Report No. 23153-TU Turkey Corporate Sector Impact Assessment Report Public Disclosure Authorized

March 2003

Private and Financial Sector Development Europe and Central Asia Region Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized

Document of the World Bank Currency Equivalents

Currency Unit = Turkish Lira (TL) US$1 = TL 1,694,915 (as of March 19, 2003)

Acronyms and Abbhrev4aflons

ASO - Ankara Sanayi Odasi (Ankara Chamber of Industry) ATO - Ankara Ticaret Odasi (Ankara Chamber of Commerce) BOTA$ - Boru Hatlari ile Petrol Tagima A$ (Petroleum Pipeline Corporation) BRSA - Banking Regulation and Supervision Agency CDRAC - Corporate Debt Restructuring Advisory Committee CIS - Commonwealth of Independent States ERDEMIR - Eregli Demir ve (elik Fabrikalari T.A.$ (Eregli Iron and Steel Works Company) FDI - Foreign direct investment FIAS Foreign Investment Advisory Service IAC - Investment Advisory Council IAS - International Accounting Standards IMF - International Monetary Fund ISE - Istanbul Stock Exchange ISO - Istanbul Sanayi Odasi (Istanbul Chamber of Industry) KOSGEB - Kuc uk ve Orta OlIekli Sanayi Gelistirme ve Destekleme Idaresi Baskanligi (Small and Medium-size Enterprises Development Organization) NGO - Nongovernmental organization PETKIMv - Petkim Petrokimya Holding A.$. POAS - Petrol Ofisi A. , (Petroleum Distribution Company) REIT - Real Estate Investment Trust SDIF - Savings Deposit Insurance Fund SSK - Sosyal Sigortalar Kurumu (Social Insurance Agency) TBA - Turkish Bankers Association TEA$ - Turkiye Elektrik Uretim ve Iletim A.$. (Turkish Electricity Generation and Transmission Company) TEDA$ - Tirkiye Elektrik Dagitim A.$. (Turkish Electricity Distribution Corporation) TL - Turkish lira TOBB - Union of Chambers of Commerce, Industry, Maritime Trade, and Commodity Exchanges of Turkey (Tuirkiye, Ticaret, Sanayi, Deniz Ticaret Odalari ve Ticaret Borsalari Birligi) TSKB - Tirkiye Sinai Kalkinma Bankasi (Industrial Development Bank of Turkey) TUPRA$ - Tiirkiye Petrol Rafinerileri A. $. (Turkish Petroleum Refineries Corporation) TUSLAD - Tirk Sanayicileri ve I,adamlari Dernegi (Turkish Industrialists' and Businessmen's Association) VAT - Value Added Tax YASED - Foreign Investors Association of Turkey (Yabanci Sermaye Demegi)

Vice President: Johannes Linn Country Director: Ajay Chhibber Sector Director: Paul Siegelbaum Team Leader: Ira Lieberman Acknowledgments

This report is truly a World Bank Group effort. It could only have been prepared with the support of the International Finance Corporation team in Istanbul, of World Bank staff in Ankara-who have been besieged by the demands of Turkey's recent economic crisis-and of various Bank staff with years of corporate and related experience. In addition, the authors were supported with great dedication, professionalism, and expertise by local Turkish consultants and by two corporate advisers in Turkey-Deloitte & Touche and McKinsey & Company.

The report was written by Ira Lieberman (Task Manager/Sector Manager, ECSPF), Robert R. Gourley (Senior Private Sector Development Specialist, PSASP), Zeynep Kudatgobilik (Consultant), Leonid Koryukin (Research Analyst, AFTM1), Yasuo Izumi (Sector Manager, ECSPF), William Peter Mako (Senior Private Sector Development Specialist, EASPS), Gurhan Ozdora (Senior Operations Officer, ECSPF), Tunc Uyanik (Senior Financial Specialist, ECSPF), Michele Shuey (Investment Officer, CSET1), Can Pamir (Investment Officer, CSETR), Sena Sancakli (Team Assistant, CSETR), Suha Satana (Consultant), Caglar Ergun (Consultant), and Erkan Ozcelik (Consultant). Sophia Cox and Meral Gokcek are the Program Assistants who assisted with the report.

The report team appreciates the time taken by senior managers of the many Turkish companies interviewed directly and through surveys during the crisis. They were invariably gracious and accommodating. The team also appreciates the time taken by senior managers of private commercial banks, private development banks, and state-owned banks. In addition, the team is grateful to Turkey's various chambers of commerce and industry-especially the Ankara Chamber of Commerce, Ankara Chamber of Industry, and Union of Chambers of Commerce, Industry, Maritime Trade, and Commodity Exchanges of Turkey, which surveyed more than 10,000 enterprises throughout Turkey. The Industrial Development Bank of Turkey and the Turkish Industrialists' and Businessmen's Association worked with the team throughout the crisis and assisted with our many requests-setting up interviews, organizing corporate and financial sector roundtable discussions, and conducting their own analysis of the crisis. More recently, the report team has worked closely with the Turkish Bankers Association on its proposal for a resolution strategy. The team thanks the association for its openness and willingness to consult with us on this issue. Finally, the team greatly appreciates the support of public officials and other institutional representatives who, despite being under great stress due to the crisis, were always available to meet with and assist us. These include representatives of the Treasury, Central Bank, Banking Regulation and Supervision Agency, Institute of Statistics, State Planning Organization, Privatization Administration, Istanbul Stock Exchange, and Small and Medium-size Enterprises Development Organization. I TABLE OF CONTENTS

EXECUTIVE SUMMARY ...... I

1. INTRODUCTION .1

2. OVERVIEW OF THIE CRISIS .3 The Govemment's Economic Growth Program-and Recent Developments . 3 A Deeper Crisis Than Before .4 3. CORPORATE PERCEPTIONS OF THE CRISIS .12 Summary ...... 29 4. ANALYSIS OF CORPORATE DISTRESS .30 Losses in Listed Companies .33 Prospects for Export-led Growth .35 Financial Indicators for Listed Companies .37 Strategies Used to Protect and Increase Cash Flows .43 Corporate Borrowing .46 Sumary .49 5. RESOLUTION STRATEGIES .51 Segmenting Problem Companies .52 Monitoring Large Corporations and Groups in Distress .53 Implementing a Voluntary Workout Program .55 Easing Tax, Legal, and Regulatory Impediments to Crisis Resolution .60 Improving Financial Reporting and Accounting Standards .65 Enhancing Corporate Goverance .66 6. OTHER STRUCTURAL REFORMS THAT AFFECT THE CORPORATE SECTOR . 69 Financing the Real Sector .70 Attracting Foreign Direct Investment .71 Accelerating Privatization .73 BIBLIOGRAPHY ...... 76 Tables Table 1. Macroeconomic Projections, 2001-02 ...... 4 Table 2. Changes in GNP by Sector, January-December 2001 ...... 5 Table 3. Exports, Imports, and the Trade Deficit, July and January-December 2000-01 ...... 6 Table 4. Annualized Changes in Industrial Production, July and January-December 2000-01 ...... 6 Table 5. Capacity Use Rates in Manufacturing, January-December 2000-01 ...... 7 Table 6. Changes in Electricity Demand, January-September 2001 ...... 8 Table 7. Employment and Unemployment Indicators, 1998-2001 ...... 8 Table 8. Changes in Production-related Labor in Manufacturing, January-August 2000-01 ...... 9 Table 9. Number of Companies Opened and Closed, July and January-July 2000-01 ...... 9 Table 10. Foreign Direct Investment, 1996-2001 ...... 10 Table 11. Findings from the ISO Survey ...... 28 Table 12. Review of FY2001 Earnings-Industrials and Services ...... 31 Table 13. Net Profitability by Sector, 2000 Q1 and Q2-2001 Ql and Q2 ...... 31 Table 14. Financial Indicators for Listed Companies, 1997-2001 ...... 32 Table 15. Exports by Sector and Sector Contribution to GDP, 1999 ...... 35 Table 16. Export Revenues as a Share of Total Revenues in Selected Sectors, 1999 ...... 35 Table 17. Export Orientation and Profitability by Sector, 2000-01 ...... 36 Table 18. Key Recommendations for Corporate Resolution ...... 52 Table 19. Key Recommendations to Complement Corporate Resolution ...... 69 Table 20. Interest Rates, 1995-2000 ...... 70

IFigures Figure 1. Change in GNP in Constant Prices, 1999-2001 ...... 5 Figure 2. Changes in Public and Private Investment, 1997-2001 ...... 7 Figure 3. TOBB and ATO Survey Questions on Overall Distress ...... 13 Figure 4. TOBB and ATO Survey Questions on Financing ...... 14 Figure 5. TOBB and ATO Survey Questions on Exports ...... 15 Figure 6. TOBB Survey Questions on Distress, by Firm Size Ql 2001 ...... 16 Figure 6a. TOBB Survey Questions on Distress by Firm Size Q4 2001 ...... 17 Figure 7. TOBB Survey Questions on Workforce QI 2001 ...... 18 Figure 7a.TOBB Survey Questions on Workforce Q4 2001 ...... 19 Figure 8. Did You Borrow from Banks in the First Quarter of 2001? ...... 20 Figure 9. Do You Expect Export Sales in 2001 to Be Greater than in 2000? ...... 21 Figure 10. If You Think Exports Will Increase, What Will Be the Approximate Level of the Increase? ...... 22 Figure 11. ASO Survey Findings in Q4 2000, QI 2001 and Expectation for 2001 ...... 23 Figurel la. ASO Survey Findings Q3, Q4 and Expectation for 2002 ...... 24 Figure 12. Average Plant Capacity Use in Ankara, 2000 Q4-2001 Q2 ...... 25 Figure 13. Exports as a Share of Sales for Firms in Ankara ...... 26 Figure 14. Financing Indicators for Firms in Ankara ...... 27 Figure 15. ATO Survey Findings on Sales and Equity Capital ...... 28 Figure 16. Ratios of Liabilities to Equity and Interest Coverage in Various Economies ...... 33 Figure 17. Profitability for Export- and Domestic-oriented Industries ...... 37 Figure 18. Interest Coverage for Export and Domestic-oriented Industries ...... 38 Figure 19. Short-term Liabilities for Export and Domestic-oriented Industries ...... 39 Figure 20. Bank Borrowing for Export and Domestic-oriented Industries ...... 40 Figure 21. Does Size Matter? ...... 41 Figure 22. Distressed Companies, 1998-2001 Ql ...... 42 Figure 23. Ages of Receivables and Inventories for Services and Industry, 1999-2001 Q2 ...... 45 Figure 24. Age of Payables for Services and Industry, 1999-2001 Q2 ...... 46 Figure 25. Institutional Structure for the Istanbul Approach ...... 57 Figure 26. Process for the Istanbul Approach ...... 58

Boxes Box 1. Why Exports Are Not a Complete Solution ...... 44 Box 2. Legal Framework for Creditor Rights and Enforcement ...... 62

Annexes Annex 1. Comparative Analysis of Recent Corporate Crises Annex 2. Survey Data Analysis Annex 3. Analysis of Istanbul Stock Exchange Data Annex 4. Interpreting Turkish Financial Statements Annex 5. Organizations and Companies Interviewed

Executive Summary

I. Introduction

1. In February 2001 Turkey was hit by its deepest economic and financial crisis since World War II, prompting a severe decline in business activity. The adverse effects of the crisis were felt throughout the economy-starting in the public sector, spreading to the financial sector, and causing increasing distress in the real sector. To restore growth and return companies to profitability, Turkey urgently needs to implement a comprehensive corporate restructuring program. Moreover, simultaneous resolution efforts are needed in cases where corporate distress is creating distress for financial institutions.

II. Overview of the Crisis

2. In 2001 Turkey's real GNP fell 9.4 percent. The crisis has hurt all sectors-industry, construction, trade, and services. Industrial production fell 6.9 percent in the first half of 2001 and 9.9 percent for the year. During 2001 plant capacity use in the private sector ranged from 62 percent in March and May to 68 percent in the fourth quarter, suggesting that the crisis may have bottomed out. Still, capacity use remains below the break-even point for most manufacturers. Lower domestic demand is the most important factor undermining growth. Increased exports in a number of sectors-such as automobiles and textiles-helped mitigate corporate losses but even these sectors suffered significant losses in 2001.

3. The downturn forced most firms to reduce their workforces throughout 2001. Efforts have also been made to control wage costs, with shorter work weeks, strict controls on overtime, accelerated vacation and maintenance schedules, and temporary furloughs. Although Turkish firms have been agile in responding to the crisis, corporate and worker distress is considerable. At the end of 2001 some 2.3 million workers-10.6 percent of the workforce-were unemployed, and another 6 percent of the workforce was underemployed.

4. The effects of the crisis on companies vary significantly by sector, reflecting the contraction in domestic demand, the February 2001 devaluation of the Turkish lira, and the share of exports in production. However, a highly volatile exchange rate in the first half of 2001 made it extremely difficult for manufacturers in all sectors to estimate costs and potential revenues. Such uncertainty has forced many companies to scale back operations, slash investments, and even close manufacturing operations, preferring the safety of liquid assets. In 2001 private investments fell by nearly a third. Although operating results worsened in the fourth quarter of 2001, the appreciation of the lira relative to the euro and the U.S. dollar led to a slight improvement in corporate earnings-the result of reduced foreign exchange losses and financial charges. m. Corporate Perceptions of the Crisis

5. To assess corporate performance in the first and second and fourth quarters of 2001 as well as expectations for the rest of the year, more than 10,000 firms were surveyed by the Union of Chambers of Commerce, Industry, Maritime Trade, and Commodity Exchanges of Turkey (TOBB), Ankara Chamber of Commerce (ATO), Ankara Chamber of Industry (ASO), and Istanbul Chamber of Industry (ISO). (See Annex 2 for a summary of the various surveys.) Among the key findings:

* About four out of five respondents to the TOBB and ATO surveys indicated that business was worse in the first quarter of 2001 than in 2000, and about one-third of TOBB respondents and three-fifths of ATO respondents expected conditions to deteriorate further during the rest of the year. * Some 56 percent of TOBB respondents and 65 percent of ATO respondents cut staff in the first quarter, and 41 and 56 percent expected further cuts before the end of 2001. * About 70 percent of TOBB and 50 percent of ATO respondents did not borrow from a bank in the first quarter, and 74 and 80 percent did not expect to borrow during the rest of the year. * Expectations that the devaluation of the lira would boost exports were validated: 25 percent of TOBB and 36 percent of ATO respondents indicated that exports increased in the first quarter, and 31 percent of TOBB respondents expected exports to increase at least 20 percent over the rest of 2001. e Size is an important determinant of distress. Firns of all sizes have been hurt by the crisis, but microenterprises and small firms were hit earlier and harder than medium-size and large firms. * The ASO survey found that many firms around Ankara cancelled orders in the first quarter-60 percent cancelled orders of raw materials, 77 percent intermediary goods, and 84 percent investment goods. * The ISO survey of manufacturers around Istanbul found that small and medium-size enterprises reduced their workforces by 19 percent in the first half of 2001. Among the complete ISO sample (including large firms), 8 percent of the workforce was cut during that period. o Nearly three-quarters of ISO respondents faced financing difficulties, and 7 in 10 were in contention with banks over outstanding loans. o A second ATO survey found that in the first half of 2001 about a third of firms had lost 60 percent or more of their capital, and half had lost 40-60 percent.

Overall, the surveys found corporate distress that is both broad (affecting all types of firms) and deep (with many finns facing the possible loss of all their equity). By mid-2001 there was a clear need for a corporate resolution program to complement bank restructuring. - iii -

6. Less extensive follow-up surveys were conducted by TOBB to assess results for the fourth quarter of 2001 and expectations for 2002, and by ASO for the third and fourth quarters of 2001 and expectations for 2002. Among the key findings:'

* The ASO survey found that most firms saw production, domestic sales, international sales, and new orders fall in the third and fourth quarters and anticipated continued declines in 2002. * The TOBB survey found that 62 percent of small and medium-size firms and 40 percent of large firms saw their situation worsen in the fourth quarter, while things improved for 8 percent of small firms and 15 percent of large firms. Looking to 2002, 26 percent of small firms expected conditions to improve, 42 percent expected no change, and 32 percent expected things to continue deteriorating. Large firms were more optimistic, with 41 percent expecting improvement, 28 percent expecting no change, and 31 percent expecting continued deterioration. * Among TOBB respondents, 70 percent of small firms andA49 percent of large firms saw sales fall in the fourth quarter. For 2002, 63 percent of small firms expected sales to decline or not to change. Large firms were more optimistic, with 48 percent expecting sales to increase. * A majority of firms in the ASO survey experienced no changes in employment in the third and fourth quarters and anticipated the same for 2002. But almost 40 percent of firms indicated that employment had decreased during the second half of the year and expected employment to continue decreasing. The TOBB survey, in contrast, found that 62 percent of small firms and 46 percent of large firms had cut workers in the fourth quarter. For 2002, 47 percent of small firms anticipated no change in their workforces, while 27 percent of large firms expect to hire. However, 37 percent of small firms and 40 percent of large firms expect to continue reducing their workforces. * About three-quarters of small firms and half of large firms in the TOBB survey indicated that capacity use had fallen in the fourth quarter. The ASO survey had slightly different results, with capacity use rising from 44 percent in the second quarter of 2001 to 48 percent in the fourth quarter-well below the national averages. * The TOBB survey confirmed expectations about borrowing-88 percent of small firms and 69 percent of large firms did not borrow in the fourth quarter, and about the same ratio did not expect to borrow in 2002. Among firms that did borrow, 13 percent of small firms and 14 percent of large firms were required to increase collateral, 23 percent and 31 percent paid higher interest rates, and 39 percent and 41 percent experienced no change in lending conditions. * The ASO survey found that 24 percent of firms had used commercial bank loans, 8 percent used Eximbank resources, and 7 percent used leasing facilities (with some overlap among these categories). Of the firms that borrowed, 13 percent were required to repay their loans in full during the fourth quarter of 2001. When asked about financial constraints, 30 percent of firms cited high credit costs, 21 percent a rapid increase in

The follow-up surveys are considerably smaller than the surveys conducted in the first half of 2001. But the TOBB survey appears to be reasonably representative of small, medium-size, and large firms, and together the two surveys sample some 330 firms. Nevertheless, caution should be used in drawing conclusions from these survey results. - iv -

working capital requirements, 20 percent an inability to generate cash flow, 15 percent insufficient credits, and 15 percent declining support from financial institutions. * The ASO survey found that 50 percent of firms had cancelled capital investments for the domestic market and 70 percent for the international market. * Finally, TOBB respondents said that the most difficult problems they faced in 2002 were taxes (22 percent of small firms and 20 percent of large firms), depressed domestic demand (14 percent and 20 percent), high operating costs (28 percent and 8 percent), difficulties in repaying or finding financing (15 percent and 9 percent), and collection of receivables (13 percent for both).

7. The follow-up surveys clearly indicate that there was no turnaround in operating performance in the third and fourth quarters of 2001 (a finding confirmed by analysis of Istanbul Stock Exchange data; see below). The employment situation was more mixed-the surveys seem to confirm a bottoming out of layoffs by the end of the year. Still, many firms remain in distress, and developments in the second half of the year did nothing to alleviate it. For 2002, small firms were more pessimistic than large firms about prospects for a turnaround: 41 percent of large firms anticipated a better year.

IV. Analysis of Corporate Distress

8. Data for nonfinancial companies (industry and services) listed on the Istanbul Stock Exchange (ISE)-a sample representative of Turkey's mid-cap and large companies-show worrisome trends. Previous crises (in 1998, 1999, and November 2000) lowered company profits and increased financial fragility. Although economic conditions improved during much of 2000, many firms remained in poor financial health and have had trouble surviving the current crisis. Net profitability declined steadily between late 1997 and late 2000, then turned into major losses in the first half of 2001 in every manufacturing sector except cement and glass. Losses totaled $1.021 billion at the end of the second quarter of 2001, down from profits of $1.567 billion in the same period in 2000. Interest rate coverage on a EBITDA basis dropped below one beginning in the first quarter of 2001 and stayed that way until the fourth quarter. Debt coverage ratio was consistently above one through 1999-2000. In addition, financial expenses rose sharply as a percentage of revenue in the first quarter, hitting 27 percent.

9. By the end of 2001 there was some optimism about corporate performance because of better earnings in the fourth quarter, with listed nonfinancial companies becoming marginally profitable. As noted, earmings were aided by the strength of the Turkish lira relative to the euro and the dollar, which lowered companies' financial charges and foreign exchange losses. However, sales and earnings from operations were actually lower than in any other quarter of the year, partly reflecting seasonal patterns. Thus the hoped-for turnaround or bottoming out in operating performance did not occur. In 2001 sales of listed companies were down 13 percent from 2000, earnings before interest, taxes, depreciation, and amortization (EBITDA) were down 11 percent, and net earnings were down a staggering 80 percent.

10. Many companies were agile in their response to the crisis. For example, they took advantage of export opportunities, with exports up 30 percent for the year. However, financial charges on foreign-denominated debt and foreign exchange losses overwhelmed firms' operating performance, leaving many in deep distress. The automotive industry, consumer durables, food and beverages, electronics and communications, media, and retail sales were the most adversely affected sectors. Only the cement, building materials, glass and ceramics, and airline and ground handling sectors saw better performance in 2001.

11. The recent crises have put a larger share of listed companies at medium or high risk of default. Between the first quarters of 1999 and 2001 the share of listed companies at medium risk rose from 63 to 69 percent-while those at high risk jumped from 2 to 11 percent. Together these companies accounted for 58 percent of listed companies' sales, 56 percent of employment, and 89 percent of bank liabilities.

12. Distressed companies have few opportunities for a turnaround in the short term. Lower domestic demand, the appreciation of the lira, price-sensitive export customers, and the soft global economy may constrain any significant increase in sales. Companies have cut production costs through import substitution and payroll reductions. They have also tried to improve management of working capital, but a general lengthening of receivables and inventories demonstrates the difficulty of doing so in a systemic crisis. As noted, companies have also significantly cut investments, with private investments down nearly a third in 2001. A few companies and banks have made rights offerings to increase equity capital, but the depressed stock market discourages equity financing. In addition, Government borrowing has crowded out the corporate bond market in recent years, and banks have limited lending to blue-chip customers.

13. It is difficult to assess corporate distress from reported financial data. Turkish accounting standards fall far short of International Accounting Standards (IAS), especially in terms of accounting for leases, inflation accounting, requirements for consolidation or equity accounting for investments, and rules on disclosing and provisioning for impaired assets and contingencies. These shortcomings are particularly troublesome for large groups (conglomerates), many of which own financial institutions.

14. Although Turkey's crisis is largely attributable to public debt and the investment activities of domestic banks-rather than, as was the case in East Asia, excess leveraging and defaults by large corporations-the spillover of financial sector distress threatens the real sector. New loans and extensions of old ones are increasingly concentrated in large blue-chip companies, and financing is becoming scarce for small and medium-size companies-especially those with no export orientation. But while the supply of credit is severely constrained, so is the demand. With real interest rates on lira-denominated loans averaging 30 percent, few corporations can afford new bank loans.

15. Bank assets contracted significantly in 2001. Factors contributing to a credit crunch for all but blue-chip borrowers include lending constraints on state banks, the exit of intervened banks from new lending, the need for banks to repay syndicated loans in the second half of 2001, and credit retrenchment by small banks-many or most of which have weakened capital and rising nonperforming loans. The credit crunch will persist throughout the current period of bank recapitalization and probably well beyond. - vi -

16. Several factors will limit the ability of Turkish financial institutions to resolve distress among corporate borrowers. Weak insolvency and foreclosure procedures may encourage a race to seize collateral, inhibiting orderly workouts of nonliquid but viable companies. Small, capital- weakened banks could be particularly nettlesome in corporate workout negotiations. In addition, the considerable power of the Savings Deposit Insurance Fund over intervened banks could work against coordinated resolution strategies. Moreover, the weakened capital positions of large private banks limit their ability and willingness to lend. Recapitalization of the banks is closely linked to corporate workouts.

17. Banks need to recognize that such workouts can reduce nonperforming loans and restore their clients' creditworthiness. In addition, the Banking Regulation and Supervision Agency needs to develop policies that encourage banks to participate in voluntary workouts. The agency also needs to consider regulatory forbearance-whether in terms of not requiring full provisioning for nonperfonning loans or allowing banks to achieve capital adequacy over time. The agency's decision requiring banks to fully disclose their nonperforming loans seems correct in light of East Asia's recent bank crises. The new banking law addresses the issue of capital adequacy. Finally, the required restructuring and privatization of state banks inhibit the Government's ability to provide liquidity to small and medium-size businesses.

18. Extemal factors are also contributing to Turkey's distress, increasing the risk of a stalled recovery. From a corporate perspective, the main external risks are the soft global economy- particularly in Europe, the destination for more than half of Turkey's exports-and the flight to quality in global capital markets. These risks make it difficult for Turkey to attract foreign direct investment and portfolio investment and for Turkish banks and companies to borrow abroad. They will also delay privatization efforts, reduce the proceeds, or both. Another concem is the threat to tourism revenues for 2002 in the wake of the September 11, 2001, terrorist attacks on the United States. Finally, potential intervention in Iraq could hurt the Turkish economy in several ways.

19. The principal factor to Turkey's advantage is that the economic slowdown in OECD countries had led to lower benchmark OECD interest rates, partly offsetting the rise in spreads for Turkey caused by increased risk aversion.

V. Resolution Strategies

20. Debt Resolution. The Government, working with banks and corporations, should implement a program to ease the debt burdens of several hundred mid-cap and large companies. Several thousand small and medium-size enterprises also need such assistance, but it should be provided through systemic measures rather than case-by-case workouts. Including small and medium-size enterprises in the workout process would only bog it down, as in Thailand's recent crisis. The debt resolution program should strengthen monitoring by the Banking Regulation and Supervision Agency (BRSA), introduce an out-of-court workout program geared toward mid-cap and large companies, eliminate tax, legal, and regulatory impediments to operational and financial restructuring of distressed companies, strengthen and streamline insolvency and foreclosure procedures, introduce an enhanced option for business rehabilitation, and expedite - vii - the use of the Savings Deposit Insurance Fund (SDIF) to restructure and sell distressed business assets.

21. In addition, the Government should establish a financial analysis unit in the Treasury to monitor the financial positions of mid-cap and large corporations in distress and with major debt or equity links to local financial institutions. The East Asian crisis showed that a few key indicators could have identified firms highly vulnerable to distress well before they defaulted.

22. A voluntary, out-of-court workout program can provide temporary, financially stabilizing solutions for distressed but viable companies without clogging the courts. To avoid chaotic races among creditors to grab collateral, short-term standstill periods (lasting, say, three months) should be introduced to allow due diligence and preliminary development of workout agreements. In addition, it is essential to have mechanisms for resolving intercreditor disputes and encouraging financial institutions to share some of the losses from corporate restructuring. Rapidly consolidating the financial sector and eliminating weak or nonviable banks would help. New money should have priority status. To impose workouts on holdout minority creditors or public shareholders, it would be useful to obtain court enforcement through an expedited process such as "prepackaged" reorganizations.

23. Drawing on various models-the London approach; the programs implemented in the Republics of Korea, Malaysia, and Thailand; and Mexico's UCABE-and working with the Union of Chambers of Commerce and the Turkish Industrialists' and Businessmen's Association, the Turkish Bankers Association has made substantial progress in formulating such a workout program. Given the level of corporate distress, the program-informally known as the Istanbul approach-should be implemented as soon as possible.

24. The role of the Savings Deposit Insurance Fund and its powers relative to other creditors warrant careful review. The fund's powers should not be used to disadvantage similarly positioned creditors. In fact, the fund-which represents state banks and intervened private banks-will need to be part of any intercreditor agreement. Thus it is important to provide indemnities for executives of state banks who agree to debt reduction or workout arrangements for state and intervened banks.

25. Efforts should be made to expedite the sale of distressed assets through cooperative arrangements with the Savings Deposit Insurance Fund or an asset resolution agency. Given fiscal constraints, however, the Government should not establish a state-owned asset resolution agency. Instead, the Turkish Bankers Association should be encouraged to create one. East Asia shows that commercializing asset management efforts is the only way to moderate the large losses that have traditionally been incurred by state-owned asset management agencies.

26. There may be an opportunity to promote the formation of equity' and debt funds to recapitalize and provide long-term loans to Turkish corporations, as well as to replace short-term with long-term debt. These funds could be modeled on the experience in Korea, where the Korean Development Bank and local commercial banks invested $1.5 billion in four funds managed by Templeton, Scudder, State Street, and Rothschilds. The funds were reasonably - viii - successful and, in at least one case, follow-on funds have been established and financed solely with offshore private capital.

27. Turkey's crisis may encourage distressed companies and banks to divest excess fixed assets or to sell and lease back primary real estate. In addition, banks will need to divest collateral (land, buildings) acquired as a result of the crisis. During its crisis Korea established a land bank so that companies could divest excess property holdings, with an option to reacquire them in the future. It did so to prevent a precipitous fall in values, as occurred in Japan. Although Korea's real estate investment trust (REIT) was owned by the state, Turkey could attract institutional investors to establish REITs.

28. Policy Measures. Some tax, legal, and regulatory impediments to corporate restructuring have already been addressed-for example, the Government has introduced tax relief for restructured debt and for corporate reorganizations and mergers. However, the banks would like to exclude value added tax (VAT) from workout transactions.

29. Insolvency and foreclosure procedures must be enhanced to facilitate the court- supervised rehabilitation of distressed but viable companies, to encourage debtors to cooperate with out-of-court workouts, and to impose reasonable solutions to corporate distress on holdout creditors and public shareholders. Key reforms include expediting procedures for seizing and selling collateral, enhancing court-supervised rehabilitation, and introducing an option for a fast- track, "prepackaged" reorganization.

30. To meet the need for increased equity and debt financing in 2002, particularly from foreign investors, Turkey should adopt International Accounting Standards for all listed companies and for unlisted affiliates and subsidiaries of large corporate groups. Better accounting standards and information disclosure are also important for companies undergoing *workouts, which typically reschedule debt over some medium-term period. The World Bank is pursuing more systematic accounting reforms with the Government, but that effort will likely take several years to complete.

31. Corporate Governance. The Capital Markets Board should adopt a corporate governance code that includes principles on transparency and disclosure. The code should also require the provision of timely, accurate information and bolster the rights of minority shareholders. In addition, Turkey should consider creating an institute of directors to train independent directors for seats on the boards of listed companies.

32. Postscript on Resolution Strategies. The Government announced the start of the workout program, known as the Istanbul Approach, as of June 1, 2002. The Turkish Bankers Association, working with Government and industry representatives, took the lead in developing a voluntary, non-judicial workout program based on the London Approach. The program, informally required the strong backing of the Treasury and the Ministry of Finance because of the policy and regulatory implications and the tax incentives required to make such a program operational. In addition, the Banking Regulation and Supervision Agency and the Savings Deposit Insurance Fund were involved in establishing clear provisioning rules in support of workouts and in coordinating workouts with intervened banks. Some 34 commercial banks and - 1x - non-bank financial intermediaries, intervened banks represented by SDIF and state banks signed an inter-creditor agreement that governs the process.

The workout program addressed the following important issues:

* The willingness of creditors to pursue a non-judicial resolution to a company's financial difficulties rather than resort to a formal process of seizing collateral or an insolvency procedure such as liquidation. The out-of-court program process was time bound, with a maximum period set at 180 days for reaching agreement between the creditors and the debtor.

* The process also required approval by a majority of creditors-those accounting for at least 75 percent of outstanding credit meant that the workout was approved. In the event that 55 percent of creditors by value approved the workout, but not 75 percent, the workout proposal was referred to arbitration.

* Creating an arbitration panel to resolve inter-creditor disputes.

* The commissioning by creditors of an independent due diligence review of each distressed company's long-term viability, drawing on comprehensive information made available by and shared between all the likely parties to any workout.

* Drawing on the independent review, encouraging each company's main creditors to work together through a Creditors' Committee to reach a joint conclusion on whether a company is viable and on what terms it is worth supporting in the longer term.

* During the review and negotiation of each workout, agreeing to a standstill, that is seeing whether the company's bankers will agree to maintain their credit facilities, thereby preserving the confidence of workers, suppliers, and customers by allowing the company to continue to operate normally.

* Allowing companies to supplement their borrowing in case of a liquidity shortfall. New money could be provided on a pro rata basis by all existing lenders, by specific lenders with priority arrangements, or by the release of asset disposal proceeds subject to priority considerations. (Other principles underlying this critical period of financial support include recognizing the seniority of existing claims and sharing losses on an equal basis between creditors in the same category.)

* If creditors agree that a company is viable over the long term, they then agreed to a formal rescheduling of the debts plus whatever other financial restructuring measures they deemed appropriate-such as an interest holiday, re-capitalization of interest in arrears, extension of loan maturities, lending of new money, or conversion of debt to equity. o These longer-term financial changes were conditioned in a number of cases on the implementation of an agreed restructuring plan that may involve management changes, injections of fresh equity, sales of assets or divisions, or even company takeovers.

o The Istanbul approach does not guarantee the survival of a company in distress. Regulatory authorities did not intervene and, because of its voluntary nature, the Istanbul Approach was only effective due to its support by the banking community.

33. Corporate iresolution results. By end January 2003, 216 companies, employing 32,000 workers and exporting goods and service in an amount of US$695 million had entered into the Istanbul Approach resolution process. Some US$3.6 billion dollars in non-performing loans were restructured in 96 different companies. Restructured loans were primarily with companies that had non-performing loans. A number of these credits had been rolled over from before the crisis. Disappointingly, there was little real restructuring to complement the workouts. Therefore, it is anticipated that a number of the re-scheduling cases will prove non-viable, as was the case in Korea. Those companies will potentially need to go through another workout round or be forced into bankruptcy or liquidation. Reform of the bankruptcy system remains an important issue.

34. The workout agreements were largely re-schedulings that ranged from 6-14 years. The banks were not prepared to provide significant new working capital to these distressed companies, but did in the end provide fresh working capital on a selective basis and non-cash support in the form of guarantees, letters of credit and construction bonds as appropriate to the workout companies. Also, debt/asset swaps, debt/equity swaps and interest rate reductions were applied to many of the agreements. In general banks were reluctant to accept a "haircut" and write-off their debts.

VI. Other Structural Refoirms That Affect the Corporate Sector

35. Financing the Real Sector. Given the difficult external environment, the Government- working with banks and companies-should take an active approach to attract institutional investors to the real sector for working capital, equity infusions, trade finance, and the substitution of long-term for short-term debt. For example, domestic and international banks should restore and expand trade lines and trade guarantees. Turkish banks had to repay substantial syndicated loans in 2001, and it appears that only four or five private banks have been able to replace these loans-though at just 45-50 percent of prior levels.

36. For economic, social, and political reasons there is a need for broad assistance to distressed small and medium-size enterprises. Thus the Government should analyze the need to provide these enterprises with liquidity and working capital beyond the $400 million already provided through Halk Bank and Ziraat Bank. Any additional liquidity should be provided through budget transfers. To the extent that public banks are used to assist in intermediation, they should act as agents for the Government and not assume additional risk in financing small and medium-size enterprises. In areas lacking sufficient banking services (such as the southeast and the Black Sea coast), the Government should encourage the entry of microfinance - xi - institutions to help create jobs and alleviate poverty. Such an effort could attract support from bilateral sources and nongovernmental organizations (NGOs).

37. Attracting Foreign Direct Investment. A study by the World Banks Foreign Investment Advisory Service (FIAS) indicates that Turkey's constraints on attracting foreign direct investment are not only legal and administrative but, perhaps more important, involve Govermment commitment. Thus the Government and the Foreign Investors Association of Turkey, working with foreign investors and major business organizations, should implement an active campaign to attract foreign investment and to counter negative attitudes-domestic and foreign. Foreign direct investment is needed to recapitalize private banks, nonbank financial institutions, and corporations in distress. The Government should also consider creating an investment promotion agency, as recommended by FIAS and in line with best practices.

38. The Government has requested World Bank Group and International Monetary Fund (IMF) support in establishing a small, high-level, private sector-driven Investment Advisory Council. The council is intended to increase understanding between the Government and private investors and to identify and accelerate Government measures to improve the investment climate, including increased productivity and employment. Thirteen chief executive officers of multinational companies with investment interests in Turkey have committed to participate in the council.

39. Accelerating Privatization. The Government should also take steps to depoliticize and strengthen the privatization process. Doing so would enable the Privatization Administration to remove saleable loss-making companies from its portfolio as quickly as possible. Finally, the Privatization Administration should do a detailed portfolio evaluation to determine potential refinancing needs based on results for 2001. Although external market conditions have delayed privatization transactions slated for 2001 and 2002, efforts to increase the Privatization Administration's independence and clean up its portfolio should take place now in anticipation of better market conditions. - xli -

Summary of Recommendations

40. The table below summarizes the recommendations offered in this report. The recommendations fall into three groups: resolution strategies to help banks and firms resolve their "mutual hostage" dilemma, policy changes for the Government to facilitate resolution and attract foreign direct investment, and financing measures to help firms overcome the credit crunch, which is expected to continue for the immediate future. The recommendations are also split between short-term measures (those likely to have an impact over the next 6-12 months) and medium-term measures (those with an impact over the next one to three years). The medium-term measures are crucial because corporate distress will likely continue well beyond the initial macroeconomic recovery. Moreover, many of these measures-such as facilitating foreign direct investment and improving the management and transparency of large corporate groups-will have long-lasting effects. - xiii -

Summary of Key Recommendations Timing of expected impact Recommendation Short term Medium term Strategies to Help Resolve Crisis-induced Problems * Establish a crisis management team and necessary X X organizational capabilities * Develop a system to assess the impact of the crisis and X X of measures taken to support the real sector - Monitor large corporations with significant debt or equity links to local financial institutions - Survey small and medium-size enterpnses regularly and consistently * Develop a corporate workout program based on the X X London approach * Commercialize asset resolution mechanisms X X * Roll over loans from state banks to small and medium- X size enterprises for 6-12 months Policy Changes * Develop an enabling legal environment for corporate X X restructuring and mergers and acquisitions * Enhance insolvency and foreclosure procedures to X X facilitate pre-packaged bankruptcies * Enact a re-drafted bankruptcy law X * Adopt IAS for listed companies to improve X transparency, compliance, and monitoring and to facilitate foreign direct investment * Strengthen corporate governance standards for listed X companies to improve management and facilitate foreign direct investment Financing the Real Sector * Expand trade finance facilities X * Provide financing to small businesses in underserviced X areas through microfinance institutions * Attract foreign direct investment to inject long-term X debt and equity into banks and companies - Encourage recapitalization of private banks through X foreign partnerships - Sell intervened banks to foreign banks X X - Privatize state banks X X - Accelerate the privatization program X X - Improve tax laws to encourage mergers and X acquisitions by foreign companies x

THE REPUBLIC OF TURKEY CORPORATE SECTOR IMPACT ASSESSMENT

1. INTRODUCTION

1. Many Turkish companies are experiencing distress as a result of the economic and financial crisis that started in February 2001. For several years companies have faced unstable political and economic conditions with high inflation, high real interest rates, and bloated state enterprises. Moreover, industry has had to deal with a series of recent crises: Turkey's 1994 crisis, the contagion effects of the 1997-98 East Asian and Russian crises, the crisis that emerged from Turkey's earthquakes in 1999, and the country's November 2000 crisis. Because previous crises lowered profits, many companies were already fragile at the onset of the current crisis.

