Turkey - Pulp and Paper Rehabilitation Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 5357-TU STAFF APPRAISAL REPORT TLTRKEY PULP AND PAPER REHABILITATION PROJECT April 5, 1985 Industry Department This document bas a restricted distribution and mav be used by recipients only in the performance of' their official duties. Its contents mav not otherw-ise be disclosed w-ithout World Bank authorization.  CUHRRENCY EQUIVALENTS (as of April 1984) US$1.00 = Turkish Lira (TL) 325 TL 1.00 = US$0.00308 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES I ton (t) = 1,000 kilsograms = 2,205 pounds 1 meter (m) = 1.094 yards = 39.4 inches 1 kilometer (km) = 1,000 neters = 0.'21 miles 1 cubic meter (m3) = 35.3 cubic feet 1 bone dry unit (BDU) = 2,400 bone dry pounds of wood chips 1 hectare (ha) = 2.47 acres Volume of wood expressed as m3 refers to solid wood volume under lbark ABBREVIATIONS DYB - Devlet Yatirim Bankasi (State Investment Bank) FAO - Food and Agriculture Organization of the United Nations GOT - Government of Turkey 0GM - Orman Genel Mudurlugu (General Directorate of Forestry) SEE - State Economic Enterprise SEKA - Turkiye Seluloz ve Kagit Fabrikalari General Mudurlugu (SEE for Pulp and Paper) SFO - State Planning Organization TA - Technical Assistance TSKB - Turkiye Sinai Kalkinma Bankasi (Industrial Development Bank of Turkey)  FOR OFFICAL USE ONLY TURE APPRAISAL OF THE PULP AND PAPER REHABILITATION PROJECT TABLE OF CONTENTS Page No. I. INTRODUCTION .*.*....... ...............*...........1........ II. THE TURKISH PULP AND PAPER INDUSTRY ........................ 2 A. Economic Background ....... ................. 2 B. The SEE System ... **................... 2 C. Performance of the Industry ...*.......*..*.......... . .. 3 D. Historical Development ... .......................... .....** 4 E. Structure of the Industry ............................... 4 F. Fibrous Raw Material Resources ........................ 5 1. Total Fiber Consumption ......... .... . ..... .. .......... 5 2. Wood ...................... ........... ............ 5 3. Waste Paper ....... 7 4. Straw/Reed *......................................... 7 G. Government Policies in the Subsector .................... 8 H. Privatization ........................................... 10 I. Bank Role in the Subsector *............................ 11 III. THE COMPANY ....................................... 12 A. Background and Organization .................. ........... 12 B. Management Information System .................. V ....... 14 C. Production Performance ......... ............ ....... 14 D. Reforms of Personnel Policy ............. .. ...... 15 E. SEKA's Historical Financial Performance ................. 16 F. Financial Restructuring ............................... 17 G. SEKA's Prices and Pricing Policy ........................ 19 IV. THE MARKET ........ *.....e.... ..& ........................... 22 A. Background .....................................o......... 22 B. Projected Demand/Supply for Paper and Paperboard ........ 25 1. Aggregate Demand and Supply ..... ..................... 25 2. Newsprint .....,276 3. Paperboard ........................................... 27 4. Pulp ................................ 29 C. Prices .......... ....*...* ....................... ... 30 1. General Market Influences ... *..*a .................... 30 2. Newsprint ................................................ 30 3. Paperboard ........ ............ . ........... .... . 32 4. Pulp ..................................... *.................. 32 Vo THE PROJECT ........ ................ ....... 32 A. Project Scope and Technology ............................ 32 B. Project Description ................... ............... 34 1. Aksu Mill ........................................ O*............ 34 2. Dalaman Mill ..................................................... 34 This report was prepared by Messrs. R. Chalk, Y. Cookes, and K. Zamani of the Industry Department. IThis document has a restriced distributon and may be used by recipients only in the performance of their official duties. Its contents way not otherwise be disdosed without World Bank authorization. |  - ii - TABLE OF CONTENTS (Continued) Page No. 3. Afyon Hill **********s*a******........... ......... 35 4. Spare Parts .......................................... 35 5. Energy Conservation ...... ............................ 35 6. Technical Assistance Program .... ..................... 35 C. Wood Supply .... ......................................... 37 D. Environmental Impact .................................... 37 E. Project Implementation Arrangements ............. ........ 38 VI. CAPITAL COSTS, FINANCING PLAN, PROCUREMENT AND DISBURSEME1IT 40 A. Capital Cost Estimate ... go .........-..... 40 B. Financing Plan .......... ..... 41 C. Channelling of the Proposed Loan .... .................... 42 D. Procurement and Disbursement ............................ 42 VII. FINANCIAL. ANALYSIS .................... ........... .... 44 A. Basis of Projections .................................... 44 B. Sales Volume and Revenues with the Project .............. 45 C. Production Costs . ..................................... 45 D. Financial Projections ....... .......................... 46 E. Financial Rate of Return and Sensitivity Analysis ....... 47 F. Financial Covenants ..... ......... Os ............ 48 G. Auditing and Reporting Requirements ..................... 48 VIII. ECONOMIC ANALYSIS AND RISKS ........... .................... 49 A. Introduction ...... ...................................... 49 B. Adjusted Costs and Benefits for Economic Analysis ....... 49 C. Economic Rate of Return ................................. 49 D. Net Foreign Exchange Savings ................... 51 E. Other Benefits ... ..........8 .... 52 F. Risks ................................... 52 IX. AGREEMENTS ................. ................................ 53 ANNEXES 2-1 Technical Assistance to the Go,ernment: Terms of Reference for Pulp and Paper Industry Study 3-1 SEKA - Historical Level of Employment 3-2 SEKA - Historical Financial Performance, 1977-83 3-3 SEKA - Consolidated Projected Income Without the Project and Without Restructuring 3-4 SEKA - Cash Flow Projection Without the Project and Without Restructuring 3-5 SEKA - Consolidated Projected Balance Sheets Without the Project and Without Restructuring 3-6 SEKA - Comparison of List Price with Import Parity Price between July 1982 and January 1984 for Selected Grades/Comparison of List Price with Average Manufacturing Cost for Selected Grades in mid-1983 3-7 SEKA - Consolidated Projected Income Without the Project (with Price Increases and Restructuring)  - iii - ANNEXES (cont.) 3-8 SEKA - Cash Flow Projections Without the Project (with Price Increases and Restructuring) 3-9 SEKA - Consolidated Projected Balance Sheets Without the Project (with Price Increases and Restructuring) 4-1 Historical Paper and Paperboard Consumption in Turkey 4-2 Newsprint Prices for United Kingdom and India 4-3 Comparison of 1983 CIF and Domestic Prices for Dalaman Mill Grades 4-4 Bleached Short Fiber Pulp Price in Major European Importing Countries 5-1 Terms of Reference for Technical Assistance Program to SEKA 6-1 Capital Cost Estimate 6-2 Projected Disbursement Schedule of the Proposed Bank Loan 7-1 Assumptions Used in Financial Analysis 7-2 SEKA - Total Projected Production Volumes with and without Project 7-3 SEKA's List Prices (April 1984) 7-4 SEKA - Projected Production Costs with the Project for 1993 7-5 SEKA - Projected Production Costs without the Project for 1993 7-6 SEKA - Consolidated Projected Income with the Project (with Price Increases and Restructuring) 7-7 SEKA - Cash Flow Projections with the Project (with Price Increases and Restructuring) 7-8 SEKA - Consolidated Projected Balance Sheets with the Project (with Price Increases and Restructuring) 7-9 Cost and Benefit Streams for Aksu Mill Project Component 7-10 Cost and Benefit Streams for Dalaman Mill Project Component 7-11 Cost and Benefit Streams for Afyon Mill Project Component 7-12 Cost and Benefit Streams for All Mill Project Components 8-1 Assumptions Used in Economic Analysis 8-2 Economic Cost and Benefit Streams for Aksu Mill Project 8-3 Economic Cost and Benefit Streams for Dalaman Mill Project 8-4 Economic Cost and Benefit Streams for Afyon Mill Project 8-5 Economic Cost and Benefit Streams for All Mill Project Components MAP IBRD - 18435 Turkey DOCUMENTS AVAILABLE IN THE PROJECT FILE Reference Title 1. Rehabilitation Project Feasibility Study for SEKA (6 volumes), April 22, 1983, prepared by Rust International 2. Software Study, Prepared by SEKA, (2 volumes) April 11, 1983 3. SEKA's Consolidated Balance Sheets for 1982 and 1983 4. Domestic Resource Cost (DRC) calculations  - iv - TURKEY PULP AND