Turkey - Small and Medium Scale Industry Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 5526-TU STAFF APPRAISAL REPORT TURKEY SMALL AND ]MEDIUM SCALE INDUSTRY PROJECT December 11, 1985 Regional Projects Department Europe, Middle East and North Africa Region |This document has a resricted distribution and may be used by recipients only in the plerformance of| tbeitr oficial duties. Its etents may not otherwise be disclosed without World BsDk sutborizatin.  CURRENCY EQUIVALENTS Currency Unit = Turkish Lira (TL) Value of US$ 1975!' TL 14.44 1976 TL 16.05 1977 TL 18.00 1978 TL 24.28 1979 TL 31.08 1980 January TL 70.00 1981 January TL 91.00 1982 January TL139.60 1983 January TL191.15 1984 January TL309.20 1985 January ' TL451.40 1985 September TL542.00 a/ Annual averages through 1979. GLOSSARY OF ABBREVIATIONS DESIYAB Devlet Sanayi ve Isci Yatirim Bankasi DYB Devlet Yatirim Bankasi EIB European Investment Bank ERR Economic Rate of Return FE Foreign Exchange FERIS Foreign Exchange Risk Insurance Scheme FER Financial Rate of Return GDP Gross Domestic Product GNP Gross National Product GTZ Deutsche Gesellschaft fur Technische Zusammenarbeit HB Halk Bankasi KfW Kreditanstalt fur Wiederaufbau msI Medium Scale Industry NPC National Productivity Council SEE State Economic Enterprise SAL Structural Adjustment Loan SEE State Economic Enterprises SEGEM Industrial Training and Development Center SIDO Small Iudustry Development Organization SKI Small and Medium Scale Industry SOE Statement of Expenditure SSI Small Scale Industry SYKB Sinai Yatirim ve Kredi Bankasi TA Technical Assistance TCZB T.C. Ziraat Bankasi, or Agricultural Credit Bank TSKB Turkiye Sinai Kalkinma Bankasi TUBITAK Scientific Technical Research Council of Turkey TURDOK Turkish Documentation Center FISCAL YEAR January I -- December 31  KaO OFFUOAL US ONLY TURKEY STAFF APPRAISAL REPORT SMALL AND MEDIUM SCALE INDUSTRY (SRI) PROJECT Table of Contents Page No. I. InTODucTION ......... .. ... 1 II. MANUFACTURING SECTOR .. ................ 2 A. Government Policies In the Industrial Sector .................... 2 B. Trends in Labor Force and Employment ............................ 3 C. Structural Characteristics and Performance ...................... 3 - Private Sector and the Role of Small and Medium Scale Industry (SRI) .................... 4 - Artisanal Enterprises ..*. . ..................**. .. 4 - Sub-sectoral Structure ................................... 6 Growth . ................. ......... 6 - Eport Performance ..................... . ... 7 - Investment ... .... .. ...................... 7 . 7 Prospects for the Manufacturing Sector .. .. ............ a D. Issues and Policies Affecting SKI Development ...oo .............. 9 - Issues and Constraints .................... . ..... 9 - Government Policies 'or SKI Development ................ 10 E. Bank's Lending and Strategy in the Industrial Sector . .......... 11 - Recent DevelopPents . .......... .. 11 - Future Strategy .... . ... .-o. .... .. .. 12 III. FINANCIAL SECTOR . .... .*. ............ 13 A. Financial System .. 13 B. Credit by the Financial System... . 14 C. Financing of the Industrial Sector Including SKI . .15 D. Interest Rates and the Cost of Capital. 16 This report is based on the findings of an appraisal mission composed of Messrs. Zafar Sbah Khan (mission leader), Shyamadas Banerji, Redha Behbehani, Geoffrey Gown, Jacob Levitsky and Ross Hammond (consultant) which visited Turkey in November/December 1984. This document has a nstrikd disibuton and may be usd by recipients only in the performance |of their officia dutieLIs contenu may nOOt otherwie be discko wiithout Wofdd Bank authodnton  (Table of Contents - continued) E. Financial Sector Issues ......* * *........................ 18 - Structure, Costs and Foreign Exchange Risk ... '............. 18 - Improving Efficiency of the Banking System ............... 20 - Development of Capital Market ............................ 21 - Local Currency Resources of Development Banks ............ 22 IV. THE PROJECT ......................... 22 A. Project Objectives and Description .............................. 22 B. Financial Intermediaries ..... ...... ..... * ... . ... . . ...... ; 23 - Sinai Yatirim ve Kredi Bankasi (SYXB) .................... 23 - Halk Bankasi (HB) ......... 0................... 9.......... 25 C. Technical Assistance Program for SMI ......... .. ............0... 29 V. MAIN FEATURES OF TiLE LOAN ....* .................................. 32 A. The Borrower and Loan Conditions ..... ........................... 32 B. Procurement and Disbursements ... ................................ 33 C. Status of Project Preparation .......34 D. Reporting ..........................*........ 34 E. Project Benefits and Risks . ............... 34 VI. AGREEMENTS AND RECOMMENDATIONS 36  ANNEXES Annex 1: Relevant Industrial Studies and Reports Annex 2: Sinai Yatirim ve Kredi Vankasi (SYKB) Attachment 1: SYKB: Organizational Chart Attachment 2: SYKB: Approvals, Commitments, and Disbursements Attachment 3: SYKB: Analysis of Loan Approvals by Sector, Geographical Location, Size, Repayment Terms, and Types of Projects Attachment 4 SYKB: Summary Income Statements Attachment 5 SYKB: Summary Balance Sheets Attachment 6 SYKB: Summary of Arrears Attachment 7 SYKB: Projected Loan Approvals, Commitments, and Disbursements Attachment 8 SYKB: Projected Income Statements Attachment 9 SYKB: Projected Balance Sheets Annex 3: Halk Bankasi (HB) Attachment 1 RB: Organizational Cbart Attachment 2 HB: Draft Terms of Reference of the Study for Review of the Institutional Structure Attachment 3 RB: Analysis of Industrial Credits Approved Attachment 4 HB: Income Statements Attachment 5 HB: Condensed Balance Sheets Attachment 6 RB: Projected Income Statements Attachment 7 HB: Projected Balance Sheets Annex 4: Technical Assistance for SMI Development Attachment I SIDO: Cost Estimates of Technical Assistance Program Attachment 2 SIDO: Recommended Additional Staff Attachment 3 SIDO: Terms of Reference of Consultants Attachment 4 SIDO: The Computerized Information System Annex 5: Projected Disbursement Schedule Annex 6: Selected Documents and Data Available in the Project File  TURKEY SMALL AND MEDIUM SCALE INDUSTRY (SMI) PROJECT Loan and Project Summary Borrower: Republic of Turkey. Beneficiaries: Sanai Yatirim ve Kredi Bankaei (SYKB) Halk Bankasi (HB) Amount: US$100 million. Terms: 15 years, including 3 years of grace, at the standard variable interest rate. Relending terms: The Government will onlend US$98.4 million to the two financial intermediaries, viz. SYKB and HB, for relending to eligible sub-borrowers in the industrial sector and US$0.35 million to HB as technical assistance. In addition, the Government will transfer USi1.25 million equivalent to SIDO for technical assistance to SMI enterprises. Sub-borrowers will be able to borrow either in local currency at the intereo. rate established under the Foreign Exchange Risk Insurance Scheme (FERIS) or in foreign exchange. Under FERIS, the Government will lend Bank funds denominated in TL to SYKB and HB at a fixed rate equal to the onlending rate to sub-borrowers minus intermediation cost (4%). Alternatively, Bank funds would be lent in foreign exchange to SYKB and HB at a fixed interest equal to the then prevailing Bank rate plus 0.75% to compensate the Government for bearing the interest risk arising from the variability of the Bank's interest rate. The onlending rate to sub-borrowers will be fixed at 5% above the Bank rate prevailing at the time of subloan approval. The repayment of the loans by SYKB and HB to the Government will conform substantially to the aggregate of the amortization schedules of individual subloans, except for the technical assistance amount of US$0.35 million to be repaid by HB over 15 years including 3 years of grace. Project description: The project is designed to support a program for the development of labor-intensive SMI through lines of credit to SYKB (US$80 million) and HB (US$18.4 million) and technical assistance for the institutional strengthening and efficiency improvement of HB (US$0.35 million) and technical assistance to  - ii - SMI enterprises (US$1.25 million) through SIDO. It would (i) provide a part of the foreign exchange requirements of SYKB and HB over 1986-88 for onlending to SMI, with special emphasis on small scale industries (SSI); and (ii) finance a program of technical assistance to SMI. Benefits and risks: The project would support the development of labor- intensive SMI projects in industries where Turkey has a comparative advantage and thus contribute to both job creation and growth of manufactured exports. The project is estimated to create about 18,000 direct jobs. The project would also provide technical assistance to SMI resulting in their increased productivity and efficiency. In addition, the project would help strengthen the institutional structure for financial assistance to SMI. The project risks mainly relate to the overall investment situation in the private industrial sector and the timely utilization of the proposed loan by the iutermediary banks. Substantial delays in loan utilization are, however, unlikely in view of the measures taken by the Government to stimulate the growth of private sector. Free limit: US$1.25 million for SYKB and US$150,000 for HEB. In addition, HB will submit the first five sub-loans for the Bank's approval irrespective of the sub-loan amount. Final date for sub- project submission: June 30, 1988. Procurement: SMIs to procure through international and local shopping procedures which require comparison of offers from at least three suppliers. However, small items costing less than US$10,000 and proprietary items may be purchased by direct contracting. Estimated (in USS millions) Bank loan FY87 FY88 FY89 FY90 FY91 FY92 disbursements: Annuai: 12.0 27.0 27.0 19.0 11.0 4.0 Cumulative: 12.0 39.0 66.0 85.0 96.0 100.0  TURKEY SMALL AND MEDIUM SCALE INDUSTRY (SMI) PROJECT INTRODUCTION 1.01 The proposed project addresses two critical issues now facing the Turkish economy-high urban unemployment and the problem of sustaining high growth rates of manufactured exports. Turkey's rapidly growing unemployment (up from 1.67 million in 1979 to about 3.06 million in 1984) has become a major social issue. The limited possibilities for job creation in agriculture and the growth of non-productive marginal jobs in the services sector make the unemployment issue a particularly complex one to tackle. It is clear that the industrial sector will need to play a much bigger role in productive job creation in future. An effective approach to urban job creation (as illustrated in the labor-intensive industry project--Loan 1952-TU) is to foster development of labor intensive enterprises in industries where Turkey has comparative advantage. This approach has proved successful in terms of generating productive employment at a low investment cost. 1.02 However, the development of small and medium scale industrial enterprises'' (SMI) as a group is being inhibited by a variety of internal and external constraints which need to be specifically addressed if this group is to develop efficiently and make an effective contribution to export and employment growth. Until recently, the Government's export promotion policy discriminated against smaller exporters. Because of depressed domestic demand, this policy adversely affected their growth. Lack of access to institutional finance, particularly for financing machinery, plant and adequate working capital has been another serious problem. The Halk Bank (HB), the only source of finance for artisanal enterprises, is constrained by limited resources and inadequate management systems and procedures for development lending. Commercial banks generally are averse to financing SMI partly as a result of perceived higher risk, the higher unit costs of smaller loans and a preference for assisting clients with whom they have a longstanding banking relationship in a period of credit scarcity. Yet another constraint is SMI's limited access to technical assistance. Specialized advice needed to resolve technical, management, marketing problems, etc. is out of reach for SMI, both because of lack of information on availability of such services and the high costs involved. Government operated institutions, so far, have not been effective in assisting small firms due to lack of qualified extension personnel, unclear objectives, and low credibility. 1.03 Since 1980, the Government has enacted a number of policy reforms to open up the economy to market forces as well as bring about structural adjustment. Some of these reforms have benefited SMI, e.g. adoption of a crawling peg exchange rate policy instead of specific export subsidies to promote exports. Reform of the financial sector and trade liberalization will undoubtedly help create a favorable environment for SMI development, but specific intervention is still needed to remove particular bottlenecks in access to finance, technology, and skilled workers to promote sustained development of SMI. The proposed project builds on the successful outcome of 1/ See para. 2.06 for the definition of SMI.  the Bank's first project aimed at assisting labor intensive SMI (Loan 1952-TU). It gives special emphasis to the development of artisanal and SSI enterprises as well as to the institution building of HB so that HB becomes capable of efficiently providing investment finance and other financial services to these firms. The project will also assist the Small Industries Development Organization (SIDO) to initiate the establishment of a nationwide network of branches to provide technical assistance to SMI as well as to start a program that would help SMI utilize the services of specialized consultants from both the private and public sectors. II. HAIUFACTURING SECTOR A. Government Policies in the Industrial Sector 2.01 Industrialization in Turkey has been viewed as an instrument for achieving faster economic growth, greater self-sufficiency, and reduced inter-regional disparities. Until recently, the main thrust of industrial development strategy had been capital-intensive import substitution in basic industries. The principal policy instruments used were large investment allocations to State Ecouomic Enterprises (SEEs) accom'enied by centralized planning and control, and generous incentives combined v'th high levels of protection for private investments. The vigorous pursuit of these policies under the first three development plans (1963-1977) resulted in high growth rates, substantial structural change, and dispersal of industry to less developed regions. On the other hand, the same policies gave rise to industrial inefficiency, extreme anti-trade bias and excessive capital intensity in production. The emphasis on costly import-substitutio., as well as several other factors, including shortcomings in the S. & D effort and inadequacies in labor training, contributed to the decline in the productivity of investment. The countrv's latent export capacity could nat offset the changes in the international environment in the aftermath of the 1973-74 oil crisis, leading to a major crisis in the balance of payments in 1977-79. 2.02 In January 1980, in response to the crisis, the Government adopted a new economic development strategy characterized by an outward orientation of the economy and an increased role to market forces with greater emphasis on the private sector to stimulate growth, employment and exports. Major policy reforms have been enacted since then in the areas of exchange rate (large devaluation followed by a crawling-peg policy); export incentives (subsidized credits, free access to imported inputs, indirect tax rebates); domestic resource mobilization (deregulation of interest rates, tax reforms, capital market legislation); pricing policy (freeing most SEEs to set their own prices); import liberalization (shifting a large number of items to more liberalized treatment); public sector investment (rationalization and removal of a number of economically unviable projects from public sector investment); private direct foreign investment (centralization of responsibility and simplification of rules and regulations), etc. A number of these reforms are far reaching and it may be several years before their full impact is felt. 2.03 The policy reforms designed to stabilize the economy and bring about structural changes produced a decline in inflation (from 100X in 1980 to below 30X in 1982). The recent resurgence of inflation (estimated at more than 50%  - 3 - in 1984), is partly attributable to SEE price increases and to the impact of the export drive on domestic food prices. Government is attempting to bring the situation under control in the context of a tighter program in place for the second half of the IMF standby. The reforms.have also led to a dramatic expansion in the value of merchandise exports (from US$2.9 billion in 1980 to an estimated US$7.2 billion for 1984) despite the recession which prevailed abroad during most of this period. Industrial value added also increased by 28S during the same period. However, many private sector industrial firms including many SMI are in serious financial difficulties because of the erosion of their equity base and very high real interest rates for working capital loans. Complex financial sector issues are at the root of these problems and are being addressed with Bank assistance (see paras. 