Turkey - Programmatic Financial and Public Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No: 25277 IMPLEMENTATION COMPLETION REPORT (SCL-46320; SCL-46330) ON A LOAN IN THE AMOUNT OF US$1.1 BILLION TO THE REPUBLIC OF TURKEY FOR A PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN 11/28/2002 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Exchange Rate Effective November 27, 2002) Currency Unit = Turkish Lira TL 1 = US$ 0.00000064 US$ 1 = TL 1,552,624 FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS ASCU Agriculture Sales Cooperatives Unions MOF Ministry of Finance BRSA Banking Regulation and Supervision Agency NBFI Non-Bank Financial Institutions CAS Country Assistance Strategy NPL Non-Performing Loans CBT Central Bank of Turkey PEIR Public Expenditure and Institutional Review CEM Country Economic Memorandum PEM Public Expenditure Management CFAA Country Financial Accountability Assessment PFMFC Public Financial Management and Financial C CMB Capital Markets Board PFMP Public Financial Management Project COM Council of Ministers PFPSAL Programmatic Financial and Public Sector Ad CPAR Country Procurement Assessment Report PFSAL Programmatic Financial Sector Adjustment L EBF Extra-budgetary Funds PIP Public Investment Program ERL Economic Reform Loan PPL Public Procurement Law ESW Economic Sector Work PPSAL Programmatic Public Sector Adjustment Loan EU European Union PSR Public Sector Reform FSAL Financial Sector Adjustment Loan QAG Quality Assurance Group FX Foreign Exchange SDIF Savings Deposit Insurance Fund GDP/GNP Gross Domestic Product/Gross National Product SEE State Economic Enterprise GFS Government Finance Statistics SPO State Planning Organization HPC High Planning Council SSF Social Solidarity Fund LOI Letter of Intent TCA Turkish Court of Accounts IDP Institutional Development Plan TIN Taxpayer Identification Number IMF International Monetary Fund UNCITRAL United Nations Commission on International LLP Loan Loss Provisioning VAT Value Added Tax Vice President: Johannes F. Linn Country Manager/Director: Ajay Chhibber Sector Manager/Director: Paul Siegelbaum, Cheryl Gray Task Team Leader/Task Manager: Lalit Raina, James Parks  TURKEY Programatic Financial and Public Sector Adjustment Loan CONTENTS Page No. 1. Project Data 2. Principal Performance Ratings 3. Assessment of Development Objective and Design, and of Quality at Entry 4. Achievement of Objective and Outputs 5. Major Factors Affecting Implementation and Outcome 6. Sustainability 7. Bank and Borrower Performance 8. Lessons Learned 9. Partner Comments 10. Additional Information Annex 1. Key Performance Indicators/Log Frame Matrix Annex 2. Project Costs and Financing Annex 3. Economic Costs and Benefits Annex 4. Bank Inputs Annex 5. Ratings for Achievement of Objectives/Outputs of Components Annex 6. Ratings of Bank and Borrower Performance Annex 7. List of Supporting Documents  Project ID: P070561 Project Name: Programmatic Financial and Public Sector Adjustment Loan Team Leader: Lalit Raina TL Unit: ECSPF ICR Type: Core ICR Report Date: January 2, 2003 1. Project Data Name: Programmatic Financial and Public Sector L/C/TF Number: SCL-46320; Adjustment Loan SCL-46330 Country/Department: TURKEY Region: Europe and Central Asia Region Sector/subsector: Central government administration (50%), Banking (46%), Capital markets (2%), General industry and trade sector (2%), KEY DATES Original Revised/Actual PCD: 05/04/2001 Effective: 07/05/2001 07/17/2001 Appraisal: 05/21/2001 MTR: Approval: 07/12/2001 Closing: 12/31/2001 12/31/2001 Borrower/Implementing Agency: GOVERNMENT OF TURKEY/UNDERSECRETARIAT OF TREASURY Other Partners: STAFF Current At Appraisal Vice President: Johannes F. Linn Johannes F. Linn Country Manager: Ajay Chhibber Ajay Chibber Sector Manager: Paul J. Siegelbaum - Cheryl Gray Paul Siegelbaum - Pradeep Mitra Team Leader at ICR: Lalit Raina - James Parks Lalit Raina - James Parks ICR Primary Author: Gurhan Ozdora; Kamer Karakurum Ozdemir Gurhan Ozdora 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome:S Sustainability:L Institutional Development Impact:M Bank Performance:S Borrower Performance:S QAG (if available) ICR Quality at Entry: S Project at Risk at Any Time: No  3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: The main objective of the Programmatic Financial and Public Sector Adjustment Loan (PFPSAL) was to address the Government's immediate financial and public sector reform priorities in the aftermath of the November 2000 financial turmoil and February 2001 financial crisis, while ensuring that social programs continued to be adequately funded. The rationale for supporting a combined package of financial and public sector reforms through the PFPSAL program was to help Turkey break definitively with the past vicious circle of inadequate fiscal management generating public deficits which in turn fueled inflation and financial sector instability. By laying out a medium-term program of combined financial and public sector reforms, the Government aims to bolster investor confidence by showing its determination to address the roots of macroeconomic instability and crises in Turkey. The PFPSAL was the first in a series of programmatic loans planned to be implemented over the 2001-2003 period in support of the Government's