Turkey - Erdemir Steel Project - Stage Two

FILE COPY Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-2352-TU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TURKEY FOR THE ERDEMIR STAGE II STEEL PROJECT June 15, 1978 This document has a restricted distribution and may be used by recipients only In the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Calendar 1977 March 1978 Currency Unit - Lira (TL) TL US$1 - LT 18.00 25.00 LT 1 US$0.05 0.04 FISCAL YEAR March 1 to February 28 ABBREVIATIONS -AID - US Agency for International Development BF - Blast furnace BOF - Basic oxygen furnace Borrower - The Government of Turkey CIF - cost, insurance and freight FOB - free on board IMF - International Monetary Fund Japanese Exim Bank - Export Import Bank of Japan Koppers - Koppers Company of the USA NKK - Nippon Kokan K.K. p.a. - per annum Recipient - Eregli Demir ve Celik Fabrikalari T.A.S. tpy - metric tons per year UEC - US Steel Engineers and Consultants US Exim Bank - Export Import Bank of America  FOR OFFICIAL USE ONLY TURKEY - ERDEMIR STAGE II STEEL PROJECT LOAN AND PROJECT SUMMARY Borrower: Turkey Beneficiary: Eregli Demir ve Celik Fabrikalari T.A.S. (Erdemir) Amount: $95 million equivalent, in various currencies Terms: 17 years, including 4 years of grace Interest at 7.5 percent per annum Relending Terms: 14 years, including 3-1/2 years of grace; interest rate of 10 percent per annum. Beneficiary will bear the foreign exchange risk. Project Description: (i) Expansion of Erdemir's production capacity from 1.5 to 2.0 million tons p.a. of ingot steel, equivalent to an increase of from 1.1 to 1.5 million tons p.a. of flat steel products. Major new facilities include: (a) additions to raw materials handling systems, a turbo blower, scrap preparation facilities, cranes, automatic baler and shearer, manual burning beds, continuous slab caster, utilities, services and effluent treatment and monitoring facilities, and improvements and balancing in slab yard, hot strip mill, and hot and cold rolled finishing facilities, including those for reduction of energy consumption and operating costs. (b) Consultant services for engineering, as also for a feasibility study of Erdemir's Stages III and IV expansion programs (including analysis of alternative sewerage treatment facilities from the plant and Eregli's township), and training. (ii) The project will considerably reduce Turkish imports of needed flat steel products, saving about $95 million p.a. at full production. The only major risk is of delays in project implementation, and delayed fulfillment of expectation of considerable improvement in Erdemir's financial position based on the future trend of production costs and steel prices in Turkey. | This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Estimated Cost: $ millions Foreign Local Total Engineering and administration 11.1 7.6 18.7 Civil works and installation 8.0 51.1 59.1 Equipment, spares and utilities 78.3 8.7 87.0 Freight and insurance 6.4 0.8 7.2 Training and technical assistance 2.1 9.2 11.3 Base cost estimate 105.9 77.4 183.3 Contingencies: (a) Physical 9.6 6.9 16.5 (b) Price 35.0 66.3 101.3 Total Project Cost 150.5 150.6 301.1 Increase in working capital 2.2 18.1 20.3 Interest during construction 20.4 - 20.4 Total Financing Required 173.1 168.7 341.8 Financing Plan: $ millions Foreign Local Total Bank 95.0 - 95.0 Obtained supplier credits 28.0 - 28.0 Expected suppliers credits 22.0 - 22.0 Internally generated funds - 168.7 168.7 Turkey (Government) 28.1 - 28.1 Total 173.1 168.7 341.8 Estimated Disbursements: $ millions Bank FY 1979 1980 1981 1982 1983 Annual 4.3 33.8 45.0 11.5 0.4 Cumulative 4.3 38.1 83.1 94.6 95.0 Consultant Services: Following evaluation of proposals from 3 reputed interna- tional firms, Nippon Kokan KK of Japan has been selected after consultation with the Bank, on terms and conditions satisfactory to the Bank. Economic Rate of return: 17 percent Appraisal No. 1875a-TU dated May 31, 1978 Report:  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TURKEY FOR THE ERDEMIR STAGE II STEEL PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Turkey for the equivalent of $95 million to help finance the foreign exchange cost of the Erdemir Stage II steel project. The loan would have a term of 17 years, including 4 years of grace, with interest at 7.5 percent per annum. The proceeds of the loan would be onlent to Eregli Demir ve Celik Fabrikalari T.A.S. (Erdemir) for 14 years with 3-1/2 years grace period, and with interest at 10 percent per annum. Part I - THE ECONOMY 1/ 2. An economic report (No. 1272-TU) entitled "Country Economic Memo- randum - Turkey" dated October 21, 1976, was circulated to the Executive Directors on November 2, 1976. Since then, the economic situation dete- riorated rapidly and culminated in a serious balance-of-payments crisis and high levels of inflation. This section analyzes the situation in 1977 against the background of more permanent structural problems; it also outlines the short-term stabilization package implemented by the new Ecevit Government shortly after receiving its vote of confidence in mid-January 1978, and prospects for the short-term. This package, formed the basis of a Standby Arrangement with the IMF, which was finalized in late March and approved by the Board of Executive Directors of the IMF in late April. The determination and sense of purpose with which the new Government has faced up to the severe economic problems confronting Turkey, holds the promise that medium-term economic and debt management policies needed to build on the stabilization package, will soon be evolved with equal seriousness. The expanded Annex I attached to this Report provides insights into those developments which precipitated the present economic crisis, and analyzes them in detail in the context of trends and the structural problems of the economy. An economic mission planned in the Fall, will further review these trends and prospects. 3. In most respects, the record of Turkish economic development over the last two decades has been good. As the result of a strong commitment to rapid growth and modernisation, real output has grown, on average, by more than 6 percent per annum. Great strides have also been made towards meeting the basic needs of the population in such areas as education, health care, water supply, and rural roads. However, employment has never been at the fore of the objectives of successive Governments. Overall, this impressive economic progress has been punctuated (in 1958, 1970 and 1977) by severe balance of payments crises, which have been the product partly of extraneous factors and partly of Turkish development strategy itself, which has paid insufficient attention to the structural weaknesses of the economy, and has perhaps exacerbated some of them. 1/ Part I is largely identical to Part I in the Report and Recommendation of the President on the Livestock IV and Northern Forestry Projects, Reports Nos. P-2332-TU, and P-2333-TU, dated May 12, 1978, and approved on June 1, 1978.  Structural Problems and the Situation in 1977 4. The emphasis which successive governments have laid on industrial- ization has been reflected in a doubling of the share of the industrial sector in total output between 1955 and 1977. It also resulted in comparative neglect of agricultural development, which has also been hampered by inappro- priate subsidy and pricing policies. Moreover, although some parts of Turkish industry are efficient, and more have the potential to become so, a strong emphasis on sophisticated capital-intensive technology has resulted in high- cost production in certain sectors; and unselective protection against com- petition from imports, has inhibited the development of an industrial structure well-suited to Turkey's comparative advantages in terms of loca- tion, natural resources and labor availability. One important consequence of this, as well as of a foreign trade strategy which has emphasized import- substitution, has been that Turkey has so far been unable to develop a strong industrial export base, and has relied instead on its traditional agricultural exports (supplemented by workers' remittances) to finance the imports of materials and capital goods needed for its ambitious modernization effort. This pattern of trade has been a fundamental cause of the difficulty, which Turkey has periodically experienced, in reconciling rapid growth with a viable external payments position. 