Turkey - Technology Development Project

Document of The World Bank FOR OFFICIAL USE ONLY D a J O S F b 7 D Report No. 9079-TU STAFF APPRAISAL REPORT REPUBLIC OF TURKEY TECHNOLOGY DEVELOPMENT PROJECT JANUARY 29, 1991 Industry, Trade and Finance Division Country Department I Europe, Middle East and North Africa Region 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 USS1.00 1986* TL 674.5 1987* TL 857.2 1988* TL 1,422.3 1989* TL 2,121.7 1990* TL 2,629.0 1991 (Januar') TL 2,961.0 I/ Annual Average LIST OF AB8REVIATIONS AFCs All.oiwable Full Costs EACHH - Economic Affairs Higher Coordination Council EC - European Community FSAL - Financial Sector Adjustment Loar. FWCT - Foundation for World Class Technology GAC - General Advisory Council GATT - General Agreement of Trade and Tariffs GNP Gross National Product GOT - Goverraient of Turkey IEC - International Electrotechnical Commission IEDP - Industrial Export Development Project IGEME Export Promotion Board IPks - Intellectual Property Rights ISO - International Standards Organisation ITD - Industrial Technotogy Development KSRI - Korea Standards Research Institute MLF - Matching Laboratory Fund MSTO Metrology, Standards, Testing and Quality System NAC - National Accreditation Council NATO North Atlantic Treaty Organisation Nics - Newly*Industrialtised Countries NMSI - National Measurement Standards Institution OECD - Organizations for Economic Co-operation and Development PIU - Project Implementation Unit PTB Physikalisch-Techr%ische Bundesanstalt R&D - Research and Development SAL Structural Adjustment Lending SBIC - Small Business Investment Corporation SDC - Science Documentation Centre SMEs - Small and Medium Enterprises SMI - Small and Medium Industries SMIDO Small and Medium Industries Development Organisation S&r - Science and Technology SPO - State Plann;ng Organisation TETM Information Technologies Centre TSE Turkish Standards Institute TUBITAK Scientific and Technical Research Organisation of Turkey TUSIAD Turkish Industrialist and Businessmen Association UCICCE - Union of Chambers of Industry and Commerce and of Commodity Exchanges UNIDO - United JNotions Industrial Development Organisation UNDP - United Nations Development Program VCC - Venture Capital Company VCF - Venture Capital Fund VCM - Venture Capital Management Company VCMF - Venture Capital Management Company and Fund YiK - Higher Education Council REPUBLIC OF TtLtKEY FISCAL YEAR January 1 - Decesber 31  FOR OFFICIAL USE ONLY STAFF APPRAISAL REPORT TURKEY TECHNOLOGY DEVELOPMENT PROJECT Table of Contents Chapter Page No. PROJECT SUMMARY ...................................... i I. INTRODUCTION ......................................... 1 II. THE STRATEGY FOR INDUSTRIAL COMPETITIVENESS .......... 2 A. Background ....................................... 2 B. Industrial and Financial Sector Strategy in the 1980s ........... ................................. 3 C. Bank Lending to Industry and Finance .... ......... 9 III. THE STRATEGY FOR INDUSTRIAL TECHNOLOGY DEVELOPMENT ... 10 A. The International Situation ...................... 10 B. The Strategy for ITD in Turkey ................... 12 C. Conclusions ...................................... 19 IV. THE PROJECT. LOAN AND CREDIT ......................... 20 A. Objectives and Scope ............................. 20 B. Justification for Bank Intervention .... .......... 20 C. Detailed Project Description ..................... 21 D. Benefits and Risks ............................... 34 E. Project Costs and Financing ...................... 36 F. Environment Impact ............................... 38 V. PROPOSED LOAN ........................................ 38 A. Terms and Conditions ............................. 38 B. Administrative Requirements ...................... 39 VI. AGREEMENTS REACHED AND RECOMMENDATIONS ...... .. ....... 42 This report was prepared by Mr. Oppenheim (EM1ID). Mr. Malas (IFC). Mr. Shetty (EMTIE) and Messrs. Hitchins. Woodcock, Street, Mast, Rathbone and Lalkaka (Consultants). The Peer Reviewer is Mr. DahLman (ZENIN). The responsible Division Chief is Ms. Nishimizu (EM11D) and Director, Mr. Wiehen (3M1). 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.  List of Annexes ANNEX 1 The SciEntific and Technical Research Council of Turkey (TUBITAK) ANNEX 2 The Turkish Standards Institution (TSE) ANNEX 3 Documents in Project File  TURKEY TECHNOLOGY DEVELOPMENT PROJECT LOAN AND PROJECT SUMMARY Borrower: Republic of Turkey Beneficiaries: The Turkish Standatds Institute (TSE) The Scientific and Technical Research Organisation of Turkey (TUBITAK) The Foundation for World Class Technology (FWCT) Amount: US$100.0 million equivalent. Terms: Seventeen years including a five year grace period at the Bank's standard variable interest rate. Relending Terms: Metrology. Standards. Testing & Quality Component. US$42.4 million of the Bank loan would be on-lent to TSE as an income note with payments based on TSE revenues over 17 years. Foreign exchange risk will be assumed by the Government. The remaining US$14.3 million of the Bank loan for this component will be allocated by the Government as a grant to TUBITAK. Research and Development (R&D) Component. US$43.3 million of the Bank loan will be allocated as a grant by the Government to the Foundation 'or World Class Technology. Venture Capital Component. IFC