Turkey - Second Small and Medium Scale Industry Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 7546-TU STAFF APPRAISAL REPORT TURKEY SECOND SMALL AND MEDIUM SCALE INDUSTRY PROJECT May 4, 1989 Industry, Trade and Finance Division Country Department I Europe, Middle East and North Africa Regional Office 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. - i - CURRENCY EQUIVALENTS Currency Unit - Turkish Lira (TL) Value of US$1.00 in TL 1980 January 70.Oe 1981 January 91.00 1982 January 139.60 1983 January 191.14 1984 January 309.20 1985 Jawuary 451.40 1986 January 586.40 1987 January 752.93 1988 January 1120.00 1989 January 1779.00 1989 March 2027.00 LIST OF ABBREVIATIONS EB - Emlak Bank EC - European Community ETC - Export Trading Company FERIS - Foreign Exchange Risk Insurance Scheme GNP - Gross National Product GOT - Government of Turkey HB - Halk Bank IEDP - Industrial Export Development Project MSI - Medium Scale Industry PCI - Participating Credit Institution SIDO - Small Industry Development Orgatization SIS - State Institute of Statistics SMI - Small and Medium Scale Industries SMI I - First SMI Project SMI II - Second SMI Project SOE - Statements of Expenditures SSI - Small Scale Industries SYKB - Sinai Yatirim ve Kredi Bankasi (Industrial Investment and Credit Bank) TKB - Turkiye Kalkinma Bankasi (Development Bank of Turkey) TSE - Turkish Standards Institute VAT - Value Added Tax VB - Vakiflar Bank FISCAL YEAR January 1 - becember 31 FOR OFFICIAL USE ONLY TURKEY SECOND SMALL AND MEDIUM SCALE INDUSTRY PROJECT Table of Contents Page No. LOAN AND PROJECT SUMMARY......... .......... iv I. INTRODUCTION........................ ................ I II. SECTORAL BACKGROUND .................. ......... 1 A. Economic Context and Recent Developments........ 1 B. The Industrial Sector........ o ........ ...... 3 C. Small and Medium Scale Industries............... 4 D. Financial Environment......... ....... 7 III. PROJECT RATIONALE......... ... .............. 10 A. Bank's Industrial Lending Strategy......... .. 10 B. Past SMI Projects ............ ........... 11 C. Rationale for Bank Involvement..... ....... 13 IV. THE PROJECT... ....................... 14 A. Objectives and Scope............................ 14 B. Project Costs and Financing Plan........ 15 C. Credit Component... .................... .. 16 D. Technical Assistance Components................ 19 E. Export Promotion Component ........... 20 F. Quality Improvement Component ............... 22 G. SMI Sector Statistics............. ......... 23 V. THE LOAN...................... #.................. 24 A. Terms and Conditions ..4..................... 24 B. Administrative Requirements....... ........ 26 VI. BENEFITS AND RISKS...................... ... ...... 28 A. Benefits................................. 28 B. Risks.................. o................... 29 VII. RECOMMENDATIONS .. ............................ 29 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 Dank authorization. LIST OF ANNEXES ANNEX 1. Industrial Structure and Performance Indicators ANNEX 2. SMI Credit Demand ANNEX 3. Participating Credit Institutions ANNEX 4. Documents Available in the Project Files This report was prepared by J. Pernia, S. Krishnan and N. Chamlou (EMlID), R. Behbehani and E. Manes (EMTTF), N. Mangosing-Koeppen (EMlCO), V. Barrios and F. Murray (Consultants), following a pre-appraisal mission in June 1988 and an appraisal mission in November 1988. - iv- TURKEY SECOND SMALL AND MEDIUM SCALE INDUSTRY PROJECT LOAN AND PROJECT SUMMARY Borrower: Government of Turkey (GOT) Beneficiaries: Participating Credit Institutions (PCI) which include: Emlak Bank, Halk Bank, the Industrial Investment and Credit Bank and Vakiflar Bank. The proposed project would also provide funds for technical assis,ance to: the Turkish Standards Institute, selected export trading companies, the State Institute of Statistics, and the Small Industry Development Organization. Amount: US$204.5 million equivalent. Terms: Seventeen years, including a five-year grace period, at the Bank's standard variable interest rate. Re-lending Terms: The final lending rate to subborrowers would be the prevailing variable Foreign Exchange Risk Insurance Scheme (FERIS) rate which would be adjusted quarterly by reference to the average 3-month Treasury Bill rate in the preceding three months. The Government through FERIS would bear the exchange and interest rate risks since the ultimate subborrowers are small and medium scale enterprises, which have relatively little capacity to judge and hedge against these risks. The Government would relend the proceeds of the Bank Loan to the PCIs at terms which would provide to them a spread of 3%. The PCIs would repay their loans on a schedule based on the composite of the maturities of their subloans. Project Description: The project would support GOT's program for SMI development by promoting efficient SMI investments and operationst improving credit access for SMI enterprises by expanding the channels for SMI finance; providing technical and marketing assistance to improve SMI product quality and expand their markets; and improving the accuracy and reliability of SMI statistics for policy and strategy formulation. -v - Benefits and Risks: The benefits arising from the project include expansion of SMI investments and operations in export-oriented activities and increased access to institutional credit for SMI enterprises, improved product and market diversification through linkage with export trading companies, and improved product quality. It is estimated that the project would assist some 900 SMI units to invest about US$400 million equivalent, and create about 26,000 new full-time jobs. There is a risk that the commercial banks participating in the project would not pay sufficient attention to SMI lending considering the small size of this operation in relation to the total business of these banks. Separate monitoring and reporting will be required to ensure attention to this operation by the top management of these banks. There is a risk that, due to weaknesses in staffing and procedures, the public sector institutions will be unable to playv the roles assigned to them for the technical assistance components of the project. Training and consultancy would be provided by the project to strengthen these institutions and strong private sector participation has been incorporated. Estimated Costs: (US$ Million) Local Foreign Total Subloan Component 300.0 200.0 500.0 Technical Assistance Components 1.5 4.5 6.0 TOTAL 301.5 204.5 506.0 Financing Plan: (US$ Million) Local Foreign Total IBRD 0.0 204.5 204.5 Private Sector 200.5 0.0 200.5 PCI 100.5 0.0 100.5 GOT 0.5 0.0 0.5 TOTAL 301.5 204.5 506.0 Estimated Disbursements: (US$ Million) IBRD FY 90 91 92 93 94 95 Annual 20.0 33.0 58.0 48.0 26.0 19.5 Cumulative 20.0 53.0 111.0 159.0 185.0 204.5 TURKEY STAFF APPRAISAL REPORT SECOND SMALL AND MEDIUM SCALE INDUSTRY PROJECT I. INTRODUCTION 1.01 Small and medium scale industry (SMI) development has become an important component of the Government of Turkey's (GOT) industrial strategy in view of the need to increase employment, reduce regional income disparities and achieve enhanced exports. The Bank's past SMI operations (Labor Intensive Project, Loan 1952-TU and the Small and Medium Scale Industry Project, Loan 2647-TU) have succeeded in helping the Government to assist the SMI sector; in encouraging two financial institutions to expand their SMI portfolios; and in guiding the Government's SMI development agency in providing promotional and extension services (paras 3.04-3.11). In view of the successful implementation of the past SMI projects, and given the need and scope fnr further SMI development, GOT has requested financing for th- proposed project to support the expansion and modernization of this sector. fais report recommends a Bank loan of US$204.5 million in support of a US$506.0 million project. 1.02 The proposed Second Small and Medium Scale Industry Project (SMI II) would expand financial, technical and marketing support for SMIs to enable them to increase their contribution to industrial employment, exports and output. The proposed project would provide US$200 million for onlending by the participating credit institutions (PCI) to eligible SMI units, which is expected to result in fixed investments of about US$400 million in about 900 units and, based on past experience, approximately 26,000 full-time jobs. Technical assistance would be provided to the PCIs to train staff and improve their operating procedures and information systems for project-based lending operations. Technical assistance would also finance export product and market development for SMI manufacturers by selected Export Trading Companies (ETC); develop a product quality assurance program for SMI units by the Turkish Standards Institute (TSE); and help finance the effort of the State Institute of Statistics (SIS) to revamp SMI data gathering, processing and analysis to ircrease their reliability and accuracy. II. SECTORAL BACKGROUND A. Economic Context and Recent Developments 2.01 In the early 1980s, Turkey initiated an extensive stabilization program, including a wide-ranging program of structural reforms. The structural reforms were designed to promote an outward orientation of the economy, and to promote allocative and dynamic efficiency through greater reliance on market forces and the private sector - representing a sharp break from the past dirigiste policy regime and the import substitution development strategy. -2- 2.02 The Turkish economy has responded well to the growth-oriented adjustment strategy; the economy has maintained high growth (over 5% per year) without jeopardizing its creditworthiness. The key to the success of this strategy has been the Turkish export response. Stabilization accompanied by aggressive devaluation, trade liberalization, and export promotion measures led to a large shift of productive capacity from domestic to export markets. The economy raised its total factor productivity in the short term, rapidly increasing capacity utilization. Aided initially by buoyant Middle East markets and 'ater by expanding European markets, exports grew at over 207 per year in real terms and the share of exports in Gross National Product (GNP) more than tripled by the mid-l:.30s. Industrial exports grew fastest, increasing their share to over 75% of the country's total exports from just over a third at the beginning of the decade. 2.03 The balance between growth and external adjustment has been unmetched by most other highly indebted countries. In 1988, the current account improved further, shifting to a significant surplus of 2% of GNP. But, internal adjustment and the requisite fiscal discipline have been subject to the country's political-economy cycle. Thus, a rapid economic and fiscal expansion in 1986-87 contributed to a rise in inflation to 70% by 1988, which reflected the pass-through effects of the public sector price adjustments that followed the November 1987 general elections. Public investment was also sharply reduced in 1988, thus enabling the Government to attain its public sector borrowing requirement target of 6% in 1988. Although economic growth has slowed markedly since mid-1988, real interest rates for lending remain high. Of particular concern, therefore, is the impact of such an environment on the sustainability of the Turkish export drive, since it has tended to divert investment into speculative purposes and away from the tradable goods sectors, and since the capacity utilization in the private sector has on average reached a historical high (in contrast to the early 1980s when underutilIzed capacity served the country's external objectives). New investment now is therefore critical for an export performance which would continue to contribute to the country's adjustment process. 2.04 Thus, policies to restore internal macro balances and to reform the financial sector remain the highest priority both for the Government and for the Bank's policy dialogue. The Government has set its macroeconomic targets within the framework of a medium-term adjustment program for 1988-91 that envisages a gradual restoration of sustainable balances. The 1988 Country Economic Memorandum ("Turkey - Towards Sustainable Growth", Report No. TU-7378) analyzed the program and proposed several additional measures to effect fiscal restraints. The Government remains committed to reduce inflation. The effects of tighter financial policies since late 1988 are beginning to be reflected, not only in slower growth and an improved balance of payments position, but also in a marked reduction of inflation in the first quarter of 1989. 2.05 The Government's medium-term adjustment program reflects the fact that there are several factors that limit its ability to address the macroeconomic problems quickly with drastic austerity measures, important among them being simultaneous reform efforts to strengthen the financial system. In addition, there is a real concern of the Government for the sizeable social cost of adjustment incurred by the population throughout this 0346 P - 3 - decade - in terms of loss of jobs, lower wages relative to other prices in the economy, and for some possibly even permanent reductions in their expected stream of lifetime income. It is partly this social concern that underlines the priority attached by the Government to the proposed project. B. The Industrial Sector 2.06 As a focus of the adjustment program, the manufacturing sector expanded during the 1980s by directing output toward the external market. The share of output being exported rose from 6% in 1980 to over 15% in 1987 as a result of the unprecedented growth in manufactured export receipts. Due to the low capacity utilization in the early eighties, this expansion of the manufacturing sector occurred without much increase in fixed inrestment. Following a large drop in 1980, private manufacturing fixed investment recovered only gradually, showing negligible growth between 1981 and 1985. Employment likewise grew slowly, partly explaining the rapid increase in labor productivity. Private fixed investment started to recover in 1986 growing by 13% and growth in manufacturing output accelerated to 10%. In 1987, manufacturing output continued to expand rapidly but private manufacturing fixed investment declined again, indicating that rapid growth will be difficult to sustain under the current financial conditions (para 2.03). 2.07 The pattern of export-led growth was prevalent across the entire manufacturing sector as all sub-sectors increased their outward orientation, some dramatically, such as textiles, leather and machinery. Naturally, without exception, the sub-sectors witb above average export growth also experienced above average output growth. Specifically, textile, leather and machinery were among the fastest growing sub-sectors in terms of output and exports, followed by chemicals and wood products. Textiles, in particular, heve been by far the most important export industry accounting for over a quarter of exports in 1987. Leather, cherdicals, electrical appliance, metal working industries, iron & steel and agro-industry also have been important export sectors, accounting for another 35% of exports. In terms of future growth, however, these industries, particularly textiles and leather, have also experienced the highest rates of capacity utilization. 2.08 The Government's commitment to the outward-oriented development strategy with an actil'e exchange rate policy, import liberalization and bureaucratic streamlining during the 1980s, have provided a supportive policy framework for industrial export activities. Recent measures aimed at improving the export environment include real devaluations in 1986 and 1987, and a reduction in tariff dispersion and rates in 1988 to offset previous increases in levies. In April 1988, the Government took further steps to reform the system of direct export incentives in accordance with long standing plans to bring Turkey's export promotion program in line with its present and potential competitors. Export tax rebates, which have been a p e subsidy since the introduction of the Valuq Added Tax (VAT) in 1985, were phased out during 1988. In place of the tax rebates, a rediscounted credit line for exporter- with greater than US$iOO million of annual exports was made available through the newly-formed Export-Import Bank (Ex-Im Bank). In addition to the Ex-Im Bank credit, exporters can still benefit from duty-free imported inputs, corporate tax allowarces and investment incentives, and two Central Bank rediscounted financing schemes. Furthermore, to strengthen the 0 346P -4- linkages among firms producing export value added, the Central Bank has starteO a Domestic Letter of Credit system similar to that successfully implemented in Korea, Mexico and Indonesia and the Treasury is discussing a strengthened legal framework for ETC and their suppliers. 2.09 The recent chdnges in the export incentive regime represent the Covernment's continued effort to increase the efficiency and effectiveness of the export promotion system by encouraging exports through an appropriate exchange rate policy, a renewed emphasis on export financing and broader export services, rather than through direct subsidies. The elimination of export rebates will discourage inefficient marginal exports, help eliminate the potential for abuse by way of export overinvoicing, and encourage ETCs to provide needed value added to exports (para 2.15). Altheugh there may be a short-term drop in the growth of export receipts as marginal exporters fall out and fictitious exports are reduced, the elimination of the export tax rebate should help reduce the disparity in export incentives among activities, make producers more quality minded and traders more servicc -iented, ultimately improving the competitiveness of Turkish exports. 