Turkey - Balikesir Newsprint Project

Document of FILE COPY *The World Bank FOR OFFICIAL USE ONLY Report No. P-1834-TU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO TURKIYE SELULOZ VE KAGIT FABRIKALARI ISLETMESI AND SEKA BALIKESIR MUESSESESI WITH THE GUARANTEE OF THE REPUBLIC OF TURKEY FOR THE BALIKESIR NEWSPRINT PROJECT May 4, 1976 This document has a restricted distrbution 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.  Currency Unit Turkish Lira (TL) US$ 1 TL 16.00 TL 1 = US$ 0.063 TL 1,000 = US$ 62.50 TL 1,000,000 = US$ 62,500 Turkish Government Fiscal Year = March 1 to February 28 SEKA Fiscal Year = January 1 to December 1  FOR OFFICI USE ONLY INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO TURKIYE SELULOZ VE KAGIT FABRIKALARI ISLETMESI AND SEKA BALIKESIR MUESSESESI WITH THE GUARANTEE OF THE REPUBLIC OF TURKEY FOR THE BALIKESIR NEWSPRINT PROJECT 1. I submit the following Report and Recommendation on a proposed loan to the Turkiye Seluloz ve Kagit Fabrikalari Isletmesi (SEKA) and SEKA Balikesir Muessesesi (The Balikesir Establishment) with the guarantee of the Republic of Turkey, for the equivalent of US$70 million to help finance the foreign ex- change cost of the Balikesir Newsprint Project. The loan would have a term of 15 years including 4 years of grace with interest rate at 8.5 percent per an- num. Turkey would charge SEKA and the Balikesir Establishment a guarantee fee of 1.5 percent per annum on the outstanding amount of the Bank loan, bring- ing the cost of the loan to 10 percent per annum. PART I - THE ECONOMY 1/ 2. An economic updating mission visited Turkey in November 1974 and its report (No. 71la-TU) entitled "Current Economic Position and Prospects of Turkey" dated June 9, 1975, was circulated to the Executive Directors on June 17, 1975. A country data sheet is attached as Annex I. 3. Despite an uncertain domestic political situation resulting in fre- quent changes of Government since 1971 and, more recently, the international recession, Turkey has maintained an impressive rate of economic growth. GNP grew rapidly in the last decade, averaging an impressive 7 percent annual growth in real terms in the period 1962-72. Industry, power, transport and construction were the sectors contributing most to this growth rate. Due largely to a decrease in agricultural production reflecting poor weather con- ditions, the growth rate dropped to 5.5 percent in 1973, but recovered to 7.4 percent in 1974, and reached an estimated 7.9 percent in 1975, compared to the Third Plan (1973-77) target of an average of 7.9 percent per annum. Despite some difficult problems that the economy faces, this relatively high growth rate underlines the basic vitality of the Turkish economy. The main issues facing the Government, which require the establishment of priorities as well as of corrective measures, are: (a) high rate of inflation; (b) insufficient mobilization of public resources; (c) employment generation problems; .(d). deterioration in the balance of payments; and (e) inadequate coordination among Government agencies in project implementation (discussed in para 14 below). 4. The budgetary situation in the last decade was dominated by the relatively rapid growth of public expenditures. Although tax revenues also 1/ Parts I and II are identical to the Presidents Report for the loan to the Agricultural Bank of Turkey (P-1816-TU) dated April 14, 1976, circu- lated to the Executive Directors April 16, 1976. This document has a restrcted 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.  - 2 - grew rapidly, the increase was more than offset by the rise in Government expenditures and transfers. As a result, the overall budget deficit widened and the Treasury borrowed increasingly from the Central Bank. In 1972 and 1973, the Treasury introduced a stricter control of current expenditures and succeeded to some degree in shifting the sources of finance for the budget deficit from the Central Bank to the sale of Government bonds to the public. However, partly due to a shortfall in tax revenues and partly due to increased current expenditures resulting from inflation and the Cyprus operations, the budget deficit rose again in 1974 to TL 7.3 billion (compared to TL 5.4 bil- lion in 1973). Central Bank financing of the Treasury rose by TL 4 billion and became a major factor in monetary expansion at a time when stricter mone- tary controls were needed. The deficit in 1975 was originally estimated at TL 9 billion, but is likely to be significantly larger. 5. Over the years, the State Economic Enterprises (SEEs) have general- ly earned low profits, necessitating an increase in budgetary transfers from public resources to meet their operating and investment needs. A significant portion of the SEEs' deficits are accounted for by the Turkish Railways and the Coal Corporation. Other SEEs have shown either small profits or small losses. During 1974, the prices of several SEE products were raised sub- stantially (ranging from 20% to 167%) to improve their respective financial situations. In addition, railway tariffs were increased by an average 56 per- cent in 1975. The savings performance of the SEEs showed some improvement in 1973 and 1974, and they were able to finance an increased proportion of their investment from their own resources. However, because of delays in implement- ation - resulting from poor managerial and limited technical capabilities - and because of difficulties in the procurement of imported materials, the gains are still below Third Plan targets. Consequently, many SEEs continue to rely on substantial budgetary transfers. The reform of the SEEs--in organization, management, executive and labor skills and pricing policies--remains crucial, especially if Turkish industry is to be prepared for competition from the ECC. Realistically, these basic reforms can only be initiated by a strong and stable Government which commands significant and coherent parliamentary support. 6. The rate of domestic inflation has been high in recent years. The average rate of increase in wholesale prices rose from about 20 percent per annum in 1973 to nearly 30 percent in 1974. Inflationary pressures have been partly fueled by growth in domestic liquidity, which averaged about 25 percent per year during 1970-74. Other contributing factors include increases in agricultural support prices for domestic and export products as well as in minimum wages, and substantial increases in import prices. Measures to re- duce the growth of domestic liquidity, without discouraging investment and growth, are essential to ease inflationary pressures. The trend towards rapid increases in Central Bank financing of the public sector needs to be reexamined. In late 1974, the Government raised interest rates to encourage private savings and long-term lending. The interest rate on medium-term credit was raised from 12 to 14 percent and rates on time deposits up to one year from 4 to 6 percent. The present government of Prime Minister Demirel regards the restoration of domestic price stability as one of the key prob- lems on which Government policy must be focused. There has in fact been a  - 3 - significant reduction in the rate of inflation in the last year. The whole- sale price index rose by only 11.0 percent in 1975 compared to 30 percent in 1974; and the Government estimates an average rate of inflation (as measured by their GNP deflator) of only around 16 percent in 1975, compared to 27 per- cent in 1974. 