Turkey - Country Assistance Strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 16992-TU MEMORANDUM OF TIHE PRESIDENT OF TBE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE REPUBLIC OF TURKEY August 6, 1997 Country Department VI Europe and Central Asia Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  The last Country Assistance Strategy for the Republic of Turkey was discussed by the Executive Directors in March 1993. It was included as Part II of the Memorandum and Recommendation of the President for the Bursa Water and Sanitation Project, Report No. P-5897-TU (February 8, 1993). CURRENCY EQUIVALENTS Currency Unit = Turkish Lira As of July 30, 1997 US$/TL = 0.00000627 TL/US$ = 159,480 Annual Average Exchange Rate per US$1 1995 45,678.2 lira 1996 80,694.3 lira Most recent Average Monthly Exchange Rate per US$1 May 1997 = 136,767 lira GOVERNMENT'S FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ANAP Motherland Party IFI International Financial Institution ASCU Agricultural Sales Cooperative Union IMF International Monetary Fund BOO Build-Own-Operate IP Implementation Progress BOT Build-Operate-Transfer MIGA Multilateral Investment Guarantee Agency CAS Country Assistance Strategy NEAP National Envirownental Action Plan CBT Central Bank of Turkey NEDP National Education Development Project CEM Country Economic Memorandum NGO Non-Governmental Organization CPPR Country Portfolio Performance Review OECD Organization for Economic Cooperation & Development CU Customs Union OECF Overseas Economic Cooperation Fund DO Development Objective PHRD Population and Human Resources Development Fund DOD Debt Outstanding and Disbursed PIP Portfolio Improvement Program DYP True Path Party PSA Private Sector Assessment EBF Extra-Budgetary Fund PSBR Public Sector Borrowing Requirement ECA Europe and Central Asia R&D Research and Development EDI Economic Development Institute RMT Resident Mission Turkey EIB European Investment Bank SBA (IMF) Stand-by Arrangement ESW Economic and Sector Work SEE State Economic Enterprise EU European Union SME Small- and Medium-Scale Enterprises FSU Former Soviet Union SOE State-Owned Enterprise GAP Guneydogu Anadolu Projesi (Greater Anatolia Project) SPO State Planning Organization GATT General Agreement on Trade and Tariffs SSK Sosyal Sigortalar Kurumu (Social Security Institution) GDP Gross Domestic Product TMO Toprak Mahsulleri Ofisi (Soil Products) GNFS Goods and Non-factor Services TCDD Turkiye Cumhuriyeti Devlet Demiryollari (Railways) GNP Gross National Product UNICEF United Nations International Children's Fund IBRD Intemational Bank for Reconstruction and Development WTO World Trade Organization IFC International Finance Corporation Vice President: Johannes F. Linn, ECA Country Director: Ajay Chhibber, ECCO6 Responsible Staff: Samuel K. Otoo, ECCO6, Suman Mehra, ECCO4  FOR OFFICIAL USE ONLY REPUBLIC OF TURKEY COUNTRY ASSISTANCE STRATEGY Table of Contents EXECUTIVE SUMMARY .........................................................i I. COUNTRY CONTEXT .........................................................1 A. Political Situation ........................................................1l B. Economic Perfornance ........................................................1I C. Social Development .........................................................3 II. DEVELOPMENT PRIORITIES ........................................................4 A. Overview .........................................................4 B. Accelerating Structural Reforms .........................................................4 C. Addressing Poverty and Social Development ......................................................... 6 D. Enhancing Competitiveness and Employment Growth ...................................................7 III. ECONOMIC OUTLOOK ........................... . 9 A. Exte rnal Environment ...........................9 B. Policies and Prospects ........................... 0 IV. ROLE OF THE BANK GROUP .......................... 12 A. Context and Challenge .......................... 12 B. Assistance Priorities .......................... 14 C. Instruments of Assistance .......................... 17 V. MANAGING THE RISKS .......................... 21 A. Strategy Risks .......................... 21 B. Country Risks .......................... 22 Text Boxes: Box 2.1: Poverty and Social Development ........................................................8 Box 4.1: Learning by Doing: The Eastern Anatolia Watershed Rehabilitation ............ 15 Figures: Figure 1.1: Budget Deficits .........................................................2 Figure 1.2: Real Effective Exchange Rate and Trade Deficit ........................................2 Figure 1.3: Per Capita GDP Growth .........................................................3 Figure 1.4: Percentage Change in Household Income Distribution ...............................3 Figure 1.5: Nutritional Status of Children Under Five Years ........................................3 Figure 3.1: Real GDP Growth and Iflation, 1976-96 ................................................ 11 Figure 4.1: Summary of Unsatisfactory DO and IP Ratings (FY94-97) ........... ......... 20 Figure 4.2: Disbursement Ratio: Turkey Compared to ECA and Bankwide .............. 21 This document has a restricted distribution and may be used by recipients only in the perforrnance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  i I I I  Tables: Table 1.1: Key Economic Indicators, 1992-97 .............................................2 Table 1.2: Selected Social Indicators-Country Comparison .......................................4 Table 3.1: Illustrative Policy Frameworks ............................................ 