Turkey - Country Assistance Strategy

Documentof The World Bank FOR OFFICIAL USEONLY ReportNo. 26756 TU MEMORANDUMOF THE PRESIDENT OF THE INTERNATIONALBANKFOR RECONSTRUCTIONAND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ONA COUNTRYASSISTANCESTRATEGY OF THE WORLD BANKGROUP FOR THE REPUBLICOF TURKEY October 2,2003 Turkey Country Unit Europe and Central Asia Region International Finance Corporation Southern Europe and Central Asia Department 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 FY01-03 Country Assistance Strategy (CAS) for Turkey was discussedby the Executive Directors on December 21, 2000 (R2000-218; IFC/R2000-221). The CAS Progress Report was considered by the Executive Directors on July 12, 2001 (R2001-0113/1; IFC/R2001- 0134/1). CURRENCY AND EQUIVALENTS CurrencyUnit: TurkishLira (TL) as of August 31,2003 US$1 = TL1,400,998 WEIGHTS AND MEASURES FISCAL YEAR Metric System January 1-December31 ABBREVIATIONS AND ACRONYMS AKP Justice andDevelopmentParty MDGs Millennium Development Goals ARIP Agricultural ReformImplementationProject MIGA Multilateral Investment GuaranteeAgency BRSA Bank Regulationand SupervisionAgency MIS ManagementInformationSystem CAS CountryAssistanceStrategy MOE Ministry of EnvironmentandForestry CBT CentralBank of Turkey NEAP NationalEnvironmentalAction Plan CCT ConditionalCashTransfers NBFI Non-BankFinancialInstitutions CEM CountryEconomic Memorandum NEP New EconomicProgram CFAA CountryFinancialAccountabilityAssessment NGO Non-GovernmentalOrganization CPAR CountryProcurementAssessment Report OECD Organizationfor EconomicCooperationandDevelopment DIS Direct IncomeSupport OED OperationsEvaluationDepartment EFIL ExportFinanceIntermediationLoan PEIR PublicExpenditureandInstitutionalReview ERL EconomicReformLoan PFSAL Programmatic FinancialSectorAdjustment Loan EU EuropeanUnion PFPSAL Programmatic FinancialandPublicSectorAdjustment Loan FDI ForeignDirect Investment PPSAL Programmatic Public SectorAdjustment Loan FSAL FinancialSector Adjustment Loan SDIF SavingsDepositInsuranceFund GDP Gross Domestic Product SMEs Small andMedium Size Enterprises GEF GlobalEnvironmentFacility SRMP Social Risk Mitigation Project GNP Gross NationalProduct SSAL Special Structural Adjustment Loan GTZ Deutsche Gesellschaftfur TechnisL..e Zusammena-it UN UnitedNations HIES HouseholdIncome andExpenditureSurveys UNDP UnitedNationsDevelopmentProgram IBRD InternationalBank for ReconstructionandDevelopmentUNICEF UnitedNationsChildren's Fund IFC InternationalFinanceCorporation WBI World Bank Institute IF1 InternationalFinancialInstitution WHO World HealthOrganization IMF InternationalMonetaryFund WB Managersand StaffResponsiblefor this CAS Vice President Mr.ShigeoKatsu CountryDirector Mr.Andrew Vorlunk ResponsibleStaff Mr.Andras Horvai Mr.JamesParks IFC Managersand StaffResponsiblefor this CAS Vice President Mr.AssaadJ. Jabre Director Mr. Khosrow Zamani ResponsibleStaff Ms.SujataLamba  TABLEOF CONTENTS EXECUTIVESUMMARY ........................................................................................................... 1 I. THECOUNTRYCONTEXT ........................................................................................... 3 Economic Crisis and Recovery...................................................................................... 3 The Medium-term Economic Program........................................................................ ..5 11. WORLDBANKGROUPASSISTANCEAND LESSONSLEARNED ....................... 8 111. MAINDEVELOPMENTCHALLENGESAND THE COUNRTYASSISTANCE STRATEGY ...................................................................................................................... 12 Turkey's Vision andEconomic Priorities.................................................................... 12 The Country Assistance Strategy................................................................................. 19 Working with Other Development Partners ................................................................ 30 IV. LENDINGPROGRAMAND TRIGGERS ................................................................... 31 V. MANAGINGTHE RISKSAND IBRDEXPOSURE .................................................. 34 Managing the Risks...................................................................................................... 34 IBRDExposure............................................................................................................ 39 VI. CONCLUSIONS .............................................................................................................. 40 BOXES,TABLES,ANDFIGURES Box 1: The Achievements andRemaining Agenda Box 2: IFC's StrategyFollowingthe 2000/2001 Financial Crisis Box 3: Impactof the Basic Education Reform Box 4: Poverty and Inequality inTurkey Box 5: Sub-regional Cooperation Box 6: CAS Consultations Box 7: Turkey's ProgressTowards the MillenniumDevelopment Goals (MDGs) Box 8: Collaboration with the EU Box 9: Triggers for the High Case Table 1: Key Economic Indicators Table 2: PortfolioOverview Table 3: Key Outcomes andBank Group Benchmarks Table 4: Indicative Lending Program FY04-06 Table 5: Public DebtDynamics Table 6: External Financing Requirementsand Sources, 2000-2004 Table 7: Summary Lending Figures Figure 1: GNP per capita ($)  ANNEXES Annex A1 Private Sector Strategy Annex A2 Retrospective Review Annex A3 CAS Consultations Annex A4 Strategic Links inthe CAS Program Annex A5 Country Gender Assessment Summary Annex A6 Financial Accountability and Public Sector Governance Annex A7 FundRelations Note Annex B1 Country-at-a-Glance Annex B 2 Selected Indicators of Bank Portfolio Performance andManagement Annex B3 IBRDProgram Summary Annex B 4 Summary of Non-lending Services Annex B5 Poverty and Social Development Indicators Annex B6 Key Economic Indicators Annex B7 Key Exposure Indicators Annex B8 Operations Portfolio (IBRD/IDA) and IFC's Portfolio Annex B 9 Country Assistance Strategy Matrix Annex B10 CAS Summary of Development Priorities  -1- EXECUTIVESUMMARY i. Turkey has learned from crises and been strengthened by reforms over the past five years. Natural disasters as well as financial crises were painful but also shocked the system and focused the nation on the need for fundamental reforms to modernize the country and its governance. The economy started to rebound strongly last year, and the Government, which came to power with significant popular support following early elections at the end of 2002, has now the opportunity to put Turkey on a sustainable economic growth path. But this will be a challenge as the economy, while recovering, i s still vulnerable and the debt remains high. The international environment presents both economic uncertainties andpolitical risks that absorb the Government's attention. The Middle East remains on edge. The Cyprus question continues to be unresolved. The international economic situation remains cloudy. Nevertheless, if Turkey i s successful in steering through this difficult period and getting on the path towards EUaccession, the country could achieve stable growth and improved living conditions. The Bank Group Country Assistance Strategy (CAS) i s designed to help Turkey to do so. .. 11. Indiscussingthe CAS, ExecutiveDirectorsmay wish to address thesequestions: D o the objective and main themes of the CAS adequately reflect Turkey's economic priorities? Are the lending scenarios, including the sharp difference between the high case and the low case and the roughly 50 percent adjustment lending in the high case, appropriate for Turkey's specific circumstances? D o Directors support the continued emphasis on programmatic lending in the areas of public and financial sector reform as a core of the highcase scenario? ... 111. The objective of the CAS is to help Turkey implement fundamental reforms to reduce economic vulnerability and achieve high and stable growth, and continue the process of addressing some long neglected social and environmental problems. The last CAS focused heavily on crisis management. This CAS aims at reducing the risk of reemergence of crises and helping Turkey address the many economic challenges of preparing for EU membership. The planned assistance program for FY04-06 and the expected outcomes are structured around four development themes in line with the Government's priorities: (i) sound macroeconomics and governance; (ii) equitable human and social development; (iii)attractive business climate and knowledge; and (iv) strong environmental management and disaster prevention. iv. The two Bank lending scenarios described in this document are very different in size and composition. This reflects the risks associated with the assistance strategy, as summarized in vii. below and in Chapter V. A lending program of US$4.5 billion i s envisaged in the high case and US$1.3 billion in the low case. The program under the high case will include support for the economic reform program, focusing on public sector management and accountability, and the business climate, includingthe financial sector, to address the underlying economic problems that make the Turkish economy vulnerable. Triggers for the high case are based on key reforms supported by ongoing and planned adjustment operations as well as on indicators of satisfactory macroeconomic performance. If lack of progress on the reform program were to push Bank lending to the low case, Bank support would concentrate on human development, disaster and environment management, and local level interventions to reduce  -2- poverty. Similar to the past CAS, the self-regulating nature of the strategy will be a key risk mitigating mechanism. V. In view of Turkey's particular poverty profile, with low levels of extreme poverty but relatively high incidence of vulnerability, the planned program, together with the implementation of the ongoing operations, will focus on: (i)malung the economy more resilient to crises (including natural disasters) that disproportionately affect the most vulnerable; (ii)contributingtosustainableeconomic growththatiscriticaltopullmanyofthepooroutof poverty; (iii) promoting human development to create opportunities for the poor, make access to health and education more equitable and the social protection system more efficient; (iv) reducing regional differences by improving the delivery of and access to services, and creating jobs in disadvantaged areas; and (v) increasing empowerment through enhanced local participation and civil society involvement. vi. The Bank Group strategy recognizes that the complex second generation policy and institutional reforms that Turkey is undertaking need to be supported over the medium term. This recognition provides the rationale for proposing a sizeable program envelope should the macro situation continue to improve and the reform process remain on track. It alsojustifies the reliance on programmatic adjustment lending as the main delivery instrument to allow for a reasonable degree of adaptability of the program to unfolding events on the ground. The lending program in the high case i s designed in such a way that investment projects in key areas would complement reforms to be supported under the planned programmatic adjustment loans. The AAA program i s also structured around the four themes of the CAS and i s focused on building an analytical base that will position the Bank to maximize the effectiveness of its assistance. vii. Turkey's reform program entails significant risks, as witnessed by developments over the past two years, which can only be overcome by sustained implementation of the reforms. The situation in Turkey has been and will continue to be subject to continued uncertainty as events unfold on the ground. The three main risk factors are: (i) the continuing macroeconomic vulnerabilities arising from the 2001 crisis and subsequent international and regional developments; (ii)a potential loss of consensus for political or social reasons stemming from the social impact of reforms; and (iii) institutional challenges in implementing the program. viii. ... The active support of the IFI's has been instrumental in helping Turkey address the risks and pursue its reform program. The economic recovery and disinflation progress recorded in 2002 and the first half of 2003 provide encouragement that the exceptional support from the IFIs has helped Turkey weather the worst of the 2001 crisis while maintaining its reform course. The new Government's stated commitment to the program demonstrates that political support for economic reform in Turkey transcends specific political parties and personalities. However, the Government will be continuously challenged by the need to implement a long list of difficult and painful reforms in a context of pressure for populist measures and special interest lobbying. The irreversibility of the structural reforms put in place since 1999cannot be taken for granted and the near-term risks remain significant given the depth of Turkey's economic vulnerabilities and extent of the reforms that lay ahead. In recognition of the situation, the CAS envisages a graduated response that corresponds to the strength of the economic program, and which will allow the Bank to mitigate the risks and tie increases in its exposure to concrete improvements in Turkey's economic fundamentals.  -3 - MEMORANDUMOFTHE PRESIDENT OFTHE INTERNATIONALBANKFORRECONSTRUCTIONAND DEVELOPMENT AND THE INTERNATIONALFINANCECORPORATION TO THE EXECUTIVEDIRECTORS ONA COUNTRYASSISTANCE STRATEGY OFTHE WORLD BANK GROUP FORTHE REPUBLICOFTURKEY I. THECOUNTRYCONTEXT EconomicCrisisand Recovery 1. For many years Turkey's economy seemingly defied rationality but fiscal imbalances and delayed structural reforms finally led to a series of crises. Until the late 1990s, Turkey achieved real economic growth of 4-5 percent in the face of chronically high inflation. Borrowing, domestic and international, allowed Turkey to keep up this high-wire act despite accumulating macroeconomic vulnerabilities. It finally came to an end in 1999 when the economy shrank by some 6 percent. Turkey then embarked on an ambitious exchange rate-based disinflation program combined with structural reforms. However, the process of implementing these second generation structural reforms (the first round of reform was implemented some 15 years before and focused on trade and financial liberalization) was interrupted in early 2001 by a very severe economic crisis which followed on an earlier bout of financial instability in November 2000. The crisis had been building up for some time and was the result of two overriding factors: the emergence of huge fiscal imbalances over the 1990s resulting from underlying structural imbalances and rigidities, and the lack of attention to the accumulation of systemic banking sector risks. 2. The 2001 crisis was deep and triggered the start of fundamental reform. The authorities responded to the crisis by designing a New Economic Program (NEP) announced in May 2001, following the collapse of the crawling peg and subsequent devaluation. The key structural and social elements of the program were: (i)a macro-framework designed to restore financial stability and ensure public debt sustainability--principally through a further tightening of fiscal policy with a primary surplus target of 5.5 percent of GNP in 2001 increasing to 6.5 percent thereafter; (ii) restructuring of the banking sector--especially of state banks and rapid insolvent private banks intervened by the regulatory authority (BRSA)--based on large resource transfers from the budget; (iii)a more ambitious program of public sector reforms centered on deeper structural fiscal reforms and institutional reforms to improve public expenditure management and public governance; (iv) a renewed privatization drive in combination with further liberalization measures (particularly in energy, telecommunications and agriculture) and strengthening of the role of independent regulatory bodies to improve the climate for private investment; and (v) strengthening of social assistance to help low. income groups adversely affected by the crisis. 3. Just when the programbegan to show initialsigns of recovery in the summer of 2001, the economy was hit by an external shock after September 11, 2001. Although Turkey's financial markets quickly regained the ground lost, this was due inlarge part to investor expectations that the country would benefit from additional support from official creditors to  -4- help overcome the negative effects of the shock. Turkey ended 2001 still very vulnerable to external events and with deep cuts in output, employment and income. Following a nominal devaluation of some 50 percent in February 2001, the exchange rate stabilized by the end of the year. Interest rates were brought down, but they remained high in real terms. The combination of highreal interest rates, a large devaluation, the huge fiscal cost of bank restructuring and deep recession caused the stock of public debt to rise significantly. The ratio of net public debt to GNP increased from 58 percent at the end of 2000 to about 95 percent of GNP by the end of 2001. A serious drought exacerbated the recession with agricultural output contracting by some 6 percent. Overall, output shrank by more than 9 percent in 2001 and the official unemployment rate increased from 6.6 percent to 8.5 percent. In response, the authorities tightened macroeconomic policies further and attempted to accelerate reform implementation with stepped up support from the IFIs. 4. The economy recovered strongly during 2002 despite continuing volatility in the financial markets. GNP growth reached 7.8 percent, more than double the original target of 3 percent, although per capita GNP in current US$ terms in 2002 remained 17 percent below the 1998 peak (Figure 1). The strong growth performance was due in part to base effects from the recession and stock building. However, there was also a positive story on exports and tourism which responded to the real exchange rate adjustment following the 2001 crisis. A rebound in agricultural output estimated at 7 percent was another factor. A sharp increase in government absorption driven by pre-election spending played an important role in sustaining demand in the second half of the year. However, private consumption also started to recover and the fall in private investment was reversed in the m m Z Z % Z S ! g Z g 8 2 O N last quarter. End-year CPI inflation z z z z s s s z z z o o N N was just below 30 percent, the lowest Source: State Insititute of Statistics 5. The prospects of war in Iraq and some initial policy signals from the new Government created new concerns at the beginning of 2003. Some of the initial actions by the Government, such as the adoption of an interim budget inconsistent with the announced  -5- primary surplus target, concerns about the independence of the regulatory boards, an ad hoc pension increase, introduction of a tax amnesty, and increased price support for tobacco, were at odds with the program. These actions sent problematic signals to the markets already nervous Table1:KeyEconomicIndicators t 1 EstimateU programy2004 Projection 4/ 2000 ActualU2001 2002 2003 2005 2006 I MAINMACROINDICATORS GNP Growth 6.3 -9.5 7.8 5.0 5.0 5.0 5.0 CPIInflation(Dec-Dec) 39.0 68.5 29.7 20.0 12.0 8.0 5.0 NominalInterestRate 38.0 99.1 63.5 46.4 31.3 29.3 25.7 UnemploymentRate 6.6 8.5 10.6 UnitWage Index(1997=100) 103.6 70.7 72.2 PUBLICSECTOR primary Balance(%GNP) 2.7 5.5 4.0 6.5 6.5 6.5 6.5 OverallDeficit (% GNP) 19.2 21.1 12.3 9.3 6.8 4.2 3.5 NetPublicDebt(% GNP)1/ 57.7 94.0 80.0 69.6 66.2 62.3 59.6 of whichnetextemaldebt (%GNP) 18.5 37.7 32.1 27.3 25.1 21.4 17.5 privatization($bn) 3.3 2.8 0.5 2.1 1.5 1.5 1.5 EXTERNALBALANCE Currentaccountbalance(% GNP) 4.9 2.4 -0.8 -3.2 -2.0 -1.1 -0.2 Exports(fob, $bn) 30.7 34.4 39.8 47.5 52.5 58.2 64.0 Tourism($bn) 7.6 8.1 8.5 8.5 9.8 10.2 10.6 ExtemalDebt (%GNP) 59.0 79.1 72.4 58.3 54.4 50.3 46.1 CBTForeignExchangeReserves (S bn) 23.2 19.8 27.9 28.3 29.0 27.8 27.4 - Memo GNP(TLquadtillion) 125.6 176.5 273.5 359.4 426.2 491.3 547.7 TLTJSDExchangeRate(annualaverage) 623,947 1,225,490 1,505,290 1/ Includesthe govemnt securitiesissuedtorecapitalizethe SDIFandstatebanks. ZGovernmentfigures as adjustedbyIMFandWBestimates. 3/ 2003-04programfigures areupdatedas of the 5thIMFreview. 4/ 2005-06f i w e s are WorldBankestimatesbased5threviewprojections. . " I Source: Govemnt, IMFandWB estimates. I about several months of reform slowdown during the run-up to the November 2002 elections. Uncertainties related to the looming war in Iraq and possible U.S. bilateral assistance added to investor concerns. As a result, the benchmark bond rate rose steadily to a peak of about 75 percent in March. This market response highlighted to policymakers the need for the Government to focus on the economic reform agenda and build up a strong track record of implementation of policy reforms in order to restore market confidence and establish the conditions for sustained recovery. The Medium-termEconomicProgram 6. The Government has shown a renewed commitment to economic reform after some initial delays. The economic program continues to rest on the three-pronged strategy articulated in response to the 2001 crisis: (i) tight fiscal and monetary policies underpinned by large primary surpluses, a flexible exchange rate, and strong initial IF1support transitioning to greater reliance on private flows; (ii) structural measures aimed at correcting the financial and public sector weaknesses underlying the crisis, improving the investment climate, and  -6- establishing a more sound basis for disinflation and growth; and (iii)strong social policies including enhanced social dialogue to achieve price and wage policies consistent with macroeconomic stability, and increased emphasis on the protection of the most vulnerable groups of society. This strategy and the specific actions to be completed by the end of 2003 are presented in detail in the Government's Urgent Action Plan adopted in January. Progress in implementing the Urgent Action Plan began in earnest with the passage in April of a full-year 2003 budget consistent with the primary surplus target. This was followed by the passage of important structural legislation by mid-year including a first phase of direct tax reform, a new FDIlaw, institutional strengthening of the social security system, and changes inthe bankruptcy law. The Government continued with implementation of key structural reforms launched earlier including the new public procurement and public debt management laws. The Government also announced an ambitious privatization program and proceeded to launch a series of tenders. 7. The Government's program sets ambitious targets for the next two years. Key program targets include economic growth of 5 percent in 2003 and 2004 (see Table 1) and inflation falling further to 20 percent by the end of 2003 and 12 percent in 2004. The program aims to ensure sustainability of the public debt through a combination of economic growth, sustained fiscal adjustment and improved investor confidence. The primary surplus of the consolidated public sector i s targeted at 6.5 percent of GNP in 2003 and 2004. After falling significantly in 2002, the ratio of net public sector debt to GNP i s now projected to fall to about 70 percent in 2003 and drop further in 2004. Finally, the program targets a continued buildupof international reserves based on a recovery of private capital inflows beginning in 2003. Private capital inflows are projected to strengthen in 2004, providing the resources to finance the onset of large repayments to the IMF starting in 2004. (The external financing plan underpinning the macroeconomic framework i s summarized in Table 5 in the risk section below. Provided the 2003-04 targets are achieved and reform implementation i s sustained, the prospects will be good for the positive growth and stabilization trends to continue into 2005-06. 8. Support for Turkey's reforms from the international community remains strong. The IMF approved in early 2002 an SDR 12.8 billion (US$16.2 billion) Stand-by Arrangement for Turkey covering the 2002-04 period, bringing total IMF commitments for the program to over US$30 billion since 1999. The fourth review under the new IMF program was completed in April and the fifth review was completed in August 2003. Bank assistance has also been substantial. Since 2000, the Bank has disbursed US$2.5 billion in quick-disbursing lending and an additional US$0.5 billion of such assistance i s available for disbursement. The Government has agreed with the Bank revised roadmaps for financial and public sector reform to continue support under the Programmatic Financial and Public Sector Adjustment Loans (PFPSAL), as well as a new roadmap to complete the privatization agenda and other structural reforms supported by the Economic Reform Loan (ERL). In parallel, the Government has made significant progress on the political criteria for EUaccession including authorization of minority language broadcasts and restructuring o f the National Security Council, thereby improving the prospects for opening accession negotiations after 2004. An agreement was signed with the United States in mid-September on an assistance package for Turkey o f US$8.5 billion in concessional loans which will further mitigate risks to public debt sustainability and the external financing plan. The authorities have agreed to direct such assistance primarily to lengtheningthe  -7- maturity of government debt. The U S bilateral assistance has not been factored into the program baseline. 9. The economy has responded well to the Government's recent reform actions and the sustained international support. Sustained export performance and increases in capacity utilization indicate that the 5 percent growth target i s achievable. Consumer price and wholesale price inflation were negative inJune and July, representing successive negative monthly inflation rates for the first time inrecent past, bringingthe year-end target within reach. Domestic interest rates have declined sharply with secondary market rates on government securities falling to the 35 percent level by mid-September, compared to 50 percent inmid-July. Real interest rates have also declined. Although fiscal performance fell short of the targets for mid-year, the Government introduced additional measures in the context of the 5thIMFreview including cuts in on- and off-budget expenditure, and increases in tobacco and alcohol excises. While the current account has deteriorated, and i s now expected to record a US$7.5 billion (3.2 percent of GNP) deficit in 2003, the Lira has been very strong with the trade weighted real exchange rate index suggesting an appreciation of about 20 percent by early September. Turkey's access to international capital markets has been restored with the Government tapping markets for a total of US$5.3 billion so far this year. 10. Sustaining Turkey's economic recovery will hinge on vigorous reform implementation. The recent growth performance has placed Turkey in the category of rapidly recovering post-crisis countries, although the positive outcomes so far represent inpart a rebound from the post-crisis overshooting seen in other crisis countries. Sustaining the improvements in financial market conditions and real sector recovery will depend on continued progress in implementing the reform program. The objective i s to catalyze a virtuous circle whereby sustained fiscal adjustment and more effective government lead to improvements in market confidence which in turn drives down real interest rates on a sustained basis. Lower rates, combined with efforts to improve the business climate, should in turn engender an increasingly robust private sector response, and eventually create the space for funding necessary public investment and social expenditures. Achieving this virtuous circle will require that the Government translate its renewed commitment to reform into credible and sustained implementation over time. The Government has achieved some important reform results, but there have also been delays and slippages, and a challenging agenda lies ahead. Structural reform priorities include restructuring/privatization of state banks; continued modernization of fiscal management; further overhaul o f the deficit-ridden social security system; privatization in the enterprise, energy and telecommunications sectors; and institutional strengthening o f the social safety net. In these areas, rapid and comprehensive action i s needed in the coming months. The key issues for sustaining the medium term recovery are analyzed in the new Country Economic Memorandum, circulated to the Board of Executive Directors in August 2003'. ' Turkey:Country Economic Memorandum: Towards Macroeconomic Stability and Sustained Growth, Report No. 26301-TU, July 28,2003.  -8- 11. WORLD BANK GROUPASSISTANCEAND LESSONSLEARNED 11. The unsustainable build-up in public debt and banking sector liabilities led ultimatelyto the 2001crisis. Based on economic indicators, the last five years is aperiod when Turkish incomes remained on average unchanged, and a series of economic and natural crises devastated many people's lives. But looking from a longer perspective, this period can be seen as the inevitable outcome of rapid, unsustainable expansion fueled in part by excessive government overspending and lax public oversight. With the crises came the opportunity for dealing more systematically with the underlying problems, and establishing modern economic and social institutions for the 2lStcentury. To this end, the Bank's assistance program has been shaped by two overriding objectives: (i) to help Turkey mitigate the impact of these crises-- financial and tectonic--on its people, and (ii)to support the modernization and strengthening of institutions for the future. 12. The CAS for FY01-03 was initially undertaken at a time of opportunity for structuralreform,buildingonmeasurestakeninlate 1999andearly 2000. The Govemment had declared its commitment to extensive reforms, and had enacted several important laws despite the disruption of the Marmara and Duzce earthquakes in August and November 1999, respectively. An IMF program was initiated in December 1999, and the ERL was approved by the Bank in May 2000. At the time the CAS was being drawn up with the Government, a program o f investment loans in support of institutional changes to buttress the structural reform policy measures of the ERL, and a Financial Sector Adjustment Loan, were being prepared. The Bank had helped lay the groundwork for extensive reforms through economic and sector work and an active dialogue, facilitated by the move of the Country Director to the field in 1998 and the subsequent strengthening of the field-based economic management, human development, and portfolio implementation teams. 13. The CAS was discussed by the Board in December 2000, as the financial market turbulenceexperiencedby Turkey in November 2000 was fresh in the minds of observers. The Government made an effort to restore the momentum of reform after the November 2000 financial turmoil, but the underlying imbalances proved impossible to resolve quickly, leading to the full-blown economic crisis of February 2001. A CAS Progress Report was discussed with the Board in July 2001, at which time the severe need for deeper reform had been made clear and the Government's resolve had firmed. The Bank was positioned to support immediately the reform actions required to initiate a rapid and sustainable recovery. The PFPSAL operations were added to the revised CAS to support the most important and urgent of the reforms. These addressed the regulatory, resolution, and recapitalization needs of the banking sector; and began to rectify the weaknesses in fiscal management and public governance that had allowed the mismanagement of government expenditure and public banks for so long. Strengthened support to the social sectors was also put in place quickly given the expected impact of the crisis on vulnerable people.  -9- ~ ~~~~ Box 1:The Achievements andRemainingAgenda The reforms have brought about some lasting changes, in particular where the supporting institutional changes have been made. Viewing each of the original CAS thrusts, the areas in which the aims have been realized and where more attention is needed during the new CAS period can be assessed. The Retrospective Review in Annex A2 provides a detailed assessment o f reform implementation supported by the Bank program during the past CAS period. Implement reformsfor growth and employmentgeneration. Significant reforms have been made including clean-up o f the banking system; enhancedregulation inthe banking, energy and telecommunications sectors; and reduction of agricultural subsidies with the parallel introduction of targeted income support for farmers. However, pressure to reverse some of these measures must be resisted. More rapid progress i s needed on privatization and the FDIagenda. Improve public management and accountability. Rationalization of public investment, elimination of most extra-budgetary funds and automation of public accounting are solid achievements. The adoption of a new Public Debt Management Law and the creation of the Middle Office for Debt Management have set the stage for more effective management of public liabilities. Enactment of the new procurement law and establishment of the independent Public Procurement Agency constitute a key improvement in fiscal transparency; but vigorous implementation of the new public procurement framework must be ensured. Enactment of the Special Consumption Tax and reform of the income tax are the first steps towards a more equitable and supportive tax system. Looking forward, further progress on public financial management and initiation of municipal reform will be important. Expandsocial services and socialprotection. Substantial, sustainable improvements have been made in basic education. Targeting has improved for social welfare for the poorest, but the system needs more funding and a stronger institutional framework. A second stage social security reform i s needed to rationalize the institutional framework, extend coverage and restore financial balance. Health outcomes remain poor for a middle income country, particularly for maternal mortality. Strengthen environmentalmanagement and disaster mitigation. In environmental management, successes have been dramatic and sustainable where achieved, but national replication of regional successes i s not yet taking place. For disaster mitigation, despite the excellent results in reconstruction after the earthquakes of 1999 and initially successful launch of a national catastrophic insurance pool, the institutional framework for disaster preventionremains weak. 14. The achievements during the CAS implementationperiod were made possible in part due to a three-prongedapproach. First,new loans have been large (up from an average size of US$95 million inFY94-97 to US$440 million in FY98-02), but focused on few strategic goals. Second, extensions on older loans not related to the current strategy have been discouraged. Third, tight adherence to the strategy has improved the Bank's ability to manage the program and work towards shared goals with the client. The Bank's ability to scale up has been built on a basis o f analytical work and dialogue. For example, the 2000 C E M laid out the need for reforms and institutional changes to improve private sector development in agriculture, energy, privatization, and telecommunications; while the PEIR, CPAR and CFAA laid the groundwork for the PFPSAL operations. Twinning adjustment operations with investment has supported required institutional changes with considerable technical assistance to contribute to the durability of structural policy reforms. For example, the Export Finance IntermediationLoan helped bring five private banks to world standards, while the FSAL and PFPSALs supported the strengthenedregulatory environment for banking.  -10- 15. As of June 2003, the portfolio of Bank-financed projects comprised 16 active operations (including an economic reform loan and a programmatic adjustment loan) with total net commitments amounting to about US$4.8 billion (see Table 2).2 Of this amount, about US$2.4 billion (some 50 percent) remained undisbursed. Net IBRD commitments more than doubled between FY99 and FY02, driven by a series of adjustment loans and several large investment loans inthe agriculture and social protection sectors which are in direct support of the economic reform program. The average age o f loans has decreased significantly from 5 years at the beginning of FY97 to about 4 years inJune 2003. Table 2: Portfolio Overview FY97 FY98 FY99 FYOO FYOl FY02 FY03 Number of Effective Projects at FY end a/ 22 22 20 23 19 18 16 Net Commitments ($m) at FY end 2,763 2,434 2,632 3,801 4,344 5,890 4,820 Undisb.Balance at FY start ($m) b' 1,633 1,233 1,509 1,673 2,419 2,542 4,002 Gross Disbursements during FY ($m) 329 259 264 957 820 1,679 788 Disb.Ratio InvestmentProjects (%) 20 21 17 20 21 17 16 Disb.Ratio inc. Fast Disb.Loans(%) 20 21 17 57 34 66 2C Cancellations ($m) 86 53 104 41 448 37 1,093 New Commitments ($m) 20 603 528 1,770 1,628 2,950 300 Unsatisfactory Projects Number 1 3 4 4 3 5 2 Percent 5 14 20 17 16 28 13 al Only IBRD financed projects, including two - one of which with unsatisfactory rating - that closed on 6/30/2003. Hybrid loans are dividedby componentfor calculating disbursementpercentages. b/ Undisbursedbalanceon 6/30/2003 was US$2,432 million. 16. The performance of the Turkey portfolio continues to compare favorably to Bank- wide averages, and has continued to strengthen. At the beginning of FY04, only one project had an unsatisfactory IP or D O rating. This i s a noteworthy accomplishment in particular in light of the 2001 crisis. A pro-active JPPR done in the late spring of 2001 helped to anticipate risks that faced project implementation as a result of the crisis and ledto early government attention to budget issues so that the feared shortfall of counterpart funding did not emerge. The JPPR completed in late 2002 did not reveal significant cross-cutting issues affecting implementation, but highlighted factors worthy of vigilance on a project-specific level. Again this was a useful guide for portfolio managers in the Government and the Bank and after a slowdown in FY02, disbursements accelerated in early FY03. Unfortunately, early 2003 brought a near stoppage of disbursements. The Government applied new budget procedures, and signaled a need to revisit the portfolio in light of changing priorities and greater commitment to managing tightly the public investment program-all based on valid principles of sound fiscal management and accountability, but at the outset bringing constraints and some confusion to project implementation. By June 2003, many of these issues had been resolved. The Government i s In addition, the World Bank portfolio includes two grant financed projects with net commitments of US$22.2 million.  -11- currently engaged in a tightly run process of examining the intended use of remaining large undisbursed balances to determine if there are issues of weak strategic alignment and a consequent need for restructuring and redesign. This i s expected to lead to decisions in a series of project mid-term reviews and the finalization of the latest JPPR inthe Fall of 2003. Box 2: IFC's Strategy Following the 2001 Crisis IFC's strategy shifted to respond to the pressing needs of the corporate sector that was forced to adjust to the effects of the economic crisis. Consequently, IFC's incremental investment approvals during the year 2002 were in the magnitude of about US$300 million diversified amongst banks, aluminum, paper, textiles, glass, tableware, electronics and ceramic products. With regards the financial sector, the IFC managed to leverage its knowledge of the financial sector to advise the Turkish government in the restructuring and rehabilitation of the banking sector during the banking crisis. In addition, the IFC has been assisting in the institutional development of banks, leasingfinance companies, the reinsurance sector and inproviding IFC funding to Sh4Es. A major focus on the IFC's investments was to enable its existing export-oriented clients to generate foreign exchange cash flows to service their debt, thereby avoiding insolvency. In addition, the IFC also helped the growth of promising companies by providing them access to global markets. IFC's assistance was geared to enabling companies to improve competitiveness and adapt to international environmental standards. In addition to traditional project finance, IFC also provided working capital finance and on occasion, restored confidence in credible operating enterprises by replacing anxious commercial lenders. In general, the IFC has and will continue to emphasize security arrangements for its credit to minimize difficulties with regards recovery. The IFC has been extremely selective in its equity investments as hyperinflation and substantial devaluation have limited opportunities for equity/quasi-equity investments. Overall however, the IFC's portfolio has managed to weather the volatile economic environment o f recent years better than others. 17. To summarize, the previous CAS represented a significant change in approach which has important lessonsgoing forward. A programmatic approach, especially in the areas of public and financial sector reform at the heart of Turkey's macroeconomic instability, combined with twinning of adjustment and investment operations, e.g. in agriculture, energy, and privatization, leveraged the impact o f the Bank's overall program and ensured close links to the reform process. Scaling up in a few focused lines of business--instead of dispersing Bank resources on a large number of smaller interventions--ensured a significant and visible development impact in the country. A self-regulating program, which offered Turkey substantial support carefully calibrated to disburse on the basis of concrete reform implementation and improved macroeconomic outcomes, helped manage risks.3 As the pace of reform slowed down over the last year, so did too the Bank's financial assistance. This support could be accelerated under the new CAS as the Government moves forward in implementing its reform program. Only one operation under the previous CAS, the PFPSAL I,has been reviewed by OED. The outcome of the operation has been considered satisfactory. OED's Evaluation Summary of the ICR review notes as an important lesson of broad applicability that "implementing financial sector and public sector reforms concurrently yields considerable benefit, in that establishing an improved fiscal situation removes the major source of the country's macroeconomic instability and thereby lessens pressureson the financial sector".  -12- 111. M A I N DEVELOPMENT CHALLENGES A N D THE COUNRTY ASSISTANCE STRATEGY Turkey's Vision andEconomic Priorities 18. Turkey's vision: a modern democracy with close ties to its history and traditions, fully integrated in Europe and playing a strategic role in the regional context. Turkey's long-term agenda i s articulated in the 23-year National Development Plan (2001-23), while priorities of the new government are spelled out in its program presented to Parliament and the Urgent Action Plan. Long-term development goals include transforming the country's economic and social structure in order to become an influential regional power, raising the level of health and education in the society, improving the income distribution, strengthening scientific and technological capacity, enhancing effectiveness in infrastructure services and protecting the environment. The vision that Turkey has for itself i s of a modern and secular participatory democracy, fully integratedin the European community, playing a critical role in its region, with an export-oriented, technology-intensive production structure. Turkey sees the EU accession process as an important opportunity for harmonization with international norms and standards. Also, Turkey's geo-strategic position offers a unique opportunity to reach its true economic growth potential. 19. Turkey's development agenda is centered around four major themes: (a) sound macroeconomics and governance; (b) equitable human and social development; (c) attractive business climate and knowledge; and (d) strong environmental management and disaster mitigation. These themes, albeit to varying degrees depending on the Bank's comparative advantage and the role of other development partners, are also the areas of focus for the CAS. (a) SoundMacroeconomicsand Governance 20. Chronic instability has prevented Turkey from realizing its full growth potential. Despite impressive achievements over the past two decades, Turkey's economy has operated under a cloud of vulnerability-plagued by persistent fiscal imbalances, chronically high inflation, and sharp swings in the business cycle. Earlier attempts to stabilize the economy fell short, and high growth has never been sustained for long. The "boomhust" cycle, which characterized Turkey's economy throughout the 1990s, has continued in the new decade with 6 percent growth in 2000 followed by a record contraction of over 9 percent in 2001 and a strong recovery of almost 8 percent in 2002. 21. While the immediate trigger for the 2001 crisis was the fragility of the banking system, underlying this and previous crises is a deeper problem of governance. This i s manifested in serious, non-transparent and unsustainable imbalances of public finances. Correcting these structural weaknesses require fundamental changes in the institutional arrangements for the management of public finances to ensure transparent public resource allocation and real accountability for results.  -13- 22. Permanent fiscal adjustment is the key to macroeconomic stability. Turkey will need to run large primary surpluses over the medium term to lower its public debt level to manageable proportions. Tight fiscal policy i s also required to meet its disinflation objectives. The longer-term permanence of fiscal adjustment i s a major issue for Turkey. The impressive adjustment since 1999 has relied heavily on revenue increases and cuts in quasi-fiscal expenditures, such as credit subsidies. Non-interest expenditures have actually increased significantly since 1999. Deeper structural reforms to the social security system, together with continued progress inpublic investment and public employment rationalization, improvements in public liability management, agriculture subsidy reform, state enterprise restructuring/privatization, and energy reform are all needed to contain non-interest expenditures as part of a broader effort to ensure sustainability o f the fiscal adjustment. 23. Continuing the public sector reforms and reshaping the role of the state in the economy will be a main challenge for the Government. Improving the effectiveness of government (understood to be a more efficient and more transparent provider of public goods and services) i s a multi-faceted task, whose full achievement i s a long-term project. The Turkish public sector i s much larger than OECD comparators such Portugal or Spain, and public spending has greatly exceeded available resources. Central to the problem has been extensive intervention by all levels of government throughout the economy and an under-performing system of public sector management. In 2001, Turkey started a comprehensive process of reforming the public sector aiming at addressing the structural factors that led to the crisis, in order to ensure that these conditions do not recur in the future. The main objective o f the program i s to break the vicious circle of an unsustainably large public sector and inadequate public sector management leading to ever increasing public indebtedness that fuels financial sector weakness. 24. A more effective and better performing judiciary is an important aspect of improved public sector governance. The Government i s giving utmost importance to judicial reform, and efforts in this area are ongoing. The key challenges of a comprehensive judicial reform program include: strengthening the effectiveness of the judiciary; facilitating access to justice and public awareness; andensuring adequate continuing legal education. 25. Effective decentralization through greater empowerment of municipalities will lead to improved services. Governance of the increasingly complex urban economies must shift from reliance on central government micro-management to municipal administrations accountable to their citizens. Greater local revenue generation would both heighten citizen oversight and reduce municipal dependence on the central government budget. Coupled with enhanced financial accountability, and improved monitoring and public reporting of municipal performance benchmarks, decentralization will foster the sustainable provision of services such as water supply, and wastewater treatment, urban transport, road maintenance and solid waste management. 26. Participation improves policy effectiveness. Greater engagement of civil society in Turkey's development-for designing strategies and implementing programs-will raise the effectiveness and relevance of the government's efforts in the eyes of its citizens. While Turkey has made noteworthy strides towards civic engagement, channels of effective communication  -14- and cooperation between the state and civil society organizations remain limited, and the regulatory system for NGOs i s complex. 27. Enhancing macroeconomic stability and strengthening public sector governance require sustained focus on: (i) implementing structural fiscal policies to help ensure permanent fiscal adjustment; (ii)carrying out a medium-term program to improve the transparency and efficiency o f public expenditure management; (iii)implementing broad-based institutional reforms to improve the quality of public sector governance; (iv) embarking on a judicial reform program based on a comprehensive judicial sector assessment; (v) improving the mechanisms for service delivery including through a process of decentralization; and (vi) strengthening the legal framework for the establishment, operation and financing of civil society institutions. (b) Equitable Human and Social Development 28. Human development is critical for Turkey's ambitions for EU accession and the reduction of inequality. Stabilizing the economy, creating and sustaining growth, and modernizing the role of the state are key strategic objectives for Turkey, but none of them may be fully achieved or sustained without improving the country's human capital. Currently, educational attainment o f the Turkishpopulation and labor force i s by far the lowest of all OECD countries. Raising the educational qualifications of the population i s a crucial requirement for improved labor productivity and employment growth inTurkey. It i s also critical for making the country more competitive inthe global economy and to meet the goal of EUaccession. 29. Turkey has made unprecedented strides in the basic education program launched in 1997 (see Box 3). Now the twin challenges are to increase gradually the share of GNP dedicated to education in a manner consistent with the medium-term fiscal targets. This will require accepting that not all improvements in education can be afforded at once and more effort i s needed to prioritize. The objective to improve skills and knowledge beginning in the early years i s the right one, and Turkey needs to stay on track with its ambitious reform of basic education. If Turkey i s to remain competitive in the global economy it should also expand and reform secondary education to provide all youth with a secondary education that will address short and long term goals, including providing them with core competencies and knowledge, including foreign language and information technology skills, as a base for lifelong learning and active participation in a modem, knowledge economy. In addition, Turkey should develop more of an enabling framework for tertiary education that would encourage postsecondary institutions to be: (i)more innovative in the creation, dissemination, and application of knowledge; (ii) more responsive to the needs o f a globally competitive knowledge economy and the changing labor market requirements for advanced human capital; and (iii) more diversified in terms of revenue sources to finance their reorientation, expansion, and increased effectiveness.  -15- Box 3: Impactof the BasicEducationReform InAugust 1997, the Government of Turkey introduced broad reforms to its education system. These reforms were supported by legislation that extended the duration o f compulsory education from five to eight years and launched a major expansion and quality upgrading of eight year basic education schools. In six years, these reforms have contributed to improving children's learning achievement by dramatically raising the conditions of schooling for millions of children: Enrolling over 10 million students in compulsory education (of which 4.8 million girls), an increase of 1.3 million children since the program started. Increasing net enrollment in 1st through 8th grades from 76% in 1996to nearly 100% today. Employing over 390,000 teachers (of which more than 218,000 are women). Providing professional development and training to 370,000 teachers, principals, and inspectors. Providing books, other didactic materials, and computers and education software to tens of thousands of schools. Bussing over 660,000 poor students from small village schools to central village schools (and providing free school uniforms and lunches). Building more than 30,000 new schools. Attaining the Government's goal of maximum 30 students per classroom in65 of 81provinces. Maintaining, by the Government, of its commitment regarding provision of education for all by: o Protecting education expenditures (4.25% of GDP) o Introducing a fine for non-attendance inbasic education. 30. Turkey ranks far behind most middle income countries in terms of health status. Furthermore, equity in the health sector i s one of the important stumblingblocks that the country must addressin order to achieve social peace and international credibility. Currently, Turkey has one of the most complex health care systems inthe world. A wide array of health care providers, financiers, and organization arrangements has resulted in an inefficient system which increasingly fails to meet effectively the health needs of the country's 70 million population. Poor health status of the population relative to the country's income level, inequitable access to health care, an unsustainable public insurance system, inefficient use of resources and the need for better public governance by the Ministryof Health make health care reform imperative. 31. Turkey is a country with low extreme poverty but high income inequality. Tight macro policies, sustained fiscal adjustment and actions to downsize staffing levels in the state enterprises, aggressive banking and corporate sector restructuring, and accelerated structural reforms all pose major political challenges to the government and entail significant social costs as well. While extreme poverty (US$1 a day) remains very low in Turkey, both urban food poverty and economic vulnerability are significant and have grown recently (see Box 4). Turkey needs a strong social protection system to reduce these. Currently, the system of social protection i s unaffordable and unbalanced. The social security system suffers from poor management, low collection performance, chronic cost overruns, and ad hoc increases in benefits. Social protection spending i s projected to reach some 9 percent of GNP in 2003, well above the benchmarks set under the PFPSAL program. However, this overall result i s due primarily to overruns in social security expenditure which mask important shortfalls in other social protection programs. The large deficit of the social security system (which i s expected to approach 5 percent of GNP in 2003) i s a key factor in crowding out social assistance which is, on the other hand, underfunded. The other key issue for social assistance i s the need to  -16- institutionalize the delivery mechanism. The root cause of much of the ad hoc nature of social assistance in Turkey i s the ad hoc nature of the institutions delivering it, including the Social Solidarity Fund. Box 4: Povertyand Inequality inTurkey e Extreme poverty (US$1 a day) i s quite low by international standards and has remained basically unchanged since 1994. In2001, less than 2 percent of the population had per capita consumption under US$1 per day, and only 3 percent had per capita income under US$1 per day. If higher poverty lines are used (corresponding to the ECA poverty report), then poverty i s more substantial-close to 18 percent of the population was under US$ 2.15 per capita per day in 2001, and 42 percent had per capita consumption under US$4.30 per day. e Inequality remains high (Gini coefficient for income was 46 in 2001 and 40 for consumption), and i s primarily driven by extreme regional differentials, with poverty rates sharply higher in the Southeast than in the rest of the country. e Larger households are poorer and children are more vulnerable than the elderly. Education and job access are major factors indetermining household well-being or poverty. Illiterate household heads and those with primary only education are much poorer than those with secondary education, and almost no households with heads with tertiary education are poor. e Rural to urban migration has been an important part of the coping strategy for many of the poor, including internally displaced families. Other coping mechanisms, especially relying on relatives and neighbors for in-kindand cash assistance, have come under stress and the poor reported a decrease in assistance from these traditional channels. e Informal employment, an important mainstay of the poor, has been reduced as a consequence of the crises. e In spite of their reluctance, some of the poor have been forced to either pull their children from school or have them attend less, for lack o f resources to cover out-of-pocket expenditures, and need o f informal earnings from child labor. e Turkey has embarked on a significant reform to address both extreme poverty and poverty more broadly defined. These efforts are supported, among others, by the Bank-financed Social Risk Mitigation Project (SRMP). e Targeting the extremely poor families with children, the SRMP helps finance conditional cash transfers (CCT) which are cash payments to mothers o f extremely poor children provided that they attend school and health clinics regularly. A new targeting mechanism, a scoring formula (proxy means test), has been developed based on the 2001 household data. The conditional cash transfers are significant in that while modest in size, they are regular cash payments to extremely poor families to enable them to cover the out- of-pocket costs of getting their children to school or health clinic. e The SRMP also includes a social fund-type component, the Local Initiatives, which is targeted towards vulnerable households. This builds on an existing program of small income generating projects but with significant systems improvements. B y design, the poorer regions benefit more from the proceeds of the loan. e Turkey is also improving its institutions for poverty monitoring, SRMP monitoring, and for social assistance and child welfare. Under the SRMP, part of the costs o f regular household income and expenditure surveys (HIES) are being financed, enabling Turkey to regularly monitor poverty. A HIES was undertaken in 2002, and the authorities have agreed to issuejoint poverty numbers with the Bank from this survey. At the same time, more work is necessary to improve Turkey's capacity to deliver a full Poverty Assessment including incidence analysis of public expenditure programs. A management information system (MIS) i s being set up in all 931 offices of the Social Solidarity Fund as well as in the General Directorate for Child Welfare, and these software and hardware costs are being financed through the SRMP. Turkey: Poverty and Coping After Crises, World Bank, 2003. Making the Transition Work for Everyone, World Bank, 2001.  -17- 32. The following activities emerge as priorities: (i)continuing the reform of the education sector by moving to secondary and technical education with the objective of linking the curricula to labor market requirements and expanding and upgrading the skills base of the country; (ii) advancing the reform of the health sector to make it more equitable and efficient; (iii)continuing the reform of the social security system as a natural complement to health sector reform and the broader public sector reform program; (iv) monitoring and assessing poverty and vulnerability for effective poverty reduction; and (v) analyzing the constraints currently affecting the Turkish labor market (formal and informal sector) to pave the way to necessary reforms. (c) Attractive Business Climate and Knowledge 33. Turkey should address the unfinished agenda of financial sector reform. The first phase of financial sector reform following the 2001 crisis addressed the urgent banking sector priorities including upgrading the regulatory and institutional framework o f the banking sector to international levels, restructuring and clean up of the private banking sector, and the financial and operational restructuring of the state banks. A degree of short-term stability has been achieved in the banking sector, and the emphasis i s now on consolidation and sustainability of the remaining reforms, focusing primarily on institutional strengthening and independence of the Bank Regulation and Supervision Agency (BRSA) and the Savings Deposit Insurance Fund (SDIF),privatization of the state banks, reform of the deposit insurance regime, and sales of non performing assets held by the SDIF. On a more strategic level, in addition to further improvements in the banking sector, development of a broader and deeper financial sector i s essential for sustained financial stability and economic growth. It i s therefore timely for the Government and the private sector to broaden their focus to encompass diversifying the financial system beyond banking, along with a balanced set of incentives for complementary development of banlung and non-bank financial institutions (NBFI) and markets. This will be essential to improve real sector access to a wider range of modern financial products and services; to improve access to finance for a broad range of economic agents, including SMEs, micro- enterprises and low income earners; and to reduce the systemic risks in the financial sector through diversification. Completion of the reform agenda in the banking sector and development of well-regulated non-bank financial intermediation are key to sustainable economic recovery. 34. Implementation of the Istanbul Approach and S M E development are important for strengthening the real sector. Business was badly affectedby the 2001 crisis, and although now exhibiting signs of growth, continued implementation of the Istanbul Approach (a voluntary workout scheme) remains essential for its full recovery. In addition, the growth of small and medium-sized enterprises (SMEs), which account for 95 percent of all enterprises and employ more than 40 percent of the workforce, should be supported through enhanced access to financial and non-financial services, knowledge and technology, as well as reduced bureaucracy, and clear official procedures. This would lead to employment generation, mitigation of regional imbalances of income, and ultimately poverty reduction. 35. More decisive political will is needed to achieve a fully private sector-led development model. Privatization in Turkey has lagged behind other emerging countries in Latin America, Asia and Eastern Europe with state enterprises continuing to account for 20 percent of total manufacturing industry value-added in 2002. Turkey should be a magnet for  -18- foreign direct investment (FDI) given its large market size, skilled domestic labor, and competitive local firms as suppliers to multinationals. However, Turkish FDI levels have stagnated during the last 15 years while total FDI worldwide increased by a factor of 12. Acceleration of privatization, a full-scale review of commercial law and competition policy to identify and address obstacles of FDI, and the development o f a strategy to facilitate the flow of "greenfield" FDIto SMEs are key actions to achieve more robust private sector-led growth. 36. Utility sector reform continues to be a high priority. Energy prices in Turkey are now well above OECD averages, which imposes a cost on the whole economy. The centralized development model based on state owned monopolies and guaranteed take-or-pay contracts has not delivered affordable energy. The transformation of the electricity and gas sectors to competitive, appropriately regulated, private energy markets aims to decrease costs and risks currently borne by the government by attracting private capital not relying on government guarantees. In telecommunications, credible restructuring and privatization of Turk Telekom and further regulatory improvements, including enhanced competition, are required to make the sector an important driver of technological change and economic growth. 37. Raising the efficiency of Turkey's transport sector will contribute to economic growth, environmental sustainability and poverty alleviation. The transport sector i s in need of major structural reform to develop a culture focusing on users' needs and affordability. This would help Turkey's competitiveness by lowering logistics costs. It would also increase the access of rural and urban populations to basic services, markets and jobs, and reduce the high human and economic costs of traffic accidents. Mobilizing private investments and managerial know-how inthis effort will also help reduce the sector's current onerous deficits. 38. In recent decades, agriculture and other rural economic activities have failed to live up to their potential as contributors to growth, rural employment, and rural welfare. Falling growth rates of value added have been the legacy of costly agriculture support policies that distorted markets. The comprehensive reform in agriculture now underway has reduced the fiscal subsidies and enabled direct income support to be paidto 75 percent of farmers. A broader strategic rural development challenge for the Government i s to curtail involvement in commercial activities and focus on improved support for market development; strengthened management of investment and services in irrigation, forestry, and rural cooperatives; and ensuringthe provision of services to rural areas to support the delivery of government activities where market failure i s prevalent. Other rural initiatives would be left to the private sector. 