Turkey - Second Financial Sector Adjustment Loan

Document of The World Bank FOR OFFICIAL USE ONLY Z-/V -2-7q(IT-) a A.' 3 - z V - L Report No. P-4784-TU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND FINANCIAL SECTOR ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO USW4OO MILLION TO THE REPUBLIC OF TURKEY May 25, 1988 Industry, Trade and Finance Division Country Department I Europe, Middle East and North Africa Regional Office 'This document has a restricted distribution and may be used by recipients only in the performance of 'their official duties. Its contents ma- not otherwise be disclosed wiithout W'orld Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Turkish Lira (TL) Value of US$ 1976 '' TL 16.05 1977 TL 18.00 1978 TL 24.28 1979 TL 31.08 1980 January TL 70.00 1981 January TL 91.00 1982 January TL 139.60 1983 January TL 191.15 1984 Jinuary TL 309.20 1985 January TL 451.40 1986 January TL 586.40 1987 January TL 752.93 1987 November TL 950.00 1988 February TL 1160.00 a Annual averages through 1979. FISCAL YEAR January 1 - December 31 GLOSSARY OF ABBREVIATIONS GNP Gross National Product PSBR Public Sector Borrowing Requirements SEE State Economic Enterprises VAT Value Added Tax WPI Wholesale Pri.ce Index FX Foreign ExcL._,ge CD Certificates of Deposit LIBOR London Interbank Offer Rate FSAL financial Sector Adjustment Loan CMB Capital Markets Board ISE Istanbul Stock Exchange SAL Structural Adjustment Lending TSKB Industrial Development Bank of Turkey BOT Build Operate and Transfer IFC International Finance Corporation CIBS Center for International Banking Studies RUSF Resource Utilization Support Fund EX-IM Export-Import Bank  FOR OMCIAL USE ONLY INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOP'MENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE GOVERNMENT OF TURKEY FOR A SECOND FINANCIAL SECTOR ADJUSTMENT LOAN (FSAL 11) Table of Contents Chapter Page No. I. THE ECONOMY .......................................... 1 A. Economic Developments of 1980s ................................... 1 B. Stabilization Measures since the November 1987 Elections ......... 4 C. Prospects for the Medium-Term .................................... 7 D. Interaction Between the Fiscal Deficit and the Financial Sector.. 10 F. Relations with the IMF ........................................... 11 II. DEVELOPMENTS IN THE FINANCIAL SECTOR ................................. 12 A.. Progress under FSAL-I ........................................... 12 B. Structure of the Financial System ............................... 13 C. Trends in Mobilization of Funds in the Financial System .... ..... 14 D. Trends in Credit Allocation .................................... 15 The Role of the Central Bank in Credit Allocation ........... 15 Preferential Rates and Selective Credits ................... 16 High Non-Preferential Lending Rates ........................ 17 Medium- and Long-term Credit ............................... 18 III. THE FINANCIAL SECTOR REFORM PROGRAM .................................. 19 A. Policy Measures to Improve Mobilization and Allocation of Funds.. 19 Interest Rate Policy ....................................... 20 Taxation of Financial Instruments and Reserve and Liquidity Requirements .................................. 20 Selective Credit Policy .................................... 21 Foreign Exchange Deposits .................................. 21 This report is based on the findings of four Bank missions which visited Turkey during 1987-88. Persons who participated in the missions and/or contributed to the report are: S. Banerji (mission chief), Ms. P. Annez, E. Segura, R. Rocha, A. de Juan, V. Polizatto, J. Reitmaier (IMF), N. Faltas (IFC), C. McCurdy (consultant), R. Shumway (consultant) and the EMlCO Turkey team. 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.  Chapter Page No. III. cont'd. B. Strengthening of the Banking System .............................. 22 Strengthening of Prudential Regulations ..................... 23 Improving the Eniorcement of Bank Regulations and Supervision 24 Improving Transparency and Informdtion Disclosure .... ....... 24 Improving the Competitive Environment: Entry into the Industry ............................................. 25 Exit: Mechanism for Dealing with Insolvent Banks .... ....... 25 Restructuring of Government-owned Banks ..................... 26 Actual Restructuring of Insolvent Banks ..................... 27 C. Measures to Develop the Money and Capital Markets .... ............ 27 Government Securities and Interbank Markets .... ............. 28 Corporate Equities and Fixed Income Securities .... .......... 29 IV. THE PROPOSED LOAN ..................................................... 30 A. Origins and Objectives ........................................... 30 B. Loan Size and Components ......................................... 31 C. Cofinancing ...................................................... 32 D. Procurement, Disbursement and Administration ..................... 32 E. Monitoring and Trancte Release ................................... 32 Actions Taken Prior to Board Presentation ................... 33 Conditions of First Tranche Release ......................... 33 Conditions of Second Tranche Release ........................ 33 Release of $100 Million for 2estructuring Banks .... ......... 34 F. Benefits and Risk3 ............................................... 35 V. BANK GROUP OPERATIONS IN TURKEY ....................................... 36 VI. RECOMMENDATIONS ....................................................... 40 STATISTICAL APPENDIX: ANNEX I: Table 1: Turkey - Key Economic Indicators ............................ 41 Table 2: Turkey - Balance of Payments, 1987-97 ....................... 42 Table 3: Composition of the Banking System ............. 43 Table 4: Indicators of Financial Depth, 1979-87 ...................... 44 Table 5: Turkey: Credit by Type of Financial Institution End of Period Real Stocks (1980-87) ...................... 45 Table 6: Proportion of Preferential Credit ........................... 46 Table 7: Turkey: Sectoral Distribution of Real Stocks of Credit (2 Share) (1980-87) ............................... 47 Table /: Turkey: Credit to the Public and Private Sectors End of Period Real Stocks (1980-87) ...................... 48 ANNEX II: Statement of Financial Sector Policies - 1988 .................... 49 ANNEX III: Proposed Conditionality .......................................... 56 0 2 a s  Page No. ANNEX IV: Decree on Provisioning to Be Made by Banks Under Article 32 of the Banking Law ................................. 60 ANNEX V: Technical Assistance Program for Strengthening Banking Supervision and for Establishing a Mechanism to Deal with Restructuring or Liquidation of Insolvent Banks .... .......... 63 ANNFX VI: Legal and Operational Framework for a Remodelled Deposit Insurance/Financial Renabilitation Fund .... .......... 67 ANNEX VII: Proposed Te;mas of Reference for Financial Restructuring of Public Sector Banks ....................................... 74 ANNEX VIII: Draft Terms of Reference for a Study of Taxation of Financial Instruments and Intermediation .... .............. 79 ANNEX IX: limetable of Key Loan Processing Events ........................ 81 ANNEX X: Status of Bank Group Operations in Turkey .......... ........... 82 MAP IBRD 16453R 0 28 s  TURKEY FINANCIAL SECTOR ADJTJSTMENT LOAN Loan Summarsy Borrower: The Republic of Turkey Beneficiaries: The Undersecretariat of the Treasury and Foreign Trade, the Capital Market Board, the Board of Sworn Bank Examiners, the Central Bank, and commercial banks. Amount. US$400 million equivalent Terms: Seventeen years including five years grace with interest at the standard variable rate. Description: The proposed loan would support the Government's continuing financial sector adjustment program for the period 1988-89. The principal objectives of the program are: (i) to improve mobilization and allocation of funds and foster financial deepening through appzopriate interest rate policies, including maintenance of positive rates on deposits and preferential credits; lowering of non-preferential lending rates through appropriate macroeconomic stabilization; further reductions in selective credit programs; and adoption of policies for foreign exchange deposits to reduce currer,cy substitution and increase maturities; (ii) with regard to the banking system, to enhance its ability to mobilize and allocate funds efficiently by fostering a competitive environment and financial discipline through new regulations on loan classification, provisioning and concentration; better enforcement of regulations; improving irformation disclosure; a more effective mechanism to deal with insolvent bangs; actions to improve the efficiency of public banks; and initiation of the financial restructuring and recapitalization of troubled or insolvent banks in a sound and systematic manner; (iii) with regard to the money and capital markets, to increase competition in the Government securities markets and to develop the secondary market for such securities; adopt external auditing of securities issuers to reduce market risks; promote foreign portfolio investments to deepen the capital markets; and to initiate a review to develop a rational framework for the taxation of financial instruments and intermediation. 