Turkey - Private Investment Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY 1, A U 1li .1 ! Report No. 9060-TU STAFF APPRAISAL REPORT REPUBLIC OF TURKEY PRIVATE INVESTMENT CREDIT PROJECT MARCH 20, 1991 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.  CURRENCY EQUIVALENTS Currency Unit - Turkish Lira (TL) Value of US$1.00* 1986 TL 674.5 1987 TL 857.2 1988 TL 1,422.3 1989 TL 2,121.7 1990 TL 2,629.0 v/ Annual Average FISCAL YEAR January 1 - December 31 GLOSSARY OF ABBREVIATIONS CIF Cost, Insurance and Freight CUR Capacity Utilization Rate FERIS Foreign Exchange Risk Insurance Scheme FSAL I First Financial Sector Adjustment Loan FSAL II Second Financial Sector Adjustment Loan FSAL III Third Financial Sector Adjustment Loan FY Fiscal Year GDP Gross Domestic Product GNP Gross National Product GOT Government of Turkey ICB International Competitive Bidding IEDP Industrial Export Development Project IERR Internal Economic Rate of Return IFRR Internal Financial Rate of Return LIBOR London Inter-Bank Offered Rate PCB Participating Commercial Bank PFI Participating Financial Institution PMI Private Manufacturing Investment PSBR Public Sector Borrowing Requirement SEE State Economic Enterprise SPO State Planning Organization SMI Small and Medium Scale Industries SSI Small Scale Industries SYKB Sinai Yatirim ve Kredi Bankasi TCZB Turkiye Cumhuriyet Ziraat Bankasi TL Turkish Lira TSKB Turkiye Sinai Kalkinma Bankasi VAT Value-Added Tax VB Vakiflar Bank  FOR OFmFCIAL USE ONLY REPUBLIC OF TURKEY PRIVATE INVESTMENT CREDIT PROJECT STAFF APPRAISAL REPORT Table of Contents LOAN AND PROJECT SUMMARY . . . . . . . . . . . . . . . . . . . . . .i I. INTRODUCTION. II. THE INDUSTRIAL SECTOR .... . . . . . . . . . . . . . . . . . . . 3 A. Economic Setting ....................... . 3 B. The Manufacturing Sector ................... . 5 C. Private Manufacturing Investment ............... . 7 D. Bank's Industrial Lending Strategy . . . . . . . . . . . . . . . 10 III. THE FINANCIAL SECTOR ...................... 11 A. The Structure of the Financial System . . . . . . . . . . . . . . 11 B. Banking Reform Program .................... . 14 C. Investment Finance ...................... . 15 D. Financial Markets ....................... . 16 IV. THE PROPOSED PROJECT . . . . . . . . . . . . . . . . . . . . . . . 18 A. Project Objectives ...... . .. . .. . .. . .. . .. . . 18 B. Project Description . . . . . . . . . . . . . . . . . . . . . . . 18 C. Project Costs and Financing Plan ............... . 19 D. Project Beneficiaries ..................... . 19 E. Participating Financial Institutions and Eligibility Criteria . . 20 F. Environmental Aspects ..................... . 24 V. THE PROPOSED LOAN ...... .. .. . .. .. . .. .. . .. . 25 A. Amount and Allocation of Funds ................ . 25 B. On-lending Rates and Foreign Exchange Risk ... . . . . . . . . 25 C. Administration ........................ . 26 D. Reporting Requirements and Audits . . . . . . . . . . . . . . . 27 E. Procurement and Disbursements . . . . . . . . . . . . . . . . . 27 VI. PROJECT BENEFITS AND RISKS .... . . . . . . . . . . . . . . . . 28 VII. AGREEMENTS REACHED AND RECOMMENDATIONS . . . . . . . . . . . . . . 29 ANNEX I - Industrial Export Development Project (IEDP) ... . . 31 ANNEX II - Selected Documents and Data Available in the Project File ................... . 37 This report was prepared based on th. findings of en appraisal mission to Turkey In June 1990, consisting of Mr. Dalla and Ms. Chamlou (EMlID). Messrs. Dhar (DMlCO). Woodruff (DITIE), Su, Gupta and Edmonds (Consultants), under tho supervision of M. Ntishimizu (Division Chief, EMIID) and Mr. Wieben (Director. EM1). It ias finalized by Mr. Parnie (EM1ID). 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.  REPUBLIC OF TURKEY PRIVATE INVESTMENT CREDIT PROJECT Loan and Project Summary Borrower: The Republic of Turkey Beneficiaries: Private financial institutions and private enterprises. Amount: US$200 million equivalent. Terms: Seventeen years, including a five year grace period, at the Bank's standard variable interest rate. On-lending Terms: The Government will on-lend the Bank funds to the Participating Financial Institutions (PFIs) on the same terms and conditions as the Bank loan plus a 0.5Z on-lending fee. The sub-borrowers would have the option of borrowing in one or more of five currencies (DM, Sf, Sterling, US$, Yen) and would bear the foreign exchange risk. The PFIs will charge the sub-borrowers the appropriate LIBOR cost of the currency or currencies selected plus a spread to be negotiated with each sub-borrower. The PFIs will carry the cross-currency risk and manage it in accordance with the prudential regulations of the Turkish banking law. Project Description: The proposed Project would provide long-term funds to help finance the private investments needed to sustain Turkey's export drive in the 1990s. By channeling these funds through the private banking system the Project would continue the process of strengthening individual financial institutions as a strategic complement to the on-going program to improve the efficiency of the financial system. The Project would also help the real sector respond adequately to on-going and planned reforms by providing it with resources needed to restructure existing, or invest in new, capacities that make economic sense in the reforming environment.  - ii - Project Beneflits & Risks: The Project would assist Turkey in its transition to a more stable economy by providing the needed long-term funds today while helping the financial system improve its ability to perform its intermediation function in future. Based on past experience, the Project is expected to support private investments in the order of US$400 million and exports of about US$200 million, and result in the creation of about 14,000 new full time jobs. With a minimum economic rate of return of 15X, the investments financed under the Project are expected to be efficient and internationally competitive. The potential project risks would stem from a slow down in private investment due to deteriorating macroeconomic conditions and a change in the investment climate; a change in relative prices due to a reversal of trade liberalization policies; and a reluctance to assume foreign exchange risk by Turkish investors in unstable economic conditions. Such a deterioration in economic conditions would trigger a reconfiguration of the Bank's overall relationship with Turkey, and a possible suspension or cancellation of the Project. Estimated Costs: (USMillion) _ Local Forei2n Total Subproject Investments 200.0 200.0 400.0 Technical Assistance O.5 0.5 1.O TOTAL 200.5 200.5 401.0 Financine Plan: Private enterprises 200.0 - 200.0 IBRD - 200.0 200.0 PFIs 0.5 0.5 1.0 TOTAL 200.5 200.5 401.0 Estimated Disbursements: IBRD FY (USS Million) Annual 20.0 60.0 75.0 35.0 10.0 Cumulative 20.0 80.0 155.0 190.0 200.0 X 10.0 40.0 78.0 95.0 100.0  REPUBLIC OF TURKEY PRIVATE INVESTNENT CREDIT PROJECT STAFF APPRAISAL REPORT I. INTODUCTION 1.01 Since 1980, the Turkish Government has been pursuing an outward oriented development strategy that places increasing reliance on market forces and the private sector. Turkey's major success in the 1980s was clearly on the export front. Exports as a share of Gross Domestic Product (GDP) tripled between 1980 and 1985 from 5X to 15X, while manufactured exports increased from $1 billion in 1980 to $9 billion in 1989, growing to 801 of merchandise exports. The growth of exports was, however, made possible by expanding utilization of existing capacity from the depressed levels of the early 1980s; investment in manufacturing actually declined significantly in real terms, and fell as a share of total investment from 341 in 1980 to 15% in 1989. This decline reflects the drastic cutback of public investment in manufacturing, in line with the Government's intention of relinquishing its role in the productive sectors, but also the sluggish response of private investment, which has declined in real terms since 1986. Export growth slowed considerably in the second half of the 1980s; the exports/GDP ratio actually declined slightly between 1985 and 1989. Owing partly to reduced export incentives (para. 2.09) and an appreciating TL (para. 2.04), exports hardly grew in 1989 and are estimated to have increased by only 41 in 1990. With today's high capacity utilization rates (average capacity utilization rates in the private sector have reached 75% and exceeded 801 in certain key sectors such as textiles), a recovery of investments in tradeable has become increasingly important for Turkey in developing its capacity for further export growth. The Project aims at providing the initial impetus to increased investments in export capacity needed for the 1990s. 1.02 The Project is proposed in light of policy reforms and institutional changes being undertaken and planned on the macro, financial and industrial fronts. Macroeconomic performance has improved with a rapid acceleration in the rate of growth to about 9X in 1990 from a sluggish 1.71 in 1989. The Central Bank has acquired the autonomy to implement an independent program of monetary restraint. As a consequence, inflation had abated from 701 in 1989 to 491 in 1990 despite the inflationary effects of the Gulf crisis. In response to this external shock, the Government has introduced significant adjustment measures beginning in September 1990. In approving the 1991 budget, the Parliament introduced a 51 cut in non-personnel expenditures across the board. Nevertheless, further fiscal adjustments are needed to reduce the fiscal deficit to a more sustainable level, and make fiscal policy more consistent with monetary policy objectives. In the financial sector, policy and institutional reforms have been successfully completed under the Second Financial Sector Adjustment Loan (FSAL II). Major distortions (and quasi-fiscal subsidies) associated with preferential credits have been eliminated, except in agriculture. Banks have strengthened their capital base in line with new prudential regulations and, after a special portfolio audit, have fully provided for non-performing loans. A bank restructuring institution to resolve future bank failure and insure small depositors is  being established, and the system for bank supervision is being improved. Reforms in agriculture credit interest rates and in the agriculture bank are being pursued under the Third Agriculture Credit Project (Loan 3090-TU). In the industrial sector, discussions with the Government on an industrial sector adjustment program have focused on a further rationalization of the structure of taxes and subsidies, to continue to remove anomalies and allow market forces to provide a stronger guide to investment decisions. 1.03 Assuming sustained progress on these fronts, private investment demand for capital goods can be expected to grow, but the availability of medium-term credit to finance such investment is likely to be constrained over the short-term without Bank assistance. Even after the planned adjustments have been made, there will still be a time lag until the fiscal and industrial policy reforms appear to be irreversible, and the banks are able to mobilize sufficient term deposits which can be used for investment financing. During the time window between policy reform and changes in the stock composition of financial assets, it is essential that the Bank provide financial and technical support for banks which want to establish a presence in the term lending market. The objective of this loan is not to substitute for the banks' own efforts to mobilize term resources. Rather, the intention is that the proposed Project will directly support the reform process by providing long term resources in the transition period between policy changes and increased financial intermediation by the banking sector, and by strengthening the financial sector's institutional capacity to carry out prudent term transformation. 1.04 The Project is designed to build on the successful experience of an earlier project. The Industrial Export Development Project (IEDP) of US$300 million was approved by the Bank in January 1988. While this loan was expected to be committed by 1992, it was actually fully committed by mid- 1989. IEDP has supported total investments in export-oriented activities amounting to US$2.1 billion resulting in annual incremental output of US$1 billion, of which US$500 million was for exports, mainly to OECD markets. Most investments were for the expansion or balancing of existing capacity in activities in which Turkey has comparative advantage - textiles, rubber products, glass manufacturing and tourism - resulting in sub-projects with high economic rates of return (averaging 39X). Through the project, compliance with the new prudential regulations and audit guidelines issued under FSAL II was enforced for each of the participating commercial and development banks, thus reinforcing at the level of individual institutions the reforms being undertaken for the system as a whole. Annex I provides a more detailed discussion of IEDP's economic impact. 