PAPER REHABILITATION PROJECT Loan and Project Summary Borrower: Government of Turkey Beneficiary: SEKA, the State Economic Enterprise for Pulp and Paper, and the Government of Turkey A.ount: US$55.1 million equivalent Terms: Currently applicable variable Bank rate for a term of 17 years including 4 years of grace. Project Description: The project would be the first phase of a continuing restructuring and rehabilitation program for Turkey's pulp and paper industry. Technical assistance (TA) would be provided to the Government and to SEKA, and physical rehabilitation would be undertaken in several of SEKA's existing plants. The TA to the Government would provide a comprehensive review of the pulp and paper subsector including ar. in-depth study of the potential for selective privatization of SEKA facilities. The TA to SEKA would involve a wide-ranging program of management and operational improvement, including study of the wood supply, and help to develop a medium-term strategy for SEKA. Physical rehabilitation in three of SEKA's mills would provide for increased production, improved quality, and cost reduction. Critical spare parts would be purchased, and energy-saving improvJements made in all of SEKA's mills. Benefits and Risks: The TA to Government is expected to have a significant impact on policies related to the pulp and paper subsector and its future development, including important steps toward the privatization of SEKA. The TA to SEKA will provide substantial improvement in the management and operation of SEKA with resulting improvement in profitability. The physical rehabilitation will provide significant economic and financial benefits with relatively small capital investment. The economic and before-tax financial rates of return for the project as a whole are 41% and 34%, respectively. There are no significant risks associated with the physical rehabilitation components of the pro,4ct. In the case of TA to SEKA, there is a risk that recommended improvements in management and operating procedures might be perceived as threats by certain levels of SEKA's staff and lesd to lack of cooperation and reduction of expected benefits. To avoid this risk and to maximize the benefits, SEA' s  - v - own management and staff will play an active role in diagnosis of problems, and the planning and implementation of the program. A second risk is that prices would be lower and input costs higher than projected. Effective implementation of SEKA's pricing policy, which allows a wide latitude and freedom to maintain market-oriented prices, plus the arrangements for wood supply, should minimize these risks. Local Foreign Total - (US$ million) - Estimated Cost: Plant Costs 17.8 30.6 48.4 TA to SEKA 1.0 2.0 3.0 Base Cost Estimate 18.8 32.6 51.4 Physical Contingencies 2.6 4.6 7.2 Price Escalation 6.6 11.3 17.9 Refinancing PPF - 0.6 0.6 Working Capital 3.4 1.5 4.9 Interest During Construction 0.2 4.2 4.4 TA to Government 0.1 0.3 0.4 Total Financing Required 31.7 55.1 86.8 Local Foreign Total -- .(US$ million) -- Financing Plan: IBRD Loan - 55.1 55.1 Government - Equity 31.6 - 31.6 - Contribution for Study 0.1 - 0.1 Total 31.7 55.1 86.8 Bank FY 1986 1987 1988 1989 1990 Estimated Disbursements: Annual 2.2 24.7 21.3 6.4 0.5 Cumulative 2.2 26.9 48.2 54.6 55.1 Economic Rate of Return: 41%.  TURE PULP AND PAPER REHABILITATION PROJECT I. INTRODUCTION 1.01 The Government of the Republic of Turkey (GOT) has requested a Bank loan of US$55.1 million equivalent to finance the foreign exchange costs of a project to begin the restructuring and rehabilitation of its pulp and paper industry. 1.02 The project would be undertaken by Turkiye Seluloz ve Kagit Fabrikalari Genel Mudurlugu (SEKA), the State Economic Enterprise (SEE), which owns and operates eight pulp and paper mills currently producing some 70% of the country's pulp and paper requirements (Map IBRD No. 18435). The proposed Bank loan would be made to the Government who would on-lend US$54.8 million equivalent to SEKA to cover about 63% of the total amount (US$86.8 million equivalent) required to finance the Droject and 100% of the foreign exchange requirements. The Government would utilize US$0.3 million for Technical Assistance. 1.03 The project would be the first step towards restructuring and rehabilitation of Turkey's pulp and paper industry. A significant component of the project would be Technical Assistance (TA) to the Government and to SEKA. The TA program to the Government would include a comprehensive study of the pulp and paper subsector to develop subsector objectives and strategies, including an appropriate structure for the subsector, forest management and wood supply, and an in-depth review of the possibilities for privatization of SERA, including assisting SEKA and the Government to identify suitable arrangements that could interest local private sector and/or international pulp and paper companies to invest in SEKA's operations. The TA to SEKA would involve a program of operational and maintenance training, study and recommendations for improvement of environmental protection, improvements to organization, manpower, financial/accounting and management information systems. Rehabilitation work would be carried out in three of SEKA's mills which would benefit from increased production and improved product quality. In addition, the project would provide funds for the import of critical spare parts and for the implementation of certain energy-savifng improvements in all SEKA mills. 1.04 The project evolved from several government policies: (i) concentrating industrial invesLMent in the rehabilitation of existing industrial capacity rather than building new plants; (ii) improving the efficiency of SEEs; and (iii) selective privatization of SEEs. The project was identified by the Industrial Projects Identification Mission to Turkey in July 1980, and was prepared by the US consulting firm Rust Overseas incorporated (RUST) who were hired by SEKA using an advance from the Bank's Project Preparation Facility. The project was appraised in October 1983, and M4ay 1984, by Messrs. Chalk, Crookes, and Zamani, of the Industry Department.  - 2 - II. THE TURKISH PULP AND PAPER INDUSTRY A. Economic Background 2.01 The Turkish economy, having grown at 6% annually between 1967 and 1978 has undergone a marked transformation over the last decade, with the share of industry in GDP rising to 23% in 1978 and to about 32% at present. The economic progress was, however, punctuated by severe balance of payments crises in 1970 and 1977, mainly because of the country's overemphasis on import substitution and inability to develop a strong export base, coupled with heavy debt service on foreign borrowings. The economic crisis in 1977 was a particularly serious one, following which real GDP increased by only 2.8% in 1978, and decreased by 0.9% in 1979, and by 0.7% in 1980. Real GDP, after falling for two consecutive years, expanded by 4.1% and 4.6% in 1981 and 1982, respectively. In 1983, GDP growth slowed to about 3.2% due in large part to the effect of adverse weather conditions on agricultural production. Industrial value added increased by an estimated 6.6%. 2.02 Turkey's development strategy prior to 1980 had given high priority to industrialization based mainly on import substitution and the development of the regions outside the major urban centers. The Government has generally been involved in basic industries where private capital has hesitated to enter because of long gestation periods, heavy capital requirements or high risks. Consequently the public sector and the SEEs have played an important role in industrialization. The present Government's program for restructuring the economy seeks to replace an industrialization strategy based on import substitution with one by an outward orientation and with more involvement of the private sector. Measures designed to stabilize the economy include, among others, a realistic and flexible exchange rate, control of inflation, deregulation of interest rates to encourage private savings, and rationalization of public investments. B. The SEE System 2.03 The SEEs in Turkey were established 50 years ago. The SEEs currently account for about 32% of total fixed investment, and about 11% of non-agricultural employment. In industry, SEEs have a virtual monopoly in petroleum refining and basic metals, and have a large share in steel, fertilizers, pulp and paper, cement, coal, sugar, machinery and chemicals. Supervision of SEE operations was the general responsibility of the related Ministry and the specific responsibility of the High Control Board, an auditing organization which reported directly to Parliament. The Government provided the SEEs with the credit and capital needed to sustain operations and to make new investments, within the framework of the Five-Year Plan and the Annual Programs. The majority of the problems afflicting the SEEs have arisen from the fact that while the enterprises have formally been organized as economic entities with the objectives of efficiency, productivity and profitability, they have in the past been  - 3 - subject to constant intervention by the Government in pursuit of different and often conflicting objectives. The causes of poor performance have included price controls, lack of autonomy, low operational efficiency, frequent changes of management, inadequate salaries for managerial and technical staff, internal organizational problems, and a confusion between economic, social and political goals. 