1he challenge will be to avoid the 1986 experience and resist pressure to re-introduce export subsidies in response to a short term fall in exports. C. Small & Medium Scale Industries 2.10 In addition to furthering important social goals, the SMI sector has played an integral role in the industrialization process in Turkey. It has contributed to robust industrial development by generating badly needed employment from expanded labor-intensive production, by strengthening backward and forward industrial linkages, and by serving as an entry level and training ground for new firms. Although there is very little data covering production characteristics of various industrial size groups, available indicators provide evidence that the SMI sector in Turkey is more labor-intensive and invests less for a unit of output than large industry. Employment growth in small (10-49 employees) and medium (50-99 employees) firms averaged 4.7% and 4.2% p.a. respectively during 1980-85 while employment in large firms grew by 2.2% (Annex 1, Table 1). The employment creation potential of SMI is further stpported by evidence that the average cost per job in the sub-projects funded by the preceding two SMI loans to Turkey is lower than the original estimate, indicating that labor-intensity and employment gene.:ation were higher than expected. In addition to these technical considerations, a UNIDO report states that the characteristics of Turkey's labor market, including the lack of skilled labor and the use of apprenticeship for introducing young workers into the labor force, make SMI firms particularly suitable to provide employment growth in Turkey. Although harder to measure empirically, there is also evidence that indirect employment creation, especially in rural areas, can be higher in the SMI sector than in large firms which have a higher import intensity. 2.11 SMI firms create backward linkages through rural income generation and induce the development of supplier services and infrastructure in underdeveloped areas. Also prevalent in the Turkish industrial structure are forward linkages, in the form of industrial and commercial sub-contracting. In industrial sub-contracting, where an SMI unit produces an intermediate good or spare part, unit-cost reductions benefit the large firm while technology, pricing and marketing information accrue to the small firm along with a ready 0 34 'r - 5 - outlet for production. Examples of these symbiotic relationships between small and larger firms abound in Turkey, especially in the provision of spare parts and intermediates to the auto and appliance industries, while in the case of textiles and garments, producers often sub-contract intermediate stages of the production process and look to SMI firms to fill demand overflows. Another linkage in the SMI sector is commercial sub-contracting, the most important example of which is the sale of final products to ETCs or other exporters. Given the need for firms to turn increasingly outward for expansion and difficulties for SMI firms to export directly, this exporter-produc r relationship can serve the SMI sector well, but needs to be developed further. Assistance in the development of the ETC relationship with SMI firms is a component of the proposed technical assistance of this project (paras 4.16-4.23). 2.12 Structure and Performance of the SMI Sector. Nearly all SMI enterprises are in the private sector as the public sector accounted for only 3.7% of SMI establishments, 4.5% of SMI employment and 4.2% of SMI value added in 1985. Of the more than 10,000 private sector firms (with greater than 10 workers) which comprised the manufacturing sector in 1985, 7,989 (78%) were small, 1,092 (11%) were medium, and 1,174 (11%) employed 100 or more workers. The share of total private manufacturing employment was 25% for small firms and 12% for medium firms. In terms of output shares, 17% was accounted for by small firms and 10% by medium firms. In terms of product coverage, small and medium firms tend to be concentrated in industries which use labor-intensive production, process local raw materia'.s and are particularly dependent on proximity to the market. The sub-sectors dominating the SMI sector in Turkey were food and tobacco which accounted for 27% of SMI output and 18% of SMI employment, textiles and leather which accounted for 23% of SMI output and 24% of employment, chemicals which accounted for 13% of SMI output and 11% of employment and machinery and fabricated metals which accounted for 17% of SMI output and 25% of employment (Annex 1, Table 2). 2.13 In terms of relative performance, available statistics make it difficult to evaluate SMI firms within Turkey's overall industrial performance and impossible to compare Turkey's SMI sector internationally. Yet, available cross-country empirical evidence indicates that firms in the SMI sector exhibit lower labor productivity than large industries, but that the level of capital productivity and even total factor productivity can be higher in small and medium firms. Static indicators shown in Annex 1, Table 1 seem to support the conjecture that smaller firms require less capital for a unit of output. In terms of productivity growth, a study carried out at Bosphorous University attempted to calculate labor, capital and total factor productivity growth for SMI (1- 99 workers) and large scale industries (100+ workers) covering the 1980-85 period. The results, though based on poor capital stock figures, show higher capital and total factor productivity growth in small and medium size firms. Surprisingly, the study also found comparable growth of labor productivity between the two size groups. In terms of sub-sector productivity differences, the study found that SMI firms in wood products, textiles, non-metallic materials, and "other manufacturing" sub-sectors experienced total factor productivity growth greater than large firms in the same sub-sectors, while large and SMI firms in the chemicals and plastics sub-sector recorded equal productivity growth. -6- 2.14 The Informal Sector. By far the largest number of manufacturing units fall within the informal sector, defined as establishments employing less than 10 workers. In 1985, there were an estimated 183,000 units in the informal manufacturing sector, accounting for almost 95% of all manufacturing establishments and consisting mostly of artisans and handicraft units. The average size of an informal manufacturing unit was 2 employees. The slow growth in the artisan sector during the seventies continued during the eighties as the number of enterp,ises grew by 3.7%, compared to 4.1% during 1970-80, and employment in the artisan sector expanded by only 4.5%, compared to 38.5% during the seventies. Thus, the share of total manufacturing workers employed in the informal sector fell from 37% in 1980 to 34% in 1985. There exists little data on production of the informal sector, but available evidence indicates that output growth in this sector has traditionally been sluggish. Between 1963-80, growth industries (in terms of number of enterprises) in the informal sector include wood and furniture, parts for transport equipment and machinery, appliances, metalware, fur, leather, footwear and clothing. 2.15 Policy Environment. The reforms pursued by the Government since 1980 have increased incentives for efficient production to private sector firms in general, and by implication, to SMI firms. The SMI sector appears to be responding well, and looks to exports as a key market for expansion. Moreover, the export prospects of the SMI sector which are to a large extent dependent on the policy environment surrounding the ETC-producer relationship, should have been improved by the recent changes in export incentives. The existence of scaled tax rebates led many firms to export through ETC to obtain the extra tax rebate, even though the producers could export directly. This type of "pass through" exporting behavior meant that the ETCs did not have to provide any value added through normal export market services and thus meant that firms which needed these services most, in particular SMI firms, were crowded out by firms which needed them least. Currently, in anticipation of fewer "pass through" exports, ETCs are becoming more service-oriented, and are aggressively seeking out new suppliers of export products, including SMI suppliers (para 2.09). 2.16 In order to encourage the ETCs to improve their export marketing services, there should be little distortion in the producer's decision to export directly - indirectly so that the ETCs would have to attract suppliers by competiig through enhanced services. One implication is that the successful indirect exporter should receive all incentives and preferences provided to successful direct exporters. There are some areas in the export incentive scheme which allow the filtering of export incentives from final exporters to "first-round" suppliers of exportable products, including VAT rebates for exporters and duty-free imports of intermediate goods. Documentation requirements, however, may have limited the use of these mechanisms. Recognizing the importance of enhancing the exporter-supplier relationship, especially given the current level of non-preferential interest rates and scarcity of working capital credit, the Central Bank has developed a mechanism whereby export finance and incentives can be automatically channeled to indirect exporters through the Domestic Letter of Credit system without the additional documentation requirements of the existing system. Since many indirect exporters are SKI firms, the implementation of such a mechanism will assist SMI export activity by providing them the same incentives as final exporters, thus allowing all export value added to face world market priceb - 7 - for inputs, outputs and finance, and by encouraging a service oriented relationship between the SMI firms and ETCs. The Government is also considering developing a stronger legal basis for the ETCs which would provide greater transparency of ETC operations and a strengthened relationship between ETCs and their suppliers. 2.17 SMI Promotion. Perhaps equally important is the lack of a coordinated set of effective programs to counteract the natural bias against small firms in cost items subject to economies of scale, such as meeting regulatory requirements, gathering information on export markets and technological developments, and implementation of production and quality control programs. Although a number of public agencies, such as the Turkish Scientific Research Board and a related information center, the National Productivity Center, Turkish Standards Institute, the Industrial Training and Development Center, and the State Export Promotion Board (IGEME), have been established to assist by providing technical and management advice, they have had limited impact due to their lack of contact with the private sector, inadequate outreach and promotional efforts and bureaucratic procedures. 2.18 In 1974, the Government established the Small Industry Development Organization (SIDO), the only organization devoted exclusively to improving SMI's access to extension services. Numerous problems and delays have prevented SIDO from becoming an effective promotional organization up to now. In April 1988, SIDO's management and function were reorganized in recognition of the need for a more coordinated development strategy for SMI. The intention is for SIDO to have a broader policy coordination and advisory role whiie at the same time maintaining its role as provider of general extension and consultancy services. As SIDO's establishment law and charter were being discussed during appraisal, the impact of the changes on SIDO's contribution to the development of the SMI sector is uncertain. There is, therefore, a need to develop other channels for services to SMI since SIDO will continue to be constrained by its being a public sector agency. D. Financial Environment 2.19 The financial sector of Turkey is quite diversified in terms of institutions but has limited market depth and is small in relation to the level of economic development of the country, with M2 being only about 23% of GDP. The system is dominated mainly by the banking sector which accounts for about 90% of total financial assets. Capital and money markets are small and the equity market is a recent creation. There are 40 private commercial banks (24 domestic and 16 foreign) but the 13 public sector banks account for about half of total banking assets. The Government-owned Agricultural Credit Bank (TCZB) is the largest bank accounting for about a fifth of total banking sector assets. The four largest banks (TCZB and three private banks) account for half of the banking sector. Thus, despite the multiplicity of institutions and the recent entry of 12 foreign banks, the banking sector remains concentrated. 2.20 Industrial Finance. Term finance for industry in Turkey is provided mainly by the two private and two public sector development banks, which rely for funding principally on multilateral and bilateral sources and from the rediscounting facilities of the Central Bank. Term lending by commercial - 8 - banks has been limited and has been undertaken by them principally with the help of rediscounting facilities of the Central Bank. As the rediscounting facilities of the Central Bank have contracted, and with the limited resource mobilization capability of the development banks and limited term transformation by the commercial banks, the volume of credit available for industrial investment has declined over the past three years. This supply constraint has been accompanied by the demand dampening effects of high real interest rates. 2.21 SMI Financing. Lerding to private SMI has been even more constrained. Not only are there the problems of resource availability and high real interest rates, but also only a limited number of financial institutions have been involved in lending to SMI. Lending to SMI is principally done by Halk Bank (HB), the Industrial Investment and Credit Bank (SYKB) and the Development Bank of Turkey (TKB, formerly DESIYAB). Halk Bank is a Government commercial-bank which is mandated to finance small scale industries. However, because of its nature as a commercial bank, it hcs traditionally concentrated on providing working capital finance to small enterprises; only recently has its project financing portfolio started to grow. SYKB is a private development bank, which has traditionally provided investment loans to small and medium industries. It has, however. recently been moving up in scale and now competes for larger projects and enterprises. TKB is a specialized public bank whose original mandate was to lend to and/or invest in factories set up by Turkish expatriate workers. Because of difficulties with this type of activity, it has moved out of it and now lends to any industrial undertaking regardless of size. Thus, not only are there a limited number of institutions dealing with SMI, but there is a tendency for the existing institutions to move up in their lending scales. 2.22 Current Financial Sector Issues. Financial sector issues were initially addressed by the Bank through its first Financial Sector Adjustment Loan (FSAL I). Under that loan, financial policies were addressed to reform the interest rate structure and reduce the volume of preferential credits. Institutional measures were included to strengthen bank supervision, to provide training, and to develop and expand the money and capitol markets. The primary and secondary markets for Treasury Bills and commercial papers have expanded, as have the listings and trading activities in the stock exchange. Auditing of banks and listed companies have been initiated with their 1987 accounts as agreed. 2.23 Despite progress in reforms under FSAL I, the financial situation of the banking system has not improved. Many banks are carrying a heavy burden of non-performing loans as the real sector suffers from high real interest rates and adjustment costs in a more liberalized environment. A second Financial Sector Adjustment Loan (FSAL II) has been made by the Bank to follow through on the reforms initiated under FSAL I and deepen the reform process. FSAL II is specifically addressing four areas of concern. The first relates to the Government's large fiscal deficit and its impact on the financial sector. Action on fiscal policy is needed in order to reduce the high interest rates on commercial loans, and Treasury and corporate securities. The second area concerns the financial health of the banking system. The economic reforms enacted in recent years have generated severe financial difficulties for firms which could not adjust rapidly and are reflected in the portfolio of banks as non-performing loans. The third area concerns the - 9 - rationalization of interest rate policies to reduce subsidies through preferential credits and also reduce currency substitution. The fourth area relates to the need to further develop the money and capital markets, by removing impediments to an orderly growth of the market, the most important being the lack of external auditing of firms selling securities.1' Steady, but uneven progress has been made in each of these areas over the past year. 2.24 Linkages with FSAL II. Consistent with the financial sector reform program agreed under FSAL II, the participating credit institutions under the project were appraised within the general framework of the 1988 Financial Sector Policies of the Goverpment. The major financial sector reforms under FSAL II are contained in new decrees which have (a) established improved guidelines for banks in loan classification, income recognition and loan loss provisioning; and (b) laid down instructions on treatment of non-performing assets and restructuring of public sector banks. A third decree is expected to be issued shortly that would set out new standards for capital adequacy, risk and exposure levels and lending limits. Through conditions of participation and financial covenants, the project would ensure that a PCI would be allowed to participate in the project only if it complies with the provisions of these decrees. Beyond compliance with the decrees, the project strongly complements the financial sector adjustment effort at the institutional level, and assists the participating credit institutions in defining policies and business strategies; in strengthening operating policies and procedures and information systems; in improving project appraisal and supervision; in enhancing procurement and disbursement procedures; and in raising their reportinr accounting and auditing practices to internationally acceptable standards. 