1.05 The proposed Project will continue to support Turkey's export expansion and diversification efforts by providing long-term funds for private investments. The Project will pursue sustained implementation of the Government's financial reforms at the intermediary level by ensuring that the participating financial institutions (PFI) continue to comply with prudential regulations and by improving the efficiency of the financial system especially in allocating investment credit. The proposed Project consists of a credit component of US$200 million and a technical assistance component of US$1  million. The credit component will finance viable private investments in the production of any tradeable product or service, excluding agriculture. However, based on past experience and the current pipeline of projects of the PFIs, most investments are expected to be in the industrial sector. The credit will be channelled initially through two private development banks and eight private commercial banks. The technical assistance component will provide training and consultancy services for the PFIs in project appraisal and supervision to improve their project finance capability. II. THE INDUSTRIAL SECTOR' A. Economic Setting 2.01 Until 1980, Turkey's industrial development strategy was based principally on import substitution in basic industries. The main policy instruments employed were large investments in State Economic Enterprises (SEEs) and generous tax and financial incentives combined with high levels of protection. These policies led to rapid industrial growth, increasing industry's share in GDP from 13% to 18X between 1963-77. But they also gave rise to some serious weaknesses, such as severe anti-trade bias and lack of competitiveness, high capital intensity, and low levels of productivity. These weaknesses became apparent following the first oil price shock in 1974, which resulted in growing current account deficits and a balance of payments crisis that required comprehensive debt rescheduling between 1978 and 1980. The ensuing shortage of foreign exchange and imports led to disruptions in industrial production, sharply reduced capacity utilization rates (CURs), declining output and an acceleration of inflation to over 1001 by 1980. 2.02 I- response to this crisis in early 1980, Turkey initiated an extensive program of stabilization and reform. The structural reforms, consisting initially of exchange rate devaluation, price deregulation, trade liberalization, and export promotion, were designed to shift the economy toward outward orientation and to promote efficiency through greater reliance on market forces and the private sector - representing a major break from the past interventionist policy regime. 2.03 During the first half of the 1980s, the Turkish economy responded well to this adjustment strategy; output grew by nearly 51 per year led by real export growth of about 201, inflation was reduced to 30X by 1986, current account deficits were reduced, and international creditworthiness re- established. However, stimulative fiscal policy accelerated the growth rate during 1986-87 to an average of nearly 81 and contributed to a rise in inflation to 701 by 1988. Despite significant reductions in public investment during 1987-89, the public sector borrowing requirement (PSBR) stood at about 71 of GNP in 1989, down only slightly from its peak of 8X in 1987. Further I Since most of the investments under the proposed Project is expected to be in industry the focus of the sectoral analysis in the report is the industrial sector.  reduction of the deficit was hampered by the large increases in public sector real wages granted in 1989 (following a period of decline over much of the 1980s) and the growing burden of fiscal interest payments. 2.04 The momentum of growth shifted swiftly in 1988, with industrial output beginning to contract by mid-year, reflecting a period of financial instability and sharp swings in real interest rates, as well as the decline in public investment. However, the large increases in real wages granted in mid- 1989 set the stage for a recovery of industrial output. GNP growth nonetheless fell to 1.7% in 1989 as a severe drought reduced agricultural output by 11. Slower growth accompanied by rapidly rising revenues from tourism and workers remittances shifted the current account into surplus in 1988-89. In a setting of current account surpluses, rising direct foreign investment, and growing foreign exchange reserves at the Central Bank, the Government liberalized intorest and exchange rate determination and capital account transactions during 1988-89. It also further removed tariff protection and abolished all quantitative restrictions. Reflecting the favorable external developments, the real exchange rate appreciated significantly, by about 30% between end-1988 and mid-1990, raising concern about the sustainability of the balance of payments performance. To slow the extent of real appreciation and also to improve its reserve position, the Central Bank purchased substantial quantities of foreign exchange in 1989-90. However, this action led to a rapid expansion of base money, which was not consistent with the targeted reduction of inflation. Despite the sharply slower growth rates in 1988-89, inflation declined only marginally, reflecting the rapid monetary expansion in 1989, the real wage increases, and the impact of higher agricultural prices as a result of the drought. 2.05 The adherence to a tighter monetary program, accompanied by a continuing appreciation of the real exchange rate and supported by a recovery in agricultural output from the drought in 1989, helped to reduce inflation from 70% in 1989 to 49% in 1990 despite the inflationary effects of the Gulf crisis. The Central Government's budget deficit, however, rose substantially. The Government was able to finance its deficit by borrowing heavily in the domestic market at relatively low interest rates; with the real exchange rate still appreciating, domestic rates remained negative in real terms. But the recovery of industrial production, appreciation of the real exchange rate, and reduction of import protection, contributed to a very rapid expansion of imports and a sizeable current account deficit. 2.06 The need for fiscal adjustment became more urgent in view of the deterioration in the balance of payments prospects following the emergence of the Gulf crisis. Given its traditional close economic relations with Iraq and Kuwait, the crisis is costing Turkey dearly not only due to the oil price increase but also in foregone royalties from the Iraqi oil pipeline, export losses, reduced worker remittances, lost income from construction contracts and non-payment of Iraqi debt. The Government's immediate response to the crisis was commendable. It allowed oil price increases to be fully passed on to consumers and it raised revenues through a 5% across-the-board increase in import duties and a 2% increase in the VAT rate on foodstuff. Additional increases in the general VAT rate and on luxury items were implemented in  October 1990, with further increases planned through June 1991. In approving the 1991 budget, the Parliament introduced a 5% across-the-board cut in non- personnel expenditures. As in the past, further budget cuts are implemented during the budget release process itself. Further fiscal adjustments, however, are needed to reduce the fiscal deficit to a more sustainable level, and to make fiscal policy more consistent with the tightening of monetary policy by the Central Bank. 2.07 Assuming satisfactory progress on the Government's fiscal stabilization efforts, private investment in industry can be expected to rise significantly from its average level of about US$2 billion p.a. during 1987- 89. Using conservative debt-to-equity ratios, the demand for investment financing would considerably exceed the loan amount under the proposed Project. However, for the reasons discussed in Section C, if fiscal deficits and inflation were to increase, investment demand in general and demand for foreign exchange financing in particular would greatly suffer. B. The Manufacturing Sector 2.08 The manufacturing sector in Turkey expanded during the 1980s by directing output toward the external market. The share of output being exported increased from 6% in 1979 to 50% by 1989, as manufactured exports grew at a compound rate of 28% per annum over the past ten years. Growth of manufactured output averaged 7X in the 1980s and, as of 1989, the sector accounted for a quarter of GDP and 13.2% of formal sector employment. The private sector accounted for about two-thirds of output and employment in manufacturing enterprises employing 25 or more persons; including small-scale production this share is even larger, rising to nearly 90% in terms of employment. 2.09 Manufactured exports, which grew from 36% of total exports in 1980 to 78% in 1989, were the beneficiaries of a fundaiental shift in trade policy towards outward orientation initiated during the 1980s. The main policy instruments used to reform the trade regime were a significant depreciation of the real exchange rate until 1988, a dismantling of quantitative import restrictions, a lowering of tariffs particularly in 1989, and provision of a wide array of special incentives for exporters. The latter have included duty-free access to imports, the now abolished system of export tax rebates, a tax credit equal to 20% of export earnings for exporters of more than $250,000 (recently reduced to 18%), direct and volume based subsidies, and export credit extended at below market interest rates. These incentives were considered necessary to spur Turkish industrialists, long used to producing for a protected domestic market, into exporting, particularly in view of the need to ease the foreign debt servicing burden. However, over the last two to three years the extent of export incentives has been steadily reduced. Exports as a share of GDP tripled during the 1980s, and the increased participation in international markets also appears to have enhanced productivity in the manufacturing sector through scale economies and learning externalities, particularly for the private sector.  - 6 - 2.10 The pattern of export-led growth was prevalent across the entire manufacturing sector (Table 2.1), as all sub-sectors increased their outward orientation. While textiles still occupy a dominant share of manufactured exports -39X in 1989- this share is actually lower than in 1980, indicating the broad based nature of growth. T.blt 2.1: Turky -Manufactured Exports bv Sectors (In mill.ions of US$) 1880 .285 1986 1987 1888 1989 Agri-based proc. products 190 647 667 954 885 919 Textiles 440 1790 1851 2707 3201 3508 Forestry products 8 106 52 32 22 16 Hides and leather products 50 108 345 722 514 605 Chemicals 92 374 350 527 734 774 Petroleum products 39 372 178 232 331 254 Cement 40 44 27 7 7 34 Glass and coramics 36 190 158 205 233 258 Pon-ferrous metal 18 116 111 134 226 266 Iron and stoel 34 969 804 852 1458 1349 Metal products and machinery 30 450 263 788 385 219 Electrical appliances 12 119 127 293 294 234 Motor vehicles 50 147 82 110 118 154 Others 10 565 310 503 536 498 Total manufactured exports 1047 5995 5324 8065 8944 9088 Total exports 2910 7958 7457 10190 11662 11627 Manufact. export/tot. export(Z) 36.0 75.3 71.4 79.1 76.7 78.2 Source: State Planning Organization 2.11 Recent developments in manufacturing have to a large extent paralleled macroeconomic developments. Following annual growth rates of nearly 101 in 1986-87, manufacturing growth rates fell to the 2-3X range during 1988-89, with three consecutive quarters of declining production (third quarter 1988 to first quarter 1989). This reflected the tightening of fiscal policy in the second half of 1988 and particularly the very sharp rise in non- preferential lending rates in the fourth quarter of 1988. However, since mid- 1989, the recovery of production has accelerated, and in the whole of 1990, output grew at an annual rate of over 8X. 2.12 Capacity utilization rates (CURs) reflect production trends. Thus the peak in weighted CURs for the private sector was reached in first quarter 1988 (Table 2.2), with several key sectors experiencing close to what is generally considered full capacity utilization in Turkish industry. With weaker production for the rest of 1988, CURs fell, but this trend was reversed in 1989, as overall private investment in manufacturing declined and production began to rise after mid-year. Thus CURs by the end of 1989 had recovered close to their previous peaks, and can be expected to reach new highs, particularly if the current industrial expansion continues.  - 7 - able 2.2: Tui,key Cao tfUtiliastion Rates in Privat Nanufacturin:. m9a-_10a SECTORS Am{ au8 198 au?ld8]g Food-beverae-tobacco 55.0 74.0 73.3 74.1 73.9 78.4 Textilo-olothing-leather 58.2 70.2 78.3 81. 9 82.1 81.3 Forestry products 52.2 57.7 U2.8 69.7 72.2 73.3 Paper-printing 50.1 71.6 77.4 83.4 80.6 78.7 Ch.micalm-potrolsum prod.-rubbor 49.9 69.8 70.6 75.7 75.2 77.0 Soil products 63.4 69.3 80.2 82.9 82.5 83.3 Basic metals 41.6 63.6 72.7 71.4 73.2 74.1 Machinery-transport equipment 51.5 59.7 69.4 71.2 86.6 67.4 Others "4 5L =L. UL9 ALI ALA Total manufacturing industry 51.1 66.8 72.7 75.2 74.3 75.6 Table 2.2 (continued) SOr& - g1988 1989 X i Z aY 1 11 Lu Food-boverags-tobacco 69.1 69.7 74.7 76.0 75.7 72.8 80.8 79.7 Textilo-clothing-loather 83.8 81.7 81.9 80.7 80.7 80,8 78.6 82.5 Forestry products 88.3 74.6 72.3 66.0 66.7 70.8 69.6 79.0 Paper-printing 87.1 81.9 78.6 75.3 80.7 77.0 77.7 79.4 Chom.-pot. prod.-rubber 77.3 74.0 73.3 75.9 74.9 76.5 75.4 79.7 Soil products 83.7 87.1 78.7 81.2 84.2 84.4 81.3 83.5 Basic metals 80.1 72.1 67.1 75.9 75.0 71.6 74.4 75.6 Machinory-tranap. equip. 73.6 68.3 61.2 63.5 66.8 68.8 65.9 68.2 Others 59.3 54.6 61.7 61.0 67.1 68.4 68.2 65.6 Total manufact. indust. 77.5 74.4 72.0 73.5 74.7 74.8 74.9 77.2 Souroe: State Planning Organization C. Private Manufacturing Investment (PMI) 2.13 The export boom of the 1980s was accommodated largely through the utilization of existing capacity from the depressed utilization levels of the early 1980s; investment in manufacturing actually declined significantly, falling in real terms to 55% of its 1980 level by 1989. This decline primarily reflects the drastic cutback of public investment in manufacturing to 15% of its 1980 level by 1989, in line with the Government's intention of relinquishing its role in the productive sectors. Thus by 1989, 83% of the investment in manufacturing was accounted for by the private sector, up from 40% in 1980. 2.14 The rising share of private investment in manufacturing does not, however, reflect buoyant growth. Indeed apart from a period in the mid-1980s (1984-86), PMI either stagnated or declined slightly, and growth in the 1980s averaged less than 2% per annum (Table 2.3). For the decade as a whole, the trend of PMI was influenced by several opposing factors. On the one hand, investors benefitted from generous tax and depreciation allowances, which provided a strong incentive for established and profitable firms to continue incremental investments for expansion and modernization. Yet, the uncertain macro environment, particularly the high and variable inflation rates tended to inhibit major investment in new plants. And the overall scarcity of  - 8 - medium-term financing, itself a reflection of high inflation (see Chapter III), also constrained investment for those enterprises that could not generate sufficient resources internally. Retained earnings and depreciation thus accounted foz much of the resources for investment financing. Within this overall pattern, growth of investment in consumer and capital goods was more sigr.ificant, whereas investment in intermediate goods, still the largest category, declined over the decade. lg 2.3: Turktey Private Fixed Capital Investments by Sectors. 1984-90 A. Value in TL Trillion (at 1988 prices) 1984 198f5 1986 ,98 1988 ,9 8 (Estimate)(Target) Agriculture 1.7 1.5 1.5 1.9 1.8 1.9 2.0 Mining 1.1 1.5 1.1 0.7 0.6 0.7 0.7 Manufacturing 4.3 4.6 4.6 3.9 3.7 3.8 4.0 Energy 2.8 3.1 3.6 3.3 3.1 2.8 5.0 Transportation 3.8 5.0 5.4 5.9 4.8 4.7 5.3 Tourism 0.2 0.3 0.5 0.7 0.8 1.0 1.3 Housing 2.3 2.7 3.5 4.9 6.4 6.9 6.9 Education 0.3 0.5 0.5 0.7 0.8 0.8 1.0 Health 0.2 0.2 0.2 0.3 0.3 0.3 0.4 Other services 1.2 1.7 _.3. 2.4 2.0 1.9 2.0 Total 17 2.7 248 B. Shares in Total (at 1988 prices) 1984 1985 1986 1987 1988 1989 1990 (Estimate)(ruTgeq Agriculture 9.5 7.1 6.4 7.7 7.4 7.7 7.0 Mining 6.1 7.1 4.7 2.8 2.5 2.8 2.5 Manufacturing 24.0 21.8 19.8 15.8 15.2 15.3 14.0 Energy 15.6 14.7 15.5 13.4 12.8 11.3 17.5 Transportation 21.2 23.7 23.3 23.9 19.8 19.0 18.5 Tourism 1.1 1.4 2.2 2.8 3.3 4.0 4.5 Housing 12.8 12.8 15.1 19.8 26.3 27.8 24.1 Education 1.7 2.4 2.2 2.8 3.3 3.3 3.5 Health 1.1 0.9 0.9 1.2 1.2 1.2 1.4 Other services 6.7 8.1 9.9 9.7 8.2 7.8 7.0 Total 100 100 100 100 00 100 100 C. Annual Percent Change (at 1988 prices) 1984 1985 1986 1987 1988 1989 1990 (Estimate)(Target) Agriculture 0.1 -11.8 0.0 26.7 -5.3 5.5 5.3 Mining -5.2 36.4 -26.7 -36.4 -14.3 16.7 0.0 Manufacturing -6.5 7.0 0.0 -15.2 -5.1 2.7 5.3 Energy -9.7 10.7 16.1 -8.3 -6.1 -9.7 78.6 Transportation 5.5 31.6 8.0 9.2 -18.6 -2.1 12.8 Tourism 100.0 50.0 66.7 40.0 14.3 25.0 30.0 Housing 9.5 17.4 40.0 40.0 30.6 7.8 0.0 Education -25.0 66.7 0.0 40.0 14.3 0.0 25.0 Health -6.2 0.0 0.0 50.0 0.0 0.0 33.3 Other services 20.0 41.7 29.4 9.1 -16.7 -5.0 5.3 Total 0.0 17.9 9.9 6.5 -1.6 2.0 15.3 Source: State Planning Organization  9 2.15 The initial period of weak investment (1980-83) reflected the ability of firms to raise production by expanding capacity, given the low levels of prevailing CURs. Investment increased rapidly during 1984-86 as manufacturing production expanded and CURs in several sub-sectors approached 75Z. Falling inflation and a period of relative political certainty were presumably also positive factors. The recent weakness of PMI, which declined by 17X between 1986 and 1989, may be attributed to higher rates of inflation with the associated shortening of planning horizons and incentives for diverting resources into housing and other inflation hedges, as well as the decline in production between mid-1988 and mid-1989. 2.16 While PMI was declining between 1986 and 1989, total private investment continued to rise, largely due to rapid growth in housing investment. This growth reflected speculative purchases among wealthier investors as well as the provision of generous interest subsidies by the Mass Housing Fund for lower income households. By 1989, investment in housing had risen to 281 of private investment while PMI had fallen to 15Z, down from 20X in 1986. Investment in tourism has also grown very rapidly since 1984, but accounted for only 41 of private investment in 1989. 2.17 At the same time that domestic investment in manufacturing was relatively stable (at a rate of about US$2 billion per annum), foreign direct investment was increasing rapidly, including in the manufacturing sector. Net inflow of foreign capital reached US$663 million in 1989, up from US$106 million in 1987 and continued to rise in early 1990. This growth appears related to the prior removal of foreign investment restrictions, the close proximity of Turkey to expanding markets in the EC and Eastern Europe, low wages in Turkey, the improved balance of payments position in 1988-89 and subsequent liberalization of cApital flows. Judging from the distribution of foreign investment permits, nearly two-thirds of the foreign capital inflow appears destined for the manufacturing sector. Recently, several major multinational corporations have announced large projected investments in sectors such as autos and chemicals, generally through joint ventures with local Turkish firms. 2.18 Finally, for the first time in several years, domestic PHI appears to have recovered dramatically in 1990, reflecting the rapid output growth since mid-1989 and the increased interest of foreign investors in joint venture projects. Indirect evidence for the recovery of PMI includes the rapid growth of capital goods imports and utilization of investment incentive certificates of the State Planning Organization in 1990. Preliminary estimates place the growth rate at close to 271. (The growth in 1990, however, was exceptionally high because of the real appreciation of the TL and the liberalization of imports. Compared to inflation in 1990, PMI grew by a high but less dramatic 151 above inflation). 2.19 Given the prevalence of higher CURs, the evolution of manufacturing investment will become increasingly important for developing the capacity for further export growth and at the same time meeting the expected growth in domestic demand. While PMI can be expected to rise in the short  - 10 - term, a sustained growth in investment will depend on a number of factors that are closely linked to macroeconomic stability. 2.20 Perhaps most important for the investment climate is the perc.ption that the Government's fiscal and monetary policies will be successful in reducing inflation. By contrast, with inflationary expectations still rampant, the risk adjusted returns from speculative investments would tend to dominate, reducing investment demand for manufacturing. This tendency would be reinforced by the knowledge that ultimately demand would have to be compressed to contain the inflation. Adherence to the Government's monetary program without a corresponding fiscal adjustment, by raising interest rates, would also weaken investment demand. 2.21 The recent liberalization of the capital account and strengthening of the Turkish Lira suggest that borrowing in foreign exchange could become a potentially more important source of investment financing particularly for investments generating foreign exchange income. The demand for such financing would arise from the continued scarcity of medium-term financing in domestic currency, and the Government's decision to phase out the Foreign Exchange Risk Insurance Scheme (FERIS), whereby the Central Bank assumes the foreign exchange risk associated with foreign borrowing, because of its fiscal cost. For this type of financing to gain importance, however, the final borrower must have reasonable confidence regarding the stability of the real exchange rate. In particular, the perception of an exchange rate that is overvalued would dampen the demand for such foreign exchange credits, thereby reducing investment. Finally, the willingness of foreign creditors to extend the maturity of their lending to Turkish investors will also be contingent on their perception of long-run macroeconomic stability. Given this uncertainty the availability of long-term investment funds from the Bank would be important and would enable PMI to continue. D. Bank's Industrial Lending Strategy 2.22 The Bank's strategy for industrial lending to Turkey is to assist GOT in: (a) strengthening and expanding the private sector, including restructuring and privatizing State Economic Enterprises (SEE); (b) developing competitive financial markets by continuing to strengthen the banking system and expanding the capital markets in support of private sector activities; and (c) establishing the technology infrastructure to promote faster productivity growth and achieve greater international competitiveness. 2.23 The strategy for private sector development comprises, first of all, correcting distortions in the incentive framework so that private investment decisions become more consistent with economic goals. Although the basic redirection of the policy framework toward market orientation has been accomplished (Chapter II), further adjustments in the incentive framework are needed to improve resource allocation. These measures would be accompanied by efforts to restructure and privatize SEEs to make them efficient and competitive enterprises. Second, the private sector requires the services not only of an efficient banking system but also of deep capital markets. Expanding the private sector entails financing requirements that the banking  - 11 - sector alone cannot meet without increasing system risks. Moreover, privatization efforts would be constrained without capital markets that are deep and broad enough not only to mobilize the required equity and debt resources but also to modify ownership patterns. Finally, within the framework of a competitive market policy, a world-class technology infrastructure is required for the Turkish private sector to upgrade process and product quality and develop new products, particularly for exports. The systems of metrology, standards, testing and quality assurance are central to this effort. They also constitute the single most important policy instrument to develop small and medium-scale industry, particularly in promoting efficient subcontracting arrangements. 