Turkey - Sumerbank Cotton Textile Rationalization Project

Document of FE COPY The World Bank FLE COPY FOR OFFICIAL USE ONLY Report No. P-2798-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 A SUMERBANK COTTON TEXTILE RATIONALIZATION PROJECT April 30, 1980 This document has a restricted distribution and may be used by recipients only in the performance of their oficial duties. Its contents may not otherwise be disclosed without World Bank authorization.  TURKEY CURRENCY EQUIVALENTS Currency Unit Calendar 1978 July 1979 Jan. 198011 US Dollar 1 = TL 24.28 TL 47.10 /2 TL 70.00 13 TL 1 = US$ 0.04 US$ 0.02 US$ 0.01 /1 Since January 1980 the rate is being adjusted for the differential inflation between Turkey and its major trading partners. TL70/$1 was used for this report. /2 Except for imports of crude oil, petroleum products and fertilizer raw materials, and exports of agricultural products benefitting from official price supports, for which it was TL35 = US$1.00 /3 Except for imports of fertilizers and insecticides/pesticides, as well as raw materials and inputs for their manufacture, for which the rate is TL55 - US$1.00. FISCAL YEAR Republic of Turkey March 1 to February 28 Sumerbank January 1 to December 31 ABBREVIATIONS CTD Cotton Textile Division in Sumerbank DYB State Investment Bank EEC European Economic Community LIBOR London Inter Bank Offer Rate M & LT Medium and Long Term PPF Project Preparation Facility SEE State Economic Enterprise SPO State Planning Organization SYKB Industrial Investment and Credit Bank TSKB Turkish Industrial Development Bank UNIDO United Nations Industrial Development Organization  FOR OFFICIAL USE ONLY TURKEY - SUMERBANK COTTON TEXTILE RATIONALIZATION PROJECT LOAN AND PROJECT SUMMARY Borrower: Republic of Turkey Beneficiary: Sumerbank Amount: $83 million equivalent in various currencies. Terms: Seventeen years including four years grace, at 8.25 percent per annum. Relending Terms: Twelve years including four years grace, at 10.5 percent per annum. Beneficiary will bear the foreign exchange risk. Project Description: Rationalization and modernization of Sumerbank's cotton textile operations to increase annual production of yarn from 41,000 tons per year to 52,000 tons, of woven fabrics from 207 to 250 million m2, finished fabrics from 152 to 207 million m2, and of garments by 1.7 million pieces. Except for garments, the increases will come from better use of existing capacity. The project includes: The provision or modernization of spinning, weaving, finishing and printing equipment, the equipping of a new garment plant, the general rehabilita- tion of existing factory facilities including ventilation, effluent disposal and lighting; about 45 manyears of training abroad; and about 460 manmonths of technical assistance for improved management, operations, training, financial and budgeting systems. The project will help meet the large domestic demand for textile products in Turkey and will yield net foreign earnings of about $5 million per year at full production. The principal risks include the possibilities of delayed price adjustments resulting in inadequate cash genera- tion for the project, delays arising from the need to carefully coordinate relocation and rehabilitation in 19 widely dispersed plants and delayed improvement in Sumerbank's financial position resulting from better organization and management. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Estimated Costs: US$ Millions Local Foreign Total Machinery and Equipment 3.6 49.7 53.3 Freight and Insurance 0.1 4.O 4.1 Civil Works, Engineering and Erection 8.1 3.0 11.1 Consultancy and Training 1.7 6.8 1/ 8.5 Base Cost Estimate 13.5 63.5 77.0 Contingencies: Physical 1.0 3.7 4.7 Price 3.5 20.8 24.3 TOTAL PROJECT COST 18.0 88.0 106.0 (of which taxes) (2.3) (0.0) (2.3) Financial Charges During Construction 3.5 14.2 17.7 Project Incremental Working Capital 5.2 1.8 7.0 Working Capital for Existing Operations 17.8 2.0 19.8 TOTAL FINANCING REQUIRED 44.5 106.0 150.5 Financing Plan: Bank 0.0 83.0 83.0 Suppliers Credits 0.0 5.0 5.0 Internally Generated Funds (Sumerbank) 26.5 18.0 44.5 New Equity Funds (Government) 18.0 0.0 18.0 TOTAL 44.5 106.0 150.5 _ - Estimated Disbursements: US$ Millions CY 1980 1981 1982 1983 Annual 1.0 36.0 38.0 8.0 Cumulative 1.0 37.0 75.0 83.0 Economic Rate of Return: 24 percent Appraisal Report: No. 2887-TU dated April 30, 1980. 1/ Including $1 million of advances under the Project Preparation Facility (P-013/018-TU).  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TURKEY FOR A SUMERBANK COTTON TEXTILE RATIONALIZATION PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Turkey for the equivalent of US$83 million, to help finance a Sumerbank Cotton Textile Rationalization Project. The loan would have a term of 17 years including 4 years of grace with interest at 8.25 percent per annum. The proceeds of the loan will be on-lent to Sumerbank for 12 years with 4 years of grace, with interest at 10.5 percent per annum. PART I - THE ECONOMY 1/ 2. A Special Economic Mission visited Turkey in April/May 1979 to evaluate the Fourth Five-Year Plan (1979-83). Following discussion with the Government in mid October 1979, its report entitled "Turkey: Policies and Prospects for Growth" (No. 2657a-TU dated December 12, 1979), was distributed to the Executive Directors on December 26, 1979. A Postscript to the Special Economic Report was distributed to the Board on March 24, 1980. Their find- ings are reflected in this Part. Annex I contains the Basic Country Data. Development Trends and Policies 3. As the result of a strong commitment to rapid growth and moderniza- tion, GDP increased at an average annual rate of 6.4 percent, 6.7 percent and 7.2 percent respectively during the First Plan (1963-67), Second Plan (1968-72), and Third Plan (1973-77) periods. This compares favorably with the experience of 55 "middle income" developing countries, whose GDP grew on an average 6.0 percent per annum between 1960-70 and 6.1 percent per annum between 1970-77. Moreover, the relatively high growth rate in Turkey was achieved without significant deposits of oil or other important natural resources. 4. Growth was accompanied by significant social changes. Although population grew at 2.5 percent per annum, rapid GDP growth nevertheless allowed substantial advances in per capita income. However, rising income levels were not accompanied by better income distribution and significant sectoral and regional inequalities in income exist, although basic needs have been satisfactorily met. 5. The public sector has played a key role in Turkey's development. Between 1963-77, its share in total fixed investment fluctuated around 50 percent, and its share of fixed investment in manufacturing increased from 21 1/ This part is identical to Part I of the President's Report on the Karakaya Hydropower Project (P-2789-TU), dated April 25, 1980.  - 2 - to nearly 49 percent. The public sector dominates basic industries. Never- theless, the private sector has emerged as an increasingly important and dynamic element in the economy and is beginning to shift its orientation from consumer goods to intermediate and investment goods, and from the domestic market to exports. Private sector investment increased at nearly 11.5 percent per year in real terms during 1967-77 compared to an average annual increase of only 4.8 percent between 1963 and 1967. 6. Turkish development between 1963-77, however, exhibited a number of structural characteristics which are of considerable relevance for future development policy. First, for a country of Turkey's size and per capita income, it has a very low level of exports relative to GDP--about 4 percent in 1977--as against a more or less "normal" import level of around 20 percent for middle income countries; this highlights the vulnerability of the balance of payments and the importance of export development to sustain the needed inflow of foreign exchange resources. Second, while the level of investment relative to GDP increased rapidly and compares favorably with other developing countries, mobilization of domestic savings has lagged; the ratio of domestic savings to GDP is well below the average for middle income countries; the growing gap between domestic savings and investment led in the mid-70s to a relatively high level of external borrowing, and domestic inflationary pres- sures emanating from excess demand and deficit financing. Third, a relatively high proportion of the labor force is still in agriculture, reflecting signif- icant disguised unemployment and the need for accelerated job creation in non-agricultural activities; that in industry is low compared to other large middle income countries; furthermore, the relatively inadequate generation of additional employment has become more serious following the near cessation of workers' migration to Europe since 1974. Fourth, despite the growing dynamism of the private sector, the industrial scene is dominated by inefficient State Economic Enterprises (SEEs) which have not been exposed to market forces and serve not only economic but social goals; their growing deficits have imposed an inflationary burden on the budget, while their ambitious investment programs were financed through Central Bank borrowings, since their controlled prices have, until recently, not enabled most of them to generate sufficient cash to cover costs or investment expenditures. Fifth, due to the successes achieved since the early sixties through economic planning, there has been an increas- ing tendency to plan to a micro-level and seek to achieve changes through administrative fiat; however, the economy has reached a stage where such excessive reliance on this becomes counter productive; planning needs to be increasingly geared towards setting a framework in which market forces could secure the desired economic results in both the public and private sectors. The Economic Crisis and Stabilization Efforts up to Mid-1979 7. These economic, institutional and structural characteristics of the economy made it particularly vulnerable to the sharp increase in import prices (including oil) in 1974 and the simultaneous occurence of recession, inflation and rising unemployment in the industrial countries. These factors  - 3 - played a key part in the deterioration of the Turkish economy. However, the politically weak governments, their policies in response to these factors and their efforts to pursue high growth policy despite the worsening international environment with increasing reliance on short-term external financing, together created forces that brought about the economic crisis that began in mid-1977 and still continues. The detailed analysis of the causes of this crisis and the government's attempts to stabilize the economy in the short-run up to mid-1979, is provided in the above-mentioned Special Economic Report and in paras. 