Turkey - Financial Sector Adjustment Loan Project

DaAmumu of The World Bank FOR OFFICIAL USE ONLY b/,t. q / / Report No. P-4258-TU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US$300 MILLION TO THE REPUBLIC OF TURKEY May 15, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  TURKEY CURRENCY EQUIVALENTS Currency Unit Jan. 1980 /1 Jan. 1982 Jan. 1983 Jan. 1984 Jan. 1984 Mar. 1986 USDollar TL 70.00 TL 139.00 TL 191.15 TL 309.20 TL 451.40 TL 658.25 TL l US$ 0.014 US$ 0.007 US$ 0.005 US$ 0.003 US$ 0.002 US$ 0.0015 /1 Since January 1980, the rate is being adjusted for the differential inflation between Turkey and its major trading partners. FISCAL YEAR Republic of Turkey January 1 to December 31 LIST OF ABBREVIATIONS CB Certificate of Deposit CMB Capital Market Board DFC Development Finance Company DYB Devlet Yatirim Bankasi FERIS Foreign Exchange Risk Insurance Scheme GDP Gross Domestic Product GNP Gross National Product OECD Organization for Economic Corporation and Development SEE State Economic Enterprise SYKB Sinai Yatirim ve Kredi Bankasi TCZB Turkiye Cumhuriyeti Ziraat Bankasi TSKB Turkiye Sinai Kalkinma Bankasi WPI Wholesale Price Index  FOR OFFICIAL USE ONLY TURKEY FINANCIAL SECTOR ADJUSTMENT LOAN Loan Summary Borrower: The Republic of Turkey Beneficiaries: The Undersecretariat of the Treasury and Foreign Trade, the Central Bank, the Capital Market Board, the Board of Sworn Bank Examiners, the Board of Sworn Financial Advisers and the commercial banks. Amount: US$300 million equivalent Terms: Seventeen years including four years of grace, with interest at the standard variable rate. Description: The proposed loan would support the Government's financial sector adjustment program during the two-year period 1986-88. The principal objectives of the program are to establish an efficient and flexible system of resource mobilization and allocation, which would respond rapidly to market forces and would offer a wide variety of financial instruments to both borrowers and savers. The principal measures to be taken would include: (i) the reduction of subsidies on preferential credit and achievement of positive real interest rates for preferential credit to the productive sectors; (ii) standardization of accounts and introduction of external audit of commercial banks, along with strengthening of bank supervision; (iii) development of the capital market through reform of the regulatory framework including introduction of external audit of corporations; and (iv) development and introduction of new financial services. Simultaneously, the institutional capacities of the major agencies in the sector adjustment process would be strengthened by provision of technical assistance at a total foreign exchange cost of $3.0 million. The loan would finance all imports with the exception of items financed by other sources, military or para-military items, luxury goods and nuclear reactors. | This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Benefits and Risks: The reforms agreed under the loan will help to create a more efficient financial sector and thus enhance growth, both by increasing savings and by channelling them to more productive investments. In particular, by developing a greater variety of financial instruments, the reforms would contribute to a revival of private investment. The main risk arises due to uncertainties in the control of inflation, as the persistence of high levels of inflation is a major constraint to the reduction of the prevailing high interest rates and consequent corporate financial distress. This risk is mitigated by the Government's determination to pursue sound macro-economic policies. Other risks relate to the prospects for the rapid development of the capital markets, and the degree of resistance that might be encountered in the introduction of external audit of banks and corporations. Both sets of risks are considered manageable in view of the progress already made and the Government's commitment to the reform program. Estimated Disbursements: The proceeds of the loan would be disbursed in two tranches, $200 million equivalent soon after effectiveness, and $100 million after a performance review expected to be carried out in July 1987. Staff Appraisal Report: No. 6095-TU, dated May 15, 1986 Map-, No. 11656R1  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN TO THE REPUBLIC OF TURKEY 1. I submit the following report and recommendation on a proposed Financial Sector Adjustment Loan to the Republic of Turkey for the equivalent of US$300 million to support the Government's program of reforms in the financial sector designed to make the sector more efficient and better able to fulfill its role of fostering economic growth. The loan would have a term of 17 years including 4 years of grace, with interest at the standard variable rate. PART I - THE ECONOMY 2. An economic mission visited Turkey in June 1982, and its report entitled "Turkey: Country Economic Memorandum, Recent Economic Developments and Medium-Term Prospects" (No. 4287-TU) was distributed to the Executive Directors in June 1983. The report of a mission to review the financial sector, entitled: "Turkey: Special Economic Report - Policies for the Financial Sector" (No. 4459-TU), was distributed in September 1983. A Bank mission reviewed the Government's Fifth Five-Year Development Plan (1985-89) in September 1984 and its report: "Turkey: The Vth Five-Year Plan in the Context of Structural Adjustment" (No. 5418-TU) was distributed in July 1985. 3. Turkey's area is about 781,000 square kilometers (i.e. about equal to the area of France and West Germany combined) with a population of around 50 million and GNP per capita of $1200 in 1984. The density of population is low (78 per square kilometer of agricultural land), and about 47 percent live in urban centers. Population growth (2.2 percent per annum) is below the median for middle-income countries. Despite rapid economic growth in the mid-1970s as well as emigration of workers (to Western Europe and more recently, to the Middle East), there is still substantial unemployment which, including disguised unemployment in agriculture, is estimated at about 19 percent of the civilian labor force. There is, however, little or no absolute poverty, although income distribution is skewed. There are considerable regional differences in income and large rural-urban disparities. Recent data indicate a probable increase in income inequality since the 1970s, especially a relative deterioration of the position of wage and salary earners and an improvement in the position of the trading and commercial classes, and, more generally, of capital-owners. Educational enrollment has expanded greatly, but the level of adult literacy remains relatively low compared to the European average for middle income countries.  -2- Background 4. During the 1970s Turkey did not make the necessary adjustments to the shocks caused by the steep rise in oil prices, stagflation in the OECD economies, and the consequent deterioration of its terms of external trade. Until 1977 Turkey maintained high rates of economic growth by increasing public investment. The foreign exchange requirements were financed initially by workers' remittances and then increasingly by borrowing, a large part of it short-term. The rapid GNP growth came to an abrupt halt in 1977 as the massive external debt burden led to a sharp deterioraLion in creditworthiness, severe shortages of imports, disruptions in industrial production and a rise in unemployment. By the end of 1979, domestic inflation had also become an issue of critical importance. 5. In response to the crisis of the late 1970s, the Turkish authorities made a major shift in development strategy in 1980, moving towards outward orientation and giving an increased role to market forces. To alleviate the balance of payments constraint and import shortages, policies were adopted to expand exports, increase workers' remittances, liberalize imports, encourage foreign investment and improve external debt management. On the domestic front, the objectives were a reduction in the inflation rate, reform of the State Economic Enterprises (SEEs), a more efficient financial sector, improved resource mobilization and better selection of investments, especially in the public sector. 6. The adjustment program, which has been supported by the Bank through five Structural Adjustment Loans and an Agricultural Sector Adjustment Loan, involves far-reaching changes in attitudes, institutions, and the legal and policy framework, all of which require time to be put in place. Major structural changes have been made in the exchange rate system, the export and import regimes, the tax system, interest rate and selective credit policies and the public investment program. Implementation of the adjustment program started in January 1980, continued under a military regime during the period September 1980 - November 1983, and has since been carried out by an elected government. The Structural Adjustment Program, 1980-85 7. The Turkish economy has shown an impressive response to the structural adjustment program and the outcome met or exceeded the Government's own targets through 1982. The overall performance deteriorated in 1983 due to a combination of factors (slowdown of export growth, slippages in the monetary program, shortfall in Government revenues), but improved again, except in the area of inflation and the budget deficit, in 1984. The improvement was maintained in 1985, this time including a slowdown in inflation and a reduction in the budget deficit. 8. After expanding by 4.1 percent in 1981 and 4.6 percent in 1982, real GNP growth slowed down to 3.2 percent in 1983, due to the effects of a bad harvest, stagnant exports and lower workers' remittances. The growth rate rebounded in 1984 to 5.9 percent, mostly on account of favorable performance in agriculture (3.7 percent growth) and industry (9.3 percent growth).  -3- Merchandise exports also expanded strongly, by more than 25 percent in dollar terms. In 1985, according to the latest estimates, the economy grew by about 4.9 percent, as against the program target of 5.5 percent. The slowdown in growth was most significant in agriculture (2.2 percent growth) and manufacturing (5.5 percent), due respectively to less favorable climatic conditions and slackening domestic demand. On the expenditure side, the average annual real rate of growth of public fixed investment over the period 1980-84 was 3.8 percent. Provisional estimates for 1985 indicate that public fixed investment totalled TL 3,289 billion, implying a much higher real growth (12.8 percent) over 1984 than programmed (5.8 percent). However, the size of public investment is overestimated for two reasons: (i) the increase in local currency cost of outstanding foreign debt due to devaluation is included in the investment figures for ongoing projects; and (ii) interest costs incurred by ongoing projects are also added to public investment. Rough calculations indicate that these could add up to as much as 30 percent of the total investment figure for 1985 cited above. The growth rate of private investment has fluctuated more severely, falling by 17 percent in 1980, recovering slowly, and then rising by 7.1 percent in both 1984 and 1985. Private consumption, after declining by 5 percent in real terms in 1980, grew by 5 percent in 1983 and 1984 before slowing down to an estimated 3.8 percent in 1985. Strict budgetary discipline contributed to a steady decline in the real rate of growth of public consumption from 8.4 percent in 1980 to 1.8 percent in 1983; however, it increased to 3.2 percent in 1984 and an estimated 3.3 percent in 1985. 