Turkey - Third Programmatic Financial and Public Sector Adjustment Loan Project

PFPSAL 3 PID May 19- Final sent to infoshop ProjeCt Name Turkey-Third ProgrammatiC Financial and Public sector Adjustment Loan (PFPSAL 3) Loan AMount US$900 million Region Europe and central ASia Sectors Poverty Reduction and Economic management; Private and Financial sector Devel opment Project ID P082996 Borrower Government of Turkey impolementing Agency Undersecretariat of Treasury, Ankara, Turkey Envi ronment category C Date this PID Prepared April 22, 2003 Appraisal Date April 2003 Projected Board Date June 2003 Loan and Program summary 1. The proposed Third Programmatic Financial and Public sector Adjustment Loan (PFPSAL 3) would the be the third in the series of Programmatic loans providing Bank support since 2001 to the Republic of Turkey for the Government's multi-year financial and public sector program. This program aims to restore confidence in the banking system, correct the underlying structural problems in the public sector that created the conditions under which the February 2001 crisis occurred, and help protect critical social spending. The proposed loan would be on standard IBRD terms for Turkey and would be disbursed in two tranches of US$450 million each, the first upon loan effectiveness and the second upon fulfillment of second tranche release conditions, as long as overall progress with the program is also satisfactory. 2. The first in this series of loans was the Programmatic Firancial and Public sector Adjustment Loan (PFPSAL) of US$1.1 billion, approved in July 2001 (us$700 million on standard IBRD terms and US$400 million on special structural Adjustment Loan- SSAL-terms) and disbursed in a single tranche in July 2001. The three-tranche Second ProgrammatiC Financial and Public sector Adjustment Loan (PFPSAL II) of us$1.35 billion (us$550 on standard IBRD terms and US$800 million on SSAL terms) was approved in April 2002. The first US$450 million tranche of PFPSAL II was disbursed upon effectiveness in AUgUst 2002. However, disbursement of the remaining tranches of PFPSAL II was delayed by a slowdown in implementation of the economic reform program during the run-up to early legislative elections held in November 2002 and establishment of the neW Government. The proposed PFPSAL 3 will support the neW Government's full ownership of the financial and public sector reform program and Page 1  PFPSAL 3 PID May 19- Final sent to infoshop will make a strong public commitment of the program's objectives. PFPSAL 3 will also facilitate the fine-tuning of the program in line with the Government's intentions and the required adjustment of the timetable for particular program benchmarks in accordance with actual developments over the past year. The undisbursed amounts under PFPSAL II will be cancelled at the authorities' request at the time of the Board approval of PFPSAL 3. Country and Sector Background 3. The design of the PFPSAL loans reflects the continuing need to address the long-standing underlying causes of the crisis of 2001 in order to reduce Turkey's vulnerability to such events. Turkey has been long been characterized by an oversized public sector living beyond its means and inadequate management of existing resources, leading to structural macroeconomic imbalances that thwarted successive attempts at disinflation. During the 1990s, these imbalances became intertwined with financial sector weaknesses in a vicious circle. state-owned banks were used to finance government-mandated subsidized lending, particularly to agriculture and small and medium-sized enterprises. This 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 artificially inflated profits from investments in government paper. Faced with prohibitively high interest rates, the Government relied on the inflation tax to keep the public debt under control. However, this created an ingrained pattern of inflationary expectations, which blocked financial sector deepening and promoted currency substitution. 4. A serious exchange rate based disinflation program was launched in late 1999, but this was ultimately unsuccessful. The disinflation effort was accompanied by an initial round of structural reform in pensions, telecommunications, agriculture and energy. In the financial sector, a new commercial bank law was passed mandating the creation of a new independent bank regulatory agency. Despite some early success, macroeconomic risks quickly built up and the program eventually collapsed at its weakest point, the financial sector. In February 2001, Turkey experienced a major currency crisis which forced the Government to abandon the crawling peg exchange rate and float the Lira. while the immediate cause of the crisis was weakness in the financial sector, its deeper roots lay 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 crisis while setting the stage for an early resumption of disinflation and growth. By moving to address the fundamental structural problems underlying the crisis, with a strong focus on restructuring the banking and public sectors, the Government hoped to avoid the prolonged recession that some other crisis countries have experienced. The program was 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; and (iii) strong social policies including Page 2  PFPSAL 3 PID May 19- Final sent to infoshop increased emphasis on protecting the most vulnerable. 