8 through 15 of the President's Report (dated February 29, 1980) for the Structural Adjustment Loan approved by the Board on March 25, 1980. 8. The new IMF Standby, which replaced the one arranged in April 1978, was negotiated after the government took the following overdue measures in March/April 1979, to reverse the continuing adverse economic trends: (a) to improve the balance of payments, the TL was devalued in several steps until June, when a new buying rate of TL 47.10 per US$1 was established for most foreign trade and all invisibles; the new rate represented a depreciation in export-weighted terms of nearly 75 percent since the end of 1970, and more than offset the differential inflation rate during the course of 1978-79 between Turkey and its major trading partners; (b) to further stimulate exports of industrial and mining products, exporters were allowed to retain 50 percent (up from 25 percent) of their foreign exchange earnings to finance their imported inputs or those of their local suppliers; (c) to improve the financial position of SEEs, further substantial price increases (34 percent to 110 percent) were announced for a number of products, raising them above world prices at the new exchange rate; these increases were estimated to yield an additional TL 80 billion in FY1979, to help reduce the overall borrowing requirement of the public sector; and (d) to ensure more effective mobiliza- tion and allocation of resources, interest rates for deposits and loans were increased substantially, from up to a maximum of 16% p.a. to over 24% p.a.; repatriated savings of migrant workers were allowed an additional interest premium. 9. The July 1979 Standby covered a twelve month period, and foresaw total purchases of SDR 250.0 million in four tranches - SDR 70.0 million initially, and SDR 60 million each after November 1979, March 1980, and June 1980. It provided for a series of specific performance targets to strengthen the public finances, reduce inflation and improve the balance of payments situation in the short term. These measures were expected to prevent further deterioration in the balance of payments during 1979, with essential imports projected at $5.0 billion, about the same level as the previous year in real terms. A substantial increase in workers' remittances to a level of $1.2 billion was expected to compensate for the increasing interest payments on foreign debt. At the same time, disbursements of medium- and long-term foreign aid (including the Bank's Program Loan) were expected to increase markedly in 1979, thus reducing the need for renewed short-term borrowing. 10. In 1978, short-term debts continued to grow. However, 1979 wit- nessed the completion of a major Turkish effort to alleviate the primary  - 4 - external debt issue through: (a) slowing the growth of short-term liabilities; (b) debt relief arrangements; and (c) efforts to pursue new sources of credits, especially M&LT credits. The first debt relief operation, arranged through the OECD Consortium for Turkey in May 1978, involved consolidation of $1.14 billion in arrears on guaranteed short-term and bilateral M&LT debt, as well as amounts due over the 13-month period May 21, 1978 to June 30, 1979. A second such major rescheduling took place in July 1979 involving about $1.02 billion of the official bilateral and private guaranteed credits due between July 1, 1979 and June 30, 1980. A third major arrangement, finalized in July and August 1979 with commercial banks, rescheduled convertible lira deposits ($2.3 billion), banker's credits ($429 million) and third party reimbursement credits ($300 million). About $317 million in oil debt was also rescheduled. The total amount thus rescheduled was about $5.5 billion. This is perhaps the largest debt rescheduling operation anywhere. 11. Turkey also succeeded in 1978 and 1979, though to a limited extent, in diversifying the sources and increasing the level of M&LT commitments, including $250 million in project credits from the Saudi Fund. Perhaps the most important arrangement arrived at was the May 1979 OECD sponsored pledging of $1.45 billion in special assistance, including about $900 million in M&LT bilateral credits and export credits, besides $407 million of medium-term credits from commercial banks (finalized in September 1979). Agreements for all these funds were expected to be finalized before the end of 1979. By that time, about $750 million of this was estimated to be disbursed. Economic Situation As Of End 1979 12. The economic crisis still continues. The measures taken in the context of the July 1979 Standby Arrangement have essentially succeeded in arresting further economic deterioration. Since it came into effect only in July 1979, it was recognized that the stabilization objectives which could be realized within one year were necessarily limited, and the progress towards them within the remaining six months of 1979 would also be quite modest. 13. After a surge up to mid 1979, worker remittances slowed down; nevertheless, they totalled about $1.7 billion, against $983 million in 1978 and the Standby's target of $1.2 billion. Industrial exports rose quite strongly in the first half of 1979 in response to the changes in the parity value of the TL in April and June 1979; but they subsequently slowed down, presumably, partly due to severe shortages of imported inputs and partly due to the anticipation of further devaluation in the second half of that year. Overall, exports totalled about $2.3 billion in 1979, against the Standby's target of $2.7 billion. As a result of higher prices and the necessity of purchasing oil on spot markets, the 1979 oil bill rose from the projected $1.7 billion to nearly $2.5 billion. While imports in 1979 were contained at $5.1 billion, marginally higher than the Standby's target of $5.0 billion, the large oil bill necessitated more than anticipated reductions in essential imports. The problem was compounded by a much lower inflow of new capital than that envisaged in July 1979, because a significant part of the $900 million committed by bilaterals in May 1979 at the OECD meeting had not been made effective up to December 1979; besides, only a portion of what was made  - 5 - effective was available to finance imports in 1979. Disbursements were also lower than expected against the $407 million of new commercial bank financing, because of its linkage with the November 1979 tranche of the Standby Arrangements which could not take place in time due to a change of government in Turkey in late 1979. Consequently, while the estimated current account deficit of $1.6 billion in 1979 was more or less in line with the target in the Standby Arrangements, the volume of imports declined by about 15 percent in 1979, following a decline of about 30 percent in 1978. Overall, GNP growth in 1979 was about 1.5 percent. Under the great pressure imposed by extremely limited supplies of vital imported inputs and products, including oil, the resulting shortfalls in export earnings, the shortages of a wide variety of consumer goods, and much stronger pressure on wages than antici- pated at the time of the Standby, the rate of inflation reached 64 percent in 1979. January 1980 Economic Program and Policy Objectives 14. Despite the difficult stabilization measures adopted since 1978 and those reflected in the July 1979 Standby Arrangements, the economic crisis persisted throughout 1979. Following elections in October 1979 a new govern- ment was formed. It obtained a vote of confidence in late November 1979. Bold and far-reaching measures to reverse the economic situation were announced on January 25, 1980. These are summarized in Annex II and more fully discussed in Part II of the President's Report (No. P-2725-TU) for the Structural Adjustment Loan approved by the Executive Directors on March 25, 1980. The announced economic policy objectives underlying these measures represent a basic departure from the past planning objectives. Turkey has undertaken, through this program, the essential first steps to initiate major structural and institutional changes in the key areas summarized in para 6, so as to foster medium-term economic development on a stable basis. 