3.12-3.20). B. Trends in Labor Force and Employment 2.04 Turkey's total population, estimated at 47.4 million in 1984, has been growing at an average annual rate of 2.42 in the past decade. Although the total working age group increased at about the same annual rate, the labor force grew at only about 1.6X per annum between 1968-77, reflecting declining labor force participation. Total civilian employment increased even slower, at slightly above li, resulting in increasing unemployment which totalled 2.1 million in 1977 or 12.82 of the labor force. Between 1977 and 1983, in spite of the large increase in out-migration to Saudi Arabia, Libya and Iraq, the unemployment situation worsened primarIly because of the higher growth rate of the labor force (1.9%) compared to a marginal increase in the number of jobs created (450,000). As a result, by 1983 total unemployment increased to 3.56 million or about 192 of the labor force. Most of the unemployed (2.9 million) are located in urban areas and 97% are barely literate or with primary or middle school education. The industrial sector's track record in job creation has been inadequate; between 1978 and 1982, industrial employment increased from 1.826 million to 1.R93 million or only by 67,000 workers. Although firm data are lacking, it is likely that most of the jobs created have been generated by organized sector manufacturing establishments engaged in export production which have had high capacity utilization ratios (see para. 2.06). C. Structural Characteristics and Performance 2.05 The manufacturing sector4' is the leading sector of the Turkish economy and, in 1984, accounted for 252 of GDP (higher than agriculture whose share was about 18S of GDP), 23Z of fixed investment, 11X of employment and 642 of total merchandise exports. State economic enterprises (SEEs) occupy a prominent role in manufacturing even though their importance has diminished over the last few years because of deliberate government initiatives to limit their growth. Manufacturing SEEs accounted for some 30S of manufacturing value added, 352 of manufacturing employment (268,000 workers) and about 602 of manufacturing investment in 1984. About 20 SEEs operate some 440 plants in practically all branches of manufacturing; the major concentrations are in food, tobacco, textiles, chemicals, paper and basic metals. Most SSEs are large capital-intensive operations and suffer from significant overstaffing. 1/ The industrial sector includes manufacturing, mining and energy; manufacturing accounts for about 801 of industrial value added.  - 4 - The private sector whose share of manufacturing employment and value added is approximately twice that of the public sector, Is particularly strong in textiles and garments, food, beverages, engineering products, furniture, plastics, and ceramics. (i) The Private Sector and the Role of Small and Medium Scale Industry (SMI) 2.06 In 1978, the organized private sector (comprising establishments employing 10 or more workers) included some 8600 establishments employing 520,200 workers. Small-scale establishments-' (employing 10-49 workers) and medium-scale establishments (employing 50-199 workers) accounted for some 5867 establishments and employed 235,000 workers. Thus small and medium scale establishments (SMI) accounted for 68Z of establishments and 451 of workers in the organized private sector. SMI firms have the highest share of total employment r.nd value added in the manufacture of furniture and wood products; other impor..ant sub-sectors of SMI activity are engineering, chemicals, non-metallic products and paper products in that order. Although recent data on SMI are not available, tha relative importance of SMI in these sub-sectors does not appear to have changed appreciably over the past five years. In some sub-sectors-engineering, garments, and food industries--SMI have increased their shares of empInymont pnd output because of higher capacity utilization rates due to improved expor: performance (para. 2.07). 2.07 Between 1970-77, SMI as a-group showed strong growth relative to larger firms and increased their share of total manufacturing employment (including SEEs) from 31S to 35S. Although comparable data by firm size are not available for 1978-82, some 2,300 new firms were established in the organized private manufacturing sector in this period and some 58,500 jobs were created.1l Analysis of the number of new firms and additional employment generated by sub-sector (see Table 2.1) indicate that most of the new firms and new jobs created belong to the SKI category. (ii) Artisanal Enterprises 2.08 In the non-organized sector, artisanal establishments (employing 1-9 workers) comprised some 177,000 establishments employing 455,000 workers and 1/ There is no single official definition of SSI in Turkey. The State Institute of Statistics uses the number of workers employed to clatsify firms into the non-organized (employing less than 10 workers) or organized (employing 1O or more workers) categories. The Small Industry Develdpment Organization defines SSI as firms employing up to 50 workers. The Halk Bank (HB) defines SSI as firms with less than 25 workers and less than TL 80 million assets (excluding land and building). Medium scale firms (MSI) are defined by BB as firms with assets (excluding land and buildings) between TL 80 million and TL 300 million (US$190,000-US$700,000). The Bank-financed project (Loan 1952-TU) defined SSI as firms with fixed assets (excluding land and building) valued at less than US$500,000 in 1984 prices; the corresponding limit for SMI is US$2.5 million in 1984 prices. These limits will be maintained in the proposed project. 2/ Only a part of the additional employment is due to the new firms.  - 5 - Table 2.1: MANUFACTURING SECTOR: SUB-SECTORAL BREAKDOWN OF GROWTH IN NEW FIRMS AND EMPLOYMENT BETWEEN 1978-82!' No. of Employment No. of Employment New Firms Growth New Firms Growth Food and Tobacco 590 10,922 Chemicals & Plastics 187 3,921 Textiles 217 495 Non-Metallic Prods. 16 2,445 Garments 68 7,376 Non-ferrous metals 52 3,394 Fur products 49 488 Fabricated Metal Prods. 225 5,199 Footwear 49 1,447 Non-electrical Mach. 215 5,300 Furniture 28 988 Electrical Machinery 196 7,882 Paper Products 141 1,521 Transport Products 81 2,878 Printing 23 504 Scientific Products 10 830 *, Private sector only; employment in manufacturing SEEs declined by 21,563 in thi period. Source: State Institute of Statistics, Turkey. Table 2.2: RANK ORDER AND SRARES OF MANUFACTURING INDUSTRIES BY PRODUCTION VALUE (Constant 1983 prices TL billions) Annual Growth Annual Growth Rate (X) Rate ({) Output S Share Rank (1978-83) (1984489) I. Consumer GoodsL' 4193.8 46.9 - 5.1 6.4 Food products 2706.9 30.3 1 5.6 6.2 Textiles 600.5 6.7 3 3.2 6.0 Garuents 254.3 2.8 9 6.1 11.1 II. Intermediate-1' Goods 3578.5 40.2 - 5.4 7.3 Petroleum prodcts. 1100.2 12.3 2 3.8 7.5 Iron & Steel 467.5 5.3 4 9.1 9.9 Chemicals 334.5 3.7 5 7.1 7.6 III. Capital Goods1' 1147.2 12.9 - 6.0 9.7 Vehicles 285.4 3.2 7 4.0 11.5 Metal Goods 274.4 3.0 8 6.8 7.0 Non-Elec. Machry. 180.0 2.0 12 8.1 8.7 IV. Total Manufacturing 8928.3 100.0 - 5.3 7.5 1/ Only the three largest sub-sectors in terms of share of output are shown. Source: Fifth Five-Year Plan in the Context of Structural Adjustment; A Review; World Bank Report No. 5418-TU.  accounted for about 201 of manufacturing value added. Major concentrations of artisanal firms occur in garments and leather (281)" metals and engineering (262), wood products (18Z), food products (81) and chemicals (61). The artisanal sector grew slowly in the decade 1970-8Q; the number of establishments increased by less than 21. The number of firms in metals, engineering, chemicals, plastics and wood products shoved substantial increases, but these were offset by losses in the more traditional sectors of textiles, garments, leather products and food industries. The major problem of the artisanal sector is one of overcrowding; this is particulary apparent in the sub-sectors of textiles, garments, leather products, wood products and in fabricated metal products. Many artisans are severely under-employed and continue in these non-produ' tive jobs because of the lack of alternative employment opportunities in organized manufacturing. (iii) Sub-sectoral Structure 2.09 The manufacturing sector is fairly broad-based; only food processing, petroleum products, textiles, and iron and steel each account for more than 51 of production value. Food processing is clearly Turkey's most important manufacturing sub-sector, accounting for 281 of manufacturing production in 1984. Table 2.2 shows the shares in manufacturing output of consumer goods. intermediate goods and capital goods (44Z, 411 and 151 respectively), and the ranking of the three most important sub-sectors in each category. (iV) Growth: 2.10 Despite the recession which prevailed in Turkey and abroad during 1980-83, manufacturing output grew at an average rate of 5.3 percent per annum during The Fourth Plan period (1978-83) and in the last two years the growth rate reached about 9 percent. Some key performance indicators are shown in Table 2.3. Table 2.3: MANUFACTURING SECTOR-SELECTED PERFORMANCE INDICATORS 1980 1981 1982 1983 1984 (est.) Value of Manufacturing Ouput (TL billion 1983 Prices) n.a. n.a. 7,673 8,223 8,750 Manufacturing Growth Rate (Z) -5.4 8.1 5.6 9.5 8.5 Private Manufacturing Investment Growth Rate (X) -14.1 -1.9 0.6 1.6 n.a. Capacity Utilization () 51.0 62.0 66.0 69.0 72.0 Manufactured Goods Exports (`US$ million) 1,047 2,290 3,430 3,658 5,100 Source: Fifth Five-Year Plan in the Context of Structural Adjustment; A Review; World Bank Report No. 5418-TU. 1/ Figures in parenthesis refer to percentage of total firm population.  -7- The fairly high output growth rate since 1981 was made possible mainly because capacity utilization rates (CURs) in most industries were low during 1980-83. Investment rates were thus able to remain low, particularly in the private sector, even though the export drive required, and obtained, substantial increases in output. Industries with high output growth rates'- include agricultural machinery (14.8%) iron and steel (9.1%), petroleum products (8.71), non-electrical machinery (8.1%), metal goods (6.8%), clothing (6.1%), and rubber products (11.5X). (v) Export Performance 2.11 During 1978-83, 291 of the total increase in manufacturing output went into exports i.e. a marginal export/output ratio of 291 compared to only about 71 between 1973-77. The table 2.4 below analyzes the strong export performance of the manufacturing sector relative to other sectors as well as the performance of different product groups. Five industries (ready made clothing, foodstuffs, textiles, iron and steel and petroleum products) contributed to 751 of the increase in manufactured exports; five others (fertilizers, measuring instruments, furniture, shoes and agricultural machinery) were the fastest growing exporting industries;together, these ten industries were responsible for about 80% of the increase in manufacturing exports. A noteworthy feature of this export performance is the appearance of new industries in the list of major exporters (iron and steel and petroleum products) and fastest growing exporters (fertilizers, instruments, - agricultural machinery). The other noteworthy feature is the penetration of new markets in Middle Eastern countries (Iran, Iraq, Libya, Algeria) particularly for foodstuff, iron and steel products and non-electrical machinery. Table 2.4: EXPORT GROWTH RATES Total Export Manufacturing Sxport Growth (1978-83) Growth (1978-83) Constant Prices, Constant Prices, 1 p.a. X p.a. Agriculture 12.0 Consumer Goods 16.0 Mining -4.3 Intermediate Goods 20.7 Manufacturing 19.1 Capital Goods 60.9 Total Total Merchandise 16.3 Manufacturing 19.1 Source: Fifth Five-Year Plan in the Context of Structural Adjustment; A Review; World Bank Report No. 5418-TU. (vi) Investment 2.12 Table 2.5 gives the trend in fixed investment in manufacturing. 1/ Figures in parenthesis give output growth rates between 1978-83.  Table 2.5: FIXED INVESTMENT IN MANUFACTURING (Constant 1983 prices, TL billions) 1977 1978 1979 198Q 1981 1982 1983 Total Manufacturing Investment 761.6 661.2 591.0 582.3 548.4 499.7 493.3 Public Sector 309.8 253.3 312.8 343.3 314.1 264.1 255.4 Private Sector 451.8 407.9 278.2 239.0 234.3 235.6 237.9 Percentage Public 40.7 38.3 52.9 59.0 57.3 52.9 51.8 Percentage Private 59.3 61.7 47.1 41.0 42.7 47.1 48.2 Source: Fifth Five-Year Plan in the Context of Structural Adjustment; A Review; World Bank Report No. 5418-TU. The table indicates that real investment in 1983 was only 65Z of the 1977 level; also the balance between the public and private sectors, which was in favo-z of the latter before 1979, shifted thereafter strongly in favor of the public sector. However, in the past couple of years, the Government has been trying to restore the balance as part of the structural adjustment strategy by cutting back on public investment. Private investment activity has been very depressed, because of low capacity utilization and high non-preferential interest rates. Borrowing in foreign currency for investment-purposes has been particularly adversely affected because of the high devaluation of the TL. The Government introduced a Foreign Exchange Risk Insurance Scheme (para. 3.10) (FERIS) in 1984 to cover borrowers of foreign currency against exchange risks which significantly helped to stimulate iwnestment borrowing. It is likely that the Government wi'll continue with the scheme as long as inflation is volatile and the investment climate uncertain. (vii) Prospects for the Manufacturing Sector 2.13 The Bank undertook a detailed review of the Government's Fifth Five-Year Plan (1984-89), approved by the National Assembly in July 1984 (Report No. 5418-TU). The Plan envisages that the industrial sector will continue its lead role in the economy with its share of value-added GDP increasing from 32Z in 1984 to 341 in 1989 at an annual growth rate of 7.5X. Manufactured exports are projected to grow at an annual average rate of 10.61. The Plan calls for a larger role for the private sector, principally by restricting the growth of industrial SEEs. The private sector's share of total manufacturing investment (TL 3015 billion in 1983 prices) is projected at 57X. Private manufacturing investment during the Plan period is projected to be nearly 41% higher and public manufacturing investment 14Z lower than their corresponding amounts in the Fourth Plan period. However, given the high real interest rates on working capital and low CURs in non export oriented industries, private investment may grow more slowly than projected in the Plan. 2.14 Based on a review of CUR trends and production targets, the Bank's review of the Plan concluded that the bulk of Plan manufacturing investment (74X) should flow to the intermediate goods sector; only 18 and 8 percent respectively should flow to the consumer and capital goods industries.  Otherwise, supply bottlenecks are most likely to constrain the intermediate goods sector, which could jeopardize export targets in the consumer and capital goods industries. An analysis of major and leading (fastest growing) export sub-sectors indicates that based on CUR trends, existing capacity and output targets, large investments are needed only in two major export industries-garments, and iron and steel. If iron and steel is excluded, the remaining nine major and leading export sub-sectors which are expected to account for 70% of the increased exports, will require only about 16Z of the fixed investment in manufacturing projected in the Plan. Thus the export targets can be attained even under stabilization conditions. Attainment of the export targets will, however, require continuing real devaluation of the TL, which in turn will facilitate the scaling down of direct incentives to an average level of 6Z-81 and redirection of direct incentives to capital goods industries. D. Issues and Policies Affecting SMI Development (i) Issues and Constraints 2.15 SMI generally face a number of internal and external constraints. Internal problems adversely affecting productivity include outdated machinery, obsolete and deficient technical and production engineering methods, poor working conditions, inadequate management, planning and control, and marketing know-how.I1 External problems tend to compound the internal ones. One problem is the limited access to institutional finance (para. 3.04) exacerbated by current stabilization measures and related factors which have maintained non-preferential working capital interest rates at record levels. 2.16 Another external constraint is the limited availability and high cost of technical assistance. Many SEEs have special R & D divisions capable of providing extension. rexvroes (such as Sumerbank's unit in Bursa) with a mandate to assist private sector including SKI, but in fact have given services only to their own operations. In the private sector mnny large enterprises have mechanisms to provide technical assistance such as production/quality control departments or "in-house" divisions that provide consulting services. They also benefit from service agreements with licensors and suppliers of technology and plant machinery. Except for firms acting as sub-contractors and suppliers to a few of the large machinery manufacturers, the availability of industrial extension services to SMI is extremely limited. The available private consulting firms tend to be geared to the requirements of larger firms and appear extremely costly to SMI. A few public institutions have been established over the years to provide advice and information in technical and management fields including the National Productivity Center (NPC), SEGEM (for training), TUBITAK/TURDOK (technical research and information services) and specialized sub-sectoral institutes. The only institution established to assist SSI-the Small Industry Development Organization (SIDO)-has had very limited impact. 1/ Constraints facing SMI in Turkey are discussed in detail in Turkey: Prospects for Small-Medium Scale Industry Development and Employment Creation, World Bank Report No. 2913-TU, 1980, Volume II, pp. 46-50.  - 10 - 2.17 SMI face complex problems in exporting because of lack of market research and data, inability to tap distribution channels, pricing and costing problems and inability to adapt products to meet export market requirements. Export trading companies established in recent years have only partially met this need in a few sub-sectors (e.g. garments) where strong sub-contracting relations exist. In view of the lack of management, production and export marketing services for SMI, it is necessary to complement any program of financial assistance with appropriate technical assistance in order to bring about desired modernization and improvements in operating efficiency. (ii) Government Policies for SMI Development 2.18 Prior to 1980, Government policies which favored large, capital-intensive, import-substitution projects did not promote the development of SMI. Following the adoption of an outward-oriented development strategy, the Government has increasingly recognized the potential of SMI to contribute to employment creation and export growth. The Fifth Five Year Development Plan (1985-89) enunciates a strategy and accompanying policy measures specifically to promote SSI. These include: (a) strengthening the Small Industry Development Organization (SIDO) to develop appropriate strategies, policies and technical extension activities to assist SMI development; (b) enlarging the flow of investment and working capital loans; Cc) expanding support for the building of industrial estates for artisanal firms and providing on-the-job and technical training in the industrial estates. 