Turkey - Economic Reform Loan Project

Report No. PID8740 Country Name Republic of Turkey Project Name Economic Reform Loan Region Europe and Central Asia Sector Multi-sectoral Project ID TUPE68792 Borrower(s) Republic of Turkey Implementing Agency Undersecretariat of Treasury assisted by Central Bank of Turkey Environment Category C Date This PID Prepared February 15, 2000 Date Initial PID Prepared December 15, 1999 Projected Appraisal Date January 17, 2000 Projected Board Date March 30, 2000 Recent Economic Developments 1. The new Government, installed following national elections last April, has launched an ambitious economic reform program geared to take Turkey into the 21st century and set the stage for the country's entry into the EU. Despite implementing a major adjustment program in the 1980s, Turkey's economic performance has remained well below that of the fastest growing developing economies. In addition, output has been highly volatile with the economy subject to periods of rapid growth followed by sharp declines. Moreover, inflation has remained persistently high, driven by an oversized public sector and extended government intervention in the economy notably in the agriculture and the infrastructure sectors. High inflation has stunted deepening of the financial sector, thereby creating bottlenecks for private sector investment and distorting resource allocation. The result has been a vicious circle of financial sector weakness and dependence on money creation and the inflation tax to finance public sector deficits. Macroeconomic imbalance has contributed to periodic crises, as in 1994, which have led to further government intervention, such as the introduction of 100 percent deposit insurance, that has restored short-term stability at the cost of increased public sector liabilities and longer-term uncertainty. Underlying fiscal problems have been exacerbated by an underdeveloped tax system, weak public sector governance and postponement of structural measures such as reform of the public pension system. Against this backdrop of macroeconomic imbalance and structural weaknesses, partial reforms, such as the introduction of private participation in the energy sector, have not had the intended effect on investment and growth, but have rather tended to increase the government's contingent liabilities and weaken the financial condition of key state owned enterprises. During much of the past decade, these weaknesses were masked by a growing economy. However, the fall off in growth over the past two years has highlighted the fragility of public finances, characterized by an unsustainable accumulation of public sector debt, and  rapid increases in external debt service driven in large part by a reliance on short-term borrowing. The Government's Economic Reform Program 2. The Government has reached agreement with the IMF on a macroeconomic framework covering the 2000-02 period. The Government's macroframework combines tighter fiscal policies, designed to put public finances on a sustainable path, with a nominal exchange rate anchor designed to lower inflationary expectations and structural reforms aimed at restoring growth and sustaining the disinflation effort. The stabilization program targets a decline in (CPI) inflation to 25 percent by the end of 2000 and to 10-12 percent by the end of 2001, compared with the 69 percent inflation registered in 1999. In parallel, real domestic interest rates are projected to fall from an estimated average of 40 percent (ex-post) in 1999 to about 25 percent in 2000 and close to 15 percent in 2001. Single digit inflation is targeted for 2002, along with real interest rates of 12 percent. In tandem with falling inflation and interest rates, the macroframework aims to pull the economy out of recession. The program targets growth of 5.6 percent and 5.2 percent in 2000 and 2001 respectively, compared with a drop in output of at least 2.1 percent in 1999. 3. The Government's structural reform program aims to underpin macroeconomic stability and create the conditions for sustainable and more equitable growth. The program focuses on six critical actions. Implement structural fiscal reforms to underpin tighter fiscal policy. Ensure a fair and financially sustainable social security system. Protect the integrity of the financial sector and improve the efficiency of financial intermediation. Promote agricultural growth and rural income generation. Deregulate the energy and infrastructure sectors and accelerate privatization. The fiscal reform program has three basic objectives. The immediate goal is to support the 2000 budget with sufficient revenue and expenditure measures to ensure that the targeted fiscal adjustment can be met. The second goal is to sustain this adjustment in 2001 by replacing the temporary measures which dominate the 2000 fiscal package with longer-term structural measures. The third goal is to consolidate the shift in the fiscal balance over the medium term. The latter is to be accomplished through institutional reforms to improve public sector management and deeper structural reforms in key areas which have been the source of quasi-fiscal deficits in the past including the social security system, the financial sector and agriculture. 