Turkey - First and Second Financial Sector Loan Projects

Document of The World Bank FOR OMCIL USE ONLY Report No. 13266 PERFORMANCE AUDIT REPORT TURKEY FINANCIAL SECTOR ADJUSTMENT LOANS I AND II (LOANS 2714 AND 2964-TU) JUNE 30, 1994 Operations Evaluation Department 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. CURRENCY EQUIVALENTS (period average) Currency Unit = Turkish Lira (TL) Value of US$1.00 1986 - 675 1987 - 857 1988 - 1,422 1989 - 2,122 1990 - 2,609 1991 - 4,172 1992 - 6,872 1993 - 10,983 ABBREVIATIONS AND ACRONYMS EBF - Extra-Budgetary Funds FSAL - Financial Sector Adjustment Loans OED - Operations Evaluation Department PAR - Performance Audit Report PCR - Project Completion Report PR - President's Report SAL - Structural Adjustment Loan SAR - Staff Appraisal Report SECAL - Sector Adjustment Loan FISCAL YEAR January I - December 31 FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation June 30, 1994 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Performance Audit Report on Turkey - Financial Sector Adjustment Loans I and II (Loans 2714-TU and 2964-TU) Attached is the Performance Audit Report on Turkey - Financial Sector Adjustment Loans I and II (Loans 2714-TU and 2964-TU) prepared by the Operations Evaluation Department. The objectives of the two operations included stabilizing interest rate and reducing deposit/lending rate spreads, improving the Central Bank's regulatory and supervisory capabilities vis-a- vis Turkey's financial institutions, as well as improving financial intermediaries' accounting procedures and the quality of their balance sheets. Government implementation of the policy conditions was partial and characterized by backsliding after release of tranches. The PAR agrees with the PCR that the outcome of the two operations was unsatisfactory and their sustainability unlikely. The operation's institutional impact was modest. The cancellation of the floating tranche and delays in release of the second tranche of FSAL II led to a more intense policy dialogue and more complete compliance with second tranche conditions. The main lesson emerging from these operations is that when the deficits of public enterprises are at the root of both fiscal deficits and financial sector difficulties, financial sector reform should follow, or at least be accompanied by, reforms in the public enterprise sector and reductions in the fiscal deficit. Also, it appears that the FSALs were processed and approved rapidly, limiting the time available for careful design and for development of government and banking sector ownership of the reforms. Robert Picciotto by H. Eberhard Kbpp Attachment '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.  FOR OFFICIAL USE ONLY PERFORMANCE AUDIT REPORT TURKEY FINANCIAL SECTOR ADJUSTMENT LOANS I AND 11 (LOANS 2714 AND 2964-TU) TABLE OF CONTENTS Page No. PR EFA C E . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i BASIC DATA SHEETS ............................................ iii EVALUATION SUMMARY ................................................. vii I. INTRODUCTION ......................................... 1 II. BACKGROUND .......................................... 2 The Macroeconomic Setting ................................... 3 Inflation .............................................. 3 Real Interest Rates.........................................3 The Fiscal Deficit........................................ 3 The Financial Sector......................................... 4 Developments in the World Bank ............................... 5 III. THE POLICY CONTENT, IMPLEMENTATION AND IMPACT OF THE FSALs .......................................... 6 Policy Content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Compliance with Conditions ................................. 8 Im plem entation ...... ... ......... .............. .. ..... .. 8 Impact .............................................. 8 IV. OVERALL ASSESSMENT AND SUSTAINABILITY ................... 9 Success ................................................ 9 Sustainability .......................................... 10 V. THE ROLE OF THE BANK ................................... 10 The Weak Link Between Lending and Policy Proposals .................. 10 Too Large, Too Fast? ...................................... 11 Cancelling the Floating and Delaying the Second Tranche Release ........... 11 VI. LESSONS LEARNED ....................................... 12 This report was prepared by Robert Myers (Task Manager) and Francis Bomani (Consultant) who audited the project in April 1994; Geri Wise provided word processing assistance. 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.  PERFORMANCE AUDIT REPORT TURKEY FINANCIAL SECTOR ADJUSTMENT LOANS I AND II (LOANS 2714 AND 2964-TU) PREFACE This is the Performance Audit Report (PAR) on the first Financial Sector Adjustment Loan (FSAL) 2714-TU in the amount of US$300 million approved on June 10, 1986, and second Financial Adjustment Loan 2964-TU in the amount of US$400 million approved on June 21, 1988. The First loan (FSAL I) closed on June 30, 1991, two years behind schedule and, the Second loan (FSAL II) closed on December 31, 1992, also two years late. While the FSAL I was fully disbursed, US$100 million representing a floating tranche of the FSAL II was cancelled. The PAR prepared by the Operations Evaluation Department draws from a wide variety of sources including the Project Completion Report (PCR)I' prepared by the Europe and Central Asia Region, President's Reports (PRs), Staff Appraisal Report (SAR), the loan agreements, related loan documents in the Bank's files and interviews and discussions with relevant Bank staff. The PAR agrees with the PCR that the outcome of the two operations was unsatisfactory and their sustainability unlikely. The operation's institutional impact was modest. The cancellation of the floating tranche and delays in release of the second tranche of FSAL II led to a more intense policy dialogue and more complete compliance with second tranche conditions. The PAR was sent to the Borrower for comments, but none were received. 1' PCR, Turkey - Financial Sector Adiustment Loan and Second Financial Sector Adiustment Loan (Loans 2714-TU and 2964-TU), Report No. 12385, October 6, 1993.  - 111 - PERFORMANCE AUDIT REPORT TURKEY FINANCIAL SECTOR ADJUSTMENT LOAN I (LOAN 2714-TU) BASIC DATA SHEET LOAN POSITION (Amounts in US$ Million) As of May 31. 