Report No. 10014-TU

TurkeyState-Owned Enterprise Sector Review(In Two Volumes) Volume l: Main Report

March3,1993 i

Country Operations DivisionCountry Department IEurope and Central Asia Region l

FOR OFFICIAL USE ONLY

Document of the World Bank

This document has a re'tricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.

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TURKEY

STATE OW1tED ENTERPRISE SECTOR REVIEW

CURRENCRY EQUIVALENTSCurrency Unit = Turkish Lira (TL'US$1.00 = TL2609 (1990 Average)

ABBREVIATION LiSt

ASOK Agir Sanayi ve Otamotiv Kurumu (steel, machinery, vehictes)BCRIC British Coluibia Resource Investment CorporationBEP Basic Earning PowerBoD Board of DirectorsBOTAS Boru Hatlari ile Petrol Tasima A.S. (oil pipeline)CAYKUR Cay Isletmeleri Genel MOdOrlOgO (tea processing)CEO Company Executive OfficerCIF Cost, insurance freightCITOSAk TIrkiye Cimento ve Topral Sanayi T.A.S. (cement)CPI Consumer Price IndexDHMI Devlet Hava Meydanlari Isletmelesi Genet MOdOrlOgO (airport administration)DITAS Deni7 Isletmeri ve Tankercitik A.S. (maritime tanker transport)DL Decree-LawDMB Deposit Money BanksDM0 Deviet Malzeme Ofisi (printing and stationary)DSF Development and Support FundEBF Extra-Budgetary FundEBIT Earnings before interest and taxesEBK Et ve BaLik Kurumu (meat and fish processing)EDC Earnings decLine ccverEM.SAN. Emekli Sandigi Genel MddOrlOgO (CiviL Servants Retirement Fund)GEMSAN Turkiye Gemi Sanayi A.S. (shipbuilding)H'B High Audit BoardHLF Housing Development FundHDPPA Housing Development and Public Participation AdmninistrationHPC High Planning CouncilIGSAS Istanbul G.Lbre Sanayi A.S. (fertilizer)IIBK Is ve Is;i Bulmu Kurumu (Turkish Employment Organization)ILO International Labor OrganizationISE Istanbul Stock ExchangeISO Istanbul Charber of IndustryJSC Joint-Stock CompanyMKEK Makina ve Kimya End0strisi Kurumu (weapons, chemicals)MoU Memorandun of UnderstandingMRR Maximun Rate of ReturnORPL Output related profits levyORUS Orman UrCinleri Sanayi Kurumu (forestry and wood products)PEI Public Economic InstitutionPETKIM Petrokisya Anonim Sirketi (petrochemicals)POAS PetroL Ofisi A.S. (oil products, retail)PPA Public Partnership AckninistrationPTT Turkiye Cumhiuriyet Posta Telegraf ve Telefon isl. Genel MOdOriOgORPI Rate of price inflationSAS Scandinavian Airline SystemSCF Societe de Ciment rran$aisSEE State Economic EnterpriseSEKA Turkiye SeLutoz ve Kagit Fabrikatari (paper)SEKER Turkiye Seker Fanrikateri A.S. (sugar)SGA Single Goverrewnt AgencySOE State Owned EnterpriseSPO State Planning OrganizationSPSF Support ard Price Stabilization rundTARIM Tarim IsletmeLeri Genel MWudrlOgOi (agro products)TCDD Turkiye Cumhuriyet Devlet Demiryollari (railways)TDCI Turkiye Demir ve Celik Isletme eri (iron & steel)TDI Turkiye Denizcilik Isletmeler; (port adninistration and shipping)TEK TOrkiye Elektrik Kurum. Celectricity)TEKEL TOtCun, Tutun Mamulteri, T'.a ve AlkoL Isletmesi GeneL MOdOrlOgO (alcohoL & tobacco)THY TOrk Hava Yollari A.O. CairLines)TKI TOrkiye Komu.r Isletmeleri Kurumu (hard coal mines)TMO Toprak Mahsulleri Ofisi (soil products)TPAO Twrkiye Petrolleri A.O. (refineries)TSEK TOrkiye SOt Endustrisi Kurum (dairy)TTK Turkiye Taskomuru Kurumu (lignite mining)TUGSAS Turkiye Gubre Sanayi A.S. (fertilizer)TUPRAS Turkiye Petrol Refinerilari A.S. (refineries)TZDK Turkiye Zirai Donatim Kurumu (distribution of agro products)USDS Ucak Servisi A.S. (airport catering)YENSAN Yem Sanayi T.A.S. (animal feed)

FOR OMCIAL USE ONLY

§TZ4E-OWNED ENTERPRISE SECTOR REVIE

Table of Contents

Volume I: Main Report

Pace No.

EXECUTIVE SUMMARY.$.$ . .. . .. .*. .... .. . . .. 0.. .. ....... .......

I * INTRODUCTION . .. . . .. . .. . .............. .*....... ....... **....

1I. OVERVIEW OF THE SCO... . .. .. .. . ....... . . . . ........ , ....

Composition and Importance ......................... ... 1 Recent Reforms andT Teir Impact of.................... . 3Deteriorating Performance. .. .. A*#* ...... y. .(El .. .. ..... 5PastExperience withPrivatization .................... 9

III. I-SSUES ............................. ... .. 10

NoncoHmercial Objectives........ 10Soft Budget Constraints ................. . . 12Inadequate Institutional and Legal Frambework .......... . . 14Failure of Divestiture. ... disclosed. . o .... .......... . ... 1

IV. REFORM: STRATEGY, SCOPE, AND AFFORDAIITY...... .. .. 17

Reform Strategy. .. . ... . .. .. .# ...... . .. ............. .17

scope of the Program. . ....... . .............. 19Affordability... . ................. .. ..... 21

V. * DIVESTITURE........ .. . ..................... . 26

L iquiidation .. ........... ........ .......... .27

Sale ofMinority Participations .............. 27The Soil Products Office (THO) and Agricultural Support

Sale/Distribution...... ........ .. ............. 28Dec.,entralization.... ... 0......... . . .. ...... 28

Share Distribution Scee.......... ....... ............ 30

This report is based on the findings of a World Bank mission that visitedTurkey in June 1991. The mission conaisted of Luc Everaert, mission leader(E?41CO); Tevfik Yaprak (EXlTO); Mats Gustavsson and Jeremy Oppenheim (EMlID);Fernando Saldanha (EMTTF); Ahmied Galal and Henry Laurant (CECPS)i and BruceFerber and Derek Bobinson (consultants). Sebnem Akkaya (EHlTU) providedexpert research assistance. Secretarial support was provided by BarbaraMondqstin.

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

Table of Contents (continued)

page K2.

VI. COMMERCIALIZATION. REGULATION. AND LABOR-RESTRUCTUR_ING ......... 33

Commnercialization ..................... to ....................... ................ 33Regulatory Framework . ... ............ ............ . .... 39

Labor Restructuring ................... ... ...... c . 41

Severance ........................................... *....* 41Social Safety Net .... ...... ..... .. ...... 42

Appendix 1: Definitions of Key Concepts . . 44

Box 1i Assumptions for Labor Restructuring ........................ 25

List of-Tables

Table 1: Economic Importance of SOEs.... 3Table 2: Key Performance Indicators . . . 6

Table 3: Forecasts of Financial Accounts .. . . . 20Table 4: Net Present Value of Reform Program ..................... 24

EXECUTIVE SUlMMARY.

i. 1'Following the liberalizati^n of the Turkish economy, the movetoward increased reliance on market forces and the private sector for 'heeconomic development of the country has left the State-Owned Enterprises(SOES) little role to play. They were originally ectablished within aframework of economic planning for the purpose of industrial development andthe provision of infrastructure, but today the SOEs are ill-adapted to facethe challenge of a dynamic market economy. Their increasingly poorperformance brings about a misallocation of resources and crowds out privatesector activities. Instead of being an engine, SOEs have become a constraintfor the industrialization of the country. Reforming the sector creates aunique opportunity to accelerate growth throughout the 19908 by improvingresource allocation. Moreover, SOE performance has deteriorated so much thatit threatens macroeconomic stability, as it did at the end of the 1970g.Hence, reforming the sector will not only raise the economy's growth potentialbut would also form a central part of any Government reform program to resolveTurkey's macroeconomic problems in a sustainable manner.

ii. Reforming the sector necessitates some politically sensitivechoices, especially in the area of labor restructuring and income supportpolicies. Reform also implies abandoning a preferred instrument of publicpatronage. Other countries that have been through massive restructuring ofthe public sector, such as Mexico and Spain, have shown that it can be doneand that the benefits are large and durable. A carefully designed socialsafety net that provides temporary income support and other measures toredeploy dislocated workers can be implemented in Turkey at affordable fiscalcost. Such a program will distribute the burden of income loss of retrenchedworkers over the entire society in an equitable manner and reduce socialopposition to the reform program.

Overview of the Sector

iii. This report covers the nonfinancial State Economic Enterprises(SEES) and Public Economic Institutions (PEIs) defined in Decree Law 233 ofJune 1984. Excluding minority holdings, there are a total of 240 enterprisesin the sector subject to Decree Law 233. This law regulates the structure ofthe management and board, investment and financing programs, and theacquisition and sale of a company, affiliated partnership, or joint venture.Assets of SOEs are considered state property, and all transactions, rights,and claims are governed by the laws on state property. Article 128 of theConstitution stipulates that principal and permanent functions of SOES beperformed by civil servants as long as the state's share of equity exceeds 50percent. Workers fall under the regular labor code, but collective bargainingis performed by a special, centralized unit attached to the Prime Ministry.Because of these regulations, most ot the Turkish commercial code does notapply to SOEs, and management has little or no autonomy. SOEs transferred tothe Public Participation Administration (PPA) for privatization are subject tothe law on privatization and are converted into joint-stock companies.

iv. SOEs are active not only in traditional areas of services(electricity, telecommunications and railways) but in almost all sectors ofthe Turkish industry with a predominance in heavy industries. This role is a

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result of the import-substitution policy pursued by the Govertment before1980. The share of the sector In aggregate value added declined marginallyover the period 1985-91 from 11.5 percent to 9.2 percent of GDP; the SOE shareis much higher in mining (60 percent); energy, gas, and water (40 percent);and transport and communications (38 percent). The SOE's share of groos fixedinvestment has fallen from just over 30 percent in 1985 to lesa than 15percent in 1991. The number of persons employed in SOSs remainedapproximately constant, resulting in a fall in the share of SOEs in non-agricultural employment from 7.8 percent to 6.7 percent. SO05 claimdisproportionately large amounts of foreign credit (2.7 times more than theprivate sector) and of domestic credit (19 percent of total).

Performance

v. Performance of the sector has worsened dramatically in recentyears. The borrowing requirement (before budget traniaere) reached 5.9percent of GNP in 1990 and 7,4 percent in 1991, or more than 50 percent of thetotal PSBR in the two years respectively. The situation is similar to the oneat the end of the 1970s when high SOE deficits also threatened macroeconomicstability. Developnients underlying this deterioration are quite worrisome: anincrease in agricultural support forced the Soil Product's Office (THO) toborrow 1.7 percent of GNP in 1990 and almost 1 percent in 1991 (up from 0.2percent in 1988)1 and the operating surplus of the rest of the sector fellfrom 3.6 percent of GNP in 1985 ta a deficit of -5.2 percent in 1991. Most ofthe deficits are concentrated in industries and trade related to agriculture,electricity, railways, iron and steel, and the coal mine. Total losses of allloss-making SOEs amounted to TL5 trillion in 1990 and TL19 (or about US$3billion) in 1991 (1.9 percent and 4.2 percent of GNP in the two yearsrespectively). Financing of deficits of these magnitudes has become verydifficult. Increasingly, SOEs are using deferred payments, arrears, andmonetary financing (e.g., TMO) to sustain operations.

vi. Financial indicators a'leo show a deterioration of operationalperformance. The return on capital employed in SOEs fell from a healthy 17.2percent in 1985 to a mere 5.3 percent in 1991, less than half of that of theprivate sector and significantly below the weighted cost of capital of firmslisted on the Istanbul Stock Exchange. Financial risk of the sector has risensignificantly over the period 1985-91. After the real wage increases of 1991(about 35 percent), SOEs on balance have not been earning enough to covertheir interest payments.

vii. Economic efficiency of the SOE sector is also lagging behind theprivate sectors. Labor productivity, although moderately 4.ncreasing due to ahiring freeze, has averaged 20 percent lower than in the private sector. In1990, it was 38 percent lower. Capacity utilization in SOEs is generallylower than it is in the private sector, and the marginal efficiency of capitalis only half that of the private sector. These differences imply that SOEsgenerate only hlalf as much value added per unit of capital invested as privatesector firms generate. Efficiency is particularly low in manufacturing SOESand in electricity (TEK). Total factor productivity has been falling in mostof the large infrastructure-oriented SOEa (electricity, railways, and postoffice and telecommunications).

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Goernmet Acion

viii. Aware of the inefficiencies of the SOE secter and consistent withthe overall macroeconomic policies of liberalization in the early 1980s, theGovernment recognized the need for reform. Consequently, during the pastdecade, it issued several new laws and regulations that resulted in changes inpricing policies, market regulation, institutional setting, personnel regime,and divestiture. Of the changes, price liberalization had the mostsignificant impact. Although a few prices are still officially controlledand, at times, SOEs in general are pressured not to raise prices too quickly,pricing of goods and services produced by SOEs is essentially free. Legalmonopolies were abolished and the personnel regime was made somewhat moreflexible, but the divestiture process, started in 1984 and declared thecornerstone of the Government's atrategy to resolve the sector's problems, hasyielded insignificant recults to date. The deteriorating performance of SOEssince 1985 did not pass unnoticed, and the Government, admitting that thereforms were faltering, attempted but failed to pass new legislation in 1990.This legislation would have strengthened financial discipline and managementautonomy; it would also have converted most SOEs into joint-stock companiessubject to the Turkish commercial code.

Issues

ix. Although it is easy to point to the recent increases in wages andagricultural support prices as direct causes of the rapid deterioration in SOEperformance, such an observation misses the fundamental, underlying problem:SOEs are not run as commercial enterprises but as government departments.Continuing political interference has deprived the SOEs of the flexibility toadjust to changing market circumstances. As the result of economicliberalization, public enterprises in former import-substituting industrieshave tended to decline. Unfortunately, the Government did not allow thesecompanies to exit, but instead forced them to borrow to sustain operations.The ultimate causes of poor performance are (a) noncommercial and conflictingobjectives imposed on SOE operations; (b) lack of financial discipline; and(c) an institutional environment prone to political interference. Inaddition, divestiture, which could have resolved some of the problems, hasmade little progress.

x. Although SOE legislation emphasizes the efficient provision ofgoods and services as the main function of the SOEs, the Government has beenusing these enterprises in the pursuit of a variety of noncommercialobjectives. These pursuits include inflation abatement, employmentgeneration, regional development, support for the agricultural sector, incomeredistribution, and industrial and infrastructure development. This practicenot only hides the true budgetary burden of these policies, but it also leadsto conflicting objectives for SOE management and renders an assessment oftheir performance very difficult. Needless to say, holding back priceincreases of SOE products is ineffective in combating inflation. While it isgenerally agreed that SOEs employ a significant amount of redundant labor,they have not created any meaningful number of new jobs in the past fiveyears; it can even be argued that inefficiency in resource allocation haslowered the rate of job creation of the economy. Locating SOEs in remote

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areas that have a small market size, high production costs, and low rates -4capacity utilization has not succeeded in attracting private industry. Theincome of some farmers may have been raised by support price policiep, butonly at the cost of increased inefficiency in the allocation of resources andan addition to macroeconomic instability. Support policies have encouragedthe movement of resources from high to low-valued crops. Selling foodproducts below cost without the explicit targeting of income groups is aninefficient way of redistributing income. In addition, the monetary financingof crop purchases have added to inflationary pressures, taxing the holders ofcash balances, which usually include the poorest group in the rural and urbanareas. In sum, none of these noncommercial objectives is actually beingachieved, and the inefficiencies created in the process are a burden on thedevelopment of the economy.

