Turkey - Challenges for adjustment (Vol. 1 of 3) : Main report

Report No. 15076-TU Turkey Challenges for Adjustment (In Three Volumes) VoIuLe I: Main Report April 1,1996 Counltrv Operations Division Co)Jntrv Department I Europes and Central Asia Region Document of the World Bank  CURRENCY EQUIVALENTS Currency Unit = Turkish Lira (TL) Turkish Lira per US dollar 1992 (average) = 6,872 1993 ( --"-- ) = 10,985 1994 ( --"-- ) = 29,608 1995 ( --"-- ) = 45,731 December 31, 1995 61,054 GOVERNMENT'S FISCAL YEAR January 1 - December 31 ACRONYMS AND ABBREVIATIONS ASCU Agricultural Sales Cooperative Union MHF Mass Housing Fund BOT Build-Operate-Transfer OECD Organization for Economic Cooperation CBT Central Bank of Turkey and Development CCT Common Customs Tariff PAYG Pay As You Go CIT Corporate Income Tax PHC Privatization High Council CU Customs Union PIT Personal Income Tax EAEC European Atomic Energy Community PSBR Public Sector Borrowing Requirement EBF Extra-Budgetary Funds SEE State Economic Enterprise ECSC European Coal and Steel Community SIS State Institute of Statistic EU European Union SOE State-Owned Enterprise LFA Legal Framework Agreement SPO State Planning Organisation FTA Free Trade Agreement SSK Sosyal Sigortalar Kurumu GATr General Agreement on Tariffs and Trade VAT Value-Added Tax IIBK Turkish Employment Authority WDR World Development report MFA Multifibre Arrangement WTO World Trade Organization MFN Most Favored Nation Thisreportwas preparedby ateam led byJacob Kolster (ECICO) and including Mediha Agar (ElTU), Sebnem Akkaya (ECICO), Ismail Arslan (ECITU), Glenn Harrison (Consultant), Sunita Kikeri (PSD), Tom Rutherford (Consultant), Anita Schwarz (ESP), David Tarr (IECIT), XSubideyz Togan (Consultant), and Sweder van Wijnbergen (Consultant). William Easterly (PRDMG), William McCleary (EA1DR), and Vladimir Konovalov (EC3C2) were peer reviewers of the report, and provided helpful comnments and guidance. The assistance of the Undersecretariat of Treasury,, Miniistry of Finance, State Planning Organization and other government institutions in the preparation tof this report is gratefully acknowledged. The report was discussed with the Turkish authorities during the first half of February 1996.  TURKEY ~~~~~~~~~~~llllW.. .................. l Annual Growth Rate of GNP General (. p.a., constamt price) Area (thous. km sq.) 779 Population (millions) 60.8 Growth rate (latest decade) 2.0 1994 Density (per km sq.) 67 US$M % of GNP 1988-91 1992 1993 1994 Social Indicator Population Characteristics GNP at Market Price 131829 100.0 3.2 6.4 8.1 -6 Crude Birth Rate (per 1,000) - Gross Domestic Investment 28363 21.5 4.3 6.2 12.3 -11.2 Crude Death Rate (per 1,000) - Gross National Savings 30299 23.0 3.3 5.4 11.8 -8.5 Health Current Account Balance 2631 2.0 Infant Mortality (per 1,000 li) 62 Exports of GNFS 27928 21.2 4.4 7.8 5.2 14.8 Population per Physician 983 Imports of GNFS 26388 20.0 5.1 7.9 33.4 -22.6 Population per Hospital Bed 406 GNP per capita 2450 Income Distribution (% of national income) Highest Quintile - Output, Employment and Productivity, 1994 Lowest Quintile Distribution of Land Ownership Value Added Labor Force Value Added % Owned by Top 10% of Owners - US$M % of Total Millions % of Total ver worker % Owned by Smallest 10% - USSM %of Total Access to Safe Water % of Urban Population 97.8 Agriculture 19506 16.3 8.2 44.7 2389 36.5 %ofRuralPopulation 84 Industry 29345 24.5 2.9 15.8 10189 155.5 Access to Electricity Services 70940 59.2 7.2 39.6 9800 149.6 % of Urban Population - Total 119791 100.0 18.3 100.0 6551 % of Rural Population . .... ..... . -.__-___ : -__ ::-_ -::-_ :_ .. - .:.:-::.:.:::_-_ -__-:: _: Nutrition Government Financ Calorie Intake Geneal Government Centmal Goverment (as % of Requirements) TL Bln % of GDP TL Bin %ofGDP Per Capita Protein Intake 1994 1994 1990 1994 1994 1990 (g/day) Education Current Receipts 778874 20.0 18.4 635611 16.3 12.5 Liteacy Rate (%) 12 Current Expenditures 830202 21.3 16.8 690670 17.7 13.0 Primazy School Enrollment 92 Current Deficit 51328 1.3 1.6 55059 1.4 0.5 (% of Relevant Age Group) Capital Expenditures 156469 4.0 4.9 92679 2.4 2.6  1M''':':' Credt' '': -'"" Mercdie Exports An.... .....- 1990 1991 1992 1993 1994 Value (millions of IL outstanding, end of period) (miDions of USS) % of Totdal Money Supply 96189 175319 309951 506400 1239342 Agriculture and Livestock 1130 7.3 Bank Credit to Public Sector 27086 53265 91815 159923 460374 Mning and Quarry Poducts 263 1.7 BankcredittoPrivateSector 71261 115736 205952 381926 662191 ManufacturedGoods 14048 91.0 Textiles 5664 36.7 (percentage or index numbers) Others 8384 54.3 Money as % of GNP Total 15440 100.0 General Price Index (1987=100) 426 661 1072 1698 3748 Annual % Chns in Exchange Rat C .(Ann Av erge . ...... General Price Index 52.3 55.4 62.1 58.4 120.7 Bank Credit to Pubic Sector 7.9 96.7 72.4 74.2 187.9 1990 1991 1992 1993 1994 1995 Bank Credit to Private Sector 75.4 62.4 78.0 85.4 73.4 TL/ US$ Rate 2608 4171 6872 10984 29608 45731 |Balance of Payments . .... . . . aExternal Debt, December.31, 1994: 1990 1991 1992 1993 1994 (miDions of US$) (millions of USS) Public 49004 Exports of GNFS 20301 21326 23343 25121 27928 Private 16597 Imports of GNFS 25652 24225 26706 33721 26388 Total 65601 Resources Gap (Deficit -) -5351 -2899 -3363 -8600 1540 Interest Payments (net) -2347 -2505 -2427 -2439 -3033 Debt Sevice Ratio for 199. . . .. ..... Other Factor Payments (net) 580 555 757 836 1032 Percentage Net Private Current Transfers 3349 2854 3147 3035 2709 Current Receipts 3374 2879 3147 3035 2709 Public 23.6 ofwhichWorkersRemittance 3246 2819 3008 2919 2627 Private 9.1 NetOfficialTransfers 1144 2245 912 733 383 Total 32.7 Current Account Balance -2625 250 -974 -6435 2631 EIBPDflDA ni (u 3 9(S Diret Foreign Inestment 700 783 779 622 559 IBRD IDA Net M&LT Borrowing 337 -160 1473 5287 374 Outstanding & Disbursd 5488 133 Nd ST Borowing 3000 3020 1396 3054 5127 Undisbursod 1994 0 Other Capital Flows (net) -468 948 -1190 2222 1769 Total Outslning Changes in Net Official Rserve 1308 -1029 1484 308 206 (Including Undisbursed) 7482 133  TURKEY: COUNTRY ECONOMIC MEMORANDUM TABLE OF CONTENTS MAIN REPORT (VOLUME 1) Page ExEcuIVE SUmmARY ................................................................................... i-vii CHAPTER I: RECENT ECONOMIC DEVELOPMENTS AND PoLicY CHALLENGEs.. 1 A. BACKGROUND: FROM BOOM TO BUST. 1 Fiscal Imbalances. 1 Volatile Growth and Mounting Imbalances. 3 The Currency Crisis. 4 B. CHANGES IN POLICIES: FIRST STEPs TowARDs REESTABLISHING MACROECONOMIC BALANCE . 6 The April 5 Program. 6 The 1995 Program. 9 C. AN ASSESSMENT: TAKING STOCK OF THE STABILIZATION EFFORT .10 Inflation: A critical Threshold Crossed? 11 Further Fiscal Adjustment is Needed .13 Sustainability and the Critical importance of Structural Reforms .14 Limitations on Monetary Policy .14 D. CHALLENGES AHEAD .15 CHAPTER II PUBLIC FINANCE REFORM ..17 A. EXPENDITURE CONTROL AND MANAGEMENT .17 Personnel Expenditures .18 Export and Investment Incentives .20 Agricultural Support Policies .22 Extra Budgetary Funds .23 Public Investment .25 B. TAX REFORMS .26 CHAPTER III: THE PENSION SYSTEM: LOOMING CRISIS AND REFORM OPTIONS ...... ............. 29 A. INTRODUCTION . ........................................................................... 29 B. PENSIONS AND OLD AGE SOCIETY ...................................................... 29 C. THE CRISIS IN THE MAKING .................. ........................................... 30 D. PROSPECTS IP NOTHING Is DONE ........................................................ 34 E. REFORMING THE EXISTING PENSION SCHEMES ......... .............................. 35 Will The Draft SSK Law Suffice? ............. ........................................ 38 F. LONGER TERM REPORMS: TOWARDS A NEW PENSION SYSTEM ....... ............. 39 Transition To A New Pension System ................................................ 41 CHAPTER IV: PRIVATIZATION AND STATE ENTERPRISE REFORM ......... ............................ 43 A. INTRODUCTION ............................................................................ 43 B. THE IMPORTANCE oP THE SEE SECTOR AND PAST REFORMS ....... ................ 43 An Overview of the SEE Sector ...................................................... 43 Reform Efforts Over the Past Decade .......... ................................... 45 C. ACCELERATING PRiVATIZATION AND SECTOR REFORMS ............................ 48 Privatization: The Way Forward .................................................... 48 SEE Reforms: Financial Discipline and Restructure Large Loss-Makers .... 53  CHAPTER V: THE CUSTOmS UNION WiTH THE EUROPEAN UNION ............. .................. . 55 A. POINT OP DEPARTURE AND SALIENT FEATURES OF THE CUSTOMS UNION ....... 55 The Point Of Departure ...................................................... 55 Features of the Customs Union ...................................................... 56 B. IMPACTS OF THE CUSTOMS UNION ...................................................... 57 Economic Impact ................................................... 57 C. POLICY CHALLENGES ................................................... 60 Concluding Remarks ................................................... 63 TABLES, FIGURES, AND BOXES CHAPTER I: Table 1: PSBR and Public Sector Domestic Debt Stock ........... ................. 2 Table 2: Key Economic Indicators ...................................................... 5 Table 3: Inflation, Growth, & Volatility of Growth ............... ................... 12 Figure 1: Saving-Investment Gap (In Percent of GNP) .............. ................... 3 Figure 2: Real Effective Exchange Rate (1992 = 100) .................... 7 Figure 3: Year-on-Year Inflation (WPI): 1993-95 .................... .................. 8 Figure 4: Inflation (WPI) and Interest Rates (3 months T-bills) ...................... 10 CHAPTER II: Table 1: Composition of Consolidated Budget Expenditures ........ ............. 17 Table 2: Fiscal Cost of Export and Investment Incentives ......... ................... 21 Table 3: Agricultural Transfers in Turkey, EU and OECD ......... ................. 22 Table 4: EBFs: Revenues and Expenditures ............... ............................ 24 Table 5: Public Fixed Capital Investments by Sectors (in shares) ................... 25 Table 6: Consolidated Central Government Budget Revenues ....................... 26 Figure 1: Size of Turkey's Civil Service ................................................. 18 Figure 2: Real Wages in the Public sector ................................................ 18 Box 1: Civil Service reform ....................................................... ...... 19 CHAPTER III: Figure 1: System Versus Dependency Ratio ........................................... 31 Figure 2: Age Distribution of New Retirees in Emekli Sandigi, 1991 and 1993 ... 32 Figure 3: Age Distribution of New Retirees in SSK, 1991 and 1993 ................ 32 Figure 4: Contribution Rates and Old Age Population in OECD Countries ........ 33 Figure 5: Projected Deficits from Alternate Reform Proposals ....................... 39 Figure 6: Real Annual Investment Returns, 1980s ...................................... 40 Box 1: Key Functions of a Pension System ........................................... 30 Box 2: Projection Assumptions . ........................................................ 35 CHAPTER IV: Table 1: SEE Sector in Turkey . ......................................................... 43 Table 2: Borrowing Requirement of the SEEs (in percent of GNP) ................. 44 Table 3: Gross Privatization Revenues ................................................... 47 Box 1: Privatization and Fiscal Stability in Argentina .......... ..................... 50 CHAPTER V: Table 1: Turkey's Exports to and Imports from the European Union ......... 56 Table 2: Decomposed Welfare Effects of Customs Union ............................. 58 Table 3: Import Taxes and Levies . ........................................................ 