the Bank to assure itself that there is a reasonable prospect for success, and for the Fund or Bank to monitor performance in the interim. Priorities and Composition of Investment 76. The Turkish authorities had further agreed under SAL I to review with the Bank "the adequacy of measures to harmonize public investment" with 1/ According to the President's Report on SAL III (Report No. P-3273-TU, dated May 7, 1982, para. 57) the level of public fixed investment pro- grammed for calendar 1982 is 6 percent greater in real terms than in 1981. However, the statement of development policy by the government (dated April 24, 1982) envisaged a decline in the share of public invest- ment in total investment over the period 1982-85 owing to the expected recovery of private investment.  - 23 - "the Borrower's investment priority criteria that: (i) existing productive capacity is used efficiently and fully and critical bottlenecks removed; (ii) on-going projects be completed which, with modest additional resources, can be expected to yield speedy returns; and (iii) new productive projects stressing exports and employment generation." 77. The generally favorable judgment on a satisfactory pursuit of these objectives expressed in the PCR is subject to some reservations. The follow- ing comments are based on the PSIR Mission Report. (a) It seems that neither the 1980 nor 1981 annual program exhibits a special contribution to productive employment generation any more than earlier programs had done in the past. It is moreover, doubtful that in a period when investment must be severely contained there could be much scope for new projects with a potential for job creation, such as construction of roads in rural areas or other infrastructure projects in urban areas. (b) The same observation applies to new productive projects stressing exports. There are no new projects in the 1980 or 1981 program specifically designed for this purpose. The PSIR mission simply notes that it is difficult to relate the 1981 public investment allocations to a reorientation of the economy toward exports. By and large the directly productive projects included in the public investment program appear to have little prospect for contributing significantly to export growth at the present real exchange rate. (c) The removal of critical bottlenecks has been a criterion applied in practice in the screening of the investment programs for 1980- 1981. It is not possible to measure the extent to which significant improvement has taken place in this respect. The proportion allo- cated to energy and mining projects is high. It is not clear, however, that a higher proportion of fixed public investment is being assigned to removal of bottlenecks than in 1979. In electric power, allocations for urban distribution facilities have been woefully inadequate from the point of view of removing bottlenecks. Many large hydropower projects with very long gestation periods and of doubtful economic priority are in the program. In industry "rehabilitation" investments with high yields and low gestation periods are assigned low priority. Again, significant amounts are allocated in the 1981 program to large manufacturing projects which are at an early stage of execution and which are of doubtful economic merit. The share of manufacturing (including refineries) in total public investment increased from 26 percent in 1979 to 29 percent in 1980 but appears to be declining in 1981. However, the PSIR mission, after examining major manufacturing projects included in the 1981 annual program, concluded that allocations could well have been reduced by 20 percent, taking into account the Govern- ment's own priorities. Governnment policy with respect to the future of public investment in manufacturing would be clarified by early formulation of a multi-year public investment program.  - 24 - 78. Thus, based on the findings of the PSIR mission and its recent dis- cussions with the Turkish authorities, it is not easy to accept the PCR's view that progress on rationalizing the investment program has been adequate. Incomes Policy 79. A memorandum of the Government of Turkey on Its Economic and Finan- cial Policies dated June 2, 1980, which was attached to the Minister of Finance's letter to the IMF, recognized that "wage settlements needed to be in harmony with the basic stabilization policy measures that are being followed by the Government." While understandings with neither the Bank nor IMF have covered explicitly the area of wage policy its importance should be recog- nized. The wage policy area has been a source of strength since September of 1980 when the new Government reactivated the High Arbitration Court and reinforced its powers to hand down wage determinations that are mandatory for the public sector (SEEs included) and act as guidelines for the private sector. One of the major reasons for success in winding down the rate of inflation in 1981 has been the decisions of the Court. 80. Nominal wage increases in 1981 were to be contained within a range of 25 percent (civil servants) and 40 percent. In its deliberations, the Arbitration Court has taken into account the impact on incomes from wages of the tax relief arising from the tax reform. Some of the success on the wage front has been attributable to the tax change, which permitted real disposable income to be maintained and in some cases increased, while nominal wage rates pcid by employers (including Government) increase at a greatly reduced rate compared with 1980. 81. In the absence of better and more up-to-date data on wages and salaries, including supplementary wage costs and fringe benefits, it is not possible to analyze the actual impact of wage policy in 1981. It does appear that the real disposable income of wage earners had been declining in previous years.!/ Some decline was probably necessary to bring the balance of payments under control. In 1981, there was at least a temporary respite. To the extent that tax policy is effective in distributing the tax burden more equitably in terms of ability to pay, wage and salary recipients may be persuaded to accept very slow improvement in their real disposable income in future years, despite the decline which occurred in 1977-80. 82. Under SAL II, one of the policy areas to be the subject of special review is the adequacy of the 1981 tax reform, which was designed particularly to increase the income tax burden on non-wage income and to bring about a more equitable distribution of the tax burden. It would be useful to include in such a review the interrelation between the effectiveness of the tax reform and wage policy even though these interrelated policy areas were not identi- fied explicitly as subject to review. 1/ This decline may be inferred from data presented in IMF, Turkey - Recent Economic Developments, SM/81/180, August 27, 1981, p. 7.  - 25 - Reforming the SEEs 83. The SEEs have for long been identified as a source of weakness in the Turkish economy. Often occupying monopoly positions in their markets, they command considerable resources, use them with less than optimal effi- ciency and end up with financial claims on the Central Bank and the budget which have tended to be inflationary. The President's Report on SAL I speci- fied the pricing policies of the SEEs as a key element in Turkey's recovery efforts supported by the loan. It stated that under-pricing of industrial goods produced or distributed by the SEEs had resulted in substantial losses, amounting to 4.1 percent of GDP in 1979, and recommended the encouragement of SEEs to improve productivity and management and generate own resources to cover their investment program. The report also described considerable progress achieved on pricing prior to the Loan and asserted that with a few exceptionsl/, the "SEEs are now allowed to fix their own prices depending on market prices". Prices of SEE products and services had been kept low by policy intended to keep down the cost of living and to contain inflation. This went hand in hand with government injunctions to SEEs to create (often unnecessary) employment, and with frequent intervention by the government in the everyday running of these organizations including changes in management. 84. Although the need for reforms in SEEs had become widely known, implementing such reforms had lagged owing to political and institutional obstacles. Short of the government divesting itself of the SEEs to the private sector, opportunity for improvement lay in greater autonomy of manage- ment and pricing, inducing them to raise their efficiency by exposing them to market forces, relieving them from the obligation to absorb labor and ulti- mately reducing their need to seek budget support and Central Bank credit. Neither SAL I nor its supplement addressed these issues, except to the extent that they were mentioned as reforms to be carried out under the January 1980 economic program to which SAL gave general support. More specifically, SAL I approached SEE reform from the point of view of resource mobilization and reduction of public sector deficit financing. Both these aspects of the reform have already been dealt with under the sections on resource mobiliza- tion and public investment. 85. As mentioned earlier, thanks to the product price increases since January 1980, the financial position of the SEEs gradually improved. Other- wise, little seems to have been accomplished by way of increasing their efficiency of operation. It was not until SAL II, however, that SEE reform began to be addressed directly under SAL and Schedule 4 of the Loan Agreement (dated May 15, 1981) referred to adequate progress being necessary on delega- tion of authority within SEEs, multi-year contracts for their managers and 1/ The exceptions were prices for "coal/lignite, railway and shipping freights and power tariffs for aluminum and ferrochrome production" (page 11).  26 .1 cies .iat contained their employment, and made particular mention of the necessity to review implementation n selective SEEs".l/ Ill. BRC.ADjER lI-iPLICATIONS 86. The preceding section commented on the major policy areas included for review and action under SAL I. While the audit finds the level of achievement in these areas, and the attention given to them, somewhat mixed, it concurs with the positive findings of the PCR on overall progress. The preceding analysis, however, also suggesLs that SAL I was based on insuffi- cient economic and sector work and was not sufficiently well designed to contribute to Turkey's continuous policy formulation and implementation process. It did improve the Bank's dialogue with Turkey on macro-economic issues, and some of the design deficiencies were overcome by Turkey's subse- quent agreements with the Fund (also see para. 93). Follow-up and SAL II 87. Experience under SAL I and its supplement should be taken into account in the design of subsequent loans, in the selection of areas subject to special review, and in defining the content of the review. The preceding analysis in part II suggests that the lessons of that experience have not been adequately reflected in SAL IIo Schedule 4 of the SAL II Loan Agreement outlines the matters subject to review in only very general terms, as follows: "The Borrower and the Bank shall review: 1. The adequacy of policies and legislative and administrative measures for export promotion, import liberalization and domestic resource mobilization, in particular with respect to tax reforms: (a) progress in enacting a law providing for a value added tax to be introduced during the Borrower's fiscal year 1928; and (b) progress in establishing adequate procedures for tax collection, especially with respect to personal and corporate income and agricultural sales tax. 2. The adequacy of progress in reforms of State Economic Enter- prises, in particular (a) by September 30, 1981, (i) carrying out the reforms decided in principle by the Council of Ministers in 1/ A full discussion of recent reforms of the SEE system, as they apply to manufacturing enterprises, is contained in World Bank, Turkey-Industri- alization and Trade Strategy, (Report No. 3641-TU, dated February 18, 1982), Chapter 6. Apart from higher prices, the report describes changes in investment allocation and finance, personnel policy and the "style of relations between government and individual enterprises." The overall judgment of these changes, however, is cautious: "The significance of the changes effected so far is still to be seen." (para, 6.85).  - 27 - February 1981, and (ii) decision of the Council of Ministers of legal changes permitting greater delegation of authority within SEEs and multi-year contracts for their managers; and (b) carrying out the decree No. 8/2022, dated November 29, 1980, with respect to the number of authorized positions and new hiring. Progress will be reviewed inter alia by examining the implementation in selected SEEs of the measures referred to under (a) (i) and (b) hereof. 