2.25 Industrial Lending Rates and Inflation. Under FSAL II, the Government reconfirmed its commitment to liberalization of lending rates, except for selective czedits that will continue to enjoy preferential rates. The volume of selective credits is to be reduced further and their interest rates are to be raised to positive real levels. By the second tranche release of FSAL II, positive real rates are supposed to be achieved for selective credits to the productive sectors. (The agreed index for determining positive real rates is the weighted average cf the change in the wholesale price index in the past 12 months and of the expected change in the next twelve months. Inflation in 1988 at the wholesale level was 70%, while the expected inflation in 1989 is 50%). For industry, short term working capical loans are available only at market rates (currently around 120%) which are at very high real levels due mainly to the large fiscal deficit (para 3.02). Long term investment loans are available mainly from external sources under the Foreign Exchange Risk Insurance Scheme (FERIS). While a local source has also been available under the Central Bank rediscounting scheme, it has been greatly reduced to date. 2.26 FERIS was introduced in 1985 as a temporary measure to encourage investments by providing some stability to long term financing at a time of high inflation, high real interest rates, and rapid devaluation on the one hand, and high capacity utilization in the industrial sector, on the other. Subloans have carried a fixed rate and a fixed maturity of 8 years without a ' See the President's Report, FSAL II. - 10 - prepayment option. Over half of the interest during a three-year grace period was capitalized. The fixed FERIS rate has been reviewed semi-annually, with the view to reflecting movements in inflation. Relative to the distorted level of market interest rates, the FERIS rate has implied a subsidy, which together with other industrial investment incentives, aims at stimulating industrial investments and minimizing resource movements into non-tradables under inflationary conditions. The FERIS rate in the past year has been set effectively at about 50% (with semi-annual compounding). While the FERIS rate is expected to result in a positive real rate of about 4% based on the Ban, s current inflation projections for Turkey for the next 8 years, the rate has turned negative since the latter half of 1988 relative to the agreed index for positive rates (para 2.25). Moreover, FERIS as a scheme continues to be vulnerable. Should inflation continue unabated, FERIS could prove costly to the Government. On the other hand should i-flation decline, large number of sub-borrowers, locked into high real rates, could wilfully or unwilfully default, aggravating distress in the financial system, or force prepayment, passing on losses to FERIS. 2.27 Since the conditions that led to the establishment of FERIS still hold today, the Government's view is that it is not yet time to abolish FERIS despite the risks cited above. However, to minimize these risks for both the Gcvernment and sub-borrowers, the Government has decided to abolish the fixed rate scheme and move completely to a variable rate system. The variable rate would be adjusted automatically on a quarterly basis and to the average 3-month Treasury Bill rate in the preceding three months. Two-third of the interest during a grace period of three years would be allowed to be capitalized but would be compounded to keep the effective rate at the nominal rate level. Based on the Treasury Bill rates of the past three months, the initial rate would be about 68% p.a. This system is expected not only to generate positive real rates but also rates reflective of market conditions. This action by the Government is expected to be taken before loan signing but is currently reflected in the loan agreement as a condition of effectiveness (para 7.01b). III. PROJECT RATIONALE A. Bank's Industrial Lending Strategy 3.01 The Bank's strategy for industrial lending to Turkey is to help to: a) achieve its "base case" macroeconomic f:amework by focusing on priority macro-sectoral linkages, and b) strengthen international competitiveness of its industrial sector by selecting export and technological development as the critical agenda for the long term. 3.02 The growth of Turkey's industrial exports is critical to enhance its creditworthiness and help meet its foreign debt service obligations. Since many sub-sectors of industry have reached high levels of capacity utilization and investment levels are relatively low, private sector investments need to be revitalized in order to maintain export growth. In other sub-sectors with some excess capacity, lack of working capital has constrained greater capacity utilization. To increase investments and capacity utilization, high real lending rates have to be reduced, since they are a major factor inhibiting the financing of investments and operations by the banking system. The reduction of real interest rates will require: (i) a reduction in the level of Government borrowings since they crowd out private borrowings; (ii) a reduction 0346P - 11 - in the high levels of liquidity reserve requirements of the banking system that contribute to a high spread between deposit and lending rates; and (iii) a Teduction in the cost of operations of the banking system. The reduction of Government borrowings and reserve requirements can only be achieved by reducing the size of the Government fiscal deficit. Macroeconomic adjustment is, therefore, an item of high priority in the Bank's dialogue with the Government and is a central item in the Government's letter of macroeconomic policy. The reduction of the cost of operations of the banking system would require a rationalization of the operations of the banks and a reduction of the high cost of non-performing assets. These problems are being addressed for the financial sector as a whole under the ongoing Second Financial Sector Adjustment Loan and for individual financial institutions under ongoing credit line operations; such efforts will continue under the proposed project (paras 2.23-2.24). Future financial intermediation operations would continue to assist the creation of stronger banks and a more competitive banking system. Moreover, these operations would be designed to enhance financial sector diversification through the promotion ot innovative financial instruments and institutions. 3.03 Within an appropriate medium-term macroeconomic froamework, a stronger and more diversified financial sector would facilitate a quicker and more effective structural adjustment of the industrial sector. Under a policy-based operation which the Bank proposes to support, Turkey would effect a medium-terr program for industrial sector adjustment with a focus on trade and industrial pzlicy reforms, in view of its plans to join the European Community (EC), and proposes to privatize more of its state enterprises in manufacturing, and further reduce the sector's reliance on the budget. In the context of such a policy framework, financial intermediation operations would continue to accelerate the growth of dynamic and export-oriented private industry that can realize new business opportunities in a more competitive environment at home and in the context of the EC. To further assist such industrial transformation, a technology development operation, which may be supported by the Bank, would accelerate technological change in private industry, by financing R&D subject to market discipline and effective technology transfer and diffusion projects, and by establishing technology policy and institutions suited for the new age. B. Past SMI Projects 3.04 The Labor Intensive Project. Loan 1952-TU of US$40 million which became effective in June 1981 financed the Bank's first SMI project in Turkey. The objectives of this project were to assist in alleviating urban unemployment by focusing on labor-intensive industries; to increase SMI's access to credit by using commercial bank branches as agents for receiving loan applications; and to provide technical assistance and consultancy services to sub-borrowers. To ensure credit access by smaller units, at least one third of the loan was earmarked for enterprises with assets (excluding land and buildings) not exceeding US$350,000 for new sub-projects and US$500,000 for expansion sub-projects. Furthermore, the Government decided to assist SSI sub-borrowers by assuming the foreign exchange risk of their subloans. 3.05 Loan utilization was slower than anticipated, mainly due to the reluctance of medium-size firms to bear the foreign exchange risk. However, after the introduction of FERIS, undet which the Government assumed the - 12 - foreign exchange risk for all sub-borrowers regardless of size, the loan was quickly committed and disbursed (paras 2.26-2.27). SYKB financed 114 sub-projects which created about 5,600 new jobs at an average cost per job of about US$10,000. The number of jobs created was higher than the anticipated figure of 5,000 and the cost per job was lower than the ceiling of US$15,000. About 64% of the loan amount went to smaller units, twice the target amount. The major industrial sub-sectors financed were: textiles, food and beverages, metal products, and machinery and electrical equipment, which experienced rapid growth in this period. 3.06 The other important objectives of the project were not achieved as successfully. Being a development finance institution, SYKB does not have the branch network of a commercial bank. In order to reach a greater number of clients outside of the greater Istanbul area, particularly SMI sub-borrowers in secondary urban areas, the plan was to utilize the branch network of the commercial banks which are stockholders of SYKB. These commercial banks were to act as agents for SYKB in identifying, screening, and referring clients. In return, SYKB was to compensate the commercial banks through a one-time commission of 1.5% of the subloan amount. The plan did not materialize since the commercial bank branches were more interested in their own lending and other operations, and much less in the promotion of term lending for SYKB. Throughout the 1981-1985 period SYKB received less than five referrals. 3.07 The technical assistance fund established under the project was to provide training and technical assistance to sub-borrowers. This component also did not achieve its objective as expected. Only 23 sub-borrowers took advantage of this fund, partly because of lack of appreciation by SMI of the advantages of consultancy services and partly because of lack of promotion of the fund by SYKB. Being a financial institution, SYKB focused more on the credit program rather than the technical assistance fund. 3.08 The Small and Medium Scale Industry Project (SMI I). Loan 2647-TU of US$100 million which became effective in May 1986 was designed to further the initiatives started under the first project by including, in addition to SYKB, Halk Bank (HB), a commercial bank with a wide branch network and by assigning technical assistance to an agency which would focus full-time on this aspect of SMI assistance. Overall loan utilization has been satisfactory with the credit component already fully committed and about US$83 million disbursed as of February 28, 1989, ahead of schedule. Sub-projects assisted under the loan are expected to create about 18,000 jobs at an average cost of US$9,600, lower than under the first project as more smaller labor intensive units have been financed through the participation of a commercial bank. 3.09 With FERIS still in effect, SYKB's portion of the SMI loan has been committed and disbursed at a rapid rate. As of February 1989, SYKB had approved 165 sub-projects for a total amount of US$80 million and had disbursed to them US$65 million. However, due to SYKB's lack of branches the majority of these sub-projects (about 80%) are located in the developed areas such as Istanbul, Izmir, Bursa, and Tekirdag, with 17% in semi-developed areas and 3% in under-developed areas. Because of location, the majority of these sub-projects are medium-scale projects (68%). The major industrial sub-sectors financed continue to be textiles, chemicals, machinery, food, metal products, and marble industries. n3 FR - 13 - 3.10 This first Bank loan for HB consisted of two components: (i) a credit line of US$18.4 million, and (ii) technical assistance for training and for organizational improvements (US$350,000). HB's utilization of the credit line portion of the loan was initially slow since it was new to Bank procedures, but has improved considerably since the end of 1987. As of February 28, 1989, the credit line had been fully committed and disbursements stood at US$12 million. To date, HB has financed 241 sub-projects with another 43 sub-projects in the pipeline at different stages of processing. RB expects the credit line to be fully disbursed by the end of FY89. HB has fully utilized its training fund and has made certain appropriate organizational changes. Further strengthening of HB's capability as a channel for SMI finance is included in the proposed project. 3.11 One of the major objectives of this loan was to provide more comprehensive technical assistance to SMI by using SIDO as the implementing agency. SIDO is the only Government agency responsible exclusively for providing promotional and extension services to SMI. Technical assistance was also provided to SIDO itself to strengthen its organizational structure and capability to carry out its role. To improve its effectiveness, SIDO was expected to expand its extension services for SMI. During the 1986-1988 period, SIDO opened branches in Istanbul, Bursa, Konya, and Adana. SIDO plans to open additional branches in Izmir, Malatya and Eskisehir which are important centers of SMI activity. Beyond these steps, however, SIDO has not been able to carry out the role envisioned for it under the project. SIDO continues to suffer from structural problems due to its public sector stature which prevents it from providing the full range of services needed by SMI. Under the proposed project, the channels for technical assistance would be expanded by including private sector organizations (para 3.13). C. Rationale for Bank Involvement 3.12 While the two previous projects assisted by the Bank have helped increase SMI's access to financial, technical and marketing assistance, the institutional mechanisms that can deliver these services effectively have to be expanded and improved to enable SMI to reach its potential. Financial institutions are not yet fully equipped to handle SMI lending and are still averse to financing SMI units due to perceptions of higher risks associated with lending to this sector and higher administrative costs associated with smaller loans. Hence, equity financing and informal credit sources at very high costs continue to be the major source of financing for SMI. The Bank's continued assistance is needed to assure adequate long-term funds for existing and other financial institutions to expand their SMI portfolio, and also as a means of providing technical assistance to make them more effective and efficient at SMI financing. 3.13 In the area of technology and export marketing services for SMI, the project would assist in improving the public sector institutions in providing technical and marketing services more effectively. However, there are areas where public sector agencies have inherent shortcomings and are not capable of delivering the required services effectively. The Bank under the proposed n- -I - 14 - project aims to catalyze efforts in developing alternative private sector mechanisms which can effectively complement the programs being undertaken by the public sector agencies (paras. 4.16 - 4.23). IV. THE PROJECT A. Objectives and Scope 4.01 By pursuing the initiatives started under past SMI projects and modifying approaches in response to lessons learned, the propoeed project aims at expanding and improving assistance for the SMI sector to enable it to increase output, exports and job opportunities in line with its potential. Specifically, the objectives of the project are to: a) promote and support efficient SMI investments and operations; b) improve SMI's access to credit by increasing the number of firnncial institutions which can serve as efficient intermediaries for SMI finance; c) assist the SMI sector to improve product quality and compete in local and export markets by providing technical and marketing services; and d) enhance policy making for the SMI sector through more reliable * statistics. 