Report No. 26301-TU Turkey Country Economic Memorandum Towards Macroeconomic Stability and Sustained Growth (In Three Volumes) Volume I: Summary Report July 28, 2003 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank Turkey: CountryEconomic Memorandum CurrencyEquivalents (ExchangeRate Effective July 28,2003) CurrencyUnit = Turkish Lira US$1 = TL1,410,000 GovernmentFiscal Year January 1-December 31 Weights and Measures Metric System Abbreviations and Acronyms AMC - Asset ManagementCompany PA - PrivatizationAdministration BK - Bag-Kur PFMC - Public FinancialManagementand Control BO - Build Operate PHC - PrivatizationHigh Council BOO - Build Operate Own REER - Real Effective Exchange Rate BOT - Build OperateTransfer SDlF - Saving DepositInsuranceFund BRSA - Banking Regulatoryand Supervisory SIS - State Instituteof Statistics Authority CAR Capital Adequacy Ratio SOE - State Owned Enterprises CEM - Country EconomicMemorandum SPO - State PlanningOrganization CPI - Consumer Price Index SRS - SustainedReformScenario EBITDA - Earnings Before Interest, Tax, SSK - Social Security Organization Depreciationand Amortization ES - Emekli Sandigi TEAS - ElectricityGenerationandTransmission Company EU - EuropeanUnion TEDAS - Turkish Electricity DistributionCompany EUAS - Turkish ElectricGenerationCompany TEIAS - Turkish ElectricityTransmissionCompany FlAS Foreign InvestmentAdvisory Service TEKEL - Turkish Tobacco Monopoly FDI Foreign Direct Investment GDP - Gross Domestic Product TETAS - Turkish ElectricityTrading Company GDR - General Directorateof Revenues TFP - Total Factor Productivity GNP - Gross NationalProduct TOBB - Union of Chambers of Commerce and Industry IA -- IstanbulApproach TOOR - Transfer of Operating Rights ISE Istanbul Stock Exchange TSFAS - Turkish Sugar Factories ISKUR - EmploymentOrganization TUSIAD - Turkish Industrialists'and Businessmen Association MOF - Ministryof Finance YOIKK - CoordinationCouncilfor InvestmentClimate NPL - Non-PerformingLoans Vice President: Johannes Linn (ECAVP) Country Director: Ajay Chhibber (ECCU6) Sector Director: Cheryl Gray (ECSPE) Sector Leaders: Samuel Otoo (ECSPE) Team Members: Ismail Arslan (Team Leader, ECSPE), Mediha Agar, Pinar Baydar, Craig Burnside, Robert J. Cull ,Annette De Kleine, Asli Demirguc-Kunt, Ira Lieberman, Kamer Ozdemir, James Parks, Philip Suttle, Matthew Verghis (World Bank) Refik Erzan, Alpay Filiztekin, Nissan Liviatan, Fatma Taskin, Erol Taymaz, Ercan Uygur (Consultant) FOR OF'FTCLALUSEONLY TURKEY: COUNTRY ECONOMIC MEMORANDUM TOWARDS MACROECONOMIC STABILITY and SUSTAINEDGROWTH TABLE OF CONTENTS EXECUTIVE SUMMARY SUMMARY REPORT DisinflationAnd Crisis......................................................................................... Economic Context ................................................................................................ 1 Crisis ResponseProgram...................................................................................... 3 5 Macroeconomic Framework............................................................................... Medium-TermAgenda ......................................................................................... 12 Public Sector Reform.......................................................................................... Business Environment ................,...........................,...........................................20 16 Medium-Term Outlook.......................................................................................33 Social Policies..................................................................................................... 28 This documenthasa restricted distributionand may be used by recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed !withoutWorld Bank authorization. TABLES TABLE1: Key Economic Indicators, 1999-2003 TABLE2: Alternative FiscalAdjustment Scenarios TABLE3: Fiscal Adjustment, 1999-2002 TABLE4: Fiscal Cost o fBank Restructuring TABLE5: Productivity and Wages in Selected Countries FIGURES FIGURE1: Per Capita GDP at PPS FIGURE2: GDP & GDP Per Capita Growth FIGURE3: REERandGDP Growth FIGURE4: AdjustedPSBR FIGURE5: Total N e t Public Debt FIGURE6: GNP Growth FIGURE7: Real Interest Rate FIGURE8: Openness: Trade to GDP FIGURE9: Public Sector FixedInvestment FIGURE10: Public Sector Wage Bill FIGURE11: Deficit of Social Security System FIGURE12: Per Capita Income & General Government Expenditure FIGURE13: Tax Burden FIGURE14: Private Sector Real Credit Volume FIGURE15: Distressed Companies, 1998-2001 Q1 FIGURE16: Privatization UnderPA FIGURE17: Post Crisis FDI FIGURE18: FDI FIGURE19: Unemployment Rate FIGURE20: Population, Labor Force and Employment FIGURE21: Growth FIGURE22: PSBR FIGURE23: Current Account Balance FIGURE24: Per Capita Income FIGURE25: Total Net Public Debt TURKEY: COUNTRY ECONOMIC MEMORANDUM TOWARDS MACROECONOMIC STABILITY AND SUSTAINED GROWTH EXECUTIVE SUMMARY 1. Economic Context. Despite many advantages ranging from its strategic location to its dynamic population, Turkey has not achieved the high growth o f leading emerging market economies. Turkey has not matched the growth rate o f EUaccession countries such as Hungary and Poland, or the fast growing cohesion countries such as Spain and Portugal. Macroeconomic instability has helped keep growth below potential. Analysis suggests that macroeconomic instability has played an important role-among many factors-in Turkey's inability to realize its full growth potential. Turkey has suffered from an exceptional degree o f macroeconomic instability characterized by chronically high inflation and sharp swings in the business cycle. The "boom-bust" cycle has continued into the new decade with a record contraction o f real GNP o f over 9 percent in 2001 followed by a strong recovery with estimated growth o f 7.8 percent in 2002. Today, Turkey i s the only major economy in the world that continues to struggle with inflation rates o f 30 percent per year or more. Fiscal imbalance has been at the root o f chronic macroeconomic instability. Unsustainable fiscal policy has repeatedly put pressure on the Lira, fueled inflation and undermined financial stability. When crises have hit, contractionary macro policies have been required to restore a semblance o f financial stability, worsening the real impacts of internal and external shocks. The impact o f unsustainable fiscal policy on macroeconomic stability has been magnified by Turkey's open capital account and, until recently, its poorly regulated banking system. The causal linkages between fiscal imbalances and instability in Turkey suggest that the key to macroeconomic stability lies in sustained fiscal adjustment underpinnedby credible structural reforms. .. 11. Crisis, Response and Recovery. Turkey's exchange rate-based disinflation program- launched in a context o f structural fiscal weaknesses and systemic banking sector problems- collapsed in early 2001. The Government responded quickly to the financial crisis and announced a strengthened economic program inMay 2001 inresponse to the crisis following the collapse o f the crawling peg and subsequent devaluation. Turkey's crisis response program benefitedfrom the lessons learned by other emergingmarket countries facing crisis. Immediate fiscal measures were introduced to shore up the primary surplus and strengthen confidence inthe sustainability o f the public debt. A front-loaded program o f bank restructuring was launched, backed by extensive fiscal resources. Bank restructuring was complemented by additional structural reforms in the financial sector designed to further strengthen prudential regulation, adopt internationally accepted financial reporting standards and practices, and enforce compliance. In parallel with accelerated financial sector reform, a comprehensive public sector reform program, including institutional reforms, was introduced to tackle the structural roots o f Turkey's chronic fiscal imbalance. Strengthened financial and public sector reforms were placed within a medium-term programmatic framework in an effort to bolster investor confidence by demonstrating the Government's intent to address the core structural causes behindthe crisis and not just the immediate symptoms. The crisis response program was backed by additional financial resources from the IMF and the World Bank. Economic activity rebounded strongly in 1 2002 and the recovery continued into early 2003. Real GNP growth reached 7.8 percent in2002, exceeding program projections by a wide margin. The extent o f the recovery and its basis in export growth place Turkey squarely in the category o f rapid-recovery, post-crisis countries, such as Korea in 1999 and Mexico in 1995. iii. Medium-termAgenda. ItiscriticalfortheGovernmenttomovequicklytoestablishits reform credentials and bolster investor confidence. Sustaining high and more fairly distributed growth over the medium-termrests on a challenging reform agenda: The path to macroeconomic stability lies in sustaining a high level o f fiscal adjustment for the foreseeable future. Fiscal adjustment must be underpinned by structural reforms and complemented by credible macro policies. Moving credibly towards international-notably EU-standards, will helpminimizingtrade-offs betweenrecession and disinflation. Determined action to modernize public sector institutions and to improve public governance i s critical to achieving quality fiscal adjustment and durably improving the business climate. Effective government i s also key to realizing Turkey's social and human development objectives through the efficient delivery o f public services. Sustaining and expanding the growth process will depend critically on improved performance o f the financial and real sectors. Wide-ranging reforms must be deepened to bolster the financial system, promote corporate restructuring, complete regulatory reforms, and accelerate privatization and market liberalization. Social policies needto be strengthenedto ensure the robust social contract among its citizens that Turkey needs to meet the challenges o f the new century and secure the social development o f the country in light o f the millennium development goals. Priorities for social policy include mitigating adverse consequences o f the ongoing structural adjustments, raising the level o f human capital, and ensuring effective operation o f the labor market. Sustained growth will hinge on Turkey's further integration with the global economy. Structural reform i s essential to maintain strong export performance, attract foreign direct investment and bolster confidence. Given continuing vulnerabilities to exogenous shocks, maintaining a policy o f exchange rate flexibility will be important. Sustained progress towards EUaccession would provide a strategic external anchor for Turkey's reform efforts. Risks. There are important risk factors that mustbe actively addressed to ensure that they don't undermine emergence o f a virtuous cycle o f sustained growth. Internal risk factors include: (i) public debt sustainability, (ii) incomplete reform in the financial sector, (iii) deep corporate distress following the crisis and the slow pace o f corporate restructuring needed to promote competitiveness, and (iv) the potential for rigidities to develop in the labor market. Private access to financing may become a serious constraint on sustained recovery over time. External risk factors are also significant and highlight the critical importance o f promoting FDI in line with the experience of other rapid-recovery post-crisis countries. O f immediate concern i s the widening current account deficit. For the medium term, the expected slower recovery in the world economy, increased risk aversion o f international investors, and the potential for post- war instability inIraqare all significant risk factors for the mediumterm. The external financing 11 plan for 2003 and beyond centers on increased access to private capital. This will be a challenge under prevailing conditions in international financial markets. Increased FDI flows inthe years following crisis have played a key role insustaining recovery inother emerging markets. Turkey will have to accelerate its efforts in order to follow suit, inparticular to strengthen productivity and expand its share inthe strategically important, but relatively slow growing EUmarket. V. Medium-term Outlook. Medium-term projections demonstrate that sustained implementation o f economic reform i s necessary if Turkey i s to attain its macro-economic stability and growth objectives. Only sustained macroeconomic stabilization and structural reform can set Turkey on a medium-term course o f disinflation, renewed growth and sustainable public debt. Thus, the medium-termprojections under the program illustrate a Sustained Reform Scenario. Economic reform i s needed to catalyze a virtuous circle whereby increasingly permanent fiscal adjustment and more effective government lead to improvements in market confidence which in turn drive down real interest rates. Lower rates combined with reforms to improve the business climate can inturn engender an increasingly robust private sector response. A sustained pick up in private sector activity that begins to generate employment will complement stronger social policies and bolster public support for the Government's reform policies. Igniting and then sustaining this virtuous circle i s the key to achieving high levels o f more equitable growth over the mediumterm. There is no roomfor error. Under an alternative low-case (muddle through) scenario, structural reforms would lose momentum, fiscal policy would become expansionary, and inflation and growth performance would likely be disappointing. With limited program credibility and a large debt rollover requirement, interest rates would remain high and private investment would be crowded out. Under this scenario, the economy would remain highly vulnerable to internal and external shocks, with significant risk o f a new economic crisis. Pursuing Turkey's social agenda would become increasingly difficult. Clearly, the low-case (muddle through) scenario i s not sustainable for Turkey. vi. Under a scenario of sustained reform, the economic program is projected to achieve the Government's stabilization and growth targets. The economy would be expected to fully recover from the 2001 recession, with stable real growth o f 5 percent in the 2003-06 period. Specific factors underlying sustained growth include: 0 greater confidence inthe policy framework, 0 improved macroeconomic stability and declining real interest rates-which would stimulate private investment and consumption demand, 0 an increase inproductivity resultingfrom structural reforms, 0 stronger exports performance-which would permit faster import and output growth, and 0 higher external inflows, including sizeable FDI. While sustained 5 percent growth i s projected under the reform scenario, even higher growth would be neededto make real progress towards EU convergence given Turkey's demographics. This underlines the strategic imperative o f determined implementation o f the medium-term reform agenda. Sustained progress towards EU accession would provide a strategic external anchor for Turkey's reform efforts. ... 