2.19 In addition to these direct measures, recent policy reforms have reduced discrimination in regard to access of SMI to incentives. With regard to investment incentives, the new regime published in October 1984 has several improvements. First, for investment of less than TL 600 million (US$1.32 million at end 1984 prices) application procedures have been simplified, with investing firms required to prepare simplified investment forms rather than submit detailed feasibility studies. Second, the newly introduced support premium rate (a one time subsidy on the total project investment) is the same as for larger investments (7%) except for the projects in the less developed regions. Third, the required percentage of production to be exported has been reduced from 25% to 5%-20%, the percentage depending upon location. Fourth, the new regime also for the first time provides incentives that directly encourage use of labor: it grants tax exemptions for wages paid to firms in sectors of special importance and in the least developed regions. Some of the qualifying sectors--electronics and communications, agriculture and livestock, production of medica'l equipment, aquatic products, and tourism--are typically characterized by firms in which labor intensive SMI are important. Finally, for smaller (less than TL 600 million) investments, the required equity percentage is lower (40Z) than the normal level (50%).  - 11 - 2.20 The problem of the export rebate system (the most important of the direct export incentives)"', which also discriminated against smaller industry by granting high rebates for large volume exporters-' has largely been removed by the Government's policy set forth in the Fifth Five Year Plan to reduce this incentive and rely increasingly on the indirect incentives of a realistic exchange rate. Rebate percentages were reduced to 80% of the previous level beginning April 1984 and further to 55Z beginning September 1984. With the institution of a system of value added taxation which the Government has implemented with effect from January 1985, the export rebate system will be reexamined and possibly further reduced in scope. E. Bank's Lending and Strategy in the Industrial Sector (i) Recent Developments 2.21 Between 1978 and 1984 the Bank undertook a number of major economic and sector studies in support of its Structural Adjustment Loans (SALs) as well as its overall macro economic and sectoral dialogue with the country (Annex 1 lists the relevant reports). The thrust of the Economic and Sector Work (ESW) has been directed along several lines-analyses of issues of comparative advantage, tariff reform, and liberalization of imports in support of the Government's policy of opening up the economy to market forces; analysis of the foreign exchange regime and export incentives to ensure competitiveness of exports; review of the financial sector to identify key institutional and policy issues in order to assist the Government in policy reforms, (e.g. introduction of positive deposit rates, reduction of interest subsidies on selective credits, development of a capital market, elimination of transaction tax, etc.); review of public sector investment programs to rationalize and improve the efficiency of public investments; review of the functioning of SEEs with the view to improving operating efficiency and resource allocation; and review of the prospects of SMI to ensure appropriate policies for their development. These studies have provided the technical underpinnings for the Bank's dialogue with the Government on the content and pace of the Structural Adjustment Lending effort. Given the continued need for stabilization of inflation and recognizing the ongoing natue of the structural adjustment process, particularly at the sectoral level, future ESW (see para. 2.23) will continue to focus on most of the above-mentioned issues. 2.22 Up to 1980, Bank industrial lending was directed at two broad areas: (i) towards State Economic Enterprises (SEEs) for improving the resource allocation process and the technical and management efficiency of SEEs, both 1/ Other direct export incentives were preferential export credits and foreign exchange allocation with duty-free imports. Export rebates account for about two-thirds of total subsidy value. Preferential export credits were discontinued as of January 1, 1985. See Turkey: The Vth Five Year Plan in the Context of Structural Adjustment: A Review, Report No. 5418-TU of January 22, 1985, para. 4.47. 2/ Since April 22, 1982 firms have received rebates which increase with the volume of exports culminating in an additional 10 percentage points for annual export levels in excess of US$30 million.  - 12 - directly as well as through the State Investment Bank (DYB); Bank loans have also attempted to strengthen DYB through improvement of systems and procedures and training of staff; and (ii) towards the private sector through the Turkish Industrial Development Bank (TSKB) and The Industrial Investment and Credit Bank (SYKB) to develop viable import substitution and export competitive industries as well as to encourage geographical and entrepreneurial diversification. The loans have also attempted to strengthen the participating intermediaries and to develop a capital market. Bank lending, however, had limited success in attaining many of these objectives e.g. development of a capital market because these projects had little impact on the larger sector policy issues. Following the economic crisis of the late 1970's, and greater receptivity on the part of the Government to Bank policy advice, the Bank made five SALs aimed at assisting the Government in implementing a number of major policy reforms in the industrial and financial sectors. The last three SALs have included a strong focus on trade policy issues and have allowed the Bank to engage in a constructive dialogue with the Government on policy reforms which conventional Bank project lending could not cover. (ii) Future Strategy 2.23 The key to future economic growth is continued successful adjustment to a market economy in which industry, particularly manufacturing, will play a critical role in sustaining the export effort and creating jobs. The Fifth Five Year Plan (1985-1989) makes clear that the Government is prepared to pursue this strategy which will require that industrial and financial sector policy reforms enunciated since 1980 be supplemented by further reforms pertaining to SEE efficiency, deepening of capital markets, adoption of realistic interest rates, restructuring of financial institutions, further lowering of trade barriers, etc. to fully bring about the changeover to a market-oriented economy. The Plan states that the private sector is in the best position to address the two critical problems facing the economy-sustaining high export growth rates and creating jobs in urban areas. 2.24 The Bank's medium term ESW and lending strategy is aimed at assisting the Government in following through with its program of policy reform. With regard to ESW, the Bank's objectives are twofold: (i) to monitor Turkey's progress towards the goals of stabilization, restructuring of the economy and restoration of creditworthiness; and (ii) to provide the macro and broad sectoral basis for sector and project lending. Following the recent reviews of the development strategy and of the Public Investment program of the Fifth Five-Year Plan, four additional studies--on agroindustries, industrial technology, a review of the telecommunications and electronics industries, and a review of engineering industries-are proposed to examine the longer term technological and R & D needs of industry and to analyze their investment and training requirements to ensure that they attain international competitiveness and continue to contribute strongly to export growth. This will be followed by a study of the effect of liberalization on the performance of selected sub-sectors to assist the Government in formulating a program of structural rationalization of private industries. 2.25 Industrial lending strategies are aimed at assisting the Government to implement the program of financial sector reform, to improve the efficiency  - 13 - of public enterprises and to strengthen the role of the private sector. The public sector, which comprises nearly 502 of manufacturing sector investments (para. 2.12), will remain an important area for Bank lending. However, in light of the Government policy to reduce the role of SEEs in manufacturing, Bank lending to SEEs will emphasize rehabilitation, improvement in efficiency and policy reforms (e.g. pricing and rationalization of investment programs) to be tackled both at the firm and sub-sector level. 2.26 The Bank is supporting the Government's long-term objective of expanding the role of the private sector, so that it produces and exports more efficiently as well as generates employment at low cost through the proposed project, which builds on the first labor intensive industry project (Loan 1952-TU). In this respect, the Bank's strategy will focus on increasing the quality and quantity of technical assistance to the SMI sector by assisting SIDO to establish a nationwide network of extension service centers which will also strengthen the industrial sector as a whole by building up suppliers and sub-contractors for larger industries. The proposed project will give special emphasis to the development of artisanal firms by earmarking funds for this group to be onlent by Halk Bankasi. Halk Bankasi itself will be strengthened so that it will develop a capability to provide medium and long term investment loans to SMI in an efficient manner. III. FINANCIAL SECTOR A. Financial Systeml-' 3.01 The financial system of Turkey is relatively undeveloped and is dominated by the banking system. At the end of 1984, there were 19 domestic Table 3.1: SIZE OF FINANCIAL SYSTEM IN TURKEY Ratio of Direct Average Direct Credit Nominal Ratio of Credits from Year M2 from the Fi- GNP Average M2 the Financial nancial Systemr; to GNP System to GNP ( TL billion ) - - -- (in percent ) - 1975 129 208 535 24 39 1980 681 1,326 4,435 15 30 1981 1,201 2,059 6,556 18 31 1982 2,052 2,673 8,657 24 31 1983 2,921 3,435 11,549 25 30 1984 4,234 4,250 18,339 23 23 Source: World Bank Report No.4459-TU, Quarterly Bulletins of Central Bank of Turkey, and IMF data. a/ Cumulative outstanding. 1/ World Bank's Report No. 4459-TU entitled Turkey-Special Economic Report- Policies for the Financial Sector, provides a comprehensive description of the financial sector of Turkey.  - 14 - commercial banks and 15 banks (including the Central Bank, Agricultural Credit Bank (TCZB) and Halk Bank (HB)) established under special laws. There were also two privately-owned development banks (TSKB and SYKB), and 13 foreign banks. The total number of banks' branch offices was 6,221. The banking sector is highly concentrated; TCZB and the three leading commercial banks (Is Bank, Yapi-Kredi Bank, and Akbank) together accounting for more than 50Z of the total assets of the banking sector (TL 12,964 billion at the end of 1984). 3.02 The size of the financial system and trends in its growth are summarized in Table 3.1. In nominal terms, the financial system in Turkey has been increasing rapidly but this growth reflects the high rates of inflation. In real terms (1975 prices), M2 was equivalent to only TL 170 billion in 1984 (average grovth of 3.2Z per annum) and total credit equivalent to only TL 171 billion (-2.1S per annum). Also, the financial system has remained small in size in relation to GNP and has fluctuated widely in 1975-84. The increase in inflation rate from 10 in 1975 to 1071 in 1980 without a corresponding increase in nominal interest rates made fir-ial assets unattractive leading to a decrease in the size of the financial system compared to GNP between 1975 and 1980. The subsequent decrease in irflation (3'1 in 1981 and 271 in 1982) and increase in nominal deposit rates (ranging from 251 for one-month deposits to 501 for 6-months and longer deposits from January 1. 1982) produced high real interest rates in 1981-82. 3.03 The Government reduced the interest rates on demand deposits in 1983 in the expectation of further declines in inflation and to alleviate the financial problems faced by businesses due to very high real interest rates. However, inflation accelerated considerably during the second-half of 1983 (30.4% for the whole of 1983), resulting in negative real interest rates on deposits (-51) by the end of 1983. The interest rates were, therefore, increased again in December 1983 (471 for 6-month and 451 for one-year time deposits). The Government also decided to maintain positive interest rates on demand deposits and to adjust these rates every quarter in line with changes in inflationary expectations and the situation in credit markets. The present rates (August 1985) for 3-month, 6-month, and one-year deposits are 45Z, 502 and 55Z respectively. The interest rate structure reflects the Government's expectation of an overall decline in inflation during 1985 which was already 38.9Z for 12 months ending October 31, 1985 as compared to an average of 50.41 for the whole of 1984. The increase in interest rates has brought an upturn in the relative size of the financial system as seen by a significant increase in real terms (32% in 1983 and 30% in 1984) in the stock of M2 and in the ratio of M2 tJ GT (from 151 in 1980 to 231 in 1984). The ratio of direct credits from the financial system to GNP, however, did not show an increase in 1980-83 and declined in 1984 mainly due to restrictions on Central Bank lending and its debt consolidation (para. 3.04). B. Credit by the Financial System 3.04 The total direct credit extended by the financial system in Turkey has increased significantly in nominal terms as shown in Table 3.2. In real terms, there was a decline of 251 in total credit between 1975 and 1980. This decline was partly related to the increase in reserve requirements imposed in 1977, but it also reflected difficulties in attrecting deposits. During the same period, the Central Bank's share in total credit increased from 321 to about 501 mainly due to its financing the increased funding needs of the  - 15 - Table 3.2: DIRECT CREDITS FROM THE FINANCIAL SYSTEM IN TURKEY&' (TL billion) Central Deposits Investment & Year Total Credit Bank Money Bank Development Credit Credit Bank Credit 1975 208(100Z) 66(32Z) 112(54Z) 30(14X) 1980 1,326(100Z) 655(492) 542(412) 129(10Z) 1981 2,059(100X) 925(45X) 942(46Z) 192( 91) 1982 2,673(1002) 910(36X) 1,484(55Z) 279( 9%) 1983 3,435(100X) 1,235(36X) 1,848(54Z) 352(101) 1984 4,250(100Z) 880(21Z) 2,871(68Z) 499(11%) Source: World Bank Report No.4459-TU and Quarterly Bulletin of Central Bank of Turkey. a/ Central Bank's credits to DYB and credits extended to banks through rediscounting are excluded from the credits of deposit and investment and development banks. public sector. Total credit started picking up in real terms from the second half of 1980 but had not reached the 1975 level by the end of 1984. The growth of credits since 1980 has been to a large extent determined by the ceilings on the expansion of domestic financial assets of the Central Bank, which were established in the context of economic stabilization policy increases agreed with the INF. One of the main functions of these credit ceilings has been to ration the credit extended by the Central Bank to the public sector and the amount of preferential credit to the private sector financed by the Central Bank. A substantial portion of the decline in Central Bank credit in 1984 was due to debt consolidation which resulted in the assumption of debts of certain SEEs and state-owned banks by the Treasury. As a result, the share of deposit money banks in total credit financing in 1984 increased to the highest level in the last 10 years. The share of Halk Bankasi, one of the two intermediaries under the proposed Bank loan, was 71 in the total credit of deposit money banks at the end of 1984. SYKB which is a development bank and the other intermediary under the proposed loan has accounted for 61 of the total credit by investment and development banks at the end of 1984 (para. 3.06). C. Financing of the Industrial Sector Including SMI 3.05 Nearly 601 of total private fixed investment in the organized industrial sector is financed by financial institutions. Of this amount, about 801 is now extended through deposit money banks which are required to maintain 201 of their deposits in medium and long-term credits, and the balance from investment and development banks. A substantial portion of deposit money banks' short term loans to the industrial sector are rolled over and thus function as medium or long-term credits, but under present conditions of financial stress faced by enterprises, most is used to finance arrears and working capital rather than fixed assets. Nearly all of the investment not  - 16 - financed by intermediaries comes from investing firms' own funds. Bonds, which comprised about 8Z of manufacturing investment in the mid-70s, presently represent a negligible proportion of such investment because of the high interest rates on deposits. Suppliers' credits also play a limited role in financing because of the private sector's reluctance to bear the foreign exchange risk (see para. 3.10). Foreign investment is a growing source of funds, but has not reached more than 1-2% of the total. 3.06 Four banks are classified as investment and development banks. DYB (State Investment Bank), which concentrates its activity in financing investment of SEEs, accounts for about 60% of total assets of this group of banks and has been a channel for three Bank loans to the public sector. The other three development banks-TSRB, SYKB (both private sector-owned), and DESIYAB (government-owned)-serve principally the private sector. Of these, TSKB, with about two-thirds of the total assets, is the largest. It is regarded primarily as a source of foreign exchange loans. SYKB formerly provided mainly medium-term local currency loans, but during the last three years it has been extending largely medium- and long-term loans in foreign currency. DESIYAB, the most recently established institution of this group (1976), channels resources of workers abroad into industrial and other productive investments in Turkey especially in the less developed regions. TSKB and SYKB have been recipients of several Bank loans. Total credits of investment and development banks have decreased in real terms by 33X during 1975-84 and their share in total direct credit by the financial system has declined from 14X in 1975 to about 10% in 1980-84 (see table 3.2). The reluctance of investors to borrow in foreign currencies (para. 3.10) and their lack of access to local currency resources (para. 3.19) are the main reasons for this situation. 3.07 Halk Bankasi (RB) is the principal source of loans to small businesses in the unorganized sector through a network of more than 600 regional offices and branches. Its borrowers include small tradesmen and artisans often organized in cooperatives. Only about 25X of its funtds go to manufacturing firms, mostly for working capital which is much less than the potential need. It is proposed as an intermediary under this project in order to assist the smaller firms (4.22-4.47). For SMI that are too large to qualify for HB financing (i.e. firms with fixed assets of TL 300 million excluding land and buildings) sources of funds are very limited. Commercial banks are reluctant to lend to SMI because of higher administrative costs and a perceived higher risk. SYKB has been providing funds under the Bank's first labor intensive industry project for firms at the larger end of the SMI spectrum and is proposed as one of the intermediaries under the project to serve that group (paras. 4.01-4.21). D. Interest Rates and the Cost of Capital 3.08 Prior to mid-1980, all interest rates were regulated by Government. Though differentiated by activity and maturity, lending rates were consistently negative in real terms, especially in priority activities and regions. Since deregulation on July 1, 1980, the banks collectively determine base lending interest rates. For loans that qualify, their rates are influenced by the rediscounting policies that are set forth periodically by  - 17 - the Central Bank which vary with different activities and maturitieo. The base lending rates are revised periodically by the banks, taking into account expectations of inflation and market conditions. The costs to the borrowers also include commission, taxes, and (for all but a few categories of high priority loans, e.g. agriculture) contributions to a new Resource Utilization Support Fund, which replaced the Interest Rate Rebate Fund at the end of 1984. The fund is being used to defray investment costs for eligible projects receiving certificates of encouragement with greatest support for less developed regions, and for exports based on net foreign exchange revenue earned. 3.09 For investment loans eligible for Central Bank rediscounting, the final cost is a blend between the cost of funds eligible for rediscounting (for which the rediscount proportion ranges from 50% to as high as 90% for the less developed regions) and the cost of funds from the banks' own sources. However, the Central Bank's rediscounting facility is not available throughout a given year, depending on progress made in meetis.g the monetary and credit ceilings; this results in postponement of investments or, on occasions, borrowings from banks at their regular rates. During 1984, the effective interest rate on the rediscounted portions of medium and long-term TL investment loans for industrial credits to the private sector, after taking into account various taxes, and charges varied between 26% for loans to the least developed regions to 38% for other investment loans. The effective cost of the rediscounted portions during 1984 was negative, since inflation averaged 50.4%. Medium and long-term loans that do not qualify for rediscounting and the non-rediscounted portion of loans made from banks' own sources are much costlier, ranging from an effective cost of 60X to 80%. Under SAL IV, the Government declared its intention to set interest rates an preferential credits at least equal to the rate of inflation and minimize the difference between preferential and non-preferential credits. In pursuit of this policy, the Central Bank rediscount rates on investment credits were raised from 19.5-30% to 33% commencing January 1985 and, thus, differences between preferential and non-preferential categories were also reduced. The effective blended interest rate of medium and long-term TL investment loans for industrial credits from the deposit money banks is now estimated at 50-55% p.a. but the cost of similar funds from the investment banks is 38-41% because a relatively higher proportion of these loans can be rediscounted. The availability of local currency term loans from the investment banks is, however, very limited (para. 3.20). Given the expectation of significantly lower inflation rates in the future, the blended interest rates are generally expected to be positive in real terms in 1985 and over the life of loans. For SSI that qualify to borrow from Halk Bankasi, a range of rates exist depending upon the source and purpose. For tradesman and artisans who are members of cooperatives and require loans for working capital, the effective cost through the Central Bank rediscount facility is 30-32%, whereas the cost of investment loans for SSI is 43-52%. 3.10 On foreign currency loans until mid-1984, the interest rate was set by the intermediary's cost (or the weighted average cost) of foreign currency borrowings plus a spread, which for TSKB and SYKB was set at about 5Z. The effective interest rate on foreign currency loans was about 14% with the borrower assuming the full foreign exchange risk. Demand for foreign funds on  - 18 - this basis has been very limited, however. Firms with loans denominated in foreign currencies have found that the amount of TL required to repay them has increased faster than the increase in earnings, due both to depressed domestic markets and the fact that the TL has had a significant and continuing level of real devaluation. This problem was particularly acute for new firms under construction which had not started operations and suffered heavy losses duo to the foreign exchange risk. Although there are presently no strong reasons to fear significant losses arising from the foreign exchange risk given the present exchange rate policies, firms are unwilling to borrow in foreign currencies under the current relatively d pressed conditions. Furthermore, with the foreign exchange constraint greatly eased in the last couple of years with the surge of exports, some firms were able to satisfy their requirements by obtaining TL loans (which could in some cases be at lower effective interest rate) and then either purchasing the requisite foreign exchange, or utilizing the foreign exchange from exports. To encourage greater use of foreign borrowings, the Government, in July 1984, instituted a foreign exchange risk insurance scheme (FERIS) applicable to IBRD loans to TSKB and SYKB in the private manufacturing sector. In this scheme, loans were denominated in TL at a fixed interest rate (26Z) over an 8-year term with a spacial fund bearing the foreign exchange risk. This scheme succeeded in stimulating investment demand for Bank loans, in part because the effective costs to borrowers, estimated at 31-332-', was low compared to the prevailing inflation rate. The question of how to harmonize the costs of domestic and foreign exchange loans and develop an acceptable long-term scheme that will stimulate investment without subsidizing it is a major issue of the financial sector (see paras. 3.12-3.14 below). E. Financial Sector Issues 3.11 The financial sector issues in Turkey have been a subject of intensive dialogue between the Bank and the Government for a number of years and most recently when the Bank report on the policies for the financial sector in Turkey (Report No. 4459-TU of September 1983) was prepared and discussed with the Turkish authorities. The major issues identified in that report are beginning to be effectively addressed by the Government including some in the context of recent SALs. These issues fall into the following four categories: (i) structure, costs and foreign exchange risk; (ii) banking sector efficiency; (iii) development of capital markets; and (iv) local currency resources of development banks. (i) Structure, Costs and Foreign Exchange Risk 3.12 There are several problems which are evident from the discussion above (paras. 3.08-3.10) regarding the structure and cost of capital. These problems are embodied partly in the system of selective credits which results in fragmentation of the financial market and in wide differences between the cost of different types of credits. Other problems stem from significant increases in inflation without corresponding adjustments in lending rates 1/ The nominal interest rate was fixed at 262. The rate of 31-33X takes into account the effect of certain additional fees and charges imposed by the intermediaries (TSKB and SYKB).  - 19 - which caused some preferential interest rates to be highly negative in real terms over most of 1983 and 1984 while non-preferential rates were generally highly positive in real terms following their liberalization. This situation leads to constraints in the optimum mobilization of domestic savings, and distortions in allocation of resources; it can also lead to inflationary pressures to the extent that preferential credits are not financed through cross-subsidization. The Government's recent 4ctions have brought improvements in the interest rate structure but further actions need to be taken to introduce and maintain real positive interest rates on all loans, and to minimize the gap between the cost of preferential and non-preferential credits. 3.13 While borrowers of local currency loans were subject to either highly positive or negative real rates, borrowers of loans in foreign currencies with exchange risks suffered large losses in recent years due to the major devaluation of TL. As a result, they became reluctant to borrow foreign currency loans, particularly those with medium and long-term maturities. In response, the Government introduced a Foreign Exchange Risk Insurance Scheme (FERIS) in 1984 (para. 3.10) and has decided to continue the scheme for the time being with a fixed interest rate of 35X and an effective cost of 38-42X applicable to loans approved during 1985. In addition, it is the Government's intention to operate the scheme on the basis of the following principles: i) FERIS will be managed in order to be self-financing. To achieve this, the lending rate to borrowers would be positive in real terms over the life of the subloans. The rate would be reviewed every six months and adjusted as necessary. In the case of prepayment of a loan under FERIS, the borrower will be required to compensate the scheme for any losses incurred on that loan between the date of disbursement of the loan proceeds and the prepayment date. (ii) The effective cost of funds to borrowers under the Central Bank Rediscount Rates will be comparable to the cost of funds to borrowers under FERIS. (iii) FERIS will not discriminate between financial institutions covered under the scheme. Onlending terms and conditions will be applied equitably to such loans and the financial institutions will be allowed an appropriate spread. (iv) In order to be eligible for financing under FERIS, projects will be required to have a Certificate of Encouragement which in turn requires normally a minimum debt/equity limit of 50:50. FERIS will, therefore, be an instrument for mobilizing private savings. (v) Financial intermediaries will continue to offer finance in foreign currency with the exchange risk to be passed on to sub-borrowers. 3.14 Accordingly, it has been agreed during negotiations that the proceeds of the proposed Bank loan may be onlent to sub-borrowers either under FERIS or in foreign exchange. Under FERIS, the Government will lend Bank funds  - 20 - denominated in TL to SYKB and Halk Bankasi at a rate equal to the onlending rate to sub-borrowers minus a spread of 4X. Alternatively, Bank funds would be lent in foreiga exchange to SYKB and Halk Bankasi at a fixed interest equal to the then prevailing Bank rate plus 0.75% to compensate the Government for bearing the risk arising from the variability of the Bank interest rate. The onlending rate to sub-borrowers will be fixed at 5% above the Bank rate prevailing at the time of subloan approval. The Government intends to discontinue FERIS in its present form as soon as the private investment climate has recovered and inflation has abated. The Bank plans to discuss the future of FERIS, together with other specialized credit schemes, with the Government in the context of the proposed Financial Sector Adjustment Loan. (ii) Improving Efficiency of the Banking System 3.15 The bankiLg system, which dominates the financial sector of Turkey, has been characterized by lack of competition, excessive number of branch office, widespread interlocking ownership between banks and enterprises, lack of accounting standards, and lack of effective supervision by the Central Bank with unsatisfactory procedures for the monitoring of loan portfolios. Though the costs of intermediation have been dropping (from 11X of total assets in 1980 to 7Z in 1983) they are significaoti.y higher than in in4ustrialized countries which range from 3% to 4-1/12. These costs have been inflated by liquidity and reserve requirements of the Central Bank and a tax on inter-bank transactions which contributed to the absence of an inter-bank money market. Improied efficiency of the banking system would improve the.cnst and terms of funds available to SMI. The Banking Law of June 28, 1983 laid the cornerstone for strengthening the banking system. Covering many of the recommendations of the Bank's report on the Financial Sector'-', it reduces under-capitalization of banks by setting a maximnu total debt/equity ratio of 20:1, places limits on tne real assets and investments of banks, links the establishment of branches to the level of a bank's equity, and reduces the interlocking ownership between banks and corporations. It also introduces a deposit insurance scheme and strengthens the role of the Central Bank in the supervision of the sector. 3.16 There are two major issues which need to be addressed further. One is the intermediation cost which despite recent measures (such as reduction of a withholding tax) is still excessive. This will require a number of approaches including tax incentives to reduce operating expenditures, better enforcement of Central Bank liquidity requirements to encourage use of the interbank market and further steps to limit banks' equity holding in companies in order to induce arm's-length relationship with customers, and the introduction of modern technology to improve accounting and auditing practices. The other issue is the supervision capability of the Central Bank which despite the Decree Law on Banking, remains weak. Further progress requires clearer demarcation of responsibility between the Central Bank and different departments in the Ministry of Finance for supervision of banks, improving the monitoring of exposure of banks to major borrowers, and raising the standards of project appraisal by banks for discounting of loans by the V/ Bank report 4459-TU, of September 21, 1983.  - 21 - Central Bank. .ne Bank has begun to address these issues for the overall banking sector in the context of the discussions of the financial sector report and to be pursued through the proposed financial sector loan. 3.17 Halk Bankasi which would be an intermediary for the proposed Bank loan is a specialized commercial bank. It does not have some of the characteristics of other commercial banks (e.g. interlocking of ownership with its assisted enterprises, under-capitalization, etc.), and its intermediation costs have been relatively low at 6-7Z. However, these costs are still high when compared to international levels. This points out to the need for greater efficiency in operations particularly with respect to deployment of staff, size and location of branches, internal operational controls, computerization of operations, etc. In order to address the above issue, the proposed project includes technical assistance to identify and introduce measures to improve operational efficiency (para. 4.16). (iii) Development of Capital Market 3.18 The development of a larger and more diversified capital market is needed in Turkey to increase competition with banks, provide savers with a wider choice of financial instruments, enable companies to restore their equity to sound levels, and facilitate broader corporate ownership. Accomplishing this task will require strengthening the institutional framework, particularly the capability of the Capital Markets Board to regulate, supervise and develop the market in coordination with the work of other agencies. Legislation concerning the accounting and auditing profession is also needed to upgrade disclosure standards and introduce the requirement of externAl audit of the accounts of firms whose securities are to be offered to the public. Other areas where progress is needed include: strengthening securities market intermediaries, promoting institutional investors; development of the primary market for securities; reducing the restrictions governing corporate debt issues, stimulating the equity market; and implementing plans to establish a new stock exchange in order to develop the secondary market for securities. 3.19 The Bank Group is assisting the Government to bring about these developments in sevex.