3. The adequacy of energy policies, in particular pricing of petroleum products at levels comparable to international market prices." 88. In view of the preceding analysis of the resource mobilization prob- lem via the public sector, it is not very helpful simply to refer to "progress in enacting a law providing for a value added tax to be introduced during the Borrower's fiscal year 1982" and "progress in establishing adequate procedures for tax collection, especially with respect to personal and corporate income and agricultural sales tax." 89. Revenue measures of these types should be defined in terms of yield, and are best formulated in terms of a medium-term public sector financial program. It is difficult to see how discussions during the review process can contribute very much in the absence of explicit revenue targets, preferably fitting into the broader framework.l/ 90. Also included for special review under SAL II are "policies and legislative and administrative measures for export promotion and import liberalization." In view of the success already achieved on the export side it is perhaps justified to be content with such a broad expression relating to exports. 91. The same cannot be said about import liberalization and changes in the protective system, on which no meaningful policy actions were defined. It was apparently not possible to schedule the Bank's Industrialization and Trade Strategy Mission so as to take account of their recommendations in defining the content of SAL II. 92. Neither the volume nor the composition of public investment was included for special review in any form under SAL II. The reason for this omission is not clear. A plausible explanation may lie in the inadequa- cies of the reporting system covering public sector investment (and its financing) and the fact that public investment was not under control. 1/ While not analyzed in the President's Report on SAL II, a specific increase in revenues as a percentage of GNP is given as a target for 1982 in the Statement on Development Policies attached to the Deputy Prime Minister's letter of February 20, 1981.  - 28 - 93. Several of the above deficiencies are related to the timing of SAL II: just over a year after approval of SAL I and six months after the Supplement. The gap between SAL I and II was not long enough to enable identification, development and introduction of the lessons of one into the design of the other. 94. There are important aspects of the Government's economic program as it has been modified and refined in 1980 and 1981 that are explicitly treated neither in the PCR nor in the above analysis. Probably the most important matters not covered are agriculture and energy. Both of these areas received attention in the discussions leading up to SAL II, but it was not possible for the Audit to provide useful comments in these areas. Comments on Policy Dialogue 95. Given the fundamental purpose of structural adjustment loans and particularly the importance attached to securing an improvement in the balance of payments over the medium term, there is no reason to quarrel with the focus of the Bank interest. Yet, the above analysis of SAL I does raise the ques- tion of how effective the Bank has been in contributing to the formulation and implementation of Turkey's economic program. 96. Prior to initiating non-project lending in Turkey, the Bank was lending actively in most major sectors and supported its operations by eco- nomic reports at regular intervals. However, the nature of the relationship was such that the dialogue on economic policy was not very constructive and often ended in agreement to disagree. Political instability in the country added to the difficulties. There were periods when disagreement between Turkey and the Bank was intense enough to lead to the postponement of some or even all lending operations.!' 97. These difficulties in relationship between the Bank and Turkey and the strength of resistance to some of the advice that the Bank had offered was only partly attributable to different substantive positions. Resistance to policy change, even when the need for change is evident, is also strengthened when the country can enjoy virtually unconditional external support in large volume either from private lenders abroad or/and foreign governments following short-term political objectives. Both of these elements appear to have been present in Turkey from 1974 to 1977. 98. A by-product of this external situation and its impact on the attitudes of the Turkish authorities was not only the adverse effect on the productivity of the policy dialogue but also on the nature of the Bank's economic work. While the Bank's economic work was of reasonably high quality, 1/ There were many cases where the dialogue on economic policy relating to project lending was not productive either, and this is illustrated in the OED report, "Sector Operations Review: The Industries and DFCs Program in Turkey", Report No. 3077, dated July 18, 1980.  - 29 - it tended to be long on generalities and short on specifics. This has been a handicap in the formulation of more precise and meaningful tests for evaluat- ing progress under SAL I, but was being rapidly corrected in 1981 as a result of the work of the special missions described above. 99. As outlined in the preceding paragraphs, an analysis of the design of SAL II still raises some questions as to the efficacy of the Bank's policy dialogue in its SAL lending. However, the external milieu is quite different from what it was earlier in the seventies. The area of common agreement between the Bank and Turkey on basic policy orientation is now broad and is growing. The Turkish authorities are aware of the fact that bilateral exter- nal assistance on a non-project basis and on concessional terms is unlikely to last very long and is subject to review. 100. The Bank's lending program in Turkey has also been expanded and reshaped to accommodate and support the structural adjustment process. To date, operations subsequent to SAL I have been divided between project and non-project loans roughly in the ratio 2:1 by value. All the project opera- tions have been in the productive sectors of agriculture and industry as well as energy development, with stress being placed through the selection of the projects and their design on labor absorption, export promotion and rationali- zation of industrial capacity. Moreover, lending to SEEs has been tied to specific reforms, and where necessary technical assistance has been provided. Bank-Fund Collaboration 101. Bank-Fund Collaboration was necessarily close during 1980-81, with the Fund taking the lead in discussing exchange rate and aggregate demand management issues with the Turkish authorities, and the Bank taking the lead in discussion on public investment, trade policy and the protective system, and energy. A real effort was made to divide priority areas between the Bank and Fund during the SAL process. Coordination has been facilitated by the staff of each institution joining the missions of the other. In this way, much has been accomplished in making both Fund and Bank assistance to Turkey more effective. 102. The character of the collaboration between the IMF and the Bank is influenced by the Fund's reliance on Central Bank credit ceilings for monitor- ing progress in the implementation of various policies affecting the balance of payments, the central government budget, the SEEs and the private sector. While the monetary program developed by Turkey in cooperation with the IMF is formulated in a broad perspective involving both monetary and income analysis, and is thus used as a framework for a wide array of measures including those outside the monetary field, Central Bank monetary targets seem to take on a life of their own. For example, agreement on specific policy measures on the side of public expenditures and revenues can be part of the general policy understanding with the Fund, and thus subject only to indirect monitoring. In addition (or alternatively as the case may be) this can be incorporated in the letter to the Bank or written in the Loan Agreement and then directly moni- tored by the Bank. In Turkey there were instances where neither institution  - 30 - was successful in getting these measures defined with sufficient precision. Besides, there was the temptation to regard agreement on the magnitude of Central Bank credit expansion to the public sector as sufficiently control- ling, and not requiring firm agreement on policies designed, say, to increase public savings or to establish the appropriate level of public investment. The Bank in the Turkish case appears to have relied on these agreements, sometimes even more so than the Fund did, citing, at least on one occasion, agreement on the monetary program as making it unnecessary to obtain a more satisfactory understanding on the level of public investment. 103. The Fund's focus on monetary aggregates in monitoring the program would appear to give rise to a greater need for the Bank to reach understand- ing on, and to monitor, the key policies affecting variations in the major components of aggregate demand, particularly private and public investment, both of which are directly related to medium-term supply responses as well as control of aggregate demand. Perhaps the Fund on its part could concern it- self more intensively with policies affecting private and public consumption. 104. More emphasis on a national accounts framework, as distinct from a monetary one, for the formulation and monitoring of measures designed to control aggregate demand would require, as Fund and Bank staff recognize, improvement in the data base outside the monetary field, particularly when it comes to quarterly estimates. Even in the vitally important field of consoli- dated public sector accounts, important for both monetary and income analyses, reporting is deficient, as noted above. The staff are so skeptical of the reliability of national accounts data relating to private and public consump- tion, savings and investment, that they are reluctant to make more than very limited use of income analysis in the formulation of policy and are even more constrained in using national accounts for monitoring progress. Yet, little has been done by the Bank and Fund in calling upon the Turkish authorities to improve the underlying data and their current (particularly quarterly) esti- mates of the expenditure components of the national accounts. 105. The greater use of an income approach as suggested here would, if pursued by the Turkish authorities, facilitate better aggregate demand manage- ment, induce a better recognition within Turkey of the relationship between aggregate demand management and longer-term economic growth on a sustainable basis, as well as facilitate a more productive collaboration between the Fund and Bank. Conclusion 106. SAL I and Supplement provided badly needed quickly disbursing external assistance, an important component in an over-all external financial operation, in support of a Turkish program designed to establish a more sustainable basis for Turkish economic growth without excessive dependence on foreign capital inflow.  - 31 - 107. Critically important policy changes have been implemented under the Turkish economic program initiated in early 1980 which was delineated only in very general terms at the time of loan approval. The continuous dialogue with Turkey in the course of implementing SAL I and preparing SAL II has, in that sense, been fruitful. A process of structural change has been initiated. Most notable is the progress made in shifting the export incentive system in the direction of relying more on market clearing price mechanisms at the same time that aggregate excess demand was being reduced through monetary, credit, interest rate, wage and fiscal policies. The resulting reduction in the rate of inflation has thus been accompanied in 1980 and 1981 by a significant real devaluation of the Turkish lira, the first in a decade. The adoption of a more flexible exchange rate policy, combined with better control over aggre- gate demand, is apparently becoming increasingly recognized as a solid feature of Turkish policy. This change in expectations as to future policy, building upon the continuity in policy intentions in this field, which have survived governmental changes in the past three years, should be reinforced by the apparent success of the policy in increasing export earnings and workers' remittances in 1981. 108. Real progress was achieved in 1980-81 in establishing a price structure in Turkey conducive to a better supply response. 