comprehensive multi-year financial and public sector reform program aimed at restoring confidence in the banking system and correcting the underlying structural problems in the public sector. The single tranche PFPSAL of US$1.1 billion (of which US$400 million is on special structural adjustment loan (SSAL) terms and US$700 million on standard IBRD terms) was followed by the three tranche PFPSAL II of US$1.35 billion (of which US$800 million is on SSAL terms and US$550 million on standard IBRD terms) approved by the Board on April 16, 2002. The PFPSAL II became effective in August 2002, and the first US$450 million tranche was released, following fulfillment of the effectiveness condition regarding submission to Parliament of legislation extending the coverage of the audits of the Turkish Court of Accounts to the Presidency and Parliament, and allowing for external audit of TCA itself. This Implementation Completion Report covers both actions completed under PFPSAL and actions supported by PFPSAL II through mid-2002. The PFPSAL and PFPSAL II operations were designed to support a medium-term program of second generation structural, policy and institutional reforms in the financial and public sectors. This program is grounded in the Country Assistance Strategy (CAS) Progress Report discussed by the Board in July 2001. It is closely integrated with other elements of the CAS and is supported by extensive Economic Sector Work (ESW) including analytical work on the key fiduciary aspects of public expenditure management. The program is designed to help Turkey prevent future crises by tackling the deep roots of financial instability in Turkey and achieve sustainable poverty reduction through macroeconomic stability and growth. The medium-term strategy for financial and public sector reform supported by the PFPSAL operations is targeted at helping the Government restore confidence by demonstrating how Turkey will resolve the underlying structural weaknesses which led to the February crisis. The PFPSAL program is part of a broader package of international assistance to support Turkey's strengthened program in response to the crisis, including an increase in IMF commitments from less than US$4 billion under the original Stand-by arrangement approved in December 1999 to over US$30 billion to date. The US$1.2 billion on SSAL terms within the PFPSALs was an addition to the original FY01-03 envelope, authorized in the CAS Progress Report as part of the Bank's broadening of support to Turkey in the crisis. In response to the February 2001 crisis, the Government committed to a significant acceleration and widening of the scope of the financial sector reform effort already initiated as part of the Financial Sector Adjustment Loan (FSAL) to bring safety, soundness and productivity in the banking sector up to EU and international standards. Such acceleration and widening of the scope of the financial sector reform program was necessary to restore banking system confidence in light of the financial turmoil in November 2000 and subsequent macroeconomic/banking crisis in February 2001 and to respond to the changed sector circumstances because of the severe forex/interest rate and credit shocks suffered thereby. The development of the revised strategy was based on two post-crisis banking sector assessments and stress test results - 2 -  carried out during December 2000 and March 2001. The Bank management, in close consultation with the Turkish authorities decided to cancel the second tranche of the FSAL and to absorb the remaining FSAL reform actions in the two new PFPSAL loans. As part of the widened scope of its financial sector reform effort, and once the initial phase of urgent post-crisis banking reform and restructuring activity is over, the Government also plans to implement a comprehensive non-bank financial institutions (NBFI) reform program to complement the banking sector reform effort, and a study is being prepared by the Bank team in collaboration with the Government for this purpose. The public sector reform (PSR) component of the PFPSAL operations aims at supporting measures to achieve sustained fiscal adjustment and create the conditions for transparent and effective government in line with EU and international norms. The Bank support for PSR through PFPSAL and PFPSAL II is designed to underpin the first phase of the reform program, notably efforts to sustain fiscal adjustment and start the change processes for core institutional reforms. The program builds on an initial set of structural fiscal reforms supported by the Economic Reform Loan approved in May 2000. The content of the public sector reform program draws on analysis presented in the 2000 Country Economic Memorandum (CEM) and the 2001 Public Expenditure and Institutional Report (PEIR). It also draws heavily on the Bank's fiduciary sector work including the Country Procurement Assessment Review (CPAR) and the Country Financial Accountability Assessment (CFAA), both completed in 2001, as well as the Fiscal Transparency Review prepared by the IMF. The PEIR and public sector component of the CFAA were carried out as a joint exercise which contributed to an integrated approach. The Bank's programmatic assistance in support of financial and public sector reform in Turkey is a graduated response