xi. Faced with so many handicaps, the only way SOEs have been able tosurvive competition with the private sector is through the soft budgetconstraint they are enjoying. This has led to a pervasive lack of financialdiscipline. Subsidies to SOEs have been disguised as equity injections,payment for duty losses, and "aid" (0.5 percent of GNP in 1990, rising to 1.6percent of GNP in 1991). More importantly, guarantees from the Treasury onforeign borrowing, loans, and rediscounts from the Central Bank, and publicdeposit money banks have given the sector significant advantages with respectto access to credit. In addition, SOEs have been allowed to run arrears tothe Treasury, Social Security, commercial banks, and suppliers without facingthe threat of bankruptcy. Moreover, the Treasury as owner has not forced SOEsto earn a reasonable rate of return on equity. Finally, some SOEs areenjoying monopolistic powers, and their privileged relation with theGovernment appears to have deterred the entry of private competitors. Forsome products, domestic prices are significantly higher than border prices,although no systematically higher trade protection for SOEs could bediscerned. Sales to other parts of the public sector and quality controls onimports appear to allow this divergence from international prices.

xii. The institutional framework embodied in Decree Law 233 and relatedlegislation is inadequate to let SOEs be run as commercial enterprises; itleaves them vulnerable to political interference, even in daily operations.The legal framework is responsible for (a) precluding the SOEs from beingsubject to the commercial code, especially from the provisions on bankruptcy;(b) overlapping ownership and management functions; (c) inadequate managerialautonomy} (d) the absence of medium-term business plans and strategies; and(e) the absence of accountability and effective economic or financialperformance evaluation with corresponding sanctions and incentives.

xiii. Despite the fact that divestiture was announced in the early 1980swith the objective of improving the efficiency of the overall economy, littlehas been accomplished to date. Between 1986-1991, total proceeds from thesale of SOEs amounted to approximately $580 million. These sales were smallrelative to the size of the sector, representing less than 1 percent of fixedassets. Following changes in the management and structure of PPA in early1992, significant progress has been realized. Sales proceeds in 1992 amountedto $412 million and with a number of sizable privatization activities close tocompletion and a well-defined five-year program (1994-1998), the outlook is

for a significant acceleration in divestiture. Concerns remain, however, thatboth past and on-going sales have not been accompanied by measures to promotecompetition or safeguard workers or consumers and that too littleconsideration has been given to the development of a regulatory framework (forinstance, in the electricity uector).

xiv. Turkey's divestiture efforts also remain hampered by politicalinterference, tVchnical problems, and exogenous factors. Those groups thatetand to benefit most from privatization (taxpayers, consumere) are diffused,unorganized, and generally poorly informed, and most of the other actorsinvolved in the process (workers, managers, potential buyers, private eectorproducers, politicians) do not perceive divestiture as a positive-sum game.Lack of political support is reflected mostly in the unwillingneos of theGovernment to address upfront the issues of labor redundancy. Compared withcountries in which divestiture was successful, the Turkish divestiture proceshas also been impeded by technical difficulties, includings (a) unclear andconflicting objectives that have shifted from efficiency gains to fiscalrevenue generation; (b) unclear guidelines and lack of transparency regardingtarget buyers, sale instruments, and valuation; (c) insufficient institutionalcapacity of the PPA due to a lack of adequate staff, and authority to handledivestiture in a relatively short period of time; and (d) failure to engagemanagers of SOEs and workers in the process. External factors frustrating theprocess include the shallowness of the Turkish capital market and the lack ofreadiness of SORs for sale.

R2form: Strategy. ScoDe. and Affordabil t

xv. The reform program should be comprehensive and focus on theobjective of improving productive and allocative efficiency. In the nearfuture, very few enterprises, if any, should remain in Government hands.Liquidation, in the past overlooked as a meaningful instrument to achieve thisobjective, needs to be brought to the forefront. Preliminary analysis of theviability of SOEs revealed that, even under fairly optimistic assumptionsabout potential improvements in productivity, about 23 percent of the SOEs(representing 13 percent of fixed asets and 21 percent of employment of thesector) will not become viable and should be liquidated. The remainder of theenterprises should be transferred to private ownership, while the Governmentshifts attention to its role as regulatory agent. For those SOEs operating incompetition with the private sector, the transfer of ownership should proceedas fast as possible. For the post office, telephone and telecommunications,the railways, electricity, and port and airport administration, the statecould maintain operating control temporarily while regulatory agencies for thenatural monopolies were being set up.

xvi. A comprehensive strategy should include the following components:

* divestiture (liquidation,sale);

* commercialization of retained SOEs;

* regulation of natural monopolies;

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O labor restructuring (retrenchment, social safety Pat)J and

* other policy changes (noncommercial objectiveo).

xvii. Efficiency gains of the reform program are difficult to estimateand would likely take several year. to accrue. However, the Bank mission hasmade some rough estimates. In a static sense, had SOEs' investments in theperiod 1985-90 been as efficient as those of the private sector, GDP couldhave been higher by 3 percent in 1990. Had anounts equivalent to the lastfive years' losses in those SOEs which are likely liquidation candidates beeninvested in the private sector, some 50,000 addltional jobs would have beencreated. The most important gains, however, are likely to come from theindirect effects of a combined program of fiscal and SOE reforms. Cutting thedeficits of SOEs will be crucial because fiscal deficits of the 1991 magnitudecannot be sustained at reasonable inflation rates. Also, tax and revenuereforms take time to irplement and in any event cannot be expected to providethe entire needed adjuetment. A reduction in the primary deficit in the orderof 8-10 percent of GDP from the 1991 level (and spread over three years) wouldreduce the need for monetary financing to levels coneistent with inflationrates below 20 percent per year. Reductions in SOE deficits would need toprovide more than half of the required adjustment. The decline in inflationrates from 60-70 percent to below 20 percent would l.ikely raise the long-termgrowth rate of the economy by 1.5 percentage points by reducing uncertainty,increasing private investment, and redirecting investment away from inflationhedges, such as housing. The additional job creation from such increasedgrowth would be sufficient to reabsorb all the retrenched workers from SOEreforms within 3-4 years.

xviii. There are also financial gains and losses from SOE reforms. Thefiscal cost (accumulated lossea and terminal value of the companies) ofcontinuing to operate the SOEs for the next ten years is conservativelyestimated at US$18 billion. As an illustration, the Bank mission hasestimated that reforming the SOE sector over a two-year period would cost US$7billion (excluding privatization proceeds). The fiscal costs includeseverance pay, temporary income support for retrenched workers, losses of thecompanies during the implementation of the program minus the final net valueof the enterprises, excluding the proceeds of sales of on-going concerns. Bysequencing the reforms properly, fiscal gaine are possible even in the firstyear of the reform program. Reforming agricultural support policles,liquidating the largest loss-makers, transferring the bulk of the enterprisesto the private sector. reducing employment in retained SoEs, and sellingminority participations could yield as much as US$9 billion in fiscal savingsover a two-year period, an amount exceeding the eotimated costs of the entireprogram. Given the need for drastic fiscal adjustment, these net gains bythemselves would not be enough to achieve the needed stabilization; thus theywould need to be complemented by other fiscal reforms. However, SOEscontribute so much to public sector imbalances, any fiscal reform program mustinclude a substantial SOE reform in order to be credible.

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xix. A preliminary analysis of the viability of SOEs indicateo that thegains from liguidAtioa of unviable unite are the largest in terms ofefficiency and contribution to budgetary irnprovements. Moreover, if theGovernment were to wait another 10 yeare before closing down theoc unite, thecost to the budget would be almost. three times ae high as closing them downover the next two years. To make liquidation socially acceptable andeconomically feasible, the Government would have to (a) implement a laborredeployment program, (b) isve guidelines for the eale of assets, (c)transfer the assets to an independent commission that would auction them, and(d) make funds available to meet net liabilitiee.

xx. The majority of the SOEs in numbera and asset size are candidatesfor immediate trgnafer to the tsrIctor The private uector is likely torun these enterprises more efficiently, partly because the Government le.cksthe resources to finance the physical restructuring needed in most of theSOEs. The limited results of oeven years of diveatituro effort indicate theneed for a new apprcach. The approach should put a premium on the speed ofthe transfer so that efficiency (and fiscal) gains can be realized in theshortest time possible. The Government could implement one of two differi,ntoptions: (a) a decentralized approach to share sales or (b) free sharedistribution.

xxi. The decentralized approach to share sales would involve requiringthe managers of the SOEs to formulate and present divestiture proposals withina short period. The approach has the virtue of involving persons withsubsector knowledge directly in the creation of divestiture planse it getsaround the resource constraints of the centralized approach used to date. Ifthe required expertise is lacking, it may be necessary to replace the existingboard or management by experienced private sector personnel prior to the startof this process. Expenditures for expansion or rehabilitation programs shouldnot be allowed in any divestiture plan. These expenditures decisions are bestleft to new private buyers. Once the proposals for divestiture are approved,managers/boards would start the implementation. In order to provideincentives for the expeditious design and implementation of divestitureprograams, boards/managers could be offered stocks in the company in proportionto sale proceeds and speed of divestiture. Workers could be granted thepreferential right to buy up to 10 percent of the shares of a given company.

xxii. Although the decentralized approach has the advantages ofovercoming resistance of management and labor and generating some fiscalresources, its main drawback is the possibility that it may not reducepolitical interference. Hence, the success of this option would depend on howefficiently tho central political authority can overcome the interests ofsectoral ministries. Therefore, it is possible that the other option, freeshare distributiun may be politically and economically more appealing.

xxiii. In its purest form, a share distribution scheme would work in thefollowing way. The majority of the shares (e.g., 80 percent) of the companiesto be privatized would be distributed to the public for free, or at a nominalchargw if legal constraints preclude giveaways of state property. The

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remaining 20 percent of the shares would be transferred to a self-liquidatingfund with the mandate to sell themo shares in blocks to private, domestic, orforeign investors. Block ealrq have a dual purpooes (a) they allow privatemanagers to gain control over a company wlthout havlng to invest excessivelylarge amounts, and (b) they prevent too wide a dispersion of ownership. Ifafter a three month period from the titribution no market has formed in theshares of any of the companies, the , i would aell 3 percent of the share. bypublic offering to establish market-based valuation. The fund would divestitself of all its shares in a two-year period and would receive compenoationbased on the realized sales proceeds. During the transition to privatecontrol, existing management would remain, but it would not be allowed to buyor sell assets, grant real wage increases, or otherwise modify the structureof the company.

xxiv. Compared with past policies, a share distribution schema is likelyto accelerate the process. It has some advantages over the other option.Specifically, once the scheme is adopted, political interference, one of themajor problems of past divestiture efforts, would be virtually eliminated.The gcheme is simple and transparent and it appears to be fair since thegeneral public would share in the division of national ansets. It would helpto increase the role of the capital markets in resource allocation. It hasone potential drawback; it wou_d forego most of the fiscal proceeds from thesales because the majority of shares would be given away. However, given thatmany SOEs are in poor financial condition, such proceeds are unlikely to bevery large. Since SOEs in the aggregate are running at a lose, the slowerspeed of share sales (as compared with a giveaway) means that losses willoffset part (or possibly all) of sales proceeds.

Labor Restructurina

xxv. The divestiture and restructuring of SOEs will be associated withsi9 .ificant labor retrenchment. Although improvement in resource allocationwill lead to an increase in the rate of job creation, there will be temporaryincome loss for many workers. This loss could be particularly severe in areaswhere SOEs were major income-employment providers. Sever-nce pay to workers,a legal obligation, is unlikely to overcome social resistance to the reformprogram. Hence, the Government should anticipate the implementation of atargeted social safety net consisting of (a) temporary income supportadditional to severance pay; (b) employment services, and (c) training andemployment generation measures. It is important to involve workers,manaaement, and the private business community as soon as possible in theprocess. Also counseling services for training and job search should beestablished before layoffs take place. The temporary income support measuresshould be designed in a way to stimulate workers to find new employment.Aside from training, mobility assistance and measures promoting self-employment should be considered. Under reasonable assumptions about the scopeof the program, the cost of labor restructuring would amount to about US$2.7billion over a two- year period. However, the program would immediately leadto annual savings in personnel expenditure of US$1.8 billion; hence, a netfiscal gain would be possible.

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xxvi. For SOEs that would, at least temporarily, remain in Governmenthands, improving efficiency requires a drastic modification of the legal andinstitutional environment. The role of ownership and management should beseparated, and interference from a multitude of public agencies should beminimized by creating a Single Government Agency that would be the soleinterface between the SOEs and the rest of the Government. All SOEs should beconverted into joint-stock companies, and the usual shareholder-board-management structure should be put in place. No members of management shouldbe allowed on the board, and management should be given full autonomy inpricing, employment, and procurement decisions. The Single Government Agencywould represent the state as owner and would instruct the board to maximizeprofits over time, i.e., maximize the value of the firm. Accountability ofboard and management should be enforced through a well-defined performancemonitoring, evaluation, and sanctioning system. Financial discipline shouldbe imposed by (a) withdrawing Government guarantees for borrowing; (b)avoiding equity injections (unless expansion of the company and the expectedreturn justify it); (c) allowing assets to be collateralized; (d) replacingsubsidies, aid, and duty loss compensation by negotiated contracts with ex-ante budgetary provisions; and (e) permitting bankruptcy and closure accordingto the Turkish commercial code. For those SOEs that are economically viabl.ebut currently insolvent due to the accumulation of past losses (e.g.,electricity and shipping services), financial restructuring would beindispensable to ensure their survival in fair competition with the privatesector.

RAqmLatioa

xxvii. Transferring public monopolies into private hands does notguarantee an improvement in efficiency; it does create rents. The sale of thecaterinrj company to the private sector, which has a de facto monopoly due tolimited space on airport premises, is a case in point. Therefore, the reformprogram must be accompanied by measures stimulating competition andefficiency. For natural monopolies (telephone, electrici'.y distribution, portand Airport adininistrations) a regulatory framework needs to be put in place,whe'her or not the monopolies are transferred to private ownership.Inoependent sector specific regulatory agencies need to be established toregulate pricing, entry and exit, and quality of services.

Ren Deloments

xxviii. With the election of a new Government in October 199', there hasbeen a renewed effort to accelerate the pace of change in the SOE sector.Recognizing the political and technical constraints on previous reforminitiatives, the Government proposed the estabAishment of a new autonomousagency - TOYOK - to oversee the SOE divestiture and restructuring process.The draft legislation enviaages that TOYOK would have (a) a Generai Assemblyof 41 shareholders, drawn from the public and private sectors; and (b) a sevenperson Board of Directors, with four directors appointed hy the Council cfMinisters and three aelecte from the General Assembly. While the fullprovisions of the legislation are not known, it appears that, if approved,

(a) all SOEU will be eligible for ..ransfer to TOYOK; (b) enterprises would botransferred to TOYCK on a case-by-case basis by a Council of Ministers'Decree; and (c) after the transfer, TOYOK inanagement would be mandated toaccomplish the SOE divestiture or restructuring by a specified time.

xxix. The TOYOK formula provides a valuable mechanism for buildingsocial consensus on the SOE reform program, and it may even help to insulatethe technicians from direct political pressure. However, ito successultimately depends on the courage of individual politicians to takeresponsibility for the reform program, to look to national rather than localinterests, and to address squarely the social costs of adjustment. The factthat SOEs will be transferred to TOYOK on a case-by-case basis is likelyto politicize and slow the process. In the absence of an adequate socialsafety net that La fully understood by the SOE employees, it io unlikely thatany reform effort can be sustained, much less command support across thepolitical spectrum. To date, the legislation for TOYOK has not been passedand it appears that the Government may be considering alternativeinstitutional arrangements.

X~~ ~ I l. P, b 1 , ....

1. 2Thin report reviews the nonfinancial state-owned enterprise sectorin Turkey. After a temporary improvement during the first half of the 1980e,performance of SOsa has deteriorated rapidly in recent years, and the sectorhas become a major burden on the oconomy. These developments prompted theBank, at the request of the Government of Turkey, to initiate a study todetermine the cause of the problem and more specifically to outline thedirection that reforms should take. Emphasis is placed on how to implemeiitthe reforms in practice.

2. The main volume of the report consists of five sections beyondthis introduction. The first section briefly reviews the sectorle performancebetween 1985 and 1991, including reform efforts and their impact. The secondsection identifies the major issues and constraints the sector is facingtoday. The third section outlines the reform strategy and discusese its scopeand fiscal implications. The fourth section details the implementation of thedivestiture component of the strategy, while the fifth section describes theissues related to commercialization of temporarily retained enterprles,including their regulation and labor restructuring. An appendix contains alist of defiriltions of frequently used quantltative indlcators.

3. The main report La accompanied by a volume of annexes that providethe background for the analysis and the technical aspects of theimplementation of the reformes. The annexes cover economic and financialperformance, fiscal performance, budgetary impact and oubsidization,divestiture, institutional and legal reform, competition and financialdiscipline, and labor policies and the social safety net.

