PFPSAL 3 PID May 19- Final sent to infoshop

ProjeCt Name Turkey-Third ProgrammatiC Financial andPublic sector Adjustment Loan (PFPSAL 3)

Loan AMount US$900 million

Region Europe and central ASia

Sectors Poverty Reduction and Economicmanagement; Private and Financial sectorDevel opment

Project ID P082996

Borrower Government of Turkey

impolementing Agency Undersecretariat of Treasury, Ankara,Turkey

Envi ronment category C

Date this PID Prepared April 22, 2003

Appraisal Date April 2003

Projected Board Date June 2003

Loan and Program summary

1. The proposed Third Programmatic Financial and Public sectorAdjustment Loan (PFPSAL 3) would the be the third in the seriesof Programmatic loans providing Bank support since 2001 to theRepublic of Turkey for the Government's multi-year financial andpublic sector program. This program aims to restore confidencein the banking system, correct the underlying structuralproblems in the public sector that created the conditions underwhich the February 2001 crisis occurred, and help protectcritical social spending. The proposed loan would be onstandard IBRD terms for Turkey and would be disbursed in twotranches of US$450 million each, the first upon loaneffectiveness and the second upon fulfillment of second trancherelease conditions, as long as overall progress with the programis also satisfactory.

2. The first in this series of loans was the ProgrammaticFirancial and Public sector Adjustment Loan (PFPSAL) of US$1.1billion, approved in July 2001 (us$700 million on standard IBRDterms and US$400 million on special structural Adjustment Loan-SSAL-terms) and disbursed in a single tranche in July 2001. Thethree-tranche Second ProgrammatiC Financial and Public sectorAdjustment Loan (PFPSAL II) of us$1.35 billion (us$550 onstandard IBRD terms and US$800 million on SSAL terms) wasapproved in April 2002. The first US$450 million tranche ofPFPSAL II was disbursed upon effectiveness in AUgUst 2002.However, disbursement of the remaining tranches of PFPSAL II wasdelayed by a slowdown in implementation of the economic reformprogram during the run-up to early legislative elections held inNovember 2002 and establishment of the neW Government. Theproposed PFPSAL 3 will support the neW Government's fullownership of the financial and public sector reform program and

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PFPSAL 3 PID May 19- Final sent to infoshopwill make a strong public commitment of the program'sobjectives. PFPSAL 3 will also facilitate the fine-tuning ofthe program in line with the Government's intentions and therequired adjustment of the timetable for particular programbenchmarks in accordance with actual developments over the pastyear. The undisbursed amounts under PFPSAL II will be cancelledat the authorities' request at the time of the Board approval ofPFPSAL 3.

Country and Sector Background

3. The design of the PFPSAL loans reflects the continuing needto address the long-standing underlying causes of the crisis of2001 in order to reduce Turkey's vulnerability to such events.Turkey has been long been characterized by an oversized publicsector living beyond its means and inadequate management ofexisting resources, leading to structural macroeconomicimbalances that thwarted successive attempts at disinflation.During the 1990s, these imbalances became intertwined withfinancial sector weaknesses in a vicious circle. state-ownedbanks were used to finance government-mandated subsidizedlending, particularly to agriculture and small and medium-sizedenterprises. This quasi-fiscal financing directly underminedfinancial sector stability. In parallel, the emergence of alucrative domestic market for high return government bondsindirectly contributed to financial sector instability as banksbecame dependent on artificially inflated profits frominvestments in government paper. Faced with prohibitively highinterest rates, the Government relied on the inflation tax tokeep the public debt under control. However, this created aningrained pattern of inflationary expectations, which blockedfinancial sector deepening and promoted currency substitution.

4. A serious exchange rate based disinflation program waslaunched in late 1999, but this was ultimately unsuccessful.The disinflation effort was accompanied by an initial round ofstructural reform in pensions, telecommunications, agricultureand energy. In the financial sector, a new commercial bank lawwas passed mandating the creation of a new independent bankregulatory agency. Despite some early success, macroeconomicrisks quickly built up and the program eventually collapsed atits weakest point, the financial sector. In February 2001,Turkey experienced a major currency crisis which forced theGovernment to abandon the crawling peg exchange rate and floatthe Lira. while the immediate cause of the crisis was weaknessin the financial sector, its deeper roots lay in the problemswith the structure and management of the public sector that areat the core of Turkey's chronic macroeconomic instability.

5. In mid-2001, the Government prepared a new economic programto overcome the immediate impact of the crisis while setting thestage for an early resumption of disinflation and growth. Bymoving to address the fundamental structural problems underlyingthe crisis, with a strong focus on restructuring the banking andpublic sectors, the Government hoped to avoid the prolongedrecession that some other crisis countries have experienced.The program was based on a three-pronged strategy: (i)macroeconomic policies geared towards restoring financialstability and resuming the disinflation process; (ii) structuralpolicies aimed at correcting the financial sector and publicsector weaknesses underlying the crisis, together with renewedefforts to improve the investment climate and promote privatesector development; and (iii) strong social policies including

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PFPSAL 3 PID May 19- Final sent to infoshopincreased emphasis on protecting the most vulnerable.

6. Economic recovery got underway in early 2002. GNPrebounded strongly, growing 7.8 percent (well above the programtarget of 3 percent), after having contracted 9.4 percent in2001. The high growth was due in part to base effects from therecession and stock-building, but strong exports and a reboundin agricultural output were also important factors. Even so,the economy has yet to recover fully from the recession withestimated per capita income still well below peak levels of1998. Annual inflation rates dropped steadily over the courseof 2002, despite the strong recovery, with CPi inflation fallingto 29.7 percent and WPI to 30.8 percent by end-2002. The fallin inflation was helped by appreciation of the real exchangerate as confidence in the Lira improved. Balance of paymentsou-tcomes were also favorable, with receipts from exports andtourism well above projections while renewed capital inflows tothe private sector contributed to a stronger-than expectedcapital account balance. This allowed a build up of grossinternational reserves to almost us$28 billion.

7. Fiscal performance fell well short of the program targetsfor 2002, with the primary surplus for the consolidated publicsector deficit falling short of the 6.5 percent program targetby over 2 percent of GNP. This resulted from factors such ascost overruns in the social security system, pre-electionspending, an unexpected drop-off in tax revenues driven byexpectations of a post-election tax amnesty, delays in raisingadministrative prices, higher-than-expected tax rebates, andunplanned spending through earmarked accounts. while higherthan programmed government spending contributed to the strongerthan expected recovery in 2002, the fiscal slippage had seriousimplications for the preparation of the 2003 budget and therequired adjustment to bring the fiscal program back on trackcould slow the pace of recovery in 2003. The fiscal cost ofcleaning up the banking sector after the 2001 crisis has weighedheavily on the public debt burden. After reaching a peak of 95percent of GNP at the end of 2001, the stock of net public debtto GNP fell to an estimated 80 percent by end-2002.

8. Financial markets fluctuated sharply over the course of2002 in line with political developments. while real interestrates fell sharply from the crisis peaks, they remained in the20 percent range during the second half of 2002. Mirroring thebond market, the stock market also fluctuated sharply over thecourse of 2002 and private credit remained stagnant. Financialmarket volatility continued during the first quarter of 2003.The new AKP (justice and Development Party) Government stressedits commitment to continuing the economic reforms, albeit withgreater emphasis on the social dimension, but it was slow inaddressing the pre-election policy slippages and introduced somecostly ad hoc payments, including support payments inagriculture and increased pensions. Markets came underincreasing pressure in January and February 2003. while marketssubsequently rallied modestly on improved prospects forinternational support and the winding down of hostilities inIraq, conditions remained fragile as of April 2003 with thebenchmark bond rate in the 55 percent range and the Lira tradingin the range of TL 1.5-1.6 million to the Dollar.

Turkey's Financial Sector Reform ProgramPage 3

PFPSAL 3 PID May 19- Final sent to infoshop

9. Turkey's financial sector reform program seeks to restorecredibility to the financial sector, reduce its vulnerability tointernal and external shocks, and enhance its intermediationcapacity in support of economic growth. The initial reformefforts from 1999 onwards have been focused on: (i) overhaul ofthe prudential regime for banking in line with internationalstandards; (ii) establishment of an independent Bank Regulationand supervision Agency (BRSA); (iii) problem bank/bank failureresolution; and (iv) state bank restructuring and privatization.At a later stage, the reform effort will also encompass non-bankfinancial institutions and capital markets activity. TheGovernment's financial sector reform program was designed withthe Bank's assistance including three banking reviews undertakenin the past five years, several financial sector loans, and anon-bank financial intermediaries review completed in 2003.

10. The Government accelerated the banking reform program in2001 after the crisis, taking rapid action in each of the fourkey areas. In particular, prudential regulations for loan lossprovisions, connected exposures and foreign exchange exposureshave been aligned with Basel/European union (EU) standards; andthe institutional basis of BRSA has been strengthened. Twentyinsolvent private banks have been intervened and resolvedthrough sale, merger or closure. With regard to the statebanks, EmIak bank has been closed and merged with ziraat bank,while long needed financial and governance restructuring ofziraat and Halk banks has been implemented. These actions weresupported by PFPSAL and PFPSAL II. A key action to be completedunder PFPSAL 3 is with respect to the privatization of thefourth state bank, vakif bank, which is now expected to occurbefore the end of 2003.

Turkey's Public Sector Reform Program

11. Public sector reform aims to underpin sustained fiscaladjustment and create the conditions for transparent andeffective government. The underlying problems with thestructure and management of the public sector were analyzed indetail in the 2000 CEM and 2001 PEIR which contributed to theanalytical underpinnings of the public sector reform program,together with the country Financial Accountability Assessmentand Country Procurement Assessment Review both completed in2001. The public sector reform program focuses on threecritical areas, each of which has a medium-term dimension: (i)structural fiscal policies to ensure permanent fiscaladjustment; (ii) a medium-term program of policy andinstitutional reforms to improve the transparency and efficiencyof public expenditure management (PEM) and (iii) broad-basedinstitutional reforms to improve the quality of public sectorgovernance.

12. The Government has made substantial progress in definingand implementing its public sector reform program. with regardto improving public expenditure management, reforms already inplace include rationalization of the public investment program,and enactment of new public procurement and public debtmanagement laws. The new public financial management andcontrol (PFMC) law, which is the cornerstone of the budgetreform, is expected to be enacted by June 2003. In the area ofstructural fiscal policies, a major package of fiscal measuresto underpin the 2003 budget targets has been adopted.Implementation of the medium-term tax strategy is moving forward

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PFPSAL 3 PID May 19- Final sent to infoshopwith adoption of indirect tax reform legislation in 2002 and thefirst legislative package for the direct tax reform in April2003. The public employment program is also making progresswith the target of eliminating one-third of SEE redundancieshaving been surpassed by the end of 2002. In the area of publicsector governance, the national strategy for improvinggovernance and combating corruption was adopted in January 2002and published in March 2003. Implementation of the newlegislation on public procurement, debt management, and publicfinancial management and control, together with the otherelements of the Government's public sector reform agenda, willbe supported by the proposed PFPSAL 3.

The Proposed Loan

13. The proposed PFPSAL 3 is the third Loan in support of theGovernment's multi-year financial and public sector reformprogram (see paragraphs 1 and 2 above). The main objective ofthe proposed PFPSAL 3 is to support implementation during 2003of the Government's financial and public sector reformpriorities in response to the 2001 economic crisis, whilecontinuing to ensure that social programs are adequately fundedand increasingly better targeted. The principal benefits of theLoan will be to: (i) support the Government's efforts to createthe conditions for sustained growth and macroeconomic stability;(ii) ensure adequate social expenditure and better targetedsocial protection, (iii) restore confidence in the bankingsystem and position the banking sector for accession to the EU;and (iv) lay the foundation for more effective government inline with EU directives and international best practice.

14. The risks associated with the financial and public sectorreform program arise from macroeconomic factors, politicalconsiderations and institutional weaknesses. The keymacroeconomic risk is that high real interest rates could derailthe economic recovery and affect public debt sustainability. Arelated risk factor is Turkey's vulnerability to both internaland external shocks. The commercialization and privatization ofthe state-owned banks is a major political and organizationalchallenge. The rapid restructuring of Halk and ziraat banks hassignificant fiscal and social implications. while theGovernment has so far been able to finance the banking clean-up,the public debt has increased sharply as a share of GNP.continued tight fiscal discipline and reform actions to bolsterthe confidence of investors in Turkish sovereign debtinstruments remain essential. satisfactory and timely failureresolution efforts and enforcement of capital restoration plansare important. The risk that such efforts will fall short isrelated to possible pressure that may be exerted to slowregulatory enforcement action and provide regulatoryforbearance. The public sector reform agenda is politicallysensitive and may be jeopardized by resistance of vestedin-terest groups.

15. The support of the Bank under PFPSAL 3 and the broadercountry assistance strategy is assisting the Government toovercome these risks and sustain implementation of its economicreform program.

Contact Points

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PFPSAL 3 PID May 19- Final sent to infoshopBank: Lalit Raina ECSPFThe world Bank1818 H St. NWwashington DC 20433-0001Tel.: (1-202) 458-2900Fax: (1-202) 522-0005

James Parks ECSPEThe World BankUgur Mumcu caddesi 88/2GOP Ankara 06700TurkeyTel.: (90-312) 446-3824Fax: (90-312) 446-2442

Borrower: Mr. Ersen Ekren, General DirectorGeneral Directorate of External Economic Relationsundersecretariat of TreasuryInonu Bulvari 3606510 Emek AnkaraTurkeyTel.: (90-312) 213-6873Fax: (90-312) 212-8550e-mail: ersen.ekren@hazine.gov.tr

Note: This is information on an evolving project. Certaincomponents may not necessarily be included in the final project.

This PID was processed by the Infoshop during the week endingMay 23, 2003.

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