2.04 Reform of the SEEs has been a major goal of the Government's structural adjustment program. The SEE reform Law 2929 of October 1983, and a later Decree of June 1984 (Decree 233 which is due to become law shortly)1/ signal the importance the Government attaches to bringing about greater efficiency in SEE performance through decentralization of responsibility, greater management autonomy, and competition. SEE reform has also been supported by the Bank through its structural adjustment loans as well as through ceveral ongoing Bank-assisted projects which include components that address specific organizational restructuring and management improvement issues. In the short run, there is considerable scope for strengthening the management and improving the operational efficiency of SEEs. The Government considers the time opportune, therefore, to shift from a broad approach of SEE reform to a more differentiated one concentrating on individual enterprises. The proposed project builds on this objective and focusses on SEKA, whose poor financial performance has placed substantial burdens on the budget. The project would assist the Government to explore ways to privatize SEKA and would address a number of serious problems in SEKA including weak organization and management as well as inefficient operating and maintenance practices. In addition, the project would focus on physical rehabilitation of existing mills rather than on investment in new facilities. This is consistent with the country's policy of limiting public sector investment in manufacturing to permit concentration of public investment on high priority infrastructure projects. Nevertheless, some manufacturing investment to rehabilitate existing productive facilities still has priority to enable the SEEs involved to earn reasonable returns on past investments. C. Performance of the Industry 2.05 In 1983, the private and public sectors of the pulp and paper industry, with output valued at approximately TL 80,000 million, accounted for around 2.5% of industrial output, and its 16,000 workers accounted for about 2% of total industrial employment. The industry has made significant progress since 1970, attaining close to full domestic self-sufficiency in the production of paper and paperboard. In 1970, domestic production of paper and paperboard accounted for only 56% of consumption of paper products. In contrast, by 1983, domestic production of 568,000 tons accounted for more than 90X of consumption. Newsprint and sack kraft have 1/ As an indicator of the importance the Government attaches to SEE improvements, the new Decree 233 places most of the manufacturing SEEs, including SEKA, under the Office of the Prime Ministry rather than the Ministry of Industry and Trade. A State Minister is directly responsible for the SEEs.  -4- been imported in varying quantities over the past few years, but such imports will be substantially reduced as production in recently commissioned mills increases (Chapter IV). In other grades in which domestic self sufficiency has been attained, e.g. hygienic papers and some coated boards, there has recently been some measure of success in exporting, amounting to about 5% of total domestic production of these grades. D. Historical Development 2.06 Turkev's first paper mill was established by the SEE, Sumerbank, at Izmit in 1934. Responsibility for this plant together with all public sector participation in the pulp and paper industry was transferred to the separately constituted SEE, SEKA, in 1955. This original mill underwent a series of expansions and production rose from an initial 9,000 tons in 1934 to more than 130,000 tons by 1970. Turkey, however, remained a substantial and growing importer of paper products, in particular, newsprint. To address this problem, the Government undertook a series of ambitious integrated pulp and paper mill investments starting In the early 1970s. Also, private investors were actively expanding existing operations and building new mills. These investments, together with substantial tariff protection, rapid industrial growth, urbanization, and increasing literacy, provided the framework within which domestic paper production grew from 151,000 tons in 1970 to 568,000 tons in 1983. E. Structure of the Industry 2.07 The pulp and paper industry has evolved over the last 25 years into two distinct sectors, public and private, with characteristic differences in grade mix, raw material requirements, and the degree of vertical integratUon. Production trends in the two sectors are illustrated in the following table. Turkey - Total Paper and Paperboard Production ('000 tpy) SEKA Private Sector Total 1940 10 10 1950 18 18 1960 56 3 59 7970 1?4 18 152 1975 308 64 372 1978 304 123 427 1979 301 '142 f43 1980, 3.n 154 455 1981 366 131 497 1982 398 138 536 1983 393 175 563 Sources: SE-KA, TSKB.  - 5 - 2.08 The private pulp and paper sector is based primarily on waste paper, straw, and some imported pulp, and mainly produces hygienic Paper, wrapping paper, and paperboard. The private sector made significant advances in the 1970s, and now accounts for about one third of the country's production. There are 36 mills in the private sector. In general, these private mills are quite small with an average capacity of about 5,000 tpy, but five are of moderate size, 20,000 tpy or larger. On the other hand, SEKA's mills have an average installed capacity of about 90,000 tpy which, overall, are of a size comparable to mills in industrialized countries. 2.09 SEKA currently has eight pulp/paper mills in operation which account for some two thirds of the country's total output of paper and paperboard. SEKA will continue to dominate the industry in the medium term, particularly in the production of chemical and mechanical pulps from *vood and the conversion of these pulps to paper in integrated mills. SEKA's production is based primarily on the extensive natural coniferous forests of the Black Sea, Marmara, Aegean, and Mediterranean Regions although some straw, reed and hemp are also used, as well as imported pulp. F. Fibrous Raw Material Resoutrces 1. Total Fiber Consumption 2.10 Wcod is SEKE's most important fibrous raw material, supporting about 80% of SEKA's pulp production. In the private sector, waste paper is the predominant fiber soerce. Ogerall, in 1983, production of paper from the various raw raaterials was approximately as follows: wood 53%, waste paper 28%, straw and reeds 10X, and imported pulp 9%7. Cor.sumption of fibrous raw materials for the past four years is summarized in the following tab'e. Turkey - Fibrous Raw Material Use SEKA Private Sector 1930 1981 1982 1983 1980 19fil 1982 1983 Wtood ( 'r0 m3) 90)5 1,193 1,230 1A043 Straw/Reed ('00'?, ton, 36 60 25 34 29 36 36 65 Waste Paper ( '0)0 ton) 29 46 43 44 130 1i7 133 148 Imported Pulp ('000 ton) 17 ?5 40 2' ?2 20 26 28 Sources: SEKA7 TSKP . _. 'Wood 2.11 Turkey has extensive natural fcrests iir the mour.tainous areas of the Black Sea, Marmara, Aegean and Mediterranean regions, which are the largest forest tesources in the Middle East. Virtually all of .he ceuntry's forest resources are vested in .he state. Approximately 20 million ha -.re classifi.ed as forested area aid over the past 5 years  total production of roundwood has averaged 7.5 million m3/yr or about 0.4 m3fha. By comparison, wood production in Scandinavia is more than 1.5 m3/ha. The lower utilization figure for Turkey reflects a more conservative forest management policy providing for lower annual allowable cut, less developed forest infrastructure, and less extensive wood-using industries. Notwithstanding these factors, the current attainable economic output is estimated by the Ministry of Agriculture and Forestry at 12 million m3/yr and a level of up to 16 million m3/yr is considered feasible with expansion of the forest road network. 