4.02 Definition of SMI. Under the proposed project, the definition of SMI would be the same as under SMI II after taking into account inflation and exchange rate movements, since most imported equipment and machinery for Turkish SMIs are from currently strong currency countries. With this definition, 78% of total private industrial firms in the formal sector would fall under the category of small scale industries (SSI) and 11% would be in the category of medium scale industries (MSI) (para 2.12). This distribution is similar to that of most developing economies. Since different institutions use different d, inition criteria, the definition under the project would allow the use of either criterion: a) Small-Scale Industries - (i) For the PCIs, the definition would use the asset criterion since this is operationally more convenient for them; an SSI firm is defined as an enterprise whose fiKed assets excluding land and buildings in book value amount to US$800,000 or below; and (ii) for technical assistance institutions which may not have access to a client's financial statements, the definition would be on the basis of labor force size, i.e., an enterprise with 50 workers or less; and b) Medium-Scale Industries - (i) For the PCIs, US$800,000 - US$4.0 million in fixed assets excluding land and buildings in book value, and (ii) for technical assistance institutions, 51 up to 100 workers. 4.03 In order to encourage expansion and growth of existing enterprises, these definitions would be applied for existing enterprises on a pre-investment basis so that sub-project sizes would not be artificially - 15 - tailored to meet the definitions. However, once an enterprise exceeds the cut-off limits, it would become ineligible for another subloan under this project and would have, in effecL, graduated from the SMI sector. On the other hand, to ensure that smaller units have sufficient access to subloans under this project, 30% of the proposed loan would be reserved for subloans to SSIs only (para 4.12 c). 4.04 Informal Sector. Since the project will not stipulate a minimum sub-project or subloan size, it could cover the informal industrial sector as well. However, the project is principally designed to address the needs of the formal SMI sector which are different from those of the informal sector. The institutional channels for assistance to the informal sector usually are not the formal credit channels. 4.05 Project Components. The proposed project would have the following components: (a) credit lines to the participating credit institutions for onlending to SMI sub-projects which are financially and economically viable for fixed investment and permanent working capital; (b) technical assistance to the participating credit institutions to improve their project appraisal and supervision capability, and their information systems and operating procedures related to SMI financing operations; (c) technical and marketing support services for SMIs to improve product quality and expand their local and export markets; and (d) technical assistance to improve SMI data collection, processing and analysis to improve their accuracy and reliability for future policy and project formulation. B. Project Costs and Financing Plan 4.06 The proposed project is estimated to cost US$506 million, of which the Bank would finance US$204.5 million, or about 40%. SMI credit demand projections in FY 89-91 are given in Annex 2 and show that the Bank Loan would contribute about 25% of the foreign exchange requirements of the entire SMI sub-sector in this period. Bank financing would be used for the credit component of the project to finance subloans for viable SMI sub-projects. The subloans would finance about 50% of sub-project cost while sub-project sponsors would contribute the other 50% as equity. The participating credit institutions are expected to support the sub-projects also with short term working capital loans from internal resources, amounting to about US$100 mill:in equivalent. A portion of the Bank loan amounting to about US$4.n million would be used to finance the direct costs of the technical assistance components. The Government, through regular budgetary allocations to the implementing public sector agencies concerned, private sector participants and the PCIs would cover all indirect local administrative and staff costs estimated at *.bout US$1.5 million. The components, cost estimates and financing sources are summarized below: - 16 - (US$ million) Private Bank GOT PCI Sector Total A. Credit Component 200.00 - 100.00 200.00 500.00 B. Technical Assistance a/ 1. Export Promotion 1.50 - - 0.50 2.00 2. Quality Control 1.00 0.25 - - 1.25 3. SMI Statistics 0.50 0.25 - - 0.75 4. Training and Consultancy for PCI 1.50 - 0.50 - 2.00 Subtotal 4.50 0.50 0.50 0.50 6.00 C. Grand Total b/ 204.50 0.50 100.50 200.50 506.00 a/ Including contingencies b/ Including taxes C. Credit Component 4.07 Participating Credit Institutions. The proposed project aims at improving credit access for SMIs by increasing the number of financial intermediaries providing SMI finance, improving the efficiency of these institutions through technical assistance, and increasing competition among institutions to encourage them to provide better banking services. In selecting the PCIs for this project, appraisal was carried out within the framework of the new financial sector policies of the Government. In March 1988, the Government announced its financial sector policies, agreed under FSAL II, which aim, among others, at improving the health of the banking system. This was followed by two decrees, one of which tightens criteria used by banks in loan classification, loan provisioning and income recognition; and the other sets guidelines for the treatment of non-performing loans and the restructuring of public sector banks burdened with portfolio problems. A third decree is in preparation which would establish new standards for capital adequacy and risk exposure limits of banks. Under the decree on loan provisioning, the banks are given two years between March 1988 and March 1990 to fully provide for bad loans as defined in the new decree. This process is under way, but has not yet been completed. 4.08 Five financial institutions were evaluated as potential participants in the proposed project during pre-appraisal in June 1988: two development finance institutions (SYKB and TKB) and three commercial banks (Emlak, Halk and Vakiflar). At that time it was made clear to them and to the Government that each financial institution would be appraised in the light of the 1988 financial sector policies and the two decrees promulgated by the Government; and that the appraisal mission would also take into account the anticipated requirements of the forthcoming decree on capital adequacy. At the time of appraisal, the process of implementing the decree was in the initial stages. 03460 - 17 - The PCIs placed their first priority on identifying the loans in the portfolio which were not performing according to the current payment schedule, and made provisions for these, in some cases, in advance of the schedule required under the decree. The other key step, identifying performing loans and off balance sheet items but with borrowers who are no longer creditworthy, is a procedure very new to the Turkish banking system and requires a full review of all borrowers. This step had not yet been completed by appraisal. At appraisal, initial estimates of the required provisions on the basis of loss of creditworthiness were made on an aggregate basis. This estimatc will then be refined as the PCIs complete the required review of creditworthiness of all their borrowers, which will take place over the next few months. Bank supervision of the loan will monitor progress in this regard and will guide the PCIs In developing creditworthiness assessment as one of their key tools for managing portfolio risk. 4.09 Due to strong objections from the banking sector on the provisioning decree, the Government issued, in October 1988, a communique to amend the decree. Among others, the major changes would allow the banks to: i) reschedule bad loans and postpone the requirement for additional provisions until the rescheduled loans go into default again; and ii) postpone provisioning on uncreditworthy non-cash credits. Considering the material change this amendment made on prior agreements with the Government, the appraisal mission disregarded the amendments to the decree in appraising the banks. On this basis and other standard appraisal criteria, HB, SYKB and Vakiflar Bank (VB) have been found to qualify to participate in the proposed project. Emlak Bank (EB) would qualify only after it shall have made adequate provisions for its non-performing loans satisfactory to the Bank. On February 3, 1989, TKB took over the entire assets and staff of another public sector development bank for the tourism sector (the lourism Bank). Since it will take at least 6 months for TKB to complete the take over, it was agreed that TKB would be reconsidered for participation in the project at that time. TKB would be re-appraised and the cinditions of its participation in this project would be formulated after appraisal. Annex 3 summarizes %..he major appraisal findings on the four financial institutions and the main conditions for their participation. More detailed appraisals are available in the project files. 4.10 Loan Allocation. The credit line would be divided such that each PCI would have an initial pre-allocated amount of USt50 million. Should TKB qualify as a PCI within 12 months of loan signing, equal amounts from each of the four PCIs would be reallocated to TKB. Each PCI would be given 21 months from loan signing to utilize its pre-allocated amount. At that time, the Bank would review loan utilization by the PCIs and on the basis of past performance and future prospects, re-allocate the Loan among the PCIs. This arrangement is designed to encourage competition among the PCIs while recognizing the fact that some PCIs have had longer experience with SMI lending and with Bank operations and, therefore, would have an initial advantage over others. 4.11 Sub-project Eligibility Criteria. An enterprise would be eligible for a subloan under the proposed project if it is a small or medium-scale enterprise as defined in para 4.02, is privately owned and is engaged or is intending to engage in manufacturing, repair, processing, industrial service, mining or tourism. An eligible enterprise can apply for the financing of a sub-project which could involve establishment, expansion, balancing, modernization or replacement proposals which are financially and economically - 18 - viable. The maximum debt:equity ratio for the sub-project would be 50:50, as required under FERIS. After a subloan, the owners/stockholders of an enterprise must have a minimum equity investment of 40% of the enterprise's assets in terms of capital, subordinated loans or retained earnings. Sub-projects financed under the project must meet the environmental protection requirements of the Government. Sub-project appraisals would assess compliance with environmental regulations as well as safety and health standards. The Bank has provided to the PCIs guidelines covering various aspects of environmental protection to assist them in assessing sub-projects in this regard. 4.12 Subloan Terms and Conditions. Sublending terms and conditions would be similar to those under SMI I but modified in response to lessons learned in past projects: (a) subloans are for fixed investment or permanent working capital purposes only since they should not be used to substitute for short-term working capital loans which the PCIs can provide from internal resources; (b) the maximum subloan would be US$3.0 million equivalent per enterprise in order to spread the loan to a greater number of SMI enterprises; (c) at least 30% if the amouncs disbursed by each PCI should be for subloans to SSIs as defined in para 4.02 (para 4.03); (d) the final lending rate to stb-borrowers would be the variable FERIS rate which would be adjusted automatically to the average of the 3-month Treasury Bill rate in the preceding three months on a quarterly basis; two-third of the interest during a grace period of three years may be capitalized but would have to be compounded to prevent an erosion of the effective rate; (e) Bank finds may be used to finance 100% of the CIF cost of imported equipment and materials, 70% of imported but locally purchased equipment and materials (to factor out taxes), 50% of the ex-factory cost of locally produced equipment and materials (to cover the cost of its imported components) and 30% of civil works but only for tourism sub-projects. Otherwise, Bank funds would not be used to finance the cost of land or buildings; (f) subloan maturities would be for eight years including a grace period of up to 36 months to match their long term uses and in accordance with FERIS rules; (g) subloans which have not been disbursed, even partially, six months after authorization by the Bank would be automatically cancelled to free up amounts for commitment to other sub-borrowers; (h) sub-borrowers would be allowed to inquire and apply for a subloan in more than one PCI to enable them to shop around for the best banking service; however, once they have formally requested loan processing they would be required to pay an appraisal fee of 0.1% of the subloan amount but not to exceed TL 10 million for each appraisal to - 19 - discourage appraisal of the same sub-project by more than one PCI and to compensate a PCI for appraisal costs should sub-borrowers ask for loan processing by more than one PCI; and (i) sub-borrowers would be required to pay a commitment fee of 0.75% to compensate PCIs for the commitment fees paid on their subsidiary loans. 4.13 Sub-project Processing and Free Limits. Sub-project appraisal and subloan processing would follow procedures which would vary depending on whether a subloan is a free limit subloan or above the free limit. For a free limit subloan, the PCI would have to furnish to the Bank a summary descrip- tion of t'se sub-project, including the expenditures proposed to be financed by the Bank; the proposed terms and conditions of the subloan; and a certifi- cation that the sub-project eligibility criteria and the subloan terms and conditions under the project have been met. For subloans above the free limit, the PCI would have to submit an appraisal of the sub-project, including the expenditures to be financed by the Bank; the terms and conditions of the subloan; and a certification that the sub-project el:gibility criteria and subloan terms and conditions under the project have been met. Since this will be its first time to participate in a Bank operation, Emlak Bank would be given a free limit cut-off amount only after it has submitted its first five sub-projects. Halk Bank would have a free limit of US$700,000. Vakiflar Bank and SYKB would have a free limit of US$2.5 million. 4.14 Technical Assistance for the PCIs. Under the project, technical assistance funds amounting to US$1.5 million would be provided to assist the PCIs in general institution strengthening, with particular focus on improving their appraisal and supervision methods, systems and procedures, through staff training and soft and hardware improvements. Details of their technical assistance needs were discussed during appraisal and are found in the appraisals of the PCIs in the project files. Since the total requirements exceed the allocation Pf US$1.5 million, as a means of rationing the funds under this project, disburqement of these funds would be made on the basis of detailed proposals by each PCI, taking into account factors such as equitable distribution among the PCIs, relevance of the proposals to SMI operations, and provision of matching funds by the PCIs. D. Technical Assistance Components for SMIs 4.15 Effective promotion of SMI consists not only of improving access to credit but also of developing and improving sector-wide complementary services in technology, marketing and other areas. Lacking specialized departments or personnel, SMI firms normally do not find it cost effective or do not have the time tc invest in marketing programs, product development or other information systems beyond what they need on a day-to-day basis. Given these inherent constraints, the proposed project seeks to assist the SMI sector enhance efficiency and competitiveness by providing assistance in the areas of quality contro. and export marketing. Improvements in these areas will enhance the operations of SMI firms receiving assistance and provide significant external benefits to the SMI sector as a whole. - 20 - E. Export Promotion Component 4.16 Export Potential of SMI. Despite Turkey's close proximity to its main export markets, exporting directly is difficult for SMI firms as most lazk the resources, know-how and expertise to obtain current market infor- mation and develop distribution channels. IGEME has been, to a great extent, a passive export promotion agency, primarily engaged in promoting trade fairs, publishing information on Turkish products, exporters, and foreign trade regulations and, for some clients, providing limited market intelligence about foreign markets. Under the Industrial Export Development Project (IEDP) a component was included to bolster the service delivery of IGEME, but has yet to be implemented. SIDO alpo has developed an export promotion program funded through SMI I which targets around 50 pre-selected firms per year considered (by SIDO) to have export potential. Although SIDO's export promotion activities are only now beginning, their targeted case-by-case approach does not seam to have the promise of a significant economy-wide impact in the short term. 4.17 Export Trading Companies in Turkey. One of the most effective channels for the promotion of SMI exports are the ETCs. The export boom in Turkey during the 1980s was accompanied by a surge in the use of ETCs. In 1981, the share of exports by ETCs in total exports was only 9%. In 1987, 30 ETCs accounted for more thin half of total exports, with a significant proportion of ETC exports coming from SMI. In addition to scale advantages, a number of factors contributed to the growing use of ETCs in Turkey: (i) since nearly all exports to Middle East countries are imported by state trading organizations, Turkish ETCs are best suited to fill the large orders of numerous types of products; (ii) ETCs are permitted to deal in counter-trade, which, because of oil and gas imports from the Soviet Union, became a significant form of exporting in the 1980s; and (iii) the exports incentives system favored large exporters, and encouraged a significant amount of "pass through" exporting (para 2.15). 