9. During 1981-82, the Government met with considerable success in reducing the rate of inflation through a combination of fiscal, monetary and incomes policies. After peaking at 107 percent in 1980, the average annual rate of increase in the wholesale price index (WPI) decelerated to 37 percent in 1981 and 27 percent in 1982. In 1983 the downward trend was reversed and the inflation rate rose to 30 percent. Inflation accelerated further in 1984, and reached 50 percent, due to the lagged impact of the expansionary monetary policy pursued during the second half of 1983, and a significant increase in agricultural product prices, especially of fresh fruits and vegetables, as a consequence of export liberalization and higher export market prices. Other contributory factors included substantial "catch up" increases of SEE prices - since January 1984 most SEEs have effectively been allowed to set their prices freely - and higher import prices resulting from the nominal depreciation of the Turkish lira. In addition, inflationary pressures stemmed from a larger than anticipated budget deficit in 1984 as a result of a slowdown in the growth of revenues. 10. In 1985 inflation declined considerably -- the average annual rate of increase in the WPI fell to 43.2 percent, after reaching a very high level in the first quarter of 1985 (about 60 percent as of March 1985). By December 1985, the month-over-month change in the WPI (i.e. December 1985 over December 1984) had correspondingly declined to 38.3 percent and by March 1986 it had dipped even further, dropping to below 30 percent for the first time in two and half years. Factors causing the high inflation rate in the first quarter of 1985 were the introduction of a value added tax (VAT) in January 1985 and continued substantial increases in the prices of several key  - 4 - intermediate goods and inputs. Thereafter, several factors combined to lower inflationary pressures: (i) monetary growth slowed, particularly in the fourth quarter, with M2 growth declining from an annual rate of 64 percent as of September 1985 to 53 percent at year-end; (ii) by April 1985 most of the catch-up increases in the prices of SEE products appeared to have been completed and the rate of price adjustment abated considerably; (iii) the significant slide of the dollar, which started after March 1985, resulted in a slowing down of the nominal depreciation of the Turkish lira against the dollar and therefore in smaller increases in prices of imported products than were witnessed in 1983-84; (iv) the persistence of high real interest rates (which increased as inflation declined) helped to channel liquidity towards savings rather than consumption and thus lowered aggregate demand; and (v) lower exports of certain agricultural products (cereals and pulses) meant that the domestic market was well supplied, thus easing inflationary pressures on food prices. The steady deceleration in the inflation rate, which has now continued for over 12 months, reinforces the expectation that the Government's target rate of 25 percent for 1986 could be achieved, particularly considering the large decline in world oil prices since January 1986, the continued weakening of the dollar relative to other international currencies, and the Government's maintenance of a tight monetary and fiscal program. 11. In the fiscal area, progress has been uneven. During 1980-82 the budget deficit declined from 5.3 to 2.1 percent of GNP, but increased to almost 5 percent of GNP in 1984, due mainly to a disappointing performance in raising tax revenues. In 1985, however, the budget deficit is estimated to have been TL 621 billion or 2.3 percent of GNP, a significant improvement over 1984. This is largely because the Government took several measures in 1985 to increase revenues, the most important of which was the introduction of VAT. In its first year, VAT collections amounted to about TL 1 trillion, significantly above the target. Other tax measures which were adopted included substantial increases in various fixed charges and duties and large increases in penalties for overdue tax payments. As a result of these measures, budget revenues rose from 15.4 percent of GNP in 1984 to 17 percent in 1985, reversing the downward trend in revenues over the previous three years. Government expenditures decreased from 20.3 percent of GNP in 1984 to an estimated 19.3 percent in 1985. 12. Progress has also been made in rationalizing interest rates and reforming the banking system. Since 1981, interest rates on time deposits at commercial banks have been positive in real terms. Positive deposit interest rates have resulted in a steady growth in deposits, about 10 percent per annum in real terms in 1984 and 1985. Improvements in incentives for savings were accompanied by administrative reforms of the banking system and the enactment of a new banking law. Other important developments in the financial sector include measures undertaken to revitalize the capital market discussed in Part IV of this report. 13. While positive real interest rates have provided an incentive to save, they have also meant high borrowing costs. Effective nominal interest rates range from 60 to 80 percent on non-preferential credits, in part because of the impact of high liquidity and reserve requirements, the option which  commercial banks have to invest in high-yielding government bonds, and high intermediation costs. The Government took a number of steps in 1985 to reduce the interest rate differentials between preferential and non-preferential credits: in particular, the preferential interest rate for export credits was discontinued in January 1985, while, during the year, interest rates for larger agricultural loans and for loans to SEEs were increased from 28 and 22 percent to 34 and 35 percent respectively. The narrowing of the gap between interest rates on preferential and non-preferential credits, together with the decrease effected in the amount of preferential credits, is expected to increase the general availability of credit and exert a downward pressure on non-preferential interest rates. 14. Improvements in the balance of payments were substantial between 1980 and 1982, with the current account deficit decreasing from $3.3 billion (5.7 percent of GNP) in 1980 to $1.2 billion (1.6 percent of GNP) in 1982. In 1983 the current account deficit increased to $1.8 billion, as merchandise exports stagnated and workers' remittances fell by one-third. These developments were reversed in 1984 as exports increased by over 25 percent in dollar terms to reach $7.4 billion. Remittances, too, registered a higher than expected increase, reaching $1.8 billion (up by 20 percent over 1983). Merchandise imports grew by more than 16 percent to reach $10.8 billion. As a result of these developments, both the trade and the current account deficits declined as compared to 1983. Latest estimates for 1985 indicate a further strong improvement of the balance of payments situation. Merchandise exports grew by 11.6 percent (in dollar terms) in 1985, while merchandise imports increased by 8 percent. Among the invisibles, tourism revenues and investment income from abroad increased significantly compared to 1984 and previous years. Workers' remittances, on the other hand, declined by 5 percent. The current account deficit in 1985 is now estimated at about $1.0 billion, or about 1.9 percent of GNP. 15. Merchandise export performance has been impressive throughout the 1980-85 period, during which exports registered an average annual rate of increase of about 23 percent in dollar terms. This growth has been led by the manufacturing sector and has involved a rise in the share of exports to the Middle Eastern countries. Industrial exports, composed primarily of processed foods and textiles, have risen from 32 percent of total exports in 1980 to more than 72 percent in 1985. These results were achieved by a combination of indirect measures (flexible exchange rate policy, import liberalization) as well as direct measures (tax rebates, preferential credits) to enhance the relative profitability of exports and offset the traditional bias towards production for the domestic market. Successful penetration of the Middle Eastern markets has brought their share in total Turkish exports from 17 percent in 1980 to around 40 percent in the 1983-85 period. 16. On the import side, the 1982-83 period was marked by a relative stability in the growth of merchandise imports, as prices of both oil and non-oil imports declined, and the vol,ume rate of growth remained moderate. In 1984, however, merchandise imports increased substantially. The increase was most prcnounced in some of the groups (e.g. raw materials and consumer goods) that have been subjected to major liberalization through a lowering of tariff rat?s and a significant removal of quantitative restrictions. In 1985, as  domestic demand eased, and the initial effects of pent-up demand for importables released by import liberalization weakened, the rate of import growth decreased to about one-half of the level recorded in 1984. Medium-Term Prospects 17. The Fifth Five-Year Development Plan (1985-89), which was approved by the Grand National Assembly in June 1984, reaffirms the Government's determination to pursue an outward-oriented development strategy and to liberalize the economy by relying increasingly on market forces. The public sector is targeted to play a supportive role by concentrating its investments in infrastructure rather than manufacturing, while the private sector is to be encouraged to play a leading role in the growth of manufacturing and exports. Some of the key targets are: (i) an average annual GNP growth rate of 6.3 percent; (ii) an average annual real rate of growth of merchandise exports of 10.6 percent; (iii) an average annual real rate of growth of 10.9 percent in private investment and 6.8 percent in public investment; (iv) a declining external debt service ratio, from 26 percent in 1984 t^ around 18 percent in 1989; and (v) z decreasing rate of inflation reaching 10 percent p.a. in 1989. 