6. Economic recovery got underway in early 2002. GNP rebounded strongly, growing 7.8 percent (well above the program target of 3 percent), after having contracted 9.4 percent in 2001. The high growth was due in part to base effects from the recession and stock-building, but strong exports and a rebound in agricultural output were also important factors. Even so, the economy has yet to recover fully from the recession with estimated per capita income still well below peak levels of 1998. Annual inflation rates dropped steadily over the course of 2002, despite the strong recovery, with CPi inflation falling to 29.7 percent and WPI to 30.8 percent by end-2002. The fall in inflation was helped by appreciation of the real exchange rate as confidence in the Lira improved. Balance of payments ou-tcomes were also favorable, with receipts from exports and tourism well above projections while renewed capital inflows to the private sector contributed to a stronger-than expected capital account balance. This allowed a build up of gross international reserves to almost us$28 billion. 7. Fiscal performance fell well short of the program targets for 2002, with the primary surplus for the consolidated public sector deficit falling short of the 6.5 percent program target by over 2 percent of GNP. This resulted from factors such as cost overruns in the social security system, pre-election spending, an unexpected drop-off in tax revenues driven by expectations of a post-election tax amnesty, delays in raising administrative prices, higher-than-expected tax rebates, and unplanned spending through earmarked accounts. while higher than programmed government spending contributed to the stronger than expected recovery in 2002, the fiscal slippage had serious implications for the preparation of the 2003 budget and the required adjustment to bring the fiscal program back on track could slow the pace of recovery in 2003. The fiscal cost of cleaning up the banking sector after the 2001 crisis has weighed heavily on the public debt burden. After reaching a peak of 95 percent of GNP at the end of 2001, the stock of net public debt to GNP fell to an estimated 80 percent by end-2002. 8. Financial markets fluctuated sharply over the course of 2002 in line with political developments. while real interest rates fell sharply from the crisis peaks, they remained in the 20 percent range during the second half of 2002. Mirroring the bond market, the stock market also fluctuated sharply over the course of 2002 and private credit remained stagnant. Financial market volatility continued during the first quarter of 2003. The new AKP (justice and Development Party) Government stressed its commitment to continuing the economic reforms, albeit with greater emphasis on the social dimension, but it was slow in addressing the pre-election policy slippages and introduced some costly ad hoc payments, including support payments in agriculture and increased pensions. Markets came under increasing pressure in January and February 2003. while markets subsequently rallied modestly on improved prospects for international support and the winding down of hostilities in Iraq, conditions remained fragile as of April 2003 with the benchmark bond rate in the 55 percent range and the Lira trading in the range of TL 1.5-1.6 million to the Dollar. Turkey's Financial Sector Reform Program Page 3  PFPSAL 3 PID May 19- Final sent to infoshop 9. Turkey's financial sector reform program seeks to restore credibility to the financial sector, reduce its vulnerability to internal and external shocks, and enhance its intermediation capacity in support of economic growth. The initial reform efforts from 1999 onwards have been focused on: (i) overhaul of the prudential regime for banking in line with international standards; (ii) establishment of an independent Bank Regulation and supervision Agency (BRSA); (iii) problem bank/bank failure resolution; and (iv) state bank restructuring and privatization. At a later stage, the reform effort will also encompass non-bank financial institutions and capital markets activity. The Government's financial sector reform program was designed with the Bank's assistance including three banking reviews undertaken in the past five years, several financial sector loans, and a non-bank financial intermediaries review completed in 2003. 10. The Government accelerated the banking reform program in 2001 after the crisis, taking rapid action in each of the four key areas. In particular, prudential regulations for loan loss provisions, connected exposures and foreign exchange exposures have been aligned with Basel/European union (EU) standards; and the institutional basis of BRSA has been strengthened. Twenty insolvent private banks have been intervened and resolved through sale, merger or closure. With regard to the state banks, EmIak bank has been closed and merged with ziraat bank, while long needed financial and governance restructuring of ziraat and Halk banks has been implemented. These actions were supported by PFPSAL and PFPSAL II. A key action to be completed under PFPSAL 3 is with respect to the privatization of the fourth state bank, vakif bank, which is now expected to occur before the end of 2003. Turkey's Public