111 TURKEY: COUNTRY ECONOMIC MEMORANDUM TOWARDS MACROECONOMIC STABILITY AND SUSTAINED GROWTH SUMMARY REPORT 1. This report addresses key questions facing Turkish policymakers: how to sustain the economic recovery that began in 2002 following the deep crisis o f 2001, how to ensure disinflation and public debt sustainability, and how to foster broad-based and equitably distributed growth in the future. After a brief review o f the 2001 crisis and the Government response, the report analyzes the economic opportunities and challenges facing Turkey, and identifies policies to build on the economic recovery which began in2002. The CEM develops a comprehensive four-point agenda for sustainable and more equitably distributed growth. The agenda encompasses: (i)macroeconomic stability, (ii)effective government, (iii)improved business environment, and (iv) stronger social policies. The report closes with medium-term macroeconomic projections to illustrate Turkey's prospects under a scenario o f sustained reform and to highlight the risks to growth and macroeconomic stability should the economic program go off track. 1 ECONOMIC CONTEXT Turkey has not achieved its growthtargets 2. Despite many advantages ranging from its strategic location to its dynamic population, Turkey has not achievedthe highgrowth of leading emergingmarket economies. Turkey has not matched the growth rate o f EU accession countries such as Hungary and Poland, or the fast growing cohesion countries such as Spain and Portugal (Figure 1). Turkey's per-capita income Figure 1: Per Capita GDP at PPS: 1991-2002 Figure 2: GDP & GDP Per Capita Growth 90 , compared to EU average 8 0 - h $-+-+-+- Rates i n Emerging Economies (1965-2001) I Spain 10 0 GDP W GDP per capita 8 - .- 0" Hungary 0 50 d EII 40 Poland 30 20 Turkey I , Source: World Bank. Source: World Bank. 1 level declined from 26 percent o f the EU average in 1991 to 22 percent in 2002.' During the same period, Poland and Hungary made significant progress in reducing the per capita income differences with the EU. On average, the Turkish economy grew slightly under 3 percent per year over the past decade-respectable, but well below the best performing emerging economies (Figure 2). Macroeconomicinstabilityhas helpedkeep growthbelow potential Turkey experienced instability in both Figure3: Turkey: an"outlier"amongcomparatorsin dimensions (Figure 3). Repeated volatility of REER and GDP growth [1990-ZOOO] ':\- attempts to stabilize the economy fell 12 .............................................................................. short, and high growth was never 10 ............................................................................. 1 + 1 sustained for long. Inflation was ..... ............................................................ *- Turkey higher and growth lower, on average, sY a 8 in the 1990s than in the 1980s. ............... ..................................................... Income volatility doubled between the 6 4 ....................................................................... 1980s and 1990s as the standard Mexim .+...................... lhailand deviation o f real GDP growth 2 ................................................. ChO , Argentin increased from 2.7 percent to 5.5 0 percent. The "boom-bust" cycle has 0.5 0.75 1 1.25 1.5 continued into the new decade with a C Y : GDP (ChYo) record contraction of real GNP o f over Source: World Bank, JPMorgan: volarilily measured by coefficient ofvariarion applied to growrh rates ofrhe variables 9 percent in2001 followed by a strong ' I recovery with estimated growth o f 7.8 percent in 2002. Today, Turkey i s the only major economy in the world that continues to struggle with inflation rates o f 30 percent per year or more. Fiscalimbalancehas been at the root of chronic macroeconomicinstabilityinTurkey 4. The 2000 CEM2 demonstrated that fiscal imbalances are key to understandingTurkey's macroeconomic instability. Unsustainable fiscal policy has repeatedly put pressure on the Lira, fueled inflation and undermined financial stability. Fiscal policy has been unable to act as a ' Ofcourse, these figures do notreflectthe informaleconomy which is likely to be substantiallylarger as a fercentage o fGNP inTurkey relativeto the EU average. Turkey: Country Economic Memorandum- StructuralReformsfor Sustainable Growth, September 15,2000, ReportNo.20657-TU. 2 macroeconomic stability has been magnified by Turkey's open capital Figure 4: Adjusted PSBR (% of GNP) account and, until recently, its poorly 3o regulated banking system. Short- 25 term capital flows have fluctuated 20 widely as investors responded to the 15 boom/bust cycle driven by unstable 10 macroeconomic conditions. The 5 causal linkages between fiscal imbalances and instability in Turkey as in many other emerging markets 1994 1995 1996 1997 1998 1999 2000 2001 2002 2 DISINFLATION AND CRISIS Turkey's exchange rate-based disinflation program-launched in a context of structural fiscalweaknesses and systemicbanking sector problems-collapsed in early 2001 5. In2000, an exchange rate-based disinflation program was launched ina bold attempt to ridthe economy o f inflation. The centerpiece o f the program was a crawling peg exchange rate regime to act as the nominal anchor. The peg was supported by front-loaded fiscal adjustment. Key structural reforms in social security, infrastructure, agriculture, privatization and banking were initiated. In fact, fiscal policy was significantly tightened in 2000 and inflation began to fall, dropping to 39 percent by the end o f the year. Turkey also carried out significant structural reforms under the program. These included establishment o f an independent banking authority, passage of legislation for an electricity market, reform o f the public pension system, a constitutional amendment to allow international arbitration, launch o f an ambitious agriculture reform, establishment o f a telecommunications regulator and a serious, albeit short-lived, acceleration o f privatization. However, these impressive achievements were insufficient to avoid a crisis given the extent o f Turkey's underlying fiscal and financial sector weaknesses built up over decades o f instability and delayed reform. 6. Internal factors combined with unfavorable external developments started to undermine the exchange rate peg by mid-2000. On the external side, rising oil prices and a prolonged slide inthe Euro contributed to a softening of Turkey's external accounts. On the internal front, the disinflation program was confronted with deep-rooted structural fiscal problems and a fragile banking sector burdenedby huge contingent liabilities. A sharp drop in interest rates following the onset o f the crawling peg-driven in part by a resurgence in short-term capital inflows- fueled a surge in demand. The economy soon began to overheat. While falling, inflation didn't come down as quickly as anticipated, generating a significant appreciation o f the real exchange rate under the peg. Imports increased sharply as consumption boomed, contributing to a 3 deterioration in the current account which recorded a deficit o f 5 percent o f GNP in 2000. Domestic banks took advantage o f the pegto borrow cheap foreign exchange inorder to finance their expanding domestic operations including growing purchases o f government securities and consumer lending. The expansion in domestic credit contributed to the consumption boom as banks quickly built up large open FX positions and aggravated maturity mismatches in their portfolios. Bank restructuring got off to a slow start and the state banks continued to be burdened with the costs o f large "duty losses" from government-mandated subsidized lendingto agriculture and SMEs. The average maturity o f TL deposits remained extremely short as confidence inthe Lira remained fragile. 7. A first bout o f financial instability hit Turkey in November 2000 presaging the full- fledged currency crisis o f early 2001 which short-circuited the exchange rate based disinflation program. As banks came under increasing pressure from shrinking profit margins on government securities and growing liquidity needs, isolated speculative attacks emerged in November 2000 which soon plungedthe banking system into a struggle for survival. Desperate for liquidity, certain banks engaged in fire sales o f government paper, causing interest rates to skyrocket and international investors to exit the market. The result was a liquidity crunch aggravated by the Central Bank's inability to inject additional liquidity into the system under the quasi-currency board rules added to the disinflation program just prior to launch o f the crawling peg, The situation stabilized temporarily in December 2000 when the IMF acted to prevent a financial meltdown by announcing an additional US$10 billion in financial assistance. This additional financing was conditioned on the Government's commitment to strengthen the program in particular to accelerate financial sector restructuring and privatization. The Government introduced an explicit blanket guarantee covering effectively all banking liabilities excluding capital. While designedto contain systemic risks in the banking system, the blanket guarantee highlighted the potentially enormous fiscal costs in case of a systemic failure and made explicit this contingent fiscal liability. Inthe wake o f these events, interest rates declined and a precarious degree o f financial stability returned, but this proved to be a temporary respite. In early 2001, persistent doubts about the peg and underlying fiscal sustainability led to a full blown speculative attack against the currency. Interest rates shot up to several thousand percent, forcing the Government to abandon the crawling peg and float the Lira on February 21, 2001. The Lira immediately lost 40 percent o f its value ina single day. Exchange rate-based disinflation programs are vulnerable in a globalizedworld 8. The reliance on a pegged or fixed exchange rate in an environment o f free capital flows and an unreformed banking system entails risks. Exchange rate anchors-while generally successful in setting inflation on a downward long-term trend in chronic inflation countries- have often been associated with currency crises. Many o f the exchange rate based stabilization programs in the 1980s encountered currency crises at some stage and the economic crises that broke out in the second half o f the nineties occurred in countries with fixed or managed exchange rate regimes. Currency attacks have often been accompanied by banking crises (e.g., Chile, Mexico and East Asia). The Asian experience shows that, with limited capital mobility, even a weak banking system can function reasonably well and support economic growth. However, such a system may not be able to handle massive entry and exit o f short-term capital induced by capital account liberalization in the context o f globalization. Exchange rate based 4 stabilization also generally results in sizeable real exchange rate appreciation and a deterioration o f the current account which can undermine investor confidence. International experiences have shown that early moves to introduce exchange rate flexibility can minimize the extent o f subsequentcurrency crises, as inIsrael. Turkey's program featured a predetermined transition to a widening exchange rate band 18 months after the launch o f the peg. However, this pre- announced exit-unique among pegged exchange rate systems-did not prevent the collapse o f the pegafter only one year. 3 CRISISRESPONSE PROGRAM T h e Government responded quickly to the 2001 crisis 9. The Government announced a strengthened economic program in May 2001 in response to the crisis following the collapse o f the crawling peg and subsequent devaluation. The key structural and social elements o f the program were: (i) macroeconomic framework designedto a restore financial stability and ensure public debt sustainability-principally through a further tightening o f fiscal policy; (ii)rapid restructuring o f the banking sector-especially o f state banks and insolvent private banks intervened by the regulatory authority (BRSA)-based on large resource transfers from the budget; (iii) a more ambitious program o f public sector reforms centered on deeper structural and institutional reforms to improve fiscal management and public governance; (iv) a renewed privatization drive-in combination with further liberalization measures focused on energy, telecommunications and agriculture-and strengthening o f independent regulatory bodies to improve the private investment climate; and (iv) enhanced social assistance to help low income groups adversely affected by the crisis. Turkey's crisis response program incorporated the experience of other emerging markets 10. Turkey's crisis response program benefited from the lessons learned by other emerging market countries facing crisis3. Immediate fiscal measures were introduced to shore up the primary surplus and strengthen confidence in the sustainability o f the public debt. A front- loaded program o f bank restructuring was launched backed by extensive fiscal resources. Bank restructuring was complemented by additional structural reforms inthe financial sector designed to further strengthen prudential regulation, adopt internationally accepted financial reporting standards and practices, and enforce compliance. In parallel with accelerated financial sector reform, a comprehensive public sector reform program, including institutional reforms, was introduced to tackle the structural roots o f Turkey's chronic fiscal imbalance. Strengthened financial and public sector reforms were placed within a medium-term programmatic framework in an effort to bolster investor confidence by demonstrating the Government's intent to address the core structural causes behindthe crisis and notjust the immediate symptoms 3See the backgroundpaper by Liviatan (2002) and Brahmbhatt (2001). 5 11. Initial outcomes under the crisis Table 1: Key Economic Indicators (1999-2003) response program were mixed as the 1999 2000 2001 2002 2003 est, Government struggled to contain the 3NP Growth -6.1 6.3 -9.5 7.8 5.0 fallout from the crisis and re-establish its :PI Inflation(Dec-Dec) 68.8 39.0 68.5 29.7 20.0 policy credibility. The immediate Vominal InterestRate 106.2 38.0 99.1 63.8 45.0 financial turmoil arising from the crisis Jnemployment Rate 7.1 6.6 8.5 10.6 12.32' was fairly quickly contained, but at the price o f a sharp increase inthe public debt Primary Balance(%GNP) " -2.0 2.7 5.5 3.9 6.5 as the costs o f bank restructuring were Net Public Debt (YOGNP) 61.0 57.7 95.0 79.8 77.0 0.1 3.3 2.8 0.3 borne by the budget. The price spike Privatisation($bn) 1.5 following the initial devaluation in Current account balance ("hGNP) -0.7 -4.9 2.4 -1.0 -3.2 February 2001 was contained, but inflationary pressures persisted with REER (1995=100) 123.1 136.5 112.5 125.3 138.0 inflation reaching 68 percent by the end o f the year (Table 1). Followingthe decision "Consolidatedpublicsector to abandon the peg, uncertainty about 2' First quarter figure Source: Government, IMF and WB estimates. exchange rate policy persisted for some time as the Government was slow to confirm its commitment to the float and the Central Bank repeatedly intervened in the foreign exchange market. Interest rates were brought down from their post-crisis peaks, but remained well above the projected program path throughout 2001, mainly due to the need to roll over large amounts o f short-term public debt in the face o f a slower than expected recovery in investor confidence. The primary surplus target o f 5.5 percent I o f GNP for 2001 was met, Figure 5. Total Net Public Debt (% of GNP) but doubts continued about 100 I the medium-term sustainability o f the fiscal 80 adjustment. The economic recession turned out much 60 deeper than projected as real GNP shrank by an 40 estimated 9.5 percent for the year. A major factor in 20 the recession was the sharp turnaround in the current 0 account driven by capital outflows. The current 1994 1995 1996 1997 1998 1999 2000 2001 2002 I account recorded a surplus ~ Source:Government, IMF and World Bank estimates. o f 2.4 percent o f G G in 2001. The combination o f highreal interest rates, devaluation, the huge fiscal cost o f bank restructuring and deep recession caused the stock o f public debt to rise significantly. The ratio o f net public debt to GNP increased from 57 percent o f GNP at the end of 2000 to an estimated 95 percent o f GNP by the end o f 2001 (Figure 5). 