0265  - ii - Benefits and Risks: The principal benefit of the adjustment program would be a more efficient, robust and deeper financial sector which would mobilize and allocate funds more efficiently thus generating a higher level of investments as well as a higher rate of return. Through the measures proposed, the banking system would be strengthened to provide services more efficiently and to a wider spectrum of clients thus spreading the benefits of access to institutional finance. Improvements in the financial position of the banks and the development of a more efficient securities market should have a positive impact on public finances and make the task of macroeconomic adjustment easier. The main risks stem from the uncertainties in the control of inflation. The persistence of high inflation will undermine the financial health of the corporate sector and delay the recovery of the banks. Delays and deficiencies in enforcing the new regulations and creating an effective mechanism to deal witb he restructuring of insolvent banks would also adverselv effect the rehabilitation of the banking system. However, these risks are considered manageable in the light of the steps already taken by the Government and its strong comnritment to the reform program. Estimated Disbursements: The loan proceeds will be disbursed in two tranches of $200 million equivalent, soon after effectiveness, and $100 million after a performance review expected to be carried out in about 12 months after effectiveness. An additional $100 million is earmarked speciffcally for restructuring banks and will be available after loan effectiveness but tied to injection of equity into banks which have I en restructured according to agreed principles by the Government. 0 28 S  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE GOVERNMENT OF TURKEY FOR A SECOND FINANCIAL SECTOR ADJUSTMENT LOAN (FSAL U) I submit the following report and recommendation on a proposed loan to the Government of Turkey for the equivalent of US$400 million to finance the Second Financial Sector Adjustment Operation. The loan would have a term of seventeen years including five years of grace, with interest at the standard variable rate. 1. THE ECONOMY 1.01 A Country Economic Memorandum entitled "Turkey: Sustaining the Adjustment Program" (6516-TU) was distributed to the Executive Directors in June 1987, and a report entitled, "Fiscal Policy and Tax Reform in Turkey" (6374-TU), was distributed in July 1987. A report entitled, "External Debt, Fiscal Policy and Sustainable Growth" (7162-TU), dated March 15, 1988 has been sent to the Government for discussion and its findings as well as those of an economic mission in March 1988, are reflected in this report. Annex I, Table 1 provides key macroeconomic indicators and projections. A. Economic Developments of the 1980s 1.02 Through much of the 1960s and into the early 1970s, Turkey enjoyed rapid economic growth with low inflation. Like other developing countries, however, an inadequate adjustment to the first oil shock and subsequent recess;.on in the OECD countries rapidly deteriorated the country's balance of payments position. Growing currenL account deficits, financed largely through short-term borrowing, more than tripled Turkey's external debt between 1974 and 1977. Following virtual cessation of external financing and accumulation of arrears, cumprehensive debt rescheduling arrangements were negotiated with both private and official creditors between 1978 and 1980. Meanwhile, the shortage of foreign exchange and imports led to disruptions in production, declines in real GNP, rising unemployment, and a sharp acceleration of inflation reaching above 100 percent by 1980. 1.03 In re-sponse to the economic crisis, major reforms were initiated in 1980 -- representing a sharp break with the past policy regime of market intervention, import substitution, and reliance on state economic enterprises (SEEs). The authorities implemented an extended stabilization program and initiated a wide-ranging program of structural reforms, supported by the IMF and World Bank adjustment lending. Stabilization was intended to restrain the growth of domestic demand, attain a manageable external payments position, and to restore international creditworthiness. The adjustment program was designed to promote allocative and dynamic efficiency through greater reliance on competitive market forces and the private sector, and to achieve an outward orientation of the economy. O285  -2- 1.04 The Turkish economy has displayed a creditable response to the stabilization and adjustment measures put in place. In a nutshell, the achievemenr.s cf Turkey have been based on a growth-oriented adjustment strategy: the country has maintained high growth (over 5 percent per year) without jeopardizing its creditworthiness. The key to the growth-oriented strategy was the Turkish export response. Stabilization accompanied by aggressive exchange rate policy, trade liberalization, and export promotion measures quickly led to a large shift of productive capacity from domestic to export markets. The economy raised its total factor productivity in the short run, rapidly increasing its capacity utilization. Aided initially by buoyant Middle East markets, exports grew at over 20 percent per year in real terms and tripled their share in GNP between 1980 and 1987. 1.05 Sustained real depreciatio- of the Turkish lira had its cost in a large reduction of national wealth; the associated capital loss on Turkey's foreign debt accounted for over half of the increase in the debt-output ratio by 1985. But ,he corresponding export record reduced Turkey's debt-export ratio substantially (by about 40 perc:nt between 1980 and 1985), and eased its access to foreign capital markets. The country's improved international creditworthiness has been reflected, for example, in the resumption of private capital inflows in the form of trade credits (since 1982) and syndicated medium-term financing (since 1983). Remittances from Turkish workers abroad also expanded rapidly in the early 1980s. Thus, Turkey continued to have access to foreign financing after rescheduling its debt, and the additional foreign saving was channeled into investment. ; gregate fixed investment increased from 19.6 percent of GNP in 1980 to about 25 percent in 1987. The higher rate of i1uvestment has, in turn, contributed to Turkey's high output growth. 1.06 Fiscal tightening, complemented by the introduction of the value- added tax, effected a substantial improvement in the primary (non-interest) fiscal balance and lowered the public sector horrowing requirement (PSBR) from 9 percent of GNP in 1980 to about 5 percent in 1985. The fiscal policy cut public consumption (by more than 3% of GNP), and more importantly restructured public investment away from manufacturing to infrastructlre -- complementing instead of competing with the private sector. Private consumption fell relative to GNP, aided by the policy to maintain positive real deposit rates that stimulated increased private savings. Higher lending rates, triggered by the higher deposit rates, were offset by investment incentives to aid a recovery of private investment. Until 1985, the fiscal deficits were mostly financed by rionetization and external borrowing. (Real domestic debt actually declined between 1980 and 1984). Price trends closely reflecteu fiscal performance, and the inflation rate declined from 107 percent in 1980 to around 40 percent by the mii 1980s. 1.07 But the burden of adjustment and the fruits of restored growth appear not to have been shared equitably among the population: real wages fell sharply in the formal sector; the labor surplus rate (including open unem- ployment, those unemployed not seeking work, and disguised unemployment in agriculture) stayed at about 15 percent of the civilian labor force; little absolute poverty is evident, but considerable differences in living standards and social indicators remain among regions and between rural and urban communities; and available data indicate a probable worsening of income distribution since the i970s. 028 SR  -3- 1.08 Against this background, the Government began to switch to more expansiona,y policies in 1985, and initiated a policy of fisca; decen- tralization. Local governments and extra-budgetary funds (EBFs) were granted access to greater sources of revenue and financing, and public investment grew rapidly (about 23 percent in 1985 and 10 percent in 1986 in real terms). This policy did sucLeed in addressing pressing social needs such as low-income housing and upgrading municipal infrastructure, perhaps in a more effective and popular manner. The policy stance was maintained thrcughout 1986 and until the general election in November 1987, resulting in real GNP growth of 7 to 8 percent per annL.. in these two years. It, however, eroded mos. of the fiscal policy gain achieved in the first half of this decade: the PSBR rose to 8.7 percent of GNP by 1987. At the same time, the scope for monetization to finance the deficit narrowed substantially, due to a progressive reduction in reserve requirements, substitution of foreign exchange deposits for Turkish Lira deposits, and financial innovations in cash management techniques among a significant segment of enterprises. The reduced demand fir money meant that higher rates of inflation are needed to generate any givea revenue from inflation tax. Thus, while monetization declined and r'course to domestic debt financing increased as a share of deficit financing, the resurgence of the fiscal deficit increased inflationary pressures. After having fallen to 25 percent in 1986, the inflation rate rose to 49 percent by end-1987. 