2.24 The Bank's lending program for industry is designed in accordance with this strategy. The planned operations would focus on further reforming the incentive framework for industry and accelerating the SEE privatization process (proposed Industrial Sector Adjustment Loan); developing the capital markets by removing distortions in the pricing between bank credit and market securities and between debt and equity instruments, strengthening the regulatory framework to promote safety, promoting institutional investors to deepen the markets, and building an efficient institutional infrastructure (proposed Third Financial Sector Adjustment Loan); and promoting technology development by improving the quality control system, providing venture capital funding and increasing the linkage between industry and research institutions and universities (proposed Technology Project). The proposed Project is a key element of this strategy. It will provide timely support for private investments to enable the private sector to continue adjusting adequately to the reforming incentive framework. Second, it will continue to increase the capacity of the financial sector to provide investment credit efficiently. Third, it will support investments in improved technology by providing import financing for capital goods and related technical services. III. THE-FINANCIAL SECTOR A. The Structure of the Financial System 3.01 Turkey has an extensive financial system. The financial system of Turkey consists of: (i) the Central Bank; (ii) seven Government owned commercial banks (four of which are being privatized); (iii) 26 private commercial banks; (iv) 20 foreign banks; (v) two private and one public sector investment and development banks; (vi) the social security system and bank employee pension funds; (vi) insurance companies and mutual funds; and (vii) a rapidly growing stock market located in Istanbul, with about a hundred active intermediaries of all sizes. Although the banking system still dominates the financial sector, accounting for about 90% of total financial assets, the capital market is growing rapidly. New institutions and instruments have been created in recent years in response to a growing interest by investors and issuers in non-bank market instruments. 3.02 About half of the banking system is controlled by the Government, but this could decline with the privatization of four banks, the expansion of  - 12 - existing private banks and the establishment of new private banks. While these public banks were established to cater to specific sub-sectors, current policies and strategies emphasize diversification as they have to compete with the private banks on a more equal basis. The number of private domestic commercial banks has remained basically unchanged since 1978, while the number of foreign commercial banks has increased from 4 to 20. The entry of foreign banks has not only introduced competition in some market segments but has resulted in large transfers of banking technology to the local banks. Foreign banks were active in interbank operations before the interbank market was established. They also introduced know-how in securities trading. 3.03 Table 1 shows the relative performance of the four banking groups for 1987-89 period. The relative shares of the four bank groups in total bank assets have not changed significantly between 1987 and 1989. The public banks account for about 47X of total bank assets in 1989. The agriculture bank (TCZB) is the largest financial institution in Turkey and accounted for 20.8% of the total assets of the banking system at the end of 1989, followed by Is Bank (10.5%), Emlak Bank (9.2%), Ak Bank (6.2%), and Yapi Kredi (5.8%). The participation of foreign banks has become more active but their relative share remains small. At the end of 1989, foreign banks accounted for about 3.1% of the assets of the system. The Turkish banking system remains highly concentrated. The share of the four largest banks (TCZB, Emlak and two private banks) in total bank assets was 46.7% in 1989. However, this share has declined slightly due to the more rapid growth of the smaller private banks. Within the group of private banks, the share of the four largest banks (Is, Ak, Yapi and Garanti) is even higher. Table 3.1: Turkey - Bankint System (TL trillion) Public Private Investment & Foreign Banks Banks Develo0. Banks Banks T o t a 1 1987 1 7f 17 1988 1989 18 198l 1989 1987 1988 1989 1987 1988 1989 Securities 1.9 3.5 6.1 2.1 3.2 5.9 0.0 0.0 0.2 0.2 0.3 0.5 4.2 7.0 12.7 Loans 9.0 13.0 21.7 7.0 10.0 16.7 2.3 4.0 6.2 0.5 0.8 1.5 18.8 27.8 46.0 Assets 19.2 30.4 52.5 18.9 30.1 46.5 3.6 7.1 10.4 1.3 2.5 3.5 43.0 70.1 112.8 Deposits 10.0 16.7 29.4 13.3 20.2 31.2 0.0 0.0 0.0 0.9 1.5 1.8 24.2 38.4 62.4 Capital 1.9 2.5 6.4 1.4 2.3 4.1 0.8 1.2 1.3 0.1 0.2 0.3 4.2 6.2 12.1 Loan/Dep.(Z) 90.0 77.8 73.7 52.6 49.3 53.7 - - - 53.0 55.0 80.1 68.0 62.0 64.0 Capital/Dsp.(Z) 19.0 15.0 21.7 10.5 11.4 13.0 - - - 11.1 13.3 16.2 17.4 16.1 19.3 Net Income 0.3 0.6 0.7 0.5 0.8 1.0 0.1 0.1 0.1 0.1 0.1 0.1 0.9 1.6 2.0 Ret.on AssetsM) 2.0 2.4 1.7 3.1 3.3 2.7 0.0 2.2 1.1 4.5 6.1 4.6 2.6 2.9 2.2 No. Of Branches 2984 3490 12 104 6590 SOUrC: The Bank Association of Turkey 3.04 The size of the financial system and trends in its growth are summarized in Table 3.2. During 1980-89, the system (M2) grew in real terms by 12.1% per year which compares favorably to the 4.9% real GDP growth during the same period. M2 as a percentage of GDP grew from 15.2% in 1980 to 27.6% in 1989. Concurrently, there has been an increase in demand for time deposits as measured by the difference between Ml and N2 which widened from 2.5% in 1980 to 16.7% in 1989. Equally interesting is the rise in foreign exchange deposits from zero percent in 1980 to 6.8% of GDP in 1988. Such rapid  - 13 - increase in financial depth after 1980 is explained by the macroeconomic and financial sector reforms initiated in 1980, which included the maintenance of positive real interest rates on deposits, the reduction of taxes and charges on financial intermediation and lower inflation.2 3.05 Although the Turkish financial system has performed well since 1980 it is still shallow by comparison with other countries at a similar stage of development. The ratio of M2 to GDP in Turkey is 27.6%, compared with thle average of 39% for developing countries at similar income levels. Also the ratio of broad money to GDP (including foreign exchange deposits) is only slightly higher than the levels achieved in the early 1970s. These two indices suggest that there is still ample scope for further progress in resource mobilization. Table 3,2: Turkey - Deoth of the Financial System (I) Year M1/GD M2/GD M2X/GDP Credit/GDP 1980 12.7 15.2 15.2 20.1 1981 11.7 17.7 17.7 22.4 1982 11.4 22.4 22.4 24.9 1983 12.1 23.1 23.1 24.4 1984 9.3 21.9 22.8 20.3 1985 8.5 23.3 26.2 17.0 1986 10.7 27.3 31.5 20.3 1987 10.8 24.9 31.4 25.6 1988 9.0 23.2 30.0 27.5 1989 Nov 10.9 27.6 34.2 n.a. Source: Central Bank 3.06 The progress in resource mobilization is not fully reflected in Table 3.2. In addition to the larger mobilization of bank deposits, several new financial instruments, such as corporate bonds and more recently, commercial paper, have been introduced. The government-issued revenue sharing certificates were very well received and some of the banks have been allowed to manage mutual funds. There has also been substantial revival in stock market activities. The value of equity trading increased dramatically from US$13 million in 1986 to US$800 million in 1989. The increase in the activities of the stock exchange has been driven by tax incentives (capital gains are tax exempt), the opening of the capital account, foreign portfolio investments and increased interest by local investors. Although the market has been growing rapidly it still shallow and volatile. Until it gains more depth and liquidity through the participation of serious institutional investors it is unlikely that it would be a major source of corporate finance 2 Developments in the financial system in recent years are documented in more detail in the IBRD reports: Financial Sector Adjustment Loan (No.6095- TU, May 15, 1986), Private Manufacturing - Assessment of the Impact of Past Policies and Future Adjustment Needs (No.6684-TU, July 21, 1987), and Second Financial Adjustment Loan (No.L2964-TU, June 21, 1988).  - 14 - in the near future. The Government has asked for Bank assistance in developing the securities market to enable it to reach its potential for efficient resource mobilization and allocation (proposed Third Financial Sector Adjustment Loan - FSAL III). B. Banking Reform Program 3.07 The structural reforms of the real sector, particularly the rapid devaluation and abrupt shift from negative to positive real interest rates, resulted in an intensification of financial distress in key sectors of the economy (Chapter II). Distress in the real sector quickly transferred to the financial sector. The large volume of non-performing loans, distress borrowing, distortions created by preferential credits, and deep-seated problems of the public sector banks threatened to undermine the banking system. In early 1988, the Government introduced a banking sector reform program with Bank assistance under FSAL II to forestall a banking crisis, strengthen the banking sector and further the process of financial liberalization initiated under FSAL I. The program was designed to improve resource mobilization and allocation by lowering taxation of the banking system, reducing distortions created by preferential credits, and minimizing currency substitution. On the institutional front, it aimed at strengthening the banking sector by reforming prudential regulations to make them consistent with internationally accepted guidelines and practices, carrying out a special portfolio audit of the system to uncover the nature and extent of portfolio problems, establishing a bank failure resolution mechanism to promote confidence, and improving bank supervision and oversight to prevent the recurrence of problems. 3.08 Implementation of the reform program is substantially completed. Its success is evidenced by the absence of a banking crisis, although some banks are still being restructured including the agriculture bank. Through changes in prudential regulations and improved audits and monitoring of banks the financial position and performance of the banking sector has been clarified. The capital base of the banking system has been increased, and non-performing loans have been identified, correctly classified and fully provided for. An institution to resolve bank failures in an orderly manner and insure small depositors is being established. With the establishment of this institution, the bank supervision system would be complete with adequate checks and balances to ensure quality on-site audits. Off-site monitoring and external audits of banks have been greatly improved by the Central Bank, through regular standardized reporting by banks and through quality control of auditors, respectively. Public sector banks are moving away from sectoral specialization into more diversified operations as they have to compete with private banks on a more equal footing. Four of the public sector banks are being privatized and the restructuring of the remaining banks, together with the growth of private domestic and foreign banks and the establishment of new banks, would reduce the absolute and relative size of public sector banking. The banking sector is, therefore, now much stronger than it was two years ago. 3.09 As part of the Central Bank's reforms to redefine its role as an autonomous monetary authority, the volume of preferential credits was severely  - 15 - curtailed and the remaining interest subsidies transferred to the Government. A gradual reduction of reserve requirements by banks reduced taxation of the banking system somewhat. It is the Government's intention to complete this reform by eventually abolishing all explicit intermediation taxes. With the full liberalization of the capital account in August 1989, and equalization of the treatment between foreign and local currency deposits, together with the real appreciation of the TL in most of 