Turkey - Second Programmatic Financial and Public Sector Adjustment Loan Project (PFPSAL II)

Report No. PID10724 Project Name Turkey-Second Programmatic Financial and (@) Public Sector Adjustment Loan (PFPSAL II) Loan amount US$1.35 billion (US$550 million on standard IBRD terms and US$800 million on special IBRD terms) Region Europe and Central Asia Sector Private and Financial Sector Development; Poverty Reduction and Economic Management Project ID TRPE70560 Borrower Government of Turkey Implementing Agency Undersecretariat of Treasury Ankara, Turkey Environment Category C Date This PID Prepared February 13, 2002 Date Initial PID Prepared September 27, 2001 Appraisal Date January 2002 Projected Board Date April 2002 The Programmatic Approach to Structural Adjustment 1. In mid-2001, the Government of Turkey (GOT) and the Bank agreed upon a comprehensive reform agenda for financial and public sector reform--including a set of near- term and medium-term objectives--in response to the economic crisis triggered by the currency devaluation in February 2001. Defining achievable medium-term goals during a financial crisis is extremely difficult. Given that these objectives may need to be adjusted from time to time as economic and social conditions develop, the GOT and the Bank agreed to a flexible, programmatic approach. A core set of immediate actions formed the conditionality for the first US$1.1 billion Programmatic Financial and Public Sector Adjustment Loan approved in July 2001. The next phase of the program formed the triggers (i.e., fixed conditionality) and benchmarks (i.e., actions which could be amended as conditions changed) for PFPSAL II. More medium-term objectives of the program in 2003-04 would be supported by follow-up programmatic lending in the financial and public sectors as described in the Country Assistance Strategy (CAS) Progress Report discussed by the Bank's Board in July 2001. 2. Some of the significant accomplishments of PFPSAL, upon which PFPSAL II will build, are as follows:  In the financial sector: Introduction of tax deductibility of loan loss provisioning and of new connected exposure limits bringing the limits in line with applicable EU Directives in a phased manner; Adoption by the Board of the Bank Regulation and Supervision Agency (BRSA) of a strategic institutional development plan for the agency; Intervention in insolvent private banks by SDIF, and agreement on into capital restoration plans with undercapitalized but still solvent banks; Elimination of the large overnight borrowing needs of the state-owned banks Ziraat and Halk and the banks intervened by the Savings Deposit Insurance Fund (SDIF - the agency responsible for bank failure resolution and administration of the deposit insurance scheme), with a view to relieve undue pressure on interest rates; and initiation of mergers and sales of the SDIF intervened banks; Resolution of the insolvent state-owned bank Emlak through merger of its banking assets and liabilities with Ziraat and liquidation of its non-banking assets and liabilities; and Recapitalization of Ziraat and Halk. In the public sector Implementation of additional fiscal measures under the supplementary 2001 budget adopted in June 2001; Establishment of policies and benchmarks to protect public expenditure envelopes for health, education and social protections; Preparation of a multi-year strategy for public expenditure management (PEM) reform encompassing budget reform, upgrading of financial accountability to international standards, and strengthened public liability management; and Initiation of work on a national strategy to improve governance and combat corruption. Country and Sector Background 3. The combination of an oversized public sector living beyond its means and inadequate management of existing resources has generated structural macroeconomic imbalances, which have thwarted successive attempts at disinflation in Turkey. During the 1990s, these imbalances and the constant search for financing of chronic public sector deficits became intertwined with financial sector weaknesses in a vicious circle. The state-owned banks were used to finance government-mandated subsidized lending to agriculture and SMEs. This recourse to quasi-fiscal financing directly undermined financial sector stability. In parallel, the emergence of a lucrative domestic market for high return Government bonds indirectly contributed to financial sector instability as banks became dependent on - 2 -  artificially inflated profits from investments in government paper. Faced with prohibitively high interest rates, the Government traditionally relied on the inflation tax to keep the public debt under control. However, this created a deeply ingrained pattern of inflationary expectations, which has blocked financial sector deepening and promoted currency substitution. 