15. Following the announcement of this program, the IMF approved a modification of the terms of the July 1979 Standby Arrangements, and the release of a larger second tranche on February 21, 1980. On March 24, 1980, it approved the release of an increased third tranche. Thus, of the balance of SDR 180 million remaining in their July 1979 Standby, only SDR 20 million remains for release by end June 1980. In addition, compensatory financing of SDR 71.6 million has been provided on February 21, 1980 together with the modification of the Standby. Together, this results in the provision of $301 million (SDR 231.6 million) now with $26 million (SDR 20 million) to be provided in June 1980. In addition, Germany took the lead in organizing the provision of sizeable external assistance, as well as a further debt relief operation. Also, in meetings sponsored under OECD auspices on March 26 and April 15, $1.16 billion of bilateral aid was pledged. The success of the January 1980 measures is clearly dependent not on Turkey's own further efforts alone, but also on the willingness of the international economic and financial community to provide adequate and timely assistance in the period immediately ahead. The alternative for Turkey would be to cut back on imports, already pared to the bone; this, in turn, would postpone the possibility of economic recovery even further, jeopardize its efforts to curb inflation, and hamper the success of the bold structural changes it has initiated.  - 6 - 16. The new economic policy oblectives underlying the Government's stated goal of "bringing about a major reorientation of the economy," can be summed up as follows: (a) Greater reliance on market mechanisms and forces by both the public and private sectors, and lesser reliance than hitherto on planning up to micro-levels and on administrative fiats to realize planned targets and objectives. (b) Reduction in the rate of inflation and improved management of balance of payments and external debts have the highest priority; in the process, Turkey may have to accept temporarily a lower GNP growth. (c) Import substitution and protection oriented policies, on which Turkish development policy hitherto relied and which resulted in a bias favoring production for the domestic markets, must give way to policies encouraging the public and private sectors to be efficient and internationally competitive. (d) In future, reliance must be placed on exports and foreign currency earning activities to finance Turkey's economic needs; the implementation of rational exchange rate policies and of measures encouraging exports are essential to achieve this objective. (e) The SEE sector must be reformed, by exposing it to market forces, by allowing it to set its own prices and by improv- ing its management; through such actions, it must generate its own resources to cover operating costs and investment expenditures. (f) Domestic resource mobilization efforts, unlike the past, must be substantially augmented through increased tax efforts, the banking system, increased savings and the development of financial markets; the elimination of deficits of the public sector is an important objective of budgets from 1980 onwards. (g) Investments aiming at fuller utilization of existing produc- tive capacity and completion of those ongoing projects requiring modest inputs should have first priority; there- after, the priority should be for new investments stressing exports and employment or those removing critical infra- structural bottlenecks; in any event, investments should be tailored to scarce resources. (h) Conditions to stimulate foreign investments in oil, industry and agriculture must be created, in contrast to the past when such investments were not encouraged; prudent external debt management policies to create confidence in and flow of large external resources to Turkey should be followed.  17. These are radical departures from past Turkish economic policy. Considerable effort will be required to implement the new policies and com- plete the structural and institutional changes which Turkey has begun. The difficulty of the task should not be underestimated. The key policy areas are: (a) a rational exchange rate policy; (b) policies ensuring increased export earnings and encouraging foreign investments; (c) reform of the SEE sector, and the use of market forces to improve its efficiency and output as well as that of the private sector; (d) policies to improve domestic resource mobilization; and (e) formulation and pursuit of rational external debt management policies. 18. The actions taken by Turkey since 1978 in these areas, including measures in the January 1980 program and those planned for implementation in the medium-term, are summarized in the Table in Annex II. Progress in implementing them so as to foster economic recovery in the medium-term will be the focus of two reviews in July 1980 and December 1980, under the recently approved Structural Adjustment Loan. While all the issues listed in the Table are important, two of them merit further discussion: (a) external debt management and (b) public sector investment program. 19. Turkey's external debt management policy has to grapple with several difficult issues. First, the large overhang of debt, and the relatively hard terms of the recent debt reschedulings, together raise a question regarding the need for further rescheduling in the near-term. A substantial improvement in the repayment profile of the rescheduled debts and the containment of Turkey's short-term indebtedness over the medium-term to no more than the present level of about $3.8 billion is necessary to alleviate the heavy debt servicing burden over the next 5 years; a critical element here is the likely posture of commercial creditors, which cannot be easily anticipated. Second, it is important that Turkey obtains sizeable external credits on as long-term and concessional a basis as possible, to complete ongoing projects and under- take new ones in accordance with its stated investment criteria (para. 20). Recognizing the importance of these issues and the longer-term concerns regarding its creditworthiness that its creditors have, Turkey has been focussing its attention on evolving a balanced and prudent policy for external debt management. The Government has already initiated a comprehensive study of external debt, which it expects to complete before October 31, 1980. This study should help Turkey to further improve and refine its present external debt management policy; that should also assist Turkey in exercising greater control over the level and terms of new external financing it would seek from various external sources over the next five years. 20. As discussed earlier, the overall size and quality of the public investment programs until 1977 have contributed to the economic crisis. Actions taken over the last several months provide some evidence that given the severe domestic and foreign exchange constraints, public investment expenditures are being channelled towards projects meeting strict investment criteria. However, the January 1980 program and the policy announcements accompanying it go beyond that. They emphasize that since control of inflation is more important at present than the past Turkish strategy of concentrating only on higher growth, the projected level of annual investments  - 8 - must be rigorously tailored to meet the availability of scarce resources each year. Investments in fiscal 1979 were lower in real terms than those in fiscal 1978. The Government proposes to continue that trend for fiscal 1980. Priority is to be accorded first to investments designed to utilize existing productive capacity more fully and to complete ongoing projects which can yield attractive returns with modest additional investments. Thereafter, the priority for new investments is for productive projects either contributing to exports or employment, or for those which remove critical infrastructural bottlenecks. A new Incentives and Investment Department has been established, whose purpose is to review which ongoing investments should be stopped, deferred or completed on an accelerated basis. 21. Successful implementation of the economic reorientation begun in January 1980 will take time, require persistence and courageous action on the part of the Government and call for substantial support from the inter- national community. In the medium term, it will strengthen the basis for Turkey's creditworthiness and reestablish a path of stable economic growth. Turkey's Medium-Term Economic Prospects 22. The Fourth Five-Year Plan (1979-83), approved by Parliament in November 1978, was in many essential ways an extension of the traditional Turkish development planning. It set out to complete the unfinished tasks of the Third Plan, and continued to emphasize a high growth rate, a large investment allocation for import substitution in basic and intermediate goods industries, and reliance on administrative controls rather than on market incentives. But it also attempted to address some development issues which came to the fore during the economic crisis, i.e. export growth and increased savings. Consequently, an export growth target of 18 percent p.a. in real terms and a marginal savings ratio of 34 percent were set, and priority was also accorded to export-oriented investments. But investment allocations provided mixed signals, favoring import substitution. In view of the continua- tion of the economic crisis, the unattainability of the targeted marginal savings ratio, and the difficulties that Turkey is facing currently, the Fourth Plan targets of investment and growth are clearly not going to be achieved. 