conditioned on concrete actions taken by the Government. The programmatic approach recognizes that the complex second generation policy and institutional reforms that Turkey is undertaking must be sequenced over the medium term. It also takes into account the uncertainties inherent in the crisis conditions that Turkey faced in 2001. It allows for a reasonable degree of adaptability of the program to unfolding events on the ground. Under the revised CAS, PFPSAL II is expected to be followed by two Programmatic Financial Sector Adjustment Loans (PFSAL) of US$500 million each and a Programmatic Public Sector Adjustment Loan (PPSAL) of US$375 million to support the continued implementation of the financial and public sector reform program. The outcomes to date demonstrate that the goals and objectives of the PFPSAL program were appropriate and consistent with enabling the government to continue with the reform process. Project objectives were realistic and linked to monitorable performance indicators. Of particular note are the concrete targets for social expenditure which are now serving as important references within the internal dialogue between the Ministry of Finance, Treasury and responsible line agencies. The technical and financial assistance from the Bank and other donors allowed the government to address the immediate crisis while protecting critical social spending. 3.2 Revised Objective: The objectives of PFPSAL and PFPSAL II have not been revised. 3.3 Original Components: The PFPSAL and PFPSAL II operations have been designed to assist the Government in the following areas: In the financial sector 1. Overhaul of the legislative and regulatory framework for banking activity to bring it in line with EU and Basle standards; 2. Institutional development of the new Banking Regulation and Supervision Agency (BRSA), and - 3 -  the bank failure resolution entity, the Savings and Deposit Insurance Fund (SDIF); 3. Problem bank/bank failure resolution to undertake restructuring of the private sector banks and, 4. State bank restructuring and privatization; In the public sector 5. Implementation of structural fiscal policies to underpin permanent fiscal adjustment; 6. Design and implementation of reforms to modernize public expenditure management in line with EU and international norms including budget reform, financial accountability and public liability management; and 7. Initiation of institutional reforms to improve public sector governance. The focus and scope of the operation on reform, restructuring and recapitalization of the banking sector; and reform, adjustment and modernization of public sector management were appropriate given that structural weaknesses in these areas were at the root of the 2001 crisis. The PFPSAL operations have helped the government to enforce financial discipline on the banks and strengthen fiscal discipline in the public sector. The PFPSAL operations also assisted the government to undertake fiscal adjustment and manage its public debt burden, which increased greatly as a result of the crisis, while protecting social expenditure. 3.4 Revised Components: Loan components of PFPSAL and PFPSAL II have not been revised. 3.5 Quality at Entry: The objectives of the PFPSAL program were designed to be fully consistent with government priorities. Government counterparts were involved in all phases of project preparation and design. Knowledge gained from ESW--notably the CEM (2000), PEIR (2001), fiduciary work under the CPAR and CFAA (2001), and informal sector work on banking (1998-99) helped in the design of the PFPSAL operation and the broader PFPSAL program. Although a quality at entry assessment for the first PFPSAL operation was not carried out by the Quality Assessment Group (QAG), the quality of preparation is judged to be satisfactory based on the fact that the project objectives were determined to be feasible during implementation. The objectives of PFPSAL II are fully consistent with the original PFPSAL program prepared together with the first PFPSAL operation. Quality at entry was rated satisfactory for PFPSAL II by a QAG panel chaired by the Vice-President of the PREM network. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: The single tranche PFPSAL was designed as the first in a series of two programmatic adjustment loans structured to support both financial and public sector reforms in response to the 2001 crisis. It was followed by the three tranche PFPSAL II operation approved in April 2002. The rationale for a combined approach to financial and public sector reform derived from the urgent need to address simultaneously the close linkages tying chronic public sector deficits and financial sector vulnerabilities to macroeconomic instability. The lack of transparency of quasi-fiscal spending, including state bank duty losses, allowed part of the public deficit to be hidden from view which, when exposed by the crisis, contributed to the surge in the public debt stock. The PFPSAL program has aimed to break the vicious circle of inadequate public sector management in Turkey that led to ever increasing public indebtedness, thus fueling financial sector dependency and speculation on high-return government securities, which in turn further increased the public debt burden. By combining urgent, up-front