1994 Loan Original Disbursed Cancelled Repaid Outstanding 2714-TU 300.0 300.0 - 92.3 256.6* CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS FY86 FY87 FY88 FY89 FY90 FY91 FY92 Appraisal Estimate (US$M) 200.0 300.0 300.0 300.0 300.0 300.0 300.0 Actual (US$M) 75.00 292.0 294.4 294.7 294.7 299.3 300.0 Actual as % of Appraisal(%) 38% 97% 98% 98% 98% 99% 100% Date of Final Disbursement: July 17, 1991 PROGRAM DATES Ori2inal Actual Initiating Memorandum 01/01/85 09/20/85 Letter of Development Policy 05/01/85 05/13/86 Negotiations 08/01/85 05/05/86 Board Approval 09/01/85 06/10/86 Signing 09/03/85 06/12/86 Effectiveness 09/05/86 06/16/86 Loan Closing 06/30/89 06/30/91 STAFF INPUTS (staffweeks) FY85 FY86 FY87 FY88 FY89 FY90 FY91 FY92 FY93 TOTAL Preappraisal 45.8 87.7 - - - - - - - 133.5 Appraisal - 25.2 - - - - - - - 25.2 Negotiations - 5.5 - - - - - - - 5.5 Supervision - 4.1 12.8 2.5 - - 0.4 0.8 6.3 26.9 Other 1.3 45.2 0.2 - - - - 61.7 Total 62.1 167.7 13.0 2.5 - - 0.4 0.8 6.3 252.8 *Includes an exchange adjustment of US$48.9 million as of end-May 1994. - Iv - MISSION DATA No. of No. of Staff Date of Month/Year Weeks Persons Weeks Report Preparation 10/85 4 4 16 11/26/85 Appraisal 01/86 3 8 24 02/10/86 Supervision I 11/86 2 1 2 11/25/86 Supervision II 02/87 2 2 4 01/25/87 Completion 06/93 3 1 3 06/30/93 YEAR-END ANNUAL REPORT ON PORTFOLIO PERFORMANCE RATINGS Evaluation Development Legal Management Year Overall Obiectives Covenants Performance 1986 1 1 1 1987 1 1 1 1988 1 1 - 1 1989 1 1 1 1 1990 1 1 1 1 1991 1 1 1 1 1992 1 1 1 1 OTHER PROGRAM DATA Borrower/Executing Agency: Republic of Turkey Follow-on Operations in Sector: Project: Financial Sector Adjustment Loan II Loan No.: 2964-TU Amount: US$400 million Board Date: June 21, 1988 PERFORMANCE AUDIT REPORT TURKEY FINANCIAL SECTOR ADJUSTMENT LOAN II (LOAN 2964-TU) BASIC DATA SHEET LOAN POSITION (Amounts in US$ Million) As of May 31, 1994 Loan Orieinal Disbursed Cancelled Repaid Outstanding 2964-TU 400.0 299.6 100.4 12.4 309.9* CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS FY88 FY89 FY90 FY91 FY92 FY93 Appraisal Estimate (US$M) 200.0 300.0 400.0 400.0 400.0 400.0 Actual (US$M) 125.0 200.0 200.0 300.0 300.0 300.0 Actual as % of Appraisal (%) 63% 67% 67% 75% 75% 75% Date of Final Disbursement: February 16, 1993 PROGRAM DATES Original Actual Initiating Memorandum 01/01/87 07/23/87 Letter of Development Policy 03/18/87 03/18/88 Negotiations 04/01/87 05/11/88 Board Approval 07/01/87 06/21/88 Signing 07/03/87 06/24/88 Effectiveness 06/03/87 06/27/88 Loan Closing 12/31/90 12/31/92 STAFF INPUTS (staffweeks) FY85 FY86 FY87 FY88 FY89 FY90 FY91 FY92 FY93 FY94 TOTAL Preappraisal - - 25.2 88.5 - - - - - - 113.7 Appraisal - - - 21.9 - - - - - - 21.9 Negotiations - - - 6.1 - - - - - - 6.1 Supervision - - - 4.4 49.3 37.3 8.2 1.0 7.4 0.5 108.1 Other 1.6 - 3.0 14.2 9.0 - 3.7 1.7 3.3 - 36.5 Total 1.6 - 28.2 135.1 58.3 37.3 11.9 2.7 10.7 0.5 286.3 *Includes an exchange adjustment of US$22.6 million as of end-May 1994. - vi - MISSION DATA No. of No. of Staff Date of Month/Year Weeks Persons Weeks Report Preparation 01/88 3 5 15 01/27/88 Appraisal 03/88 2 5 10 03/19/88 Supervision I 11/88 2 3 6 12/21/88 Supervision II 06/89 2 5 10 07/14/89 Supervision III 12/89 2 4 8 02/06/90 01/90 21h 2 5 09/20/90 Completion 01/93 3 1 3 06/30/93 YEAR-END ANNUAL REPORT ON PORTFOLIO PERFORMANCE RATINGS Evaluation Development Legal Management Year Overall Objectives Covenants Performance 1988 1 1 - 1 1989 3 3 3 3 1990 3 3 3 3 1991 2 2 2 2 1992 3 3 3 3 OTHER PROGRAM DATA Borrower/Executing Agency: Republic of Turkey Follow-on Operations in Sector: None (after FSAL II) - Vii - PERFORMANCE AUDIT REPORT TURKEY FINANCIAL SECTOR ADJUSTMENT LOANS I AND II (LOANS 2714 AND 2964-TU) EVALUATION SUMMARY 1. This is a desk audit of two financial sector major source of credit demand for the financial adjustment loans (FSALs I and II) to Turkey system, was prone to overborrow in order to which were approved in June 1986 and 1988, support very inefficient operations. Loan respectively. Together the FSALs disbursed a processing in the Bank was affected, first by the total of $600 million for general BOP support. rise of adjustment lending (which was shifting FSAL I was one of the first FSALs and SECALs the balance of power between the programs and in the Bank. This evaluation is based on the the projects departments) and then by the 1987 Region's PCR, the loan documents and files reorganization. relating to the operations as well as systematic interviews with most of the Bank staff associated 3. Neither operation was accompanied by a with the operations. It agrees with the PCR that formal IMF program although for FSAL II there the outcome of both operations was unsatisfac- was a shadow program. Their policy thrust was tory and their sustainability unlikely. The PAR to improve the Central Bank's and Treasury's focuses on two issues. One is an expansion of institutional disclosure and supervisory capabili- the PCR's conclusion that the operations were ties vis-a-vis Turkey's financial institutions, as inappropriately sequenced to occur before well as improving financial intermediaries' Turkey had achieved macroeconomic stability. accounting procedures and the quality of their The other is a review of different aspects of the balance sheets. In addition, the FSALs aimed at loans' processing which might have led to their stabilizing interest rates and reducing depos- approval and disbursement in spite of country it/lending rate spreads. Government implemen- conditions that led to their unsuccessful and tation of the policy conditions was "grudging", unsustainable nature. partial and characterized by backsliding after release of the tranches. Given this and the 2. FSAL I began as a $300 million, sixth sequencing and design problems, the economic SAL, which was changed to a SECAL following impact of the FSALs was small. Inflation rates a sudden, unanticipated decision by the Bank to rose during the 1986-92 FSAL period, from the extend no more than five SALs to a country. It 30%-40% range to the 60%-70% range. Real is still referred to by some as a "weak SAL". interest rates, which had been "too high" became FSAL II was a $400 million follow-up operation very low. The public sector deficit, fueled by which aimed at intensifying the financial sector the financing of public enterprise losses, became reforms which were initiated under FSAL I. larger during the 1986-92 period. The most Both were approved in an uncertain and unstable innovative aspect of either FSAL was the macro setting in Turkey characterized by high floating tranche in FSAL 11. It closely linked public sector deficits, large foreign debt service the disbursements of the tranche to compliance payments, high inflation, and real interest rates with carefully defined policy conditions with which were at first too high and then uncertain clearly demarcated completion indicators, and and uneven across borrowers. The country's embodied most closely the spirit of what a large public and parapublic enterprise sector, a SECAL was supposed to be. The most - Vili - significant developments in Bank/country 6. With regard to the conditions in Schedule 4 relations, and an important sense in which the of the FSAL I Loan Agreement, out of eight FSALs had a positive impact, were the cancel- covenants, four were fully complied with, two lation of the floating tranche and the delay in the were partially fulfilled while the condition release of the second tranche of FSAL II. concerning introduction of external audit requirements for firms listed in the Istanbul 4. Both FSALs are rated unsuccessful and Stock Exchange as well as corporations issuing unsustainable. Key macro indicators worsened securities to the public was delayed and the during the FSAL period. In addition, even if condition relating to the appointment of the implementation had been better, and the finan- Board of Sworn Financial Advisers was cial institutions' portfolios had improved, there unfulfilled. Out of ten conditions for FSAL 1I, was not a prospect that they would remain three were fully met. The remaining seven