60 Box 1: Spain' s Successful Accession to the EU ............. .......................... 63  TURKEY COUNTRY ECONOMIC MEMORANDUM EXEcunIVE SUMMARY i. Among the many challenges facing Turkey today, two stand out as key to the country's medium-term economic prospects: to reduce inflation decisively; and to position the economy so that it can reap the full benefits of the Customs Union with the European Union. Diminishing the financial burden of the public sector and reducing the role of the State in those areas of the economy where the private sector is clearly capable of assuming responsibility are at the core of both challenges and constitute the central themes of this report. Following an account of recent economic developments, the subsequent three Chapters of the report discuss the structural reforms required in the key areas of government expenditure and revenue policies and administration, the social security system and the state enterprise sector. The last Chapter of the report deals with the economic implications of the Customs Union with the European Union. Volume I contains Annexes which provide detailed technical analysis of some of the issues discussed in the main report. Volume III is the Statistical Annex. Recent Economic Developments ii. The Turkish economy went through a boom in 1992 and 1993. A broad-based expansion in domestic demand, stimulated by expansionary fiscal and monetary policies, led to real growth of more than 7 percent per year. With annual inflation around 60 percent in both years, the internal imbalances spilled over to the external accounts. The current account deficit soared to 3.6 percent of GNP in 1993 -- the largest deficit in ten years. Sharply weakened financial market confidence in the last months of 1993 combined with successive down-gradings of Turkey's international credit rating triggered a run on the currency and the lira depreciated by about 50 percent during the first quarter of 1994. iii. The underlying cause of the 1994 crisis was an unsustainable fiscal position. The public sector borrowing requirement (PSBR) had increased from 4.8 percent of GNP in 1988 to 12.6 percent in 1993. The main causes of the growing deficit were large wage increases for public sector workers, generous agricultural support prices, costly incentives programs, and a continued deterioration in the financial performance of state-owned enterprises (SOEs) and of the social security system. iv. The April 5 Program. In the face of spiraling inflation and severe financial market instability, the Government announced a major program of stabilization and structural reform measures on April 5, 1994. The core of the April 5 Program was a front-loaded fiscal retrenchment to reduce inflation, improve the external balance and restore stability to the foreign exchange market. The program target was to reduce the PSBR to 6.2 percent of GNP in 1994. The principal measures adopted were: one-off tax measures, sharp increases in SOE prices, reduced agricultural subsidies, and sharp real cuts in personnel outlays and investments. The program also foresaw a number of structural initiatives, including measures to down-size the public  ii v. In the event, the PSBR was reduced to 8.0 percent of GNP in 1994, down by 4.6 percentage points of GNP from the 1993 level. Whereas the primary balance improved significantly and went into surplus for the first time since 1988, interest payments were higher than expected due primarily to a lack of confidence in the inflation targets. Major shortfalls in privatization receipts also occurred as privatization was effectively suspended following the Constitutional Court's ruling in July 1994 that the legal underpinnings of the process were inadequate. Political sensitivities and lack of consensus on the need for closures of loss-makings SOEs blocked progress on this front as well. Pension reforms also suffered major delays and the fundamental factors behind the system's unsustainable financial position remained unaddressed. vi. The financial crisis and fiscal tightening resulted in a sharp compression of domestic demand, and real GNP fell by 6 percent in 1994. The reduction in domestic absorption and large real exchange rate depreciation during the first half of the year led to an 18 percent increase in exports (dollar value), while imports fell by almost 25 percent. As a result, the current account balance recorded a surplus of 2.1 percent of GNP. However, inflation remained high, with wholesale prices increasing an average of 120 percent in 1994. Given the size of the fiscal contraction, this suggests that underlying inflationary expectations remained largely unaffected by the stabilization effort due to the lack of progress with the structural reforms needed for a sustainable adjustment. vii. The 1995 Program. The Government launched a new stabilization program in early 1995 primarily aimed at reducing inflation below 40 percent by year-end, implying an annual average of 70 percent. The program envisaged a further reduction in the PSBR to 5.6 percent of GNP through a combination of increased tax revenues, reduced personnel and transfer outlays and, in particular, sharply increased privatization revenues amounting to 3.3 percent of GNP. A critical new element in the 1995 program was the adoption of the exchange rate as a nominal anchor. viii. Preliminary data suggest that 1995 outcomes differ significantly from the program targets. Fiscal policy turned expansive during the last quarter of the year ahead of early general elections and the PSBR is likely to exceed 7 percent of GNP. Economic growth was much stronger than expected, driven by a rapid recovery in private consumption and investment, and real GNP growth is estimated at over 7 percent. The sharp increase in domestic demand and appreciation of the real exchange rate fueled import growth and the external current account slipped back into a deficit of about 0.8 percent of GNP. Inflation also remained stubbornly high in 1995, averaging 90 percent for the year. The poor inflation performance reflects increasing difficulties in sterilizing the domestic counterpart of strong capital inflows and the strong movement into lira denominated assets (reverse currency substitution), as well as the burgeoning domestic demand. Sunmnary Assessment ix. Although the Government's stabilization efforts in 1994-95 produced some noteworthy results, they failed to reduce inflation to moderate levels. This is due in large part to the persistence of high inflationary expectations, reflecting the slow implementation of structural reforms and consequent lack of confidence in the sustainability of the stabilization effort. At the end of 1995, annual inflation was still running at 90 percent despite the improved fiscal position.  iii reforms and consequent lack of confidence in the sustainability of the stabilization effort. At the end of 1995, annual inflation was still running at 90 percent despite the improved fiscal position. During the six years preceding the currency crisis, inflation hovered around 60 percent. Turkey may be in danger of crossing a critical threshold: many countries have managed to maintain good growth performance at moderate inflation rates, a limited number of countries have experienced periods of rapid growth at high inflation rates, but none have let inflation slip towards triple digit levels without either sliding further towards hyper-inflation or launching determined efforts to reduce inflation. x. Achieving a substantial and sustainable reduction in inflation will require significant additional fiscal adjustment. Specifically, the analysis contained in this report indicates that the primary (non-interest) public sector surplus would need to improve by about 2 percent of GNP compared to the level attained in 1994 in order to stabilize the ratio of public debt to GNP ad reduce inflation and real interest rates to moderate levels. The challenge for this fiscal adjustment is complicated by the Customs Union, which will lead to an estimated net-revenue loss of about 1 percent of GNP due to tariff reductions. Since the preliminary indications are that there was little improvement in the overall public finance position in 1995, new fiscal measures yielding a total of 3 percent of GNP are needed to provide the necessary fiscal underpinning for a significant reduction in inflation. xi. Fundamental structural reforms of the public sector are needed to achieve this fiscal adjustment and to reassure market expectations as to its sustainability. The three main areas for reform are: government finances, particularly through reducing investment incentives, agricultural subsidies and personnel outlays, and broadening the tax base; the social security system, which needs to be reformed to ensure its financial sustainability; and the state-owned enterprise sector, a long-standing and serious cause of fiscal imbalance. Strong and visible progress in these areas would set in motion a virtuous circle of reduced pressures on the domestic financial markets, enhanced creditworthiness and access to external capital, lower real domestic interest rates and a steadily declining PSBR. The private sector supply response in such a scenario would likely be rapid and strong due to the increased availability of financial savings for private investment, reduced uncertainty from macroeconomic instability and the overall improvements in productive efficiency. Government Finances xii. The complex system of levies, tax exemptions and concessional credit that forms the investment incentive regime is costly (over 1 percent of GNP in recent years) and induces a serious misallocation of resources. Analysis of available time series data suggests that the incentives have largely failed to achieve their objectives of stimulating and re-orienting investment. Indeed, some create a strong bias towards capital-intensive production -- running counter to employment objectives and labor-intensive production where Turkey would have a natural competitive advantage vis-a-vis the EU. The Government should abolish the specific incentives programs, adopt a uniform investment tax credit at a moderate rate, and institute measures to wind-down the large stock of outstanding certificates.  