23. Against this background, the Bank has made its own prognosis based on a general equilibrium model of the economy which permits quantification of alternative policies and a detailed and consistent examination of Turkey's medium-term prospects. Given the accumulation of economic problems of the last three years, the political difficulties besetting the country, the addi- tional resources needed to cover the significantly increased cost of imports (including oil), and the limitations which Turkey is likely to encounter over the medium-term in significantly increasing the net inflow of capital, GDP growth in real terms may average around 4 percent p.a. with a real growth of exports about 12 percent p.a., during 1980-85. These growth rates appear attainable, assuming continuation of appropriate economic policies (including those announced in January 1980), and taking into account the low export base  - 9 - and present underutilization of capacity. I/ The international oil situation, following the recent substantial oil price increases at end-1979, has a major impact on future prospects. Even if Turkey allows only a marginal increase in oil imports during 1980-1985 to sustain a lower level of growth, the oil import bill is estimated to increase to $3.2 billion in 1980 and $6.1 billion by 1985, which as a percentage of merchandise exports and non-factor services reached 78.1 percent in 1979 and is likely to remain at a level of about 68 percent until 1985. The pressure this will exert on Turkey's already difficult balance of payments position is obvious. Although in constant dollars the ratio appears manageable, in current prices the projected current account deficit as a percent of GNP increases from 3 percent in 1979 to about 5.3 percent in 1980 and remains at a level of about 4 percent thereafter until 1984. Considering the limitation on the gross inflows of available external assistance and given the need for sound external debt management, Turkey can sustain an average annual current account deficit of the order of $2-2.2 billion annually over the next 5 years. 24. Taking into account international inflation and the growing obliga- tions for debt amortization, this situation necessitates a large and sharply increasing gross annual average inflow of foreign capital, rising from the current relatively low levels to about $5.2 billion during the next five years, implying an annual average of about $2.3 billion of net capital inflow for the same period. Such major inflows of foreign capital can only be sustained on the basis of prudent external debt management. In any case, debt service obligations are likely to remain very high over the coming 5 years. In 1978, total debt service payments had risen to 26.7 percent of exports of goods, non-factor services and workers' remittances after making allowance for the rescheduled service payments. In 1980, the ratio is projected to reach close to 37 percent, and is likely to peak in 1985 at a high level of about 48 percent, before declining. This, however, should represent the culmination of the financial consequences of the present crisis and the debt burden should remain manageable, provided the new policies are successfully implemented and the export drive is sustained. PART II - BANK GROUP OPERATIONS IN TURKEY 25. A-large lending program for Turkey essentially began following the introduction of its 1970 Stabilization Program. To date, the Bank/IDA have lent $2,320 million through 56 projects. Agriculture accounts for 30 percent of funds lent, industry and DFCs for 34 percent, power for 14 percent and urban development, transportation, education and tourism for the rest. Annex III contains a summary statement of Bank loans, IDA credits and IFC invest- ments as of March 31, 1980, with notes on the execution of ongoing projects. 1/ See "Turkey: Postscript Special Economic Report", Attachment 1, Report No. 2918-TU dated March 20, 1980, circulated to the Executive Directors on March 24, 1980.  - 10 - 26. Since mid-1975 the implementation of private sector projects has been satisfactory. Political uncertainty, limited coordination amongst ministries and staffing problems resulted in uneven and delayed project imple- mentation in the public sector. Therefore, a system of joint project reviews between Turkey and the Bank was instituted in June 1975. This resulted in distinct, but modest, improvements up to end 1977. The situation was again reviewed with the Government in March 1978, and further discussed during my visit in April 1978. Subsequently, Turkey established a new high-level coordination team. This team set up procedures for monitoring and achieving realistic implementation and disbursement targets. As of December 1979 disbursements increased to 69 percent of appraisal estimates against 51 percent in June 1975. The last joint review was held in April 1979. The encouraging progress that is now manifest allows cautious optimism that performance will gradually improve further. 27. Bank lending is now aimed at supporting Turkey's efforts to improve its: (a) capacity to earn foreign exchange, through promotion of industrial and agro-industrial exposts; (b) income distribution, employment opportunities and living standards, through rural and urban development projects; (c) lagging public sector savings, through the encouragement of improved management and financing of the investments of key SEEs; and (d) infrastructure posing critical bottlenecks for development. The Bank has begun discussions with the new government on how its lending can best contribute to the government's medium-term objectives, especially export promotion, without being handicapped by past policy and institutional obstacles. Meanwhile, agriculture and industry remain the key sectors for lending. In agriculture, projects empha- size livestock, exports, and rural development; in industry (including DFCs), the emphasis is on promotion of exports and employment, as also the gradual strengthening of the SEEs. Projects for urban development, public utilities and transportation supplement these efforts. We propose to maintain a close macroeconomic and sector dialogue with Turkey. The economic and sector work planned over the next few months includes an updating economic mission and completion of sector memoranda on industry and energy. In addition, the progress made in fostering the structural adjustments initiated by the Govern- ment through the January 1980 program will be discussed in the context of the disbursements of the Structural Adjustment Loan. 28. A thirteenth TSKB loan designed to stimulate investments in export projects of the private sector, loans for a Private Sector Textile Project and an engineering loan to assist the alleviation of air pollution in Ankara, were approved by the Board in the first four months of FY80. A loan for Structural Adjustment was approved on March 25, 1980. The Karakaya Hydropower and the Fifth Livestock Development Projects are scheduled for Board considera- tion this fiscal year. Projects being processed for future fiscal years include those for pilot enhanced oil recovery and oil exploration, fruit and vegetables, livestock products, rural development, fertilizer production, employment generation in selected cities, pulp manufacture, seed production and sewerage disposal in Istanbul. 29. The Bank Group's share of the estimated total external debt (includ- ing short-term obligations) was 5.9 percent in 1978, and is expected to grow to 10.0 percent by 1981 and to 12.5 percent by 1985. The Bank's share of  - 11 - service payments is projected to fall slightly from its level of 7.7 percent in 1978 to 6.4 percent in 1981, thereafter increasing to 7.6 percent by 1985. 30. IFC has invested in synthetic yarns, pulp and paper, glass, aluminum, iron and steel products, motor bicycle engines, piston rings and cylinder liners, and tourism. It has also invested in TSKB. As of March 31, 1980, gross IFC commitments totalled about $208 million, of which $96 million were still held by IFC. New investment opportunities are being pursued. PART III - THE TEXTILE INDUSTRY AND SUMERBANK Background 31. Textiles has long been one of the most significant industrial sub- sectors in Turkey. Second only to food processing in value of production, it is the largest source of manufactured exports and the largest source of industrial employment providing over 300,000 jobs. It is built upon the firm basis of significant domestic cotton production, plentiful labor and a large domestic market. 32. Turkey is the world's sixth largest cotton grower, and the third largest cotton exporter. There is considerable scope for further domestic value-added through the development of the cotton textile industry, especially weaving, finishing and garment making. Wage levels, although above those in some developing countries, are well below those in the industrialized coun- tries. Labor productivity is also low when compared with the latter. Never- theless, some firms are internationally competitive. Over 90 percent of domestic cotton textile production, which reached 288 thousand tons of yarn and about 1.0 billion m2 of fabric in 1978, goes to meet domestic demand. Domestic textile fiber consumption averaged 7.7 kg per capita in 1978, higher than most comparable developing countries, but lower than the industrialized countries. Textile exports were estimated at $352 million in 1979. Of this, about 80 percent went to the EEC, where Turkey's share ranged from 22 percent in cotton yarn to 1 percent in fabrics and garments. 