4. The exchange rate based disinflation program launched in late 1999 was a bold and ultimately unsuccessful attempt to break the unsustainable cycle of inflation, financial sector weakness, high interest rates and ever increasing public indebtedness. The program included ambitious structural reforms. A major reform of the public pension system was undertaken in August 1999 and ambitious reforms were launched in the agriculture, energy and telecommunications sectors. In the financial sector, a new commercial bank law was passed in December 1999 that called for the creation of a new independent bank regulatory agency, initiated a much needed overhaul of the banking sector regulatory regime and enhanced the powers of the SDIF, the agency responsible for bank failure resolution and administration of the deposit insurance scheme. After some early success including a rapid decline in interest rates, resistance to particular aspects of the program began to increase during the course of 2000. The macroeconomic risks quickly built up and the program eventually collapsed at its weakest point, the financial sector. In late February 2001, Turkey experienced a major currency crisis, which forced the Government to abandon the crawling peg exchange rate and float the Lira. The immediate cause of the crisis is attributable to weaknesses in the financial sector. However, its deeper roots lie in the problems with the structure and management of the public sector that are at the core of Turkey's chronic macroeconomic instability. 5. In mid-2001, the Government prepared a new economic program to overcome the immediate impact of the February crisis while setting the stage for an early resumption of disinflation and growth. The program targets a more gradual disinflation path, together with a renewed emphasis on structural reforms. By moving to address the fundamental structural problems underlying the crisis, with a strong focus on restructuring the banking and public sectors, the Government hopes to engineer a quick recovery closer to the experience of Brazil and Korea, and avoid the prolonged recession that some other crisis countries have experienced. The program is based on a three-pronged strategy: (i) macroeconomic policies geared towards restoring financial stability and resuming the disinflation process; (ii) structural policies aimed at correcting the financial sector and public sector weaknesses underlying the crisis, together with renewed efforts to improve the investment climate and promote private sector development; - 3 -  and (iii) strong social policies including increased emphasis on protecting the most vulnerable groups of society. Turkey's Financial Sector Reform Program 6. In the aftermath of the February 2001 crisis, the Government has committed to a significant acceleration and widening of the scope of the financial sector reform effort. This is clearly necessary to restore banking system confidence and put the banking system on a sustainable path towards competitiveness at the international level and towards EU accession. As part of the widened scope of its financial sector reform effort, and once the initial phase of immediate urgent post-crises banking sector reform and restructuring activity is over, the Government will also implement a comprehensive non-bank financial institutions reform program, to complement the banking sector reform effort. While NBFI activity in Turkey is currently limited, it is anticipated that this activity could grow rapidly once the macro-economic situation stabilizes. As banks are the key players in NBFI activity, and as it is anticipated that in the aftermath of the banking crisis stronger, larger banks with a universal mandate will appear, a proactive approach on the part of the Government will be necessary to manage the risks and vulnerabilities of such rapid NBFI growth. 7. As the experience in other crisis countries (e.g., East Asia, Latin America) has shown, banking crisis resolution efforts will take time. Therefore, the Government has structured its financial sector reform effort in two phases, with the first phase focused primarily on implementation of urgent banking system reform and restructuring efforts, and the second phase focused more on the medium term broad based financial sector development agenda. As such, this effort will stretch over several years. 