10 Table 3.2: Projections of Main Indicators, 1997-2002 ............................................ 11 Table 4.1: Portfolio Performance ............................................ 20 Table 5.1: IBRD Exposure Ratios for Base Case Financing ....................................... 22 Attachments: Attachment 1: Country Assistance Strategy Summary Attachment 2: Possible Adjustment Operations Attachment 3: IFC Strategy Attachment 4: CAS New Financing: Balancing Risks and Rewards Annexes: Annex 1: Turkey at a Glance Annex 2: Selected Indicators of Bank Portfolio Performance and Management Annex 3: Bank Group Fact Sheet, FY94-00 Annex 4: Summary of New Program, FY97-00 (Financing Services) Annex 5: Summary of New Program, FY97-00 (Technical and Advisory Services) Annex 6: Poverty and Social Development Indicators Annex 7: Key Economic Indicators Annex 8: Key Exposure Indicators Annex 9: Status of Bank Group Operations in Turkey Maps: IBRD No. 28848: Turkey, World Bank Support IBRD No. 28849: Turkey  I I  TURKEY: COUNTRY ASSISTANCE STRATEGY EXECUTIVE SUMMARY The last Country Assistance Strategy (CAS) for Turkey was presented to the Board in March 1993. The CAS noted that the Bank's ability to provide assistance to Turkey was constrained by the rapidly growing financial imbalances and distortions and limits in capacity. It highlighted public sector adjustmnent as Turkey's highest priority, and urged the Government to take strong and effective action to reduce the fiscal deficit to levels consistent with low inflation and broad-based, rapid growth The CAS also pointed out that accelerating Turkey's productivity growth required investment to develop its human capital base and, after a decade of relative neglect, effective measures to alleviate long-term poverty. In the event, the last four years have been characterized by considerably heightened uncertainty in economic and political conditions.' Turkey's dynamic and resilient private sector has weathered these vicissitudes remarkably well, the public sector much less so. Severe fiscal and other financial imbalances persist and much of the public sector reform agenda remains to be addressed. The operational environment for the Bank's assistance program has also been very difficult, and the overall development impact of our activities has been mixed. Counterpart funding shortages became more acute due to the Government's financial problems. Bureaucratic caution and outmoded controls increased in the uncertain political environment. Adjustment lending proved infeasible because the Government lacked a political mandate to implement key reforms. Progress on sectoral policy issues was also slow, and institutional capacity continued to be weak. As a result, even the Low Case lending program proved difficult to deliver. For its part, the Government found that Bank-supported activities were frequently too ambitious and our procedures too cumbersome. Greater use of narrowly focused policy notes and technical assistance would also increase considerably the contribution of the Bank's non-lending services. As at the time of the last CAS, Turkey's immediate development challenge is to achieve a durable fiscal adjustment and lower the very high inflation and real interest rates that constrain its growth potential and penalize most the poor segments of society. The new coalition Government's economic program recognizes that meeting this challenge requires both strengthened fiscal discipline and timely implementation of a broad range of structural reforms. Its initial policy actions are also encouraging. However, the overall outlook for policy reform is clouded by a number of political uncertainties. The 1998 budget will provide an important signal of the Government's ability to follow through. Our analysis indicates that the pay-off to a bold and resolute adjustnent effort would be considerable. Turkey's vigorous private sector has repeatedly shown that it will respond positively to an improved macroeconomic environment. The prospect of closer ties with the EU through the 1996 customs union 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 positive private sector response and set the stage for broad-based and rapid growth of incomes and employnent. In order to ensure this strong supply response, weaknesses in the financial system will also have to be addressed. Equally important, the Government needs to turn its attention more effectively to the many unmet human development needs that are constraining economic growth, limiting its benefits, and fueling social tensions. A Country Economic Memorandum, Turkey: ChallengesforAdjustment, Report No. 15076-TU was distributed in April 1996.  Given this backdrop, and in view of Turkey's considerable social and economic needs, the central thrust of our CAS for the period FY98-00 is to increase the development impact of the Bank Group's activities in Turkey. Accordingly, we are adapting our approach based on the lessons learned from recent experience in Turkey and other client countries. Key elements of the new CAS are: 1. Increasing administrative resources for activities aimed at social development and poverty alleviation from 30 percent to 40 percent. We will also shift the focus of investment activities to poorer regions, and catalyze private involvement in previously state-run activities especially through guarantees. 