Document of The World Bank

Report No. 27643

IMPLEMENTATION COMPLETION REPORT

REPUBLIC OF TURKEY

SECOND PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN

(LOAN NUMBER -46560;LOAN NUMBER-46570)

IN THE AMOUNT OF $550 MILLION ON STANDARD IBRD TERMS AND $800 MILLION ON SPECIAL STRUCTURAL ADJUSTMENT LOAN TERMS

DECEMBER 2003

World Bank Group ECCUG Country Management Unit Europe and Central Asia Region

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CURRENCY AND EQUIVALENT UNITS (Exchange Rate Effective December 30,2003)

Currency Unit = Turkish Lira US$l = TRL1,428,571

FISCAL YEAR January 1 - December 3 1

ACRONYMS AND ABBREVIATIONS

BRSA CAR CAS CEM CFAA CPAR CSIA DIS EBA ERL FSAL GFS IBRD IDF IMF MOE; NBFI NEP NPLs PEIR PFPSA PFMC PFSAL PIP PPA PPL QAG SDIF SEE SPO SSAL TCA UAP

Bank Regulation and Supervision Agency Capital Adequacy Ratio Country Assistance Strategy Country Economic Memorandum Country Financial Accountability Assessment Country Procurement Assessment Report Corporate Sector Impact Assessment Direct Income Support Execution and Bankruptcy Act Economic Reform Loan Financial Sector Adjustment Loan Government Finance Statistics International Bank for Reconstruction and Development Institutional Development Fund International Monetary Fund Ministry of Finance Non-Bank Financial Institutions New Economic Program Non-Performing Loans Public Expenditure and Institutional Review Programmatic Financial and Public Sector Adjustment Loan Public Financial Management and Control Programmatic Financial Sector Adjustment Loan Public Investment Program Public Procurement Agency Public Procurement Law Quality Assurance Group Savings Deposit Insurance Fund State Economic Enterprise State Planning Organizatin Special Structural Adjustment Loan Turkish Court of Accounts Urgent Action Plan

I Vice President: Shigeo Katsu Country Directors: Andrew N. Vorkink, Anand Seth

Sector Director: Cheryl W. Gray Sector Managers: Samuel Otoo, Khaled Sherif

Task Team Leaders: James Parks, Lalit Raina

TURKEY

SECOND PROGRAMMATIC FINANCIAL AND PUBLIC SECTOR ADJUSTMENT LOAN

CONTENTS

1. Program Data 2. Principal Performance Ratings 3. Program Description 4. Achievement of Objectives and Outputs 5. Major Factors Affecting Implementation and Outcome 6. Bank and Borrower Performance 7. Findings and Implications for Subsequent Operation(s) in Series

Box 1: PFPSAL II Status (as of end-June 2003)

Page No. 1 2 2 4

12 12 12

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Simplified Implementation Completion Report For Programmatic Adjustment Operations

Operation ID: PO70560 Operation Name: Second Programmatic Financial and Public Sector Adiustment Loan

Team Leader: James Parks, Lalit Raina TL Unit: ECSPE, ECSPF Report Date: December l&2003

1. Program Data

Name: Second Programmatic Financial and Public Sector Adjustment Loan

Country/Department: TURKEY

L/C Number: Loan No. 46560; Loan No. 46570

Region: Europe and Central Asia Region

SectorYsubsector: Central government administration (54%); Banking (40%); General industry and trade sector (2%); Non-compulsory pensions, insurance and contractual savings (2%); Other social services (2%)

Theme: Public expenditure, financial management and procurement (P); Other financial and private sector development (P); Regulation and competition policy (S); State enterprise/bank restructuring and privatization (S); Administrative and civil service reform (S)

KEY DATES Original Revised/Actual

PCD/PR: 03/22/ 2002 Effective: 06/23/2002 08/23/2002 I Aopraisal: 1 01/14/2002 I M-TR: 1 I I 1 Approval: 1 04/16/2002 Closing: 1 12/31/2002 1 06/18/2003 -

Borrower/implementing Agency: Other Partners:

Undersecretariat of Treasury

STAFF Vice President: Country Director: Sector Manager:

I Team Leader at ICR:

Current Shigeo Katsu Andrew N. Vorkink Samuel Otoo, Khaled Sherif

I James Parks, Lalit Raina

At Appraisal Johannes F. Linn Ajay Chhibber Samuel Otoo, Yasuo Izumi

I James Parks. Lalit Raina ICR Primary Author: Kamer Karakurum Ozdemir,

Gurhan Ozdora

2. Principal Performance Ratings focused on this operation s contribution toward overall program objectives)

(HS=Highly Satisfactory, S=Satisfactory, U--Unsatisfactory, HL=Highly Likely, L=LikeIy, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SWSubstantial, M=Modest, N=Negligible)

Outcome: I S Sustainabilitv: I L

Institutional Development Impact: M Bank Performance: S

Borrower Performance: S

QAG (if available) Quality at Entry: S

Operation at Risk at Any Time:

ICR S

3. Program Description

3.a. Description of the Program

In February 2001, Turkey was hit by the worst economic crisis of its history initiated by the collapse of the crawling peg exchange rate based disinflation effort. The Government of Turkey launched a new economic program (NEP) in May 2001 in response to the crisis. Under the NEP, the Programmatic Financial and Public Sector Adjustment Loan (PFPSAL) program was designed to support the combined package of financial and public sector reforms which spearheaded the Government’s crisis response. The overarching objective of the program has been 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. Under the program included in the Country Assistance Strategy (CAS) Progress Report endorsed by the Board of Directors in July 2001, the World Bank envisaged a total of US$2.45 billion in adjustment lending under two programmatic financial and public sector adjustment loans (PFPSAL and PFPSAL II) to meet Turkey’s external and budgetary financing requirements arising from the 2001 crisis, to support the Government’s short and medium-term reform goals in the financial and public sectors, and to help protect critical social spending. Subsequently the Government requested cancellation of the second and third tranches of PFPSAL II and preparation of a new loan, the proposed PFPSAL III.

3.b. Description of the Operation

The Second Programmatic Financial and Public Sector Adjustment Loan (PFPSAL II) for US$1.35 billion was approved by the Board in April 2002. The PFPSAL II operation was the second of two programmatic financial and public sector adjustment loans designed to be implemented in 200 l-03 period. The PFPSAL II operation included US$550 million on standard International Bank for Reconstruction and Development (IBRD) terms for Turkey and US$SOO million on Special Structural Adjustment Loan (SSAL) terms. The loan was structured into three equal tranches of US$450 million each. It followed the first PFPSAL of US$l. 1 billion which was disbursed in a single tranche in July

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2001. The objective of the first PFPSAL was to address the Government’s immediate financial and public sector reform priorities in the aftermath of the 2001 financial crisis, while ensuring that social programs continued to be adequately funded.

The main objective of PFPSAL II was to support the second phase of the Government’s financial and public sector reform program. Key priorities included:

In the financial sector: 0 overhaul of the regulatory framework for banking activity, l institutional development of the new Bank Regulation and Supervision Agency (BRSA), l problem bank/bank failure resolution, and 0 state bank restructuring and privatization.

In the public sector: l further deepening of structural fiscal policies for sustainable fiscal adjustment, l broadening of the public expenditure management reform program, and 0 implementation of the strategy to strengthen public sector governance.

Quality at entry for PFPSAL II was rated as satisfactory by a Quality Assurance Group (QAG) panel in August 2002.

3.~. Implementation Status of the Operation

As a condition of effectiveness for the loan, the Borrower submitted the draft Public Financial Management and Control (PFMC) law to the Parliament in August 2002. The draft law included articles (i) to extend the coverage of audits by the Turkish Court of Accounts (TCA) to include the Parliament and Presidency, and (ii) for making possible the external audit of TCA itself.

Upon effectiveness, the first US$450 million tranche of PFPSAL II was disbursed. However, while several of the conditions for release of the second and third tranches of PFPSAL II were met on schedule, disbursement of these tranches was delayed by a slowdown in implementation of the economic reform program during the run-up to early elections in November 2002 and subsequent establishment of a new government. Further delays resulted from external developments in the region, notably in Iraq.

After the elections, the new Government requested an extension of the closing date of PFPSAL II from December 3 1, 2002 to March 3 1, 2003 in order to determine its specific plan and timetable for the reform program. During this period, the Government prepared a roadmap for the reform program, which was signed in April 2003, and the Bank extended the loan closing date to June 30, 2003. The Government subsequently requested the Bank to cancel the second and third tranches of PFPSAL II and prepare a new loan (proposed PFPSAL 3) to support the financial and public sector reform program. The rationale for this approach was three fold. First, as Turkey moved from crisis response to the economic recovery phase, the Government felt that it no longer needed to draw on the undisbursed SSAL funds under PFPSAL II. Second, the preparation of a new loan supported the new Government’s determination to take full ownership of the financial and public sector reform program and make a strong public commitment to the program’s objectives. Third, this approach facilitated

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fine-tuning of the program timing and sequencing in line with the new Government’s intentions and the required adjustment of the timetable in accordance with actual developments since PFPSAL II was approved in mid-2002. The cancellation of the last two tranches of PFPSAL II and preparation of the proposed PFPSAL 3 has not led to changes in the core objectives of the program. The second and third tranches of PFPSAL II for a total of US$900 million were cancelled on June 18, 2003, at the Government’s request, and preparation began on a new, two-tranche PFPSAL 3 operation for an equivalent amount on standard IBRD terms.

PFPSAL 3. The backbone of the structural conditionality for the proposed PFPSAL 3 consists of the conditions that are outstanding for PFPSAL II second and third tranche. In key areas of the program where there have been delays or new issues have arisen, relevant conditionality has been added. These areas include: (i) implementation of the direct income support (DIS) program for farmers-a key component of the targeted social protection system, (ii) maintenance of BRSA’s independence and support for its institutional development, (iii) completion of actions to prepare Vakif bank for privatization, (iii) elimination of the system of earmarked revenues and expenditures left in place after closure of budgetary and extra-budgetary funds, and (iv) revisions to the legal framework for public procurement. In several other areas where implementation has progressed, PFPSAL 3 goes beyond the agenda set under PFPSAL II, for example, new, more ambitious benchmarks have been set under the tax strategy and public employment program. As was the case for PFPSAL II, macroeconomic outcomes under PFPSAL 3 will be monitored quarterly on the basis of indicators consistent with the macro-framework agreed with the International Monetary Fund (IMF).

Currently, PFPSAL 3 is in the negotiation stage with a number of pending Board presentation conditions. The Government is on track to meet one of these conditions through enactment of legislation to terminate the system of earmarked revenues and expenditures for the closed budgetary and extra-budgetary funds. Discussions are continuing on other conditions related to the financial sector reform, notably reform of state banks, and institutionalization of the DIS program.

The PFPSAL 3 operation is included in the US$4.5 billion high-case program of the new CAS for FY 04-06 endorsed by the Board in November 2003. Bank support for sustained implementation of reform in the financial and public sectors is planned to continue under the high-case scenario through three follow-up operations: two programmatic public sector adjustment loans (PPSAL and PPSAL II) and a programmatic financial sector adjustment loan (PFSAL).

4. Achievement of Objectives and Outputs

The PFPSAL II had achieved a number of its core objectives, as measured by the program benchmarks (triggers), when the last two tranches of PFPSAL II were cancelled in mid-2003 (Box l), and some important steps have been accomplished since then. In the financial sector, three of the four main under PFPSAL II program benchmarks were reached by mid-2003, including: (i) implementation of the BRSA’s Institutional Development Plan and effective enforcement of new FX and connected lending regulations, (ii) elimination of capital deficient banks through capital restoration plans or supervisory interventions, and (iii) closure, merger or sale of most of the Savings Deposit Insurance Fund (SDIF) banks. With regard to the fourth benchmark, operational restructuring and capital strengthening of Ziraat and Halk banks has also been carried out, but the privatization of Vakif bank remains pending following an unsuccessful attempt during 2002.

BOX 1: PFPSAL II Status (as of end-June 2003)

Macroeconomic Framework 0 Macroeconomic outcomes for 2002 generally surpassed PFPSAL II indicators; growth rebounded strongly, inflation fell,

and debt dynamics improved. A gap of about 2 percent of GNP emerged with respect to the primary surplus target but did not disrupt improvement in debt dynamics. Macroeconomic performance remained strong in the first half of 2003.

0 Total social spending in 2002 was well above the PFPSAL II benchmark of 14.5 percent of GNP, but there were shortfalls in DIS and social assistance spending. The Government took steps to correct the shortfalls in the 2003 budget.

Financial Sector Reform a Regulatory Framework

P Program had moved beyond enactment of suitable regulatory framework to emphasis on enforcement compliance. 0 Institutional Development

> First phase of BRSA institutional development was achieved, but several difficulties emerged in the second, mature development stage related to independence, governance, staffing and budgets.

P First phase institutional development of SDIF was successful in intervention and resolution of banks, but progress was slow in sales of non-performing assets, governance, and development of long-term financially viable structure.

0 Problem Bank Resolution P Identification of the correct capital position of all private banks was completed and capital restoration plans for all

capital deficient banks were under implementation. > All SDIF banks intervened as of 2002 were sold, liquidated or merged with the exception of Ticaret, Bayindir, and

Pamuk. P Review was completed of improvements required in the legal framework for bankruptcy and collateral foreclosure

and accelerated/more efficient NPL resolution, and amendments to the Execution and Bankruptcy Act prepared. 0 State Bank Restructuring and Privatization

3 All planned branch closures and reduction of excess personnel for both Ziraat and Halk banks were completed. > Strategic study for Ziraat was completed and study for Halk was launched. P Public tender for Vakif bank in June 2002 did not result in viable bids and Government was slow to address

ownership, governance and porfolio problems affecting the bank.

Public Sector Reform a Structural Fiscal Policies

9 Under the tax strategy, Special Consumption Tax was introduced and the first direct tax reform package was enacted to harmonize personal and corporate income tax regimes.

k Public employment monitoring system became fully functional. Under the SOE redundancy program, 28,000 redundancies out of the 45,800 identified had been eliminated.

0 Public Expenditure Management > The pilot program for the government finance statistics (GFS) based budget classification was underway. > In the 2002 budget, most extra-budgetary funds and all but one budgetary funds were closed, although the special

accounts linked to many of these funds remained in place. > The Government rationalized the Public Investment Program significantly, cutting the average completion time by

32 percent in 2002 to 8.5 years. The average completion time was further reduced in 2003 to an estimated 7.6 years.

> The automated accounting system for consolidated budget agencies went on-line in January 2002. The new modified accrual chart of accounts was being piloted within consolidated budget agencies.

P The new public procurement agency became operational and the new public procurement law went into effect in January 2003 as planned.

I+ Law on Public Finance and Debt Management was enacted followed by secondary legislation to tighten government guarantees. A new Debt Management office was established.

0 Public Sector Governance k A national strategy to enhance transparency and good governance in the public sector was published in March

2002 whose main elements are reflected in the Urgent Action Plan (UAP) of the new Government. The ministerial committee for enhancing transparency and improving good governance was established in March 2003.

> Work on civil service reform was revitalized under the UAP. The draft functional review was prepared by State Planning Organization (SPO).

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In the public sector reform area, three of the four PFPSAL II program benchmarks were achieved by mid-2003, including rationalization of the public investment program and enactment of the new public procurement and public debt management laws. Following publication in November of the Ministry of Finance general regulation on new accounting standards for general government and passage of the PFMC law, the fourth benchmark regarding budget reform will be fully reached by early 2004 with the scheduled publication of the new modified accrual based chart of accounts. These institutional reforms lie at the heart of the strategy for improving public expenditure management.

A. Macroeconomic Framework

Macroeconomic outcomes for 2002 generally surpassed the indicators set under PFPSAL II, although fiscal performance fell short of the primary surplus target. GNP growth reached 7.8 percent, more than double the 3 percent original program target. Annual inflation rates dropped steadily over the course of the year, despite the strong recovery, with CPI inflation falling to 29.7 percent by end year, well below the 35 percent target. Balance of payments outcomes were also favorable as the current account deficit of 1 percent of GNP was financed with little difficulty. Renewed capital inflows to the private sector contributed to a stronger-than-expected capital account balance which allowed a buildup of gross international reserves to almost US$28 billion. While fiscal outcomes remained on track through mid-year, a gap of over 2 percent of GNP emerged during the second half of the year with respect to the end-year primary surplus target of 6.5 percent which however did not prevent an improvement in the debt dynamics. Financial markets experienced continued volatility in 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 the year. 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, as real exchange rate appreciation and higher-than-expected growth more than offset weaker- than-programmed fiscal performance.

The economic recovery has gained strength in 2003 while inflation has continued to fall. The program targets of 5 percent GNP growth and 20 percent end-year CPI inflation are well within reach. Since August, financial market indicators have improved following the postponement of repayments to the IMF and the prospect of US$8.5 billion in loans from the United States. The exchange rate has appreciated against the US Dollar and Euro, and Treasury’s borrowing cost has declined in domestic and international markets. Consequently, the debt to GNP ratio is projected to fall to the 70 percent range by end year. Although the current account deficit has widened with the recovery and is projected to reach 3 percent of GNP this year, this has been financed by larger-than-expected capital inflows and Central Bank gross reserves have climbed well past the US$30 billion mark. The fiscal program has remained broadly on track to meet the 6.5 percent of GNP primary surplus target, with additional corrective measures taken in mid-year. The 5th IMF program review was completed in August 2003 and the 6th review was completed in mid-December. The Government has set targets of 5 percent growth, 6.5 percent of GNP primary surplus, and 12 percent end-year inflation for 2004. A 2004 budget consistent with the primary surplus target has been approved by the Parliament.

Social Spending. The Government acknowledged certain problems with social spending outcomes in 2002 and began to take corrective action in 2003. The estimated outcome for total social spending (covering education, health and social protection) under the 2002 budget was in the range of 17.5 percent of GNP, well above the PFPSAL benchmark of 14.5 percent. However, this overall result was

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due primarily to a large unplanned overrun in social security expenditure which masked important shortfalls in targeted social protection programs. The spending target of 0.3 percent of GNP was not reached for the Social Solidarity Fund (SSF), while total expenditure under the DIS program was only TL 1.5 quadrillion (0.5 percent of GNP), below the initially committed TL 1.9 quadrillion. Funding for the SSF and DIS was increased in the 2003 budget. Payments under the 2002 DIS program were completed by mid-2003 and an additional TL 500 trillion in payments under the 2003 DIS program are planned by end year which will bring total DIS spending to TL 2.2 quadrillion (0.6 percent of GNP). Some TL 3.0 quadrillion (0.7 percent of GNP) has been budgeted for the DIS in 2004. Spending by the SSF is expected to come close to the 0.3 percent of GNP target in 2003 and adequate funding has been included in the budget to reach this target in 2004. The Government is preparing a new package of social security reforms to unify the institutional structure of the social security system and reduce the financial imbalance.

B. Financial Sector Reform

Regulatory Framework for Banking Activity. Under PFPSAL II, the authorities moved beyond the enactment of a suitable regulatory framework to an emphasis on enforcement compliance and this has been proceeding satisfactorily. PFPSAL II board presentation conditions related to the overhaul of the regulatory framework for banking activity were completed by February 2002. Overall connected exposure regulatory limits began to come down as of January 2003 and will decline stepwise every year until they reach full compliance with the applicable EU Directive by 2010. The BRSA will continue to monitor compliance for all banks and will obtain by December 2003 updated action plans with specific restructuring proposals from banks if necessary. Enforcement of FX exposure regulations has been stepped up, repo transactions have been brought on balance sheet, and most obstacles to transformation of financial-industrial groups into separate financial and corporate conglomerates have been removed.

Institutional Development. The first phase of BRSA institutional development was achieved under PFPSAL II. The institution exists and has performed effectively under pressure. However, there are several difficulties in the second, more mature development stage, e.g., independence, governance, staffing and budgets which need to be addressed. In June 2001, BRSA’s Board adopted a time-bound Institutional Development Plan (BIDP) covering a wide range of institutional priorities. Since then, BRSA has achieved substantial progress in implementing the BIDP. As part of the conditionality for the proposed PFPSAL 3, the Bank is seeking the Government’s commitment to maintain the independence of BRSA and to support its institutional development by: (i) removal of requirements for regulatory oversight by other government entities of BRSA Board decisions, and (ii) removal of ad hoc administrative restrictions on staffing, compensation, equipment, travel and other similar expenditures. The recent resignation of the BRSA chairman following the Imar Bank failure (see below) has created new questions about the future development and independence of the institution which will have to be addressed under PFPSAL 3.

The first phase of SDIF institutional development was successful under PFPSAL II in terms of intervention and resolution of banks, but there has been slow progress in sales of non-performing assets, governance, and development of a long term financially viable structure. In August 2002, the Board of the Savings Deposit Insurance Fund (SDIF) adopted a time-bound institutional development plan targeting a more effective organizational structure with clearly separated line responsibilities for

bank resolution, liquidation, asset disposition, administration of deposit insurance scheme, and supporting functions such as legal, HR and information technology (meeting a second tranche condition for PFPSAL II). Several key strategic issues that are still under discussion and need to be implemented include: (i) governance of the SDIF as a separate entity and potential conflicts of interest with it being a BRSA subsidiary and (ii) development of a long-term financial sustainability strategy for the SDIF including operating budget and performance plans. As regards the first issue, new legislation (Law No. 5020) was enacted on December 26, 2003 which stipulates the separation of BRSA (regulation and supervision) and SDIF (deposit insurance, bank resolution and asset management) in order to enhance the asset recovery process. While this initiative is to be supported, care must be taken to ensure that the independence, effectiveness, professionalism, and accountability of each institution is maintained. The transition to a limited deposit guarantee to replace the current blanket guarantee was set out in the BRSA Board resolution of October 31, 2003 which determined the deposit insurance coverage to be applied

Problem Bank/Bank Failure Resolution. By end-May 2002, the BRSA had completed a three-stage audit process for all banks and corrective actions were completed by August 2002 (meeting a second tranche condition for PFPSAL II). A number of banks that had fallen below the minimum Capital Adequacy Ratio (CAR) level were re-capitalized from private sources. Vakif bank received a subordinated loan from the SDIF to meet the minimum CAR requirement. Presently only two banks remain with SDIF (Bayindir and Pamuk). Liquidation proceedings for Ticaret are continuing, although these have been interrupted from time to time by legal actions taken by the employee pension fund. Pamuk bank was re-offered for sale as of April 2003 and SDIF is currently evaluating the two active proposals. Bayindir’s status as a “bridge bank” and the timing of its eventual liquidation will be reviewed at the appropriate time.

The failure of Imar bank in mid-2003 was a serious blow. The bank, owned by the controversial Uzan Group, saw its license revoked by the BRSA in July 2003. A subsequent investigation found that the bank: (i) vastly understated its deposits- a true total of US$SS billion in contrast to the balance sheet figure of US$SSO million; (ii) had paid only a fraction of its with-holding tax obligations; and (iii) had sold some US$500 million in T-bills that it had never owned and was not licensed to sell. The Government announced a payment plan for individual depositors in November which will create a burden on the Treasury totaling some 2.2 percent of GNP. Imar bank has not been formally intervened by SDIF and therefore the blanket guarantee for depositors and creditors has not been invoked.

Following completion of a review of the improvements required in the legal framework for bankruptcy and collateral foreclosure to facilitate resolution of non-performing loans (NPLs)--meeting a second tranche condition for PFPSAL II, a series of amendments to the Execution and Bankruptcy Act (EBA) were enacted in mid-2003. The Government has prepared a second set of amendments to introduce a pre-packaged bankruptcy option in the EBA and these additional amendments are expected to be enacted by early 2004.

State Bank Restructuring and Privatization. As of end-2002, all planned branch closures and reduction of excess personnel for both Ziraat and Halk banks had been completed (meeting second and third tranche conditions for PFPSAL II). The Treasury has continued to adhere to the agreed protocol for cash payments for interest and principal of the Government securities portfolios held by Ziraat and Halk (fulfilling additional second and third tranche conditions). The state banks are operating under

legislation enacted in November 2000 (Law. No. 4603) which provides them with their own financial and administrative authority. Under the new legislation, the state banks cannot be assigned duties without advance payment by the budget. As of 2003, the sworn bank auditors are to certify every six months that the lending procedures in the state banks are based on commercial principles. The study of Ziraat’s future strategic direction has been completed and indicates that the bank cannot survive on agricultural finance alone, and should become a full service bank serving retail and SME customers and also covering rural areas. A privatization study for Halk was completed in early November. On the basis of these studies, the Bank has recommended that the Government consider a merger of the two banks. The Government has indicated that a strategy regarding privatization of Ziraat and Halk will be determined following the resolution of Pamuk and Vakif banks, however, the Bank has recommended that the authorities not delay the formulation of this strategy.

A public tender for sale of Vakif bank in June 2002 did not result in viable bids. Lack of a clearly defined ownership and corporate governance structure for the bank makes it difficult to negotiate a customized privatization transaction. After considering and rejecting several options, the Government now proposes to carry out a due diligence exercise for Vakif, to be completed by end-February 2004, and then determine the privatization strategy within one month. The Bank has concerns about the drawn-out nature of this approach, given the overall situation of the state banks, and the issue remains under discussion in the context of the proposed PFPSAL 3.

C. Public Sector Reform

Structural Fiscal Policies. The medium-term strategy for improving the tax system was adopted by the Government in January 2002. A special consumption tax (SCT) law replacing the complex system of excise taxes was adopted by the Parliament in June 2002 (fulfilling a second tranche condition) and earmarking of SCT revenues was eliminated in early 2003 (meeting a third tranche condition for PFPSAL II). In April 2003, the first direct tax reform package harmonizing the personal and corporate income tax regimes was enacted. A second direct tax package rationalizing regional incentives and free-trade zone benefits was approved by the Parliament in December 2003. On the other hand, the functional reorganization of the tax administration has been delayed and is now expected to be initiated in 2004.

Progress has also been made under the public employment program. An assessment of 45,800 redundancies in state enterprises (SEES) was provided to the Bank in April 2002 (meeting a second tranche condition for PFPSAL II) and a circular on implementation of the redundancy program was issued. As of mid-October 2003, 36,700 redundancies had been eliminated (going well beyond the third tranche condition). In order to accelerate completion of the redundancy program, the Government has included in the 2003 supplementary budget a temporary incentive scheme for SEE workers in the form of higher severance payments. The public employment monitoring program has been extended to all municipalities and special provincial administrations and quarterly monitoring system is now fully functional (meeting second and third tranche conditions for PFPSAL II).

Public Expenditure Management. The Steering Committees established by the previous government to coordinate the relations with the Bank on public sector reform issues were not effective. The new Government has incorporated the core elements of the public sector reform in the Urgent Action Plan

(UAP) assigning clear responsibility to specific agencies under the overall coordination of a Deputy Prime Minister.

Budget Reform. The pilot program for the Government Finance Statistics (GFS) budget classification got underway in six consolidated budget agencies in 2002. The Ministry of Finance issued a circular in July 2003 to expand the GFS classification to all general government agencies (meeting a second tranche condition for PFPSAL II). The new budget classification is being rolled out in the 2004 budget cycle for all general and annexed budget agencies. This is scheduled to be launched in local administrations, social security institutions, boards and supreme boards having legal entities and in agencies and in institutions subsidized from funds and from investment and transfer items of the budget as of January 1, 2005; and in other agencies and institutions (with the exception of state economic enterprises) as of December 1,2006.

In the 2002 budget, a majority of extra-budgetary funds (along with all but one budgetary fund) were eliminated. The special accounts/special appropriations mechanism which has remained after closure of the funds has perpetuated the earmarking of significant amounts of revenue. To address this problem, the MOF has prepared legislation that will terminate the use of special appropriations mechanism, close the accounts linked to the closed funds and incorporate their earmarked revenues into the general revenue base effective with the 2005 budget.

The Government has undertaken a rationalization of the Public Investment Program (PIP). The average completion time was cut by 32 percent, from 12.5 years in 2001 to 8.5 years in 2002. An action plan for further rationalization of the PIP in 2003-04 prepared by SPO was adopted by the High Planning Council in October 2002 (meeting a second tranche condition for PFPSAL II). An assessment prepared by SPO in May 2003 confirmed the reduction in the average project completion time in the 2002 PIP, and indicated a further reduction in the average completion time to an estimated 7.6 years in the 2003 PIP along with a continued reduction in the number of projects.

Financial Accountability. The say2000i internet based automated accounting system went on-line in January 2002 for the consolidated budget agencies. The initiative to introduce modified accrual accounting in compliance with GFS requirements is making progress. The new chart of accounts is being piloted within consolidated budget agencies including several joint pilots with the GFS budget classification. The new public accounting general regulation which covers general government was published in November 2003 (partially meeting a third tranche condition for PFPSAL II). The regulation will be effective as of January 2004 for the consolidated budget agencies and from January 2005 for the full general government. The implementation regulation for consolidated budget agencies is scheduled to be published in early 2004 following TCA approval. This will clear the way for publication of the modified accrual based chart of accounts consistent with GFS requirements.

The new public procurement law (PPL) was enacted in January 2002. The new Public Procurement Agency (PPA) has been established and amendments to the PPL to reduce the procurement thresholds in line with international practice were enacted in June 2002 (meeting a third tranche condition for PFPSAL II). The PPL went into effect on January 1, 2003 as planned. In July 2003, a set of further amendments was enacted which authorized limited procurement by SEES under commercial practice. New procurement legislation for SEES in the public utilities sectors consistent with the relevant EU

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directive is now being prepared. The Bank is providing support to the PPA under a US$350,000 International Development Fund (IDF) grant.

The PFMC law will establish the legal framework for harmonizing and modernizing budgetary practices across all of general government. It will reduce fragmentation and provide for a more comprehensive presentation of the budget. The law will also allow for future decentralization of financial control to spending agencies. Finally, it will extend the external audit mandate of the TCA to all general government agencies and allow for external audit of TCA itself. The revised PFMC law was re-submitted to Parliament in November 2003 and passed in December. The expansion of the TCA’s audit mandate under the PFMC law meets a second tranche condition for PFPSAL II, while enactment of the PFMC law itself meets a Board condition for PFPSAL 3. The PFMC Law was published in the Official Gazette on December 24,2003.

Public Liability Management. Law on Public Finance and Debt Management was adopted in March 2002. Communiques for the issuance of government guarantees and for borrowing by SEES were published in April 2002 (meeting a second tranche condition for PFPSAL II). A Communique on establishment of the middle office and a Public Debt Committee to set policy within the Treasury, originally published in September 2002, was reissued in January 2003 with a strong emphasis on the risk control function of the middle office. A review of the government guarantee portfolio was completed by May 2003, providing a preliminary valuation. In order to support the capacity-building efforts of the new middle office, a US$320,000 IDF grant was approved in November 2003. The multi-year capacity-building program will help improve the transparency of fiscal management by assisting the Turkish Treasury to adopt best international practices and technical tools in public liability management, including financial and fiscal risk management.

Public Sector Governance. A national strategy to enhance transparency and good governance in the public sector was published in March 2002. The basic structure and actions of this strategy have been reflected in the UAP of the new Government. The ministerial committee for enhancing transparency and improving good governance was established in March 2003. The committee will steer relevant actions of both the UAP and national strategy in this reform area. The Freedom of Information law envisaged under the national strategy was enacted in October 2003. The law establishes the processes and rules under which information may be obtained from government. The Government has prepared a draft code of conduct for civil servants and public administrators, another action in the strategy, and plans to submit it to Parliament for passage by end-2003.

Work on civil service reform has been revitalized under the UAP. The functional review has been re- launched under the responsibility of SPO (meeting a second tranche condition for PFPSAL II) and an initial draft is being revised before submission to the Government. Responsibility for preparation of the civil service reform strategy has been confided to the State Personnel Presidency under the overall direction of a Deputy Prime Minister. A timetable of end-2003 has been set under the UAP for the adoption of the civil service reform strategy by the Council of Ministers, but this has been delayed into 2004. A draft State Personnel Regime Law has been prepared and is expected to be finalized after passage of reform legislation on public administration and local government.

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5. Major Factors Affecting Implementation and Outcome

During the run-up to the early elections in November 2002, there was a slowdown in the implementation of the economic reform program which led to a delay in the disbursement of the second and third tranches of PFPSAL II. After the elections, the new Government prepared a roadmap for the reform program and requested the Bank to cancel the remaining tranches of PFPSAL II and prepare a new loan to support the financial and public sector reform program. PFPSAL 3 for US$900 million was prepared by the Bank which includes the outstanding conditions of PFPSAL II and new conditionality in areas where there have been delays or emergence of new issues.

6. Bank and Borrower Performance

Overall Bank performance has been satisfactory. The Bank task team worked from a basis of in-depth country and sector knowledge. A good relationship with the government agencies was sustained throughout the preparation and supervision stages. Combined with strong continuity in the project team and management, this helped ensure coherence of the financial and public sector reform program even after the Government changed following the 2002 elections. The interaction with the IMF was also satisfactory, with the Bank complementing the Fund’s focus on the macroeconomic framework and providing substantive support to the structural conditionality under the Fund program. The Bank team also coordinated its work closely with the European Commission on key structural reform areas related to the acquis. The continuous approach adopted under the Bank’s adjustment lending operations (Economic Reform Loan (ERL), Financial Sector Adjustment Loan (FSAL), PFPSAL and PFPSAL II) was critical in sustaining implementation of the financial and public sector reforms. The design of the PFPSAL program benefited extensively from relevant economic sector work and fiduciary due diligence including the 2000 Country Economic Memorandum (CEM), 2001 Public Expenditure and Institutional Review (PEIR), 200 1 Country Procurement Assessment Report (CPAR), 200 1 Country Financial Accountability Assessment (CFAA), the 2003 Non-Bank Financial Institutions (NBFI) study, the 2003 Corporate Sector Impact Assessment (CSIA) report and the 2003 CEM.

While implementation of certain actions was delayed as a result of the political uncertainty which preceded the November 2002 elections, the overall performance of Government agencies involved in implementing the policy measures supported by PFPSAL II was satisfactory. The Treasury, Ministry of Finance (MOF), State Planning Organization (SPO), BRSA and other Government agencies involved worked in close collaboration with the Bank. Productive relations have been established with government counterparts in these core institutions and these are continuing under PFPSAL 3 preparation.

7. Findings and Implications for Subsequent Operation(s) in Series

The combination of financial and public sector reforms under the PFPSAL operations has proved useful in supporting the early stages of Turkey’s crisis response program. This combination has provided important synergies, most importantly ensuring consistency between fiscal adjustment and the financing requirements of the front-loaded bank restructuring pr economic recovery, disinflation and debt sustainability have been approach has allowed for a reasonable degree of adaptability to unfol

ogram. The results in terms of impressive. The programmatic ding events on the ground while

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maintaining overall coherence and direction of the reforms. The single tranche PFPSAL provided substantial up-front support in the critical period immediately following the February 2001 crisis, while the multi-tranche structure of PFPSAL II provided the necessary flexibility for the Bank to calibrate its financial support in accordance with actual implementation of specific reform measures. Looking ahead, as the emphasis of the Government’s program shifts from crisis recovery to sustained growth over the medium term, the Bank is planning to shift to separate programmatic public sector adjustment loans (PPSALs) and programmatic financial sector adjustment loans (PFSALs) under the new FY04-06 CAS. This shift will allow the Bank’s assistance program to take account of the differing implementation requirements for the public and financial sector reform programs, including supplementary technical assistance and related investment financings.

Events in Turkey have shown that the programmatic approach is not automatically robust to political change, and that additional flexibility may be needed to adjust to the priorities and timetable of a new government. While the run-up to the November 2002 elections resulted in implementation delays, the PFPSAL II program provided the new Government with an established framework for core financial and public sector reforms. The new Government demonstrated its commitment to the program by signing the April 2003 roadmap. However, the Iraq war and other internal and external developments led to further implementation delays which required adjustments in the timing of key conditionality under the program. Upon the Government’s request, the remaining tranches of PFPSAL II (a mix of SSAL and IBRD terms) were cancelled in June 2003 and work began on PFPSAL 3 (fully on IBRD terms). As PFPSAL 3 preparation progressed, the Government continued to articulate its reform strategy, particularly with regard to the DIS and certain elements of the financial sector reform. This has resulted in extended negotiations of PFPSAL 3 and could lead to further adjustments in the conditionality. The Bank and the Government are now intensifying the dialogue in order to bring PFPSAL 3 to the Board as soon as possible while maintaining the overall objectives of the program.

Sustainability of the PFPSAL program and the specific reform actions taken under PFPSAL II is rated as likely provided that PFPSAL 3 is implemented as planned. This evaluation is based on a number of factors related to continuity of the program and renewed Government commitment to its implementation. Continuity of the program will be ensured under PFPSAL 3 which is expected to encompass the key outstanding objectives foreseen under the second and third tranches of PFPSAL II, including further progress on the state bank agenda, as well as additional conditionality in areas where implementation under PFPSAL II ran into delays. The renewed Government commitment to program implementation was highlighted by passage of the PFMC law in mid-December. Sustained implementation of the public and financial sector reforms over the medium term is a priority for the new CAS under the planned PPSALs and PFSAL.

In this context, the full objectives of the PFPSAL II operation can be expected to be achieved as part of the overall program of the new Government, although over a somewhat longer timeframe than originally envisaged.

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