iv sales cooperative unions (ASCUs) and SOEs that carry out the bulk of the output price intervention activities, and have benefited mainly large farmers. Although the scope of price intervention was reduced in 1994, a number of programs and subsidies were reintroduced in 1995 prior to the elections. With the recent reductions in tariffs on industrial goods under the Customns Union, the relative protection of agriculture in Turkey has increased. This provides an opportumnity for the Government to reduce the high levels of transfers to the agriculture sector. A first step would be to give greater autonomy and accountability to the ASCUs. This should be followed by a phasing out of all commodity price intervention activities, to be replaced by better targeted programs to address rural poverty. Finally, material input and output prices should be allowed to move closer to world levels and credit subsidies phased out. This would facilitate privatization or liquidation of agricultural SOEs, producing important fiscal gains and allowing the private sector to take over. xiv. A sizable reduction in public personnel outlays must be a central part of any sustainable stabilization effort, and the public wage bill was successfully reduced from 12 percent of GNP in 1993 to 8.5 percent in 1995. However, the upward pressure on Government wage expenditures cannot be held in check over time unless financial management and controls are improved and the civil service is down-sized and reformed fundamentally. In the short run, the Government should proceed with retrenchment through non-renewal of temporary and seasonal workers and the non-replacement of retirees. To ensure the necessary retrenchment of the civil service over the medium term while improving the quality of public services, the Government should commence inmediately the background work necessary for a comprehensive civil service reform. The medium-term target should be to bring personnel costs down to the 4-5 percent found in rapidly growing middle income economies such Argentina and Thailand. xv. Turkey's overall tax effort is respectable when compared to countries at similar per capita income levels. However, there are major deficiencies in the equity, efficiency and administration of the tax system. The tax base has been heavily eroded by the complex system of incentives granted through special rates and exemptions to the corporate income tax (CIT). Also, adjustments for inflation vary considerably among different types of tax liability and across sectors -- e.g., full deduction of interest payments is allowed for the manufacturing sector while other sectors are allowed only partial deduction. Recently, the Government has launched a major effort to strengthen tax administration. The Government should ensure this translates into improved personal income tax compliance, expansion of corporate tax audits and higher collection rates for the value added tax (VAT). The Seventh Five Year Plan (1996-2000) that was unveiled in mid- 1995 indicates that a number of important reforms initiatives are likely in the coming years. Particular attention should be given to the following. The corporate tax treatment should be streamlined through the elimination of the general income tax (which has been imposed on top of the CIT) and a uniform tax deductibility of interest payments across all sectors. Taxation of financial securities should also be unified to eliminate current differences in treatment across tax- payers and types of securities. Finally, harmonizing the number as well as the level of VAT rates in line with the European Union would bring important efficiency gains.  v Pensions and Social Assistance xvi. The deteriorating financial situation of the three funds making up Turkey's social insurance system is a relatively new problem that deserves immediate attention. The deterioration is primarily caused by large social assistance payments for which no contributions are made; inadequate contribution compliance; and relaxation of the eligibility criteria for retirement benefits (particularly the removal of the minimum retirement age in 1992). By 1994 the deficit had reached almost 1 percent of GNP. The financial imbalance of the three funds could double within the next 5 years and reach almost 5 percent of GNP by 2010 without prompt measures to arrest the deterioration followed by more fundamental reforms. xvii. The key reforms that would enable the existing pension system to survive into the next century without becoming an intolerable burden on public finances are well known. Reinstating a minimum retirement age is indispensable for any lasting solution; reinstating it at 55/60 for women/men would produce a temporary surplus if done without delay and phase-in arrangements. However, in view of Turkey's relatively young population, long-term sustainability can only be assured if the minimum retirement age is raised to 60/65 for women/men. xviii. Reducing the burden on the pension funds of large unfunded social assistance payments is also essential to reverse their current deficit trends. Ideally, the authorities should adopt a separate program specifically for social assistance targeted at poor older persons. However, if the current arrangement is retained as a transitional measure, it could be improved by restricting eligibility to old pensioners -- say above age 65 -- and ensuring adequate funding through the budget. Finally, to significantly increase contribution revenues, the Government should raise the minimum contribution period to ensure that all individuals contribute for at least twice as long as they can expect to collect full benefits; introduce a unified contributions collection system for all social insurance benefits through an independent agency, with cross-checks to the tax system or through the tax collection system itself; and allow the funds to charge the present value of outstanding contributions and apply variable market rates to the payments in arrears. xix. The quantification of the above pension reform elements (as presented in the report) is based on specific assumptions regarding changes in the key parameters under consideration. Alternative configurations of change -- e.g., involving matching calibration of pension contributions and benefits, transition periods -- are conceivable and may have the desired impact. It is also recognized that in order to secure the necessary political and popular backing, for the reforms there may have to be some sort of a phase-in period. However, the critical point to keep in niind when considering different alternatives is the need to reverse the current deficit trends of the pension system and bring it on a fiscally sustainable footing. State-Owned Enterprises xx. Turkey can no longer afford a gradual approach to state enterprise reform. The precarious public finance situation dictates a sharp reduction in the financial burden imposed by the sector. Decisive progress in SOE sector reforms has also been embraced by the financial markets - inside and outside Turkey -- as the key indicator of credibility of the Government's stabilization program.  vi Moreover, the onset of the Customs Union and the need to liberalize the domestic economy along with the external provides a unique opportunity to proceed swiftly with the well-known but long overdue structural reforms. Accelerated privatization is key and will help build confidence in the Government's overall commitment to economic reform. Simultaneously, restructuring of large loss-makers that are not immediately sold or closed is critical to stem the hemorrhage of public resources. xxi. Broad based consensus is essential for successful privatization. One way to develop political and popular support is to employ privatization methods that ensure gain-sharing by key stake-holders, including labor. A properly designed public information campaign along with appropriate safeguards to ensure transparency and fairness in the privatization process are also needed to obtain public and investor support. Establishing a national consensus on privatization requires that its social impact be squarely addressed by assuring workers and the public at large of the adequacy of the protective social safety net provided by the new privatization law. xxii. The Government should set clear privatization priorities for the coming years. The strategy of privatizing the simpler cases first was appropriate at the start of the program, providing a learning curve and allowing for early successes. Now, however, the immediate priority should be to complete the privatization of a critical mass of large competitive or potentially competitive enterprises. Their rapid privatization would yield significant efficiency gains to the economy and provide a strong test of the Government's commitment to reforms. xxiii. Real structural change will come from the divestment of loss-makers within the privatization agency's portfolio, and particularly from restructuring the large loss-makers that are presently not on the privatization agenda. Such restructuring should take place on a priority basis - - but before the enterprises are transferred to the privatization portfolio -- to prepare them for privatization. To prevent a further hemorrhage of public resources and to free up assets for more productive use elsewhere in the economy, non-viable units of large loss-makers should be liquidated. Where immediate closure is not feasible, for political or social reasons, avoiding new investments and shrinking employment through attrition and accelerated retirement can yield significant gains; such a strategy would also reduce the political sensitivity of outright closure. Tailor-made restructuring plans will have to be developed for each of the seven large loss-makers; implementation of these plans should be done in conjunction with overall policy changes for the respective sectors in which the enterprise is operating. xxiv. Enterprises that temporarily or permanently remain in the public portfolio should be made subject to commercial incentives and financial discipline. This requires an emphasis on profitability and separation of commercial from social objectives; appointment of SOE boards and management on technical rather than political basis including having private representatives on boards; simplification of Government-SOE relations in comparison to the present situation where SOEs report to several bodies at once; instituting performance-based incentives and sanctions; and increasing competition with private firms. In addition to timely price increases and restraint in wage and agricultural support-price adjustments, the Government should improve financial discipline through continued reductions in budget transfers; strict controls on borrowing from commercial banks and transparent appropriation of borrowing from the Treasury; and more stringent auditing and accounting requirements.  vii Confronting the Challenges of the Customs Union xxv. The Customs Union (CU) with the European Union (EU), which entered into force on January 1, 1996, offers Turkey a unique opportunity to accelerate its development. The static gains to Turkey of the CU are estimated at 1.1-1.5 percent of GNP per year depending on the complementary policies adopted. The largest part of this gain would result from Turkey's improved access to third country markets with whom the EU has preferential trade agreements. Since Turkey will need to establish the agreements reciprocally with each of the third countries in question, the Government should seek to accomplish the negotiations of these agreements as soon as possible. xxvi. The CU also presents certain challenges for the Government. One important challenge is to compensate for the net-revenue loss, estimated at 1.1 percent of GNP, from a lowering of import tariffs (and elimination of subsidies on exports to the EU). A second challenge, whose resolution is consistent with the necessary fiscal adjustment, is to reform trade and tax policies available to Turkey to avoid introducing unintended distortions into the economy. Agriculture will become even more protected relative to manufacturing unless Turkey takes unilateral action to reduce agricultural protection. xxvii. The solutions to all these challenges point to the same policies suggested earlier: a stable macroeconomic climate; competitive markets for products and labor; neutral incentives for all firms, domestic and foreign; and a substantial reduction of the state's role in production. Thus, the most efficient way to compensate for the revenue loss from the tariff reductions would be through broadening the tax base by rationalizing exemptions and strengthening tax administration and enforcement, and by reducing subsidies for agriculture and investment incentives. These actions would help to eliminate existing distortions in the economy as well as those created by the implementation of the Customs Union. Prospects xxvii. A renewed effort at both stabilization and reform is needed urgently in order to sustain and improve upon the progress achieved in 1994-95. Public sector adjustment, both strengthened financial discipline and structural reform, remains the key. Turkey's near-term prospects depend critically on the Government's ability to address problems in areas such as state enterprises, the public administration and social security system in a resolute and timely manner. The imperative for these internal adjustments is mandated by Turkey's large burden of external debt repayments in the next several years (almost US$10 billion each year in 1996-2000) and recent entry into the customs union with the EU. Turkey's dynamic private sector has shown repeatedly that it will respond positively to an improved macroeconomic environment. The prospect of closer ties with the EU has also created favorable business expectations. Hence, there is every indication that a determined effort now to address the root causes of the macroeconomic instability would elicit a very favorable private sector response and set the stage for broad-based and rapid growth of incomes and employment.   