18. While the overall thrust of the Plan is in accord with the goals of the structural adjustment program, the Plan targets, if viewed collectively and in the light of the developments in 1984 and 1985, appear somewhat ambitious and likely to strain domestic resources (especially in the public sector) as well as have an adverse impact on the external balance. Accordingly, the Government is adjusting the annual programs to ensure that they remain compatible with the fight against inflation and with a growth strategy commensurate with the Government's ability to generate resources. 19. The recent decline in international oil prices is likely to have a favorable impact on Turkey's balance of payments. The Bank's projections presented below take into account the most recent decline in oil prices. The analysis shows that the savings from direct petroleum imports alone could be about $1.3 billion in 1986. The favorable direct impact would be offset to some extent by lower export growth to oil-exporting countries (which account presently for about 40 percent of Turkey's exports) as well as lower profit and workers' remittances from construction activities in these countries. However, a compensating increase in Turkish exports to, and workers' remittances from, OECD countries on account of a more favorable OECD growth outlook is likely in the medium term. Our estimate puts the net positive impact of the oil price decline on Turkey's balance of payments at about $400 million in 1986. There would be indirect benefits as well in the medium term, including a reduction in the cost of debt servicing as a consequence of a decline in inflation and interest rates in OECD countries. An improvement  - 7 - in the balance of payments would give the Government the option of repaying its external debt sooner, thus improving Turkey's debt service ratio in the coming years, or using the extra resources to support a faster growth strategy. Given the uncertainty associated with the oil price projections, we have been cautious in revising GDP growth targets significantly at this time, in order to emphasize inflation control and a greater build-up of foreign exchange reserves. 20. The Bank's projections indicate a GDP growth of 5.9 percent p.a. on average for the 1986-90 period. At the beginning, growth might be relatively slow (5.3 percent p.a.), gradually accelerating in the outer years to an avexage rate of 6.1 percent p.a. in 1987-90. The inflation targets in the Bank's projections are also more conservative compared to the Plan targets, implying a reduction from about 43 percent in 1985 to around 18 percent in 1990. Key economic variables in the Bank's projections for the period 1986-90 are presented in Table 1. Table 1: TURKEY - SELECTED ECONOMIC INDICATORS, 1984-90 tum3 uil yraAb ratn III Seictars Act. 1.t. Proj. Pro). Itt. hl. ---r.jtse----- am sa am am i 1 1w11,-" ;4til Kt_t IFt iss ricn, 3il 1IL W at wrkui gren 2633.6 P418.6 2n 3.9 36210.1 5.3 4.9 .1 La W-icltwr 4313.3 4136.2 062.7 521.1 3.7 2.2 3.0 3.2 1i-ty 7m7.3 1195.3 352.6 1175.3 9.3 L I 6.3 7.6 I,waIn 1205.0 234n.3 s23.2 172"9. 4.7 3.0 L.2 .7 CIteI 21797.4 2212.0 24125.5 30154.3 4.3 3.3 6.7 5. Flood a,ntet 4112.2 .0 364.9 7332.1 2.0 1@.5 L.2 6.7 .iulutmn So 5. 43.2 33.3 2.I I_1m3e Price 1mgd! bilcs o0 payests (at garret , Pill 2 mpart d 3b,d 3h*l 733. 1255.0 3.O 12543.0 26.2 13.5 -4.3 *.I apart S Nadi 9m 2 232 11K31.0 123. 10339.0 3261.0 33.3 3.0 13.0 7.4 Trig, lalca, -2"2.0 -2975.0 -27.0 -3573.0 frkir, rjltmen 1857.0 1314.0 129.3 239.0 Carret Kceet bl0.2c -2407.3 -1023.0 417.0 127.0 kfm 'lts tea Copiltl rqaareauet, 4*7.3 355.0 4222.1 4534.0 by Iacrecaaamc ratios II Iantit/ M 20.2 20.0 20.0 212. I'Z 17.2 11.0 1.9 29.7 (xperts d gSe. 1MP 14.9 15.7 15.7 19.0 arret kct. h4*riJt 2.7 1. 0.17 0.9 Si svicg rata io 27.0 31.0 312. 25.0 Pollgt fated ina.etaiutal flAi eltsit 6o., 61.3 59.6 53.5 la Total dct arvwic. Iecldig abwt-tarallap rt of Inds and wa-fictir ,rnace PIn ariars reattgca. Shwee 312, la stamti.  - 8 - 21. Achievement of these growth rates will depend primarily on the performance of agriculture and manufacturing. This in turn will depend to a large extent on the Government's determination to constrain the growth of the public sector in line with resources and to create a more favorable investment climate for the private sector. This translates into a projected real growth in public fixed investment of about 3.9 percent p.a. on average for the 1986-90 period. In 'ight of the developments in 1985, this implies a tighter control of public investment. The comparable figure for the growth of private fixed investment is 10.6 percent p.a. The projections allow for a modest increase of per capita consumption of slightly above 3.0 percent p.a. on average over the period 1986-90. 22. Merchandise exports are projected to grow at an average rate of 8.1 percent per annum in real terms during 1986-90. This assumes the maintenance of a realistic exchange rate, further import liberalization and the ability of Turkish exporters to take advantage of higher expected growth in the OECD market. Merchandise imports are projected to grow at an average annual r-.te of 7.4 percent. This is consistent with the import liberalization program of the Government. On these assumptions, the current account deficit is projected to decrease to $927 million in 1990 as compared to an estimated 1985 figure of $1,013 million. The projected capital account would remain manageable throughout the period, even in the face of some sharp increases in amortization payments arising from the debts rescheduled during 1978-80. 23. The medium-term scenario presented above is, of course, only one of many possibilities and is used specifically to illustrate Turkey's potential in the light of the Government's own development strategy. Given Turkey's progress in the structural adjustment program, the favorable response which this has evoked from the international financial community, and the present outlook for both lower oil prices and a decline in interest rates, the GNP growth projected in the medium-term base case scenario could be exceeded if the current account deficit is lowered and there is an improvement in the mobilization of publ-c resources. 24. In view of the sensitivity of the projections to the assumptions regarding export growth, a downside risk case has also been developed. With Turkey's export performance heavily dependent on exogenous factors such as the world economic condition. and movements in international prices, a slower growth of merchandise exports (an average of about 6 percent p.a. over the 1986-90 period) coupled with lower mobilization of public resources (3 percent lower revenues than envisaged under the base case scenario) would lead to a more difficult but still manageable balance of payments situation, a lower GDP growth (averaging about 4.7 percent p.A.) and a higher debt service ratio. In such a situation the Government would have less chance of absorbing the unemployed and improving tangibly the average standard of living. However, if the Government in such circumstances were to resort to a high growth strategy, then it could witness a repeat of the situation which prevailed in the 1970s, and which led to a debt crisis. It is unlikely that the Government would risk such a situation. It is therefore more probable - even if exogeneous developments are unfavorable - that the Government would continue with the structural adjustment program as implemented to date.  - 9- External Debt and Creditworthiness 25. At the end of 1978, Turkey had $7.2 billion in short-term debt and $7.0 billion in medium and long-term debt. Between 1978 and 1980, furkey rescheduled some $9.2 billion of outstanding obligations through a series uf rescheduling arrangements concluded with official and commercial creditors. Following the resolution of the debt crisis, inflows were mostly from official sources -- OECD countries, the World Bank and the IMF. Since 1983 commitments from commercial banks have outstripped those from official sources, reaching an estimated level of $2.4 billion in 1985. Of the estimated total debt outstanding of $25.4 billion (including IMF) at end-1985, medium and long-term debt accounted for about 75 percent. Short-term debt as a percentage of total debt outstanding fell from 51 percent in 1978 to about 11 percent in 1982, then increased to an estimated 25 percent in 1985. Much of this growth in the stock of short-term debt is due to the inflcws associated with the Dresdner Bank scheme. 1/ At end-1985, the outstanding liabilities associated with the Dresdner scheme amounted to $2.7 billion, constituting 40 percent of short-term external obligations. Inflows from the Dresdner scheme have been steadily growing with few withdrawals, which is a reflection of increased confidence in the Government's economic policies. The Government is sensitive, however, to the build-up of short-term debt and intends to limit its share of total debt in the medium term to the present level. Based on the growth scenario outlined in paras. 19-22, debt outstanding and disbursed as a percentage of GDP is projected to fall from an estimated 46 percent in 1985 to 38 percent in 1990. This translates into a forecast of total debt outstanding in 1990 of $31 billion, with short-term debt constituting about 26 percent of the total. 26. The debt service ratio for medium and long-term credits increased from about 26 percent in 1984 to an estimated 31 percent in 1985, mostly as a result of large repayments of rescheduled debt falling due. Debt service obligations are expected to be on average about $4.3 billion a year during 1986-90, a quarter of which is attributable to service obligations on rescheduled debt. However, the debt service ratio is projected to decrease to about 25 percent in 1990, due largely to improvements in the current account of the balance of payments. The debt burden should remain manageable provided current policies are successfully implemented, the export drive is sustained, and Turkey continues to receive support from international commercial and official sources. Confidence in Turkey's overall economic performance, its stable record in meeting debt servicing obligations and its improved debt management, encouraged commercial banks to commit about $1.9 billion of medium-term credits in 1985. In the first quarter of 1986, nearly $500 million out of a total of $700 million borrowed from commercial banks consisted of medium and long-term loans. Several major American, European, Japanese and Middle Eastern banks have been involved in these operations. 1/ UJnder this scheme the Dresdner Bank collects deposits from Turkish workers in West Germany and automatically places these funds at the disposition of the Central Bank of Turkey, which guarantees the deposits and pays an interest rate commensurate with the Euro-market rate.  - 10 - 27. Turkey's economic program has been supported by the IMF through a series of staudby arrangements during 1980-84. The Government did not ask for a new standby in 1985. The Government's decision seems to reflect the view that the favorable economic developments in 1985 indicate that Turkey has "graduated" from the IMF's program and that the IMF presence through Article IV consultations and periodic staff visits to review economic performance should suffice for purposes of maintaining internatiornal confidence. PART II - THE FINANCIAL SECTOR A. Structure 28. The financial system of Turkey comprises (a) the monetary institutions, i.e. the Central Bank and the commercial banks; (b) the development banks; (c) the social security system; (d) insurance companies and credit cooperatives; and (e) the securities markets. Although Government incentives and the sale of Government bonds have encouraged the development of a more active securities market in the last few years, the commercial banks still dominate the financial system. In the early 1980s, commercial banks accounted for about 65 percent of the total domestic resources mobilized by the financial system, the Central Bank for 20 percent and other institutions for 15 percent (Table 2). Of the latter, the share of the social security system declined steeply from 23 percent in 1970 to less than 10 percent in 1983 as high inflation eroded the real value of its assets. Domestic bonds issued by the development banks accounted for only 4 percent of the total domestic liabilities of the Turkish financial system in 1983. The ratio of total domestic resources of the financial system to GDP declined rapidly from 54 percent of GDP in 1970 to 40 percent in 1981 and then recovered to 48.7 percent in 1985 following the liberalization of deposit interest rates. Table 2: STRUCTURE OF THE TURKISH FINANCIAL SYSTEM (percent of total financial assets) 1970 1981 1983 1985 (Sept.) Central Bank 16.4 21.5 18.2 16.5 Commercial Banks 52.2 64.0 66.6 69.2 Development 3anks 6.3 2.4 4.0 4.0 Social Security 22.6 10.1 8.8 7.7 Others 2.5 2.0 2.4 2.6 Total 100.0 100.0 100.0 100.0 Memo: Outstanding Domestic Instruments 54.0 40.0 47.5 48.7 (as percent of GDP)  - 11 - 29. Changes in the Government's interest rate policy have had a dramatic impact on the ability of banks and other institutions to mobilize domestic resources. Consequently, the depth of the financial system as measured by the ratio Ma/GDP has fluctuated considerably over the past 15 years as shown in the following table. Table 3: DEPTH OF THE FINANCIAL SECTOR /a (TL billion) 1970 1980 1981 1982 1983 1984 1985 (Sept.) Ml 30.5 569.1 784.6 1,012.2 1,436.7 1,810.9 2,313.4 Quasi Money 7.4 117.7 428.2 995.0 1,291.8 2,390.7 4,036.2 Mz 37.9 686.8 1,212.8 2,007.2 2,728.5 4,201.6 6,349.6 M,/GDP {X) 21.0 13.2 12.2 11.8 12.5 9.9 8.3 Mz/GDP (2) 26.1 15.8 18.9 23.4 23.8 22.9 22.9 /a Quarterly geometric averages. 30. Rising inflation in the 1970s brought returns on all deposits to increasingly negative levels in real terms. As a consequence, nominal growth in monetary assets barely kept pace with inflation, and the ratio of M2 to GDP declined foom 26.1 percent in 1970 to 15.8 percent in 1980. The authorities effectively lifted ceilings on deposit interest rates in July 1980. Deposit interest rates rose substantially and have remained generally at positive levels in real terms thereafter. In response to the interest rate reform, money balances grew on average by 58 percent per annum in the period 1981-83, while inflation averaged 33 percent per annum. As a result, the ratio of M2 to GDP increased significantly. Although the ratio in 1985 was still somewhat below the levels attained in the early 1970s, it should be noted that the M2 figures exclude holdings of Government bonds outside the banking sector as well as foreign currency deposits by residents, which had grown rapidly and reached nearly $2 billion bu the end of 1985, representing approximately 2.8 percent of GDP. If these other financial assets are included, the ratio of broad M2 to GDP is probably about 26-27 percent at present. This is still rather low for a country at Turkey's stage of economic development, although it represents a considerable increase over the level of 1980. Composition of Money SupplY 31. Large differentials in the yields offered on the various types of financial instruments have caused significant changes in the composition of Mz during the last few years (Table 4). Interest bearing time and savings deposits increased rapidly from 2.6 percent of GDP in 1980 to 6.7 percent in 1981 and 13.0 percent in 1984. However, some of the increase in the volume of time and saving deposits resulted from a shift within the money supply from non-interest or low-interest bearing instruments (i.e. currency and demand  - 12 - deposits) to interest bearing time and savings deposits. Thus Ml (currency and sight deposits) fell as a percentage of GDP from 17.3 percent in 1979 to 9.9 percent in 1984. In aggregate, the share of sight, time and savings deposits in the money supply increased from nearly 72 percent in 1979 to 85 percent in 1985. Table 4: TRENDS IN THE COMPOSITION OF MONEY SUPPLY (percent of total) 1979 1980 1981 1982 1983 1984 1985 (Sept.) Currency 28.3 26.0 35.3 18.1 15.9 16.7 15.0 Sight Deposits 56.6 56.9 44.6 32.3 36.8 26.4 21.4 Time and Savings 15.1 17.1 20.1 49.6 47.3 56.9 63.6 Broad Money (M2) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 32. The dramatic change between 1980 and 1985 in the relative shares of the different kinds of deposits can be linked directly to changes in the comparative yields of these financial instruments. Since 1981, time and savings deposits have been yielding nominal interest rates of approximately 50 percent p.a. The rapid fall in the share of currency within the money supply reflects the high opportunity cost of holding zero-yielding cash balances. Holdings of sight deposits, which until recently carried an interest rate of 5 percent (para. 49), have declined in relative terms for the same reason. 33. These major changes in the composition of financial assets have had important consequences, most notably a rapid increase in the average cost of bank deposits. The increasing share of time deposits carrying higher interest rates has pushed up the average interest cost of bank deposits from about 30 percent in 1982 to about 40 percent in 1985. As a result, many branches in rural areas which were able to operate profitably because cheap sight deposits offset their high administrative costs became unprofitable when the average interest cost of deposits increased drastically. In response to these developments, commercial banks have begun to close down their least profitable branches. The rising interest cost of bank deposits has caused a significant increase in the lending rate of banks. Similarly, the opportunity cost to the banks of the compulsory liquidity and reserve requirements imposed by the Central Bank has risen in step with the cost of mobilizing deposits. In order to mitigate the impact of these requirements on the lending rates of commercial banks, the Central Bank has gradually reduced the level of reserve requirements (Dara. 56).  - 13 - 34. The second development in the past few years has been a rapid shortening of the average maturity of all types of bank deposits, from 8.8 months in 1979 to 3.4 months by the end of 1984. Excluding demand deposits, the average maturity of time deposits has declined from 32.6 months in 1979 to 6.1 months in 1984. This development resulted from the combination of high and volatile inflation since 1980 with the system of fixed deposit interest rates. In a context of uncertainty as to the course of inflation, depositors have become extremely reluctant to commit their funds for more than short periods of time. In addition, the effective yield set by the Government on 12 month deposits has been consistently less than on 3 or 6 month deposits, reflecting the expectation that inflation will decline. The increasingly short maturity of bank deposits has placed a serious constraint on the ability of banks to lend Turkish lira funds on a long-term basis. 35. Another consequence of the change in the composition of monetary assets in Turkey has been a change in the manner the Government has financed the budget deficit. As demand declined for currency holdings (which earn no interest), the ability of the Central Bank to expand its advances to the Treasury without fuelling inflation declined as well. This consideration led the Government to increase its reliance onI bond issues as a means of financing the budget deficit. As of December 1985, the volume of Government bonds outstanding stood at TL1,526 billion. Role of the Central Bank in the Financial System 36. The changing composition of financial assets in Turkey has caused structural changes in the role of the Central Bank relative to commercial banks within the financial system. In response to the decline in the ratio of currency to GDP and the reduction in compulsory reserve requirements, the Central Bank has cut the volume of its credit to public sector enterprises and reduced its rediscounting of credits advanced by commercial banks. Outstanding Central Bank rediscounts to banks were cut in half in nominal terms between 1983 and 1984. As a result, the net flow of resources from the Central Bank to commercial banks has become negative as repayments of Central Bank advances have exceeded the level of new rediscounts. The Commercial Banks 37. The impact of the reform of the Turkish financial system has been particularly strong on the commercial banks. Entry of new banks, including foreign banks, has increased competition and helped to improve the efficiency of intermediation as well as profitability. At the end of 1985, there were 50 comuercial banks operating in Turkey. The 12 public sector banks accounted for 52 percent of totai assets as against 44 percent for the 19 private banks and 4 percent for the group of 19 foreign banks. The foreign banks have thus far concentrated their efforts on a relatively small number of the better managed firms operating in Turkey, and have tended to specialize in export trade financing. A deposit insurance scheme covering funds held in commercial banks was introduced in 1983. The scheme presently provides coverage of principal amounts up to TL3 million. The Government intends to review the scope of deposit insurance periodically and raise the ceiling as necesssary to maintain the level of coverage in real terms.  - 14 - 38. Interlocking ownership between commercial banks and major industrial conglomerates has been commonly recognized as a factor inhibiting competition among banks in providing services to the corporate sector in Turkey. However, the increasing export orientation of large industrial groups is giving them access to competitive sources of credit from foreign and, increasingly, domestic banks specializing in trade financing. The availability of such alternative financing has mitigated the problems of credit allocation caused by interlocking ownership. But the reluctance of banks to stop extending credit to associated corporations that are no longer creditworthy, or to enforce repayment of existing loans, remains a serious concern. The new Banking Law (para. 61) has introduced certain restrictions on the operations of banks to deal with this and other problems. The restrictions include a 20:1 debt/equity ratio limit, a limit to the maximum exposure to any single customer of 10 percent of a bank's net worth, and limits on a bank's exposure to officials of the bank and their relatives, or to companies in which the bank has an equity investment. 39. The Banking Law also contains more stringent capitalization requirements aimed at improving the soundness of the banks and their ability to weather abnormal loan losses. The debt/equity ratio of banks has improved substantially in the last few years, from about 39:1 in 1980 to 15:1 in 1984. Although paid-in capital and reserves increased from 2.5 percent of total assets in 1980 to 6 percent in 1984, the ratio is still very low by international standards. Overdues are officially estimated at 2.8 percent of assets but are probably higher given the inconsistency of classification criteria among the various institutions. It seems, however, that the portfolio quality of banks has improved somewhat in recent years and that banks are increasingly able and willing to set aside provisions for bad debts. Provisions have been raised from 0.3 percent of assets in the late 1970s to an average of 0.6 percent in the period 1981-84. At the same time, the profitability of banks increased significantly, from 1.2 percent of assets in 1983 to 2.3 percent in 1984, although performance has been uneven at the individual bank level. Major banks with a national network of branches have tended to perform less well than some of the small but fast-growing urban banks, primarily because of the rising costs of branch banking as depositors have shifted from low yielding sight deposits to higher yielding time deposits. Some of the major banks are now responding to these developments by closing down unprofitable branches, a desirable development in view of the overbranching which characterizes the Turkish banking system. The closing by commercial banks of their most inefficienit branches, computerization of operations and expansion of services are a few of the ways open to the banks to reduce their administrative costs which remain high in comparison with banks in other countries. The increasing cost of branch banking has also favored the emergence of smaller, urban based commercial banks which concentrate their activities on providing services to the corporate sector. The Securities Markets 40. The relative underdevelopment of the securities (particularly equities) markets as d channel for the direct financing of corporations and as an element of competition to the commercial banks is an important structural  - 15 - weakness of the financial sector in Turkey. Securities market operations took place in a virtual regulatory and supervisory vacuum until 1982. In that year, the collapse of a large number of brokers prompted the enactment of a Capital Market Law which gave to a new agency, the Capital Market Board (CMB), the responsibility for the regulation and supervision of the primary and secondary markets, including inter alia the approval of public offerings of corporate securities. In response to the actions taken by the CMB, public offerings of equities have risen in the last three years and amounted to TL76 billion in 1985. The corporate bond market, after fast growth in the late 1970s, lost ground after 1982, but is again showing signs of revival, with new corporate bond issues in 1985 totalling TL32 billion. The growth of the securities markets in Turkey has been hampered not only by high inflation but also by the inadequacy of accounting and auditing sLandards and the absence of disclosure requirements, which puts a severe limitation on the ability of financial institutions and investors to evaluate corporate financial statements. Growth of Credit 41. Total credit extended by the financial sector, consisting of credit extended by the Central Bank, commercial or deposit money banks (DMBs) and investment and development banks, has grown from TL796 billion in 1979 to TL5,851 billion in September 1985, excluding holdings of Government bonds by commercial banks. This increase in nominal terms is however a decline in real terms from TL796 billion in 1979 to TL606 billion in September 19E5 (in 1979 prices), a decline at a compounded annual rate of 4.6 percent. The sharpest decline has been in direct credit extended by the Central Bank to the Government, as the Government has resorted increasingly to financing the budget deficit by the issue of bonds which are purchased mostly by commercial banks, rather than by borrowing from the Central Bank. Holdings of Government bonds by commercial banks increased from TL32.3 billion in 1979 to TL1,080 billion in 1985. Impact of Government Borrowings 42. The rising volumes of Government bond issues which have been purchased by commercial banks have been partially substituting for credits to the private sector. The share of the private sector in total domestic credit extended by the financial sector declined for the first time in 1984 following a steady increase since 1980 (Table 5). It is also noteworthy that the share of public sector enterprises in total domestic credit has declined rapidly since 1982 while the share of Government has increased significantly during the same period, the latter primarily as a result of the Government's reliance on the issue of bonds to finance the budget deficit (para. 35). While this has introduced a measure of budgetary discipline, it has also inevitably resulted in some crowding out of the private sector from the domestic credit markets. The situation is likely to change only gradually, as the inflationary situation improves and the budget is balanced.  - 16 - Table 5: COMPOSITION OF CREDIT OUTSTANDING (percent of GDP) 1979 1980 1981 1982 1983 1984 1985 (Sept.) Total Domestic Credit 32.3 30.4 31.7 34.5 35.8 35.4 37.9 Of which - Net Claims an Govt. 8.6 10.9 10.4 10.8 12.0 18.8 20.9 - Claims on Public Enter. 7.2 6.6 6.0 5.4 3.6 2.0 1.4 - Claims on Private Sector 16.5 12.9 15.3 18.3 20.2 14.6 15.6 Share of Govt. in Total Domestic Credit (X) 26.6 35.9 32.8 31.3 33.5 54.9 55.1 Share of Private Sector in Total Domestic Credit (%) 51.1 42.4 48.3 53.0 56.4 42.6 39.6 PART III - THE FINANCIAL SECTOR ADJUSTMENT PROGRAM The Macro-Economic Setting 43. Turkey's structural adjustment program has brought about major reforms in the macro-economic environment, particularly in exchange rates, the trade regime, the incentives framework, rationalization of public investment, the taxation system, pricing policies, the state enterprise sector, and the planning framework. Most of the reforms have been aimed at accomplishing two central medium-term objectives -- subjecting Turkey's economy to market forces and achieving an outward orientation. The macro-policy framework put in place since 1980 mainly affects the real sectors of the economy, principally agriculture, industry and energy, but it also affects in a major way how the financial sector operates. Starting with the Bank's Financial Sector Report, and continued under the Fourth and Fifth Structural Adjustment Loans, emphasis began to be placed on financial sector reform. Some important reforms were launched -- mainly in the structure and level of deposit interest rates, reductions in the financial transactions tax and the withholding tax on interest earnings, rationalization of preferential lending rates, and setting up of an auctioning system for Treasury Bills. 44. Efficient functioning of the financial sector is very closely linked with the macro-economic policies followed by the Government as part of its strategy for the next phase of its adjustment program. The challenge is essentially to achieve an appropriate balance between stabilization and growth. The Government has undertaken to pursue monetary, fiscal and trade policies aimed at curbing the budget deficit, controlling inflation and maintaining export growth through the revival of private investment. An efficient financial sector will greatly strengthen the Government's program in these three areas. In particular, a smoothly functioning financial sector is a crucial requirement for the healthy expansion of the private sector. At the  - 1.7 - same time, financial sector reform can only be carried forward effectively within a framework of sound fiscal and monetary policies. The Government's macro-economic program emphasizes stabilization with controlled output expansion to reduce unemployment and improve the average standard of living. Striking the right balance is crucial to maintaining Turkey's creditworthiness. Progress towards achieving these objectives will be monitored in the context of the Bank's ongoing dialogue on economic policies with the Government. Financial Sector Reform 45. The overall objective of the Government's financial sector reform effort is to deepen the financial system and to establish, over the medium term, an efficient and flexible system of resource mobilization which would respond rapidly to market forces and offer a wide variety of instruments to both borrowers and savers. Such a system would make resources available to borrowers at positive but reasonable real interest rates and would continue to grow both in real terms and in relation to GDP. It is clear that the achievement of these objectives would require coordinated action on a wide front. 46. The issues to be addressed in the financial sector relate essentially to improved resource mobilization and allocation, and call for measures covering financial policies, instruments and institutions. Financial policies have strong linkages to fiscal and monetary policy, interest rates and selective credit policies. Development of instruments includes measures to integrate the growth of Treasury bonds, commercial paper, and corporate bonds and equities. Institutional development includes strengthening of the banking system and expanding the role of the Central Bank in bank supervision, strengthening the accounting system, developing the capital market, and developing new institutions and services. Medium-Term Framework 47. These actions are wide-ranging and ambitious, and can only be completed over the medium term. The Government has committed itself to implement the reform program within a medium-term framework described in its Statement of Financial Sector Policies-1986, which is annexed to this report (Annex IV). The expected results of the medium-term reform program can only be delineated in indicative terms because as the financial system becomes more market responsive, targets set exogenously will become less useful. However, as the process of financial sector reform evolves, Turkey's financial system can be expected over the medium term to exhibit characteristics similar to those of more developed financial systems of other medium-income countries, namely: (a) financial depth, mezsured by the percentage of M2 to GDP, increasing from the present 20-25 percent to 30-35 percent; (b) the intermediation margins of commercial banks declining to about 3-5 percent of assets from the present 7-10 percent; (c) the share of long-term instruments in financing of investments increasing to about 7-10 percent from the present 3-4 percent; and (d) issues of corporate bonds increasing by about 50 percent, equity issues by about 15 percent and the volume of trading in the inter-bank market by about 30 percent, all in real terms.  - 18 - The Program for Reform 48. The proposed loan would support a program of reforms in the financial sector that would be compatible with the medium-term framework and would complement the ongoing macroeconomic adjustment program. The reform actions would address a range of issues central to the financial sector, including interest rates, selective credit policies, development of the accounting profession, audit and supervision of commercial banks, development of capital markets, and audit of corporations with publicly-issued securities. In parallel, technical assistance would be provided to upgrade the institutional capacities and skills of the Treasury, the Central Bank, the Capital Markets Board, the commercial banks and supervisory agencies. Finally, the loan would support actions to introduce new financial services such as medium-term export credit and export credit insurance. The various components are elaborated below. A. Sector Policies Interest Rates 49. Deposit Rates. Since 1981, deposit rates have been maintained at positive real levels, except for sight deposits which still yield only 5 percent per annum. The Government's ultimate objective is to liberalize all deposit rates fully, once the financial system has improved its robustness and competitive efficiency. At the present time, however, the effective cost of deposit resources is largely determined by Government decisions on maximum permissible deposits yields 1/ and other regulatory requirements such as compulsory reserve and liquidity requirements. The yield structure on bank deposits has been kept largely unchanged since August 1985. Comparison with the December 1984-December 1985 rate of inflation (measured by the change in the Wholesale Price Index) of 38 percent shows that current after-tax yields are significantly negative in real terms on sight deposits but generally positive for time deposits, with the highest real yields of approximately 12 percent being paid for 6-month maturities 2/. In establishing deposit interest rates, the Government takes into account expectations of domestic inflation as well as the yields available on foreign currency deposits of comparable maturity. 1/ Banks have been authorized to determine yields freely on foreign currency deposits by Turkish residents. 2/ With effect from March 1, 1986, the nominal interest rate ceilings on 3-month and 6-month deposits were reduced by 1 and 2 percentage points respectively. More recently, from May 1, 1986, the rates on 3, 6 and 12-month deposits have all been reduced by 2-3 percentage points. In addition, the interest on sight deposits has been raised to about 12 percent (one-third of the rate on 1-month deposits), with a further rise to two-thirds of the rate to take effect on August 1, 1986. These changes have been designed to establish a more appropriate yield structure. The current nominal interest rates are 42 percent, 45 percent and 52 percent for 3, 6 and 12-month deposits respectively.  - 19 - 50. Lending Rates. Since the deregulation of lending rates on non-preferential credits in 1983, the lending rates charged by commercial banks on short-term credit have exceeded 50 percent p.a. in nominal terms and currently range between 53 and 64 percent. A nominal rate of 60 percent represents an effective rate of about 75 percent after quarterly compounding of interest payments. In addition, borrowers are required to pay a bank commission of 2 percentage points, a contribution to the Resource Utilization Support Fund 1/ of 10 percent of the base rate and a financial transactions tax of 3 percent of the base rate. However, the high real rate of over 40 percent p.a. charged on short-term credit does not represent the average cost of borrowed funds in the corporate sector. The average cost has indeed been rising in the past few years, but this is mitigated by some lower rate preferential credits and short-term foreign currency borrowings from domestic banks. Nevertheless, the very high cost of Turkish lira borrowings has reduced the demand for domestic credit. Selective Credit Policies 51. Central Bank Rediscount Facility. Turkey, in common with many developing countries, maintains a formal system of selective credits to encourage the development of high-priority sectors, although there are now no mandatory controls instructing banks to lend any specified proportion of their deposits to priority sectors. Rather, the Government has relied on the Central Bank's rediscount facility to support the selective credit system and to influence lending, especially medium-term lending for investment 2/. The Government intends to achieve positive interest rates for all preferential credit to the productive sectors, namely agriculture, industry, mining, trade, transport and tourism, before the end of 1986. 52. Central Bank rediscount rates currently range from 28 percent for small scale industries and agriculture to 52 percent, the "general rate". The list of rediscount rates has undergone substantial rationalization in the past two years and essentially includes only five categories now as compared to more than 30 categories three years ago. The actual cost to the borrowers is higher than the rediscount rate. The lending bank's commission (1 to 2 percentage points), the contributions to the RUSF and, in some cases, the 3 percent financial transactions tax are added to the rediscount rate. These "add-ons" result in a final cost of a rediscounted loan which ranges between 30 percent for agricultural credit and about 60 percent for general credit (Table 6). The sector receiving the largest volume of preferential credit is the housing sector. Lending rates of the Mass Housing Fund, which is the major source of housing credit, are not negative except for loans for small 1/ The Resource Utilization Support Fund (RUSF) was introduced in December 1984 as a scheme to finance capital grants to investors as an incentive for investment. Grants ranging from 7 to 20 percent of the capital costs of a project are paid, depending upon the location of the investment. The RUSF replaced the Interest Rate Rebate Fund (IRRF) which was a cross-subsidization scheme used to lower the interest cost on certain types of credit. 2/ For housing credit, a similar role is performed by the Mass Housing Fund.  - 20 - units of 60-80 sq.meters (which carry a rate of 15-25 percent). Housing loans generally carry a maturity of 15 years. The Government is reluctant to raise housing interest rates at present because it regards the provision of mass housing at affordable cost as an important part of its effort to alleviate the social costs of its economic adjustment program. As part of the Bank's economic and sector work program, a study has been undertaken of housing finance, which is expected to be forwarded to the Government shortly. The report highlights the need to integrate changes in housing credit policy with other aspects of housing policy, consistent with the overall objective of developing an efficient financial sector. It must be noted also that for preferential credit, the Central Bank only rediscounts a part of the loan amount, typically between 50 and 70 percent. The lending institution (commercial or development bank) is free to charge its own interest rate (typically around 65 percent) on the non-rediscounted part of the loan, except in the case of loans for agriculture. Thus the blended cost of a loan package can vary between 37 and 63 percent, depending upon the terms of the lending bank. Table 6: KEY LENDING RATES FOR INVESTMENT CREDITS (in percentage points, TL denominated loans) Type of Credit 1983 1984 1985 1986 (June) (June) (Aug.) (Jan.) I. Manufacturing Investment Credits - Central Bank Rediscounted Loans 26 30 35 35 - FERIS /a Loans - 26 35 35 II. Agriculture Investment Credits - Investment Loans from TCZB /b 22 28 30-34 30-34 - Agro-industry Loans from TCZB 20-22 28 45 45 III. SSI - Artisans, Entrepreneurs, etc. 22 24 26 30 IV. Tourism 15-30 15-30 15-30 35 V. Housing - Mortgage Loans by Emlak Kredi Bankasi and Mass Housing Fund 15 15 15-40 15-40 VI. SEEs - Ir.vestment Credits from DYB /c 21.5 21.5 35 35 VII. General - Commercial Bank Credits /d 36 33-62 53-62 53-64 /a Foreign exchange risk insurance scheme. /b Agricultural Bank of Turkey. /c State Investment Bank. /d These are usually short-term, but frequently rolled over. Source: Central Bank and Mission estimates.  - 21 - 53. Due to the need to meet the limits on growth of net domestic assets of the Central Bank stipulated in the Government's monetary program, the Central Bank's rediscount window has had to be closed at various times. thus reducing the stoeL of rediscounted credit outstanding gradually. Substantial decreases in the flow of such credit over several quarters of 1984 and 1985 has now resulted in a significant decline in the proportion of the stock of rediscounted credit in total credit, from around 14.5 percent in 1982 to 5.2 percent in September 1985. 54. Subsidy on Preferential Credit. An estimate of the flow of preferential credit, defined as credit carrying interest rates below the prevailing inflation rate, can be used to throw light on the level of subsidy (financial and economic) in the system, and the trend in the volume of such credit can indicate the movement of the financial system towards market orientation. Using the change in the Wholesale Price Index over a 12-month period as the measure of inflation, and taking the final cost to the borrower (not the rediscount rate) as the interest rate for comparison purposes, the proportion of preferential credit outstanding to the productive sectors of the economy (i.e. agriculture, industry, mining, tourism and trade) is estimated to have declined from 41.6 percent to 13.5 percent over the last two years. This represents a very substantial shift to a less subsidized and therefore more market-determined credit system. 