were strong. This is because the FSALs took place either partially complied with, relaxed or stalled. before any improvements in public enterprises The floating tranche whose release was increased their efficiency and reduced their contingent upon preparation of action programs tendencies to overborrow. As a result, any to restructure and improve performance of State- restructuring of the banks' poor loan portfolios owned banks was cancelled. would have been eroded over time by their need to lend more money to poor credit risks. Some Lessons Learned improvement in the Government's appreciation of the significance of policy adjustment seems to (i) FSALs or operations consisting of policy have occurred as a result of cancellation of the proposals to reform interest rates and floating and delays in release of the second spreads, bank balance sheets and the tranche of FSAL II. These actions, which were mobilization and allocation of non-infla- accompanied by intensive dialogue, increased tionary credit, must be sequenced to occur compliance with FSAL II loan conditions and after the achievement of macro stabilization strengthened internal voices for reform. a public enterprise reform if the latter is needed. FSALs might be introduced 5. The Bank bears some responsibility for the before or along with stabilization, when FSALs' problems. The FSALs were inappropri- inflation is not caused by deficits and ately sequenced and could not have experienced inefficiency and overborrowing by sustained success in the enterprise-deficit-in- enterprises. However, ifoverborrowingby duced, macro instability which existed in Turkey public enterprises is allowed, for example at the time. In addition, the operations were in order to avoid increased unemployment, probably too large for the changes expected in sustained improvement in bank portfolios the financial sector and disbursements were too can only be achieved by removing the fast, occurring before the changes could possibly overborrowing by enterprises. This in turn have taken place. The floating tranche was an involves strengthening the enterprise innovative element of FSAL II; it linked dis- ownership function or the owners' desire to bursement of a dollar amount ($100 million) protect the net worth of enterprises. with completion of clearly defined and demar- cated conditions, without setting an explicit (ii) For FSALs or SECALs to be successful deadline. It probably came the closest to the and sustainable, it is important that their true spirit of SECALs. It appears that cancella- truly "hybrid" nature be recognized by tion of the floating tranche and delay of the designing the operations to link the second tranche of SAL II caused the Govern- amounts of lending to the successful imple- ment to implement more conditions than they mentation and impact of specifically de- otherwise would have and also increased the fined lending conditions. The floating Bank's credibility with the Government. tranche of FSAL i is a good example of - ix - this. In effect, the last two tranches of FSAL II were treated as a "SECAL pro- gram" consisting of two $100 million, floating tranches. Following extensive dialogue, the Bank and the Government jointly decided to cancel the floating tranche and jointly re-agreed on the specif- ics of what had to be done to release the second tranche.  PERFORMANCE AUDIT REPORT TURKEY FINANCIAL SECTOR ADJUSTMENT LOANS I AND II (LOANS 2714 AND 2964-TU) 1. INTRODUcTION 1. In the mid/late 1980s, the World Bank made two Financial Sector Adjustment Loans (FSALs) to Turkey to support the Government's efforts in reforming and developing the country's financial sector. The first FSAL (Loan 2714-TU) in the amount of US$300 million was approved on June 10, 1986, and the second FSAL (Loan 2964-TU) in the amount of US$400 million was approved on June 21, 1988. The first loan closed on June 30, 1991, two years behind schedule and the second loan closed on December 31, 1992, also two years late. While FSAL I was fully disbursed, only US$300 million of FSAL II was disbursed because US$100 million, representing a floating tranche, was cancelled. 2. The FSALs followed quickly after five structural adjustment loans (SALs) to Turkey, with a total value of US$1,356.3 billion. Along with companion IMF programs, the SALs disbursed a large amount of foreign exchange to Turkey to help the Government to stabilize the economy and liberalize external trade and the exchange rate in order to improve resource allocation. A major element of the stabilization program was to reduce the public sector deficit. This seems to have been made somewhat more difficult by the large amounts of domestic currency equivalents of the foreign exchange loans. These accrued to the Government and were used to finance the public sector deficit. 3. The two FSALs were some of the first sector adjustment loans (SECALs) undertaken by the Bank and were considered, at the time, to be path-breaking efforts in the developing world's adjustment process. The Region's joint PCRV for the operations is negative, however, and suggests that they were unsuccessful, unsustainable. They had a modest institutional impact, however. A primary reason for their weaknesses was that they were attempted too early, before Turkey's economic stabilization had been completed. This is confirmed by OED's evaluation of the first five SALs for Turkey. Though it points out that a lot of good resulted from the SALs it notes that stabilization had not yet been fully achieved. This Performance Audit Report (PAR) agrees with the PCR's ratings for the FSALs and does not dispute or duplicate the analysis and the lessons presented in the PCR. Instead, it looks at two issues not considered by the PCR. One is whether the sequencing lesson presented in the PCR, that is, that FSALs should not take place before stabilization is complete, can be made more detailed and specific. The second concerns whether there are lessons to be learned from the Bank loan processing procedures, as they were applied to FSALs I and II in Turkey, which help explain why the results of the operation were meager. 4. The answers to these questions have been derived from interviews with the relatively large number of staff who were involved, from the World Bank side, in the two lending operations. The interviews were initiated via a short, standard questionnaire. In most cases answers to the questionnaire 1' PCR, Turkey - Financial Sector Adjustment Loan and Second Financial Sector Adjustment Loan (Loans 2714-TU and 2964-TU), Report No. 12385, October 6, 1993. PPAR, Evaluation of Structural Adjustment Lending in Turkey, (Fourth and Fifth Structural Adjustment Loans (Loans 2321-TU and 2441-TU) and Overview of SALs I-V), Report No. 7205, April 13, 1988. -2- led to follow-up interviews in order to narrow the focus and increase the specificity of the responses received. Expanding on the sequencing issue, as presented in the PCR, involved calling on staffs' knowledge of other Bank operations and of the problems which the banking sector in Turkey faced. What emerged was a strong indication that the budget deficits and banking sector problems were significantly related to problems in the (mainly parastatal) enterprise sector in Turkey. Specifically, some of