6 Strong recovery is now underwaybut remainsvulnerable 12. Economic activity rebounded strongly in 2002 and the recovery continued into early 2003. Real GNP growth reached 7.8 percent in 2002, exceeding program projections by a wide margin (Figure 6). The recovery was led by robust export performance and exceptionally large inventory rebuilding inthe first halfof the year. The recovery was further buoyed by a sharp rise in public consumption and investment during Figure 6: GNPGrowth the second semester 15 reflecting accelerated 10 government spending 5 ahead o f early s o elections held in -5 November 2002. An increase inagricultural -10 output estimated at 7.1 -15 percent was another factor. Overall, stock building accounted for Quarterly percentage change over the same quarter of the previous year. - private consumption and government spending making significant contributions to offset declines inprivate investment and net factor income. The impact o f strong export performance in the 2002 growth accounting was offset by even faster growth in imports as the recovery gained steam. The recovery continued into the first quarter o f 2003, with GNP 7.4 percent higher than inthe first quarter o f 2002. Importantly, private consumption and investment ledthe way for the first time since the crisis, recording increases o f 6.5 percent and 20.4 percent respectively. While stronger than expected growth has beendue inpart to base effects from the recession, the genuinely positive news i s that the recovery has been export-led with exports in USDterms increasing by some 30 percent duringthe first five months of 2003 compared to one year ago. Strong export performance, buoyant tourism and renewed capital inflows have eased the pressure onthe BOP evenas imports have expanded rapidly withthe economic recovery. The modest current account o f some one percent o f GNP in 2002 was easily financed. The extent o f the recovery and its basis in export growth place Turkey squarely in the category o f rapid- recovery, post-crisis countries, such as Korea in 1999 and Mexico in 1995. Turkey's recovery began three quarters after the crisis trough was reached, in line with the fastest recoveries worldwide over the past decade. 13. In contrast with the real-side recovery, financial outcomes have been more mixed. On the positive side, inflation has fallen sharply. Consumer prices increased 29.7 percent over the course o f 2002, well below the program target o f 35 percent. The fall ininflation was helpedby the rebound ofthe nominal exchange rate from its crisis lows. The strengthening Lirahas not yet hurt export performance as it has been counterbalanced by a very sharp drop in real wages. More problematic were slippages in the fiscal program during the run up to the November elections. A gap o f about 2.5 percent o f GNP emerged with respect to the 2002 primary surplus 7 target o f 6.5 percent of GNP. Contributing factors included: (i)cost overruns in the social security system, (ii) pre-election spending (new agriculture support purchases and civil service wage increases), (iii) unexpected drop-off in tax revenues driven by expectations of a post- an election tax amnesty, and (iv) unplanned spending through earmarked accounts left over following closure of the extra-budgetary funds. A series of stop-gap fiscal measures were identifiedto close the fiscal gap in late 2002, but were left largely unimplemented. Despite the fiscal slippage, the stock of net public debt fell to an estimated 80 percent of GNP b the end of 2002, helped by the rebound in the real exchange rate after the 2001 overshooting and higher Y than expectedgrowth. 14. The new Government's grace period with the financial markets was short lived as concerns about a slow start on economic reform, hintsof political tension, and the looming threat o f hostilities in neighboring Iraq started to weaken investor confidence in mid-December. Ad- hoc increases inpensions in early January and other populist measures raised concerns about the Government's political will to implement tough economic reforms. The average yield of the benchmark government paper moved up to the 60 percent range and the Lira came under some pressure. Financial market volatility continued during the first quarter o f 2003. However, the winding down of hostilities in Iraq and approval by the US Congress in early April of a scaled- down assistance package for Turkey (a grant-equivalent of US$1 billion, potentially convertible to up to US$8.5 billion inloans) eased some of the market tension once again. The new Governmentneedsto build up its credibilityquickly 15. Inresponseto market developments, the Government has shown a renewedcommitment to program implementation. The economic program for 2003 aims to sustain the recovery with the projected growth of 5 percent. Continued strong export performance and a return of private consumption and investment demand are expected to lead the recovery. Growth in 2003 will also be helped by strong carry over effects from the second half of 2002. Industrial production and export data suggest that the recovery continued in the second quarter, albeit probably at a slowing rate. Building on the positive outcome last year, the program targets a further reduction inCPI inflationto 20 percent by the end of the year. The authorities are counting on tight fiscal andmonetary policies, a positive output gap and a stable exchange rate to bring the inflation rate down to the targeted level. The program aims to ensure sustainability of the public debt through sustainedfiscal adjustment. The primary surplus i s targeted to returnto the program level of 6.5 percent of GNP in2003 based on a package o f fiscal measures equivalent to about 4.9 percent of GNP introduced by the Government to cover boththe slippage recorded in2002 and a number of temporary measures which expired. Together with the continued recovery, the tight fiscal stance i s expected to underpin a further modest decline inthe public debt to GNP ratio. On the external side, the current account i s projected to weaken substantially, reflecting increasing imports, higher oil prices and flat tourism revenues following record receipts last year. A 10 percentmove inthe real exchange rate causes an 4-5 percentage point adjustment inthe public debt to GNP ratio. The real exchange rate path is given inTable 1. 8 16. It is critical for the Government to move quickly to establish its reform credentials and bolster investor confidence. Sustaining the economic recovery will depend on the path o f real interest rates. While interest rates have fallen from crisis peaks, they continue to include a very highriskpremium(Figure7). To reduce the risk premium, the new Government will have to bolster investor confidence by demonstrating i t s determination to Auction rate discountedby implement economic reforms. With regard 100 - 12 month historical inflation to the broader structural reform program, the 80 - Government has prepared an Urgent Action 60 - Auction rate ascounted by I 2 month Plan for the coming year which draws on the 40 forward looking inflation expectation 7 reform progress achieved since 1999. As a 20 - further step, the Government has announced an ambitious privatization program for 2003. 0 - The key to rebuilding investor confidence -20 ` and achieving the growth and inflation targets for 2003 now lies in the speed and determination with which the Goiernment Source: Central Bank and World Bank. turns its announced plans into action. Sustaining high and more equitably distributed growth over time will depend on the Government's ability to meld its near-term actions into a coherent medium-termreform agenda. 4 MEDIUM-TERM AGENDA Sustaininghighand morefairly distributedgrowthover the medium-termrests on a challengingreformagenda 17. Turkey faces difficult challenges to sustaining high growth and achieving durable macroeconomic stability. The new Government must address the structural roots o f macroeconomic imbalance in order to prevent a recurrence o f the "boom-bust'' cycle that has characterized Turkey's economic performance over the past decade. Positive public debt and external financing dynamics hinge on rebuilding investor confidence. The medium-term agenda for sustained and equitable growth can be summarized as follows: The path to macroeconomic stability lies in sustaining a high level o f fiscal adjustment for the foreseeable future. Fiscal adjustment must be underpinned by structural reforms and complemented by credible macro policies. Moving credibly towards international-notably EU-standards, will help minimizingtrade-offs betweenrecession and disinflation. Determined action to modernize public sector institutions and to improve public governance i s critical to achieving quality fiscal adjustment and durably improving the business climate. Effective government i s also key to realizing Turkey's social and human development objectives throughthe efficient delivery o f public services. 9 Sustaining and expanding the growth process will depend critically on improved performance o f the financial and real sectors. Wide-ranging reforms must be deepened to bolster the financial system, promote corporate restructuring, complete regulatory reforms, and accelerate privatization and market liberalization. Social policies needto be strengthenedto ensure the robust social contract among its citizens that Turkey needs to meet the challenges o f the new century and secure the social development o f the country in light o f the millennium development goals. Priorities for social policy include mitigating adverse consequences o f the ongoing structural adjustments, raising the level o f human capital, and ensuring effective operation o f the labor market. Sustained growth will hinge on Turkey's further integration with the global economy. Structural reform i s essential to maintain strong export performance, attract foreign direct investment and bolster confidence. Given continuing vulnerabilities to exogenous shocks, maintaining a policy o f exchange rate flexibility will be important. Sustained progress towards EUaccession would provide a strategic external anchor for Turkey's reform efforts. Sustained growth hinges on a strong private sector response 18. Sustained growth depends on a strong private sector response. Given the budget constraint and disinflation imperative, traditional Keynesian mechanisms for economic stimulus are realistically not available to Figure 8 Openness the Government. In the past, Trade to GDP has risen by more than 50 percentage points ... Turkish governments sought to foster growth through expansionary fiscal policies and 25 ......................................................................................... 70 - I direct government intervention in 60 production, the results o f which were short-lived growth spurts 50 brought to a halt by balance-of- 40 payments constraints or financial 30 crises. Many o f the conditions for sustained, private sector-led 20 growth are in place in Turkey. -5 1........-........ /I 7 I ........................................................................ I /I 10 Export competitiveness i s stronga5 1980 1981-90 1991-95 1996-2000 2000 Source: World Bank data, EPPG calculations Opennes: share in GDP of exports plus imports The very rapid pace o f opening of goods and non-factor svcs Speed of Inrepration. Trade growth less GDP growth. - - and integration o f Turkey's economy over the past twenty years has set the stage for even stronger export performance inthe future (Figure 8). Turkey has yet to take full advantage o f the customs union with the EU introduced in 1996. Capacity utilization rates are low, so the economy has the productive capacity with which to meet increased demand without fueling inflation. Growing demand will, inturn, stimulate private investment over time. 19. Deeper structural reforms will support both fiscal adjustment and the private sector response. The structural reforms will underpin fiscal adjustment by rationalizing public expenditure, improving the efficiency o f revenue collection and containing contingent liabilities. 5Backgroundpapers by Taskin (2002) and Taymaz (2002). 10 The reforms will promote private sector led growth and raise total factor productivity by improving the incentive framework, stimulating competition, and encouraging productive investment. Core structural reforms inthe public sector, banking and finance, corporate sector, and labor market are analyzed in detail in this CEM. Other key elements o f the medium-term structural agenda include completing the agriculture, energy and telecommunications reforms launched since 1999. These reforms were discussed in the 2000 C E M and are therefore not covered further here. Reemerging deficits inthe social security system have focused attention on the urgentneed for further structural reforms inthis area to more effectively implement the 1999 reforms and introduce deeper changes to the system. The issues surrounding social security reform were also analyzed in depth in the 2000 C E M and the most recent developments are summarized inthis report. There are important risks to be addressed 20. There are important risk factors that must be actively addressed to ensure that they don't undermine emergence o f a virtuous cycle of sustained growth. Internal risk factors include: (i) public debt sustainability-in particular the need to rollover large amounts o f short-term domestic debt, (ii) incomplete reform in the financial sector and the potential for large-scale government borrowing to crowd out private investors, (iii) deep corporate distress following the crisis and the slow pace o f corporate restructuring neededto promote competitiveness, and (iv) the potential for rigidities to develop in the labor market which could delay increases in labor productivity and job creation in the formal sector. Private access to financing may become a serious constraint on sustained recovery over time. Sustained fiscal adjustment i s essential to free up domestic credit for the private sector. Another important mechanism to improve private credit access i s the "Istanbul Approach" to out o f court restructuring o f illiquid, but potentially performing, corporate sector liabilities to the banking system. A related action concerns the establishment o f one or more asset management companies with majority private ownership to resolve non-performing loans. 