5. The rate of growth of production in Turkey, unlike almost every other country, accelerated during the recent world recession. The average annual real rate of GDP growth in the period 1970-73 was under 7 percent; in the period 1973-77, it rose to nearly 8 percent. This was made possible by a rising public sector deficit, which provided a stimulus to aggregate demand and offset the depressing effect of sluggish exports and the increased outflow of payments for oil. As a result, the growth of output was con- strained not by demand, but by supply. Favorable weather and good harvests caused the average annual rate of growth of agricultural output to increase from about 2 percent in the period 1970-73 to about 7 percent in the period 1973-77, while industrial output grew at about 10 percent in both periods - principally as a result of the sustained high level of industrial investment. The pace of investment in Turkey, moreover, did not slacken during the world recession; on the contrary, largely as the result of an intensified public investment drive from 1975 onwards, the share of fixed investment in GDP increased from under 19 percent in the period of the Second Plan (1968-72) to over 20 percent in the period of the Third Plan (1973-77). 6. The favorable performance of Turkish production during the 1970's, was not matched by that of employment. Unemployment and underemployment were relatively high (12 percent of the labor force) in 1970, and have since risen to over 13 percent in 1977. This has been the result of a sharp reduction in the rate of emigration since 1973, a high rate (2.5 percent per annum) of population growth, and the adoption of relatively capital-intensive methods of production in both agriculture and industry. 7. There was a gradual deterioration in the external trading position of Turkey since 1973, which culminated in the serious balance of payments  - 3 - crisis in 1977. The resource gap increased from $623 million in 1973 or 3 percent of GDP, to about $4.0 billion in 1977 or more than 9 percent of GDP. Imports of goods and non-factor services increased from $2.3 billion in 1973 to about $6.5 billion in 1977, or by about 30 percent per year, as a result of: (a) significant increases in import prices since 1973, especially the price of oil; (b) rapid increase in the demand for imported capital goods due to high levels of investment and emphasis on industrial development; and (c) a general liberalization of import restrictions. The remainder of the deterioration is attributable to a decline in the rate of growth of exports, both absolutely and in relation to the rate of growth of GDP. In dollar terms, Turkish exports of goods and non-factor services grew during 1970-73 at an average annual rate of 31 percent; during 1973-77, the average annual growth rate was only 10 percent. This decline in export performance had its roots in ineffective administration of agricultural export sales, the world recession, an uncompetitive exchange rate, and excess aggregate demand in the domestic economy. 8. The widening of the resource gap was amplified in the current account deficit, which rose from $0.7 billion in 1973 to $3.4 billion in 1977 as the result of a decline in workers' remittances, which was a consequence of the overvaluation of the lira, as well as of changes in the composition of the Turkish emigrant population, including a decline in the proportion of relatively recent migrants. 9. The rapidly rising current account deficit was not matched by an increased inflow of medium and long-term external capital. Turkey has deliberately kept foreign private investment to a minimum. Borrowing from long-term official sources has also stagnated since 1970, and recourse to long-term market sources has been minimal, for lack of a dynamic and coherent external borrowing policy. In consequence, the overall balance of payments moved from a surplus of $0.9 billion in 1973 to a deficit of $2.7 billion in 1977. The cumulative deficit from 1974 to 1977 amounted to $6.6 billion. Of this, $1.3 billion was financed by running down the foreign exchange reserves which by the end of 1977 stood at $770 million, equivalent to only one and a half month's imports. The remainder, amounting to some $5.3 billion, was financed mainly by various forms of short-term borrowing. 10. An important source of short-term borrowing was the Convertible Lira Accounts (CLAs), which provided nearly $2 billion, in 1975 and 1976. These are deposits placed with Turkish banks by non-residents and commercial banks, offering a spectrum of interest rates according to maturity, and until recently were guaranteed against exchange rate risk. Various other types of short-term loans were also obtained. During 1977, however, foreign lenders became reluctant to roll over the outstanding stock of short-term debt, and even more reluctant to make further substantial loans. The Central Bank was thus driven to delaying payments for imports on a large scale. This action made it even harder to obtain credit by conventional means. Financing of the current account deficit in 1975-77 through recourse to CLAs and other short- term borrowings is the main cause of the sharp increase in the debt burden.  - 4 - 11. This deterioration in the balance of payments position can be viewed partly as a reflection of inadequate efforts at domestic resource mobilization, especially in the public sector. The public sector deficit increased from TL 6.2 billion in 1973 to TL 77.0 billion in 1977. This increased deficit was mainly due to a deterioration in the financial position of the State Economic Enterprises (SEEs), and in particular of the operational SEEs, which dominate the transport and energy sectors and account for half the output of mining and manufacturing. Successive governments, in an effort to slow inflation, held SEE price increases below the rate at which SEE costs were rising. In addition, the scale of SEE investment was greatly escalated. The net effect has been a very rapid widening of the gap between SEE savings and investment, which has caused the overall public sector deficit to rise from 2 percent of GDP in 1972-73 to 9 percent of GDP in 1976-77. Most of this increased deficit has been financed by borrowing from the Central Bank, since administered ceilings on interest rates made it hard to attract purchasers for government bonds. As a result, the money supply increased rapidly at an aver- age annual rate of about 30 percent between 1974 and 1977. This was paralleled by a high rate of credit expansion to the private sector. 12. The rate of inflation (as measured by the wholesale price index), which had declined between 1974 and 1975, rose to about 35 percent in 1977 and accelerated in early 1978. There are important cost-push influences on the price level in Turkey, including a powerful labor union movement and a farmer- oriented agricultural price support policy. But the recent acceleration of inflation has been the result principally of excess demand. The rise in the public sector deficit caused an increase in aggregate demand well beyond the amount needed to offset the damping effect of reduced exports and an increased import propensity. The consequent upward pressure on the price level was aggravated in 1977 by ad hoc import restrictions, which reduced the avail- ability of goods requiring imported inputs, and contributed to the development of a substantial idle capacity. 13. The crisis of 1977 was thus a result of a combination of external and internal forces. The rise in the price of oil and the world recession, by increasing the cost of imports and reducing exports and workers' remittances, adversely affected Turkey's trading position which was already structurally weak. The effect of these elements on the balance of payments deficit was amplified by the increase in the growth rate after 1973, which was a reflec- tion of the basic Turkish commitment to rapid growth, manifested in an escala- tion of public sector investment without a commensurate increase in public sector savings. In addition, the seriousness of the crisis was aggravated by inadequate management of agricultural exports, an inappropriate exchange rate policy, and lack of a coherent policy to develop and tap fresh sources of medium and long-term external finance. Recent Stabilization Measures 14. The previous coalition government had initiated in mid-1977, nego- tiations with the IMF for a Standby Agreement. In the fall of 1977, it announced drastic price increases for a number of goods and services of the  - 5 - SEEs (ranging from 50 to nearly 300 percent), devalued the Turkish Lira by 10 percent in September with a further adjustment of 5 percent in early December. In the midst of the IMF negotiations, the new Ecevit Government came into power, with a slim majority in the National Assembly. It decided to first prepare its own stabilization package, before resuming negotiations with the IMF. Within weeks of receiving its vote of confidence, it finalized its