109. The critical issue then is the adequacy of the Turkish action program and the speed of its implementation. It is a cliche found in Bank (and Fund reports) that "important progress has been made, but much remains to be done." The preceding analysis suggests that while medium-term targets had not been set and a time-phased action program to accomplish these targets had not been specified, there are many policy areas where progress has been made. Whether progress is being achieved at a sufficiently rapid pace depends partly on how ready external sources of capital are to provide large amounts of capital on a non-project basis and on concessional terms for many years ahead. The Turkish authorities have stated that they would reduce their need for such support rapidly. Until they come forward with a time bound action program it will be difficult to judge whether or not this target has reason- able prospects of success. 110. While this memorandum agrees with the generally positive tone of the PCR, it has provided an independent assessment of areas of slow progress, particularly on the rationalization of public investment, on facilitating the financing of private investment, on reforming the SEEs and on resource mobili- zation. The claim in the PCR that progress in many respects "exceeded all expectations" loses significance if expectations are not clearly formulated. The potential contribution of the Bank to the acceleration of the adjustment process is also thereby reduced.  ANNEX A -32- FIRST STRUCTL'&AL AnJUSTMlENT LOAN No. 1810-TU Schedule 5 of Loan Agreement In reviewing the progress achieved by the Borrower in the carrying out of the economic program and the measures referred to in paragraphs (A) and (3) of the ?reamble to this Agreement, the Borrower and the Bank shall focus in particular on: 1. the adequacy of export promotion policies and administra- tive measures to facili-ate actairment of an average real growth of exports of not less than 10 per annum over the period of 1979 through 1983, including: (a) review by October 31, 1980 of the efficiency of the interim arrangements established by the Borrower to cover export credit risk insurance and priority access of exporters to term credits, working capital credit and the like; (-b) completion of the on-going review by October 31, 1980, of institutional arrangements to promote further development of the Borrower's traditional and non-traditional export products and commodities; and (c) initiation, to be made not later than April 30, 1-980, of a study for the purpose of introducing more rational protection and incentive system based on tarrifs for industry. .2. Completion of an on-going comprehensive study on external debt management by October 31, 1980, with a view to introducing further imzrovements and refinements in the Borrower's external ;:debt management policy. 3. Adequacy of measures to increase -domestic resource mobili- zation, including (i) the objective of eliminating overall deficit financing in the public sector in 1980, (ii) the,completion of a review by July 31, 1980, of measures needed to encouirage increases in household savings and tine deposits, and (iii) the review and further study of the various aspeccs of the Borrower's draft study of its financial sector. 4. Adequacy of the Borrower's measures to harmonize public investments, including those oi SF.'s in 1980 and 1981, with the available financial resources and the Borrower's investment priority criteria that: (i) existing productive capacity is used efficiently and fully and critical bottlenecks removed; (ii) on-going projects be compleced which, with modest additional resources, c-n be expected to yield speedy returns; and ('ii) new productive projects stressing exports and employment generation.  -33- ANNEX B STRUCTURAL ADJUSTMENT LOAN SUPPLEMENT No. 1915-TU Schedule 5 of Loan Agreement In reviewing the progress achieved by the Borrower in the carrying out of the economic program and the measures referred to In paragraphs (A) and (B) of the Preamble to this Agreement, the Borrower and the Bank shall focus in particular on: 1. The adequacy of export promotion policies and administra- tive measures, including: (a) carrying out of a study for the purpose of introducing a more rational protection and incentive system based on tariffs for industry, the first phase of such study to be completed by January 31, 1981; (b) establishment by March- 31, 1981 of an export credit risk -insurance scheme; and (c) :implementation of institutional arrangements to promote, turther development of the Borrower's traditional and non- traditional export products and commodities on the basis of the review of such arrangements referred to in paragraph 1 (a; of Schedule 4 to the Prior Loan Agreement. 2. Adequacy of the Borrower's measures to harmonize public Investments, including those of SEE's in 1980 and 1981, with the available financial resources and the Borrower's investment priority criteria that: (i) existing productive capacity is used efficiently and fully and critical bottlenecks removed; (ii) on-going projects be completed which, with modest additional resources, can be expected to yield speedy returns; and (iii) new productive projects stressing exports and employment generation. 3. Adequacy of measures to increase domestic resource mobilization, including the objective of minimizing overall deficit financing in the public sector in 1980 and 1981. 4. Continuation of sound external debt management policy and computerization of external debt data.  - 34 - STATISTICAL ANNEX TABLE 1: INDICATORS OF PRICE CHANGE/a Percentage Change over Preceding Period Wholesale Prices/b Cost of Living/b Implicit GNP Period Average (General) Ankara Istanbul Deflator 1977 24.1 22.5 26.0 24.9 1978 52.6 53.4 61.9 43.7 1979 63.9 62.0 63.5 73.3 1980 197.2 101.4 94.3 103.3 1981/c (36.6) (30.7) (34.3) - 1980 I 39.7 31.4 27.6 II 18.5 25.0 14.4 III 5.2 7.7 9.8 IV 14.1 8.3 11.0 1981 I 9.3 7.3 8.1 II 3.0 2.7 4.7 III 6.9 8.3 7.2 Source: Ministry of Commerce and IMF. /a Quarterly data are not seasonally adjusted. /b Indices compiled by the Ministry of Commerce. /c September 1981/September 1980.  - 35 - STATISTICAL ANNEX TABLE 2: REAL EXCHANGE RATES FOR TURKISH LIRA/a Indices of the Real Exchange Rate Nominal Exchange vis-a-vis the Currencies of Rate Lira/Dollar Turkey's Trading Partners A B 1970 11.500 92.5 92.7 1971 14.917 110.6 110.5 1972 14.150 99.1 98.1 1973 14.150 100.0 100.0 1974 13.927 93.9 95.3 1975 14.442 93.9 95.3 1976 16.053 90.3 90.5 1977 18.002 89.5 85.8 1978 24.282 91.8 88.1 I 21.379 91.2 88.1 II 25.250 91.2 89.4 III 25.250 93.6 89.9 IV 25.250 90.1 83.3 1979 31.078 86.4 74.6 I 25.250 82.4 76.1 II 28.360 78.8 71.1 III 35.350 92.3 82.9 IV 35.350 82.4 74.5 1980 76.038 110.4 108.7 I 61.595 106.9 103.9 II 75.529 111.5 111.3 III 80.095 116.1 114.8 IV 86.934 107.0 105.0 1981 I 94.589 101.7 103.9 II 102.914 101.5 103.2 Source: World Bank, "Turkey: Industrialization and Trade Strategy" (Report No. 3641-TU, dated November 2, 1981), Table 1.4. /a A rise in the real index indicates depreciation of the Turkish Lira. Note: The index of the real exchange rate (1973 = 100) has been calculated by adjusting an index of the nominal exchange rate for changes in wholesale prices at home and abroad. Calculations for Turkey's prin- cipal trading partners covering about two-thirds of Turkey's imports and exports in 1973 were made by weighting with the sums of exports and imports in that year. Variants A and B are based on wholesale price indices in Turkey as calculated respectively by the Ministry of Commerce and by the Instanbul Chamber of Commerce.  - 36 - STATISTICAL ANNEX TABLE 3: MAIN OUTLINE OF TURKEY'S BALANCE OF PAYMENTS 1979-81 (US$ billion) 1979 1980 1981 (Forecast) Exports 2.3 2.9 4.5 Workers' Remittances 1.7 2.1 2.6 Other Invisibles 0.4 0.4 0.9 Total Current Earnings 4.4 5.4 8.0 Capital Inflows (including debt relief) 1.7 3.4 2.5 Total Receipts 6.1 8.8 10.5 Interest Payments (before debt relief) 1.0 1.1 1.5 Imports 5.1 7.7 9.0 Memo Item Current Account Deficit (including accrued interest) 1.7 3.4 2.5 Source: IMF, EBS/81/180, except for 1981 forecasts which are partly obtained by audit mission.  - 37 - STATISTICAL ANNEX TABLE 4: CONSOLIDATED BUDGET AND SEE FINANCES 1978 1979 1980 1981/a -----------(TL billion)------ I. Consolidated Budget/b Revenues 287.5 507.5 854.7 1485.0 Expenditures 340.0 595.4 1062.6 1548.2 Budget Balance - 52.5 - 87.9 - 207.9 - 63.2 Cash Deficit/C - 61.0 - 45.9 - 192.3 - 125.2 II. State Economic Enterprises/d Total Expenditures 308.2 501.4 1165.4 1854.3 Sales Revenue 256.2 429.9 1142.3 1849.8 Profit/Loss Before Taxes - 52.0 - 71.5 - 23.1 - 4.5 Total Investment 80.1 171.7 476.6 432.7/e Financing Requirements/f 132.1 243.2 499.7 437.27-e Memo Items As % of GNP/! Budget Cash Deficit 4.7 2.1 4.3 1.9 SEE Adjusted Own Resources/h 0.4 0.7 1.3 1.1 SEE Financing Requirements From Outside the Public Sector!i 7.2 7.2 7.7 3.5/i Source: IMF, SM/81/180 and Audit Mission estimates. /a Official estimates unless otherwise indicated. /b Fiscal years from March to February. /c Equals budget balance adjusted for advance and deferred payments. /d Calendar years. /e SEE investment in 1981, and thus financing requirements, are probably underestimated by TL 100 billion according to information obtained by the Audit Mission. /f Total of loss and total investment. /g 1981 GNP forecast on basis of 3 percent growth and 40 percent inflation. /h Gross profits/loss less taxes plus depreciation, less duty losses on account of low sales prices. /i Total financing requirements less budgetary transfers. /j Works out to 5.1 percent of GNP if TL 100 billion is added (see footnote 5).  - 38 - STATISTICAL ANNEX TABLE 5: TURKEY - CREDIT TO PRIVATE SECTOR AND HOUSEHOLDS TL Million Wholesale Price TL Million Index of End of Period Current Index Constant Prices Private Credit (Constant Prices) December 1978 267,582 100.0 267,582 100 December 1979 396,236 181.4 218,432 59.4 December 1980 689,211 353.1 195,189 53.1 May 1980 458,026 285.1 160,655 43.7 May 1981 812.614 379.5 214,128 58.3 Source: Central Bank of Turkey, Quarterly Bulletin.  - 39 T?MKEY - Structural Adiustment Loan r and Supplemental Loan (Loan No. 1818-TU and 1915-TU) Completion Report On March 26, 1980, the Bank signed a $200 million First Structural Adjustment Loan (SAL 1) with the Republic of Turkey, one of the first such loans in the Bank. The amount provided under this loan was based on a conservative estimate of Turkey's ngeds over a tvelve month period, and on assumpCions as to the extenc of ocher external support Turkey was likely to receive through the OECD Consortium. The Executive Directors were advised in the Board presentation that consideration wouLd be given later in 1980 to a further loan, and on Naovember Z4, 1980, a V75 million Supplemencal Loan co SAL I was signed. These loans had been preceded by a -1.50 million First Program Loan (1627-TI) in November 1978 focussed more narrowly on improving Utilization of productive capacitv. These loans were in support of Che Government's ambitious January 1980 stabilization.program to restructure the Turkish economy, and measures already iniciated or proposed over the foiloving few months, in furtherance of chat program. While this far-reaching program was solely the creation of the Turkish Govertment, it reflected many of the concerns highlighted by the Bank's 1979 Economic Report, and was a fundamental departure from previous government policies i n a number of areas. 2. The Government's objectives set out in the 1980 Program and subsequene policy statements were essentially: (a) to bring about a rapid and continuing reduction in the underlying rate of inflation, to a level closer to that in industrialized countries; (b) to secure a substantial and continuing increase in gross forei- exchange earnings from the low level of 6 percent of GN? in 1980, and gradually foster a sustainable balance of payments and external debt position over the longer-term; and (c) to improve domestic resource mobilization, both in the public and private sectors. The achievement of these objectives was regarded by the Government as essential for restoring a sustainable race of economic growth. The program to achieve them, pursued during 1980 and 1981, had the following basic elemencs; substantial devaluation and the adoption of a flexible exchange race policy; incencives to encourage producers to export vigorously instead of concentrating on selling domestically; tight monetary conditions; deregulacion of interest rates and their adjustment to reflect market conditions; implementation of a lebc information system and effective debt managemenc policies; stren-thenin- of public finances through a major tax reform and through che initiation or reforns or che State Economic Enterprise (SEE) sector, including exzosing of the SEEs to markec forces, granting of pricing autonomy co them, constraining cheir access to the budget and Cencral 3ank, and restrictin2 over-emplovmenc; and encouraging the private sector to spearhead Turkish economic development. The initial elements of this ?rogram were supoorted by SAL I and its Supplemenc and were further delineated in connection wich the subsequenc SAL II loan in Xa7 1981.  