7. Turkey's development strategy places greater emphasis on growth of output through higher labor productivity, than on increased employment. As a result, the labor surplus, including that in agriculture, rose from an esti- mated 1 million in 1962 to 1.6 million in 1973, representing about 10 percent of the labor force. Until 1973, emigration, especially to Germany, partially eased the pressure on employment. Between 1965 and 1973, net emigration totaled about 450,000. The economic slowdown in Europe has, however, consider- ably reduced labor emigration from Turkey, from 136,000 in 1973 to only 20,000 in 1974 and 5,000 in 1975. Nevertheless, the Third Plan continues to emphasize investment in capital-intensive industries and estimates the non-agricultural labor surplus to grow to 300,000 by 1977. With prospects of further emigration of Turkish labor to Europe reduced, at least in the medium-term, unemployment should be a major concern of economic policy. A pilot land reform program is currently underway in Urfa province in the southeast where most of the larger farms are located; expropriation of land was started in November 1974. Speedy implementation of rural development programs would also help to slow migration and ease unemployment in rural and urban areas. In addition, labor intensive production methods need to be emphasized, where appropriate, in the formulation of projects. However, even with these measures, and faster growth than planned in construction and services, unemployment is likely to remain a significant problem. 8. The Third Plan constitutes the first phase of Turkey's long-term strategy for the period 1973-95. The ultimate objective is to raise stand- ards of living in 1995 to those of Italy in 1970, through rapid industraliza- tion and decreasing dependence on external resources. The Plan aims at an- nual growth rates of 8 percent in GDP, 12.7 percent in fixed investment, a marginal national savings ratio of 38 percent (compared with about 18 per- cent in the Second Plan), an annual increase in commodity imports and exports of 9.4 percent and 7.1 percent respectively, which taken together with pro- jected growth in invisible earnings (mainly workers' remittances), is ex- pected to result in a decline in gross inflows of official external assistance. 9. Prospects for continued high economic growth remain good, although in view of the shortfall of the first two years of the Third Plan, achievement of the 7.9 percent average rate of annual growth during the Plan period seem un- likely. The Plan's projections also seem to be overly optimistic on prospects of an increased savings level and balanced external accounts with reduced levels of external assistance. Experience during the last two years suggests that present efforts to mobilize greater domestic savings to support a rapid growth of investment, especially in the public sector, need to be greatly intensified. The Plan anticipates that two-thirds of the increase in national savings will come from the public sector, through increases both in surpluses  - 4 - of the SEEs and in tax revenue. Given the past performance of SEEs and delays in implementing a general reform in the SEEs (see paragraph 5 above), the ex- pected rapid growth in their surpluses is not likely to be realized. Given the present domestic political outlook, it will also be most difficult to raise tax revenues to the extent envisaged by the Plan. There is nevertheless scope for increases, if appropriate policies are pursued more vigorously, e.g. im- proving tax administration, widening tax coverage to include agricultural in- comes and service incomes, increasing the rate of property taxation and intro- ducing a value added tax. Domestic resource mobilization in the public sector is, in any case, likely to continue to be a significant constraint in the growth of public investment. Besides improved financial performance from the SEEs, increased borrowing abroad as well as increased long-term borrowing from the domestic private sector will be necessary to achieve the ambitious public sector investment targets. As Turkey's development program requires funds in excess of savings that can be mobilized domestically, and these can- not be provided in adequate amounts if foreign finance is limited to foreign exchange cost of high-priority projects, some local cost financing by foreign lenders will be required. 10. The balance of payments projections of the Plan have not taken into account recent developments on the international scene. The sharp increase in the price of petroleum and other imports during 1974 and the prospects of further increases in import prices in the next several years, indicate that foreign exchange needs for financing imports will be much higher than projected. Commodity imports and exports in 1973 were already above the level projected for 1977. Workers' remittances in 1972 were higher than the 1977 target and continued to grow until recently. However, they decreased by 8.0 percent in 1975 as compared to 1974, and their future is uncertain, due to the temporary restriction on further entry of foreign workers into the major labor-importing countries of Europe. On the other hand, recent agreements between Turkey and Libya to send Turkish workers to Libya, and the possibility of similar arrange- ments with other oil-producing countries, should help alleviate the situation. 