Annual Program for 1978 and the 1978 Budget. As soon as the budget was approved on February 28, it presented its stabilization package to the IMF. The main features of the Annual Program for 1978, the 1978 Budget and the short-term economic stabilization package, which formed the basis of the IMF Standby Arrangements, included: devaluation of the Turkish Lira by a further 30 percent in March, removal of the exchange rate guarantees for new CLAs in an effort to minimize new inflows of these short-term deposits, increased interest rates on deposits of Turkish workers abroad to encourage increased remittances, increased interest/deposit rates to stimulate better resource mobilization and allocation within Turkey, introduction of new tax legislation (including a substantial increase in stamp duties on imports) which will inter alia increase public revenues by about TL 20 billion per annum (equal to about 2 percent of GDP), substantial adjustments in the prices of key SEEs products and services (with further increases expected in the near future) in an effort to improve resource mobilization, plans to limit the growth of consolidated public sector expenditures (including those of SEEs) within available resources to thus sharply reduce recourse to Central Bank financing of public sector deficits, reduction in the level of imports in 1978 to $5 billion from the peak of $5.8 billion reached in 1977, and a projected reduction in the current account deficit in 1978 to $1.45 billion. Although much remains to be done, these steps should help bring some order in the chaotic economic house which the new government inherited. 15. The Standby Agreement was finalized on the basis of the above pack- age and was approved by the IMF Board in late April. It provides for the withdrawal of about $89 million equivalent in Compensatory Drawings, within two weeks of the signing of the Agreement. In addition, since the Witteveen Facility is not in operation, Turkey would be eligible to draw up to 150 per- cent of its quota, which amounts to about $360 million under the Exceptional Circumstances Clause. This would entitle Turkey to withdraw about $174 million in the first two tranches as follows: $60 million in May 1978; $48 million in August 1978; $36 million in November 1978 and $30 million in February 1979. IMF will review economic developments and the progress of the stabilization measures in January 1979. Following that, Turkey will be entitled to withdraw a further $186 million over a one year period. In other words, in calendar 1978, Turkey can withdraw a maximum of $233 million. 16. With the signing of the Standby Agreement, it is expected that Turkey would now be in a much better position to cope with its large short- term debt currently estimated at $5.8 billion (excluding $409 million owed to IMF), much of it due in 1978. This is its most critical immediate problem. To tackle this problem, Turkey will immediately need to roll-over about $1.3 billion of CLAs falling due in 1978, but for which no major problem is expected. It has begun negotiations with leading European and US commercial banks to restructure the CLAs due in 1978 as well as an additional $1.2 billion of  short-term debt into medium- and long-term debts. These banks, in principle, have already agreed to present viable proposals shortly. The Government has also sought the reactivation of the OECD consortium, in order to restructure trade debt guaranteed by bilateral export financing agencies and public bilateral debt. The consortium met in late May in Paris and a working party of creditors meeting within the consortium framework has agreed to the restruc- turing of such debt. The Government is also actively pursuing other available financial sources of external medium- and long-term capital aid, including the tapping of possible new ones in the Middle East. 17. If the current account deficit in 1978 is to be brought down to $1.45 billion it will be necessary to bring about improvements in performance of Turkish exports, both agricultural and industrial. This will require the maintenance of a competitive exchange rate and an increase in the proportion of investments devoted to export-oriented industries. It will also require greater emphasis on agricultural development, together with revision of price support policies and reform of agriculture export procedures. In addition, other sources of foreign exchange earnings which have been neglected so far, such as tourism, would need to be tapped in a systematic and effective fashion. At the same time, the growth of imports will have to be kept down by much greater care in the selection of investment projects and continued restriction of nonessential imports. The 1978 Annual Program is considered by the new government to be an interim one, which will constitute the first year of Turkey's Fourth Five-Year Plan (1978-82) to be finalized by late 1978. The new government seems determined to approach the formulation of future planned targets and some of the key immediate and medium-term economic and debt management policies, on a sound and realistic basis, and not on that of ineffectual compromises which plagued the previous coalition governments. 18. In 1978 and 1979, the measures necessary to recover from the present crisis will probably cause the annual growth rate of real GDP to fall to 3 or 4 percent, but for the remainder of the Fourth Plan period (1978-82), higher growth should be possible. To achieve this, it will be indispensable to increase domestic savings, primarily by raising the rate of growth of budgetary revenues, and improving the financial equilibrium and low productivity of State Economic Enterprises. The consequent reduction in the public sector deficit should help both to maintain external equilibrium and to moderate the pace of inflation. 19. A major medium and long-term problem is the high and rising level of unemployment and underemployment. To alleviate this, will require a high growth rate to be resumed in the long run, with more emphasis than hitherto on comparatively labor-intensive commodities and techniques of production. Moreover, increased attention to agricultural development, by reducing the disparities of income both between the agricultural and non-agricultural sectors and between rich and poor farmers, should further improve Turkey's income distribution. Similarly, the tax system needs to be restructured in such a way as to make it more progressive (as proposed in the new tax law which is before Parliament), while the government continues its already rather successful policy of reducing the inequality of living standards by providing for basic needs through public expenditure. In the longer run, Turkey will have to formulate policies which would help curb the population increase which has, to a large extent, dampened the benefits of growth so far.  - 7 - 20. The extensive short-term borrowing of the past three years has greatly increased Turkey's external debt, giving it an unattractive maturity structure, and causing a sharp rise in debt service payments. At the end of 1977, the country's total external indebtedness amounted to approximately $10.0 billion, of which about $5.8 billion (excluding $409 million owed to IMF from both figures) was short-term, most of which is likely to be rerolled or restructured into medium-term borrowings as mentioned in paragraph 16. The remaining $4.2 billion was mainly public and publicly guaranteed medium and long-term debt. Of this, about one third was owed to international organi- zations, mainly the Bank ($0.8 billion, plus $0.6 billion in committed but undisbursed loans) and the European Investment Bank; and about one half to foreign governments and government agencies, notably those of the United States, West Germany, Canada, and the USSR. In 1977, debt service payments (including interest on short-term debt) amounted to 15.0 percent of exports of goods and non-factor services plus workers' remittances. 