2. Although economic conditions were favorable for most of 2000, they were not sufficient to improve the financial condition of many firms. And while Turkish firms have learned how to cope with crises, the current crisis is deeper than the previous ones and will leave in its wake many struggling companies. In addition, Turkey's economy is being hit by adverse external factors- including a weakening global economy, particularly in Europe, and the difficulty of attracting portfolio investment and foreign direct investment amid the regional turbulence resulting from the September 11, 2001 terrorist attacks on the United States. Further destabilization in the region could significantly harm the economy, particularly tourism revenues.

3. Until recently Turkey's weak coalition governments lacked the will to address deep-rooted structural problems. Reforms proceeded in starts and stops, causing considerable damage to industry. Moreover, banks are just as distressed as firms (if not more) and cannot be restructured unless their portfolio problems are addressed through a corporate resolution strategy. Ultimately, resolving Turkey's corporate distress will require political will to implement a new economic program. This report evaluates Turkey's current crisis to provide senior policymakers with an assessment of its effects on firms and to provide policy and operational recommendations to help the Government address corporate distress during and immediately after the crisis.

4. In the short term the Government's Economic Growth Program projects a recovery led by a rebound in exports, supported by strong tourism. In the medium term the program expects bank reforms-as detailed in the World Bank's Programmatic Financial and Public Sector Adjustment Loan -to lower real interest rates. The program also expects a growing role for the private sector, to be led by foreign direct investment. The timing of certain actions will depend on when the real sector starts to recover. In the first half of 2001 tourism was at its highest level in several years. However, external developments, starting with the September 11 terrorist attacks, lowered expectations for the rest of 2001 and 2002. In addition, external remittances have fallen due to Europe's softer economy, especially in Germany. Finally, it remains unclear when and to what extent growth will resume in other sectors. - 2 -

5. The main data sources for this report are Government statistical agencies-primarily the Central Bank and State Institute of Statistics-and filings of companies listed on the Istanbul Stock Exchange. The report also uses the annual reports of some large corporate groups and corporate financial analyses prepared by brokerage firms and investment banks inside and outside Turkey. In addition, the report draws on surveys conducted by Turkish organizations and on interviews conducted by the authors.

6. A few caveats are in order. First, the report does not discuss the events that led to the crisis or include a detailed macroeconomic analysis of the crisis or of the Government's Economic Growth Program, except to the extent that these are relevant to the assessment of corporate distress. Such analyses can be found in the World Bank's revised Country Assistance Strategy (June 2001) in the report describing the Bank's recent structural adjustment loan, "Turkey: Programmatic Financial and Public Sector Adjustment Loan" (June 2001) in the Intemational Monetary Fund's country program; and in reports prepared by many associations, investment banks, and brokerage firms inside and outside Turkey. Second, the report does not address the banking sector except to the extent that banking issues affect the corporate sector. However, World Bank staff have been working with the Turkish Govermment on bank reformns since 1998. These reforms are documented in Bank reports on the "Financial Sector Adjustment Loan" (December 2000) and on the Programmatic Financial and Public Sector Adjustment Loan (see above). In addition, the Bank has provided support to Turkey's Eximbank through the Export Finance Intermediation Project (June 1999), which supplied about US$250 million in financing to eligible exporters. - 3 -

2. OVERVIEW OF THE CRISIS

7. Companies and business associations have little confidence in Turkey's political establishment. This, together with the collapse of domestic markets, translates into a lack of business confidence-a fact clear from surveys of some 10,000 firms across Turkey (see Chapter 3). Many businesspeople had confidence in the Government's early 2000 stabilization program, established in conjunction with the International Monetary Fund (IMF). When the program failed in February 2001 over what was perceived as political infighting, businesses across the country were hurt-with many on the brink of insolvency-and business activity was paralyzed for several months. For the economy to grow and remain competitive, consumer and business confidence must return and the boom and bust cycles of recent years must end.

The Government's Economic Growth Program-and Recent Developments

8. The Goyernment's Economic Growth Program aims to sharply reduce inflation by the end of 2002, stabilize the Turkish Lira (which underwent around 40 percent devaluation in February 2001, from 685 thousand TL/$ to 957 thousand TLI$ in one day on February 22, was as high as 1,639 thousand and slowly stabilized in the first quarter of 2002 to 1,356 thousand TL/$), lower real interest rates, and ease public sector borrowing requirements and the associated crowding out of financial markets (Table 1). In addition, the Government has committed to a series of structural reforms, including restructuring and privatizing state banks, divesting previously intervened banks, resuming the privatization program, and attracting foreign direct investment (FDI). However, these reforms will be slowed by the deep recession in the domestic economy and the worsening extemal environment, especially since September 11. Increasing FDI by restarting the privatization program and attracting FDI and portfolio investment to distressed corporations and banks will be especially difficult with the flight to quality occurring in international capital markets. It will also be difficult for the Government to raise funds in global capital markets-funds that it desperately needs to service debt.

9. Making matters worse, worker remittances dropped by a third in the first half of 2001 (Morgan Stanley 2001c). In addition, tourism revenues-robust through August 2001 and one of the economy's few bright spots-could suffer if there is further conflict in the region. All these developments have made Turkey far more reliant on official capital flows than was anticipated in the Government's economic program.

10. The Government has enacted important reforms in support of its economic program and by the end of 2001 macroeconomic stabilization was evident, with lower inflation and interest rates and the generation of a primary surplus. In addition, the Government has managed its debt servicing requirements and debt rollovers with agility. However, GNP growth remains a challenge, having fallen by 9.4 percent in 2001-far below the original forecast of a 3.0 percent drop and a revised forecast of a 5.5 percent drop. Moreover, Turkey remains highly indebted, leaving it vulnerable to external shocks-political or economic. In addition, corporate interest rates will remain high as long as the Government has to rely on capital markets to finance itself. -4 -

Table 11. Macroeconomlies Parameters, 1997-2002

1997 1998 1999 2000 2001 2002 Estimate

Real GNP growth 8.3% 3.9% -6.1% 6.3% -9.5% 6.5%

GNP TLtillions 29,393 53,518 78,283 125,596 176,484 271,406 Percentage Change 96.2% 82.1% 46.3% 60.4% 40.5% 53.8%

GNP US$ biHlons 193.9 205.5 187 4 201.3 144.0 180.5

GNP deflator (average) 81.2% 75.3% 55.8% 50.9% 55 3% 44.4%

CPI (average) 85.7% 84.6% 64.9% 54.9% 54.4% 45.1% Dec-Dec 99.1% 69.7% 68.8% 39.0% 68.5% 31.0%

WPI (average) 81.8% 71.8% 53.1% 51.4% 61.6% 50.0% Dec-Dec 91.0% 54.3% 62.9% 32.7% 88.6% 30.0%

Average interest rate on T-biIIs 105.2% 115.7% 106.2% 38.0% 99.1% 63.9%

Average exchange rate TL/US$ 151,628 260,403 417,758 623,973 1,225,490 1,503,745 Percentage change (average) 87.1% 71.7% 60.4% 49.4% 96.4% 22.7%

End-of-period exchange rate TI 205,110 313,707 540,098 671,765 1,446,638 1,612,106 Percentage change (Dec-Dec) 90.8% 52.9% 72.2% 24.4% 115.3% 11.4%

RER (average period, 1990=100 94.0 102.0 106.2 116.7 89.6 104.2 average 6.4% 8.5% 4.1% 9.9% -23.3% 16.3% Dec-Dec 13.5% 3.9% 5.6% 13.7% -23.6% 15.6% Source: Treasury, IMF and WB.

11. The difficult external environment will continue to put pressure on the Turkish economy. Achieving the goals of the Government's growth program will require political will, political cohesiveness, and staying power. None of the resolution measures recommended in this report (see Chapter 5), either together or separately, will be as important for establishing a political and economic environment that builds consumer and business confidence. Still, those measures will provide crucial short-term assistance to firms and banks.

A Deeper Crisis Than Befoire

12. Economic indicators point to a steep decline in business activity since Turkey's crisis began in February 2001. The crisis is deeper and potentially more adverse to industry than any since World War II. Instead of a V-shaped recovery led by an export surge resulting from the sharp devaluation of the lira, as in 1994, Turkey is experiencing a U-shaped recovery- potentially extending over a long period, with only modest growth in 2002 (JP Morgan 2001c). - 5 -

Private consumption fell 4.8 percent in 1994 and 2.6 percent in 1999, but in 2001 consumption fell by 9.4 percent (Morgan Stanley 2001a).

13. Sales and Demand. Consumer demand-expressed as sales-has fallen in all industrial sectors. In the second quarter of 2001 GNP dropped by 11.8 percent (Figure 1), private consumption by 11.5 percent (the largest drop since World War II), and gross fixed investment by 32.1 percent. In year 2001, as GNP declined by 9.4, industry declined by 7.5 percent, construction by 5.9 percent, financial institutions by 9.9 percent (though these losses are understated), and transportation and communication by 4.9 percent (Table 2).

Figure 1. Quarterly Changes in GNP in Constant Prices, 1999 Q3-2001 Q2 (%)

10 7.2

4 2 7 6

0 3rd - 99 4U st-00 2nd-00 3=.9(0 45 - 1 01 2nd -Ot

.106 -11 8 -15

Source: State Institute of Statistics, February 2002.

Table 2. Changes in GNP by Sector, 2001 (%) Sector 2001 2001 2001 2001 2001 Q1 Q2 Q3 Q4 Overall Agriculture 8.5 -2.9 -5.6 -13.6 -6.1 Industry - 0.8 -10.1 8.9 -10.7 -7.5 Construction -5.2 -5.8 8.3 -3.6 -5.9 Trade 2.3 -12.1 -7.4 -14.4 -9.4 Transportation and Communication -2.3 -8.8 -4.5 -3.7 -4.9 Financial Institutions -5.3 -10.0 -9.8 -14.2 -9.9 Home Ownership 2.2 2.1 2.1 2.0 2.1 Miscellaneous Services -0.3 9.7 -7.8 -10.4 -7.4 Public Services 2.2 1.9 0.9 1.0 1.5 Private Nonprofit Organizations 1.7 -0.3 -0.3 0.0 0.2 Import Tax -10.1 -28.0 28.0 -28.4 -25.1 GNP --3.1 -12.1- -9.0 -12.3 -9.4 Source: State Institute of Statistics, March 2002.

14. Exports and Imports. Turkey's trade deficit has shrunk in line with Government expectations, with exports increasing 12.3 percent and imports falling 25.7 percent in 2001 (Table 3). However, there is evidence that the gains from the devaluation of the lira have peaked. Moreover, export growth may slow in 2002 due to the appreciation of the lira and - 6 - adverse economic conditions in Europe (which accounts for 53 percent of Turkey's exports) and the United States (8 percent).

Table 3. Exports, Imports, and the Trade Deficit, December and January-December 2000-01 (millions of U.S. dollars) December January-December Indicator 2000 2001 Change (%) 2000 2001 Change (%)

Exports 2,489 2,536 1.9 27,774 31,186 12.3

Imports 4,437 3,473 -21.7 54,502 40,506 -25.7

Trade Deficit -1,948 -936 -51.9 -26,727 -9,320 -65.1

Sufficiency Ratio (%) 56.1 73.0 51.0 77.0 Source: State Institute of Statistics, Foreign Trade Statistics, February 2002.

15. Production and Capacity Use. Industrial production fell 8.9 percent in the first half of 2001 relative to the first half of 2000, with manufacturing dropping 9.9 percent (Table 4). Capacity use in private manufacturing declined to 62 percent in March 2001 but by the end of the year had rebounded to 68 percent-though this is still below the use rate many plants require to break even (Table 5). For most of 2001, capacity use exceeded 80 percent in public plants for commodity industries such as steel, oil, and petrochemicals, largely due to import substitution.

Table 4. Annualized Changes in IndustriaR Production, December and January-December 2000-01 (%) lDecember Janua-December Sector 2000 2001 2000 2001 All Industry -4.1 -9.4 5.5 -8.9 Mining -10.0 -7.2 - 4.4 -7.9 Manufacturing -4.3 -10.9 5.7 -9.9 Energy (Electricity, Gas, and Water) 0.2 2.1 7.3 -1.5 Source: State Institute of Statistics, Monthly Industrial Production Index Bulletin, February 2002. -7 -

Table 5. Capacity Use Rates in Manufacturing, January-December 2000-01 (%) Total Public Private Month 2000 2001 2000 2001 2000 2001 January 73.0 71.7 78.4 76.7 69.7 68.3 February 74.0 71.0 74.8 76.6 73.5 65.5 March 74.0 71.0 78.4 87.8 71.7 61.8 April 77.2 68.0 81.3 75.0 74.8 63.8 May 77.1 70.4 76.7 84.3 77.4 62.3 June 76.7 71.3 74.4 80.5 78.2 66.3 July 76.4 71.0 78.4 82.9 75.1 65.4 August 75.8 71.4 80.6 81.7 71.8 64.9 September 73.9 72.9 66.0 82.2 79.0 66.8 October 81.3 73.9 84.0 84.6 79.6 67.8 November 79.6 74.1 82.3 84.8 77.6 67.8 December 74.5 73.6 86.7 83.3 65.4 67.6 Source: State Institute of Statistics, Monthly Manufacturing Tendency Survey, September 2002.

16. Investments. During a crisis, capital investments are usually among the first discretionary spending items to be cut-a fact reflected in Turkey's statistics. In constant dollars, gross fixed investments (public and private) fell 32 percent in 2001 (Figure 2).

Figure 2. Changes in Public and Private Investments, 1997-2002 (%)

40- 30 20

-10 Sr1997 Ecni 1999.I 2 2002; S00 r0-20 X -30- -40J

-.- Public Sector Investments --- ~. -PiateAw Sector tnvestments

*Realization estimate. ** Economic Growth Program projection. Source: Economic Indicators of Treasury, January 2002; State Planning Organization, Gross Fixed Investment by Sector, December 2001.

17. Energy Production. In a normal year the demand for power grows by 8-10 percent. Even in 1994 (another crisis year) and 1999 (the year of Turkey's devastating earthquakes) electricity demand grew 4 percent a year. In 2001, however, demand declined (Table 6). Moreover, electricity prices-already subsidized before the crisis-initially failed to keep pace - 8 - with inflation. Adjustments starting in April 2001 have since brought the tariff in line with prices agreed to in the IMF program. However, costs have risen as well, mainly because of higher oil prices and a drought that has forced TEA$ (electricity generation and transmission) to rely more on thermal production instead of less expensive hydropower. In addition, contracts with private producers have forced TEDA$ (electricity distribution) to pay as much as 12 cents per kilowatt-hour, compounding its losses.

Table 6. Changes in Electricity Demand, January- September 2001 (%) January February March April May June Change 4.7 -2.4 -8.9 0.1 -1.6 -0.6 July August September Change -0.9 0.9 -2.2 - - Source: Turkish Electricity Generation and Transmission Company (TEAS) data.

18. TEA$, TEDA$, and BOTA$ (gas distribution) have accumulated a financial deficit of 3.5 quadrillion lira because of overdue accounts with each other and other public institutions. Losses in 2001 increased this deficit. It is not clear if TEA$ or TEDAa have assessed how the crisis will affect them. Large losses would lower the value of electricity distribution companies, impeding their proposed privatization.

19. Unemployment. Formal labor statistics are released quarterly in Turkey. According to the Treasury, formal unemployment rose to 10.6 percent in the fourth quarter of 2001-making for about 884,000 more unemployed workers than in 2000 (Table 7).

Table 7. Employment and Unemployment Indicators, 1998-2001 Number of Number of Unemploye Unemployment Year Employed Workers Workers Rate (%) 1998 22,399,000 1,527,000 6.8 1999 23,187,000 1,774,000 7.6 2000 22,029,000 1,451,000 6.6 2001 Ql 21,031,000 1,809,000 8.7 2001 Q2 21,127,000 1,567,000 6.9 2001 Q3 21,875,000 1,907,000 8.0 2001 Q4 19,742,000 2,335,000 10.6 Source: Turkish Treasury based on State Institute of Statistics, February 2002.

20. Interviews and surveys suggest that unemployment is much higher among small and medium-size enterprises than among large manufacturers. Small companies lost an average of 19 percent of jobs in the first half of 2001, with much larger losses in transport, forestry products, and furniture manufacturing. In medium-size companies job losses ranged from 10-22 percent (ISO 2001a; see also Chapter 3). However, in large companies the real issue is underemployment. Employers are reluctant to lay off workers and so have used every means possible of cutting their hours: accelerating vacation schedules, eliminating overtime, closing plants earlier for maintenance, and informally furloughing workers with the promise of rehiring them when conditions improve. The number of production-related manufacturing workers in the - 9 -

private sector fell 11.9 percent and hours worked fell 13.8 percent in the third quarter of 2001 compared with the same period in 2000 (Table 8).

Table 8. Changes in Production-related Employment in Manufacturing, 2000-0-1 Q3 (%) Number of Number of Sector Workers Hours Worked Public -10.4 -8.9 Private -11.9 -13.8 Average -11.7 -13.2 Source: State Institute of Statistics, February 2002.

21. Company Openings and Closings. According to the State Institute of Statistics, the crisis has slowed the rate of company openings and sped up closings. In 2001 company openings fell 10.5 percent, while firm openings (small businesses and sole proprietorships) fell 24.4 percent (Table 9). Meanwhile, company closings increased 30.5 percent and firm closings 13.7 percent.

Table 9. Number of Companies and Firms Opened and Closed, January - December, 2000 and 2001 2000 2001 Change (%) Category Dec Jan- Dec Dec Jan-Dec Dec Jan-Dec New companies and cooperatives 3,472 33,161 2,410 29,665 -30.6 -10.5 Closed companies and cooperatives 225 1,887 298 2,464 32.4 30.5 New frms 1,863 21,404 1,415 16,171 -24.05 -24.4 Closed frnns 1,135 12,055 866 13,707 -23.7 13.7. Note: Companies are enterprises that have a corporate form4 while firms are usually sole proprietorships. Source: State Institute of Statistics, Enterprise Creation and Closure Statistics, December 2001.

22. Foreign Direct Investment. It has become increasingly important for Turkey to attract FDI to help recapitalize banks and corporations starved for new equity. In addition, the privatization program depends on attracting domestic investors, institutional portfolio investment, and FDI for shares of large firms such as POAa (oil distribution and retailing), TUPRA* (oil refining), PETKIM (petrochemicals), Turk Telecom, Turkish Airlines, and TEDA$. Finally, during bank restructuring in East Asia and Eastern Europe, institutional investors entered the market to purchase the assets of distressed banks-an urgent priority for Turkey. However, Turkey's track record in attracting FDI is poor, and external economic and political conditions will make it difficult to attract external capital in the immediate future.

23. FDI in Turkey hovered around $900 million a year in 1995-99 (Table 10), while in 2000 FDI was about $1,700 million, largely due to privatization revenues. In 2001 FDI reached $3,288 million. In 2000 per capita FDI was $20 in Turkey-compared with $200 in Hungary and $4,300 in Ireland. Increasing FDI is an urgent priority not only to attract resources, but also to improve competitiveness and managerial skills. - 10-

Table 10. Forei n Direct Investment, 1996-2001 Number of Annual Realization Year Foreign Capital Permits Inflows Outflows Net Companies 1996 3,582 3,837 937 325 612 1997 4,068 1,678 873 319 554 1998 4,533 1,647 982 409 573 1999 4,950 1,701 823 685 138 2000 5,328 3,060 1,707 725 982 2001 5,841 2,739 3,288 22 3,266 2002(l) 523 55 0 55 Total ______8,655 2,485 6,180 () January-Ma rch, 2001. Source: Undersecretariat of Treasury; State Planning Organization. 24. The Informal Economy. The informal economy consists of income-generating activities that are unregulated or concealed from govermment. In Turkey these activities involve tax evasion, off-the-books employment, self-employment, and illegal activities such as drug trafficking. The informal economy is quite large and will undoubtedly grow because of the economic crisis. Among the most important causes of the informal economy are the lack of job opportunities in the formal economy and high taxation and excess regulation of formal economic activity.

25. The informal economy is a problem for several reasons. First, it reduces tax revenues. Second, it makes taxes a heavier burden for honest taxpayers, creating inequalities in incomes and tax burdens. Third, the informal economy may draw resources from more productive parts of the economy. Fourth, the informal economy may make official economic statistics misleading, causing errors in government management of the economy. However, the informal economy also has some desirable features, serving as a social and political safety valve by providing income and job opportunities.

26. The so-called suitcase trade is a unique feature of Turkey's informal economy. The suitcase trade gets its name from the luggage used by traders from Commonwealth of Independent States (CIS) countries and the Balkans who transport Turkish goods to CIS and Eastem European markets. The trade, which is largely unrecorded and untaxed, is a major source of hard currency for Turkey. The suitcase trade is expected to increase as a result of the crisis.

27. Inspections by Ministry of Finance auditors indicate that the rate of tax evasion was 25 percent in 1997, 28 percent in 1998, 45 percent in 1999, and 35 percent in 2000. A total of 11.5 quadrillion lira in tax revenue was evaded in 2000 (Turkish Daily News, 30 October 2000). The Central Bank estimates that the informal economy accounts for 20-26 percent of the economy, depending on how it is calculated. In 2001 the Association of Tax Controllers estimated that unregistered transactions represent 45 percent of economic activities and that tax evasion and tax losses equal $15 billion a year. -11 -

28. Poverty. Per capita income was projected to fall to $2,261 in 2001, the lowest level since 1994 (Executive Digest, 15 October 2001). The crisis is having an especially adverse effect on industry, especially small and medium-size enterprises in poorer areas such as the southeast and the Black Sea coast. The crisis will worsen Turkey's income distribution and increase inflation, hitting poor people especially hard (World Bank 2001a).

29. An increase in consumer confidence and a healthier macroeconomic environment-with lower inflation and interest rates and less government crowding out of borrowing-are crucial for resolving corporate distress, as are interrelated structural reforms such as resolving the banking crisis, attracting FDI, and accelerating privatization. However, in the interim there is a need for a resolution program so that healthy businesses hurt by the crisis can continue operations. A resolution program will also lower the social and poverty impact of the crisis. The next chapter uses business surveys to show the depth and extent of corporate distress caused by the crisis. These surveys underscore this report's overall thesis that a program for resolving systemic corporate distress is urgently needed. - 12 -

3. COREPORATE PERCEPTIONS OF THE CRISIS

30. During 2001 several organizations in Turkey-mainly chambers of commerce and industry-conducted surveys to assess corporate distress as well as company expectations for the rest of the year or for 2002. The primary survey for the first quarter was conducted by the Union of Chambers of Commerce, Industry, Maritime Trade, and Commodity Exchanges of Turkey (TOBB), the umbrella organization for all Turkish chambers of commerce. The sample covered all of Turkey, with responses from 3,476 firms. TOBB considers this sample representative of Turkish industry. The Ankara Chamber of Commerce (ATO) conducted a similar survey of 1,720 retailers and small and medium-size enterprises in the Ankara region. Although the TOBB survey is more representative of Turkey as a whole, the TOBB and ATO survey results are presented together in the next section.

31. Thereafter, that the chapter presents the findings of several other surveys-follow-up surveys by TOBB and ATO as well as surveys by the Ankara Chamber of Industry (ASO) and Istanbul Chamber of Industry (ISO) that asked companies in Ankara and Istanbul about results for the first half of 2001 and expectations for the second half. Finally, TOBB and ASO conducted a smaller survey covering the fourth quarter of 2001 and expectations for 2002. (See Annex 2 for a summary of the various surveys.)

32. Overall Distress. A series of TOBB and ATO surveys conducted during the course of 2001, were designed to measure corporate distress in the first quarter of 2001 and expectations for the rest of the year. (See Annex 2 for the dates and other details of these surveys.) About 80 percent of respondents in the first TOBB survey and 83 percent in the first ATO survey said that their businesses were worse off in the first quarter than in 2000 (Figure 3). Moreover, 33 percent of TOBB and 58 percent of ATO respondents believed that conditions would worsen over the rest of the year. In addition, 56 percent of TOBB and 65 percent of ATO respondent firms had cut their workforces, and 41 percent and 56 percent expected such reductions to continue over the rest of the year. Lower demand had hurt nearly all the respondents-77 percent of TOBB and 86 percent of ATO respondents saw sales fall in the first quarter of 2001. - 13 -

Figure 3. TOBB and ATO Survey Findings on Overall Distress, 2001 Ql

1. Hbw was the situation of your estabishment 2. What are your expectations for the remaining In the let quarter of 2001 relative to year 2000? part of 2001 as compared to the first quarter?

go - _

60 -0

40 4

30 m a3

TOBD ATO TOBB ATO

U6.B4.t,SBoo6 f3N.d1 . *W 6,.n200 | |11W8ll. b.~ a0M..dli,,. *--Ilb. |

3. In the first quarter of 2001, what happened to 4. What are your expectations for the remainder the workforce employed at your establishment? of 2001 In the workforce employed at your establishment?

100~~~~~~~~~~~~~~~~~~~~~~~~~0 gooc

60~~~~~~~~~~~~~~~~~~~~~~~9

90 70 70

60~~~~~~~~~~~~~~~~~~~~~~~6 t1 * .86.00,.Inmpln 50 -

40 - 40

30 300.- 10 -2

T ea ATo3TOS 970~~~~~~~~~~~~~~~~~ ATO

8. How did your ealos volume change In the lst quarter ot2001 relative to the last quarter of 2000?

1001. -- - 90

70 90 _

30 10 _

TOBB AT0

1e0bo Cl No diftr. Deose_ | - 14-

33. Financing. More than two-thirds of TOBB respondents and half of ATO respondents did not borrow from a bank in the first quarter, and 74 percent and 80 percent did not expect to borrow during the rest of 2001 (Figure 4). Among the 1,262 firms that did borrow in the first quarter, half paid higher interest rates than in 2000. Just 3 percent of borrowers had their loans withdrawn or additional collateral requested.

Figure 4. TOBB and ATO Survey Findings on Financing, 2001 Qi

8. Did you borrow from tho banks In tho lotquartorof 2001?

100 - 90 80

60O =

50 U & 40 ______30

10

TOBB ATO

| Yes o From time to time o No

7. WUIl you borrow from any bank for tho remalndor oV 2001 ?

100 -

70-

.so

30

20 10-

o - TOBB ATO

34. Export Growth. The Government's economic program expects growth to resume partly as a result of a surge in industrial exports resulting from the devaluation of the Turkish lira. These expectations appear to be validated by the surveys. A quarter of TOBB and more than a third of ATO respondents said that exports had grown in the first quarter of 2001 (Figure 5). For the rest of the year, 31 percent of TOBB and 1 percent of ATO respondents expected exports to grow by more than 20 percent, 38 percent of TOBB and 30 percent of ATO respondents expected growth of 11-20 percent, and 31 percent of TOBB and 69 percent of ATO respondents expected growth of less than 10 percent. - 15 -

Figure 5. TOBB and ATO Survey Findings on Exports, 2001 Ql

9. How did your exports change In the 1st quarter of 2001 relatve to 2000?

100 90 p 80 r 70 s1 57 CS 0 nt 50 40 30 20 7 10

TOga ATO

10. Ityou think yourexports will Increase whatwill be the approximate level of this Increase?

100

80 70 5

40 0 30 20 10 0 TOBB ATO

| More then 20% 0 Between 11% and 20% * Less than 10%

35. Size as a Determinant of a Firm's Condition. Firm size is usually important during a crisis, with the presumption that small firms have less capacity to weather the storm. The initial TOBB survey asked basic questions such as: Is the crisis hurting small firms more than big firms, and do big firms expect to benefit more from the economic program than do small firms? Firms of all sizes have been hurt, but a far larger share of mnicroenterprises (1-10 employees) and small firms (11-59 employees) have been adversely affected. At the end of the first quarter 42 percent of microenterprises and 32 percent of small firms expected the situation to worsen over the rest of 2001, while 37 percent of medium-size firms (60-200 employees) and 46 percent of large firms (more than 200 employees) expected conditions to improve (Figure 6). A majority of all firms expected conditions to stay the same or deteriorate, which is problematic. As for demand and sales, 84 percent of microenterprises, 76 percent of small firms, 71 percent of medium-size firms, and 61 percent of large firms saw sales fall in the first quarter of 2001 relative to the fourth quarter of 2000.

36. TOBB's second follow-up survey found that 62 percent of small and medium-size enterprises and 40 percent of large companies saw conditions deteriorate between the third and fourth quarters of 2001. These findings are supported by an analysis of Istanbul Stock Exchange companies for the third and fourth quarters. Looking to 2002, 33 percent of small and medium- size enterprises and 31 percent of large companies expected the situation to continue to -16- deteriorate (Figure 6a). Just 26 percent of small and medium-size enterprises expected things to improve, compared with 42 percent of large companies.

Figure 6. TOBB Survey Findings on Distiress, by Number of EmpRoyees, 20011 QIl

How was the situation of your establishment in the first quarter of 2001 relative to 2000?

100

80- 60 U

2040 4 _-+ I - . 7 ,1.' 0-10 11-59 60-200 >200

a Better than 2000 o No difference n Worse than 2000

What are your expectations for the remaining part of 2001 as compared to the first quarter?

50 40 30

0-10 11-59 60-200 >200

o Wil be better o No difference o Wdl be worse - 17 -

How did your sales volume change in the first quarter of 2001 relative to the fourth quarter of 2000?

100.0 80.0 600 m - . -M M - 0-10 11-59 60-200 >200

o Increased a No difference * Cecreased

Figure 6a. TOBB Survey Findings on Distress, by Number of Employees, 2001 Q4

How was the situation of your establishment in the fourth quarter of 2001 relative to the third quarter?

70 60 50 40

- 30- 20 10 - 0 Small Enterprises Large Enterprises | Better than Q3 2001 IBNo difference * Worse than Q3 2001

What are your expectations for 2002 as compared to the fourth quarters of 2001 ?

45 40 35

30__ _ 20015 _| 15 10

Srrmaler Enterprises Larger Enterprises

|E A- VWAIIbe better m B- No difference * C- Will be w orse - 18 -

How did your sales volume change in fourth quarter of 2001 relative to the third quarter?

80 70- 60- so -_ s40- 230 M 20 10

Smaller Enterprises Larger Enterprses

| A Increased GS- No difference n C- Decreased

37. In the first quarter of 2001, firms of all sizes-over 40 percent of microenterprises and small firms, 40 percent of medium-size firms, and over 30 percent of large firms-cut their workforces. TOBB's second follow-up survey found that dunng the fourth quarter of 2001, workforces were cut at about 60 percent of small and medium-size enterprises and just under 50 percent of large companies (Figure 7a). About 40 percent of all firms expected to continue reducing their workforces m 2002

Figure 7. TOBB Survey Findings on Changes in Workforce, by Number of Employees, 2001 Q1 In the first quarter of 2001, what happened to the workforce employed at your establishment?

600 50 0

*30 0 20 0 10 0

0-10 11-59 1200 60-200

ao hcrease 0 No difference o Decrease - 19-

What are your expectations for the remainder of 2001 in the workforce employed at your establishment ?

60.0 50.0 ---- _----

40.0 - - fl 1 _2 30.0 20.0 - | | !3 10.0 -_l . . E

0-10 11-59 60-200 >200

EoIncrease l No difference * Decrease

Figure 7a. TOBB Survey Findings on Changes in Workforce, by Number of Employees, 2001 Q4

In the fourth quarter of 2001, what happened to the workforce employed at your establishment?

70 60 50

- 40 ._. -30 - 20__

10 - ___ 0 Srraller Enterprises Larger Enterprises

|IB A, Increased an B- No difference m C- Decreased] - 20 -

What are your expectations for 2002 in the workforce employed at your establishment9

50 40

30

Smaller Enterpnses Larger Enterprises

o Ae Increase 3 B- No difference a C- Decrease

38. As noted, few firms borrowed during the first quarter, no matter what their size (Figure 8). Over the rest of 2001, 37 percent of medium-size firns and 46 percent of large firns expected to borrow. However, with limited credit available, borrowing m the fourth quarter followed a pattern similar to that in the first. Some 88 percent of small and 69 percent of large enterpnses did not borrow in the fourth quarter of 2001 and about the same number did not expect to borrow m 2002.

Figure 8. TOBB Survey Findings on Financing, by Number of Employees, 2001 QI and Q4

Did you borrow from a bank in the first quarter of 2001?

1000

800 -m- - 40 0rr 20 0 wflME=

0-10 11-59 60-200 >200

[n Yes GiziN - 21 -

Did you borrow from a bank in the fourth quarter of 2001?

100 80-- 60

20 __

Smaller Enterprises Larger Enterprises

| Yes * No

39. Size matters significantly for exports-57 percent of medium-size and 68 percent of large firms expected exports to increase in 2001 (Figure 9). Moreover, more than a third of these firns expected exports to increase between 11-20 percent.

Figure 9. TOBB Survey Findings on Expected Export Sales, by Number of Employees, 2001 Ql

Do you expect export sales in 2001 to be greater than in 2000?

100.0 80.0 600

20.0

0-10 11-59 60-200 >200

Yes * No - 22 -

Figure 10. TOBB Survey Findings on Expected Changes in Export Sales, by Number of Employees, 20011 Qi

If you think exports will increase, what will be the approximate level of the increase?

80.0

60.0

40.0 20.0 -_

0-10 11-59 60-200 >200

13 More than 20% O3 Between 11% and 20% * Less than 10%

40. Several surveys assessed firms' responses to the crisis through the first half of 2001, along with their expectations for the second half. Among them are an Ankara Chamber of Industry (ASO) survey, for the third and fourth quarter of 2001 and expectations for 2002, of 167 large manufacturing companies in the Ankara region, an Istanbul Chamber of Industry (ISO) survey, a second Ankara Chamber of Commerce (ATO) survey of 8,170 firms, and a second TOBB survey of 2,542 firms covering all of Turkey.

41. Ankara Chamber of Industry Survey. The first ASO survey, conducted for the first quarter of 2001, provided a number of insights that the other surveys did not. It confirmed the overall decline in sales but indicated that it affected both domestic and intemational sales. This finding supports field interviews in which firms noted that their inability to set an exchange rate for dollars and euros constrained domestic and export sales-with the challenge to domestic sales reflecting the "dollarization" of the domestic economy. Two out of three of the firms surveyed reported a decline in new orders in the fourth quarter of 2000, and four out of five reported a decline in production in the first quarter of 2001 (Figure 11). In nearly every category-production, domestic sales, new orders, and employment-almost three-quarters of these firms expected the situation to worsen during the remainder of 2001. For the third and fourth quarter of 2001, ASO surveys found that most firms saw production, domestic sales, intemational sales and new orders fall and expected continued declines in 2002.

42. Plant capacity use in Ankara fell from a low 59 percent in the fourth quarter of 2000 to a dismal 45 percent in the first two quarters of 2001 and continued to be 45 percent in the third quarter and rise to 47.5 in the fourth quarter of 2001 (Figure 12). Thus capacity use in Ankara was much lower than the national average (about 64 percent in April for private firms). In addition, most of the firms in the ASO survey cancelled orders in the first quarter-60 percent cancelled orders of raw materials, 77 percent cancelled orders of intermediate goods, and 84 percent cancelled orders of investment goods. The third figure is consistent with the large drop in private investment between January and June. Exports became more important, rising from 24 percent of sales in the fourth quarter of 2000 to 36 percent in the second quarter of 2001 (Figure - 23 -

14). Finally, exports rose to over 30 percent in the third quarter of 2001 and fell under 30 percent in the fourth quarter of 2001.

Figure 11. ASO Survey Summary Findings, 2000 Q4 and 2001 Ql, and Expectations for the Rest of 2001

ASO Survey - Evaluation of Qrt 4 2000

80 54 57 ^ O 60 41 ,40 V c22 -U s0 120t1- WWI 0 m ?VodUCt\0r porvl\stis\siac r\ a\esa eOrdefivps rvt

| Increased 0 No Change o Decreased

ASO Survey - Evaluation of Qrt 1 2001

10090------8 6------__ * 70 60 50 - - - 3013-40 -_-____ - - - 20 13-

ptod wOn es"', Sas SravOas tAeNf o gePs

|M Increased E No Change * Decreased

Expectation for the rest of 2001

80.- - 73 _ _75 . 71_72 60 -* 537 4~0 20 -

,Mdu6o * r -deesesd0 Caes

| tBncreased 13 No Change n Decresed - 24 -

Figure Ila. ASO Survey Summairy Findings, 2001 Q3 and Q4, amd Expectatlioms for 2002

ASO Survey- Evaluation for the Gnd of Q3 2001

70- 60-r- '50 40 l i

20

Roduction Domestic tnternatlonal New 6Tnployment Sales Sales Orders

[1Increased n No Change O Decreased

ASO Survey - Evaluation for the end of Q4 2001

60 so ~,40- 30- ~20-

Roduction Domestic nternational New Enployment Sales Sales Orders

0 Increased El No Change El Decreased_|

ASO Survey - Expectation for 2002

60

-50 N ~40

-30 a

C 20in a.0 _ roduction Domestic International New Enployrent Sales Sales Orders

a Increased E No Change El Decreased - 25 -

Figure 12. ASO Survey Findings on Average Plant Capacity Use, 2000 Q4-2001 Q4

Average Capacity Utilization 59.07 60

45 24 44.59

40-

, 20

0.

Fourth quarter of Rrst quarter of Second quarter of 2000 2001 2001

Average Capacity Utilization

60

43.72 45.81 47.56

E 2040 ; ,

Second quarter Thlird quarter of Fourth quarter of of 2001 2001 2001 - 26 -

Figure 13. ASO Survey Findings on Exports as a Share of Sales, 2000 Q4-2001 Q4

ASO-Survey Share of Exports inTotal Sales Average

40 -36 32

,30 24 ~20-

10

10

Fourth quarter of First quarter of Second quarter of 2000 2001 2001

ASO-Survey Share of Exports in Total Sales Average

40-

30-

~20-

10

0 - Second quarter of Third quarter of Fourth quarter of 2001 2001 2001

43. For financing, 46 percent of the Ankara firms used commercial banks, 12 percent used leasing companies, 10 percent used Eximbank, and 3 percent used factoring (with some overlap between these categories). During the first quarter 30 percent of firms were required to repay a loan in full (Figure 14), for a third of those firms, that repayment represented 40-100 percent of external financing. Firms indicated that the number of bounced checks and rejected promissory notes they received rose substantially during the fourth quarter of 2000. Some 87 percent of firms indicated financing constraints, including (in order of importance) high credit costs, higher working capital requirements, failure to generate capital resources, and insufficient credit. (Again, these categories are not exclusive.) - 27 -

Figure 14. ASO Survey Findings on Financing, 2001 Ql

Do you have a credit that you have to closed In the 1st Quarter of 2001?

Yes 3A0%

NoD - 70%

Ranking of Constraints

4 2

High Credit Costs Rapid increasing of Not to Create Own Insufficient Credits Decreasing of Others Managemnnt Resources Supports Capital

44. Istanbul Chamber of Industry Survey. The ISO survey provided the first specific estimates of employment contraction, indicating a 19 percent reduction in workers at small and medium-size enterprises and an 8 percent reduction in the total workforce (Table 11). The survey also found that during the first half of 2001, 58 percent of companies operated at less than half of production capacity. Surprisingly, nearly 80 percent of companies were unable to increase exports appreciably following the devaluation. Nearly three-quarters of responding firms faced financing bottlenecks; to cope, they adopted strategies that included stopping credit sales, reducing employment, delaying payments, offering paid and unpaid leave to workers, and simply halting production. - 28 -

Table 11. ISO Survey Summary Findings

Imidicator Share Capacity use 43 Companies facing financing bottlenecks 73 Companies facing contention with banks 70 Companies contracting production 62 Companies with reduced sales 63 Share of workforce laid off 8 Companies stopping credit sales 38 Companies reducing employment 37 Companies delaying payments 33 Companies offering paid leave to workers 25 Companies offering unpaid leave to workers 29 Companies halting manufacturing 26 Companies halting sales 10

45. Second Ankara Chamber of Commerce Survey. The ATO survey for the second quarter, with 8,170 respondents, provides specific data about reductions in company sales and equity. About a quarter of firms saw sales drop more than 60 percent, and more than half saw drops of 40-60 percent (Figure 15). Nearly a third of firns lost more than 60 percent of their capital, and half lost 40-60 percent-clear indicaiors of extreme corporate distress.