CHAPTER I RECENT ECONOMIC DEVELOPMENTS AND POLICY CHALLENGES 1.1. Following several years of volatile growth, the Turkish economy, stimulated by expansionary fiscal and monetary policies, went through two years of boom in 1992 and 1993. The unsustainability of the macroeconomic policy stance became increasingly clear towards the end of 1993. Internal imbalances spilled over into a sharp deterioration of the external current account and resulted in a foreign exchange and financial market crisis in early 1994. Against this background, an ambitious stabilization program was launched on April 5, 1994, which received early support under an IMF Stand-by Arrangement (SBA). The program produced some noteworthy results but inflation remained strong as confidence in the stabilization effort failed to materialize, and 1994 saw average inflation (WPI) rise to 120 percent. In light of the inflation performance in 1994, a revised program was launched in early 1995, which focused more on disinflation and structural reforms. However, market confidence remained elusive and the program, as it turned out, had little discernible effect on underlying inflation in 1995. 1.2. This Chapter provides a brief account of economic policies and developments leading up to the 1994 crisis, followed by a discussion and assessment of the stabilization program in 1994-95. The last section discusses the key policy challenges facing the Government over the short-to-medium term and sets the stage for the topics covered in the subsequent Chapters of the report. The areas in which the Government should seek further fiscal adjustment and structural reforms are covered in the three subsequent Chapters: public finance reforms are discussed in Chapter II, the looming crisis of the Social Security System is covered in Chapter III, and the performance of the public enterprises and the critical issues facing the sector is presented in Chapter IV. The economic impact and policy challenges of the Customs Union with the European Union are discussed in Chapter V. Volume II contains Annexes which provide further analysis of the issues discussed in this volume. Volume III contains statistical Annexes. A. BACKGROUND: FROM BOOM TO BUST Fiscal Imbalances 1.3. Since the late 1980s, Turkey has experienced growing fiscal deficits, persistently high inflation, and increasingly volatile economic performance. The public sector borrowing requirement (PSBR)1 rose steadily from 4.8 percent of GNP in 1988 to 12.6 percent in 1993. The major causes of the growing deficit included large wage increases for public sector workers and civil servants, generous agricultural support policies, costly incentives programs, and continued worsening of the performance of the state-owned enterprise sector. In an attempt to reduce monetization of the deficits and contain inflationary pressures, the Government substantially increased its recourse to debt financing in late 1992/early 1993. Large amounts of domestic debt were placed through short-term debt instruments at high real interest rates. The Government's external borrowing also increased significantly, with almost US$4 billion in international bond issues in 1993. The increasing and more X The non-financial Public Sector Borrowing Requirement (PSBR) is the net borrowing requirement of the following five sub- sectors: central government; extra-budgetary funds (EBFs); local governments; social security and revolving funds; and non- financial state economic enterprises (SEEs).  2 frequent need for debt refinancing resulted in a steep rise in the public sector's interest payments, from 5.9 percent of GNP in 1992 to 8.2 percent in 1993. Faced with rising costs of Government borrowing, the Treasury relied increasingly on short-term advances from the Central Bank of Turkey (CBT) during the second half of Table 1 1993. PSBR and Public Domestic Debt Stock (in percent of GNP) 1994 1/ 1995 11 1.4. The extent 1919 1992 1993 PM. hu Pro. O.E L Et2 of the fiscal 1. PSBR 5.4 11.1 12A 4.2 LO 5 U1 deterioration and By End Coneolidted Budget 3.3 4.3 6.7 2.6 3.9 3.2 3.5 dwindling room for Exta Budgetary Funds (EBFs) 0.4 1.3 0.9 0.1 1.0 -0.5 0.7 maneuver is Other Funds (social seocrity) -0.4 0.3 0.6 1.0 0.6 0.6 0.5 revealed by the Local govenrments 0.2 0.8 0.9 0.2 0.6 0.2 0.4 evolution of the Nonfinanoial SEEs 1.8 4.4 3.5 23 1.9 21 1.0 .2 By sUEU oeraltiona defict,e operational deficit, IL nItemst Payments 4.6 5.9 8.2 9.5 10.2 11.3 which more than fl.aReal Intpsyments 3/ 2.6 2.8 4.4 ... 5.4 ... doubled from 1989 lI.bInflacti onCopenticn4 2.0 3.1 3.8 ... 4.8 Me. Primary Deficit (= I - 11) 0.8 5.2 4.4 -3.3 -2.2 -5.7 to 1993 (see Table IV. Operational Deficit (= - Mb) 3.4 8.0 8.8 ... 3.2 1). The stock of Finandre of PSBR: public debt held in Net Forenp Financing 0.7 0.9 1.2 ... .1.5 ... private portfolios N>etDanestioFinancing 4.7 10.2 11.4 ... 9.5 . Central Bank 0.2 1.5 3.1 ... 1.7 ... (net of public Govern. Bonds & hBills 3.0 3.6 2.6 ... 4.5 ... sector deposits in Other SourC3 5/ 1.5 5.1 5.7 ... 3.3 ... the banking system) Public Sector Dormtic Debt Burden increased from GrouDebtStlo 19.9 21.7 17.5 ... 20.5 ... NetDdew. Private Secw 61 10.4 13.8 13.6 ... 14.5 ... 10.4 percent of -in%of WY 27.7 46.6 49.6 ... 47.g ... GNP 1989 to Mmemranm Ron (excL ,slvi"zatin receh,tsa almost 14 percent Pnvitanace*pz 0.0 0.0 0.3 1.6 0.4 33 in 1993, indicating PrsR 5.4 11.1 12.9 7.8 8.4 8.9 the increasing Priy 0DeGci O.8 5.2 4.7 -1.7 41.8 -24 OperameonalmDerwit 3.4 8.0 9.1 ... 3.6 pressure on the n: SPO& Tresmuystffestimats financial system of 1/ Compsrion fcIxrm tmerds scbnIas(oreuim te)inpuamtofONPisompliced bytbb.kdut the mounting fiscal sit r mid norniml GNP is im ly how dn pepmmad leveb imbalance. The 2/ spO nfmZ Odf odi995. private sector's 3/ Drice between total interest pqamn mnd mprmtion for inflticray wn ofrc incip1l. private secor s 41 The infitionay ion ofde pruqal dock ofpublic deb held by thei pncvat growing reluctance S/ ldude: brrOwig of non-furnc.l SEEc uA EBF, duWe in net defered peymats end in casunk *oe to finance large 6/ Gram o* c*uged for mairpublic cdebt ndnet ofpublic - dcepcitbw. brkingtem. public deficits was reflected in a dramatic shortening of the maturity of domestic debt (the share of Government securities with a maturity of one year or more declined from 50 percent in 1989 to 10 percent in 1993), real interest rates required to place public debt increased sharply, and the real (inflation adjusted) burden of interest payments jumped from 2.2 percent of GNP in 1991 to 4.4 percent in 1993. In parallel, there was a general shift away from lira denominated assets, with the share of foreign exchange 2The Operational Deficit is equal to the PSBR less the inflation compensting part of total interest payment, the atter corresponding to the inflationary erosion of the principal stock of public debt held by the private sector.  3 deposits in total bank deposits increasing from about 20 percent in 1989 to more than 50 percent in 1993. This contributed to a significant erosion of the base for monetary financing and fueled inflationary expectations. These developments indicated the growing limits to the domestic financing of large fiscal deficits in Turkey, and the vulnerability of the economy to crises of confidence. Volatile Growth and Mounting Imbalances 1.5. The rising fiscal imbalances were mirrored in increasingly volatile growth and mounting pressures on the external accounts (see table 2). Although real GNP rose by about 4 percent per year in 1988-91, there was considerable annual variation, reflecting the uncertain course of macroeconomic policies. Following robust growth in 1992, GNP grew by more than 8 percent in 1993 as the sharp rise in public expenditures and large real wage increases fueled a broad-based expansion in aggregate domestic demand; private consumption rose by almost 8 percent and total investment demand climbed by an unprecedented 31 percent. Imports moved in step with domestic demand and increased sharply in 1993. Consistently high at around 60 percent since the late 1980s, inflation continued at this level in 1992 and 1993; it edged upwards in the second half of 1993 as monetization of the PSBR became more pronounced and the economy began to show clear signs of overheating. 1.6. The widening public sector deficit Figure 1 also showed up in divergent paths of private % and public savings. Private saving increased Saving-Investment Gap (In PacentoIONP) from 19 percent of GNP in 1990 to 24.5 8 percent in 1993 while public savings 4 .. .. .... . _ ... declined from 3.5 percent of GNP to -2.8 2 percent. Although the increase in private o..... ....... saving (reduction in public saving) is less -2 .~..~ steep when proper adjustment is made for 4.~ -.. . the inflationary erosion of net domestic . ...... ....... public debt,3 the trend of increasing public 4_. dissaving remains unchanged. With the -10 exception of 1990 and 1993, public I 9 v9t*11 1b - Foreign investments have been declining since the mid-1980s. Yet, the gap between public saving and investment continued to increase, reaching almost 10 percent of GNP in 1993. As shown in Figure 1, this gap has been financed by a combination of foreign savings and an excess of private savings over investment, suggesting that current outlays by the public sector were crowding out capital investments by the private sector. 1.7. Turkey's increasing internal imbalances were reflected in foreign deficits from 1990 onwards. Significant external trade imbalances were partly compensated by official transfers (related to the Gulf crisis) and a continued increase in service related foreign exchange earnings (tourism in particular). 5Private disposable income includes the nominal rather than the real component of interest payments, thereby including a compensation for the loss in the real value of the assets, and does not take into account the inflation tax. As a result, inflation creates an upward bias in the measured private saving rate. The absence of inflation accounting thus introduce a bias in the estimation of private and public savings. An adjustment to account for inflationary erosion of privately held public debt lower private saving and similarly increases public saving.  4 However, with a sharp deterioration in the trade balance, the current account deficit jumped to an estimated 3.6 percent of GNP ($6.4 billion) in 1993, up from 0.2 percent ($0.9 billion) in the previous year. The poor external performance appears to be the result of the general state of buoyant domestic demand and a real exchange rate appreciation. Despite growing financial imbalances, Turkey experienced little difficulty in meeting external financing requirements during 1993. As a result, the stock of external debt increased from US$55.6 billion by end-1992 to $67.4 billion (equivalent to 37 percent of GNP) by end-1993. Much of the financing was short-term borrowing ($5.9 billion) contracted by the banking system ($4 billion). This left the banking system with a large uncovered foreign exchange position by the end of 1993. The Currency Crisis 1.8. The unsustainable macroeconomic policy stance caused a severe currency crisis during the early months of 1994. In addition to the mounting internal and external imbalances, a number of circumstances contributed to the sharp weakening in financial market confidence which occurred during the last months of 1993. Treasury bill auctions were repeatedly canceled in the last two quarters of the year to avoid paying higher interest rates. It also was clear that the 1994 draft budget presented to Parliament would not adequately address the growing imbalances. Successive downgradings of Turkey's credit rating by the international rating agencies, exacerbated by the (temporary) introduction, in the beginning of 1994, of a withholding tax on Government securities 4. held by private individuals, triggered a run on the currency. 