II. pBnVIE OF THE SECTOR

4. This report defines SOEs as all. nonfinancial enterprises owned bythe state and subject to Decree Law 233 issued in June 1984. State-ownedbanks, enterprises outside the scope of Decree Law 233 and stateparticipationa in cooperatives, as well as minority participations, areexcluded from the quantitative analysis. The resultLng sample consists of 28holdings, which own 62 companies and hold a majority at', in 44 affiliatedpgrtnerships. Altogether, they make up about 240 separate production unite.The analysis is conducted at the level of the holding based on consolidatedaccounts, with a few exceptions in cases where more disaggregated informationwas available. The group of enterprises holds minority participations in morethdn 100 joint-stock companies (JSCs). This point is taken into account onlyto the extent that it affects the parent-company through changes inparticipations and transfer of profits.

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5. SOEs continue to be active in almost all sectors of the economy.Aside from the usual monopolies in the service aector (e.g., railways,telecommunications, electricity), SOEs dominate the mining sector and theproduction of basic metals and chemicals as a consequence of the Government'simport substitution policies before 1980. A list of all SOEs, with their mainareas of activity, is included in Table Al.l of Annex 1. Their importance forthe economy and its recent evolution can be summarized as follows (see Table1):

(a) Aggregate value added has declined moderately from 11.5 percent ofGDP in 1985 to 9.2 percent of GDP in 1991.Y It declined more inmanufacturing and mining, rose in transportation andcommunication, and remained roughly constant in the other sectors.

(b) Gross fixed investment in the period of 1985-1991 declinedsignificantly in real terms (approximately 48 percent) and as ashare of total gross fixed investment of tha economy (30 to 15percent). This decrease reflects not only the Government'sdeliberate policy to move out of activities competing directlywith the private sector but also the increasing difficulty offinancing the public sector's deficits. The bulk of SOEinvestment takes place in energy, transportation, andtelecommunications.

(C) Employment has gradually declined in most SOEs, due to a hiringfreeze and a regulation to replace only 70 percent of job-leaver.Despite these policies, SOEs still employed about 600,000 peoplein 1991. This number is mainly due to rising employment inexpanding sectors (e.g., airlines, telecommunications, andelectricity). Excluding Petkim and SUmerbank (for lack ofcomparable data in 1989-1990) employment in the sector rose by 2.2percent between 1985 and 1991 and by 23.5 percent since 1979. Thesector's share of nonagricultural employment fell from 7.8 percentin 1985 to 6.7 percent in 1990.

(d) Compared with the private sector, SOEs obtain a disproportionatelylarge amount of foreign and domestic credits. Medium- and long-term external debts have risen steadily to over US$5 billion in1991 (about 10 percent of Turkey's external debt, excludingonlending by the Treasury), while short-term borrowing jumped byabout US$l billion in 1°90, mainly due to THO's financing of croppurchases. SOEs obtained more than two and a half times as muchmedium- and long-term foreign credit as the private sector.Domestic interest-bearing liabilities constitute one fifth oftotal credits extended by the banking system, but they declinedsomewhat over the past three years. Conversely, nonintereat-

1 Value added estimated as the sum of factor payments of SOEs is biaseddownward because of the practice of some SOEs to include interest payments ininvestment and in cost of inputs.

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bearing liabilitiesV have risen sharply. The bulk of domesticcredit is extended to SOEs by public deposit money banks.

Teble 1: Economic Importance of SOEsCTL tritLion)

1985 1986 1987 1988 1989 1990 199t

Gross VaLue Added (current prices) 2.9 3.8 5.7 9.2 16.0 26.6 36.6Share of GE (X) 11.5 10.8 10.8 10.0 10.5 10.6 9.2

Fixed Investmest (current prices) 1.6 2.4 3.3 5.1 6.9 9.8 13.1Share in TotaL (1988 prices)(X) 30.4 27.4 22.7 21.2 18.0 16.1 14.8

EmpLoyment (in thousands)2/ 583.7 600.1 597.0 602.5 602.3 596.2 561.61/Percent ef nonagric. employment 7.8 7.6 7.3 7.2 7.0 6.7 5.8

Foreign Debt (USS mitlion)-' 2343 3551 4217 4260 4551 6045 5485.0

Domestic Debt/Total credits(%) 15.6 20.4 22.4 23.6 17.2 19.2 16.9

Source: /Treasury, CentraL Bank and S15.Notes: - Preliminary.

Excluding Petkim and S(Imerbank.V Excludes employment in those SOEs transferred to PPA.V Including short term.

Recent 8!eforMs and Their Imtnact,

6. In 1980, when the borrowing requirement of the SOEa soared to 6.4percent of GNP (about two thirds of the entire public sector deficit) theGovernment promptly initiated measures to improve the sector's financialperformance. In light of the underlying economic inefficiencies and in linewith the overall macroeconomic liberalization of the early 1980s, theGovernment accepted the need for deeper reforms. It issued several laws andregulations that resulted in changes in pricing policies, market regulation,institutional setting, personnel regime, and divestiture strategy, atdifferent episodes during the decade.

7. Pricino Policies. Increases in prices of goods and services soldby SOEs were part of the stabilization package that brought macrobalances backunder control in 1980-81. Prices continued to be regulated until 1984, whenthe new decree law for the sector explicitly liberalized tnem by shiftingprice setting authority to the management of "State Economic Enterprises" asdefined by the law. However, the law reserves the right of the Council ofMinisters to intervene in pricing decisions, provided that foregone profitsare compensated by duty loss payments from the central government's budget.

9 Mainly deferred payments to the Treasury, Social SecurityInstitution, extra-budgetary funds, and private suppliers.

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For Public Economic Institutions (PEIs) as defined in Decree Law 233a', theCouncil of Ministers can set prices and rate schedules. At present, prices ofonly seven goods and services of minor importance continue to be formallyregulated.

8. In practice, the new legislation did not lead to full pricingautonomy. SOE managements are subject to informal pressure to hold back priceincreases, especially prior to important electiona. Before the Novemberelections of 1987, for example, the public wholesale price index was laggingits private sector equivalent by almost 20 percent since the beginning of theyear. The present system of price guidance also leads to cross-subsidizationamong SOEs, and the compensations for noncommercial duties imposed on theenterprises are generally paid with a lag of at least one year and withoutinterests.

9. Market Regulation. Recognizing the virtue of competition tostimulate efficiency, the Government abolished state monopolies in theproduction of sugar, tea, alcoholic beverages, and the distribution offertilizers in 1984. In June 1991 the monopoly on tobacco distribution andimportation wau also abolished. In the energy sector, private generation isbeing encouraged. The only remaining production monopolies are weaponry,newsprint, and cigarette paper. In practice, however, many large SOEe stillenjoy monopolistic positions, and the Government abstained from measures tobreak up SOEs in order to foster competition between plants in the same lineof business. It also eschewed the introduction of private sectorparticipation through subcontracting of services, franchising, or leasing. Inthe service sector, scheduled domestic airline flights, broadcasting, railwaytransportation, telecommunications, port and airport administration, and thebulk of electricity distribution are exclusively in the public domain. TheGovernment did not set up regulatory mechanisms to enhance efficiency and didnot foster private sector participation.

10. Institutional Framework. The main objective of Decree Law 233, isto raise efficiency by granting more autonomy to boards and management and byreducing political interference. This law effectively keeps SOEs outside thecommercial code, however, and perpetuates outside ex ante control over thedecision-making process of SOEs through annual budgets and financing programsthat need to be ratified by other public agencies. In 1990, after realizingthat the changes had not had noticeable effects on efficiency, the Treasuryattempted to pass new legislation that would have converted all SOEs intojoint-stock companies (hence, subjecting them to the commercial code) andwould have strengthened the supervisory role of the Treasury in order toimpose financial discipline. For political and, to a lesser extent, technicalreasons the law was never passed. Efforts continue, however, to prepare theintroduction of a more comprehensive legal reform package.

I These are TEX (electricity), TCDD (railways), PTT (post office,telephone, and telecommunications), THY (airline), DHMI (airportadministration), TEKEL (alcohol and tobacco), CAYKUR (tea), and TARIM (agro-products).

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11. Personnel. The constitutional requirement to have SOEs managed bycivil servants was perceived as excessively restrictive. To circumvent thisrequisite, Decree Law 233 introduced the possibility of hiring staff underone-year renewable contracts. This measure was designed to attract betterqualified people by offering higher salaries. The High Court of Justice ruledthis practice unconstitutional, however. Subsequently, in January 1990 a newlaw on personnel in SOEs was enacted. This time a new category wasintroduced: civil servants with contracts. Again, the High Court annulledthis practice in August 1991, citing abuses as the main reason. Even underthe new regime, however, salaries were not linked to performance. Decree Law233 and subsequent amendments eliminated the provisions of previous lawsrequiring experience in the publi^ sector as a prerequisite for appointment tothe management of an SOE. By enacting a hiring freeze and issuing aregulation that only 70 percent of job-leavers could be replaced, theGovernment attempted to address the issue of redundant labor. Whileemployment was reduced in most companies, the expansion of a few of themprevented total employment in SOEs from falling. Since 1989, wagenegotiations in SOEs have become highly politicized, leading to a more thandoubling of the real wage of workers in the two years prior to June 1991.

12. Divestiture Strateay. In the wake of the economic liberalizationof the early 1980s, the Government declared its intention to privatize SOEsthat no longer had a specific national mission. Efficiency of resourceallocation was the initial objective. In a first phase, it translated intoprice liberalization of goods and services produced by SOEs. Divestiture hadto wait until 1984, with the creation of the Housing Development and PublicParticipation Administration (HDPPA) from which the Public ParticipationAdministration (PPA) was subsequently separated in 1990. Several majorstudies were initiated in the period 1984-86, and a masterplan forprivatization was prepared by private consultants, but not implemented becauseit was considered "too remote from Turkey's reality." In 1986, a specific lawon privatization was issued, outlining the responsibility of the HDPPA and thetransformation of SOEs to be divested. However, the law was not clear onbidding procedures, target groups of buyers, and sales instruments. In 1986,the objective of divestiture shifted from. improvement in efficiency to thedevelopment of domestic capital markets through widespread distribution ofownership. However, valuation problems and the shallowness of the capitalmarkets prompted the PPA, which was eager to show results, to resort back toblock sales to foreign investors (cement and catering). These sales havesubsequently been overturned by court decision, but the foreign ownerscontinue to operate the firms and are expected to continue to do so.Pressured by increasing fiscal deficits in the period 1989-91, the centralgovernment urged the PPA to generate resources for the budget. Consequently,the PPA shifted back to public offerings of minority stakes of SOEs andcompanies in which it held a minority participation.

Deteriorating Performance

13. Despite all these reforms, the borrowina reauirement (beforetransfers) of the SOEs soared to 5.9 percent of GNP in 1990 more than 50percent of the entire public sector's borrowing requirements (see Table 2).

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In 1991, the borrowing requirement jumped to 7.4 percent. The increase Inborrowing requirements were the result of large real wage increase, increasesin agricultural support prices, and government admonitions to SOEs to heldtheir price increases down. All of these tendencies grew in anticipation ofthe general elections of 1991. The following developments underlying thisdeterioration are quite worrisome (see Annexes 1 and 2 for details)s

(a) Income support to the agricultural sector has increased in recentyears, forcing the Soil Products Office (TMO) to raise itsborrowing from 0.2 percent of GNP in 1988 to 1.7 percent in 1990and almost 1 percent in 1991.

(b) The aggregate operating surplus of the sector (excluding TMO) hasbeen on a declining path since 1985; it fell from 3.6 percent ofGNP to a deficit of -5.2 percent in 1991.

(c) Gross fixed investment of the sector has fallen by 48 percentsince 1985 and the sector's contribution to value added hasdeclined.

Table 2: Key Performance Indicators1/(Percent of GNP)

1985 1986 1987 1988 1989 1990 1991

Borrowing Requirement:Before Transfers 3.7 3.8 5.2 3.7 3.4 5.9 7.4After Transfers 3.1 3.4 4.4 2.7 2.6 5.5 4.7of which TMO: 0.4 0.9 0.8 0.2 0.6 1.7 0.8

Share of total public sector(X): 66.6 72.1 56.6 43.6 37.0 53.6 49.3Operating surplus 3.6 1.5 1.1 0.4 0.8 -0.6 -5.2

Return on Capital Enployed CX) 17.2 14.3 12.7 10.6 10.3 6.7 5.3Free Cash Flow n.a. -7.4 -12.5 -8.5 -8.8 -4.0 n.a.Financial Leverage Ratio 2.3 2.5 1.9 2.8 2.3 2.4 2.4Earnings DecLine Cover (%) 85.4 78.8 70.1 68.8 61.1 50.4 31.9

Industrial SOEs in Top 500 firmsErployment (X of total) n.a. 57.0 55.0 55.5 54.5 53.4 54.5Fixed Assets (X of total) n.a. 69.0 68.7 69.8 68.9 65.9 60.0Value Added (X of total) n.a. 46.0 44.8 47.0 45.8 41.6 35.4Labor productivity (X of private) n.a. 85.0 75.0 86.0 90.0 62.3 45.8

Source:1 Treasury, SIS, ISO, IBRD and calculations.Notes: All indicators, except borrowing requirement, exclude TMO.

14. The contribution of individual SOEs to the deficits in the secondhalf of the 1980's has been a function of the size and the nature of theenterprise (see Annex 2 for details). Deficits have been concentrated interms of size in electricity (TEK), industries and trade related toagriculture (TMO, SEKER (sugar), and, TEKEL, (alcohol and tobacco)), railways(TCDD), telephone and telecommunications (PTT), and iron and steel (TDCI).Four major types of performance can be identified: (a) large SOEs with on-going investment programs that require outside financing (TEK); (b) large SOEswith recently completed projects that have led to a noticeable increase in

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retained earnings and a reduction in financing needs (PTT and PETKIH,petrochemicals); (c) SOEs used for agricultural support with persistentdeficits (TMO, SEKER, TEKEL); (d) genuinely poor performers, mainly in import-substituting industries (TTK (coal), and TDCI). It should be noted, however,that in 1990 only three SOEs had a surplus rather than a borrowingrequirement: PTT, THY (airline), and BOTAS (oil pipeline). Operating losseswere concentrated in TEK, TTK, TDCI, and TCDD. Together, all loss-making SOEsaccumulated a loss of TL5 trillion (1.9 percent of GNP) in 1990 rising in 1991to TL19.2 trillion or 4.2 percent of GNP. Three SOEs (PTT, TEKEL, and TPAO)have generated in recent years about 80 percent of SOE profits.

15. The increasing financing needs of the SOE sector not only crowdedout the private sector from domestic financial markets but also increased theburden on the rest of the public sector. The contribution of foreign sourcesto the financing of SOE deficits fell from between 50 and 60 percent in theperiod 1985-88 to around 20 percent in 1989-90. This decline reflects thechange from project financing to financing of operating costs. About 25percent of the deficits have been financed through domestic interest-bearingliabilities. An increasing proportion (56 percent in 1989-90) is beingfinanced through deferred payments to the private sector (16 percent) and thepublic sector (40 percent). Together with budgetary transfers, subsidies anaarrears to Treasury, the Social Security Institution, and extra-budgetaryfunds (EBFa), the budgetary burden of the SOE sector rose rapidly to anestimated 3.9 percent of GNP in 1990 (see Table 2).

16. The rise in the SOE sector's deficits was accompanied by adeterioration in financial pLerformance (indicators exclude TMO, see Annex 1for details):

(a) Return on capital employed (ROCE) in SOEs has fallen from 17.2percent in 1985 to 5.3 percent in 1991. During this period, thedecline was continuous, and since 1988, the return has been belowthe cost of financing as measured by the return on equity on theIstanbul Stock Exchange (ISE). SOEs earned only half as much, onaverage, as the private sector firms in the largest 500 industrialenterprises in Turkey (to which most of the SOEs belong).

(b) The sector's cash flow shortage (i.e., the cash borrowingrequirement plus working capital needs) has been very high duringmost of the period 1985-90. As a share of GNP it was as high as12.5 percent in 1986, but it fell to 4 percent of GNP in 1990 as aresult of a reduction in investment and working capital.

(c) The sector employs 2.5 times as much debt as equity, a much higheramount than the private sector. This difference mainly reflectsthe fact that the choice of equity versus debt financing is notbased on corporate criteria but rather on a decision of thecentral Goveinment, which must approve equity injections into thesector.

