Turkey - Second and Third Structural Adjustment Loan Projects

Docum_t of The World Bank FOCR OMCL USE ONLY RepwtNt. 5763 PROGRAM PERFORMANCE AUDIT REPORT TURKEY - SECOND AND THIRD STRUCTURAL ADJUSTMENT LOANS (LOANS 1987-TU AND 2158-TU) June 28, 1985 Operations Evaluation Department ThRk dmet_ hS a rlkWd d_aftW= ad ay be eSd by re1Plets ey In the pnfoame oF tb& ged dudes lb Caut ma " ohewbe be Wdsedi wi_*ut Wodi Bak aulh.rh0k  FOR OFCIAL USE ONLY ABBREVIATIONS DSI - State Hydraulic Work DYB - State Investment Bank EDI - Economic Development Institute IMF - International Monetary Fund OECD - Organization for Economic Cooperation and Development PETKIM - Petrochemical Corporation SDR - Special Drawing Right SEE - State Economic Enterprises SPO - State Planning Organization TEI - Turkish Coal Enterprises TEK - Turkish Electricity Authority TPAO - Turkish Petroleum Corporation TL - Turkish Lira VAT - Value Added Tax IThis document has a resticted distribution and may be used by recpients only in the perfomane of tfiofficial dutile Is contents may not oterwe be discosed without Wodd Bank authoizatiomn  PROGRAM PERFORMANCE AUDIT REPORT TURKEY - SECOND AND THIRD STRUCTURAL ADJUSTMENT LOANS (LOANS 1987-TU and 2158-TU) TABLE OF CONTENTS Page No. Preface ........................................................... ......i Basic Data Sheets ........................................ ......... ii-iii Highlights . ..................... iv PROGRAM PERFORMANCE AUDIT MEMORANDUM I. BACKGROUND ............................................... I II. THE SAL PROGRAM: OBJECTIVES AND POLICIES .... ............. 2 A. The Design of SAL II ................................ 2 B. The Design of SAL III ..... ...................... 4 III. EVALUATION OF SAL DESIGN ................................. 5 A. Need for Program Aid ..... .................. 5 B. Realism of Conditionalities ..... .................... 6 C. Nonitorability of the Action Program ............... . 7 D. Complementarity with IMF Program .................... 8 IV. IMPLEMENTATION OF SAL PROGRAMS ..... ............. 8 A. Domestic Resource Mobilization ..................... 9 B. Export Promotion ................................... 11 C. Import Liberalization ..... ......................... 13 D. Rationalization of Public Investment ........... .... 14 E. Energy Sector Policy .. ............................. 15 F. Agricultural Sector Policy ..... .................... 16 G. Reform of State Economic Enterprises ... ............ 17 H. Summary on Program Implementation .... 20 I. IMF Operations ....... .............................. 21 V. MAJOR ISSUES ............................................. 21 A. Reform and Pricing Policy of the SEEs ............... 22 B. Public Investment Reform . ........................... 24 C. Financial Market Instability ..... ................... 25 D. Interest Rates and the Exchange Rate ............. ... 28 E. Medium-Term Strategy and Reviving Private Investment ........................................ 31 F. Trade Policy ........................................ 32 G. SEE Prices, Inflation, and Interest Rates ... ........ 34  TABLE OF CONTENTS (continued) Page No. VI. SUSTAINABILITY OF REFORMS ................................ 37 A. Institutional Reforms ............................... 38 B. Economic Policy ..................................... 39 C. Conclusion on Sustainability ........................ 41 VII. IMPACT OF STRUCTURAL ADJUSTMENT PROGRAM ............. ..... 42 A. Economic Growth ................. .. ................. 42 B. Balance of Payments ................................ 43 C. Financial Stabilization ............. .. ............. 45 D. Social Impact .................. .. .................. 47 VIII. ROLE OF THE BANK ......................................... 49 IX. PERFORMANCE OF BORROWER .................................. 52 X. CONCLUSIONS AND LESSONS .................................. 53 Annexes: 1. Letter of Development Policies (SAL II) .......... .. ........... 56 2. Letter of Development Policies (SAL III) ......... .. ........... 73 3. Schedule 4 of Loan Agreement (SAL II) ......................... 83 4. Schedule 4 of Loan Agreement (SAL III) ........................ 84 5. Turkey: Review of the Second Structural Adjustment Loan ...... 85 6. Turkey: Review of the Third Structural Adjustment Loan ....... 90 Attachment - Comments from Borrower ................................ 94 PROGRAM COMPLETION REPORT I. Introduction ............................................. 97 II. The Structural Adjustment Program ........................ 97 III. Monitoring the SAL Process ............................... 98 IV. Loan Impact and Implementation ........................... 113 V. Summary and Conclusions .................................. 114  - i - PROGRAM PERFORMANCE AUDIT REPORT TURKEY - SECOND AND THIRD STRUCTURAL ADJUSTMENT LOANS (LOANS 1987-TU and 2158-TU) PREFACE This is a performance audit of the Bank's second and third struc- tural adjustment loans (SALs) to Turkey. The second SAL (Loan 1987-TU, US$300 million) was approved on April 20, 1981, signed on May 15, 1981 and was fully disbursed by November 30, 1982. The third SAL (Loan 2158-TU, US$304.5 million) was approved on May 27, 1982, signed on May 28, 1982, and was fully disbursed by June 30, 1983. The audit consists of a Program Performance Audit Memorandum (PPAM) prepared by the Operations Evaluation Department (OED) and a Program Comple- tion Report (PCR), prepared by the Europe, Middle East and North Africa Regional Office. The PPAM is based on a review of the President's Reports (No. P-3034-TU, dated April 20, 1981 and No. P-3273-TU, dated May 7, 1982), the Loan Agreements, the summaries of Board Discussions, the combined PCR and related documents in the Bank's files. Bank staff associated with the SALs have been interviewed, and discussions have been held with IMF staff. An OED mission visited Turkey in July/August 1984 to review the structural adjust- ment operations with Government officials and private sector representa- tives. The valuable assistance provided by representatives of the Borrower is gratefully acknowledged. Copies of the draft report were sent to the representatives of the Borrower in April, 1985. Comments have been received from the Acting Directo--General of External Economic Relations in the Undersecretariat for Treasury and Foreign Trade; they have been reflected in the report and are reproduced as an attachment to the PPAM.  PROGRAM PERFORMANCE AUDIT REPORT TURKEY - SECOND STRUCTURAL ADJUSTMENT LOAN (LOAN 1987-TU) BASIC DATA SHEET STRUCTURAL ADJUSTMENT LOAN DATA (amounts in US$ million) Original Disbursed Cancelled Repaid Outstanding Loan 1987-TU 300 300 0 0 300 Actual or Original Loan Dates Re-estimated Initiating Memorandum 10/31/80 10/31/80 Letter of Development Policies 02/20/81 Negotiations 04/1/81 04/-/81 Board Approval 04/20/81 05/12/81 Loan Agreement 05115/81 05/15/81 Effectiveness 05/15/81 05/15/81 Loan Closing 11/30/82 Actual Completion 11/30/82 CUMULATIVE LOAN DISBURSEMENT FY81 FY82 (i) Planned 200 100 (ii) Actual 200 100 (iii) (ii) as X of (i) 100 10O MISSION DATA No.of No. of Late of Month/Year '1_ks Persons Report Appraisal 02/-/81 6 Supervision I 11/8-20/81 2 7 Superviancn II 12/07/81 2 2 12/30/81 Supervision III Supervision IV Completion FOLLOW-ON SAL OPERATIONS Turkey Third Strutural Adjustment Loan 2158-TU, approved on May 27, 1982, in the amount of US$304.5 million.  - iii - PROGRAM PERFORMANCE AUDIT REPORT TURKEY - THIRD STRUCTURAL ADJUSTMENT LOAN (LOAN 2158-TU) BASIC DATA SHEET STRUCTURAL ADJUSTMENT LOAN DATA (amounts in US$ million) Original Disbursed Cancelled Repaid Outstanding Loan 2158-TU 304.5 304.5 0 0 304.5 Actual or Original Loan Dates Re-estimated Initiating Hemorandum 10/22/81 10/22/81 Letter of Development Policies 04/24/82 04/24/82 Negotiations 05/--/82 05/1/82 Board Approval 05/27/82 05/27/82 Loan Agreement 05/28/82 05/28/82 Effectiveness 06/-/82 07/16/82 Loan Closing 12/15/83 12/15/83 Actual Completion 06/30/83 CUMULATIVE LOAN DISBURSEMENT FY81 FY82 'i) Planned 50.0 254.5 (ii) Actual 50.0 245.5 (iii) (ii) as Z of (i) 100 100 MISSION DATA No.of No. of Man- Date of Month/Year Weeks Persons weeks Report Appraisal 02/--/82 Supervision I 10/18-27/82 4 4 4 n.a. Supervision II 0'/27-29/83 1 2 Supervision III 02/28-03/83 1 4 n.a. FOLLOW-ON SAL OPERATIONS Turkey Fourth Structural Adjustment Loan 2321-TU, approved on June 23, 1983, in the amount of US$300.8 million. Fifth Structural Adjustment Loan 2441-TU, approved on June 14, 1984. in the amount of US$376 million.  iv - PROGRAM PERFORMANCE AUDIT REPORT TURKEY - SECOND AND THIRD STRUCTURAL ADJUSTMENT LOANS (LOANS 1987-TU and 2158-TU) HIGHLIGHTS During the First and Second Plan periods (1963-72), Turkey's strategy of economic development, based on import substitution with heavy protection, had provided it with growth r&tes averaging 6.6 percent annually. However, with the onset of the first oil criniq in the early seventies, and tb,e subsequent ecor-omic slow-down in OECD zountries, Turkey encountered severe resource constraints. It responded by adopting policies which relied on drawing down foreign exchange reserves and heavy short-term borrowing abroad to maintain high levels of investment and consumption. For a short time this approach succeeded in maintaining and even increasing the economic growth rate to an unprecedented 7.7 percent annually during 1973-76, which was the period of the Third Plan. The prosperity came to an abrupt halt in mid-1977, culminating in a sharp deterioration in external payments and creditworthiness, severe import shortages and disruptions in industrial production, and rising unemployment. GNP growth declined from an annual rate of 4 percent in 1977 to a negative figure in 1979 and domestic inflation accelerated over the same period from 24 pc:cent to 64 percent. Economic difficulties were aggravated by political and social unrest (PPAM, paras. i-3). The Government responded to the economic crisis by introducing major reforms if 1980 which relied more heavily on market forces and encour- aged exports in preference to production for the home market. The reform program included demand restraint to quell inflation and deregulation of interest rates to promote savings and optimize investment decisions. A realistic exchange rate was combined with fiscal and credit incentives to accelerate exports. A reform of the tax system and improved budgetary management were supported by measures to reduce the operacing deficits of the State Economic Enterprises (SEEs). Imports were selectively liberalized to promote competition among domestic producers and to enhance their competi- tiveness in export markets (PPAM, paras. 3-4; PCR, paras. 2-3). In support of its reform program the Government negotiated a Stand-by Arrangement with the IMF for the period 1980-83; this was renewed in December, 1983. A First Structural Adjustment Loan (SAL) was approved by the Bank in March 1980 and complemented the IMF stabilization program (PPAM, paras. 5-7; PCR, paras. 17-18). This was followed by four furti.er SALs during 1981-84. The programs of action for the second and third SALs, approved in 1981 and 1982, focussed on export promotion, import liberaliza- tion, domestic resource mobilization, rationalization of public investment  programs, increased agricultural efficiency, energy conservation and resource development, and improved performance of the SEEs (PPAM, paras. 10-11). The Government demonstrated a strong commitment to the SAL program throughout and fulfilled all major undertakings. It recognized that the process of adjustment would at times be painful, as it necessitated some decline in real incomes as well as the tolerance of higher levels of unemploy3ment. The Government did not falter in its resolve to proceed with the corrective measures but a number of difficulties surfaced in the process of implementation. First, several laws had to be passed in an exceedingly short period. Second, an overworked bureaucracy that was being depleted of staff resources, had to cope with the impact of a broad spectrum of policy changes and difficulties in implementation surfaced, especially in the agriculture and energy sectors (PPAM, paras. 171-174; PCR, para. 7). Third, the concern with short-term financial results for the SEEs clouded the longer-term objective of achieving improvements in management and operational efficiency. Fourth, some reforms were hastily prepared, as in the case of the value added tax, and had to be postponed till their impact was carefully assessed. In contrast to the situation which existed at the time of the first SAL, the Bank was better prepared for the subsequent SALs. A well focussed program of analytical economic and sector work was executed and Bank staff regularly supervised the SAL program and carried out a close dialogue with Government representatives to prepare further SALs. The tranching of the loans enhanced the chances of full compliance, though the second tranche of SAL II had to be delayed, pending passage of agreed legislation on SEEs which had been delayed till the assumption of office by the new Government. Disbursement and procurement proceeded smoothly under both loans. The Bank's lending program supported the SAL process by concentrating on agriculture, industry, energy and transportation. Training courses were held to strengthen the capacity of key control points in the administration (PPAM, paras. 162-170; PCR, para. 5). Overall the programs connected with SALs II and III are deemed to have been a success. Exports grew rapidly in response to a plethora of incentives and markets were diversified. The flexible use of the exchange rate and import liberalization policies improved resource allocation. Delinking of SEEs from the Treasury improved their financial self-reliance. Fiscal and credit incentives widened the opportunities for many producers, many of whom had previously relied excessively on domestic markets. Finan- cial deregulation and policies for strengthening the func ioning of capital markets improved financial intermediation. Finally, institutional reforms in agriculture helped to improve productivity over the longer-term. Major reforms were also instituted to conserve as well as to exploit Turkey's energy resources (PPAM, paras. 147-149; PCR, paras. 8-15). Nevertheless, a number of problems still exist. inflation and high levels of unemployment persist. High interest rates, combined with stringent monetary management and full cost monopoly pricing by SEEs are curtailing  - vi - investment needed for long-run growth (PPAM, para. 148). The social impact of five years of structural adjustment has yet to be addressed (PPAM, paras. 157-161). Exports are propped up by subsidies and preferential credits and the future of some newly won markets remains uncertain (PPAM, paras. 150- 152). Hopefully, these and other ongoing problems of adjustment will be addressed within the context of the medium-term strategy embodied in the Fifth Five-Year Plan (1984-89) (PCR, para. 45). The lessons emerging from SALs II and III are: - the need for strong political commitment to the program (PPAM, para. 171; PCR, para. 2); - the availability of thorough analytical work to back up the policy prescription (PPAM, paras. 169-170); - the design of programs that are consistent with institutional and administrative constraints of the Borrower; (PPAM, paras. 127-138, 146); and - the adoption of time frames for action that are appropriate to the exigencies of the Borrower's legislature (PPAM, paras. 172-173).  PROGRAM PERFORMANCE AUDIT MEMORANDUM TURKEY - SECOND AND THIRD STRUCTURAL ADJUSTMENT LOANS (LOANS 1987-TU and 2158-TU) I. BACKGROUND 1. Turkey's economic policies from the early 1960s until 1972 con- tributed to the achievement of rapid growth in GNP (6.6 percent a year, 1963-1972), with substantial growth in industrial capacity. During the Third Plan period, 1973-77, Turkey maintained, even increased, its growth rate (7.7 percent average, 1973-76) with increasing recourse to external borrowing, accumulating a heavy load of short-term debt. 2. Since the mid-1970s, however, external con-straint, to sustained growth became increasingly severe. They included a sharp rise in Turkey's import prices (including oil), and a significant deterioration in its terms of trade. High interest rates resulted in an increased external debt burden, and recession in Western Europe led to reduced export prospects and emigration and remittance possibilities. Continued expansionary policies delayed Turkey's adjustment to the changed international environment, so that by 1977 the country was in a severe foreign exchange crisis. After 1977, the Government made a series of efforts, exemplified in stabilization programs worked out in close consultation with the IMF (1977, 1980, 1983, 1984), to restore price stability, creditworthiness, and a sustainable balance in domestic and external finances. 3. Toward the end of che 1970s, the financial situation deteriorated again, partly as a result of the 1979 increase in oil prices. In view of the severity of the external financial squeeze, the Government accepted in January 1980 the need for a temporary sacrifice of growth and of social objectives in order to bring down inflation, improve the balance of payments, and restore creditworthiness as quickly as possible. 