8. The initial phase of the Government's multi-year reform program supported by PFPSAL has focused on measures in the following four areas: (i) acceleration of upgrades to banking system prudential regulation; (ii) institutional development of the new Bank Regulation and Supervision Agency (BRSA); (iii) accelerated resolution of problem banks and failed banks already intervened by the SDIF; and (iv) comprehensive financial restructuring of the state- owned banks Ziraat and Halk, and resolution of the insolvent state-owned Emlak bank. The second phase of the reform program, to be supported by PFPSAL II, will focus on: (i) finalizing the overhaul of the banking system prudential regime; (ii) continued institutional development of the BRSA and initiation of a comprehensive institutional development effort at the SDIF; (iii) completion of the resolution of all banks already intervened by the SDIF; (iv) recapitalization of all undercapitalized private - 4 -  banks, through a combination of owner and Government support, and SDIF intervention of any remaining insolvent private banks; and (v) comprehensive operational restructuring and initiation of privatization of the state- owned banks Ziraat and Halk, and sale of the state-owned bank Vakif. The follow-up reform efforts in the banking area (especially the completion of the state-owned bank privatization effort) as well as the reform efforts in the NBFI segment of the financial sector will be rolled out during late 2002 and early/mid 2003. Turkey's Public Sector Reform Program 9. The Government's public sector reform program aims to underpin sustained fiscal adjustment and create the conditions for transparent and effective government. In combination with the financial sector reform program, the public sector reform addresses the underlying structural factors that led to the crisis, thereby trying to ensure that these conditions do not recur in the future. In particular, the program aims to break the vicious circle of inadequate public sector management leading that fuels financial sector weakness. The reform aims to achieve permanent fiscal adjustment; as well as radical improvements in public policy formulation, the framework for resource mobilization and allocation, the system of public oversight and accountability, and public sector governance. This is an agenda for modernizing the Turkish state to meet the challenges of the new century. 10. The reform program focuses on three priority actions, each of which has a medium-term dimension; (i) implement structural fiscal policies to ensure permanent fiscal adjustment; (ii) launch a medium-term program of policy and institutional reforms to improve the transparency and efficiency of public expenditure management including action to improve budget preparation and execution, policy formulation, and the operational performance of public agencies; and (iii) initiate broad based institutional reforms to improve the quality of public sector governance. In each of these areas, the Government has developed or is preparing a strategic approach to guide its actions over the next three years. In the area of structural fiscal policies, the approach is based on (i) a medium-term strategy for improving the tax system and (ii) a comprehensive public employment program to adjust staffing levels in the central government and SEEs, both of which are now in place. With regard to public expenditure management, the Government prepared a three-year Strategic Framework for Public Expenditure Management Reform, which draws on the Public Expenditure and Institutional Review (PEIR) prepared jointly with the Bank. In the area of public sector governance, a high-level - 5 -  steering committee has finalized preparation of a national strategy for improving governance and combating corruption, which is under review by the Government. 11. The initial phase of the multi-year public sector reform program was supported by the PFPSAL. It focused on sustaining the fiscal adjustment and setting into motion the key change processes for institutional reform including: (i) deeper structural fiscal polices to sustain the fiscal adjustment; (ii) the PEM reform process including preparation of key legislation to underpin improvements in public procurement and liability management; and (iii) preparation of the national strategy to improve governance and fight corruption. The second phase of reforms to be supported by PFPSAL II will focus on: (i) introduction of structural fiscal policies paving the way for permanent fiscal adjustment; (ii) implementation of the first round of PEM reform including rationalization of the public investment program; (iii) enactment of legislation on public procurement and public debt management; and (iv) adoption and publication of the national anti-corruption strategy. Additional reform efforts, including deepening of the PEM reform, steps to retrench employment in the state economic enterprises (SEEs), and deeper institutional changes in the areas of tax administration, financial accountability and public sector governance--including civil service reform--are planned for 2002 and beyond. The Proposed Loan 12. The proposed US$1.35 billion (US$550 million on standard IBRD terms and US$800 million on special IBRD terms) Second Programmatic Financial and Public Sector Adjustment Loan (PFPSAL II) continues to support the Government's multi-year financial and public sector reform program and builds upon the measures already taken under the first FFPSAL. The main objective of the proposed PFPSAL II is to support the next phase