21. The first objective of a prudent debt management policy should be an adequate restructuring of the short term liabilities following upon the first agreement reached at the OECD consortium meeting (para 16). A deter- mined medium- and long-term borrowing effort during the next few years should restore a satisfactory balance between short and longer-term debt. But despite the Government's current restructuring efforts, a substantial increase in debt service payments is inevitable. The debt service ratio can be expected to rise to about 23 percent in 1978 and peak at anywhere between 30 to 40 percent in the early eighties, depending on the rerolling and restructuring terms ultimately agreed to by commercial banks and other bilateral creditors and export financing agencies. In these circumstances and until the outcome of the restructuring negotiations as well as the strategy of the Government in its Fourth (1978-82) Development Plan becomes available, it does not appear meaningful to venture firm projections on growth, balance of payments or debt service. However, if as the new Government intends, Turkey pursues sound medium-term and debt management policies and shows the same seriousness as it has shown in its short-term policies since assuming office, and as the financial consequences of the recent crisis are gradually remedied, the debt service ratio should decline after reaching a peak in the early eighties. Although a tight balance of payments situation is likely to remain a medium- term feature of the economy, Turkey would continue to have a substantial borrowing capacity for medium- and long-term funds provided the present short-term debt is restructured on adequate terms and future short-term borrowing is strictly contained. However the situation will need to be carefully watched and evaluated as soon as a more concrete basis for doing so becomes available. PART II - BANK GROUP OPERATIONS IN TURKEY 1/ 22. The 1970 economic stabilization program and devaluation of the Turkish lira, which improved the balance of payments, enabled Bank Group 1/ Part II is substantially the same as Part II in the Report and Recom- mendation of the President on the Livestock IV and Northern Forestry Projects, Reports Nos. P-2332-TU and P-2333-TU, dated 12 May 1978 and approved on 1 June 1978.  - 8 - lending, which had previously been intermittent, to be established on a continuing basis at a high level. As of April 30, 1978, the Bank Group had lent $1,456 million to Turkey through 49 lending operations (or 43 projects, since both loans and credits were provided for some projects), including 14 IDA credits totalling $178 million. Fourteen of these operations have been in agriculture and rural development (including multipurpose projects), eighteen in industry (including DFCs), ten in power, and the rest in urban development, transportation, education and tourism. Agriculture and rural development account for 24 percent of the funds lent, industry and DFCs for about 42 percent and power for about 24 percent. Annex II contains a summary statement of Bank loans, IDA credits and IFC investments as of April 30, 1978, with notes on the execution of ongoing projects. 23. Implementation of projects has been satisfactory in the private sector, but much less so in the public sector where significant delays resulted from political uncertainty, limited coordination among agencies, staffing problems and related administrative delays. Disbursements have consequently been slower than expected. To improve this situation, the Government and the Bank in June 1975 initiated joint reviews to identify and resolve key bottlenecks impeding satisfactory project implementation. So far, six such reviews have taken place, the most recent one in March 1978. The results have been mixed, with improvements having occurred in adminis- trative areas, e.g training programs and speeding-up of disbursement actions, but with so far only modest impact on key policy problems, whose resolution has been considerably delayed or prevented up to now by frequent changes in coalition governments. Loan disbursements as of December 31, 1977, amounted to 70 percent of appraisal estimates and 83 percent of revised estimates. A comprehensive analysis of the main sector policy constraints which lay at the root of inadequate project implementation was carried out with the new Government in March 1978, and further discussed during the President's meetings with the Prime Minister and other key ministers in April 1978. It is antici- pated that as a follow-up on these discussions, the new coordination mechanism being established in Turkey, will be able to take effective steps to improve implementation of on-going projects, and accelerate disbursements further, to provide a sound basis for expanding the Bank's future contribution to Turkey's development. The sector policy perspectives outlined by the new Government, and actions it has already initiated since coming into power, if followed by sustained efforts on the part of the administration and by Cabinet decisions to remove bottlenecks, should enable project performance to take a turn for the better and strengthen the Bank's activities in Turkey. 24. Bank lending has so far been mainly directed at supporting Turkish efforts to improve: (a) income distribution and the level of living stand- ards, through rural development efforts, urban planning, and increased employ- ment and income opportunities; (b) the long-term capacity to earn or save foreign exchange, through promotion of industrial and agro-industrial exports and tourism; (c) lagging public sector saving, through the encouragement of improved management and financing of the investments and operations of the SEEs; and (d) institution-building in key public services, through selective assistance for infrastructure. In light of the new Government's program,  - 9 - which will be progressively refined and specified as the draft 5-year Plan for 1978-82 takes shape by the end of this year, it will be necessary for the Bank to review jointly with the Turkish authorities, how best its lending and technical assistance can meet the above objectives, without facing the policy and institutional obstacles encountered in the past. Pending the outcome of this review, which should be carried out in the coming months, it is proposed to continue to devote the Bank's development efforts to certain key sectors, of which agriculture and industry are the most important. In agriculture, emphasis is being put on rural development, the strengthening of agricultural credit mechanisms, livestock, forestry, and fruit and vegetables. Industry (including DFCs), where promotion of exports and employment, together with the gradual strengthening of the SEEs are the key tasks, will also receive sig- nificant support. This program is supplemented by projects in power, urban development and transportation. 25. Two projects, the Fourth Livestock Development and Northern Forestry Projects have already been approved by the Executive Directors earlier this month. With the proposed project, a total of $205 million will have been provided to Turkey in the current fiscal year. Projects under preparation for FY79 and future fiscal years include: in agriculture, rural development in Erzurum, a second fruit and vegetable project, seed production, grain storage; in industry, a second IGSAS fertilizer project in Central Anatolia, moderniza- tion of public and private sector textile production, and a third forest industries project in northern Turkey; in power, a hydroelectric project; in transportation, port rehabilitation; and in urban development, a possible sites and services project. 26. At the end of 1977, the Bank Group's share of Turkey's medium and long-term external debt (outstanding and disbursed) was 18 percent; its share of Turkey's estimated total external debt (including short-term obli- gations) was about 8 percent. The expected conversion of a large part of this short-term debt into medium and long-term debt will cause the Bank's share of medium and long-term debt to fall sharply, to around 10 percent by 1980. Thereafter, assuming the currently projected increase in Bank lending, the share would increase. The Bank's share of service payments on medium and long-term debt is expected to follow a similar path, dropping from 20 percent in 1977 to about 8 percent in 1980, but rising thereafter. 27. IFC has invested in the production of synthetic yarns, pulp and paper, glass, aluminum, iron and steel products, and tourism, and has an investment in the largest private development finance company, TSKB. As of April 30, 1978, gross IFC commitments totalled $157 million, of which $76 million were still held by IFC. The Corporation is currently investigating additional investment opportunities in the industrial sector, including motor bicycle engines, piston rings and cylinder liners, and possibly aluminium products.  - 10 - PART III - THE STEEL INDUSTRY AND ERDEMIR A. The Turkish Steel Industry 28. The modern steel industry in Turkey began in the 1930's with the establishment of the Karabuk integrated plant in northern Turkey. Erdemir, (hereafter also referred to as 'the Company') the second integrated and only flat steel producer, began operating at Eregli, on the Black Sea coast about 300 km east of Istanbul, in 1965. A third plant, located at Iskenderun in south Turkey and constructed with assistance from Russia, started production at the end of 1976. Besides these large integrated plants, all majority-owned by the State and using mainly blast furnaces and basic oxygen furnaces, Turkey has about 20 smaller plants, most privately owned, and based on electric fur- naces using scrap as raw material; most are located in Western Turkey. The annual production capacity of the three integrated steel producers is at present 2.4 million tons of liquid steel - 1.6 million for non-flat and 0.8 million for flat products. The private smaller plants, together have an annual capacity of 950,000 tons liquid steel for non-flat products. Thus installed capacity in Turkey is for about 3.4 million tons of liquid steel per annum. 29. Growth in steel consumption has considerably exceeded the growth of other economic indicators as well as earlier forecasts. From 1963 to 1976, GNP grew annually by 6.9 percent; industrial output by 9.9 percent; and con- struction by 7.9 percent. However, steel consumption increased by about 13 percent per annum, and reached 3.5 million tons in 1976. Relatively, steel consumption in Turkey, increased faster than in most other countries of the world. Nevertheless, Turkey's 1976 per capita liquid steel consumption of 110 kg was still low, compared with 500-700 kg per capita in the USA, Germany and Japan, 350-450 kg in the UK, France and Italy, but already higher than in Brazil and Mexico (85 kg). The main consumption has been of non-flat products, reflecting large infrastructure and heavy construction-related investments in a still developing industrial economy. However, the share of flat products in total consumption has grown from 32 percent in 1962 to 36 percent in 1976, reflecting the growing importance of domestic production of items such as vehicles, machinery, appliances and containers. Consumption of flat products was 1.3 million tons in 1976 and an estimated 1.6 million tons in 1977. 30. Total steel production grew by about 13 percent per annum from the early 1960s to reach 2.6 million tons in 1976 part of which was derived from imported semi-finished products and the industry's output is sold on the domestic market. Over the same period, imports rose from 0.1 to 1.6 million tpy, and provided an increasing share of total supply of steel products, especially flat products. In 1977, imports of semi-finished and finished products, worth almost $700 million accounted for 40 percent of steel consump- tion. 31. With a projected growth rate of GNP of around 6 percent per annum and industrial growth at 8 percent per annum, demand for non-flat and flat steel products together is estimated to increase from 3.5 million tons in 1976 to at least 6.7 million tons in 1985. While these growth figures may be modi- fied by the new government when the draft Fourth Five Year Plan is finalized  - 11 - later this year, the demand for steel products would still be substantially higher than the 1976 figure, even if the growth rates were adjusted downwards. The share of flat products is expected to continue to rise, following the experience in other countries with a similar economic development pattern, to reach 45 percent in 1985. This would result in a demand for flat steel products of 2.9 million tons in 1985. 32. The Government, in its medium-term planning, continues to accord high priority to domestic steel production as a critical input for the industrial and construction sectors. It is accordingly carrying out a major expansion of non-flat products capacity at the Iskenderun plant. The scope and timing of the fourth steel complex, now in an early planning stage and proposed to be located at Sivas in central Anatolia, has not yet been decided. Flat product capacity will be built up initially through the proposed project. Finally, initial planning is underway for additional flat steel capacity of 2 million tpy at Iskenderun, to be implemented after the expansion noted above. These investments would make Turkey self-sufficient in all basic steel products by the late 1980's; however, the timetable of construction is likely to be somewhat less rapid, so that imports will have to continue to provide a significant proportion of total supply. 33. The justification for an expansion of Erdemir is based on saving foreign exchange, transforming domestic raw materials into higher-valued products, and increasing the companies' scale of production to enable them to operate at competitive prices. Turkey is self-sufficient in low-grade coal and lignite and produces the greater part of its iron ore needs (see also para. 57). The industrial sector includes major steel consumers, producing mostly for the domestic market at present but with export potential in some lines, for whom a competitive price is essential. 34. There would be a supply gap in flat steel products of 1.4 million tons in 1985, assuming the expected production build-up of Erdemir. Addi- tional capacity at Iskenderun, if built, is not expected to become available before 1986. Nevertheless, to ensure a balanced long-term increase in capaci- ty, (as done under Stage I) the Government agreed to coordinate future invest- ments in flat products taking into account market conditions in Turkey (Loan Agreement, Section 4.06). 35. Erdemir is an efficient steel producer and the Company sets its own prices for its products, which are, however, reviewed informally with the Government. It increased its prices in 1977 and 1978 by levels sufficient to cover increases in its costs and to generate part of funds needed for expan- sion. The prices for Erdemir's product-mix are expected to be about in line with the opportunity costs of Turkey's imports during project period. To help ensure the maintenance of a sound steel pricing policy that permit Erdemir under normal circumstances to operate effectively and profitably, agreement was reached on criteria that would guide the Company in fixing the prices of its products. In addition, as under the Stage I loan, Erdemir will consult the Bank prior to any such price changes (Project Agreement, Section 4.07). B. Erdemir 36. Ownership. Erdemir was established in 1960, by a Law which pro- vides inter alia that, regardless of the size of the public shareholding, the  - 12 - Company will be run according to private commercial law. Fifty-one percent of the shares are held in equal parts by two state-owned companies, Karabuk and Sumerbank, while private and quasi-private organizations and individuals hold the remainder. 37. With the provision to Erdemir in June 1977 of a Government 5-year interest free loan of TL 1,200 million ($48 million) which is convertible to equity (para 43), the direct and indirect Government ownership of Erdemir may rise considerably above the present 51 percent. However, the new Govern- ment has confirmed its intention to retain the present semi-private status of Erdemir. Since its semi-private status is of great significance to the success of the project and long-term company operations, the Government has agreed to maintain its present status for the life of the proposed loan (Loan Agreement, Sections 4.03, 5.01(g) and 5.02 (b)). 38. Management. During the Stage I implementation period, Erdemir's management suffered from frequent changes of Chairmen, members of the Board and Presidents, at times interference by the Board, in day-to-day operational and administrative matters, as well as appointment of some insufficiently qualified senior personnel. As a result, the Company's management was not as effective as both Turkey and the Bank might have wished. In light of this recent history, the Bank conveyed its concern to both Turkey and Erdemir. The new government, itself very anxious to ensure efficient management in the Com- pany has appointed as Chairman of the Board a prominent steel industry manager who had been a senior executive of the Company for many years. It has also appointed as President, the highly respected former Vice-President of Opera- tion. These new appointments confirm the new government's assurances that appointments to Erdemir will be based on technical and managerial competence. In addition to this, the Government and the Company have assured that the Company will have as President, Vice President for Expansion and Stage II Project Manager, persons whose qualifications are consistent with duties, job descriptions and functional relationships as stated in the Company's standard procedures and which have been found satisfactory by the Bank. While rela- tively minor reallocation of duties among managers must be expected, the deliberation and care with which the new appointments have been made, hold promise that the new senior management will be effective and will continue to be supported by a capable middle management. 