39. Key medium-term priorities for promoting private sector development include: (i) completing the process of reforming the banking and financial sector; (ii) implementing the fully Istanbul approach to revitalize the enterprise sector; (iii)addressing constraints to S M E growth; (iv) accelerating privatization and removing barriers to FDI; (v) improving the governance of the transport sector to reduce its fiscal burden and improve its competitiveness; (vi) continuing the restructuring and privatization of public utilities coupled with sector reform; (vii) following up on the agricultural sector reform implemented under the previous CAS; and (viii) implementing the reform process inherent inthe EUacquis communautaire.  -19- (d) StrongEnvironmental Management andDisaster Prevention 40. Turkey is highly vulnerable to natural disasters, especially earthquakes and floods. In 1999, the Marmara earthquake caused extensive loss of human life and large economic costs, pointing to the need to improve disaster prevention and emergency preparedness. High priority needs to be given to reducing the impact of future earthquakes affecting Istanbul and, specifically, to saving lives and mitigating the social and economic impacts that can be expected to occur. Special emphasis should be attached to strengthening the region's emergency management capabilities, including planning, public education, and conducting region-wide emergency exercises. Seismic strengthening of Istanbul's most critical facilities (hospitals, emergency facilities) and major lifelines would assure that the essential infrastructure of the region would continue to function in the aftermath of a major earthquake. More broadly, Turkey needs a coherent approach to environment protection, otherwise, like many other industrializing countries, it faces the risk of allowing its economic growth to result in unacceptable depletion of water, forestry, biodiversity and air quality. As part of the EU accession process, Turkey i s required to enhance its environmental standards and compliance mechanisms, and the EU i s taking the lead in supporting this effort. Complying with the EU environmental directives i s a major challenge for Turkey, and requires significant increases in environmental investments over a long period of time. Appropriate management of the environment i s also fundamental to the Government's poverty reduction efforts since the relationship between poverty and environmental degradation presents the characteristics of a vicious circle: in some rural areas depleting natural resources appears to be the only way for the poor to survive and in poor urban areas a degraded environment contributes to illhealth and social exclusion. 41. As reversing the trends of environment degradation is a long-term agenda, requiring institutional and cultural changes, it is important to concentrate on key priority areas: (i) strengthening the country's capacity for emergency preparedness; (ii) making further progress in adopting EU environmental standards; and (iii) introducing sound practices for air, water, solid waste, soil and forestry management. Box 5: Sub-regional Cooperation While in its foreign and economic policy, Turkey is projected towards Europe and the west, at the same time, its ambition i s to establish its status as a regional power by keeping close ties with the Caucasus and Central Asia countries, taking the lead in the reconstructioneffort in Afghanistan, and playing a conflict-resolution role in the Middle East. Turkey has close economic and cultural relationship with the Caucasus and Central Asia countries, nurtured by playing a prominent role in a whole range o f multilateral regional activities. The Committee for Economic and Commercial Cooperation of the Organization of Islamic Conference (COMCEC); the Economic Cooperation Organization (ECO); and the Black Sea Economic Cooperation (BSEC) are among those initiatives where Turkey has assumed a leading role. The Bank will provide assistance to Turkey to support selected activities under the Black SedDanube Partnership Initiative and the Caspian Oil and Gas Initiative. The Country Assistance Strategy 42. The objective of this CAS is to help Turkey continue to implement fundamental reforms to reduce economic vulnerability and achieve highand stable growth, and continue  -20- the process of addressing long neglected social and environmental problems. This i s not a crisis management strategy but one which aims at reducing the risk of reemergence of crises and helps Turkey achieve its key objective of getting ready for EU membership. The two lending scenarios described in this document are very different in size and composition, reflecting the risks associated with the assistance strategy. If the authorities are ready to pursue consistent implementation of structural reforms resulting in reduced economic vulnerability, the Bank would be willing to increase its exposure from its current level. However, if this were not the case, the low case lending program would be quite limited. 43. The Bank strategy has been developed in close cooperation with the Government. There is consensus on the main elements of the reform program that the Bank would support under the CAS. At the same time, there i s a risk that implementation may falter or certain reforms may proceed as scheduled while others may encounter implementation difficulties. This i s evidenced, for example, in the limited progress in institutionalizing social assistance and delays inprivatization. Inrecognition of this risk, the assistance strategy contains important risk mitigation measures, including: (i)a comprehensive set of triggers to help the Government maintain its overall focus on the program; (ii) the use of programmatic lending that transforms the triggers into specific implementation benchmarks, but with the flexibility to adjust the benchmarks from one operation to the next based on evolving circumstances on the ground and the variations in reform progress in specific areas; (iii) selective investment lending in the high case to support reform implementation in specific sectors; and (iv) an AAA program aimed at helping the Government design specific reform measures and providing the analytical fundamentals of the Bank's program. 44. The planned assistance program for FY04-06 is structured around four development themes inline with the Government's priorities: .. Sound macroeconomics and governance Equitable human and social development Attractive business climate and knowledge Strong environmental management and disaster prevention Table 3 summarizes, by development theme, the key outcomes the Government would like to achieve by the end of the CAS period, as well as a select number o f Bank Group benchmarks representing outcomes and outputs that the Bank's program aims to influence. In addition to these monitoring indicators, a series of other country performance indicators and Bank Group benchmarks have been identified in each of the four development themes, and these are presented inthe Country Assistance Strategy Matrix (Annex B9). Box 6: CAS Consultations The choice of priority areas of assistance also reflects the outcome of consultations with the civil society and other stakeholders, carried out jointly by the Government and the Bank in July 2002. The consultations took place in Ankara, Istanbul, Gaziantep and Izmir, and included Parliamentarians, local leaders (Governors' and Mayors' offices), business representatives, NGOs and the Bank's key development partners. A summary of these discussions is included in Annex A3.  -21- Table3: Key Outcomesand Bank G up Benchmarks Development Themes Key Outcomes BankGroupBenchmarks Sound jtabilization of public creditworthiness Satisfactory macroeconomic and fiscal Macroeconomics and ndicators at sustainable levels 'ramework consistent with the key outcomes Governance Less volatile economic growth in the [mplementation o f public sector reforms, .ange of 5% 'ocusing on: (i) the tax system; (ii) public :xpenditure management; (iii)the social Single digit inflation security system; (iv) the civil service; (v) oca1government; and (vi) anti-corruption Equitable Human and Low extreme poverty (1.8%) Public expenditure on health, education and SocialDevelopment maintained and vulnerability reduced jocial protection are sustained at pre-crisis from 15% in 2001 to 12% in2006 levels. The benchmarks as shares of GNP ire: (i) education: 4.25%; ?Jet enrollment rate in basic education :ii)health: 3.25%, and(iii) protection: social naintained at not less than 99%; girls' 7.00% Znrollment increased, especially in iecondary education: male/female ratio [mplementation of (i)the Conditional Cash improvedfrom 1.20 to 1.15 by 2006 Transfer program to benefit over 1 million children, and (ii) at least 1,500 local initiative Child mortality reduced and maternal projects to support vulnerable people health improved to make progress towards the MDGs Renovation and modernization of schools, including in disadvantaged areas, and implementation of reforms in secondary education Improvements in access and quality of basic health provision AttractiveBusiness Exports growth rate exceeds GNF Increase in export capacity of enterprises Climateand growth rate financed through lines o f credit provided by Knowledge the World Bank Group Foreign Direct Investment reaches US$1.5 billion on average during the Improvements in the overall investmen1 CAS period climate, implementation of the new FDIlaw. and establishment o f an Investmenl Stability of financial markets improved Promotion Agency Continued independence o f financial markets regulatory agencies Completion of privatization o f state banks passage o f new Bankruptcy Law anc Commercial Code, and implementation 0' non-bank financial institutions reform StrongEnvironmental Significant convergence with EL Environmental sector priorities updated intht Managementand environmental standards EUcontext DisasterPrevention Disaster prevention and managemeni Introduction of mandatory insurance cover o system improved private housing units; creation of a strict and enforced construction code enforcement system, and strengthening of emergency preparedness  -22- 45. The planned assistanceprogram supports poverty reduction. It aims at: (i) making the economy more resilient to crises (including natural disasters) that disproportionately affect the most vulnerable; (ii) contributing to sustainable economic growth that is critical to pull many of the poor out of poverty; (iii) promoting human development to create opportunities for the poor, make access to health and education more equitable and the social protection system more efficient; (iv) reducing regional differences by improving the delivery of and access to services, and creating jobs in disadvantaged areas; and (v) increasing empowerment through enhanced local participation and civil society involvement. (a) Sound Macroeconomicsand Governance 46. Top priority will be given to completion of the public sector reform. The first step will be for the authorities to complete the agreed actions under the program supported by the Programmatic Financial and Public Sector Adjustment Loans (PFPSALs). The first PFPSAL was approved in July 2001 and disbursed in a single tranche. The PFPSALII was approved in April 2002 as a three-tranche operation in part on SSAL terms. However, disbursement of the second and third tranches of the PFPSALIIwas delayed by a slowdown in implementation of the economic reform program during the run-up to the elections held in November 2002. The new Government decided not to draw on the PFPSALII and the undisbursed amount of US$900 million was canceled at the Government's request. At the same time, the Government committed to the principle objectives of the program and requested the Bank to prepare a new two-tranche PFPSAL3 operation with a revised implementation timetable in line with the Government's priorities for 2003 and early 2004. The backbone of the structural conditionality for the PFPSAL3 draws on the program for the PFPSALII second and third tranches. In key areas of the program where there have been problems, the conditionality has been strengthened. These include adoption of legislation to institutionalize the direct income support program for farmers, lifting of restrictions on BRSA's operational independence, a new roadmap for Vakif Bank privatization, and elimination of the system of earmarked revenues and expenditures left in place after the closure of budgetary and extra-budgetary funds. New benchmarks are also being set under the tax strategy and public employment program. Macroeconomic outcomes under the PFPSAL3 will be monitored against key indicators determined on the basis of the macroeconomic framework agreed with the IMF. 47. Going forward, programmatic lending will be split between the financial sector and public sector components. As Turkey moves beyond crisis management, the more specialized nature of the reforms implies that it will no longer be optimal to combine the two strands of the PFPSAL program in the same operations. Two Programmatic Public Sector Adjustment Loans (PPSALs) will continue to support the phased process of restructuring the public sector started under the FYO1-03 CAS. This support will be closely coordinated with the IMF program and will focus on structural fiscal policies to underpin adjustment; public expenditure management (encompassing budget reforms, financial accountability and public liability management); and public sector governance. The legal and institutional framework for the PPSALprogram will encompass the Public Financial Management and Control law expected to be enacted in the fall of 2003, implementation of the new public procurement law which went into effect in January 2003, introduction of a comprehensive risk management framework under the Public Debt Management law enacted in early 2002, implementation of the National Anti-  -23- corruption Strategy adopted in late 2001, and introduction of the civil service reform strategy scheduled to be adopted by end-2003. The first PPSAL, scheduled for early FY05, will focus on the next phase of institutional and structural reform of the social security system which i s essential to underpin the fiscal adjustment and create the financial headroom needed for rebalancing the social protection system. It will also continue support for the on-going agenda of public sector reforms supported by the PFPSAL operations and underpin initiation of local government reforms based on analytical work noted below. The second PPSAL, scheduled for FY06, will build on the progress and momentum established under the program and begin to shift the emphasis from reforms to measurable improvements in public service delivery. The programmatic nature o f Bank lending to support continuation o f the Government's public sector reforms will help phase Bank assistance inline with program progress, and provide the necessary flexibility to adjust to future developments with regardto program implementation. 48. The Bank is ready to support the Government's activities in the legal andjudicial reform area, initiated under the Urgent Action Plan. With respect to legal reform, Bank assistance will continue to focus on improvements in the legal framework for economic reforms and private sector development in the context of the planned adjustment operations. With respect to judicial reform, the Bank i s prepared to provide financial and technical assistance, through an IDF grant or other means, to support the Government's efforts in this area. Strengthening and modernizing the judicial organization, administration and resource use, improving the efficiency of the judicial system through better case management, ensuring adequate continuing legal education, and facilitating access to justice through adequate awareness and public education campaigns are the main elements of a judicial reform program. In order to share experience between Turkey and other countries in the region, WBI is considering the possible participation of Turkey in the distance learning program on judicial reform targeted to ECA countries. 49. Bank assistance to help improve decentralized service delivery and implement municipal reform is planned. The Bank has been working with the Government to develop a local government reform strategy with the objective of providing better local infrastructure services (water, roads, transport, solid waste management etc.) to the urban population that represents about 70 percent of the population. A Municipal Reform and Services Project i s foreseen for FY05 in support of an overall effort to improve municipal services to the urban population. The design of the program will be based on the results of analytical work carried out under an IDFgrant, and will also take into account lessons learned through the work financed by other development partners, in particular GTZ and KfW. This operation will be closely linked with the PPSALs that will address the overall public sector reform agenda, including local government reform. Turkey would also benefit from training and capacity building activities plannedby WBI inthe area of municipal reform. 50. The Bank will continue to support the role of civil society organizations. It will holdregular consultations on program and project design, and will use the Small Grants Program to provide small-scale financing for local NGOs. It will also contribute to the preparation o f a comprehensive NGO directory. 51. Analytical work will support implementation of the reform program and provide the basis for Bank interventions. The Bank plans to carry out a series of economic reports and  -24- sector studies to inform the debate on key reform issues. Following a set of comprehensive Policy Notes prepared for the new govemment in FY03, a CEM focusing on the recovery and medium-term agenda for sustained growth was finalized in July 2003. In FY04, economic work will be launched to analyze the interactions between the financial sector, the real sector and the labor markets, the results of which will be used in the context of the planned adjustment operations. A new C E M i s planned for FY05 on the implications of the process towards EU accession. As in the past, the public sector reform program will be guided by the PEIR, the CFAA and the CPAR that will be updated in the later part o f the CAS period. The Bank will also continue its support for implementation of Turkey's anti-corruption strategy, including through the key fiduciary economic work mentioned above and continued collaboration with national NGOs for diagnostic surveys on corruption. (b) Equitable Humanand Social Development 52. Reform of the education sector will be continued at the secondary and post- secondary education level. The process of reforming the education sector started with the comprehensive basic education reform that the Bank i s supporting through an adaptable program loan begun in FYOO(see Box 3). The Government has now expressed willingness to address the reform agenda for secondary education, and requested Bank support through a Secondary Education Project, scheduled for FY05. This operation has the objective o f improving access to high quality and economically relevant secondary education on an equitable basis. The project would focus on three priority areas: (i) formulation, planning and launching o f a secondary education reform strategy including revision of general and vocational programs, provision of information communication technology, and career guidance and counseling; (ii) support for post-secondary programs including pre-service teacher training, in response to changes in secondary programs, and improving the quantity and quality of post-secondary technician training; and (iii)improving quality and assessment of students, programs, and institutions. The EU is actively engaged in the reform of secondary education, and the preparation of the Secondary Education Project i s being closely coordinated with EU-financed activities. A WBI conference on secondary education, and education sector work are also planned for FY04 and FY05, respectively. IFC has taken an active interest inthe education sector and efforts aimed at the expansion of higher educational services will continue, in addition to monitoring existing investments in the sector. 53. Radical reforms are necessary in the health sector. Given the complex nature of the sector and the vast fragmentation in financing and delivery, reforms in the health sector need to be accompanied by reforms of the social security system. The objective o f the reforms i s to streamline service provision, do away with arbitrary differences in the provision of health care, and extend health insurance coverage to 100 percent of the population in a fiscally sustainable manner. Improvements in resource utilization need to be accorded high priority, and efficiency in the delivery of health services in hospitals needs to be improved. Systemic changes in the health sector should also target improvements in management and organization of health services. Specific reforms should aim at improving the poor health status o f the population, particularly for mother and child health, increasing the coverage and use of preventive care, and enhancing equity in access to health services. Given the extensive role o f social security institutions in health care provision, the financial imbalances in the social security system, and  -25- the overall fiscal constraints, it i s necessary to coordinate closely reforms in the health sector with the broader reform of the social security system and ensure that these reforms can be financed within the overall fiscal program. 54. These issues are highlighted in the Government's Urgent Action Plan.It envisages: (i)introduction of universal public health insurance to ensure equity and access to health services for the entire population; (ii)separation of provision and financing of health care for more efficient resource allocation and use; (iii)financial and administrative autonomy for public hospitals to improve technical efficiency and strengthen management; (iv) introduction of family medicine to integrate and streamline delivery of primary health care with inpatient care and ensure comprehensiveness and continuity in health care; and (v) a special emphasis on improving maternal and child health, in conformity with the Government's commitment to the MillenniumDevelopment Goals (see Box 7). A Health Sector Transformation Project i s planned for FY04to support implementation of the Government's plan and facilitate improvements in the health status of Turkey's population. The project would also provide financial and technical assistance to improve the health information management system necessary for effective functioning of the transformed health care system, and may include a component to help strengthen the social security administration. IFC i s hoping to increasingly take an active role in the health sector, with a recent example inthe field of private health care. 55. The assistance program will continue to focus on social protection. With a long history of economic, financial and natural crises, Turkey has learned the importance of protecting its population against lifetime risks associated with drops in income and loss of assets. In 2001, the Bank supported the Social Risk Mitigation Project which financed a wide range of social assistance activities, including cash and in-kind benefits, as part of the immediate crisis- response strategy. Following up on a review of the crisis impact carried out in FY02-03, a full Poverty Assessment is planned for FY05 which will also provide an in depth understanding of how the economic crisis has affected people's living standards, and how a social protection strategy can build upon most commonly utilized coping mechanisms. The reform of the social security system will constitute a key component of the PPSAL program. The Bank would support implementation of the pension policy reforms enacted in 1999 and the administrative/institutionalreforms launched in 2000 under the ERL. It would also support the design of further policy and institutional reforms in response to the unexpected re-emergence of financial imbalances in the pension system, and in the areas of health insurance and social safety net. Finally, labor market policies will be reviewed to identify potential misalignments with the requirements of a modernizing economy, and to enhance the poverty reduction and income- redistribution impact of economic growth. The Labor Market study, scheduled for completion in FY04, will explore why Turkey has had difficulties generating sufficient formal sector jobs for its growing work force.  -26- I Box 7: Turkey's ProgressTowards the MillenniumDevelopmentGoals (MDGs) Within the international system, the monitoring of the MDG targets and indicators, and progress towards achieving them, i s being led by the UN. These efforts involve monitoring at the country level through country MDGReports, sponsored by the UNCountry Teams, which also involves participation by World Bank staff. In Turkey, UNDPhas been working with the Turkish authorities and the State Institute o f Statistics to establish an appropriate database and monitoring mechanism, and the first comprehensive MDG Report for Turkey is expected to be ready by the first quarter of 2004. The summary below represents a preliminary assessment by Bank staff of Turkey's status vis-h-vis the MDGs on the basis of information available to the Bank. This assessment will be revised once the results of the UNDP-led effort become available. Eradicate extremepoverty and hunger. The prevalence of extreme poverty at $Uday was limited to 1.8 percent of the population in 2001, declining from 2.4 percent in 1994. However, poverty more broadly measured has increased following the 2001 crisis. As much of this poverty i s shallow, the recovery of 2002 should already have started some reversal of this situation. Several Bank interventions are in place to help reduce poverty directly including the Social Risk Mitigation Project approved inFY02. Achieve universal primary education. Net primary enrollment rate i s now close to 100 percent. Turkey has achieved major strides in extending the coverage of primary education since 1997 when the compulsory 8-year education system was introduced-now the Government proposes to increase this to 12 years, posing an even larger financial challenge. The Bank, through the Basic Education APLs I.and II., i s contributing to the success of the Government's efforts inthis area. Promote gender equality and empower women. There remains a gender gap of 15-20 percent in enrollment rates o f girls and boys in secondary education. While there have been improvements during the past few years in reducing this difference, eliminating gender disparity in secondary education by 2015 will be a challenge. The Bank-financed education projects have supported the faster increase in girls' school enrollment, and the secondary education project inthe lending program will continue to focus on this objective. Reduce child mortality. Under-five mortality rate i s high at 45 of 1,000 live birth in 2000 but the steady improvement in the last decade holds promise for attainment of the target of reducing the under-five mortality rate by two thirds between 1990 and 2015. Zmprove maternal health. Although data i s scarce, maternal mortality rates are high and the target for this MDG, i.e. the reduction of the maternal mortality rate by three quarters between 1990 and 2015 might be difficult to meet. Through improving girls' education, better access to services and targeted health sector interventions supported by the Bank-financed education and health projects, the Bank will continue to support the authorities' efforts to reduce child and maternal mortality. Combat HZV/AZDS, malaria and other diseases. There were 1,000 registered HIV/AIDS cases in 2000. In view of the low base, the target of halting the spread of HIV/AIDS by 2015 and beginning to reverse it thereafter may not be realistic. Turkey is currently on track on the MDG target related to the incidence of tuberculosis. The recently completed health sector report (Turkey: Reforming the Health Sector for Improved Access and Efficiency, June 2002) provides a detailed review o f Turkey's MDG status. Ensure environmental sustainability. The percentage of people served with improved water supply reached 83 percent in 2000, an increase from 80 percent in 1990. While the trend i s improving, it is difficult to judge whether the target of halving the proportion of people without sustainable access to safe drinking water by 2015 will be met. The rural sector study will review the water supply situation inrural areas. The planned Municipal Reform and Services operation could contribute to better access to safe drinking water in urban areas, and could also improve the lives of slum dwellers. The Anatolia Micro Watershed Project should help address natural resource deterioration but there i s much progress to be made on protected area management. Turkey has adopted sound energy policies overall, and the planned Renewable Energy Project will help manage dependency on fossil fuels. The environment work related to EU accession should also help Turkey move forward in this area.  -27- (c) Attractive Business Climate and Knowledge 56. The Bank will continue to support the comprehensive financial sector reform program. This support started under the FSAL, and continued with the PFPSAL Iand 11, and the proposed PFPSAL 3 (see above). Two subsequent Programmatic Financial Sector Adjustment Loans (PFSAL Iand 11) are planned, the first falling in the CAS period. The reform program supported by these loans will strengthen the foundation for an efficient and healthy banlung system that could be competitive in quality and performance at the international level; reduce its vulnerability to external shocks; and position Turkey's banking system for EU accession. The loans, as the two previous ones, will focus on: (i)the legal and regulatory framework for banking; (ii) the privatization of state-owned banks; and (iii) regulatory issues related to capital markets, insurance and other non-bank financial institutions. Sector work on the ongoing banking reform i s also planned for FY04. To support the reform o f the financial sector, the IFC will help restructure and strengthen the banking system and to expand the range of financial institutions in the market. The IFC strategy will focus on: (i) assisting the authorities with the sale of intervened banks, as appropriate, and of the non-performing loans of these banks; (ii)working with mid-sized banks to strengthen their balance sheets and to use them as a platform in the consolidation process; (iii) continuing with efforts aimed at institution building and the introduction of new products. 57. Bank Group assistance will help revitalize the real sector. An important factor to determine future growth prospects for Turkey will be the capacity of transforming the economy into an export-oriented, technology-intensive production structure. In addition to advisory work related to the improvement of the overall business climate, and adjustment lending to help the completion of financial sector reforms, the Bank Group intends to support this priority through several interventions. A Second Export Finance Intermediation Loan (EFIL 11) i s scheduled for FY04 to succeed the successful EFILwhose implementation has come to an end.4 The EFILsfill an important gap by providing funds to exporters with longer maturities than those available otherwise through the banking sector. In addition, a Knowledge Economy Assessment will be completed in FY04 to identify success factors and lessons learned from world leaders and Turkey's competitors, analyze Turkey's strengths and weaknesses in the area of knowledge economy and define an agenda for the future. The Assessment would also set up the framework for a Knowledge Economy and Technology Development Project planned for FY05. The program also includes an S M E Finance Project in FY06 to improve SMEs' access to commercial credits. Inthe area of privatization of state-owned enterprises, the Bank Group will follow up on the initiatives undertaken under the Economic Reform Loan and will take up the dialogue with the Government on the various case by case privatization strategies, and provide know how and technical advisory assistance to the Government. Such dialogue and non-lending assistance could be further supported by technical assistance lending components in any o f the forthcoming adjustment loans. IFC will continue to finance viable private sector export oriented projects in line with efforts to revive the corporate sector, including SMEs (see Annex A1 on Private Sector Strategy). IFC i s also looking for ways to enable intermediaries to increase the amount of trade finance through the provision of trade facilities and risk sharing mechanisms that will increase Exports of enterprises benefiting from the EFILhave increased by some 60 percent over the last 3 years.  -28- the amount of trade financing capacity inTurkey by helping supplement restrictedcountry limits available to banks. Finally, Turkey would continue to benefit from MIGA guarantees, and several Turkey-specific and regional training programs related to corporate governance and broader issues o f investment climate offered by WBI.' 58. Bank assistance in agriculture will focus on increased productivity. This includes addressing issues of human capital and employment in an effort to promote diversification of employment sources in rural areas and reduce excessive reliance on agriculture alone. The agriculture reform carried out under the ARIP started the process of transforming the rural sector by reversing the trends of high subsidies, low productivity and obsolete technological inputs. A stock-taking study i s beingcompletedto review the impact of the reforms to date on productivity and, in particular, on the economically vulnerable in rural areas. The reform process will be continued through the activities described in the CAS. A Rural Sector Study, planned for FY05, will identify further steps to improve productivity in agriculture and increase off-farm income opportunities for rural inhabitants. This study will also provide the basis for identifying the most suitable area of intervention for the Bank in the rural sector, scheduled for FY06. Such intervention could focus on: (i)improving rural services key to sustaining off-farm private sector development in rural areas; or (ii)developing a sustainable rural finance system (e.g. through the restructuring of credit cooperatives) capable of serving the many small and medium sized farmers currently losing access to rural finance. The preparation of the study and the project will be coordinated with the EU's program of assistance in the rural sector and for the development of a Regional Development Strategy. 59. A n important element of the program will be continuing the reforms in infrastructure. In the energy sector, a Renewable Energy Project i s planned for FY04 to help increase privately owned and operated generation from renewable resources, without the need for government guarantees, within the market-based framework of the new Turkish Electricity Law. Under the previous CAS, the Bank supported privatization in the energy sector, and this process will continue with an Energy Project, scheduled for FY06, which will improve the regulatory framework for the sector and finance priority investments. A Gas Sector Note, planned for FY04, will support preparation of this operation. In the transport sector, the Bank will focus on the restructuring of the railways, based on a recently completed report that outlined options for reform. A Railway Restructuring Project, scheduled for FY05, will, in coordination with the acquis communautaire, aim at improving sector governance and advancing the decentralization process through (i) unbundlingports and railways; (ii) separating infrastructure, freight and passenger services; (iii)reducing staff; (iv) divesting non-core activities; (v) supporting a sound investment program; and (vi) involving the private sector in freight operations. Intelecommunication, sector reform, and within that a clear time-bound roadmap for privatization of Turk Telekom will continue to be in the center o f the Bank Group's dialogue with the authorities and an important component of the Economic Reform Loan. IFC aims to play a key role in the anticipated increase in the need for infrastructure financing as the privatization process gains momentum. The IFC can potentially stimulate foreign investor interest in the privatization of some of the most visible projects (ports, telecommunications, transport), providing both advisory and direct lending roles in the envisaged transactions in the A detaileddescriptionof the PrivateSector Strategyof the Bank Group is attachedin Annex Al.  -29- infrastructure sector. Overall, the Bank Group will be selective in financing new infrastructure investments, bearing in mind the active role of some of its development partners in this area, especially that of the European Investment Bank. (d) Strong EnvironmentalManagement and Disaster Prevention 60. Given Turkey's high seismic risks and history of flooding, improving emergency preparedness and seismic risk mitigation is critical. The Marmara quake o f 1999 demonstrated the urgent need for a more comprehensive approach to disaster preparedness, catastrophic insurance, sound governance of construction practices and other risks minimization. The Seismic Risk Mitigation Project (scheduled for FY05) will finance activities to mitigate seismic risks in the municipality o f Istanbul and to further strengthen capacity for emergency preparedness in order to reduce social and economic impacts of future earthquakes. The project would assist the Government and the municipality of Istanbul by: (i)strengthening the institutional capacity to identify and prioritize essential risk-mitigation investments; (ii) providing funding and technical assistance for implementation of a comprehensive risk- mitigation program for seismic strengthening o f critical facilities: schools, hospitals, public safety and other essential public services; and (iii)strengthening and upgrading Istanbul's emergency response capacity. The project will explore the possibility of introducing a system of incentives that will encourage private building owners to improve the safety o f their buildings. In addition, technical assistance will be provided to promote strict enforcement of building standards and safety codes. To complement and support the Bank's operational work, WBI i s considering the continuation of its disaster management related activities following the successful workshop on the Role of Local Government in Natural Disaster Risk Management held earlier this year inIstanbul. 61. Environment and natural resources management is a high priority for Turkey, particularly in view of EU accession, which will require the adoption of European environmental standards. Bank-supported activities to follow up on the National Environmental Action Plan (NEAP) would be designed to assist Turkey in this endeavor. Such activities may include the updating of priorities for public investments related to the EU environmental directives, as well as for the implementation of the legal and regulatory framework, and the adoption of environmental directives. The Bank may also assist the Ministry of Environment and Forestry (MOE) in providing clear guidelines on the present compliance status of enterprises slated for privatization and to indicate how environmental regulations will change as the country moves toward EU accession. Since the EU i s playing a key role in this area assisting the authorities through an active program aiming at increasing environmental awareness and building institutional capacity, Bank-supported activities will continue to be closely coordinated with the EU. As regards Bank lending, a Micro-Watershed Management Project i s planned for FY04 to build on the successful community-level experience o f the East Anatolia Watershed Project, and an accompanying GEF project will contribute to the regional effort to reduce chemical run-off into the Black Sea. A GEF project to address critical industrial environmental problems (perhaps inthe context of privatization) will also be explored.  -30- Working with Other Development Partners 62. The Bank's assistanceprogram is built on and implemented in close collaboration with other development partners. Working with other development partners to develop synergies, applying selectivity, and focusing on the Bank's comparative advantages in supporting national priorities are key features of the Bank's program in Turkey. The Bank has been working very closely with the IMF, particularly in the areas o f public sector, financial and enterprise sector reforms. Inthe collaboration on the public sector, the Fundhas taken the lead with respect to the short-term measures needed for fiscal adjustment such as incomes policy, urgent revenue and expenditure measures, and budget monitoring and reporting. The Bank has taken the lead in assisting the Government with the preparation and implementation of the medium-term public expenditure management strategy, including budget management reforms, rationalization of the public investment program, public procurement reform, accounting reform, and public liability management. Inthe financial sector, the Bank has taken the lead with respect to the reform of the legal framework and regulations for bank supervision, the institutional development of the regulatory bodies, and the structural reforms required to guide the restructuring and improve the governance of the state banks, as well as the work on non-bank financial institutions. The Fund has taken the lead in assessing the soundness of the banlung system and where there was an immediate macro-fiscal impact such as the re-capitalization of the state banks, the closing o f insolvent banks, and the private bank re-capitalization scheme. On the state banks agenda and resolution of private banks, the Fund and the Bank have worked closely as a team. This cooperation i s expected to remain strong in view of the interlinked reform agenda supported by the Fundand the Bank inthe CAS period. 63. The Bank has also established close collaboration with the EUand members of the UN system. As regards the EU, strategic joint agendas include environment, education, financial and public sector reforms, including governance and anti-corruption (see Box 8). Partnershipwith the UNsystem is particularly close in the social sectors (UNICEF, WHO), and in poverty alleviation and local development/participation (UNDP). Finally, in the area of municipal reform and decentralized service delivery, the Bank is looking at the significant experience gained by GTZ and other bilateral partners active in this field. The Country Assistance Strategy Matrix in Annex B 9 provides details of ongoing and planned activities of the Bank's development partners.  -31- Box 8: Collaboration with the EU The Bank pays special attention to support Turkey's preparation for EU membership and to work closely with the EU in this process. For example in the area of public and financial sector reforms, the PFPSAL program is consistent with Turkey's national program for EU accession and the Bank is working closely with EU staff responsible for Turkey. The banking sector reforms supported by the PFPSAL operations are designed to ensure that Turkey's banking supervision framework complies with both EUstandards and Base1norms. The Bank has coordinated closely with the EUits advice on the new public procurement law and follow up technical assistance to the Public Procurement Agency established under the law. The new public procurement law moves Turkey towards compliance with EU directives. The Bank's assistance on public debt management issues has been oriented towards EU practices and the Maastricht criteria. The Bank i s coordinating its dialogue on financial management issues with the EU, and the new law on public financial management and control i s expected to be consistent with EU standards on internal control. The EU is preparing to support additional institution-building initiatives under the public sector reform program including support for a peer review and twinning arrangements for the TurkishCourt of Accounts. EUassistance to Turkey is undergoing a major change. The European Council meeting held in Copenhagen at the end o f 2002, announced a significant increase in pre-accession financial assistance and requested the Commission to prepare a revised Accession Partnership document that was subsequently approved inMay 2003. The pre-accession financial assistance i s expected to increase gradually from Euro 250 million in2004 to about Euro 500 million in2006, and will cover the following main elements: 0 The Copenhagen political criteria 0 Economic reform and support to the new regulatory bodies 0 Strengthening public administration Justice and home affairs 0 Economic and social cohesion This program offers both important complementarities as well as areas o f collaboration, especially in the fields of economic reform, public administration, and economic and social cohesion, with the Bank Group assistance. IV. LENDINGPROGRAMAND TRIGGERS 64. The CAS presented to the Board in December 2000, was designed to help Turkey lay the basis for sustained long-term growth and reduce economic vulnerability. It envisaged a lendingprogram of US$5 billion in the high case for FYO1-03. The CAS Progress Report, discussed by the Board in July 2001, focused on assisting Turkey to: (i) recover from the economic crisis of February 2001; (ii) mitigate the worst effects of the crisis on the population; and (iii) address its deeper causes, especially the large and inefficient public sector and the fragile banking sector. Accordingly, the lending program in the Progress Report proposed exceptional financing of US$l.2 billion, on Special Structural Adjustment Loan (SSAL) terms, over the original CAS envelope. 65. With initialstabilization and economic recovery, this CAS returns to the primary objective of helping Turkey move to a path of sustained growth by addressing the root causes of macroeconomic and social vulnerability. A lending program of US$4.5 billion i s envisaged in the high case and US$1.3 billion in the low case (see Table 4). The program under the high case will include support for the economic reform program, focusing on public sector management and accountability, and the business climate, as described in the previous section. Triggers for the high case lending program, some of which will be further elaborated in the relevant loan documents, are summarized in Box 9. Macroeconomic outcomes will be evaluated  -32- on the basis of the overall program and with respect to agreed indicators. If the reform program were to progress sufficiently slowly to push Bank lending to the low case, Bank support will concentrate on human development, disaster and environment management, and local level interventions to reduce poverty. Indesigning the strategy, the introduction o f a base case lending scenario was also considered but it was discarded. While actual lending outcomes may, at the end, fall between the high case and the low case, the planned program, with significantly different lending scenarios, reflects the risks associated with the strategy. Similar to the past CAS, the self-regulating nature of the strategy will be a key risk mitigating mechanism. ~ ~ ~ ~ _ _ _ _ _ _ _ _ _ ~ ~ Box 9: Triggers for the High Case Macroeconomic Implementation of a satisfactory macroeconomic framework consistent with the Country Performance Indicators included in the Country Assistance Strategy Matrix. Macroeconomic indicators will be monitored on a quarterly basis. Structural Sustained satisfactory implementation of public sector reforms, including: P budget reformsto improve transparency andeffectiveness of public expenditure; 9 tax reformsto improveefficiency andequity, andpromotegrowth; and 9 public liability managementreforms to managefinancial andfiscal risks. 0 Sustained satisfactory implementation of regulatory reforms, privatization and liberalization of the energy and telecommunications sectors; and of the agriculture reform program designed to replace indirect subsidies with direct income support and promote the development o f agriculture markets. Sustained satisfactory implementation of financial and private sector reforms, including: 9 continued independenceandfurther strengthening offinancial marketsregulatory agencies; P completion of privatization of statebanks; 9 passageofanamendedBankruptcyLaw andrevisedCommercial Code; Design and implementation of the next phase of a comprehensive social security reform. Social Maintenance of public expenditure targets for health, education and social protection as agreed with the Bank. 66. The Bank strategy recognizes that the complex second generation policy and institutional reforms that Turkey is undertaking need to be supported over the medium term. This recognition provides the rationale for proposing a sizeable program envelope should the macro situation continue to improve and the reform process remain on track, and the reliance on programmatic adjustment lending as the main delivery instrument to allow for a reasonable degree of adaptability of the program to unfolding events on the ground. The use of programmatic lending i s also envisaged to enhance focus, achieve sustained impact and scale up results. The lending program in the high case i s designed in such a way that investment projects in key areas would complement reforms to be supported under the planned programmatic adjustment loans. Finally, the AAA program i s also structured around the four themes of the CAS and i s focused on building an analytical base that will position the Bank to maximize the effectiveness of its assistance. The strategic links in the CAS between the AAA program and lendingas well as the adjustment and investment operations are illustrated inAnnex A4.  -33- Table 4: IndicativeLendingProgramFYO4-06'' US$ million HighCase Low Case PFPSALS 900 Health Sector Transformation 200 Export Finance I1 300 RenewableEnergy 202 Health Sector Trans. 200 Micro Watershed 37 Renewable Energy 202 Micro Watershed 37 Total 1650 Total 450 PPSAL 500 Seismic Risk Mitigation 400 Municipal Reform and Services 200 Secondary Education 200 Railway Restructuring 200 Knowledge Econ. & Tech. Dev't 100 Seismic Risk Mitigation 400 Secondary Education 200 Total 1600 Total 600 PPSAL I1 400 Rural Development 250 PFSAL 400 SME Finance 100 Energy 100 Rural Development 250 Total 1250 Total 250 TOTAL 4500 TOTAL 1300 I!InadditiontoUS$SOOmillionforpossibleemergencylendingincaseofalargescalenaturaldisaster. Theamountsarerounded.The specific loanamounts will be determinedduringprojectpreparation.  -34- V. M A N A G I N G THE RISKS AND IBRDEXPOSURE Managingthe Risks 67. Risks and mitigating measures. Turkey's reform program entails significant risks, as witnessed by developments over the past two years, which can only be overcome by sustained implementation of the reforms. The situation in Turkey has been and will continue to be subject to continued uncertainty as events unfold on the ground. The three main riskfactors are: the continuing macroeconomic vulnerabilities arising from fundamental structural problems, the continuing impact o f the 2001 crisis, and international and regional developments; a potential loss of consensus for political or social reasons stemming from the social impact of reforms; and institutional challenges inimplementing the program. 68. Macroeconomic risks. The main macroeconomic risk is the potential for market confidence in the credibility of the reform program to weaken which could lead to higher interest rates than in the program baseline. High real interest rates would slow the recovery, negatively affect public debt sustainability and create the conditions for renewed instability. Sustainability of the public debt i s critical to macroeconomic stability and the ultimate success of the reform program. Under the program, the public debt to GNP ratio (net of CBT net assets), which fell from 95 percent of GNP in 2001 to some 80 percent in 2002, i s now projected to fall further to about 70 percent in 2003 (see Table 5) in part due to the unexpectedly strong Lira. The debt burden i s projected to fall to about 66 percent of GNP in 2004. Extending the programmed trends for the key macroeconomic parameters (including growth, interest rates and the primary surplus) until 2006 results in a further steady decline in the public debt to GNP ratio to the 60 percent range. Realizing this outcome hinges on sustained recovery, a fall in real interest rates, and a sustained primary surplus of 6.5 percent of GNP. It also depends on stability o f the real exchange rate at or near current levels. While the strong Lira has underpinned the fall in inflation and decline in the public debt ratio, the extent of the exchange rate appreciation and current account deficit that have accompanied the recovery has generated additional sources of macroeconomic risk. 69. A sensitivity analysis of the public debt dynamics demonstrates the central role of credible policies to build confidence and deepen the fiscal adjustment. The level and structure of Turkey's public debt leave the Treasury's borrowing program vulnerable to a potential loss of market confidence. The short average maturity of the domestic debt leads to high monthly rollover requirements. Foreign exchange exposure i s another important determinant. Turkey's crisis response program has featured debt swaps by the Treasury to eliminate the excess open FX position of the banks, together with increased FX and FX-linked borrowing. As a result, the share of FX and FX-linked debt in the total public debt stock has risen sharply. Moreover, a high proportion of the domestic debt i s in floating rate notes which increases exposure to interest rate movements. Finally, a very substantial share o f Turkey's  -35- public debt is to preferred creditors. To illustrate the risks, a low-case scenario can be formulated where the political will to strengthen the fiscal program falters and the primary surplus does not exceed the 4 percent of GNP realized in 2002. As a result, real interest rates could be in the 20 percent range, i.e., well above the projected program path. The recovery would be expected to falter under the burden of sustained high real interest rates with growth falling short of the 5 percent target for 2003 and slowing further in 2004. A slowdown in the recovery and deterioration in the public debt dynamics could lead to renewed capital account outflows and exchange rate instability which would exacerbate the impact on the debt burden. Under these conditions, the projected decline in the debt to GNP ratio in 2003 could fail to materialize and the public debt burden could begin to increase in 2004. This analysis underscores the critical need for the Government to strengthen the fiscal program and establish its reform credentials firmly. Table 5: PublicDebtDynamics Baseline PublicDebt Forecasts(in % of GNP) I 2000 2001 2002 2003 2004 2005 2006 Total Debt Stock 57.7 94.0 80.0 69.6 66.2 62.3 59.6 Domestic Debt Stock 39.2 56.3 47.8 42.3 41.0 40.9 42.2 Domestic Interest Payments 11 14.9 14.9 14.9 13.1 12.7 9.9 9.3 DomDebt Amortization 12.9 23.2 24.8 22.6 29.6 28.5 35.6 2000 2001 2002 2003 2004 2005 2006 Nominal Interest Rate (%) 38.0 99.1 63.5 46.4 31.3 29.3 25.5 CPI Inflation (%, Dec/Dec) 39.0 68.5 29.7 20.0 12.0 8.0 5.c Real Interest Rate 3/ -11.4 31.4 11.8 16.0 15.7 17.2 18.2 Depreciation (Dec/Dec) 24.8 115.3 13.3 -3.0 9.0 5.O 2.5 REER (Dec/Dec) 13.7 -24.0 11.1 20.2 -0.2 -0.2 -0.2 GNPgrowth rate (%) 6.3 -9.5 7.8 5.0 5.0 5.0 5.c Primary Balance (% of GNP) 2.3 5.5 4.0 6.5 6.5 6.5 6.5 Avg Maturity of new dom bor inTL 41 4.8 8.7 9.8 11.9 11.9 11.5 Notes: 1)For the Central Government 2) For the Consolidated Public Sector 3) Computed as the averageof the monthly auction rates deflated by inflation over the previous 12 months. 4) For Auction Debt ,Source:IMFand WB staff estimates. 70. Balance of payments risks. The risks to the balanceof payments are significant. Turkey's external vulnerability i s exemplified by the currency crisis and large capital outflows in 2001, as well as the September 11 shock. A forward-looking indicator i s the projected annual gross financing requirement of US$29 billion in 2003 falling to US$18 billion by 2006 (Table 6). Recent history, including the 2001 crisis aftermath, indicates the responsiveness of Turkey's current account to shocks, although at a significant cost to growth. Moreover, the improving level of Central Bank gross reserves (nearly US$31.5 billion as of mid-September) could provide some additional cushion in case of a severe external shock. However, the scope for a reserve draw-down i s limitedand could raise investor concerns about the longer-term external payments picture. The stock of external debt i s now projected to reach US$136 billion by the end of 2003,  -36- equal to about 58 percent of GNP, of which about US$24 billion in IMF credit and some US$6 billion in World Bank debt. Strong export performance kept the debt service ratio to below 40 percent in 2002, and it i s projected to remain in the 40 percent range through 2006. The high level of private capital outflows in 2001 was partially reversed in 2002. Loolung ahead, the extent to which Turkish banks and enterprises will be able to roll over their external obligations and attract new financing on favorable terms will remain an important determinant for the program. The reliance on private capital inflows will increase in 2005-06 when Turkey will face annual repayments to the IMFaveraging US$9 billion. 71. Mitigating macroeconomic risks. Reform progress has mitigated a number of macroeconomic risk factors, but the economy remains vulnerable. The floating exchange rate regime introduced in 2001 has increased the economy's ability to absorb shocks. Systemic risks in the banking sector are being addressed, the state banks have been re-capitalized, and the open foreign exchange position of the banking sector has moved close to balance. Central bank independence and the newly established regulatory bodies for banking, energy, telecommunications and public procurement are helping to de-politicize economic management in line with international and EU norms. Structural reforms since 1999 have helped shift the primary fiscal balance from deficit to surplus and the legal framework for better fiscal management i s being gradually put inplace. Stronger economic and fiscal management, coupled with steadily improving financial accountability and oversight, will assist sound program implementation and reduce the risk of backtracking.6 Nevertheless, the problems of Turkey's banking sector and public finances will take time to resolve, and the country will remain vulnerable to internal and external shocks over the medium term. The effectiveness of the floating exchange rate as an adjustor will be limited for some time to come by the large public debt a substantial share of which i s inforeign currency. 72. Further improvements in investor confidence require a combination of credible economic policies and adequate financing. Bringingreal rates to sustainable levels depends on further improvements in investor confidence which requires in turn a combination of credible economic policies and adequate financing for the public debt. Policy credibility depends first and foremost on strong political leadership and sustained progress in tackling the core structural issues inthe banking and public sectors. The new Government's confirmation of the basic thrust of the reform strategy and continued external financing from the IFIs will help bolster credibility and build up market confidence. Attracting additional capital inflows will also be important in creating the conditions for a sustained decline in domestic interest rates. If a significant share of the "hot money" outflow in 2001 can be replaced with longer maturity inflows-especially FDI, the country's external vulnerability will be permanently reduced. In this regard, decisive implementation of measures to promote FDIwill be extremely important. Even with sustained reform effort, Turkey i s likely to face continued volatility with respect to growth and the real exchange rates which will impact the public debt dynamics. Adherence to the program will reduce volatility but not eliminate it in the timeframe of the CAS. 73. Political and social risks. Political stability has increased following the election of the new single-party Government. Political uncertainty did materialize in mid-2002 leading to Annex A6 provides a summary of financial accountability and public sector governance issues.  -37- the early elections in November 2002 which resulted in the victory of the Justice and Development Party (AKP). The popular support and parliamentary majority enjoyed by the new Government provide a good opportunity for consistent pursuit of reforms. However, continuing the economic reform program with its emphasis on fiscal discipline on the one hand while pursuing a more active social agenda as described in its program on the other, will test the Government. Maintaining public support while taking tough measures to build up investor confidence will require a constant balancing act. At this point the biggest political risk i s that the stated commitment to comprehensive reform will not be fully realized. The Government could also be distracted from a focus on economic reform by other pressing issues such as Iraq, Cyprus and the political conditions for EUaccession. 74. The social risks of the reform program cannot be fully mitigated despite efforts to protect social spending and improve targeted social assistance. The commercialization and privatization of the state-owned banks remains a major political hurdle. The restructuring and privatization of Halk and Ziraat banks have social implications as their workforces are downsized, although this i s mitigated to a significant extent by the relatively extensive social protection programs for civil servants and public sector workers. The reform agenda for the public sector i s also politically sensitive. Institutional change has faced resistance from vested interest groups that would prefer to maintain the status quo. To mitigate this risk, the program relies on strong consensus and up-front ownership o f the strategy by the Government. Sustained fiscal adjustment i s generating social costs; incomes policy and action to retrench staffing levels inthe public sector is particularly sensitive. The Government is trying to mitigate these risks by strengthening its social protection programs and through dialogue with key social partners. The introduction of direct income support starting in late 2001 has eased the burden of the crisis on farmers and the programs of the Social Solidarity Fund are being strengthened in collaboration with the Bank. However, funding for targeted social protection faltered in 2002. To help build and sustain social consensus for the program during the tough austerity phase, the new Government will need to fully fund these social programs in order to deliver on its election promise to strengthen the social dimension of the reform program. 75. Implementation risks. There are implementation risks related to institutional constraints as well as to possible problems with counterpart funding. The complex reforms are challenging the institutional capacity of the administration. The Bank has provided intensive technical support for key public sector institutions, and it stands ready to consider additional financial support for selected institution-building initiatives linkedto the CAS program. Finally, meeting the counterpart funding requirements of Bank-financed projects on time in an environment of fiscal austerity will be a challenge. This requires appropriate planning, and close collaboration between the sector ministries and the central government agencies, especially the State Planning Organization and the Treasury.  -38- Table 6. External FinancingRequirementsand Sources,2000-2004 (inbillionsofUSdollars) Actual Estimate Program 5/ Projection 6/ 2000 2001 2002 2003 2004 200s 2m kossfinancing requirements 25.9 10.5 243 28.8 24.0 20.0 18.1 Currentaccount deficit (excl.officialtransfers 10.0 -3.2 2.0 8.0 5.8 3.6 1.1 Amortizationondebt securities, o/w: 1.7 2.1 2.7 3.8 3.5 3.1 2.t Public sector 1.4 2.0 2.3 3.7 3.5 2.8 2.: Depositmoneybanks 0.4 0.0 0.4 0.1 0.0 0.3 0.. Mediumandlong-termdebtamortization,o/w 13.8 14.3 13.4 16.4 14.1 14.5 14.' Publicsector 1/ 3.6 3.6 3.0 3.4 3.4 3.2 3.( Private sector 7.9 8.9 8.8 11.9 9.6 9.9 10.: Depositmoneybanks 2.3 1.9 1.6 1.1 1.2 1.4 1.! Accumulationof grossreserves 0.4 -2.7 6.2 0.5 0.6 -1.2 - 0 . d Lvailablefinancing 25.9 10.5 243 28.8 24.0 20.0 18. Foreigndirect investment(net) 0.1 2.8 0.9 1.3 1.0 1.3 1.6 Portfolioflows 3.4 -1.7 4.2 5.5 6.6 7.6 8.6 Publicsector 7.5 2.1 3.3 4.5 4.7 5.0 5.0 Depositmoneybanks 0.5 0.0 0.0 0.2 0.2 0.3 0.3 Privatesector (net) -4.6 -3.8 0.9 0.8 1.7 1.8 1.9 Mediumandlong-termdebtfinancing,o/w: 18.1 13.2 15.7 17.2 19.5 19.9 21.0 Publicsector 11 3.4 3.2 2.9 3.5 3.6 3.0 3.1 Private sector 12.8 9.2 11.5 13.1 14.2 15.0 15.9 Depositmoneybanks 1.9 0.9 1.3 0.6 1.6 1.8 2.0 Short-termdebt financing(net) 3.6 -12.1 -2.5 4.7 -1.6 -1.4 -1.5 Officialtransfers 0.2 0.2 0.5 0.5 0.5 0.5 0.6 Other 2/ -2.8 -2.1 -0.9 -0.4 0.0 0.0 0.0 IMF(net) 3.4 10.2 6.4 0.0 -2.1 -7.3 -10.7 Purchases 3.4 11.3 12.5 1.7 2.4 0.0 0.0 Repurchases -0.1 -1.1 -6.1 -1.7 -4.4 -7.3 -10.7 nemo Vet officialinfiows 4.2 11.3 7.0 0.6 -1.1 -6.4 -10.5 d w WorldBank (updated09/2003) 0.8 1.1 0.6 0.6 1.o 1.o 0.2 rotalExtemalDebt 118.7 113.9 131.6 136.2 140.4 140.3 138.2 dw Short-termDebt 28.3 16.2 15.2 18.1 20.1 22.2 24.4 rotalExtemalDebt/GNF' 59.0% 79.1% 72.4% 58.3% 54.4% 50.3% 46.1% Debt ServiceRatio 314/ 35.4% 44.0% 38.2% 40.4% 40.6% 40.8% 41.1% I/ Generalgovernment andCentral BankofTurkey. 2/ Errorsandomissions. 3/ Interest plus medium-andlong-termdebt repaymentsincluding IMFrepurchases as percent of exportsof goods andservices. U 2002figure does notincludethe SRFrepaymentsof $6.1billion. 5/ 2003-04 programfiguresupdatedas of the 5th IMFreview. 6/ 2005-06 figures are World Bank estimates basedon 5threviewprojections. Source: CentralBank, IMFandWB estimates.  -39- 76. The active support of the IFI's will continue to be instrumental in helping Turkey address the risks and pursue its reform program. The economic recovery and disinflation progress achieved since early 2002 provide encouragement that the exceptional support from the I F I s has helped Turkey weather the impact of the 2001 crisis while maintaining its reform course. The new Government's stated commitment to the program demonstrates that political support for economic reform in Turkey transcends specific political parties and personalities. However, the Government will be continuously challenged by the need to implement a long list of difficult and socially painful reforms in a context of pressure for populist measures and special interest lobbying. The irreversibility of the structural reforms put in place since 1999 cannot be taken for granted and the near-term risks remain significant given the depth of Turkey's economic vulnerabilities and extent of the reforms that lay ahead. Inrecognition of the situation, the Bank's assistance strategy incorporates significant mitigation measures, in particular disbursements under adjustment lending will continue to be closely linked to actual progress in reform implementation as per the previous CAS. IBRDExposure 77. With the sharp increase in IBRD lending, since 2000, which reversed a period of decline over the last ten years, Turkey is becoming an increasingly large part of the IBRD portfolio. However, this increase has been carefully managed andthe Bank's response has been closely linked to fundamental reforms. Waivers under adjustment operations have been consistently avoided and disbursements have been strictly tied to the actual implementation of agreed policy actions. Moving forward, management of exposure with the same careful link to reforms which will improve Turkey's creditworthiness will continue to be a highpriority. 78. Under the high case lending program, IBRD debt outstanding and disbursed (DOD) would increase to about US$8.2 billion in 2006. This would represent about 7.5 percent of the IBRD portfolio, up from 3.0 percent in 2000. Financial markets perceive Turkey as a risky country, as seen in the large premium on Turkish dollar Eurobonds over LIBOR. Additionally, Turkey has a high external debt burden with a debt service ratio in the 40 percent range. As shown in Table 7, debt service to preferred creditors as a share of external public debt service i s expected to reach about 34 percent, while IBRDdebt service as a percentage of exports of goods and services will remain modest at 1.5 percent in 2006. 79. Bank lending envisaged in this CAS for FY04-06 would amount to US$4.5 billion in the high case and US$1.3 billion in the low case. This compares to the CAS Progress Report lending program for FY01-03 of US$6.2 billion in the high case, including US$1.2 billion on Special Structural Adjustment Loan (SSAL) conditions, and US$l billion in the base case. In this CAS, under the high case scenario, IBRD D O D at its peak (US$8.2 billion) would be well below the level projected under the CAS Progress Report (US$9.2 billion). If Turkey's reform progress significantly surpasses the performance contemplated by this CAS, a CAS Progress Report may be considered during the FY04-06period to assess any possible additional financial needs.  -40- Table 7: SummaryLendingFigures Calendar Year (millionUS$) 2000 2001 2002 2003 2004 2005 2006 CommitmentsI' 1,787 2,200 1,650 1,238 700 1,950 1,100 Disbursements 1,291 1,537 1,031 1,096 1,591 1,705 1,020 IBRDDOD 3,634 4,707 5,367 6,005 7,019 7,970 8,179 Share of IBRDPortfolio 3.0 3.9 4.4 5.2 6.3 7.3 7.5 Preferredcreditor DS/pubicDS(%) 15.7 24.8 14.6 16.3 23.7 29.0 33.8 IBRDDebt Service 1.2 1.3 1.2 1.2 1.3 1.5 1.5 (as % of exp. of goodsandserv.) BRDPortfolio I 121,637 121,658 121,836 115,544 111,394 109,348 109,055 1/ US$384million second tranche of the FSAL was cancelled and merged into the PFPSAL. The second and thirdtranches of the PFPSALIIof US$900million were cancelled in 2003. Source: IMFand WB VI. CONCLUSIONS 80. The Bank is ready to assist Turkey to reduce economic vulnerability, achieve high and stable growth, and address long neglected social and environmental problems. These efforts will also prepare Turkey for EU membership, an objective pursued with full determination in Turkey. As described above, the risks to the success of Bank support are not insignificant. As in the past, the Bank will, through a graduated response that corresponds to the strength of the economic program, mitigate the risks and contain the Bank's exposure. Whether Turkey succeeds in putting its economy on a sustainable, high growth path i s important not only for the well-being of its 70 million citizens but also for the prosperity and stability of the region. James D.Wolfensohn President By: Shengman Zhang Peter Woicke Washington D.C. October 2,2003  Annex A 1 Private Sector Strategy Introduction 1. A central objective of the Country Assistance Strategy (CAS) is to assist in reducing Turkey's economic vulnerability as it strives to achieve the goal of high and stable economic growth. The private sector has an essential role to play in generating this stable economic environment and it i s within this context that the private sector strategy (PSS) should be considered. Turkey's development strategy requires the creation of an enabling environment for private sector development to boost growth, employment creation and assist the country in taking advantage of its unique geographical location, its large domestic market, and accession plans with the European Union (EU). 2. Despite the difficulties of years of macroeconomic instability, high real interest rates, the limited availability o f long term credit, an inefficient regulatory environment, and the dominance of state owned enterprises in economic activity, Turkey's entrepreneurial private sector has taken advantage of the opportunities available, particularly in terms of export orientation and regional expansion. While large companies continue to dominate productive activities, the small and medium size enterprise ( S M E ) sector also has an important role to play. This importance of the private sector in generating economic growth has been acknowledged by the Government, with the focus increasingly on improving Turkey's competitiveness and facilitating a business environment conducive to private sector development and increased foreign direct investment. 3. The PSS i s organized into three sections: i)a description of the private sector and the current business environment, including impediments to private sector development; ii)asummaryoftheGovernment's strategytopromoteprivatesectordevelopment; and iii)an outline of the World Bank Group's strategy geared towards the further development of the private sector. Turkey's Private Sector 4. Turkey's private sector has a major role to play in the future growth and development of the country. The potential for private sector development i s based on the following factors: i)Turkey's strategic location between the former Soviet Union, the Balkans, Central Asia and the Middle East; ii)Turkey's well developed and vibrant entrepreneurial culture; iii)a large domestic market; iv) an open economy; and v) strong ties to the EU(both through the customs union and discussions on EUaccession). 5. Turkey's economic development has suffered from global and domestic crises, most recently the 2001 financial crisis. As a result, private sector development remains below its potential and below levels seen in fast growing developing countries. There are a number of factors that have and continue to impede private sector growth. These include i)macroeconomic instability; ii)financial sector weakness; iii)consequent low  2 levels of foreign direct investment; iv) a large public debt burden leading to high real interest rates and a crowding out of private borrowers; v) a regulatory environment and bureaucracy that i s not conducive to attracting necessary private investment; and vi) issues surrounding corporate governance. Progress has been made over recent years to address these issues, facilitating improvements in the business environment and renewed opportunities for a dynamic private sector. 6. 2000/2001 Crisis and Economic Impact: The cumulative effects of the crises ending with the February 2001 crisis were felt throughout the economy - starting in the public sector, spreading to the financial sector and causing increasing distress in the real sector. The crisis hit SMEs especially hard. The uncertain macroeconomic environment combined with the limited availability of reasonably priced term credit financing to the private sector negatively affected private sector investment rates during the 1990s. Gross fixed capital formation as a share of GNP declined duringthe 1990s from 26.3% in 1993 to 17.2% in 2002. Similar evidence can be found inprivate sector fixed capital formation data, which fell by a third as a share of GNP, from almost 20% of GNP in 1993 to 11.3% of GNP in 2002. Private investment inthe housing sector decreased inimportance during the 1990s (housing accounted for 21.6% of total private investment in 2002, down from over 40% in the early 1990s). Investment in industrial production (mining and manufacturing) has remained largely static as a share o f total private investment during the late 1990s and through to 2002l. In addition, private sector investment in energy and infrastructure has remained low (see Table 1). While macroeconomic uncertainty has been a dominant factor in investment decisions duringrecent years, the strong role played by the state in industry and in particular, infrastructure development, has further limited the opportunities for private sector investment in productive activities. However, given the improving regulatory environment (as Turkey looks towards EU accession) and the increased focus on privatization of state economic enterprises, the potential for increased private sector investment to boost Turkey's economic growth outlook and employment opportunities are promising. Private InvestmenffGrossDomestic Fixed Investment (Yo) Private Sectoral lnvestmentrrotal Private Investment(%) 1998 1999 2000 2001 2002 1998 1999 2000 2001 2002 Agriculture 63 45 41 34 36 5 3 3 2 2 Mining 73 72 70 58 53 1 2 1 1 1 Manufacturing 96 96 96 91 92 23 24 27 23 23 Tourism 96 97 97 96 97 4 5 6 6 7 Energy 36 30 31 45 42 3 3 3 6 5 Transportation 64 56 62 63 64 21 20 26 21 23 Housing 99 98 99 99 98 34 34 24 27 25 Education 19 26 30 26 31 1 2 2 2 2 Health 70 67 68 62 71 4 3 4 4 5 Other Services 37 39 36 40 40 4 5 5 6 7 Total b 4 70 70 69 69 1100 100 100 100 100 Source : SPO '2002SPOdata.  3 7. Trade Structure: Turkey i s a fairly open economy, with exports and imports accounting for over 50% of GNP. Regional trade incentives, including with the EU, provide a range of opportunities for Turkey's industry. However, increased competition on the domestic front and the need to focus on higher value added goods and services away from low quality, labor intensive products represent a serious challenge for Turkey's industry. 8. The structure of Turkey's export sector has been shifting over recent years. Exports of food and beverages have shown a sizeable decline, while exports of chemicals, textiles, plastics and mining-related products have increased significantly on an annual basis. Infact, the share of agricultural products in total product exports shrank from 7.1% in 2001 to 5.7% in 2002, with manufacturing sector exports managing to gain further ground, accounting for 93% of total product exports. Despite the global economic slowdown, exports have continued to improve and have managed a further 27% rise in value terms from the first quarter of 2002 to the first quarter of 2003. 9. FDI Inflows: Turkey should be a magnet for foreign direct investment (FDI) given its large market size, skilled domestic labor and the competitiveness of local firms as suppliers to multinationals. However, Turkish FDI levels have stagnated during the past 15 years while total FDIworldwide has increased by a factor o f 12. FDIflows have consistently been below US$1 billion per year (less than 1% of GDP), modest by Asian or Latin American standards (see Graph 1and Table 2). As can be seen from Graph 1, the exception was 2001 when privatization receipts boosted FDI flows to US$2.8 billion. Increased FDI i s necessary to boost the competitiveness of Turkey's productive sector and to meet the growing energy and infrastructure needs of a country looking towards EU accession. Within this context, certain key actions are required to boost FDI flows, including the acceleration of privatization, a full scale review of commercial law and competition policy to identify and address obstacles of FDI and the development of a strategy to facilitate the flow of `greenfield' FDI to SMEs. Within this context, the recently adopted new Foreign Direct Investment Law and the decision to create an Investment Promotion Agency will facilitate an environment conducive to increased foreign direct investment. Graph 1 :Foreigndirect investment (US$ mn) 3,000 2,500 2,000 1,500 1,000 500 0 Source :Central Bank 10. Performance of the Real Sector: Net profitability of companies declined between late 1997 and late 2000, then turned into major losses in the first half of 2001 in the manufacturing sector (except for cement and glass) as a consequence of the 2001  4 financial crisis. Industrial production fell 8.9% in 2001 but rose 9.1% during the course of 2002, returning the industrial production index back to levels seen before the 2001 financial crisis. Most of this growth in industrial production has taken place in the manufacturing sector, specifically, petroleum products, plastics, machinery and motor vehicles. The need for a comprehensive corporate restructuring program emerged to deal with the damaging effects of the 2001 crisis on the real sector (see Istanbul Approach below). Most firms were adversely affected by the high financial charges associated with high real interest rates, the high cost of servicing debt denominated in foreign exchange and associated foreign exchange losses following the sharp devaluation of the Lira. In addition, despite improved opportunities for exporting firms, sharply lower domestic demand affected firms catering for the domestic market resulting in a number of firms failing or suffering severe difficulties. 11. The Financial Sector: Turkey's financial services industry is in an early stage of development. Credit markets are dominated by banking (accounting for over 85% of financial system assets), while capital markets are dominated by government securities (accounting for over 90% of trading). Furthermore, government securities account for an increasing percentage o f banks' assets, subjecting banks to increased risk from any perceived or actual risk of sovereign default. As a result, financial intermediation in Turkey remains small when compared with the size of the economy, with the financial services industry vulnerable to shocks and crises that hinder the development of private sector growth. 12. In response to the environment of high real interest rates, high inflation, limited availability o f credit, volatility and tough regulatory environment, Turkey's economic agents have tended to focus on financial contracts of a shorter duration, while banks have looked to government securities for their strong source of income. Moreover, any real sector lending tends to focus on clients with known credit credentials and sufficient collateral. As a result, the S M E sector has suffered. Financial institutions in Turkey remain reluctant to lend to SMEs2 given their low level of financial literacy, lack of a credit history and low levels of collateral. Given the importance o f SMEs in the Turkish economy3, particularly from an employment perspective, there i s a definite need to improve financial intermediaries' outreach to SMEs. The Turkish Government recognizes the fact that SMEs face serious constraints to growth, specifically, lack of access to working capital and long term finance, lack of adequate collateral, high real interest rates, excessive bureaucracy, opaque tax legislation and corruption. Efforts to improve the general business environment and macroeconomic stability will have a beneficial effect on S M E development, as will moves to address issues such as bureaucracy and corruption. 13. The financial crisis of 2001 resulted in a further significant contraction of bank credit, as the financial condition of private banks deteriorated sharply. As can be seen from Table 2, credit to the private sector as a share o f GDP was significantly lower in * Internalfinancing i s the main source of funds for most SMEs. SMEs are estimated to account for over 95% of all enterprises in Turkey, employing more than 40% of the workforce and accounting for half of all investment and 30-40% of total exports.  5 Turkey than in comparable countries in 2000 (with the exception of Mexico), a trend that continues to manifest itself at present. Gross domestic Private Investment Foreign Direct Investment Credit to Private investment(% GDP) (% GDFI) (9%GDFI) (% GDP) Sector (% GDP) 2000 2000 2000 2000 2000 Turkey 24 12 2 0.9 24 Thailand 23 68 12 2.8 68 Malaysia 26 51 7 2.0 136 Mexico 23 90 10 2.3 13 Brazil 21 86 21 6.0 38 Upper Middle IncomeCountries 22 78 15 4.0 48 HighIncomeCountries 22 82 14 10.1 136 14. Banking Sector: Turkey's banking sector is undergoing rapid change as part of the reform program to align Turkey's banking sector to EUrequirements. There are 53 banks of which 39 are commercial banks and 14 development and investment banks4. Around 30% of total banking assets are held by the three state banks (the govemment- owned Halkbank and Ziraat Bank and the govemment controlled Vakif Bank), and another 7.5% held by foreign and investment banks. About 54% of banking assets are held by private banks, with the remainder under the control of the Savings Deposit Insurance Fund (SDIF)'. To sustain growth over the medium term, changes in the incentive structure of financial institutions and increasing the level and quality of financial intermediation in the long term will be important. While there are a number of sophisticated players in the market, Turkey's financial system i s not deep relative to the size of the economy. As the regulatory and taxation issues are addressed and with further consolidation and privatization of state banks, Turkey's banking sector will have an increasing role to play in private sector development, particularly in facilitating access to long-termfinancing to the private sector. 15. Non-bank FinancialInstitutions(NBFIs) such as insurance companies, private pension funds, leasing, factoring and venture capital firms account for less than 15% of financial system assets and less than 15% o f GNP. The equity market accounts for only 30% of GNP, while the corporate debt market does not exist and organized derivative markets are in their infancy. There i s significant scope for expansion of the insurance, pension and mutual fund industry, while venture capital and capital market development will further facilitate opportunities for private sector development. The future development of NBFIs and capital markets can provide a means towards improving funding opportunities for the private sector thereby increasing the scope and level of private sector economic activity inTurkey. 16. Infrastructure: The pace of infrastructure reform suffered during the crisis of 2001 and while the need to boost Turkey's competitiveness, improve investment flows and align Turkey towards EUmembership has led to an increased focus on infrastructure EndDecember 2002data (www.tbb.org.tr). The SDIF is tasked with insuring savings deposits, restructuring banks intervened by the BRSA and transferring these banks to a third party. There are currently 3 banks under the control of the SDIF, Bayyndyrbank, Pamukbank and Imar Bank.  6 reform and privatization, developments have largely remained modest. The telecoms sector has seen the sale of three GSM licenses, although progress towards the privatization of Turk Telekom has been slow. Regulatory developments in the energy sector have improved more recently, although energy prices remain well above OECD averages. While raising the efficiency of the transport sector will undoubtedly have a positive impact on Turkey's economic growth potential, major structural reforms have yet to be implemented, with little scope for private sector participation at present (see sections below for a detailed review). Furthermore, the privatization process has only recently gained momentum, with privatization sales consistently falling short of expectations over the last decade. 17. An analysis of developments inthe private sector suggests that there are a number of key themes that should emerge in any private sector agenda aimed at improving Turkey's growth potential, its competitiveness and importantly, its capacity as an investment destination. The first area requiring further attention is the financial sector, where the momentum o f financial sector reform needs to be sustained. In addition, continued emphasis must be placed on expanding the range of financial products and access to finance available to the private sector, particularly SMEs. A closely related issue i s the continued refinancing and restructuring of the corporate sector to further augment the current recovery of the real sector. In order to foster investment flows, particularly FDI, a review of commercial laws and competition policy remains crucial, as does a review of the existing regulatory environment affecting SMEs. A further theme that provides significant scope for private sector development is that of privatization and the sustained commitment from the government towards a viable and effective privatization agenda. This i s particularly crucial in the context of the reforms and restructuring required to generate effective and competitive utilities that foster economic growth and the further development of the private sector. Government Strategy for Private Sector Development 18. The Government remains committed to the development of a more attractive business environment to encourage the private sector, thereby improving economic growth and employment prospects in Turkey. To assist in achieving private sector led growth, the Government i s increasingly focusing on an enabling environment, including : i)macro-economicstabilization(seemainCASfordetails); ii)improvedefficiencyofthe financial sector; iii)deregulation and privatization; iv) improvement o f the investment climate to boost investment, both foreign and domestic; v) improved delivery of social services (see main CAS for details); and vi) infrastructure investment. 19. Financial Sector: Substantial progress has been made in terms o f financial sector reform, with banking legislation continuing to move towards EU norms. Reform measures have included the creation o f an independent Bank Regulation and Supervision Agency (BRSA), the intervention b y BRSA and SDIF in over twenty insolvent private banks, the implementation of a recapitalization program for private deposit taking banks and the restructuring o f two state-owned banks. While reform is still required in a number of areas, there are a few crucial issues that need to be addressed to improve the  7 functioning o f the financial sector. The Government needs to further strengthen the institutional capacity of the BRSA and create a long term role for SDIF. Continuedeffort must be made to privatize the remaining state banks and deal with the few insolvent banks still under the auspices of the SDIF. Bankruptcy laws must be reformed to deal with the difficulties arising from non-performing loans (NPLs) held by the banking system and the SDIF, and bankruptcy issues as pertaining to the Istanbul Approach, especially as there are many companies that have not fallen under the Istanbul Approach but which remain financially weak and could cause further NPLs to banks should the economic recovery falter. In July 2003, amendments to the Bankruptcy Law were enacted which will enhance enforcement of creditor rights. In addition, the Government intends to introduce provisions in the Law on pre-packaged bankruptcy before the end o f the year. 20. The Istanbul Approach (IA),the cornerstone of the Government's efforts to revitalize the real sector, i s a comprehensive corporate restructuring program that began functioning in mid-2002. Once a firm voluntarily enters the IA, there i s a formal review process by a Creditors Committee to determine the long term viability of each candidate. Once this i s ascertained, a formal restructuring is considered (such as an interest holiday, capitalization of interest in arrears, extension o f loan maturities, lending o f new money, or conversion of debt to equity). These longer-term financial changes are conditional on the implementation of an agreed business plan that may require some form of company restructuring (management changes, fresh equity, sales of assets or divisions, mergers or even company takeovers by new owners). Once the details have been agreed to, the creditors and the company sign an agreement stipulating the terms and conditions of the deal, including details on triggers that could result in a review of the agreement. As of June 2003, close to 300 firms were participating in the Istanbul Approach with some US$4.8 billion in loans being restructured. These firms had approximately 46,000 employees, sales of US$2.9 billion and exports of about US$0.8 billion, and about US$7.5 billion in assets. Disappointingly, however, in several cases, only debt rescheduling rather than real corporate restructuring was actually carried out. Within the context of corporate restructuring, corporate governance issues remain a concern. For example, bankruptcy legislation must be overhauled to facilitate efforts to bolster the private sector. 21. FDI: The government is currently developing an FDI strategy in an attempt to improve FDI flows and improve Turkey's global competitiveness. Assessments of the FDI environment have been undertaken with the assistance of the Foreign Investment Advisory Service (FIAS). In an attempt to address some of the issues raised by FIAS, a new FDIlaw and a new company registration law have been passed by parliament6, while the Government i s looking to create an Investment Promotion Agency (IPA). Further work i s needed to foster FDI flows particularly with regard to issues relating to commercial law and competition policy and the pace of privatization. This new FDIlaw allows foreign investors to be treated in line with local investors and looks to introduce measuresto remove existing obstacles to attracting FDI.  8 22. Privatization Program: Privatization in Turkey has proceeded much more slowly than in other emerging countries in Latin America, Asia, and Eastern Europe. Privatization sales have consistently fallen below US$1 billion per year, with the exception of 2000, when the sale o f the majority stake in POAS (petroleum distribution) and a third GSM license pushed sales above US$5 billion. Turkey has managed US$11.5 billion in privatization revenues since 1985. Delays in implementation can be attributed to a number of factors, including the requirement that the Privatization High Council7 approve all transactions, regardless of size; the existing cross subsidy mechanism between profit and loss making companies inthe Privatization Administration's portfolio; the focus on revenue gains and not on improving competitiveness; as well as the fact that the privatization of large holdings (telecommunications and state banks) are the responsibility of the line and state ministries. Turkey's disappointing privatization performance has been a factor in its failure to attract significant levels o f FDI. However, the Government has embarked on an ambitious privatization program for 2003 as it aims to improve competitiveness and investment flows into the Turkish economy. The new program includes the privatization of major companies of national importance. These include Petkim (petro-chemicals), Tupras (oil refinery, partly divested in 2000), Turkish Airlines, Erdemir (steel), Tekel (tobacco and steel) and Seker (sugar). In addition, a number of smaller holdings and Government land holdings have also been mandated for privatization. The further privatization of state banks and ports are also anticipated. 23. Energy: Energy prices in Turkey are well above OECD and other comparable countries. Despite high prices, the sector continues to suffer from serious financial difficulties due to expensive independent power producers (IPP) contracts, excessive distribution losses and poor billing and collection. Turkey's electricity and gas sectors are undergoing significant reform as part of a policy of continuing market reforms and harmonization with the European Union. The reforms aim to decrease costs and risks currently borne by the Government by attracting private capital into the sectors. The creation of an energy regulatory authority, and new electricity and gas laws enacted in 2001 have set the stage for privatization of the energy sector and initial steps towards privatization have been taken, particularly inthe field of renewable energy. However, the energy sector faces a number o f difficulties that negatively impacts on profitability and will hinder the privatization process unless adequately resolved. These include the large scale of non-payment for electricity services; a large number of generation and distribution projects with transfer-of-operating-rights (TOOR) or a Built-Operate- Transfer (BOT) approach to private participation that have still to be resolved, as well as a large number of contracts signed in anticipation of increased demand at high take-off volumes and prices that will take many years to realize. 24. Information and Communication Technologies: Turkey's telecommunications sector has continued along a path of further liberalization and i s currently considered to be at a comparable stage to developments in other EUaccession countries such as Poland and Hungary. Following on from the two G S M licenses issued in the 1990s, the The Privatization Administration is responsible for carrying out the privatization program under the authority of the HighPrivatization Council, a group of ministers chaired by the PrimeMinister.  9 Government successfully auctioned a third license to Aria in 2000 and following the failure of attracting bidders for a fourth license, issued the fourth directly to Turk Telekom (Aycell). At present, there are plans to restructure the mobile telephony subsector, with substantial private sector participation. The privatization plan of Turk Telekom itself has progressed more slowly. With the full liberalization of the telecoms sector scheduled for the end of 2003, and given the difficulties experienced globally in the telecoms sector, the restructuring of Turk Telekom to improve competitiveness ahead of full liberalization has taken precedence over privatization. The Board o f Directors has undertaken a corporatization plan to commercialize Turk Telekom' s operations by restructuringthe company along business lines. However, in line with the Government's agreement with the IMF,the privatization of Turk Telekom remains a key objective. The Government plans to announce a new privatization strategy during the third quarter of 2003 and the privatization of the entire entity is tentatively scheduled for the second quarter of 2004, although significant work remains to be done on the regulatory environment ahead of a successful privatization initiative. 25. Physical Infrastructure: Turkey's EU accession plans require significant investment in physical infrastructure, both to meet EUnorms and to address the growing demands on urban utilities. However, high logistic costs continue to hinder the country's competitiveness, further obstructing private sector development. The transport sector accounts for 30% o f public investments, but i s a substantial financial drain on the Government's accounts thereby adding to the country's substantial public debt burden. Major structural reforms are necessary to effectively meet growing infrastructure demands. This requires institutional reforms to improve efficiency and accountability as well as incentives to mobilize private sector participation to improve existing infrastructure given the Government's budgetary constraints. BankGroup's Strategy 26. The World Bank Group has provided significant assistance to Turkey. As of end- FY03, IBRDhad a portfolio of active projects for which loan commitments totaled over US$4.8 billion. IFC's Turkey portfolio was the fourth largest in terms of exposure after Brazil, Argentina and India, accounting for 4.8 percent o f the total IFC portfolio. Total IFC committed portfolio for Turkey stood at about US$S05 million. With gross exposure of about US$214 million, Turkey was the fifth largest host country in MIGA's portfolio in FY03. Thus, the role of the World Bank Group has been important, as a leading multilateral source of long-term finance for the Government and the private sector. 27. The World Bank Group's private sector strategy in FY04-06 will focus on supporting the Government's program of further improving the business climate. There has been a shift in emphasis from crisis management, which followed the 2001 crisis, to policies that support further recovery of the corporate sector. The priorities include: completing the unfinished agenda of financial sector reform, supporting the strengthening of the corporate sector, especially SMEs, in the aftermath of the financial crisis, accelerating privatization and removing barriers to FDI, continuing the restructuring and privatization of public utilities, and investments in infrastructure.  