Sector Reform Program 11. Public sector reform aims to underpin sustained fiscal adjustment and create the conditions for transparent and effective government. The underlying problems with the structure and management of the public sector were analyzed in detail in the 2000 CEM and 2001 PEIR which contributed to the analytical underpinnings of the public sector reform program, together with the country Financial Accountability Assessment and Country Procurement Assessment Review both completed in 2001. The public sector reform program focuses on three critical areas, each of which has a medium-term dimension: (i) structural fiscal policies to ensure permanent fiscal adjustment; (ii) a medium-term program of policy and institutional reforms to improve the transparency and efficiency of public expenditure management (PEM) and (iii) broad-based institutional reforms to improve the quality of public sector governance. 12. The Government has made substantial progress in defining and implementing its public sector reform program. with regard to improving public expenditure management, reforms already in place include rationalization of the public investment program, and enactment of new public procurement and public debt management laws. The new public financial management and control (PFMC) law, which is the cornerstone of the budget reform, is expected to be enacted by June 2003. In the area of structural fiscal policies, a major package of fiscal measures to underpin the 2003 budget targets has been adopted. Implementation of the medium-term tax strategy is moving forward Page 4  PFPSAL 3 PID May 19- Final sent to infoshop with adoption of indirect tax reform legislation in 2002 and the first legislative package for the direct tax reform in April 2003. The public employment program is also making progress with the target of eliminating one-third of SEE redundancies having been surpassed by the end of 2002. In the area of public sector governance, the national strategy for improving governance and combating corruption was adopted in January 2002 and published in March 2003. Implementation of the new legislation on public procurement, debt management, and public financial management and control, together with the other elements of the Government's public sector reform agenda, will be supported by the proposed PFPSAL 3. The Proposed Loan 13. The proposed PFPSAL 3 is the third Loan in support of the Government's multi-year financial and public sector reform program (see paragraphs 1 and 2 above). The main objective of the proposed PFPSAL 3 is to support implementation during 2003 of the Government's financial and public sector reform priorities in response to the 2001 economic crisis, while continuing to ensure that social programs are adequately funded and increasingly better targeted. The principal benefits of the Loan will be to: (i) support the Government's efforts to create the conditions for sustained growth and macroeconomic stability; (ii) ensure adequate social expenditure and better targeted social protection, (iii) restore confidence in the banking system and position the banking sector for accession to the EU; and (iv) lay the foundation for more effective government in line with EU directives and international best practice. 14. The risks associated with the financial and public sector reform program arise from macroeconomic factors, political considerations and institutional weaknesses. The key macroeconomic risk is that high real interest rates could derail the economic recovery and affect public debt sustainability. A related risk factor is Turkey's vulnerability to both internal and external shocks. The commercialization and privatization of the state-owned banks is a major political and organizational challenge. The rapid restructuring of Halk and ziraat banks has significant fiscal and social implications. while the Government has so far been able to finance the banking clean-up, the public debt has increased sharply as a share of GNP. continued tight fiscal discipline and reform actions to bolster the confidence of investors in Turkish sovereign debt instruments remain essential. satisfactory and timely failure resolution efforts and enforcement of capital restoration plans are important. The risk that such efforts will fall short is related to possible pressure that may be exerted to slow regulatory enforcement action and provide regulatory forbearance. The public sector reform agenda is politically sensitive and may be jeopardized by resistance of vested in-terest groups. 15. The support of the Bank under PFPSAL 3 and the broader country assistance strategy is assisting the Government to overcome these risks and sustain implementation of its economic reform program. Contact Points Page 5  PFPSAL 3 PID May 19- Final sent to infoshop Bank: Lalit Raina ECSPF The world Bank 1818 H St. NW washington DC 20433-0001 Tel.: (1-202) 458-2900 Fax: (1-202) 522-0005 James Parks ECSPE The World Bank Ugur Mumcu caddesi 88/2 GOP Ankara 06700 Turkey Tel.: (90-312) 446-3824 Fax: (90-312) 446-2442 Borrower: Mr. Ersen Ekren, General Director General Directorate of External Economic Relations undersecretariat of Treasury Inonu Bulvari 36 06510 Emek Ankara Turkey Tel.: (90-312) 213-6873 Fax: (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 May 23, 2003. Page 6