21. External risk factors are also significant and highlight the critical importance o f promoting FDI in line with the experience o f other rapid-recovery post-crisis countries. An immediate issue for policymakers i s the widening current account deficit which i s now expected to reach US$6.9 billion (3.2 percent o f GNP)in2003. While the floating exchange rate provides an automatic adjustment mechanism, the large foreign exchange component o f the public debt and high domestic interest rates put constraints on the effectiveness o f this adjustor. High domestic interest rates are now attracting short-term capital inflows and puttingupward pressure on the Lira. Policymakers will need to ensure that this situation does not lead to an excessive buildup o f short-term external debt as seen in2000. The expected slower recovery inthe world economy, increased risk aversion o f international investors, and the potential for post-war instability in Iraq are all significant risk factors for the medium term. The external financing plan for 2003 and beyond centers on increased access to private capital. This will be a challenge under prevailing conditions in international financial markets. IncreasedFDIflows inthe years following crisis have played a key role insustaining recovery inother emergingmarkets. Turkey will have to accelerate its efforts in order to follow suit, inparticular to strengthen productivity and expand its share in the strategically important, but relatively slow growing EU market. It remains uncertain what the medium-term consequences o f developments in Iraq will be for 11 Turkey. Oil prices have come back down and increased regional trade as a result o f lifting the UNtrade restrictions on Iraq is positive for Turkey's balance of payments. On the other hand, tourism has beennegatively affected. The consensus for reformmust be maintainedand strengthened 22. To be successful, the Government must adapt its medium-term reform agenda to the realities o f Turkey's complex political economy.6 Turkey has a long tradition o f clientelistic politics characterized by top-down decision-making and populist policies aimed at resource distribution to perceived political supporters. Formal interest groups are not strong by international comparison. The underlying social situation i s characterized by a young and growing population and continuing high rate o f urbanization which creates strong demand for public services and investment. Pursuing macroeconomic stabilization and structural reforms in such a socio-economic context i s not easy. The recovery has yet to translate into welfare gains for the average citizen and there i s significant reform fatigue. None o f the parties inthe previous governing coalition passed the 10 percent threshold for representation in the Parliament during the November 2002 elections due to a strong protest vote. Areas o f the program which are particularly sensitive include: reform o f agriculture support policies, social security reform, privatization, and public employment. The new Government's fresh election mandate and comfortable parliamentary majority are powerful advantages, but it will still needto work hard to maintain and strengthen the social consensus for reform. Continuing the economic reform program with the emphasis on fiscal discipline, while pursuing a more active social agenda as described in its UrgentAction Program, will requirea constant balancing act by the Government. This dilemma is evidenced in the dichotomy between the Government's written policy documents, which have a strong reform orientation; and its early actions, particularly the ad hoc pension increases and generous tax amnesty, which had a strong populist flavor. The recommendations on strengthening social policies presented in Section 8 below can help the Government square this circle. Over the medium term, enhanced efforts are also likely to be needed to introduce more participatory approaches and gradually shift towards more decentralizedmodes o f decision-making. 5 MACROECONOMIC FRAMEWORK Sustainedfiscaladjustmentis the key to macroeconomicstability remain anchored in sustained fiscal GNP RealInterest Rates adjustment underpinned by credible Growth 7 9 11 13 15 17 structural reforms. Turkey will need to 3 2.8 4.3 5.9 7.3 9.0 10.5 run large primary surpluses over the 4 2.0 3.5 5.0 6.6 8.1 9.6 medium and long term to lower its 5 1.1 2.7 4.2 5.7 7.2 8.7 This paragraphdrawson Gunes-Ayata(2001). 12 presented in Table 2 confirms the view that a very conservative fiscal position i s required to maintain fiscal sustainability inTurkey. With a 5 percent real growth rate, and a 13 percent real interest rate, a primary surplus o f about 5.5 percent o f GNP would be requiredto keep the stock o f debt stable at 80 percent o f GNP. However, if growth were only 3 percent per annum, the primary surplus would need to be about 7 percent o f GNP. Under the program projections o f 5 percent growth and a primary surplus o f 6.5 percent o f GNP, the stock o f public debt to GNP i s projected to decline only slowly (para. 66), thereby indicating the need to maintain the primary surplus at this level over the medium term and beyond. To the extent that actual fiscal outcomes exceed the primary surplus target, the need to maintain such large surpluses will diminish more quickly as will the risks inherent in such a program. Therefore, fiscal over-performance in the near term would accelerate progress towards macroeconomic stability. 24. Tight fiscal policy will provide additional credibility to monetary policy-already anchored by central bank independence under legislation passed in 2001-and open the way for continued disinflation. Other complementary macro policies include: (i) continued exchange rate flexibility under the floating foreign exchange regime; and (ii)active policies to ensure competitiveness including efforts to attract FDI. There i s an extensive body of research highlighting the importance o f policy credibility to successful stabilization outcomes. The experience o f the Central and Eastern European Accession countries (CEE10) inthe second half o f the nineties i s instructive. In these countries, the disinflation process enjoyed considerable credibility because it was part o f a broader change in economic regime geared towards EU accession. As a result, they were able to maintain positive growth on average throughout this transition period. The lesson for Turkey i s that if it can move credibly towards EU standards, there i s a good chance o f minimizing trade-offs between recession and disinflation, at least inthe mediumterm. Fiscaladjustment must be highquality 25. International experience Table 3: Fiscal Adjustment,1999-2002 (% of GNP) has shown that fiscal 1999- adjustments are usually 1999 2000 2001 2002 2o02 sustained only when they are o f Total expenditures 40.5 41.5 48.7 43.7 high quality reflected in a Non-interest expenditures li 20.0 20.8 22.2 22.8 2.8 reliance on permanent Total revenues 26.2 28.6 32.3 31.5 5.3 expenditure reduction rather PSBR 14.3 12.9 16.4 12.2 than revenue increases7. Quasi-fiscal deficit 10.4 6.3 1.5 0.4 Turkey's recent experience Adjusted PSBR 24.7 19.2 18.0 12.6 shows how revenue increases Net interest payments 22.0 21.9 23.5 16.5 can lead to only temporary Primary balance -2.0 2.7 5.5 3.9 5.5 improvement in the fiscal Inflationary comp. interest paym. 9.7 9.6 11.1 9.9 position as expenditures catch Operational balance -12.4 -6.9 -5.6 -4.9 up over time. Total non-interest liConsolidated budget only. expenditures o f the consolidated Source: Treasury, IMF and staff estimates. budget increased from 20 percent o f GNP in 1999 to an estimated 22.8 percent o f GNP in 2002, a 2.8 percentage point jump (Table 3). Quality i s further ensured through measures to address 7For empirical evidence, M c Dermott and Wescott (1996). 13 deeper structural problems which undermine fiscal discipline such as contingent liabilities, public enterprise losses, and inefficient subsidy programs. High quality fiscal adjustment i s critical to convince markets that the debt burden i s sustainable over the medium term and lower the risk premiumon domestic debt to manageable levels*. 26. To ensure a high quality fiscal adjustment, the Government must address the structural sources o f Turkey's fiscal difficulties, not just achieve numeric targets. Important structural fiscal weaknesses must be definitively corrected. Historically, these weaknesses have included: (i) deficitsinthesocialsecuritysystemdespiteTurkey'sveryfavorabledemographics; (ii) large off-budget subsidies to farmers and small businesses channeled through the state banks as "duty losses"; (iii)indirect subsidies to the banking system in the form o f implicit and explicit guarantees to bank depositors and creditors, which translated into an actual liability in the February 2001 crisis; (iv) losses incurred by public enterprises burdened by over-employment and charged with channeling non-transparent and untargeted subsidies to the agriculture and private enterprise sectors; and (v) lax provision o f financial guarantees to local governments. Another problem has been the under developed tax system which relies excessively on distortionary commodity taxation and generates large tax expenditures through inefficient tax administration. Important structuralfiscal reforms havebeen implementedsince 2000.. . 27. Real progress to tackle many of Turkey's structural fiscal problems has beenmade since the 2001 crisis which the new Government can now build on and consolidate. Under the financial sector reform, legislation i s inplace to prevent future duty losses inthe state banks and private banking risks are under much stricter regulation and supervision. The agriculture reform has eliminated agriculture credit subsidies and replaced most Figure 9: Public Sector Fixed Investment (%of GNP) inefficient and fiscally costly 8 indirect subsidies with direct income support to farmers. The legal framework for competitive electricity and gas markets has been introduced which will facilitate the shift o f risk from the Government to the private sector. Under the public sector reform program, the criteria for financial guarantees to local 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 governments have been tightened and a "middle office'' Source: SPO and World Bank. has been established in the Treasury to improve public liability management. The legal framework for public procurement has been upgraded to international standards. A major rationalization o f the public investment program has been undertaken easing the real impact o f the reduction in the investment budget The importanceofquality o f fiscal adjustment has beenhighlightedinrecent researchby Alesina and Perroti (1995) and Easterly(1999). 14 following the crisis (Figure 9). Initial steps have been taken to I Figure 10: Public Sector Wage Bill (YOof GNP) rationalize public employment, l6 I 1 ~ including establishment o f a monitoring system and reduction o f redundancies in state enterprises, which has facilitated a reduction in the public wage bill (Figure 10). Progress i s also being made to tackle problems with the tax system under the 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 strategy adopted in late 2001. In many cases, these reforms will t?!Generalgovernment HNon-financialSOEs not only underpin the fiscal Source: SPO and World Bank. adjustment effort, they will also promote development o f a stronger, more resilient private sector. ...But the medium-termagendaremainsextensive 28. Looking ahead, further structural reforms are needed to support the fiscal adjustment'. Continuation o f the public investment and public employment rationalization programs can support further fiscal adjustment inthese areas. However, the most pressingtask i s to tackle re- emerging problems in the social security system. While Figure 11: Deficit o f Social Security System (% of GNP) parametric reforms to the public pension system adopted in 1999 n 7." I" raised the pension age and linked 3.5% n benefits to lifetime contributions, 3.0% the fiscal sustainability o f the 2.5% social security s stem has not yet 2.0% been secured': After initial 1.5% improvement in 2000, the fiscal 1.O% position o f social security system 0.5% worsened considerably in 2001 - 0.0% 02 (Figure 11). With the ad-hoc pension increase introduced in 1995 1996 1997 1998 1999 2000 2001 2002 Est. January, the deficit could well approach 5 percent o f GNP in 2003. The first reform priority i s Source: SPO and World Bank. to enact legislation to underpin institutional and administrative reforms designed to improve collections and expenditure management, contain health expenditure, consolidate the legal basis for the unemployment insurance fund, and facilitate implementation o f the 1999 reforms. A second priority i s to introduce further institutional reforms to reorganize the social protection system by function World Bank Policy Research Report, 1994. loSee the CEM 2000 for the detailed analysis o f 1999 pension reform. 15 (pensions, health insurance, social assistance, and employment services), together with a new phase o f parametric reforms notably in Emekli Sandigi-the pension fund for civil servants. A third priority is to improve management o f the system, particularly financial management including credible efforts to address the massive buildup o f contribution arrears. While the prospects o f generating additional short-term fiscal savings relative to the program baseline may be limited, decisive action in these key structural areas (public investment and wage bill, and social security reform) can have a major impact on the quality o f fiscal adjustment and hence on real interest rates. 6 PUBLICSECTORREFORM Publicsector reformis neededto underpinsustained fiscal adjustmentand promotemore effectivegovernment Central and Eastern European Accession countries* Turkey's total expenditure and non-interest Figure 12:Per Capita Incomes & General Government Expenditure in the European Union, Cohesion & CEE Accession Countries, & Turkey, 2001 expenditure in percent o f GDP have increased over the period 1995-2001 while the EU15 and CEElO both experienced a decline c 55 in general government spending. In 2001, Turkey's general government expenditure reached an extreme 58 percent of GDP; a 1 6 0 40 clear outlier (Figure 12). The main 35 factor has been the increase in the interest burden following the 0 5,000 10,000 15,000 20,000 25.W 30,000 35,000 40,000 45,OOO 50,00(1 February 2001 crisis, but non- GDPpercapta at FTP(USS) interest expenditures have steadily +EU15 0 CEElO Turkey A comprehensivepublicsector reformprogramis underimplementation 30. Turkey's public sector reform program aims to support sustained fiscal adjustment and create the conditions for transparent and effective government. The program strives to break the vicious circle o f inadequate public sector management leading to ever increasing public indebtednessthat fuels financial sector weakness through dependency on highreturn government securities which in turn inflates the public debt burden. The public sector reform program focuses on three critical areas, each o f which has a medium-term dimension: 16 0 Structural fiscal reforms focused on tax policy and administration and public employment; 0 Policy and institutional reforms to improve the transparency and efficiency o f public expenditure management (PEM) including action to: 0 Improve budget preparation and execution, policy formulation, and the operational performance o f public agencies, 0 Upgrade public accounting, procurement and audit standards to achieve international standards o f financial accountability, and 0 Ensureprudentpublic liability management; and 0 Broad based institutional reforms to improve the quality o f public sector govemance. 