Turkey - Economic development (Vol. 2 of 5) : Domestic and external finance

I |e iv N j~ n Report No. 316a-TU The Economic Development of Turkey (In Five Volumes) Volume II: Domestic and External Finance April 22, 1974 Country Programs Department II Europe, Middle East and North Africa Region Not for Public Use Document of the International Bank for Reconstruction and Development International Development Association This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report.  CURRENCY EQUIVALENTS Prior to August 9, 1970 US $1.00 TL 9.00 TL 1.00 US $0.11 August 9, 1970 to December 22, 1971 US $1.00 = TL 15.00 TL 1.00 = US $0.067 After December 22, 1971 US $1.00 = TL 14.00 TL 1.00 = us $0.07  VOLUME II DOMESTIC AND EXTERNAL FINANCE Table of Contents Page No. Chapt. 5 PUBLIC FINANCE *.............................. 1 Central Government ................ ... ..****** 3 Local Governments ............... . , 6 State Economic Enterprises 7 Current Outlook ..... 0"...........0 4"00***.**0..* 12 Third Plan Targets .0. . . . . . . ......0094*0600000000 12 Revenue Policy .0..00*.. ...............* .. .... 0 15 SEEs Policies 01 00000e00.09000 00 0000.0 16 Current Spending Policy ... .................. 17 Public Saving Prospects ..................... 18 Borrowing Policies ..................... 18 Short-Term Budgetary Policy ......... 19 Chapt. 6 THE FINANCIAL SYSTEM, MONEY AND PRICES ........... 20 The Financial System . . 20 Interest Rate Policy . . 22 Money and Credit ....... 28 Credit Distribution and Policies .................. 29 Selective Credit Policies ..................... 31 Medium-Term Credit ....36 The Securities Market 38 Policies Recommendations 43 Prices and Price Policies 45 Changes in Relative Prices ....48 affects of Price Policies -.53 Monetary Policy and Price Stability .............. 54 Chapt. 7 TRADE, EXTERNAL PAYMENTS AND DEBT .............. 56 Exchange and Trade Policies and Controls . 56 The Effects of the System of Controls .......59 Current Account ......... .......... , 60 The Services Account .... 64 Capital Movements, Reserves and External Debt .... 64 Official Capital and External Debt .........o..... 66 Balance of Payments Prospects 68 Exchange and Trade Policy Prospects 72 Annex 1 - Relations with the European Economic Community (EEC) Annex 2 - Convertible Lira Accounts o Annex 3 - Enigrant Workers' Remittances ..........   VOLULE II CHAPTER 5 PUBLIC FINAN4CE 5.1 The public sector, which comprises the Central Government, several levels of local governments and a large sector of state economic enterprises (SEEs), increased its relative importance during the past two decades, and particularly in the 1960's. This increase was accoinpanied by remarkable continuity in the main directions of Government policies despite changes in the political leadership of the country. Successive Turkish Governments e:pnaded considerablv the physical infrastructure which the growth of all econOMic activities, particularlv industry and mining, required. The Govern- ment itself invested growiing amounts in state economic enterprises mainly to pursuie the objective of rapid industrialization. It also made special efforts to raise the standards of social services, particularly education and health. Consenuentlvy Government administration expanded to execute its prograns and implement its economic policies and controls. These Government programs and policies resulted in an increase in the shares of public fixed investment in CGDP and in total investment (Table 1t). Table 11- P1]BLIC FIXTD TIVESTMENT (Annual Averages) Item 1953-62 1963-67 1967-72 Annual averace (TL millions; 1968 prices) 4,330 7,200 11,960 Annuial grotxth rate (percent; 1968 prices) 3.9 11.9 9.1 Percent of total investment /1 47.1 52.3 51.8 Percent of GDP /1 7.2 10.3 10.0 /1 At current prices. Source: State Institute of Statistics, State Planning Organization. Public fixed investment has risen from less than 5% of GNP in 1952 to 7.4% in 1962 and 9.6%' in- 1972. A very substantial effort was made to raise the level of public investment in manufacturing, power and transportation during the past ten years. These three sectors which accounted for 47% of total public investment in 1963, increased tlheir relative importance to nearly 66%  - 2 - in 1972. Bty comparison, the share of investment in agriculture, mining, housing, education and health declined. Public investment in agriculture and education has declined in absolute real terms as well since 1968 (Table 2.3). Available evidence indicates that the public sector has probably improved its saving performance during the 1962-72 period, with the exception of 1971 when public salaries and wages were raised abruptl.y. Evidence supporting this conclusion includes the good tax record of the Central Government and the incomplete series of saving figures for the SEE's. Savings of local governments have probably declined in relation to GDP, but this probably did not influence the trend in total public savings since local governments savings are small. 5.2 The large and rising investments undertaken by the public sector during the past two decades and the concomittent increase in current spending imposed a continuing strain on public financial resources, despite the Central Governrent's success in raising tax revenue. This strain was aggravated by the results of the Government's pricing policies concerning agriculture and the state economic enterprises which required substantial subsidies. Most of the tirne during the past two decades, the Government's tendency has been mainly for political and social reasons, to maintain relatively high prices for agricul- tural products and to restrain the rise in prices of goods and services provided b- the state economic enterprises, so that losses were incurred on public trans- ports, commercial and some industrial activities. In addition, little was done to raise the revenue earning capacity of local governments despite rising needs for local investments and services. In particular, the municipalities laad to provide for the needs of rising numbers of migrants from rural areas as a restl1' of rapid industrialization. Transfers from central to local budgets have increased hut not enough to provide adequiate focal services. The propor- tion of city dwellers wlho are squatters without such essential services as water supply and sewerage dlisposal has risen, and this situation is now a matter of some serious concern for the Government and the large municipalities. 5.3 UTnder these circumstances, the public sector has experienced a shortage of financial resources and has covered its deficit partly with limited amounts of long-term external borrow7ing, but mainlv by recourse to short-term advances from the Central Bank. During the 1950's more than a dozen public bodies, includine Central Government departments and state economic enterprises, were authorized to have recourse to the Central Bank in case of need. Net Central Bank credit to the public sector rose from TL 1.0 billion in 1952 to TL 3.1 billion in 1960. This system was changed in 1960 as part of an effort to im- prove Government control over the financial operations of public bodies. There- after, access to Central Bank credit was restricted to the Treasury, the Direc- torate General of Monopolies and three state economic enterprises (Sumerbank, the Soils Product Office and the Sugar Corporation). Other public bodies were required to obtain their financing from the Treasury. Most short-term advances were consolidated into long-term debts. These were important steps to bring greater financial discipline to bear on public bodies. Nevertheless, Central Bank credit to the puiblic sector continued to rise under the new system. The net amount of such credit, outstanding, increased further to about TL19.0 billion at the end of 1972, most of it to the Treasury (Table 6.4). The increase reached a record of TL 4.9 billion in 1971 (12% of GNP increment) which was an exceptionally good crop year, but was stronglv moderated in 1972 (5% of GNP increment) and in 1973.  - 3 - 5.4 The reliance on short-term advances from the Central Bank for public sector deficit financing has been a major factor behind price inflation in the past. Successive governments tried to control price inflation by restraining the rise in prices of goods and services provided by the state economic enter- prises, but these attempts were only partly successful since the enterprises turned to the Treasury - and the Treasury ultimately turned to the Central Bank - for the additional resources which they could not raise through price increases. Central Government 5.5 The importance of the Central Government in allocating and mobilizing national resources has increased substantially during the past two decades. Table 2 provides a direct measure of this growing importance. In addition, the Central Government exercised controls and provided incentives which greatly influenced the mobilization and allocation of resources by the rest of the public sector and the private sector. Table 12: CENTRAL GOVERNMENT EXPENDITURES AND TAX REVENUE (Percent of GNP at market prices) Item 1953-57 1958-62 1963-67 1968-72 Total expenditure 15.9 16.6 20.2 23.2 Tax revenue 12.8 14.3 14.9 17.2 Difference 3.1 2.3 5.3 6.0 Source: Statistical Appendix, Table 5.6. 5.6 The growth of Central Government expenditures in relation to GNP has clearly accelerated since 1962 - that is, during the First and Second Plan periods when the public sector was assigned the main role in promoting econo- mic and social development. Central Government expenditures, which had in- creased from 16.4 percent of GNP in 1952-54 to only 17.2 percent in 1960-62 with several annual setbacks reflecting temporary expenditure restraint, reached 24.1 percent of GNP in 1970-72. 5.7 Expenditures on social services (particularly on education), security, debt service, transport and communications and to a lesser extent agriculture were the main sources of expenditure growth throughout the past two decades. Transfers to the state economic enterprises also became a large expenditure item towards the end of the period. Detailed time series of expenditure data are not available up to 1964. From 1965 to 1972 (Table 13), Central Government expenditures rose by TL 35.4 biliion, which is equivalent to nearly 24% of the GNP increment during this period. Current expenditures accounted for about 46% of this increase and transfers for about 41%. A sizeable part of the rise in current spending was due to salary increases granted in 1971  under a new Personnel law. Current expenditures rose by 51% in 1971, but were restrained in 1972 when they increased by 8% only (a decline in real terms) and also in 1973. The rise in transfers was due mainly to cepital transfers to the state economic enterprises which went up from TL 0.5 billion in 1969 to TL 5.0 billion in 1972, 1/ and to debt service payments wAich now represent more than 10% of total expenditures. Investment expenditures accotnted for only about 12% of total expenditure growth during 1965-72 since they had to be restrained in view of the large increases in current spending and transfers. The Government functions which have contributed most to ex- penditure growth since 1965 were education and health (23%), security (15%), agriculture (9%), and transport and communications (8%). In 1972, education represented 4.2% of GNP and security 4.0%. Table 13: CENTRAL GOVERNMENT EXPENDITURES (Billions of Turkish Liras) 1965 1970 1971 1972 Expenditures by category 15.0 32.8 /1 48,0 /1 50.4 /1 Current 7.6 14.7 22.2 24.0 Capital 3.6 7.0 7.9 7.7 Transfers 3.8 10.5 17.3 18.5 Expenditulre bv function 1 _. 30.0 /2 38,5 /2 52.0 /2 Security 3.4 5.1 7.1 9.0 Agriculture 1.3 2.5 3.0 4.5 Education 2.6 4.4 6.4 9.4 Hlealth 0.6 1.0 1.4 2.3 Trans. & Comm. 1.4 3.4 4.0 4.4 Industrx & Power 0.7 1.4 1.5 1.6 Housing 0.1 0.2 0.3 0.3 Interest Payments 0.5 1.0 1.7 1.8 Debt Repayments 0.8 1.9 2.4 3.7 Other 3.6 8.9 10.6 14.7 /1 Breakdowns on prelininary estimates, do not add up to totals. /2 Budget estimates. Source: Tables 5.4 and 5.5. 1/ Alostly to the State Railways, Etibank, Iran and Steel Mill, Sumerbank, mechanical and chemical industry, and petroleum.  - 5 - 5.8 The Central Government has been successful in raising the nation's tax effort and in making tax revenue more responsive to economic growth, particularlv since 1962. Tax revenue increased from 12.0% of GNP in 1962 to 16.1% in 1967 and 17.9% in 1972. Adding local tax revenue and the compul- sory contributions to employees' benefit funds to central tax reverue, the relation of tax and quasi-tax revenues to GNP becomes 22.8% in 197,. More importantly perhaps, Turkey has introduced tax changes and new taxes to bring taxation to bear on the most rapidly growing elements of the country's poten- tial tax base. Few of these elements, of which agricultural incomes is the most important one, now escape taxation. As a result, the tax structure has changed markedly (Table 14) and the ratio of tax revenue growth to GNP growth has risen from 1.1 during 1952-62 to 1.3 during 1962-72. Table 14: STRUCTURE AND GROWTH OF TAX REVENUE /1 Percentage Shares Percent Annual Growth Taxation on: 1952 1962 1967 1972 1953-62 1963-72 - Income 22.0 35.6 36.2 39.0 22.5 19.3 - Wealth 2.0 1.8 3.1 4.6 15.8 29.7 - Production 27.4 21.5 21.5 18.9 14.1 16.6 - Expenditures 8.7 4.4 3.7 3.8 9.2 16.6 - Services 8.4 10.0 10.0 11.3 18.9 19.7 - Imports 31.5 26.7 25.5 22.4 15.0 16.1 Total 100.0 100.0 100.0 100.0 16.9 18.2 /1 At current prices; the annual rate of price inflation, as measured by the GDP defl-itor, was 10.3% in 1953-62 and 7.5% in 1963-72. Source: Tahble 5.1. 5.9 Turkey's creditable tax performance since 1962 has been a result of the Government's will to reach Plan targets, but significant shortfalls were experienced. First, tax revenue failed to reach the Second Plan target of 19.5%, of GNP bv 1972. Second, several tax recommendations contained in the Plans were not implemented due to strong political opposition. Nonetheless, procress has been made since the income responsiveness of tax revenue has risen, and the structural shift towards taxes on income and wealth rmiay be interpreted as a move, albeit still limited, towards greater eqjuity. 5.10 Turkey's tax effort, however, has not been commensurate with the country's rising expenditure commitments since 1962. As shown in Table 12, the difference between expenditures and tax revenue rose to 6.0% of GNP on average during the Second Plan period (1968-72). However, this average covers a sharp increase in this difference from 5.3% of GNP in 1968 to 8.4% in 1971, which was followed bv a drop to 4.6% in 1972. Expenditures ran increasingly ahea(d of tax revenue (luring the first four years of the Plan mainly because  - 6 - of the Government's desire to reach the Plan targets for public investment, and the salarv increases of 1971. In 1q72, the Central Government exercised strong exnenditure restraint; expenditures growth was 5.0% only, which in real terms was a significant decline (by perhaps more than 10%). Expenditures fell from 26.3% of GNP in 1971 to 22.6% in 1972, while tax revenue remained at 17.Q% in both years. There was an absolute decline in investment expendi- tures. 5.11 In 1972 and 1973 the Central Government began to use long-term borrowing on large-scale as a means of reducing the inflationary impact of deficit financinIg. Gross sales of development bonds, which had been small in previous years, amounted to TI 4 billion in 1972. However, almost half of this amount was sold to banks. Borrowings from the Central Bank were small, and the net cash position of the Treasury improved significantly (Table 5.7). Local Governments 5.12 Local governments include 67 provinces, 1,571 municipalities and about 36,000 villages. Provincial governments received their current organizations, Functions and revenue powers in 1913, municipalities in 1930 and villages in 1924. Few changes have been made to the original organic laws establishing local governments. The main problem facing local governments arose from the fact that legislation assigned costly functions to them but did not provide them with enough revenue-earning powers. As a result, local resources were not enough to provide local services and infrastructure in accordance with needs. Central agencies have helped both technically and financially in providing the most essential services and infrastructure, but cooperation and coordination among these agencies and with the local governments concerned were often lacking. This insufficiency of funds has affected municipalities more particularly since they have had to meet the needs of a large and rising number of rural migrants, as well as respond to demands for better standards of services. These needs have been met only partly so far for lack of resources. A 1965 survey found that a very large part of urban dwellers were illegal squatters without most municipal services (59% of population in Ankara, 45% in Istanbul and Adana, one-third in Bursa, Izmir, Erzurum, Samsun and Iskenderun, etc.) The First and Second Plans did not propose specific solutions to the problem of matching local needs and resources, and not enough has been done so far to improve the situation. 5.13 The Central Government approves local budgets which must be balanced and make provisions for the compulsory functions enumerated in organic laws. Tocal governments have therefore little freedom in the allocation of their expenditures. These represented only about 13% of Central Government expen- ditures in the late sixties, and this proportion may have declined since then. The most evident unsatisfied needs include municipal streets, water supply, sewerage disposal and power distribution. 5.14 Local taxes and other revenues are also specified in detail in organic laws. Tax revenues represented 9.4% of Central Government tax revenues in 1968 and this proportion has probably declined since then. A part of local governments revenue come from tax receipts shared with the Central Government,  - 7 - and local governments normally receive less than their statutory shares 1/. Another part comes from local taxes whiclh have fixed rates and are not buoyant. I!ser charges for local services are also determined by law, and often do not recover the full costs of services such as street cleaning and waste water disposal. A new tax on real property was introduced in 1970 and began to be implemented in 1972. Since 457 of the proceeds are for the municinali;ties and 35 for other local governments, the new tax may help re- lieve the difficult financial position of local governments. Iowever, the new tax rates are low, so that the relief will probably be limited. (Taxeq on real propertv and real property purchases were estimated to yield TL 1,425 million in 1973, or 2.9 of Central Government tax revenue). The revenue potential of taxation on real property has only begun to be tapped in Turkey. The Government has felt the need to improve the financial situation of muni- cipalities for some time, and draft laws to reform municipal revenues and fines have been in Parliament for several years. Legislation to reform the organization and functions of local governnents has also been prepared. 5.15 Local governments are not allowed to borrow directly fro'n the market. Their deficits are covered by grants and loans from the Central Government, most of which are for investment and made through Iller Bank (the Bank of Provinces). Iller Bank acts as a disbursing and debt collecting agent for the Central Government. It also helps local governments prepare and imnlement prolects. Most of its financing is for power distribution, water supply and waste disposal in municipalities with population between 3,000 and 10(,000. In the 22 larger municipalities, the State Waterworks Department (DSI) is responsible for water supply and waste disposal, and the Turkish Power Company (TEK) for power. Municipal debts to the Central Government have reached a high level as a result of borrowing for investment. In 1971, debt service payments were estimated at 13% of municipal tax revenue despite relief from debt consolidations. The municipalities therefore also need a better resource base to increase their debt carrying capacity. State Economic Enterprises 5.16 The Government established and developed state economic enterprises (SEE's) more on the basis of pragmatism and expendiency than on the basis of any doctrine, although it was in the 1930's influenced by the Russian, German and Italian experiences with state capitalism. Their origin may be found in the inability of indigenous private enterpreneurs during the early years of the Republic (1923-31) to rise to the expectations of Turkey's political leaders that they become the main agents of modernization and development. 1/ For instance, municipal shares are 87 of the petroleum tax, 2% of the monopoly tax, 11% of the motor-vehicle tax, 11% of traffic fines, 45% of the property tax, 5% of income taxes and a 15% surcharge on customs duties. Only the latter two are paid to municipalities (through Iller Bank) on the basis of actual receipts. The others are paid from budget allocations (transfers) which are usually much lower than municipal statutory shares.  - 8 - Indigenous private enterprise lacked at that time the entrenreneurial and managerial talents to assumne this responsibility although generous Govern- ment incentives were available. The Government therefore began to invest heavilv in industry, transportation and to a lesser extent in agriculture, trade and services. This investment was carried out for the most part through state-oxmed enterprises. Sumerbank and Etibank, which have created numerous subsidiaries in manufacturing and mining respectively, were established in 1933 and 1935 respectively. The Agricultural Bank acquired SEE status in 1937. The SEE sector was organized in 1933 by Law 3460 which vested the control of SEE's in two administrative bodies (the Administrative Board and the General nirectorate) and two political bodies (the Parliamentary General Assembly and the Ihigh Control Board). Acquiring a political and economic mementum of its own, the SEE sector has expanded ever since. Table 14 presents three indexes describimq the real growth of non-financial SEE's; in addition, there are several snecialized public financial institutions (see Table 5.11 under "Financial SEE's") and a number of commercial banks in which the Govern- ment is a sharehol.ler 1/. Table 15: GROWTH OF NON-FINANCIAL SEE's Indexes (1952=100) Percent of National Totals Item 1939 1952 1960 1968 in 1963 Real value added 31.3 100.0 174.1 292.7 10.2 Deflated capital stock 49.5 100.0 147.0 210.4 _ Employment 32.1 100.0 146.3 181.5 2.8 Source: State Institute of Statistics and Table 5.9 and 5.10. 5.17 Controversies about the role and deficiencies of the SEE sector have surrounded its growth during the past two decades, mainly because of disappoints- ing financial results andl the conconmittent need for Government subsidies. About the role of the SEE sector, a wide range of views have been expressed reflecting the spectrum of economic doctrines represented in Turkey. A con- sensus has, however, emerged about the desirability of a mixed economy in 1/ The State Institute of Statistics has compiled the economic accounts of non-financial public enterprises from 1939 to 1968. Since 1969, the Ministry of Finance has compiled the financial accounts of financial and operational SEE's. These financial accounts are unfortunately difficult to compare with the Institute's economic accounts due to differences in coverage and methodology. Hence, the analysis here is based on the economic accounts till 1968 and the financial accounts since 1969.  - 9 - wlhichi the SEE sector plaved a leading role in pursuing the country's overridinp objective of modernization througlh rapid industrialization although differences persisted as to the desirable scope and extent of the sector's activities, In fact, the SEE sector has invested heavily in industry, transportation, comruni- cation and power, but its relative importance in the economy has increased little since the private sector was also encouraged to expand rapidly (Table 16). The shares of SEE's in national value added for industry (i.e. manufacturing, mining, power and water) and transportation have declined continuously from 1952 to 1968. Table 16: COMPOSITION AND IMPORTA4CE OF SEE's Percentage Shares Percent of National Totals Value ad(led in: 1952 1962 1968 1952 1962 1968 'manufactxiring 32.7 30.2 31.8 State TIonopolies /1 24.9 24.9 24.7 1:inm 11.7 11.2 10.9 Electricity - 2.1 4.2 SUb-Total, InTlustry 69.3 68.4 71.6 46.2 35.4 33.0 Transport s, Communication 23.1 23.0 21.8 40.9 36.2 35.0 Other Sectors 7.6 8.6 6.6 ... ... Total SEE's 100.0 100.0 100.0 9.4 9.6 10.0 /1 Mostly processing of agricultural products such as tobacco. Source: Table 5.9. 5.18 The growth of the SEE sector has been accompanied by serious financial difficulties for some SEE's, particularly in transportation and coal mining, and to a lesser extent manufacturing up to the mid-1960's. The resulting need for annual Government subsidies (Tahles 5.9 and 5.14) has kept the issue of dificiencies in SEE's performance alive in Turkey's political circles. The Government ordered an investigation of this issue after the 1960 change in Government. About a quarter of the outstanding debts of SEE's (mainly to the Central Bank) were consolidated in 1961 and their freedom to borrow was res- tricted. A review comrmission was organized. The commission, the Ministrv of Finance, and the State Planning Organization (SPO) hlelped prepare Law 440 wlhich wns passed in Mlarch 1964 replacing in part Law 3460. This was followed bv the establishment of the State Investment Bank (SIB) under Law 441 to sutpplv the SEE's witlh long-term investmient funds. Under this new legal frame- work, the investment programs of SEE's came under the scrutiny of SPO and SIB while their finances were controlled by the Treasury. The main purpose of these measures was to raise productivitv and generate more savingps in the SEE sector. It was partly achieved. SEE's saving, net of subsidies, rose  - 10 - from 13.8% of SEE's value added in 1962 to 16.7% in 1968, but were still be- low the 1952 level of 19.2%. SEE's profits, excluding subsidies, rose from about 1.5% of nominal capital stock in 1962 to more than 4.0% in 1968, but again this was still less than the 1952 level of nearly 7.0%. The need for subsidies was however virtually eliminated in sectors other than transporta- tion and industry, but showed a strong tendency to rise in transportation (see below and Table 5.9). 5.19 Since 1969, the financial accounts of producing SEE's indicate that previous trends have continued (Table 5.13): (1) SEE's fixed investment has continued to rise markedly from TL 4.2 billion (3.5% of GNP) in 1969 to TL 10.4 billion (4.7% of GNP) in 1972 with 75% of the increase in industry and 24% in transportation and communication; (2) SEE's own resources have risen much less rapidly from 1.1% of GNP in 1969 to 1.3% in 1972, mainly because of the Government decision to restrain SEE's prices in the face of large cost increases (particularly wages), and also because of delays in bringing a few large SEE projects into operations, such as a thermal station, a coal project and an iron and steel project; (3) The net financing provided to SEE's by SIB has declined from iL. 1.3 billion in 1969 to a negligible amount in 1972 because SIB's main sources of long-term funds (the pension and social security funds) have been drying up; (4) As a result, and despite a sizeable increase in net financing from external loans, budgetary transfers have risen from TIL 1.5 billion in 1969 to TL 6.7 billion in 1972. 5.20 There overall indicators hide sharp differences among SEE's. The economic and financial accounts of SEE's reveal that poor results have been concentrated in transportation and the coal industry. The economic accounts indicate that the saving rate (depreciation and profits net of subsidies over value added) declined in transportation (from 17.6% in 1952 1/ to 1.5% in 1972)., became negative in the coal industry in 1966 and 1968, but increased in the rest of the SEE sector (from 20.2% in 1952 to 23.6% in 1968). In particular, the saving rate rose sharply in manufacturing, from 14.5% in 1962 to 27.9% in 1968. Similarly, profits (net of subsidies) in manufacturing increased from 0.5% of nominal capital stock in the sector in 1962 to 7.7% in 1968, compared to 14.2% in 1952. The financial accounts confirm these findings (Table 5.16). Three enterprises accounted for 80% of total losses during the 1962-72 period; these were the State Railways, 64%, the Maritime Bank, 8% and the Turkish Coal Corporation 8%. The Nitrogen Industry Company 1/ First year for which this information is available. See Appendix Table 5.10  - 11 - also sustained large losses until 1970, but has been in the black since then. Finally, there were sizeable losses by the Soils Product Office (Cereals Office), the M4eat and Fish Organization and the Milk Industry, but part of these losses were temporary and attributable mainly to the Government's agri- cultural price policy which affected products handled by these enterprises (see Chapter 10). 5.21 The fact that poor performance is attributable to a few enterprises while most show relatively good results provides a partial refutation of the view that producing SEEs suffer from congenital deficiencies due to their status. It suggests that a sensible approach to eliminating "the deficiencies of the SEE sector" should perhaps begin by tackling the problems of the three big losers (State Railways, Maritime Bank and Coal Corporation). Regarding the State Railways, an investment prog;ram is being carried out together with other improvements to raise the operating efficiency of the network, but the Government is still reluctant to raise passenger tariffs. Regarding the Maritime Bank and the Coal Corporation, improvement programs are still to be designed. 5.22 Although important, the differences among producing SEEs should not detract attention from a number of common problems which have affected adversely the performance of all of them in varying degree. First among those has been excessive rigidity in management and pricing due to Government controls. Despite the provisions of Act No. 440, SEEs managers have been subjected to considerable outside interference in the conduct of SEEs affairs. This interference has made it difficult for them to introduce programs for improv- ing productivity. Frequent changes in management decided by the Government have also been an impediment to the implementation of such programs. Further, the SEEs have been bound by Government decisions regarding their prices. Most of them have had to restrain prices despite cost increases, particularly since 1969, while a few have enjoyed monopoly rights over competing imports enabling them to charge high prices for costly locally-manufactured products (for instance, the enterprise manufacturing PVC). The common problems facing producing SEEs have also included relatively high labor costs because political pressures have been exercised on many enterprises to keep redundant employees on their payrolls. On the other hand, bound by the rules and low pay scales of public employment, the producing SEEs have often found it difficult to retain their key managerial and technical staff who wanted to leave for better paid jobs in the private sector. Finally, there have been isolated cases of enterprises with insufficient size, poor location and other technical deficiencies. All these problems have appeared mainly because the Government has used the SEE sector as an instrument for achieving various social and political purposes, such as the development of backward areas, the provision of maximum employment and the sale of essential goods and services at low prices. The pursuit of these purposes has in some cases been in contradiction with the principles of sound financial management and perhaps also economic efficiency.  - 12 - Current Outlook 5.23 A shift in emphasis is noticeable in the 1973 public investment program. Investment growth in two of the previously leading sectors, manufacturing and transportation, is planned to slow down whereas large increases are provided for agriculture, mining and education which had been lagging in the past. The 1973 program provides for a continuation of past trends in power (rising sharply) and housing (declining). Overall, the growth of public investment at constant prices is expected to reach 24% in 1973 compared to 19% in 1972 according to the 1973 Program. However, most of the growth in 1973 will come from the Central Government rather than from state enterprises as was the case in the last decade. 5.24 The rapid growth of investment by the Central Government is reflected in total expenditures, which the 1973 budget put 25% above 1972 actuals (Table 5.5). A 24% rise in tax revenue, which seems feasible, and a TL 4 billion bond issue will help finance rising expenditures. Taking other bud- getary receipts into account and considering results in the first nine months of the year, the financing of the 1973 budget required only a small increase in Central Bank (net) advances to the Treasury. In the first nine months of the fiscal year, tax revenues rose by 35 percent, total revenues by 23 percent and total expenditures by 12 percent only. However, public investment ex- penditures fell short of the target in real terms. 