4. On development issues there was a change in sectoral concerns to favor energy and agriculture, at the expense of manufacturing, especially as far as allocation of public sector resources was concerned. There was a new emphasis on the division of labor between the public and private sectors, with the former expected to concentrate on the provision of infrastructure, while the latter was to provide the main impetus to industrial growth and exports. In the external sector much greater weight was given to exports relative to import substitution. Finally, and most significant, was a shift toward reliance on market mechanisms as against centralized planning (PR, SAL II, paras. 13-15). 5. After the announcement of the January 1980 program, the IMF released the remaining tranches of the stand-by arrangement that had been  - 2 - agreed in July 1979. Soon after, in March 1980, the first SAL (US$200 mil- lion) was signed making quick disbursing funds available to Turkey in support of the reforms already initiated. The major objectives of the SAL program were to reduce inflation, increase foreign exchange earnings, and improve domestic resource mobilization in the public and private sectors. Priority was given to export incentives and institutional arrangements in support of exports; studying the protection and incentive system; improving external debt management; eliminating the overall public deficit in 1980; reviewing measures to encourage private savings and time deposits; harmonizing public investment and adjusting its composition to the new priorities.l/ 6. In June 1980, a new three-year stand-by agreement was signed with the Fund, involviag SDR 1.25 billion (about US$1.63 billion), with SDR 460 million in the first year, SDR 400 million in the second year, and SDR 390 million in the third year. The key conditions of the new stand-by were that the exchange rate was to be kept flexible; the financial position of the public sector was to be improved, mainly through restructuring the operational policies of State Economic Enterprises (SEEs) (i.e., raising prices); monetary conditions were to be stabilized by observing strict limits on Central Bank lending; and interest rates were to be adjusted to reflect market conditions. 7. The conditions set by the Bank and IMF were mutually reinforcing, with the Fund taking the lead on exchange rate and aggregate demand and management issues while the Bank focussed on public investment and the protective system. There was extensive exchange of information between the Bank and IMF during the preparation of the SALs. Bank and IMF staff members also participated in the missions of the other institution. II. THE SAL PROGRAM: OBJECTIVES AND POLICIES 8. The second and third Structural Adjustment Loans further supported Turkey's January 1980 reform program, and measures initiated and implemented since then. The first SAL and its Supplement were made in response to Turkey's immediate external and internal economic problems. By the end of 1980, the effects of the stabilization and adjustment measures began to appear, with exports growing and the rate of inflation falling. A. The Design of SAL II 9. Turkey's second Structural Adjustment Loan (SAL II) was approved in May 1981, and was designed to further address structural factors responsible for the country's economic difficulties. The proceeds of the loan (US$300 million) were to finance high priority imports in agriculture and industry, 1/ See Project Performance Audit Report No. 4015, June 30, 1982 (Sec. M82-620).  which were necessary to produce goods for domestic consumption and exports. For both sectors, the imports consisted of raw materials and intermediate products. 10. The action program agreed to under SAL II was viewed as the second phase of a more comprehensive structural adjustment process, which was to be followed by other SALs over a number of years. The program was more detailed than its predecessor; in addition to new reforms it continued to address policy reforms that did not reach full implementation under SAL I. The program emphasized: (a) domestic resource mobilization, to reduce external borrowing for investments; (b) export promotion, to help earn foreign exchange needed to finance Turkey's imports; (c) liberalization of the import regime, to facilitate imports of raw materials and intermediate products, necessary for production of export; (d) an improved public investment program, to fully utilize existing productive capacity in areas which could increase exports and create employment; (e) development of the country's energy resources, to cut the energy import bill and to increase energy production in the long run; (f) increased production of agricultural export crops, and (g) reform of the SEEs in the areas of finance, management and investments so they could contribute effectively to the overall growth of the economy.2/ 1'. To achieve the objectives stated above, the following specific policy actions were to be adopted by the Government of Turkey: (a) Financial Policies. To mobilize domestic resources, a major fiscal reform was planned. This would improve the system of taxation by restructuring and revising existing taxes, introducing new taxes, and significantly strengthening tax administration. In addition, savings were to be encouraged by increasing the real rate of interest to a positive level. The capital market was to be developed via a new Capital Market Commission. (b) Export Promotion. This was to take place through adjustment of the exchange rate, incentives for exporters (mainly credit incentives), and improving the administrative framework for exports. (c) Import Liberalization. Imports were to be liberalized by abolishing the quota list and moving many items to a system of import licensing consisting of two liberalized lists, for noncompeting and competing commodities, which were allowed to be imported.3/ 2/ SEE's investments have exceeded 25 percent of total fixed investment since the late 1970s. 3/ Specific details on the liberalized lists is given in the President's Report on SAL II, paras. 57 and 64.  (d) Investment. Public and private investment was to be improved by channeling resources to the most productive and profitable projects. Priority was to be given to projects which emphasized exports rather than projects that helped substitute for imports. (e) Energy. This sector was to be developed by channeling investments into development of domestic energy resources, while adjusting energy prices and strengthening public agencies in the sector. (f) Agriculture. Production and export of agricultural products was to be increased through export policies, financial incentives, and institutional reforms. (g) SEE Reform. To reform SEEs it was decided to restrict their access to the Central Bank and the Treasury for concessionary funds and to increase the interest rates charged to SEEs by the State Development Bank (DYB). This was to increasingly expose SEEs to market forces and to make them more self-sufficient financially. Measures were also to be taken to overcome problems of overstaffing and to upgrade management. B. The Design of SAL III 12. Even before the completion of SAL II (November 1982) the third SAL (US$304.5 million) was approved by the Board (May 1982). The action program for SAL III constituted the third phase of the comprehensive structural adjustment process that began in January of 1980. As with previous Turkish SALs, the SAL III package embraced a number of decisions already taken, as well as others which remained to be implemented in 1982 and early 1983. The major policy objectives supported by SAL III were as follows: (a) Macro-economic Policies. The program included further tax reforms and capital market development for domestic resource mobilization, exchange rate adjustment and measures for export promotion, and further import liberalization. (b) Public Investment. The rationalization of the public investment program was to continue with a reduction in the number of programs and reorientation toward infrastructure, supported by a strength- ening of the project evaluation capacity. (c) SEE Reform. A major reform package for State Economic Enterprises (SEEs) was to be enacted, designed to improve their economic and financial performance through increasing their autonomy and market orientation; interim reforms designed to increase their efficiency and reduce their drain on the budget were to continue. (d) Agriculture. Public inve-tment was to be redirected toward the agricultural sector, to promote growth including exports.  - 5 - (e) Energy. The objective Was to reduce the growth of energy imports (PR, SAL III, paras. 92-98). 13. The design of SAL III supported the policies initiated in the January 1980 reform program. It promoted an outward-oriented development strategy, by continuing to open external trade. Greater reliance was anticipated on domestic resources in light of the anticipated decline of concessional external borrowing and the modest prospects for obtaining significant new commercial loans. These resources could only be tapped by reforms in the financial sector, tax reform measures, appropriate incentives for new investment, technological policy, continued restraint in private and public consumption growth, and a more efficient functioning of the SEEs. III. EVALUATION OF SAL DESIGN 14. The reforms that were designed and implemented under SAL II and III were appropriate for their goals. Efficient use of resources and improvement in the external balance required adjustments in exchange rates, interest rates, and quota, tariff and licensing arrangements, as well as demand restraint. However, under SAL II the focus was still on short-run stabiliza- tion problems which had been addressed under SAL I, and not enough attention was given to reforms necessary for the medium-term development of Turkey. 15. SAL III appropriately began to redirect attention to development issues. The principal thrust of the new policy was a shift toward open, export-oriented growth. Turkey started on this new path with a large and diversified industrial sector, which is the legacy of past SEE development. This sector has been able to respond to the shift in incentives and to play a leading role in the growth of exports. The development of the industrial base and especially of technologically advanced sectors has long been a major goal of Turkish economic policy. Given the current industrial base, the shift to an outward-looking development strategy is entirely consistent vith this emphasis. The opening up of export markets and the liberalization of imports provides opportunities fir transfers of new technologies that have clearly benefitted other countries which have pursued this strategy. 16. One weakness in SAL II and III, however, was the ab'ence of a medium-term strategy document that systematically linked the short-run stabilization program to a longer run development plan. Such a strategy document would have integrated the public investment program and the structural reforms in at least an indicative framework showing a feasible transition to sustainable growth. The strategy document could then have facilitated private sector investment planning, and mobilized aid for private investment. A. Need for Program Aid 17. Due to large external borrowings since the mid 1970's, Turkey faced high debt service obligations in the carly 1980's. However, the debt burden  - 6 - was thought to be manageable, provided the new policies were successfully implemented and the export drive was sustained. The projections in the President's Report indicated that under such conditions the economy could attain a growth rate of 5 percent by 1985, without unduly straining the balance of payments or domestic financial stability. The current account deficit was projected to reach US$2 billion by the end of 1982, with exports rising 25 percent to US$5.9 billion; imports by 12 percent to US$10 billion; and an increase in workers' remittances projected to US$2.8 billion (PR, SAL III, paras. 102-105). All of the above necessitated further financial support from private and official donors, much of it in the form of program aid. This support also provided an incentive for the commercial banks to provide Turkey with medium-term credit to finance profitable projects. 18. Under the SAL program, agriculture, industry and energy were to be the key sectors for project lending. In agriculture, projects emphasized livestock, exports, and rural development; in industry (including DFCs), the emphasis was on promotion of exports and employment, and strengthening the SEEs. Energy projects emphasized power generation based on domestic hydro and lignite generation. The priorities supported increases in production, exports and employment, and SEE reform, all of which were important objectives under the SAL program. B. Realism of Conditionalities 19. Some of the policy reforms planned under the SALs posed few administrative problems during implementation. These included adjustments of exchange and interest rates, and tax and credit incentives for exports. Other reforms required more sophisticated analysis and studies before they could be implemented, such as planned liberalization of imports through reducing the quota and tariff barriers designed to protect Turkey's manufacturing from outside competition. Most of the sector reforms, however, required substantial improvement of institutions before they could be properly implemented: this was especially true for agriculture and energy, and for the SEEs. 20. In the agriculture sector the main ,oal was to resume growth, which required an increase in agricultural productivity. Production growth was to come from more intensive use of cultivated area, expanded multiple cropping, crop yield increases, and an increase in the productivity of livestock. The Government was not organized to intensify the use of either of these resources (land or animals). A reorganization, consolidation and regionali- zation of crop and animal husbandry research was required as well as an improved system to establish and monitor priorities for technology transfer and generation. Increased emphasis on product quality and the needs of the importing countries was also required. 21. In the energy sector an important factor in the reduction of the energy deficit was the ability of the institutions involved to implement the domestic energy development program. Some of the more important energy institutions, however, were facing serious problems, including the Turkish  Electric Authority (TEK), the Turkish Coal Mining Authority (TKI) and DSI, the central authority responsible for water supply, waste disposal and major hydro power projects in Turkey. These institutions had management teams with uncertain terms of office, little autonomy even in day-to-day decisions, and no real accountability. They suffered shortages of experienced professional staff, especially engineers in key operating and planning departments, and were losing experienced staff at an increasing rate because their salaries were low, typically in late 1981 about one-third of those in the private sector. Only the Turkish Petroleum Company (TPAO) had been less affected by these problems, and was able through salary adjustments to retain qualified staff. 22. The institutional constraints in the energy sector were symptomatic for the SEEs in general, most of which experienced a high turnover of skilled staff and unfilled positions due to comparatively low pay scales. There was considerable day-to-day political interference and individual plant managers hes'tated to assume responsibility for long-term improvements. Highly centralized internal organizations stymied managerial initiative and made adjustments to changing circumstances difficult. 23. The institutional and managerial rigidities in agriculture, energy, the SEEs, and indeed the Government itself made reform in these sectors itself a problem of structural adjustment that could be achieved only over a period of several years. So in several areas, SALs II and III could only begin a process that would take years to complete. Generally this was recognized in the design of the conditionalities, but there were exceptions. Introduction of a value-added tax, scheduled for May 1982 under SAL II, has yet to be realized. Reform of the export subsidy regime has proceeded at a slower pace than SAL III anticipated, as has capital market development. C. Monitorability of the Action Program 24. For most reforms a clear timetable was set for implementation. Out of the approximately 26 specific actions agreed under the 1982 SAL III loan, 18 were scheduled for implementation in the same year, of which seven were completed in 1982 and the rest showed some progress in 1982. Of the two that were scheduled for 1982/1983, one was completed on time and the second one showed some progress in 1982/83. For the remaining six actions no date was specified, since they required either more than one year for completion or they were dependent on outside consultants for completion. This suggests that the action program was monitorable for the most part, in terms of timing for completion. 