the deficit spending of the Government was used to prop up inefficient enterprises, while much of the portfolio problems of the banks were similarly related to their questionable loans to the same enterprises. This suggested that a single solution to hgth the stabilization and banking problems might have been to reform and improve the efficiency of the enterprise sector. Answers to interviews suggested that this option was not considered by many at the time, and those who considered it were negatively influenced by the failure of a previous privatization attempt supported by the Bank. 5. Regarding Bank processes, the questions/interviews focussed separately on the determination of the loan amount and on the design and dialogue concerning the policy packages of the operations. What emerged from the analysis of Bank processes is that there was only a scant relationship between the amounts and disbursement patterns of the BOP support on the one hand and the design and implementation of the policy packages on the other. With the exception of a floating tranche in FSAL II, the two components of each operation seem to have been developed independently. In addition, it appears that the pressure to lend large amounts of BOP support money to Turkey, perhaps too rapidly, adversely affected the design quality of the operations. This may have been reinforced by the Government's expectation that they were going to get the financing, almost regardless of the policy packages associated with them. 6. The interviews also disclosed two significant differences between FSAL II and FSAL I and the SALs I-V. The first was the inclusion of a $100 million "floating" tranche closely linked to specific policy changes with clearly demarcated compliance indicators. This floating tranche, which was to be released at any time following compliance with the conditions, was later cancelled. In addition, disbursement of the second tranche of FSAL II was delayed substantially by Bank staff for reasons which the Government fought, but grudgingly recognized as being substantively valid. The floating tranche was an innovative instrument which came very close to defining what ought to be the difference between SALs and SECALs. The cancelling of it and delays in the release of the second tranche increased the Government's appreciation of the importance of the operations' policy importance and resulted in modest institutional development. II. BACKGROUND 7. The two FSALs were introduced following the completion of a structural adjustment program which consisted of five SALs (SALs I-V) supplemented by IMF stabilization programs. In spite of a general acknowledgement that the stabilization elements of these programs had not yet been achieved, it was decided that no more SALs and no more IMF programs would be undertaken. In a sense, therefore, the FSALs which, as SECALs, were new instruments for the Bank, were expected to handle a relatively disparate set of problems which had formerly been approached from two separate directions, one the SAL route and the other the project or later, investment operation, route. 8. The FSALs added a goal of improving credit allocation to the SAL goals of stabilization and trade and exchange rate liberalization. Viewed from this perspective, Turkey's economy faced four major issues: (a) relatively high levels of real interest rates; (b) weak budgetary control and too large fiscal - 3 - deficits; (c) inflation; and (d) the weak portfolios of financial intermediaries, mainly banks. A very important derivative of the fourth issue was poor management and inefficiencies in the (mainly parastatal) enterprise sector. It was the problems in this sector combined with excessive Government intervention in the banking system, which weakened the banks' portfolios and caused them to become captive to lending more and more to the public enterprises. Because an earlier World Bank technical assistance loan had failed to reform and privatize these enterprises, it was felt that financial reform, including bank privatizations and elimination of preferential credits, would strengthen the financial system to the point where it could "force" greater financial discipline on the enterprise sector. The Macroeconomic Setting 9. Inflation. Inflation was at a relatively low level, but was a persistent problem during the five SAL period running up to the first FSAL. Annual inflation levels varied between 30% and 50% from 1981 to 1986, less than the 110% of 1980, but still a continual destabilizing threat. It was not difficult to see that once the large BOP current account deficits and large amounts of new foreign borrowing declined, inflation would again rise to over 50% per year. 10. Real Interest Rates. During the SALs period, the Government raised interest rates primarily by raising deposit rates, which were still controlled. These were maintained at a positive level and adjusted at least quarterly to reflect changes in inflation, through the end of 1986. Lending rates were completely deregulated and the commercial banks were free to set their lending rates except on loans rediscounted with the central Government. The lending rate liberalization spurred a significant rise in the real level of these rates. Beginning from a negative level in 1980, the real interest rates rose throughout the early and mid-1980s, so that by 1986 real deposit rates had risen to 20% and real lending rates had reached 30%. While positive real deposit rates helped to simulate a rapid growth of financial resources, the high real lending rates contributed to the instability of the government budget and the vulnerability of the financial sector. 11. The Fiscal Deficit. An important cause of the high level of real interest rate was the failure of the Turkish Government to bring the fiscal deficit under control. Although an explicit objective of the SAL programs was to reduce the fiscal deficit to a sustainable level, little progress had been achieved in this area by the time the FSALs became effective. While total expenditures were reduced during the SAL period by paring down public investment programs, total revenue fell even more sharply, from an average of 22% of GNP in 1980-81 to just 16% in 1984; it subsequently recovered slightly with the introduction of the value-added tax in 1985. As a result of the weakened tax effort, the consolidated public sector deficit remained at a high level of around 6% of GNP. Fiscal control was further eroded by the emergence of the Extra-Budgetary Funds (EBFs), which grew rapidly after 1983. The EBFs were assigned specific revenue sources and were largely out of the control of the Central Government. They also, ruinously, had the authority to borrow both domestically and on international money market. By 1987, EBFs controlled 20% of the revenues. The earmarking of the revenue sources for the EBFs eroded the government revenue base and increased the central government fiscal deficit, while their borrowing competed against budgetary borrowing, thus raising real interest rates. 