10 28. The strategy i s based on the complementary roles and instruments of the members of the World Bank Group. IBRD will support the implementation of economic reforms through adjustment lending, and will complement these operations with investment projects in support of reforms in key areas, as detailed in the main CAS text. IFC will rely on its established multi-prong strategy focusing on projects with tangible benefits o f growth and reform and on demonstration projects that could be replicated elsewhere. MIGA will continue to play an important role in facilitating foreign direct investment flows through its guarantee program and its Investment Marketing Services' support to the Center for Private Sector Development in Istanbul. FIAS will follow up on its work with the Government on improving the environment for increased foreign direct investment on issues such as streamlining administrative procedures, establishment of the investment promotion agency, FDIspilloverAinkages, andcompetition policy. 29. As in the past, IFC will collaborate with IBRD on private sector inputs for the structural reform program. Improvements, recommended by the Bank, in the legal and regulatory framework for telecommunications, energy and financial sectors are expected to increase investment opportunities for IFC in these areas. The complementary focus of IBRD,IFC andMIGA ininfrastructure and financial markets will enhance the quality of the economic reform being supported by the World Bank Group. 30. Financial Sector: Completing the unfinished agenda of financial sector reform, including the further strengthening of the banking sector and deepening financial intermediation through development of the non-bank financial sector, are key to improved economic stability and private sector growth. IBRD's planned assistance, which includes a combination of economic and sector work, adjustment and investment lending, is described in detail in the main CAS text. IFC's strategy in the financial sector will be closely coordinated with and will reinforce the proposed Bank support. IFC will focus on: (i) assisting the authorities with the sale o f intervened banks, as appropriate, and o f the non-performing loans of these banks; (ii)working with mid-sized banks to strengthen their balance sheets and to use them as a platform for helping in the consolidation process; and (iii)expanding the range o f financial institutions in the market. Box 1:IFC's Plans inthe Financial Sector F C has been working actively with SDIF to support the non-performing loans (NPLs) auction process. IFC will provide funding to successful bidders in the auctions, by so doing potentially attracting a higher number of bidders to the auctions, enhancing the value of the portfolios being auctioned, and acting as a safeguard that the process will be transparent and according to international standards. The consolidation of the banking sector will probably continue although at a slower pace than in the previous two years. In the short term, the focus needs to be on strengthening viable financial institutions hit by the downturn. In this regard, IFC has assisted a mid-size bank to strengthen its capital base; this could be used as a platform to promote the consolidation of the banking system, by acquiring weak or intervened banks, assets, andor through management contracts. This could also provide a channel for extending credit to the SME and corporate sectors, both of which are facing a liquidity squeeze. Inaddition, IFC will also continue with efforts aimed at institutionbuilding and introduction of new products, including the development of the insurance sector, mortgage finance and contractual savings institutions, and development of the private equity market.  11 31. Corporate Sector/SMEs: The financial crisis in 2001 hit hard the enterprise sector as documented in the Corporate Sector Impact Assessment Report prepared by IBRD. While the Istanbul Approach provided debt relief for many enterprises and 2002 registered strong economic recovery, the corporate sector remains vulnerable and generally lacks access to commercial bank credit. Therefore, the Bank Group's strategy, in addition to focusing on the improvement of the overall business climate and financial sector reform, also envisages the provision of finance through proper financial intermediaries to the enterprise sector. IBRD's program, as described in the main text of the CAS, includes operations to support export finance and the S M E sector. IFC, despite the difficult environment, will continue to pursue new investments o f projects with strong operating intrinsics. In addition, the IFC's short-term focus will be on highly visible interventions with strong demonstration effects and positive impact on market psychology. Special emphasis will be made to address the paucity o f equity financing and the lack of access to capital markets by developing model transactions to demonstrate how companies can de-leverage their balance sheets, improve their liquidity and enhance corporate governance. Instruments to address these needs include, inter alia, corporate and working capital loans. The IFC has increasingly been successful in investments in Turlush projects in Central and Eastern Europe and Central Asia, with over US$lSO million already invested in the former Soviet Union, Romania, Azerbaijan and Kazakhstan. The IFC has deliberate plans to further grow this development partnership with Turkey. In addition, IFC i s looking for ways to enable intermediaries to increase the amount of trade finance through the provision of trade facilities and risk sharing mechanisms that will increase the amount of trade financing capacity in the country by helping supplement restrictedcountry limits available to banks. 32. Inconnection with the planned Baku-Tbilisi-Ceyhan (BTC) Pipeline investments, IFC i s considering ways to have the local businesses (mainly SMEs) benefit from supply chain linkages to the large investment expenditures surroundingthe B T C project: 0 IFC will first undertake an S M E map detailing the S M E business environment and hurdles to growth at both the firm and institutional levels. The map will also identify potential follow-on initiatives via workshops and seminars with the business community. 0 SMEs in several oil and gas sub-sectors will receive specific technical assistance to improve their productivity and quality assurance in a program fundedjointly by IFC, BP, Statoil, Unical, the AIOC Enterprise Centre and GTZ (German Development Corporation). 0 In addition, training will be provided to local business development service providers, which inturn will assist SMEs. 0 SMEs may be funded through credit lines to the banks or a specialized S M E fund, which could have participation from private investors involved inBTC.  12 0 Lastly, some community development programs area also expected to ensure that a wider segment of the population i s able to benefit from the ACG/BTC investment. 33. Privatizationand FDI. Privatization in the main infrastructure sectors has been an important component of the Bank Group's policy dialogue with the authorities, including in the context of the Economic Reform Loan. The establishment of a proper regulatory and legal framework for privatization in the telecommunications and energy sectors, supported by IBRD, provides for the necessary environment for private investment. IFC's strategy i s to support flagship privatization to help restore investor confidence, attract foreign interest and stimulate the flow of foreign direct investments in privatization deals. To achieve this goal, IFC will support privatization of visible telecommunication and infrastructure projects. 34. Inview of Turkey's great potentialto expand foreign investment flows-both as a significant source of private investment in neighboring countries and as a large recipient of foreign investment, MIGA will continue to play an important role in facilitating foreign direct investment flows. Thus far, the amount of foreign direct investment facilitated by MIGA i s close to US$1 billion, and it i s expected to grow as the Government's ambitious privatization program i s implemented. 35. FIAS has led a Bank Group initiative to enhance the quantity and quality of FDI inflows. An analysis of administrative and regulatory barriers has been carried out, and a work plan for their removal has been agreed with the authorities. These measures are central to improving the investment climate and addressing some of the underlying causes of the 2001 crisis. As a result of this work, a new FDI law and a law on the creation of an Investment Promotion Agency have been passed. FIAS will continue its dialogue with the authorities as the recommendations o f the study on the administrative and regulatory barriers to FDIare implemented. 36. Infrastructure. IBRD's planned assistance in infrastructure, beyond the policy dialogue in the telecommunications and energy sectors, will focus on supporting investments at the municipal level in the context of local government reform, the restructuring and renewal of the railway sector, and the liberalization process in the energy sector to allow for increased private sector participation without government guarantees. IFC, as noted above, would be ready to support privatization of Turk Telekom and other visible projects in infrastructure. As part o f a regional undertaking, IFC i s also considering the financing of the Baku-Tbilisi-Ceyhan Oil Pipeline. 37. Baku-Tbilisi-Ceyhan (BTC) Oil Pipeline: IFC, together with EBRD, is considering supporting the investments needed for the Baku-Tbilisi-Ceyhan (BTC) pipeline. The BTC pipeline will carry oil primarily from the Azeri, Chirag and Gunashli (ACG) oil fields in Azerbaijan to the Turkish port o f Ceyhan on the Mediterranean Sea through Georgia. The Shah-Deniz pipeline will transport gas from Azerbaijan to Turkey, also through Georgia, and the development and exploitation of the Shah Deniz gas field and associated gas pipeline project i s to be assisted by EBRD.  13 The project is expected to be considered by the Board in FY04 and the IFC expects to provide up to US$lSO million to finance the BTC project. IFC's role inthis proposed investment is to: 0 assist in mitigating political risk perceived by international investors in a cross- border project and help ensure stability of the project's arrangement and operation; provide long-term financing (both directly and by mobilizing commercial bank funding through its B loans) that is especially needed by the smaller borrowing companies; 0 provide a framework for the development and operation o f the project in an environmentally and socially sustainable manner; help ensure broader development impacts by IFC's S M E and community development programs; 0 help assist inthe effective governance and promote transparency; and 0 act as a neutral third party in projects, which are based upon a number of Host Government Agreements (HGAs) and an Inter-Governmental Agreement (IGA) for oil transport involving cooperationbetween three Govemments, several state companies, as well as a diverse group of the international oil companies.  Annex A2 Retrospective Review The Opportunity 1. The CAS for FY01-03 was undertaken at a time of opportunity for structural reform, building on initial measures taken in late 1999 and early 2000. The Government, following its entry into office in the spring of 1999, had declared a commitment to extensive reforms, and had enacted several important laws despite the disruption of the Marmara and Duzce earthquakes in August and November 1999, respectively. An IMF program was initiated in December 1999, and the Economic Reform Loan (ERL) was approved by the Bank in May 2000. At the time the CAS was being discussed with Government, a program of institutional changes to buttress the structural reform policy measures of the ERL was being prepared, as well as a Financial Sector Adjustment Loan. The Bank had laid the groundwork for extensive reforms through economic and sector work and an active dialogue, facilitated by the move of the Country Director to the field in 1998 and the subsequent strengthening of the field-based economic management andportfolio implementation teams. 2. The CAS was discussedwith the Board in December 2000, as thefinancial market turbulence experienced by Turkey in November 2000 wasfresh in the minds of observers. The slowing of reform implementation in mid-2000 was reversed and some momentum emerged briefly, but the underlying imbalances proved impossible to resolve quickly, leading to the full-blown financial crisis of February 2001. 3. The CAS Progress Report (CAS PR) was discussed with the Board in July 2001, at which time the severity of the need for reform had been made clear by the crisis and the Govemment's resolve had again firmed. The Bank was positioned to support immediately the rapid reform actions needed to get a sustainable recovery underway. The Programmatic Financial andPublic Sector Adjustment Loans (PFPSALs) were put in the revised CAS to support the most important and urgent of the reforms: to address the regulatory, resolution, and recapitalization needs of the banking sector; and to rectify the weaknesses in governance and public management that had allowed the mismanagement of public expenditure and public banks for so long. Strengthened support to the social sectors was also put in place quickly, given the expected impact of the crisis on vulnerable people, and the demonstrated need for a more robust social welfare system to mitigate the social risks associated with economic fluctuations. The Results 4. The reforms have brought about some lasting changes, in particular where the institutional changes neededfor sustained implementation have been made. There have also been difficulties, stemming from periods o f crisis, political uncertainty, and wavering counterpart commitment to priorities. Viewing each of the original CAS  2 thrusts, we can assess the areas in which the aims have been realized and are likely to be sustained, and those where more remains to be done. Implement reforms for growth and employment generation. Significant reform progress has been achieved, but permanence of some of the reforms i s unclear. With much of the legal and regulatory framework in place, the focus i s now on implementation. Backtracking has been signaled in certain socially sensitive areas (e.g. agricultural subsidies) and other areas have been subject to implementation delays (e.g. privatization). > Macroeconomic outcomes under the IMF program have been broadly positive with a strong recovery startingin early 2002 and a reduction in inflation to the 30 percent level achieved by end-2002. However, there have been problems achieving the primary surplus targets, and the quality of fiscal adjustment has fallen short of expectations. There have also been delays in a number of structural areas. > Banking reform has been a major area o f progress. Prudential standards have been upgraded to international norms, an independent bank supervision and regulatory agency has been established, insolvent private banks have been intervened and resolved, a recapitalization exercise has been carried out for the remaining private banks, one public bank was merged with another, and the remaining public banks have undergone operational restructuring. Legislation i s inplace to prevent un-funded"duty-losses" in the public banks. Privatization of the public banks i s on the agenda but the means of doing this are still under debate. > The shift from indirect agricultural subsidies to direct payments to farmers (DIS) as the major instrument of agriculture support has been largely achieved, and framework legislation to institutionalize the DIS has been prepared. However, further progress in reducing indirect subsidies i s needed; additional, unplanned payments to hazelnut farmers were made in 2002-03. Progress towards privatization of agricultural SOEs has been halting, but may be gaining momentum with the adoption of a privatization plan for TEKEL (tobacco, alcohol and salt) in early 2003. Legislation i s in place to liberalize gradually the tobacco and sugar markets. Restructuring of the agriculture sales cooperative unions (ASCUS) has been initiated, but stricter financial discipline i s needed to see this program through. No irrigation strategy has been adopted, but pilot management of local systems by Water User Associations has led to efficiency gains and increased private funding. > Considerable progress has been made towards creating a competitive, regulated electricity market, including creation of an independent regulatory agency which also oversees the gas sector. However, progress towards privatization of electricity generation and distribution has been slower than planned.  P An independent regulator has been established in the telecommunications sector with full licensing responsibility, a GSM 1800 license was sold to a private consortium in 2000, and the national operator Turk Telekom i s being corporatized. However, efforts to privatize Turk Telekom have fallen short so far. P A package of laws to help promote FDIwas passed by Parliament in June 2003 introducing a more level "playing field" between foreign and local investors. However, implementation of other reforms including tax administration and further administrative reform of social security to ensure collection discipline are needed to establish a truly level playing field. P Enterprise privatization has been slow, partly due to poor market conditions and partly as a result of insufficient political will. POAS (petroleum distribution) has been 100 percent privatized and the state stake in ERDEMlR (steel) has been reduced below 50 percent. A new privatization program was announced in January 2003 and a number of smaller sales have occurred, with several large ones scheduled to be completed duringthe second half o f 2003. Zmprovepublic management and accountability. A comprehensive public sector reform program has been launched encompassing structural fiscal reforms (taxation and public employment), public expenditure management, and governance. Tax reform, rationalization of public investment, elimination of most extra-budgetary funds, and improvements in public debt management have been solid achievements. Other aspects of public sector reform have progressed more slowly. Municipal reform i s needed to lay the basis for matching revenue raising capability with responsibility for public service delivery. P Reform of tax policy has made significant progress with the introduction of a unified special consumption tax in mid-2002 and a package of legislative reforms to simplify andrationalize the direct tax system in April 2003. > A comprehensive public employment program is in place with an overall ceiling and quarterly monitoring in the public administration, and gradual reduction of identifiedredundancies inthe SOE sector. P The public investment program is undergoing phased rationalization and the Government has shown increasing resolve in focusing on fewer priority projects with speedier implementation. The average project completion time has been reduced from 12.5 years in 2001 to an estimated 7.6 years in 2003. P Almost all budgetary and extra-budgetary funds have been eliminated. However, further legislation i s needed to close the special accounts and special appropriation mechanisms left in place after closure of the funds. P A fully automated public accounting system has been introduced for the consolidated budget agencies and an international standard budget coding system  4 (GFS) i s being introduced in the 2004 budget cycle. A comprehensive public financial management and control act was submitted to Parliament in August 2002 and i s undergoing further revision in consultation with the Bank. k Under the new public debt management law enacted in 2002, procedures for issuance of Treasury guarantees have been greatly tightened and a new office for public debt and risk management has been established in the Treasury. k A new procurement law inline with the internationalUNCITRALstandards went into effect in January 2003. An independent Public Procurement Agency to oversee public procurement has been established. A series o f amendments to the law were enacted in July 2003, including articles to authorize the limited use of commercial practices by public enterprises. k The public debate on reducing opportunities for corruption has intensified. The Bank's support to the anti-corruption conference in late 2001 and related fact- finding by a leading local think-tank has contributed to this. A national strategy for combating corruption was published inMarch 2002. k Some aspects of infrastructure management have been improved, but the results of the limited introduction of private operators in municipal water have been mixed. Expand social services and social protection. There have been substantial and sustainable improvements in basic education. Targeting has improved on social welfare for the poorest, but that system i s under-funded. Social security i s not well targeted and i s unsustainably expensive. The crisis increased urban vulnerability and poverty. Health outcomes remain poor for a middle income country, particularly for maternal mortality. 9 A major social security reform was enacted startingin 1999. Parametric reforms to the public Pay-As-You-Go (PAYG) pension reform have been introduced, and legislation to support individual supplementary pension schemes was enacted. However, planned institutional and administrative reforms have lagged behind. The improvements in the financial balance of the social security system expected from the reform have not materialized and ad hoc increases in pensions in January 2003 have pushed the system's overall deficit to close to 5 percent of GNP. k Seventy-five percent of the nation's farmers are enrolled in the Direct Income Support system; DIS payments are being made, albeit with some delays, and targeting i s good, based on annual farmer registration. k Fundingfor social assistancethrough the Social Solidarity Fundhas increased but remains short of the 0.3 percent of GNP target. A Conditional Cash Transfer system has been tested and i s ready to roll out, with a scoring formula for careful targeting to the poorest 6 percent.  5 > Girls' enrolment in basic education reached a target of 4.8 million in 2001-2. A remaining challenge i s to get attendance to match enrolment. All basic education schools have improved educational materials. Teacher training has been strengthened towards the aim of yearly training. > The unemployment insurance fund began to pay claims in March 2002, but benefit payments have lagged behind projections and the fund is running a large surplus. A structured approach to rebalancing the fund is needed. Establishment legislation for the unemployment insurance fund was adopted in June 2003 following a long delay. Strengthen environmental management and disaster mitigation. In environmental management, successes have been dramatic and sustainable where achieved, but national replication of regional successes i s not yet taking place. For disaster mitigation, despite the excellent results in reconstruction after the earthquakes of 1999, the institutional framework for disaster prevention remains weak. > The number of communities with natural resource management plans under implementation has increased. > The Turkey Emergency Management Agency was established in name only; lack of a shared concept among the many ministries and agencies involved in emergency mitigation has blocked adoption of a single coordination model. > The Turlush Catastrophic Insurance Pool was established; the number of policy holders has been fluctuating over the past year between 2.5 and 1.7 million. Currently, there are about 1.8 million policy holders. One of the main reasons for this fluctuation is that the law to make such insurance compulsory has not yet been passed. Accelerate connectivity and technologicalcapabilities. > 2,802 ICT classrooms have been installedinprimary schools, but teacher training to shift from teaching how to use computers to how to use using computers to learn i s a remaining challenge. > Despite some slowdown after the February 2001 crisis, the profits and number of private sector clients of R&D agencies supported through the Industrial Technology Project have increased, and the linkages between R&D institutions and industryhave been strengthened. ProgramDesignand Delivery 5. The achievements during the CAS implementation period were made possible in part due to a three-pronged approach: new loans have been large (up from an average size of US$95 million in FY94-97 to US$440 million in FY98-02) but focused on few  6 strategic goals; extensions on older loans not related to the current strategy have been resisted; and taking advantage of tight adherence to our strategy has improved our ability to manage as well as work towards shared goals with the client. Our ability to scale up was in turn predicated upon a basis of analytical work and dialogue; for example, the C E M of 1999 laid out the need for reforms and institutional changes to improve private sector development in agriculture, energy, privatization, and telecommunications, while the PEN, CPAR and CFAA laid the groundwork for the PFFSAL series. Twinning adjustment operations with investment has enabled institutional changes to be undertaken with considerable technical assistance to contribute to the durability of structural policy reforms; for example, the Export Finance Intermediation Loan helped bring five private banks to world standards, while the FSAL and PFPSALs supported the strengthened regulatory environment. 6. Due to the many political issues involved for any govemment to implement sweeping structural reforms in times of economic volatility, it is important to be poised opportunistically to support openings as they arise. The Bank program succeeded inthis respect because intensive ESW was available to provide guidance for reforms as they became feasible, and the dialogue on these issues was kept strong through significant field presence and strategic technical assistance. 7. Despite the achievements during the CAS period, there are vulnerabilities in Turkey's development prospects. There is "reform fatigue". The new government, whose election was an expression o f a desire for change, does not wish to replicate the program of its predecessor and faces large demands for populist measures. Poverty has risen and there i s not yet a coherent approach to pro-poor development. The Government's urge to assist the economically vulnerable i s manifested through discussion of such possibilities as new crop-based subsidies, agricultural debt write-offs, initiating universal health insurance, and raising pension payments, but the fiscal cost and risk of weak targetingwith such measures must also be considered. The Portfolio 8. As of end-June 2003, theportfolio of Bank-financed projects in Turkey comprised 16 active projects, including an economic recovery and an adjustment loan. Total net commitments' amounted to US$4,820 million of which US$2,432 million (50.4 percent) remain undisbursed. In addition, the World Bank portfolio includes two grant financed projects with net commitments of US$22.2 million. Net IBRD commitments more than doubled between FY99 and FY02, driven by a series of adjustment loans and several large investment loans in the agriculture and social protection sectors, which are in direct support of the Government's economic reform program. The net commitments dropped in FY03, in particular due to cancellation of US$900 million from the PFPSAL I1and US$120 million from the Emergency Flood and Earthquake loan, as well as closure of some loans. Six loans were closed during FYO1, two during FY02, and three during the course of N 0 3 . 2 Two new investment projects and one adjustment loan, with total * Netadditional commitments are defined as original loan amount minuscancellations. An two projects closed on June 30,2003.  7 commitments of US$1.6 billion, were approved in FYOl, one investment project and two adjustment loans with total commitments of US$2.9 billion were approved in FY02, and one investment loan of US$300 million was approved inFY03 (see Table 1). 9. Reflecting the priorities set in the CAS and the CAS PR, the portfolio's emphasis has shifted towards supporting the Govemment's reform program with adjustment loans and higher lending in sectors where structural reforms can be supported with investment projects such as rural development and social protection. As of June 2003, 29 percent of commitments were for human development and social protection, one quarter of commitments for adjustment lending in support of private sector development and public and financial sector reform, and 18 percent for emergency preparedness and reconstruction. Table 1: Portfolio Overview FY97 FY98 FY99 FYOO FYOl FY02 FY03 Number ofEffective Projectsat FY enda/ 22 22 20 23 19 18 Net Commitments ($m) at FY end 2,763 2,434 2,632 3,801 4,344 Undisb. Balance at FY start ($m) b/ 1,633 1,233 1,509 1,673 2,419 Gross Disbursementsduring FY ($m) 329 259 264 957 820 Disb.Ratio Investment Projects(%) 20 21 17 20 21 17 Disb.Ratio inc. Fast Disb.Loans (%) 20 21 17 57 34 66 Cancellations($m) 86 53 104 41 448 37 1,093 a New Commitments ($m) 20 603 528 1,770 1,628 2,950 3 Unsatisfactory Projects Number 3 4 4 3 5 Percent 51 14 20 17 16 28 13 a/ Only IBRDfinancedprojects, including two - one of which with unsatisfactoryrating that closed on 6/30/ 2003. Hybridloans are - divided by componentfor calculatingdisbursementpercentages. b/ Undisbursedbalanceon 6/30/2003 was US$2,432 million. 10. Theperformance of the Turkeyportfolio continues to comparefavorably to Bank- wide averages, and has continued to strengthen. At the beginning of FY04, only one project had an unsatisfactory IP or DO rating. This i s a noteworthy accomplishment in particular in light of the severe economic crisis that affected Turkey starting in February 2001. A quick pro-active JPPR done in the late spring of 2001 helped to anticipate risks that faced project implementation as a result of the crisis and led to early government attention to budget issues so that the feared shortfall of counterpart funding did not emerge. The JPPR completed in late 2002 did not reveal significant cross-cutting issues affecting implementation, but highlighted factors worthy of vigilance on a project- specific level. Again this was a useful guide for portfolio managers in the Government and the Bank and after a slowdown in FY02, disbursements accelerated in early FY03. Unfortunately, early 2003 brought a near stoppage of disbursements. The Government applied new budget procedures, and signaled a need to revisit the portfolio in light o f changing priorities and greater commitment to managing tightly the public investment  8 program-all based on valid principles of sound fiscal management and accountability, but at the outset bringingconstraints and some confusion to project implementation. By June 2003, many of these issues had been resolved, and the Government is engaged in a tightly run process of examining the intended use of remaining large undisbursed balances to determine if there are issues o f weak strategic alignment, and a consequent need for restructuring and redesign. This i s expected to lead to decisions in a series o f project mid-term reviews and the finalization of the latest JPPR inthe fall of 2003. Box 1: Client Survey Insummer 2002, over 200 stakeholders participated in a client survey to provide views on the Bank's assistance to the country. Some 44 percent of the respondents worked for the central government while the rest o f the participants represented a variety of groups, such as the media, academia, NGOs, donors, the private sector and local administrations. Some of the highlights, based on the responses provided by the participants of the survey, are summarized below: Perceived overall value of the Bank inTurkey Most important: financial resources, resource mobilization, facilitation Relatively less important: lending when others will not, policy advice, and the Bank's knowledge Areas where the Bank should be involved Most important: encouraging greater transparency in governance and safeguarding against corruption in projects, closely followed by strengthening the financial sector, bringing about economic growth and strengthening the education sector Relatively less important: improving the judicial system, strengthening the public sector, and ensuring that attention i s paid to gender disparities Specific areas of effectiveness Most effective: improving the regulatory framework, strengthening the financial sector, and safeguarding against corruption inprojects Relatively less effective: improving the judicial system, reducing poverty, and strengthening the health sector The results o f the client survey suggests a need to (i) make the Bank's policy advice and knowledge transfer even more relevant to Turkey's particular circumstances; (ii)increase the effectiveness of Bank support for poverty reduction, and disseminate information more widely on these efforts; and (iii)improve the efficiency of Bank assistancein the health sector. Lessons for the Future There are benefits to a scaled-up and tightly focused program. This approach concentrates effort and funding for each o f the limited number of strategic priorities. Because it improves the ability to communicate and clarify to the client and inside the Bank what the objectives of our work are, a focused program easesjoint work and makes the Bank's efforts more comprehensible to other partners. Nevertheless, this approach can lead to complex operations. Although a few strategic objectives are agreed, and a small number of larger operations designed for each, often a large number of actions on the institutional front have to be undertaken in a concerted way to reach those objectives. This i s not always recognized in budgeting and planning  9 for intensive supervision, but where it has been properly resourced, including by the counterparts, it i s successful. Comprehensive structural reform requires supporting institutional changes, which in turn take time. Thus it has been important not only to link institution building investment loans to policy based SALS,but also to get a longer term programmatic approach, with consistent objectives for more than a 2-3 year CAS periodto make reforms permanent. Keeping project implementation times shorter is important to avoid disproportionate effort by the Bank to supervise the tail end of projects that are no longer aligned with objectives of a government different from the one that undertook the project originally. The ability to proactively restructure or cancel parts of loans i s vital for a program that mustrespondto changes on the ground inuncertain and risky times. An emerging lesson of experience in the portfolio is the need to press for legal and institutional changes prior to project implementation, if they are important for efSective implementation. There i s often a trade-off between needing to begin quickly (e.g. for reasons of emergency or economic crisis, perceived short window of opportunity, or desirability of keeping momentum on critical issues) and having to pursue certain regulatory and institutional changes with due allowance for necessary procedures and consensus building.  