31. The complexity and lack o f transparency o f the Turkish tax system exacerbated by tax policy instability and the distorting effect o f high and unstable inflation rates have been highlightedinseveral detailed studies. Much o fthe complexity and instability arises from the ad hoc addition o f special taxes, surcharges and levies inresponse to the ongoing struggle to contain the budget deficit. Over the past decade Turkey has steadily increased its revenue Figure 13: Tax Burden effort. Including social security contributions, total tax revenues rose from 35 5 18.9 percent to 31percent of GNP between 1990 and 2002 (Figure 13). However, this revenue effort has multiplied the disincentives to growth inherent in the structure o f tax system. Partial inflation indexation, in combination with differential nominal tax rates and investment incentives across financial instruments, has created highly distorted real effective tax rates across financial instruments and business I TaxRevenues 0 TaxRevenues (incl. SSls) 1 investments. An over-reliance on Source: MOF and World Bank. transaction and commodity taxes arising from weaknesses in direct taxation has had a negative equity impact and hindereda shift in the burdeno f taxation towards upper income groups. Tax administration i s also an issue. Investors have identified concerns with bureaucratic redtape, delays inprocessing applications for licenses or investment allowances and VAT refund claims, and corruption as negative factors for investment and business operations in Turkey. The problems o f tax administration are exacerbated by Turkey's tradition o f tax amnesties which the new Cabinet has unfortunately continued with a broad-based amnesty introduced inearly 2003. 32. In January 2002, the Government adopted a medium-term tax strategy to improve the Turkish tax system and reduce marginal tax rates. Sustained implementation o f the tax strategy will promote growth by improvingthe stability, transparency and equity of Turkey's tax system. The chief objectives are to minimize tax distortions, broaden the tax base and improve the efficiency of tax administration, all leading towards a reduction in marginal tax rates. Indirect taxes have been simplified under the strategy through the Special Consumption Tax enacted in June 2002 which replaced the two highest VAT rates and the increasingly complex array o f 17 excise taxes. Further legislation enacted in April 2003 has addressed a number o f issues in the system o f direct taxation including: (i)harmonizing taxes on investment income at the declaration stage; (ii) rationalizing and simplifying the system o f investment incentives; (iii) reforming the system o f income tax credits for wage earners; and (iv) simplifying taxation o f corporate earnings and dividends. This legislation simplifies and consolidates the direct tax regime and brings Turkey's personal and corporate income tax regimes closer to OECD standards and international best practice. The tax strategy includes a major overhaul of the tax administration encompassing institutional improvements, automation, transparency, compliance, taxpayer services and tax audit. It i s designed to align Turkey progressively with best practice in other OECD countries. The planned functional reorganization will reorient the MOF's General Department o f Revenues from a structure based on administration o f individual taxes to one based on the core functions o f tax administration including taxpayer registration, taxpayer services, collections, audit, legal, information technology, and human resources. The Government i s also considering the option o f upgrading the General Directorate of Revenuesto the status ofa separateunder-secretariat inline with the practice o fmost OECD countries. 33. A comprehensive approach to public employment supports quality fiscal adjustment. In 2002, Turkey began to implement a more comprehensive public employment program. The current focus of the program i s on strengthening monitoring o f civil service employment and accelerating retrenchment o f redundant labor in the state enterprise sector. A ceiling on civil service employment in the central government agencies i s in place and has been expanded to cover civil servants inthe local administrations. The limit on replacement hiringinthe SEEs has been tightened to 10 percent o f attrition and no replacement hiring i s authorized for SEEs requiring finance from the budget. A comprehensive monitoring mechanism to track compliance with these policies i s being established. A total o f nearly 46,000 redundant SEE workers were identified inearly 2002 and this number is beingreduced, mainly through voluntary separations, under an agreement with the trade unions. Further retrenchment o f public employment i s expected over the medium term. The ceilings on civil service employment will also need to be maintained and the monitoring system improved. Ensuring effective coordination among the relevant agencies and the necessary political will for tough measures will be important issues in sustaining the public employment program over time. 34. The key elements o f Turkey's strategy for public expenditure management (PEM) reform are laid out inthe Strategic Frameworkfor Public Expenditure Management Reform prepared in 2001 in the context o f the Public Expenditure and Institutional Review carried out jointly with the World Bank. This strategic framework is the result of many years o f internal discussion in Turkey about modernization o fpublic expenditure management. The PEMstrategy is articulated around three priorities: 0 Reform the processes for budnet preparation and execution. Better budget management involves steps to: (i)improve the transparency and comprehensiveness o f the budget in line with international standards, (ii)strengthenthe credibility o f the budget preparation process, (iii)build capacity for policy formulation at all levels o f government, and (iv) realize concrete improvements in the operational performance of line ministries and agencies through a progressive shift to performance budgeting. The cornerstone for improved budget management will be set by the Public Financial Management and Control (PFMC) law expected to be enacted by late-2003. The law will harmonize and 18 modernize budgetary practices across all o f general government, reduce fragmentation and provide for a comprehensive presentation o f the budget, allow for the establishment o f modem internal control systems in the spending agencies in line with EU norms, and unify external audit under the auspices of the TCA. As part o f the effort to improve budget preparation, impressive progress has been made in 2002 and 2003 to rationalize the public investment program and further actions are envisaged in 2004 under the plan prepared by the SPO. Initial steps have been taken to introduce strategic planning into the budget process and to improve operational performance o f line agencies. It will be important to deepen these efforts as Turkey moves in a phased manner to full performance budgeting. 0 Upgrade public accounting, procurement and audit functions to improve financial accountabilitv. Strengthening financial accountability encompasses legal changes to introduce international fiduciary standards, as well as institutional changes to build capacity to implement the new standards and shift from formalistic ex ante control to effective ex post monitoring. Key milestones to date include enactment o f the new Public Procurement law in 2002 and establishment o f the independent Public Procurement Agency charged with overseeing its implementation. Preparation o f new public accounting standards i s also underway with the objective o f introducing modified accrual accounting for all general government agencies in line with GFS standards. This will involve a massive training effort which will require significant resources to be sustained. The audit reform centers around transformation o f the T C A into a true modem supreme audit institution. This is a serious collective action challenge which will require strong political support from the new Government. 0 Ensureprudent public liability management. More effective public liability management involves measures to establish clear lines o f borrowing authority and transparent reporting o f public liabilities, as well as institutional measures to build up the capacity for modern fiscal risk management. The foundation for better liability management was laid by the Public Debt Management law enacted in 2002 which also established a "middle office" for debt and risk management within the Treasury. Under this framework, the Treasury i s gearing up to address broader fiscal risks (e.g., BOT and similar take-or-pay schemes in the utilities sectors and the blanket guarantee on bank liabilities) and financial risks (e.g., foreign exchange exposure) in its debt and guarantee portfolio. The key now lies in vigorous implementation o f the debt law and full functionality o f the middle office. 35. Actions to improve public sector governance aim to reduce political influence over economic management and upgrade the quality and effectiveness o f government action. The agenda includes implementation o f a national anti-corruption strategy and comprehensive civil service reform. A national strategy to enhance transparency and good governance in the public sector under the slogan "A Transparent and Clean Turkey: Together Hand in Hand" was announced in January 2002. The objective o f the strategy is to provide a comprehensive framework which establishes clear priorities and benchmarks, and empowers and energizes public opinion to fight corruption. The strategy covers five core areas: public administration, the judicial system, the political system, civil society and the competitive private sector. It 19 complements on-going regulatory reforms in the enterprise and financial sectors, as well as the financial accountability agenda discussed above. The Government i s counting on the active involvement o f national NGOs. One o f the major national NGOs, TESEV, has completed two diagnostic surveys on corruption covering households and the business community respectively, and has completed preparations for a third survey covering civil servants. The core actions under national anti-corruption strategy have been reflected in the Urgent Action Plan o f the new Government. A ministerial committee for enhancing transparency and improving good governance was established inMarch 2003. The committee will monitor implementation o f the anti-corruption strategy inthe context o f the Urgent Action Plan. 36. Under its Urgent Action Plan, the new Government intends to adopt a civil service reform strategy by the end o f 2003. As part o f the preparation process, the authorities have initiated a broad-based functional review of government. The functional review has two objectives. First, it will help the Government to decide what type o f organization or combination o f organizations should undertake any given public service function within what type of legal framework. Second, it will help individual public entities figure out the best business process design including organizational structure and staffing requirements. The timetable for preparation o f the civil service reform i s ambitious and the Government will have to move quickly to complete the functional review process and related actions. These initiatives are essential buildingblocks towards a comprehensive overhaul of Turkey's public administration. 7 BUSINESSENVIRONMENT A positivebusiness environmentattractsinvestmentand ensures competitiveness 37. Structural reforms to improve the business environment are an essential component o f Turkey's economic reform program. The core objective o f these reforms i s to fuel growth through productivity increases driven by private investment, enhanced competition and efficient financial intermediation. As in other areas, substantial progress has been achieved since the initial disinflation program was launched in 1999,particularly interms o f financial sector reform and improvements to the regulatory framework. Looking ahead, medium-term priorities for improvingthe business environment center around five core pillars: deepeningfinancial sector reform 0 promoting corporate restructuring completing regulatory reforms accelerating privatization and market liberalization 0 attracting highlevels o f FDI 20 A healthy financial sector will support macro stability and fuelprivate investment 38. In response to the 2001 crisis, the authorities have redoubled efforts to reform the banking system, but important challenges remain. An independent bank regulatory and supervisory authority, the BRSA, was Table 4: Fiscal Cost of Bank Restructuring established in 2000. Prudential regulations (As of end of 2002) have been upgraded in line with EU and TL trillions % of GNP Basle norms. Insolvent private banks have State Banks 29,022 16.4 been intervened and resolved, and a full Ziraat 15,385 8.7 scale re-capitalization o f the banking Halk 12,627 7.2 system has been carried out. In line with Emlak 710 0.4 the experience o f other emerging market Vakif 300 0.2 countries by banking crises, the fiscal cost o f bank restructuring has been very high SDIF Banks 28,784 16.3 Grand Total 57,806 32.8I sustained political support. Development o f the non-bank Figure 14: Private Sector Real Credit Volume financial sector i s another 14000 lDTL.FX/ I important issue on the medium- 12000 term agenda. 10000 39. Although econometric F! 8000 analysis does not indicate .Q C evidence o f credit rationing 6000 following the 2001 crisis, the 4000 stock o f credit to the economy has fallen sharply in real terms 2000 (Figure 14). This post-crisis 0 contraction in private credit is consistent with the experience o f other emerging market jource: CentralBank and World Bank. economies. Generally, 21 resumption o f bank credit i s not a leading indicator and only follows output recovery". For example, in Mexico, credit growth turned positive only some seven years after the 1994 crisis. While a timely rebound in credit would help sustain the economic recovery, the Treasury's financing requirement will remain very large for the foreseeable future and the financial deepening expected from macroeconomic stabilization and the banking reforms will take time to materialize. Inthe interim, it i s important to avoid artificial measures to encourage bank lending. Ifnecessary, certaintemporary measures directedto firms ratherthanbanks couldprovide relief. Possible measures include: (i)schemes that give firms a limited amount o f government backed financing for a temporary period, (ii) automatic roll-over o f small SME loans, and/or (iii)trade a finance scheme. Given that SMEs finance themselves primarily by using trade credit, measures such as allowing receivables to be protected in bankruptcy and allowing borrowing against invoices and accounts receivable may be more important in relaxing the credit constraints on these firms. 