1.09 Growing fiscal deficits have not adversely affected Turkey's current account performance, which declined substantially to $957 million in deficit (1.5 percent of GNP) in 1987. With the reduction of concessional flnancing over the last few years, the real cost of foreign debt has, however, risen. Turkey therefore respcnded quickly with reduced non-interest current account deficits, reflecting an exceptionally rapid growth of Turkish exports to the OECD markets, in addition to renewed growth of workers' remittanlces and tourism revenues. The price for this trend, however, has been the need to maintain high rates of interest ill real terms, in order to elicit the net private saving. Arbitraging with lending rates, the cost of public domestic debL has also risen, at the time when the reduced scope for monetization and constraints on external financing necessitated greater recourse to domestic debt issue. To restore macroeconomic balances, therefore, the re-elected Government attaches the highest priority to reducing the fiscal deficit, and with it inflation and interest rates. 1.10 Despite the reduction in the current account deficit, Turkey's external debt has risen rapidly. At end-1987 external debt is estimated at slightly over $40 billion. About two-thirds of the increase in debt measured in dollars since end-1985 is due to the decline of the dollar, since more than 60 percent of Turkey's debt is denominated in non-dollar currencies. Turkey's debt service payments have riqer since the expiration in 1984 of the grace periods on payments due under the OECD reschedulings of 1978-80. Principal payments due from the 1979 commercial bank rescheduling have also raised debt servicing requirements, along with the net repayments to the IMF. Debt service payments (including IMF repurchases and charges, and interest on shor'.-term debt) rose to $5.6 billion in 1987 from $4.7 billion in 1986. Nevertheless, the external debt service ratio feli. from 37 percent in 1986 to 34 percent in 1987, reflecting the rapid growth in the country's exports (at 37 percent). 0 26 S  -4- B. Stabilization Measures since the November 1987 Elections 1.11 A substantial tightening of fiscal and monetary policies has been implemented since the general elections of November 1987. A series of stabilization measures have been (and are being) undertaken in the context of an explicit set of targets for 1988, which in turn forn, the basis for the Government's medium-term macroeconomic framework to the year 1991. As part of the policy dialogue with the Bank on these issues, the Government presented to the Bank a Statement of Macroeconomic Policy (dat May 9, 1988; the Statement is to be circulated to the Board separately) and thus formally reaffirmed its commitment to improve the country's macroeconomic conditions. Principal objectives setting the Government's medium-term framework include: (a) real GNP growth of 5 percent; (b) reduction in the annual inflation rate to 20 percent by 1991; (c) limiting the PSBR to at most 5 percent of GNP; (d) reduction of the current account deficit to 0.6 percent of GNP by 1991; and (e) reduction in the ratio of debt service to current account receipts from 37 percent in 1988 to 27 percent by 1991. In this context, the key macroeconomic targets for 1988 include: (a) real GNP growth of 5 percent; (b) PSBR cf at most 6 percent of GNP; (c) M2 growth of 40 percent, but with a sharp reduction in the growth of the currency component of M2, compared with 1987; (d) depreciation of the real exchange rate by about 5 percent in 1988; and (e) a current account deficit of $885 million (1.3 percent of GNP); 1.12 This program signifies the Government's acknowledgement that the reduction of the fiscal deficit is of crucial importance in restoring macroeconomic stability and the recognition that the fiscal adjustment effort will need to be sustained beyond 1988. The establishment ot a medium-term framework which envisages substantial reduction of the fiscal deficit and lowering the growth rate of the economy attests to the Government's determination to reduce inflation and non-preferential lending rates. Adherence to the fiscal deficit targets in the program would constitute a major shift in the Government's macro-policy stance from the previous two years. It should be noted here that the Government's measure of the fiscal deficit -- the nominal PSBR -- includes all. interest payments as an above the line expenditure item. In an inflationary environment it overstates the Governmen'-`s claim on real resources compared with the "operational" deficit concept used in many high inflation countries, in vhich only the real component of interest payments is included while the inflationary component (which comprises thc bulk of actual payments) is not. 1.13 The stabilization measures taken to date includcc both actions to raise fiscal revenues and to reduce expenditures. Immediately following the elections, the Government raised prices on the full range of goods and services produced by the SEEs to improve their financial condition and reduca their need for budgetary transfers. Such price adjustments between December 024S  -5- 1987 and February 1988 averaged above 20 percent, and in some cases were as high as 40-50 percent. Subsequently, public sector prices have continued to be adjusted frequently to offset higher operating costs. Most notably, prices of petroleum products were increased by 12-23 percent at the beginning of April. In addition to public sector price adjustments, tax rates have been raised to generate sigrnificant increases in revenue. In January 1988, higher value-added tax (VAT) rates were put into effect. A number of VAT exemptions were eliminated, including basic foodstuffs and key agricultural products. The VAT for luxury consumer goods was raised from 12 to 15 percent, and for agricultural pesticides, pharmaceutical products, health and other services from 5 to 8 percent. Motor vehicle taxes for luxury cars were increased up to 3 times their previous levels and an additional tax was imposed on the purchase of all motor vehicles. Tae gasoline consumption tax was raised from 9 to 21 percent, and new consumption taxes on alcohol and tobacco products were introduced. 1.14 On the expenditure side, the Government has imposed a hiring freeze for the public sector including SEEs, and real wages in the public sector are also expected to decline. The growth of public investment is to be limited to below the targeted rate of output growth. No new major investment project is to be started, while there is to be a gcneral slowdown in the implementation of ongoing projects. To restrain the growth of expenditures by the EBFs, the Treasury has been empowered to transfer 30 percent of EBF revenues to the consolidated budget. In addition, a system to monitor EBF accounts on a monthly basis has been introduced, and if expeuditure exceeds revenue, the EBF accounts would be subject to an audit by the Auditor General's office. As a result of these measures, EBF expenditures and investments are targeted to decline sharply. Finally, the establisnment of a Debt Coordination Committee at the ministerial level, which will have authority over all aspects of foreign borrowing, is expected to reduce the access to such financing by both the EBFs and local governments, thus reducing their ability to invest. 1.15 The measures taken to raise fiscal revenues since December 1987 following the overheating of the economy prior to the elections, increased upward pressure on prices and led to speculation against the Lira. In February, the Government swiftly -ook the following actions to contain the weakening of the Lira: (a) inte.ct rates on all Lira deposits were increased significantly, with the 6 month deposit rate raised to 52 percent and the one year rate to 65 percent; (b) reserve requirements were raised from 14 to 16 percent and liquidity requirements from 23 to 2' percent; and (c) a 5 percent withholding tax was imposed on interest earned on foreign exchange deposits, and the interest paid to commercial banks on reserve requirements on foreign exchange deposits was reduced. The implementation of these measures increased the demand for Turkish Lira deposits and encouraged a shift into deposits of longer maturity. While non-preferential lending rates rose to over 115 percent following the increase in deposit rates, it is expected that the lending rates will decline commensurately as the fiscal deficit and inflation are reduced (see Chapter II). 