Y 0 Y E 3 i       i      i    Annex A3 CAS Consultations In addition to several rounds of discussions with the Government, the Bank team held consultations with different groups of stakeholders to gauge their views on economic priorities and the Bank's role. CAS consultations took place in Ankara, Istanbul, Gaziantep and Izmir, and included Parliamentarians, local leaders (governors' and mayors' offices), business representatives, NGOs and the Bank's key development partners. The summary of these discussions are presentedbelow, organized around four main themes: 0 Reform of the public sector and better governance; 0 Improvement of the business climate; 0 Human development; and 0 Environment management and disaster prevention. With respect to the reform of the public sector and better governance, opinions focused mainly on the need to improve transparency, combat corruption and increase the role of local administrations. In order to enhance transparency, participants emphasized the importance of information dissemination to the public and participation in decision-making, Participants also pointed out that sharing information and carrying out consultative meetings with interest groups, including parliamentarians, regarding the reform program would improve the chances of success inimplementation. It was also suggested that the Bank be more transparent and share more information with the public regardingits activities in Turkey. Giving consultative role to NGOs inevery stage of project implementationwas also recommended. Introduction of measures to fight corruption was stressedduring the consultations. In order to reduce corruption, participants suggested that the role of government be reduced parallel to speedy privatization. Efficiency of public activities and spending was one of the major issues raised by the participants. In this context, recommendations were made for simplification of the tax system and making the private sector responsiblefor collecting some of the taxes. Majority of participants, including the governors and mayors, stressed the urgency of transferring increased responsibility to local administrations. They pointed out that delivery of services locally would also ensure improved transparency through public participation and monitoring. This would also help encourage the application of the user pays/polluter pays principle to recover the cost of services because it i s easy to control and monitor the local administrations. The municipalities consulted, requested financial and technical assistance from the Bank inorder to upgrade the level of services delivered by them. Regarding the improvement of the business climate in Turkey, the main complaint of the participants concerned the difficulty for businesses to have access to credit at reasonable terms. They pointed to the high interest rates and very short maturities. In addition to the question of bank financing, the following common problems were mentioned: - inefficient bureaucracy highinflationrate ~ - severely fluctuating exchange rate  2 -- high taxes and complex tax system expensive telecommunication, energy and transportation services - insufficient support for R & D Participants also noted the need for technical and financial advice to SMEs to restructure their operations, prepare new projects, develop or adopt new technologies, identify new markets and manage their financial risks. In order to increase efficiency, support for training of the work force and industry-university cooperation was also emphasized. Participants confirmed that completion of the banking sector reform agenda, the strengthening of the non-bank financial sector, and the continuation of the debt work-out scheme under the Istanbul approachwere important priorities. In order to attract more foreign direct investment, participants referred to the necessary legislative changes. Some participants suggested that select central bureaucratic responsibilities, such as the provision of permissions, licenses or some incentives, could be turned over to local chambers of industry or commerce. There was nearly full consensus regarding the need to speed up privatization. Finally, several participants suggested that a new strategy should be prepared for the modernization of agriculture. With respect to humandevelopment,participants stressedthe importance of developing new strategies for the social sectors. Education was mentioned as the highest priority. Participants stressed that transportation problems should be addressed, regional boarding schools, especially for girls, should be established, and that curriculum development should be given highpriority. Participants also notedthe need to improve technicaltraining. In addition to formal education, participants also drew attention to special education needs, including education programs for handicapped persons, literacy and entrepreneurship programs for women, and skills upgradingprograms for youth. As regards the health sector, participantspointed out that family planning was still a problem, resulting infast population growth and highinfant mortality rate, health services inrural areas remained limited, and the health insurance system needed reform. Some participants recommendedthat health care services should be privatized together with the health insurance system. Training activities regarding preventive health care should be continued, especially for the poor segments of the population. Several participants advocated an increased role of NGOs in the social sectors. Participants also noted that strengthening the family structure and implementing youth development programs could prevent the emergence of many social problems. Finally, participants recommended that social sensitivity analysis be carried out before the introduction of reforms to ensure their success. Awareness regarding the importance of environment managementand disaster prevention increased in Turkey, as noted by participants. Consecutive large-scale natural disasters and increased coverage of environmental problems by the media helped both the Government and the public understand how serious the problems were. Participants stressed the importance of the following steps:  3 - projects should be developed and implemented, as soon as possible, in - order to prevent natural disasters in sensitive areas soil protection and erosion control measures shouldbe taken - further migration from rural areas should be avoided to solve urban environmental problems - the use of alternative energy sources, such as wind and solar energy, should - be increased pollutionof the Black Sea shouldbe prevented - historical and cultural heritage inventory should be completed and these two concepts should be included in the definition of environment  Annex A4 Strategic Links in the CAS Program ESW Dialogue Operations Policy Notes for the New Government, CEM, PEIR, CPAR, Programmatic Financial and Public Sector .Adj. Loan 3 CFAA, Social Cost of Adjustment Programmatic Public Sector Adjustment Loans Policy Notes for the New Government,CEM, NBFI Financial Sector Adjustment Loans Corporate Sector Assessment, Social Cost of Corporate Sector Assessment, Banking Sector Report Health Sector Report th Sector Transformation Project 1Municipal Sector Review, Water Sector Report 1Railway Restructuring Report Railway Restructuring Project 1Knowledge Economy Assessment Knowledge Economy and Technology Development Project 15nergy Sector Strategy, Gas Sector Note gy Project I<UralSector Strategy Rural Development Project -  Strategic Links in the CAS Program Adjustment and Investment Lending Policies for public sector reform Support implementation of health finance reform and strengthening of the social security administration Municipal Reform and Services Project tment in municipal services Railway Restructuring Project Support downsizing of the railway company to reduce fiscal burden of the railways and increase efficiency Support privatization, and reduction of government liabilities in Programmatic Financial Sector Adjustment Loan Support financing, through the strengthenedfinancial sector, for Policies for financial sector reform SME Finance Project Policies for agriculture reform Support improved productivity in agriculture and increase in  Programmatic Approach: Public Sector Reforms on Promoting Macroeconomic Public Expenditure Good Governance Expenditure Reform and Institutional and Sustained September 2000 July 2001 August 2001 September 2001 December 2001 June 2003 May 2000 July 2001 April 2002 fall 2003 fall 2004 * Al ,, * Launch fiscal Implement urgent Implement 2002 fiscal Implement 2003 fiscal Implement 2004-05 fiscal Implement 2005 - 2006 adjustment. supplementary fiscal package. package. packages. fiscal package. Initiate closures of package for 200 1. Adopt tax strategy and Enact direct tax reform and Initiate second phase of Implement second phase of budgetary funds and Initiate preparation of tax enact indirect tax reform. functional reorganization social security reform. social security reform. EBFs. strategy. Initiate comprehensive of tax administration. Deepen public Complete initial phase of lmplement structural Adopt medium-term public employment Implement public expenditure and public PEM reform with new reforms to social strategy for PEM reform. program. employment program. governance reforms. Medium-term Expenditure security system, Complete planned closures Initiate PEM reform Framework and continue agriculture, energy Continue PEM reform Initiate local government of budgetary funds and including pilots for GFS implementation of public and including enactment of reform. EBFs. classification and modified governance reforms. telecommunications. accrual accounting, PFMC law and institutional development of PPA and Implement local Establish regulatory Launch PIP rationalization. adopting rationalized 2002 Treasury middle office. government reform. agencies for Initiate preparation of PIP, and enacting new telecommunications national anti-corruption public procurement and Implement anti-corruption and energy which strategy. debt management laws. strategy and prepare civil support transparency Adopt and publish national service reform strategy. anti-corruption strategy.  r Programmatic Approach: Financial Sector Reforms Strengthening financial intermediation through @@ :--,i, ~~~~~~~~ November 1998 February 2000 January 2002 March 2003 December 2003 August 1999 December 2000 July 2001 March 2002 fall 2003 2005 Establishing dialogue Banking Law, Introduce LLP tax Implement BRSA Advance regulatory Implement SDIF with the banking creation of an deductibility, consol. institutional enforcement, institutional sector, introducing independent Connected and forex development, remove substantially complete development, resolve comprehensive risk BRSA, exposure, institutional tax and legal hurdles BRSA and SDIF remaining insolvent management to 5 of intervention in strengthening of BRSA, for bank mergers, institutional development private banks, the largest/strongest failed banks, eliminate overnight repos resolve all 13 SDIF programs, resolve privatize Halk, new private banks, enabling law on and recapitalize SDIF and banks, re- remaining SDIF banks, insurance law, full provision of export privatization of state banks, revoke Emlak capitalization of improve legal/tax regime IAS for banks, listing finance. state banks. license & merge with private banks by for insolvency and debt and disclosure reform Ziraat, initiate owners, Vakif workouts, privatize Vakif for ISE, deposit recapitalization of privatized, and do Halk strategic insurance reform, remaining capital deficient operational re- study. consolidated private banks. structuring of Ziraat supervision, and Halk 50% privatization of complete. Ziraat, SDIF autonomy.  Turkev High Case: Business Lines Fiscal Years 1 FY 00 FY 01 FY02 FY03 FY 04 FY 05 FY 06 Sound Macroeconomics and Governance Public Finance Management Project Economic Reform Loan Programmatic Financial and Public Sector Adjustment Loan I Programmatic Financial and Public Sector Adjustment Loan II Programmatic Financial and Public Sector Adjustment Loan 3 Programmatic Public Sector Adjustment Loan I Health Sector Transformation Riclf hditinrh-m IAttractive Business Climate and Knowledae I I Total number of oDerations at vear end1 17 18 20 16 15 15 16 I  Annex AS Country Gender Assessment Summary A comprehensive gender assessment has been prepared by a group of Turkish experts covering ten areas to reflect gender issues with special relevance to poverty: the legal framework; education; health; labor and social security; microenterprises; rural women and poverty; migration, poverty and social protection; state, politics and civil society; violence against women; and disaster assistance (Turkey: Country Gender Assessment, draft, December 2002). Below are excerpts from the Conclusions of the draft report: "Regional and rural-urban differences were relevant in all sectors (particularly in education, health, labor and social security, and violence) and they appeared to compound gender differentials. Moreover, not only these two dimensions were highly instrumental in analyzing gender disparities, but they proved to be equally significant in understanding poverty. As expected, highest levels of gender inequality were found to coexist with worst cases of poverty in the society. Gender disparities reflected in women's unfavorable position get further magnified in all sectors in rural as opposed to urban areas and in Eastern, Southeastern and Black Sea regions, which also suffer from deeper poverty. Another striking observation was that the women in `second wave' of migrants experienced pronounced forms of gender inequality while the major transformation caused by this migration introduced new faces of poverty and disrupted existing social safety nets in urban areas. [...Icomparing dejure v. defacto dimensions o f gender equality also reflected significant differences between the two. For instance, despite the Civil Law providing for equal inheritance and property ownership rights for women and men since 1926, women are estimated to own less than 10% of agricultural land and about 9% of urban real estate. In light of the analyses of gender disparity [...I, main cross-cutting issues can be three identified. These constitute fundamental factors which are responsible for hampering women's attainment of equality with men in Turkish society. They are also inextricably linked to poverty, since they reflect women's inadequate access to opportunities and capabilities or inability to attain desirable levels of security and empowerment to escape poverty. Economic dependence of women emerges as a primary problem area. It i s reflected in findings such as low and decreasing labor participation rates of women; their higher urban unemployment rates; remarkably high proportions as unpaid family workers; lower average wages; high ratios in insecure jobs in the informal sector; disproportionately low ownership of real estate; inability to provide collateral as entrepreneurs in the different sector analyses. Lack of skills as reflected mainly by education and employment data constitutes another underlying force accounting for women's disadvantaged position in the society. It i s not only demonstrated in women's lower levels of literacy and education or  2 rural women's lack of access to technology and machinery and urban migrant women's inability to join the formal labor market, but also through the difficulties experienced by different groups of women in accessing information and services such as health, transportation, banlung or dealing with bureaucracies. Traditional values and cultural stereotypes pose a major obstacle for women to attain equality with men. Reflections of discriminatory and debilitating traditions and gender stereotypes are observed in the whole range of sectors reviewed. Sex-typing of occupations and gender-segregated labor markets; women primarily defined as `care givers' and men as `breadwinners'; women's lack of mobility; notions of women's outside work being considered incompatible marriage and motherhood are only some examples of such practices. Moreover, women's exposure to suppression and violence in the family and community i s often legitimized on the basis of traditions and culture that are internalized by women themselves to function as self-limiting influences. [...] The analyses and recommendations [...]regardingthe measures needed to combat gender inequality are also informative for poverty reduction strategies. In this context, targeting of poverty assistance schemes to vulnerable women (e.g., illiterate, non-workmg migrant women of the `second wave'; single migrant women; female headed households; rural older women) appears as the most obvious need for the short term. Similarly, immediate attention i s required to devise measures (e.g., insurance coverage) to reduce vulnerability of unemployeduninsured women in rural and urban areas. Short-term to medium-term measures are required to improve women's capabilities and opportunities. In order to address poverty, informing rural and urban women of assistance and job possibilities, as well as providing know-how and facilitating application for assistance and jobs promise significant benefits for the vulnerable groups. While neighborhood and community solidarity networks come across as important safety nets for needy women, their potential to function as social control agents on women thereby impeding women's long-term empowerment should not be overlooked. Literacy and vocational training of women to improve their chances of employment in better paying and securejobs can be provided by state and civil society agents, with a view to promote women's participation in unconventional areas. On the legislative front, enactment of equal opportunity legislation as well as legislation to prevent sexual harassment and discrimination at the work place; establishment of new mechanisms (e.g., gender ombuds) to monitor practices are deemed essential to ensure gender equality in the labor market. Comprehensive and coordinated efforts by state, civil society, and mass media as well as international organizations need to be expanded in the medium- to long-term to effectively combat discriminatory traditions and practices that impede women's economic independence and perpetuate low status in the family and community. To this end, sustained programs to socialize and train women and men in a `culture of equality' will ensure improvement of women's equal opportunities and empowerment."  Annex A6 Financial Accountability and PublicSector Governance Financial Accountability 1. Modernization of Turkey's system of public financial accountability in line with international standards i s an urgent public expenditure management priority. As detailed inthe August 2001CFAA, some of the basic buildingblocks are inplace: an established legal framework; reliable, albeit fragmented, accounting processes; regular reporting of financial results; an apparently independent Supreme Audit Institution, the Turkish Court of Accounts (TCA), which reports to Parliament; a relatively open system of accountability and plenty of skilled personnel. However, deeper analysis reveals significant problems andlack of systemic coherence. Complex institutional relationships, multiple sources of public funds, heavy emphasis on ex ante controls and inadequate reporting to the legislature reduce transparency and weaken financial management. Accounting and procurement legislation have not kept up with evolving international standards. Similar to the budget, the audit system i s fragmented with many bodies besides the TCA carrying out activities analogous to external inspectionand audit. 2. Accounting. Efforts to upgrade the public accounting system are steadily gaining momentum under the PFPSAL program after many years of limited progress. The say2000i automated accounting system i s operational invirtually all of the approximately 1,500 sites of the MOF's General Directorate of Public Accounting across Turkey. Under this internet based system, the MOF's central accounting data base contains data on all individual transactions wherever they occur in the system. The initiative to introduce modified accrual accounting in compliance with GFS requirements i s making progress. The Public Financial Management and Control (PFMC) law will replace the existing public accounting law (No. 1050) and provide MOF with permanent authority to issue budget coding and accounting standards for all general government agencies. The M O F has prepared a regulation referring to accounting policies and principles, and containing framework accounting standards and a framework chart of accounts consistent with GFS. This framework chart of accounts will be adapted to meet the specific requirements of individual agencies while maintaining full compliance with GFS standards.' The new chart of accounts i s being piloted within consolidated budget agencies including several joint pilots with the GFS budget classification. Following approval by TCA, the new accounting regulation will be published in the official gazette in 2003.2 Based in part on the experiences from the pilots, the timetable for the accounting reform has been revised and i s now as follows: (i) introduce modified accrual accounting in consolidated budget entities in 2004, (ii)begin introduction of the full ' The new chart of accounts is based on an economic classification. The coding for the functional, institutional and financial classifications are being built into the accounting software running under say2000i. This will be a framework chart of accounts which will be adapted by MOF to meet the specific requirements of individual agencies while maintaining overall consistency with GFS standards.  2 accrual basis in entities outside the consolidated budget in 2004, and (iii) introduce full accrual accounting for consolidated budget entities by 2007. The government accounting standards board to be established through the PFMC law will be responsible for transforming the framework standards included in the accounting regulation into full- fledged accounting standards over time. 3. Procurement. Turkey has moved decisively over the past year to upgrade its public procurement legislation and practices in line with international standards. The new public procurement law was enacted in January 2002. The new law i s based on the UNCITRAL model and moves Turkey in the direction of compliance with EUstandards. The independent Public Procurement Agency (PPA) established under the law to oversee public procurement and ensure enforcement of the new procurement standards i s fully operational. A set of technical amendments to the law were adopted in mid-2003, and the Government is working on new procurement legislation for SEESin the public utilities sectors consistent with the relevant EUdirective. 4. Auditinn. Effective financial accountability requires extensive modernization of Turkey's public audit system. The objectives are two fold: (i)clarify institutional responsibilities, promote improvements in audit quality in line with international standards and support the shift from ex-ante controls to ex-post monitoring in harmony with the efforts to improve operational performance; and (ii) expand the scope of TCA audits to cover the entire general government including local administrations, autonomous agencies, social security institutions, remaining extrabudgetary funds and revolving funds, with the overall objective of transforming the TCA into an effective state audit institution. These objectives will be facilitated by enactment of the PFMC law. With regard to audit quality, the law will clarify the roles and responsibilities of the line agencies, the MOF and the TCA. The law will establish a framework for decentralizing internal audit to the line agencies in line with EU requirements. It will allow the TCA to discontinue involvement in budget execution and focus on ex-post audits, including performance audits. With regard to the transformation o f TCA, the law will: (a) include all consolidated budget agencies under TCA's annual audit; (b) subject TCA's own accounts to external audit with reports submitted to the Parliament; and (c) expand the scope of TCA audits to cover the entire general government. As with any major institutional reform, the transformation of TCA into a modem state audit institution must be carefully designed to build consensus with the public administration. The TCA i s committed to undertake internal reforms to align its institutional structure with international standards for state audit institutions, to upgrade its audit capabilities, and to reach consensus with the other government audit bodies on implementation of the reform. A draft action plan for the TCA's internal reform has been prepared and will be improved, including through a peer review by auditors from other European state audit institutions. The action plan i s expected to be adopted by the Government and TCA in the fall of 2003.  3 Public Sector Governance 5. Good governance. A national strategy to enhance transparency and good governance in the public sector was published in March 2002 under the slogan "A Transparentand Clean Turkey: Together Hand in Hand". The objective of the strategy i s to provide a comprehensive framework for improving governance and reducing political influence over the economy which establishes clear priorities and benchmarks, and empowers and energizes public opinion to fight corruption. Priorities under the national anti-corruption strategy are summarized in Box 1below. The basic structure and actions of this strategy have been reflected in the Urgent Action Plan (UAP) of the new Government. The ministerial committee for enhancing transparency and improving good governance was established in March 2003. The committee will steer relevant actions of both the UAP and national strategy in this reform area. The ministerial committee will prepare regular implementation reports for the national strategy within the context o f the UAP. Among a comprehensive set of substantive actions is the Law on "Freedom of Information for Citizens", which has already been drafted and sent to agencies for comments. This law i s expected to be passedin the fall o f 2003. Legislation establishing a code of conduct for civil servants and public administrations i s expected to be passed by end-2003. The Government is counting on the active involvement of national non- governmental organizations (NGO) to improve public awareness about good governance. One of the major national NGOs, Foundation for Economic and Social Studies (TESEV), has completed two diagnostic surveys co-sponsored by the Bank on corruption covering households and the business community respectively. Work on a third survey covering civil servants was delayed by the elections. 6. Civil Service Reform. Sustained improvements in public governance will hinge in large part on effective reform of the civil service. Indeed, civil service reform features prominently in the national anti-comption strategy and features in the UAP. Civil service reform i s vital to raising the quality of public services and ensuring the quality o f the fiscal adjustment. The Government has already initiated work on a nom cadre system to establish benchmarks for staffing in public agencies which i s now operational within the Ministry of Education. There i s widespread acknowledgement that a more complete, medium-term approach i s needed in order to adapt the civil service to the changing role of government in Turkey and to internalize the on-going reforms to PEM. In addition to questions about the size and composition of the civil service in a changing Turkey, the reform will need to address issues such as distorted salary incentives, career development requirements and inadequate operational budgets in most agencies. In February 2002, a ministerial committee was established to oversee the preparation of a civil service reform strategy and carry out a full functional review o f government in preparation for further decisions about what functions to retain within government and what to devolve to the private sector. Preparations for the functional review were initiated in mid-2002, but then delayed by the run-up to elections. The functional review has been re-launched under the responsibility of SPO and the draft report was completed in July 2003. Responsibility for preparation of the civil service reform strategy has now been confided in the UAP to the State Personnel Presidency under the overall direction of a Deputy Prime Minister. A timetable of end-2003 has been set for the preparation and adoption of the civil service reform strategy by the Council of Ministers.  4 Box 1: Prioritiesunderthe NationalStrategy to EnhanceTransparencyandGood Governance inTurkey's PublicSector Accelerating the completion of ongoing work, within the framework of public administration reform, for institutional improvement and financial management. Implementing amendments to the Law on the Contents of a Declaration of Wealth, Bribery and Anti-Corruption (No. 3628) in order to make these declarations public and to require mandatory audits and public access to the declarations for all elected officials. Enacting regulations to ensure that inspections of campaign financing, income and the expenses of political parties and election candidates are made available to the public. Amending the existing Law on Political Parties to require that political parties and candidates make a public declaration of contributions from individuals and legal personsabove a fixed amount. The High Elections Board will be responsible for publishing and auditing this information. Implementing amendments to the Law on the Prevention of Money Laundering Law (No. 4208) to expand the list o f criminal activities giving rise to illegitimate profits and to restructure MASAK inorder to provide investigative powers to MASAK experts inspecific areas. Creation o f an Inspection and Audit Services Class and passage of an Inspection Law to put intc effect inspection standards, to allow for a complete restructuring of all inspection and auditing units, and tc implement changes to appointment procedures to allow for fixed-term appointment of presidents. . Amending the Civil Service Law (No. 657) to include a specific employment category for inspection anc auditing services. Establishing specialized courts to facilitate quick resolution of corruption cases. Founding specialized units within the security forces and under the supervision and inspection of the Chief State Prosecutor to investigate corruption cases. Implementing ethic agreementsinTurkey.  