40. Further strengthening o f the institutional and incentive framework will propel the transformation to a modern banking sector inTurkey. International experience demonstrates that bank re-capitalization efforts which pay inadequate attention to factors that can undermine the effectiveness o f regulatory/supervisory environments and impediments to bank profitability are doomed to be repeated. On the institutional side, bank supervision tends to be much more effective when it i s free from political intervention and reinforced by private discipline. Therefore, the most critical issue for Turkey i s to consolidate the independence and operational capacity o f the BRSA. Important steps have been taken to improve the incentive structure o f the Turkish banking system since the crisis but more actions will be needed to complement macroeconomic stabilization efforts. O f particular importance i s the need to introduce a well designed deposit insurance scheme in line with EU norms to replace the blanket guarantee introduced in 2000. Care must be taken to ensure that the deposit insurance scheme does not undermineprivate incentives for improved bank performance. Phasing out distortionary banking transaction taxes under the tax strategy will be another important step to improve profitability, particularly as disinflation progresses. Governmentsare not good at providing financial services 41, Restructuring and privatization o f the state banks-which make up over 30 percent o f banking system assets-is critical to the long-term success o f the banking reform. International evidence indicates that state ownership o f banks has negative consequences for financial development and economic growth. As part o f the reform program, one state bank, Emlak, has been closed through merger with Ziraat, the main state bank. Another state bank, Vakif, has initiated its privatization process but will require fwther portfolio restructuring for this to be successful. The largest state banks, Ziraat and Halk, have beenre-capitalized with government securities at market terms thereby eliminating their accumulated stock o f duty loss claims on the Treasury. An independent board has been appointed to manage Ziraat and Halk in accordance with commercial principles, and to streamline their operations in preparation for privatization. Significant progress has been made in closing unprofitable branches and reducing redundant labor. An important factor in facilitating privatization o f Ziraat and Halk i s to shrink their size. About 60 percent o f the combined asset portfolio o f Halk and Ziraat i s made up o f government " Park and Lee (2003). 22 assets, with loans making up less than 20 percent. It may be possible to spin o f f part o f this government portfolio into a money market mutual fund or other financial vehicle(s). An additional critical step will be to limit the state banks' role in provision o f subsidies. Legal safeguards against future duty losses are in place which require that any subsidies are transparently provided through the budget. Another key issue for privatization i s the future strategic direction o f the state banks. As Ziraat Bank i s expected to move towards full service banking, it will compete with the SME client base o f Halk. Therefore, consideration should be given to ensuring viable strategies for these two banks prior to privatization. Decisive actions will make privatization of the state banks a more realistic goal. A clear strategy and timetable will prevent a long and drawn-out privatization process and minimize the chances that the process i s derailed by political interference. Non-bank financial institutions are important to balanced financial sector development 42. A modern financial system features a dynamic balance of bank and non-bank financial intermediation. Both types o f intermediation are important and they are complements, not substitutes. Banks, securities markets, and a range o f other types o f intermediary and ancillary financial firms like insurance, leasing, factoring and venture capital companies, and mutual and pension funds all contribute to an efficient and developed financial sector able to successfully meet the full range o f financing needs of individuals, business and the public sector. Non-bank financial institutions (NBFIs) provide alternative financial services. NBFIs improve general system-wide access to finance, facilitate longer term investments, and match funding sources with investments based on appropriate riskheturn characteristics. A recent World Bank study on NBFIs and capital markets provides a road-map on the development o f non-bank financial markets inTurkey12. The study highlights the needto: (i) mobilize savings effectively from both domestic and foreign investors; (ii)build an institutional investor base by promoting the development o f insurance, private pension funds and the mutual fund industry; (iii) develop securities markets through deepening and enhancing the efficiency o f existing markets and market infrastructure; (iv) develop other non-bank sources o f finance such as leasing, factoring and venture capital; and (v) strengthen confidence in financial markets by improving corporate governance, accounting and auditing standards and practices and by further strengthening the regulation and supervision o f financial markets. Corporate restructuring will strengthen the private sector response 43, Comprehensive corporate restructuring i s a continuing priority in dealing with the aftermath o f the 2001 crisis and sustaining the recovery. Many firms failed during 2001 as the crisis hurt all sectors-industry, construction, trade and services. Firms were hit by falling demand coupled with rising financial charges stemming from high real interest rates, the high cost o f servicing debt denominated in foreign exchange and associated foreign exchange losses. N e t earnings o f Istanbul Stock Exchange (ISE) listedcompanies were down 80 percent for 2001. For listed companies, interest coverage ratios fell and levels o f corporate leverage rose in 2001- 02. While the burdenwas particularly acute for small and mediumenterprises, many mid-cap to larger firms are in distress as well (Figure 15). Corporate distress must be addressed to sustain l2Non-BankFinancialInstitutionsand Capital Markets inTurkey, April 2003. 23 the recovery. This i s also a window o f I opportunity for deeper restructuring to Figure 15: DistressedCompanies, 1998-2001Q1 - (ISE Listed Companies) strengthen the competitiveness o f Turkey's corporate sector and open the way to productivity gains over the medium term. Lessons from the recent crises in East Asia, Mexico and Sustainable elsewhere indicate that an effective corporate resolution strategy should include measures to: (i)segment problem companies; (ii)implement a voluntary workout program; (iii) improve the bankruptcy framework including allowing for pre-packaged bankruptcies that would recognize 1998 1999 2coo 2001Q1 voluntary workouts in the courts; (iv) `source: TOBB ease tax, legal, and regulatory impediments to restructuring; (v) establish an asset management company or companies; and (vi) ensure adequate credit access for SMEs. The resolution strategy should be tailored to address the need for deeper restructuring o f Turkey's corporate sector where large financiaUindustria1 groups play a very prominent role and many sub-sectors are characterized by oligopolistic structures that hinder competition. In parallel with restructuring, structural reforms are needed to improve corporate governance inline with international standards. 44. InJune 2002, a voluntary corporate workout program, known informally as the Istanbul Approach (IA), was introduced. Introduction o f the IA was timed to coincide with completion o f the bank re-capitalization program. Newly capitalized banks should, in principle, have the proper incentives to restructure potentially performing loans and to collect every penny possible on provisioned loans, as improvements in loan classification and collection will be directly reflected in increased profits and bank capital. To promote the IA, a number o f tax incentives have been introduced. Banks will be eligible for incentives under the program for an initial period o f three years and the Government retains the option o f extending the program. Experience in most crisis countries indicates that a systemic workout process may well take several years to complete. Moreover, it i s difficult to get the workout just right the first time, given the unstable economic conditions that normally exist when the workouts are concluded. Therefore, the process has to allow at a minimum for a second round or modifications o f some workouts a couple o f years into the process, once economic conditions have stabilized. As of end-June 2003, a total o f 299 firms had entered into the IA representing US$4.8 billion in loans and 46,333 jobs. 45. The Istanbul Approach will need to be complemented by a broader array o f structural measures to promote deeper corporate restructuring. These include facilitating access to credit for small and medium-size enterprises-including development o f NBFIs and commercially sound credit guarantee schemes-and taking a more pro-active approach to foreign direct investment-thereby facilitating new entry. Also important is accelerating the privatization program-including a careful review o f state enterprises to assess their need for workouts and restructuring. In addition, there i s a need for improved corporate governance encompassing 24 accounting reform, enhanced corporate disclosure, as well as strengthened independence for boards o f directors and better protection o f minority shareholder rights. O f critical importance are steps to upgrade the legal framework for bankruptcy and facilitate resolution o f non- performing loans. The bankruptcy law was amended in July 2003 in line with international standards which will strengthenincentives for companies to participate inthe IA and improve the broader business environment by facilitating exit. Further amendments to the law to introduce a pre-packaged bankruptcy option are scheduled to be enacted later in 2003. To make asset management and recovery more effective, it may be a good idea to split the asset management function from the BRSA's Savings and Deposit Insurance Fund (SDIF) which deals with failed banks. Private asset management companies are probably also going to be needed. To promote competition, the Competition Board will needto shift from passive to active competition policies inline with EUpractice. Deeper corporate restructuring will also be drivenby the programmed tightening o f prudential rules on connected lending by banks scheduled to reach EU standards over the next seven years. This will require banks to build up a new client base and compel corporations to look outside their own financialhndustrial groups for resources to finance investment. Regulatory reforms are critical for a well functioning market economy 46. Regulatory reforms are essential to the development o f a well functioning market economy. Intemational experience has demonstrated the importance o f strong regulatory frameworks anchored by independent regulatory bodies inkey areas such as competition policy, finance and network infrastructure. Effective regulation also involves transparent processes for regulation-making; consultation with interested parties; plain language in drafting, publication and other ways o f making rules accessible; clear lines o f accountability; and appeal processes that are predictable and consistent. Regulatory reforms had been slow to emerge in Turkey until the last few years, with some important exceptions such as the Competition Board and Capital Markets Authority. Weaknesses in the regulatory framework played a key role in Turkey's chronic macroeconomic instability, disappointing performance in attracting FDI, and accumulation o f contingent government liabilities. 47. The depth o f the 2001 crisis and prospects o f eventual EU accession have created a window o f opportunity for deepening regulatory reforms in Turkey which the new Government must build upon. Turkey has increasingly favored the "independent regulator" model in line with OECD and EUpractice as part o f its strategy to separate ownership, policy formulation and regulatory oversight. Such agencies are particularly important in Turkey's environment to ensure impartial and effective regulation isolated from political influence. Since 2000, regulators have been established in the banking, energy and telecommunications sectors, together with an independent oversight board for public procurement. These agencies have been established by specific legislation which defines their roles, objectives and powers. They are accountable to the Parliament and independently funded from license fees, permits and levies. The principles on which the regulators are based are generally sound, and demonstrate commitment to de- politicized economic management. The transparency and accountability o f the regulators will be enhanced under the PFMC law which will subject their budgets to Parliamentary approval and include them under the audit mandate o f the TCA. It will be critical to the new Government's credibility to sustain this reform effort and respect the independence o f the new regulatory 25 boards. This renewed commitment will help secure the levels o f private investment needed to underpin growth by demonstrating Turkey's determination to level the playing field for all investors as part o f the improved business environment. Accelerated privatization will strengthen reform credibility and support private sector development 48. Privatization in Turkey has lagged behind other emerging countries in Latin America, Asia and Eastern Europe (Figure 16). In 2002, state enterprises continued to account for 20 percent o f total manufacturing industry value-added and 3.3 percent o f total non-agricultural employment. The Privatization ~~ Administration (PA) i s responsible for carrying out the Figure 16: Turkey: Privatization Under PA Portfolio and GSMLicenses Sales ($ million) privatization program under the 5,500 authority o f the High 5,000 Privatization Council (PHC), a 4,500 group o f ministers chaired by 4,000 3,500 the Prime Minister. The 3,000 program has suffered from 2,500 many flaws. A requirement 2,000 that the PHC approve all 1,500 1,000 transaction, regardless o f size, 500 has led even small divestitures to be recycled several times- significantly lowering their value and reducing Source: Privatization Administration and World Bank. transparency. The prevailing cross subsidy mechanism between profit making companies and loss makers in the PA's portfolio removes incentives for the managers o f loss makers to restructure these companies and improve operational performance. As a result, the P A has effectively become a large state holding group-a function it i s not equipped to handle. Privatization o f telecommunications and state banks has remained the responsibility o f line ministries, inter-ministerial committees or o f the company managers and directors themselves, who have little incentives to sell these assets. Privatization has been viewed by the authorities primarily as an important revenue source, particularly during crises, thereby subordinating the more important objective o f making Turkish industry more efficient and competitive. Not surprisingly, this approach has contributed to delays and de-capitalization o f state enterprises, while facilitating resistance to privatization. 