will invest up to US$5.0 million in the Venture Capital Fund and US$0.1 million in the related Management Company. There is no Bank loan financing for this component. Project DescriDtion: The strategy of the Government of Turkey for industrial technology development (ITD) has been to support firm- level productivity growth within competitive markets through (a) investing in the Metrology, Standards, Testing and Quality System (KSTQ), (b) funding research and development activities and (c) strengthening the framework for capital market activities. Despite gains made in these three areas, weaknesses persist constraining the performance of the Turkish economy. The project therefore has three components. The first component will bring the MSTQ system to OECD standards by (a) capacity building in the key public sector institutions and (b) fostering private participation in  - ii - the system. The second component finances a Foundation that will use seed capital to catalyse private sector investment in ITD (especially applied research). The third component aims co develop a venture capital industry by (a) estabiishing a legal and regulatory framework, (b) rationalizing the tax treatment of venture capital funds and (b) financing through the IFC a role model venture capital fund and management company. Benefits and Risks: The project will facilitate the outward-oriented industrial strategy of the GOT. Its main beneficiary will be the private sector whose technological effort and consequent productivity growth will be stimulated and assisted by the project. The project will generate three principal benefits. First, it will catalyse private investment in technical know-how. For some firms, the project will provide venture capital for innovative investments. For a much larger group, the main consequence will be a MSTQ system that 6nables improved quality management of existing operatiors. Second, the project will strengthen the organisation and delivery of public sector services in those areas where market imperfections or commercial uncertainty result in an under-investment of private resources. In this respect, the project has focused on investment in MSTQ, preempting a potential competitive disadvantage of Turkish firms in their OECD markets, and on the provision of seed capital for ITD in industries where Turkey can develop a dynamic comparative advantage. Third, the Project will strengthen linkages across the different stakeholders in the technology community. This project is financing two new institutions, the Venture Capital Company and the Foundation that will invest in sub-projects where the payback can be hard to quantify and where failures are ar. inevitable part of the innovative process. Nevertheless, the project has been designed to minimlse these risks. First, the major financial commitment of this project is to its lowest risk component - the MSTQ system. This aspect of Turkey's technology infrastructure can only grow in importance and its long term significance will not be affected by short term economic cyclicality. Second, the private sector through their participation in a National Steering Committee for the proposed Project, has played an active role in all phases of the Project preparation and implementation. This involvement helps to ensure the commercial relevance of the proposed operations and to build a culture of client orientation. Moreover, the selected interventions which this project  -iii- sup;f,rts have parallels in other OECD countries. The design of each component transfers best international practices to Turkey. Estimated Costs: Local Foreign Total --- (USS million)------ MSTQ 17.2 57.0 74.2 R&D 49.1 43.3 92.4 Venture Capital 58.0 37.6 95.6 Total Costs 124.3 137.9 262.2 Financing Plan: Government of Turkey 6.2 0.0 6.2 Private Sector Investors 99.0 32.3 131.3 Development Banks 4.0 0.0 4.0 TSE 7.6 0.0 7.6 Multilateral Donors 2.0 1.5 3.5 Bilateral Donors 0.4 4.0 4.4 IFC 0.0 5.1 5.1 IBRD 5.0 95.0 100.0 Total Financing 124.3 137.9 262.2 Estimated Disbursement: 91 92 93 94 95 96 Bank Fiscal Year Annual 5.1 10.4 22.7 28.4 18.0 15.4 Cumulative 5.1 15.5 38.2 66.6 84.6 100.0 X 5.1 15.5 38.2 66.6 84.6 100.0 Economic Rate of Return: Not applicable &R: IBRD 22207  'URKEY STAFF APPRAISAL REPORT T'ECHNOLOGY DEVELOPMENT PROJECT I. INTRODUCTION 1.01 Technology development is a firm-level activity that drives productivity growth and international competitiveness. Firms that invest in renewing their productive knowledge base and that compete by creating specialised assets - technical, organisational and human capital - lie at the heart of the process. It is their investment in technology development that sets the speed at which an economy changes the basis of its comparative advantage and raises the standard of living. 1.02 Competitive pressure from the market and the human capital endowment are the two main factors that influence the willingness and capacity of firms to increase productivity. Even in an economy where these two factors are present, there are nevertheless a number of reasons why, from a welfare perspective the private sector is likely to under-invest in technology development. First, the field is characterised by extensive free rider problems where measurement techniques, standards and reputation are concerned. Second, externalities make it hard for firms to capture the full return from investments in acquiring information and creating knowledge. Third, imperfections and information asymmetries in the capital markets may limit the supply of finance for innovative business ventures. The role of the public sector in technology development is therefore to catalyse private resource mobilisation for these activities. 