2. Building an assistance program that is more robust with respect to political and policy uncertainties, and placing special emphasis on strengthening institutional frameworks, which would reduce the likelihood of policy reversals and improve implementation. 3. Increasing support for economic management through technical and advisory services, with an emphasis on: (a) improving Government's capacity to design and implement reforms; and (b) providing a firm basis for participatory approaches to poverty alleviation and social development We will provide substantial technical and advisory services regardless of the level of new Bank financial assistance. 4. Sustaining the recently increased attention to portfolio management. The Government and the Bank have adopted a detailed Portfolio Improvement Program to resolve critical implementation botflenecks with good results. We have increased the frequency of Country Portfolio Performance Reviews and delegated responsibility for them to the Resident Mission. 5. Providing for a Base Case (most likely) financing program of up to US$1.5 billion in investment lending for the next three years, consistent with gradual but steady progress in macroeconomic adjustment, while maintaining readiness to provide up to an additional US$3.0 billion in adjustment financing if the Government adopts and implements a bold and comprehensive program of structural reforms, underpinned by a macroeconomic framework endorsed by the IMF. The proposed strategy carries some risks. For instance, the planned shift towards poverty alleviation and social development activities involves a move into areas with a very high developmental impact, but also difficult policy and implementation problems. There are also risks stemming from the possibility of renewed heightened political uncertainty, including policy reversals. Mitigation of these risks is provided for in the CAS. Ultimately, however, success in establishing the Bank's relevance to poverty alleviation and social development in Turkey is the best insurance against the failure of the CAS. Prior to the end of the CAS reporting period, we would evaluate the appropriateness of the strategies pursued and the results delivered. In the event of a major change in Government priorities, we would update the CAS and inform the Board as appropriate. Executive Directors may wish to focus their discussion on the following issues: *%Whether the thrust of the strategy outlined is appropriate. In particular, whether the proposed allocation of the administrative budget in favor of activities aimed directly at poverty alleviation and social development is appropriate in light of the Bank's comparative advantage, Turkey's development needs and the relative difficulhies in achieving concrete results. * Whether the volume of financing proposed and its composition under alternative macroeconomic scenarios is justified by country conditons. * Whether the characterization of the risks is appropriate and whether the arrangements proposedfor managing the risks are adequate. ii  Turkey CAS 1 I. COUNTRY CONTEXT A. POLITICAL SITUATION 1.1 Over the course of the last decade, Turkey's political environment has become increasingly difficult. The political liberalization that followed the period of military rule in the early 1980s resulted in considerable fragmentation of the polity. Consequently, short-term considerations have tended to divert attention away from the implementation of policies with a longer-term focus. The troubled security situation in southeastern Turkey has complicated domestic politics and foreign relations, and places heavy financial demands on the government. Since the early 1990s, the weak public finances, persistent macroeconomic instability, and tensions between secular and Islamist forces have eroded support for the traditionally-dominant centrist and socialist parties, resulting in a succession of weak coalitions. The difficulties in designing and implementing economic policy initiatives in this environment cannot be overemphasized. 1.2 Against this background, general elections held in December 1995 failed to yield a clear outcome, with no single party winning enough seats to govern alone. The minority center-right ANAP/DYP coalition government that finally emerged in March 1996 fell within three months. It was succeeded in June 1996 by a Refah (Islamist)/DYP (centrist) coalition with a small majority in Parliament. Beginning in February 1997, the coalition came under severe pressure from secular elements (notably the military) due to concerns about the perceived threat of growing Islamist activism to Turkey's secularist traditions. There were large-scale defections from the coalition ranks, mainly from the DYP, and the Government resigned in June 1997. It has been succeeded by a three-way coalition Government, involving ANAP, DSP (socialist) and DTP (defectors from the DYP). The new Government does not have a majority in Parliament and relies on support from the CLP (socialist) and independents. The Government has been characterized as a "transitional" Government, and is expected to lead the country to early general elections in 1998.1 Whether and when new elections are actually calied will depend on a number of uncertain factors. In any event, the advent of the new Government has led to a marked reduction in political tension. B. EcoNoMIC PERFORMANCE 1.3 After several years of large and growing fiscal deficits, Turkey suffered a severe currency crisis in early 1994.2 In response, the Government launched a broad stabilization and reform program, which received early support from the IMF. The program focused on fiscal adjustment, based on large cuts in investment and personnel expenditures and a variety of one-off taxes. It also provided for a range of public sector reforms, notably divestiture of state enterprises. The program had some important initial successes, with large corrections in the fiscal and current account deficits in 1994-95 and a sharp rebound in economic activity in 1995. However, the Government was unable to carry through with the structural reforms in its program, which raised serious questions about the sustainability of the fiscal adjustment and prevented Bank assistance through renewed adjustment lending. Although declining from the peak levels witnessed at the time of the crisis, inflation and real interest rates remained high, (Table 1.1, below). 1.4 The policy framework deteriorated sharply beginning in mid-1995 as Turkey entered a protracted period of political uncertainty. The fiscal deficit doubled in real terms to 8.8 percent of GDP in 1996, fueling an unsustainably rapid pace of economic expansion, with real GDP growth of seven percent and annual inflation of 80 percent. Much of the deterioration in the fiscal position is explained by the rising real borrowing cost associated with meeting virtially all of the fiscal deficit financing from the shallow domestic financial markets, (Figure 1.1, below). Another important factor was the deficit of the social security system, which ballooned to two percent of I The next scheduled national elections would be in late 2000. 2 The fiscal or budget deficit refers to the deficit of the consolidated budget, including central government, extra budgetary funds, revolving funds and local governments.  Turkey CAS 2 GDP. The situation was mitigated somewhat by Table 1.1: Key Economic Indicators, 1993-96 uncharacteristically small operating losses by the state Percent period average, unless otherwise noted owned enterprise (SOE) secto. 1993 1994 1995 1996 DOMESTIC INDICATORS 1.5 The Refah/DYP Government announced an ~~~Real GDP growth 8 -6 7 7 1.5 The Refah/DYP Government announced an Atlas GNP per capita, US$ 3,110 2,640 2,800 2,890 ambitious fiscal program for 1997, with a balanced Gross Domestic lnveatmnen/GDP 27 22 24 23 budget targeted mainly on the strength of large increases Public 3 2 1 2 Private 24 20 23 22 in tax revenues and privatization receipts. By mid-1997, Gross Domestic Saving/GDP 21 23 21 20 the budget was clearly very badly off-track, and headed Public -3 -I -3 -7 for a deficit of more than 10 percent of GDP for the Private 25 24 26 28 year as a whole. Revenues were far below the very dimary balance/GDP -71 -4 -34 9 optimistic assumptions made in the budget, while Public sector domestic debtlGDP 18 21 18 18 expenditures were well in excess of planned outlays due Inflation 66 106 89 80 to the rapidly growing deficit of the pension funds and ExTFRNAL INDicAToRs grwt 8 1 7 pressures for increased public sector wages and GNFS import growth 36 -22 30 26 salaries, and agricultural subsidies. A variety of new Current account balance/GDP -4 2 -1 -2 thni ~~~~~ldin f and ~~~~~~~ FDI/Gross domestic investment 1 2 2 1 financing technques, mcludig foreign currency and Oficial Foreign exchange inflation-indexed domestic debt, were used to ease reserves in months' imports 2 3 3 4 pressures on the Treasury bill market, permitting longer External debt/GDP 38 51 43 43 maturities and lower yields. However, the short-term Debt service/exports 29 31 28 24 respite provided by this was at the cost of larger debt Sources: SPO, Treasury, Central Bank and staff estimates payments in 1998. Fi re 1.1 _ _ _ _ _ _ _ _ _ _ _ 1.6 A steadily appreciating real exchange rate combined with Budge 1.1 reductions in protection under the EU customs union led to a Shares of GDP deterioration in the extemal trade and current account deficits in 1996, 10% (Figure 1.2). This was financed mainly by short-term capital inflows 8% attracted by high interest rates, which helped boost official reserves to W/o US$16.5 billion at end-1996, or 4 months of imports. Turkey's 4% l external debt rose to almost US$80 billion in 1996, 43 percent of 2% GDP, including over US$20 billion in short-term debt. Despite credit o11 rating downgrades in late 1996/early 1997, the Government has been -2% able to maintain access to capital markets due to favorable global -4% trends. With continued strong growth in domestic demand, the external -4% , IZ 9 v 96 accounts are projected to remain weak in 1997 and medium- and long- term capital inflows may not be large enough to prevent a decline in m PnmatY 0Operational *Cash reserves or renewed recourse to short-term borrowing. 1.7 The new Government has openly acknowledged the risks Fi Rure1l.2 presented by the large fiscal and other financial imbalances. It has Real Effective E e Rae | installed a particularly strong economic team and its economic 140 2.5 program gives priority to preventing any further deterioration in the 130 fiscal situation and to dampening turbulence in the financial markets. 120 t . A number of early actions have been taken, notably much-delayed 0.5 increases in the petroleum consumption tax and a range of public '1D t.o sector prices and the adoption of a new protocol restricting Treasury -0.5 access to central bank finance. These and other planned measures are , -1.0 expected to contain the budget deficit in 1997 to no more than 9 70;