Figure 15. ATO Survey IFindings on Saes and Equity Capital, 2001 Q2

Degree of Shrinkage In Sales Betw een 10-30 percent Vvbre than 18% X-60 percent 26%

Betweei, 40-60 percent 56% - 29 -

Between Eroslon In Euity Capital 10-30

percent X 19% Nbre than 60 percent 30%

Betw een 40-60 percent 51%

Summary

46. The surveys discussed above convey an impression of a crisis that is both broad (affecting all types of firms) and deep (affecting all aspects of business)-and so support the view that the corporate sector will need help through some type of resolution program. Given the high distress among small and medium-size enterprises, any effort to resolve their problems will need to be systemic. For medium-size and large corporations, it appears feasible to take a case-by-case approach to resolving distress. The next chapter confirms that view through financial analysis of more than 200 firms listed on the Istanbul Stock Exchange. - 30 -

4. ANALYSIS OF CORPORATE DISTRESS

47. Data for 1997-2001 for nonfinancial companies-that is, those engaged in industry and services-listed on the Istanbul Stock Exchange (ISE) indicate that:

o Net profitability declined steadily between late 1997 and late 2000-and turned sharply negative in the first quarter of 2001 for a broad range of sectors and companies. These losses continued in the second quarter, leaving many listed companies in fragile condition, but in the third quarter the situation stabilized. Domestic demand grew modestly, so companies saw lower losses, were able to break even, or even showed a small profit. But the recovery in the third quarter was far too modest to relieve corporate distress.

o The fourth quarter of 2001 was a setback, with industry experiencing the worst operating losses, partly due to seasonal factors and partly due to the events surrounding the September 11 terrorist attacks on the United States. However, poor operating results were obscured by the fact that reported corporate net profits were positive for the quarter (Table 12). Profits were positive only because the lira appreciated during the fourth quarter, reducing financial charges and foreign exchange losses.

o In 2001 sales fell 19 percent but exports increased 31 percent, cash flow from operations (EBITDA) declined 13 percent, financial charges and foreign exchange losses increased 240 percent, and net earnings fell by $504 million. The 30 largest companies, which were more leveraged than the average listed company, lost more than $1 billion. - 31 -

Table 12. Earnings of Industrial and Service Companies Listed on the Istanbul Stock Exchange, Fiscal 2001 (millions of U.S. dollars) Cumulative YoY Quarterly 4Q-3Q WS$nu) 2001 2000 Growth 4Q2091 Growth Sales 28,427 35,149 -19.1% 6,706 -8 8% Exports 6,358 4,870 30 6% 1,480 -7 5% Operating Income 2,481 2,740 -9 5% 314 -63 5% EBITDA 4,246 4,871 -12 8% 697 -462% Financial Expenses 4,327 1,799 140% 182 -85 3% Earnings 617 1,121 -44 96% 160 - Earnings All Companies 124 1,716 -92 7% 251 -

Equity 5,480 9,846 -44 3% 5,480 9 6%

Sales ISE-30 16,857 20,934 -19.5% 3,925 -102% Oper.Inc. ISE-30 1,106 1,678 -34 1% 127 -68 1% EBITDA ISE-30 2,153 2,845 -24 3% 349 47.3% Earnings ISE-30 16 1,074 -98 5% 66 176 00% Source Raymond lames Secunties, Turkey, Equity Research, 2002

48. During 2001 losses were broad, affecting every sector of the economy, and deep. Sectors largely dependent on domestic demand-such as automobile manufacturing, food, retailmg, and communications-absorbed especially large losses (Table 13). But considerable losses occurred even in sectors, such as textiles, that reonented themselves primanly to export.

Table 13. Net Profitability by Sector, 199S-2001 (millions of U.S. dollars) _ ~~~1998 1999 _ 2000 2004 INFOMTO TECNLG (1 59) 7 22 7.36 (2 04 CONSUMER DURABLES 225 04 _159 93 171 71 _(36 07 ELECRONICS AND 53 78 249.84 249 52 (533 26 ENER0Y 85.76 164143 56 98 (7 1690 FOOD __ =73.85 19.13 42.05 (189 2

PACKAGINGANDPAPER 21018 (40713 1056 (21.8 HE SRCA ES 675 05 845.62 56116 228.9 STATIONERY 4 40 3.22 3.20 1.4' MAHINERY EQUrPMENT5 1 71 0 08 5 52 (7 731 PUBI ISHING AND MEDIA 74 64 34.84 32 98 (5.9!M MEETAIS (110 22) 114.33 74.22 (169.95 FURNITrURE __ _ _601 2.91_ 1.31_ 1.0X AUTOMOTfVE 243.1 6 45.93 188.1 3 (9 124 MARKE1IING 101 81 64.03 12 43 (175.80 HEALTHISERVICES 0 97 4 80 5 24 0 8 - 32 -

Compas a ,98 19 2.00 200 'FEXTILES 27.56 175.19 38.08 (180.13' GLASS-CEMDENT- CERAMVICS 249.52 210.05 152.99 152.12 TOURISM 7.67 2.25 3.89 (5.11, TRANQSPORTATION 49.24 147.69 91.41 4875 frOTA.L 1,740.74 1,127.33 839.34 (1,016.65, Source. TSKB Research, Main Financial Figures and Ratios of Industrial and Commrercial Listed Companies at ISE, 2002.

O Companies' ability to service debt has declined markedly. The average ratio of liabilities to equity ranged from 124-151 percent between 1997 and 2000 but increased to 177 percent in the first quarter of 2001 (Table 14). This is much lower leverage than, for example, the 500 percent average ratio for the Republic of Korea's 30 largest chaebols at the end of 1997. Still, some sectors and companies (especially large companies) started to see leverage rise above 200 percent in the first quarter of 2001. By the end of the second quarter average leverage had fallen to 156 percent and by the end of 2001 to 149 percent. Leverage was higher for large companies (173 percent), reflecting their ability to borrow in euros or dollars prior to the crisis. Leverage also remained high in sectors such as food, beverages, metals, and textiles.

o Average interest rate coverage dropped below a ratio of 1.0 in the fourth quarter of 2000 and stayed there in the first and second quarters of 2001-meaning that cash flows did not cover interest expenses. Debt is predominantly short term-up to 85 percent for many listed companies-which increases financial vulnerability because loans are repriced quarterly. The spike in interest rates during the early part of the crisis and prevailing high real interest rates since then have made it difficult for firms to service debt. By the end of 2001 average interest rate coverage had improved from second and third quarter levels, but were still below levels needed to service debts.

Table 14. FinanciaR lindicators for Listed Companies, 1997-2001

Indicator 1997 Q4 1998 Q4 1999 Q4 2000 Q4 20,0;Q1 2001 Q2 2001 Q3 2001 Q4 Net Profitability 7.40% 4.80% 2.00% 3.30% -10.60% -4.0% -2.1% 0.2% Liabilities/Equity 124% 126% 147% 129% 177% 156% 165% 149% Eamings before Interest and n.a. 1.7 1.3 1.9 0.6 0.8 0.8 1.02 Taxes/Interest Expenses

Source: Istanbul Stock Exchange data; World Bank staff estimates.

49. Taking pre-crisis average ratios of 131 percent for liabilities to equity and 1.6:1 for earnings before interest and taxes to interest coverage, listed Turkish companies were comparable to companies from Argentina, Colombia, and Mexico (Figure 16). Relative to East Asian companies, Turkish companies had lower ratios of liabilities to equity but similar interest coverage. Compared with companies from Westem Europe, Japan, and the United States, listed Turkish companies had similar or lower liabilities to equity but much lower interest coverage. - 33 -

50. These data suggest that Turkish companies are vulnerable to drops in operating cash flows (such as those arising from contractions in demand) and spikes in interest expenses. During the first several months of the crisis, the debt of most listed companies rose to unsustainable levels, with the average ratio of net debt to equity (weighted by market capitalization) jumping from 13 percent at the end of 2000 to 53 percent in the first quarter of 2001-and then to 95 percent in the second quarter. By comparison, during the 1994 crisis this ratio peaked at 68 percent (Morgan Stanley 2001c, p. 15).

Figure 16. Ratios of Liabilities to Equity and Interest Coverage in Various Economies

V 450 400 * Kcrea 1997 C 350 ; * b~~~~~~~~~~~Idonesia 3350 0 300 rea1998 ._ \ * ~~~~~~~~~~~~~Thailand 250 -200 * Korea 1999 JlPhppmes .0 PakLtant G*o EbaKon8 ISOer * GersalawNorway 9F49ahden lo * Mexic Argcntama * U5 *N#hfflkad * Malaysa X5 * Colomb0a Pet Taiwan * Stng dMa

00 0 1 2 3 4 5 6 7 8 Interest Coverage Ratio Source. LGEconomic Researrh hlstitute, September2000;basedon World BankandAsian Devebopment Bankdata.

Losses in Listed Companies

51. Financing for corporations comes from creditors, internally generated profits, or equity injections by owners. Losses consume resources and can be financed in only three ways. The first is to use the corporation's assets to finance the losses-say, by selling noncore assets or cutting investment in working capital assets such as receivables and inventories. A second way is to rely more on creditors, by delaying payments to trade creditors, negotiating extended repayment terms, failing to make statutory remittances on time, and a host of other techniques. Alone or together, both strategies increase the leverage of a corporation's financial structure and so make it more vulnerable. Both are by nature temporary; a business cannot indefinitely consume its assets or increase its leverage beyond a certain level before creditors take action to protect themselves. The third way to finance losses is for owners or new investors to inject additional equity. Businesses in Turkey have used all three techniques in their efforts to survive the current crisis. The central questions facing Turkish businesses are how long it will take them to recover profitability and whether they or their creditors (or both) have sufficient resources to finance the intervening period.

52. This report's statistical assessment of listed companies is based on the ratios described in Annex 2 and on macroeconomic data from the State Institute of Statistics. Where possible, company data have been segmented by size, sector, and ownership. The five listed state enterprises are treated as a separate group. Listed companies that are part of a group are also treated separately, because the results reported for an enterprise in a group do not necessarily - 34 - reflect the financial situation of the group but are not necessarily comparable to those for independent companies. The main reason is that Turkey's generally accepted accounting principles and Capital Markets Board accounting rules do not require consolidated financial statements. (though the Capital Markets Board recently introduced new requirements for consolidated statements, to take effect in 2003.) The absence of such statements means that intragroup transactions are included in the results reported for individual companies. This approach does not necessarily present a true picture of the situation for the reporting corporation because the results may contain non-arm's-length transactions with other group companies.

53. In the absence of consolidated group financial statements, interviews with many of these groups provided insights into the effects of the crisis on their operations. Although not entirely satisfactory due to a lack of factual underpinning, these interviews lead to a working assumption that large groups are sufficiently diversified, have access to a wide variety of financing (including significant economic power relative to many of their suppliers), and have not been as badly affected by the crisis as stand-alone companies. Thus large groups present fewer risks than smaller conglomerates, which appear increasingly fragile, and stand-alone medium-size companies. This assumption is supported by a review of publicly listed group companies. At the end of March and June 2001, listed companies belonging to a large group were more export- oriented than stand-alone listed companies, were slightly less leveraged, and had less short-term debt as a share of total debt. Still, all the main groups have subsidiaries that have seen their financial situations worsen considerably.

54. Many groups undertook rationalization programs during 2001. These efforts included significant reductions in wage costs, reduced production, asset sales, and injections of new equity. There is a need to rapidly expand and accelerate such efforts in a few groups. In addition, some group subsidiaries will require extensive restructuring, including debt rescheduling. The idea that large, highly complex groups are too big to fail was debunked by the 1997-98 crisis in East Asia and the 1994-95 crisis in Mexico, and there is no reason to assume that Turkish groups are immune to failure-especially given their losses and deteriorating debt service ratios.

55. Of greater immediate concern, however, are the losses that have been suffered by small conglomerates. By the end of March 2001 their losses were -$126 million (compared with profits of $38 million in the same period in 2000), and by June losses had reached -$284 million (down from profits of $48 million). Medium-size stand-alone companies have also suffered losses in sectors such as textiles, food and beverages, retailing, marketing, and distribution.

56. When reviewing the analysis of listed companies, it is important to bear in mind that their reported results are prepared in accordance with accounting principles specified by the Capital Markets Board, which depart in several major ways from International Accounting Standards (see Chapter 5 and Annex 4). Until recent changes by the Capital Markets Board, there were no comprehensive requirements for consolidated financial statements or accounting for inflation, and wide latitude was given to the treatment of depreciation and interest. - 35 -

Prospects for Export-led Growth

57. The Government's economic program anticipates that, as with past crises, recovery will be led by a surge in exports. Thus this report, using 1999 as a starting base, focuses on the recent performance of the sectors with the largest export components (Table 15). The goal is to determine the extent to which these sectors appear to be taking advantage of the improvement in their competitive position resulting from the February 2001 devaluation. It is also useful to examine export revenues as a percentage of total revenues in the most important of these sectors (Table 16). Finally, Table 17 compares the export orientation and profitability of the main export sectors.

Table 15. Exports by Sector and Sector Contribution to GDP, 1999 (%) Share of Share of manufacturing manufacturing sector's contribution to Sector exports GDP Textiles 37.0 16.1 Metal Goods, Machinery, and Equipment 23.6 12.9 Chemicals, Gasoline, Rubber, and Plastic 8.7 19.4 Iron, Steel, and Castings 8.1 7.2 Food, Beverages, and Tobacco 6.0 23.5 Cement and Glass 4.1 4.3 Forest Products 2.5 4.2 Pulp, Paper, and Publishing 0.7 2.4 Other 11.8 14.2 Source: Istanbul Stock Exchange data; World Bank staff estimates.

* Table 16. Export Revenues as a Share of Total Revenues in Selected Sectors, 1999

Sector Share Textiles 42 Iron, Steel, and Castings 36 Metal Goods, Machinery, and Equipment 31 Food, Beverages, and Tobacco 15 Chemicals, Gasoline, Rubber, and Plastic 8 Source: Istanbul Stock Exchange data; World Bank staff estimates. - 36 -

Table 17. Export Oirienitationm and Profitabfiity by Sector9 2000-01 (percenitage of sales) Sector 2000!Ql 2000 Q2 2000 Q3 2000 Q4 2001 !Q1 2001 Q12 2001 Q3 2001 Q4 Tei;Aes Export Orientation 28.6 30.6 26.6 29.4 36.5 38.8 36.9 37.9 Profitability 0.4 1.4 1.9 0.3 -17.2 -8.3 -5.4 -1.4

"G';c-'os' Af.Nwbty mMfynd E -n.- ,ma Export Orientation 43.8 47.4 39.3 34.2 46.7 34.1 46.1 46.5 Profitability -2.0 -1.7 -1.3 0.3 -3.0 -5.8 -0.3 -0.6

2 k'r.-i - Export Orientation 7.9 8.0 6.7 6.4 5.8 10.3 9.4 10.8 Profitability 2.1 3.6 3.4 2.9 -18.3 -12.6 -10.2 -1.7 rin, Stc II and C$st1Lns Export Orientation 7.9 47.4 39.3 6.4 5.8 45.6 46.1 46.5 rofitability 2.1 -1.7 -1.3 2.9 -18.3 -5.0 -0.3 -0.6 acd ; e -, Export Orientation 14.4 18.3 18.7 19.6 12.9 18.2 17.1 15.0 Profitability 3.2 2.2 3.4 1.8 -17.8 -9.0 -4.1 -3.2

,- 5' .- , . .

Export Orientation 29.4 21.5 20.1 21.4 23.2 28.1 30.5 31.8 Profitability 2.0 3.7 4.9 4.6 4.2 5.6 8.5 8.5

Export Orientation 3.7 6.1 4.4 5.7 3.5 5.8 4.8 5.4 Profitability 3.9 6.9 6.4 4.9 -8.8 -1.6 0.4 -1.6

Export Orientation 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Profitability 2.0 0.2 0.9 0.9 -12.7 -10.3 -26.0 -11.4 Source: Istanbul Stock Exchange data; World Bank staff estimates.

58. During the first quarter of 2001 the textiles and the machinery and equipment sectors were able to export a significantly larger portion of their sales than in the comparable period in 2000. All sectors except cement and glass suffered major losses in the first half of 2001. In commodity sectors such as steel and chemicals, the ability to export helped reduce losses in the sector. By the fourth quarter the rate of loss in most sectors had mitigated and the cement and glass sectors remained profitable.

59. The benefits of the devaluation should be assessed for the entire corporate sector, including sectors that do not export a significant amount of their production. Sectors that historically have been major exporters have benefited the most from the devaluation. However, the economy can be divided into sectors that import raw materials and export them after processing, those that import raw materials to make products for the domestic market, those that use domestic inputs for sales in export markets, and those that use primarily domestic inputs for sales in the domestic market. Even the main export sectors derive more than half of their revenues from the domestic market. Thus the health of the domestic market will determine when and how quickly the real sector will recover. Companies in every sector have incurred losses- - 37 - exporters and nonexporters. Some large compames, such as automobile manufacturers and white goods producers, that mcreased exports, are far more dependent on domestic sales than on exports And traditional exporting sectors, such as textiles, remam mired m financial difficulty. Thus a restoration of busmess confidence and an mcrease in domestic demand are essential to economic recovery

Financial Indicators for Listed Companies

60 A companson of the performance and status of listed compamnes for 2001 and in 2000 indicates both the damage the companies have suffered and the ways they have adapted to the Cnsis.

61 A Steep Decline in Profitability As noted, all the main sectors except cement and glass suffered losses in the first and second quarters of 2001 (Figure 17) Food, beverages, tobacco, textiles, chemicals and fuels suffered the sharpest reversals m profitability relative to both all of 2000 and the same quarters in 2000. In 1999 these three sectors accounted for nearly 60 percent of the manufacturing sector's contribution to GDP and for 52 percent of manufacturing exports (see Table 15)

Figure 17. Profitability in Export- and Domestic-oriented Industries, 1997 Q4-2001 Q4

Profitability: Export Industries 150%

10 0% -

50% - - - 00% - r N

-1150%7-S. S _9__ -200%

- - - -Textiles Machinery & Eq - Iron, Steel, Metal

Profitability: Domestic Industries 150%

-50% q8q34-9q1-Oq4--Oq4 9O2-40q3-O tO4-- WQ- , q4

t-O00% -~ ------.------.

-20 0%

- - . -Chemwicals & Fuel -Food & Beverages iPaper and Printing - Cement & Glass_

Source Istanbul Stoc Exc,hange data, World Bank sffes7tiates - 38 -

62. llmadequate lunterest Coverage. Throughout 2001 interest coverage with cash from operations was weak in all sectors except cement and glass (Figure 18). Textiles, chemicals, fuels, food and beverages appear especially vulnerable. Because reported financial expenses can include exchange losses, it is difficult to discern the extent to which these data are distorted. But because the sectors involved are so important-in terms of exports and contributions to GDP- the duration of the weakness in the coverage of financial expenses is critical.

Figure 18. Elnterest Coverage in Export- and Domzestic-oriented lindustries, 1997 Q4-2001 Q4

Onterest Coverage: Export Industries 5.00 4.00 3.00

2.00 _ - 1.00

0.00 97q4 98q1 98q4 99q1 99q4 OOql OOq2 OOq3 OOq4 01ql 01q2 01q3 01q4

-- -Te4iles -Machinery& Eq. Iron, Steel, Metal

Interest Coverage: Domastic lndusMstrs 6.00 5.00 _h. 4.00--______

3.00 -' - 1.00 0.00 97q4 98q1 98q4 99q1 99q4 OOql OOq2 OOq3 OOq4 Olql 01q2 01q3 01q4

| - -*Chemicals & Fuel -Food & Beverages - - -Paper and Printing -Cement&Glass

Source: Istanbul Stock Exchange data; World Bank staff estirnates.

63. Hligh Short-term Liabilities. Short-term liabilities as a percentage of total liabilities increased marginally in all sectors from already high levels. At the end of June 2001 short-term liabilities accounted for an average of 81 percent of the total; among the major exporting sectors the average was closer to 85 percent (Figure 19). This is an unusual, unstable financial structure, and exposes enterprises to far more risk than if their liabilities had more balanced maturities. - 39 -

Figure 19. Short-term Liabilities in Export- and Domestic-oriented Industries, 1997 Q4-2001 Q4 Short-Term Liabilities: Export Industries 1000% 80 0%6----e

60 0% - r 400% 20 0%- 00% 1- - T- 97q4 98q1 98q4 ggql 99q4 OOql OOq2 OOq3 ooq4 Olql 01q2 01q3 01q4

-5- -- Texhles -.- M chinery& Eq - - Iron, Steel, Metal

Short-term Liabilities: Dormstic Industries 100 0%

800%0 - -

600% - - _ . . . -__ _ . 400%0__ %_ 20 0% -______4._._

97q4 98q1 98q4 98q1 99q4 OOq1 00q2 OOq3 OOq4 Olql 01q2 01q3 Olq4

| *- - -Chemicals & Fuel Food & Beverages I - Paperu and Pnnfing Cement & Glass

Source Istanbul Stock Exchange data, World Bank staff estimates

64. High Reliance on Bank Borrowing. Most of the major export sectors have mcreased bank borrowing as a percentage of both long- and short-term liabilities. Textiles, machinery and equipment, and food, beverages, and tobacco not only have the largest shares of short-term liabilities, they also have high shares of bank debt in those ltabilities (Figure 20) Dependence on bank financing may pose difficulties if banks continue to resist sxgmuficantly increasing loans. At the least, the compames with the most bank debt will suffer the most from banks' hlgher pncing structures. The economic recovery will require lower real interest rates from banks, but there is no sign that these will be available in the foreseeable future - 40 -

Figure 20. Bank BTorrowing in Export- aind ID)onmestic-oriemted llmdustries, 1997 Q4-2001 Q4

3Bank Borrowing: Export IndusMres 70.0% -

50.0% - 40.0% - ___ 30.0% 20.0% --._ __-_-_-__-______10.0% ~- - 0.0% 97q4 98q1 98q4 99ql 99q4 OOql OOq2 OOq3 00q4 Olql 01q2 01q3 01q4

| - - -TeAiIes -I\chinery& Eq. IIron, Steel, Metal

Bank Borrowing: Donmstic Mndustrles 60 0% 50.0% <.<--- '=_ 40.0% ------____. 30.0% ~ . - ___ -

10.0% -_ 00% 97q4 98q1 98q4 99q1 99q4 OOql OOq2 OOq3 OOq4 Olql 01q2 01q3 01q4

| - - -Chemicals & Fuel -Food & Beverages

|. -Paper and Printing -Cement & Glass Source: Istanbul Stock Exchange data; World Bank staff estimates.

65. Sma$lenr Companies, Bigger Losses. Small listed companies (these companies would be considered mid-cap companies relative to traditional definitions of small and medium-size enterprises) were hit harder by the crisis than were medium-size and large companies. In the first quarter of 2001 their profits dropped 20 percent (compared with 5 percent for medium-size and large companies), their financial expense burden was a staggering 30 percent of sales (compared with 20 percent for large companies), and their interest coverage fell to 0.5-meaning that they could not service their debt (Figure 21). Over the rest of 2001 the losses of small companies declined, averaging 5 percent of sales in the fourth quarter. The assumption is that small listed companies were able to cut costs and in many cases probably stopped servicing their debt. At the end of 2001 their average debt service ratio remained below 1. - 41 -

Figure 21. Does Size Matter? Profitability by Size 100% 50% - ,

-50OW -- 98qt- 98q4 99q -49q4--O0qt- 00q2- OOqS-G4q4 - 2 -0193 -44 -1 00% -150%- -200% - -25 0%

| -Large Medium 4 Small

Financial Expense Burden

40 0% 30 0% f_---____--- ______20 0% - -______… 10 0% - = 00% 97q4 98q1 98q4 99q1 99q4 OOq1 OOq2 OOq3 OOq4 01q1 01q2 01q3 01q4

| _-Large --a-Medium us Small

Export Orientation 400%

30 0% - __ . - - - - - 4 20 0%- >;-- 100% ..

97q4 98q1 98q4 99q1 99q4 OOql 00q2 OOq3 OOq4 Olql 01q2 01q3 01q4

L_ Large -- Medium n Small

Interest Coverage with EBIT 400 3 00-.... ____ 200 - - =< _

1 00 -_ _.--,=

O 00 97q4 98ql 98$ ggq1 99q4 OOqI OOq2 OOq3 00q4 01q1 01q2 01q3 01q4

I + Large -u-Medium t Sall Source Istanbul Stock Exchange data; World Bank staff esmates - 42 -

66. How Many Companies Have Been Damaged by the Crisis? During the first quarter of 2001, 70 listed firms were in distress: 24 had negative equity and were technically insolvent, 40 were financially distressed, and 6 were operationally distressed (Figure 22). Some 210 companies are listed on the Istanbul exchange, but that includes financial companies, group holdings, and state enterprises, all of which were excluded from this analysis. Thus the crisis has greatly increased corporate distress in the private sector. During 1999, a year of crisis due to earthquakes, corporate distress peaked in the fourth quarter at 41 firms in distress among 213 listed companies.

Figure 22. Distressed Companies, 1998-2001 Ql

Total companies listed 194 213 213 210

Sustainable

Operationally distressed

Financially distressed 24

Technically insolvent 1998 1999 2000 2001 Q1

Note: Financial distress is defined as firms that operate at a loss after all financial changes . Operational distress is defined as losses from operations, prior to financial changes.

67. More than 200 listed firms were analyzed in terms of their solvency and categorized under a scoring system devised to reflect their financial distress (see Annex 2). The firms were segmented by size, time (starting with the fourth quarter of 1997 and continuing through the second quarter of 2001), and criteria such as sales, employment, and bank debt. Debt coverage was the primary financial ratio used to define financial distress. A score of 2 indicates some financial distress and a firm's inability to cover its debt service, and a score above 2 means deep financial distress or technical insolvency.

68. Under this system there was a significant increase in deep corporate distress between the first and second quarters of 2001, with the share of firms jumping from 15 to 43 percent. By the fourth quarter 27 percent of bank debt was held by firms with a score of 2, down from 59 percent in the first quarter. However, 41 percent was held by firms with a score above 2, up from 15 - 43 -

percent at year end 2000- meaning that highly indebted firms have moved from some degree of distress to deep distress. This increase demonstrates the urgent need for corporate workouts.

69. Firms with scores of 2 are most eligible for corporate workouts, which are designed to restore a fium's creditworthiness, allow it to continue operating, and retain its value. Firms with scores above 2 have negative equity-that is, they are technically insolvent. This implies that due diligence is needed to determine whether the firm is viable and a workout is likely to restore its creditworthiness.

Strategies Used to Protect and Increase Cash Flows

70. The report team's interviews with companies indicated that they all moved quickly to stem losses by trying to increase exports, lower production and labor costs, and reduce working capital requirements. Various strategies were used to pursue those goals.

71. Increasing Exports. Many of the firms interviewed were accelerating export programs. However, where these programs succeeded, the new sales were often less profitable than sales in the domestic market (Box 1).

72. Substituting Domestic Supplies for Imports. Some companies were substituting local supplies for former imports-for example, the textiles industry used more domestic cotton in 2001 than in 2000. Not all sectors can do this: petroleum products, for example, must be derived from imports. Similarly, inputs may be priced in foreign exchange equivalents even if they are produced and sold locally-particularly inputs such as power purchased from state enterprises. The ability to substitute local intermediate products for former imports is also limited by the manufacturing capacity of local producers. Petkim, for example, cannot produce enough petrochemicals to meet the demand for products that used to be imported. - 44 -

lBox 1. Why Exports Are Not a Complete Solution

The experience of Turkey's white goods sector since the crisis highlights the reduced profitability that can accompany a shift to more competitive export markets. Although production fell to 1.726 million units in the first five months of 2001, down from 2.018 million units in the same period in 2000, exports increased from 0.756 million to 0.945 million units. Thus exports have increased to 55 percent of production, up from 37 percent.

However, while the net profit margin on domestic sales is 10-12 percent, sales to Western Europe produce a margin of just 2-3 percent. Other sales, accounting for less than a third of exports, generate margins of 4-10 percent. The shift from high-margin domestic markets to low-margin export markets reduces the average net profit margin for the sector from 8.5 to 7.2 percent.

Although increased exports are crucial in the face of a major contraction in the domestic market, other changes are needed to ensure the financial viability of the white goods sector. The sector is well positioned to benefit from the devaluation of the lira, because cost components in the, sector are largely denominated in that currency. Sectors with a larger portion of inputs denominated in foreign currencies may not fare as well.

Source: Global Securities Research 2001d.

73. Cutting Labor Costs. Most of the businesses interviewed used a combination of strategies to reduce labor costs, including accelerated vacation schedules and maintenance shutdowns, unpaid leave, and reduced hours. At the time of the interviews, none of the companies had formally terminated workers.

74. Shortening Receivables. Companies tried to shorten payment terms for their customers-to the point of promoting cash sales whenever possible. Despite these efforts, in the first quarter of 2001 the average age of receivables increased in all sectors except textiles (Figure 23). However, during the second quarter there was a marginal improvement in days of receivables outstanding for all listed companies, most likely reflecting the move toward cash transactions. In addition, by the end of the year there was clear improvement, with average days of receivables lower than in 2000. Some sectors-services, chemicals, cement and glass- shortened receivables significantly. Companies have also tried to improve the quality of their aging receivables by taking additional security for payment from their customers. As a measure of the depth of the crisis, some companies have been forced to execute against their security for the first time. -45 -

Figure 23. Ages of Receivables and Inventories for Services and Industry, 1999-2001

Industry 120 100

40 20 -

S9qI 99q4 OOql OOq2 OOq3 OOq4 Otqi Oq2 Olq3 01q4

[-- tDays Receivables - Days Inwentones]

Services 80 - 70 - - 60 -- _ - = = -- --

4 0 - 10- - -- - 30

99q1 99q4 OOq1 OOq2 OOq3 MOq4 Olql 01q2 01q3 01q4

I - Days Receivables -uDays, In anknle7s

Source Istanbul Stock Exchange data, World Bank staff estimnates

75. Aging Inventories. Sales fell so rapidly at the start of the cnsis that manufacturers have been unable to reduce their mventones. Instead, inventones have become much older in most sectors except textiles, where old inventones have long been a problem. The increase in the average age of inventones was particularly pronounced in the machmery and equipment sector, rismg from 53 days at the end of 2000 to 107 days at the end of March 2001, and m the cement and glass sector, where the increase was from 78 to 100 days By the end of June the cement and glass sector had reduced mventories to historical levels and the machinery and equipment mdustry had reduced them to 80 days, still far above histoncal averages. Industry had little success in movmg older mventory over the rest of 2001; the age of inventornes averaged around 80 days

76 Extending Payables. Compames unable to generate resources by reducing shortening receivables and reducmg inventories have tended to meet their financing needs by draggmg out payments to suppliers and others (Figure 24). During the first quarter of 2001 all sectors except paper and pintig saw the average age of payables increase. However, by the end of 2001 - 46 - payables m mdustry averaged 80 days, down from 90 days m the first quarter. Payables in the service sector also declined, to about 45 days-down from almost 60 days.

Figure 24. Age of Payables for Services and Industry, 1999-2001 Q2 Days Payables 100

80 - -_

eO - 20 _ _ _ -- 0 99ql 99q4 OOql OOq2 X0q3 OOq4 Olql 01q2 01q3 01q4 -- Industry - SeNces I

Source Istanbul Stock Exchange data, World Bank staff estimates

77. Aging Obligations to the Government. A companson of the mcrease in the age of payables for commercial liabilities and for all liabtlities suggests that-in the absence of profits or increased bank loans-other liabilities have provided a disproportionate share of the financing needed by businesses This mference is evident in the growing arrears in payments to the Government of vanous taxes and contributions to the Social Insurance Agency. For example, collections as a percentage of assessments for the value added tax collapsed from 81 percent at the end of 2000 to 49 percent at the end of March 2001.

78 Delaying Investments. A number of the compamnes interviewed had deferred or scaled back capital mvestments. These changes are reflected in public and private investment data.

79. Increasing Capital. According to the Industrial Development Bank of Turkey, in the 5.5 months to mid-June 2001, 28 companies and banks made nghts offenngs totaling 266 trillion bra to attract funds to increase their capital bases. The depressed stock market makes equity very expensive, however Many compames have received permission from the Capital Markets Board to increase their capital bases but have not approached the market

Corporate Borrowing

80. Loans to corporations account for a small percentage of Turkish bank assets. By the end of June 2001 corporate credit had fallen to a low of 24 percent of the broad money supply (Morgan Stanley 2001c). In addition, the credit available to corporations is being channeled to a small set of blue-chip companies and large groups. The crisis will likely increase connected lending, despite regulations to the contrary, because banks favor affiliated compames and prefer to reduce their exposure to the rest of industry

81 Maturity Matches-and Mismatches. One unusual feature of Turkey's bankmg system is the short-term nature of both lending and sources of financing. As of March 2001, 69 percent - 47 -

of bank loans to nonbanks were classified as short-term. Surprisingly, given the information provided by corporate borrowers, that is down from 76 percent in March 2000. This shift may be a result of loan reschedulings. Borrowers consistently told the report team that the banks able to continue lending were shortening the terms of such lending. The interviews suggest that three months is the average tern of short-term lending to corporate customers.

82. The average due dates of bank liabilities are also extremely short. According to Garanti Securities, deposits with maturities of less than 30 days account for more than 70 percent of banks' financing base. Disbank reports that the average maturity of foreign exchange deposits fell from 94 days just before the February crisis to 89 days at the end of March 2001. In light of continuing uncertainty, expressed in part by the reluctance of depositors to invest for longer terms, banks have shown little interest in extending the average age of their loans. On the contrary; the banks interviewed indicated that in the near term their strategy was to shrink their loan portfolios, reprice and shorten the terms of the remaining loans, and reorient their assets toward liquid investments.

83. Security and Enforcement. Most bank loans to corporations are secured by pledges, typically against fixed assets, and by guarantees from owners or major shareholders, which are also supported by security. Turkey has little or no lending based on cash flows. There is also no way to support working capital loans through liens on floating collateral (inventories and accounts receivable). Banks typically ensure that the value of the pledged property significantly exceeds the loan amount. In addition to shorter terms and higher prices, banks have recently often requested additional collateral as a condition for continued lending. Obviously there is a limit on banks' ability to take additional real property to secure existing loans. Moreover, the crisis is bound to make collateral less valuable, making it harder for banks to sell. Thus the level of collateral is likely to stabilize, and lending is likely to fall.

84. When it comes to collection, this approach to security can lead to a "race to the swiftest," where banks try to seize assets to satisfy amounts owed them without regard for the impact on other lenders or on borrowers. However, the preponderance of mortgage and hypotec security provides a limited number of remedies for lenders. The banks interviewed indicated that while they preferred to negotiate loan reschedulings with borrowers, they were also willing to resort to enforcement procedures to realize their security-even if the procedures took a long time to conclude.

85. Execution proceedings against borrowers who have granted security for their loans are largely outside the scope of the Execution and Bankruptcy Act. Secured creditors are not bound by a framework of collective resolution and are largely free to pursue individual remedies. This and other features of Turkey's insolvency framework seriously impede the establishment of a framework for restructuring corporations (see Chapter 5).

86. Fragmented Banking. Turkish corporations typically deal with several banks, depending on their needs. Syndicated lending to large borrowers is not common, so different banks may hold different security. With this crisis, this approach affects firms in at least two ways. First, many of the banks interviewed indicated that they were. not lending to new customers or would lend only to the highest-quality new borrowers. Thus if a corporation is - 48 - asked to repay a foreign-denominated loan so that one of its banks can repay syndicated loans, the borrower may have considerable difficulty replacing the lost financing through its other banks. Second, the lack of syndicated lending to corporations makes it potentially more difficult to negotiate a rescheduling or restructuring if the borrower is temporarily illiquid.

87. Nonbank Financial Institutions. Nonbank financial intermediaries such as leasing and factoring companies suffered large losses in the first quarter of 2001. Turkey has 88 registered leasing companies, most of them affiliated with banks. Junior players in the market face tough collection problems, particularly for receivables denominated in foreign currency-which account for 60-70 percent of the domestic lease portfolio. Large groups such as Is are urgently recapitalizing their leasing affiliates and other nonbank financial intermediaries.

88. Leasing companies reached a new contract volume of $1.6 billion in 2000, a year of remarkable declines in interest rates in Turkey. While most leasing companies augmented their portfolios more than 50 percent in real terms, income on leasing interest declined considerably due to shrinking interest rates. To offset lower profits, many of the companies increased their foreign currency open positions to take advantage of interest rate differences between foreign borrowing and domestic currency placements. However, the liquidity crisis in November 2000 eliminated their already reduced lease income, and the February 2001 crisis created large capital losses that placed heavy burdens on undercapitalized companies. With the meltdown in financial markets and the payments chain immediately following the February devaluation, leasing companies dramatically increased interest rates on arrears. Interest rates on foreign exchange arrears rose to 30 percent, while interest on lira arrears reached an average of 250 percent. These punitive charges lasted about a month, after which they were restored to current levels of 15-20 percent for foreign exchange leases and 90-100 percent for lira leases.

89. During the first half of 2001 the supply of new leases declined dramatically. Increased prudence, conservatism, and reluctance to establish new credit facilities now characterize the industry's loan process. In 2001 market volume shrank by more than a third.

90. Though it is almost certain that nonperforming loans will grow, it is difficult to say by how much because loans are not uniformly classified by leasing companies. Arrears in the industry increased 15-20 percent in the first quarter and continued to grow over the rest of the year. Increased collection problems were expected to be the most serious problem for the industry in 2001.

91. A Potential Credit Crunch. Many indicators suggest that Turkish businesses have faced a credit crunch since the crisis began.

e Banks are limiting loans to all but blue-chip companies. As noted, many banks are unwilling to increase or even maintain their loan portfolios. There is little appetite for increased lending to the corporate sector, particularly to new customers. Growing nonperforming loans and requests for loan reschedulings are naturally taken as indicators that risk is increasing in the corporate sector-not a conducive environment for increased lending. - 49 -

* Nonbankfinancial intermediation-suchas leasing andfactoring-hasdried up.

* The market in negotiable instruments has declined substantially. In the past there was an informal system of negotiable instruments-consisting of endorsed and discounted postdated checks-that was used to settle accounts directly between businesses. This alternate source of financing has decreased dramatically because transactions between companies have dropped significantly and because an increase in bounced checks has made this system much riskier.

* Fewer banks can offer tradefinancing. In June 2001 no more than five Turkish banks were able to offer the full range of trade finance needed by importers and exporters. The problem mentioned most often was that importers were not able to have letters of credit issued by local banks confirmed by those banks' correspondent banks. The problem apparently is a combination of the caution with which foreign banks are looking at Turkey and weakened correspondent relationships as local banks pay off their syndicated loans without being able to renew them. Countering these influences, however, foreign banks are taking advantage of the void left by the crisis in the banking sector. It is not possible to tell whether foreign banks will be willing to provide all the trade financing needs of the real sector as it attempts to recover or whether these banks will serve only the strongest companies-but the latter seems more likely.

* Interenterprise credits are an unsustainable source of working capital. Attempts to preserve working capital by reducing receivables and inventories while extending payables are a viable strategy for economically strong companies. However, this strategy is not viable on a sustained basis for the entire real sector. Ultimately some businesses will have to secure increased equity infusions if they are to stay in business.