1989 and 1990, substitution of local currency deposits into foreign currency deposits not only stopped but reversed. With these reforms, currency holding is now mainly market driven. C. Investment Finance 3.10 Although the volume of credit to the private sector has increased in real terms, medium- and long-term investment credit remains scarce. Term finance in Turkey is provided mainly by the investment and development banks, which until recently relied heavily on multilateral and bilateral institutions, and Central Bank's rediscounts for their resources. Domestic resource mobilization by these institutions has been limited. The deposit money banks provided medium- and long-term loans to the extent that these loans were partly rediscounted by the Central Bank (the rediscounted share varies from 50% to 80% of the loan). However, the Central Bank facility has been abolished as of December 1989. Medium- and long-term industrial loans financed entirely out of the deposit money banks' own resources are limited. Their access to long-term credits from international financial markets is also limited to maturities of up to two years. With the availability of long-term refinancing resources under the proposed Project, the commercial banks are expected to play a more important role in this area. 3.11 Table 3.4 shows data on total industrial credit, as well as estimates of medium- and long-term industrial credit in Turkey. The table suggests that the growth in long-term credit has generally been stagnant for four reasons: (i) Central Bank rediscounts have not increased in real terms; (ii) development banks have experienced difficulties in mobilizing domestic resources and their utilization of foreign credits were constrained by the aversion by borrowers toward taking foreign exchange risks in unstable conditions; (iii) deposit money banks have been unwilling to provide long-term loans from their own resources a. they do not have long-term resources; and (iv) in line with the dramatic growth in private investment in the non- tradable sectors, the share of bank's overall credits to industry declined from 31% in 1985 to 17% in 1989 while the share of the housing sector rose from 11% in 1985 to 18% in 1988. However, the share of bank credits for the housing sector declined to 15% in 1989 because of the general slow down in the real estate market (Table 3.5).  - 16 - Taile 3.4: Turkey - Industrial Crwdit (1980-89) (in 1980 TL billion) Total Deposit Industrial Change Central Money Change Year Credit CZ) -Bank Banks 2F Total ,.S 1980 572 -- 11 9 149 189 -- 1981 697 222 24 18 189 231 37Z 1982 688 -12 54 40 206 301 302 1983 548 -20S 68 52 191 310 3S 1984 453 -175 58 46 158 262 -16S 1985 538 19S 56 44 131 231 -12S 1986 623 168 66 52 162 280 21S 1987 667 7S 69 50 157 277 -1X 1988 412 -38Z 42 27 126 194 -302 1989 Nov 335 -i9X 31 18 119 168 -13 Source: Central Bank of Turkey Table 3.5: TurkeY - Consolidated Commercial Banlk Credit by Economic Sector (X of total in current prices) Foreign Cons- Year ARriculture Industry Trade Tourism truction pthg Total 1980 18 36 9 -- 2 34 100 1981 20 25 11 -- 3 30 100 1982 19 31 16 -- 4 31 100 1983 21 22 20 -- 5 32 100 1984 17 27 18 -- 8 30 100 1985 17 31 16 -- 11 25 100 1985 18 25 20 -- 13 24 100 1987 18 23 22 -- 17 20 100 1988 20 19 22 1 18 21 100 1989 Nov 16 17 25 1 15 26 100 Source: Central Bank 3.12 To carry out necessary investments the private sector has increasingly resorted to equity financing in recent years. The average debt/equity ratio of 109 projects financed under the IEDP (Ln.2901-TU) was 30:70. Most investors are not willing to undertake large projects using short-term loans. The availability of long-term investment funds under the Project will therefore provide a strong impetus to increased private investments. D. Financial Markets 3.13 There has been considerable progress in the area of money and capital markets. First, in May 1985, the Treasury moved to an auction system for selling its securities and at the end of 1986 set up a regular auction schedule, which has enhanced the Treasury's ability to sell its debt. Second, in early 1987 the Central Bank introduced open-market operations. The further development of these operations will enable the Central Bank to control more effectively the money supply. Third, the interbank market is widely considered a success. Daily volume is estimated to be around TL 150-200 billion compared with TL 4 billion in early 1985. The development of the market has enabled banks with excess reserves to lend to banks facing temporary liquidity shortages. Fourth, the introduction of foreign exchange market in 1988 and gold market in 1989 have made a major contribution in  - 17 - developing the financial market in Turkey. Finally, the opening of the capital account in August 1989 was perceived as the final step needed to complete the liberalization process. 3.14 Turkey's stock market has become much more active since 1986 when it accounted for less than 3% of the financial system. The market capitalization of the listed shares increased from US$935 million in 1986 to US$3.2 billion in 1987, declined to US$1.1 billion in 1988, and then rebounded sharply to US$6.8 billion at the end of 1989. As of December 31, 1989, the market capitalization of the 50 companies listed in the Senior Market of the Istanbul Stock Exchange amounted to US$6.8 billion, or roughly 10% of the financial system and 8.6% of GNP. However, the size of the market is very small in comparison to the stock markets in other developing countries such as Korea (US$140 billion), Malaysia (US$39.8 billion), and Thailand(US$25.6 billion). The stock market in Turkey has not thus far been a major source of investment finance. The growth of the market has been inhibited by several factors: high and volatile inflation, low dividend payout, lack of adequate disclosure requirements and audited financial statements3 and the absence of institutional investors. High interest rates on other instruments especially treasury bonds and deposits make it less attractive for investors to invest in equities. Corporations are also allowed to issue commercial paper up to 6 times their equity. Moreover, interest expense on bank credit is fully tax deductible including the inflation component making debt financing more attractive than equity financing. FSAL I has made a major contribution in developing the stock market by supporting the Government's efforts to improve public dissemination of financial information by requiring auditing of companies listed on the stock exchange and companies selling securities to the public. A more comprehensive program to develop the capital markets is being prepared under the proposed FSAL III. 3.15 Although the financial markets have grown rapidly and performed relatively well their size is small and a large share has been channeled towards the financing of the budget deficit through large holdings of government bills and bonds. The most recent increase in deposit mobilization is due to the foreign exchange deposits but these resources are mainly used for trade financing. Sustained increases in long-term lending to the private sector will therefore depend principally on: (i) greater resource mobilization by the financial system with a more stable economy; and (ii) reduced absorption of domestic financial resources by the government through adequate fiscal adjustment. The project is designed in light of progress on these reforms and serves as a transitory catalyst to encourage an adequate supply response from both the financial and real sectors to these reforms. I Starting January 1, 1988, the 50 companies listed in the first market of the Istanbul Stock Exchange were required to have their 1988 accounts audited.  - 18 - IV. THE PROPOSED PROJECT A. ProJect Objectives 4.01 Building on the success of the Industrial Export Development Project (Ln. 2901-TU) the proposed Project aims to help finance the expansion of Turkey's productive capacity needed to sustain its export drive by providing long-term funds, and improving the credit delivery system that can perform the investment financing function on its own in future. Specifically, the objectives of the proposed Project are: (i) to support financially and economically viable private investments in areas of Turkey's comparative advantage, especially export-oriented activities, excluding agriculture; (ii) to continue to assist TSKB and SYKB in their business and resource diversification efforts to enable them to grow in an increasingly competitive financial system; and (iii) to support the implementation of the Government's financial sector reforms at the intermediary level by ensuring that participating private commercial banks continue to be financially sound and develop into intermediaries capable of mobilizing and allocating long-term resources more efficiently. B. Project Description 4.02 The proposed Project would provide long-term funds for private investments to help fill the financing gap. Conservatively, Turkey would need investment credit in the order of US$3.1 billion in the period 1991-93. This estimate of credit needs is based on recent investment trends, the pipelines of investment projects of the Participating Financial Institutions (PFIs) and their projected lending programs over the same period. Private industrial investment over the 1991-93 period is estimated at roughly US$6.3 billion assuming no growth. Assuming a debt/equity ratio of 1:1 credit requirement would be about US$3.1 billion. 4.03 The funds would be sub-lent initially tnrough ten private financial institutions (eight commercial banks and two development banks) to sub-borrowers in foreign currency at LIBOR plus a spread for the PFIs, with the sub-borrower taking the foreign exchange risk. The on-lending rate to the PFIs would be the same as the Bank variable rate plus an on-lending fee of 0.5Z. The PFIs would bear the cross-currency risk and manage it in accordance with the prudential regulations of the Banking Law. The participating financial institutions would also bear the credit risks and be responsible for appraising investment sub-projects in accordance with Bank standards, ensuring that sub-projects are financially and economically viable with a minimum Internal Financial Rate of Return and Internal Economic Rate of Return of 15Z in real terms. Each sub-project appraisal report would also include a statement of the impact of the proposed investment on the environment and proposed preventive measures where appropriate (para. 4.19). Only private investments in the production of tradeable goods and services, excluding agriculture, will be eligible for financing. 4.04 A technical assistance component of US$1 million is geared to assist the PFIs in institutional strengthening, with particular focus on  - 19 - improving their project finance techniques, systems and procedures, through staff training and consultancy services. Details of training and consultancy requirements were discussed during appraisal. Considering its importance, the PFIs have decided to finance this component with their own resources. Implementation of this component would be monitored in the course of project supervision to ensure that adequate funding by the PFIs of this component is provided as planned. C. Proiect Costs and Financing Plan 4.05 The total cost of the proposed Project is estimated at US$400 million of which about half would be in foreign exchange. The proposed Bank loan amounting to US$200 million will finance about 50X of the project cost. The balance will be financed through equity financing by private enterprises (US$200 million equivalent). The project funds would finance less than 5X of the investment credit needs of the private industry over a three-year period. The technical assistance component of US$1 million will be financed fully by the PFIs themselves. D. Proiect Beneficiaries 4.06 Sub-Droiect Eligibility Criteria. Under the IEDP explicit eligibility criteria were prescribed to promote export-oriented investments. These criteria were made flexible to avoid excessive concentration in a particular activity. The sub-projects financed under the IEDP were required to meet certain export achievement targets. However, with the opening-up of the capital account, the full convertibility of the Turkish Lira (TL) and further trade liberalization measures undertaken since 1989, the rationale for targeting lending to export-oriented industries has disappeared. Thus the proposed loan would be available for financing any efficient investment in the production of tradeable goods and services, except agriculture. However, since the loan funds under the proposed Project would be on-lent in foreign currencies, prudence in lending is required to minimize unhedged exposures to foreign exchange risk. To signal this need for prudence some differentiation in lending terms between export and non-export oriented investments would be required. Non-export o-iented industries would be subject to more stringent financial covenants. Specifically, the debt/equity ratio for non-export oriented companies would be 40:60 while that for export-oriented companies would be 50:50. The debt service coverage ratio would be 2:1 for non-export oriented companies and 1.5:1 for export-oriented companies. During negotiations an agreement was reached with the Government and participat'ing financial institutions that only sub-projects that meet the above-mentioned eligibility criteria will be financed under the Project.  . 20 - E. Particliating Financial Institutions and Eligibility Criteria 4.07 Under the proposed Project, Bank funds will be channelled initially through two private development banks and eight private commercial banks. As the leading private development banks in the country, TSKB and SYKB have been the major sources of long-term foreign exchange resources for the Turkish industry. TSKB enjoys good standing in the industrial and financial communities. It has developed a cadre of competent staff with good project appraisal skills and experience. During 1980-85, it faced severe financial problems but, with Bank assistance, it has since fully restored its financial viability. SYKB is a well managed financial institution and has played a more active role in financing small- and medium-scale industries. However, it is expanding its market scope and is moving into large-scale industry financing as well. Participation in the Project by both institutions will be subject to the eligibility criteria discussed below. 4.08 I=. The project files contain a detailed appraisal of TSKB. TSKB was set up in 1950 by a group of Turkish commercial banks and insurance companies with the objective of providing long-term financing for private industry. IFC also assisted TSKB as an investor and co-financier and at present holds 2% of TSKB's equity. The Bank has actively supported TSKB's development and as of June 30, 1987, had made to it 15 credits and loans totalling $532 million. The latest loan of US$150 million for export industries (IEDP) was approved in January 1988. Since 1980, TSKB has operated in an extremely difficult financial environment. During the 1980-85, TSKB faced severe financial problems because of the massive and successive devaluations which resulted in large non-performing loans. The situation was exacerbated by the lack of domestic resources and the restrictions in its Charter, which prohibited TSKB from diversifying its activities beyond term lending. Because of low profitability TSKB was unable to build up adequate reserves and to raise new capital. As a result, TSKB was undercapitalized for the type of business it was doing. The high non-performing assets and lack of domestic resources led to a tight liquidity position and a negative interest rate spread in 1985 on its existing portfolio. 4.09 The Bank mission which visited TSKB in October 1986 assisted TSKB's management in devising a comprehensive financial and operational restructuring program to address its fundamental problems so that it could again play an active role in the financial system. The main elements of the financial restructuring plan consisted of: (i) doubling share capital from TL 20 billion to TL 40 billion over the 1987-88 period; (ii) raising long-term TL resources by TL 20 billion to enable TSKB to lend in local currency; (iii) increasing the spread by introducing a 2% p.a. service charge; and (iv) restructuring the terms of its existing quasi-equity loans. The main elements of the operational diversification plan entails offering of a broader range of banking services including: (i) working capital finance initially limited to its existing clients; (ii) money market operations, especially commercial paper; (iLi) capital market operations, especially government securities and finance bonds; (iv) portfolio management; and (v) leasing.  - 21 - 4.10 To enable it to implement the diversification program, TSKB initiated a reorganization study in November 1986 with the assistance of a consultant from Morgan Guaranty Bank. The study was completed in January 1987 and implementation of the study's recommendations started in mid-1987. The main objective was to transform TSKB from a development bank to a merchant bank capable of performing all capital market activities. TSKB also sought assistance from the Saudi American Bank for its treasury and computerization program. TSKB's financial and operational restructuring is now substantialiy completed. TSKB's paid-in capital was increased from TL 22.6.billion in 1986 ,to TL 76.8 billion in 1989. A new quasi-equity agreement was reached with the Government in May 1987. These arrangements have substantially increased TSKB's capital base. On February 15, 1987, TSKB raised Y 9.5 billion in the Japanese market through a private placement on satisfactory terms and conditions. The proceeds of US$62 million equivalent of the seven year yen issue was swapped in TL with the Central Bank at the discount rate. During 1988-90 TSKB raised an additional Y 20 billion from the Japanese bond markets. These additional resources together with US$150 million from the Bank under IEDP, enabled TSKB to increase its lending sharply during the 1987-89 period. TSKB's net profit rose from TL 1.0 billion in 1986 to TL 28 billion in 1989. Its assets rose from TL 544 billion in 1986 to TL 1,858 billion in 1989. Today, TSKB is liquid and is considered a sound financial institution by the financial community. 4.11 TSKB has developed good liability management skills. It has been successful recently in raising domestic funds by selling its commercial paper. TSKB is now one of the most active participants in the fast growing Istanbul Stock Exchange and is active in the money market and interbank trading operations. It is also active in the underwriting of commercial paper for its clients. The most difficult part of TSKB restructuring i.e., organization and personnel was completed in May 1990. TSKB has managed its reorganization with great care and is now well staffed to play a greater role in Turkey's financial system. 4.12 Partici_ation Conditions. The participation conditions for TSKB under the proposed Project are: (i) its adherence to its board-approved revised policy and strategy statements, as agreed with the Bank; (ii) satisfactory implementation of its board-approved corporate development program, as agreed with the Bank; (iii) a maximum debt/equity ratio of 10:1 and a minimum debt service coverage ratio of 1.10:1, as defined in the Loan Agreement; (iv) a clean audit by external auditors in accordance with internationally accepted accounting principles; (iv) compliance with the loan loss provisioning and loan concentration standards, as agreed with the Bank; and (vi) a minimum annual collection ratio of 85% (excluding cases under legal action and write-offs). TSKB is currently in compliance with all the participation conditions. Its continued compliance with these conditions will be monitored regularly in the course of project supervision. Together with its annual audit, TSKB's external auditors will certify in a separate opinion TSKB's compliance with its maximum debt/equity ratio, its minimum debt service coverage ratio, its minimum collection ratio and its compliance with the loan loss provisioning and loan concentration standards agreed with the Bank. Should it violate any of these conditions at any time the Bank will have the  - 22 - option of suspending TSKB's participation in the Project. Continued suspension for a period of six months would result in the cancellation of its participation in the Project. A free limit of US$6 million equivalent is approved for TSKB. 4.13 SK. The project files contain a detailed appraisal of SYKB. SYKB was set up in 1963 by five major commercial banks in Turkey to finance private industrial investment. Is Bank, the largest private commercial bank in Turkey, owns 60% of SYKB's paid-in capital, which amounted Lv TL 20 billion at the end of 1989. SYKB has, to-date, received six loans amounting to US$285 million from the Bank. These were loans for the textile industries (US$15 million); labor-intensive industries (US$40 million); the small- and medium-scale industries - SMI (US$80 million); Industrial Export Development Loan (US$50 million), Agro-industries (US$50 million); and the Second SMI Loan (US$50 million). As a whole, the investment objectives of all of these loans have been met satisfactorily. The performance of SYKB was evaluated by the Operations Evaluation Department and found to be satisfactory (PPAR dated June 6, 1989). 4.14 SYKB is a well managed financial institution and has built up a team of competent staff. During the last few years, SYKB concentrated mainly on providing long-term finance to small- and medium-size industries. However, in line with the changes in the financial system and the expected demand for funds from large industries, SYKB plans to amend its strategy to enable it to expand its market scope. As a prudently managed financial institution, SYKB plans to proceed cautiously in its diversification efforts. In this connection, it has prepared a new operational. strategy to guide its operations. It is also in active dialogue with a money center bank in New York to obtain technical assistance for its zapital market operations and its computerization needs. The appraisal missiton found SYKB's strategy to be satisfactory. 4.15 Participation Conditions. rThe conditions for SYKB's participation in the Project would be the following: (i) ..zisfactory implementation of its board-approved business diversification plan, as agreed with the Bank; (ii) adherence to its board-ap-roved revised policy :ind strategy statements, as agreed with the Bank; (iii) a clean audit by exv:ernal auditors in accordance with internationally accepted accounting princ DIes; (iv) compliance with the loan loss provisioning and loan concentration cvtarudards, as agreed with the Bank; (v) a minimum debt service coverage ratio of 1.10:1 and a maximum debt/equity ratio of 10:1, as defined in the Loan Agreement; and (vi) a minimum collection ratio of 85% (excluding cases under legal action and write- offs). SYKB is currently in compliance with all the participation conditions. Its continued compliance with the participation conditions will be monitored regularly in the course of project supervision. Together with its annual audit, SYKB's external auditors will certify in a separate opinion SYKB's compliance with its maximum debt/equity ratio, its minimum debt service coverage ratio, its minimum collection ratio and its compliance with the loan loss provisioning and loan concentration standards agreed with the Bank. Should SYKB violate any of these conditions at any time the Bank would have the option of suspending SYKB's participation in the Project. Continued  - 23 - suspension for a period of six months would result in the cancellation of its participation in the Project. A free limit of US$3 million is approved for SYKB. Particigating Commercial Banks (PCB) 4.16 In addition to the two development banks, Bank funds will be channelled initially to eight commercial banks. The Industrial Export Development Project was the first Bank project in Turkey that used private commercial banks as a vehicle to provide long-term funds to private industries. The commercial banks' performance under this project has been satisfactory. As commercial banks are major players in the financial system, their participation has increased competition in the provision of investment funds for private investments. The overall efficiency of the financial system has been promoted because of the added competition. In the past, participation by commercial banks has been constrained by their limited project appraisal capacity and their lack of access to long-term domestic and foreign resources. The proposed Project would help address these constraints by providing the PCBs with matching long-term resources for on-lending and technical assistance to improve their appraisal capacity. 