4.18 ETCs in Tur ._ were supposed to resemble the large Japanese and Korean general trading compenies (GTC) which export a wide variety of mostly standardized manufactures and engage in a number of activities, including importing, domestic sales, counter trade, financing and foreign investment. Generally, two types of ETCs have developed in Turkey, such as RAM or EDPA, the exporting arms of large holding companies which may not be profit maximizing, and independent profit-making enterprises like TEKFAN, PENTA and ENKA which export numerous products and develop linkages with domestic suppliers. Although these independent ETCs are the traditional exporters of SMI products, trading arms of holding companies are now also seeking suppliers outside of their sister companies. Up until now, Turkish ETCs have not been providing the export value added and aggressive marketing effort normally associated with Asian ETCs, since the export subsidy system in Turkey provided a financial incentive for producers to utilize an ETC. In anticipation of reforms in the export promotion system, Turkish ETCs recognize the need to develop alternative types of exporting arrangements and expand their service delivery capacity. The Asian experience, where there are multiple linkages between export trading companies and manufacturers, shows that for Turkey's ETCs to prove viable for the long-term, they must continue the development toward aggressive multi-service entities and engage in all facets of their supplier's business including the channelling of technological information, - 21 - the financing and importing of raw materials, pankaging, storing, and marketing of final goods and even investing in their equity. The development of the Domestic Letter of Credit scheme and the law for ETCs should help to support the continued development of ETC-supplier relationship (para 2.16). 4.19 As the result of recent payment problems in important Middle East markets, an immediate need of ETCs is to deepen and widen penetration in new industrialized markets. Specifically, exports to Iraq are being substantially cut back and now even require licensing due to over US$2 billion in overdue payments on an official line of credit. Exporters are also experiencing payment problems from other important markets, such as Algeria and Iran. The prospect of losing the easy export conditions in the Middle East markets which boosted Turkish exports in the 1980s, namely strong domestic demand from oil revenues, modect requirements on quality, technology and pricing, minimal marketing efforts, and generous official credit to Iraq, are leading ETCs to investigate new markets and products. The nature of Turkey's comparative advantage with OECD countries is that labor intensive products from the SMI sector will be well suited to penetrate new, industrialized markets. 4.20 Technical Assistance Program for Export Trading Companies Administered by the Ex-Im Bank. This component of the technical assistance program is intended to help realize the export potential of the SMI sector by bringing professional marketing consultants (e.g. professional buyers from foreign retail chains) to Turkey who specialize in SMI product areas and can assist ETCs and their supplier firms in product development. The program will also increase familiarity and cooperation among organizations involved with various facets of SMI exporting, specifically SIDO, IGEME, the Foreign Trade Association of Turkey (TURKTRADE), the Ex-Im Bank and the ETCs themselves. Despite the importance of ETCs to SMI export prospects, tkese agencies are jointly involved in surprisingly few integrated programs aimed at strengthening links between producers and ETCs. Finally, the program will provide additional positive externalities, by introducing Turkcy as a potential supplier to the marketing consultants. 4.21 The technical assistance program would assist export trading companies expand the exports of SMI products to new markets. It would be administered by the Ex-Im Bank, in conjunction with IGEME. Representatives from Ex-Im Bank, TURKTRADE, IGEME and SIDO will be represented %;n a working level management committee which will develop disbursement policy and advise of project development and approval. The program will run for three years but, given that infrastructure and experience will have been developed, it is envisaged that the program would continue beyond the technical assistance as ETCs find this to be a cost-effective method of market development. 4.22 General Principles. The intention of this component is to finance consultants specializing in product lines predominantly produced by firms in the SMI sector. It would finance part of the cost of hiring specialized market consultants to come to Turkey for 1-2 months. The consultants should be professional buyers borrowed from wholesale or retail firms in the targeted ifiarket in order to bring expertise and information about market demands and product specification directly to manufacturing firms in Turkey's SMI sector. The consultants would work with ETCs and their domestic suppliers to develop their product design and export competitiveness. To ensure an active interest in the program, ETCs themselves would be expected to pay for part of the cost 0346R - 22 - of the consultants. Since the proposed operations should be of interest to a umber of export houses it is likely that the consultant would be shared across a number of ETCs so that the benefits can ultimately reach as many ,irms as possible. If suitable projects could be developed, the consultants themselves could theoretically be eventually available to smaller exporters which are not formal ETCs but also export SMI products. The proposed management committee, the responsibilities of the administering agency, and suggested guidelines for project approval were prepared and finalized at appraisal. 4.23 Costs. The total cost of the export promotion component is estimated at approximately US$2.0 million over three years. Of that, the establishment and operational costs in the Ex-Im Bank is estirated to cost U3$300,000. Assuming US$20,000 per man-month for a market consultant, an average of two months spent per project, and 14 consultants per year (based on an estimate of the number of interested ETCs and their perceived absorption capacity), the total cost of the fund will be US$1.7 million, to which the ETCs would contribute about US$0.5 million. The Bank loan would finance the balance of US$1.5 million. F. Quality Improvement Component 4.24 Background. Although the TSE provides a service to all Turkish industry for the achievement of quality standards, there is a need to develop this service in such a way as to make it more accessible to small and medium scale enterprises. Presently, TSE's approach has been to certify companies which have attained quality levels on their own. Invariably, these have been large companies with the resources to reach acceptable standards without external assistance. A different approach is needed for SMI not because standards are different for small firms but because the importance of high quality as a means of securing higher prices and profits is less obvious to small scale manufacturers. The loss of some Middle East markets, which have had few quality restrictions, and the need to seek new markets in Europe, makes the question of quality improvement of even greater importance for exporting companies. This component would combine the resources of SIDO and TSE to ensure that it has both a strong orientation towards small firms and, at the same time, conforms to national standards. Added benefits would come from bringing the two agencies into a closer working relationship than exists at present. 4.25 Objectives. The objectives of this technical component are: (i) to promote to SMI the benefits of operating to recognized standards; (ii) to identify companies which are motivated and can profit from improved standards; (iii) to assess the current operating levels of companies in order to advise on improvements; and (iv) to provide certification of companies which reach the required operating standard. This component would: (i) train a special group within TSE in the approaches used in other countries with successful programs; (ii) produce promotional literature and advertising to bring the program to the attention of industry; (iii) publicize the program so as to make it attractive to participating companies; (iv) hold regional seminars and workshops on quality improvement, using mobile testing equipment when appropriate; (v) follow up with company visits and in-company assistance; and (vi) publicize the names of successful companies to large firms and overseas buyers in a special buyers' guide. 034SR - 23 - 4.26 Institutional Arrangements. The scheme would operate within TSE under TSE management. In order to promote close cooperation with SIDO some personnel would be seconded to TSE for the duration of the prugram. The program would be centered in Ankara but would also be operated through TSE offices in other centers. There would be a joint management committee for tb project comprising the Director and one other staff member from SIDO and two members from TSE. A memorandum of cooperation has been drawn up and agreed between the two agencies and was finalized at appraisal. 4.27 Costs. The project would require about eight people, four of whom would be seconded frim SIDO. Costs would include overseas training, the use of foreign advisors and a substantial print and advertising budget. For a three year program the total cost would be about US$1.25 million, of which US$0.25 million in administrative overhead would be met by the implementing agencies. The Bank loan would finance the direct costs of US$1.0 million. G. SMI Sector Statistics 4.28 Background. There is a conspicuous lack of statistical and analytical information on the SMI sector. Each institution which collects data on SMI firms (SIS, SIDO, Halk Bank) uses a different definition, preventing a consistent analysis of the sector. The official SIS statistics are derived from a census of manufactures which is carried out every five years with a two to three-year lag for publication. The survey technique, instrument and coverage has changed significantly for each survey, making the time series inconsistent ar,1 unreliable. Accompanying the limited statistical information is a dearth of analytical studies. Therefore, apart from anecdotal evidence and isolated plant visits, there is no way to gauge the performance of SMI units on their own, in relation to their larger counterparts in the same sub-sector, or in comparison to the SMI sector in other countries. There are also questions regarding the reliability, coverage and timeliness of the resulting output of the surveys. Studies using SIS and ISO firm level data, carried out by the Bosphorous University as one example and another ongoing at the World Bank have attempted to examine various types of productivity and efficiency indicators. The results of these studies have been hindered by inconsistencies and gaps in the dataset. This lack of basic statistics on the structure and performance of the SMI sector naturally hinders effective policy formulation for the sector. In contrast to the extensive analysis available on the top 500 firms in Turkey, there is a need to obtain data on the export performance, capital and labor productivity, capacity utilization and other performance indicators for the industrial sector as a whole, with emphasis on the relative position of the SMI sector. 4.29 Objectives and Scope. In order to help improve the statistical database on the SMI sector in Turkey, a component is being proposed for SIS to institutionalize rn annual survey of manufacturing industries which will collect performance and structure data, stratified according to various size definitions (e.g. number employed, fixed capital, etc.). The program will provide three years of financing for SIS to: (i) employ consultants to develop the survey instruments and the survey methodology, including the establishment of the universe, the sampling frame and the survey procedure; (ii) hire interviewers to follow up the mailed questionnaires; (iii) process and publish the data; (iv) develop a system whereby the raw data can easily be provided in a "diskette format" on request, and (v) train SIS staff to institutionalize 034BR - 24 - the program within SIS. The objective of the survey will be to establish a timely information base to enable better policy making toward the SMI sector. To do so, information on capital stock, investment, markets for inputs and outputs, and profitability is required, none of which is currently available from present survey exercises. From the information obtained from the proposed survey, a better picture will be obtained of SMI structure and performance in terms of import and capital intensity, labor, capital and total productivity, market structure and industrial otganization, export orientation and competitiveness and other indicators necessary to evaluate Turkey's SMI sector within the domestic industrial sector as a whole and in comparison to SMI sectors in other countries. 4.30 Program Design and Costs. The program will involve the financing of three years of consultants, processing and computer costs, the survey pro- cedure including development and implementation, publication and distribution of the results and the training of SIS staff. The first stage of the technical assistance program will be to define the type of statistical data to be collected. This will be jointly determined by SIS, and the World Bank with advice from economic and engineering consultants. The second stage of the program will be hiring a consultant to develop the survey instrument. The third stage will be to identify an appropriate universe oi enterprises in Turkey, utilizing the existing addresses compiled by SIS and supplementing them by an additional effort to identify omitted firms and new enterprises established since the last census. Once the universe of firms is defined, a sampling frame will be developed haich will scientifically represent the universe. In the fourth stage, the questionnaire will be distributed and followed up by interviewers to ensure that all questions are understood and answered as accurately as possible. In the fifth stage, the statistics will be compiled on the mainframe computer at SIS, processed and published in hard copy form. The last stage will be to develop a routine "downloading" procedure, whereby the raw data can be transferred to micro diskette to enable convenient distribution of data. In order to institutionalize the survey exercise and updating procedure, a significant amount of SIS training is necessary to upgrade in house staff. The three year cost of the program is estimated at US$0.75 million, of which The Bank loan would finance US$0.50 million. V. THE LOAN A. Terms and Conditions 5.01 Under the proposed project, the Bank would provide a Loan of US$204.5 million to the Government of Turkey of which US$200 million would be made available for onlending by the participating credit institutions to small and medium scale enterprises and US$4.5 million for technical assistance. The Bank loan would be at the Bank's standard variable interest rate with a repayment period of 17 years including 5 years of grace. The US$200 million would be onlent to the PCIs under terms and conditions to be spelled out in subsidiary loan agreements between GOT and each of the PCIs. The Government would bear the exchange and interest rate risks through FERIS, since the ultimate sub-borrowers are small and medium scale enterprises, which have relatively little capacity to judge and hedge against exchange and interest rate risks. The Loan would be onlent on terms which would provide the PCIs a fixed spread of 3% per annum plus 2% per annum commission. This is the spread - 25 - available to the financial intermediaries under the ongoing Industrial Export Development Project and is comparable with the spread the PCIs normally make on their other funding business. Since the final lending rate to small and medium scale enterprises would be the prevailing FERIS rate, the rate from the Government to the PCIs for new subioans would be adjusted from time to time in line with FERIS rate adjustments. Since the Government would bear the exchange risk, the exchange rate for each subloan would be set at the time of disbursement and the liability of the PCI to the Government consequent to the subloan disbursement would be denominated in local currency (para 7.01 a). 