11. After substantial surpluses in 1972 and 1973, Turkey's overall bal- ance of payments experienced a deficit in 1974, with net reserves declining by about $360 million. This was due partly to a sharp increase in the trade deficit and a slowdown in the growth of workers' remittances, as well as to a reduction in official capital aid inflows. The large trade deficit resulted mainly from an 80 percent increase in the import bill (in particular, petro- leum, wheat, iron and steel), due mainly to higher prices. Imports continued to rise at a rather rapid rate in 1975, and totaled about $4.7 billion during the year. On the other hand, export earnings, which totaled about $1.4 bil- lion in 1975, registered a decline because of the recession in major importing countries, agricultural supply constraints, restrictions on exports to relieve domestic shortages, relatively inflexible export pricing policies, diversion of some goods to Cyprus, and deteriorating terms of trade. As a result, gross reserves declined to about $1.8 billion at the end of 1974, and further to about $1.0 billion at end of December 1975 (the equivalent of about 2.7 months of imports at the present rate). In the medium-term, Turkey's balance of payments is likely to come under significant pressure. Such pressure could,  however, be partly eased, by lifting quantitative restrictions on certain ex- ports, e.g. cement and olive oil, designed to accommodate domestic supply. The Government should also avoid fixing commodity prices at levels above those prevailing in international markets. Even more important are deliberate mea- sures to contain the growth of imports. Without such measures, and in the absence of a resurgence of growth in Europe, Turkey faces the prospect of continued, perhaps intensified, pressures on its balance of payments and its reserves. In May 1974, the Turkish lira was revalued vis-a-vis the dollar from TL 14.00 per US$ to TL 13.50 per US$, without a change in parity with other currencies. In September 1974, the exchange rate per US$ was readjusted to TL 13.85, and in April 1975, it was restored to the previous parity of TL 14.00. As a result of subsequent small devaluations, the rate per US$ stood at TL 16.00 as of April 2, 1976. 12. At the end of 1974, total external debt outstanding and disbursed was estimated at $3.1 billion, of which all but 3 percent was public or pub- licly guaranteed. The share of the Bank Group was about 11 percent of total debt outstanding and about 8 percent of total debt service in 1974. The aver- age terms of new credits made available to Turkey have been hardening in recent years, and this trend is expected to continue. Debt service as a ratio of exports of goods and non-factor services plus workers' remittances was about 6.5 percent in 1974, compared to 12 percent in 1971. Despite the deterioration in the balance of payments in 1975, the debt service ratio is expected to remain within acceptable limits in the medium term, if proper policies are pursued. In view of the decline in foreign reserves and anti- cipated pressures on its balance of payments in the medium-term, Turkey should continue to exercise considerable care in its external debt management, and its resort to suppliers' credit financing should also be kept within closely monitored limits. Meanwhile, Turkey continues to be creditworthy for Bank financing. PART II - BANK GROUP OPERATIONS IN TURKEY 13. The 1970 economic stabilization program (see para 11 above) and devaluation of the Turkish lira, which improved the balance of payments, en- abled Bank Group lending, which had previously been intermi-ttent, to be es- tablished on a continuing basis at a high level. As of March 31, 1976, the Bank Group has lent $1,085.2 million to Turkey through 44 lending' opera- tions (or 39 projects, since both loans and credits were provided for some projects), of which $1,000.8 million is outstanding. Fourteen of these operations have been in agriculture and rural development (including multi- purpose), sixteen in industry (including DFCs), eight in power and the rest in urban development, transportation, and education. Agriculture and rural development account'for 28 percent of the funds lent, industry and DFCs for 37 percent and power for about 26 percent. Annex II contains a summary statement of Bank loans, IDA credits and IFC investments as of March 31, 1976 respectively, with notes on the execution of ongoing projects. Imple- mentation of projects has been satisfactory in the private sector, but less so in the public sector where significant delays have resulted from political  - 6 - uncertainty, limited coordination among agencies, staffing problems and related administrative delays. Disbursements have consequently been slower than expected. To improve this situation, the Government established in August 1975, a ministerial coordinating committee, supported by a new secre- tariat located in the Ministry of Finance, which is responsible for coordi- nating all aspects of Bank Group operations. In connection with this new framework, the Government and the Bank initiated in June/July 1975, joint quarterly reviews to identify and resolve key bottlenecks impeding satisfac- tory project implementation. The results so far have been encouraging, con- sidering that these reviews were initiated only a few months ago, and the rate of commitments and disbursements in the last few months has begun to improve. 14. A serious issue continues to beset the Elbistan power project (Loan No. 1023-TU). As a condition of effectiveness of the loan, the Government had undertaken to raise electricty tariffs by about 30 percent in order to enable the power authority (TEK) to earn the 8 percent rate of return prescribed by the TEK law and set forth in Loan Agreements with the Bank. Because of serious inflationary pressures faced in 1974-75 and in recognition of the Government's anti-inflationary policies, agreement was subsequently reached on a lesser tariff increase that would enable TEK to earn 6 percent in 1976 as a transitional measure. Since the Government has not yet implemented the requisite measures, the Bank has not been able to declare the Elbistan loan effective. The Bank is in close consultation with the Turkish Government on this issue, as well as with its co-lenders for the Elbistan project. 15. Bank lending to Turkey is mainly directed at supporting Turkish ef- forts to improve: (a) lagging public sector saving, through gradual improve- ment in the SEEs; (b) better income distribution and improvement in the level of living standards, through rural development efforts, better urban planning and increased employment and incomes; and (c) long-term capacity to earn fo- reign exchange, through promotion of industrial and agroindustrial exports and tourism. While the Bank continues to support gradual institutional and structural changes in the sectors in which lending is provided, continued substantial external financial assistance is equally important, in view of the increase in projected capital import requirements and the anticipated medium-term pressures on the balance of payments and on overall fiscal re- sources, mentioned in paragraphs 9-11 above. 16. In support of these objectives, it is proposed to continue to devote the Bank's development efforts to certain key sectors, of which agriculture is the most important. In this sector, emphasis is being put on rural devel- opment, livestock and the strengthening of agricultural credit mechanisms, as provided for under the proposed project. Industry (including mining and DFCs) and- power, where the gradual strengthening of the SEEs is the key task, are also receiving significant support. This program will be supplemented by future projects in selected sectors including urban development, tourism and transport. Until recently, Bank lending was also focused in two geographical areas: (i) the Istanbul region, with emphasis on urban planning, water supply, power distribution and industrial finance; and (ii) the Cukurova region around Adana on the southern coast, with emphasis on power, irrigation, and fruit and vegetable production. Lately, the focus has been gradually  - 7 - broadened, especially to include the Anatolian plateau and eastern Turkey, in support of efforts to widen the geographical base of development, develop rainfed agriculture, improve the distribution of income, and discourage rapid urban migration and encourage tourism development. The latter will be sup- ported through the proposed tourism infrastructure project in the south Antalya coastal area likely to be ready for Board consideration at the end of FY76. Also being prepared for Board consideration in FY76, is a Third Live- stock Development Project focused on the dairy subsector. Other projects under preparation and being processed towards appraisal include wastewater disposal in Istanbul, a hydroelectric project, a second DFC operation with the State Investment Bank (DYB), and a second railways project. 17. IFC has invested in the production of nylon yarns, pulp and paper, glass, aluminum and steel pipes. As of March 31, 1976, gross commitments totaled $118.1 million, of which $70.8 million were still held by IFC. IFC is currently investigating investment opportunities in the industrial sector, including textiles, synthetic fibers and inorganic chemicals. PART III - THE PULP AND PAPER AND FORESTRY SUB-SECTOR AND THE BORROWERS General 18. Turkey with 19 million hectares of forests, has the fourth largest forestry resources in Europe after Finland, Sweden and Spain. However, the yields per hectare and the contribution made by forestry products to GNP are much lower, largely due to outdated forest management techniques and the fact that wood processing enterprises are still being developed. It is estimated that perhaps 20 percent of the labor force depends on this sub- sector for their employment and they are among the poorest people in Turkey. 19. Recognizing the economic potential of its forestry resources, some years ago Turkey began a series of-studies with UNDP assistance to survey these, develop better management techniques and identify and prepare plans for more intensive utilization. The first series of studies resulted in the Antalya Forest Utilization Project (Ln. 957-TU) - now renamed the Akdeniz (Mediterranean) Forest Utilization Project - Turkey's first large-scale in- tegrated wood products project, for which the Bank provided a loan of $40 million, and the European Investment Bank a loan of $24.4 million equivalent. The second series of detailed forestry resource studies covering the North Aegean, Marmara and Black Sea regions, is nearing completion and indicates that these also have substantial wood resources available for exploitation. The proposed project resulted from the preliminary findings of these studies. The Borrowers 20. The major consumer of forestry resources in Turkey for conversion into pulp and paper is the State Pulp and Paper Enterprise (SEKA), which was established in 1955 as a Government-owned State Economic Enterprise (SEE). Its share capital of TL 2.6 billion is held fully by the Government. A six-man  - 8 - Board of Directors closely supervises operations, and includes a representative each from the Ministries of Industry and Finance and from the labor unions. The remaining three members are SEKA's General Manager, who is also the Chair- man of the Board and his two Assistant General Managers. All of them are appointed by the Council of Ministers. Overall, SEKA's management and staff is sound. In 1975, SEKA employed over 10,000 persons and had a sales of nearly TL 3 billion. 21. SEKA's head office is in Izmit, the site of SEKA's original plant. In 1970, SEKA began an ambitious program of expansion. Three new plants (Caycuma, Aksu and Dalaman) are now in production and another three, including the proposed project, are at various stages of implementation (Afyon, Akdeniz and Balikesir). Each of these plants is organized as a wholly owned subsidiary ("Establishment" under Turkish law) of SEKA, with its own legal personality and separate financial structure. However, their autonomy in most matters is limited and they operate more like divisions set up as cost centers. The Balikesir Establishment, set up to deal with the proposed project, has an authorized share capital of TL 100 million, which will be increased to TL 1,280 million as the project is implemented. Its day-to-day operations will be supervised by an administration committee consisting of the manager and his two assistant managers. For major decisions, the manager will coordinate closely with SEKA's general management. 22. SEKA's production has increased from about 100,000 tons of paper and paper board in 1966 to about 308,000 tons in 1975. It is expected to reach about 540,000 tons by 1980. SEKA's three new plants which are now in produc- tion all faced start up difficulties, but these are being gradually overcome. In 1975, the Caycuma plant reached 96 percent of capacity, Aksu 86 percent and Dalaman 93 percent. Attracting and retaining high caliber technical staff has been and remains a problem, in part because of the lack of competitiveness of public sector salaries. SEKA has developed training and other programs to compensate for this. Other problems include overmature and too dry wood sup- ply which reduces product output and quality, and power outages. SEKA is working with the General Directorate of Forestry to resolve the former problem. 