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(d) The earnings decline cover (EDC), indicating the percentagedecline in earnings that can be sustained before interest paymentsare no longer covered, has also gradually fallen from 85 percentin 1985 to 50 percent in 1990. After the real wage increases of1991, the sector is unlikely to be able to cover its interestpayments.

17. Financial performance has not been equally poor or deterioratingfor all SOES, and, if plant level data were available the picture wouldpresumably become even more diverse. Particularly poor performers are thehard coal mine (TTh), the railways (TCDD), and, in recent years, the soilproducts office (TMO). But also the electricity company (TEK), the steel mill(TDCI), and a few smaller companies (meat and fish, cement, agriculturalmachinery) are in poor financial shape. With the exception of ORUS (forestryand wood products) and PETKIM (petrochemicals), chere are no completelyfinancially sound SOEs.

18. Even though only partial indicators of economic rerformance areavailable, the evidence appears to be strong enough to suggest a deteriorationin this area as well. Among the major indicators are the following:

(a) Over the period 1985-1990, the marginal efficiency of capital(i.e., how much value added can be produced per unit of fixedcapital invested) in SOEs has been about half of that of theprivate sector. If the same efficiency could have been achieved,GDP could have been higher by about 3 percent in 1990.

(b) Capacity utilization in manufacturing SOEs, especially in 1989-90,has been significantly below that of the private sector.

(c) Labor productivity in industry has been, on the average, 20percent lower in SOEs than in the private sector, and it was up to38 percent lower in 1990. In some sectors it was as much as 75percent lower. Although labor productivity increased by 12percent over the period 1985-90, it lags about 90 percent behindreal wage increases.

(d) The share of SOEs in total employment (53 percent) and in fixedassets (66 percent) of the 500 largest industrial firms exceedsthat of value added (42 percent). This gap indicates the use ofan inefficient factor combination or too large a scale ofproduction.

(e) In the seven largest SOEs (in terms of fixed assets), total factorproductivity (TFP) fell over the period 1985-90 in all that wereincreasing their capital stock (TEK, PTT, TCDD, and TTK), exceptfor the airline company. TFP rose in SOEs with declining capital(TKI, TDCI) and in the airlines.

19. Although it is easy to point to recent increases in wages andagricultural support prices and to the real exchange rate appreciation induced

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loss in competitiveness as continuity to the rapid deterioration ofperformance, such an observation misses th3 fundamental problem: SOEs are notrun as commercial enterprises but more as government departments. Continuingpolitical interference has denied SOEs the flexibility to adjust to changingmarket circumstances. In particular, the continuing liberalization of theeconomy and lack of self-financing capacity has left them with an obsoletecapital stock. Thus they are unable to compete with the private sector, andsurvive primarily because of a soft-budget constraint.

20. Signs of serious problems in the SOB sector were already apparentat the end of the 1970s. The record SOE deficits of 1980 were resolved byraising prices and forcing a real wage erosion. In 1987, the deficit roseagain (to 4.4 percent) and a financing crisis was averted by drastic cuts inreal investments and further real-wage erosion. By 1988, real wages hadfallen by 25 percent below their 1980 levels, and by 1990 real investment wasbelow its peak by 40 perc4nt. The current SOE deficit will not be as easy tocure because (a) prices cannot be adjusted upward because of competition fromimports and the domestic private sector, except for the natural monopolies;(b) investment is insufficient to maintain an adequate capital stock; and (c)wages (which have risen by over 100 percent in real terms since 1988) are nowset by contracts, including almost complete indexing. Addressing theunderlying problems can no longer be avoided.

Past Z,xerience with Privatization

21. Although the Government emphasized divestiture as the key toimprove the performance of the SOE sector and to promote overall economicefficiency, results have fallen short of expectations. With changes in themanagement and structuring of PPA in early 1992, significant progress howeverhas been realized recently. The results of the process through 1992 can besummarized as follows (see Annex 3 for details):

(a) No major holding, subsidiary, or partnership has been liquidated.

(b) Between 1986-91, total proceeds from 42 sales amounted toapproximately $580 miliion. Almost one-third of this total wasgenerated by the sale of 8 percent of PETKIM and another 10percent by the sale of 3 percent of Erdemir (iron and steel).These sales were small relative to the size of the sector,representing less than 1 percent of fixed assets.

(c) As a result of the changes within PPA, 16 companies wareprivatized in 1992 with total Bales proceedo of $412 million.

22. On-going PPA privatization activities that are close to completion(an additional 5 cement companies, trucks (TOE), department stores (GIMA),electric utilities (Cukurova and Kepez) and a variety of agriculturalprocessing operations) and PPA's five-year program (1994-1998) suggeEt that asignificant acceleration in divestiture is imminent. There are concerns,however, that past sales have not been accompanied by measures to promotecompetition, or to safeguard consumers or workers. For instance, in the

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electricity sector, where private participation in generation is welcomed, aregulatory framework addreasing the issues of competition, pricing, servicestandards or consumer interests has not been developed. As to workers, inrecent cement company sales, as much as 50 cement of the labor force han beenlaid off, without consideration of the need for income and employment supportmeasurea.

23. Progress on the secondary objectives of privatization, thedevelopment of domestic capital markets, diffusion of ownership, andgeneration of fiscal proceeds has been equally slow. The first publicoffering turned into a major failure, and most subsequent offerings have beenundersubscribed. The need to generate fiscal revenue from eales of shares hasgenerated a tendency to overvalue the shares. For most companies, where theGovernment retained control, share prices have not kept up with the ISE indexsince the date of issue.

III. ISSUES

24. As in many countries, public enterprises in Turkey are animportant instrument for public patronage. The boundary between Governmentand enterprise control is ill-defined and continues to shift. The recentdeterioration in performance is not just the result of a decision to raisewages and agricultural support prices but also reflects the cumulative effectsof past policies in the sector. Against the background of the liberalizationof the economy and its integration in world markets, it should be expectedthat former import-substituting industries would decline. Not being allowedto exit, and continuing to be run in the rigid tradition of governmentdepartments, SOEs lack the resources to face the challenge of the marketeconomy. Although some policy decisions can be reverted and somemacroeconomic developments (such as the recent real exchange ratedepreciation) can provide temporary relief, the sector is facing a number ofstructural problems. SOEs are not run as commercial enterprises, must pursuemultiple and often noncommercial objectives, enjoy a soft-budget constraint,and live in an institutional and legal environment prone to politicalinterference. Moreover, the divestiture process has failed to producesignificant results, so far.

Noncommercial Obiectives

25. Although SOE-related legislation emphasizes the efficientprovision of goods and services as the main function of the SOEs and stressesproductivity and profitability, the Government has been using SOEs asinstruments to achieve a host of noncommercial objectives. These in.lude, butare not limited to inflation abatement, employment generation, regionaldevelopment, agricultural support, income redistribution, and industrial andinfrastructure development. The use of SOEs for these purposes not only hidesthe true budgetary burden of the policy but it also leads to conflictingobjectives for SOE management and renders an assessment of their performancedifficult. According to the law, SOEs are to be compensated for these duty

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losses. However, since the Government does not provide for ex ante budgetarysupport and its policies take the form of open-ended commitments, claims forduty losses need to be audited. This delay often means that compensation ispaid with a year's lag, and without interest. Hence, on a net basis, thesector's financial performance Li adversely affected and the noncommercialobjectives are rarely attained.

26. Holding back price increaaes of SOE products is ineffective incombating _t_J_on. Even if, on theoretical grounds, a marginal case couldbe made for using public prices as a nominal anchor in an all-out inflationstabilization attempt, in practice, such aztempts have almost always failed inTurkey and in other countries. Hence, manipulating SOB prices can, at best,shift the timing of inflation somewhat, as shown in the 1987 episode when,prior to the November elections, public prices lagged behind private prices byabout 20 percent. Moreover, lower inflation only reaults from the directcontribution of public prices to the price indices, while the private sectorcontinues to raise its own prices based on calculation of present and futureexcess demand and on the anticipated future inflation. Prices in the publicsector, especially for utilities, have not been adjusted smoothly: forextended periods they lag behind their private sector equivalents, and then,in a general round of public price hikes, they attempt, but often fail, tomake up the lost ground.

27. It is difficult to reconcile the establishment of SOEs in the mostcapital intensive industries with the intention to directly create emRlovment.Burdening them with redundant labor only leads to inefficient factorcombinations. SOEs in Turkey did not employ more than 7 percent of thenonagricultural labor force during the last decade, and their share in totaleimployment has fallen. As a group, they have not created any additional jobsin the last five years; in fact, their large borrowing requirements, starvingthe private sector from resources that could be profitably invested, lower therate of job creation of the Turkish economy. Although difficult to measure,redundant labor might well amount to one-third of total employment in thesector. Had the equivalent of one-third of the SOEs 1990 wage bill been putat the disposal of the private sector for productive investments, almost50,000 jobs could have been created.y In this fashion, all redundant jobsin the SOE sector could be replaced by productive employment olsewhere in fouryears' time.

28. SOEs have failed to induce regional development, despite thedeliberate location of some of their plants in the lesser developed areas ofthe country. As a result, the share of SOB in total employment in thoseregions is much higher than in other regions. Capacity utilization isgenerally low; at best, SOEs have maintained a marginally higher level ofemployment in the region at significant cost to the Treasury. The SOEB failto induce regional development primarily because industry tends to remain in

A This observation in derived by applying the capltal/labor ratio ofprivate industry in Turkey to the amount of resources freed from reducing SOBpersonnel expenditure. It is, therefore, a maximum estimate.

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the area where it was first located since (a) the increasing availability ofcapital in that area increases the scale of production and raines fixed costs,preventing easy relocation; (b) the industry attracts workers and, therefore,demand for its products; and (c) improvements in infrastructure lower the costof transportation, making it easier to service a larger area from the samelocation. Only natural resource-based activities (such as tourism) escapethis rule, but the eastern and eouth-eastern areas of Turkey do not have anyspecific advantage in this respect.

29. The Government's agricultural sunnort policy placed the financialburden of its policy squarely on TMO, which, in recent years, was required topurchase wheat at prices twice as high as border prices while selling it indomestlc and foreign markets below international prices. TEKEL (tobacco) andSEKER (sugar) suffer from the same interference, albeit to a lesser extent.Although the Government achieved its objective of supporting the agriculturalsector, it did so in an inefficient way in the case of wheat is that it warencouraging the p:oduction of a relatively low valued crop at the expense ofhigher value-added crops. These support policies also contributed tomacroeconomic instability. In 1991, for example, TMO was financed fromcentral bank advances, shifting the burden of the policy onto the holders ofcash balances who cannot easily diversify their asset portfolio. To a largeextent, these are usually the lower income groups, many of whom are located inrural areas.

30. Income redistribution is pursued through SOEs by (a) selling

agricultural purchases of TMO below cost and often below international prices;and (b) granting real wage increases to workers far in excess of changes inproductivity. As is well known, the first practice is not selective enough toreach its target group: the urban poor. Higher income groups often consumeproportionately more per capita, even of basic foods. The second practicecreates a privileged labor elite, which not only enjoys high benefits but alsojob security, and lowers mobility in labor markets.

31. With respect to industrial development SOEs played an importantrole during the 1950s and 1960s, but over the last two decades, they havebecome more of a drag than a catalyst. In the 1980s, SOEs did not engage inhigh growth activities and did not enter new lines of business, except perhapsin airline services, telecommunications, and petrochemicals. The privatesector has proven to be a much stronger engine of economic growth in Turkeybringing in new technologies and creating virtually of the additional modernsector employment in the 1980s.

Soft Budqet Constraints

32. Faced with so many handicaps and unable to adjust to changingmarket demands, SOEs have survived only because of the soft-budget constraintthat they are enjoying. The SOEs have benefited from: (a) noncommercialfinancing by the central bank and public deposit money banks; (b) guaranteeson foreign loans; (c) arrears, and; (d) explicit and implicit subsidies,disguised as aid, equity injections, and duty loss compensation. Under (c)and (d), SOEs have received a stream of resources from the public sector,

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equivalent to 1l75 percent of GNP per year for the period 1985-1990. SOEereceived an average annual flow of 0.6 percent of GNP in net deferred paymentsto the private sector, which conasiste of arrears and normal deferred payments.Two 3asily identifiable sources of noncommercial financing, the central bankand the State Development Bank (now Exirnbank), providrd an average annual flowof 0.2 percent of GNP. Given the lack of sufficiently detailed data onoutstanding stocks, it has not been possible to identify other sovrces ofnoncommercial financing nor to calculate the effective interest-rate subsidyinvolved in these transactions.

33. Noncommercial Financi b the Central Bank and e osit oeyBanks. Although direct central bank lending to SOEs was considerably reduced,ThO and SEKER continue to be major borrowers, directly and throughrediscounts. The rediscount rate was 54 percent in May 1991, hence, negativein real terms. Outstanding debts to commercial banks at the cnd of 1990amounted to TL10 trillion, of which about TL3 trillion was owned or guaranteedby Ziraat Bank. The second largest lender to SOEs is Is Bank, in which theState has a 40 percent stake. There is an implicit understanding in Turkeythat public banks lend to SOEs under preferential access. Banks also do notconsider SOEs a financial risk, do not provision for loans to SOEs, and do notapply the same selection criteria they use for lending to private firms. OnlyTTK (coal) and TDCI (iron and steel) have had rifficulties obtainingcommercial credits.

34, Guarantees on Foreian Loans. Treasury guarantees on foreignborrowing allowed SOEs to obtain large amounts of medium- and long-termforeign credits at favorable rates compared with the private sector, as firm-specific risk is converted into sovereign risk. At the end of 1990, the MLTstock of debt of SOEs was 2.7 times that of the private sect'3r. Treasurymakes funds available to service foreign debts on a priority basis whenever anSOE has a cash shortage. These debts are then converted into TL debts to theTreasury.

35. Arrears. SOEs unable to service their debts have been runningarrears to a variety of creditors: the Social Security organization, theTreasury (on account of taxes, onlending, and foreign guarantees), commercialbanks (Exim and Ziraat), the Central Bank and suppliers. Although penaltyinterests apply, these arrears are unlikely to be settled from resourcesgenerated by SOEs.

36. Subsidies, Aid. and Eguity Contributions. With the exception ofIGSAS (fertilizer production), SOEs do not obtain explic.t subsidies.However, aid (for the railways and shipbuilding), equity injections, andpayment for duty losses can all, implicitly, be defined as subsidies. Thereare also some transfers from an extra-budgetary fund (Development and SupportFund, DSF) to TEX. Equity injections (or debt-equity conversion) has beenGovernment's preferred way to rescue SOEs in difficulties. All of these"subsidies" taken together, amounted to TL1.3 trillion (0.5 percent of GNP) in1990; and to about TL7 trillion (1.6 percent of GNP) in 1991.

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37. In addition to these explicit tranefers from the budget, SOEs arenot forced to earn an acceptable rate of return on equity invested. They makealmost no dividend payments to Treasury and hence they are not subject to theusual discipline stockholders impose on firms through capital markets. Theprivileged relation of SOEs with their owners appears to have acted as aneffective entry deterrent for potential private competitors. Although importprotection is not broadly targeted to the SOE sector, some SOEs are able toprice their products sign.tficantly above border prices. Prices of a limitedoample of tradeable goods sold by SOEs were on average 44 percent above borderprices at end 1990. In some cases, this advantage stems from the fact thatthey are selling to other public entities (e.g., paper and printing); inothers it is because of nontariff barriers (e.g., quality control on importedsteel). Finally, some SOEe, enjoying monopolistic positions, entirely escapemarket saictions on their activities.

Inadeauate Institutional and L_gal Framework

38. The present legal and institutional environment in which SOEsonerate does little to prevent political interference or to promoteefficiency. Few countries in the world have a legal environment regardingstate-owned enterprises that is as enc'Ambered with the degree of detail thatis found in Turkish laws, including the Constitution itself. The result is arigid environment where bureaucratic attitudes and procedures prevail, turningthe enterprises into government departments. The main problems are (a)inadequate corporaf-e form, (b) overlapping management and ownership functions,(c) inadequate man gerial autonomy, (d) absence of business plans andcorporate planning, and (e) lack of accountability and meaningful performanceavaluation.

39. Corporate Form. Regulated by a special law, SOEs escape thenormal commercial code and are not subject to the same reporting and auditingrequirements as private sector firms. Most SOEs are holding companies. Theyare responsible for several subsidiaries and/or affiliat3s, with centralizedaccounting. Such a system results in over-bureaucratization and facilitatescross-subsidization. Managers must be civil servants with pay scalesunrelated to performance. The High Audit Board checks the compliance of SOEactivities with all rules and regulations pertaining to the public sector(including foreign travel and vehicle use). Although managers' salaries canbe higher than those of regular civil servants, they are still some 30 percentbelow those paid in comparable private sector companies.