5.02 Statements of Policy and Corporate Strategy. Each PCI would have to prepare and submit to the Bank a policy and corporate strategy statement detailing its financial and operating policies, business strategy and organizational plan governing its activities in the short- and medium-term. This statement, which should be satisfactory to the Bank, has to be approved by the PCI's board of directors and would serve as the basis on which the PCI would operate under the project. Drafts of the PCIs' policy and strategy statements, which were prepared during appraisal, were discussed and agreed upon during negotiations (para 7.02). 5.03 Repayment Terms. The PCIs would repay their subsidiary loan from the Government on a schedule based on the composite amortizations of their subloans. Based on subloan maturities of eight years, grace periods of three years and a disbursement period of five to six years, the subsidiary loan maturities would be well within the Loan maturity of 17 years. 5.04 Conditions of Loan Effectiveness. Completion of the following steps would be conditions of Loan effectiveness: (a) abolishment of the fixed rate FERIS and its replacement by a variable rate (para 7.03) (b) signing of subsidiary loan agreements by GOT and at least two PCIs (para 7.03); and (b) approval by their respective boards of directors and submission to the Bank by these signatory PCIs of their policy and corporate strategy statements, satisfactory to the Bank (para 7.03). 5.05 Technical Assistance Components. The US$4.5 million for technical assistance would be onlent to the Government which would pass on these funds to the implementing institutions to carry out their respective technical assistance components under the project. The US$1 million for the quality control program would be disbursed to TSE against eligible expenditures to support the quality assurance program for SMI enterprises. The US$1.5 million for the export promotion component would be disbursed to the Ex-Im Bank to finance eligible product and market development expenditures of selected export trading companies. The US$0.5 million for the improvement of SMI statistics would be disbursed to SIS to meet expenditures associated with the improvement of the census and annual surveys of the industrial and SMI sector. The US$1.5 million would be disbursed to the PCIs to meet expenditures associated with staff training and organizational improvements related to the SMI lending operations. -26- B. Administrative Requirements 5.06 Special Account. Since the credit component of the proposed project would involve the financing of many sub-projects, each one with many, small expenditure items, a special account would be created for the project in the Central Bank to simplify disbursement procedures. All expenditures under subloans which are approved by the PCIs and subsequently authorized by the Bank would be met out of the funds of the special account. Disbursements from the special account for free-limit subloans would be made on the basis of certified statements of expenditures submitted by the PCIs. For subloans above the free-limit full documentation would be required (para 5.10). The Bank would disburse an initial amount of US$12 million (about four months of disbursement) into the special account upon effectiveness of the Loan and would periodically replenish the fund on the basis of reimbursement requests from the PCIs. 5.07 Procurement. Procurement procedures under the proposed project would be the same as those established under the past SMI projects which were found acceptable to the Bank. Since this is a SMI project which involves the procurement of a great number of small items, international competitive bidding would not be required. The procurement of goods would be as follows: goods costing US$100,000 equivalent or more per item or US$500,000 equivalent or more per contract procured outside the borrower's territory would be let through international shopping on the basis of at least three competitive quotations; for goods procured locally or goods procured outside Turkey with sitkgle items costing less than US$100,000 or combined items costing less than US$500,000 equivalent, the PCIs would use their existing procedures which consists of requiring clients to submit three competitive quotations as the basis for a procurement decision. The PCIs would also have to certify that these goods were purchased at reasonable and competitive prices, due account being taken also of other relevant factors such as time of delivery, quality and reliability of goods and availability of maintenance facilities and spare parts. For civil works for tourism sub-projects, local competitive bidding procedures, satisfactory to the Bank, would be used. 5.08 The PCIs would also be required to maintain records of the procurements made under the project, with summaries of offers received and awards made under each subloan. These records would be used by external auditors in auditing the PCIs' certified statement of expenditures and would be examined by Bank missions on a sampling basis (para 5.13). 5.09 Procurement of equipment, vehicles and materials under the technical assistance components procured outside Turkey would be let through international shopping on the basis of at least three responsive price quotations. For goods procured locally, the procurement procedures shall be those of the Government for local competitive bidding, which have been reviewed recently by the Bank and found to be satisfactory after appropriate modifications. For consultants to be employed under the proposed project, the respective implementation agencies would follow the guidelines for the use of consultants issued by the Bank in August 1981. All terms of reference and appointment of consultants would be subject to prior Bank approval. - 27 - 5.10 Disbursements. For the credit component, due to the great number of small disbursements, disbursements for free-limit subloans would be made against certified statement of expenditures for which appropriate documentation would be retained by the PCIs and made available to Bank missions and external auditors. Disbursements for subloans above the free-limit would be on the basis of full documentation. Larger payments would be submitted to the Bank for processing outside the special account. The Bank's reimbursement would be limited to expenditures made by a sub-borrower not more than 180 days prior to the Bank's receipt of the request for reimbursement. This time lag is needed because subloans would be administered at the branches of the PCIs and would require time to consolidate for submission to the Bank. The Loan is expected to be committed in three years and disbursed in six years, based on the latest regional sub-sector disbursement profile. 5.11 For the credit component, the Bank would disburse 100% of the CIF cost of imported equipment and materials, 70% of the cost of imported but locally purchased equipment and materials (to factor out taxes), 50% of the ex-factory cost of locally produced equipment and materials (to cover the cost of its imported components) and 30% of the cost of civil works in tourism sub-projects only. For the technical assistance components, the Bank would disburse 100% of expenditures for consultants and foreign training; 100% of the CIF costs of imported equipment, vehicles and supplies; and 100% of the ex-factory cost of local equipment, vehicles and supplies. For imported equipment, vehicles and supplies which are purchased locally, the Bank would disburse 70%. The disbursement percentages have been calculated in compliance with the Bank's policy that the proceeds of the Loan would not be disbursed on account of payment for ta.-es and duties levied by the Government. Withdrawal applications would be submitted to the Bank by the implementing agency concerned. 5.12 Reports, Accounts and Audits. The PCIs would submit semi-annual progress reports on commitments, disbursements, collections and arrears under the project to the Bank. In addition, the PCIs would maintain proper accounts for subloans including supporting procurement and disbursement documents, which would be audited annually by external auditors, acceptable to the Bank. Currently, there is a list cf external auditors authorized by the Central Bank to audit accounts of banks, which list is acceptable to the Bank. Since most subloans would be disbursed on the basis of certified statements of expenditures (SOE), they would need a separate audit or the regular annual audit of a PCI has to include a special opinion by the auditors on the adequacy of SOE procedures. Audit reports have to be submitted to the Bank no later than six months after the close of PCI's financial year, and should also include a certification that the PCI is in compliance with the financial c,)venants agreed under the project and the banking decrees issued under FSAL II. After a subloan is fully disbursed, the PCI concerned would prepare a sub-project completion report, comparing actual vs. projected costs and benefits of the sub-project and submit this to the Bank periodically. 5.13 The technical assistance implementing agencies would prepare and submit semi-annual progress reports to the Bank. Accounts specific to the project would be maintained separately and would be audited annually by external auditors acceptable to the Bank. Audit reports should be submitted to the Bank no later than six months after the close of the agency's fiscal year. - 28 - VI. BENEFITS AND RISKS A. Benefits 6.01 The sm4ll and medium scale industry sector is an increasingly important segment of the Turkish economy and plays a major role in generating employment opportunities, nurturing entrepreneurship, reducing regional income disparities, and expanding and diversifying exports. The proposed project would help the Government attend to the needs of the sector by making investment finance more readily accessible to SMI units, by providing effective technical and marketivg services and by improving the information base for better policy making o.t this sector through more reliable statistics. The Bank loan would not only provide long-term resources to the participating credit institutions for onlending to SMI enterprises, but also technical assistance to improve their operating systems and train their staff to make them more efficient channels for SMI finance. The project would also expand the channels for technical and marketing services by including private sector institutions which can complement the assistance provided by Government agencies to the SMI sector. 6.02 Based on past experience, it is anticipated that the project would finance about 900 SMI units creating about 26,000 new full-time jobs and resulting in about US$400 million of incremental investments. The sub-projects financed are expected to be fairly labor intensive, with a cost per job usually not exceeAng US$15,000. While the SMI units financed are not necessarily expected to be direct exporters themselves, many of them would be producing for exporters and export trading companies. Several of the SMI units would be processing local raw materials with close linkages with the agricultural sector. Many of the worker. employed by these units would be less skilled or new entrants into the labor force. 6.03 By increasing the number of financial institutions participating in SMI finance, it is expected that this would increase competition, improve credit access and enhance banking services for SMI clients. By assisting the participating credit institutions develop expertise in project-based lending methodology, it is expected that improved project selection would result in mort efficient investments. As the financial institutions get more acquainted with this market segment and can appreciate better its risks and rewards, it is anticipated that they would continue to expand their SMI portfolio on their own. 6.04 The quality improvement component is expected to assist SMIs reach quality thresholds which would allow them to use the national quality mark, thereby improving market acceptance for their products both locally and abroad. The export promotion component would increase linkages between SMI producers and export trading companies to allow them to concentrate on production. By encouraging economies of scale in export marketing, Turkey would develop better exporters who can be competitive and can gain a better reputation for the country as a whole. The technical assistance for the State Institute of Statistics would improve data collection, processing and analysis and provide more reliable and accurate information for future policy and project formulation. - 29 - B. Risks 6.05 Due to high inflation, high cost of money and the crowding out of the private sector by Government borrowings, industry in general and SMI in particular have experienced strained financial positions in the past few years. Should the fiscal and financial imbalance continue Cr deteriorate, many investment plans by SMIs would not only not materialize but existing operations could be jeopardized, adding to the existing stock of non-performing assets of the financial system. The Government, through its letter of macroeconomic policy, has committed itself to a package of adjustment measures to reduce the fiscal deficit and inflation. The Bank is assisting the government in its reform program, most recently through FSAL II. The Government and the Bank are closely monitoring implementation of the adjustment program to ensure that it continues to be on the right track and to make modifications as needed. 6.06 There is a risk that the commercial banks participating in the proposed project would not pay sufficient attention to SMI lending considering the small size of this operation in relation to the total business of these banks. A major criterion in the selection of the participating credit institutions was their interest in and firm plans for developing their SMI portfolio. Separate monitoring and reporting would be required to ensure attention of this product line by the top management of these banks. 6.07 Success in the implementation of the technical assistance component assigned to the private sector would depend on how effective the private sector would be in attending to activities which benefit a group of firms rather than individuals and are meant for the medium term rather than for immediate profits. Involvement of relevant Government agencies in policy and strategy formulation for these components would help ensure that broader interests get sufficient attention in implementation. 6.08 There is a risk that, dve to weaknesses in staffing and procedures, the public sector institutions will be unable to play the roles assigned to them under the project. Training and consultancy services would be provided under the project to strengthen these institutions. Private sector involvement has been inco-porated to help ensure responsiveness and public accountability. VII. RECOMENDATIONS 7.01 During negotiations, agreement by the Government on the following were confirmed: (a) that the Government would be the Borrower of the Bank loan and that it would pass on the proceeds of the Loan to the participating credit institutions and the final sub-borrowers, with the Government bearing the exchange and interest rate risks (para 5.01); (b) that, as a condition of loan effectiveness, the fixed rate FERIS be abolished and that FERIS be placed on a variable rate basis; the variable rate would be adjusted automatically every quarter and to the average of the 3-month Treasury Bill rate in the preceding three months; the interest during a grace period of three years may be capitalized but would have to be compounded (para 2.27); - 30 - (c) onlending terms and conditions, margins, and eligibility criteria for the credit component (para. 4.11 - 4.13). (d) conditions of participation and financial covenants for the participating credit institutions (Annex 3); (e) procedures for procurement, disbursemenc, reporting, accounting and auditing (para. 5.06 - 5.13). 7.02 Drafts of the following, which were prepared during appraisal, were discussed and agreed upon during negotiations: (a) subsidiary loan agreement between GOT and the five PCIs; (b) statements of policy and corporate strategy for each PCI; 7.03 The following were agreed as conditions for Loan effectiveness: (a) abolishment of the fixed rate FERIS and placing of FERIS only on a variable rate basis (para 5.04); (b) signing of the subsidiary loan agreement between GOT and at least two PCI (para 5.04); and (c) approval by their respective boards of directors and submission to the Bank by these signatory PCIs of their policy and strategy statement (para 5.04). 7.04 The proposed project constitutes a suitable basis for a Bank Loan of US$204.5 million at the standard variable interest rate for a period of 17 years including 5 years of grace for the Government of Turkey, under conditions outlined in Chapter V. TABLE.I TURKEY SECOND SMALL AND M4EDIUM INDUSTRY PROJECT INDUSTRIAL STRUCTURE AND PERFORMANCE INDICATORS By SIZE (1980) Additions to Ave. # of employed fixed invest. per year Output Value Added # of establishments per year (bil TL) (bil TL) (bil TL) Erat Publi ntal rivat Public l l Erate Puhlic Ttal rxate Public Ttal Private Eublic Inl Informal 177,034 0 177.034 454,931 0 454,931 - 0 - - 0 - - 0 - Small 6,509 80 6.589 132.714 2,100 134.814 6 0 6 282 2 284 76 1 77 Medium 889 38 927 61.202 2,650 63,852 5 0 5 176 6 182 54 2 56 Large 904 290 1.194 314.545 282,439 596.984 40 22 62 889 881 1.770 360 330 691 SmI + med 7.398 83 7,516 193.916 4.750 198,666 11 0 11 458 9 466 131 3 133 Total (10+) ....,30.2. .08 .1 .08.Aa 28.18.A9 72A5S . .....