3. SEAL .was disbursed in tranches of 1l0O, W5O million and t5o million, the second and chird following two satisfactory reviews of progress, and was fully disbursed on tMarch 31, 1981. The SuppLement was fully disbursed in October 1981. As discussed below, considerable progress bas been made by the Governmentc in implementing the structural adjustment program supported by these loans; loan implementation has also been satisfactory. These loans have played an important role in supporting the Covernment's efforts to incroduce significant structural adj'ussments in areas critical to restoring economic viability, and secting the base for continuing of the structural adjustment process in coming years. Monitoring of Policv Areas under SAL I and its Supplement 4. The policy measures which provided the basis for SAL I and its supplement were in th.e following areas: exports, external debt management, domestic resource mobilization and public investment. Benchmarks for evaluating progress in these fields were reflected in Schedule 5 to the Loan Agreements and in two Supplemental Letters to the Loan Agreement for SAL I Supplement. For SAL I progress in these specific areas, together with overall economic performance and policies, was reviewed in June 1980 and again in September/October 1980 prior to reiease of the second and third tranches, respectively. Although some reservations were noted, the reviews' were generally favorable, recommending release of the tranches. 5. The two reviews took place only three and six months, respectively, after the signing of the loan. This was too short a time span to expect any substantial improvemenc in overall economic performance, with the nocable exception of a marked deceleration in: the race of inflation. wcowever, in the four areas described above, progress in adooting policy measures was generally satisfactory! This is described below and in che attached memoranda to the Execucive Direccors on the *cranche releases (Actachmencs I and 2). Progress in Areas Monitored (a) Exports 6. On export promotion, a significant change was the adoption of a more flexible exchange rate policy. In contrast to the past policy of minimal and belated adjuscments in exchange rates, a substanti.al devaluation in the exchange rate and the adoptica of a Dolicy of continued adjustnents to maintain external competitiveness improved the profitabilitc of exports and stimulated remittances from migrant workers. Other export promocion policies undertaken included an improvement in exporters' accez. co foreign exchange through (a) extensions and improvmencs in che foreign exchange retention scheme, and (b) measures co improve exporters' access _o domestic credit. The foreign exchange retention scheme increased from 25 percenc to 50 percent the share of net export receipts which exvorters of manuractures and minerals could retain. In addition the scheme was extended to allow exporters of fruit and vegetables and fishery products, and Turkish contractors working abroad to retain 10 percent of their earnings. This foreign exchange, which previously could only be used either b, the exporter  - 41 - or his sub-cortcractor, could now also be sold in the market. These eXpOrt promotion policies were continued under the Supplemental Loan, and further extended. The most important development was allowing income from exports of industrial foods, fruits, vegetables and fishery products, and receipts from freight and tourism to be deductible in various degrees from taxable income. All foreign exchange earnings of contractors abroad were also made deductible. There were also improvements in access to export credit and in administrative procedures for exporters. 7. One action included in the SAL t Loan Agreement was a review of the interim arran-ements for export credit insurance by October 31, 1980. At the time of the first review1 however, _c was clear that these arrangements vere not functioning. A revised interim arrangement was instituted in May 1981, and.the Government prepared a draft law establishing more permanenc arrangements. Howeverr the law has been deferred owing to .ncertaincy on -the costs of the scheme, given che rapid increase in exports (60 percent *-growth in dollar terms during the first nine months of 1981 over che same period in 1980), and concentration on high-risk countries. .Moreover, foreign banks are now providing financing for Turkish exports to low-risk countries. 8. The Government fulfilled its agreement under SAL I to complete its review of the institutional arranzemencs for promoting exports by October 31, 1980, and progressed iurcher than agreed. A major step has been the centralizacion of responsibility within the Government for export promocion in a new department under the 2 niaing Miniscry. A. July 1980 decree facilitates the establishment of export trading companies and offers them the same incentives available to manufacZ&er-exporters. Proposals to establish free trade zones and trade centers for individual industries are being prepared. Administrative procedures are being progressively simplified. % In the first part of 1980, export performance responded somewhat slowly to the oromocion measures, reflecting bath normal time Lags and the severe dislocation of the economy. In the first nine months of 1980, exports grew by only 6 percent in value over the corresponding period of 1979. Over the remainder of 1980 and che first nine monthTs of 1981, exports showed a dramatic improvement, with the dollar value of export receipts 60 percent more than over che corresponding period in the previous year. Workers' remittances also improved markedly, growing by 26 percent over the first eight months of 1981 compared to the same period in 1980. (b) Protection and Incentives -Systems 10, Progress on a study of the protection and incentives system .ras initially slow. The Government did not initiate this study bv April 30, 1980 as it had intended. However, since then, understandings were reached during.the negotiations for the SAL I Supplement Loan in Occober 1980 setting out the objectives, scope, methodology, organization and timetable of the study (Attachmenc 3). 2hase I of the studv was compLeted in advance of the revised schedule (January 31, 1981) and changes which considerably exceeded Bank expectations were implemnented in the 1981 Import Regime:  - 42 - formal quotas have been abolished, and about one-third of the ieems subject to quotas shifted to the imporc lists (List I) with the most liberal procedures (allowing free import subject to foreign exchange availability), and the remainder to List 1 (requiring proof that goods of comparable quantity and quality cannot be supplied locally withii a reasonable period of time); in addition, a number of items were transferred from List IT to List I. Implementation of the long-cerm study is underway in Turkey, partially financed from the Bank's external research oudget, and its campletion is expected in December 1982 on schedule. Cc) External Debt Manazement i1t The reviews found chat the Government had improved its debt management and that the policies followed were sound. Under the IMF Standby Arrangement of June 1980, the Governrent agreed; (i) to specific limits on aew M&LT commitments over the next 12 months; (ii) not to allow the build-up of any new arrears over the next 12 months; and (iii) e.o reschedule or repay existing arrears within 3 years. Arrangements were concluded for consolidating long-standing arrears on unguaranceed trade credits. Banks holding a majority of Turkey's commercial debt agreed to extend the repayment schedule applyin- to the $3 billion rescheduling package agreed in August 1979. A subsequent rescheduling with commercial banks has taken place. With regard to debt data, however, the technical problems of manually dealing with the large and complex volume of data were such that the Gcvernment decided to computerize the debt data and sought Bank ascistance. Understandings were reached at the negotiations for che SAL I Supplemenc t,oan on the organizational arrangements, plan of action and timetable, and projected Bank assistance. ?rogress in the compucerization of debt data has been disappoincing. Although a competent Project Coordinator has been appointed, and the coordinator and a programmer visited the Bank in July 1981 to gain knowledge of the 3ank's debt reportin syvstem, there has been no further progress. The Turkish auchorities are seekihg external financing for hardware and consultants for this project. (d) Doiestic Resource M'tobilization 12. The reviews found progress on domestic resource mobilization efforts generally satisfactorv. The January 1980 policy reform granted pricing autonomy to most SEZs; this was followed by a considerable initial rise in prices of SEE products and services with uwvard adjustcents continuing to be made periodically. While che SEEs as a group scill recorded an operating loss, this loss was reduced from TL 72 billion (about $1.9 million equivalent or 3.4 percent of GDP) in 1979 to XL 23 billion (about $0.3 million equivalenc or abouc 0.5 percent of GDP) in 1980. Of major concern, however, was the accumulation of a subscantial volume of &rrears in SEE payments. Moreover, increased budgetary transfers to the SEEs Co finance their investment programs combined with the failure of most categories of ta:x and non-tax revenues to keep pace wich inflation meant that the consolidated budget deficic for Q30 grew to more than 4 percenc o. WI?P In the short run, there was Little which could be done to remedy chis; >iowever, the second review noted the publicly stated intention of the  - 43 - military Government and the new Cabinet to enact important tax reforms shortly. Under SAL I Supplement, the Government enacted a major tax reform package in early 1981; important changes were implemented in the taxation. of income and goods, as well as in tax administration. These reforms are being uonitored under SAL II. 13. A significant policy measure undertaken with regard to private savings was the deregulation on July 1, 1980 of all com=ercial bank deposit interest races. The ceiling interest rate on private bonds and the yield on Covqrnment bonds were also raised. These actions far exceeded the agreements under SAL I, and represented a major advance in Turkey's program of policy reforms in the financial sector. There bas been a significant response to these developmencs in deposic ratas. In che one month of July 1980, total deposics grew TL 48 billion, only slig?-v -less than the total increase over the January to June period, and berweent August and November 1980 total deposits grew by TL 107 bilion, three times the deposits accumulated over the same months in 1979. This rapid growch has continued in 1981. Under SAL I Supplement the Government int.oduced a new savings scheme to promote the inflow of emigrant workers. The scheme provides Turkish workers abroad with a competitive outlet for their savings in Turkey, while avoiding the problems of the previous convertible Turkish lira deposit scheme. 14. The Covernment agreed under SAL I to review and further studv various aspects of a financial sector study undertaken in 1976-78 with Bank encouragement. The principal reconmendations.of the study (involving the- liberalization of incerest rates, increasing yields on privare bonds, and- the issue of a competitive government savings inscrumenc) were subsequently implemented during the period covereW by SAL I. The only major recommendation on which action was not taken concerned the securicies market. This issue was discussed during our SAL reviews and was finally dealt with in mid-1981 with the passage of a. capital 7arket bill )roviding.a framework for the stock and bond markets and escablishing a regulatory authority. (e) Public Investment 15. The reviews concluded that progress in rationalizing the public investment program had been adequate. Overall, the level of public investment had been cailored to available resources, with a substantial real decline over the 1979 level. The criteria used for allocations were appropriate to turkey's economic situation; removal or critical bottlenecks (40 percent of the tocal was spent on energy and. nining projects); completion of ongoing projects which are over 80 percent comDlete or wichin a year of completion and those wich secured foreign tinancinz; and export-orienced projects. The 30 priority projects Listed 'or the Bank as those on which resources should be concentrated in the event of overall shortfalls, continued to receive approoriace priority in allocacions. However, there was a concinuing tendency not to distinvuish sufficiencly between the relative priorities of several ongoing projects and to spread available resources thinly amongst them.  - 44 - Loan Impact and Implementation 16. The total loan amount of t200 million for SAL t and $75 million for its Supplement accounted for about 2.4 and 1.0 percent, respectively of Turkey's total imoorts over the period of disbursement. For the specific items eligible for financing under the loans, the impact was greater. For example, it is estimated that the loan financed about 35 percent of imports of eligible agricultural inputs. Loan funds financed essential imports for both industrial and agricultural production at a time when the availability of foreign exchange, especially untied capital, was particularly tight, and when production was seriously disrupted by a shortage of essential imports. 17. Administratively, loan implementation was generally satisfactory'. Because of the experience gained by the Ministry of Finance and the Central Bank in administering the Program Loan, the administration of these loans generally went more smoothly. The Ministry of Finance and the Central Bank bore the main responsibility for administering the loans, and applications for import licenses received substantive approval from the appropriate technical ministry. An interesting feature was the arrangements made for speeding up disbursements (described in para. 28 below). 18. Eligible Commodities and Allocations: The SAL I loan was fully disbursed on Mlarch 31, 1981, ana its Supplement .ully disbursed in October, 1981. The original and final allocations were as follows: SAL I Supplement Disbursements (W) Disbursement ($) Category Original Final Original Final 1. Agriculture 100,000,000.00 110,783,154.90 45,000,000 53,168,364.65 2. Industry 100,000,000.00 89,2L6,3U5.10 30,000,000 21,331,635.35 200,000,000.00 200,000,000.00 75,000,000 75,noo,000.00 Eligible comnodities were spelled out in detail in Schedule 1 of the Loan Agreement, and consisted of materials for production of fertilizers, planc protection chemicals and their raw materials, steel, copper and aluminum products, and petrochemicals and other chemicals. At the request of the Government, Schedule 1 of the SAL I Loan Agreement was amended during implementation, to include in Category l(a) (macerials for production of fertilizers) an addicional product (mono ammonium ohosohate) and in Category 2(a) (steel industry) an additional import (iron ore) limiced to $10 million. Private sector firms received allocations from SAL I of $100.3 million, exceeding che rarget of .65 million. Apart from Bank financing, SAL I provided that the Government would allocate $30 million from its own resources during the loan period for imports of spare parts. Of this, $10 million was to be for private firms. Since monitoring of actual allocacions vas impossible given the Central Bank's current recording mechods, a copy of the Government's instruccions implementing this allocation was obtained.  -45- 19. Counterpart Funds; Counterpart funds equivalent to the loan amounts were channelled oy Government decision to five of the highest priority energy projects, including the Bank-financed Bibistan and Karakaya projects. 20. Procurement: tmports were made directly by actual users, except vhere import by certain SEEs for sale to both private and public sector enterprises is prescribed by law. Procurement provisions were simplified fz'ou& those of the Program Loan, by increasing the minimum value of bulk imports to S5 million which would be procured. on the basis of ICS procedures consistent with normal Bank guidelines. All contracts of a lesser value vere awarded under the normal procurement procedures of public and private sector firms concerned. The procurement procedures of public sector firms already provided for substantial international bidding, and private sector firms had adequate choice of international suppliers to ensure reasonable availability and pr.ce. 11. Disbursements; 1isbursemeats initially were rather slow, despite the high level of cormicmenrs. The reasons were twofold; first, there is a minimum time normally required for the many steps that must be taken for concluding contracts for World Bank disbursements; and, second, there were financing problems peculiar to Turkey's economic situation. As regards the latter, most foreign banks continued to demand 100 percent cash coverage b the Central Bank for any Turkish letters of credit, and Turkey's forei exchange shortage constrained the amounts that could be so covered. 22. The Government therefore arranged to use two 40-day bridge financial arrangements with two foreign conmiercial banks which it made under the Program Loan. These banks guaranteed Turkish letters of credit, which otherwise were not accepted, and covered expenditures from the time they vere incurred until reimbursement was made by the Bank. This introduced an element of flexibility which made it possib.e for the Government to manage the process of disbursement much more effectively, speeded up disbursement, and avoided tying up Bank funds in guaranteeing letters of credit whose disbursements might not be made for some time. The coimercial bank limits (initially $40 million for one bank and $10 million for the other) regulated the pace of corimiitments and Bank disbursements. However, a raising of the limits on the bridge financing by one of the banks (from $40 million to $60 million) in late June, eased the situation. Thereafter, disbursements proceeded at a rather rapid rate, and the SAL I Loan was fully disbursed Oft ?larch 31, 1981, and its Supplement fully disbursed in October 1981. Summary and Conclusions 23. The economic philosophy underlying the January 1980 program marks a decisive break with the previous period of Turkish economic development strategy. It involves an acceDtance of the need to emphasize stabilization of the economy initially so that growth can be resumed on a viable basis thereafter while beginning to reorient Turkey's development strategy outward through the development of exports and other foreign exchange earning activities instead of the heavy import substitution bias of the past. It  - 46 - introduces the. principle of using the market mechanism and incencives wherever possible to guide economic activity, rather than the quantitative controls and physical planning of much of che last two decades. These changes are generally appropriate to the present scage of Turkey's development and its current difficult economic situation. 24. This First Structural Adjustment Loan and its Supplemenc were in support of this policy reorientation, and, while the percentage of imports vwich they financed was not large, these loans provided quick-disbursing foreign exchange at a time when the need was critical. Given the gravity of Turkey's economic problems and the policies pursued over recent years which gave rise to them, it must be expected thae it will take some time before the effects of the rescructuring program become fully evident and conditions which would permit sustainable growch with financial stability are restored. Meanwhile, the Government's program concinues to deserve, and require, substantial support in terms of external funds at better than coa ercial market terms, without which ic is unlikely to be successful. ferformance under the First Structural Adjustment Loan and ics Supplement vas better than expecced in many key areas and generally atisfactory in others. The reviews of progress in implementing policy reforms have probably played a useful purpose in expediting progress towiard agreed goals.  - 47 - List of Attachments 1. Memo to EDs on Second Tranche Release 2. Memo to EDs on Third Tranche Release 3. Supplemental Letter to SAL I Supplement on Protection Study. 4. Supplemental Letter to SAL I Supplement on External Debt Study. EM2DA December 16, 1981  International Bank for Reconstruction and Development FOR OFFICIAL USE ONLY - 48 - Attachment 1 SecM80-596 FROM: Vice President and Secretary August 1, 1980 TURKEY - STRUCTURAL ADJUSTMENT LOAN Attached for information is a note regarding the consultations under the Turkey Structural Ad-ustment Loan ralating to t-.e release of the second tranche. Questions on this document may be referred to Mr. Berk (extension 72379). Distribution: Executive Directors and Alternates President President's Council Vice Presidents, IFC Directors and Department Heads, Bank and IFC This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY - 49 - August 1, 1980 MEMORANDUM TO THE EXECUTIVE DIRECTORS SUBJECT: Review of the Turkey Structural Adjustment Loan As provided in Section 3.08 of the Loan Agreement for the Structural Adjustment Loan to Turkey (Loan 1818-TU), a mission visited Turkey from June 9 to 27 to exchange views on progress achieved in carrying out the economic program assisted by the loan. General The bold and significant measures announced by the Government in January 1980, which provided the framework for the Loan, have generally been implemented in an efficient and effective fashion. The initial measures have been buttressed by a number of important additional reforms, most notably, an agreement with the IMF in June 1980 to introduce more flexible exchange rate arrangements, the successful conclusion of $3 billion debt rescheduling talks with OECD in July 1980, and as a significant resource mobilization measure, the freeing from government control of virtually all interest rates. Opposition to the Government's initiatives has been relatively restrained given their far-reaching nature, although sufficient to lead to a recent close vote of confidence. The severe political constraints, discussed in the President's Report remain but,there is no evidence of any change in the Government's determination to carry out the program of economic reform. The review focussed on recent performance and policies in the four areas agreed for monitoring of progress: (i) adequiate export promotion policies and measures; (ii) external debt management; (iii) domestic resource mobilization measures; and (iv) measures to harmonize public investments with available resources. Export Promotion Policies and Measures The Government's export target is an average real growth of exports of not less than 10 percent per annum during the period 1979 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY - 50 - through 1983. Export developments in 1979 were disappointing. Exports rose by 9 percent in dollar terms in the first five months of this year over the previous year, and the Government expects a strong increase in the second half of 1980, when the large January devaluation, the new exchange rate policy, reduced domestic demand and slower inflation since March should have their effect. Performance on policies and measures in support of exports is generally in advance of the agreed timetable of monitorable actions. The Government has pursued the more flexible exchange rate policy announced in January 1980, implemented largely through cross-rate adjustments. Exporters can now have more confidence that competitiveness will be maintained. Other important changes to export incentives include an extension of the foreign exchange retention scheme to exporters of fruit and vegetable and fishing products and allowing exporters to freely sell the foreign exchange so retained. The Government also has undertaken a number of measures on the financial side: exporters' access to foreign exchange from commercial banks has been improved as has their access to commercial bank credit. Incentives are offered to both exporters and banks to expand '-n.ding for exports and rediscounting facilities for exports at the Central Bank have been increased. The interim export credit insurance scheme has not functioned but a draft scheme prepared by the Ministry of Finance is under review within government and satisfactory permanent arrangements are likely to be completed before October 1980. Institutional arrangements for promoting exports are the subject of an ongoing review agreed to be completed by October 31, 1980. Administrative changes made to date include the centralization of responsibility for export promotion in a new department in the State Planning Office, a simplification of administrative procedures involved in exporting, and a proposal to set up sectoral/industrial export promotion organizations. The study of protection has not yet been initiated but discussions were held with Bank staff in May and June on the general approach to be used. A group consisting of representatives of various ministries and supported by private institutions has now been organized to undertake the study in two phases. The Government, in consultation with the Bank, has decided to focus on a selected sample of subsectors where the greatest distortions exist, so that policy results can be more quickly obtained. The first phase (August-September 1980) will attempt to identify those industrial subsectors where the most obvious distortions exist. These subsectors would be the subject of study in a second phase (September 1980 to September 1981). In view of the importance of reform of tariffs, quotas and other non-tariff barriers to trade in manufactures, to the restructuring of the economy and improvement in export competitiveness, we have conveyed to the Government our concern that the study get underway without further delay and are working with the Government on the sampling and analytical methodology. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY - 51 - External Debt Management Under the new standby arrangement with the IMF, the Government has agreed to limit new commitments of 1 to 5 years maturity to $500 million and new commitments of 1 to 10 years maturity to $1 billion during the 12-month period up to June 30, 1981. The successful rescheduling of about $3 billion of debt service obligations falling due over the three years ending June 30, 1983 has substantially improved the short-term debt position of the economy. The IMF and the Bank are collaborating on providing technical assistance to improve the reporting and computerization of the large and complex volume of external debt data which currently is assembled manually. Domestic Resource Mobilization Measures Price increases in the state sector, announced under the Government's January 1980 program, are expected substantially to increase SEE revenues in 1980. SEE access to the Central Bank in the first six months of 1980 was sharply lower than the same period of 1979. A major tax reform package is currently before Parliament, but stalled because of the political situation. The Government has not only completed the agreed internal review of measures to increase household savings prior to July 31, 1980, but has already implemented a number of key policies. A June 1980 Decree freed interest rates on all time deposits and permitted the issuance of bearer certificates of deposits. While the Banks then agreed among themselves to raise deposit rates by 2-10 percentage points, up to a level of 36 percent for four-year money, the Government is determined to break any cartel arrangements by competitive increases on public bonds. The issuance of competitive public bonds and the freeing of interest rates on private bonds is expected shortly. In the longer-term, a proposal to develop the capital market is under discussion by the Council of Ministries. Moreover, most of the principal recommendations of the draft Financial Sector Study have been implemented or will be implemented shortly, obviating the need for further review of the study. Public Investment The overall level of public investment has been tailored to available resources in several stages this year, and the current estimate implies a real decline in public investment over the 1979 level. The criteria used for including project allocations in the 1980 program are generally appropriate to Turkey's present circumstances. Priority projects have been given a substantial increase in real allocations. t. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwisc be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY - 52 - The progress made to date is fully consistent with the obligations in the Structural Adjustment Loan. Consequently, the Government of Turkey has been advised of the availability of the second tranche of $50 million. Ernest Stern Vice President Operations This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  International Bank for Reconstruction and Development FOR OFFICIAL USE ONLY Attachment 2 - 53 - SecM80- 804 FROM: Vice President and Secretary October 24, 1980 TURKEY - STRUCTURAL ADJUSTMENT LOAN Attached for information is a note regarding the consultations under the Turkey Structural Adjustment Loan relating to the release of the final tranche. Questions on this document may be referred to Mr. Berk (extension 72379). Distribution: Executive Directors and Alternates President Senior Vice Presidents President's Council Vice Presidents, IFC Directors and Department Heads, Bank and IFC This document has a restricted distribution and may be used by recipients only in the performance of their official duties. its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY - 54 - October 24, 1980 MEMORANDUM TO THE EXECUTIVE DIRECTORS SUBJECT: Review of the Turkey Structural Adjustment Loan As provided in Section 3.08 of the Loan Agreement for the Struc- tural Adjustment Loan to Turkey (Loan 1818-TU), discussions were held in Washington from September 24 to October 3 on progress achieved in carrying out the economic program assisted by the loan. General After the military takeover on September 12, the new Government reaffirmed publicly its commitment to the January 1980 program and its intention to enact those parts of it previously held up by deadlock in Parliament, notably tax reform. The senior official largely responsible for the program holds the position of Deputy Prime Minister in charge of economic affairs in the new Government. The program continues to be implemented in a consistent way. Progress under the IMF standby arrange- ment remains satisfactory. The review focussed on recent performance and policies in the four areas agreed for monitoring of progress: export promotion, external debt management, domestic resource mobilization, and public investment. Export Promotion In the first eight months of 1980, exports increased only 6 per- cent in value over the corresponding period of the previous year against the Government's target of 10 percent in volume terms. While price move- ments have been uniformly favorable, and most commodities have shown volume increases, certain important agricultural and manufactured items have shown significant volume declines. The reasons include low initial agricultural stocks, lack of domestic finance for additional crop purchases, lower manu- facturing production due to shortages of imported inputs and energy and labor disputes, and the need for time for the January 1980 and subsequent measures to have their full effect. Neither lack of adequate policy nor institutional weakness appears to have played a part. Now that a number of the problems have been overcome, the Government expects a large increase in exports during the remainder of the year. There have been few changes recently in export policies and institutional arrangements. The Turkish Lira continues to be devalued in small steps approximately each two months. Export credits benefit from subsidized rates, especially since the interest rate liberalization in July. The Government has prepared a draft decree to establish an export This document has a restricted distribution and may be used by recpients only in the performance of their official duties. Its contenst may not otherwise be disclosed without World Bank authorization.  ,55 FOR OMCIAL USE ONLY credit insurance scheme. The establishment of specialized exporting companies has been facilitated. Agreement has now been reached on all aspects of the study of the protection system. The first phase, to be completed by January 31, 1981, will be a short-term review of manufacturing industry to identify distor- tions, and define measures to increase export capability and capacity utilization, and remove bottlenecks. It is expected to lead to earlier action than originally anticipated, through changes in the 1981 import regime and other relevant policies. The second phase involves an in-depth study of export incentives, the import regime, and investment incentives; policy papers with recommendations for reform, and restructuring programs to assist affected industries, will also be prepared. The work will take until the end of 1982, about nine months after the originally agreed date; but reforms will be introduced as they are ready. The new system resulting from the liberalization program is expected to be fully in place by the end of 1984, which was the original expectation. External Debt Management External debt management policies have remained sound. Following the large rescheduling of debts to OECD member countries in July, Turkey is in contact with commercial banks regarding possible further assistance. Detailed agreement has been reached on the computerization of the large and complex volume of external debt data, currently assembled manually, with Bank technical assistance. Domestic Resource Mobilization Domestic resource mobilization efforts present a mixed picture. Large price increases in the state sector, both in the January 1980 program and repeatedly since then, are expected to permit a small operating profit for SEEs in 1980. However, budgetary transfers to them have increased beyond original expectations due to a consolidation of their tax payments and repayment of part of their large arrears to contractors. While Govern- ment revenues and expenditures have both declined in real terms over 1979 levels, revenues in particular are lagging, with substantial arrears in tax collection due to increased evasion prompted by failure to adjust income tax schedules for high inflation. The anticipated budget deficit for 1980 has increased significantly, borrowing from the Central Bank has stayed high, and Government arrears to contractors are still accumulating. Little can be done to correct these problems in the short run. The failure of Parliament to pass two tax bills since February 1980 has been a further major problem. The new Government has, however, stated publicly its intention to enact tax reforms shortly. Interest rates on time deposits (and most loans) were liberalized on July 1, and have risen by 4 to 12 percentage points, depending on maturity. Bank deposits have responded immediately, with an increase in July only slightly less than total increases in the preceding six months. This document bks a resoed distribution and my be sed by re nts only in the performance of their ofwil duties. Its a>ntenst may not otherw be dislosed without World Bank authorization.  - 56 - FOR 3MICIAL USE ONLY Moreover, w.th greater competition emerging within the banking sector, it seems likely that interest rates will continue, at least in the short term, to be sufficiently attractive to financialize substantial private savings. The yield on private bonds has been raised somewhat, and that on Government bonds from 18 percent before July to 30 percent currently, both tax-free. Measures to increase the financialization of private savings thus go well beyond agreements under the loan. Public Investment The overall level of public investment continues to be tailored to available resources, and the current estimate implies a substantial real decline over the 1979 level. The criteria used for sector and project allocations remain appropriate to Turkey's present circumstances. Priority projects have retained a substantial increase in real allocations. Conclusion The progress made to date is consistent with the obligations in the Structural Adjustment Loan. Consequently, the Government of Turkey has been advised of the availability of the final tranche of $50 million. Ernest Stern Senior Vice President Operations This docum)ent has arestricted distribution and may be used by recpeents only in the performance of their ofricial duties. Its contenst may not otherwise be discosed without World Bank authorization.  ATTACHMENT - 57 - Letter No. 1 REPUBLIC OF TURKEY November 24, 1980 International Bank for Reconstruction and Development 1818 H Street, N.r. Washington, D.C. 20433 U.S.A. Re: Loan No. 1915 TJ (Structural Adjustment Loan Supplement) Protection Studv Dear Sirs, With reference to Schedule 5, paragraph l(a) of the Loan Agreement of even date herewith, we wish to confirm that the study will be carried out in accordance with the attachment to this letter. Please confirm your agreement with the foregoing by signing the form of confirmation below. Very truly yours, REPUBLIC OF TURXEY By s Tevfik Altinok A horized Represent ive CONFIRMED: INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT By /s/ ioger Chaufournier Attachment  - 58 - ATTACHMENT Page 1 of 4 TERMS OF REFERENCE FOR THE STUDY ON RESTRUCTURING THE EXISTING PROTECTION AND INCENTIVES SYSTEM A. Purpose of the Study 1. Turkey has started to use protection and incentives policies since the beginning of the Planned Development Strategy. 2. Turkey adopted an industrialization policy which was foreign exchange saving rather than foreign exchange earning. In order to protect these industries, which were mainly import substituting and inward oriented, from foreign competition Turkey implemented a protective import regime aimed at preventing the import of industrial goods. 3. Parallel to these policies, and in order to reach the rates of growth and economic structures aimed at in the Development Plans, incen- tives were used to direct investments to priority areas. 4. Our past economic history and experiences clearly indicate the necessity of restructuring the existing incentives and protection system. While the demand for consumer goods has reached a certain level of saturation, these industries protected from foreign competition behind custom walls have been gradually losing their economic and technical efficiency. At this stage, and with the existing levels of protection, local production has been losing its income effect and industry has been more import-oriented. With this industrial structure, it is impossible to expect an export-oriented approach from these industries. While high production costs have prevented greater exports of industrial goods, without the expanded production effects of exports, production costs could not be lowered. 5. In view of increasing balance of payments deficits arising mainly on account of these past "inward-looking" import substitution policies, a serious effort has to be directed towards a reform of the protection and incentive system, in order not only to facilitate the much needed export drive, but also to direct investment into the priority areas. To do this, the aims are to progressively reduce any remaining bias of the incentives against exports, reduce the variability of effective protection and effec- tive subsidy across activities to rationalize incentives so as to correct distortio,ns in resource allocation, move from reliance on quantitative restrictions to the use of tariffs, and reduce effective protection where excessive. B. Phasing 6. The detailed incentives study, which will also spell out a phased program of trade liberalization, will take about 2 years. In the mean- while, a short-term review will identify certain policies which need to be implemented quickly by the Government. These policies are geared towards  - 59 - ATTACHMENT Page 2 of L improving the import regime in the short-term, and are also in conformity with the broad longer-term objectives of restructuring the protection and incentive system to promote exports, and in general to introduce trade liberalization. For this reason the protection study will be conducted in two stages; (a) Short-Term Action-Oriented Review; 4nd (b) Long-Term Incentive Study and Recommendations for Trade Liberalization. C. Short-Term Action-oriented Review 7. Organization and Timetable. Responsibility for conducting the short-term review will rest with a special expert commission for which the State Planning Organization (SPO) will serve as the secretariat, and which will include representatives of SPO as well as of the Ministry of Finance, Ministry of Commerce, Ministry of Customs and Monopoly, Ministry of Industry and Technology, Industrial Development Bank, and the Chambers of Commerce and Industry. The commission will prepare a report covering an incisive review of the policies outlined below before January 31, 1981. Its major recommendations will be incorporated after review into the 1981 Import Regime and other relevant measures. 8. Bank Role. An English translation of the commission's report will be provided to the Bank within one month of its issue, for comments. A statement of the consequent changes made in the 1981 Import Regime and other relevant measures will be provided to the Bank within one month of their enactment. 9. Scope. The commission will analyze the following set of policies related to the import licensing system as well as other studies and data available, and suggest the required changes and additional insertions in the 1981 Import Regime and other relevant measures, if found desirable. Keeping in view the question of overall foreign exchange availability, these policies are directed towards increasing export capability, fuller utilization of existing capacity, and the elimination of bottlenecks and inefficiency. The recommendations will be in the direction of more liberalization, both by removing quotas where possible and by increasing the dollar amounts of applicable quotas for the following necessary imported inputs; Ci) Imported inputs for increased capacity utilization. One of the current limiting factors to industrial production for domestic use is the presence of widespread unutilized capacity. A major reason behind this phenomenon is the unavailability of imported materials and spare parts. These needed items should be identified, and imports of them should be increased whenever feasible. Alloca- tions for inputs should be increased at the expense of those for  - 60 - ATTACHMENT Page 3 of 4 consumer and (if necessary) investment goods, to permit an in- crease in output in the short-run while limiting any impact on investment prospects. (ii) Import of machinery needed for export industries. The study should identify and recommend any necessary increase in provision for import of machinery needed for export industries, i.e. exporters should be given priority claim on licenses for the import of machinery. (iii) Import of machinery needed for projects which are identified, on cost-benefit grounds, as priority projects even though producing goods primarily for domestic use. The rationale for such a policy is to prevent bottlenecks in critical sectors/subsectors of the economy. 10. In addition the committee will study the scope for increasingly admitting competing imports in order to improve all round efficiency, keeping in view the short-run foreign exchange liquidity problem. D. Long-Term Study of the System of Protection and Incentives 11. Organization and Timetable. The research will be carried out by a qualified full-time coordinator and other experts selected by the Govern- ment of Turkey and reporting to the State Planning Organization. Active participation of other related agencies, experts and university staff will be provided in a planned and coordinated way. Before starting the quanti- tative research, we intend to hold a colloquium with the participation of all related personnel and agencies. 12. The research will commence in January 1981 and it will be com- pleted by September 1982. Policy papers containing recommendations for reforming the system of protection and incentives, and restructuring programs to assist industries which will have difficulty in adapting to increased competition from imports to make the transition to greater efficiency, will be prepared during the period September 1981 to December 1982, making use of the results of the research as they become available. A timetable of the policy papers will be prepared by May 1981. Actions to reform the protection and incentives system will be taken as appropriate during the course of the research, and the new system resulting from the liberalization program will be fully in place by the end of 1984. Partic- ular attention will be paid to the phasing of the implementation of the recommendations so as to minimize dislocations. 13. Bank Role. The Bank will generally review the implementation of the study. In particular, the initial selection of industries, and the guidelines to be applied in the selection of firms within these industries, will be reviewed with the Bank by January 31, 1981. The Bank will also receive periodic reports on the progress of the research and English trans- lations of the policy papers as they are prepared.  - 61 - ATTACHMENT Page 4 of 4 Scope. The research will be carried out for a sample of firms in individual industries, selected so as to include firms possessing different characteristics, in particular as far as ownership and export orientation is concerned. Initially emphasis will be given to industries producing exported or potentially exportable items and those where import liberaliza- tion is expected to cause considerable dislocation. 15. The study will encompass the following: (i) the calculation of incentive indicators (nominal protection, effective protection, and effec- tive subsidies); (ii) the calculation of cost-benefit indicators (the domestic resource costs of foreign exchange and the first-year economic rate of return); (iii) an analysis of the relationship of incentive and cost-benefit indicators with various attributes of the firms, including capital, employment, ownership (public, private and foreign), export orientation, and location. The methodology for items (i)-(iii) is summar- ized in the Annex and detailed in documents already transmitted by the Bank to the Government; any proposed changes from this methodology will be approved by the Bank. 16. The recommendations will cover regulations concerning import quotas and other forms of quantitative restrictions, tariffs, export taxes and subsidies, and investment incentives.  - 62 - ANNEX Page 1 of 4 LONG TERM STUDY OF THE SYSTEM OF PROTECTION AND INCENTIVE SYSTEM IN TURKEY METHODOLOGY I. Indicators of Incentives 1. The research under this heading will first of all involve estimat- ing nominal protection coefficients (NPC's) for the output and material inputs of each firm. The NPC is defined as the ratio of the domestic price of a product to its world market or border price. For products sold domestically that are not subject to quantitative restrictions, price control, prohibitive tariffs, or smuggling, the nominal protection coeffi- cient is taken to be one plus the ad valorem rate of tariff, under the assumption that domestic products will sell at the tariff-inclusive price of comparable imports. For exported prodcuts, the NPC is the ratio of the price received by the exporter to the f.o.b. export price. 2. The expression "tariff" is used here to refer to the ad valorem equivalent of all tariff-type measures. The ad valorem equivalent of specific duties is obtained by relating the amount of duties paid to the c.i.f. price of imports. The same procedure is followed in regard to import taxes and surcharges. The results are further adjusted for differ- ences in indirect taxes on domestic production and on imports. 3. In Turkey the tariff schedule generally applies the same (prin- cipally ad valorem) most-favored-nation rates to imports of a given commodity regardless of the country of origin (except for EEC prefer- ences). The schedule rates will be used for the estimate of the NPC in the case of imported intermediate inputs which are not produced domestically. 4. However, for the wide range of final goods manufactured by local firms, the NPC's will be estimated by comparing domestic ex-factory prices with the c.i.f. import prices of equivalent or similar products. This is necessary owing to the prevalence of quantitative import restrictions, the administrative allocation of foreign exchange, prohibitive import duties on many consumer goods, and the existence of smuggling. Price comparisons will also be needed for local primary product inputs that are subject to subsidies and other government intervention and for locally produced inter- mediate goods. 4. While the nominal protection coefficient expresses the effects of the various incentive measures on the price of a particular product, for the firm what matters is not only the price of its output but also the cost of purchas - inputs. The protection of these inputs will raise their cost to the f-r.and can be considered as a tax on the use of these inputs. The combined effects for the domestic producer of protective measures on its output and inputs are represented by the effective protection coefficient (EPC), which -cpresses the extent of protection to value added. The EPC is defined as the ratio of domestic value added, obtainable as a result of the application of protective measures, to value added i-  - 63 - ANNEX Page 2 of 4 Value added is the difference between the price of the product and the cost of traded inputs, including material inputs incorporated in non-tradeable inputs, and the material input component of the revalued capital stock as reflected in annual depreciation charges. The components of value added include post-tax profits, royalties, profit, tax, miscellaneous taxes, rent, interest and wages. Value added in domestic prices, or domestic value added, is derived by valuing the product and its purchased inputs in domestic prices. Value added in world market prices, or world market value added, is obtained by valuing the product and its purchased inputs in world market (border) prices. 5. The estimates of nominal protection for outputs and material inputs, combined with the firm level input-output data, are the principal requirements for the estimation of effective protection coefficients. Firm level input-output data will be obtained through a survey of a sample of firms in individual industries. 6. In addition it is necessary to take into account the effects of trade taxes and subsidies on the cost to the firm of non-tradeable inputs such as electricity, water, commercial margins, domestic transport, and miscellaneous business services, and also on the cost of capital equipment as reflected on an annual basis in depreciation and explicit or implicit interest charges. 7. As regards non-tradeable inputs, the so called Corden methodology will be followed of decomposing each such input into components consisting of direct and indirect traded inputs valued in border prices, trade taxes and subsidies, other taxes and subsidies, and value added. To estimate the cost of capital equipment, it is necessary to estimate the replacement cost of the capital stock of each firm. 8. Effective protection coefficients relate the effects of protective measures on the product and its inputs to world market value added. The effective subsidy coefficient (ESC) expresses the effects of the protective measures, together with the effects of credit, tax and price preferences, on domestic value added. It is derived by adjusting the effective protec- tion coefficient for the difference between profit taxes, interest, and the prices of non-traded goods and services actually paid by the firm, and what are estimated to be "normal" charges under these headings. The norms used will be the averages for all the firms surveyed, taken together, so as to ensure that the overall averages of EPCs and ESCs are identical. This will involve, for example, calculating averages of interest rates, weighted by the amount borrowed, and averages of profit taxes, weighted by pre-tax profits. II. Indicators of Economic Costs and Benefits 9. In Part I the firm level data will be used to present quantitative estimates of incentives. This analysis is entirely positive in the sense that it says nothing about the desirability or otherwise of the various  - 64 - ANNEX Page 3 of 4 activities. In Part II, building on the incentive results the analysis will be carried further in order to provide normative indicators relating to the economic desirability of the activities in question and to throw some light on the comparative advantage of the various Turkish industries. 10. In order to value economic as distinct from private costs and benefits, shadow prices will be estimated, updating and expanding on the recent Bank Staff Working Paper (No. 392) as necessary. The shadow prices relate to the following: (i) Foreign exchange. (ii) A shadow rate of discount for valuing capital costs. (iii) Five categories of Turkish labor (unskilled, semi-skilled, skilled, clerical, and technical and management). (iv) Industrial land. 11. Having estimated the shadow prices, they will be applied to the firm level data in order to calculate two cost-benefit indicators. These are: (i) a DRC ratio (abbreviated as DRC) in which the numerator consists of the opportunity costs of primary factors valued in domestic shadow prices, and the denominator consists of net foreign exchange earnings also valued in domestic shadow prices; (ii) a coefficient of economic profit- ability (CEP) in which the profit for the year (1980 or 1981 will be used) is expressed as a ratio of the invested capital, both defined in domestic shadow prices. This coefficient is the one-year (cross-section) variant of the economic rate of return calculated in the cost-benefit analysis of projects. 12. The incentive and cost-benefit indicators will be calculated for the total output of each firm and aggregated by subsectors and sector. Separate estimates for domestic exportables will be made. III. Analysis of Incentive and Cost-benefit Indicators 13. In this part of the research the incentive and cost-benefit indicators will be analyzed in relation to a variety of factors of policy interest to the Government. In particular the following questions will be investigated. (i) The relation between the cost-benefit indicators and the level of incentives. (ii) The relation between capital intensity, skill intensity, and the cost-benefit indicators. (iii) The relation between employment and the cost-benefit indicators.  - 65 - ANNEX Page 4 of 4 (iv) The relation between location and the cost-benefit indicators. (v) The cost-benefit indicators in relation to equity ownership by the Government, and by private firms. (vi) The relation between private and economic profitability. (vii) The relation between the cost-benefit indicators and the orienta- tion of production towards the domestic market or towards exports.  - 66 - Letter No. 2 REPUBLIC OF TURKEY November 24, 1980 International Bank for Reconstruction & Development 1818 H Street, N.W. Washington, D.C. 20433 Re: Loan No. 1915 TU (Structural Adjustment Loan Supplemenc) Computerization of External Debt Dear Sirs, With reference to Schedule 5, para. 4 of the Loan Agreement of even date herewith, we confirm that we will computerize the recording and anal2,sis of all external debt obligations of, or guaranteed by, the Republic of Turkey. We have decided that the Ministry of Finance will be responsible for co- ordinating the collection, processing and analysis of all data cn short-term and medium-term debt. To supervise and ensure the smooth working of this orocess, we have set up a Coordination Committee chaired by the Ministry of Finance, and con- sisting of senior representatives of the Ministry of Finance, Central Bank and State Planning Organization, and have already informed the Bank of che names and positions of these representatives. In future, should these rep- resentatives be changed, we shall keep the Bank fully and promptly informed. This Committee will be responsible for: 1. Advising the Prime Minister or Deputy Prime Minister on decisions on the ultimate objectives, and hence the characteristics, of the system to be installed, in particular: (a) that the system will be a statistical rather than an accounting one, in that it will deal with approximate amounts involved during a certain period, rather than exact amounts and dates of transactions; (b) frequency of update, in light of the capacity of the reporting agencies to provide data, and the Ministry of Finance's ability to process it; - C-(c) analytical capabilities, e.g. implications of variations in terms of any new borrowings, Eurocurrency interest rates, and rescheduling alternatives;  - 67 - (d) location of staff, facilities, equipment, etc., for the computerization project as needed; (e) arrangements for access by each of the three main agencies (Ministry of Finance, Central Bank and State Planning Organization) con- cerned, as necessary. 2. Ensuring the timely exchange of all external debt data among the three agencies on a continuing basis. In particular, we have taken steps to ensure that the short-term external debts, the statistics of which have so far been both collected and maintained by the Central Bank of Turkey, will from hereon be maintained and analyzed by the Ministry of Finance, under the proposed new system. 3. Efforts to improve the quality and timeliness of debt reporting by agencies utilizing external credits. The Ministry of Finance will be responsible for setting up the system; for system maintenance; and for coordinating and timing the update of infor- mation, and quality control over reporting by agencies utilizing external credits, to permit the production of reliable and timely records. To carry out the work, the Ministry of Finance has appointed, and will maintain at all times, a competent Project Coordinator. It has also appointed three staff members to assist the Coordinator, and will maintain and supplement such staff as necessary, especially as provided in para. 3 of the Attachment. The Coordinator will report to the Director General of the Treasury responsible for International Economic Relations, and will also be the technical counter- part in dealing with the Bank and other external agencies. The work will follow the plan of action and timetable set out in the Attachment to this letter. We understand that the Bank will provide the following assistance in carrying out the project: 1. Suggestions on the detailed input and output of the system appropriate to the circumstances and external debt transactions of Turkey; 2. An opportunity for the relevant personnel to visit the Bank to gain detailed knowledge of the Bank's debt reporting system, including its input requirements, operation and output; 3. Follow-up missions at periodic intervals as necessary to assist us in designing, implementing and operating the system; 4. Advice on machine capabilities and training needs.  - 68 - Once the computerization project is completed, we shall use the new system to develop external debt profiles, for periodic reviews of external debt management by the Government under the direction of the Minister of Finance. Please confirm your agreement with the foregoing by signing the form of confirmation below. Very truly yours, REPUBLIC OF TURKEY By sI Tevfik Altinok /A torized Representati e CONFIRED: INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOP=T y, _ C By Roger Chaufournier  - 69 - ATTACEM=NT Plan of Action by Government & Timetable 1. User Survey October and November 1980 Survey of both those using and those providing data. This will involve establishing a joint working committee with representatives from the Ministry of Finance, SPO and the Central Bank and designation of counterparts in other agencies and SEEs. This survey should recommend the scope of the system, type of output required, data availability and frequency of updating. 2. Initial SDecification of the required system. December 1980 3. Appointment of a Programmer. December 1980 Ideally someone with a background in economics/statistics. 4. Visit to Washington of project coordinator and programmer January 1981 to study the World Bank system: its composition, how it is used and updated. Technical assistance to be provided including advice on system design, specification and data content. 5. Programming of recuirements together with detailed speci- February through fication of each item to be put on file. Determination June 1981 of editing routines, i.e. data checks for consistency and accuracy to be performed by the machine, design of output format. 6. Redesign of forms for requesting data from other agencies February through in conjunction with these agencies. Design of coding June 1981 forms and output request forms for using the system. Outline of supporting files, i.e. exchange rates, variable interest rates, debtor/creditor name files. Allocation of codes to be used for each item. 7. Choice of machinery to be used/location. Either (a) pur- March through chase of new equipment taking into account need, servicing June 1981 facilities and availability of spare parts. Location of this hardware; or (b) arrangement of access to existing facilities, determination of time sharing arrangements and possibility of access terminals. 8. Implementation and testing of the system. Actual recording July through of programmes and testing with sample data. September 1981 9. Input of basic data file for all loans, i.e. creation of October through the master file and checking of data against specified December 1981 edit routine. 10. Refinement of the system and additional updating. First half of Teaching familiarity and use of the system. 1982  - 70 Letter No. 3 REPUTBLIC OF TURM November 24, 1980 international Bank for Reconstruction and Development 1818 H Street, N.W. Washington, D. C. 20433 United States of America Re: Loan No. 1915-TU CStructural Adjustment Loan Supplement) External Debt Dear Sirs: Tn connection with the proposed loan to the Republic of Turkey for the above Project, in an amount in various currencies equivalent to $75,000,000, am writing on behalf of the Republic of Turkey to set forth certain facts relating to the external debt of the Republic of Turkey. 1. You have been furnished with the following: Non-standard Forms 1: Description of individual external public debt listed in Form 2; Non-standard Forms 1A: Schedule of principal and interest payments for individual external public debt described in Form 1; Non-standard Forms 2: Individual external public debts: current status and transactions during period as of December 31, 1979; Non-standard Forms 4: Aggregate external private debt: current status and transactions during period, as of December 31, 1979; and estimated future service on private debt. 2. You have also been furnished with a list of public debts contracted during the period January 1, 1980 through March 31, 1980. The Annex to this letter provides su-Ary information on external public debt contracted between April 1, 1980 and November 9, 1980. 3. Such forms and lists accurately set forth: (a) the amounts and principal terms and conditions of all outstanding external public debt of the Republic of Turkey, its political subdivisions and agencies, and of the agencies of its political subdivisions, and debts guaranteed by them up to November 9, 1980.  - 71 - V. We represent that no mortgages, pledges, charges, privileges, priorities or other liens exist on any governmental assets as security for any external debt. It is our understanding that, in making the proposed loan, tha Bank may rely on the statements and facts set forth herein and in the documents mentioned above. Very truly yours, REPUBLIC OF M=X! By //s ,Tevfik Altinok jt rized Representative