12. Prior to the FSALs, the Turkish government had shifted from money-finance to bond-finance to meet its borrowing requirements. It issued government bonds and bills, mostly of short maturity, to the domestic banking sector. The issuance of bonds helped avoid an immediate inflationary impact; while inflation was still high, it was kept partially in check until late 1987, when the rapid rise in money supply caused a more than doubling of the inflation rate. It also was instrumental in creating a new financial market. But large-scale borrowing from the commercial banking system exerted strong upward pressures -4- on the interest rates, and crowded out private investment. Those securities, which were tax exempt, typically carried an interest rate of 50% and an effective rate of above 80% after taking into account tax exemption, well above the growth rates of real government revenue, which were about 6%. To finance the fiscal deficit at an interest rate in excess of the growth rates of revenue made the fiscal system inherently unstable. With interest expenses increasing faster than government revenues, the fiscal deficit would rise indefinitely and growth of government debt would accelerate. 13. The exchange rate policy and the opening of the capital account to attract capital inflows pursued under the SALs also contributed to the high level of real interest rates and the increase in fiscal deficits. Following a massive devaluation of the Turkish lira, the Government adopted a policy of gradual nominal devaluation to prevent a real appreciation of the domestic currency. While necessary to promote exports, nominal devaluation increased the Government's debt service obligation on the existing foreign debt stock in terms of domestic currency, which in turn fed into the fiscal deficits. Throughout the SAL period, prior to the FSALs, Turkey was running a current account deficit of roughly 3% of GDP every year. Given an open capital account, to generate capital inflows so as to finance the current account deficits, the Government had to hold domestic interest rates high enough to attract foreign investors. The Financial Sector 14. Three features characterized Turkey's financial sector: (i) the oligopolistic market structure of and government involvement in the banking sector; (ii) the cross-ownership between commercial banks and industrial groups; and (iii) the weak financial position of the commercial banks because of the amount of non-performing loans. Of these, the third was the most threatening in the short run. The banking sector was made up of about fifty commercial banks in 1985. But the three largest banks played a dominant role; together they accounted for 75% of the financial assets in the private banking sector. The three banks were also the primary market for Government securities. Commercial banks were affiliated with specific industrial conglomerates through the arrangement of cross-ownership. Most of the loans the banks made were to firms within the same industrial groups. Government involvement in and the oligopolistic structure of the banking system and the interlocking between the banks and industrial groups were significant factors for the low efficiency of the banking system. 15. Through the arrangement of cross-ownership, commercial banks became an instrument through which profitable units in the industrial groups provided subsidies to those making losses to prevent them from going bankrupt. Because of the equity interconnections, banks were generally reluctant to stop lending to firms affiliated to the same group that were no longer creditworthy. Loans that could not be serviced were typically rolled over and covered by new loans as they came due. This practice increased the cost of financial intermediation as the banks tried to pass on the cost to solvent borrowers and the Government by increasing the spread between the deposit and lending rates. It also effectively reduced funds that could otherwise be invested in more profitable business areas. More importantly, interlocking between the banks and industrial groups increased the financial vulnerability of the entire banking sector. Should the profits for the whole group became negative and bankruptcy of the loss-making firms became unavoidable, it would inevitably have an tremendous impact on the financial viability of the captive bank. 16. Most of the commercial banks were in a very shaky financial situation because of the problem of bad debts arising from imprudent and later "captive" lending practices. This problem was further exacerbated by the high level of real interest rate which made it difficult for many firms to service their debts, thereby increasing the non-performing loans of the banking system. An accurate estimate of the true extent of the problem was difficult to obtain because of the common practice among the Turkish -5- banks to capitalize the debt service on non-performing loans. Those de facto bad loans could exceed the book value of some of the banks, making them technically insolvent. 17. Some steps had been taken during the SALs to develop a capital market, improve the efficiency of financial intermediation, strengthen prudential regulation, and reduce the share of preferential credit. To these ends the Government reduced taxes on financial transaction in the banking sector, which was believed to be the cause of the large spread between the lending and deposit rates. A new Banking Law was enacted in 1984, which limited the exposure of a bank to a single customer. Additional achievements were reductions in the amounts of selected credit; rediscounted credit with the Central Bank, which accounted for the largest proportion of the preferential credit, declined significantly from 14.5% of total credit outstanding in 1982 to just 5% in 1985. However, it was felt that these pre-FSAL measures fell far short of addressing the fundamental problems of the financial sector, and, in any event, some have subsequently been reversed. Developments in the World Bank 18. At the same time that these stabilization, banking and enterprise problems were occurring in Turkey, the World Bank was going through some changes which seem to have affected the timing, essence and success of the FSALs. The immediate problem vis-a-vis Turkey was the decision to limit countries to five SALs after Turkey had received a fifth SAL. The programs (later country operations) department had been planning to have two more SALs (VI and VII), notionally targeted for US$300 million each as part of an overall strategy of a lending program of slightly over US$1 billion per year. Problems in the financial sector had been presaged by conditions in SALs IV and V and had led to the issuance in late 1983 of a financial sector studyY known generally as the "Silva Lopes" study. As a result, a decision was taken in reaction to the five SAL limit to develop an innovative lending instrument, using the Silva Lopes report, attaching the US$300 million notionally allocated for SAL VI to a new lending instrument, or SECAL. 19. The Turkish Government, apparently, saw no reason for the change. They were happy with SALs, which provided a large amount of funds for BOP support quickly, and in a relatively "hassle-free" fashion. SALs enabled the Turkish Government to get very large amounts of money through a small number of Bank operations while dealing with a smaller number of Bank staff in the context of a much more concentrated reform focus. The Government seems to have decided to treat the FSALs mainly as if they were SALs anyway. 20. The five SAL limit and the subsequent development of the FSALs as SECALs also had an impact on how the Turkey operations were handled in the Bank. There had been a tendency to concentrate major responsibility for the SALs in the country programs department. This caused shifts in the balance of power and prestige between the programs and the projects departments, in favor of programs. The advent of SECALs had the potential, at least, to redress this process because SECALs explicitly brought the project or sector staff back into the lending and country dialogue process. While this broadened and diversified Bank staff participation and the application of expertise to the operations, it also made things somewhat more bureaucratically difficult within the Bank and between the Bank and the country. Everyone now had to deal again with a larger and more diverse group of Bank staff. 1/ Turkey: Special Economic Report - Policies for the Financial Sector, Report No. 4459-TU, September 21, 1983. -6- 21. The other major event which affected these operations was the Bank's mid-1987 reorganization. To some extent, the reorganization confirmed the increased importance of structural adjustment lending. However, the reorganization also caused uncertainty amongst staff and some turnover across countries and specializations, including the staff working on Turkey. III. THE POLICY CONTENT. IMPLEMENTATION AND IMPACT OF THE FSALS 22. Policy Content. Given the way that the previous SALs and IMF programs had influenced the Government, there was a tendency in designing both FSALs to feel that the Government would solve its macro instability problems without much further prompting. As a result, the IMF withdrew and FSAL I went ahead with little in the way of stabilization conditionality. However, because of its preoccupation with interest rates, it was indirectly concerned with the same sorts of problems that the previous five SALs had addressed. When the time came to design FSAL II, staff were less complacent about the instability issue so the operation included requirements of an IMF shadow program and that the Bank review and approve the Government's fiscal and monetary programs, which were annual plans, revised semi-annually. 23. The schematic (following page) sets out what the FSALs hoped to accomplish and how it was to be done. It assumed that the budgetary expenditure/GDP ratio would be appropriate and that the budget would be made "non-inflationary" through the appropriate fiscal and monetary policy. That is, by lowering deficits with tax increases and financing any remaining deficits with "non-Bank" borrowing rather than through money creation. When and if this first measure (upper right on the schematic) was accomplished, the remainder of the measures listed in the right hand column below it, if taken together, would achieve financial sector adjustment thus simultaneously improving resource mobilization and allocation. The package is essentially an "all-or-nothing" one, something which may not have been appreciated at the time by either Bank staff or the Government. 24. Both FSALs had a significant number of conditions concerning interest rates and/or interest spreads for release of each of the four "formal" tranches. These conditions usually related to keeping all rates positive in real terms, reducing preferential interest rate lending and reducing the spread between the banks' effective lending and deposit rates. Each tranche, now also including the floating one, contained a series of relatively detailed accounting, supervision and institutional conditions aimed at improving disclosure and/or restructuring the financial institutions so as to lower costs of operation, improve or write down loan portfolios and raise the profitability of new loans by altering the banks' credit allocation patterns. -7- Figure 1: Financial Sector Adjustment Relationships and Measures Fiscal Policy: Reduce inflation and crowding out of privAce sector. Monetary Policy: Reduce reserve and liquidity requirements, to reduce Financial high cost of lending. Policies Interest rates: Positive deposit races to increase depth of financial sector. Selective credits: Reduce subsidies on Resource credit. Mobilization Short-term Instruments: encourage secondary markets for Treasury bills and commercial paper. FIANCIAL Financial SECTOR Instruments Media-term Instruments: Develop ADJUSTMENT Treasury bond market, corporate bond market and equity market. Cencral Bank: Strengthen bank surveillance capacity. Resource Allucation Bank Examiners' Board: Reorient examination procedure. Commercial1 Banks: Standardize accounting, introduce external audit, and train staff. Financial Institutions Capital Markets: Improve :egulatory framework and functioning of Capital Markets Board. Money Markets: Deepen interbank market. Equities Markets: Improve financial disclosure requirements. -8- Compliance with Conditions 25. The Government's compliance with the FSALs' conditions, characterized by backsliding, was inadequate. It complied fully with only those sections of Article III of the two Loan Agreements it considered palatable while it either delayed or sought modification of the conditions it felt were "politically" difficult to fulfill culminating, for example, in the cancellation by the Bank of the floating tranche of the FSAL II. 26. With regard to the conditions in Schedule 4 of the FSAL I Loan Agreement, out of eight covenants, two requiring completion of a review of the Foreign Exchange Risk Insurance Scheme (FERIS) and introduction of external audit requirements for commercial banks were complied with fully. Another two calling for actions to ensure adequate progress in strengthening the auditing techniques utilized by the Board of Sworn Bank Examiners, etc., and preparation of an implementation program for the establishment of a system of export credit insurance were also unfilled. Two conditions requiring actions to ensure adequate progress in implementing the 1986 economic program and adoption of a 1987 economic program, etc., and, achievement of positive real interest rates for preferential credit to the productive sectors were partially complied with. The condition concerning introduction of external audit requirements for firms listed in the Istanbul Stock Exchange as well as corporations issuing securities to the public was delayed while the condition relating to the appointment of the Board of Sworn Financial Advisers was unfulfilled. 27. Compliance with conditions governing release of the second and floating tranches of the FSAL II was similarly, unsatisfactory. Out of ten conditions, three relating to satisfactory measures to increase the attractiveness of local currency deposits, etc. and maturity of foreign exchange deposits and completion of two studies to develop a framework for taxation of financial instruments and for improving the marketing of Government securities and development of a secondary securities market were fully met. The remaining seven were either partially complied with, relaxed or stalled. The floating tranche whose release was contingent upon preparation of action programs to restructure and improve performance of the State-owned banks (which had stalled) was eventually cancelled. 