1.16 The measures already taken to reduce the fiscal deficit are substantial. They are estimated to amount to a cut in the primary (non- interest) fiscal balance in 1988 by about 4.5 pt-rcent of GNP, assuming, as is the Governmert's intention, that public sector price adjustments continue to keep pace with inflation. The share of public sector interest payments is, however, estimated to grow by nearly 3 percent of GNP in 1988. (Rising 0285  -6- interest payments in 1988 reflect both higher interest payments on domestic debt resulting from the increase in inflation, and higher interest payments on foreign debt resulting from the accumulation of external debt and the declining concessionary element of such debt.) Thus, based on the measures already taken, the PSBR in 1988 is estimated to decline to about 7 percent of GNP, with the primary fiscal balance swinging from a deficit of about 2 percent of GNP in 1987 to a surplus of about 2.5 percent in 1988. 1.17 That policies have been tightened substantially in 1988 is clearly evident from the actions already taken thus far by the authorities. To be sure, these actions are not to be regarded as the entirety of the stabili- zation measures for 1988. As declared in the Statement of Macroeconomic Policy, the Government "has firmly commnitted itself to introducing all necessary measures in the course of the year to curb the public expenditure and to increase the public revenue in order to keep the PSBR less than 6 percent of tjiP." The Government is also aware of the fact that maintenance of the deficit reduction achieved thus far would require further actions as well, particularly in view of the current environment where the differential impact of inflation among various revenue and expenditure items may generate unanticipated fiscal developments. The achievement of the intended targets will therefore depend critically on close monitoring of macroeconomic developments and the steady implementation of fiscal adjustment measures. The Government has already intensified its monitoring effort. The Bank is also devoting greater resources to its ongoing monthly and quarterly economic reporting and updating on Turkey (enhanced by the presence of the new Resident Mission in Ankara). The Government and the Bank have agreed to undertake regular reviews of developments on a semi-annual basis, beginning this susner. In terms of the additional stabilization measures, the Government intends to focus on delaying the implementation of selected public investment projects further, including those in the transport sector, where a large increase had been programmed for 1988. Table 1: PUBLIC SECTOR BORROWING REQUIREMENT a (in Percent of GNP) Prov. Government Actuals Program 1985 1986 1987 1988 Central Government 2.8 3.6 4.4 2.8 State Economic Enterprises 3.2 4.2 4.7 1.6 Local Governments -0.2 0.2 0.4 0.3 Extra-Budgetary Funds -0.5 -2.1 -0.6 1.0 Revolving Funds -0.4 -0.4 -0.2 0.2 Total 4.9 5.5 8.7 6.0 A' Negative sign indicates surplus. 0 2 & 5  -7- C. Prospects for the Medium Term 1.18 In order to assess the macroeconomic framework of Turkey, the intended fiscal policy targets must be judged against a path of fiscal deficits that is consistent with the Government's macroeconomic objectives for the medium term. Fiscal deficits can be financed from three sources: external borrowing, issue of domestic interest-bearinig debt, and monetary financing. Attaining the multiple objectives of reducing inflation, stabilizing domestic debt and real interest rates, and improving external creditworthiness impose constraints on each of the sources of deficit finance. The objective of sustaining economic growth also imposes constraints on the speed of deficit reduction. These constraints have been incorporated into the Bank's projections, in order to evaluate the Government's medium- term framework. On the basis of more conservative assumptions (relative to the Government) regarding export growth and the extent of adjustment of the PSBR in 1988, the Bank's projections indicate the existence of a viable scenario in whicn the Go ernment can achieve its principal macroeconomic objectives over the medium term. 1.19 The fundamental assumption of the Bank's (Base Case) medium-term projections is that the process of fiscal adjustment is adhered to, so that the ratios of both domestic and external public debt to GNP can be lowered gradually, while lessening reliance on monetary financing to achieve a steady reduction of inflation. Two medium-term objectives of the Government are retained in the Base Case: real GNP growth is to average 5 percent per year, and the rate of inflation is targeted at 20 percent by 1991. (Inflation is expected to decline significantly by the summer of 1988 as a result of the stabilization measures undertaken thus far. For 1988 as a whole, itn view of the price increases of the first quarter discussed earlier, it is expected that the year-end inflation rate would not be below 55 percent and an year-average inflation rate of 65 percent is assumed. The reduction in inflation in 1989 is expected to be substantial, however, predicated on the progz ss assumed for the second helf of 1988.) 1.20 On the external front, export volume is assumed to grow by about 9 percent in 1988, aided by the Government's intention to depreciate the real effective exchange rate by about 5 percent this year and to further rationalize the system of export incentives. A constant real effective excnange rate and real export growth of 6 to 7 percent per annum are assumed after 1988. Coupled with the Bank's projections on traded goods prices this results in a somewhat slower rate of nominal export growth (10 percent) than projected by the Government (13 percent per year). Imporc elasticities are assumed to range between 1 to 1.3. This represents a reduction from recent years and is based on the assumption that the pace of import liberalization will be slower over the projection period, reflecting the progress already made in the 1980s. The resulting currert account deficit is projected to decline gradually in real terms (para 1.24), with the public sector assumed to utilize the entire net inflow of foreign capital. The principal additional assumptions used, and key macroeconomic indicators and projections are presented in Annex I, Tables I and 2. O zS s  -8- 1.21 The available financing consistent with the above output, inflation and sustainable borrowing targets indicate that a steady reduction of the PSBR to about 4 percent of GNP by 1991 would be consistent with the Government's medium-term objectives as outlined in para. 1.11. Iv If the outcome of the PSBR/GNP ratio in 1988 is indeed 7 percent, (resulting as discussed previously from a primary fiscal adjustment of about 4.5 percent of GNP and increased interest payments of nearly 3 percent), the PSBR would have to be further reduced by about 3 percent of GNP by 1991. However, the corresponding increase in the primary fiscal surplus between 1988 and 1991, is not as substantial, estimated at under one percent of GNP. This arises from the fact that as inflation declines sharply in 1989 (to about 35 percent) and more gradually thereafter (to 20 percent by 1991), interest payments on domestic debt are proiected to decline as a share of GNP. Furthermore, as recourse to external financing by the public sector also declines gradually, the share of external interest payments to GNP is also expected to begin to decline. Under this scenario, the bulk of the primary fiscal adjustment required through 1991 (estimated at 5.3 percent of GNP) would therefore have been achieved during 1988. 1.22 it should be noted that maintenance of a significant primary surplus over an extended period would nonetheless require sustained fiscal vigilance. In particular, if increased fiscal resources are needed for financial restructuring, further fiscal adjustment would be required to maintain consistency with other macroeconomic objectives. Moreover, if the decel- eration of inflation is not as rapid or sustained as projected, this would again call for additional fiscal adjustment. Finally, the assurptions underlying the concep and composition of financeable fiscal deficits them- selves may need to be modified over time. For example, a downward shift in the demand for moniey arising, for instance, from an increase in currency substitution wouid imply reduced monetary finanocing for a given level of inflation. Alterna 4vely, a sharper reduction in foreign savings than assumed in para. 1.24 would necessitate a more rapid fiscal adjustment than envisaged in the base case projections. 