25. In terms of delegation of responsibility, however, there were weaknesses. The President's Report on SAL III repeatedly notes that "the Government would undertake implementation of various reforms. In most cases, however the specific Government agency responsible for reform implementation was not identified. High turnover of managers in SEEs and various sectoral agencies was another factor that made monitoring of the action program difficult.  - 8 - 26. From 1979 to 1983 various World Bank missions visited Turkey for technical support and economic aad sector work in the areas of industry, energy, agriculture, public sector investment, and the financial sector. The reports written and the data compiled by these missions pointed to the areas that were weak and needed immediate attention. Also, the recommendations that were given provided a f,amework on which work on macroeconomic and sec- toral reforms could be undertaken. Follow-up missions that visited Turkey to monitor progress after each SAL and general sector missions pointed out areas in which more decisive attention was required. Overall, the quantity and quality of the Bank's technical support and economic work was timely and adequate, with some exceptions at the macroeconomic level, to be discussed in Chapter V below. D. Complementarity with IMF Program 27. The Bank's support of the structural adjustment process from the beginning involved a close working relationship with the IMF (see paras. 5-7 above). The Bank was in agreement with the Fund's basic position that stabi- lization of the economy was an essential prerequisi-e for a return to a sus- tainable growth path. The Bank took the view that the period of austerity, necessary to bring inflation under control, redress the public finances, and improve the balance of payments was needed to lay the groundwork for a major restructuring of the Turkish economy. Thus, the Fund's attention to the country's monetary and fiscal balance, the maintenance of external competi- tiveness, and SEE's financial performance complemented the Bank's structural adjustment efforts in the areas of SEE reform, import liberalization, export promotion, and rationalization of public investment (PCR, SAL II & III, para. 18). IV. IMPLEMENTATION OF SAL PROGRAMS 28. The Government of Turkey immediately expanded its efforts to imple- ment the policies outlined in its Statement of Development Policy for the 1981 Structural Adjustment Program under SAL II. The SAL III program extend- ed the effort begun in SAL II, and expanded it in agriculture and energy. Most of the specific policy actions were implemented on time (see para. 41). The effects of the policy actions did not appear as quickly as expected in some cases, however. This was especially true in the cases of institutional reforms. 29. The sections on implementation that follow concentrate on: (a) the exact nature of policy actions implemented, (b) the timetable for implementation compared to the program, (c) overall success or failure of the policies, and  (d) the extent to which unresolved issues were carried over to the fourth Structural Adjustment Loan. A. Domestic Resource Mobilization 30. The programs agreed under SAL II included policies (a) to reform the tax system to increase revenue and to stimulate saving and investment, and (b) to maintain positive real interest rates and begin development of a capital market, in order to mobilize domestic saving. These program objec- tives were continued in SAL III; structural reform of financial markets became a major objective in SAL IV. 31. Tax Reform. During the period of SAL II the Government initiated a major tax reform package. The financial transaction tax was reduced from 25 percent to 15 percent in 1981, and to 3 percent in 1983, with an exemption for development banks and exporters. The sales and production taxes were rationalized with extended coverage, in preparation for the value-added tax (VAT). In 1982, under SAL III, the minimum tax bracket in the personal income tax was reduced and the corporate profits tax rate was reduced from 50 to 40 percent. Also in 1982, a Tax Court law was enacted to reduce tax evasion. The number of tax controllers was more than doubled, with an increased budget for tax collection (PCR, para. 25). 32. Other tax reforms were also to be implemented. Indexing of various tax brackets and penalties was to take place by December 1981, and the VAT tax was to be introduced in 1982. Although the authorities started work on these reforms, some have not yet been implemented. The Bill for VAT was referred to the consultative assembly by the National Security Council, but after consultation with the World Bank it was agreed that implementation was not feasible before 1983 (PCR, paras. 23-25). The VAT was only enacted on January 1, 1985. In terms of indexing of various tax brackets the Government was given authority to adjust tax rates by up to 100 percent to take account of inflation, but actual indexation has not been achieved. 33. In the short run, the tax measures have made a modest contribution to an increase in revenue, which together with expenditure control, reduced the budget deficit from 5.3 percent of GNP in 1980 to 2.1 percent in 1982. The deficit, however, worsened to about 3.3 percent of GNP in 1983, as a result of rapidly rising budget expenditures. Tax revenue has shown little buoyance over the medium term: its share in GNP has remained more or less constant during 1980-83. Patient and determined efforts will be necessary over the coming years to mobilize adequate financial resources to match the expenditures envisaged in the fifth five-year plan (1984-89). The Borrower, in his comments (see Attachment), has furnished revised data for tax revenue and the fiscal deficit; they do not, however, change the substance of the argument for a substantially improved fiscal effort.  - 10 - Table 1: CONSOLIDATED CENTRAL GOVERNMENT BUDGET (In billions of Turkish lira) 1980 1981 1982 1983 Revenues 838 1,329 1,424 2,156 Direct taxes Indirect taxes 471 768 826 1,149 Nontax Revenue 279 422 479 784 88 139 119 223 Expenditures Transfers to SEEs 1,073 1,503 1,575 2,533 213 214 233 292 Budget Balance -235 -174 -151 -377 Memoranda Items: (in percent of GNP) Revenues 18.9 20.3 19.6 18.8 of which: Tax Revenues (16.9) (18.2) (14.9) (16.8) Expenditures 24.2 22.9 21.6 22.1 of which: Transfers to SEEs (4.8) (3.3) (3.2) (2.5) Budget Balance -5.3 -2.7 -2.1 -3.3 34. Reform of the Capital Market. Under SAL II a Capital Market Bill was enacted to develop and regulate the capital market. The Bill had three main aspects. First, it established a legal framework for the issue and trading of shares and bonds, by setting up a new high council on regulation and control of Capital Markets. Second, it introduced regulation of financial intermediaries dealing in stocks and bonds. Third, it allowed banks to establish a Stock Investment Fund for the purpose of operating a stock portfolio. The Bill was to take the essential first steps in developing the Capital Market through establishing an independent Capital Market Board. One objective of the Bill was to increase the flow of private savings by offering savers a wider portfolio choice, in a financial market that was dominated by commercial banks and small savers. 35. The Capital Market Law was enacted in July 1981 and the Capital Market Board was set up on February 1, 1982. After the law was enacted, banks began to issue profit-sharing certificates permitting them to provide additional financing. The Board has published accounting standards and in 1982-83 it supervised 92 bond issues and 174 stock issues. The coverage of the Board is still very small; of some 25,000 joint stock companies in Turkey, only 564 are publicly held and 535 of these are in the purview of the  - 11 - Capital Market Board.4/ So while the specific policy steps have been taken, the organized capital market is still insignificant for financing private investment (as of September 1984). 36. Deregulation of Interest Rates. To stimulate savings and rationalize investment the Government continued its policy of maintaining positive real interest rates on deposits and deregulation of interest rates on loans. Deposit rates have been generally positive, in real terms, since 1981, as have non-preferential loan rates. Real deposits increased significantly in 1981 and 1982 as savings appeared to flow into the banking system. 37. The Government also has raised the rates it pays on bill issues to positive levels, competitive with bank deposits. Further structural reforms of the financial markets and banking system have been undertaken under SAL IV. The Government has generally followed through on agreed policy actions in the financial and banking sector. There remain serious doubts about the stability of the financial sector, questions about the reasons for the high level of real interest rates, and concern about their effect on the solvency of companies and the level of investment. These topics will be discussed in Chapter V below. B. Export Promotion 38. The Government's program under SALs II and III emphasized export promotion by (a) continued maintenance of a -realistic and flexible- exchange rate, (b) improving financial incentives for exports, and (c) improving the institutional and administrative framework for exports. The policy of daily adjustment of the exchange rate against a currency basket, to keep it in line with the inflation differential, had been adopted after the -maxl" devalua- tiLon of January 1980. This policy was continued, even accelerated. The result has been a fairly steady real depreciation of the lira in effective terms, increasing the competitiveness of Turkish exports. 39. Financial Incentives for Exports. Financial incentives include varying degrees of tax exemption-up to 100 percent for contractors- on export earnings; credit subsidies for exporters; a direct subsidy in the form of a percentage tax rebate on export earnings; and duty-free imports of inputs entering into the production of exports. The tax exemptions were enacted in the tax reform package under SAL II. They cover all industrial exports and some agricultural exports. 40. Credit subsidies include lower borrowing rates for exporters and measures requiring commercial banks to maintain a minimum fraction of their portfolio in export loans. The direct subsidy takes the form of a payment in Turkish lira equal to a fraction of lira export earnings that varies across 4/ These data come from an interview with the Chairmaa of the Capital Market Board.  - 12 - commodities. The level of the subsidy has been reduced over time, and stood at about 16 percent on average in 1984. The subsidy rate increases for exporters earning over US$50 million in foreign exchange. The subsidy is generally described (by Turkey and by the World Bank) as a tax rebate, since it is a substitute for the VAT rebate available to European exporters. It appears, however, that the subsidy rate is not systematically related to taxes paid by exporting firms. During SAL III, rebate of duties on imported inputs into exports was introduced. 41. The Government recognizes the need to phase out financial incen- tives for exports, moving toward use of a realistic exchange rate as the principal export incentive. A study of the export incentive system is mandated under SAL IV. The surge of exports in early 1984 after the real depreciation was resumed (following a pause in 1983) provides evidence for the rapid response of exports to the real exchange rate. 42. Institutional and Administrative Framework. There was to be continued improvement in the institutional and administrative framework for exports under SAL II-III including the establishment of a permanent Export Credit Insurance Agency, and of free trade zones, through enactment of two separate Bills. Also, it was planned to revitalize the already established export promotion center to make it effective and to encourage the establishment of an export promotion organization by the private sector. Following an internal Government study it was decided to set up a new public/private export promotion center and in the meantime a small privately-operated center was established. Two regional fruit and vegetable marketing corporations were established under a Bank-assisted fruit and vegetable project. 43. There were areas in which progress was not as fast as desired. The Bill to establish a Free Trade Zone was enacted as law not in 1981, but later in 1983. The Bill to establish an Export Cred4t Insurance Agency was deferred because of the high costs associated with such a scheme. A recomr- mendation to introduce export credit insurance was made again in a Financial Sector Report (1983), and the feasibility of the proposal was to be reviewed in the study of export incentives proposed under SAL IV. 44. The Government of Turkey has shown a firm commitment to export- oriented growth. This commitment was renewed by the new administration that took office in December 1983. Export performance has been strong since the SAL program began. Total exports in US dollars grew by an annual average of 16.9 percent from 1980 to 1983 and by 32 percent in the first half of 1984. Growth in exports to the Middle East has been particularly rapid, but the growth of other exports was a healthy 7.7 percent over the same period. In 1980 exports covered 37 percent of imports; by 1983 this figure was 62 percent. The reorientation of industry toward exporting is clear; movement toward reliance on the exchange rate instead of direct incentives should leave the export sector strong and growing.  - 13 - C. Import Liberalization 45. The Government had made clear in 1980 its intention to open the Turkish economy to competition from abroad. Its long-term policy was that import restrictions would not be used to protect domestic producers. The main feature of the 1981 import regime under SAL I was the abolition of the quota list. According to the SAL II Completion Report, all items on the quota list were transferred to two import licensing liberalized lists. Of the 312 items previously on the quota list, 100 items were moved to the more liberalized list I, which consisted of items which were noncompetitive with domestic production. The remaining 212 items, which accounted for most of the imports (US dollar value) and mainly included machinery and capital goods, were shifted to the intermediate category, liberalized list II (PR, SAL II, paras. 59-60). Further shifts were made from list II to list I in 1982 and 1983, under SAL III (PCR, para. 35). 46. The Government also made arrangements to undertake the agreed long term study of Turkey's protection and incentive system. The World Bank was to propose detailed organizational arrangements for this study and provide financing for it (PR, SAL II, para. 10). The study was scheduled for completion by end of 1982. Although it was undertaken and a paper entitled Coefficients of Import Tariffs and Interpretation of Results was drafted, the study was not completed until two years later in February 1984. The results of the study are to guide further tariff rationalization. 47. The degree of quota elimination under SAL II-III is ambiguous and requires clarification. As noted above, the SAL II PCR announced the elimin- ation of quotas in 1981, with quota items shifted to the two liberalized lists (PCR, para. 22). However, in early 1984, the Government also eliminated (or greatly reduced) quotas, simultaneously imposing new tariffs. Borrower representatives cited to the audit mission the removal of 75 percent of existing quotas in January 1984. This is confirmed by an internal Bank memorandum of February 8, 1984 which also refers to the removal of quotas on a number of items in early 1984. iNote: perhaps the shift to a licensing list in 1981 was interpreted as elimination of quotas in the earlier reports .1 48. The trend under SALs II-IlI was toward import liberalization, as items were shifted from less liberal to more liberal lists. Again, the Government's general commitment to movement toward an open, trade-oriented system was clear. After the shifts in 1981, there was little movement on import liberalization until early 1984, during the SAL IV period. In January, 1984 existing quotas were largely replaced by what seems to be an escalated tariff system providing effective protection for manufacturing. At the same time the installation of a variable Housing Fund duty on imports with domestic competition provided a flexible instrument that is used in general to keep Turkish lira prices of competitive imports above those of home production. Thus the degree of actual import liberalization is not yet clear. This topic is taken up in Chapter V.  - 14 - D. Rationalization of Public Investment 49. Under the SAL program, the Government was to rationalize its public investment program. The level of investment was to be brought in line with available resources. Resources were to be concentrated on a smaller number of major projects with reasonably early completion dates. Priorities among projects were to be allocated as follows: First, among sectors priority was to be given to agricultural projects in view of the export potential of the sector; to energy projects, so as to remove bottlenecks; and to communica- tions and transportation projects, to facilitate industrial and agricultural production. Second, priority was to be given to export-oriented projects, particularly those in agriculture. Third, within the sectoral priorities, projects were to be grouped as follows: (a) high priority project, which could be completed within 24 months, where there was substantial sunk capital, and where high cash flows were expected; (b) profitable projects, the additional requirements of which exceeded the resources available to the public sector; Cc) reserve projects of uncertain merits were to be subject to further study or to be eliminated from the program. 50. Under SAL II, public investment resources were to be concentrated on the high priority projects. The Government was to have profitable projects implemented through equity participation of the private sector. This objective faded into the background in 1982-83; it reappeared with force in the 1984 program. Under SAL III the high priority goal was defined as direction of 85 percent of public investment funds into about 100 defined high priority projects. 51. The Government was expected to discuss the report of the World Bank's public investment review mission, around May 1981, and take account of the views expressed in the preparation of the 1982 public investment program (PR, SAL II, paras. 65-69). This was done in September/November 1981 due to delays on the part of the World Bank. There was some progress in rationali- zation in the 1982 public investment program. Within the key sectors, there was a redirection toward communication, energy, and agriculture. On the project level, due to the large size of the program, with slightly over 8,000 ongoing projects V it was obvious that a significant reduction in the number of projects, to shorten completion time, could only be attained over a number of years. 52. Redirection of the public investment program toward infrastructure, and restraint of its overall growth, were continued in SAL III. In fact in 5/ For a listing of projects in progress, see Annex II of President's Report on SAL II.  - 15 - 1983 the growth of public investment of 1.9 percent fell far short of the programmed 4.8 percent. Emphasis in SAL III was also placed on the use of economic criteria for selection of public investments and training of project analysts. The EDI course in 1983 in Ankara was only a modest success, how- ever. It did not attract relevant personnel from decision-making minist- ries. 53. The thrust of the Bank and the Government program to restrain the aggregate growth of public investment and redirect its composition toward social infrastructure made sense, and the Government has made good progress on this front. However, the shift from simple rule of thumb restraint and reallocation to economic selection of projects has been slow in coming. It was planned in SAL IV, but is still at best incomplete. The topic will be discussed in more depth in Chapter V. E. Energy Sector Policy 54. In the SAL II program, and its continuation in SAL III, energy was the sector of first priority for both public investment and policy formula- tion. To assist in the elaboration of an overall view of energy issues, the Government and the World Bank agreed to make a sector-wide study. Major changes in the areas of energy pricing, conservation, organization of the sector, and encouragement of exploration were to be part of the Government's energy policy in SAL II. 55. Energy Pricing. The Government was to follow the policy of pricing energy resources at levels which broadly reflected the cost of these resources in international terms. While there wer3 some exceptions to this rule, this meant that several adjustments had to be made to domestic energy prices to keep up with both domestic inflation and world price changes. To rationalize energy prices the Government made frequent adjustment of energy prices in 1981 and 1982, bringing prices in line with international prices. Major adjustments of other products were also undertaken, i.e., coal prices were increased in March 1982 by an average of 20 percent, and prices of lignite and power were also increased. 56. Conservation Measures. A draft law was to be prepared, which would create a new unit within the Ministry of Energy and National Resources - the Energy Survey Administration - under which all energy conservation activi- ties, energy audits, enforcement, etc., was to be centralized. There was no date specified for the enactment of the law, and by the end of the SAL III period the draft law was still under consideration (PR, SAL III, para. 96). It was, however, passed during SAL IV, in 1983. 57. Organizational Changes. The intensification of energy policy called for the need to strengthen certain public agencies in the energy sector. The following organizational changes were to take place. (a) A proposal was being developed to reorganize the management struc- ture of Turkish Petroleum Corporation (TPAO) into five operating  - 16 - agencies for exploration and exploitation, for refining, for pipe- lines, for marketing and distribution, and petrochemicals, each with its own budget. This was to improve the overall TPAO opera- tions and to ensure that emergency budgetary demands in one area of operation did not interfere with the ongoing work in other areas. There was no date specified for the reorganization, but it was implemented as part of a SEE reform decree in 1983. This reorgani- zation was reversed in 1984. (b) A draft bill was to be prepared to provide for redefinition of Turkish Coal Enterprises (TKI) responsibilities. TKI was to pro- vide lignite to users with close proximity to its large mines, and fuel for industrial users and power generation. Private firms were to assume the task of mining and supplying other uses. This dives- titure was to reduce the need for subsidiaries to TKI, and to narrow its management responsibilities to the main area of its operations mentioned above. No data was specified for preparation of the law. However, the law was prepared in the SAL II period, following the development of private mining of lignite and redefi- nition of TKI's responsibilities (PCR, para. 27). (c) A draft bill was to be enacted for takeover of Turkish Electricity Authority's (TEK) municipal distribution of power by autonomous companies. The law was enacted in the SAL II period (PCR, para. 27). 58. Oil Exploration. Several decrees were issued during 1980 to encou- rage private Turkish and foreign companies to engage in exploration activi- ties. The decrees contained statements of operating procedures and certain guarantees, including a guarantee of 35 percent of oil production as company equity free to be exported. In response to this, eight foreign companies visited Turkey in 1980 and discussed exploration possibilities and clarified certain issues relating to taxation. Later in 1981 and 1982 sixteen licenses were issued to private companies for exploration of oil, and consultants were hired to advise and promote foreign investments. F. Agricultural Sector Policy 59. Support of agricultural sector policies was introduced in SAL II and refined under SAL III. The objective was productivity growth through efficiency improvements and shifting the crop mix toward areas of Turkey's comparative advantage. SALs II and III concentrated on efficiency improve- ments that can be grouped under three headings: institutional reform, rationalization of support prices, and rationalization and gradual elimina- tion of input subsidies. In addition, export incentives were to be provided, mainly by investments to remove transport bottlenecks. The share of agricul- ture in the public investment budget was targeted at 11 percent in SAL IV. This share turned out to be 9.8 percent in 1982 and 11.5 percent in 1983.  - 17 - 60. Institutional Reform. The Government realized that the effective- ness of public programs in agriculture could be increased through the reor- ganization of responsibilities within the sector and particularly within the Ministry of Agriculture and Forestry. The objective of the planned reorgani- zation was to streamline and improve the delivery of agricultural extension and related support services to agricultural producers. No date was speci- fied for such a reorganization, but the undertaking was envisaged as a long term process. During the period of SALs II and III substantial progress was reported. Government approved and carried out internal reorganization of the Ministry of Agriculture and Forestry. Substantial progress was achieved in both provincial and central reorganization and new provincial directors were appointed in most of the provinces. Reorganization of the Agricultural Bank to allow more credit to reach small and medium-sized farmers, and generally to increase the efficiency of the agricultural credit system, was begun dur- ing SAL III. Reform of the agricultural credit system was a continuing pro- blem at the end of SAL III, but was not addressed in SAL IV. 61. Support Prices. Estimates of the input and product price relation- ships were made for 1980-81 and were to provide the basis for annual changes in support prices, in order to provide incentives for increased production, and to maintain or improve the competitive position in export markets. A coordinated price analysis was carried out to determine price levels for wheat, sugar beet and oilseeds, which comprised the most important items for export and for import substitution. The number of support commodities was reduced from 25 to 16, and the real value of budgetary and financial costs of support prices was reduced. 62. Input Subsidies. It was the intention of the Government in 1981 to eliminate all fertilizer subsidies within five years. The five-year plan was to give farmers time to adjust to higher prices for fertilizers and the five percent sales tax on their marketed production. The Government was also to encourage increased fertilizer production from existing domestic capacity and to reduce the import requirement for finished fertilizer. Fertilizer prices have been raised, and the subsidy on the retail price reduced. This remained an issue for SALs IV and V, with the five-year phase-out period. 63. During SALs II and III, important steps were taken toward eventual reform of the agricultural sector. But these were only the initial steps, and some mandated actions, such as improvement in statistics on land use and production (SAL III) are clearly very long run projects, not completed in SAL III nor carried over to SAL IV. G. Reform of the State Economic Enterprises 64. The State Economic Enterprises (SEEs) have been important economic institutions in Turkey since the 1920s. They were a major instrument in the import substitution industrialization that developed the manufacturing sector that indeed was able to shift toward exporting in the 1980s. In 1980, however, it was generally agreed that the SEEs were too inefficient. In addition to production of the usual services and infrastructure provided by  - 18 - the public sector, about 40 percent of manufacturing output was provided by SEES. Their aggregate losses in the late 1970s were 4 percent of GNP. Financing these losses was a major source of the budget deficit. Therefore the Government and the World Bank agreed from the beginning of SAL I that the size of the SEE sector should be reduced, SEE efficiency should be improved, and SEE activity should be redirected coward provision of the usual public goods. The SEEs were to be reoriented toward economic and financial objectives. 65. In 1980 the SEEs were largely cut off from direct financing by the Central Bank, and their access to the budget was limited. They were freed to raise prices and did so, in some cases by 200 percent. This reduced their aggregated gross loss from 3.3 percent of GNP in 1979 to 0.1 percent in 1980, and also reduced their Lontribution to the budget deficit. 66. The SEE reform program under SALs II-III was aimed at exposing them to more rigorous external economic conditions and at generating internal reforms. The restricted, if not altogether eliminated, access to the public budget and freedom to price to "market conditions continued (although prices were again suppressed in 1983 prior to the election). The redirection of the public investment program toward infrastructure greatly slowed the growth of manufacturing SEEs. A series of internal refora actions were prc-posed to freeze hiring, increase management efficiency and productivity, and eliminate credit subsidies. Some of these measures were implemented during the period of SALs II-III. The major reform decree was delayed until May 1983, however, and the internal reforms other than the personnel reduction were not evident in July 1984. The SEE reform until then was mainly redirection of public investment, cutting access to public funds, and pricing to market conditions. The following paragraphs review the specific actions taken under the SAL II-III program. 67. Improved Investments. The quality of the SEE's investment program was considerably improved through the increased rationalization of the public investment program. After years of grouth, the size of the program as a percent of GNP was reduced, projects were dropped or reevaluated, self- financing increased, and ftnds were directed away from manufacturing towards infrastructure. The program was reviewed by the World Bank, and to help SEE's prepare future projects, US$10 million equivalent was allocated to hire consultants. 68. Reduced Access to Concessionary Funds. Measures were taken to in- crease the cost and reduce the availability of soft funds, to which SEEs had enjoyed easy access in the past. The 1981 program decree for SEE cut off all SEE from their previous direct access to the Central Bank, except for two export-oriented agricultural purchasing SEEs; the interest rate they paid was raised in July 1980. Other SEEs were to seek short-term financing from com- mercial banks on the same terms as private firms, which substantially increased their cost of capital. Foreign exchange loans contracted by the Government were to be made available to operational SEEs through the State Investment Bank (DYB). DYB increased its interest rate from 14 to 21.5  - 19 - percent in 1980 and began to charge market rates in 1981. To permit SEEs to borrow commercially on an increasing scale in the future, the Government studied ways to strengthen their capital structure. 69. Financial Structure of SEEs. The overall financial structure of the SEEs may not have improved. This structure is summarized in Table 1, which shows the sources of funds for total SEE "financing requirement" plus net tax payments. Borrowing from the Central Bank was reduced to zero by 1983. But budget transfers were up to 37 percent of the total requirements, and short-term borrowing plus net arrears were up to 30 percent in 1983. This could indicate an overall weakening of SEE financial structure under SALs II-III. Table 2: FINANCING OF SEEs 1980 1981 1982 1983 Financing requirement plus net tax payments (Billion TL) 474 621 625 794 (percent) 100 100 100 100 Distribution across sources (percent) 100 100 100 100 Budgetary transfers 32 38 33 32 Borrowing from Central Bank 11 5 5 0 State Investment Bank 3 3 9 4 Foreign Borrowing 14 20 17 17 Transfers from Price Stabilization Fund 6 12 12 12 Short-term Borrowing plus Net Arrears 34 22 24 39 Source: Turkey DIS, Table 4.4. 70. Management and Staffing. To improve management quality, it was decided to offer multi-year contracts to SEE managers, and to increase their salaries to more acceptable levels. The law enabling multi-year contracts for senior SEE managers was passed in November 1981 and modest salary increases resulted in February 1982 (PR, SAL III, Annex VI, p. 4). The Government also took steps to reduce overstaffing, within the constraint that personnel cannot be laid off. The 1981 program decree froze employment in the SEEs at the level of November 30, 1980. New hiring could be done for replacement only; it was limited to replacement up to 50 percent of the normal complement at the plant level, and to be done from within as far as possible. The program was successful in reducing employment levels well below program ceilings.  - 20 - H. Summary on Program Implementation 71. From the start of SAL I the Government of Turkey was firmly com- mitted to the structural adjustment program. The Statements of Development Policy for SALs II and III outlined a number of policy reforms that had to be implemented to bring about stability and growth to the economy. Overall, substantial progress was made in implementation of the structural adjustment program during SALs II and III. The major achievements in SAL IT were in the areas of tax reform, interest rate policy and trade reforms. Most tax reforms were implemented as planned; the ones that were delayed were not feasible within the time envisaged. The interest rate deregulation raised interest rates to positive, if excessively high levels. Policies to promote exports led to substantial improvements in export performance as reflected in the rise in the volume of total exports. Import liberalization measures were satisfactory and consistent with Government's intention of liberalization on a step-by-step basis. Implementation of investment reform was satisfactory, but more time was needed to rationalize the investment program due to the large number of ongoing projects. Implementation within the sectors, how- ever, required more time, and the program was stretched into SALs IV-V. In the energy sector timely progress was made on adjustment of prices, but institutional reforms turned out to be more time-consuming. 