* Foreign direct investment is limited. Despite the Government's best efforts, foreign direct investment is unlikely to play a significant role in providing the capital needed to fund increased real sector activity in the near term.

92. Eximbank Financing of Exports. Eximbank's management claims that it has adequate resources to finance exports. But since it is a second-tier bank, its lending is constrained by the inability of commercial banks to provide acceptable guarantees for corporations seeking export financing. Eximbank finances firms operating inside and outside Turkey. There has been no change in the terms of the outstanding financing since the devaluation, and the bank continues its financing at a concessional rate of less than 10 percent on U.S. dollar loans and less than 56 percent on lira loans. With current inflation, these rates have a negative real cost to domestic borrowers and thus are in great demand by exporters.

Summary 93. As expected, the February 2001 devaluation of the lira has stimulated exports and reduced imports. However, recovery and growth will require additional financing, including increased bank and nonbank facilities. Ideally, firms should also be able to tap the Istanbul Stock Exchange to raise equity, but this is likely to be a limited source until there is a perception - 50 - that the crisis has receded. For several years the bond market has been crowded out by government financing needs, and this is unlikely to change in the near future. For large groups, tapping international equity and bond markets will also be difficult and expensive given the negative sentiment toward the Turkish economy, the flight to quality in global capital markets, and the overall decline in major equity markets. At present, adequate financing is not available to the corporate sector-a matter of considerable concern.

94. Just as important, stress on the real sector continues. Increased nonperforming loans will cause problems for banks and should prompt a revision of the framework for rehabilitating potentially viable illiquid companies. If that is not done, the Government will have a harder time recovering from the crisis because there will be fewer viable firms and, from the perspective of banks, there is some question of whether enforcement procedures will remain adequate when the volume of enforcement actions doubles. Given the heavy caseload of courts, that seems unlikely. Thus Turkey should adopt a corporate resolution strategy to resolve the mutual hostage dilemma between distressed banks and their distressed corporate clients. This strategy and recommended approaches to various resolution issues are discussed in the next chapter. - 51 -

5. RESOLUTION STRATEGIES

95. Implementing a comprehensive resolution strategy should be the top short-term priority in dealing with the Turkish crisis and its effects on corporations. Lessons from the recent crises in East Asia and Mexico (see Annex 1) indicate that the strategy should include:

* Segmenting problem companies. * Monitoring large corporations and groups in distress. * Implementing a voluntary workout program based on the London approach. * Easing tax, legal, and regulatory impediments to crisis resolution. * Improving corporate disclosure and accounting standards. * Enhancing corporate governance.

96. The Government should focus on policy changes that encourage banks and companies to participate in its workout program. The program, known as the Istanbul approach, officially began on June 1, 2002, but implementation was delayed until banks had flushed out nonperforming loans and recapitalized. Newly capitalized banks will have the incentive to reclassify loans and to collect every penny of provisioned loans, because better loan classification and collection of provisioned loan will increase their capital. Banks can also benefit from the tax incentives that are part of the Istanbul approach. Companies that have defaulted on loans, on the other hand, could face accelerated seizure of their collateral if they abstain from the workout process. Getting these kinds of incentives right has proven difficult in East Asia and Mexico.

97. At the same time, banks need to adopt a corporate resolution program, need to be restructured, and require capital. Direct government participation in such efforts-for example, by creating an asset management agency-has proven expensive and generally ineffective. Given the Turkish Government's fiscal constraints, it is preferable that it use its suasion to catalyze a resolution program, not its fiscal resources.

98. The Government, the Turkish Bankers Association, and industry representatives-from the Union of Chambers of Commerce, Industry, Maritime Trade, and Commodity Exchanges (TOBB) and the Turkish Industrialists' and Businessmen's Association (TUSLAD)-are developing a workout program that addresses many of these issues.

99. The recommendations discussed in the rest of this chapter are summarized in Table 18. These measures are divided between resolution strategies to help banks and firms resolve their "mutual hostage" dilemma and policy measures that the Government can adopt to facilitate resolution and attract foreign direct investment (FDI). Some of the measures are short-term (likely to have an impact over the next 6-12 months ), some are medium term (with an impact over the next one to three years). The medium-term measures are just as vital as the short-term measures because corporate distress will likely continue well beyond the initial macroeconomic recovery. Moreover, a number of the medium-term measures will likely have a lasting impact- such as those to facilitate FDI and improve the management and transparency of major corporate groups. - 52 -

Table 18. Key Recommendations for Corporate Resolution Timing of expected impact Recommendation Short term Medium term Strategies to Help Resolve Crisis-induced Problems

a Establish a crisis management team and necessary X X organizational capabilities o Develop a system to assess the impact of the crisis on the X X real sector as well as measures taken to address it -Monitor large corporations with significant debt or equity lmks to local financial institutions -Survey small and medium-size enterprises regularly and consistently (say, through TOBB, ATO, and ASO surveys) o Implement a voluntary workout program based on the X X London approach e Commercialize asset resolution mechanisms X X -Sell distressed assets through an asset resolution agency- preferably one not created by the Govemment -Sell land and real estate through real estate investment trusts (RErTs) a Roll over credits from state banks to small and medium- X size enterprises for six months to a year Policy Changes o Establish an enabling legal environment for corporate X restructuring and mergers and acquisitions o Enhance insolvency and foreclosure procedures to facilitate X X pre-packaged bankruptcies o Enact a re-drafted bankruptcy law X o Adopt International Accounting Standards for all listed X companies to improve transparency, compliance, and monitoring and to facilitate FDI e Improve corporate govemance for listed companies to X enhance management and to facilitate FDI

Segmenting Problem Companies

100. Experiences in other crisis countries suggest that thousands of small and medium-size enterprises, hundreds of microenterprises, and a few large groups may all be in trouble at the same time. Countries have dealt with these issues in various ways (see Annex 1), but all eventually recognized the need to segment problem companies. For example, small and medium-size enterprises-the first and most numerous casualties of such crises, with little power to effect outcomes-are usually too numerous to include in a corporate workout program. Solutions in support of small and medium-size enterprises need to be systemic, such as extended rollovers of credits-including recapitalizations of past-due interest and extended grace periods for principal repayments. The Government also needs to consider injecting liquidity into small and medium-size enterprises to keep them afloat. The financial costs of stabilizing small and - 53 -

medium-size enterprises are small relative to the social and political costs of allowing thousands of them to sink, and should not take much time or effort to apply.

101. At the other end of the spectrum are the large corporate groups that dominate the economy, with complex structures that may include a mix of industrial and financial companies. To the extent that these groups exhibit distress, they need to be monitored carefully and addressed on a case-by-case basis so that their problems do not provoke a secondary crisis and spill over into the banking sector, causing banks and nonbank financial institutions to collapse. The Daewoo collapse in the Republic of Korea is perhaps the most prominent recent example of such a case.

102. Finally, in the middle are mid-cap corporations. Depending on the economy, these firms have $25-100 million in annual sales, normally require bank financing for working capital and to expand, and may be the most adversely affected if a crisis causes a credit crunch, as has happened in Turkey (and happened in East Asia and Mexico). Mid-cap companies-usually using several banks and other financial intermediaries such as leasing companies, as well as supplier credits-normally form the core of a voluntary workout program. With adequate due diligence and a well-structured workout, they can be restored to creditworthiness.

103. Companies can also be segmented by their status: those that are insolvent and need to be liquidated, those that need help and should be saved, and those that can emerge from the crisis on their own. For the first group, crisis resolution demands an agile, effective bankruptcy system so that procedures run smoothly and creditor rights are protected. In addition, an effective bankruptcy system encourages firms to enter into voluntary workouts. The absence of a functioning bankruptcy system created significant problems for early efforts at voluntary workouts in Indonesia, Mexico, and Thailand, slowing the resolution process. For firms that are viable under normal conditions but need assistance as a result of a crisis, the goal is to buy time until the economy normalizes and to provide working capital so that the firms can continue to operate. Finally, some firms can resist a crisis because they have high liquidity, they are export- oriented and can increase exports due to a local currency devaluation, or they are part of a larger group that will support them through the crisis. These firms may not need specific resolution assistance, but they generally need financing to restore growth.

104. A resolution program is also vital to restore the soundness of viable banks and may include an asset management agency to remove the most distressed assets from the books of these banks. The types of segmentation discussed above are at the heart of the resolution strategy proposed below.

Monitoring Large Corporations and Groups in Distress

105. The Government should establish a financial analysis unit in the Treasury to continuously monitor the financial positions of large corporations with significant debt or equity links to local financial institutions. This proposal is drawn directly from the lessons of the East Asian crisis and is intended to help the Government anticipate corporate distress that may lead to deeper distress and to failures in the financial sector-as happened in Korea and Thailand. This unit should also track large firms and mid-cap corporations that analysis shows to be vulnerable to - 54 -

failure, regardless of whether they have financial affiliates. The unit should standardize and consolidate reporting and analysis to facilitate the tracking of problems and should require frequent reporting by firms of a few key measures of liquidity and vulnerability to insolvency. This measure will take on additional importance as Turkey develops forward-looking criteria for provisioning.

106. In most countries systemic banking crises are recognized fairly quickly and dealt with by using established techniques for intervention, restructuring, and eventual merger, privatization, disposal, or liquidation. This task is facilitated by bank regulations and requirements to report on universally defined measures such as capital adequacy, portfolio at risk, and portfolio losses. Because most countries have relatively few banks, tracking their performance is comparatively easy.

107. The corporate sector is very different, however, and poses substantial challenges for governments trying to anticipate or track a crisis. Most governments are not equipped to measure corporate distress. Complicating factors include:

o Large number offirms. Most countries have many enterprises-even just counting large and mid-cap enterprises-making it difficult to figure out which ones are highly indebted and potentially in distress.

o Inadequate accounting and reporting. Accounting standards and external audit requirements are highly variable and often lax. Generally, companies that are publicly listed must report regularly. But disclosure requirements vary considerably across countries, and accounting and audit standards may be so weak that such disclosures are not very meaningful. In Turkey such deficiencies make it difficult for external parties to interpret the financial performance of large corporate groups.

o Accounting gaps. Even where reporting is relatively accurate and comprehensive, as in Korea, it may miss vital areas of analysis-such as intragroup transactions, guarantees between corporate holdings and group subsidiaries and affiliates, and offshore liabilities of corporations-rendering the system incomplete. Requiring the use of International Accounting Standards would address this shortcoming.

o Lack of consolidated reporting. Very large, typically family-owned groups-like those in Argentina, Brazil, Indonesia, Korea, Mexico, the Philippines, and Turkey-may be privately held even if they own publicly listed subsidiaries and affiliates. As a result they may not be required to disclose or report their financial data on a consolidated basis.

o Weak monitoring by banks. Banks content with holding real collateral may not require periodic or adequate reporting from borrowers.

o Fragmented reporting. Reporting requirements may lead to fragmented reporting to different agencies or ministries, making it difficult to piece together a comprehensive picture of corporate performance. - 55 -

108. Given these factors, it is no surprise that governments have difficulty measuring corporate distress and have been slow to address these problems during crises. In fact, the only readily available measure of corporate distress is the extent of portfolio losses or nonperforming loans in the banking system relative to GDP. Although such information may trigger action in the banking system, it is not sufficient to assist in formulating policies and programs for the corporate sector. Moreover, corporate distress needs to be tracked independently as a check against banks that hide their distress and make inadequate provisions for potential losses-as happened often in East Asia and Mexico during their crises.

109. In East Asia standard measures of corporate performance would have allowed governments to quickly assess the degree of distress and take corrective action. Following the progress of corporations during a crisis is vital to anticipate the potential for large-scale failures and for secondary crises in both the corporate and financial sectors. Equally important is the availability of data to enable authorities to implement decisive measures to head off a potential crisis. Analysis from a variety of sources2 indicates that firms highly susceptible to distress during a crisis could have been identified by looking at a few key indicators early on (Mako 1998; Pomerleano 1998; Claessens, Djankov, and Lang 1998; Kawai, Mako, and Lieberman 2000). A rapid but comprehensive analysis of corporate distress by governments, focusing on the largest and most indebted firms, is a vital first step for guiding policy decisions in corporate restructuring.

Implementing a Voluntary Workout Program

110. The Turkish Bankers Association, working with Government and industry representatives, has taken the lead in developing the Istanbul Approach, a voluntary, nonjudicial workout program based on the London approach. The program will require the strong backing of the Treasury and the Ministry of Finance because of the policy and regulatory implications and the tax incentives normally required to make such a program operational. In addition, the Banking Regulation and Supervision Agency and the Savings Deposit Insurance Fund will need to be involved in establishing clear provisioning rules in support of workouts and in coordinating workouts with intervened banks. Moreover, some 34 commercial banks, non-bank financial intermediaries plus intervened banks represented by the SDIF and state banks agreed to sign an inter-creditor agreement that governs the process and its to participants.

111. The Istanbul Approach addresses the following important issues:

* Whether creditors are willing to pursue a nonjudicial resolution to a company's financial difficulties rather than resort to a formal process of seizing collateral or an insolvency procedure such as liquidation. The process is time bound with 180 days as the outer limit for creditors and a debtor to reach agreement.

2 These sources include reporting by publicly traded and registered comnpanies to capital market authorities and line ministries; privately administered databases from think tanks, trade associations, investment banks, and brokerage firms; and company surveys and firm interviews. - 56 -

o The workout needs approval of a majority of creditors-those accounting for at least 75 percent of credits by value. If 55 percent of creditors approve the workout, but not 75 percent, than the workout proposal is sent to arbitration. In Korea some 210 banks and nonbank financial intermediaries signed an intercreditor agreement that specified the terms and structure of the workout program.

o Creating an arbitration panel to resolve intercreditor disputes.

O The commissioning by creditors of an independent due diligence review of each distressed company's long-term viability, drawing on comprehensive information made available by and shared between all the likely parties to any workout. o Drawing on the independent review, encouraging each company's main creditors to work together to reach a joint conclusion on whether a company is viable and on what terms it is worth supporting in the longer term. o During the review and negotiation of each workout, seeing whether the company's bankers will agree to maintain their credit facilities (a standstill agreement), thereby preserving the confidence of workers, suppliers, and customers by allowing the company to continue to operate normally. o To facilitate discussions among creditors, designating a lead bank and forming a steering committee of creditors for each workout. o Allowing companies to supplement their borrowing in case of a liquidity shortfall. New money could be provided on a pro rata basis by all existing lenders, by specific lenders with priority arrangements, or by the release of asset disposal proceeds subject to priority considerations. (Other principles underlying this critical period of financial support include recognizing the seniority of existing claims and sharing losses on an equal basis between creditors in the same category.) o If creditors agree that a company is viable over the long term, they should consider a formal rescheduling-such as an interest holiday, recapitalization of interest in arrears, extension of loan maturities, lending of new money, or conversion of debt to equity. o These longer-term financial changes will need to be conditional on the implementation of an agreed business restructuring plan that may involve management changes, injections of fresh equity, sales of assets or divisions, or even company takeovers. o The Istanbul Approach does not guarantee the survival of a company in distress. Regulatory authorities do not intervene and, because of its voluntary nature, the Istanbul approach is only effective if it is supported by the banking community. - 57-

112. The Intercreditor Agreement for Financial Restructuring. The intercreditor agreement signed by private banks, including the Savings Deposit Insurance Fund representing intervened banks, and by a representative of state-owned banks. This agreement is to last three years (with a provision for extending it) and provides for the following:

Eligiblefirms. Eligible firms are primarily large and mid-cap manufacturing firms. To qualify, firms must have met at least two of the following criteria by the end of 2001: having two or more banks, debt of more than $10 million, more than 100 permanent employees, annual exports of $15 million, total annual turnover of at least 25 trillion lira, and assets on an audited balance sheet of at least 15 trillion lira. Although small and medium-size enterprises are covered by a modified form of the process, the number of firms that can be restructured in the first phase needs to be limited to 150 or so to prevent the process from bogging down. Thus a more systemic approach will need to be adopted for small firms. Excluded from the process are marketing and trading firms (that is, non- producing firms) and firms with more than 50 percent state ownership.

* Organizational structure. A Coordination Secretariat, under the direction of the Industrial Development Bank of Turkey (TSKB), will oversee the process and ensure that its logistics and timing work (Figure 25). A three-person arbitration panel, to be appointed by the Turkish Bankers Association, will make decisions on workouts if only 55-75 percent of creditors (by value) approve them (Figure 26). If more than 75 percent of creditors approve a workout, minority creditors will need to accede to the workout plan or be crammed down. A consortium of creditor banks will be formed for each workout and led by a lead bank-usually the one with the most outstanding credit. Representation will be consolidated in each consortium for subsidiary and affiliated banks and other financial institutions (such as leasing companies), including offshore banks, through representation by the controlling shareholder. Other creditors will be included on a case-by-case basis.

Figure 25. Institutional Structure for the Istanbul Approach

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Figure 26. Process for the Istanbul Approach

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* Standstill period. Each workout will provide for a reasonable standstill period, with creditors' obligations during the standstill spelled out by the intercreditor agreement. The obligations of the debtor also need to be addressed, however.

* Inclusion of Savings Deposit Insurance Fund and public banks. The new banking law (Law on Restructuring of Debts to Financial Sector, Law 4743 passed on January 10, 2002) includes intervened banks-represented by the Savings Deposit Insurance Fund- and state banks in the workout process. This approach implies that representatives of state banks will need indemnities so that they can agree to workouts and that the Savings Deposit Insurance Fund will agree not to exploit its preferred status in collecting collateral during the workout process.

Corporate resolution results. By end January 2003, 216 companies, employing 32,000 workers and exporting goods and service in an amount of US$ 695 million had entered into the Istanbul Approach resolution process. Also, by end January, US$ 3.6 billion dollars in non- performing loans were restructured in 96 different companies. Restructured loans were primarily with companies that had non-performing loans. A number of these credits had been rolled over from before the crisis. Disappointingly, there was little real restructuring to complement the workouts. Therefore, it is anticipated that a number of the re-scheduling cases will prove non- viable, as was the case in Korea. Those companies will potentially need to go through another workout round or be forced into bankruptcy or liquidation. Reform of the bankruptcy system remains an important issue. - 59 -

The workout agreements were largely re-schedulings that ranged from 6-14 years. The banks were not prepared to provide significant new working capital to these distressed companies, but did eventually provide fresh working capital on a selective basis and non-cash support in the form of guarantees, letters of credit and construction bonds as appropriate to the workout companies. Also, debt/asset swaps, debt/equity swaps and interest rate reductions were applied to many of the agreements. In general banks were reluctant to accept a "haircut" and write-off their debts.

113. Commercialization of Asset Resolution. The Government should commercialize its asset resolution strategy to the fullest extent possible by:

* Selling distressed assets through an asset resolution agency. Many countries have found it difficult to dispose of assets acquired by an asset resolution agency due to the lack of a secondary market for them. As a result the value of such assets quickly plummets toward zero. In East Asia and Eastern Europe large financial groups have entered the market to purchase distressed assets-for example, in Korea they did so through a profit participation arrangement with the Korea Asset Management Company. The Turkish Bankers Association is working with external advisers to explore the creation of an asset resolution agency. Given Turkey's fiscal constraints, it is recommended that the Government not set up an asset resolution agency, but rather encourage the Turkish Bankers' Association to do so. It is also strongly recommended that the Government consider profit participation deals for assets that need to be divested for intervened banks already being overseen by the Banking Regulation and Supervision Agency and for any new resolution agency.

* Corporate workout funds. Corporate workouts will leave banks with many assets that they are poorly equipped to manage and that might be difficult to dispose of during the crisis. Moreover, these assets will not earn interest and will impair banks' reported financial performance. For example, a debt overhang will inevitably require debt-equity conversions or the swap of straight debt, at high real interest rates, for longer-term convertible debentures at low interest rates. (In Korea the interest rate on convertible debentures introduced in workouts was 1 percent.) In addition, many companies going through a workout will require additional long-term debt or equity injections to operate in the future. Intemational debt and equity funds could manage these assets for banks and potentially bring in institutional capital. Korea, for example, set up four funds with the participation of the Korean Development Bank, commercial banks, and internationally recognized fund management groups (Scudder, State Street Bank, Templeton, Rothschilds) to help mid-cap companies seeking investors. The International Finance Corporation also made several direct investments in mid-cap companies. Such a role might be ideal for Turkey's private development banks, supported by commercial banks.

* Land and real estate sales. Distressed companies and banks may seek to divest excess fixed assets or sell and lease back primary real estate. Banks will also need to divest land and buildings acquired as collateral during the crisis. During its crisis Korea established a land bank to allow companies to divest excess property, with an option to reacquire it in - 60 -

the future. It did so to prevent a precipitous fall in values, as occurred in Japan. Although Korea's was owned by the state, there is no reason Turkey could not attract institutional investors to establish such real estate investment trusts (REITs).

114. Small and Mednum-size Enterprises. The surveys by TOBB, ATO, and ISO clearly demonstrate the distress faced by small and medium-size enterprises (see Chapter 3). Similarly, the interviews conducted for this report indicate that 70 percent of small and medium-size enterprises saw business decline in the first quarter of 2001, and more than 60 percent cut staff. Moreover, most of these firms did not expect conditions to improve or to have access to bank finance during the rest of the year. As noted, small and medium-size enterprises require systemic assistance for economic, social, and political reasons. These enterprises seem to have suffered the most in poorer regions such as the southeast and the Black Sea coast, implying that poverty could increase in those regions. Efforts to address the problems of small and medium- size enterprises should involve:

* Liquidity injections. The Government should continue to inject liquidity into small and medium-size enterprises, as it did recently by allocating $400 million in credits through Halk Bank to cap interest rates for these enterprises during the crisis. Given the restructuring efforts under way in state banks, it would be preferable to use Halk, Ziraat, and possibly private banks as agents in this process, with the extra liquidity injection explicitly recognized in the budget. During the Korean crisis, when 3,000-4,000 small and medium-size enterpnses were failing each month in 1998, the Government injected $1 billion to finance small and medium-size enterprises through a window at the Central Bank and through an existing credit insurance fund. The Government also induced Korean banks, a number of which had been intervened, to roll over credits to these enterprises for two successive six-month periods.

o Resolution efforts. The Turkish Government and banks should promote the development of a systemic workout process to resolve the immediate liquidity problems of viable but nonliquid small and medium-size enterprises. This process would require recapitalizing interest in arrears, lowering interest rates, providing a grace period for principal repayments, and extending loan maturities. This systemic approach would not only help small and medium-size enterprises but, to the extent that it lowers the bankruptcy rate, it would likely also lower bank losses. Apparently Halk Bank has restructured 28,000 of 30,000 small and medium-size enterprise loans requiring restructuring. The bank's losses (nonperforming loans) from small and medium-size enterprise loans have been moderate, at 6 percent of its portfolio. Following its restructuring in 2001, in 2002 Halk Bank is focused on expanding its lending to small and medium-size enterprises by strengthening branch management, decentralizing credit decision authority for such loans, and establishing branches in export zones to provide financing for small and medium-size enterprises that export (interview with Halk Bank general manager, April 2002).

Easing Tax, Legal, and lRegulatory Impedinments to Crisis Resolution

115. The East Asian crisis highlighted numerous impediments to corporate restructuring, mergers and acquisitions, and the easy entry of foreign direct investment. Turkish firms face - 61 -

many of the same obstacles. Significant impediments encountered in one or more East Asian countries included:

* Treatment of debtor gains from debt restructuring as taxable gains.

* An inability by corporate creditors to deduct losses from corporate debt restructuring and voluntary workouts to reduce taxes (in process of amendment in Turkey).

* Immediate taxation of noncash corporate reorganizations such as mergers or spinoffs (in process of amendment in Turkey).

* Little or no opportunity to transfer net operating tax loss carry-forwards to a corporate acquirer or new merged entity.

* Excessive fees and taxes on property transfers.

* Long periods (say, six months) for creditors to review proposed corporate mergers.

* Potential de jure breach of legal lending limits, especially in cases of large corporate credits held by banks with diminished capital.

* Limits on or difficulties for foreigners to own real property.

* Constraints (such as the personal liability of staff) on the ability of state-owned financial institutions to incur losses on corporate debt restructuring.

* Rights of public shareholders in publicly listed companies.

* Banks not being able to legally hold equity in debt-equity swaps or similar instruments such as convertible debentures. (In Turkey banks can only hold equity in affiliates of a related group.)

116. Prepackaged Bankruptcies. East Asia and Mexico show that any of these impediments can delay a corporate restructuring. Some-such as bank exposure limits, protections for public shareholders, and controls on tax deductions for credit write-offs-serve broader public policy interests and cannot simply be eliminated. But in some cases waivers may be appropriate (for example, on legal lending limits). Public shareholder rights to oppose dilutive equity restructuring can be particularly difficult or impossible to override in an out-of-court workout, as seen in recent cases involving Daewoo affiliates in Korea. To deal with valid shareholder protections, it may be necessary to rely more on court-supervised processes (such as "prepackaged" reorganizations) to effect equity restructurings of companies. In addition, the insolvency system can provide "front end" support to encourage debtors to cooperate with out- of-court workout efforts-as well as important "back end" support that makes it possible to force a corporate workout on dissident creditors or shareholders. - 62 -

117. Recent Amendments to Turkish Tax Laws. The Turkish Government has amended corporate tax laws and regulations to encourage mergers, acquisitions, asset spinoffs, and the sale of real estate and participation shares by banks augmenting their capital. It has also eliminated stamp, value added, and other duties on such transactions. These amendments seem to address many of the obstacles to restructuring and workouts encountered in East Asia.

118. Enforcement and Insolvency System. Enforcement systems provide a vehicle for resolving disputes between creditors and debtors, while insolvency procedures offer a means for collective resolution when poor performance raises questions about an enterprise's viability (Box 2). Informal workout systems provide a framework under which a fundamentally viable but temporarily illiquid debtor can reschedule or restructure its debt to its major lenders, as well as obtain new working capital to maintain its business activities. These two systems are complementary and mutually reinforcing. Experiences in East Asia and Mexico have shown that voluntary corporate workouts are enhanced by a viable insolvency process. Turkey's insolvency process needs to be reformed. Because the courts are already jammed with creditors seeking to enforce their rights to seize collateral, the insolvency framework should be modified and a dedicated insolvency court created as soon as possible.

Bols 2. Legal Framework for Creditor Rights and Enforcement Turkey's legal framework for creditor rights and enforcement deals with procedures for enforcing the commercial rights of unsecured and secured creditors. For secured creditors it also covers laws and procedures for creating, registering, and enforcing collateral rights such as mortgages and pledges. Up to 90 percent of bank lending in Turkey is done on a secured basis, and most is guaranteed by a major shareholder. Types of collateral include real estate and movable assets; an unconditional mortgage on real estate is the most reliable form of security because it allows the creditor to bypass the courts and move directly to execution or foreclosure procedures. In the event of a default, creditors can pursue execution or apply for an insolvency proceeding. Nearly all cases-almost 500,000 a year-are filed under the execution procedure. Procedures for debt recovery and foreclosure are generally effective, lasting an average of four to eight months over the past decade. Shorter proceedings tend to be uncontested, meaning they go directly to an executioner, which sends a collection order to the debtor. If creditors choose to go to court or a collection order is contested, it generally takes two to three years to reach a final judgment. In most cases, however, either the debtor does not contest the proceeding or a default judgment can be obtained. Courts are stretched to capacity and will likely become even more overburdened by efforts to collect on the nonperforming loans of failed banks.

119. Enforcement of secured loans. As noted, Turkish banks typically secure their loans with real property worth far more than the loans. If a lender is unable to resolve a dispute with a borrower when a loan is not being properly serviced, the bank may initiate an enforcement action in the courts. The initiation of such lawsuits has been the trigger for a bank to classify such loans as nonperforming. New loan loss provision rules require classification based on perfornance and creditworthiness, but it is not clear how well the new rules are reflected in the nonperforming loans reported by banks to the Central Bank. - 63 -

120. Private banks expected nonperforming loans to at least double in 2001. Thus the volume of enforcement actions initiated could also double. Given that the courts are already overloaded, the increased caseload will likely slow the completion of enforcement cases as well as all others. Because a contested enforcement proceeding can take more than two years to resolve, the prospect of further delays is worrisome. The banks interviewed said that they were confident that court enforcement procedures are effective, if slow. The question is whether the system will work as well when caseloads increase. Just as important is whether an enforcement system that works for lenders-because they typically hold considerable excess security-is effective in protecting borr'owers. Except where lenders work together on an informal or ad hoc basis to work out a restructuring plan, the answer seems to be no.

121. Enforcement of loans owed to Savings Deposit Insurance Fund banks. The Savings Deposit Insurance Fund (SDIF) has intervened in 18 private banks that went bankrupt. To expedite recovery, the loan portfolios of these banks have been redefined as state receivables subject to collection under the Public Recovery Act. Because court judgments are not necessary for state receivables, this change could shorten average recovery periods to six months-down from as long as two and a half years. But giving the loans of SDIF banks the status of state receivables raises several issues. First, accelerated collections enable the SDIF to recover in less time, potentially giving it access to debtor assets more quickly than other creditors. Second, the Public Recovery Act applies to all of a debtor's assets, not just assets that have been pledged- which may give the SDIF an effective priority and greater likelihood that it will be able to recover amounts owed to it relative to other creditors. In addition, because the act provides limited scope for rescheduling and almost no capacity to write off debt, it can be difficult to develop a workout plan for a troubled debtor. Just as important, Public Recovery Act enforcement proceedings take place outside the commercial court system, while other creditors must use the courts-making restructuring more cumbersome.

122. The question of whether the SDIF acquires greater rights than the original holder of the debt simply by virtue of subrogation or assignment is certain to be challenged in the courts, resulting in delays. Indeed, this issue could have a widespread impact because other courts will likely take a wait-and-see approach. Depending on the final ruling, it could even undermine one of the key strategies for the resolution process.

123. Turkish insolvency procedures are usually not relied on as a means of recovering debt, even in cases where borrowers are clearly insolvent. The average number of cases, about 1,500 a year-less than 0.5 percent of execution proceedings-reveals that insolvency has been marginalized. Unsecured creditors see the process as ineffective, fraught with extremely long delays, and yielding little or no benefit. Distributions to unsecured creditors reportedly do not exceed 3-5 percent, and no consideration is given to the time value of payments. For secured creditors the process is even less attractive, despite the fact that such creditors can generally pursue their rights and remedies without restraint. Weak insolvency procedures seriously impede the development of viable workout plans for illiquid debtors. If secured creditors can execute against a debtor's core assets, there is little scope for developing a plan to rehabilitate the debtor.

124. As a general rule, secured creditors enjoy a privileged status under the Execution and Bankruptcy Act. The declaration of bankruptcy does not result in a stay on actions by secured - 64 - creditors to foreclose on their collateral. Where foreclosure proceedings have not commenced, pledged assets can be entered as part of the bankruptcy proceeding, and the secured creditor has the option of disposing of the collateral on its own or allowing the administrator to do so. As a general rule it is difficult to salvage viable enterprises when secured creditors are exempt from the process and can collect on collateral that may be essential for the business. Given the inordinate delays and marginal use of the bankruptcy process, however, the current treatment of secured creditors offers a more reliable framework for risk assessment and management by lenders.

125. The Ministry of Justice has formed a commission to recommend ways to improve the insolvency process, make the system more efficient, and accelerate appeals. If the commission's focus is on expediting appeals, as appears to be the case, it is doubtful whether these changes will be sufficient to improve the process. Indeed, given the infrequent use of bankruptcy proceedings for the reasons outlined above, consideration should be given to more comprehensive reforms of the legislation and institutional procedures.

126. Creating a framework for corporate workouts and restructurings in the shadow of the insolvency law. In other countries corporate workouts and restructurings generally take place in the shadow of the law. This type of consensual resolution requires reliable fallback options through existing legal mechanisms for individual enforcement and debt collection or through collective insolvency procedures. As the Mexican and East Asian experiences show, voluntary workout programs are constrained by inadequate insolvency systems and by legal environments that discourage restructuring.

127. In particular, Turkey's insolvency law should be amended to restrain secured creditors from executing against their collateral as long as their property interests have not been affected. The insolvency law should provide a mechanism that preserves the value of the security for secured creditors but that allows the excess security value to be used to help restructure the debtor. There is little point to this change, however, unless it is accompanied by wholesale changes that allow the procedure to be expedited. Time destroys the chances of successful restructuring-a process that takes years, instead of months has little to offer. Expediting matters requires changes to judicial procedures, and ideally to the structure of the courts.

128. In addition, priority should be given to creating an enabling environment for restructuring, including laws and procedures that require disclosure of or ensure access to timely, reliable, accurate financial information on distressed enterprises; encourage lending to, investment in, or recapitalization of viable but financially distressed enterprises; support a broad range of restructuring activities, such as debt write-offs, reschedulings, restructurings, and debt- equity conversions; and provide favorable or neutral tax treatment for restructuring.

129. Debt rescheduling is the primary method for restructuring debt in Turkey. Tax losses for write-offs are allowed only where legal proceedings have commenced to recover the debt. This setup creates a perverse incentive for banks to pursue legal action even when such proceedings may be futile. It also contributes to congestion in the courts. Another means of restructuring is debt-equity conversions. However, under Turkish law such transactions are allowed only for shareholder loans. These adverse laws, combined with unfavorable collateral legislation for movable assets and inefficient enforcement and insolvency procedures, make it difficult to - 65 -

achieve meaningful workouts and restructurings. In addition, in the current environment long- term lending has virtually ceased-ensuring that rescheduled debt will have to be recycled again and again. Consideration should be given to developing an accelerated system for corporate workouts and debt restructurings that can be approved by the courts, as a form of prepackaged insolvency proceedings, or by another competent authority.

Improving Financial Reporting and Accounting Standards

130. Turkey's reporting and accounting standards make it extremely difficult to analyze the financial results of major industrial groups or even the performance of complex stand-alone companies. The main problem is the lack of International Accounting Standards (IAS) in the reporting and disclosure required for listed companies by the Capital Markets Board, and for unlisted holding groups that have listed subsidiaries or affiliates or that own banks.

131. Turkish banks are required to adopt IAS for 2002. The Capital Markets Board should apply those standards to all listed companies, including unlisted subsidiaries and affiliates of major groups. In addition, reporting should be required on a consolidated basis for all groups. The Capital Markets Board has taken a major step in that direction with its new inflation accounting and consolidation standards. A number of major groups (I§ Group, Sabanci Group, Koc) have, on their own, moved to IAS and to audits based on generally accepted accounting principles, primarily to raise funds in international capital markets. Turkey requires a fundamental change in its accounting and auditing standards, and it is recommended that the country adopt LAS. In addition, an Accounting and Auditing Standards Board should be established to provide the leadership and incentives needed to rapidly expand the use of these standards.

132. Lack of Consolidation Requirements (IAS 27). Until the Capital Markets Board introduced its new standards, no Turkish accounting standard required consolidation aside from the fact that banks were required to prepare, in addition to their main annual financial statements (which are unconsolidated), financial statements consolidating their financial sector participation. The lack of consolidation was a serious weakness considering that large parts of Turkish industry are controlled by holding companies.

133. No Requirement for Equity Accounting for Associated Companies (IAS 28). IAS 28 requires the equity method of accounting for associated companies (normally those with a shareholding of 20-50 percent). Under the equity method, the company includes in its income statement its share of the profit or loss of its associated companies and adjusts the carrying value of its investment in each associated company to reflect changes in each company's net assets. Until the new Capital Markets Board standards, equity accounting was not required by any Turkish standard except in the financial statements of banks consolidating their financial sector participation.

134. No Requirement to Use Inflation-adjusted Accounting (IAS 29). Hyperinflation distorts the financial statements of businesses in fundamental ways. First, reported profitability may not be "real" for several reasons: - 66 -

o If the real value of trade receivables erodes during the period up to collection, companies will charge higher prices to compensate for the delay in collection.

o The high prices lead to a high reported gross margin, but the loss from the erosion of receivables during the credit period does not appear in financial statements. The amount can be significant when credit periods are long.

o Trade payables erode in the same way, but receivables are often larger than payables.

O Reported profitability and the gross margin are overstated because the goods sold were purchased earlier, when prices were lower. Second, the real value of fixed assets-especially land-becomes much higher than the book value. Similarly, the current value of stocks is often higher than the purchase cost. Finally, if interest rates are very high but a large part of the interest compensates for an erosion of the principal, companies with borrowings may report profitability below real levels. Until the new requirement for inflation accounting, financial statements prepared in Turkey ignored all these problems except for the annual revaluation of tangible fixed assets and conversion of revaluation reserves to share capital.

135. IAS may not be suitable for all types of companies. For example, small and medium-size unlisted companies may not need financial statements prepared according to these standards. However, companies interested in raising capital from foreign sources must prepare financial statements based on IAS. Turkey's recovery from its crisis involves, among other things, an expectation of substantial foreign direct investment. There are many reasons Turkey has not received as much foreign investment in the past as it might have expected. Nevertheless, if it is to become more attractive to foreign investors in the future, Turkish companies must provide financial statements that are understandable to foreigners. (Annex 3 compares Turkish accounting standards and IAS.)

136. There are other obstacles to understanding the real position and financial performance of Turkish businesses. These include the lack of publicly available information, which can only be solved with changes in legislation, and a widespread belief that many transactions are not recorded in financial statements for tax evasion purposes. Although there is little research on the second problem, it is thought to affect mainly small and medium-size enterprises.

Enhancing Corporate Governance

137. The Commercial Code provides the legal framework for corporate governance in Turkey, focusing on the duties and obligations of directors and protection of minority shareholders. In addition, listed companies must comply with Capital Markets Board requirements on disclosure, independent audits, and stronger minority shareholder rights. Apart from these laws, there is no separate corporate governance code in Turkey. 138. Internationally, there is growing recognition that strong corporate governance standards are important in establishing an attractive environment for long-term institutional investors. The - 67 -

Capital Markets Board should consider adopting a Corporate Governance Code that incorporates principles of transparency and disclosure and that requires timely, accurate information along with protection of minority shareholder rights. In addition, an institute should be established to train independent directors for seats on the boards of listed companies. Corporate governance should follow a few basic principles. 139. Role of the Board of Directors. Boards should operate independently from management, with a clear fiduciary mandate to oversee company performance and make policy decisions on such crucial issues as reorganization, sales of substantial assets, mergers with or acquisitions of other companies, efforts to borrow or raise capital, and the adoption of a corporate strategy. Increasingly, good practice principles of corporate governance require that a substantial portion of board members be independent-that is, not management. To foster responsibility for performance and protect the decisionmaking power of top managers, as well as the fiduciary and' oversight responsibilities of the board, roles and decision-making responsibilities should be separated between execution (management) and supervision or policy- making (the board). In Turkish businesses board and management positions are usually filled by the same individuals, making for less effective overall management.

140. Shareholder Equality and Fairness. All shareholders, including foreign and minority shareholders, should have equal voting rights and transparent, enforceable rights in the case of significant corporate events such as dividends, mergers, acquisitions, liquidation, or bankruptcy. The Turkish Commercial Code does not provide sufficient voting equality and minority shareholder rights. Each share does not necessarily have only one vote; multiple voting powers are allowed. Minority shareholder rights are infringed on in three main areas: dividends policy, voting rights (that is, blocking rights) for key corporate events, and treatment in cases of bankruptcy or liquidation.

141. Transparency. Corporate activities and performance should be reported and disclosed in a clear, understandable, consistent way. As noted, Turkey's accounting standards and the Capital Markets Board accounting standards do not comply with IAS or generally accepted accounting principles. This setup makes it impossible to accurately assess the real financial situation of companies because of obstacles such as high inflation, use of accelerated depreciation laws for taxation purposes, accounting treatment of foreign exchange losses and profits, treatment of finance charges as revenue in cases of deferred payment sales, and lack of consolidation requirements (though as noted, the Capital Markets Board recently issued a new requirement for consolidated financial statements and inflation accounting).