1.23 Attainment of the macro objectives described above requires a significart reduction in each of the three sources of deficit financing by 1991 compzired to 1987. Reduced inflation targets imply reductions in the recourse o monetary financing (adjusted for once-off shifts in seignorage losses or gains arising from the effects of changes in inflation on the demand for base money). Fhe objective of reversing the recent trend of escalating interest costs on Governmert securities is achieved through limiting domestic borrowing so as to reduce the ratio of domestic public debt to GNP. Finally, external horrowing by the public sector is also limited to the extent neces- sary to reduce the shares of public external debt and interest payments to GNP (althougt; at a somewhat less rapid pace than implied by the Government's own external borrowing targets through 1991) The methodology underlying this analysis is contained in "External Dett, Fiscal Policy and Sustainable Gr eLth" (7162-TU). .1  -9- 1.24 S'tstained export growth, together with a decl_ne in the reliance on foreign savings leads to a 3teady improvement in external creditworthiness ratios after 1988. Between 1987 and 1992, the Bank's projections anticipate a decline in the debt service ratio from 34 percent to 32 percent (after rising to 39 percent in 1988), the debt/GDP ratio from 60 to 49 percent, and the current account deficit/GDP ratio from 1.5 to 1.2 percent. Further improvement in these ratios is anticipated througr. 1997 (Annex I, Table 1). It should be noted that these projections are based on significantly slower export growth than has beer achieved in the past. If exports were to grow faster than assumed (as prcjected by the Government), the improvement of these ratios would be more rapid. External Capital Requirements 1.25 The process of fiscal adjustment, reduction of inflation and decline in the ratios of real external indebtedness would act to enhance Turkey's creditworthiness over the medium term. Nonetheless, gross financing requirements are expected to average about $5.5 billion during 1988-92, largely reflecting an increase in amortization payments, which are projected to average more than $4 billion over the same period. (By comparison principal repayments in 1986 and 1987 amounted to $2.5 billion and $3.2 billion, respectively.) In 1988, principal repayments including IMF repurchases are estimated at $4.3 billion, of which about $2 billion is due to OECD governments. Net capital requirements during 1988-92 are estimated to average $1.4 billion, ariFing fron. an average current account deficit of about $1 billion and steady increases in fzreign exchange reserves. 1.26 The Government's intention is to rely increasingly on private sources to finance the higher debt servicing requirements. The regulations governing foreign direct investment have been rationalized, and it is anticipated that the Government's intention to proceed with privatization of SEEs will stimu- late further foreign investment. Recent bond placements in the Federal Republic of Germany and Japan have generated significant capital inflows, and further recourse to bond issues is planned. Capital inflows from Turkish citizens residing abroad (mainly Europe and the Middle East) continue to provide a large proportion of Turkey's financing requirements. It is the intention of the Government to rely to a greater extent on balance of payments financing from ccmmercial banks and to a lesser extent on project financing, in line w'th its objective of restraining new projects to reduce the fiscal deficit. Reduced reliance on short-term borrowing is also anticipated, consistent with the ability to generate greater inflows of medium-term private capital. While the share of short-term to total debt is expected to rise marginally in 1988 to 23 percent, this ratio is expected to stabilize thereafter. The ratio of short-term debt to trade, possibly a more relevant indicator, is however expected to decline steadily. 1.27 Improvement in domestic and external indicators over the medium term would indicate favorable prospects for the Government being able to realize its external financing strategy. Nonetheless, financing requirements in 1988 are at a peak in real terms, as evidenced by an estimated debt service ratio of 39 percent. The proposed FSAL II loan, with its expected cofinancing with the Japanese Government and Japanese commercial banks, could make available about $1.1 billion, of which $700 million could be expected to be disbursed in 328$P  -10- 1988. The projected 1988 disbursements would amount to about 12 percent of gross financing requirements in 1988, of which the proposed $200 million of Bank disbursements would comprise about 3.5 percent. The $700 million of capital inflow linked to this loan would permit Turkey to contain its recourse to short-term borrowing. D. Interaction Between the Fiscal Deficit and the Financial Sector 1.28 Large fiscal deficits have an adverse impact on the financial system. Structural reform of the financial sector, therefore, must be accompanied by appropriate macroeconomic policies. But a weak financial system tends to constrain vigorous fiscal retrenchment as well. Macroeconomic adjustm.ent, therefore, also requires improvements in the health of the financial sector. When large fiscal deficits and a fragile financial system exist side by side, both problems need to be addressed simultaneously. 1.29. In Turkey, as in other developing countries, major structural reforms of the real sector have imposed a significant strain on the economy's financial system, since the shifts in relative prices and profitabilities in the real sector have resulted in substantial changes in profitabilities of the financial sector's asset portfolio. This strain has been made more difficult to bear due to a sustained period of large fiscal deficits. As discussed earlier, large fiscal deficits together with declining net external financing have increased the domestic financing requirements of the public sector, thus generating upward pressure on inflation as well as on real interest rates. The public sector's increased borrowing requirements have led to financial crowding out of private investment and deteriorated the loan portfolio of commercial banks. Higher inflation has also accelerated the process of currency substitution, which by reducing the demand for base money and hence the revenues from the inflation tax, generate larger public borrowings for a given rate of inflation. A reduction in the borrowing requirement of the public sector would therefore contribute to reversing these trends and permit the Gcvernxment to reduce the taxation of financial intermediation, which would narrow the large spread currently prevailing between deposit and lending rates. Reducing the fiscal deficit is thus indispensable for improving the health of the financial sector. 1.30 The distress within the financial system is also a factor perpet- uating fiscal deficits. Weak financial institutions dppear to 'Le indIrectly supported by being allowed to purchase government securitiet yie'ding high interest, thus increasing the burden on public finances. a.estruzturiiig of insolvent financial ins.itutions would also increas? the need f3r puLblic funding. The high proportion of non-performing assets tends to burden the system, as banks attempt to charge higher rates from healthy cuscomers to compensate for their losses elsewhere. Such high interest rates. in turn, can increase the borrowing costs to the Government. Thus improvenxJnts in the financial sector's health would have a favorable impact on public finances by reducing the need for direct and indirect support from the budget. Finally, a severe fiscal retrenchment could result in recession, which, in turn, would exacerbate the financial distress of the banking system. Thus, the fragility of the banking system itself may inhibit a more vigorous fiscal retrenchment than m.y be considered appropriate in an unconstrained environment. 0 2 8 5  -11- E. Relations with the IMF 1.31 Turkey received extensive financing from the IMF during the first half of the 1980s to support its stabilization effort. A three-year stand-by arrangement with the Fund was approved in 1980 and was fully utilized. Two subsequent one-year stand-bys were approved in 1983 and 1984. Since 1984, repayments to the Fund have increased, reaching $443 million in 1987. Debt outstanding to the IMF at end-1987 was $770 million, and is due to be repaid by 1990. At the Government's request, between annual Article IV Consultations, the IMF has been carrying out periodic staff visits to Turkey to provide advice and discuss economic issues. 1.32 Collaboration between the IMF and Bank staff remains close and productive. In addition to regular sharing of information and informal technical briefings, the collaboration includes mission participation. IMF staff participated in the appraisal mission of the proposed FSAL II loan, in the mission to prepare the "External Debt, Fiscal Policy and Sustainable Growth" Bank report (para 1.01), as well as in the Bank's recent CEM mission. Bank staff routinely participate in the IMF's Article IV Consultation missions and staff visits, including the one completed in early May 1988. 