of the Government's financial and public sector reform program, while ensuring that social programs continue to be adequately funded. Key priorities include, in the financial sector: (i) finalizing the overhaul of the banking system prudential regime; (ii) continued institutional development of the BRSA and initiation of a comprehensive institutional development effort at the SDIF; (iii) completion of the resolution of all banks already intervened by the SDIF; (iv) recapitalization of all undercapitalized private banks, through a combination of owner and Government support, and SDIF intervention of any remaining insolvent private banks; and (v) comprehensive operational restructuring and initiation of privatization of the state-owned banks Ziraat and Halk, and sale of the state-owned bank Vakif; and in the public sector: (i) structural fiscal policies, (ii) public expenditure management, (iii) financial accountability, (iv) public liability management, and (v) - 6 -  public sector governance. The PFPSAL II will provide budgetary support to help the Government finance the costs arising from the crisis while continuing to fund its critical social programs. 13. The principal benefits of the Loan will be to: (i) support the Government's macroeconomic policy framework which aims to overcome the affects of the February crisis and create the conditions for renewed growth and disinflation, (ii) restore confidence in the banking system; (iii) strengthen the foundation for an efficient and sound banking system which can be competitive in quality and performance at the international level; (iv) reduce the vulnerability of the banking system and enhance its capacity to withstand external shocks and thereby reduce systemic failure risk; (v) position Turkey's banking sector for accession to the European Union (EU) by starting the process of aligning the prudential regime for the banking system with applicable EU banking sector directives; (vi) support structural fiscal measures to underpin the sustainability and quality of the fiscal adjustment needed to achieve macroeconomic stability while ensuring that social spending is protected; (vii) lay the foundation for durable improvements to public expenditure management and fiscal transparency in line with international standards; and (viii) raise the quality of public sector governance. 14. The risks associated with the Government's financial and public sector reform program arise from macroeconomic factors, political factors and institutional weaknesses. The key macroeconomic risk is that real interest rates will remain higher than projected which would delay the economic recovery and affect public debt sustainability. A related macroeconomic risk factor is Turkey's vulnerability to both internal and external shocks as evidenced by the impact of the September 11 events. The commercialization and privatization of the state-owned banks is a major political and organizational challenge for the Government. The rapid restructuring of Ziraat and Halk also has significant fiscal and social implications (the latter as a result of large-scale branch closures and staff reductions). While the Government has so far been able to raise sufficient resources to finance the restructuring of the state banks and the resolution of the banks under the SDIF, the public debt has increased sharply as a share of GNP. Continued tight fiscal discipline and further reform actions to bolster the confidence of domestic and international investors in Turkish sovereign debt instruments will be essential. Finally, implementation of the recapitalization scheme for undercapitalized private banks will test the capacity of the BRSA and may run into resistance from the owners of the banks concerned. The public sector reform agenda is politically sensitive and may be jeopardized by resistance of vested interest groups that would prefer to - 7-  maintain the status quo. Capacity constraints and crisis management efforts at key Government agencies may also slow down the pace of the envisaged public sector reforms. 15. The support of the Bank under PFPSAL II and the broader country assistance strategy is instrumental in assisting the Government to overcome these risks and sustain implementation of its economic reform program. Contact Points: Bank : Lalit Raina, ECSPF The World Bank 1818 H Street N.W. Washington, DC 20433 Tel No.:(202) 458-2900 Fax No.:(202) 522-0005 James Parks, ECSPE The World Bank Ugur Mumcu Caddesi No.88 Ankara, Turkey Tel No.(90-312)446-3824 Fax No.(90-312)446-2442 Borrower: Mr. Ersen Ekren Undersecretariat of Treasury In-no Bulvan No. :36 06510 Emek Ankara, Turkey Tel. No." (90.312) 213 6873 Fax No.: (90.312) 212 8550 e-mail: ersen.ekren@hazine.gov.tr Note: This is information on an evolving project. Certain components may not necessarily be included in the final project. This PID was processed by the InfoShop during the week ending April 26, 2002. -8-