23. SEKA's sales, which consist of different types of paper products in- cluding newsprint, have expanded rapidly in pace with production; they in- creased from TL 951 million in 1971 to TL 2,750 million in 1975. Operations showed net losses in the years 1971 to 1973 reflecting the start-up of the new plants. Although the good overall results in 1974 resulted in a profit of TL 135 million, a cost-price squeeze in 1975 led to a loss of TL 119 million. SEKA has, however, essentially mastered its first wave of expansion projects. Sawnwood 24. Sawnwood consumption in Turkey has grown at 7.5 percent per year for the last ten years and reached about 2.7 million m3 in 1974. The 17 public sector sawmills operated by the Ministry of Forestry accounted for 0.3 mil- lion m3 of this and the approximately 5,000 small private sawmills the re- maining 2.4 million m3. Imports and exports are not significant. -Demand in 1982, the year when the sawmill under the proposed project will yield  - 9 - full production, is projected to be 4.2 million m3, or an increase of about 1.5 million m3 over 1974. The only known firm expansion plans are for SEKA's two sawmills at Silifke (170,000 m3), being built under the Akdeniz Project, and at Balikesir (105,000 m3) to be built under the proposed project, which together would supply less than 20 percent of the expected increase in demand. Therefore, by 1982, demand will substantially exceed planned sawnwood produc- tive capacity in Turkey. Besides, since the proposed Balikesir sawmill is well located to supply the markets of Istanbul, Izmir and Ankara, no problems are expected in marketing the wood. Prices for sawnwood vary considerably in Turkey and SEKA does not currently sell sawnwood. In any case, to market its substantial production, SEKA has agreed to introduce new marketing methods for sawnwood in connection with its two mills (Loan Agreement, Section 4.05). In contrast to the present auction system, it is planned that prices will be set in published price lists, sales will be through regional selling offices of SEKA instead of at plant site, and in order to provide for steady product flow, SEKA will arrange transportation from the plant instead of the buyer having to do so. Pulp and Paper 25. The high capital cost associated with maximum economies of scale in producing pulp and paper has been a major deterrent for Turkish private investors. Its manufacture has therefore been dominated by SEKA. In 1974, SEKA produced 301,000 tons of paper and paperboard products, including 95,000 tons of newsprint. Another 62,000 tons of pulp and paper products was pro- duced by the private sector, who mainly use imported pulp and waste paper as raw materials. Over one-half of the production in the private sector comes from the three largest manufacturers, including Viking Kagit ve Seluloz A.S., in which IFC has invested about $3.2 million. While it is anticipated that SEKA will continue to dominate the production of pulp and paper, private sector enterprises will continue to concentrate in converting paper products, such as corrugated containers. The two largest private converters are current- ly going forward, as part of a vertical integration program with the construc- tion of two small pulp/paper mills, to produce a total of about 55,000 tpy of fluting and bogus linerboard from straw and waste kraft paper. SEKA is Turkey's sole producer and importer of newsprint. 26. Demand for pulp and paper products has grown at a rate of 10 percent per year for the last ten years reaching 386,000 tons in 1974, of which 23,000 tons was imported. Demand is expected to continue to grow at this rate and reach about 685,000 tons in 1980. Newsprint accounts for about 25 percent of total demand, or 93,000 tons (2.4 kg per capita) in 1974, and consumption of newsprint has also grown at about 10 percent per annum. Turkey was an im- porter of newsprint until 1972 when domestic production became sufficient to meet demand. In 1973, Turkey exported some production, but in 1974 production and demand again came into balance.  - 10 - 27. The democratic features of the Turkish society with its free and unfettered press, a trend towards urbanization and the Government's efforts to increase literacy levels, as well as rising expenditures for advertising, support an expectation of continued strong growth of newspaper consumption, and projected demand for newsprint is 138,000 tons in 1979 and 188,000 tons in 1983. On the basis of the projected domestic market and production, small exports from the proposed project would be possible only between 1979 and 1982, probably to some of Turkey's neighboring countries in the Mediterranean and the Middle East who are newsprint importers. By 1983, however, Turkey once again will have to resort to importation. To plan for meeting this demand, SEKA and the General Directorate of Forestry (GDF) of the Ministry of Forestry, assisted by UNDP financed consultants, are undertaking a study for utilization of the remaining northern forest regions resources in light of the future de- mand for wood industry products including newsprint. SEKA has undertaken to review with the Bank, the results of the study as it pertains to newsprint demand and production (Loan Agreement, Section 3.05(c)). 28. The ex-factory price of domestically produced newsprint is control- led by Government under specific Turkish legislation covering "basic commodi- ties". The 1975 ex-factory price is set at 4,500 TL/ton ($281), which com- pares with domestic production costs excluding financial charges at SEKA's Aksu plant of about 5,840 TL/ton ($365) and average CIF import prices on a spot basis of about 6,000 TL/ton ($400). However, the price paid by pub- lishers is a weighted price between the domestic fixed price and the price of actually imported newsprint plus internal transportation, and was about 5,000 TL/ton ($313) in Istanbul at the end of 1975. The international CIF spot price is not a satisfactory basis for comparison, since most international sales of newsprint are on a long-term contract basis: Turkey, because of small volume and intermittent need has in the past bought on the spot market where prices fluctuate above and below contract prices. The Government presently compensates SEKA for the difference between the ex-factory price and its production and financial costs, by including an amount in the follow- ing years' budget equal to the actual losses for the preceding year. SEKA's 1975 losses under this price structure were TL 264 million ($16.5 million) or about 3,000 TL/ton. Wihile these losses are made up a year later, since the subsidy is paid from the budget only after the year of production, SEKA has meanwhile to borrow to cover working capital needs. These subsidies do not provide for a return on investment, nor incentives for efficient production. 29. The Bank has asssisted the pulp and paper manufacturing sub-sector and SEKA through the Akdeniz Project mentioned in para 19 above. This project met with initial problems arising from the site location which was changed based on a site relocation study done by consultants satisfactory to the Bank and EIB. This study has now been completed, its review confirms the viability of the new project site and a Presidents Memorandum covering the necessary changes was submitted on April 27, 1976, for the Executive Directors' con- sideration on a no-objection basis (R-76-95). Meanwhile, SEKA and the Govern- ment have taken the risk of going ahead with procurement following the Bank's guidelines, as a result of which the Akdeniz project is now expected to come into production by 1978.  - 11 - PART IV - THE PROJECT Project History 30. Based upon the preliminary results of the UNDP forestry surveys in Turkey's Northern Aegean and Marmara forest regions (para 19 above) a pre- feasibility study and subsequently a full feasibility study for a newsprint plant was commissioned in 1974 by the UNDP, with FAO as executing agent. This study was prepared by the Canadian consulting firm of Sandwell and Co. Upon its completion in early 1975, the Government (the Guarantor) and SEKA requested the Bank to consider a loan to cover the foreign exchange cost of the project. The proposed project was appraised in October 1975. Nego- tiations were held in April 1975 in Washington, with a delegation led by Mr. Muamer Akinci, Chief Economic and Financial Counsellor of the Turkish Embassy in Washington and which included SEKA's Chairman and General Manager, Mr. Aziz Gumus. Project Description 31. The primary objectives of the proposed project are to provide for Turkey's growing need for newsprint and to make more intensive use of avail- able forest resources. The project consists of an integrated sawmill, wood preparation plant, pulp mill and paper mill, complete with pollution abatement and ancillary facilities, at Balikesir (which lies midway between Istanbul and Izmir), together with a housing colony for about 1000 persons, and consultant services for engineering, training, operational and management assistance. The integrated complex will annually consume 221,000 m3 of sawlogs and 86,000 m3 of pulplogs. The sawmill will produce for sale about 105,000 m3 per year of air dried sawnwood and will deliver 97,000 m3 annually of wood residue (in- cluding sawdust) to the pulp mill. Another 86,000 m3 of wood chips will be provided to the pulp mill by the wood preparation plant. The pulp mill will have a capacity to produce about 80,000 tpy (bone dry) of thermo mechanical pulp, which the paper mill will use together with 14,000 tpy (bone dry) of imported semi-bleached chemical pulp, to produce about 100,000 tpy of news- print. The details are provided in the Loan and Project Summary in Annex III and in the report entitled "Appraisal of the Balikesir Newsprint Project, Turkey" (No. 1046-TU), dated April 30, 1976, distributed separately to the Executive Directors. 32. An integrated mill permits processing sawlogs and pulplogs at the same time, besides utilizing the sawmilling residues for pulping. Although larger newsprint machines operate in industrialized countries, in the light of SEKA's capability for operation and management as demonstrated at its existing newspr-int mill at Aksu, a plant of 100,000 tpy was considered ap- propriate. However,-the project will utilize two recently developed, but firmly-established, process improvements: thermo mechanical pulping and twinwire sheet forming which offer advantages of lower cost and improved quality, and is the process most used in the latest newsprint plants abroad. Results of pilot plant tests show that the species of wood available in Turkey are suitable for newsprint manufacture utilizing the proposed process.  - 12 - 33. The problem of site acquisition which delayed the Akdeniz Project does not arise at Balikesir. The 180 ha site, acquired by SEKA in 1971, is suitable for the erection of industrial buildings supported on footings and offers ample space for future expansion. The structures will be designed to withstand major shocks, since the area has a history of earthquakes. Project water requirements of 0.133 m3/s can be met from local sources. Transport for the project will be entirely by road. 34. Sufficient wood, without the application of more intensive forest utilization practices, is available from the five forest regions closest to the project site (Balikesir, Canakkale, Izmir, Bursa and Eskisehir) to meet the project's current raw material demand. The project, will in fact, use only about 25 percent of the current annual allowable cut from these regions. SEKA and the General Directorate of Forestry (GDF) have already signed a protocol specifying the cost and quantity of wood to be supplied for the project, which will be changed appropriately by December 31, 1976, in consul- tation with the Bank, after the results of the UNDP financed Northern Aegean and Marmara Forest Study are obtained around mid-1976 (Loan Agreement, Section 4.06). It is anticipated that since the Government will be introducing more intensive forest utilization methods in the 15 conservancies covered by this study, wood costs will be reduced and sufficient pulpwood and sawn logs can be obtained from the three conservancies closest to Balikesir to meet the needs of the project. This should help reduce the costs of the logs to the mill by about 25 percent. Electric power (60 MW) required for the project will be supplied by the Turkish Electricity Authority (TEK), through its Balikesir substation and by a 9 MW process steam turbogenerator. A 12 km long, 154 Kv transmission line will be built by TEK. The Guarantor has agreed to take all necessary actions and provide necessary funds to TEK, to build the necessary power facilities by July 1, 1978, to serve the proposed project (Guarantee Agreement Section 3.02(a)). Environmental Impact 35. The project is expected to have a minimal effect upon the environ- ment. The principal source of air and water pollution in the pulp and paper industry is the manufacture of chemical pulp, which will not be produced by this project, since it is based on the thermomechanical process. Water pol- lution will come from fiber losses and from the small part of the pulpwood which goes into solution during pulping. The liquid effluent will however be treated in a clarifier, to remove suspended solids and in an aereated lagoon to biochemically consume oxygen-depleting organic matter which will remove 95 percent of both deleterious components. Discharge would be to the receiving stream at a downstream point, where sufficient flow is available to assimi- late the small remaining pollution. The process itself would vent only water vapor; but the power boilers would discharge sulphur dioxide into the air in amounts depending upon the sulphur content of the available oil, and small quantities of fly ash that might escape the fly ash separators. The anti- pollution controls will be designed to meet environmental protection stand- ards agreed with the Bank (Loan Agreement Section 3.06).  -13 - Project Costs and Financing Plan 36. The total project costs, including contingencies but excluding about $15 million of interest and other charges during construction, are estimated at $185 million; total financing needs including interest and other charges are thus $200 million, of which about $82 million is foreign exchange including about $7 million of interest and other charges on the Bank loan. The proposed Bank loan of $70 millon would finance about 85 percent of the foreign exchange needs and 35 percent of the total financial requirements of the project. The loan will be made directly and jointly to SEKA and its sub- sidiary, the Balikesir Establishment (also called the Borrowers). Lending jointly to SEKA and the Balikesir Establishment is necessary, since SEKA's subsidiaries have only limited autonomy in financial matters. The loan will carry a guarantee fee of 1.5 percent to be paid by Borrowers to the Guar- antor (Guarantee Agreements, Section 3.03 and Loan Agreement, Section 5.09). The loan provides for up to $2.5 million equivalent of retroactive financing for expenditures after March 1, 1976. This is needed to cover downpayments in respect of contracts for time critical equipment which are to be let under Bank guidelines in April and May, 1976. 37. The remaining financial requirements, including interest during construction, of $12 million in foreign exchange and $118 million equivalent of local expenditure will be provided or arranged by the Government. The Balikesir Establishment will increase, as a condition of loan effectiveness, its authorized capital from TL 100.0 million to the TL 1,280 million ($80.0 million) or 40 percent of the total financing requirements (Loan Agreement Section 7.01). SEKA, because of its large expansion program currently under- way, is unlikely to have any internally generated funds available for this project. The Government has, therefore, agreed to provide SEKA with the equity as required for the Establishment. To complete the financing plan, the Government has arranged with the State Investment Bank (DYB) to provide a loan to SEKA, in an amount of at least TL 800 million ($50.0 million), for a term of 17 years, including 5-1/2 years of grace, at an interest of 11.5 percent per annum. Effectiveness of the DYB Loan is a condition of effectiveness of the Bank loan (Loan Agreement Section 7.01(a)). The Government will also provide, or cause to be provided, promptly any addi- tional financing required to complete the project on terms and conditions satisfactory to the Bank (Guarantee Agreement Section 3.02(c)). Project Implementation 38. The project will be executed by SEKA and the Balikesir Establish- ment, assisted by their consultants, Sandwell & Co., Ltd., who have been engaged under satisfactory terms and conditions. Sandwell is responsible for: (a) the design of the entire plant, other than the civil and structural engineering which SEKA has contracted locally; (b) procurement; (c) engineer- ing supervision of construction; and (d) training, operational and management assistance. The extent of consultant support in engineering and supervision is typical of the pulp and paper industry, and the project provides for about 1,600 man-months of consultant services for the engineering and construction  - 14 - phase, and about 200 man-months for the training and operational assistance phase. Cooperation between SEKA and Sandwell is good. SEKA has agreed not to assign, abrogate, waive or amend its contract with the consultants without the prior consent of the Bank (Loan Agreement Section 3.05(a)). At the same time, the Balikesir Establishment which will be responsible for the operation of the project, is headed by a manager, who has worked in SEKA for nearly 20 years in several positions. During project construction, the staff of six expatriate resident engineers provided by Sandwell will informally train the Balikesir Establishment staff and help them become familiar with the equip- ment. After project start-up, the 18-month training and operational assist- ance program will provide senior Sandwell executives to support the Establish- ment's top management, and a field staff of 12 experienced operating personnel, who will be assigned adequate Turkish counterparts. (Loan Agreement Section 3.05(b)). 39. Project implementation is already under way. General design devel- opment is nearing completion and detailed design has begun. Site grading, road construction, and drainage work in preparation for construction of the main mill buildings, is under way. The construction of offices, worker facil- ities, a central steam heating plant, social facilities and the housing colony is well advanced. Start-up of the sawmill is scheduled for October 1978 and of the newsprint mill in January 1979. This timetable is considered realistic. Procurement 40. Procurement procedures have already begun, and advertisements and notifications have been made in compliance with Bank Guidelines, except for five items of wood processing equipment with a value of about US$750,000, for which bidding had been completed prior to appraisal and which will be financed from local sources. International competitive bidding will be followed for machinery and equipment procured under the Loan, except for items that are estimated to cost less than US$100,000 equivalent which may be procured by local procedures up to a total value of US$1 million. SEKA's consulting en- gineers are combining bid packages to the maximum extent feasible in order to concentrate vendor responsibility. It is expected that there will be about 80 bid packages. 41. A margin of preference of 15 percent or the applicable duty, which- ever is lower, will be accorded local manufacturers who participate in inter- national competitive bidding. Contracts for the remaining items (estimated at US$20 million equivalent) and the civil works contracts (US$47 million) will be awarded in accordance with local procedures and will be financed from local funds. Disbursements 42. The Bank loan will be disbursed against 100 percent of the foreign exchange expenditures on imported machinery and equipment, and foreign con- sultants, 100 percent of the ex-factory cost of locally manufactured equip- ment, if awarded after international competitive bidding and 100 percent of the total costs of local consultants. In the event that local manufacturers win bids after international competitive bidding, the Bank loan would finance such purchases with an estimated total value of about $10 million equivalent.  - 15 - Financial Analysis 43. Total production costs of newsprint, excluding financial charges of the Balikesir Establishment, are projected to be about TL 6,400 ($400) per ton. The three major items in manufacturing costs are the wood, imported kraft pulp and power. Wood prices without taking the possible reductions mentioned in paragraph 33 into account, are estimated to be TL 600 (US$38) per m3 of sawlog and TL 400 (US$25) per m3 of pulplog which are in line with prices paid by other manufacturers outside Turkey. Kraft pulp will be im- ported at an estimated price of TL 7,600 ($475) per ton. 44. The present system of fixing ex-factory newsprint prices below full cost and covering only operating losses at the end of each year through a gov- ernment budget subsidy has several deficiencies (see also paragraph 28 above). The Government has, therefore, agreed that SEKA and the Establishment will be allowed to set an ex-factory price sufficient to earn, under the assumption of efficient operation at 100 percent of design capacity, a reasonable annual return on the Balikesir Establishment's investment (Loan Agreement, Section 5.07). A reasonable annual return is understood to be sufficient to provide for interest and other charges and a reasonable profit after covering operatin administrative and distribution expenses including provisions for maintenance, straightline depreciation, taxes, surcharges and other levies. Should the Government wish to continue to subsidize the sales price of newsprint after Balikesir goes into production, it will arrange that the difference, if any, between the sales price to the consumer and the ex-factory price of the Balikesir Establishment as determined above, is provided to the consumer in such a way as to put no financial burden on either SEKA or the Establishment. The Government is expected to propose an appropriate arrangement for this by January 1, 1978 or about one year prior to the anticipated date when Balikesir will begin production. 45. Assuming a reasonable annual return on the Establishments invest- ment, under conditions of efficient operation, an ex-factory newsprint price of about 8,200 TL/ton ($512) in 1975 prices, including about 250 TL/ton of profit, can be anticipated after start-up of operations. This price has been used in the financial analysis and yields a discounted rate of return, before income taxes, of 9.7 percent. The projected CIF contract price in 1975 dollars at that time is estimated to be $430/ton, or about 20 percent above present prices reflecting the anticipated impact of recent world-wide sharp increases in investment costs of newsprint mills. The difference between the Turkish price and the estimated CIF price is due to economies of scale in the larger world producers, direct taxes on inputs and higher power costs in Turkey as compared with major manufacturers who are in traditionally lower power cost areas. Moreover, the Turkish price reflects conservative assump- tions about the efficiency of production in Turkey. 46. To provide the Balikesir Establishment with'a sound financial structure and adequate liquidity when it begins operations, assurances were obtained from Government that it will provide SEKA sufficient equity funds during the construction of the project to enable the Establishment to maintain a debt-equity ratio of 60/40 and such additional funds as may be needed at  - 16 - completion to make current assets at least 1.5 times current liabilities (Guarantee Agreement Section 3.02, Loan Agreement Section 5.06). Following start-up, to ensure adequate funds are retained in the Establishment, SEKA and the Balikesir Establishment have agreed that transfer of profits to SEKA will only take place if the Establishment would continue to maintain current assets at least 1.3 times current liabilities (Loan Agreement Section 5.05). Should the Establishment face liquidity problems, the Government has agreed to enable SEKA to provide the funds necessary to keep Balikesir's current assets at least 1.1 times current liabilities (Guarantee Agreement, Section 3.02(e) and Loan Agreement Section 5.05). 47. Financial projections indicate, however, that, with the ex-factory price set as described above, liquidity is not likely to be a problem. The Establishment is expected to accumulate cash in excess of operating needs. However, start-up losses will be experienced in the first 2 years causing the debt/ equity ratio to rise to a peak of 65/35 in 1980 before returning below 60/40 in 1982. The debt service coverage would be 1.1 in the first operating year increasing thereafter to a level of about 1.5. These ratios are accept- able in view of the expected cash accumulation. The project would break even in 1981 at a capacity utilization of about 81 percent. The Enterprise could be in a position to pay dividends to SEKA by about 1982, in time to help fi- nance the anticipated needed expansion in newsprint production capacity. The projections are conservative and reflect reasonable assessments of risks due to delay in completion and slower production build up. Economic Analysis 48. The economic rate of return for the project, including the townsite, is estimated at about 16 percent, using a shadow exchange rate and the above- mentioned cif contract prices for newsprint. If prices increased an addi- tional 10 percent, the economic rate of return would increase to about 20 percent. If manufacturing costs would increase by 10 percent more than the estimates, the return would drop to 14 percent. Direct employment effects are small in relation to the investment, in total about 850 employees will be re- quired. However, about another 2,500 jobs are expected to be generated in forestry operations related to the project. Net annual foreign exchange sav- ings, which are important for a country like Turkey which is experiencing pressures on its balance of payments, are estimated at $34 million as compared with total project foreign exchange requirements of $82 million. This implies that after the Balikesir plant goes into production, the foreign exchange cost of the project will be paid off within 2-1/2 years, through the foreign ex- change savings resulting from reduced newsprint imports.  - 17 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 49. The draft Loan Agreement between the Bank, SEKA and the Balikesir Establishment, the draft Guarantee Agreement between the Republic of Turkey and the Bank, the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement, and the text of a Resolution approving the proposed loan are being distributed separately to the Executive Directors. The draft agreements conform to the normal pattern for loans for industrial projects. 50. Special conditions of effectiveness are: (a) the authorized share capital of the Balikesir Establishment has been increased to TL 1,280 million, and (b) the execution and delivery of the agreement related to the DYB loan of TL 800 million has been authorized and ratified and is in full force and effect (Loan Agreement Section 7.01). 51. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 52. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments May 4, 1976   AasL I Pag-e I of 6 Pages TABLE 3A TURKEY - SOCIAL INOtCATORS DATA SHEET LAND AREA (THOU KR21 - --