72. There was some impact on institution building during the period of SAL III, but more technical support was needed from the World Bank to over- come prevailing problems. Although the Bank provided nseful advice for improving institutional capability, the technical support was not sufficient to cause a major change. SALs by their nature (providing quick access to foreign exchange for investment, production and employment), are not designed to cause major institutional changes in a relatively short time. 73. The policy reforms carried out under SALs II and III, the financial support those loans provided for the balance of payments, and the support from the IMF stand-by undoubtedly contributed to the improved short-term per- formance of the Turkish economy in 1981-83. After declining for two years, industrial output grew at an average annual rate of 5.9 percent. Growth in industrial exports had already begun at rates of 6.1 percent in 1978 and 26.4 percent in 1979. In 1980 industrial exports were approximately US$1 billion. Under the SAL program, by 1983 they had more than tripled to US$3.7 billion. The underlying rate of inflation was reduced from about 70 percent to under 30 percent. 74. There were remaining problems, of course. The financial structare of SEEs remains weak. Private investment is very low, possibly implying a supply-side constraint when expansion begins. Real interest rates are high, contributing to the slow pace of investment and potential financial instability. It is not clear how the transition to a longer-term growth path will be achieved. This suggests the need for a medium-term framework for policy for this transition, a framework which still did not exist at the end of SAL III, but may be implicit in the 1985-89 plan that was published in mid-1984, at the end of SAL IV.  - 21 - I. IMF Operations 75. Turkey purchased the full amount (SDR 1.25 billion) available under the three-year stand-by agreement signed in June 1980 (see para. 6), with the last of twelve purchases taking place on May 2, 1983. The agreed performance criteria were all deemed to have been met at a review conducted in May, 1983 76. Following completion of the three-year agreement, a new one-year stand-by in an amount of SDR 225 million was approved in June 1983. Upon election of a new Government in December, 1983, Turkey requested cancellation of the existing stand-by and its replacement with a new one-year arrangement in an amount equivalent to SDR 225 million. This proposal was approved in early April 1984 by the Fund's Executive Board and immediately went into effect. Conditions of the new stand-by were broadly similar to the previous ones. V. MAJOR ISSUES 77. The general thrust of the process of structural adjustment in Turkey since 1981 has been to open the economy to foreign competition in order to promote manufacturing exports, and to shrink the SEE sector and increase its efficiency. These objectives were supported from the beginning of SAL I. Gradually, sector reforms in energy and agriculture, and in finance were added to the process. The general direction of the structural adjustment program is commendable, and deserving of SAL support. However, there are some specific issues that call for further evaluation. These are raised in this Chapter of the audit report. 78. The Governmpnt of Turkey, with the support of the IMF and the World Bank, has initiated reform in a wide range of sectors, using a wide variety of policy instruments. This has been done very rapidly, in a process that gained momentum in 1981, flagged somewhat in 1983, but returned in full force in 1984. Perhaps it is inevitable that in a period of such rapid change in policy, unanticipated problems arise. These can be in areas of policy action based on hasty or insufficient analysis, unanticipated conflicts or inconsis- tencies between seemingly separate policies, or problems in moving from policy decision to implementation. 79. An example of an unanticipated result may be that the combination of a policy of real depreciation to improve export competitiveness plus the policy of virtually freeing the foreign exchange market requires real interest rates in Turkey to exceed those abroad by the expected rate of real depreciation. This problem will be discussed in some detail below; here it is only mentioned as an example of policies having unexpected results that could have been anticipated by more thorough analysis. We now review the issues, beginning with aspects of SEE reform.  - 22 - A. Reform and Pricing Policy of the SEEs 80. An important aspect of the structural adjustment program since SAL I has been reform of the State Economic Enterprises (SEEs). In addition to producing the usual range of public services, the SEEs produce approximately 40 percent of manufacturing output in Turkey, plus a significant fraction of agricultural output such as milk, sugar, and tea. Much of the SEE output is intermediate goods: for example iron and steel, cement, paper, fertilizer. The SEEs are generally considered to be inefficient, with lower productivity than the private sector, and with bureaucratic management not oriented toward risk, innovation, and profit. In 1979, the year before SAL I, SEE sales revenue was 19.5 percent of GNP, and the SEEs' 'oisses were three-quarters of the public sector borrowing requirement of 8.6 percent of GNP. The SEE system needed reform. 81. The main thrust of the SEE reform program to date has been to place the SEEs in a more competitive environment, to free them to raise prices to adjust to market conditions, and to reduce drastically their access to public funds. The SEEs' access to financing through the Central Government budget has been substantially reduced, as has been their access to investment financing by the Central Bank. The public investment budget has been reduced, and redirected from the manufacturing SEEs to infrastructure. In 1981-82 there was some discussion of privatization of manufacturing SEEs. This diminished in 1983, but has reappeared as policy in 1984, with the establishment of a privatization wing in the office of the Prime Minister. The SEEs are now free to set their own prices, within fairly loose supervi- sion by the office of the Deputy Undersecretary of Treasury and Foreign Trade for SEEs. 82. This reform package has improved the SEEs' profit position, and reduced somewhat their drain on the budget. In 1980, when SEE prices were first raised substantially, their sales revenue increased by 167 percent, with sales rising from 19.5 to 25.8 of GNP. This ratio was up to 30 percent in 1982 and 1983. In 1982 the SEEs still accounted for three-quarters of the public sector borrowing requirement, but the latter was down to 5.8 percent of GNP from a peak of 10.1 percent in 1980. The reform package described in the previous paragraph will shrink the manufacturing SEE sector by attrition, and produce an economic Darwinist result. The survivors will be those which can raise their prices enough to become profitable, and invest by normal financing procedures. 83. However, little was done to improve the management structure and internal efficiency of the SEEs during the SAL II-III period. Budget trans- fers were limited and a hiring freeze has been imposed. But internal reform just began with the reform decree of May 1983, and that reform was stalled by the election politics of 1983. In March 1984, the Bank made a technical assistance loan of US$7.6 million to support a serious beginning of internal reform in the SEEs. The previous program promoted efficiency at best indirectly by squeezing the SEEs, perhaps now direct action on management techniques and production and marketing efficiency will be possible.  - 23 - 84. The SEE pricing policy supported by SALs II and III has several potentially troublesome aspects. Since 1980, the SEEs have been encouraged to be profit-oriented; SAL IV put in a minimum profit target of 0.6 percent of GNP. In their pursuit of profits, the SEEs are free to raise their prices subject to clearance from the relevant ministry and the Deputy Undersecretary for Treasury and Foreign Trade for SEEs. As noted above, by raising prices, especially in early 1980, the SEEs in aggregate increased sales revenue from 19.5 percent of GNP in 1979 to 30.4 percent in 1982. The 167 percent increase in SEE revenue in 1980 most likely understates their average price increase, since non-agricultural output fell by about 2 percent that year. The fact that revenues have increased substantially when prices were increas- ed means that the demand curves facing the SEEs are relatively inelastic. This, in turn, is the traditional indicator of market power. Given the pres- sure on the SEE management to produce profits, and the absence of systematic regulation based on cost or rate of return, it seems likely that many of the SEEs are monopoly pricing, above competitive levels. 85. The administration of the SEEs and the import regime by the rele- vant Deputy Undersecretary for Treasury and Foreign Trade is consistent with a monopoly pricing hypothesis. Even after the liberalization of the import regime in January 1984, some 300 items, which are 20 percent of import value, remain under license. These are mainly items that compete with domesti- cally-produced manufactures, or inputs to manufacturing, all SEE products. The license scheme is generally applied to keep the import price slightly above the price of the domestic product. Thus import competition does not seem to police SEE pricing. In fact, the opposite might be a more accurate description of the system. 86. On first impression, the frequent changes in flexible duties might appear to be confusing or disruptive to the SEEs or to private industry. For example, the import duty on paper was raised in January, April, and May 1984, and a Housing Fund duty was imposed in April. In July 1984 plans were being made co reduce the tariff. However, even though this behavior might seem to increase uncertainty, it seems that domestic producers understand the policy of generally keeping the import price a bit above the domestic price. This view was confirmed by discussion with private sector business people and SEE managers. They seem to be aware that, within limits that are not well defin- ed, they can raise prices under an umbrella of protection. 87. If SEEs are pricing above marginal costs and earning monopoly pro- fits, this has implications for private sector manufacturing companies. Much of SEE output is input to the private sector. To the extent that the SEEs earn monopoly profits, these may come at the expense of profits in the pri- vate sector using SEE output as input. This could contribute to the profit squeeze and potential financial instability discussed in paragraphs 95 to 102 below. 88. A combination of severa] factors leads to consideration of the hypothesis that at least some of the SEEs are monopoly pricing. These factors, to summarize, are relative freedom in price setting, pressure to be  - 24 - profitable, and implicit protection from the import regime. Each of these factors does indeed seem to exist. Monopoly pricing remains a hypothesis, however. One would have to perform an industrial organization study of costs, profits, and market structure in each case to determine the existence and extent of monopoly pricing. However, perhaps policy thinking on SEEs, especially those producing public services, should move toward suitable regu- lation schemes and away from simple profit criteria. B. Public Investment Reform 89. Under the structural adjustment program public sector investment was to be reduced and redirected toward provision of infrastructure. It was also to be concentrated on completion of major projects. In broad terms this program has been carried out. The public investment program has been redirected; in the new five-year plan for 1984-89 there are no new public investment projects in manufacturing. The completion rate has also greatly improved. Thus the stated SAL objectives are being met in this area. 90. The rationale for determining the desired level of public invest- ment has been unclear in the structural adjustment program. This was not a serious problem early in the program, where the obvious direction for policy was to reduce public investment in manufacturing and to redirect it towards projects that had high returns and could be completed reasonably quickly. But by 1984 the program may have reached a level and composition that require a clear view of the desired level. 91. One view of the effects of public investment that pervades the World Bank documents is that it -crowds out- private investment. The most recent manifestation of this view is in the SAL V President's Report: -This led to the evolution of a public investment program whose size encroached on private savings..." (para. 42). It is generally true that in a well-func- tioning ecoaomy at full employment with approximately fixed private saving, financing the government deficit competes with private investment. But Turkey has not been such an economy for quite some time. The data for public and private investment are shown in Table 2. There is no correlation among the contemporaneous data. If the private investment changes are lagged one year on the assumption that the crowding out takes time, there is a slight positive correlation, possibly indicating -crowding in.' Table 3: PERCENT CHANGES IN REAL FIXED INVESTMENT FROM PREVIOUS YEAR 1978 1979 1980 1981 1982 1983 Public -13.7 4.6 -3.7 9.4 2.2 1.8 Private - 6.1 -11.6 -17.3 -8.7 5.5 4.8  - 25 - 92. There are three reasons why puhblic investment might induce, or .crowd in" private investment. First, by expanding demand it might improve profit prospects. Second, if it increases income it will raise saving. Third, public investment in infrastrcture may raise the marginal productivity of private investment. So the "crowding out" argument cannot serve as a general argument for reducing public investment. 93. This point is important for the assessment of the 1983 results. Public investment in 1983 was programmed to increase 4.8 percent, but the actual increase was only 1.7 percent, as shown in the table above. Private investment was programmed for a 7.0 percent increase; actual was 4.8 per- cent. The combined shortfall in investment contributed to the slowdown in growth of real GNP. If the programmed 4.8 percent increase was based on an economic rationale, the shortfall is undesirable. If policy is simply to reduce public investment as far as political pressure will permit, the short- fall is a good thing. In the absence of a clear rationale for the choice of the programed level, it is hard to choose between these two views. 94. The public investment program has been successful at the macro level in reducing the size of the program and redirecting it from manufactur- ing toward infrastructure. However, the program still needs to be reviewed and evaluated at the micro level using the usual public finance criteria. Eventually, the program should be formulated and published on a multi-year basis with geographical and sector disaggregation. Then the program would also be useful for planning by private sector investors. C. Financial Market Instability 95. Real interest rates have been extremely high in Turkey throughout the course of the programs of stabilization and structural adjustment since 1980. While there was some slippage in 1983, on average demand management has also been quite austere. The combination of restrained domestic demand and high real interest rates can make it difficult for firms oriented toward the domestic market to service their debt to the banking system. Turkish bankruptcy lav makes recovery of assets from a bankrupt firm a long and difficult process. In addition, there is no serious system of bank auditing in Turkey. These circumstances provide a strong incentive for banks to carry bad loans by capitalizing the interest payments as new loans. There are no data that can confirm directly how serious this problem has been, or still is. In the absence of a serious system of auditing, data on non-performing loans, even though they show increases over the period, remain unreliable. 96. If non-performing loans were a widespread problem, capitalization would result in bank credit growing at approximately the rate of interest. At the same time, the banks would write up deposit values by the interest rate, so deposits would also grow at approximately the rate of interest. If the real interest rate were positive and high, this would imply growth in real deposits at the real rate of interest without any flow of new savi-3 into deposits. This could be misinterpreted as a positive response of the demand for real balances to a stabilization program in a situation in which  - 26 - the financial system is expanding partially on a base of bad debt, with some business firms decapitalizing and making transfers to depositors. 