40. Overlapnina Manaaement and Ownership Functions. Half of SOEBoards consists of enterprise managers. The result is a severe conflictbetween management and ownership interests. Moreover, the CEO is chairman ofthe Board with ultimate authority in the case of a split vote. All Boardmembers are appointed by joint decree, requiring signatures of the President,the Prime Minister, and the concerned minister. Requirements for eligibilityto Board and management are vague and can be waived by the concerned minister.The frequency of Board meetings, two per month, is too high, and its functionsreach into normal daily operational decisions that should be left tomanagement.

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41. Inade9uat-M a erial Autonomy. In the key areas of pricing,employment and procurement, management has virtually no autonomy. Althoughformal price controls were lifted, informal ones still prevent management fromreacting to market sig:.als in a timely manner. There are no limits on hiring,but dismissal of workers is hampered by a regulation that only nine workerscan be laid off involuntarily per month in any given SOE. Informal pressurefrom the politicians exacerbate the problem. Managers are not directlyimplicated in collective bargaining with labor unions, which is centralizedthrough the Union of Public Employers. They must accept the wage settlementsirrespective of productivity developments or the financial situation of theSOE. All legislative attempts to amend the employment contracts of SOEemployees to circumvent Bome of these rigidities have been ruled illegal.Even for small items, procurement by SOEs must follow the lengthy andcumbersome process spelled out in bidding procedures for governmentinstitutions.

42. AeceofBusinessPlaps and Cornorate Planning. Annualfinancing and investment planning is partly performed and fully sanctioned byinstitutions outside the SOE (Treasury and SPO). This planning follows theannual budget cycle for the public sector. Transfers from the centralgovernment to SOEs, as well as large investment expenditures, are part of thebudget law that must be passed in Parliament each year. Planning is not donefrom the corporate perspective but depends on national investment priorities.Even if investments are needed and are potentially profitable, SOEs can onlysubmit their own investment plans to the extent that they can be fullyfinanced from internally generated funds. Whenever there is a need to borrow,several institutions intervene in the process of design and approval of theproject, and political interference is common.

43. Lack of Accountablitv and Meanincful Performance Evaluation. Allthe processes and approval procedures regarding SOEs are of an ex antecharacter. Emphasis is placed on input (compliance with regulations) ratherthan on output (successful performance). SOEBs report to a large number ofdifferent institutions, mainly for statistical purposes, because noperformance indicators are calculated and the various institutions do notfollow up on the reports. The only exception is the High Audit Board, whichis required by the Constitution to submit an audit report of each of the SOEsto Parliament. Audits have little to do with financial or economicperformance, and no formal evaluation yardaticks exist, aside from the annualbudget of the SOE. Because performance is not closely monitored and evaluatedand salaries of management do not depend on performance, there is noaccountability. In the present system, where managers have no autonomy, itwould be unfair to hold them accountable in any case.

Eailure of Divestiture

44. Two sets of obstacles appear to account for the gap betweenannournced divestiture plans and actual progress. These barriers are politicaland technical in nature, amplified by some exogenous factors, such as theshallowness of domestic capital markets and the lack of readiness of SOEs forsale.

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45. Poltical obstacles. In Turkey, the divestiture process is notperceived as a positive-sum game. Workers perceive the sale of their companyas threatening, especially because the Government does not address their fearof losing income when laid off. Civil aervants view divestiture as deprivingthem of the status and authority associated with managing an SOE. Politiciansoppose the process because it would diminish their ability to use the SOEs forpolitical patrona'ge. Even some private sector producers consider divestitureunwelcome, fearing increased competition. Potential buyers have becomesuspicious, after some early mistakes and continuing legal problems. Finally,those groups that stand to gain most from the process, consumers and taxpayers, are diffused, disorganized, and generally, poorly informed.

46. Technical obstacles. Implementation of divestiture, compared withcountries where the program took off successfully, has suffered from thefollowing obstacles:

(a) Unclear, conflictina. and shifting obiectives: Although at theoutset the Government's objective of divestiture was uniquelydefined in terms of efficiency and private sector development, itshifted gradually toward the promotion of widespread ownershipand, more recently, to the financing of fiscal deficits.Targeting employees, local investors, and Turkish workers abroadas potential buyers slowed down the process, and an attempt torevive it by selling directly to foreign investors ran intounanticipated legal problems: the sales were overturned by courts,although they did not violate any specific legislation. Most ofthe proceeds of divestiture have come from sales of small amountsof shares and minority participations, forced by the need togenerate revenues rapidly.

(b) Unclear guidelines and lack of trans arency: Unclear guidelineson sales instruments and valuation have also led to ad hocpractices and genezated considerable public criticism. Both salesto foreigners and the earlier sales of cement factories on the ISEwere criticized as being underpriced, while sales of two largeSOEs (Petkim and THY) were blamed for the opposite. Block salecontracts included restrictions on decision-making by the newprivate owners, especially regarding labor restructuring, demandsfor new investments, and provisions requiring the sale of shareson the ISE.

(c) Inadeguate institutional capacity: Divestiture is excessivelycentralized in the PPA, which, despite its achievements, lacks theadequate staff, autonomy, and incentives to handle rapiddivestiture of all SOEs. Staff has little or no experience indivestiture. The PPA is run as a government department subject tothe usual regulations and political interference. Its mandatealso covers the issues of physical restructuring of companies tobe sold, management of SOEs as long as they are owned by the PPA,and the sale of uncompleted plants and of other types of assets,such as revenue-sharing certificates in infrastructure projects.

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(d) flure to enaage managers and-workers in the Process: SOBmanagers were given almost no role to play in the divestitureprocess, leading them to reject privatization plans. Neithermanagers nor workers have been given stock options or redeploymentprograms.

47. The chances for successful divestiture also depend on someexooenous factors, such as domestic savings and capital markets and thereadiness of the companies for sale. Lack of both also hampered theprivatization efforts with the following results:

(a) Capital_mark_ets The Istanbul Stock Exchange reopened in December1986; since then, it has grown rapidly. Yet average daily tradingvolume is only about US$40 million, a small amount compared withthe value of SOEs. Moreover, the market is still dominated by afew actors, reducing the depth, resiliency, and liquldity of theexchange. Institutional investors are very small, with a totaloutstanding value of mutual funds at the end of March 1991 of onlyTLl.4 trillion, of which only 3 percent is invested in stocks.The market for direct placements also appears to be small. Hence,restricting the PPA to sell through public offering or only todomestic investors will slow down the process and reduce thenumber of companies that can be divested.

(b) Structure of S1Es: Because SOEs were never fully subject to thecommercial code and accounting was excessively centralized, ittakes time to prepare them for conversion to joint-stock companiesprior to sale. Although it would have been better to break largeenterprises into separate companies, this has not been done sofar. The Government has not addressed the issue of guaranteeddebt and the resolution of outstanding arrears of SOEs with thetax administration, social security organizations, and theTreasury. Nor has it confronted the issue of labor restructuring.

IV. REFORM: STRATEGY. SCOPE. AND AFFORDABILITY

Reform Strategv

48. During the past decade, Turkey has attempted several times tobring its SOEs into the mainstream of a market-oriented approach. Yet, priceliberalization, institutional reform, and divestiture all failed to producethe desired result. Even such measures as hiring freezes and cuts in theinvestment budget could not ease the financial burden of the SOEs on theeconomy. Reforming the sector is not a matter of price increases, cuts ininvestment, or other decisions that could quickly lower operating costs of thesector. Such measures have some role to play but they can and should only betemporary. In any case, price increases for tradeables are no longer a realpossibility because prices are already at or above border prices. For someproducers of services, such as railway and sea transportation, competitionfrom other forms of transportation limits the freedom to raise prices. There

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are a few remaining monopolistic producers (PTT, TEK, airport and portadministration) that could have recourse to price hikes in order to resolvesome of their financial problems. However, PTT and DHMI (airports) arealready among the most profitable enterprises in the sector, and excessivelytaxing telecommunications and airport administration services to finance therest of the public sector should be avoided. In any case, exploiting monopolypricing simply transfers the burden of the inefficiencies of the producer fromthe taxpayer (or holder of money balances) to the consumer and does notimprove resource allocation. The reduction of the investment budget of thesector has already left many SOEs (with exceptions such as PTT, TEK, and THY)with an obsolete capital stock. For some (e.g., TTK and TDCI) thisdevelopment appears to be irreversible.

49. The objective of any SOE reform program should be cast in terms ofefficiency. However, the exact magnitude of the direct efficiency gains andthe time frame within which they coulC be achieved is difficult to gauge. Wecan obtain some orders of magnitude of the gains through illustrativeexamples. Had investment in the SOEs over the past five years been asefficient as that of the private sector, GDP in 1990 would have been at least3 percent higher. Had the losses of liquidation candidates over the past fiveyears been invested productively in private industry, some 50,000 jobs couldhave been created. The most important gains are more likely to arise from theindirect effects of the program, however. Cutting the deficit of the SOEs isurgently needed as fiscal deficits of the level of 1991 cannot be financed atreasonable inflation rates in the medium-term.V A reduction in the primarydeficit in the order of 8-10 percent of GDP from its 1991 level spread over 2-3 years would reduce the need for monetary financing to levels consistent withinflation rates below 20 percent per year. Reductions in SOE deficits wouldneed to contribute more than half of the required adjustment as revenuereforms take time and, in any event, cannot be expected to contribute theentire amount. Such a decline in actual inflation rates would, in turn,increase the long-run potential growth rate of the economy significantlybecause it would reduce uncertainty and steer investment away from inflationhedges, such as housing. A 40 percent decline in actual inflation could raisethe annual long-term growth rate by 1.5 percentage points.§/ Given a primarydeficit of the SOEs in the order of 5 percent of GNP in 1990, there is ampleroom to achieve the needed reduction by reforming the sector. The other sideof the coin is that without a drastic SOE sector reform, Turkey is unlikely tobe able to solve its macroeconomic problems. The adjustment effort needed inthe rest of the public sector would be infeasible. Moreover, withoutreforming the SOEs, efficiency gains would be foregone.

I As indicated by the model used in "Turkey: External Debt, FiscalPolicy and Sustainable Growth (7162-TU)", September 1988.

4 See "Turkey: Country Economic Memorandum: The Challenge ofDisinflation" (9621-TU), (Washington, D.C.: World Bank, October 1991), Annex2, p.2.

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50. Introducing secondary objectives, such as the maximization offiscal proceeds from sales of SOEs, is almost certain to slow down the processor to lead to the granting of preferential treatments. Clearly, the privateinvestors would be willing to pay a higher price for a public enterprise ifthey are guaranteed greater tariff protection or monopoly rights. Suchpreferential treatment would not only defeat the purpose of the reforme but itwould also prevent Turkey from reaching its growth potential in the shortesttime possible.

51. Successful implementation of the reform program will requirekeeping it within well-defined boundaries and preannouncing it to the public.In the past, insufficient attention was paid to the public perception of theGovernment's program, resulting in confusion and often, in a hostile reactionto any reform. Successful reform programs in other countries have almostalways included an explanation of the program to the public and a consultationwith all groups directly or indirectly involved in the process. Consultationwith workers is particularly important, because the reform program is likelyto require significant restructuring of labor.

52. Although there is general agreement on the principles of thereform program, the Government has not yet developed a comprehensive strategy.The remainder of this report will focus on the key elements of a reformstrategy and their implementation. The elements are:

(a) DIVESTITURE(i) LIQUIDATION(ii) SALE/DISTRIBUTION

(b) COMMERCIALIZATION (RETAINED SOES)(c) REGULATION OF MONOPOLIES(d) LABOR RESTRUCTURING

(i) RETRENCHMENT(ii) SOCIAL SAFETY NET

(1) Income Support(2) Employment Services(3) Training

(e) OTHER POLICY CHANGES(i) AGRICULTURAL SUPPORT(ii) INFRASTRUCTURE DEVELOPMENT

Score of the Progras

53. The scope of the reform program crucially depends on the viabilityof the firms and on the timing of availability of fiscal resources. Apreliminary viability analysis of the sector at the level of the holdingcompany was conducted by the mission in order to clasuify SOEs into threegroups: (a) unviable enterprises that would best be liquidated; (b) viableenterprises that can be sold to the private sector; and (c) enterprises (DHMI,PTI, TCDD, TDI, TEK) that, at least temporarily, would remain in publicownership but would still be subject to significant labor restructuring (fordetails, see Annex 1). Petkim and SUmerbank were excluded for lack of recentdata. The decision to liquidate or sell was based on a financial forecasting

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model to which the following assumptions were applied in the best casescenario: (a) revenues increase by 20 percent; (b) personnel expenditure iscut by 30 percent; and (c) the cost of financing is reduced to 7 percent inreal terms. A firm with increasing negative net income and negativ- free cashflow, deteriorating financial indicators, and a negative projected terminalvalue was classified as a candidate for liquidation, because it would have novalue for private sector purchase. Firms not satisfying all of these criteriawere considered candidates for sale. The model is based on 1990 data; hence,it does not include the 1991 wage increases. Even if a more disaggregatedanalysis is required before the implementation of the reform program, theresults indicate the magnitude of the problem. Under the assumptions of thebest case scenario, approximately 23 percent of the SOEs, representing 13percent of fixed assets and 21 percent of employment, will not become viable(see Table 3).

Table 3: Forecasts of Financial Accounts(Percent of Total)

InviabLe Sate Retain1'

Best Case Scenario 9'Number 23.3 60.0 16.7Debt 19.1 16.3 64.7Fixed Assets 12.9 16.5 70.6Emptoyment 20.9 35.0 44.1

Reatistic Scenario 3JNuTber 56.7 26.7 16.7Debt 26.5 8.8 64.7Fixed Assets 23.6 5.8 70.6Enptoyment 33.6 22.3 44.1

Source: IBRD Calculations.

Notes: 1/ DHMI,PTT,TEK,TCDD, TDI are sssumed to be kept in publichands, at Least temporarily.

Assurptions: 20 percent increase ir revenue, 30 percent faLlin personneL expenditure, 7 percent real interest.

3/ Assumptions: 5 percent decrease in revenue, 30 percent fallin personnel expenditure, 7 percent real interest.

54. The assumptions of the best case scenario, especially with respectto revenues, are rather optimistic. If there was systematic evidence of lowerprices for SOE products, the combined effect of price and productivityincreases could perhaps raise revenues by 20 percent. However, if prices are"uncompetitively" low, rationing mechanisms would have to be in place, unlessSOEs are able to satisfy domestic demand entirely. SOEs producing miningproducts, iron and steel, and petrochemicals may be able to supply the entiredomestic market. Prices of selected products of these SOEs are higher thanCIF border prices, however: iron and steel products (28 to 38 percent), coal(37 percent), and fertilizer (34 to 95 percent). Prices of a sample oftradeables produced by SOEs averaged 44 percent higher than border prices atthe end of 1990. Hence, it is likely that prices of SOE products will have tofall further as trade liberalization continues. Therefore, a more realistic

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scenario (assuming a 5 percent decrease in revenues while keeping the otherassumptions identical) rsveals that 57 percent of the SOEs, representing 24percent of fixed assets and 34 percent of employment, are likely to beliquiaation candidates, according to criteria defined in paragraph 53 (seeTable 3).

55. Even admitting that the above analysis is rough, the results aresimilar to the experience of other countries that have reformed their publicenterprise sector. The privatization of the Rumasa group in Spain includedliquidation of some 400 of the group's 800 production units. Mexico, between1989 and 1990, liquidated 70 public enterprises out of a total of 139. oncethe hard choice between liquidation and sale is made, the fiscal problembecomes an intertemporal one, to a large extent. If there are loss-makingSOEs to be liquidated, the net present value of the reform program will alwaysbe higher the sooner it is implemented. It is possible that given the cost ofliquidation, labor restructuring and the social safety net, the necessaryfiscal resources cannot be made available at once. Nevertheless, the programshould be started as soon as possible.