4With the objective to equalize the tax treatment of TL and foreign exchange denominated securities (and deposits), the withholding tax on all TL denominated securities and deposits was set at a flat 5 percent rate at the end of 1993 (decree no. 93/5148, dated December 30, 1993). However, this entailed the introduction of a 5 percent withholding tax on Govemment securities held by private individuals which, previously, had been subject to no tax. The timing of the change in the withholding tax proved to be unfortunate, and contributed to the collapse of the domestic securities market in the first weeks of 1994 and fueled the already strong move out of TL denominated assets into foreign exchange instruments. While the withholding tax on Government securities held by private individuals was abolished again by the end of January (in decree 94/5255, dated January 27, 1994), the effects on currency flows could not be undone and uncertainties about taxation of financial instruments had been introduced.  5 1.9. As a result, the market value of the lira depreciated by about 50 percent during the first quarter of 1994. The crisis was compounded by the fact that the banks carried about US$5 billion equivalent or almost 120 percent of their capital in uncovered foreign exchange positions at the end of 1993. When the Lira tumbled in early 1994, the capital position of the banking system effectively turned negative, causing major havoc to the financial system in Turkey. In an attempt to stem the depreciation, the Central Bank of Turkey (CBT) intervened heavily in both foreign exchange and money markets. Foreign exchange reserves of the CBT declined by over $3 billion during this period, while overnight money market rates averaged over 200 percent, with considerable daily variation. These developments compelled the Treasury to increase its recourse to CBT financing, exacerbating inflationary pressures and the depreciation of the lira. By March, the Treasury had reached the legal limit of CBT advances for all of 1994. In the face of spiraling inflation and severe financial market instability, the Government announced a stabilization program on April . Table 2 Key Economic Indicators (1990-95) 1990 1991 1992 1993 1994 1991 Real Growth Rates ---------------------------- Is %------------ GNP 9.4 0.4 6.4 8. 1 -6.1 5.9 1/ Private Consumption 10.0 2.2 5.4 7.7 -4.1 Price Increases ----------------------- ebaage I ---------------------- Wholesale Price Index: Average Annual 52.3 55.4 62.1 58 .4 120.7 88.5 End-of-year 48.6 59.2 61.4 60.3 149.6 64.9 Resource Balances --------------------- 1 6% ar GD P ------------------------ Total Consumption 78.1 78.4 79.0 77.9 77.2 78.6 Groxs Domestic Fixed Investment 25.5 23.5 23.1 26.8 21.6 23.3 Private investment 16.8 16.0 16.5 19.8 17.9 19.2 Government investment 8 7 7.5 6.7 7.0 3.7 4.1 Resource balance -3.6 -1.9 -2.1 -4.8 1.2 -1.8 Exports GNFS 13.5 14.1 14.7 13.9 21.3 Imports GNFS 17.0 16.0 16.8 18 .7 20.1 Gross domestic savings 2/ 21.9 21.6 21.0 22.1 22.8 21.4 Balance atPaymient ------------------ b USS b-illos- Current Account 3/ .2 0 3 L09 4J 2 6 - Trade Balance -9.6 -7.3 -8.2 -14.2 -4.2 -10.1 Export (fob) 13.0 13.7 14.9 15.6 18 .4 17.5 Import (fob) 22.6 21.0 23.1 29.8 22.6 27.6 Interest Paym ents 2.9 3.3 3.4 3.5 3.9 3.5 Capital Account 19 LA Lod3 L fi 68 Portfolio & Direct Investment 1.2 1.4 3.2 4.5 1.7 1 5 Long-Term Capital (net) -0.2 -0.8 -0.9 1.4 -0.8 -0.2 Short-Term Capital (net) 2.9 -1.9 0.2 0.8 -3.4 7.6 Change In Official Reserves 4/ 1I -3 0 R5 21 0 21 L External Debt (end-of-period) Total External Debt 49.1 50.0 55.6 67.4 65.6 73.2 Long Term Debt 39.6 40.9 42.9 48.9 54.3 57.6 Public & Publicly Guaranteed 38.5 39.0 39.5 42.9 48.2 50.3 Private. Non-Guaranteed 1.1 1 9 3.4 6.0 6.1 7.3 Short Term Debt 9.5 9.1 12.7 18.5 11.3 15.6 Total Debt Service 5/ 7.3 8.2 9.0 8.6 10.2 8.3 ------------------- - oef GNP ----------------------- Current Account Balance 4/ -1.7 0.2 -0.6 -3.6 2.0 Total External Debt 32.2 32.9 34.6 38.4 49.5 External Debt Service 5/ 4.8 5.4 5.6 4.9 7.7 Son rse Turkish Authorities; Staff Estim ates. I/ Provimiosal estimate for 1995; SPO. October 1995. 2/ Includes not unrequited trnsferr excludinS official capitel grants. 3/ After O fficial transfers. 4/ Include use of IM F rourc; (+)() - incrse/decras. 5/ Includes debt servica on short term debt, private and public.  6 B. CHANGE IN POLICIES: FIRST STEPS TOWARDS REESTABLISHING MACROECONOMIC BALANCE The April 5 Program 1.10. The April 5 Program aimed at reducing inflation, improving the external balance and restoring stability to the foreign exchange market. The core of the program was a front-loaded fiscal retrenchment, and the PSBR was to be reduced by half, to 6.2 percent of GNP. The principal measures adopted were a variety of once-off tax measures, immediate price-increases for products of SEEs, reduced transfers and subsidies and a nominal freeze in most budget expenditure appropriations, particularly for investments. These fiscal measures were to be supported by restrained monetary and credit policies. To restore financial market stability, the Government also took the radical step of extending guarantees to 100 percent of individuals bank deposits. Furthermore, legislative measures were adopted to ensure a gradual reduction in the Treasury's recourse to short- term advances from the Central Bank. 1.11. The program also foresaw a number of structural initiatives, including measures to: down-size the public sector and improve its efficiency; streamline the tax system and raise efficiency of tax collection; lower import protection and revise competition legislation in preparation for the impending Customs Union with the EU; reform agricultural support policies and incentive programs; reduce financial deficits of enterprises maintained in the public portfolio, strengthen their operational performance and subject them to a hard budget constraint; privatize SEEs; and reform the social security system. The program thus set out to address the critical causes behind the crisis and an important part of the envisaged measures was actually implemented. However, it turned out that the Government did not have necessary political support to implement the critical structural reforms related to privatization and the social security system in a coherent way. Shortfalls in Implementation 1.12. The primary balance improved by an impressive 6.6 percentage points of GNP from the 1993 level and went into surplus for the first time since 1988. As a result, the PSBR was reduced to 8.0 percent of GNP, down by 4.6 percentage points from the 1993 level, but falling short of the program target. Key to the improved financial performance was a sharp reduction in primary expenditures in the consolidated budget; reduced outlays on personnel, investment and transfers to state enterprises accounted for most of the decline. The package of once-off tax measures compensated for declines in other revenue sources and produced a modest increase in total budgetary revenues. Higher-than- envisaged transfers (TL 35 trillion or 0.7 percent of GNP) to cover the deficit of the social security institutions contributed significantly to the deficit of the consolidated budget. The PSBR overrun was almost exclusively due to higher-than-expected interest payments and shortfalls in privatization receipts. 1.13. Higher interest payments were due in part to higher-than-envisaged interest rates and domestic borrowing in the early months of the program that locked-in debt service at very high interest rates. After an initial reduction in its outstanding balance at the CBT, the Government was compelled to resume borrowing from the CBT and reached the legal limit on such borrowing in the third quarter of 1994. Repeated attempts to exert downward pressure on interest rates, including through  7 manipulating liquidity and reserve ratios and commercial bank rates, had little discernible effect and interest rates remained high relative to contemporaneous inflation throughout the last two quarters of 1994, indicating limited confidence in the ongoing disinflation process. 1.14. The shortfall in privatization receipts illustrates the key shortcoming in the execution of the stabilization program -- the slow progress in implementing structural reforms. While the financial performance of the SEE sector was broadly in line with expectations, privatization and closure of loss- making enterprises was much slower than anticipated. Privatization was effectively suspended following the Constitutional Court's ruling in July 1994, that the legal underpinnings of the process were unconstitutional. Political sensitivities and lack of consensus on the need for closures of loss- making SEEs blocked progress on that front. The envisaged pension system reforms also suffered major delays and the system's unsustainable financial position was largely unaddressed. Economic Downturn and Improved External Balances 1.15. The currency crisis and accompanying loss of investor confidence combined with the sharp fiscal tightening and high interest rates resulted in a substantial and broad-based compression of domestic demand. Real GNP thus fell by an estimated 6.1 percent in 1994. Total investments declined sharply by almost 30 percent and consumption declined by more than 5 percent. The only positive growth impetus in 1994 came from external trade. 1.16. A major success of the April 5 Program was the rapid restoration of external balance. The improvement in the current account reflected the sharp drop in domestic demand combined with a 25 percent plunge in the real effective exchange rate from 1993 to 1994 (see Figure 2). The trade deficit was reduced by almost $10 billion from 1993, Figure 2 as the dollar-value of exports increased by 17 Real Effective Exchange Rate (1990-100) percent and imports 110 dropped by 21 percent. 100 As a result, the current 90 account improved by 8a0 almost 6 percentage point of GNP and 70 moved into a surplus of 60 ___l _l _l _l _l _l _l _e _l _l_l _l _l__ 2 percent of GNP in 1ow 19w 192 1993 193 1994 19 196 1w6 2a 40 20 40 20 40 1994. In conjunction with large short-term Souce: IMF. CPI based Index using ede weight far 20tadIng putem capital inflows, partly making up for the exodus in the first quarter, the current account surplus enabled a small gain in foreign reserves from the end-1993 level. This also allowed Turkey to service debt payments of about US$10 billion in 1994 without major  8 problems. Large net-repayments, particularly of short-term borrowing, reduced the stock of external debt by some US$1.8 billion to US$65.6 billion (50 percent of GNP) by end-1994.5 Failure to Control Inflation 1.17. In spite of the large fiscal contraction, the program failed to bring inflation under control (see Figure 3). After increasing somewhat in the Figure 3 first months of 1994, Year-on-Year Inflation (WPI): 1993-95 inflation jumped as the YActual, April Program & 1995 Program Targets effects of the sharp 10 A exchange rate depreciation 140 and price increases for 120 SOE-products were passed 100 13-0 on to the wholesale and so retail prices; as a result, e_ the WPI increased by 45 40 percent in April and May i c f X X alone, raising the 12- -Actual --April 5 Prog -^-95 ProO month increase from 75 percent in March to 140 percent. While the summer months saw a significant easing in inflation, prices rose sharply and out of line with program targets through the last 4 months of the year. Consequently, WPI inflation averaged over 120 percent in 1994. 1.18.The resurgence in inflation during the last 4 months of 1994 came after a shift in monetary policy aimed at decreasing the burden of public domestic debt service through lower interest rates and, temporarily, accelerating the depreciation of the exchange rate. The fact that inflation remained on its higher path through the end of 1994 (and continued to do so into 1995), notwithstanding some tightening of monetary policy later in the year, could suggest that this shift caused a critical blow to public confidence in the sustainability of the anti-inflation program. It can also be argued that the resurgence in inflation was due to insufficient sterilization of excess liquidity and strong growth in broad money (M2) in earlier months, thus suggesting a lax monetary policy stance from the very outset of the stabilization program. Implementation of monetary policy was complicated by strong reflows of short-term capital and reversals in currency substitution. The shift in policy made evident the authorities concern about the trade-off between the budgetary costs and credibility-enhancing effects of a contractionary monetary policy and high interest rates. However, whatever were the proximate causes of the uneven inflation performance in 1994, the fiscal sustainability analysis discussed below indicates that the underlying core inflation was indeed close to actual inflation and gives credence to the notion that inflationary expectations remained strong and unaffected by the stabilization effort. Mirrored in high real interest rates, the strong inflationary expectations reflected a general lack of confidence in the stabilization program and slow implementation of structural reforms. 5Despite the decline in the dollar value of external debt from 1993 to 1994, the ratio to GNP increased significantly due to the valuation effect of the sharp lira depreciation.  9 The 1995 Program 1.19. In light of the inflation performance in 1994, the Government launched a revised stabilization program in early 1995. The program, which received support under a new IMF SBA, set out to reduce end-year (WPI) inflation to 37 percent (corresponding to an average annual inflation of 70 percent) through further tightening of the fiscal stance and a monetary policy aimed at maintaining a stable path for the nominal exchange rate. The targeted reduction in the PSBR, to 5.6 percent of GNP in 1995, was expected to be brought about by a combination of increases in regular tax revenues, reduced expenditures (primarily personnel and transfers) and, in particular, sharply increased revenues from privatization of SOEs. The program laid out an ambitious agenda for privatization of public enterprises as well as sales of other public assets. Initially these measures were expected to yield the equivalent of 3.4 percent of GNP in revenues or about US$ 2.4 billion in receipts.6 Furthermore, measures were announced to stabilize the financial position of the state pension funds and to maintain the 1994 policy stance of contained subsidies to the agricultural sector. However, by mid-year, it became clear that privatization of SOEs was proceeding significantly slower than anticipated and the PSBR target was revised upward (to 6.6 percent of GNP) to accommodate anticipated shortfalls in privatization receipts amounting to about 50 percent of the original objective. Reform of the social security system also suffered delays as the discussion and approval of the revised legislation for the largest pension fund, Sosyal Sigortalar Kurumu (SSK), was held up in the Parliament. Furthermore, program implementation lost momentum during the last quarter of 1995 as political imperatives took precedent over economic ones in the wake of the announcement of national elections (which took place on December 24). Consequently, the review of the IMF SBA, envisaged for November, was not carried out. Preliminary Results 1.20. Preliminary data for the PSBR in 1995 point to a relatively small improvement compared to 1994, and a significant shortfall from the program target. Officially estimated at 6.1 percent of GNP in October 1995, the actual PSBR is likely to be somewhat higher as a number of unforeseen elements occurred during the last months of 1995. While the fiscal stance had been well within the program over the first 3 quarters, additional spending appropriations were granted in October, primarily to enable a significant adjustment in civil servant salaries (and retroactive pay increases) and to cover higher-than-envisaged deficits in the social security institutions. Furthermore, receipts from privatization only reached about US$500 million, significantly below the revised target for 1995. 1.21. The 1995 progran included a more concrete commitment to use the exchange rate as a nominal anchor for prices. The principle that interest rate policies should be determined by monetary and exchange rate policy, rather than fiscal, considerations seems to have been accepted, at least in part. The pre-determined exchange rate path was observed throughout most of 1995, aided by the continued large short-term capital inflows and a substantial shift toward lira denominated deposits. However, as they were only partly sterilized, the same flows into lira assets resulted in a significant increase in domestic monetary aggregates. The Central Bank's attempt to limit the growth in domestic money in September 1995, through an announced temporary stop for purchases of foreign exchange, had little intended impact but created significant turbulence and uncertainty in the financial markets. 6 The program envisaged that 20 major privatization projects would be implemented in 1995 involving enterprises with an estimated market value of some US$5 billion. The Government expected to fuly privatize 7 of these projects and realize USS 2.4 billion from privatization in 1995.  10 In fact, monetary expansion accelerated subsequently as the additional budget appropriations enabled the Treasury renewed access to short-term advances from the Central Bank. 1.22. The decline in inflation turned out to be slower than targeted in 1995. WPI inflation reached 64 percent in the 12 months to December, exceeding the 37 percent target by a wide margin. Average annual inflation (WPI) in 1995, while below the level in previous year, remained at almost 90 percent. The continued high inflation was joined by a stronger-than-anticipated rebound in economic activity. GNP grew by an estimated 7.6 percent in the first 3 quarters of 1995, driven by vigorous growth in private consumption, a sharp recovery in private investment, and continued strong exports. 1.23. The recovery in economic activity, combined with an appreciation of the real effective exchange rate (see Figure 2 above) led anew to a growing trade deficit in the first 10 months of 1995. While exports rose by 30 percent compared to the same period in 1994, imports grew by 43 percent. Despite the widening trade deficit and mainly due to higher foreign exchange receipts from tourism, workers remittances and other transfers, the current account balance only registered a minor deficit of US$70 million during the first 10 months of 1995. Turkey also gained renewed, but limited access to international financial markets. The short-term capital inflows continued in the first 10 months of 1995, underpinning the real exchange rate appreciation and causing significant problems to the implementation of the envisaged monetary policy as the authorities found it difficult to sterilize the monetary effects. The experience in 1995 shows the difficulty of using the exchange rate as a nominal anchor when other macroeconomic imbalances are not being addressed adequately. C. AN ASSESSMENT: TAKING STOCK OF THE STABILIZATION EFFORT 1.24. While the stabilization program in 1994-95 achieved a significant reduction in the fiscal imbalances it did not succeed in addressing the fundamental structural problems related to the public sector at large and the public enterprise sector and social security system in particular. Inflation and real interest rates remain very high, pointing to strong underlying inflationary expectations and a lack of confidence in the program. By the beginning of 1996, Figure 4 there were no signs that Contam poraneous Inflation (WPI) and inflation was on a downward Interest Rates (3 Months T-bilIsl 200 trend from the 90 percent 10o level reached in 1995 (WPI, 14o annual average), and W120 contemporaneous real interest 100 rates remained at , o0- unsustainably high levels as 420 2 0 shown in Figure 4 by the 0 differencebetweenthe | i I i I l E I I i! -3M T-bilIs (snnualiz.d) -S--W Pi (3 subsequent M. annuallzad| annualized compounded interest rate on 3 month T- bills and annualized inflation during the subsequent 3 months.7 7Assuming that investors' have perfect foresight with respect to inflation (i.e., expected inflation equals realized), the differenmc between the annualized compounded interest rate on 3 month T-bills and annualized inflation during the subsequent 3 months providcs an indication of the real interest rate required by investors to hold Govemment securities during that period. Adjusting  11 1.25. The high and rising real interest rates on Government securities experienced over the past couple of years also, to some extent, reflect the increasing pressure of large internal transfers from the private to the public sector. As the public sector had very limited access to foreign financing during 1994-95, Treasury was compelled to cover the PSBR and the bulk of its external debt service through domestic borrowing. Turkey's sizable external debt service in both years was thus met primarily through private inflows and transfer of private sector net-savings to the public sector through the domestic financial markets. The pressure on the domestic financial markets was accentuated by a dramatic shortening of maturities for Government securities; about 70 percent of (gross) borrowing in 1994 and almost 50 percent in 1995 took place through 3 months Treasury bills, compared to less than 15 percent in 1993. The external portfolio management problem is further complicated by the relatively large share of short-term debt; although short-term debt to total debt outstanding and disbursed (DOD) declined from a peak of 27 percent in 1993 to about 14 percent in 1994, there was renewed recourse to short term borrowing abroad in 1995. As Turkey will continue to face a major external debt service burden during the next several years, improved access to longer-term foreign capital and reduced domestic borrowing of the public sector will be critical to reduce the pressure on the financial markets and achieve lower real interest rates. However, improved access to international financing and reduced domestic borrowing will only be achieved through smaller fiscal deficits and significantly lower inflation. 1.26. The current level of inflation is significantly higher than that prevailing during the period prior to the currency crisis and Turkey may be close to crossing a critical threshold towards dangerously high inflation. The lack of confidence in the stabilization program and the failure to quell underlying inflationary expectations in 1994-95 stem primarily from two related factors: insufficient fiscal adjustment and slow progress in implementing critical structural reforms to ensure sustainability of the tighter fiscal stance over the medium-to-long term. The experience from 1994-95 also highlights the limitations of monetary and exchange rate policies in the current stabilization effort. Although the PSBR was met primarily through domestic debt issuance and recourse to central bank advances declined significantly, the negligible impact on inflation trends could reflect market expectations of future monetization and inflation. These issues are discussed below. Inflation: A Critical Threshold Crossed? 1.27. With annual average inflation running at almost 90 percent in 1995, up from the plateau of 60 percent prevailing during the 6 years preceding the currency crisis, Turkey may be in danger of crossing a critical threshold. Many countries have managed to maintain good growth performance at moderate inflation rates. A limited number of countries have experienced periods of rapid growth at high inflation rates. But no country has let this process slip into triple digit inflation without either sliding towards hyper-inflation or launching determined efforts to reduce inflation. 