97. Data on money and credit growth and interest rates are snm-arized in Table 4. For 1983, money growth was around 40 percent in nominal terms, while domestic credit to the private sector grew by 44 percent. The latest available data show slightly higher money growth in 1984, and slightly lower credit growth. Panel B of the table shows nominal interest rates. Time deposit rates were 40 percent on January 1, 1983, down from 50 percent in 1982. The time deposit rate was reduced to 35 percent in June 1983 and raised again to 37 percent on January 1, 1984. Lending rates at the beginning of 1983 were unchanged from 1982; they were reduced a bit in mid 1983 and then raised again on January 1, 1984. Table 4: MONEY AND CREDIT GROWTH AND INTEREST RATES A. Growth rates (percent per year) 1983/82 March '84/March '83 Reserve money 38.3 42.8 Ml 41.4 K2 37.7 45.2 Domestic credit to private sector 44.4 41.0 B. Interest rates (percent per year) Jan. 1983 June 1983 Jan. 1984 Commercial banks Time deposits (6-12 months) 40 35 37 Short-term loans General 36 32 50 Export 31.5 25-30 35 Long-term general loans 41 34 52 98. The overall patterns of growth rates of money and credit and of interest rates are consistent with the hypothesis that a significant fraction of loans of the Turkish banking system are non-performing. The result could be instability in the financial system. If a combination of firms and, implicitly, banks were bankrupt de facto, a small shock could trigger a wave of impending bankruptcies in the banking system. This would require intervention by the Treasury or Central Bank to provide liquidity to stop the  - 27 - process at the beginning. This may have happened in the Kastelli crisis of 1982 and the bank consolidation in 1983. These occasional financial crises could be symptoms of an underlying instability in the financial system caused by the combination of slack demand and high real interest rates, rather than isolated cases of bad financial management. 99. Companies and banks attached to the major industrial groups in Turkey can avoid this problem for some time by financing obtained from the outward-oriented members of the group. Growing export revenues flow to the group's bank, providing liquidity to support the firms oriented toward the home market. There is evidence that the major groups with successful export business have been absorbing failing domestic firms. However, the potential instability in the financial sector could remain until a combination of stronger demand and lower real interest rates permits the average firm to service its debt. 100. A separate source of instability in financial markets is the combination of the policy of positive real interest rates with the use of recent observations on inflation as estimates of expected inflation. Neither World Bank documents nor the Government or Central Bank in Turkey have provided a clear explanation of how -inflationary expectations- are measured [see the President's Report on SAL V, paragraph 75, for example]. Discussion by the audit mission with staff in the Central Bank and in the office of the Undersecretary for Treasury and Foreign Trade indicated that recent actual inflation was taken as an indicator of expected inflation. 101. Inflation in Turkey has been highly variable. Table 4 shows the quarterly variation in annual inflation rates in the historical data. In four quarters, from 1980.3 to 1981.3, the CPI inflation rate fell from 101 percent to 29 percent. In 1983.2 the CPI inflation rate was 30 percent; by 1984.2 it was near 50 percent. With a highly variable inflation rate in the range of 25 to 100 percent for the past six years, the expected inflation rate is not likely to vary as much as the actual. This is because market participants will have observed that in the past, unusually high rates and unusually low rates have indeed been temporary. Thus when the inflation rate suddenly jumps, as ia spring of 1984, the expected rate will not increase as much. This is reinforced by the knowledge that SEE price changes have made major contemporary contributions to inflation in periods when it suddenly increased, as is argued in Section V, G below. 102. If expected inflation does not vary as much as actual inflation, but policy moves nominal interest rates to match fluctuations in actual inflation, then the policy causes variation in real rates. This variation is approximately equal to the difference between actual and expected inflation. Since the sudden movements in actual inflation are not generally anticipated, the induced variation in real interest rates cannot be anticipated by financial market participants. Thus the policy can cause unanticipated capital losses as actual inflation and real rates rise, and unanticipated gains as actual inflation falls. In periods of rising inflation, these losses can add to the pressure on financial markets and the banking system described earlier.  - 28 - Table 5: INFLATION RAIES, 1978-83 (Percentage Increase Each Quarter Over The Same Quarter of Year Earlier) Inflation rate (Ankara) Qluarter CPI WPI 1978.1 39.6 43.1 2 52.1 50.0 3 64.9 56.9 4 54.7 49.7 1979.1 58.9 50.2 2 59.5 61.7 3 60.9 66.6 4 67.2 76.8 1980.1 99.1 118.8 2 117.4 118.71 3 100.7 101.51 4 91.5 98.6 1981.1 56.4 55.4 2 28.5 34.0 3 29.2 37.2 4 27.7 27.5 1982.1 26.2 26.1 2 30.2 30.0 3 28.3 24.7 4 28.6 22.4 1983.1 30.7 24.8 2 29.8 25.8 D. Interest Rates and the Exchange Rate 103. One explanation for the high levels of real interest rates in Turkey in 1984 is that they are tied to world real interest rates through the foreign excbange market. This is a connection that seems not to have been taken into account in the January 1984 liberalization of the foreign exchange regime. These actions are described in the President's Report on SAL V, para. 68, pp. 28-29. Coumercial banks are now free to hold foreign exchange; citizens with passports can purchase foreign exchange from comercial banks; exporters can etain 20 percent of their foreign exchange earnings; export- oriented groups can borrow in foreign exchange; foreign exchange can be traded freely amongst legal holders. These reforms mean that a significant fraction of market participants can choose, at the margin, whether to hold short-term assets, such as deposits, in Turkish lira (TL) or in foreign exchange.  - 29 - 104. In this situation an arbitrage equilibrium develops, tying Turkish nominal interest rates to external nominal rates. For deposit holders to be indifferent between lira and foreign exchange deposits, the nominal rate on TL deposits must exceed the external rate by the expected nominal rate of depreciation of the TL plus TL risk premium. This is the nominal arbitrage equilibrium. 105. The commitment of the authorities to a flexible and realistic ex- change rate to support the export drive converts this into a real arbitrage equilibrium. To improve competitiveness, a policy of real exchange rate depreciation has been adopted. This is described in the President's Report on SAL V, paragraph 39. From the beginning of the daily adjustment policy in May 1981 to the end of 1983, the real effective depreciation of the TL proceeded at an annual rate of approximately 10 percent. In January 1984, the introduction of an exchange rate band for commercial bank trading brought a six percent nominal depreciation. The widespread expectation in Turkey is that real depreciation will continue. 106. Expected real depreciation implies that the nominal effective depreciation will be faster than the expected inflation differential between Turkey and its major trading partners and competitors. If nominal arbitrage enforces the condition. that the nominal interest differential must at least equal the expected nominal rate of depreciation plus the risk premium, the additional condition that the nominal depreciation exceeds the inflation dif- ferential means that the real interest rate in Turkey must exceed the exter- nal real interest rate by the expected real depreciation plus the risk pre- mium. 6/ 6/ This can be made more precise in a simple mathematical formulation: Let r, r* = home, foreign, nominal interest rates; P, P* home, foreign price levels; E - exchange rate, TL/FX; D - expected rate of real depreciation; o - TL risk premium; - % rate of change. Then we have (1) r - r* + E + o. (2) D = 2 - (P - P ). Exchange rate policy This implies that (2') E = D + p - p* Put (2') into (1) to obtain r - P - r* - P* + D + o So the arbitrage condition (1) and the exchange rate policy (2) combine to give (3) w*ich says the Turkish real interest rate must be the external real r* - P* rate plus the expected rate of real depreciation D plus the risk premium o.  - 30 - 107. Since expectations of inflation and depreciation are involved in all of these calculations, it is difficult to estimate empirically what this implies for real interest rates in Turkey. But a rough calculation can be attempted. The real short-term interest rate in the U.S. in mid-1984 was estimated by Blanchard and Summers (1984) to be about 4 percent.7/ If exchange rate behavior since May 1981 is taken as a guide for expected real depreciation, 10 percent per year is indicated. This would be reinforced if financial market participants expect the import liberalization measures of early 1984 to require a further real depreciation to prevent an increase in the current account deficit. A risk premium of perhaps 2 percent would then mean that the real short-term rate in Turkey would have to be above 16 percent to hold deposits in Turkish lica. The monthly WPI inflation, for the first eight months of 1984 is given in Table 5. The inflation bulge in April-June of 1984 is clearly associated with one-time increases in SEE prices (mining, energy, and manufacturing) and a reversible increase in agriculture. Even the January increase contained a 34.6 percent rise in energy prices. So it can be argued that the high rates of April-June should not have been expected to continue.8/ If this is the case, for illustration we might use 35 percent as the expected short-term rate of inflation in mid 1984. This would then imply that nominal short-term rates would have to be about 50 percent to hold deposits 50 percent in Turkish lira. The actual 6-12 month deposit rate in July 1984 was 48 percent, fairly close to the value calculated here. Table 6: INFLATION, JANUARY-MAY, 1984 (Percentage increase in WPI over the previous month) Jan. Feb. March April May June July Aug. 3.9 3.4 3.3 8.3 6.9 4.7 -0 7 3.2 108. The combination of liberalization of the foreign exchange regime and a policy of expected real depreciation can require high real interest rates to prevent capital outflow. If the gradual real depreci. .ion is needed to stimulate exports, the same could ie achieved by an unanticipated jump in real depreciation, combined with an announced policy of hol]4ing the real effective rate constant. If this policy were credible, real interest rates could then be reduced substantially without provoking an outflow of capital. 7/ 0. J. Blanchard and L. H. Summers, Perspectives on High World Real Interest Rates, Brookings Papers on Economic Activity, Vol. II, 1984, pp. 273-325. 8/ The EMENA Region disagrees with this conclusion and suggests that the resurgence of inflation cannot be easily ascribed to SEE price bubbles.  - 31 - More generally, if the exchange regime remains liberalized, the connection between exchange rate policy and interest rates should be taken into account in analyzing monetary policy. This I4s an area where empirical analysis is needed to test the hypothesis. E. Medium-Term Strategy and Reviving Private Investment 109. The audit report for SAL I noted the lack of a medium-term strategy document that would link the short-term stabilization program to a long run developmenE plan. Making this transition successfully should be a principal objective of structural adjustment lending. SAL III correctly emphasized the importance of developing a coherent view of the medium-term strategy, but due to the postponement of the 1983-88 five-year planning no document was forthcoming. In May, 1984, a medium-term strategy was formulated as part of the 1985-89 five-year plan. 110. The five-year plan projections take as given the path of real exports as the basic constraint. Export volume and dollar revenue are both projected to rise by 22.2 percent in 1984, implying no average change in dollar export prices.9/ Subsequently, during the plan period, export volume is projected to increase at an average annual rate of 10.1 percent and dollar earnings at an average annual rate of 14.6 percent.10i In both cases the growth rate is projected to rise over time. These export projections seem realistic in the absence of another major recession in the OECD area. One can also argue that political stability in the Middle East would improve Turkey's export potential, especially construction inputs and services. ill. The major potential problem with the medium-term strategy and the projections in the five-year plan may be private investment and a capital constraint. Private sector fixed investmeat is projected in the plan to grow at annual rates that increase from 8.2 percent in 1985 to 12.7 percent in 1989, with a compound annual average of 10.3 percent over the plan period. These are much higher growth rates than in any year since 1978; the peak during this period was 5.4 percent in 1982. However, these rates of growth may be attainable. From 1979 to 1983 capital goods imports grew at a compound annual rate of 11.8 percent.l1/ To attain this growth in private fixed investments, real interest rates will have to fall substantially and 9/ See the five-year plan, Table 12 for volumes and Table 14 for doilar values. 10/ To avoid confusion, note that the corresponding figures in Tables 12 and 14 in the plan are 10.63 and 15.67 percent. These are the averages of the annual growth rates, not compounded. Compounding lowers the growth rates and makes them look even more moderate. 1l/ Here capital goods are defined as -metal products and machinery- plus Electrical appliances." Data are from Table 3.4 of the Turkey Data Information System.  - 32 - profit prospects improve. Much of the growth will probably also require capital goods imports. The import content of private investment projects should be studied carefully. 112. More serious for the transition to export-oriented growth may be a potential capacity constraint. The combination of domestic .emand restraint and high real interest rates has severely reduced private invesament at the same time that public sector investment has been squeezed. The growth rates of private sector fixed investment in real terms since 1978 are given in Table 7. Private fixed investment fell from 1977 to 1981 by 37 percent. The result is that the level of real private investment in 1983 was less than 70 percen_.. of the 1977 level. The growth rate of private investment in the 1985-89 plan assumptions of 10.1 percent a year would barely bring 1988 real investment up to the 1977 level. Aside from the problem of reviving investment demand, these numbers suggest that growth may face a capital constraint on Lhe supply side due to the low level of private investment since 1977. Table 7: GROITH OF PRIVATE FIXED INVESTMENT, 1978-84 Year 1978 1979 1980 1981 1982 1983 Growth rate -6.0 -11.7 -17.2 -8.8 5.4 4.8 113. Economists at the State Planning Organization (SPO) suggest that the problem is not serious for the supply-side because of the low level of capacity utilization in 1984. It is not at all clear, however, how much of this capacity is economic' with the decline in investment from 1978 through 1981, and slow growth in the years or SALs II and III (1981-83); much of existing capacity having been built before 1979-80. The oil price increase, real devaluations, and increases of prices of inputs produced by SEEs, all since 1979, make some capacity installed before 1980 not economic. It is not clear that running old capacities now would cover variable cost. This is a point that should be studied in more depth. A key to the level of demand that can be supported by the existing capital stock is the proportion that is economic now. 114. The high level of private investment in the plan, combined with the possibility that a significant fraction of the existing capital stock may be obsolete, emphasize two points for the medium-term strategy. The first is the need for realistic policies to stimulate private investment. The second is the need to maintain a liberal policy on capital goods imports. F. Trade Policy 115. Liberalization of the import regime, and rationalization of the system of export incentives with the aim of eventually replacing it with a devalued real exchange rate have been policy objectives of the Government of  - 33 - Turkey since 1980. Impressive progress has been made in shifting from a quota system to tariffs on the import side. In addition the import regime has been shifted from an implicitly restricted system with lists of permitted goods to an implicitly free system with lists of restricted goods. Less pro- gress has been made on the export side, with subsidized credit and an expli- cit subsidy still remaining. 