142. In the absence of clear financial data, banks often make corporate credit decisions based on collateral. As a result, companies that would not be eligible for credits based on business and cash-flow viability are able to borrow, while others may not be able to even though they have a viable business-but not the required collateral.

143. The solution is to apply LAS, especially the inflation-adjusted accounting rules stipulated in LAS 29-and as noted, the Capital Markets Board recently issued a new requirement for inflation accounting. Even if tax collections fall, better corporate governance and the ability to determine the real profitability of companies will be better for all stakeholders in the long run. - 68 -

144. While the use of LAS 29 is adequate on a company basis, transparency should also be required for entire holdings. Hence requirements for consolidating and disclosing financial results should be imposed on listed holding companies as well as private ones that have listed subsidiaries. Moreover, disclosure rules are needed for all contingent liabilities between a holding company and its subsidiaries as well as collateral (such as shares of the subsidiary) given to banks for loans or guarantees provided by the parent for subsidiaries or cross-guarantees from one subsidiary to another. During Korea's recent crisis a web of guarantees left many chaebols in trouble. The chaebols were unable to detach good assets (subsidiaries and affiliates) from bad because of the cross-guarantees from subsidiaries and affiliates to other subsidiaries and affiliates. Implementing LAS 29 in Turkey will enable banks and capital markets to analyze the financial situation of holding companies and their subsidiaries. - 69 -

6. OTHER STRUCTURAL REFORMS THAT AFFECT THE CORPORATE SECTOR

145. Several efforts should complement the corporate resolution process. These include providing financing for the real sector through increased liquidity for small and medium-size enterprises and for exporters, taking an active approach to attract foreign direct investment (FDI), and accelerating the privatization program to maximize returns-including a careful review of the performance of state enterprises to assess their need for workouts and more fundamental restructuring (Table 19). The Government has a window of opportunity to introduce structural changes that will strengthen the economy, improve accounting and disclosure, modify corporate governance to attract institutional investors, accelerate privatization, improve competitiveness in key infrastructure sectors (such as telecom and energy), and attract FDI. FDI would bring not only resources but also high levels of technology and better managerial skills. The Government, banks, and corporations need to use the crisis to forge ahead with such changes.

Table 19. Key Recommendations to Complement Corporate Resolution

Timing of expected impact

Recommendation Short term Medium term Financing the Real Sector * Increase trade financing to support exports X * Provide financing to small and medium-size enterprises in X underserviced areas through microfinance institutions and a postal savings bank, to fill the gap resulting from restructuring of state banks

Attracting Foreign Direct Investment * Attract FDI to inject long-term debt and equity into banks X and companies -Encourage recapitalization of private banks through foreign X partnerships -Sell Savings Deposit Insurance Fund banks to foreign X X banks -Privatize state banks X -Accelerate privatization (see also below) X -Encourage mergers and acquisitions with foreign X X companies by improving tax laws

Accelerating Privatization * Review the performance of state enterprises to determine X their needs for workouts and restructuring

______x ____ - 70 -

Financing the Real Sector

146. Turkish companies require a varied mix of capital to finance their growth. Moreover, they need this capital at competitive costs and with maturities that match their investment and working capital requirements. However, due to bank distress and crowding out by public sector borrowing, available credits have been short term and at high real interest rates.

147. Market capitalization on the Istanbul Stock Exchange has plummeted since early 2001 and continues to show high volatility on low trading volumes. That, combined with depressed international markets, means that no more than a few firms will likely be able to raise capital through the domestic exchange or international capital markets. Turkey's bond market has largely been closed to the corporate sector in recent years, again due to public sector borrowing. And after the crisis began, the volume of bank credits (looking only at deposit banks) dropped by more than one-third, from $38.8 billion in January 2001 to $24.1 billion in mid-June.

148. Only recently has the Government been able to significantly lower its borrowing rates and extend its maturities. But it continues to crowd out the private sector due to the need to roll over existing debt. The "duty losses" paid to state banks to recapitalize them and the funds transferred to the Savings Deposit Insurance Fund for bankrupt private banks were in the form of Government paper, which almost tripled domestic debt.

149. High Real lnterest Rates. High real interest rates are one of the most serious problems facing Turkish industry. Interest rates have been high for several years (Table 20) and in 2001 stayed at or above 30 percent. But during 2002 inflation is projected to fall to 20 percent, and nominal interest rates to 41 percent (in lira terms).

Table 20. Interest Rates, 1995-2000 (%) % 1995 1996 1997 1998 1999 2000 Nominal nterestRate(O/N)* 108.2 115.8 101.4 111.9 108.6 63.1 CPI 76.0 79.8 99.1 69.7 68.8 39.0 FX basket 63.3 71.7 82.9 55.8 65.6 21.8 Real Interest (CPI) 18.3 20.0 1.2 24.9 23.6 17.4 Real Interest (FX basket) 27.5 25.7 10.1 36.0 25.9 34.0 Source: Akat 2001 *compounded annually

150. Working Capital Needs and the Potential for a Credit Crunch. The potential for a credit crunch is expected to worsen over the next 6-12 months (see Chapter 4 ), as has happened in other crisis countries that have experienced financial sector distress. In Turkey reasons for the crunch include:

State-owned commercial banks are reducing or eliminating new lending. Because of strong pressure on the Government and on the managers of these banks, however, the managers have announced that they will resume lending. - 71 -

* Banks that have received intervention from the Savings Deposit Insurance Fund have presumably exited from new business lending.

* Banks had to repay $4 billion in syndicated loans by the end of 2001. Renewals of syndicated loans have been below 50 percent in 2001, and have been available only for the largest private banks. The payment of syndicated loans is expected to be a problem for corporate borrowers, especially those that want to borrow in foreign exchange.

* A more severe credit retrenchment is expected among other, smaller Turkish banks.

* Because of the impact of the crisis on the real sector, nonperforming loans in private, non-intervened banks were expected to rise substantially in 2001. However, as noted, under the new banking law, commercial banks are required to undergo intensive external audits to determine the extent of their nonperforming loans. Based on those findings, to the extent that a bank's capital falls below Basle capital adequacy ratios, its shareholders will be required to recapitalize it, seek new financing, or obtain financing support from the state-assuming the bank's capital meets minimum standards of 4 percent tier one capital.

Because of these issues, commercial credits from Turkish banks continued to contract significantly during the fourth quarter of 2001 and in 2002. Other sources of credit-leasing, factoring, discounting of postdated checks and promissory notes, and long-term consumer installment credits-have also fallen significantly.

151. Trade Financing to Support Exports. Although Eximbank claims that its resources are adequate to service export needs, it is a second-tier institution and requires guarantees from commercial banks to finance exporters. Thus the inability of Turkish banks to meet guarantee requirements has slowed Eximbank financing. Resolving the problems of trade finance facilities remains an important priority. Such support could come from restoring and expanding trade lines from major international banks to Turkish private banks.

152. Financing for Regions Without Enough Banks. The Government should consider encouraging the entry of microfinance institutions to finance self-employment opportunities in regions short on banking services. Islamic finance houses have apparently recognized this need and are providing some financing in southeast Turkey. A longer-term, more structured solution could be to establish a postal savings bank. Such a bank would provide safe savings facilities for individuals, microentrepreneurs, and small businesses. It could also handle payments such as social security and pensions and eventually could extend microcredits and small loans. Such an effort could attract both bilateral assistance and private investment.

Attracting Foreign Direct Investment

153. As noted, Turkey has lagged behind nearly all comparable countries in attracting FDI (see Chapter 2). The constraints are not only legal and administrative but, perhaps more important, relate to Government commitment. For example, the Government could have sold Turk Telecom several years ago for billions of dollars, but resistance to foreign investors led to - 72 - the failure of at least two sales efforts. The Government has amended the requirements of the telecom sale, providing for up to 100 percent of shares to be sold-but only 49 percent can go to a foreign investor. The foreign investor can, however, be part of a consortium that buys a majority of shares. However, fixed telecom systems are a wasting asset, their value is in constant decline, and market conditions make a sale at this time almost impossible for any significant value. Turkey's unstable political and economic environment has also deterred FDI. External factors, provoking a flight to quality in Western capital markets, will further deter such investments.

154. The crisis, however, also offers opportunities for Turkey to attract FDI and associated expertise. The Government, working with the Foreign Investors Association of Turkey and major business associations (such as the Turkish Industrialists' and Businessmen's Association), should launch an active campaign to attract FDI. The campaign should be conducted in Turkey to change negative attitudes and in international financial markets.

155. In the future the Government should also consider creating an investment promotion agency to facilitate foreign investment. The Korean Government undertook such a campaign and managed to increase foreign investment from $3.2 billion in 1996 (the year before its crisis) to $15.7 billion in 2000. However, due to entrenched attitudes, Korea also missed a number of opportunities to raise even more. These included the failure to sell KIA to foreign investors (rather than to Hyundai) and the extended bidding process for Daewoo's operating companies- particularly its automobile business. The Government of Turkey has requested World Bank Group and IMF support for the establishment of a small, high-level, private sector-driven Investment Advisory Council (IAC). The purpose of the IAC is to increase understanding between the Government and companies driving private investments and to identify and accelerate Government measures to address impediments to an improved investment climate, including increased productivity and employment.

156. Foreign investors can help Turkish business both in the short run-by injecting long-term debt and equity into firms and banks-and in the long run. Opportunities for foreign investment include:

o Recapitalizingprivate banks and nonbankfinancialaffiliates of banking groups. Several banking groups have been in discussions to attract foreign capital.

O Selling intervened banks. Demir Bank was sold to HSBC, and the Savings Deposit Insurance Fund intends to sell or liquidate all other intervened banks by the end of 2001..

o Privatizingpublic banks. In addition, it is important to stop or strictly limit new lending by state banks to the amount of cash collections, to avoid a recurrence of additional portfolio-related losses and resulting recapitalization needs. The sales process should be accelerated to avoid the moral hazard and politicization of an extended restructuring period prior to sale.

o Renewing the privatization program. International financial markets will view the renewal of privatization as a signal that Turkey is serious about reform. Moreover, - 73 -

TUPRA, (oil refining), and electricity distribution companies, as examples, would likely attract significant FDI.

Encouragingmergers and acquisitions. Many companies will seek FDI directly in order to recapitalize. The most immediate impact will be on joint venture companies that have been decapitalized. In Korea, once FDI laws were liberalized, foreign partners often bought out their chaebol partners. To facilitate such investments, Turkey has amended its tax laws on asset transfers and on mergers and acquisitions.

Accelerating Privatization

157. The Government's economic program commits Turkey to renew its privatization program, but international market conditions have made this difficult. So has the Turkish economy, to the extent that direct sales of smaller companies and portions of larger companies depend on substantial improvements in the economy and the resurgence of the Istanbul Stock Exchange. Still, the privatization program could generate significant external resources, make important sectors of the economy-such as telecommunications and energy-far more efficient, and send a strong signal to foreign investors and financial markets about Turkey's commitment to reform. However, increased efficiency will not happen automatically: it will require implementing appropriate regulations, creating independent regulators, and allowing competition in these sectors. These are not simple tasks. To achieve them, the Government must make a long-term commitment to reforming these sectors.

158. An Ambitious Plan. The privatization program targets several major Privatization Administration holdings: those in TUPRA, (oil refining, partly divested in 2000), Turkish Airlines, ERDEMIR (steel), TEKEL (tobacco and spirits), and $EKER (sugar). TEKEL and ,EKER are not ready for sale and will take time to divest. The Privatization Administration will also continue to divest its smaller holdings. In addition, state banks will be privatized over the next several years, and intervened banks will be divested or liquidated by the end of 2001. Moreover, the Government plans to sell other assets, such as some of its land holdings.

159. This privatization program is very ambitious and goes well beyond recent efforts. Over the past 15 years privatization revenue averaged $500 million a year, though 2000 was an exception: a majority of POA* (oil distribution) was divested for $1.3 billion, a portion of TUPRA$ shares were sold in a public offering for $839 million domestically and $266 million internationally, a cellular phone license was granted to a Turkish and international consortium for $2.5 billion, and other smaller properties sold for $129 million in asset sales and $220 million in block share sales.

160. Stalled Efforts and Impediments. But while Turkey began its privatization program in 1985-making it the first developing country to do so-it is now lagging far behind comparable economies in Latin America (Argentina, Chile, Mexico) and the main economies in Central and Eastern Europe (Czech Republic, Hungary, Poland). Despite the high competence and considerable experience of Privatization Administration managers in executing privatization transactions, the program has had many flaws: - 74-

e The requirement that the Council of Ministers approve all sales, regardless of size, has forced even small divestitures to be recycled several times-significantly lowering their value and reducing transparency.

o A number of loss-making companies were recently transferred to the Privatization Administration, and they have been absorbing its resources-both financial and human.

* Once corporatized, many companies are transferred to and remain with the Privatization Administration for years. For example, PETKIM became part of the authority's portfolio in 1987, Suimer Holding in 1987, ERDEMIR in 1987, TUPRAS in 1990, and Turkish Airlines in 1990. The Privatization Administration has effectively become a large state holding group-a function it is not equipped to handle.

o Many of the funds from privatization have been used to finance the Privatization Administration's unprofitable holdings rather than being retumed to the Treasury to retire debt. Of some $9 billion in privatization proceeds since 1986, just $3.3 billion has been transferred to the Treasury.

e Privatization has been viewed as an important way of generating revenue to overcome fiscal problems, particularly during crises. The real objective of privatization-making Turkish industry more efficient and more competitive-has been subordinated. As a result important regulatory, structural, and efficiency issues have been ignored or considered of secondary importance, leading to suboptimal sales and less efficient companies. For example, ERDEMIR, TUPRA$, Turkish Airlines, and PETKIM should be sold to strategic investors or through strategic sales followed by public offerings.

o Privatization of large holdings-energy-related companies, telecommunications, state banks-has remained the responsibility of line and state ministries. In other countries this approach has led to delays, decapitalization of state enterprises, and covert (if not overt) resistance to privatization. Turkey has not been immune to these problems.

161. Privatizationm and the Crisis. Despite tariff and price adjustments and the advantage of negative effective protection for producers of commodities such as petrochemicals and steel, some of the companies to be privatized experienced large losses in the first half of 2001. Thus they will require increased financing from the Privatization Administration or from banks, and could result in less revenue from privatization. By the end of the first quarter the leverage of Turkish Airlines had increased substantially, to 687 percent. Similarly, ERDEMIR had experienced much lower sales, much higher inventory accumulation (228 days of sales are held in inventory), and a substantial increase in debt (measured in lira), eroding its financial position. If losses deepen, these companies will need to be recapitalized before divestiture. Perhaps the greatest concem about privatizing state enterprises is the potentially substantial erosion in value in the energy system, where TEDAS (distribution) has been unable to keep its payments current with TEA$ (generation) and TEAS is not paying BOTAS (gas transmission). The substantial accumulation of arrears needs to be cleared before any of these companies are privatized and could lower the value of the distribution companies, especially if the losses are the result of nonpayments by private customers (commercial and industrial users and households). - 75 -

162. Therefore it is important for the Privatization Administration to carefully evaluate its portfolio after receiving financial and operating results for 2001, to determine if refinancing or recapitalization is required and to assess any material impairment in privatization values.

163. Monitoring of State Enterprises. The crisis will almost certainly adversely affect the state enterprises monitored by the Treasury but under the control of line ministries, such as enterprises responsible for hard coal, railways, and energy. These enterprises are outside the scope of this report, but it is strongly recommend that the Treasury carefully review these firms using financial and operating data at the end of 2001-to assess their refinancing and restructuring needs. - 76 -

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CORPORATE SECTOR IMPACT ASSESSMENT REPORT

ANNEXES

March 2003 - 2 -

ANNEXES

Annex 1. Comparative Analysis of Recent Corporate Crises ...... 1 Annex 2. Survey Data Analysis ...... 24 Annex 3. Analysis of Istanbul Stock Exchange Data ...... 51 Annex 4. Interpreting Turkish Financial Statements ...... 86 Annex 5. Organizations and Companies Interviewed ...... 91 ANNEX 1

COMPARATIVE ANALYSIS OF RECENT CORPORATE CRISES

Drawing similarities and distinctions between the recent crises in East Asia and Mexico and the current crisis in Turkey, this annex identifies the corporate features- behavior, culture, and situation-that contributed to those crises, traces the spread of real sector distress, and assesses measures introduced to resolve corporate distress, mitigate the effects of the crisis on the real sector, and promote corporate reform.

East Asia

Corporate Features. East Asian corporations engaged in a variety of risky behaviors that helped precipitate the 1997 crisis.

* Throughout the region, companies emphasized debt-financed growth at the expense of profitability and cash management. Many large groups diversified into competitive and cyclical businesses and expanded into emerging markets with-at best-remote prospects for payback. Profits and investment returns declined, leverage grew, and interest coverage remained razor-thin. At the end of 1997 the 30 largest chaebols (excluding financial affiliates) in the Republic of Korea had an average ratio of liabilities to equity exceeding 5:1, and half were insolvent. Thailand experienced excess investment and asset bubbles in several sectors, especially property development, construction, and petrochemicals.

* In Thailand and especially Indonesia, much of the corporate debt was denominated in foreign currencies. The heavy use of foreign-denominated debt pummeled corporate balance sheets and severely strained debt service capacity when local currencies suddenly devalued sharply. (Even as recently as November 2000, 80 percent of the debt of Indonesian corporations was foreign denominated. Many of the country's corporate restructuring deals, predicated on an exchange rate of 8,000 to the U.S. dollar, are threatening to come undone because in 2001 the rupiah sank below 10,000 to the dollar, where it has remained.) In some cases, especially in Indonesia, corporations' use of derivative contracts to speculate rather than hedge aggravated their distress with the onset of crisis.

* In all countries a large percentage of debt was short term, often financing expansion of fixed assets.

* Related party lending contributed to the onset and persistence of corporate distress, especially in Indonesia and Korea. Bank Indonesia was unable to recover substantial liquidity loans to the country's largest banks and -2 -

apparently onlent to related nonfinancial affiliates, leading to takeovers of both by the Indonesia Bank Restructuring Agency. In Korea investment trust companies and other nonbank financial institutions-often owned and managed by the largest chaebols-were able to raise huge sums from the public, then use the money to buy bonds and commercial paper. As a result a number of highly distressed chaebol affiliates-notably the Daewoo companies and several affiliates in the Hyundai 'MH' group-put off needed operational restructuring.

Spread of Corporate Distress. In Indonesia, Korea, and Thailand sudden and severe devaluations and interest rate hikes had deeply damaging effects on corporate balance sheets and debt service ability-especially for companies with foreign- denominated debt and little or no export earnings. The maximum increase in the real interest rate over the "threshold" rate was 11.4 percentage points in Korea (with 7 months of elevated interest rates) and 12.3 percentage points in Thailand (with 12 months of elevated interest rates).' In addition, in 1998 the four East Asian crisis countries (the three above plus Malaysia) experienced severe contractions in domestic demand (Figure 1). Credit also contracted due to the failures of banks and nonbank financial institutions, the curtailment of lending by capital-weakened banks seeking to avoid intervention, and the reduction or withdrawal of credit lines.2 Large companies seeking to conserve cash by delaying payments passed on distress to their small and medium-size enterprise suppliers.

These shocks spread distress throughout the corporate and financial sectors:

o In Korea at least 31 chaebols and 38 medium-size corporations with cumulative debt of $151 billion were in distress at the end of 2000. This included 13 chaebols that entered court-supervised insolvency in 1997, Daewoo and other chaebols and standalone corporations that went through out-of-court workouts in 1998 and 1999, and the affiliates of some Hyundai '"MH Group" companies (for example, Hynix and Hyundai Engineering & Construction). In addition, thousands of small and medium-size enterprises failed: 8,200 in 1997 and 10,500 in 1998. Nonperforming loans peaked at 18 percent, and four large banks were nationalized-while more than 200 nonbank financial institutions were closed.

o In Thailand the central bank's Corporate Debt Restructuring Advisory Committee (CDRAC) monitored 2,821 cases of distress among medium-size and large companies with $64 billion in debt. Another 400,000 small and medium-size enterprises reportedly defaulted, reflecting a combination of distress and Thailand's extremely weak insolvency and foreclosure system. lBased on overnight interbank call rates. The "threshold" real interest rate is the average real rate during the 24 months preceding the crisis. Comparable figures for the 1995 Mexico crisis were a maximum increase in real interest rates of 32.2 percent and 5 months of elevated interest rates. See Ajai Chopra and others, "From Crisis to Recovery in Korea," IMF, 2001. 2Korean banks managed to roll over just 85 percent of their credit lines with foreign banks. - 3 -

The authorities nationalized 4 banks and closed 1 bank and 59 finance companies, and nonperforming loans peaked at 48 percent.

O In Indonesia 200 large groups and companies with $47 billion in debt became subject to debt restructuring by the Indonesia Bank Restructuring Agency Although the number of affected compames is unknown, distressed debt among small and medium-size enterprises is estimated at $14 billion. The authorities closed or nationalized 74 banks, and nonperfomting loans peaked at about 60 percent.

Figure 1. GDP Growth in East Asian Crisis Countries, 1995-99

10

5o -=----. -. .kasl 5 7/^4 *b1* 7 1i /; 2tXKaa 4-

-10 7

-15

Financd by Borrowing .Rapid Aso Accumulation.. 80%~~~~~~~~~~~~~0

70% ____ U0m__ __.______s 25% a_s

7ff 20% _ 10W m m. 10%m 0%U

1 °3, 103 / / Au p o rcot a +ge l /I

1"3_10WII Avinage pomet change Intnpaib nxd !t= SS9 -4 -

And an Increasingly heavy debt burden Produced Low-or Negatve-Value Added 12 15%-

3 10 E10

6 I 0% 4 z 42| | | | MIiliE| Ii 8~~~~~~~~~~~~~~~-5%| O- Rlyllllll -15% -

Source: Pomerleano 1998

Resolution of Distressed Corporations. The four crisis countries responded to systemic corporate distress by using or attempting to use court-supervised insolvency procedures to resolve the most distressed corporations; by developing out-of-court workout procedures for a larger number of-usually less distressed-companies; by addressing tax, legal, and regulatory impediments to corporate restructuring; and by creating public asset management companies to take over financial institution credits for pooling and auction or restructuring and sale. East Asia illustrates the need to link corporate and financial sector restructuring, to centralize crisis management, and to ensure adequate implementation capacity.

Insolvency andforeclosure. Korea and Malaysia entered the crisis with relatively strong insolvency and foreclosure systems and made extensive use of these options. In Korea 13 companies with debt of $26 billion entered court-supervised insolvency in 1997. Of these, 10 were receiverships, which entailed loss of management control and equity ownership for corporate insiders. In Malaysia more then 10,000 companies were subject to liquidation by October 1999, and by the end of March 2000, 192 companies had filed for court-supervised reorganization. The ability of the insolvency and foreclosure systems in Korea and Malaysia to impose prompt losses encouraged debtors to cooperate with out-of-court workout schemes.

By contrast, corporate restructuring efforts in Indonesia and Thailand have suffered from weak insolvency and foreclosure regimes. In Indonesia a new bankruptcy law and special commercial court went into effect in August 1998. Although the law is considered workable, its administration has been abysmal. Creditors have yet to prevail in any significant insolvency case, and reports of anomalous judicial decisions are legion. During the midst of the crisis Thailand introduced an option for court-supervised rehabilitation and established a Central Bankruptcy Court. The court was established relatively quickly (by June 1999) and has been reasonably effective. But court- supervised rehabilitation has been underused-apparently because of weaknesses in Thailand's foreclosure regime and a high threshold for the commencement of court- supervised insolvency. Changes to Thailand's code of civil procedure have reduced the time needed to seize and sell collateral from more than 10 to about 2 years. The local consensus is that a two-year process is still too long and uncertain and that debtors feel insufficient pressure to cooperate with out-of-court workout efforts or to seek the - 5 - protection of a court-supervised reorganization. Although the option of court-supervised reorganization has provided a useful means for a supermajority of creditors (representing at least 75 percent of debts) to "cram down" a reorganization on dissenting creditors, it cannot reliably impose corporate restructuring on uncooperative debtors. Thai insolvency law features a balance sheet test for commencing court-supervised reorganization. As a result an uncooperative debtor that has generally failed to pay debts as they come due may rebut the presumption of insolvency by claiming that assets (possibly inflated) exceed liabilities-as happened in an infamous hotel case where creditors had not been paid in two years. In both Indonesia and Thailand weak insolvency and foreclosure regimes undermined the volume and quality of out-of-court workouts.

Out-of-court workouts. During financial crises or periods of liquidity tightening it may be necessary for banks and large corporations to come together and resolve debtors' inability to meet their obligations. This is often difficult if a number of creditors are involved with one corporation. Moreover, during a crisis there are many such cases to resolve. Banks and corporations may be fragile, and a weak bankruptcy system cannot meet the demands put on it by a large number of cases. At such times it is important to have a systemic approach to corporate workouts. Indonesia, Korea, and Thailand have developed systemic, voluntary approaches to corporate workouts based on the London approach (also known as the London rules). During its 1994-95 crisis Mexico set up a presidential commission to handle corporate workouts.

LONDON APPROACH. Under the original London approach the Bank of England used its powers of suasion to bring the debtors and creditors to the table. Over time clear rules have evolved and been used in countries around the world. Although institutional structures have varied, common features include:

* A standstill period while negotiations occur.

* A lead creditor institution.

* A higher authority that can serve as an arbiter and push cases to resolution.

* Professional due diligence-usually by external experts (an audit firm) and in large cases insolvency experts.

* A majority agreement binding all creditors.

* Rescheduling of financial obligations complemented by needed defensive restructuring.

* Willingness of creditors and debtors to absorb losses.

* New working capital to allow the company to operate when an agreement is reached. -6-

During the mid-1970s, when the United Kingdom entered an industrial recession with high inflation, commercial banks had to rapidly establish workout units and internal policies to deal with a vastly increased number of bad loans. But there was little experience with workouts and with organizing workout units within banks. Insolvency legislation was outdated and did not provide tools for voluntary restructuring, including protection of new money and processes limiting the ability of a small group of creditors to block a workout settlement between the majority of creditors and the company. In this environment the Bank of England (BOE) became actively involved in individual company workouts. The bank's main objectives were to:

e Minimize losses to banks and other parties incurred from unavoidable company failures, through coordinated and well prepared workouts.

o Avoid unnecessary liquidation of viable companies, through their reorganization and the preservation of employment and productive capacity.

O Provide support in cases where creditors could not agree to the terms for a workout.3

The BOE's involvement in company workouts was possible because its statutes did not limit its activity to a narrowly defined role. In fact, BOE policy was entirely unrelated to bank regulation. Companies trusted the BOE because it was considered impartial, independent, and confidential. In many cases the BOE would call participating banks together and, if there was no lead banker, arrange for one of the main lenders to assume that position. The BOE led the meetings where solutions were prepared, immediate actions (such as payment of wages) were taken, and premature liquidations by banks that chose to call in their loans ("renegade banks") had to be avoided. Other important steps were taken with BOE guidance, such as agreements on new money- with special arrangements for security or priority-and changes in management.

In response to the elections of more market-oriented governments in the United Kingdom and United States, long and sustained economic growth in the mid-1980s, and a completely changed financial industry, the BOE reviewed its policy on corporate workouts. The bank decided to reduce its direct contact with companies in difficulty, leaving the development of restructuring strategies to the private sector. It saw its new, reduced role as a diplomat and catalyst that would motivate parties to work toward generally agreeable workout solutions.

After consulting with the U.K. banking community, the BOE decided in the early 1990s not to formalize its restructuring fiamework, now called the London rules. It was feared that foreign banks might challenge such strictly formalized rules in court. In addition, the framework had to remain flexible and adaptable.

3Pen Kent, "Corporate Workouts - A UK Perspective," InternationalInsolvency Review. -7-

The London approach provides general guidance to banks and other creditors on how to respond to a company facing serious financial difficulties. But this guidance is not statutory, and the BOE does not have any enforcement powers. Banks and other parties act in their self-interest. But by ensuring certain rules for. restructuring, the London approach aims to avoid unnecessary damage and fosters solutions that benefit all involved banks and creditors. The key features of the London approach are:

* A willingness by the main creditors to consider a nonjudicial resolution to a company's financial difficulties, rather than resorting to a formal insolvency procedure such as liquidation, administration, or a company voluntary agreement (CVA), and without recourse to other enforcement procedures such as receivership and administrative receivership.

* As part of this consideration, the commissioning by creditors of an independent review of the company's long-term viability, drawing on comprehensive information made available by, and shared between, all the likely parties to any workout.

* During the period of the review, the company's bankers agreeing to maintain their facilities, operating an informal standstill sufficient to preserve the confidence of suppliers and customers by allowing the company to continue to trade normally.

* Drawing on the review, the main creditors working together to decide whether, and on what terms, a company is worth supporting over the long term.

* To facilitate these discussions, a coordinating or lead bank may be designated, and a steering committee of creditors formed.

* In addition to maintenance of existing facilities, it may be necessary to allow the company to supplement its existing borrowing with new money, in case of an immediate liquidity shortfall. New money may be provided on a pro rata basis by all existing lenders, by specific lenders with priority arrangements, or by the release of asset disposal proceeds subject to priority considerations.

* Other principles underlying this critical period of financial support include the recognition of existing seniority of claims and the sharing of losses on an equal basis between creditors in a single category.

* If, based on the review, there is an agreement among creditors that the company is viable over the long term, the creditors move on to consider more lasting forms of financial support-such as an interest holiday, extension of loan maturities, further lending of new monies, and conversion of debt into equity. - 8 -

o Such longer-term financial changes will need to be conditional on the implementation of an agreed business plan that may involve management changes, sales of assets or division, or even the takeover of the company.

o The London approach does not guarantee the survival of a company in difficulty. Regulatory authorities do not intervene and, because of its voluntary nature, the London approach can be effective only as long as it is supported by the banking community.

The London approach was instrumental during the U.K. recession of the early 1990s. Many companies survived only because their banks, bondholders, and other creditors reached a collective solution for the financial restructuring of viable businesses. The BOE has been actively involved in more than 160 restructurings since 1989. Even more important, numerous workouts have been achieved using the London Aapproach without the Bank's direct intervention. The London approach preserved value for creditors and shareholders, and it saved jobs and productive capacity.

KoREm's CORPORATE WORxOUTS. Korea's governrment, under the auspices of the Financial Supervisory Commission (FSC), encouraged lead banks to focus on voluntary (out of court) workouts of the mid-tier chaebols (chaebols 6-64), ranked by asset size. These tended to be the chaebols in deepest distress, generally lacking the financial resources and clout to restructure on their own. A large number of insolvencies among this group could have created an upsurge in unemployment, bringing severe social distress and political pressure on the govemment to abandon its reform program. Moreover, a series of major defaults could have provoked a secondary financial crisis, leading to pressure on the currency and on interest rates. The 6-64 chaebols tended to be less complex and so potentially easier to restructure than the five largest chaebols- Hyundai, Samsung, Daewoo, SK, and LG. In the FSC's view, experience gained in restructuring the 6-64 chaebols would prepare lead banks (and their advisers) to take on the five largest chaebols, whose size and complexity place them in a league of their own.

To support restructuring of the 6-64 chaebols, the FSC promoted a corporate restructuring accord (CRA), signed in June 1998 by more than 200 banks and nonbank financial institutions. The workout process follows the London approach. Key provisions of the CRA include:

o A Steering Committee consisting of 10 representatives from participating financial institutions was responsible for implementing, amending, and terminating the CRA. The CRA was to run until the end of 1999 unless amnended by the Steering Committee. In fact, the CRA's term was extended for an additional year, until the end of 2000.

O A Corporate Restructuring Coordination Committee (CRCC) was created to act as an arbitration committee. The CRCC consists of a chairman and seven senior banling and industry representatives, supported by a technical unit of some 10 full-time staff. The CRCC was responsible for assessing the viability -9-

of corporate candidates for restructuring, arbitrating differences among creditors, and, as necessary, modifying workout plans proposed by participating creditors.

* Six lead banks were nominated to take charge of corporate restructuring for the 64 largest chaebols. Workout units focusing on corporate restructuring were created in all commercial banks. In addition, the workout units in the lead banks augmented their capacity and were assisted by external financial advisers retained under a World Bank technical assistance loan.

* A council of creditor financial institutions is formed when such creditors must cooperate on restructuring. In other countries the council is often known as a creditors committee. The organization and operation of each council are managed by a presiding bank-either the lead bank or the bank holding the most debt for a company. Each council is convened within 10 days of a request from any financial institution that holds more than 25 percent of a debtor's financial institution debt.

* Financial institution creditors holding a majority of financial institution credits in a chaebol affiliate may decide to pursue joint workouts with one or more other chaebol affiliates if a majority of their financial institution creditors agree.

* From the date of notice that a council will be convened, CRA signatories defer their rights for discharge of debts, including debt repayment, and claims for discharge of guaranteed obligations. In essence a standstill agreement goes into effect.

* A workout may involve debt-equity conversions, term extensions, deferred payment of principal or interest, reduction of interest rates, waiver of indebtedness, provision of new credits, cancellation of existing guarantee obligations, sale of noncore business, and new equity issues; the workouts employed combinations of all these instruments.

* Council decisions require approval by financial institution creditors holding at least 75 percent of financial institution credits (it is important that 100 percent be avoided so that small banks or creditors cannot prevent solutions). A presiding bank may apply to the CRCC for arbitration at any point in the process to clarify an issue or after having failed three times to get voluntary agreement among creditors on a proposed workout.

* Within one month of an application for arbitration from a presiding bank, the CRCC provides written opinion to all the debtor's financial institution creditors as well as the relevant regulatory agencies. - 10-

o If a CRA signatory fails to comply with an approved workout agreement or CRCC arbitration decision, the CRCC may fine this signatory up to 30 percent of the credit amount in question or up to 50 percent of the cost of noncompliance. The council will decide on criteria for distributing any fine among the other financial institutions.

Thus the CRA provided for expedited procedures and tight deadlines. These timeframes, while aggressive, encouraged an initial emphasis on balance sheet restructuring prior to asset sales and new equity investment, which will tend to be more time consuming. It took an average of three to six months to reach agreement on workout plans. Under the pressure of tough deadlines, the initial due diligence prior to a workout agreement tended to focus on financial viability and financial projections. Not enough emphasis was placed on sensitivity analysis and alternative restructuring scenarios. Moreover, too little emphasis was placed on deeper restructuring, replacement of management, and analysis of the fundamental viability of the business over the long term.

Between September 1998 and March 1999 CRA workouts involving about $31 billion of debt restructuring and $9 billion of corporate "self-help" (business or asset sales, new capital, cost reductions) were agreed for 41 affiliates of 16 chaebols and 38 standalone companies. Financial restructuring relied mostly on term extensions, rate reductions, and grace periods along with conversions of $3.3 billion of debt into equity or convertible bonds (Table 1). Daewoo's 12 large affiliates failed in July 1999, and CRA workouts were agreed by the end of 1999 to restructure almost $54 billion in debt- mostly through rate reductions and conversions of debt into convertible bonds or equity-which were to be followed by spinoffs, strategic sales, operational restructuring, and liquidation of nonviable operations.

In general, CRA workouts provided for the financial stabilization of distressed corporations but have not done enough to induce operational restructuring or de- leveraging. By the end of 1999 CRA workout negotiations and agreements were increasingly jeopardized by intercreditor disputes-often between large nationalized banks and small, private nonbank financial institutions over such matters as the provision of new money-and by disputes between creditors and public shareholders over equity restructuring. Because CRA workouts were out of court, public shareholders retained substantial rights and were able to block equity write-downs, debt-equity conversions, and spinoffs in order to obtain preferential terms from creditors. On balance, the workouts were valuable in stabilizing distressed corporations and preventing greater losses among creditors. But as soon as the pressure was off and the economy began to surge, it became increasingly difficult to maintain both bank and corporate discipline. - I1 -

Table 1. Debt Restructuring Methods Applied in the Republic of Korea Amount % Typical Application Method (Won billions) Rate reduction 16,968 69 Secured debt Debtlequity conversion 1,093 5 Unsecured debt Convertible bonds 1,701 7 Excess unsecured debt Interest exemnption 3,639 15 Cross-guarantees Forgiveness of principal 562 2 Cross-guaranteed debt and excess unsecure debt Tenn extension only 555 2 Secured debt Total 24,518 100 Source: FSC and CRCC.

THAILAND'S CORPORATE WORKOUTS. Thailand initially tried a purely consensual approach to out-of-court workouts. A Corporate Debt Restructuring Advisory Committee (CDRAC) was formed in June 1998, consisting of representatives from creditor and debtor interest groups and chaired by the govemor of the Bank of Thailand (BOT). CDRAC members identified priority cases, developed principles for voluntary workouts based on the London approach (the "Bangkok rules") in September 1998, and attempted to facilitate negotiations and identify legal or regulatory impediments. When it became clear that a purely consensual approach to corporate restructuring was not producing sufficient progress, the BOT promoted a contractual approach.

In January 1999 the BOT created a CDRAC unit to track progress on high- priority cases and promulgated a model debtor-creditor agreement (DCA) to govern out- of-court workouts and an intercreditor agreement (ICA) to resolve intercreditor differences. DCA signatories agreed to a six- to eight-month schedule for developing and agreeing to a workout plan, information sharing, designation of a lead creditor, and thresholds for creditor approval. Approval by 75 percent of creditors (credit-weighted) was necessary to finalize a restructuring-the same threshold as for a court-supervised reorganization. In cases of 50-75 percent creditor approval, a dispute or proposed plan was to be submitted for ICA arbitration. If less than 50 percent of creditors favored a proposed workout plan, the DCA obliged creditors to petition the court for collection of debts, foreclosure, or insolvency. Violation of DCA obligations exposed financial institution signatories to reprimands or fines from the BOT. According to the ICA, differences among creditors would be arbitrated by a three-person panel.4

By the end of 1999, 84 Thai and foreign financial institutions had acceded to the ICA and to corporation-specific DCAs with 2,124 medium-size and large companies. In the context of a weak insolvency and foreclosure regime, Thailand's contractual approach to out-of-court workouts produced disappointing results. The CDRAC ultimately

4Notably, an ICA signatory could opt out of ICA arbitration in any case where debt totaled I billion baht (about $28 million)-a very low threshold. This escape clause was in response to concerns by some creditor groups (such as unsecured foreign creditors) that they might be systematically disadvantaged in arbitration decisions. -12- monitored 2,821 medium-size and large corporate restructuring cases, accounting for $64 billion in debt.

By the end of January 2001, 45 percent of target corporate cases had reached restructuring agreements. Because many debt restructurings relied on term extensions and rate reductions, corporations remain overleveraged. Higher-quality debt restructuring has occurred in some large multicreditor CDRAC cases involving foreign creditors. Another 53 percent of medium-size and large CDRAC cases failed to settle by early 2001. Most of the cases that failed the CDRAC process are being transferred to civil courts. The prospective backlog of cases in the civil courts poses a serious threat to the resolution of distressed assets. One estimate suggests that it could take seven years to reach judgments and an, additional two years to auction the collateral in order to clear the backlog of mortgage enforcement cases.

MALAYSLI 'S CORPORATE WORKOUTS. In Malaysia, with secretariat support from the central bank, a Corporate Debt Restructuring Committee (CDRC) was established in August 1998 to provide a framework for out-of-court workouts in complex cases involving debts of more than 50 million ringgit and three or more creditors. Key principles governing the CDRC approach included efforts to preserve viable businesses, establishment of a creditors committee representing at least 75 percent of the outstanding debt in each case, full disclosure and information sharing, appointment of independent consultants, a 60-day standstill (which can be extended), and continuation of existing credit lines. Workouts could apparently be approved with 75 percent creditor support.