-l ways. IFC is providing technical assistance to the Capital Markets Board. Programs have been agreed to and are being implemented to adopt a system of standardized accounts for companies making public issues of securities, and to enact a law regulating the activities of external auditors and providing for the opening of the Stock Exchange. Finally, the Government-Bank dialogue on these matters, initiated in the context of the IFC's TA program and to be pursued through a possible financial sector loan (para. 3.16), should assist in improving the institutional, supervisory and developmental framework of the capital markets in parallel with measures already planned to strengthen primary markets for securities and activate equity markets through the opening of a new stock exchange. These measures will have an impact on medium and large-sized enterprises both directly by facilitating access to sources of equity, and indirectly by increasing competition with the banking system and thereby increasing the availability of and reducing costs of short and medium-term financing.  - 22 - (iv) Local Currency Resources of Development Banks 3.20 In addition to the problems related to the use of foreign exchange funds discussed above (para. 3.10), the four major development banks in Turkey (TSKB and SYKB in the private sector and DYB and DESIYAB in the public sector) face a common problem: lack of access to local currency resources. The two private sector development banks (TSKB and SYKB) are also inhibited from competing with commercial banks because their shares are mostly owned by the leading commercial banks and both are dominated by a single shareholder, Is Bank. The continuing dialogue between the Government and the Bank on these issues in this context of a possible financial sector loan is intended to address these medium-term issues by seeking an increase in private sector development banks' share of medium and long-term loans in the Central Bank discowit facility and stricter requirements of project evaluation by commercial banks to participate in the facility. As regards the proposed project, HB is a deposit money bank and does not face constraints similar to development banks in mobilizing local currency resources. SYKB has projected an increase in its local currency loans of only 332 p.a. in nominal terms during 1985-38 and does not foresee any difficulty in meeting the fund requirements from its traditional sources, viz. Central Bank rediscounting facility, capital increases and internal generation of funds. IV. THE PROJECT A. Project Objectives and Description 4.01 The proposed project will assist in the development of efficient labor-intensive industries, mainly in the SMI category, here- Turkey has comparative advantage and thus contribute both to job creation and growth of manufactured exports. The project will place special emphasis on assistance to small scale industrial enterprises, particularly those located in remote area of the country, through Halk Bankasi (HB) which has a widespread branch network. The project will also concurrently assist in developing financial intermediaries capable of providing term finance and financial services to SMI in an efficient manner and thus improve SMI's access to term finance. Finally, the project will help start a national program of technical assistance for SMI involving both private and public sector institutions to provide a range of technical and management services to SMI in a cost effective manner. In order to achieve the above objectives, the project includes (i) credit lines of US$80 million and US$18.4 million for Sinai Yatirim ve Kredi Bankasi (SYKB) and Halk Bankasi (HB) respectively; and (ii) technical assistance of US$1.25 million for SMI to be implemented by the Small Industry Development Organization (SIDO), and US$350,000 for the institutional strengthening and efficiency improvements of RB. On the basis of past operations and project pipeline of SYKB and RB, and overall financial needs of the SMI sector, it is anticipated that most of the subprojects to be financed under the loan would be for the manufacture of food products, ready-made garments, furniture, leather products, and metal works and engineering. The project objectives support those in the Five Year Plan (para. 2.18), and are consistent with the Bank's strategy and lending objectives in Turkey (paras. 2.23-2.25).  - 23 - B. Financial Intermediaries (i) Sinai Yatirim ve Kredi Bankasi (SYKB)'-' 4.02 The Institution: SYKB was established in 1963 by five major commercial banks in Turkey, to meet the investment financing needs of the private industrial sector. Its paid-in capital is TL 2,000 million of which 60% is owned by Is Bank-the largest bank in Turkey--and the remainder is equally divided among the four other banks. It has very competent management and staff. The total professional staff of SYKB was 49 in December 1984; this included 9 engineers and 24 economists/financial analysts and their total number has increased by 50% during the last four years. The staff is experienced and has been provided with adequate training in project appraisal and supervision. SYKB plans to increase its staff gradually and the total member of engineers and economists would reach to 54 by 1988; this would be adequate to meet projected operational requirements. SYKB's internal staff training arrangements are satisfactory and it does not need special project- related training. 4.03 SYKB's operational and financial policies are laid down in its policy statement of January 1979 which is designed to ensure sound lending operations and a strong finnncial position. SYKB's appraisal procedures are satisfactory as indicated by the review of subprojects financed by SYKB under the Bank's loans for the textile industry (Loan 1755-TU) and labor intensive industry (Loan 1952-TU) projects. As regards project supervision, there is scope for its further strengthening by closely following the details of supervision system agreed with the Bank under the labor-intensive industry project. In particular, SYKB staff has to increase the frequency of visits to all projects under implementation (at least once every six months) and to monitor non-financial aspects of projects (including physical implementation and technical and marketing aspects) on a regular basis. SYKB management coanfirmed that its staff has been instructed to carry out above improvements 4.04 Operations and Financial Positaon: Total loan approvals of SYKB have increased from TL 2,765 million for 29 projects in 1980 to TL 16,782.9 million for 83 projects in 1984. The increase in real terms during the period was 14% p.a. and the number of projects almost trippled which is quite impressive. Local currency loan approvals were 33% of total loans during the 1980-1984 period. The foreign currency loans increased from US$17.4 million (13 in number) in 1980 to US$22.0 million (46 in number) in 1982 but declined to US$18.1 million (41 in number) in 1983, due to reluctance of sub-borrowers to accept foreign exchange risk (para. 3.13). Foreign currency loan approvals, however, increased to US$37.7 million (66 in number) in 1984 with the introduction of the Foreign Exchange Risk Insurance Scheme (FERIS) (para. 3.13). SYKB has continued financing priority projects which have obtained Certificates of Encouragement from the Government. The projects assisted by SYKB have high labor-intensity, particularly in more recent years. It is estimated that about 26,000 direct jobs would be created by projects which 1/ For details, see Annex 2.  - 24 - received loans from SYKB for fixed investment during 1980-1984 period, with an estimated average cost per job (excluding land and buildings) of US$19,726 in 1980, US$20,720 in 1981, US$7.975 in 1982, US$11,111 in 1983, and US$8,247 in 1984. 4.05 SYKB's net income as percentage of equity has increased from 22% to 32% in 1980-84. Its administrative expenses in relation to total assets have remained at around 2% which is satisfactory. SYKB's average interest spread for the last few years has been about 10% p.a. which is high mainly due to charging interest from the date of loan commitments and interest free loans (TL 725.4 million as of September 30, 1984) from shareholding banks. (The spread would, however, reduce to 6.5X by 1988 mainly due to the conversion of shareholding banks' loans into equity and increase in the share of loans in the total resources of SYKB). The returns to shareholders in nominal terms on their capital and loans to SYKB (received in the form of annual dividends) have gone up from a low of 1 in 1980 to 32% in 1984 which are still low, compared to interest rates on term deposits or other financial instruments in Turkey. The long-term debt/equity ratio has gone up from 4.2:1 at the end of 1980 to 8.6:1 at the end of 1984 which is within the maximum limit of 9:1 agreed with the Bank under the labor intensive industry project. At the end of 1984, the current ratio was 1.9:1 and showed a satisfactory liquidity position. SYKB's arrears and loans affected by arrears of more than three months were 2.5% and 14.71 respectively of the total loan portfolio on December 31, 1984 and were reasonable. 4.06 According to SYKB's financial projections, its return on equity would increase to 45Z in 1988 and its liquidity and long-term financial position would continue to be satisfactory. In view of its sound financial position, it is proposed to increase the debt/equity limit of SYKB from 9:1 to 10:1 under the proposed project. 4.07 SYKB's audit has been performed satisfactorily by independent auditors who have given unqualified audit reports. 4.08 Bank-financed Operations: SYUB has so far received two loans of US$15 million (Loan 1755-TU) and US$40 million (Loan 1952-TU) from the Bank in support of the development of textile industry and labor-intensive industry, respectively. Due to reluctance of firms to incur foreign exchange risk, the last date for loan commitments was extended for both Loens. With the help of the 1984 FERIS, the two loans were almost fully committed (textiles 1001 and labor-intensive 99%) by December 31, 1984. SYKB has approved 112 subprojects (net of cancellations) with a total amount of US$39.5 million up to December 31, 1984 under the Bank loan for labor-intensive industries. About 38% of the loan amount has been approved for SSI subprojects against the original target of 33%. Subprojects assisted under the loan would create about 8,600 jobs at an average cost of US$8,700 each (excluding land and buildings). The ERR and FRR were calculated for subprojects with fixed investment of above US$750,000 each and these ranged between 16Z to 45% and 19.6% to 54% respectively. SYKB's performance in utilizing the loan as reflected by good quality of subproject appraisal, financing of a large number of SSI subprojects and low cost per job, has been very satisfactory.  - 25 - 4.09 Proposed Bank Loan: Total foreign currency loan commitments of SYKB during the 1986-1988 period are estimated at US$171 million. The proposed Bank loan of US$80 million and an expected loan of US$35 million form EIB would meet the bulk of the resource requirements. The unidentified resource gap may be met from existing or new sources (e.g. KfW). 4.10 The proposed Bank loan of US$80 million would be used by SYKB to finance mainly labor-intensive small and medium scale industry projects. The definition of SSI, SMI and the cost of per job criteria for assistance will be the same in real terms as under the last labor-intensive industry project. The definition of SSI subprojects would include new projects with maximum investment limit, excluding land and building, of US$500,0001' and expansion projects with a limit of US$650,000." For medium-scale industry projects (MSI) the respective maximum investment limits would be US$2.5 million and US$3.5 million1' for new and expansion projects. At least 80X of the loan would be reserved for financing SMI projects and, within this limit, at least 30% of the loan would be onlent to SSI. All eligible subprojects will have a maximum capital investment (excluding land and buildings) of US$18,0001' per job. Non-SMI projects which satisfy the cost per job criteria and are considered export-oriented based on Certificates of Encouragement would be eligible for financing from the balance of the loan proceeds (up to a maximum of 20% of the loan to SYKB). This would allow SYKB leeway in financing a small number of subprojects which, besides being labor-intensive, were also export-oriented. The Bank's experience has shown that such subprojects could be somewhat bigger than typical SMI subprojects because of the need to capture economies of scale. As a consequence of SYKB's policy guidelines, regarding the size of subloans, the maximum subproject and subloan sizes for these larger subprojects are expected to be in the range of US$4-5 million and US$2-2.25 million respectively, i.e. not significantly larger than the subprojects that would belong to SMI category under the loan. 4.11 As agreed under the labor-intensive industry project, SYKB will calculate economic and financial rates of return for all subprojects receiving term financing and having total investment in fixed assets exceeding US$750,000 equivalent. The eligible subprojects will also have a minimum economic rate of return of 1Z% and a minimum financial rate of return which will be not less than the Central Bank's rediscount rate for the industrial investment loans at the time of subloan approval. (ii) Halk Bankasi (HB)!-' 4.12 Role of HB in the Proposed Project: The Bank has endeavored under its industrial credits to Turkey to diversify its assistance on a geographical basis and to enhance the support to SSI. The achievement of these objectives has been constrained by the inadequate branch network of DFCs in Turkey and the lack of interest of commercial banks in assistance to SSI. 1/ All in end-1984 prices. 2/ For details, see Annex 3.  - 26 - 4.13 The Balk Bankasi (HB) is a specialized bank in Turkey which caters mainly to the credit needs of small traders, artisans, and SSI and mobilizes small savings. It has been established on the pattern of "popular banks" in many European and Asian countries and is a member of the International Popular Credit Confederation.L' HB has a large branch network (para. 4.14) whichprovides easy access to small enterprises all over the country. It has recently received technical assistance from the Federal Republic of Germany (to be continued up to 1987) which includes advisory services to assist the head office and selected branches of RB in the policies, procedures and criteria of assisting SSI, particularly small metal and wood-working and processing industries.' In view of the above and considering that the Government and the chief executive of EB are keen to enhance its developmental role, the Bank can provide technical and financial assistance to HB and, thus, help in the development of SSI on an extensive basis. At this stage, it is proposed that the Bank support the institutional strengthening of HB and provide technical assistance (para. 4.17) for this purpose. In addition, a relatively small amount of the loan (US$18.40 million) is proposed to be provided for onlending to SSI through HB (para. 4.21) as a pilot project. The technical and financial assistance programs are designed to lay the basio for further Bank assistance to HB and the SSI sector. 4.14 The Institution: HB was established in 1938 as a State Enterprise (SEE) to provide specialized banking services for the promotion of small businesses. The Ministry of Finance is the main shareholder of HB as it holds 95% of HB's paid-in capital of TL 11.5 billion (US$26.4 million as of December 1984). HB operates from its head office in Ankara and regional offices in Istanbul and Izmir as well as its 598 branches and 9 foreign currency bureaus throughout Turkey. Its management and senior staff have generally long banking experience. During the last five years (1979-84). the number of RB staff increased by 27Z to 11,726 of which 4,260 (36X) are in managerial and executive positions. 4.15 HB's lending operations are governed by four different credit departments, each having its own specialization including one for the industrial sector. RB has an established system of delegation of loan approval authority from the Board to branch managers. The branches are authorized to approve loans up to their permitted limit. The limit varies among different branches depending upon their size and it can go up to TL 25 million. Most of the day-to-day banking operations are therefore carried out at the branch level. 4.16 HB has followed conservative commercial banking practices. Although its decisions on investment loans are made after a review of technical, financial and market aspects of the project, the financial structure of the 1/ An international organization playing an active role in bringing together "popular banks" and institutions engaged in the development of small businesses for the purpose of sharing their knowledge and experience. 2/ Bank's proposals for the institutional strengthening of HB take into account the detailed discussions that Bank staff had with the lead advisor provided under the TA from the Federal Republic of Germany.  - 27 - borrowers and the collateral of the loan are given high importance. There is a need for more project-oriented lending by HEB by increasing the emphasis on project viability rather than the loan collateral and directing/coordinating technical assistance to SSI. This objective is proposed to be achieved by increasing the number of professional staff for industrial projects, appoint- ment of a training officer for preparation and implementation of training programs in project appraisal and supervision, adoption of an appropriate policy statement, and active coordination with the Small Industry Development Organization (SIDO). HB has already appointed additional professional staff (8 financial analysts/economists) for the immediate needs of the Industrial Credit Department and completed the training of a core staff with other DFCs in Turkey. It has also adopted a policy statement acceptable to the Bank. During negotiations, assurances were received from HB on the appointment of a training officer before sending the first withdrawal application under a sub-loan. The proposed loan includes technical assistance of US$50,000 for the training of HB's staff in foreign institutions. As HB would need to increase the number of engineers from 66 to 100 and the number of economists/financial analysts from 32 to 70 by 1987 to meet the targets of its projected industrial investment operations, assurances were also received from RB on an appropriate annual recruitment plan to meet the above target. 