116. Import Liberalization. The process of import liberalization since 1980 is well-described in paragraphs 56-64 of the President's Report on SAL V. Two aspects of the existing regime should be noted here, however. The first is the apparent escalation of the tariff structure to provide effective protection for manufacturing; the second is the use of the variable levies for the same purpose. The interaction of the policy with SEE pricing was discussed earlier. As the SAL V President's Report notes, while more nominal tariffs were reduced than increased in the major shift in the import regime in January 1984, it appears that the escalation of the effective tariff structure has increased. Tariffs have been reduced on basic materials and capital goods, but less on semi-finished goods. Tariffs on finished products may have increased, on average. This would be consistent with the Govern- ment's objective of a tariff structure ranging from 0-15 percent on basic materials to 30-40 percent on finished products. 117. The new import regime includes a 'Housing Fund' list of goods against which a variable import levy can be applied. The revenues from this levy go to a new housing fund. Combined with the levy list existing since 1982, this extends the variable levies to a broad range of imports, including most of those which compete with domestic output. These levies are not included in the nominal tariff schedule. The Deputy Undersecretary of Treasury and Foreign Trade for Imports is authorized to determine the level of the variable levy, item by item. The principles by which his decisions are made are unclear, however. Examples can be given of levies being reduced to allow import competition to discipline the pricing behavior of domestic producers. The borrower, for example, states that as a general policy, import liberalization is the dominant criterion in establishing the protec- tion framework. Domestic industries which are unable to compete in interna- tional markets on the basis of price or quality are protected on a very limited scale (see Attachment). On the other hand, the dominant impression obtained by the audit mission was that the levies are used to keep prices of competing imports slightly above those of domestic producers, as part of a system of "flexible" use of import levies. 118. Export Subsidies. Exports in Turkey are subsidized in at least three ways: (a) imported inputs into exports are admitted duty-free, (b) export credit is subsidized, and (c) exports receive a direct subsidy called an export tax rebate. The interest rate on export credits has been increased substantially since 1980, but it appears that the increase has come only as part of the overall policy of increasing interest rates. At the end of December, 1980, the general scheduled short-term lending rate was 31 percent, and the special export rate was 22 percent, a spread of 9 percentage points. According to the Central Bank staff, in July 1984 the range of general rates  - 34 - was up to 55-62 percent, while the range for exports was 42-52 percent. The spread narrowed to about 5 points in 1982-83, widened to 15 points in January 1984 when general interest rates were increased, and then narrowed again to about 10 points in May 1984. Thus while the export credit rate has indeed been increased, the subsidy component seems to have fluctuated around 10 percentage points since 1980, rather than being reduced. 119. The explicit export subsidy is defined as an export tax rebate to maintain competitiveness with other members of the European Community, who rebate their value-added tax. It can be argued that since Turkey has other taxes, the equivalent to the EC value-added tax should be rebated through an export subsidy. The existing subsidies range from 5 percent to 20 percent of the TL value of exports.lf/ The case for calling it a tax rebate is weakened by the fact that its level is not systematically related to tax payments by exporters. 120. The Government intends to reduce both the tax rebate subsidy and the credit subsidy over time. This will strengthen the expectation of real depreciation, exacerbating the interest rate problem discussed in Section V, D above. It might be preferable to eliminate the export subsidies, reduce proportionately import duties, and have a jump depreciation of the TL in the same proportion to avoid the side effect on interest rates. G. SEE Prices, Inflation, and Interest Rates 121. A central feature of the structural adjustment program supported by SALs II and III has been the freeing of SEEs to set their own prices as a general guide to policy. As the inflation gained mom?ntum in the late 1970s, SEE prices were somewhat suppressed in order to hold down the open infla- tion. The degree to which they were suppressed remains unclear, however. In 1978 and 1979 the wholesale price index rose by 52.6 percent and 63.9 percent, respectively. SEE sales revenue rose 64.3 percent and 67.8 percent in these same years. In 1978 real GDP increased by Z.8 percent, and in 1979 it fell by 0.9 percent. So presumably nearly all the SEE revenue increases came from raising prices even in 1978 and 1979. 122. In any event, in early 1980, as a part of the new stabilization and structural adjustment programs, the SEE prices were largely freed from controls. Real GDP fell by 1.1 percent in 1980, so SEE sales volumes were most likely falling. But their total sales revenue rose by 167 percent, providing a minimum estimate of their aggregate price increase. The overall WPI increased by 107 percent in 1980. If the SEEs were assigned a weight of 0.4 in the WPI, this would imply an increase in 1980 in non-SEE prices of 68 percent, as compared with 64 percent in 1979. This suggests that most, if not all, of the increase in inflation to over 100 percent was due to the SEE price increases. A clear analysis of the consequences of this burst of SEE 12/ The borrower indicates that subsequent reductions in the rebate have resulted in an upper limit of only 11 percent. (See Attachment)  - 35 - price increases is essential as it strongly influenced the perceived macro- economic environment that conditioned the stabilization program supported by SALs II-III. 123. The SEE price increases appeared first in February 1980. The monthly WPI and CPI inflation data from October 1979 to the end of 1980 are shown in Table 8. The WPI inflation rate had a higher peak at a monthly rate of 29.3 percent in February 1980 than the CPI peak, but the WPI inflation came down more quickly. The SEE price increases spread into the CPI over three months. The quarterly data are shown in Table 9. The WPI inflation peaked at 118.8 in the first quarter; the CPI peaked at 117.4 in the second quarter of 1980. To a large extent, this was a one-time inflation bubble intended by the policy to raise SEE relative prices after a period of suppression in the 1970s. The policy succeeded; SEE prices relative to non-SEE prices increased by 250 percent, and SEE gross profits rose from -3.3 percent of GNP in 1979 to -0.1 percent in 1980. Table 8: MONTHLY WPI AND CPI INFLATION, 1979-80 (percent increase over previous month) Year/Month WPI /a CPI /b 1979.10 5.1 6.8 11 7.9 1.6 12 4.2 5.0 1980.1 9.2 10.0 2 29.3 21.5 3 4.4 8.4 4 3.5 5.7 5 2.9 12.5 6 2.8 -1.6 7 1.8 1.8 8 1.5 0.7 9 3.4 3.4 10 7.1 3.6 11 3.8 1.7 12 3.1 0.1 /a WPI data are the IFS A series. 7T; CPI data are the IFS A series.  - 36 - Table 9: CHANGES IN PRICES AND REAL BALANCES, 1979-81 (percentage increases over same quarter, previous year) Year/Quarter CPI WPI MU/CPI M2/CPI lS79.3 60.9 66.6 -6.3 -3.9 .4 67.2 76.8 -6.3 -5.8 1989.1 99.1 118.8 -27.0 -24.2 .2 117.4 118.7 -34.3 -35.3 .3 100.7 101.5 -19.7 -18.9 .4 91.5 98.6 -17.2 -12.7 1981.1 56.3 55.4 -10.1 5.9 .2 28.5 34.0 12.3 39.6 .3 28.2 37.2 1.0 34.1 .4 27.7 27.5 8.2 45.4 124. The jump in tbo price level however, reduced real money balances substantially. The third column of Table 8 shows the real MI fell sharply in 1980, by 34 percent in the second quarter. Real M2 followed a similar path in 1980. This sudden shrinkage in the real money stock in the first half of the year created a substantial excess demand for money. Interest rates were still controlled, however; they began to be freed only in July 1980. We can calculate the implied increase in a market-clearinj rate using a demand- for-money equation estimated by Khan and Knight.1'/ This says that the market-clearing short-term rate should increase in percentage points by about 80 percent of the percentage decrease of the real money stock. This implies an increase in the equilibrium short-term rate of about 27 percentage points for a given rate of inflation; this is the equilibrium jump in the real rate. 125. As deposit rates were gradually liberalized from 1980 to 1982, the real rate on six-month deposits rose to around 25 percent, less than the Khan-Knight coefficients would predict. / So the shrinkage of real balances in 1980 can approximately explain the rise in interest rates as financial markets were liberalized in 1980-81. 13/ Mohsin S. Khan and Malcolm D. Knight, Stabilization Programs in Developing Countries; a Formal Framework, IMF Staff Papers, Vol. 28, March 1981, pp. 1-53. 14/ See Turkey: Special Economic Report, Policies for the Financial Sector, Report No. 4459-TU, September 21, 19F3, para. 1.8.  - 37 - 126. The excess demand for money was probably increased by the stabili- zation program of 1980, and the change in political regime in September of that year. A successful stabilization program should reduce the expected rate of inflation. In Turkey, it did, so that expectation would have been fulfilled. This in turn, should increase the demand for money. So the very success of the stabilization program was increasing the demand for real balances even as the corrective SEE inflation was cutting the supply. A policy package to prevent the run-up in real interest rates would have included a one-time increase in MI to reduce the shrinkage in real balances at the same time as the future growth rate was credibly announced to be reduced. 127. To summarize, the SEE price increases in 1980 generated a one-time inflation bubble. This reduced the real money supply and raised market- clearing real interest rates substantially. The effect may have been exacerbated by the announcement of a credible stabilization program. VI. SUSTAINABILITY OF REFORMS 128. The principal objective of the structural adjustment program supported by the SALs has been to put the economy of Turkey back on an export-led sustainable growth path. The stabilization programs since 1980 have been regarded by the Bank as necessary to restore the initial conditions for growth. The approach has been to open the economy to international competition, to increase efficiency in financial markets, to shrink and restructure the SEEs and the public investment program, and g;-erally to move toward more market-oriented growth. 129. The process of structural adjustment, in many aspects has only begun. In Chapter IV on implementation it was noted that many of the fundamental reforms require institutional changes that can be implemented only over the long run. In Chapter V it was pointed out that some aspects of the stabilization program leading to financial market instability and a low level of private investment could constrain longer-term growth. This Chapter draws together the relevant points to ascertain the likelihood that the structural adjustment process is sustainable. 130. The question of sustainability can be approached by discussing the degree to which genuine institutional change has been achieved, and by discussing whether the economic policies have created conditions conducive to growth. Under the first heading questions arise about SEE reform, import liberalization, planning capacity, and staffing. Under the second heading the main questions revolve around monetary policy and pcivate investment and structural problems in financial markets.  - 38 - A. Institutional Reforms 131. The first major question regards reform of SEE management. The entire program of SEE shrinkage and reform is based on the view that the SEEs were inefficient in the late 1970s, compared both to the private sector then and to their potential in a competitive environment. During SALs II and III, and even later during SAL V, the SEEs were encouraged to become more profitable. But they could do this by raising prices behind an import regime that they still perceive as protective. Thus to some extent they are able to avoid exposure to competition, which would be the external stimulus to efficiency. At the same time, there has been little evident progress on internal reform. 132. The SEE management has been characterized as "bureaucratic" rather then managerial". The distinction is that managers in the private sector accept risk in order to earn return, while managers in the government sector are more prone to avoid risk altogether. Internal reform of the SEEs may have to attack this problem of managerial attitude by actually exposing the SEEs to competition and by rewarding success. 133. Inefficient SEEs making profits may be a greater obstacle to growth than inefficient SEEs making losses. In addition, the lack of internal reform to improve efficiency makes it extremely difficult to expose the SEEs to a competitive environment. They produce nearly half of industrial output, and a significant fraction of exports. Early exposure to competition could lead to bankruptcy problems with broad consequences. So more rapid progress on internal reform of the SEEs may be necessary for sustainability. 134. A closely related problem area is liberalization of the import regime. Very substantial progress has been mdde since 1980 in shifting from a system of quantitative restrictions to tariffs, and in shifting from a system with lists of permitted goods with all else implicitly banned to a system with a limited list of banned goods and everything else explicitly free. 135. A remaining major problem is the possibility that the flexible Housing Fund levy is used to maintain protection for domestic producers, including the SEEs, at unduly high levels. As SEEs raise their prices in response to the profit-oriented policy of the new government, they may be protected by increases in the flexible levy. This could lead to pricing above marginal cost in the SEEs. The policy of freeing SEE prices should be accompanied by more free competition from abroad, not less. Thus the flexible administration of the Housing Fund levies may work against SEE reform and bhift the brunt of the demand squeeze even more toward the private sector. This, in turn, could -exacerbate the problems with investment and financial markets described below. Protection for the SEEs should be systematically and predictably reduced as part of the SEE reform program. The EMENA Region points out that import liberalization has been most significant in "intermediate goods," where SEEs are predominant. However, the existence of the Housing Levy" represents a potent instrument for  - 39 - ensuring that the prices of competing imports would be raised to levels that are not unduly competitive with SEE prices. 136. The delay in defining an effective medium-term strategy and the reliance on macro targets and ceilings co cut back public investment both indicate a lack of capacity for planning and evaluation. The present medium-term strategy seems to be mainly publication of optimistic projections for private investment in the five-year plan for 1985-89. The 10 percent average annual growth rate is well above any year's growth since 1976. The supply of capital goods could be provided through imports. But the demand for investment would have to be stimulated through improved profit prospects and lower real interest rates. It is not clear that the plan (to date avail- able only in Turkish) contains a consistent medijin-term strategy to make the transition from the 1984 conditions of high real interest rates and demand stringency to the desired growth path. The Bank has since 1981, had a continuous dialogue with the Government on the medium-term strategy, to underpin the short-term stabilization program, but it has essentially been ad hoc. 137. In SA..s II-III the public investment program was reduced by focusing on completable projects. During the period it was obvious which projects should be eliminated; they were unmistakably below the margin. But by 1984, public investment had been under four years of pressure of this kind. If the program had been successful, by 1984 it should have reduced and refocused public investment to the point where project choice should be made on the basis of objective criteria. It is not clear that this is being done, or could be, given the personnel situation in Turkey. One priority is to develop project evaluation capability in the investment banks and the State Planning Organization. This process has been started by EDI in its joint course with the State Investment Bank (DYB) in September-October, 1983. 