Affordability

56. Except for the potential proceeds from the sale of SOEs andminority participations, all other components of the reform program requirefiscal outlays, at least initially. There are, of course, the followingfiscal gains: labor restructuring reduces personnel expenditure; liquidationeliminates a flow of losses; sale avoids the need for investment outlays; andrestructuring of temporarily retained SOEs is likely to lower losses.Indirect gains (through tax revenues) also come from increases in efficiencyand economic growth, but these will not be available to finance the reformprogram. Taken in its entirety, the reform program has a positive net preeentvalue for the fiscal budget. It is even possible, with appropriate sequencingand timing of the components of the reform program, to generate fiscal gainsduring the implementation of the program. Reforming agricultural supportpolicies --- which burden the Soil Products Office and the sugar and thetobacco companies --- would free d significant amount of fiscal resources.Increases in stocks alone in 1990 amounted to US$3 billion.

57. To get an estimation of the other fiscal costs and benefits of thereform program, two polar scenarios were developed. The reform ecenarioassumes that labor restructuring, liquidation, and sale/distribution of SOEswill be completed over a two-vear period. This scenario does not includeother rehabilitation (e.g., physical capital), because it is unnecessary inthe case of companies to be sold or liquidated and will take additionalresources and more time to accomplish in retained SOEs (TCDD and TEX).Clearly, the two-year period is a minimum estimate of the time it would taketo implement the reforme. The alternative "no reform" scenario assumes thatno labor restructuring or sale of SOEs takes place for the remainder of thecentury. The scenario also assumes it will take 10 years to liquidateinviable SOEs. Reality is likely to fall somewhere in between, but given the

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fact that many SOEs have difficulties maintaining an adequate capital stock,delaying the reform program is almost certain to raise the costs.

58. The reform scenario focuses especially on the costa involved inliquidation and labor restructuring. The other SOEs were divided betweenliquidation and privatization candidates based on the best case scenario offinancial viability (see Annex 1).

59. For both scenarios the following three types of costs wereestimated for each of the three components (liquidation, sale, andrestructuring of retained SOEs) of the reform program: administrative cost,labor restructuring cost, and other costs. The results are reported inTable 4. Administrative costs are estimated at US$100 million for theliquidation component and US$300 million for the sale component. These costsreflect salaries of additional staff, valuation of assets and companies, laborrestructuring atudies, and other miscellaneous items. If a share distributionscheme were implemented instead, the administrative costs could besubstantially lower because much of the valuation costs would be avoided. Itis assumed that the administrative costs of liquidation woUld rise over timeso that the present discounted value is the same across the scenarios. In anycase, this component is relatively small and does not significantly influencethe overall costs and benefits. Labor restructuring, the most importantcomponent of the program, is detailed in Text Box 1. In the case ofliquidation, it is assumed that the net present value of the cost remains thesame across the scenarios. This assumption implies that labor restructuringcosts are likely to rise over time, mainly reflecting increases in senioritythat raise severance payments. In the no-reform scenario, it is assumed thatno labor restructuring takes place in SOEs that are candidates for sale orthat are retained in government hands.

60. Other costs reflect the net worth of the SOEs. They consist ofthe following two components: (a) the discounted stream of operatingsurpluses or deficits; and (b) the terminal value of the firms either at theend of the 10-year period (in the no-reform scenario) or at the time ofliquidation or sale (in the reform scenario). The following commonassumptions were used:

(a) real growth: zero for liquidation and privatization candidates,10 percent for retained SOEs (per year);

(b) change in real fixed assets: zero for liquidation andprivatization candidates, 10 percent growtli for retained SOEs (peryear);

(c) real wage increases: nominal wage increases in 1991 translateinto an average real wage increase by 35 percent, which is addedto personnel expenditure;

ld) valuation of assets: inventories and accounts payables/receivablesat 80 percent of book value; fixed assets at 50 percent of book

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value for liquidation candidates and at 70 percentV forprivatization candidates;

Note: All figures are expressed in 1990 US dollars and in netpresent value terms using a (rather high) 13 percent discount rate(the real rate of return on equity of firms listed on the ISE).

For liquidation candidates and for retained SOEe the other costs are negative;they reflect a stream of losses and/or a negative net worth position of theseenterprises. For sale candidates, other costa have a positive aign; theyreflect a stream of profits and/or positive net worth of the firms. However,mainly due to inadequate capital replacement and operation inefficiencies, thevalue of these firms declines over time. In 1991 these firms generated atleast US$2.5 billion from sales, but waiting 10 years reduces the net presentvalue to US$400 million.

61. As Table 4 below shows, the reform program compares veryfavorably: it will cost less than half as much as continuing the operation ofthe SOEs, even if the Government were to forgo the revenue of privatization(by implementing a share distribution scheme; see below). The majorcontribution to the losses comes from continuing operation of SOEs that shouldbe liquidated. Postponing liquidation for another 10 years might cost up tothree times more (US$13 billion) than closing down immediately.

62. Hence, perhaps the better question becomes: Can Turkey afford notto reform the sector? Most of the assumptions used have a purposely built-inbias against reforms: the discount rate is higher than on Government paper,reducing the present value of future losses; restructuring of retainedcompanies was limited to labor only, but other types of restructuring wouldimprove their performance as well; the effect of employment services andtraining programs on the duration of unemployment benefits was not taken intoaccount; and SOEs owe a considerable amount to other public sectorinstitutions, which does not require immediate cash outlays for the Treasuryto resolve. On the other hand, postponing the reforms will cost about US$1.8billion per year (1990 prices).

Z For ongoing concerns, if accounts are done properly, the book valueof assets should represent their market value, but in the Turkish case thefollowing two observations induced us to use only 70 percents (a) fixedassets are revalued across the board with a Government imposed inflator,reflecting the GDP deflator; and (b) the rate of depreciation in the publicsector is only 70 percent of that of the private sector.

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Table 4: Net Present Value of Reform Program(USSmillion, 1990 pri6eb 13 percent discount rate)

Reform No Reform

(1) LiguidatlonAdnin. Cost (100) (100)Labor retri2chment (1,600) (1,600)Other Cost- (2.000) t1.300Total (3.70u (13,000)

(2) SaLeAdmin. Cost (300)Labor rest 9cturing (600)Other Costa "500 40Total 1600 400

(3) Restructuring of Retained SOEsLabor restpycturing (490)Other Costs (1.800) e5.300Total (2,290) (5,300)

(4) Total (4,390) (17,900)without privatization proceeds (6,890) (18,300)

Memorandum Item: Intra-public sector debt of SOEs2/: USS1.9 billion

Source: IBRD caLcutations.

Notes: 1 Discounted stream of profits, losses, and terminal value of the firm.2 Liquidation and sale candidates only.

63. Although the fiscal cost of the reform program looks impressive(about US$7 billion), additional financing needs would not be very large. Ifthe reform program is implemented in a comprehensive manner, it is evenpossible that the program could generate fiscal gains immediately. Thefollowing items would significantly offset the outlays:

(a) reforms in the agricultural support program (USS1.5-3.0 billionper year)l

(b) savings in personnel expenditure and losses of liquidationcandidates (US$2.8 billion per year);

(c) proceeds from sales of minority participations (for a total ofUS$500 million); and

(d) proceeds from sales of SOEs (a total of US$500, under sharedistribution scheme).

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BMX 1: AtsuWptions for Labor Restrtucturing

1. The following labor restructuring Is assumed to take ptace:

.-liquidation case: b;. staff dismissed;-privati2ation case: 25 percent layoffs in aLl emptoyee categoriesV,.-retained SOEs: *20 percent layoffs in all categories In PTT, TEK, TDI,

-40 percent layoffs all categories in TCUI,-no tayoffs in DHM!,-

.2. LAt retrenched civit servants- are absorbed in thie pubtic sector, reducing new hfrings into thecivit service with the equivalent numter.

3. .- Unionized and nonunionized permypent workers tbtain severance pay equal to 60 percent of totalpersonnel expenditure for 199i.-

4. .In addition, the government Is responsible for the following socfal safety net:

(a) income support: *contract employees (exci. PTT): 6.75 months of saleriesV-permanent workers (Inct. PTT contract workersa) 10.1 months of wages-temporary workers. 2 months wage

b) training/counseting/information and other incentives: US$200 mitlion (a likety overestimate).

: T fhe most. importanit' guideline for labor restructuring in the case of privatization io that theporivate.sector should not face any restrictions on hiring and firing once It has become owner. Theissue of whether any labor restructuring.should be done by the Government prior to the sale is not one-of fiscat revenue or cost. Since SOEs hove not provisioned for severance pay, the sale value of thecompanfes'would fatl.by theamount of the sociat liabilities if tabor restructuring were left to the

.tsprivate owner. ln.the atternative case the Government would pay the severance pay but receive a.:hfgher price. There might, however, be other reasons why prior Government action could be preferabloe-

*t-a) uncertainties on'.value of social liabiLlties Lowering the bids; and (b) fear for a bad social -.reputetion of the new conpany. If there is sufficient conWpetition, the first argunent would not hold,

.,:endc against the second4 one observed the dismissat of about half of the wo kers by USAS afterprfveatziatlon, viotating'the' purchase contract that stipuLated that onty 5 percent of the workerscould be Leid off per year.> No.Government action followed.

*- tisdoes not'imply that no Labor restructuring is necessary, but a study by the TurkishProductivity Center has revealed that it is merety a matter of relocation of staff not so much ofreiucing the level.

Only half of total personnel expenditure reported in SOE accounts is wages and salaries; theremainder consists of bonuses, social security contributions from the employbr, and other items suchas work,clothing, etc.

f'IrZncome support in months of wages for contract emptoyees and permanent workers are calculated onthe basisWof' the" incentive scheme described in Annex 6 under the ,ssur.0tions that unemployment

..compensetion' is paid at the 75 percent of the last wage (w.1), the tltu sun termination benefit istonverted at 50 percent of the wage (z=.SO),' and affected workers leave the unemployment coqxensation

*:. scheme proportionalty. over its duration, which is set at 12 months (T112) for contract employces and18 months .(T18) for workers. Under the worst case assurptfons, when everybody remains unemployed for'

.the whole duration of the scheme, the cost woutd rise to 7.55 months for contract workers and 11.2months for workers (NPV of the schemes).

. . . . .~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ - - -

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These reforms add up to a possible fiscal gain of US$9.6 billion or more in atwo-year period, exceeding the estimated costs. Moreover, writing offintrapublic sector debt to Treasury and tax administration and convertingobligations to the social security system into medium-term Government paperwould further lower actual financing needs by US$1.9 billion. There could behidden liabilities and other costa that the misoion could not estimate, but onbalance it appears that the reform program could yield an immediate, modestfis.-al gain. Of course, given the need for a stabilization program thatrequires a reduction of the primary fiscal deficit by 3 to 4 percent of GNP,this gain may not be sufficient. However, since most of the deficit islocated in the SOE sector, it is most unlikely that fiscal reforms in otherparts of the public sector could by themselves generate the requiredadjustment. Therefore, stabilization without reform of the SOE sector isunlikely to succeed. In this respect, the implementation of the completereform program, perhaps with external assistance, could be a sufficientlystrong signal to the domestic private sector to render a broader stabilizationprogram credible, thereby easing its financing.

V. DIVESTITURE

64. As shown above, the slow progress on divestiture has prevented theTurkish economy from dchieving its growth potential. Even under optimisticassumptions, liquidation appears to be the only solution for some SOEs. TTK,the hard coal mine, is commonly cited as the most urgent candidate, but otherSOEs or parts thereof will also have to be closed. Succeasful transfer ofownership to the private sector will require finding a solution to thepolitical and technical constraints identified in Section III. Aside from thepolitical decision to implement the new divestiture strategy, the followingpreparatory oteps are indispensable:

(a) a detailed analysis of SOEs at a sufficiently disaggregated levelin order to determine the viability of individual companieas andto establish independent accounts for each;

(b) the conversion of these companies into joint-stock companies inorder to prepare them for sale or for liquidation according to theTurkish commercial code; and

8 Since most SOEs are producing goods and services in competition withthe private sector or that can be provided under competitive conditions, thecriteria to decide on the viability of an SOE or part thereof should be basedon an estimation of its net worth. Firms with negative net worth that have novalue to the private sector should be liquidated. The financial valuationmodels need to be designed carefully in order to reflect the true economicvalue of the firm. In particular, the impact of noncommercial duties shouldbe eliminated.

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(c) the announcement of a social safety net to deal with laborrestructuring.

Liquidation

65. In order to make the liquidation component of the reform programpolitically and socially acceptable, the Government should take the followingsteps:

(a) Initiate a dialogue with workers, labor unions, management, andthe local business community to implement a redeployment programfor redundant labor.

(b) Issue transparent guidelines on the management of the dispositionof assets, including sales methods, bidding rules, and procedureeand valuation.

(c) Transfer the assets to an independent commission created todispose of them.

(d) Make funds available to (i) meet net liabilities; and (ii)compensate worke7s.

The institutional mechanism for the disposition of assets should promote thespeed of the process. Separating the task of selling off assets from that ofthe divestiture of enterprises as ongoing concerns, as was done in thePhilippines, will be helpful because these transactions are very different innature, in terms of objective, valuation, and procedures. Priority should beaccorded to the sale of physical assets that would yield the maximum revenuesin the shortest time possible. Such a step would free resources to pay forthe liabilities of the program. Approval of sales should be automatic, basedon the guidelines issued. Aside from the establishment of an independentself-liquidating Asset Privatization Trust, no further institutional or legalchanges are required for the liquidation of SOEs. Part of the costs of theprogram will be related to the absorption of former civil servants into therest of the public sector.

Sale of Minority ParticiDations

66. The sale of minority participations does not directly affectefficiency, unless the state's share prior to the sale was sufficient tocontrol the companies. While in those cases the efficiency objective shouldcontinue to dominate, the maximization of proceeds within a short-time periodshould be the guiding principle for all other minority participations. Thesale of the mir.ority participations could potentially generate a significantamount of revenue: the market value of the remaining participations held bythe PPA in these companies listed on the ISE was approximately US$450 millionon August 8, 1991. In addition, since 80 percent of the companies in whichthe state holds minority participations are not yet listed, the total proceedsfrom these sales may rise to a multiple of this amount. An acceleration ofthe sale of minority participations does not require any legal or

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institutional reform. The PPA is probably the best suited inetitution: byfocusing on the minority participations, the PPA could accelerate their sale,and the proceeds could be made available to finance liabilities resulting fromthe other components of the reform program.

The SoilProducts Otfice and Agricultural support Policies

67. The SOEs that are involved in implementing the Government'sagricultural price support policies will need somewhat different treatment.The Soil Products Office (TMO) and, to a lesser extent, the sugar (SEKER) andtobacco (TEKEL) companies are the main executing agencies for the Government'sagricultural and food price support policies. As such, they have limitedcommercial activity. TMO does not determine purchase or sale prices neitherdoes it determine qaiantities bought and sold, nor customers. The use of anSOE for this type of policy is costly and inefficient. There are a number ofalternative more efficient instrurnents to use to increase rural welfare and,in particular, to protect the incomes of smaller (i.e., poorer) farmers.Within the context of a broader reform of agricultural policy (which is beyondthe scope of this report), possible measures include (a) targeted incomesupport for sma.ler farmers; (b) interventions to increase agriculturalproductivity (e.g., improvements in agricultural research); (c) investments inrural infrastructure that would support the development of off-farm employmentgrowth; (d) catalytic support for private crop insurance schemes; and possibly(e) a flexible import tariff system that would insulate farmers from exogenousprice shocks. Similar price protection mechanisms could be put in place forother agricultural products, especially sugar and tobacco. The revisiun ofthe Government's agricultural policies should also include the agriculturalsales cooperatives that are not SOEs2 ' but perform similar functions.

Sale/Distribution

68. To achieve the desired efficiency gains, the process oftransferring SOEs into private handu needs to be accelerated significantly.Whereas improvement in the environment, such as deepening of domestic capitalmarkets and promoting the role of institutional investors might help, the maincause of delays in divestiture are to be found in the implementation process.To remedy these problems, the Government could pursue one of two options. Thefirst option -- decentralization -- focuses on improving the existing processby introducing mechanisms to reduce or remove the problems mentioned above.The second option -- free share distribution -- attempts to circumvent theexisting problems by adopting a different approach which is more radical andbold but which offers the prospect of speeding up the process.

DecenItralization

69. In order to reduce or eliminate the constraints that have sloweddown the sale process in the past, implementation of this policy requires thefollowing decisions:

2 Therefore, excluded from the coverage of this report.

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(a) The divestiture objective should be uniquely defined in terms ofefficiency. Maximization of sale proceeds for fiscal reasonsshould not be pursued at the expense of efficiency. This meansthat the Government would not grant any monopoly rights, importprotection, preferential credit or tax exemptions, even if thatwere to increase sale revenue.