measures in response to the crisis with initiation of deeper structural reforms, the PFPSAL program is geared to rebuild investor confidence by demonstrating that Turkey is finally addressing the core institutional weaknesses in the financial and public sectors that have contributed to macroeconomic instability. The status of the macroeconomic framework and structural - 4 -  reforms supported by PFPSAL and PFPSAL II is given in the sections below. Macroeconomic Framework. For the macroeconomic environment, conditions to be fulfilled prior to Board presentation of PFPSAL included: (i) satisfactory macroeconomic framework consistent with the core objectives for 2001, including positive Gross National Product (GNP) growth during the second semester, inflation of 2 percent per month and nominal interest rates of 50-55 percent by the end of the year, and a primary surplus for the consolidated public sector of 5.5 percent of GNP, and (ii) approval of a satisfactory supplementary budget for 2001 consistent with the Government's macroeconomic objectives which would also ensure satisfactory expenditure envelopes for health, education and social protection. These conditions were met prior to Board presentation of PFPSAL. For PFPSAL II, corresponding macroeconomic objectives were set for 2002 including an increase in the primary surplus to 6.5 percent of GNP and a decrease in the inflation rate to 35 percent by the end of the year. The macroeconomic objectives supported by PFPSAL were established under the Government's strengthened program announced in May 2001. The strengthened program was also supported by an additional US$8 billion from the IMF. As of end-2001, the fiscal targets of the program were broadly met including an overshooting of the primary surplus target. However, some of the macroeconomic outcomes deviated significantly from program targets; the recession turned out to be deeper than expected with GNP contracting by 9.4 percent and inflation reaching 68.5 percent by the end of the year. Nominal interest rates remained substantially higher than program levels which contributed to a higher than expected debt-to-GNP ratio of 93.3 percent. In September 2001, Turkey was hit by a new external shock as global financial markets and trade were affected by the terrorist attacks in the United States. In February 2002, the IMF approved a new US$16 billion Stand-by arrangement for Turkey covering 2002-04. Macroeconomic performance improved considerably in the first half of 2002, with a slow down in inflation, a drop in nominal interest rates combined with a relative stabilization of the exchange rate following the sharp depreciation in 2001, and encouraging signs of increased economic activity. However, interest rates increased once again from below 55 percent in April to above 70 percent by June, as political uncertainty increased prior to the announcement of early elections of November 3rd. The upward movement in interest rates was reversed immediately after the elections as the markets reacted favorably to the new single party government. Interest rates were down to the 50-55 percent range by mid-November. GNP expanded by 8.8 percent in the second quarter (year-on-year) and inflation has remained low. The end-year targets of 4 percent growth (revised upward from 3 percent) and 35 percent inflation are well within sight. The IMF program has remained on track. The 3rd IMF program review was completed in August 2002. Initial discussions on the 4th program review were held in October and resumed in December. Macroeconomic outcomes in 2002 have also remained on track on the basis of the quarterly indicators agreed under PFPSAL II. With regard to the social expenditure targets for education, health, and social protection, outcomes in 2001 were in line with the targets set under PFPSAL including overall social spending of 15 percent of GNP. Under PFPSAL II, the Government has committed to maintaining, or even exceeding, this target. As of October, preliminary data indicate that social spending is broadly on track, although there are significant shortfalls in spending on direct income support to farmers and social assistance payments throughthe social solidarity fund on which the Bank is following up with the Government. Financial Sector Reform. In the financial sector, PFPSAL objectives were: to accelerate banking sector prudential regulation reform, especially concerning capital adequacy, foreign exchange exposure, loan loss provisioning, connected lending and risk management, to strengthen the newly created BRSA through a targeted institutional development effort, thereby strengthening banking supervision, enforcement and corrective action programs, to step up SDIF interventions in additional insolvent private banks and actions to resolve these banks rapidly, and accelerating the financial and operational restructuring of the state banks, including resolution of the duty loss issue. Most of these objectives were realized or will be - 5 -  realized through the ongoing PFPSAL II. Outcomes achieved through PFPSAL can be summarized as: restoring confidence and reducing the vulnerability of the banking system; and strengthening the foundation for an efficient and sound banking system through reform in the prudential regulations. Further actions are