Annex A7 FundRelations Note Public Information Notice (PIN) No. 02/46 International Monetary Fund April 19,2002 700 19t" Street, NW Washington, D. C. 20431 USA IMFConcludes 00 Article IV Consultationwith Turkey On April 15, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Turkey.' Background Turkey i s in the midst of a determined campaign to turn around decades of weak performance. Not only has growth been on a downward trend since the 1970s (and inflation on an upward one), it has also become increasingly volatile. This performance reflects pervasive structural rigidities, weak public finances, and low policy credibility. Despite many achievements since the economic liberalization o f the 1980s, deep-rooted structural problems remain a drag on growth, and past disinflation attempts have had little success. The past couple of years have witnessed three major attempts at addressing underlying weaknesses. The first was during 2000 under the three-year Standby Agreement initiated in December 1999. The program instituted strong fiscal adjustment and a preannounced exchange rate crawl to restore debt sustainability and to break entrenched inflation expectations. The program also included a wide- ranging structural reform agenda-especially in banking, social security, privatization, and agriculture-to set Turkey on a higher sustainable growth path. Despite some notable achievements in structural reforms, inturning around the public sector primary balance, and in reining in inflation, a worsening current account and a fragile banking system led in late 2000 to a liquidity crisis which turned into a full-blown crisis, with a large loss of reserves. Prompted by political tensions, this was followed by another speculative attack in February 2001, forcing the government to float the currency amidst highinterest rates and a renewed acceleration in inflation. The second phase was the adoption in May 2001 of a strengthened program aimed at restoring investor confidence by addressing the roots of the crises, with the help o f additional IMF support. Under Article IV of the IMF'sArticles of Agreement, the IMFholds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. A t the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary i s transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the April 15, 2000 Executive Board discussion based on the staff report.  - 2 - The authorities' revised program featured a fundamental restructuring o f the banking sector (a key source o f vulnerability in the past), a commitment to a floating exchange rate (reducing vulnerability to shocks), continued disinflation, substantial fiscal adjustment to underpin debt sustainability, and an enhanced role for the private sector. Just as the revised program was beginning to show results, the events of September I 1 triggered a deterioration in market sentiment and a re-emergence of serious financing problems. Meanwhile, Turkey continued to suffer from an inefficient public sector, barriers to private sector development, a banking sector damaged by the earlier crises, and a high public debt burden, fuelled in part by publicly-funded bank recapitalization. In response to September 11, the Turkish government initiated a new intensified IMF-supported program, both to protect the economy against future crises, and to continue Turkey's ambitious reform agenda. Under the 2002-04 program, the continuation of the float will limit the potential for speculative attacks. Ongoing financial sector reform together with corporate sector restructuring will help strengthen the banking and business sectors, and continued fiscal discipline should foster medium-term debt sustainability. The program's strong structural reform agenda should, once macroeconomic stabilization i s achieved, finally set the stage for sustained economic growth. Developments under the new program have been promising. Financial market conditions have improved markedly from their post-September 11 lows; the benchmark bill rate has fallen sharply, and the Turkish lira has appreciated by more than 20 percent to around TL 1.3 million to the U.S. dollar. Against this background, the trend toward dollarization has diminished, and even shown signs of reversal in recent months, the stock market has risen by over 50 percent in lira terms since mid- September, and the roll-off of external interbank credits has ceased. Short-term concerns about the public debt rollover have also largely abated, allowing a lengthening of maturity of domestic debt and strong demand for new Eurobond issues. Inflation has started to decline, helping to reduce inflation expectations and allowing the Central Bank of Turkey (CBT) to reduce the overnight rate by 14points (to 66 percent) in three steps over the past two months. A large number of policy measures have been taken under the new program. In January, the authorities met more than ten prior actions in the fiscal and structural areas needed for the approval of the SBA. Subsequently, all quantitative performance criteria relevant for the first review were met. Base money came in below the end-February ceiling, while Net International Reserves and Net Domestic Assets targets were met comfortably. The public sector primary surplus target of 5.5 percent of GNP for 2001 was exceeded by an estimated 0.4 percent of GNP, and in January the consolidated government sector exceeded its primary surplus target comfortably. Solid progress has also been made in meetingthe program's structural conditionality. Executive BoardAssessment Executive Directors welcomed the Turkish authorities' decisive efforts to address the problems o f the past and implement an ambitious economic reform program to lay the basis for sustainable growth. In the past, financial indiscipline and structural weaknesses had prevented Turkey from realizing its economic potential, and had created an environment of highly volatile growth and inflation spanning several decades. These problems had their roots in fiscal laxity, deficiencies in governance, lack of a  - 3 - nominal anchor, and inefficiencies and nontransparencies in the public sector, and were evident in barriers to private sector development and a banking sector damaged by the two recent crises. Directors welcomed the Turkish authorities' progress in addressing these weaknesses and reduce the vulnerability o f the economy to shocks through their bold three-year program. They noted that the program represents a further decisive step away from the interventionist policies of the past, and that it would lay the groundwork for a stronger performance inthe future. In this regard, Directors commended the authorities for maintaining the positive momentum of macroeconomic adjustment and structural reform established in response to the events of September 1I.Macroeconomic policies have remained prudent; and the government has continued to press ahead with structural reform, notably with respect to the identification of public sector staffing redundancies and the adoption of the legislative basis for improved public debt management. The authorities' efforts have been rewarded by a substantial decline in interest rates, a strong balance of payments position with an associated appreciation of the Turkish lira, and a drop in inflation and in inflation expectations. Directors noted that, while these positive results should help lay the basis for sustainable growth, there are downside risks. In particular, they emphasized that the strength and timing o f the recovery in output are uncertain, and that financial markets have remained alert to the possibility of further shocks. Directors expressed concern that prolonged slow economic growth would have an adverse impact on Turkey's debt sustainability. To boost growth, they emphasized the importance of structural reforms to raise private investment and productivity and to lower real interest rates. Directors stressed that successful program implementation in the months ahead will require the undivided support of the government coalition. Directors stressed that, although fiscal developments remain on track, strict budget implementation must continue in order to ensure a sustainable debt position. While commending the authorities' commitment to the target of a public sector primary surplus of 6.5 percent of GNP in 2002, they stressed the need to remain mindful of possible downside risks, and urged the authorities to stand ready to take further offsetting measures to safeguard the primary surplus target and maintain external debt sustainability. Directors noted that, to be sustainable, the achievement of the overall budget targets will need to be underpinned by decisive reforms. They were encouraged by the government's efforts to improve expenditure management, streamline tax policy, and strengthen revenue administration. On the tax side, they stressed the importance of simplifying the tax code. On the expenditure side, they noted the importance o f moving expeditiously with the much-needed downsizing o f the state economic enterprises and civil service reform. Directors noted the increasing scope for monetary policy to promote disinflation and enhance confidence. In this regard, Directors were encouraged by the recent decline in current and expected inflation. The introduction o f inflation targeting will further anchor inflation expectations. While a number of Directors noted that, with strong efforts by the CBT and the government, the preconditions for introducing formal inflation targeting could be in place by midyear, some other Directors  - 4 - considered that a longer track record on disinflation would be needed for such a framework to be credible. Regarding reserve management, they urged the CBT to continue to make use of the better- than-expected balance o f payments developments to build up foreign exchange reserves, which should further improve confidence, and welcomed the authorities' recent move to pre-announced foreign exchange purchase auctions. They urged further development of the money and foreign exchange markets to help ensure a smoother functioning of the floating exchange rate regime, and welcomed the authorities' plans to lower distortionary taxes and reform the system of reserve requirements. They also stressed the need to closely monitor Turkey's external competitiveness in light of the recent appreciation of the Turkishlira. Directors welcomed the progress in banking sector reform, including the implementation of the bank recapitalization plan, but called for further rapid movement on corporate debt restructuring. Moving forward, Directors stressed the importance of preserving the integrity and transparency of the bank recapitalization process, and of sticking to its announced timetable. They also underlined the need to maintain the independence of Turkey's regulatory institutions. Directors urged the authorities to accelerate privatization now that market conditions are more favorable, noting that inefficiencies in state economic enterprises are a core factor behind Turkey's disappointing growth performance inthe last decade. Similarly, Directors urged the government to be forceful in demonstrating its commitment to dealing with deficiencies in the investment environment and promoting transparency and efficiency o f public administration both at the central and local levels. Directors welcomed the measures taken to combat money laundering and the financing of terrorism. Directors commended recent moves to improve transparency and data provision. Although some deficiencies remain in fiscal statistics, they welcomed the recent extensive improvements in fiscal transparency.  - 5 - Press ReleaseNo. 03/135 InternationalMonetaryFund August 1,2003 700 19thStreet,NW Washington, D.C. 20431USA The Executive Board o f the International Monetary Fund(IMF) today completed the fifth review of Turkey's economic performance under its Stand-By Arrangement. Completion of the review enables Turkey to draw SDR 340.2 million (about US$476 million) immediately under the arrangement. The Executive Board also approved a one-year extension to the obligation dates of time-based repurchase expectations for the period 2004 and 2005 in an aggregate amount equivalent to SDR 8.2 billion (about US$11 billion). Turkey's Stand-By Arrangement was approved on February 4, 2002 (see Press Rclcase No. 02/7) in a total amount o f SDR 12.8 billion (about US$18 billion). So far, Turkey has drawn SDR 10.4 billion (about US$15 billion) under the arrangement. Followingthe Executive Board discussion, Horst Kohler, Managing Director and Chairman, said: "The Turkish authorities have made strong and welcome efforts in recent weeks to implement their program o f stabilization and economic reform. These include the measures put in place to safeguard the primary surplus target of 6%percent of GNP, the enactment of legislation to underpin social security reform while excluding amnesties, and the progress made on the program's structural reform agenda. These actions bring policies back on track to achieve the basic objectives of the Fund-supportedprogram, namely, disinflation, debt reduction, and sustained economic growth. "Economic conditions have improved following the rapid conclusion of the war in Iraq. Progress on European Union-related legislation i s also welcome; this has undoubtedly contributed to improved market sentiment. With strong output recovery and continued disinflation so far this year, the program's projections of 5 percent output growth and 20 percent inflation in 2003 are within reach. However, real interest rates remain high reflecting underlying fragilities. "Completion of the review provides a valuable opportunity for the Turkish authorities to demonstrate full program ownership, and continue with consistent and steadfast program implementation. Key in this regard would be the maintenance of fiscal discipline to safeguard the 6% percent of GNP primary surplus target, not only for this year but also in 2004. "The Central Bank of Turkey (CBT) i s to be commended on its skillful conduct of monetary policy. The CBT has successfully managed to increase confidence in its inflation objective, cut interest rates and accumulate reserves. The diligence shown by the Banking Regulation and Supervision Agency (BRSA) in its supervision o f banks i s welcome, as are other banking sector reforms. The  - 6 - authorities need to build on this progress by further improving bankruptcy procedures, privatizing state banks, and resolving the intervenedbanks. To enhance policy credibility, the authorities need to strengthen the operational and financial independence of regulatory agencies, including the BRSA. "In line with Fund policy, the Fund's Executive Board supported moving part of Turkey's repayments from 2004-05 to 2005-06 to strengthen debt management and thereby contribute to the success of the authorities' reform program. "Continued strong policy actions will allow Turkey to achieve its macroeconomic targets and maintain a viable debt position in the medium term. The Government's recent actions bode well for the success of the Fund-supported program. On this basis, Turkey's efforts deserve the continued support of the international community," Mr.Kohler stated.  Annex B1 Turkey at a glance 9/26/03 Europe & Lower- POVERlY and SOCIAL Central middle- Turkey Asia income Developmentdiamond' 2002 Population,mid-year (millions) 69.6 476 2,411 Lifeexpectancy GNI per capita (Atlas method, US$) 2,500 2,160 1,390 GNI (Atlas method, US$ billions) 173.9 1,030 3,352 Average annual growth, 1996-02 Population(%) 1.7 0.1 1.o Labor force (%) 2.2 0.4 1.2 GNI Per Most recent estimate (latestyear available, 1996-02) capita Poverty (% of population below nationalpovertyline) Urbanpopulation(% of totalpopulation) 77 63 49 Life expectancy at birth (years) 70 69 69 - Infant mortality(per 7,000 live births) 33 25 30 Child malnutrition(% of children under 5) 8 11 Accessto imDrovedwater source Access to an improvedwater source (?Aofpopulation) 82 91 81 Illiteracy(% ofpopulation age 15+) 14 3 13 Gross primary enrollment (% of school-age population) 101 102 111 - Turkey Male 105 103 111 __Lower-middle-incomegroup Female 96 101 110 KEY ECONOMIC RATIOS and LONG-TERMTRENDS 1982 1992 2001 2002 Economic ratios' GDP (US$ billions) 64.4 158.9 145.2 183.7 Gross domesticinvestmenUGDP 17.0 23.9 16.8 21.3 Exports of goods and serviceslGDP 11.9 14.4 33.7 28.7 Trade Gross domesticsavingslGDP 13.8 20.9 19.2 19.6 - Gross nationalsavingslGDP 18.5 24.4 20.7 20.6 I Current account balancelGDP -1.5 -0.6 2.3 -0.8 InterestpaymentslGDP 1.a 2.0 3.6 3.4 Domestic ~ Investment Total debVGDP 30.6 35.6 78.5 71.6 savings Total debt servicelexports 29.4 32.1 44.0 38.2 Present value of debVGDP I Present value of debVexDorts Indebtedness 1982-92 1992-02 2001 2002 2002-06 (average annualgrowth) - GDP 5.1 2.8 -7.5 7.8 4.7 Turkey I GDP per capita 2.7 1.o -9.0 6.1 3.6 1 - Lower-middle-incomegroup Exports of goods and services 5.5 11.4 7.4 11.0 4.9 STRUCTURE of the ECONOMY 1982 1992 2001 2002 1 Growth of investment and GDP (Yo) (% of GDP) I Agriculture 22.7 15.3 12.8 13.0 industry 25.1 29.9 26.1 25.4 Manufacturing 17.7 18.9 15.8 16.0 Services 52.2 54.7 61.1 61.6 I 1 - 4 0 - Private consumption 76.3 66.2 66.6 66.2 ~-50 - General government consumption 9.9 12.9 14.2 14.0 - Imports of goods and services 15.0 17.3 31.3 30.4 GDI ' I O I G D P 1982-92 1992-02 2001 2002 (average annualgrowth) Growth of exports and imports (%) I Agriculture 1.4 1.1 -6.0 7.6 Industry 7.2 2.6 -7.2 5.7 Manufacturing 7.2 3.3 -8.0 8.2 Services 4.2 3.1 -6.2 7.0 Private consumption 4.3 2.2 -9.2 2.6 General government consumption 3.4 4.4 -8.5 5.4 -30 - Gross domestic investment 5.0 1.1 -42.0 35.7 -Exports -Imports Importsof goods and services 8.8 8.3 -24.8 15.7 I ~ Note 2002 data are preliminary estimates *The diamonds show four key indicators in the country (in bold) comparedwith its income-groupaverage If data are missing, the diamond will be incomdete  Turkey PRICES and GOVERNMENT FINANCE I 1982 1992 2001 2002 Domestic prices (% change) Consumer prices .. 70.1 53.9 44.8 Implicit GDP deflator 28.2 63.7 54.8 43.8 Govemment finance 40 (% of GDP,includes current grants) Current revenue 19.0 29.3 28.1 Current budget balance -1.3 -15.0 -4.6 Overall surplusideficit ...... -10.7 -21.9 -12.2 TRADE 1982 1992 2001 2002 (US$ millions) Exportand importlevels(US$ mill.) Total exports (fob) 5,890 14,891 34,373 39,827 60,000 Textiles 1,145 5,603 10,344 12,066 Processed agricultural products 1,571 2,293 1,876 1,705 50,000 Manufactures 4,655 13,440 28,695 32,673 40,000 Total imports (cif) 0,843 22,871 41,399 51,270 30,000 Food 123 1,398 848 1,211 20,000 Fuel and energy 3,943 3,903 8,316 8,955 10.000 Capital goods 2,214 7,970 7,344 8,949 0 Export price index (1994-100) 87 90 99 Q6 97 98 99 00 01 02 Import price index (1994=100) 87 09 98 QExports mlmports Terms of trade (1994-100) .. 100 101 101 BALANCEof PAYMENTS11 1982 1992 2001 2002 (US$ millions) Currentaccountbalanceto GDP (%) Exports of goods andservices 7,818 23,343 50,403 54,608 ' 7 . Imports of goodsand services 9,592 26,706 45,816 55,095 Resource balance -1,774 -3,363 4,507 -487 Net income -1,455 -1,670 -5,000 -4,549 Net current transfers 2,277 4,059 3,803 3,496 Current account balance -952 -974 3,390 -1,540 Financing items (net} 1,120 2,458 -16,314 1,328 Changes in net reserves -168 -1,484 12,924 212 Memo: I Reserves includinggold (US$ millions) 2,027 15,252 30,192 38,067 Conversionrate (DEC, local/US$) 162.9 6,881.3 1,228,367 1,505,290 EXTERNAL DEBT and RESOURCEFLOWS 1982 1992 2001 2002 (US$ millions) Compositionof 2002 debt(US$ mill.) Total debt outstandingand disbursed 19,716 56,554 113,949 131,551 IBRD 1,962 5,564 4,707 5,367 IDA 107 148 95 89 G 15.155 A 5'367 R RQ Total debt service21 2,968 9,086 24,606 22,540 IBRD 209 1,207 723 708 IDA 3 6 7 7 Composition of net resourceflows Official grants 307 506 0 334 Official creditors 762 -509 74 797 Privatecreditors 146 3,604 -2,187 3,811 Foreign direct investment 55 779 2,769 862 Portfolioequity 0 -1,194 -4,611 -1,180 World Bank program Commitments 648 686 2,200 1,650 A IBRD E. Bilateral Disbursements 500 286 1,537 1,031 B IDA D Other multilateral - F - Private Principal repayments 86 733 437 442 C IMF --- G Short-term - Net flows 415 -447 1,100 588 Interestpayments 127 480 292 272 Net transfers 288 -928 808 316 DevelopmentEconomics 9/26/03 I / 2001 and 2002 are based on the new classification 2/ Year 2002 figure does not include the SRF payment of $6.1 billion.  CAS Annex B2 Turkey - Selected Indicators* of Bank Portfolio Performanceand Management As of 06/30/2003 Indicator 2001 2002 2003 PortfolioAssessment Number of Projects Under Implementationa 19 20 16 Average Implementation Period(years) 3.4 3.8 4.2 Percent of Problem Projects by Number 15.8 25.0 6.3 Percent of Problem Projects by Amount as 14.7 18.8 6.8 Percent of Projectsat Risk by Number a,d 15.8 25.0 6.3 Percent of Projectsat Risk by Amount a,d 14.7 18.8 6.8 Disbursement Ratio (%) e 21.2 17.5 22.0 Portfolio Management CPPR during the year (yes/no) Yes Yes Yes Supervision Resources(total US$ million) 2.1 3.0 2.5 Average Supervision(thousand US$/project) 112 149 142 Memorandum Item Since FY 80 Last Five FYs Proj Eva1by OED by Number 97 13 Proj Eva1by OED by Amt (US$ millions) 10,365.7 2,482.0 % of OED Projects Rated U or HU by Number 30.5 8.3 % of OED Projects Rated U or HU by Amt 32.5 1.I a. As shown in the Annual Report on Portfolio Performance (exceptfor current FY). b. Average age of projects in the Bank'scountry portfolio. c. Percent of projectsrated U or HU on development objectives (DO) and/or implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio of disbursementsduring the year to the undisbursed balanceof the Bank's portfolio at the beginningof the year. Investmentprojects only; hybrid operationsare considered adjustment loans. * All indicatorsare for projects active in the portfolio, includingGEF grants, with the exception of the DisbursementRatiowhich includesall active projects as well as projects which exited during the FY.  CAS Annex B3 IBRD ProgramSummary Turkey - - ProposedIBRD High-CaseLendingProgramal As of 06/30/2003 Fiscalyear Proj ID US$(M) Strategic Rewards b/ Implementationb/ (H/M/L) Risks (H/M/L) 2004 PFPSAL3 900.0 H H EXPORT FINANCE II 300.0 M L HEALTH SECTOR TRANSFORMATION 200.0 H M RENEWABLE ENERGY 202.0 M L MlRCOWATERSHED 37.0 M L Result 1,650.0 2005 PPSAL 500.0 H H MUNICIPAL REFORMAND SERVICES 200.0 H H RAILWAY RESTRUCTURING 200.0 H H KNOWLEDGE ECON. & TECH DEVT 100.0 M M SEISMIC RISK MITIGATION 400.0 M L SECONDARY EDUCATION 200.0 M M Result 1,600.0 2006 PPSAL II 400.0 H H PFSAL I 400.0 H H SME FINANCE 100.0 M L ENERGY 100.0 M M RURAL DEVELOPMENT 250.0 H M Result 1,250.0 Overall Result 4,500.0 a/ This table presents the proposedhigh case lendingprogram for the next three fiscal years. The amounts are rounded. The low case program amountsto US$I.3 billion. b/ Foreach project, the table indicateswhether the strategic rewards and implementation risks are expected to be high (H), moderate(M), or low (L).  CASAnnex B3 (IFC & MIGA) for Turkey Turkey IFCandMIGA Program,FY 2000-2003 - - 2000 2001 2002 2003 IFCapprovals(US$m) 181.18 108.51 283.77 118.60 Sector (%) FINANCIAL SERVICES 32 51 51 8 FOOD & AGRO-BUSINESS 24 HOTELS & TOURISM 1 INFRASTRUCTURE 14 1 MANUFACTURING 14 37 27 65 OIL, GAS andMINING 17 PRIMARYMETALS 9 SOCIAL,SERVICES 11 2 9 TEXTILES 11 1 TIMBER,PULP & PAPER 6 8 Total 101 100 100 100 Investmentinstrument(%) Loans 83 63 91 100 Equity 3 9 4 Quasi-Equity 14 5 5 Other 23 Total 100 100 100 100 MIGA guarantees (US$m) 246.9 153.8 256.9 213.9  CAS Annex 64 Summaryof NonlendingServices Turkey - - As of 0613QI2QQ3 Product Completion FY Cost (US$OOO) Audience a/ Obiective b/ Recent completions Policy Notesfor the New Government FY03 35 GDPB KG,PS CEM FY03 270 GDPB KG,PS Non-Bank Financial InstitutionsReport FY03 330 GDPB KG,PS Municipal Sector Review FY03 175 GDB KG,PS Water Sector Report FY03 60 GDB KG,PS EnergySector Strategy FY03 60 GDB KG,PS Gender Assessment FY03 50 GDB KG,PD EU Accession Conference FY03 50 GDPB KG,PD Underwaylplanned CAS FY04 300 GDPB KG Labor Market Study FY04 295 GDB KG,PD,PS Social Cost of Adjustment FY04 100 GB KG Impact of Agriculture Sector Reforms FY04 140 GDB KG,PS Banking Sector Report FY04 100 GDB KG KnowledgeEconomyAssessment FY04 190 BDPB KG,PD,PS InvestmentClimate Dialogue FY04 125 GB KG,PS Gas Sector Note FY04 50 GB KG,PS Caspian Oil and Gas Dialogue FYO4 15 GB KG NGO Outreach FY04 95 GPB PD,PS CEM FY05 350 GDPB KG,PD,PS PovertyAssessment FY05 120 GDPB KG,PD,PS Rural Sector Study FY05 140 GDB KG,PS Education FY05 150 GDB KG Environment FY05 70 GDB KG PS NGO Outreach FY05 150 GPB PD,PS CAS PR FY05 100 GDPB KG CFAA FY06 30 GB KG,PS CPAR FY06 30 GB KG,PS PElR FY06 300 GDPB KG,PD,PS NGO Outreach FY06 150 GPB PD,PS a/ Government,donor, Bank, public dissemination, b/ Knowledgegeneration,public debate, problem-solving.  Annex B5 Turkey Social Indicators Latest single year Same region/income group Europe& Lower- Central middle- 1970-75 1980-85 1995-2001 Asia Income POPULATION Total population, mid-year (millions) 40.0 50.3 66.2 474.6 2,163.5 Growth rate (YOannual averagefor period) 2.5 2.5 1.5 0.1 1.o Urban population (% of population) 41.6 52.5 66.2 62.8 45.6 Total fertility rate (birthsper woman) 4.7 3.8 2.3 1.6 2.1 POVERTY ("7 of population) National headcount index Urbanheadcount index Rural headcount index INCOME GNI per capita (US$) 1,180 1,320 2,530 1,970 1,230 Consumer price index (1995=100) 0 1 2,439 Food price index (1995=100) 1 201 INCOMEKONSUMPTIONDISTRIBUTION Gini index 40.0 Lowest quintile (% of incomeor consumption) 6.1 Highestquintile(% of incomeor consumption) 46.7 SOCIAL INDICATORS Publicexpenditure Health (%of GDP) 3.6 4.0 2.6 Education(%of GDP) 2.1 1.8 3.5 4.4 4.6 Social security and welfare (% of GDP) 0.3 0.2 2.7 8.8 Net primaryschool enrollment rate (% of age group) Total 9a 99 92 Male 102 92 Female 96 93 Access to an improvedwater source ("7ofpopulation) Total 82 91 80 Urban a i 96 95 Rural 86 a3 70 Immunizationrate ("7under 12months) Measles 61 90 95 84 DPT 55 88 94 83 Child malnutrition (% under 5 years) 8 10 Life expectancyat birth (years) Total 59 63 70 69 69 Male 57 61 67 64 67 Female 62 66 72 73 71 Mortality infant (per 1,000 live births) 127 82 36 31 33 Under5 (per 1,000 livebirths) 167 104 43 38 41 Adult (15-59) Male (per 1,000 population) 218 317 205 Female(per 1,000 population) 120 137 130 Maternal (modeled, per 100,000N e births) 55 Births attended by skilledhealth staff (%) 76 a i 87 Note: 0 or 0.0 means zero or lessthan half the unit shown. Net enrollment rate: break in series between 1997and 1998due to change from ISCED76to ISCED97; ratios exceeding 100indicate discrepancies betweenthe estimates of school-agepopulation and reportedenrollment data. 2003 World DevelopmentIndicatorsCD-ROM,World Bank  Annex B6 Page 1 of 2 Turkey Key Economic Indicators - Estimate Projected Indicator 2001 2002 2003 2004 2005 2006 National accounts (as % of GDP) Gross domestic producta 100 100 100 100 100 100 Agriculture 13 13 12 12 12 11 Industry 26 27 27 27 27 27 Services 61 60 61 61 62 61 Total Consumption 81 84 86 84 83 82 Gross domestic fixed investment 18 18 18 18 19 19 Government investment 6 6 6 6 6 6 Private investment 13 12 12 12 13 13 Exports (GNFS)b 34 30 27 27 28 28 Imports (GNFS) 31 30 29 28 28 28 Gross domestic savings 19 16 14 16 17 18 Gross national savings' 21 17 15 17 18 19 Memorandum items Gross domestic product 145,244 183,665 235,940 259,990 279,266 299,857 (US$ million at current prices) GNF' per capita (US$, Atlas method) 2410 2500 2720 3270 3720 3990 Real annual growth rates (%, calculated from 1994prices) Gross domestic product at market prices -7.5 7.8 4.8 4.7 4.5 4.8 Gross Domestic Income -8.3 9.9 5.1 6.1 4.8 5.3 Real annualper capita growthrates (%, calculated from 1994prices) Gross domestic product at market prices -9.0 6.1 3.2 3.1 3.O 3.3 Total consumption -10.6 13.6 6.5 2.7 1.4 2.1 Private consumption -10.7 14.7 7.3 2.5 1.2 1.9 Balance of Payments (US$millions) Exports (GNFS)b 50,403 54,608 63,292 70,120 76.800 83,550 Merchandise FOB 34,373 39,827 47,484 52,515 58,225 63,998 w o r t s (GNFS)~ 45,816 55,095 68,043 72,846 77,517 82,572 Merchandise FOB 38,916 48,194 59,759 63,847 67,949 72,425 Resource balance 4,587 (487) (4,750) (2,726) (717) 977 Net current transfers 3,803 3,496 3,611 4,056 4,546 4,757 Current account balance 3,390 (1,540) (7,496) (5,264) (3,056) (550) Net private foreign direct investment 2,769 862 1,327 1,042 1,280 1,567 Long-termloans (net) (1,131) 2,832 3,647 3.841 4,653 4,373 Official 1,296 1,651 692 1,170 529 (147) Private (2,427) 1,181 2,956 2,671 4,124 4,520 Other capital (net, hcL errors &ommissions) (17,952) (2,366) 3,051 3.059 3,292 4,932 mange inreservesd 12,924 212 (530) (2,678) (6,168) (10,321) Memorandum items Resource balance (% of GDP) 3.2 -0.3 -2.0 -1.0 -0.3 0.3 Real annual growthrates ( YR94 prices) Merchandise exports (FOB) 16.2 10.6 10.6 9.0 9.7 8.7 Merchandise imports (0 -23.2 21.2 12.6 6.4 5.9 6.1 (Continued)  Annex 66 Page 2 of 2 Turkey Key Economic Indicators - (Continued) Projected Indicator 2001 2002 2003 2004 2005 2006 Public finance (as % of GDP at market prices)e Current revenues 29.3 28.1 30.2 30.5 30.7 30.2 Current expenditures 44.3 32.7 31.9 29.8 29.4 27.0 Current account surplus (+) or deficit (-) -15.0 -4.6 -1.7 0.7 1.4 3.2 Capitalexpenditure 6.9 7.6 7.5 7.4 7.7 7.7 Foreignfinancing 0.7 8.5 1.3 1.7 0.3 -0.5 -21.9 -12.2 Monetary indicators M2/GDP 40.8 41.7 42.5 45.1 46.4 45.5 Growthof M2 (%) 29.4 26.0 33.9 25.4 18.0 9.1 Privatesector credit growth/ 65.0 70.6 78.3 65.0 70.3 40.7 total credit growth (%) Price indices( YW4 =loo) Merchandise export price index 87.3 90.1 99.0 100.5 101.6 102.7 Merchandiseimport price index 87.3 89.2 98.2 98.6 99.1 99.6 Merchandise terms of trade index 100.0 101.0 100.8 101.9 102.5 103.1 GDP deflator (% change) 54.8 43.8 25.2 12.9 9.8 6.2 a. GDP at factor cost b. "GNFS" denotes "goods andnonfactorservices." c. Includesnet unrequitedtransfers excludingofficial capital grants. d. Includesuse of IMFresources. e. Consolidatedcentralgovemment. f. "LCU" denotes "localcurrencyunits." An increaseinUSS/LCU denotesappreciation.  Annex B7 Page 1 of 1 Turkey Key Exposure Indicators - Projected Indicator 2001 2002 2003 2004 2005 2006 Total debt outstanding and 113,948 131,551 136,212 140,295 140,283 138,156 disbursed ( D O ) (US$m)" Net disbursements (US$m)a (4,742) 40,301 29,997 24,163 18,235 5,792 Total debt service (TDS) 24,606 22,540 27,340 30,485 33,515 36,985 (US$m)a Debt and debt service indicators (%) TDO/XGSb 203.7 222.8 201.3 186.6 170.6 153.4 TDO/GDP 78.5 71.6 57.7 54.0 50.2 46.1 TDS/XGS 44.0 38.2 40.4 40.6 40.8 41.1 Concessional/TDO 3.6 3.2 3.3 3.3 3.3 3.3 IBRDexposure indicators (%) IBRDDS/public DS 5.5 4.7 3.1 3.2 3.4 3.4 Preferred creditor DS/public 24.8 14.6 16.3 23.7 29.0 33.8 DS (5%)' IBRDDS/XGS 1.3 1.2 1.2 1.3 1.5 1.5 IBRD TDO (us$mld 4,707 5,367 6,005 7,019 7,970 8,179 Share of IBRDportfolio (96) 3.9 4.4 5.2 6.3 7.3 7.5 IDA TDO (us$m)d 95 89 84 79 74 68 a. Includes public andpublicly guaranteed debt, privatenonguaranteed, use of IMFcredits andnet short- term capital. b. "XGS" denotes exports of goods and services, including workers' remittances. Year 2002 figure does not include the SRF payment of $6.1billion. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bankfor International Settlements. d. Includes present value of guarantees. e. Includes equity and quasi-equity types of bothloan and equity instruments.  E 2 -.- a a n E a P L 'ia* b  CAS Annex 68 (IFC) for Turkey Statement of IFC's Heldand DisbursedPortfolio As of 06/30/03 (In US DollarsMillions) 1998 AdanaCement 5 00 0 0 OW 5 00 0 0 ow 200112003 Akbank 55 w 0 0 0 00 55 00 0 0 0 00 199612000 Alternatif Bank 5 36 0 5.00 000 2 36 0 5 00 000 1995/1996/200112003 Arcelik 76 66 0 0 50 03 76 66 0 0 50 03 2000 Arcelik LG Klima 1377 0 0 4 71 1377 0 0 4 71 1994/1997/2002 ASSan 26 99 0 1.50 000 26 99 0 150 0 00 2002 Atilim 6 50 0 0 000 4 58 0 0 0 00 2wO Banvit 1500 5 00 0 ow 15 00 5.00 0 000 19941199@2000 BayindirbankA.S 7 50 0 0 000 7 50 0 0 0 00 2002 Beko 29 03 0 0 29 03 29 03 0 0 29 03 2w1 Bilgi 1200 0 0 000 12w 0 0 OW 1994/1995/199611997 Borcelik 1000 9 66 0 0 00 1000 9 66 0 ow 1995/1996 CBS Boya Kimya 0 3 65 0 OW 0 3.65 0 0 00 1994 CBS Holding 400 0 0 000 4 00 0 0 ow 199612001 CBS Printas 0 OM 0 0 00 0 0.64 0 ow 1992 Cayeii Bakir 4 20 0 0 000 4 20 0 0 OW 19901199312002 Conrad 1064 0 0 000 1064 0 0 000 199711998 Demir Leasing 111 0 0 000 111 0 0 OW 2002 EKS 1214 0 0 000 1214 0 0 ow 19861199311996 Elginkan 0 40 0 0 000 040 0 0 000 1995 Entek 21 25 0 0 1491 21 25 0 0 1491 199711998 Finans Leasing 111 0 0 000 111 0 0 ow 19901999 Finansbank 6 67 0 0 1035 6 67 0 0 1035 1994/199wzo00 Garanti Leasing 111 0 0 000 111 0 0 000 1999 GumussuyuKap 400 0 3.24 ow 400 0 324 ow 2001 Gunkol 6 69 0 6.69 ow 6 69 0 6 69 000 1998 lndoramalplik 6 88 0 66 0 000 6 88 0.66 0 000 199612000/2002 lpek Paper 33 68 0 5.00 1329 33 88 0 5w 1329 1990 Kepez Elekirik 6 48 0 0 000 6 48 0 0 0 00 19861199011996 Kiris 25 W 0 0 000 25 00 0 0 000 1991 Kuia 4 93 0 0 000 4 93 0 0 0 00 199311996 Medya 2 47 0 4.99 0 00 2 47 0 4 99 000 2w2 MilliRe 50 00 0 0 000 ow 0 0 000 199612w2 Modern Karlon 22 73 0 0 000 22 73 0 0 ow 1991 NASCO I018 0 0 3 55 1018 0 0 3 55 2002 Pasabahce 7 50 0 0 000 7 50 0 0 OW 1998 Pasabahce-Schotl 2 43 0 0 0 00 2 43 0 0 OW 1983/199411998 Pinar ET 6 29 0 0 000 6 29 0 0 000 199412WO Pinar SUT 1608 0 0 000 1281 0 0 000 1999 SAKoSa 21 67 0 0 1695 21 67 0 0 1695 198M99011998 Silkar Turizm 2 98 0 0 3 40 2 98 0 0 340 1993/1996120002W3 Sise Ve Cam 97 85 0 0 39 28 59 17 0 0 1511 199612002 Soktas 11 79 0 0 000 11 79 0 0 ow 1999 TEB Finansal 2 22 0 0 000 2 22 0 0 0 00 1979/1980198311989/19911199611999 TrakyaCam 0 343 0 000 0 3.43 0 000 1995/1999/2002 Turk EkonBank 26 67 0 15.00 ow 26 67 0 1500 ow 2001 Turkish PEF 0 1000 0 000 0 120 0 000 1999 UnyeCement 1457 0 0 000 1457 0 0 000 1999 Uzel 9 48 0 0 5 69 948 0 0 5 69 197W1971119801983'1998 . Viking 8 17 0 0 0 00 8 17 0 0 000 1995 YalovaActylic 2 50 0 0 133 2 50 0 0 1 33 199711998 Yapi Kredi Lease 0 96 0 0 0 00 0 96 0 0 000 Approvals PendingCommitmentfor Turkey As of 06l30l03 (In US DollarsMillions) 2001 Akbank 10022 000 25 00 0 00 000 25 00 80 00 2003 Cayeli Expan2 11690 000 000 20 w 000 20 00 0 00 2wO Erbakir 9602 000 0 00 5 00 5 00 1000 0 00 2002 KCC 11309 OW 0 00 50 00 000 50 00 000 2003 MESA Hospital 20661 0 00 0 00 11 w 000 11 00 OW 2002 Mil11Reasurans 11061 1000 000 000 0 00 1000 000 2w3 Slsecam EXD 11627 000 000 0 00 000 0 00 7 50 2002 T i 8 ' 11325 3 00 000 c 00 0 co 000 5c 00 TOTAL Pmdlng: 10.00 25.W 86.00 5.00 126.w 137.50  I  x            c     \