4. Reforming the social security system is essential to restore the system's solvency over the medium term and ensure an adequate and sustainable level of benefits. The Government is following a three phase reform strategy. The first phase focuses on policy reforms to the public pay-as-you-go (PAYG) pension system to stem operating losses--which were approaching 3 percent of GNP per year before the Parliament enacted a major policy reform last August. The second phase of the social security reform strategy, planned for 2000, focuses on strengthening the organizational underpinnings of the system, extending its coverage, separating the pension system from associated health insurance and unemployment schemes, and eliminating accumulated arrears. The third phase is to introduce a framework for supplementary individual pension schemes. Achieving these goals will set the stage for the transition over the longer term to a modern, multi-pillar pension system within the framework of a broader, financially sound and administratively coherent social security system. -2-  5. The Government's agriculture reform program encompasses three main initiatives designed to reduce the heavy burden on the budget and Turkish consumers, while promoting agricultural growth which has fallen over the decade. The first step is to introduce a unified national program of direct income support which will improve the access of poorer farmers to budget support and create new income generation opportunities by improving incentives. A pilot direct income support program will be carried out in 2000. In parallel, the Government intends to phase out the unsustainable and distortionary system of price and credit subsidies which disproportionately benefit large farmers and regressively tax consumers. The third reform initiative is to privatize most state enterprises in agriculture in order to reduce government involvement in the marketing and processing of agricultural products. Completing the agriculture reform program is a medium-term objective. The Government has set a target date of 2002 for completing the rollout of the direct income support system and the elimination of price subsidies. 6. Turkey needs to attract private investment in the energy, telecommunications and infrastructure sectors in order to sustain growth over the medium term. Accelerating privatization and private participation in existing facilities is also essential to generate the revenues needed to restructure and stabilize the public sector debt. At the same time, it is critical that proper legal and regulatory measures be taken to support private sector participation in infrastructure. The Government is trying to move simultaneously on several fronts to remove legal obstacles to private participation and investment, and accelerate privatization. A core objective is to bolster the legal and regulatory framework in the telecommunications and energy sectors in order to support the transition over the medium term from centralized models to competitive market structures which meet EU standards. The development of transparent and independent regulatory structures will help Turkey to achieve the maximum gains from private sector participation and privatization in the infrastructure sectors. 7. The Government is restoring the momentum of Turkey's privatization program which was dissipated in early 1999. Accelerating privatization is a key supply-side element in the effort to restore growth. It also represents a core component of the fiscal package for 2000. The Government is committed to raising privatization revenues in cash of US$ 7.6 billion (3.5 percent of GNP) and a total of US$ 18 billion over 2000-02. This is a very ambitious goal. By comparison, Turkey raised a total of US$ 6 billion in privatization revenues over the past decade. A new privatization program, which includes major companies of national importance, has been approved. The first pillar of the privatization program involves opening the capital of Turk Telekom and sale of two additional GSM wireless licenses to private investors. 8. The second and third pillars of the privatization program cover the electricity and enterprise sectors respectively. Electricity sector privatization was originally targeted to generate US$ 1.1 billion in revenue in 2000. However, this process will take time to complete and it is not clear how much revenue will actually be generated in 2000. If there is a revenue shortfall from the energy component, the Government will compensate by accelerating further the other components of the privatization program. The third pillar is the program managed by the Privatization Administration (PA) which is targeted to raise about US$ 5.3 billion (US$ 3.2 billion in cash) from privatization of state economic enterprises. The PA is making -3 -  progress in implementing its program. An important benchmark is the privatization of the Petroleum Distribution Company (POAS) for which the tender has been closed and the bids received are under review. This deal will be finalized in the second quarter of 2000. A second major operation in the program for 2000 is the sale of shares in the Petroleum Refinery Company (TUPRAS) for which IPO preparations are underway and are expected to be launched in April 2000. Three additional large-scale companies for which sales are planned in 2000 are Turkish Airlines (THY), a major iron and steel complex (ERDEMIR) and a petrochemical company (PETKIM). The program also includes a number of smaller-scale companies which could provide a more immediate supply-side boost to the private sector. 9. While economic reform will have many positive impacts on people's lives, it will put stress on Turkey's underdeveloped social safety net. At the macroeconomic level, while the disinflation program centers on a large fiscal adjustment, it does not require a reduction in domestic absorption given that Turkey does not face a balance of payments problem. The price stability induced by the disinflation program will be beneficial to vulnerable groups who have been adversely affected by previous episodes of unanticipated inflation, albeit temporarily. The targeted resumption of growth will also help the vulnerable. The social security reform will strengthen the social insurance pillar of the safety net, although the positive impact will take time to materialize. On the other hand, the reform will generate losers as well as winners. Among the groups likely to be hardest hit by the reform are workers in state-owned enterprises slated for privatization. The authorities are defining a strategy for strengthening the social protection that can be provided to groups adversely affected by the reforms. Rationale for Bank Involvement 10. The ERL is part of a broader program of adjustment lending from the Bank under the high case program of the Country Assistance Strategy. The Government's