2.12 The paper industry's wood purchases over a recent 4-year period have varied from 1.0 million m3/yr to 1.5 million m3/yr and, as the table below indicates, have comprised between 12% and 21Z of industrial roundwood production. Turkev - Production and Utilization of Roundwood ('000 mi/yr) 1978 1979 1980 1981 Pulpwood 987 1,032 653 692 Sawlogs/Veneer Logs 5,660 4,820 4,847 5,165 Pitprops 663 558 533 702 Small Industrial Roundwood, etc. 796 545 654 787 Total Industrial Roundwood 8,106 6,955 6,687 7,346 Paper Industry Purchases 984 1,467 1,206 963 % of Industrial Roundwood 12.1 21.1 18.0 13.1 Sources: FAO, SEKA. 2.13 SEKA's current and prospective maximum annual pulp production capacity requires some 2.3 million m3/yr of wood, or only about 20% of the currently attainable industrial wood production. The availability of logs for SEKA is reasonably secure, particularly as SEEs are given priority. However, delays sometimes occur due to the production and storage system where logs may be stored for long periods in forest depots. SEKA is responsible for log transport from the forest depot to its mills, and delays in finalizing trucking contracts can cause further delays in wood delivery. However, in the past year SEKA has had considerable success in improving the delivery and other arrangements for wood supply at one mill, and expects to extend these arrangements to other mills (para 5.14). Under the Bank-financed Mlorthern Forestry Project (Loan 1585-TU), industrial roundwood production in 1984 was limited to some 53% of the appraisal estimate due to problems of regenerating cut-over forests and encroachment and illegal fellings by forest villagers. These difficulties are to be studied in depth by the mid-term project review initiated in March 1985. Moreover, these issues will be addressed on a national scale under the TA component of the proposed project (para 5.11).  - 7 - 2.14 Wood Prices. The price of sawlogs to SEKA is based on the average actual open market auction price for the previous six months. Pulpwood price on the other hand is negotiated annually by SEKA and the General Directorate of Forests to cover the cost of replacing wood that is consumed by the industry, plus the cost of managing and protecting such forests and an appropriate return on the invested forestry capital. The price currently paid by SEKA is substantially in line with international prices. Provision is made in the TA component of the project (para 5.11) to review the whole process of setting wood prices. 2.15 Privatization of Forest Management. In view of the Government's privatization policy and successful examples around the world of private forest industries managing their own wood resources (Canada, Sweden, USA, Chile, Swaziland, etc.) the possibility of doing this in Turkey will be reviewed under the project (para 5.11). In other countries, harvesting licenses or other forms of concessions have been granted to integrated forest industries companies so that they can manage their own wood supply in accordance with sound forest management and silvicultural practices. The company benefits by having direct control over the harvesting and delivery of its main raw material, while the Government benefits because private industry becomes more encouraged to invest in forest industry and the cost of forest management passes to the entity concerned. Government retains all its power to assure that the resource is managed efficiently on a sustained yield basis. 3. Waste Paper 2.16 Waste paper usage constitutes about 30% of Turkish paper and paperboard consumption and about 28% of the subsector's fibrous raw material supply. The usage of waste paper is low in relation to its use in Europe where it accounts for about 40Z of paper products consumption. The availability of this material depends on the collection system, and this is rather poorly organized. However, in recent years a company has been formed which deals specifically in the collection and sale of waste paper, and, furthermore, the association of Turkish pulp and paper manufacturers has since formed an industry working group to study ways of improving the collection system even further. 4. Straw/Reed 2.17 These materials are used by SEKA to produce short-fiber bleached chemical pulp which basically substitutes for imported hardwood pulp. Although the physical properties of this raw material result in a pulp slightly inferior to imported hardwood, the quality is fully acceptable for the limited number of grades of paper in which it is used. SEKA and the private sector also use straw to produce a relatively high yield chemi-mechanical pulp which is used for corrugating medium and other types of lower-quality boards. An estimated 10-15 million tons of straw is generated in Turkish agriculture each year. This material is mostly used in animal husbandry. The requirements for pulping, about 100,000 tons per year, represent less than 1% of the amount generated. Although the  - 8 - abundance of straw makes it a relatively cheap material to purchase, the costs of c-llection, baling, and transportation are significant, and reduce the comparative cost advantage over wood to only about 30%: typically in SEKA's mills fibrous raw material cost to produce I ton of bleached pulp will be about USS100 when using straw compared with US$150 for wood. Reeds are used only in the Afyon pulpmill (para 5.07). SEKA has contracts with local peop'le who manually harvest reeds from a nearbv lake and deliver them to the mill at a fixed price. As is the case for straw, the high cost of collecting and delivering reeds reduces the comparative advantage over wood such that fiber cost per ton of pulp is only 25% lower than when pulping wood. C. Government Policies in the Subsector 2.18 The expansion of the pulp and paper industry during the !960s and 1970s was inspired principally by the desire to attain domesti-c self-sufficiency in paper produlcts in line with the dominant theme in Turkish industrial policy of import-substitution in that period. The state played a major role in this process. 2.19 The Government had to finance all the large-sca'le integrated wood-pulp and paper mills because of the capital intensive, long gestation nature of the projects and the private sector did not have the required financial resources. M,oreover, these investments -were concentrated in the paper grades that were of key importance to the state's policy in promoting education and industry, namely, newsprint, printing/writing paper and sack kraft. As domestic output of these grades started to expand, the pursuit of these objectives was reinforced with formal price controls on printing/writir-g paper and newsprint. In addition, within the framework of the policy of self-sufficiency, the expansion of output in these grades prov-ded a domestic source of waste paper, a key raw material for the private sector. 2.20 Furthermore, in the 1970s, the Government provided a highly protective cariff structure within which domestic output could expand. The high nomii.ai tariff was also reinforc-ed by restrictions on imports under a foreign exchange allocation system. However, over the past few years, SEKA was under political pressure to limit price increases and prices did not keep pace witth domestic inflation. By the end of 1983, SEKA's average sales price was about 20% below the comparable import parity price. The Goverrnment has recently adopted new industrial and trade policies, the thrust of which is to open up the Turkish economy to more competition from abroad, through import liberalization measures and lower tariffs and import duties. Under the new policies, since the beginning of 1984, controls over importation of paper and paper products have been relaxed and nominal tariff rates have been significantly reduced, i.e., for newsprtnz from 23% to '5;O for printing and writing paper trom 60% to 25%, for kraft sack and wrapping paper from 50% to 3O% However, the Government has recently  levied a temporary surcharge 2/ to soften the impact of trade liberalization and the reduction in tariffs on the existing mills and to safeguard the industry from dumping practices. Further progress in rationalization of the tariff structure and other trade policies are being monitored under the Fifth Structural Adjustment Loan (2441-TU). 