55. Cost of Non-Preferential Credit. Several factors are responsible for the high level of non-preferential lending rates prevailing at present (para. 49). The most important of these is the high cost of deposit resources, resulting from the policy of providing real positive depocit interest rates in an environment of high inflation. To this has to be added the cost of meeting the liquidity and reserve requirements imposed on the commercial banks by the Central Bank, which raises the effective cost of the net loanable resources of the banks significantly above the cost of deposits, to the extent of 7-10 percentage points. The earnings on the banks' liquidity deposits with the Central Bank (the reserve deposits now earn no interest) offset only a part of the additional cost. Finally, the banks' intermediation costs, and applicable taxes and surcharges, add about 6 percentage points and 4 percentage points respectively to the cost of non-preferential credit passed an to borrowers. 56. The Government is aware of the cost pressures which are pushing up non-preferential lending rates. The high base cost of deposit resources is expected to decline gradually as inflation is brought under control and deposit rates are lowered. In regard to the other contributing factors, as a part of the program supported by the loan, the Government intends to: (i) reduce the reserve requirements imposed on commercial banks, from the level of 20 percent that prevailed in late 1985 to 15 percent by September 1986; (ii) support the improvement of efficiency of banks to reduce their intermediation costs further (they are already estimated to have fallen from over 10 percent in 1983 to 6 percent in 1986); and (iii) reduce the financial transaction tax from its present level of 3 percent to 1 percent.  - 22 - 57. Foret8n Exchang Risk. Until mid-1984, the interest rate on foreign currency loans was set by the Intermediary's cost (or the weighted average cost) of foreign currency borrowings plus a spread (about 5 percent), with the borrower assuming the full foreign exchange risk. The substantial depreciation of the Turkish lira in 1982-84 caused heavy losses to borrowers carrying the foreign exchange risk and therefore demand for such loans virtually ceased. To encourage greater use of foreign borrowings, the Government, in July 1984, instituted a foreign exchange risk insurance scheme (FERIS). which was made applicable to IBRD loans to two development banks (TSKB and SYKB). Under this scheme, loans were denominated in TL at a fixed interest rate (26 percent) over an 8-year term, with a special fund bearing the foreign exchange risk. The scheme succeeded in stLimulating investment demand, in part because the eEfective cost to borrowers was low compared to the prevailing inflation rate. The Government decided to continue the scheme in 1985, witlh a fixed interest rate for sub-loans which would be reviewed every six months and adjusted as necessary. The rate is currently 35 percent for sub-loans of eight years final maturity. The scheme aLso lays down guidelines for the treatment of prepayment. Coverage of intermediary banks under FERIS has been extended to include some additional development banks. The Government's intention is to operate FERIS as a temporary, self-financing and non-discriminatory scheme to mobilize private sector investment. In particular, the Government intends to discontinue FERIS in its present form as soon as the private investment climate has revived, and to manage the scheme on a self-financing basis, i.e. without any subsidy from the budget. The Government has agreed to review before the end of 1986 the need for continuation of FERIS, taking into account the prevailing rate of inflation, the cost of financing from other sources and the level of private investment. The possibility of introducing a floating rate option for sub-loans to reduce the interest rate risk inherent in a fixed rate long-term loan scheme will continue to be explored. 58. Reference Rate for Preferential Credit. While there has been significant progress in adjusting rediscount rates and reducing the level of preferential credit to the productive sectors of the economy, the practice followed by the Government of adjusting rediscount rates on an ad hoc basis results in adjustments lagging behind changes in the inflation rate, resulting in fluctuating real rates. An appropriately formulated reference rate could be helpful in providing a basis for adjustments to selective credit rates. Under such a system, the structure of selective credit rates would be adjusted regularly on the basis of market signals, thereby making the system more transparent. The Government intends to develop a reference rate to help monitor and adjust preferential credit interest rates, although it has stressed the need to preserve some flexibility in managing the monetary program under conditions of fluctuating inflation. B. Strengthening the Banking System Role of the Central Bank 59. The Government's intention is that the Central Bank should increasingly concentrate on the formulation and implementation of monetary policy, and on the supervision of the banking sector. In line with this objective, the Government intends to reduce the Central Bank's intervention in credit allocation through the array of selective credit schemes used very extensively in the past. Satisfactory fulfillment of the role envisaged for  - 23 - the Central Bank requires a clear program regarding the goals of monetary policy, as well as the use of appropriate monetary instruments to implement this policy. The classical instruments are the setting and enforcement of liquidity and reserve requirements, the influencing of the overall direction of interest rates through such means as the discount rate and the inter-bank deposit rate, and controlling money sutpply through open market operations. 60. The economic stabilization program in Turkey calls for a tight monetary policy to combat inflation, combined with consistent, steady growth rates in money supply to restore economic growth on a stable path. During the last twelve months in particular, the Central Bank has moved energetically to gain effective control over monetary developments. Reserve requirements for commercial banks are now being monitored at shorter intervals (weekly instead of monthly as was the practice previously). As part of the tightening of monetary policy, interest payments on reserve deposits maintained by commercial banks with the Central Bank have been eliminated from January 1, 1986. During 1986 the Central Bank intends to monitor more closely the growth of reserve money, the movement of the money multiplier, as well as the broader monetary aggregates (M2 and MzX, the latter including foreign exchange deposits). It also plans in the near future to start open market operations. Finally, the Central Bank plans to start acting as an intermediary in the interbank market, which would provide it with another instrument for influencing liquidity in the banking system. Supervision of Banks 61. Historically, the Central Bank has played only a minor role in the supervision of banks. Its primary responsibilities included monitoring liquidity and reserve requirements and gathering information from the banks through its modest reporting mechanisms. When concerns were identified, the Board of Sworn Bank Examiners and the Banking Directorate witnin the Undersecretariat of Treasury and Foreign Trade were notified so that they might undertake appropriate action. In keeping with the Government's intention of redefining the Central Bank's responsibilities. the Banking Law of April 25, 1985 envisages a greater role for the Central Bank in the supervision of banks. As part of the changes enacted by this law, banks are required to maintain their accounts, annual balance sheets, and profit and loss statements according to a standardized system from January 1, 1986. The Uniform Chart of Accounts, as it is known, has for the first time established a body of definitions and rules for the classification of accounts and thus provided a reasonable basis for the presentation and comparison of financial results. 62. A critical adjunct to the Uniform Chart of Accounts is the Decree on Non-Performing Assets dated December 11, 1985. Under the previous system, non-performing assets, other than those in litigation 1/, were determined subjectively by banks without regard to delinquency status or other criteria. Further, banks could continue to accrue interest on such assets. Provisions 1/ The Government has separately amended the Law of Procedure and the Execution and Bankruptcy Law to improve procedures for the collection of debts through legal action, but problems arising from the major increase in the number of cases before the courts and the inadequate staffing of the courts and court offices are likely to persist.  - 24 - for losses were made on the basis of the bank's profitability, and bad debts were written off at the sole discretion of management. With the passage of the Decree, non-performing status for loans other than current accounts (i.e. overdraft limits) is to be determined on the basis of delinquency. Upon reaching non-performing status, the accrual of interest must be discontinued and mandatory minimum provisions are to be made, thus establishing a linkage between portfolio quality and the reserve for loan losses. For current accounts, the principal form of commercial bank credit in Turkey, the Decree on Non-Performing Assets is less specific concerning the criteria triggering default, so that a declaration of default continues to remain at the discretion of management. However, the Government is considering actions to correct this situation and to lay down guidelines for current account lending. 63. Closely linked to the Uniform Chart of Accounts is the requirement contained in the Banking Law that annual balance sheets and profit and loss statements of commercial banks be certified by external auditors. Because of the absence of an established accounting profession in Turkey, the Central Bank has undertaken the task of initially defining the criteria for eligible auditors. These criteria are expected to include certain minimum qualifications related to education, work experience, and professional reputation. The audits of banks' financial statements are to commence from the fiscal year 1987. To improve the quality of financial reporting by banks, the Central Bank will require the submission of nearly 50 periodic reports, most of them quarterly, for the purpose of supervising each bank's activities. These reports will provide a substantive base of detailed information for analysis, and will be used to generate a standard package of analytical information for each bank covering four primary areas: capital adequacy, asset quality, profitability and efficiency and liquidity. Transactions involving related entities, insiders, large borrowers and large depositors will also be monitored. 