1.03 The reform of Turkey's policy framework over the last decade has fostered an era of rapid economic growth and structural change. Trade liberalisation and domestic deregulation have created competitive pressure on firms to increase productivity. Incentives to export have generated opportunities for learning th;ough interaction with buyers and suppliers in the international markets. Financial market reform is providing signals for resource reallocation towards high productivity sectors. At the same time, the rate of technological and economic change in the OECD markets is posing a fresh set of challenges to Turkish firms. To build a sustainable competitive position in the OECD markets, they will need to increase productivity and acquire know-how in the evolving technologies of informatics, biotechnology and materials development. 1.04 The strategy of the Government of Turkey for industrial technology development (ITD) has been to support firm-level productivity growth within competitive markets through (a) investing in the Metrology, Standards, Testing and Quality System (MSTQ), (b) funding research and development activities and (c) strengthening the framework for capital market activities. Despite gains made in these three areas, weaknesses persist constraining the performance of the Turkish economy. The project therefore has three objectives. The first is to develop the MSTQ system to OECD standards by (a) capacity building in the key public sector institutions and (b) establishing the mechanisms for  greater private sector participation in the system. Second, the project will stimulate private investment in ITD by providing seed capital for projects that generate business-urniversity collaboration. A third objective is to foster the growth of a venture capital industry that can finance innovative business projects. 1.05 Turkey's ITD strategy is at a point of transition. Only a few years ago, the core policy problem was how to create a competitive environment in which firms would have an incentive to demand modern technological inputs and services. Today, the problem has become more a function of supply side weaknesses. If Turkish firms are to exploit opportunities created by an open economic environment, the public policy agenda of MSTQ, an effective system for research and development, and specialised finance for innovation need to be brought into line with the most progressive elements in Turkey's economic framework. In future years, the ITD agenda is likely to grow, incrrporating the issues of intellectual property rights, extension services and informatics policy. By providing technical and financial support at this point, the proposed project can exert a positive influence over the future direction of the ITD program in Turkey. 1.06 This report is organised in 6 main chapters. Chapter II analyses the industrial and financial context for the proposed project and summarises the Bank's lending strategy in these two sectors. Against an international background of growing public sector investment in national manufacturing competitiveness, Chapter III lays out the GOT's strategy for intervention in ITD and identifies the key steps required to stiengthen the public sector role. Chapter IV provides a detailed description of the proposed project, while Chapter V explains how the loan and credit would operate. Chapter VI summarises the agreements reached with the Government and participating institutions. II. THE STRATEGY FOR INDUSTRIAL COMPETITIVENESS A. Background 2.01 In the 1980s, the Government of Turkey moved decisively away from the model of import substituting industrialisation led by direct public sector investment. In it.s place came a strategy to accelerate industrial growth through policies that increase the efficiency of sec'oral investment and enhance international competitiveness. The main instruments of this strategy have been: * market liberalisation to increase incentives for firm-level technology development and to discipline producers; * export orientation to generate productivity growth through economies of scale and learning externalities; and * financial sector reform to improve the efficiency of resource allocation.  - 3 - At the same time, the COT's own investment program has shifted away fromn direct competition with the private seccor. Rather, the emphasis has been on those infrastructural investments in transport and communication that are more complamentary to private investment. 