(b) New Boards of Directors should be appointed. Their members shouldbe mainly selected from the private sector and have expertise inthe area of operations of the respective SOE and/or diveetituro.

(c) The process should be decentralized by requiring that the Board ofDirectors and/or managers develop, within a short period (e.g.,six months), divestiture proposals. These proposals would specifyan appropriate course of action for each subsidiary and atimetable for implementation. SOE Board of Directors/managersshould not be allowed to include expansion or major rehabilitationplans as these slow the process and preempt decisions that arebetter left to the new private owners. Boards of Directors/managers ahould be given strict deadlines for completingdivestitura proposals.

(d) Once the proposal is approved by the PPA for the SOEs currentlyunder its portfolio and by the Single Government Agency (SGA) (seepara. 78) for the rest, the Board of Directors/managers wouldstart the implementation. The decision by the agencies would bemade within the shortest period possible (e.g., 30 dayo).

(e) To motivate the Boards of Director/managers, and to ensure timelyimplementation, stocks in the company could be offered inproportion to sale proceeds and speed of divestiture, subject to areasonable ceiling.

(f) To prevent possible abuse and to ensure that the process is fairand transparent, guidelines on bidding procedures, saleinstruments, and target buyers should be issued. The guidelinesshould be flexible, though, in order to allow for combinations ofmethods (for example, public offering with block sale and employeeparticipation) and to seek the participation of domestic andforeign private investors.

(g) To give momentum to the exercise, the process could be initiatedby offering workers a preferential right to buy up to 10 percentof the shares of any given company. This practice could win theirstupport and if the ahares start to be traded, provids a benchmarkfor valuation.

70. Compared with current practice of PPA, the decentralization of theprocess has the advantaae that it could accelerate implementation. Thisoption avoids institutional bottlenecks, and, combined with a social safetynet, generates support from management and reduce opposition of labor. If

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implemented successfully, it would generate more fiscal resources, which couldbe used to finance labor and minor financial restructuring. Finally, byallowing more flexible sales methods and creating consensus to includeforeigners as potential buyers, this option could relax the limitationsimposed by the shallowness of the domestic capital market and relativelymodest domestic savings.

71. The main _rawhack of the decentralization approach is: thisapproach may not reduce political interference. Further, it would stillrequire auditing, valuation, and stock listing of enterprises, all of whichare difficult, time consuming, and often costly. Therefore, a more aweepingapproach to divestiture, such as share distribution, offers a possibility ofgetting around these problems.

Share Distribution Scheme

72. Under this option, the Government would distribute the majority ofthe shares of each company to Turkish citizens, free of charge, or for anominal fee (to cover distribution costs or to guard against legal provisionsprohibiting the give away of state-owned assets). This action immediatelyprivatizes the ownership of the companies by returning them to the public atlarge. To guard against excessive dispersion of ownership, 20 percent of theshares would be allocated to a fund set up controlling blocks of the shares toprivate managing groups in the shortest time possible. This step privatizescontrol over the companies. However, trade in the shares could establishprivate control even before the remaining blocks are sold. This option hasbeen used in Canada, and it is now under consideration in several countries inEastern Europe. The share distribution proposal also embodies a strongparallel with the early 1980s privatization experience in the United Kingdom.There, in order to gain initial support for the program, the Governmentsystematically (a) under-valued SOE shares sold through public offerings; and(b) introduced rationing devices to ensure that domestic households (ratherthan foreign or institutional investors) received the windfall gains. The UKGovernment chose to forego fiscal proceeds in order to achieve structuralchange and efficiency objectives.

73. In its purest form, imnlementation of the share distributionscheme would include the following steps:

(a) Following the transformation of SOEa into joint stock companies, anew Board of Directors would be appointed. It would consist offive to nine members selected from competent candidates (mainlyfrom the private sector, provided there is no conflict ofinterest).

(b) Prior to divestiture, debt explicitly guaranteed by the Governmentwould be swapped into commercial debt (to avoid legaluncertainties), and a social safety net for labor restructuringwould be announced. No physical restructuring would be performedby the state.

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(c) Eighty percent of the shares of all companies to be divested wouldbe distributed to the public for free. Each citizen would receiveone share of each company. Shares would be immediately negotiableand after six months a shareholders meeting would be called. Ifdeemed desirable, no more than 10 percent of the shares would bedistributed to the employees of the cornpanies; the shares to bedistributed to the public would then be reduced by the equivalentamount.

(d) The remaining 20 percent of the shares are transferred to a self-liquidating fund under a private management contract, created forthe purpose of selling its shares in blocks during a limitedperiod of time (e.g., two years). The main purpose of these blocksales is to create a core investor/manager who would effectivelyrun the company, since ownership would be diffused. The fund'smanagement would consist of a small group of financialspecialists. Their compensation would comprise a fixed salary anda bonus based on the realized net worth of the fund. After a two-year period, the fund would sell the remaining shares on the StockExchange and transfer the accumulated proceeds to the Government.

(e) If after a fixed period (i.e., three months) from the creation ofthe fund, a market has not yet been created in the shares of agiven company, the fund would sell through a public offering3 percent of the shares of the company to establish market-basedvaluation.

(f) When the companies are listed, the fund would announce that blocksof shares are available for sale during a fixed period of time.At the end of this time, the fund would transfer the shares to thehighest bidder. Block sales at a price below the observable shareprice would not be permitted.

(g) During the transition period to private control, existingmanagement would remain. No sales or purchases of fixed assetc orreal-wage increases would be allowed, and management would be heldaccountable to the fund. As soon as a single shareholder or agroup of them accumulated 15 percent of the shares, they couldcall a General Assembly. The General Assembly could elect a newBoard and management group. If no assembly is called, the fundwould monitor the performance of the existing management. Becausethe fund would have 20 percent of the shares, it could call, if itso wishes, a shareholders meeting in order to remove the existingmanagement and/or board.

74. The share distribution scheme has several advantages over thefirst option including the following:

(a) Aside from the initial, admittedly difficult politlcal decision toimplement the process, it eliminates all further politicalinterference.

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(b) It allows potential investors (15 to 20 percent of equity)I2 totake control over the company with limited means.

(C) It is equitable, because the companies are returned to theiractual owners (i.e., the public at large). Thereby, it avoids thecommon concern that public wealth is transferred into the hands ofa few private people.

(d) It avoids the valuation problem, because a market would be createdup front; hence, it averts the common public criticism of sellingassets below a fair price, as well as the significant costinvolved in valuation.

(e) It is simple and transparent.

75. Share distribution schemes often have been criticized, but each ofthe purported drawbacks can be mitigated with the following results:

(a) Giving away the shares for free, the Government forgoes theproceeds of privatization. However, given the deterioratingperformance of the SOEs, potential proceeds from privatization arediminishing rapidly, and alternative, slower schemes, may generatelittle revenue in the end. The Government will receive 20 percentof the proceeds, as well as more direct taxes from increasedprofits of the companies and capital gain taxes.

(b) The option could potentially lower the level of new investment andthe transfer of technology because it does not allow fordivestiture through joint ventures with the private sector.However, facing competition, the new private sector owners wouldeventually have to rehabilitate enterprise technology.

(c) The scheme may depress the price of the shares because recipientsof these assets may prefer to liquidate them at once. Thispossibility has led some governments considering giveaways topropose a freeze of the exchange of shares for a certain period oftime. Because most people are relatively uninformed about therole of capital markets and risks and rewards of individual shareownership, the announcement of a share distribution scheme shouldbe accompanied with a media campaign directed to educate thepublic on these issues. Massive sales of shares that could

1t If shares are sold rather than distributed, at least 51 percent ofequity would have to be transferred to the private sector. Moreover, if theGovernment maintains a large share, it will still have a representation on theBoard. Thus, the Government could limit the possibility of the private sectorto sell shares to the public, without risking loss of control over thecompany.

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temporarily depress share prices would then reflect the frOechoice of an informed public; thus large volume should not be areason to freeze the exchange of shares.

(d) The distribution of shares in each company!'Y to each citizencould pose serious logistical problems, could be costly, and couldlead to each share having a negligible value. Such events wouldmake it difficult to create a market. However, reducing thenumber of shares to be distributed by restricting eligibility orsimplifying the allocation mechanism could mitigate this drawback.Limiting eligibility to Turkish citizens over 18 years old wouldreduce logistics by two-thirds. Distributing only one share of agiven company to each citizen would not only reduce logistics andcosts but would enhance the potential to create a market byconcentrating ownership. There would be fewer shares in eachcompany, reducing the amount of shares needed to obtain acontrolling stake in the company.

VI. COMMERCIALIZATION. REGULATION, AND LABOR RESTRUCTURING

76. While divestiture would address most of the problems of thesector, reforms are needed for those SOEs that would temporarily remain instate hands i.e., utilities such as railways, electricity, post office andtelecommunications, and port and airport administration. The reforms shouldenable these SOEs to operate much like private commercial enterprises. Thesewould entail a new legal and institutional framework, complemented by aregulatory framework that promotes efficiency, stimulates competition, andsafeguards the rights of consumers. This arrangement would prepare theconcerned SOEs for further divestiture and private sector participation.Moreover, because the reform program for utilities is likely to require laborrestructuring, this issue should be addressed up front.

Commercialization

77. The new institutional model is based on certain key concepts,including (a) the separation of state ownership and SOE management functions;(b) the granting of operational autonomy to management, especially in thebasic areas of pricing, procurement, and most importantly, employment; (c) theelimination of political influence to the extent possible; (d) the orientationof SOEs toward a hard-budget constraint that will induce financial discipline;and (e) the establishment of clear and simple lines of oversightresponsibility that reflects management's accountability to its owners. Itshould be emphasized, however, that no model of public ownership can fullymimic private ownership; thus there will always be some political

ii Because SOEs work best when broken up in separate entities (it isdifficult to sell an operation which, for example, does banking, retailing,and production of textiles and leather at the same time), the number ofcompanies could become quite large.

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interference. In the transitory phase, the essential features of the newmodel can be summarized as follows:

(a) Objective: profit maximization in a dynamic sense, i.e.,maximization of the value of the firm (subject to regulation fornatural monopolies);

(b) Corporate form: joint-stock companies fully subject to thecommercial code;

(C) Government-SOE relations: Single Government Agency (SGA) as thesole link between other public agencies and the board of the SOE;

(d) Management policy and oversight: independent Board of Directors;and

(e) Operations: autonomous and accountable management subject toperformance monitoring, evaluation, and sanctioning.

78. Cornorae Fom. All SOEs should be organ-zed as joint-stockcompanies (JSCs) subject to the commercial code. ownership should bestructured through the shareholder assembly. The commercial code requires thepresence of at least five shareholders before such an assembly can be called.This stipulation can readily be met without altering effective control. Inaddition to its own share, the Government could issue four nominal shares tonongovernmental persons (e.g., managers of the SOE or of the SGA). Thecorporate mechanism (e.g., shareholders, board, executive management) can thenfunction as it would in a private company. One reason why the conversion ofSOEs to JSCs is so basic to meaningful reform is that the commercial codeprovides for an orderly procedure for closure. Effective competition with theprivate sector and financial discipline can be a reality only if the ultimatesanction for failure of an SOE, bankruptcy and closure is available. Atpresent, only the High Planning Council can decide to close an SOE;furthermore, no court action can be initiated by its creditors.

79. Government-SOE Relations. As a consequence of converting SOEs toJSCS, many of the present functions of sectoral and other concerned ministriesand public agencies would be eliminated or modified. Since the key tosuccessful reform is the elimination of political influence on SOE operations,a single channel of communications between SOE management and the Governmentas owner should be established. This link can best be made operational bycreating a Single Government Agency (SGA); its basic purpose should be toexercise the ownership functions of government as sole or majority SOE owner.To set up an SGA, the following steps should be taken:

(a) Nominate the Board of Directors (to be appointed by the HighPlanning Council).

(b) Define shareholder objectives in terms of profit maximization overtime (i.e., maximization of the value of the firm), inconsultation with Treasury, SPO, and the concerned ministry.

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(c) Instruct the Board of Directors (BoD) to pursue these objectives,reach agreement on simple performance indicators (mainlyprofitability), and when appropriate, cast all of these parametersin the form of a mutually committing agreement (e.g., performancecontract).

(d) Receive the SOE's annual operational program and budget forpurposes of information and comment only, except when equitycontribution from the central government'a budget is involved. Insuch a case, SGA also retains approval authority jointly withTreasury.

(e) Monitor and evaluate the SOE's Ferformance through receipt andanalysis of BoD reports, and apply the incentive system previouslyagreed to by the SOE.

(f) Approve major changes in the SOE's structure, including its lineof business, its capitalization, its closure and other significantchanges.

80. This list of functions is exhaustive: the SGA should do nothingmore. If it did more it could possibly perpetuate political interference andmake meaningful performance evaluation impossible. If the Government iscommitted to changing its role into a regulatory agent, it should establishthe SGA as a temporary and self-liquidating agency. The SGA should not be aholding or a government department, and it should be as small as possible.Examples of small units effectively performing as an SGA can be found inNorway and Sweden.

81. If the objective of minimal political interference is to beachieved, the two crucial questions need to be addressed: (a) who willappoint the members of the SGA, and (b) whom will they be accountable to? Thepotential for successful operation of the entire remaining SOE sector rides onthe resolution of these issues. There are, unfortunately, no best answers tothese problems. Perhaps one solution would be new SOE legislation that wouldrequire the appointment of SGA members with experience in managing largeenterprises in the private sector. Appointments could be made by decree ofthe cabinet subject to a confirmation vote from the Parliament. A furtherissue to be resolved is how to provide the proper incentives to the SGA.Clearly, members of the SGA should be hired on a contractual basis, not onconditions of employment in the civil service. The possibility of linkingtheir remuneration to the performance of the enterprises should beinvestigated.

82. Board of Directors. Conversion to JSC status should be followedat once by the creation of a new Board of Directors for each SOE. The BoDshould be set up as the top management body of the SOE rather than as aninstrument of day-to-day government control. Its members should be selectedby the SGA from candidates with technical and managerial experience relevantto the SOE's activities. To correct the now prevailing conflict of interestsituation, the BoD should not include any member of the executive management.

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The board should be the only body of the SOE to deal with and report to theSGA.

83. The BoD should have the following principal functions:

(a) agree with the SGA on the quantification of indicators thatcorrectly reflect the degree of attainment of the objectives;

(b) appoint the CEO;

(c) prepare and approve SO operational and financial policies andplans on both current and capital accounts, after consulting withthe SGA and management;

(d) monitor CEO's and management's performance;

(e) approve investments and sales of assets; and

(f) approve major changes in corporate policy.

84. Management Autonomy. the above recommendations imply that theGovernment give the managements of retained SOEs the freedom to run them asprofitable businesses under the comme-cial code in a competitive and cost-effective manner. To do this, SOE managers will need autonomy in all areas oftheir activity, especially in pricing, procurement, and employment. If an SOEenjoys a monopoly, pricing would have to be regulated, however. The continueduse of SOEs in the pursuit of noncommercial activities is incompatible withthe requirement of autonomy. Not only are SOEs inefficient instruments toachieve noncommercial goals, but forcing them to finance these activities (a)hides the true cost to the budget, (b) leads to conflicting objectives, and(c) makes performance evaluation impossible. At the minimum, noncommercialactivities should be separated from the remainder of SOE operations in such amanner that makes it impossible for them to distort the results of commercialactivities. To achieve that aim, noncommercial activities should only beadmitted to an SOE on condition that the Government (a) negotiates a contractwith the SOE just as private customers would; and (b) takes advance measures,primarily through adequate appropriations in the national budget, to ensurethat it actually has the money to pay for the activities.

85. Performance Monitoring, Evaluation, and Incentives. An autonomousmanagement must be held accountable to its owner for its performance. Bothefficient performance and accountability can only be successfully pursued if(a) autonomy is accompanied by both positive and negative incentives tomanagement, (b) performance is correctly monitored, and (c) it is properlyevaluated. Such measures involve the following actions:

(a) Monitoring: Upon the conversion of SOEs to a regular corporatestructure, performance monitoring becomes the task of the Board ofDirectors and the Single Government Agency. The currentsituation, which requires management to respond to all types of

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ad hoc requests for information from different publicinstitutions, should be abandoned.