39. Operating History and Stage I Expansion Project (Loan 817-TU). Erdemir started operating in 1965 with a rated annual raw steel capacity of 470,000 tpy and fixed assets of $255 million. It has operated at essentially full capacity. In 1972 it embarked, with financial support from the Bank, AID and the U.S. Export-Import Bank, on its Stage I expansion, which should bring its annual installed ingot steel capacity to 1.5 million tpy (equivalent to 1.1 million tpy of finished products) in late 1978. 40. This project encountered varied problems, although all of them have by now been resolved, with a three years completion delay and a cost overrun of 75 percent in US$ equivalent terms and 110 percent in local currency terms,  - 13 - the estimated investment in Stage I project is now $425 million instead of $243 million estimated during appraisal in 1971. The overrun stemmed from: (a) an increase in project scope, agreed with the Bank, involving a 20 percent increase in finished products, because market growth was faster than antici- pated; (b) delay in its completion, partly due to difficulties between Erdemir and its previous engineering consultants; and (c) exceptionally high inflation, in both foreign exchange and especially local costs. The problems were aggravated by the abovementioned frequent changes in senior management. 41. The cost overrun required a change in the financing plan. It was originally foreseen that all local costs would be financed by internally generated funds. However, the Government had to make available to Erdemir $83 million equivalent (at then-prevailing exchange rates) in Government and other funds, (including the interim loan referred to in paras 37 and 43). 42. Financial Performance and Capital Structure. As a result of the above, the Company's capital and financial performance were inevitably affected during the Stage I implementation. Due to increased borrowings for Stage I expansion, in 1977, Company's debt/equity ratio peaked at around 83/17. With high financial charges on increased borrowings, and the Government's influence, exercised during discussions with the Company, on steel prices from rising too rapidly, net profit before taxes as a percentage of net sales declined to an average of 8 percent over the last three years (1975-77), despite a seller's market for flat steel products. The Company's current ratio reached 1.3 and debt service coverage fell to 1.0. 43. The Government and Erdemir's major shareholders have now, however, agreed to the Bank's request to improve the Company's financial structure by an infusion of TL 1,200 million ($48 million equivalent) in new paid-up equity. This requires an amendment to Erdemir's founding law. Hence, the Bank agreed, as an interim solution, to a five-year zero interest Government loan of TL 1,200 million to Erdemir in June 1977, to be converted into equity subsequent to parliamentary approval of the amendment. The necessary amendment has been submitted to the Parliament and its early passage is anticipated by the Government. PART IV - THE PROJECT Project History 44. Turkey and Erdemir requested Bank financing for the Stage II expan- sion project, in December 1976. Even taking into account the Stage I expan- sion project (which is nearing completion) flat steel capacity in Turkey is still falling far short of domestic market demand. In view of this and the high priority commanded by the gradual development of the steel industry in Turkey, the Bank agreed to consider the proposal. The proposed project was designed by U.S. Steel Engineers and Consultants (UEC) in broader terms in 1971, along with Stage I, and detailed by them by the end of 1976 to reflect the latest market and operating conditions. It was appraised in October 1977.  - 14 - Negotiations were held in Washington, D.C. in May, 1978 with a delegation which was led by Mr. Guven, Chief Financial and Economic Counsellor, Turkish Embassy in Washington, D.C. and included Mr. Aktutay, the new President of Erdemir. Project Description 45. The project would expand Erdemir's production capacity from its planned level proposed at the end of Stage I of 1.5 million tpy of liquid steel to 2.0 million tpy, equivalent to an increase from 1.1 to 1.5 million tpy of finished products. The project complements the Stage I expansion, by provid- ing balancing facilities necessary to fully utilize the inherent iron and steel-making and hot-rolling capacities installed under Stage I. 46. The technology would be mainly an extension of the conventional and established technology already utilized for Stage I, which is considered to be appropriate. Major new facilities include additions to raw materials handling systems to increase overall handling capacity and improve quality control and operating flexibilility, to support iron production of 1.8 million tpy, and also provision of a new turbo blower. Steel-making capacity would be increased to a level of 2.0 million tpy through the provision of new scrap preparation facilities, cranes, automatic baler and shear, and manual burning beds. A continuous slab caster and other improvements in the slab yard and hot strip mill are included to achieve capacity of 1.7 million tpy. Finally, improvements in hot and cold rolled finishing facilities would be made to achieve a capacity of 1.5 million tpy of finished products. 47. Facilities to reduce consumption of energy and operating costs as well as for environmental protection, are also included in the project. Expanded utilities, services and effluent treatment and monitoring facilities will be provided. The latter will include a new biological treatment plant designed to treat coke plant effluents and possibly overall plant and company housing area wastes generated by existing operations as well as by future Stage I and II operations, thus reducing present and preventing further con- tamination of the Eregli bay waters, which currently affects fishing and pollutes nearby beaches. A new bag house filter system for sinter plant dust, is also envisaged. 48. Finally, the project includes the feasibility study of Erdemir's Stages III and IV expansions, which, for technical reasons, need to be studied together. This study will include recommendations for adequate treatment of wastes anticipated from these expansions and Eregli township. However, financing this study implies no Bank commitment to financing the resulting project. The details of the proposed project are amplified in the Loan and Project Summary, and in the Staff Appraisal Report No. 1875a-TU dated 31 May 1978 being distributed separately to the Executive Directors. 49. It might be noted that Erdemir agreed to exclude from the scope of the proposed project, its originally proposed addition of 250,000 tpy of tinplate capacity at a cost of $110 million since a review initiated by the Bank proved this component to be uneconomic at this time. More generally,  - 15 - so as to ensure available resources are fully devoted to Stage II project implementation, Erdemir agreed to limit capital expenditures outside Stage I and Stage II works to no more than the TL equivalent of $4 million per annum through 1982 and $8 million per annum thereafter (Project Agreement, Section 4.04). Project Cost and Financing Plan 50. The total cost of the proposed project, excluding about $20 million for interest during construction and some incremental working capital, but including all contingencies, is estimated to be $301 million. Out of $151 million in foreign exchange, $145 million is the direct foreign exchange cost. Marginal refinements of these estimates are possible following engineering consultants review of design engineering and cost estimates, to be completed by October 30, 1978, prior to initiating the tendering process. 51. The proposed Bank loan covers about 28 percent of total cost including interest during construction and about 55 percent of the foreign exchange. Erdemir has finalized agreements with European banks for a loan of $8 million to finance Nippon Kokan K.K. engineering services. It has also received a firm supplier credit offer for $20 million for financing some equipment items. Conclusion of these agreements for $28 million is a condi- tion of loan effectiveness (Loan Agreement, Section 6.01 (c)). The Govern- ment and the Company will seek, and it is expected will successfully obtain, supplier-arranged financing for another $22 million worth of selected equip- ment. To the extent that the marginal refinements in cost estimates, fol- lowing the engineering consultants' review, entail an increase in foreign exchange cost, however small, the Government and the Company would also obtain supplier-arranged financing for this amount over and above the said $22 million. As these financing arrangements will be linked to procurement of selected items, for which bid invitations are to be issued only next year, in line with project implementation schedule, it is not appropriate to make the completion of these financing arrangements a condition of loan effectiveness. However, as these arrangements are an integral part of the financing plan, failure to obtain these amounts by December 31, 1979, would be a condition of default, Section 5.01(j). 