0 2 8 SR 0285  -12- II. DEVELOPMENTS IN THE FINANCIAL SECTOR 2.01 Although Turkey initiated major economic reforms in 1980, the need for financial sector reforms (which are crucial to economic development because of their pivotal role in efficiently mobilizing and allocating resources) was not fully recognized until the "Bankers' Crisis" in 1982 brought out the urgent necessity of overhauling the financial system. The Bank supported the Government by launching a major financial sector study: "Turkey- Policies for the Financial Sector" (4459-TU), dated September 21, 1983. This study and subsequent discussions helped the .Jovernment to initiate a number of important financial sector reforms under SAL-IV and SAL-V--focusing on the structure and level of deposit interest rates, rationalization of preferential lending rates, reduction in the financial transactions tax and withholding tax on interest earnings, establishment of an auctioning system for Treasury bills, and establishment of the Capital Market Board (CMB). Furthermore, in April 1985, a new Banking Act was promulgated, which established loan concentration and lending limits, gave more prominence to the supervisory role of the banking system by the Government, and introduced deposit insurance by creating a Deposit Insurance Fund in the Central Bank. However, both the Government and the Bank recognized that these were initial steps and, while extremely important, would need further deepening over the next several years. 2.02 Recognizing that the process of .nancial sector reform in Turkey would require a sustained effort over th, medium term, the Bank approved the first Financial Sector Adjustment Loan (FSAL-I) in May 1986 in support of a medium-term program of policy and institutional reform measures set out in the Government's letter of Financial Sector Policies."' The FSAL-I supported reforms in three main areas: (i) Financial Policies: maintenance of positive deposit raLes and positive lending rates on selective credits; reduction of selective credits to reduce subsidies and improve credit allocation; reduction of reserve and liquidity requirements to lower the high cost of non-preferential borrowing; (ii) Financial Institutions and Regulation: introduction of standardized accounting, external audit and training of staff of commercial banks; strengthening of Central Bank's off-site surveillance and supervision capacity; strengthening of the Board of Sworn Bank Auditors (BSBA) and procedures; strengthening of the interbank market; and (iii) Money and Capital Markets: development of short term instruments (Treasury bills and commercial paper); development of medium term instruments (Treasury bonds and corporate bonds); improvement of the Capital Market Board's (CMB) procedures; and introduction of external audit for corporations listing their shares in the stock exchange or selling commercial paper. A. Progress under FSAL-I 2.03 Satisfactory progress has been made under FSAL-I.- / In the area of financial policy, except for selective credits, lending rates for all other credits are now totally liberalized. The volume of selective credits was See Turkey FSAL-I, SAR 6095-TC, May 1986 for a description of the financial sector and the reforms covered uncer the loan. 2/ See Turkey - Release of the Second Tranche of tt2 Financial Sector Adjustment Loan Sec M87-278, dated March 19, 1987. 0 2a s  -13- reduced from 42 percent of the total in 1983 to 23 percent in 1987 (paragraph 2.11 below). Administered deposit interest rates and most preferential lending rates (with the exception of some loans to agriculture) have been maintained at positive levels. Because of the sharp increase in inflation in late 1987, a period of negative deposit interest rates occurred at that time, which resulted in some erosion of financial depth. In response, deposit rates were increased substantially in early 1988. As agreed under FSAL-I, reserve and liquidity requirements were also drastically reduced during 1986 and 1987, though there was a minor and temporary increase in late 1987, again due to fiscal exigencies. Considerable progress has been made in strengthening the institutional framework for bank supervision, developing a standardized accounting system for banks, training of bank officers and auditors, etc., and in the development of money and capital markets. The primary and secondary markets for both Treasury bills and cormercial papers have expanded significantly, as have listings and trading activities in the Istanbul Stock Exchange. Auditing of banks and a limited number of corporations will be initiated with their 1987 accounts. However, the establishment of the Council of Sworn Financial Advisors, a required action under the FSAL I, has been delayed by legal obstacles. A major issue that could not be adequately addressed under the FSAL-I concerns the high level of non-preferential lending rates which are freely set by banks. These rates have increased to very high levels (40-50 percent in real terms) resulting in substantial crowding out of private borrowings. There are clear signs that the fi .ncial situation of the banking system has been deteriorating because of high interest rates. Many banks are carrying a very high burden of non-performing loans in their portfolios. The prevailing lack of progress in reducing real lending interest rates and improving banks' portfolios is due to inefficiencies in the banking system as well as to expansionary macroeconomic policies, both of which are now being addressed by th- Government. As noted in Part I above, the Government intends to give high priority to improving macroeconomic policies over the next two years. The proposed operation will support a deepening of the financial sector reforms initiated under the FSAL I. Recent developments in the financial sector are discussed in greater detail below. B. Structure of the Financial System 2.04 As in most developing countries, the banking system in Turkey is the centerpiece of the financial system. Its share in the total financial assets of the country is 93 percent. At the end of 1987, there were 56 banks, of which 12 were specialized public banks, 26 were private domestic banks and 18 were private foreign banks. The shares of public and private banks in total assets are about equal and have not ch.anged significantly since 1980, as shown in Annex I, Table 3. The share of fore.gn banks has also remained small, despite the entry of 14 new foreign banks bet%een 1980 and 1986, partly due to foreign banks concentrating their operations on foreign trade financing. The banking system has also remained highly concentrated. The share of the four largest banks in :otal banks' assets in 1986 was 52 percent--the same as in 1980. The share c' the four largest private banks in total private banks' assets has also remained high and constant, around 70 percent. The banking system in Turkey has a large number of branches: in total, there are, about 6,400 branches throughout the country, of which 55 percent belong to private banks and 45 percent to public banks. In addition to the banking system, other financial institutions in Turkey include insurance companies, mutual funds, the social security system, private pension funds, and the securities market. As noted earlier, howe-er, these non-banking institutions represent only 7 percent of the assets of the financial sector in the country. 0 28 S  -14- C. Trends in The Mobilization of Funds in the Financial System 2.05 Given the preponderant size of the banking system in Turkey, the degree of financial deepening in the country can be measured by the ratio of currency and bank deposits (money supply M2 or M2X which includes foreign exchange depcsits) to GNP. At the end of 1986, M2/GNP and M2X/GNP reached 23.5 percent and 28.4 percent, respectively--which represented a considerable improvement in resource mobilization compared with 1979-80 when the ratios stood at about 15.0 percent (Annex I, Table 4). The increase in financial depth between 1980 and 1986 can be attributed to the macroeconomic and financial reforms initiated since 1980 (paras 2.01-2.03). However, during 1987, Turkish Lira (TL) resource mobilization faltered somewhat, due to the d '.ayed adjustment of interest rates on deposits in the face of increasing inflation. The ratio of M2 to GNP declined by one percentage point, despite the liberalization in July 1987 of interest rates on one-year time deposits and on large denomination CDs. However, as currency substitution took place, the ratio of M2X to GNP increased, offsetting the loss in TL deposits. In February 1988, the Government increased interest rates on TL deposits of all maturities, including sight deposits, while reestablishing control over the interest rate on one-year deposits. The rate on large denomination CDs can be flexibly set within the ceiling fixed for TL deposits of corresponding maturities. Interest rates on sight, one-, three-, six-months and one-year time deposits are currently 36 percent, 40 percent, 45 percent, 52 percent, and 65 percent, respectively, compared with an inflation rate of around 50-55 percent per year in 1987. These adjustments of interest rates should thus contribute to improved resource mobilization by the banking system during 1988. 