2.02 Perhaps the most striking indication that this strategy is succeeding has been the export response of the manufacturing sector. A significant shift in relative prices in favor of export industries coupled with domestic stabilisati.on efforts resulted in a sustained growth of Turkish manufactured exports from UJ$1.0 billion in 1980 to just over US$9.0 billion in 1989. Studies of productivity growth before and after 1980 confirm the improvement in the performance of Turkish industry. The trend of negative productivity growth experienced in the latter half of the 1970s was reversed after 1980 in both the private (-4% to +3.5% per annum. growth) and public (-7% to +6%) manufacturing sectors. This improvement was not restricted to the narrow range of export leading sectors (textiles, garments, leather products). Rather, it has been a broad based phenomenon embracing industriss which enjoy scale economies (iron and steel, chemicals, fertilisers) as well as those characterised by batch production techniques (machinery, appliances, ceramics). This Chapter examines the three main policy instruments employed by the GOT and describes how the Bank has supported the strategy. it concludes with a brief discussion of the challenge facing Turkey in the 1990s. B. Industrial and Financial Sector Strategv in the 1980s 2.03 The manufacturing sector in Turkey accounts for 1/4 of GNP, 1/8 of formal sector employment and over the last decade has grown at an average rate of 7% per annum. The composition of production has also changed markedly over the period. As might be expected from the change in relative prices, the last decade has seen faster growth in the labor intensive sub-sectors of apparel (including leather), pottery and machinery accompanied by a relative contraction in the production share of petroleum products, rubber products and non-ferrous metals. Export performance has been impressive (see para. 2.02), with the share of manufactured goods in total exports increasing from 1/3 to 3/4 over the period. Most of this growth has come from the penetration of OECD markets. 2.04 Market liberalisation. The policy regime inherited by the GOT was one of widespread public sector ownership of industrial assets, market intervention and a protectionist trade regime characterized by non-tariff barriers. Although this regime had succeeded in generating rapid economic growth with low inflation during the 1960s and early 1970s, the external price shocks of the 1970s (coupled with inadequate adjustment) revealed the inherent unsustainability of this approach. 2.05 Starting in 1980, the authorities implemented an extended stabilisation program and initiated a wide-ranging program of structural reforms. A progressive liberalisation of the foreign trade regime has been the hallmark of reforms to increase competition and to generate a more efficient set of price signals. Non-tariff barriers have been eliminated. The tariff structure has been rationalised and average rates significantly  -4- reduced. To accelerate industr'al sector adjustment, the Government has (a) raised the financial return on i.vestment through the tax, incentive and preferential credit systems, (b) improved state enterprise efficiency by cutting low productivity capital expenditure and initiating a privatisation program, (c) liberalised the regime for direct foreign investment (Box 2.1) and (d) reduced barriers to entry and growth through domestic market deregulation. 2.06 The private sector has responded vigorously to the challenge of catching up with international competitors by (a) importing more modern technology (both embodied in machinery and disembodied in the form of licenses and technical agreements), (b) buying designs'l and marketed know-how from international consultancies and (c) where possible, forming strategic alliances with foreign partners. As Table 2.1 indicates, demand for modern technology has jumped since thd early 1980s. Demand is expected to strengthen further as a result of proposed changes in the tax code that lower corporate tax liability to 10% for companies using or producing advanced technologies. Table 2.1: Inflows of Foreign Technology (embodied and disembodied) - 1982 to 1989 1982 .... 1986 1987 1988 1989 Direct Foreign Investment Permits ($) 167 364 537 825 1471 Realised investments ($m) 55 125 106 354 738 Investment Good ImRorts ($m) 1940 34,0 3816 3989 3850 Foreign License Aereements (#' 25 76 94 76 74 Source: SPO 2.07 As Turkish firms approach the international productivity frontier, the catch-up potential of foreign technical know-how will diminish. To strengthen competitiveness, firm-level strategies will need to emphasize complementarities between local ITD effort and outward-oriented technology scanning and acquisition. Today however, private sector research and development remains weak, as revealed by the 1989 total of 13 firms applying for R&D fiscal incentives. Few firms have the in-house skills needed to succeed in the local ITD process of adapting, capital-stretching and upgrading their imported technological base. There is little systematic monitoring of competitors' core technological competences. Total quality management is only ' in both "mature" industries (e.g., textiles) as well as "technology intensive" industries (e.g., consumer electronics).  -5- BOX 2.1: POICY RFOi AND WECHN(OGIML CHANGE IN THE AUTO INOUSTW The Turkish Govemment has targoted the auto Industry as a leading sector for the 1990s. The maln policy Instruments are: * liberal OFR roalmo to brlng leading Intomaeaonal auto companies to Turkey and create competiion for dromestic iiceosees; * taflif harrnonisatio wilth the EC to make Turkey dn attractive exporl base for auto-assembly and components prodtuction. * IncentIves to large-scale flial assembly operatlons. The Govemmenl strategy relies on rapid expansion of final ass.mbly operallens to generate backward linkages Into the auto compononts and matorlis industry. The most dramallc resuis of this policy are 1he I OYOTA/SABANC and possible PEUGEOT/CITROEN/PPI/CUKUROVA lolnt ventures, each representing Investments of roughly US$500 million and a possible Initial capacilles of 100,000 p.a. The existing domestic suppilers are already responding, FIAT licensee TOFAS will Invest US$320 mllilon to Produce 200.000 ot .he new Tempra line. RENAULT/OYAK another long-time presence on the market, will also do away with revampod rodels from the 1 970s aWd Move to prodw.e 100,000 of the newly unveiled Ft21 model. GM has adoptod a different approach. Investing In only a limied assembly operattin (10,000 Vectras p.a.) as a defensIve market strategy. GM has used the experience to Identily and Integrate leading Turkish suppilers of lectrIcal harnessing oquIpment, exhausts and textiles Into the GM (Eutope) supplier network. Turtey's advantages (low wages, strong ,nglneerlng base, low EC tariffs) togelher wIth a major shakeout 'i the European components Industry Is attracting other manufacturers. BOSCH (FRG). VALEO (France), ASB, AK-ZO and PHILLIPS (both of Holland) and SIEMENS (FRG) have all made Investments, while VOLVO (Swe*n) Is discussIng body pats manufacture. On the materIals side, Turkey's three largest steel producers have all announced new Investments In sheet metal production to meet rlsirg demand for car bodies. 525.000. 500, 000- 400,000- ... 300,000-! 200,000- TOFAS/ FIAT RENAULT/ 100,000- OYAK FORD Existing TOFAS/FIAT Renault Toyota Peugeot/ GeneraL 1995-96 Auto Expansion Expansion Citroen Motors Auto Products Production beginning to supersede more limited product testing. The public sector institutions to support (a) applied R&D, (b) product testing and quality assurance, (c) market intelligence and (d) industrial extension remain inadequately developed. 2.08 Export Orientation. The key to the Government's industrial strategy has been the export response, particularly in the private sector.  - 6 - Stabilisation accompanied by aggressive exchange rate policy, trade liberalisaticn and export promotion measures quickly led to a large shift of production capacity from domestic to export markets. The economy raised its total factor productivity in the short run, rapidly increasing capacity utilisatlon. Aided initially by buoyant Middle East markets and latterly by successful penetration of OECD markets, exports grew over 20Z per year in real terms and tripled their share in GNP by 1985. Industrial exports (especially processed foods, textiles a;.d iron/steel) grew fastest. 2.09 Nevertheless, real exchange rate appreciation since 1989 and a sharp reduction in export incentives have resulted in a plateauing of manufactured exports at the 1988 level of US$9.0 billion. OECD analysis2' points to three underlying problems. First, the regional composition of exports still leaves Turkish firms exposed to relatively unstable demand from the Middle East. Second, firms have enjoyed only limited success in entering the international market for investment goods (the fastest growing segment of intra-OECD trade), making commodity composition of exports unattractive. Third, the majority of exports are in labor and scale-intensive industries that are highly price- sensitive and pro-cyclical. Sustained productivity growth through know-how acquisition and a shift into products that are less price and more quality sensitive is essential if firms are to buil(' a competitive advantage in more discriminating market segments (Box 2.2). Collective action (by the public sector, industry and consumer associations, horizontal pre-competitive alliances by firms) is needed to capture the full economic return on investments in knowledge, reputation, information and human capital development. 2.10 Financial Sector Reform. The objectives of the Government's financial sector program have been to (a) increase the efficiency of resource mobilisation and allocation through financial liberalisation, (b) create an independent Central Bank and (c) strengthen banking sector adjustment to the real and financial shocks experienced early in the 1980s. Initiated under the SAL and FSAL I programs, the banking system component of financial sector reform has now been successfully accomplished under FSAL II. The introduction of prudential regulations on loan classification, provisioning, capital adequacy and loan concentration, the impact of the Central Bank in redefining its role as an autonomous monetary authority, the severe curtailment of preferential credits and near elimination of net interest subsidies, the establishment of a bank restructuring institution and the formulation of a strategy for the state banks all constitute radical change in the banking system. 2.11 The Government is now emphasising development of capital markets, today accounting for 10% of financial assets. The Capital Market Law, enacted in 1981, together with subsequent laws and regulations, provided a framework for their development. A Capital Market Board was established in 1985 to regulate and supervise private issuers and brokerage firms. The Istanbul Stock Exchange was reopened in 1986. Measures to stimulate capital markets I OECD Economic Survey: Turkey (1990) pp. 33-43.  - 7 - BOX 1