138. A related problem is the lack of motivation among Turkish govern- ment personnel. This stems from frequent changes in personnel for reasons that are perceived to be arbitrary, low pay relative to the private sector, long hours, and a feeling that the system will not be responsive to reform. In terms of institutional reform, attention should go towards improving and to some extent depoliticizing the government service system. B. Economic Policy 139. Sustainability of the reform program is sensitive to two areas of economic policy. The first is monetary policy, construed to include interest rate and exchange rate policy. The second is the structure of financial markets, including potential banking system instability. In both of these areas forces are at work that depress private investment. A major objective of the reform program is to increase the share of private investment in total investment. Thus the factors leading to a depressed level of private investment could raise doubts concerning the sustainability of the program. 140. The difficulties with monetary policy in Turkey were discussed in Chapter V above. The combination of a perceived policy of gradual real depreciat_f3n combined with a liberalized foreign exchange market require  - 40 - Turkey to hold real interest rates above the 'world- market real rate, which is already at an historically high level, by at least the sum of the expected rate of real depreciation and the TL risk premium. A lower real interest rate would lead to capital outflows through the foreign exchange market. 141. This mechanism is reinforced by use of recent actual inflation rates as a measure of the expected rate. In 1984, as in 1980, there was an unexpected surge in inflation as SEE prices were raised. In 1984 this came mainly in the second quarter, with a jump in monthly inflation rates shown in the first column of Table 10. For comparison with more familiar annual data, the second column shows the annualized equivalent of the monthly rate. Monthly inflation peaked in June 1984, and then fell to an apparent core annual rate of around 30 percent. This is an improvement over the 1983 performance. But the point here is that with SEE prices jumping in the second quarter, the rate of inflation would have been expected to increase temporarily, as in 1980. But with the degree of wage restraint that exists in Turkey, the inflation rate should also have been expected to fall back to the apparent core rate by the end of 1984. Thus if we take 30 percent as a rough estimate of this core rate, lending interest rates in mid-1984 of 50 percent represented true real rates around 20 percent. Thus using the actual inflation rate as representing the expected rate can lead to excessively high real interest rates when the inflation rate surges temporarily. Table 10: MONTHLY CPI INFLATION, 1983-84 (percent increase over the previous month)/a Year/Month Monthly Rate Annual Rate 1983.1 4.2 65.5 2 2.5 35.0 3 2.0 27.1 4 0.9 11.4 5 0.7 8.8 6 1.3 16.9 7 1.0 12.7 8 2.3 31.8 9 3.2 46.8 10 5.3 88.9 11 3.7 55.9 12 4.2 65.5 1984.1 3.4 50.4 2 1.5 19.7 3 3.0 43.3 4 5.2 86.6 5 4.1 63.4 6 6.5 118.1 7 0.9 11.4 8 2.5 35.0 9 2.1 28.7 /a Turkey General Cost-of-Living Index, new SIS series. The borrower has partially updated this series (see Attachment).  - 41 - 142. Real interest rates could be lowered in Turkey by the following policy steps at the macro level. If the authorities perceive that a real devaluation is ne-ded, this could be done in one step, a "maxi" devaluation. Over time, the stated objective of the 'flexible and realistic' exchange rate policy could be to keep the real effective exchange rate roughly constant. This would take the expected depreciation premium out of the real interest rate, and permit the authorities to lower real interest rates. Structural reforms in the banking system, to be discussed below, would permit lending rates to come down more than deposit rates. In implementing the policy of positive real interest rates, the authorities might consider adopting a smoothing model to estimate the expected inflation rate. This should make explicit allowance for specific events such as movement in SEE prices or *maxi" devaluations. 143. The inefficiency and fragility of the financial structure 4Q Turkey also threatens the sustainability of the reform program. The potential instability of the system was discussed in Chapter V. Somewhat more rapid demand expansion and lower real interest rates would alleviate that situation by improving profits and debt service capacity in the industrial sector. 144. The other major problem with the existing system is the inefficiency of the banking system. The banks are the main intermediaries providing investment finance in Turkey. Their inefficiency causes a spread of lending over borrowing rates that is very large by international standards. This has been noted in several previous World Bank reports. With limited administrative and financial resources in Turkey, it may be more productive to concentrate on improving the banking system instead of trying to develop more sophisticated capital markets. These stock and bond markets play a marginal role in financing investment in Turkey; diverting scarce resources into their development at this time may not be efficient. 145. Three major policy actions could be recommended for the Turkish banking system. First, steps could be taken to consolidate branches, which contribute to very high overheads. Second, an effective external auditing system should be developed. This would require training of bank auditors. Third, steps could be taken to improve competition in the banking sector. The Government has moved on this front, for example by opening the system to foreign banks. But more could be done, especially to weaken the links between captive banks and industrial groups. A more efficient and stable banking sector could provide the finance that is necessary for efficient growth in private investment. C. Conclusions on Sustainability 146. The structural adjustment program in Turkey has at its core four elements: liberalization of the trade regime, liberalization of financial markets, shrinkage and reform of the SEEs, and growth of private investment. Substantial progress has been made in the first three areas, but not in the fourth. To improve the probability that the economy will move toward a sustainable and more efficient growth path, steps can be taken in each area.  - 42 - The operation of the present import regime may be delaying SEE reform. High real interest rates and a weak financial structure may prevent the growth of private investment. An efficient public investment program requires an effective process for evaluating projects. But most important may be, moving fairly quickly to a path of somewhat faster demand expansion with lower real interest rates. VII. IMPACT OF STRUCTURAL ADJUSTMENT PROGRAM 147. The structural adjustment program had three basic objectives: {i) promoting economic growth; (ii) strengthening the balance of payments; and (iii) promoting financial stability. It was recognized that the implementation of the reforms would involve some hardship and substantial social costs during a transition period. The actual results during the first four years of the program were on the whole satisfactory even though the high expecrations projected at the outset were not fully realized. There are, however, indications that the task of sustaining the basic economic objectives over the longer term is become increasingly difficult. A. Economic Growth 148. The strategy for the promotion of growth essentially focussed on the liberalization of foreign trade through incentives for exports and reduced regimentation of imports in combination with price incentives for production and trade. These measures were supplemented by strict control over monetary expansion and subsidies to uneconomic state enterprises CSEEs). The reforms had a major impact on the industrial sector and to a lesser degree on agriculture. The response of the industrial sector in particular was almost immediate and in combination with smaller production increases in other sectors, raised the growth rate sharply in 1981 and 1982, followed by a slight decline in 1983, principally a result of a fall in agricultural output. The increased market incentives spurred industrial capacity utilization markedly from a low point of 51 percent reached in 1980 to 69 percent in 1983. The aggregates, however, mask some of the costs involved in the reform program. The higher cost of capital sharply curtailed the expansion of new investment in the private manufacturing sector. In addition, a sharp increase in market interest rates and the scarcity of credit exacerbated the financial difficulties of many small enterprises. Larger businesses which have substantial access to family owned funds or are tied up with banks have been able to cope with the credit stringency and consolidated themselves. This leaves the question as to whether the reforms have facilitated oligarchial market structures.  - 43 - Table 11: NATIONAL ACCOUNTS, 1980-83 1983 Level 1980 1981 1982 1983 At Current In ----Actual-- Prices Percent Real Change From (TL billions) of GNP Previous Year (Z) Consumption 9,585.3 83.5 -3.4 0.6 3.9 4.5 Public 1,167.3 10.2 8.4 0.9 2.0 1.8 Private 8,418.0 73.3 -4.9 0.6 4.2 4.9 Fixeu Capital Investment 2,180.8 19.0 -10.0 1.7 3.5 3.0 Public 1,315.8 11.5 -3.7 9.4 2.2 1.8 Private 865.0 7.5 17.3 -17.3 -8.7 4.8 Stockbuilding 194.7 1.7 (3.8) (0.8) (-1.0) (0.3) Total domestic demand 11,960.8 104.1 1.2 1.6 2.8 4.4 Foreign balance 475.6 4.1 (0.2) (2.5) (1.7) (-1.2) GNP 11,485.2 100.0 -1.1 4.1 4.6 3.2 Memorandum Items Agriculture 2,058.0 17.9 1.7 0.1 6.4 -0.3 Industry 3,096.0 27.0 -5.9 7.6 4.6 7.6 Construction 447.6 3.9 0.8 0.4 0.5 0.6 Services 5,183.2 45.1 -0.3 5.4 3.6 4.4 GDP at Factor Cost 10,784.8 100.0 -1.0 4.7 4.3 3.8 Note: Figures in parentheses are the contribution in percentage points to the growth in GNP. Source: State Planning Orgnaization. B. Balance of Payments 149. An important development has been the marked improvement in Turkey's balance of payments deriving from a sustained growth in export earnings and an improvement in the current account, as compared with the base year (1980). It has enabled a substantial build up of reserves in 1980-82, moderated by a small loss in 1983. One of the marked features of the strong export performance is the growth of industrial exports, whose share in the total rose from 36 percent in 1980 to 60 percent in 1982 and further to 64 percent in 1983. This trend has been accompanied by a marked diversification into newer markets. Thus besides the growth of exports to OECD markets from $1.7 billion in 1980 to $2.8 billion in 1983, the increase in exports to  - 44 - Middle East countries was even faster, rising from $495 million to $2.5 billion over the same period, increasing the latter's share from 17 percent to 43 percent. Table 12: BALANCE OF PAYMENTS, 1980-83 ($ millions) 1980 1981 1982 1983 Exports of goods & NFS 4,171 6,486 7,744 7,950 Imports of goods & NFS 8,798 9,716 9,611 10,240 Workers' remittances 2,071 2,490 2,187 1,554 Net transfers Current account balance -3,272 -1,982 -1,188 -2,122 Direct private investment 128 113 90 143 Public M&LT capital (gross) /a 2,351 2,238 2,503 2,155 Amortization on M&LT debt /a -436 -560 -954 -1,513 Public M&LT capital (net) 7aT 1,915 1,678 1,549 642 Other capital /b 1,836 461 -31 1,389 Change in reserves (- increase) -607 -270 -482 52 Reserves as months of imports 2 2 3 3 /a Includes private guaranteed and non-guaranteed debt. 7! Includes errors and omissions. Source: Ministry of Finance and Central Bank. 150. Despite the outstanding export performance since the commencement of the structural adjustment program, a number of questions remain. While the incentive created by a favorable real effective exchange rate has been a major element in the export thrust, the export effort has also bad to be buttressed by a plethora of subsidies, among which special access to credit and favorable interest rates combined with -export tax rebates- are the most important. Questions arise about the ability of Turkey to continue supplementary subsidies of this nature indefinitely, especially when the costs and benefits are weighed. Recent research purports to supports the thesis that a close relationship exists between the package of subsidies and  - 45 - the volume of exports, meaning that considerable resistance would be encountered if they were to be dismanrled.15/ 151. The buoyancy in exports is also the result of the stringent demand management policies that have been put in place since 1980 compounded by the high real interest rates. As the economy adjusts to a higher level of activity and the limits on credit expansion are relaxed it is likely that suppressed consumer demand may restrict the volume of exportable commodities, principally manufactures.16/ This underscores the point made earlier in the report that attention needs to be paid to resuscitation of private investment to overcome present limits of manufacturing capacity. 152. The sustainability of the export promotion program implicit in the structural adjustment reforms is also compromised to some degree by the continued high level of protection afforded to a range of industries. Turkey continues to protect a variety of industries that are exceptionally susceptible to international competition. As a result, it has been found, that large segments of Turkish industry are still far from ready to face full international competition. There is a perception that having gone thus far in its import liberalization program, Turkey would find it increasingly difficult to address the hardcore of import protection. A failure to move adequately on this front could retard the export oriented growth strategy and the improvements in the balance of payments that have recently occurred. C. Financial Stabilization 153. The promotion of financial stability has been a major goal of the structural adjustment process. The strict measures to contain monetary growth and aggregate demand quelled the high rate of inflation. Government action concentrated on making the SEEs more cost efficient, and on reducing the overall budget deficit. While rather successful during the early years these measures have been less effective in the recent past. 15/ The yearly average subsidy in terms of export values is estimated to range from 32-44 percent to exporters of capital goods, to a moderate 18-30 percent to exporters of intermediate goods, and to relatively low 16-18 percent to exporters of consumer goods. Turkey: Trade Policy Issues in the Structural Adjustment Process, IBRD Report No. 5365-TU August 1, 1984). 1E The highest elasticity is observed in the case of consumer goods exports where each percent of increase in real export exchange rate leads, on the average, to 2.5 percent increase in the volume of exports. Hence, direct export subsidies in consumer industries produce greater effects on exports than the same relative increase in subsidies to intermediate and capital goods. IBRD Report No. 5365-TU, op cit. p. 18.  - 46 - Table 13: INCREASE IN WHOLESALE PRICES, 1979-84 Year 1979 + 65% 1980 + 107% 1981 + 38% 1982 + 25% 1983 + 30X 1984 + 52% Source: IMF, International Financial Statistics. 154. While early results of operations of SEEs indicated an improvement in their financial performance, especially during 1980-82, there was a marked turn for the worse in 1983 when losses reached an all time high of 1L 160 billion; hence the financing requirement rose from 7.8 percent of GNP in 1982 to 9.4 percent in 1983. These developments serve to stress the fragility of the reforms that have been mounted and the need to continue with the longer-term task of sustaining fundamental structural reforms. Table 14: SEE ACCOUNTS, 1980-83 (TL billions) 1980 1981 1982 /a 1983 Sales revenue 1,146 1,767 2,650 3,596 Total expenditures 1,184 1,800 2,640 3,756 Profit/loss -38 -33 10 -160 Total investment 459 616 684 914 Fixed investment 281 406 533 769 Change in stocks 178 210 151 145 Financing requirement /a 497 649 674 1,074 Memorandum items (In percent of GNP) Profit/loss -0.9 -0.5 0.1 -1.4 Financing requirement /a 11.2 9.9 7.8 9.4 /a E..cludes depreciation. Source: Treasury.  - 47 - 155. The attainment of financial stability was also predicated on an improvement in budgetary performance. Early trends seemed to indicate that this goal was within reach of the government; the budget deficit was sharply reduced between 1980-82. However, there was a marked deterioration in 1983, partly as a result of increased financing needs of SEEs. This increased the public sector's borrowing requirements, which expressed as a percentage of GNP rose fro,i 6.9 percent in 1982 to 8.7 percent in 1983 and may have been even higher 1984. Table 15: PUBLIC SECTOR BORROWING REQUIREMENTS, 1980-84 (TL Billions) Actual Estimate 1980 1981 1982 1983 1984 Budget Balance -235.0 -174.0 -181.0 /b -377.0 -645.0 SEE Financing /a -474.0 -621.0 625.0 -919.0 -1,152.0 Budgetary Transfers 149.0 241.0 205.0 292.0 250.0 PSBR -560.0 -554.0 -602.0 /b -1,004.0 -1,547.0 (In percent of GNP) PSBR/GNP -12.6 -8.5 -6.9 -8.7 -8.8 /a Includes depreciation. /b March-December data annualized. Source: Treasury and Bank Estimates. 156. The budgetary impact of deteriorating SEE performance has been compounded by a failure of tax revenue to grow proportionately with income; its share in GNP has consistently declined from about 20.3 percent in 1981 to 18.