2.06 Ihe Government has been successful in mobilizing foreign exchange (FX) deposits via Turkey's commercial banks, which have grown rapidly since their introduction in December 1983. As of December 1987, the stock of FX deposits amounted to about US$5.2 billion, or about 30 percent of M2. One-third of the foreign exchange stock is held in sight deposits and two-thirds in time deposits, with the overall average maturity being about five months. Turkish residenlt individuals hold the majority of the stock. The interest rates offered on these accounts vary significantly across banks, but they range from LIBOR to LIBOR plus 6 percent. in order to reduce currency substitution from TL to FX deposits, a 5 percent withholding tax on FX deposits was introduced in 1987. This tax is half of the 10 percent tax applicable to interest earnings on TL deposits. In addition, in January 1986, the Central Bank imposed a reserve requirement ratio of 15 percent on the stock of FX deposits and, in mid-1987, it increased it to 20 percent. Furthermore, the Central Bank has recently reduced the interest rates paid to comrwercial banks Ot. FX deposits (previously equal to LIBOR rates) by 2 percentage points in order to induce banks to lower their own rates and thus help further reduce currency substitution. These measures to equalize the treatment of TL and FX deposits are effective, since they allow the Central Bank to recover a portion of the loss in seignorage and inflation tax arising from lower TL base money creation. 2.07 Although mobilization of funds by non-banking institutions is still a minor element in the financial sector, it has shown progress in recent years. Net issues of corporate bonds have been increasing at a fast rate and new financial instruments--such as commercial paper, ban: bills and profit and loss sharing certificates--have recently been introduced successfully. The 0 28 5  -15- current stocks of these instruments are small (0.5 percent of GNP in 1987); however, they are expected to become a mole significant source of private sector financing. Measures to further develop these instruments are included in the ongoing and proposed FSALs. In addition, seven mutual funds started operating in the second half of 1987, which should also contribute to financial deepening. Finally, the stocks of Government revenue sharing certificates (first issued in 1984) have increased rapidly and amounted to approximately 1.3 percent of GNP in June 1987. The share of the stocks of private fixed-income securities and government securities (revenue sharing certificates and bonds and bills) held outside the banking system is estimated to be around 3.5 percent of GNP. Therefore, the ratio of broadly defined money supply (M2X plus securities held outside banks) to GNP is currently around 32.5 percent. 2.08 In spite of the progress already achieved, the Turkish financial system is still shallow in comparison to other countries at a similar stage of development. The ratio of broad money supply to GNP of 32.5 percent (including foreign exchange deposits and securities held outside the banks) still compares unfavorably with an average ratio of M2 to GNP of 36 percent for similar developing countries. This suggests that there is ample scope in Turkey for further progress in mobilization of funds. In addition, further increases in financial depth based on the growth of foreign exchange deposits may not be desirable, since the excessive growth of these deposits is likely to complicate the management of monetary and exchange rate policies and also introduce instability into the financial system (para 3.08). Continued progress in resource mobilization will require the maintenance of the attractiveness of TL-denominated assets not only through an adequate interest rate policy but also through improved macroeconomic management and lower inflation, which the Government is committed to achieve as described in the Statement of Macroeconomic Policy (para. 1.15). D. Trends in Credit Alocation The Role uf the Central Bank in Credit Allocation 2.09 In order to improve credit allocation, since 1980 the Government has been liberalizing the credit allocation system. At present, there are no global or sectoral credit allocations for banks. The commercial banks may, at their own discretion, raise and use deposits within the legal, financial parameters established by the Government. Furthermore, the direct credits and rediscounts made available by the Central Bank for special purposes have been reduced substantially (para 2.11). As a result of these measures, the role of the Central Bank has declined considerably, relative to the commercial banks. These measures complement other measures to liberalize the financial system, including the removal of interest rate ceilings on normal non-preferential loans. As shown in Annex I, Table 5, from 1980 to 1986, the share of commercial banks in total credit increased from 41 percent to 75 percent, while the share of the Central Bank declined from 49 percent to 15 percent. However, in lQQ7, there was a slight reversal, with the Central Bank's share rising to 18 percent reflecting increased support to the agriculture sector. The smaller role of the Central Bank and the increased capacity of the commercial banks to lend from their own funds represents a shift to a less-subsidized and more market-oriented financial system, which has increased the flow rf credit to activities with high returns and contributed to a decrease in the overall ratio of selective credit to total credit. Instead of 02S 5  -16- credit ceilings ar.d allocations for purposes of monetary control, the mechanisms used by the Central Bank are reserve and liquidity requirements and the newly developed open market operations. 2.10 The share of development banks in total credits has declined from 10 percent to 7 percent, a reflection of the difficulties encountered in mobilizing medium- and long-term TL funds in a period of high and volatile inflation, as well as difficulties encountered in obtaining medium-term foreign exchange resources. Lending by developme.nt banks, which is mainly directed to the industrial sector, was also adversely affected by the lower level of investment in manufacturing during this period (especially by the public, but also by the private sector). However, the Industrial Development Bank of Turkey (TSKB) has been successful in raising TL resources through sale of bonds and bills during 1986-87, which should help boost its lending and share. Preferential Rates and Selective Credits 2.11 Under FSAL I, the GovernmenF committed itself to raise selective credit interest rates to positive levels by end the of 1986, and to reduce the proportion of Central Bank selective credits, which flow to the economy on preferential terms."' Except for some lc. s for agriculture, selective credits are now granted at positive interest rates, but below the very high rates in the liberalized sectors. It is estimated that the proportion of selective credit extended on preferential terms tn the productive sectors declined from about 42 percent of total crediL. in 1983 to about 23 percent in September 1987 (Annex I, Table 6). Moreover, the qhare of rediscounted credit by the Central Bank to total credit declined from 16.6 percent in 1983 to 7.4 percent in 1987. Selective credits under preferential terms are now provided only to agricuiture (fertilizer and livestock), industrial artisans, exports and housing--sectors in which the Government believes that current market failures and conditions (including high real interest rates on non-preferential credits (para 2.12) would prevent funds from reaching these priority or underprivileged groups. Although the share of selective credits under preferential terms to agriculture increased somewhat in early 1988 due Lo the large jump in inflation in the end of 1987, the share of selective credits under preferential terms to the productive sectors should continue to decline during 19SS for two reasons. First, interest rates were significantly increased for both short- and medium-term selective credits in February 1988 resulting in a substantial proportion becoming positive. Second, with inflation expected to decline as a result of the Government's macroeconomic adjustment program, all selective credits should become non-preferential in the course of the year if the current levels of interest rates are maintained. Short term credits are considered as preferential when extended at an interest rate lower than the inflation rate as measured by the change in the WPI during the 12 months preceding the calculation. Medh'u-term credits are considered preferential if the interest rate as lower than an index computed by averaging the previous 12 months change 4n the WPI with the forecasted change in the WPI for the next 12 months. These definitions were adopted under the Bank's first Financial Sector Adjustment Loan to Turkey (See Annex 5, Report No. 6095-TU, dated May 15, 1986 for details). 