28. Implementation. Implementation was generally poor, slow and characterized by backsliding after release of each tranche. The Government often expressed good intentions which were then not carried out. Appropriate annual economic programs were formulated, the requested Boards and Commissions were established and the laws and acts of Parliament were passed as requested. However, little actual change seemed to occur. 29. There are indications that neither the Government nor some in the Bank thought that even if perfectly implemented, the FSAL policy package would achieve the expected positive results. The major reasons for doubts were similar for both Bank staff and the Government. One relates to the substantive shortcoming of the operations; their lack of consideration of the prior need to stabilize the economy, importantly, by reforming the least efficient large enterprises. A second relates to the speed of loan processing and the inability of Bank staff and the Government to complete the intellectual underpinnings and design needs before approval of the loans. 30. Impact. The impact of the FSALs was limited, as can be seen from the economic indicators presented in Table 1. The period for the two FSALs was essentially between 1986 and mid-1992, or the five right columns of the Table. The consolidated Government deficit was continuously "too high", particularly in the latter years. This was the result of a combination of an inability to collect sufficient revenue, as a percentage of GNP, as well as a tendency for government expenditures to be too large, as -9- a percentage of GDP, particularly in the latter years. Inflation, which should have fallen further during the FSAL period, actually rose from the 30-48% range to the 60-70% range. In addition, primarily because of the inflation, most real interest rates dropped to very low levels during the 1988-1990 period. Table 1: TURKEY - MACROECONOMIC INDICATORS (% or % of GNP) 1980 1981-1985 1986 1987 1988-1990 1991 1992 1. Consolidated Govt. Deficit -3.7 Between -3.5 -4.5 Between -9.1 -7.0 -1.7 & -5.3 -3.8 & -4.8 2. Revenue 20.6 Between 18.2 17.8 Between 19.6 21.8 15.3 & 21.3 17.5 & 19.1 3. Expenditure 24.3 Between 21.7 22.3 Between 28.7 28.8 18.3 & 23.1 21.3 & 23.9 4. Inflation (%) 110.0 Between 35.0 39.0 Between 66.0 70.0 31.0 & 48.0 63.0 & 75.0 5. Real Deposit Rate (%) -95.4 Between 20.4 -3.8 Between -3.0 1.3 5.2 & 3.06 -9.82 & -24.6 6. Real Lending Rate (min., %) -80.6 Between 30.8 11.2 - - 6.3 & 20.0 7. Cur. A/C Balance (% GDP) -6.0 Between -2.5 -1.2 Between 0.3 - -18.8 & 3.8 -0.2 & 2.3 31. As the PCR notes, there were a series of technical assistance, institutional, and disclosure successes related to the FSALs. The banks' accounting system was changed to coincide with a "western" style, a significant number of new bank examiners were appointed and trained, and the Treasury and Central Bank obtained increased authority to force disclosure of the financial institutions' financial condition. It was the FSALs' limited success in these areas which led them to have a modest impact on institutional development. However, one Bank staff member who was interviewed said, "these were important and necessary changes, but they were well short of what should have been accomplished for the amount of money actually disbursed with the two FSALs". IV. OVERALL ASSESSMENT AND SUSTAINABILITY 32. Suce. The FSALs were unsuccessful and unsustainable. Their major goals, improved mobilization and allocation of financial resources in the domestic economy, were not achieved during the 1986-1991 "FSAL period". This is most easily seen by the deterioration of the macro indicators - 10 - presented previously, in Table 1. Inflation and public sector deficits are now higher than they were in 1986, the initial FSAL year. Real deposit rates were (perhaps too highly) positive in 1986 but have been negative since then. 33. There were some modest institutional gains from the FSALs and there may have been a shift in Turkey's policy receptiveness as a result of the operations, particularly because of the cancellation of the floating and delaying release of the second tranche of FSAL II. The Government became more convinced than they were before that fiscal deficits and the portfolio losses of financial institutions are serious economic problems. Turkey has essentially repaid the IMF, and is now, therefore, in a much better position to use that institution's short-term stabilization programs effectively. Following significant improvements in the management of the Agricultural Bank, policymakers in Turkey are now more aware of the important impact which well selected and appropriately motivated bank managers can have on improving the financial sector. But these lessons did not come cheaply, particularly in terms of opportunities foregone. Furthermore, they seem to have been learned primarily because of the failures rather than successes associated with the FSALs. 34. Sustainability. It appears that even had these operations been successful, they would most probably not have been sustainable. This is because the design of banking reform elements in the FSALs, including the "bank hospital" approach of FSAL II, were oriented toward a static goal of improving the balance sheets of the banks without addressing dynamic problems relating to poor, sometimes even perverse bank management incentives and the inefficiencies and pervasive borrowing habits of the large, mainly public, enterprises in Turkey. As a result, even if the institutional reforms regarding greater disclosure, improved supervision, correct portfolio evaluation and recapitalization of the banks had succeeded, the lending behavior of the banks would probably not have been changed so that the reforms could be sustained. Instead, it is most likely that even reformed banks, unless they would have been able to lend abroad, would have been forced to make new loans to an enterprise sector which had a pervasive tendency to overborrow in order to finance profligate and inefficient behavior. V. THE ROLE OF THE BANK 35. The previous sections suggest that the Bank bears some responsibility for the lack of success and sustainability of the FSALs. The FSALs were inappropriately sequenced and could not have experienced sustained success in the enterprise-deficit-induced, macro instability which existed in Turkey at the time. What was it about the processing of the operation which caused this fundamental flaw to be overlooked? Interviews with Bank staff associated with the FSALs suggest several reasons. One concerns the absence of a tight link between the dollar amount of the loan and the likely impact of policy success. Another concerns the relationship between the size and speed of processing of the loans or the possibility that they were too large and too fast. A positive factor, demonstrative of better practices, was the very intense dialogue motivated by consideration of whether to release the floating tranche and the second tranche of FSAL II. The Weak Link Between Lending and Policy Proposals 36. In general, Bank staff were surprised by questions regarding the links between the size of the FSAL lending and the focus of and expected impact of the policy packages. The most often mentioned explanations for the amounts of the loans were country and political considerations, partial achievement of a lending target of slightly over $1 billion per year, BOP needs (including servicing and repayment - 11 - of other foreign loans) and, that the normal size of adjustment loans to Turkey at that time was between $300 and $400 million. Concepts such as absorptive capacity or the estimated impact on the productivity of capital were not used. There was a general feeling amongst the staff who worked on FSAL II that FSAL I was too big and too easy. Several also expressed an opinion that the earlier SALs (I-V) were also too big and too easy. All felt that "too big" meant that the domestic currency equivalent of adjustment loans enabled the Government to avoid or circumvent necessary policy changes, particularly relating to the need to reduce government expenditures. 