52. Erdemir will finance most of the local project cost, including the interest during construction and increase in net working capital, from inter- nally generated funds. The foreign exchange, equivalent to $23 million, towards these two items, will be provided to the Company from Turkey's own foreign exchange resources. The Government has agreed to provide, or cause to be provided, any remaining funds needed to complete the project in the form of paid-up equity or in interest-free loans with a maturity of not less than 20 years, so as to bring the debt/equity ratio of the Company to at least 60:40 (Loan Agreement, Section 3.02). To ensure prompt provision of funds as needed, Erdemir would each year prepare updated 5-year financial projections showing annual estimated needs along with a financing plan for meeting the needs of the coming year, review the projection and plan with the Bank, and supply its financing requests to its shareholders and the Government by September 30 of each year, in time to permit either inclusion of the item  - 16 - in the Government's budget or alternative timely action e.g. issues of new shares (Project Agreement, Section 4.08). For 1978, the Bank reviewed Erdemir's latest financial projections, and found Erdemir will generate needed domestic currency requirements. 53. The proposed Bank loan would be to Turkey. As under Stage I, the proceeds would be onlent to Erdemir for 14 years, including 3-1/2 years grace, and an interest rate of 10 percent per annum. These terms correspond to Erdemir's projected profitability and repayment capability, with the Company bearing the foreign exchange risk (Loan Agreement, Section 3.01(b)). The signature of a subsidiary loan agreement between the Government and Erdemir, containing inter alia these provisions, is a condition of effectiveness (Loan Agreement, Section 6.01(b)). Project Execution and Operation 54. Erdemir will implement the project, with the technical advice and assistance of engineering consultants, who are acceptable to the Bank and have been appointed on terms and conditions acceptable to the Bank (Project Agree- ment, Section 2.02). Nippon Kokan K.K. (Japan) has been selected from among the three firms which submitted proposals, and the contract with them was recently signed. About 98 man-years of engineering services are envisaged, at a rate of about $6,000 per man-month. Much of the engineering work will be done in Turkey and about 60 percent of the man-hours will be from Turkish employees working under direct control of the engineer. The Company's expe- rience with delays and cost overruns in Stage I have led it, after analyzing the reasons for these delays, to reach arrangements with NKK for more effective assistance with project implementation. The contract gives significantly more responsibility and authority to the engineers, than in Stage I. Their services will also be provided under more effective organizational arrangements for project management. The purview of their services include staffing planning, expediting, follow-up, and critical path analyses and control, in addition to the usual functions of engineering design, preparation of bid documents, bid evaluation, supervision of construction, and startup. 55. An implementation schedule has been drawn up which will be used to monitor project execution, and key dates have been agreed with the Bank. The engineers will be responsible in addition for developing a complete PERT sched- ule for implementation, to be reviewed, updated and reported to the Bank on a quarterly basis. These arrangements, together with Government's assurances on ensuring sound and qualified management, should facilitate proper and timely project execution. 56. US Steel Engineers and Consultants (UEC) currently provides special- ized technical assistance to the Company on a continuing basis. Erdemir will continue this arrangement, which is critical to the attainment of efficient operations at a high level of capacity utilization, through the end of 1983 (Project Agreement, Section 3.07). This assistance will include the main training needed, which is for the basic oxygen furnace/continuous casting complex; suppliers will provide additional training.  - 17 - 57. Erdemir's annual raw material requirements at full production, include 2.6 million tpy of iron ore, 1.6 million tpy of coal, and 0.5 million tpy of limestone. Most of the iron ore will come mainly from existing mines and possibly from new developments at Divrigi and Hasancelebi in central Turkey, with about 20 percent of requirements coming from imports. Enough limestone is available domestically. Demand for coal may exceed domestic supply in the early 1980s. The Government agreed to permit imports of coal and iron ore as needed to ensure full utilization of installed capacity (Loan Agreement, Section 4.04). 58. Erdemir's present permanent work force is about 10 percent higher than the level recommended by its consultants. Erdemir has agreed to maintain employment policies to increase the Company's labor productivity (Project Agreement, Section 3.02 (b)), so that future increase in labor force will be held to a minimum as production, through the project, increases. Future Profitability and Financial Position 59. The financial projections assume that the buildup in production following the completion of Stage I facilities, will take effect in late 1978, while the Stage II facilities will start producing by end 1981 and reach full capacity in 1985. 60. A 40 percent increase in steel prices in September 1977 in Turkey, and a further 24 percent increase in March 1978, are together expected to improve the financial position of the Company in the short term. The years prior to the Stage II production buildup, are extremely important for the Company's future financial condition. 61. With the buildup in Stage I production beginning in late 1978, the financial position is expected to improve continuously throughout the Stage II implementation period. Sales are expected to increase from 1.1 million tpy in 1978 to 1.5 million in 1985. Operating costs are expected to fall by 12 percent (due mainly to increased labor productivity) after completion of Stage I, and by another 7 percent after completion of Stage II. Net profits before tax as a percentage of net sales, are expected to improve from 9 percent in 1977 to 13 percent in 1978 and to increase further thereafter. This should provide a cash buildup in the 1980s, needed ahead of the envisaged (much larger) Stage III expansion project. The increasing profits, combined with dividend restrictions (para. 62), will cause the current debt/equity ratio of 83/17 to come down, if equity of $48 million equivalent is paid in during 1978, to 54/46 in 1979, and to improve further thereafter. 62. In keeping with prudent financial management, and bearing in mind Erdemir's difficulties with low debt/equity and liquidity ratios, the follow- ing financial covenants were also agreed: (i) Erdemir should at all times maintain a 60/40 debt/equity ratio (Project Agreement, Section 4.03); (ii) Erdemir should maintain a current ratio of at least 1.3 (Project Agree- ment, Section 4.06); and (iii) dividend payments, until project completion,  - 18 - should be restricted to private non-founders and would be paid thereafter, only if after such payments the debt/equity ratio would remain below 60/40 and the current ratio above 1.3 (Project Agreement, Section 4.05). 63. The incremental financial rate of return is 18 percent. A 10 percent increase in investment costs would reduce it to 17 percent, which together with a slippage of one year in start-up would lower it to 15 percent. Procurement and Disbursement 64. All equipment covered by the Bank loan would be procured after international competitive bidding/shopping in accordance with Bank guidelines except for proprietory or semi-proprietory items required for reasons of com- patibility with existing equipment and standardization as a result of tech- nical and design considerations. The Bank loan may finance not more than $15 million of such items. Suppliers of major items will be prequalified, and for purposes of bid comparison, a 15 percent margin of preference, or the appli- cable import duty in Turkey, whichever is the lesser, will be given to clearly identified Turkish bids. The Bank loan will also finance the foreign exchange costs of Stages III/IV feasibility study, involving up to $500,000 in retroac- tive financing for expenditures incurred after May 1, 1978. This study should go ahead immediately, as its findings may affect the design of raw material handling facilities under Stage II. It will require about three man-years of consultant services, at a rate of almost $10,000 per man-month, as this kind of service is relatively costly. The Bank loan will also finance foreign exchange costs of technical assistance, training and other services. Civil works will not be financed out of the Bank loan, but will be subject to com- petition within Turkey. The Bank loan is expected to be about fully disbursed by the end of 1982. 