33. The private sector now accounts for 80 to 85 percent of textile production. Sumerbank--the only public sector textile company--accounts for the remainder. The organized private sector includes some 1,400 establish- ments, in which some 200 large integrated plants provide 73 percent of employ- ment. There are another 8,000 or so small establishments in the unorganized private sector. Sumerbank controls 26 large textile plants. 34. The textile industry faces many of the general problems of industry in Turkey: low capacity utilization, low productivity, power shortages, short- ages of spare parts and materials due to constraints on foreign exchange and excessive orientation to the domestic market at the expense of exports. In addition, the textile industry suffers from bottlenecks--an estimated 60 per- cent of yarn can be absorbed by domestic looms--and a need for rationalization,  - 12 - balancing, modernizing and increased efficiency. There are regional shortages of finishing capacity and a national shortage of dyeing capacity. A consider- able portion of dyeing and printing and finishing equipment is obsolescent, and requires replacement. Garments, while a fast growing segment, is rela- tively undeveloped and most units are small and poorly organized. 35. In light of these factors, national planning emphasizes renewal and rehabilitation of existing facilities and expansion of capacity mainly to correct bottlenecks and balance the various segments in the industry. Investment in spinning capacity is to be discouraged, while investment in intermediate goods and auxiliary materials for garments and knitting is to be fostered. The overly domestic orientation of the textile industry has arisen from its protected position, the large and profitable domestic market, and trade restrictions imposed by Turkey's major trading partners. The economic policy packages of recent Turkish governments, including the January 1980 package described in Part I of this report, have begun to reorient the incen- tives provided to manufacturers toward export markets, and to encourage the domestic processing of raw cotton and yarn into finished products. 36. The Bank is supporting Turkey's initial efforts to modernize key selected segments of this industry and improve its efficiency through the Private Sector Textile Project (Lns. 1754 & 1755 for $80 million to TSKB and SYKB), approved by the Executive Directors in September 1979, and the proposed project. In the past, the Bank Group has supported the textile industry through loans by IFC (about $11 million total), textile subprojects under loans to TSKB (about $30 million total), and through SEE subprojects under loans to DYB (about $26 million). The Private Sector Textile Project, besides providing subloans for equipment, provides for technical assistance for an extension service providing training and consultancy services, establishes a fund for supplementary training, technical assistance and technology, and supports training in textile research, oriented towards improved export performance. Markets and Marketing 37. Based on past trends, the Fourth Plan projects a 9 percent annual increase in the value of production and a tripling of textile exports. How- ever, in view of recent economic developments, much lower expectations for per capita income growth and constraints on imports in the major trading partners, the Bank projections are more conservative. Production of yarn and woven fabrics are projected to increase at about 4 percent and 3 percent per annum respectively in volume through 1985, with most of the increased yarn production going to meet the domestic yarn requirements of weaving and knitting and most of the increased fabric production going to meet increases in domestic fabric demand. Because of trade restrictions, exports of yarn and woven fabrics are expected to grow only by 3 percent per annum. The main prospects for increasing exports lie in garments and made-up goods where exports are now expected to grow by 8 percent per annum during the 1980-85 period.  - 13 - 38. Marketing of fabrics in the private sector is generally carried out through large central wholesalers, mostly located in Istanbul, who sell in turn through regional wholesalers. These large wholesalers keep in touch with market trends and developments and provide guidance in production plan- ning and product design to the mills. They often finance the working capital needs of the manufacturers. Exports are usually handled by agents; only a limited number of firms have their own overseas offices or representatives. Garment firms in particular are inexperienced in export marketing. The technical assistance provided under the Private Sector Textiles Project is focused on improvements in export marketing with special emphasis on the garments sector for which the extension service will provide export marketing assistance. The proposed project provides similar and complementary assistance for Sumerbank (para. 49). Sumerbank 39. Sumerbank was founded in 1933 as one of the original conglomerate SEEs with operations in banking, manufacturing and retailing. Sumerbank has spawned a number of independent SEEs over the years and presently has opera- tions in leather products, building materials, ceramics, chemicals and vege- table oil, as well as a small banking division. However, its main business is textiles, which account for about 80 percent of its total sales revenue (60 percent from cotton, 20 percent from wool). The cotton textile operations include ginning, spinning, weaving, finishing and garment manufacture in 19 plants employing 25,600 people and located throughout the country (Map IBRD 14575). Annual installed capacity is 79,800 tons of yarn (524,000 spindles), 315 million meters of woven fabric (7,800 looms), 215 million meters of finished fabric, 3,500 tons of yarn dyeing and 1.7 million pieces of garments. The company's retail division, which also sells some private firms' products, has 430 shops throughout Turkey, mostly in rural areas. Like other SEEs, Sumerbank's objectives go beyond profit making, and include the provision of mass consumption fabrics to the rural and urban poor throughout Turkey, stabilizing prices in the domestic market, generating employment in less developed regions and training textile industry personnel. 40. Sumerbank's operations are directed by a six member Executive Committee, or Board, comprising the General Director, two deputy directors and representatives each of the Ministries of Industry and Finance and a labor organization. Like other SEEs, Sumerbank has suffered from frequent manage- ment changes, inadequate compensation and incentive systems, overstaffing and overcentralization of operational and investment decision making at the senior management and board levels. Moreover, until recently, functional respon- sibility for cotton textile operations was scattered among a number of divi- sions, plants and subsidiaries. Coordination between headquarters, the production units and the retail division is weak. Operational efficiency is low, ranging from 48 percent of installed capacity in spinning, to 58 percent in weaving. 41. To provide a more cohesive organization with better coordination between units and a clearer understanding of responsibility and function, Sumerbank consultants (provided under the Project Preparation Facility, para. 46 below) recommended consolidating and reorganizing all the functions related  - 14 - to cotton textile operations, except retail sales, under a single organization. Initially, consideration was given to forming a subsidiary company along private sector lines under a separate law. However, this would have required lengthy legislative changes. Sumerbank therefore, in March 1980, established a new Cotton Textile Division (CTD) within the company, responsible for administering, coordinating and directing all cotton textile operations, including the 19 existing plants. This is a major step towards improving the situation. An understanding has been reached on the main functions of CTD and the key principles for its operations. Detailed proposals, satisfactory to the Bank, covering these functions and responsibilities, the relations with the plants and other Sumerbank units, will be provided to the Bank by December 31, 1980 (Project Agreement, Section 3.02(c)). Amendment of Sumerbank's Statutes, or of the board decision establishing CTD or of the SEE laws in a way to adversely affect the project are conditions of suspension or cancella- tion (Loan Agreement, Section 5.01). 42. With the creation of CTD, the individual cotton textile plants retain their independent legal status as "establishments" to encourage their operation as profit centers. They are to be given additional autonomy in noncentralized areas, including increased freedom to hire staff. They will also propose their own production targets, costing and industrial engineering standards, pricing of their products and plans for rationalization and expan- sion of their capacity, which CTD would coordinate. An improved information system between the units will permit faster management decisions by CTD. Technical assistance, and action programs financed under the loan, will help foster these changes. 