4.1/ While the above measures would help to bring an immediate improvement in the capability of HB to identify, appraise, and supervise industrial projects, an in-depth review of its overall institutional structure would enable adjustments which may be called for (i) to respond effectively to the new and growing role of HB, particularly with respect to greater development- orientation in its operations; and (ii) to improve cost and operational efficiency. A technical assistance of US$300,000 is, therefore, proposed for HB to undertake a study which would review mainly (a) organizational structure, policies, and procedures; (b) accounting, internal auditing and management information system; and (c) the developmental role of HB. The study would also make recommendations for further institutional strengthening of HB and means to improve efficiency. The findings and recommendations of the study will form the basis for preparation of an action program and timetable for its implementation by HB, in consultation with the Bank. The terms of reference of the study (Annex 3, Attachment 2) were agreed during negotiations. 4.18 Operations and Financial Position: During the 1981-1984 period, HB's total loans increased by 1.5% p.a. in real terms and amounted to TL 207 billion (US$ 475 million) at the end of 1984. The Industrial Credit Department which has the overall responsibility for loans to SMI for working capital and investment purposes accounted for 25% of total portfolio of HB as of December 31, 1984. The industrial credit portfolio (including both short and long-term loans) increased by 1% p.a. in real terms during 1981-84 and amounted to TL 48 billion (US$110 million) at the end of 1984. The credit available for investment to the small businesses and industry-i' out of this 1I/ This breakdown is based on BB's own internal definitions of SSI and M1SI. SSI includes very small euterprises, i.e. those with less than 25 employees and less than TL 80 million (US$ 190,000) capital investment (excluding land and buildings). MSI enterprises are those having capital (excluding land and buildings) between TL 80 million to TO 300 million (US$190,000 to US$700,000).  - 28 - department was TL 21 billion (US$48 million) at the end of 1984; an increase of 4Z p.a. in real terms during 1981-1984. The working capital loans were about 70Z of total loans made in 1984; the balance of 30X being for fixed investment. 4.19 Although HB is not a profit-motivated institution, its net profit as percentage of equity was 19Z in 1982, 12% in 1983, and 25Z in 1984. The major adjustments in deposit and lending rates in the last few years have been responsible for the deviation in the net profit of HB. HB's average interest spread was 7% in 1982, 6Z in 1983 and 9X in 1984 which is high from international st-ndard. HB's administrative expenses as a share of total assets between 1981-1984 have also been high at 3-4% mainly due to the large number of branches and the small size of sub-loans of HB. At the end of 1984, the total debtl/-equity ratio of HB stood at 12:1 which is low for a commercial bank and well within the maximum limit of 20:1 required by the Central Bank for all commercial banks.2/ HB follows sound liquidity policies and complies with the liquidity reserve requirement of the Central Bank. Total arrears for all credits of HB at the end of 1984 were TL 8.1 billion (USt 18.6 million) or 3.9Z of the loan portfolio, which is on the low side. HB's financial projections show that its return on equity will be about 18X in the next four years and that it will maintain a satisfactory liquidity and long-term financial position. 4.20 HB's financial statements are audited by BLxsbakanlik Yuksek Demetreme Kurulu (Supreme Board of Auditors) in the Prime Minister's Office. The audit is carried out in accordance with the Government's requirements for the state enterprises and is considered acceptable by the Bank. HB's accounts have been found satisfactory by the auditors. 4.21 Proposed Bank Loan: The proposed Bank loan of US$18.40 million would be used by HB to finance labor-intensive subprojects in the SSI category only as defined in para. 4.10. Furthermore, within SSI category, RB will concentrate its financing on very small enterprises, which is the main area of is operations. It will thus use at least 70% of its share in the Bank loan (US$13 million) for assistance to subprojects with total fixed assets, excluding land and buildings, not exceeding US$200,000 in 1984 prices.3/ The proposed loan would meet about 37% of investment fund needs of HB (i.e. Investment Credit Department) on commitment basis for financing the procurement of machinery and equipment by small industrial enterprises during 1986-88, the balance coming mainly from paid-in capital, term-deposits, and a loan of DM 10 million from KfW. 1/ Includes short-term and long-term deposits and borrowings. 2/ In view of this general limit and considering that HB is an almost fully Government-owned commercial bank, a separate long-term debt/equity limit is not considered necessary for HB. 3/ This limit is almost equivalent to the present SSI limit of TL 80 million used internally in HB.  - 29 - C. Technical Assistance Program for SMIl/ 4.22 Turkey's industrial sector is at a fairly advanced stage of development compared to most developing countries. The technical assistance needs of SHI are relatively sophisticated and include access to improved product designs, production technology, management methods and marketing skills, particularly for competing in export markets. There is a need to develop inter-firm linkages between SMI and larger firms to allow SMI access to national and international markets. Until now, SMIs have had very limited access to existing institutional sources of technical assistance because these institutions were not geared towards serving the needs of smaller firms. In 1970, with the support of UNDP/UNIDO, the Government established the Small Industry Development Organization (SIDO) with a pilot project in Gaziantep in Eastern Turkey to assist small enterprises of that district. The Gaziantep facilities comprise a demonstration center for metal working industries. The pilot project has not been successful primarily because of the incompatability of its relatively complex machinery and technology with the needs of most of the small enterprises in the area for relatively simple knowhow and the lack of an effective extension service for SMI. 4.23 In June 1983, the Government decided to substantially strengthen SIDO. SIDO became a semi-autonomous body of the Ministry of Industry and Trade (MOIT) with the mandate of providing technical assistance to SMI on a nation-wide basis. At the same time, UNDP approved a three-year project at an estimated cost of $9l2,000 to assist SIDO establish a demonstration center cum common facilities for small foundries in Ankara, which is under implementation. 4.24 In the light of its experience with the (Mziantep pilot project, SIDO's management has adopted a new strategy to assist SMI. The new strategy calls for SIDO to build up a decentralized network of branch offices staffed with multidisciplinary extension teams. Each branch office would promote technical assistance by visiting and undertaking diagnostic surveys of SMI firms to assess their individual problems and needs and refer firms needing specialized assistance to appropriate experts or institutions capable of providing such services. The firms will receive in-plant services tailored to their specific needs with minimum disruption of work. Also, SIDO will become a catalyst in mobilizing existing sources of technical, marketing, training and management expertise to assist SMI rather than attempting exclusively on its own to service all the diverse technical assistance needs of SMI. 4.25 SIDO currently employs a total staff of 72 (16 professionals) of which 66 are at Gaziantep and the remaining 6 are at Ankara headquarters. SIDO's present management has considerable experience in small industry development and appears competent. SIDO's operations are reviewed by a governing body chaired by the Deputy Under-Secretary of MOIT and includes a representative of Halk Bankasi (HB). However, SIDO's organization and staffing need substantial strengthening to implement effectively its new development strategy. 1/ For details see Annex 4.  - e0 - CAbrT No. I PMMAII cSoUTo CIUULTAJT *oUl Boomy INAINM 113 $01JPNOUT& 6 M uIK MUIMII EDit (OM6) (foal) (OM1) A. L..immin I*iniii I) Plaqetag a borgium Mn..Tlll U fl rrMtl u _ a_^~~~~~~~~~~~~~~. "e w, wereB _te qllr coa ul n"L ploisg eleee) 1POM M U 1) EiilihO h.ai Is teaglet I. .raietiee pI.gie Llir. c t.r sIKe asaare ) il iefetii_ ,i_reae 6 effia" (2 PMr pr) to to daelap treijig programs for with apprwrits ledutrial ) ( pabiasti_es parledi^les ato.) editlee to amhbe and SIO sltff. to partnlapate in eatuI Gatg.gsm, Graeal.tivae to amipr J 2) *eyaigitiae Of muIti-proagniag U0 "aiastap C_eag. tranile. ga _u gt prasiel l daigatretive polieD.. prarM ) _mputer with, psriperai 1qulipmat 2) Icresams pdofauiael staff eble*a. m_ prsaduwg gd to gbarw ) g *rlttre tg headquarte I- bra 1bee nin _ Ud t h.mlosglhs adlemu*. (3 parse. ) It_Ollti. All es to el of 0 by mi- for 1-2 _mthl _ak). 3) Adeqasitiee of *a sf1ie 25 M. a ) hicl. 2 elastrle tpwrittevg 3) ra a11 staf and ) ,sar0 _ p_rm;ar_ r, o a _ _tsir. _ftt. sadi adienat aqulpast. 4) MOMs p.llsy a pre wedarebsius te s11e progras epamostm is pbaad somma. 3. tiiz~wlwI a @ 1) Ustreprar aleiam AInieor 26 3) Trsatg prram gmr JIM togae_ *- s aats to dwelsp tralinig program professioa.l setae with epr p *rrwi for *qdaetuy *s MI t_re and rasara. Vite Ledstrial *sts_i_e lualataga oftaalaatlaea iLesldLeg working ) 13 aub_sis - pgelr_ 2) Usst tons. adviaos to as"lat loo aewigao ad abwtl tsarm ef ) diaci_ ai rtferrl4 9INK aRSpet. Vaiee aPeSILetS relavevat l a lt net gb-samtare ) IJ auprt prmclas: e.g. quLity emenl. pechalam. (15 parese-mtha). 3) astrraparg tialog; prad" t adaptatie.i *-Ct soueg"a.t A) _estS prILti aid set. 3) &gLsata to tt 6 Nib sabasi. 3) hUM will establish lib btlaan Ell ad _ Prt tradiss coaaatis. C. _gm alable tfd wn lme ta b r S 2 U3 B!"901FUNNICASic OMW Woomrera. ouilcatiea of cataleg 10 b} Iciei- * t Put-fAs d dat bam, bae gad he_thua med etber elotod ressue"a, pablinetlo. trsaing an primay am _asdery actIvitist to bhelp ElI's a rt materiala, tc. data fr_swe," _ s tbr prE_tis. 2) s1wg aqiumat PM"" for ash 260 eree f. t aab h attics imasludgs _a Cs tar 2) Doe"Iee fltrfa with lattat Zualt, prila. etba *ibba*a batese gim e ad 6) lsa IPaa A yt to dsi l tur toner Uas_ to pw_t asb- a *.pwt5 fess rr _ate r tyw system to link all M O fies; . e asalratle OM Seea" arre"gs- to 6a 0 eB teff J. headquateCo campr; am type- mats band o aimp I wit_.: as pbatscapie; am, audio- urfls . todata kgss. ela a.dt ebruvisual packsga (33 -. comrve. 3) aga-torleAd data dismaL- aIar5a a"f rssus,sLg to "seLot prejeater. pertable ~anus. TV ashes ef adhahsl ad voaet lm 415"IeU Ugdad dates bhea comers. ICR. TV masswl MM aieteaeW isfosagtian to ams "hog ad to presses use of Computer csbiegt)& tm ofgf vn ebicles. 3 l leetrlal _a_*Mi 97st_m, As appropriae by SK. Tsta pashag net - 6b.ab. L-M ftT e prebla dgW L) Er Lrt acesat I[to load Cat r isn Abara ed NeW[ as passrt o* mami 2) as1 anatiag napebility 145 sa WIst -ackagee _rri to Resume rle_ma t 145a1er pmpck =rethe, n_Ilt_u to 3) hedntliy Lprsu nmt. mire MI& spsnaliad pr'edt d1elea t. tratar essagmat. mabtiug aid of te o"e. dLvsrsif ties 1'5 ta=ia preblin 5 ce.t-sba#le heal. go Tatel e Si I .105.0S0  - 31 - 4.26 The proposed project component will assist in the implementation of the new development strategy of SIDO (para. 4.24) with a modest beginning. It will provide assistance to SIDO over a three-year period to (i) develop a decentralized organization structure and strengthening management and staff capabilities; (ii) develop an effective extension service through six branch offices; (iii) develop a computerized information system (a) to monitor and manage the decentralized technical extension program; and (b) to meet the information needs of SMI and promote inter-firm production and marketing linkages; and (iv) develop an efficient system including a financial mechanism to promote other specialized institutions and private consultants in assisting SMI. The impact of SIDO's new development strategy as well as the range and cost-effectiveness of its overall activities, including the role of two demonstration centres at Gaziantep and Ankara, will be reviewed by the Government with SIDO in mid-1987 and in end-1988 (which would be the middle and end respectively of the implementation of the TA component of the project) and the findings and conclusions will be discussed with the Bank with the objective of adjusting/redirecting the strategy and future activities of SIDO, if necessary. 4.27 The major elements of this project component (see Chart 1 for summary description) include advisory assistance, overseas training for SIDO management and staff, equipment and reference information, materials and funding for consulting assistance for SMI firms to resolve complex and specialized problems. The foreign exchange cost of the project component is estimated at $1.25 million. The local currency needs of SIDO to implement the project component, and to meet its operating costs are estimated at TL 330 million in constant 1985 prices. 4.28 The proposed work program will be a substantial addition to SIDO's existing activities involving significant increases in its branches and staff, introduction of a new computerized information system, provision of extension services, promotion of sub-contracting, etc. To ensure that the technical assistance component of the project is adequately implemented and that the expansion of SIDO activities is carried out on schedule, a supplementary project monitoring procedure will be instituted in addition to normal project supervision as follows: (i) copies of final reports by foreign advisors to SIDO will be sent to the World Bank for review and conmment; briefing and debriefing sessions will be held with the advisors as appropriate; (ii) SIDO will prepare a semi-annual progress report for the World Bank; (iii) SIDO will prepare a more complete annual report detailing activities, expenditures and results as related to the annual goals under the program; and (iv) SIDO will maintain separate accounts for the expenditures under the proposed technical assistance component. These accounts will be audited and submitted together with the annual accounts of SIDO for the Bank's review. 4.29 Assurances were received from the Government during negotiations that it will provide to SIDO all the funds necessary to implement the above program and will commit SIDO to implement the new development strategy, build up its organization structure including branch offices, hire and train additional staff, introduce new information system and procedures, implement the technical assistance component of the project according to an agreed timetable and submit periodic reports on the implementation of the project.  - 32 - V. MAIN FEATURES OF THE LOAN A. The Borrower and Loan Conditions 5.01 Lending and Relending Arrangements: The Government will be the borrower of the proposed loan of US$100 million. The Government will onlend the respective loan amounts to SYKB and HB, including the technical assistance component of US$350,000 to HB, and transfer the technical assistance funds of US$1.25 million to SIDO. The Government will repay the loan to the Bank over a fixed period of 15 years including a grace period of 3 years. SYKB and HB will make subloans normally of 8-10 years but in no case more than the loan maturity period. They will repay the loans to the Government commensurate with the aggregate amortization schedule of individual subloans. HB will repay the technical assistance component of US$350,000 over 15 years. The Government will be responsible on behalf of SIDO, for the repayment of technical assistance component of US$1.25 million. The execution of subsidiary loan agreements, acceptable to the Bank, between the Government and SYKB and HB, will be a condition of loan effectiveness. 5.02 Interest Rates and Foreign Exchante Risk: As elaborated in paras.3.13 and 3.14, the proceeds of the Bank loan will be onlent to sub-borrowers either under FERIS or in foreign exchange. Under FERIS, the Government will lend Bank funds to SYKB and HB at a fixed rate equal to the onlending rate to sub-borrowers minus the intermediation cost of 42. Alternatively, Bank funds would be lent in foreign exchange.to SYXB and EB at a fixed interest rate equal to the then prevailing Bank rate plus 0.75S to compensate the Government for bearing the risk arising from the variability of the Bank's interest rate. The onlending rate to sub-borrowers will be fixed at 5S above the Bank rate prevailing at the time of sub-loan approval. The onlending rates to sub-borrowers would be positive in real terms over the life of sub-loans based on projected inflation (para. 3.09).. These arrangements would ensure that onlending rates are: (i) free of any subsidy from the Government, (ii) comparable to interest rates on other similar funds in Turkey, and (iii) provide a reasonable spread to SYKB and HB. 5.03 Free Limit: In view of the generally satisfactory quality of project appraisal under the textile and labor-intensive industry projects, SYKB's free limit for subloans is proposed to be US$1.25 million; all subprojects above this limit will require prior approval of the Bank based on a full review of their viability to be submitted by SYKB in the form of an appraisal report. On the basis of experience under the labor-intensive industry project and the project pipeline of SYKB, it is estimated that the total number of subprojects to be financed by SYKB would be about 200 of which about 101 by number and 351 by amount would be above the free limit. While all SSI subprojects would be below the free limit, about 502 of the subprojects in MSI category wolild be above the limit and would require the Bank's prior approval. 