Turkey - Financial Sector Adjustment Loan Project (FSAL III)

Report No. PID8628 Project Name Turkey-Financial Sector Adjustment Loan... (FSAL III) Region Europe and Central Asia Sector Financial Sector Project ID TRPE66511 Borrower(s) Republic of Turkey Implementing Agency Undersecretariat of Treasury Ankara, Turkey Contact person: Mr. Teoman Kerman Deputy Undersecretary Tel: 312 212 8719 Fax: 312 212 5891 Environment Category C Date This PID Prepared January 18, 2000 Projected Appraisal Date February 1, 2000 Projected Board Date March 30, 2000 Country and Sector Background 1. Country Background. Over the past years, successive Governments have struggled to address Turkey's vulnerability to internal and external shocks, stemming from its unsustainable fiscal policies and structural weaknesses in its economy. Despite implementing a major adjustment program in the 1980s, Turkey's economic performance has remained below that of the fastest growing developing economies. GDP growth has been volatile, with the economy subject to periods of rapid growth followed by sharp declines, and inflation has remained persistently high, driven by an oversized public sector and extended Government intervention in the economy. Macroeconomic imbalance has contributed to periodic financial crises, as in 1994, leading to further Government intervention that has restored short-term stability at the cost of increased Government liabilities and reduced longer-term sustainability. Underlying fiscal problems have been aggravated by an underdeveloped tax system, weak public sector governance and postponement of structural measures such as reform of the public pension system. 2. Following the Parliamentary elections in April 1999, in a concerted attempt to address once and for all these macroeconomic and structural imbalances, the new Government has committed itself to a multi-year stabilization and structural reform program. This program combines tighter macroeconomic policies, designed to lower inflationary expectations, with a package of structural reforms to underpin the fiscal adjustment and to encourage a sustainable decline in real interest rates. The Government's program is designed to put public sector finances on a sustainable path, with a crawling peg exchange rate regime providing a nominal anchor to lower inflationary expectations. In addition, the program is aimed at: (a)  sustaining macroeconomic stability through appropriate fiscal and monetary measures; (b) ensuring a fair and financially sustainable social security system; (c) ensuring the integrity of the financial sector and improving the efficiency of financial intermediation, through a series of targeted financial sector reform measures; (d) promoting investment and private sector participation; and (e) promoting agricultural growth and income generation. In late December 1999, the IMF Board approved a 3-year Standby Arrangement in support of the Government's reform program. The Bank also intends to support the Government's efforts with a series of adjustment loans, including an Economic Reform Loan and the proposed Financial Sector Adjustment Loan (FSAL). 3. Sector Background. Turkey and the Bank have had a long relationship in the financial sector since the early 1980s through a series of SALs (I-V) during the 1980-85 period and two FSALs during the late 1980s. A number of policy and institutional reforms were undertaken during that period. The focus of both the FSALs was on financial policies, financial institutions and regulations, and money and capital markets. The FSAL programs were, however, only partially completed, as Turkey's political and economic arena remained caught up in ad hoc short term choices during most of the 1990s, making it difficult to engage in long term policy and institutional development decisions. 4. After some years of lower intensity interaction during the early and mid 1990s, the level, nature and quality of the dialogue on financial sector policy between the Bank and the Government has recently substantially improved. The evolving situation in the Far East, followed by the August 1998 crisis in Russia, necessitated a review and analysis of the policy and regulatory framework and a vulnerability assessment of the banking sector. Such a review was undertaken by a Bank mission in November 1998, and based on the assessment of that mission, a financial sector reform agenda and the Bank's financial sector assistance strategy for Turkey have been developed. The strategy consists of: (i) the proposed FSAL, to address the most pressing banking sector reform priorities; (ii) a financial intermediary operation, the Export Finance Intermediation Loan (EFIL--approved by the Bank's Board in July 1999), to build up dialogue and consensus for banking sector reform directly with a core group of healthy commercial banks; (iii) a comprehensive risk management workshop and Pilot Risk Management Audits of selected banks to enhance awareness in the banking sector of the latest developments and tools and techniques in the area of bank risk management; (iv) a Non-Bank Financial Institutions (NBFI) Review to determine the risks and vulnerabilities, as well as development priorities of the NBFI sector; and (v) an eventual follow-up FSAL II adjustment operation to address the remaining reform agenda in the banking sector and urgent reform priorities for the NBFI sector. The Proposed Loan 5. Objectives. The main objective of the proposed FSAL is to support the Government's banking sector reform efforts, which intend to lay the foundation for an efficient, sound and healthy banking system that can be competitive in quality and performance at the international level. The reform actions required to achieve this objective would include: creation of a competent and independent Banking Regulation and Supervision Agency (BRSA); bringing all the prudential regulations up to international best practice - 2 -  standards; empowerment of the bank failure resolution entity, the Savings Deposit Insurance Fund (SDIF) with a set of legal tools and operating guidelines; and making a major tangible push towards restructuring and privatization of the state-owned banks which are still a dominant factor in Turkey's banking system. 6. Description. The proposed FSAL of US$750 million would be made to the Republic of Turkey represented by the Undersecretariat of Treasury. The Undersecretariat also will act as the implementing entity and coordinate the reform efforts undertaken by other institutions involved such as the new BRSA and the SDIF. The Loan would be on standard IBRD terms and would provide quick disbursing balance of payments support. It would be released in two tranches: a first tranche of US$375 million upon effectiveness, and a second tranche of US$375 million upon fulfillment of specific tranche release conditions, as long as general progress on implementation of the Letter of Development Policy is also satisfactory. The Loan is expected to be fully disbursed within one month upon the release of the second tranche. The closing date of the Loan would be September 30, 2001. Lessons Learned from Past Operations in the Country/Sector 7. Based on the Project Completion Reports for the earlier two FSALs undertaken in late 1980s, the critical lessons from the two operations are summarized below: (i) serious macroeconomic stabilization program for the overall economy which is successfully implemented and adhered to by the Government is essential for the success of financial sector reforms; (ii) a high degree of political ownership and consensus behind the reform program are necessary preconditions for the successful adoption and implementation of financial sector reforms; and (iii) there is sometimes a risk of overestimating the institutional capacity of the Borrower to implement reforms, and future financial sector reform programs need to be designed with a sharper focus on institutional issues. The timing and design of the proposed FSAL operation has taken these lessons into consideration. Environmental Category 8. Category C Contact Points: The InfoShop The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Lalit Raina, ECSPF FSD/PSD Program Team Leader for Turkey -3 -  The World Bank 1818 H Street N.W. Washington, DC 20433 Telephone: (202) 458-2900 Fax: (202) 522-0005 Note: This is information on an envolving project. Certain components may not be necessarily included in the final project. Processed by the InfoShop week ending January 21, 2000. - 4 -