43. About 75 percent of CTD's production is currently sold to the semi-autonomous retail division of Sumerbank for sale primarily through its 430 retail outlets, and occasionally to private wholesalers. An addi- tional 15 percent is sold directly to government institutions, 5 percent sold directly to the public, and 5 percent exported. Yarn is mostly used internally and up to 50 percent of garments are exported, the rest being sold through Sumerbank's retail division's stores. Under present practices, the retail division sells CTD's products on a consignment basis. This has been costly and inefficient since CTD carries the financial risk of the accept- ability of the products, but has limited direct contact and feedback from the markets on the acceptability of various items, while the retail division has little incentive to ensure a proper product mix. This situation will be corrected in connection with the project (see paragraph 56). Financial Performance 44. Sumerbank's total sales reached TL 29.6 billion in 1979, of which about 40 percent were intercompany sales. Net profit as a percent of sales, has fluctuated between 0 and 3.5 percent over the last five years for Sumer- bank as a whole. The cotton textile operations showed losses prior to 1979, and a modest profit in that year, reflecting the burden of low production efficiency, low capacity utilization and prices lagging behind costs. The debt/equity ratio for the cotton textile operations had increased from 31/69 in 1975 to over 50:50 in mid 1979 and the current ratio was below 1; reflect- ing the increased recourse to debt financing from the Government and short- term borrowings from the Central Bank, mainly to finance raw cotton purchases.  - 15 - 45. To partly correct this situation, the Government recently increased the authorized capital of Sumerbank to TL 8 billion and converted approx- imately TL 4.6 billion of outstanding debt owed to the Treasury into paid-up capital. Sumerbank allocated TL 2.5 billion of this converted debt to CTD's plant. After the conversion, CTD's debt/equity ratio declined to 33/67 and the current ratio improved to 1.1. Past financial performance also suffered from government control of Sumerbank prices. Under the economic policy package introduced in January 1980, this situation has been liberalized and Sumerbank is now free to set its prices in accordance with market conditions. Immediately on the introduction of this change, Sumerbank's Board increased textile prices by 100 percent, which exceeded the inflation rate since the last increase in May 1979. Sumerbank prices, however, are still 10-15 percent below those of the private sector, partly because the latter peg their lower price items to Sumerbank's. Individual plants have now been authorized to make further increases of up to 20 percent if needed. Assurances were obtained from Sumerbank, that prices would be adjusted as needed in future, in order to meet competitive market conditions, production cost increases due to inflation and earn a reasonable return on capital (Project Agreement, Section 4.09). Assurances were obtained from Government that it would assist Sumerbank in meeting this requirement (Loan Agreement, Section 3.01(b). However, these steps alone are not sufficient to restore the viability of the textile opera- tions. What is needed is a phased rationalization and modernization of these operations, to ensure improved productivity, higher capacity utilization and increased financial viability. That is the essence of the proposed project. PART IV - THE PROJECT Project History 46. A Bank mission visited Sumerbank in April 1977 to review an invest- ment program Sumerbank had prepared. The mission and Sumerbank concluded that investments in equipment alone could not bring about the needed improve- ment in its textile operations. In September 1978, the Government requested an advance of $400,000 under the Bank's Project Preparation Facility (PPF) to prepare a comprehensive project that would lay a basis for a phased moderniza- tion and rationalization of Sumerbank's cotton textile operations, including integration of operations and improved product mix as well as improvements in management, nrganization, marketing and other policies. Sumerbank completed the feasibility study in September 1979, with the assistance of the Swiss consulting firm, Gherzi. The project was appraised in November 1979. Imple- mentation of the proposed institutional and technical improvements proposed under the said feasibility study has begun under a second PPF tranche of $600,000. Negotiations took place in April 1980 with a delegation headed by the Acting Economic Counselor, Turkish Embassy and representatives of the Treasury and Sumerbank. Project Objectives and Description 47. The project is the first phase of a six year (1980-86) rationaliza- tion and modernization program. Phase I (1980-83) is a self contained project that addresses the immediate needs of Summerbank's textile operations, while  - 16 - Phase II will address long term structural changes notably in finishing and garments. The main objective of the Phase I project is to increase the overall efficiency, capacity utilization and labor productivity in the plants operated by Sumerbank's Cotton Textile Division (CTD) in order to achieve a significant increase in production volume, reduction of production costs, upgrading the product mix and improvement in the product quality. The project is designed to optimize the production from the existing spinning facilities through a relatively inexpensive modernization and rehabilitation program and to utilize practically all the yarn produced to manufacture fabrics (80 percent of which will be in the finished state), as well as to increase the production of garments in view of their better market prospects. It will also rationalize the production schedules within and between the plants so as to achieve a maximum utilization of the existing and new equipment. Equipment will be transferred between plants to increase standardization and economies of scale and permit better spare parts management. Maintenance will be restored to acceptable levels. The project will thus result in higher revenues and higher value added than at present. As part of the project, CTD will assume increased responsibility for marketing its production domestically and abroad, pricing its products, market research, product development, as well as coordination between production and marketing. In view of Turkey's severe domestic and foreign financial constraints, the project was scaled-down to the essential elements needed to achieve its objectives of balancing existing capacity to achieve the highest return. Civil works have been kept to a minimum and limited to rehabilitation and repair of floors and ceilings in existing mills, improvements to lighting, ventilation, humidification, steam delivery and effluent disposal systems. 48. The project will replace and rehabilitate equipment in CTD's 19 existing plants (Map IBRD 14575). It will result in increased production without increasing installed capacity, except for garments, as follows: (a) yarn from 41,000 tons per year to 52,000 tons per year with significantly higher overall quality; (b) woven fabric from 207 million m2 to 250 million m2 with overall improvements in quality, and increased volumes of wide fabric, color woven materials, blended materials and terry fabrics; (c) finished fabrics from about 152 million m2 to about 207 million m2; and (d) garments by about 1.7 million pieces. Details of the project are provided below and in the Loan and Project Summary and the Staff Appraisal Report (No. 2887-TU dated April 30, 1980), distributed separately to the Executive Directors. 49. The project thus includes general improvements as well as the following specific items: (i) Spinning. Modernization of about 50,000 spindles and 8 opening lines; provision of about 30 new drawing and 12 new combing units; installation of overhead cleaners in 8 plants and electronic yarn cleaners in 6 plants; provision of testing instruments; and the replacement of 72 drawing frames and modernization of 126 cards, 46 roving frames and 232 ring frames in 2 plants; (ii) Weaving. Provision of about 800 new looms; rehabilitation or replacement of about 800 looms and auxiliary machinery;  - 17 - (iii) Finishing and Printing. Modernization of equipment in 11 plants, and provision of new equipment at 7 plants including: 9 new machines for preparation, 9 machines for dyeing and 6 machines for fabric finishing; (iv) Garments. Equipping of a new garment plant in the vacated spinning section of the Bakirkoy plant, with a capacity of 1.7 million pieces per year; (v) Engineering Facilities. Providing new boilers in 4 plants, effluent treatment units in 9 plants and water softening facilities in 3 plants; (vi) Technical Assistance. Provision of about 360 manmonths of technical assistance in carrying out the project, reorganizing operations under CTD, and imDroving marketi ng (of which 60 manmonths has been started under the second tranche of the PPF) and about 100 manmonths of technical assistance for improved financial and budgeting systems. The first stage of the technical assistance program, 60 manmonths, will focus on improvements in CTD's headquarters and general