5.04 The free limit for HB's portion of the loan is proposed to be kept at a low level of US$150,000 because it would be financing small subloans and this would be the first Bank loan to HB. Also, EB will submit for the Bank's approval the appraisal of the first five subprojects irrespective of the sub- loan amount. This would give an opportunity to the Bank to review the quality  - 33 - of project appraisal of HB and to provide necessary advice and guidance to its staff at an initial stage. In addition, HB will make available to the Bank's supervision missions 10X of the subprojects with loan amounts of US$100,000- US 150,000, to be identified by the Bank's staff, for an ex-post review. It is estimated that HB will use the loan proceeds to finance about 500 sub- projects of which 10X by number and 30X by amount would be above the free limit. 5.05 Closing Date: On the basis of resource requirements of, and the expected pace of utilization of loan proceeds by SYKB and HB, the last date for submission of subloan applications to the Bank will be June 30, 1988; the last date for submission of applications will not apply to the technical assistance component. The closing date of the loan will be June 30, 1992. B. Procurement and Disbursements 5.06 The subloan proceeds of US$98.4 million (US$80 million for SYKB and US$18.4 million for HB) will be used to finance the full costs of acquiring imported machinery and equipment (including the foreign costs of know-how acquisition, commissioning and training costs incurred with the initial investment) and the initial stock of imported raw materials and spare parts. In addition, Bank funds will be used to finance 70X of the cost of imported machinery and equipment procured off-the-shelf in the domestic market, and to finance 50Z1' of the cost of domestically produced machinery and equipment, net of taxes, reflecting the imputed import content of such items. The technical assistance component of US$1.6 million (US$1.25 million for SIDO and US$350,000 for HB) will be used to finance the full cost of imported equipment, engaging the services of advisors and consultants and foreign training of SIDO and HB staff. 5.07 The procurement procedures will be consistent with those provided under the labor-intensive industry project. SYKB and HB will require their sub-borrowers normally to obtain at least three bids from suppliers eligible under Bank guidelines. However, small items costing less the' US$10,000 and proprietary items will be purchased by direct contracting. Goods and services will be procured by SIDO through international shopping or ICB in accordance with Bank guidelines. 5.08 The estimated disbursement schedule of the loan is g ren in Annex 5. This is based on actual disbursement profiles of the IDF sub-sector in the EMENA Region for 1974-83. Disbursement of funds will normall- be done against standard documentation. A Special Account (Revolving Fund) will be established in the name of the borrower (i.e. the Government) and it will have 1/ The last labor-intensive indu;stry project had provided for the financing of 40X of the cost but it is now proposed to be increased to 50Z because the devaluation of TL has been higher than domestic inflation in the last four years, thus increasing the imputed import content by at least 10 percentage points.  - 34 - sub-accounts for SYKB, HB and SIDO for disbursement purposes. An amount of US$6 million will be initially deposited by the Bank in the Special Account. The Account will be maintained in US dollars. 5.09 As a large number of subloans of HB will be very small in size with only one contract of up to US$20,000, Statement of Expenditures (SOE) will be used for reimbursements of contracts of up to US$20,000. SYKB and HB will submit a monthly SOE giving information on amounts of individual subloans, amount of payments, purpose of loans, name and address of machinery suppliers, and the country of origin of the machinery. All supporting documents for disbursements covered under SOE will be made available on request, to the Bank's supervision missions. Also, an independent auditor will verify all SOE and the Special Account within five and six months respectively for SYKB and HB after the end of each of their financial year and his report will be submitted to the Bank. C. Status of Project Preparation 5.10 Both SYKB and HB have a well-developed project pipeline and sub-loan commitments are expected to commence immediately upon loan effectiveness. HB has employed and trained additional professional staff for the immediate needs of its Industrial Credit Department. The terms of reference of the study for the institutional strengthening of HB have been agreed and the selection of consultants is expected to be completed by June 30, 1986. SIDO has already got core staff in position and does not foresee any difficulty in the recruitment of additional staff to implement the technical assistance program for SMI. The terms of reference for the advisors to be employed by SIDO under the project have been agreed and their selection would be made in accordance with the timetable agreed during negotiations. D. Reporting 5.11 SYKB will submit to the Bank periodic reports, as under the labor-intensive industry project. These reports will include summary of operations, progress on utilization of loan and annual accounts and audit reports. Similar reports will also be submitted by HB. SIDO will submit quarterly reports on the progress in implementation of various components of TA program for SMI. SYKB, BB, and SIDO will also submit a project completion report. E. Project Benefits and Risks 5.12 The project will support the development of labor-intensive SKI in which Turkey has comparative advantages. This would, in turn, create productive jobs at relatively low cost and contribute to exports of manufactured goods. Although the maximum limit for the cost per job (excluding land and buildings) is US$18,000, it is estimated, based on the experience under the labor-intensive industry project, that the average cost would be about US$16,000 as compared to the average of US$120,000 in the manufacturing sector as a whole. Thus, about 18,000 direct jobs will be  - 35 - provided by subprojects to be financed under the project. The project would also use, for the first time, HB as a financial intermediary which has branch offices all over the country. As a result, investment funds would become accessible to SSI and artisans located outside the main urban centres. This would contribute to a balanced industrial development at the regional level. The project would also assist HB in developing the project appraisal and supervision capability and to promote its developmental role as well as its overall institutional strengthening and efficiency improvement through technical assistance. The role of HB in the project is of a pilot nature but, based on a satisfactory experience, HB can play a much bigger role in the Bank's future assistance to SSI. Technical assistance for SMI would initiate the development of institutional capability in Turkey to provide extension services to SMI and to facilitate sub-contracting on a national basis. This would result in improved productivity and efficiency of SMI and the development of a much-desired complementary relationship between SSI and larger industries. Upon the completion of the TA program, SIDO would be able to provide assistance and guidance to about 350 SMI enterprises, train about 200 entrepreneurs and to develop about 900 company profiles per year. 5.13 The project risks relate to mainly two areas: meeting of investment targets by the intermediary banks and implementation of technical assistance by SIDO. The private sector investment situation has been uncertain in Turkey in the recent past mainly due to very high real interest rates on working capital loans, adverse effects of large devaluation of Turkish Lira on the debt-servicing burden of enterprises which had carried exchange risk on their foreign currency borrowings, and slow recovery of domestic markets in many industries. The Government's policies for the promotion of private sector investment, the emphasis on development of industries with comparative advantages in export markets, and the FERIS scheme have helped to revive the private sector investment. A reversal in this situation may slow down the investments by SYKB and HB and the utilization of the proposed loan. However, the present Government is fully committed to the promotion of the private sector. Also, the proposed loan is expected to meet only a part of demand for funds on SYKB and HB (paras. 4.19 and 4.46). It is therefore unlikely that SYKB and HB will experience significant delays in the utilization of the proposed loan. As regards SIDO, it has been operating in only two areas of Turkey with a relatively s:iall staff who have generally limited practical experience. Also, the equipment and information resources at SIDO are inadequate. These factors introduce an element of risk in the proposed technical assistance component of the loan which would require substantial increase in staff and tax the management resources of SIDO. However, as the designated Government unit to provide technical assistance to SMI, SIDO is the logical choice for strengthening. The activities outlined under the technical assistance component are designed to improve the administration capabilities and services of SIDO for SMI, and to further enlarge the scope of SIDO's efforts through the backup resources of other organizations. In addition, the Bank staff would need to cli ely monitor the implementation of technical assistance and SIDO's activi:ies. The risks are therefore reasonable and should be accepted considering the potential benefits of the project.  - 36 - VI. AGREEMENTS AND RECOMMENDATIONS 6.01 The Bank has reached agreement with the Government, SYKB, and HB on making a loan of US$100 million. The Government will (i) onlend US$80 million to SYKB and US$18.4 million to HB for onlending to eligible enterprises in the industrial sector in Turkey (para. 4.01), (ii) onlend US$0.35 million to HEB for the preparation of a study for its institutional strengthening and improvements in efficiency and staff training (para. 4.17), and (iii) allocate US$1.25 million to SIDO to implement the program of technical assistance to SKI enterprises (paras. 4.22-4.29). 6.02 Agreement was reached with the Government on the following main points: (i) The Government will implement the TA program for SMI through SIDO (paras. 4.22 to 4.29). (ii) The Government will make the necessary funds available to SIDO for implementing and operating the TA program for SMI (para. 4.29). (iii) The impact of SIDO's new development strategy as well as the range and cost-effectiveness of its overall activities, including the role of two demonstration centres at Gaziantep and Ankara, will be reviewed by the Government with SIDO in mid-1987 and end-1988 and the findings and conclusions will be discussed with the Bank with the objective of adjusting/redirecting the strategy and activities of SIDO, if necessary (para. 4.26). (iv) The repayment term of the loan will be 15 years including a grace period of 3 years (para. 5.01). (v) The proceeds of the Bank loan will be onlent to sub-borrowers either under FERIS or in foreign exchange. Under FERIS, the Government will lend Bank funds to SYKB and HB at a fixed rate equal to the onlending rate to sub-borrowers minus the inter- mediation cost of 4%. Alternatively, Bank funds would be lent in foreign exchange to SYKB and HB at a fixed interest rate equal to the then prevailing Bank rate plus 0.75Z to compensate the Government for bearing the risk arising from the variability of the Bank's interest rate. The onlending rate to sub-borrowers will be fixed at 5% above the Bank rate prevailing at the time of sub-loan approval (para 3.14). (vi) The Government will sign, before loan effectiveness, subsidiary loan agreements with SYKB and HB, acceptable to the Bank (para. 5.01). 6.03 Assurances have also been received from the Government to ensure that SIDO implements the technical assistance program which would include the appointment of advisors and additional staff in SIDO, staff training, procurement of equipment and reference material, establishment of branches, strengthening of extension activities, development of information system, provision of technical advisory services, and submission of periodical reports to the Bank; as elaborated in paras. 4.22-4.29 and Annex 4.  - 37 - 6.04 Agreement was also reached with SYKB and HB on the following points: (i) The following definitions will be used for SSI and SMI enterprises (para. 4.10): (a) SSI - Fixed assets, excluding land and buildings, up to US$500,000 for new projects and US$650,000 for expansion projects. (b) SMI - Fixed assets, excluding land and buildings, up to US$2.5 million for new projects and US$3.5 million for expansion projects. All values are in 1984 prices and would be adjusted according to the international inflation index. (ii) All enterprises eligible for financing under the proposed Bank loan would be labor-intensive with an average capital investment (excluding land and buildings) not exceeding US$18,000 per job in 1984 prices (para. 4.10). -iii) SYKB and HB will onlend the loan proceeds to eligible enterprises for terms not exceeding 15 years including a grace period of up to 3 years (para. 5.01). (iv) The loan repayment by SYKB and HB will be according to the aggregate amortization schedules of individual sub-loans, except for the technical assistance of US$350,000 for HB will be repaid in 15 years including a grace period of 3 years (para. 5.01). (v) SYKB will use at least 80% of its share of loan proceeds to finance SMI and within the above limit it will use at least 30X of loan proceeds for onlending to SSI (para. 4.10). HB will use its share of loan proceeds for onlending exclusively for the financing of SSI and at least 70% of the above amount will be channelled to very small SI, i.e. enterprises with fixed assets, excluding land and buildings, not exceeding US$200,000 (para. 4.21). (vi) The free limit will be US$1.25 million for SYKB (para. 5.03) and US$150,000 for HB. The first five sub-projects of HB will be treated as above the free limit irrespective of their size (para. 5.04). (vii) The last date for submission of sub-loans will be June 30, 1988, and the closing date will be June 30, 1992 (para. 5.05). (viii) ERR and FRR will be calculated by SYKB for all sub-projects with total investment cost of above US$750,000. The minimum ERR will be 12% and minimum FRR will be not less than the Central Bank's rediscount rate for the industrial investment loans at the time of subloan approval (para. 4.11).  - 38 - (ix) The debt/equity limit of SYKB will not exceed 10:1 during the life of the loan (para. 4.06). (x) HB will carry out the program of its institutional strengthening and efficiency improvements through appointment of additional staff, training of staff and an in-depth review of its institutional structure (para. 4.16-4.17). (xi) HB will submit its annual audited financial statements to the Bank within six months of the end of each year. (xii) SYKB will submit its annual audited financiai statements to the Bank within five months of the end of each year. 6.05 The proposed project is ruitable for a Bank loan of US$100 million on the terms and conditions outlined above.  - 39 - Annex 1 page 1 of 2 TURKEY SMI PROJECT Relevant Industrial Studies and Reports 1. Turkey: Country Economic Memorandum (in 2 volumes), IBRD, June 1983 (Report No. 4287-TU). 2. Turkey: Special Economic Report for the Financial Sector, IBRD, September 1983 (Report No. 4459-TU). 3. President's Report for SAL V, IBRD, May 24, 1984 (Report No. P-3783-TU). 4. Turkey: Public Sector Investment Review (in 3 volumes); IBRD, December 1981 (Report No. 3472-TU). 5. Turkey: Industrialization and Trade Strategy (in 3 volumes); IBRD, February 1982 (Report No. 3641-TU). Also available in published cussntry study. 6. Turkey: Development Prospects for Small - Medium Scale Industry and Potential for Urban Employment Generation (in 3 volumes), IBRD, September 1980 (Report No. 2913-TU). 7. OED Special Study - Sector Operations Report: The Industries and DFCs Program in Turkey, 1980 (Report No. 3077-TU). 8. Bertil Walstedt, State Manufacturing Enterprise in a Mixed Economy: The Turkish Case; John Hopkins University Press, 1980. 9. J. Lewis and S. Urata, Turkey: Recent Economic Performance and Medium Term Prospects. 1978-1990; World Bank Staff Working Paper No. 602; 1983. 10. K. Dervis and S. Robinson, Foreign Exchange Gap, Growth and Industrial Strategy in Turkey: 1973-1983; World Bank Staff Working Paper No. 306; 1978. 11. Turkey: Policies and Prospects for Growth, published World Bank Country Study; March 1980. 12. B. Balassa, Outward Orientation and Exchange Rate Policy in Developing Countries: The Turkish Experience, August 1982. 13. A. Krueger and B. Tuncer, Microeconomnic Aspects of Productivity Growth under Import Substitution: Turkey, NBER Working Paper No. 532, August 1980.  - 40 - Annex 1 page 2 of 2 14. A. Krueger and B. Tuncer, Estimating Total Factor Productivity Growth in a Developing Country, March 1980. 15. F. Yagci, Macro-Micro Link in Policy Modelling: Suggestions for the Turkish Economy, World Bank Development Research Department, April 1983. Source: Bank Staff EMENA/IDF March 1985  - 41 - TURKEY Annex 2 SMI PROJECT Sinai Yatirim ve Kredi Bankasi (SYKB) (i) Institutional Aspects 1. Establishment and Ownership: SYKB was established in 1963 by five major commercial banks in Turkey; namely Is Bankasi, Akbank, Garanti Bankasi, Osmanli Bankasi and Vakiflar Bankasi, to meet the investment financing needs of the private industrial sector. The paid-in capital of SYKB is TL 2,000 million of which 60X is owned by Is Bank -the largest bank in Turkey- and the remainder is equally divided among the four other banks. 2. Board: SYKB's Board consists of six members. Mr. Cahit Kocaomer, who represents Is Bank, has been the Chairman since February 19i6. The other 5 members are the representatives of the four remaining shareholder banks ane SYKB's General Manager, Mr. Orhan Altan. 