On some occasions dissenting creditors have been bought out by Danaharta, Malaysia's public asset management company. In addition, the central bank has been willing to persuade holdout banks that opposed workouts supported by a majority of creditors. By the end of August 2000 the CDRC had resolved or was making progress on 38 of 75 cases referred to it, representing 26 billion of 45 billion ringgit. The completed cases include two large, politically connected conglomerates. These conglomerates have converted large loans into seven-year zero-coupon bonds and-far from selling assets- have actually acquired additional assets and companies for which attractive bids had been received from foreign investors.

INDONESi 'S CORPORATE WORKOUTS. Indonesia also attempted to facilitate out-of- court workouts through a debtor-creditor forum. In September 1998 the government established corporate restructuring principles and a Jakarta Initiative Task Force (JITF) to mediate between corporate debtors and creditors, expedite regulatory approval, and seek regulatory relief By the end of 1999 debt workout agreements mediated by the JITF amounted to just $1.7 billion-out of registered cases with debts of $23 billion. This slow progress led to government approval of time-bound mediation procedures, a requirement for cases to reregister for time-bound mediation or else be dropped from the JITF, government referral of some cases in which the public asset management company was a minority creditor for time-bound JITF mediation, and an opportunity for the JITF to refer uncooperative debtors to the government for possible investigation or bankruptcy petition by the attorney general. - 13 -

Given the aforementioned state of creditor protections, the JITF's referral power poses little or no threat to uncooperative debtors. Thus its ability to mediate restructuring agreements for $7.3 billion in corporate debt during 2000 must reflect other factors. These may include debtor desires to nonnalize their affairs in response to macroeconomic improvements, negotiation fatigue, the readiness of foreign creditors (who represent more than 40 percent of the debt in JITF cases) to resolve problem loans, for which they had become fully provisioned, and debt restructuring agreements favorable to the debtors.5

Tax, legal, and regulatory impediments. The East Asian crisis highlighted numerous impediments to corporate restructuring. Significant impediments encountered in one or more crisis country included:

* Treatment of debtor gains from debt restructuring as taxable gains.

* Inability of creditors to deduct losses from corporate debt restructuring to reduce taxation.

* Immediate taxation of noncash corporate reorganizations such as mergers and spinoffs.

* Little or no opportunity to convey net operating tax loss carry-forwards to a corporate acquirer or newly merged entity.

* Excessive taxes on property transfers.

* Long period (for example, six months) for creditors to review proposed corporate mergers.

* Potential de jure breach of legal lending limits, especially in cases of large corporate credits held by banks with diminished capital.

* Limits or prohibitions on the ability of foreigners to own real property.

* Constraints (such as personal liability of staff) on the ability of state-owned financial institutions to take losses on corporate debt restructuring.

* Various protections for public shareholders.

Any of these impediments can delay a corporate restructuring. Some-such as controls on tax deductions for credit write-offs, bank exposure limits, and protections for public shareholders-serve broader public policy interests and cannot simply be swept

5 For debt restructuring agreements mediated by the JITF in 2000, terms were extended to seven years on average and 87 percent of the rescheduled principal was subject to a two- to three-year grace period. About a third of the debt was to be converted into equity. Prompt repayment (from existing cash balances, sales of assets, or debt-asset swaps) represented just 5 percent of the restructured debt. - 14- away. In some cases waivers may be appropriate (for example, on legal lending limits). Public shareholder rights to oppose dilutive equity restructuring can be particularly difficult or impossible to override in an out-of-court workout-as in recent cases in Korea involving Daewoo affiliates. To deal with valid shareholder protections, it may be necessary to rely more on court-supervised processes (such as "prepackaged" reorganizations) to effect equity restructuring of companies. In addition to providing "front end" support to encourage debtors to cooperate with out-of-court workout efforts, the insolvency system can provide important "back end" support by making it possible to "cram down" a corporate workout on dissident creditors and shareholders.

Public asset management companies (AMCs). Public AMCs were used in all four crisis countries to take over and manage assets from failed financial institutions or to purchase assets from nonintervened financial institutions, for subsequent pooling and auction or restructuring and sale:

MALAYSIA 's DANAHARTA. Malaysia established a public AMC, Danaharta, in August 1998 to acquire nonperforming loans and assets in order to provide bank liquidity, facilitate an orderly resolution of distressed debt and underlying assets, and restructure or liquidate distressed companies with outstanding debts of less than 50 million ringgit. The necessary legal framework for rapid acquisition, management control, and disposition of distressed companies was provided in the September 1998 Danaharta Act and in amendments to the National Land Code. This legislation empowered Danaharta to acquire titles to assets while preserving existing registered interests in the assets and to foreclose or sell the assets through public auction, public tender, or direct negotiation without consent of the borrower as long as the sale was at market value and 30 days' notice was provided:

Danaharta is also empowered to appoint special administrators to manage the affairs of distressed companies. Under the Companies Act, practically speaking, such an appointment could only be made by a debenture holder. Enabling Danaharta to appoint special administrators was intended to compensate for the lack of well-defined procedures for judicial management of corporate insolvency cases. Finally, special vesting powers insulate Danaharta-and subsequent purchasers-from undisclosed claims made after assets were acquired from creditors.

Danaharta was to resolve corporate nonperforning loans by restructuring viable companies, selling its interests in distressed companies in viable sectors, or selling the underlying assets in cases where neither the corporate debtor nor its sector appeared viable. If Danaharta could not reach agreement on a loan workout within three months, the loan was to be deemed nonviable, which should have set the stage for liquidation. Danaharta's loan workouts were to follow certain principles-the debtor's shareholders were to bear most of the loss; the debtor's management was to have only one opportunity to implement an agreed workout, with no opportunities for revision; and the debtor's business operations were to be closely monitored. Danaharta also developed nonbinding guidelines for corporate workouts-restructured debt should not be zero-coupon, but should provide a yield commensurate with cash flow; the repayment period for - 15 -

restructured loans should not exceed five years; existing shareholders should be prevented from diluting shareholdings obtained by creditors through debt-equity conversions; and the workout agreement should include monitorable covenants on intercompany lending, disposal or transfer of assets, dividend payments, and additional lending.

As of the end of June 2000 Danaharta had resolved 31.5 billion ringgit of its 46 billion ringgit portfolio. Danaharta focused first on the largest 20 percent of its borrowers and on easier cases involving sales of foreign loans and residential property. Progress was expected to slow as Danaharta turned to smaller debtors, commercial real estate, and enterprises in need of fundamental operational restructuring. Moreover, by December 1999 a quarter of corporate cases had been resolved through simple debt rescheduling. Thus fundamental corporate distress may have been deferred rather than resolved in some cases. 6

INDONESA BANK RESTRUCTURING AGENCY. In Indonesia credits from 70 failed banks and all Category 5 loans-which together represented 30 percent of GDP-were transferred to the Indonesia Bank Restructuring Agency (IBRA). At the end of 2000 IBRA's portfolio of business loans had a face value of about $28 billion. Having sold or outsourced its retail, small and medium-size enterprise, and smaller commercial credits, IBRA staff focused on resolving about $8.8 billion in credits to its 21 largest obligors, each a multi-affiliate conglomerate. By the end of 2000 almost $8 billion of these credits were in the late stages of negotiations or covered by court filings. Restructuring agreements have been finalized and become effective for credits amounting to only about $600 million. Thus, implementation of restructuring agreements could slip, especially given continued rupiah devaluation (which hinders rupiah earners with dollar debts) and the lack of legal protections for creditors.

IBRA's top 21 debt restructuring deals appear to be about 34 percent debt rescheduling, 57 percent conversion of debt into equity or convertible bonds, and only 9 percent prompt repayment (foe example, use of cash balances or debt-asset swaps). Especially if convertible bond yields are artificially low and debt rescheduling involves significant rate reductions and grace periods, these deals will fail to resolve fundamental corporate distress. For some high-profile conglomerates it has been proposed that if the corporate debtor can repay principal owed IBRA within 12 years (including an 8-year grace period), the former controlling shareholder could regain 100 percent equity ownership-despite the large present value cost to IBRA. By possibly encouraging other entrepreneurs to go for broke in pursuing debt-fueled business expansion, such deals would create major moral hazard risks as well as peril for state-owned financial institutions.7

THAILAND's FINANCL4L SECTOR RESTRUCTURING AUTHORITY took over loans with a book value of about $17 billion from 56 failed finance companies and auctioned these

6 Hood, pp. 25-26. 7The question may well arise-who, other than a state-owned financial institution would lend in such a legal environment to such companies? - 16-

relatively quickly, achieving realizations of almost 50 percent for mortgages and car loans and 22 percent for unsecured business loans. Some loan pools were sold to another public asset management corporation that was established to prevent sales below reservation prices.

THE KOREA ASSET MANAGEMENT COMPANY (KAMCO) has focused on providing bank liquidity and repackaging and selling assets. As of the end of 2000 it had accumulated assets with face value of $84 billion-nearly half of nonperforming loans. Initial asset purchases were at above-market prices, with recourse. As a result of subsequent pricing reductions, the management company's purchases have totaled $32 billion (38 percent of face value). Realistic transfer pricing facilitated the company's disposal of 48 percent of its assets by the end of 2000 using a variety of methods, including "equity partnerships." 8 But other than its involvement in Daewoo, the company has played almost no role in corporate restructuring. For Daewoo, the management company purchased about $4.8 billion in Daewoo debt (at relatively generous prices) from foreign creditors who were blocking agreement to CRA workouts. As a result state institutions (the asset management company, the deposit insurance agency, Korea Development Bank, and nationalized banks) hold a controlling position in Daewoo debt.

Strong and perhaps irresistible pressures may arise to create a public asset management company in a crisis, despite potential drawbacks (such as the time needed to organize and staff the company and the possible politicization of commercial transactions).9 If a decision is made to create a public asset management company, recent experience from East Asia highlights the desirability of giving it superpowers (for example, to appoint company administrators and to seize and sell collateral without court approvals), of transferring assets to it at realistic values instead of inflated book values, and of using multiple methods (auction, issuance of asset-backed securities, formation of joint ventures with outside professionals to manage pools of distressed assets) to resolve large volumes of distressed corporate and small and medium-size enterprise credits.

Corporate/financial sector linkages and regulatory forbearance. To avoid recognizing losses that could impair their capital adequacy, financial institutions in East Asia often sought to delay or minimize the restructuring of unsustainable corporate debt. Recent experience also shows that failure on the part of financial institutions to pursue the financial and operational restructuring of distressed companies can leave these companies in a "zombie" state-with uncompetitive cost structures, capital tied up in

" Equity partnerships worked as follows. KAMCO created several loans pools, each with about $300 million face value of assets. In response to solicitations, potential partners conducted due diligence on these pools and negotiated with KAMCO on the valuation of pools. Each selected partner obtained 50 percent ownership of a pool in return for payment of 50 percent of the negotiated pool value to KAMCO. Each pool was to be managed by a management company owned 65/35 between the partner and KAMCO and controlled by the partner. KAMCO entered into a number of such equity partnerships-for example, with Goldman Sachs, Deutsche Bank, Morgan Stanley, and Lonestar Partners. 9 For an assessment of pre-East Asian crisis asset management companies, see Daniela Klingebiel, "The Use of Asset Management Companies in the Resolution of Banking Crises: Cross-Country Experiences," World Bank, 1999. - 17- loss-making or low-return assets, and unable to obtain financing. To alleviate corporate distress, the authorities must force or induce all local financial institutions-private as well as nationalized or otherwise state-owned-to resolve unsustainable corporate credits and assets and recognize resulting losses in a timely manner. To induce financial institutions to resolve unsustainable corporate debt, East Asian authorities provided various forms of regulatory forbearance:

* In Korea, in the case of restructured corporate debt, the Financial Supervisory Commission (FSC) exempted financial institutions from having to apply standard forward-looking criteria and instead allowed them to provision restructured corporate debt at just 2-20 percent for up to three years. Had standard criteria been applied, it would probably have been necessary to provision much of this restructured corporate debt at 50 percent or more. A lower-of-cost-or-market rule also enabled financial institutions to carry illiquid converted equity at unrealistically high "market" prices.10 It is generally agreed that these instances of forbearance deterred financial institutions from following up financial stabilizations with sales of converted equity, asset sales, liquidations, or conveyance of debt-equity holdings to joint ventures managed by turnaround professionals compensated on an incentive basis, because such "restructuring transactions" would have forced the financial institutions to recognize additional losses. Indeed, the FSC terminated the 2-20 percent exemption from standard forward-looking criteria after just two years.

* Bank Indonesia provided forbearance on capital adequacy requirements. Other factors, however-notably Indonesia's weak insolvency and foreclosure regime-undermined progress on corporate restructuring.

* The Bank of Thailand allowed banks to phase in losses from corporate restructuring over 2.5 years. In addition, provisions could be calculated net of collateral-on mostly overvalued real estate. This forbearance on loss recognition may have discouraged private investment in Thai banks with murky balance sheets and-by encouraging banks to stage the losses on corporate restructuring to manage their capital write-downs-slowed corporate restructuring.

While regulatory forbearance is a superficially interesting option for inducing corporate restructuring, recent forbearance on loss recognition in East Asia may have delayed corporate restructuring as well as financial sector restructuring.

Crisis management. Centralized crisis management approaches were tried in East Asia but were not wholly successful.

1° While shares could be traded in many cases, several factors kept "market" prices unrealistically high- thin public floats, agreements among creditor-shareholders not to sell converted equity during the workout period (three years on average), and legal protections for public shareholders that conferred an incremental "greenmail" value on the shares. - 18-

o In Korea, in addition to its regulatory and supervisory duties, the FSC was put in charge of financial sector restructuring as well as the government's corporate restructuring policy. Bank recapitalization bonds were issued by the Korea Deposit Insurance Corporation and Korea Asset Management Company. The FSC established a "war room" to track emerging distress, but this does not seem to have facilitated responses to Saehan's bankruptcy and emergency workout in May 2000 or emerging distress in Daewoo in early 1999 and Hyundai's "MH Group" companies in 2000. More significantly, tasking the FSC with corporate in addition to financial sector supervision gave rise to potential conflicts of interest. For example, the 2-20 percent special provisioning rule for restructured corporate debt may have reduced the immediate costs of financial sector restructuring, but it contributed neither to enhancing the strength and security of Korea's financial sector nor to facilitating corporate restructuring. More recently, the FSC has reportedly found itself in the position-highly anomalous for a financial supervisor-of threatening to fine reluctant financial institutions for refusing to honor workout agreement commitments to provide new money to distressed corporations.

o In Indonesia a Financial Sector Policy Committee was established in January 2000 to review and approve IBRA transactions, oversee Ministry of Finance bank recapitalization bond issues, and enhance coordination among IBRA, the ministry, Bank Indonesia, and the J1TF. In addition, an Oversight Committee was established to oversee B1RA and its adherence to approved corporate restructuring principles. Implementation of corporate restructuring, however, has been uneven.

Crisis management team. Recent experience points to the desirability of a special purpose, temporary crisis management team to consolidate responsibility, ensure consistency of work and decisions, provide the necessary specialized skills, and insulate crisis resolution from other official duties and related conflicts of interest. The team should report to a governing body that balances political interests and resolves differences of opinion among the permanent government agencies represented on the team. Since a country's ministry of finance usually underwrites bank recapitalization bonds, it should play a leading role on any crisis management team. To avoid conflicts of interest between minimizing costs and safeguarding the nation's financial system, the financial supervisor should normally keep out of financial sector restructuring and focus on supervising financial institutions. The finance ministry and financial supervisor need to coordinate, however, on questions of regulatory forbearance. To achieve a strong link between corporate restructuring and financial sector restructuring, it would be desirable for the finance ministry to require a professional assessment (say, by an individual or firm with corporate restructuring experience) and certification of the "adequacy" of corporate restructuring agreements above some threshold as a precondition for making up financial institution losses on the implementation of these corporate restructuring agreements. - 19-

Corporate and financial sector restructuring involve a variety of considerations and costs-including knock-on effects through the economy. The government should seek to minimize the present value of the multiyear costs of corporate and financial sector restructuring. But this is easier said than done. Governments often succumb to the temptation to focus only on first year costs, "kick the can down the road," and hope for some macroeconomic deus ex machina in subsequent years to lessen the ultimate cost of resolving corporate and financial sector distress. A government's crisis management team would likely benefit from an independent assessment of the net present value costs and effects of alternative strategies for resolving corporate and financial sector distress. Particular attention should be paid to projections of corporate cash flows, unsustainable corporate debt, and bank recapitalization requirements; alternatives for protecting the workers, suppliers, and subcontractors of failed companies; and the potential effects of below-market interest rates and other debt restructuring concessions on market competition. To the extent that a government can develop credible cost projections and educate the public on the likely costs of available alternatives, it may be easier for the government to act decisively to resolve corporate and financial sector distress at least cost to the taxpaying public.

Implementation capacity. Recent experience from East Asia shows that restructuring hundreds of medium-size and large corporations (leaving aside thousands of small and medium-size enterprises) can absorb every accountant, lawyer, investment banker, workout professional, and receiver in a crisis-stricken country and run up enormous professional fees. There must be sufficient implementation capacity to conduct due diligence, structure and negotiate workouts, conclude asset sales, and manage converted equity. Professional support will have to be brought in from outside the country and acclimated to local legal and financial systems. Because debtor companies may be unwilling or unable to pay for professional support, it may be necessary for creditors or the national treasury to pay at least some of these costs.

Banks and public asset management companies will lack professionals with experience in corporate workouts and turnarounds. Efforts to develop in-house workout capacity can take time, and the results may not be completely satisfactory. Thus banks and public asset management companies would be well advised to retain outside professionals-on some incentive compensation basis, when possible-to conduct due diligence, structure and negotiate corporate workouts, and manage asset sales. Finally, reason suggests and recent experience indicates that corporate restructuring deals in a systemic crisis will leave financial institutions with masses of converted corporate equity. Banks will have enough difficulty managing themselves in a crisis and will have no experience managing corporate shareholdings or exercising corporate governance. Thus the management of converted equity should be outsourced to asset management and corporate turnaround professionals-perhaps through equity partnerships.

Crisis mitigants may include both micro program measures to ease the distress of critical sectors and segments of the real economy as well as macroeconomic policies to - 20 - restore sustainable economic growth. Measures adopted in East Asia to mitigate the effects of the crisis included:

o Additional facilities-some with support from international financial institutions-to provide trade finance. * Small and medium-size enterprise financing facilities-including a central bank discount window for small and medium-size enterprise and construction subcontractor notes receivable. X Enhanced safety nets for displaced labor-such as higher benefits and longer periods for unemployment insurance. e Debt and equity funds for medium-size companies.

The Korea Development Bank provided 60 percent and local financial institutions provided 40 percent of $1.5 billion in capital for four funds-three to make equity investments or provide long-term debt financing to replace short-term debt and one to provide just debt financing. Recognized managers-State Street, Scudder, Templeton, and Rothschild-ran the funds. In at least one case the fund manager has started a follow-on fund with offshore private capital.

Macroeconomic policies. The contribution that programs like those described above can make to mitigating the effects of a crisis on critical sectors and segments of the real economy paled in comparison with the effects of macroeconomic stabilization and renewed growth. Discussion of the components of successful macroeconomic stabilization programs-as important as these are-is beyond the scope of this annex.

The link between macroeconomic perfornance and corporate restructuring behavior, however, warrants brief consideration. The depth of macroeconomic decline and speed of recovery in East Asia posed a quandary for corporate restructuring. While imprudent debt-fueled corporate investments contributed to the onset of systemic crisis and sharp GDP drops, rapid macroeconomic rebounds occurred without much in the way of needed corporate restructuring. This raises a question of whether macroeconomic recovery encourages or discourages corporate restructuring. It is commonly suggested that rapid macroeconomic turnarounds saved distressed companies in East Asia from having to undertake more fundamental operational restructuring-massive layoffs, closures of loss-making or noncompetitive businesses, sales of noncore assets, greater acceptance of foreign equity ownership-for their short-term survival.

This is not necessarily what happens in a systemic crisis. While it may be possible for creditors to impose major losses on controlling corporate shareholders (say, through debt-equity conversions) and for governments to impose major losses on financial institutions (say, through increased provisions, capital write-downs, and interventions) in a systemic crisis, governments will find it substantially more unpleasant to witness massive layoffs, asset "fire sales," and wholesale foreign takeovers. Neither the corporations that ho purchased assets nor the banks that financed those purchases will readily sell or force the sale of assets at the bottom of a crisis. Macroeconomic recovery may encourage debtors to normalize relations with their creditors and thus stimulate sales -21 - of noncore businesses and real estate. But there is also a danger that macroeconomic recovery will encourage inflated expectations for asset values. In Korea, for example, the failure of chaebols to complete sufficient operational restructuring during favorable market and economic conditions in 1999-2000 may now be acting as a drag on growth.

Corporate reforms. While responding to short-term corporate reforms, some East Asia governments-notably Korea-implemented measures to encourage long-term corporate reform and lessen opportunities for a future repetition of risky corporate behavior. These measures included:

* Liberalization of rules on foreign direct investment-for example, eliminating limits on foreign shareholdings. * Liberalization of merger and acquisition rules-for example, eliminating or reducing the ability of corporate boards to block hostile takeovers. * Adoption of international accounting standards and enhanced disclosure-for example, bad debt provisions based on realistic expectations rather than tax deductibility; limits on capitalization of research and development; limits on asset revaluation; and consolidation of accounts, both domestic and offshore. * Enhanced corporate governance standards-for example, requirements for appointment of at least one outside director. * Enhanced rights for public shareholders-for example, to sue. * Tighter exposure limits, including limits on borrowing from related financial institutions. * Enforcement of prohibitions on anticompetitive business practices-for example, elimination of intra-chaebol cross-guarantees on debt and fines for purchases of related-party commercial paper and bonds at above-market prices (below-market interest).

Mexico

The Crisis. Following the reprivatization of Mexican banks in 1992,11 credit expanded very rapidly, reaching a peak of $117.8 billion in 1994.12 Facing an acute shortage of foreign reserves, the Mexican central bank in December 1994 allowed the peso to float against the dollar. The resulting sharp rise in interest rates and increased cost of foreign debt created a liquidity crisis that was exacerbated by the slump in domestic demand. The crisis forced a number of Grupos (large corporate conglomerates), which had diversified and grown rapidly in the early 1990s, to restructure their debts.

The Mexican Bankruptcy Law, perceived by almost all analysts of Mexico's financial system as very weak even before the crisis, was an ineffective instrument for

"Mexico's commercial banks were nationalized during the external debt crisis in December 1992 as the last act of outgoing President Lopez Portillo. 12 World Bank, "Mexico: Strengthening Enterprise Finance," Report 1773-ME, September 1998, p. iii. - 22 -

orderly workout or liquidation of troubled companies.13 It permitted many debtors to stave off creditors' claims almost indefinitely-, during the so-called tequila crisis debtors used bankruptcy as a threat or weapon more often than creditors did. The law does not provide for consolidated bankruptcy, so a company with many subsidiaries and affiliates would have many separate bankruptcy cases under separate judges. Any company that is insolvent (liabilities exceeding assets) is likely to be put into quiebra (liquidation) by a motion of its creditors, and not be reorganized. 4

As a result of the shortcomings of the Bankruptcy Law, the Mexican government created an institutional structure known as Unidad Coordination del Acuerdo Bancario Empresal (UCABE) during the crisis to orchestrate the voluntary restructuring of 3040 of the largest debtors. UCABE, the entity for coordinating agreements between banks and enterprises, was created on 13 December 1995 as a unit of the joint commission between the Mexican Banking Commission (Comision Nacional Bancaria y Valoresi, or CNBV) and the Mexican Banking Association (Asociacion Mexicana de Bancos, or AMB). UCABE was established largely at the initiative of Mexican President Ernesto Zedillo in an attempt to bring stalled debt negotiations between banks and major debtors to rapid conclusions. Four senior executives ran UCABE on a voluntary basis at the request of the president. The government and the AMB had concluded that "satisfactory progress in large corporate debt restructuring was not being made by the workout groups in the individual banks, and that the relationships between debtors and creditors had deteriorated to such a degree that productive negotiations had become severely impeded."15

UCABE could be traced back to President Zedillo's experience in the external debt crisis of the 1980s, in which agreements on corporate workouts were negotiated years after the initial crisis in 1982. Critical lessons from the "lost decade" include:16

* Debt restructurings could take years to complete. * Solutions required sacrifice by all parties in the negotiations. * Creative financial mechanisms and instrumentation could catalyze a solution. * New cash was often critical to reaching agreement. • Active sponsorship by the government of Mexico was essential.

UCABE was a mediator in large corporate restructuring cases, targeting companies with $150-500 million of bank debt. Holding some $8 billion in debt, these companies represented 8 percent of outstanding loans in the Mexican banking system at the end of 1995. UCABE sought to preserve the viability of these firms, sustain

13 Ibid, p. 75, quotes a Mexican expert on the Bankruptcy Law "In summary we know of no one who believes that (The Bankruptcy Law) is a good law, not even a mediocre (law)." Davalos Mejia, Titulos Y Contratos de Credito, Quiebras, Haria, SA.A. de C.V., Primnera Edicion, p. 527. 14 Raymond Davies, Lehman Brothers, "Overview of Post Peso Crisis Mexican Corporate Restructurings and Lessons Learned," Seoul Korea, Conference on Corporate Restructuring, 7-8 May 1998, p. 113. 15 Peter Jones, "UCABE: A Troubled Debt Restructuring Unit," consultant's report to the World Bank, 1996. 16 Ibid, p. 2; the discussion is also based on interviews conducted by Ira Lieberman in 1995-96 with UCABE's senior management. - 23 -

employment, and promote economic recovery. UCABE limited itself to potentially viable companiesdefined as those having a positive cash flow and significant base of employment, being a leader or important player in its market niche, and having a competitive cost structure. In addition, many other corporate workouts occurred outside the framework of UCABE's mandate, but based on the workout process and procedures established by UCABE.

Banks operating within the UCABE framework needed to compensate for the weaknesses in the legal framework, namely the absence of a viable bankruptcy system and any formal framework for workouts. They agreed to follow specific rules of conduct' 7 regarding:

* Selection of a lead negotiator bank * Decision by majority rule * Adoption of standstill agreements * Seniority of secured credit * Preferential treatment of new voluntary loans * Subordination of existing guarantees * Identification of a sustainable amount of debt * Use of debt swaps between banks * Use of debt capitalization and other financial engineering techniques to reduce the overall debt burden and to allow exit.

Shareholders and debtor companies also followed rules regarding the provision of new capital, dilution of ownership rights, and strengthening or replacement of company management, to facilitate reaching a final agreement.

The advantages of the scheme appear to be clear-a flexible and agile voluntary process to meet the needs of the debtor and the creditors, top government commitment through the office of the president, and provision of new financial resources. The disadvantages were that the process was discretionary and ad hoc-it lacked published principles or guidelines, did not address the fundamental weaknesses in the Mexican bankruptcy system, and is an extralegal system that could be subject to court challenge.

Some 30-40 companies were restructured through UCABE, but no results or proceedings of its operations have been published. This is also true for the London approach, in which confidentiality is maintained. Some of the workout cases, such as Mexicana de Aviacion and Aeromexico, were problematic state-owned firms in the 1980s that were privatized in the early 1990s-apparently without adequate restructuring-and reemerged as problem cases in the most recent crisis.

7 Peter Jones, op. cit., pp. 2-3. - 24 -

ANNEX 2 SURVEY DATA ANALYSIS

ILGeneraR Status of Surveys

First Round

___KOSGEB ATIO ASO TOBB 3500 randomly Sample Size About 220 1720 1039 - but very low received response rate. participatingforms from chambers. Period covered QR I 2001 QR I 2001 QR I 2001 QR I 2001 Survey designed toMa25frctf Cutoff date for data be launched at the data for data entry. ate Completed entry was May 31, April 29 to May end of each quarter. June 8 - press 001. 2001. ~~1, 2001 receivedLatest results end ofwere results.announcement of May. results. Target Group SUEs Business, Service anufacturing usiness, Service Tand SMEs afun and Manufacturing Stratification Employment None None Yes Yes Sector None None Yes Yes Location Ankara Ankara Ankara Entire country Largest 33% (1039 size out Convenience units) selected from a t l Access to Kobinet Convemence 2886 members. ofatotal (SME WEB Service satnpling. Very low response membership of 1 M Sampling Method Unit) users. Distrbute forms ate - 177 units for enterprises Responses received and collect at March 31, 2001 belonging to 248 via internet. selected survey. Somewhat chambers and 102 locations. biased sample in Commodity favor of large firms. Exchanges

Scientific data Only % Elaborate analysis. collection, Only frequency frequency Need improvement processing and Data Analysis distributions. No distributions in format and depth analysis by interpretations. No provided. No info of analysis. Some experienced staff. graphics. on sample sizes elevance to crisis. Use of SPSS. Very for each item Need to follow up. flexible database structure. - 25 -

Second Round ISO ATO ASO TOBB 2542 randomly 934 of which 499 125 forms received eceived forms Sample Size small, 254 medium 8170 out of some 1039 from participating and 181 large 87ot of chambers out of enterprises sent out. some 11,000 forms sent out April 1 through Period covered First half 2001 First half 2001 First half 2001 September 30, 2001. Date Completed Aug-01 Aug-01 Sep-01 1-Nov-01 Small. Medium and Business, Service Larger Business, Service Target Group Large Industrial and SMEs Manufacturing ues Servfce Enterprises d Enterprises Stratiflcation Employment Yes one es Yes Sector es one Yes Yes Location stabrl AAa A Eire country

Largest 33% (1039 units) selected from Modified and bout 10% of Convenience 2886 members. enlarged size out of embership. Some sampling. Very low response a total membership SamplmMethod980 forms were Distribute forms - 125 units for of 1 M enterprises Sampling Method out and 934 anbut at Fist half 2001. belonging to 248 sent out and 934 and collect at Somewhat biased chambers and 102 were received. selected locations. beat bias Commodity because of its Commodity emphasis on large Exchanges enterprises.

Scientific data Elaborate Report o collection, Issued by ISO - Only / frequency . processing and Economic Situation distributions Elaborate analysis. Data Analysis Sesymentuo rovided. No info Substantially analysis by Assessment, on sample sizes for imnproved, experienced staff. Survey Results each item Use of SPSS. Very 2001 - I flexible database structure. - 26 -

Third Round TOBB ASO

Sample Size Firms or 247 2 enterprlses)

Period covered QR IV - 2001 QR - IV 2001

Administered March 4-12, 2002 Date Completed and submitted to WB team on February 2002 March 14, 2002 Target_Group Business, service and Larger scale manufacturing Target Group manufacturing enterpnses

Stratification Employment es Yes Sector Yes Yes Location ountry-wide Ankara

Convenience sampling on the same questionnaire. Forms were Targeted finns still come from Sampling Method ut on the internet. Firms with e largest third of membership intemet access completed forms in the Chamber. which were sent via internet.

Processing and analysis by laborate analysis and experienced staff. Use of SPSS. ublication which have been ata Analysis Also a comparative analysis of stantially improved selected nine simple questions following Turkey CSIA team was performed by TOBB for uggestions. Bank use. - 27 -

II. TOBB Survey evaluations for Quarter 4 of 2001 and expectations for whole 2002

General Question: How did capacity utilization of your establishment change between the last quarter of 2001 relative to the third quarter of 2001?

Smaller E terprises Larger E terprises N % N % A- Increase 12 7.5 12 15.4 B- No difference 30 18.6 26 33.3 C- Decrease 119 73.9 40 51.3 Totals 161 100.0 78 100.0

50 or Fewer Workers More Than 50 Workers

80 70 60 50 ~40 30- 20- 10

0 - Smaller Enterprises Larger Eterprises XA *BO3C| - 28 -

General Question: I[s younr compamy engaged in exporting goods?

Smaller Enterprises Larger Enterprises N 0/O ~ ~~N ~% Yes 37 22.6 58 76.3 No 127 77.4 18 23.7 Totals 164 100.0 76 100.0

100 80- 60 40=

2 0 sI -],i 4

Smaller Enterprises Larger Enterpnises

l Yes iNo]

Question No: 11How was the situation of youir establishment in the last quarter of 2001 relative to the thAird quarter of 2001?

=. Small Enterprises = Large Enterprises N NP%% A- Better than Q3 2001 13 8.0 12 15.4 B No difference 45 27.6 33 42.3 C- Worse than Q3 2001 105 64.4 33 42.3 Totals 163 100.0 78 100.0

70 60 - 50 40 30 - 20 -_ _

OW1-...1 0 Small Enterprises Large Enterprises 0 Better than Q3 2001 o No difference i Worse than Q3 2001 - 29 -

Question 2: What are your expectations for 2002 as compared to the last quarter 2001?

______Smaller Enterprises Larger Enterprises N % N % A- Will be better 42 26.1 32 41.0 B No difference 67 41.6 22 28.2 C- Will be worse 52 32.3 24 30.8 Totals 161 100.0 78 100.0

45

3035 -S25 15 10 5 0- Srrniller Enterprises Larger Enterprises

IE3A- iB C

Question 3: What happened to the workforce employed at your establishment in the last quarter of 2001 relative to the third quarter in 2001?

.______Smaller Enterprises Larger E terprises

______~~~ _ ~ _~~N _ _N _ _ _ _ A- Increased 7 4.3 4 5.1 B- No difference 54 33.5 38 48.7 C- Decreased 100 62.1 36 46.2 Totals 161 100.0 78 100.0

70- 60 . 50 .40- 30

10-- Snmller Enterprses Larger Enterprses

BlA aBatC. - 30-

Question 4: What are your expectations for 2002 in the workforce employed at your establishment?

Smaller Enterprises Larger Enterprises N______N . _ ___ A-Increase 26 16 1 21 26.9 B No difference 76 47.2 26 33.3 C- Decrease 59 36 6 31 39,7 Totals 161 100 0 78 100.0

50 40L i $30

10 0 Snuoer Btterprbes Larger Enterprises

Question 5: Did you borrow from the banks in the last quarter of 2001?

Smaller Enterprises Larger Enterprises

Yes 20 12 4 24 30 No 141 87 6 54 69 2 Totals 161 100.0 78 100

S100L 80 - _60 - .

&a SDEr 6wprlses Larger Enwwpises - 31 -

Question 6: If you borrowed from banks, what kind of changes occurred in your relations with banks?

Smaller Enterprises L arger Enterprises N % N % A-Added Collateral Was 4 12.9 4 13.8 equired Loan Was Recalled 1 3.2 0.0 - Credit Interest Rates 7 22.6 9 31.0 ncreased

- Other 2 6.5 0.0 E- C and B Above 4 12.9 1 3.4 F- No Change Occurred 12 38.7 12 41.4 G- Other Combinations of 1 3.2 3 10.3 Above Answers Totals 31 100.0 29 100.0

|No Credit Used 133 49

45 40 35 30- 25- 20O 15 10 5 0 Smraer Enterprises Larger Enterprises

mA *B oC oD* EmF *G - 32 -

Question 7: Do you expect to borrow from a bank in 2002?

Smaller Enterprises Larger Ente rprises __N _ __ % _ N h Yes 21 13 1 _ 26 33 8 No 139 86 9 51 66.2 Totas 160 1000 77 100 0

100 g0 80 70 _ 60

40 30 -

20

Smaner EBterprbes Larg Eterprises

Question 8: How did your sales volume change in last quarter of 2001 relative to the third quarter of 2001?

______T______Smaller Enterprlses Larger Etrprises

______~~~ _ ~ ~~N_ _ _N _ _ _ A-Increased 13 S2 13 17.3 B- No dlfference 35 22 0 26 34 7 C- Decreased I11 69 8 36 48 0 Total 159 10010 1 75 1000

80 70 60-_. --- _ ____

20 10

Smaller Enterprises Larger Enterpnses

oAorl oCrI -33 -

Question 9: What is your expectation for sales in 2002?

SmaUer Enterprises Larger E teprises ._____ N % N l % A- Increase 43 26.7 37 48.7 - No difference 58 36.0 17 22.4 C- Decrease 60 37.3 22 28.9 Total 161 100.0 76 100.0

60

50 40 S30 20

Srnaller Enterprises Larger Enterprises |O9A wB - -C|

Question 10: If you think your sales will increase, what will be the approximate level of this increase?

SmaUer Enterprises Larger E terprises N % N % A- More than 20% 7 14.9 11 28.9 B Between 11% and 23 48.9 14 36.8 20% C- Less than 10% 17 36.2 13 34.2 Total 47 100.0 38 100.0

60 50

40 . - ~30 20 . - __- 10 - , . .- Smaller Enterprises Larger Enterprises

FG>A _ C2 _ C_ - 34 -

Question 11: H1ow do you intend to continue your establishment in 2002?

Smaller Enterrises Larger rises _N % N % A- By growing 17 11.0 18 23.4 B- By maintaining 90 58.1 42 54.5 eisting situation sBybecoming 48 31.0 17 22.1

otal 155 100.0 77 100.0

70 60 50

30 -- _ 20 -

100 : --- l---- Snafler Enterprises Larger Enterpr'ses - 35 -

Question 12: If you intend to continue by downsizing your operations, how do you plan to do it?

Smaller Larger Enterprises Enterprises N __ _ N % A- By Depleting 2 2.6 1 4.0 Existing Stocks B By Reducing 9 11.7 4 16.0 Labour Force C- By Reducing Other I1 14.3 3 12.0 Costs______

Aboveh10 13.0 2 8.0

E- A, B and C Above 31 40.3 12 48.0

F- Other Combinations (A&B 14 18.2 3 12.0 and A&C) Totals 77 100.0 25 100.0 No Intention to 87 An Downsize .A._... *A total of 87 small enterprises and 53 large enterprises have no intention to downsize their operations.

60 50 40

20 - r _ 10 0 Snmller Enterprises Larger Enterprises

|OA *BoCODEMFI - 36-

ML. ASO (Ankara Chamber of Industry) Survey -

4 tb Quarter 2001 Analysis (Selected Questions)

Questions on Employment

Number of Number of Average number Percentage N-umber of workers: _of workers I change

______company _____ End of uarer 2of 2001 92 23,379 254 12 End of Quarter 3 of 2001 92 22,072 239 91 -5 6 End of uarter 4 of 2001 92 21,919 238 25 -0 7

2 2 umbernomc of reasons workes dunng dismissed Quarter due 4 to of 30 2,440,440 200 1 .-- SEu

Average Number of WorkerslCompany Percentage Change In Number of Workers

26000 00 255 W -1 0 W0ofQ e Id Qua r44 f 2001 25000 -20 245 00 i - 24000 - j -30 - 23500 -40 23000 1 Bid of Quarter 2 BEd of Cjarter 3 nd ofCartnr 4 -5 0 of 2001 of 2001 of 2001 4 0

Nurrber of Workers | -4 Prcentage Change

In Q3 and Q4 2001, sampled ASO (Ankara Chamber of Industry) member compamnes employed an average of 239 and 238 workers, respectively In Q4 2001, the same companies declared that their average work force decreased shghtly from 22,072 to 21,919, representing a 07 percent of reduction m work force In the same survey, 30 compames reported that some 2,440 workers were laid off due to economic reasons - 37 -

Using the headings provided below, please state your evaluations for Q3 and Q4 of 2001 and your expectations for 2002?

ASO Survey- Evaluation for the end of Q3 2001

70 60

so50 *40 30

Prduction Domestic International NewOrders Employment Sales Sales

| Increased Q3No Change o Decreased

ASO Survey - Evaluation for the end of Q4 2001

60

50 ~40 ~30

o

Production Domestic International NewOrders Employment Sales Sales

| Increased 13No Change G Decreased

ASO Survey - Bxpectation for 2002

60 so

*40- 130 1, ~20 A

0. 4

Productlo n Domestic Intematlo nala New Orders Employ,ment Sales Sales

* Increased 03 No Change 0 Decreased - 38 -

What was your average capacity utilization during the foilowing periods?