manage- ment, with operational assistance to two pilot plants. The second stage, 400 man months, will focus on plant level improvements. UNIDO has provided an additional 20 man months to initiate the financial technical assistance, for which consultants have been selected. (vii) Training. About 45 manyears of training abroad for technical instructors, supervisory and management staff to backstop Sumer- bank's existing staff and technician training facilities at Bursa. Project Costs and Financing 50. The total cost of the proposed project (including an average 31 percent price and 6 percent physical contingency on base costs) is estimated at $106 million, including about $2.3 million of taxes. International escala- tion rates have been used for local costs, on the assumption that differences between local and international inflation will result in exchange rate adjust- ments in line with the Government's January 1980 economic package. The esti- mated foreign exchange cost is $88 million. These costs include $1 million to repay the abovementioned advances from the PPF. Costs of expatriate consultants are expected to be about $14,500 per man month, including expenses and a man month rate of about $10,800, which is reasonable in view of the kind of expertise required. In addition, about $25 million (of which $16 million is foreign exchange) is required for financial charges during construction and incremental working capital. Besides the project working capital requirements, another $20 million are required to restore working capital for existing textile operations to a reasonable level. Total requirements are thus about $151 million. 51. The proposed Bank loan of $83 million will finance 94 percent of the estimated foreign costs and 80 percent of the total project costs net of  - 18 - taxes. The Bank loan will meet 56 percent of the total financing requirements, net of taxes, which include financial charges during construction and working capital requirements. The company intends to obtain the remaining $5 million of foreign exchange prior to December 31, 1981 either by seeking suppliers credits or by demonstrating to the Bank that its retained foreign exchange earnings will be sufficient to meet this need (Project Agreement, Section 3.04). The remaining foreign exchange requirements for working capital as well as the financial charges during construction ($18 million), will be met by Sumerbank from retained earnings. 52. The $45 million equivalent required for local costs, local interest during construction and the local component of working capital will be financed as follows: about $27 million equivalent will be provided by Sumerbank from internally generated funds; about TL 1.7 billion (about $18 million equivalent allowing for exchange rate adjustments in line with inflation) will be provided in the form of additional equity contributions by the Government. This cash equity is required, in addition to the TL 2.5 billion of debt recently conver- ted into equity by Government, because of the need for outside funds early in project implementation when internal cash generation is low and to provide a cushion against the risk of delay in price increases. The initial cash equity contribution of TL 400 million is thus.a condition of effectiveness (Loan Agreement, Section 6.01(b)). An understanding was obtained that an additional TL 800 million will be provided prior to December 31, 1981 and the remaining TL 500 million by December 31, 1982 (Loan Agreement, Section 3.02(ii)). Moreover, to ensure that sufficient funds are generated for the project, CTD will not make non-project investments costing more than $3 million equivalent per year unless the Bank shall agree (Project Agreement, Section 4.08). 53. The Bank loan will be to the Government for 17 years including 4 years of grace, and will be onlent to Sumerbank at 10.5 percent per annum for 12 years including 4 years of grace. Sumerbank will bear the foreign exchange risk. Exchange rate adjustments are expected to compensate for the difference between the rate of inflation in Turkey and that of its major trading partners. Inflation was 24 percent in 1977, 53 percent in 1978 and 64 percent in 1979. Because of uncertainties associated with changes in economic structure expected in response to government policy initiatives, it is difficult to forecast the rate of inflation. It is tentatively projected to decline to 50 percent in 1980, 45 percent in 1981 and 35 percent in 1982, if Government policies are effectively implemented. Interest rates charged by domestic lending institu- tions for broadly similar types of lending have fallen behind the rate of inflation and range from 16 to 22 percent, plus, in some cases, fees and taxes. However, when adjusted for interest rebates, differences in exchange risks, service charges, etc., the effective cost of domestic loans with terms and currencies similar to Bank financing is between 10 and 11 percent. Project Execution and Operation 54. Sumerbank will implement the project through CTD, with the technical advice and assistance of qualified operational and financial consultants. Signing of the contract for the second stage of the operational technical  - 19 - assistance is a condition of effectiveness (Loan Agreement, Section 6.01(c)). The financial consultants for the second stage will be employed prior to March 31, 1981 (Project Agreement, Section 2.02). CTD will be primarily responsible for marketing its products, planning its investments, production planning, financial planning, and centralized purchasing for Sumerbank's entire cotton textile operations. To ensure that sufficient qualified senior staff are pro- vided, in view of low Government salaries for management positions, authority for 55 contractual positions (which can pay higher than official pay scales) have been provided to Sumerbank for CTD by Government. Assurances were obtained that these positions will be maintained until project completion (Loan Agree- ment, Section 3.01(b)). The Director of CTD has recently been appointed. Because of overstaffing at certain levels, an understanding was reached that the further growth of personnel in CTD beyond the levels approved in 1980 will be limited to positions needed for operating requirements. To encourage increased productivity with the new equipment provided by the project, Sumerbank will provide the Bank, prior to April 30, 1981, proposals for improvements in the existing workers' incentives based upon recommendations made by the consultants provided under the project (Project Agreement, Section 3.02(e)). 55. A project implementation unit within CTD, headed by a project manager and supported by 16 financial, technical, marketing and engineering employees, has been established and will be directly responsible for the project and work closely with the consultants. Because of the 19 plants involved and the planned relocation of existing equipment between plants, the project unit and the consultants will have a key role in coordinating procure- ment and installation of equipment with production and relocation schedules in order to minimize the interruption of production. After an initial period, staff of the project unit will be assigned to individual plants to assist plant level project managers to carry out the project with minimum disruption of production. Quarterly progress reports will be prepared at the plant level and assembled at the division level for Sumerbank management, with copies furnished to the Bank. In addition, each plant will prepare annually an action program covering the upcoming year's production, maintenance, technical assistance, training and investment programs (Project Agreement, Section 3.03). 56. A key project reform is to centralize primary responsibility for planning and contracting domestic and export sales of its products in CTD, and thus broaden its contact with the markets. Direct sales to private whole- salers would be sought in order to permit CTD and its individual plants more direct feedback on market trends. Export sales promotion will be provided by CTD through active participation in trade fairs, canvassing of export markets and use of the export promotion facilities provided under the Private Sector Textile Project. An understanding on the main features of the marketing arrangements was obtained during negotiations. Detailed proposals for imple- menting marketing arrangements satisfactory to the Bank will be provided to the Bank prior to December 31, 1980 (Project Agreement, Section 3.02(c)). 57. To ensure effective use of the equipment provided under the project, a detailed training and staffing program satisfactory to the Bank, the former utilizing Sumerbank's existing training center at Bursa, will be prepared by Sumerbank and its consultants prior to April 30, 1981 (Project Agreement, Section 3.02(d)). Initially, about 50 technical instructors will be sent  - 20 - abroad for training arranged by the consultants. On return, they will organize short training courses in the plants. It is expected that over 1,000 techni- cal staff will be so trained. In addition, about 40 specialized staff will be sent abroad for special six-month training programs. 