4.17 All eight commercial banks (Ak, Is, Dis, Yapi, Garanti, Vakiflar, Ekononi, Iktisat) which participated under the IEDP have indicated their keen interest to participate under the proposed Project. Table 4.1 provides a profile of these eight banks.' Based on the mission's assessment, all of the banks except for Is and Iktisat are in compliance with the Project's participation conditions and will be active participants. Is Bank is most likely to be in compliance in early 1991. A more comprehensive evaluation of Iktisat will need to be carried out to determine its eligibility. Continued compliance by the PCBs with the participation conditions will be monitored regularly in the course of project supervision. Should any PCB violate any of the participation conditions at any time the Bank will have the option of suspending its participation in the Project. Continued suspension for a period of six months would result in the cancellation of a PCB's participation in the Project. 4.18 Participation Conditions. In view of the reforms undertaken in the banking system, the selection of participating commercial banks has been carefully done to ensure that only those banks that remain creditworthy in the new regulatory environment participate in the Project. In the Turkish context, these are important regulations that have had a positive impact in institutional building and in encouraging financial discipline in the banking system. All PCBs are required to meet the following conditions: (i) a clean audit by external auditors in accordance with the internationally accepted accounting principles; (ii) compliance with the new prudential regulations on loan loss provisioning, capital adequacy, and loan concentration in accordance with the Banking Law; (iii) adherence to their board-approved policy and strategy statements, as agreed with the Bank; (iv) a positive real return to 4 Appraisal reports on these banks are available in the project files.  - 24 - equity, defined as the ratio of year-end net profits after tax to total equity at the beginning of the year less the WPI change for the same year; and (v) a minimum collection ratio of 85X on its medium and long term loans (excluding cases under legal action and write-offs); anL (vi) satisfactory project appraisal and supervision capacity for investment projects. The annual audits of the PCBs would have to include separate opinions by the external auditors that the PCBs are in compliance with the prudential regulations on loan loss provisioning, capital adequacy and loan concentration, and have achieved a positive real return to equity and a minimum collection ratio. Table 4,1: TurkeX - Particinatina Commercial Banks (1989) (TL billion) Tot liab Return Sec Parti- Other Total Total Other Net & Net Net on PCBs Portf. Loans civat. Assets Assets Dewosi. Liabil. Worth Worth Profit Eo3uitX AkBank 882 2368 198 816 6956 4939 1142 875 6956 345 49.6 Isbank 1380 4147 583 1635 11805 8776 2146 882 11805 124 16.6 Disbank 60 535 6 128 922 389 458 75 847 20 30.3 Yapi ve Credit 813 1788 301 1340 6505 4918 1162 425 6505 134 35 Garanti Bankasi 433 1665 196 532 4201 3019 898 284 4201 71 31.7 Ekonomi 113 314 0 36 729 308 314 107 729 39 48.1 Iktisat 85 662 82 145 1198 453 650 96 1198 35 49.6 Vakiflar 980 1919 223 307 5870 4123 1348 399 5870 150 43 Total PCBs 4746 13398 1589 4939 38186 26925 8118 3143 38111 918 38.0 Total Private Banks 5929 16716 1881 6833 46484 31150 11282 4053 46484 1028 32.2 Total Dom.Com.Banks 12014 38379 3346 18701 98967 60557 27990 10421 98967 1751 23 Foreign Banks 462 1477 19 329 3453 1844 1310 299 3453 137 58.5 Total Com. Banks 12476 39856 3365 19030 102420 62401 29300 10720 102420 1888 24.1 Total PCBs as% of pri 80.01 80.2X 84.5X 72.3X 82.11 86.41 72.01 77.52 82.0S 89.3% 118.02 Total PCBs as% of pri 38.02 33.62 47.2X 26.0S 37.31 43,11 27.71 29.31 37.21 48.61 157.61 Source: The Banks Association of Turkey F. Environmental AsRects 4.19 All sub-borrowers would be required to comply with the environmental protection regulations of the Government. In appraising subprojects, the PFIs will be responsible for ensuring that sub-borrowers have received clearance from the relevant regulatory agencies regarding the environmental impact of their investments. Sub-borrowers will thus be required to submit evidence of clearance from the environmental authorities that environmental concerns identified would be addressed through appropriate measures. During subproject implementation, the PFIs will review compliance with environmental regulations and requirements by subprojects in the course of normal subproject supervision. The PFIs would report and coordinate regularly with the environmental authorities to help monitor compliance. This approach to environmental protection by the PFIs is reflected in their policy and strategy statements.  - 25 , V. THE PROPOSED LOAN A. Amount and Allocation of Funds 5.01 The proposed Bank loan of US$200 million will be made to GOT for on-lending through eligible PFIs to private enterprises. The Bank loan to GOT will be made at the Bank's standard variable interest rate and will have a fixed amortization of 17 years including a grace period of 5 years. The Government will on-lend the loan funds to the PFIs on the same terms and conditions as the Bank loan plus an on-lending fee of 0.5%. Each PFI will be allowed to extend loans to its borrowers for up to 8 years including a grace period of no more than 3 years in one or more of five currencies (DM, Sf, Sterling, US$, Yen). The PFIs will carry the cross-currency risk. The PFIs could manage this risk basically by relending to sub-borrowers in currencies that reflect the Bank's currency pool. Other risk management tools will have to supplement this basic approach. In any case, the PFIs will have to comply with the Central Bank's prudential regulations on foreign exchange risk exposure. 5.02 Out of the US$200 million loan, US$50 million will be allocated to TSKB and US$40 million to SYKB through subsidiary loan agreements between the Government and these institutions that are satisfactory to the Bank. The balance of US$110 million will be allocated to the PCBs on a first-come- first-served basis through subsidiary loan agreements as well. Signing of the subsidiary loan agreements, satisfactory to the Bank, by at least one development bank and one commercial bank will be a condition of loan effectiveness. Each PCB would have an initial allocation ceilirg of US$30 million or 100% of its net worth, whichever is lower. These ceilings will be reviewed from time to time during project implementation and appropriate adjustments will be made in coordination with GOT and the PCBs. Since the amount utilized by each PCB would only be known ex-post, the Government will initially pay the commitment fees on the amount allocated to the PCBs. However, to enable the Government to recover the commitment fees, each subloan disbursed to a PCB would carry a one-time commitment fee of 0.75% which would be paid by the sub-borrower, collected by the PCB and remitted to the Government. These arrangements were finalized and agreed during loan negotiations. B. On-lending Rates and Foreign Exchange Risk 5.03 Foreig-n Exchange Risk Insurance Scheme (FERIS). The funds under other Bank projects including IEDP were on-lent in local currency and the foreign exckange risk was assumed by FERIS. In connection with the preparation of the proposed Project, the Bank carried out a study of the viability of FERIS. The study showed not only that improved management of FERIS would reduce its losses but also that FERIS would continue to incur losses due to its basic mandate and structure. In October 1990, the Government decided to abolish FERIS but allow it to wind down until all committed loans are disbursed. In the meantime, no new resources will be added to FERIS until December 1992, the end of the current government's political mandate. The Bank supports the Government's decision to abolish  - 26 - FERIS since it is highly distortionary. An agreement was reached that should there be a reversal of this decision, the Bank would have the option of suspending or cancelling the Project. A revival of FERIS would not only dampen the demand for loans under the Project, but more importantly, would perpetuate a major distortion in the credit market. 5.04 In view of the FERIS reform, it is proposed that the sub-loans under the Project be denominated in foreign currency. The sub-borrower will be given an option to borrow in a currency of his choice at the prevailing 6- month London Interbank Offered Rate (LIBOR) plus a spread to be negotiated with his PFI. Since the Bank loan is based on a currency pool (30% in US$, 30% in Yen, 30% in European currencies and 10% in other currencies) and it is a targeted pool, it is not possible to ask the sub-borrower to bear the exchange risk of the pool, which is unknown ex-ante on a subloan by subloan basis. It is therefore proposed that the sub-borrower be allowed to borrow in single foreign currencies. Under this arrangement, the Government will on- lend the Bank funds to the PFIs on the same terms and conditions as the Bank loan plus an on-lending fee of 0.5%, with the PFIs carry the cross-currency risk. Based on present market conditions, the cost to the sub-borrower could be around LIBOR + 2-3 % plus other fees, such as commitment fees, appraisal fees, etc. Naturally, the willingness of the su,b-borrowers to assume the foreign exchange risk will depend inter alia on their assessment of the future value of the TL, and the structure of their assets and liabilities. After the three-year grace period, the sub-borrower will be given an option to prepay the subloan to the intermediary without any penalty to reduce this risk. To make things simple the PFIs may consider limiting the currency option initially to five currencies (DM, Sf, Sterling, US$, Yen). These arrangements were agreed with the Government and the PFIs during loan negotiations. C. Administration Subloan Size. Free limits and Review procedures 5.05 TSKB. SYKB and VB. The proposed free limits for TSKB, and SYKB and Vakiflar Bank (VB) under the project are US$6 million, and US$3 million, respectivref-. The free limits for TSKB, and SYKB and VB have been increased from US$5 million and US$2.5 million respectively, to reflect inflation, exchange rate changes and the expected change in client mix under the proposed Project. It is expected that about 20 sub-projects would be financed by TSKB, and 30 by SYKB and VB. The proposed free limits would give the Bank adequate control on the quality of subproject appraisals and assurance that only enterprises that meet the agreed eligibility criteria will be financed. The maximum subloan size per subproject under from a single PFI would be US$8 million. However, when a subproject is financed jointly by several PFIs, the maximum aggregate subloan under the Project may go up to a maximum amount of US$20 million equivalent, provided the maximum exposure of each PFI does not exceed the maximum allowed by the Banking Law, in the case of the PCBs, and the limits agreed with the Bank, in the case of TSKB (15% of networth) and SYKB (20% of networth). Currently, there is a single borrower exposure limit of 10% of net worth and a single group exposure limit of 100% of net worth. Under consideration is a revision in the regulations to reduce the single  - 27 - group exposure limit to 50% of net worth. Under the project, the new group limit would already apply to the PCBs for subprojects financed by Bank funds. Since the Bank has funds for small and medium-scale enterprises under SMI II, the minimum subloan size under the Project would be US$500,000, to minimize overlapping coverage. 5.06 Participating Commercial Banks. Since, except for VB, the commercial banks still have limited experience in appraising subproject proposals, it is proposed that the Bank review each subloan application from them. The participating commercial banks would submit their subloan applications together with the appraisal reports to the Bank. D. Reporting Reguirements and Audits 5.07 TSKB will be required to submit quarterly progress reports in formats acceptable to the Bank. These reports will cover TSKB's financial condition and results, utilization of Bank funds, the achievement of operational targets, achievement of the agreed operational diversification and financial restructuring programs, and training. TSKB will also provide revised financial projections twice a year. TSKB's reporting requirements were discussed during appraisal and were confirmed during negotiations. SYKB will continue to provide the same quarterly progress reports as under the previous loan. However, the coverage will be expanded to include performance monitoring of its major portfolio problems, its diversification efforts, and semi-annual financial projections. The PCBs will submit quarterly reports on the utilization of Bank funds. The report'ng requirements were agreed upon during negotiations. 