= Z & .4 -.j2R -23 1 __W Z of Total (Excludina Informal Sector) Additions to Ave. # of employed fixed invest. per year Output Value Added a of establishments per year (bil TL) (bil TL) (b1 TL) ariate Publi Iotal Private Pulc Intal Privte Eublic 10W1 Priiat Publ Io. Erivatj Public IgW81 Small 78.40 19.61 75.65 26.10 0.73 16.94 11.85 0.32 8.40 20.95 0.26 12.72 15.52 0.24 9.35 Medium 10.71 9.31 10.64 12.04 0.92 8.03 9.98 0.26 7.07 13.06 0.70 8.14 11.08 0.60 6.84 Large 10.89 71.08 13.71 61.86 98.35 75.03 78.17 99.42 84.53 65.99 99.04 79.14 73.40 99.16 83.81 3m) * med 89.11 20.34 86.29 38.14 1.65 24.97 21.83 0.58 15.47 34.01 0.96 20.86 26.60 0.84 16.19 Total 10* J.1.O0 10AA 1 0.0. .1AA ..100.&0 100.00 I00.20 I0L0 1 0 1AD.00 IKA.4 100J 0J 1 ..00 L0QAA 100.00 100.00 10.0 Industrial Ratios Fixed investment per Avg. a of workers Worker Output per worker Value added per worker Output/additions to (# per firm) (000 TLAlorkerl (000 TL/ workers (000 TL/Workerl fix investment Erivn Publi Iotal Priat EuhtS Inta.l Private Public Ia. Erixat Eublic Intal Erizate Eubli Ictal Informal 2.6 0.0 2.6 - - - -- - - - - Small 20.4 26.3 20.5 46 33 46 2.125 1.096 2,109 574 382 571 46.1 33.0 46.0 Medium 68.8 69.7 68.9 84 22 82 2,874 2.340 2,852 889 753 883 34.2 108.8 35.0 Large 347.9 973.9 500.0 128 78 104 2.825 3,121 2,965 1.146 1.169 1.157 22.0 40.2 28.4 Sml 4 Med 26.2 57.2 26.4 58 27 57 2,362 1,790 2.348 673 589 671 40.7 67.0 41.0 Total (10+) 61.2 703.9 91.3 101 77 93 2,648 3,099 2.811 982 1.159 1.047 26.1 40.4 30.4 Source: SIS, 1980 Survey of Manufactures 0345R.P 7 TABLE 1 (Continued) TURKEY SECOND SMALL AND 4EDIUM INDUSTRY PROJECT INDUSTRIAL STRUCTURE AND PERFORMANCE INDICATORS BY SIZE (1985) Additions to Ave 9 of employed fixed invest. per year output Value Added # of establishments per yea- (bil TL) (bil TL) (bil TL) Erivate Euhli Total Erivate Eublc iutal Ervat Public lW Erivata Public lotal Private Publi Iotal Informal 183.572 0 183.572 475,198 0 475,198 - 0 - - 0 - - 0 - Small 7.989 47 8,036 168,039 1.595 169,634 45 0 45 1,952 14 1.967 469 3 472 Medium 1.092 36 1.128 75.807 2,724 78.531 47 0 47 1,164 45 1,209 305 11 316 Large 1.174 309 1.483 416.875 271,700 688.575 685 338 1.023 8.324 6.311 14.634 2.732 2.137 4.869 Sal + ar-d 9,081 83 9,164 243.846 4,319 248,165 92 0 92 3.116 59 3,175 774 14 788 Total (10+) 10,255 392 10.4 660,721 276.01 936.74 777 -M LU1 I1A44 6,371 17.811 .50 ..L.1 S,bS7 % of Total (Excluding Informal Sector) Additions to Avg # of employed fixed invest. per year Output Value Added # of establishments per year (bil TL) (bil TL) (bil TL) Eivate Publi Icotal Privat Eublic Total Erivate Pukic Tale Erivate PubicT Ial erihate Eubli Ital Small 77.90 11.99 75.48 25.43 0.58 18.11 5.78 0.05 4.04 17.07 0.22 11.04 13.38 0.13 8.34 Medium 10.65 9.18 10.59 11.47 0.99 8.38 6.05 0.09 4.24 10.17 0.71 6.79 8.69 0.53 5.58 Large 11.45 78.83 13.93 63.09 98.44 73.51 88.18 99.86 91.72 7?.76 99.07 82.17 77.93 99.34 86.08 Sal + med 88.55 21.17 86.07 36.91 1.56 26.49 11.82 0.14 8.28 27.24 0.93 7.83 22.07 0.65 13.92 Total (10+) M.H 100.0 0.00 l00.0 1.0 100 L.0 100.0 I00.0 100.00 IPJLAg 1.0. L00A0 0.00 10L.0 Industrial Ratios Fixed investment per Avg. # of workers Worker OutpLt per worker Value added per worker (0 per firm) (000 TL/Worker) (000 TL/worker) (000 TL/worker) Output/fix invest. ratio Private Public Iotal Privata Eublic Intal rivate Eublic Ital Priat Public ial Privat Public il Informal 2.6 0.0 2.6 - - - - - - - - -- -. Small 21.0 33 9 21.1 267 106 266 11,619 8.857 11,593 2,791 1,619 2.781 43.5 83.7 43.6 Medium 69.4 75.7 69.6 620 110 602 15,348 16,616 15,392 4,017 4,152 4.022 24.8 51.6 25.6 Large 355.1 879.3 464.3 1,644 1.243 1.486 19,967 23.229 21,254 6.54 7.866 7,072 12.1 18.7 14.3 Sml + med 26.9 52.0 27.1 377 108 372 12.778 13.750 12,795 3,172 3,242 3,174 33.9 127.1 34.4 Total (10+) .4..a 704.1 .0 1,17Z 1,225 ..1239 17.314 23,081 1901 5,380 7,793 6,098 14. .Ij 16.0 Source: SIS, 1985 Survey of Manufacture 0345R.P.8 不爾無藪藪’不騵酈可跚 礫’〕嘎玀 個二 ~-‘■■■‘■唱口口口目口口口■■■自口口口口 /！牌。‘鸞！ TABLE 2 (Continued) TURKEY SECOND SMALL AND MEDIUM SCALE INLUSTRY PROJECT BRIAKDOI&I OF PR IVAIf NO 10TAl "AWFACTURING INDMIRT By S1. and Industrial sub-sector iges (cam inumd) PRIVATE SECTOR Input Output value Added (bill ism of It) (billions of It) (billions of It) 10-24 25-49 50-99 1004 1 10-24 25-49 50-" lOO* 1 10-24 25-49 SO-910 1000 1 ......................... ................................................ ................................................... .................................................. food, Tm'nrro (31) 181,970 274,199 2".SSI 830.109 1.530,828 225,049 330,781 295.684 1.161."? 2.012.%2 43,079 56,W3 S1.133 331.330 482.134 Textiles. Leather (52) 182.599 197.855 166.206 9M.676 1.517,33? 234.524 263.056 224.SZ3 I.S48.631 2.2?0. n4 S1.925 65.200 S11.317 S17.95S 753.397 Wood incl. furniture (35) 26,132 14,2?6 13,S32 40,949 94,M 3S.578 20,410 19,SBS S9,679 liS.052 9,246 6,134 6.053 16, M 40.162 Paper a !'.q*r Prod (34) 31.91S 18. ?" 28.099 136.%1 215.718 43 467 $1.106 43.253 227.561 345,40 11,5?2 12. 3" IS.IS4 90.601 129AQI thmical.Coet,gubber (55) 73,863 06,007 132,655 1,189,079 1,481.603 99:875 117,666 '188,S90, l,"8,468 2,054,601 26,012 31,662 SS,93S 4".3119 54096 am-Metallic 436) W,551 18.678 18.7% 324.958 372,983 17.1% 30.199 33,713 600,679 609.752 6,604 11 521 16.922 283. ?21 316. F69 Usk Metal (37) 33,910 105,723 122493 671 691 033, 8 17 40,240 130,809 148,659 892.022 1.211,730 6.330 25,386 26, U6 220,330 217,"3 Fabricated Metal (38) 113.S97 103.2% 129:M6 1.4111:900 1,757.992 159,516 158,534 203,36 2,141.770 2,66% 146 4S.919 55,276 76.0119 ?n.87D 905.1S3 other Manufacturing (39) 3,965 6.196 3,400 15.409 28.%9 5.862 8.794 6.179 3S,600 $6,434 1.097 Z. 599 2.M 20.191 27.W 0 0 0 0 total (5) 6SO.502 1124.935 =,%9 5.591.731 7.934.137 86t.086 1.091.360 1.163,517 8,323.8% 11.439.819 202.SW Z66,424 306.S49 2, n2.125 S.S05,682 ......................... ................................................ ................................................... ....................... .......................... PWLIC AND PRIVATE ESTABLISHMENIS WIN GREATER TKAX 10 WRKERS Input Output Value Added (bit(ions of It) (billions of It) (billions of It) 10-24 2S-49 50-99 1004 1 10-24 2S-49 sa-99 100* 1 10-24 25-49 50-99 1w I ......................... ............... ............... ................ ....................... ........................... .................................................. food. Tobacco (31) 181.970 284.747 275.51a 1,420.631 2.162.866 22S.049 343,80,11 335.141 2.440,579 3,344.S?? 43,079 59,061 59.624 1.019.947 1,181JI1 Text Iles I Leather (32) la2,599 197.4155 166.297 1,112,192 1,658.943 234,5A 263,056 224,797 1. ?68.619 2.490,996 S1.925 65.201) 58.501 06,427 &W.03 Wood inct. furniture (33) 26,132 14 Z76 14,328 82.318 07.055 35,378 20,410 2t. 119 131.?27 206.633 9,246 6.134 6 791 49.40 F1.5m Paper & Paper Prod (34) 31,915 18:757 26,122 266,117 346,971 43 467 31,148 43.350 43S,"2 553.42? 11,S72 12.391 IS:228 10.266 206.06 Chemical,Coal.lLfter (35) 73.863 86.007 134,3% 3,613,635 3,927.899 99:875 117.665 191,932 4,976.956 5,386,451 26,012 31.662 57.538 1.343.321 1.4S$.S32 Non-Hetattic (36) IO.5SI 18,678 Ia. 7% 415,9SO 465,975 17,155 50. 1" 33JIS 753.822 04,1194 6.6" 11,521 14,9?? WX2 370.920 Basic Metal (37) 31,910 WS, 723 122,493 1.227,533 1,489,659 40 240 130.809 148.659 1 6S4,091 1,973,799 6.330 2S,Ob& 26.166 426,558 4&. 14a fabricated Met&l (38) '113,597 U14,0192 129,574 1,590.201 1,937,4" 159:516 IS9,539 203,04 2:438,491 2.961.430 0.919 55.447 74,311 848,290 1.023,%6 Other Manufacturing (39) 3,965 6,196 3,400 15,409 28,%9 5,862 8.7% 6,179 35,600 56,434 1.89? 2.599 2. -V 20.191 27,46S Total (3) 658,S02 836,331 $92,921 9.766.047 12,153,801 861,086 1,105,431 1, 208. rN 14,635,325 17,810,621 202. SW 269.100 315,858 4.869.279 5.656.1121 .. .. . .. . ...... .. ........ ............... ...... ...................... ........................... Source: SIS, 1985 Survey of Manufactures 0. 0 4. ANNEX 2 Page 1 TURKEY SECOND SMALL AND MEDIUM SCALE INDUSTRY PROJECT SMI Credit Demand (1989-1991) 1. The rising rates of capacity utilization in most sub-sectors, mean that future expansion of manufacturing output and exports are dependent on a rebound of investment in new and modernized capacity. Given its capital saving characteristics, the SMI sector is particularly suitable ior contributing to that growth under the current financial environment. 2. Given the lack of investment statistics covering the SMI sector, indications of past and projected SMI investment and can only be imputed from total private manufacturing investment. Though falling, estimates indicate that SMI's share of private manufacturing fixed investment was 35% in 1985. For discussion purposes, a conservative estimate of 30% is assumed for the 1989-91 period. Manufacturing investment has experienced a significant shift toward the private sector during the 1980s. Table 1 shows manufacturing investv-ent broken into its private and public components, and in real and nominal terms. The tables illustrate the shift in investment patterns but indicate that private investment needs to expand faster for output growth to remain strong. During the 1980s, public sector investment grew by 20% per year in nominal terms, but fell by a yearly average of 8% when calculated in constant prices. Private sector investment on the other hand, raised its share in total manufacturing investment from 41% in 1980 to 71% in 1987 by expanding at 43% p.a. In 1987, the value of total fixed manufacturing investment in the private sector was TL 1650 billion which amounted to almost US$2 billion, compared to US$588 million invested by public sector manufacturing. When calculated in real terms however, private sector manufacturing investment expanded at only a 2% annual rate; which at current capacity utilization rates, is likely to be insufficient to sustain the current growth rate of output without a significant fall in the already low ICOR. TABLE 1 GROSS FIXED MANUFACTURING INVESTMENT 1980-1988 Current Prices Share of Total Real Growth Rate (million TL) (M) (M) Private Public Private Public Private Public 1980 128,819 139,885 47.9% 52.1% -14.1% 9.8% 1981 183,001 186,194 49.6% 50.4% -2.0% -8.5% 1982 242,551 205,110 54.2% 45.8% 0.6% -15.9% 1983 323,379 192,624 62.7% 37.3% 1.0% -3.3% 1984 510,592 248,833 67.2% 32.8% 5.9% -17.4% 1985 766,513 407,875 65.3% 34.7% 6.0% 6.8% 1986 1,271,406 515,787 71.1% 28.9% 13.2% -19.3% 1987 1,650,274 504,207 76.6% 23.4% -9.0% -38.4% 1988 2,983,400 715,600 80.7% 19.31 - - Source: SPO 4NNEX 2 rage 2 3. The sixth five year plan estimates a rebound in private manufacturing investment to TL 2983.4 billion in 1988 (amounting to US$2.19 billion, assuming 1366 TL/US$ average yearly exchange rate) and TL 4763.1 billion in 1989. In the absence of official estimates, a broad indication of investment during 1990-91 is obtained by using estimates of nominal investment, manufacturing output growth, and inflation, to obtain a 2.44 ICOR for the 1983-89 period. Given this ICOR and a conservative assumption of 5% expansion of manufacturing output during 1990 and 1991, private manufacturing investment is projected to reach TL 7829.9 billion in 1990 and TL 11,774 billion in 1991. Assuming a continuing nominal devaluation in line with projected inflation, gross fixed investment in private sector manufacturing would total US$6.69 billion for the three years between 1989-91. Applying the assumed 30%, the SMI share of total private investment in the manufacturing sector would average US$669 million per year, totaling US$2.0 billion for the three year period. 4. Past SMI Loans. Under a previous Bank loan to the SMI sector, the Bank accounted for 18% of the needs of the entire SMI sub-sector, while other financing sources accounted for another 44%, with the remaining 38% financed from equity. Under the current financial condition surrounding industrial term lending, Bank financing is expected to increase to 25% of the entire SMI sub-sector investments, as indicated by the sub-loan pipeline in Table 2. TABLE 2 SUB-LOAN PIPELINE FOR PARTICIPATING CREDIT INSTITUTIONS (As of November 11, 1988) HALK EMLAK SYKB VAKIFLAR TOTAL NUMBER OF PROJECTS 617 68 60 42 787 of which: Manufacturing 587 44 52 23 706 PROJECT COST (US$'000) 41,339 205,380 41,384 304,480 592,583 Fixed Assets 30,957 - 41,384 295,583 367,924 Working Capital 10,381 - - 26,671 37,052 FINANCING REQUIREMENT (US$'000) 19,434 90,056 33,608 81,743 224,841 Local Currency 9,640 37,216 732 38,117 85,705 Foreign Exchange 9,794 52,840 34,340 43,626 140,600 Source: Appraisal Mission Estimates 5. Subloan Pipeline. The projections of buoyant credit demand in the SMI sector is supported by the strong list of projects in the PCIs' pipeline. The current pipeline of projects, presented in Table 2, refers to annual applications and shows 787 projects at various stages of processing, costing almost US$600 million, of which 62% is accounted for by fixed assets. The financing requirement for these 787 projects is estimated to be US$224 million, of which US$140 million is foreign exchange financing. The substantial amount of credit demand in the PCI pipeline of sub-projects is ANNEX 2 Page 3 evidence that there will be a sufficient start-up of projects at the time of loan effectiveness. The annual amount of credit demand shown in the sub-project pipeline is consistent with the global projections of credit demand by the SMI sector as a whole. Taking the projections for SMI investment during 1989-91 and using the financing pattern from the pipeline of projects, the demand for credit would be about US$415 million per year, of which US$167 million per year could be the foreign exchange resource gap. The Bank Loan would meet about a quarter of this resource gap. ANNEX 3 Page 1 TURKEY SECOND SMALL AND MEDIUM SCALE INDUSTRY PROJECT Participating Credit Institutions A. Emlak Bank (EB) 1. Emlak Bank is a state commercial bank established in January 1988 through the merger of two public sector banks, the Anadolu Bank and Emlak Kredi Bank. The former Anadolu Bank inherited a serious loan portfolio problem with a number of bad loans that were made before new management took over in late 1986. By merging Anadolu Bank with the larger and financially stronger Emlak Kredi Bank, the Government has aimed at the creation of a virtually new institution under new and professional management. The new Emlak Bank is now the third largest bank in aasets and the fifth largest in deposits in Turkey. 2. Emlak Bank intends to be a major player in the banking sector with three divisional profit centers: a corporate banking division catering to the needs of the top industrial, export trade and construction companies of Turkey; a division for property development using its real estate holdings and its expertise in financing real estate development; and a retail banking division with a network of over 400 branches catering to consumer and small business needs and becoming a major, if not the sole, provider of housing finance. It is as part and parcel of the strategy of this last division that Emlak would expand its small and medium scale industry lending operations, initially by using the project appraisal and supervision expertise developed in the credit department at headquarters and later decentralizing to the regional offices and branches as lending volumes and needed expertise grow. These are reflected in Emlak's policy and corporate strategy statements which were discussed with the appraisal mission and will be finalized at negotiations. 3. One of EB's biggest assets is the quality of the management and staff that it has recently attracted. Many of the key personnel have been brought in over the last one and a half years by the new general manager from the private sector and from other banking institutions, and constitutc a dedicated and professional team. EB has been able to recruit these personnel though compensation that is comparable with the private sector, and by offering the challenge of transforming a public sector organization into an innovative force in the Turkish banking system. The bank's management intends to broaden the ownership base by selling 50% of the shares to the bank's pension fund and the general public. This will give the bank greater operational autonomy as well as needed accountability for sound and responsible management. This is planned to be done in 1989 and was encouraged by the appraisal mission and is one strong argument for Bank support of Emlak. 4. Emlak's .;ost urgent problem is its problem portfolio, inherited from past management. As of June 30, 1988, arrears were TL 220 billion and total infected portfolio was TL 242 billion, indicating that the arrears are quite old and hard core. Collection performance of the bank, although improving, is substandard, at 21%, due to the past problem portfolio. While this is only ANNEX 3 Page 2 about 10% of total loan portfolio, provisions for them are only TL 27 billion. If these were fully provisioned for, the current networth of the bank of TL 219 billion would be wiped out, rendering the bank technically insolvent. Management is currently taking steps to deal with its portfolio problem. It has completed a portfolio audit and has increased its provisions for bad loans in accordance with the findings of the audit. These are steps in the right direction and should allow the bank to clean up its books. Management would then be able to focus on the future without having to constantly deal with the burden of past management. 