1.28. Turkey's performance over the past two decades places it among the small group of countries which seemingly defies the conventional wisdom that high inflation is necessarily associated with low growth.' However, those same countries, sooner or later, experienced severe foreign exchange and inflation for seasonal patterns, while appropriate for other purposes, would not provide a meaningful indication of contemporaneous real interest rates. I See Stanley Fischer: The Role of Macroeconomic Factors in Growth, Journal of Monetary Economics, December, 1993. The oountries identified by Fischer which experienced spells of 'high inflation - rapid growth' includes (reference period is indicated  12 economic crisis which either became a turning point for a serious stabilization effort or triggered even higher inflation and a deep crisis. Table 3 Tburiey hIflation, Grwth & Volatility 1960-70 71-77 78-79 . 9i. 81-87 88-93 3i 199S Anual inlabon (WPI) 1/ 5.2 19.1 58.3 .... 36.4 60.3 8 8.5 Per CapitaGN wth 3.0 3.9 -2.0 -.4. 3.5 2.3. . 4.03 Volaiity of NPCvwth2/ 0.50 0.38 - 0.26 077 - 1/ Simple averdp of anumal avwd iflation 2/ Coefficiert of Variaion for real GmN Gwt1h (= Standard DcvationwMan GNP Growth). 3/ Based on SPO estnute for GNP growth October 1995.. Source: SPO 1.29. A recent World Bank study on inflation and long-term growth suggest that 40 percent inflation may constitute a critical threshold (see Annex I for a brief discussion of the study)." First, it seems to be a breaking point for even higher inflation. Those countries (127 countries were included in the study) with inflation rates in the 20-40 percent range during the 1970s experienced higher inflation in the 1980s, although they still did not go into extreme inflation; however, most of the countries that crossed the 40 percent threshold in the 1970s were on their way to extreme inflation rates in 1980s. Second, growth rates appear to be severely, negatively affected at inflation rates above 40 percent. The study found that growth during inflation crisis (defined as inflation of 40 percent or higher prevailing for two consecutive years or more) was both significantly below the world average for the period and below the country's growth rate prior to the outbreak of the crisis. Low-to-moderate inflation may not lead to immediate growth reductions but it is very likely to lead to much higher inflation and thus eventually cause negative growth. 1.30. As shown in Table 3, Turkey itself fits the pattern during the earlier 1978-80 inflation crisis and again in 1994 when per capita growth was negative and significantly below the world average. Although still above world average, Turkey's growth rate declined during the high-inflation period 1988-93 compared to previous periods. Recent experience also suggests that Turkey passed the 40 percent threshold in the late 1980s. Furthermore, the performance in 1995 should provide a serious warning that Turkey may be on the way to triple-digit inflation in the second half of the 1990s unless strong stabilization efforts start taking hold. While Turkey's growth-inflation performance over the past 10-15 years has been exceptional, international evidence points to the slim likelihood of maintaining robust growth at even higher inflation rates and the increased probability and higher frequency of crisis under such conditions. in parenthesis): Argentina (1975-87), Brazil (1980-87), Chile (1972-77), Ghana (1977-78), Israel (1979-85), Peru (1979, 1983- 87), and Uganda (1981, 1985-88). 9 Michael Bruno and William Easterly, Inflation Crises and Long-run Growth, mimco June 1995, World Bank.  13 Further Fiscal Adjustment is Needed 1.31. Developments in 1994 and 1995, as in previous years, point to the overriding role of an unsustainable fiscal position as the root cause of Turkey's high inflation. Demand pressure and cost- push factors, including one-time devaluations, can cause shifts in price levels but cannot explain sustained inflation. Continued devaluation of the nominal exchange rate and excessive monetary expansion can provide proximate explanations of high levels of inflation but beg the questions of why authorities need to resort to such policies and what drives the process of sustained monetization. Economic theory, supported by evidence accumulated world-wide, suggests that the answer to those questions is fiscal deficits which are unsustainably high. 1.32. An indicator of whether the actual fiscal stance is consistent with the inflation target is provided by the so-called "financeable deficit." For a given inflation target and assumptions regarding other macroeconomic variables, the financeable deficit is the level of the overall public sector's operational budget balance which will maintain a constant public debt-to-GNP ratio.'0 Analysis carried out using this approach (see Annexes II-A and II-B, Volume II, for details) suggests that to reduce inflation to 40 percent (the target for 1995), the primary surplus would need to improve by another 1 'h - 2 percent of GNP compared to the level attained in 1994. Moreover, as discussed in Chapter V, the Customs Union and the ensuing tariff reduction are estimated to result in a net-revenue loss of up to 1.1 percent of GNP. As preliminary indications regarding the overall public fnance position in 1995 suggest little improvement over 1994, new fiscal measures in the range of 2.5-3 percent of GNP are thus needed to provide the necessary fiscal underpinning for a significant reduction in inflation. This corresponds closely to the magnitude of fiscal adjustment set out in the seventh Five Year Plan (1996-2000) that was unveiled in mid-1995. However, whereas the P'an document aims at achieving this goal by the year 2000, the analysis summarized in Annex I! i to this report points to the importance of accomplishing the fiscal adjustment as quickly possible. A the prevailing high real interest rates, which exceeds the real growth of the economy by a wide alargin, and in view of the limited confidence in the stabilization effort, delaying the adjustment cr; .d lead to escalating adjustment problems and the magnitude of the required fiscal retrenchment may, eventually, be signficantly larger. 1.33. This result is sensitive to a number of critical assumptions, the most important of which concerns the composition of monetary aggregates (the ratio of foreign exchange deposits in M2Y, in particular) and the real interest rate on public debt. A lower level of real interest rates than that assumed in the calculations (i.e., 16 percent corresponding to the average level in 1994) would reduce somewhat the need for additional fiscal retrenchment. However, as noted above, interest rates have remained stubbornly high, averaging about 25 percent in 1995, and suggesting that the magnitude of the fiscal adjustment recommended above constitute a lower bound. This also suggests that Turkey may find itself in a classical credibility gap situation where interest rates are high because the targets set out in the stabilization program are not believed and, as a result of high interest rates, the fiscal targets are indeed difficult to achieve. The credibility gap experienced in 1994-95 was primarily due to the disappointingly slow implementation of structural reforms and the perception that the fiscal retrenchment achieved could not be sustained over time. 10 An assumption of constant debt-to-GNP ratio may seem arbitrary. However, under current circumstance it is probably the most reasonable asumption: a continued increase in the ratio would clearly not be sustainable whereas a decline, while conceivably desiable over the longer term, would amplify the need for fiscal adjustment in the short-to-medium term.  14 Sustainability and the Critical Importance of Structural Reforms 1.34. The fiscal adjustment in 1994 and that expected in 1995 might have been sufficient to achieve the envisaged reduction in inflation had it been complemented by the announced and desirable structural reforms. However, the critical structural reforms of the public enterprise sector and the pension system were not carried out and program credibility suffered as a result. This also raises concerns about the extent to which the fiscal measures can be considered to be permanent and not easily reversed, and the ability to maintain a tighter fiscal stance over time. 1.35. Personnel expenditures and public investment outlays bore the brunt of the fiscal adjustment in 1994. In 1995, personnel expenditures were to remain roughly constant in real terms, but public investment has been squeezed further. Civil servant salaries declined by almost 40 percent in real terms in 1994, and no real increase was envisaged for 1995; a significant (60 percent) salary adjustment occurred in November 1995, however, this did not bring about any increase in real terms for the year as a whole. It is an open question whether and for how long such a squeeze can be maintained, even if the salary increases granted until 1993 were excessive. The cutback in public investments has been implemented in a costly fashion; the reduction was implemented across-the- board and could increase the total completion cost of the projects. On the revenue side, the contribution to the deficit reduction in 1994 came entirely from temporary tax measures which were phased out in 1995. However, the efficiency and revenue enhancing tax reforms enacted in 1993-94 are expected to result in a significant improvement in revenue performance beginning in 1995. 1.36. The envisaged improvement in the fiscal position in 1995 was expected in large measure to come from privatization receipts. However, privatization receipts -- which, as it turned out, fell short of programmed levels by a wide margin -- cannot be expected to be recurrent. Moreover, a portion of these receipts will be needed to cover the liabilities which will arise in the context of privatization and liquidation of public enterprises. With the exception of an improvement in tax revenue performance, the fiscal adjustment envisaged in. 1995 was short on measures with lasting and sustainable impact. To bolster the credibility of the stabilization effort, more fundamental structural reforms will need to be implemented to compensate for revenue losses emanating from the Customs Union and allow adequate room for investment in public infrastructure. Limitations on Monetary Policy 1.37. The open capital account combined with easier and more prevalent currency substitution has serious implications for the design, implementation and effectiveness of fiscal, monetary and exchange rate policies. The scope for discretionary monetary policy and its ability to control aggregate domestic demand are limited. The increased vulnerability to external shocks and to changes in investors expectations has significantly reduced the time span during which a contractionary monetary policy can be sustained if not backed by an appropriately tight fiscal policy stance. 