2.21 Since 1980, the Government has focused on strengthening the SEEs, and has undertaken several measures to make their economic environment more competitive (para 2.04). As a result, SEKA has benefited from greater managerial autonomy with continuity of senior management and stability of policies. Since the passage of the SEE Reform Law in October 1983, the Government has encouraged SEKA to excercise its freedom to set its own prices in the light of market conditions (para 3.19). Since early 1984, the Government also has focused on SEKA's (and other SEEs') capital structure and significant outstanding debts of SEKA have been consolidated and converted to equity (para 3.16). Moreover, the Government intends to strengthen management and operational efficiency of SEKA through a rehabilitation program, and explore opportunities for privatization of SEKA. Even though the Bank, through its previous lending in the sub-sector, has acquirea considerable knowledge of the pulp and paper industry in Turkey, as part of the proposed project the Government will undertake a comprehensive sector study, under which it will: review the problems and prospects of the pulp and paper industry; develop subsector objectives and develop targets for the next decade; formulate industry strategies which would be most effective in achieving the objectives; and establish a pulp and paper industry development program, including investment plan, necessary policy reform, and other appropriate adjustments. The study will also include identifying pulp and paper rehabilitation projects in the private sector and an in-depth review of the possibilities for privatization of SEKA including suitable packaging that could interest local private sector firms and/or international pulp and paper companies to participate in privatization of SEICA. The draft Terms of Reference for the proposed study, which have been discussed and agreed upon with the Treasury and State Planning Organization (SPO), are included as Annex 2-1. SPO, on behalf of the Government, will undertake the study, assisted by consultants, and with the support of Turkiye Sinai Kalkinma Bankasi (TSKB) and SEKA. During negotiations, agreement was reached with the Government that the study will be completed by September 30, 1986, and be made available to the Bank for review and comment. 2/ The amounts vary by grade of paper and are stated in US$ but payable in TL. The amounts are, per ton: newsprint $70, printing and writing $125, kraft paper $25, coated board $100. According to SEKA, Swedish export prices for certain grades of kraft paper, newsprint, and printing papers are 5-15% lower on average than if these products were purchased locally in Sweden. Swedish newsprint can be landed in Istanbul at $340/ton cif. A similar situation exists with Romanian paper imports.  - 10 - H. Privatization 2.22 The Government's objective is to improve the efficiency of manufacturing SEEs to develop their competitive position domestically and internationally. Privatization is considered a useful mechanism to accelerate the process. At this stage the Government is considering various privatization alternatives including divestiture, sale of shares to the public, leasing, management contracts, etc. However, the Government has no preconceived ideas regarding privatization of specific sectors and believes that all related aspects should be studied before a definite strategy is adopted. In the case of SEKA specifically, the Government view is that SEKA must first be put on a sound footing, both financially and operationally, so that it may attract sufficient interest from the private sector and also provide to t'e Government an appropriate and reasonable value for its assets. In preparation for this, the Government has agreed with the Bank to include in the project a TA program which would, in part, examine appropriate industry structure and privatization possibilities. This approach is prudent. It is also pertinent to point out that previous Government policies have enabled private sector participation in some sections of the pulp and paper industry and in fact about one third of the country's production of paper and paperboard currently comes from private sector enterprises. There are, however, a number of factors which have discouraged private sector investments in large integrated mills such as are owned and operated by SEKA. These are: (a) high capital investment and long implementation period; (b) main raw material (wood) is uader government control; and (c) a major portion of the output is sold to a limited number of powerful buyers -- in the case of newsprint, newspaper publishers and in the case of kraft paper, cement companies and sack manufacturers -- and prices have been kept too low in the past to realize a satisfactory return on investment. 2.23 In spite of these and other difficulties, there are certain components of SEKA which may be suitable for spinning off, as a short-term first step towards full privatization of SEKA, including the following units: (a) Akdeniz sawmill; (b) Balikesir sawmill; (c) Akdeniz Tug and Barge facilities; and (d) Bolu fiberboard plant. The above units are considered as suitable possibilities because capital costs are relatively low (US$5-15 million), there is good potential for profit, and although in most cases the units are integrated with SEKA mills they can still be operated as independent units. As a first step, and following up on the Bank's suggestion during appraisal of the project, SEKA has decided that their Bolu fiberboard plant is a suitable candidate for immediate privatization, and has already made such a recommendation to the High Economic Council. The Government has confirmed that a few individual cases such as this should be pursued even before the strategic studies are completed. During negotiations, agreement was reached with SEKA that they would consult with the Bank prior to divesting any of their major assets if such action would significantly affect their financial position.  - 11 - 2.24 In the longer term, larger scale privatization possibilities, short of complete sale of SEKA, might logically be concentrated on certain product lines which could be attractive to private investors, both foreign and local. Specifically, newsprint and bleach kraft pulp operations and their expansions could be considered. Newsprint requires coniferous wood (e.g. pine), and in contrast to other countries in the Middle East, Turkey is well endowed with this resource. Also it has a relatively good position with regard to electric power supply in those regions where EFKA's mills are located. Furthermore, projection of Turkey's domestic demand for newsprint (para 4.07) indicates that construction of a third newsprint mill should start in about 1987. A new private or joint ventL.re company might be formed to take over SEKA's two existing newsprint operations (Aksu and Balikesir) and build the third mill. Such a proposal might be attractive to a foreign newsprint producer as a means of gaining access to Turkey's large domestic market and other Middle East markets. Bleached kraft pulp production by local private sector paper producers could be achieved through sale of SEKA's Afyon pulp mill. This mill produces short fiber pulp, partly to replace imports, from wheat straw and reeds, which are obtained from farmers and local villagers. Thus the major impediment of government control of the main raw material, wood (para 2.22), would not be a factor. Also, SEKA's long proposed Karadeniz project to produce long fiber bleach kraft pulp makes technical and commercial sense and lacks only a guaranteed wood supply and financing. A private group operating Afyon might logically expand their interest to the Karadeniz project which would have an assured domestic market and would provide a controlled source of high-quality long fiber pulp for their non-integrated paper mills. I. Bank Role in the Subsector 2.25 Bank participation in the subsector began in 1974 with a loan to the Government of US$40 million for the Antalya Forest Utilization Project (Loan 957-TU), of which US$35.5 million was onlent to SEKA for the Akdeniz integrated pulp and paper and sawmills and the remaining US$4.5 million was for modernization of forestry operations. There were delays in the implementation of the Akdeniz component, primarily due to initial changes in the site location. The mill was commissioned in late 1983 and is now exceeding the production rates estimated at the time of appraisal. The Bank also provided a loan of US$70 million to SEKA for the Balikesir Newsprint Project (Loan 1258-TU) which was signed in 1976. The objective of the loan was to finance construction of a newsprint paper and sawmill, as well as pollution abatement facilities. Implementation was delayed on account of a shortage of materials and domestic financing during a period of general economic crisis in Turkey. The facilities were commissioned in 1981. After initial technical difficulties, production performance is currently at 80% of design capacity, which is close to appraisa'l estimates. The experience gained from these projects has been taken into account in the design of the proposed project, which provides for a comprehensive technical assistance program aimed at strengthening SEKA's management structure and improving operation and maintenance procedures. The Bank also made a US$86 million loan for the Northern Forestry Project (Loan 1585-TU) signed in 1978 and currently under implementation. The  - 12 - project has sought to improve the Government's forest management planning and operations as well as to increase industrial roundwood production. Industrial roundvood production is below project estimates due to difficulties experienced in regenerating cut-over forest areas and adherence to outdated and conservative forest management practices. Nonetheless, efforts are continuing on introducing more modern forestry practices. 