64. The performance of offsite surveillance and early warning analysis is a critical part of the Central Bank's emerging role in the system of bank supervision in Turkey. In support of these efforts, the Central Bank is committing additional resources for bank supervision under a newly created Division of Bank Surveillance. The division is to be staffed with approximately ten analysts at inception, but the number is expected to increase as the Central Bank's role in the supervisory process strengthens. The Central Bank has sought technical assistance in the area of bank supervision, and also to upgrade its internal training effort. A technical assistance program with a total foreign exchange cost of $484,000 has been formulated for this purpose, to be funded from the proceeds of the proposed loan. The Board of Sworn Bank Examiners 65. The Board of Sworn Bank Examiners was established in 1958 and is the principal onsite supervisory body charged with implementing the provisions of the Banking Law and other laws concerning banks and control of banking operations. Examinations are undertaken once during a two-year period although problem banks and branches are examined more often. The examination process as it now exists is designed primarily to determine compliance with the law and to report on the financial condition of the bank at a point in time. As part of the effort to encourage bank managements to adopt modern management practices, including the systems, policies, procedures and controls necessary for efficient operation in a dynamic environment, the Board of Sworn  - 25 - Bank Examiners intends to revise the current examination manual with the assistance of consultants financed under the proposed loan. In parallel, a technical aisistance program will be carried out in cooperation with the Office of The Comptroller of the Currency in the United States for the training of bank examiners, and essential office equipment including computers and related software will be acquired. The foreign exchange cost of the program, estimated to be $255,000, is proposed to be funded out of the loan. The Proposed Banking Institute 66. The desired improvements in the commercial banking system necessitate the introduction of modern banking methods and technology, upgrading and internationalizing the skills of the existing personnel, and recruitment and training of new talent. For this purpose, the Central Bank has taken a decision in collaboration with the Turkish Banks Association to set up a banking institute or training school which would servc the needs of the entire banking industry. The proposed banking institute will be modelled after the Citibank Training Center in Athens and will be a residential school with its own facilities. Citibank will manage the school during the first five years under a management contract on a not-for-profit basis, with its costs fully reimbursed by the Turkish Banks Association, which will be the owner. The initial capital expenditures for buildings and grounds will be provided by the Turkish Banks Association, while the recurrent coots will be met from tuition fees from the training programs and seminar participation fees. Resolutions to this effect have already been approved by the Association, and core training programs to be offered at the institute have been identified with the help of consultants. Under the proposed loan, an amount of $882,000 will be provided to finance the foreign exchange component of the capital cost of setting up the institute. Tho amount would cover the cost of teaching equipment including personal computers and audio visual equipment, copying and printing equipment, and computer software, which wiil remain the property of the Government. The establishment of a training school for banking personnel would be a condition of disbursement of funds earmarked .or this component. C. Developing the Money and Capital Markets Background 67. Money and capital markets have traditionally been a weak link in the Turkish financial sector. Their growth has been hampered by an inadequate institutional and regulatory environment and more recently, by high inflation. Under these circumstances, the markets have been characterized by low activity levels, segmentation, high intermediation costs and occasional speculative bursts. Recently, however, there has been increasing appreciation of the potential benefits of well-organized financial markets. Consequently, their development has been accorded high priority by the Government. 68. A large but completely unregulated market for a variety of private paper had emerged in Turkey in the late 1970s as a result of the rigid deposit interest rate structure which produced highly negative real rates in a period of high inflation. As savings consequently moved out of bank deposits, smaller banks experiencing liquidity problems devised ways to circumvent deposit rate ceilings by selling CDs through brokers at discounts. These brokers would resell the CDs to the public at par, adding to the interest by issuing parallel promissory notes in their own names. The difference between the brokers' buying and selling prices (the discount) was lent, usually at  - 26 - very high interest rates, to marginal businesses desperate for cash. The brokers thus acted as bankers, borrowing and lending money in their own names, but without being subject to reserve or liquidity requirements or controls. Initially this line of business proved highly profitable and a large number of brokerage houses sprang up, raising the volume of CDs to 10 percent of bank deposits in 1981, but the system collapsed in 1981-82 as brokers could not collect the loans they had made, and in the absence of a lender of last resort, could not honor their repurchase guarantees. These events have profoundly affected the attitudes of the authorities towards the money markets and have influenced the regulatory framework set up in response to the crisis. Interbank Market 69. The drying up of CDs in the wake of the collapse left smaller commercial banks with no alternative but to borrow from the larger banks. This gave considerable impetus to the interbank market, which hardly existed until the late 1970s. However, annual turnover in the interbank market still remains low at under $2.0 billion equivalent. The market is also rather fragmented, transaction costs are as high as 4-5 percent and yields vary greatly even for deposits of comparable risk and maturity. The most active participants in the interbank market are the foreign banks operatir.g in Turkey, but there is a general unidirectional flow from the larger banka with extensive branch networks to smaller banks in need of funds. 70. The Government is implementing a number of actions to develop the potential of the interbank market fully. These include the reduction of the financial transactions tax from its present level of 3 percent and the enforcement of the reserve and liquidity requirements on commercial banks every week, thereby providing an impetus to the interbank market. The Government is also reviewing Article 11 of the Corporate Tax Law, which is being interpreted presently by the tax authorities as subjecting the foreign banks to a withholding tax of 25 percent of the income from interbank deposits. Finally, the Central Bank ;s corsidering entering the interbank market itself, to overcome the traditional reluctance of Turkish banks to deal directly with each other and as a tool for influencing the amount of liquidity in the system. Treasury Securities 71. After years of reliz-ce on the financing of deficits by recourse to the Central Bank, the Government began to issue securities priced at competitive rates in 1984. Initially these securities were sold "on tap" through the Central Bank. In May 1985, a market pricing mechanism was introduced through weekly auctions of six-month, one-year and two-year securities. The volume of Government bonds outstanding has thereafter increased rapidly, from TL886 billion in December 1984, to TL1,526 billion in December 1985. The introduction of the regular weekly auctions has significantly increased the supply of market-priced securities. The Government is currently considering actions to improve the functioning of the system and to diversify the maturities offered. The secondary market for Government securities has grown in volume from TL35 billion in 1984, when trading of any consequence started, to TL410 billion in 1985. Commercial banks account for 85 percent of the trading, and ten licensed firms for the rest. The growing secondary market should offer opportunities for introducing open market operations by the Central Bank as an effective tool for monetary policy purposes.  - 27 - Regulatory Framework 72. Despite recent improvements, the institutional framework -- particularly the scarcity of reliable corporate financial information -- and the current inflationary environment are not conducive to the rapid development of the Turkish capital markets. Pending the strengthening of the institutional framework and the stabilization of macro-economic conditions, it is likely that markets for longer-term securities will develop more slowly than markets for short-term Government and bank instruments. 73. The Capital Market Board (CMB) has the main responsibility for the regulation and supervision of the primary and secondary markets for securities. Its duties include: (a) Supervision of corporations which have made public offers of securities or have at least 100 shareholders. (b) Supervision and regulation of investment companies, mutual funds and securities market intermediaries, including securities firms and -- limited to their securities operations -- banks. (c) Review a.ad approval of all public offerings of corporate securities and negotiable instruments, with the exception of bank instruments. The CMB "approves" public offerings, depending not just on the applicant's compliance with financial disclosure and other legal requirements, but also on a judgement of the investment merits of securities. This approach carries some potential risks, because it can be perceived as CMB having responsibility for losses suffered by investors who bought "approved" issues, and by encouraging investors to rely on the Board's judgement on the merits and safety of securities, may hamper the development of an independent market capability to appraise and price securities. Further, from a practical point of view, a thorough screening of all new issues would require a huge CMB staff. The fact that the CMB's review is based on unaudited data adds to the above reasons for concern. 74. Considering its short existence, the CMB has a creditable record of success in restoring some order and confidence to the securities markets. These positive results, h,werer, hav: often been achieved by imposing restrictions on permissible