1.38. This was borne out by developments in 1994 and 1995 as Turkey experienced some of the problems involved in a situation characterized by lack of confidence, insufficiently tight fiscal policy, and aggressive monetary and exchange rate policies. The relatively tight monetary stance resulted in large short term capital inflows and reversal of currency substitution. Attempts to sterilize these flows have largely been defeated by the resulting upward pressure on interest rates which, in turn, attract even more external capital and increase the interest burden of public debt. Unless confidence is established, this vicious spiral may eventually lead to sharp reversals in capital flows and/or  15 prohibitive interest rates to stem the flows. The appreciation in the real exchange rate experienced since May 1994, and cemented with the formal adoption of an exchange rate anchor in early 1995, contributed to the sharp deterioration in the external trade balance in 1995, and may lead to increasing pressures on the authorities to relax its policy stance. Going back on these policies, however, could undermine the credibility of the stabilization program further. The surest way out of this dilemma is through additional fiscal restraint and confidence-building structural reforms. D. CHALLENGES AHEAD 1.39. Among the many challenges facing Turkey today, two stand out as key to the country's medium-term economic prospects: the need to reduce decisively inflation and to position the economy so that it can reap the full benefits of the Customs Union with the European Union. As recognized in the Seventh Five Year Plan, diminishing the financial burden of the public sector and reducing the role of the State in those areas of the economy where the private sector clearly is capable of assuming responsibility are at the core of both challenges. 1.40. Recent experience suggests that a sustainable reduction in inflation will require a significant additional fiscal adjustment (i.e., 2.5-3 percent of GNP as discussed above) and fundamental structural reforms of the public sector. In the short term, Turkey may be able to substitute an even stronger fiscal effort for somewhat weaker structural reforms while achieving the objective of moderate inflation (30-40 percent). However, the additional fiscal adjustment required to compensate for weaker or slower structural reforms is likely to be prohibitively large. Moreover, as structural reforms will be required in any case to sustain the fiscal position over the medium-term, the Government should move decisively on fundamental reforms of the public sector in combination with some additional fiscal restraint. This approach would also have the advantage of improving overall economic efficiency and allowing Turkey to reap the full benefits of closer integration with the EU through the Customs Union. Briefly summarized below, the key areas in which the Government should seek to achieve the required fiscal adjustment and structural reforms as well as the challenges presented by the Customs Union are the topics of the remainder of this report. 1.41. As noted above, a large part of the fiscal adjustment in 1994 has been through sharp cuts in personnel expenditures and public investment, and privatization receipts made up the bulk of the adjustment envisaged in 1995. Although effective in the short-term, these measures do not provide an adequate basis for continued fiscal restraint. As acknowledged in the recently adopted Five Year Plan, more fundamental reforms will need to be considered, in particular related to: reducing incentives and agricultural subsidy programs; containing wage expenditures through down-sizing of the civil service; and strengthened performance of the tax system which, despite recent improvements, still suffers from a number of weaknesses related to its administration and is causing equity and efficiency concerns. These issues are discussed in Chapter II. 1.42. Turkey's social insurance system suffers worsening financial imbalances and will absorb an increasing share of public expenditure unless fundamentally reformed. The growing deficits are of immediate concern in view of their adverse impact on public finances. However, a number of features in the current social insurance system give rise to serious microeconomic distortions, adversely affecting factor markets, labor and employment levels in particular, savings levels, and social equity and welfare distribution. These problems are also identified in the Five Year Plan, and addressing them will not only help provide a lasting solution to Turkey's fiscal deficit problems but will also  16 improve the allocation of production factors. The looming crisis of Turkey's social insurance system is discussed in Chapter III. 1.43. The importance of decisive progress in reforming the public enterprise sector has been embraced by the financial markets -- inside and outside Turkey -- as the key indicator of the Government's resolve and credibility in carrying out its overall stabilization program. Moving swiftly on reforms in the sector is thus not only dictated by the precarious public finance situation but also by the urgent need to build confidence in the stabilization effort. Furthermore, the advent of the Customs Union, and the need to open the internal economy along with the external, provides Turkey with a good opportunity to proceed swiftly with the well-know but long overdue structural reforms in the sector. Accelerated privatization is key in this regard and will boost the credibility of the Government's stabilization effort. These and other issues related to the public enterprise sector are discussed in Chapter IV. 1.44. As will be discussed in Chapter V, the Customs Union (CU) with the European Union (EU) offers Turkey a unique opportunity to develop and catch-up with the largest and most prosperous economic region in the World. The economic benefits are apparent as Turkey will gain better and freer access to a larger export market. The movement toward a more open economy also presents certain challenges for Turkey's policy-makers. In the short term, the most important task concerns the replacement of lost revenues from lower import tariffs. More generally, the critical challenge for the Government is to establish and maintain economic conditions which are conducive to adjustments in production and trade patterns, and to do so for all sectors in the economy.  CHAPrER II PUBLIC FINANCE REFORM 2.1. A fiurther and more sustainable reduction in the PSBR is required to underpin the current stabilization effort. To ensure that a tighter fiscal stance can be sustained over time while leaving adequate room for increased expenditures in areas critical to Turkey's longer-term development, the retrenchment achieved in 1994 and envisaged in 1995 needs to be consolidated and complemented by structural reforms in the public sector. The reforms required in the social security system and the public enterprise sector are covered in the two subsequent Chapters. This Chapter discusses the key elements of the consolidated Government budget which should be considered in such an effort. The most urgent structural problems in the Government budget relate to the expenditure side. However, this Chapter also discusses the tax system, which continues to suffer from a number of weaknesses. Extra Budgetary Funds, although not included in central Government budget, will also be discussed here as they are intrinsically linked to the consolidated budget and their full consolidation into the budget is essential to gain full control and transparency in the use of public resources. A. EXPENDITURE CONTROL AND MANAGEMENT 2.2. A significant part of the fiscal deterioration prior to the 1994 crisis can be attributed to the rapid growth in expenditures, from 16.3 of GNP in 1988 to 24.3 percent in 1993 (See Table 1). Increases in personnel costs were Table 1 a major part of the problem as was the Composition of Consolidated Budget Expenditures mounting burden of 1988 1991 1992 1993 1994 interest payments. Total Exoenditures 100.0 100.0 100.0 100.0 100.0 Transfers and -in%ofGNP 16.3 20.5 20.1 24.3 23.1 subsidies have, on Current (rimam) 61.3 68.3 68.6 65.0 58.6 average, absorbed Personnel 24.1 37.8 42.4 34.9 30.4 about 21 percent of Transfers/Subsidies 25.9 22.0 17.1 22.8 20.0 Government's -o/w SOEs 4.8 9.4 3.7 5.3 2.3 outlays. By .O/W Soc. Sec. 3.6 1.2 1.8 2.8 4.4 contrast, investment OtherCunrent 11.3 8.5 9.1 7.3 8.2 outlays have been Interest Pavments 23.7 185 18i 24.0 33.3 declining Investments 15. 13, 13. 11.0 8.1 continuously. The Source: SPO, 1MF reduction in government expenditures in 1994 was mainly achieved through a freeze in nominal wages (at the level prescribed by the original budget provisions for 1994) and through arbitrary, cross-the-board cuts in investment outlays. These measures resulted in a 40 percent reduction in average real wages and investments dropped to a level where they absorbed about 8 percent of total government expenditures, or only 1.2 percent of GNP. 2.3. Although effective in the short-run, the measures implemented in 1994 do not provide an adequate basis for sustainable fiscal adjustment. More fundamental reforms will need to be  18 implemented to allow room for necessary public investments, to compensate for revenue losses emanating from the Customs Union, and counter expenditure pressures in other areas where the Government has less discretionary control, particularly interest payments. Personnel Expenditures 2.4. The Government wage bill, gure 1 consistently exceeding budget appropriations, increased more than twofold in real terms between 1988 and 1993 to reach 12 percent Size of Turkey's Civil Service 1.9D0 3.10% of GNP. The problem stems in part from a 180 3.00% significant increase in the number of civil e1700 2.90% servants, from 1.2 million in 1980 to more _ 1.600 t280% a- than 1.8 million in 1994 (see Figure 1). Real I 1400 2.70% wages also rose considerably since 1988, a I30 2.60% MM1,200 helped by de facto full indexation of wages 1,100 2.50% and salaries to inflation, outpacing real per 1,000 2.40% capita GNP growth by a wide margin (see i figure 2).The rise in wage expenditures has been exacerbated by the routine practice of CMI Se,rts (in 000) -Percent of Total Popuatlon accommodating increases in personnel costs without offsetting adjustments in other budget items. Given the impact that public sector wage policies have on the fiscal deficit Figure 2 and on inflationary expectations, wage Real Wages in Public Sector restraint for civil servants (and public Compared to real GNP per Capita (1981-100) enterprise employees) must be a critical element in short-term stabilization efforts. 200 However, as noted in Chapter I, civil servant 15 - salaries were reduced significantly in real 125 _ terms in 1994, and it is an open question 1001 9 whether and for how long such a squeeze can 75 be maintained; although, significant salary 50 adjustments were granted towards the end of 8 i 1995, they did not result in an increase in _ _ - _ _ _ real terms for the year as a whole. F Public Sector Real GNP/Capita Furthermore, the motivation of existing staff and the quality of new staff may suffer from continued wage depression in the civil service. To make room for competitive remuneration while containing or reducing the share of wage outlays in public expenditures the central administration will need to be significantly down-sized; this should be done as part of a comprehensive civil service reform aimed at improving the quality of public administration.' 1 The number of civil servants and labor employed by the public sector in Turkey may not seem excessive when compared to other OECD countries. However, the revenues and taxes collected by the public sector are significantly lower (in terms of GNP) in Turkey compared to the OECD average. Consequently, a civil service similar in size to OECD countries (relative to the population and other demographic measures) will exert a much greater pressure on the Turkish economy.  19 Box 1 W~~~~~~~v Seie ke-rn ,s he lin bewee ef;:cient publc a,dmnistt io ...........ndthe ' b'-iy:t:.l:y-':e:-etive:o z S S ' '- S' . s.s.su s. s .: . S: - . -: ........................................... : S . . .; s- . : : . . . . . . . . . . . . S . . . . .. *o*aosk dev*znetijs ~More. acuteyprevd t6the r for fcvlsrie isbcm ao ot velop gwea ls countri around t,e world. Th recogiooflWb .SImpo Sed bylagead nrain govermet wagffe bil was th mai coner bein the 'at F) removal of .ghostsX' front the government ... bero 7m..MS rerncmn ofsiX tempo,rirary orseasonalS woke" A<.z.<. ai entbvcen. of retie met ; i;. . -...; s tgs ; ' x '$:ND 3<~. . . . . . . . . : s,<,,,, , :' X , Si......................... . .. . . .. . . . . . . . S > ;~~~~(t freting f recuiten- st; i -5* : beo : i g t Y s .