37. It is interesting that there was early consideration of making FSAL I a $25 million investment operation. The logic was that the loan amount would be adequate to finance the cost of carrying out the technical assistance and institutional requirements identified in the Silva Lopes report. It was expected that such an operation would be held up until the Turks had completed macro policy reforms because, "the Bank shouldn't pay them to do what they ought to do anyway". Too Large. Too Fast? 38. Interviews with staff indicated a perception that the size of the two FSALs was not sufficiently linked to the physical and/or policy impact of the reforms supported by the two operations. Similarly, there was a perception that the speed of loan processing and disbursements was faster than justified by the speed of the reform process. 39. The clearest example of this was the conundrum regarding the need for prior enterprise reform if financial sector reform were to be successful for a sustained period of time. The issue appears to have been raised twice; once, early in the design stage of FSAL II and later on, as part of a broader concern that the public sector deficit could not be contained appropriately in the absence of limits on "public" resource flows to the enterprises. These doubts were addressed by adding "macro" provisions such as a shadow IMF program and the monitoring of Turkey's annual economic programs to the conditions for FSAL II. Together, these were intended to limit the flows of public resources to the inefficient enterprises. The particular flows were not identified, however, and their reduction was not attended to in considerations regarding the release of the second tranche. Cancelling the Floating and Delaying Release of the Second Tranche 40. In a design sense, the most innovative aspect of either FSAL was FSAL II's "floating" tranche. Also, the most important implementation issues relating to either FSAL were the cancellation of this floating tranche and delaying disbursements of the second tranche until significant progress in implementing second tranche conditions was made. Both incidents involved Bank staff efforts to improve the impact of FSAL II, in the face of what was perceived as the unsuccessful nature and loss of credibility associated with adjustment lending in Turkey. The floating tranche tied disbursement of $100 million to the undertaking of certain clearly demarcated institutional reforms, primarily in the state banks, and in the Agricultural Bank in particular. What constituted fulfillment of the conditions was clearly defined and the conditions could be fulfilled and disbursements made at any time. The floating tranche thus embodied the spirit of a SECAL; the money was not targeted with respect to use, but the amounts of money were closely linked to specified policy and/or institutional reforms, the completion of which was clearly demarcated. Both the Bank and the country knew well what had to be done to release the tranche. The country, therefore, controlled whether and at what time the tranche would be released. Interviews disclosed that the Government tried to force the release of the tranche by requesting premature release and/or by substituting other policy initiatives, etc., but they did not completely comply and the tranche was cancelled, a most unusual event for an adjustment operation. - 12 - 41. Coupled with the cancellation of the floating tranche was Bank staff intransigency over the release of the second tranche of SAL II. By the time of the consideration of the release of the second tranche, Bank staff had a very clear idea of what it was that the second tranche conditions meant. As a result, they held fast until the Government carried out the proposed reforms. This, coupled with the cancellation of the floating tranche, can be viewed as a step in improving the Bank's policy credibility with the Government. VI. LESSONS LEARNED 42. The most important substantive lessons to emerge concern sequencing. It is generally the case that FSALs should not be attempted until after stabilization is achieved although there may be exceptions. It is more universally the case that FSALs should not be attempted when the enterprise sector needs reforming/privatizing. Overborrowing by the enterprise sector, in order to finance recurrent losses and inefficiencies, will lower the value of banks' lending portfolios. Another important lesson relates to loan design and processing by the World Bank. The FSALs were processed and approved very rapidly, like the previous SALs. There was not enough time to carefully design the operations and convince the Government and the banking sector of the importance of their policy contents. Because of this, the operations were referred to by some staff as having been "intellectually backloaded". Later on, Bank staff were able, by means of cancellation of the floating tranche and delay of release of the second tranche, to partially redress this problem. (a) FSALs or operations consisting of policy proposals to reform interest rates and spreads, bank balance sheets and the mobilization and allocation of non-inflationary credit, must be sequenced to occur after the achievement of macro stabilization And public enterprise reform. FSALs might be introduced before or along with stabilization, when inflation is not caused by deficits and inefficiency and overborrowing by enterprises. However, if overborrowing by public enterprises is allowed, for example in order to avoid increased unemployment, sustained improvement in bank portfolios can only be achieved by removing the overborrowing by enterprises. This in turn involves strengthening the enterprise ownership function or the owners' desire to protect the net worth of enterprises. (b) For future FSALs or SECALs to be successful and sustainable, it is important that their truly "hybrid" nature be recognized by designing the operations to link the amounts of lending to the successful implementation and impact of specifically defined lending conditions. The floating tranche of FSAL II is a good example of this. In effect, the last two tranches of FSAL II were treated as a "SECAL program" consisting of two $100 million, floating tranches. Following extensive dialogue, the Bank and the Government jointly decided to cancel the floating tranche and jointly re-agreed on the specifics of what had to be done to release the second tranche.