Capacty Uiization RtlWo ftr Average Capacity tlizateon 04 of 2001 60 45-458475 40 4372 4581 36~~~~~~~~~~~~$4 .30 c 25

O 50 t 60 N 90 90 20120120

Per-o Range

45 - 45 I~~~~~~~~~~~~~~~~~. - 10 4

CapacEq UUilizaUon RfWo for Capacity lWRalidn Ratio for tl2 of2001 <130ot

t35 _ W

02 20

50 60 70 80 90 100 0 50 70 so 90 10O 0 50o 60 To so 9 0200 20 20e 0 Percentage ngg ng - 39 -

What is the share of exports in your total turnover?

ASO Survey- Share of Exports In Total Sales ASO-Survey Share of Exports in Total Sales O4 of 2001 Average

30% 40 25% &20%& 30

of . ~~~~~~~~~~Secondquarter of Third quarter of Fourlhquarter2001 0 5.1 10.1 20.1 40-1 60.1 801 2001 2001

ASO-Survey Share of 0xports in Total Sales ASO-Survey Share of Exports in Total Sales Q2 of 2001 03 of 2001

30% 30% 25% 210 &20% e 20% 30% 30% 5 10 20 40 60 80 100

5.1 10.1 20.1 40.1 80.1 80.1 0 5.1 10.1 20.1 40.1 801 80.1 0 - 40 -

lDo you have flaimed coms raims Gml todLay's ecomnmic sAtuatom?

No 27%

-~Yes 73%

iAankftng onstraWs 5 4 3 2 iI _ _ _ _ _

F{gh Oredft Oosts Ppid Increasing of Not to Create Ow n !nsufficlent Credits Decreasing of IMnagertnt Capital Resources Supports - 41 -

IV. Addendum to TOBB Surveys in 2001- Comparative Analysis of Three TOBB Surveys

1_/ Questions 9, 10, 12, 13, 14, 15, 16 and 17 have not been analyzed here due to complexities (multiple choice type questions) of the question concerned.

2 / Percentages only have been used in the comparison of the three surveys due to different sample sizes for each of the three surveys.

Sample Size Data Collection Period (Number of Firms Method Responding) Ist quarter of The questionnaires 1st Survey 001(between January 3,254 were collected by March) fax. nd and 3rd quarter of The questionnaires 2nd Survey 001(between April to 2,519 were collected by September) fax and mnail. 4th quarter of The questionnaires rd Survey 2001(October through 242 were collected by e- December) mail - 42 -

Question No XX:HEow did the sUatdoon of younnr estblishsment change relatve to the previous peniod?

2nd 3rd Ist Survey Survey Survey esponses Jen-March Apr.-Sept. Oct.-Dec. 2001 2001 2001 Percent A- Better than previous 5.14 6.45 10.16 period I 1 No diference 15.14 25.58 32.12 C- Worse than previous 79.72 67.97 57.72 periodl

Total 100.0( 100.00 100.00

90 - 80, 70 - 60 (% 50 40 30 20

1-0

A- Better than previous B- No difference C- Worse than previous period period

QlstSurvey 02ndSurvoy 33rdSurvey - 43 -

Question No 2: What are your expectations for the next period as compared to the previous period?

1st Survey 2nd Survey |3rd Survey Responses Jan.-Mar Apr.-Sept. Oct.-Dec. 2001 2001 2001 Percent A- Will be better 25.11 8.30 30.33 than previous period B No difference 41.35 39.17 37.70

- Will be worse 33.54 52.53 31.97 han previous period

Total 100.00 100.00 100.00

60

50 _ _ _ _ _

40 _ _ _ ?30

20

A- WViVbe better than previous B- No difference C-Wil be worse than previous period period

In 1st Survey * 2nd Survey a 3rd Survey - 44 -

Question No 3: What happened to the workforce employed at your establishment as compared to the previous period?

2nd 3rd lst Survey Survey Survef Responses Jan.-Mar Apr.-Sept. Oct.-Dec. 2001 2001 2001 Percent A- Increased 2 47 5 02 4.51

B No difference 4110 35.07 38 52

C- Decreased 56.43 59.91 56 97

Total 10 00 100 00 100 00

70- 60.

40

30 20-so

10

A- htcreased 8- ft difference G Decreased

o lst Survey u 2nd Survey a 3rd Survey - 45 -

Question No 4: What are your expectations in the next period for the workforce employed at your establishment ?

1st Survey 12nd Surveyl 3rd Survey Responses Jan.-Mar Apr.-Sept. Oct.-Dec. 2001 2001 2001 Percent A- Will increase 8.70 3.96 19.26

B No difference 50.62 47.09 42.62

C- Will decrease 40.68 48.95 38.12

Total 100.00 100.00 100.00

120 100 80 60 40 20 - 0

f~~~C t0 e, 4Sv

Ia 1st Survey * 2nd Survey 0 3rd Survey - 46 -

Question No 5: Did you borrow from the Ibanks ~m the corresponding period?

1st Survey 2nd Survey 3rd Survey Responses Jan.-Mar Apr.-Sept. Oct.-Dec. 2001 2001 2001 Percent yes 29.77 26.401 18.03

No 70.23 73.60 81.97

Ota 100.00 100.00 100.00

90 80 70 60

'40

30______20 10- 0 Yes No

1st Survey a 2nd Survey o 3rd Survey - 47 -

Question No 6: If you borrowed from banks in the corresponding period, what kind of changes occurred in your relations with banks ?

1st Survey 2nd Survey 3rd Survey Jan.-Mar. 2001 Apr.-Se t. 2001 Oct.-Dec. 2001 Responses Rank Percent Rank Percent Rank Percent redit interest rates increased 5 68.7 5 59.80 5 40.90 B Added collateral was required 4 16.40 4 23.00 3 25.00 C No change occurred 3 9.1C 3 21.20 4 34.10 D Loan was recalled 2 8.0 1 5.90 2 4.50 E)ther changes occurred 1 6.6 2 6.60 1 2.30

In this chart 5 represents the highest frequency.

6 5 _

4 4 -.- --

2 _ _

2 -edi-t Iners ''atesi' |

-~ * X-. Credit interest rates Added collateral No change occurred Loan was recalled Other changes increased was required occurred

Io -ist Survey a 2nd Survey o 3rd Survey - 48 -

Quesiom No 7: IEDo you empect to bIorow cire&t finomm miy buk aimte met Iperfod?

1st Survey 2nd Su-ey 3rd Survey Responses Jan.-Mar Apr.-Sept Oct.-Dec. 2001 2001 2001 _Percent Yes 25.90 22.36 19.83

No 74.10 77.64 80.17

ot0l 100.0( 100.00 100.00

90 80 _

70 -~' 60-

250 1~0' 30

Yes Ro

o *st Survey o 2nd Survey o 3rd Survey - 49 -

Question No 8: How did your sales volume change relative to the previous period?

1st Survey 2nd Survey 3rd Survey Jan.-Mar Apr.-Sept. Oct-Dec. 2001 2001 2001 Responses Percent A-Increased 7.01 10.41 11.30

B No difference 16.42 19.91 25.94

C- Decreased 76.5 69.68 62.76

Total 100.00 100.00 100.00

90 80 70 60 .50 ~40 30 20 10

A- kicreased B- No difference C-Decreased

1st Survey * 2nd Survey o 3rd Survey - 50-

Question 111: IElow do you iimtemd to colmi¢ue younr estB Elinllmemt rm thfe mext perlod?

1st Survey 2nd Survey 3rd Survev Responses Jan.-Mar Apr.-Sept. Oet.Dec. 2001 2001 2001 Percent A- By Growing 4.82 3.21 14.77 B3By Maintning 63.28 63.47 56.96 zisting Situation C- By Becoming Smaller 31.90 33.32 28.27

otaow 100.00 100.00 100.00

70

60

50

40

30 20

10

A- By Gow Ing B-By aintaining Existing Situation C- By Becomrng Snaller

Io 1st Survey 0 2nd Survey o 3rd Survey - 51-

ANNEX 3

ANALYSIS OF ISTANBUL STOCK EXCHANGE DATA

Istanbul Stock Exchange Coverage

The ISE dataset covers about 300 listed companies that operate in the sectors shown in Table 1. There are nine reporting points in the dataset: end-year statements for 1997-2000, first quarter statements for 1998-2001, and second quarter statements for 2002. The second column of the table contains the average number of reporting companies for the nine periods. Note that the number of companies with valid data is usually smaller than 300. It depends on the item in question. Sectors represented by fewer than five companies are shaded, and aggregations for these sectors are not constructed in the analysis, as they must be considered unreliable. The third column of Table 1 indicates which sectors were used in the analysis: the focus is on nonfinancial real sector companies.

Table 1. Sectoral distribution of comranies in the ISE dataset

Used In sector btle Average U anslsis 0 Unidenllfled 1 BANWING -BANKA 1a 2 INSURANCE- SIGORrA a 3 FIRMS THPRIVATE TERM ACCOUNTS -OZEL HESAP DONEMLI RETLER 3 4 FRS wTH PIVATE TERM ACCOUNTS -OZEL HESAP DONEML IRKETLER I 5 LEASING AND FACTORING -F;NANSAL K/RALAMA VE FACTORING 11 a MUTUAL FUNDS -YATIRIM OR TAKLIKLARI 20 7 INVESTMENTAND HOLDING -YATIRIM VEHOLDIG 185 8 FINANCIAL INTERMEDIARIES -ARACI KURUMLAR 2 9 IRON, STEEL CASTING AND METAL -DEMIR-CELIK, DOKOM VE METAL 13 10 CHEMICALS, PETROL RUBBER AND PLASTIC -KIMYA, PETROL, KAUCUK VE PLASTIK 2 I 11 CEMENT, GLASS &CERAMICSAND SOILS LEANING INDUSTRIES -TAS VE TOPRAGA DAYAU SANAYI 25 12 FOOD. DRINKS AND TOCACCO -GIDA, ICKI VE TUTUN 27 I 13 METAL GOODS, MACHINERY AND ACCESSORI ES MANUFACTURING -METAL ESYA, MAKINA GERECYAPIMl 26 IE 14 OTHER MANUFACTURING INDUSTRJES -DIGER IMALAT SANAYI 1 9*1

18 REAL ESTA TE MUTUAL FUNDS - GA YRIMENKUL YATIRIM ORTAKUKLARI 7

19 TEXTILES -TEKSTIL 38 20 TOURISM AND HOSPITALITY -TURIZM VE OTELCALIK ae 21 PAPER, PULP, PUBLISING AND DISTRIBUTION -KAGIT, KAGITrURUNLE-RT, ASIN VE YAYIN 13 22 WHOLESALE COMMERCE -TOPTAN TICARET 6 S 23 RETAIL COMMERCE -PERAKENDE TiCARET 7 S

T6EKN4OLOJI 6 li ______S__ I ZII 1I

Average #,totl 288 207 *I -cassttsd as Industry, S -classted as non-financial servlne, blank -not used In analysis Shaded sectors have less than 6 companIes Separate awoegaons for these sectors ameunnetable and amenot povkded

Table 2 shows the relevance of the ISE dataset's coverage. We compare the aggregates for net sales and total shareholder equity with those based on the 1999 ISO datasets, which include major data on the 975 largest (in net sales from own production 18) companies operating in the sectors shown in the third column of Table 1. 9 While the

18 Sales from production is different from (overall) sales, as the latter may include resale and the like. '9 Further correction may be needed, but it is unlikely to materially affect the results. - 52 -

(sector-adjusted) number of companies in the ISE dataset amounts to only some 18 percent of the 975 companies in the ISO datasets, the ISE dataset (as measured at the end of 1999) covers around 36 percent of net sales or equity and about 23 percent of employment reflected in the ISO datasets. Thus the ISE dataset has fairly good coverage. At the same time, as one would expect, the ISE dataset is biased toward larger companies. Some 36 companies from the ISE dataset have not been identified among the companies in the ISO datasets.

Table 2. Comparison of ISE and ISO datasets, end-1999 end-I 999 data Not in ISE dataset In ISE dataset Total ISO 1000 In ISE, % Net Sales (TL tm) 18,304 10,418 28,722 36% Equity (TL, trn) 6,920 4,004 10,924 37% Count of companies 804 171 975 18% # of employees 527,162 156,696 683,858 23% Count of companies 798 170 968 18% Note: No employment data for companies with negative equity.

Financial-Industrial Group Affiliation and Other Company Characteristics

Each company in the ISE dataset was assigned a group affiliation if it is a member of one of the groups in listed in Table 3.

Table 3. Grou s in Turkey Group name Group code Alarko Holding I Anadolu Group 2 Cukurova 3 Dogan 4 Dogus 5 EGS 6 Enka 7 Ezzacibasi 8 Ihas 9 Is Bankasi 10 Isiklar 11 Koc 12 Net 13 Sabanci 14 Yasar 15 Oyak 16 Akkok 17 Borusan 18 Sanko 19 Zorlu 20 Rumeli 21 Tekfen 22 Fiba 23 - 53 -

Distinction also was made between majority state-owned companies and majority privately owned ones. None of the ISE state-owned companies is a member of a financial-industrial group.

Companies with valid net sales data were classified into three categories, according to their size:

* Large: Net sales > 1 trillion lira in 1993 prices (PPI deflator used). * Small: Net Sales <= 0.4 trillion lira in 1993 prices. * Medium: the rest, except where data are missing. - 54 -

Table 4. Financial Ratios Used in the Analysis (See Table Al at the end for definitions of the varia bles)

Codo Rado Indator of Calculation F routused Rstmai Vartabl"pectfic cleantnv PFt FAoffre"tY RtoFybbt Net IncomeSaes venes v4300 For non-zemoNet m ordy

tNTGI Interet expemsebrden Solency Fb r v51CI (v430D+ v5100) t r =e, l nr

IC-1 Fhanca expensecovage Sotvr EBIr/ Ontancdt (v60t(4W0W(tOO) tr ed financial For non-zeroNet nwme beomretea. w __t _ __E _ ___ _ex__ e__eXDernserd Feanct Exence rovaxe (OCF+Wx+fl1Cna ShiowathOm acv coverageof Iccaetr operationswth cash feabhtw fror SoltWcy epensey fIngmna! SEEEXPLANATION I Ilvedl expense wilh cas,h SEEEXPLANATION I financial exerw ense eywsft terr Operaton

Cufrent Assets,only CR Currentrewo Liy temw UshOttiestAsntAets/S v11OOtv21oN For non-zero

Liuid Assetsf S- (v111Gw1120)f OR Otdtk ratio leuhS tefn UeatdiUee (v2111+v112>)

LV Leverage-I Solvency EquItyNo eiuy (v3a10-300yv30O0 scatteredMayhae dItultlbulionnae so Ivr values.aMmwy+odon- TonlyynAssetsT otnlv

12Ild (v3900O30)v1000 Abovedelieredes of Lverage For non-zeroTotal Aasets=Total LV_2 Levere-2 SolvWncy Non-TtdAssets 1 elTbdrnata abe Shoar-tenrnend lo- B Bartka debt as Ohereof Totel Snxure of tent beankdeW (v21111+v211Y(900no (non-eqI) Uab8flies 1let Total non-equIty v3000)

5L S-termLabtties e ehereof Suclterof SbTtel MqI v2I(v396v300) nonr Toted(nen-equlty) LiebESe Uabt3be TotalnOLt 20/E30-W )r

S-tnt,firenlatIttiotsasSjtrctte ofe-tern, Nogini s-tentm SFSL Stln o ae _ Srabtleif otals-tsrrt,rn(v2100.v211 4100 none

36V36W reoelvables Heriltrafter mcov~ #of Observetions wet,n recelneteesIn OR uDastedr Sovecy((v43O0j12h,ronvVy(v1130lernover rnont coeebf eIthe paerdset lo rntssbV DR ou¢ngoov LlqdetSo %v rc v12104+Lv130Lv21 Oy2) sraeet en h

DP-2 tdon r Llq SoNerty 36S pWables L v 1 50)rj12moo3Y((v212 Ste Oservetiorm wt no e -term bP2tased on altcaommercit aSN, IlO)lIrrol(v1 Same coTrreodat tbtEes l eSte period ______2 v2220.Ls2120.LvmO))f22 setI mIssIng Dl DEW#Stawnvtod2s hr, i d ~ WY' u,verahnioirn 36/ (([(-v4 - hvenInnen no3erVtYieS Cost ofof nopIneretse In Di DayshddInvenbm Lkwdw Sdvency ~~~de)fll2hrrcovy((vl l50vLv Goodssold. eackudite eObsr eervalnseth to miessing I ternvex 1lSO)#2) depedetin experreeo ettDMW

EO EN>ortortbon hedgetncome marency steeForeten nforensaleseas _ nd v41201(v41204v4110) nors domestic (Cash +cash Shom t- abLbtyto bweealy SDC Shor-tm bantkdebt t e.S- vab E (vii1O1120v110 cave ri-tem bankdebt by coverage SWWWICY +securitie.-,,,,. N)EI

_term bark derbt _ceivables

-in addItIon to .naturarcleaning resxdthn tim no-denorntnatmr. ete... Explanrltlon 1:

O ner 2bns tWassets, Receivables recxvl 130+4v210 Inventoies invvl 150

Cleamfonsselmted llaWk=es commerciBl Ilablilbes. c=v21204v2220 other labitlies resulUng thtn operations: oi=v2140+v2240 DEPRECIATiON EXPENSE comes famm MO datEt.For Milssing or Invalid deprecIation eqesa, such expense is esttmated In the fotowtng mannor dearetion: dc=-v i248 Debrectiaro erense asswmes S-year straloht deotrdcalln of fixed assets sublar to deoreciation. denL(vl240-v1241-v1249-v12491-v1248ti1St12.ncovl Further, de is assumed nomnecrtatve and no oreater than OSx(-v44001 - I.e. not exaeedtno hal of Cost of Sales Cash flo,ws fomn opereto (atir tlax): OCF=vE200+ de+ (.ec4rl4olIK4ec4-nvcI*ol), where Ira cl, dp and their lags are nonzer Fintally, lCasah=(OFwvOC4-62O 0(e5SO)Y(-v3O) - 55 -

Results

Our primary interest is in the degree of short-term solvency that Turkish businesses exhibit. To classify companies with respect to their solvency, we devised a simple scoring system. Scores assigned to each company operating in industry or nonfinancial services reflect its vulnerability to tightening credit market conditions. Table 5 describes the scoring system, which uses three indicators. The first is based on total shareholder equity. If the sign is negative, the company is technically insolvent. The second and third indicators (financial expense coverage and short-term bank debt coverage) show the ability of a company to remain (or become) solvent in the short run. One would perhaps be interested in separating companies with negative equity from the rest. Thus total scores of 10, 11, or 12 are assigned to such companies, where the second digit indicates how many of the remaining two indicators fail. Quite expectedly, almost all the technically insolvent companies appear to have a score of 12. Companies with positive equity may only have scores of 0, 1, or 2.

While convenient for tabulations, this scoring system becomes an obstacle when the total score is aggregated across companies (by sector, by size, and so on), because scores 10-12 become "outliers" and have perhaps too high a weight when aggregations (by averaging) are done. Of course, how much weight each of the three underlying indicators has in the total score depends on the analyst's preferences. In our analysis, for aggregation purposes we switch from the total score ranging from 0-12 to the total score ranging from 0-3 (scorel, see Table 6), which is simply equal to the number of indicators that fail. Aggregations are then done by averaging scorel.

Note that leverage is not used in calculating the scores. The reason is that, given the high fixed asset revaluation activity, 20 leverage may not be a reliable indicator of solvency: it may overestimate solvency. In addition, leverage is more an indicator of long-term than short-term solvency.

Table 5. The scorigsstem used Score Condition Score Rationale code YoestonNo ______EQ Negative EquRty 1 Insolvent already, may need restructuring ______or liquidation Interest (Financial Expense) coverage with Cash from Under no addRtonal borrowing available to FE Operations (Iccash)<1 1 0 cover the residual Financial Expence, may OetIon 5 Peed debt restructuring

Short4.erm bank debt coverage vwth liquid assets Under bank credit rationing, may not be able to service current bank debt, and may SE(SB DC1<0(SBDC)

For each company, Total Score = I Ox EQ + FE + SB; For Tables A2 and A3, Scorel =EQ+ FE + SB

20 The high asset revaluation activity is due to high inflation. Asset revaluation is usually a highly volatile process (at the company level) and may not track actual (market) asset values well. In aggregate, the share of equity arising from fixed asset revaluation is relatively high, around 30 percent (median), and is stable over 1997-2001. - 56 -

Table 6 shows the distribution of net sales, employment, and total bank debt by period, size, and score for 2000-2001.

TABLE 6. DISTRXBUTIONS BY SCORE AND SIZE, 2000-2001, ISE COMPANIES

Net Sales

All sample

score Missing 0 1 2 12 20001g 16% 33% 32% 17% 2% 2000q4 16% 31% 28% 22% 3% 2OOlql 16% 26% 18% 35% 5% 2001gq4 11% 1 23% 39% 15% 12%

Large

score Missing 0 1 2 12 2000qg 17% 35% 31% 15% 2% 2000q4 17% 33% 27% 20% 3% 2OOlql 17% 27% 16% 34% 6%6 2001 q4 12% 23% 40% 1 12% 12%

Medium

score _ Mlssing 0 1 2 12 ZOOOgi 11% 24% 34% 30% 2% 000q4 9% 14% 37% 35% 5% O20gi 2% 23% 26% 48% 0% 001q4 2% 20% 32% 40% 6%

Small

score

_MOssing 0 - 2 12 2000q1 9% 10% 17% 16% 1% 2000q4 14% 8% 40% 37% 3% 2OOlql 11% 14% 29% 30% 15% 2001gq4 11% 17% 26% 30% 16% - 57-

Efstributlono by ocoro and sizo, 2000-2001, ISE companies Klt Seioc, %(all oam ple)

40% , _ -

30%

25% L 02000q1 25S6 - - - VLi 20 U 20_14oI

bS6* z =§ _ i 0 s | _ _ _ a * t~02DO19

5%

0y%p MissIng 0 1 2 V Score

Distributions by core and bzo, 2000-200t, ISEcompanles itt Salon, % (all amn pIG) Companleo acored 2 only

40%

35% 1_

30% _ ------_ _

15%20% x X

2000q1 2000q4 2001q1 2001q4

DIstrIbutIons by ocore and tzo, 2000-2001, ISE companles Nat Sales, % (all arn ple) Companios acored above 2

14% / 17 4

120% . -

0% I r X w -S-,.L. r.. - -, 2000q1 2000q4 2001ql 2001q4 - 58-

Net Sales, Large size companies

CItrilbutions by score and soze, 2000-2001, ISEcompanles Mgt Sales, %(large size) Companies scored 2 only 35% LrI 30% ,q 1_

20%t-gi

2000q1 2000q4 20Olql 2001q4

Motributiono by score and size, 2000-2001, ISEcompanioe Nat Sales, % (large size) Com panles scored above 2

14%. t - 12%

12% 4

10% .

,.z!~~~~~~~~~~~~~~~~~~~7

2% ue_-L.

0% . , ..S .'' ;tai. - 2000q1 20 $ 2001q1 2001q4 - 59 -

Net Sales, Medium Size Companies

Matrlbutiono by ocore and eizo, 2000-2001, ISEcompanion PNat Salon, % (medium sizG) Com ponies scorod 2 only

40% 1

10%L

o%. 2000q1 2000q4 2001q1 2001q4

otributlono by score and uize, 2000-2001, ISE companleo Rat Salen, % (medium size) Companies scored above 2

4% I 3%- 2000_ 201 2%+

1%- _ 5° -

0% -- 4 :. 2000q1 200Oq4 2001q1 2001q4 - 60 -

Net Sales, Small size companies

Mlstributions by score and size, 2000-2001, ISEcompanles Mat Sales, %(small size) Companies scored 2 only

4096% 35%

30% - li 01;, 25%- . 3*| MA>gJ 20% l, -l ; .. F 15%-

5% , _ h l _ 0% 2000qI 2800q4 2001q1 2001q4

tDlatributons by score and aize, 2000-2001, ISEcompanisa Mat Sales, % (small size) Companies scored above 2

146 X9 12% :%%~~~~3 10% |" 8% a 6%, 30/. 4% 1-i 2% . - -

2000q1 2000q4 2GOlq1 2DO1q14 - 61 -

Estimated Employment, %

All sample

______score ______Missing 0 1 2 12 20001l 16% 36% 26% 18% 3% 2000q4 16% 31% 26% 24% 3% 2001 ql 17% 27% 22% 29% 5% 2001q4 12% 25% 38% 20% 5%

Large

score Missing 0 1 2 12 20001g 19% 41% 24% 13% 3% 2000q4 19% 36% 23% 20% 2% 2001 q1 20% 30% 21% 25% 5% 2001q4 14% 26% 39% 16% 4%

Medium

score Missing 0 1 2 12 20001g 5% 23% 33% 36% 4% 2000q4 6% 8% 38% 44% 4% 2ooiqi 0% 14% 28% 59% 0% 2001q4 2% 19% 34% 39% 7%

Small

score Missing 0 1 2 12 20OOgq 6% 8% 17% 17% 3% 2000q4 9% 6% 45% 37% 4% 2O001a 8% 11% 32% 35% 14% 2001 q4 8% 12% 32% 30% 18% - 62 -

Wetributions by score and sIze, 2000-2001, ISEcompanbe Etlmatad mnploymont. % (all eample)

40%- _ 35A-%

2%20% I*zcn--- 20% ,__2_lt$I

MInbs 0 1 2 U Scare

Distributlona by acorn and uIze, 2000-2001, ISEcomapanleo ttmatod Bnployment, %(all sample) Companies cored 2 only

30% /5- 25% - _ 20%

3%1 3.

2000ql 2000q4 2001q1 2001q4

Olotributlono by score and otko, 20002001, ISE compcnboc EbtimatedSn ployment, % (ll sample) Companies scored above 2 5% / - ---.1 - 0%6%- . - 4 - 5 5S

4% - 3- 3%t o _ d %

0% 4 I 2000q1 2000q4 2001q1 2001q4 - 63 -

Estimated Employment, large size companies

Ostributions by score and size, 2000.2001, ISEcomponloc ttimatod Bnploymont.%(Iargo clze) Companioe scored 2 only

20X .j

10 %

2000q1 2000q4 2001q1 2001q4

DiEtributions by score and osz, 2000-2001, ISEcompanbos ttimated enplymoent, % (large size) Companion scorod above 2

5% 1 4- - 5%- 4% i - 4% { - - -- 3% - 2 3%MI' ., .: 2% '. 2% 4

O%-- 2000q1 2000q4 2001q1 2001q4 - 64-

Estimated employment, medium size companies

Distributions by score and ske, 2000-2D01, ISEcompanies Estimated Bnployment, %(medium size) Companies scored 2 only

60%

30% 1 q I-

20%/r i _ v15l

ZOOOql 200Oq4 2001q1 2001q4

Dlstrlbutions by score and size, 2000-2001, ISE companies stimated BEnployment, % (medium size) Companies scored above 2

8% -- ./ - 7% -- - 6% . f 5% 4. 4% , X , . _

3% E. - - 2% , _ 1% 0% ,= 2000q1 2000q4 20Q1q1 2001q4 - 65 -

Estimated Employment, Small size companies

Distributlons by score and osie, 2000-2001, ISE companieso Estimated Buployment, %(small size) Com panies scored 2 only

40% . 35% -1

30X .zt ' 34%z

20% /ss_i r_ 5 % ,- .e s 1

0% F i . W z- - 2000q1 2000q4 2001q1 2001q4

Distributlons by score and size, 2000-2001, ISE com panleu Estimated Enploymnent, % (small size) Companies scored above 2

18%

16% - 7 14% _ 12% - 4 10%

8% -

4%- ~~~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 0%2% -.. ; i.... 2000q1 2000q4 2001q1 2001q4 - 66 -

T'otall bank debt, %

All sample

b__ilzin_g_ 0 1 a 12 20009g 3% 22% 43% 22% 9% 2000q4 2% 14% 45% 28% 11% 2oolql 1% 10% 16% 59% 15% 2001q4 4% 8% 20% 27% 41%

Large

_iz_ _nlsg 0 1 2 12 2000qg 2% 25 50% 15% 8% 2000q4 2% 15% 52% 22% 8% 2OOl9q 1% 9% 16% 62% 12% 2001q4 6% 6% 22% 24% 43%

Medium

scan I_w_slng--- 0 1 2 12 2000g 9% 15% 30% 41% 5% 2000q4 2% 15% 21% 49% 14% 2OOlql 0% 16% 17% 67% 0% 2001q4 0%Y 12% 19% 56% 12%

Small

zcore Mi$z_n_ 0 1 2 12 2000gi 2% 16% 21% 33% 16% 2000g4 0% 2% 20% 46% 33% 2oolq9 0% 6% 14% 27% 51% 001gq4 0% 13% 7% 26% 54% - 67 -

Dlstrlbutlono by score and sIze, 2000-2001, ISE com panies Total bank debt. % (all sample)

40%, 2i000q1 30%, ~~~~~~I132000q4 0200t1l

Score

Distributions by score and stze, 2000-2001, ISEcompanles Total bank debt, %(all sample) Companies scored 2 only

30%S10%- 20% -. >g et i1X 10% A i

2000q1 2000q4 2001q1 2001q4

Ilatrlbutlons by score and oIze, 2000-2001, ISEcompanbeu Total bank debt, % (all sample) Companies scored above 2

50s2-/l

40% . l

30%- -

20%

10% .

2000q1 2000q4 Z001q1 2001q4 - 68 -

Total Bank Debt, Large Size Companies

3strlbuUlons by score and size, 2000-2001, ISEcompanles Total bank debt, % (large size) Companies scored 2 only

70% 60% _

50% 40% -_

20% - -

10% Z,

2000q1 20Wq4 2001 ql 2001*4

Clstrlbutlons by score and sEze, 2000-2001, ISEcompanles Total bank debt, %(large size) Companies scored above 2 43% 4596% f4 45% - -2!------40% 35% s

25% -

20%Y 12% -

0% , -- 2000q 2000q4 2001q1 2001Q4 - 69 -

Total Bank Debt, medium size companies

Distributions by score and size, 2000-2001, ISEcompanies Total bank debt, % (medium size) Companies scared 2 only

70%2/.<., -_.

50% -',/.I*Mui;

2000q1 2WOq4 2001ql 2001q4

Distributions by score and size, 2000-2001, ISEcompanbes Total bank debt, % (medium size) Companies scored above 2 14 12%vr

1 0%-r--

8% -S__n, - 6% 4%

2% 20q 2001q1 2'001 2000ql 2000q4 20Otq1 2001q4 - 70 -

Total Bank Debt, Small size companies

Distributions by score and tize, 2000-2001, ISEcompanbo Total bank debt, % (small size) Companies scored 2 only

50%- _.. .

45% i

2000q1 2000q4 2001ql 2001$4 40% $3

30% 1St Distributions by score and sIze. 2000-2001, ISE comnpanhes Total banke de bt, %(sm ail sizEe) Compainles scored above 2 20% . -,

10% _

2000q1 2000q4 2001q1 2001q4

Correcting for the size bias in the ISE dataset. Because ISE companies tend to be larger (and more capital-intensive) than unlisted comnpanies, one may want to adjust for size bias Table 7 shows bow distributions for numnber of companies, sales, and employment change if we amalgamate ISO and ISE datasets We also assume that weights are the same throughout 1999-2001. - 71 -

Table 7. Adjustment of the basic distributions, end-1999, %

Indicator Number of companies Net Sales Employment Dataset ISE ISE and ISO E ISE and ISO ISE ISE and ISO Large 35.6% 19.5% 6.2% 69.9%- 69.9% 55.2% Medium 28.7% 28.4% .9% 17.9% 20.4% 23.9% Small 35.6% 52.1% .9% 12.2% 9.7% 20.8% Total 100.0% 1100.0% 100.0% 100.0% 100.0% 100.0%

Table 8 shows aggregations (medians, except for scorel where averages are used) of the ratios by sector for industry and nonfinancial services. Sector-specific aggregations are only shown for sectors with more than 5 observations. Table 8. ISE data: Industry By Sector medians 1997 Q4- 2001

4) 0 0~~~~~~~~~~2 0~~~~~~~~~~~~~~~~~~

Eei ice _. -5 A 1 a o

Sq 1e n5lce s T.1 oS ufis 4 Z m1 a 1 9 9 8 -1 .7t o .s l o Fo s 5 4.4 Q v 3 5 .2 N 8 4 .9 8 9 7 t _ .20 T o u f i 1 9 9s 9 q 1m 1. 4 i 0 . 1 o 5 14 7 ° 86es7 a 3 o ,~~~~~~~~~~~~~~~~~~~~~- j3181 '2 PR ~ING ~ ICaC0 IC_ CR Q0V_0V2 3D S)FL D P_t l E BC soe '2 1 ~~~~~~~~~~~~~~~~~~~~~~o 1

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To~ceudism 7.1j7A13.8 __ 2.32 1'17 01 3.0- 2.5 9% 17.9 708B- 5.99/ _____ 25.7 047__ TGucesautism 199q4i -220.1 4216 °1 -1.7 0.9 0.01 54.4°4 35.2Y 44.2-A 84.9 9 4 73 7 3i 15.2 004t0 1 Services aoutism 2000q1 59A 200 1.5 10 O.0 39.39/ 28.2 57 20A 825 5411° 1624 27.9 0o21 1.a ervices Touism 9991 -112.0 40.4 1.47 -0.41 0.91 0.14 51 8S534.1A 42.7.A 8034 5 7 f 4 15 7.1 024 1 20

Tuesrutism '1OO4 1.2r 67 07 1 15 117 0.0 448 30 n 0620 74.9 698e3 __ 74 3 14.A 0o4 14. ices auism 201 -90.519 12.9% .0.12 0.1 0.8t 0.04 51.7 34.1/ 54.7.A 831 65.40A 167 11( 48: 15.97/° 0.o 1.3 eices Toutsm gDOq 0.2' 9.7% 1 A 1.2 091i 0.0 62.4'/ 38.4A 49 9%80.7 57 49/ ( 121 29J 19.8'/ 0.311 17 c Tsoudsm 300 11 99 44% 1 2 3.1, 1 3 0 04 53.5'/ 348BO 40 5 78.5'/ 63.1% 4 67 8___ 10.4 0

Tvceoutism qj 6 7 3.8% 1 5 2.3 0 7 00Od44.7- 30 9- 30 5- 82.6- 637 2 74 __ 11 0.3d 1. e Tcsutism lcl -151.9 9.7' 0.2A -0.& 0.6d 0.0 591I- 37.1 OA31.9- 82.3- 41.0% 13~ 11C 11A 22.7- 0 2 1. Settes aoutism 21q2 -34.1°O 440% 0 611 0 0.7d o.o 4 44 39 25 1°/ 86.0 244 5: 10 se 00°A 0.1 1.6 revices outism 1g3 -140 2.6 1 2a 0.77 o 74 o.o0 68.8A 40 70/ 23.4A 89.n 32.7A 3 72 00A 0.2 1.40 erCoes outism 01q4 -10 9' 2 8 1 03 0.6f 08o 0.0o 55 2% 35.60A 39.0'A 95 30 58 1 2 78 2 00A/ O01 1.33 ervices Wholesale 1997q4 0.90A 5 2 _ 1.2 1.04 0 0 478.7A 82.70A 19 20A 98.1 17V 20°f I 31.4°A 0 5i

oniesWholesale 1998cjl 2.20A 3 0 _ _ 8 01 1.0d 0.0 431 4 81.29/ 14.60 98.79/c 13 IOA _ ____ 35.59/ 05o __ e Wicsholesale 19980i4 0 40 3 ___ 1.0! 11 0074 8866'15.99 92 15 9' 8 ____ 306'! 1.1 ervices Wholesale- 1999{q1 0 90 54% -65 1.4 10a 0.01729.6% 87 30 17.1 93A 7 75 7 2 32.79/ 0.8 1 0 ervices Wholesale 1999q4 0 50A 9 7% .0 96 1.1f 1.0 00 798 22 88 8°f 42 5S 95 1w 35.79/ 4 64 f 10 2 0o 2o Services Wholesale 2000q1 1 1% 5 4% 1 3 1 45 1.0o0.0 724.302 87 9sY 41 2 925 2959 5i 9 f_ 9.2A 0.1 06 10~~~~~~

~~~~~~~~~~~W 0 - C 2 :3~~~~~~~~~~. 0 00r

0 CRPR Qo 0 I0 t_ Se ces W e0 80 .0 O, 0 Sewi-8 4 8 ,es Wholesale2') ~ 02 2001Q108! 9 O O 6187.0 92 9S 42.0S 97 8S 4 6 01; ZOt 0emcesWholesale 2001a2 -7.3 ~-27_15.0S 21 _ 3 4: 1.02 _ O O S 84.0S 27 2S 98 5S 30 5 6: 6 5' 3 8Y. 0.2- 2 01 to 4 3 0 7 5S 010 5 0o E u. R3 01 3. 1. .1t 0. c .

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___sPR INTOI ICcash IC I CR QR LV0 I LV 2 D SL SFSL OR DP 2 34 EO SBDC scor1 l Nvicesholesale 1.42 210 -85 74 13 10.9 00m 259 2S 72.1' 20.28 944 19753919 1 7 0 240.3

Retal2hlsces 20 3 2 3.6 -5. 16 1.1 0. 30481 75.3r 5460.0 92.1% 551% 81 _ 4 53, 70.S0.% 210.

Ncesholesale 106 39 -O 414 1.01 0 0/ 422 5% 80.2S 35.51 97.96 3526. 1! _ 93OOX 001 2.O. ces holesale 2 q -840 18 021 08 0.8: 001 943.6 1.92 42.072 9787 4217 67 71 69 11 01ld 2.01

rvlces Rholesale 01q4 -71.3 15. -7 1.08 00 84.0 27 985 305 8 91 3_ 3 0.2 200 erio holesale 13 -220O%31 8 -03 0.W 0 9 0.01 798 5- 92.9% 59.3- 96 3A 67 3 61 75 6, 6 3 0.11 2.5

eivicesOleSate ~~~~~1 -290O 274% - . . 99.3% 63 3 92.6 621I 63 78 7, 6 4 011 2.

ervicesetail ~~~~~1997q45.1- 2.1 ____ 4 5, 1.04 0.24 423.5- 80.8A 10.8- 78.20 1.2- ____ .0* -41 64 ___ ervices I 998ql 3.9- 0 ______4 71 10o 0.2 714.41 87.7 18.9- 80 6 1.8% 14 ______.0 -11 ___

ti UMe 1998q4 4 3- 2 89 1___ 423 1.O 0.1 322.71 71.5A 13.1- 91.7A 12.3% 1 ______.0O -1.1 ____ Serces Total 1999q 85 6.59' 169 2 5 10 O02 217.68 68523 9.8 9581I 7.6S 1= 0.0 -0.t 1 Serces eotal 1998q1 1. 36 25 1 3' 0.91 0.31 18'66.4 2084S 87.485 13 7' 34 03-4ff 0 1 1 etvice2etail320 3.91 1.74 1.O 0.24 237.3A 73 7A 296O- 825V0/ 15.9% 74 34_ 00OO -0 511 1.6 e Riestall 0 46BA 1 12d 0.91 0.2 231. 68.5A 318BO 83.4% 31.9A I11 7A 31 0.01 -0.6A 1. ericetail 0 9 5.4 1 8 1.3 1.04 03A1 98.0 68.2- 36.0- 88 2 27.2 11 7 3__ 00OO -.05 1.5

cesetail 0 9 4.4 37 1.6 1.d 0.3 192.5 71.OO 213M 90.2 25.5A 11 ____ 37 00O -081 1.17 evs idil 1 1 -12.7 19 0 4 0.2 1.07 014 153.6A 87.A 35. 1 -A766 32.09 1 4 00 01Aol 1.87

ceetall1 -5 1 15. 04 0 64 0 8 ~0.24158.2- 78.8-A221 8-0.5% 25 5A 15 _ 47 00O -00OA I1 erie til 103 -26.0% 17.4 0. 0 1 0.83 01i 13859 100.7- 29 9- 790- 27 8- 14 __ 44_ 0 -0.55 2.2 erAlces Rtili 1 -1140 11 8 0.9 0 51 068 01I 145.2 83.0A 208 08 340 1 _ - 4 00-% -0. 2.0

- Total 69.4A 1.9 ___ 351 11 0. 109.8 523 3 81 26 __ ___ 2.6 0.7 ____

Tvcsotal 11998q 1 1.7 A 1.5 ____ 1.9 1.1 0.1I 216.8- 68.2- 13 4 8. . __ ___ 4 01__ 10l X i !: 4 + !0 ' W 0 P R CD 0

5 5 .~~~~~~~' * .0 ~~~~~~~~ S

b201.40A.01 o1 A 0 2 . a

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osTIc Mtal 1998q4 21% 23 % 24247 1 d 0.0 140.1% 5948 21.94 854.7 168 3_s% 2.0% 1.1

Tocetal 199 1i 02 688 1.47 0.6 1.0d 0.1 179.0% 841% 11.4% 87.8- 18.0%5 __57 _2_ 0.8% 024 1.12 e urvcs Total 2990q4 1.7° 8.7% 1.1 1.49 1.04 0 1 189.4 65.46 25.48 81.4 21.0% 4561 301E6 30% 0.7 1.31 e esW Melotal 20 q10 2 0 .4 7 5 4 % 0 5 4 1.0. 1 2 0 .07 19 4 19 73 .02 37 .0 . 8 3 61 %2 9 .5 5 4 1 1.4 % 0 .2 1. 61 s TodMtal 2 1.3 4.2e 1. 1.81 0.1 158.4 ° 6107 33 7 o825 32 4 8 E1 4S 1.9 0 12 eIndesE eotal q 400.0 3.8% 1.1 1.61 1 2 0.1 165.205 62.3% 38 2% 81 5 °A 21.9 ° 41 3i 64 4.6% 0.47 1 ervtesbTotal 1.w7% 3. 1.44 1.81 1 21 0.1 181.4% 85.8% 220% 871 *A21.3 42 7 0 3 60%. 02 1.21 orvices Total i -14.3% 17.3% 0 36 0.49 1 0( 00O 212.1Y% 71 1 33 5 85.2- 28.8% 69 91 3___ 40% 0 1.4 TricstEl 1 -10.3% 13.8% 0.61 0.63 09Q 0.1d 11886- 63.3% 22.4 844 23 4A 51i go_ 4___ 00 0.2 1. Service kotal 20aSg -12.1 14.9% 1.4 0.79 0.97 0.1d 115 7 66 7 28.5% 88.90A 28.56A738 78 2f 0.2 010 1.56 SerAices otal 14 -8.9% 11.8% 08 0.70 9 0.0 93.1% 53- 30 0 87143-A 0 4 83 3___ 020A 0.1A 1.5

~~~etal ~~~~~197q 8.1- 5.1%___ 415 1.5 0.36 96 3A 48.9A 48.0- 84 8 40 2 ______38 5 1.00 owl 199etal 61 8O.7% _____ 1 1.5 0.08 102 4- 50.6A 37 7 78.0V 40 5% 4___ 44.3% 1 04___

etalI1dusby 5.1- 6.7 ____ 1.8d 1 4, 0.20 117.A 537% 50.3A 79.6A 580% 4 ___ 36 9 124___ ndustrv etal 992gj 2.6- 10.9% 0.61 1.1 131 0.1I 131.2 58 7 44.A 80.90 452 a, 4_ 81 34.10/ 127 1.0d ndusby~~~~~~~~~gj etal ~ -2.0 129 0.8- 0.8d 1. 0.1 184.0% 64 8 52.4- 83.7- 44.8% 1 4; 78 38.0 0.8 1.1d ndustry etal 1 ~~~~ ~8 2% ~ ~~~-2.0-0 U 0.7A 1.4 0.0d 218.2% 68.6A 48 6- 81.40 45 80A 4 67 43 8 0.74 1

ndustzytat ~ ~ ~~~~~~-1.7% 69% -1.6 0.84 127 0.0~ 199.6% 67.20 40.60 86.1- 427% 4 _____4 47.4% 0.71 1.8 ndustry etal 0p3 ~~~~~~~~-1.3%8.1 .06el IO 1.27 0.0 21687 71 70 38.6- 860O- 38.60 8dB 39.3% 1. 14 ndustryI 4 ~~~ ~~~6 3 ~~~~03%-0 1.1l 1 2 0.04 205 9- 71.8A 420O 84 5 46.9 3___ 4 . Industry etl 0 -3.0 3. 0.8 0.86 1.21 0.1 303.A 76.2 421 85 47 51__7 4.7 06 1 Industry oetai 5. 29 0 0 81 121 0.111 200.5970 3 2 854 56 09 .