reform program has met all of the high-case triggers included in the 1997 CAS. Financing under the proposed loan will provide immediate balance of payments and budgetary support to Turkey to meet requirements arising from the reform program. Technical advice and dialogue provided through the loan will help the authorities shape the specific reform measures included in the program with the benefit of international best practice. Up- front support from the Bank in the form of the ERL, and other associated adjustment operations under the high case, will also provide an important signal of confidence in the program to the international financial markets and official creditors. This commitment from the Bank will help catalyze co- financing for the program from other official partners. Without the Bank's involvement, the Government may not sustain such a strong program of structural reforms. Project Objectives and Description 11. The proposed Economic Reform Loan will assist Turkey to implement its economic reform program by providing quick disbursing financing for the balance of payments and the budget. The loan is designed to help the Government implement its economic reform program and achieve its macroeconomic objectives of taming inflation and restoring sustainable growth. The ERL will support the Government's structural reform program in - 4 -  the areas of structural fiscal reforms, modernization of the social security system, reform of agricultural support policies, deregulation of the telecommunications and energy sectors, and acceleration of the privatization program. A key objective is to ensure that the core structural components of the reform program are implemented effectively. The ERL will help the authorities develop a track record of reform implementation and help keep the program on track by providing well defined benchmarks in key sectors. Monitoring of economic developments by Bank staff in close collaboration with the IMF will help ensure adequate macroeconomic diligence on the part of the Government. 12. The proposed ERL would be structured as a two tranche operation for a total of US$ 759.6 million. The proposed loan will provide quick-disbursing support against the Bank's standard negative list. The proposed loan is part of a larger package of adjustment lending from the Bank, including a proposed FSAL under preparation, which takes into account the support expected from the IMF and Turkey's other international partners. The loan will be disbursed in two tranches: the first tranche of US$ 384.6 million (including a one percent fee to the Bank) will be released upon effectiveness and the second tranche of US$375 million will be released upon fulfillment of the specific conditions, as long as general progress on implementation of the Letter of Development Policy (including achieving macroeconomic stabilization objectives) is also satisfactory. The Borrower will allocate US$ 2 million from the first tranche to support the pilot direct income support program in agriculture for which TL 120 billion has been appropriated in the 2000 government budget. Disbursement arrangements will be consistent with standard Bank policy for adjustment operations. Implementation Arrangements 13. The project will be implemented by the Central Bank of Turkey (CBT) based on an Implementation Agreement between the Undersecretariat of Treasury and the CBT. Implementation arrangements will be fully consistent with Bank practice for adjustment loans. Upon notification by the Bank of project effectiveness and second tranche release, the proceeds of the first and second tranches respectively of the loan will be deposited by the Bank into the designated Deposit Account at the request of the Borrower. In accordance with the Operational Directive on the Simplification of Disbursement Rules under Structural Adjustment and Sector Adjustment Loans (February 8, 1996), disbursements will not be linked to specific purchases. Therefore, there will be no procurement requirements. The loan is expected to be fully disbursed within one month of second tranche release. The expected timing for release of the second tranche would be the first quarter of CY 2001. The closing date will be September 30, 2001. Risk Factors 14. The program of structural reforms that the proposed ERL would support faces significant economic and political risks. Among the more important economic risks are those related to the feasibility and sustainability of the fiscal adjustment, the behavior of real interest rates, the pace and extent of economic recovery, and the ability of Turkey to attract the necessary levels of external capital inflows. There is also a risk that certain aspects of the reform program could adversely affect vulnerable groups. A further issue relates to the administrative capacity of the Government to - 5 -  implement such a broad and fast-paced reform program. Although the Turkish administration is quite strong compared to most Bank clients in the region, implementation capacity remains a significant source of risk. The Bank is responding to this latter risk by preparing a program of investment projects which will support implementation of key reform measures. Political risks arise from the range of socially sensitive structural reforms included in the program such as the pension reform and the reform of agricultural support policies, as well as the privatization and market deregulation measures which may impact on established interests. The ERL will be designed to support ambitious, yet achievable benchmarks. However, acceleration of structural reform will ultimately depend on political will and internal consensus. Contact Points: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Task Manager James Parks, ECSPE The World Bank Turkey Office 211 Ataturk Bulvari 06683 Kavaklidere Ankara, Turkey Telephone: 90- (312) 468-4527 Fax: 90- (312) 468-4526 Note: This is information on an involving project. Certain components may not be necessarily included in the final project.Processed by the InfoShop week ending Fabruary 25, 2000. -6-