5. For the SMI project, the major units involved would be the credit department at headquarters which would undertake project appraisal and supervision and the retail banking division which would promote, identify and screen loan applications from SMI borrowers and handle loan administration and collection through its retail branches. Management felt, and the appraisal mission agreed, that this somewhat centralized set-up is an efficient way to start this program. Decentralization would be undertaken as the volume of lending increases and as more staff in the regional offices and branches are trained. The credit department is adequately staffed to handle the number of loans expected to be generated under the project, with 19 professionals in finance and economics. However, the department would need the services of technical specialists for more technically complex sub-projects. This could be achieved by reassignment, retainer arrangements or recruitment and would be reassessed once the workload under the project becomes more defined. To improve the appraisal and supervision standards, methods and procedures of Emlak, technical assistance would be provided under the project as part of the overall institution building objectives of the project. 6. Although a the result of the merger of two old banks, Emlak is virtually a new bank, with a new team of professional managers, a new mandate, new goals and an articulated business strategy. It still carries the burden of past bad loans but it has the means for resolving this problem satisfac- torily because of its extensive land holdings. It is still a state bank and is subject to the constraints of one but should it succeed in broadening its ownership base, it would gain operational autonomy needed to achieve its goals more efficiently. Emlak has the right ingredients for success but it will need support to succeed. The Bank would provide this support, initially through this project. Already through the process of project preparation and appraisal, the Bank has helped Emlak define its goals, policies and strate- gies. It has identified areas that need strengthening through operating policy and procedural modifications and information system improvements. In the specific area of project financing, the Bank will provide assistance in improving project appraisal and supervision standards and procedures. The Bank's requirements for improved procurement and disbursement procedures, together with improved appraisal and supervision and tighter credit policies, will help improve portfolio quality. The Bank's reporting, accounting and auditing requirements will raise Emlak's standards to internationally acceptable levels. Should Emlak perform well under this project, it could expand its relationship with the Bank in areas like housing finance, export financing, large scale industrial lending and construction financing. 7. Conditions for Participation and Financial Covenants. To participate in the project, Emlak would have to: a) make adequate provisions for its non-performing portfolio, satisfactory to the Bank; b) prepare and issue ANNEX 3 Page 3 policy and strategy statements, approved by its boird and acceptable to the Bank; and c) sign the subsidiary loan agreement with the Government. To be able to continue participating in the project, Emlak would have to submit annually to the Bank, together with its audit report, a certification from its auditors that it continues to comply with the financial covenants under this project, as follows: a) a minimum collection ratio of 75% for all its medium and long-term loans; b) a minimum debt-service-cover ratio of 1.2 to 1; -' c) a capital adequacy ratio in compliance with the Banking Law; and d) adequate provisions for bad debts as prescribed under the original provisions decree of May 1988. B. Halk Bank (HB) 8. Halk Bank was established in 1933 as the public sector commercial bank responsible for attending to the needs of small and medium scale industries, artisans and cooperatives. It started by focussing on the provision of working capital loans to these sectors but has broadened its assistance by expanding into investment financing as well. Halk Bank is a participant in the credit component of SMI I. After a slow start, it improved its performance and proved to be an effective channel for SMI investment finance. Halk has recently had frequent changes at its top management level which has caused some instability and delayed decision making. However, in May 1988, the Government appointed a new general manager, who was formerly an assistant general manager of the agricultural bank (Ziraat Bankasi) and was responsible for Bank agriculture loans. This appointment appears to have restored stability within the bank, and Halk Bank has resumed implementing its commitments under SMI I. 9. Halk Bank has played a lead role in providing financing to small and medium scale industries, cooperatives and artisans, and in the 1985-1987 period, over 75% of its outstanding loans were for these sectors. RB has been able to accomplish this because of its wide branch network, its access to low- cost funds from the Government and its expertise in dealing with this sector developed over the years. 10. Despite its developmental role, HB has continued to be a profitable and liquid bank. It is conservatively managed, and its credit policies require that all its loans be fully secured by mortgages and/or personal and bank guarantees. This, together with its close contacts with its borrowers through its branch network, has allowed Halk Bank to develop a good portfolio of small loans with little arrears. Halk's financial position is strong, and 1/ The debt-service-cover ratio for the commercial banks among the PCIs is calculated by dividing the sum of the net income after tax, interest payments (adjusted for taxes) on medium and long-term loans (over one year maturity), provisions for losses and loan collections from medium and long-term loans (over one year maturity)by the sum of the repayments of debt and payments of interest (adjusted for taxes) on medium and long-term debt (over one year maturity). For the development banks among the PCIs, the debt-service-cover ratio is calculated by dividing the sum of the net income after tax, interest payments adjusted for taxes, provisions for losses and loan collections by the sum of the repayments of debt and payments of interest, adjusted for taxes. ANNEX 3 Page 4 its past profitability has allowed it to adequately provide for its entire non-performing portfolio. Based on the information provided to the appraisal mission, Balk Bank has already set aside sufficient provisions as required under the decree to cover loans that are not current and made preliminary allowances for loss of creditworthiness in performing loans contingencies. It is anticipated that Halk will successfully complete its participation in SMI I and would have a bigger role in SMI II under revised policies and strategies, agreed during the appraisal mission. 11. Conditions for Participation and Financial Covenants. In order for Halk Bank to participate in the proposed project, it would have to: a) finalize and issue its policy and corporate strategy statements, as approved by its board and satisfactory to the Bank; and b) sign a subsidiary loan agreement with the Government, satisfactory to the Bank. To be able to continue participating, Halk Bank would have to submit, together with its annual audit report, a certification by its auditors that it is in compliance with the following financial covenants under the project: a) a minimum collection ratio on all its medium and long term loans of 75%; b) a minimum debt-service-cover ratio of 1.2 to 1; c) a capital adequacy ratio as required by the Banking Law; and d) adequate provisions for bad loans as prescribed under the provisions decree of May 1988. C. Industrial Investment Credit Bank (SYKB) 12. SYKB was established in 1963 by five commercial banks primarily to provide working capital loans to projacts provided with investment loans by the Industrial Development Bank of Turkey (TSKB), the other private development bank in Turkey. Since the early 1970s SYKB has significantly expanded its role and has moved into investment financing in a big way. The Bank has been instrumental in the growth of SYKB as a development finance institution. SYKB's relationship with the Bank has grown cver the years, and to date, it has been the recipient of four Bank loans amounting to US$185 million primarily earmarked for private sector industry: (i) textile industries (US$15 million); (ii) labor-intensive industries (US$ 40 million); (iii) small and medium scale industries (US$80 million); and (iv) the export industrieL (US$50 million). The implementation of the loans for textile and labor intensive industries was delayed somewhat because of the reluctance of final borrowers to bear the foreign exchange risk. However, with the introduction of Foreign Exchange Risk Insurance Scheme (FEPIS) in 1985, the implementation of these two loans was accelerated and the two loans were disbursed with only minor cancellations. SYKB has performed well under the current SMI loan, and has met its major objectives, financial covenants and timetable for disbursements. SYKB's participation in the export loan which became effective in April 1988 is also satisfactory. 13. SYKB is a well-managed financial institution and has build up a cadre of competent staff. SYKB has concentrated mainly on providing long-term finance to small and meditm scale industries and has built a strong portfolio. However, the difficult financial environment in recent years has had a significant impact on the performance of SYKB's clients. The non-performing portfolio of SYKB has recently been increasing as firms suffered from high cost of money and adjusted to new market realities. The increasing level of non-performing assets is putting pressure on the spread of the bank, could lead to 'Liquidity problems and stifle SYKB's growth. SYKB ANNEX 3 Page 5 would have to improve its portfolio management, diversify its sources of funds domestically and externally and increase its capital, if its growth -projections are to be achieved. These have been discussed with SYKB and constitute important elements of its corporate strategy statement which was reviewed by the appraisal mission. 14. Over the long term, SYKB would need to diversify its business and move into areas other than its main business of long-term finance. Long-term viability on the basis of this product line alone will become more difficult as spreads on this business become thinner due to greater competition. As spreads decline very high collection levels would be needed to achieve even modest profitability and even minor shocks in the economy could hurt SYKB's profitability. Considering its large pipeline of funds available for long-term lending, SYKB could easily be lulled into an attitude of business as usual. Management would need to implement more aggressively its business diversification plans and resist a tendency to postpone them. 15. Conditions for Participation and Financial Covenants. Despite being a non-bank and not subject to the new provisioning decree, SYKB has agreed to provide for its non-performing portfolio in the spirit of the provisions decree. It has already set aside the provisions required under the decree for loans which are not current and made preliminary provisions for loss of creditworthiness. It is considered eligible to participate in the project subject to the following conditions: a) that it issues a policy and corporate strategy statement, as approved by its board and satisfactory to the Bank; and b) that it signs a subsidiary loan agreement with the Government, satisfactory to the Bank. To continue participating in the project, SYKB would have to submit, together with its annual audit report, a certification from its external auditors that it continues to meet the financial covenants under the project as follows: a) a minimum debt-service-cover ratio of 1.1 to 1; b) a minimum collection ratio on all its medium and long term loans of 75%; c) a maximum debt-equity ratio of 10 to 1; and d) adequate provisions for bad loans as required by the provisions decree of May 1988. D. Vakiflar Bank (VB) 16. Established in 1954 originally as the government commercial bank responsible for administering the income and expenditures of public foundations, Vakiflar Bank has evolved into a leading bank, ranking fifth in deposits and seventh in total assets by the end of 1987. It is a well managed bank with a track record of growth, profitability, liquidity and overall financial scundness. Vakiflar's general manager, who has extensive experience in the private and public banking sector, has set a strong leadership and direction for the bank. Looking to the future, the appraisal mission assisted the bank management team in strategic planning, by articulating its goals and objectives in a policy statement and defining the means for attaining them through a corporate strategy statement. It also helped the bank get into medium-term projection exercises as the bank for the first time prepared a three-year operational and financial projection. 17. The bank has had significant experience in term-financing since 1974, with term loans representing 17% of total loans by 1987. In view of its goal to become a diversified bank and to increase its term loan portfolio, in February 1988 the bank established a specialized group to handle the appraisal ANNEX 3 Page 6 and supervision of project loans, with emphasis on general industrial and SMI investment financing. The unit has a total staff of 24 professionals in engineering, finance and economics. The preponderant expertise is in engineering but it was agreed with the appraisal mission that this imbalance would be remedied through appropriate training. Under the project, technical assistance would be provided to assist the bank in this regard as well as in general institution building. 18. Although highly liquid, profitable and sound, Vakiflar Bank has not articulated its guidelines for asset-liability management and general risk management. The appraisal mission assisted the bank's management team in this regard and agreements were reached on single borrower limits, group limits, sub-sectoral concentration limits, liquidity management guidelines, currency matching, foreign exchange trading guidelines, leveraging and loan-deposit ratios. These guidelines would assist management in ensuring that the bank's officers and staff continue to follow sound banking practices and are important defensive tools in times of macroeconomic difficulties. 19. Anticipating the new provisions decree, Vakiflar's management took the initiative of providing adequately for its bad loans, by voluntarily setting aside a significant amount for extraordinary loan loss provisions. As of September 30, 1988, Vakiflar's accumulated provisions amounted to TL 72 billion, already representing the full amount of provisions required for loans that are not current and a preliminary provision for loss of creditworthiness. On a worst-case scenario that no additional collection would be made from administrative and legal cases, Vakiflar would need to make an additional provision of TL 42 billion by December 1988. This amount can be readily covered by the earnings of 1988. 20. Conditions for Participation and Financial Covenants. To participate in the proposed project, Vakiflar Bank would have to: a) prepare and issue a policy and corporate strategy statement, approved by its board and satisfactory to the Bank; and b) sign a subsidiary loan agreement with the Government. To be able to continue participating in the project, Vakiflar Bank would have to submit annually, together with its audit report, a certification by its external auditors that: a) it is in compliance with the original provisions decree of May 1988; b) it has a minimum collection ratio on its medium- and long-term loans of at least 75%; c) it meets the capital adequacy ratio prescribed in the Banking Law; and d) it has a minimum debt-service-cover ratio of 1.2 to 1. ANNEX 4 Page 1 TURKEY SECOND SMALL AND MEDIUM SCALE INDUSTRY PROJECT Documents Available in the Project Files A. General 1. Total Factor Productivity in Turkey (Bhosphorus University) 2. Desktop Study on Productivity (Bhosphorus University) 3. Some Economic Indicators and Productivity Measures in the Turkish Economy (SYKB) 4. Economic and Financial Appraisal at Small and Medium Scale Industrial Establishments (ISO) B. Credit Component .- Appraisal of Emlak Bank - "Defining the Strategic Directions for Emlak Bank" (September 9, 1988) - Financial Projections - 1988-89 - Financial Statements - 1985-87 - Responves to Questionnaire of Pre-appraisal/Appraisal Missions - Articles of Association - Resolution of the Council of Ministers - merging Emlak Kredi Bankasi and Anadolu Bankasi - CVs of Senior Management - Portfolio Audit - September 30, 1988 2. - Appraisal of Halk Bank - Audited Financial Statements - 1987 - Portfolio Audit - September 30, 1988 - Annual Report - 1987 - Past Financial Performance - 1986-88 - Projected Financial Statements - 1989-91 - Institutional Review - March 1989 - Institutional Development Project - March 1989 3. - Appraisal of the Industrial Investment and Credit Bank - Audited Financial Statements - 1987 - Annual Reports - 1985-87 - Financial Projections - 1988-92 - Preliminary Financial Statements - June 1988 4. - Appraisal of Vakiflar Bank - Preappraisal Report on Vakiflar Bank (Consultant's Report) - Audited Financial Statements - 1987 - Portfolio Audit - September 30, 1988 5. Subprojects Financed under Past SMI Projects ANNEX 4 Page 2 C. Technical Assistance Components 1. Protocol of Cooperation between the Turkish Standards Institute and the Small Industry Development Organization 2. Research Proposal on Exploring Productivity in Istanbul's Industrial Sector (Bhosphorus University) 3. Qua'ity Control Component (Consultant's Report)