Industry WWaI 1a 03 2. 0A 1. 1. 1177 67 57 8 0 ___ 81 1 0~~~~~~~~~~~~ ~~~~~4D z s C & F 18 4 4)~~~~~~~~~~~~~~~~~~~~~~~~~ l IndU2'ra D 01 2 . 0 4)e 4)... Eo

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Industrv Chemkals & Fuel 2000q 5.3. 5.4A 2211 1 3 01 16315. 62.09 33.9 844 25. 4. 71 __ __ 84 081.59 1 Industrv Chetrnit ais & Fuel 24q.3 4 6.59 4,0t 2.0 1.4 0.1 155.29 608 38A 8381.35A 35.S S 68. 0.910 1 ndustrv lals& Fuel igj 2.3 129 0 2d 1.79 1. 101 i 206.8S% 67.6 333 82.5 44.7S 4 5 e I141 S1.1 ndusrv micals & Fuel 199q 11 13. O09 1.14 1.Z 0.1 16.A 4432 39S 825 48.8 8. 576S 7 A 0.81 127

'ndustrv Chemicals & Fuel 2002gj 2.18 7. 420 1.5. 1 1i 0.11 238.4 71 8 30 82.9 35s6 6 5 _ 7t 1 739 07 12 undusvChemals & Fuel 2001q3 3.81l 5.69O -1.321 1.3t 0 1 155.512 61. 21.9O 81.3 37.29 7C56< 51 840 08 1.S

udistry 6 icess& Fuel 3 4- 5.59 0.0. 1 91 1.42 0 1 172 A 88. 27.8- 82.7 32.5- 81 ______6.79 101i 1.24 ndus heicals &Fuel 2 4-. 0.1 1. 1.3 0.1 149.045 4.80 21.6 781.5 31.60 S Si 6 64S 1O0 1.

udIsfv 6 micats& Fuel 19 18.3 24.81 0 2 0 1.2 0.1, 198.85 71 22.69 85.3A 29.5- 7, ______5. 8 A 0 72 174 nidustry icals &Fuel Ij2g -12.8% 21.3 -0.2 0.63 114 0.11 126.4- 71.4A 286a- 79 5A 391I- 71 7 10 3- 0.7i 177 ndusr ml.cal & Fuel laS -10.2 19 OA 027 0.7 1.3 0.10 138 A 84.5A 31 A 81.4% 35.3- -4 70 __ 9 4 0.7 1.5 ndsr 6heicais &Fuel 2Dl4 -1.70 130OO 0.47 0.9c 1.1 O 324 74.0- 28.6- 78.4A 34.8~ ____el___ 8 0.5 1.67 ndustry Cement & Glass 1997q4 12.7 3 6S6 5.28 1.7i 0.2' 64 7SI 39.39 28 3 71 1 11 99__I 18 59 4 1 rndust ent& Glass 1998q1 4.n 5.8 M 1.7 1 51 0.01 85.55 40.1S 20 8 80.2S 13 5S 61 20.3S 2.9 IndustrvCement & Glass 1998q4 10 1 5.59A 2.3 1.91 Z 88.0S 48 2 A 28.2 70.6 30-60ASI 5f 15 7 481 Industrv ement& Glass 1999q1 3.40 5 12 12 1 15 0.1 97 1S 49.39 24 O. 71 68 17.6 2 7f 42 1Q f 18.4 64 0 8 Industrv Cement & Glass 19Sq 7 5S 68S 1.21 2.5 1.51 01 77.89 43 7S 34.5 72.4 32.9S 5F 45 89 16.6 2. 0 71 ndustr nt& Glass q 2.0 5 041 1 71 1.4 0.1 80.3 445 25 7 76.5S 30.9S 7f C 11 294 2.4 0.8: ndustrv ent& Glass 2002 3. 443 -0 2.9 1 71 01 78.1 43 8S 25 3 70 7S 33.5 71 S_ 8 21.5 29 0 8 ent & Glass 3 i .I 3 79 184 3 Z 17 01: 75 42.89 23.6 728 295l 6f 5C 7, 20.1 264 06 Industrv Zement & Glass 2000q- 33i 3.41 1.79 0 1 6 329 10 22.3 313 6 40 74 21.49 1 9 05S 0 0)~~~~~~~~~~~~~~~~~~~~~~~~0:

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______PR INTGI ICcash IC I CR OR LV I LV 2 BD SL SFSL DR DP 2 01 EO SBOC scorel ndutry &Glass 2DjgjI 4 18.9 1 ( 1.3 1 4 0.1, 106.4% 51.5% 28.8% 75.99 271Y 8 4 01 23 2% 22 0.7 ndustrv Cement & Glass 2001 q2 5.6 P 12 3Y 0.0( 1.51 15 O.Z 88.5 48.9° 25.7f 744 28.7 E 4! 81 28.1% 27 0.8 ndustrv Cement& Glass 200tq3 8.56 10.9f 1.4 1i.7 17 0 Z 807 44.7f 21 6f 77 9°A 26.2i 6 4 a 30 50A 3.2 08 ndustrv men& Glass 2001q4 8.5P 8.4W 1 2.1 2.0 0 91 67.2W 43 3Y 22.8Y 76.4W 24 3J 6, 41 a 31.8W 3.31 0 74 ndustv aod& Beverages t997q4 5.9 9.5f I 81 1 2 0 138.6 58.1 P 54 40A 81.0 57.5S =_= 20.1 P 0 8 _ Industrv Food & Beverages 1998q1 4.05 1t1t O K 1.4 1.3 0.0d 134.6B 57.4ff 50.9ff 80 2°s 53.0 i 51 15.2 0894 Industrv Faod &Beverages t998q4 4.68 1 .0S 1 1.S t 311 0.0 127t 2 P 55 9 Y 53.6Y 83.1W 529 57_A 14.7° 0.S Industrv Food &Beverages 999a11 2.3S 12.8W 0.7, 1.2 1 o.o 125 9 55 7 Y 53.2ff 84 5 511 5t 71 10.4W 0 6 1.2 ndustry hod&Beverages 3.2 9.1tf 0. 1.7! 1.3 0.0 143.4/ 58.9X 43.8ff 83.1 440 5f 4: 6 18.9% 05o 1.14 ndustrv d& Beveraaes 3.2 6.0 0.6 1.S 1.4: 0.0 138.86j 581 Y. 49.0W. 76.68 47.50 71 4_ _ 14.4W 0.68 11 Industrv Food & Beverages 0 2 2. 4.4 -2 S t 8 1.61 00 1184° 54.0Y 55.8W 77.8i 55.8A 64 5 71 18.3W O 1. ndiis~aod&Bvrage3 3.4 3 1 . 134 0.0 126 6- 58.8- 49.3A 81.0O 54.2V 62 7A 18.7 0.4 I1. Industrv Faod& Beverages 4 1.80 3.4 -1.01 14 1.37 00: 148.5 8 1 O/Y 43.8Y 82.A 541° 81 51 8 19 6 01 t1. Industry Food& Beverages -17.89 18.9 0.1t 04i 1.1! 0.0 2470A 71.4Y 44.9Y 84. 58.1i 7 7 129W 0 a 1.71 Industrv Food& Beveraes 2 -9.0S 19.2W -.0 0 7: 1.11 0.0 259.60 74.0 48.4W 83.3 5850A 68 5 18.2 0 3! 18 ndustrv ood & Beverages 1q3 -4.1% 12.9W -0.0: 0.7/ 1.21 0.0 29710- 77.9Y 48.0. 80.1 62.1 * 61 4A 92 17.1 0.2Z 1.7 Industrv Food& Beverages 2 q -3.2 16.8 I 0.4 0.81 i.22 00 X972 73.7-/ 40 7K 81.8 66 5A 5A 42 79 15.0W 0.24 1.5: Industrv Machlnery &Eq. t997q4 11.1t 5.10A 3 111 1.87 0.2 107.7°/ 523 Y 30.1 W 8t1 25 O - t3 51 4.31 1

Industrv Machinery& Eq. 1998qt _ 10.0 550K 2.S 1.68 0 1 41.7P 59.70A 28 7W 82.0 178 6; ____' 14.6N 2.2 ndustry achnery& Eq. t998a4 9.3% 8.3w 21 1. 0.21 114.7 58 8Y. 32 5K 79.8P 33.2% 6 18.3 13 Industrv achlnery &Eq. t999q1 0.4° 14.6 08 1.01 1 0 1177.80 67.30Y 32.0Y 79.6W 32.5% 8 8 20.3° 12 08 Industrv achinery& Eq. t999q4 3.1 98 W t31 1.3 . 178.30 64 1t 32.0 W 82.8 P 38.5a 8 S 6 2 t.6W 12 09 Industr Machlnery & Eq. _20 q 5 5 5.9W .8 1.8t 0.21 1521 803 350° 83.9n 4 t7o 6t_ 21.0 1 0 7, C 2

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Tobd______PR INTGI 4Ccash IC I CR QR LV I LV 2 OD SL SFSL DR OP 2 D1 EO SBDC scorl ndTjs~Total 1 -3.9q 21 8. -0.0 0.8C 1.2d 0.1c 157.5$ 68.40 39.3 801I. 44.9% 5i 5 7 263 0.7 1 5C iTijl Total 2-20 21 190 0.2G 0.& 1.2E 0.0i 172.15 88.5 39.50 81.3A 48.3% tU 76 22.4Qh4 0 1.37 nciustv Total 20. 15.7% 0.47 1.08 1.34 0.07 154.7% 83.1x 368.30 79.5 4201 8 5147 23.1% - 0 87 1. Total Total 2000q4 7.4A 64 % 2.5 1.39 0.1t 123.9 55.8. 34.0 80.48 34.2 3; 5 _t 14.8 1.40.9; 12i ot Total SOOgi ____ 4.7- 8.4A . 1.41 0.0 138.9A 58.2- 32.4% 81.3- 290. 6 ___ 14.2% 1.3____ Total Total 1998Q4 4.9- 7.7 __A _ 1.71 1A 0.1111126.4A 88.3A 37.7A 81.00/ 42.8-A 5 15.2 1.0_____ Total Total 2001q1 1.28 112.7 0.87 1A. 12 0.1O137.6A 537.5 39.6 83.49 42.21A 811 51 go 17.8. 1.11 1.0 Total Total 2.0N21 10.43 0.71 1. 1.3 0.1 147.0 88.S0X 34.21A 82.75 40.809 tM 51 7i 158.4 0.7. 1.21 Total Total 001 2.1 7.2 0.41 1.3t 1.25 0.01 1851.1%61.1 38.00A 82.89 39.11P SS57 15.4S 0.87 1.1 T21otal Tota 3.1- 0.0 - 1.012. 1.36 0.0~ 140.9- 80.1A 38.1A 79.W 41.1A ______~ 14.9- 0.93 1 Total kotal 4.1- 8.8 -0.4 2.02 1.41 0.0~ 127.7- 58.8- 37.1A 79.8- 38. ___5___ 13.4- 1.4 12 Total Total 3.3 8.5 0.04 1.90 1.30 0.1 130.8 58.5 35.10 80.8 38. ____ 12.5 0.9 1.2 Total Total Olgi .10.6- 27 0A 0.4 1.24 0.0 177.3- 874- 39.1- 83.4 42.1% 7 as___ 16. 0.71 1 Tog otal aM01q2 -4.0- 21.3 .0.01 0.80 1.2 0.1 158.9 68.0 37.1 80.7 44.0% 77__ 22.1% 0.76 1. Total Total !&3g -2.1- 18. 0.0 0.8 1.20 0.10 165.5/ 6U.50 39.0- 81.8- 44.8% 71 20.4% 0.7 11.3 Total Total 01q4 0. 1.1 0 1.0 11.3~ 0.0~ 149.5- 63.0- 37.7A 79.8A 41.5A 71 20.8% 0.74 1.31 * Companles' statements were analyzed for the period for which they were filed. Most companies have their statements cover one quarter In March, two -June, thrGe -In September, and four -In December Some companles have dIfferent schedules, but their number Is very small Therefore, the numbers for ql represent the medians for qi, the numbers for q2 cover tha first six months... finally, those for q4 cover the whol year. - 81 -

Table 9 Turkish English Variable I. DONEN VARLIKLAR 1. Current Assets vI 100 A. Hazir Degerier A. Liquid Assets v1110 1. Kasa Cash vllll 2. Bankalar Banks vlII2 3. Diger Hazir DeAerier Others vI l13 B. Menkul Klymetier B. Securities vl l20 1. Hisse Senetleri Shares vl 121 2. Ozel Kesim Tahvil, Senet ve Bonolan Corp Bonds / CPs vl 122 3. Kamu Kesimi Tahvil, Senet ve Bonolari Pub Sec Bonds 11123 4. Diger Menkul Kiyffetler Others vl 124 5. Menkul Klymetler Deger Dt1f0k1Adt Kar$.(-) Prov for Sec Losses vl125 C. Kisa Vadeli Ticari Alacaklar C. ST Com Rec vi 130 1. Ahcilar Acct Receivable vl 131 2. Alacak Senetleri Notes Rec vl 132 3. Verilen Depozito ve Temninatlar Gttee and Depo given vl 133 4. Diger Kisa Vadeli Ticari Alacaklar Other ST com Rec vl134 5. Alacak Reeskontu (-) Discounts on Rec vl 135 6. Sfpheli Alacaklar Kar§iligi (-) Prov for Doubtful Rec vi 136 D. Diger Kisa Vadeli Alacaklar D. Other ST Rec vl140 1. Ortaklardan Alacaklar Rec fin Partners vl 141 2. t1tiraklerden Alacaklar Rec fm Participations vl 142 3. Baghl Ortakltklardan Alacaldar Rec fin Subsidiaries vi 143 4. Kisa Vadeli DiAer Alacaklar Other ST Rec vl 144 5. Alacak Reeskontu (-) Discounts on Rec vl 145 6. SUpheli Alacaklar KarsiltAg (-) Prov for Doubtful Rec vi 146 E. Stoklar E. Inventories vI i50 I. lk Madde ve Malzeme Raw Materials vll51 2. Yan Mamclhier Unfnished Products vl 152 3. Ara Mam(iller Semi-finished Products vl 153 4. Marinller Finished Products v1154 5. Emtia Products vl l55 6. Diger Stoklar Other Inventories vl 156 7. Stok Deger DO4(Qk1tit1 Karpligi (-) Prof for Loss of Value of Inventories vi 157 8. Verilen Sipari§ Avanslan Payments for Orders vl158 F. Diger Donen Varliklar F. Other Current Assets vl 160 il. DURAN VARLIKLAR II. FIXED ASSETS vl200 A. Uzun Vadeli Ticari Alacaklar A. LT Com Rec vl210 1. Alicilar Acct Receivable LT vl211 2. Alacak Senetleri Notes REc LT vI212 3. Verilen Depozito ve Teminatiar Depo Gttee Given v1213 4. Diger Uzun Vadeli Ticari Alacaldar Other LT Com Rec vl214 5. Alacak Reeskontu (-) Discounts on Rec LT v1215 6. $0pheli Alacaklar Karqliki (-) Prov for Loss for Doubtful Rec vI216 B. Diger Uzun Vadeli Alacaklar B. Other LT Rec v1220 1. Ortaklardan Alacaklar Rec fin Partners v1221 - 82 -

Turkish English Variable 2. 1stiraklerden Alacaklar Rec fin Participations 1222 3. BaAgi OrtakldkJardan Alaciklar Rec fin Subsidiaries v1223 4. Uzun Vadeli Diger Alacaklar Other LT Rec v1224 5. Alacak Reeskontu (-) Discounts on Rec v1225 6. StOpheli Alacaklar Karilhii (-) Prov for Doubtful Rec 1226 C. Finansal Duran Varhklar C. Financial Fixed Assets 1230 1. BaAli Menkul Kiymetler Sec in Custody v1231 2. Bagi Menkul Kiy.DeA.DtL,.Kar,ilhAi (-) Prov for Loss on Sec in Custody v1232 3. Istirakler Participations 1233 4. I§tiraklere Serinaye Taahh0tleri (-) Unpaid Cap Commfiitments to Partipations v1234 Prov for Decrease of Value of 5. 1ttirakler Deger D0sI0klOgO Kar,shiAI (-) Participations 1235 6. Bakli Ortakliklar Subsidiaries v1236 7. BaghI Ortakhklara Sermaye TaahhOJtleri (-) Unpaid Cap Commitments to Partipations 1237 Prov for Decrease of Value of 8. Bagii Ortakliklar Deger DWQUlitAt Kar. (-) Participations v1238 9. Diger Finansal Duran Varltklar Other Financial Fixed Assets v1239 D. Maddi Duran Varliar D. Tangible Fixed Assets v1240 1. Arazi ve Arsalar Land v1241 2. Yer0st0 ve Yeralti DOzenleri Above & Underground Installations v1242 3. Binalar Buildings v1243 4. Maldne, Tesis ve Cihazlar Machinery and Equipment 1244 5. Ta§it Arac ve Geregleri Transportation Machinery & Equipment v1245 6. Doseme ve Demirba,lar Fumishings & Fixtures v1246 7. Diger Maddi Duran Varliklar Other Tangible Fixed Assets 1247 8. Birikmis Amortismanlar (-) Accumulated Depreciation v1248 9. Yapilmakta Olan Yatnmmlar Work in Progress v1249 10. Verilen Sipari§ Avanslarn Prepayments for Orders v12491 E. Maddi Olmayan Duran Varllddar E. Intangible Fixed Assets 1250 1. Kurulu, ve Teskilatlanma Giderleri Opening Expenses 1251 2. Haklar Rights 1252 3. Ara5tirma ve Gelistirme Giderleri R&D Expenses v1253 4. Diger Maddi Olmayan Duran Varhldar Other Intangible Fixed Assets v1254 5. Verilen Avanslar Advances Given v1255 F. Diger Duran Varliklar F. Other Fixed Assets v1260 AKTIF TOPLAMI Total Assets vl000 I. KISA VADELI BORCLAR I. ST Liabilities v2100 A. Finansal Bor,lar A. Financial Liabilities v21 10 1. Banka Kredileri Bank Loans v2111 2. Uzun Vadeli Kredilerin Anapara Taksitleri ve Faizleri Principal and Interest on LT Loans v2112 3. Tahvil Anapara Taksitleri ve Faizleri Principal and Interest due on Bonds v2113 4. ClkarllnuL Bonolar ve Senetler Outstanding Bonds & Notes v2114 5. Diger Finansal Bor,Iar Other Financial Liabilities v2115 B. Ticari Borclar B. Commercial Liabilities v2120 1. Saticilar Suppliers v2121 2. Bor, Senederi Notes Payable v2122 3. Alman Depozito ve Teminatlar Deposits & Gttee Rec v2123 - 83 -

Turkish Endlsh Varlable 4. Diger Ticari Bor,lar Other Conmnercial Liabilities v2124 5. Borg Reeskontu (-) Discounts on Liabilities v2125 C. DiAer Kisa Vadeli Bor,lar C. Other ST Liabilities v2130 1. Ortaldara Bor,lar Liabilities to Partners v2131 2. Istiraklere Borclar Liabilities to Participations v2132 3. BaPli Ortakhldara Borclar Liabilities to Subsidiaries v2133 4. Odenecek Giderler Accrued Expenses v2134 5. Odenecek Vergi, Har, ve DiAer Kesintiler Accured Tax, Fees & Other Deduction v2135 6. Ertelenen ve Taksite BaAlanan Deviet Alacaklan Rescheduled Obligations to Govt v2136 7. Kisa Vadeli Diger Borclar Other ST Liabilities v2137 8. Borg Reeskontu (-) Discounts on Liabilities v2138 D. Alman Siparis Avanslan D. Prepaid Orders v2140 E. Borg ve Gider Kar,iliklari E. Prov for Expenses & Payables v2150 1. Vergi Kar,sliklarn Tax Provisions v2151 2. DiAer Borg ve Gider Kariliklain Other Liabilities and Expenses Provisions' v2152 11. UZUN VADELI BORCLAR H. LT Liabilities v2200 A. Finansal Bor,lar A. Financial Liabilities v2210 1. Banka Kredileri Bank Loans v2211 2. Cikarilmr Tahviller Bonds Issued v2212 3. Cikanlmi§ Diger Menkul Kiymetler Other Issued Securities v2213 4. Diger Finansal Borclar Other Financial Liabilities v2214 B. Ticari Bor9lar B. Commercial Liabilities v2220 1. Saticilar Suppliers v2221 2. Borg Senetleri Notes Payable v2222 3. Alman Depozito ve Teminatlar Deposits & Gttee Rec v2223 4. DiAer Ticari Bor,lar Other Commercial Liabilities v2224 5. Borg Reeskontu (-) Discounts on Liabilities v2225 C. Diger Uzun Vadeli Borclar C. Other LT Liabilities v2230 1. Ortaklara Borclar Liabilities to Partners v2231 2. Istiraklere Bor,lar Liabilities to Participations v2232 3. BaPih Ortakliklara Borglar Liabilities to Subsidiaries v2233 4. Ertelenen ve Taksite Baglanan Devlet Alacaklan Rescheduled Obligations to Govt v2234 5. Uzun Vadeli Diger Bor9lar Other LT Liabilities v2235 6. Borg Reeskontu (-) Discounts on Liabilities v2236 D. Alnan Sipari§ Avanslan D. Prepaid Orders v2240 E. Borg ve Gider Karpliklan E. Prov for Expenses & Payables v2250 I. Kudem Tazninati Karfliklarn Prov for Retirements v2251 2. Diger Borg ve Gider Karpllklan Prov for Other Liabilities & Expenses v2252 III. OZ SERMAYE [H. Shareholders Equity v3000 A. Sermaye A. Capital 3100 B. Sermaye Taahh0tleri (-) B. Unpaid Capital Commnitments v3200 C. Emisyon Primi C. Premniums v3300 D. Yeniden DeAerleme Deger Artii D. Revaluation Increase v3400 1. Duran Varliklardaki DePer Artip Rev Inc for Fixed Assets v3410 2. Istiraklerdeki De_er Arti4i Rev Inc for Subsidiaries v3420 3. Borsa'da Olusan Deger Artis Rev Inc for Stock Markets v3430 - 84 -

Turkish Engllsh Variable E. Yedekler E. Reserves v3500 1. Yasal Yedekler Legal Reserves v3510 2. StatU Yedekleri Statutory Reserves 3520 3. Ozel Yedekler Special Reserves v3530 4. Olaganist1l Yedek Extraordinary Reserves v3540 5. Maliyet Arts Fonu Fund for Cost Increase v3550 Realized Capital Gains fin Share & Land 6. Serm.Eklenecek I§t.His.ve Gayr.Sati§ Kazanylan Sales v3560 7. GeVmi§ Yil Kan Previous Year's Earnings v3570 F. Net DOnem Kari F. Net Profit of the Period v3600 G. DOnem Zaran (-) G. Net Loss of the Period v3700 H. Germi5 YllIar Zararlan (-) H. Previous Year's Losses v3800 PASIF TOPLAMI TOTAL LIABILITIES 3900 A. Brilt Sati$lar A. Gross Sales v41 00 1. Yurtiyi Satl§lar Domestic Sales v4110 2. Yurtdii Sati*lar Foreign Sales v4120 3. Diger Sati§lar Other Sales v4130 B. Sati$lardan Indirimler (-) B. Deduction from Sales v4200 1. Satistan ladeler (-) Sales Retuns v4210 2. Sat l skontolan (-) Sales Discounts v4220 3. Diger Indirimler (-) Oher Discounts v4230 C. Net Sati5lar C. Net Sales v4300 D. Satiylann Maliyeti (-) D. Cost of Sales v4400 BROT SATIS KARI (ZARARI) GROSS SALES PROFIT (LOSS) v4500 E. Faaliyet Giderleri (-) E. Operational Expenses v4600 1. Araqtprma ve Gelistirme Giderleri (-) R&D v4610 2. Pazarlama, Sati§ ve Dagitim Giderleri (-) Marketing, Sales and Distr Expenses v4620 3. Genel YOnetim Giderleri (-) Gen Mgt Exp v4630 ESAS FAALIYET KARI (ZARARI) MAIN OPERATIONAL PROFIT (LOSS) v4700 F. Diner Faaliyetlerden Gelirler ve Karlar F. Income & Profit fin Other Activities vS 100 1. §tfiraklerden Temetto Gelirleri Dividends fin Participations v5110 2. Baghi Ortakliklardan TemettO Gelirleri Dividends fm Subsidiaries v5120 3. Faiz ve Diger Temettll Gelirleri Interest and Other Div Income vS 130 4. Faaliyetle Ilgili Diger Gelirler ve Karlar Other Income and Profit fm Operations v5140 G. Diger Faaliyetlerden Giderler ve Zararlar - G. Expenses & Losses fn Other Activities v5200 H. Finansman Giderleri (-) H. Financial Expenses v5300 1. Kasa Vadeli Bor5lanma Giderleri (-) ST Borrowing Expenses v5310 2. Uzun Vadeli Borlanmna Giderleri (-) LT Borrowing Expenses v5320 FAALtYET KARI (ZARARI) OPERATIONAL PROFIT (LOSS) v5400 L OlaAan0sttl Gelirler ve Karlar I. Extraordinary Profit & Income v5500 1. Konusu Kalmayan KarMihldar Recovery fin Prev Provisions v5510 2. Onceki Donem Gelir ve Karlan Prev Period Profit & Income v5520 3. DiAer Olagantlst0l Gelirler ve Karlar Other Extraordinary Profits & Income v5530 1. OlagantlstU Giderler ve Zararlar (-) J. Extraordinary Losses & Expenses v5600 1. (alimayan Kistm Giderleri ve Zararlan (-) Expenses due to Idle Capacity v5610 2. Onceki D0nem Gider ve Zararlan (-) Prev Period Losses & Expenses v5620 3. Diger Olagan0stb Giderler ve Zararlar (-) Other Extraordinary Losses & Expenses v5630 - 85 -

Turkish Engltsh Variable DONEM KARI (ZARARI) PROFIT (LOSS) OF THE PERIOD v6000 K. Odenecek Vergi ve Yasal YOknlmlfllUkler (-) K. Taxes & Other Legal Payables v6100 NET DONEM KARI (ZARARI) NET PROFIT (LOSS) v6200 - 86 -

ANNEX 4

1ENTERPRIETRNG TURIUSI[ RFLINANCLAL STATEMENTS2 1

This annex discusses the substantial differences between Turkish accounting standards and International Accounting Standards (LAS). LAS may not be suitable for all types of companies; for example, small and medium-size unlisted companies may not need financial statements according to LAS. But for companies that intend to raise capital from foreign sources, financial statements prepared on the basis of LAS are essential. The recovery from the present crisis involves an expectation of substantial foreign direct investment (FDI), among other things. There are many reasons Turkey has not received as much FDI in the past as it might have expected. If it is to become more attractive to foreign investment as a way to build a base for rapid sustained growth, financial statements understandable to foreigners will be an important part of this effort.

This annex does not address other obstacles to understanding the real position and financial performance of Turkish business. The other main issues are the lack of publicly available information, which can only be solved with changes in legislation, and the widespread belief that many transactions are not recorded in financial statements, for tax evasion purposes. Although there is little research on this latter problem, it is believed to affect mainly small and medium-size businesses, not the larger businesses for which financial statements are publicly available..

The Lack of IUmiffbimity: D?erent Stamdairds Now Mm Use

There is no uniform, generally accepted set of Turkish accounting standards. Different standards have been developed for different users:

Cajp Mairlkets Booard (CM[B) accounDng standards must be used by companies that have shares traded on the Istanbul Stock Exchange and by other companies subject to CMB authority (that is, those companies that, although not publicly traded, have more than 250 shareholders). The CMB enforces its standards rigorously, with companies being forced to reissue financial statements if the CMB detects noncompliance. Companies subject to CMB standards are also required to have independent audits, which further ensures compliance with the standards. There has never been any attempt to require other companies, not subject to CMB authority, to follow its standards.

Most CMB standards were written in the late 1980s. One of the key influences at the time was LAS, but various factors caused differences in the intervening years, which the CMB has now started to tackle with its new inflation and consolidation regulations. These new regulations represent major progress in bringing CMB financial statements closer to IAS.

21 This analysis was prepared by Deloitte & Touche, Turkey. - 87 -

The analysis in this report is based primarily on financial reports prepared according to CMB standards.

Bank accounting rules set out in regulations issued under Banks Act 4389 must be followed by banks. Banks with shares traded on the Istanbul Stock Exchange have a special exemption from CMB accounting standards.

Insurance accounting rules must be followed by insurance and life insurance companies. Insurance companies with shares traded on the Istanbul Stock Exchange have a special exemption from CMB accounting standards.

The Uniform Code of Accounts, tax law, and the commercial code must be used by all other companies. The Uniform Code of Accounts, issued in 1992, contains various required accounting policies. However, tax law requirements remain dominant in most companies' selection of accounting policies. The traditional authority is the Ministry of Finance as the authority setting tax law. Most companies are concemed solely with following tax law, since the main extemal user of most companies' financial statements is the tax office, and since the tax office has the power to levy penalties for noncompliance. Although it is possible to follow different policies in financial statements and then adjust when preparing tax retums, most companies do not see the point of such a two-stage approach. Tax law is mainly designed to prevent the understatement of profit.

Turkish Accounting Standards were developed during the mid-1990s by technical \groups set up by the Chambers of Accountants ("YMM" and "SMMM" qualified accountants). These standards were closely modeled on LAS, with tailoring to fit Turkish conditions. Theoretically in force, they are not in practice applied by any companies.

At present, banks and numerous other major companies prepare a second set of financial statements in accordance with IAS. These statements are usually prepared for specific users such as foreign correspondent banks or shareholders, or the International Finance Corporation, and may not be made publicly available.

Main Differences between LAS and Turkish Standards

The following table sets out a brief guide to the main differences between IAS and CMB standards. - 88 -

Main ULS Policdes Differences flrom Turldish CMII Standards

RAS 4 Depreciation Accounting

Assets are depreciated over their Depreciation rates are freely chosen useful lives, within limits allowed by the tax authorities, but from December 2001 should be reconsidered in line with useful lives, in the new inflation adjusted financial statements. hAS 111 Coimstrctioim Costs Costs and revenues should be recognized Costs and revenues are as the contract progresses, with a share accumulated in the balance sheet of profit if the outcome of the contract is until completion of the project. reasonably certain.

ILAS 12 lnmcosme Tamses In addition to current corporation tax, CMB companies do not account for deferred tax should be provided on all deferred tax assets. temporary differences. hAS 17 Leases Assets acquired under finance leases There are no rules for finance should be capitalized and depreciated. leases. All leases are accounted The liability to the leasing company should be recorded in the balance sheet as operatmg leases (off balance Rentals are divided between interest and sheet, with rentals recorded as principal repayment. expenses), even in the financial statements of leasing companies.

MAS 19 Emqklee Bemeflts The Turkish system of lump sum Most companies do not build up a "kidem tazminati" retirement provision for retirement payments. classified as an CMB companies build up a provision, payminden cafinedbenefit system. but not discounted to a present value. unfunded defined benefit system. A provision should be built up for the employer's liability, assessed actuarially (including discount to a present value). - 89 -

IAS 23 Borrowine Costs Rules to limit the capitalization of Capitalization of borrowing costs borrowing costs. Borrowing costs must (only foreign exchange losses for be expensed once an asset is ready for (ol companies)hay cotie use. CMB compames) may contmue after an asset is in use. This is an expedient in the absence of inflation accounting and will cease to be acceptable, except for the element of finance costs which exceeds inflation, as from December 2001.

IAS 27 Consolidated Financial Statements and Accounting for Investments in Subsidiaries Sets out the definition of a No requirement until now. The CMB subsidiary and the requirement to has produced requirements similar to consolidate. LAS 27 applicable from December consohdate. ~~~~2001.

LAS 28 Accounting for Investments in Associates Defines an associated company. No requirement until now. The Requires the equity method of CMB has produced requirements accounting for such companies similar to IAS 28 applicable from December 2001.

IAS 29 Financial Reportin2 in HyIerinflationary Economies. Defines a hyperinflationary No requirement until now, but economy. Requires an indexation the CMB has introduced an method of accounting (using a inflation accounting regulations general price index) in such with effect from December 2001. countries. Results in the recognition of a monetary gain or loss, showing the effect of inflation on the company's position.

IAS 33 Earnines Per Share Sets out the EPS calculation method for CMB rules are simpler than IAS, companies traded on a stock exchange. such that bonus shares and discounted rights issues distort the trend of reported EPS.

LAS 36 Impairment of Assets Rules for testing whether assets may No such rules. Provisions are not have been impaired, and for making made. provisions in such cases. - 90 -

IAS 37 ]irovisons, Comp Liabffiies sand Contigmn t Asset Rules for making provisions, No such rules in practice. Provisions including those for contingent might not be made for contingent liabilities. hiabilities in practice. - 91 -

Annex 5 Organizations and Corporations Interviewed

State organizations Central Bank Ministry of Finance Privatization Administration (PA) State Planning Agency (SPO) State Statistical Institute (SIS) Undersecretariat of Treasury

Other organizations and NGOs Ankara Chamber of Commerce (ATO) Ankara Chamber of Industry (ASO) Banking Regulation and Supervision Agency (BRSA) Eximbank Foreign Investors Association of Turkey (YASED) International Finance Corporation (IFC) Istanbul Stock Exchange Istanbul Chamber of Industry (ISO) Istanbul Chamber of Commerce (ITO) Savings Deposit Insurance Fund (SDIF) Small and Medium Industry Development Organization (KOSGEB) Turkish Bankers Association (TBA) Turkish Industrialists' and Businessmen's Association (TUSIAD) Union of Chambers of Commerce, Industry, Maritime Trade, and Commodity Exchanges of Turkey (TOBB) Undersecretariat of Foreign Trade Istanbul Exporters Union

Banks Alternatif Bank EGS Bank Finansbank Industrial Development Bank of Turkey (TSKB) I$ Bank Halkbank Turkish Economy Bank (TEB) Vakif Bank Yapi Kredi Bank Ziraat Bank - 92 -

Companies Alarko Holding Arcelik ASAS Aluminyum Qukurova Deloitte Touche Dogus Group EGS Investment Ezzacibasi Holding Ihlas Holding Indorama Iplik Ko, Holding Merko Gida Modem Karton McKinsey & Company MEBAL Textiles SARTEN Ambalaj Sabanci Holding Si§ecam Standard Profil Tepe Group Tofag Yatas Yildirim Consulting

Repo0ri No.: 23153 TU Type: S