3. Organization: Project identification, appraisal and supervision are undertaken by the Financial Analysis, Technical, and Economic Study and Research Departments. Resource mobilization and loan administration including legal and insurance aspects are handled by the Loans Department and accounting matters are carried out by the Accounting Department. There have not been any changes in the overall organization of SYKB since its appraisal in 1980 by the Bank for the labor-intensive industry project (SAR 3189-TU) and its organizational structure (Attachment 1) is satisfactory. 4. Magement and Staff: The general manager, Mr. Altan, appointed on January 1, 1979, is a competent chief executive and has gradually transformed SYKB into a dynamic and development-oriented financial institution. The Assistant General Manager, Mr. Omer Kizilkaya, provides support and continuity in management. The total professional staff of SYKB was 49 in December 1984, including 9 engineers and 24 economists/financial analysts. The staff is experienced and turnover has been very low. SYKB has been increasing its professional staff according to its operational needs. The staff has been provided with adequate training in project appraisal and supervision. SYKB plans to increase its staff gradually and the total member of engineers and economists would reach to 54 by 1988. This would be adequate to meet projected operational requirements and no difficulty is foreseen in the employment and training of additional staff. 5. Policies: SYKB adopted a policy statement in January 1979 which ensures sound lending operations. The statement provides, inter alia, for conducting sectoral and sub-sectoral studies to identify priority development areas and viable projects with high economic priority. It further stipulates that SYKB will finance projects whose majority control is vested with the private sector and provide up to 602 of the fixed investment cost of the project; its total exposure in an enterprise will not normally exceed 20% of its own equity; equity investment will not exceed 25% of the enterprise's capital and 10% of its own equity; and it will not carry foreign exchange risk. SYMB follows conservative though reasonable collateral policies.  - 42 - 6. Procedures: SYKB's appraisal procedures are satisfactory as indicated by the review of subprojects financed under the Bank's loans for the textile industry (Loan 1755-TU) and labor intensive industry (Loan 1952-TU) projects. Appraisal includes assessment of the management capability and credit-worthiness of the applicant and economic, technical, marketing and financial viability of the proposed project. As regards supervision, SYK5B's staff makes periodical visits to projects and monitors the cost and financing of projects under implementation and the financial performance of projects in operation. There is, however, scope for further strengthening of the project supervision by increasing the frequency of visits to projects under implementation (at least once every six months) and monitoring non-financial aspects of projects (including physical implementation and technical and marketing aspects) as provided in the supervision system agreed under the labor-intensive industry project. SYKB agreed with the appraisal mission to carry out above improvements and this was reconfirmed during loan negotiations. 7. SYKB's procurement procedures are designed to ensure economy and efficiency. Normally at least three bids from suppliers in different countries are required for purchase of imported goods. For local procurement, adequate domestic shopping is required. These procurement procedures are consistent with those adopted by other Bank assisted DFCs providing loans to SMI and are considered satisfactory. Disbursement procedures are also satisfactory. Dii) Operations 8. Overall Operations; Approvals, commitments and disbursements of loans and equity investments for 1980-1984 are given in Attachment 2. Total loan approvals of SYKB have increased from TL 2,765 million for 29 projects in 1980 to TL 16,782.9 million for 83 projects in 1984, i.e. 57% p.a. in nominal terms. The increase in real terms during the period was 14X p.a. and the number of projects almost trippled which is quite impressive. Local currency loan approvals were 33% of total loans during the 1980-1984 period, and their relative share has decreased from 38% in 1980 to 13% in 1984 mainly because of the availability of new foreign currency resources to SYKB. The foreign currency loans increased from US$17.4 million (13 in number) in 1980 to US$22.0 million (46 in number) in 1982 but declined to US$18.1 million (41 in number) in 1983 due to reluctance of sub-borrowers to accept foreign exchange risk (para 3.10). Commitments were also low in 1983 (56X of approvals) for the same reason. Foreign currency loan approvals, however, increased to US$37.7 million (66 in number) in 1984 with the introduction of the Foreign Exchange Risk Insurance Scheme (FERIS) (para 3.10 in text). 9. Structure of Operations: Analysis of SYKB's loan approvals during the 1980-1984 period by sector, geographical location, size, repayment terms and type of projects is giveit in Attachment 3. During this period, the main beneficiaries of SYKB's loans have been textile (36%), food (14%), chemical (12%), and clothing (10%) industries. Fixed investment loans were 40% and 60% for expansion and new projects respectively, and 48% of the loans approved were for sub-projects of above US$1 million each in 1984. SYKB's own contribution to the total fixed investment in its assisted projects was 46% in 1980, 41% in 1981, 75% in 1982, 35% in 1983 and 59% in 1984; the balance of  - 43 - funds coming from equity sources and other borrowings. With the availability of foreign currency funds under the Bank's textile project (Loan 1755-TU) and labor-intensive industry project (Loan 1952-TU), SYKB's own contribution in project financing increased in 1982. It decdlned in 1983 due to borrowers' reluctance to accept foreign exchange risk but again picked up in 1984 with the introduction of the FERIS. 10. Development Impact of SYKB's Operations: SYKB's promotional activities include the identification and development of and assistance to SMI projects of high economic priority. In order to achieve the above objective, SYKB has completed studies of various industrial sub-sectors, including textile goods, exports, forest products processing industry, meat processing industry, and marble extracting and processing industry. The above studies have led to the identification and financing of a large number of sub-projects, some of which are export-oriented. Currently, SYKB is undertaking studies of electro-mechanical industry and treatment of leather products. SYKB has continued financing priority projects which have obtained Certificates of Encouragement from the Government. SYKB's loan approvals for projects located in the semi-developed and less-developed regions of Turkey have increased from TL 1.9 billion in 1980 to TL 6.6 billion 1984, but have declined in real terms reflecting general reluctance of investors to develop projects in these areas as Government priorities have favored exports for which these areas are less suitable. The projects assisted by SYXB have high labor-intensity, particularly in more recent years. It is estimated that about 26,000 direct jobs would be created by projects which received loans from SYKB for fixed investment during 1980 - 1984 period, with an estimated average cost per job (excluding land and buildings) of US$19,726 in 1980, US$20,720 in 1981, US$7,975 in 1982, US$11,111 in 1983 and US$8,247 in 1984. 11. Bank-financed Operations: SYJB has so far received two loans of US$15 million (Loan 1755-TU) and US$40 million (Loan 1952-TU) from the Bank in support of the development of textile industry and labor-intensive industry, respectively. Due to reluctance of firms to incur foreign exchange risk, the last date for loan coamitments under the textile projects was extended twice. With the help of the 1984 FERIS, it was almost entirely comitted by December 1984. The last date for commitments under the loan for labor-intensive industry project was also extended by one year to December 31, 1984 for the same reason. This loan has also been couitted rapidly after the introduction of FERIS. At least one-third of the loan for labor-intensive industry was earmarked to finance SSI sub-projects defined as enterprises with assets, excluding land and buildings, not exceeding US$350,000 in case of new sub-projects, and US$500,000 in case of expansion of sub-projects 1/. 12. SYKB has approved 112 sub-projects (net of cancellations) with a total amount of US$39.5 million (99Z) up to December 31, 1984 under the Bank loan for labor-intensive industries. About 38Z of the loan amount has been approved for SSI sub-projects. Sub-loan disbursements as of the same date have amounted to US$17.5 million 2/ which corresponds to 144 of the total loan amount. Sub-projects assisted under the loan would create about 8,600 jobs at 1/ December 31, 1980 prices. 2/ US$9.4 million for SSI and US$8.1 million for non-SSI.  - 44 - an average cost of US$8,700 each (excluding land and buildings) 1W. The major industrial sub-sectors which have been beneficiaries of Bank-funded loans are textile, chemical, machinery, food, metal products, and marble industries. The majority of projects have been located in Istanbul (41X), Bursa (92), Izmir (6S), and Tekirdag (52). The ERR and FRR were calculated for subprojects with fixed investment of above US$750,000 each and these ranged between 16S to 452 and 19.6S to 54X respectively. SYKB's performance in utilizing the loan as reflected by good quality of subproject appraisal, financing of a large number of SSI subprojects and low cost per job has been very satisfactory. (iii) Financial Situation 13. Profitability: SYKB's income statements for 1980-1984 are given in Attachment 4. Net income increased from TL 112 million in 1980 (222 of equity) to TL 832 million in 1984 (32S of equity). SYKB's administrative expenses in relation to total assets have stayed at around 21 between 1980-1984 which are satisfactory. SYKB's average interest spread for the last few years has been about 101 p.a. The high interest spread is mainly due to charging of interest from the date of loan commitments and special treatment of interest on loans from shareholding banks. Until 1976, these loans carried an interest rate of 111 per annum but, in 1977, the shareholding banks made them interest free and elected to take the return in the form of higher dividends on their equity investment. The interest spread is, however, projected to decline in future years and would be 6.51 by 1988. SYRB's payout ratio (relationship of dividend payments to net profit after tax) has gradually increased and was 77:23 in 1984 as compared to the limit of 82:18 permitted by SYKB's Articles of Association. The actual returns to shareholders in nominal terms on their capital and loans to SYKB have gone up from a low of 11X in 1980 to 32Z in 1984 which are still fairly low, compared to interest rates on term deposits or other financial instruments in Turkey. 14. Financial Position: SYRB's Comparative Balance Sheets for the years ending December 31, 1980 - 1984 are given in Attachment 5. Total assets increased, in current prices, from TL 4,169 million at the end of 1980 to TL 34,867 million at the end of 1984. In nominal terms they increased by over 7002. The paid-in capital has increased from TL 400 million at the end of 1980 to TL 2 billion at the end of 1984 with the biggest increases occurring in 1983 and 1984 by TL 400 million and TL 1200 million respectively. The long-term debt/equity ratio has gone up from 4.2:1 at the end of 1980 to 8.E:1 at the end of 1984 which is within the maximum limit of 9:1 agreed with the Bank under the labor intensive industry project. At the end of 1984, the current ratio was 1.9:1 and showed a satisfactory liquidity position. 15. Resource Mobilization: The long-term resource position of SYKB as of December 31, 1984 was as follows: 1/ It was agreed under the loan (No. 1952-TU) to limit the maximum investment cost (excluding land and buildings) per job created to US$15,000 in December 1980 prices.  - 45 - Table 1: SYKB: LONG-TERM RESOURCE POSITION AS OF DECEMBER 31, 1984 Local Currency Foreign Currency (TL millions) ($ '000) Sources: Paid-in Capital 2,000.0 - Reserves 6 Surpluses 338.0 - Provision 844.0 - Revaluation Gains 311.0 - Retained Earnings 832.0 - Loans from: Central Bank Credit 3,707.0 - EIB - 11.4 Eximbank - 0.1 IBRD Textiles - 14.9 IBRD Labor Intensuive - 40.0 Total Sources 8,032.0 66.5 Apulications 6.662.2 36.0 Surplus/ (Deficit) on Disb. basis 1,369.8 30.5 Amount Comitted but not yet disbursed 69.6 29.7 Surplus/ (Deficit) on Comuitmnent basis 1,300.2 0.8 Amount Approved but not yet Comitted 2,204.5 0.3 Surplus/ (Deficit) on Approval basis (904.3) 0.5 As can be seen from the above table, SYBD's major sources of local currency funds are loans from the Central Bank uwder its discount facility followed by paid-in capital, and provisions and reserves. Although SYKB's local currency loan approvals exceeded its resources as of December 31, 1984, the shortfall could be covered through the fuller utilization of discounting facility of the Central Bank and loan recoveries. The major utilised foreign currencies resources are from the World Bank (Textile US$15 million, Labor Intenswive US$40 million) and from EIB (US$11.4 million). S7KB's foreign currency resources exceeded the loan approvals by only a small amount of US$0.5 million as of December 31, 1984. 16. Quality of Portfolio: SYXK's arrears situation is given in Attachment 6. Although SYKB'8 arrears have increased over the years, they are still on the low side. Arrears and loans affected by arrears of more than three months were 2.51 and 14.71 respectively of the total loan portfolio on December 31, 1984. The loan portfolio is well spread among different industrial sub-sectors and a large portion (70X) is secured by bank guarantees. The quality of the loan portfolio is, therefore, good. SYRB has agreed under the textile project to retain at least 5% of its net annual income as a provision for bad and doubtful loans and investments up to a maximum of 2S of its loan and equity portfolio. It has been complying with this loan condition and its provisions amounted to TL 844 million at the end of 1984. 17. Audit: SYKB's audit has been performed satisfactorily by Muhas, a local audit firm in cooperation with Price Waterhouse, an international audit firm, and it has given an unqualified audit report.  - 46 - (iv) Future Operations and Prospects 18. Operational Forecast; SYKB's operational projections for the 1985 - 1988 period are given in Attachment 7. The loan approvals are projected to increase at an annual average rate of about 41% in current prices or 8% in real terms. SYKB's loans will form about 3% of the estimated total private sector investment in the industrial sector in 1985-88 and it is considered a reasonable target in view of the lending operations of SYKB in recent years. The project pipeline of SYKB as of December 31, 1984, consisted of loan applications for US$35.37 million equivalent in foreign currency and TL 1.85 billion in local currency. The projects included in the pipeline are mainly in textile (35Z), food (17%), chemical (11X), clothing (10%), and machinery(8Z) subsectors. Foreign currency loan approvals are projected at US$25.3 million (60 in number) in 1985 (US$37.6 million in 1984) and are estimated to increase to US$70.5 million (110 in number) in 1988. The projected foreign currency loan approvals also include sub-projects in the SKI sector to be financed during 1986-1988 under the proposed Bank loan (US$80 million). SYKB's local currency loan approvals are expected to increase from TL 5.9 billion (18 in number) in 1985 to TL 14 billion (42 in number) in 1988, an increase of 33% p.a. in current prices or 3% in real terms. The equity investments of SYKB are expected to remain low (TL 500 million in 1985) and would increase at an average rate of 17X p.a. in current prices during 1985-1988. 19. Total foreign currency loan commitments of SYKB during the 1986-1988 period are estimated at US$171 million. The proposed Bank loan of US$80 million and an expected loan of USt35 million equivalent from EIB would reduce the foreign currency resource gap to about US$56 million. SYKB does not yet have firm plans to fill this gap but expects that existing and new sources (e.g. KfW) will provide additional funds. SYKB plar.s to meet its local currency requirements largely through increases in paid-in capital, borrowings from the Central Bank and internal generation of funds. 20. Projected Profitability and Financial Position: SYKB's projected income statements and balance sheets for the 1984-1988 period are given in Annexes 8 and 9. Net income is projected to increase from TL 1,103 million in 1985 to TL 6,463 million in 1988 in current prices. The return on equity is expected to increase from 32% in 1984 to 45% in 1988. The liquidity position will also be satisfactory as indicated by the current ratio of 1.12:1 to 1.23:1. SYKB's financial structure will continue to be sound with debt/equity ratio being below the 9:1 limit at least until 1987. At that stage a further increase in equity would be required and has been planned for (para 21). 21. Debt -Equity Limit: Under the Bank Loan (1952-TU), SYKB was authorized a debt/equity limit of 9:1. The projections indicate that SYKB's debt/equity ratio will remain below this limit up to 1987 and thereafter will increase to about 10:1, despite increase in equity. (SYKB's shareholoers are planning to increase their paid-in capital from TL 2 billion to TL 6 billion in 1987 and to TL 10 billion by the end of 1988). It is recommended that SYKB's maximum debt/equity limit be increased to 10:1 considering its efficient management, highly prucent financial policies and practices, satisfactory project appraisal, and sound portfolio (para 15).  TURnY SKI PROJECT SYKS - ORGANIZAMIONAL CHART I BORD OF DlRECrORSI =ASSISTANT CGRE L MANAGER F iscal AJdviserI Stam Duty Consultanti Loans Co_ittee I Seeiretey' * Of ficesI Financial~~~ ~ ~ ~ ~ Anlyi Tehnca lc studyor | on ta oto I -~~~~~~~~~~~ Fn nac ml Analys * |Techrnca Ecnoi Std l [lD~ r Accuntu. CostPronnl Dent] a Doc_oftnoion Source: SYIII Il ENKA/IDF Harch 1985  - 48 - attachment 2 snB - A4eaas. Comtet soD (TL 1W 1981 1982 1983 1904 ND. AND.t No1 hmudt NO. No. Auiut No. A ime. NoMdr CkAw