5.25 The financial position of SEE's was also projected to improve in 1973. Factors contributing to this improvement included a reduced increase in financial requirement due to the slower pace of SEE's investment growth, a better self financing capacity mainly due to the coming into operation of large projects in power, coal and steel, and the resumption of large net financing from the State Investment Bank. Nevertheless, budget transfers to the SEE's will remain at a high level (TL 6 billion in 1973 compared to TL 6.7 hillion in 1972). However, the freezing of prices of SEE products, when prices and costs were rising rapidly, has probably resulted in larger current transfers than expected. In February 1974, prices of many enterprises (sugar, cement, paper, iron, oil products) were increased by 40 to 80 percent. This measure should considerably ease the financial pressure on the budget of transfers to SEE's. Third Plan Targets 5.26 The Third Plan calls for an acceleration of public fixed investment (Table 17). Public fixed investment in the Plan is estimated at TL 158.4 bil- lion, an increase at constant prices of 91 percent over investment during the Second Plan which in turn was 65% larger than during the First Plan. This amount covers tital expenditures of the Central Government (45%), local governments (3%), operational SEEs (51%) and financial SEEs (1%). It implies that public fixed investment would increase by 12% a year, from 10.9% of GNP in 1972 to 13.4% in 1977.  - 13 - Table 17: PUBLIC FIXED INVESTMENT Item 1963-67 1968-72 1973-77 Actual Estimate Plan Public fixed investment (TL billions; 1971 prices) 50.2 82.8 158.4 Annual rate of growth (percent) 11.7 9.0 12.0 Percent of total: Agriculture 18.4 13.3 11.0 Mining 7.8 5.0 8.5 Manufacturinp 12.2 21.2 27.1 Energy 11.2 15.0 14.0 Transportation 22.6 22.0 20.1 Education 12.3 8.6 8.4 Ilealth 3.1 2.6 2.4 Housing 3.5 3.6 1.4 Other 8.9 8.7 7.1 Percent of GNP (last year of period) 9.2 10.9 13.4 Source: Table 2.2, and Third Plan. 5.27 The Third Plan gives priority to public investment in manufacturing, mining, energy and transportation, which together account for 70% of planned public investment. Among other sectors, education and health would barely keep their shares, and the share of agriculture would continue to decline, although the level in real terms is substantially higher than in the Second Plan. Public investment in housing would show an absolute decline of 27%. These shifts in the sectoral balance of public investment clearly reflect the Plan's strong emphasis on industrialization as the means of attaining a high rate of economic growth and modernizing the country. Regarding agriculture, education and health, the Plan argues that the most urgent need is to make full use of existing physical facilities, and consequently it provides for a relatively high growth of the Government's current spending in these sectors (see below) while slowing down somewhat the pace at which new investments will be undertaken. With respect to housing, in which the share of the public sector has been small (10%) in 1968-72, the Plan finds the results of past public investments disappointing, and therefore calls for increased reliance on private initiative with the provision of incentives to low-cost housing (the overall investment strategy is discussed in Chapter 2). 5.28 The Plan expects that public saving will rise faster than public investment. It sets the target of growth for public saving at nearly 15% a year, thus raising its share in CNP from 10.1% in 1972 to 13.7% in 1977. Public  - 14 - saving would begin to exceed public fixed investment in 1977. This would enable the public sector to show a small overall surplus in that year, and the Plan foresees a diminishing need to borrow domestically and externally for the financing of planned investment and debt amortization. The financing plan given in the Third Plan document, is summarized in Table 18. Its feasibility and the policy implications are discussed below. Table 18: PUBLIC FINANCES IN THE ThIRD PLAN 1 (TL billions; 1971 prices) Percent Annual 1973-77 1972 /2 1977 Increase Disposable income /3 334.2 49.2 82.2 10.8 Current expenditures -183,5 -29.4 -42.7 7.8 Public saving 150.7 19.8 39.5 14.8 Fixed investment 158.4 -21.4 -38.5 12.5 Stock increases -3.8 -0.4 -1.1 22.8 Capital transfers -0.8 -1.9 0.2 - Overall deficit -12.4 -3.9 0.1 /1 Consolidated accounts of the Central Government, local governments, SEEs and social funds. /2 1973 Program estimates at 1971 prices which are more recent than Third Plan estimates. /3 Includes tax revenue, non-tax revenue, factor income of SEEs and receipts from social funds, less current transfers and interest payments. Source: Table 5.25. 5.29 Before turning to this discussion, however, it is worth noting several difficulties in assessing the technical aspects of the financial part of the Plan. First, it is difficult to assess the proposed financing plan in the light of past experience since the plan is not presented on the same basis as past financial results. This difficulty is compounded by the fact that there are no reasonably accurate estimates of public saving in the past, with which the Plan projections could be compared. Second, in order to es- timate precisely future current expenditure commitments, the commitments arising from the program of public investments should be explicitly calculated. On the revenue side, the analysis of sources of finance other than taxation is far from being explicit; this applies to non-tax revenue, domestic borrow- ing, and external finance.  - 15 - Revenue Policy 5.30 The Plan targets for tax revenue are somewhat high but can be realized. The Government intends to increase the income elasticity of the tax system and to improve it without resort to new taxes. Tax revenue of the Central Government, including taxes on wealth, is expected to rise by 11.4% a year in real terms from 1972 to 1977. The absolute increase would represent 31% of the projected GNP increment during this period, compared to an actual 19% in the Second Plan period. The local governments are expected to increase their tax receipts by 10.6% a year. On the basis of estimates at 1971 prices, the combined tax receipts of the Central Government and local governments would rise from 20.9% of GNP in 1972 to 24.2% in 1977. Since these receipts represent more than 80% of projected disposable income for the public sector, they are the crucial element of its financing plan. 5.31 The Ministry of Finance is confident that these ambitious targets can be reached. As noted earlier, it has demonstrated its ability to improve the country's tax system and raise the responsiveness of tax revenue to in- come changes. The Government's intention is therefore to continue improving over past tax policies and administration. However, it will increasingly be difficult to achieve these improvements since, inasmuch as past success is mainly explained by rate increases and use of new revenue sources, 1/ there is correspondingly less room left for future rate increases and correspondingly less revenue sources left to be opened up in the period ahead. Nonetheless, there are several possibilities of increasing tax revenue substantially, among which the following may be the most important ones: 2/ (a) Further improvements in tax administration and effective collection of taxes, which are now under way; (b) Adjustments in the rules governing the taxation of agricultural incomes, which would raise the coverage of agricultural income taxation from less than 1% now to about 3% of farms covering approximately 20% of the cultivated area before the end of the Third Plan; (c) Introduction of a value-added tax which would help decrease tax evasion; 1/ An IBRD staff study of April 1973 found that three-fourth of the tax revenue increase from 1963 to 1971 was due to rate increases and use of new revenue sources. 2/ An IMF staff study of November 20, 1972, has reviewed in detail the various possibilities envisaged by the Government and the mission agrees with most of its conclusions. Here, the main possibilities are indicated soley from the revenue standpoint.  - 16 - (d) Gradual increase in the presently low rates of real property taxation, which would raise the buoyancy of local tax revenue; and (e) Liberalization of imports which do not result in decreasing domestic production and taxes thereon. This would make up for the losses of import tax collections due to further import substitution, to the agreed gradual reductions of custom duties on imports from the European Economic Community over the next 20 years and to the agreed elimination of the stamp duty on imports from GATT countries over the next 10 years. 5.32 The Plan does not pay sufficient attention to non-tax revenue. The 1977 target (TL 3.5 billion) is below the level reached in 1972 (an estimated TL 5.3 billion in 1973). Although the question has still to be examined, it would seem probable that the Central Government and the local governments could raise non-tax receipts substantially above current levels in at least two areas. One is the area of user charges (see paragraph 14 in the case of municipal services), for which a systematic study appears needed. The other concerns profit transfers and dividend payments by publicly-owned enterprises to the Government. In this case, the problem is not only to raise the profit- ability of SEEs owned by the Central Government, which is discussed below, but also to induce local governments to make their own commercial and indus- trial undertakings improve their financial results. SEEb Policies 5.33 The saving targets which the Third Plan sets for producing SEEb are very ambitious. Producing SEEb are expected to increase their combined savings by almost 33% a year in real terms from 1972 (1973 Program estimate) to 1977. This target will be out of reach, unless the Government changes radically its policies which affect the pricing of goods and services produced by SEEs and the management of SEL's, and accelerates the implementation of SEE projects. 5.34 The Third Plan devotes considerable space to the principles of the mixed economy, the problems of SEE sector and the outline of a reform plan. Starting from the premise that the country's long-term objectives for industry would be attained through reliance on private initiative only at the cost of excessive incentives, it argues that "it would be more rational for the Govern- ment directly to indulge in entrepreneurship than to bear most of the risk and financial burden while letting private hands do the managing." However, it finds faults with the existing SEE system, its organizational structure and its neglect of marketing, cost-accounting, purchasing, stock control, research and programming. These faults affect adversely the efficiency and productivity of the SEE sector. The Plan therefore outlines a reform plan which is expected to enable SEEs to improve the efficiency and productivity of their operations. In two annexes, however, the Plan states principles for pricing and investment by SEEs which are fundamentally the same as those that have guided the SEE sector in the past. Following the proposal made in the Third Plan, the 'Government is preparing a reform plan for the SEE sector which sets efficiency targets and provides for an administrative reorganization. Perhaps the most important provisions of the reform plan are those which would  - 17 - enable producing SEES to hire managers, engineers and technicians under con- tracts outside the regulations governing public employment and thus compete for good staff with the private sector. The Plan also provides -"or a special body to coordinate SEEs activities with the policies of the ministries con- cerned, and for an upper body headed by the Prime Minister to determine overall investiment policies. Under the plan, SEEs will be combined into holding com- panies for the various sectors. The bill for this reform plan may be presented to Parliament after the elections due in October 1973, where it may undergo substantial changes. Many studies have already been undertaken previously on this matter, but little action has been taken because of lack of political decision. On balance, the uncertainties still surrounding the fate and the content of the new reform and the hesitations in tackling the problems of enterprises making the largest losses indicate that a substantial shortfall may be expected on the saving target for producing SEEs in the Third Plan. 5.35 The saving target for financial SEEs seems conservative, but there is a question concerning the expected performance of social funds (mainly the Social Security Fund and the State Pension Fund). The social funds have been a major means of tapping private savings for the financing of investment by producing SEEs through the SIB. However, benefit payments by the funds are catching up with employees' contributions and this important source of long- term finance is drying up. The Third Plan estimates that the funds will begin to show large deficits from 1976 onward. This prospect is alarming because of the additional burden that social funds would be putting on. public financial resources. An early consideration of the measures that would be needed to reverse current trends in the social funds' financial position would be highly desirable. Current Spending Policy 5.36 The Plan targets for current expenditures of the Central Government and the local governments raise serious questions. The growth of current spending by the Central Government is expected to be kept at 7.8 percent a year from 1972 (1973 Program estimate) to 1977. Priority would be given to current spending on education, health and agricultural extension, which would increase by 10% a year, while the growth of other current expenditures would be kept at 6% a year. The priority given to social and agricultural services is consistent with the Plan's targets for investment in these sectors and with the Plan's emphasis on improving these services and the use of related physi- cal facilities. The restraint on other current spending expected by the Plan seems difficult to achieve. There is reportedly considerable scope for raising staff productivity in the departments and agencies concerned, and in 1973 the Government introduced a system of program budgeting with the aim of reducing staff underutilization. However, it is unlikely that program budget- ing alone will suffice to root out the deep-seated problems arising from lack of incentives and consequent shortages of crucial skills in these departments and agencies. More fundamental changes in staff policies and service regula- tions would be needed to solve these perennial problems of public administra- tion. No such changes are prescribed specifically in the Plan. It is likely that a significant expenditure overrun will have to be incurred in order to maintain the Government's capacity to undertake planned investments and support planned developments in the sectors concerned.  - 18 - 5.37 Even greater restraint in current spending is expected of local governments (7.2% a year) which at the same time are projected to increase their fixed investments by less than 9% a year. The pressure to exceed both investment and current expenditure targets will probably also be great, given in particular the fast expected rate of urbanization. Municipalities, in particular, have accumulated a backlog of unsatisfied needs for basic services and facilities (see paragraphs 5.12-14), and will be asking for higher ex- penditures. The Third Plan could have been the occasion for making a start at clearing this backlog, and thus make urban development more consonant with the Plan objective of rapid industrialization. Public Saving Prospects 5.38 The discussion of prospects for tax revenue, SEEs saving and current spending during the Third Plan period indicates that the saving target for the public sector is probably too ambitious. The discussion points to the likeli- hood of a small shortfall on tax revenue, an overrun on current spending and a sizeable shortfall on SEEs saving. Of course, the possibility still exists of making up part of the shortfalls on these accounts in such areas as non-tax revenue, receipts of social funds and pricing of SEEs products and services (especiallv in transportation and power), assuming the necessary policy changes are adopted. Unless such policies and measures as outlined above are under- taken, then it would seem likely that public savings will fall short of Plan targets. The implication would be that the overall deficit of the public sector would remain at around TL 5 billion a year, instead of declining and turning into a small surplus by 1977 as shown in Table 5.25. Borrowing Policies 5.39 In view of this possibility, there is a need for the Government to adopt more active borrowing policies than those stipulated in the Plan, if projected investments are to be financed without excessive recourse to expan- sionary deficit financing (i.e., borrowing from the Central Bank). At the time the Plan was prepared, Turkey's external position was improving but it was difficult to foresee how large and permanent the improvement would be. Hence, the Plan cast the Government's borrowing policies against conservative assump- tions regarding the prospective position of the balance of payments. Now, how- ever, external circumstances seem to be considerably better and this enhances the prospects for active borrowing policies, both domestically and externally. 5.40 Domestically, the better balance of payments and the concurrent in- crease in liquidity of the economy have created conditions favorable to placing more long-term Government bonds with the public. The special features of these bonds (tax-free 9% annual interest, and redemption on demand) make them an at- tractive instrument for private investors. The Government has begun to avail itself of this opportunity (see paragraph 5.11). Larger issues could be en- visaged in future with more aggressive marketing if necessary. Part of the proceeds could be used to retire the debt of the Treasury with the Central Bank, as a powerful means of countering inflationary pressures. In addition, consideration could be given to enabling the strongest SEEs to issue their own long-term bonds without Government guarantee (but subject to Treasury approval), which would be made easier if the reform plan of the SEE sector is carried out.  - 19 - 5.41 Externally, Turkey's international creditworthiness has been in- creased by the expansion of its exports and the strengthening of its external position. The scope for external borrowing has correspondingly been enlarged. The Government is therefore in a position to borrow at a higher level from abroad to supplement national saving in financing planned public investments. Reviewing the public investment program to prepare a list of projects suit- able for external financing would be the first requirement of a more active external borrowing policy. It would be necessary for the Government to make sure that external borrowing would not accentuate inflationary pressures, if the rapid rise of foreign exchange reserves continues to fuel inflation. Ex- ternal borrowing in these circumstances should be accompanied by the appro- priate monetary, credit and trade policies. 5.42 In summary, while the 1973-77 financing plan sets ambitious targets for public saving, it underrates substantially the growing potential which is already apparent for borrowing from domestic and external sources. Given the likelihood that public savings will fall short of targets, the forecast of net proceeds from borrowing, especially from external sources, is thus likely to exceed the Plan expectation to make up for a large part of the possible saving shortfall. Short-term Budgetary Policy 5.43 Large public borrowing from the Central Bank has been in the past an important element putting pressure on the level of prices and the balance of payments. In some years, however, the Government had to restrain public investment for lack of financial resources or to take account of the imple- mentation capacity in the public sector. From 1969 to 1971, public investment hardly increased in real terms, staying at around TL 16 billion (at 1971 prices). In 1973, fixed investment by producing SEEs was set at TL 12.4 bil- lion (at 1972 prices) in the 1973 Program, whereas the Third Plan called for an amount of TL 13.2 billion (at 1971 prices). 5.44 A more active short-term budgetary policy would seem desirable in the future. The Third Plan states that "the short-term aim of fiscal policy is to preserve the general stability of the economy" and calls for changes in the tax system which would give the Government powers to use taxation to counteract cyclical conditions in the economy. Few governments in the world have been successful in applying this textbook prescription, and it is unlike- ly that in Turkey Parliament will give the necessary powers over taxation to the Government. It might be well to recognize that adjustments in the levels of public expenditures and domestic borrowing will remain the main budgetary instruments left at the disposal of the Central Government to influence the short-run course of domestic demand. Fortunately, as indicated earlier, re- cent trends in the balance of payments and private deposits have created con- ditions favorable to an active borrowing policy on the part of the Government. Full use should be made of this opportunity for purposes of demand management, too. There is a need for the Government to draw up annual borrowing plans which would be better related to its objectives for price inflation and ex- change reserves than they were in the past, and to keep these plans under re- view during the fiscal year with a view to adjusting them in case of unfore- seen developments.  - 20 - CHAPTER 6 THE FINANCIAL SYSTEM, MONEY AND PRICES The Financial System 6.1 By conventional measures, Turkey's financial sector is well-develop- ed in relation to the level of aggregate economic activity. Assets of fi- nancial institutions have grown at 7.6% per year from 1963 to 1971, at constant prices, whereas real GNP has grown at 6.8% and real investment at 8.6%. An increasing proportion of the nation's expenditures has, therefore, been chan- nelled through financial institutions. 6.2 The financial system of Turkey consists almost exclusively of depo- sit banks and specialized development banks, whose combined assets amounted to 73% of all financial assets in the economy. The only other financial in- stitutions are insurance companies whose total assets are less than 1% of GNP. Direct financial debt of the non-financial sectors is rather small and not rising as fast as GNP; it consists of long-term government bonds which are sold primarily to financial institutions and corporate stock which is closely held. Private corporations have issued bonds publicly since 1967 but the total volume is still very small. 6.3 There is considerable amount of specialization among the principal financial institutions in the scope of their lending and sometimes also in their sources of funds. The State Investment Bank (SIB) lends exclusively to state economic enterprises and draws its resources almost exclusively from compulsory social insurance funds. There are two other development banks, TSKB (Turkiye Sinai Kalkinma Bankasi) and SYKB (Sinai Yatirim Kredi Bankasi) which provide medium- and long-term credit to private industry. Deposit banks also started to provide medium and long term credit to private industrjy under special arrangements in 1972. Among the deposit banks there is a group of government owned "special law" banks which specialize in lending to agricul- ture, real estate, local administrations, small artisans, religious founda- tions, etc. 6.4 The physical facilities of the banking system have grown rapidly. The number of bank branches has increased from 1,916 in 1961 to 3,524 in 1972 (an average of a branch for every 10,300 people). The number of deposit accounts has grown from 5 million in 1963 to 13 million in 1971. As pointed out later, there is probably some waste in such development. 6.5 Money and quasi-money (i.e. currency in circulation and total depo- sits) has grown from 20% of GNP in 1952 to 32.6% in 1972, (Tables 6.3 and 6.4) The process of monetization has undoubtedly been helped by the rapid decrease in the share of agriculture in GNP (from 43% in 1952 to 25% in 1972) as well as the spread of modern agriculture. Another major influence has been the  - 21 - increase in interest rates paid to depositors, especially on longer maturities 1/ and the scarcity of alternative financial assets (which can serve as stores of value and still retain some liquidity) in an inflationary situation. 6.6 The slow growth of the securities markets is reflected in the pat- tern of financing of private investment. Of private sector investment aver- aging TL 11.3 billion per year from 1965 to 1971 (including changes in stocks), about 38% has been financed by the banking system and only 1% by the sale of bonds (Table 19). The balance, 61% has been financed by the resources of the investors, including the issue of shares. Table 19: PRIVATE INVESTMENT AND FINANCING (TL million; annual average for period 1965-1971) TL X Fixed Investment 9,855 87.2 Increase in Stocks 1,442 12.8 TOTAL 11,297 100.0 Banking System 4,321 38.2 Bonds 114 1.0 Self-finance 6,862 60.8 6.7 The sources of finance for various sectors differ greatly from the aveirage. Bank credit financed 34% of total investment in industry and mining, as much as 63% of investment in agriculture but only 9% of investment in housing and construction. This wide variation reflects the institutional and legal situation regarding the supply of credit to different sectors rather than the profitability of such credits to banks (see below). Thus agricul- tural credit is given very high priority in the use of Central Bank resources and is the exclusive concern of the largest commercial bank in Turkey (Agri- cultural Bank). On the other hand, only one bank is legally authorized to lend against immovable property. Housing construction is financed only by this one bank (Real Estate Bank) and by loans, made by the social security institutions to their members (subject to many conditions). 6.8 The above specialization illustrates a general practice of forcing credit flows through rigid channels, discouraging movement between the channels. The extent of this "compartmentalization" is difficult to quantity but is strikingly high. Transactions between financial organizations are relatively 1/ Developments in 1973 may affect the future growth of deposits adversely. Deposit interest rates have been reduced in the 6 to 24 month maturity range by 1 percentage point and the rate of inflation has been high.  - 22 - small 1/ and most of these flows represent statutory purchases of SIB bonds by social insurance agencies and flows between the Central Bank and the com- mercial banks reflecting legal reserve requirements and Central Bank advances. In their dealings with non-financial sectors, the financial institutions are highly specialized. The Central Bank finances the government and a few SEEs; social insurance institutions collect premia from households and firms to fi- nance the SIB and make some investments of their own; the SIB receives funds from the government and social insurance to finance SEEs; the "special law" banks have limited sources of funds and lend to specified categories of borrow- ers. Only the other commercial banks appear to deal with a wide range of non- financial sectors. Their lending, too, is subject to government influence through differential interest rate ceilings and selective credit policies. Interest Rate Policy 6.9 Strict control over the structure of interest rates in Turkey dates back to 1938 and has been one of the most important instruments of monetary policy in the last decade together with reserve requirements. Official pro- nouncements regarding the desirable structure and the degree of control to be exercised have varied greatly and the Third Development Plan would like to see interest rates that reflect the scarcity of capital. But in practice, the policy has been to keep interest rates below the market equilibrium rate, and there was in fact a reduction in interest rates in early 1973. 2/ 6.10 A variety of motivations can be adduced to explain the policy of low interest rates in Turkey. The dominant motivation appears to be the desire to reduce the cost of production in industry, thereby increasing in- ternational competitiveness and combating domestic inflationary pressure. It is highly unlikely that the policy has these intended effects. First, with the possible exception of the construction industry, interest costs are only a small part of the cost of production and probably make no significant 1/ A study of the flow of funds through financial institutions during 1963-68, by Professor Ertuna, indicates that four classes of institutions (Central Bank, banks, Social insurance agencies and SIB) received and distributed a total of TL 56 billion, of which TL 43 billion went to non-financial sectors. Thus, flows between these classes of financial institutions were only TL 13 billion, or only 31% of flows out of the financial sector (Table 6.19). 2/ In addition to keeping the general level of interest rates low, the structure of interest rates is also changed to favor borrowers in priority sectors. Only the former will be discussed here. The latter will be discussed in the following sections along with other selective credit policies.  - 23 - difference to export potential. 1/ Secondly, once-for-all reductions in in- terest rates as in 1972 cannot have much effect on inflationary pressure, which is a continuing process. Finally, it is generally agreed that banks are able to evade the interest ceilings by charging a variety of commissions (which are nominally regulated as well) and by requiring compensating depo- sii:s (which is not legally permitted); consequently, ceilings on interest rates probably do not reduce the actual cost of credit to borrowers. Con- versely, interest ceilings have some undesirable consequences on the mode of allocation of credit and on equity tetween savers and investors which will be discussed further below. 6.11 The ceilings on interest rates extend over all categories of credits, rediscounts and deposits, and in practice, actual interest rates are set at the prescribed ceilings. There have been only two revisions in the structure of legal interest rate ceilings since 1961 (Tables 6.1 and 6.2). In 1961, the ceilings on lending rates ranged from 7.0 to 10.5% and on deposit rates from 2.0 to 6.5%. In 1970, there was an upward adjustment of 1.0 to 1.5% in most rates and the maximum time deposit rate was increased by 3%. In 1973, there was a partial return to the 1961 structure of interest rates. Short-term lending rates were reduced by 1.0 to 1.5%. Medium-term lending rates remained at the 1970 ceiling of 12%. Interest rates on demand deposits were reduced by 0.5 to 1.0% and the maturity structure of time deposit rates was altered, making them less attractive to depositors (Chart 5 and Appendix Table 6.2). Since 1970, a ceiling of 15% has been decreed for private corporate bonds; and in 1973, interest rates on inter-bank deposits were allowed to find their own level. 6.12 The ceilings on deposit interest rates are a consequence of the ceilings placed on lending rates on the one hand and the desire of banks to protect their profitability. Interest on deposits and other banking questions are examined by a trade association which is endorsed by the government (The Bank's Association of Turkey). Its membership is compulsory for all banks and its board meetings are presided over by the Governor of the Central Bank. 2/ While the payments on deposits have been strictly limited, bank charges and commissions (see details below) increase earnings from loans. From 1963 to 1971, the average payments on outstanding deposits (inclusive of interest, commissions and "premiums") were slightly below 4% for the samll depositors in national commercial banks other than special law banks whereas income from lending operations (inclusive of interest, commissions and charges for banking 1/ A study of 245 firms in modern, industrial sectors financed by TSKB shows that, in 1971, interest payments, inclusive of taxes and commis- sions average 7% of the cost of production. However, the burden of in- terest on profits may be more significant, thus affecting investment decisions in the less profitable industries. 2/ The Association also regulates the use of lotteries and other means to attract deposits. Prices offered are now limited to a maximum of 0.5% of outstanding deposits plus a fixed sum determined by the Central Bank.  -24- ChartL5. Changes in Interest Rate on Savings Deposits (1960 - 1970 - 1973) Interest r 1973 JUiuuiiUihEuuuhEIURIE!IUIUE nIjIUlTfl U 1970 ! - ,8 ; 1961 4 2 0 3 6 12 18 24 Mtrt Maturity (months) Source: Table 6.2  - 25 - services) was about 10% of outstanding deposits and about 15% of outstanding loans. 1/ Income from investments was an additional 0.5% of deposit volume. The spread available for expenses and profits of banks is, therefore, about 7% on the volume of deposits (except in 1971 when the ratio of credits to deposits was exceptionally low). 6.13 This high spread has made it possible for the banks to compete strongly for deposits by excessive advertising and expansion in the number of branches. The number of branches increased by 67% over the five years from 1966 to 1971. The private, national banks expanded by 94% while branches of special law banks mostly by the Agriculture Bank and the People's Bank grew 43% during this period. Judgments on the net economic benefits of branch expansion (authorized by the Ministry of Finance) must obviously be preceded by careful, detailed study. However, the available evidence suggests that the branch expansion by private banks has been wasteful. With price competition between banks (through interest and premiums) being severely circumscribed by regulation, the justification for branch expansion has to be a significant improvement of public access to banks and better mobilization of savings. In fact, the 1,369 new branches opened between 1966 and 1971 brought banks to only 23 new towns. In 19 of these 23 towns, the pioneers were special law banks rather than private banks. The proportion of bank branches in the three main metropolitan provinces (Istanbul, Ankara and Izmir) increased from 33 to 35%. Thus the 874 new branches of private national banks were established almost exclusively in towns which already had banks and mostly in medium and large cities. 2/ 6.14 Because of the ceilings on interest rates and the price inflation, depositors have earned a negative real rate of return on both sight and time deposits throughout the last decade; in this situation the convenience yield of branch expansion has probably been small. It is difficult to quantify the effect of the low rate of return, or of the expansion of bank branches, on deposit accumulation because there are many other factors influencing it at the same time. In particular, Government monetary policy has allowed a rapid increase in the supply of currency and hence in deposits; interest ceilings and other factors have discouraged the development of a capital market that 1/ The calculations are based on balance sheets and profit and loss state- ments published by the Banks' Association in Turkey. Outstanding depo- sits are defined as the sum of official, commercial, bank and savings deposits. Special law banks are excluded because they rely on non- deposit sources for a significant part of their funds. 2/ Branch expansion has been accompanied by expansion of the number of deposit accounts but this is a misleading indicator of the number of depositors. Up to TL 500 of interest income from each deposit account is exempt from income tax provided the accounts are in different branches. This encourages the multiplication of accounts. There were 12,6 million savings accounts at the end of 1971 when the total population in the 15-64 age group was only 20 million.  - 26 - could have provided other investment opportunities to private savers; im- provement in the balance of payments has resulted in a reduction of blocked import deposits with the Central Bank, part of which must have been transfer- red to commercial banks; part of workers' remittances that surged after de- valuation has been saved in the form of deposits. 6.15 The ratio of time deposits to total monetary liabilities of the banking system was less than 27%o for a number of years, but increased sharp- ly to 30% at the end of 1970 and 33% at the end of 1971. The various factors mentioned in the previous paragraph would also affect this ratio but the in- crease in the interest rate from 6.5 to 9% probably had a significant effect as well, indicating that deposits would respond to the stimulus of higher interest rates. 6.16 The reasons advanced in favor of deposit rate ceilings are the need to avoid "excessive" competition among banks, reduce bankruptcies and retain public faith in the banking system. However, these objectives can be achiev- ed more effectively by supervision of bank liquidity (which is already being done by the Central Bank) and the introduction of a deposit insurance scheme. Such measures would permit a general increase in interest rates paid to depo- sitors, would probably result in greater deposit mobilization and raise the capacitv of banks to extend medium-term credit. 6.17 A serious objection to a policy of low deposit interest rates can be advanced on grounds of equity. Two-thirds of the deposit outstanding at the end of 1971 were held by individuals and two-thirds of the individual accounts had outstanding balances of less than TL 1,000 at the end of 1971. Even allowing for a substantial duplication of accounts, at least half of the depositors can be classified as small savers to whom bank deposits are the only available financial asset (other than currency). A policy of low depo- sit interest rates discriminates unfairly against this class of saver. 6.18 With excess demand for credit, the cost of credit is substantially above bank lending rate ceilings due to the existence of various taxes, fees and commissions the borrower is required to pay. There are detailed regulations regarding the taxes and commissions that a bank can (or ought to) charge on each type of transaction (Table 6.17). In addition, the bank can also charge communication costs for inter-town transactions and fees for insurance. (Some banks in Turkey also have associated insurance companies.) Further, some borrowers may be asked to maintain compensating deposits, thereby increasing the cost of net bank credit tolthem. Banks tend to negotiate a package of financing with their customers that would assure them a satisfactory composite yield. Regulations on specific transactions, therefore, are easily avoided. The broad categories of the additional costs of bank credit are shown in Table 20 below. The net effect of these charges is to increase the cost of credit by 7 to 8 percentage points above the nominal interest rates.  - 27 - Table 20: ADDITIONAL COSTS OF BANK CREDIT /1 Commission: 1.5 to 3.0 percent of value of credit. Stamp tax: 0.5 percent, incurred twice if a letter of credit is used. Communication costs: 0.5 percent. Insurance: 1.0 percent, if credit is against merchandise. Transaction tax: 25 percent of interest and all othcr charges except stamp tax and insurance. /1 Costs other than interest charges which are paid by the borrower. 6.19 On the basis of official charges alone, the cost of short-term credit to prime borrowers is increased from 10.5% to a maximum of 17.7% of medium-term credit from 12% to a maximum of 19.9%. In practice, the cost of short-term credit can vary from 16 to 22%, and there is wide variation in the cost of medium-term credit as well. Corporate bonds, which are subject to an interest ceiling of 15% usually cost about 20% because of the need for bank guarantees of most issues. Consumer credit is not offered in large vo?ume by banks and its interest rate is not regulated. Its cost is estimated to be over 36%. 1/ 6.20 On this evidence, it appedrs that ceilings on interest rates have not achieved their major purpose: to reduce the cost of credit to investors and other borrowers. Interest ceilings, by leading commercial banks to rely on commissions and fees for a major part of their income, have at the same 1/ Of course, the actual prevailing cost varies in time and according to purpose, client and generaly supply-demand conditions. Only fragmentary evidence is available on what the equilibrium rate realy is. When the corporate bond market flourished briefly in early 1970 in Istanbul, in- terest rates around 15% per annum were prevalent; compulsory savings bonds were traded in a secondary market until 1967 at a discount which implied interest rates around 30%. The interest rate implied by trans- actions in the secondary bond market in Istanbul in mid-1972 was about 16.5% and the coupons of compulsory savings bonds are also traded at similar discounts. But these markets are so thin that one hesitates to draw firm conclusions on this basis.  - 28 - time introduced serious distortions in the supply of credit for fixed invest- ment. With interest and commissions fixed, banks have no incentive in fi- nancing new investments which are good but involve risk, leading them to pre- fer established borrowers to new entreprenuers, and to prefer credit against discounts and short-term credits rather than medium-term investment credits. Money and Credit 6.21 Monetary liabilities of the banking system have grown at an average annual rate of 18% over the past two decades, and at 26% in the last two years (1970-72). The very rapid growth of deposits, especially time deposits since 1970 is the result of several factors, including the transfers of emigr-ant workers, the higher interest rates on deposits and the inflation of money incomes. The liabilities of the public sector have grown at a much lower rate and their share in the expansion of banking system liabilities fell from 61% in 1952-62 to 41% in 1962-67 and 21% in 1967-72 1/ (Table 21). Since 1970 liabilities of the rest of the world have shot up dramatically, the rapid in- crease in the liabilities of the banking system reflects the rise in deposits (including foreign exchange deposits in 1970-72), the inability of the public sector to mobilize adequate savings for growing public investments up to 1972 and the policy of price support for major agricultural commodities. 6.22 The proximate determinants of the supply of money during most of the past 2 decades have been Central Bank credit to the Treasury and for agriculture, both of which are determined by government policy (see paras. 6.71-73). Central Bank credit to state economic enterprises was a major influence on the growth of money supply until 1960, but has been severely restricted since then. Since 1970, the growth of net foreign assets has also been a major factor behind the growth of money supply but has so far been less amenable to policy control. 6.23 Central Bank advances to the Treasury are influenced by the size of the budget deficit and the extent to which the government is able to borrow from other sources. Short-term advances to the Treasury have increased rapidly in the last decade, prlmarily as a result of the expanded public in- vestment program. They are legally limited, however, to 15% of the general budget expenditure. Central Bank credit to agricultural agencies is deter- mined primarily by the needs created by price support policies and harvest surpluses. In essence, high purchase prices and inadequate margins to meet operating costs were responsible for additional borrowing needs of the Soil Products Office and the Agricultural Sales Cooperatives which administer the price support program. 1/ Excluded from these claims on the public sector are large SIB credits to public enterprises which are financed from the expansion of compulsory social insurance funds. Both SIB and social insurance funds are not part of the banking system.  - 29 - 6.24 Net foreign assets of the banking system showed no growth from 1952 to 1970 but have grown very rapidly since (from $11 million at end 1970 to $556 million at end 1972) due mainly to the accelerated inflow of workers' remittances and improved exports. While these inflows have very obvious eco- nomic benefits, it should also be recognized that they contribute significant- ly to inflationary pressures in the economy. The growth of net foreign as- sets accrued despite exchange liabilities which took the form of convertible lira deposits in Turkish banks in early 1972. The recognition of Turkey's improved balance of payments position and prospects, the relatively low in- terest rates and excess liquidity in European money markets and the exchange rate quarantee provided by the Turkish Government on convertibility of these deposits all combined to raise their volume from $135 million at the end of 1971 to $463 million at the end of 1972. Under the prevailing regulations, these deposits were used as a cheap source of short- and medium-term credit bv Turkish industrialists. They also provided a base for expansion of money supplv, especially as they were classified as inter-bank deposits, exempt from reserve requirements. Convertible lira deposits were partly responsible for the increase by 32% in bank credit to the private sector in 1972. Various measures taken in 1973 have already resulted in the reduction in ctonvertible lira deposits and should gradually eliminate them over the next twc years (see Chapter 7, Annex 2). Table 21: CHANGES IN MONETARY ASSETS AND LIABILITIES (TL billion and percent) 1952 - 1962 1962 - 1967 1967 - 1972 TTL% TL TL Money 8.55 81 11.71 81 30.39 67 (of which demand deposits) (5.17) (49) (7.53) (52) (23.31) (52) Quasi-money 2.02 19 2.74 19 14.83 33 TOTAL 10.57 100 14.45 100 45.22 100 Net Claims on Public Sector 6.45 61 5.97 41 9.64 21 Claims on Private Sector 7.23 68 11.69 81 30.90 68 Net Foreign Assets 0.38 4 -0.36 -2 7.81 17 Other -3.49 -33 -2.85 -20 -3.13 -6 Source: Tables 6.3 and 6.4 Credit Distribution and Policies 6.25 The trend in the allocation of credits to both private and public sector reflects the emphasis on industrialization in the planned development strategy of the country and the major role of the public sector in fixed in- vestment. Table 22 presents the sectoral allocation of the increase in out- standing credits from 1963 to 1971. Industry and mining have taken 34% of the expansion in credits to the private sector, raising their share of out- standing credits from 17% in 1963 to 29% in 1971. This increase has been  - 30 - achieved primarily by restraining the growth oE credits for housing and con- struction. Credits to industry and mining have taken the lion's share of the increase in credits to the public sector. Table 22: ALLOCATION OF INCREASE IN OUTSTANDING CREDITS, 1963 TO 1971 (TL million and % shares) Private Public Total Sector TL TL TL Industry, 'Mining 9,696 34 15,274 57 24,970 45 Agriculture 6,954 24 2,732 10 9,686 18 Small Artisans, etc. 1,065 3 - - 1,065 2 Housing, Construction 2,818 10 - - 2,818 5 External trade, Tourism 2,531 9 433 2 2,964 5 Financial 176 1 7,023/* 26 7,199/* 13 Distribution, Services 5,418 19 1 476 5 6.894 12 TOTAL 28 658 100 26,938 100 5 596 100 - ~ ~ -a ._a _ - -_ /* Including credit to State economic enterprises, primarily for invest- ment in industry and mining. Source: Table 6.15. 6.26 A comparison of the distribution of the increase in credit with the distribution of fixed investment expenditures among the principal invest- ment sectors during 1963-71 shows that agricultural credit to the private sector (24% of total credit to the private sector) and industrial credits to the public sector (57% of public) absorbed a considerably higher proportion of the expansion of credit than their shares in total fixed investment (11% and 32% respectively) perhaps due to their heavier demand for working capital. The sector in which credit lagged was the private housing and construction sector (10% vs 41%). 6.27 In aggregate, the public sector received 48% of the increase in outstandinig credits from 1963 to 1971, its share of these credits increasing from 26% to 44%. During this period, the public sector undertook 56% of total fixed investments. The most striking increase in public sector credit between 1963 and 1971 was in industry and mining (from 19% to 59% of the total), as a result of SIB credits which accounted for 48% of total credits to the public sector in 1971 (SIB was created in 1964). The only sector in which the public share has declined is distribution and services, but even in this sector credit to the public sector has been growing at 2.8% per year at constant prices from 1963 to 1971 (Table 23).  - 31 - Table 23: OUTSTANDIN,C CREDITS TO PUBLIC SECTOR /* (TL million and % share) 1963 1971 %. share % share of credits of credits Sector TL to sector TL to sector Industry, Mining 400 18.7 15,674 57.8 Agriculture 977 28.3 3,709 28.3 External Trade, Tourism 104 6.2 537 11.6 Financial 815 87.2 7,838 96.4 Distribution Services 1,221 43.5 697 27.8 TOTAL 3,517 25.6 30X455 43.9 /* Credits made by the banking system and SIB. Source: Table 6.15. Selective Credit Policies 6.28 The monetary authorities in Turkey have taken a wide variety of measures that discriminate in favor of one or another sector in the alloca- tion of credit. The objective of these measures is to improve the role of the financial sector in economic and social development by increasing the availability or reducing the cost of credit to specified priority nectors. Broadly, the selective credit policies that have been adopted have favored the financing of public investment, agriculture, and medium-term lending to industry with some emphasis on export-oriented activities. It can be assumed that, by and large, credit was used for the acknowledge purpuse, with no more than small leakages to other activities. 6.29 A wide.range of instruments has been used in pursuit of these policy goals: specialized institutions with privilege access to specific sources of funds, differential interest rate ceilings, tax exemptions and subsidies, access to the central bank, quotas and prohibitions on commercial bank lending and differential reserve requirements. 6.30 Specialized financial institutions (para. 6.3) have been established as a result of government policy and tend to be heavily dependent on financial support from the government. They are subject to interest rate ceilings which inhibit these institutions from raising resources by issuing non-depo- sit obligations. Further, the banking transaction tax is applied to transac- tions between various financial institutions, thereby discouraging such flows of funds.  - 32 - 6.31 The private development banks (TSKB and SYKB), lend at 12% 1/, whereas they would have to pay at least 15% to raise long-term resources from the public or from other financial institutions. Consequently, they have to rely on the supply of funds as a result of negotiated arrangements rather than commercial borrowing. The only private cource of funds that'TSKB has is its equity (11% of its capital in 1971). Domestic debt, 21% of its capital, is entirely supplied by the government and the rest is foreign exchange borrow- ing from official lending agencies, guaranteed by the Turkish government. SYKB (Industrial Investment and Credit Bank) is entirely independent of government finances and gets its funds primarily from six large commercial banks which have agreed to transfer to SYKB 5% of the increase in their depo- sits each year. But, as a result of interest ceilings and a tax on financial transactions, SYKB can pay no more than 9% interest on this debt - far less than the banks can earn on other lending. Therefore, the arrangement between SYKB and the banks is a rather precarious one. Further, SYKB has had only limited access to foreign exchange resources and consequently has a rather high ratio of working capital credits in its lending portfolio. 6.32 The State Investment Bank lends to SEE's at 9.5 - 10.5%, which is even cheaper than the chean credits offered by private development banks, and is correspondingly more reliant on tied sources of finance. The State Investment Bank gets all its resources either by direct government subsidy or by the sale of bonds to the government-managed social security institutions and uses them to finance the investmenits of state economic enterprises. The surplus of social security institutions is rapidly vanishing and will soon turn to a deficit. 2/ Unless it is able to sell its bonds to private institu- tions and individuals or borrow from abroad, the viability of the SIB will depend on the resources generated by the expansion of the coverage of social insurance to self-employed persons and/or on direct subsidization by the Treasury. 6.33 The Agricultural Bank has the largest deposits of any bank in Turkey. Official deposits accounted for 39% of one bank's total deposits at end of 1971. It also has privileged access to the Central Bank, which finances a large part of its credit to agricultural sales cooperatives and agricultural credit cooperatives. The latter is another form of specialized institution making credits to agriculture, but in fact is almost wholly dependent on the Agricultural Bank. The proportion of credit cooperative loans not financed from the Agricultural Bank has dwindled from 26% to 11% in recent years. 1/ The actual cost to the borrower is about 16%. 2/ This is the result of a number of influences, the most important of which are the maturing of their obligations (especially a retirement "bulge" expected from 1975) the additional burden placed on them by the 1970 Personnel Law, the low rate of return on their investments, and the Parliament's unwillingness to raise the insurance premia.  - 33 - 6.34 The special law banks depend primarily on government rather than on deposit mobilization for their financing. The very striking difference in this regard between special law and other national banks is shown in Table 24. Non-official deposits, the only significant private source of funds to special law banks, accounted for only 53% of loans made by special law banks and 143% of loans made by other national banks. Iller Bank (which specializes in fi- nancing local administrations) obtained only 1% of its loan volume as non- official deposits at the end of 1972. With the exception of the Agricultural Bank, banking operations are a minor part of the activities of special law banks. Table 24: BANK LOANS ANiD DEPOSITS AVERAGE OUTSTANDING AT YEAR END 1963 TO 1972 Special Law Banks Other National Banks ________ - ---- TL milliorns)- -- Loans /* 17,732 11,170 Deposits 12,260 16,552 Official (2,897) (579) Other (9,362) (15,973) -