49. Determined action to improve and de-politicize the privatization process will help strengthen the new Government's reform credentials. Accelerated privatization is needed in order to reduce SOE losses, pay down the public debt and transfer productive assets to the private sector. Equally important, progress on privatization i s essential to ensuring the irreversibility o f the reform program and convincing investors that the fiscal adjustment is permanent. The Government has announced an ambitious US$4 billion privatization program for 2003, but credibility will depend on implementation. As a first step, the PA's mandate should be broadened to include a "fast track" privatization process for non-strategic companies 26 inits portfolio which would not requirePHC approval ofthe actual transactions. Inparallel, the cross subsidization mechanism should be terminated to improve transparency and incentives for SEE managers. The PA should be given a free hand to tackle its inventory o f loss-making companies through mergers and liquidations. Finally, future privatizations should not be carried out by line ministries and the authorities should take full advantage o f the PA's experience and technical abilities. The on-going reforms to promote market forces in energy, telecommunications and agriculture will help secure the efficiency gains expected from privatization. Accelerated privatization will have social implications. The Government will need to ensure sufficient funds cover all severance payments and other benefits due to workers laid off through privatization. Active labor market programs such as retraining and reinsertion should be enhanced to provide additional support to these workers. FDIcan helpspur recoveryand growth 50. International experience highlights the importance o f FDI to spurring recovery and sustaining growth. Inrecent years, nearly all countries experiencing crisis saw net FDI inflows remain positive through the crisis and subsequent years, unlike short-term capital flows such as portfolio investment. With the exceptions o f Chile, Indonesia, and Malaysia, net FDI flows in the year subsequent to the onset o f crisis were higher relative to GDP Figure 17:Post-Crisis F D I Ratio ofFDImflou6 land2 years aftercrisis relative to lyearpriorto CIISIS, ~ I than in the year immediately preceding the crisis (Figure 17). The policy environment appears to explain an important part o f the differences in relative FDI performance. Countries that introduced economic reforms in general and in particular geared toward FDI inflows-such as Brazil, Mexico, Korea and Thailand- witnessed sustained increases in FDI inflows in the post-crisis period. FDI plays a strategic role beyond recovery from crisis. Competition pressures bource: Bank I from foreign firms can promote product innovation, the overall diffusion o f new technology, investment in new plants and sales growth. Increased FDI can play a crucial role in broader corporate restructuring through exposure to advanced organizational and managerial skills. Studies indicate that FDI stimulates growth through spill-over effects and enhances export performance. FDI should also be encouraged for projects oriented to domestic markets and be linked to local enterprise development. The benefits o f FDI are not automatic and depend on the overall policy environment and quality o f institutions. Important factors include the prevalence o f rule o f law, transparent administrative practices, effectively combating corruption, good corporate governance, sound competition policy, and protection o f labor rights and the environment. More and more research argues that absorptive capacity inthe host country i s crucial. Pro FDIpolicies need to be complemented by appropriate human capital development and R&D policy to maximize the benefits. 27 51. Turkey has begun to develop an FDI strategy, but this does not yet address all of the challenges to realizing significant FDI inflows (Figure 18). Initiatives are required to: (i) improve the institutional environment by streamlining administrative procedures and de- politicizing the privatization process; (ii) in investment promotion activities to improve engage Turkey's image with foreign investors; and (iii)build on Turkey's locational Figure 18: FDI(US%million) advantages such as its abundant labor 3,000 force, developed infrastructure and 2,500 geographic location. Turkey i s making progress towards an improved 2,000 environment for foreign investors. 1,500 Based on recommendations by Foreign 1,000 Investment Advisory Service (FIAS), a 500 consultative process has been set up with the private sector through the 0 Coordination Council for Investment 1997 1998 1999 2000 2001 2002 Climate (YOIKK), which i s chaired by I Source: Treasury and World Bank. a cabinet minister. A new FDI law was enacted in June 2003 to upgrade the legal framework and legislationhas beenpreparedto establish an investmentpromotionagency. The Government can build on this momentum by: (a) activating the Investor Council consisting of high-level representatives of the intemational business community; (b) initiating a full-scale review of commercial law and competition policy in Turkey to identify and address important obstacles to FDI, and (c) developing a strategyto facilitate the flow of "greenfield" FDIto SMEs. 8 SOCIAL POLICIES Social costs of the financial crisis have been high 52. The cumulative social costs of stagnation and crisis have beenvery~-high. Per capita GDP contracted by 13 percent between 1998 and 2001. The officially recorded Figure 19: Unemployment Rate unemployment rate rose from 6.4 percent 14 1 in 1998 to 8.5 percent in 2001, and rose 12 further to 10.6 percent during 2002 and 12.3 percent in the first quarter of 2003 10 (Figure 19). The unemployment rate % 8 increased again in the first quarter of 2003 6 despite the recovery. Agriculture and 4 services, the two sectors most likely to 2 employ the poor, shed large numbers o f 0 workers, In 2001 there were about 3 million fewer Deode emdoved in these I sectors relative to the peak in 1999. Real * A I . wages in manufacturing remained relatively constant through 2000 as nominal wage increases kept pace with inflation, but then declined sharply in 2001. Inthe fourth quarter of 2001, real wages in manufacturing fell by a stunning 20 percent compared to the same period in the 28 previous year. While the fall in real wages has helped maintain Turkey's external competitiveness, the associated household welfare loss has been large. World Bank estimates suggest that in 1994 some 6 percent o f the urban population were below a food poverty line, but by 2001the percentage hadjumpedto approximately 17percent. The primary coping strategy of the poor has been to reduce consumption, particularly o f food. There are also indications that education expenses have been reduced and some children withdrawn from school. The Southeastern region has been particularly affected. Although it accounts for less than 7 percent o f the population, about 25 percent o f the urban food poor live inthis region. 53. The new Government i s working to strengthen the social dimension o f the program, but faces obstacles inthe burgeoning social security deficit and heavy debt burden. Benchmarks for public spending on health, education and social protection have beenset by the Goverment. This policy has succeeded inmaintaining, and even increasing, the overall level o f social expenditure. However, this result has been due primarily to large overruns in social security expenditure which have masked important shortfalls in other social protection programs. Targeted social assistance spending fell short o f the targets inkey areas in 2002, including the DIS program for farmers and the social assistance programs funded by the Social Solidarity Fund (SSF). The Government is now moving to correct some o f the shortfalls insocial protection and improve the institutional framework, however, its initial steps to introduce ad hoc increases in pensions exacerbated the problem. Permanently shifting the balance o f social programs more in favor o f poor and vulnerable groups will take more time and effort, as well as substantial political will. To strengthen the institutional framework, the authorities are preparing legislation to reform the SSF and institutionalize the DIS program. The Government is also aiming to increase targeted social spending in 2003, but this will depend on measures to contain cost overruns in the social security system. On-going quality improvements to education under the basic education reform program need to be maintained and policy reforms to underpin improvements in the health system are an urgent priority. More effective measures to ease labor adjustment costs also need to be developed including a review o f the unemployment insurance scheme introduced in 1999. Over the medium term, the need to service the public debt burden will pose a continuing challenge to ensuring adequate funding o f social programs. The public debt will also be an obstacle to improvements in the distribution o f income as tax collections are used to meet obligations to government bondholders. The engine ofjob creation mustbe the private sector 54. The private sector must be the source o f job creation in Turkey over the medium term. Permanent fiscal adjustment will require a sustained retrenchment inpublic employment given a public sector wage bill that consumes 24 percent o f central government expenditure. In comparison, Australia allocates only 2.4 percent o f expenditure for wages, while even France with a traditionally large public sector allocates only 16 percent. What is striking over the last three years o f economic stagnation i s that the opposite has happened as public sector employment increased by 5 percent between 1999 and 2001, while private employment decreased by 6 percent. Under the public sector reform program, the Government has now begun a serious effort to restrain public employment. Another stand-out feature o f the Turkish labor market i s the large and growing gap between the labor force (adult population who are either employed or looking for work) and adult population. In 2001, o f the 46 million adults only 22 29 million were in the labor force and o f Figure 20: Adult Population, Labor Force and these 20 million were employed, Employment (in millions) according to the labor force survey (Figure 20). H a l f the adult population (conventionally defined as persons 35 30 /*- above 15 years o f age) were not employed and not looking for work. Possible explanations for the low labor participation include women dropping out o f the work force, undercounting o f employment in a growing informal sector, and discouraged job seekers dPopulation,15&over --)- Labor Force dropping out o f the labor force. - -A- -Employment Source: SIS Eliminatingconstraintson employmentcreationis important 55. Policies play an important role inemployment creation. Labor market policies geared to promote formal private sector employment enhance equity and complement other pro-growth reforms aimed at macroeconomic stability, a sound financial system and a competitive corporate sector, Inmany countries, labor laws provide employment protection particularly for vulnerable groups such as women and the young. At the same time, strict labor laws can affect employment creation or, alternatively, in countries with inadequate enforcement, stricter labor laws can unintentionally lower worker protection by promoting growth o f the informal sector. Labor costs relative to productivity also impact employment prospects; if labor costs are high relative to productivity then employment prospects will be reduced. Payroll taxes are a key factor in determining overall labor costs and provide the most direct link between social security reform and job creation. Many OECD countries, including Turkey, have begun to use active labor market policies to promote employment. There is now a reasonably large literature which provides guidance on how these programs can be usedeffectively. 56. Turkishlabor law provides very strong employment protectionon paper, butenforcement i s a question mark and in practice the system may provide strong incentives to the informal sector. A comparison o f employment protection laws in 26 OECD countries finds that Turkey (along with Greece) has provided the greatest degree o f formal protection for workers, This comparison does not take into account the new Labor Law enacted in June 200313. Turkey's employment regulations stand out on two aspects: (i) and payment required for severance notice pay, and (ii) inthe regulation oftemporary workers. The severance pay regulations imply that a typical worker with 20 years tenure i s entitled to 26 months severance pay. Only Portugal among the 26 OECD has a stricter requirement. On regulation o f temporary workers, Turkey's regulations are rated very strict because fixed-term contracts are allowed only for so-called objective reasons such as the task itself being o f temporary duration. Temporary employment i s generally restricted to seasonal and agricultural work. Ofthe countries rated by the OECD, only Greece has similarly restrictive criteria on the use o f temporary workers. Temporary work ~ l3 The impact ofthe new Labor Law will be analyzedas part o fthe on-going Labor Market Study. 30 agencies are not allowed at all in Turkey, again with the exception of agricultural work. Here too, Greece and Turkey have the strictest regulation. 