necessary, however, and are in the pipeline; these involve institutional development and strengthening of the BRSA/SDIF, bankruptcy reform, deposit insurance reform and the privatization of the state banks. Public Sector Reform. In the public sector, PFPSAL objectives were: (i) to support urgent fiscal measures to respond to the crisis while ensuring that social spending is protected, (ii) to lay the foundation for permanent fiscal adjustment to ensure a sustainable path for the public sector debt and prevent a recurrence of the conditions which led to the 2001 crisis, (iii) to modernize the public sector through improving transparency and management of public expenditure and liabilities, (iv) to ensure financial accountability in line with international standards, and (v) to raise the quality of public sector governance. The actions in support of these objectives to be taken before Board presentation of PFPSAL were all achieved. Further progress towards the objectives is being made under the ongoing PFPSAL II. 4.2 Outputs by components: FINANCIAL SECTOR REFORM The approach to financial sector reform adopted in PFPSAL was essentially similar to the one incorporated in the FSAL. The first tranche of FSAL was disbursed in December 2000. But within a few months of project effectiveness, a severe financial crisis in February 2001 required the Bank and the Government to reconsider their strategy. The second tranche of FSAL was cancelled and the remaining actions envisaged for FSAL's second tranche were subsequently implemented as Board presentation conditions for the PFPSAL in July 2001 and PFPSAL II in April 2002, and the remaining actions are planned to be carried out as second and third tranche conditions for PFPSAL II. Continuity of the strategic reform framework, as envisaged during the preparation of FSAL and still valid during the preparation of the PFPSALs, was maintained with necessary tactical changes based on the circumstances at the time. The banking reform had four strategic pillars (each loan had tactical implementation components of the strategic objectives): (i) strengthening the legislative and prudential regulatory framework to international standards; (ii) strengthening banking supervision and failure resolution institutional capacity (BRSA and SDIF); (iii) reform/restructuring/resolution of private banks to increase systemic safety and soundness; and (iv) restructuring and privatization of the state owned banks. Under the FSAL first tranche, a new banking law was enacted by parliament (in place of a constitutionally obsolete decree law). The law created a new independent and dedicated banking regulation and supervision entity (BRSA), strengthened the banking supervisor's rights and obligations for undertaking corrective actions on problem banks in order to ensure banking system safety and soundness, and strengthened the legal authority and capacity for BRSA and the failure resolution entity SDIF (Savings and Deposit Insurance Fund) to intervene in problem banks. In conjunction with FSAL, the government also upgraded all key prudential regulations like capital adequacy, foreign exchange exposure, loan loss provisioning and connected lending regulations to international standards, initiated corrective action through intervention in a number of private banks, including closure, sale or merger for such banks; and enacted enabling legislation for the restructuring and privatization of the state owned banks Vakif, Emlak, Halk and Ziraat. Once FSAL second tranche was closed and replaced by PFPSAL and PFPSAL II, the PFPSAL: (i) completed the deepening and broadening of the regulatory framework to bring consolidated regulation, and a risk management approach; (ii) initiated formal institutional development program for BRSA and SDIF; - 6 -  (iii) undertook broad intervention and cleaning up of mismanaged and insolvent private banks; and (iv) amended the legislation facilitating the privatization of Vakif bank, liquidated the third largest state owned bank, Emlak; and completed the financial restructuring (including duty losses)of the two largest state owned banks, Halk and Ziraat. Under the ongoing PFPSAL II, the key reforms being undertaken or planned include: (i) clarifying the collateral valuation regime for loan loss provisions, strengthening enforcement of the regulatory regime with the help of corrective action programs, and bringing repo transactions on balance sheet; (ii) implementing the institutional strengthening programs of BRSA and SDIF; (iii) completing the restructuring of the private banking sector including closures, mergers or recapitalizations as necessary; (iv) implementing the asset resolution strategy for the stock of assets with the SDIF; (iv) strengthening and improving the effectiveness of the bankruptcy framework including a corporate workout framework; and (v) completing the operational restructuring of the two state owned banks, Halk and Ziraat, and the full privatization of Vakif bank. All the actions planned under PFPSAL were completed before loan signing as a single tranche operation and the details are presented below. The details of the progress to date of actions under PFPSAL II are also outlined below with the objective of presenting the updated status of the sector. A. Regulatory Framework for Banking: