World Bank Document...ABBREVIATIONS DYB - State Investment Bank IMF - International Monetary Fund OECD - Organization for Economic Cooperation and Development PIR - (World Bank) Public

Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 4015

TURKEY'S STRUCTURAL ADJUSTMENT

A PROGRAM PERFORMANCE AUDIT REPORT:

FIRST STRUCTURAL ADJUSTMENT LOAN (NO. 1818-TU)AND SUPPLEMENT (NO. 1915-TU)

June 30, 1982

Operations Evaluation Department rIECO Y

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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ABBREVIATIONS

DYB - State Investment BankIMF - International Monetary FundOECD - Organization for Economic Cooperation

and DevelopmentPIR - (World Bank) Public Investment Review ReportSAL - Structural Adjustment LoanSDR - Special Drawing Right

SEE - State Economic EnterpriseSPO - State Planning OrganizationTL - Turkish Lira

CURRENCY EQUIVALENTS

TL per US$

1978 March 25.25

1979 June 47.10

1980 January 70.00August 80.00December 91.75

1981 April 98.20June 107.50September 121.10

1982 January 138.00April 147.30

FISCAL YEARS

Until February 1982, fiscal years from March 1.


A PROGRAM PERFORMANCE AUDIT REPORT

TURKEY: FIRST STRUCTURAL ADJUSTMENT(LOANS 1818-TU AND 1915-TU)

TABLE OF CONTENTSPage No.

Preface .................... iBasic Data Sheet .iiiHighlights. v

PROGRAM PERFORMANCE AUDIT MEMORANDUM

I. INTRODUCTION. 1

Growth and Diversification of Turkey's Economy. 1The Pattern of Development. 1External Shocks. 2Required Adjustments. 3The January 1980 Program. 3

II. THE LOANS. 3

SAL I Background. 3Design of SAL I Loan. 5Growth Versus Inflation. 6Export Expansion. 8The Balance of Payments and Capital Inflows .11Imports and Capacity Utilization .13Protection and Incentives Systems .14Domestic Resource Mobilization .15Private Credit and Mobilization of Private Savings 18Level of Public Investment .20Priorities and Composition of Investment .22Incomes Policy .24Reforming the SEEs .25

III. BROADER IMPLICATIONS .26

Follow-up and SAL II .26Comments on Policy Dialogue .28Bank-Fund Collaboration .29Conclusion .30

Annex A: Schedule 5 of Loan Agreement (SAL I) .32

Annex B: Schedule 5 of Loan Agreement (SAL I, Supplement) .33

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

TABLE OF CONTLNTS (Continued)Page No.

Statistical Annex

Table 1: Indicators of Price Change ........... .. ............. 34Table 2: Real Exchange Rates for Turkish Lira ........ ........ 35Table 3: Main Outline of Turkey's Balance of

Payments 1979-81 ............... .. ................. 36Table 4: Consolidated Budget and SEE Finances ............... . 37Table 5: Credit to Private Sector and Households ............. 38

PROJECT COMPLETION REPORT .......................................... 39

Monitoring of Policy Areas under SAL I and its Supplement 40Progress in Areas Monitored ................................... 40Loan Impact and Implementation ................................ 44Summary and Conclusions ....................................... 45

Annexes:

1. Memo to EDs on Second Tranche Release ..................... 482. Memo to EDs on Third Tranche Release .................. .... 533. Supplemental Letter to SAL I Supplement on

Protection Study ....... ................................. 57

4. Supplemental Letters to SAL I Supplement onExternal Debt Study ..................................... 66

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PREFACE

The present Performance Audit Report covers the first StructuralAdjustment Loan (SAL) made to Turkey, together with its Supplement.

Loans No. 1818-TU for US$200 million, signed on March 25, 1980and No. 1915-TU for US$75 million, signed on November 24, 1980 were bothmade to the Government of Turkey and were fully disbursed by October 1981.Prior to these loans the Bank had advanced a Program Loan to Turkey (LoanNo. 1627-TU for US$150 million in November 1978) which is the subject of aseparate Performance Audit Report. A Second Structural Adjustment Loan (LoanNo. 1987-TU for US$300 million) was made in May 1981 and a third SAL (forUS$304.5 million) was approved by the Board on May 27, 1982.

During the period covered by SAL I and its Supplement, the IMFreached a number of arrangements with Turkey which were closely related to theBank operations under review; these are touched upon in this report whereappropriate.

The report comprises a Program Completion Report (PCR) preparedby the Europe, Middle East and North Africa Region and a Program PerformanceAudit Memorandum (PPAM) prepared by the Operations Evaluation Department(OED). In preparing the latter, extensive documentation research was under-taken and discussions held with staff members in the Bank and the Fund. Afield mission to Turkey was undertaken by a staff member and an OED consultantin October 1981. Discussions were conducted with the Prime Minister's Office,the Ministry of Finance, the State Planning Organization, the Central Bank,Turkish Industrial Development Bank (TSKB), commercial banks, Chambers ofCommerce and Industry, and representatives from the private sector, theacademic community and others. OED is most grateful to the Government andthe various institutions and individuals visited for the help given and thecourtesies extended to the mission.

The PCR provides a discussion of the actions taken by the governmentconcerning those policy areas selected for special review under SAL I and itsSupplement. It also reviews the implementation of these loans and theircontribution to Turkey's adjustment program. The Audit Memorandum examinesthe design of SAL I, and reviews progress of policy actions in order toarrive at an independent evaluation of the loan effectiveness. It alsoconsiders whether the experience gained was adequately reflected in the designof SAL II.

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As background to the present series of operations in support of

structural adjustment, the Audit Memorandum comments on the evolution of themacro-economic policy dialogue between the Bank and the Turkish authorities.In so doing, the audit has made use of information that has become available

subsequent to the initiation of SAL I and its Supplement, in particular theBank staff draft reports on trade policy and on public investment. SAL I was

initially conceived as a second program loan. The evolution of thinking inthe Bank and economic conditions in Turkey, however, led to its presentationin support of structural adjustment. Inevitably, the operation had an experi-mental aspect and lacked some of the characteristics - especially the full

definition of policy objectives and monitorable actions - that have come tomark subsequent operations of this type. This fact has reinforced, in this

case, OED's normal practice in performance auditing to include some comment on

the follow-up operation.

Finally, it should be added that the SAL process is a long one, and

earlier operations, by their nature, unfold into later ones with a continuity

that is difficult to break. Subjecting a slice of this continuum to perfor-mance audit has obvious limitations; defining the boundaries of legitimate

comment is difficult. And yet, it would be incorrect to have waited until theprocess of structural adjustment in Turkey is completed, given the internaland external uncertainties in reaching such an outcome. This audit is,therefore, offered in full awareness equally of the difficulties inherent in

an early assessment of a process that is still incomplete, as of the need tobring such an assessment to the Executive Directors and the management withoutdelay. Discussion of earlier drafts of this audit has coincided with thepreparation of Turkey SAL III, and may have had a beneficial effect on thedesign of that operation.

Copies of the draft report were sent to the Borrower on March 19,

1982, but no comments have been received.

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PROGRAM PERFORMANCE AUDIT BASIC DATA SHEET

TURKEY: FIRST STRUCTURAL ADJUSTMENT(LOANS 1818-TU)

PROJECT DATA(US$ Million)

As of 03/31/82Original Disbursed Cancelled Repaid Outstanding

Loan 1818-TU 200.0 200.0 0 0 -

Cumulative Loan Disbursement

FY80 FY81

(i) Estimated 90.0 200.0(ii) Actual 17.0 200.0(iii) (ii) as % of (i) 19 100

Original Dates Actual Dates

Board Approval 03/25/80 03/25/80Loan Agreement 03/26/80/a 03/26/80Effectiveness 04/28/80- 04/01/80Loan Closing 09/30/81 03/31/81

MISSION DATA

Month, No. of No. of Man- Date ofYear Weeks Persons weeks Report

Identification - - - - -

Preappraisal - - - - -

Appraisal 07/79 - - - 02/29/80

Supervision I 06/9-27/80L.a 2 3 6 07/07/80Supervision II 09/24/80 2 3 6 10/17/80Supervision III 10/03/80c - - - -

Supervision IV - - - - -

Supervision V - - - - -Completion 0 6/8 a/d 1 - 1 12/17/81

FOLLOW-ON PROJECTS

Turkey Structural Adjustment (Supplement), Loan No. 1915-TU, approved onNovember 18, 1980, in the amount of US$75.00 million.

/a Or earlier if conditions of effectiveness satisfied.

/b First Review on progress of SAL I and appraisal of proposed SAL I(Supplement).

|c Second Review on progress of SAL I.

/d Necessary work for completion report done during another mission.

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PROGRAM PERFORMANCE AUDIT BASIC DATA SHEET

TURKEY: Structural Adjustment Supplement(LOANS 1915-TU)

PROJECT DATA(US$ Million)

As of 03/31/82Original Disbursed Cancelled Repaid Outstanding

Loan 1915-TU 75.0 74.98 0 0

Cumulative Loan Disbursement

FY81 FY82 FY83

(i) Estimated 47.8 72.7 75.0(ii) Actual - - -(iii) (ii) as % of (i) 154 103 100

Original Dates Actual Dates

Board Approval 11/18/80 11/18/80Loan Agreement 11/24/80 11/2 4/8 0/aEffectiveness 02/25/81 01/07/81/Loan Closing 08/31/81 10/31/81

MISSION DATA

Month, No. of No. of Man- Date ofYear Weeks Persons weeks Report

Identification - - - - -

Preappraisal - - - -

Appraisal 06/9-27/801b. 2 2 4 10/30/80Supervision I - - - - -

Supervision II - - - -

Supervision III - - - - -

Supervision IV - - - - -

Supervision V - - - - -Completion - /c - - - 12/17/81

FOLLOW-ON PROJECTS

Turkey Structural Adjustment II, Loan No. 1987-TU, approved onMay 12, 1981, in the amount of US$300 million.

/a Or earlier if conditions satisfied.

/b Negotiating/appraisal missions. Office Memorandum of 07/07/80.

/c Necessary work for completion report done during SAL II pre-appraisalmission (November 1981).

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HIGHLIGHTS

The first Structural Adjustment Loans (SAL I: Loan No. 1818-TU,signed in March 1980 and its Supplement: Loan No. 1915-TU signed in Novemberof the same year) were made to Turkey when the economy of the country was in astate of crisis. Inflation (in terms of the implicit GNP deflator) wasrunning at an annual rate of 73 percent in 1979; exports could only pay forless than half of the imports in 1978 and 1979 (the latter constrained toessentials for sustaining domestic activity); the current account of thebalance of payments continued to be substantially in deficit (US$3.6 billionin 1977; US$1.7 billion in 1978; US$1.8 billion in 1979) and capital inflowswere sharply declining. Arrears mounted on payments for imports and for debtservice, and the short-term debt (before debt rescheduling) had grown fromunder $300 million in 1974 to $8.4 billion in 1978. In the same period grossofficial reserves had declined by half, and economic growth had ground to ahalt, giving way to negative growth in 1979. This accentuated the economy'sstructural tendency toward unemployment and underemployment and fueled growinglabor unrest (PPAM, paras. 2-4).

ii. Amid internal political difficulties that rendered basic adjustmentdifficult, external relief came in the shape of a series of debt resched-ulings, beginning in 1978, stabilization arrangements worked out with theFund, and OECD extraordinary assistance, among others (paras. 34-35). A majorshift of policy was declared in January 1980: away from administrativecontrols and inward-looking strategies and in the direction of a betterresource balance, greater use of market forces and more liberal externaltrade. It presaged the structural adjustment process which the Bank began tosupport by the lending operations under review.

iii. The immediate objective of SAL I and the Supplement was to makequick disbursing funds available to Turkey in support of the program ofreforms already initiated. The timing of the operation, however, did notpermit the kind of thorough advance economic work which has marked a number ofsimilar Bank operations in other countries. Quantitative objectives agreedunder SAL I were few, the emphasis being on policy change which the borrowerundertook to effect and to discuss intermittently with Bank staff beforetranches of the loan were released. The major objectives of the program wereto reduce inflation, increase foreign exchange earnings, and improve domesticresource mobilization in the public and private sectors. Priority was givento export incentives and institutional arrangements in support of exports;studying the protection and incentive system; improving external debt manage-ment; eliminating the overall public deficit in 1980; reviewing measures toencourage private savings and time deposits; harmonizing public investment andadjusting its composition to the new priorities.

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iv. Progress was made in practically all the areas earmarked for reform,thus enabling the Bank to proceed with SAL II and, later, with SAL III.Significant success was achieved in reducing inflation from over 100 percentin 1980 to under 40 percent in 1981 when GNP began to expand, propelled byrapid growth in exports (paras. 20-21). The target set for export growth (of10 percent per annum in 1979-82 in real terms) was readily realized (para.39), though some of the institutional reforms were not carried out in the formagreed upon. The Lira was effectively devalued, and the rate of exchange madeflexible. Preferential access of exporters to credit turned out to be farmore effective in promoting exports than either the credit insurance scheme orthe exporters' foreign exchange retention scheme, both of which receivedemphasis under SAL (paras. 25-29). Workers' remittances also increased.The balance of payments improved on current account, and higher importsfacilitated the growth of exports, although the impact on capacity utilizationin industry was mixed (paras. 38-39). Though radical reforms of the protec-tion and incentive systems were not expected under SAL I and Supplement, someprogress was made, particularly after the Bank's Industrialization and TradeStrategy Mission of May 1981 (paras. 42-46).

v. The objective of eliminating public deficit in 1980 was notachieved; nor was it (apparently) intended, considering that there existed noconsolidated public sector accounts. It appears, however, that public savingsdid increase, owing partly to wage restraints, but public investment, insteadof stabilizing, actually increased and its rationalization is still incomplete(paras. 76-78). Interest rates became positive (paras. 60-61), but theoverall success of the domestic resource mobilization program in 1980 and1981 was limited (para. 65). Some progress was made towards improving therecording of external debt, but the objective of improving debt management isyet to be put to the test once Turkey's ability to contract new debts is fullyrestored (para. 35).

vi. Overall, the prospects appear bright for Turkey's ability to com-plete its structural adjustment over the medium term. Other areas of reformhave been adressed by the Bank under subsequent SALs, and the results ofvarious studies of the economy undertaken since the initiation of the programare emerging to guide policy changes. A by-product of this process has beenthe greatly improved dialogue between the Bank and the borrower in supportof Turkey's economic development. While the cost to the Bank of increasedeconomic work on Turkey since the adjustment process has been high the resultsof this work have contributed to the improved design of SAL III.

A PROGRAM PERFORMANCE AUDIT MEMORANDUM


I. INTRODUCTION

Growth and Diversification of Turkey's Economy

1. Thirty years ago, when the Bank began operating in Turkey, thecountry was underdeveloped, income per capita below US$200,1/ and agriculturecontributed 45 percent of GDP and industry only 12 percent. Agriculture ledeconomic development in the fifties, but during the next two decades, underthe umbrella of comprehensive economic planning (which began in 1962), indus-try became the focus of the development effort. During this period of planneddevelopment, and until the current balance of payments crisis which firstbecame evident in 1977, economic growth was rapid, averaging 7 percent a year.In the process the economy was transformed structurally so that by 1980agriculture contributed a quarter of GDP and industry 21 percent, and percapita income exceeded US$1,100.

The Pattern of Development

2. The pattern of development adopted by Turkey in this period restedon three fundamental elements. First, active public participation in theeconomy through State Economic Enterprises; secondly, employment of capital-intensive methods of production in preference to labor-intensive techniques inpursuit of modernization; and thirdly inward orientation of production tosubstitue for imports irrespective of whether or not the country had, or wasexpected to develop, a comparative advantage in the activities promoted. Themacro-economic policies that were pursued during this period complemented thisapproach, and led among other things to an overvalued exchange rate; excessiveprotection given to domestic industrial production through tariffs and quanti-tative controls on imports, which blunted the edge of competition and fosteredinefficiency; low interest rates which discouraged savings, particularlyfinancial savings, and, in combination with the overvaluation of the lira,kept capital cheap and militated against labor employment; and State EconomicEnterprises which lacked managerial autonomy and whose production, employmentand pricing practices often addressed national social and economic needs tothe detriment of their own profitability and thus forced them to rely on agreatly overburdened public treasury for finance. Meanwhile the structuralproblem of unemployment and underemployment, which had been alleviated some-what by migration to other countries, had gradually become much more serious.

1/ Equivalent to some US$630 in 1980 prices.

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External Shocks

3. Turkey's economic problems were further compounded in the seventiesby the energy problem, the serious deterioration of its terms of trade and therecession, inflation and rising unemployment in the industrial countries. Theconsiderable rise of world petroleum prices in the early seventies coincidedwith the decline of local extraction rates. Under the impact of low domesticprices and rapid economic growth, petroleum consumption expanded, as did thepetroleum import bill, which in 1977 absorbed 84 per cent of the proceeds ofthe stagnating exports. Inflation in Turkey's trading partners also raisedthe prices of other imports of goods and services as well as interest onexternal borrowing; and the rise of unemployment affected Western Europe'sability to continue to absorb Turkey's migrant laborers, the source ofsubstantial foreign exchange earnings. The shock of the payments crisis whichwas evidenced most clearly in 1977 and 1978, and the attendant accumulation ofarrears on payments for debt service and imports, and the decline of capitalinflows, in addition to the slowing down in economic activity that resultedfrom the lack of essential imports, all helped to crystallize thinking inTurkey about the required adjustment and emphasize the inevitability ofaction. Such crystallization, however, was slow and difficult to accept.Turkey "took an inordinately long time, compared to almost all other develop-ing countries, to make appropriate adjustment..."l/.

4. Political instability during the latter part of the seventies didnot advance the chances of implementing the required change which meantshort-and medium-term sacrifices during a period of structural adjustment, inproduction and employment, reduced overall growth and decline in certainactivities, and perhaps also changes in the distribution of income which couldbe destabilizing. The economic problem was further complicated by a raginginflation which was fueled also by reduced imports.

Required Adjustments

5. The ability of Turkey to continue with past economic policies hadcome gradually to be doubted with the periodic recurrence of balance of pay-ments crises. Both from within Turkey and from outside (particularly Bankmissions and the IMF) alternative approaches to development were intermit-tently discussed with the authorities, but the dialogue on these matters wasnever easy.

6. Within Turkey there developed a conflict between those who advocateda new approach based on an outward-looking development strategy giving morerein to market forces, and those who, while conceding the need for a more

1/ World Bank, Turkey: Policies and Prospects for Growth, (Report No.2657a-TU), December 12, 1979, Volume I, page ix, para. 31.

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outward-oriented strategy, wanted to conserve as much as possible of the oldsystem, characterized by public sector dominance and administrative controls,claiming that more efficient planning and administration would restore theeconomy to its previous health. Although the private sector had grown con-siderably in the sixties and early seventies, contributing much to Turkey'srapid growth on a wide front of activities that spanned industry, trade andagriculture, there were claims that it was unduly favored by protectionistpolicies and government incentives; and that the private sector entrepreneursof Turkey have been mainly rentiers in a system of public controls which theyhad learnt to manipulate.

7. The successive governments that began to grapple with Turkey'seconomic difficulties in the late seventies were gradually moving towardrecognizing the necessity of turning the economy outward. But controversyover the part to be played by the private sector and market forces seemed tofreeze action on reform. The Fourth Plan itself (1979-83), with its hightarget growth rates for output and exports, while avoiding fundamental policyadjustments, reflected this ambivalence. This program was critically examinedby the Bank mission report cited above.

The January 1980 Program

8. By the end of 1979, however, a new government, spurred by thecrisis, formulated a new economic program much more responsive to the concernsexpressed by the Bank, the Fund, and Turkey's other creditors; this programwas later supported by the regime that assumed power in September 1980. Therole to be undertaken by the private sector and the mix between market forcesand administrative controls remain, as in most countries, questions to beaddressed on a continuing basis.

II. THE LOANS

SAL I Background

9. SAL I and its supplement were extended in support of Turkey'scommitment to the policies stated in the January 1980 program and communicatedto the Bank in a letter dated February 7, 1980. These policies were sum-marized in that letter as follows:

'(a) Reliance on economic planning down to micro levels and administra-tive controls to realise planned targets and objectives needs to be shed, andreplaced by greater reliance on market mechanisms and forces;

(b) Curbing of inflation has more importance and greater priority thanthe attainment of higher growth rates in the current situation;

(c) Import substitution and protection oriented policies, which resultedin bias against exports in favor of the domestic market, must give way tothose which encourage both our public and private sectors to improve produc-tivity and, to the extent feasible, be internationally competitive;

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(d) The fulcrum of our development policy should be to correctly setthe rate of exchange and operate an effective exchange rate policy to ensurethat our foreign trade orientation changes to one where Turkey should relyheavily in future on export earnings and other foreign currency earningactivities, including workers remittances, private foreign investment, tourismand transfer of savings from abroad;

(e) Reform of the State Economic Enterprise (SEE) sector is needed sothat it no longer constitutes a drain on the Government's budget, nor itsinvestment programs continue to be one of the basic causes of inflationarypressures;

(f) Since one of the most alarming features of our economy is thedecrease in domestic savings as a percent of GDP, domestic resource mobiliza-tion efforts stressing reliance on taxes, augmentation of public and householdsavings and greater reliance on the banking system and financial markets,needs to be substantially increased;

(g) Utilization of existing productive capacity and essential newinvestments stressing exports and employment or those removing criticalinfrastructure bottlenecks must be made, with due consideration to the scar-city of resources."

10. The Bank was convinced that the new policy direction enunciated bythe Government was truly responsive to Turkey's needs. Further, some impor-tant actions had already been taken towards implementing a 1979 stabilizationprogram which formed the basis for a standby with the 1MF. Most importantamong these actions was a more rational exchange rate policy, considered byboth the Bank and the Fund as a sine qua non for a fundamental structuralchange. Already, it appeared that during the course of 1979 some success hadbeen achieved in producing an effective devaluation of the Turkish Lira inreal terms, which it was believed would be further consolidated by actionsunder the 1980 program. The Bank, moreover, was encouraged by the continuingdiscussions between the Fund and Turkish officials, which led to furtherreleases under the 1979 Standby after the January 1980 program was adopted andbefore the SAL was brought before the Bank's Executive Directors. Finally, itwas decided to go ahead with the loan, even in the absence of a time boundmedium-term framework for structural adjustment and despite a lack of specifi-city in many policy areas. Turkey's need was urgent for non-project assis-tance from the Bank as well as from other sources. Without such assistance,and given its foreign debt service obligations, Turkey would not have hadsufficient room for maneuver in 1980 and 1981 on the external side to recon-cile the potentially conflicting policy objectives which it had adopted. Itwas envisaged that a comprehensive and more specific actiOil plan would beprogressively developed pari passu with the implementation of the existingprogram, and that future SALs would be contingent on such progress. Discus-sions between the Bank and the Turkish authorities during --he course of loandisbursement and prior to new loans were supposed to contribute, along withdiscussions between the IMF and Turkey, to continuing improvement in policyformulation and implementation. The audit finds this approach to have beenappropriate and justified in the circumstances.

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Design of SAL I Loan

11. The key features of SAL I Loan Documents relating to Turkey'seconomic program are the following:

(a) The Economic Program and Medium-Term Economic Policies are formallydescribed in the letter cited above dated February 7, 1980, from the Under-secretary of the Prime Ministry to the President of the World Bank, and arefurther articulated in the President's Report.

(b) Performance in carrying out this program is to be appraised by theBank during the disbursement of the Loan and at stated intervals leading to anexchange of views, particularly on the measures described in Schedule 5 of theLoan Agreement. (See Annexes A and B)

(c) The Bank shall not permit commitments or withdrawals under theloan beyond specified amounts (or tranches) of the Loan (the equivalent of40 percent and 75 percent) unless the Bank is satisfied with the progress ofthe borrower in carrying out the program, particularly on those aspectscovered in Schedule 5 of the SAL Agreement. Quantitative objectives werecited in Schedule 5 in a couple of fields. The emphasis, however, was onpolicies to achieve objectives, whether stated in quantitative or qualitativeterms. If during the course of implementation of the policies, it appearedthat objectives were either not being pursued, or were not going to beachieved, the reasons would have to be examined. If policies were implementedunsatisfactorily and the Government was unresponsive, the implication was thatthe Bank could refuse to permit further commitments and withdrawals of theloan proceeds.

(d) Subsequent SAL loans would also be conditional upon findings ofsatisfactory progress on the economic program, with specific items to beselected for special monitoring in subsequent loans on the basis of a newevaluation of critical policy areas.

12. The specific policy areas to be monitored explicitly under Sched-ule 5 covered:

(a) the export expansion program;

(b) adjusting the composition of public investment to new priorities;

(c) regulating the level of public investment;

(d) initiating a rationalization of the protective and incentive systemby carrying out studies (which were later elaborated under the SAL I Supple-ment;

(e) domestic resource mobilization measures, including interest ratepolicies, which would presumably lead to actions affecting the mobilization ofprivate savings and their more effective deployment;

(f) the size of the public sector deficit; and

(g) external debt management.

13. Some of the policy areas listed above may be regarded primarilyas supply side, and others as demand side measures; both are viewed as meansof restoring growth on a sustainable basis, limiting the size of the balanceof payments deficit and controlling inflation. In fact, interaction among theeffects of the measures falling under most of these policy areas is so broadthat the distinction between demand-management and supply-oriented measuressoon breaks down.

14. The agreement under the SAL I and the agreements under IMF standbyarrangements with Turkey are in most respects complementary, but are sometimesoverlapping. It is illusory to expect exclusive areas of interest. Thepractical arrangements are, however, for one institution to be primarilyresponsible for monitoring and for discussing with the Turkish Governmentcertain specific policy actions (such as the exchange rate [IMF] or the sizeand composition of the public investment program [IBRDI).

15. SAL I was approved in March of 1980. Only three months later athree year standby arrangement was concluded with the IMF. This standbycovered with much greater specificity many of the same areas as the SAL, andin some respects incorporated revisions in the Government's program for1980-81. During the course of 1980, major political changes took place inTurkey, culminating in military intervention in September. While the newGovernment confirmed its intentions to carry out the program and promoted itsarchitect to a deputy premiership, important changes were made in emphasis.Prospects for implementation, particularly in the field of taxation, interestrates and incomes policy, were greatly improved.

Growth versus Inflation

16. Turkey's January 1980 program was based on a realization thatthe difficulties of 1977-79 arose in large part from an attempt to maintain anunrealistically high rate of growth under adverse external conditions. Itwill be recalled that the list of major policy objectives contained in theFebruary 7, 1980 letter cited above included the statement: "Curbing ofinflation has more importance and greater priority than the attainment ofhigher growth rates in the current situation." The way in which these twoobjectives, inflation control and growth, would be balanced was not, however,made explicit in any medium-term program at the time of the SAL. The short-run aspects of this trade-off only became clear as the new agreement with theFund emerged in mid-year.

17. With respect to the medium-term, the Turkish authorities, in view ofmany prevailing uncertainties, did not and had not formulated an up-to-dateset of growth objectives at the time of audit. The Bank itself at the time ofSAL I spoke of a 4.2 percent average rate of growth between 1978 and 1985

instead of the 6.1 percent projected in the December 1979 Economic Report.l/This reduced rate was found by the Bank to be consistent with balance ofpayments constraints if substantial capital inflows and debt reschedulingcould be obtained.

18. With respect to the short run, a gradualist approach to the controlof inflation was already in process in early 1980. The July 1979 letter tothe Fund had envisaged "a slowing down of the rate of inflation but this canonly be achieved gradually." This gradualist approach was confirmed by theTurkish Government in the June 2, 1980 Memorandum given to the IMF on itseconomic and financial policies. The Government stated its objective for 1980to be a 2-3 percent rate of growth, with inflation to be brought down from anaverage annual rate of 65 percent in 1979 to a rate of 30-40 percent per annumby the end of 1980.

19. The President's Report on the SAL (Supplement) of October 30,1980, perhaps recognizing that positive growth was unlikely to be achieved in1980, mentioned a range of 0 and 2 percent, but continued to be optimisticabout growth in 1981, projecting it at 3 percent.

20. The actual results in 1980 differed somewhat but not in a basicway from these projections. On the general price level, success was achievedin bringing down the rate of inflation in the latter part of 1980, but theintended reduction was not realized until 1981 when the annual rate dropped toabout 35 percent in tfhe course of the year (see Table 1). For 1980, however,the year as a whole had an average rate of over 100 percent which was consid-erably higher than the rate envisaged under the IMF-supported monetary pro-gram. Growth in 1980 was below the original expectations of the TurkishGovernment, and GNP actually declined. As foreseen in 1980, GNP began toexpand in 1981, and the reduction in the rate of inflation accomplished inlate 1980 appears to have been consolidated in 1981 and will probably prove tobe the lowest rate of inflation in the past four years.2/

21. Cutting the rate of inflation by two-thirds from its peak whilesuffering only a one year interruption in growth, must be considered a sub-stantial achievementJ/ As noted below, credit must be given not only to

1/ See "Turkey: Postscript Special Economic Report" (Report No. 2918-TU,dated March 20, 1980).

2/ The latest estimates of output show a reduction in GNP at constant pricesby 0.5 percent in 1979 and 0.7 percent in 1980. A 4.4 percent growth isprojected for 1981 (see Turkish Government, Prime Ministry, Institute ofStatistics, "The Second Estimation of Gross National Product According toSix Months Figures", September 15, 1981).

3/ In fact, growth was also interrupted in the year preceding adoption ofthe January 1980 program.

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the effectiveness of the Government's anti-inflation program, but also to thesuccess achieved in mobilizing foreign capital inflow and in devising measureswhich had a fairly rapid response in terms of expanded exports and workers'remittances.

22. We must recognize that there probably remained in 1981 imbalanceswithin the Turkish economy which could generate a return to higher rates ofinflation, or a more difficult trade-off between inflation and growth. Thelong-term tendency of the economy toward unemployment and under-employment wasaggravated by the slow-down of economic growth, and there was little evidencethat the resumption of growth had yet been accompanied by a reduction inTurkey's high rate of unemployment. The readjustment in income shares whichoccurred in the period 1977-80 may also make it difficult, as noted below, toreconcile the objectives of growth, balancing external payments and inflationcontrol. Until a medium-term program has been formulated by the TurkishGovernment it will be difficult to judge how good the prospects are formaintaining a reasonable balance among program objectives.

23. Rather disturbing is the conclusion which appears to be emerging inrecent Bank staff appraisals of the Turkish economy that medium-and longer-term prospects for a significant reduction in the rate of unemployment are notbright. The Bank was perhaps justified in not pressing the Turkish authori-ties in the context of the present operation for a more precise time boundmedium term action program placed within a comprehensive economic framework.The agreement under SAL II also does not envisage the early formulation ofsuch a program, and the Turkish authorities themselves are unlikely to addressthis problem before a new five-year plan is drawn, perhaps to apply from 1984.

24. Each of the major policy areas subject to review under SAI. I isdiscussed below in order to see what light this experience sheds on the designof SAL I and its contribution to Turkey's policy formulation and implementa-tion. Progress in each of these areas, as noted above, was considered to beparticularly important in determining tranche releases.

Export Expansion

25. As explained in the Audit Report on Turkey's First Program Loan,that 1978 loan was geared to initiating a shift to export expansion._ During1979 a more active policy of exchange rate changes was initiated and othermeasures were taken. These measures were supported by an IME standby arrange-ment under which greater monetary discipline was followed. It was believed atthe time that the net result was to accomplish during 1979 a significant realdevaluation of the Turkish lira, thus establishing a price-cost frameworkconducive to export expansion.

1/ OED, Program Performance Audit Report, Loan No. 1627-TU (1978).

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26. A key objective of the January 1980 program was to introduce furtherpolicy changes and consolidate the real effective devaluation of the lira. Asthe Turkish authorities letter to the Bank stated, "The fulcrum of our devel-opment policy should be to correctly set the rate of exchange and to operatean effective exchange rate policy....''_1 By a real devaluation is meant anincrease in the Turkish lira equivalent of a unit of foreign exchange earningssubstantially in excess of the rate by which costs (and prices) increased inTurkey compared with Turkey's trading partners. While the test was by nomeans explicit in the agreement with the IMF, the real value of the Turkishlira in late 1970 and early 1971 seems to have been the historical standardselected for comparison. Successive devaluations taken during 1979 and 1980reversed the real appreciation in the Turkish Lira which had occurred between1971 and 1979 and re-established in real terms the 1970-71 value.1! In late1980 and early 1981 there appears to have occurred some backsliding in thereal results achieved, but with continuing concern being expressed on the partof the Fund and Bank, exchange rate policy became even more flexible after May1981 with competitiveness of exports being maintained roughly at the 1970-71real value. Moreover, other evidence accumulated that the private sector wasbecoming more optimistic concerning the maintenance of a price cost structureconducive to export expansion.

27. Additional measures were taken under the January 1980 export expan-sion program, some of which were monitored under SAL I. These measures aredescribed in the PCR (page 3). Among these measures, the Turkish authoritiesthemselves attached most importance to the right given to exporters to importmaterials and intermediate inputs without restraint and duty free under theforeign exchange allocation scheme. The actual administration of this measurewas not monitored explicitly under SAL I. Judging from discussions of theAudit Review Mission with the private sector this measure, aided greatly byincreasing availability of foreign exchange, appeared to be working. Majorattention under SAL I was given to arrangements for establishing export creditinsurance, priority access to credit for exporters, and institutional arrange-ments to promote exports. With respect to export credit insurance it appearsthat the revised interim arrangements which the PCR asserts were instituted inMay 1981, were not functioning. The PCR seems to attach undue weight to theforeign exchange retention scheme, the relative importance of which has in

1/ This emphasis given to exchange rate policy in this quotation from theFebruary 1980 letter to the Bank was further confirmed by discussionswith the Turkish authorities during the Audit Mission.

2/ This kind of standard has several weaknesses, particularly when the baseperiod extends back 10 years, a period during which structural changes ofconsiderable importance had occurred. It is not possible to quantify inTurkey (as in most other countries) the impact of changes in productivityin the major sectors on the competitiveness of domestic industry, agri-culture, and other tradeables, mainly because of the weak data base.

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fact declined because of the narrowing of spreads between the formal andinformal markets for foreign exchange. On the other hand, preferential accessof exporters to domestic credit, which was one of the items to be monitoredunder SAI. I has been of considerable importance. This is discussed below.

28. A recent Bank mission on Industralization and Trade Strategy re-viewed the various incentives to industrial exports and attempted to quantifytheir impact. It concluded that between 1979 and the first quarter of 1981,the real export exchange rate (combining the nominal exchange rate with theexport subsidy rate, with adjustment made for relative price changes athome and abroad), depreciated by 18 percent if foreign exchange premia wereincluded, and by 30 percent if these premia were excluded. These resultsreflect the increased incentives industrial exports received after January1980.

29, As noted in the PCR, exports (and workers' remittances), after anot unexpected lag, have been increasing at a rapid pace. This tends toconfirm the Fund's findings that price-cost relationships have moved in favorof tradeable goods and services, as suggested by estimates of movements in thereal exchange rate.

30. Under SAL I the adequacy of export expansion measures was to bejudged to be positive if real export growth averaged not less than 10 percentper annum between 1979 and 1983.!/ In the event, according to the Region,the volume of exports increased by 42 percent between 1979 and 1981, and thefour-year target was reached in two years. It should be noted that a quanti-tative test of export performance was not incorporated in the SAL II Loan.

31. It may, however, be useful in this Report to consider the durabilityof some of the factors accounting for the rapid expansion of exports.

(a) A key factor in stimulating interest in exports was the reductionin real domestic demand in 1980 and the modest growth in 1981, at the sametime that substantial excess capacity existed. As GNP growth accelerates,even if fiscal and monetary policies succeed in containing aggregate demand,the incentive to export may be reduced. On the other hand, increasing famil-iarity with foreign markets, particularly in the Middle East and the estab-lishment of better marketing channels will help to maintain some momentum.

(b) Regarding the permanence of the interest in exports, a more seriousquestion perhaps arises from the employment policy which has been applied bythe Turkish Government since September 1981. Private employers, as well asGovernment enterprises, are not permitted to lay off large numbers of workers

1/ This is the period specified in the Loan Agreement (Schedule 5, Article1). However, the letter on the economic program dated February 7, 1980(para. 6) refers to the period 1980-83, when the 1980 level of exportscould not have been known.

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without approval from the Government. In a period of declining domesticdemand for industrial products, this is a powerful factor forcing producers tocompete actively for export business. This approach may well have to besubstantially modified as policies are addressed more and more to increasingproductivity in the industrial sector, both private and public. Thus, unlessprice cost relationships move even more in favor of exports and import substi-tutes, i.e., in favor of tradeables against non-tradeables, it may becomeincreasingly difficult to reconcile policies designed to raise productivity inthe manufacturing sector with short-run employment objectives.

32. In the final analysis, the excellent record of export growthrealized in 1981 can only be expected to be consolidated if it derived fromlines of activity that conformed with Turkey's comparative advantage, thelatter being defined in a dynamic sense. Too many controls and specificincentives have been at work for such comparative advantage to emerge withoutambiguity. While certain lines of exports may still be handicapped by thepresent set-up of controls, others may be enjoying excessive subsidization,and it is possible that some of the recently expanded exports generate littleor even negative value added.l/

33. At the same time, the increase in workers remittances during 1980and 1981 may also be unsustainable. Analysis of monthly data shows a peak inFebruary 1980 following the enunciation of the January program and a muchhigher peak in mid-year on the deregulation and rise of interest rates and thefurther depreciation of the lira. More recent figures have been considerablybelow this latter peak which may have reflected in part a one-time transfer ofaccumulated savings in response to the higher interest rates, the more advan-tageous exchange rates and the introduction of the new savings scheme men-tioned in para. 13 of the PCR. On the other hand the opening up of freshsources of workers' remittances in neighboring petroleum countries is likelyto be an element of potential growth, but it is too early to reach firmconclusions on how these remittances will develop.

The Balance of Payments and Capital Inflows

34. An important aspect of Bank involvement in the structural adjustmentof the Turkish economy was the attempt by the Bank to contribute by itspresence, and to a lesser extent also by its lending, t6 the improvement ofcapital inflows into Turkey. Net capital inflows had sharply declined: by 34percent in 1978 and again by 33 percent in 1979, precipitated partly by an

1/ The Region disagrees with this assessment, holding to the view that theemerging export pattern conforms broadly with Turkey's comparativeadvantage.

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adverse swing in credits supplied by foreign commercial banks.l/ Simul-taneously arrears accumulated on foreign debt service and on payments foriMports which had to be drastically curtailed. Shortages in essential importsresulted in further reductions in production and exports. The Bank and theFund moved to increase their own disbursements to Turkey and, under the aegisof the OECD, three successive rescheduling of debt obligations were worked outboth with official and commercial creditors, in May 1978, July 1979 and July1980. This resulted in relief for the balance of payments of US$295 millionin 1978, US$924 million in 1979 (and about US$1.5 billion in 1980), butdeferred much of the service burden to the later 1980s. Bilaterally Turkey'sother creditors rallied also to help by pledges of extraordinary assistance inthe form of quick-disbursing program loans both under the auspices of theAid-to-Turkey OECD Consortium and outside the OECD framework.

35. There were initial delays in the mobilization of capital assistanceto Turkey. Less than half of the US$900 million pledged in 1979 under theOECD special assistance program was committed by end-1979, and only part ofthis could be disbursed. Things began markedly to improve in the latter partof 1980, and total disbursements under program aid from all sources rose fromUS$0.5 billion in 1979 to US$1.6 billion in 1980, and debt relief from US$0.9billion to US$1.5 billion. In all, capital inflows in 1980 (including debtrelief) aggregated US$3.4 billion or 5.75 percent of GNP as compared withUS$1.7 billion and 2.5 percent of GNP in 1979.1/ The level of caDital in-flows in 1981 was being estimated at a lower level than in 1980, but remainedquite high. It should be noted, however, that there is no indication that theforeign commercial banks increased their net contribution in Turkey.3'

36. The growth of exports and workers' remittances together with therevival and expansion of foreign capital inflows gave Turkey the means toexpand its imports which had fallen in real terms by 30 percent in 1978, andby another 7 percent in 1979. Since petroleum imports could not be muchsqueezed, the reduction in non-petroleum imports was even more severe,amounting to some 40 percent in real teras in 1978 and an additional 5 percentin 1979.

1/ See IMF, Turkey - Recent Economic Developments, August 27, 1981,(SM/81/180) page 70.

2/ IMF, Turkey - Review of Standby Arrangement, August 24, 1981 (EBS/81/180).

3/ SAL I had made improvement in external debt management a focus forperiodic review (Schedule 5, Article 2). The PCR describes (para. 11)the disappointing progress made toward improving the recording of thedebt data. In recent years external debt management has been exercisedlargely by Turkey's creditors without Turkey having to formulate a policyin this respect. As Turkey's creditworthiness improves, the importanceof an external debt management policy will increase.

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37. The improvement in the foreign exchange earnings and in capitalinflows that took place in 1980 made it possible to finance US$7.7 billion ofimports (or 13 percent of GNP) as compared with US$5.1 billion (or 7 percentin GNP) in 1979, but the import volume was some 27 percent below the unsus-tainable level of 1977. Imports in 1981 are expected to climb further toUS$8.5-9.0 billion, thanks to the greatly improved earnings from exports andworkers' remittances as described above, though the level of capital inflowsis likely to be lower than in 1980. The broad outlines of Turkey's balance ofpayments during the past three years are shown in Table 3.

Imports and Capacity Utilization

38. A key objective of SAL I and its Supplement was the provision offoreign exchange required for the importation of raw materials and intermedi-ate goods in order to increase the utilization of Turkey's productive capacityin industry and agriculture.l/ The proceeds of the loan were earmarked forthe financing of materials for the production of fertilizers, plant protectionchemicals, steel, and steel products, copper products, aluminum products,petrochemicals and chemical products.

39. No system was established under the loan for monitoring the utiliza-tion of capacity in the specified industries, or in industry (includingindustry supplying agriculture) at large. In the absence of information aboutcompleted investments in this period, the following interpretations may bevalid. Production of fertilizers increased greatly in 1980 and even more inthe first part of 1981, suggesting increased capacity utilization. Statis-tical indicators of iron and steel production in 1980 point to reduced capa-city utilization. No index of production is available which covers steelproducts, aluminum products, petrochemicals and chemical products. Scattereddata on chemicals suggest some improvement. However, given the widespreadoutbreak of work stoppages in 1980 the significance of production or capacityutilization changes would not be very clear, and interpreting these in termsof imports availability could not be conclusive.

40. With the overall increase in industrial output in 1981, now esti-mated to be 7 percent,2/ utilization probably increased. Data on capacityutilization collected by the Istanbul Chamber of Commerce do not go beyond thefirst quarter of 1981 and do not permit comparisons with 1979 or earlier

1/ This formulation is based on the wording of Item (c) of the Preambleof the Loan Agreement. Schedule 2 of the Loan Agreement refers toimproving the Borrower's "productive capacity in agriculture and indus-try" rather than increasing utilization.

2/ See "The Second Estimation of Gross National Product According to SixMonths Figures", Prime Ministry, Irstitute of Statistics, September 15,1981, already cited.

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years. Answers to questionnaires reveal that raw materials were considered aslimits to capacity utilization during late 1980 and early 1981, after the endof massive work stoppages, in chemicals and metal products but not in basicmetals. It can probably be assumed that as the implementation of the 1980import policies proceeded, increased availability of raw materials and inter-mediate products facilitated increased capacity utilization overall. Whetherthe industries selected for special treatment under SAL I achieved this resultcould not be determined on the basis of the available data.

41. The private sector got more than the share allocated to it ofthe proceeds of the loan under SAL I (a third of the total). However, thecondition that the government allocate out of its own resources US$30 millionfor imports of spare parts could not be adequately monitored, and inclusion ofsuch a condition in the loan documents was therefore of doubtful value.

42. Thus, SAL I was successful in contributing to the expanded flow ofimports in 1980 and 1981, and to the increased utilization of capacity in1981. Moreover, as a result of the favorable developments of exports andworkers' remittances in 1981 the Turkish authorities were able to reduce thecurrent account deficit, taking in stride the reduced foreign capital inflow.

43. The Audit Mission was unable to obtain from the Turkish authoritiesan analysis of the significance of these developments for the medium-term.Bank staff projections made at the time of the SAL I supplement showed acurrent account deficit being reduced relative to GNP but at a very slow pace.The PCR does not include an assessment of the significance of 1980-81 develop-ments for the balance of payments outlook over the medium term.

44. The Audit is, however, disposed on balance to agree with the PCRthat the growth of foreign exchange earnings in 1981 is a very positivedevelopment. If the final estimates of the balance of payments for 1981confirm the reduction of the current account deficit at the same time thatgrowth has been resumed, SAL I and its Supplement must be regarded as havingcontributed to an adjustment process which shows promise even if there aremany policy areas in which weaknesses persist.

Protection and Incentives Systems

45. As indicated in the PCR, major changes in the protection and incen-tives systems were not expected during 1980-81. In fact, some actions weretaken to liberalize imports but it has not yet been possible to appraise howthe reallocation of items to the various lists has precisely influenced theprotective system. Moreover it should be noted that the importation isprohibited of many items not included in any of the lists. No estimates,however, are available to enable an assessment of the importance of theseitems to domestic production.

46. In the letter to the Bank dated February 7, 1980, it was statedthat the Turkish authorities "would envisage that the rationalized protectionsystem will be in place by 1984." There were of course serious practical

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obstacles to an earlier and more radical changes in the protection system, notthe least of which was considerable uncertainty concerning the availability offoreign exchange. With this uncertainty, drastic changes in the administra-tive controls could only be embarked upon after a tariff reform had alreadytaken shape and if the authorities were prepared to accept a much largerdevaluation of the Lira, or even a market determined exchange rate. Someconsideration was apparently given later in 1980, during discussions with theIMF and the Bank, to earlier action in the field of tariff reform, but thearguments of the Turkish authorities seemed persuasive at that time. TheBank's Industrialization and Trade Strategy Mission of May, 1981 had furtherdiscussions with the Turkish authorities on these issues, having formulated aseries of proposals for early action with respect to the protective system.l/

Domestic Resource Mobilization

47. A critical area in domestic resource mobilization and aggregatedemand management is the change in the balance between public sector receiptsand expenditures covering both the consolidated budget and state enterprises.In Schedule 5 of the Loan Agreement it was agreed that one of the criteria forjudging progress achieved in carrying out the economic program would be anassessment of the "adequacy of measures to increase domestic resource mobili-zation including (i) the objective of eliminating overall deficit financing inthe public sector in 1980..." (para. 3). Discussions between the AuditMission and the parties concerned revealed that this objective of eliminatingthe deficit which was not precisely defined in the Loan Documents, was prob-ably impracticable even on the basis of optimistic assumptions about taxreforms and expenditure controls as conceived at the time and was probably notconsistent with the gradualist approach to inflation control incorporated inthe 1979 agreement with the IMF. Many of the measures taken during 1980,including the devaluation and loosening of controls over prices, involved''corrective inflation." A fairly substantial increase in the price level wasnecessary to improve price relationships within the economy and between Turkeyand the outside world, taking into account pressures for increases in moneywages which could not be resisted during most of 1980. Complete eliminationof the public sector deficit, or even reducing public sector domestic borrow-ing to zero, could probably have been accomplished only by accepting muchlower levels of output and employment. By the time the June 1980 agreementwith the Fund was signed, the Government's program for 1980 involved a limiton Central Bank lending to the public sector, including State Economic Enter-prises, a figure which implied a very substantial public sector deficit.Since, however, no consolidated public sector accounts existed for 1980,reference to any target for public sector deficit in the Loan Agreement waspremature. To this day the Government of Turkey does not construct consoli-dated public sector accounts on a regular basis. Such a consolidation isnecessary if public sector resource mobilization were to be defined in terms

1/ The report of this mission was published on February 18, 1982 (ReportNo. 3641-TU).

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of public savings. While an increase in public sector savings is an objectiveof Government policy, the Government has no quantitative targets for publicsavings. Moreover, monitoring of results in this field requires substantialchanges in the way in which actual receipts and expenditures are reported.

48. Included in the Government's February 7, 1980 letter is a statementdealing with public investment, which is also relevant for domestic resourcemobilization: Public investment is to be contained "in 1980 and future yearsto available fiscal resources." The same statement is echoed in paragraph 4of Schedule 5 of the SAL I Loan Agreement. Performance reviews have failed togive a precise definition to this objective.

49. As noted above, it is by no means easy to quantify under presentcircumstances targets for public sector resource mobilization. The Fund'sapproach incorporated in the standby agreements with Turkey is indirect:limiting the increase in Central Bank lending to the public sector, and thusencourage the authorities to take measures to raise public savings, and toincrease financial resources in the banking system and in the hands of thepublic, which can be tapped for public sector borrowing. Such targets, whichif violated, may lead to suspension of drawing rights, are arrived at in abroad monetary framework and are constructed in the light of the outlook forthe "consolidated budget" and the accounts of the State Enterprises. Themonetary framework in which the ceiling on public sector borrowing from theCentral Bank is set, involved projecting a reasonable rate of growth for money(including broad money M2) in relation to projected increases in prices andGNP, and the limit on net domestic assets involved also a forecast of absorp-tion through the balance of payments. In a period when inflationary expecta-tions are themselves to be influenced by the anti-inflation program and whensubstantial interest rate changes are being made, changes in demand for moneybecome very difficult to predict. This has posed special difficulties forthe application of the monetary benchmarks adopted by the Turkish Government,with Fund (and Bank) support.

50. Partly to overcome this problem the understandings on Central Bankasset limits contained in the 1980 agreement in the framework of the 3-yearstandby of June 1980 were set only six months ahead. The limits on theincrease in net domestic assets and in credit to the public sector must bereconciled with the outlook projected only on an annual basis for the con-solidated budget and the accounts of the State Economic Enterprises, takinginto account the measures underway to restrain the size of their deficits, andthe availability of credit from external and other domestic sources. Bank andIMF reports on Turkey have not dealt explicitly with the implications of thelimit on Central Bank financing for the availability of total bank credit tothe private sector.

51. In this respect, neither the Fund nor Bank reports on Turkey havetried to pierce the monetary veil and examine in depth the impact of monetarypolicy in those parts of the private sector of the economy most sensitive tocredit conditions, including impacts via credit availability and interestrates. We shall return to this subject below.

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52. During 1980 credit limits to the public sector were observed butonly after limits for the end of the year were adjusted upward in the fall of1980. This readjustment which applied also to overall credit limits, rose inpart from the unexpected high cash deficit of the consolidated budget, whichincreased from 2.1 per cent of GNP in 1979 to 4.3 percent in fiscal 1980-81(ending February), and even more from the financing requirements of the StateEconomic Enterprises, which increased from 7.2 percent of GNP in calendar 1979to 7.7 percent of GNP in 1980. If progress in resource mobilization isdefined in terms of reducing total financing requirements relative to GNPthere was no progress in 1980.

53. There were extenuating circumstances, however. Financial require-ments of the SEEs were greatly increased by inventory accumulation. Itappears that the 1980 budget program did not foresee adequately the need torebuild stocks of petroleum products, which had been reduced to very lowlevels during the 1979 exchange shortage. Moreover, with the unanticipateddecline in GNP and domestic demand, stocks of other products, particularlybuilding materials, increased. Even if these factors had been foreseen it isdifficult to see how they could have been countered by effective action in thecircumstances prevailing. It proved impossible during 1980 for the Governmentto obtain the enactment of any major tax measures. In fact, governmentrevenues as a percentage of GNP declined by almost 4 percentage points from1979 to 1980, partly because of the (unexpectedly) negative effects of accel-erated inflation on tax revenues.

54. If progress in domestic resource mobilization is defined in terms ofthe movement of public savings, the picture in 1980 was better.L/ The primaryfactor in this was the reduction in the operating losses of SEEs, followingupon the long postponed price increases which the SEEs were authorized tomake. While tax receipts lagged, as noted above, some success was achieved inholding down wage increases and in reducing the volume of a wide variety ofmiscellaneous transfers. Thus, the decline in tax receipts as a percent ofGNP was probably associated with a similar, if not greater decline in currentexpenditures included in the consolidated budget. SEEs' current accountdeficits were reduced also by the wage policy in effect during 1980.

55. Thus, there was a mixed picture in 1980 with respect to progresson domestic resource mobilization via improvement in public sector finance.

56. Actions in connection with the 1980-81 budget, formulated in late1980, and actions since taken, may provide a basis for a more positive judg-ment, but this is by no means assured. The 1981 Government program for SEEsshows some but not significant improvement in reducing losses. (See Table 4).

1/ According to unofficial estimates by SPO, public savings increasedfrom 3 percent of GNP in 1979 to over 5 percent in 1980. See table onpage 20, November 1981 draft of the PSIR Mission. It is difficult toplace much confidence in these estimates because their basis is notknown.

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While sales proceeds in 1981 may be increasing, the planned pace of furtherprice adjustments in those sectors still subject to control is scheduled to beslow, and in the decontrolled sectors appears to be lagging. Managers of SEEsare on the whole still reluctant to take independent decisions. Not all ofthe related Ministries are encouraging rapid action. As for the consolidatedbudget, the picture is more favorable: control over wage increases and thetax changes cited in the PCR are likely to produce a significant increaseduring 1981 in public savings from this source.

57. The outlook for a reduction in the overall public sector deficit in1981 was favorable. A further increase in stocks of petroleum products wasnot foreseen. However, at the time of the audit mission, public sector fixedinvestment expenditures were expected to increase in constant prices by about9 percent instead of stabilizing, and would represent an even greater increasethan was implied in mid-1981 in the Government's letter to the IMF.l/ Onthis basis, and barring the possibility of foreign project financing, thelimits during 1981 on Central Bank lending to the public sector will probablyonly be fulfilled if there is a further build-up in arrears to the privatesector, or by otherwise borrowing more within Turkey.

Private Credit and Mobilization of Private Savings

58. The implications of the 1980 and 1981 fiscal program for the avail-ability and cost of credit to the private sector are not fully discussed inthe PCR.

59. The agreements under SAL I did include a joint review of adequacyof measures to increase household savings and time deposits and a review of afinancial sector study. No action program in this area was defined, but rapidprogress was not expected. The PCR is correct in stating that the actionsdescribed exceeded expectations.

60. The establishment of positive interest rates on the deposit sideinitiated in June 1980, was a forward step and has led to a rapid expansion ofsavings in the hands of financial intermediaries, as noted in the PCR. It isnot at all clear to what extent have these positive deposit interest ratesaffected private savings. There is little hope of reaching conclusions on theimpact of these and other measures on household consumption and savings, ascontemplated in SAL I President's Report (page 4), because of the lack ofreliable estimates.

61. In 1979 and to a lesser extent in 1980 the volume of credit tothe private sector declined. (See Table 5). The growth of financial savingsin the hands of financial intermediaries in response to the establishment of

1/ The 9 percent figure is taken from the PSIR mission report of November1981. However, the President's Report on SAL III (Report No. P-3273-TU),dated May 7, 1982, p. 28) shows an estimated increase of 5.7 percentonly. See also footnote 1 to paragraph 68 below.

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positive deposit rates made it possible to reverse this decline. In the yearending May 1981, the latest month for which data were available to the AuditMission, the volume of credit to the private sector expanded at a rapid rate.Thus the Government during the latter part of 1980 and the first part of1981 was able to draw increasing financial resources from the banking systemwithout unduly depressing private investment, insofar as the availability ofcredit is concerned.

62. There was still apparently a squeeze on private investment, result-ing probably from declining profits and other factors reducing internal cashflow generation and increasing non-investment uses for funds. One of thesefactors is the increasing public sector arrears to the private sector. Nodata are yet available to confirm these impressions which are based on dis-cussions with the private sector, including bankers and borrowers.

63. An additional cause for declining profit margins on existing invest-ments, which also reduces the profitability of new investment, are the highinterest rates on the lending side, resulting from the new policies. Theserates were adjusted on July 1, 1980 and again in February 1981.1/ Short-termgeneral credits thus carry in 1981 a rate of 36 percent, compared with 21percent before July 1, 1980, medium-term general credits 38 percent (22percent) and long-term credits 41 percent. To these rates must be added a 15percent levy accruing to the Differential Interest Rate Rebate Fund and a 15percent financial transactions tax. When these taxes and bank commissions aretaken into account, and with some allowance for compensatory balances whichborrowers are required by lenders to deposit, effective lending rates to theborrower even on short-term approach 60 percent during most of 1981.2/ Asinflationary expectations came down during the course of the year and assumingthe inflation rate for a year ahead to be 35-40 percent, this implies for thesecond half of 1981 real interest rates of 12 to 17 percent. Borrowers,needless to say, are greatly concerned with the high cost of borrowing,accustomed as they were to negative interest rates. There is, however, noquestion that rising interest rates have produced declining profits and aredeterring private investment. New fixed capital investment in industryis in any case limited because of excess capacity. The high interest ratesaffect the cost of working capital and the profitability of investment in

1/ Interest rates on the deposit side in Turkey though "deregulated" ortheoretically free, are in fact determined by a gentleman's agreementamong the banks, subject to direct and indirect influence of the Govern-ment. On the lending side, the influence is not only in the form of"imoral suasion". There is a complicated system of special rediscountrates as well as taxes and levies which are quantitatively important indetermining the final rate.

2/ Calculation of real interest rates on longer-term loans is more difficultbecause expectations of inflation on the part of borrowers (and lenders)are less firm. As for the short term (1 year or less) borrowers seem toextrapolate recently prevailing rates of inflation.

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residential buildings and other construction. Some restraint on investment inbuildings is probably desirable, but the present high real rates of interestmight, if continued, unduly depress construction activity. Since marketforces are operating only to a limited extent in setting interest rates, self-correcting forces cannot be depended upon to adjust money rates of interest.

64. The situation is complicated, however, by the complex system ofpreferential interest rates, both short- and medium-term available to a widearray of borrowers. Preferential borrowers, particularly those eligible forexport credits, continue to enjoy negative interest rates; these implicitsubsidies are financed in part by levies imposed on the general borrowers.l/There is thus a problem of avoiding unduly high real interest rates for thegeneral borrower while providing adequate implicit subsidies to favoredborrowers, such as exporters. This is a new problem for Turkey. In theprocess of liberalizing the interest rate system, increasing borrowing by thepublic sector, whether from the central bank, commercial banks, generalpublic, or suppliers has led to a squeeze on private sector borrowers. Thissqueeze is perhaps temporary, but the outlook for public sector financing in1981 does not guarantee it and the squeeze could become an even greaterproblem for the future.

65. Taking into account the size of public sector deficits in 1980and 1981 and other policies influencing the cost and availability of credit tothe private sector, it must be concluded that while the results for 1981 arestill not in, the measures taken during the period of disbursement of SAL Iand its Supplement to increase domestic resource mobilization were not fullyadequate in that they had some serious side effects on private investment,though the inflation was certainly reduced.

66. Under SAL II, the Loan Agreement (Schedule 4) provides for a con-tinuing review of actions in the field of domestic resource mobilization, withspecial attention to tax policy (value added tax) and tax administration, bothof which are important for resource mobilization through the public sector.No quantitative framework is established for this review, however. Explicitattention is not given to the possible crowding out effect on private invest-ment, nor is there any mention of the new danger of excessive positive realrates of interest.

Level of Public Investment

67. Harmonizing public investment in 1980 and 1981 with availablefinancial resources, as called for under Schedule 5, Article 4 of the LoanAgreement, has two sides: resources, discussed above, and the investmentlevel. The PCR concludes (para. 15) that "overall the level of publicinvestment had been tailored to available resources, with a substantial realdecline over the 1979 level."

1/ During much of 1981, the interest cost to borrowers of export credits was19 percent, taking into account their special status under the financialtransactions tax, interest equalization levy, and interest rebate system.

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68. It is not clear that the substantial real decline in the level ofpublic investment in the last two years, has in fact occurred. Public fixedcapital investment is estimated by the SPO to have declined by 2.2 percent in1980, but stock increases in public enterprises were very large.!/ In 1981,there were indications that fixed capital investment in the public sector wasincreasing by much more than the decline which occurred in 1980.2/ Thus,fixed capital investment may well have increased significantly since 1979.Moreover, it appears to be on a rising trend, threatening to jeopardize theGovernment's program objectives. This is the lesson which can be drawn fromthe report of the Public Sector Investment Review Mission.

69. The central authorities in the Turkish Government have attempted intheir annual programs to put a lid on fixed public investment, but the resultsare ambiguous. The small decline in fixed public investment in 1980 may haveresulted less from a conscious process of tailoring investment to availableresources, and more from the unexpected effects of a higher rate of inflation.Such an interpretation is consistent with the finding that "budgetary cutshave tended to be made across the board, rather than by selecting the highpriority projects and more fully funding them."13 In 1981, evidence wassupplied of projects of doubtful economic merit being dropped or receivingonly nominal allocations. The 1981 annual program reduced the total number ofprojects from 9,000 to 8,000, and several very large projects were explicitlydeferred. The fact that fixed investment was nevertheless rising at a rapidrate in 1981, is cause for concern. Moreover, according to the PSIR missionreport, the projects currently in agency pipelines which were sanctioned bybeing given some recognition in the 1981 annual program, if actually imple-mented according to a reasonable schedule, would require over the next threeyears, resources which are almost twice as large as those utilized in 1980.

70. The State Planning Organization has not laid down meaningful guide-lines for the preparation of agency plans. As described by the PSIR Missionmany investing agencies are still planning their multi-year programs on thebasis of GNP growth rates which the central authorities recognize to be

1/ As late as October 1980 at the time of presenting to the ExecutiveDirectors the SAL I Supplement, the Government's figures for 1980 implieda fall in public investment of around 14 percent (P-2888TU, p. 15).There, it was further observed: "The effective constraint on totalpublic investment continues to be IMF Standby's limit on the increase inCentral Bank credit to the public sector."

2/ As mentioned earlier (para. 57), the PSIR mission reports a 9 percentincrease in 1981, based on provisional data. Later, the President's

Report on SAL III (May 1982) showed an increase of estimated public fixedinvestment of 5.7 percent in real terms in 1981 after a decline of 2.4percent in 1980.

3/ Turkey: Public Sector Investment Review, (dated December 7, 1981),Report No. 3472-TU, Volume I, para. 6, page iii.

- 22 -

unrealistically high - over 8 percent. Until the investing agencies them-selves scale down their investment programs the pressures for increasingpublic investment are difficult to resist.

71. An official consolidated public sector investment program with afinancing plan was not insisted upon as a precondition for SAL I. No under-taking to prepare such a program was included in SAL II either. However, inearly 1980, the Turkish Government did request the Bank to review the coun-try's public investment program in the context of its new economic policiesand long-term growth potential. Discussions with the Turkish Government onthe mission's draft report were held in October 1981.

72. The above comments draw heavily on the draft report which takesthese discussions into account. It is still not clear whether the Turkishauthorities will accept one of the major conclusions of this report, namelythat public investment in the period 1982-85 should not on average much exceedin real terms the level recorded for 1980.1/

73. The Audit Mission discussed with the Turkish authorities the obsta-cles to preparation of a multi-year program. The obstacles cited were these.Such a program cannot be kept secret. Such a program, which would have to berestrictive rather than expansive under present circumstances, would triggerstrong public pressures from regions and groups, and thus by its very compre-hensiveness would encourage the consolidation of the opposition to theGovernment's program from many different quarters.

74. There is some merit in this argument. But this also applies to theannual investment programs, which, however, have been found useful and neces-sary. The political advantages of keeping low priority projects on the books,with small annual appropriations assigned to them, are likely to be soon lostas their advocates come to realize what is happening.

75. The fact remains that in the absence of a multi-year investmentprogram and financing plan, it is going to be extremely difficult for theauthorities to tailor investment to available resources, for the Bank toassure itself that there is a reasonable prospect for success, and for theFund or Bank to monitor performance in the interim.

Priorities and Composition of Investment

76. The Turkish authorities had further agreed under SAL I to reviewwith the Bank "the adequacy of measures to harmonize public investment" with

1/ According to the President's Report on SAL III (Report No. P-3273-TU,dated May 7, 1982, para. 57) the level of public fixed investment pro-grammed for calendar 1982 is 6 percent greater in real terms than in1981. However, the statement of development policy by the government(dated April 24, 1982) envisaged a decline in the share of public invest-ment in total investment over the period 1982-85 owing to the expectedrecovery of private investment.

- 23 -

"the Borrower's investment priority criteria that: (i) existing productivecapacity is used efficiently and fully and critical bottlenecks removed; (ii)on-going projects be completed which, with modest additional resources, can beexpected to yield speedy returns; and (iii) new productive projects stressingexports and employment generation."

77. The generally favorable judgment on a satisfactory pursuit of theseobjectives expressed in the PCR is subject to some reservations. The follow-ing comments are based on the PSIR Mission Report.

(a) It seems that neither the 1980 nor 1981 annual program exhibits aspecial contribution to productive employment generation any morethan earlier programs had done in the past. It is moreover,doubtful that in a period when investment must be severely containedthere could be much scope for new projects with a potential for jobcreation, such as construction of roads in rural areas or otherinfrastructure projects in urban areas.

(b) The same observation applies to new productive projects stressingexports. There are no new projects in the 1980 or 1981 programspecifically designed for this purpose. The PSIR mission simplynotes that it is difficult to relate the 1981 public investmentallocations to a reorientation of the economy toward exports. Byand large the directly productive projects included in the publicinvestment program appear to have little prospect for contributingsignificantly to export growth at the present real exchange rate.

(c) The removal of critical bottlenecks has been a criterion appliedin practice in the screening of the investment programs for 1980-1981. It is not possible to measure the extent to which significantimprovement has taken place in this respect. The proportion allo-cated to energy and mining projects is high. It is not clear,however, that a higher proportion of fixed public investment isbeing assigned to removal of bottlenecks than in 1979. In electricpower, allocations for urban distribution facilities have beenwoefully inadequate from the point of view of removing bottlenecks.Many large hydropower projects with very long gestation periods andof doubtful economic priority are in the program. In industry"rehabilitation" investments with high yields and low gestationperiods are assigned low priority. Again, significant amounts areallocated in the 1981 program to large manufacturing projects whichare at an early stage of execution and which are of doubtfuleconomic merit. The share of manufacturing (including refineries)in total public investment increased from 26 percent in 1979 to 29percent in 1980 but appears to be declining in 1981. However, thePSIR mission, after examining major manufacturing projects includedin the 1981 annual program, concluded that allocations could wellhave been reduced by 20 percent, taking into account the Govern-ment's own priorities. Governnment policy with respect to the futureof public investment in manufacturing would be clarified by earlyformulation of a multi-year public investment program.

- 24 -

78. Thus, based on the findings of the PSIR mission and its recent dis-cussions with the Turkish authorities, it is not easy to accept the PCR's viewthat progress on rationalizing the investment program has been adequate.

Incomes Policy

79. A memorandum of the Government of Turkey on Its Economic and Finan-cial Policies dated June 2, 1980, which was attached to the Minister ofFinance's letter to the IMF, recognized that "wage settlements needed to be inharmony with the basic stabilization policy measures that are being followedby the Government." While understandings with neither the Bank nor IMF havecovered explicitly the area of wage policy its importance should be recog-nized. The wage policy area has been a source of strength since September of1980 when the new Government reactivated the High Arbitration Court andreinforced its powers to hand down wage determinations that are mandatory forthe public sector (SEEs included) and act as guidelines for the privatesector. One of the major reasons for success in winding down the rate ofinflation in 1981 has been the decisions of the Court.

80. Nominal wage increases in 1981 were to be contained within a rangeof 25 percent (civil servants) and 40 percent. In its deliberations, theArbitration Court has taken into account the impact on incomes from wages ofthe tax relief arising from the tax reform. Some of the success on the wagefront has been attributable to the tax change, which permitted real disposableincome to be maintained and in some cases increased, while nominal wage ratespcid by employers (including Government) increase at a greatly reduced ratecompared with 1980.

81. In the absence of better and more up-to-date data on wages andsalaries, including supplementary wage costs and fringe benefits, it is notpossible to analyze the actual impact of wage policy in 1981. It does appearthat the real disposable income of wage earners had been declining in previousyears.!/ Some decline was probably necessary to bring the balance of paymentsunder control. In 1981, there was at least a temporary respite. To theextent that tax policy is effective in distributing the tax burden moreequitably in terms of ability to pay, wage and salary recipients may bepersuaded to accept very slow improvement in their real disposable income infuture years, despite the decline which occurred in 1977-80.

82. Under SAL II, one of the policy areas to be the subject of specialreview is the adequacy of the 1981 tax reform, which was designed particularlyto increase the income tax burden on non-wage income and to bring about a moreequitable distribution of the tax burden. It would be useful to include insuch a review the interrelation between the effectiveness of the tax reformand wage policy even though these interrelated policy areas were not identi-fied explicitly as subject to review.

1/ This decline may be inferred from data presented in IMF, Turkey - RecentEconomic Developments, SM/81/180, August 27, 1981, p. 7.

- 25 -

Reforming the SEEs

83. The SEEs have for long been identified as a source of weakness inthe Turkish economy. Often occupying monopoly positions in their markets,they command considerable resources, use them with less than optimal effi-ciency and end up with financial claims on the Central Bank and the budgetwhich have tended to be inflationary. The President's Report on SAL I speci-fied the pricing policies of the SEEs as a key element in Turkey's recoveryefforts supported by the loan. It stated that under-pricing of industrialgoods produced or distributed by the SEEs had resulted in substantial losses,amounting to 4.1 percent of GDP in 1979, and recommended the encouragement ofSEEs to improve productivity and management and generate own resources tocover their investment program. The report also described considerableprogress achieved on pricing prior to the Loan and asserted that with a fewexceptionsl/, the "SEEs are now allowed to fix their own prices depending onmarket prices". Prices of SEE products and services had been kept low bypolicy intended to keep down the cost of living and to contain inflation.This went hand in hand with government injunctions to SEEs to create (oftenunnecessary) employment, and with frequent intervention by the government inthe everyday running of these organizations including changes in management.

84. Although the need for reforms in SEEs had become widely known,implementing such reforms had lagged owing to political and institutionalobstacles. Short of the government divesting itself of the SEEs to theprivate sector, opportunity for improvement lay in greater autonomy of manage-ment and pricing, inducing them to raise their efficiency by exposing them tomarket forces, relieving them from the obligation to absorb labor and ulti-mately reducing their need to seek budget support and Central Bank credit.Neither SAL I nor its supplement addressed these issues, except to the extentthat they were mentioned as reforms to be carried out under the January 1980economic program to which SAL gave general support. More specifically, SAL Iapproached SEE reform from the point of view of resource mobilization andreduction of public sector deficit financing. Both these aspects of thereform have already been dealt with under the sections on resource mobiliza-tion and public investment.

85. As mentioned earlier, thanks to the product price increases sinceJanuary 1980, the financial position of the SEEs gradually improved. Other-wise, little seems to have been accomplished by way of increasing theirefficiency of operation. It was not until SAL II, however, that SEE reformbegan to be addressed directly under SAL and Schedule 4 of the Loan Agreement(dated May 15, 1981) referred to adequate progress being necessary on delega-tion of authority within SEEs, multi-year contracts for their managers and

1/ The exceptions were prices for "coal/lignite, railway and shippingfreights and power tariffs for aluminum and ferrochrome production"(page 11).

26

.1 cies .iat contained their employment, and made particular mention of thenecessity to review implementation n selective SEEs".l/

Ill. BRC.ADjER lI-iPLICATIONS

86. The preceding section commented on the major policy areas includedfor review and action under SAL I. While the audit finds the level ofachievement in these areas, and the attention given to them, somewhat mixed,it concurs with the positive findings of the PCR on overall progress. Thepreceding analysis, however, also suggesLs that SAL I was based on insuffi-cient economic and sector work and was not sufficiently well designed tocontribute to Turkey's continuous policy formulation and implementationprocess. It did improve the Bank's dialogue with Turkey on macro-economicissues, and some of the design deficiencies were overcome by Turkey's subse-quent agreements with the Fund (also see para. 93).

Follow-up and SAL II

87. Experience under SAL I and its supplement should be taken intoaccount in the design of subsequent loans, in the selection of areas subjectto special review, and in defining the content of the review. The precedinganalysis in part II suggests that the lessons of that experience have not beenadequately reflected in SAL IIo Schedule 4 of the SAL II Loan Agreementoutlines the matters subject to review in only very general terms, as follows:

"The Borrower and the Bank shall review:

1. The adequacy of policies and legislative and administrativemeasures for export promotion, import liberalization and domesticresource mobilization, in particular with respect to tax reforms:(a) progress in enacting a law providing for a value added tax to beintroduced during the Borrower's fiscal year 1928; and (b) progressin establishing adequate procedures for tax collection, especiallywith respect to personal and corporate income and agricultural salestax.

2. The adequacy of progress in reforms of State Economic Enter-prises, in particular (a) by September 30, 1981, (i) carrying outthe reforms decided in principle by the Council of Ministers in

1/ A full discussion of recent reforms of the SEE system, as they apply tomanufacturing enterprises, is contained in World Bank, Turkey-Industri-alization and Trade Strategy, (Report No. 3641-TU, dated February 18,1982), Chapter 6. Apart from higher prices, the report describes changesin investment allocation and finance, personnel policy and the "style ofrelations between government and individual enterprises." The overalljudgment of these changes, however, is cautious: "The significance ofthe changes effected so far is still to be seen." (para, 6.85).

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February 1981, and (ii) decision of the Council of Ministers oflegal changes permitting greater delegation of authority within SEEsand multi-year contracts for their managers; and (b) carrying outthe decree No. 8/2022, dated November 29, 1980, with respect to thenumber of authorized positions and new hiring. Progress will bereviewed inter alia by examining the implementation in selected SEEsof the measures referred to under (a) (i) and (b) hereof.

3. The adequacy of energy policies, in particular pricing ofpetroleum products at levels comparable to international marketprices."

88. In view of the preceding analysis of the resource mobilization prob-lem via the public sector, it is not very helpful simply to refer to "progressin enacting a law providing for a value added tax to be introduced during theBorrower's fiscal year 1982" and "progress in establishing adequate proceduresfor tax collection, especially with respect to personal and corporate incomeand agricultural sales tax."

89. Revenue measures of these types should be defined in terms of yield,and are best formulated in terms of a medium-term public sector financialprogram. It is difficult to see how discussions during the review process cancontribute very much in the absence of explicit revenue targets, preferablyfitting into the broader framework.l/

90. Also included for special review under SAL II are "policies andlegislative and administrative measures for export promotion and importliberalization." In view of the success already achieved on the export sideit is perhaps justified to be content with such a broad expression relating toexports.

91. The same cannot be said about import liberalization and changesin the protective system, on which no meaningful policy actions were defined.It was apparently not possible to schedule the Bank's Industrialization andTrade Strategy Mission so as to take account of their recommendations indefining the content of SAL II.

92. Neither the volume nor the composition of public investment wasincluded for special review in any form under SAL II. The reason for thisomission is not clear. A plausible explanation may lie in the inadequa-cies of the reporting system covering public sector investment (and itsfinancing) and the fact that public investment was not under control.

1/ While not analyzed in the President's Report on SAL II, a specificincrease in revenues as a percentage of GNP is given as a target for 1982in the Statement on Development Policies attached to the Deputy PrimeMinister's letter of February 20, 1981.

- 28 -

93. Several of the above deficiencies are related to the timing ofSAL II: just over a year after approval of SAL I and six months after the

Supplement. The gap between SAL I and II was not long enough to enableidentification, development and introduction of the lessons of one into thedesign of the other.

94. There are important aspects of the Government's economic programas it has been modified and refined in 1980 and 1981 that are explicitlytreated neither in the PCR nor in the above analysis. Probably the mostimportant matters not covered are agriculture and energy. Both of these areasreceived attention in the discussions leading up to SAL II, but it was notpossible for the Audit to provide useful comments in these areas.

Comments on Policy Dialogue

95. Given the fundamental purpose of structural adjustment loans andparticularly the importance attached to securing an improvement in the balanceof payments over the medium term, there is no reason to quarrel with the focusof the Bank interest. Yet, the above analysis of SAL I does raise the ques-tion of how effective the Bank has been in contributing to the formulation andimplementation of Turkey's economic program.

96. Prior to initiating non-project lending in Turkey, the Bank waslending actively in most major sectors and supported its operations by eco-nomic reports at regular intervals. However, the nature of the relationshipwas such that the dialogue on economic policy was not very constructive andoften ended in agreement to disagree. Political instability in the countryadded to the difficulties. There were periods when disagreement betweenTurkey and the Bank was intense enough to lead to the postponement of some oreven all lending operations.!'

97. These difficulties in relationship between the Bank and Turkey andthe strength of resistance to some of the advice that the Bank had offered wasonly partly attributable to different substantive positions. Resistance topolicy change, even when the need for change is evident, is also strengthenedwhen the country can enjoy virtually unconditional external support in largevolume either from private lenders abroad or/and foreign governments followingshort-term political objectives. Both of these elements appear to have beenpresent in Turkey from 1974 to 1977.

98. A by-product of this external situation and its impact on theattitudes of the Turkish authorities was not only the adverse effect on theproductivity of the policy dialogue but also on the nature of the Bank'seconomic work. While the Bank's economic work was of reasonably high quality,

1/ There were many cases where the dialogue on economic policy relating toproject lending was not productive either, and this is illustrated in theOED report, "Sector Operations Review: The Industries and DFCs Programin Turkey", Report No. 3077, dated July 18, 1980.

- 29 -

it tended to be long on generalities and short on specifics. This has been ahandicap in the formulation of more precise and meaningful tests for evaluat-ing progress under SAL I, but was being rapidly corrected in 1981 as a resultof the work of the special missions described above.

99. As outlined in the preceding paragraphs, an analysis of the designof SAL II still raises some questions as to the efficacy of the Bank's policydialogue in its SAL lending. However, the external milieu is quite differentfrom what it was earlier in the seventies. The area of common agreementbetween the Bank and Turkey on basic policy orientation is now broad and isgrowing. The Turkish authorities are aware of the fact that bilateral exter-nal assistance on a non-project basis and on concessional terms is unlikely tolast very long and is subject to review.

100. The Bank's lending program in Turkey has also been expanded andreshaped to accommodate and support the structural adjustment process. To

date, operations subsequent to SAL I have been divided between project andnon-project loans roughly in the ratio 2:1 by value. All the project opera-tions have been in the productive sectors of agriculture and industry as wellas energy development, with stress being placed through the selection of theprojects and their design on labor absorption, export promotion and rationali-zation of industrial capacity. Moreover, lending to SEEs has been tied tospecific reforms, and where necessary technical assistance has been provided.

Bank-Fund Collaboration

101. Bank-Fund Collaboration was necessarily close during 1980-81, withthe Fund taking the lead in discussing exchange rate and aggregate demandmanagement issues with the Turkish authorities, and the Bank taking the leadin discussion on public investment, trade policy and the protective system,and energy. A real effort was made to divide priority areas between the Bankand Fund during the SAL process. Coordination has been facilitated by thestaff of each institution joining the missions of the other. In this way,much has been accomplished in making both Fund and Bank assistance to Turkeymore effective.

102. The character of the collaboration between the IMF and the Bank isinfluenced by the Fund's reliance on Central Bank credit ceilings for monitor-ing progress in the implementation of various policies affecting the balanceof payments, the central government budget, the SEEs and the private sector.While the monetary program developed by Turkey in cooperation with the IMF isformulated in a broad perspective involving both monetary and income analysis,and is thus used as a framework for a wide array of measures including thoseoutside the monetary field, Central Bank monetary targets seem to take on alife of their own. For example, agreement on specific policy measures on theside of public expenditures and revenues can be part of the general policyunderstanding with the Fund, and thus subject only to indirect monitoring. Inaddition (or alternatively as the case may be) this can be incorporated in theletter to the Bank or written in the Loan Agreement and then directly moni-tored by the Bank. In Turkey there were instances where neither institution

- 30 -

was successful in getting these measures defined with sufficient precision.Besides, there was the temptation to regard agreement on the magnitude ofCentral Bank credit expansion to the public sector as sufficiently control-ling, and not requiring firm agreement on policies designed, say, to increasepublic savings or to establish the appropriate level of public investment.The Bank in the Turkish case appears to have relied on these agreements,sometimes even more so than the Fund did, citing, at least on one occasion,agreement on the monetary program as making it unnecessary to obtain a moresatisfactory understanding on the level of public investment.

103. The Fund's focus on monetary aggregates in monitoring the programwould appear to give rise to a greater need for the Bank to reach understand-ing on, and to monitor, the key policies affecting variations in the majorcomponents of aggregate demand, particularly private and public investment,both of which are directly related to medium-term supply responses as well ascontrol of aggregate demand. Perhaps the Fund on its part could concern it-self more intensively with policies affecting private and public consumption.

104. More emphasis on a national accounts framework, as distinct from amonetary one, for the formulation and monitoring of measures designed tocontrol aggregate demand would require, as Fund and Bank staff recognize,improvement in the data base outside the monetary field, particularly when itcomes to quarterly estimates. Even in the vitally important field of consoli-dated public sector accounts, important for both monetary and income analyses,reporting is deficient, as noted above. The staff are so skeptical of thereliability of national accounts data relating to private and public consump-tion, savings and investment, that they are reluctant to make more than verylimited use of income analysis in the formulation of policy and are even moreconstrained in using national accounts for monitoring progress. Yet, littlehas been done by the Bank and Fund in calling upon the Turkish authorities toimprove the underlying data and their current (particularly quarterly) esti-mates of the expenditure components of the national accounts.

105. The greater use of an income approach as suggested here would, ifpursued by the Turkish authorities, facilitate better aggregate demand manage-ment, induce a better recognition within Turkey of the relationship betweenaggregate demand management and longer-term economic growth on a sustainablebasis, as well as facilitate a more productive collaboration between the Fundand Bank.

Conclusion

106. SAL I and Supplement provided badly needed quickly disbursingexternal assistance, an important component in an over-all external financialoperation, in support of a Turkish program designed to establish a moresustainable basis for Turkish economic growth without excessive dependence onforeign capital inflow.

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107. Critically important policy changes have been implemented under theTurkish economic program initiated in early 1980 which was delineated only invery general terms at the time of loan approval. The continuous dialogue withTurkey in the course of implementing SAL I and preparing SAL II has, in thatsense, been fruitful. A process of structural change has been initiated.Most notable is the progress made in shifting the export incentive system inthe direction of relying more on market clearing price mechanisms at the sametime that aggregate excess demand was being reduced through monetary, credit,interest rate, wage and fiscal policies. The resulting reduction in the rateof inflation has thus been accompanied in 1980 and 1981 by a significant realdevaluation of the Turkish lira, the first in a decade. The adoption of amore flexible exchange rate policy, combined with better control over aggre-gate demand, is apparently becoming increasingly recognized as a solid featureof Turkish policy. This change in expectations as to future policy, buildingupon the continuity in policy intentions in this field, which have survivedgovernmental changes in the past three years, should be reinforced by theapparent success of the policy in increasing export earnings and workers'remittances in 1981.

108. Real progress was achieved in 1980-81 in establishing a pricestructure in Turkey conducive to a better supply response.

109. The critical issue then is the adequacy of the Turkish actionprogram and the speed of its implementation. It is a cliche found in Bank(and Fund reports) that "important progress has been made, but much remains tobe done." The preceding analysis suggests that while medium-term targets hadnot been set and a time-phased action program to accomplish these targets hadnot been specified, there are many policy areas where progress has been made.Whether progress is being achieved at a sufficiently rapid pace depends partlyon how ready external sources of capital are to provide large amounts ofcapital on a non-project basis and on concessional terms for many yearsahead. The Turkish authorities have stated that they would reduce their needfor such support rapidly. Until they come forward with a time bound actionprogram it will be difficult to judge whether or not this target has reason-able prospects of success.

110. While this memorandum agrees with the generally positive tone of thePCR, it has provided an independent assessment of areas of slow progress,particularly on the rationalization of public investment, on facilitating thefinancing of private investment, on reforming the SEEs and on resource mobili-zation. The claim in the PCR that progress in many respects "exceeded allexpectations" loses significance if expectations are not clearly formulated.The potential contribution of the Bank to the acceleration of the adjustmentprocess is also thereby reduced.

ANNEX A-32-

FIRST STRUCTL'&AL AnJUSTMlENT LOAN No. 1810-TU

Schedule 5

of Loan Agreement

In reviewing the progress achieved by the Borrower in thecarrying out of the economic program and the measures referred toin paragraphs (A) and (3) of the ?reamble to this Agreement, theBorrower and the Bank shall focus in particular on:

1. the adequacy of export promotion policies and administra-tive measures to facili-ate actairment of an average real growthof exports of not less than 10 per annum over the period of 1979through 1983, including:

(a) review by October 31, 1980 of the efficiency of theinterim arrangements established by the Borrower to cover exportcredit risk insurance and priority access of exporters to termcredits, working capital credit and the like;

(-b) completion of the on-going review by October 31, 1980,of institutional arrangements to promote further development ofthe Borrower's traditional and non-traditional export products andcommodities; and

(c) initiation, to be made not later than April 30, 1-980,of a study for the purpose of introducing more rational protectionand incentive system based on tarrifs for industry.

.2. Completion of an on-going comprehensive study on externaldebt management by October 31, 1980, with a view to introducingfurther imzrovements and refinements in the Borrower's external;:debt management policy.

3. Adequacy of measures to increase -domestic resource mobili-zation, including (i) the objective of eliminating overall deficitfinancing in the public sector in 1980, (ii) the,completion of areview by July 31, 1980, of measures needed to encouirage increasesin household savings and tine deposits, and (iii) the review andfurther study of the various aspeccs of the Borrower's draft studyof its financial sector.

4. Adequacy of the Borrower's measures to harmonize publicinvestments, including those oi SF.'s in 1980 and 1981, with theavailable financial resources and the Borrower's investmentpriority criteria that: (i) existing productive capacity is used

efficiently and fully and critical bottlenecks removed; (ii)on-going projects be compleced which, with modest additionalresources, c-n be expected to yield speedy returns; and ('ii) newproductive projects stressing exports and employment generation.

-33- ANNEX B

STRUCTURAL ADJUSTMENT LOAN SUPPLEMENT No. 1915-TU

Schedule 5

of Loan Agreement

In reviewing the progress achieved by the Borrower in thecarrying out of the economic program and the measures referred toIn paragraphs (A) and (B) of the Preamble to this Agreement, theBorrower and the Bank shall focus in particular on:

1. The adequacy of export promotion policies and administra-tive measures, including:

(a) carrying out of a study for the purpose of introducinga more rational protection and incentive system based on tariffsfor industry, the first phase of such study to be completed byJanuary 31, 1981;

(b) establishment by March- 31, 1981 of an export credit risk-insurance scheme; and

(c) :implementation of institutional arrangements to promote,turther development of the Borrower's traditional and non-traditional export products and commodities on the basis of thereview of such arrangements referred to in paragraph 1 (a; ofSchedule 4 to the Prior Loan Agreement.

2. Adequacy of the Borrower's measures to harmonize publicInvestments, including those of SEE's in 1980 and 1981, with theavailable financial resources and the Borrower's investmentpriority criteria that: (i) existing productive capacity is usedefficiently and fully and critical bottlenecks removed; (ii)

on-going projects be completed which, with modest additionalresources, can be expected to yield speedy returns; and (iii) newproductive projects stressing exports and employment generation.

3. Adequacy of measures to increase domestic resourcemobilization, including the objective of minimizing overalldeficit financing in the public sector in 1980 and 1981.

4. Continuation of sound external debt management policyand computerization of external debt data.

- 34 -STATISTICAL ANNEX

TABLE 1: INDICATORS OF PRICE CHANGE/a

Percentage Change over Preceding Period

Wholesale Prices/b Cost of Living/b Implicit GNPPeriod Average (General) Ankara Istanbul Deflator

1977 24.1 22.5 26.0 24.91978 52.6 53.4 61.9 43.71979 63.9 62.0 63.5 73.31980 197.2 101.4 94.3 103.31981/c (36.6) (30.7) (34.3) -

1980

I 39.7 31.4 27.6II 18.5 25.0 14.4III 5.2 7.7 9.8IV 14.1 8.3 11.0

1981

I 9.3 7.3 8.1II 3.0 2.7 4.7III 6.9 8.3 7.2

Source: Ministry of Commerce and IMF.

/a Quarterly data are not seasonally adjusted.

/b Indices compiled by the Ministry of Commerce.

/c September 1981/September 1980.

- 35 -

STATISTICAL ANNEX

TABLE 2: REAL EXCHANGE RATES FOR TURKISH LIRA/a

Indices of the Real Exchange RateNominal Exchange vis-a-vis the Currencies ofRate Lira/Dollar Turkey's Trading Partners

A B

1970 11.500 92.5 92.71971 14.917 110.6 110.51972 14.150 99.1 98.11973 14.150 100.0 100.01974 13.927 93.9 95.31975 14.442 93.9 95.31976 16.053 90.3 90.51977 18.002 89.5 85.81978 24.282 91.8 88.1

I 21.379 91.2 88.1II 25.250 91.2 89.4III 25.250 93.6 89.9IV 25.250 90.1 83.3

1979 31.078 86.4 74.6

I 25.250 82.4 76.1II 28.360 78.8 71.1III 35.350 92.3 82.9IV 35.350 82.4 74.5

1980 76.038 110.4 108.7

I 61.595 106.9 103.9II 75.529 111.5 111.3III 80.095 116.1 114.8IV 86.934 107.0 105.0

1981

I 94.589 101.7 103.9II 102.914 101.5 103.2

Source: World Bank, "Turkey: Industrialization and Trade Strategy"(Report No. 3641-TU, dated November 2, 1981), Table 1.4.

/a A rise in the real index indicates depreciation of the Turkish Lira.

Note: The index of the real exchange rate (1973 = 100) has been calculatedby adjusting an index of the nominal exchange rate for changes in

wholesale prices at home and abroad. Calculations for Turkey's prin-cipal trading partners covering about two-thirds of Turkey's importsand exports in 1973 were made by weighting with the sums of exportsand imports in that year. Variants A and B are based on wholesaleprice indices in Turkey as calculated respectively by the Ministry ofCommerce and by the Instanbul Chamber of Commerce.

- 36 -

STATISTICAL ANNEX

TABLE 3: MAIN OUTLINE OF TURKEY'S BALANCE OF PAYMENTS 1979-81(US$ billion)

1979 1980 1981(Forecast)

Exports 2.3 2.9 4.5Workers' Remittances 1.7 2.1 2.6Other Invisibles 0.4 0.4 0.9

Total Current Earnings 4.4 5.4 8.0

Capital Inflows(including debt relief) 1.7 3.4 2.5

Total Receipts 6.1 8.8 10.5

Interest Payments(before debt relief) 1.0 1.1 1.5

Imports 5.1 7.7 9.0

Memo Item

Current Account Deficit(including accrued interest) 1.7 3.4 2.5

Source: IMF, EBS/81/180, except for 1981 forecasts which are partlyobtained by audit mission.

- 37 -STATISTICAL ANNEX

TABLE 4: CONSOLIDATED BUDGET AND SEE FINANCES

1978 1979 1980 1981/a-----------(TL billion)------

I. Consolidated Budget/b

Revenues 287.5 507.5 854.7 1485.0Expenditures 340.0 595.4 1062.6 1548.2Budget Balance - 52.5 - 87.9 - 207.9 - 63.2Cash Deficit/C - 61.0 - 45.9 - 192.3 - 125.2

II. State Economic Enterprises/d

Total Expenditures 308.2 501.4 1165.4 1854.3Sales Revenue 256.2 429.9 1142.3 1849.8Profit/Loss Before Taxes - 52.0 - 71.5 - 23.1 - 4.5

Total Investment 80.1 171.7 476.6 432.7/eFinancing Requirements/f 132.1 243.2 499.7 437.27-e

Memo Items

As % of GNP/!

Budget Cash Deficit 4.7 2.1 4.3 1.9SEE Adjusted Own Resources/h 0.4 0.7 1.3 1.1SEE Financing Requirements FromOutside the Public Sector!i 7.2 7.2 7.7 3.5/i

Source: IMF, SM/81/180 and Audit Mission estimates.

/a Official estimates unless otherwise indicated.

/b Fiscal years from March to February.

/c Equals budget balance adjusted for advance and deferred payments.

/d Calendar years.

/e SEE investment in 1981, and thus financing requirements, are probablyunderestimated by TL 100 billion according to information obtained by theAudit Mission.

/f Total of loss and total investment.

/g 1981 GNP forecast on basis of 3 percent growth and 40 percent inflation.

/h Gross profits/loss less taxes plus depreciation, less duty losses onaccount of low sales prices.

/i Total financing requirements less budgetary transfers.

/j Works out to 5.1 percent of GNP if TL 100 billion is added (see footnote 5).

- 38 - STATISTICAL ANNEX

TABLE 5: TURKEY - CREDIT TO PRIVATE SECTOR AND HOUSEHOLDS

TL Million Wholesale Price TL Million Index ofEnd of Period Current Index Constant Prices Private Credit

(Constant Prices)

December 1978 267,582 100.0 267,582 100

December 1979 396,236 181.4 218,432 59.4

December 1980 689,211 353.1 195,189 53.1

May 1980 458,026 285.1 160,655 43.7

May 1981 812.614 379.5 214,128 58.3

Source: Central Bank of Turkey, Quarterly Bulletin.

- 39

T?MKEY - Structural Adiustment Loan r and Supplemental Loan(Loan No. 1818-TU and 1915-TU)

Completion Report

On March 26, 1980, the Bank signed a $200 million First StructuralAdjustment Loan (SAL 1) with the Republic of Turkey, one of the first suchloans in the Bank. The amount provided under this loan was based on aconservative estimate of Turkey's ngeds over a tvelve month period, and onassumpCions as to the extenc of ocher external support Turkey was likely toreceive through the OECD Consortium. The Executive Directors were advisedin the Board presentation that consideration wouLd be given later in 1980 toa further loan, and on Naovember Z4, 1980, a V75 million Supplemencal Loan coSAL I was signed. These loans had been preceded by a -1.50 million FirstProgram Loan (1627-TI) in November 1978 focussed more narrowly on improvingUtilization of productive capacitv. These loans were in support of CheGovernment's ambitious January 1980 stabilization.program to restructure theTurkish economy, and measures already iniciated or proposed over thefoiloving few months, in furtherance of chat program. While thisfar-reaching program was solely the creation of the Turkish Govertment, itreflected many of the concerns highlighted by the Bank's 1979 EconomicReport, and was a fundamental departure from previous government policies i na number of areas.

2. The Government's objectives set out in the 1980 Program andsubsequene policy statements were essentially: (a) to bring about a rapidand continuing reduction in the underlying rate of inflation, to a levelcloser to that in industrialized countries; (b) to secure a substantial andcontinuing increase in gross forei- exchange earnings from the low level of6 percent of GN? in 1980, and gradually foster a sustainable balance ofpayments and external debt position over the longer-term; and (c) to improvedomestic resource mobilization, both in the public and private sectors. Theachievement of these objectives was regarded by the Government as essentialfor restoring a sustainable race of economic growth. The program to achievethem, pursued during 1980 and 1981, had the following basic elemencs;substantial devaluation and the adoption of a flexible exchange race policy;incencives to encourage producers to export vigorously instead ofconcentrating on selling domestically; tight monetary conditions;deregulacion of interest rates and their adjustment to reflect marketconditions; implementation of a lebc information system and effective debtmanagemenc policies; stren-thenin- of public finances through a major taxreform and through che initiation or reforns or che State EconomicEnterprise (SEE) sector, including exzosing of the SEEs to markec forces,granting of pricing autonomy co them, constraining cheir access to thebudget and Cencral 3ank, and restrictin2 over-emplovmenc; and encouragingthe private sector to spearhead Turkish economic development. The initialelements of this ?rogram were supoorted by SAL I and its Supplemenc and werefurther delineated in connection wich the subsequenc SAL II loan in Xa7 1981.

3. SEAL .was disbursed in tranches of 1l0O, W5O million and t5omillion, the second and chird following two satisfactory reviews ofprogress, and was fully disbursed on tMarch 31, 1981. The SuppLement wasfully disbursed in October 1981. As discussed below, considerable progressbas been made by the Governmentc in implementing the structural adjustmentprogram supported by these loans; loan implementation has also beensatisfactory. These loans have played an important role in supporting theCovernment's efforts to incroduce significant structural adj'ussments inareas critical to restoring economic viability, and secting the base forcontinuing of the structural adjustment process in coming years.

Monitoring of Policv Areas under SAL I and its Supplement

4. The policy measures which provided the basis for SAL I and itssupplement were in th.e following areas: exports, external debt management,domestic resource mobilization and public investment. Benchmarks forevaluating progress in these fields were reflected in Schedule 5 to the LoanAgreements and in two Supplemental Letters to the Loan Agreement for SAL ISupplement. For SAL I progress in these specific areas, together withoverall economic performance and policies, was reviewed in June 1980 andagain in September/October 1980 prior to reiease of the second and thirdtranches, respectively. Although some reservations were noted, the reviews'were generally favorable, recommending release of the tranches.

5. The two reviews took place only three and six months, respectively,after the signing of the loan. This was too short a time span to expect anysubstantial improvemenc in overall economic performance, with the nocableexception of a marked deceleration in: the race of inflation. wcowever, inthe four areas described above, progress in adooting policy measures wasgenerally satisfactory! This is described below and in che attachedmemoranda to the Execucive Direccors on the *cranche releases (Actachmencs Iand 2).

Progress in Areas Monitored

(a) Exports

6. On export promotion, a significant change was the adoption of amore flexible exchange rate policy. In contrast to the past policy ofminimal and belated adjuscments in exchange rates, a substanti.al devaluationin the exchange rate and the adoptica of a Dolicy of continued adjustnentsto maintain external competitiveness improved the profitabilitc of exportsand stimulated remittances from migrant workers. Other export promocionpolicies undertaken included an improvement in exporters' accez. co foreignexchange through (a) extensions and improvmencs in che foreign exchangeretention scheme, and (b) measures co improve exporters' access _o domesticcredit. The foreign exchange retention scheme increased from 25 percenc to50 percent the share of net export receipts which exvorters of manuracturesand minerals could retain. In addition the scheme was extended to allowexporters of fruit and vegetables and fishery products, and Turkishcontractors working abroad to retain 10 percent of their earnings. Thisforeign exchange, which previously could only be used either b, the exporter

- 41 -

or his sub-cortcractor, could now also be sold in the market. These eXpOrtpromotion policies were continued under the Supplemental Loan, and furtherextended. The most important development was allowing income from exportsof industrial foods, fruits, vegetables and fishery products, and receiptsfrom freight and tourism to be deductible in various degrees from taxableincome. All foreign exchange earnings of contractors abroad were also madedeductible. There were also improvements in access to export credit and inadministrative procedures for exporters.

7. One action included in the SAL t Loan Agreement was a review of theinterim arran-ements for export credit insurance by October 31, 1980. Atthe time of the first review 1 however, _c was clear that these arrangementsvere not functioning. A revised interim arrangement was instituted in May1981, and.the Government prepared a draft law establishing more permanencarrangements. Howeverr the law has been deferred owing to .ncertaincy on-the costs of the scheme, given che rapid increase in exports (60 percent

*-growth in dollar terms during the first nine months of 1981 over che sameperiod in 1980), and concentration on high-risk countries. .Moreover,foreign banks are now providing financing for Turkish exports to low-riskcountries.

8. The Government fulfilled its agreement under SAL I to complete itsreview of the institutional arranzemencs for promoting exports by October31, 1980, and progressed iurcher than agreed. A major step has been thecentralizacion of responsibility within the Government for export promocionin a new department under the 2 niaing Miniscry. A. July 1980 decreefacilitates the establishment of export trading companies and offers themthe same incentives available to manufacZ&er-exporters. Proposals toestablish free trade zones and trade centers for individual industries arebeing prepared. Administrative procedures are being progressivelysimplified.

% In the first part of 1980, export performance responded somewhatslowly to the oromocion measures, reflecting bath normal time Lags and thesevere dislocation of the economy. In the first nine months of 1980,exports grew by only 6 percent in value over the corresponding period of1979. Over the remainder of 1980 and che first nine monthTs of 1981, exportsshowed a dramatic improvement, with the dollar value of export receipts 60percent more than over che corresponding period in the previous year.Workers' remittances also improved markedly, growing by 26 percent over thefirst eight months of 1981 compared to the same period in 1980.

(b) Protection and Incentives -Systems

10, Progress on a study of the protection and incentives system .rasinitially slow. The Government did not initiate this study bv April 30,1980 as it had intended. However, since then, understandings were reachedduring.the negotiations for the SAL I Supplement Loan in Occober 1980setting out the objectives, scope, methodology, organization and timetableof the study (Attachmenc 3). 2hase I of the studv was compLeted in advanceof the revised schedule (January 31, 1981) and changes which considerablyexceeded Bank expectations were implemnented in the 1981 Import Regime:

- 42 -

formal quotas have been abolished, and about one-third of the ieems subjectto quotas shifted to the imporc lists (List I) with the most liberalprocedures (allowing free import subject to foreign exchange availability),and the remainder to List 1 (requiring proof that goods of comparablequantity and quality cannot be supplied locally withii a reasonable periodof time); in addition, a number of items were transferred from List IT toList I. Implementation of the long-cerm study is underway in Turkey,partially financed from the Bank's external research oudget, and itscampletion is expected in December 1982 on schedule.

Cc) External Debt Manazement

i1t The reviews found chat the Government had improved its debtmanagement and that the policies followed were sound. Under the IMF StandbyArrangement of June 1980, the Governrent agreed; (i) to specific limits onaew M&LT commitments over the next 12 months; (ii) not to allow the build-upof any new arrears over the next 12 months; and (iii) e.o reschedule or repayexisting arrears within 3 years. Arrangements were concluded forconsolidating long-standing arrears on unguaranceed trade credits. Banksholding a majority of Turkey's commercial debt agreed to extend therepayment schedule applyin- to the $3 billion rescheduling package agreed inAugust 1979. A subsequent rescheduling with commercial banks has takenplace. With regard to debt data, however, the technical problems ofmanually dealing with the large and complex volume of data were such thatthe Gcvernment decided to computerize the debt data and sought Bankascistance. Understandings were reached at the negotiations for che SAL ISupplemenc t,oan on the organizational arrangements, plan of action andtimetable, and projected Bank assistance. ?rogress in the compucerizationof debt data has been disappoincing. Although a competent ProjectCoordinator has been appointed, and the coordinator and a programmer visitedthe Bank in July 1981 to gain knowledge of the 3ank's debt reportin syvstem,there has been no further progress. The Turkish auchorities are seekihgexternal financing for hardware and consultants for this project.

(d) Doiestic Resource M'tobilization

12. The reviews found progress on domestic resource mobilizationefforts generally satisfactorv. The January 1980 policy reform grantedpricing autonomy to most SEZs; this was followed by a considerable initialrise in prices of SEE products and services with uwvard adjustcentscontinuing to be made periodically. While che SEEs as a group scillrecorded an operating loss, this loss was reduced from TL 72 billion (about$1.9 million equivalent or 3.4 percent of GDP) in 1979 to XL 23 billion(about $0.3 million equivalenc or abouc 0.5 percent of GDP) in 1980. Ofmajor concern, however, was the accumulation of a subscantial volume of&rrears in SEE payments. Moreover, increased budgetary transfers to theSEEs Co finance their investment programs combined with the failure of mostcategories of ta:x and non-tax revenues to keep pace wich inflation meantthat the consolidated budget deficic for Q30 grew to more than 4 percenc o.WI?P In the short run, there was Little which could be done to remedy chis;>iowever, the second review noted the publicly stated intention of the

- 43 -

military Government and the new Cabinet to enact important tax reformsshortly. Under SAL I Supplement, the Government enacted a major tax reformpackage in early 1981; important changes were implemented in the taxation. ofincome and goods, as well as in tax administration. These reforms are beinguonitored under SAL II.

13. A significant policy measure undertaken with regard to privatesavings was the deregulation on July 1, 1980 of all com=ercial bank depositinterest races. The ceiling interest rate on private bonds and the yield onCovqrnment bonds were also raised. These actions far exceeded theagreements under SAL I, and represented a major advance in Turkey's programof policy reforms in the financial sector. There bas been a significantresponse to these developmencs in deposic ratas. In che one month of July1980, total deposics grew TL 48 billion, only slig?-v -less than the totalincrease over the January to June period, and berweent August and November1980 total deposits grew by TL 107 bilion, three times the depositsaccumulated over the same months in 1979. This rapid growch has continuedin 1981. Under SAL I Supplement the Government int.oduced a new savingsscheme to promote the inflow of emigrant workers. The scheme providesTurkish workers abroad with a competitive outlet for their savings inTurkey, while avoiding the problems of the previous convertible Turkish liradeposit scheme.

14. The Covernment agreed under SAL I to review and further studvvarious aspects of a financial sector study undertaken in 1976-78 with Bankencouragement. The principal reconmendations.of the study (involving the-liberalization of incerest rates, increasing yields on privare bonds, and-the issue of a competitive government savings inscrumenc) were subsequentlyimplemented during the period covereW by SAL I. The only majorrecommendation on which action was not taken concerned the securiciesmarket. This issue was discussed during our SAL reviews and was finallydealt with in mid-1981 with the passage of a. capital 7arket bill )roviding.aframework for the stock and bond markets and escablishing a regulatoryauthority.

(e) Public Investment

15. The reviews concluded that progress in rationalizing the publicinvestment program had been adequate. Overall, the level of publicinvestment had been cailored to available resources, with a substantial realdecline over the 1979 level. The criteria used for allocations wereappropriate to turkey's economic situation; removal or critical bottlenecks(40 percent of the tocal was spent on energy and. nining projects);completion of ongoing projects which are over 80 percent comDlete or wichina year of completion and those wich secured foreign tinancinz; andexport-orienced projects. The 30 priority projects Listed 'or the Bank asthose on which resources should be concentrated in the event of overallshortfalls, continued to receive approoriace priority in allocacions.However, there was a concinuing tendency not to distinvuish sufficienclybetween the relative priorities of several ongoing projects and to spreadavailable resources thinly amongst them.

- 44 -

Loan Impact and Implementation

16. The total loan amount of t200 million for SAL t and $75 million forits Supplement accounted for about 2.4 and 1.0 percent, respectively ofTurkey's total imoorts over the period of disbursement. For the specificitems eligible for financing under the loans, the impact was greater. Forexample, it is estimated that the loan financed about 35 percent of importsof eligible agricultural inputs. Loan funds financed essential imports forboth industrial and agricultural production at a time when the availabilityof foreign exchange, especially untied capital, was particularly tight, andwhen production was seriously disrupted by a shortage of essential imports.

17. Administratively, loan implementation was generally satisfactory'.Because of the experience gained by the Ministry of Finance and the CentralBank in administering the Program Loan, the administration of these loansgenerally went more smoothly. The Ministry of Finance and the Central Bankbore the main responsibility for administering the loans, and applicationsfor import licenses received substantive approval from the appropriatetechnical ministry. An interesting feature was the arrangements made forspeeding up disbursements (described in para. 28 below).

18. Eligible Commodities and Allocations: The SAL I loan was fullydisbursed on Mlarch 31, 1981, ana its Supplement .ully disbursed in October,1981. The original and final allocations were as follows:

SAL I SupplementDisbursements (W) Disbursement ($)

Category Original Final Original Final

1. Agriculture 100,000,000.00 110,783,154.90 45,000,000 53,168,364.65

2. Industry 100,000,000.00 89,2L6,3U5.10 30,000,000 21,331,635.35

200,000,000.00 200,000,000.00 75,000,000 75,noo,000.00

Eligible comnodities were spelled out in detail in Schedule 1 of the LoanAgreement, and consisted of materials for production of fertilizers, plancprotection chemicals and their raw materials, steel, copper and aluminumproducts, and petrochemicals and other chemicals. At the request of theGovernment, Schedule 1 of the SAL I Loan Agreement was amended duringimplementation, to include in Category l(a) (macerials for production offertilizers) an addicional product (mono ammonium ohosohate) and in Category2(a) (steel industry) an additional import (iron ore) limiced to $10million. Private sector firms received allocations from SAL I of $100.3million, exceeding che rarget of .65 million. Apart from Bank financing,SAL I provided that the Government would allocate $30 million from its ownresources during the loan period for imports of spare parts. Of this, $10million was to be for private firms. Since monitoring of actual allocacionsvas impossible given the Central Bank's current recording mechods, a copy ofthe Government's instruccions implementing this allocation was obtained.

-45-

19. Counterpart Funds; Counterpart funds equivalent to the loanamounts were channelled oy Government decision to five of the highestpriority energy projects, including the Bank-financed Bibistan and Karakayaprojects.

20. Procurement: tmports were made directly by actual users, exceptvhere import by certain SEEs for sale to both private and public sectorenterprises is prescribed by law. Procurement provisions were simplifiedfz'ou& those of the Program Loan, by increasing the minimum value of bulkimports to S5 million which would be procured. on the basis of ICS proceduresconsistent with normal Bank guidelines. All contracts of a lesser valuevere awarded under the normal procurement procedures of public and privatesector firms concerned. The procurement procedures of public sector firmsalready provided for substantial international bidding, and private sectorfirms had adequate choice of international suppliers to ensure reasonableavailability and pr�.ce.

11. Disbursements; 1�isbursemeats initially were rather slow, despitethe high level of cor�micmenrs. The reasons were twofold; first, there is aminimum time normally required for the many steps that must be taken forconcluding contracts for World Bank disbursements; and, second, there werefinancing problems peculiar to Turkey's economic situation. As regards thelatter, most foreign banks continued to demand 100 percent cash coverage b�the Central Bank for any Turkish letters of credit, and Turkey's forei�exchange shortage constrained the amounts that could be so covered.

22. The Government therefore arranged to use two 40-day bridgefinancial arrangements with two foreign conmiercial banks which it made underthe Program Loan. These banks guaranteed Turkish letters of credit, whichotherwise were not accepted, and covered expenditures from the time theyvere incurred until reimbursement was made by the Bank. This introduced anelement of flexibility which made it possib�.e for the Government to managethe process of disbursement much more effectively, speeded up disbursement,and avoided tying up Bank funds in guaranteeing letters of credit whosedisbursements might not be made for some time. The coim�ercial bank limits(initially $40 million for one bank and $10 million for the other) regulatedthe pace of corimiitments and Bank disbursements. However, a raising of thelimits on the bridge financing by one of the banks (from $40 million to $60million) in late June, eased the situation. Thereafter, disbursementsproceeded at a rather rapid rate, and the SAL I Loan was fully disbursed Oft

?larch 31, 1981, and its Supplement fully disbursed in October 1981.

Summary and Conclusions

23. The economic philosophy underlying the January 1980 program marks adecisive break with the previous period of Turkish economic developmentstrategy. It involves an acceDtance of the need to emphasize stabilizationof the economy initially so that growth can be resumed on a viable basisthereafter while beginning to reorient Turkey's development strategy outwardthrough the development of exports and other foreign exchange earningactivities instead of the heavy import substitution bias of the past. It

- 46 -

introduces the. principle of using the market mechanism and incenciveswherever possible to guide economic activity, rather than the quantitativecontrols and physical planning of much of che last two decades. Thesechanges are generally appropriate to the present scage of Turkey'sdevelopment and its current difficult economic situation.

24. This First Structural Adjustment Loan and its Supplemenc were insupport of this policy reorientation, and, while the percentage of importsvwich they financed was not large, these loans provided quick-disbursingforeign exchange at a time when the need was critical. Given the gravity ofTurkey's economic problems and the policies pursued over recent years whichgave rise to them, it must be expected thae it will take some time beforethe effects of the rescructuring program become fully evident and conditionswhich would permit sustainable growch with financial stability arerestored. Meanwhile, the Government's program concinues to deserve, andrequire, substantial support in terms of external funds at better thancoa ercial market terms, without which ic is unlikely to be successful.ferformance under the First Structural Adjustment Loan and ics Supplementvas better than expecced in many key areas and generally atisfactory inothers. The reviews of progress in implementing policy reforms haveprobably played a useful purpose in expediting progress towiard agreed goals.

- 47 -

List of Attachments

1. Memo to EDs on Second Tranche Release

2. Memo to EDs on Third Tranche Release

3. Supplemental Letter to SAL I Supplement onProtection Study.

4. Supplemental Letter to SAL I Supplement onExternal Debt Study.

EM2DA

December 16, 1981

International Bank for Reconstruction and DevelopmentFOR OFFICIAL USE ONLY

- 48 - Attachment 1

SecM80-596

FROM: Vice President and Secretary August 1, 1980

TURKEY - STRUCTURAL ADJUSTMENT LOAN

Attached for information is a note regarding the consultations

under the Turkey Structural Ad-ustment Loan ralating to t-.e release of

the second tranche.

Questions on this document may be referred to Mr. Berk

(extension 72379).

Distribution:

Executive Directors and AlternatesPresidentPresident's CouncilVice Presidents, IFCDirectors and Department Heads, Bank and IFC

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.


- 49 -August 1, 1980

MEMORANDUM TO THE EXECUTIVE DIRECTORS

SUBJECT: Review of the Turkey Structural Adjustment Loan

As provided in Section 3.08 of the Loan Agreement for theStructural Adjustment Loan to Turkey (Loan 1818-TU), a mission visitedTurkey from June 9 to 27 to exchange views on progress achieved incarrying out the economic program assisted by the loan.

General

The bold and significant measures announced by the Governmentin January 1980, which provided the framework for the Loan, havegenerally been implemented in an efficient and effective fashion. Theinitial measures have been buttressed by a number of importantadditional reforms, most notably, an agreement with the IMF in June 1980 tointroduce more flexible exchange rate arrangements, the successful conclusionof $3 billion debt rescheduling talks with OECD in July 1980, and as asignificant resource mobilization measure, the freeing from governmentcontrol of virtually all interest rates. Opposition to the Government'sinitiatives has been relatively restrained given their far-reachingnature, although sufficient to lead to a recent close vote of confidence.The severe political constraints, discussed in the President's Reportremain but,there is no evidence of any change in the Government'sdetermination to carry out the program of economic reform.

The review focussed on recent performance and policies in thefour areas agreed for monitoring of progress:

(i) adequiate export promotion policies and measures;

(ii) external debt management;

(iii) domestic resource mobilization measures; and

(iv) measures to harmonize public investments with availableresources.

Export Promotion Policies and Measures

The Government's export target is an average real growth ofexports of not less than 10 percent per annum during the period 1979



- 50 -

through 1983. Export developments in 1979 were disappointing. Exportsrose by 9 percent in dollar terms in the first five months of this yearover the previous year, and the Government expects a strong increase inthe second half of 1980, when the large January devaluation, the newexchange rate policy, reduced domestic demand and slower inflation sinceMarch should have their effect. Performance on policies and measuresin support of exports is generally in advance of the agreed timetable ofmonitorable actions. The Government has pursued the more flexibleexchange rate policy announced in January 1980, implemented largelythrough cross-rate adjustments. Exporters can now have more confidencethat competitiveness will be maintained. Other important changes toexport incentives include an extension of the foreign exchangeretention scheme to exporters of fruit and vegetable and fishingproducts and allowing exporters to freely sell the foreign exchangeso retained.

The Government also has undertaken a number of measures on thefinancial side: exporters' access to foreign exchange from commercialbanks has been improved as has their access to commercial bank credit.Incentives are offered to both exporters and banks to expand '-n.ding forexports and rediscounting facilities for exports at the Central Bankhave been increased. The interim export credit insurance scheme has notfunctioned but a draft scheme prepared by the Ministry of Finance isunder review within government and satisfactory permanent arrangementsare likely to be completed before October 1980.

Institutional arrangements for promoting exports are the subjectof an ongoing review agreed to be completed by October 31, 1980.Administrative changes made to date include the centralization ofresponsibility for export promotion in a new department in the StatePlanning Office, a simplification of administrative procedures involvedin exporting, and a proposal to set up sectoral/industrial exportpromotion organizations.

The study of protection has not yet been initiated but discussionswere held with Bank staff in May and June on the general approach to beused. A group consisting of representatives of various ministries andsupported by private institutions has now been organized to undertake thestudy in two phases. The Government, in consultation with the Bank, hasdecided to focus on a selected sample of subsectors where the greatestdistortions exist, so that policy results can be more quickly obtained.The first phase (August-September 1980) will attempt to identify thoseindustrial subsectors where the most obvious distortions exist. Thesesubsectors would be the subject of study in a second phase (September 1980to September 1981). In view of the importance of reform of tariffs, quotas andother non-tariff barriers to trade in manufactures, to the restructuring ofthe economy and improvement in export competitiveness, we have conveyed tothe Government our concern that the study get underway without further delayand are working with the Government on the sampling and analyticalmethodology.



- 51 -

External Debt Management

Under the new standby arrangement with the IMF, the Governmenthas agreed to limit new commitments of 1 to 5 years maturity to$500 million and new commitments of 1 to 10 years maturity to$1 billion during the 12-month period up to June 30, 1981. The successfulrescheduling of about $3 billion of debt service obligations falling dueover the three years ending June 30, 1983 has substantially improved theshort-term debt position of the economy. The IMF and the Bank arecollaborating on providing technical assistance to improve the reportingand computerization of the large and complex volume of external debt datawhich currently is assembled manually.

Domestic Resource Mobilization Measures

Price increases in the state sector, announced under theGovernment's January 1980 program, are expected substantially to increaseSEE revenues in 1980. SEE access to the Central Bank in the first sixmonths of 1980 was sharply lower than the same period of 1979. Amajor tax reform package is currently before Parliament, but stalledbecause of the political situation.

The Government has not only completed the agreed internal reviewof measures to increase household savings prior to July 31, 1980, but hasalready implemented a number of key policies. A June 1980 Decree freedinterest rates on all time deposits and permitted the issuance of bearercertificates of deposits. While the Banks then agreed among themselvesto raise deposit rates by 2-10 percentage points, up to a level of36 percent for four-year money, the Government is determined to break anycartel arrangements by competitive increases on public bonds. Theissuance of competitive public bonds and the freeing of interest rates onprivate bonds is expected shortly. In the longer-term, a proposal todevelop the capital market is under discussion by the Council ofMinistries. Moreover, most of the principal recommendations of the draftFinancial Sector Study have been implemented or will be implemented shortly,obviating the need for further review of the study.

Public Investment

The overall level of public investment has been tailored toavailable resources in several stages this year, and the current estimateimplies a real decline in public investment over the 1979 level. Thecriteria used for including project allocations in the 1980 program aregenerally appropriate to Turkey's present circumstances. Priority projectshave been given a substantial increase in real allocations.

t.This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwisc be disclosed without World Bank authorization.

FOR OFFICIAL USE ONLY- 52 -

The progress made to date is fully consistent with the obligationsin the Structural Adjustment Loan. Consequently, the Government of Turkeyhas been advised of the availability of the second tranche of $50 million.

Ernest SternVice PresidentOperations


International Bank for Reconstruction and DevelopmentFOR OFFICIAL USE ONLY

Attachment 2

- 53 -

SecM80- 804

FROM: Vice President and Secretary October 24, 1980

TURKEY - STRUCTURAL ADJUSTMENT LOAN

Attached for information is a note regarding the consultations

under the Turkey Structural Adjustment Loan relating to the release of the

final tranche.

Questions on this document may be referred to Mr. Berk (extension

72379).

Distribution:

Executive Directors and AlternatesPresidentSenior Vice PresidentsPresident's CouncilVice Presidents, IFCDirectors and Department Heads, Bank and IFC

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. its contents may not otherwise be disclosed without World Bank authorization.


- 54 - October 24, 1980

MEMORANDUM TO THE EXECUTIVE DIRECTORS

SUBJECT: Review of the Turkey Structural Adjustment Loan

As provided in Section 3.08 of the Loan Agreement for the Struc-tural Adjustment Loan to Turkey (Loan 1818-TU), discussions were held inWashington from September 24 to October 3 on progress achieved in carryingout the economic program assisted by the loan.

General

After the military takeover on September 12, the new Governmentreaffirmed publicly its commitment to the January 1980 program and itsintention to enact those parts of it previously held up by deadlock inParliament, notably tax reform. The senior official largely responsiblefor the program holds the position of Deputy Prime Minister in charge ofeconomic affairs in the new Government. The program continues to beimplemented in a consistent way. Progress under the IMF standby arrange-ment remains satisfactory.

The review focussed on recent performance and policies in the fourareas agreed for monitoring of progress: export promotion, external debtmanagement, domestic resource mobilization, and public investment.

Export Promotion

In the first eight months of 1980, exports increased only 6 per-cent in value over the corresponding period of the previous year againstthe Government's target of 10 percent in volume terms. While price move-ments have been uniformly favorable, and most commodities have shown volumeincreases, certain important agricultural and manufactured items have shownsignificant volume declines. The reasons include low initial agriculturalstocks, lack of domestic finance for additional crop purchases, lower manu-facturing production due to shortages of imported inputs and energy andlabor disputes, and the need for time for the January 1980 and subsequentmeasures to have their full effect. Neither lack of adequate policy norinstitutional weakness appears to have played a part. Now that a number ofthe problems have been overcome, the Government expects a large increase inexports during the remainder of the year.

There have been few changes recently in export policies andinstitutional arrangements. The Turkish Lira continues to be devalued insmall steps approximately each two months. Export credits benefit fromsubsidized rates, especially since the interest rate liberalization inJuly. The Government has prepared a draft decree to establish an export

This document has a restricted distribution and may be used by recpients only in the performance oftheir official duties. Its contenst may not otherwise be disclosed without World Bank authorization.

,55 FOR OMCIAL USE ONLY

credit insurance scheme. The establishment of specialized exportingcompanies has been facilitated.

Agreement has now been reached on all aspects of the study of theprotection system. The first phase, to be completed by January 31, 1981,will be a short-term review of manufacturing industry to identify distor-tions, and define measures to increase export capability and capacityutilization, and remove bottlenecks. It is expected to lead to earlieraction than originally anticipated, through changes in the 1981 importregime and other relevant policies. The second phase involves an in-depthstudy of export incentives, the import regime, and investment incentives;policy papers with recommendations for reform, and restructuring programsto assist affected industries, will also be prepared. The work will takeuntil the end of 1982, about nine months after the originally agreed date;but reforms will be introduced as they are ready. The new system resultingfrom the liberalization program is expected to be fully in place by the endof 1984, which was the original expectation.

External Debt Management

External debt management policies have remained sound. Followingthe large rescheduling of debts to OECD member countries in July, Turkey isin contact with commercial banks regarding possible further assistance.Detailed agreement has been reached on the computerization of the large andcomplex volume of external debt data, currently assembled manually, withBank technical assistance.

Domestic Resource Mobilization

Domestic resource mobilization efforts present a mixed picture.Large price increases in the state sector, both in the January 1980 programand repeatedly since then, are expected to permit a small operating profitfor SEEs in 1980. However, budgetary transfers to them have increasedbeyond original expectations due to a consolidation of their tax paymentsand repayment of part of their large arrears to contractors. While Govern-ment revenues and expenditures have both declined in real terms over 1979levels, revenues in particular are lagging, with substantial arrears in taxcollection due to increased evasion prompted by failure to adjust incometax schedules for high inflation. The anticipated budget deficit for 1980has increased significantly, borrowing from the Central Bank has stayedhigh, and Government arrears to contractors are still accumulating. Littlecan be done to correct these problems in the short run. The failure ofParliament to pass two tax bills since February 1980 has been a furthermajor problem. The new Government has, however, stated publicly itsintention to enact tax reforms shortly.

Interest rates on time deposits (and most loans) were liberalizedon July 1, and have risen by 4 to 12 percentage points, depending onmaturity. Bank deposits have responded immediately, with an increase inJuly only slightly less than total increases in the preceding six months.

This document bks a resoed distribution and my be sed by re nts only in the performance oftheir ofwil duties. Its a>ntenst may not otherw be dislosed without World Bank authorization.

- 56 - FOR 3MICIAL USE ONLY

Moreover, w.th greater competition emerging within the banking sector, itseems likely that interest rates will continue, at least in the short term,to be sufficiently attractive to financialize substantial private savings.The yield on private bonds has been raised somewhat, and that on Governmentbonds from 18 percent before July to 30 percent currently, both tax-free.Measures to increase the financialization of private savings thus go wellbeyond agreements under the loan.

Public Investment

The overall level of public investment continues to be tailored toavailable resources, and the current estimate implies a substantial realdecline over the 1979 level. The criteria used for sector and projectallocations remain appropriate to Turkey's present circumstances. Priorityprojects have retained a substantial increase in real allocations.

Conclusion

The progress made to date is consistent with the obligations inthe Structural Adjustment Loan. Consequently, the Government of Turkey hasbeen advised of the availability of the final tranche of $50 million.

Ernest SternSenior Vice President

Operations

This docum)ent has arestricted distribution and may be used by recpeents only in the performance oftheir ofricial duties. Its contenst may not otherwise be discosed without World Bank authorization.

ATTACHMENT- 57 - Letter No. 1

REPUBLIC OF TURKEY

November 24, 1980

International Bank for Reconstructionand Development

1818 H Street, N.r.Washington, D.C. 20433U.S.A.

Re: Loan No. 1915 TJ(Structural Adjustment Loan Supplement)Protection Studv

Dear Sirs,

With reference to Schedule 5, paragraph l(a) of the Loan Agreementof even date herewith, we wish to confirm that the study will be carriedout in accordance with the attachment to this letter.

Please confirm your agreement with the foregoing by signing theform of confirmation below.

Very truly yours,

REPUBLIC OF TURXEY

By s Tevfik AltinokA horized Represent ive

CONFIRMED:

INTERNATIONAL BANK FOR RECONSTRUCTIONAND DEVELOPMENT

By /s/ ioger Chaufournier

Attachment

- 58 -

ATTACHMENTPage 1 of 4

TERMS OF REFERENCE FOR THE STUDY ON RESTRUCTURING THE EXISTINGPROTECTION AND INCENTIVES SYSTEM

A. Purpose of the Study

1. Turkey has started to use protection and incentives policies sincethe beginning of the Planned Development Strategy.

2. Turkey adopted an industrialization policy which was foreignexchange saving rather than foreign exchange earning. In order to protect

these industries, which were mainly import substituting and inwardoriented, from foreign competition Turkey implemented a protective importregime aimed at preventing the import of industrial goods.

3. Parallel to these policies, and in order to reach the rates of

growth and economic structures aimed at in the Development Plans, incen-tives were used to direct investments to priority areas.

4. Our past economic history and experiences clearly indicate thenecessity of restructuring the existing incentives and protection system.While the demand for consumer goods has reached a certain level ofsaturation, these industries protected from foreign competition behindcustom walls have been gradually losing their economic and technicalefficiency. At this stage, and with the existing levels of protection,local production has been losing its income effect and industry has beenmore import-oriented. With this industrial structure, it is impossible toexpect an export-oriented approach from these industries. While highproduction costs have prevented greater exports of industrial goods,without the expanded production effects of exports, production costs couldnot be lowered.

5. In view of increasing balance of payments deficits arising mainlyon account of these past "inward-looking" import substitution policies, aserious effort has to be directed towards a reform of the protection andincentive system, in order not only to facilitate the much needed exportdrive, but also to direct investment into the priority areas. To do this,the aims are to progressively reduce any remaining bias of the incentivesagainst exports, reduce the variability of effective protection and effec-tive subsidy across activities to rationalize incentives so as to correctdistortio,ns in resource allocation, move from reliance on quantitativerestrictions to the use of tariffs, and reduce effective protection whereexcessive.

B. Phasing

6. The detailed incentives study, which will also spell out a phasedprogram of trade liberalization, will take about 2 years. In the mean-while, a short-term review will identify certain policies which need to beimplemented quickly by the Government. These policies are geared towards

- 59 -ATTACHMENTPage 2 of L

improving the import regime in the short-term, and are also in conformitywith the broad longer-term objectives of restructuring the protection andincentive system to promote exports, and in general to introduce tradeliberalization. For this reason the protection study will be conducted intwo stages;

(a) Short-Term Action-Oriented Review; 4nd

(b) Long-Term Incentive Study and Recommendations for TradeLiberalization.

C. Short-Term Action-oriented Review

7. Organization and Timetable. Responsibility for conducting theshort-term review will rest with a special expert commission for which theState Planning Organization (SPO) will serve as the secretariat, and whichwill include representatives of SPO as well as of the Ministry of Finance,Ministry of Commerce, Ministry of Customs and Monopoly, Ministry ofIndustry and Technology, Industrial Development Bank, and the Chambers ofCommerce and Industry. The commission will prepare a report covering anincisive review of the policies outlined below before January 31, 1981.Its major recommendations will be incorporated after review into the 1981Import Regime and other relevant measures.

8. Bank Role. An English translation of the commission's report willbe provided to the Bank within one month of its issue, for comments. Astatement of the consequent changes made in the 1981 Import Regime andother relevant measures will be provided to the Bank within one month oftheir enactment.

9. Scope. The commission will analyze the following set of policiesrelated to the import licensing system as well as other studies and dataavailable, and suggest the required changes and additional insertions inthe 1981 Import Regime and other relevant measures, if found desirable.Keeping in view the question of overall foreign exchange availability,these policies are directed towards increasing export capability, fullerutilization of existing capacity, and the elimination of bottlenecks andinefficiency. The recommendations will be in the direction of moreliberalization, both by removing quotas where possible and by increasingthe dollar amounts of applicable quotas for the following necessaryimported inputs;

Ci) Imported inputs for increased capacity utilization. One of thecurrent limiting factors to industrial production for domestic useis the presence of widespread unutilized capacity. A major reasonbehind this phenomenon is the unavailability of imported materialsand spare parts. These needed items should be identified, andimports of them should be increased whenever feasible. Alloca-tions for inputs should be increased at the expense of those for

- 60 -ATTACHMENTPage 3 of 4

consumer and (if necessary) investment goods, to permit an in-crease in output in the short-run while limiting any impact oninvestment prospects.

(ii) Import of machinery needed for export industries. The studyshould identify and recommend any necessary increase in provisionfor import of machinery needed for export industries, i.e.exporters should be given priority claim on licenses for theimport of machinery.

(iii) Import of machinery needed for projects which are identified, oncost-benefit grounds, as priority projects even though producinggoods primarily for domestic use. The rationale for such a policyis to prevent bottlenecks in critical sectors/subsectors of theeconomy.

10. In addition the committee will study the scope for increasinglyadmitting competing imports in order to improve all round efficiency,keeping in view the short-run foreign exchange liquidity problem.

D. Long-Term Study of the System of Protection and Incentives

11. Organization and Timetable. The research will be carried out by aqualified full-time coordinator and other experts selected by the Govern-ment of Turkey and reporting to the State Planning Organization. Activeparticipation of other related agencies, experts and university staff willbe provided in a planned and coordinated way. Before starting the quanti-tative research, we intend to hold a colloquium with the participation ofall related personnel and agencies.

12. The research will commence in January 1981 and it will be com-pleted by September 1982. Policy papers containing recommendations forreforming the system of protection and incentives, and restructuringprograms to assist industries which will have difficulty in adapting toincreased competition from imports to make the transition to greaterefficiency, will be prepared during the period September 1981 to December1982, making use of the results of the research as they become available.A timetable of the policy papers will be prepared by May 1981. Actions toreform the protection and incentives system will be taken as appropriateduring the course of the research, and the new system resulting from theliberalization program will be fully in place by the end of 1984. Partic-ular attention will be paid to the phasing of the implementation of therecommendations so as to minimize dislocations.

13. Bank Role. The Bank will generally review the implementation ofthe study. In particular, the initial selection of industries, and theguidelines to be applied in the selection of firms within these industries,will be reviewed with the Bank by January 31, 1981. The Bank will alsoreceive periodic reports on the progress of the research and English trans-lations of the policy papers as they are prepared.

- 61 -

ATTACHMENTPage 4 of 4

Scope. The research will be carried out for a sample of firms inindividual industries, selected so as to include firms possessing differentcharacteristics, in particular as far as ownership and export orientationis concerned. Initially emphasis will be given to industries producingexported or potentially exportable items and those where import liberaliza-tion is expected to cause considerable dislocation.

15. The study will encompass the following: (i) the calculation ofincentive indicators (nominal protection, effective protection, and effec-tive subsidies); (ii) the calculation of cost-benefit indicators (thedomestic resource costs of foreign exchange and the first-year economicrate of return); (iii) an analysis of the relationship of incentive andcost-benefit indicators with various attributes of the firms, includingcapital, employment, ownership (public, private and foreign), exportorientation, and location. The methodology for items (i)-(iii) is summar-ized in the Annex and detailed in documents already transmitted by the Bankto the Government; any proposed changes from this methodology will beapproved by the Bank.

16. The recommendations will cover regulations concerning importquotas and other forms of quantitative restrictions, tariffs, export taxesand subsidies, and investment incentives.

- 62 -ANNEXPage 1 of 4

LONG TERM STUDY OF THE SYSTEM OF PROTECTION AND INCENTIVESYSTEM IN TURKEY

METHODOLOGY

I. Indicators of Incentives

1. The research under this heading will first of all involve estimat-ing nominal protection coefficients (NPC's) for the output and materialinputs of each firm. The NPC is defined as the ratio of the domestic priceof a product to its world market or border price. For products solddomestically that are not subject to quantitative restrictions, pricecontrol, prohibitive tariffs, or smuggling, the nominal protection coeffi-cient is taken to be one plus the ad valorem rate of tariff, under theassumption that domestic products will sell at the tariff-inclusive priceof comparable imports. For exported prodcuts, the NPC is the ratio of theprice received by the exporter to the f.o.b. export price.

2. The expression "tariff" is used here to refer to the ad valoremequivalent of all tariff-type measures. The ad valorem equivalent ofspecific duties is obtained by relating the amount of duties paid to thec.i.f. price of imports. The same procedure is followed in regard toimport taxes and surcharges. The results are further adjusted for differ-ences in indirect taxes on domestic production and on imports.

3. In Turkey the tariff schedule generally applies the same (prin-cipally ad valorem) most-favored-nation rates to imports of a givencommodity regardless of the country of origin (except for EEC prefer-ences). The schedule rates will be used for the estimate of the NPC in thecase of imported intermediate inputs which are not produced domestically.

4. However, for the wide range of final goods manufactured by localfirms, the NPC's will be estimated by comparing domestic ex-factory priceswith the c.i.f. import prices of equivalent or similar products. This isnecessary owing to the prevalence of quantitative import restrictions, theadministrative allocation of foreign exchange, prohibitive import duties onmany consumer goods, and the existence of smuggling. Price comparisonswill also be needed for local primary product inputs that are subject tosubsidies and other government intervention and for locally produced inter-mediate goods.

4. While the nominal protection coefficient expresses the effects ofthe various incentive measures on the price of a particular product, forthe firm what matters is not only the price of its output but also the costof purchas - inputs. The protection of these inputs will raise their costto the f-r.and can be considered as a tax on the use of these inputs. Thecombined effects for the domestic producer of protective measures on itsoutput and inputs are represented by the effective protection coefficient(EPC), which -cpresses the extent of protection to value added. The EPC isdefined as the ratio of domestic value added, obtainable as a result of theapplication of protective measures, to value added i-


Value added is the difference between the price of the product and the costof traded inputs, including material inputs incorporated in non-tradeableinputs, and the material input component of the revalued capital stock asreflected in annual depreciation charges. The components of value addedinclude post-tax profits, royalties, profit, tax, miscellaneous taxes,rent, interest and wages. Value added in domestic prices, or domesticvalue added, is derived by valuing the product and its purchased inputs indomestic prices. Value added in world market prices, or world market valueadded, is obtained by valuing the product and its purchased inputs in worldmarket (border) prices.

5. The estimates of nominal protection for outputs and materialinputs, combined with the firm level input-output data, are the principalrequirements for the estimation of effective protection coefficients. Firmlevel input-output data will be obtained through a survey of a sample offirms in individual industries.

6. In addition it is necessary to take into account the effects oftrade taxes and subsidies on the cost to the firm of non-tradeable inputssuch as electricity, water, commercial margins, domestic transport, andmiscellaneous business services, and also on the cost of capital equipmentas reflected on an annual basis in depreciation and explicit or implicitinterest charges.

7. As regards non-tradeable inputs, the so called Corden methodologywill be followed of decomposing each such input into components consistingof direct and indirect traded inputs valued in border prices, trade taxesand subsidies, other taxes and subsidies, and value added. To estimate thecost of capital equipment, it is necessary to estimate the replacement costof the capital stock of each firm.

8. Effective protection coefficients relate the effects of protectivemeasures on the product and its inputs to world market value added. Theeffective subsidy coefficient (ESC) expresses the effects of the protectivemeasures, together with the effects of credit, tax and price preferences,on domestic value added. It is derived by adjusting the effective protec-tion coefficient for the difference between profit taxes, interest, and theprices of non-traded goods and services actually paid by the firm, and whatare estimated to be "normal" charges under these headings. The norms usedwill be the averages for all the firms surveyed, taken together, so as toensure that the overall averages of EPCs and ESCs are identical. This willinvolve, for example, calculating averages of interest rates, weighted bythe amount borrowed, and averages of profit taxes, weighted by pre-taxprofits.

II. Indicators of Economic Costs and Benefits

9. In Part I the firm level data will be used to present quantitativeestimates of incentives. This analysis is entirely positive in the sensethat it says nothing about the desirability or otherwise of the various


activities. In Part II, building on the incentive results the analysiswill be carried further in order to provide normative indicators relatingto the economic desirability of the activities in question and to throwsome light on the comparative advantage of the various Turkish industries.

10. In order to value economic as distinct from private costs andbenefits, shadow prices will be estimated, updating and expanding on therecent Bank Staff Working Paper (No. 392) as necessary. The shadow pricesrelate to the following:

(i) Foreign exchange.

(ii) A shadow rate of discount for valuing capital costs.

(iii) Five categories of Turkish labor (unskilled, semi-skilled,skilled, clerical, and technical and management).

(iv) Industrial land.

11. Having estimated the shadow prices, they will be applied to thefirm level data in order to calculate two cost-benefit indicators. Theseare: (i) a DRC ratio (abbreviated as DRC) in which the numerator consistsof the opportunity costs of primary factors valued in domestic shadowprices, and the denominator consists of net foreign exchange earnings alsovalued in domestic shadow prices; (ii) a coefficient of economic profit-ability (CEP) in which the profit for the year (1980 or 1981 will be used)is expressed as a ratio of the invested capital, both defined in domesticshadow prices. This coefficient is the one-year (cross-section) variant ofthe economic rate of return calculated in the cost-benefit analysis ofprojects.

12. The incentive and cost-benefit indicators will be calculated forthe total output of each firm and aggregated by subsectors and sector.Separate estimates for domestic exportables will be made.

III. Analysis of Incentive and Cost-benefit Indicators

13. In this part of the research the incentive and cost-benefitindicators will be analyzed in relation to a variety of factors of policyinterest to the Government. In particular the following questions will beinvestigated.

(i) The relation between the cost-benefit indicators and the level ofincentives.

(ii) The relation between capital intensity, skill intensity, and thecost-benefit indicators.

(iii) The relation between employment and the cost-benefit indicators.


(iv) The relation between location and the cost-benefit indicators.

(v) The cost-benefit indicators in relation to equity ownership by theGovernment, and by private firms.

(vi) The relation between private and economic profitability.

(vii) The relation between the cost-benefit indicators and the orienta-tion of production towards the domestic market or towards exports.

- 66 - Letter No. 2

REPUBLIC OF TURKEY

November 24, 1980

International Bank forReconstruction & Development

1818 H Street, N.W.Washington, D.C. 20433

Re: Loan No. 1915 TU(Structural Adjustment Loan Supplemenc)Computerization of External Debt

Dear Sirs,

With reference to Schedule 5, para. 4 of the Loan Agreement of even dateherewith, we confirm that we will computerize the recording and anal2,sis ofall external debt obligations of, or guaranteed by, the Republic of Turkey.We have decided that the Ministry of Finance will be responsible for co-ordinating the collection, processing and analysis of all data cn short-termand medium-term debt.

To supervise and ensure the smooth working of this orocess, we have setup a Coordination Committee chaired by the Ministry of Finance, and con-sisting of senior representatives of the Ministry of Finance, Central Bankand State Planning Organization, and have already informed the Bank of chenames and positions of these representatives. In future, should these rep-resentatives be changed, we shall keep the Bank fully and promptly informed.This Committee will be responsible for:

1. Advising the Prime Minister or Deputy Prime Minister on decisionson the ultimate objectives, and hence the characteristics, of the system tobe installed, in particular:

(a) that the system will be a statistical rather thanan accounting one, in that it will deal withapproximate amounts involved during a certainperiod, rather than exact amounts and dates oftransactions;

(b) frequency of update, in light of the capacity ofthe reporting agencies to provide data, and theMinistry of Finance's ability to process it;

-C-(c) analytical capabilities, e.g. implications ofvariations in terms of any new borrowings,Eurocurrency interest rates, and reschedulingalternatives;

- 67 -

(d) location of staff, facilities, equipment,etc., for the computerization project asneeded;

(e) arrangements for access by each of the threemain agencies (Ministry of Finance, CentralBank and State Planning Organization) con-cerned, as necessary.

2. Ensuring the timely exchange of all external debt data among thethree agencies on a continuing basis. In particular, we have taken steps toensure that the short-term external debts, the statistics of which have sofar been both collected and maintained by the Central Bank of Turkey, willfrom hereon be maintained and analyzed by the Ministry of Finance, under theproposed new system.

3. Efforts to improve the quality and timeliness of debt reporting byagencies utilizing external credits.

The Ministry of Finance will be responsible for setting up the system;for system maintenance; and for coordinating and timing the update of infor-mation, and quality control over reporting by agencies utilizing externalcredits, to permit the production of reliable and timely records.

To carry out the work, the Ministry of Finance has appointed, and willmaintain at all times, a competent Project Coordinator. It has also appointedthree staff members to assist the Coordinator, and will maintain and supplementsuch staff as necessary, especially as provided in para. 3 of the Attachment.The Coordinator will report to the Director General of the Treasury responsiblefor International Economic Relations, and will also be the technical counter-part in dealing with the Bank and other external agencies.

The work will follow the plan of action and timetable set out in theAttachment to this letter.

We understand that the Bank will provide the following assistance incarrying out the project:

1. Suggestions on the detailed input and output of the system appropriateto the circumstances and external debt transactions of Turkey;

2. An opportunity for the relevant personnel to visit the Bank to gaindetailed knowledge of the Bank's debt reporting system, including its inputrequirements, operation and output;

3. Follow-up missions at periodic intervals as necessary to assist us indesigning, implementing and operating the system;

4. Advice on machine capabilities and training needs.

- 68 -

Once the computerization project is completed, we shall use the newsystem to develop external debt profiles, for periodic reviews of externaldebt management by the Government under the direction of the Minister ofFinance.

Please confirm your agreement with the foregoing by signing the formof confirmation below.

Very truly yours,

REPUBLIC OF TURKEY

By sI Tevfik Altinok/A torized Representati e

CONFIRED:

INTERNATIONAL BANK FOR RECONSTRUCTIONAND DEVELOP=T

y, _ C

By Roger Chaufournier

- 69 - ATTACEM=NT

Plan of Action by Government & Timetable

1. User Survey October andNovember 1980

Survey of both those using and those providing data. Thiswill involve establishing a joint working committee withrepresentatives from the Ministry of Finance, SPO and theCentral Bank and designation of counterparts in otheragencies and SEEs. This survey should recommend the scopeof the system, type of output required, data availabilityand frequency of updating.

2. Initial SDecification of the required system. December 1980

3. Appointment of a Programmer. December 1980

Ideally someone with a background in economics/statistics.

4. Visit to Washington of project coordinator and programmer January 1981to study the World Bank system: its composition, how it isused and updated. Technical assistance to be providedincluding advice on system design, specification and datacontent.

5. Programming of recuirements together with detailed speci- February throughfication of each item to be put on file. Determination June 1981of editing routines, i.e. data checks for consistency andaccuracy to be performed by the machine, design of outputformat.

6. Redesign of forms for requesting data from other agencies February throughin conjunction with these agencies. Design of coding June 1981forms and output request forms for using the system.Outline of supporting files, i.e. exchange rates, variableinterest rates, debtor/creditor name files. Allocation ofcodes to be used for each item.

7. Choice of machinery to be used/location. Either (a) pur- March throughchase of new equipment taking into account need, servicing June 1981facilities and availability of spare parts. Location ofthis hardware; or (b) arrangement of access to existingfacilities, determination of time sharing arrangements andpossibility of access terminals.

8. Implementation and testing of the system. Actual recording July throughof programmes and testing with sample data. September 1981

9. Input of basic data file for all loans, i.e. creation of October throughthe master file and checking of data against specified December 1981edit routine.

10. Refinement of the system and additional updating. First half ofTeaching familiarity and use of the system. 1982

-70 Letter No. 3

REPUTBLIC OF TURM

November 24, 1980

international Bank for Reconstructionand Development

1818 H Street, N.W.Washington, D. C. 20433United States of America

Re: Loan No. 1915-TUCStructural Adjustment Loan Supplement)External Debt

Dear Sirs:

Tn connection with the proposed loan to the Republic of Turkey for the aboveProject, in an amount in various currencies equivalent to $75,000,000, amwriting on behalf of the Republic of Turkey to set forth certain facts relatingto the external debt of the Republic of Turkey.

1. You have been furnished with the following:

Non-standard Forms 1: Description of individual external public debtlisted in Form 2;

Non-standard Forms 1A: Schedule of principal and interest payments forindividual external public debt described inForm 1;

Non-standard Forms 2: Individual external public debts: current statusand transactions during period as of December 31,1979;

Non-standard Forms 4: Aggregate external private debt: current statusand transactions during period, as of December 31,1979; and estimated future service on private debt.

2. You have also been furnished with a list of public debts contracted duringthe period January 1, 1980 through March 31, 1980. The Annex to this letterprovides su-Ary information on external public debt contracted between April 1,1980 and November 9, 1980.

3. Such forms and lists accurately set forth: (a) the amounts and principalterms and conditions of all outstanding external public debt of the Republic ofTurkey, its political subdivisions and agencies, and of the agencies of itspolitical subdivisions, and debts guaranteed by them up to November 9, 1980.

- 71 -

V. We represent that no mortgages, pledges, charges, privileges, priorities orother liens exist on any governmental assets as security for any external debt.

It is our understanding that, in making the proposed loan, tha Bank may relyon the statements and facts set forth herein and in the documents mentionedabove.

Very truly yours,

REPUBLIC OF M=X!

By //s ,Tevfik Altinokjt rized Representative