57. While there is strong evidence of wage and employment flexibility, Turkey's very strict employment protection laws may well be having adverse employment effects particularly for the most vulnerable segments of the population. Employment protection rules are meant to enhance job security by making dismissal costly to the employer. Inmany countries these laws do tendto reduce layoffs in downturns, but they also reduce hiring as the economy recovers. Stricter employment protection legislation, all other things being equal, also leads to longer average unemployment duration, lower labor force participation rates and positive employment effects for skilled primary age males, but lower employment for women, young people, and less-skilled workers. Perhaps most importantly in Turkey, there is extensive anecdotal evidence that the labor laws are not effectively enforced and statistical data indicate that informal employment is widely tolerated. Under these circumstances, tightening the legal framework for employment protection may well have the unintended consequence of channeling employment from the formal to the informal sector where wages are low and workers have limitedor no effective legal protection. Policiesare needto improvelabor productivityand maintaincompetitiveness 58. Wage levels inTurkey remain Table 5: Productivityand Wages in SelectedCountries competitive but rising social security 1980-85 1986-90 1991-1995 1996-2000 contributions represent a serious Value added per worker in industry ($) medium-term risk. The impact of Turkey 6,771 11,311 15,062 12,819 wages on competitiveness can be Hungary 10,610 12,992 measured through productivity and Korea 9,504 15,974 32,638 42,747 also by comparing with other Poland 9,765 13,693 countries. Labor productivity in Portugal 28,324 29,474 Turkey (measured by value added) Spain 22,889 41,530 59,775 57,099 i s roughly comparable to Hungary Labor cost per worker ($1 and Poland, but well below the levels Turkey 1,902 2,583 6,377 4,9 17 reached in Korea, Portugal or Spain Hungary 5,573 6,475 6,929 (Table 5). Labor costs on the other Korea 4,43 1 7,914 14,459 15,708 hand are below Hungary and Poland, Mexico 3,069 2,354 4,340 4,104 and well below other comparator Poland 4,114 5,948 countries except for Mexico. The 4,119 6,254 11,644 14,872 ratio of value added to labor cost Spain 9,819 16,655 24,929 23,907 provides a measure of Value addednabor cost competitiveness. This ratio was very Turkey 3.636 4.879 2.394 2.607 high in Turkey in the 1980s 1.556 1.875 reflecting low wage levels. Although Korea 2.143 2.033 2.243 2.721 it has declined since then, labor in Poland 2.436 2.302 Turkey is still competitive relative to Portugal 1.869 1.982 other countries. Employer-paid Spain 2.343 2.491 2.397 2.388 Source: OECD percentage point increase over the 1980-85 period. Employer contributions as a percentage of labor costs are now equal to the level of Spain and higher than all other countries inthe sample. This comparison highlights the risks to formal job creation posed by growing social security taxes and points once again to the criticalneedfor further overhaul of Turkey's social insurance system. 59. Labor market programs can be useful in assistingjob seekers and alleviating the social costs of adjustment in Turkey, but the cost effectiveness o f these programs must be carefully monitored. Active programs seek to assist the unemployed in finding work while passive programs aim to provide a safety net. Over the last few years, Turkey has begunto implement both active and passive labor market programs. Active labor market policies can broadly be classified into three types. Job search assistance and employment services to match employers and potential employees have been relatively the most cost effective program, mainly because the costs are low. However, they tend to be most helpfulto people who are likely to have found jobs anyway. Trainingprogramswhether for the long-termunemployed, retraininginthe case of mass layoffs, or training for youth tend to be significantly more expensive than job search assistance and no more effective. The rates of return on training programs are often low. Job creation programs include employment or wage subsidies, public works programs and micro- enterprise programs. Employment or wage subsidies tend to have unintended consequences (such as subsidizedworkers replacingunsubsidizedones, or employers firing subsidizedworkers once the subsidy periodends). Public works programs are amongthe most heavily funded inthe OECD. Evaluations show that these programs can have a desirable short term effect in raising employment but they generally do not have a long-term impact in reducing unemployment. They are thus best thought of as a short run anti-poverty measure. There is little evidence available on the cost effectivenessofmicro-enterpriseprograms. 60. An important leg of Turkey's passive labor market policy is the recently introduced unemployment insurance scheme. This was established in June 2000 and has enrolled approximately 5 million workers. Individual accounts are created to which workers transfer 1 percentoftheir salary while employers contribute 2 percentandthe state 1percent. Workers can draw on their account when they are separated from their jobs. Despite the increase in unemployment with the crisis, only about 60,928 workers are receiving payments as of May 2003 because of the requirement that contributionshave to be made for 600 days before workers can start receivingpayments. The unemploymentinsurancescheme overlaps with the mandated severance payment system and the way is opento phaseout mandatedseverance payments. The shift of the mainpillar of unemployment protection from the old severance payment system to the unemployment insurance scheme should promote labor adjustment in response to changing economic conditions. However, this requires that the unemployment insurance scheme become more effective. Given the large surplus building up inthe UnemploymentInsurance Fund, it is essentialthat there is a comprehensivereview of the future use of the fund with the intentionof ensuring that it is brought into balance with due regard to the existing employment benefit policies. A prerequisite for more effective functioning of the unemployment insurance scheme-and indeed any active labor market policy-is the establishment law for the Turkish Employment Organization (ISKUR) adopted by Parliament in July 2003 as part of the broader legislative package to underpinthe institutional and administrative reform of the social security system. 32 9 MEDIUM-TERM OUTLOOK14 61. Medium-term projections demonstrate that sustained implementation o f economic reform i s necessary if Turkey i s to attain its macro-economic stability and growth objectives. Only sustained macroeconomic stabilization and structural reform can set Turkey on a medium-term course o f disinflation, renewed growth and sustainable public debt. Thus, the medium-term projections under the program illustrate a Sustained Reform Scenario. Economic reform i s needed to catalyze a virtuous circle whereby increasingly permanent fiscal adjustment and more effective government lead to improvements in market confidence which in tum drive down real interest rates. Lower rates combined with reforms to improve the business climate can in tum engender an increasingly robust private sector response. A sustained pick up in private sector activity that begins to generate employment will complement stronger social policies and bolster public support for the Government's reform policies. Igniting and then sustaining this virtuous circle i s the key to achieving high levels o f more equitable growth over the mediumterm. Under a low-case (muddle through) scenario, structural reforms would lose momentum, fiscal policy would become expansionary, and inflation and growth performance would likely be disappointing. With limited program credibility and a large debt rollover requirement, interest rates would remain high and private investment would be crowded out. Under this scenario, the economy would remain highly vulnerable to internal and extemal shocks, with significant risk o f a new economic crisis. Pursuing Turkey's social agenda would become increasingly difficult. 62. Under a scenario o f sustained reform, the economic program is projected to achieve the Government's stabilization and growth targets. The economy would be expected to fully recover from the 2001 recession, with stable real growth o f 5 percent inthe 2003-06 period (Figure 21). Specific factors underlying sustained growth include: 0 greater confidence inthe policy framework, 10% 1 Figure 21: Growth 1 0 improved macroeconomic stability and declining real interest rates-which would stimulate private investment and consumption demand, 0 an increase inproductivity resulting from structural reforms, 0 stronger exports performance-which would permit faster import and output growth, and Source: World Bank 0 higherexternal inflows, including sizeable FDI. l4 Sustainedreformscenario is consistentwith baselineprojections for the fourth IMF programreview completed in April 2003. However, BOP figures have beenupdatedfor further developmentsthrough May2003. Basedon the TL appreciationsince April, inthe 5" programreviewscheduledto be completed inAugust, the projectedpublic debt to GNP ratio for end-2003 is expectedto be adjusteddownwardto about 70 percentcomparedto 77 percentin the 4" review baseline. Ifrealized, this downward adjustment would improvethe medium-termdebt path provided the exchange rate adjustmentis maintained. 33 Figure 22: PSBR (YOo f GNP) Figure 23: Current Account Balance (YOof GNP) 3.0% I I 24% 20% 16% 12% -1.0% 8% -2.0% 4% -3.0% 0% -4.0% 2001 2002 2003 2004 2005 2006 2001 2002 2003 2004 2005 2006 SustainedReform Muddle Through 10SustainedReform Muddle Through 1 Source: World Bank. Source: World Bank 63. Achieving high and stable growth rates over the medium term will depend on the continuation o f disinflation and structural reforms. Under the sustained reform scenario, high quality fiscal adjustment will yield a permanent reduction in the PSBR (Figure 22). This will underpinthe projected stabilization o f the net public debt stock below 75 percent o f GNP by 2005. High quality fiscal adjustment will also support the projected decline in CPI inflation to single digits by 2005. The viability o f the sustained reform scenario depends critically on the availability o f additional external financing from private resources and higher privatization proceeds (reflected in part by steadily increasing levels o f FDI) in the next 2 to 3 years to accommodate import demand associate with sustained growth as shown in the BOP projections (Figure 23). 64. While sustained 5 percent growth is projected under the reform scenario, even higher growth would be needed to make real progress towards EU convergence given Turkey's demographics. This underlines the strategic imperative o f determined implementation o f the medium-term reform agenda including: 0 deepening structural fiscal reforms; 0 continuation o f the on-going institutional reforms to improve public expenditure management; 0 sustained implementation o f structural reforms inbanking, energy, agriculture and telecommunications; 0 accelerating privatization with a focus on public utilities and the state banks; and 0 stronger social policies including more investmentinhuman capital and labor market policies which ensure competitiveness andpromote employment. 65. A muddle-through approach to economic reform will not work given Turkey's vulnerabilities to internal and external shocks and the imperative o f improving investor confidence. Under a low-case (muddle through) scenario where structural reforms would lose momentum starting from 2003, the key conditions for sustainable fiscal adjustment would not be met. Budget revenues would be expected to decline as the recovery stalled, while expenditure would grow under the assumption o f expansionary fiscal policy. The PSBR would deteriorate 34 and progress in taming inflation would begin to unravel. Turkey's creditworthiness would deteriorate and the economy would remain highly exposed to shocks. Turkey's public sector debt burdenwould increase to very high levels over the medium-term. A combination o f poor fiscal performance, low growth, and high interest rates would produce an unsustainable path for public debt. The return o f inflation and higher interest rates would squeeze out private investment. The economy would be forced to generate current account surpluses to service external debt in the absence o f fresh capital inflows. Under these conditions, annual GNP growth in 2003-06 would be projected to average no more than 2 percent. This scenario would have very negative welfare implications (Figure 24). By 2006, projected per capita income would be about 20 percent less than in the sustained reform scenario. Clearly, the low-case scenario i s not sustainable for Turkey. 66. Realizing the improvements in stability and growth projected under the sustained reform scenario will depend on unwavering commitment and determined - Figure 24: Per Capita Income (US) implementation o f the program. Further I improvements in confidence will be 3.400 4I I l l 3,000 required to generate the reduction in real interest rates needed to underpin the 2,600 recovery and ensure public debt 2,200 sustainability. Under the sustained 1,800 reform scenario, the public debt to GNP 1,400 ratio, which fell from 95 percent o f GNP 1,000 in 2001 to some 80 percent in 2002, is 2001 2002 2003 2004 2005 2006 projected to fall further to under 75 10SustainedReform Muddle Through 1 percent over the 2003-06 period (Figure 25). Realizing this outcome hinges on Source: World Bank sustained recovery, a fall in interest rates from current levels, and a primary surplus on the order o f 6.5 percent o f GNP. The scenario also assumes accelerated privatization with cash privatization revenues o f US$2.1 billion in 2003 and an average o f US$2 billion annually over the 2004-06 period. The sustained reform scenario further assumes that the Figure 25: Total Net Public Debt (%ofGNP) I Government establishes effective control 100 , I over contingent liabilities. The four most important contingent liabilities are: (i) 90 potential further liabilities from troubled banks and corporations; (ii) future liabilities 80 o f the social security system; (iii) 70 contingent liabilities in the energy sector; and (iv) FX risk inthe public debt portfolio. 60 One important mitigating factor is the 2001 2002 2003 2004 2005 2006 structure o f the public debt with nearly half 10SustainedReforms Muddle Through 1 of the Treasury's external debt held by bilateral and multilateral creditors and h ~ r c eWorld Bank : about one half o f the domestic debt held by public entities which can facilitate short-term rollover. However, care must be taken to ensure the liquidity and financial autonomy o f these 35 public entities given that illiquidity o f the state banks was a key factor inthe lead up to the 2001 crisis. 67. Medium-term prospects also depend on developments in Turkey's balance o f payments and external environment. First and foremost, sustained recovery will hinge on continued strong export performance building on Turkey's traditional strengths and developing new sources o f comparative advantage. Moreover, the debt dynamics are vulnerable to external financing and movements in the real exchange rate. The government has shifted a great deal o f its domestic debt portfolio to foreign currency denominated securities. At the end o f 2002 about 59 percent of the Treasury's debt was either external or FX-denominated domestic debt. Therefore, debt sustainability depends on relative stability o f the real exchange rate over the medium-term. While the current level o f international reserves provides some cushion, Turkey faces very large external financing needs. Turkey has to generate ample capital inflows to: (i) underpin the floating exchange rate regime; (ii) finance the moderate current account deficits projected to accompany growth; and (iii) service repayment o f external debt including IMF loans. Gross external financing requirements are projected at nearly US$22 billion per year over the 2003-06 period under the sustained reform scenario. A key priority i s to increase the volume o f FDI to improve the structure o f Turkey's external finances and strengthen the dynamic for increased productivity, competitiveness and employment. Accelerated privatization and a range o f structural reforms will be needed to improve the outlook for FDI flows. Given the likelihood that Turkey will remain exposed to external shocks for some time, continuation o f the policy o f exchange rate flexibility under the float will be important. Sustained progress towards EU accession would provide a strategic external anchor for Turkey's reform efforts. 36