2.26 In addition to these direct loans, about US$7 million in proceeds from the DYB I and DYB II Projects (Loans 1024-TU and 1379-TU) were utilized to finance partially investments designed to balance production facilities at the Dalaman and Caycuma mill. The Project Completion Report of February 10, 1984 for DYB I (Loan 1024-TU) and the Bank report entitled, Sector Operations Revilew: The Industries and DFCs Program in Turkey (No. 3077-TU), dated July 18, 1980 concluded that a major lesson learned from the Bank's experience with DYB is that improvements in SEE performance can be better achieved through direct loans and industrial sector policy dialogue. Both of these recommendations have been taken into account in designing the proposed project. 2.27 Through TSKB, the Bank is also indirectly involved (Loan 2093-TU) in the expansion of the private sector with Kartonsan, a company which produces coated board and is currently increasing its production to 85,000 tpy. IFC has been actively involved in the private sector and currently holds equity in Viking Pulp and Paper Company, one of the larger private sector mills producing about 12,000 tpy of wrapping paper. III. THE COMPANY A. Background and Organization 3.01 SEKA was established in 1955 as the SEE in charge of public sector operations in the pulp and paper sector. Until the 1960s, Izmit was the only SEKA plant. However, since then, SEKA has gone through a major expansion program involving the construction of seven mills. Each of these mills is a separate legal entity, incorporated as a company under Turkish laws. However, autonomy is limited to general and routine operational matters, and in practice they operate as divisions of SEKA. SEKA's authorized capital, fully Government owned, as of the end of 1983 was TL 70,000 million. SEKA has about 11,000 employees in headquarters and operating mills. 3.02 Since April 1983, as a part of the SEE reorganization and reforms, an additional company, Bolu fiberboard plant, has been added to SEKA's operation, bringing the total number of companies under SEKA to nine. SEKA's total installed annual capacity as of the end of 1983 amounts to over 500,000 tons of pulp, paper and paperboard, 275,000 m3 of sawnwood, and 6 million m2 of fiberboard and laminated board.  - 13 - 3.03 As per the new SEE decree (para 2.04), SEKA's Board of Directors is now composed of six members, a chairman, who is also General Director, and five directors. Two of the directors are drawn from the Assistant General Directors of the Enterprise. All board members are appointed by the Government for three-year terms. The Board of Directors concentrates on policy issues, leaving executive powers to the General Director. The General Director is assisted by a Technical Assistant General Director, and an Administrative Assistant General Director. 3.04 At the mill level, the organizational structure is similar to that of SEKA's headquarters, but overall mill management autonomy is limited and confined to undertaking instructions from headquarters. Each mill has a management committee consisting cf a chairman and four members. The duty of the management committee is to reach and implement decisions regarding the management of the mill in accordance with predetermined operating targets, plans and budgets. 3.05 The management committee members are nominated from among the higher level mill managers. The chairman of the management committee is the Mill Manager, who is aided by two assistants, one in charge of technical matters and the other in charge of administration. Both are members of the management committee. The Technical Assistant Mill Manager is responsible for day-to-day manufacturing, including quality control and production record keeping. The Administration Assistant Mill Manager is responsible for accounting, personnel functions, security, welfare and sales. 3.06 the lack of continuity and motivation of management have been major problems confronting SEKA. Historically, most senior management appointments have been politically motivated, subjecting the day-to-day operations of the enterprise to a political process which in turn has prodlced several undesirable results, including lack of continuity in policies and practices, insecurity for professional staff, low morale, and inappropriate investment decisions. As in all SEEs, low salary structure has been a major deterrent for attracting and holding competent mangers. In recent years, the situation in SEKA has improved. Since 1982, the enterprise has benefitted by the appointment of a General Director who is a professional manager with an engineering background and more than 25 years of experience in industrial management and administration. Since his appointment he has launched at least two major developments in SEKA. First, he has given more autonomy to mill managers and made them more accountable for operational performance. Second, he has created a "Department of Management and Methods", headed by a professional recruited from outside SEKA. This department has already initiated a Job Evaluation Program in the Izmit mill, with the objective of linking salaries to performance. The program will be extended to all SEKA mills in due course. While SEKA has enjoyed for the past three years continuity of management, relative freedom from political interference, and more autonomy for mill mangers who are therefore better motivated, the major issue of low pay and other benefits for management and professional staff remains outstanding, and can only be addressed in the context of reform of the overall SEE system, which is currently under way.  - 14 - B. Management Information System 3.07 SEKA's present management information system, similar to that of other SEEs in Turkey is designed for general purpose requirements and without due consideration for the special features and characteristics of the industry it serves. The system does not provide an adequate basis for planning and control and requires major review and upgrading. SEKA's reporting requirements from its mills is extensive and involves substantial clerical work and bookkeeping often with delays. Under the present system, headquarters is kept informed daily on such items as production figures and cash position. There are weekly, monthly, quarterly and annual reports. SEKA in turn consolidates these reports and submits them to the Government. However, at SEKA's headquarters, data collected are often insufficiently focused on relevant aspects and data are not processed adequately, partly because it is overly voluminous. Upgrading of the management information system and computerization of the system is included in SEKA's rehabilitation program. C. Production Performance 3.08 SEKA's production during 1977-83 for paper and paperboard for each mill is given below: Turkey - SEKA - Paper and Paperboard Production (1977-83) a/ (v000 tons) Design capacity 1977 1978 1979 1980 1981 1982 1983 Izmit 150c/ 126 124 126 128 128 132 118 Caycuma 75 65 58 49 43 57 57 56 Aksu 82 71 56 61 63 63 61 60 Dalaman 75c/ 77 66 65 67 75 81 79 Afyon 50b/ - - - 7 9 19 20 Balikesir 100 - - - - 42 67 80 Total 482b/ 339 304 301 301 365 398 393 a! Not including Akdeniz, which began production in 1984, and Kastamonu, which will start commercial production in 1985. b/ Afyon was commissioned in 1980 and produces only pulp which is currently transferred only to SEKA mills. To avoid double counting, its output is not included in total figure. c/ Capacity of Izmit and Dalaman may be considerably higher depending on grade mix. Source: SEKA. With a few exceptions, SEKA's capacity utilization is low in comparison with similar mills in North America and Scandinavia where utilization of at least 90% is normal. In the past year SEKA, including the Afyon mill,  - 15 - averaged only about 75Z. The production of Izmit has been relatively stable with minor fluctuations between 118,000 to 13X,000 tons per year. The production at Caycuma has fluctuated significantly, between a peak of 65,000 tons in 1977 (87% of the design capacity), to a low of 43,000 tons in 1980 (57% of the design capacity). The low production level in 1979 and 1980 was mainly the result of general material shortages during those years, and poor maintenance practices and frequent unscheduled downtime. Another major factor affecting Caycuma's operations is the significant imbalance between the pulp mill and the paper mill. The principal bottleneck is the chemical recovery boiler which can only support 45,000 tons of pulp production per year. Actual production is maintained at a higher level by purchasing additional pulping chemicals and wasting the spent chemicals, an expensive and environmentally harmful practice. Production at Aksu has been low, averaging only 75% of design capacity over the past five years, and fluctuating between a high of 71,000 tons (87% of the design capacity), in 1977, to a low of 56,000 tons (68% of the design capacity) in 1978. This has been mainly due to poor maintenance practices exacerbated by shortages of spare parts, power interruptions, and frequent unscheduled downtime. For example during 1981, the Aksu plant experienced 188 incidents of power disturbances, which caused over 5,000 tons of lost paper production. Since this time, the Turkish Electric Authority has made significant improvements to the system and power interruptions are no longer considered a serious problem. Production at Dalaman has been relatively stable, with capacity utilization close to 100%. The Dalaman mill is well maintained and well managed. Afyon performance has been poor since its commissioning in 1980, although the production level has improved somewhat in 1983, and actual production for the year was 20,000 tons of pulp, about 40% of its rated capacity. The low capacity utilization at Afyon has been in the past mainly due to technical problems in the mill design. Balikesir was commissioned in 1981 and production build-up has been satisfactory and is expected to reach design level before 1986. D. Reforms of Personnel Policy 3.09 Overstaffing has been a major problem confronting SEKA's management. In line with the SEE policy reform, since 1980, SEKA has taken specific measures to address the issue of the overstaffing. These measures were: freezing the number and structure of job positions for existing operations at the level of November 1980; canceling 50% of job positions becoming vacant through resignation, retirement or death; and allocating priority to staffing new mills with existing manpower. As a result, during 1980-83 some 1,382 positions representing 10% of total job positions in SEKA were eliminated, of which 913 positions were related to Izmit, 158 to Afyon, 110 to Caycuma, 94 to Aksu, 67 to Dalaman and 40 positions were related to SEKA Headquarters. During the same period, some 197 additional hirings took place to cover the needs of the Balikesir mill which was coming to full production. The net impact of these measures which amounts to 36% higher productivity for SEKA's employees is shown in Annex 3-1 and is summarized in the following table:  - 16 - Turkey - SEKA - Labor Productivity Between 1980-83 1980 1981 1982 1983 Production of Paper & Paperboard ('000 tons) 301 365 398 393 Number of Employees a/ 11,300 11,082 11,068 10,952 Productivity (tons of paper & paperboard/ employee) b/ 26.6 32.9 35.9 35.9 a/ Excluding employees in the mills under construction. bI Comparisons with other countries may be misleading owing to the wide range of mill sizes and product mix. However, in the major pulp and paper producing countries, labor productivity of companies which, like SEKA, have a broad mix of pulp and paper grades, ranges typically from 50 to 100 tpy/employee. E. SEKA's Historical Financial Performance 3.10 The historical financial performance for 1977-83 is presented in Annex 3-2 and summarized in the following table: Turkey - SEKA - Summary of Historical Financial Performance for 1977-83 (Million TL) 1977 1978 1979 1980 1981 1982 1983 Income Statement Net Sales 4,281 6,785 10,956 22,821 33,307 46,918 60,802 Gross Profit 293 1,339 425 4,170 2,593 2,586 2,429 Financial Charges 468 544 908 1,450 3,136 6,811 6,991 Profit Before Tax (463) 602 (1,504) (324) (2,313) (8,457) (14,673) Balance Sheet Current Assets 3,456 4,531 9,496 14,720 20,304 25,918 31,810 Current Liabilities 4,299 5,791 12,526 16,395 28,996 40,631 55,112 I.ong-Term Debt 6,163 9,318 13,881 21,690 27,453 32,175 39,767 Equity 101 843 2,788 12,031 14,353 16,541 44,190a/ Key Financial Ratios Gross Profit/Net Sales (%) 6.8 19.7 3.9 18.2 7.8 5.5 4.0 Gross Profit/Cost of Goods Sold (x) 7.3 24.6 4.0 22.3 8.4 5.8 4.2 Current Ratio 0.80 0.78 0.76 0.90 0.70 0.64 0.58 Long-Term Debt:Equity 98:2 92:8 83:17 64:36 66:34 66:34 47:53a/ a/ In May 1984 the Government revalued SEKA's assets by TL 28,409 million retroactive to 1983. Without this revaluation, the debt:equity ratio would be 72:28.  - 17 - 3.11 The deteriorating financial situation of SEKA over the period 1977-83 can clearly be seen from the above figures. Although total sales revenue has increased consistently over this period both as a consequence of increasing production volumes and prices, costs have been increasing at a more rapid rate, resulting in gross profit margin (net sales minus cost of goods sold) which has been erratic between 1977-1980, and gradually declining in 1981-83. For the period as a whole, gross profit margin as a percentage of sales averaged about 10X. However, for 1982 and 1983, it averaged about 5%. The poor gross profit margin record is largely the consequence of the slow and partial adjustment of product prices to increasing input and conversion costs (paras 3.17 to 3.18), as well as low capacity utilization and low operating efficiency. 3.12 SEKA had accumulated losses of about TL 30,515 million by the end of 1983, largely as a result of price restraints, high financial charges (representing 48% of the total loss in 1983) and other expenses such as depreciation. The long-term debt to equity ratio improved from 98:2 in 1977 to 47:53 in 1983 largely as a result of the injection of additional equity for the establishment of new mills and the revaluation of assets to the extent of TL 28,409 million in 1983. The current ratio stayed consistently below one over the period 1977-83 in spite of relatively extensive restructuring and funding of liabilities undertaken by the Government over the years. In summary, SEKA's financial position at the end of 1983 was weak and unless effective measures were taken to result in adequate profits and satisfactory financial ratios, the situation would have deteriorated further. F. Financial Restructuring 3.13 Without major restructuring, the decline of SEKA would continue at an accelerating rate as current liabilities increase to cover the operating deficit. Financial projections have been prepared on this basis (Annexes 3-3 through 3-5), and are summarized in the following table:  - 18 - Turkey - SEKA - Financial Projections without Financial Restructuring and Without Price Increases al (US$ million at current prices) 1984 1985 1986 1987 1988 Net Sales Revenue 302 350 392 431 470 Operating Profit (14) 0 8 14 18 Interest 29 30 31 31 30 Other Expenses (net) 4 5 5 5 6 Net Income (pre-tax) (47) (35) (28) (22) (18) Cash From Operations Before Debt-Service 15 28 36 41 45 New Equity _ _ _ _ _ Short-Term Borrowing 35 25 18 10 5 Net Change in Working Capital 12 7 7 7 7 Total Debt Service 46 45 46 45 44 Net Cash Flow (8) 1 1 (1) (1) Gross Profit on Net Revenue (%) (0-4) 3.7 5.7 6.9 7.5 Gross Profit on Cost of Goods Sold (Z) (0.4) 3.9 6.1 7.4 8.1 Debt Service Coverage Ratio 0.4 0.6 0.8 0.9 1.0 Current Ratio 0.5 0.5 0.5 0.5 0.5 Long-Term Debt:Equity 99:1 - - - - a/ Numbers may not add due to rounding. 3.14 These projections indicate that without financial restructuring, short-term borrowings over the next five years of about US$100 million equivalent would be required to cover projected cash deficits, even though the production from the new mills (Balikesir, Akdeniz and Kastamonu) would be increasing. Under these circumstances, debt-service coverage and the current ratio would be inadequate, and the equity base would be eroded to zero. Even with price increases (para 3.19), without major financial restructuring, SEKA's financial position would remain unacceptable (e.g. current ratio below 1.0). 3.15 In early 1983 the Government realized that largely due to past controls on pricing, SEKA was in a serious financial situation, and recognized that unless some major financial restructuring was undertaken, SEKA's financial situation would quickly deteriorate, and SEKA's operations could come to a stop. As a result, and as part of an overall rehabilitation program for SEKA to make the Enterprise more competitive both domestically and internationally, the Government had drawn up a financial assistance plan involving a subscription to about TL 12,000 million of SEKA's new equity through various measures of cash injection and capitalization of outstanding treasury short term debts in 1983, and capitalization of some additional TL 835 million of long term debt in 1984, along with provisions for revaluation of assets. In October 1983, the Bank's appraisal mission discussed the scope and impact of these  - 19 - measures with the Government and estimated that SEKA needed about US$100 million equivalent additional financial restructuring over and above that already provided to restore an adequate level of liquidity. The Government at that time acknowledged the need for additional restructuring but no decision was made. 3.16 The present Government also recognized the gravity of SEKA's financial situation and the need for additional financial restructuring, and included SEKA in its plan for the restructuring of selected SEEs. Under this plan, initiated in January 1984, as a decree law, certain debts of selected SEEs to each other, to the Treasury and to the Central Bank are to be consolidated and taken over by the Central Bank. This plan affected significant portions of SEKA's debts, and some TL 39,195 million of SEKA's debt in different categories was consolidated to a single liability and converted to equity capital (or equivalent) from the Central Bank in SEKA.31 G. SEKA's Prices and Pricing Policy 3.17 After 1980, Government control of SEE's selling prices was discontinued except for certain basic necessities, which in SEKA's case includes newsprint. Theoretically, SEKA has been free to set prices for all other paper products. However, in spite of its semi-autonomy in setting prices, SEKA has not had a well-defined pricing policy. SEKA's stated practice has been that prices be set to recover manufacturing costs plus a margin of about 2-10%, depending on the product, with due consideration of CIF prices. Although stated by SEKA, this general rule, in the past has not been applied consistently, as shown in Annex 3-6. 3.18 One of the serious difficulties with SEKA's price setting in the past has been that increases have often been implemented with too large a time lag and been insufficient to keep up with domestic inflation. To illustrate, the recent price trends for three of SEKA' s main grades are tabulated below. 31 The conversion amounts to about US$121 million of new equity by reducing debts to trade creditors (US$28.8 million), treasury (US$54.7 million), central bank (US$37.0 million), and other short-term creditors (US$0.4 million).  - 20- Turkey - SEKA - Percentage Real Price Change for Selected Paper Grades List Price in Current Terms (TL/ton) Real Price Change (Z) Printing Wholesale Printing & News- Price a/ & News- Writing print Sack Index Writing print Sack July 1982 165,000 107,000 110,000 171.5 - - - July 1983 214,000 119,400 127,000 215.7 3.1 (11.2) (8.2) Jan. 1984 235,400 131,300 139,700 265.0 (10.5) (10.5) (10.5) a/ Source: International Financial Statistics, IMF. The table shows that, in spite of significant price increases In cur-rent terms, for all three grades, there has been a steady decline of prices in real terms for rnewsprint and sack paper of 11.2% and 8.2Z, respectively, between July 1982 and July 1983, and of 10.5% for all grades between July 1983 and January 1984. Considering that the selected grades make up about 70% of SEKA's total output in 1983, the financial impact of the decline in real prices is severe. Also, as illustrated in Annex 3-6 for the selected grades, a decline in equivalent current prices in US dollar terms, as a result of the declining value of the Turkish lira, has occurred during a perLod when international paper prices, in current terms, have held steady or Lacreased. 3.19 Clearly, SEKA's pricing policy has been a major issue affecting both its short- and long-term viability. In early 1984, the Government reaffirmed its policy to allow SEKA to set its own prices freely for all the grades according to market conditions. The Government policy towards SEEs is stated in Decree Law 233 (June 1984). However, in the Decree Law, there is provision for Government intervention in price setting. In such situations, the Decree Law stipulates that if the administered prices are below cost, then the loss as well as unrealized profit will be compensated through budgetary transfer, and the amount of unrealized profit will be set by computing a 10% profit on the cost of goods sold. It is this Decree Law that sets the broad outline of SEKA's new pricing policy. As a result, in the first four months of 1984, SEKA has increased its prices by more than 40% across the board in two steps - 10% in January 1984 and 30% in April 1984. While new prices are well above those of December 1983, on average they are substantially equal to import parity prices, but well below the landed cost after addition of applicable duty and levies. Recently, as protection against dumping, the Government has levied a new tax on various imports in the form of a lump sum amount per ton, stated in dollars but payable in local currenc_ (para 2.20). In case of paper and paperboard these amounts per ton are: newsprint US$70, sackpaper US$25, and printing and writing US$125. The following table illustrates this comparison:  - 21 - Turkey - Current Price Comparison for Selected Grades in May 1984 CIF & CIF & Duty & SEKA List Price CIF b/ Duty Levy Item TL/ton $/ton a/ $/ton $Iton $/ton Printing & Writing 306,000 900 860 1,075 1,200 Newsprint 167,500 493 490 564 634 Sack Kraft 182,000 535 600 780 805 a/ Exchange rate TL 340 = $1.00. b/ Based on current estimates of Western European spot prices. 3.20 During negotiations SEKA's pricing policy was thoroughly discussed and the following policies were enunciated by SEKA: (i) SEKA's prices are set in accordance with the provisions of Decree No. 233 of June 1984; and (ii) it is SERA's objective to produce efficiently, so as to be in a position to set prices at levels which do not depend on protection measures and are not increased unduly to cover high costs caused by inefficient operations. It was agreed that the Bank and SEKA shall from time to time, at the request of either party, exchange views with regard to operational and pricing policies and measures to be taken for their implementation. These arrangements provide a satisfactory basis for guiding SEKA's pricing strategy. 3.21 The measures regarding financial restructuring and price increases stated above have the effect of stabilizing the present financial situation, and providing some assurance that future levels of profitability will be satisfactory. Financial projections prepared on this basis (without the proposed rehabilitation project) are contained in Annexes 3-7 through 3-9 and summarized in the following table:  - 22 - Turkey - SEKA - Financial Projections with Financial Restructuring and Price Increases a/ (US$ million at current prices) 1984 1985 1986 1987 1988 Net Sales Revenue 312 372 417 459 500 Operating Profit (4) 22 33 41 48 Interest 19 16 14 13 11 Other Expenses (net) 4 5 5 5 6 Net Income (pre-tax) (28) (2) 14 23 31 Cash From Operations Before Debt-Service 24 50 57 63 67 New Equity 121 - - - - Short-Term Borrowing 17 - - - - Net Change in Working Capital 12 7 7 7 7 Total Debt Service 156 31 30 27 25 Net Cash Flow (6) 12 21 29 36 Gross Profit on Net Revenue (Z) 2.7 9.5 11.4 12.5 13.0 Gross Profit on Cost of Goods Sold 2.7 10.5 12.8 14.2 15.0 Debt Service Coverage Ratio - 1.6 1.9 2.3 2.7 Current Ratio 1.4 1.6 2.0 2.5 3.1 Long-Term Debt:Equity 33:67 30:70 26:74 22:78 18:82 a/ Includes price increases in effect up to April 1984. Numbers may not add due to rounding. 3.22 While there remains a need for modest short-term borrowing in 1984, no further borrowing is required, and from 1985, debt-service coverage and current ratios would exceed 1.5. Thus, SEKA would be in a reasonable financial position and able to undertake the proposed rehabilitation project. IV. THE MARKET A.. Background 4.01 Turkish paper and paperboard production, imports, exports and apparent consumption over the period 1970 to 1983 are as follows:  CUHRRENCY EQUIVALENTS (as of April 1984) US$1.00 = Turkish Lira (TL) 325 TL 1.00 = US$0.00308 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES I ton (t) = 1,000 kilsograms = 2,205 pounds 1 meter (m) = 1.094 yards = 39.4 inches 1 kilometer (km) = 1,000 neters = 0.'21 miles 1 cubic meter (m3) = 35.3 cubic feet 1 bone dry unit (BDU) = 2,400 bone dry pounds of wood chips 1 hectare (ha) = 2.47 acres Volume of wood expressed as m3 refers to solid wood volume under lbark ABBREVIATIONS DYB - Devlet Yatirim Bankasi (State Investment Bank) FAO - Food and Agriculture Organization of the United Nations GOT - Government of Turkey 0GM - Orman Genel Mudurlugu (General Directorate of Forestry) SEE - State Economic Enterprise SEKA - Turkiye Seluloz ve Kagit Fabrikalari General Mudurlugu (SEE for Pulp and Paper) SFO - State Planning Organization TA - Technical Assistance TSKB - Turkiye Sinai Kalkinma Bankasi (Industrial Development Bank of Turkey)