0 2 8 5  -17- 2.12 In spite of the support to agriculture under selective credits, since 1980 total credits for agriculture have remained at atout 15 percent of total credits. Total credits to industry, on the other hand, have declined from 45 percent of the total in 1980 to 30 percent in 1987. This decline reflects the reduction in Central Bank rediscounts to industry and the lower investments by public state enterprises. Credits for foreign trade, supported by preferential but positive rates, increased from 6 percent in 1980 to 13 percent in 1987. Credits for housing increased from from 2 percent to 14 percent during the same period in response to a major injection of funds through the Mass Housing Fund program (Annex I, Table 7). High Non-Preferential Lending Rates 2.13 A major problem facing the allocative efficiency of the financial systeir is that liberalized, non-preferential lending rates have remained exccedingly high in real terms. In early 1988, effective prime rates on short term commercial loans were around 98 percent per year, up from about 66 percent per year in the first semester of 1987. The recent increase in lending rates has resulted from two factors. First, the banks' average annual cost of deposits has increased substantially (from 35 percent in 1987 to 51 percent in February 1988) after the adjustment of interest rates on deposits for increased infl.i on. Second, the increase in reserve requirements (from 15 percent in early 1987 to 16 percent in December 1987), the increase in liquidity requirements (from 23 percent to 27 percent) and the increase in the transaction tax (from 3 percent to 5 percent) have increased even further the spread between deposit rates and the effective cost of funds--the major determinant of lending rates. The difference between the banks' average deposit rates (51 percent) and effective cost of funds (94 percent) is now 43 percent and is accounted as follows: reserve and liquidity requirements (25 percent net), Resource Utilization Support Fund (RUSF) and transaction taxes (9 percent), and operating costs (9 percent). Adding 4 percent for average profits yields a p:ime rate of about 98 percent. Real lending rates at such high levels (40-50 percent per year) are a strong deterrent to further increases in private manufacturing investment, which has not recovered significantly beyond thn levels reached in the late 1970s. In addition, the present high real rates of interest tend to aggravate the problem of non-performing loans in the portfolij of public banks. As noted above, the largest component of the spread between lending and deposit rates are reserve and liquidity requirements and transaction taxes, both of which are the result of the Government's high fiscal deficit. The reduction in fiscal deficit is, therefore, a precondition to the reduction in the level of real lending rates, and of the restablishment of the health of the banking system. 2.14 The Government's large fiscal deficits are also reflected in large borrowings by public agencies. Annex 1, Table 8 shows the increasing importance of government bonds and direct credit to public administrations. Their share in total credit and bonds peaked at 30 percent in 1985, and declined to about 26 percent in 1987, a level which is still high. The growth in the stock of government bonds has been particularly high between 1983 and 1987. In addition, the share of public state enterprises in total credit and bonds, (which had declined steadily to about 10 percent of total by 1984) increased by almost 6 percent in 1987. Both these factors have led to crowding out of the private sector, which is reflected in the reduction of the share of credit to the private sector since 1985 and the prevailing high real lending a zas  -18- rates. In 1987, total credit supply in real terms increased, although only slightly, but real credit supply to the private sector declined. In order to reverse this trend, thie public sector borrowing requirment needs to be reduced. This is one of the key objectives of the Government's macroeconomic adjustment program as discussed in Chapter I. Medium and Long-term Credit 2.15 Anocher key issue in the area of credit allocation is the availability of medium- and long-term credit for investment in the key productive sectors of industry and agriculture. For industry, the main sources of medium- and long-term credits have been selective credits granted through Central Bank rediscounts and external funds onlent by the specialized development banks. Medium-term loans financed purely out of the commercial banks' own funds are very scarce. Between 1980 and 1987, medium- and long-term credit to industry as a share of total industrial lending grew from 34 percent to about 45 percent. However, this increase was due mainly to a reduction in the total amount of credits to industry, rather than a major increase in term lending. The stock of irmedium- and long-term loans to industry has remained stagnant at a level below the peak reached in 1983. Basically, this dearth of longer-term funds stems from the difficulties encountered by the specialized banks in mobilizing long-term resources in an environment of high and volatile inflation, and from the Government's pclicy of reducing medium-term selective credits to industry. Similarly, only 20 percent of total credit to agriculture in 1986/87 is estimated to be medium- and long-term lending. But in agriculture, the key constraint to term lending (more than availability of funds) is the institutional capacity to undertake sound lending at longer maturities. A sustained reduction in inflation to a more reasonable level will be needed to enable banks to provide medium- and long-term credits to the productive sectors. The Government's fiscal adjustment program aims at cutting inflation to a more reasonable level which would enable this objective to be achieved over the next few years. 0285  -19-- Ill. THE FINANCIAL SECTOR REFORM PROGRAM 3.01 The Government's agenda for financial sector reform over the next two years is described in the "Statement of Financial Sector Policies-1988" issued to the Bank (Annex II), wherein the Government has reaffirmed its intention to continue its medium-term program of liberalization of the financial sector by sustaining and deepening reforms in key areas of fiscal, monetary and finanrial policies, banking institutions, and money and capital markets. In particular, the Covernment recognizes that sound macroeconomic policies are essential if financial sector reforms are to be effective. Hence, the Government has adopted a program of fiscal and monetary stabilizatioi to reduce the public sector deficit which, ii. turn. should lead to a reduction of inflation as well as real interest rates. 3.02 The proposed agenda for deepening and expanding financial sector reforms covers actions in three key areas which are as follows: The first concerns policy actions to improve the efficiency of mobilization and allocation of funds, in particular, aiming at maintaining both deposit and lending rates at realistic levels, reducing the volume of selective credits (including interest subsidies), reducing taxation of financial intermediation to lower distortions in lending rates and measures to improve the attractiveness of lira deposits vis-a-vis foreign exchange deposits to reduce currency substitution; The second concerns measures to strengthen financial discipline and the health of the banking system, the more important of which include new regulations on classification of loans (including current account loans' by risk class and provisioning according to international norms, improving enforcement of regulations through enhanced supervision, external audizs according to international norms, initiating actions towards establi;ning an institutional mechanism to deal with banking insolvency and initiating actions to restructure banks according to sound financial principles includ4ng the implementation of actual restructuring of some government owned banks in 1988; The third concerns measures to develop tLie money and capital markets further and includes such measures as increasing competition in the auctions of Government securities, promoting the development of the secondary market by eliniinating legal restrictions and fostering the establishment of special funds to promote foreign portfolio investment in equities. These actions are discussed below in greeter detail. The proposed loan conditions, their timing, and their relationship to conditionalities under previous adjustment loans are summarized in a matrix in Annex III. A. Policy Measures to Improve Mobilization and Allocation of Funds 3.03 The Government is aware that the most important measure to improve funds mobilization and allocation in the country is to reduce its large fiscal deficit and the consequent inflation. Together with these fiscal measures, as discussed in Part I, the Government proposes to take further measures in the following areas: (i) interest rate policy; (ii) taxation of financial instruments and reserve ax,-' liquidity requirements; (iii) selective credit policy; and (iv) foreign excLkange deposits. These measures are described below: 0z2 5  -20- (i) Interest Rate Policy 3.04 With regard to deposit rates, the Government has committed itself to maintaining these rates at positive levels in order to provide adequate incentives for mobilization of savings. The Bank agrees with the Government that full liberalization of deposits at the present time is not desirable, since it may lead to even higher destabilizing of real lending rates, given the current large size of Lhe fiscal deficit and net domestic demand and the high level of non-performing assets in the banking system. The Government, however, has expressed its intent to lift the ceilings on