65. As mentioned in para 51, supplier financing will cover the $8 mil- lion cost of NKK's engineering services. $20 million equivalent of equipment is also being procured with suppliers' credits, for which the Company has already received offers. A tentative list of items of equipment, whose procurement will be linked to supplier-arranged financing, and therefore be outside Bank procurement procedures, has been agreed upon. This list will be reviewed with the Bank in October 1978, following NKK's engineering review and preparation of specifications. During this review, bid packages for all items to be financed by the proposed loan will be finalized, as also the items to be procured through supplier-arranged financing for an amount of $22 million, which will be subject to procedures related to such financing. Benefits and Risks 66. The project has a relatively high economic rate of return of 17 percent, as compared to other steel projects around the world. Erdemir has operated its present facilities efficiently. It is expected that on comple- tion of Stage II, Erdemir's production costs will decline by 7 percent, over a 12 percent reduction anticipated on full utilization of capacity being installed under Stage I. These results are mainly derived from the economies of scale which Erdemir will enjoy on project completion.  - 19 - 67. Net foreign exchange savings of the project would amount to about $95 million equivalent per annum at full production. An assured, fairly competitive local flat steel supply will stimulate Turkey's steel-consuming industries and the development of the wider industrial sector. 68. Although the proposed project requires only a small additional labor force, there will also be indirect job creation in Erdemir's supplier and user industries. The project will indirectly provide a further stimulus to the town of Eregli, which has a population of around 50,000. Its growth has been based on the steel plant, where about 8,000 people work in operations and expansion, representing, with their families, about three quarters of the town's population. 69. The main project risk is the possibility of implementation delays and ineffective cost controls. However, Erdemir's new approach to project management as evidenced by the new appointments to top positions in the Company, and the strengthened role of the engineers should reduce this risk to acceptable levels. This will be continuously monitored by Erdemir, the engineers and the Bank, to avoid problems of the type experienced in Stage I. 70. There are no special technical risks, since all basic iron and steel-making operations are to be continued from Stage I and represent conven- tional modern steel plant technology. No major (or abnormal) commercial or economic risks are foreseen either, as flat steel production in Turkey will be below domestic demand for many years to come. A 10 percent shortfall in revenue from the levels forecast would lower the return to 14 percent; a 10 percent increase in investment costs would lower it to about 16 percent, which together with a delay in startup of one year, would reduce it further to 14 percent. These lower returns are not only acceptable, but attractive for a steel manufacturing project. PART V - LEGAL INSTRUMENTS AND AUTHORITY 71. The draft Loan Agreement between the Republic of Turkey and the Bank, the draft Project Agreement between the Bank and Erdemir, and the Report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement are being distributed separately to the Executive Directors. 72. Special features of the Loan and Project Agreements of particular interest are: (a) The following are special events of suspension and default, namely: (i) Any action taken resulting in a change in Erdemir's private status (Loan Agreement, Section 5.01(g)); and  - 20 - (ii) Failure to obtain supplier-arranged financing in an amount of $22 million by December 31, 1979 (Loan Agreement, Section 5.01(j)). (b) Other special conditions of effectiveness include: (i) authorization and ratification of the execution of the Project Agreement (Loan Agreement, Section 6.01(a)); (ii) authorization and ratification of the execution of the subsidiary loan agreement between the Government and Erdemir providing for relending the Bank loan (Loan Agreement, Section 6.01(b)); and (iii) conclusion of agreements for $28 million foreign exchange financing (Loan Agreement, Section 6.01(c)). 73. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 74. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments June 15, 1978 Washington, D.C.  TABLE 3A ANNEX I TURKEY - SOCIAL INDICATORS DATA SHEET Page 1 of 21 LAND AREA (THOU KM2) ------------------------------------------------- --------------- TURKEY REFERENCE COUNTRIES (1970) TOTAL 780.6 MOST RECENT AGRIC. 558.4 1960 1970 ESTIMATE COLOMBIA IRAN ITALY -- -___ -_ --------__ -___ -__ -_ ---_ ---- --------_ --_ - ----_ -_ --_ ------_ -_ ---- GNP PER CAPITA (USS) 270.0* 500.0* 990.0* 350.0* 670.0* 1910.0* POPULATION AND VITAL STATISTICS _______________________________ POPULATION (MID-YR. MILLION) 27.8 35.6 41.2 20.6 29.0 53.7 POPULATION DENSITY PER SQUARE KM. 35.0 46.0 53.0 18.0 18.0 178.0 PER so. KM. AGRICULTURAL LAND 52.0 65.0 74.0 93.0 107.0 266.0 VITAL STATISTICS CRUDE BIRTH RATE (/THOU. AV) 44.8 40.6 39.4 44.3/a 45.9 18.6 CRUDE DEATH RATE (/THOU.AV) 16.9 14.4 12.5 11.0 18.5 9.7 INFANT MORTALITY RATE (/THOU) 187.0/a,b153.0/a * 70.0/b 140.0 29.6 LIFE EXPECTANCY AT BIRTH (YRS) 49.3 54.4 56.9 58.5 48.8 71.9 GROSS REPRODUCTION RATE 2.9 2.6/b,c 2.3 3.2 3.4 1.3 POPULATION GROWTH RATE (X) TOTAL 3.0 2.5 2.5 2.9 3.1 0.8 URBAN 5.1/a 4.9/d 4.2 5.5/c 4.8 0.8 URBAN POPULATION (% OF TOTAL) 31.9 38.7 42.6 60.3 41.0 51.5 AGE STRUCTURE CPERCENT) 0 TO 14 YEARS 41.3 41.7 41.7 45.6 46.0/a 24.4 15 TO 64 YEARS 55.2 54.0 53.9 50.4 SO.0 7 65.2 65 YEARS AND OVER 3.5 4.3 4.4 3.0 40 10.4 AGE DEPENDENCY RATIO 0.8 0.9 0.8 1.0 1.o/a 0.5 ECONOMIC DEPENDENCY RATIO 1.0 1.1/e 1.2 /a 1.6/d 1-9/a 0.9/a FAMILY PLANNING ACCEPTORS (CUMULATIVE. THOU) .. .. ,. 306.9 662.4 USERS f% OF MARRIED WOMEN) 5.3 8.2 .. .. 10.0 EMPLOYMENT TOTAL LABOR FORCE (THOUSAND) 13000.0 l4000.0/f 16400-0/b 6200.0 8700.0 19600.0 LABOR FORCE IN AGRICULTURE CX) 71.7 63.4 52.5/c 39.0 43.0 19.0 UNEMPLOYED (X OF LABOR FORCE) 9.7/d 11.9 i 13.37w 7.0 2.1 3.1 INCOME DISTRIBUTION % OF PRIVATE INCOME REC D BY- HIGHEST 5 OF HOUSEHOLDS 33.o/e f 32.8M 28.0/e 3,.9 /e 29.7 /b HIGHEST 20% OF HOUSEHOLDS 61 07T 60.6 W 56. pi 60.1 -r 54.47 . LOWEST 20% OF HOUSEHOLDS 42/ t 2. 3.5/e 35 4 t LOWEST 40% OF HOUSEIJLDS 10.6jm 9-4 F 11574 10.1 7 12.7 . DISTRIBUTION OF LAND OWNERSHIP % OWNED BY TOP 10% OF OWNERS .. 39.0 /1 .. .. % OWNED BY SMALLEST 10% OWNERS 0.7 /7i HEALTH AND NUTRITION POPULATION PER PHYSICIAN 3220.0OL 2250.0 1880.0 2110.0 3300.0 550.0 POPULATION PER NURSING PERSON 3260.0/h 1770.011 1140.0 /f *- 3230.0 470.0/b POPULATION PER HOSPITAL BED 650.0 500.0 470.0 430.0 780.0 90.0 PER CAPITA SUPPLY OF - CALORIES (% OF REQUIREMENTS) 110.0 112.0 113.0 92.0 90.0 126.0 PROTEIN (GRAMS PER DAY) 75 3 78.0 76.0 51.0 53.0 100.0 -OF WHICH ANIMAL AND PULSE . 2 2.0/k 24.7 29.0/f 14.0/C 42.0 DEATH RATE (/THOU) AGES 1-4 16.0/e 14.7/1 .. 8.4 .. 1.0 EDUCATION ADUUSTED ENROLLMENT RATIO PRIMARY SCHOOL 75.0 104.0 108.0 100.0 83.0 110.0 SECONDARY SCHOOL 14.0 28.0 30.0 23.0 26.0 60.0 YEARS OF SCHOOLING PROVIDED (CIRST AND SECOND LEVEL) 11.0 11.0 11.0 11.0 12.0 13.0 VOCATIONAL ENROLLMENT (X OF SECONDARY) 18.0 14.0 15.0 20.0 3.0 26.0 ADULT LITERACY RATE CX) 40.0/i 55.0/r .. 73.0 .. 97.0 HOUSING PERSONS PER ROOM (URBAN) 2.0 1.9 2.2/a,d OCCUPIED DWELLINGS WITHOUT PIPED WATER (%) 81.0 66.0 52.0 *- 87.0/a,e ACCESS TO ELECTRICITY (X OF ALL DWELLINGS) 29.0 40.0 57.0 . 25.0/a RURAL DWELLINGS CONNECTED TO ELECTRICITY CX) 2.0 18.0 *- *- 4.0/a CONSUMPTION RADIO RECEIVERS (PER THOU POP) 49.0 89.0 107.0 105.0 93.0 218.0 PASSENGER CARS (PER THOU POP) 2.0 4.0 8.0 11.0 10.0 190.0 ELECTRICITY (KWH/YR PER CAP) 102.0 247.0 400.0 414.0 246.0 2262.0 NEWSPRINT (KG/YR PER CAP) 0.8 0.7 2.3 2.7 0.4 5.3