58. Existing environmental standards for industrial effluents in Turkey, issued in 1973, are generally less stringent than current Bank guidelines. Thus, agreement was reached that CTD's dyeing and finishing plants will meet acceptable environmental guidelines for textile plants (Project Agreement, Section 3.01(e)). In addition, the project provides for rehabilitation of ventilation and air conditioning equipment, the provision of exhaust systems and the improvement of lighting and fire protection systems. Procurement and Disbursement 59. Machinery and equipment totalling about $52 million will be procured under international competitive bidding in accordance with Bank guidelines. Proprietary items (largely spare parts) required for compatibility with the existing equipment (about $17 million total) will be purchased under competi- tive procedures appropriate to the circumstances (Project Agreement, Schedule, para. C2). Items costing less than $100,000 equivalent, but not exceeding an aggregate amount of $4 million will be purchased through limited international tendering on the basis of suitability, availability and price considerations (Project Agreement, Schedule, para. CI). The lists of goods will be approved by the Bank before tendering. Domestic manufacturers will be allowed a preferential margin under international competitive bidding of 15 percent or the actual customs duty, whichever is lower. The Bank loan will be disbursed as follows: 100 percent of the foreign expenditure for imported equipment and spare parts, foreign consultants (including repayment of advances under the PPF) and training; and 100 percent of the ex-factory local costs of contracts won by local suppliers under international competitive bidding. Invitations to bid are expected to be issued in mid-1980 and the project completed by December 31, 1983. Financial Analysis 60. Financial projections for CTD have been prepared assuming the production build-up will begin in 1982 and reach full capacity by 1986 and that regular price increases are made in line with inflation. These show that improved results may be expected as early as 1982, as spare parts, components and technical assistance begin to yield substantial improvements in efficiency. By 1983-84, sales, profits and internal cash generation are expected to be substantially improved. Given the high rate of inflation, the projections are very sensitive to pricing policy. Net profits after tax as a percentage of sales for CTD are projected at 1.4 percent in 1980 increasing to 3.0 percent in 1984 and 4.1 percent in 1986, in line with industry norms. More important, internal cash generation is expected to increase from about $11 million in 1980 to about $37 million in 1984, in current dollars. The total surplus cash flow in the 1980-83 period, after meeting payments on existing loans, is con- servatively estimated at about $50 million, of which, about $45 million will be required to finance project related expenditures. CTD's other financial  - 21 - ratios are expected to remain within acceptable limits throughout the imple- mentation period. Assurances were obtained that CTD's consolidated debt/equity ratio will not exceed 1.5, its current ratio will not fall below 1.2 after 1981, its debt service ratio will be above 1.5 before additional debt is incurred, and, during project implementation, its current ratio will be above 1.5 before profits are transferred from CTD (Project Agreement, Sections 4.06 and 4.07). CTD will maintain separate consolidated accounts for its operations and plants and have these audited annually (Project Agreement, Section 4.01 and 4.02). 61. Incremental financial projections, a better measure of the impact of a rehabilitation project, show an incremental operating profit as a percent of sales of about 34 percent after 1984. The incremental financial rate of return before tax for the project is estimated at 25 percent. A 10 percent increase in operating costs would reduce the return to 22 percent while a 10 percent decrease in sales revenue would drop it to 19 percent, underlining the importance of technical assistance and regular price adjustments in an infla- tionary environment. A one-year delay in project implementation would reduce the return to 20 percent. Benefits and Risks 62. The incremental economic rate of return is estimated at 24 percent, which is due to the low capital investment and the low present state of main- tenance of equipment. If operating costs increase 10 percent, the return would drop to 20 percent; but if sales decrease by 10 percent, the return would drop to 18 percent. The return is not very sensitive to changes in capital costs or working capital requirements. When operating at full capac- ity in 1986, the project is expected to yield net foreign exchange earnings of $5 million per annum. After project completion, CTD's products are expected to be cost competitive both in Turkey and internationally for the low and medium quality items which it will produce. 63. Direct employment effects are small in relation to the investment and total about 1,680 new jobs being provided in the garment sector, offset by a possible attrition of about 940 redundant jobs in spinning, weaving and processing, or a net gain of 740 jobs. However, this ignores the very large amount of over-employment in the present facilities and the very low produc- tivity of the present work force. The main anticipated benefit of the pro- posed project is substantially increased production from the same labor force, achieved through a careful balance of modernizing investments, better orga- nization and management. In spinning, capacity utilization is expected to increase from 47 to 78 percent and production to increase by 32 percent. In weaving, the corresponding increases are from 67 to 74 percent in capacity utilization and 21 percent in production, while in finishing they are from 51 to 78 percent and 36 percent respectively. Since these levels can be achieved with less employees than at present, the productivity increase of the labor force is expected to be even greater. Besides demonstrating how to organize production and plant more efficiently, the project is expected to have a major impact on the financial viability of the company, help meet substantial local demand, particularly for low cost textile products, and lead to increased exports and foreign exchange earnings.  - 22 - 64. The main technical risks arise from the need to carefully coordinate the relocation and rehabilitation of existing equipment in CTD's 19 widely dispersed plants, so as to minimize the disruption of current operations. The technical risks are acceptable, in view of: (a) the amount of expatriate technical assistance provided by the project; (b) the allowance already given for production losses due to dismantling, transport and erection of the equipment; (c) a special physical contingency provided for new machinery to replace existing equipment damaged during relocation or rehabilitation; and (d) the fact that production levels anticipated after completion of the project are estimated to be only marginally higher than those already achieved in 1973. The project's technical success will also depend on Sumerbank's management's ability to complete the reorganization of its cotton textile operations along the lines discussed earlier. Delays or problems in that direction, could delay implementation and benefits. 65. Risks also arise from the general economic situation, in particular: the severe inflation, which will require frequent price adjustments to maintain cash flow and provide the substantial internally generated funds required for financing and operating the project; the very tight budget position which could delay the provision of even the minimal cash equity funds required; and the possibility of power shortages disrupting production. The pricing risk has been mitigated by the new government policy of letting the SEEs set prices and the budget risk minimized by keeping the requirements for such funds at a minimum. In addition, there are the risks usually associated with the deficiencies of the SEE sector in Turkey, especially the lack of management continuity, inadequate management compensation and lack of incentives to produce efficiently. Again, the new government policy of exposing the SEEs to market forces is a step towards correcting some of these deficiencies and assurances have been sought in connection with the project to minimize the impact of others. The major risks are thus those related to common economic or SEE problems. While in aggregate, they are not insignificant, care has been taken to take all possible steps to minimize their effects. PART V - LEGAL INSTRUMENTS AND AUTHORITY 66. The draft Loan Agreement between the Republic of Turkey and the Bank, the draft Project Agreement between the Bank and Sumerbank and the report of the Committee provided for in Article III, Section 4(iii) of Articles of Agreement are being distributed to the Executive Directors separately. The special features of the Loan and Project Agreements are referred to in the text and listed in Section III of Annex IV. 67. Special conditions of loan effectiveness include: (i) execution of the Subsidiary Loan Agreement between the Republic of Turkey and Sumerbank; (ii) provision of the initial portion of cash equity of at least TL 400 million; and (iii) hiring of the operational consultants for the Stage II technical assistance (Loan Agreement, Section 6.01). 68. I am satisfied that the proposed loan would comply with the Articles of Agreement of Bank.  - 23 - PART VI - RECOMMENDATION 69. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President By Ernest Stern Attachments April 30, 1980 Washington, D.C.  - 24 - ANWEX I 7>JL