5.08 TSKB and SYKB are audited by private external auditors with international affiliations which are acceptable to the Bank. Audit reports will continue to be required for submission to the Bank within 150 days of the close of their financial years. In addition to the financial audit reports, they will continue to be required to provide long form audits. Both TSKB's and SYKB's 1989 audit reports were unqualified. The PCBs are audited by private external auditors with international affiliations which are acceptable to the Bank and are among the Central Bank-approved auditors. They will continue to be required to submit their annual financial reports in accordance with the eligibility criteria no later than 150 days after the close of their respective financial years. The six PCBs that are already considered eligible to participate in the Project had clean audits for FY 1989. E. Procurement and Disbursements 5.09 Goods and services financed under the proposed Project will be subject to standard procurement procedures for financial intermediation projects. For contracts below US$5 million, the present commercial practice of local and international shopping and limited bidding with at least three quotations will be followed. Project sponsors would seek bids from a list of potential suppliers broad enough to ensure competitive prices. Sponsors would notify embassies and trade representatives of Bank Group member countries, Switzerland and Taiwan. Advertising in the international press will not be  - 28 - required. However, International Competitive Bidding (ICB) would be required for individual contracts of US$5 million and above except for the following reasons, with the prior approval by the Bank: (i) for modernization and expansion subprojects when the equipment or machinery required is standardized or proprietary; (ii) when there is a limited number of suppliers; and (iii) for justifiable technical reason. The participating financial institutions will be required to maintain records of the methods of procurement used for Bank supervision. 5.10 The proceeds of the Bank loan for the credit component would be disbursed at the rate of 100% of the CIF cost of machinery and equipment, 70% of the cost of imported machinery and equipment procured locally (to factor out taxes and duties paid), and 50% of the ex-factory cost of locally manufactured machinery and equipment (to capture the foreign cost content). Special accounts will be established for TSKB, SYKB and the PCBs to facilitate disbursements. The amounts in the special accounts were agreed with the Government and the PFIs during negotiations, i.e., a total of US$15 million for the PCBs and US$5 million each for the TSKB and SYKB. All disbursements would be on the basis of full documentation due to their large sizes. 5.11 Closing Date. Based on the pipelines of the participating banks, it is expected that the credit component of the Project will be committed within three years and disbursed within five years of Board approval. Therefore, it is proposed that the last date for submission of sub-loan applications to the Bank will be December 31, 1994. The closing date of the loan will be June 30, 1996. VI. PROJECT BENEFITS AND RISKS 6.01 Benefits. The proposed Project will provide some of the long term funds needed to expand Turkey's productive capacity to sustain its export drive. In the transition to a more stable economy, the Bank's assistance will help the banks develop more capacity to mobilize resources domestically and prudently perform their term transformation function. 6.02 Based on past experience, the Project is expected to support private investments in the order of US$400 million and exports of about US$200 million, and result in the creation of about 14,000 new full time jobs. With a minimum economic rate of return of 15%, all sub-projects financed under the Project are expected to be efficient and internationally competitive operations. The Project would continue to promote greater competition among financial iustitutions and improve their performance. It would continue to encourage the development of a market-based credit delivery system for industrial finance that can efficiently mobilize and allocate long term resources. 6.03 Risks. The potential project risks would stem from: (i) a slow down in private investment due to deteriorating macroeconomic conditions and a change in the investmert climate; (ii) a change in relative prices due to a reversal of trade liberalization policies; and (iii) a reluctance by Turkish  - 29 investors to assume foreign exchange risk in unstable economic conditions. The Government, however, has made macroeconomic stabilization as a primary policy objective and fiscal policy is expected to be aligned with the restrictive monetary policy of the Central Bank not only as a central anti- inflationary tool but also as a signal to the markets. It is also the announced Government policy to continue to liberalize imports, maintain a realistic exchange rate policy, promote exports and rationalize the industrial incentive framework to promote greater efficiency. Should these policies be reversed to an extent that the Project's viability is jeopardized, there could be a suspension or cancellation of the Project in the context of a reconfiguration of the Bank's overall relationship with Turkey. VII. AGREEMENTS REACHED AND RECOMMENDATIONS 7.01 During negotiations, agreements with the Government and the PFIs were reached Gn the following: (a) Abolition of FERIS and option by the Bank to suspend or cancel the Project should there be a reversal of this decision (para. 5.03); (b) Allocation of funds (US$50 million for TSKB, US$40 million for SYKB and US$110 million for PCBs on a first-come-first-served basis) (para. 5.02); (c) On-lending by GOT of the amounts allocated to TSKB, SYKB and the PCBs by means of satisfactory subsidiary loan agreements. Signing of satisfactory subsidiary loan agreements between GOT and at least one development bank and one commercial bank would be a condition of loan effectiveness (para. 5.02); (d) The participation conditions for the TSKB (para. 4.12); (e) The participation conditions for SYKB (para. 4.15); (f) The participation conditions for PCBs (para. 4.18); (g) On-lending rates and foreign exchange risk (para. 5.04); (h) Sub-project eligibility criteria (para. 4.06); (i) Reporting and auditing requirements for TSKB, SYKB and the PCBs (paras. 5.07-5.08); (j) The amounts in the Special Accounts (para. 5.10). 7.02 Agreement was reached with the Government and the PFIs that the maximum subloan size for a subproject from a single PFI would be US$8 million. However, when a subproject is financed jointly by several PFIs, the aggregate subloan amounts under the Project may go up to a maximum of US$20 million, provided that in no case can the maximum exposure of any PFI exceed the limits  - 30 - required under the Banking Law, in the case of the PCBs, and the limits agreed with the Bank, in the case of TSKB and SYKB. The minimum subloan size per subproject would be US$500,000, to minimize overlap with the Second SMI Loan (para. 5.05). 7.03 Agreement was reached with the Government that the initial allocation to a PCB would be a maximum of US$30 million or 100% of equity of the PCB whichever is less unless otherwise agreed by the Bank (para. 5.02). 7.04 Agreement was reached that sub-borrowers would be allowed to prepay their subloans at any time after the grace period of three years without a penalty (para. 5.04). 7.05 The proposed Project constitutes a suitable basis for a Bank Loan of US$200 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.  - 31 - ANEXI TURKE PRIVATE INVESTMENT CREDIT PROJECT ECONOMIC IMPACT OF THE INDUSTRIAL EXPORT DEVELOPMENT PROJECT (LN.2901-TU) Summary 1. The US$298.5 million loan for private export-oriented investment projects became effective in January 1988 and was fully committed by mid- 1989, two years ahead of schedule. Originally designed to contribute to the financing of a total of around US$600 million in sub-project investments, the loan actually facilitated total investments in excess of US$2 billion, with incremental export sales from the sub-projects projected at around US$500 million and total sales at US$1 billion. Sub-projects had an average projected internal economic rate of return (IERR) of 391, well above 151 minimum IERR set for sub-project eligibility. The high average IERR and high ratio of total incremental sales to total investment stem largely from the fact that many of the sub-projects involved the expansion or balancing of existing manufacturing facilities rather than the establishment of new facilities. Description of Project 2. The Industrial Export Development Project (IEDP) was designed to support Turkey's drive to expand exports. It consisted of a credit component of US$298.5 million and a technical assistance component of US$1.5 million. The project was implemented by two private development banks (TSKB) and SYKB), eight major private commercial banks. At the time of appraisal, it was projected that the Bank line of credit along with other loans and equity contributions would finance eligible sub-projects with a total investment cost of around US$600 million. Eligible sub-projects were expected to export at least 20% of incremental production within 3 to 5 years after start-up and generate a minimum economic rate of return of 151 in real terms. The loan became effective in January 1988. At the time of appraisal, it was projected that the loan would be fully disbursed by 1992. Preliminary Results of Project 3. The June 1990 data on the implementation of the project show that the project had already far exceeded initial expectations. Already by mid- 1989 funds were fully committed. Though a number of sub-projects are at the implementation or start-up stage, as of June 1990 the project had assisted in financing over US$2 billion in eligible investments. Incremental sales as a result of these investments are estimated at around US$1 billion per year and incremental exports are projected to be around 50% of this amount or US$500 million per year. The weighted average economic rate of return for the sub- projects was estimated at 39% which is higher than appraisal estimates.  - 32 - 4. Sub-project Financing. As shown by the table in Annex 1.1, 115 sub-loans were financed using US$248 million from the line of credit. It is noteworthy that the sub-project sponsors had strong balance sheets with an average debt:equity ratio of 28:72. Equity contribution amounted to around US$980 million or 472 of the total cost of these sub-projects (see also Annex 1.2). Furthermore, resources mobilized from other sources were three times the amount of the Bank sub-loans. 5. Sub-sectoral Distribution of Sub-projects and Investments. From Annex 1.2 it can be seen the textile sub-sector accounted for roughly 40% of the number of sub-projects and 441 of total sub-project investments. The rubber sub-sector, which accounted for only 4% of the sub-projects, represented almost 24X of total investments. Other major sub-sectors included glass manufacturing (10 of sub-projects and 7X of total investments) and tourism (10% of sub-projects and 13% of total investments). Thus, four sub- sectors accounted for 64% of all sub-projects and 882 of total investment. 6. Export by Destination. From Annex 1.4, it can be noted that EEC, with 47% of total exports, is the most important export market of the sub- projects financed under the project. The Middle East, with 222 of total exports, is the second most important market.  ANMEX 1.1 TURKEY - IIDUSIRIAL EXPORT DEVELOPMENT PROJfCt Project Financing and financial Situation of Subborrouers by Sector .. ......... ............ I.... --------------------------------------------- (S thousands) Subproject financing .---.------..-..----.--.-..-.--.----.--.. Subborrowers Recent Financial Debt Subproject Structure and perforaanre No of ............................. Rates of Return 1.----------------------- Sub- Project IEOP I Other Other Cross Debt:Equit Sector projects Cost Subloan IORD Loans Total Equity fRR ERR Sales Profit Ratio 2 Food 3 13,792 4,012 0 425 4,437 9,355 41 28 90,724 2,525 22 78 lextiles