(b) Auditinat The present requirement (resulting from Article 165 ofthe Constitution), which subjects SOEs to the same auditingprocedure as government departments, should be replaced by asystem of financial auditing similar to private sector companies.All nonfinancial auditing, such as the verification of compliancewith administrative rules on travel and vehicle use, for example,would lose its significance as autonomy is granted to management.The High Audit Board (HAB) could become the implementing agencyfor financial auditing by hiring qualified private audit firms,approving their reports, and submitting them to the Parliament'sstanding committee on SOEs, if still required. Follow-updecisions and recommendations should be communicated to the SGAonly.

(c) EyaluatiLon: The performance evaluation system should beadministered by the single oversight agency mentioned earlier.The frequency of evaluation will vary, but, at least, annualreview is needed to monitor progress. The system should be (a)simple, practical, and neutral; and (b) follow previously agreedobjectives (e.g., profitability, supported by other financial andeconomic indicators when necessary).

(d) Sanctionin:s The performance evaluation system must be tied tomonetary incentives and disincentives. The ranking systems shouldbe incorporated in the evaluation process, and it should lead to apredetermined bonus for management, depending on how differentweighted aspects of performance compare to targets. Forunsatisfactory performance the system could rely mainly on thewithholding of bonuses rather than on outright pay cuts. Anincentive system will be most effective if it is adapted to thecountry's circumstances and culture, but a crucial element in thesystem'a successful application is that its administration be asconsistent and transparent as possible. Toward this end, apredetermined scale of performance indicators should correspondwith a predetermined scale of rewards; and discretion should beavoided.

86. Implementation of Reforms. The implementation of the reforms assuggested above will have a profound impact on the role of many Governmentagencies and on the corporate culture of the SOEs. The reforms (a) require anoverhaul of the existing legislation regarding the SOEB; (b) could necessitatefinancial, and to some extent, physical restructuring in order to allow SOgsto survive in the new environment; and (c) require the establishment of aregulatory framework where needed.

(a) Institutional Chances: Only one additional inmtitution is neededsthe Single Government Agency (SGA). This agency should neLther bea new ministry nor administrative body or a holding company. It

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should deal with matters related to the commercial operation ofthe SOE only, be staffed by highly competent officers, and possesssufficient authority. The location of the administrativefunctions of the SGA would be up to the Government, but it shouldbe such that it has independence and can implement theGovernment's intentions with minimum political interference. Formost other institutions presently involved in SOE operations, thenew setup would 'mply a curtailment or modification of theirfunctions.

(b) Legal Reforms: A careful analysis of the entire legal corpusrelevant to SOEs should be performed prior to implementation, toavoid legal challenges. Most of the specific legal obstacles toreform are embodied in Decree Law 233 and in the Constitution, butmany of the smaller impediments come from the indiscriminateapplication of bureaucratic rules (procurement, travel, vehicleuse) that pertain to public agencies, including SOEs. As ageneral guideline, the new law should limit itself to generalprinciples in order to avoid the rigidity of Decree Law 233. Thekind of detail that is typical of the present decree law is bestleft to the governmental oversight agency and the SOEs' topmanagement. Articles 128 (decreeing SOE management to be carriedout by civil servants) and 165 (obliging all wholly or majority-owned SOEe to be audited by Parliament) of the Constitution arealso excessively detailed. Both articles are ill-adapted topresent-day circumstances, and, if they remain in place, much ofthe suggested reform will be difficult to implement. If Article128 of the Constitution cannot be modified, it would be best todivest quickly as many of the retained SOEs as possible. Sellingor distributing 51 percent of the shares of these companies wouldtransform them into private enterprises subject to the commercialcode and, hence, free them from these legal constraints. In suchcase, putting the appropriate regulatory framework in plan wouldbe critical (see paras. 87-89).

(c) Restructuring: The aim of SOE reform is to have retained SOEsoperate profitably without benefit of subventions, subsidies, orother favorable treatment by government. Government financialsupport would only occur in the form of specifically justifiedcapital injections for SOEs that are expanding their activities;thus such support should be considered unlikely since the SOEreform is precisely geared to reducing size in order to foster thedevelopment of the private sector. However, as a result of thepast inefficiencies, some of the retained SOEs may not be able tooperate under strict financial discipline, since they areinsolvent. Hence, it may be necessary to restructure existingdebts of retained SOEs to allow them &ccess to financing on acompetitive basis. Financial restructuring may not be sufficientin itself to prevent SOEs from becoming insolvent again, becauseoperational inefficiencies caused by redundant labor and obsoletecapital and unprofitable lines of businesses may still cause SOEs

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to have negative net worth, barring them from competitive accessto credit. Labor restructuring, liquidation of unprofitable linesof business, and selective capital investments will be required.Investments, however, should only be undertaken if the continuedinvolvement of the state can be economically justified.

Re9Rlator_Eramewo.rk

87. SOEs linked to natural monopolies (e.g., electricity, mail,telephone and telecommunications, port and airport administration) should beretained in public hands only until a regulatory framework is put in place.Partial divestiture could already be implemented without delay. Care shouldbe taken not to define natural monopolies too broadly: in most cases,monopolies are linked to distribution networks that cannot efficiently beduplicated (e.g., local telephone networks), but technological progress mayalleviate some of this burden (e.g., cellular phone). Even in some areas ofmail services (e.g., express mail and parcels) competition can be introduced,as for example in the United States.

88. Regulation of the natural monopoly problem should be implementedthrough the establishment of agencies endowed with powers to control price.,entry, and conditions of aervice in a particular industry or group ofindustries. These agencies should be independent of the owners of theenterprises. Initially, these agencies should be set up to monitor thebehavior of the public enterprises. As divestiture takes place, their roleshould shift to monitoring privately-owned companies. The basic aim ofregulation is to achieve the benefits of cost efficiency without thedisadvantages of monopolistic behavior. Although regulation puts constraintson the decisions of firms, they should not modify their objective of makingprofits. There are very few general rules about regulation that apply acrossthe board, so the regulations and regulatory agencies will have to be industryspecific. A detailed analysis of each of the different industries concernedgoes beyond the scope of this report. Hence, only some general considerationsfollow.

(a) Agencies. Economic behavior of the regulated firm will stronglydepend on the regulatory procedures followed by the agency. Therewill always be a trade off between consumer and producerinterests, and the way in which, for example, prices are regulatedwill determine how much the firm will invest, whether it will beinduced to innovate, and what factor mix it will use. Usually,regulatory agencies have been given rather vague mandates, whichleaves them vulnerable to pressure-groups. This suggests the needfor carefully framed guidelines with respect to pricing,competition, and quality of services.

(b) Pricing. Maximizing profits in a natural monopoly will lead to alower amount of goods and services provided and, hence, to lowerwelfare. Regulating prices poses the problem of deciding on aprice rule. There are many possibilities: maximum rate ofreturn, output related profits levy, profit ceiling, or a rate of

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price inflation minus x rule. All these rules try to avoiddifficulties involved with long-run marginal cost pricing, whichnormally would be the optimal rule. However, it is difficult tocompute long-run marginal costs as they depend, among otherthings, on demand. Moreover, in industries characterized byincreasing returns to scale, long-run marginal cost pricing wouldimply that the firn) would be running losses, and, therefore, wouldrequire subsidization. In practice, an appealing pricing rule isthe "rate of price inflation-xW rule (ao used in British Telecom).A price index of a basket of searvices is calculated, and the firmis required to increase its price below that index by x percent ina given period. The "x" should present a binding constraint,should take into account technological progress, and should be setby the regulatory agency (it should not be negotiated with thefirm, as has been, for example, the practice with BritishTelecom). The "x" should preferably be set to achieve a certainrate of cost reduction. The cost reduction achieved by otherfirms in a aimilar business (or from other countries) couldprovide useful guidance.

(C) ComnetitiLo. By far the most effective way to achieveimprovements in efficiency is competition. The effective threatof entry should complement price regulation. A regulatory agencymay intervene for the following three reasonss (a) to preventexisting enterprise from deterring the entry of other firms; (b)to limit the activities of monopolies in networks and vertically-related markets, so that their monopoly power in one activity tothwart competition in one that is not a natural monopoly (e.g.,electricity distribution versus generation, or local phone serviceversus telephone equipment); and (c) to establish yardstickcompetition, in which regionally separated units of one naturalmonopoly are forced to charge prices based on the costs of anotherunit. In Turkey, generation plants of TEK, for example, could betreated as independent units, and their increases in efficiencycould be stimulated by forcing the companies to price their outputon the basis of the cost of the least cost company.

(C) Qualitv of Services. As prices are regulated, providing asufficiently high quality of services to the consumer becomes anissue. For producers, lowering service standards could be one wayof maximizing profits. For this purpose, the regulatory agencymust look after the interests of the consumers, which often arequite diffused. The need for regulation also stems from servicesexhibiting a common problem (e.g., radio frequencies); when thereis free access to a limited resource, agents do not internalizethe social costs. Overcrowding of radio frequencies could lead topoor quality of service or no service at all.

89. The two main SOEs that will temporarily remain in state hands andthat are monopolies are PTT and TEK. They must be regulated, according to thegeneral principles just outlined. PTT is a multiproduct firm, and, ideally,

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should be split into distinct companiess for example, into a supplier ofpostal services and a telephone and telecommunications company. Of these,only local telephone services are, at least with the current technology, anatural monopoly. Nevertheless, it could be broken into independent regionalcompanies to generate yardstick competition. Even so, technological progress(e.g., cellular phone) is breaking up the monopoly character as well.Electricity generation may be open to competition. There are already privategenerators in Turkey, but the current state of TEK prevents fair competition.TEK dominates the market; it has shown poor operational performance and reliedheavily on support from the central government's budget. Onse TEK regainsfinancial independence, pricing of electricity should be left free, butdistribution would need to be regulated. .t would be preferable to separateTEK's distribution function from its generation function in order to preventTEK from using its monopoly in distribution to favor its own generation plantoat the expense of the private sector. Similarly, private sector entrants intothe business of generation should not be granted specific privileges ormonopoly rights.

Labor Restructuring

90. Each of the components of the reform program will lead to asignificant amount of labor restructuring. In the case of liquidation offirms, restructuring is self-evident. For all other SOEs only indirectevidence on the amount of labor redundancy exists. Labor productivity in theprivate sector for similar industries appears to be significantly higher thanin SOEs, on the average. Discussions with management of SOEs yieldedestimates of redundancy between 20 and 40 percent. Upon sale of USAS (theairline catering company) to private investors, reportedly 50 percent of theworkers were dismissed. Resistance to this type of reform is understandable,and the Government's unwillingness to deal with the problem in the past haccaused major delays in the reforms. Labor restructuring needs to.be addressedup front, preferably even before the reforms are implemented. The processwill involve the payment of severance or termination benefits ka legalobligation), the establishment of a social safety net, and restructuring oflabor policies in SOEs, which will be temporarily retained in Governmenthands.

Severance

91. Except for civil servants, all categories of employees can bedismissed. Where restructuring leads to the displacement of civil servants,they are placed elsewhere in the public sector. The potential number ofpeople in this situation is relatively small: in 1990 there were fewer than30,000 civil servants in the SOE sector. Moreover, the Government couldreallocate these people to axpanding areas of the public sector and reduce newhiring so that the budgetary impact of thie transfer was negligible.

92. All permanent workers, unionized (318,000 in 1990) andnonunionized (5,400 in 1990), hiave a legal right to 30 days' severance pay foreach year of seniority on the job. There could be additional provisions inthe collective bargaining agreements signed with the trade unions, but no

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information was available at the time this report was wrltten. Becauseaverage seniority is about 10 years, average severance pay per unionized andnonunionized worker would be about US$7,000 and US$13,000, respectively.Wages differ significantly across SOEs and actual layoffs could falldisproportionately on workers with higher seniority; thus average wages shouldbe interpreted with care,

93. There is one legal provision concerning dismissal of workers thatmight hamper labor restructuring in all SOEs that are not liquidated. Section24 of Law 1475 stipulates that "Employers shall not employ any new worker inplace of workers whose contracts are terminated... for a period of six months,effective from the date of such termination. If an employer is obliged toengage new workers for the same jobs... h. shall give notice...to thepreviously terminated workers.' This right of reinstatement would appear toprevent new private owners frcm, filling positions previously held byunqualified workers with bet, ̂ tr skilled workers. Rather than suggesting thatlabor legislation be modific-d, it would seem sufficient to make receipt of thesocial safety net benefits conditional on voluntary resignation accompanied bya guarantee of notice, severance, and all components of the safety net. Thiostrategy would avoid the application of Section 24 of Law 1475.

Social Safety Net

94. Aside from severance payments (a legal obligation), the Governmentshould antlcipate (a) the implemerntation of temporary income support measures,(b) the provision of employment services, and (c) the establishment oftargeted training and employment generation programs. Except for the incomesupport measures, the other components of the social safety net can beprovided by expanding existing services and targ,eting them to the relevantcases. The amount and balance of services to be provided must necessarily betailored to the specific situation. If layoffs occur in areas with littlealternative employment, more emphasis should be placed on job searchcounseling, mobility assistance, and generation of new employment. In eachindividual case, the Government should hold open discussions with workers andmanagers and agree on the components of ide redeployment program.

95. Income Suort. The temporary income support measures should bedesigned to offset some of the income loss incurred upon retrenchment. Theyalso should stimulate workers to find new employment as soon as possible.Under such a scheme, workers would receive a percentage of the last wage for aduration of, for example, 18 months, and a lump-sum payment when they find newemployment. The sooner the workers find a job, the higher their bonus wouldbe. Experience in other countries indicates that support that is too generousprolongs the duration of unemployment. Failure to provide temporary incomesupport may lead to social or political pressures to reabsorb employees in thepublic sector. Temporary workers might be given some ex gratia bonus butshould not otherwise be included in the safety net scheme. Safeguards will beneeded to ensure that individuals receiving the bonus payment do move intoreal employment or self-employment. Under relatively generous assumptions,the fiscal cost of the income support scheme could range between US$l billionand US$1.6 billion.

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96. Emplovment Services. Prior to large layoffs, and especially inthe case of liquidation of SOEs, on-site counseling services for training andjob search should be provided. It is important to involve workers,management, and the private business community as soon as possible in theprocess. To do this effectively, the counseling service should be linked tothe centralized labor inrormation system, and additional staff should betrained to provide the services. As soon as possible (certainly before actuallayoffs take place), labor restructuring committees consisting ofrepresentatives of the Ministries of Labor and Education, local government,and labor unions, and management of the SOEs should be established. A projectto provide counseling through the 102 offices of the Turkish EmploymentOrganization (IIBK) was estimated to cost US$30 million. If implemented, theadditional fiscal resources needed to counsel dislocated workers of SOES wouldbe small. Moreover, if successful, job counseling would pay for itself,because less income support would be needed. Temporary housing subsidiesand/or relocation grants to promote mobility are similarly cost effective.This type of assistance may be required to cushion the regional impact ofplant closing in areas where the SOE is the major income-employment provider.

97. Training and Employment Generation. Different types of trainingcan be provided. The labor restructuring committees could play a crucial rolein matching workers with types of skill and occupational training. Atpresent, a small employment guarantee scheme, providing the worker and hisemployer with financing for on-the-job training, already exists, and it couldbe expanded. This type of training is estimated to cost about US$400 perworker and, if effective, it would pay for itself in no time by reducing theamount of income support needed. More specifically, for workers with interestin self-employment, specific training in business methods, accounting, andfinancial matters and targeted assistance could be given. Granting workersthe bonus linked with income support to start up their business might be oneconsideration.

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APPENDIX 1: Definitions_f Key_ Concents

-Operating Surplus/Deficit a savinqs or the residual of theprofit and loss account of thestate-owned enterprises (i.e.,operating and nonoperating revenue -current expenditures - direct taxes)

-Borrowing Requirement (PSBR) = need for financing from outsidesources: fixed investments +changes in stockB + changes in fixedassets -internally generated funds -budgetary transfers

*-nternally Generated Funds - retained earnings + depreciation +provisions

-Retained Earnings - operating surplus/deficit -dividends + subsidies

-Return on Capital Employed - earnings before interest and taxesdivided by (equity + interestbearing liabilities)

*Financial Leverage Ratio = total liabilities/equity

-Earnings Decline Ratio 1 - (interest payments/earningsbefore interest and taxes)

-Free cash Flow - gross cash flow - (working capital +capital investment) + (nonoperatingincome - nonoperating expenditure)

-Gross Cash Flow - operating surplus + depreciation

*-arginal Efficiency of Capital = additional amount of value addedproduced per unit of fixed capitalinvested

'Total Factor Productivity Growth = amount of change in value added notaccounted for by changes in thequantity of production factors(labor and capital) but, hence, byincrease in their joint productivity